Acca Help Text

ACCA HELP TEXT

FROM ACCASTART.COM

Paper 1.1Chapter 1

The Definition, Purpose, and the Regulatory Framework of Accounting

well, this report isn’t an introduction to accounting as it may seem to be. It’s more like a summary to the purpose of studying paper 1.1.

Accounting is a way of recording, analyzing, and summarizing transactions of a business. Transactions are recorded in books of prime entry, and then analyzed and posted to the ledgers and finally they are summarized in the financial statements. Yet, the term ‘Accounting’ not only refers to Financial Accounting, but moreover,a) Management Accountingb) Financial Managementc) Auditing The Purpose, of going through the process of preparing financial statements, may not be required or needed by most companies, yet some must comply to do so by law. Nonetheless, they are prepared so that owners, managers, lenders and other interested parties can see how the business is doing. In other words, to provide information about the financial position, performance and financial adaptability of an enterprise that is useful to a wide range of users.

Depending on the users of financial statements, many may require access to different information, but all share some basic needs. Some of the basic users of financial and accounting information are:

a) Managersb) Shareholdersc) Trade contactsd) Providers of Financee) Governments and their Agencies, e.g. Inland Revenue and Registrar of Companiesf) Employeesg) Financial Analysts and Advisorsh) Investors/ Public

As one may imagine, it may be very hard to satisfy all of the different users, yet, the basic financial statements at the end of the day, are:

a) The Profit and Loss Accountb) The Balance Sheet

Furthermore, some companies may be required to produce annual reports, which contain :Non-Financial Statements, such as:a) Director’s Reportb) Auditors’ Reportc) Chairman’s Report

Limited companies are required by law to prepare and publish accounts annually. The form and content of the accounts are regulated primarily by the Companies Act 1985, but must also comply with accounting standards.

ACCA HELP TEXT Page 1

The Regulatory System

Basically the Company Law requires that all companies must comply with the Companies Act. Of the many requirements and regulations, it must be brought to one’s attention, that the Financial Statements are required to represent a True and Fair view of the state of affairs and Profit and Loss.The Accounting Standard’s Board, previously known as the Accounting Standard’s Committee, has issued the Accounting Standards, such as FRS’s and SSAP’s. The accounting standards were developed with the aim of narrowing the areas of difference and variety in accounting practice.

The Urgent Issues task force is an important part of the ASB in that it is required to tackle urgent matters not covered by existing standards. The review panel is concerned with the examination and questioning of departures from accounting standards by large companies.

Furthermore, the companies are required to follow the Accounting Policies, set out in FRS 18 and the Companies’ Act. Those policies are summarized in the diagram above, but it must be noted that there is a distinction between the accounting policies and accounting estimates.The accounting policy is concerned with: a) the recognitionb) Selection of measurement base andc) Presentation

Of assets, liabilities, gains and losses of an entity. E.g. ‘Prudence or Accruals’? The choice must be based on which may provide the most true and fair view.

The accounting estimate is the method used to establish the monetary value of assets, liabilities, gains and losses using the measurement base selected by the accounting policy,e.g. depreciation (straight line or reducing balance?)The ASB also developed a Statement of Principles, which is concerned by:a) the objective of financial statementsb) the reporting entityc) The qualitative characteristics of financial information.

Basically the statement of principles provided a Conceptual Framework, which forms the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. A conceptual framework is a statement of generally accepted theoretical principles, which form the frame of reference for financial reporting. These theoretical principles provide the basis for the development of new reporting standards and the evaluation of those already in existence. In other words, they are there to provide consistency, clarity and information.

Furthermore, companies are required to comply with the regulations of the European union, and various international bodies, and any stock exchange requirements depending on their circumstances. In addition to the Financial Statements, limited companies are required to provide certain notes and disclosures to the accounts, such as:

1. Statement of movements in reserves2. Details of Fixed Assets3. Details of post balance sheet events


4. Details of contingent liabilities and contingent assets5. Details of research and development expenditure.6. Statement of total recognized gains and losses.7. Note on historical cost profits and losses.

The following are the important features of Financial Statements1- Relevance 3-Reliability 5-Objectivity 7-Comparability2-Comprehensibility 4-Completeness 6-Timeliness

The Qualitative Characteristics of Financial StatementsContenta) Relevance – Info that has the ability to influence decisions, Predictive Value, Confirmatory Value.b) Reliability – Info that is complete and faithful representation. Free from material error, faithful representation, neutral, complete, and prudence.

Presentationa) Comparability – similarities and differences can be discerned and evaluated. Consistency and Disclosure.b) Understandability – the significance of the information can be perceived. Users’ abilities, Aggregation and classification


Paper 1.1Chapter 2The Accounting Concepts – Part 1 (The Summary)

Just a basic summary of those little things that we always tend to forget. The Going Concern Concept implies that a business is a going concern, i.e. that there is no reason to expect the liquidation of assets. Thus, the business may be valued at its historical, or current cost, rather than its break-up or replacement value. A further example to illustrate the application of the Going Concern concept, may be clearly seen, when stock is valued. It is a practice to value stock at the lower of its net realizable value or cost of purchase, this is because the going concern concept implies that the stock is held to be sold at a future date.The Accruals Concept is based on several ‘ideas’ or practices, which may be clearly illustrated, if summarized in the following form:

1. Revenue and Costs must be recognized as they are earned or incurred.2. Revenues must be matched with costs, and vice versa, and dealt with in the profitand loss account of the period to which they relate.

It is for this reason, that we actually disclose the value of the creditors in the Balance Sheet, and the value of debtors. Furthermore, although we may have paid rent of BD 1000, for the next two years for example, we may only note the amount relevant to this year’s profit and loss account, and the remaining balance, as a prepayment in the Balance Sheet.

Furthermore, this is the reason why it is required to account for sales and purchases when made, even though on credit, rather than when they are paid for .As well as this, the figure for closing stock is also deducted from the figure of purchases because the figure of closing stock relates to the opening stock figure of next year’s accounts.

The Prudence Concept1. a) Where there are alternative procedures b) Or alternative valuations c) The one selected should be the one which gives the most cautious presentation of the business’s financial position or results.2. a) Revenues and profits are not anticipated but are related to the period in which they occur. E.g. when a sale is made. b) Provision is made for all known expenses or losses whether these are known for certain or just estimates.

What definition means in layman’s terms is simply, if the company is in doubt about an expense or a liability that it may have, it should create a provision for it immediately, and if the company anticipates any future gains or profits, from a future sale for example, it should ignore it, unless realized. Examples:

1. Provisions for Bad & Doubtful Debts2. Stock should be valued at the lower of net realizable value or cost

Sales Revenue could be realized, if the following circumstances apply:1. The transaction is for a specific quantity of goods at a known price.2. The sales transaction is completed or it is known for certain that it will be completed.3. Cash is received for a purchase, or it is virtually certain that cash will eventually be received.

Consistency Concept states that similar items within a single set of accounts, should be similarly accounted for, and that they are treated the same from one period to another. The Entity concept states that a business must be regarded as a separate entity distinct from its owners or managers. Money Measurement, states that accounts will only deal with those items to which a monetary value can be attributed, which means that subject matter such as staff is ignored.

Separate Valuation Principle refers to the amount/cost attributable to an asset / liability, since the valuation should deal with each component separately. E.g. an independent valuation should be obtained for each item of stock, and their net


realizable values should then be aggregated to obtain the total value of stock. The Materiality Concept refers to the following:Only items material in amount or in their nature affect the true & fair view given by a set of accounts. In other words, immaterial items are not paid that much attention. But this is obviously based on a subjective judgment in deciding whether an item is immaterial or not. Either way, the amount of the item and its context must be considered.

Historical Cost Convention states that transactions should be recorded at their cost. Stable Monetary Unit states that the Financial Statements must be expressed in terms of a monetary unit, e.g. $.

Objectivity Concept states that accounts must be free from bias or subjectivity as much as possible.Time Interval, states that the activities of an entity must be split up into blocks of time,e.g. daily, monthly or annually.

Substance Over Form, refers to a transaction in two distinct ways, ‘subject’ and ‘form’. Thus, the transaction should be accounted for and presented in accordance with their economic ‘substance’ not their legal ‘form’. E.g. assets required on a hire purchase are not legally owned by the buyer even though the substance of the transaction refers to the buyer as the owner.

The Realization Concept states that revenues and profits are recognized when they are realized. Basically the Realization Concept refers the question of when does an entity realize a profit or a gain? Simply, revenue may be recognized at the point of sale, when the following conditions are satisfied:

1. The product or service has been provided to the buyer2. The buyer recognized his liability to pay for the goods3. The ownership of the goods has passed from the seller to the buyer.4. The buyer has indicated his willingness to pay.5. The monetary value of the goods has been established.

Revenue or profits may also be recognized at other situations even if a sale hasn’t been established, such as:

1. Long-term Contracts, where profits/revenues are recognized when the production on a section of the total contract is complete, rather than when the entire project is complete.2. Retail & Hire Purchase, where an actual sale isn’t made unless the buyer finishes all of his installments. In this case, profit would be the interest added to the cost of the asset sold.


Paper 1.1Chapter 3The Accounting Concepts - Part 2 (The Statement of Principles)

The accounting concepts and conventions are based on years of practice and judgment. But that doesn’t necessarily mean that they are fool-proof. FRS 18 recognizes this fact, and it provided us with a conceptual framework to base our accounting standards on. In the previous paper I have explained some of the accounting concepts which we may have to deal with day in day out, but there are only two accounting standards that have been emphasized by FRS 18, which are Going Concern, and the Accruals Concept.The conceptual framework mentioned above is the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user.Yet, prior to the ASB’s release of the Statements of Principles, the lack of a conceptual framework created some of the following problems,

1. Fundamental principles were tackled more than once in different standards, which have caused contradictions, ambiguity and as a result, affected the true & fair view of Financial Reporting.2. In the USA for example, the highly detailed number of standards created a set of rules rather than general principles.

As a result, a basis now exists for reducing the no. of alternative accounting treatments permitted by accounting standards and company law. Furthermore, the problems tackled or associated due to the lack of a conceptual framework are now voided.

Although, many argue that the release of the statement of principles doesn’t necessarily make things easier or clearer for its users, but I believe that a future framework for the development of accounting standards now exist, and auditors may now confirm whether financial statements are based on accountancy standards or not.

The BPP, suggests, that the end-result of the Statement of Principles is that Objectivity now exists, which decreases the scope of manipulation. Uniformity means that there’s less scope for disagreement between current conventions and new ones, and finally Familiarity means that the more people use the accounts, the more they’ll get used to them.


Paper 1.1Chapter 4The Accounting Concepts - Part 3 (Why does the ASB hate Prudence?)

Through time and age, men always seemed to be in contradiction with women, and that’s how it is with Accruals and Prudence. The puzzled look on every man’s mind when the lady asks “Do I look fat?” is very similar to that of an accountant, when asked “Should we report the worst possible situation, prudence? Or the most likely position, matching?!”

On a more serious note,1. Prudence is in a conflict with the going concern concept because it may not be prudent to assume that the business is a going concern.2. Furthermore, prudence makes it difficult to treat items consistently because at one period, an item may require different treatment than it did in a previous period.E.g. prior year adjustments.3. The prudence concept also contradicts the objectivity concept in that it requires subjective judgment in prudent situations.4. It is also difficult to value assets at anything but the historical cost convention because it wouldn’t be prudent to recognize a gain in revaluation for example. Seems short, and incomplete doesn’t it? Well any suggestions are welcomed!

Paper 1.1Chapter 5The Accounting Concepts - Part 4 (Historical Cost Accounting vs. CPP vs. CCA)


Traditionally, accounts were prepared to fulfill the needs of the owners of the business and to assist the managers’ for the business to make decisions about the future. Yet, it was later made clear that the accounts prepared under the historical costconvention provided misleading information because of the inability to reflect the changing price levels.

Examples1. When property appreciates in value, the historical cost convention which values it at its purchase cost, wouldn’t reflect its true and fair value. This means that unrealized holding gains are not recognized until the period in which the asset is realized, rather than spread over the period during which it was owned.2. Depreciation based on a Fixed Assets Historical Cost may be inadequate to finance the replacement of the Fixed Asset if the appreciation in value is larger than the depreciation charged!3. Furthermore, the depreciation charge wouldn’t fully reflect the value of the asset consumed during the accounting period.4. The following example applies to stock appreciation during a period of inflation. During Inflation No InflationSales (100 Units) $ 500 $ 500Less: Cost of SalesOpening Stock (100 Units) $ 200 $ 200Purchases (100 Units) $ 200 $ 200Closing Stock (100 Units) ($300) ($100) ($200) ($200)

Gross Profit $ 400 $ 300

Basically, the trading account above compares the gross profit of a certain company at two different accounting periods, one being inflationary whilst the other excludes inflation. At the beginning of the year the trader had 100 units of stock at a cost of $200, during the year the trader purchased 100 units at a cost of $200, and at the year end, the Historical Cost of the 100 units remaining after the sale of $100 units is $300 due to the appreciation in stock, and thus, inflating profit by $100.

5. HCA ignores any holding gains or losses of net monetary items during a period of a change in prices6. The effect of inflation on capital maintenance is not known. Capital maintenance is the amount of sufficient retained profit to ensure that the net assets at the end of a period are at least equal to those at the beginning of the period. I.e. to keep the capital intact.

As a result of all the previous examples, one can see that over time, the inability of the HCA to account for changes in price level means that one cannot obtain realistic, true and a fair view of the company’s accounts from one period to another.

Reasons for Continued Use

1. Easier and cheaper to record transactions, and analyze them based on their HC.2. The figures are easy to obtain and they are objective and readily verifiable, being tied to actual transactions, whereas other methods seem to be subjective.3. HC is easier to understand and users are aware of its limitations.4. Since revaluations of fixed assets are permitted, the problems associated with understating the value of property are avoided.

The Current Purchasing PowerThe use of the CPP means that the profit for the year is calculated after an adjustment designed to reflect the effect of general price inflation on the purchasing power of equity shares. In other words, if you refer back to the example concerning the appreciation in the price level of the closing stock, you’d find, that previously, $200 would be adequate to purchase 100 units of stock, whereas, now, the 100 units cost $300 to purchase, thus the purchasing power has dropped by $100, or by 1/3rd.The Current Cost AccountingThis method of accounting doesn’t attempt to cater for general prince inflation, instead, profit for the year is to be


calculated after allowing for the effects of price increases, specifically on the operating capability of the particular business.

a) In other words, assets are stated at current value, which is what we do when were value property.b) Holding gains are excluded from profit in the P&L. how? Well it’s very simple, let’s just look at the example below.

Paper 1.1Chapter 6

The Accounting Concepts - Part 5 (Should we depreciate buildings?)

Those Who Say Yes1. The value of the assets at the start of the period is the same at the year end, thus no depreciation is necessary.2. The buildings are well maintained.3. The value exceeds its cost at the year end, since it appreciates in price, and when the asset is sold, the sales proceeds would be greater than cost.


Those Who Say No1. Freehold buildings do not last forever!2. The depreciation charge is a means of matching the cost of the asset with the revenue earned over its useful life. This is called the Accruals Concept

Paper 1.1Chapter 7

FRS 3The Structure of the Profit & Loss Account

I have always found this topic to be hard to understand and quite tedious on my brain, until I began writing about it. So probably, that maybe the best option for those finding difficulty regarding FRS 3 or any of the other theoretical materials. This article will cover most of the areas required by Paper 1.1 (as far as I know!).

Well, let’s begin.


If we go back through our mind and reorganize the information we have regarding the concepts behind accounting and the ASB’s brief history, we’d find that FRS 3 is the natural step forward after the statement of principles, even if they didn’t necessarily come in that order.To put it simply, one of the aims of FRS’s and accounting conventions is to provide a true and fair view of the company’s financial reports, but to the question is, to whom? The obvious answer is simply the users of the financial information. As such, FRS 3 was developed to enable the users of financial reports to obtain information of higher quality by concentrating on the following matters:- Continuing, Discontinuing Operations and New Acquisitions- Exceptional and Extraordinary Items- Disclosures by way of notes e.g. STRGL and Historical Cost Profit/Losses

Continued, Discontinued Activities and New AcquisitionsFRS 3 requires an analysis of the P&L A/C as far as the figure of profit on ordinary activities before interest, into 3 elements.1. Continuing Operations, which are activities that will continue to next year.2. Discontinuing operations, which are activities that have ceased during the year.3. New Acquisitions, which are new activities that did not exist last year.

What do those things mean again?Well, if we consider any kind of business during one accounting period, we might find that the business may acquire new assets, dispose of old ones, and obviously keep the ones it already uses for the next accounting period.So basically, the ones it disposes of are referred to as ‘discontinuing operations’, the ones it keeps are ‘continuing operations’ and the new acquired assets are under the heading ‘new acquisitions’.

Yet, these three elements do not only relate to the purchase, sale of fixed assets, they relate to the entire activities of the business. Further examples may be provided at the end of this article. At the moment let us focus on the reasons why FRS 3 requires that companies go through this kind of trouble.Well, to make realistic comparisons between one year and another, FRS 3 emphasizes the need to differentiate between the turnover, cost of sales and the profit of the three different elements, because in comparing like with like, someone needing to forecast next year’s turnover and profit can now see how much of this year’s operations will continue into the future.

The following format of the Profit & Loss Account is a simplified version of that found in FRS 3, which relate to discontinuing, continuing and new acquisitions: 19x1 19x1 19x0 $m $m $mTurnoverContinuing Operations 600 400Acquisitions 50 650Discontinued Operations 50 25 700 425Cost of Sales (400) (300)


Gross Profit 300 125Net Operating Expenses (140) (85)Operating ProfitContinuing Operations 110 30Acquisitions 60 30 170 60Discontinued Operations (10) (20) 160 40Profit on sale of properties in continuing operations 10 5Loss on disposal of discontinued operations (15) (10)Profit on ordinary activities before interest 155 35

The profit and loss account seems very had to grasp at first, but that should be remedied through practice questions.

Paper 1.1Chapter 8FRS 3Exceptional & Extraordinary Items

When we previously discussed the structure of the profit and loss account as regards to the continuing, discontinued operations and new acquisitions, the format we drew up ended with ‘Profit on ordinary Activities Before Interest.’ We will now continue from there.

Profit on ordinary activities before interest XInterest Payable (X)Profit on ordinary activities before taxation XTax on profit on ordinary Activities (X)Profit on ordinary activities after taxation X


Well, what should strike you whilst taking a look at the previous profit and loss account statements is the use of ‘ordinary activities’. The reason simply being is that if there exist a profit on ordinary activities, there may be profits or losses on ‘not so ordinary activities’. But are there?Well FRS 3 states that there are two types of ‘out of the ordinary items’, which are:A) Exceptional ItemsB) Extraordinary Items

Basically Exceptional items are those items that occur during the ordinary course of the business but need to be disclosed due to their size or incidence. E.g. a main customer goes bankrupt, which may increase our bad debts by 50%. This event isordinary in that, many of our debtors’ accounts return unpaid, which is why we create a bad debts provision. Yet, this event is classified as an exceptional item because of its sheer size.

Furthermore, exceptional items, maybe divided into the following categories:A) Profit or loss on sale or termination of an operationB) Cost of fundamental reorganizationC) Profit or loss on the disposal of fixed assets.D) Other items, if they are sufficiently material.Extraordinary items are those that possess a high degree of abnormality which arise from events or transactions that fall outside the ordinary activities of the business. They are so abnormal, that the ASB doesn’t even provide us with an example!

Finally, much has been left unsaid, but the basic information has been motioned, and it is up to most of us to enquire further and to obtain more information. Yet, at the end of the day, FRS 3 has put an end to the manipulation of the Profit and Loss account by limiting the usage of extraordinary items, and providing us with a strict definition of exceptional items.

Paper 1.1Chapter 9FRS 3Note of the Historical Cost Profits and Losses

I have found this note difficult to understand and follow, perhaps due to the difficulty of the terms used to describe this note. But who needs this kind of formality? Simply this note says, okay you’ve revalued your assets in the past, you’ve made some profits, some losses, you may have disposed some of them too, if that is so, suppose that the revaluations did not take place, what would the profit or loss be if they were based on the historical cost figure?

We may answer that question by taking the following steps:

Step 1Find out the profit on ordinary activities before taxation.

Step 2a) Calculate the depreciation charges of all assets based on their revaluation figures.


b) Then calculate the depreciation charges but based on their original historical cost figure.c) Find the difference between a) and b), and note it down.

Step 3Were there any disposals of F.A that have been previously revalued? (There must be or else, this note wouldn’t be needed in the first place).

a) Well, if the answer is yes, we should calculate the profits/losses made on the revalued figure. E.g. the revalued cost of the F.A is 200,000, and the sales proceeds are 300,000. Then the profit would be 100,000. Simple Right?!

b) Now we should calculate the profits/losses that would have made if we used the asset’s historical cost figure rather than the revaluation cost. E.g. if the Historical cost of the fixed asset was 100,000 rather than 200,000 (revalued amount), then the profit would be 200,000. Get it?!c) We will now simply calculate their difference, in this case the difference between the two profits is 200 less 100, which is 100,000.

Step 4We now simply add up the figures obtained in step 2c) and 3c) and the profit before tax to obtain the historical cost profit on ordinary activities before taxation.FRS 3, requires that we note down the steps taken from 1 to 4 in a way of note to be disclosed in the financial statements, and this should be done as per the following format:

Reconciliation of Profit to Historical Cost ProfitFor the year ending 31 December 20x3 $’000Reported profit on ordinary activities before taxation Step 1Realization of property revaluation gains Step 3Differences between historical cost depreciation charge and the actual depreciation charge of the period calculated on revalued amounts. Step 2Historical cost profit on ordinary activities before taxation xxx

Now, we know why we do it, how to do it, but the next question is why did we do it this way?

Step 1Profits before tax were used because taxation levels may vary from year to year.

Step 2It is known that the larger the depreciation charges, the lower the profit before tax would be, since depreciation is an ‘operating expense that is deducted before arriving at the profit before tax.As such, revaluing an asset means that, the depreciation charge based on the revalued amount would change, and thus, affecting the value of the net profit before tax.Therefore, to arrive at the Historical cost profit, one must reconcile the current profit before tax, with any changes of depreciation charged due to revaluations.This is done, by finding the differences between the historical based depreciation charges and the revaluation based depreciation charges. Their difference is added back to the net profit before tax, (if the revaluation depreciation charges are larger than the historical ones), or subtracted from the net profit, (if the revaluation depreciation charges are lower than the historical ones.)


Step 3Once an asset is revalued, the difference between the historical cost and the revalued figure is transferred to the Revaluation Reserve. If at a later period, the asset is disposed of, any profits or losses would be calculating the difference between the book value of the asset (Revaluation figure less accumulated depreciation), and the Sales proceeds.Thus, the amounts transferred to revaluation reserve remain untouched. If however, the asset remained at its historical cost figure, rather than revalued, the profit or loss on its disposal would be the book value (historical cost less accumulated depreciation), and the sales proceeds.

If an asset was revalued upwards, the profit or loss on the asset would be much lower, and the opposite is correct if the asset was revalued downwards. This profit or loss, is transferred to the P&L A/C, which in turn increases or decreases the net profit before tax.

Therefore, to arrive at the historical cost profit, one must follow the steps in Step 3.

Paper 1.1Chapter 10FRS 3Statement of Total Recognized Gains and Losses

Up until this section, FRS 3 has restructured the P&L, defined the difference between ordinary, exceptional and extraordinary activities. Now, FRS 3 takes us a step further. Let us suppose that we have made a holding gain of $50,000, which means that we have purchased an asset, and through time, it appreciated in terms of value, and now it is worth $50,000 more than it used to at the time of purchase.Well, anyone who studied how to revalue assets, which they should before reaching this topic in their studies, knows that revaluation gains are only recognized if a professional external valuer valued the asset. The holding gain would then betransferred to the revaluation reserve (subject to the deduction of any related accumulated depreciations).

So now, we have $50,000 in a revaluation reserve. How do we know that this 50,000 relates to this year? Furthermore, what about other reserves, and other holding gains or holding losses? Would an average user understand these terminologies and how they affect the financial position of the company as a whole?

Well, to answer these questions, as well as other reasons, FRS 3 introduced the idea of a Statement of Total Recognized


Gains and Losses, which brings together the information from the profit and loss account, the balance sheet and other supporting notes for asset revaluations. The following format demonstrates how this is done:

Statement of Total Recognised Gains and Losses

Profit for the financial year $M

(I.e. profit after tax and extraordinary items if any) 29Unrealised surplus on revolution of properties 4Unrealised loss on trade investment (3) 30Foreign currency translation differences (2)Total gains and losses recognised since last annual report 28

Paper 1.1Chapter 11Post Balance Sheet Events

The previous topics dealt mostly with the reasons for accounting standards, their concepts, how they’re regulated and some of their limitations. Along with FRS 3 and FRS 18, we will now be discussing further accounting issues which are the subject of standards.

FRS 3 introduced the idea of disclosure in the form of notes, the reason being is that in order for the financial statements to provide a true and fair view of the company’s activities they must include all the information necessary for an understanding of the company’s position.

Yet, up until now, we have only dealt with those events that have occurred during the current accounting period. But what about activities that occur after the balance sheet date? Well, prudence would have us provide a provision for it, wouldn’t it? The accruals would say if it’s affecting the position of the company at the balance sheet date, then a provision too should be provided.

E.g. suppose that at the 10th of January, the company decides to go into liquidation and the company is yet to publish its accounts for the year up to 31/12/2003. Would the company go ahead and publish its financial statements with any


adjustments or disclosure? Please bear in mind that the accounts were initially prepared on the basis of the going concern concept.

I believe that you got the idea now. Well, SSAP 17 says okay, any event that occurs after the b/s date is called a post balance sheet event, some of which may need to be disclosed without adjusting the balance sheet, while some may need to be disclosed whilst adjusting the balance sheet.

Post Balance Sheet Events are those events, both favourable and unfavorable, which occur between the balance sheet date and the date on which the financial statements are approved by the board of directors.

Well, now that we know what post balance sheet events are, we need to know when the accounts may need adjustments, or when disclosure in the form if notes is adequate enough.

Those events, that may need adjustments, are referred to as ‘Adjusting Events’, and they are defined as:

Adjusting Events are post balance sheet events whicha) Provide additional evidence of conditions existing at the balance sheet date.b) They include events which because of statutory or conventional requirements are reflected in financial statements.

Well, if there are adjusting events, then there must be non-adjusting events, right? Yes!Non-Adjusting Events are events whicha) Arise after the b/s date and concern conditions which did NOT exist at that time.b) They do not result in changes in amounts in financial statements.c) Yet they may however, be of such *materiality that their disclosure is required by way of notes to ensure that financial statements are not misleading.*An example of the significance of the materiality concept.

Suppose for example a company decides to issue shares after the b/s date, i.e. in the next accounting period, whilst it is doing so, the accountants are still busy preparing the financial statements.

Think with me, do we need to disclose the information? Well, yes! But subject to the following conditions1) If they are material enough, which they are!2) If they do not affect the amounts in the previous financial statement.

Finally, a list of examples of Adjusting and Non-Adjusting Events:Adjusting Events:

1 Resolutions relating to proposed dividends and amounts appropriated to reserves2 The effects of changes in taxation rates3 The declaration, by subsidiaries or associated companies, of dividends relating to periods prior to the balance sheet date of the holding company.4 The subsequent determination of the purchase price or of sale proceeds of assets purchased or sold before the year end.5 The valuation of a property which provides evidence of a permanent diminution in value6 The receipt of a copy of the financial statements or other information in respect of an unlisted company which provides evidence of a permanent diminution in the value of a long-term investment.7 The receipt of proceeds of a sale or other evidence after the balance sheet date concerning the net realizable value of


stock8 The receipt of evidence that the previous estimate of accrued profit on a long term contract was materially inaccurate9 The renegotiation of amounts owing by debtors, or the insolvency of a debtor10 Amounts received or receivable in respect of insurance claims which were in the course of negotiation at the balance sheet date.11 The discovery of errors or frauds which show that the financial statements were incorrect

Non-Adjusting Events

1 Issue of Shares and debentures2 Purchases and sales of fixed assets and investments3 Losses of fixed assets or stocks as a result of a catastrophe such as fire or flood4 Opening new trading activities or extending existing trade activities5 Closing a significant part of the trading activities if this was not anticipate at theyear end6 Decline in the value of property and investments held as fixed assets, if it can bedemonstrated that the decline occurred after the year end7 Government action, such as nationalization8 Strikes and other labor disputes.

Paper 1.1Chapter 12FRS 12: Provisions, Contingent Liabilities and Contingent Assets

As with the requirements of all financial reporting standards, financial statements must provide all the information necessary for an understanding of the company’s financial position, in order for them to present a true and a fair view of the company’s affairs.

As a continuation to the previous standards, such as FRS 3, the statement of principles and SSAP 17, FRS 12 takes things further by tackling the subject of provisions,contingent liabilities and contingent assets.According to FRS 12, a provision is a:

a) Liability of uncertain timing or amount.b) Liability is an obligation of an entity to transfer economic benefits as a result of past transactions or events.

According to ME, or in layman’s terms, a provision is a liability that we are uncertain of, which we may be obliged to settle.

E.g. If a company is obliged to incur clean up costs for environmental damage that has already been cause, should a provision be made?

Yes, because we incurred the liability of the cleaning costs during a period of time in the past, and we are now obliged to settle it, but we don’t know when or its amount.Thus a provision should be made.But, when are provisions recognized?


1) When a business has a PRESENT obligation as a result of a past event.2) It is probable that a transfer of economic benefits will be required to settle the obligation.3) A reliable estimate can be made of the obligation.

Good, now we know when to recognize them, but what is their accounting treatment?

Well, once a provision is recognized, the company can do one of three things, one is to provide for the provision and disclose it in our accounts, the next choice is simply disclose it by way of notes, or to simply ignore it.

If there is a high probability of a transfer of economic benefits and a reliable estimate could be made for the amount, the company should provide for the provision.Otherwise, whether there is a remote transfer of economic benefits or not, the inability to provide a reliable estimate, means that we could do is to disclose the provision by way of notes.

Worked Example

This example is provided by FRS 12 concerning the costs of restructuring, and it defines it as a program that is planned and controlled by management and materially changes either:a) The scope of a business undertaken by an entityb) The manner in which the business is conducted.

Such as:• Sale or termination of a line of business• Closure of business locations• Changes in the management structure.Well, should a provision be made for any of these events, knowing that FRS 12 was mainly introduced to target abuses of provisions for restructuring?If there is a present obligation, in a form of a contract or a sale agreement, in which areliable estimate can be made for the provision, then a provision should be provided for, but the costs of the following items should NOT be included:• Marketing Costs• Retraining of New Staff• The cost of investing in new systems.

FRS 12: Provisions, Contingent Liabilities and Contingent Assets

FRS 12 refers to n obligation that arises from a past event, which we discussed earlier,as a Contingent Liability.

FRS 12 takes the definition further to include the following:

1) A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control, OR 2) A present obligation that arises from past events but is not recognised because,a) It is not probable that a transfer of economic benefits will be required to settle the obligation.b) Or the amount of the obligation cannot be measured with sufficient reliability.

In other words, a contingent liability is an event that may occur subject to uncertain events beyond the company’s control or it arises from a present obligation from past events, but couldn’t be recognised due to points 2 a) and 2 b) above.This means that contingent liabilities should not be recognised in financial statements,they should only be disclosed.

The required disclosures for a contingent liability are:• A brief description of the nature of the contingent liability• An estimate of its financial effect• An indication of the uncertainties that exist• The possibility of any reimbursement.


FRS 12: Provisions, Contingent Liabilities and Contingent AssetsA contingent asset, as a oppose to a contingent liability is:A possible asset, which arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity’s control.Therefore, a contingent asset should not be recognized at all, in fact they could only be disclosed.In conclusion, one can obviously see the application of the prudence concept indealing with provisions, contingent liabilities and contingent assets, and as such there is no surprise as to the accounting treatment of these items. One must also note that the accounting limitations of the prudence concept also apply.

Paper 1.1Chapter 13The Preparation of Financial StatementsThe Application of the Accounting & Business Equations

The first article in this site is basically about the definition and importance of accountancy, its purpose and its role. We will now go further to discuss what the actual accounts look like and what they are based on.But before we do so, one must realize the distinction between the preparation of the final accounts and the bookkeeping process. The bookkeeping process is the steppingstone of accounting, as it is the process by which the transactions arerecorded in the business, and the preparation of the final accounts begins from there.Therefore one must learn the mechanics of bookkeeping first, and this is the aim of the following article.

Setting up a businessOkay, suppose we are required to set up a business, the first thing that we need to do is to take a loan from the bank, or to save enough money before we actually buy any premises or whatever.Well, the money we raised through a loan or through any other way is called the Capital. The premises that we have purchased is called an Asset, the loan from the bank is called a Liability.

Capital, Assets and Liabilities are the basis of accounting and they form the Accounting Equation:

Assets = Capital + Liabilities


So basically, an asset is what a business owns, and a liability is what a business owes (in this case to the bank), and capital is the investment of money with the intention of earning a return.Strictly, capital is the money owed to the proprietor of the business, due to the ‘entity concept’, which basically means that the business is considered distinct from theowner, i.e. it is considered as a separate entity. Therefore, it isn’t surprising when we say ‘the business decided to do this’ rather than the owner or the manager.Okay, now the company is set up, we bought premises or most likely rented it or leased it. Now we need to purchase some furniture, maybe a teller, and most importantly goods to sell!Well, any expenses in relation to assets such as premises, furniture or teller machine are referred to as Capital Expenditure which results in the purchase or improvement of fixed assets, which are assets that will provide benefits to the business in more than one accounting period, and which are not acquired with a view to being resold in the normal course of trade.

On the other hand, the expenditure incurred in relation to the purchase of goods is referred to as Revenue expenditure, which is expenditure incurred for the purpose of the trade of the business, such as selling and distribution expenses, administration expenses and finance charges.The distinction between the two types of expenditure is extremely important, since each is treated differently in accounting.To summarize what we have just discussed, any transactions that a business undertakes may either be classified as capital or revenue transactions, (income or expenditure), and our capital is made up of assets and liabilities.

Paper 1.1Chapter 14The Bookkeeping Process

The process of bookkeeping begins by the issue or the receipt of source documents, such as invoices, purchase orders or sales orders. Once invoices are issued or received, the details of that particular invoice are recorded in the appropriate book of prime entry.

The books of prime entry are summarized above with the inclusion of the journal, which is shown separately for illustrative reasons only. Well, whenever a sale is made, the details of the sales are recorded in the sales day book, and similarly for purchases. Sales returns or purchase returns are similarly recorded in their own books of prime entry. Any cash related payments or receipts are recorded in the cash day book, which includes bank related transactions as well.

A separate book is kept for petty cash since most businesses keep a small amount of cash on the premises to make occasional small payments in cash, e.g. postages, taxi fares, etc. the petty cash account can also be the resting place of occasional small receipts, such as cash paid by a visitor to make a phone call, etc. As one may imagine, although the amounts involved are small, petty cash transactions still need to be recorded, otherwise the cash float could be abused for personal expenses!Furthermore, under what is called the imprest system, the amount of money in petty cash is kept at an agreed sum or ‘float’. The imprest system is a system where a refund is made of total cash paid out in a period. E.g. if the float is agreed to be at $250, then at the end of the period, whatever is spent, would be refunded back from the cash account.Sales or purchases on credit are not only recorded in books of prime entry, such as the sales or purchase day books, but


they are also recorded in what is known as memorandum accounts or personal accounts. As such, these accounts contain the balances outstanding for each personal debtor or creditor. These books aren’t a part of the accounting system, but they are necessarily kept for the company to know who to pay, and how much, and who to expect payment from, etc.

In addition, on a periodic basis, (daily, weekly, monthly), the business would begin to summarize the transactions recorded in the books of prime entry, and it would record them in the nominal ledger, which consists of a large number of accounts, each account having its own purpose or ‘name and an identity or code. E.g. we could have a ledger account for rent, in which all rent payments are recorded, similarly for telephone expenses, etc.On a monthly basis, or during another periodic basis, the business might begin a process of bank reconciliation, which is basically a way of making sure that the amounts reflected in the cash book are equivalent to that found in the bank statement.The company may also keep a set of control accounts, which refer to an account in the nominal ledger in which a record is kept of the total value of a number of similar but individual items. Control accounts are used chiefly for debtors and creditors.For example, a debtors control account is maintained in which records of transactions involving all debtors in total are kept so that the balance on the debtors control account at any time will be the total amount due to the business at that time from its debtors.Basically control accounts are impersonal ledger accounts that will appear in the nominal ledger.At the end of the year, any necessary adjustments to the accounts, either due to error or change in accounting policy, or for whatever reasons are recorded in a journal, which is one of the books of prime entry. Hence, the journal entries and the ledger account balances are summarized in a trial balance, which is a list of ledger balances shown in debit and credit columns. The journal entries and the trial balances are then used to formulate the profit and loss account and the balance sheet.

Paper 1.1Chapter 15Preparing Financial StatementsThe Cost of SalesThe Trading Profit & Loss Account

At the end of the accounting period, when the accountants begin to close off accounts in preparation for the financial statements, there are a few important tasks to do first.The first of which is to calculate the closing stock of the period, to prepare the Trading, Profit & Loss Account, Bank Reconciliation, etc.StocktakingOn the bases of the accruals concept, revenues should be matched with their relevant cost as per the corresponding period. As such, any stock that remains unsold at the end of the accounting period isn’t included as a part of the cost of sales for thatperiod. Get it? Well, it’s like a prepayment, u don’t actually account for it during the current period, because it is relevant only to the following period.Well, for this reason, the company should find out how much stock it has on hand at the end of the accounting period, this stock is called closing stock, and the process offinding out how much you have of it is called stocktaking.This process is easy if the company is a relatively small where it could actually physically count each item of stock. Yet as the business grows larger the quantity of stock held becomes harder to determine.Therefore a business may wish to close down for a short period for a stock take, or a business may prefer to keep a detailed record of stock movements whilst baring the large related costs and headaches!In more complicated cases, a business may wish to maintain continuous stock records.This means that a card is kept for every item of stock, showing receipts and issues from the stores, and a running total.


The Cost of Goods SoldNow that we figured out what the closing stock value is, all we simply need to do is to deduct it from the cost of sales during a period to determine the profit. The cost of sales, or cost of goods sold is simply the expense incurred purchasing stock during the period. It is calculated using the following formula:Cost of Sales:Opening StockAdd: PurchasesAdd: Carriage InLess: Returns Inwards / Purchase ReturnsLess: Damaged or Stolen goodsLess: Closing Stock

Please note that the cost of goods manufactured or purchased is adjusted to allow for increases or reduction in stock levels during the period. This is why purchases, opening stock and closing stock are used in the formula.The next step is to draw up the Stock Account and the Trading, Profit & Loss Account.

These accounts are usually drawn up at the end of the accounting period once thestocktaking process has ended, and all adjustments to the accounts and corrections have been made.

The trading profit and loss account has allowed us to calculate the net profit and the gross profit for the period. If you would look at the date entries, you’d notice that aside from the opening stock, all are at the year-end.Other expenses would include selling and distribution expenses, administration expenses, such as depreciation, bad debts, wages, etc.

Paper 1.1Chapter 16Stocks and How To Value Them

In this article we would briefly explain how to determine the purchase cost of stocks, the problems associated in determining how they are valued, and the basic methods used to solve these problems.

The Purchase Cost of StocksBasically, when a company purchases stock from a creditor, whether by cash or on credit, the company would gather the source documents, and enter the details in the books of prime entry. Thus, the cost paid for each purchase is the purchase cost of stock, right?Not necessarily, because first of all, the cost paid for each item purchased may differ during each purchase, either due to discounts, sale, inflation, etc. In addition, imagine purchasing 100 items of stock every month, and at each month the amount paid for each item differs slightly, how is it possible to calculate which item was sold and how much money we made on each item?Furthermore, imagine items being returned others being damaged or stolen. The process of thinking about it is tedious enough imagine trying to record it!NRV, Current Replacement Costs and the Selling Price of Stocks .Basically, before we proceed, Stock is valued at the lower of its net realizable value and its historical cost value. The net realizable value is the expected selling price for each item of stock less any costs still to be incurred in getting them ready for sale. The Current Replacement Cost is the amount it would cost to replace each item of cost. Historical Cost is simply the cost at which they were originally bought.


The reason why stock is valued at the lower of the net realizable value and historical cost is due to the prudence concept. The selling price is avoided because it would include a profit figure for the business before the stock is even sold!

Furthermore, SSAP 9 encourages the use of two methods FIFO and AVCO, and discourages the use of LIFO whilst valuing stock.

FIFO, AVCO and LIFOFIFO stands for, First in, First Out, and it assumes that materials are issued out of stock in the order in which they were delivered into stock. In other words, the first item supplied is the first item sold. Hence, issues are priced at the cost of the earliest delivery remaining in stock.

LIFO stands for Last in, First Out, and it assumes that materials are issued out of stock in the reverse order to which they were delivered. In other words most recent deliveries are issued before earlier ones, and are priced accordingly.

AVCO stands for Cumulative Weighted Average Pricing, which calculates a weighted average price for all units in stocks. This could be very helpful in determining the cost of consignment stock. Basically a new weighted average price is calculated whenever a new delivery of materials into store is received.

Well basically it says that at the particular date we either had a receipt of goods into the company, or we issued some goods. In other words receipts are purchases and issues are sales (I used the terms receipts and issues as it was used in the BPP example). The number of units received or issued, their corresponding unit price and their market value on the date of transaction are also presented.

The problem is to put a valuation on the issues of materials, and the closing stock, and how they would be valued using FIFO, LIFO and Average Cost.

FIFOFirst, entering and calculating the details as per the requirements of each header. As you can see, whenever units are issued, we select the balance of the first remaining

LIFOThe process of calculating the closing stock value in terms of LIFO is very similar to FIFO except for a major difference, in that whenever units are issued we select the pricing of the latest units received.

AVCOThe process of using AVCO is slightly more complicated. A new cumulative weighted average cost per unit is calculated whenever units are received/purchased/supplied. It is calculated by dividing the Closing Stock Value by the total balance of units remaining. Furthermore, whenever items of stock are issued, the cost per item is the cumulative weighted average cost calculated previously. This cost is also used to calculate the new cumulative average cost whenever units are later received.Let us now take this example a little further, in order to realize how the closing stock figure affects the cost of goods sold and the company’s gross profit.Remember the sale price per unit in the table that includes the summary of the transactions above?Well, each unit was uniformly sold for a price of $20, thus since total issues (sales) are 1000 units, the figure for sales is $22,000.To calculate the cost of sales (COGS), we need to obtain the values for opening stock, closing stock, and purchases. The first two are already available. But what about purchases?


Well purchases is simply calculated, by adding up the value of each receipt. Now let us summarize all this information, into the following profit and loss account: FIFO LIFO AVCOSales 22,000 22,000 22,000Less Cost of SalesOpening Stock 3600 3600 3600Purchases 16600 16600 16600Closing Stock (6000) (14200) (5700) (14500) (5874) (14326)Gross Profit 7800 7500 7674

Now, although these calculations may look difficult at first, practicing selected questions make them seem really easier. Yet, in reality the calculations may actually be much more complicated and more difficult to manage.The next point that I would like to bring to your attention is how the gross profit differs when each method is selected. Yet, the continuous use of each method, would mean that the profit differences are only temporary, since the closing stock values would be the next period’s opening stock values, which would affect the cost of sales and profits in the future so that the inequalities of the cost of sales each month will even themselves out.

Paper 1.1Chapter 17Defining, Finding and Correcting Bookkeeping ErrorsThe Trial Balance, Reconciliation and Control Accounts

Whilst maintaining records during the bookkeeping process, human error could occur quite easily, and as such, it becomes necessarily important to spot the errors and correct them accordingly.There are various types of errors that may occur, and each is classified under one of the following categories:

1. Omission – a transaction is not recorded at all2. Error of commission – an item is entered to the correct side of the wrong account.3. Error of principle – an item is posted to the correct side of the wrong type of account.4. Error of original entry – an incorrect figure is entered in the records and then posted to the correct account5. Reversal of entries – the amount is correct, the accounts used are correct, but the account that should have been debited is credited and vice versa.6. Addition Errors – figures are incorrectly added in a ledger account.7. Posting Errora) an entry made in one record is not posted at allb) an entry in one record is incorrectly posted to another8. Compensating errors – two equal and opposite errors leave the trial balance balancing9. Trial balance errors – a balance is omitted, or incorrectly extracted, in preparing the trial balance.

The Correction of Errors

The Trial Balance

Many of us believe that the trial balance forms the bases of summarizing all the debits and credits of the company’s


nominal ledger and journal entries in order for us to simply pull out the data to reproduce the profit and loss account and the balance sheet. While that is so, it is further used to spot any errors that usually cause the trial balance not to balance. In other words we find that the debits are larger than the credits or vice versa. The following methods are often used to find and correct these errors and to further test the accuracy of the accounts. Obviously compensating errors are the hardest to spot since they couldn’t affect the balance of debits and credits on the trial balance.

Suspense Accounts

Errors are often corrected by the use of journal accounts or through the use of a suspense account when the trial balance does not balance. Basically a suspense account is a temporary account that may be used to correct any mistakes at the year-end or whilst preparing the draft accounts. An accountant may also use it when he is not sure of where to post a transaction. Errors 6, 7, and 8, mentioned above, require a suspense account to correct them; otherwise only a journal entry is necessary. Trial balance errors do not require journal entries or a suspense account, it is simply amended.

Suppose a company revalued an asset and the accountant wasn’t sure whether he had to create a revaluation reserve or not. The accountant may open a suspense account and debit it with the balance on the provision for depreciation account. Once the accountant realizes that he should actually create a revaluation reserve account, he would simply credit the suspense account and debit the revaluation reserve. As such the suspense account is closed off, and the error is corrected.

When tackling examination questions involving the correction of errors, one must pay attention to the following points.

1. Deal with the errors in order and mark those that affect the balancing on the trial balance, as these would require a suspense account.2. Then open a suspense account, if the trial balance shows that debits are more thancredits, one must credit the suspense account with the difference, otherwise debit the suspense account with the difference.3. Adjust the suspense account with the necessary amendments until the debits equal the credits on both sides of the account. Please note however, that it is necessary to make sure that you debit or credit the right side of the suspense account!

Bank ReconciliationIt is not surprising to find that the balances on the bank statement do not match those found in the cashbook. There are many reasons for this, and not necessarily only do to errors.

The circumstances that may affect the cashbook are:

1. Interest, Dividends charged or received may not be recorded in the cashbook as these things are usually automated.2. The company might have a standing order, which the accountant may have forgotten to record.3. A bounced cheque.

The circumstances that may affect the bank statement from representing the correct picture shown in the cashbook are:

1. Errors – the least possible reason2. Unpresented Cheques, i.e. customers yet to present their cheques to the bank, and as such the company’s bank account is yet to be debited.3. Timing differences. These may occur frequently since the company records a transaction in its book as soon as a sale is realized, not necessarily when cash is received. Suppose that two days prior to the receipt of the statement, we sell somegoods, and we deposit the customer’s cheque in the bank. This cheque would take a few days more prior to having the money actually credited to the bank account.

This process is called ‘clearing’, and as such we receive a bank statement that doesn’t mention any cheques being deposited, even though it had.

It is therefore necessary to reconcile the cashbook with the bank statement to make sure that the differences are due only because of Unpresented Cheques or Timing Differences,because otherwise, the closing balance in the cashbook may


include bad debts in the form of bounced cheques, or any form of error.

This process of reconciliation is fairly simple, but may be confusing at start. The first thing one does is to spot the errors, and the reasons for difference. The reasons are then divided in the form shown above. The balance on the cashbook and bank statements are then corrected accordingly, and hopefully they would both match. The balance on the cashbook will always be the balance shown in the balance sheet.

Debtors and Creditors Control Accounts

Another way of checking the accuracy of the bookkeeping process and to locate the errors is through the use of Control Accounts. Control accounts are impersonal accounts that will appear in the Nominal Ledger.A debtors control account is an account in which records are kept of transaction involving all debtors in total. In other words the balance on the debtors control account at ay time will be the total amount due to the business at the time from its debtors. Does BPP explanations make sense? NOPE. This is why I’m writing this article.Whenever a business makes a sale on credit, the bookkeeper will send out an invoice to the debtor, and the details of the transaction would be recorded in the debtor’s personal account. Well, imagine trying to aggregate the total of the outstanding balances of all debtors at the year end? Imagine the room for error?

Therefore, the bookkeeper may simultaneously open a debtors control account in the nominal ledger, where the accountant would summarize the entire transactions of the day, week or month, depending on the volume of credit sales.

Obviously at the year end when the bookkeeper decides to double check whether the balance on the debtors account is correct, he may add up the balances on the personal accounts, if they both match, then obviously the debtors control account is correct.Otherwise, there’s an error that must be corrected.Furthermore, the multiple-choice questions really test your ability to understand the topics mentioned above. I have just summarized them but without serious practice,Paper 1.1Chapter 18Suspense Accounts and Journal Entries

Suspense accounts have been a troubling issue whilst studying Paper 1.1 maybe it just requires more practice. As such, I have decided to present some tips that I found to be extremely helpful:1. You must have a very good understanding of the errors, especially those that require the use of suspense accounts.2. Obviously a sound knowledge of the double entry system.3. Even when journal entries aren’t required, please make sure to prepare them for each error, as it will indefinitely lead you to solving the problem correctly.Furthermore, if you follow the following steps, you shouldn’t go wrong:

Step 1

Identify the type of each error or adjustment, if it requires a suspense account,mark it with an ‘S’, if it requires a journal entry mark it with a ‘JE’, otherwise, mark it with an X. Nearly all errors require journal entries, even those that need suspense accounts such as:

a) Casting Errorsb) Posting Errors (only those affecting the balance). Those not affecting the balance only require journal entries.c) All trial balance errors that affect the balance, e.g. something is omitted or incorrectly extracted to the trial balance, etc.d) Deliberate errors, these are due to the accountant deliberately trying to make the trial balance ‘balance’.

Step 2

Once you’re done with step 1, try to picture the affect of the error in your mind, try to tell yourself for example “the result of this error is that the sum of the debits of the trial balance is larger than the sum of credits”, which means that to correct


this error,you need to do the opposite.

Step 3

If the debits are greater than the credits, then you immediately know that we needmore credits to balance the account, so we need to CREDIT the suspense account with the difference.

Remember, if:

a) DR>CR then CR the suspense account with the differenceb) CR>DR then DR the suspense account with the differenceLet us look at the following situations, remember you need to think about three important matters regarding each error:

1. Do they affect the trial balance?2. What kind of account are they affecting?a) Assets or Expenses?b) Capital, Liabilities or Income?3. What kind of error is it?

Now for the situations, taken from various question papers to give you a good understanding of the errors.

Situation 1

A creditor’s account had been debited with a $300 sales invoice (which had been correctly recorded in the sales account).‘Sales’ is an income account, it should have therefore been credited, as such, a debtor’s account should have been debited. This error does not affect the suspense account, because although the transaction was posted to the wrong account, the account was debited with the correct amount.

As such, the journal entry would beDebit Debtor’s $300Credit Creditor’s $300

Situation 2The heat and light account had been credited with gas paid $150.The heat and light account, is an expense account, it should have been debited rather than credited. This error therefore increases the credits rather than increasing the debits, as such it involves the use of a suspense account, but how?Well, let us start by using journal entries first.

Debit Heat and Light $300Credit Suspense Account $300

Situation 3G Gordon had been credited with a cheque received from G Goldman for $800. Both are debtors.Wow, is this slightly confusing or what? Well we are told that both are debtors, so I assume that instead of crediting G Goldman for $800 we credited the wrong debtor.That’s all. Therefore the transaction doesn’t affect the trial balance, only a journal entry is needed to correct the error, which is:

Debit G Gordon $800Credit G Goldman $800

Situation 4The insurance account contained a credit entry for insurance prepaid of $500, but the balance had not been carried down and hence had been omitted from the trial balance.This means that a trial balance wasn’t debited with $500, which affects


the balance.As such, a suspense account is needed. The journal entries would look like:

Debit Insurance Account $500 Credit Suspense Account $500Remember a prepaid account is a debit account, and an accrued account is a credit account!

Situation 5The purchase returns account had been over-cast by $700.Remember a purchase returns account is a credit account, if it has been over-cast by $700, this means, that the credits on the account have been added incorrectly, whereby the credits have been increased by $700. Therefore, the transaction affects the trial balance, and needs a suspense account to correct it. The journal entries are:Debit Purchase Returns $700Credit Suspense Account $700

Situation 6$8,980, the total of the sales returns book for September 20x8, had been credited to purchase returns account.We said a purchase returns account is a credit account, and sales returns book is a debit account. Therefore in this case we credited the purchase returns instead of debiting the sales returns, in which we increased our credits. Thus a suspense account is needed, as well as two transactions!Debit Sales Returns $8980 (this is done to post the correct entry)Credit Suspense Account $8980

Debit Purchase Returns $8980 (this is done to cancel out the error made)Credit Suspense Account $8980

Situation 7$9600 paid for an item of plant purchased on 1 April 20x8 had been debited to plant repairs account.Instead of debiting plant at cost with 9600, we debited plant repairs account, this is an error of principle, it doesn’t affect the trial balance, and it therefore doesn’t need a suspense account. The journal entry would be:Debit Plant at cost $9600Credit Plant Repairs Account $9600


Paper 1.1Chapter 19FRS 1 – Cash Flow Statements

Cash flow statements concentrate on the sources and uses of cash and are a useful indicator of a company’s liquidity and solvency. In other words it is about a page long and it summarizes the inflows and outflows of cash under specific sections. Most importantly though, a cash flow statement distinguishes between profit and cash.

Why?

Well, it has been argued that the figure for profit in the profit and loss account is misleading because it is calculated after numerous non-cash deductions or additions such as depreciation, profit on disposal of assets and accruals, whereas a cash flow statement simply says, let’s just discuss what the company paid or received in terms of cash only.

To illustrate this further, suppose a company made a profit of 1 million pounds, does this necessarily mean that it has that amount of money in its bank account? As such, the survival of a business depends not so much on profits as on its ability to pay its debts when they fall due.Obviously a company’s net cash flow within a specific period may be measured by deducting the opening cash balance from the closing cash balance. However, would not one prefer to know the details of the transactions? Or what their effects are?

Without disclosing much information, it is recommended that a cash flow statement summarizes the inflows and outflows of cash under the following categories:1. Net Cash Flow from Operating Activities2. Returns on Investments and Servicing of Finance3. Taxation4. Capital Expenditure and Financial Investment5. Acquisitions and Disposals6. Equity Dividends Paid7. Cash Flow before Management of Liquid Resources and Financing8. Management of Liquid Resources9. Financing

Okay, but what do these headlines mean, and where do we get the information to find the net cash flow for each of these


categories?

Operating ActivitiesOperating activities refer to the company’s trading activities and day-to-day operations, such as selling, distribution, administration expenses, etc. The cash flow statement attempts to summarize the net cash flow of these transactions, and this may be done in two distinct ways:1. The Direct Method2. The Indirect Method

The direct method of calculating the net cash flow from operating activities is done in the following way:

Cash received from customersLess: Cash paid to suppliersCash paid to and on behalf of employeesEquals: Cash flow from operating activities

The indirect method calculates the net cash flow from operating activities using the information from both the balance sheet and the profit and loss account, and it does so in the following way:Operating Profit before Interest and TaxAdd: DepreciationLoss on sale of fixed assetsDecrease in stocks and debtorsIncrease in creditorsLess: Profit on sale of fixed assetsIncrease in stocks and debtorsDecrease in creditorsEquals: Net cash flow from operating activities

Please Note1. Depreciation is not a cash expense, similarly for the loss or profits on disposal.2. Increase in stocks or debtors means that the company paid more money during the period to do so.3. An increase in creditors means that the company paid less money during the year for its purchases.

Returns on Investments and Servicing of FinanceThis section includes cash received resulting from the ownership of investments other than those invested in joint ventures and payments made to providers of finance other than equity finance. It also includes where appropriate, the interest element of payments made under finance leases.E.g. interest paid for loans, or dividends paid to preference shareholders

TaxationAny taxation paid in respect to the profits of the company less any tax rebates or returns in respect of overpayments.

Capital Expenditure and Financial InvestmentThese include the sales proceeds or the payments to purchase fixed assets such as plant, buildings, equipment, motor vehicles, etc, including long-term investments made in the shares or debentures of other companies, unless the acquisition of other companies is involved.

Acquisition and DisposalsCash flows in respect of acquisition and disposals are only related to parent undertakings, such as the acquisition or disposal of any investment in a subsidiary, associate or joint venture.

Equity Dividends PaidThese are simply the amount of dividends paid to equity shareholders.


Management of Liquid ResourcesLiquid resources are current asset investments that are held as disposable stores of value. They are eithera) readily convertible into known amounts of cash at, or close to, its carrying amountb) traded in an active market E.g. treasury bills and shares on the stock exchange.

FinancingThese represent amounts received from providers of finance, both debt and equity finance, less principal amounts repaid. This section also covers the capital elements of payments made under finance leases.E.g. Receipts from issues of shares or debentures, and any repayments of amounts borrowed.

Paper 1.1Chapter 20An Example of a Cash Flow Statement & Accompanying Notes

Cash flow Statement for the Year Ended 31st December 20x3 $000 $000Cash Flow From Operating Activities (note 1) 15672

Returns on Investments and servicing of finance:Interest Received 858Interest paid (1939)Prefernece dividend paid (450)Interest element of finance lease rentals (358) (2239)Taxation (2887)

Capital expenditure and financial investment:Purchase of tangible fixed assets (3512)Sale of trade investment 1595Sale of plant and machinery 1052 (865)Acquisitions and disposals: (not required for Paper 1.1 Students)

Purchase of subsidiary undertaking (12705)Net overdrafts acquired with subsidiary (5516)Sale of business 4208Purchase of interest in a joint venture (3811) (17824)Equity dividends paid (2606)Cash outflow before use of liquid resources and financing (10399)


Management of liquid resources:Cash withdrawn from 7 day deposit 200Purchase of government securities (5000)Sale of government securities 4300Sale of corporate bonds 1200 700Financing:Issue of ordinary share capital 600Inbcraese in short term borrowings 2006Repayment of secured loan (850)New secured loan repayable in 20x7 1091New unsecured loan repayable 20x5 1442Capital element of finance lease repayments (1342) 2947Decrease in cash (6752)

Note 1 – Reconciliation of operating profit to operating cash flows

Operating Profit 17213Depreciation Charges 3488Increase in stocks (11840)Increase in debtors (3774)Increase in creditors 10585Net cash flow from operating activities 15672


Paper 1.1Chapter 21Share and Business Valuation

Breakup Valuation is based on the forced sale of individual assets in the second hand market. Basically, the current values of all assets are added up together.The Advantages1. It represents the minimum value at which the company can be sold2. If company ignores breakup value, an opportunity exists for asset-strippers3. An indication of the min amount of capital that could be obtained for investment elsewhere.

The Disadvantages1. Ignores that the company is a going-concern2. Values on assets are estimates3. Sale value of fixed assets is hard to ascertain.

Book Value: Original Share Capital + Reserves

The Advantages1. The figures are factual as they are based on historical cost2. They are easily obtainable3. The figures for debtors and non-equity liabilities are accurately reflected.

The Disadvantages1. Inflation means that historical cost is not an accurate measure of current value2. Historical costs aren't very accurate due to inaccurate measures of depreciation.3. The book value of stock is unlikely to reflect its current value, because market values often include an element of profit.4. Ignores the existence of intangible assets such as goodwill.

Replacement Cost: Replacement Cost of Assets less: All Liabilities

The AdvantagesAssets are valued at their replacement cost!The Disadvantages


1. The cooperation of the company is needed to identify assets2. Intangible assets such as goodwill aren't recognized3. Replacement cost may overvalue the company.

Earnings Yield 100 = Annual Earnings Yield X 100 or 1 X 100 Required Earnings Yield P/E Ratio

The value of a company on the earnings-yield basis is the value of the stream of profit, or earnings which the company is expected to generate.

The Disadvantages1. It is based on predictions, assumptions and estimates.2. Micro/Macro economic factors may cause distortions in present/future value of shares.3. Dependant on access to inside information.4. Results achieved in the past don't necessarily reflect future earnings.

Price Earnings = Market Price of One Share (from Stock Exchange) Earning per share ( profit after tax/Issued shares )

An unlisted company can therefore be valued by multiplying its earnings by the P/E ratio of a similar company.

The Disadvantages 1. The P/E ratio of an unlisted company is expected to be less than that for a corresponding listed company and so the use of unadjusted quoted ratios can results in overvaluation on2. High trading may cause overvaluations of share prices.

Dividend Yield =Dividend for the year (Including Interim Dividend) X 100 Quted Market Price ( In Pence )


Paper 1.1Chapter 22Solvency & Financial Strength

Short-Term Solvency

Working Capital (Current) Ratio = Current Assets : 1 Current Liabilities

1. The ability to pay debts as they fall due2. The rate of stock turnover must be considered, since the lower it is, the more stock there is.3. The average ratio for the industry and the economy must also be considered.4. A ratio below 1 means that a company may not be able to pay its short term debts

Liquidity (Quick) Ratio = Current Assets - Stock:1 Current Liabilities

1. One must carefully consider which of the current assets to include or omit.2. Stocks should be normally excluded, as well as prepayments.3. All liabilities should be included, but one must understand the significance of including tax which is usually paid within 9 months, and an overdraft, which is a revolving source of finance.4. A ratio below 1:1 usually causes a company great difficulty in meeting its debts as they fall due.5. An excess of 1:1 means that the company is in possession of surplus cash, although solvent, there must be some doubt whether it is making the best use of available resources.

Longer-Term Financial Strength

Proprietorship Ratio = Shareholders' Equity X 100 Total Sources of Finance

1. The proportion of business assets financed by shareholders.2. The larger the proportions of business activity financed by shareholders the smaller are the creditors' claims against the company.3. This said Equity finance is normally repaid only when the company is wound up, and only when there is sufficient finance, although dividends are paid, the company is not legally obliged to do so.


4. One normally expects shareholders to provide at least half the finance.5. It represents, to the creditors, the extent to which a company can stand a fall in the value of its assets before the creditor's position is prejudiced. E.g. 75% means that assets must fall by 25% before the creditors' position on liquidation is jeopardized.

Interest Cover = Net Profit Before Interest And Tax Interest Charged

1. It stresses the importance of a company to meet its interest charges out of revenue, and this is expressed as a multiple of operating profits.2. A low figure indicates that interest payable imposes a heavy burden on the company's finances, thereby increasing the risk of insolvency.3. It is expected that it will fall immediately following a loan issue, e.g. Debentures.4. Interest charges are usually fixed per year, so one should also consider the possibility of a fall in profits, a low interest cover could basically make a company insolvent.

Paper 1.1Chapter 23Asset Turnover Ratios

Stock Turnover Period = Avg. Stock Level X 365 Cost of Goods Sold

1. Measures the speed with which a company turns over its stock2. Multiplying the ratio by 365 represents this ratio in terms of days that elapse between the date that goods are delivered by suppliers and dispatched to customers. I.e. the stock holding period.3. Companies must strive to keep the stock holding period as low as possible in order to minimize associated costs.4. A reduction in the average period for which stocks are held, suggests that the purchasing, distribution, and selling functions have been streamlined5. Higher sales and market activity, usually increases the stock figure to ensure that additional consumer requirements can be met without delay.6. An increase in sales without a similar increase in stock means that resource which would otherwise be tied up in stock, is available for use elsewhere in the business.

Rate of Collection of Debtors (Debtor’s Payment Period) Avg. Trade Debtors X 365 Credit Sales

1. The higher the figure, the more it is assumed that money tied up in debts are resources that are yielding no return and also losing value during a period of inflation.2. Therefore the reasons for the change should be carefully investigated, to find out whethera) There was an increase in the credit period to generate more salesb) There is slackness in the credit-control department.3. Please note that the sales figure in the P&L is exclusive of VAT but the debtor’s figure is inclusive.

Rate of Payment of Creditors = Avg. Trade Creditors X 365 Credit Purchases1. Measures the average period of time taken by companies to pay their suppliers.2. A change in the rate of payment may well reflect an improvement or decline in liquidity.3. Normally it is expected that rate shouldn't vary very much from year to year.The Cash Operating Cycle:


Stock Turnover of Raw MaterialsAdd: Turnover of Work in ProgressTurnover of Finished GoodsRate of Collection of DebtorsLess: Rate of Payment of Creditors

1. A period of time elapses between the payment for goods or raw materials received into stock and the collection of cash from customers in respect of their sale. The gap is known as the Cash Operating Cycle' and, during this period of time, the goods acquired, together with the value added in the case of a manufacturer, must be financed by the company.2. The shorter the length of time between the initial outlay and the ultimate collection of cash, the smaller is the value of working capital to be financed.Fixed Asset Turnover = Sales :1 Avg. Fixed Assets1. Measures the degree of fixed asset utilization2. The ratio is likely to reveal excess capacity from time to time during the life of a business.3. The excess capacity may be unavoidable for a number of reasons, e.g. acquisition of new assets4. Similarly, the Total Asset Turnover may indicate the same assumptions; it is calculated by calculating the figure for Total Assets rather tan the Avg. Fixed Assets.Paper 1.1Chapter 24Profit Ratios

Gross Profit Margin = Gross Profit X 100 Sales

1. Since all costs that are deducted when computing the gross profit are directly variable with sales, it is assumed that the gross profit margin should remain unchanged.2. Yet this view is less popular for a manufacturer because the COGS includes fixed costs such as factory lighting and heating, factory rent and rates, and semi-variable costs.3. The change may occur due to: Price cuts, cost increases, changes in mix, under- or overvaluation of stocks.

Net Profit Percentage = Net Profit before interest and tax X100 Sales

1. It is designed to focus attention on the net profit margin arising from business operations.2. Net profit, like gross profit, increases with sales, and this increase occurs as a percentage of sales.

Rate of Return on Gross Assets = Net profit before intrest and tax X 100 Avg Gross Assets(Total Assets less Current Liablities)

Or = Total Asset Turnover x Net Profit Percentage

Sales X Profit Before Interest & TaxCapital Employed Sales

1. Also known as the Rate of Capital Employed, Shareholder's Equity, Long-Term Capital Employed.2. It measures the extent at which the management makes the most effective use of available resources3. Since Total Asset Turnover multiplied by the Net Profit Percentage is equivalent to the Return on Gross Assets, one must note that lower asset utilization must be compensated by the profit margins, or vice versa, to effectively manage the Rate on Gross Assets. This is why this ratio is described as the primary accounting ratio. Therefore, it may be necessary to calculate the asset turnover ratio and the net profit margin to find out why the ROCE is high or low.4. As such there’s a tradeoff between the net profit percentage and the total asset turnover, the reasons being, a high net


profit percentage, means a higher price per unit, which may not generate a high number of sales, hence, a lower asset turnover.Rate of Return on Shareholder's Equity = Earning (Pre or Post) X 100 Avg. shareholder's Equity (Share Capital + Reserves)

1. Measures whether the rate of return on the shareholder's funds is adequate enough to continue with their investment or not, the earnings yield and dividend yield should also be examined.2. A popular view is to compare the rate of return with current interest rates.3. Whilst there might be a significant drop in the rate of return on gross assets, similarly, the same may be expected with the rate of return on shareholder's equity. Yet, the difference is that the return earned for shareholder's is dependant on 3 key factors, profit margins, asset utilization and capital structure, whereas the return on Gross Assets ignores the last factor.

Earnings per Share = Earnings (Post Tax Profit less Preference Dividends) X 100 Number of equity shares issued(less: Preference Shares)

1. Applies only to listed companies.2. When a loss is suffered the EPS is negative.Gearing Debt ratios are concerned with how much the company owes in relation ot its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

The debt ratio is the ratio of a company’s total debts to its total assets

Debt Ratio = Total Debts (Total Creditors) X 100 Total Assets

Capital Gearing Ratio = Perior charge capital (Capital carrying right to fixed return) X 100 total capital (Total Assets less Current Liabilities)

When a loan is raised, the effect is to introduce an element of gearing or leverage into the capital structure of the company. The debt: equity ratio is perhaps the most commonly used, and it may be calculated in either of two ways:

1. These ratios are used to assess whether the rate earned on the additional funds raised exceeds that payable to the providers of the loan.2. In other words to increase the return on gross assets and on shareholder's equity.3. The shareholders of a highly-geared company reap disproportionate benefits when earnings before interest and tax increase. This is because interest payable on a large proportion of total finance remains unchanged.4. The converse is also true; a highly geared company is likely to find itself in severe financial difficulties if it suffers a succession of trading losses.


Paper 1.1Chapter 25Sole traders vs. Partnerships vs. Limited Companies

Sole tradersWhoever opens up a business is a sole trader as long as he is the single owner of the business. Legally, the business and the owner are not separate entities; they are one and the same. However, accounting views the business as a separate entity to be distinguished from its owner. Nevertheless, the sole trader is still personally liable for the debts of the business.

PartnershipA partnership is an unincorporated business that is owned by two or more persons known as partners. A partnership is governed by the Partnership Act 1890, and it is formally established by means of a partnership agreement, which specifies such matters as the distribution of profits, salaries, etc.As with sole traders, accounting views the partnership as a separate business entity to be distinguished from its owners. Similarly, each partner is responsible for the debts of the business. This means that each partner has what is called an unlimited liability.

Limited CompaniesLimited companies are governed by the Companies Act 1986, and the owners of a limited company are its members or shareholders.There are two classes of a limited company, which are:- Private Companies, they are owned by members and they cannot invite members of the public to invest in their equity (ownership).- Public Companies, they are owned by shareholders, who may purchase further shares or sell the ones they own to the general public on a Stock Exchange.As with Sole Traders and Partnerships, a limited company is also viewed as a separate entity from its shareholders. Yet, shareholders benefit from what is known as a limited liability. This means that their liability extends as far as the capital they invested, and nothing more. Hence the term ‘limited’ in reference to limited companies.

The following table summarizes the advantages and disadvantages of being a sole trader, having a partnership or a limited company.

Sole Traders Partnerships Limited Companies


Advantages

sole traders partnerships Limited companies

1. Easier to set up 1. Risks are spread over a large number of partners 1. Limited Liability2. The owner is the manager of the business. 2. Easier to raise finance from external sources such as banks. 2. Easier to raise capital through the issue of shares.

Disadvantages1. Unlimited Liability 1. unlimited Liability 1. Compliance with the Companies Act, Accounting Standards.2. Harder to raise capital. 2. Profits are spread over a large number of people 2. Prepare annual audited accounts, and keep accounting records which are sufficient to show and explain the company’s transactions.3. Control is diluted over the business amongst several partners 3. Disclose a lot of information which may not be advantageous to disclose to competition4. Partners may have disputes 4. Must keep statutory books5. At a partner’s death, insolvency or mental incapacity, the partnership must go through what is known as dissolution 5. Formation and annual registration costs.paper 1.1Chapter 26Partnerships

Capital Accounts

When a partnership is formed each partner puts in some capital to the business, and each is recorded separately in a series of capital accounts, so that a record I skept of how much is owed to whom.

Current AccountsEach partner will also have a current account, which is used to record the profits retained in the business by the partner and it differs from the capital account in that the later remains ‘static’ from year to year whereas a current account is continually changing due to the making of profits and drawings.Basically any income transferred to the current account, is a credit entry, and any expense charged to the current account is a debit entry.

Interest on CapitalA partnership agreement also provides for interest on the balance of the partner’s capital account NOT the current account. The interest received by each partner is transferred to the current account.

DrawingsWhenever a partner makes any drawings, the transaction is recorded in a drawings account as with sole traders. Yet, in addition, at the year end the drawings will be cleared to the current accounts.

Loan to the PartnershipsPartners may loan the business some money, whilst earning interest from the business too. This loan is treated as a current or long term liability rather than a partners’ fund.The interest received by each partner on the loan is transferred to their current account and it is treated as an expense in the profit and loss account. In addition, if there’s no interest rate specified, the Partnership’s Act 1890 provides for interest to be paid at 5% p.a.

Appropriation of Net ProfitsIn preparing the final accounts of the business, we would normally arrive at the net profit of the business at the end of the profit and loss account. Since each partner may share a different amount of profit in what is known as a profit sharing ratio, the net profit should be appropriated to each of the partner’s current account. This process is done as follows:


Step 1 – Arriving at the Net Profit figure.Operating ProfitLess: DrawingsSalariesInterest payable to partners’ (Except those payable on loans)Add: Interest on Drawings (These are deducted from the current account)Equals: Residual Profit

Step 2 – The Profit Sharing RatioThe Residual Profit is now divided amongst the partners in proportion to the profit sharing ratio.

Please Note1. Drawings, interest on capital and salaries are NOT expenses in the P&L.2. Interest on loans ARE expenses, therefore they are not deducted from the Operating Profit.

Paper 1.1Chapter 27Group Accounts & Consolidated Balance Sheets

Group accounts are required when a company acquires another company. The first company is called the holding or parent company and it controls the latter company,which is called the subsidiary.Group accounts basically consist of a consolidated balance sheet, which is a balancesheet that shows the net assets that the Holding Company controls and the ownership of those assets.The Group’s Capital and Reserves consist of the holding company’s capital and reserve and the group share of post-acquisition retained reserves of the subsidiary company. It also consists of what is called Minority Interest.The Preparation of the Group’s Consolidated Balance Sheet

Step 1You must first make sure at what date the acquisition took place. The reason for this is to have a clear picture in your mind concerning the events that occurred at the acquisition date and those of which occurred since.

Step 2The next step is to find out whether other parties hold a minority interest of the subsidiary’s consolidated net assets. This is done by dividing the amount of shares acquired by the subsidiary’s total share capital. The percentage of minority interest should be noted down.

Step 3when separate calculations of post acquisition profits, goodwill or minority interest are needed rather than all of them, just take a look at the column of each category to find out how to calculate it.Going through the calculations in this manner ensures that the possibility of your errors is minimal, and if they do occur you can systematically find out where they did.80% Total of Total Equity


Paper 1.2 Financial Information for ManagementChapter 01 The purpose of cost accounting Chapter 02 Cost Behaviour Chapter 03 Understanding the Correlation between Total Costs and the Volume of Output

Chapter 04 Direct and Indirect Materials: Part 1 - The control of stock itemsChapter 05 Direct & Indirect Materials: Part 2 – Stock Reorder Levels Chapter 06 Overheads and Absorption Costing: Part 1 - ApportionmentsChapter 07 Overheads and Absorption Costing: Part 2 - Absorption

Paper 1.2Chapter 1The Purpose of Cost AccountingCost accounting is part of management accounting, and its purpose arises due to the management’s need for specific or more detailed information as oppose to that provided by financial statements. Hence cost accounting will provide information to assist the management with planning, control and decision making as well as accumulating historical costs to establish stock valuations, profits and balance sheet items. All of this is done with the help of a Management Information System, which is simply a general term for the computer systems in an enterprise that provide information for management.Therefore the key points of cost accounting are :• The recording and analysis of actual costs• The forecast of future costs• Cost control

Cost ClassificationsAs such, it is necessary to be able to understand the basic cost classifications and behaviour to manage a cost accounting system.Costs may be classified as either of the following :1. Direct or Indirect Costs2. Function Costs3. Fixed or Variable Costs4. Product Costs or Period Costs5. Available or Unavailable


6. Controllable, Uncontrollable, or Discretionary Costs

Direct or Indirect CostsA direct cost is a cost that can be traced in full to the product, service or department that is being costed. These costs consist of direct labour, direct materials, and any other direct costs.Whereas an indirect cost is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. These costs consist of the following:a) Production overheads: indirect materials, indirect wages and indirect expensesb) Administration overheads: e.g. depreciation and office salariesc) Selling Overheads: e.g. commissions, advertising, market research, sales promotiond) Distribution Overheads: e.g. cost of packing cases, insurance charges.The two definitions mean that every product, service or department will incur a direct and indirect cost. Furthermore the total cost of every product, service or department is the sum of the relative direct and indirect costs.Total Cost = Direct Cost + Indirect CostFunction CostsCosts may also be classified by their function, i.e. what kind of service was the cost incurred to do? The answer to this question may be categorized in any one of these classifications:a) Production Costs b) Administration Costs c) Selling Costsd) Distribution Costs e) Research & Development Costs f) Financing Costs

Fixed or Variable CostsA fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity. A variable cost however is a cost which tends to vary with the level of activity.

Product Costs or Period CostsProduct costs are those identified with a finished product, as a part of the value of stock. They become expenses in the form of cost of goods sold. Whereas period costs are costs that are deducted as expenses during the current period without

ever being included in the value of stock held.

Avoidable or UnavoidableSimply costs are avoidable, if the company could avoid them, and similarly for unavoidable costs.

Controllable or UncontrollableControllable costs are those that can be controlled by the company whereas uncontrollable costs are those outside the scope of the business.

Discretionary CostsThese costs are likely to arise from decisions made during the budgeting process. They are likely to be fixed amounts of money over fixed periods of time. E.g. Advertising, R&D, training budgets.

Cost UnitsOnce costs are recorded, i.e. the total costs of department ‘A’ are $100,000; one may prefer to analyze the cost per each unit. This is referred to as a cost unit, and it could be cost per kg, cost per machine hour, etc.

Cost ObjectsWhat if the manager comes up to you and says, what’s the cost of operating department ‘A’? This cost is referred to as a cost object, or objective, and it is any activity for which a separate measurement of costs is required, e.g. the cost of a product or the cost of a service, etc.

Responsibility CentresA responsibility centre basically involves analyzing costs, profits or revenues and attributing them to specific managers or ‘centres’. In other words, the costs of department ‘A’ are the responsibility of Manager ‘A’, whereas the costs of Machine


‘A’ is attributed to the operator of Machine ‘A’. Basically, responsibility centres maybe categorized as follows:a) Cost Centresb) Profit Centres, where profit centre managers should normally have control of how revenue is raised and how costs are incurred.c) Revenue centres, whose responsibility is revenue only.d) Investment centres, whose responsibility is that of a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment.

Conclusion1. We know what information is, why it is needed and that it is managed within a Management Information System.2. We said that an MIS is needed to enable the management to have sufficient information to do their job.3. Cost Accounting is a part of MIS and it basically helps us witha) The classification of actual costs incurredb) The preparation of budgets of planned costsc) The comparison of actual costs and budgeted costs

4. This system involves the classification of costs into several categories such as direct and indirect costs, function costs or fixed and variable costs.5. Costs are based on cost units and cost incurred is allocated to a cost centre such as a department or a machine.Paper 1.2Chapter 3Understanding the Correlation between Total Costs and the Volume of Output

Although the cost behavior pattern of fixed, variable and semi-variable costs seem to be straightforward, the mere cost behavior pattern isn’t sufficient enough to enable us to control or anticipate future costs in order for us to set budgets, or to base management decisions on them. It is necessary, to determine the correlation between total costs and volume of output.

This article will focus on the various methods available, how to use them for forecasting purposes and their limitations. It is important however to realize that each of the following methods is only an estimate and each of them will produce different, but rather similar results. The following methods are available:1. High-low method (with or without inflation)2. Scattergraph method and the line of best fit3. Regressoin analysis4. Least squares method

The High-Low Method

The high-low method may be used to determine and differentiate betw


Paper 1.2Chapter 4Direct and Indirect Materials: Part 1 - The control of stock items.

The purpose of this article is to develop an understanding of how cost accountants deal with stocks, how they are valued and most importantly, how they are controlled. Remember that costs may either be an expense, which would be written off in the profit and loss account, or a cost may be an asset, which would be carried forward in the balance sheet. This is due to the application of the accruals concept. It is therefore necessary to classify costs in the most appropriate manner, so that they are valued, accounted for, and controlled as efficiently as possible.As such, this article would answer the following questions:

1. How are items of stock, such as materials, controlled within a cost accounting system?2. What are the reasons for holding stock and what are the limitations of doing so?3. What are the appropriate methods of establishing reorder levels whilst minimizing the cost of holding stock trough the interpretation of optimal reorder quantities?

How are items of stock, such as materials, controlled within a cost accounting system?1. Stocks are controlled using what is known as a stock control system. This system should cover the following functions:a) The ordering of stockb) The purchase of stockc) The receipt of goods into stored) Storagee) The issue of stock and maintenance of stock at the most appropriate level.

The reasons are due to the following points:a) Holding costs of stock may be expensiveb) Production will be disrupted if we run out of raw materialsc) Unused stock with a short shelf life may incur unnecessary expenses.

2. Furthermore, proper records must be kept regarding the ordering, receipt and issue of stock using the following process:

a) When stocks reach the reorder level, the stores department issues a purchase requisition to the purchase department to order further stock.


b) The purchase department then issues a purchase order to the supplierc) Once the stock is delivered, the storekeeper signs a delivery note. The stocks are then further inspected for deficiencies. If all is okay, the store keeper prepares a goods received note (GRN) to the accounts department that check it with the purchase order. The supplier is paid.

The reasons are to ensure that:a) Enough stock is heldb) There is no duplication of orderingc) Quality is maintainedd) There is adequate record keeping for accounts purposes.

3. Storage of Raw Materials; Storekeeping involves storing materials to achieve the following objectives:a) Speedy issue and receipt of materialsb) Full identification of all materials at all timesc) Correct location of all materials at all timesd) Protection of materialse) Efficient use of storage spacef) Maintenance of correct stock levelsg) Keeping up to date records

This is done through the use of:a) Bin Cards – kept with the actual stock and updated whenever items are issued or received.b) Stores Ledger Accountsc) Stock Codes – materials held in stores are coded and classified

4. Stocktaking – this process involves counting the physical stock on hand at a certain date and matching it with the balance shown in the stock records. This process should enable us to avoid discrepancies, check our records, and make sure that we know the free stock balance, which is actual stock that is available for future use. Stocktaking may be periodic or continuous, in which the later involves using a perpetual inventory system.

Remember that:• Materials in stock plus Order from Suppliers less materials requisitioned equals free stock balance.

5. An Order Cycling Method may be used, where quantities on hand of each stores item are reviewed periodically.6. A Two-bin system may also be used whereby each stores item is kept in two storage bins. When the first bin is emptied, an order must be placed for re-supply.7. Materials may be classified as expensive, inexpensive or middle-cost range. Whilst the last two items are stored in large quantities, the expense items are subject to careful stores control procedures.8. Computerization, whereby stock masters file is maintained concerning all the transactions and details of stock movement. This will ensure the following:a) Easier processb) Better maintenance of recordsc) Backup copies could be made.

What are the reasons for holding stock and what are the limitations of doing so? The main reasons for holding stock are:

1. To ensure that sufficient goods are available to meet expected demand.2. To provide a buffer between process (in cases where output stock is the input stock for another process.3. To meet any future shortages4. To take advantage of any bulk purchasing discounts5. To absorb seasonal fluctuations and any variations in usage and demand.6. To allow production process to flow smoothly and efficiently.


7. Holding stock is necessary due to fermentation, e.g. wine.8. As a deliberate investment policy, e.g. in times of inflation or shortages.

There are two kinds of limitations arising due to stock holding

A) If stocks are held at a high level:1. Cost of storage and stores operations increase2. Insurance costs arise3. Risk of obsolescence – stock being damaged or going out of fashion4. Opportunity costs – instead of purchasing stock and holding them you could have invested the money elsewhere.

B) If stocks are held at a low level:1. Cost of obtaining stock may increase – if stocks are kept too low, every time a new order is needed, the firm must incur cost of obtaining stock, such telephone calls, transportation, etc.2. Stock out costs- whereby items of stocks run out. This may result in a lost contribution from sales, or a loss of future sales from disappointed customers, or worse, cost of production stoppages.

Paper 1.2Chapter 5Direct & Indirect Materials: Part 2 – Stock Reorder Levels

What are the appropriate methods of establishing reorder levels whilst minimizing the cost of holding stock?

Step 1An analysis should be made regarding past stock usage and delivery times, whereby a series of control levels can be calculated and used to maintain stock at their optimal level.

Step 2Basically, stock control levels are established, such as:a) Reorder levelsb) Reorder quantityc) Maximum leveld) Minimum levele) Average stock level

a) When stocks reach the reorder level, an order should be placed to replenish stocks. The level is determined by the following formula :Reorder level = Maximum level x Maximum Lead time Where maximum lead-time refers to the time between placing an order with a supplier and the stock becoming available for use.b) The reorder quantity is the quantity of stock to be ordered when stocks reach the reorder levels.c) Maximum levels could lead to unnecessary holding costs, and this level may be established by the following formula:Maximum level = Reorder level + Reorder Qty – (Minimum level x Maximum lead time)d) When stocks reach the minimum level, stockouts may occur, and the level may be established by applying the following formula: Minimum level = reorder level – (Avg. Stock Level x Average Lead Time)e) The average stock level refers to the average stock held within an accounting period.The following formula assumes that stock levels fluctuate evenly between the minimum stock level and the highest possible stock level.

Average Stock = Minimum Stock + ½ Reorder Quantity

Step 3: Economic Order QuantityNow it is necessary to calculate the Economic Order Quantity. This is the order quantity that minimizes the total costs of holding and ordering stock.Usually the economic order quantity is found at the point where holding costs equal


ordering costs, which will be demonstrated by the following graph:

As you could see, as the average stock level or the order quantity increases, the holding costs increases proportionately or variably, yet the cost of ordering stock gradually decreases. The total cost curve is the sum of both the ordering and holding costs. As one could obviously see, the point where holding costs equal ordering costs, is the same point where the total costs are at the lowest level. This is referred to as the economic order quantity, i.e. the point where it is most efficient to order stock items.This could also be demonstrated, or calculated using the following formula (Refer to Mathytpe)

Step 4: Economic Batch Quantity

In step 3, we assumed that the re-supply of stocks is instantaneous, i.e. whenever we need the stock we order that amount exactly. Yet, what if re-supply is gradual rather than instantaneous, i.e. an order of units is received gradually in batches?This situation requires an amendment to the economic order quantity, to what is known as the Economic Batch Quantity.Where:If you compare this formula to that for the EOQ, you would notice that the amendment involved replacing ….Ordering CostsHolding CostsTotal CostsActual Costs ($)Order Quantity (Units)Average Stock Level (Units)

So if the annual demand per year is 100 units, and the annual rate of production is 200 units, then we are selling half of what we’re producing. As such the costs of holding will drop by one half because we aren’t storing all of our productions, get it?As you could see … is used because total stocks held per annum aren’t ‘Q’ but …. This is due to batch productions and as such there is a gradual resupply.

Step 5: Economic Order Quantity and DiscountsObviously the EOQ must be modified if bulk discounts are available. This is done to decide whether it would be worthwhile to take a discount and ordering large quantities, or not.

Obviously the deciding factor will be the lower of total costs whena) Discounts are taken (minimum order size needed to take the discount)b) Pre-discount EOQ level.This is simply calculated as follows:Total Costs of a) =PurchasesLess: DiscountsAdd: Holding CostsAdd: Ordering Costs

Total Costs of b) are found using the EOQ formula. The lower of a) or b) wins the vote!


Paper 1.2Chapter 6Overheads and Absorption Costing: Part 1 - Apportionments

In accounting, there are various methods in dealing with direct and indirect costs,some of which have been explained in previous articles, such as direct/indirect materials and labour costs. The following series of articles aim to define and explain the different methods of dealing with overheads.Overheads are by nature, indirect costs. They are defined as a cost incurred in making a product or a service, but cannot be traced directly and in full to the product or service.

Overheads may be classified as manufacturing or non-manufacturing overheads for the purpose of this article.Manufacturing overheads being those costs related to the product or service as defined above, and non-manufacturing overheads are those that cannot be directly allocated to particular units of output.

Absorption Costing

In absorption costing, overheads will be added to each unit of output of products manufactured and sold. It is a method for sharing overheads between different products on a fair basis.In other words, it says, look at all those manufacturing overheads incurred, and lets add them to the cost of sales!SSAP 9 recommends this method because cost of all stocks should consist of all costs incurred in the normal course of business in bringing the product to its ‘present location and condition.’ Overhead costs are incurred to produce the finished product(s) including administration and directors’ wages, without them the products wouldn’t exist! Therefore it is justifiable to charge each unit of output with some of the overhead costs.There are also various practical reasons for using absorption costing:1. Stock Valuations – Closing and Opening Stock would consist of manufacturing overheads, as such, increasing the value of gross profit, by carrying forward the cost in the balance sheet as a current asset, rather than writing it off as an expense in the profit and loss account.2. Pricing Decisions – If you were to provide a service or a product for a customer, you would like to know the full cost to be incurred, including nonmanufacturing costs as well. This will enable you to determine how much of this cost should be bared by the customer. Kapiche?3. Profitability of different products – Since overheads are shared on a fair basis and charged to the cost of sales of each product/department/service, one could ascertain the profitability of each product/department/service.

The Process of Absorption CostingSimply, there are three stages:


1. Allocation2. Apportionment3. Absorption

Allocation involves allocating manufacturing and non-manufacturing overheads to various cost units or cost centers. Apportionment is the process by which general overheads are shared out on a fair basis between each cost center. In other words, it’s a process of taking all the non-manufacturing overheads and distributing them to those involved in production. Absorption is the process by which the costs calculated for each cost center is finally added to unit, job or batch costs. Thus, establishing the cost per each unit produced, which would enable us to value both opening and closingstocks, the cost of sales, and the gross profit of the business.

AllocationThis step is very simple. First we establish the various cost centers within the business, e.g. Production Department A and B, Services Department C and D. We then allocate all relative costs to each of these departments.

ApportionmentThe process of apportioning overheads is based on what is called Basis of Apportionment. This means that overhead costs are shared out on a fair basis which could be the floor area occupied by each cost center, when rent, rates heating and light repairs are concerned, or cost or book value of equipment when depreciation of equipment is concerned, etc.

Once a basis for apportionment for each service or non-manufacturing cost is established, the overheads should be apportioned in either one of the following ways:1. Direct Apportionment2. Reciprocal method of apportionment3. Step Method of Apportionment

Direct Method of Apportionment

Suppose that we have four departments within an organization, two of which are production departments, whereas the other two are non-manufacturing departments,they provide a service for example, such as repairs, etc. Production department Arequisitioned materials from department C to the value 12,000 and B requisitioned materials worth 8000. Service department D provided 500 hours of work to department A and 750 hours to department B. The following costs are incurred:

Production Departments Service Departments A B C DAllocated Costs 6000 4000 1000 2000Apportioned Costs 2000 1000 1000 500Total Overheads 8000 5000 2000 2500

The process of apportionment means that we should distribute the total costs of service departments C and D on a FAIR basis to production departments A and B.The first step would be to establish the apportionment basis for each overhead.Obviously, the costs incurred by department C would be apportioned on the basis ofrequisitions that it provided to departments A and B. The costs incurred by department D would be apportioned on the basis of the hours of service provided to both department A and B

Therefore, the costs of departments C and D would be apportioned in the following way:Production Departments Service Departments TotalA B C DValue of Requisitions 12000 8000 20000 % Of requisitions 60% 40%Work Hours 500 750 1250 % Of work hours 40% 60%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 800Apportionment of D 1000 1500


Total Overheads 10200 7300 17500Did you see what happened?To apportion the costs of C, its overheads are apportioned to each department depending on the percentage of requisitions supplied, and the overheads of department D have been apportioned to each department depending on the percentage of work hours received.

The Reciprocal Method of Apportionment

The reciprocal method of apportionment is useful when services are not only provided to manufacturing departments, but to service departments as well. Therefore, costs are apportioned between all departments, rather than just the manufacturing ones.Let us suppose that, in the previous example, department D requisitioned materials and provided hours of service to department C. The following table summarizes the transactions and the solution:

Production Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10% Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 600 (2000) 200Apportionment of D 1080 1404 216 (2700)Apportionment of C 129.6 64.8 (216) 21.6Apportionment of D 8.64 11.232 1.728 (21.6)Apportionment of C 1.728 0 (1.728) 0Total Overheads 10420 7080 0 0 17500

As you could see, using the reciprocal method, overheads are repeatedly apportioned until the final cost to be apportioned becomes so small and immaterial in value.One could also determine that the total costs of department C consists of a proportion of the total costs of department D, and vice versa.Therefore, as an alternative to using repeating the appropriations of each of the service departments, simultaneous equations may be used to establish the total cost of C and the total cost of D, which we could then directly apportion to departments A and B.

Total Cost of C = 2000 + 8% of department D overheadsHence C = 2000 + 0.08*DTotal Cost of D = 2500 + 10% of department C overheadsHence D= 2500 + 0.1*CApply C to DC = 2000 + 0.08(2500 + 0.1C)Hence, C= 2000 + 200 + 0.008CHence, 0.992C = 2200Therefore C=2217.7419Hence, D= 2500 + 0.1*2217.7419 = 2721.7741Therefore the solution would now be Production Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1330.6451 665.3225 (2217.7419) 221.7741Apportionment of D 1088.7096 1415.3225 217.7419 (2721.7741)Total Overheads 10419 7081 0 0 17500

Notice what happened? Instead of apportioning the 2000 and 2500 overhead costs, the overhead costs apportioned where those found in the simultaneous equations above.


The same result is obtained either way; the slight difference shown is due to rounding off only.

The Step MethodThe step method is very similar to the reciprocal method but the apportionments aren’t repeated since costs are not reapportioned to the service departments again. Thus, whatever is apportioned first will affect the results obtained. If we apply it to the above example, the following results are obtained: Production Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 600 (2000) 2009200 5600 0 2700Now the 2700 will be distributed to A and B only, based on work hours.Apportionment of D 1173.69 1526.04Total Overheads 10374 7126 17500

Please notice how the apportionment basis percentages were recalculated to distributethe overheads to A and B only, similarly if D was apportioned first. Yet in the later case, the results would differ. Try it yourself.Paper 1.2Chapter 7Overheads and Absorption Costing: Part 2 - Absorption

After allocating and apportioning overheads to cost units or cost centers, we need to add the costs calculated for each cost center to unit, job or batch costs. This is called overhead absorption or overhead recovery. Therefore, the production overheads calculated using absorption costing would be included in the following formula:

Direct MaterialsPlus: Direct LabourPlus: Direct ExpensesPlus: Overheads (based on recovery rate)Equals: Actual Costs of Production

The previous formula is known as normal costing. The actual costs of production are necessary to calculate the cost of sales, hence, the profits of the organization.

Opening StockPlus: Production CostsLess: Closing StockEquals: Cost of Sales

Yet, the final process of absorbing the overhead costs into unit and batch costs aren’t based on actual costs incurred during the course of the business. Absorption costing is based on a predetermined absorption rate, which is established from a budget for a forthcoming period.This could be illustrated using the following example. Suppose that a company makes two products, A and B, each respectively taking 2 and 5 hours to make. If the total estimated overheads are $50,000 and the estimated labour hours would be 100,000 hours, what would the absorption rate be?

Calculation Result


Absorption Rate 50/100 $0.5 per labour hourOverhead absorbed per unit A 2 x 0.5 $1 per unitOverhead absorbed per unit B 5 x 0.5 $2.50 per unit

The results obtained above mean that whatever the cost of producing one unit of A or B is, the overhead absorbed per unit should be added to it. Suppose further that the direct labour, materials and expenses are $12 per unit, and we produce 1000 units of A and 2000 units of B during a the year. We have no opening stock, and no closingstock, we simply sold all the stock of A and B produced during the year for $30 per unit. What would the Profit and loss account look like?Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Overheads ‘A’ 1 x 1000 1000Overheads ‘B’ 2.5 x 2000 5000 (42000)Gross Profit 48,000

In the previous example we assumed that a separate absorption rate is used for each product, and this could be similarly applied to other cost centers and cost units.However, the predetermined absorption rate may not always be distinguishable for each product. Sometimes, a blanket absorption rate is used, in which a single absorption rate is used throughout a factory and for all job units of output irrespective of the department in which they were produced.The result of using a blanket absorption rate may drastically affect the costing of products and units or services manufactured or offered to customers. This can be illustrated by slightly modifying the previous example:Previously we said that the overhead absorption rate of A is $1 per unit, and $2.5 per unit of B. These are separate valuations. Suppose now, that we alternatively use a blanket absorption rate, calculated as follows:Total Overheads: 50,000Total Labour Hours: 100,000Absorption Rate: 50/100 = $0.50 per labour hour.Total Units Produced = 3000Taking 7 hours to make a unit of both A and B, thus Total Labour Hours is 21000,(7*3000).Production Overheads = 21*0.5 = $10, 500Therefore:Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Production Overheads 21000 x 0.5 10500 46500Gross Profit 43,500

As you could easily see, the gross profit changed dramatically, from 48,000 to a mere 43,500.Furthermore, one may still be confused as I have whilst trying to understand why I have divided 50/100 to calculate the absorption rater per labour hour, and then multiply that with the total labour hours taken to produce 3000 units, which


resulted in a total cost of 10,500. Especially since we didn’t do that when we used separate absorption rate, because we calculated the absorption rate per unit at the time.I have done what I have done because I believe the costs associated with producing unit of ‘A’ are different to those taken producing unit of ‘B’, because each takes a different number of hours to produce. Therefore, it is essential to absorb the costs the way I have.Another reason for the discrepancy may be due to what is known as over/under absorption. The problem is that normal costing (refer to the formula on the first page!) is based on overheads absorbed at a predetermined rate, which is based on budgets and estimates, rather than what is actually incurred. This would lead to either one of the following:1. Over Absorption – overheads charged to the cost of sales are greater than the overheads actually incurred.2. Under Absorption – insufficient overheads have been included in the cost of sales.

To solve this problem, an adjustment to reconcile the overheads charged to the actual overheads incurred is necessary, in which the under/over absorbed overheads will bewritten as an adjustment to the profit and loss account, at the end of the accounting period.

At the moment, the budget for the previous example says that the production overheads should be 46,500, but what if at the end of the year, we find that the actual costs incurred, weren’t 46,500 but only $30,000. This means that we over-charged our cost of sales by $16,500. This is referred to as over-absorption.To correct this problem we simply add the bold line below to the cost of sales account:Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Production Overheads 21000 x 0.5 10500Under / Over absorption 46500 - 30000 (16500) 30000Gross Profit 43,500

Remember over-absorption is due to overcharging the cost of sales, as such; we have to deduct it from the cost of sales, whereas under-absorption is the opposite.


Paper 1.3 Preparing Financial StatementsChapter 01 Organizations Chapter 02 The role of management Chapter 03 The role of the manager Chapter 04 Individual and group behaviour Chapter 05 Team management Chapter 06 Objective settingChapter 07 Authority, responsibility and delegation Chapter 08 Standard setting and performance management Chapter 09 Recruitment and selection Chapter 10 Selection

Paper 1.3Chapter 1Organizations

How they are defined and classified, their differences and why we need them.Basically an organization is a group of individuals operating together in a systematic way to achieve a set of objectives. Therefore, the three characteristics of an organization are:1. People2. Purpose3. Structure

Organizations may also be defined as a machine. It receives inputs from its environment in the form of resources and converts them into outputs, which satisfy demand.Inputs -> Organization Processes -> OutputsWhy are organizations needed?

Organizations enable objectives to be achieved that could not be achieved by the efforts of individuals on their own, therefore they exist to:1. Overcome people’s individual limitations


2. Enable people to specialize3. Save time4. Enable people to pool their expertise5. They are power centres – organization may be able to influence events on a large scale by influencing demand, winning orders and creating wealth.6. Enable synergy: i.e. 1+1=3! By bringing together two individuals their combined output will exceed their output if they continued working separately.

How do organizations differ?The differences between organizations are so large that it may be quite impossible to list them all; yet, one may classify their differences into the following categories:

1. Structure: Formal or Informal?2. Classification by size: e.g. number of employees, volume of output3. Classification by profit motive: Profit or non-profit oriented4. Classification by legal form: sole traders, partnerships or limited companies5. Ownership: Public vs. private?

Formal and informal organizationsThe difference between formal and informal organizations is in the way they are structured. An organisation structure is the grouping of people into departments or section and the allocation of responsibility and authority. As such the structure affects the communication process within the organization.Within a formal organization, a hierarchical structure exists, reflecting communication flowing downwards from top management to the departments further down the organisation.

Schein defines a formal organization as ‘the planned co-ordination of the activities of a number of people for the achievement of some common, explicit purpose or goal, through division of labour and function, and through a hierarchy of authority and responsibility.’

Within an informal organization however, communication tends to be horizontal, between individuals and departments, rather than the upwards or downward flow. This is known as the Matrix Structure, whereby levels of power or authority are difficult to define and the person taking the lead at any one time will vary.Furthermore, within a formal organization, an informal organization may exist, as it arises from the interaction of people working together.


Paper 1.3Chapter 2

The role of managementClassical theories

Scientific• Planning• Standerdising• Improving human effort at the operative level• To maximize output with minimum input

AdministrativeFayol divides the activities into six main groups:• Technical – production, manufacturing• Commercially – buying, selling, exchange• Financial – obtaining and using capital• Security – protection of people and property• Accounting – stocktaking, costing, statistics, balance sheet• Managerial – planning, organizing, commanding, coordinating and controlling

Fayol’s fourteen rules of management conduct are:1. division of work 2. Authority 3. Discipline 4. unity of command 5. unity of directors6. subordination to the 7. Remuneration 8. Centralization 9. scalar chain 10. order general interest 11. Equity 12. tenure of personnel 13. Initiative 14. esprit de corps

Bureaucratic• Rational – legal authority• Traditional – based upon custom & practice• Charismatic – the individual has some special personal quality

Rosemary Steward summarises the four main features of bureaucracy as:• Specialisation


• Hierarchy of authority• System of rules• Impersonality

She explains the high growth of bureaucracy as due to:• Increasing size of the organisation• Greater complexity• Scientific management stresses rationale and prescribed processes• Demands for equality of treatment

The change!

Elton Mayo’s Hawthorne experiment brought about the human relations movement, which emphasizes social factors at work, groups, leadership, the organisation and the behaviour of people.Modern writers contribution to management

BehaviouralismThis is concerned with the personal adjustment of the individual within the work organisation and the effects of group relationships and leadership styles, such as Maslow (hierarchy of needs) and McGregor (theory X and theory Y).

Contingency approachIt adapts management behaviour to suit the particular circumstances. It could therefore result in an approach being formed which has features at several different schools of organisational thought. (T Burns and G.M Stalker – page 16)

Systems approachViews an organisation as a social system consisting of individuals who co-operate within a formal framework, drawing resources from their environment and putting back into that environment their products or services. (Handy – page 17/18)

Peter DruckerHe identified five basic operations in the work of a manager:• Set objectives• Organize• Motivate and communicate• Establish yardsticks• Develop people

Ouchi’s theory ZWithin a formal hierarchy there is an emphasis on interpersonal skills and building trust through informal democratic relationships.Peters and Waterman’s Seven-S’s formula:• Structure• Strategy• Systems• Style of management• Skills• Staff• Shared values

MintzbergHe says that an organisation is more complicated than a simple hierarchical structure,it consists of several components, which he refers to as ‘building blocks of an organisation’.


Paper 1.3Chapter 3The role of the manager

What is management?Peter Drucker ‘management is tasks. Management is a discipline. But management is also people’.

McFarland defines management as ‘the process by which responsible persons in an organisation combine resources in achieving given ends’.Therefore, management is needed to reach objectives, maintain a balance between conflicting goals and to achieve efficiency and effectiveness.Following from the above, an effective manager could be defined as ‘one who achieves the results required by the organisation in an efficient manner to motivate staff’.

In conclusion, management may be looked at from the point of view of:• Function: what is responsible for directing & running of an org• Process: the management of various activities and resources• Discipline: management as a science and art• Profession – occupational status providing a definite services after advanced training and education.

Furthermore, managerial work may be classified by activity or level of operation.

ActivityA functional manager will generally specialize in one major area of organizational activities such as finance, and a general manager is responsible for all the functional activities within an enterprise, division, etc. Level of operation

This refers to top managers, senior managers, middle managers, and supervisory managers.The role of the manager in the organisation of workFayol: to forecast and plan, to organize, to command, to control and to co-ordinate

Brech: Planning, organizing, commanding, coordinating, controlling, leading, motivating, creating, communicating and staffing.

Mintzberg: Interpersonal roles: figurehead, leader, liaison,Information roles: monitor, disseminator, spokesperson Decision making roles: entrepreneur, disturbance handler,resource allocator and negotiator


Paper 1.3Chapter 4Individual and group behaviour

Explain the concept of organisational culture:What are cultures?• It is the way we do things, the way we work• Beliefs, attitudes, values, norms of behaviour, practices shared by members

Strong culturesWe find: core values, intensity held, widely shared, innovative & dynamic operating company.

Weak cultures:We find: lack of unity & commitment

According to Handy there are:• Power cultures: 1 man, 1 king• Role culture: where people describe their jobs by its duties not its purpose• Task culture: tasks and results• Person culture: to satisfy requirements of particular individuals involved.

Discuss the differences between individual and group behaviour• Behaviour is a way of acting: Cause->Needs------(Behaviour)----->Goal

Factors affecting Individual behaviour:• Psychological factors: Motivation, perception, attitudes and personality• Personality traits: Authoritarianism, dominance, introverts and extroverts

Factors affecting Group behaviour:• Group norms• Synergy• Cohesive groups: atmosphere, participation, commitment, communication, leadership and progress• Teamwork

Understand perception and role theory• Role theory is concerned with the roles that individuals adopt. A role is the expected pattern of behaviour associated with members occupying a particular position with the structure of the organisation.


• As such, the perception of other people and interactions with other people will be influenced by the different roleso Role ambiguity – people unsure of what role they are to playo Role conflict – individuals find a clash between the different roles they’ve adoptedo Role incompatibility – other people’s role expectations different than that having the roleo Role signs – e.g. uniform, visible indications of the roleo Role behaviour – type of behaviour associated with the role

Paper 1.3Chapter 5Team management

Objectives:• Define the purpose of a team• Explain the role of the manager in building the team and developing individuals• Outline the composition of successful teams: Beblin – Peters and Waterman• Explain the development of a team: Tuckman• List team building tools• Examine ways of rewarding a team• Identify methods of evaluating team performance

Define the purpose of a team• A team is any group of people who must significantly relate with each other in order to accomplish shared objectives• A team is a formal group, the purpose of a team is to solve complex problems because a team is more than the sum of its individual team members• The key difference between groups and teams is their behaviour.• In a team, we find:o More openness and trusto Feelings are expressed freelyo There are common objectiveso Process issues are part of worko Conflict is worked out; ando Commitment is very high

Explain the role of the manager in building the team and developing individuals• This process can be:o Inward looking: team members evaluating themselveso Outward looking – team leader sets out to focus the team’s efforts on real and existing problems

• Team building is needed where any of the following are negatively affected:


o Efficiencyo Effectivenesso Performance

• The role of the manager in developing a team is to satisfy (Adair’s action-centered leadership model):o Task needs: the purpose and completion of the task must be fulfilled by Setting objectives Planning tasks Allocation of responsibilities Setting performance standards

o Group needs: the manager must maintain spirit and morale by: Communication Team building Motivation Discipline

o Individual needs: managers must try to motivate and satisfy each individual’s needs by: Coaching Counseling Development Motivation

• According to Woodcock you must first identify the blockages to team-building and then decide on the building blocks to be used by:o Identifying blockages to an effective teamo Identifying the building blockso Putting ideas into action

• Teambuilding is the process of removing obstacles that prevent the team from working effectively and planning how to improve overall team performanceOutline the composition of successful teams: a) Beblin b) Peters and Waterman

a) According to Beblin:• The composition of successful teams depends upon the balance of individual skills and personality types within the team• There are eight different personality types and the absence of one of these functions can mean a reduction in effectiveness of the team• The eight types are:o Leader – coordinating the teamo Shaper – committed to the task, aggressive, challengingo Plant – thoughtfulo Monitor-evaluator – criticizes others’ ideas, brings group down to eartho Resources- investigator – picks up others’ ideas and adds to themo Company worker – forms general ideas into specificso Team worker – supportive, diffuses potential conflicto Finisher – makes sure timetables are met.


• A person may hold one or more of these personality types.b) According to Peters and Waterman:• The key aspects of successful teams are:o Small numberso Time-limited durationo Voluntary membershipo Information communicationo Orientation towards action

Explain the development of a team: Tuckman

According to Tuckman group development goes through four stages, and may reach a fifth stage called dorming, as follows:• Forming – the group just started, individuals are defining their purpose and how they’ll operate.• Storming – this is a conflict stage, where perceptions are challenged, members compete for their chosen roles• Norming – the establishment of the ‘norms’, how the group will take decisions, behaviour patterns, etc.• Performing – at this stage the group will operate at its full potential• Dorming – where a group operates for a long time it may reach a stage where it loses its ability to make good decisions, and a process called ‘Groupthink’ occurs. At his stage, team building may be required.

List teambuilding tools:• Identify difficulties and/or blockages• Use the following teambuilding:o Eventso Activities; ando Exercises

To help group members change individual behaviour and improve team performance

Rewarding a team• Companies are increasingly attempting to relate pay to performance, where group or team incentive schemes offer a bonus to the team where they have achieved or exceeded targets.• This may be done in the following way:o Long-term and large group incentive plans: By tying the performance of the entire company to individual groups or teamso Value added schemes – if the team’s performance exceeds expected returns, the team may share the surplus profits

Identify methods of evaluating team performance• These involve measures on:o Effectivenesso Efficiencyo Team-member satisfaction

• The company may focus on:o The quantity of work performedo The quality of work performed


o Work performed vs. time allowed

• When objective measures of evaluation are not available, subjective evaluation based on the following may be made:o Observe and rate team behaviour against a set of agreed criteriao Interview all who may have a view about the team’s performanceo Administer a pre-prepared questionnaire to team members and their managers.

Paper 1.3Chapter 6Objective setting

IntroductionOrganisations are more than a set of departments, functions or activities; they involve people taking part in various aspects of the organisation, and most importantly, the objective setting process.Objectives are specific targets that the organisation is committed to achieve. For objectives to be successful they must be Specific, Measurable, Attainable and Timely, this is often known as SMART.Objectives are set at various levels of an organisation, and must importantly at its strategic level, as it defines the direction the organisation is moving in. Objectives set at both the tactical and operational levels must therefore conform to the overall strategic objective. This is the reasoning behind John Humble Management by Objectives. (See below).

The importance of objective setting:• Planning• Monitoring• Controlling• Decision making

The objective setting process• At a strategic levelo Setting mission & visiono Setting goals and objectiveso Setting overall strategy• At a tactical levelo Monitoring and control• At an operational levelo Task oriented

Behavioral theories of objective setting:• Cyert & March, believedo Organisations make decisions based on very small proportions of the total informationo The decision process concerns three characteristics of the organisation: Organisation goals Expectations


Choiceo The decision process has our additional features explaining how decisions are arrived at, which are: Quasi-resolution of conflict – org mixture of conflicting interest Uncertainty Problematic search Organisation learning

Ethics and social responsibilityCompanies are now developing a social conscious and new factors such as pollution control, conservation of natural resources, environmental disfigurement and accepting employee pressure, all add to the responsibility faced by companies.Corporate objectives vs. personal objectivesCorporate objectives are often based on financial terms, such as sales, profits and growth. But organisations are made up of groups of people, and those have personal objectives such as the fulfillment of their needs and aspirations. This creates a conflict of needs, which falls under the Consensus theory by Cyert & March. As such, there are a number of possible relationships between organisation objectives and individual objectives, such as:• Totally opposing• Partially opposing• Neutral• Compatible• Identical

Management role in identifying performance standards and accountability• MBO: management by objectives:o Establish objectives to enable individuals to determine their contribution to the corporate objective as well as their personal ones This is developed by John Humble, and it’s a system for:• Implementing strategic plans• Improving management performance• Providing criteria for performance appraisal• Management responsibility: different objectives for each manager, middle vs. lower-level managers.

Advantages of objective setting• Commitment• Results• Establish & control network• Clear task/job description• Measure output – align short term and long term objectives• Monitor mgt’s effectiveness• Measure the output of groups & teams

Disadvantages• Too result focused• Too focused on short-term objectives that we lose sight of our long term objectives• Communication problems• Conflict between corporate & personal objectives• Management slow to change short term objectives


Paper 1.3Chapter 7Authority, responsibility and delegation

Objectives:• Describe, recognise and understand the importance of organizational structure• Compare and contrast classical and modern approaches to organizational structure:o Burns and Stalkso Contingency theoryo Fayolo Mintzbergo Trist and Bamfortho Urwicho Webero Woodward• Define the terms authority, responsibility and delegation• Explain the term legitimized power: Weber• Describe the process of determining authority and responsibility• Examine the case of responsibility without authority

Describe, recognise and understand the importance of organizational structureDescribe and recognise• Organisational structure means grouping people into departments or sections and allocating responsibility and authority• The structure can be presented in organisation charts, by position and job descriptions and by rules and procedures• It is also concerned with patterns of authority, communication and workflow• The organizational structure will determine the direction of responsibility and the rela6ti8onship between line, functional and staff organisation• A structure may be analysed by reference to the level at which decisions are made.o Centralised: the upper level of an org hierarchy retain the authorityo Decentralised: the authority to take decisions is passed down to units and people at lower levels in the organisation’s hierarchyo The choice between the two will depend on the preference of the organisation’s top management and the size and scale of the organisation’s activities the importance of the organizational structure

Entrepreneurial structure• Reflects the position of the owner-manager who makes all key decisions• All power and authority resides in one person• It has the benefits of quick decision making and short lines of communication• The success depends on the abilities of the owner/manager


Functional structure• It is the most widely used• Specialization and the division of labour is based on the type of activities taken by the staff• The organisation may usually be divided into selling, production and finance departments/functions• The benefits of this structure are:o Employee’s work can be much more effectively controlled and coordinatedo Specialized departments can provide clear promotional and staff development.

Product-oriented structure• A variety of specialists grouped in a department that focuses on a product or product range.• The main functions of production, sales, people and finance are apportioned to the relative products• Such an organisation allows considerable delegation by top management and clear profit accountability by division heads.• The benefits are:o The focus of attention is on product performance and profitabilityo Encourages growth and diversity of productso A number of skills and abilities are combined together on the development of a particular product.• BUT:o Its difficult to maintain centralization of services such as accounting and R&D economicallyo Success is dependant on the ability of the people in charge of the product

Geographical structure• Divides the enterprise into regions or countries• The geographic unit can itself be organized by function or product• The benefits are:o The organisation can identify and respond quickly to local opportunitieso The profitability for each region can be clearly identified and managedo The interaction with local communities

Matrix structures• Is a structure where employees from various departments form a group to achieve a specific target, they usually have dual reporting roles.• It combines a job based group with a project based structure• Provides greater flexibility and coordination of tasks and people• Team members become customer oriented• Motivational, requires employees’ participation and control

Compare and contrast classical and modern approaches to organizational structure:Classical writers looked at structure in terms of division of work, chain of command, span of control and reporting relationships:• They focused on the requirements of the formal organisation and the search of a common set of principles applicable to all circumstances.• The organisation structure was designed for the most efficient allocation and coordination of activities• The position in the structure, not people, had the authority and responsibility of setting tasks done.

Fayol – the functional organisation• People are placed into formal groups which may be further sub-divided by sections and departments.• Formal groups will vary in the degree of cohesion and size, but all will have a common purpose and a set of rules, which govern relationships.

Lyndal Urwich – the 8 classical management principles1. Scalar concepta. Hierarchy of clearly defined posts


b. Authority moves from top to bottom

2. Unity of commanda. Orders are received from one person~!

3. Exception principlea. Delegation maximizedb. Decisions taken at the lowest possible level

4. Span of control concepta. Optimum number of sub-ordinates per hierarchical superior

5. Scientific methoda. Observationb. Hypothesizingc. Experimentationd. The formulation of laws should be used in arriving at decisions

6. Specialisation

7. Principle of the objectivea. Every part of the org to be needed for the purpose of the org

8. Principle of correspondencea. In every position, authority and responsibility should correspond

Weber – the bureaucratic model• Great emphasis on formal relationships• Discouraging upward communication to the superior• Orders are given and obeyed!• Clearly defined duties and responsibilities for all org members• Hierarchically arranged staff• Elaborate system of rules• Staff motivated by sense of duty and career prospects• No regards to personal, family or emotional commitments

Trist & Bamforth – Socio-technical systems approach• Emphasized the interrelationships of subsystems and multiple channels of interaction• Individuals are outlived by the system, therefore the mgt should concentrate attention on improving the system• People can adapt to a new system

The Contingency approach• May be seen as a development of the system’s approach in restating the environment and other variables to specific structures of the organisation• Due to the large number of variables that influence operations, flexibility and acceptance of change are more than necessary within an organisation• This reflects the need for co-ordination, often by the use of matrix systems

Joan Woodward

• Organisational patterns were found to be more related to similarity of objectives and production techniques than to size, type of industry or to the business success of the firm.o e.g. unit of production -> flatter structures


o e.g. process production -> taller and narrower pyramids

Burns & Stalker – Mechanistic and organisation structures• Organisational structures could be placed in a continuum, from mechanistic (based on order, clear definitions, stability and rigidity) to organic (flexibility).• Mechanistic, appropriate for stable environment, with the ability to resist pressure to change• Organic, unstable ones, with a high level of change, requiring a responsive organisational structure• Ability to respond promptly and appropriately to change.

Mintzberg – structure exists to coordinate activities of different people and work pressures.• Nature of coordination changes with size of organisations• There are six configurations which determine the importance and the relativesize of the organisation’s building blocks:o Simple structure – entrepreneurial org Simple structure Flexible Able to cope with dynamic environmento Machine bureaucracy – no speedy reaction to changeo Professional bureaucracy – focus on org’s operating coreo Divisionalised form – powerful middle managers E.g. medical staff in hospitalo Adhocracy Complex Disorderly Informal structure Best used for dynamic environmento Missionary organisations Formed on a basis of a common set of benefits Valued shared by all workers in the org Unwilling to compromise or change. The org can only prosper in simple, static environments

Define the terms authority, responsibility and delegation

Authority & Power – according to Fayol• Authority is the right to exercise powers such as hiring and firing or buying and selling on behalf of the organisation• Power can be defined as the ability to influence the action of others• Authority in an org is the right in a position to exercise direction in making decisions affecting others. Therefore it is one type of power. Yet it is possible to have authority without power (weak supervisor) or power without authority (strong individual)• Authority can arise from any of three main sourceso Formal – org bestows authority – e.g. job titleo Technical – due to personal skills or expertiseo Personal informal – not recognized in org chart as it exists because person is accepted and respected

Responsibility• The obligation placed on a person who occupies a certain position• ‘liable to be called to account, answerable’• It is an obligation owed• Superior cannot escape responsibility for actions of subordinates, and subordinates have a responsibility back to their superior

Delegation• Fayol explains it as ‘The act by which a person or group of persons possessing authority transfers part of that


authority to subordinate person or group’• Delegation is an important aspect of org and effective management. Without it, formal org could not exist, because the person with the authority is the only one who could make decisions• It is needed for the followingo Lack of time or energyo Need for specialistso Need for training of future managers• Principles of delegationo Authority must be understood by both partieso Mgr responsibility to make sure employee has the ability to do the worko Resources to do the work are available

Explain the term ‘Legitimised Power’, according to Weber

• Legitimised power is based on agreement and commonly held values, which allow one person to have power over another person• It normally arises from position and derives from our cultural system of rights, obligations and duties in which a ‘position’ is accepted by people as being legitimate.• Weber identified three grounds on which legitimate authority could exist:o Charisma – the individual has some special quality of personalityo Traditional – authority based upon custom and practiceo Rational-legal (classic bureaucracy) It is rational because its goal is to achieve certain objectives with max efficiency It is legal because authority is recognized by a system of rules and procedures.

Describe the process of determining authority & responsibility• The process of determining authority and responsibility may be distinguished on the bases of power, which are:o Legitimateo Reward – Gives X power over Y because X can mediate rewardso Coercive – through the mediation of punishmentso Referent – where a person wants to be like anothero Expert – where X perceives Y has an expert knowledge on things• The process may also be described by the way in which a manager or supervisor would delegate the authority:o Determine results expectedo Allocate duties to subordinateso Grant them authority to enable those duties to be carried outo Holds them responsibility for the completion of the work and achievement of results• An organisation chart may be used!

Examine the case of responsibility without authority• Responsibility must be3 supported by authority and by the power to influence the areas of performance for which the subordinate is to be held responsible• The principle of correspondence states that in any position, authority and responsibility should correspond• Therefore, a person who has authority without responsibility is unaccountable• Difficulties can arise when an individual has responsibility for some aspect of work but lacks authority associated with it.


Paper 1.3Chapter 8

Standard setting and performance management

Objectives• Define the term performance management• Identify a process for establishing work standards and performance management• Outline a method to establish performance indicators• Illustrate ways of applying performance management• Describe management contribution to personal development planning• Explain the term ‘performance related pay’

Define the term performance managementPerformance management is a means of getting better results by understanding and managing performance within an agreed framework of planned goals, standard and competence requirements.

• It is an ongoing communication process that involves both the performance manager and the employee in:o Identifying and describing essential job functionso Developing realistic and appropriate performance standardso Giving and receiving feedbacko Performance evaluationso Planning education and development

Identify a process for establishing work standards and performance management The performance management process provides an opportunity for the employee and performance manager to create a plan for achieving development goals:

• Strategic plans and annual goalso Job description and essential functions Standard of performance• Performance observation and feedbacko Performance development plan

It must also consider the emerging environment with five main areas:1. Economy2. government3. social4. technology5. competition

Outline a method to establish performance indicators


• Standards should be written in clear and understandable languageo Describing the specific behaviours and actions required for work performanceo They should also be: Consistent Realistic Specific Measurable Challenging Dynamico The org reporting system should be able to measure and report any quantitative data applicable and an acceptable margin for error should be specifiedo The standards should be developed using the collaborative approach where possible as oppose to the directive approach

Illustrate ways of applying performance management• Performance related pay:o Measuring the performance of individuals and rewarding them accordingly, yet it will motivate only if the prospective payment is significantly large in relation to the normal income of that person.o These include incentives such as: Piecework or payment by results Measured day work Commission Productivity plans Profit sharingo Obviously such rewards cannot be set without establishing the standards and criteria for work performance• Performance evaluation – it is a process of:o Assessingo Summarizing; ando Developing the work performance of employees• Performance development plan – it is a process of developing the employee’s work related skills, knowledge and experience

The above should enable the org to:• Get better results• Continuous communication between the employees and the managemento Hence getting feedback to evaluate plan/set standards/solve problems• Constructive, enabling the employees to make decisions

Describe the management’s contribution to personal development planning• Assessment: assess needs of employee and orgo Set career goals, which are consistent with the employee’s: Skills, knowledge, experience and interests• Providing information: informing employee about far and possible barriers to career movement• Referral – referring employees to others who assist them• Guidance – encouraging them to focus on clear and specific and attainable career goals• Development – delegating responsibilities, training and other learning and development opportunities.


Paper 1.3Chapter 9, 10, 11 & 12Recruitment and selection

Objectives• The importance of recruitment and selection• Who is involved in recruitment and selection• The recruitment process• Job analysis• Job description• Person specification• Advertising the position

The importance of recruitment and selection• The overall aim of the recruitment and selection process in an organisation is to obtain the quantity and quality of employees required to fulfill the objectives of the organisation. • Recruitment is the process of selecting a supply of possible candidates for a position within the enterprise.• Selection is the choosing from a number of candidates the one most suitable for a specified position.• The importance is due to the belief that employees are a scarce resource to be used properly for the following reasons:

o Organisations need to deploy skills in order to succeedo Obtaining the right candidate for the right position in accordance with the overall business strategyo Reducing turnover, idle time, training and other costs.

Who is involved in recruitment and selection, and what are their responsibilities?• Senior managers – involved in recruiting senior personnelo Although they are responsible for human resource planning, they will not be directlyinvolved for most positions

• Personnel/human resource departmento Assessing needs for human resourceso Maintaining records of people employedo Keeping in touch with trends in the labour marketo Advertising for new employeeso Ensuring the organisation complies with equal opportunities and other legislationo Designing application formso Liaising with recruitment consultantso Preliminary interviews and selection testing.


• Line managers:o Small orgs: soul responsibility for recruitmento Larger organisations:

Asking for more human resourcesAdvising on requirementsHaving a final say on candidates presented in the personnel department, perhaps at a final interview.

• Recruitment consultantso Analyzing, or being informed of, the requirements, such as

The demands of the postThe org’s preferences for qualifications, personality and so on

o Helping to draw up, or offering advice onJob descriptionsPerson specifications

o Designing job advertisementso Screening applicantso Helping with short-listing for interviewo Advising on the constitution and procedures of the interviewo Offering a list of suitable candidates with notes and recommendationso Should we use consultants? Consider:

Costs, level of expertise and knowledge available both in-house and externallyNeed for impartialityTimeSupply of labourStructure and politics of the organisation

The recruitment process• Recruitment begins with identifying vacancies, from the requirements of the man power plan or by a job requisition from a department, branch or office that has a vacancy• Job analysis – by analyzing the sort of work that needs to be done:o Job descriptiono Person specification

• Attracting a field of candidates and persuade them to apply• Sorting candidates – find out if candidates have required knowledge, skills and aptitudes• Selection interviews – make actual choice• Induction – ensure new recruit starts with enthusiasm and settles down quickly

BUT, BEWARE:• The recruitment process is part of a wider whole through detailed human resource planning


• Detailed procedures should be devised in order to make recruitment activity systematic and consistent throughout the org.• Applicants who feel they have been unfairly treated or recruits who leave because they have been misled are NOT GOOD!

Job analysis• Job analysis involves defining as precisely as possible the job requirements and the type of person required• The information obtained from job analysis includes:o Purpose, content and accountabilities of the jobo Performance criteria and responsibilityo Org and development and environmental factors:

AuthorityPromotion pathsWorking conditions

• It has to be done systematicallyo Obtain documentary info about the job and ask the mgrs and job holders about ito Observe the job holders to see what they actually do

• It is not easy to carry out a job analysis, and it often requires a number of methods:o Questionnaires or checklists to save timeo Interviews to give a better idea of the detailo Self description to show how people perceive their jobso Diaries and logs for management jobs in which a lot is going on

• Job analysis and the job description resulting from it, may be used by managers ino Recruitment and selection – for a detailed description of vacancyo Appraisal – did the employee fulfill requirementso Devising training programmeso Establishing rates of payo Eliminating risks

Job descriptions• A job description is the result of job analysis and it covers:o Purposeo Duties; ando Relationships of the job and:PhysicalSocial; andEconomical factors that affect it.


Paper 1.3Chapter 13 & 14

Selection

Objectives

• The selection process in outline• Application forms• Selection methods in outline• Interviews• Tests• Other selection methods• Which selection method is best• Evaluating and improving recruitment and selection practices

The selection process in outline• Deal with responses to job advertisements.• Assess each application against key criteria in the job advertisement and specification• Sort applications, from which a shortlist for interviews may be drawn up• Interview them• Reinforce interviews with selection testing• Review un-interviewed ‘possibles’ and archive them for future reference• Send standard letters to unsuccessful candidates ‘Sorry…’ and potential candidates ‘should any vacancy arise’• Make a provisional offer to the recruit

Application formsJob advertisement usually ask candidates to fill in a job application form, or to send a CV along with a covering letter briefly explaining why they think they are qualified to do the job.

Application forms are used to:• Obtain all essential information• Eliminates unsuitable candidates• Identify possible candidates• It gives information about the candidates’:o Underlying personalityo Neatnesso Literacyo The ability to communicate in writing

Although there may be some design faults in application forms they still have:• The merit of being standerdised, so all candidates are asked the same information• It may form the basis for a biodata questionnaire (Biodata is the term given to techniques which aim to score and structure biographical information about a candidate in order to predict work performance)


Selection methods in outline• Interviewingo One to oneo Interview panelso Selection boardso Assessment centers

• Biodata selection testso Intelligenceo Aptitudeso Personalityo Proficiency• Work sampling• Group selection methods

InterviewsInterviews are conducted to find the best person for the job by assessing the applicants’ interpersonal communication skills.• It could be used to make sure applicants understand what the job and career prospects are• Provides the best impression and suitable information about the company• Assess appearance, verbal ability and social skills of the applicant• Opportunity for the candidate to learn about the job and organisation

Types of interviews:• Individual and one-to-one interviews:o Advantages Direct face to face communication Rapport between candidate and the interviewero Disadvantages Candidate may be able to disguise lack of knowledge in a specialist area of which the interviewer knows little The interviewer’s perception may be selective or distorted Rapport could cause a weakening of the interviewer’s objective judgment

• Successive interviewso Those are based on a series of face-to-face interviews. Although this is more costly and can be more wearing on the candidate, it may enable a more balanced judgment to be made.

• Panel interviewso Advantages A number of people see candidates and share info about them at a single meeting, thus the advantage of sharing judgmentso Disadvantages Thro of candidates, not allowed to expand on answers One member may influence the judgment of others Research shows that members rarely agree

Limitations of interviews

• Scopeo An interview is too briefo It is an artificial situation, candidates may be on their best behaviour or too nervous• The halo effect


o A tendency for people to make an initial general judgment about a person based on a single obvious attribute• Contagious biaso The interviewer changes behaviour of applicant by suggestion• Stereotypingo It assumes some people share certain characteristics• Incorrect assessmento Qualitative factors such as motivation, honesty or integrity are very difficult to assess in an interview• Inexperienced interviewers• Lack of preparation by interviewer

The remedy:• Careful choice of:o Openo Probingo Problem solving; ando Closed questions• Avoiding multiple and leading questions• Candidates should be allowed and given the opportunity to ask questions and they should be listened to carefully• Candidates should be given the opportunity to learn about the organisation• The interview room, manner and tone, and physiological effects of the interview

TestsAlong with the interview, the group of potential employees may be required to sit some tests. Types of test commonly used in practice are:• Intelligence test• Aptitude tests – potential for perform a job• Personality tests• Proficiency tests – ability to do work involved• Medical examinations

Tests must be sensitive, standardised, reliable and validLimitations include• No direct relationship between ability to do the test and the ability to do the job• The interpretation of the test results• Needs constant revision – no cheating!• People can guess ‘the right answer’• Could be misleadingEvaluating and improving recruitment and selection practices• Ineffective recruitment may arise from many factors:o Inadequate job analysiso Unattractive terms; oro Failure in the media chosen to attract candidates• Ineffective selection may arise from:o Poor job analysiso Bad interviewingo Inadequate advertisingo Ignorance of the jobo Lack of a validation system• Recruitment and selection practices can be reviewed in these ways:o Performance indicators – assess each stageo Cost effectivenesso Monitoring the workforce


o Attitude surveyso Actual performance• Improving the effectiveness of recruitment and selectiono Specifying more carefully what is expected from employeeo Employing a variety of methods of selection rather than just interv

Paper 2.1 Information Systems

Chapter 01 I/S and Business Strategy Chapter 02 Impact of IT Chapter 03 I/S Function, and Org' Issues (1) Chapter 04 I/S Function, and Org' Issues (2) Chapter 05 Feasibility Studies Chapter 06 Project Manager & Stakeholders Chapter 07 Project Phases and Mgt Tools Chapter 08 I/S Development Process Chapter 09 Systems analysis; user requirements Chapter 10 External Design Chapter 11 Software sources and selection Chapter 12 Quality assurance and testing Chapter 13 Implementing systems Chapter 14 Security and legal compliance Chapter 15 Post-implementation issues

Paper 2.1 Chapter 1 Business Strategy and IS/IT AlignmentInformation Systems

Study Guide Objectives• Explain an approach that an organisation may follow to formulate its strategic business objectives• Discuss how information systems may be used to assist in achieving these objectives• Identify current trends in information technology and the opportunities they offer to organisations• Distinguish between a business strategy and an information systems strategy• Identify responsibility for the ownership of the IS strategy Organisational Information Requirements

Organisations require information for the following purposes:1. Planning – knowledge of all available resources, timescales, outcome on alternative scenarios2. Controlling – are things proceeding as planned or not?3. recording transactions – as evidence, legal requirement, for control purposes4. performance measurement – comparisons against budget, plan or competitors


5. decision making – self-explanatory

Quality of information1. Accurate – figures should add up, the degree of rounding should be appropriate, there should be no typos, items should be allocated to the correct category, assumptions should be stated for uncertain information.2. Complete – information should include everything that it needs to include, relevant and comparitve3. Cost-beneficial – it should not cost more to obtain the information than the benefit derived4. User-targeted – needs of the user should be in mind, manager or clerk?5. Relevant – information that is not needed for a decision should be omitted6. Authoritative – basically, reliable!7. Timely – available when needed8. Easy – information should be clearly presented, not excessively long, and sent through the right medium of communication.

Strategic PlanningStrategy can be defined as ‘a course of action including the specification of resources required, to achieve a specific outcome’.Strategic planning is the formulation, evaluation and selection of strategies for the purpose of preparing a long-term plan of action to attain objectives. Strategic information is therefore used to plan the objectives of the organisation, and to assess whether the objectives are being met in practice. Such information includes overall profitability, the profitability of different segments of the business, future market prospects, the availability and cost of raising new funds, total cash needs, total manning levels and capital equipment needs.

Strategic information is:• Derived from both internal and external sources• Summarised at a high level• Relevant to the long term• Concerned with the whole organisation• Often prepared on an ‘ad hoc’ basis• Both quanittative and qualitative• Uncertain, requiring assumptions to be made regarding the future

Tactical information is used to decide how the resources of the business should be employed, and to monitor how they are being and have been employed. Such information includes productivity measurements (output per hour) budgetary control or variance analysis reports, and cashflow forecasts,staffing legvesl and profit resuls within a particular department of the organisation,labour turnover statistics within a department and short-term purchasing requirements.

Tactical information is:• Primarily generated internally (but may have a limited external component)• Summarised at a relatively low level• Relevant to the short- and medium- terms• Concerned with activities or departments• Prepared routinely and regularly• Based on quantitative measures

Operational information is used to ensure that specific operational tasks are planned and carried out as intended.

Operational information is:• Derived from internal sources• Detailed, being the processing of raw data• Relevant to the immediate term• Task-specific• Prepared very frequently


• Largely quantitative

Business strategy and information systems strategyISS is a long-term plan to use Information systems and information technology. Its purpose is to support business strategies, create new strategic plans and to gain a competitive advantage through information and technology.

The information systems include all systems and procedures for collection, storage, production and distribution.Basically, the IS strategy describes the IT strategy used. IT is basically the equipment used to capture, store, transmit or present information.The point is to formulate a strategy of gathering the information needed to give us competitive advantage over our competitors, collection the right information at the right time will also help us with our controls, etc. (As has been discussed above).

Developing an IS/IT strategyThree factors must first be considered:1. Corporate Plan2. Management view of the role of IS/IT in organisation3. Maturity of use of IS

Now that these things are considered, the strategy should be developed with the aim of ensuring IS/IT is utilised as efficiently and effectively as possible in the pursuit of organisational goals and objectives.Basically, it should tell us where we are, where we want to be and how do we get there.


Paper 2.1 – Information SystemsChapter 2The impact of information technology

Study Guide Objectives• Identify current trends in information technology and the opportunities they offer to organisations• Describe the typical hardware, software, data and communications infrastructures found within information systems functions

1. In many circumstances, manual systems are less productive than computerised systems.2. Computers can be classified as supercomupters, mainframes, minicomputers and PCS.3. The amount of RAM and the processor speed are key determinants of computer performance. Hard drive size is another important factor4. Four types of software are: Operating system, utilities, off-the-shelf applications and Bespoke applications5. Data can be collected from within and beyond an organisation. Information systems are used to convert this data into information and to communicat it to management at all levels6. A system receives inputs which it propcess and generates into outputs. Any system can be thought of in terms of inputs, procesing and outputs7. The channel of communication will impact on the effectiveness of the communication process. The characteristics of the message will determine what communication tool is best for a given situation.8. Different types of information systems exist with different characteristics – reflecting the different roles they perform9. The main network architectures are client-server and peer-to-peer. Client-server systems aim to ensure best utilisation of computing resources.10. Many organisations are now utilising the internet as a means of gather and disseminating information, and conducting transactions.

Technological Change

Technological change can affect the activities of organisations as follows:1. The type of products or services that are made and sold2. The way in which products are made3. The way in which services are provided4. The way in which markets are identified5. The way in which employees are mobilised

The benefits might therefore be:1. to cut production costs2. to develop better quality products and services3. to develop new products and services4. to provide products or services to customers more quickly or effectivley5. to free staff from repetitive work and to tap their creativity

Organisations that operate in an environment where the pace of technological change is very fast must be flexibel enough to adapt to change quickly and must plan for change and innovation. Technological change can be planned for by developing strategies for improved productivity and for innovation.

It is argued that success or failure in implementing IT is a result not so much of the systems themselves but the


management effort behind them. For example, information systems will fail for any of the followinreasons:1. they are used to tackle the wrong problem2. senior management are not interested3. users are ignored in design and development4. no attention is given to behavioural factors in design and operation

Types of information systems – specifally covered in Paper 3.4 – but might be useful to know1. Executive Support Systems (ESS) – it pools data from internal and external sources and makes information availabe to senior managers in an easy-to-use form. Makes them make strategic, unstructured decisions.2. Management Information Systems (MIS) – these convert data from internal scources into information, summaries, reports, and it enables managers to make timely and effective decisions for planning, directing and controlling the activites for which they are responsible.3. Decision-Support Systems (DSS) – combine data and analytical models or data analysis tools to support semi-structured and unstructured decision making4. Knowledge Work Systems (KWS) – these facilitate the creation and integration of new knowledge into an organisation, such as CAD, CAM and specialised financial software that analyses trading transactiosn.5. Office Automation Systems (OAS) – designed to increase productivity of data and information workers e.g. excel6. Transaction Processing Systems(TPS) – performs and records routine transactions and tasks. E.g. bookeeping system.


Paper 2.1 – Information SystemsChapter 3The Information System Function: Organizational Issues

1. Information Systems DepartmentMost organizations choose to have an information systems department, or team responsible for the tasks and responsibilities associated with information systems. Information systems increasingly utilize information technology.At the head of the information systems function will be either the IS/IT manager, or theIS/IT director.

The head will have responsibility for:1. IS/IT Strategy Development – the strategy must compliment the overall strategy of the organization. The strategy must also be achievable given budgetary constraints. Returns on investments in IS/IT should be monitored.2. IS/IT Risk Management – this is a wide ranging area including legal risks, such as ensuring compliance with relevant data protection legislation, ensuring adequate IS/IT security measures and disaster recovery arrangements3. Steering Committee – the IS/IT directory should play a key role in a steering committee set up to oversee the role of IS/IT within the organization.4. IS/IT infrastructure – standards should be set for the purchase and use of hardware and software within the organization5. Ensuring employees have the IS/IT support and tools they require – Efficient links are required between IS/IT staff and the rest of the organization. Technical assistance should be easily obtainable.The director, therefore, requires a wide range of skills. The ideal person would possess technical know-how, excellent general management ability, a keen sense of business awareness and a good understanding of the organisations’ operations.

IS/IT Steering committeeThe general propose of an IS/IT steering committee would be to make decisions relating to the future use and development of IS/IT by the organization. The steering committee should contain representatives from all departments of the organization.Common tasks for such a committee could include:

• ensuring IS/IT activities comply with IS/IT strategy• Ensuring IS/IT activities compliment the overall organization strategy• Ensuring resources committed to IS/IT are used effectively• Monitoring IS/IT projects• Providing leadership and guidance on IS/IT

Committee members should be chosen with the aim of ensuring the committee contains the wide range of technical and business knowledge required. The committee should liaise closely with those affected by the decisions it will make.

Database administratorA key information systems role is that of database administrator. A database administrator is responsible for all data and information held within an organisation. Key tasks include:• preparing and maintaining a record of all data held within the organisation (the data dictionary)• co-coordinating data and information use to avoid duplication and maximize efficiency• analyzing the data requirements of new applications• implementing and controlling procedures to protect data integrity• recording data ownership

Operations Control


Operations control is concerned with ensuring IS/IT systems are working and available to users. Key tasks include:• maintaining the IS/IT infrastructure• Monitoring network usage and managing network resources• Keeping employees informed, e.g. advance warning of service interruptions• Virus protection measures e.g. ensuring anti-virus software updates are loaded• Fault fixing

Systems development staffIn medium to large organisations it is likely that the IS department will include staff with programming and systems analysis skills. Key tasks for staff involved in systems development include:• Systems analysis• Systems design and specification• Systems testing• Systems evaluation and review

Data processing staffThis has become less common nowadays, since most of the departments do their own data processing, rather than batching up the documents to be sent to a centralized data processing department.

Information Centre staff• An information centre is a small unit of staff with a good technical awareness of computer systems, whose task is to provide a support function to computer users within the organisation.These are very useful in organisations which use distributed systems and so are likely to have hardware, data and software scattered throughout the organisation.

They provide:• Help – telephone, helpdesk, email, searchable knowledge or a person• Problem Solving – they will maintain a record of common problems, provide training when needed.• Improvements – to software and hardware• Standards – setting and encouraging users to conform to common standardso Hardware standards – compatibilityo Software – sharedo Programming – follow best practice and easy to modifyo Data processing – format of file names, etc.• Security – backups and protection against viruses• End-user application development - basically this is a task to make sure that applications are developed with the end-user in mind, through providing documentation and a user-friendly environment.Summary:Basically, an information systems department should ensure that the IS/IT strategy follows and supports the overall corporate strategy. Its director would have responsibility for various areas such strategy development, risk management, infrastructure, and should play a key role in the steering committee.The steering committee is made up of representatives from various departments to influence the role and activities of the IS department according to their needs and strategies.

The IS department should also include the roles of a database administrator, operations control, systems development and data processing.In larger organizations an Information centre, with good technical awareness may be needed to support the computer users within the organisation, providing a more intensive role in comparison operations control. It is more directed to the end-user rather than the system itself.

Centralisation and 2. DecentralisationThe IS/IT department could be structured in two main options – centralized or decentralized. A centralized IS/IT department involves all IS/IT staff and functions being based out at a single central location, such as head office.A decentralized IS/IT department involves IS/IT staff and functions being spread out throughout the organization.


There is no single ‘best’ structure for an IS/IT department – an organisation should consider its IS/IT requirements and the merits of each structure.

Advantages of a centralized IS/IT department1. Assuming centralized processing is used, there is only one set of files. Everyone uses the same data and information.2. It gives better security/control over data and files. It is easier to enforce standards.3. Head office is in a better position to know what is going on4. There may be economies of scale available in purchasing computer equipment and supplies5. Computer staff are in a single location, and more expert staff are likely to be employed. Career paths may be more clearly defined.

Disadvantages of a centralized IS/IT department1. local offices might have to wait for IS/IT services and assistance2. Reliance on head office. Local offices are less self-sufficient3. a system fault at head office will impact across the organisation

Advantages of a decentralized IS/IT department1. Each office can introduce an information system specially tailored for its individuals’ needs. Local changes in business requirements can be taken into account2. each office is more self-sufficient3. Offices are likely to have quicker access to IS/IT support/advice.4. A decentralized structure is more likely to facilitate accurate IS/IT cost/overhead allocations.

Disadvantages of a decentralized IS/IT department1. control may be more difficult – different and uncoordinated information systems may be introduced2. self-sufficiency may encourage a lack of co-ordination between departments3. increased risk of data duplication, with different offices holding the same data on their own separate files

Other Organisational Issues1. Organisation structure – the structure of the organisation and the structure of the department are related issues. Organisations that disperse decision making power to local offices will require an effective local management information system2. Constant change – a reliance on IS/IT commits an organisation to continual change.3. Interoperability – this refers to the ability for systems to share and exchange information and facilities with other systems regardless of the technology platform or service provider. This implies an ability to cope with a variety of datastructures, and the easy transfer of skills between applications and technologies4. Backward compatibility5. Legacy system – old computerized system that continues to be used, because the costs and benefits of replacing it may take significant time and effort.6. Open systems – ensure compatibility between different systems. An open systems infrastructure supports organisation-wide functions and allows interoperability of networks and systems. Authorized users are able to access applications and data from any port of the system.

Accounting IssuesProviding and maintaining information systems to deliver good quality information involve significant expenditure. The costs incurred are summarized in the following table.Capital Costs Revenue costs (one-off) Revenue costs (ongoing) capital cost• hardware purchase• cabling• system installation

Revenue costs (one-off)• system development--costs, programming,analyst, testing, fileconversion, etc• initial training costs


• redundancy costs attributable to the new system

Revenue costs (ongoing)• IS/IT staff costs• Communication andtransmission costs• Power• Maintenance and support• Ongoing training• Consumables, paper,printer ink, floppydisks, CDs, etc.

File conversion issues are common when replacing legacy systems (old systems):1. establishing the formats of data files held on the legacy system2. assessing the data held for accuracy and completeness3. automated file conversion procedures may not be applicable due to system compatibility and data issues4. Ensuring transferred data is available in the required format for all applications that access it.

The organisation must account for the costs incurred providing and maintaining information systems. The IS charging system should encourage the efficient use of IS/IT resources. There are three broad possibilities when accounting for costs related to information systems.• IS costs are treated as an administration overhead• IS costs are charged out at cost• IS costs are charged out at market value

Information technology as an administrative overhead(For small and less technological organisations)

Under this system IS/IT costs are treated as a general administrative expense, and are not allocated to user departments.

Advantages1. simple and cheap to administer, as there is no charge out system to operate2. may encourage innovation and experimentation as user-departments are more likely to demand better quality systems if they will not bear any cost3. The relationship between IS staff and user departments is not subject to conflict over costs.

Disadvantages1. User departments may make unreasonable (and economically unjustifiable)demands2. Any inefficiencies within the IS/IT department are less likely to be exposed – as user departments will not be monitoring cost levels3. User departments may accept sub-standard service, as it is ‘free’

Information technology charged out at costA cost-based charge out involves IS/IT costs being allocated to user departments. Costs may be allocated according to methods such as: cost per transaction processed; cost per page; cost per hour of programmer’s and/or analyst’s time; cost

per number of terminals/workstations; cost per unit of CPU time.

Advantages1. simpler than charging at market value – the amount recharged is the total IS/ITcosts incurred2. User departments are encouraged to consider the cost of their usage of IT services3. Encourages efficiency within the IS/IT department as excessive recharges are likely to result in complaints from other departments

Disadvantages


1. Inefficiencies in the IS/IT department are merely passed on to users. This could be avoided if the department is only permitted to recharge budgeted or standard costs.2. the basis for recharging must be realistic – or users will feel that costs recharged are unfair which could lead to conflict3. it may be difficult to choose a realistic basis to allocate the costs• Under both the central overhead approach and the charge-out-at-cost approach the IS function is treated as a cost centre. This can influence the way in which information systems and technology are viewed within an organisation – it encourages the view that they are a drain on resources rather than tools in the quest for competitive advantage.

Market-based charge out methodsUnder market-based methods, the IS/IT department acts as a profit centre. It sets its own prices and charges for its services with the aim of making a profit.

Advantages1. User departments have the right to demand external standards of service. If the service provided by the IT department is sub-standard, it should be given the chance to improve – with the ultimate sanction of users choosing an outsidesupplier2. It encourages an entrepreneurial attitude. IT managers are in charge of a department that could make a profit – this should help motivation3. Efficiency and innovation within the IS/IT department is encouraged, as the more efficient the department is, and the more services users buy, the greater the profit will be. Bonuses for IT staff could be based on departmental profit4. A true picture of user departments financial performance is able to be obtained –as the IS/IT cost charged to each department are based on market-rates.

Disadvantages1. It can be difficult to decide on the charge out rate, particularly if there is no comparable service provider outside the organisation.2. If users feel rates are excessive, they may reduce their usage to below optimal levels, and relationships between the IS/IT department and user departments may become strained.3. Even if the service provided is poor, it may not be in the organisation’s interest for user departments to buy from outsiders: the IS function’s fixed costs still have to be covered, and there may result an under-use of resources available within the organisation. Given the choice of going outside, means that if the services are poor, departments will go outside. There if each department deals with different suppliers the organisation will find it difficult to implement a coherent ISS plan.

Establishing the IS/IT function as a separate company.Establishing the IS/IT department as a profit centre can be taken a step further – the IS/IT function could become a separate legal entity.User departments with the ‘main’ company would purchase IS/IT services from the separate IS/IT company, and ideally should be free to charge suppliers if service or value levels are sub-standard.The new IS/IT company can also offer its services to other organisations – with the aim of making profit.

Additional advantages include:1. the opportunity for increased revenue and profit2. increased career opportunities for IS/IT staff3. Opportunities for economies of scale if the company grows

Additional disadvantages include:1. IS/IT staff may lose touch with the main company operations2. increased administration required for the additional company3. the standard of service provided to the main company may suffer, as the focus switches to new clients4. setting appropriate prices for new clients may be difficult – tasks may not be similar to those undertake within the original companySummary:Although there is no single ‘best’ structure for an IS/IT department, the organisation’s requirements and strategies will


determine the choice between a centralized and a decentralized structure. The structure itself will determine the way in which costs are charged, how activities and functions are organized, and how the actual strategy is implemented.Constant change, interoperability, compatibility and the general organisation structure are further influences that affect the way in which the IS/IT department operates.The way in which costs are charged, as an administrative overhead, departmental costs or as a profit-centre are further influences that may affect the standard of service, inter-departmental conflict, or the opportunities for increased revenues and profit.Paper 2.1 – Information SystemsChapter 4The Information System Function: Organisational Issues

3. OutsourcingOutsourcing is the contracting out of specified operations or services to an external vendor.There are four broad classifications of outsourcing, as described in the following table:Classification CommentAd-hoc The organisation has a short-term requirement for increased IS/IT skills. An example would be employing programmers on a short-term contract to help with the programming of bespoke software (tailormade)

Project ManagementThe development and installation of a particular IS/IT project is outsourced. For example, a new accounting system. (This approach is also called system integration.)Partial Some IT/IS services are outsourced. Examples include hardware maintenance, network management or ongoing website managementTotal An external supplier provides the vast majority of an organisation’s IT/IS services; e.g. third party owns or is responsible for IT equipment, software and staff.Levels of service provision (to what extent?!)The degree to which the provision and management of IS/IT services are transferred to the third party varies according to the situation and the skills of both organisations.a) Time-share – the vendor charges for access to an external processing system on a time-used basis. Software ownership may be with either the vendor or the client organisation. E.g. internetb) Service bureaux – usually focus on a specific functi8on. Traditionally bureau would provide the same type of service to many organisations e.g. payroll processing. As organisations have developed their own IT infrastructure, the use of bureaux has decreased.

c) Facilities management (FM) – In the context of IS/IT, facilities management involves an outside agency managing the organisation’s IS/IT facilities.

Organisations involved in outsourcingFacilities management companiesAll equipment usually remains with the client, but the responsibility for providing and managing the specified services rests with the FM company. FM companies operating in the IK include Accenture and Cap Gemini.

Software HousesSoftware houses concentrate on the provision of ‘software services’. These services include feasibility studies, systems analysis and design, development of operating systems software, provision of application program packages, ‘tailor-made- application programming, specialist systems advice, and so on. For example, a software house might be employed to write a computerized system for the London Stock Exchange.Consultancy firms Some consultancy firms work at a fairly high level, giving advice to management on the general approach to solving problems and on the types of system to use.


Others specialize in giving more particular systems advice, carrying out feasibility studies and recommending computer manufacturers/software houses that will supply the right system. When a consultancy firm is used, the terms of the contract should be agreed at the outset.The use of consultancy services enables management to learn directly or indirectly from the experience of others.The following categories of consulting activity have been identified by Beaumont and Suterland

a) strategic studies – involving the development of a business strategy or an IS strategy for an organisationb) Specialist studies – where the consultant provides a high level of expertise in one area.c) Project management – involving supervision of internal and external parties in the completion of a particular projectd) Body-shopping – where the necessary staff, including consultants, project managers, systems analysts and programmers, for a project are identifiede) Recruitment – involving the supply of permanent or temporary staff Hardware manufacturers and suppliers Computer manufacturers or their designated suppliers will provide the equipment necessary for a system. They will also provide, under a maintenance contract, engineers who will deal with any routine servicing and with any breakdown of the equipment.

Developments in outsourcingOutsourcing arrangements are becoming increasingly flexible to cope with the everchanging nature of the modern business environment. Three trends are:1. Multiple sourcing – this involves outsourcing different functions or areas of theIS/IT function to a range of suppliers. Some suppliers may form alliances to present a stronger case for selection.2. Incremental approach – organisations progressively outsource selected areas of there IS/IT function. Possible problems with outsourced services are solved before progressing to the next stage.3. Joint venture sourcing – this term is used to describe an organisation entering into a joint venture with a supplier. The costs (risks) and possible rewards are split on an agreed basis. Such an arrangement may be suitable when developing software that could be sold to other organisations4. Application Service Providers (ASP) – these are third parties that manage and distribute software services and solutions to customers across a Wide Area Network.ASPs could be considered the modern equivalent of the traditional computer bureaux.

Managing outsourcing arrangementsManaging outsourcing arrangements involves deciding what will be outsourced, choosing and negotiating with suppliers and managing the supplier relationship.When considering whether to outsource a particular service the following questions are relevant.

a) Is the system of strategic importance? Strategic IS are generally not suited to outsourcing as they require a high degree of specific business knowledge that a third party IT specialist can not be expected to possessb) Can the system be relatively isolated? Functions that have only limited interfaces are most easily outsourced, e.g. payrollc) Do we know enough about the system to manage the outsourced service agreement? If an organisation knows very little about a technology it may be difficult to know what constitutes good service and value for money. It may be necessary to recruit additional expertise to manage the relationship with the other party.d) Are our requirements likely to change? Organisations should avoid tying themselves into a long-term outsourcing agreement if requirements are likely to change!A key factor when choosing and negotiating with external vendors is the contract offered and subsequently negotiated with the supplier. The contract is sometimes referred to as the Service Level Contract (SLC) or Service Level Agreement


(SLA).After a supplier has been selected, and the contract negotiated and signed, the contract provides the framework for the relationship between the organisation and the services provider.The nature of the relationship between the organisation and the service provider will depend on the service that has been outsourced and the preferences and personalities of the people involved.

If full facilities management is involved and almost all management responsibility for IT/IS lies with the entity providing the service, then a closer relationship between the parties is necessary (a ‘partnership’). Factors such as organisation culture need to be considered when entering into such a close and critical relationship On the other hand, if a relatively simple function such as payroll were outsourced, such a close relationship with the supplier would not be necessary. A ‘typical’ supplier-customer relationship is all that is required. (Although issues such as confidentiality need to be considered with payroll data.)Regardless of the type of relationship, a legally binding contract is the key element in establishing the obligations and responsibilities of all parties.

The contract elements include:1. Timescale2. Service level3. Exit route4. Software ownership5. Dependencies – if related services are outsourced the level of service quality agreed should group these services together.6. Employment issues

Advantages of outsourcing arrangements1. Outsourcing can remove uncertainty about cost, as there is often a long-term contract where services are specified in advance for a fixed price. If computing services are inefficient, the costs will be borne by the FM company. This is alsoan incentive to the third party to provide a high quality service.2. Long-term contracts (maybe up to ten years) encourage planning for the future.3. Outsourcing can bring the benefits of economies of scale. For example, a FMcompany may conduct research into new technologies that benefits a number of their clients.4. A specialist organisation is able to retain skills and knowledge. Many organizations would not have a sufficiently well-developed IT department to offer IT staff opportunities for career development. Talented staff would leave to pursue their careers elsewhere.5. New skills and knowledge become available. A specialist company can share staff with specific expertise between several clients. This allows the outsourcing company to take advantage of new developments without the need to recruit new people or re-train existing staff, and without the cost.6. Flexibility (contract permitting). Resources may be able to be scaled up or down depending upon demand. For instance, during a major changeover from one system to another the number of IT staff needed may be twice as large as it will be once the new system is working satisfactorily.

An outsourcing organisation is more able to arrange its work on a project basis,whereby some staff will expect to be moved periodically from one project to the next.Disadvantages of outsourcing arrangements1. It is arguable that information and its provision is an inherent part of the business and of management. Unlike office cleaning, or catering, an organization’s IT services may be too important to be contracted out. Information is at the heart of management.


2. a company may have highly confidential information and to let outsiders hand itcould be seen as risky in commercial and/or legal terms3. If a third party is handling IS/IT services there is no onus upon internal management to keep up with new developments or to suggest new ideas.Consequently, opportunities to gain competitive advantage may be missed.Any new technology or application devised by the third party is likely to be available to competitors.4. An organisation may find itself locked in to an unsatisfactory contract. The decision may be very difficult to reverse. If the service provider supplies unsatisfactory levels of service, the effort and expense the organisation would incur to rebuild its own computing function or to move to another provider could be substantial.5. The use of an outside organisation does not encourage awareness of the potential costs and benefits of IS/IT within the organisation. If managers cannot manage in-house IS/IT resources effectively, then it could be argued that they will not be able to manage an arrangement to outsource effectively either.InsourcingOutsourcing involves purchasing information technology expertise from outside the organisation. Several factors have led some to believe this is not the best solution in today’s environment.1. many organizations have found there is a shortage of qualified candidates with the skills they require2. The cost of acquiring people with high-tech expertise and business skills, whether employing or outsourcing, fluctuates due to factors affecting supply and demand.3. There is increasing recognition that to do a good job, IT professionals must understand the business principles behind the systems that they develop and manage Insourcing involves recruiting IS/IT staff internally, from other areas of the business, and teaching these business-savvy employees about technology. The logic behind the idea is that it is easier (and cheaper) to teach technical skills to business people than to teach business skills to technical people.

Advantages include the potential to:1. create a better quality workforce that combines both technical and business skills2. reduce costs3. improve relationships and communication between IT staff and other departments4. increase staff retention – through providing an additional career path

Disadvantages1. the risk that non-technical employees will not pick up the IS/IT skills required2. finding staff willing to make the change3. replacing staff who do make the switch


Paper 2.1 – Information SystemsChapter 5Feasibility Studies

• Explain the purpose and objectives of a feasibility study• Evaluate the technical, operational, social and economic feasibility of the proposed project• Describe and categorize the benefits and costs of the proposed project• Apply appropriate investment appraisal techniques to determine the economic feasibility of a project• Define the typical content and structure of a feasibility study report

A feasibility studyA feasibility study is a formal study to decide what type of system can be developed which best meets the needs of the organisation.

This involves a feasibility study team:a) they should be drawn from the departments affected by the projectb) at least one person should have a detailed knowledge of the organisationc) it is possible to hire consultants to carry out the study, but the knowledge about the organisation may adversely affect the usefulness of their proposalsd) the steering committee must ensure that they possess suitable personal qualities, e.g. the ability to be objectively criticale) All members of the study group should ideally have some knowledge of information technology and systems design. They should also be encouraged to read as widely as possible and take an active interest in current innovations.

With larger projects it may well be worthwhile for a small firm to employ a professional systems analyst and then appoint a management team to work with the analyst.Why is it important to carry out a feasibility study before undertaking an information systems project?

The reason being is that a new or amended system may:a) be complicated and costlyb) Disrupt operations during development and implementation (e.g. staff and management time).c) Have far reaching consequences in a way an organisation conducts future businessd) Impact on organisation strategy and structure.

Therefore, a planned approach is needed when identifying and selecting new information systems projects and the following actions should be considered:1. IS projects almost always utilise IT. This means that an IT strategy should form a core part of the overall corporate strategy and should be developed/updated whenever the organization’s strategy is reviewed or as otherwise necessary.2. Because IT is critical, it requires adequate representation at senior management level. It is no longer suitable for IT to be under the control of the MD, FD or computer center manager. It really needs a separate Board level person responsible, such as an Information Director or an IS director. This will help to ensure that IT is given adequate consideration at


strategic level.3. The IT development can no longer function as a subsystem of accounting, administration or finance. It should be given separate departmental or functional status in the organisation with its own reporting lines and responsibilities.4. Once the IT department has been set up, its funding must be considered. A simplistic approach would be to treat it as an overhead; this is simple but inefficient. There are various approaches possible to the recovery of IT costs from user departments, and the IT department may even operate as a commercial concern providing services to third parties at a profit.5. A strategic plan for the use of IT should be developed. This should take in separate elements such as information technology and information systems. It should also acknowledge the importance of the organization’s information resource.6. If new computer systems are to be introduced regularly, the organisation may set up a steering committee to oversee systems development. A steering committee can also be set up for a one-off project. The role of the steering committee include approving or rejecting individual projects and where appropriate submitting projects to the Board for approval. The composition and determination of terms of references for the steering committee must be agreed (see below).7. The approach of the organisation to individual projects must be decided. Will it follow the traditional life cycle or will it use a methodology? Commercial methodologies impose discipline on the development process.8. Procedures for evaluating and monitoring performance both during and after a project need to be put into place. Many methodologies require formal sign-off of each stage, but this does not obviate the need for good project management or for post-implementation evaluation.9. Details of the systems development procedures must be agreed. If a commercial methodology is used, many of these procedures will be pre-determined. Areas to be considered include the approach to feasibility studies, methods of cost-benefit analysis, design specifications and conventions, development tools and techniques, reporting lines, contents of standard invitations to tender, drawing up of supplier conditions and procedures for testing and implementation.

Terms of reference ???The terms of reference for a feasibility study group may be set out by a steering committee, the information director or the board of directors, and might consist of:1. to investigate and report on an existing system, its procedures and costs2. to define the systems requirements3. to establish whether these requirements are being met by the existing system4. to establish whether they could be met by an alternative system5. to specify performance criteria for the system6. to recommend the most suitable system to meet the system’s objectives7. to prepare a detailed cost budget, within a specified budget limit8. to prepare a draft plan for implementation within a specified time-scale9. to establish whether the hoped-for benefits could be realized10. to establish a detailed design, implementation and operating budget11. to compare the detailed budget with the costs of the current system12. to set the date by which the study group must report back13. To decide which operational managers should be approached by the study group.

The remit of a feasibility study may be narrow or wide. The feasibility study team must engage in a substantial effort of fact finding. These facts may include matters relevant to the project, which are not necessarily of a data processing nature.

Problem definitionIn some circumstances the ‘problem’ may be quite exact, in others it maybe characterized as ‘soft’. The problem definition stage should result in the production of a set of documents which define the problem.


a) A set of diagrams representing, in overview:i) The current physical flows of data in the organisation (documents).ii) The activities underlying them (data flows).b) A description of all the people, jobs, activities and so on (entities) that make up the system, and their relationship to one another.c) The problems/requirements list established form the terms of reference and after consultation with users.

The problems/requirements listThe problems/requirements list or catalogue can cover, amongst other things, the following areas.a) the data input to the current systemb) the nature of the output informationc) methods of processingd) the expected growth of the organisation and so future volumes of processinge) the systems control in operationf) staffing arrangements and Organisational structureg) the operational costs of the systemh) type of system (batch, on-line)i) response timesj) current organizational problems

Option evaluationThis stage involves suggesting a number of options for a new system, evaluating them and recommending one for adoption. It concludes with a final feasibility study report.Step 1. Create the base constraints in terms of expenditure, implementation and design time, and system requirements, which any system should satisfy.a) operations – faster processing, larger volumes, greater security, accuracy, better quality, real-time as opposed to other forms of processingb) Information output – quality, frequency, presentation, e.g. GUIs, database for managers, EIS facilitiesc) Volume processingd) General system requirements – accuracy, security and controls, audit trail, flexibility, adaptabilitye) Compatibility/integration with existing systemsStep 2. Create outlines of project options, describing, in brief, each option. The number will vary depending on the complexity of the problem, or the size of the application, but is typically between three and six.Step 3. Assess the impact each proposal has on the work of the relevant user department and/or the organisation as a wholeStep 4. Review these proposals with users, who should indicate those options they favour for further analysis.

System justificationA new system should not be recommended unless it can be justified. The justification for a new system would have to come from:a) An evaluation of the costs and benefits of the proposed system, and/or b) Other performance criteria

Key Areas of FeasibilityThere are four key areas in which a project must be feasible if it is to be selected.• Technical feasibility• Operational feasibility


• Social feasibility• Economic feasibility

Technical feasibilityThe requirements, as defined in the feasibility study, must be technical achievable. This means that any proposed solution must be capable of being implemented using available hardware, software and other technology. Technical feasibility considerations could include the following:a) Volume of transactions which can be processed within a given timeb) Capacity to hold files or records of a certain sizec) Response times (how quickly the computer does what you ask it to)d) Number of users which can be supported without deterioration in other criteria

Operational feasibilityOperational feasibility is a key concern. If a solution makes technical sense but conflicts with the way the organisation does business; the solution is not feasible. Thus an organization might reject a solution because it forces a change in management responsibilities, status and chains of command, or does not suit regional reporting structures, or because the costs of redundancies, retraining and reorganization are considered too high.

Social feasibilityAn assessment of social feasibility will address a number of areas, including the following:• Personnel policies• Redrawing of job specifications• Threats to industrial relations• Expected skills requirements• Motivation

Economic feasibilityAny project will have economic cost and economic benefits. Economic feasibility has three strands.a) the benefits must justify the costsb) The project must be the ‘best’ option from those under consideration for its particular purpose.c) The project must compete with projects in other areas of the business for funds.Even if it is projected to produce a positive return and satisfies all relevant criteria, it may not be chosen because other business needs are perceived as more important.

The costs of a proposed systemIn general the best-cost estimates will be obtained for systems bought from an outside vendor who provides a cost quotation against a specification. Less concrete cost estimates are generally found with development projects where the work is performed by the organization’s own employees.

The costs of a new system will include costs in a number of different categories.

Cost ExampleEquipment costs • Computer and peripherals• The initial system suppliesInstallation costs • New buildings

• The computer room


Development costs These include costs of measuring and analyzing the existing system and costs of looking at the new system. They include software/consultancy work and systems analysis and programming. Changeover costs, particularly file conversion, may be very considerable.Personnel costs • Staff training• Staff recruitment/relocation• Staff salaries and pensions• Redundancy payments• OverheadsOperating costs • Consumable materials• Maintenance• Accommodation costs• Heating/power/insurance/telephone• Standby arrangements, in case the system breaks down

Capital and revenue costsThe distinction between capital costs and revenue costs is importanta) the costs-benefit analysis of a system ought to include cash flows and DCF b) The annual charge against profits shown in the financial accounts is of interest to stakeholders. Capital items will be capitalized and then depreciated, and revenue items will be expensed as incurred as a regular annual cost.

The benefits of a proposed systemThe benefits from a proposed new system must also be evaluated. These ought to consist of benefits of several types.a) Savings because the old system will no longer be operated. Savings may include:i) savings in staff costsii) savings in other operating costs, such as consumable materialsb) extra savings or revenue benefits because of the improvements or enhancements that the new system should bring:i) possible more sales revenue and so additional contributionii) better stock control (with a new stock control system) and so fewer stock losses from obsolescence and deteriorationiii) Further savings in staff time, resulting perhaps in reduced further staff growth.c) Possibly, some one-off revenue benefits from the sale of equipment which the existing system uses, but which will no longer be required. Second-hand computer equipment does not have a high value,however! It is also possible that the new system will use less office space, and so there will be benefits from selling or renting the spare accommodation.

Some benefits might be intangible, or impossible to give a money value to.a) Greater customer satisfaction, arising from a more prompt service (e.g. because of a computerized sales and delivery service).b) Improved staff morale from working with a ‘better’ system.c) Better decision making is hard to quantify, but may result from better MIS, DSS or EIS.

The Feasibility Study ReportOnce each area of feasibility has been investigated a number of possible projects may be put forward. The results of the study should be compiled into a report that makes a recommendation regarding future action (e.g. a new system, modify the existing system, or to remain with the status quo).A typical feasibility study report may include the following sections.• Terms of reference• Description of existing system• System requirements


• Details of the proposed system(s)• Cost/benefit analysis• Development and implementation plans• Recommendations as to the preferred option.

Paper 2.1 – Information SystemsChapter 6The Project Manager and Project Stakeholders

• Identify the roles and responsibilities of staff who will manage and participate in the project• Define in detail the role and responsibilities of the project manager• Explain the concept of a flat management structure and its application to project-based systems development.

What is a project?A project is ‘an undertaking that has a beginning and an end and is carried out to meet established goals within cost, schedule and quality objectives’. Common examples of projects include:• Producing a new product, service or object• Changing the structure of an organisation• Developing or modifying a new information system• Implementing a new information system

The following table show how projects are distinguished from operations Projects Operations Have a defined beginning and end On-going Have resources allocated specifically to them, although often on a shared basis Resources used ‘full-time’ Are intended to be done only once A mixture of many recurring tasks Follow a plan towards a clear intended end-result Goals and deadlines are more general Often cut across organisational and functional lines Usually follows the organisation or functional structure

What is project management?Project management is the combination of systems, techniques, and people used to control and monitor activities undertaken within the project. Project management co-ordinates the resources necessary to complete the project successfully.The objective of project management is a successful project. A project will be deemed successful if it is completed at the specified level of quality, on time and within budget.Quality – the end result should conform to the project specification. In other words, the result should achieve what the project was supposed to do.

Budget – the project should be completed without exceeding authorized expenditureTime-scale – The progress of the project must follow the planned process, so that the ‘result’ is ready for use at the agreed date. As time is money, proper time management can help contain costs.

Managing a project presents a variety of challenges. Some common challenges are outlined below:

1. Teambuilding – the work is carried out by a team of people often from varied work and social backgrounds. The team must ‘gel’ quickly and be able to communicate effectively with each other.2. Planning – Many possible problems may be avoided by careful design and planning prior to commencement of work3. Problem solving mechanisms – there should be mechanisms within the project to enable Unforeseen problems to be resolved quickly and efficiently.


4. Delayed benefit – there is normally no benefit from a project until the work is finished. This means that significant expenditure is being incurred for no immediate benefit5. Dealing with specialists – project managers often have to deal competently and realistically with specialists at differing stages of the project.6. Potential for conflict – projects often involve several parties with different interests. This may lead to conflict.

Project management ensures responsibilities are clearly defined and that resources are focussed on specific objectives. The project management process also provides a structure for communicating within and across organisational boundaries.All projects share similar features and follow a similar process. This has led to the development of project management tools an techniques that can be applied to all projects, no matter how diverse.

The Project ManagerThe person who takes ultimate responsibility for ensuring the desired result is achieved on time and within budget is the Project Manager.

The way in which a project manager co-ordinates a project from initiation to completion using project management and general management techniques, is known as the Project Management Process.The role a project manager performs is in many ways similar to those performed by other managers. There are however some important differences, as shown in the following table.

Project Manager Are often ‘generalists’ with wide-ranging backgrounds and experience levelsOperations manager Usually specialists in the areas managed project manager Oversee work in many functional areasoperations manager Relate closely to technical tasks in their area project manager Facilitate, rather than supervise team membersoperations manager Have direct technical supervision responsibilities

The duties of a project manager are summarised below.1. Outline planning – Project planning (e.g. targets, sequencing)a) developing project targets such as overall costs or timescale neededb) dividing the project into activities and placing these activities into the right sequence, often a complicated task if overlappingc) Developing a framework for the procedures and structures, manage the project (e.g. decide, in principle, to have weekly team meetings, performance reviews etc).2. Detailed planning – work breakdown structure, resource requirements, network analysis for scheduling3. Team building – build cohesion and team spirit4. Communication – the project manager must let superiors know what is going on, and ensure that members of the project team are properly briefed.5. Coordinating project activities – between the project team and users, and other external parties6. Monitoring and control – the project manager should estimate the causes for each departure from the standard, and take corrective measures.7. Problem-resolution – even with the best planning, unforeseen problems may arise8. Quality control – there is often a shortsighted trade-off between getting the project out on time and the project’s quality.

The responsibilities of a project manager


A) Responsibilities to management1. ensure resources are used efficiently – strike a balance between cost, time and results2. keep management informed with timely and accurate communications3. manage the project to the best of his or her ability4. behave ethically, and adhere to the organization’s policies5. maintain a customer orientation (whether the project is geared towards an internal or external customer) – customer satisfaction is a key indicator of project successB) Responsibilities to the project and project team1. take action to keep the project on target for successful completion2. ensure the project team has the resources required to perform tasks assigned3. help new team members integrate into the team4. Provide any support required when members leave the team either during the project or on completion.

The skills required of a project manager (what he has to be to fulfill these responsibilities!)

1. Leadership and teambuilding – enthusiastic, positive and realistic, understand the big-picture, delegate tasks appropriately, build team spirit through cooperation, not to be restrained by organisational structures.2. Organisational – ensure all documentation is clear and distributed to who require it, use project management tools, such as time sheets and performance sheets to analyze and monitor project progress.3. Communication – listen, persuade, and ensure management is kept informed and NEVER SURPRISED!4. Technical – providing, or provide access to technical expertise and experience needed to manage the project5. Personal – be flexible, show persistence, be creative and patient.

The Project TeamThe project team comprises the people who report directly or indirectly to the project manager.

Project success depends to a large extent on the team members selected. The ideal project team achieves project completion on time, within budget and to the required specifications – with the minimum amount of direct supervision from the project manager.The team will comprise individuals with differing skills and personalities. The project manager should choose a balanced team that takes advantage of each team member’s skills and compensates elsewhere for their weaknesses.

The project team will normally be drawn from existing staff, but highly recommended outsiders with special skills may be recruited. When building a team the project manager should ask the following questions.

a) What skills are required?b) Who has it!c) Are the people identified, available, affordable and able to join the project team?d) What level of supervision will be required?

If the project manager feels the best available team does not possess the skills and talent required the project should be abandoned or delayed. Would it be feasible to build a house without wood? Similarly,would it be feasible to do it with out construction men?

Once the team has been selected each member should be given a project briefing, outlining the overall aims of the project, and detailing the role they are expected to play.The following will enhance the performance of the project team.


1. effective communication2. All members being aware of the team’s purpose and the role of each team member3. Collaboration and creativity among team members4. Trusting, supportive atmosphere in group5. A commitment to meeting the agreed schedule6. Innovative/creative behaviour7. Team members highly interdependent, interface effectively8. Capacity for conflict resolution9. Results orientation10. High energy levels and enthusiasm11. An acceptance of change – miss-planning is one thing, but things never go as planned, so a team must be able to accept it!!

Collaboration and interaction between team members will help ensure the skills of all team members are utilised, and should result in ‘synergistic’ solutions. Formal (e.g. meetings) and informal channels (e.g. email links, a bulleting board) of communication should be set up to ensure this interaction takes place.

Team members should be responsible and accountable. The project manager should provide regular updates on project progress and timely feedback on team and individual performance.

Most effective project managers display the ability to:• Select the right people• Connect them to the right cause• Solve problems that arise• Evaluate progress towards objectives• Negotiate resolutions to conflicts• Heal wounds inflicted by change

A computerized information system project team

In this case a more horizontally structured team is ideal, because multi-talented individuals will adopt different roles at different times – rather than occupying a particular ‘status’.

Developing a computer system can be divided in to two parts:a) Designing a program that will do the data processing work that the user department wants, and to the user’s specification – this is the job of the systems analystb) Writing the software – this is the job of the programmer.

Systems analysts – their jobs are generally as follows:1. systems analysis – involves carrying out a methodical study of a current system (manual or computerized) to establish:a) what the current system doesb) whether it does what it is supposed to doc) what the user department would like it to do, and so what the required objectives the system are2. System design – having established what the proposed system objectives are, the next stage is to design a system that will achieve these objectives.3. Systems specification – in designing a new system, it is the task of the systems analyst to specify the system in detail this involves identification of inputs, files, processing, output, hardware, costs, accuracy, response times and controls.


4. The system design is spelled out formally in a document or manual called the systems specification (which includes a program specification for each program in the system).5. The analyst will be responsible for systems testing6. Once installed, the analyst will keep the system under review, and control system maintenance with the co-operation of user departments.

Controlling the project teamThe project manager is responsible for overall control of the project team.There are two types of control strategies related to supervision.a) Behaviour control – deals with the behaviour of team members. In other words, control is exercised through agreed procedures, policies and methodologies.b) Output control – is where management attention is focused on results, more than the way these were achieved.

Flat management structuresSpan of controlSpan of control or ‘span of management’, refers to the number of subordinates responsible to a person.

Classical theorists suggest:a) there are physical and mental limitations to a manager’s ability to control people, relationships and activitiesb) There should be tight managerial control from the top of an organisation downward. The span of control should be restricted to allow maximum control.

Project managers may control very large teams. On large projects management layers will be required between the overall project manager and team members. The appropriate span of control will depend on:a) Ability of the manager – a good organizer and communicator will be able to control a larger number.The manager’s workload is also relevant. (The more under his control, the less control he has!)b) Ability of the team members – the more experienced, able, trustworthy and well-trained subordinates are, the easier it is to control larger numbers.c) Nature of the task – it is easier for a supervisor to control a large number of people if they are all doing routine, repetitive or similar tasksd) The geographical dispersal of the subordinates, and the communication system of the organisation.

The span of control has implications for the ‘shape’ of a project team and of an organisation overall. An organisation with a narrow span of control will have more levels in its management hierarchy – the organisation will be narrow and tall. A tall structure reflects tighter supervision and control, and lengthy chains of command and communication.A team or organisation of the same size with a wide span of control will be wide and flat. The flat organisation reflects a greater degree of delegation – the more a manager delegates, the wider the span of control can be.The wide range of people and skills required to successfully complete a systems development project has led to the acceptance of flat management structures being the most appropriate for this process.The justification is that by empowering team members (or removing levels in hierarchies that restrict freedom), not only will the job be done more effectively but the people who do the job will get more out of it.Project team members must be flexible to be able to respond quickly to specific and varied customer demands. Team members must therefore be committed. Managing Conflict It is inevitable when people from wide-ranging backgrounds combine to form a project team that conflict will occasionally occur. Some conflicts may actually be positive, resulting fresh ideas and energy being input to the project. Other conflicts can be negative and have the potential to bring the project to a standstill.Ideally, conflict should be harnessed for productive ends, such as better thought out ideas, forces people to search for


new approaches, causes for persistent problems surface to be dealt with, people are forced to clarify their views and causes tension which stimulates interest and creativity.

Project StakeholdersProject stakeholders are the individuals and organisations who are involved in or may be affected by project activities.As well as the project manager, who may be seen as the director, the project team, which may be regarded as actors, in a movie, called ‘the project’, we have the following:1. Project Sponsor (the producers) – is accountable for the resources invested into the project and responsible for the achievement of the project’s business objectives. The sponsor may be owner, financier, client, etc.2. Project support team – is a term used to designate the personnel working on a project who do not report to the project manager administratively.3. Users – the individual or group that will utilise the end product4. Risk Manager – for large projects it may be necessary to appoint someone to control the process of identifying, classifying and quantifying the risks associated with the project.5. Quality manager – for large projects it may be necessary to appoint someone to write the quality plan and develop quality control procedures.

Project stakeholders should all be committed towards a common goal – successful project completion. The project plan should be the common point of reference that states priorities and provides cohesion.

However, individuals and groups that comprise the stakeholders will have different roles, and therefore are likely to have different points of view. There is therefore the potential for disagreements between stakeholder groups.

In practice, disputes are often resolved by the acceptance of the view of the party that has the most financial ‘clout’ in the project. In such a situation mediation and negotiation may only deliver an outcome which is a reflection of the original power imbalance.


Paper 2.1 – Information SystemsChapter 7

Project Phases and Management Tools

1. The project life cycle2. Management tools and techniques3. Project management software4. Documentation and reports5. Risk management6. Information systems projects – common problems

1. The project life cycleA successful project relies on two activities – planning first, and then doing. These two activities form the basis of every project.Projects can be divided into several phases to provide better management control. Collectively these phases comprise the Project Life Cycle.As seen in the diagram, resource use (such as funds and staff hours required) is relatively low at the start of the project, higher towards the end and then drops rapidly as the project draws to a close.The cost of making changes to the project increases the further into the life cycle the project has progressed.

Project phases and stagesThe phases of a project can be broken down into a number of stages. Again, the number of stages identified varies depending on type of project and the conventions of the organisation undertaking the project.

Definition phaseThe defining phase of a project is concerned with deciding whether a project should begin and committing to do so.- Initiation- Formation- Objective settingThe initiation stage describes the beginning of a project at which point certain management activities are required to ensure that the project is established with clear reference terms and an appropriate management structure.

At the start of a project, a Project Initiation Document (PID) may be drawn up, setting out the terms of reference for the project. Typical contents might include:a) Business objectives - so the project is in line with itb) Project objectives – in general termsc) Scope of the project – what it is intended to cover and what is notd) Constraints – budgets and deadlinese) Ultimate customerf) Resourcesg) Analysis of risksh) Project plan – preliminary targets, activities and so on.i) Purchasing and procurement policy – specifying acceptable suppliers and delivery details

The formation stage involves selecting the personnel who will be involved with the project. First to be selected is usually the Project Manager and the Project Board. The project manager should select and build the project team.The Objective Setting Stage initially starts by establishing general project goals before specific objectives are set.


Clear goals and objectives give team members quantifiable targets to aim for. This should improve motivation and performance, as attempting to achieve a challenging goal is more inspiring than simply being told ‘to do your best’.The overall project goal or project definition will be developed. In complex projects it is likely that the goal will require to be writing in stages, with each definition being more detailed and refined than before. The project goal might be defined in a:a) contractb) product specificationc) customer’s specification

Finally project objectives should be SMART:

• Specific• Measurable• Agreed upon• Realistic• Time-bound

Planning phaseThe planning phase of a project aims to devise a workable scheme to accomplish the overall project goal.

- Task planning- Feasibility- Fact finding- Position analysis- Options generation- Options evaluation- The task planning stage involves breaking down the project into manageable tasks.- Task is an individual until of work that is part of the total work needed to accomplish the project.- Activity is a set of tasks that are carried out in order to create a deliverable- Deliverable is another name for a required outcome (e.g. product, service, document, etc) from a project.

By breaking the project down into a series of manageable tasks it is easier to determine skills needed to complete the project. A task list should be produced showing what needs to be done and the work sequence necessary.

This process is often referred to as Work Breakdown Structure (WBS).WBS:- Identifies the work that must be done in the project- Determines the resources required- Sequences the work done, to allocate resources in the optimum way

The feasibility and fact finding stageOnce all the tasks have been defined a basic network diagram can be developed, together with a complete list of resources required.Fact finding may have been performed substantially during a pre-project feasibility study as covered in Chapter 4.Position analysis, options generation and options evaluation stagesOnce the current position has been clearly established options can be generated with the aim of utilizing the internal strengths identified.The general management technique of SWOT analysis can be applied to establish the current position, generate available options and evaluate those options.

Implementing phaseThe implementing phase is concerned with coordinating people and other resources to carry out the project plan.- Design and development- Implementation


The design and development stage is where the actual product, service or process that will be the end result of the project is worked on. The activities carried out in this stage will vary greatly depending on the type of project. For example, in a software implementation this is when the programming of the software would take place; in a construction project the building design would be finalized.The implementation stage starts after the process, service or product has been developed, as it will be implemented or installed so it is available to be used.If the project involves a new system or process, a period of parallel running alongside the existing system or process may be carried out. This enables results to be checked and any last-minute problems to be ironed out before the organisation is fully reliant on the new system or process.

Controlling and CompletingThe controlling phase is concerned with ensuring project objectives are met by monitoring and measuring progress and taking corrective action when necessary- Review- Completion

Actual performances should be reviewed against the objectives identified in the project plan. If performance is not as expected, control action will be necessary.Completion involves formalizing acceptance of the project and bringing it to an orderly end.Following installation and review there should be a meeting of the Project Board (at the completion stage) to:- Check that all products are complete and delivered- Check the status of any outstanding requests for change- Check all project issues have been cleared- Approve the project completion report- Arrange for a post-implementation review.

2. Management tools and techniques

Project BudgetThe project budget refers to the amount and distribution of resources allocated to a project.There are two main methods for establishing the project budget; top-down and bottom-up.Top-down budgeting describes the situation where the budget is imposed from above. Project managers are allocated a budget for the project based on an estimate made by senior management. The figure may prove realist, especially if similar projects have been undertaken recently. However the technique is often used simply because it is quick, or because only a certain level of funding is available.In bottom-up budgeting the project manager consults the project team, and others, to calculate a budget based on the tasks that make up the project. Work breakdown structure is a useful tool in this process.The budget may express all resources in monetary amounts, or may show money and other resources – such as staff hours. A monetary budget is often used to establish the current cost variance of the project. To establish this we need:a) Actual Cost of Work Performed (ACWP) – amount spent to date on projectb) Budgeted Cost of Work Scheduled (BCWS) – the amount that was scheduled to be spent to datec) Budgeted Cost of Work Performed (BCWP) – this figure is calculated by pricing the work that has actually been done – using the same basis as the scheduled work.

BCWP – ACWP = The cost variance for the project

BCWP – BCWS = The schedule variance for the project

During the project actual expenditure is tracked against budget on either a separate Budget Report, or as part of a regular Progress Report.

Gantt ChartsA Gantt chart is a horizontal bar chart used to plan the time scale for a project and to estimate the amount of resources


required.

The Gantt chart displays the time relationships between tasks in a project. Two lines are usually used to show the time allocated for each task, and the actual time taken.A simple Gantt charts and network analysis will often be used for project planning and resource allocation.

Network AnalysisNetwork analysis, also known as Critical Path Analysis (CPA), is a useful technique to help with planning and controlling large projects, such as construction projects, research and development projects and the computerisation of systems.Network analysis requires breaking down the project into tasks, arranging them into a logical sequence and estimating the duration of each.This enables the series of tasks that determines the minimum possible duration of the project to be found.These are the critical activities.CPA aims to ensure the progress of a project, so the project is completed in the minimum amount of time.It pinpoints the tasks which are on the critical path, i.e. those parts which, if delayed beyond the allotted time, would delay the completion of the project as a whole.The technique can also be used to assist in allocating resources such as labour and equipment.

Drawing the diagram or chart involves the following steps.1. Estimating the time needed to complete each individual activity or task that makes up a part of the project2. Sorting out what activities must be done one after another, and which can be done at the same time, if required.3. Representing these in a network diagram4. Estimating the critical path, which is the longest sequence of consecutive activities• An activity within a network is represented by a rectangular box (each box is a node)• The ‘flow’ of activities in the diagram should be from left to right• A path is simply a sequence of activities which take you from the start to the end of the network• The duration of each activity is shown in the top right hand of the box• The critical path is the longest past taking the most duration period• This is derived from adding the duration of each activitiy for each path• The earliest start time for the first node in the network is 0, this is shown in the bottom left corner of each node.• The earliest start time for each activity is derived from working left to right through the diagram• So if task A starts on week 0, and task B takes 5 days, the earliest start time for task B, is 0+5= week 5• If two or more activities precede an activity then the highest figure should be taken as the later activity’s start time.• Latest start times at which each activity can start if the project as a whole is to be completed in the earliest possible time is derived from working backwards, i.e. right to left.• The latest start time for the last activity is the critical time less the duration of that activity.• If an activity, task C leads to two activities D and E. First calculate the latest start time for activity D and E, then subtract that figure from the duration of activity C. The lower figure should be chosen to ascertain the latest start time of C.

Criticisms of critical path/network analysis1. It is not always possible to devise an effective WBS for a project2. It assumes a sequential relationship between activities.3. There are problems in estimation4. it does not appear to develop plans for contingencies, other than crashing time5. CPA assumes a trade-off between time and cost. This may not be the case where a substantial portion of the cost is indirect overheads or where the direct labour proportion of the total cost is limited.

Project evaluation review technique (PERT)PERT is a modified form of network analysis designed to account for uncertainty.PERT is a technique fro allowing for uncertainty in determining project duration. Each task is assigned a best, worst, and most probable completion time estimate. These estimates are used to determine the average completion time. The average times are used to establish the critical path and the standard deviation of completion times for the entire project.

Resource histogramA useful planning tool that shows the amount and timing of the requirement for a resource (or a range of resources) is the


resource histogram.A resource histogram shows a view of project data in which resource requirements, usage, and availability are shown against a time scale.Another (horizontal) line may be added to the chart showing resource availability. The chart then shows any instances when the required resource hours exceed the available hours. Plans should then be made to either obtain further resource for those peak times, or to re-schedule the work plan. Alternatively the chart may show times when the available resource is excessive, and should be re-deployed elsewhere.

Float times and costsFloat time is the time built in to allow for unforeseen circumstances.1. Total float on a job is the time available (earliest start date to latest finish date) less time needed for the job. If, for example, job A’s earliest time was day 7 and its latest end time was day 17, and the job needed four days, total float would be:(17-7) – 4 = 6 days2. Free float is the delay possible in an activity on the assumption that all preceding jobs start as early as possible and all subsequent jobs also start at the earliest time3. Independent float is the delay possible if all preceding jobs have finished as late as possible, and all succeeding jobs have started as early as possible.3. Project management softwareProject management techniques are ideal candidates for computerisation. The most famous project management software is Microsoft Project.

Software might be used for a number of purposes:1. Planning2. Estimating3. Monitoring4. Reporting

Most project management packages feature a process of identifying the main steps in a project, and breaking these down further into specific tasks.A typical project management package requires four inputs1. The length of time required for each activity2. the logical relationships between each activity3. the resources available4. when the resources are available

The advantages of using project management software are:1. Enables quick re-planning – estimates changing, results, etc.2. Document quality3. Encourages constant progress tracking4. What if? analysis

The disadvantages of project management software are:1. Some packages are difficult to use2. Some project managers become so interested in producing perfect plans that they spend too much time producing documents and not enough time managing the project.

4. Documentation and reports1. Project Plan2. Project Quality Plan3. Progress Reports4. Completion Report5. Post-completion AuditThe project plan is used to guide both project execution and project control. It outlines how the project will be planned, monitored and implemented.


The project plan should include1. Project objectives and strategies2. how any changes to these procedures are to be controlled3. the management and technical procedures, and standards, to be used4. details of the quality strategy5. the budget and time-scale6. Safety, health and environmental policies7. Inherent risks and how they will be managed.The Project Plan evolves over time. A high level plan for the whole project and a detailed plan for the current and following stage is usually produced soon after project start-up. At each subsequent stage a detailed plan is produced for the following stage and if required, the overall project plan is revised.

The Project Quality Plan outlines the quality strategy to be followed and links this to any formal quality management approach the organisation has chosen to follow.

A project quality plan may include a number of elements, for example:1. Project overview2. project organisation and management3. project requirements4. development/production methods5. quality management6. risk management and procurementA Progress Report shows the current status of the project, usually in relation to the planned status.

The frequency and contents of progress reports will vary depending on the length of the project and the progress being made.The report is a control tool intended to show the discrepancies between where the project is, and where the plan says it should be.A common form of progress uses two columns – one for planned time and expenditure and one for actual.Any additional content will depend on the format adopted. Some organisations include only the ‘raw facts’ in the report, and use these as a basis for discussion regarding reasons for variances and action to be taken, at a project review meeting.The Completion Report summarises the results of the project, and includes client sign-off.On project completion the project manager will produce the Completion Report. The main purpose of the completion report is to document (and gain client sigh-off for) the end of the project.The report should include a summary of the project outcome. The completion report should contain:

1. Project objectives and the outcome achieved2. The final project budget report showing expected and actual expenditure (if an external client is involved this information may be sensitive – the report may exclude or ‘amend’ the budget report).3. A brief outline of time taken compared with the original schedule.

The completion report will also include provision for any on-going issues that will need to be addressed after completion. Such issues would be related to the project, but not part of the project.Responsibilities and procedures relating to any such issues should be laid down in the report.

A Post-Implementation Audit is a formal review of the project that examines the lessons that may be learned and used for the benefit of future projects.The audit looks at all aspects of the project with regard to two questions.1. Did the end result of the project meet the client’s expectations?- the actual design and construction of the end product- was the project achieved on time- was the project completed within budget2. Was the management of the project as successful as it might have been, or were there bottlenecks or problems?

The post-completion audit should involve input from the project team. A simple questionnaire could be developed for all


team members to complete, and a reasonably informal meeting held to obtain feedback.

On what went well (and why), and what didn’t (and why).This information should be formalized in a report. The post-completion audit report should contain the following:

1. A summary, emphaisisng any areas where the structures and tools used to manage the project have been found to be unsatisfactory2. A review of the end result of the project.3. a cost-benefit review should be included, comparing the forecast costs and benefits identified at the time of the feasibility study with actual costs and benefits4. Recommendations should be made.5. Risk management

Projects and other undertakings carry an element of risk, for example the risk of an inappropriate system being developed and implemented. Risk management is concerned with identifying such risks and putting in place policies to eliminate or reduce these risks. The identification of risks involves an overview of the project to establish what could go wrong, and the consequences. Risk management may be viewed as a sixstage process:1. Plan risk management approach2. Identify and record risks, for example in a risk register3. assess risks and record this assessment4. plan and record risk responses5. carry out risk reduction actions6. Review the risk management approach.

Dealing with risk involves four strategies1. Avoidance2. Reduction or mitigation3. Transference4. Absorption6. Information systems projects – common problems

it is not uncommon for information systems projects to be years late, wildly over budget, and produce a system that does not meet user requirements.A number of factors can combine to produce these expensive disasters.

Project managersIS project managers were often technicians, not managers. Technical ability for IS staff is not guarantee of management skill – an individual might be a highly proficient analyst or programmer, but not a good manager.

Other factors1. The project manager may accept an unrealistic deadline – the timescale is fixed early in the planning process. User demands may be accepted as deadlines before sufficient consideration is given to the realism of this2. Poor or non-existent planning is a recipe for disaster. Unrealistic deadlines would be identified much earlier if a proper planning process was undertaken3. a lack of monitoring and control4. users change their requirements, resulting in costly changes to the system as it is being developed5. Poor time-tabling and resourcing. It is no use being presented on day 1 with a team of programmers, when there is still systems analysis and design work to do. The development and implementation of a computer project may take a considerable length of time. A proper plan and time schedule for the various activities must be drawn up.A project is affected by a number of factors, often in conflict with each other.

1. Quality of the system required, in terms of basic system requirements2. Time, both to complete the project, and in terms of the opportunity cost of time spent on this project which could be spent on others3. Costs and resources allocated to the project.


The balance between the constraints of time, cost and quality will be different for each project.

1. If a system aims to provide competitive advantage then time will tend to be the dominant factor2. if safety is paramount then quality will be most important3. if the sole aim of a project is to meet administrative needs that are not time dependent then cost may be the dominant factor Dealing with slippage When a project has slipped behind schedule there area range of options open to the project manager.

Some of these options are:1. Do nothing2. Add resources3. Work smarter4. Replan5. Reschedule6. Introduce incentives7. Change the specification

Project change procedureSome of the reactions to slippage above would involve changes that would significantly affect the overall project. Other possible causes of changes to the original project plan include:1. the availability of new technology2. changes in personnel3. a realization that user requirements were misunderstood4. changes in the business environment5. new legislation e.g. Data protection

The earlier the change is made the less expensive it should prove. However, changes will cost time and money and should not be undertaken lightly.

When considering a change an investigation should be conducted to discover1. the consequences of not implementing the proposed change2. the impact of the change on time, cost and quality3. the expected costs and benefits of the change4. the risks associated with the change,a nd with the status-quo


Paper 2.1 – Information SystemsChapter 8The Information Systems Development Process

1. Systems development lifecycles2. The waterfall approach3. The spiral approach4. Systems development methodologies5. Software support for the systems development process6. User involvement

1. Systems development lifecyclesThe term ‘systems development lifecycle’ describes the stages a system moves through from inception until it is discarded or replaced.In the context of information systems projects a distinction can be made between the project lifecycle and the systems development lifecycle. As a project has a definite end it is unlikely that ongoing maintenance would be included in the scope of a project, but falls within our definition of the system development lifecycle.

1. Identification of a problem or opportunity – this involves an analysis of the organisation’s information requirements2. Feasibility Study – this involves a review of the existing system and the identification of a range of possible alternative solutions.3. Systems investigation – once the working of the existing system have been documented, they can be analysed. This process examines why current methods are used, what alternatives might achieve the same, or better, results, and what performance criteria are required from a system4. Systems design – this is a technical phase which considers both computerized and manual procedures, addressing, in particular, inputs, outputs, program design, file design and security. A detailed specification of the new system is produced.5. Systems implementation – this stage carries development through from design to operations. It involves acquisition (or writing) of software, program testing, file conversion or set-up, acquisition and installation of hardware and ‘going live’.6. Review and maintenance – this is an ongoing process which ensures that the system meets the objectives set during the feasibility study, that it is accepted by users and that its performance is satisfactory.

2. The waterfall approachRoyce’s waterfall model breaks the systems development process into sequential stages – with the output from a stage forming the input to the following stage

System feasibility Software plans and requirements Product Design Detailed Design Code Integration Implementation Operations and Maintenance

Each stage is divided into two parts – the actual work associated with the stage followed by a procedure (validation) to check what has been done. Verification in this context is concerned with ensuring required specification shave been met.


Validation is concerned with ensuring the system is fit for its operational role.

Drawbacks of the waterfall approachThe waterfall approach is an efficient means of computerizing existing procedures with easily defined processing requirements. It produces systems modeled on the manual systems they are replacing.

Sequential models restricted user input throughout much of the process. This often resulted in substantial and costly modifications late in the development process. It becomes increasingly difficult and expensive to change system requirements the further a system is developed.Time overruns were the norm. the sequential nature of the process meant a hold-up on one stage would stop development completely – contributing to time overruns. Time pressures and lack of user involvement often resulted in a poor quality system and blame for the developers.Operations and maintenance are treated as if the activity had a distinct start and end. Maintenance is in fact on-going and open-ended.

3. The spiral approachWhen developing systems where requirements are difficult to specify it is unrealistic to follow a sequential process which relies on getting things correct at each stage of development before starting subsequent activities. In these more complex situations the spiral approach is appropriate.The spiral model represents an evolutionary approach to systems development. It involves carrying out the same activities over a number of cycles in order to clarify requirements and solutions.The development process starts at the centre of the spiral. At the centre requirements are not well defined. System requirements are refined with each rotation around the spiral. The longer the spiral, the more complex the system and the greater the cost.

The model is divided into four quadrants.

a) Top left• Objectives determined• Alternatives and constraints identified

b) Top right• Alternatives evaluated• Risks identified and resolved

c) Bottom right• Systems development• Covers the activities described in the waterfall model including implementation

d) Bottom left• the next phase in the development process is planned

Boehm’s spiral model of system development includes the processes of objective setting and risk management. The spiral approach aims to avoid the problems of the waterfall model (lack of user involvement, long delays). It is usually used in conjunction with prototyping.

4. Systems development methodologiesA systems development ‘methodology’ is a collection of procedures, techniques, tools and documentation aids which will help systems developers in their efforts to implement a new information system.

Characteristics of methodologies1. Separation of logical and physical – the initial focus is on business benefits. Physical design and implementation issues are looked at later2. User involvement – user’s information requirements determine the type of data collected or captured by the system. Users are involved throughout the development process


3. Diagrammatic documentation – diagrams rather than text-based documentation are used as much as possible to ensure the focus is on what the system is trying to achieve and to aid user understanding of the process4. Data driven – most structured methods focus on data items regardless of the processes they are related to. The type of data within an organisation is less likely to change than either the processes which operate on it or the output information required of it.5. Defined structure – Most methodologies prescribe a consistent structure to ensure a consistent and complete approach to the work.

All methodologies seek to facilitate the ‘best’ solution. But ‘best’ may be interpreted in a number of ways, such as most rapid or least cost systems. Some methodologies are highly prescriptive and require rigid adherence to stages whilst others are highly adaptive allowing for creative use of their components.

SSADMThe Structured Systems Analysis and Design Method covers five stages from the early and middle stages of the system development process. SSADM refers to stages as modules.

1. Feasibility Study – SSADM may be adopted without conducting a feasibility study, or after a study has been conducted. If the study is conducted under SSADM, it focuses on investigating system requirements and conducting a cost-benefit analysis2. Requirements analysis – involves an analysis of current operations followed by the development and presentation of options for the new system3. Requirements specification – this stage involves defining the data and processes that will be used in the new system. The systems specification documents will be produced.4. Logical system specification – this focuses initially on technical options for hardware and communications technology. Then the user interface and associated dialogue is designed. Logical rules for processing are established5. Physical design – the logical data structure is converted to actual physical data specifications, for example database specifications.

Advantages of methodologies

1. detailed documentation is produced2. standard methods allow less qualified staff to carry out some of the analysis work, thus cutting the cost of the exercise3. using a standard development process leads to improved system specification4. systems developed in this way are easier to maintain and improve5. users are involved with development work from an early stage and are required to sign off each stage6. the emphasis on diagramming makes it easier to relevant parties, including users, to understand the system than if purely narrative descriptions were used7. the structured framework of a methodology helps with planning. It defines the tasks to be performed, sets out when they should be done and identifies an end product. This allows control by reference to actual achievements rather than to estimates of progress8. a logical design is produced that is independent of hardware and software9. techniques such as data flow diagrams, logical data structures and entity life histories allow information to be cross-checked between diagrams and ensure that the system delivered does what is required.

Disadvantages of methodologies

1. It has been argued that methodologies are ideal for analyzing and documenting processes and data items at an operational level, but are perhaps inappropriate for information of a strategic nature that is collected on an ad hoc basis.2. some are a little too limited in scope, being too concerned with systems design, and not with their impact on actual work processes or social context of the system3. arguably, methodologies encourage excessive documentation and bureaucracy and arte just as suitable for documenting bad design as good.5. Software support for the systems development process


There are a number of software tools that can be used to facilitate systems development process. These are:1. CASE tools2. Fourth Generation languages3. Prototypes

Computer aided software engineering (CASE)CASE tools are used in systems development to automate some development tasks, such as the production of documentation and to provide an efficient tool to control developmental activities.

CASE tools are software tools used to automate some tasks in the development of information systems, e.g. generating documentation and diagrams. The more sophisticated tools facilitate software prototyping and code generation.

There are a range of CASE tools available. Some focus on certain phases of development such as analysis and design, others may be used throughout the complete development lifecycle.

The facilities offered by CASE tools are;1. Project initiation – generate project schedules in various formats2. Analysis and design – Produce diagrams, generate data dictionary3. Design (logical and physical) – Produce system model diagrams, data structures, automate screen and report design4. Maintenance – version control, change specification and tracking

CASE tools can be grouped into Upper CASE tools and Lower CASE toolUpper CASE tools are geared towards automating tasks associated with systems analysis. They include

1. Diagramming tools2. Analysis tools – that check the logic, consistency and completeness of system diagrams, forms and reports.3. A CASE repository – that holds all data and information relating to the system. The DATA dictionary records all data items held in the system and controls access to the repository. The dictionary will list all data entities, data flows, data stores, processes, external entities and individual data items.

Lower CASE tools are geared towards automating tasks later in the development process (after analysis and design) they include:1. Document generators – that automate the production of diagrams using a range of modeling techniques2. Screen and report layout generators – that allow prototyping of the user-interface to produce and amended quickly3. Code generators – that automate the production of code based on the processing logic input to the generator.

Advantages of using CASE tools1. Document/diagram preparation and amendment is quicker and more efficient2. Accuracy of diagrams is improved. Diagram drawers can ensure consistency of terminology and maintain certain standards of documentation.3. Prototyping is made easier, as re-design can be effected very quickly4. Blocks of code can be re-used. Many applications incorporate similar functions and processes; blocks of software can be retained in a library and used (or modified) as appropriate.

Fourth generation languages (4GLs)4GL is a high-level computer language that uses commands that are closer to everyday speech than previous languages. 4GLs usually also include a range of features intended to automate software production.Most 4GLs use a graphical user interface. Icons, objects, help facilities; pull down menus and templates present programmers with the options for building the software. Sections of code are often treated as components, which may be used in a variety of applications.

A 4GL will often include the following features:1. Relatively easy to learn and use


2. often centered around a database3. includes a data dictionary4. uses a relatively simple query language5. includes facilities for screen design and dialogue box design6. includes a report generator7. code generation is often automated8. documenting and diagramming tools

4GLs are often used to facilitate object-oriented programming. With object-oriented programming, programmers define the types of operations that can be applied to data structures. In this way, the data structure becomes an object that includes both data and functions. In addition, programmers can create relationships between one object and another. For example, objects can inherit characteristics from other objects.One of the principal advantages of object-oriented programming techniques over procedure programming techniques is that they enable programmers to create modules that don’t need to be changed when a new type of object is added. A programmer can simply create a new object that inherits many of its features from existing objects. This makes object oriented programs easier to modify.

PrototypingThe use of 4GLs, together with the realization that users need to see how a system will and feel to assess its suitability, have contributed to the increased use of prototyping.A prototype is a model of all or part of a system, built to show users early in the design process how it is envisaged the completed system will appear.

Advantages1. it makes it possible for programmers to present a ‘mock-up’ version of an envisaged system to users before a substantial amount of time and money have been committed. The user can judge the prototype before tings have gone too far to be changed.2. the process facilitates the production of ‘custom build’ application software rather than off-the-shelf packages which may or may not suit the user needs.3. it makes efficient use of programmer time by helping programmers to develop programs more quickly. Prototyping may speed up the ‘design’ stage of the systems development lifecycle4. a prototype does not necessarily have to be written in the language of what it is prototyping, so prototyping is not only a tool, but a design technique.

Disadvantages1. Some prototyping tools are tied to a particular make of hardware, or a particular database system2. it is sometimes argued that prototyping tools are inefficient in the program codes they produce, so that programs are bigger and require more memory than a more efficiently coded program3. prototyping may help users to steer the development of a new system towards an existing system4. as prototyping encourages the attitude that changes and amendments are likely, some believe prototyping tools encourage programmers to produce programs quickly, but to neglect program quality.

4. User involvementThe importance of user involvement in the development process cannot be over-estimated.1. Structured walkthroughs2. joint applications development3. Rapid applications development4. User groups

Structured walkthroughsStructured walkthroughs are a technique used by those responsible for the design of some aspect of a system to present their design to interested user groups. Structured walkthroughs are formal meetings, in which the documentation produced during development is reviewed and checked for errors or omissions.These presentations are used both to introduce and explain the new systems to users an dalso to offer the users the


opportunity of making constructive criticism of the proposed systems, and suggestions for further amendments/improvements, before the final systems specification is agreed.

Users are involved in structured walkthroughs because their knowledge of the desired system is more extensive than that of the systems development personnel. Walkthroughs are sometimes referred to as user validation.

Joint applications development JAD is a workshop that unites management, IT specialists and knowledge workers to define and specify the logical requirements and technical alternatives of a proposed system.

Purposes1. breaks down the communication barriers between users and programmers2. work as a team to define logical requirements for a new system3. explore several technical alternatives for the new system

Rapid Applications DevelopmentRAD can be described as a quick way of building software. It combines a managed approach to systems development with the use of modern software tools such as prototyping. RAD also involves the end-user heavily in the development process.

Basically it combines JAD and prototyping.

RAD has become increasingly popular as the pace of change in business has increased. To develop systems that provide competitive advantage it is often necessary to build and implement the system quickly.

RAD can create difficulties for the project manager as RAD relies to a certain extent on lack of structure and control.

User GroupsUser groups enable users to share ideas and experience relating to a particular product; usually a software package.User groups can provide valuable insights and suggestions when system upgrades are being considered.


Paper 2.1 – Information SystemsChapter 9Systems Analysis; User requirements

• Investigating user requirements• Process models (DFD and Flowcharts)• A static structure model (ERM)• An event model (ELH)• Structured English• Other system design issues

Investigating user requirementsThe systems investigation is a detailed fact-finding exercise about the areas under consideration. It may be performed substantially during the feasibility study.The project team has to determine the inputs, outputs, processing methods and volumes of the current system. It also examines controls, staffing and costs and reviews the organisational structure. It should also consider the expected growth of the organisation and its future requirements.

The stages involved in this phase of the study are as follows.• Fact finding• Fact recording• Evaluations

At the beginning of the investigation phase, one will be interested in the organisational context of the system, as it is important to have an overall view of what the system does. The emphasis in each area will be on the potential for improvement.• Plans and objectives• Organisation structure• Policies, systems and procedures• Personnel• Equipment and the office• Operations and control

The fact finding stage could be derived from:• Interviews• Questionnaires• Observation• User workshops• Document review• Existing computerized systems• Requirements creep

User workshopsA workshop is a meeting with the emphasis on practical exercises. User workshops are often used in systems analysis to help establish and record user requirements.At a user workshop, user input is obtained by the analyst to analyse business functions and define the data associated with the current and future systems. An outline of the proposed new system is produced, which is sued to design more detailed system procedures.Depending on the complexity of the system, the workshop may devise a plan for implementation. More complex systems may conduct a workshop early in the design stage and hold a later workshop with the aim of producing a detailed system


model. Prototyping may be used at such a workshop to prepare preliminary screen layouts.User workshops should be facilitated by a facilitator. The facilitator co-ordinates the workshop activities with the aim of ensuring the objectives of the session are achieved.The facilitator would most likely be a systems analyst with excellent communication and leadership skills. The skills of the person in this role are critical to the success of the workshop.

Many user workshops also utilize a scribe. The scribe is an active participant who is responsible for producing the outputs of the workshop. The scribe may use a CASE tool.

Document reviewThe systems analyst must investigate the documents that are used in the system for input and output. One way of recording facts about document usage is the document description form, which is simply a standard form which the analyst can use to describe a document.This may be a wide ranging investigation, using for example organisation charts, procedures manuals and standard operational forms. One risk, however, is that staff do not follow documented policies and procedures or that these documents have not been properly updated. Document review should therefore be used in tandem with one or more other investigative techniques.An analysis of documents, together with historical operational data, should help the analyst estimate future processing requirements and volumes.

Existing computerized systemsExisting computer systems can provide much information relevant to the requirements for a new computerized system. Areas where an existing system could provide useful information include:• File structures• Transaction volumes• Screen design• User satisfaction• User complaints• Help-desk/information centre records• Causes of system crashes• Processor speed.

Requirements creepIf the user requirements are investigated and established effectively, an accurate picture should be established of what the new system should achieve. This should prevent a common problem occurring later in the project, the problem of ‘requirements creep’.Requirements creep refers to the situation where users appear to change their requirements throughout the development process. Requirements creep may be due to actual changes in user requirements, but is often caused by an inaccurate original system specification.

Process models (Data flow diagrams and flowcharts)Business systems (which may include manual and computerized components) involve the input, processing and output of data. Process models may be used to model business systems – usually at a fairly high level.Process models show the movement and processing actions data is subjected to as it moves through a system. The production of a process diagram is often one of the first task s in the systems analysis – the diagram provides a basic understanding of how the system works.

Data flow diagrams (DFD)Four symbols are used in data flow diagrams

An external entity is a source or destination of data which is considered external to the system (not necessarily external to the organisation). It may be people or groups who provide data or input information or who receive data or output information. (The line indicates that the entity appears more than once in the diagram).


A data store is a point which receives a data flow and holds data. Most data stores would be either digital or paper. (The identifying number is shown in the left most box, and the second line shows that the store is repeated in the diagram).A data flow represents the movement or transfer of data from one point in the system to another.Data processes involve data being used or altered. The processes could be manual, mechanized or computerized. (The identifying number is shown in the upper left box).A data flow could ‘physically’ be anything – for example a letter, a telephone call, a fax, an email, a link between computers, or a verbal statement. When a data flow occurs, a copy of the data transferred may also be retained at the transmitting point.

A process could involve changing the data in some way, or simply using the data. For example, a mathematical computation or a process such as sorting would alter data, whereas printing data out does not change it – the process makes the same data available in a different form.DFDs may be drawn to represent different levels of detail. The top level (least detailed) diagram would show one process only. The source of the data for this process, and its destination are also shown. This type of diagram is known as a Level 0 DFD, or a Context Diagram. Data stores are not shown in context diagrams.The level 0 DFD may be ‘exploded’ into a more detailed data flow diagram, known as a Level 1 DFD. Further detail can be represented on a Level 2 DFD, and so on until all individual entities, stores, flows and processes are shown.

Flow Charts

Flowcharts are another type of a process model. Flowcharts use special shapes to represent different types of actions or steps in a process. Lines and arrows show the sequence of the steps, and the relationships among them.

Start/End Action/Process Document Decision Input/Output Flow

A static structure model (entity relationship model)An entity is any item, role, object, organisation, activity or person that is relevant to the data held in a system.

An attribute is a characteristic or property of an entity. For a customer, attributes include customer name and address, amounts owing, date of invoices sent and payments received, credit limit, etc.An Entity Relationship Model (ERM) provides an understanding of the logical data requirements of a system independently of the system’s organisation and processes.

The following relationships may be identified between attributes and entities:1. One-to-one2. One-to-many3. Many-to-one4. Many-to-many

An event model (Entity life History)An entity life history ELH is a diagram of the processes that happen to an entity. An entity life history gives a dynamic view of the data.Data items do not always remain unchanged – they may come into existence by a specific operation and be destroyed by another. For example, a customer order forms part of a number of processes, and is affected by a number of different events. At its simplest, an entity life history displays the following structure

Entity life histories identify the various states that an entity can legitimately be in. it is really the functions and events which cause the state of the entity to change that are being analyzed, rather than the entity itself.

The following notation rules are used for Entity Life Histories.• Three symbols are used. The main one is a rectangular box. Within this may be placed an asterisk or a small circle, as


explained below• At the top level the first box (the ‘root node’) shows the entity itself• At lower levels the boxes represent events that affect the life of the entity• The second level is most commonly some form of ‘create, amend, delete’, as explained earlier. The boxes are read in sequence from top to bottom and left to right.• If an event may affect an entity many times (iteration) this is shown by an asterisk in the top right hand corner of the box. A customer account, for example, will be updated many times• If events are alternatives (selection) – for example accept large order or reject large order – a small circle is placed in the top right hand corner.

Structured English Comprises a limited vocabulary of words that may be used to describe a process. In systems development, the process depicted by a model could be described using Structured English as a step towards producing the actual program code.

Other system design issues

Requirements specificationModels of an existing system may be referred to when developing the requirements specification of a new system. Developing a requirements specification involves the following activities:

• Detailed dataflow diagrams, flowcharts and other models are produced, and the proposed system compared with the current system to ensure that all necessary processing will be performed. If necessary, the diagrammatic models are modified• Specifications for input and output are prepared. These details what appears on screen, or on documents? Prototyping could be used at this stage• Relational data analysis (normalization) is performed on the input and output descriptions. This is to identify any entities that might have been noticed, or drawn in enough detail, in the existing logical data structure. (Normalization is a way of analyzing and simplifying the relationships between items of data.)• Entity life histories are drawn up, indicating what happens to each entity, i.e. what functions (processes) it is subjected to.

Logical design – at this stage the data and file structures for the next system are designed

Physical designPhysical design involves the following tasks:• Initial physical design• Further define the processing required• Program specifications are created. These provide in detail exactly what a particular program is supposed to achieve• Program specifications are assessed for their performance when implemented. It should be possible to estimate the times that programs will take to run• File and data specifications are finalized• Operating instructions are drawn up (user documentation)

Prototyping may be used so that users can actually see what the system will look like and get a feel for how it will work.

Technical systems optionsThe organisation will have to make choices concerning the specifications of the physical components of the new system

There might be a number of options available so choices will need to be made regarding:• Hardware configuration• Software


Performance objectives for the system are then specified in detail so that these can be followed in the actual design of the system.Paper 2.1 – Information SystemsChapter 10 External Design

• Define the characteristics of a ‘user-friendly’ system• Describe the task of external design and extinguish it from internal design• Select appropriate technology to support output design• Design effective output documents and reports• Select appropriate technology to support input design• Design effective inputs• Describe how the user interface may be structured for ease of use

External and internal system elementsExternal design refers to the elements of a computer system that the user can see

Internal design refers to the elements of a computer system that the user does not see.

Input devices

Data collection and inputA computerized information system receives data and instructions via input devices, stores data and programs on storage devices and outputs processed data using output devices. The system may also interact with other systems via communications devices.Data must be in put into a computer system in a form the computer is able to interpret. There are a number of various methods of data input. When choosing a method of data input for a given situation, key considerations are:• Speed• Accuracy• Cost• Volume of data/transactions• System reliability• Flexibility required

Typical input devices include:• Keyboard• Mouse• Magnetic ink character recognition (MICR) – involves the recognition by a machine of special formatted characters printed in magnetic ink. The characters are read using a specialized reading device. The main advantage of MICR is its speed and accuracy, but MICR documents are expensive to produce. The main commercial application of MICR is in the banking industry – on cheques and deposit slips.• Optical mark reading (OMR) – involves the marking of a pre-printed form with a ballpoint or pen typed line or cross in an appropriate box. The card is then read by an OMR device which senses the mark in each box using an electric current and translates it into machine code.• Scanners and Optical Character Recognition (OCR) – a scanner is a device that can read text or illustrations printed on paper and translates the information into a form the computer can use. A scanner works by digitizing an image, the


resulting matrix of bits is called a bit map.• Bar coding and EPOS – Bar codes are groups of marks which, by their spacing and thickness, indicate specific codes or values. Large retail stores have Electronic Point of Sale devices, which include bar code readers. This enables the provision of immediate sales and stock level information.• EFTPOS – Electronic Funds Transfer at the Point of Sale is used with a customer’s credit card or debit card to pay for goods or services. The customer’s credit card account or bank account will be debited automatically.• Magnetic stripe cards – bank credit or debit-cards• Smart cards – is a plastic card in which is embedded a microprocessor chip. A smarty card would typically contain a memory and a processing capability. The information held on smart cards can therefore be updated.• Touch screens• Voice recognition

Output devicesThe two most common methods of computer output are output to a printer and output to the screen. Other methods include output to a computer file or onto microfilm.

The choice of output medium• Hardcopy – is a printed version of output needed• Quantity – number of pages or characters displayed on screen is less than that displayed on two monitors.• Speed – if a single enquiry is required it may be quicker to make notes from a VDU display rather than print it.• Suitability for further use – output to a file would be appropriate if the data will be processed further, maybe in a different system. Large volumes of reference data might be held on microfilm or microfiche.• Cost – the ‘best’ output devices may not be justifiable on the grounds of cost – another output medium should be chosen.

The Human-Computer Interface (HCI)HCI includes all external elements of a system. Elements of the HCI include keyboard, mouse, VDU, screen layout and the dialogue between the user and the system.The HCI should be appropriate to the purpose of the system, the situation the system is sued in and to users’ levels of competency.

Human-computer dialogueThe exchange of information between a computer system and a user is known as human-computer dialogue.The screen provides ‘feedback’ for the user, allowing the system to be flexible, interactive and conversational. This dialogue between the system and the user is the key factor in how the system is operated. The term ‘conversational mode’ describes the continual dialogue between the user and the system.

Well-designed human-computer dialogue takes account of the following factors:• Usability• On-Screen help• Use of dialogue boxes and on-screen prompts• Convenience

Graphical User Interfaces (GUI)To meet the requirements of well-designed human dialogue, most software interacts with the user via a Graphical User Interface. A GUI involves the user of two design ideas and two operating methods which can be remembered by the


abbreviation WIMP. This stands for ‘Windows, Icons, Mouse, Pull down menu’ and is an environment which offers a method of accessing the computer without using the keyboard. Dialogue is conducted through images rather than typed text.GUIs were designed to make computers more ‘user-friendly’. They are now the most prominent method by which people and systems conduct dialogue.

Input and output designEffective performance of a computer system depends on how the system interacts with its environment. Well-designed input forms, dialogue and output are key to ensuring effective and efficient communication between the users and the system.Communication between user and a computerized system is influenced by the following factors:• Human-computer dialogue• Input design• Document and screen design (input and output)• The use of codes

Input design is concerned with data collection, data entry and data validation. There are a number of considerations for input design.• What data input method will be used? Bar code readers or magnetic ink character readers may be able to be utilized rather than the use of manual input devices such as a keyboard.• What volumes of input are expected? Large volumes of input are more likely to require automated input procedures• Does the system use batch processing or real-time processing. This will impact on the frequency and method of input• Will data be required to be transcribed from a source document?• The need for accuracy. How extensive should built-in data validation checks be to ensure all data entered is input correctly, and that no data is missed or entered twice.

Document and screen designThe contents and design of a document or on-screen display depends on the purpose of the document or screen.

There are two main categories of documents output from a computer system.• Working documents, e.g. purchase orders, invoices, statements, credit notes• Information presentation documents, e.g. management accounts, sales analysis reports

Working document design should focus on ensuring the document is functional. Many working documents are printed on pre-printed stationery e.g. invoices produced using popular accounting packages.

Information presentation documents, such as a report, should be clear and understandable. Reports should use a simple structure. An example, that could be adapted to suit the report requirements, would include:• Meaningful title• Author name and position• Purpose/Terms of Reference• Procedure followed• Findings• Conclusion / Recommendations

CodesComputers are able to organize and use data more efficiently if some data is expressed in the form of codes.


In a computer system, the use of codes saves storage space. For example, a product code could be stored on a computer record, rather than the full product description, and the description obtained from the product master file when required.Codes also save user-time. For example a customer code may consist of four characters, which when input retrieve full customer name and address details.Coding systems may include validation techniques such as the use of a check digit.Types of coding systems include:• Sequenced, e.g. 0001 Cars, 0002 Vans, 0003 Trucks• Grouped, e.g. 1000-1999 types of car, 2000-2999 types of van• Faceted, e.g. first digit vehicle type, second digit vehicle colour• Hierarchical – multi-digit codes, often with decimal points, where digits to the right represent sub-sets of the digits to the left, e.g. the decimal coding system used in libraries• Mnemonic – a mixture of alpha-numeric characters to signify characters of the items, e.g. PV101 is purchase voucher 101, PO101 is purchase order 101.

A coding system should be;• Easy to use and remember• Flexible, including the ability to expand• Designed to avoid errors and confusion


Paper 2.1 – Information SystemsChapter 11 Software Sources and Selection

• Software sources• Invitations to tender• Evaluating supplier proposals• The advantages and disadvantages of bespoke and off-the-shelf software• Software contracts and licenses

Software sourcesAn organisation has a range of options when sourcing software for information systems. The four main options are:• Standard off-the-shelf package – this is the simplest option. The organisation purchases and installs a ready-made solution• Amended standard package – a standard package is purchased, but some customization is undertaken so that the software meets the organisations requirements. This may require access to the source code.• Standard package plus additions – the purchased standard package is not amended itself, but additional software that integrates with the standard package is developed. This also may require access to the source code.• Bespoke package – Programmers write an application to meet the specific needs of the organisation. This can be a time-consuming and expensive process.

Bespoke software is designed for a specific user or situation. It may be written either in-house by the IS department or externally by a software house.An off-the-shelf package is one that is sold to a wide range of users. The package is written to handle requirements that are common to a wide range of organisations.

Choosing an application package off-the shelfOff-the-shelf packages are generally available for functions that are likely to be performed similarly across a range of organisations e.g. accounting. The following describes some of the factors to consider when choosing an off-the shelf application package:• User requirements• Processing times• Documentation• Compatibility• Controls• User-interface• Modification• Support, maintenance and updates• Cost

Developing a bespoke applicationProducing a bespoke software system involves all the tasks included in the software development and testing cycle.

The software development cycleFeasibility Acceptance Test


Analysis System Test

Design Integration Test

Program Specification Unit Test

Coding

Feasibility and analysisThe feasibility of software solutions would have usually been covered during the overall system feasibility study. An analysis of the software requirements should therefore be available

Design and program specificationThe software requirements are used to develop a systems design specification, which in turn is used to produce a detailed program specification. The specification would be used by in-house software developers, or would be distributed to software producers (as part of the invitation to tender)

CodingSoftware producers will decide how to build the package, for example identifying parts of existing programs that may be used, and establishing what will need to be coded (i.e. written) from scratch. Prototyping may be used to help ensure user requirements are met.

Testing• Unit testing – tests individual programs or units operating alone• Integration testing – tests how two or more units of software interact with each other• Systems testing – tests the complete package and how it interacts with other software programs• User acceptance testing – aims to ensure all user requirements included in the software specification have been met.

Invitations to Tender (ITT)A number of suppliers may be invited to tender (bid) to supply specific software (the tendering procedure could also be used for hardware or for a complete system).An invitation to tender is a document that invites suppliers to bid for the supply of specified software, or hardware, or both.There are a number of possible options available to identify possible suppliers who may be in a position to submit a realistic tender:• Trade magazines and websites may include software advertisements and reviews• Computer consultants may have experience and/or knowledge of suitable suppliers• Establish who supplies other similar organisations – it is likely these suppliers could also meet the requirements of a similar organization. The contents of a typical invitation to tender are outlined below. This format could be used when inviting tenders for bespoke or off-the-shelf software – although sections such as the development methodology would be shorter for off-the shelf tenders, as this would refer only to any proposed amendments to the package.

ITT SectionCovering letterAn ITT will include a letter inviting the supplier to tender. The letter should specify:• Contact names for queries relating to the tendering process and for technical queries


• The closing date for submitting tendersInstructionsInstructions to tenderers should specify the information required in tender. Instructions are likely to require tenderers to specify:• Areas of their tender that do not comply with the software specification provided, and the reasons why• The period of validity for the tender• The basis for calculating prices, whether prices are estimates or a quote• An indication of timescale – when work could start and an approx. completion date• Alternative ways of approaching parts of the software design than indicated in the requirements specificationDetailed Software RequirementsThe ITT must include a detailed requirements specification so tenderers know exactly what they are tendering for. This should include:• The purpose of the system• The volume of data to be processed• Processing requirements including details of inputs and outputs, and interfaces with other systems• The number of locations and user requiring access• The speed of processing required, e.g. response times• Expected life of the system• Possible upgrades or expansion anticipated

When submitting their bids, some potential suppliers may come up with alternative specifications – these must be fully explained Details of development model/methodologyThis section of the ITT requires tenderers to provide a description of the methodology or systems development model used to develop their software. The aim is to ensure that the supplier produces software using accepted development techniques – reducing the possibility of poor quality softwareRequest for details of the proposed contract The ITT document should request information from potential suppliers relating to the key terms of any future software contract.

Evaluating Supplier ProposalsOnce vendor proposals have been obtained, they should be evaluated against what was requested within the ITT. There are many factors that should be considered when evaluating proposals. The factors to consider fit into three general categories:• Technical – how well does the proposal meet the specified technical requirements• Support – what after sales support is included• Cost – what do we get for our money

Some of the main factors to consider when evaluating supplier proposals are described in the following table:Factor and commentOrganisation needsHowe well does the software meet the requirements of the organisation? If some requirements aren’t met, how important are they – can they be satisfied through other means?SpeedCan the systems cope with data volume; is response time affected by high data volumes?DocumentationIs there full and clear documentation for the user, and a technical manual that would allow further developments?CompatibilityIs the package compatible with existing hardware and software? Can data be exchanged with other related systems?


ControlsAccess and security controls should be included, as should processing controls that enable the accuracy of processing operations to be confirmed User-friendlySoftware should be relatively easy to use and tolerant to user errors. Menu structures should be logical, the software should follow standard user-interface conventions

ModificationCan the package be modified by the user – allowing the organisation to tailor it to meet their specific needs?

DemonstrationA demonstration version of the software may be available – this should provide a good idea of how the finished product would look, feel and operate

Training providedTraining is essential for the organisation to utilize the software effectively

Support, maintenance and updatesThe viability and cost of support, such as a telephone help-line, should be considered, as should the arrangements for updates and upgrades. This is particularly important if software is likely to be affected by changes in legislation e.g. a payroll package

Conditions included in the software contractThe software contract includes terms relating to the actual supply and use of the software Supplier size, reputation and customer base Software suppliers that have been in business for a reasonable amount of time, and who have an established client base, are more likely to remain in business – and therefore be in a position to provide support. References may be available form existing customers, attesting to the quality of software and support.

CostAn organisation should aim to purchase a package that will meet their requirements. However, a package should not be purchased if the cost outweighs the value of the benefits it should bring

Comparing supplier proposalsAn organisation may receive a number of apparently viable tenders. Tenders are likely to have different strengths and weaknesses – a process to establish the ‘best’ tender needs to be established. Two common ways of comparing software or systems are benchmark tests and weighted ranking scores.

Benchmark testsThere are several factors involved in measuring the capability of a system. Benchmark tests are particularly useful to compare system speed and capacity.Benchmark tests test how long it takes a machine and program to run through a particular routine or set of routines.

Benchmark tests are carried out to compare the performance of a piece of hardware or software against pre-set criteria. Typical criteria which may be used as benchmarks include speed of performance of a particular operation, acceptable volumes before degradation in response time is apparent and the general user-friendliness of equipment. Benchmarks can cover subjective tests such as user-friendliness, although it may be harder to reach definitive conclusions.


For example, an organisation comparing accounting software packages may test a number of different packages on its own existing hardware to see which performed the best according to various predefine criteria (e.g. speed of response, ability to process different volumes of transactions, reporting capabilities and so on).

Once the performance of the software package under consideration has been evaluated, the acquiring organisation should consider other features of the proposal, possibly using a weighed ranking system.

Weighted rankingA weighted ranking system involves establishing a number of factors important to a system, giving each factor a numerical weighting to reflect its importance, and using these weightings to calculate a score for each supplier (or software, or system).The factors chosen to be sued in the weighted ranking and the relative importance of each factor will vary according to the purpose of the software/system under consideration. Judgments need to be made in the selection of criteria, the weightings applied to the criteria and the scores allocated. These judgments must be made by people who have a good understanding of the software/system requirements.

The advantages and disadvantages of bespoke and off-the-shelf software

Bespoke SoftwareAdvantages1. If it is well written, the software should meet the organisation’s specific needs2. data and file structures may be chosen by the organisation rather than having to meet the structures required by standard software packages3. The company may be able to do things with its software that competitors cannot do with theirs. In other words it is a source of competitive advantage4. similar organisations may wish to purchase the software5. The software should be able to be modified to meet future needs.

Disadvantages1. As the software is being developed from scratch, there is a risk that the package may not perform as intended2. There is a greater chance of ‘bugs’. Widely used off-the-shelf software is more likely to have had bugs identified and removed3. development will take longer than purchasing ready-made software4. the cost is considerable when compared with a ready-made package5. support costs are also likely to be higher than with off-the-shelf software

Overcoming the risks of bespoke softwareBuilding a bespoke software application involves much time, effort and money. The risks associated with such an undertaking are that the resulting software:• Does not meet user needs• Does not interact as intended with other systems• Is produced late• Is produced over-budget

These risks can be overcome by:• good project management• involving users at all stages of development


• ensuring in-house IT staff are able to maintain and support bespoke systems supplied from outside parties• ensuring the ITT document includes details of all file structures required, and details of interfaces with other systems

Off the shelf packagesAdvantages1. The software is likely to be available immediately2. a ready-made package will almost certainly cheaper because it’s mass-produced3. the software is likely to have been written by software specialists and so should be of a high quality4. a successful package will be continually updated by the software manufacturer5. other users will have used the package already, and a well-established package should be relatively free of bugs6. good packages are well-documented, with easy-to-follow user manuals or online help7. some standard packages can be customized to the user’s specific needs

Disadvantages1. The organisation is purchasing a standard solution. A standard solution may not be well suited to the organisation’s particular needs2. The organisation is dependant on the supplier for maintenance of the package – i.e. updating the package or providing assistance in the event of problems. It is unlikely that the supplier would give access to the code that would allow organisations with the relevant expertise to amend the software themselves.3. Competitors may well use the same package, removing any chance of using IS/IT for competitive advantage.

Customized versions of standard packagesStandard packages can be customized so that they fit an organisation’s specific requirements. This can be done by purchasing the source code of the package and making modifications in house, or by paying the producer of the package to customize it.

Advantages1. Development time should be much quicker, given that most of the system will be written already2. If the work is done in house the organisation gains considerable knowledge of how the software works and may be able to ‘tune’ it so that it works more efficiently with the company’s hardware

Disadvantages1. It may prove more costly than expected, because new versions of the standard package will also have to be customized2. customization may delay delivery of the software3. customization may introduce bugs that do not exist in the standard version4. if done in house, the in house team may have to learn new skills5. if done by the original manufacturer disadvantages such as those for off the shelf packages may arise

Add-ons and programming toolsTwo other ways of trying to give a computer user more flexibility with packages are:1. the sale of add-ons to a basic package, which an organisation may purchase if the add-ons suit their particular needs2. the provision of programming tools such as 4GLs with a package, which allows users to write amendments to the software without having to be a programming expert

Software Contracts and licenses


Software contractsThe agreement to supply bespoke software should be formally laid out in a contract. The contract to supply the software is likely to include terms relating to:• The cost, and what this figure does and does not include• Delivery date• Ownership of the source code, sometimes referred to as ownership rights• Right to make copies• Number of licensed users• Performance criteria, such as what the software will and will not do, processing speed• Warranty period• Support available• Arrangements for upgrades• Maintenance arrangements

Software licensesPackaged software generally has a license, the terms of which users are deemed to have agreed to the moment the package is unwrapped or a seal is brokenA license typically covers matters such as:• How many users can use the software• Whether the software may be modified• In what circumstances the license is terminated• A limitation of liability should the software contain bugs or be misused. This is a complex area that is still developing. The representations that the software supplier makes regarding the package’s capabilities would also be taken into account in any legal dispute.

Please note:1. When a user purchases software they are merely buying the right to use the software in line with the terms and conditions within the license agreement.2. A breach of the license conditions usually means the owner’s copyright has been infringed.3. The unauthorized copying of software is referred to as software piracy. If an organisation is using illegal copies of software, the organisation may face a civil suit, and corporate officers and individual employees may have criminal liability.4. The most common type of software misuse in a business setting is referred to as Corporate-Over-Use. This is the installation of software packages on more machines than there are licenses for.

To ensure they do not infringe copyright organisations should:• Make sure they receive and keep licenses – these are valuable documents• Track the number of users with access to licensed programs• Periodically check all computers for unlicensed software• Buy from reputable dealers• Get a written quote listing hardware/software specification version• Require an itemized invoice giving details of all hardware and software supplied.


Paper 2.1 – Information SystemsChapter 12Quality Assurance and Testing

• Quality software• Approaches to quality• External quality standards• Quality and information system development• Stages of testing• Methods of testing• Developing a testing strategy

Quality SoftwareThe concept of quality is concerned with fitness for purpose, i.e. the conformance to customer (user) needs.

High quality software should possess the following characteristics:1. No major bugs2. Produced within budget3. Produced on time4. Meet user needs and specification5. Competitive and compatible with other products6. Produced according to best practices.

Approaches to qualityAn organisation may attempt to maintain quality throughout their operations through one of, or a combination of, three approaches:• Quality management – is concerned with controlling activities with the aim of ensuring that products or services are fit for their purpose, and meet specifications. Quality management encompasses quality assurance and quality control.• Quality assurance – involve a supplier guaranteeing the quality of goods or services supplied. Procedures and standards are devised with the aim of ensuring defects are eliminated.• Quality control – is concerned with checking and reviewing work that has been done. Quality control therefore has a narrower focus than quality assurance.

Quality managementFaulty output is costly – as it wastes resources and damages relationships. The essence of quality management is that quality should be ‘built-in’ to all processes and materials used within an organisation, with the ultimate aim of no sub-standard output.

Quality management focuses on the belief that the quality is essential if an organisation is to prosper. Quality management, sometimes referred to as Total Quality Management or TQM, has been adopted as a business philosophy.

Principles of TQM1. Prevention – it costs less, in the long run, to prevent defective production than to employ teams of inspectors, to scrap materials or to rework shoddy output.2. Right first time – defective production is o9wrse than no production3. Zero defects – the aim should be no defects. In products with many components, the defect rates in components should be extremely small.4. Eliminate waste – this includes time, materials and money spent on dealing with customer complaints5. Everybody’s concern – quality is not just the concern of the production department, but is a culture for the whole business6. Internal customers – each part of an organisation requires services form other parts of the organisation. User departments are thus internal customers


7. Quality chains – internal customers are linked in quality chains – they are dependant on the product/service they receive from, and pass on to, each other8. Continuous improvement – TQM is not a goal that is achieved, but a way of managing. Firms should continually seek ways to improve their performance9. Employee participation – as so much attention is paid to the production process itself, the production workforce has a vital role to play in managing and improving quality10. Teamwork – ‘Managing quality involves systems and techniques, and requires the identification of individuals with company success through teamwork’. Holmes.

Holmes’ eight-stage model for implementing quality management1. Find out the problems – from customers and employees2. Select action targets – on the basis of cost, safety, importance, and feasibility3. Collect data – about the problem4. Analyze data – by a variety of techniques to assess common factors behind the data, to tease out any hidden messages the data might contain5. Identify possible causes6. Plan improvement action7. Monitor the effects of the improvement8. Communicate the result

Quality assuranceThe term ‘quality assurance’ is used where a supplier guarantees the quality of goods or services they su7pply. Quality assurance programs usually involve a close relationship between supplier and customer, which may extend to allowing customer representatives to view and/or monitor production procedures.Quality assurance emphasizes the process and procedures used to produce a product or service – the logic being that if these are tightly controlled and monitored the resulting product and service will be high quality. As quality has been ‘build-in’, the routine inspection of goods after production should be required.

Quality controlQuality control focuses on the product or service produced, rather than the production procedures.Quality control involves establishing standards of quality for a product or service, implementing procedures that are expected to produce products of the required standard in most cases and monitoring output to ensure sub-standard output is rejected or corrected.

The cost of qualityQuality involves four types of cost. These are:1. Prevention costs – are costs incurred to ensure the work is done correctly – for example ensuring the system design is correct before beginning production. Prevention costs are the cost of avoiding poor quality2. Appraisal costs – are the costs of inspection and testing – for example design reviews, structured walkthroughs and program testing3. Internal failure costs – are the costs of correcting defects discovered before the system is delivered4. External failure costs – are costs arising to fix defects discovered after the system has been delivered.

However, operating to high quality standards and procedures should also produce savings. Expenditure on failure prevention can reduce the cost of failure. Another saving is the reduction in quality inspection costs.

External Quality StandardsA number of organisations produce quality standards that can be applied to variety of organisations. The most widely used are those published by the International Organisation for Standardisation (ISO).ISO standards can be applied to many types of organisations – including those involved in producing software. The standards are updated periodically – the current standards are the ISO 9000 series.

Quality and information system developmentThe V Model


The V model shows the relationship between system development, testing and quality throughout a system development project.The left leg of the V shows the system development stages of analysis and design – including programming. The upward leg covers the assembly and testing phases and product delivery.

V model ‘quality links’The model shows three links between the left and right legs of the V. these links all refer to testing of some sort.

• Starting from the bottom point of the V traveling up the right leg, the first link is between ‘debugged’ modules of the system and the module design. This check ensures individual models operate as intended. (Modules = components).• The second quality link checks the integrated software against the design specification for the integrated modules. (interface testing)• At the top of the V is the final test of quality. The verified system is checked against the overall systems specification. This process includes user acceptance testing and system hand-over or sign off.

Stages of Testing

Component TestingStarting from the bottom the first test level is "Component Testing", sometimes called Unit Testing. It involves checking that each feature specified in the "Component Design" has been implemented in the component.In theory an independent tester should do this, but in practice the developer usually does it, as they are the only people who understand how a component works. The problem with a component is that it performs only a small part of the functionality of a system, and it relies on co-operating with other parts of the system, which may not have been built yet. To overcome this, the developer either builds, or uses special software to trick the component into believing it is working in a fully functional system.Interface Testing

As the components are constructed and tested they are then linked together to check if they work with each other. It is a fact that two components that have passed all their tests, when connected to each other produce one new component full of faults. These tests can be done by specialists, or by the developers.

Interface TestingInterface Testing is not focused on what the components are doing but on how they communicate with each other, as specified in the "System Design". The "System Design" defines relationships between components, and this involves stating:• What a component can expect from another component in terms of services.• How these services will be asked for.• How they will be given.• How to handle non-standard conditions, i.e. errors.

Tests are constructed to deal with each of these.The tests are organised to check all the interfaces, until all the components have been built and interfaced to each other producing the whole system.

System TestingOnce the entire system has been built then it has to be tested against the "System Specification" to check if it delivers the features required. It is still developer focused, although specialist developers known as systems testers are normally employed to do it.In essence System Testing is not about checking the individual parts of the design, but about checking the system as a whole. In effect it is one giant component.System testing can involve a number of specialist types of test to see if all the functional and non-functional requirements have been met. In addition to functional requirements these may include the following types of testing for the non-functional requirements:• Performance - Are the performance criteria met?


• Volume - Can large volumes of information be handled?• Stress - Can peak volumes of information be handled?• Documentation - Is the documentation usable for the system?• Robustness - Does the system remain stable under adverse circumstances?

There are many others, the needs for which are dictated by how the system is supposed to perform.

Acceptance TestingAcceptance Testing checks the system against the "Requirements". It is similar to systems testing in that the whole system is checked but the important difference is the change in focus:• Systems testing checks that the system that was specified has been delivered.• Acceptance Testing checks that the system delivers what was requested.

The customer and not the developer should always do acceptance testing. The customer knows what is required from the system to achieve value in the business and is the only person qualified to make that judgment.The forms of the tests may follow those in system testing, but at all times they are informed by the business needs.

Release TestingEven if a system meets all its requirements, there is still a case to be answered that it will benefit the business. The linking of "Business Case" to Release Testing is looser than the others, but is still important.Release Testing is about seeing if the new or changed system will work in the existing business environment. Mainly this means the technical environment, and checks concerns such as:• Does it affect any other systems running on the hardware?• Is it compatible with other systems?• Does it have acceptable performance under load?

These tests are usually run the by the computer operations team in a business. The answers to their questions could have significant a financial impact if new computer hardware should be required, and adversely affect the "Business Case".It would appear obvious that the operations team should be involved right from the start of a project to give their opinion of the impact a new system may have. They could then make sure the "Business Case" is relatively sound, at least from the capital expenditure, and ongoing running costs aspects. However in practice many operations teams only find out about a project just weeks before it is supposed to go live, which can result in major problems.

Methods of Testing

Static testing and dynamic testingSoftware testing may be carried out in a static environment or a dynamic environment.Static testing describes the process of evaluating a system or component based on its form, structure and content. The program or process is not executed or performed during static testing.Dynamic testing is testing that is performed by executing a program. It involves running the program and checking the results are as expected.Both static and dynamic testing play an important role in software development. Static testing allows the program or part of program to be looked at in isolation – which means that other programs or parts of the system do not influence the test, and are not affected by the test. Many logical and coding errors are able to be found by simply checking and reviewing the code.However, it is only when actually running a program that some errors will be discovered. Dynamic testing will reveal any potential conflicts between the program and other elements of the system (hardware and software).

Test scripts and decision tablesA test script is a document that lists all tests that a new piece of software will be subjected to. It is likely that some tests from the script would be carried out by the programmer, and some by users. The script should include procedures for noting the results of the test, and for details of any suspected errors.Decision tables also known as cause-effect charts are used as a method of demonstrating the effect of a process or action in a concise manner. Decision tables are useful in deciding what action to take if an error is identified when following a


test script.A decision table consists of four quadrants, as shown below:Condition stub – specifies what is being tested Condition entry – the outcome for the condition stub, in the form of Y (yes) or N (no)Action stub – the range of possible actions Action entry – when the action or actions that will be performed, in the form of Xs (just a mark!)

The basic principle is to find the number of conditions first, and then the number of actions that can be performed.

ExampleJed decided to draw up a decision table demonstrating the decision-making process he executed when he woke up each day.He identified 3 conditions, is it 8 O’clock yet? Is it a weekday? Is it a weekend?

The actions are, either wake up, or stay in bed.

AnswerSince there are three conditions and two actions, the number of possible entries (represented in columns) are: 2^3 = 8.

1 2 3 4 5 6 7 8Is it 8 o’clock yet? Y Y Y Y N N N NIs it a week day? Y Y N N Y Y N NIs it the week end? Y N Y N Y N Y NGet up X Stay in bed X X X

Note that columns 1, 4, 5, and 8 have no marks, this is because these conditions cannot occur at the same time.

Also note that in condition one, the Ys are listed in fours and the Ns are listed in fours.Condition 2, The Ys and Ns are listed by twosCondition 3, The Ys and Ns are listed one after the other.

This is very important!

Performance TestingTests can also be classified according to what they are testing – specifically performances and usability.

Performance testing is conducted to evaluate the compliance of a system or component with specified performance requirements.The specific performance requirements which performance testing uses will vary depending on the nature of the system. The initial specification for the software should provide suitable performance testing criteria.As it is possible that the demands placed on the system and software may increase over time, it is useful to know what volume of transactions the system can cope with. Performance testing is therefore taken a ‘step-further’, to establish the volume of transactions or data the system can process before the software ceases to operate. This process is known as ‘stress testing’.

Usability testingUsability testing is conducted to establish the relative ease with which users are able to learn and use a system.Usability testing is vital as a system may look great on paper and perform well when tested by analysts and programmers, but prove inefficient when used by users in the required operating environment.

Usability testing has a slightly different emphasis than user acceptance testing. Usability testing is concerned with lessons that could be learned regarding system design, in order to produce a system that is easier to learn and use. It is possible to


improve usability without actually changing system capabilities – by making something more user-friendly. User acceptance testing is more specific- its purpose is to establish whether the users are satisfied that the system meets the system specification when used in the actual operating environment.

Automated testing toolsSoftware testing can be very time consuming – often accounting for 30 percent of software development effort and budget. The need for thorough testing to achieve a quality product often conflicts with the requirement to produce the system on time and within budget.The need for more efficient testing has led to the development of automated software testing. Automated testing involves using computer programs that automatically run the software to be tested, and record the results.Automated testing tools are sometimes referred toa s Computer Aided Software Testing (CAST) tools. There are products available that can automate a variety of tasks, including:• Executing various command combinations and recording the results• Testing software in a variety of operating environments and comparing results• The debugging of some ‘obvious’ programming errors• Facilities to track and document all testing and quality assurance information

Automated testing routines may be written by the same organisation that is writing the software, or, a specialized software testing product could be used.

Developing a Testing StrategyThere are numerous testing stages and techniques available to system developers. To ensure a coherent, effective approach to testing, a testing plan should be developed. This plan would normally form part of the overall software development quality plan.A testing strategy should cover the following areas:1. Strategy approach – a testing strategy should be formulated including the testing tools/techniques that will be used2. Test plan – what will be tested, when, and the test environment3. Performing tests – detailed procedures4. Documentation – the results, a starting point for error correction procedures5. Re-testing – after error correction, to ensure they haven’t affected other aspects of the software.

The limitations of software testing are:1. Poor testing process2. Inadequate time3. Future requirements not anticipated4. inadequate test data5. software changes inadequately tested


Paper 2.1 – Information SystemsChapter 13 Implementing Systems

• Implementation strategy and Changeover• Training• Documentation• File conversion

Implementation StrategyThe implementation of a new computer system is a complex task, particularly with large systems. As with any complex task involving a number of related issues, planning is the key to success.The implementation phase involves distributing the system to those parts of the organisation which must use it. This involves distributing:1. forms2. manuals3. documentation4. training materials5. equipment as well as the computer programsOnce the new system has been fully and satisfactorily tested the changeover can be made. This may be according to one of four approaches.• Direct changeover• Parallel running• Pilot operation• Phased or ‘staged’ changeover

Direct changeoverThe old system is completely replaced by the new system in one move.This may be unavoidable where the two systems are substantially different, or where the cots of parallel running are too great. While this method is comparatively cheap it is risky. The new system should be introduced duringa quiet period, for example over a bank holiday weekend or during an office closure.

Parallel runningThe old and new systems are run in parallel for a period of time, both processing current data and enabling cross checking to be made.This method provides a degree of safety should there be problems with the new system. However, if there are differences between the two systems cross-checking may be difficult or impossible.There is a delay in the actual implementation of the new system, a possible indication of lack of confidence, and a need for more staff to cope with both systems running in parallel.

This cautions approach, if adopted, should be properly planned, and the plan should include:• A firm time limit on parallel running• Details of which data should be cross-checked• Instructions on how errors are to be dealt with e.g. previously undiscovered errors in the old system• Instructions on how to report and act on any major problems in the new system

Pilot operationPilot operation involves selecting part or parts of an organisation (e.g. a department or branch) to operate running the new system in parallel with the existing system. When the branch or department pioloting the system is satisfied with the new system, they cease to use the old system. The new system is then piloted in another area of the organisation.Pilot operation is cheaper and easier to control than running the whole system in parallel, and provides a greater degree of safety than does a direct changeover.


Phased changeoverPhased changeover involves selecting a complete section of the system for a direct changeover, e.g. in an accounting system the purchase ledger. When this part is running satisfactorily, another part is switched – until eventually the whole system has been changed.

A phased series of direct changeovers is less risky than a single direct changeover, as any problems and disruption experienced should be isolated in an area of operations.

The advantages and disadvantages of the various changeover methods are outlined below.Method Advantages DisadvantagesDirect Changeover • Quick• Minimised cost• Minimises work load • Risky• Could disrupt operations• If fails, will be costlyParallel running • Safe, built in safety• Provides way of verifying results of new system • Costly-two systems need to be operated• Time consuming• Additional workloadPilot operation • Less risky than direct changeover• Less costly than complete parallel running • Can take a long time to achieve total changeover• Not as safe as complete parallel runningPhased Changeover • Less risky than a single direct changeover• Any problems should be in one area other operations unaffected • Can take a long time to achieve total changeover• Interfaces between parts of the system may make this impractical

How the system implementation is conducted will have a significant impact on how users perceive the new system. A poorly planned implementation, that causes widespread disruption, is likely to result in users viewing the system negatively – which will hinder system operation.It is important, therefore, that implementation procedures are designed so that likely problems are avoided and that unavoidable problems are managed to cause minimal disruption. Project management tools and techniques are relevant here.The introduction of a new system will change the way some people work, and will impact on enstablished working relationships. To ensure staff support for change, users should be involved and kept informed at all stages of system development.If the new system will result in some roles becoming redundant, management should handle these issues sensitively and openly. Re-training should be offered if other positions are available.To get full value from a system, it is essential that staff are aware of what the systems capabilities are, and how these can be applied to help staff perform their roles. Training is the key to achieving this.

TrainingStaff training in the use of information systems and information technology is essential if the return on investment in IS/IT is to be maximized.Training is not simply an issue that affects operational staff. Training in information technology affects all levels in an organisation, from senior managers learning how to use an executive information system for example, to accounts clerks learning how to use an accounting package.Training will be needed when:


• a new system is implemented• an existing system is significantly changed• job specifications change• new staff are recruited• skills have been forgottenDocumentationDocumentation includes a wide range of technical and non-technical books, manuals, descriptions and diagrams relating to the design, use and operation of a computer system.

Technical manualThe technical manual is produced as a reference tool for those involved in producing and installing the system. The technical manual should include the following:1. contact details for the original developers2. system overview3. system specification sincluding performance details4. hardware technical specification5. system objectives6. flowcharts or data flow diagrams7. entity models and life histories8. individual program specifications9. data dictionaryThe technical manual should be referred to when future modifications are made to the system. The technical manual should be updated whenever system changes are made.

User manualThe system should be documented from the point-of-view of users. User documentation is used to explain the system to users and in training. It provides a point of reference should the user have problems with the system.

The manual provides full documentation of the operational procedure necessary for the ‘hands-on’ running of the system. These would include:• System setup procedures• Security procedures• Reconstruction control procedures• System messages• Samples

File ConversionFile conversion, means converting existing files into a format suitable for the new system.Most computer systems are based around files containing data. When a new system is introduced, files must be created that conform to the requirements of that system.The various scenarios that file conversion could involve are outlined in below:

Held in manual (i.e. paper) filesData must be entered manually into the new system – probably via the use of input forms, so that data entry operators have all the data they require in one document. This is likely to be a time-consuming process.

Held in existing computer filesHow complex the process is in converting the files to a format compatible with the new system will depend on various technical issues such as whether coding systems are changing. It may be possible to automate much of the conversion process.Held in both manual and computer files Two separate conversion procedures are required

Existing data is incomplete


If the missing data is crucial, it must be researched and made available in a format suitable for the new system –or suitable for the file conversion process.Paper 2.1 – Information SystemsChapter 14 Security and Legal Compliance

• Security• Physical threats• Physical access control• Building controls into an information system• Privacy and data protection• Internet security issues• Information systems and the accountant

SecuritySecurity, in information management terms, means the protection of data from accidental or deliberate threats which might cause unauthorized modification, disclosure or destruction of data, and the protection of the information system from the degradation or non-availability of services.Security refers to technical issues related to the computer system, psychological and behavioural factors in the organisation and its employees, and protection against the unpredictable occurrences of the natural world.Security can be subdivided into a number of aspects:1. Prevention2. Detection3. Deterrence4. Recovery procedures5. Correction procedures6. Threat avoidance

Physical threats1. Fire2. Water3. Weather4. Lightning5. Terrorist activity6. Accidental damage

Physical Access controlPhysical access controls are designed to prevent intruders getting near to computer equipment and/or storage media. These include1. Personal identification numbers2. Door locks3. Card entry systems4. A log of all equipment to prevent computer theft of smaller and portable items

Building controls into an information systemIt is possible to build controls into computerized processing. A balance must be struck between the degree of control and the requirement for a user friendly system. The computerized system includes all procedures related to the system.

Controls can be classified into• Security controls (as discussed above)• Integrity controls• Contingency controls


Integrity controlsData integrity in the context of security is preserved when data is the same as in source documents and has not been accidentally or intentionally altered, destroyed or disclosed.Systems integrity refers to system operation conforming to the design specification despite attempts (deliberate or accidental) to make it behave incorrectly.Data will maintain its integrity if it is complete and not corrupted. Input controls should ensure the accuracy, completeness and validity of input.

Audit trailsAn audit trail is a record showing who has accessed a computer system and what operations he or she has performed. Audit trails are useful both for maintaining security and for recovering lost transactions. Accounting systems include an audit trail component that is able to be output as a report.In addition, there are separate audit trail software products that enable network administrators to monitor use of network resources.An audit trail should be provided so that every transaction on a file contains a unique reference.

Typical contents of an accounting software package audit trail include the following items• A system generated transaction number• A meaningful reference number• Transaction type• Who input the transaction• Full transaction details• The PC or terminal used to enter the transaction• The date and time of the entry• Any additional reference or narration entered by the user.

Contingency controlsA contingency is an unscheduled interruption of computing service that requires measures outside the day-to-day routine operating procedures.The preparation of a contingency plan is one of the stages in the development of an organisation-wide security policy. A contingency plan is necessary in case of a major disaster, or if some of the security measures discussed elsewhere fail.A disaster occurs where the system for some reason breaks down, leading to potential lossess of equipment, data or funds. The system must recover as soon as possible so that further losses are not incurred, and current losses can be rectified.

Contents of a disaster recovery plan1. Definition of responsibilities – who takes control?2. Priorities – some tasks more important than others3. Breakup and standby arrangements – reverting to manual procedures or other systems?4. Communication with staff – poor communication will compound the problem!5. Public relations – if it has public impact, more pressure is there from the media6. Risk assessment – it must be contained with the continued operation of the co as a whole!

Privacy and data protectionPrivacy is the right of the individual to control the use of information about him or her, including information on financial status; health and lifestyle (i.e. prevent unauthorized disclosure).

The Data Protection Act 1998 is an attempt to protect the individual. The terms of the Act cover data about individuals – not data about corporate bodies.

The Act refers to:• Personal data – it is information about a living individual, including expressing an opinion about him or her.• Data users – organisations or individuals who control personal data and the use of personal data• Data subject – is the individual who is the subject of personal data

The data protection principles include eight Data Protection Principles with which data users must comply.1. Personal data shall be processed fairly and lawfully


2. Personal data shall be obtained only for one or more specified and lawful purposes and shall not be processed in any manner other than for that purpose.3. Personal data shall be adequate, relevant and not excessive4. Personal data shall be accurate, where necessary, kept to date5. Personal data shall not be kept for longer than is necessary for its purpose6. Personal data shall be processed in accordance with the rights of data subjects7. Appropriate technical and organisational measures shall be taken against unauthorized or unlawful processing of personal data8. Personal data shall not be transferred to a country or territory outside the European Economic Area unless that territory ensures an adequate protection for the rights and freedoms of data subjects.

Processing of personal data is forbidden except in the following circumstances1. With the consent of the data subject2. As a result of a contractual arrangement3. Because of a legal obligation4. To protect the vital interests of the subject5. Where processing is in the public interest6. Where processing is required to exercise official authority

Internet Security IssuesHackingVirusesEncryptionJokes and hoaxesDenial of service attack

Information systems and the accountantDepending on the size and structure of the organisation, the responsibility for ensuring an organisation’s information systems operate efficiently and comply with relevant legislation may fall to the accountant. In other organisations these responsibilities may rest with the Company Secretary or the Information Systems Manager.Historically, accountants have played an important role in information systems installations. The accounting function was often the first area of an organisation to be computerized and many organisations lacked specialist IS/IT staff.

As the importance of IS/IT has increased large and medium sized organisations have created specialist IS/IT departments. In many smaller organisations the accountant still has responsibility for information systems.Even in larger organisations, the accountant has an important role to play in the information systems function. Key areas include• Investment appraisal• Cost-benefit analysis• Internal audit requirements• Performance measurement e.g. metrics• Presenting user concerns (e.g. accounts department staff)• Assessing usability


Paper 2.1 – Information SystemsChapter 15 Post-Implementation Issues

• Post-implementation review• Systems maintenance• End-user development and user groups• Evaluation• Computer-based monitoring• System performance

Post-implementation reviewPost implementation review should establish whether the objectives and targeted performance criteria have been met, and if not, why not, and what should be done about it.In appraising the operation of the new system immediately after the changeover, comparison should be made between actual and predicted performance. This will include:• Consideration of throughput speed (time between input and output)• Use of computer storage (both internal and external)• The number and type of errors/queries• The cost of processing (data capture, preparation, storage and output media, etc)

A special steering committee may be set up to ensure that post-implementation reviews are carried out, although the internal audit department may be required to do the work of carrying out the reviews.The post-implementation measurements should not be made too soon after the system goes live, or else results will be abnormally affected by ‘teething’ problems, lack of user familiarity and resistance to change.

The post-implementation review reportThe findings of a post-implementation review team should be formalized in a report.• A summary of their findings should be provided, emphasizing any areas where the system has been found to be unsatisfactory.• A review of system performance should be provided. This will address the matters outlined above, such as run times and error rates.• A cost-benefit review should be included, comparing the forecast cost and benefits identified at the time of the feasibility study with actual costs and benefits• Recommendations should be made as to any further action or steps which should be taken to improve performance

Systems maintenance

Types of maintenance:• Corrective – is carried out when there is a system failure of some kind, for example in processing or in an implementation procedure. Its objective is to ensure that systems remain operational.• Perfective – is carried out in order to perfect the software, or to improve software so that the processing inefficiencies are eliminated and performance is enhanced.• Adaptive – is carried out to take account of anticipated changes in the processing environment. For example new


taxation legislation might require change to be made to payroll software.

Corrective maintenance usually consists of action in response to a problem. Much perfective maintenance consists of making enhancements requested by users to improve or extend the facilities available. The user interface may be amended to make software more user friendly.

The key features of system maintenance ought to be flexibility and adaptability.• The system, perhaps with minor modifications, should cope with changes in the computer user’s procedures or volume of business• The computer user should benefit from advances in computer hardware technology without having to swich to another system altogether.

The causes of system maintenanceBesides environmental changes, three factors contribute to the need for maintenance.

ErrorsHowever carefully and diligently the systems development staff carry out systems testing and program testing, it is likely that bugs will exist in a newly implemented system. The effect of errors can obviously vary enormously.

ConstraintsCost constraints may have meant that certain requested features were not incorporated. Time constraints may have meant that requirements suggested during development were ignored in the interest of prompt completion.

Changes in requirementsAlthough users should be consulted at all stages of systems development, problems may arise after a system is implemented because users may have found it difficult to express their requirements, or may have been concerned about the future of their jobs and not participated fully in development.

Poor documentationIf old systems are accompanies by poor documentation, or even complete lack of documentation, it may be very difficult to understand their programs. It will be hard to update or maintain such programs. Programmers may opt instead to patch up the system with new applications using newer technology.

The systems maintenance lifecycleCorrective and adaptive maintenance should be carried out as and when problems occur, but perfective maintenance may be carried out on a more scheduled system-by-system basis.If maintenance requires major changes to bespoke software, this will involve all the tasks included in the software development and testing cycle.Systems should be built with a certain amount of flexibility that allows changes to be made in the future to cope with different demands. Changing a system carries the same risks associated with the initial system development. Any system changes should therefore pass through a formal change procedure.

System change procedure

Raise the change requestThis is a definition of the required change in business functionality. It is usually specified in business terms. For example, ‘the ability to support three regions rather than one’. The reason for the required change should be specified, with


business benefits defined and quantified.

Evaluate the impact of the requested changeThe change is investigated and the time and cost taken to develop, test and implement the change is estimated. This time and cost must take into account the total impact of the change on the system. The cost of the change is compared with the benefits that it will bring and if the decision is taken to proceed, then a priority is allocated to the change.

Specifiy the change requestA detailed specifications for the change is prepared by the systems developer. This detailed specification must be developed in consultation with, and subsequently signed off by, user representatives

Program and unit testing the changeProgrammers write the program code, and then unit testing is carried out

Regression, system and acceptance testingFollowing unit testing, the amended program is tested in a realistic environment.

Implement the changeFollowing user acceptance testing, the changes are implemented on the live system

In-house maintenanceWith large computer systems, developed by the organisation itself, in-house systems analysts and programmers might be given the responsibility of software maintenance.To ensure that maintenance is carried out efficiently, the principles of good programming practice should be applied.

Regression testingRegression testing involves the retesting of software that has been modified to fix ‘bugs’. It aims to ensure that the bugs have been fixed and that no other previously working functions have failed as a result of the changes.Regression testing involves repeating system tests that had been executed correctly before the recent changes were made.Only the changes expected as a result of the system maintenance should occur under the regression test – other changes could be due to errors caused by the recent change.

Problems with regression testing include:• Deciding on the extent of testing required• Envisaging all areas possibly effected• Convincing users and programmers that the tests are necessary.

End-user development and user groupsEnd-user developmentEnd-user development is the direct, hands-on development of computer systems by users.Accounts staff designing and using complex spreadsheet models is an example of end user computing.Many users who develop their own applications have little or no formal training in programming, consequently their programs might be extremely crude and virtually incomprehensible.

While these programs may work they will be very difficult to modify and they will very often be the personal property of the individual who developed the system, with no wider use. This is undesirable from the organisation’s viewpoint: a great deal of time and energy is going into producing inefficient programs which are unusable by anyone


other than their developer.

Other disadvantages are as follows:• The risk from elimination of the separation of the functions of user and analyst• The risk from limits on user ability to identify correct and complete requirements for an application• The risk from lack of user knowledge and acceptance of application quality assurance procedures for development and operation• The risk from unstable user systems.• The risk from encourage private information systems• The risk from permitting unstructured information systems development

User groupsA user group is a forum for users of particular hardware or, more usually, software, so that they can share ideas and experience.User groups are usually set up either by the software manufacturers themselves or by groups of users. The term is used most commonly with users of packaged software.

EvaluationIn most systems there is a constant need to maintain and improve applications and to keep up to date with technological advances and changing user requirements. A system should therefore be reviewd after implementation, and periodically, so that any unforeseen problems may be solved and to confirm that it is achieving the desired results.The system should have been designed with clear, specified objectives, and justification in the terms of cost-benefit analysis or other performance criteria.Just as the feasibility of a project is assessed by reference to technical, operational, social and economic factors, so the same criteria can be used for evaluation.

Cost-benefit reviewA cost-benefit review is similar to a cost-benefit analysis, except that actual data can be used.For instance when a large project is completed, techniques such as DCF appraisal can be performed again, with actual figures being available for much of the expenditure.

Efficiency and effectivenessIn any evaluation of a system, two terms recur. Two key reasons for the introduction of information systems into an organisation are to improve the efficiency or the effectiveness of the organisation.An activity uses resources such as staff, money and materials. If the same activity can be performed using fewer resources or if it can be completed more quickly, the efficiency of the activity is improved. An improvement in efficiency represents an improvement in productivity.

Effectivieness is a measurement of how well the organisation is achieving its objectives.

MetricsMetrics are quantified measurements used to measure system performance.Metrics should be carefully thought out, objective and stated clearly. They must measure significant aspects of the system, be used consistently and agreed with users.

Computer-based monitoringComputer themselves can be used in systems evaluation. Three methods used are:• Hardware monitors


• Software monitors• System logs.

System performancePerformance measurementIt is not possible to identify and isolate every consequence of a project and the impact on each on organisational effectiveness. To achieve some approximation to a complete evaluation, therefore, certain indirect measures must be used.• Significant task relevance – attempts to observe the results of system use, use of metrics.• Willingness of users to pay might give an indication of value• System logs• User information satisfaction• Adequacy of system documentation

Performance reviewsThese will vary to content from organisation to organisation, but the matters which will probably be looked at are as follows:1. Growth rates in file sizes and the number of transactions processed2. The clerical manpower needs for the system3. The identification of any delays in processing and an assessment of the consequences of any such delays4. An assessment of the efficiency of security procedures5. A check of the error rates for input data6. An examination of whether output is being used to good purpose7. Operational running costs

Improving performanceComputer systems efficiency audits are concerned with improving outputs from the system and their use and/or reducing the costs of system inputs. With falling costs of computer hardware and software, and continual technological advances, there should often be scope for improvements in computer systems.

Output from a computer systemThese can be improved by raw processing power, storage facilities, and report generation.

Input to a computer systemThe efficiency of a computer system could be improved if the same volume and frequency of output could be achieved with fewer input resources, and at less cost. Here’s how:• Multi-user or network systems might be more efficient than stand-alone systems.Multi-user systems allow several input operators to work on the same files at the same time, so that if one person has a heavy workload and another is currently short of work, the person who has some free time can help his or her busy colleague – thus improving operator efficiency• Real-time systems might be more efficient than batch processing.• Using computers and external storage media with bigger storage capacity• Using more up-to-date softwareManagement might also wish to consider whether time spent checking and correcting input data can be eliminated. An alternative method of input might be chosen. For example bar codes and scanners should eliminate the need to check for input errors.


Paper 2.2CHAPTER 1Comparison of Criminal and Civil Law

Purpose

Criminal punishment of the wrongdoerCivil compensation of the victim

Case brought by

Criminal – the stateCivil – the victim

Action

Criminal – prosecutionCivil – suing

Burden of proof

Criminal – beyond reasonable doubtCivil – on a balance of probabilities

CourtCriminal – Magistrates Court, Crown CourtCivil – County Court, High Court

Outcome if defendant losesCriminal – imprisonment, fine, community serviceCivil – specific performance, injunction, damages


Paper 2.2CHAPTER 2SOURCES OF LAW

There are four sources:EquityLegislationEuropean Union Law1 COMMON LAW

Prior to the Norman Conquest there was no centralised system of Government or law.

All laws being based on local customs.With the coming of the Normans after 1066 they selected the best customs anddeveloped a law that was common to the whole country. i.e. Common Law .Before a litigant could bring an action in a common law court he first had to obtain a writ. In the early thirteenth century new writs were refused and as a consequence the law began to stagnate. This led to the expression “No writ, no remedy” If a litigant were successful, the only remedy given by the common law was damages,which in all situations were not the most appropriate remedy.Common law was also very rigid, complicated and inflexible.Due to the above defects litigants began to petition the king. Initially he dealt with the complaints himself but later delegated the responsibility to his own Lord Chancellor who developed his own system of law based on his own conscience. i.e. Equity

2 EQUITY(Equity means fairness and equality)Developed to overcome the defects in the common law and to supplement it.The Lord Chancellor set up his own court, the Court of Chancery to administer this new source of law.Equity was far more flexible, recognising new rights, e.g. The trust and mortgage.Developed new remedies, specific performance, Injunctions and rescission.The two systems of law ran parallel to each other, however conflict arose and as aresult of the Earl of Oxfords case 1615, it was decided that in the event of conflict “equity was to prevail”.Equity did not replace the common law, it supplemented the common law, it filled inthe gaps left by the common law, it was a gloss on the common law not a substitute for it.

The Current Position:If there is a conflict, equity prevails The common law remedy is damages, equity providing alternative remedies of specific performance, injunction and rescission. Common law remedies are available as of right. Equitable remedies arediscretionary Civil courts can award both common law and equitable remedies in any action i.e., they are not mutually exclusive.Both are subject to the doctrine of judicial precedent

Equitable Maxims:Equity will not suffer a wrong to be without a remedyHe who seeks equity must do equityDelay defeats equity

3 LEGISLATION

In the United Kingdom legislation is made by or on behalf of Parliament. i.e. House of Commons, House of Lords and the Crown

3.1 USING LEGISLATIONLegislation may be used to develop law by:Creating new law


Repealing or altering new lawConsolidating existing lawCodifying existing lawImplementing European Union directives

3.2 TYPES OF LEGISLATION:That made by Parliament itself i.e. an act of Parliament (statute) Delegated legislation

3.3 THE LEGISLATIVE PROCESS:The procedure that has to be followed before the Bill becomes an Act is as follows:First Reading The name of the Bill and its proposer is laid before the House of Commons Second Reading Detailed debate on the principles of the Bill and vote Committee Stage Bill is examined as to it’s wording, and amendments suggested Report stage Amendments reported back to the house and discussion on the amendments.

Third Reading Final debate on the principles of the Bill and a vote House of Lords Similar procedure is followed The Royal Assent

3.4 DELEGATED LEGISLATIONThis is not created by Parliament itself but by persons or bodies to whom Parliament has delegated some of its powers and responsibilities, such as Ministers, Local Authorities, Inland Revenue Types:Orders in CouncilStatutory InstrumentsBye-lawsActs of the Scottish, Welsh and Northern Ireland AssembliesAdvantages:Time savingTechnical expertiseFlexibilityDisadvantages:BulkUndemocraticLack of publicityControls/Safeguards:ParliamentHouse of Commons committee on statutory instrumentThe 40 day ruleCan withdraw the powerBye-laws must be approved by a ministerCourtHigh Court can under its supervisory powers declare them “Ultra Vires” i.e. beyond the powers

4 EUROPEAN COMMUNITY LAWBritain became a member of the European Community by virtue of the European Communities Act 1972. The single European Act 1993 has brought about a greater degree of economic and political union. As a result Parliament has accepted that UK law is subject to EC Law and consequently has surrendered a degree of national sovereignty.

Parliament the supreme law maker in the UK cannot override EC law and English Courts must apply it.

4.1 INSTITUTIONS OF THE EUROPEAN UNIONThe European CommissionComprises of 20 European Commissioners from the member states. They propose draft legislation and ensure treaty obligations are observed and can refer cases to the European Court of Justice (ECJ)


Council of MinistersComprises 15 ministers from member states. The council adopts the proposed legislation from the commission.

The European ParliamentComprises of directly elected members mostly concerned with budgetary matters, but can veto legislation.

European Court of JusticeEnsures observance and recognition of community rules with regard to legal interpretation and application. English courts must apply them.

4.2 E.U. LEGISLATIONThere are two forms:Primary LegislationThe treaties i.e. The Treaty of Rome 1957 which established the institutions and set up the communityThe Maastrict Treaty which amended the Treaty of Rome and created the Single European Union

Subordinate LegislationRegulations directly applicable on all member states. They are binding andenforceable from the time of their creation, i.e. self executing Directives are not directly applicable, but member states must alter national law within a specified time by it’s own legislation.Decisions are addressed to states, institutions or individuals and are directly applicable and have the immediate force of law.


Paper 2.2CHAPTER 3

HUMAN RIGHTS

1 THE HUMAN RIGHTS ACT 1998The overall effect of the Act is to incorporate the European Convention on Human Rights into English Law and to allow actions for their contravention to be brought in UK courts rather than the European Court of Human Rights in Strasbourg.

2 THE CONVENTION RIGHTSThe main rights are:The right to lifeProhibition of tortureProhibition of slavery and forced labourRight to liberty and securityRight to a fair trialRight to freedom of thought, conscience and religionRight to freedom of expressionRight to freedom of assembly and association

3 INCORPORATION OF THE RIGHTS INTO ENGLISH

LAWAll UK Courts and tribunals must take into account the convention when deciding a question that has arisen in connection with convention rights.When interpreting a convention right a fair balance must be struck between the demands of the public and the need to protect an individual’s rights.It is unlawful for any “public authority” E.g. Police courts, to act in such a way, which is incompatible with a convention right.The Act does not allow for actions to be brought against a private individual acting in his private capacity.When Parliament is making new legislation before the second reading of the Bill, the minister responsible must make a statement that either legislation is compatible with convention rights or such statement cannot be made but the government still wishes the bill to continue


Paper 2.2

CHAPTER 18

FORMATION AND PROMOTION OF COMPANIES

1 REGISTRATION OF COMPANIESDocuments to be delivered to the Registrar:Signed Memorandum of AssociationSigned Articles of Association (or Table A applies)Signed statement of first director(s) and secretaryAddress of registered officeStatutory declaration of complianceSmall feeOn registration the Registrar issues a Certificate of Incorporation and gives notice in the Gazette.2 TRADING CERTIFICATEA public company must obtain an additional certificate (Trading Certificate) before they can commence trading S117 CA 85To obtain this a public company must provide more information to the Registrar:Share CapitalPreliminary expensesAmount due or paid to promotersIf everything is in order the Registrar will issue a trading certificate under S117 and publish notice of it in the GazetteIf a PLC commences trading without first obtaining such a certificate the consequences are:The company is primarily liableIf the company does not meet it’s liabilities within 21 days of a demand being made the directors have personal liabilityThe company and its officers are liable to a fineIf a S117 certificate is not obtained within one year of incorporation it is grounds for winding up under the Insolvency Act 19863 RE-REGISTRATION OF COMPANIES3.1 PRIVATE TO PUBLICSpecial ResolutionAlter memo and Articles as requiredApplication to Registrar, supported by a balance sheet not less than seven months old and unqualified auditors report, plus statement that the net assets not less than the share capital plus undistributable reserves.Registrar then issues a new Certificate of Incorporation plus notice in the Gazette.3.2 PUBLIC TO PRIVATESpecial ResolutionAlter Memo and Articles as requiredApplication to RegistrarRegistrar then issues a new certificate of incorporation plus notice in the GazetteMinority Protection: - Dissentients representing 50 members or 5% of the nominal value of issued shares of any class have 28 days to apply to court3.3 LIMITED TO UNLIMITEDUnanimous written consent of membersDeclaration by directors that all members have consentedApplication to Registrar accompanied by appropriate documentation


Registrar then issues a new certificate of incorporation plus notice in Gazette. Thecompany may not change back to limited.3.4 UNLIMITED TO LIMITEDSpecial ResolutionApplication to Registrar accompanied by appropriate documentationRegistrar then issues a new certificate of incorporation plus notice in GazetteThe company cannot change back. Members at the date of the change retain unlimitedliability in the event of liquidation within three years.

3.5 PROMOTERSThere is no statutory definition. Those who decide to form a Company and take the necessary steps to set it going; see Twycross v GrantThe term does not include a person (eg a solicitor or an accountant) acting purely in a professional capacity on behalf of a promoter.3.6 DUTIESA promoter stands in a Fiduciary relationship to the company he is promoting. This means that he is in a position of trust and must act in good faith in the best interests of the company.This means:General duty of care and skillFiduciary duty not to make a secret profitAny profit made must be disclosed to an approved byAn independent board of directors and/orThe members andPotential members via a prospectus.3.7 REMEDIES FOR BREACH OF DUTYRecovery of the secret profit; see Gluckstein v BarnesRecission of the contract; see Erlanger v New Sombero Phosphate CoDamagesDisqualification under the Companies ActDirectors Disqualification Act 19864 POSSIBLE LIABILITIES OF PROMOTERS4.1 PRE INCORPORATION CONTRACTSA Company has no legal existence until it receives a certificate of incorporation. Therefore it cannot enter into contracts prior to incorporation, as it has no contractual capacity. At common law such a contract purportedly made on behalf of a company before it comes into existence cannot therefore be enforced by or against the company even once it is incorporated. Nor can it be unilaterally ratified after incorporationSee Kelner v BaxterS36C CA 85 states a person who contracts in behalf of a company prior to incorporation is personally liable on any such contract unless “there is an agreement to the contrary”.See Phonogram Ltd v Lane4.2 POSSIBLE SOLUTIONSPossible solutions for this problem are:-Postpone binding contracts until the company is formedOptionsAssignmentExclusion ClauseBuy a ready-made company i.e. off the shelf


Paper 2.2

CHAPTER 19

MEMORANDUM OF ASSOCIATION

This is the basic constitutional document outlining information about the company that outsiders need to know. In the event of any conflict between the memorandum and the articles, the memorandum being the superior document, will prevail.1 CONTENTS OF THE MEMORANDUMThe memorandum must contain the following clauses:Name ClauseRegistered Office ClausePublic Company Clause (if relevant)Objects ClauseLiability ClauseCapital ClauseAssociation Clause1.1 THE NAME CLAUSEThis states the corporate name of the companyA company can choose any name subject to restrictions imposed by the CA 1985The last word in a Private Company must be Limited or an abbreviation.The last word in a Public Company must be Public Limited Company or an abbreviationIt cannot be offensive (in the opinion of the Secretary of State)See AG v Lindi St Clair (Personal Services) LtdCertain words are prohibited by statute eg words associated with recognised charitiesIt cannot be the same as a name already appearing in the index kept by the RegistrarIt cannot be where words require permission and this has not been provided:It cannot imply a connection with Central or Local GovernmentIt cannot include any word or expression specified in the Business Names Act 1985 or its regulations1.2 CHANGE OF NAMEVoluntaryThis regulates the passing of a special resolutionApplication to the RegistrarChange effective from the date on the new certificate of incorporationMandatoryUnder the CA 85 the Secretary of State may order a company to change its name in the following circumstances:If the name is the same as or similar to an existing registered nameIf the name gives a misleading impressions as to the nature of the business as to cause harm to the publicIf the company gave misleading information when applying for the use of a regulated name.1.3 PASSING OFF


There is a tort of “passing off” where a person carries on a business under a name that would mislead the public into believing the business is conducted by another person.The most common method is to trade under a similar name. The injured party must prove that there is a genuine possibility of confusion. The court tends to allow the use of a person’s name who is directly involved with the company.RemediesAn injunction to prevent further violationDamagesSee Ewing v Buttercup Margarine Co and Fortnum and Mason Ltd v FortnumLtd1.4 BUSINESS NAMES ACT 1985Where a company is using a trade name, the true name must be clearly identified on all business correspondence and at the premises.The company must provide its true name to anyone who requests it.The legislation applies to all businesses.2 THE REGISTERED OFFICE CLAUSEThis shows the domicile ie the situation of the registered office eg England and Walesor ScotlandNo alteration of this is permitted except by an Act of ParliamentThe precise address of the Company must be within the domicile given in the memorandumChange must be notified to the Registrar. The choice of location is the director’s responsibility.2.1 FUNCTION OF THE REGISTERED OFFICEIt is the official address of the company and where legal documents, notices and communications may be served.The following statutory books must be kept at the registered office:Register of charges affecting the company’s propertyMinutes of general meetingsRegister of directors and secretariesAlso the following may be kept at the registered office:Register of debenture holdersRegister of substantial shareholdingsRegister of directors’ interests in shares/debenturesCopies of directors’ service contracts3 THE OBJECTS CLAUSEThis sets out the objects ie purpose of the company and defines the company’s contractual capacity.The clause was designed to protect shareholdersPrior to the Companies Acts 1985 and 1989, if a company entered into a contract which was outside its objects it was “ultra vires” and was void and unenforceable by either party to it.This rule could operate unfairly on third parties entering into transactions with the company since they were deemed to have “constructive notice” of the memorandum.3.1 THE COMPANIES ACT 1989A company may effectively opt out of the ultra vires rule completely by stating that the object of the company s to carry on business as “a general commercial company”.This means that:The object of the company is to carry on any trade or business whatsoever and The company has power to do all such things as are incidental or conducive to the carrying on of any trade or business by it.NB: many companies still have traditional objects, therefore the rules on ultra vires transactions are still relevant.3.2 REMEDIES FOR AN ULTRA VIRES TRANSACTIONS S35 CA 85 -


SHARE HOLDERSCan restrain an ultra vires act by seeking an injunction. Must be done before the agreement becomes bindingCan sue the directors for breach of a fiduciary dutyCan ratify the ultra vires act by a special resolutionNB: if the directors are to be absolved for breach of duty a separate special resolution must be passed3.3 THIRD PARTIESThe doctrine of ultra vires has effectively been abolishedThe validity of an act done by a company shall not be called into question on the grounds of lack of capacity by reason of anything in the company’s memorandum,provided the contract was entered into by the board Constructive notice no longer appliesThe objects clause can be altered at any time for any reason by special resolution. A copy of such resolution must be sent to the Registrar within 15 days notification in the London Gazette.4 MINORITY PROTECTIONThe holders of not less than 15% of the nominal value of the companies issued share capital of any class of shares may within 21 days apply to court for an alteration of the objects clause to be cancelled. The court can then do as it thinks fit. A copy of the amended memorandum must then be sent to the Registrar after the 21 day period has expired.5 THE CAPITAL CLAUSEThis must state:The amount of the share capital in poundsThe number of shares into which the share capital is dividedThe nominal value of each shareThis clause may be altered by an ordinary resolution6 THE LIMITED LIABILITY CLAUSEThis serves as a general notice to those dealing with the Company that the liability of its members is limited to the amount unpaid on their shares. If a member’s shares are fully paid up no further liability is owed.7 THE ASSOCIATION CLAUSEThe subscribers simply sign up to say that they are taking up a share in the company.This is a record and it cannot be altered.


Paper 2.2

CHAPTER 20

THE ARTICLES OF ASSOCIATION

The Articles are concerned with the internal regulations of a company ie the division of power between directors and shareholders.A limited company can register its own articles, adopt Table A (model form) or register amendments to Table A.1 THE CONTRACTUAL EFFECT OF THE MEMORANDUM AND THE ARTICLESThe company and its members are bound by the memo and articles.S14 CA 85 states that they are bound as if they had signed and sealed covenants to that effect, ie they constitute a contract between:member and company; see Hickman v Kent Sheep Breederscompany and member; see Pender v Lushingtonmember and member; see Rayfield v HandsNB: They do not constitute a contract between the company and a third partySee: Eley v Positive Life Assurance2 ALTERATION OF THE ARTICLESBy S9 CA 85 a company has a general power to alter its Articles by passing a special resolution. There is no statutory provision for a dissenting minority to appeal against the change. The special resolution, together with an altered copy of the articles must be filed with the Registrar of Companies.2.1 RESTRICTIONS


The general power, however, is subject to overriding restrictions:The alteration must not conflict with the Memorandum nor with the Companies Act or other relevant laws.The number of shares that a member is bound to subscribe for may not be increased without his consent.The alteration may not override an order of the courtThe alteration must be bona fide for the benefit of the CompanyExpulsion of members is viewed with suspicion; see Dafen Tinplate v Llanelly Steelbut note Sidebottom v Kershaw Leese & CoShuttleworth v Cox Brothers LtdNo contract outside the articles can prevent a company from altering its articles but the Company is liable for damages if, in altering the Articles it commits a breach of any such contract; see Southern Foundries v Shirlaw

Paper 2.2

CHAPTER 21

OFFICERS OF THE COMPANY

The following are officers of the Company:DirectorsCompany SecretaryAuditors1 DIRECTORSThe Companies Act 1985 defines a director as “any person occupying the position of director by whatever name called”. The basic test is one of function, ie by taking part in making decisions by attending board meetings1.1 TYPES OF DIRECTORSExecutiveNon ExecutiveShadow DirectorsA private company must have at least one directorA public company must have at least two directors


1.2 METHODS OF APPOINTMENTThe first directors are appointed on incorporation by being named on Form 10.Subsequent directors are appointed in accordance with the Articles either:By ordinary resolution of members in General Meeting orBy the board1.3 PERSONS ELIGIBLEAnyone can be appointed except:Persons disqualified by the articlesUndischarged bankruptsCompany auditorAnyone over 70 (PLC’s only) unless permitted by the articles – Ordinary ResolutionA person who does not meet the shareholding requirements (if any)Persons disqualified by the Company Directors Disqualification Act 1985, ieFor fraudulent or wrongful tradingFor persistent default in filing returnsFor the conviction of a serious offence relating to the companyFor unfitness1.4 REMUNERATIONAs a general rule, directors are not eligible to remuneration, however Executive Director and Managing Directors will have their salary fixed by their service contracts.Non-Executive Directors are not eligible unless the Articles so provide and approved by members in general meeting. Directors are entitled to be indemnified for expenses incurred in the performance of their duties. Payment may be challenged if it is not a genuine payment and payment of an unreasonable amount may be classed as a gift;see Re Halt Garage Ltd1.5 VACATION OF OFFICERetirementTable A states:That at the first AGM all directors shall retireAt subsequent AGM’s one third of the total number of non-executive directors must retire on a first in first out basisResignationA director may resign either by notice in writing given to the company or by not offering himself for re-electionRemovalS303 CA 85 gives members an overriding power to remove a directorProcedure:Pass an Ordinary ResolutionGive special noticeThe director can make written representations and has the right to speak at the meeting

ConsequencesIf a director is removed before the expiry of a fixed term contract he may sue the company for breach of contract; see Southern Foundries v ShirlawWeighed voting rights may make S303 ineffective; see Bushall v FaithDirectors of a partnership type company may apply for a winding up under S122 IA 86 on just and equitable groundsAction under S459 – conduct unfairly prejudicialNB: Individual members have no automatic right to compel the company to include a S303 resolution on the agenda of a meeting and may have to satisfy S376 CA 85; See Pedley v Inland WaterwaysCompensation for loss of office (S312 CA 85)Any payment made to a director in connection with his loss of office or retirement must


be:Approved by the voting shareholders and disclosed to shareholders Re Duomatic LtdLawful (eg Golden Handshakes) unless it is in respect of contractual obligations2 DIRECTORS DUTIESDirectors have a general duty to act bona fide for the benefit of the company as a whole. Duties are owed to the company and not to the shareholders; see Percival v WrightAlthough directors must act collectively, duties are owed individually. Directors must have regard to the interests of employees (S309 CA 85)Directors have three broad areas of duty:Care and skillFiduciaryStatutory2.1 CARE AND SKILLDirectors must demonstrate the skill and care of a reasonable man looking after his own affairs.The issue of care and skill was considered in Re City Equitable Fire Insurance Co where the court laid down three principles:SkillThe standard is subjective and depends on the directors’ knowledge and experience.A director is not expected to have any particular skill; see Re Brazillian Rubber Co.However if a director has some special skill he should use that for the benefit of the company; see Dorchester Finance Ltd v StebbingsContinuous AttentionA director does not have to give continuous attention to the affairs of the Company, but should attend meetings whenever he is reasonably able to do so.DelegationA director is justified in trusting an official to perform duties honestly, provided there are no grounds for suspicion and delegation is permitted by the Articles.2.2 FIDUCIARYA director is in a position of trust, being in control of the company’s assets. This gives rise to the following:Act in good faith for the benefit of the company as a whole; see Percival v WrightUse the powers given to him for the proper purpose; see Hogg v CrampthornTo retain freedom of actionTo avoid a conflict of interestNot to make a secret of their position; see Cook v Deeks and IDC v CooleyNB: Peso Silver Mines v CropperExercise appropriate confidentiallyRelief from LiabilityIf directors are in breach of their duties they can be sued for the loss caused by thebreach. However directors can be relieved from liability by:Resolution of members in general meetingBy the court – provided they have acted honestly and reasonably and ought in all the circumstances to be excused.S727 CA 85NB: any provision in the company’s articles indemnifying directors from breach of duty is void.2.3 STATUTORYThe Companies Act 1985 contains many duties on directors in order to reduce the risk of conflicts of interest and to require disclosure of interests:S312 CA 85:Approval of compensation for loss of officeS317 CA 85:Disclosure of interests in contractsA director who is interested in a contract with the company, either directly or indirectly,


has a duty to declare the nature of his interest at a meeting of the directors.Disclosure to the board must be made at the earliest opportunity. See Guinness PLC v Saunders If there is a failure to comply the contract is still valid but the director is liable to a fine.S319 CA 85:Approval of Long Term Service Contracts.A company may not enter into an agreement for the employment of a director for a period exceeding five years (where the ability to terminate is limited) unless the agreement has been approved by Ordinary Resolution If the proper procedure is not followed, the offending part of the contract is void and the remainder of the contract is valid but deemed to contain a clause entitling the company to terminate at any time by giving reasonable notice S320 CA 85: Approval of Substantial Property Transactions.These must be disclosed to and approved by members in G.M to be valid. It relates tocontracts to transfer to, or receive from, a director or a connected person, a non-cashasset. This means over £100,000 in value or exceeding 10% of the Company’s net assets whichever is the lowest. Transactions under £2000 are exempt.S330 CA 85: Prohibitions on loans to directorsThere is a general prohibition under S330 preventing a company from:Making a loan to a directorEntering into a guarantee on behalf of a directorProviding any security in connection with a loan to a directorIf the company is a public company the prohibition is extended to cover connected persons of a director.Exceptions:Loans to directors for any purpose under £5000 are validIn a public company loans to directors to perform their duties of up to £20,000 provided prior approval has been by members.Loans by money lending companies in the ordinary course of business on terms not more favourable than to others (£100,000 maximum).Effects of BreachTransaction is voidable by the companyDirector or connected person who benefited must account for the gain and indemnify for the lossPublic Companies directors and connected persons are liable to criminal penaltiesConnected persons for both loans and substantial property transactions include:Director’s spouseChildBusiness partnerThe Powers of DirectorsCompany Law divides the exercise of power between the board and the members.The extent of the board’s powers is generally defined by:The ArticlesThe objects clauseThe directors’ service contractsThe powers delegated to directors are exercised collectively voting at board meetings.Any director may call a board meeting. Decisions are by majority and each director has one vote. Provided the directors act within their powers, members cannot overturn decisions of the board.Members own the business and have delegated the power to run the business to directors. In relation to directors’ actions they can:Remove directors under S303Alter the ArticlesRestrain an ultra vires act by an injunctionSue for breach of dutyValidate an ultra vires act by a Special Resolution


Absolve directors from breach of duty by a Special Resolution S35 CA 85Unauthorised contracts made by the Board are binding on the company as long as the third party was acting in good faith. However members have rights as outlined above against the directors.3 OFFICERS WITH SPECIAL RESPONSIBILITY3.1 MANAGING DIRECTORAn MD may be appointed by the other directors if the Articles permit. His powers will depend on his service contract. He can be dismissed by the board but will remain a director unless dismissed in General Meeting.Not normally subject to retirement by rotation but will lose office if they cease to be a director. The MD is an agent of the company and cam bind the company to contracts within his express or apparent authority; see Freeman and Lockyer v Buckhurst Park Properties

3.2 COMPANY SECRETARYEvery company must have a secretary. A sole director cannot also act as secretary.AppointmentAppointed by the directors. Particulars of first and subsequent secretaries must be provided to the Registrar. Details kept in Company’s Register.QualificationsPrivate Company No requirement by statute to hold any particular qualification Public company Directors of a public company must take all reasonable steps to ensure that the secretary is a person who appears to them to have the necessary knowledge and experience.PowersThe Chief Administrative Officer of the Company and in matters of administration can bind the company in contracts both within his express or apparent authority.See: Panorama Developments v Fidelis Furnishing FabricsA secretary’s authority does not extend to:Making trading contractsBorrowing money on behalf of the companyTalking or defending proceedings in the company’s nameDuties include:Documentation is in orderTaking minutes of meetingsSending notices to membersCounter signing documents to which company seal is affixedAppointment may be terminated by the Board.4 AUDITORSAn audit is an independent examination and expression of opinion upon the financial statements of the enterprise.The audit report may be: Unqualified Qualifiedie stating if the accounts give a true and fair view of the Company’s financial statements.4.1 APPOINTMENTEvery company must appoint auditorsThe directors who hold office until the end of the first AGM appoint first auditorsSubsequently appointed by members at each AGMDirectors or members can fill a casual vacancyAppointed by the Secretary of State if no appointment is made4.2 TERMINATION OF OFFICERemoval by Ordinary Resolution with Special Notice; auditors have the right to make written representations and to speak at the general meeting.Resignation by notice in writing to the company; auditors can requisition an EGM.Auditor does not seek re-election


4.3 QUALIFICATIONSMust be eligible under the rules of a recognised supervisory body. Must be independent of the company, therefore cannot be:A director or employee of the companyA partner or employee of such a person4.4 POWERS OF AN AUDITORTo gain access to the company’s books, accounts and vouchersTo receive notice of, attend and speak at a GMTo require information and explanation from the company’s officers as necessaryTo require directors to call an EGMNB It is a criminal offence to knowingly or recklessly make a false or misleading statement to an auditor4.5 DUTIES OF AN AUDITORBasic statutory duty is to report on the annual accounts to the members. Must investigate:That proper records have been keptProper returns have been receivedAccounts agree with accounting recordsInformation in the directors’ reports is consistent with the accountsAuditors owe a duty of care and skill and may be sued in negligence for breach.


Paper 2.2

CHAPTER 22

INSIDER DEALING

A director who makes a profit through buying or selling shares on the basis of inside information, gained as a director will be in breach of common law fiduciary duty no to make a profit and can be sued by the company to account for such profit.The Criminal Justice Act 1993 makes it a criminal offence to deal with securities of listed companies as an insider with inside information, e.g. a company director who is aware that his company is about to announce far better interim results than predicted, buys shares in his company before the announcement1 THE OFFENCEAn insider commits an offence if he:Deals in securities on a recognised market or Encourages another person to do so i.e. tips them offDiscloses the information except in the proper performance of the function of his office employment or professionSecurities are shares, debentures and options on listed companiesPenalties include seven years imprisonment and an unlimited fine2 MEANING OF AN INSIDERAn insider is a person who has information if he knows the information is inside information and that he has it from an inside source.Inside information is that which:Relates to particular securities or to a particular company or companiesIs specific and preciseHas not been made publicIs price sensitiveA person has information from an inside source if he has it:Through being a director, employee or shareholder, orThrough having access by virtue of his job, or Directly or indirectly from a person in either of the above categoriesDefences:There was no expectation that the dealing would result in a profit or the avoidance of a lossReasonable belief that the information had been widely disclosedThey would have dealt anyway even if the information had not been availableThey did not expect the person to whom they disclosed the information to deal or they did expect them to deal, but not to make a profit or avoid a loss.


Paper 2.2

CHAPTER 23

CAPITAL OF A COMPANY

There are two types of Capital:Share CapitalLoan Capital1 SHARE CAPITALThis is raised by the issue of shares and those who apply for and are allotted shares become members of the companyDefinition “the interest in a company measured by a sum of money” “a bundle of contractual rights”2 TERMINOLOGYAuthorised Share Capital: Total amount of share capital which the company is authorised to issueIssued Share Capital (Allotted): Nominal value of share which have been issued to membersCalled up share capital: Aggregate amount of calls, which a member is required to payPaid up capital: Aggregate amount of money paid up on shares ,which have been issuedReserve Capital: Capital which the company has resolved not to call except in the course of winding up3 ORDINARY SHARES3.1 VOTING RIGHTSOrdinary shareholders usually have full voting rights and therefore determine the company’s management and thus the direction the company will pursue.3.2 DIVIDEND RIGHTSOrdinary shareholders fully participate in profits after the preference shareholders have been paid in full.3.3 SURPLUS CAPITAL ON A WINDING UPOn liquidation ordinary shares usually carry the right to participate fully in capital after the return of nominal value to preference shareholders. If the company does well and profits are not distributed there will be growth in the value of the shares.4 PREFERENCE SHARES4.1 VOTING RIGHTSUsually have no voting rights or very restricted.4.2 DIVIDEND RIGHTSThe dividend is usually fixed as a percentage of par values of the share; therefore they


do not participate in profits beyond the fixed dividend .They have priority over ordinary shares, usually in that the dividend is paid before the dividend on ordinary shares .Unless otherwise stated, the dividend is cumulative. Therefore, if an annual dividend is not declared, the right to receive that dividend is carried forward and when a dividend is declared the arrears of dividend must be paid in addition to the current dividend.4.3 SURPLUS CAPITAL ON A WINDING UPPreference shares are usually given priority on repayment of share capital but have no right to share in any surplus. This means they will only receive assets equal to the nominal value of their shares. Preference shares are unlikely to see any capital growth in the value of the shares.5 VARIATION OF CLASS RIGHTSThese are the rights attached to the various types of share.One class of shareIf the rights are in the Articles, alter the Articles by a Special Resolution.More than one class of shareIf rights are in the Memorandum and there is no provision, all members of the Company must consent. If rights are in the Articles and no provision – ¾ NV of thatclass must consent. If the Rights are in the Articles including the provision – follow that provision.Dissenting MinorityS127 CA 85 provides that 15% of the issued shares of that class concerned can within 21 days object to the court. The court has discretion, ie “can do as it thinks fit”.

6 ALLOTMENT OF SHARESS121 CA 85 allows for the authorised share capital to be increased. By S80 CA 85Directors can do so provided:A power is contained in the Articles, or An O.R is passed in G.MThe resolution and a copy of the memorandum must be filed with the Registrar within 15 days.The directors’ authority to allot may be general or specific to a particular issue.It must state the maximum number of shares which may be allotted and the date on which the authority expires. It must not generally be for a period of more than five years. It may be revoked at any time or varied by the members in General Meeting by Ordinary Resolution.7 DIRECTORS’ DUTIESThe purpose of issuing shares is to raise capital and an issue for any other reason can be challenged.Shares issued for the following reasons are therefore for improper purposes:To facilitate a takeoverTo defeat a takeoverTo dilute a members voting shareNB 1 & 2 above can be sanctioned by a General Meeting.8 PRE-EMPTION RIGHTS - S89 CA 85Where a company public or private issues equity shares wholly for cash. It must first offer them to existing equity shareholders in proportion to the nominal value of theirequity holding.The holders of registered shares must receive notice in writing. Open for 21 days.8.1 DISAPPLICATION OF PRE-EMPTION RIGHTSDirectors need not first offer shares to existing shareholders in the following circumstances:If the shares are subscriber shares or employee share scheme or bonus sharesIf the shares are issued for a non cash considerationIf pre-emption rights are excluded by a Special Resolution9 PAYMENT FOR SHARES


9.1 ALL COMPANIESUnder S100 the issue of shares at a discount is prohibited. In general shares in “any” company may be paid up in money or moneys worth including goodwill and knowhow.9.2 PRIVATE COMPANIESA private company may allot shares for inadequate consideration by acceptance of goods or services at an over value.9.3 PUBLIC COMPANIESA public company may not allot shares unless at least 25% of their nominal value and the whole of any premium is paid upAny shares issued by a public company to the subscribers to the Memorandum must be paid for in cashShares in a public company may not be paid for by an undertaking to do work or to perform servicesPayment for shares by a non-cash considerationA public company may not allot shares whether fully or partly paid for a non-cash consideration unless:The non-cash consideration has been independently valued and A report on the valuation has been made to the company within the 6-month period prior to the allotment The auditor or someone they consider to be suitably qualified must perform the valuation. The company must get the asset within 5 years from the date of the allotmentA breach of the above rules has the following consequences:The company and its officers are liable to a fineThe allottee must pay the deficiency in cash plus interest at 5%.10 SHARE PREMIUM ACCOUNTWhere shares are issued at a premium, ie in excess of their nominal value, SA130 CA85 requires the premium to be credited to a share premium account.This account can be used only for certain purposes defined by statute:To write off preliminary expensesTo write off the discount on the issue of debenturesTo write off underwriting commissionTo write off a premium on the redemption of debenturesTo write off the premium on the redemption of sharesTo issue fully paid bonus shares to existing members.<<>>

Paper 2.2

CHAPTER 24

LOAN CAPITAL

This is where the company borrows money and will be raised by means of the company issuing a Debenture. As debenture holders have loaned money to the company they are creditors of the company not members.1 DEBENTURESDefinition: “a written acknowledgement of a debt”In essence it is a loan to a company.The document states the terms on which a company has borrowed money. They may be secured or unsecured. To ensure that the debenture holders are adequately protected the debenture loan is usually secured by a charge on the company’s assets, which may be either fixed or floating.2 CHARGES


2.1 FIXED CHARGESThis relates to a specific asset, which may be realised by the debenture holder to repay their loan. It provides excellent security for the debenture holder (lender) as the assets may not be traded or exchanged while there is a fixed charge on them without the lenders consent.The value of the charge is fixed. The charge takes priority over all other creditors in respect of his charged asset. Any amount of loan not satisfied by selling the charged asset will rank as an unsecured creditor.2.2 FLOATING CHARGESThis is secured on the company’s assets generally.It has three characteristics:It is a charge on a class of assets present and future. The class of assets will change from time to time in the ordinary course of the company’s businessThe company has the general freedom to deal with the assets in the ordinary course of its business.2.3 CRYSTALLISATIONThis is the process by which the floating charge ceases to float over the assets but becomes attached to the assets subject to the charge when crystallisation occurs.This will happen in the following circumstances:There is a breach of the debenture agreementWhen the company ceases businessWhen receivership, liquidation or administration commences.From the moment of crystallisation the company loses the right to deal freely with the assets subject to the charge.2.4 PRIORITY OF CHARGESIf there are a number of charges over the same property it is important to ascertain their rankings:Similar Charges rank in order of creationFloating charges rank behind fixed charges even if those are created later.NB: Negative Pledge ClauseThis forbids the creation of a later fixed charge on the same asset. Its effect will be that subsequent fixed charges will rank behind the floating charge if they have actual notice of the NPC.3 ADVANTAGES AND DISADVANTAGES OF FLOATING CHARGES3.1 ADVANTAGES FROM THE COMPANY POINT OF VIEWIt can charge property which is unsuitable for a fixed chargeIt can deal with and trade the assets chargedNB: there are no advantages from the lenders point of view.3.2 DISADVANTAGES FROM THE LENDER’S POINT OF VIEWUncertainty of value, as the value of the asset will fluctuatePotential priority of subsequent fixed chargesPriority of other creditorsAvoidance under S245 Insolvency Act 1986ie Floating Charges created within the 12 months prior to the commencement of liquidation or administration may be invalidated by the liquidator/administrator of the company was unable to pay its debts at the time the charge was created.

4 REGISTRATION OF CHARGESParticulars of all charges must be registered with the Registrar within 21 days of creation.This can be done by either the company or the creditor. Failure to register renders the charge void against the liquidator and any person who acquires an interest in property subject to the charge. The company and its officers can be fined; the charge remains valid but unsecured.Every company must keep a register of debentures and charges, which can be inspected by members and creditors free of charge; others must


pay a reasonable fee.Failure to record the charge does not invalidate it.5 DEBENTURE HOLDERS REMEDIES5.1 UNSECUREDSue for the debtPetition for compulsory liquidationPetition for an administration order.5.2 SECUREDTake possession of the asset and sell it.Apply to court for a transfer ofownershipAppoint a receiver

Paper 2.2

CHAPTER 25

CAPITAL MAINTENANCE

Capital contributed to a company by its shareholders is regarded as a guarantee of buffer of funds for creditors, ie a pool of funds on which creditors can draw if the


company goes into liquidation.Therefore the capital of a company raises must be maintained in the sense that it must not be returned to members except under certain procedures which are designed to protect the interests of creditors.1 REDUCTION OF CAPITALA limited company can only reduce its issued share capital by complying with S135 CA 85.Procedure:Three criteria must be satisfiedPermission in the articles, andSpecial resolution passed, andCourt approvalS135 allows a reduction in three circumstancesTo extinguish liability in share capital not paidTo repay capital in excess of the company’s requirementsTo cancel paid up capital which is lost and no longer represented by an assetBefore the court gives its approval it will take into account the following:The need for protection of creditorsThe effect of the reduction on the membersThe amount of issued share capital, the company will be left withUntil the above has been considered and given no reduction may take place.Purchase of own sharesThere is a general prohibition on a company from purchasing its own shares; see Trevor v WhitworthA company can only purchase its own shares if the following are complied with S143 CA 85:Permission in the ArticlesSpecial ResolutionBy cancelling sharesBy maintaining capitalA private company has more flexibility than a public company in relation to purchasing its own shares2 FINANCIAL ASSISTANCE FOR THE PURCHASE OF SHARESDespite a general prohibition a company can lend for purchase of its shares provided it satisfies S151 CA 85:It is not the principal purpose of the loan or it is incidental to a wider purpose.It is part of the ordinary business of a money lending companyIt is to or for the benefit of the employeesA private company can lend to anyone provided conditions are complied with. The reason for this is that it is regarded as less of a risk because there is no “market place” for their shares.3 DIVIDENDSA company can only pay dividends out of profits; dividends out of capital (undistributable reserves) are illegalA dividend is only payable when it has been recommended by the directors and approved by the voting shareholders.“Profits available for the purpose”No company can pay a dividend other that from “accumulated realised profits less accumulated realised losses” S263 CA 85. “Accumulated” means that a company cannot pay a dividend if it has a debitbalance on revenue reserves“Realised” profits are determined by reference to the best accounting practise“Profits” include both revenue and capital profits3.1 PUBLIC COMPANIESPLCs are subject to a further restriction: a PLC cannot pay a divided which would reduce


its net assets to less than its called up share capital and undistributable reserves. This means that a PLC must take into account a net unrealised loss.3.2 RELEVANT ACCOUNTSIn determining what is available for distribution, reference should be made to therelevant accounts; in most cases these will be the most recent audited annual financial statements. If these have been qualified the auditor must report that the qualification is“not material” in terms of the legality of the proposed distribution.Unlawful Distributions:If a dividend is paid in breach of these rules:Any shareholder who knew or ought to have known that the dividend was illegal is liable to repay it, andIf it cannot be recovered, any director who was knowingly party to the decision to pay it can be made to pay to the company the amount lost plus interest.


Paper 2.2

CHAPTER 26

MEETINGS AND RESOLUTIONSThere are two major purposes of company meetings:The power to manage the company is delegated to the directors through the articles and the general law, but directors can only do certain things with the authority of members.The board are requested to account to the shareholders by giving them information relating to the management of the company1 TYPES OF MEETINGSGeneral meetings are meetings of the whole company. There are two types:An Annual General Meeting (AGM)Extraordinary General Meeting (EGM)NB: Class meetings are meetings of one class of shareholder.Type of Meeting Frequency Agenda Notice Power to CallAnnual General Meeting(AGM)• Once every calendar year• Maximum interval of 15 months between meetings• First AGM must be held within 18 months of incorporation• Consider accounts, directors’ and auditors’ reports• Declaration of a dividend• Appointment and remuneration of auditors• Election of directors• 21 days, unless all voting members consent to shorter notice• The board of directors• If the directors default in calling an AGM, the Secretary of State may convene the meeting of any memberExtraordinary GeneralMeeting (EGM)• Held whenever business arises between AGMs which requires members’ sanction• Reason for which EGM called• 14 days, unless a special resolution is to be moved in which case 21 day’s notice is required• Shorter period of notice is permissible if agreed by members holding at least 95% in nominal value of voting shares• The board of directors• Members holding 10% paid up voting capital may requisition and EGM(s368)• Court may also call an EGM if it is impractical for anyone else to call (s371)• Court may make any direction regarding the meeting as it sees fit (see Re El Sombrero Ltd)Class Meetings• Held whenever • Variation of class• 14 days, unless • The board of business arises which affects a particular class of shareholders rights


members holding at least 95% in nominal value of the voting shares consent to shorter notice directors• The court if it is impractical for anyone else to call2 CONDUCT OF MEETINGSThe following are the main requirements for a valid meeting:It must be properly convened by noticeA quorum must be presentThere should be a chairman who must discharge his duties in a proper mannerResolutions and any amendments should be proposed and put to the vote in a proper mannerThere are also other rules on matters such as adjournments and proxies2.1 QUORUMThe minimum number of persons suitably qualified who must be present at a meeting before it can validly transact business. Table A says two members or their proxies constitute a quorum. If no quorum is present then the outcome depends upon who convened the meeting:If directors convened, the rule is “same time next week”If members convene, it is cancelled2.2 CHAIRMANTable A states that a director must act as chairman of the meeting but if none is present the members can appoint one of their number.The chairman must:conduct business in an orderly manner per the agendaAllow points of view to be madePut motions to the vote and declare the resultAdjourn the meetingSign the minutes of the meeting2.3 PROXIES“A written instrument authorising another person to vote on behalf of an absent shareholder”The term also applies to the person appointed.In a private company a proxy may attend vote and speak.In a public company he may not speak.A proxy can vote on a poll unless the articles provide otherwise.Proxies can vote as they like unless:They have received instructions and have been paidThere is a fiduciary duty involved2.4 VOTINGShareholders with voting rights can vote on resolutionsVoting is usually by a show of hands, i.e. one person, one vote, irrespective of the number of shares heldA poll can be demanded, this is based on voting strength.Table A allows that a poll can be required by:The chairman, orTwo voting members or their proxies, orMembers with one tenth of the voting rights2.5 SPECIAL NOTICENormally notice is given by the company to its members.Special notice is given by members to the company. It must be given 28 days before the meeting. It is only given in relation to ordinary resolutions.It is used for the following purposes:Removing a directorAppointing or re-appointing a director over the age limitRemoving an auditor


Appointing a different auditorRe-appointing an auditor originally appointed by directors to fill a casual vacancyAppointing an auditor to fill a casual vacancy if not done by directors3 MEMBERS RIGHTS3.1 REQUISITIONING AN EGM S368 CA 85Two or more members holding 10% of the issued share capital with voting rights Signed requisition is sent to the company’s registered office Directors give notice of EGM within 21 days Must hold EGM within 28 days of that notice.3.2 PROPOSING RESOLUTIONS S376 CA 85Members can demand that an item be included on the agendaThey must have at least 5% of the voting rights or they number at least 100 members holding shares paid up to at least £10,000.Signed requisition is sent to the company’s registered office 6 weeks before GM.They deposit sufficient funds to cover the company’s reasonable expensesFailure to respond makes officers of the company liable to a fine4 RESOLUTIONS4.1 GENERAL RESOLUTIONSType of ResolutionMajority Filing RequirementNotice ExamplesSpecial resolution75% of members who are entitled to,and do, vote.Copy must befiled within 15 days21 days Shorter period of notice is permissible if agreed by members holding at least 95% in nominal value of voting sharesAlter nameAlter objectsAlter articlesReduce share capitalRe-register as public/privatedisapply preemption rightsExtraordinary resolution75% of members who are entitled to, and do, vote .Copy must be filed within 15 days Same notice as is required for meetingShorter period of notice is permissible if agreed by members holding at least 95% in nominal value of voting sharesVoluntary liquidation of an insolvent companyOrdinary ResolutionSimple majority of members who are entitled to, and do, vote .Same notice as is required for meeting (21 days for an AGM and generally 14 days for an EGM)Whenever law or articles do not require special / extraordinary resolutionAlter authorized share capitalDeclare dividendGenerally not requiredExceptions include resolutions to:Increase authorized share capital Grantauthority for directors to allot sharesFile within 15 daysSpecial notice 28 days from proposer to company21 days notice to membersRemoval of directors (s303)Removal of auditorsAppointment of director >70 to plcAdditional resolutions for private companiesThe CA 1989 allows private companies to pass two additional resolutions. These are not


available to public companies.Elective ResolutionsFor this to apply the following conditions must be satisfied:At least 21 days notice must be givenThe resolutions must be agreed by 100% of all members eligible to vote and votingA copy of the resolution must be filed within 15 days.Elective resolutions can only be used for the following purposes:Dispense with holding an AGMDispense with the annual approval of accountsDispense with the annual appointment of auditorsReduce from 95% to 90% the majority required to authorise the holding of EGM’s at short noticeTo grant directors a permanent authority to allot shares.Elective resolutions may be revoked by an ordinary resolution.Written ResolutionsThis enables the passing of any resolution, i.e. ordinary, special extra-ordinary or elective by means of a written resolutionExceptions:It cannot be used to pass ordinary resolutions requiring special notice The resolution must be signed by all members who would be entitled to attend and vote at a meeting. The resolution takes effect from the date the last person signs.

Paper 2.2

CHAPTER 27

MINORITIES

What a company does is generally determined by the board of directors, and approved, where necessary, by the members in General Meeting. If the members do not approve of the board’s actions their ultimate legal sanction is to remove the board from office. This is the principle of majority rule known as the rule in Foss v HarbottleFoss v HarbottleIf a wrong is done to a company or there is some internal irregularity in its operation the proper plaintiff is the company acting through its majority shareholders.The rule illustrates:The company should bring an action to redress a wrong done to it .Generally the courts do not allow minority interference if the majority have the power to actThe rule perserves:Majority rulePrevents multiple or futile actionsRecognises that a company is a separate legal entityCommon law exceptions to the rule:Where the act is illegalWhere the act is ultra viresProcedural irregularitiesWhere the act is a fraud on the minority, see Cook v DeeksWhere personal rights have been infringed; see Pender v LushingtonWhere the majority acts negligently and derives a personal benefit; see Daniels v DanielsForm of Action:PersonalRepresentative


Derivative1 STATUTORY EXCEPTIONS1.1 S459 CA 85 – CONDUCT UNFAIRLY PREJUDICIALAn application can be made to the court by any member on the grounds that the company’s affairs are being, have been or will be conducted in a manner unfairly prejudicial to him. An action can also be commenced by “members generally”When will it apply?Prolonged payment of low dividends Issue of share to directors on grossly advantageous termsRefusal to register shareholders, ownership of shares .Unfair removal from the board or other exclusions from management.1.2 RELIEF FROM UNFAIR PREJUDICEIf unfair prejudice is proved the courts may make any order “it sees fit”.In particular the court can make an order:Regulating the future conduct of the company’s affairs – see Re HarmerRequiring the company to do or refrain from doing any act Authorising civil proceedings in the name of the companyProviding for the purchase of shares of any member by other members of the company or the companySee SCWS v Meyer1.3 S122 1A 86 – “JUST AND EQUITABLE” WINDING UPEnables a member or a creditor to petition the court for the company to be put into compulsory liquidation. This is fairly drastic and therefore quite unusual and will not be granted if:Some other remedy is available to the petitionerThe petitioner is being unreasonable in seeking to have the company wound up.Therefore S459 CA 85 (Unfairly prejudicial conduct) is usually used by disaffected minorities.Just and equitable winding up has been granted in the following circumstances:If the substratum has failed; see Re German Date Coffee CoIf there is deadlock in management; see Re Yenidje Tobacco CoExclusion from management in a quasi partnership company; see Ebrahimi v Westborne GalleriesWhere there is justifiable loss of confidence in the probity of management; see Loch v John Blackwood2 OTHER MINORITY RIGHTS15% can object to the alteration of the objectsIf no AGM is called any member can inform the DTIAny member can veto conversion to an unlimited company .5% or 50 members can object to conversion of a PLC to a private companyAny member of a private company can veto an elective resolution or prevent a resolution in writingIf class rights are in the memorandum they can only be altered if all agree, otherwise class rights can only by altered by special resolution and 15% of that class can as the court to cancel the alteration.


Paper 2.2

CHAPTER 28

INSOLVENCY

Insolvency PractitionersThey must be authorised either by belonging to a professional body or granted as a license by the DTIMay act as:LiquidatorsAdministratorsAdministrative Receivers1 RECEIVERSHIPTypesAdministrative ReceiverA person appointed under a floating charge to take control of and to manage the whole or substantially the whole of the company’s property Receiver


Appointed under a fixed charge to take control of specific assets. Appointment is normally by the debenture holder or by the court.1.1 ADMINISTRATION ORDERSThese were introduced in 1986 to give companies in difficulties an opportunity to find a means of survival. It is an alternative to liquidation. It gives a “breathing space” from which to trade out of their difficulties. It is becoming increasingly popular in the case of a “one off” problem e.g. a major fraud or a single large debt.It begins with an application to the court by the company, directors or a creditor.An insolvency practitioner will be appointed Administrator. The Administrator draws up proposals. They are voted upon at a meeting of creditorsand applied if approved.The theory is that after the proposal has been fully implemented the company will have overcome its difficulties. The Administrator will then resign.The ultimate success of an administration order will depend on floating charge holders since they can appoint their own administrative receiver instead.The major disadvantages are:ExpenseTime taken1.2 CONSEQUENCES OF A PETITION BEING GRANTEDWinding up cannot be commencedNo goods can be recoveredLegal proceedings cannot be commenced without the courts permissionThe effect of an administration order is that:There is a moratorium on debts and petitions for liquidation are dismissed.PowersThe administrator has general powers of managementHe can:appoint and remove directorscall meetings of members and creditorssell charged assetsTerminationBy resignation, court order or ceasing to be a qualified insolvency practitioner.LiquidationThis means that company must be dissolved and its affairs wound up or brought to an end, ie assets realised, debts paid, surplus returned to membersLiquidation may take one of two formsWinding up by the court, ie compulsory liquidationVoluntary winding up by either members or creditorsCompulsory Liquidation S122 1A 1986The following are reasons that a company may be out in liquidation by the court the company has passed a Special Resolution a PLC is not issued with a S117 certificate within one year business does not commence within one year of incorporationthe total number of members in a PLC is reduced to below the legal minimumthe company is unable to pay its debtsthe court is of the opinion that it is just and equitable that it should be wound upAn application can be made to a court byThe companyThe Official ReceiverThe DTIA member – (on just and equitable grounds)A creditor – (unable to pay its debts)E.g. a) a creditor has served a written demand for £750 or more to the company and the creditor has failed to pay within a period of 21 daysb) A creditor has sued the company and obtained judgement but remains unpaidThe company is insolvent in the “balance sheet test”, ie liabilities exceed assets The


company is insolvent on the “commercial insolvency test”, ie it is unable to pay its debts as they fall due because of lack of cashThe court appoints a provisional liquidator, usually the Official Receiver (DTI official, who are officers if the court and do not have to be qualified insolvency practitioners).He will require the officers if the company to produce a Statement of Affairs. This includes:assets and liabilitiesdetails of creditorsdetails of chargesProceduresAs soon as liquidation begins:Directors powers cease and are transferred to the Official Receiver until a Liquidator is appointedBusiness StopsFloating charges crystalliseEmployees are automatically dismissed but maybe re-employed until completion of winding up can sue for breach of contract and/or redundancyOfficial Receiver calls a meeting of members and creditors. They can replace him as liquidatorMeetings can appoint a liquidation committee.First meeting within 3 months, thereafter as often as the liquidator wantsOnce all creditors are paid a final meeting of creditors is calledLiquidator informs the Registrar that all is completeThree months later the Company is dissolved2 VOLUNTARY LIQUIDATION2.1 MEMBERS VOLUNTARY LIQUIDATIONCompany is solventDirectors’ meeting resolves that:EGM meeting will be calledMembers VL be recommended to membersStatutory declaration of solvency is swornThis means the directors have declared that the company will be able to pay its debts infull within 12 monthsIt is a criminal offence to make a declaration without adequate groundsEGM:Special resolution to go into MVLOrdinary resolution to appoint a liquidatorDirectors’ powers ceaseMeetings of members at the end of each year.Final meeting when it is complete.Accounts presented at each meetingLiquidator informs Registrar that it is complete and three months later the company iswound upNB: If at any time during the MVL it becomes clear that the company cannot pay itsdebts in full a meeting of creditors must be called and the liquidation converts to aCVL2.2 CREDITORS VOLUNTARY LIQUIDATIONThe company is insolventDirectors’ meeting resolves that:EGM will be calledCreditors VL be recommended to membersMeeting of creditors calledShareholders Meeting:Extraordinary resolution to wind up the company on the grounds it cannot pay


its debtOrdinary resolution to appoint a liquidatorCreditors Meeting:The company must call a creditors meeting within 14 days of the EGMNotice must be sent by post to creditors. It must also be placed in the LondonGazette and two local newspapersAt the meeting the directors must produceA full statement of the company’s affairsA list of creditors and their claimsCreditors and members nominate a liquidator, creditors choice prevails.A liquidation committee can be appointedMeetings are held each year until the liquidation is complete and accounts arepresented at each meeting. A final meeting when it is complete.Registrar is informed when complete and three months later the company is dissolved.3 LIQUIDATORSA liquidator must be a qualified insolvency practitioner. He has powers given to himby legislation. He must exercise reasonable care. He owes a fiduciary duty to thecompany.3.1 LIQUIDATORS FUNCTIONTake over the powers of the directorsAct as agent of the companyCollect in the assetsIncrease the assets in any way, such as:Reclaim secret profitsFraudulent tradingWrongful tradingNegligence4 ORDER OF PAYMENT ON LIQUIDATIONCost of winding up, such as:Costs of realising the assetsLiquidation remunerationLiquidation ExpensesDebenture holders secured by a valid Fixed ChargePreferential creditors (all rank equally):PAYE & NIC due and unpaid 12 months prior to appointmentVAT due and unpaid 6 months prior to appointment4 months arrears of salaries wages (limited to £800 gross per employee)All accrues holiday payRepayment of loans made to pay any other preferential creditorsDebenture holders secured by a floating chargeAny surplus is returned to shareholders. Preference shareholders’ capital is returnedfirst, the remaining capital is then returned to ordinary shareholders.PAPER 2.3 BUSINESS TAXATIONCHAPTER 1INTRODUCTION TO CORPORATION TAX

• How do you determine whether a company is subject to UK corporation tax?• What is the basis for charging corporation tax?• What types of profits are taxable?

1 THE SCOPE OF UK CORPORATION TAXA company is subject to UK corporation tax if it is UK resident by virtue of being:(a) Incorporated in the UK, or


(b) Centrally managed and controlled from the UKAll UK resident companies pay corporation tax on their total profits chargeable to corporation tax (PCTCT)

PCTCT = All sources of income + chargeable gains

For tax purposes, income is classified under ‘Schedules’ and sub-categories of Schedules called ‘Cases’. The following are relevant for companies.Schedule D Case I Trading profits Eg profits of a car manufacturing companySchedule D Case III Interest receivable Eg Bank interestSchedule A Income from UK land and buildings Eg RentSchedule D Case V Income from certain overseas assets Eg Dividends from shares inoverseas resident companies

The tax is calculated by reference to a company’s chargeable accounting period (CAP). This is usually the period for which it draws up its financial statements. However,corporation tax cannot be charged for ‘long’ periods ie > 12 months long.

A CAP starts• When a company commences trading or acquires a source of income, or• As soon as the last one ends

A CAP ends• 12 months after it began, or• On the date to which the company draws up its financial statements eg 31 December, or• When the company ceases to tradeSo, a chargeable accounting period can be any length not exceeding 12 months, depending on the accounting period end of the company, and when and if it starts to or ceases to trade.

2 PROFITS CHARGEABLE TO CORPORATION TAX – A PROFORMAPCTCT for an accounting period is calculated as follows:Adjusted trading profits XLess: Capital allowances (X)Schedule D Case I XSchedule D Case III XSchedule A XSchedule D Case V XChargeable gains XTotal profits XLess: Charges on income ( e.g. gift aid payments) (X)Profits chargeable to corporation tax (PCTCT) X

This proforma will be expanded upon in the next chapter, although the following points should be noted now;(a) The proforma contains items found in the company’s P&L account, with some significant adjustments(b) Capital allowances are the tax equivalent of depreciation(c) Chargeable gains arise when the company disposes of capital assets(d) Charges on income are simply payments for which the company receives a corporation tax deduction(e) A significant source of income for a UK company may be dividends from other UK companies. However, these are not taxable and do not appear anywhere in the calculation of PCTCT.


PAPER 2.3 BUSINESS TAXAYIONCHAPTER 2CALCULATING ‘PCTCT’

• How are trading profits determined?• How do taxable trading profits differ from the amounts in the P&L?• What relief is available when capital assets are purchased?• What other sources of income are taxable?1 WHAT PROFITS ARE TAXABLE – TRADING PROFITS1.1 THE CALCULATION OF SCHEDULE D CASE I PROFITS


The starting point for calculating Schedule D Case I profits is the net profits before tax per the financial statements.

However, the items and amounts in the financial statements are drawn up according to accounting rules, which do not always coincide with the tax rules. Therefore, certain adjustments need to be made to arrive at Schedule D Case I profits.

1.2 PROFORMA FOR THE ADJUSTMENT OF PROFITS

Net profit before tax per the accounts XAdd:Disallowable expenditure charged in the accounts XLess:Income credited to the P&L but not taxable (X)Income credited to the accounts, but not taxable under Schedule D Case Ias trading (X)Adjusted trading profits for tax purposes XNotes:

Add: Not all expenses deducted in the P&L for accounts purposes are deductible for tax purposes.

Therefore, it is necessary to reverse the deduction of certain items, ie add back the amount charged in the accounts.

Less: Not all items of income included in the P&L are taxable eg dividends from other UK companies.

These amounts must be subtracted to arrive at trading profits for tax purposes.

Some of the items of income in the P&L are taxable, but not under Schedule D Case I eg rent. These items must be subtracted in the adjustment of profits proforma and will then reappear under the appropriate category eg Schedule A for rent, when the complete calculation of PCTCT is drawn up.

1.3 DISALLOWABLE EXPENDITUREThe following items should be added back to the profit per the accounts(a) Any expenses not incurred ‘wholly and exclusively’ for the purposes of the trade(b) Depreciation/amortisation(c) Entertaining, except staff entertaining which is deductible(d) Capital expenditure eg acquisitions of capital items, or repair expenditure which is not revenue in nature ie represents an improvement or enhancement(e) Fines(f) Charitable donations (see note 1)(g) Gifts unless they• Cost <£50 per donee per year; and• Incorporate a conspicuous advert for the company; and• Are not food, drink, vouchers or tobacco(h) Appropriations of profit eg dividends paid(i) Part of any amount paid to hire expensive cars (cost> £12,000)The amount to be added back is ½(retail price when new -£12,000) X rental charge in P&L Retail price when new(j) Fraud (except petty theft by non-senior employees)(k) Movements on general provisions (see note 2)

Note 1 – donationsTrade and professional subscriptions are usually deductible as they meet the ‘wholly and exclusively’ test. Donations to charity will only be deductible if


• They are wholly and exclusively for trading purposes ie promote trade; and• Are made to a local benevolent organisation; and• Are small in relation to the company’s sizeIf a donation fails these tests it can still be deducted as a charge on income under the Gift Aid rules.

These rules allow amounts actually paid during the accounting period to be deducted from total profits to arrive at PCTCT.

Note 2 –Movements on general provisions eg bad debts Increase (Dr P&L) ,Decrease (Cr P&L)General bad debt provision Not deductible – add back Not taxable – subtract from profits per accounts Specific bad debt provision No adjustment No adjustment .These principles apply to movements on other provisions eg stock obsolescenceWrite-offs of trade debts are deductible ie no adjustment necessary, but non-trade write-offs eg loans to staff must be added back.

1.4 EXERCISE 1

Avon Limited draws up accounts for the year ended 31 December 2003. The net profit per the accounts is £30,452 after charging the following items:

Rent 12,000Staff costs 42,000Depreciation 5,560Repair expenditure Note 1 8,200Donations and gifts Note 2 700Subscriptions 1,750Lighting and heating 2,170Bad debts Note 3 2,570Travel costs 850Administrative expenses Note 4 3,865Note 1:

Redecoration costs 1,500New office furniture 3,850New roof 2,275Replacing broken window with toughened glass 575Note 2:

Payment for banner at local church fete 550Donation to the Green Party 150Note 3:

Increase in specific provision 5,100Decrease in general provision (3,750)Trade debts written off 1,220

Note 4: This amount includes a salary of £2,000 paid to Mrs Katharine Avon for secretarial work.She is the wife of the majority shareholder and a director of the company. Note 4 also includes parking fines of £45 which she incurred on company business.Calculate the adjusted trading profits of Avon Limited for the year ended 31 December 2003.

2 CAPITAL ALLOWANCES

• If depreciation has been added back to profit, how is relief obtained for capital expenditure?• Which assets attract capital allowances?• How are the allowances calculated?


• What about buildings?

2.1 CAPITAL ALLOWANCES – AN INTRODUCTIONAccounting depreciation is added back to arrive at adjusted trading profits for tax purposes.

However, capital expenditure does obtain tax relief by way of capital allowances – the tax equivalent of depreciation.

Capital allowances are granted on• Certain types of assets• At set rates – on a reducing balance or straight line method

2.2 PLANT AND MACHINERYCapital allowances are given for the fall in value of assets used in a business. For a company, any assets on hand or acquired in an accounting period are granted an allowance, according to set rates.The allowance is an additional trading expense in arriving at the final Schedule D Case I figure which forms the starting point for computing PCTCT.There is no statutory definition of plant and machinery. However, the following principles can be followed• Distinguish between capital and revenue expenditure• Plant and machinery must not form part of the building in which the trade is carried on (eg a wall would not normally be plant or machinery) and should perform a function• Certain items are deemed to be plant and machinery eg cost of complying with fire safety regulations

2.3 CALCULATION OF ALLOWANCES – PLANT AND MACHINERYA basic writing down allowance of 25% (reducing balance) is available each year. The ‘written down value’ of assets is carried forward to calculate next years allowances – like the net book value for accounting purposes.

The calculation of P&M allowances is subject to the following points:• A full allowance is given in the year of acquisition, regardless of when the asset is purchased within the accounting period• All items of plant and machinery are pooled• There is no WDA in the period of cessation of trading, instead balancing allowances or charges arise• The WDA is pro-rated for short accounting periods• Not all assets are pooled in the general pool – see later for the treatment of cars, short life assets, and long life assets• When an asset is sold, the sales proceeds (limited to a maximum of the original cost) are deducted from the pool before allowances are calculated for that accounting period

2.4 EXERCISE 2

Baben Limited draws up accounts to 30 June each year. The tax written down value at 1 July 2002 is £2,780. During the year ended 30 June 2003 the following transactions occur.(Ignore first year allowances)Additions:1 August Office furniture 5,27523 September Moveable partitioning 12,500Disposals:24 February Photocopier (cost £1,500) 800(a) Calculate the capital allowances available for the year ended 30 June 2003(b) Given that adjusted profits for the year ended 30 June 2003 and 30 June 2004 are £23,857 and £45,782 respectively, calculate Schedule D Case I profits for both of these years.

2.5 FIRST YEAR ALLOWANCES (FYA)

A one-off enhanced allowance @ 40% is available for plant and machinery in the accounting period in which it is


purchased. This allowance replaces the WDA @ 25%.FYA is only available for small and medium companies (Companies Act definition).The allowance is not pro-rated for short accounting periods.An FYA is not normally available on cars (see later for the treatment of cars), but 100% FYA can be claimed by all companies on low emission cars registered after 16 April 2002.

FYA @ 100% is available for ‘small’ companies on ‘information and communication technology’ (ICT) assets eg computers. Expenditure must be incurred between 1 April 2000 and 31 March 2004.

2.6 EXERCISE 3

Catastrophe Ltd - a small company for CA 1985 purposes - starts trading on 1 July 2003 and draws up accounts to 31 March 2004 During that period the following transactions occur.

Acquisitions:27 June 2003 Van 15,00026 July 2003 Office furniture 12,25031 July 2003 Stationery 2,5681 October 2003 Computer 2,860The adjusted trading profit for the period ended 31 March 2004 is £34,000. Calculate The capital allowances and the Schedule D Case I profits for that period.

2.7 EXPENSIVE CARS – ORIGINAL COST MORE THAN £12,000

‘Cheap’ cars are included in the general pool of plant and machinery. However, cars costing more than £12,000 are treated as separate assets and the capital allowance is calculated separately at 25% writing down basis, subject to the following rules:• FYA not available• The WDA @25% is subject to a maximum of £3,000 p.a.• The WDA (and therefore the max) is pro-rated for short accounting periods.On disposal, the sales proceeds (subject to a max of cost) are deducted from the balance of expenditure and a balancing adjustment calculated.

A balancing allowance represents extra capital allowances; a balancing charge is a clawback of previous allowances given.

2.8 EXERCISE 4Data Ltd undertakes the following transactions during the years ended 31 March 2003 and 2004.Acquisition:2 May 2002 Car for the Chief Executive 28,000 16 June 2002 Land Rover for the FD 35,000Disposal:27 September 2003 Sale of the FD’s car 28,000(a) Calculate the capital allowances available for the years ended 31 March 2003 and 2004.(b) Recalculate the allowances for the year ended 31 March 2004 assuming the Landrover is sold for £36,000.

The private use of cars, by employees, is not relevant for calculating the allowances due to the company – although may affect the employee’s income tax computation.2.9 SHORT LIFE ASSETS Short life assets are items of plant and machinery (excluding cars) which may be de-pooled and dealt with separately for the purpose of calculating allowances. Balancing adjustments will occur on sale of the asset. If the asset is sold for much less than cost or scrapped, a beneficial balancing allowance may arise, which would not if the asset were included in the general pool.If an asset has been de-pooled as the result of a short life asset election and is still in use more than 4 years after the end of the accounting period in which it was acquired, then the written down value is transferred into the general pool.


The short life asset election must be made within 2 years of the end of the accounting period in which the expenditure is incurred.

2.10 LONG LIFE ASSETSLong life assets are items of P&M with a working life of 25 years or more.Long life assets are pooled and allowances calculated as follows;• No FYA’s for expenditure incurred after 1 July 1998• WDA @ 6% reducing balance• Only applies where the company spends >£100,000 pa on long life assets

2.11 CALCULATION OF ALLOWANCES – A PROFORMA

Follow this proforma for the calculation of allowancesGeneral pool Exp car Short life assetTotal Allow’sWDV b/fAdditionsDisposalproceeds(max cost)WDA @25%Additions qualifyingfor FYAsFYA @40%/100%WDV c/fRemember that balancing allowances or charges will arise on the disposal of any de-pooled asset eg each expensive car and short life assets.

2.12 EXERCISE 5 – COMPREHENSIVE EXAMPLE

Enterprise Ltd - a small company per CA 1985 - started trading on 1 September 2002 and draws up accounts to 31 December 2002 and 2003.

The company incurs the following expenditure during that time.3 September 2002 Computer 4,50015 October 2002 Office equipment 12,0001 December 2002 Car for sales director 20,2505 January 2002 Redecoration 2,80027 March 2003 Pool car 10,0006 June 2003 Car for MD 45,0004 April 2003 Company van 7,870The car acquired for the sales director was sold on 28 November 2003. In addition, office equipment (cost £2,760) was sold for £1,200 in October 2003.

Adjusted trading profits for the period ended 31 December 2002 and the year ended 31 December 2003 were £42,470 and £84,450 respectively.

Calculate the Schedule D Case I profits for both of the accounting periods.

2.13 INDUSTRIAL BUILDINGS ALLOWANCES (IBAS)IBAs are available for expenditure on the buildings used as• Factories• Mills• Storage facilities• Staff welfare buildings in a manufacturing trade


• Sports buildings in any tradeThe following expenditure qualifies for the allowance• Cost (excluding the cost of the land)• Site preparation costs eg levelling land• Architect fees• Non-industrial part (eg general office space if not more than 25 % of total cost) Allowances are given on the following basis• 4% of cost each year – straight line (in the past a one off initial allowance has been available – this would be given in the exam)• IBA given if the building is in industrial use at the end of the accounting period• Pro-rate for short accounting periods• Balancing adjustment calculated on sale by deducting sale proceeds (max cost) from WDV before sale• Second owner can claim allowances on the lower of• Purchase price paid• Original cost of the buildingspread over the remaining tax life of the building (25 yrs-period of use for first owner)

2.14 EXERCISE 6

Frontier Ltd bought a factory for £160,000 on 4 March 2001. It brought the factory into industrial use from that date and draws up accounts to 31 December. During November 20021, a new machine was installed in the factory – cost £25,500. On 12 December 2003, the factory was sold for £246,000 (including £20,000 for plant).

Calculate the IBAs available for the three years ended 31 December 2003.

3 OTHER TAXABLE INCOME• Rent• Interest• Other types of income

3.1 INCOME FROM PROPERTY – SCHEDULE AIncome from furnished and unfurnished property is taxed on an accruals basis, using the same rules that are used to calculate Schedule DI trading profits.All profits and losses are pooled to arrive at a net Schedule A figure .If the property is furnished, a ‘wear and tear’ allowance (10% x rent) is available as an extra expense.If a premium is paid for the grant of a short (<50years) lease, part of it is treated as Schedule A income, all taxable in the year of grant. The amount taxable is calculated as Premium – (2% x (no of yrs of the lease – 1) x premium)

Schedule A losses can be set against• Other income/gains of the same accounting period ;then• Income/gains of future accounting periods

4 INTEREST – LOAN RELATIONSHIPS• How is corporate debt treated?• How is interest payable and receivable treated?• What about any profits/losses on redemption/disposal of debt?

4.1 CORPORATE DEBT – INTERESTThe treatment of corporate debt is governed by the loan relationships rules. These rules apply to any situation whereby a company is in the position of debtor or creditor in relation to a money debt.

Any interest receivable or payable by a company is governed by these rules.All interest payable/receivable is deductible/taxable on an accruals basis. Therefore, the amounts shown in the financial accounts should not need adjustment unless further information is provided.


A distinction is made between trading and non-trading purposes as follows;InterestPayable ReceivableTrading Non-trading Non-Trading TradingSchDI

expensePool Banks onlySchedule DIIITax under DIIIDeficit not examined

4.2 EXERCISE 7 – COMPREHENSIVE EXAMPLE

Gan Ltd had the following income and expenses for the year ended 31 March 2004NotesAdjusted trading profits 550,000Capital allowances 27,250Bank interest accrued (Amount received £2,800) 2,850Rental income 8,690Dividends received from UK co’s 12,850Interest payable (Loan to purchase office premises) 7,590Debenture interest receivable (gross) 2,520Gift Aid payment 1,200Chargeable gain 7,860

Calculate PCTCT for Gan Ltd for the year ended 31 March 2004

PAPER 2.3 BUSINESS TAXATIONCHAPTER 3CALCULATING THE TAX LIABILITY

• How does a company calculate its corporation tax liability?• What rates apply?• Do the rates vary from company to company?• How is the liability settled? When are the payment dates?• How does the self-assessment system affect companies?


1 CORPORATION TAX RATESCorporation tax rates are set by reference to financial years (FY) which run from 1 April to 31 March.Eg FY2003 runs from 1 April 2003 to 31 March 2004.The corporation tax rate applicable to a company’s PCTCT depends on the size of the company. Size is determined by calculating the level of ‘profits’‘Profits’ = PCTCT + Franked investment income (FII)FII = UK dividends received from non-group co’s x 100/90For FYs2002 and 2003 the following rates apply:‘Profits’ Rate Up to £10,000 0% ‘starting rate’ (10% for FY2001) £10,000-£50,000 19% with marginal relief >£50,000-£300,000 19% ‘small companies’ rate’ (20% for FY2001) >£300,000-£1.5m 30% with marginal relief £1.5m and above 30% ‘full rate’ Between the respective upper and lower limits of £10,000:£50,000 and £300,000:£1.5m, tax is calculated at 19%/30% with a deduction which is known as marginal relief.Marginal relief (MR) is calculated according to the following formula MR fraction x (Upper limit – ‘Profits’) x PCTCT ‘Profits’[MR fraction for FY2002 and 2003 is 11/400 for small companies and 19/400 for starting rate companies]The upper and lower limits must be pro-rated if the accounting period is less than 12 months longThe upper and lower limits are also divided between all associated companies ie group (>50%) companies, including overseas, excluding dormant companies.

Where an accounting period straddles financial years eg 31 December 2002, then PCTCT and ‘profits’ must be pro-rated and corporation tax for each financial year calculated separately.However, the overall liability is still in respect of the accounting period.

1.1 EXERCISE 1Harrison Ltd has PCTCT for the year ended 31 March 2004 of £275,000. During the year it received dividends from UK companies of £72,000.Calculate the corporation tax liability for the year ended 31 March 2004.

1.2 EXERCISE 2India Ltd has PCTCT for the year ended 28 February 2003 of £55,000. On 1 February 2003 it received dividends from UK companies of £2,700.Calculate the corporation tax liability for the year ended 28 February 2003.

2 THE SELF-ASSESSMENT SYSTEMCompanies must calculate their own tax and submit a corporation tax return in a similar way to individualsThe deadline for submission of the return is 12 months after the end of the accounting period. The company can• amend the return within the 12 months of the filing date• make an error or mistake claim to recover any overpaid tax Once the return has been filed, the Inland Revenue can• correct obvious mistakes or errors within 9 months• launch an enquiry into the return

The normal due date for the payment of tax is 9 months and 1 day after the end of the accounting period, unless the company is ‘large’.If the return is filed late• A penalty arises• The Revenue may determine the tax due• Interest is charged on late paid tax

A company is also required to• notify the Revenue of any chargeable income or gains if it does not receive a return


• keep records for 6 years after the end of the accounting period

2.1 ENQUIRIES INTO RETURNSThe Revenue can• give notice that an enquiry is to be launched• demand the production of documents• raise a ‘discovery assessment’ even after the 12 month deadline from the filing date

Once written notice of completion of the enquiry is given, the company has 30 days to amend the self assessment return.

2.2 PAYMENT BY INSTALMENTSFor accounting periods ending on or after 1 July 1999, large companies (‘profits’ of £1.5m or more) must pay corporation tax in installments.Four quarterly payments are made on the 14th day of• month 7• month 10• month 13• month 16after the start of the accounting periodThe installments are not based on last year’s liability, but must represent 25% of the current year’s liability. Interest is charged on late installments.

3 LONG PERIODS OF ACCOUNTWhere a company prepares accounts for a period >12 months eg 16 months to 30th April 2004, for tax purposes two separate accounting periods exist:• The first in respect of the first 12 months ie 12 months to 31 December 2003• The second in respect of the remaining months ie the 4 months to 30 April 2004.Two separate computations are prepared and there exist two separate payment dates. Items of income and expenditure are allocated between the two accounting periods as follows:Adjusted trading profits Time-apportion, once net profit has been adjusted for the long period as a whole Capital allowances Separate calculations (restrict WDA in 2nd short period)Schedule D Case III Amount accruing in each periodSchedule A Amount accruing in each periodChargeable gains According to date of disposal of the assetGift Aid payments According to date of payment

PAPER 2.3 BUSINESS TAXATIONCHAPTER 4CORPORATION TAX LOSSES

• How does a loss arise?• How can it be relieved against other sources of income?1 THE USE OF TRADING LOSSES1.1 CALCULATION OF THE LOSS

A Schedule D Case I trading loss is calculated in exactly the same way as a profit ie the net profit/loss per the accounts is adjusted and capital allowances are deducted in the normal way.


The Schedule D Case I assessment in the corporation tax computation is NIL and then the loss may be utilised/relieved in a number of ways.

1.2 METHODS OF RELIEF – CURRENT YEAR CLAIM (S393A ICTA 1988)A company can elect to set the trading loss against total profits (ie income and gains) of the loss making accounting period.

The loss is offset• before charges on income• without restriction ie as much loss as possible must be used to eliminate total profits• on the making of a claim within 2 years of the end of the loss making accounting period This claim is not compulsory – it is an option

1.3 METHODS OF RELIEF – CARRY BACK CLAIM (S393A ICTA 1988)A company may elect to set any remaining trading loss against total profits before non-trading charges of the previous 12 months. If the carry back period spans more than one accounting period, the set off is on a LIFO basis.However,• the current year claim must have been made first ie the c/b cannot be made in isolation• the c/b claim is not compulsory• a claim must be made within 2 years of the end of the loss making accounting period

1.4 METHODS OF RELIEF – CARRY FORWARD (S393(1) ICTA 1988)Any remaining loss after the current year and carry back claims, or the whole of the loss, should these claims not be made, is carried forward indefinitely.The loss is then offset• against Schedule D Case I trading profits of future accounting periods, but• the profits must arise from the same trade and• losses must be offset as soon as possible, as far as possibleA claim to establish the amount of the loss carried forward must be made within 6 years of the end of the accounting period in which the loss first arose.

2 APPROACH TO LOSS RELIEF QUESTIONS• More than one accounting period will no doubt be involved, so set out proforma computations in separate columns for the various years across the page• Identify the loss making accounting period and remember to put ‘NIL’ as the Schedule DI assessment• Set up a loss working on a separate piece of paper which describes how the loss is utilised (‘Loss Memo’)• Leave enough space to show potential current year and carry back claims and remember there may be some loss to carry forward v DI• Read the requirement carefully to determine which claims are to be made• If the relief is to be taken ‘as early as possible’ then a current year and carry back claim will precede the carry forward• If the relief is to be taken in the most beneficial way, then it will be necessary to decide whether current year/carry back claims are to be made based on the rate of tax saved and cashflow considerations• As you decide how to use the loss, show the offset in the computations and keep a track of the use of the loss in the working as you go along.• Notice how charges on income may be unrelieved as a result of the loss relief claims

2.1 EXERCISE 1


Jeremy Ltd draws up accounts to 31 March each year. Results for the three years to 31 March 2004 are as follows: Y/e 31.3.02 Y/e 31.3.03 Y/e 31.3.04Trading profit/(loss) 15,000 (45,000) 17,000Schedule DIII 2,000 3,000 5,000Schedule A 1,500 1,700 1,800Chargeable gain - 2,600 -Gift Aid payment 700 700 700Calculate PCTCT for each accounting period, assuming loss relief is claimed as early as possible.

2.2 EXERCISE 2

Kumar Ltd draws up accounts to 31 December. Results for the recent accounting periods are as followsY/e 30.6.01 6mths/e 31.12.01Y/e 31.12.02 Y/e 31.12.03Trading profit/(loss)18,000 17,000 (39,000) 3,000Schedule A 2,000 2,000 2,000 1,800Chargeable gain - - 700 -Gift Aid payments 500 500 500 500

Calculate PCTCT for each accounting period assuming loss relief is claimed as early as possible.

3 TERMINAL LOSS RELIEFWhen a company ceases to trade in a loss-making scenario, all of the normal loss reliefs apply (except the carry forward, as there are no future Schedule D Case I profits from the same trade).However, in addition, any loss incurred in the last 12 calendar months of trading may be carried back and set against profits of the previous 36 months, rather than just 12 months.The offset is on a LIFO basis.

PAPER 2.3 BUSINESS TAXATIONCHAPTER 5GROUPS OF COMPANIES

• What is the effect on the corporation tax computation if a company is in a group?• How is a group defined?• What advantages exist for loss relief purposes• What about the transfer of assets between group members

1 LOSS RELIEF IN GROUPSAll UK companies produce separate corporation tax computations, even if they are in a group.


However, being in a group brings several tax opportunities and advantages.

1.1 GROUP RELIEF - DEFINITIONThe surrender of losses between UK companies is possible if those companies are in a group relief group.

A group relief group exists when• Parent company owns at least 75% of the ordinary share capital of a subsidiary• The parent company must also have an effective 75% holding in any sub-subsidiaries• All companies in the group must be UK tax resident, although the link between UK companies may be formed by non-UK resident companies• In addition to the share capital requirement, the holding company must be entitled to at least 75% of the assets on a winding up and 75% of the profits on a distribution

1.2 GROUP RELIEF – SURRENDER OF LOSSESGroup relief allows the surrender of losses between one UK surrendering company and another UK claimant company in the same group relief group. The surrender can be in any direction but only between UK companies in the group.The corporation tax computation of the claimant company is amended as follows:PCTCT before group relief XLess : group relief surrendered (X)Revised PCTCT XAmounts that may be surrendered include

• Current year trading losses – the surrendering company does not have to make any loss relief claims itself, in priority• Unrelieved current year charges on income• Unrelieved current year Sch A losses

1.3 EXERCISE 1The Livia group has the following structureLivia plc 100% 75% Claudius Ltd Germanicus Ltd 80% 75% Rome Ltd Hemlock Ltd(a) Explain how trading losses may be surrendered between these companies by way of group relief.(b) What are the upper and lower limits for the purpose of calculating corporation tax for these companies?

1.4 GROUP RELIEF – MAXIMUM SURRENDERThe maximum amount of loss that may be surrendered by way of group relief is :PCTCT of the claimant company LowerLoss available in surrendering companyAny amount up to the maximum may be surrenderedHowever, group relief claims may only be made between companies with corresponding accounting periods eg both 31 December 2003.

If the companies have non-coterminous year ends, apportionment is necessary to determine how much can be surrendered.

1.5 EXAMPLEMaggie Ltd makes a loss of £240,000 for the year ended 31 December 2003 and Bart Ltd (a 75% subsidiary) makes a profit of £148,000 for the year ended 30 June 2003.Bart Ltd 30.6.03


Profit = £148,000 6/1231.12.03 Maggie LtdLoss = £240,000

The corresponding accounting period is 1.1.03 – 30.6.03

Therefore the maximum group relief is the lower of:• 6/12 of Bart’ Ltd’s profit of £148,000 = £74,000• 6/12 of Maggie Ltd’s loss of £240,000 = £120,000ie £74,000 A claim for group must be made by the claimant company and the consent of the surrendering company is required.

1.6 CHOICE OF LOSS RELIEF IN GROUPSLosses should be used within a group in the way that saves the highest amount of tax.This may be by way of;• Current year claim in the loss making company• Current year and carry back claims (a carry back will generate a repayment of tax)• Neither claim but carry forward of the loss (although note the cashflow disadvantage)• Group relief to one or more group companies for any amount up to the maximum for each claimant or• A combination of the above (although remember that current year and carry back claims cannot be restricted in amount). The aim of saving the most amount of tax will be achieved if profits are relieved in the following order (using FY2003 rates), if possible• Profits falling between upper and lower which suffer tax at an effective rate of 32.75%• Profits taxed at 30%• Profits in the starting rate marginal band which suffer an effective rate of tax of 23.75%- unlikely to be relevant in sizeable groups• Profits taxed at 19%

1.7 EXERCISE 2Nicholas Holdings Ltd has two 75% subsidiaries - Lofty Ltd and Tally Ltd. The companies had the following results for the year ended 31 March 2004:Trading resultsNicholas Holdings Profit 120,000Lofty Ltd Profit 750,000Tally Ltd Loss (600,000)In addition, Tally Ltd had other income of £2,000 in the year ended 31 March 2004. For the year ended 31 March 2003 Tally Ltd had trading profits of £50,000 and other income of £2,000.Requirement(a) What are the options for relieving the loss?

2 CHARGEABLE GAINS - GROUPSA gains group requires the same 75% direct holding described for group relief purposes.However, the effective holding of sub-subsidiaries only needs to be >50%.Again, non-UK resident companies can form the shareholding link between UK companies in a gains group.


2.1 TRANSFER OF ASSETS IN A GAINS GROUPWhen assets are transferred between companies in a gains group (no matter at what value for accounting purposes), the transaction occurs, for tax purposes, such that no gain or loss arises.This is useful for planning purposes. Capital losses cannot be transferred between companies but can be used to offset chargeable gains (but no other type of income).Therefore, assets to be sold at a gain can be transferred into a company with a capital loss, allowing the gain on sale to offset by the loss already existing in the transferee company.

From 1 April 2000, an election can be made which effectively means that this transfer does not have to actually take place. A group can elect which company is treated as having made a disposal of an asset outside the gains group.

2.2 ROLLOVER RELIEFAn asset sold by one company in a gains group can be ‘rolled over’ in to the acquisition of an asset acquired by a different member of the gains group (see later)

PAPER 2.3 BUSINESS TAXATIONCHAPTER 6OVERSEAS ASPECTS OF CORPORATION TAX

• How can overseas operations be structured?• How can a UK company be affected by overseas tax issues?• How is double taxation eliminated?

1 SETTING UP OPERATIONS OVERSEASIf a UK company is expanding abroad, that company could set up either a branch or a subsidiaryBranch : an extension of the UK company overseas, not a separate legal entity.


Subsidiary : a separate legal entity

The differences are as follows:Branch Subsidiary Taxation of profits Tax as part of UK co profits – Sch DI.Also taxed in overseas jurisdiction?Not taxed – dividends paid to UK taxed as received - Sch DVDouble taxation relief (see below)

Assets acquired Capital allowances available No capital allowancesLosses UK loss relief available No use of losses in the UKAssociated for tax purposes? No (so no division of limits) Yes

2 TAXATION RELIEF

2.1 RELIEF FOR OVERSEAS TAXATION – DOUBLE TAX RELIEFIncome subject to UK tax may also have suffered tax in an overseas jurisdiction eg rent, dividends,branch profits. Double tax relief (DTR) is available to eliminate or reduce this double taxation.The following examples all concern dividends received by a UK company from an overseas subsidiary.

The types of overseas taxes suffered are:• Withholding tax (WHT) – a direct tax imposed by the overseas jurisdictionThis tax is always potentially recoverable and is normally expressed as the % withheld by the overseas jurisdiction• Underlying tax (ULT) – the overseas equivalent of corporation tax which has been paid on profits out of which the dividend is declared• ULT is calculated according to the following formula:Dividend gross of WHT x Actual overseas tax paidDistributable profits per overseas accountsNB: Underlying tax is only relevant for dividends where the UK company has at least 10% of the voting power of the overseas company. If not, ignore.

2.2 RELIEF FOR OVERSEAS TAX – CALCULATING DTRThe overseas income should be included in the computation of PCTCT gross of all overseas taxes ie withholding tax and underlying tax (if relevant) is added back on.Cash dividend received in the UK XAdd: Withholding tax XDividend gross of withholding tax XAdd: Underlying tax XSchedule D V X

PCTCT and the corporation tax liability is calculated as normalThen, a DTR credit is given for:Overseas tax suffered (WHT+ULT if relevant) LowerUK CT on that overseas income

2.3 EXERCISE 1Octopussy Ltd receives dividends from a subsidiary, Bond, resident in Sniberia, in which it holds 65% of the voting shares. Octopussy has 3 other 100% UK subsidiaries. The following information is available for the year ended 31 December 2003:


Octopussy Ltd:Schedule DI 430,000Chargeable gain 7,400Dividend received from Bond 70,000Bond:Distributable profits 500,000Tax charge per accounts 200,000Actual tax liability 220,000WHT rate on dividends paid from Sniberia to UK 15%Calculate the corporation tax payable for Octopussy Ltd for the year ended 31 December 2003.

3 TRANSFER PRICINGWhere transactions occur between UK and overseas company, UK PCTCT could be reduced by setting prices at an over/undervalue.The Inland Revenue has the power, in these circumstances to substitute an ‘arm’s length’ price, for the purposes of calculating UK profits.

PAPER 2.3 BUSINESS TAXATIONCHAPTER 7THE INCOME TAX COMPUTATION• Who pays income tax?• On what sources of income?• What allowances, deductions and reliefs are available?• What does the income tax computation look like?• How is the tax calculated?1 TAXABLE INCOMEIncome tax is paid by individuals, regardless of age or marital status, on taxable income.


1.1 INCOME TAX – THE BASICSThe income tax computation sums all taxable sources of income, deducts certain items (reliefs, personal allowances, deductions) and then subjects an individual’s income (be they single, married or a child) to income tax at rates levied in bands.Tax is charged by reference to the fiscal year 6 April – 5 April following eg 2003-04 runs from 6 April 2003 to 5 April 2004.

The same system of Schedules and Cases is used as for Corporation Tax.Tax rates and allowances are set for fiscal years – straddling is not a problem but you must be clear about how much of each source of income is taxed in any particular fiscal year – these rules describe the basis of assessment.

1.2 THE INCOME TAX COMPUTATION – A PROFORMANotesEarned income:Sch DI X 1Employment income X 2Savings income: 3Schedule D III- Bank interest x 100/80 X 4- BS interest x 100/80 X 5 XDividends x 100/90 X 6 XLess: charges on income: 7Patent royalties x 100/78 (X)Statutory total income (STI) XLess: Personal allowance (X) 8Taxable income XTax at: 10% on income up to £1,960 X22%/20% on income up to £30,500 X40%/32.5% on income>£30,500 X XAdd: Basic rate income tax (BRIT)on charges paid net X 9Less: Tax suffered at sourceTax credits on dividends X 10PAYE X 11Tax credits on interest X 12 (X)Income tax payableLess: payments on account (X) 13Sweep up payment X 14Notes:1 Trading income2 Income from an office or employment– gross amount taxable – tax the amounts received in the fiscal year3 Savings income = interest received4 Received net of 20% income tax – gross up x 100/80 – tax the amount received in the fiscal year5 Received net of 20% income tax – gross up x 100/80 – tax the amount received in the fiscal year6 Deemed tax credit of 10 % - gross up x 100/90- tax the dividends received in the fiscal year


7 Paid net of BRIT if patent royalty – gross up x 100/78. Paid gross if copyright royalty.Deduct the gross equivalent of amounts paid in the fiscal year8 Available to all as deduction from STI - £4,615 for 2003-04, any unused amount not transferable/refundable9 BRIT must be deducted on charges on income paid net eg patent royalty. The tax deducted is added on to the IT liability10 10% tax credit - not repaid is credit exceeds liability11 Tax deducted by employer credited12 20% tax credit13 Instalment payments in respect of this year which have already been made under self assessment14 Balancing payment to be made under self assessment

1.3 EXERCISE 1Lady Penelope is a single woman with the following income for 2003-04.£ NotesSalary from FAB Ltd 37,000 PAYE deducted £7,320Bank interest 2,580 Amount receivedDividends from Parker Ltd 8,560Calculate STI for 2003-042 THE TAX CHARGE2.1 CALCULATING THE TAX LIABILITYIncome tax is charged in bands at progressive ratesThe bands are as follows for 2003-04:Taxable income up to £1,960Taxable income in excess of £1,960, up to £30,500 the basic rate bandTaxable income in excess of £30,500 the higher rate thresholdIn order to tax the various sources of income, the taxable income figure must be separated into ‘slices’ or tiers.The top slice is dividend incomeThe middle slice is savings incomeThe bottom slice is any other income eg Employment incomeThe progressive income tax rates are then applied, moving through the slices of income, subject to the following:• Savings income is taxed at 20%, not 22%, in the basic rate band• Dividend income is taxed at 10% , not 22% in the basic rate band• Dividend income is taxed at 32.5%, not 40% above the higher rate threshold2.2 EXERCISE 2Using the information in exercise 1, calculate Lady Penelope’s income tax payable for 2003-04

PAPER 2.3 BUSINESS TAXATIONCHAPTER 8INDIVIDUALS IN BUSINESS –CALCULATING SCHEDULE DI PROFITS

• How does the Revenue determine whether an individual is earning trading profits?• How are those profits taxed?• How do the Schedule DI rules apply to individuals differ from the rules which apply to companies?• How are capital allowances calculated for individuals?

1 SCHEDULE DI ASSESSMENTS

1.1 WHEN IS AN INDIVIDUAL ASSESSED UNDER SCHEDULE D CASE I?A sole trader is taxed under Schedule D Case I on their trading profits.The following criteria – the ‘badges of trade’ – are


used by the Revenue to determine whether trading transactions arise.(a) Subject matter(b) Frequency of transactions(c) Length of ownership(d) Supplementary work(e) Profit motive(f) Reason for saleNo one factor is decisive – the Courts will look at all factors. A non-trading transaction may give rise to a capital gain.

1.2 CALCULATION OF SCHEDULE D I PROFITSThe basis of calculating Schedule D Case I profits is the same as that which applies for a company ie start with the net profit per the accounts drawn up by the sole-trader and adjust eg add back depreciation, entertaining etc.However, when performing the profit adjustment, the following differences arise for an individual(a) Disallow appropriations of profit eg proprietor’s drawings, however described(b) Disallow any of the proprietor’s tax liability charged to the accounts(c) Disallow any NICs of proprietor(d) Disallow any private element of expenses eg running costs for the private use as opposed to the business use of the proprietor’s car(e) If goods are withdrawn from the business by the proprietor for private consumption, the market value must be included as taxable income.

1.3 EXERCISE 1Mr Q runs his own business marketing and selling specialist executive toys. His accounts for the year ended 31 December 2003 show the following:Net profit 59,870Including the following:Depreciation 3,210Gifts to customer – Christmas turkeys cost £9 each 780Staff Christmas party 50Salary to wife 8,430Motoring expenses 6,270Legal fees for acquisition of lease on business premises 780Rent 4,900Employer’s NICs 980Debt collection fees 650Increase in general bad debt provision 430Trade debts written off 1,800Light and heat 2,540Repairs to office roof 925Insurance 1,600Bank interest on business current account 805

The motoring expenses relate solely to Mr Q’s car, which he uses 60% for business purposes.

During the year, Mr Q took various items of stock for his own use. The cost of this stock was £200.They would normally have been sold for £550.Calculate Mr Q’s adjusted profit (before capital allowances) for the year ended 31 December 2003.

2 CAPITAL ALLOWANCES2.1 CAPITAL ALLOWANCES FOR INDIVIDUALS – THE DIFFERENCESCapital allowances are available for an individual in a similar way to those for companies.

Assets are treated and allowances calculated in the same way, noting the following points and exceptions:(a) FYAs are available for business that meet the small or medium criteria


(b) Any asset which is used partly for private purposes by the proprietor is treated separately(c) Capital allowances are calculated for the accounting period – as for companies – and pro-rated for both short and long (>12 mths) accounting periods

2.2 PRIVATE USE ASSETSA separate calculation of capital allowances is maintained for each asset on which there is an element of private use by the proprietor. The normal rules for calculating allowances on the type of asset eg plant and machinery, expensive car are followed.The full WDA is calculated, but only the business proportion is available to reduce adjusted profits.

2.3 EXAMPLE 2Mrs Renfrew runs her own cheese shop. On 5 June 2002 she buys a car – cost £24,000 – which she uses 75% for business purposes. She also buys a van on 18 April 2003 – cost £5,800 – which is used by her employee, Colleen, both to deliver cheese and for private purposes.

At 1 January 2002, the written down value of the general pool of plant and machinery was £4,860.Show the capital allowances available to Mrs Renfrew for the year ended 31 December 2002 and 31December 2003.

PAPER 2.3 BUSINESS TAXATIONCHAPTER 9SCHEDULE D CASE I FOR INDIVIDUALS –THE BASIS OF ASSESSMENT

• How are Sch DI profits assessed each fiscal year?• What happens if there is a change of accounting period date by a sole trader?• What special rules exist in the opening and closing years?

1 BASIS OF ASSESSMENTIncome tax is charged for a fiscal year. Traders draw up accounts for an accounting period which does not necessarily coincide with that time period.

To determine which profits are taxed in any particular fiscal year, the current year basis (CYB) applies ie the profits of the


12 month accounting period ending in the current fiscal year are the ones that are taxed.Eg Accounts for the year ended 31 May 2003 would be taxed in 2003-04.The rules for the taxation of Sch D Case II profits are exactly the same.

2 OPENING YEAR RULEIn the opening years of a business, the CYB is amended accordingly Basis of assessmentYear 1 Actual ie Date of commencement – 5.4Year 2 Either: 12 mth AP ends in year : CYB ‘Short’ AP ends in year : 1st 12 months of trading No AP ends in year Actual ie 6.4 – 5.4Year 3 12mths to AP ending in yr 3 (Normally CYB)

As a result of the operation of these rules, some profits may be taxed twice. It depends on the choice of accounting date. The profits taxed twice are ‘overlap profits’ and are deducted from the final Sch DI assessment of the business on cessation or used if there is a change of accounting period date.

2.1 EXERCISE 1Sarah starts trading on 1 July 2001. She draws up accounts as follows:(a) Year ended 30 June 2002 13,890Year ended 30 June 2003 24,900(b) 11 mths to 31 May 2002 2,790Year ended 31 May 2003 19,610

Calculate Sch DI assessments for all years, based on the information provided and identify any overlap profits

2.2 EXERCISE 2Took commences trading on 1 January 2001 and draws up accounts as follows.15 months to 31 March 2002 21,895Year ended 31 March 2003 59,280Calculate Sch DI assessments for all years, based on the information provided and identify any overlap profits

3 CLOSING YEAR RULESSchedule DI assessments in the closing years are calculated as follows:Penultimate year CYB normally Final year ie the fiscal year in which the business ceases Tax from end of the last basis period – date of cessation

3.1 EXERCISE 3Ulrich ceases trading on 31 March 2004. His adjusted profits are as follows:NB Overlap profits 2,250Year ended 30 June 2002 6,860Year ended 30 June 2003 12,860Period ended 31 March 2004 10,050Calculate the Schedule DI assessments for Ulrich for all years concerned.

4 CHANGE OF ACCOUNTING PERIOD DATEA change of accounting period date is valid if• The change is notified to the Revenue• The new accounts are not more than 18mths long• No change of AP date in the last 5 years unless for genuine commercial reasons If the conditions are not met, the old AP date will continue to apply.

Otherwise, to construct assessments to the new date, follow the following three rules• Calculate DI profits to the new accounting date, if that ends in the fiscal year• The assessment must be for at least 12 mths of profit to that date


• Leave no gaps – all profit must be taxed

As a result of these rules:• Additional overlap profit is generated, or• Overlap profit is released to proportionately reduce an assessment > 12 months long

PAPER 2.3 BUSINESS TAXATIONCHAPTER 10INCOME TAX LOSSES

• How does a Schedule D Case I income tax loss arise?• How can that loss be relieved against other income?• What happens in the opening and closing years?

1 LOSSES

1.1 CALCULATION OF A DI LOSS


A Schedule DI loss may arise as a result of the adjustment of profits calculation (including the deduction of capital allowances).The Schedule DI assessment in the income tax computation (using the CYB rules) is NIL for the fiscal year. The loss can then be relieved against other income in the following ways.

1.2 CARRY FORWARD – S385 ICTA 1988A trading loss can be carried forward and set against• First available• Trading profits• Arising from the same trade• As soon and as far as possible

Any unrelieved loss after alternative loss relief claims eg s380 will be carried forward in this way.Unrelieved trade charges (patent royalties) are also carried forward in this way – s387 ICTA 1988

1.3 SET-OFF AGAINST TOTAL INCOME – S380 ICTA 1988A Schedule DI loss may be offset against• STI of• The fiscal year in which the loss making accounting period ends and/or• The preceding fiscal yearThe offset cannot be restricted to preserve the personal allowance – the claim is all or nothing. If claims are made for both years, they may be in any order.

1.4 SET-OFF AGAINST CAPITAL GAINS – S72 FA1991Where an individual makes a s380 claim in respect of a particular loss, that claim can be extended to allow the remaining loss to be set off as a deemed capital loss in that same fiscal year.The deemed capital loss is offset in the same way as a current year capital loss ie before b/f capital losses, taper relief and the annual exemption (see later).The maximum amount of loss that can be the subject of a s72 claim is calculated as followsCurrent year capital gains XLess :current year capital losses (X)Less : brought forward capital losses (X)Maximum amount X

1.5 EXERCISE 1Van Gogh runs his own painting and decorating business. He makes up accounts to 31 July and recent results have been as follows:

Year ended 31 July 2001 Profit 35,000Year ended 31 July 2002 Loss (75,800)Year ended 31 July 2003 Profit 20,000In addition, Van Gogh has other income each year of £6,000 and charges on income of £1,200.During 2002-03, Van Gogh undertook a number of capital transactions, giving rise to a capital gain of £12,000 and a capital loss of £1,700Describe the ways in which the loss may be used and state how much loss is carried forward to 2004-05, assuming all available claims are made. Comment on how efficiently the loss has been used.


2 LOSS RELIEF IN THE OPENING YEARS – S381 ICTA 1988In the opening years of a business, the opening year rules are used to calculate the Schedule DI assessments. Loss making accounting periods are treated in exactly the same way as profit making periods, with one important difference. Overlap losses do not occur. If any part of a loss has been taken into account to calculate a result for a fiscal year, it is not double counted in a subsequent assessment.

In the first four fiscal years of trading, an additional relief is available under s381. All of the previous loss reliefs described are still available – this is just another option.Section 381 allows a loss to be relieved against• STI of• The three fiscal years preceding the year of the loss• On a FIFO basis• One claim covers all three years

2.1 EXERCISE 2Winona runs a boutique selling second hand designer clothes. She commenced trading on 1 January 2001 and drew up accounts as follows.4 months to 30 April 2001 Loss (10,380)Year ended 30 April 2002 Profit 24,800Year ended 30 April 2003 Profit 30,600In 1997-98, 1998-99 and 1999-00 Winona had STI of £2,000, £6,900 and £5,700 respectively.

Her only other source of income from 00/01 onwards is interest on her building society account of £2,100 p.a.

Describe how Winona can obtain relief for her loss, assuming she claims relief as soon as possible.

3 LOSS RELIEF IN THE CLOSING YEARS – S388 ICTA 1988No further carry forward of losses is available once a sole trader’s business ceases. In addition to s380 in the closing year, an extended carry back is provided by s388 ICTA 1988.The loss available for terminal loss relief is the loss of the last 12 months of trading, which will require a separate calculation.The calculation is in three stages(a) The loss arising from 6 April – date of cessation + overlap relief(b) Unrelieved charges of the final year(c) Any loss arising in the 12 months before cessation to the 5 April(d) Any unrelieved trading charges for the penultimate fiscal year, but only a proportion corresponding to the period described in (c) above If the calculation in (a) or (c) results in a profit, use nil in the overall calculation of the terminal loss The terminal loss is then available for offset against• Schedule DI –charges not offset by other income – any s380 claims• In the fiscal year of cessation and• The 3 preceding fiscal years• On a LIFO basis

3.1 EXERCISE 3Xavier ceases trading on 31 May 2004 having drawn up accounts as follows.Year ended 30 November 2001 Profit 27,500Year ended 30 November 2002 Profit 16,800Year ended 30 November 2003 Profit 18,000


6 months ended 31 May 2004 Loss (12,720)(a) Show the Schedule D Case I assessments for the final 4 years of the business(b) Calculate the terminal loss(c) Describe how the terminal loss may be relieved(d) Describe any other available loss reliefs availableOverlap relief available = £4,800

4 TRANSFER OF BUSINESS TO A COMPANY – S386 ICTA 1988Any unrelieved losses on cessation cannot be carried forward under s385. However, if the business is transferred to a company in return for shares, the unrelieved loss may be carried forward and set against• First available• Earned then unearned income• Received by the ex sole trader• From that company

PAPER 2.3 BUSINESS TAXATIONCHAPTER 11PARTNERSHIPS

• How are partners taxed?• What happens when the partnership starts up/ceases trading?• What happens when a partner joins/leaves• What loss reliefs are available?

1 BASIS OF TAXATION FOR PARTNERSHIPS1.1 ALLOCATION OF PROFITSA partner is taxed in the same way as a sole trader ie Schedule DI under the CYB, except an allocation of the partnership tax adjusted profit needs to be made to each partner first, in accordance with the profit sharing ratio (PSR).Any fixed allocation of profit eg salary, interest on capital, rent is allocated first.The allocation must be prorated if the membership and/or PSR changes in the year


1.2 PARTNERS JOINING AND LEAVINGA change in the composition of a partnership does not trigger a cessation of the partnership as a whole, instead• When a partnership commences, opening year rules apply to all founding partners• When a partnership ceases, closing year rules apply to all partners on cessation• When a new partner joins during the currency of a partnership, opening year rules apply to that partner, only• When a partner leaves/retires, closing year rules apply to that partner only.

1.3 EXERCISE 1Yvonne and Zak are in partnership, sharing profits equally. On 1 September 2002, Anthony was admitted to the partnership and each partner was entitled to 1/3rd of the profits from that date onwards. On 31 March 2003 Zak retired and the PSR reverted to 1:1. Zak had overlap profits brought forward of £3,700.Accounts were drawn up as followsYear ended 31 December 2001 Profit 125,000Year ended 31 December 2002 Profit 267,000Year ended 31 December 2003 Profit 126,000Show the Schedule DI assessments for each partner for all years concerned.

2 LOSS RELIEF FOR PARTNERSLosses are allocated between partners in exactly the same way as profits. Loss relief is then available for each partner separately.The normal Schedule DI loss reliefs apply ie• Carry forward - s385• Offset v STI of year of loss and preceding year -s380• Extension claim v capital gains - s72• 3 year carry back in opening years - s381 - for joining partner/commencement as a whole• 3 year carry back in closing years - s388 for leaving partner/on cessation as a whole

PAPER 2.3 BUSINESS TAXATIONCHAPTER 12EMPLOYMENT INCOME

• How and when is employment income taxed?• How are benefits in kind taxed?• How is tax collected from employees?

1 EMPLOYED V SELF EMPLOYED

1.1 CONTRACT OF SERVICE V CONTRACT FOR SERVICES

The Inland Revenue look at the following factors to decide whether an individual is employed (Employment income) or self-employed (Sch DI)(a) Obligations of both parties


(b) Control(c) Ancillary benefits(d) Integration(e) Economic risk(f) Provision of equipment(g) Exclusivity

2 BASIS OF ASSESSMENT

2.1 INCOME ASSESSABLE

Emoluments of employees and directors are taxed under new rules. The rules relating to income tax on employment income are now found in the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). The income is taxed in the fiscal year in which it is received.Emoluments include:• Salary, wages, bonuses• Benefits• Pensions• Certain state benefits eg statutory sick, maternity pay, job-seeker’s allowance

2.2 EXPENSESAllowable Employment income expenses must be incurred wholly, exclusively and necessarily in the performance of duties However, the following specific rules exist;(a) Fees and subscriptions to professional bodies are allowable(b) Contributions to pension schemes allowable within certain limits(c) Travel expenses are allowable if incurred• Necessarily in the performance of duties eg from office to customer• To temporary place of work(c) Where an employee uses their own car for business purposes, a tax free mileage may be paid by the employer. An employee may claim a deduction for any shortfall in the allowance paid, compared to the approved Inland Revenue rates. Any excess is taxable.

3 BENEFITSBenefits can be categorised as follows:• Exempt• Taxable on all directors and employees• Taxable on all directors and employees earning at least £8,500 p.a. (When testing this limit, all potentially assessable benefits are quantified and then compared to the threshold)

3.1 EXEMPT BENEFITSThe following are the more important exempt benefits(a) Employer’s contribution to pension scheme(b) Canteen facilities available to all staff(c) Luncheon vouchers ; 15p per day(d) Relocation costs up to £8,000(e) Car parking space near work(f) Job-related accommodation(g) Mobile phone(h) Use of computer worth up to £2,500(i) Employee liability insurance(j) Expenses paid by employer whilst away from home - £5 per night UK, £10 per night overseas(k) Employer funded training(l) Security assets(m) Work place crèche


(n) Recreational or sports facilities(o) Work functions up to £75 per head pa(p) Work buses

3.2 BENEFITS ASSESSABLE ON ALL EMPLOYEES(a) Vouchers exchangeable for goods – cost of providing is assessable amount(b) Credit tokens – value of goods bought(c) Living accommodationThe provision of job-related accommodation is tax free if it is:• Necessary for the proper performance of duties or• For the better performance of duties and is customary or• Part of security arrangements

Otherwise, a benefit arises as follows:(a) Annual charge: higher of (i)Annual value or NB Not assessable if job-related accom(ii)Rent paid by employer(b) Additional charge:if cost >£75,000NB Not assessable if job-related accom :Owned < 6yrs (Cost – 75,000) x 5% NB 5% is the official rate of interest to be used for the May and Dec 2004 exams (unless told otherwise by the examiner) :Owned > 6yrs (MV – 75,000) x 5%(c) Expenses paid by employer NB limit to 10% emol’s if jobrelated accom(d) 20% x OMV furnishings NB only for employees earning > £8,500 and directors(e) Less : contribution by employee

3.3 EXERCISE 1Bob works for a firm in Southampton and is provided with a flat in connection with his job. The annual value is £5,800. He earns salary of £18,000 p.a. The firm also pay the heating and lighting bills of £2,500 for 2003-04. The flat was bought by Bob’s employer in 1999 for £85,000.Bob earns bank interest of £820 (net) for 2003-04Calculate Bob’s taxable income for 2003-04

3.4 BENEFITS ASSESSABLE ON ALL DIRECTORS AND EMPLOYEESEARNING AT LEAST £8,500 PA(a) Use of assets (separate rule for cars) Assessable = 20% x MV of asset when first provided(b) Car benefit Assessable = % x list price• % based on CO2 emissions• Minimum is 15% for emissions of 155 g/km• 1% increase per extra 5gms• Maximum 35%• 3% supplement for diesel cars• Benefit reduced by any employee contribution• Benefit reduced if car unavailable for part of year• Assessable amount covers all benefits in connection with the car eg insurance(c) Fuel benefit Assessable = a fixed rate of £14,400, multiplied by the same % applied to the car benefit above. Note that partial contributions by an employee do not reduce the charge(d) Beneficial loans Assessable amount = Average capital outstanding x official rate of interest (Use 5% as for expensive accommodation)• Benefit is reduced by the actual interest paid• No charge where total loans (excluding qualifying loans) do not exceed £5,000• No charge for qualifying loans – interest is charge on income(e) VansAssessable amount = £500 or £350 where van at least 4yrs old at start of fiscal year(f) Assets given to employeesAssessable amount = MV when given – contribution by employee (more complex is given when second hand)


3.5 EXERCISE 2Caroline is the sales manager Minehead Ltd and earns £35,000 per year. Minehead Ltd provided her with a car from 1 January 2004 which has a list price of £26,000. The car has a CO2 emission rate of 214 g/km. Caroline contributes £40 per month towards the use of the car.Calculate Caroline’s Schedule E assessment for 2003-04

4 PAYE

4.1 NOTICE OF CODINGThe PAYE system requires employers to deduct income tax from employees remuneration.The income tax is paid over to the Inland Revenue on 14th day after end of tax month ie 19th.

The tax collected is governed by the each employees’ tax code.The tax code is made up as follows:Allowances: Personal allowanceQual’ing interestAllowable expensesDeductions: Benefits in kindUnderpaid tax from previous yearsThe code is 1/10th of the net allowances, rounded down and prefixed or suffixed by a letter

4.2 ADMINISTRATIVE PROCEDURESLeaving employees P45 4 partsJoining employee(no P45) P46Year end summary by employer P35 Due 19 MayYear end summary for employee P14-P60 19 May to IR, 31 May to employee

PAPER 2.3 BUSINESS TAXATIONCHAPTER 13PENSIONS

• What pensions are available to employees?• What pensions are available to the self-employed?• What are the tax consequences of making pension contributions?

1 OCCUPATIONAL PENSION SCHEMESThese are schemes set up by employers for the benefit of employees. The employer must contribute and the employee also makes contributions into the scheme. The pension fund represents a tax efficient method of saving in the long term.

1.1 TAX CONSEQUENCES OF OCCUPATIONAL SCHEMES


For the employee: Contributions up to 15% x earnings tax deductibleDeductible from Employment incomeEarnings capped at £99,000 for 2003-04For the employer: Employer contributions deductible for DINot a benefit for employeesBenefits on retirement: Tax free lump sum + pension taxable as earned income

2 PERSONAL PENSION SCHEMES/STAKEHOLDER PENSIONSPersonal pension schemes are available for the self-employed and stakeholder pensions are simply a form of personal pension with a few extra rules.All individuals can take out a stakeholder pension and contribute up to £3,600 p.a. with the exception of persons in pensionable employment earning > £30,000 p.a. The self employed and those not in pensionable employment may contribute more than £3,600 p.a. according to the following formula:Max contribution = Age related % x Net relevant earnings (NRE)NRE = Earned income ie Schedule DI or Schedule E from non-pensionable employmentNRE restricted to a max of £99,000 for 2003-04NRE based on current year or any of 5 previous fiscal years

2.1 TAX CONSEQUENCES OF PERSONAL PENSION SCHEMESFor the employee : Contributions are deductible Contributions paid net of BRITRelief is given by extending the higher rate threshold (£30,500) by the value of the gross contributionsCarry back of contributions – an individual may elect to have a contribution paid by 31 January in the fiscal year treated as if it were paid in the previous fiscal year

PAPER 2.3 BUSINESS TAXATIONCHAPTER 14NATIONAL INSURANCE CONTRIBUTIONS

• What classes of NIC do employees pay?• What classes of NIC do self-employed persons pay?• What classes of NIC do employers pay?

1 EMPLOYEES

1.1 CLASS 1 CONTRIBUTIONS - PRIMARYClass 1 contributions are paid by employees on their earnings which includes cash, non-cash vouchers, shares, any asset convertible into cash. Benefits in kind and pensions are disregarded.

Primary contributions are payable by employees earning £4,615 per annum or more (the earnings threshold). The


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examiner has stated that from the June 2004 sitting onwards Class 1 NIC limits will be shown on an annual basis rather than a weekly one. Therefore students should calculate them on an annual basis unless told otherwise The rate is 11% of earnings in excess of the earnings threshold up to the upper earnings limit of £30,940 per annum (2003-04 rates). Lower rates apply if the employee is contracted out of SERPS.The contributions are deducted by the employer through PAYE.

1.2 CLASS 1 CONTRIBUTIONS - SECONDARYSecondary contributions are payable by employers at 12.8% on all earnings above the earnings threshold of £4,615 per annum.Lower rates apply if the employee is contracted out of SERPS.

1.3 CLASS 1A CONTRIBUTIONSClass 1A contributions are payable by employers at 12.8% on the value of most taxable benefits paid to employees earnings at least £8,500 p.a.

The contributions are collected annually in arrears,

2 SELF-EMPLOYED PERSONS

2.1 CLASS 2 CONTRIBUTIONSClass 2 contributions of £2 per week are payable by self-employed persons aged 16-retirement age.

2.2 CLASS 4 CONTRIBUTIONSIn addition, Class 4 profit based contributions are payable at 8% on profits between £4,615 and £30,940 (2003-04) and 1% for profits in excess of that They are payable.by those aged 16- retirement age

Profits = Schedule DI – losses – trade chargesContributions are collected through self-assessment.

PAPER 2.3 BUSINESS TAXATIONCHAPTER 15SELF-ASSESSMENT – INDIVIDUALS

• How do individuals pay tax?• When are the payment dates?• What filing obligations exist?

1 SELF ASSESSMENT1.1 THE RETURN

The individual self assessment tax return must be submitted by 31.1 following the end of the fiscal year (or 3 months after issue, if later). Income tax is payable by way of payments on account and then a balancing payment. Partnerships are subject to the same rules.Taxpayers have an obligation to self asses their liability, although the IR will calculate the tax liability if the return is sent in by 30 September after the fiscal year.

Once filed, the return can be amended within 12 months by the taxpayer or an error or mistake claim filed after such time.




Even if no return is received, a taxpayer must notify the Revenue of income chargeable to tax by 5 October after the end of the fiscal year.

1.2 PAYING TAXPayments on account of the liability for 2003-04 are due on• 31 January in the year ie 31 January 2004• 31 July following the year ie 31 July 2004

These payments are calculated as 50% of last year’s liability under self assessment. A claim may be made to make reduced payments on account, at any time before 31 January. Interest and penalties may arise if this claim is incorrectInterest is automatically calculated on tax paid late. Surcharges can also apply.In calculating the amount due under self-assessment, credit is given for tax deducted at source ie PAYE, tax credits on interest, dividends.

A balancing or ‘sweep-up’ payment is due on 31 January following the year • ie 31 January 2005 for 2003-04 Capital gains tax is also payable at this time ie 31 January following the end of the fiscal year.

If not return is filed, the Inland Revenue will determine the amount to be paid.2 OTHER ADMINISTRATIVE MATTERS(a) Penalties arise for• failure to submit a return (£100)• tax geared if default persists for > 12 mths after filing date(b) Records must be kept for• 12 months after filing date• 5 years after filing date if in busine

PAPER 2.3 BUSINESS TAXATIONCHAPTER 16CAPITAL GAINS TAX

• What happens when a capital asset is sold, generating a capital rather than income profit?• How is the gain calculated?• How is the gain taxed?• What special rules apply to shares?• What are the differences between companies and individuals?

1 CAPITAL GAINS – AN INTRODUCTIONCapital profits arising on the disposal by chargeable persons of chargeable assets are subject to• Capital gains tax in the hands of individuals• Corporation tax on chargeable gains (as part of PCTCT) for companiesThe principles involved in calculating gains for both individuals and companies are broadly similar.


This chapter will focus on individuals first and then the differences for companies will be highlighted.

1.1 BASIS OF ASSESSMENT FOR INDIVIDUALSA capital gain arises on the chargeable disposal of a chargeable asset.Chargeable disposal = sale/gift/sale at undervalue but a transfer on death is exemptChargeable asset = all property except cars (other exempt assets ignored for the purposes of the exam)

1.2 CALCULATION OF CAPITAL GAINS TAX PAYABLE BY INDIVIDUALSGains and losses arising from disposals in a fiscal year are netted off and any net gain is charged to tax after deducting an annual exemption (£7,900 for 2003-04). Any unused exemption is lost.The net gain is treated as if it were an additional top slice of income and taxed at the same rates as savings income ie 10%, 20% and 40%.

1.3 EXAMPLEDesmond Maurice realises a gain of £18,500 in 2003-04 His taxable income for 2003-04 is £26,000.The capital gains tax payable is calculated as follows:Gain 18,500Annual exemption (7,900)Taxable amount 10,600Taxable income 26,000Basic rate band remaining 4,500 CGT on £4,500 @ 20% 900£6,100 @ 40% 2,440 3,340

1.4 CALCULATION OF GAINS AND LOSSESThe basic computation:Gross proceeds XLess: incidental disposal costs (X)Net proceeds XLess: Cost (X)Unindexed gain/loss XLess: Indexation allowance (X)Indexed gain X(a) Indexation allowance (IA) is calculated based on the RPI difference from the month of acquisition to the month of disposal.IA = RPI(mth of disposal) – RPI(mth of acquisition) X Cost RPI(mth of acquisition)The indexation factor from the RPI fraction is rounded to 3 decimal places.However, indexation allowance for individuals was ‘frozen’ at April 1998 ie this is the latest RPI which is considered, even if the disposal is after this date.You will be given the indexation allowance for individuals in the exam.(b) Indexation allowance cannot create or increase a loss(c) As well as original cost, any subsequent enhancement expenditure (ie expenditure permanently increasing the value of the asset) may be deducted. The enhancement expenditure is indexed separately.(d) Capital losses are netted of against chargeable gains in the fiscal year (without any restriction). Any unused capital loss is carried forward and netted off against capital gains in future fiscal years, but only to the extent needed to reduce the gain to the value of the annual exemption ie the use of b/f losses may be restricted to preserve the use of the annual exemption(e) For individuals, taper relief is given against gains (net of losses). See below(f) For assets acquired post April 1998, IA is not available. The unindexed gain is simply reduced by taper relief.(g) Where a disposal is made to a ‘connected person’ MV is substituted for sales proceeds.

1.5 EXERCISE 1Eva Dolittle buys a plot of land in December 1986 for £50,000. The land is sold in May 2003 for £179,500. The indexation allowance for this sale is £36,900. During 2003-04, she also sells another asset giving rise to a capital loss of £4,670. Eva


has taxable income for 2003-04 of £45,090.Calculate the CGT payable by Eva for 2003-04.(Ignore taper relief)

1.6 TAPER RELIEFTaper relief is applied to gains (but not losses) according to the length of time for which an asset has been held (since 5 April 1998). Only complete years of ownership since 5 April 1998 are counted.The amount of taper relief also depends on whether the asset is a business or non-business asset.

The following assets are business assets for taper relief purposes:(a) Assets used in a trade(b) Shares in unquoted trading companies(c) Shares in quoted trading companies where the shareholder is a director or employee (the ‘trading company’ requirement is waived if the shareholder owns < 10%)(d) Shares in quoted trading companies where the shareholder has at least 5% of the votes• AIM counts as unquoted• A company is ‘trading’ if its value of investment assets < 20% total assets

The taper relief % is applied to the gain, prior to the annual exemption.Taper relief %’s are as follows. This is an extract of the table which will be given in the exam:Complete years of ownership after 5.4.98Business assets Non-business assets0 100% 100%1 50% 100%2 25% 100%3 25% 95%4 25% 90%5 25% 85%6 25% 80%In addition, non-business assets held on 17 March 1998 qualify for one additional bonus year of ownership.

1.7 EXERCISE 2Fanny Bryce runs her own business. During September 2003 she sold the building which she had been using as business premises for £270,000. The building had cost £67,800 in September 1975.She incurred selling expenses of £7,800. The indexation allowance available on this disposal is 75%.Fanny’s taxable income for 2003-04 is £65,800. She also made a loss of £3,600 on the disposal of some unquoted shares in October 2003.Calculate Fanny’s CGT payable for 2003-04.

2 SHARES AND SECURITIESSpecial rules apply to the gains calculated on the disposal of shares and other securities.

2.1 SHARE MATCHING RULESWhere an individual builds up a portfolio of shares in a particular company and then makes a disposal, the shares are deemed to be sold for tax purposes in a certain order.

For an individual, shares sold on or after 6 April 1998 are matched against acquisitions in the following order:• Shares acquired on the same day• Shares acquired in the next 30 days (FIFO basis)• Shares acquired on or after 6 April 1998 (LIFO basis)• Shares in the 1985 pool

The 1985 share pool contains shares acquired from 6 April 1982 onwards. The pool also contains indexation which is added to the pool prior to ‘operative events’ ie purchases, sales and rights issues.As indexation is frozen at 6.4.98, a final indexation is added into the pool at that date, but none subsequently.


The examiner has stated that a detailed calculation of this pool will not be required in the exam.You are likely to be given the number of shares in the pool, the cost and indexed cost (ie cost + IA)After calculating the indexed gain, taper relief is applied according to the normal rules.Acquisitions post-5 April 1998 are treated separately. There is no IA and any gain is tapered by reference to the relevant taper %.

2.2 EXERCISE 3Mr Giverny purchased the following shares in Waterlilly Plc.No of shares Cost May 1989 200 6,000Feb 1998 150 12,000May 2000 100 19,200In August 2003, he sold 250 shares for £32,000. The indexed cost of the 1985 share pool at April 1998 was £36,820.The shares are not business assets for taper relief purposes.(Note that the cost of the 1985 pool and the no of shares can be derived from the above information)Calculate the gain/loss on the disposal of the shares in August 2003.

2.3 BONUS AND RIGHTS ISSUESBonus and right issues increase the existing holing of a shareholder in proportion to the no of existing shares.For tax purposes, the bonus/rights shares attach to the original shares for identification purposes ie they do not form a separate holding.A bonus issue simply results in an increase in the number of shares held.Indexation applies for rights issue shares (but not bonus shares, as they have no cost).

2.4 EXERCISE 4Horatio owns shares in Hornblower Ltd as follows400 in 1985 pool – indexed cost at 6.4.98 1,800950 acquired in November 2001 9,500In December 2002 a 1 for 5 rights issue is declared. The rights issue price is £8.50 /share.In December 2003 Horatio sells 1,200 shares for £27,000.Calculate the chargeable gain arising in 2003-04 assuming the shares represent business assets for Horatio.

2.5 REORGANISATIONS AND RECONSTRUCTIONSWhere shares are exchanged for new shares as a result of a reorganisation of share capital or a takeover (reconstruction :• There is no disposal for gains purposes• The new asset acquires the old asset’s cost and date of acquisition• Where there is more than one type of consideration eg ordinary and preference shares, the old cost of the original shares is apportioned to the new consideration in proportion to their respective market values.

3 CALCULATION OF CHARGEABLE GAINS FOR COMPANIESCompanies are subject to corporation tax on their net chargeable gains (ie current year gains – current year losses – b/f losses), as part of PCTCT.The annual exemption is not available to companies.Taper relief does not apply – indexation is not frozen at April 1998 but calculated to the month of disposal.

3.1 GAINS ON SHARES AND SECURITIESThe 1985 share pool contains all shares acquired from 1 April 1982 onwards. Post April 1998 acquisitions are not treated separately – they are contained within the pool.Indexation is added to the pool in the normal way – ie before operative events.Disposals are matched in order, according to the following share matching rules• Shares acquired on the same day• Shares acquired in the previous 9 days (FIFO basis)• Shares in the 1985 share poolBonus and right issue shares are treated in the same way ie added to the original shares, indexation applying in the 1985 pool on the occasion of a rights issue.


Similar rules regarding reorganisations and reconstructions apply to corporate shareholders.

PAPER 2.3 BUSINESS TAXATIONCHAPTER 18VALUE ADDED TAX

• How is VAT levied?• On what transactions?• When do businesses have to account for VAT?• What administrative procedures exist?

1 VALUE ADDED TAX – THE BASICSVAT is a tax on transactions. It is administered by Customs and Excise. The following rules apply equally to individuals and companies VAT is charged on taxable supplies of goods and services made by a taxable person in the course of business.A chargeable person making taxable supplies must charge VAT to their customers but may recover input tax suffered ie VAT on expenses/purchases.

A person making wholly exempt supplies cannot register for VAT Supplies are classified as follows:


Supplies Within the scope Outside the scopeExempt TaxableStandard ratedZero-rated• Standard rated supplies are charged at 17.5%• Zero-rated supplies are charged at 0% but are still taxable supplies

1.1 CLASSIFICATION OF SUPPLIES – MORE DETAILSupplies are standard rated unless they fall within the definition of exempt and zero-rated – the following lists are not exhaustive(a) Exempt• Land (certain transactions only)• Insurance• Finance• Education• Health(b) Zero-rated• Food (except for catering, confectionery and hot-take away food)• Books and stationery• Children’s clothing• Drugs/medicines• Transport

1.2 VAT REGISTRATIONIf a person makes taxable supplies (standard + zero rated) > £56,000 in the previous 12 months, that person is required to register within 30 days from the date the limit is exceeded..If a person believes that the value of their taxable supplies in the next 30 days will be > £56,000, they are required to register within 30 days from that anticipation Voluntary registration is possible• Input tax can then be recovered• VAT must be charged on outputs• VAT returns must be completedOn registration, input tax incurred on stock on hand/assets in use and services in the last 6 months may be recovered in the first return period.Deregistration is compulsory within 30 days of ceasing to make taxable supplies Voluntary deregistration is possible if taxable supplies< £54,000 in the next 12 months.(On deregistration a self-supply occurs)

1.3 CONSEQUENCES OF REGISTRATIONOutput tax is charged on all taxable supplies (including gifts > £50, excluding trade samples) Input tax suffered is recoverable, with the following exceptions:

• Cars (except those used 100% for business purposes)• Client entertaining• Expenses partly for business purposes – apportion

2 VAT ADMINISTRATIONVAT returns are normally prepared quarterly and submitted by the end of the month following the end of the quarter. A


trader will be allocated quarterly return dates – stagger group.

2.1 FILLING IN THE VAT RETURNStrictly, tax is accounted for based on the basic tax point date ie the date when goods are made available or services performed. For convenience, the basic tax point may be overridden by an actual tax point which occurs:• If payment or invoicing occurs earlier than the basic tax point, or• If invoicing occurs within 14 days of the basic tax pointHowever, small business (ie taxable supplies in next 12 months not > £600,000) can join the cash accounting scheme.Output tax is paid over when the money is received/input tax is recovered when the expense is incurred.

Business must leave the scheme if taxable supplies> £750,000 in 12 months to date.The scheme brings automatic bad debt relief.

2.2 VAT RECORDSTax invoices must be issued by registered persons showing:(a) Invoice number(b) Suppliers name, address and VAT no.(c) Time of supply(d) Name and address of customer(e) Description of supply(f) Rate of VAT, VAT exclusive amount, VAT payable VAT records must be kept for 6 years

2.3 VAT APPEALS AND PENALTIESAppeal is to the VAT TribunalThe following penalties apply:(a) Penalty for late registration(b) Default surcharge for late returns/payments (surcharge liability notice for first late payment)(c) If further default in surcharge period, notice extended for further 12 months(d) Late payment of VAT in surcharge period incurs penalties = % of VAT unpaid(e) Serious misdeclaration penalty – 15 % tax lost(f) Default interest

2.4 VAT PLANNINGThe following schemes exist:(a) Cash accounting – see above(b) Annual accounting• Taxable turnover not > £600,000• 9 monthly payments = 1/10th of previous years VAT liability• Paid by direct debit• Balancing payment and return filed 2 months after year end• Leave scheme if taxable supplies > £750,000(c) Flat rate scheme• Taxable turnover not > £100,000 and total income not > £125,000 for next 12 months• VAT liability calculated by applying flat rate (varied according to trade sector) to total income• No input tax recovered• Still need to issue VAT invoices and charge VAT to VAT registered businesses


PAPER 2.3 BUSINESS TAXATIONCHAPTER 19TAX PLANNING SCENARIOS• One of the optional questions in the exam will consider one of the following six tax planning topics• Employment v self-employment• Remuneration packages• Director/shareholder v sole trader• Incorporation• Disposing of a business/shares• Comparing salary/bonus v dividends

1 EMPLOYMENT V SELF-EMPLOYMENTThe following points are not new, but merely apply knowledge gained so far to the situation described:Employee Sole trader Income tax:• Employment income –amount received• Sch DI – CYB• PAYE (including NIC) • Self-assessment• Expenses restrictive (…’necessarily incurred’ )• More generous (‘wholly and exclusively’)• Employment income for company car

National Insurance


• Class 1 primary and secondary/1A for employer• Class 2 and 4

Capital allowances• Given for plant ‘wholly, exclusively and necessarily’ incurred for employment duties• CAs available - private use restriction

2 STRUCTURING REMUNERATION PACKAGESConsider the position of both employee and employer. Look at the after tax cost.Salary/Bonus • Employment income when received• PAYE• Deductible for employer• Primary Class 1 NIC• Employer contributions deductible

Benefits• Some exempt• Cost of providing tax deductible• Cars – benefit under Employment income• Fixed profit car scheme mileage allowance if use own car• Expensive car restriction for employer• Class 1A NIC• Cash/car comparison

3 DIRECTOR/SHAREHOLDER V SOLE TRADERAlso see the points about comparing salary/dividends as methods of extracting profits.The main points are covered in section 1 above although notice the following extra points:• Director/shareholders can usually control their method remuneration to make it tax efficient• Retaining profits rather than paying out as remuneration/dividends will result in corporation tax at lower(?) rates only• Sole traders are taxed on Schedule DI profits as they accrue, not on drawings.• Loss relief in opening years (s381 3 year c/b) is particularly generous.

4 INCORPORATION IE TRANSFERRING A BUSINESS INTO A NEW OR EXISTING COMPANYAside from the advantage of limited liability, tax savings may arise by incorporatingThe following points should be noted• Corporation tax payable by company (0%, 19%?). Income tax on dividends/ salary extracted• Different tax administration regimes/payment dates• Gains on incorporation can be deferred v cost of shares• Trading losses from business may be carried forward (s386)• Ownership structure more flexible ie can include other shareholders• Occupational pension scheme now an option• More flexible remuneration available eg exempt benefits

5 DISPOSING OF A BUSINESS/SHARESThe disposal may be by way of shares or giftBusinessSharesSale• Gain arises on chargeable assets – CGT rates -business asset taper relief• Gain on shares for shareholders – business asset taper relief?• DI assessments – closing year rules (overlap profit)• No implications for company itself• Balancing adjustments for CAs


• No VAT if certain conditions met (transfer as a going concern)• Terminal loss relief Gift • Gain on chargeable assets – use MV as proceeds• Same as above – gift relief may be available• Same as above for other tax consequences• Gift relief available to defer gain

6 SALARY/BONUS V DIVIDENDSThe way in which profits are extracted from a company affects the tax cost.The following points should be noted when evaluating the overall tax cost of different routes Salary/bonus DividendTax deductible• Sch DI deduction • No deductionNI • Employer and employees (up to upper limit) contributions• No NIPensions • NRE • Not NREIncome tax • Marginal rates of IT apply • 10% tax credit – tax at 10%/32.5%

Paper 2.4CHAPTER 1COSTING

1 ABSORPTION COSTING

Absorption costing involves the apportionment of indirect costs (or overheads) when costing a product, in addition to direct costs. The indirect costs are shared or apportioned to a product unit using overhead absorption rates.Indirect costs are allocated and apportioned to production and service cost centres. Costs are then re-apportioned from service costs centres to production cost centres and overhead absorption rates then used to absorb the costs into cost units.Overheads are indirect expenses, i.e. costs that cannot be economically allocated to a unit of product (see chapter 3).To enable us to calculate the total cost of producing one unit of product, we must somehow split the overheads between the units of product made.1.1 SINGLE PRODUCT COMPANIES – EXERCISE 1To determine the total cost of producing one unit of product, when the company only makes one product, is very simple. Divide the total costs incurred by the company (direct and indirect costs) by the number of units made to achieve a total cost per unit.A company makes plastic cups. £Total direct costs: 140,000Total indirect costs 50,000Total cost 190,000If 2 million cups are made every year, what is the cost per cup?


1.2 MULTI-PRODUCT COMPANIESWhere a company produces more than one product, it is more difficult. The direct costs can be allocated to the different products, but the overheads will need to be split between thedifferent products. One way of achieving this is to apportion overheads to cost centres. Cost Centres: A cost centre is an area of the business with which costs can be identified.They are often referred to as departments of the businessAllocating: Where 100% of a cost can be allotted to one cost centreApportioning: Where a cost is not solely incurred due to one cost centre, and therefore should be split between the relevant cost centres. Each cost centre collects its fair share of the overheads, which will be attributed to products asthey pass through the department.1.3 STAGES TO SPLIT OVERHEADS BETWEEN DEPARTMENTS1. If possible ALLOCATE indirect costs to a specific department e.g. Repair costs can all go to the maintenance department2. APPORTION overheads that apply to several departments on a fair basis e.g. Rent will be apportioned between departments on the basis of floor area3. Determine an overhead recovery rate for jobs done in the department.As a unit passes through the department it picks up a share of the indirect costs (allocated and apportioned) of that department .If the main cost driver is direct labour, the cost is allocated per labour hour. This gives the predetermined Overhead Absorption Rate.4. Calculate the total cost of producing a unit by adding the direct and indirect costs for the unit together.1.4 EXERCISE 2The rental expense of a business for a year is £20,000.3 departments: Purchasing 100 square feetSales 400 square feetMaintenance 500 square feet1,000Apportion the rental expense between the departments.1.5 EXERCISE 3In a production department: Total allocated £ 50,000Total apportioned costs £100,000£150,00025,000 labour hours are worked in the departmentIf a unit of product A passes through the production department, having 2 hrs work on it,how much overhead will be allocated to it?1.6 EXERCISE 4The machining department incurs a total of £120,000 apportioned and allocated overheads in the year ended 31 December 2002. In that year 8,000 labour hours and 15,000 machine hours were worked.How much overhead would be apportioned to a unit of Product X, which took 2.5 machine hours and 2 hours of labour in the machining department.1.7 EXERCISE 5Product X Product YDirect labour 35 70Direct materials 30 40Product X spent 3 hours in Department A and 5 hours in Department B.Product Y spent 2 hours in Department A and 1 hour in Department BThe following information is available about the two departments:Dept A Dept BLabour hrs 3,200 50,000Machine hours 22,500 4,700Overheads 58,000 260,000Calculate the total cost of producing one unit of Product X and one unit of Product Y.2 SERVICE DEPARTMENTSService departments are departments that are not directly involved in the production of units.This causes a problem, as the product never passes through a service department, therefore it never ‘picks up’ any of that departments costs.Examples of service departments are the Canteen and Maintenance departments.Service department costs are re-apportioned to other departments.


2.1 RE-APPORTIONING SERVICE DEPARTMENT COSTSIf there is only one service department or there are no reciprocal services being provided between two or more service departments:Allocate direct costs to productsAllocate overheads that are directly attributable to a specific department (service or production department).Apportion costs that cannot be allocated to several departments (service or production department). This will leave costs in production departments and the service departments.Total up the allocated and apportioned costs for each department.Apportion the service department costs between the other departments.2.2 EXERCISE 6Departments A B Canteen MaintenanceTotal overheads 175 210 52.5 78.6(in £000’s)Reapportionment basis for Service Departments:Canteen 50% 30% - 20%Maintenance 50% 50% - -2.3 SOLUTION 6Total overheads 175 210 52.5 78.6Apportioning canteenApportioning maintenance2.4 RECIPROCAL COSTS BETWEEN SERVICESSometimes, when there is more than one service department, each service department provides a service for another service department.The repeated distribution method is then used to reapportion each service departments costs.2.5 EXERCISE 7Departments A B C Canteen MaintenanceTotal overheads 15 26 58 12 6.8Reapportionment basis for Service Departments:Canteen 50% 25% 15% - 10%Maintenance 40% 20% 35% 5% -2.6 SOLUTION 7The service department with the largest value of work carried out for other service departments is selected first, and reapportioned, i.e. the canteen department.Departments A B C Canteen Maintenance(£) (£) (£) (£) (£)Total overheads 15,000 26,000 58,000 12,000 6,800CanteenMaintenanceCanteenMaintenanceCanteen2.7 OVERHEAD ABSORPTIONThe overheads in each department are then absorbed into the cost of the products passingthrough, using a basis which reflects the amount of work carried out on the product in eachdepartment.For example, a company produces 2 types of DVD players, a playback-only model and arecording model, which pass through 3 departments. The budgeted total direct and indirectcosts are as follows: Dept 1 Dept 2 Dept 3 TotalDirect materials 100,000 150,000 50,000 300,000Direct labour 45,000 50,000 15,000 110,000Indirect/Overheads 60,000 40,000 10,000 110,000Total cost 205,000 240,000 75,000 520,000The direct costs applicable to each product will be easy to calculate. The company can measure the quantity of materials and hours of labour ‘incurred’ by each product.The overhead costs, due to their very nature, are indirect, and so will not


be easily traced to each type of DVD player. An overhead absorption rate will therefore be calculated for each department the DVD player passes through.Note how the overhead absorption rate (OAR) for each department is calculated using a different basis; for example, machine hours for Department 1 and labour hours for Department 2. This implies machine hours drive or are the main cause of Dept 1 overhead costs and therefore costs should be recovered on such a basis.OAR Dept 1 Budgeted overhead cost £60,000 £24 per hourMachine hours 2,500OAR Dept 2 Budgeted overhead cost £60,000 £12 per hourLabour hours 5,000OAR Dept 3 Budgeted overhead cost £60,000 £4 per £ of labourLabour cost 15,000The playback-only model spends 3 hours in Dept 1, 2 hours in Dept 2, and incurs 5 hours of labour, costing £4 per hour in Dept 3.The recording model takes 3.5 hours in Dept 1, 3 hours in Dept 2 and incurs £24 of labour in Dept 3.Overhead cost absorption:Playback-only 3hours x £24/hr + 2 hours x £12/hr + £4/£ labour x £20 = £176Recording 3.5hours x £24/hr + 3 hours x £12/hr + £4/£ labour x £24 = £216The direct costs are added to these indirect cost per units to calculate the total product cost.3 ACTIVITY BASED COSTING (ABC)3.1 DISADVANTAGES OF ABSORPTION COSTINGAbsorption costing is judgemental. How do you decide machine hours are the best basis to absorb the overhead costs of Dept 1, and therefore calculate the cost of one DVD player?The basis used for Absorption costing is important when a company uses the information in decision making. For example, to calculate the profitability of each of the two products. A product manager responsible for the profitability on sales of Recording DVD players will be de-motivated if the overhead absorbed by his product appears to be arbitrary.Overhead or indirect costs can be variable or fixed costs. Absorption costing treats fixed indirect costs, such as the rental cost of a factory, as variable with the number of units produced.3.2 ACTIVITY BASED COSTINGActivity based costing recognises that absorbing overhead costs on machine hours or labour hours is becoming less appropriate.This is primarily due to the increasing complexity of the number and types of products and the move of industry from a manufacturing to service-oriented structure. This has led to an increase in support activities, such as materials handling, batch set-up, quality control and marketing, and a reduced link between overhead costs and machine and labour hours.The main steps in applying ABC are:1. Identify the various support activities that cause (or drive) costs2. Estimate and pool the costs caused by each activity (ie not on the basis of cost centres as in traditional absorption costing but according to the activity such as batch set-up)3. Identify the cost driver, the volume of which has a direct impact on the cost pool.For example:Cost driver Activity identified as a cost pool Number of machine set-ups Batch set up4. Calculate the cost driver rate, and allocate indirect/support costs to products Cost driver rate = Activity costNumber of set-ups3.3 ADVANTAGES OF ABCABC leads to more accurate product costing. This improves company decision making on product and customer profitability and therefore product and customer mix. Many companies are now rationalising their portfolio of products after discovering through ABC-type analysis that the cost of supporting their numerous products, lines and brands hasled to unprofitable products.It allows a company to calculate long run product/customer profitability by allowing all costs to be allocated to products to determine a ‘bottom-line’ profitability. Again, this has led to a rationalisation of products.The ABC process increases manager awareness to identify the activities that drive costs. This increased understanding improves cost management and allows better performance measurement.3.4 DISADVANTAGES OF ABCMany companies who have implemented ABC have not seen their profits increase. The cost of identifying the individual cost drivers has outweighed any benefits derived from a better understanding of costs and more accurate product costing.ABC provides information based on historic data. Long- run strategic decisions should be based on future data.Identifying activities and cost-drivers can be difficult and in some cases may be a complex combination of cost drivers.


3.5 EXERCISE 8The following budgeted information relates to Brunti plc for the forthcoming period.Products XYI YZT ABW(000) (000) (000)Sales and production (units) 50 40 30£ £ £Selling price (per unit) 45 95 73Prime cost 32 84 65Hours Hours HoursMachining (machine hours per unit) 2 5 4Assembly (direct labour hours per unit) 7 3 2Overheads allocated and apportioned to production departments (including service cost centre costs) are normally recovered in product costs as follows:Machine department at £1.20 per machine hourAssembly department at £0.825 per direct labour hourYou ascertain that the above overheads could be re-analysed into ‘cost pools’ as follows:Cost pool £000 Cost driver Qty for the periodMachine services 357 Machine hours 420,000Assembly services 318 Direct labour hours 530,000Set-up costs 26 Set-ups 520Order processing 156 Customer orders 32,000Purchasing 84 Suppliers’ orders 11,200941You have also been provided with the following estimates for the period:ProductsXYI YZT ABWNumber of set-ups 120 200 200Customer orders 8,000 8,000 16,000Supplier orders 3,000 4,000 4,2001. Prepare and present profit statements using conventional absorption costing, and activity based costing2. Comment on why activity based costing is considered to present a fairer valuation of the product cost per unit.4 MARGINAL COSTINGMarginal costing costs products at their variable production cost. Fixed costs are treated as period costs, ie they are written off in the period in which they are incurred.Marginal costing is useful to management in calculating Contribution:Contribution = Sales – all Variable CostsContribution per unit = Selling price – Variable cost per unitAs all its constituent parts are variable, contribution per unit tells management the increase in (or contribution to) profit if one more unit is sold.Notice that contribution can also be calculated as Profit + Fixed Costs.4.1 EXERCISE 9A company sells on average 15,000 units per month.Selling Price £20 per unitVariable cost £11 per unitFixed costs for the year are £240,0000Calculate:Contribution per unitMonthly contributionMonthly profitTotal contribution for the year4.2 ADVANTAGES OF MARGINAL COSTING1. It is useful in short term decision making as it assumes fixed costs do not change2. Fixed costs are treated as period costs, which could be argued is reasonable as fixed costs do not change with volume


and so should be allocate dot the period in which they are incurred.3. It avoids the arbitrary apportionment of overheads4.3 DISADVANTAGES OF MARGINAL COSTING1. Fixed costs are only constant in the short term Focussing on short-term costs only ignores the risk fixed costs may increase. If a company continues to do more and more marginal projects, eventually fixed costs will increase when factory capacity is reached and an additional machine is necessary.2. Non-compliant with SSAP 9. Financial accounts need to be prepared in compliance with SSAP 9.3. It requires costs to be split between fixed costs and variable costs.5 ABSORPTION V MARGINAL COSTING STATEMENTSAbsorption costing Value stock at full production cost (direct and indirect)Marginal Costing Value stock at marginal production costTreat Fixed costs as period costs ie charge in full in the period incurredReconciling profit statements:Difference between TAC profit and MC profit = change in stock x Fixed production overheadcost per unitIncrease in stock TAC profit > MC profitDecrease in stock MC profit > TAC profit5.1 EXERCISE 10A business commences production of a single product on 1 January. The following information relates to the budget for the first two months of production.No of unitsJanuary FebruaryOpening stock - 2,000Production 12,000 6,000Sales 10,000 8,000Each unit is sold for £25. The variable cost per unit is £15 and the fixed production cost per unit is £5 per unit.Actual production and sales are as budgeted and Actual fixed costs are £50,000 per month.Prepare profit statements under marginal and absorption costing and reconcile the profits calculated.6 FIXED AND VARIABLE COSTS6.1 HIGH LOW METHODThe High Low method enables fixed and variable costs to be calculated from Total Cost data,and therefore estimates of costs at other output levels can be made.6.2 EXAMPLEOutput Total Cost (£)1,000 17,0002,000 22,0005,000 37,000Variable Cost per unit = Total cost at the ‘High’ – Total cost at the ‘Low’Output at the High – Output at the LowVariable cost per unit = 37,000 – 17,000 = £5 per unit5000-1000Using the High or Low data:Fixed Cost = Total Cost – (Output level x Variable cost per unit)Fixed Cost = 37,000 – (5000 x 5) = £12,000Total costs at say 1500 units is therefore expected to be 1,500 x 5 + 12,000 = £19,500.6.3 BREAK EVEN ANALYSISBreak-even is the point at which a company makes neither a profit nor a loss.Break Even (number of units) = Fixed CostsContribution per unitBreak Even (sales value) = Fixed CostsContribution margin6.4 EXERCISE 11Selling price £20 per unit


Variable cost £15 per unitFixed costs £100,000 per annumCalculate the Break Even point.

Paper 2.4CHAPTER 2MODERN MANAGEMENT TECHNIQUES

Most industries have seen major changes over the past fifty years as:• Customers have become more sophisticated and knowledgeable about competitors products.• Competition has increased and become international• Technology plays a greater role and hence production techniques change more rapidly• Product lifecycles have shortened.As a result the management approach to a business has had to be adapted. The management accountant needs to be aware of some of these modern developments in order to provide relevant information on areas of concern to management.1 TOTAL QUALITY MANAGEMENT (TQM)1.1 COSTS ASSOCIATED WITH QUALITYThese can be summarised in four categories:Costs of poor quality:• Internal failure costs ( such as the cost of reworking faulty items)• External failure costs (such as the loss of customer goodwill) Costs of ensuring good quality:• Preventative costs (such as training) to ensure it was right first time• Appraisal costs (such as quality control) to pick up any items which were not good enough.


Any quality system is a balance between the costs of ensuring good quality and the costs of poor quality.For example, it might be possible to check every single item and therefore incur no external failure costs. The cost of the appraisal would be very high, however, and might not be justified in terms of the customer goodwill saved.1.2 QUALITY CONTROLTraditionally, a system of quality control put the emphasis on appraisal. However, this has generated three problems:• With large volumes, quality control had to rely on sampling, which meant companies could never be certain about their quality.• Customers in most markets have become more conscious of quality, less tolerant of substandard service, and more aware of other suppliers world-wide.• Other employees tended to regard quality as someone else’s responsibility. These problems led companies to examine other ways of improving and maintaining quality.1.3 TOTAL QUALITY MANAGEMENTTQM recognises that quality is crucial in most markets and tries to ‘continually improve’. It uses a variety of techniques but most concentrate on preventative measures and ‘getting it right first time’.A TQM system might include:• Investment in training• Incentive schemes to encourage quality• More participative decision-making• Cell manufacturing• Internal markets• Requiring quality assurance of components from suppliers• Quality circlesEffectively, companies recognised the rising cost of external failure and therefore increased the spend on ensuring good quality to restore the balance. It was more effective to increase the preventative measures rather than the checking procedures in appraisal costs.2 JUST IN TIME (JIT)JIT attempts to make the whole production process much more flexible, so that resources are only used (or purchased) as they are needed to meet customer demands. Features are likely tobe:• Low finished good stocks (goods are made quickly to customer specification)• Low raw material and component stocks (suppliers send them as they are needed)• Emphasis on eliminating bottlenecks in production and hence reducing work in progress.In order to ensure supplies arrive when they are needed, the company will have to make sure that its main suppliers are• reliable• of a high standard of qualityThis may make the relevant components more expensive (to be balanced against the saved stockholding costs) and often involves sharing detailed information, where known, about future production plans.3 THROUGHPUT ACCOUNTING3.1 PRINCIPLESThroughput accounting uses the theory of constraints which attempts to focus attention on bottlenecks in production and encourages managers to progress items through the production process as quickly as possible.To do this it looks at an adapted contribution, in which labour counts as a fixed cost in the short term and all material purchases are included, not just cost of sales. This has the effect of discouraging build up of WIP, raw materials, FG stocks, which are caused by bottlenecks.3.2 TERMINOLOGYThroughput = sales revenue – material purchasesReturn per factory hour = Throughput / Time at bottleneckTotal factory cost = Fixed production costs (inc labour)


Cost per factory hour = Total factory cost / time at bottleneckThroughput (TA) ratio = Return per factory hourCost per factory hourTo be profitable, the TA ratio needs to be greater than 1. The greater the TA ratio, the faster the throughput (i.e. the less bottlenecks)3.3 EXERCISE 1Two divisions, A and B, make and sell an identical product. A operates a production line with three departments, Cleaning, Cutting and FixingCleaning Cutting FixingCapacity 6,000 4,000 5,000Labour cost / product £3 £4 £2Each unit of production uses material costing £4 (which is purchased as needed by Cleaning) and sells for £30.B operates a cell structure with 4 cells each able to make 1,400 with virtually no WIP stock.Labour is paid £11 / unit in B, and there is the same material cost and selling price.Both divisions have production fixed costs of £5,000 (excluding labour).Calculate for each division:a) the profit madeb) the throughput accounting ratio3.4 CONCLUSIONSClearly B has a far better throughput, while A has a bottleneck with WIP building up waiting to go through the cutting department. Notice, however, that increasing cuttings capacity to 6,000 to match cleaning would lead to another bottleneck before the fixing department.4 PRODUCT LIFE CYCLE (PLC)4.1 THE LIFE CYCLE4.2 LIFE CYCLE COSTINGThe product life cycle can be estimated by studying the life cycle of similar products in the past and through careful market research. The difficulty is in predicting precisely how long each stage will last, as the whole cycle length can last from a few months (children’s toys at Christmas) to many years.Product lives are generally becoming shorter due to shortening customer satisfaction, linked to increasing innovation and development, and a worldwide competitive market.


Paper 2.4CHAPTER 3BUDGETING1 PURPOSE OF BUDGETING

A budget communicates the financial plans of the business for a specified period. It is an estimate of what the company believes it can achieve. It provides a tool to control the business by highlighting the differences between the budgetand actual results, enabling action to be taken.1.1 FUNCTIONS OF A BUDGETA budget is like the financial code for the business and is useful for a number of reasons:C – Co-ordination of activities and resourcesO – Open statement of plansD – Delegation through responsibility accounting and increasing motivationE – Evaluation of business performance and management1.2 BUDGET PREPARATIONBudget preparation normally starts with identifying budgeted sales. Sales, in this case, is therefore known as the principal limiting factor. However, the principal factor could be for example, the number of units that can be produced, the finance or labour hours available.1.3 EXERCISE 1


Complete the following budget by filling in the gaps below:Sales Budget10,000 unitsProduction BudgetUnitsOp stock 5000Production(Cl stock) (2000)Sales 10,000Overhead budget Materials Usage Budget Labour budgetunits x £1/unit units x 2 kg/ unit units x 2hrs/unit = hrs @ £4/hrMaterials Purchases BudgetKgOp stock RM 2000Purchases RM(Cl Stock RM) (4000)Usage 14,000Kg x £2/kgMaster BudgetBudgeted Profit & LossBudgeted Cash flowBudgeted Balance Sheet1.4 CASH BUDGETThe cash budget shows the amount and timing of all the cash inflows and outflows throughout the budget period.The cash budget and profit and loss account budget will differ due to the profit and loss account being prepared on an accruals basis. This means the profit and loss account includes income and expenses, which have been earned or incurred but the cash flow may not have physically been received or paid.Another reason for the cash budget and profit and loss account budget to differ is due to depreciation. Depreciation appears in the profit and loss account, but not in the cash flow statement. Depreciation is an accounting technique to spread the cost of the asset over its useful economic life – it is not a cash flow. The cash out flow associated with the purchase of asset is often an initial outflow upfront.1.5 PROFORMA CASH BUDGETJan Feb MarchCash receiptsDebtorsCash salesRental incomeShare issueCash paymentsPurchases of materialsLabourCapital expenditureInterest on loanTaxDividendsNet cash inflow/(outflow)Bal b/f


Bal c/f1.6 EXERCISE 2A company’s year end is 31 March. You have been asked to prepare the cash budget for the first three months of the company year, 2003 Sales data collected is as follows:2002/3Jan Feb Mar Apr May Jun Jul Aug Sep£’000 210 200 210 220 230 240 250 260 270The company usually received 70% of sales in the the month of sale, 25% after one month,and 14% after two months. 1% of sales are bad debts.An asset no longer used by the company is scrapped in April for £2000. However, a new machine will be purchased in April and paid for in May, costing £100,000.The company makes a gross margin of 30%. It maintains opening stock at a level of the following three months sales. All purchases are paid for in the month following purchase.Dividends of £10,000 are paid twice a year in January and June.Monthly advertising costs incurred are £5,000.Depreciation of £5,000 is also incurred.Corporation tax of £20,000 will be paid in June 2003.The cash balance on 31 March 2003 is £5,000.Prepare the cash budget for the first three months of the company year.2 BUDGETING METHODS2.1 ZERO BASED BUDGETINGOne of the problems of budgeting is the risk a company looks at the prior year budget and ‘adds a percentage’ for the current year (incremental budgeting). This can lead to inefficiencies being carried forward to subsequent years.ZBB avoids budgetary slack by preparing the budget from scratch – a zero base. Each item in the budget must be justified on its own merits- irrespective of the spend in prior years.The main disadvantages of ZBB are that it is expensive and time consuming to create the budget from scratch each year. In addition it may encourage a short term focus on planning,whilst ignoring the long term.2.2 PARTICIPATION IN BUDGET SETTINGIdeally management should include employees in the budget setting process. Employees are asked to propose an achievable budget. This is submitted to senior management, who review the budget to ensure consistency with longer term strategic goals. The budget should then be returned to the employees to sign off to encourage their buy-in.One danger of employee participation is that of pseudo-participation. Senior management are not really interested in bottom-up participation and ignore junior input. This leads to demotivation.The culture of an organisation should encourage participation and realistic, achievable budget setting. If the culture is one of distrust, this can lead to budgetary slack being incorporated into the budget.Whilst participation may be timely, if encouraged in the right environment, the result is a realistic, achievable budget which motivated employees are committed to.2.3 BUDGETARY CONTROLOne of the main uses of a budget is for control – when the actual results are received they are compared to the budget for deviations, investigated and. Any necessary action taken. Both negative and positive deviations from budget are investigate. Negative variances to identify areas for improvement and positive variances to ensure they are repeated in the future.2.4 FLEXIBLE BUDGETSThe original budget is flexed to the actual activity level of the company to ensure the comparison of actual results to budget are meaningful.2.5 EXERCISE 3Flex the following budget, and compare it to the actual results to determine whether the company has a negative or positive variation from budget:


Budget ActualLevel of activity 1,000 units 1,500 unitsSales £20,000 £29,000Costs £10,000 £14,000

Paper 2.4CHAPTER 4STANDARD COSTING & VARIANCES1 STANDARD COSTS

Management prepare a standard cost card – the expected cost of one, standard unit of output under particular working conditions.. This is then used to prepare the budget, and to perform variance analysis when the actual results are obtained.2 VARIANCE ANALYSISVariances help us to understand any differences that arise between the budgeted and actual profit. The budgeted profit is based on standard costs and revenues, but many factors may affect what actually happens.Variance analysisBudgeted profit Actual profit2.1 OPERATING STATEMENTSOperating statements list all of the variances, and show their effect on the budgeted profit.The last entry in the operating statement is the actual profitOperating statement (absorption costing)Budgeted profit XSales volume variance X


XFavourable AdverseSales price variance XLabour rate variance XLabour efficiency variance. XMaterial price variance XMaterial usage variance XV O/H efficiency variance XV O/H expenditure variance XF O/H volume variance XF O/H expenditure variance XXX XX X / (X)Actual profit XXXX2.2 EXERCISE 1 – INFORMATIONActual BudgetSales & production (units) 120,000 110,000Sales (£) 295,000 275,000Direct Materials 115,000 (23,000 kgs) 110,000 (27,500 kgs)Direct Labour 87,500 (17,500 hrs) 82,500 (13,750 hrs)Variable overhead 24,000 22,000Fixed overhead 19,250 15,125Profit 49,250 45,3752.3 EXERCISE 1 – STANDARD COST CARDPreparing a standard cost card is a useful first step when preparing an operating statement as it creates an easy point of reference.£ per unitSelling price 2.50DM 0.25kg x £4per kg 1.00DL 0.125hrs x £6per hr 0.75VOH 0.125hrs x £1.60 per hr 0.20FOH 0.125 hrs x £1.1 ph 0.1375Profit 0.41252.4 EXERCISE 1 – SALES VOLUME VARIANCEThe sales volume variance accounts for the change in profit due to selling a different number of units than budgeted. It flexes the budgeted profit to the profit level that would have occurred if the change in volume sold was the only change to the budget.UnitsActually soldShould have soldunits x £0.4125 = £ Favourable2.5 EXERCISE 1 – SALES PRICE VARIANCE120,000 units Sold forShould have sold forAdverseReasons for adverse sales price variances:More discounts offered than was plannedSupply surplus meant customers are willing to pay less


Unrealistic sales price budgeting.2.6 MATERIALSThere are 2 reasons for the actual expenditure on materials being different from the flexed budgetMaterials cost more / less (Material price variance)More/less materials are used (Material usage variance).2.7 EXERCISE 1 – MATERIAL PRICE VARIANCE£23,000kgs Should costActually costAdverseCauses of material price variance:Efficient / inefficient purchasingQuality material is more expensiveUnrealistic budget.2.8 EXERCISE 1 – MATERIALS USAGE VARIANCEKgs120,000units Should useActually usedFavourablekgs x £4 = £ FavourableCauses of material usage variances:Production efficiencies (motivated workforce)Higher quality material used so less wastage (note link)Unrealistic budgeting.2.9 LABOURTwo factors can cause the actual labour costs to be less than the flexed budget:Amount paid per hour (Labour rate variance)Number of hours worked (Labour efficiency variance).2.10 EXERISE 1 – LABOUR RATE VARIANCE£17,500 hrs should costactually costFavourableReasons for labour rate variances:Labour force was working overtimeLabour force was more/less skilled than expected – so more/less expensiveUnforeseen pay risesUnrealistic budgeting.2.11 EXERCISE 1 – LABOUR EFFICIENCY VARIANCEHours120,000units should useactually usedAdversehrs x £6 = £ AdverseCauses of labour efficiency variances:Production process was less efficient than expected (machine breakdowns)Materials were inferior there wasted time dealing with rejects


Higher quality labour force so faster at the jobLow moraleUnrealistic budgeting.2.12 VARIABLE OVERHEADSActual variable overheads might be different to the flexed budget because:More or less hours were worked than expected (Variable overhead efficiency variance)Budgeted overheads were incorrectly estimated (Variable overhead expenditure variance).2.13 EXERCISE 1 – VARIABLE OVERHEAD EFFICIENCY VARIANCEVariable overheads are usually incurred per labour hour. Therefore, when the workforce is inefficient, it leads to more variable overheads being incurred. For this reason the variable overhead efficiency variance is very similar to the labour efficiency variance.Hours120,000 units should useactually usedAdversehrs x £1.60 = £ Adverse2.14 EXERCISE 1 – VAR OVERHEAD EXPENDITURE VARIANCEThis occurs when the variable overheads are wrongly estimated for the budget.£17,500 hrs should costactually costFavourable2.15 FIXED OVERHEADSBecause we are currently looking at absorption costing variances, two types of FixedOverhead Variances need to be considered:Fixed overhead volume varianceFixed overhead expenditure variance2.16 EXERCISE 1 – FIXED OVERHEAD VOLUME VARIANCEThe fixed overhead volume variance arises due to producing more / less than budgeted.Because of this, more / less fixed overhead is absorbed.UnitsShould have producedActually producedFavourableunits x £0.1375 = £ FavourableThe variance is favourable because more units than budgeted were produced.2.17 EXERCISE 1 – FIXED OVERHEAD EXPENDITURE VARIANCE£Budgeted fixed costsActual fixed costsAdverse2.18 EXERCISE 1 – OPERATING STATEMENT£ £ £Budgeted profitSales volume varianceFlexed profitFavourable Adverse


Sales priceMaterial priceMaterial usageLabour rateLabour efficiencyVariable overhead expenditureVariable overhead efficiencyFixed overhead volume varianceFixed overhead expenditureActual profit3 VARIANCES UNDER MARGINAL COSTINGThe majority of variances are identical whether using marginal or absorption costing. Thereare however some differences:Sales volume variance: Use the standard contribution per unit rather thanstandard profit per unit.Change in units sold x standard contribution per unit(10,000 units x £ = £ )Fixed overhead volume variance: Not applicable for marginal costing.3.1 EXERCISE 1 – MARGINAL OPERATING STATEMENT£ £ £Budgeted profitSales volume varianceFlexed profitFavourable AdverseSales priceMaterial priceMaterial usageLabour rateLabour efficiencyVariable overhead expenditureVariable overhead efficiencyFixed overhead expenditureActual profit3.2 EXERCISE 2Use the following data to calculate all variances and produce both absorption and marginal operating statements:Standard Cost card £/unitMaterials 3kg @ £5/kg 15Labour 5hrs @ £5/hr 25Variable Overheads 5hrs @ £3/hr 15Fixed Overheads 5hrs @ £2/hr 1065The company budgets to sell 10,000 units and produce 11,500 units. There is no openingstock. The budgeted selling price is £80 per unit.The company actually sold 9,800 units for £81 per unit, and produced 11,000 units.Actual quantity of materials purchased is 35,600 kg for £160,000.Actual quantity of material used is 34,420 kg.


Labour was paid £287,175 for 54,500 hours.Variable overheads were £166,225 and fixed overheads £120,0004 ADVANCED VARIANCES4.1 FIXED OVERHEAD VOLUME (TAC) – BREAKDOWNIf the fixed overhead is absorbed on an hourly basis, the volume variance can be broken down into the fixed overhead efficiency variance and the fixed overhead capacity variance. The efficiency variance is like all the other efficiency variances, ie (The hours it should have taken (standard hours) less actual hours) @ the standard rate/hourThe capacity variance is (actual hours less original budgeted hours) @ standard rate/hourTogether they will make up the volume variance. Efficiency quantifies the effect on fixed overheads of workers taking longer than expected to produce the actual number of units. The fixed overhead efficiency variance does not add any additional insight into controlling the budget as fixed overheads are fixed, and therefore do not vary with the number of hours worked!Capacity quantifies the effect of actual hours worked differing from budget. If AHw > BH ,then the capacity variance is favourable.4.2 EXERCISE 3Calculate the fixed overhead efficiency and capacity variances from the information in Exercise 2.4.3 SOLUTION 34.4 MATERIALS MIX AND YIELDThe materials usage variance can be further analysed into Mix and Yield if more than one material is used in the production of a unit. Yield variance quantifies the effect of having to use more/less material to yield the actual production, while mix variance quantifies the effect of using the actual quantity of material in a different mix to that in the standard.4.5 EXERCISE 4Standard Cost Card£/unitMaterial X 2kg @ £3/kg 6Material Y 4kg @ £5.50 2228The company produced 1,000 units, and used the following quantities of materials X and Y:Actual Cost£Material X 2,250 kg 7,000Material Y 3,800 kg 21,100Calculate the materials price and usage variance and break down the usage variance into Yield and Mix variances.4.6 SOLUTION 4Flexed Budget Actual total split as std Actual usage @ std cost ActualYield = Mix = Price =4.7 SALES MIX AND QUANTITY VARIANCESWhen a company sells more than one product, the Sales Volume Variance can be split into Sales Mix and Sales Quantity variances.4.8 EXERCISE 5Budget SP Cost/unit ActualProduct A 8,000 units 10 7 7,500 unitsProduct B 5,000 units 8 6 6,200 unitsCalculate the Sales Volume, Sales Mix and Sales Quantity variances.4.9 SOLUTION 5Budget Total actual sales in std mix Actual salesQuantity = Mix =Quantity variance quantifies the effect of selling more/less products than budgeted.


Mix variance quantifies the effect of selling products in a different mix to standard.4.10 OPERATIONAL AND PLANNING VARIANCESTraditional variance analysis reviewed so far compares actual results to flexed results. The flexed results are based on the standard cost card, prepared early in the year.When conditions change that are not controllable by the company, variances can be split into those controllable (operational variances) by the company, and those not under the control of the company (planning variances).A revised flexed budget is prepared, taking into account the conditions imposed on the company.For example, the work force may decide to strike, meaning there are less hours available for production.Operational variances are investigated to identify improvements. Planning variances are not investigated further – the company knows why they arose.4.11 EXERCISE 6A company prepares its standard cost card and budget based on sourcing material X220 from a supplier:Standard Cost Card£/unit5kg @ £3/kg 15The supplier unexpectedly stops making X220, and supplies X221 a substitute product:6kg @ £2.80/kg 16.80Actual production is 2000 units.11,500 kg were actually purchased from the supplier, costing £31,050.Calculate the traditional price and usage variances and then the operational price and usage variances.4.12 SOLUTION 6

Paper 2.4CHAPTER 5FINANCIAL MANAGEMENT OBJECTIVES1 FINANCIAL MANAGEMENT – WHAT IS IT?

The various functions carried out by a company to obtain and use long-term finance efficiently in order to achieve corporate financial objectives.1.1 OBTAINING FINANCEA company must ensure it has the right finance available at the right time, to fund working capital and capital expenditure requirements.The financial manager will consider:Sources of finance (Internally generated, Debt or equity)Short term Vs long term fundingCost of financeAvailabilityTerms and conditionsRisk v return1.2 COMPANY OBJECTIVES & STAKEHOLDERSMost profit-oriented companies objective is to maximise shareholder wealth.However, some companies may have different objectives such as maximising sales growth or satisficing (achieving satisfactory profits).It is also important to understand a company has many parties interested in it, not just shareholders. Each of the different parties has their own and often conflicting interests. These are called stakeholders. Stakeholders include:


ShareholdersManagementEmployeesCustomersSuppliersLocal communityGovernmentDue to the potential conflict between stakeholder objectives, companies often have secondary objectives, which may be non-financial. For example, to provide a flexible working environment, research and development focussed, ensure long term survival or to be environmentally friendly.1.3 SHAREHOLDERS V MANAGEMENTWhilst management are ‘agents’ of the company acting on behalf of shareholders.Management, just as the rest of the stakeholders, have their own objectives, which may conflict with other stakeholders.For example, management performance is often based and assessed on the short-term, and therefore management take short-term decisions. Management job security is based on the firm and therefore management are incentivised tobuild their own empire, even if it is of no benefit to shareholders.Management are concerned with maintaining the stability of the firm to safeguard their own jobs. Shareholders, who are more diversified, are concerned with long-term growth and wealth maximisation.Shareholders however own the company and as has recently been seen in many public companies, management can be forced to ‘step down’ if performance does not meet shareholder expectations.1.4 NOT FOR PROFIT ORGANISATIONS (NFPO)NFPOs exist for the benefit of a particular group of people. Examples include Trade Union organisations, charities, and the National Health Service. Their primary objective will not be to maximise profit or shareholder wealth but to maximisefundraising in order to further achieve objectives set for the benefit of the target group of people.Assessing NFPOs is difficult, there is no share price or profit figure to benchmark. They are often assessed via a ‘Value for Money’ (VFM) audit.A VFM audit assesses the extent of the services provided (the outputs), based on the resources input, by evaluating the economy, efficiency and effectiveness of the organisation.

1.5 THE 3 E’SEconomy The ability to minimise the cost of inputs whilst maintaining an appropriate serviceEfficiency Maximising the output for the resources inputEffectiveness The ability to achieve objectives1.6 NFPO PERFORMANCE INDICATORSPerformance indicators are calculated for NFPOs due to the absence of profit measures.Examples include:Cost of waste collection per householdCost of handling a Housing Benefit ClaimNumber of days to process new claimsNo of kg of household waste collected/residentNo of playgrounds provided/1000 children under the age of 12No of burglaries/1000 householdsNo of vehicle crimes/1000 householdsNo of violent crimes/1000 households


Paper 2.4CHAPTER 6PERFORMANCE MEASUREMENT1 CORPORATE FINANCIAL ANALYSIS

1.1 STAKEHOLDERSAs was seen in the last chapter, a number of stakeholder groups are interested in the financial performance of an organisation. These include the management, investors, lenders and potential investors and lenders. A number of others, such as society, government, suppliers,customers and employees may be interested in specific areas as well.1.2 RATIO ANALYSISThe above stakeholders will be interested in the following areas:Profitability - shareholders, managersReturns on market price - shareholders, existing and potentialLiquidity - lenders, managersGearing - lenders, managers1.3 PROFITABILITY RATIOSa) Return on capital employed (ROCE) = Profit before interest + tax (PBIT)Long term debt + equityb) Operating profit margin = PBITSales turnoverc) Asset turnover = Sales turnover


Capital employedd) Return on equity = Profit after interest and taxShareholders’ fundse) Expense ratio = ExpenseSales turnoverf) Operating gearing = Fixed CostsVariable Costs1.4 RETURNS ON SHARE PRICEa) Earnings per share (EPS) = Distributable profit for the yearNumber of shares in issueb) P/E ratio = Share priceEPSc) Dividend yield = DividendShare priced) Payout ratio = DividendDistributable profit for the yeare) Dividend cover = Distributable profit for the yearDividend1.5 LIQUIDITY RATIOSa) Debtors collection period = Average trade debtors x 365 daysAnnual credit salesb) Creditors payment period = Average trade creditors x 365 daysAnnual purchasesc) Stock holding period = Average stock x 365 daysAnnual cost of salesd) Current ratio (liquidity ratio) = Current assetsCurrent liabilitiese) Quick ratio (Acid test) = Current assets excluding stockCurrent liabilities1.6 GEARING RATIOSa) Gearing ratio = Long term debtLg tm debt + shareholders’ fundsb) Interest cover = PBITInterest1.7 APPLICATION AND INTERPRETATIONMany of the above ratios (such as ROCE and Gearing) have several different definitions. This does not matter as long as the result is compared to a ratio calculated in the same way.It is important to realise that a ratio on its own tells you very little and no absolute targets can be set without reference to the circumstances of a particular organisation. To make informed comments we need to make comparisons. These can be with:- The previous year- The budget- An investor's expectations- A competitor- The industry average1.8 EXERCISE 1Analyse and comment on the results of a large listed pharmaceuticals company, Drugsco plc.


The Profit and Loss Accounts and Balance Sheets for the last two years are given below:20X1 20X2£m £mTurnover 8,341 9,000Cost of sales (5,209) (6,178)3,132 2,822Interest (206) (136)2,926 2,686Taxation (933) (819)1,933 1,867Dividends (1,202) (1,249)Retained profits …791 61820X1 20X2£m £mFixed assets 4,312 4,188Current assets:Stock 804 855Trade Debtors 2,302 2,285Investments 1,001 1,447Cash 261 2154,368 4,802Current liabilities:Trade creditors 2,608 2,7051,760 2,0976,072 6,285Loan stock (4,439) (3,842)1,633 2,443Share capital (25p shares) 886 894Share premium account 621 805Other reserves 126 7441,633 2,443Share price at year end £5.45 £4.18The company has a policy of writing off all development expenditure as incurred. The patent on a revolutionary drug expired at the end of 20X1; 20X2 saw many competitors producing similar products. As a result there has been some fierce competition on price on what was in 20X1 one of the company’s strongest products. Note: Assume Purchases approximates to Cost of Sales in both years.1.9 EXERCISE 2Snowdome PLCProfit and Loss Account for the year ending 31 December 2002£000'sTurnover 105,430Cost of sales (73,801)Gross profit 31,629Operating expenses (29,654)Profit before interest and tax 1,975Interest (1,613)362


Tax (131)Profit after tax 231Dividends (143)Retained profit 88Balance sheet as at 31 December 2002Fixed Assets 15,964Current AssetsStock 12,932Debtors 15,574Cash 13028,636Creditors due within one yearTrade Creditors 10,943Total assets less current liabilities 33,657Share capital 1,100Reserves 16,4277,52710% debentures 16,13033,657Using the data above, Calculate the following ratios:Return on Capital EmployedOperating profit marginAsset TurnoverReturn on EquityEarnings per sharePrice Earnings ratioDividend per shareDividend CoverDividend Yield (assume Snowdome shares are currently trading at 260p)Interest CoverGearing (based on book values)Current ratioQuick ratio2 DIVISIONAL PERFORMANCE APPRAISAL2.1 RESPONSIBILITYResponsibility can be delegated in a number of ways:Responsibility for:Cost centre CostsProfit centre Costs and revenuesInvestment centre (division) Costs, revenues and some capital expenditure2.2 FINANCIAL ASSESSMENT OF DIVISIONSThe two most common financial measures both use the profit generated in the period and thevalue of the investment in the division.Return on Investment (ROI) = ProfitInvestmentResidual Income (RI) = Profit – Notional interest on investment2.3 COMPARISON


a) ROI gives a percentage while RI is an absolute figure in £.b) Investment will be net assets, either at the beginning or end of the period in question,depending on how the value being compared has been calculated.c) RI builds in the target return as an interest charge so any positive RI is welcome; the ROI has to be compared to some target return.d) If RI has interest equal to the cost of capital, the PV of the Residual Incomes = NPV of the project.2.4 EXERCISE 3A division has a single project, which will generate annual cash flows of £20,000 for five years. Net assets comprise a single machine which has just cost £60,000 and which will be depreciated on a straight-line basis to £10,000 over the next five years. Calculate ROI and RI (using an interest rate of 20%) for each of the next five years, using net assets at the beginning of the year as investment.2.5 DYSFUNCTIONAL DECISIONSROI, in particular, can cause divisional managers to take decisions that may not be in the best interests of the company, as they are likely to compare any new investments returns to the return currently being achieved rather than with an absolute company standard.2.6 EXAMPLEDivision X currently has net assets of £1m and is expecting a profit of £200,00 for the year.The division manager receives a bonus of £5,000 for every percentage point by which the divisional ROI beats 15% (which is also the company’s cost of capital).A new project would produce a profit of £18,000 on an investment of £100,000.For the company: project gives 18% which is better than 15%, so the company would like the division to undertake the project. For the division: the project will pull down the ROI from its current 20% (to 218/1100 = 19.8%) and so the manager would reject it.2.7 FURTHER PROBLEMSBoth ROI and RI suffer from being annual short-term measures. Many investments, when the calculations are based on an investment base including depreciated assets, show a poor returnin early years and a higher return later.2.8 LONG TERM V SHORT TERMNo one financial measure (either ROI or RI) can summarise successfully a division's performance. We need a collection of financial and non-financial measures, both short and long term, to assess this.


Paper 2.4CHAPTER 7FINANCIAL MANAGEMENT ENVIRONMENT

1 FINANCIAL INTERMEDIARIES

The financial institutions available to match individual and corporate lenders with those who wish to borrow.1.1 UK FINANCIAL INTERMEDIARIES(a) Clearing Banks: the UK high street banks provide a wide range of business services,including payment, cheque clearing, and lending(b) Merchant Banks: independent or part of a financial group. Provide financial advice,financing services such as handling share issues, and assistance in foreign trade transactions.(c) Savings banks: government organisation such as National Savings Bank.(d) Building societies: focus on providing finance to the household sector.(e) Finance companies: Finance Houses providing medium-term credit, Leasing and Factoring companies, providing credit secured on trade debtors.(f) Pension funds: collect company and personal pension contributions and invest for the long-term.(g) Insurance companies: collect contributions/premiums for long-term investment.(h) Investment and unit trusts: limited liability companies where fund managers use the pool of trustees money to invest.1.2 MONEY & CAPITAL MARKETSThe financial markets consist of primary and secondary markets allowing borrowers and lenders to meet to satisfy their needs. The money market mainly consists of the banks who take deposits and lend to individuals and corporates. It provides medium and short-term finance in sterling and foreign currencies.The capital market provides long-term finance. It is dominated by the stock exchange, trading company shares, but also accounts for the trading of debt.Primary markets are responsible for the raising of new finance, such as new share issues.Secondary markets provide liquidity to the market by allowing the holders of investments to sell their investment. Investors can therefore buy and sell a wide range of investments of varying risk. They are able to reduce risk by holding a diversified portfolio of investments.The many buyers and sellers in the market also allow investors to hedge their investment. This means an investor can


reduce risk relating to a transaction. For example, a UK company may be due to receive a large foreign currency balance in 3 months time. Due to exchange rate fluctuations, the sterling value of the foreign currency receipt will fluctuate until it is converted. The UK company can enter into an agreement today to sell say US dollars to a bank at a specific rate, on a specified date in the future. As a result the UK company has hedged; it knows today the exact value of the US$ receipt, it has reduced its risk/uncertainty.1.3 INTERNATIONAL CAPITAL MARKETSThe main international capital markets are the Euromarkets and the foreign bond markets Euromarkets: where domestic funds are supplied to foreign users and vice versa. For example, a Eurodollar is where US dollars are deposited in any bank outside the USA (not necessarily a European bank despite the name)..Foreign bond market: where bonds are issued and traded in the market in which they are issued.1.4 STOCK MARKETSThe stock markets include the markets for shares, government bonds, debt issued by public owned institutions and some overseas stock. Investors trade in the various securities which result in a liquid market with a fair price for the assets.The price is determined by supply and demand. Information relating to a company is incorporated into its share price. If positive information is released relating to a company, demand for its shares will increase, increasing its share price.1.5 EFFICIENT MARKET HYPOTHESISThe Efficient Market Hypothesis refers to the information processing efficiency of a stock market; the ability of the market to value shares fairly. This refers to the extent to which the information is incorporated into the current share price.The market can be described asWeak form efficientSemi-strong form efficientStrong form efficientThe difference in the efficiency of the market is determined by the type of information incorporated into the share price.Tests have been performed on the USA and UK stock market to establish how efficient they are. They are believed to be semi-strong efficient.1.6 WEAK FORM EFFICIENTShare price only incorporates past share price information or past share price movements.The market is believed to be at least weak form efficient as share prices do incorporate information about the past.However, the next movement by the share will not be due to what movement has occurred in the past - past movements are already incorporated in the current share price. The next movement, either up or down, will be dependent on new information (see below).As a result shares are said to follow a random walk. This does not mean they move randomly but each successive movement is independent of the previous movement. Each successive movement is dependent on the new information released. Theoretically, if the market is only weak form efficient an investor is able to beat the market by being up to date with all publicly available information such as newspaper articles, published accounts etc.1.7 SEMI STRONG FORM EFFICIENTShare price incorporates past share price information and current easily available public information about a company.Evidence suggests the market is semi-strong efficient. If the market is semi-strong information, an investor can beat the market by conducting in depth research on the fundamentals of the market, the economy, the industry and thecompany's position as this information is not yet incorporated into the share price, but not by analysing the published accounts or reading old newspaper reports (the price will have already adjusted for this information when it came out).1.8 STRONG FORM EFFICIENTShare price contains all information possibly available in the public domain about a company, both easily accessible and involving in-depth research. Evidence suggests the market is not strong form efficient. Professional analysts can spend time profitably researching the economic and industry forecasts and examining the company's position within the industry. By then advising their clients to buy or sell, they are disseminating that information which will eventually be incorporated in the share price (ie they are helping the market to operate efficiently.1.9 EXERCISE 1A company has a share price of £2 and has one million shares. On 1st January, the chief executive thinks of an investment while having a bath. He calculates (and is later proved correct) that the net present value of this project will be £250,000.On 7th January, he shares his idea with the board, who approve it, but keep the minutes of the meeting confidential.On 1st February, the company makes the planned investment, without any public announcement, but in a way that would be immediately obvious to any informed observer (and who would instantly be able to calculate the NPV of the project). Nobody in the media notices.


On 1st March, the company reveals the project to the media, who publish it widely. Investors believe the company’s estimates.Calculate the share prices under weak, semi-strong and strong form efficient market conditions at:1st January7th January1st February1st March

Paper 2.4CHAPTER 8DIVIDEND POLICY1 DIVIDEND POLICYInvestors earn a return via dividends and capital growth. Dividend policy refers to the pattern in which companies pay out a dividend.Different companies have different policies. Microsoft for example has never paid a dividend,whilst other companies pay out a steady dividend each year.Does the dividend policy affect the wealth of shareholders?1.1 DIVIDEND IRRELEVANCY THEORYThe dividend irrelevancy theory suggests shareholders wealth is not affected by the pattern of dividends.As a result shareholders are indifferent in the pattern of pay-out by a company.Note, the theory is referring to the pattern of the pay-out. It is not suggesting shareholders are indifferent between receiving a dividend and not receiving a dividend at all. If the dividend is delayed, investors will expect to be compensated for the delayed dividend by their required return.1.2 EXAMPLE 1Suppose, an investor receives an annual dividend of 10p every year, and the required return of investors is 10%.The share price is the present value of future cash flows.Assuming the investor will receive dividends (no growth) forever, the first cash flow at T1:T0 T1 T2 T3 …………. TnDividends 10p 10p 10p …………10pShare price = 10p / 0.1 = 100pIf the dividend is delayed 1 year, the first cash flow will be in T2. However, if the first cash flow is in T2, the investor must be compensated for the delay in the cash receipt by the required return, for the shareholder wealth to be unchanged.The cash flow in T2 will be 10p x 1.1 = 11p + 10p = 21p.T1 T2 …………. TnDividends 21p 10p …………10p Share price = 21/(1.1 x 1.1) + ((10p/0.1) x (1/(1.1 x 1.1))= 21/(1.1 x 1.1) + 100/(1.1 x 1.1)= 121 / (1.1 x 1.1)= 121 / 1.21= 100p


Thus, the dividend irrelevancy hypothesis is theoretically correct in assuming shareholder wealth is maintained irrespective of the pattern of dividend pay-out, providing the shareholder is compensated at their required return for any delay in payments. The dividend irrelevancy theory assumed perfect capital markets. This means investors haveperfect information. Thus if the dividend is delayed they understand they will be compensated accordingly.In addition, it assumes there are no transaction costs so if investors need cash, and the dividend is being retained by the company to reinvest, the investor can sell their shares at no cost. The cash received for the shares is the present value of the future cash flows ie the dividend.1.3 DIVIDEND POLICY DOES MATTER IN PRACTICEIn practice, evidence suggests the pattern of dividend pay-out does matter.(a) Dividend SignallingDividends contain information and therefore act as a signal. If a dividend is paid out, the perception is the company is doing well. If a dividend is delayed it signals negative information about the company. As markets are not perfect, even if the directors of the company communicate to shareholders why they are retaining the dividend, to invest in newprojects, the share price may fall as shareholders do not believe management, and therefore sell their shares.The argument suggests companies should maintain a constant dividend policy, in line with investors expectations.(b) Income preferenceInvestors invest in a company because the dividend policy suits their cash flow needs. A company paying a regular dividend will be valued more highly as the regular cash payments satisfy their need for current cash.(c) TaxationDividends are taxed differently to capital gains, therefore investors will have a preference as to receiving a return in dividends or capital growth as they will have to pay a different amount on tax depending on the status of the income.An investor invests in Microsoft knowing their return will be through capital growth and therefore knows the tax implications of such an investment, and can plan for them. This is known as the ‘clientele effect’ – the notion that investors invest in a particular company as the company’s method of providing a return is consistent with their needs, for all of the reasonsabove.


Paper 2.4CHAPTER 9SOURCES OF FINANCE - EQUITY1 RETAINED PROFITS, SHARE ISSUES OR DEBT?

A company needs to finance its investments in order to generate shareholder wealth. There are three main sources of finance, retained profits, share issues and debt. The most important source of finance for a company is retained profits. These are internally generated undistributed profits. However, a company with insufficient retained profits to meet its investment plans needs to generate additional finance externally (see below).1.1 FACTORS TO CONSIDER IN CHOOSING A SOURCE OF FINANCEDurationAmountAccessibility of the financeAdministration costsServicing costs – eg interest or dividendsGearing (current debt to equity levels)Dividend policy (if choosing between retained profits and equity issues)Pricing issues (if choosing between different equity issues)SecurityTax implications1.2 EXERCISE 1 - RETAINED PROFITSWhy do you think Retained Profits are the major source of finance for a business?1.3 SOLUTION 11.4 EQUITY – ORDINARY SHARESShareholders are the owners of a company. They contribute capital and receive a shareholding in proportion to their contribution. This means if the company is successful shareholders will earn a return via dividends and capital growth. The level of dividends paid are determined by the directors, unlike debt with its obligation to pay interest charges. This greater uncertainty results in equity earning a higher return than debt. Shareholders, as owners of the company, are subject to risk. Ordinary shareholders often have limited liability meaning if the company fails, the maximum they risk losing is their capital contribution. They rank after all other creditors and preference shareholders in company


liquidations. From the company point of view, in the normal course of trading, the capital contribution is not repaid. (This in contrast to debt finance where debt finance/loans are often repaid).Ordinary shareholders also have voting rights. Recently, shareholders have become more active, particularly in voting against corporate remuneration packages.1.5 EQUITY – SHARE ISSUESThere are two types of share issue – issue of shares to new shareholders and issue of shares to existing shareholders.1.6 ISSUE OF SHARES TO NEW SHAREHOLDERS(a) Offer for sale by prospectus: shares are offered at a fixed price to the public. Thecompany details – past and expected future performance – are presented in a prospectus The company appoints an issuing house to deal with the public, advertise in the national press etc.This is usually the most expensive form of share issue.(b) Offer for sale by tender: potential shareholders are asked the number of shares and the amount they are prepared to pay. The issuing house then ranks the bids to determine which applicants are at the top of the list, and who therefore become shareholders. The company often sets a minimum bid price. All shareholders pay the same price, the strike price,for the shares, even those who offered to pay more.(c) A placing: shares are placed with a broker who sells the shares to its clients. This tends to be the cheapest way to issue new shares.(d) Introduction: shares have already been issued eg on an overseas stock exchange or already have a wide distribution, and are introduced to the marketplace. No additional finance is raised but new shareholders now have access to the existing shares1.7 RIGHTS ISSUES - SHARES ISSUED TO EXISTNG SHAREHOLDERSThis is an issue of shares to existing shareholders in proportion to their current holding, as required by Company Law and tends to be cheaper due to less advertising costs. If all shareholders take up their rights to new shares, the balance of control of the company does not change.However, the company must decide what price to offer shares under a rights issue to ensure the issue is successful.Rights issues are usually underwritten which is an additional cost. This is a guarantee by an organisation to buy any unsold shares.1.8 PRICING A RIGHTS ISSUERights issues are often prices at below the market price to ensure the issue is successful ie shareholders take up their rights. This means that the share price after the rights issue, the ex-rights price, often falls.Theoretical ex-rights price = Current market value Proceeds of company + of(Market value of existing shares Rights Pre-rights) Issue Number of shares ex-rights1.9 EXERCISE 2X PLC has 1,000,000 shares with a current market price of £ 1.50 each. The company holds a rights issue of one new share for every two existing shares, at a price of 75p. What is the exrights price?1.10 SOLUTION 21.11 EXERCISE 3Using the data in Example 2, assume a shareholder Mr Y owns 1000 shares in the company.Show Mr Y’s position if he takes up his rights sells his rights does nothing1.12 PREFERENCE SHARESPreference shareholders receive a fixed dividend. For example,8% £1 preference shares8% is the coupon rate.£1 is the nominal value of the shareThis share pays out a dividend of 8p each year.Preference shareholders are paid a dividend before ordinary shareholders. When cumulative preference shares are held,


the arrears in dividend and the current year dividend must be paid before ordinary shareholders receive a dividend.On liquidation, preference shareholders rank above ordinary shareholders (but after other creditors).Preference shareholders do not usually carry voting rights unless a dividend has not been paid for 5 years. In which case shareholders may obtain the right to vote if it is written into the company constitution.Although preference shareholders receive a fixed dividend, if the company has profits available, the dividend is not tax deductible as are interest payments associated with debt.1.13 BONUS/SCRIP ISSUESBonus issues are the issue of shares to existing shareholders in proportion to their existing holding. The issue does not raise any cash.1.14 SCRIP DIVIDENDSCertain companies allow shareholders to opt to receive their dividend as a new share, as opposed to a dividend payment. Shareholders who do not opt for the new share receive a dividend as normal.1.15 SHARE SPLITSThe division of existing shares into smaller units. This does not raise any cash for the company.For example, a company whose shares have a market value of £10 may decide to cancel its current shares and split each share into 5 shares of £2 each.

Paper 2.4CHAPTER 10SOURCES OF FINANCE - DEBT

1 SHORT, MEDIUM OR LONG TERM – THE CHOICESHORT-TERM MEDIUM-TERM LONG-TERMBank OverdraftsTrade creditGovernment grants and loansBank loansLeasingHPGovernment grants and loansBondsDebenturesPreference shares1.1 LONG-TERM – CORPORATE DEBENTURESCompanies can raise finance through the issue of debentures, offering fixed interest payments.Debentures are traded, just as shares are. They pay a lower return than equity as there is less uncertainty – the interest payment is a legal obligation, the debenture holder does not have any voting rights and has priority on liquidation.Debentures can be redeemable or irredeemable.1.2 REDEEMABLE AND IRREDEEMABLE DEBENTURESLenders of redeemable debentures receive their initial capital back after a certain number of years.For example, 2% 2008 Debentures redeemable at par Market Value = £90 ex-intThe company will redeem/repay the debt 5 years from issue, 2003The company will repay £100 (redeemable at par)Interest of 2% of nominal value is paidNominal value is always £100, therefore interest of £2 is paidDebentures are currently trading at £90/£100 of debtEx-interest means no right to this year's interestA company must consider the maturity dates of its debt financing, to ensure capital repayments do not fall all at once.1.3 CONVERTIBLE DEBENTURES – QUASI-DEBTConvertible debentures are a hybrid between debt and equity. They initially have debt status, but give the holder the right to convert to an equity holding at some point in the future at a pre-determined price. The holder no longer is a debt


holder.1.4 WARRANTSA warrant gives the holder the option to purchase shares at specified dates in the future. The holder remains a debt holder, but also a shareholder of they exercise the option.2 CONDSIDERATIONS WHEN ISSUING DEBT2.1 SECURITY – FIXED V FLOATING CHARGEA company must offer security on its debt against the company assets. A fixed charge is over specific assets giving the lender the right to seize the asset in the event of default by the company. Alternatively, the company has a floating charge over its assets in general, giving the lender the right to appoint a receiver in the event of default to run the company and repay the debt. In light of the high price paid in the event of default on interest payments, a company must ensure when it issues debt it can afford to pay the interest charges, irrespective of company profits in that year.2.2 GEARINGA company must consider the effect of issuing debt on its gearing and EPS levelFinancial gearing is the ratio of debt to equity. It can be based on book values or market values.A company must consider the current gearing level when raising more finance. Increasing the gearing level further may be impossible if the company will not be able to meet its interest obligations. In addition, equity holders may be against additional debt holding by the company if their dividend return is made more uncertain by the increased interest obligations of the company. As a result their required return may increase.2.3 EPSEarnings per share is calculated as follows:EPS (in pence) = Earnings available to shareholdersNo of equity shares in issue

2.4 EXERCISE 1A company is considering investing in a £4m in a project. The project will increase profits each year by £1.8m.The finance can be raised either by issuing new shares at £2 per share or new 10% debentures.The profit and loss account and balance sheet extract for 2003 is as follows:£mProfit before interest and tax 5.765Interest 0.2405.525Taxation @ 30% 1.658Profit after tax 3.867Dividends 1.250Retained Earnings 2.617Share Capital 5m shares @ 50p each 2.5Reserves 3.86.36% debentures 4.0Calculate the EPS in 2003Calculate the EPS in 2004 if the project is financed by debtCalculate the EPS in 2004 if the project is financed by equityCalculate the effect of the project on the gearing level2.5 INTEREST RATESInterest rates are mainly dependent on the duration of the loan, risk, profitability and size.2.6 DURATION OF THE LOANShort term interest rates tend to be lower than long term interest rates.2.7 EXERCISE 2Why do you think short-term interest rates tend to be lower than long term interest rates?2.8 SOLUTION 22.9 RISKThe higher the risk associated with the borrower, the higher the interest rate charged. The lender will be ensuring any higher risk taken on, is matched with a higher expected return.2.10 PROFIT


The lender must make a profit after transaction, administrative and bad debt charges.2.11 SIZE OF LOANThe larger the loan the less administration associated with handling the money, compared to lots of small loans.2.12 YIELD CURVEA financial manager must consider the likely movement in interest rates when choosing the type of finance, for example whether to borrow short or long term. It shows the market expectation of interest rates and should be reviewed before making large borrowing decisions.The yield curve graphs the different yields given to different gilts against their time to maturity.Yield Maturity2.13 YIELD CURVE SHAPEThe shape of the yield curve is determined by(a) Expectations Theory: if interest rates are expected to rise, the yield curve will be ‘normal’, sloping upwards, with long-term gilts providing a higher return than short term gilts. If interest rates are expected to rise, there will be more demand for short-term gilts, as investors/lenders do not want to be locked into a lower longer term interest rate now. As a result the price of short term gilts will increase, reducing their yield.(b) Liquidity Preference Theory: as discussed before, a lender will want a higher return if they deposit/lend cash for longer.(c) Market segmentation theory: different investors are interested in different sections of the curve. Banks are interested more in the shorter term gilts, compared to pension companies who are interested in longer term gilts. As a result there is an anomaly in the middle of the yield curve where the different interests of the two parties meet.2.14 EXERCISE 3As noted above, the yield curve shows the market’s expectation of future interest rates. As a result, financial managers should look at the curve before borrowing or lending to determine the expected movement in interest rates.As a financial manager, if the yield curve is normal, what does this imply if you are wishing to borrow?2.15 SOLUTION 33 SHORT / MEDIUM TERM DEBT FINANCEShort/medium-term sources of debt finance are detailed at the beginning of the chapter. Bank overdrafts, bank loans and trade credit are covered in Chapter 15 on Working Capital management.3.1 MEDIUM TERM FINANCE - LEASINGA lease is a contract to hire a fixed asset, such as plant and machinery or motor vehicles. The lessee does not legally own the asset but has the right to use it for the duration of the contract. The lessee pays regular payments for the right to use the asset, This avoids the company having large cash outflows in one year to purchase an asset outright.. Companies tend to lease assets from 1-10 years. A company identifies the asset it needs, and then enters into a contract with a finance house who buys the equipment and leases it to the lessee.3.2 OPERATING V FINANCE LEASESThere are two different types of leases, operating and finance.Under a finance lease the lessee is responsible for all the ‘risk and rewards of ownership’. This means that if the asset needs repairs, the lessee must undertake them. Under an operating lease, the lessor who usually deals in the particular asset organises any repairs. Under a finance lease, the lessee leases the asset for the whole of the useful economic life of the asset, whereas under an operating lease the lessor will lease the asset to a number of different companies.As the lessee is responsible for all the risks and reward of owner ship under a finance lease,the substance of the transaction is that the lessee effectively purchases the asset, and thepurchase is financed by a debt finance provided by the finance house.Under an operating lease the substance of the transaction is considered to be the short-termrental of the asset.The accounting treatment will follow the substance rather than the legal position of ownership. Hence, an asset used under a finance lease will be recorded on the balance sheet with a matching liability (the current value of future lease payments). This could have a detrimental effect on ratios such as gearing.3.3 GOVERNMENT ASSISTANCEThe government has assisted small forms through the provision of a Loan Guarantee Scheme,grants and loans.The Loan Guarantee System helps companies with inadequate security and track record to obtain finance. The government guarantees approximately 70% of a loan from an approved lender. Loans tend to be up to £100,000 and the borrower pays a premium to the government.The government also offers a number of grants: Enterprise Grants, Regional Innovation Grants, Small firms Training Loans, and through the Regional Selective Assistance Scheme.


Paper 2.4CHAPTER 11SOURCES OF FINANCE – SME PROBLEMS

1 FUNDING GAPSMEs (Small and Medium Enterprises) often find themselves with a funding gap. They are too small for a full stock market quotation but need to raise significant finance which proves very expensive/impossible through basic loans or increasing the overdraft.1.1 AIM LISTINGOne problem for SMEs in raising finance is the lack of marketability of their shares.In 1995, AIM, the Alternative Investment Market was introduced to enable firms’ shares to be traded in a lighter regulated environment.This enabled newer, fast growing companies, without the track record and infrastructure of established companies who would be able to comply with Full listing regulations, to trade their shares.1.2 TAX INCENTIVESThe government has introduced a number of tax incentives to encourage investment in SMEs.The Enterprise Investment SchemeVenture Capital TrustsShare Incentive Schemes1.3 VENTURE CAPITALVenture Capital companies, such as 3i, and some banks provide equity finance to SMEs.Venture Capitalists retain an interest in a company for a number of years, before looking for an exit route.Venture Capitalists invest after assessing the viability of a company, credibility of its management, realistic forecasts of growth, retention and distribution of profits, prospects of a successful future listing, and the proportion of shareholding on offer. However, as they are accepting a high level of risk, they will require a very high return. This is usually in the form of capital gain over 5 to 7 years.1.4 BUSINESS ANGELSBusiness Angels are often business people who provide small capital amounts (< £100,000) for an equity stake (sometimes called the informal venture capital market). They may also offer their management expertise.


1.5 DEBT FINANCEDebt finance can be difficult for SMEs to obtain, as they will be required to provide security on the debt. The Loan Guarantee Scheme introduced by the Government to assist the problem has not been very successful, partly due to the high interest rate charged.

Paper 2.4CHAPTER 12INVESTMENT APPRAISAL

The methods of investment appraisal required for this paper are ARR, Payback, NPV and IRR.NPV is considered to be the theoretically superior technique but IRR, ROCE and payback are also useful. For example, a company which needs to recover its cash investment quickly due to liquidity issues will look at the payback period with interest.1 NON-DISCOUNTING APPRAISAL METHODS1.1 ACCOUNTING RATE OF RETURN (ARR)The company sets a target ARR and accepts all projects exceeding the required ARR.ARR = Average annual profits (before interest and tax)Initial capital costsARR can be calculated using Average capital costs = Initial capital cost + final scrap value21.2 EXERCISE 1Initial investment £400mScrap value £ 40mCash flows Year 1 £200mYear 2 £100mYear 3 £ 100mYear 4 £ 100mCalculate the ROCE based on Initial investment and Average investment.1.3 ADVANTAGES OF ARRSimple to calculateManagers understand the idea of returnRelative measure1.4 DISADVANTAGES OF ARR


Ignores the length of the projectIgnores the time value of moneyDepends on accounting measures which can be manipulatedArbitrary nature of choosing a target ARRAlternatives ways to calculate (Initial investment, Average investment).1.5 PAYBACK (EQUAL ANNUAL CASH FLOWS)The company sets a target number of years in which to recoup its investment and accepts all projects which repay within the target time.Payback = Initial Investment (where project generates equal annual cash flows)Annual Cash flow1.6 EXERCISE 2Calculate the payback period, based on the forthcoming information:Initial investment £10mAnnual cash flows £ 4.m1.7 EXERCISE 3 - PAYBACK (UNEVEN CASH FLOWS)Initial Investment £86,000Cash flow Year 1 £20,000Year 2 £20,000Year 3 £20,000Year 4 £15,000Year 5 £15,000Year 6 £15,000Calculate the payback period1.8 ADVANTAGES OF PAYBACKSimple to calculateGood for companies who need to focus on liquidity (ie return of initial investment quickly). Based on relevant cash flows1.9 DISADVANTAGES OF PAYBACKBasic payback ignores time value of money (although it can be incorporated)Ignores cash flows after payback periodIgnores shareholder value2 DISCOUNTED CASH FLOW TECHNIQUESThe Net Present Value (NPV) method of investment appraisal uses discounted cash flow techniques.An investor would prefer £100 now as opposed to £100 in one year's time. This is because there is a time value of money. Why?If the investor had the £100 now they could spend it now. The investor could invest the £100 now and earn a return over the next year .There is a risk the offer may not be around in one year. As a result £100 is worth more now than in the future or money in the future is worth less today. Discounting is used to reflect the time value of money.Present value of a single future cash flowDiscount factor = 1 .(1 + r)nr = interest rate(discount rate)n= number of time periodsAnnuitiesTo calculate the present value of a number of future, equal, annual cash flows, the first cash flow is assumed to start in one years time.The annuity factor is effectively a cumulative discount factor.Annuity factor = 1 ( 1 - 1 )


r (1 + r)nPerpetuitiesTo calculate the present value of an annuity that will continue indefinitelyPerpetuity factor = 1rNPVNet present value is the present value of cash inflows less the present value of cash outflows;NPV is equal to the increase in shareholder wealth from carrying out a project. A company accepts all projects with a positive NPV.NPV is covered in more detail in the next chapter.2.1 ADVANTAGES OF NPVTheoretically superiorRelates to shareholder wealthProvides an absolute figure ie the increase/decrease in shareholder wealthIncorporates time value of moneyIncorporates all cash flowsBased on relevant cash flows2.2 DISADVANTAGES OF NPVNeed to understand time value of moneySelecting appropriate discount rateAll cash flows are assumed to occur at single points in time eg end of period2.3 EXERCISE 4Assuming a discount rate of 10%Calculate the present value of £110 receivable in one year's timeCalculate the present value of £161,051 receivable in 5 years' timeCalculate the present value of receiving £100 forever, the first cash flow received in one year's timeCalculate the present value of £2000 receivable for 6 years, the first cash flow in one year'stimeCalculate the NPV of the following investmentInitial investment £100kCash inflowsYear 1 £30kYear 2 £30kYear 3 £25kYear 4 £25kYear 5 £20k(Ignore tax)2.4 INTERNAL RATE OF RETURN (IRR)A company accepts all projects in which the IRR is greater than the company costs of capital/discount rate. This means at the discount rate the project will have a positive NPV. The IRR is the discount rate at which the NPV is zero.For a well behaved set of cash flows the profile of NPV against discount rate looks as follows:NPVPositive IRRDiscount RateNegativeThe IRR is calculated via trial and error using the following formula:IRR = r1 + NPV1 (r2 - r1)


NPV1 - NPV2Where r1 is the discount rate giving NPV1Where r2 is the discount rate giving NPV22.5 EXERCISE 5Calculate the IRR if the NPV at 10% is £250,000, and at 15% the NPV is -£175,000.2.6 ADVANTAGES OF IRRIncorporates time value of moneyBased on relevant cash flowsManagers understand the idea of return2.7 DISADVANTAGES OF IRRMultiple IRRs can occur if the net cash flows change direction more than once.Relative measure.Does not directly relate to shareholder wealth.2.8 NPV V IRRInvestment decisions based on NPV and IRR may conflict when a company can only do one project and is choosing from two or more projects – a mutually exclusive investment decision.When there is a conflict, always use the NPV method of investment appraisal.T0 T1 IRR NPV at 10%A (1000) 1,250 25% 136B (100) 140 40% 27A has the highest NPV but B has the higher IRR. If both projects can be undertaken, they should both be selected as both have a positive NPV. However, if only one project can be undertaken, choose the project with the highest NPV.2.9 MULTIPLE IRRSSome projects have more than one IRR, whilst others have no IRRs. This makes using the IRR investment appraisal technique, choosing the project with the highest IRR, difficult.In this situation, always use the NPV method.


Paper 2.4CHAPTER 13NPV ADJUSTMENTS AND USES1 RELEVANT COSTS

Relevant costs are the costs a business must take into consideration when making a decision.The key point is to always consider what changes if I go ahead with this decision – what change in cash (inflow or outflow) arises by making this decision.1.1 KEY POINTS(a) Include future, incremental cash flows(b) Ignore sunk costs(c) Ignore depreciation(d) Ignore committed costs1.2 RELEVANT COST OF MATERIALSIn stock Not in stockWill be replaced Won’t be replaced Replacement CostReplacement costNRV or Lost Contribution1.3 RELEVANT COST OF LABOURFull capacity Spare capacityCost of extra labour Contribution forgone No cost unless from alternative projects extra costs1.4 EXERCISE 1A company has just received a last minute order to manufacture a complex component, the RBS 2. RBS 2 is made up of two materials, X and Y. 2500 kg of material X is required and 1200 kg of material Y. 5000 kg of Material X are currently in stock. X originally cost £5 per kg 5 years ago. Its current purchase price is £9 per kg, and if sold today it has a NRV of £4per kg. 1200 kg of Material Y is required. Y is used frequently. 1000 kg of Y is in stock which cost £10 per kg. The supplier has just increased the cost to £12 per kg and it has a NRV of£9per kg.RBS 2 will require 100 hours of skilled labour and 40 hours of unskilled labour. The skilled labourers are paid £24,000 pa and currently have spare capacity. The unskilled labour is at full capacity and currently working on another project. Unskilled labour is paid £5 per hour.The other project is making the RBS 1.The standard cost card of RBS 1 is as follows:SP 200Material cost 60Labour cost 100Contribution 40


The manager in charge of RBS 1 will also oversee production of RBS 2. He is currently paid £25,000 and expects to spend 1 week of his time in total on RBS2.What is the minimum price the company would accept for manufacturing the RBS 2?2 NPV ADJUSTMENTS2.1 INFLATIONMoney MethodIf the cash flows are inflated by their specific inflation rates, the discount rate must be inflated This means use the money cost of capital(1+m ) = (1 + ig ) (1 + r )where: m = money cost of capitalig = general inflation rate (eg RPI)r = "real" cost of capital (ie excludes inflation)Effective MethodIf the cash flows are not inflated they are said to be in current terms ie in T0 terms. This means we use the effective cost of capital, i.e, where(1 + e ) = ( 1+ m )( 1 + is )and is = specific inflation of the relevant cash flows.

2.2 EXERCISE 2Investment £10,000Cash inflows £5000 pa for 3 years, inflating at 5%Money cost of capital = 10%Calculate the NPV using the money method and the effective method (Ignore tax).2.3 TAXATIONThere are 2 effects caused by tax for our purposes – tax on operating cash flows and capital allowancesAssume tax on operating cash flows arise with a one-year delay unless told otherwise.Assume capital allowances are taken as soon as possible, ie assume the asset is purchased on the last day of the year, unless told otherwise. Therefore, the capital allowance is obtained immediately and the tax saved one year later.2.4 EXERCISE 3A company buys an asset for £10,000 on the last day of the previous accounting period (31 December 2003). It undertakes a two year project generating cash flows of £5,000 in year 1 and 2. The asset is scrapped in year 2 for £4,000.Corporation Tax = 30% with one year delayWriting down allowances = 25%Discount Rate of 10%Calculate the NPV2.5 DEALING WITH UNCERTAINTYAll investment appraisal projects have to deal with uncertainty, cash flows have to be forecast, tax rates estimated for the whole project and discount rates have to be estimated. Such uncertainty can be incorporated into project appraisal using:Expected values – for example Revenue in Year 1 will either be £2000 with a probability of 0.6 or £3000 with a probability of 0.4. Therefore, the expected revenue is £2,400.Simulation – the use of random numbers to simulate the range of possible outcomeAdjusting the discount rate – to reflect the amount of risk associated with the cash flowsSensitivity analysis – a technique to look at how the NPV of the project changes when one factor is changedTo calculate the sensitivity of a factor eg the sensitivity of the outcome to sales revenue, material costs, labour costs etc :% Sensitivity = NPVPV cash flow consideredThe formula calculates the amount by which the relevant variable can fall or increase before the investment decision would change. To calculate the sensitivity to sales volume, use contribution as the denominator in the above formulaTo calculate the sensitivity to the discount rate, calculate the IRR2.6 EXERCISE 4Rock Ltd invests £100,000, and proposes to make exclusive rocking chairs for 10 years. The company will plans to make 250 chairs pa, earning a contribution of £151 per chair. Fixed costs are expected to be £17,500 pa and the scrap value of machinery after 10 years is forecast at £10,000.Ignore tax and writing down allowances, and use a discount rate of 15%.Calculate the NPV and the sensitivity to the:


Initial investmentVolumeContributionFixed costsScrapDiscount rate2.7 STRENGTHS OF SENSITIVITY ANALYSISEasyIt identifies variables to which the project is sensitive. The cash flow forecasts of these factors can be reviewed to ensure they are accurate.2.8 WEAKNESSES OF SENSITIVITY ANALYSISIt can only deal with one changing variable at a timeThe result does not indicate the likelihood of the variable changing, it only quantifies the amount by which the variable can change It does not provide an answer to whether a project should be undertaken, only information on the amount by which a variable can change3 ASSET REPLACEMENT3.1 PRINCIPLEWhen an asset is purchased for a long-term project it will probably be periodically replaced after a number of years.Asset replacement calculations determine the optimum frequency with which an asset should be replaced. Identify all the cash flows associated with purchasing the asset, the initial cost, maintenance charges and scrap valueCalculate the present value of the cash flowsCalculate the Annual Equivalent Cost of holding the asset for each of the years it is possible to replace the asset. This is so assets that are held for different number of years, accumulating costs over a different number of years, can be compared fairly by calculating an effective annual cost however long the asset is held for.AEC = NPV AFThe optimum replacement cycle will be that which has the lowest annual equivalent cost3.2 EXERCISE 5A company buys a machine costing £50,000. It can either replace the machine after 1 or 2 years. The running costs in year 1 and 2 are £10,000 and £12,000 respectively. If the machine is scrapped after one year £35,000 will be received, however if the machine is used for another year the scrap proceeds will only be £25,000.Calculate the optimum replacement cycle4 CAPITAL RATIONINGCapital rationing occurs when there is inadequate finance available to undertake all projects with a positive NPV.Single period capital rationing occurs when there is inadequate funding to finance the initial investment but finance is freely available in subsequent years.Multi-period capital rationing occurs when capital is rationed over a number of periods. Hard capital rationing occurs when lending institutions will not provide the finance required.Soft capital rationing is imposed by the management who opt for slower growth and decide not to undertake further investment projects for the time being.Projects can either be divisible, ie the whole or any fraction of the project can be undertaken, or indivisible, ie only the whole project can be undertaken.A summary of possible situations and approaches is as follows:Single periodMulti-periodDivisibleIndivisibleDivisibleMaximiseNPV per LFTrial and errorLinear programming4.1 SINGLE PERIOD CAPITAL RATIONING, DIVISIBLE PROJECTSA company has the option of 5 projects, which are all are divisible. Capital is rationed to £100,000 at T0 only.A B C D ENPV 200 100 (10) 160 54Initial Investment (100) (20) (5) (40) (30)


4.2 SINGLE PERIOD CAPITAL RATIONING INDIVISIBLE PROJECTSCapital restraint as before, but projects are not divisible. Using the data above and comparing the projects by trial and error:A aloneOrB,D & ETherefore, undertake4.3 MULTI-PERIOD CAPITAL RATIONING, DIVISIBLE PROJECTSTo solve this problem, Linear Programming must be used.4.4 EXERCISE 6Suppose a company has the choice of two projects, X and Y. The cash flows associated with each of the projects are as follows:X YYr 0 (15,000) (20,000)Yr 1 (10,000) (5,000)Yr 2 (20,000) NilYr 3 60,000 30,000There is capital rationing in Years 0, 1 and 2 as follows:AvailableYr 0 25,000Yr 1 12,000Yr 2 15,000Using a discount rate of 10%, calculate the proportion of project X and Y that should by undertaken in order to maximise NPV.4.5 SOLUTION 6Calculate the NPV of each project:NPV of project X isNPV of project Y isDefine the objective of the problemLet x be the proportion of project X to be performedLet y be the proportion of project Y to be performedTherefore the objective for this problem is to MaximiseDefine the constraints using the cash flow and capital constraint criteriaYear 0Year 1Year 2Define the non-negativity constraints0 ≤ x ≤ 10 ≤ y ≤ 1Graph the constraints and identify the feasible region.Calculate the NPV at the boundary points by substituting the co-ordinate values into the objective function and identify the optimal solution.5 LEASE V BUY5.1 PRINCIPLEWhen a company is considering a project, it has two decisionsDoes the project have a positive NPV at the company cost of capital ?Should the asset be purchased outright or leased?To solve the problem:Calculate the NPV of the project assuming that the company purchases the asset; use the company’s cost of capital as a discount rate. Calculate the change in cash flows that would arise if the company leased the asset instead; use the after tax borrowing rate as a discount rate.Decide whether to purchase or lease the asset.5.2 EXERCISE 7A company is considering purchasing an asset costing £1m. The asset will generate cost


savings of £400k pa for 4 years when it will be scrapped for £300k. The company will save tax one year in arrears and obtain writing down allowances at 25%.The first WDA will be obtained immediately.The company cost of capital is 10% and the firm intends to finance the new plant via a 4 year loan costing 6% pa. Alternatively the company could lease the asset and a leasing companywill lease the asset for £240k pa in advance for 4 years.5.3 SOLUTION 7Investment decision:T0 T1 T2 T3 T4 T5Cost savingsTax on costSavingsInvestmentScrapWDACFsDF10%PVFinancing decision:T0 T1 T2 T3 T4 T5Lease paymentsTax savingOn lease paymentsLost WDACFsDF4%PVNPV


Paper 2.4CHAPTER 14DIVIDEND VALUATION MODEL

When evaluating an investment opportunity, it is important to not only identify the correct cash flows, but to use an appropriate discount rate. This chapter will examine how such a “cost of capital” can be found.1 THE COST OF EQUITY1.1 PRINCIPLEAs we need to give a return to the shareholders on their investment in the company, any project undertaken must give at least this return. If we use the return required by shareholders (the cost of the capital used for the project) as the discount rate, then any positive net present value represents an extra benefit to the shareholders.1.2 DIVIDEND VALUATION MODELThis says that the share price represents the present value of all the future dividends, and that shareholders have discounted the expected cash flows at their required return.This can be complicated if dividends are expected to vary in the future, so we normally assume a constant dividend growth rate forever. This simplifies to a growing perpetuity:P0 = . D1 .Ke – gHowever, we want the discount rate used, Ke, so…Ke = D1 + gP0Where,D1= dividend in one year’s timeP0 = Today’s ex div share priceg = constant annual dividend growthRemember:a) It assumes constant dividend growthb) P0 is ex divc) D1 probably has to be estimated as D0 (1+g), where D0 = today’s dividend.1.3 EXERCISE 1Find the cost of equity using the dividend valuation model in the following situations:a) Current share price is £2.50. It has just paid its annual dividend of 20p, which has been the same for the last 10 years.b) Current share price is £2.50. It will shortly pay its annual dividend of 20p, which has been the same for the last 10 years. The share price is still cum div.c) Current share price is £2.30. It has just paid its annual dividend of 20p, and investors expect annual growth in dividends of 5%.d) Current market capitalisation (total value of all the equity) is £8 million and it has just paid a total annual dividend of £500,000. Investors expect annual dividend growth of 6%.1.4 ESTIMATING ‘G’ FROM PAST DIVIDENDSClearly an important assumption is the dividend growth expected by investors. One way to estimate this is to look at previous growth and assume that, on average, this growth will continue.However, this is only valid if previous growth is expected to continue in the future.1.5 EXAMPLE 1


A company has paid the following dividends:20X0 20X1 20X2 20X3 20X4 20X5Dividend 20p 20p 22p 24p 25p 28pWe calculate the average compound growth over the 5 years between 20X0 and 20X5.20(1+g)5 = 28(1+g)5 = 1.41+g = 1.40.21+g = 1.0696 so g = 6.96%1.6 ESTIMATING ‘G’ USING GORDON’S GROWTH MODELMyron Gordon developed a model to estimate future dividend growth:g = b x rWhere, b = proportion of profits retained (i.e. not paid out as dividends)r = return achieved on funds invested1.7 EXERCISE 2Estimate g in the following situations:Previous dividends have been:4 years ago 3 years ago 2 years ago Last year Now10p 12p 12p 14p 16pPrevious dividends have been:6 yrs ago 5 yrs ago 4 yrs ago 3 yrs ago 2 yrs ago Last yr Now3p 4p 16p 17p 19p 21p 23pJust over 4 year ago, the company floated on the stock market.Dividend pay-out ratio averages 70% and the company generates returns of 15%, based onbook values. Profits last year in an all-equity company were £100,000, out of which dividends were paid of £60,000. Shareholders’ funds at the end of the year were £1.29m.1.8 ASSUMPTIONSThe dividend valuation model assumes a perfect capital market is operating, so that the share price will always represent the expected dividends discounted at the required return. In other words, if the share price is lower than would be expected, given the forecast dividends and return required, there will be many buyers of this bargain, which will force the share price up until it reaches “equilibrium”.It is therefore dependent on all investors having similar views of the dividends and return, of perfect information in the marketplace, and on there being no restraints on buying or selling (such as transaction costs).


Paper 2.4CHAPTER 15WORKING CAPITAL MANAGEMENT1 WHAT IS WORKING CAPITAL?

Working capital is short-term net assets – stock, debtors and cash, less current liabilities.A company must balance the need to have working capital, - for example, it must have some stock to meet customer needs - with the cost of holding working capital, for example the opportunity cost of having cash tied up in stock or debtors. If working capital is not managed effectively, a company runs the risk of liquidity problems, which in extreme situations can lead to liquidation.1.1 CASH V PROFITSCash and profits are very different; a company can be profitable, but have no cash. For example, a new company has a profitable product. It has already started selling the product and sales revenue for the first period exceed the costs in the first period. However, demand for the product is increasing so the company needs to buy another machineto make the product in order to meet demand. In addition, it needs to buy more raw materials from its supplier. As the company is a relatively new customer, it is not allowed any credit and needs to pay for the materials upfront.The company converts the product from raw materials to WIP to finished goods.All this time, cash has been leaving the business, to purchase the machine, to pay for the materials, pay labour, pay overheads but no cash has been received.The finished goods are sold to customers. The customers expect to receive trade credit as that is the industry norm. As a result the company has to wait at least another 30 days before receiving any cash.In the meantime, they need to purchase more raw materials……As can be seen the company has sold products in the period, and incurred costs, making a profit. However, it has not received any cash from customers yet, but cash has been flowing out of the business.1.2 LIQUIDITY RATIOSCurrent Ratio = Current assetsCurrent LiabilitiesThe Current Ratio indicates the ability of a company to meet its current liabilities.Quick or Acid Test = Current assets - stockCurrent liabilitiesThe Quick Ratio is a harsher test of liquidity. It removes stock as a current asset available to meet current liabilities, arguing stock is to removed from cash to be available to pay off current liabilities.1.3 CASH OPERATING CYCLEThe cash operating cycle is the length of time between cash leaving the business to pay for raw materials and cash flowing into the business from customers. The aim of the business is to find its optimum cash operating cycle. This will vary depending on industry.Supermarkets tend to have a short cycle or even negative. Consumers pay cash at the till for the final product before the company has even paid its suppliers for all the products.1.4 CALCULATING THE CASH OPERATING CYCLECash Operating Cycle = RM holding period + WIP holding period + FG holding period +Debtors’ collection period – Creditors’ payment period


Average raw materials x 365 = DaysPurchasesAverage WIP x 365 = DaysCost of productionAverage finished goods x 365 = DaysCOSAverage debtors x 365 = DaysCredit salesLessAverage creditors x 365 = DaysPurchasesNet operating cycle = Total Days1.5 EXERCISE 1The following data has been extracted from the annual accounts of ABC Ltd.Credit Sales £100,000Purchases £ 60,000COS £ 70,000RM £ 3,500FG £ 5,000Debtors £ 12,400Creditors £ 2,000Calculate the cash operating cycle.2 STOCK MANAGEMENTManagement have to balance the need to hold to stock to meet customer orders with the costs of holding stock.The main costs of holding stock include holding costs and order costs.Holding CostsHolding costs include administrative costs, storage costs, obsolescence costs, insurance costs and an opportunity cost of capital (the cash invested in stock could have be invested elsewhere in the business earning a return).If a company does not hold stocks, it will not be able it meet customer demand and it will therefore incur a stock out cost.Order costsA company incurs order costs each time it places an order. For example, the company may be charged by the supplier for each order placed, in addition to internal administration costs incurred for placing an order. A company therefore needs to evaluate whether it should place relatively few orders of large stock. (Order costs will be reduced, but holding costs increased) or to place numerous orders of one or two stock items.(Holding costs reduced but order costs increased).This problem is solved theoretically by the Economic Order Quantity model.2.1 ECONOMIC ORDER QUANTITY MODEL (EOQ)As stated above the company can determine the theoretical optimum number of units to order each time they place an order:X = { 2 C0 D }CHwhereX = Economic Order QuantityCO = Fixed cost per orderD = Expected annual demandCH = Holding cost per unitThis minimises the Total Costs incurred on stock, whereTC = Holding cost + Ordering Cost + Total purchase price


2.2 EXERCISE 2A company sells 5000 model boats per annum.The administrative costs of placing each new order is estimated at £100.Each model boat costs £150 and the company finances its working capital via an overdraft costing 10% pa.Calculate the optimum economic order quantityCalculate the total cost at EOQ2.3 DISCOUNTSWhen discounts are offered at an order level above the EOQ, solve as follows:Calculate the EOQ as normal, ignoring discountIf EOQ is below level at which obtain discount, calculate Total stock costRecalculate Total stock cost at level required to just obtain a discountCompare (b) and (c) and choose cheapestRepeat at all discount levels2.4 EXERCISE 3A company requires 10,000 units of a product each year. The purchase price per unit is £20and it costs £32 to place an order with the supplier. The company cost of capital is 10%. The supplier has offered a discount incentive depending on the number of units ordered at a time.Minimum Order Quantity Discount1000 1%2000 2%4000 3%Calculate the size of order that should be placed if the company’s objective is to minimize costs.2.5 JITAs discussed in Chapter 2, Just in Time is a stock management technique which aims to minimise stock levels. It aims to manufacture to customer demand. As a result, short, flexible production runs are necessary to ensure customer orders are met promptly. The JIT company does not carry vast stock and therefore relies on suppliers to supply quality products as and when required. This reduces stock holding costs for the company, passing the risks onto the supplier.A JIT company must have a good relationship with its suppliers, often sharing production plans for years ahead with the supplier. The supplier must be located near to the JIT company ensuring prompt delivery and easy communication.The workforce must also be flexible prepared to meet large orders at short notice.3 CASH MANAGEMENTA company needs cash for three purposes:Transactions motive – to meet everyday operational needs, pay employees, pay suppliers etcPrecautionary motive – a buffer to cover unexpected cash needsSpeculative motive – to exploit unexpected opportunities3.1 CASH SURPLUSA cash surplus is cash held temporarily by the business to use to meet operational needs or investment opportunities. The objective is to invest the surplus for appropriate time scales, ensuring that when the cash is needed it will be available.This may be easy to manage if the timing of a payment is known with certainty, eg to pay a tax bill but the timing cash outflows is not always known. The company has infinite alternatives of what to do with surplus cash (and a number ofconsiderations such as what are interest rates expected to do and what is the most tax efficient home for the cash):Invest in fixed interest investments (choose between long and short maturity period,fixed and variable rates)Invest in government securitiesBuy foreign currency (if have an obligation to make a foreign currency payment)3.2 CASH SHORTAGES(a) Bank overdraft Short term finance, variable interest rate charged Tends to be flexible and cheap, although repayable on demand


(b) Bank loan More formal than overdraft and more expensive3.3 BAUMOL CASH MANAGEMENT MODELObjective of the model is to minimise the total costs associated with managing cash between the current account and short-term investments It is similar to the EOQ model for stock discussed above.X = { 2 x Annual cash required x cost per sale of security }Interest rate ie cost of holding cashWhere:X = Optimum cash injection into the current account3.4 EXERCISE 4A company’s annual demand for cash is £100,000. It obtains the cash for its current accountby selling short-term investments. The company is charged £10 each time it sells one of itsinvestments. The investments are currently earning 5% pa.Calculate the optimum value of the cash injection into the current account3.5 MILLER-ORR CASH MANAGEMENT MODELThe Miller-Orr model recognises there is uncertainty in cash receipts and payments. It allows the cash balance to fluctuate between a lower and upper limit. When the cash balance reaches the limit the company must take action to return to the Return Point.The lower limit is set by the firm and the upper limit calculated by the model.The lower limit is a safety, buffer amount of cash held. When the cash balance reaches the lower limit the company must sell investments or withdraw cash on deposit.When the cash balance reaches the upper limit, the cash balance must be reduced by buying investments, or placing cash on deposit.4 DEBTOR MANAGEMENTA company is often obliged to offer credit to attract customers and comply with industry averages. The company must balance the cost of offering trade credit with the increase insales generated from offering trade credit.When offering trade credit, a credit assessment is performed on the potential customer by for example obtaining bank and trade references, obtaining a credit rating from an agency etcThis determines the appropriate credit limit for each customer. Often a company will start by setting a low credit limit for a new customer, which is slowly increased as the customer complies with credit terms. Customers must be invoiced promptly,and overdue debts chased.Aged debtor analysis reports are generated to monitor overdue debts in total and on an individual basis.4.1 EXAMPLE 1 - COST OF OFFERING A DISCOUNTA company offers a 1 ½% discount to customers if they settle their account within 30 days.What is the annual cost of the finance?4.2 SOLUTION 1Consider £100If pay now If pay in 30 daysObtain discount No discountPay £98.50 Pay £100Therefore, discount = £1.50 for 30 days creditCost to company of 30 days credit = 1.50 / 98.50 = 0.0152Annual equivalent : (1 + 0.0152)365/30 – 1 = 0.2014 = 20.1% paThis is a very expensive deal for the company to offer suppliers- if the company needs cash they should look to other sources of finance, bank loans, overdraft etc which will not be as expensive under current interest rates.4.3 FACTORING V INVOICE DISCOUNTINGFactoring debtors involves appointing an agency to collect debtor balances. The agency or factor may also run the sales ledger, and provide loans secured on outstanding debts.The factor can be said to ‘have recourse’. This means if a debtor does not pay, the factor agency will reclaim the debt from the company who appointed them. ‘No recourse’ means the


agency suffers any costs from bad debts. Factoring ‘without recourse’ or with ‘no recourse’ is more expensive.Invoice discounting is the sale of outstanding debts to an agency with recourse to the company for bad debts. The agency does not offer the variety of services of the factoring company.5 CREDITOR MANAGEMENTObtaining trade credit is a cheap source of finance. However, extending the credit period beyond industry norms in the long run will result in loss of supplier goodwill and financial cost. For example, suppliers can increase the initial cost of the raw materials, reduce available discounts and reduce credit terms on future supplies.

Paper 2.4CHAPTER 16THE ECONOMIC ENVIRONMENT1 POLICIES

This chapter outlines the main areas of the economic environment: Macroeconomic policy, Monetary policy, and Fiscal policy. These three areas affect the costs of businesses.1.1 MACROECONOMIC POLICYMacroeconomic policy describes government policy for managing the economy as a whole. It includes the objectives of achievingEconomic growthLow unemploymentPrice stabilityBalance of payments equilibriumThe problem is that often the objectives may conflict; for example achieving full employment leads to inflation, making price stability difficult to achieve. As a result the government has make trade-offs between its objectives.Macroeconomic policy influences aggregate demand ie the total demand for goods and services in the economy. It can also affect the exchange rate, for example making imported goods more expensive, increasing the production costs of UK companies.1.2 MONETARY POLICYMonetary policy is concerned with the control of the volume of money in circulation and the price of money ie the interest rate. Monetary policy affects firms by for example, increasing the cost of borrowing, affecting the availability of finance, altering the discount rate used to appraise projects, changing exchange rates and the inflation rate.1.3 FISCAL POLICYFiscal policy refers to the balance of taxation and expenditure by the government to manage demand and supply in the economy. The government finances its expenditure of public services through taxation and borrowing.Taxes can be direct (income tax, national insurance) or indirect (VAT). Excessive taxation can lead to disincentives to work, and invest, resulting in less tax revenue in the long run. The balance of the government income and expenditure is known as the budget:Income > expenditure Budget surplusExpenditure > Income Budget deficitIncome = Expenditure Balanced budgetThe government can borrow from the public (eg Premium Bonds) and the banking sector (eg Treasury Bills) by issuing debt. Large government borrowing may lead to a ‘crowding out’ effect where other borrowers find it difficult to obtain finance and therefore interest rates rise.1.4 GOVERNMENT INTERVENTIONEconomic welfare is maximised in a competitive market. However, the government may intervene if a monopoly situation arises where a company has the power to set prices and set output levels.


For example, a major supermarket's offer to purchase a rival would be looked at by the Monopolies and Merger Commission and the Competition Committee.1.5 CORPORATE GOVERNANCECorporate Governance is best practice guidance given to companies on reporting and control, as summarised in the Combined Code. Companies have a duty to explain any non-compliance with the Combined Code.It covers issues such as the make-up of board membership, remuneration committee guidelines, and reporting recommendations. Corporate Governance has had significant press interest recently following corporate scandalssuch as the collapse of Enron and World Com.

Paper 2.5CHAPTER 1

BASIC CONCEPTS REVIEWED AND THEREGULATORY FRAMEWORK

1 OBJECTIVE OF FINANCIAL STATEMENTSThe objective of financial statements is to provide information about a business entity to a range of users:• Shareholders and other investors, current and potential• Lenders, suppliers and other creditors• Employees• Customers• Government, taxation authorities and statisticians• Environmental groups• General publicInformation must be - RelevantReliableUnderstandableComparableMaterial2 THE FRAMEWORKTo ensure the above objective is met there are rules governing the preparation of financial statements. These rules are laid down from two sources:[1] COMPANIES ACT 1985 (amended by CA 1989) which sets out the rules concerning disclosure. The act also requires that financial statements show a ‘True and Fair View’. This is a concept requiring financial statements to be representative of the reality of the financial circumstances of the business entity. This has the effect of recognizing that in certain cases the real position is better represented by deviating from the prescribed rules. It is of paramount importance to show the substance over legal form.[2] REPORTING STANDARDS which provide rules concerning accounting treatment. These are developed by the Accounting Standards Board (ASB). From these sources the regulatory framework develops. There are a number of terms and concepts referred to as part of the framework. These are as follows:Generally Accepted Accounting Practice (GAAP) is the umbrella concept for all rules governing accounting.The conceptual framework is a system of agreed principles in accordance with which GAAP is developed.The Financial Reporting Council (FRC) is a body whose purpose is to:• Promote sound financial reporting• Guide the ASB• Ensure financial reporting is efficient• Review ASB fundingThe Statement of Principles is a list of topics set out by the Accounting Standards Board (ASB) whose aims are to ‘establish and improve financial accounting and reporting’. The eight Statements of Principle are:• Objective of financial statements• Accounting for interests in other entities• Qualitative characteristics of financial information


• Elements of financial statements• Recognition in financial statements• Measurement in financial statements• Presentation of financial statements• The reporting entityThe Urgent Issues Task Force (UITF) exists to provide a rapid reaction when conflicting or unsatisfactory interpretations arise.The Public Sector Liaison Committee liaises with the ASB regarding differences in the public and private sectors.The Financial Reporting Review Panel (FRRP) reviews and if necessary enforces the adherence to accounting standards and best practice.3 FINANCIAL REPORTING STANDARDSFinancial Reporting Standards (FRS’s) are rulings made by the ASB regarding best practice. The process involves discussion with the accounting profession and business. The first stage after a problem is identified is the issue of a Discussion Document.After extensive discussion has taken place this becomes a Financial Reporting Exposure Draft and eventually an FRS.Prior to FRS’s there were Statements of Standard Accounting Practice (SSAP’s). Many of these have now been superseded by FRS’s but those which have not have been ratified by the ASB and still stand. FRS’s and SSAP’s have the effect of being legally binding.4 ACCOUNTING CONVENTIONSFinancial accounting conventions are assumptions adopted in the preparation of financial statements.4.1 ACCOUNTING CONCEPTSThe four Fundamental accounting concepts are:• Going concern• Accruals• Consistency• PrudenceThese were set out by SSAP 2 Disclosure of accounting policies, which has been superseded by FRS 18 Accounting policies. The latter has given greater prominence to going concern and accruals, but all remain important to good accounting practice.4.2 FRS18: ACCOUNTING POLICIESAccounting policies aim to ensure that an entity:• Adopts appropriate policies• That the policies are regularly reviewed• That there is sufficient disclosure for maximum understandingThe main effects of FRS 18 are:• That recognition, measurement and presentation are addressed when determining if an accounting policy has been changed• Clarification of policy changes regarding prior year adjustment• Going concern and accruals are the overriding accounting concepts• Consistency and prudence are no longer fundamental although desirable• There is further disclosure required if in order to provide a true and fair view a departure is made from the requirements of an accounting standard• There is a distinction between accounting policies and estimation techniques4.3 FURTHER ACCOUNTING PRINCIPLES• Separate entity• Accounting period• Stable standard of measurement• Materiality• Objectivity• Substance over form.5 EC DIRECTIVESAccording to the aims of the European Union (EU) that members will eventually operate as a single economic entity, businesses must operate within some of the constraints of the EC Directives. The effect of these is that:• Financial statements must be presented in prescribed formats


• There are exemptions from some of the requirements of the Companies Acts for small and medium-sized companies• There are various requirements relative to groups of companies.6 THE STOCK EXCHANGEThe Stock Exchange imposes rules on Public Companies and those desiring a Stock Exchange listing.7 INTERNATIONAL ACCOUNTING STANDARDSThe International Accounting Standards Committee (IASC) came into existence in 1973 after agreement by accountancy bodies in various countries. In 2001 the InternationalAccounting Standards Board (IASB) became the standard setter for International Financial Reporting Standards (IFRS’s). Member countries are working to make their own FRS’s consistent with IFRS’s where possible.In 2002 the European Union agreed to the use of IFRS’s, and this will become mandatory for the consolidated financial statements of listed companies with regard to accounting periods beginning on or after 1st January 2005. This impacts some 7,500 companies within the EU.The challenges for the preparers of IFRS compliant financial statements areconsiderable as the accounting regulatory framework undergoes considerable change.• In 2004 the IASB completed an Improvements Project for many of their existing standards to reduce some of the variation between and IFRS’s and national GAAP (Generally Accepted Accounting Practice)• New IFRS’s continue to be issued• In the UK new company legislation is awaited plus the ASB continue to issuetheir own accounting standards for the many companies not required to transfer to IFRS (these new standards largely mirror their international counterparts)The USA and Canada are highly resistant to the implementation of international accounting regulations, but there is a long term desire in the accounting community to move towards a single worldwide accounting framework. To this end a Convergence Project has been started, but will not be completed in the near future.


Paper 2.5CHAPTER 2

PUBLISHED ACCOUNTS1 FORMAT

The format in which the accounts of a limited company are presented and the disclosures required are specified in Schedule 4 to the Companies Act 1985. There is a choice of four profit and loss account formats and two balance sheet formats. Of the profit and loss formats two would only very rarely used in the UK. There is a distinction between the other two as follows:• Operational format – analyses expenses according to the operation to which they relate• Expenditure format – analyses expenses according to the nature of the expense.The most usual balance sheet format is the vertical format in which all items are listed continuously. The horizontal format lists assets on one side of the page and liabilities on the other.2 LEGAL BACKGROUNDThe Companies Act 1929 was the first time that limited companies were required to produce financial statements to shareholders at regular intervals. The 1948 Act laid down requirements regarding disclosure of information and presentation. Acts in 1967 and 1981 further developed the requirements of the previous legislation. The 1985Companies Act consolidated the previous Acts and various amendments were made to the 1985 Act by the 1989 Act.The responsibility for the preparation of accounts rests with the directors. These must be prepared and presented to the company in general meeting within eighteen months of incorporation and once a year after that.3 PROFIT AND LOSS ACCOUNTA profit and loss account in the operational format follows, together with the related disclosure notes. Every profit and loss account must show:• The profit or loss on ordinary activities before taxation• The movement on reserves• The aggregate amount of all dividends paid and proposed.The objectives of the notes are to explain the figures on the face of the profit and loss account.HARRIS LIMITEDPROFIT AND LOSS ACCOUNTFOR THE YEAR ENDED 31 MARCH 20X2Note £Turnover 2 XCost of sales (X)GROSS PROFIT XDistribution expenses (X)Administration expenses (X)Other operating income XOPERATING PROFIT 3 XInvestment income 6 XInterest receivable 7 XInterest payable and similar charges 8 (X)PROFIT BEFORE TAXATION X


Tax on profit on ordinary activities 9 (X)PROFIT AFTER TAXATION XDividends 10 (X)RETAINED PROFIT FOR THE YEAR XPROFIT AND LOSS ACCOUNT – NOTES TO THE ACCOUNTS1. Accounting policiesThis states that the accounts have been prepared according to the accounting standards applicable. It is usually the first note to the accounts. The note details the accounting policies used in relation to any figure in the accounts which could be subject to alternative treatments. The most common of these are:DepreciationStockDeferred taxLeasingResearch & development2. Segmental informationThis note divides turnover geographically and by class of business.3. Operating profitThe following expenses must be disclosed:DepreciationAmortisationHire of plant and equipmentAuditors’ remuneration (including accountancy and incidental expenses)Exceptional itemsDirectors’ emolumentsStaff costsResearch & development4. Directors’ emolumentsThese should be broken down into their different components. Emoluments include:SalaryFeesExpense allowancesBenefits in kind‘Golden hello’Additional disclosures include:Contributions to pension schemesAmounts receivable re incentive schemesGains on share optionsPensions paid to former directorsHighest paid directorCompensation for loss of office5. Employee informationStaff costs must be categorised either by class of business or by qualification of employee. The average number of employees must be shown.6. Income from investmentsDividend income should be split between income from listed companies and other companies.7. Interest receivableInterest receivable should be split between interest from listed investments and others.8. Interest payableAll types of interest should be listed separately.9. TaxationThe total figure should be broken down as follows:UK Corporation tax (at x%)Over/under provision for previous periodsTransfer to/from deferred tax


Irrecoverable tax credits on franked investment incomeOverseas tax10. DividendsThe amount paid and proposed by each class of share must be shown.4 BALANCE SHEETA full balance sheet showing presentation requirements as prescribed by the Companies Act 1985 is shown below, followed by the required notes with explanations. The objective of the notes is to provide explanations of the figuresappearing on the face of the balance sheet and to show movements from one period to the next.HARRIS LIMITEDBALANCE SHEETAS AT 31 MARCH 20X2Note £ £FIXED ASSETSIntangible 11 XTangible 12 XInvestments 13 XXCURRENT ASSETSStock 14 XDebtors 15 XBank and cash XXCREDITORS: amounts fallingdue within one year 16 (X)NET CURRENT ASSETS XXCREDITORS: amounts fallingdue after one year 17 (X)XPROVISIONS FORLIABILITIES & CHARGES 18 (X)DEFERRED INCOME (X)NET ASSETS XCAPITAL AND RESERVESCalled up share capital 19 XShare premium 20 XRevaluation reserve 20 XProfit and loss account 20 XXBALANCE SHEET - NOTES TO THE ACCOUNTS11. Intangible fixed assetsGoodwill£COSTAt 1 April 20X1 XAdditions XDisposals (X)At 31 March 20X2 XAMORTISATIONAt 1 April 20X1 XCharge for year XEliminated on disposal (X)At 31 March 20X2 XNET BOOK VALUE


At 31 March 20X2 XAt 31 March 20X1 X12. Tangible fixed assetsFreeholdLand & Plant & Fixtures &Buildings Machinery FittingsTOTAL£ £ £ £COSTAt 1 April 20X1 X X X XAdditions X X X XRevaluations X X X XDisposals (X) (X) (X) (X)At 31 March 20X2 X X X XDEPRECIATIONAt 1 April 200X1 X X X XAdditions X X X XRevaluations X X X XEliminated on disposal (X) (X) (X)(X)At 31 March 20X2 X X X XNET BOOK VALUEAt 31 March 20X2 X X X XAt 31 March 20X1 X X X XNBLong leases are > 50 years at balance sheet date Motor vehicles are included in P&M unless materialRevaluations:• give name of valuer• state if employee of company• must also state NBV based on original cost13. InvestmentsMovements must be disclosed.14. Stock£Raw materials and consumables XWork-in-progress XFinished goods XX15. Debtors£Trade debtors XOther debtors XPrepayments and accrued income XX16. Creditors: amounts falling due within one year£Loans (specify) XBank loans and overdraft XTrade creditors XTaxation and social security XProposed dividends XOther creditors XAccruals and deferred income (specify) XX


17. Creditors: amounts falling due after one year£Debentures XLong term loans XXNBDisclose for each creditor:• redemption date• rate of interest• security• amounts repayable after five years18. Provisions for liabilities and chargesDisclose movement on: deferred taxationprovision for losses on long-term contracts19. Share capital£1 Ordinary 5% PreferenceShares Shares£ £Authorisedx shares X XIssued and fully paidx shares X XNBDisclose number and amount raised relating to shares issued during the year.20. ReservesShare ProfitPremium Revaluation and loss TOTAL£ £ £ £At 1 April 20X1 X X X XRetained profit for year X X X XRevaluation - X - XAt 31 March 20X2 X X X X21. MiscellaneousCapital commitmentsContingent liabilitiesPost balance sheet eventsNB: These figures do not appear in the balance sheet.5 DIRECTORS’ REPORTAll published accounts need to include a directors’ report. The main requirements come under the following headings:• Principal activities• Business review• Post balance sheet events• Future developments• Dividends• Research and development• Asset values• Directors• Interests of directors• Purchase of own shares• Disabled employees• Donations• Approval of report.


Paper 2.5CHAPTER 3

REVENUE RECOGNITION AND INFLATIONDIFFERENT APPROACHES TO REVENUE RECOGNITION

This is an area not covered by an Accounting Standard and as such is open to different interpretations. The ASB has set out general principles to be used in order to recognize gains and losses but their approach is not the traditional one and has been controversial.The problems regarding the recognition of revenue involve timing – at what point has a sale been made? There are several areas in which the actual timing of a sale can be open to discussion, for example when goods are ordered for delivery later, when services are ongoing or when time is being charged.1 REALISATIONTraditionally revenue must be both earned and realised for it to be reported in the profit and loss account. There must also be the capability of its being verifiably measured. The realisation aspect is covered by the Companies Act. This ensures that only available profit is distributed to shareholders after all creditors have been paid. Realisation occurs when events have taken place which make the conversion of assets into cash reasonably certain. This is usually the date of sale. However, ‘reasonable certainty’ is open to interpretation.1.1 ACCRUALS AND PRUDENCEThe accruals concept states that revenue must be matched with related costs and charged to the profit and loss account in the same period. The concept of prudence has the effect of enforcing the realisation requirement.1.2 EXERCISE 1A company whose year end is 31 October received £300,000 subscriptions in advance for 4 quarterly magazines the first of which was produced in August. The costs incurred were £60,000, two thirds of which related to the first issue and the remaining third to all four issues. How much revenue and costs should be allocated to the profit and loss account at the year-end?1.3 SOLUTION 1Revenue for the year should be __________________, the balance being treated as a _______________ in the balance sheet. The related costs would be two thirds of _________________________________, the remaining ___________ being treated as a __________. Perhaps prudence would dictate that the __________ should be written off in the period? But as we have actually received the related income and are deferring it to the following period it is fair to hold back the matching costs.1.4 ARGUMENTS AGAINST THE REALISATION APPROACH• Revenue is earned over time – often spanning more than one accounting period. In particular some commodities take years to produce. It can therefore be argued that breaking revenue into separate amounts to fit into accounting period is unrealistic.• As revenue-earning is continuous there is a possible conflict with the going concern principle.


• The emphasis on conversion into cash can cause problems with some investment transactions and also those involving barter.• Transactions concerning options to purchase in the future can be so complex that the substance differs significantly from the legal form.2 CRITICAL EVENTDuring an operating cycle there is usually an event which occurs at which point there ceases to be any uncertainty about the fact that a sale will be taking place. There is an argument for taking this critical event as the point at which revenue should be recognised.For example, if an order for a very specific product is made it could be that the obtaining of the materials to fulfil the order is the critical event. Again during a long construction job it could be fair to recognise revenue during the production process. The critical event most usually used in determining revenue recognition is the deliveryof goods. However this might not be the conclusive point of sale as the goods might be returned, not paid for or liabilities may arise under warranty.

3 ACCRETIONThis approach recognises revenue over time rather than at one particular time. This is appropriate when there is a long production period or when a service is provided over time – e.g. rental income and long-term contracts.4 ASB’S APPROACHThe ASB uses a balance sheet approach to revenue recognition as set out in the Statement of Principles. Gains and losses are based on changes in assets and liabilities.An increase in net assets means a recognisable gain and a decrease in net assets indicates a loss. This is a controversial approach as it has the effect of dispensing with the matching and accruals concepts. In order for a cost to be deferred it would have to fall within the definition of an asset.Return to the answer in 1.3 above and the ASB would probably require the costs for the year ended 31 October to be the full £60,000 as it would be difficult to define the £15,000 of deferred costs as an asset. To take this one step further, the same logic must be applied to the income – this will also need to the recognised in the period. This is where the controversy arises as most accountants would view this treatment as imprudent. The ASB believes that many traditional accounting concepts are not adequate to deal with today’s complex transactions.5 INFLATIONThis concerns the measurement of income in times of price level changes. There are two main alternatives to historic cost accounting. These are current purchasing power (CPP) and current cost accounting (CCA), both of which have been around for many years and it is important to understand the ideas behind them. The ASB has addressed these issues in its Statement of Principles. It is important to remember that these are alternative ideas only and not alternative ways of preparing financial statements at present. The historic cost is still used as none of the alternatives are as suitable.6 HISTORIC COST ACCOUNTINGThis is the traditional approach whereby all transactions are recorded at their original monetary cost. Only monetary cost is recognised. Prudence, matching and accruals concepts must be exercised.6.1 ADVANTAGES OF HISTORIC COST• All items are factual and verifiable.• Thus there is minimum subjectivity.6.2 PROBLEMS OF HISTORIC COST• Net book value of fixed assets often significantly below current value.• Stock could be undervalued in relation to its current value.• Expenses could be understated in the profit and loss account as there is not a fair charge for assets consumed in the period.• Monetary items in the balance sheet do not reflect price increases in the period.• Profits can thus be overstated so the financial statements do not show a true and fair view.


7 CURRENT PURCHASING POWER (CPP)CPP works on the principle that all figures are restated into a stable monetary unit with the same purchasing power. To achieve this items are adjusted for inflation using the Retail Price Index (RPI). The resulting profits are the increase in the current purchasing power of equity after allowing for the declining purchasing power of money.7.1 MONETARY AND NON-MONETARY ITEMSMonetary items are those whose value is fixed in £’s by contract – e.g. cash, debtors, creditors etc. In times of inflation these £’s are of a lower purchasing power.Non-monetary items are those items whose value is not fixed in £’s – e.g. fixed assets,stock etc. The purchasing power of these assets does not change in times of inflation. In CPP accounting non-monetary assets are adjusted by the RPI to reflect the general price increase experienced by the business. Monetary assets are unaltered. Sales and costs are deemed to accrue evenly throughout the period unless it is stated otherwise.7.2 ADVANTAGES OF CPP• Greater comparability between companies – aiding comparisons• Less subjectivity of financial statements than other current value methods• Financial statements are auditable.• Gains and losses due to inflation are highlighted.7.3 DISADVANTAGES OF CPP• Usefulness of restatement of assets must be questioned. Realisable value may still not be accurately represented.• Users might not gain any value from the restated information.• Indices are approximates so there is scope for misstatement.8 CURRENT COST ACCOUNTING (CCA)CCA operates on the basis that assets consumed or sold by the business together with the fixed assets and stock in the balance sheet are restated in the financial statements at their value to the business – that is their deprival value. Monetary assets are already shown at their current value therefore do not need restating.8.1 DEPRIVAL VALUEThis is the lower of replacement cost and the higher of net realizable value (NRV) and economic value (EV). Depreciation is charged on the basis of gross replacement cost of the asset. Where NRV or EV is used the charge in the CCA P&L will be the CCA loss in value during the period. Goods sold during the period are charged in the CC P&L at their replacement cost regardless of actual historic cost.8.2 EXERCISE 2Calculate the deprival value of the following four assets:A B C DHistoric cost 75 45 55 155Replacement cost 100 40 72 150Economic value 120 27 84 140Net realisable value 90 38 85 1308.3 ADVANTAGES OF CCA• Restated asset values help users assess the recent performance of the business, its stability and liquidity. Thus the future prospects are clearer.• Gains related to the holding of assets are eliminated so the operating capability of the business is clearer.8.4 DISADVANTAGE OF CCACollecting the necessary data for the restatement of figures is very difficult.9 EXERCISE 3Z Ltd reported a profit before tax of £90,000 for the year ended 31 December 20Y2.During the year the following transactions took place:An asset with a book value of £20,000 was revalued to £30,000. The estimated remaining useful life was five years.At the end of 20Y1 an asset was revalued by £20,000 (book value £30,000). In 20Y2 the asset was sold for £48,000.Retained profit for the year was £47,000.


Required:Show the reconciliation of profit to historical cost profit for the year ended 31December 20Y2.

Paper 2.5CHAPTER 4

REPORTING FINANCIAL PERFORMANCE

This chapter has to do with the requirements of FRS 3 which requires businesses to analyse results between continuing and discontinuing operations, acquisitions and extraordinary items. There is a requirement for a statement of total recognised gains and losses and for earnings per share to be shown.The ASB introduced FRS 3 in order that users would have more confidence in financial statements. Prior to these requirements it was common practice to treat large infrequent items of expenditure as extraordinary items so that the earnings per share ratio and the price earnings ratio (which are based on the profit on ordinary activities) would be more favourable. The ASB wanted the profit to be that of all operations during the year and so required that all items now appear above the line, i.e. that the profit figure reflects the performance of the business as a whole.1 EXCEPTIONAL ITEMSExceptional items are those which occur within the normal activities of the business but which need to be disclosed because of their size or incidence.1.1 SUPER-EXCEPTIONALThese are: Closure costsReorganisation costsProfit or loss on disposal of fixed assets and need to be shown on the face of the P&L after operating profit.1.2 STANDARD-EXCEPTIONALOther exceptional items are disclosed with explanations in the operating profit note.2 EXTRAORDINARY ITEMSThese have effectively been banned by FRS 3.3 STRUCTURE OF THE PROFIT AND LOSS ACCOUNTThe profit and loss account must be analysed from turnover to profit before interestand tax between:Continuing operationsNew acquisitionsDiscontinuing operations.3.1 EXAMPLE OF PROFIT AND LOSS ACCOUNTContinuingoperationsAcquisitions DiscontinuedoperationsTOTAL£000 £000 £000 £000


Turnover 550 50 175 775Cost of sales (415) (40) (165) (620)Gross profit 135 10 10 155Distribution costs (35) (4) (8) (47)Administrative expenses (50) (7) (57)Operating profit 50 6 (5) 51Profit on sale of properties 22 22Loss on sale of discontinued operations(10)(10)Profit before interest and tax 72 6 (15) 63Interest payable (18)Profit before taxation 45Tax (16)Profit for the financial year 29Dividends (8)Retained profit for the financial year 213.2 DISCONTINUED OPERATIONS• A discontinued operation is one that satisfies the following three conditions:• A sale or termination of business has been completed in the period or before the earlier of three months after the commencement of the next period and the date of approval of the financial statements;• On termination the activities must have ceased permanently;• The effect of the sale or termination must be material on the nature and focus of the reporting entity and represent a material reduction in its operating facilities resulting from either:• The withdrawal from a particular market; or• A material reduction in turnover in existing markets.• The assets, liabilities, results of operations and activities are clearly distinguishable,physically, operationally and for financial reporting purposes.4 STATEMENT OF TOTAL RECOGNISED GAINS ANDLOSSES (STRGL)This statement is designed to show the whole picture of an entity’s performance over the period by bringing together all gains and losses for the period – realised and unrealised.4.1 EXAMPLE£Profit for the year from P&L XUnrealised surplus on revaluation of fixed assets XSurplus/(deficit) on revaluation of investment properties XImpairment loss (X)Total recognised gains and losses for the year XPrior period adjustments (X)Total gains and losses recognised in period X5 RECONCILIATION OF MOVEMENT INSHAREHOLDERS’ FUNDSFRS 3 requires that this statement is either a primary statement or is included in the notes to the accounts. Its aim is to draw together profits, losses and gains from other statements and to show an overall picture of performance for the year.5.1 EXAMPLE£ £


Profit for the year from P&L XDividends (X)Retained profit XOther recognised gains and losses XCapital and reserve movements:Share issue XRevaluations XXNet addition to shareholders’ funds XOpening shareholders’ funds (amended for prior period adjustments) XClosing shareholders’ funds X5.2 EXERCISE 1Extracts from the profit and loss account of A Ltd for the year ended 31 December 20Z1.£000Profit after tax 321Dividend (58)Retained profit 263During the year the following events took place:• Assets were revalued by £55,000.• Proceeds of £350,000 from share capital issued during the year.• Stock was written down by £25,000.• A fixed asset with a carrying value of £120,000 was written down to £90,000. The impairment occurred as a result of general price changes. The depreciated historic cost of the asset was £100,000 at the date of impairment.• Shareholders’ funds at the beginning of the year were £825,000.Show how the events for the year would be shown in the statement of recognised gains and losses and the reconciliation of movements in shareholders’ funds.6 PRIOR PERIOD ADJUSTMENTSPrior period adjustments only occur when there are material adjustments applicable to prior periods arising from:• A change in accounting policy e.g. development expenditure• Correction of fundamental errors. An error is fundamental if the truth or fairness of the financial statements is compromised. The adjustment will involve restating comparative figures and reserves. The restatement should be disclosed and explained in the notes and in the statement of total recognised gains and losses.


Paper 2.5CHAPTER 5

FIXED ASSETS1 TANGIBLE FIXED ASSETS

Tangible fixed assets are items which are owned by the business, have a physical substance and are used on a continuing basis in order to earn revenue for the entity.This subject is covered by FRS 15 which states that the value of fixed assets should be measured by their cost. This is purchase price less trade discount plus any further costs payable before the asset is ready for use. This applies to assets purchased or constructed. Assets which have been donated should be capitalised at their value at the date of receipt.1.1 FINANCE COSTSThe capitalisation of finance costs is optional – property companies are keen to capitalise the loan interest relating to the construction of properties. FRS 15 sets out rules which must be followed if interest is capitalised, as follows:• Costs must be directly attributable • Total finance costs capitalised in a period must not exceed total amount of finance costs incurred in that period• Capitalisation should begin when finance costs and expenditure for the asset are being incurred and when activities relating to getting the asset ready for use are inprogress• Capitalisation must be suspended during long periods when activity relating to the asset is suspended• Capitalisation must stop when all the activities necessary for the asset to be useable are finishedWhen finance costs are capitalised the following disclosures are necessary:• Accounting policy• Total amount of finance costs capitalised• Amount of finance costs capitalised in the period• Amount of finance costs in the profit and loss account• The interest rate used regarding the capitalisation of finance costs, i.e. the capitalisation rate.1.2 SUBSEQUENT EXPENDITUREThere are three circumstances when subsequent expenditure on a fixed asset should be capitalised, as follows:• When the economic benefits of the asset are enhanced• When a component of an assets which has been separately depreciated is renewed• When an asset which has been depreciated is overhauled thereby restoring its economic benefits.1.3 REVALUATIONThe ABS encourages the use of current valuation of fixed assets. FRS 15 gives guidance on this subject. The rules are as follows:• Revaluation is optional• One asset in a class cannot be revalued in isolation – the whole class must be revalued• The policy on revaluation chosen must be applied to all revaluations• The carrying value of a revalued asset should be its current value at the BS date.In general valuations should be carried out by a qualified valuer every five years unless there is a material change in value in the intervening period. However, there are specific rules for properties. Disclosures where assets have been revalued are as follows:• Name and qualification of valuer• Basis of valuation


• Date and amount of valuation• Depreciated historic cost• Whether valuer is internal or external• A statement to the effect that the directors are aware of no material change to the valuation if there is no update• Date of the last full valuation1.4 EXERCISE 1An extract from the balance sheet of A Ltd at 31 March 20X3:£000Buildings Cost 1,400Depreciation 2001,200The building is revalued on 1 April 20X3 at £1,700,000. Its useful economic life is 50 years from then.What would be the relevant extracts from the final accounts for the year ended 31March 20X4?1.5 SOLUTION 1Profit and Loss Account for the year ended 31 March 20X4£’000DepreciationNotes to the accounts for the year ended 31 March 20X4Tangible fixed assets: £’000BuildingsCost 1 April 20X3Revaluation ______Valuation 31 March 20X4 ______Accumulated depreciation at 1 April 20X3RevaluationCharge for the year _____Accumulated depreciation at 31 March 20X4 _____Net book value at 31 March 20X4 _____Net book value at 31 March 20X3 _____ReservesRevaluation reserve _____NB The revaluation reserve is made up of the credit entries relating to the write back of accumulated depreciation of £200,000 and the revaluation of £300,000. These gains can only be taken to the profit and loss account when they are realised, although losses on revaluation relating to absolute loss of economic benefits should be taken directly to the profit and loss account.1.6 DEPRECIATIONFRS 15 requires that fixed assets should be depreciated over their expected useful lives. The depreciable amount is cost less residual value. In practice the residual value is often estimated as nil but it is important to remember the definition and that there are cases when it is relevant. Expected useful economic life should be reviewed at the end of each accounting period and revised if significantly different from previous periods. A similar process should be carried out for residual value if it is material. If an asset comprises more than one major component with different economic lives then these should be depreciated separately. Where an asset requires material expenditure at times throughout its economic life and the costs are capitalised, these should be separately depreciated. For example, if an aircraft has an estimatedeconomic life of 10 years and must be overhauled every two years at significant cost, then the cost of each overhaul should be spread over two years in the form of depreciation.1.7 INVESTMENT PROPERTIESAn investment property is an interest in land or buildings which is being held for its investment potential and in respect of which all construction and development has been completed. SSAP 19 requires that such assets are held at their current open market value and not depreciated as they are not being consumed. The names and qualifications of valuers together with the basis of valuation should be disclosed. Changes in the value of the assets from period to period should be shown in the STRGLThe requirements of SSAP19 conflict with those of the CA85 regarding depreciation however in this case CA85 is overridden in order to show a true and fair view.


2 GOODWILLGoodwill is the difference between the value of a business as a whole and the fair value of its separate components. FRS 10 Goodwill and intangible assets was issued in 1997 and replaced SSAP22.Purchased goodwill arises when one business acquires another as a going concern.This will be recognised in the accounts of the acquiring entity and will be depreciated in the profit and loss account.Non-purchased (inherent) goodwill exists in all successful businesses but does not appear in the financial statements as nothing has happened that could establish itsvalue.Goodwill is an accounting anomaly and there are many arguments for and against each way of accounting for it.2.1 EXERCISE 2List the arguments for and against each of the following accounting treatments of goodwill:• carry as an asset, amortise over useful life in profit and loss account• eliminate against reserves on acquisition• carry as an asset without amortisation unless there is permanent impairment in value.2.2 NEGATIVE GOODWILLThis arises when an entity is purchased for less than the aggregate fair value of its separate components. FRS 10 requires that negative goodwill should appear on the face of the balance sheet immediately below goodwill. The goodwill figures should then be subtotalled. The negative goodwill should be released to the profit and loss account in the periods in which the non-monetary assets (fixed assets and stock) are recovered. Negative goodwill in excess of the fair values of the non-monetary assets should be released to the profit and loss account in the periods during which it is expected that the benefit will be felt.For example, if a business with fixed assets of £100,000 (5 years useful life remaining)and stock of £30,000 were acquired with negative goodwill of £40,000 arising, then the credit in the profit and loss account for the following year would be:(100,000 + 30,000) = 50,000 x 40,000 = £15,2005 130,0003 INTANGIBLE FIXED ASSETSIntangible fixed assets are those which are controlled by the business but have no physical substance and are non-financial. Examples are patents, licences, brand names and publishing rights. Goodwill is also intangible but whereas goodwill is an intrinsic part of the entity other intangibles can be disposed of separately without disposing of the business as a whole. Until the issue of FRS10 there was no standard dealing with intangible assets (other than development expenditure and goodwill, discussed above). Most businesses assigned fair values to these assets but it was possible to incorporate such assets into the balance sheet by revaluation which did not help users.FRS 10 requires that goodwill and intangible assets be capitalised and depreciated in the profit and loss account over the periods during which they are depleted. There must be adequate disclosure to ensure that users can determine the impact of intangibles on the financial statements.3.1 DISCLOSURESThe following disclosures are required regarding intangible fixed assets:• Method of valuation• For each class of intangible asset at the beginning and end of the period:• Cost or revaluation• Cumulative amount of amortisation or impairment• Reconciliation of movements• Net carrying amount• Profit or loss on each material disposal• Methods and periods of amortisation with reasons• Details of changes to methods or periods used• Grounds for choosing periods of amortisation of longer than 20 years4 RESEARCH AND DEVELOPMENT (R & D)There are three categories of R&D as defined by SSAP 13. These are:• Pure research• Applied research• DevelopmentThe only one of these which may be capitalised is development and then only when certain conditions are met:• There must be a clearly defined project• Expenditure must be separately identifiable


• Outcome of project must have been assessed with reasonable certainty regarding technical feasibility and ultimate commercial viability• Total costs must reasonably be expected to be exceeded by future revenue• Adequate resources exist to enable the project to be completedWhen development costs are capitalised they must be amortised and the accounting policy stated with explanations. The profit and loss account must show a breakdown of R&D expenditure incurred in the year and that which relates to amortisation. Movements on the R&D account during the year must also be disclosed.5 IMPAIRMENT OF FIXED ASSETSImpairment is a reduction in value of a fixed asset to less than its carrying value. This is covered by FRS 11 which requires that a review for impairment must be carried out if there are indicators that impairment might have occurred. Assets should be stated at the lower of their carrying value and recoverable amount. The recoverable amount is the higher of the net realisable value and the value in use (which is determined by assessing the present value of future cash flows from the asset’s continued use).5.1 INDICATORSExamples of indicators that impairment could have occurred are:• Continuing periods of losses• Significant decline in market value• Obsolescence or physical damage• Significant adverse change in the asset’s related business or market• Commitment by management to undertake a significant reorganisation• Loss of key employees• Significant increase in interest rates5.2 ALLOCATION OF IMPAIRMENT LOSSESIf it is not obvious which particular assets are impaired (in which case losses would be allocated to those assets) then losses arising are allocated as follows:• Goodwill• Other intangible assets• Tangible assets5.3 EXERCISE 3An impairment loss of £40,000 arises in connection with an income-generating unit.The carrying amount of the assets in the unit, before impairment, is:£000Goodwill 20Patent (no market value) 15Tangible fixed assets 5085How should the impairment loss be allocated?5.4 RECOGNITION OF LOSSES IN FINANCIAL STATEMENTSImpairment losses should be recognised as follows:• For assets at historic cost in the P&L (as an exceptional item if appropriate)• Revalued assets in the P&L if impairment caused by clear consumption of economic benefits, otherwise in the STRLG until carrying value reaches historic NBV and thereafter in the P&L .The remaining useful life and residual value of the asset should be reviewed and the revised carrying amount depreciated as normal. When a reversal of impairment is necessary the adjustments should take place according to how the original entries were made.5.5 DISCLOSUREDisclosure of impairment in the notes of the accounts should be as follows:• For assets at historic cost impairment should be included with cumulative depreciation• For revalued assets at market value impairment should be included with the revaluation• For revalued assets held at depreciated replacement cost impairment in the P&L should be included with cumulative depreciation but impairment in the STRGL should be deducted from the carrying amount


Paper 2.5CHAPTER 6

STOCK AND LONG-TERM CONTRACTS1 STOCK

SSAP 9 requires that stock is valued in the balance sheets at the lower of cost and net realisable value.Cost includes all directly attributable costs incurred in bringing stock to its present location and condition i.e.• Raw materials• Delivery – including import duties, transport and handling costs• Manufacturing – including production overheadsNet realisable value (NRV) is the expected proceeds of sale net of all expected costs of sale.1.1 EXERCISE 1Spidergirls have cost S Toys Ltd the following:Per unit£Plastic 0.3Variable manufacturing costs 0.4Fixed manufacturing costs 0.6Advertising 0.7They can be sold for £1.20 each although this will involve an additional cost of £0.2.Calculate the cost, NRV and value of stock of the 2,000 Spidergirls.1.2 DISCLOSURECA85 requires that disclosure must be made for separate groups of stock items that they have been valued at the lower of cost and NRV. Stock must be classified as follows:• Raw materials• Work in progress• Finished goods and goods for resale• Payments on account2 LONG-TERM CONTRACTSA long-term contract is one which straddles a year end and falls substantially into two or more accounting periods. It can be argued that it is prudent to take any profit arising from such contracts at the end. However this goes against the matching concept allowing costs to appear in former periods and the related income in later periods which has the effect of skewing the results, and does not present a true and fair view of the activities of the business. Therefore where the eventual profit can be assessed with reasonable certainty a proportion of the turnover and profit may be recognised in theprofit and loss account in earlier periods when related costs are charged.2.1 CALCULATION OF ATTRIBUTABLE PROFITSSAP 9 requires that a proportion of the profit equal to the proportion of work which has been carried out at the accounting date may be recognised in the profit and loss account. In order to arrive at this amount for profit the percentage of turnover must be credited to the P&L from the ‘amounts recoverable on contract’ account and relatedcost of sales debited from the ‘work in progress’ account.2.2 ACCOUNTING TREATMENTAs costs are incurred:


Dr. Long-term contract a/c, WIP/Stock a/c,Cr. Cash/CreditorsAs progress payments are invoiced:Dr. Trade debtorsCr. Amounts recoverable on contractAttributable profit is arrived at by:Dr. Amounts recoverable on contractCr. TurnoverDr. Cost of salesCr. Work in progressThe percentage of both amounts, turnover and costs of sales, must be the same.2.3 MEASURING THE DEGREE OF COMPLETIONThe two commonly used methods for measuring the degree of completion are:Work certified basis which is the percentage of work certified to date compared to the total contract valueCost basis which is the percentage of cost incurred to date compared to the total estimated cost.It must be stressed that profit may only be recognised where the outcome of the contract can be assessed with reasonable certainty. Usually the price has been agreed in advance but costs are always difficult to assess with certainty and consequently will have to be estimated.2.4 EXERCISE 2Total contract price £120,000Costs incurred to date £55,000Estimated costs to completion £35,000Progress payments receivable- £60,000 received £70,000Percentage complete 60%What would be the relevant extracts from the P&L and BS?2.5 SOLUTION 2Profit and loss account £000TurnoverCost of sales ____Gross profit ____Balance sheetWork in progress ____Trade debtors ____Amounts recoverable on contract ____2.6 PROGRESS PAYMENTS IN EXCESS OF RECOGNISED TURNOVERIf the amount received or receivable on a contract exceeds the amount taken to turnover in a period then the excess should either be deducted from work in progress or, if there is none, then it should be separately disclosed in creditors as ‘excess payments on account’.2.7 FORESEEABLE LOSSESLosses should be recognised by setting up a provision as soon as they are foreseen.2.8 DISCLOSURESSAP 9 requires the following disclosures:• Stock – costs incurred net of transfers to cost of sales separating, for long-term contracts, net cost less foreseeable losses and applicable payments on account• Debtors – amount by which turnover exceeds payments on account• Creditors – excess payments on account received• Provisions for liabilities and charges – amount by which provision for future losses exceeds costs incurred.2.9 EXERCISE 3Using the information in 2.4 above, rework the answer assuming that the contract is only 55% complete.


Paper 2.5CHAPTER 7

PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS FRS 12

FRS 1 Provisions, contingent liabilities and contingent assets sets out precisely when provisions should be recognised and contingent assets and liabilities disclosed in financial statements. This was previously covered by SSAP 18, which has now been superseded. The need for FRS 12 was that provisions were being used increasingly to smooth profit trends leading to the possibility of misleading information in the financial statements.1 PROVISIONS1.1 DEFINITIONFRS 12 defines a provision as a liability of uncertain timing or amount. A liability is an obligation to transfer economic benefits as a result of past transactions or events.1.2 RECOGNITIONA provision should be recognised in the financial statements only in the following circumstances:• When an entity has a present obligation as a result of a past event• When it is probable that a transfer of economic benefit will be required to settle the obligation• When a reliable estimate can be made of the amount of the obligation.• The circumstances relating to the recognition of a provision should be reviewed each year and adjustments made if necessary1.3 MEASUREMENTThe amount of a provision should be realistic. This means that a prudent view should be taken of the amount needed to discharge an obligation existing at the balance sheet date.1.4 EXAMPLEIf a retail store has a well-known policy of no-questions-asked refunds then a provision can be made in the financial statements at the 31 December year-end as the three circumstances in 1.2 above are met. The amount of the provision will be based on previous years.1.5 APPLICATION• Provision should not be made against future operating losses.• Provision should be made for the net loss arising on an onerous contract. An onerous contract is one in which the unavoidable costs of completion exceed the benefits.• Provision should only be made for restructuring costs when an entity has an obligation to restructure. This arises when an entity has a formal plan and has raised valid expectation in those affected that a restructuring will take place.• Provision should not be made for periodic repairs to assets. The obligation could be avoided by sale of the asset and the liability should be reflected in the depreciation charge.• Provision should be made for rectification of environmental damage at the time and to the extent that obligation arises1.6 DISCLOSUREFor each class of provision disclose:• Carrying amount at beginning and end of the period• Additional provisions made in the period• Amounts used in the period• Amounts reversed in the period• Effect of discounting in the period


• Description of nature of obligation and expected timing of outcomes• Indication of uncertainties of amount or timing of outcomes• Amount of any expected reimbursements2 CONTINGENT LIABILITIESA contingent liability is either:A possible obligation arising from past events which will be confirmed in the future by the occurrence of events not within the control of the entity, or A present obligation arising from past events not recognised in the financial statementsbecause it is probable that either no transfer of economic benefit will be necessary for discharge or because it is not possible to reliably measure the amount needed for discharge of the obligation.Contingent liabilities should not be recognised in the financial statements but should be disclosed unless the possibility of transfer of economic benefit is remote. The disclosure required is an estimate of its financial effect and an indication of the uncertainties relating to the amount or timing of future outflows.3 CONTINGENT ASSETSA contingent asset is a possible asset arising from past events which will be confirmed in the future by the occurrence of events not within the control of the entity. Contingent assets will not be recognised in the financial statements because of the uncertainty element, however they should be disclosed where there is a probable inflow of economic benefits. The disclosure required is a brief description of their nature with an estimate of financial effect.The most common examples of contingent assets and liabilities are in connection with legal action. When one entity is suing another and damages may be involved but the outcome is uncertain there could well be a contingent liability in the financial statements of one entity and a contingent asset in the other.4 POST BALANCE SHEET EVENTS (PBSE)PBSE are events which occur between the balance sheet date and the date of approval of the financial statements by the board of directors. PBSE’s are covered by SSAP 17, can be favourable or unfavourable and are either adjusting or non-adjusting events.4.1 ADJUSTING EVENTSAdjusting events are those which provide additional evidence regarding conditions existing at the balance sheet date about items which are reflected in the financial statements. Examples include:• Provisions for stock and bad debts• Insurance claims under negotiation• Dividends• Transfers to reserves• Taxation4.2 NON-ADJUSTING EVENTSNon-adjusting events are those which concern conditions which did not exist at the balance sheet date. Therefore there will be no effect on any amounts in the financial statements. However, disclosure of such events will be necessary if they are material in order that a true and fair view is shown and that the financial statements are not misleading.Examples include:• Issue of share or loan capital• Financial consequences of losses due to fire or flood damage• Changes in the composition of the entity4.3 WINDOW DRESSINGSSAP 17 requires disclosure of material transactions entered into prior to the year-end and reversed after the year-end which have the effect of enhancing the financial statements of the entity – i.e. no transaction has really taken place but rather legal form has been entered into with no substance. A popular way of improving the liquidity ratio is to increase liquid assets and creditors to produce a higher ratio thereby impressing users of the accounts.4.4 FUTURE CHANGESIn May 2004 the ASB issued FRS 21 Events after the Balance Sheet Date which will replace SSAP 17. This is effectively the international standard rebadged, and the primary point of difference is that dividends declared after the year end date will be classified as non-adjusting events.


Paper 2.5CHAPTER 8

HIRE PURCHASE AND LEASING

It is normal for businesses to acquire assets through hire purchase and leasing and in many cases the benefits of ownership pass in substance to the entity acquiring and using the asset even though ownership itself does not pass in true legal form. SSAP 21 covers the accounting treatment necessary for the correct disclosure of these contracts in order that the transaction is reported fairly in the financial statements without misleading effects on the gearing ratio.1 HIRE PURCHASEUnder a hire purchase contract ownership does not pass until the final instalment has been paid if the option to purchase is exercised. However the accounting treatment for such contracts requires that the asset be capitalised at the outset at its cost and that the interest payments be put through the profit and loss account as they are paid – being a cost of finance.2 CREDIT SALE AGREEMENTA credit sale agreement is one whereby payment for goods is spread over five or more instalments. Ownership passes on delivery of the goods to the buyer. Credit instalments are paid and the accounting treatment is the same as that for goodsacquired under a hire purchase agreement.3 FINANCE LEASESUnder a lease agreement goods are hired for a fixed minimum period with rights of renewal. The goods remain the property of the hirer. A finance lease is one in which the rights and responsibilities of ownership of the asset pass to the lessee. The substance of such a lease is the same as an asset acquired under a hire purchase agreement. There are certain features which indicate whether a lease falls into this category. The two main ones are:• The ‘90% test’ – if at the beginning of the lease the present value of the minimum lease payments amounts to substantially all (90% or more) of the fair value of the leased asset. This test is performed in the following way:• Discount MLP to the present value• Calculate the minimum lease payment (MLP)• Estimate the fair value of the asset i.e. the value at which the asset could be acquired in an arm’s length transaction• Compare the fair value with the discounted MLP• That all the risks and rewards of ownership pass to the lesseeSSAP 21 states that the even if the 90% test applies a lease should not be treated as a finance lease if the risks and rewards of ownership have not passed to the lessee. Also if it fails the 90% test but the risks and rewards have passed then it should be treated as a finance lease. However, this should only be done in ‘exceptional circumstances’ which can cause interpretation problems.Essentially a lease is a finance lease if:• The lessee may use the asset for its economic life• The lessee is responsible for repairing and insuring the asset• The asset is a specialist item so that only the lessee can use it• There is an option of a secondary lease term at a nominal rent.3.1 ACCOUNTING FOR FINANCE LEASESAt the outset of the lease an amount equivalent to the fair value of the leased asset should be capitalised ie the capital cost. The credit entry is to the obligation under finance lease account. The asset should be depreciated over the shorter of:• The useful economic life• The lease term


The finance charge is the difference between the fair value of the asset and the total amount to be repaid. This is charged to the profit and loss account over the period of the lease. The difficulty arises with how to apportion the finance charge between the relevant periods. There are three main methods of apportionment:• Actuarial methodThe implied rate in the lease is used, the charge for each period being calculated according to the capital outstanding.• Sum of the digits methodThis is an approximation of the above method and should only be used when the implied rate is not available.• Straight line methodThis involves apportioning the charge equally over the period of the lease. It is not very accurate, and should only be used when the amounts involved are immaterial.The finance charge should be debited to the profit and loss account and credited to the obligations under finance lease account to increase the liability. On payment of an instalment the obligations under finance lease is debited to reduce the liability and cash will be credited.3.2 DISCLOSUREThe amount included in the deprecation charge in the profit and loss account which relates to assets held under finance leases must be disclosed separately in the operating profit note. The finance charge must be disclosed separately in the interest payable and similar charges note.In the fixed assets note the net book value of assets held under finance leases should be shown separately. The creditors notes must also specify the amounts outstanding under finance leases and in addition the following sub-divisions:£Amount falling due within one year X2-5 years XAfter 5 years XXLess: future finance charges (X)XAlternatively the above break-down may be shown net without the separate figure for future finance charges.3.3 EXERCISE 1Winthrop Ltd leases an asset which has a useful economic life of 5 years. It is responsible for maintenance of the asset. The item could be purchased for £33,000.The implied rate of interest in the lease is 10%. The annual rentals, which span its useful economic life, are £7,500.Is this a finance lease?4 OPERATING LEASESAny lease which does not fall into the category of a finance lease is an operating lease. The accounting treatment of an operating lease is straightforward – rentals are charged to the profit and loss account on a straight-line basis over the period of the lease.4.1 DISCLOSUREIn the operating profit note the amount charged as operating lease rentals must be specified and broken down into that relating to the hire of plant and machinery and that relating to the hire of other items.A note must be made of commitments under operating leases. This does not relate to any figure in the accounts but rather gives information about future liabilities. The amounts must be broken down into commitments for land and buildings and those for other items. The timing of such payments must be specified – within one year, 2-5 years andafter 5 years.5 EXERCISE 2Winthrop Ltd leases another asset which would cost £20,000 on the open market. They will pay a deposit of £1,150 and then seven annual instalments of £4,000 at the end of each year.Calculate the interest charge for each year using• the actuarial method (the implicit rate of interest is 11% pa)• the sum of the digits method• the straight-line method.


Paper 2.5CHAPTER 9THE SUBSTANCE OF TRANSACTIONS, CAPITAL INSTRUMENTS, SHARES AND RESERVES

1 FRS 5: REPORTING THE SUBSTANCE OF TRANSACTIONS

FRS 5 was issued to address the issues of ‘off balance sheet financing’ and the resultant problems and misleading effects caused in the financial statements. Prior to the issue of the FRS it was possible, and becoming increasingly popular, to make complex arrangements and account for them in a strictly legal form which had the effect of misrepresenting the overall financing of an entity in the accounts. FRS 5 states that the commercial substance of a transaction should be recognised in the financial statements of a business in preference to the legal form. To determine the substance of a transaction it is necessary to define assets and liabilities so that it can be readily established whether a change to either has taken place.• An asset is defined as rights or other access to future economic benefits as a result of a transaction.• A liability is an obligation to transfer economic benefits as a result of a transaction1.1 RECOGNITIONThis is the process of including an item into the primary financial statements in the form of a verbal description and monetary amounts. For this to be done there must be a process of enquiry. This involves asking the following questions:• Has a transaction taken place?• If so, has this lead to future economic benefits and/or future risks?• Is the asset controlled by the entity?• Is there evidence of existence of the item?• Can measurement be made in monetary terms with sufficient reliability?1.2 CONSIGNMENT STOCKThis is stock held by one party but owned by another and is common in the motor trade. It must be ascertained at what point the holder acquires the benefits of the stock to identify when the asset changes hand. This might not be the same point at which legal title is transferred.1.3 EXERCISE 1Supercar Ltd owns many car dealerships. The agreement between the manufacturer and the dealerships is as follows:• Legal title passes when cars are used for demonstration by the dealers or sold to a third party• The price is fixed at the date of transfer• There is no right of return vehicles to the manufacturer• The dealer pays a finance charge between the date of delivery and the date that legal title passes.How should Supercar Ltd account for the acquiring of cars from the manufacturer?1.4 SALE AND REPURCHASE TRANSACTIONSUnder these arrangements a business sells items to a third party on terms which allow the business to repurchase the items under certain circumstances. It needs to be determined whether there has, in fact, been a sale or whether the transaction is a secured loan. If the seller retains the benefits of use of the item and repurchase is likely then it should be


accounted for as a loan.1.5 SALE AND LEASEBACKThis is similar to a sale and repurchase above however, it must be ascertained whether the leaseback is a finance or operating lease. If it is a finance lease the lessee retains the risks and benefits of the asset then the transaction amounts to a loan secured on the asset rather than a sale. The lessee retains the asset in their balance sheet and the amount received is treated as a lease creditor.1.6 DEBT FACTORINGThe factoring of debts involves the original creditor selling the debts to a factor. If the benefit of the debts passes to the factor who then collects the money and takes the risk of non-payment upon himself then the asset passes to the factor. If, however, the original creditor has to pay interest on amounts passed to him by the factor and retains the risk of bad debts then the transaction amounts to a loan.2 CAPITAL INSTRUMENTSFRS 4 defines a capital instrument as any instrument issued by reporting entities as a means of raising finance. This includes shares, debentures, loan and debt instruments, options and warrants giving the holder rights to subscribe for or obtain capital instruments. It is important that there is consistency between reporting entities on how each instrument is accounted for otherwise the gearing ratio becomes meaningless and it is impossible to compare between one entity and another.2.1 CLASSIFICATIONAll capital instruments should be accounted for on the balance sheet within one of the following categories:LiabilitiesShareholders’ fundsMinority interests (only in the case of consolidated accounts)Paragraph 24 of FRS 4 states that:“Capital instruments should be classified as liabilities if they contain an obligation to transfer economic benefits.”The most common economic benefit is the payment of cash either as interest or on redemption. Those instruments that do not contain such an obligation should be reported within shareholders’ funds.Shares should not be classified as liabilities as they have a distinct legal status as set out in company legislation regarding the circumstances in which payments may be made in respect of them.2.2 ACCOUNTING FOR CAPITAL INSTRUMENTSISSUE COSTSAfter issue the carrying amount should be stated at the amount of the net proceeds. The net proceeds is the value of consideration less issue costs. In subsequent periods the carrying amount is increased by finance costs and reduced by payments made to reduce the debt.FINANCE COSTSThis is the difference between the amount of the fair value of consideration less issue costs and the payments required to be made by the issuer of the instrument. These should be allocated to periods over the term of the debt at a constant rate on the outstanding amount.CONVERTIBLE DEBTConvertible debt should be shown as a liability and finance costs charged as if the debt will not be converted. On conversion the outstanding debt should become the amount of consideration for the shares.2.3 EXERCISE 2Pickle Ltd issues a discount bond of £400,000 on 1 April 20X0 the proceeds of which are £315,526. Interest is 4% and payable annually on 31 March. The redemption date for the bond is 31 March 20X5 at par.The total cost of borrowing to be charged through the profit and loss account over the seven years is:£Annual interest payments (5 x 16,000) 80,000Discount (400,000 – 315,526) 84,474


164,474The internal rate of return is 9.5%.Show, for each year, the carrying value of the bond and the P&L charge.2.4 SOLUTION 2Year P&L Liability£ £31.03.X131.03.X231.03.X331.03.X431.03.X5If there was an option to convert the bond into 220,000 ordinary shares of £1 each at 31 March 20X5 and this option were taken then the credit entries corresponding to the £400,000 debit to the bond liability account would be:Share capital ?Share premium ?2.5 DISCLOSUREMATURITY OF DEBTThis is determined by reference to the earliest date on which the lender can demand repayment. The financial statements must include an analysis of the maturity of debts with the timing split as follows:• Due in one year or less, or on demand• Due between one and two years• Due between two and five years• Due after five years or moreCONVERTIBLE DEBTThis should be shown separately from other liabilities with the following details:• Date of redemption• Amount payable on redemption• Number and class of share into which debt may be converted• Period in which conversion may take place• Whether conversion is at the option of the issuer or holder.3 SHARE CAPITALUnder FRS 4 the balance sheet must show the amount of shareholders’ funds attributable to equity and non-equity interests separately.3.1 EQUITY SHARESEquity shares are those which are other than non-equity.3.2 NON-EQUITY SHARESNon-equity shares:• Are redeemable, or• Are those in which rights to receive payments are limited and not calculated by reference to profits, assets or equity dividends, or• Are those in which rights to receive payments on a winding up are limited and not calculated by reference to profits or assets.The most common example of non-equity shares is preference shares. Non-equity shares are treated as liabilities except that the finance charge should be reported as an appropriation of profit.3.3 SCRIP DIVIDENDSWhen shares are issued in lieu of dividends the value of the shares issued should be reflected in the profit and loss account as an appropriation of profit – just as it would have been had a dividend been paid.


3.4 ISSUE COSTSCosts relating directly to the issue of shares should be deducted from the gross proceeds of the issue resulting in a net proceeds figure.3.5 DISCLOSURE• Analysis of share capital between equity and non-equity• Summary of rights of each class of share as follows:• Rights to dividends• Dates at which shares redeemable and amounts payable• Priority and amounts receivable on winding up• Voting rights.• Details as above for warrants or convertible debt where new class is required• Aggregate dividends for each class of shares.3.6 PURCHASE OF OWN SHARESAny limited company may, if authorised in its articles, purchase its own shares. There are detailed requirements regarding notice to the registrar and disclosure in the directors’ report. The reasoning behind the facility is that a company may use surplus capital and enable the existing shareholdings to remain undiluted. This could be ofmbenefit to a private company where the existing shareholders are unwilling or unable to purchase available shares but where it is important to them to retain the same percentage holding.4 RESERVES4.1 DISTRIBUTABLE PROFITA company with limited liability may not pay out capital to its members except by a strictly regulated process of reduction of capital or in a liquidation. This safeguards the rights of creditors. A company may only pay its members out of distributable profits.4.2 DIVIDENDSFor the same reason as above, dividends may only be paid out of profits. Profits available for dividend are accumulated, realised profits which have not been used less accumulated, realised losses which have not been written off.• AccumulatedThis requires that the balance of profit or loss from previous years be brought into account in the current period• RealisedThis prohibits the use of unrealised profits from being distributed – e.g. relating to the revaluation of fixed assets.The Companies Act 1985 gives further rules concerning distributable profits as follows:• A provision in the accounts is a realised loss• A revaluation surplus is an unrealised profit• A revaluation deficit is an unrealised loss• Additional depreciation charged relating to revaluation may be added back for the purposes of calculating the amount available for distribution – this is done by transfer between reserves• Unrealised losses or surpluses become realised upon disposal of a revalued asset• Where there is no record of the original cost of an asset, its cost may be taken as that when there was the first available record• Where there is no record of whether a profit or loss brought forward is realised or not, the profit may be treated as realised and the loss unrealised.• A capitalised development cost is a realised loss and must be deducted from profits when calculating amounts available for distribution; unless SSAP 13 capitalisation criteria met in full when deemed to be unrealised4.3 ADDITIONAL RULES FOR PUBLIC COMPANIESA public company may not pay a dividend unless its net assets are at least equal to the aggregate amount of its called-up share capital and undistributable reserves.The undistributable reserves are:


• Share premium• Capital redemption• Unrealised profits less unrealised losses• Any other reserve which the company is prohibited from distributing by statute or by its own memorandum or articles of association. This means that any excess of unrealised losses must be deducted from realised profits when calculating the amount available for distribution.

Paper 2.5CHAPTER 10

TAXATION1 CURRENT TAX

Current tax is covered by FRS 16 and includes corporation tax, income tax and tax credits on investment income. It should be recognised in the profit and loss account except when it is attributable to a gain or loss in the STRGL in which case the relevant tax should also be recognised in that statement.1.1 CORPORATION TAXCorporation tax is provided in the financial statements but is never an accurate amount as the actual amount payable will be agreed with the Inland Revenue at a date after the accounts have been approved. Each period will therefore usually have a profit and loss charge made up of the current year’s provision and an over or under provision forthe previous year.1.2 DIVIDENDS AND OTHER INCOMEThe financial statements should show dividends and interest at an amount that includes withholding taxes payable and excludes any other taxes. Withholding tax is tax on dividends or other income that is deducted by the payer of the income and paid over by them to the Inland Revenue wholly on behalf of the recipient. The amount is then paid to the recipient net but tax is paid on the gross amount so it is shown in the profit and loss account gross.1.3 INCOME AND EXPENSES SUBJECT TO NON-STANDARD RATES OF TAXIncome and expenses subject to non-standard rates of tax should be included in the financial statements on the basis of the income or expenses actually receivable or payable. No adjustment should be made to reflect a notional amount of tax that would have been paid or relieved in respect of the transaction if it had been taxable, or allowable for tax purposes on a different basis.Examples of these items are some leasing transactions and advances and investments made by financial institutions. The idea of making them non-taxable or subject to lower rates of tax is to make them attractive and profitable.1.4 EXERCISE 1Gee Limited has trading profits of £350,000. The estimated liability for corporation tax is £100,000. The proposed dividend is £75,000.During the year corporation tax of £80,000 was paid relating to the previous year in whose accounts the provision was £90,000. Also during the year Gee Limited received a dividend of £30,000. The tax credit relating to this dividend was 1/9 of the net amount.Prepare extracts from the financial statements of Gee Limited reflecting the above.2 DEFERRED TAXThe rationale behind deferred tax is that the profit as reported in the financial statements often bears little relation to the profit for taxation purposes because of differences between the rules covering tax and those covering financial accounts.There are two types of difference:• Permanent differences – those arising because some income and expenditure is not subject to taxation or not allowable for tax, e.g. entertainment expenses.• Timing differences – those arising because the attributable tax is dealt with in different periods in the tax computations and the financial accounts. These differences can therefore reverse in subsequent periods. Deferred tax is covered by FRS 19 and has come about in order to smooth over the timing differences above. Providing for deferred tax in full eliminates the effect of timing differences so that the tax charge reported in the financial statements relates directly to the reported


profit. FRS 19 has two objectives:• To provide for the future tax consequences of past transactions and events• To ensure that any special circumstances which may have an affect on future tax charges are disclosed in the financial statements2.1 TIMING DIFFERENCESShort-term timing differencesThese are differences arising though items being dealt with on an accruals basis in the accounts and a receipts/payments basis in the tax computations. Examples of these are provisions for repairs made in the accounts but not allowable for tax until expenditure is incurred and general bad debt provisions which are not allowable for tax.Accelerated capital allowancesThese arise when capital allowances are available at a higher rate than the related depreciation charged in the accounts.Revaluation surpluses on fixed assetsThese arise due to the fact that the actual taxation liability does not arise until the gain is realised on disposal. FRS 19 states that deferred tax should not be recognised on a revaluation unless there is a binding agreement to sell the asset.2.2 RECOGNITIONDeferred tax should be recognised in the statement where the related timing differences have been reported e.g. in reserves for revaluations.2.3 PRESENTATIONAn increase or decrease in the provision for deferred tax appears in the profit and loss account charge as part of tax on profit on ordinary activities (except where recognized as above).In the balance sheet, net deferred tax liabilities are shown under ‘provisions for liabilities and charges’ and net deferred tax assets as debtors.2.4 CALCULATIONDeferred tax should be calculated at the average rates expected to apply when timing differences reverse. Thus,provisions may need to be restated for a change in tax rates.2.5 EXERCISE 2Keep Limited buys an asset for £100,000 and will depreciate it at 20% on a straight line basis. 25% writing down allowance on a reducing balance basis will be claimed as capital allowances. The rate of corporation tax is 30%.Calculate the deferred tax for two years.2.6 SOLUTION 2£Year 1Year 2In year 1 the accounting entries are:Dr Profit and loss account – taxationCr Deferred tax accountIn year 2 the accounting entries are:Dr Deferred tax accountCr Profit and loss account – taxationThe balance on the deferred tax account at the end of year 2 is £1,125. The original timing difference arising due to capital allowances exceeding depreciation will continue reversing and then become negative recognising a future tax saving because depreciation exceeds capital allowances.


Paper 2.5CHAPTER 11

GROUP ACCOUNTS – CONSOLIDATIONS1 INTRODUCTION

A number of companies controlled by a single body of shareholders is a group. Although each company is a separate entity legally the shareholders are interested in the performance of the group as a whole and so a single set of financial statements is needed to show the combined performance of the group. The accounts of the individual companies are combined into a set of consolidated accounts. There are other forms of group accounts but the most common is consolidated accounts. The essential feature of a group is that one company, the holding company, controls allthe others, the subsidiary companies. Control is of fundamental importance in the definition of a subsidiary by FRS 2 and CA 89 to reflect the commercial substance of the relationship between parent and subsidiary.2 BASIC CONSOLIDATIONWhen a company is acquired the shares in that company are purchased and these represent the assets and liabilities of the company. The acquiring company records the purchase of share capital as an investment in subsidiary. This investment remains at its historic cost. On consolidation the assets and liabilities of the companies are added together and the investment in subsidiary is cancelled out by the shareholders funds of the company acquired. Only the share capital of the holding company remains in the consolidated balance sheet.2.1 EXERCISE 1The balance sheets of Peter plc and Paul Ltd at 1 January 20X4 are as follows:Peter plc Paul Ltd£ £ £ £Fixed assets 50,000 5,000Current assetsStock 24,500 3,000Debtors 17,000 2,500Bank and cash 8,800 1,00050,300 6,500Creditors < one year 32,000 18,300 4,700 1,80068,300 6,800Share capital 30,000 2,000Profit and loss account 38,300 4,80068,300 6,800Peter plc acquired all the share capital of Paul Ltd on 1 January 20X4 for £6,800 paid for in cash.Show Peter plc’s balance sheet after the acquisition, and the consolidated balance sheet.


2.2 SOLUTION 1The balance sheet of Peter plc after this transaction is:£ £Fixed assetsInvestment in subsidiaryCurrent assetsStockDebtorsCash ______Creditors < one year __________________Share capitalProfit and loss account ____________The consolidated balance sheet is:£ £Fixed assetsCurrent assetsStockDebtorsBank and cash ______Creditors < one year __________________Share capitalProfit and loss account ____________2.3 GOODWILL ON CONSOLIDATIONIn the above example the consideration paid by Peter plc was exactly the same as the fair value of the net assets of Paul Ltd. This is not usually the case. When the consideration is more than the value of the net assets then goodwill on consolidation arises. This does not impact the balance sheet of the holding company itself but does affect the consolidation, where it is treated as an intangible asset and dealt with in accordance with FRS 10.When the consideration is less that the value of the net assets acquired this is negative goodwill or discount on acquisition. This is shown on the face of the consolidated balance sheet under goodwill and written back to the profit and loss account over the periods expected to benefit from the discount.2.4 RESERVESWhen a company is acquired part of the way through the year it is necessary to split the reserves on consolidation between those which existed at the date of acquisition (pre-acquisition reserves) and those arising after the acquisition date (post-acquisition reserves). Post-acquisition reserves form part of the group’s profit on consolidation.2.5 EXERCISE 2Assuming for the above example Peter plc had paid £8,000 for the share capital on 30 June 20X3 when the profit and loss account stood at £4,000, show the consolidated balance sheet at 31 December 20X3.2.6 SOLUTION 2£ £Fixed assetsGoodwill


Current assetsStockDebtorsBank and cash ______Creditors < one year __________________Share capitalProfit and loss account ____________2.7 MINORITY INTERESTSA minority interest arises if a company acquires a controlling amount of the share capital of another company but not all of it. In order to represent the fact that the holding company controls the assets of a subsidiary even though it does not own all of them – there being shares owned by others – a consolidation is usually done bringing in the counterbalancing liability of minority interest on the consolidated balance sheet. It must be shown as a separate main heading on the balance sheet, either under total assets less current liabilities or after the profit and loss account balance. It must not beshown between share capital and the profit and loss account amount as this presentation would imply that it is part of shareholders’ funds, which it is not.

2.8 EXERCISE 3Again using Exercise 1, if Peter plc acquired 1800 shares (i.e. 90%) in Paul Ltd for £7,200 on 30 June 20X3 what would have been the consolidated balance sheet at 31 December 20X3?2.9 SOLUTION 3£ £Fixed assetsGoodwillCurrent assetsStockDebtorsBank and cash ______Creditors < one year __________________Share capitalProfit and loss accountMinority interest ____________The minority interest is worked out as follows:Share capital 2,000Profit and loss account 4,8006,800 of which 10% is not held by Peter plc, i.e.£6802.10 SUMMARYWhen goodwill, a split of reserves or minority interests are involved in a consolidation each will require a consolidation schedule to show how the figures are calculated.When a subsidiary is acquired part of the way through the year a consolidated profit and loss account will also be necessary for that year, as it will be for all subsequent years when the group trades. The net assets of subsidiaries must be brought into the consolidated financial statements of the group at their fair value as opposed to their book value. Fair value is exchange value at arms length between willing parties. An


adjustment may need to be done in the consolidation if this has not been done in the books of the subsidiary.2.11 EXERCISE 4Plunder plc acquired 80% of Victim Ltd on 1 April 20X2. The profit and loss account balance of Victim Ltd at that date was £3,300. The balance sheets of the two companies at 31 December 20X2 are as follows:Plunder plc Victim Ltd£ £ £ £Fixed assets 55,000 10,500Investment in subsidiary 15,000Current assets 37,000 9,800Creditors < one year 18,200 6,40018,800 3,40088,800 13,900Share capital 40,000 10,000Profit and loss account 48,800 3,90088,800 13,900Goodwill is to be written off over four years.Prepare a consolidated balance sheet and the necessary supporting schedules at 31 December 20X2.3 EXEMPTIONS FROM GROUP ACCOUNTS3.1 GROUP ACCOUNTSThere is no requirement for groups which fulfil two out of the three following conditions to prepare group accounts:• Turnover < £11.2m net• Total assets < £5.6m net• Average number of employees < 2503.2 INDIVIDUAL SUBSIDIARYSubsidiaries may occasionally be excluded from a consolidation – in exceptional circumstances - on the following grounds:• Differing activities (this is rare)• Materiality• Severe long-term restrictions on control• New subsidiary held for resale• Disproportionate expense or undue delay (permissible under CA 85 but rejected by FRS 2)The completeness of the information presented in the consolidated accounts should not be put in jeopardy by excluding a subsidiary, but in cases where the exceptional circumstances listed above are identified FRS 2 makes it mandatory for the subsidiary to be excluded.


Paper 2.5CHAPTER 12GROUP ACCOUNTS –INTERCOMPANY TRANSACTIONS

1 TRADING TRANSACTIONS1.1 INTERCOMPANY BALANCES

Trading between two companies within the same group will be recorded through current accounts which should be equal to each other at all times unless there are items in transit. On consolidation these balances – payable in one group-company and receivable in another – will cancel each other out. Inter-company balances which do not agree on the consolidation date will need to be reconciled and the balances agreed. Differences due to items in transit will need adjustment in the books of the recipient to the cash or goods.1.2 STOCK SOLD AT A PROFIT WITHIN THE GROUPOn consolidation only profits made by the group selling goods to third parties should be recognised. Therefore any inter-group profits must be eliminated by making a provision in the books of the company making the sale, although the profit will be recognised in the company’s own accounts. This provision will only affect goods sold within the group which are in stock at the balance sheet date, as those which have been sold on have effectively only had their profit element split between members of the group. FRS 2 requires that the whole of any inter-group profit in closing stock should beeliminated on consolidation even if the subsidiary is partly owned. The minority’s percentage of the profit will be debited to the minority interest account thereby reducing it.1.3 EXERCISE 1Big Ltd acquired 80% of the share capital of Little Ltd on incorporation.There was cash of £5,000 in transit from Little to Big.During December 20X3 Little sold goods to Big for £20,000. Little sells its goods at a mark-up of 25%. Big had sold £4,000 of these goods before 31 December 20X3. Big sells its goods at a mark-up of 20%.Consolidate the balance sheets of Big Ltd and Little Ltd, which are shown on the next page, at 31 December 20X3.The balance sheets of Big Ltd and Little Ltd at 31 December 20X3 are as follows:Big Ltd Little Ltd£ £ £ £Fixed assets 100,000 30,000Investment in Little Ltd 8,000Current assetsStock 25,000 9,000Debtors – Little Ltd 10,000- Other 30,000 12,000Cash 20,000 3,00085,000 24,000Trade creditors (24,000) (6,000)Big Ltd - . (5,000)61,000 13,000169,000 43,000


Share capital 80,000 10,000Profit and loss account 89,000 33,000169,000 43,0001.4 TRANSFER OF FIXED ASSETSIf fixed assets are transferred at a profit within the group, then the profit must be eliminated on consolidation for the same reasons as the elimination of a profit on stockholding. The adjustment to the carrying value should be made in the books of the company which made the sale but the associated adjustment to reduce the amount of depreciation charged to an amount based on original cost rather than the new carrying value should be made in the books of the company holding the asset. Thus the entries are as follows:Dr P&L account reservesCr Fixed assetsFor the amount of unrealised profit in the books of the company making the saleDr Fixed assetsCr P&L account reservesThis reverses the extra depreciation in the books of the company holding the asset.2 PREFERENCE SHARES AND DEBENTURES IN SUBSIDIARY2.1 PREFERENCE SHARESWhen there are preference shares in a subsidiary and an interest in these is acquired with a controlling interest in the equity share capital, the percentage holding of the preference shares is applied only to those shares whereas the percentage holding of equity shares is applied to the shareholders’ funds for the purposes of calculating the group’s share of net assets and the share attributable to the minority. This is because it is most usual for preference shareholders to be entitled only to repayment of their capital in a winding up and not any of the profits.2.2 DEBENTURESThe nominal value of debentures held by the parent company will be cancelled out with a similar value of the same debentures in the subsidiary, leaving only those held by third parties as a creditor in the consolidated balance sheet.This procedure differs from the treatment of preference shares above as those shares not held by the parent company are treated as part of the minority interest in the consolidated balance sheet.3 DIVIDENDS AND DEBENTURE INTEREST IN SUBSIDIARY 3.1 DIVIDENDSDividends paid by a subsidiary to a parent company should not appear in the consolidated balance sheet – only those paid to the minority interest shareholders should appear. Adjustments will need to be made in a consolidation if dividends areproposed but not paid or those receivable have not yet been received.3.2 ACCOUNTING TREATMENTIf the dividend has been paid by the year-end no adjustment is necessary on consolidation as the amount paid by one company and received by the other will cancel each other out.If the dividend is outstanding at the year-end it is also just a question of cancelling out the proposed dividend and dividend receivable leaving the remaining portion as ‘dividend payable to minority shareholders’. If the dividend has not been accounted for correctly in either of the companies’ books then the entries must be made or corrected in the relevant company’s books before consolidation takes place.3.3 DEBENTURE INTERESTThe treatment of debenture interest from a subsidiary is treated the same way as dividends except that the remaining liability due to third parties is described as a creditor in the consolidated balance sheet – it has nothing to do with minority interest.3.4 EXERCISE 2The balance sheets of C Ltd and D Ltd for the year ended 31 July 20Y2 are as follows:C Ltd D Ltd£ £Fixed assets 175,000 35,000Investment in D Ltd 60,000 0Current assets 310,000 83,000Sundry creditors (110,000) (32,000)Proposed dividend (35,000) (6,000)400,000 80,000Ordinary share capital 250,000 40,000


Preference share capital 50,000 15,000Profit and loss account 100,000 25,000400,000 80,000C Ltd purchased 75% of the ordinary share capital and 33% of the preference share capital of D Ltd 4 years ago when the balance on the profit and loss account of D Ltd was £12,000. Goodwill has been fully amortised. The proposed dividend in C Ltd is made up of £10,000 relating to the preference shares, the balance to the ordinary shareholders. C Ltd has not accounted for any dividend due from D Ltd. The proposed dividend in D Ltd relates to the preference shares. There is also a dividend due of £10,000 to the ordinary shareholders which has not been accounted for.Prepare the consolidated balance sheet as at 31 July 20Y2.Paper 2.5CHAPTER 13

GROUP ACCOUNTS – PROFIT AND LOSSACCOUNT

A consolidated profit and loss account is prepared so that shareholders and other interested parties can see the results of the group for a period as though it were a single entity. It will also show how much of the profit accrues to the shareholders of the parent company and how much to the minority and how the directors will distributethe profit accruing to the shareholders. A parent company which is not a wholly-owned subsidiary must publish:• Its own balance sheet• A consolidated balance sheet• Its own profit and loss account• A consolidated profit and loss accountHowever a parent company may, and many do, take advantage of a dispensation offered by CA 85 - the ability not to publish its own profit and loss account if group accounts have been prepared in line with CA 85 and its own profit is disclosed in a note to the balance sheet.1 METHOD OF PREPARATION1.1 TURNOVER TO PROFIT AFTER TAXAmounts for parent and subsidiary are aggregated regardless of percentage owned by the parent – as long as control has been established.1.2 DIVIDENDS AND INTEREST RECEIVABLEDividends from subsidiaries are excluded. The part attributable to the minority is included in their share of the profit as the owners of the group are only interested in the amount of profit due to the minority – not how it is distributed to them. Intragroup interest should be eliminated on consolidation.1.3 MINORITY INTERESTThis is the profit after tax due to the minority.1.4 DIVIDENDSThis is the figure for dividends paid and payable by the holding company only.1.5 RETAINED PROFITSThis is the same calculation as that required for the balance sheet.1.6 MID-YEAR ACQUISITIONSPre-acquisition items should be excluded from group figures. It is most usual for profits to accrue evenly throughout a period although this might not be the case with seasonal trades.1.7 EXERCISE 1The profit and loss accounts of Large Ltd and Small Ltd for the year ended 31 December 20X0 are as follows:Large Ltd Small Ltd£ £Turnover 240,000 90,000Total costs 170,000 72,000Trading profit 70,000 18,000Taxation 25,000 6,000Profit after taxation 45,000 12,000Proposed dividend 15,000 4,000


Retained profit 30,000 8,000Reserves brought forward 70,000 20,000Reserves carried forward 100,000 28,000Large Ltd acquired 75% of the ordinary share of Small Ltd on 1 May 20X0. Profits have accrued evenly over the year and there is no goodwill.Prepare the consolidated profit and loss account.2 INTER-COMPANY TRADINGWhere there has been trading between group companies it is necessary to take out these transactions from sales and cost of sales, which would be inflated if this were not done. It is also necessary to take out any unrealised profit from the closing stock figure, as was done in the balance sheet section.2.1 EXERCISE 2• F Ltd and G Ltd are members of the same group• F Ltd buys an item of stock for £120• F Ltd sells it to G Ltd for £160 who has sold it by the balance sheet date What adjustments are necessary to the consolidated profit and loss account and balance sheet?3 PREFERENCE DIVIDENDSWhen the holding of preference shares is a different percentage to that of ordinary shares the relevant percentage for preference shares must be applied to the preference dividend for minority interest purposes. In calculating the minority interest the whole of the preference dividend is deducted from the subsidiary’s profit after tax, the resulting figure being the profit available for ordinary shareholders. The minority’s share of profits is computed from this figure in the normal way and the minority’s percentage of the preference dividend added to it.3.1 EXERCISE 3O Ltd owns 75% of the ordinary shares and 30% of the preference shares of P Ltd. The profit and loss account of P Ltd is as follows:£ £Sales 500,000Total costs 300,000200,000Taxation 30,000Profit after taxation 170,000DividendsPreference 30,000Ordinary 80,000110,000Retained profit60,000Calculate the minority interest.3.2 SOLUTION 3The minority interest is as follows:Profit after taxationLess: Preference dividend _______Profit available to ordinary shareholders _______Minority interest:_______ _______4 PRE-ACQUISITION DIVIDENDS4.1 ACCOUNTING TREATMENTThese are dividends paid to a parent company by a subsidiary out of pre-acquisition profits. There are two possible accounting treatments:• Treat the dividend as part of the cost of investment – i.e. as a reduction to the carrying value of the investment• Treat the dividend as investment income.The Companies Acts do not specify which treatment is preferable. However FRS 6 states that the carrying value of the investment should be reduced to the extent that the payment of the dividend represents a diminution in the investment’s value.4.2 CALCULATIONThere are two ways of apportioning a dividend between the pre- and post-acquisition periods:


• Time apportionment – traditional method and theoretically correct• Pre-acquisition dividend is the portion that cannot have been paid out of postacquisition reserves – minimises pre-acquisition dividends.5 TRANSFER OF FIXED ASSETSWhen fixed assets have been transferred between group companies adjustments need to be done on consolidation to show the profit and loss account as if the transfer had not taken place. Profit or loss arising on the transfer must be eliminated and depreciation must be adjusted so that it is based on the cost of the asset to the group. For a fixed asset sold to a group company at a profit the accounting entries are:Profit on transfer£ £Dr Profit on sale of fixed assets XCr Fixed assets XDepreciation expense XThe minority’s share of the reduction in depreciationDr Minority interest (P&L) XCr Minority interest (BS) X


Paper 2.5CHAPTER 14

FRS 9: ASSOCIATES AND JOINT VENTURES1 ASSOCIATED UNDERTAKINGS

An undertaking is a term used by CA 89 to include companies and unincorporatedbusinesses. An associate is an undertaking:• Which is not a subsidiary of the investing group or company• In which the investing group or company has a long-term interest• In which the investing group or company exercises significant influence.•CA 89 requires that associated undertakings be included in group accounts under the equity method which is detailed by FRS 9.1.1 SIGNIFICANT INFLUENCEIn theory significant influence involves participation in the financial and operating policies of a company rather than control. Such participation is indicated by representation on the board of directors. However, in practical terms significantinfluence is determined by voting rights in a company as set out in company law and similarly enforced by FRS 9.A holding of 20% or more of the voting rights of a company is deemed to be indicative of the ability to exercise significant influence and therefore associated status unless it can be otherwise demonstrated. The reverse also holds true for holdings of less than 20%.2 EQUITY ACCOUNTINGWhere an associate relationship exists, merely showing an investment at historic cost and dividends received is not fully reflective of the true substance of the relationship. FRS 9 requires that equity accounting is used. Equity accounting should also be used for subsidiaries excluded from consolidation under FRS 2 and joint ventures under FRS9.2.1 CONSOLIDATED BALANCE SHEETThe group’s share of the net assets of the associate should be included in the consolidated balance sheet separately as a fixed asset investment, not aggregated with the group’s assets. The carrying amount is therefore adjusted at the end of each period.Unamortised goodwill relating to the acquisition of the associate should be shown as part of the investment but separately disclosed. Negative goodwill should be deducted from the carrying value of the investment.The investment in the associate comprises:• Cost, plus• Group’s share of retained post-acquisition profits, less• Amounts written off.Equity accounting has the following effects on the total reserves figure of the group:• Increase due to share of post-acquisition reserves• Decrease due to write-offs (goodwill).2.2 CONSOLIDATED PROFIT AND LOSS ACCOUNTThe group’s share of the following are brought in immediately following the headings in which the group’s own figures are shown:• Operating results• Exceptional items• Interest receivable• Interest payable• TaxationAmortisation of goodwill due to the investment in the associate will be written off in the operating profit section and must be separately disclosed. There is no cancellation of intra-group items when accounting for an associate.3 JOINT VENTURES3.1 DEFINITION


FRS 9 defines a joint venture as follows:‘an entity in which the reporting entity holds an interest on a long-term basis and is jointly controlled by the reporting entity and one or more other venturers under a contractual arrangement’.A venture is jointly controlled if none of the parties concerned can control its activities alone but together they can.3.2 ACCOUNTING FOR JOINT VENTURESThe accounting treatment of joint ventures in consolidated accounts should be the equity method as detailed above. They are treated identically to associated undertakings except:• In the consolidated balance sheet the group’s share of gross assets and gross liabilities should be shown separately resulting in a net figure• In the consolidated profit and loss account the investor’s share of the joint venture turnover is shown but not as part of the group turnover. These points are illustrated by the illustrative lay-out reproduced from FRS 9 on the next page.4 JOINT ARRANGEMENTS4.1 DEFINITIONFRS 9 defines a joint arrangement as follows:‘a contractual arrangement under which the participants engage in joint activities that do not create an entity because it would not be carrying on a trade or business of its own’.A ‘joint venture’ must have some independence as an entity, carry on its own business and carry out more than a single project. Where these criteria are not met it is likely to be a joint arrangement.4.2 ACCOUNTING FOR JOINT ARRANGEMENTSThe ways in which joint arrangements will be accounted for are numerous. Each party will be responsible for accounting for their own assets, liabilities and profit according to the terms of their particular agreement.5 DISCLOSUREThe following disclosure is needed for all associated undertakings and joint ventures:• Name• Proportion of issued share capital, in each class, held by investor• Accounting period or date of financial statements used if different from investor• Indication of the nature of the business• Notes in accounts of associate necessary for understanding of the whole picture.6 ILLUSTRATIVE EXAMPLE (NO. 1 FROM FRS 9)CONSOLIDATED PROFIT AND LOSS ACCOUNT£m £mTurnover: group and share of joint ventures320Less: share of joint ventures’ turnover (120)Group turnover 200Cost of sales (120)Gross profit 80Administrative expenses (40)Group operating profit 40Share of operating profit in:Joint ventures 30Associates 245494Interest receivable (group) 6Interest payable:Group (26)Joint ventures (10)Associates (12)(48)Profit on ordinary activities 52Tax on profit on ordinary activities:Parent (5)Subsidiaries (5)


Associates (2)(12)Profit on ordinary activities after tax 40Minority interests (6)Profit on ordinary activities after tax and minority interest 34Equity dividends (10)Retained profit for group and its share of associates andjoint ventures24CONSOLIDATED BALANCE SHEET£m £mFixed AssetsTangible assets 480InvestmentsInvestments in joint ventures:Share of gross assets 130Share of gross liabilities (80)50Investment in associates 20550Current assetsStock 15Debtors 75Cash at bank and in hand 10100Creditors (due within one year) (50)Net current assets 50Total assets less current liabilities 600Creditors (due after more than one year) (250)Provisions for liabilities and charges (10)340Capital and reservesCalled up share capital 50Share premium account 150Profit and loss account 100300Equity minority interest 40340


Paper 2.5CHAPTER 15

FRS 6: ACQUISITIONS AND MERGERS1 DEFINITIONS

A merger occurs when two companies combine to share resources and form a new business entity but neither one dominates the other. Both groups of shareholders retain their shares as before as there is no acquisition – i.e. no transfer of ownership. An acquisition is a business combination that is not a merger.1.1 CRITERIA FOR MERGERFRS 6 requires that all the following criteria have to be met in order for merger accounting to be used:• Neither business is seen as purchaser or purchased• Both (or all) businesses participate in management structure of new entity• Size of participating businesses is similar so one does not dominate• Only an immaterial proportion of the fair value of consideration may be in the form of non-equity consideration• No equity holders in either business may retain interests in only part of the new entity.The Companies Act 89 criteria are as follows:• The arrangement for the acquisition provides for the issue of equity shares by the parent company or its subsidiary• At least 90% of the equity is obtained by the group• Fair value of consideration which is not equity does not exceed 10% of the nominal value of the equity shares issued• The adoption of merger accounting fulfils generally accepted accounting principles.These are stringent criteria and therefore there are not many situations when business combinations will fall into the category of a merger. So, mergers are rare but when the above criteria are met merger accounting must be used.2 ACCOUNTING FOR ACQUISITIONS AND MERGERS2.1 ACQUISITION ACCOUNTINGIn order to reflect the fact that the purchaser has acquired control of a company acquisition accounting requires that net assets are included at their fair values and that only post-acquisition reserves are included in the consolidated reserves. The investment will be recorded in the books of the purchaser at cost – which is normally the fair value of consideration.2.2 MERGER ACCOUNTINGThe main points of merger accounting are as follows:• Interests in the new business are pooled – net assets are aggregated• Investment is recorded at nominal value of shares issued• No adjustment is needed to the carrying value of net assets to reflect fair value• Differences between carrying value of investment and nominal value of shares is either• treated as a reserve arising on consolidation if carrying value is less than the nominal value of shares, or• deducted from reserves if carrying value is more than the nominal value of shares• Accounting policies must be consistent between the two businesses• Profits or losses for the period in which the merger takes place should all be included in the group accounts• Group accounts are presented as if entities had always been combined – i.e. corresponding amounts should be shown.• Pre-merger and post-merger figures must be detailed in the notes to the accounts.2.3 MERGER RELIEFWhen a company issues shares at a premium CA85 requires that this amount must be credited to a share premium account. An exception is made to this rule when the company issuing the shares will be holding at least 90% of the equity in another company by an arrangement including the exchange of shares. In this case there is a merger relief provision


and there is no need for a share premium account.2.4 EXERCISE 1B Ltd acquires all of the share capital of C Ltd by issuing 5,000 £1 ordinary shares. The market value of these shares is £1.60. Using (1) acquisition accounting and (2) merger accounting what entries would be made in the books of B Ltd?2.5 SOLUTION 1£ £Dr Investment in C LtdCr Share capitalCr Merger reserveUsing merger accounting what entries would be made in the books of B Ltd?£ £Dr Investment in C LtdCr Share capital2.6 EXERCISE 2M Ltd makes an offer to all of T Ltd’s shareholders to acquire their existing shares on the basis of one £1 share (market value £1.50) plus 10 pence for every 2 £1 shares in T Ltd (market value 65pence). The total number of existing shares in T Ltd is 200,000 and the holders of 186,000 accept the offer.How will the investment in T Ltd will be recorded as follows in the books of M Ltd?• Using acquisition accounting• Using merger accounting?2.7 EXERCISE 3B Ltd makes an offer to acquire L Ltd by issuing 10,000 £1 ordinary shares worth £2 each with £800 cash.Can this offer meet the requirements of merger accounting?2.8 EXERCISE 4H Ltd acquired 95,000 (out of a total of 100,000) shares in G Ltd on 31 December 20X1 by issuing 190,000 shares as consideration. The market value of shares in H Ltd was £2.10 each. The reserves in G Ltd at 31 December 20X1 were £120,000. The issued share capital of H Ltd at that date was £300,000 and reserves £500,000. The fair value of the net assets of G Ltd was £25,000 in excess of their book value. Prepare consolidated balance sheets at 31 December 20X1 using acquisition and mergeraccounting.Balance sheets for H Ltd and G Ltd at 31 December 20X1 are as follows:H Ltd G Ltd£’000 £’000£1 ordinary shares 300 100Profit and loss account 500 120800 220Net assets 800 2202.9 SOLUTION 4Acquisition accounting:Cost of investment in G Ltd£’000 £’000Dr Cost of investmentCr £1 ordinary sharesCr Merger reserveFair value of net assets£000 £000Dr Net assetsCr Revaluation reserve


Goodwill£ £Cost of investmentLess: share of net assets at acquisitionShare capitalRevaluation reserveProfit and loss account ______________ _______Goodwill _______Minority interest in G LtdAs above _______Consolidated balance sheet as at 31 December 20X1£GoodwillSundry net assets ________________£1 ordinary sharesMerger reserveProfit and loss accountMinority interest __________________Merger accounting:Cost of investment in G Ltd£’000 £’000Dr Cost of investmentCr Share capitalDifference on consolidationCost of investmentLess: nominal value of shares acquired ____Difference to write off to consolidated P&L account ____Consolidated profit and loss accountH LtdG LtdLess: Difference on consolidation ________Minority interest in G LtdShare capitalProfit and loss account____Consolidated balance sheet as at 31 December 20X1£Sundry net assets _____£ ordinary sharesProfit and loss accountMinority interest __________


Paper 2.5CHAPTER 16

ANALYSIS AND INTERPRETATION OF ACCOUNTS1 INTERPRETATIONFinancial statements are produced as a means of communicating information. The information contained must therefore be interpreted by the user in order to be of any value. The figures themselves give a certain amount of information but a greater insight may be gained by the use of ratio analysis. Ratios are a neat way of analyzing the figures and can be used in order to detect trends and compare results. Ratios are only of any value when used in comparison, either with previous years for the same entity or between different companies in the same business sector. Different users of accounts will be interested in different sets of ratios.2 PROFITABILITY RATIOS2.1 RETURN ON CAPITAL EMPLOYED (ROCE)Profit before interest and taxation (PBIT) x 100%Capital employedThis is known as the primary ratio because of its importance as a measure of profitability. The ROCE indicates profit relative to the size of the business and so is the key in assessing financial achievement and the earning power of the business as it shows how effectively the business is using its resources to generate profit. This ratio is also known as return on assets.2.2 GROSS PROFIT PERCENTAGEGross profit (GP) x 100%TurnoverThe GP% shows the margin that a company makes on its sales and should be reasonably constant. Changes can be investigated quite easily because of the small number of components in the ratio.2.3 PROFIT MARGINPBIT x 100%TurnoverThis ratio will be used instead of the GP% where a company does not disclose the cost of sales. However as there are more components to this ratio, tracing changes can be more difficult especially as there will probably be items of a subjective nature included, e.g. depreciation. Therefore for comparisons to be made effectively certain adjustments may have to be made.2.4 RETURN ON EQUITYProfit after tax and non-equity dividends x 100%Equity shareholders’ fundsThis shows the profit generated in relation to equity and shows how efficiently equity is used in order to make profits. It is a measure of profitability which would be of interest to investors.3 LIQUIDITY RATIOSThese ratios show how working capital is being managed and whether liquid funds are sufficient for the short-term needs of the business.3.1 CURRENT RATIOCurrent assets (CA) x 100%Current liabilities (CL)This measures the adequacy of liquid funds to cover the short-term liabilities – i.e. can bills be paid as they fall due. Generally it is regarded that a current ratio of 1.5 is appropriate for most businesses to maintain creditworthiness.3.2 QUICK RATIO


CA – stock x 100%CLThis ratio is also known as the acid test. By eliminating stock – the least liquid of the current assets – it is a true measure of whether liabilities can be met by liquid funds as they fall due.3.3 STOCK TURNOVERCost of sales = times per annumStockThe calculation of this ratio produces a yield of the number of times stock is turned over per annum or it could be expressed in days by inverting the ratio. Sometimes, for consistency, average stock is used. An increasing stock turn, i.e. when stock is turning over more slowly, can be a warning that something is amiss – but not always.However, it is at this point that investigation should be carried out to ensure that the reasons are clear.3.4 DEBTORS TURNOVERTrade Debtors x 365 daysTurnoverWhen debtor days have been calculated as above, the number should be compared with the credit policy of the company. Increasing debtor days is a usually a bad sign, however there may be good reasons why – but the questions should be asked and the reasons ascertained.3.5 EXERCISE 1Trade debtors at 31 December 20X0 are £200,000 and the turnover is £1,000,000. At 31 December 20X1 trade debtors are £300,000 and turnover £2,000,000. What is the debtors’ turnover for each year? What are the possible reasons for the change?3.6 SOLUTION 1At 31 December 20X0 debtors’ turnover is ___ days. At 31 December 20X1 it has reduced to ___ days.Possible reasons:••••••4 EARNINGS PER SHARE (EPS)This is a fundamental ratio because it forms part of the P/E ratio which is the most important of all for analysis and comparison of UK companies and is widely used as a measure of a company’s value for money. EPS is defined by FRS 14 in order that meaningful comparisons can be made.4.1 DISCLOSUREFRS 14 applies to all companies with shares which are publicly traded, and requires both basic and diluted EPS to be shown on the P&L.The notes must show:• Basis of calculation• Earnings figure used• Number of equity shares.4.2 CALCULATIONEarnings penceNumber of sharesEarnings is profit after tax, minority interests, preference dividends and extraordinary items.4.3 CHANGES IN EQUITY SHARESFor a bonus (scrip) issue, the EPS will be adjusted to take account of the new shares and will be diluted. In order not to be


misleading, it is necessary to adjust the previous year’s EPS to be in line with the new number of shares.For an issue at full market price then the weighted average number of shares in issue should be used as the denominator and no adjustment is needed to the previous year’sEPS.A rights issue should be treated as an issue at full market price and a bonus issue. Therefore a weighted average is used but adjusted to take account of the bonus element which is:Actual cum rights priceTheoretical ex rights price (TERP)4.4 EXERCISE 2• There is a rights issue on a 1 for 3 basis.• Cum rights price on last day of quote £8.• Rights price £5What is the bonus fraction?4.5 EXERCISE 3• On 1 January 20X1 A plc had 1,550,000 ordinary shares of £1 each in issue.• On 1 April 20X1 a rights issue of 1 for 5 at £3.20 was made. The cum rights price was £4 per share.• Profit for the year was £180,000.• EPS for the year ended 30 December 20X0 was 11pence.Calculate the EPS for the year ended 31 December 20X1 and restate the comparative figure.4.6 DILUTED EPSIf a company is committed to issuing shares at some time in the future – referred to by FRS 14 as potential ordinary shares - basic EPS might have to be changed. Because the number of shares will change and there is the possibility that earnings will change (reflecting the change in the capital structure of the company) then a diluted EPS figure must be calculated to reflect the potential future changes. Convertible loan stock and preference shares A notional figure for the interest or dividend saved must be added back to the earnings figure. The maximum additional number of shares on conversion must be added to the basic weighted average number of shares to arrive at the diluted number.Options or warrantsShares issued at full market price have no effect of dilution whereas those deemed to have been issued for no consideration need to be adjusted for.Maximum dilutionEach potential issue of shares must be considered for its dilutive effect separately and in sequence from the most dilutive to the least by calculating the marginal EPS of each issue.4.7 EXERCISE 4There are 3,000,000 convertible preference shares entitled to a dividend of £5 per share.Each preference share is convertible into 3 ordinary shares. What is the marginal EPS?4.8 LIMITATIONS OF EPS• No account taken of inflation• Takes no account of future developments and this must be kept in mind when it is used for future prediction• Accounting policies must be checked before different companies are compared.5 CAPITAL STRUCTURE RATIOSThese ratios are the ones that are of particular interest to investors.5.1 DEBT/EQUITY RATIOInterest-bearing net debt x 100%Shareholders’ fundsThis is the ratio for computing the gearing of a company. Gearing is the relationship between the shareholders’ funds and fixed return capital. A company is highly geared if it has a high proportion of fixed interest funds in comparison with shareholders’ funds. If a company is funded entirely by equity shares, it has no gearing.The effects of gearing are as follows:


• Loan interest is an allowable deduction before taxation whereas dividends are paid out of profits• Earnings in higher-geared companies are more sensitive to profit changes. This is because debenture interest must be paid out whether there are sufficient profits or not.5.2 DIVIDEND YIELDDividend per share x 100%Market price per shareThis shows the relationship between the gross dividend and the market price –important for a potential investor.5.3 DIVIDEND COVEREarnings per share (EPS)Dividend per shareThis shows the relationship between profits available for distribution and dividends paid. This is relevant for investors who will want a split portfolio between high dividends and high capital growth – lower payment of dividends out of availableprofits increases the wealth of the company.5.4 PRICE/EARNINGS RATIO (P/E RATIO)Market price per shareEPSThis is the stock market ratio most widely referred to. It represents the market’s opinion of the future prospects of the share. The higher the P/E ratio the faster the future growth in the company’s EPS is expected by the market.5.5 EXERCISE 5Two companies, in the same business sector, both have £10,000 capital. Tiny plc has 10,000 ordinary shares of £1 each, Large plc has 5,000 ordinary shares of £1 each and £5,000 10% debentures.Tiny and Large both show profit before interest and tax of £7,000 in year 1 and £3,000 in year 2. Tax is 35% and the dividend paid by each is 10 pence per share. The market value of an ordinary share in Tiny plc is £9.70 in 20X0 and £6.20 in 20X1 and in Large plc is £11.40 in 20X0 and £5.50. What is the P/E ratio for each year for both companies?Can you tell how the company is geared?6 OTHER RATIOSThere are almost unlimited other ratios – any figure can be divided by any other in the accounts to derive a ratio which can then be compared with others. This can sometimes be of great value but it is also quite easy to calculate useless information.7 LIMITATIONS OF RATIO ANALYSISRatios must always be compared, never looked at in isolation. Ratios point towards areas of possible concern – they do not provide the answers. Data from which ratios are compiled must be uniform and the calculation must be uniform otherwise comparisons will be misleading. Differences in accounting policies between different companies should be taken into account. Guidelines concerning ratios are generalisations – each case must be looked at and analysed on its own and not compared to a ‘normal’ figure. The timing of the year-end must be taken into consideration. A retail company making up its accounts to the end of February would have a significantly different balance sheet from a company in the same business having a November year-end. Ratios are confined to monetary items – they give an incomplete picture of the company as a whole.


Paper 2.5CHAPTER 17

CASH FLOW STATEMENTSThe objective of a cash flow statement is that a company’s trading may be viewed in terms of its ability to generate cash by showing the effect of a period’s transactions on the cash balance. A cash flow statement helps with the assessment of liquidity and solvency and so is of help to potential investors. FRS 1 (Revised) requires all ‘large’ companies to include a cash flow statement in their financial statements.1 STANDARD HEADINGSThe following headings are required by FRS 1 (Revised):• Net cash flows from operating activities• Dividends received from associates• Return on investments and servicing of finance• Taxation• Capital expenditure and investment• Acquisitions and disposals• Equity dividends paid• Management of liquid resources• Financing2 DEFINITIONSCash – cash in hand and deposits repayable on demand less overdrafts Cash flow – increase or decrease in cashLiquid resources – Current asset investments which are readily disposable without curtailment of business and convertible into an amount of cash which is specified or one which is close to their carrying valueNet debt – borrowing less cash and liquid resourcesQualifying financial institution – an entity in the business of receiving deposits for its own account3 EXAMPLEThe following illustrative example is included in FRS 1 (Revised). The reconciliation and notes required are included.XYZ LIMITED CASH FLOW STATEMENTFOR THE YEAR ENDED 31 DECEMBER 20X7£’000 £’000Net cash inflow from operating activities (note 1) 6,889Returns on investment and servicing of financeInterest received 3,011Interest paid (12)2,999Taxation (2,922)Capital expenditurePayments to acquire intangible fixed assets (71)Payments to acquire tangible fixed assets (1,496)Receipts from sale of tangible fixed assets 42(1,525)Equity dividends paid (2,417)Management of liquid resourcesPurchase of treasury bills (650)Sale of treasury bills 200(450)FinancingIssue of ordinary share capital 211Repurchase of debenture loan (149)Expenses paid in connection with share issues (5)57Increase in cash 2,631


NOTES TO THE CASH FLOW STATEMENTNote 1: Reconciliation of operating profit to net cash inflow from operating activities£’000Operating profit 6,022Depreciation charges 899Increase in stocks (194)Increase in debtors (72)Increase in creditors 234Net cash inflow from operating activities 6,889Note 2: Reconciliation of net cash flow to movement in net debt£’000 £’000Increase in cash in the period 2,631Cash to repurchase debenture 149Cash used to increase liquid resources 450Change in net debt 3,230Net debt at 1.1.X7 (2,903)Net funds at 31.12.X7 327Note 3: Analysis of changes in net debtAt 1.1.X7 Cash flows OtherchangesAt 31.12.X7£’000 £’000 £’000 £’000Cash in hand and at bank 42 847 889Overdrafts (1,784) 1,7842,631Debt due within one year (149) 149 (230) (230)Debt due after one year (1,262) 230 (1,032)Current asset investments 250 450 _____ 700TOTAL (2,903) 3,230 - 3274 EXPLANATIONSOperating activities – Note 1 above is necessary as there needs to be a reconciliation between the operating profit as shown in the accounts and the starting point of the cash flow statement.Returns on investments and servicing of finance – These include payments to providers of finance and receipts from investments. Hire purchase interest is also included.Taxation – As with interest above the way to calculate the amount of tax actually paid is by calculation using the brought forward and carried forward balances and charge to the P&L.Capital expenditure – Acquisitions and disposals of intangible and tangible fixed assets and trade investments are included here. Also included are current asset investments which are not classified as liquid resources (see definition above).Equity dividends paid – These are dividends paid on the reporting company’s equity shares.Management of liquid resources – The components of liquid resources must be stated.Financing – These cash flows represent receipts and repayments of principal amounts to providers of finance. Opening and closing figures are used for calculation but adjustments must be made for any items not involving cash flows e.g. bonus issues.5 EXERCISE 1The operating profits for B Ltd for the year ended 31 January 20X1 were £500,000.Extracts from the balance sheet are as follows:31.01.X1 31.01.X0£’000 £’000Stocks 90 95Debtors 120 110Creditors (120) (105)Creditors at 31.01.X1 include an amount of £35,000 relating to taxation. At 31.01.X0 £27,000 of the creditors figure related to taxation. The P&L charge for taxation for the year ended 31.01.X1 was £30,000 and the charge for depreciation


for the year was £21,000.Calculate the net cash inflow from operating activities and the taxation figure.Paper 2.5CHAPTER 18

RELATED PARTIES AND SEGMENTAL REPORTING1 FRS 8: RELATED PARTY DISCLOSURES

FRS 8 requires disclosure in the financial statements of the existence of relationships and transactions with related parties.1.1 DEFINITIONTwo or more parties are related if at any time during the financial period:• One party has direct or indirect control over the other• Both parties are under the same source of control• One party has such influence over the other that it could be stopped from pursuing its own interests• Both parties are subject to influence from the same source to the extent that one is stopped from pursuing its own interests.1.2 RELATED PARTIES OF A REPORTING ENTITYThese cover:• Parent, subsidiary and fellow subsidiary undertakings• Associates and joint ventures• Investor and venturer in associates and joint ventures• Directors and those of parent undertakings• Pensions funds for benefit of employees or those of a related party.1.3 PRESUMED RELATED PARTIESThe following are presumed to be related parties unless it can be demonstrated that they are not:• Key management and that of parent undertakings• Individual owning or controlling more than 20% of voting rights• Individuals acting together who can exercise control• Entity managing or managed by reporting entity under contract• Members of close family of individual falling into the above categories• Partnerships, companies or trusts in which individuals falling into the above categories, or members of the close family, have a controlling interest.1.4 TRANSACTIONS BETWEEN RELATED PARTIESA related party transaction is one in which assets, liabilities or services are transferred by, to or for a related party regardless of price, and they are a common feature in business. Many transactions with related parties do not take place on arm’s length terms, and their disclosure together with the relationships involved is important to users of financial statements so that they can judge their significance on the entity’s results.1.5 CA85 AND STOCK EXCHANGE REQUIREMENTSCA 85:• Requires disclosure of a material interest of one of its directors in a significant contract• Prohibits loans from the company to a director unless they are less than £5,000 or funds for business expenditure.

The Stock Exchange:• Requires a circular to shareholders if there is an acquisition or disposal of assets between the company and a related party (referred to by the Stock Exchange as ‘Class 4 parties’)• Has issued numerous other provisions relating to transactions between the company and Class 4 parties – relating only


to listed companies – which have effectively reduced the number of related party transactions.2 SEGMENTAL REPORTING SSAP 25This standard was introduced in order to give further information about entities carrying on several different classes of business or operations in different locations with potentially different profitability rates. It applies to any plc (or any company that has a plc subsidiary), any banking or insurance companies and any company that exceeds the criteria multiplied by 10 for defining a medium-sized company.2.1 DEFINITIONSAll significant segments should be reported on individually with regard to:• Return on capital employed• Risk• Growth rate• Potential for future developmentA segment is significant if:• Third party turnover is 10% or more of total third party turnover• Results of the segment are 10% or more of aggregated segments’ profit or loss• Net assets of the segment are 10% or more of total net assets.A class of business is identified by consideration of the following factors:• Nature of products• Nature of production processes• Markets• Distribution channels• Organisation of activities• Separate legislative framework2.2 DISCLOSURESIf there are two or more classes of business or geographical locations disclosure should be made of:• Each class of business and geographical segment in the financial statements• For each class or segment disclose:• Turnover• Results before tax, minority interests and extraordinary items• Net assets2.3 PROBLEMS WITH SEGMENTAL REPORTINGIt is relatively easy for directors not to comply with this standard as segmental information need not be reported if it is believed to be detrimental to the company’s interests. It can be argued that the associated cost would come under this heading or that it is detrimental to provide too much detail to competitors.Other problems are as follows:• Allocation of costs common to more than one segment can be arbitrary• Split between classes and geographical segments can be arbitrary• No need to disclose basis for transfer pricing between group companies• Net assets’ disclosure need not be based on year-end position so can be based on average position in year, again arbitrary• Exceptional items can be left out of segmental reports – no guidance is given• Effect of changes in the group on segmental reports not addressed by SSAP 25 –although it is by FRS 3.


PAPER 2.6CHAPTER 1

INTRODUCTION TO AUDITING

1 AN AUDITDefinition: An exercise whose objective is to enable auditors to express an opinion on whether the financial statements give a true and fair view (or equivalent) of the entity’s affairs at the period end and of its profit or loss (or income and expenditure) for the period then ended and have been properly prepared in accordance with the applicable reporting framework (e.g. relevant legislation and applicable accounting standards) or where statutory or other specific requirements prescribe the term, whether the financial statements “present fairly”.• Audit has a well established role in society• Auditor reports to the shareholders of the company• Report on the truth and fairness of the financial statements• High level of assurance• Usually as a result of a statutory requirement• SAS’s provide guidance on how to undertake an audit• An audit is required for all companies with a turnover>£5.6m• An audit is required by all PLC’s, banks or insurance companys or a company registered under the Financial Services Act.

2 AN ASSURANCE ENGAGEMENTDefinition: Assignment whereby a professional accountant is required to evaluate or measure a subject matter that is the responsibility of another party against identified suitable criteria, and to express a conclusion that provides the intended user with a level of assurance about that subject matter.• Assurance is a relatively new concept• Auditor reports to the persons requesting the assurance• May be a low/moderate level of assurance• Non statutory• No standards available for guidance.Examples of assurance engagements- internal control review, report on compliance with relevant laws and regulations, debt management, etc.

3 EXERCISE 1List the advantages and disadvantages of an audit.

4 AUDITING STANDARDS AND GUIDELINES

4.1 AUDITING PRACTICES BOARDThe board aims to• Establish high standards of auditing• Ensure public confidence in the auditing process• Meet the developing needs of users of the financial statements.To meet these aims the APB issues the following forms of guidance for auditors Form Nature Authority Statements of Auditing Standards (SAS’s) Basic principals


and essential procedures Explanatory material to assist in interpreting and applying the above Mandatory-failure to comply could lead to disciplinary action.

Practice Notes (PN’s)Guidance to assist auditors in applying SAS’s to particular industries or circumstances Persuasive but not prescriptive.Indicative of good practice Bulletins Provide up to date guidance on new or emerging issues Persuasive but not prescriptive.

Indicative of good practice.

5 THE AUDIT PROCESS

Consider legal, ethical, practical issues Ascertain document and confirm accounting and internal control system Planning Preliminary evaluation of internal controls Internal controls weak Internal controls good Full substantive testingReduced substantive testing Overall review of financial statements Audit report

PAPER 2.6CHAPTER 2

LEGAL CONSIDERATIONS

1 THE AUDIT REQUIREMENTThe auditing profession is governed by the CA85 and the profession itself (see Chapter 3). Legal requirement is that all companies must appoint an auditor except dormant companies and those with a turnover of less than £5.6m. All Plc’s,


banks and insurance companies etc. must still have an audit regardless of size.

2 ELIGIBILITY OF AN AUDITORMust be Must not be Member of RSB e.g. ACCA An officer (director or company secretary) or employee of the company Eligible for appointment under rules of that body The partner of an employee or an officer of the company

3 APPOINTMENTWho By When How Members AGM-reappoint retiring auditor Ordinary resolution-appoint an auditor other than retiring auditor Ordinary resolution with special notice-appoint an auditor appointed by directors Ordinary resolution with special noticeAutomatic annual reappointment Private companies only via an elective resolution with ordinary notice. This can be revoked by ordinary resolution Fill a casual vacancy Ordinary resolution with special noticeDirectors Fill a casual vacancy Must be reappointed by members at next AGMAppoint first auditor Must be reappointed by members at first AGM Secretary of state If no auditor appointed at end of AGM Company inform secretary of state within a week

4 DUTIES4.1 DUTIES OF DIRECTORS• To keep books of accounts and proper accounting records• To produce a P&L account and BS that show a true and fair view• To produce a directors’ report which is consistent with the financial statements

4.2 DUTIES OF AUDITORSAuditor must report

5 RIGHTS OF AUDITORS• To require all relevant information and explanations from the company/directors• Access to all books and records at all times• AGM-to receive notice-to attend specifically by exception Whether the Financial Statements are true and fair Returns from branches not visited Accounts agree with the underlying records Whether the Financial Statements are properly prepared Proper books and records have been kept Information and explanations received Directors’ report consistent Disclosure of directors’ information been complied with in the accounts-to be heard on business that concerns them as an auditor.

6 VACATION OF OFFICEMethod Auditors’ rights Auditors’ dutiesRemoval Ordinary resolution with special noticeHave written representations circulated to all membersMake a statement of circumstancesNotice of resolution to state if auditor made representationsAGM-receive notice-attend-be heardwhere term of office would have expired and it is proposed to appoint new auditor


Resignation Auditor submits written notice to company To requisition an EGM to consider reasons for resignationMake a statement of circumstancesCompany notify registrarAll parties entitled to receive accountsTo require company to circulate statement in advance of meeting:-at which the term of office would have expired-at which they intend to appoint a new auditor-he has requisitionedAdditionally the auditor may not seek reappointment or the company may chose not to reappoint him.

7 STATEMENT OF CIRCUMSTANCESWhen ceasing to hold office for whatever reason an auditor must deposit at the company’s registered office a statement of circumstances to be brought to the attention of members, or, if none, state none.Resignation is not effective unless it is accompanied by a statement. If circumstances are to be notified the company has 14 days to:a)send a copy to everyone entitled to copies of the accounts orb)apply to the court, notifying the auditor.The purpose of these provisions is to make sure members are made aware of any important circumstances surrounding the removal or resignation of the auditors.

PAPER 2.6CHAPTER 3

PROFESSIONAL ETHICS

1 INTRODUCTIONThe ethical principals for the ACCA are laid out in the “rules of professional conduct”. The auditor must comply with these rules at all times during an audit.

2 THE FUNDAMENTAL PRINCIPLESa) Members should behave with INTEGRITY in all professional, business and personal financial relationships. Integrity implies not merely honesty but fair dealing and truthfulness.b) Members should strive for OBJECTIVITY in all professional and business judgements. Objectivity is the state of mind, which has regard to all considerations relevant to the task in hand but no other.c) Members should not accept or perform work, which they are not COMPETENT to undertake, unless they seek advice, which would enable them to competently carry out a task.d) Members should carry out their professional work with DUE SKILL, CARE,DILIGENCE AND EXPEDITION and with proper regard for the technical and professional standards expected of them as members.e) Members should conduct themselves with COURTESY AND CONSIDERATION towards all with whom they come into contact during the course of their work.

3 INTEGRITY, OBJECTIVITY AND INDEPENDENCEArea of Risk Threat Response Undue dependence on audit client If recurring fees constitute a substantial proportion of


fee income , a self interest threat is likely to arise and therefore objectivity is threatened.The fees for audit and other recurring work paid by one client or group should not exceed 15% of the gross practice income. (For Plc’s and other public interest companies this is reduced to 10%).Loans/overdue fees Self interest threat. Audit firm/principal should not receive/make any loan from/to a client.Family and other personal relationships Objectivity threatened Member should not take part in audit of company if they have been an officer or employee of that company within the last 3 financial years.A practice should not report on a company if a company associated with the practice fills the appointment of secretary to the client. Beneficial interests in shares and other investments Self interest threat Employee having the beneficial interest should not take part in the audit.A principal should not have a PEP/ISA which has among its investments any audit client.Where a principal acquires shares the investment should be disposed of as early as possible.Where a provision requires the auditor to be a shareholder, the auditor should hold no more than the minimum and it should be disclosed in the accounts.Beneficial interests in trusts Self interest-considered similar to holding shares in audit client If the principal holds a beneficial interest and:a) the principal is a trustee, then the practice should cease to report.b) principal is not a trustee, then he should cease personally to take part in the audit.Trusteeships Principal/employee acts as a trustee which holds shares in a client company then a self interest threat arises Trust holds>10% of shares in listed or other public interest company the firm should not accept or continue appointment as auditor.

Goods and services/hospitalitySelf interest Benefits should not be accepted unless value is modest. Should be the same level as is offered to staff of the company. Provision of other services Objectivity threatened Auditor not to perform management functions.Listed and public interest companies auditor should not participate in preparation of accounts.

4 CONFIDENTIALITYInformation acquired in the course of a professional work should not be disclosed except where:a) consent has been obtained from the client, employee or other proper source, orb) there is a legal right or duty to disclose.Information acquired during the course of a member’s professional work should not be used for his personal advantage or for the use by a third party (e.g. share dealing).

5 CONFLICTS OF INTEREST

5.1 FIRM V CLIENTA firm should not accept or continue an engagement where there is likely to be a significant conflict of interest. Any material financial gain that occurs as a result of the engagement will always amount to a significant conflict of interest.Where commission is rewarded for the introduction of a client the client should be informed in writing as soon as possible of the amount and its terms, etc.

5.2 CLIENT V CLIENTIn theory there is nothing wrong with having two clients whose interests may conflict but safeguards should be implemented to avoid the interests of one client affecting another. These might include:• Using different partners and teams to staff the audits• Clear instructions to prevent the leakage of confidential information• Regular review by a senior partner or compliance officer not personally involved with either client


• Disclosure of the potential conflict to the clients concerned so they can make an informed decision whether to stay with the firm• Advising one or both clients to seek additional independent advice.

6 CHANGES IN PROFESSIONAL APPOINTMENTOld Auditor CLIENT NewAuditor1 The newly approached auditor must request the client’s permission to communicate with the existing auditor. If permission is refused, they should decline the appointment.2 The prospective auditor writes to the existing auditor requesting relevant information3 The existing auditor receiving such a request should request the client’s permission to communicate with the prospective auditor4 The existing auditor then sends the prospective auditor the relevant information.

7 EXERCISE 1Explain the issues and any safeguards available on each of the following, and reach a conclusion:1) John has decided to go into practice alone. His current fee income is £20,000. He has been approached by his nephew to take over the audit of his company. He predicts the audit fee to be £10,0002) Aleph and Co are the auditors of Bet plc. During the year Bet has expanded rapidly and is currently planning to float on the stock exchange. Due to the extra work involved this year total fees from Bet amount to 18% of the total fee income of Aleph and Co. Additionally Aleph and Co’s corporate finance manager owns a number of shares in Bet plc.3) The audit senior of Gimmel Ltd is having an affair with the wages clerk, staying with her during the week and leaving the audit files in the boot of his car.4) Daled Airways offers its staff flights at a 90% discount. It has extended this offer to the audit team. Additionally the auditors of Daled have just taken on the audit of Hay airlines.

8 FRAUD AND ERROR (SAS 110)

8.1 RESPONSIBILITIESDirectors are responsible for the detection of fraud and error. It is not the auditors’ function to prevent fraud and error, but the auditors work should be designed to ensure they pick up material misstatements.This means the auditors are required to design suitable audit tests at the planning stage of the audit with the reasonable expectation to discover material fraud.

8.2 DETECTIONAuditors should:• Use personnel with appropriate knowledge and experience• Assess the risk of fraud and error given the control environment• Understand the business, particularly the substance of the company’s transactions• If reliance is placed on internal controls ensure the system is evaluated and weaknesses investigated• Discuss any events involving dishonest or fraudulent conduct and any breakdown in internal controls with management and obtain written representations where appropriate• Remain alert to possible instances of fraud and error during the audit• Where possible obtain evidence from external sources.

8.3 REPORTINGSuspected fraud and material error should be reported to management as soon as possible.


Fraud should be reported to the highest level of management but if the directors are implicated then it may be appropriate to involve the audit committee (if no audit committee then seek legal advice).Where there is a fundamental uncertainty over the consequences of the fraud and or error the auditors should include an explanatory paragraph in their report.Auditors must also consider whether the matter should be reported to a ‘proper authority in the public interest’. If the auditors decide to report it, they must notify the directors in writing that the matter is reportable and that if the directors do not report the matter themselves, the auditors will do so.

PAPER 2.6CHAPTER 4

AUDIT PLANNING

1 WHY PLAN?There are a number of valid reasons why you would plan an audit:• To devote appropriate attention to different audit areas• To identify problems• To ease review• To assist in assigning work.Why Plan? Knowledge (SAS210) Engagement letters SAS(140) New ClientExisting clients Materiality (SAS220) Analytical procedures (SAS410) Risk assessment (SAS 300) Documentation Working papers (SAS 230)

2 KNOWLEDGEKnowledge of a business is required in order to ensure the audit is carried out properly. This knowledge is used for:• Assessing risk• Developing the overall audit plan and programme• Determining materiality• Recognising conflicting information/unusual circumstances• Making informed enquiries and assessing responses.

2.1 EXERCISE 1You are about to the plan the audit of Vayikra Ltd. List 5 pieces of information you will require to enable you to plan the audit.

2.2 NEW V EXISTING CLIENTSThere will be different requirement levels depending on whether the client is new or existing.

2.3 NEW CLIENTThe audit firm must ascertain knowledge to ensure that:


• Firm is independent• Firm is competent• Firms resources are adequate and meet clients needs• New client is not a credit risk• Communication with existing auditor• Rules re changes in professional appointment apply• Any statement of circumstances received• Engagement letter sent.

2.4 EXISTING CLIENTMost of the required information should be available in the previous year’s working papers and other files.The planning meeting should update the information with any changes in the business, personnel, accounting etc. or with any external changes such as changes in accounting standards, industry, regulation, competitors etc. The engagement letter should be reviewed to ensure it is still appropriate.

3 SAS 140 ENGAGEMENT LETTERS

3.1 PURPOSE• To agree the terms under which the assignment is to be carried out• To minimise the chances of misunderstanding between the client and auditor.

3.2 PROCEDURES• Agree content with new client prior to sending. Letter must be sent before audit starts • Consider whether new letter should be sent for recurring audits.

3.3 PRINCIPAL CONTENTS• Responsibilities of directors and auditors (see Chapter 3)• Scope of Audit (explanation of scope and nature)• Other services• Fees• Applicable law• Agreement of terms (letter remain effective until replaced).

4 SPECIFIC PLANNING MATTERS

4.1 ANALYTICAL PROCEDURES (SAS 410)Analytical procedures should be used at the planning, evidence and review stages of the audit.Analytical procedures can compare the relationship between financial data (e.g. compare debtors with turnover) or between financial and non-financial data (e.g.payroll with the number of employees). They can include comparisons between:• Financial periods• Budgets• Industries.At the planning stage they are used to:• Assist in understanding the business• Identify areas of potential risk• To plan the nature, timing and extent of other audit procedures.Analytical procedures can be based upon interim accounts, draft financial statements, budgets etc.

4.2 MATERIALITYDefinition - an item can be considered material if its omission would reasonably influence the decisions of an addressee of the auditors report.The decision as to whether an item is material is a matter of professional judgement.An item can be said to influence the user due to its:• Nature -material regardless of size e.g. directors’ information or share capital


• Size -%of turnover, net assets or profit is often used as a guide• Effect -an error that turns a profit to loss or net assets to net liabilities or vice versa

Auditors must plan the audit to provide reasonable assurance that the financial statements are free from material misstatement. Considering materiality at the planning stage helps auditors determine what and how many items to test etc. Note that materiality can change as the audit progresses.

4.3 RISK ASSESSMENT (SAS 300)Auditors should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach.Audit risk The auditors may give an inappropriate opinion Inherent risk The susceptibility of an account balance or class of transactions to material misstatement, irrespective of related internal controls.Control risk Material misstatement could occur and not be prevented, or detected on a timely basis, by the accounting and internal control systems Detection risk .Substantive procedures do not detect a material misstatement Some firms quantify their overall acceptable level of audit risk as the basis for mathematical derivation of detection risk and sample sizes.Inherent risk and control risk are integral to the business, while detection risk is the balancing figure set to achieve an acceptable total audit risk.

4.4 EXAMPLE 1A firm sets its audit risk at 5 %,( it will accept a 5% risk that it gives an inappropriate audit opinion). At the planning stage of the audit, knowledge of the business is assessed and it is deemed to have a very high inherent risk and a very high control risk (the business is in technology, there are many complex transactions, all the personnel have changed in the year and there are no internal controls in place).Thus inherent risk is calculated at 90% and control risk at 100%:Therefore detection risk is calculated at 5.56%. Detection risk must be rendered low i.e. there must be a low risk of an error not being detected via substantive testing so sample sizes must be set high.

4.5 EXERCISE 2Audit RiskInherent RiskControl RiskDetection RiskAR =IR x CR x DR=90 x 100 x DRYou are planning the audit of Bemidbar Ltd. List factors that would indicate to you there is high inherent and control risk.

4.6 DOCUMENTATIONPlanning culminates in an overall strategy (audit plan) and a detailed audit approach (the audit programme).Example of an audit plan:Prepared byDateReviewed byClient XYZ LtdAccounts to 31 December 20X2Date

1 Term of the engagement including report required by client expectations Normal Companies Act report – we write up the nominal ledger and prepare draft statutory accounts from client records – modified accounts to be filed at Companies House.2 The company and its business Manufacturer of hospital equipment.Turnover £6,000,000.3 Special audit problems Obsolete stock a possibility. Discuss provision with directors and attend stock take.


4 Evaluation of audit risk Accounting – all posting etc to be accurate – wherever possible work to nearest £ or £10. Audit materiality- £10,000 based on 5% of profits.5 Audit approach No reliance can be placed on internal controls or analytical review. A substantive approach will be adopted.6 Other matters None7 Budget and fee £30,0008 Timetable Accounts to be ready for discussion with client on 9 April 20x29 Staffing Senior – 2 weeksJunior – 1 weekAudit plan approvedManager ... ………….. Date ………………………………..Partner ………………… Date ………………………………..

4.7 WORKING PAPERS (SAS 230)Definition: the material auditors prepare/obtain and retain in performing an audit.Working papers support the auditors’ assertion that Auditing Standards have been complied with.

They are the record of:• planning and performance of the audit• supervision and review of audit work• evidence resulting from the work performed on which auditors have relied.They must be sufficiently complete for an experienced auditor with no previous connection with the audit to ascertain what work was done and the conclusions that were reached.Working papers are the property of the auditor and they should be retained for at least 6 years. They are confidential although extracts may be made available to the client provided disclosure does not undermine the independence or validity of audit process (e.g. basis of sample collection).

4.8 EXERCISE 3List the advantages and disadvantages of standardised working papers.

PAPER 2.6CHAPTER 5

ACCOUNTING AND INTERNAL CONTROL SYSTEMS

1 DEFINITIONSAccounting systems Tasks and records by which transactions are processed tomaintain financial records.Internal control system Environment and procedures to ensure efficient conduct of the business, safeguarding assets, prevention and detection of fraud and error, accuracy and completeness of accounting records and timely preparation of financial information.


2 DOCUMENTING THE ACCOUNTING AND INTERNAL CONTROL SYSTEMAn auditor must understand the accounting system that is being audited and therefore must document the system fully. This can be done via:• narrative notes –written explanation of the system and controls within itDocumentationtechniquesObjectives of controlsTypes of controlBusiness Transaction cyclesReports to directors/management (SAS 610)• flowcharts –diagrammatic representation outlining the sequence of events in a system showing document flow and the department or function responsible for each event• internal control questionnaire (ICQ) –checklist of questions designed to discover the existence of internal controls and the possible weaknesses within them. A ‘yes’ answer to a question indicates a strength and a ‘no’ indicates a weakness. (Are all purchases >£1000 authorised?).• internal control evaluation (ICE) –similar to an ICQ but contains only key control questions• walkthrough tests –these involve tracing a transaction from beginning to end through the accounting system. This ensures the auditor has correctly understood how the system works.

2.1 EXERCISE 1Compare and contrast narrative notes, flowcharts and questionnaires as a method of documenting the accounting system.

2.2 SOLUTION 1Narrative notes Flowcharts Questionnaires

3 INTERNAL CONTROLS

3.1 OBJECTIVES OF CONTROLSInternal controls strive to ensure that:• C -all transactions are complete• A -all transactions are accurate• V -all transactions are valid• E -recorded assets exist.

3.2 TYPES OF CONTROLSControl environment (overall attitude and management) cover the:• philosophy and operating style of management• internal audit function• segregation of duties• supervision of work.

Control procedures (to achieve specific objectives) consist of:• P -physical access to assets and records are limited• A -approval and control of documents• C -controls over computerised applications• A -checking of arithmetical accuracy of records• M -maintaining and reviewing control accounts and trial balances• A -performing accounting reconciliations• C -comparing records with physical counts and internal data with external data.

3.3 EXERCISE 2Give 5 internal controls you would expect to see in place at a:a)Fast food restaurant


b)Gymc)Cinemad)Professional training college.

4 TRANSACTION CYCLES4.1 SALES CYCLEObjectives Control examples To ensure that:Company only deals with credit worthy customersCredit checks for new customersExisting customers orders checked against pre-agreed credit limitsAll orders dealt with promptlySequence check of ordersStock availability check on receipt of orderDespatches are valid, and adequately recordedMovements. out of warehouse matched to customer orderCustomers signature for all deliveriesDespatches recorded on a GDNDespatches are complete Check for quality/quantity before despatchTwo people checking contents Invoices raised for all All invoices matched to GDNOrder receivedGoods despatchedInvoicedespatchesReview unmatched GDNSecond account clerk check calculation.sInformation complete, accurate and up to dateGrid stamp invoice once recordedReview unstamped invoicesProduce debtors’ listingReconcile DLCAMonthly statement to customers.Receipts are recorded/banked properly and intactMail opened by 2 staff membersRegular bank reconciliations.TransactionsrecordedCash receipts4.2 PURCHASES CYCLEObjectives Control examplesTo ensure thatRequisition for valid business expenseAuthorised by second person.Stock check made to ensure goods not in stock and a purchase is requiredOrdering is efficient and cost effectiveAgree price to suppliers price listOnly use approved suppliersAll orders must be in writing on a serially numbered purchase order formGoods are not damaged/wrong items etcAgree goods received to purchase orderCheck goods for quality/damage on receiptReview unmatched purchase orders and follow up with supplierRaise a GRNSuppliers do not overcharge e.g. fail to recognise discounts etc.Match invoice to purchase order


Match quantity to GRNArithmetical checkManagement has timely information concerning liabilitiesRecord invoice promptly inPurchase day bookRegular reconcilitiations of supplier statementsReconcile control accounts with ledgersPayments are made to bona fide suppliers for goods receivedAuthorised cheque signatoriesFor amounts >£x two signatures requiredSignatories must review underlying documentation before signingRequisition raisedOrders GoodsInvoice receivedTransactions recorded in booksCash

4.3 WAGES CYCLEObjectives Control example To ensure that Only bona fide employees are paidClockcards kept in safe locked room Clockcards issued each week by manager to employees based on a list of employees from personnel Only paid for work doneSupervised clocking in and outHours worked on clockcard authorised by managerCalculations are accurateSecond person manually recalculate a sampleReview for reasonablenessAmendments (e.g. starters and leavers are valid)Personnel inform payroll of starters/leavers on a timely basis Input onto PC and report of standing data changes must be printedReport of standing data changes must be checked one on one and authorised by payroll supervisor

Deductions for PAYE,NIC, SSP etc are accurateIndividual payslips produced and final payslip (total)-Cheque signed by director who checks to supporting documentation-Cheque paid to Securicor who deliver cash to premises or at least 2 people bank cheque and deliver cash to premises Payments are made to those entitled to receive them Total cash counted and documented by 2 peopleEach individual pay packet counted out by 2 people Payout performed by 2 peopleEmployees sign for wages on pre printed formEmployees show ID to collect wages Cannot collect wages for other people Clockcards submitted and input Gross pay, deductions and net pay calculatedOther amendments input Final payroll calculated and payslips produced Payments to employees and Inland Revenue Payroll costs and payments recorded in Uncollected wages kept locked awayAmounts are correctly posted in N/L accounts.Reference to NL codes on posting Independent review

4.4 STOCKObjective

To ensure that Control examplesDamaged goods are not accepted Physical inspection Goods cannot be misappropriatedSecurely stored


All stock movements authorisedTwo warehouse employees involved in despatchAll movements accurately recordedSerially numbered GRN’s and GDN’sReceipt matched to purchase orderCustomer signature as proof of deliveryMatched with customer orderManagement has accurate timely information re stock levelsGRNs and GDNs to update stock recordsGRNs and GDNs evidenced as processed and filed numericallyRegular stocktakes, comparison book v actual and variances investigated

4.5 CASH SYSTEMGoods despatchedPosted to N/L and stock cardsDespatch recordedObjectiveTo ensure thatControl examples Payments are only requested for valid business expensesStandardised cheque requisitionSupporting documentationPayments are accurate and take advantage of credit termsDepartmental/buyer approvalAgreement to supplier statementsCash/cheques are not misappropriatedSafe custody of cheque booksInvoices/requisitions stamped paidCustomer signature as proof of deliveryMatched with customer orderManagement has accurate timely info re cash positionSegregation of dutiesMonthly bank reconciliationsPayment authorisationRequest for paymentPayments and receipts Payment madeReceipt

5 AUDIT APPROACHAs far as the audit is concerned as well as fully understanding the accounting system and the controls contained therein an auditor may well be able to reduce the amount of substantive testing they do if the controls in place within a company’s accounting system are accurate and efficient. In order to decide whether internal controls exist and can be relied upon the controls must be tested.

5.1 TESTS OF CONTROL• Enquiries and observations collaborating the internal control function• Inspect a document to evidence control has operated (e.g. authorised purchase order)• Examination of evidence of management reviews (e.g. board minutes)• Reperformance of control procedures (e.g. control account reconciliations)However, substantive testing cannot be eliminated entirely due to the inherent limitations present in internal controls. These are:• The potential of human error• The possibility of circumvention of a control via collusion• The possibility of management overriding the control• Changes over time making the control inadequate


• The cost of the control outweighing the benefit• Controls only picking up routine transactions, so that other transactions go undetected.

6 REPORTS TO DIRECTORS OR MANAGEMENT (SAS 610)At the completion of the audit auditors usually send a report to directors or management to communicate points that have come to their attention during the audit. A management letter is not compulsory but it often “adds value” to the audit process.

6.1 CONTENTS• Material weaknesses in the accounting and internal control system• Implications of the weakness• Consequences of the weakness• Unsuitable accounting policies• Non compliance with SSAPs/legislation.

6.2 PROCEDURES• State that the letter is not a comprehensive statement of all weaknesses• Write it as soon as possible after completion of audit (maximises effectiveness)• Ask for a reply to points made• If significant matters raised in previous letters have not been addressed, ask why• Address it to a person having authority to act (usually board of directors)• State that the letter is a confidential communication, not for use by third parties

6.3 EXERCISE 3You are the auditor of Devarim Ltd, a paper merchants in Swindon. You spend some time in the office and observe the following. Milo the office junior completed a purchase requisition for a new computer. He phoned PC world and placed the order himself. He then completed a purchase order form and sent it to the warehouse to inform them of the computer’s impending arrival. Draft the appropriate sections of the management letter.


PAPER 2.6CHAPTER 6

AUDIT EVIDENCE (TECHNIQUES)

1 INTRODUCTIONAudit evidence is the information the auditor is to rely on that leads to an unqualified or qualified audit report. The auditor needs to obtain sufficient (enough) and appropriate (relevant and reliable) evidence in order to draw a reasonable conclusion.

1.1 SUFFICIENTThis is a measure of quantity and is influenced by:• Risk assessment – the higher the risk the more evidence is required• Accounting and internal control assessment - better system less evidence required• Auditors cumulative accounting knowledge and experience (cake)• Audit findings• Source and reliability of information.If sufficient evidence is not obtained then the auditor must consider the implications for the audit report.

1.2 APPROPRIATEIn order to be appropriate, evidence must be both relevant and reliable. Evidence is deemed to be relevant if it supports one or more of the following financial statement assertions:Completeness -All assets, liabilities and transactions are includedOccurrence -Transaction occurred in the relevant periodMeasurement -Transaction recorded at the proper amountPresentation -Disclosure with applicable reporting frameworkAppropriate carrying value -Recorded at correct valuationRights and obligations -Assets and liabilities rightly belong to the clientExistence -Assets and liabilities actually exist at a given date.

The reliability of evidence is assessed by considering the following:• Documentary/written better than oral• Third party better than internal• Original documents better than copies• Auditor obtained is better than entity obtained.

2 SUBSTANTIVE V TESTS OF CONTROLControl tests: these test the controls operating within the system and obtain evidence regarding the suitability of the design and effective operation of the accounting and internal control system (e.g. ‘Inspect a sample of GRN’s for evidence of goods being checked before being passed into the warehouse’).Substantive tests: these test the transactions and balances in order to provide evidence on the completeness, accuracy and validity of items contained within the financial statements (e.g. ‘Agree a sample of stock lines on the computer printout to actual physical stock held in the warehouse’).

3 PROCEDURESThere are a number of procedures for obtaining evidence:• Analytical procedures review trends and ratios and investigate any unusual variations• Enquiry of knowledgeable persons• Inspection documents, records and assets• Observe a process or procedure being performed• Calculate arithmetical accuracy of documents.


3.1 EXERCISE 1Using the 5 procedures above (aeiou) list some audit tests for fixed asset additions

4 SAMPLINGDefinition: applying procedures to less than 100% of the items within an account balance or class of transactions in order to form a conclusion on the population. In some cases however a 100% check is required e.g. few transactions with a high value, specific areas (directors’ loans etc), unusual one off transactions, etc.

4.1 EXERCISE 2List the reasons why an auditor does not check 100% of all balances.

4.2 STAGES OF SAMPLINGThere are four stages to sampling:• Design• Selection• Testing• Evaluation.

4.3 DESIGNMatters to considerSpecific audit objective Population, sampling unit and use Sample size (purpose of test) of stratificationAppropriate Sampling Stratification into & complete unit sub populations .To ensure debtors not Total Individual UK V Overseas overstated debtors per customer balance NL ConsiderationsSampling risk Tolerable error Expected error (overall risk of client (maximum error/ (expected by auditors decided at planning stage) materiality) based on past experience)

4.4 SELECTIONThe sample should be selected such that it is representative of the population as a whole. Thus all items in the population should have an equal opportunity of being selected.There are three methods commonly used:• Random using random number tables• Systematic constant interval between items with a random start (e.g. every 10th)• Haphazard acceptable alternative to random provided auditors satisfied that bias and predictability are avoided

4.5 TESTINGThe audit procedures are carried out on each sample item and the results obtained.

4.6 EVALUATIONAuditors must now analyse the errors obtained and draw inferences for the population as a whole.

When analysing the error the auditor considers whether:• It is an isolated error• The possible effect on other areas• The cause of error.In order to draw inferences for the rest of the population auditor should:• Project error results on to whole population (via extrapolation)• Consider/estimate further errors not detected• Re-assess sampling risk if projected error exceeds tolerable error.

4.7 EXAMPLE 1Lamed Ltd has debtors of £500,000. This is made up of 150 individual balances. The auditors have circularised 25 debtors (value £300,000) and received back all the replies. One debtor circulated stated an amount owed of £10,000 but the debtors ledger stated an amount owed of £15,000.What effect does this error have on the population as a whole?


£ Total error X population£ Sample5,000 X 500,000 =£8,333300,000If this error is projected to the whole population the maximum error would be £8333Materiality of Lamed Ltd is set at £8,000. What effect does this have on the above result?The sample size would need to be increased until the projected error was lower than materiality.E.g. A further two debtors were circularised each with a balance of £9000 each. Both letters were returned to the auditors agreeing with the ledger balance. The calculation is then re performed. 5,000 318,000 X 500,000 = £7,862A maximum error of £7,862 is immaterial and therefore no further work is required.

5 ANALYTICAL PROCEDURES (SAS 410)Analytical review procedures (ARP’s) should be used at the planning, evidence and review stages of the audit.

Analytical procedures can compare the relationship between financial data (e.g. compare debtors with turnover) or between financial and non-financial data (e.g. payroll with the number of employees). They can include comparisons between: • Financial periods• Budgets• Industries.At the evidence stage the decision as to whether to use ARP’s is based on the auditor’s judgement about the effectiveness and efficiency of the available procedures in reducing detection risk.

When determining whether to use ARP’s at the evidence stage auditors must consider:• Plausibility and predictability of relationships• Objectives of ARP’s and the extent results reliable• Availability of information• Relevance of information• Comparability of info available.

ARP’s when applied correctly can provide sufficient audit evidence where an item can be verified directly by reference to another (proof in total) e.g. calculate commission by 2% of sales. In most cases however ARP’s will be used in conjunction with other substantive tests.

6 MANAGEMENT REPRESENTATIONS (SAS 440)Throughout the audit, management will make representations to the auditors both on specific and general matters. To reduce the possibility of misunderstandings between the auditors and management these representations should be confirmed in writing. Where the representations are material to the financial statements the auditors must:• Seek corroborative audit evidence• Evaluate whether the representations are reasonable and consistent with other audit evidence• Consider whether the individuals making the representations can be expected to be well informed in these particular matters.Representations are not a substitute for other audit evidence and only where other audit evidence is unavailable, such as where knowledge of the facts is confined to management or where the matter is one of judgement or opinion, can management representations be considered sufficient audit evidence.

6.1 EXAMPLE OF A MANAGEMENT REPRESENTATION LETTER(Company letterhead)(To the auditors)(Date)We confirm to the best of our knowledge and belief, and having made appropriate enquiries of other directors and officials of the company, the following representations given to you in connection with your audit of the financial statements for the period ended 31 December 19…


(1) We acknowledge as directors our responsibilities under the Companies Act 1985 for preparing financial statements which give a true and fair view and for making accurate representations to you.All the accounting records have been made available to you for the purpose of your audit and all the transactions undertaken by the company have been properly reflected and recorded in the accounting records. All other records and related information, including minutes of all management and shareholders’ meetings, have been made available to you.(2) The legal claim by ABC Limited has been settled out of court by a payment of £258,000. No further amounts are expected to be paid, and no similar claims have been received or are expected to be received.(3) In connection with deferred tax not provided, the following assumptions reflect the intentions and expectations of the company:(a) capital investment of £450,000 is planned over the next three years;(b) there are no plans to sell revalued properties; and(c) we are not aware of any indications that the situation is likely to change so as to necessitate the inclusion of a provision for tax payable in the financial statements.(4) The company has not had, or entered into, at any time during the period any arrangement, transaction or agreement to provide credit facilities (including loans, quasi-loans or credit transactions) for directors or to guarantee or provide security for such matters.(5) There have been no events since the balance sheet date which necessitate revision of the figures included in the financial statements or inclusion of a note thereto.As minuted by the board of directors at its meeting on ………… (date)____________ _________________Chairman Secretary

7 USING THE WORK OF OTHERS (SAS 520)Auditors have sole responsibility for there opinion but may use the work of an expert.The need to use an expert may apply in the following examples:• Valuation of certain assets (works of art, precious stones etc.)• Determining quality and/or quantity of assets (minerals stored in stockpiles, underground petroleum reserves)• Valuations using specialist techniques (pensions accounting and actuarial valuations)• Measurement of work completed and to be completed on contracts in progress• Legal opinions re the outcome of disputes, interpretation of agreements etc.It is also becoming increasingly common for companies to outsource certain activities to service organisations who have more expertise than the entity e.g. payroll function. Thus the auditor must consider the sufficiency and reliability of evidence provided by these experts and service organisations. During the planning stage of the audit the auditor must assess the objectivity and professional qualifications, experience and resources of the expert.

During the evidence gathering stage the auditor must obtain sufficient and appropriate audit evidence that the expert’s work is adequate for the purposes of the audit. The auditor must also assess the appropriateness of the auditor’s work by considering:• Source data used• Assumptions and methods used• When work carried out• Any changes in assumptions compared with previous years• Results of the experts work in the light of auditors overall knowledge of the business. During the reporting stage of the audit, no reference to the work of the expert is made by the auditors in the audit report.SAS 480: Service organisations states auditors must consider whether sufficient and appropriate audit evidence is available from records held at the entity. If evidence is not available at the entity, auditors should try and obtain evidence via direct access to the service organisation or via the service organisation’s auditors.

8 ACCOUNTING ESTIMATES (SAS 420)Definition: an approximation of an amount of an item in the absence of a precise means of measurement. For example, allowances to reduce stock and debtors to estimated realisable value, depreciation provisions, provision for loss from a lawsuit etc.Directors and management are responsible for making the estimates and are likely to include an element of uncertainty; therefore audit evidence obtained is likely to be less conclusive.


8.1 NATURE OF ESTIMATES• High degree of special knowledge and judgement• May be produced non-routinely e.g. at year end• May be complex (stock valuation)• Audit evidence more difficult to obtain and less conclusive.

8.2 AUDIT PROCEDURES• Review and test process used by management to develop the estimate (evaluate the data used, consider the assumptions, test any calculations, compare with prior periods etc.)• Use an independent estimate for comparison• Review subsequent events.


PAPER 2.6CHAPTER 7

AUDIT EVIDENCE (SUBSTANTIVE TESTS)

1 INTRODUCTIONTo obtain audit evidence from substantive procedures, auditors must consider the extent the evidence meets the financial statement assertions. Assertions are the representations of the directors that are embodied in the financial statements.• Completeness All assets, liabilities and transactions are included• Occurrence Transaction occurred in the relevant period• Measurement Transaction recorded at the proper amount• Presentation Disclosure with applicable reporting framework• Appropriate carrying value Recorded at correct valuation• Rights and obligations Assets and liabilities rightly belong to the client• Existence Assets and liabilities actually exist at a given date.

2 FIXED ASSETS

2.1 EXERCISE 1Using the financial statement assertions, consider the key risks in the audit of tangible fixed assets.

2.2 EXERCISE 2Considering both the financial statement assertions and the risks, design the audit tests appropriate for auditing tangible fixed assets.

3 STOCK AND WIP

3.1 EXERCISE 3Consider the key risks in the audit of stock.

3.2 CUT OFFCut off determines where one accounting period ends and another begins. Errors or inconsistencies can create a misleading profit figure.

3.3 EXERCISE 4Fimbles Ltd has a year end of 31st December X3. December’s transactions have not yet been posted. Stock as at 30th November was £100,000..1) Purchase invoice dated 28th December X3 for £10,000. The invoice was received on the 3rd January X4. The goods were received on the 15th December X3.2) Sales invoice dated 5th January X4 for £15,000. The goods were despatched on the 28th December X3.3) Purchase invoice dated 4th January X4 for £8,000. The goods were received on the 31st December X3.4) Sales invoice dated 29th December X3 for £5,000. The goods were despatched on the 2nd January X4.What should the value of closing stock be as at 31st December X3?

3.4 AUDIT PROCEDURESObtain a sample of pre year-end GRN’s and ensure:• included in purchases and creditors/cash paid• included in year-end stock.Obtain a sample of pre year-end GDN’s and ensure:• included in sales and debtors/cash received• not included in year end stock.


Obtain a sample of post year-end GRN’s and ensure:• not included in year-end stock• not included in purchases and/or creditors.Obtain a sample of post year-end GDN’s and ensure:• included in year-end stock• not included in sales and/or debtors.

3.5 STOCKTAKESWhere stock is material the auditor should attend the stock take to ensure the proper functioning of management’s stocktaking procedures and hence the existence of stock and its condition/valuation. Before During After

3.6 EXERCISE 5Using the COMPARE mnemonic and considering the risks generate substantive tests for the audit of stock.

4 DEBTORSA specific technique exists to test for the existence rights/obligation of debtors. This is known as a debtors’ circularisation.

4.1 REASONS FOR A DEBTORS’ CIRCULARISATION• Auditor should consider direct communication with debtors as a way of checking the system of internal controls over sales• It may also help to check the accuracy of the cut-off procedures• Helps draw attention to irregularities.Procedures at stocktaking• Review last period’s WPs• Discuss types of stock with MGT• Obtain copy of instructions *• Any use of internal audit• Write to third parties for confirmation• Any experts needed• Any on the road• Observe procedures• Test counts both ways• Look for obsolete/slow moving stocks• Is there cut off segregation?• Photocopy all stock• Check calculation of valuation• Check third party confirmations• Test cut off• Agree disclosure• Check draft to final sheets [*]• two people countingan area• 1 should be unfamiliar with the area• mark all goods counted

4.2 NATURE• Circularisation is an act of the client carried out at the request of the auditors (i.e. letter on client headed paper, signed by client.)• Debtor is requested to confirm the accuracy of the balance shown or state in what respect he is in disagreement.• All replies should be returned direct to the auditor• Must establish an adequate sample with particular reference to:-old unpaid accounts-accounts w/o during the period-accounts with credit balances


-nil balances-material balances.• Auditors must despatch the letter• Follow up all those who fail to respond (phone ,fax etc)• Where no response use other audit methods such as cash received after date etc.

4.3 EXERCISE 6Consider the key risks associated with the audit of trade debtors

4.4 EXERCISE 7Using the COMPARE mnemonic and the risks identified, outline the audit tests for the testing of debtors.

5 CREDITORS AND ACCRUALSWhen auditing creditors the auditor must focus on understatement. The key item of evidence available to test trade creditors will be supplier statements. These are sent by the supplier to the client on a monthly basis and detail the balance brought forward, transactions in the month and balance carried forward.

The auditor should use these statements when checking understatement of trade creditors.

5.1 EXERCISE 8Generate the key risks associated with the audit of trade creditors.

5.2 EXERCISE 9Using the COMPARE mnemonic and considering the risks, generate audit tests for the audit of creditors and accruals.

6 BANK AND CASHThe main external source of evidence available to test bank and cash is a bank letter.This details existence, amount, ownership, and custody of assets as well as detailing the existence and amounts of any liabilities.Banks require the written authority of their customers before disclosing any information. This usually takes the form of an ongoing standing authority.

Key information requested:• Account and balance details• Facilities (overdraft, loans guarantees etc)• Securities• Additional banking relationships.

6.1 KEY RISKS IN THE AUDIT OF BANK AND CASHCompleteness Interest may not be accruedBank balances may be omittedOccurrence Window dressing of year end balances by holding back chequesMeasurement/valuation Mistranslation of foreign currency balances Presentation Balances may be incorrectly netted offLoans > and < 1yrDisclosure details re loansRights and obligationsValid title to accountsExistence Cash/cheques may be misappropriatedBalances may be overstated

6.2 KEY AUDIT TESTS FOR BANK AND CASHCompleteness Review bank letter for confirmation of all accounts heldCount petty cash balancesCheck cast of bank reconciliations


Occurrence Trace outstanding items to after date bank statements to ensure subsequently cleared close to the year endMeasurement/valuation Agree to bank letterPresentation Agree correctly disclosedRights and obligations Review bank accounts to ensure valid title heldExistence Agree recorded assets and liabilities to bank letter to confirm balances


PAPER 2.6CHAPTER 8

COMPUTERS

1 INTRODUCTIONA computerised environment exists if a computer of any type or size is involved in the processing of financial information of significance to the audit.

2 STAGES OF THE AUDITIf a computer environment exists the auditor must consider this at various stages of the audit:• Planning• Internal controls• Evidence gathering.

2.1 PLANNINGSpecialist computer skills may be required to:• obtain a sufficient understanding of the auditing and internal control system• Determine the effect on risk• Design and perform appropriate audit tests.

2.2 INTERNAL CONTROLSThe controls that should be implemented for computer systems should be split into two categories:• General Controls around the system to ensure it is operating in a secure environment• Application Controls within the computer system to ensure information is accurate, complete and valid.

2.3 GENERAL CONTROLSPassword protection hierarchical changed frequently (forced by computer every month) invisible inputBack up procedures (agreement with bureau which is tested regularly) files (taken each day and stored off site)Maintenance up to date service agreement mainframe stored in air conditioned roomOther system fully documented and tested before use user’s manual training of staff.

2.4 APPLICATION CONTROLSBatch control totals data is processed in batches. A batch total of invoice amounts is calculated manually. The data is then entered on to the computer and totalled. The computer will only accept the information if the totals agree.Hash control totals as above except the total is of non £ information e.g. supplier numbers, invoice numbers etc.Check digits codes are determined via a mathematical formula and data will not be accepted for codes which do not match the set pattern.

Used to prevent transposition errors.Range/Limit checks specify maximum and minimum expected values (e.g. exception report if payroll greater than £X.Standing data authorisation of amendments either manually before input or on screen to make amendments live.One for one checks a printout of standing data amendments should be checked against a list of those that should have been made.2 people two people (user id’s) required to be involved e.g. update and authorise.


2.5 EVIDENCE GATHERINGComputer assisted audit techniques (CAAT’s) involve using a computer to perform audit work. They can be used to perform either tests of control or substantive work.

Test Data Audit softwareData run through the clients system Programs written to to ensure controls working (e.g. invoice) extract and examineMust include valid and invalid data contents of client files. Real data (but will not test extremes) Bespoke (specifically Dummy data written for client)Live system (may lose data on clients Off the shelf system-high risk)Dead system (can you be 100% sure it’s the same)Tests of control Compliance and substantive testing e.g. sample selection recalculating, casting, analytical reviewWHAT FEATURES WHY/WHEN USECheaper and easier ExpensiveRarely changed TechnicalUses restricted Several tests at onceCheaper but not cheap 100% testingIf change system must change software

2.6 EXERCISE 1Give examples of how audit software may assist you in the audit of trade debtors.

PAPER 2.6CHAPTER 9


AUDIT COMPLETION

1 OVERALL REVIEW (SAS470)An overall review is performed to ensure compliance with accounting regulations and to review for consistency and reasonableness1.1 ACCOUNTING REGULATIONSAccounting policies should be:• Appropriate to the industry• Properly disclosed• Consistently applied• In accordance with accounting standards.

Information must be disclosed in accordance with statutory requirements. A checklist is often completed to ensure the statutory requirements, accounting standards and other relevant regulations are complied with.

1.2 CONSISTENCY AND REASONABLENESSMatters to consider:• Do financial statements reflect the information and explanations received during the audit?• Does the review reveal any new factors?• Are analytical procedures performed at the completion stage consistent with the knowledge of the business?Audit completionOverall review (SAS470)Subsequent events (SAS150)Opening balances and comparatives (SAS450)Going concern review (SAS130)• Has presentation been influenced by management bias?• What is the impact of aggregated misstatements?

2 SUBSEQUENT EVENTS (SAS150)Relevant events (favourable or unfavourable) which occur, and those facts that are discovered between the period end and the laying of the financial statements before the members, or equivalent.

2.1 TIMESCALEYear end Directors approve FS FS issued AGMAudit report issued (AR)Active duty Passive dutyExamples of enquiries to management:• Status of items involving subjective judgement e.g. litigation in progress• Any new commitments, guarantees etc• Sale of assets has occurred or planned• New shares/debentures issued, or mergers etc planned• Any assets destroyed by fire or floodNormal audit work involving looking at items post year-end.Additional audit work:-checking managementprocedures to identify post balance sheet events-read minutes post year-end-review budgets/forecastsIf auditors become aware of information, discuss with directors and decide if financial statements need Directors amend:Extend procedures and issue new reportDirectors refuse to amend: make a statement at the AGM, possibly take legal advice, or Event before audit report: -consider whether revision needed -if revised do


Event after audit report: no statutory requiremen Consider making statement at AGM and legal advice• Developments regarding risk areas or contingencies• Any unusual accounting adjustments• Any events which cause doubt about the appropriateness of accounting policies.

3 OPENING BALANCES AND COMPARATIVES (SAS 450)3.1 OBJECTIVES• Opening balances correctly brought forward• Opening balances do not contain errors which affect current period FS• Accounting policies consistently applied or changes have been adequately disclosed.

3.2 AUDIT WORK• Agree balances correctly brought forward• Agree consistent accounting policies or change in policy treated correctly in accordance with FRS3• Agree disclosure of comparatives.

3.3 IF PRECEDING PERIOD AUDITOR DIFFERENTAdditional procedures:• Consultations with management• Review clients working papers, records etc. for preceding period• Consultations with previous auditor• In exceptional circumstances, substantive testing of opening balances.

3.4 IF PRECEDING PERIOD QUALIFIED• If matter now resolved and properly dealt with, then unqualified report• If matter material to current period, then current report explains how matter resulting in the qualification has been dealt with and may include a qualification on the current period’s financial statements.

4 OTHER INFORMATION (SAS 160)

5 GOING CONCERN REVIEW (SAS 130)FRS 18 and CA85 both contain going concern as a fundamental concept. The financial statements are prepared on the going concern basis. The going concern concept presumes that the enterprise will continue in business for the foreseeable

future. The foreseeable future is not defined by either FRS 18, SAS130 or CA85. It is usually understood to mean at least one year from the date the directors sign the financial statements.

If the enterprise is not a going concern then:• The value of assets may not be recovered• The amounts and dates of liabilities may change• New liabilities may arise.Does management agree to make the required Is the required amendment one that requires to be made to the financial statements? Does the matter relate to an inconsistency in a directors’ report on which auditors have a statutory

CONSIDER OBTAINING LEGAL ADVICE OR RESIGNING FROM AUDIT REFER TO INCONSISTENCY IN AUDITORS’ REPORT CONSIDER THE IMPLICATIONS FOR THE AUDITORS’ NO FURTHER ACTION Yes

5.1 RESPONSIBILITIESAuditors Directors Assess whether the FS To prepare FS giving a true and are true and fair and hence is fair view going concern basis appropriate and disclosures correct To assess whether the enterprise is a going concern.Consider how the directors have assessed going concern

5.2 INDICATORS OF A GOING CONCERN PROBLEM• Net liabilities


• Net current liabilities• Necessary borrowing facilities not yet agreed• Breaches of borrowing covenants• Severe cash flow difficulties• Major losses arising since balance sheet date• Significant fixed asset sales without replacement• Major debt restructuring• Inability to pay debts as they fall due• Changes in technology to which the company cannot adapt• Loss of key management staff• Loss of key suppliers• Essential product lines become redundant• Major litigation where adverse judgement affect company’s existence

5.3 AUDIT EVIDENCEAuditors consider the adequacy of directors’ assessment by:• Review clients system for identifying risks• Assess budgets including a review of sensitivities and assumptions.• Review obligations including loans and guarantees• Review bank facilities• Discuss plans with directors• Obtain written representations from directors.

5.4 EXTENT OF EVIDENCE REQUIREDDirectors’ assessment of the applicability of going concern depends on the company’s circumstances.

The assessment involves comparing available cash with requirements and assessing the ‘headroom’ available. If ‘headroom’ is large and business is stable then discussion with the directors of developments in the business and a discussion regarding outline plans rather than detailed budgets may be sufficient appropriate evidence.

5.5 AUDIT ASSESSMENTAuditors must decide whether the directors’ assessment is sufficient based on the evidence obtained.If the directors have not actively looked forward 12 months, auditors should document any concerns they may have, and make the appropriate disclosure in the Financial Statements.

5.6 DISCLOSUREUnqualified Report Qualified reportAgree with going concern basis Not received all relevant evidence, gives rise to a limitation in scope No significant level of concern Disclosures not made or inadequate,Concern but do not disagree gives rise to a disagreement with preparation of FS or disclosures:requires an explanatory paragraph Disagreement, and the company having little or no possibility of continuingDirectors assess period <1 yr and gives rise to an adverse opinion this has not been disclosed:requires an explanatory paragraph


PAPER 2.6CHAPTER 10

AUDIT REPORTS (SAS 600)

1 INTRODUCTIONThe auditors report should contain a clear expression of opinion based on review and assessment of the conclusions drawn from evidence obtained in the course of the audit.

2 UNQUALIFIED AUDIT REPORTAn unqualified report means that:• Financial statements have been prepared using appropriate accounting policies ,consistently applied• Financial statements prepared in accordance with relevant legislation, regulations or applicable accounting standards• There is adequate disclosure of all information• Auditors have obtained sufficient appropriate evidence enabling them to form their opinion.

An unqualified opinion for a company incorporated in Great Britain:

INDEPENDENT AUDITORS’ REPORT TO THE SHAREHOLDERS OF XYZ PLCWe have audited the financial statements of XYZ plc for the year ended.... on pages . . . to . . . . These statements have been prepared under the historical cost convention as modified by the revaluation of certain fixed assets and the accounting policies set out therein.

This report is made solely to the company’s members, as a body, in accordance with s235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in a auditors’ report and for no other purpose. To the fullest extent permitted by the law, we do not accept or assume responsibility to anyone other than the company and the company’s members as a body, for our audit work, or for the opinions we have formed.Respective responsibilities of directors and auditorsThe directors’ responsibilities for preparing the Annual Report and the financial statements in accordance with applicable law and United Kingdom Accounting Standards are set out in the Statement of Directors’ Responsibilities.

Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and the United Kingdom Accounting Standards.

We report to you our opinion as to whether the financial statements give a true and fair view and are properly prepared in accordance with the Companies Act 1985. We also report to you if, in our opinion, the Directors’ Report is not consistent with the financial statements, if the company has not kept proper accounting records, if we have not received all information and explanation we require for our audit, or if information specified by law regarding directors’ remuneration and transactions with the company is not disclosed.

We read other information contained in the Annual Report and consider whether it is consistent with the audited financial statements. The other information comprises only [the Directors’ Report, the Chairman’s Statement and the Operating and Financial Review]. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any other information.


Basis of opinionWe conducted our audit in accordance with Auditing Standards issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the company’s circumstances, consistently applied and adequately disclosed.

We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements.

OpinionIn our opinion the financial statements give true and fair view of the state of the company’s affairs as at 31 December 20.. and of its profit [loss] for the year then ended and have been properly prepared in accordance with the Companies Act 1985.

Registered auditors AddressDate

2.1 EXPLANATIONSFS on pages …to… So all users understand exactly which areas the auditors are giving their opinion on.Directors are responsible So the users understand who is responsible for the preparation and that the audit function is just to give an opinion. This aims to lessen the expectation gap.

Accordance with auditing Standards followed during the course of the audit standardsTest basis Not 100% testingAssessment of significant Some areas are not totally quantifiable estimates…Accounting policies are Shows these have been considered appropriateSufficient evidence, Not 100% accurate reasonable assurance, free from material misstatementTrue and fair view No statutory definition.A widely accepted definition indicates true relates to factual accuracy (bearing in mind materiality), fair relates to presentation and the overall view conveyed to user.

Properly prepared In accordance with CA85 with regards to formats and disclosure requirements, valuation rules, fundamental concepts.Reporting by exception Auditors have additional responsibilities to report by exception on the following (RAPIDD)

3 QUALIFIED

AUDIT REPORT QualifiedReturns from branches not visitedAccounts agree with the underlying records Proper books and records have been keptInformation and explanations receivedDirectors’ report consistentDisclosure of directors’ information been complied with in the accounts.Disagreement Limitation in scope


Auditors disagree over accounting Evidence the auditors reasonably treatment, facts, disclosure. expected to be available is not Except for:MaterialIn opinion paragraph, detail the itemState “except for”Adverse:Highly material or pervasiveIn opinionparagraph detail the itemState “financialstatements do not give a true and fairExcept for:Material In basis of opinion paragraph,explain limitationIn opinion paragraph, state “except for”Disclaimer:Highly material or persuasiveIn basis of opinion paragraph, explain limitation In opinion paragraph, “we are unable to form an

4 FUNDAMENTAL UNCERTAINTYInherent uncertainty an uncertainty whose resolution is dependent upon uncertain future events (outside directors’ control) at the date the Financial Statements are approved.

Fundamental uncertainty an inherent uncertainty whose potential impact is so great that without clear disclosure regarding the nature and implications the Financial Statements would be seriously misleading. Examples are going concern doubts, major litigation etc.If an uncertainty is judged to be fundamental the auditor must include an explanatory paragraph (in their basis of opinion) describing the matter and the possible effects on the Financial Statements, including, where possible, quantification.

An appropriate sub-heading should be used e.g. Going concern, so as to differentiate the explanatory paragraph from other matters included in the basis of opinion section. An explanatory paragraph is not a qualification. Inadequate disclosure within the Financial Statements of a fundamental uncertainty would however require an ‘except for’ qualification on the grounds of disagreement.

5 EXERCISE 1In the following examples state the type of audit report you would issue and explain why you have reached these conclusions.

1)Due to an administrative error a new branch of Spencers and Marks did not receive any stock take instructions and no count took place. The stock was material and estimated to be £40,000 in the final accounts.2)Milo Ltd started development on an odourless tobacco in June X2. Expenditure is expected to be £600,000 over 5 years. The outcome of the project will not be certain until the end of the second year of the project. The directors have capitalized development costs to date of £150,000. Materiality is £50,000.3)Bella Ltd is currently being sued by a former employee for unfair dismissal. Bella Ltd’s year end is 31st December X3. The case is not due in court until March X4. The solicitors letter states Bella may lose the case and may have to pay damages of up to approx £80,000. The directors have fully disclosed all the information in accordance with FRS 12.


PAPER 2.6CHAPTER 11

INTERNAL AUDIT (SAS 500)1 INTRODUCTION

Internal audit is a review of the accounting and internal control systems within a company as an aid to management.The internal audit function may be carried out by an internal department, or it may be sub-contracted out to an independent firm of accountants.The Cadbury Report concluded ‘We regard it as good practice for companies to establish internal audit functions to undertake regular monitoring of key controls and procedures.’

2 EXERCISE 1List the advantages and disadvantages of outsourcing the internal audit function

3 COMPARISON BETWEEN EXTERNAL AND INTERNAL AUDITORSExternal InternalRequired by Statute for all companies with turnover > £5.6mManagement Appointed by Shareholders ManagementReports to Shareholders via audit reportManagement Reports on Financial statements Internal controlsForms opinions on True and fair view and proper preparation of accountsWide ranging but may include adequacy of internal controls, Value For Money audit, special investigations e.g. suspected fraud etcStatus Independent Employee of company or contracted by company (outsourced)

Qualification Usually ACCA, ICAEW, ICAS or ICAI May also be a member of other professional bodies (e.g. AAT) or be unqualified Scope Unlimited to fulfil As prescribed by statutory obligation management Conduct of work In accordance with SAS’s Similar stages of planning, evaluation of accounting systems and internal controls, evidence and reporting

4 UNDERSTANDING AND ASSESSMENT OF THE ROLE OF EXTERNAL AUDITORSExternal auditors should obtain an understanding of any internal audit procedures to assist in planning the audit approach.The external auditors should perform an assessment of the internal audit function if they consider that it may be possible and desirable to rely on certain internal audit work in specific audit areas for the purpose of the external audit of the financial statements.If the external auditors can rely on the work of the internal auditors then the volume of work undertaken by the external auditors may be reduced.

4.1 FACTORS TO CONSIDEROrganisational status Reports to highest level of managementFree of operating responsibilityFree to communicate with external auditors.Scope of function Nature/extent of assignmentsWhether management/directors act on recommendations.Technical competence Performed by persons having adequate technical trainingRecruitment policyProfessional qualifications.Due professional care Work properly planned, supervised, reviewed, documentedAdequate audit manuals, work programmes, working papers exist.

4.2 USING THE WORK OF INTERNAL AUDITORSIf the external auditor decides to use the work of the internal auditors they must assess how much reliance they can place


on the work and evaluate the work to confirm its adequacy for their purposes.

4.3 FACTORS TO CONSIDER• Audit risk• Materiality of areas• Level of judgement involved• Sufficiency of other evidence• Skills of internal audit staff• Conclusions are appropriate in the circumstances• Reports prepared by internal auditors are consistent with results• Exceptions properly resolved.The external auditor must test the work of the internal auditor to confirm its adequacy.

5 CORPORATE GOVERNANCEDue to a number of business failures the Cadbury committee was formed to advise on the prevention of further failures. Sir Adrian Cadbury said “if you look at all the failures of quoted companies in the past, they have all been failures of internal controls.’’…an effective internal control system is an essential part of the efficient management of a company.

Cadbury key requirement ‘directors should report on the effectiveness of the company’s system of internal controlGreenbury reported on directors remuneration Hampel reviewed Cadbury and its implementation. Subsequently published the Combined Code which brought together principles of good governance and a code of best practice based on Hampel, Cadbury and Greenbury.

Turnbull rules for how companies report on their internal risk systems.It should be noted that since its first release the Combined Code has been reissued to incorporate further enhancements to corporate governance.

5.1 PRINCIPLES OF GOOD CORPORATE GOVERNANCEDirectors: The boardEvery listed company should be headed by an effective board, which should lead and control the companyDirectors: Chairman and CEOThere should be a clear division of responsibilities at the head of the company, which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision CadburyGreenbury HampelCombinedcodeTurnbullDirectors: Board balanceThe board should include a balance of executive and non-executive directors such that no individual or small group can dominate the board’s decision makingDirectors: Supply of informationThe board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties.Directors: Appointments to the boardThere should be a formal and transparent procedure for the appointment of new directors to the board.Directors: Re-electionAll directors should be required to submit themselves for re-election at regular intervals. Ideally for executive directors this should be annually, but. can never exceed three years

Directors’ remuneration: Level and make-upRemuneration should be sufficient to attract and retain the directors needed to run the company successfully, but companies should avoid paying more than is necessary for this purpose.

A proportion of executive directors remuneration should be structured so as to link rewards to corporate and individual


performance.Directors’ remuneration: ProcedureCompanies should establish a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration package of individual directors.

No director should be involved in deciding his/her own remuneration.Directors’ remuneration: Disclosure

The annual report should contain a statement of remuneration policy and details of the remuneration of each director.

Relations with shareholders: Dialogue with Institutional Shareholders Companies should be ready, where practicable, to enter into a dialogue with institutional shareholders based on the mutual understanding of objectives. Relations with shareholders: Constructive use of the AGMBoards should use the AGM to communicate with private investors and encourage their participation.

Accountability and Audit: Financial ReportingThe board should present a balanced and understandable assessment of the company’s position and prospects.

Accountability and Audit: Internal ControlThe board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.

Accountability and Audit: Audit Committee and AuditorsThe board should establish formal and transparent arrangements for considering how they should apply financial reporting and internal control principles.They should also establish arrangements for maintaining an appropriate relationship with the company’s auditors.

6 RISK MANAGEMENTThe Turnbull Report recognised the importance of risk management and gave guidance as to how to apply it in practise.

6.1 OBJECTIVES• Identify significant risks which could be damaging to the achievement of the company’s objectives• Provide a framework for a company to fulfil its business objectives• Reinforce what senior management and the board are seeking to achieve in order to meet the company objectives.

6.2 PROCESS OF RISK MANAGEMENTTo enable directors to assess the risks and evaluate the controls faced by their business.

DecideMaterialityList ObjectivesIdentify risksList existingcontrolsList existingassurancesIdentifymissingcontrols andAction planReport


PAPER 2.6CHAPTER 12

NOT-FOR-PROFIT ORGANISATIONS

1 INTRODUCTIONThe most common not-for-profit organisations are charities. Other examples are clubs (sports, political or religious) and societies and public sector institutions. If the organisations are limited companies they may require audits; however they if they are not incorporated under CA85 they may simply require assurance reports.

2 AUDIT PROCEDURESAuditors must apply the same professional standards even if the fee charge is negligible or nil. If an opinion on truth and fairness is required an auditor should follow the SAS’s. Whilst there are special features of not-for-profit organisations,auditors still need to take the same kind of approach to audits, reviewing background information, identifying and evaluating risks, reviewing controls, carrying out tests and reporting.

2.1 MATTERS TO CONSIDER• Is an audit needed?• Size of organisation• Risks and controls and accounting records• Main outgoings• Constitution• Principal accounting policies• Accuracy of the financial statements.

2.2 COMMON INTERNAL CONTROLS• Control over collection boxes/tins• Dual counting of tins• Dual opening of mail• Acknowledgements sent to all donors• Deeds of covenants regularly checked and amounts outstanding checked• Tax on covenants recovered regularly.

2.3 COMMON RISKS• Understatement of income, especially legacies, gifts in kind, etc• Accounting treatment of lifetime subscriptions incorrect• Accounting treatment of government grants not in accordance with SSAP4• Overstatement of expenses• Mis-analysis or misuse of funds• Misstatement of assets• Misstatement of expenses to disguise excessive administration expenses• Omission of branches• Grants to beneficiaries not in line with charity objectives• Banking not made promptly.


2.4 REPORTING• Audit report in line with SAS600 if charity is incorporated under statute• If organisation not incorporated then report will be determined in accordance with the terms of the engagement.

2.5 DIFFERENCE BETWEEN AUDITING PROFIT AND NOT-FORPROFITORGANISATIONSProfit Not-for-profitObjective Maximise profitabilityVarious but don’t include profitControls May be many internal controlsProcedures may be simpler and less formalisedPeople Employed workersMay be lots of volunteersFunding Generated income to make a profit Subscriptions, fund raising


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