MSIN 6004 Accounting for Business Revision Notes Lecture 1. Introduction A Definition of Accounting:
Accounting is the process of identifying, collecting, measuring, analyzing and communicating.
Accounting shows the financial information of an organization to enable users of the information to make informed Judgments and decision.
Accounting has two main stands:
Management Accounting: internal reporting, seeks to meet the needs of the business’s manager.
Financial Accounting: external reporting, seeks to meet the needs of other user group.
Forms/ types of Businesses:
Sole proprietorship: easy to set up but owner has unlimited liability.
Partnership: easy to set up, spreads burdens between partners, but has unlimited liability and ownership risks.
Limited company: limited liability, but relatively high regulation and obligations imposed on company’s conduct (both private and public).
Main financial statements:
Statement of financial positions (balance sheet)
Income statement (profit and loss account)
Statement of cash flows
Notes comprise a summary of very detailed accounting policies.
Qualitative characteristics:
Relevance: relevant financial information is capable of making a difference in the decisions made by users. (Through predictive and confirmative value)
Faithful representation: information should be complete, neutral, and free from error.
Some supplementary characteristics: comparability (consistency over years), verifiability, timeless (information should be published on time, when it is useful) and understandability.
Accounting Conventions:
Accruals (also known as matching principle)
Business entity
Consistency
Dual aspect (credit and debit)
Going concern (remain in business)
Historic cost (inventory valuation)
Money measurement (only tangible assets can be easily valued)
Prudence (not expecting profit until it is generated)
Realization
Cash Measurement and Profit Measurement:
Cash flows are recorded regardless of the accrual basis, when we buy two tables (each at $50) and only sell one of them at $70, the cash outflow will be $100 and inflow would be $70, results in an -$30 outflow.
However, profit measurement is in an accrual basis, which means in the same case the revenue would be $70 and cost of good sold (COGS) is $50, results in an $20 profit. We did not take the other table into account because it has not been sold, so it is counted as an asset (inventory).
Lecture 2: Financial Frameworks for Financial Statements 1 Cash Flows Statement: Sample structure:
Tax is also a component of both the cash flows statement and income statement, but only gets recorded in the cash flow statement if the entity pays it during the year (no matter it is the tax for last year or this year). There is no tax component for sole trader as income tax is charged on individual basis. For limited companies, tax is charged on net profit, after deducing tax, it gives the figure for profit after tax (PAT). Interests earned on investment should also be recorded in the cash flows.
Income statement: sample structure:
Cost of goods sold (COGS) = Open Inventory + Purchases – Closing Inventory
Tax for limited companies are calculated based on net profit figure.
Balance Sheet: sample structure
Retained earnings are net profit less drawings (for unlimited entity); net profit less dividend (for limited entity).
Retained earnings will be transferred into reserve account (in the equity side of the balance sheet).
Accounting Equation: Total Asset = Equity + Total Liability
Every time we record a transaction, we need to make sure that we keep the Balance Sheet in balance hence the need to record in systematic way.
General method to distinguish debit and credit:
Increase in Asset -> Debit
Decrease in Asset -> Credit
Increase in Liability or Equity -> Credits
Decrease in Liability or Equity -> Debit
This means any increase in income statements such as revenue should be counted as a credit, because it increases profit, and therefore belongs to the Equity. Vise Versa.
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On the other hand, any increase in cash, namely cash inflows, should be counted as a debit as it contributes to cash, which is a component of asset in balance sheet.

DEBIT always stays on the left and Credit always stays on the right. In asset accounting, debit (+) and credit (-). Vice Versa, in the liability and equity account, debit (-) and credit (+).
Lecture 3: Financial Frameworks for Financial Statements 2 Assets
Asset: a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to that entity.
Non-current assets: are those assets that are not purchased for resale in the normal course of business: this means that the assets are retained within the business for periods of more than one year and are not acquired with the intention of reselling them immediately or in the near future. It is also held for long-term use in the business to produce goods or services.
Current assets: are short-term assets which are constantly changing, such as inventory, receivables, cash and cash equivalents.
Liability: A present obligation of an entity arising from past events, the settlement of which is expected to result in a outflow from the entity of resources embodying economic benefits.
Current liability (usually payable within one year) and non-current liabilities (payable in more than one year).
Inventory valuation:
In general there are three types of inventory valuation method: first in first out (FIFO), last in first out (LIFO) and average cost (AVCO).
The closing inventory is valued at historic cost or net realizable value, depending on which one is lower, as it aims to maximize profit.
If the closing inventory is deteriorated and can only be sold at $10 (originally $60), then inventory should be written down by $50 in Asset (as a credit) and Income statement/profits retained (as a debit).
Debtor valuation – doubtful debts:
There are always some risks that customer failed to pay, so the risk of nonpayment is dealt by reducing the asset by an estimate for doubtful debts, which is bee referred to as a provision (allowance) for bad/doubtful debts.
So in receivables account, it decreases due to bad debt so the increase in bad debt is a credit item. In the bad debt expense account (sub-section of receivables), bad debt is debit as it increases.
For writing off bad debts, it is better to put it in the receivables account. If the provision of bad debt changes, it should be written in the debt provision account.
Example, if the same business was owed $100,000 at the start of the year and is now owed $80,000 at the end, assume bad debt provision is at 10%, then the provision should be $8000 and must be decreased form $10,000 by $2,000 to $8,000. So there will be a debit entry of $2000 in the provision of bad debt account and a credit entry with the same amount in the income statement.
Depreciation:
Since non-current assets are gradually used up in providing goods and services over time, depreciation is used to spread the cost of a non-current asset over its expected useful life and charge an appropriate proportion to the income statements of the period benefiting from use of that asset.
Net book value (NBV): is the historical cost minus the depreciation value. It is not intended to represent the asset’s market value
There are in general two depreciation methods: straight-line method and reducing balance (declining balance).
Straight Line method:
Reducing balance method:
Residual value / Value at the end of useful life:
Under straight-line method, the value at the end of the useful life is zero. Whereas under the reducing-balance method, there will always be an end book value.
However, if the question gives the residual value of an asset, and asks to use straight-line method, we should take into account the residual value in order to calculate the depreciation each year ((value at purchase – residual) / number of years). But if we are using the reducing balance method, there is no need to consider the residual value.
If the asset is disposed, the book value is set against any sale value received, and a profit or loss on disposal arises.
Non Current Assets: Valuation 
Tangible assets are normally valued at net book value or carrying amount (after revaluation). Revaluation may take place where the Asset is given a valuation above cost, usually applied to land and buildings.
Examples of Current liabilities:
Lecture 4: Double Entry Bookkeeping and Trail Balance Double Entry Bookkeeping: 
A transaction is the carrying out and performance of any piece of business, usually an economic event, and all transactions have a twofold effect which are recorded in the accounts using double entry system.
Examples of balances on accounts:

Asset accounts and expenses accounts will have a debit balance at the end of an accounting period, whereas liabilities accounts, equity accounts and income accounts will have a credit balance at the end of an accounting period.
Example:
The Trail Balance:

This is a statement complied at the end of an accounting period, it lists the balances on each account in the account books. The total value of all debit balances must equal the value of all credit balances.
Example:
Lecture 5. Cash Flow Statements and Accounting for Limited Companies. Cash Flow Statement
The simple cash flow statement is informative at least to a degree in that it does show cash in and cash out. When a cash flow statement is published, accounting regulation requires that the layout to be re-arranged, show three major cash flow activities: operating, investing and financing.
There are two methods of preparation: direct and indirect. The direct method is used within your own company where you already have available all the cash receipt and payments details.
Indirect method is used where the opening and closing balance sheets and income statement are available. Direct Method: Cash flow from operating activities Debtor Admin Creditor Expenses Interest(outflow) Tax Dividend
$$$
Cash flow from investing activities Interest on lending to others (inflow) Purchase on non-current asset Cash flow from financing activities Share issued Bank loan
Indirect method Net profit before tax
$$$
+ Depreciation expenses + Interest expenses + Increase in payables + Decrease in receivable + Decrease in inventory - Interest paid - Corporation taxation - Dividend paid = Net Cash flow from operation + Net Cash flow from investing + Net Cash flow from financing 1. loan 2. shares 3. capital injection
For investing activities, cash spent on acquiring new long live assets and cash received from sale of existing long lived assets are identified. (If in the balance sheet, starting NBV is 90000 and closing NBV is 130000, the depreciation charged during the year is 10000, then the amount spend on purchase new equipment should be (130000 – (90000-10000)) = 50000.
Disposal of non-current asset is included in investing activities.
For financing activities, cash relating to any repayments of loans, acquisition of new loans, buy-back of shares, issues of new shares are identified.
Limited companies:
Ordinary share (common stock) are found in all companies and in the majority of cases represent the only type of share issued.
Preference shares (preferred stock) often do have a guaranteed right to a set dividend and any dividends are paid first to preference shareholders, so there is less risk.
Authorized share capital: maximum amount of share capital the company can issue.
The value placed on a share at the time of formation is known as the par or nominal value. The selling price may be higher (at a premium) or at the nominal value.
Lecture 6. Using Ratio to Analyze and Interpret Financial Performance. 
There are three steps involved in financial ratio analysis: firstly, identifying for whom and for what purpose the analysis and interpretation are required; secondly, selecting appropriate ratios and calculate them; finally, forming a view based on the information produced.
Main Ratios to be identified:

The GEARING category can also be written as solvency, which refers to the company’s long-term ability to pay its debts. The LIQUIDITY category refers to the company’s short-term ability to manage its debt.
The Profitability Ratio: 
The main objective of most businesses is to earn money for the owners, so the measure of return to equity (ROE / ROSF) can be a good gauge. đ?‘?đ?‘&#x;đ?‘œđ?‘“đ?‘–đ?‘Ą đ?‘Žđ?‘Łđ?‘Žđ?‘–đ?‘™đ?‘Žđ?‘?đ?‘™đ?‘’ đ?‘Ąđ?‘œ đ?‘œđ?‘&#x;đ?‘‘đ?‘–đ?‘›đ?‘Žđ?‘&#x;đ?‘Ś đ?‘ â„Žđ?‘Žđ?‘&#x;đ?‘’ â„Žđ?‘œđ?‘™đ?‘‘đ?‘’đ?‘&#x;đ?‘
ROE = đ?‘œđ?‘&#x;đ?‘‘đ?‘–đ?‘›đ?‘Žđ?‘&#x;đ?‘Ś đ?‘ â„Žđ?‘Žđ?‘&#x;đ?‘’â„Žđ?‘œđ?‘™đ?‘‘đ?‘’đ?‘&#x; ′ đ?‘ đ?‘’đ?‘žđ?‘˘đ?‘–đ?‘Ąđ?‘Ś đ?‘‚đ?‘… đ?‘Ąđ?‘œđ?‘Ąđ?‘Žđ?‘™ đ?‘’đ?‘žđ?‘˘đ?‘–đ?‘Ąđ?‘Ś 
For multiple periods, use average value of the equity to compare across time.

A good ROE comes from good return of capital employed (ROCE):
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ROCE = đ?‘Ąđ?‘œđ?‘Ąđ?‘Žđ?‘™ đ?‘?đ?‘Žđ?‘?đ?‘–đ?‘Ąđ?‘Žđ?‘™ đ?‘’đ?‘šđ?‘?đ?‘™đ?‘œđ?‘Śđ?‘’đ?‘‘
Operating Profit Margin% =
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x100% đ?’”đ?’‚đ?’?đ?’†đ?’”
Net Asset Turnover (sales to capital employ) = đ?’•đ?’?đ?’•đ?’‚đ?’? đ?’„đ?’‚đ?’‘đ?’Šđ?’•đ?’‚đ?’? đ?’†đ?’Žđ?’‘đ?’?đ?’?đ?’šđ?’†đ?’…  The total capital employed is assumed to be equal to Total Asset – Current Liability, which means ROCE can be derived from Operating Profit % and Net Asset Turnover: ROCE = Operating Profit % x Net Asset Turnover.  So profit margin and net asset turnover are the drivers of profitability as measured through ROCE. Gross Profit % =
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x100%
 Gross profit is simply revenue minus cost of goods sold. So when cost of goods sold increases or price decreases, the gross profit % will decrease and vice versa. However, bear in mind that decrease in price may lead to higher quantity sold, so the actual figures for gross profit may increase or decrease while gross profit % falls.  These ratios may be compared with targets for the year, with competitors’, and with industry averages, and if company is older than one year, it can be compared with previous years.
Efficiency Ratio: đ?’”đ?’‚đ?’?đ?’†đ?’”
Non-current Asset Turnover (aka fixed asset turn) = đ?’?đ?’?đ?’?−đ?’„đ?’–đ?’“đ?’“đ?’†đ?’?đ?’• đ?’‚đ?’”đ?’”đ?’†đ?’•
Liquidity Ratio: 
Liquidity ratios mainly refer to the firm’s short-term ability to maintain its business. They provide a good implication of how the company is managing the working capital cycle.

Management of the working capital cycle demands minimum investment of money in working capital and maximum speed of cash through the cycle. These can be monitored via: current ratio, quick ratio, receivables days, payables days, inventory days. đ?’„đ?’–đ?’“đ?’“đ?’†đ?’?đ?’• đ?’‚đ?’”đ?’”đ?’†đ?’•đ?’”
Current ratio= đ?’„đ?’–đ?’“đ?’“đ?’†đ?’?đ?’• đ?’?đ?’Šđ?’‚đ?’ƒđ?’Šđ?’?đ?’Šđ?’•đ?’Šđ?’†đ?’”
Quick ratio=
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Inventory Days= đ?‘Şđ?’?đ?’”đ?’• đ?’?đ?’‡ đ?’ˆđ?’?đ?’?đ?’…đ?’” đ?’”đ?’?đ?’?đ?’… x 365 đ?‘šđ?’†đ?’„đ?’†đ?’Šđ?’—đ?’‚đ?’ƒđ?’?đ?’†đ?’” đ?’ƒđ?’‚đ?’?đ?’‚đ?’?đ?’„đ?’†
Receivable Days=đ?‘¨đ?’„đ?’„đ?’?đ?’–đ?’?đ?’• đ?’”đ?’‚đ?’?đ?’†đ?’” ( đ?‘śđ?‘š đ?’–đ?’”đ?’† đ?’”đ?’‚đ?’?đ?’†đ?’” đ?’‚đ?’” đ?’‚đ?’? đ?’‚đ?’‘đ?’‘đ?’“đ?’?đ?’™đ?’Šđ?’Žđ?’‚đ?’•đ?’Šđ?’?đ?’?) x 365 đ?‘ˇđ?’‚đ?’šđ?’‚đ?’ƒđ?’?đ?’† đ?’ƒđ?’‚đ?’?đ?’‚đ?’?đ?’„đ?’†
Payable Days=đ?‘¨đ?’„đ?’„đ?’?đ?’–đ?’?đ?’• đ?’‘đ?’–đ?’“đ?’„đ?’‰đ?’‚đ?’”đ?’†đ?’”( đ?‘śđ?‘š đ?’–đ?’”đ?’† đ?’„đ?’?đ?’”đ?’• đ?’?đ?’‡ đ?’ˆđ?’?đ?’?đ?’…đ?’” đ?’”đ?’?đ?’?đ?’… đ?’‚đ?’” đ?’‚đ?’? đ?’‚đ?’‘đ?’‘đ?’“đ?’?đ?’™đ?’Šđ?’Žđ?’‚đ?’•đ?’Šđ?’?đ?’?) x 365 
Use these ratios to compare with targets for the year, competitors’, industry averages and with previous years.
The Cash Conversion Cycle = Inventory Days + Receivable Days – Payable Day 
Overtrading is a situation when the level of activity carried out by the company cannot be supported by the level of the working capital financing. It occurs when the business faces rapid increase in demand for its product; managers miscalculated the level of expected sales and when financing is simply not available.
Capital Gearing Ratio (Leverage ratio): 
Leverage ratio can be expressed in one of three different ways, and it is common to use External Funding (Debt = long term borrowing + short term borrowing) as a proportion of the total capital employed.

Three leverage ratios: đ?‘Źđ?’™đ?’•đ?’†đ?’“đ?’?đ?’‚đ?’? đ?’‡đ?’–đ?’?đ?’…đ?’Šđ?’?đ?’ˆ
Debt to Total Capital Employed = đ?‘ťđ?’?đ?’•đ?’‚đ?’? đ?’„đ?’‚đ?’‘đ?’Šđ?’•đ?’‚đ?’? đ?’†đ?’Žđ?’‘đ?’?đ?’?đ?’šđ?’†đ?’… Debt to Equity (Gearing ratio) =
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Equity to Total Capital Employed = đ?‘ťđ?’?đ?’•đ?’‚đ?’? đ?’„đ?’‚đ?’‘đ?’Šđ?’•đ?’‚đ?’? đ?’†đ?’Žđ?’‘đ?’?đ?’?đ?’šđ?’†đ?’…
Interest cover ratio =
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Investment Ratio: Earnings Per Share:
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Price Earning (PE) Ratio:

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The book value and market value are very different: book value is the total equity in the balance sheet, and the assets of the company are often recorded at the historical cost. On the other hand, market value is the market capitalization value, which includes people’s expectation for growth and company’s intangible assets like human resources, which are not recorded in the book value.
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The market to book ratio can be used by analyst to determine if a share is undervalued or overvalued. Investors often look for low market to book companies, which implies that the market places relatively low value to the book value of a company.
Dividend Cover =
Dividend Yield =

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It is important to bear in mind that there are limitations for ratio analysis, as ratios analysis depends on the quality of financial statement, inflation, the basis for comparison and the restrictive view of the ratios.
Lecture 7: Investment Appraisal  There are four main investment appraisal methods that we can use to evaluate a proposed project: Accounting Rate of Return (profit based); Payback (cash based); Net Present Value (cash based) and Internal rate of return (cash based).  Cash is reality, profit can subject to manipulation, whereas cash is less likely to be manipulated.  Financial analyst, credit analyst and suppliers often focus on the operating cash flow.
Accounting Rate of Return: =
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
Note that the denominator (simple average investment to earn that profit) can be calculated either by the initial investment, or (investment / project life) or ((investment + residual)/2). But remember to be consistent with the figure you use.

This accounting rate of return is based on accounting figures, which are influenced by accounting policies (i.e. depreciation, inventory valuation) and take no account of actual cash generated. It also neglects the timings of returns (inflation) and the rate of return is in percentage, so it is not in real scale, always compare in real scale.
Cash Payback Period: 
Cash payback period is much favoured by risk averse methods, it simply answers the question of how long will it be before the same amount of cash as has been invested will be return.
Example: 0
1
2
3
4
5
Cash Flow
-400
50
160
120
80
40
Cumulative Cash Flow
-400
-350
-190
-70
10
50
As the cumulative cash flow turns positive between year 3 and year 4, the cash payback period is 3 + ((70/80)x12) = 3 years 11 month.
Cash Payback period method ignores all cash flows after the cumulative cash flow turns positive, and the risks involved in the cash flows. It also neglect the time value of money, as future is uncertain, the longer we wait, the risky the cash flows.
Net Present Value:
Lenders of capital often have an expectation of return for their investment (as shareholders expect % return, banks expect % interest), so organization have to meet this expectation or suffer the consequences of not getting the extra capital they need. This obligation of certain expectation of return is called cost of capital, and is used as a discounting factor in calculating the Net Present Value.
In order to take the time value of money into account, the future cash flows must be discounted back to the value of the original investment at Time Zero in order to produce the discounted cash flow:
Discounted cash flow example: Cash flow Discount at 10% DCF Cumulative DCF
0 -400
1 50
2 160
3 120
4 80
5 40
1.00 -400.00
0.91 45.45
0.83 132.23
0.75 90.16
0.68 54.64
0.62 24.84
-400.00
-354.55
-222.31
-132.16
-77.52
-52.68
As the table shows, the cumulative DCF at the end of the project is the net present value, which in this case is -52.68, so it is a negative number. A negative NPV means if the company borrows money to fund the project, the project will not be able to return what the lenders expected at this interest rate, so the company will lose money as the return of the project will not be able to pay the expected interest of borrowing.
Company should always choose the project that has the largest NPV.
Internal Rate of Return (IRR) 
Internal rate of return is the discount rate which, when applied to the future cash flows of a project, will produce an NPV of zero.

The rationale behind calculating IRR is because the discount factor used in the initial investment appraisal may, for a whole variety of reasons, adjust during the project as the risk associated with the project changes. If the discount rate increases, the NPV would decrease. Thus, it is useful to calculate in advance the discount factor at which the NPV is zero to help in making the investment decision.
Calculating IRR by interpolation: First, find two discount factors that give one positive NPV (X %) and the other one gives negative NPV (Y %).
IRR = X% +
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x (Y % - X %)
Numerical example: if the NPV of a project at 9% is $4300, at 12% is -$2100, then the IRR will be somewhere between them: 4300
IRR = 9% + 4300 – (−2100) x (12% - 9%) = 11.016%. So internal rate of return for this project is 11.016%. 
Bear in mind that this figure, calculated by interpolation method, is only an approximation.
Chapter 8: Costing the Full Cost of Products and Services: 
Cost is an issue for the internal management team of the company, as the business is aiming to make a profit. Before selling prices can be set, the costs of a product or service must be known.

The full cost of a product comprises the direct cost of the product (raw materials) and the indirect cost (overheads).

Direct cost: the cost directly associated with the production of output, can be measured specifically in respect of the job. For example, wages of electrician doing the job or cost of material on production.
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Indirect cost: the cost that is not directly used for production, it does not relate specifically to any particular job. For example, the salary of accountants, rent of offices and depreciation of equipment.
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In order to apply indirect cost (overheads) to different unit of the company, or different products produced, there are varies methods. But once a decision has been made regarding the charging of overheads, it should be on a consistent basis
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Overheads can be allocated in a number of ways: proportion of projected sales, material cost, labour cost or equal share.
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Because this approach is far from accurate, in reality, business managers look at cost number from a number of other angles.
A range of approaches to charging in Overheads to Cost Units: đ?‘ˇđ?’?đ?’‚đ?’?đ?’?đ?’†đ?’… đ?’?đ?’—đ?’†đ?’“đ?’‰đ?’†đ?’‚đ?’…đ?’”
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Unit of Output rate =
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Direct Labour Hour rate =
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Direct Materials cost % =
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Direct Labour cost % =
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Example: Allocating overheads using the direct labour rate approach: 
Cost of one product = direct cost + (overheads / direct labour hours)(number of hours it takes to produce one product).
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Limitation of those methods arises when we are dealing with tailor-made products, non-steady costs and cost specific to a particular order.
Lecture 9: Using Contribution and breakeven Analyses Contribution:
In chapter 8, the distinction between direct and indirect costs makes sense, but the charging of indirect costs (overhead) brings challenges.
As a result, accountants look at cost number from other angles, for example, looking at the fixed and variable costs. The total cost of a job is the sum of those costs that remain the same irrespective of the level of activities (fixed costs) and those that vary according to the level of activities (variable costs).
Contribution is equal to the income/revenue minus the variable costs.
When there are several project available and require different number of hours of labour, since labour in the short run is limited, it would be appropriate to calculate the contribution per unit of limiting factor (labour). Company should cut back on production with least efficient use of limiting factor.
When a business is able to produce several products which cost different and sale at different price. In order to produce optimally, company should first determine the limit factors, then rank its products based on the contribution per unit of limiting factor, and produce these products following such rank, until the limiting factor is used up completely.
Break Even, Break Even Point (BEP) & Marginal of Safety (MOS)
The concept of contribution costing is particularly useful where break even points need to be established. Contribution point is sales value less variable cost value.
BEP is the point at which income and total costs for that level for activities balance each other out.
BEP can be determined by this equation:
The calculation of BEP should always be integer and rounded up.
Margin of Safety (MOS) = Expected (target) Sales of Units – BEP units.
The bigger the MOS, the greater the degree to which things can go wrong, so the less risky the project os.
Breaking Even Chart:
Above the break even quantity, profits are made. Below the break even quantity, losses are incurred.
If costs are not linear, it is possible to have multiple BEPs along the curve.
Harder questions on BEP: A company produces a standard product and details are given below: January
February
Sales (units)
200
350
Sales Revenue
$5000
$8750
Profit
$1000
$2500
Calculate the BEP? From the changes in sales units and sales revenue, we can get the price of the product: (8750 – 5000) / (350 – 200) = 3750 / 150 = $25, From changes in profit and changes in sales units, we can get the profit for each unit: (2500 – 1000) / (350 – 200) = 1500 / 150 = $10, Since profit equals price minus average variable cost (AVC) in the short run, AVC = $25 - $10 = $15 Formula for BEP is Fixed cost (constant between Jan and Feb) = Revenue – profits – fixed cost = $5000 - $1000 – ($15*200) = $1000 Contribution per unit = (sales revenue – variable cost) / (number of units sold) = (5000 – 15(200)) / 200 = $10 So BEP = 100 Therefore, BEP in this case is 100 units.
Lecture 10: Budgeting 
It is vital that businesses develop plans for the future. Whatever a business is trying to achieve it is unlikely to come unless the managers are clear about what the future direction of the business is likely to be. The strategic planning process involves five key steps to be taken: Establishing mission and objective -> Undertaking a position analysis -> Identify and access the strategic options -> Select strategic options and formulate plans -> Perform review and control. Budgeting benefits the organisation because: 1. Promote forward thinking and identification of short-term problems. 2. Motivates managers to better performance. 3. Provide a basis for a system of control. 4. Provide a system of authorisation. 5. Help co-ordinate the various sections of the business.
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The budget is a short-term financial plan for the business that is prepared within the framework of the strategic plan. Control can be exercised through the comparison of budgeted and actual performance. When there is a significant divergence emerges, some form of corrective action should be taken. If the budget figures are based on incorrect assumptions about the future, it might be necessary to revise the budget.
Approaches to Budgeting: Incremental & Zero Base Incremental Budgeting
Zero Base Budgeting
Very common
Starts at zero
Starts with last year’s figures and adds for inflation
Sets targets for next year, regardless of last years
Susceptible to playing games
Identified activities needed to achieve targets Time-consuming
Assumes tomorrow is the same as today No incentive to change
Behavioural issues of budgetary control:
The existence of budgets generally tends to improve performance.
Demanding, yet achievable, budget targets tend to motivate better than less demanding targets.
Unrealistically demanding targets tend to have the adverse effect on managers’ performance.
The participation of managers in setting their targets tends to improve motivation and performance
However, managers often ‘play games’ with budget.
Managers may ‘play games’ with budget by
Setting higher budget, so employee and manager could become complacent and feel good.
Playing hockey: when the budget is massively under-spend at the nearly end of the budget period, managers may decide to spend the rest of budget at the end.
Preparation of the Cash Budget:
The cash budget or cash flow forecast can be prepared by estimating the cash receipts and cash payment to calculate net receipts. Also adding opening cash balance to get budgeted closing cash balance.
Remember that only included cash items, depreciation is an expense but not takes the form of cash, it is necessary to consider all cash items from revenue, expenses and capital income. Cash payment = opening payables + purchases – closing payables Cash receipt = opening receivables + sales – closing receivables
Cash generation is critical business task, without adequate cash inflows, businesses will not be able to meet their commitments, and will fail. Thus, business should know when they might need to access additional cash resources. Preparing the cash flow forecast enables them to identify cash shortfalls and plan ahead to make sure cash is on hand to meet liabilities as they fall due.