Chapter 3: Accounting Beyond The Current Year

Question 1

What is strategic management accounting?

Answer 1

The notion of strategic management accounting (SMA) is linked with business strategy and maintaining or increasing competitive advantage.

The Chartered Institute of Management Accountants has defined strategic management accounting as the provision and analysis of management accounting data relating to business strategy, particularly the relative levels and trends in real costs and prices, volumes, market share, cash flows and the demands on a firm’s total resources.

It has been argued that firms place more emphasis on particular accounting techniques depending on their strategic position.

Question 2

What is the difference between strategic and traditional management accounting?

Answer 2

Perhaps the single largest differentiators between strategic and traditional management accounting are that strategic management accounting:
• looks beyond the financial year to the longer term, particularly in relation to the product/service life cycle
• looks beyond the boundary of the organisation to its supply chain (from raw material supplier to consumer)
• makes comparisons with competitors to continually seek competitive advantage.

Question 3

What other techniques fall within the umbrella of strategic management accounting?

Answer 3

. Target costing and

. Environmental management accounting

Question 4

What is target costing?

Answer 4

Target costing is concerned with managing whole-of-life costs during the design phase of the product life cycle. It involves four stages:
1. Determining the target price that customers will be prepared to pay for the product/service.
2. Deducting a target profit margin to determine the target cost, which becomes the cost to which the product/service should be engineered.
3. Estimating the actual cost of the product/service based on the current design.
4. Investigating ways of reducing the estimated cost to the target cost.

Question 5

What is the target cost equation?

Answer 5

Target price - target profit margin = target cost.

Question 6

What is the aim of a target cost?

Answer 6

It aimed to build a product at a cost that could be recovered over the product’s life cycle through a price that customers would be willing to pay to obtain the benefits (which in turn drive the cost).

Target costing is equally applicable to a service. Eg. the design of an Internet banking service involves substantial upfront investment, the benefits of which must be recoverable in the selling price over the expected life cycle of the service.

Question 7

More on target costing.

Answer 7

An investigation seeks to find which elements of design, manufacture or purchasing contribute to the costs and how these can be reduced, or whether features can be eliminated that cannot be justified in the target price.

This is an iterative process, but an essential one if the life cycle costs of the product/service are to be managed and recovered in the (target) selling price.

Importantly, this process of estimating costs over the product/service life cycle and establishing a target selling price takes place before decisions are finalised about product/service design and the production process to be used.

Question 8

What is environmental management accounting?

Answer 8

Environmental costs involve recognition of the importance of corporate social responsibility, this is becoming increasingly important to entities.

Environmental management accounting is concerned with recognising environmental costs for the purposes of internal decision making. The principles of measuring environmental costs are similar to those for measuring quality costs in total quality management.

Environmental management accounting involves collecting, measuring and reporting costs about the environmental impact of an organisation’s activities.

Question 9

What is International Standard ISO 14000?

Answer 9

International Standard ISO 14000 is a series of international standards on environmental management. It provides a framework for the development of both a system and supporting audit program against which an organisation can be certified by a third party.

Question 10

What can environmental costs be classified into?

Answer 10

• prevention costs to avoid environmental damage, which could include the cost of employee training and equipment to reduce pollution
• measurement costs to determine the extent of an entity’s environmental impact, which could include testing, monitoring and external certification
• internal failure costs where remedial action has to be taken, for example, of cleaning spillages or leakages and to cover employee health- and safety-related damages
• external failure costs, including penalties incurred for environmental damage caused.

Question 11

What is one of management’s major responsibilities?

Answer 11

Planning - this is the process of establishing entity-wide objectives. A successful organisation makes both long-term and short-term plans. These plans set forth the objectives of the company and the proposed way of accomplishing them.

Question 12

What is a budget?

Answer 12

A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms.

It normally represents the primary method of communicating agreed-upon objectives throughout the organisation.

Once adopted, a budget becomes an important basis for evaluating performance.

It promotes efficiency and serves as a deterrent to waste and inefficiency.

Question 13

What is a fixed budget?

Answer 13

This covers a defined period, usually a financial year. For a financial year period, the annual budgeting process is geared to producing a fixed budget for the following 12-month period.

Question 14

What are rolling budgets?

Answer 14

They are continuously updated, with additional months added to the end of the period so that at any time during the financial year there is always a 12-month forward-looking budget for the business.

Alternatively, budgets may be re-forecast part way through a year (e.g. quarterly or 6 monthly) to take into account changes since the last budget cycle.

Question 15

What is a forecast?

Answer 15

This usually refers to a revised estimate, or a budgetary update, part-way through the budget period, hence the common distinction made by organisations between budgets and forecasts.

Question 16

Budgets and accounting.

Answer 16

Accounting information makes major contributions to the budgeting process. From the accounting records, historical data on income, costs and expenses can be obtained. This data may be helpful in formulating future budget goals.

Normally, accountants have the responsibility for expressing management’s budgeting goals in financial terms. In this role, they translate management’s plans and communicate the budget to all areas of responsibility.

Accountants also prepare periodic budget reports that provide the basis for measuring performance and comparing actual results with planned objectives. The budget itself, and the administration of the budget, however, are entirely management responsibilities.

Question 17

What are the benefits of budgeting?

Answer 17

1. It requires all levels of management to plan ahead and to formalise their goals on a recurring basis.
2. It provides definite objectives for evaluating performance at each level of responsibility.
3. It creates an early warning system for potential problems. With early warning, management has time to make changes before things get out of hand.
4. It facilitates the coordination of activities within the business. It does this by correlating the goals of each segment with overall company objectives. Thus, production and sales promotion can be integrated with expected sales.
5. It results in greater management awareness of the entity’s overall operations and the impact on operations of external factors, such as economic trends.
6. It motivates personnel throughout the organisation to meet planned objectives.

A budget is an aid to management; it is not a substitute for management. A budget cannot operate or enforce itself. The benefits of budgeting will be realised only when budgets are carefully prepared and properly administered by management.

Question 18

What is essential for effective budgeting?

Answer 18

. Sound organisational structure - in such a structure, authority and responsibility for all phases of operations are clearly defined.
. Research and analysis - should result in realistic goals that will contribute to the growth and profitability of a company.
. Acceptance by all levels of management - as a budget cannot operate and enforce itself

Question 19

How can budgets be used for evaluation?

Answer 19

Once the budget has been adopted, it should be an important tool for evaluating performance.

Variations between actual and expected results should be systematically and periodically reviewed to determine their cause(s).

However, individuals should not be held responsible for variations that are beyond their control.

Question 20

What can influence the length of a budget period?

Answer 20

. the type of budget
. the nature of the organisation
. the need for periodic appraisal
. and prevailing business conditions. 

The budget period should be long enough to provide an attainable goal under normal business conditions. Ideally, the time period should minimise the impact of seasonal or cyclical fluctuations. 

On the other hand, the budget period should not be so long that reliable estimates are impossible.

Question 21

Length of the budget period.

Answer 21

The most common budget period is one year. The annual budget, in turn, is often supplemented by monthly and quarterly budgets.

Many companies use continuous twelve-month budgets. These budgets drop the month just ended and add a future month. One advantage of continuous budgeting is that it keeps management planning a full year ahead.

Question 22

Explain the budgeting process.

Answer 22

The development of the budget for the coming year generally starts several months before the end of the current year.

1. The budgeting process usually begins with the collection of data from each organisational unit of the company - past performance is often the starting point from which future budget goals are formulated.
2. The budget is developed within the framework of a sales forecast - this forecast shows potential sales for the industry and the company’s expected share of such sales.

Question 23

What does sales forecasting involve?

Answer 23

Sales forecasting involves a consideration of various factors:

(1) general economic conditions,
(2) industry trends,
(3) market research studies,
(4) anticipated advertising and promotion,
(5) previous market share,
(6) changes in prices and
(7) technological developments.

The input of sales personnel and top management are essential to the sales forecast.

Question 24

What is the difference between budgeting and long-range planning?

Answer 24

. The time period involved - the max length of a budget is usually one year (budgets are also often prepared for shorter periods of time), whilst long-range planning usually encompasses a period of at least five years.
. Emphasis - Budgeting focuses on achieving specific short-term goals, (such as meeting annual profit objectives), whilst long-range planning identifies long-term goals, selects strategies to achieve those goals, and develops policies and plans to implement the strategies (In long-range planning, management also considers anticipated trends in the economic and political environment and how the company should cope with them).
. The amount of detail presented - Budgets, can be very detailed. Long-range plans contain considerably less detail (data intended more for a review of progress toward long-term goals than as a basis of control for achieving specific results).

Question 25

What is the primary objective of long-range planning?

Answer 25

The primary objective of long-range planning is to develop the best strategy to maximise the company’s performance over an extended future period.

Question 26

What is a master budget?

Answer 26

The term ‘budget’ is actually a shorthand term to describe a variety of budget documents.

All of these documents are combined from all sources into a master budget.

The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period.

The master budget contains two classes of budgets.

Question 27

What are the individual budgets included in the master budget?

Answer 27

Operating budgets:
. Sales budget
. Cost of sales budget
. Selling and administrative expenses budget
. Budgeted income statement 

Financial budgets:
. Capital expenditure budget (not covered in text)
. Cash budget
. Budgeted statement of financial position

Question 28

What are the two classes of budgets in the master budget?

Answer 28

Operating budgets and financial budgets.

The operating budgets are developed first, beginning with the sales budget. Then the financial budgets are prepared.

Question 29

What are operating budgets?

Answer 29

Operating budgets are the individual budgets that result in the preparation of the budgeted statement of profit or loss. These budgets establish goals for the company’s sales and production personnel.

Question 30

What are financial budgets?

Answer 30

In contrast, financial budgets are the cash budget and the budgeted balance sheet. These budgets focus primarily on the cash resources needed to fund expected operations and planned capital expenditures.

Question 31

Behavioural aspects of budgeting.

Answer 31

Budgets can have a significant effect on human behaviour because they set targets to be achieved or define limits on activity.

People may or may not agree with the budgets set, yet may be rewarded (or penalised) for achieving (or not achieving) the budget target.

Although the tools of budgeting and cash forecasting are well developed and made easier by the wide use of spreadsheet software, the difficulty in budgeting is in predicting sales volume, the sales mix between different products or services and the timing of income and expenses for a business in a competitive environment.

Question 32

What are the 10 reasons why budgets cause problems (identified by The Beyond Budgeting Roundtable (www.bbrt.co.uk))?

Answer 32

They:
• are time consuming and expensive
• provide poor value to users because they may be unrealistic
• fail to focus on shareholder value
• are too rigid and prevent fast response
• protect rather than reduce costs; for example, many organisations spend their budget before the end of their year to avoid losing it
• stifle product and strategy innovation because opportunities may not be able to be grasped as they arise because of budget limitations
• focus on sales targets rather than customer satisfaction
• are divorced from strategy
• reinforce a dependency culture, relying on a predetermined budget rather than making decisions based on more current business conditions
• can lead to unethical behaviour through bias, the creation of budget slack and gaming (explained below).

Question 33

What is one of the main problems associated with setting budgets?

Answer 33

The ‘politics’ of budgeting. Budgets are one of the main sources of power in organisations, as a result of the influence of accountants over budgetary allocations.

Various studies have described the budgetary process and have shown that budgeting systems help to represent vested interests in political processes and maintain existing power relationships as budgets provide a vehicle through which the proposed reallocation of funds is translated, communicated and made visible.

Budgets can also provide a basis for much of the discourse that takes place between various interest groups in a business (sales, operations, purchasing, accounting, etc.).

Question 34

How can budgets improve communications and information flow throughout an organisation?

Answer 34

By providing a focus for the efforts of many different people and departments. Increasingly, the budget and performance relative to budget targets is included in decisions about salary, bonuses and career promotion.

Question 35

What does ‘good budgeting practice’ also involve?

Answer 35

‘Good budgeting practice’ also involves clear communication by accountants to non-accountants as part of the organisational planning process. However, as budgets are often seen as being ‘owned’ by accountants, non-accountants often distrust the process of allocating resources through the budget process.

Question 36

Participation, slack and bias.

Answer 36

Another political issue in budgeting is the tension between the ‘top down’ budget expectation driven by the entity’s board of directors who have knowledge of capital markets and shareholder expectations and the ‘bottom up’ budget prepared by line managers who have considerably more local and operational knowledge.

Consequently, a degree of bias and ‘game playing’ exists in relation to the budgeting process.

To avoid this, there are significant behavioural benefits associated with participation by managers in the budget process. Managers are more likely to accept budget targets and be motivated to strive to achieve them if they feel they have participated in the budget process, even if the final targets are difficult to achieve.

Question 37

What happens if budgets are simply imposed?

Answer 37

Without any management participation, managers are unlikely to be motivated to achieve them.

Question 38

What is budgetary slack?

Answer 38

As managers are held accountable for their actual performance compared with the budget, there is a temptation to inflate cost forecasts so that the manager will come in ‘under budget’ or to depress sales forecasts so that the manager will exceed budget.

This is called budgetary slack and is particularly relevant where managers are paid a bonus or are otherwise rewarded or promoted based on their perform- ance relative to budget.

Question 39

What are the three sources of budgeting or forecasting error?

Answer 39

. Unpredicted changes in the environment
. Inaccurate assessment of the effects of predicted changes and
. Forecasting bias.

The sources of forecasting bias include the organisation’s reward system, the influence of recent practice and norms and managers’ insecurity. Forecasting bias is likely to be a common behavioural phenomenon, for example, where there is a desire to please senior managers to compete for promotion.

Question 40

The beyond budget movement.

Answer 40

Page 77

Question 41

What is a sales budget?

Answer 41

The sales budget is the first budget prepared. Each of the other budgets depends on the sales budget. The sales budget is derived from the sales forecast.

It represents management’s best estimate of sales revenue for the budget period. An inaccurate sales budget may adversely affect profit.

Some companies classify the anticipated sales revenue as cash or credit sales and by geographical regions, territories or salespersons.

Question 42

How can a sales budget be inaccurate?

Answer 42

By being overly optimistic or unduly conservative.

For example, an overly optimistic sales budget may result in excessive inventories that may have to be sold at reduced prices. In contrast, an unduly conservative budget may result in loss of sales revenue due to inventory shortages.

Question 43

How is the sales budget prepared?

Answer 43

Expected unit sales
(Times) Unit selling price
(=) Total sales

Question 44

What is a cost of sales budget?

Answer 44

The cost of sales is related to the units sold, not purchased.

Expected unit sales
(Times) Purchase cost per unit
(=) (Total) Cost of sales

Can also be costs of services, can use variable cost instead of purchase cost per unit.

Question 45

What is a selling and administrative expenses budget?

Answer 45

This budget projects anticipated selling and administrative expenses for the budget period.

Expenses are classified as either variable or fixed.

Question 46

How is the selling and administration expenses budget prepared?

Answer 46

Variable expenses 
   1st variable expense
   (Plus) 2nd variable expense 
   (Plus) Etc.
       Total variable expenses 
Fixed expenses 
   1st fixed expense
   (Plus) 2nd fixed expense 
   (Plus) Etc.
       Total fixed expenses 
Total selling and administrative expenses

Question 47

Time length of budgets.

Answer 47

Can be divided into months or quarters and usually have a yearly total on the far right column.

Question 48

What are some examples of variable expenses?

Answer 48

Sales commissions, freight-out, personal trainer wages, delivery van

Question 49

What are some examples of fixed expenses?

Answer 49

. Advertising 
. Sales salaries
. Office salaries
. Depreciation
. Insurance 
. Office supplies
. Phone service
. Internet services
. Utilities  
. Bathroom supplies

Question 50

What is the budgeted statement of profit or loss?

Answer 50

The budgeted statement of profit or loss (sometimes called the budgeted income statement) is the important end-product of the operating budgets.

This budget indicates the expected profitability of operations for the budget period. The budgeted statement of profit or loss provides the basis for evaluating company performance.

Question 51

How is the budgeted income statement prepared?

Answer 51

Sales/services revenue
(Less) cost of sales/services
(=) Gross profit
(Less) Selling and administrative expenses 
(=) Profit from operations
(Less) Interest expense
(=) Profit before income taxes
(Less) Income tax expense
(=) Profit

Question 52

What is the cash budget?

Answer 52

The cash budget shows anticipated cash flows. Because cash is so vital, this budget is considered to be the most important output in preparing financial budgets.

Question 53

What are the sections of the cash budget?

Answer 53

. Cash inflows/receipts
. Cash outflows/cash disbursements and
. Other cash outflows

It also displays the beginning and ending cash balances.

Question 54

Explain the following section of the cash budget: cash inflows/cash receipts.

Answer 54

The cash receipts section includes expected receipts from the company’s principal source(s) of income.

These are usually cash sales and collections from customers on credit sales. This section also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, assets and the company’s share capital.

Question 55

Explain the following section of the cash budget: cash outflows/cash disbursements.

Answer 55

The cash disbursements section shows expected cash payments.

Such payments include payment to suppliers, overhead, and selling and administrative expenses. This section also includes projected payments for income taxes, dividends, investments and plant assets.

Question 56

Explain the following section of the cash budget: other cash outflows

Answer 56

This includes drawings, shop fittings acquired, principle loan repayment and interest loan repayment.

Question 57

How is the cash budget prepared?

Answer 57

CASH INFLOWS
   Collections from customers (comes from SoECfC)
CASH OUTFLOWS
   Payments to suppliers (comes from SoEPfP)
   Payment for expenses:
     . 1st expense 
     . 2nd expense
     . Etc.
   Other cash outflows:
     . 1st other cash outflow
     . Etc.
NET CASHFLOW FOR THE MONTH (cash inflows (less) cash outflows)
(Plus) Opening check balance
(=) Closing check balance

Opening check balance - bank balance at the beginning (usually the remainder of borrowed/invested money or in instructions of question)

Question 58

Cash budget summary.

Answer 58

Cash inflows 
(Less) Cash outflows
(=) Net cashflow for the month
(Plus) Opening check balance
(=) Closing check balance

Question 59

What does SoECfC and SoEPfP mean?

Answer 59

SoECfC - Schedule of Expected Collections from Customers

SoEPfP - Schedule of Expected Payments for Purchases

Question 60

What is the schedule of expected collections from customers?

Answer 60

It is used in the cash inflows section of the cash budget and is based on the sales budget.

This schedule is split into two sections, being cash sales and credit sales (you will be told the percentage of sales dedicated to each section, however, credit sales tend to be higher).

Total credit sales are further divided into the number of months it takes to receive collections. For example, 60% can be expected in the month of the sale, 30% can be expected in the following month and 10% can be expected in the third month.

As a result, credit sales has the same amount of months/quarters (in the top row of the table) under it.

Question 61

How is the schedule of expected collections from customers set out?

Answer 61

Expected cash collections - months/quarters (no yearly)
Cash sales - percentages for each month sales
Credit sales (smart to write the % of total sales/services which are credit sales)
. 1st month/quarter - correlating percentage is further divided into when cash is received
. 2nd month/quarter
. Etc.

TOTAL (simply add up the values in the the column above)

Question 62

What is the schedule of expected payments for purchases?

Answer 62

It is used in the cash outflows (payments to suppliers) section of the cash budget and is based on the purchase budget.

This schedule only has one section, being credit purchases.

Total credit purchases are further divided into the number of months it takes to pay suppliers. For example, 60% can be expected in the month of the purchase and40% can be expected in the following month.

As a result, credit sales have the same amount of months/quarters (in the top row of the table) under it.

Question 63

How is the schedule of expected payments for purchases set out?

Answer 63

Expected payments - months/quarters (no yearly)
Credit purchases/accounts payable
. 1st month/quarter - correlating percentage is further divided into when purchases are payed for
. 2nd month/quarter
. Etc.

TOTAL (simply add up the values in the the column above)

Question 64

What is the purchases budget?

Answer 64

Expected sales (units) - from sales budget
(Plus) Closing inventory
(=) Total required units/available units
(Less) Opening inventory
(=) Required purchases of units/total purchases
(Times) Purchase price
(=) PURCHASES

This can be for months or quarters and can have a yearly value at the end too.

Question 65

How do budgets contribute to control of operations?

Answer 65

The use of budgets in controlling operations is known as budgetary control. Such control takes place by means of budget reports that compare actual results with planned objectives.

The use of budget reports is based on the belief that planned objectives lose much of their potential value without some monitoring of progress along the way.

Budget reports provide management with feedback on operations. The feedback for a crucial objective, such as having enough cash on hand to pay bills, may be made daily.

For other objectives, such as meeting budgeted annual sales and operating expenses, monthly budget reports may suffice. Budget reports can be prepared as frequently as needed.

From these reports, management analyses any differences between actual and planned results and determines their causes. Management then may take corrective action, or it may decide to modify future plans.