Efhamcma - TN 2020

October 2020 CMA Handouts
Part one - 2020
Part 1: Financial Planning, Performance, and Analytics

CMA Online course - 2020
Table of Contents
Section A) External Financial Reporting Decisions … 15% .......................................................................... 5
Unit 1. Financial Statements .................................................................................................................... 5
1. Basics of Financial Accounting .......................................................................................................... 5
2. Statement of Financial Position (balance sheet) ............................................................................ 10
3. Income Statement........................................................................................................................... 17
4. Statement of Comprehensive Income ............................................................................................ 24
5. Statement of Changes in Equity ...................................................................................................... 27
6. Statement of Cash Flows (SCF)........................................................................................................ 29
7. Integrated Reporting....................................................................................................................... 40
Unit 2. Recognition, measurement, valuation and disclosure ............................................................. 57
1. Basic Accounting Principles ............................................................................................................. 57
2. Assets Valuation .............................................................................................................................. 61
A) Cash ............................................................................................................................................ 61
B) accounts receivable .................................................................................................................... 61
C) Inventory..................................................................................................................................... 76
D) Investments ................................................................................................................................ 89
E) Fixed assets ............................................................................................................................... 105
F) Intangible assets........................................................................................................................ 115
3. Valuation of Liabilities ................................................................................................................... 121
A) Reclassification of Short-term Debt ......................................................................................... 121
B) Warranty liabilities.................................................................................................................... 122
C) Income taxes ............................................................................................................................. 129
D) Leases ....................................................................................................................................... 137
4. Equity Transactions ....................................................................................................................... 143
5. Revenue Recognition .................................................................................................................... 151
a. Five Steps to Revenue Recognition ........................................................................................... 154
b. Special Revenue Recognition Issues ......................................................................................... 166
6. Major Differences Between US GAAP & IFRS ............................................................................... 178
Section B) Planning, Budgeting and Forecasting … 20% ......................................................................... 183
Unit 3. Strategic planning and forecasting techniques ....................................................................... 183
1. Strategic Planning: ........................................................................................................................ 183
2. Forecasting Techniques: ............................................................................................................... 204
Instructor, Tarek Naiem, CMA 1 of 543

a- Regression Analysis ................................................................................................................... 204

b- Learning Curves: ....................................................................................................................... 209
Unit 4. Budget concepts, methodologies and preparation................................................................. 220
1. Budget Concepts: .......................................................................................................................... 220
2. Budget Methodologies:................................................................................................................. 232
1. The Annual Master Budget: ...................................................................................................... 232
2. Flexible budget: ......................................................................................................................... 234
3. Project budget:.......................................................................................................................... 235
4. Continuous (Rolling) Budget: .................................................................................................... 236
5. Kaizen Budget: .......................................................................................................................... 236
6. Activity based budget (ABB):..................................................................................................... 237
7. Zero Based Budget (ZBB):.......................................................................................................... 237
8. Incremental budget:.................................................................................................................. 238
9. Life cycle budget: ...................................................................................................................... 238
3. Annual Profit Plan and Supporting Schedules .............................................................................. 239
A) Operating Budget: .................................................................................................................... 241
B) Financial Budget: ...................................................................................................................... 248
4. Top-Level Planning and Analysis ................................................................................................... 250
Section D) Cost Management … 15% ....................................................................................................... 256
Unit 5. Cost Management Measurement Concepts ............................................................................ 256
1. Cost Management Terminology: .................................................................................................. 256
2. Cost Behavior and Relevant Range: .............................................................................................. 259
3. Cost Classification: ........................................................................................................................ 261
4. Capacity Levels: ............................................................................................................................. 271
Unit 6. Cost accumulation systems ...................................................................................................... 274
1. Costing Techniques: ...................................................................................................................... 274
2. Job Order Costing: ......................................................................................................................... 282
3. Activity Based Costing: (Transaction-Based Costing) .................................................................... 287
4. Process Costing Accounting: ......................................................................................................... 293
5. Life-cycle costing ........................................................................................................................... 304
6. Accounting for spoilage................................................................................................................. 305
Unit 7. Cost allocation .......................................................................................................................... 308
1. Service Departments Cost Allocation............................................................................................ 309
2. Joint Cost Allocation...................................................................................................................... 315

3. Absorption and Variable Costing .................................................................................................. 323

Unit 8. Supply Chain Management and Business Process Improvement........................................... 334
A. supply chain management (operational efficiency): .................................................................... 334
1. Just in Time (JIT) ........................................................................................................................ 334
2. Materials requirements planning (MRP) .................................................................................. 337
3. Outsourcing ............................................................................................................................... 340
4. Theory of constraints (TOC) & Throughput costing .................................................................. 341
5. Capacity management & analysis ............................................................................................. 345
B. Business process performance ..................................................................................................... 346
1. Value chain analysis .................................................................................................................. 346
2. Process analysis & Business Process Reengineering (BPR) ....................................................... 347
3. Benchmarking ........................................................................................................................... 348
4. Activity based management (ABM) .......................................................................................... 348
5. Continuous improvement concepts.......................................................................................... 349
6. Cost of quality analysis (COQ) ................................................................................................... 350
7. Efficient accounting processes .................................................................................................. 352
Section C) Performance Management … 20% ......................................................................................... 355
Unit 9. Cost and variance measures .................................................................................................... 355
1. Variance Analysis .......................................................................................................................... 355
2. Static Budgeting variance.............................................................................................................. 358
3. Flexible budget .............................................................................................................................. 360
Direct material and Direct labor flexible budget variances: ......................................................... 363
Overhead costs flexible budget variances .................................................................................... 372
4. Sales Variances .............................................................................................................................. 382
5. Market Variances .......................................................................................................................... 387
Unit 10. Responsibility Accounting and performance measures ....................................................... 391
1. Responsibility accounting ............................................................................................................. 391
2. the contribution income statement.............................................................................................. 395
3. Transfer pricing ............................................................................................................................. 396
4. Performance Measures ................................................................................................................. 400
5. The Balanced scorecard ................................................................................................................ 403
Section E) Internal Control … 15% ........................................................................................................... 408
Unit 11. Governance, Risk & Compliance ............................................................................................ 408
1. Corporate Governance.................................................................................................................. 408

2. Internal Controls ........................................................................................................................... 416

3. Components of Internal Control ................................................................................................... 418
4. Legal aspects of internal controls ................................................................................................. 426
a. FCPA (Foreign Corrupt Practices Act) 1977 ............................................................................... 426
b. Sarbanes-Oxley act SOX ............................................................................................................ 427
Unit 12. Systems Controls and Security Measures.............................................................................. 438
1. Information systems controls ....................................................................................................... 438
2- Internet security ........................................................................................................................... 443
Section F) Technology and Analytics … 15% ............................................................................................ 448
Information Systems ............................................................................................................................ 449
A- Accounting Information Systems ................................................................................................. 449
B- Data, Database, and Database Management System (DBMS) ..................................................... 462
C- Enterprise Resource Planning Systems ......................................................................................... 466
D- Enterprise Performance Management......................................................................................... 469
Data Governance .................................................................................................................................. 473
A- Data Policies and Procedures ....................................................................................................... 473
B- Data Life Cycle and Records Management ................................................................................... 479
C- Controls Against Security Breaches .............................................................................................. 482
TECHNOLOGY-ENABLED FINANCE TRANSFORMATION ...................................................................... 488
A- Systems Development Life Cycle (SDLC) ...................................................................................... 488
B- Business Process Analysis ............................................................................................................. 489
C- Robotics Process Automation (RPA) ............................................................................................. 490
D- Artificial Intelligence (AI) .............................................................................................................. 492
E- Cloud Computing .......................................................................................................................... 496
F- Blockchains and Smart Contracts.................................................................................................. 500
Date Analytics....................................................................................................................................... 508
A- Business Intelligence (BI) .............................................................................................................. 509
B- Data Mining .................................................................................................................................. 514
C- Analytic Tools and Simple Regression Analysis ............................................................................ 522
D- Sensitivity Analysis ....................................................................................................................... 532
E- Data Visualization ......................................................................................................................... 536

Section A) External Financial Reporting Decisions … 15%

Unit 1. Financial Statements
Subunits:
1) Basics of financial accounting
2) Balance Sheet
3) Income Statement
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4) Statement of comprehensive income
5) Statement of changes in equity
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6) Statement of cash flows
1. Basics of Financial Accounting
Financial accounting:
a.
The process of reporting the financial transactions of any business.
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Comparison between management accounting and financial accounting:
Management Accounting Financial Accounting
Purpose of Help managers to make Communicate financial
Information decisions position to outsiders
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Primary users Internal managers External users: investors,

creditors, authorities
Time dimension Current and forward- Mainly historical
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looking
Nature of the Financial and non- Mostly financial
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information financial
Reporting frequency As/when desired by Generally, at the end of the
management year
Information recorded Kept voluntarily to meet Accounts are prepared to
the requirements of meet the legal requirements
management
Control Information is supervised by internal Information is typically
auditors supervised by public
auditors

Financial reporting objectives:

Providing financial information that is useful for decision-making. Such as present
and potential equity investors, lenders, and other creditors, to make decisions
about resourcing the company. Also, decisions relate to buying, selling, or holding
debt or equity instruments and providing credit. And not only those users that they
are supposed to provide capital to the entity, as there are other users, such as
management, financial analysts, employees and regulators also find the financial
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statements are very useful.
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So, we could brief financial reporting objectives mainly in providing information in
order to make the following decisions:
Investment and credit Assessing future cash Information about the
decisions flows firm’s resources
Management performance evaluation
a.The compliance of the entity to the

regulatory requirements
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Users of financial statements:
Direct Vs. Indirect
Direct Users Indirect Users

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Directly affected by the results of a Users with indirect interests such as

company, so for example they might advice, influence, or represent users
lose money if the company losses. with direct interests.
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1) Investors or potential investors 1) Financial advisers and analysts

2) Suppliers and creditors 2) Stock markets or exchanges
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3) Employees 3) Regulatory authorities

4) Management
External Vs. Internal
External Users Internal Users
Use financial statements to make a Internal users use financial statements
decision whether to do business with to make decisions affecting the
the firm will be beneficial or not. operations of the business. These
users include management,
employees, and the board of directors.
1) Investors
Need to make decision to increase, 1) Management
decrease, or obtain an investment in Needs financial statements to assess
the firm. internally the financial strengths and
2) Creditors deficiencies (SWAT analysis), to

Need information to decide whether evaluate performance results and past
to extend credit and under what decisions (Control – comparative
terms. reports), and to plan for future
3) Financial advisors and analysts financial goals and steps (planning and
Need financial statements to help Budgeting).
investors evaluate the investment. 2) Employees
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4) Stock exchanges To negotiate wages and fringe benefits
Need to evaluate whether to accept a based on the increased productivity
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firm’s stock for listing or to prevent the and value they provide to a profitable
stock’s trading. firm.
5) Regulatory agencies
Need financial statements to evaluate
the firm’s application of regulations
and to determine price levels when
a.
Tarek Naiem, CMA, Online course
needed.
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Now you can understand the purpose of the accounting standards of such as GAAP,
and why the accounting profession is always keen to be sure of the compliance to
those standards, and that’s for two main reasons:
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1- To provide a kind of form that will be understood by these vast number and
purposes of external users, imaging if every firm will publish its own format!!! If no
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formation users will be lost and not knowing where to look for what information,
also
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2- These tide standards are also for the protection of those mentioned users,
otherwise, if every firm will use its own individual format for disclosure, then there
will be no control on what information firms could disclose or even hid!!
Therefore, regarding this aspect we have to look at

Financial accounting Vs. management accounting: from this prospective
Management accounting assists management decision making, planning, and
control. So, it is mainly for internal purposes, there for it is not a must for
management accounting that is used internally to be following GAAP.

GAAP: represent the U.S standards, which is referred to as Generally Accepted

Accounting Principles, are developed by the Financial Accounting Standards Board
(FASB).
IFRS: represent the international standards, which is referred to as International
Financial Reporting Standards, are developed by the International Accounting
Standards Board (IASB).
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Differences Between IFRS and US GAAP
IFRS used in many countries around the world. IFRS is primarily a principles-based
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set of accounting standards with few practical examples and limited interpretative
guidance. Neither acting as a tax standard nor applying to government
organizations, IFRS is intended for multiple countries with different cultural, legal,
and commercial standards; IFRS’s main objective is to be more open and flexible
a.
US GAAP, on the other hand, is largely a rules-based body of standards with
extensive interpretive guidance for individual industries and specific examples for

auditors and practitioners. It targets United States-based entities and foreign
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companies that participate in the US financial markets. In addition, the standard
setters actively interpret the standards.
Despite their differences, the general principles, conceptual framework, and
accounting results between US GAAP and IFRS are often very similar, if not the
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same, because the two standards are more alike than different for most common
transactions.
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Basic Financial Statements are:

1) Balance Sheet, statement of financial position
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2) Income statement, statement of earnings

3) Statement of cash flows
4) Statement of stockholders (owners) equity, statement of retained earnings
5) Statement of comprehensive income.
The notes to the financial statements (such as management discussions and

analysis) are also considered to be a part of the financial statements. While these
notes shouldn’t be used to correct wrong presentations, instead the notes are to
provide information essential to understand the financial statements and are a
required part of financial statements that are prepared in accordance with GAAP.

Relationship among the financial statements:

Financial statements are completing each other, the components of one statement
relate to those of other statements, for example:
1) Net income / loss from the P&L, is reported and accumulated in the retained
earnings account, which is a component of the equity section in the balance sheet.
2) The components of cash from the statement of financial position are reconciled
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with the corresponding accounts in the statement of cash flows.
3) The company may use assets from the beginning balance sheet in an income
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producing activity or it may sell them as a source of cash
4) Items of equity from the statement of financial position are reconciled with the
beginning balances on the statement of changes in equity.
4) Ending inventories are reported in current assets on the balance sheet and are
a.
reflected in the calculation of cost of goods sold on the statement of income.
5) Amortization and depreciation reported in the statement of income (expenses)
also are reflected in asset (long-term fixed assets) and liability (accumulated
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depreciation) balances in the statement of financial position.
Accounting Principle
@ Accruals:
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Accrual accounting: is to record the financial transactions when they occur,

regardless of when their associated cash is paid or received.
1) Revenues are recognized in the period in which they were earned even if the
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cash will be received in a future period.

2) Expenses are recognized in the period in which they were incurred even if the
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cash will be paid in a future period.

NOTE: Under the cash basis, revenues are recognized when cash is received, and
expenses are recognized when cash is paid. Under GAAP, financial statements
should be prepared under the accrual basis of accounting.
To enhance the usefulness of the information provided by the financial statements,

this information should be comparable with similar information for other entities
and the same entity for another period or date. Thus, comparability allows users
to understand similarities and differences

2. Statement of Financial Position (balance sheet)
Assets = Liabilities + Equity
Also
Assets = liabilities + (common stock + Retained earnings – Dividends + Revenue – Expenses)
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The balance sheet, also called a statement of financial position, provides
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information about an entity’s assets, liabilities and owners’ equity at a point in
time. The statement shows the entity’s resource structure—the major classes and
amounts of assets—and its financing structure—the major classes and amounts of
liabilities and equity
The purposes (use) of balance sheet report:

a.
A balance sheet is not intended to show the value of a business, while along with
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other financial statements and other information, a balance sheet should provide
information that will be useful to someone who wants to make his or her own
estimate of the business’s value, so a company’s balances sheet is intended to help
external users:
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1) Assess its liquidity, financial flexibility, solvency, risk and operating ability.
To have a full picture of liquidity and flexibility BS should be used in
conjunction with at least a statement of cash flows.
2) Provides basis for computing rates of return, evaluating the capital structure
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of the business, and predicting a company’s future cash flows.

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3) Can also be used in financial statement analysis to assess the company’s

ability to pay its debts and its ability to distribute dividends to the owners.
Liquidity the ability of the company to convert assets into cash or cover its due
liabilities in the short term, usually less than one year. The greater a company’s
liquidity, the lower its risk.
Solvency refers to the company’s ability to pay its long-term liabilities. A company
with a high level of long-term debt compared to its assets has lower solvency than
that with a lower value of long-term debt.
Risk refers to the unpredictable future events, transactions, and circumstances that
can affect the company’s cash flows and financial results.
Balance sheet accounts are permanent (real) accounts: They are not closed out at
the end of each accounting period but rather their balances are cumulative, which

means the ending balance of one period (ex. Yearend balance sheet balances) will
be carried forward as beginning (opening) balances to the following (next) period.
Elements of the balance sheet: Three conditions

a. Assets are resources that presently owned or controlled by the entity, as a result
of past transactions, and represent probable future economic benefits to the
entity, for example inventory, accounts receivable, investments, plant, and
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equipment. Assets are generally reported for liquidity.
b. Liabilities are present obligations owed by the entity, as a result of past
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transactions, and present probable future sacrifice of economic benefits, for
example loans, bonds issued by the entity, and accounts payable.
c. Equity is the residual interest in the assets of the entity after subtracting all its
liabilities, this definition means that Equity = assets – liabilities, it includes the
a.
company’s common stock, preferred stock, and retained earnings. Equity is
affected operational results, but also effected by owners’ transactions, such as
dividends and contributions.

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Assets and liabilities are divided in the balance sheet between current and
noncurrent categories.
Statement of financial position (Balance sheet) at XX/XX/XXXX

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Assets: Liabilities:
Current assets: Current liabilities:
Cash Accounts payable
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Account receivables current notes payable

Short term investment current maturities of noncurrent liabilities
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Inventory Noncurrent liabilities:

Prepaid expenses noncurrent notes payable
Deposits bonds payable
Noncurrent assets: Equity:
Long term investments investments by owners
Property, Plant and Retained earnings (income reinvested)
Equipment (PPE) accumulated other comprehensive income
Intangible assets

Current and noncurrent assets:

Current assets:
Assets are classified as current on the balance sheet if it is expected to be
converted/realized in cash or consumed within the entity’s normal operating cycle
usually 1 year
operating cycle: the average time between the acquisition of materials or services
and their final cash realization.
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a one-year time period is to be used as the basis for the segregation of current
assets when an entity has several operating cycles occurring within a year.
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However, if the period of an entity’s operating cycle is greater than twelve months,
for example as in the tobacco, distillery, and lumber businesses, the longer period
is used as the entity’s operating cycle. If an entity has no clearly defined operating
cycle, the one-year rule governs.
Examples:
1) Cash
a.
2) Cash equivalents – Short-term highly liquid investments that are convertible
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to known amounts of cash without a significant loss in value and have
maturities of 3 months or less from the date of purchase.
3) Receivables – Trade accounts receivable, notes receivable.
4) Inventories – Goods on hand and available for sale and, for a manufacturer,
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raw materials and work-in-process.

5) Short-term investments maturing (ending) in less than one-year, Marketable
securities
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6) Prepaid expenses – Amounts paid in advance for the use of assets (such as
prepaid rent) or the use of services to be received at a future date. Prepaid
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expenses are not convertible to cash.
Noncurrent assets:
Assets or resources other than those that are reasonably expected to be realized in
cash or sold or consumed during the normal operating cycle of the business, such
as:
1) Property, plant, and equipment (Fixed assets) (PP&E) are tangible assets that
are used in operations, and will be used longer than the end of the current period,
when the fixed assets are purchased they are recorded at the cost, then expensed
over the life of the asset, therefore they are reported at the net value subtracting
the accumulated depreciation. For example:

a) Land, land improvements and natural resources subject to depletion, e.g., oil
and gas (that’s applicable for USA not to many other countries such as
Arabian countries where governments own and manage natural resources
for the benefit of its people)
b) Buildings, equipment, furniture, fixtures, leasehold improvements,
noncurrent assets under construction, and any other depreciable assets
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2) Intangible assets are nonfinancial assets that can’t be physically touched.
Examples are copyrights, patents, goodwill, trademarks and franchises. An
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intangible asset with a limited life is amortized over its useful life. An intangible
asset with an indefinite life such as goodwill is assessed periodically for impairment.
3) Marketable securities that do not represent the investment of cash available for
current operations.
a.
Held-to-maturity debt securities are normally classified as non-current assets.
• Investments or advances, whether marketable or not, made for the purpose of
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obtaining control, for affiliation, or other continuing business advantage.
• Right-of-use assets obtained under lease agreements.
FASB has not specified whether right-of-use assets obtained under lease
agreements are to be considered tangible or intangible assets.
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4) Restricted Cash: An Asset That Could be Either Current or Non-Current

Cash could be restricted for a number of reasons:
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• Petty cash and payroll funds or funds to be paid in dividends

• Cash in accounts outside the United States may be restricted by country
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regulations against exportation of money

• Cash set aside for plant expansion, retirement of a long-term debt, or for other
purposes
• Compensating balances required to be maintained by a bank or other lending
institution to support existing borrowing arrangements with the institution
Material amounts of restricted cash should be segregated from cash on the balance
sheet. The restricted cash should be classified as a current or a non-current asset
depending on the date the cash will be available for disbursement. If the cash is
being held for payment of existing obligations or obligations due within the
operating cycle, the cash should be reported on a separate line in the current assets
section of the balance sheet. If the restricted cash is to be held for a longer period
of time, it should be reported on a separate line in the non-current assets section
of the balance sheet.

Deposits held as compensating balances to support borrowing arrangements

should be reported separately within the cash and cash equivalents area of the
balance sheet as current assets if they support short-term borrowing
arrangements. They should be reported as non-current assets if they support long-
term borrowing arrangements.
Companies should describe the arrangements and the amounts involved in the
notes to the financial statements.
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Current and noncurrent liabilities:
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Current liabilities:
Current liabilities are expected to be settled or liquidated using the current assets
or through creating other current liabilities, which means during the normal
operating cycle.
Main categories of current liabilities:

a.
1) Trade or accounts payable for purchasing of operating goods and services,
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such as raw materials and supplies to manufacture finished goods
2) Other operational payables, such as accrued wages, salaries, rentals and
taxes.
3) Contract liabilities representing an entity’s obligation under the new revenue
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recognition standard, ASC 606, to transfer goods or services to a customer

for which the entity has received consideration. Contract liabilities may be
current liabilities or non-current liabilities or both, depending on factors such
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as when the entity expects to satisfy its performance obligations—over time

or at a point in time.
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4) Short-term notes payable (30, 60, 90 days)

5) Agency collections, which means collections for others, such as: employee
tax, withholding tax and sales tax
6) Current portions of long-term debt and lease liabilities (the portions of the
principal due within the operating cycle, usually twelve months).
7) Assurance-type warranties: for which the term of the warranty extends only
into the next accounting period or the portion of a longer-term warranty that
extends only into the next accounting period.
Current liabilities do not include:

1) Short-term debts that will be covered or paid by a noncurrent fund
2) A short-term debt if there is an intention to refinance it using a noncurrent
obligation.

In case of a short-term debt that will be refinanced or replaced with another long-
term debt, this debt that should be due within 12 months, maybe reclassified as a
noncurrent liability, as long as the company can show that they have the intent and
the ability to refinance it with a long-term debt, this type of reclassification might
be important in large amount cases, and that will then effect company’s related
balance sheet ratios.
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Noncurrent liabilities:
Liabilities that will not be covered (paid) settled within short-term of one year or
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the operating cycle if it is longer than one year, examples are:
1) Contract liabilities classified as non-current liabilities.
2) Long-term notes or bonds payable.
3) The principal portions of long-term debt and lease liabilities (the portions of
4) Pension obligations.
5) Deferred tax liabilities. a.
the principal due after the operating cycle (usually twelve months).
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6) The non-current portion of assurance-type warranties for which the term of
the warranty extends beyond the next accounting period.
Equity:
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Any transaction that does not have offsetting equal effect on assets and liabilities
will change the equity value, since Equity = Assets – Liabilities. The following are
the major items of owners’ equity in corporations:
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1) Capital contributions by owners: par value or stated value of issued shares

2) Additional paid-in capital: Additional paid-in capital is the excess of amount
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over the par value of the issued stock, that are contributed by owners
3) Retained earnings are the accumulated net income that have not been
distributed to owners as dividends, which is to be decided by board of
directors.
4) Treasury stock or treasury shares which means that the company decided
to purchase back from the stock market its own stock that belong to the
company itself using the company’s cash.
a) Treasury stock is reported either at cost or at par.
b) Treasury stock is reported as a reduction of equity.
c) These shares are no longer outstanding shares
5) Accumulated other comprehensive income items that are not included in
net income.

6) Non-controlling interests: the reporting company’s share (portion of equity)

that it owns in other subsidiaries, which the reporting company don’t fully
own but only owns portion or share of it, that’s why it is also known as
“minority interest”
Limitations of Balance sheet:

1) Value of fixed assets are valued at historical costs (purchase cost –
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accumulated depreciation = NBV net book value), instead of the market
value of the assets, which could be that market value is much greater than
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the NBV, so is not reflecting real value of assets if let’s say company will
decide to liquidate its assets now
2) The balance sheet shows a company’s financial position at a certain date,
accounts may be changing significantly in few days before or after the
a.
publication of the balance sheet, so it does not reflect the major transactions
in the short term and that might affect users’ decisions in a way or another.
3) Many items reported in the balance sheet are estimated values based on
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management judgments, such as expected useful time of fixed assets,

estimated doubtful balances of A/R
4) It does not reflect some other valuable assets for the company, such as
employees, competitive advantages, human resources, etc. although these
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values could affect many users’ decisions
Major notes to be disclosed in the footage of the balance sheet:

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1. Significant accounting policies, such as the use of estimates and rules for
revenue recognition
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2. Investment securities
3. Property, plant, and equipment holdings
4. Maturity patterns of bond issues
5. Significant uncertainties, such as pending litigation
6. Details of capital stock issues

3. Income Statement
Income statement: reports the company’s results from operation during a period
of time (not at a specific date like balance sheet), which means the report address
will be (income statement for the period from XX/XX/XXXX to XX/XX/XXXX) so it
reports the results between these two dates.
There is a good comparison in a simple word here:
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Balance sheet is a photograph that takes a photo as some point (certain date)
While the income statement is like a video recorder, that films transaction during
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a period
Income statement equation
Income / loss = revenue + gains - Expenses
a.
The elements of income statement, revenue, gains, expenses and losses are
temporary (nominal) accounts, because it will be closed in another permanent
account which is the retained earnings (real account) at the end of each period, in
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another word, at the beginning of each period (usually beginning of each fiscal year)
those accounts balance will be zero.
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Income Statement of Company (………..)

For the period Between XX/XX/XXXX to XX/XX/XXXX
Sales or service revenues
− Cost of goods sold (COGS)
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= Gross profit
− Selling, general, and administrative expenses (SG&A)
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= Operating income
+ Interest and dividend income
− Interest expense
+/- Non-operating gains/(losses)
= Income from continued operations before income tax
− Provision for income taxes on continued operations
= Income from continued operations expected to be continued in the
future
Discontinued operations:
+/- Income / (loss) from operations of discontinued component (net of tax)
+/- Gain / (loss) on disposal of -the same- discontinued component (net of tax)
= Net Income
The purpose or uses of the Income Statement:

• It helps users to evaluate the company’s past performance and to compare it
against the performance of its competitors.
• It provides a basis for predicting future performance.
• It helps users assess the uncertainty of achieving future cash flows.
Elements of the Income Statement:
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The income statement is made up of four major elements:
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1) Revenues: what you do all day every day
Are inflows (other enhancements) of assets or reduction (settlement) of liabilities
(or both) as a result of delivering or producing goods, providing services, or other
activities that are the entity’s major or central operations (core operation).
a.
The revenue recognition: Under ASC 606, revenue is to be recognized in the
accounting period in which the performance obligation is satisfied, that is, when
the customer obtains control of the asset, which is the good or service that is
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transferred to the customer. Revenue is recognized to depict the transfer of goods
or services to customers in an amount that reflects the consideration the company
expects to be entitled to in exchange for the goods or services.
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2) Expenses:
Are outflows or other usage of assets or incurrences (incurrence) of liabilities (or
both) from purchasing goods, services, or other activities that are necessary to
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provide the entity’s ongoing major or central operations.

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Expenses are recognized (which is commonly called the matching principle) that
relates expenses recognition to the changes of assets or the recognition of
revenues, and it can be treated through one of the following three methods:
• Cause and effect. For example, recognizing the cost of goods sold when an item
is actually sold.
• Systematic and rational allocation, such as depreciation.
• Immediate recognition. If an expense will not provide future benefit.
Other Expenses
Selling, general and administrative expenses (SG&A): general and administration
expenses are incurred for the benefit of the whole entity and not related to a
specific function, unlick the major selling or manufacturing activities. Such as
accounting expenses, legal, and other fees for professional services, admin.

Salaries, insurance, wages of office staff, other supplies and office rent cost, while
selling expenses obviously those are incurred in selling or marketing, such as sales
representatives’ salaries, commissions, and traveling expense, advertising, sales
department expenses, and credit and collection costs, as well as shipping costs.
3) Gains:
Are increases in equity (or net assets) and not from the entity’s main revenues or
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investments and not from revenues or investments by owners of the entity
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4) Losses are decreases in equity (or net assets):
Are losses or decreases in equity (or net assets) and not from the entity’s main
operations and not from expenses or distributions to the owners of the entity
Other Income Statement Items

1- Discontinued Operations
a.
Strategic change that will have a major effect on operation, such as ceasing
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operations in a major geographical area or ceasing a major line of business, a major
equity investment, or other major parts of the entity.
Gains / losses from discontinued segment are reported in the period in which the
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gain or loss occurred in the net of associated taxes that relates to this discontinued
process.
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Discontinued operations must be reported when any of the following occurs:

1) The held-for-sale: disclosed in the period in which all of the following are met:
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• Management commits to a plan to sell the entity.

• The entity to be sold is available for immediate sale.
• initiate an active program to complete the plan to sell the entity.
• The sale is probable within one year, unless events beyond the entity’s control
will happen during this year.
• The entity is being marketed at a reasonable price in relation to its fair value.
• Actions required to complete the plan to sell the entity, make it difficult to pull
back from the plan or significantly change it.
2) The component or group of components is already sold.
3) The component or group of components is disposed other than by sale, such as
by abandonment or by distribution to owners in a spinoff.

Any gain or loss from the disposal is reported net of tax below income from
continuing operations, in the discontinued operations section of the income
statement.
All gains and losses from the component to be discontinued should be disclosed as
previously stated, so users of the financial statements can see what income from
continuing operations is without this ceased operation or that will be disposed.
Companies use the term “Income from continuing operations” on their income
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statement, if there are gains or losses on discontinued operations.
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Intra-period Tax Allocation
The income tax effect of discontinued operations needs to be reported on the
income statement separately from income taxes applicable to continuing
operations, and discontinued operations are reported on the income statement net
a.
of their applicable taxes. Therefore, taxes must be allocated between income from
continuing operations and income from discontinued operations on the income
statement.
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In addition, any items reported on the balance sheet in accumulated other
comprehensive income are to be reported net of tax. Allocation of tax among
income from continuing operations, discontinued operations, and accumulated
other comprehensive income is called intra-period tax allocation (allocation within
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one period).
The income tax due should be allocated first to income from continuing operations.
The remaining tax due should be allocated to gains/losses from discontinued
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operations and items reported in accumulated other comprehensive income

according to each one’s proportion of the total other taxable items.
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Transactions not to be included in the income statement of the period:

1) Transactions with owners
2) Prior-period adjustments (such as error correction or a change in accounting
principle)
3) Items reported initially in other comprehensive income
4) Transfers to and from appropriated retained earnings

Limitations of the Income Statement:

a) The income statement does not always show all items of income and
expense. Some items are reported on a statement of other comprehensive
income and not included to calculate the net income.
b) Income statement itself is not sufficient enough for assessing liquidity. This
statement must be viewed in conjunction with other financial statements
such as the balance sheet and statement of cash flows.
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c) Net income is an estimate that reflects a number of assumptions.
d) The effect on income numbers due to the different used accounting methods
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used. Such as different methods of depreciation, which will lead to difficulty
in comparisons between companies as results from these differences in
accounting methods.
e) Income measurement requires judgments. Such as the estimation of
a.
depreciation percentage, depending the estimation of the useful life of the
asset.
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Major notes to be disclosed in the footage of the income statement:
1) Earnings per share
2) Depreciation schedules
3) Components of income tax expense
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4) Components of pension expense

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A) Multiple step INCOME STATEMENT ‫ﻟﻺﻳﻀﺎح ﻓﻘﻂ‬
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a.
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Condensed multiple step INCOME STATEMENT
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a.
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B) Single step INCOME STATEMENT
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4. Statement of Comprehensive Income
Statement of comprehensive income

Net income XXX
Other comprehensive income (net of tax):
Gains or losses associated with pension (post retirement plans) XX
Unrealized holding gains and losses on available-for-sale securities XX
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Foreign currency translation adjustments XX
Effective portion of gains and losses on cash flow hedges XX
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Other comprehensive income Gains / (loss) XXX
Total comprehensive income XXX
a.
Certain income items are excluded from the calculation of the original income
statement and instead are included in comprehensive income, comprehensive
income (income statement + comprehensive income = total comprehensive net
income) is the change in equity (net assets) of an entity during a period of time from
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transactions relates to non-owner sources, which means other than distribution of
dividends or the sale of shares, it includes everything on the income statement +
some things that do not appear on the income statement, for example unrealized
holding gains and losses on available-for-sale securities, which are not included in
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net income but included in comprehensive income. Accumulated other

comprehensive income is a line in the equity section of the balance sheet that
includes these items that are not reflected on the income statement.
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The following are the major items included in other comprehensive income:
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a) The effective portion of the gain or loss on a derivative designated as a cash flow
hedge
b) Unrealized holding gains or losses on available-for-sale securities
c) Foreign currency translation adjustments
d) Certain amounts associated with accounting for defined benefit pension plans
or other postretirement benefits.
e) Gains and losses on intercompany foreign currency transactions, that are of a
long-term investment nature.
The comprehensive income items may be shown as either net of tax or not net of
tax. However, if they are not shown net of tax, the tax effects of these items must
be disclosed separately.

If a company does not have any items of other comprehensive, it is not required to
prepare it.
All items of comprehensive income are recognized for the period in either
1) Single continuous financial statement, so it must represent it in two sections, net
income and other comprehensive income
It must present
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 Total net income along with the components that lead to the net income;
and
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 Total amount for the other comprehensive income along with its
components.
Or
2) Two separate but consecutive financial statements.
income and total net income.

a.
a) The first statement (the income statement) presents the components of net
b) The second statement, total other comprehensive income and the components
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of other comprehensive income in a statement of other comprehensive income
that immediately follows the statement of net income. The statement of other
comprehensive income must begin with net income.
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PUFE
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P U F E
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Pension Unrealized Foreign Effective

‫ﻟﻺﻳﻀﺎح ﻓﻘﻂ‬
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a.
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5. Statement of Changes in Equity

A statement of changes in stockholders’ equity presents a reconciliation for the
beginning balance in each account of the equity to the ending balance of this
account, stockholders’ equity accounts are permanent accounts that keep on
accumulating their balances from year to year, and each change is disclosed
separately in the statement.
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Statement of changes in stockholders’ equity
Additional Paid-
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Comprehensive
Preferred Stock
Common Stock
Accumulated
Total Equity
in Capital
Retained
Earnings
Income
a.
Other

Balance, December 31, Year 1 Beginning balances
Net income
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Preferred dividends paid
Common dividends paid
Issuance of common stock
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Balance, December 31, Year 2 Ending balances

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The following are the common changes in the equity accounts during the
accounting period:
1) Net income (loss) for the period, which increases (decreases) the retained
earnings balance.
2) Distributions to owners (dividends paid), which decreases the retained earnings
balance.
3) Issuance of common stock, which increases the common stock balance. If the
amount paid for the stock is above the par value of stock, the balance of additional
paid-in capital is also increased.
4) Total change in other comprehensive income during the period.

Changes in accounting principle

Reconciliation of Retained Earnings and corrections of prior period
financial statement errors
Retained earnings reconciliation
Retained earnings beginning balance XXX

+ Net income (loss) for the period XX
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– Dividends distributed during the period (XX)
+ prior-period adjustments XX
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Retained earnings ending balance XXX
A statement of retained earnings reconciles the beginning to the ending balances

of the retained earning account. This statement is reported as part of the statement
a.
of changes in equity in a separate column, since being a component of equity.
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6. Statement of Cash Flows (SCF)
The SCF is one of the three main financial statements presented by companies, the
primary purpose of the statement of cash flows is to provide relevant information
about the cash receipts and uses of cash (cash payments) of an entity during the
period, it reconciles the period’s beginning balance of cash and cash equivalents
with the ending balance.
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Statement of Cash Flows
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For the Year Ended XXXX XX, 20XX
Cash flows from operating activities
Net income XX
a.
+ Depreciation XX
+/- Gain/(loss) on PPE sales XX XX
Inventory movement (Increase / Decrease) XX
A/R net movement (Increase / Decrease) XX
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A/P net movement (Increase / Decrease) XX
Received dividends XX
Interest received XX
Interest paid (XX)
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Net cash flows from operating activities XXX
Cash flows from investing activities

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Cash Inflow: sale of fixed assets XX

Cash Outflow: Purchase of fixed assets XX
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Net cash flows from investing activities XXX
Cash flows from financing activities

(+/-) Cash In / Outflow: intercompany paid to / from subsidiary XX
+Proceeds from issued shares XX
+ loans
Dividend distributed (XX)
Net cash flows from financing activities XXX
Net increase in cash and cash equivalents XXX
Cash and cash equivalents at beginning of year XXX
Cash and cash equivalents at end of year XXX

 Notes to the Financial Statements:

A) Supplemental schedule of noncash investing and financing activities:
1) Investing
Didn’t involve cash in transaction
2) Financing
B) Cash paid in taxes XX XX

Cash paid in interest XX XX
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The order of the three sections and the order of the beginning and the ending cash
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balances for the year. This is the correct order.
Note: The above format can be used for either the direct or indirect methods.
a.
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The statement of cash flows should provide information about cash inflows and
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outflows, cash activities are broken down into three main categories for the
presentation of the statement of cash flow in the following order:
• Operating activities.
• Investing activities.
• Financing activities.
The total of the cash flows from the three previous categories equals the net
increase / decrease in cash and cash equivalents during the period. Which is also
reported in the SCF.
All transactions that involve cash in the whole company must be included and
classified in one of those three categories.

The three categories items are listed as per below illustration:
A) Operating Activities:
Cash flows from operating activities are primarily derived from the main business
activities of the entity. The operation cash inflows and operation cash outflows are
the result from transactions that relates to the determination of net income.
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Operating cash collections examples (cash inflows from operating activities):
1) Cash receipts from the sale of goods and services (including collections of
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accounts receivable)
2) Cash receipts from royalties, fees, commissions, and other revenue
3) Cash received in the form of interest or dividends received from debt and equity
investments
a.
Operating cash payments examples (cash outflows from operating activities):
1) Cash payments to suppliers for goods and services
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2) Cash payments to employees
3) Cash payments to government for taxes, duties, fines, and other fees or penalties
4) Payments of interest on debt
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Cash flows from the purchase, sale, and maturity of trading securities usually
will be classified as operating activities, not investing activities.
Also, tax payments to government and tax refunds are classified as an
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operating activity
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B) Investing Activities:
Cash flows from investing activities represent the expenditures have been made to
generate future profit or return from investments.
Investing activities cash collections and payments examples, of cash outflows (and
inflows):
1) Purchasing and selling property, plant and equipment (fixed assets).
2) Cash payments to acquire (cash receipts from sale and maturity of) equity and
debt instruments of other entities for investing purposes
3) Cash advances and loans made to other parties (cash receipts from repayment
of advances and loans made to other parties)

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C) Financing Activities:
a.
Financing activities are the activities that are used to raise cash to finance the
business.
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Financing collections examples (cash inflows from financing activities):
1) Cash proceeds from issuing stock
2) Issuing debts (bonds)
3) Cash proceeds from issuing loans, notes, and other short-term or long-term
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borrowings.
Financing payments examples (cash outflows from financing activities):

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1) Cash repayments of amounts borrowed and loans

2) Payments of cash dividends
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(note the dividends received are operating activities)

3) Treasury stock transactions
In investing and financing activities’ sections we concentrate mainly for cash paid
and cash received (clear cut point).
D) Noncash Investing and Financing Activities:

The SCF also presents information about noncash investing and financing activities,
for example of the borrowing to purchase an asset, when the company borrows
loan to buy asset but the lender sends the cash directly to the seller of the asset
not to the company (borrower) and therefore as well the cash payment to the buy
the asset never went out from the company, an asset is purchased (investing) and
a new obligation for a liability is incurred (financing), while no actual cash inflows
or outflows had been occurred through the company’s accounts. Information on

noncash investing and financing activities is presented in the disclosures (notes) to
the statement of cash flows, which means outside the body of the statement of
cash flows.
Noncash investing and financing examples (no collections or payments of cash):
1) Conversion of debt to equity
2) Acquisition of assets either by assuming directly related liabilities (as per
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explained in the previous example) or by finance lease
3) Exchange of a noncash asset or liability for another
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For CMA exam purposes must know items under each category.
a.
Indirect Method of Presenting Operating Cash Flows:
There are two methods to present the operating section of cash flows, direct and
the indirect methods, both methods are leading to the same result of net cash flow
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from operation, while the two methods are different only for the presentation of
the net cash flows from operating activities, and everything else is the same, as
under the direct method we will adjust each of the individual lines on the income
statement, while under the indirect method will adjust the bottom line only which
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is the net income amount.

According to the ICMA LOS the CMA exam requires candidates to know how to
prepare the statement of cash flows using the (indirect method) ONLY
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Preparation of SCF under indirect method / also known as reconciliation method:

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Generally, in order to prepare SCF we need:

2 balance sheets (let’s say previous and current)
+ 1 income statement (in this case the current year income statement)
So we could have a question here say” we can prepare SCF using one balance sheet,
or one balance sheet and one income statement” right / wrong

The net cash flow from operating activities is the adjusted net income for the effect
of the following:
1) Eliminate whither by deducting or adding back noncash revenue and expenses

that were included in net income, such as depreciation and amortization expenses.
Noncash losses and expenses included Added to net income
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in net income
Noncash gains and revenues included Subtracted from net income
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in net income
2) Eliminate Items included in net income whose results effects relate to investing
or financing cash flows, such as gains or losses on sales of fixed assets (investing
a.
activities) and gain or losses on settling of debt (financing activities)
Losses and expenses which are related Added to net income

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to investing or financing cash flows
Gains and revenues which are related Subtracted from net income
to investing or financing cash flows
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3) All changes of past or future operating cash flows (adjustment of beginning

balances and ending balances of previous balance sheet and the current balance
sheet), such as changes during the period in net (not total) accounts receivables,
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accounts payable, inventory and deferred income

The following rules apply for adjusting net income:
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Assets
increase in an asset deducted from net income
decrease in an asset added to net income
Liabilities
increase in a liability added to net income
decrease in a liability deducted from net income
4) If purchases, sales and maturities of trading securities are classified as operating

activities, deduct from net income cash used to purchase trading securities and add
to net income cash received for trading securities that were sold or that matured

5) Finally, must disclose the cash amounts for income taxes payments and interest
payments, in a supplemental schedule at the end of the SCF.
Summary: The Indirect Method

Summary of the steps to prepare the operating activities section under the indirect
method.
1) Add all depreciation and amortization expense back to net income.
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2) Add all non-operating losses on the income statement back to net income.
Subtract all non-operating gains on the income statement from net income.
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3) Add and subtract the changes in balance sheet accounts that are related to
operating activities: net accounts receivable, accounts payable, inventory, other
payables and receivables, bond discount or premium, and other assets and
liabilities.
a.
4) If purchases, sales, and maturities of trading securities are classified as operating
activities, subtract cash for purchasing trading securities and add cash received for
trading securities that were sold or that matured.
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5) In addition to the above adjustments, the cash amounts for income taxes paid
and interest paid need to be disclosed in a supplemental schedule.
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Exam note: in the exam there might be a question to prepare SCF under indirect
method, but there is no information about the amount of net income, and that can
be found by you in calculating the retained earnings changes, so
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Increase in retained earnings means net income

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And decrease in retained earnings means dividends

So net income = retained earning ending balance – retained earning beginning
balance + dividends paid for the ended period

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Direct Method of Presenting Operating Cash Flows
a.
for info only
Under the direct method, the entity presents details of cash movements line by
line.
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If the direct method is used, the reconciliation of net income to net cash flow from
operating activities (the operating section of the indirect method format) must be
provided in a separate schedule.
It is entirely for entities to choose the presentation method of their statement of

cash flows, there is no obligation with that, while FASB prefers the direct method,
but the indirect method is most commonly used by entities, remember always that
the result at the end will be the same while it is a different method of presentation
for the operating activity only.

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a.
The purpose or uses of the Statement of Cash Flows SCF:

It is very important to determine a company’s financial health, although net income
provides information about a company’s success or failure, SCF will provide
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important information about cash that company needs in order to survive.
A company can report high and growing net income but may have negative cash
flow from operations. For example, most of company’s profits are increased against
higher balances of receivables and inventory; that might mean not enough cash to
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pay ongoing expenses. Increasing receivables can result from sales growth (which
is great), but increasing receivables can also result from delayed customers
collections of bills (which is not good).
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It can also be used in conjunction with balance sheet to generate ratio to assess the
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company’s financial liquidity to cover the current liabilities and financial flexibility
to cover the total liabilities from cash generated from operation.
Low or negative cash flow from operations could be an indication of the company’s
serious financial trouble.
Creditors use the cash flow statement, particularly the cash flow from operations
section, to determine whether they will get paid. A high amount of operating cash
flow indicates a company is generating enough cash from its operations to cover its
debt obligations. A low or negative operating cash flow indicates the company may
have to borrow to pay its ongoing operating costs.

If the company pays a dividend, investors look at the statement of cash flows to
determine whether the dividend is sustainable.
Limitations of the Statement of Cash Flows:

The statement of cash flows needs to be interpreted in the context of the other
financial statements, because for example the statement of cash flows alone would
not show that a positive operating cash flow was achieved by not paying the
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payables when due. The existence of due payables is important information for a
user to analyse the statement of cash flows in order to understand the financial
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position of the company, in order to recognize something like past due payables,
the balance sheet and income statement are needed
The indirect method has its own limitation, as it does not show the sources and
a.
uses of operating cash individually, instead it shows only adjustments to accrual-
basis net income. Because of this limitation, a user can have difficulty in
understanding the presented SCF.
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Notes to the Financial Statements

A complete set of financial statements requires notes to the financial statements
in order to present a thorough picture of a company’s financial position and the
results of its operations. The notes are used to explain the items presented in the
main body of the financial statements and the methods used to determine the
amounts reported. For example, if a company recognized a loss in the income
statement due to impairment of a fixed asset, a note is a way to explain how the
asset became impaired. The notes can also provide further breakdown and analysis

of certain accounts that are deemed important, such as an analysis of depreciation

recorded for the period.
Accounting Policies
The first note is a summary of significant accounting policies, such as what method
of depreciation is being used or how inventories are valued and what cost flow
assumption is being used. Disclosure of accounting policies is used to identify and
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describe the principles of accounting being followed by the reporting entity and the
methods used for applying the principles that materially affect the determination
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of the company’s financial position, cash flows, or results of operations.
The disclosure needs to include important judgments regarding the principles and
methods that involve any of the following:
• A selection from acceptable alternatives available
a.
• Any principles or methods that are unique to the industry in which the company
operates, even if those principles and methods are commonly followed in that
industry
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• Any unusual or innovative applications of generally accepted accounting
principles.
However, ASC 235-10-50-4 does include examples of accounting policy disclosures

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that are commonly required, as follows:

• The basis of consolidation used,
• Depreciation method(s) used,
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• Information on amortization of intangibles,

• Inventory pricing,
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• Recognition of revenue from contracts with customers, and

• Recognition of revenue from leasing operations.
The summary of significant accounting policies can suggest to the user whether the
company is using liberal or conservative accounting policies.
Limitations of financial statements in general:

• Measurements are using money bases, so qualitative aspects are not included.
• Financial reporting involves estimation, classification, summarization, judgment,
and allocation.
• Financial statements primarily reflect transactions that many of them are
historical cost.
• Only transactions involving an entity being reported. However, information
related to other entities such as competitors may be very important.

7. Integrated Reporting
An integrated report incorporates non-financial information along with the
financial information provided in financial reports and shows how the financial
information is influenced by the non-financial information over the short, medium,
and long term.
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So, it is providing more information than just the financial information to help
making decisions, for example what are the different types of capitals that the

company has, how the company is using those capitals, business process, business
model, how to increase the capitals for example, in which areas, and how to
continue to be successful in the short, medium and long term, so it is a kind of an
overall reporting of the company’s performance that’s not only based on the
financial information but also using the nonfinancial information as mentioned how
the company is operating its business and how it is going to work in the future.
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Nonfinancial information:
Over the years, two separate but compatible concepts have emerged, one
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becoming “corporate social responsibility” and the other becoming “sustainable
development.” Corporate social responsibility focuses on organizations’ impacts on
society, and sustainable development focuses on organizations’ meeting the needs
of the present without compromising the ability of future generations to meet their
own needs.
a.
As corporate social responsibility and sustainable development have become more
important to stakeholders, the need for information that is outside the scope of
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the financial statements has become desired by many users, which is exactly what
we are looking at in the integrated reports is to provide more information other
than the financial information provided in the financial statements
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ISO 26000, Guidance on Social Responsibility, is an international standard that was

introduced in 2010 and aids organizations in structuring, evaluating, and improving
their social responsibility, including their stakeholder relationships and community
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impacts. It sets forth society’s expectations about what constitutes socially

responsible behaviour.
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social responsibility:
Incorporates sustainable development under the umbrella of social responsibility.
According to ISO 26000, social responsibility is an organization’s responsibility for
the impacts of its decisions and activities on society and the environment through
transparent and ethical behaviour that:
1) Contributes to sustainable development, including the health and welfare of
society,
2) Takes into account the expectations of stakeholders,
3) Complies with applicable law and is consistent with international norms of
behaviour, and
4) Is integrated throughout the organization and practiced in its relationships.

So, it gives a guidance for the companies how to be sociable responsible, but it does
not give a framework for reporting on its sociable responsibility to communicate
how is it that the company doing that, so there is a need to come up with a
reporting framework for this purpose
Reporting framework:
The earliest framework for reporting on social responsibility and sustainable
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development activities was introduced be the Global Reporting Initiative (GRI), the
first GIR reporting guidelines were launched in 2000 and GRI has updated them
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several times since.
The U.S. has no mandatory non-financial reporting requirements other than some
required disclosures about mine safety and conflict minerals. However, many of
a.
the largest U.S. companies prepare non-financial reports on a voluntary basis.
While many countries outside the U.S. have mandatory non-financial reporting
requirements.
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Some national reporting requirements led to the development of the international
integrated reporting council (IIRC)
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IIRC’S Purpose:
Is to create a globally accepted framework for a process that result in
communications by an organization about value creation over time.
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The international integrated reporting framework was published in December 2013

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 The IIRC’s mission is “to establish integrated reporting and thinking within
mainstream business practice as the norm in the public and private sectors.”
 The IIRC’s vision is “to align capital allocation and corporate behaviour to
wider goals of financial stability and sustainable development through the
cycle of integrated reporting and thinking.”
 The IIRC’s objective is “to change the corporate reporting system so that
integrated reporting becomes the global norm.”, so at some point in the
future instead of getting only the financial statements, the normal reporting
process is going to include as well nonfinancial information.
The International <IR> Framework introduces the concept of reporting non-

financial information as an integral part of the annual report that may be read by
all stakeholders. And according to IIRC the look at stakeholders as not only those

who are affected by the organization but also everyone who are going to affect the
organization and its ability to create value over time, such as providers of financial
capital, employees, customers, suppliers, business partners, local communities,
NGOs, environmental groups, legislators, regulators, and policy-makers.
The Framework builds on the concepts of corporate social responsibility and

sustainable development, but it also introduces new and enhanced concepts.
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An integrated report is defined by the IIRC in the Framework as:
A concise communication about how an organization’s strategy, governance,
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performance and prospects, in the context of its external environment, lead to the
creation of value over the short, medium, and long term.
Integrated reporting is defined in the Framework as:
a.
“A process founded on integrated thinking that results in a periodic integrated
report by an organization about value creation over time and related
communications regarding aspects of value creation”.
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Integrated thinking is defined in the Framework as:
The active consideration by an organization of the relationships between its various
operating and functional units and the capitals that the organization uses or affects.
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Integrated thinking leads to integrated decision making and actions that consider
the creation of value over the short, medium, and long term.
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The capitals and value creation:

The 6 types of capitals:
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Capitals are the resources that organization uses in producing and providing
products and services
Financial capital is the pool of funds available to an organization to use in the
production of goods or the provision of services. It is funds obtained through
financing activities such as debt, equity, or grants or generated through the
reinvestment of funds obtained from operations or investments. Financial capital
is increased when a corporation earns a profit or obtains additional financing.
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Manufactured physical capital is manufactured physical objects available to an
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organization for use in the production of goods or the provision of services.
Manufactured capital includes property, plant, and equipment that belong to the
organization, but it includes much more, as well. It includes external manufactured
assets or infrastructure available to the organization such as roads, bridges, and
a.
waste and water treatment plants. It also includes assets manufactured by the
reporting organization for sale or for retention by the organization for its own use.
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Intellectual capital results from employees’ efforts that generate intangible assets.
Thus, it is intellectual property such as patents, copyrights, software, rights, and
licenses. It is also “organizational capital” such as knowledge, systems, procedures,
and protocols.
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Human capital is the skills, capabilities, and experiences of people. It includes

employees’ motivations to innovate, their alignment with and support for the
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organization’s governance framework, approach to risk management, and ethical

values; their ability to understand, develop and implement the organization’s
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strategy; and their loyalties and motivations for improving processes, goods, and
services. It also includes their ability to lead, manage, and collaborate. The quality
of a company’s human capital is improved when employees become better trained.
Social and relationship capital derives from the relationship between a company
and the society from which it secures its license to operate. It is the institutions as
well as the relationships within and between communities, groups of stakeholders,
and the ability to share information to enhance individual and collective well-being.
It includes intangibles associated with the brand recognition and reputation that
an organization has developed and the willingness to engage that the organization
has with external stakeholders.

Natural capital is renewable and non-renewable natural and environmental

resources such as air, water, land, forests, and minerals that provide goods or
services supporting the past, current, or future prosperity of an organization.
Natural capital also includes the health and biodiversity of the ecosystem.
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The capitals serve as part of the theoretical underpinning for the concept of value
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creation within the Framework.

These all should lead to the main purpose of our study about the integrated
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reporting to let’s start with the purpose of the integrated reporting
Purpose of integrated reporting:

An integrated report is a single report that presents both financial and nonfinancial
information in a manner that emphasizes the whole picture and the
interdependence of its parts. It communicates how an organization's strategy,
governance, performance, and prospects lead to the creation of value in the
context of its external environment in the short, medium, and long term.
The primary purpose of an integrated report is to explain to providers of financial

capital how an organization creates value over time. An integrated report also
benefits all stakeholders that are interested in the organization’s ability to create

value, including employees, suppliers, business partners, local communities,

legislators, regulators, and policy-makers.
Goals of integrated reporting are to:

The IIRC’s goal is a world in which integrated thinking is embedded within
mainstream business practice in the public and private sectors. So, it is part of the
way company’s running its business, part of decision-making process, part of
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company’s culture and usual normal practices. The IIRC sees integrated reporting
as facilitating that vision. Thus, the goals
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• Improve the quality of information available to providers of financial capital to
enable more efficient and productive allocation of capital.
• Promote a more cohesive and efficient approach to corporate reporting that
draws on different reporting strands and communicates the full range of factors
a.
that materially affect the ability of an organization to create value over time.
• Enhance accountability and stewardship for the broad base of capitals (financial,
manufactured, intellectual, human, social and relationship, and natural) and
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promote understanding of how they are connected to each other and their
interdependencies.
• Support integrated thinking, decision-making, and actions that focus on the
creation of value over the short, medium, and long term.
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Value creation:
One of the major key words in this subject, that’s what we are trying to report
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about, is the process of creating outputs that are more valuable than the inputs
used to create them. An organization’s business activities and outputs create value
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over time. An organization’s ability to create value for itself enables financial
returns to the providers of its financial capital.
The value created is manifested by increases, decreases, or transformations of the

capitals. The value is created for
• the organization, enabling financial returns to the providers of financial capital,
and
• others, including all stakeholders and society at large.
So briefly we are trying to create value for organization and others and its all
interconnected, by reporting how to reach that value, the thinking, the process, the
plans to reach that value now and in the future

Value creation activities:
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a.
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An organization creates value through making sales, which creates changes in
financial capital. However, a wide range of other activities, interactions, and
relationships also create value. Those other activities, interactions, and relations
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include but are not limited to:

• Effects of the organization’s business activities and outputs on customer
satisfaction,
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• Suppliers’ willingness to trade with the organization and the terms under which
they do it,
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• Initiatives the organizations’ business partners agree to undertake with the

organization, and
• The imposition of supply chain conditions or legal requirements.
Organization is not in business by its own self, it must look at customers, and
suppliers, and all its business partners, how to get its goals together, how is it they
can do together to create value and develop it over time, sure we are not talking
about each and single relationship in business, but let’s say the material
relationships of those who would have a material impact on the company’s ability
to create value

The value creation process:

The value creation process is central to integrated reporting. Remember that the
objective of an integrated report is to communicate how an organization creates
value over time. And how we do it is influenced by the organization’s external
environment, its governance, and its business model. An organization’s business
model draws on various capitals as inputs and, through its business activities,
converts the inputs to outputs. The outputs are products, services, by-products,
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and waste. The organization’s activities and its outputs lead to outcomes, which
are their effects on the capitals.
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An integrated report should include insights about:
• The external environment affecting the organization.
• The resources and relationships used and affected by the organization: its
capitals.
a.
financial, manufactured, intellectual, human, social and relationship, and natural
• How the organization interacts with the external environment and the capitals to
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create value over the short, medium, and long term.
The graphic below from the Framework depicts the value creation process:
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The elements of the graphic are as follows.

• The six capitals are the inputs to the value creation process, and they enter the
process at the left side of the graphic.
• The external environment (for example, economic conditions, technological
change, societal issues, and environmental challenges) creates the context within
which the organization operates. The external environment is the background of
the graphic.
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• The organization’s mission and vision this is what the company is trying to do, the
purpose of the company and intentions of the company.
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o Monitoring and analysis of the external environment in light of the
organization’s mission and vision is needed in order to identify risks and
opportunities (on the top left of the circle).
o The organization’s strategy identifies the way it plans to mitigate or manage
a.
risks and maximize opportunities. Strategic objectives are implemented
through resource allocation plans (on the top right of the circle).
• Governance involves creating an oversight structure that supports the
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organization’s ability to create value. Governance includes all of the means by
which an organization is directed and controlled, including the rules, regulations,
processes, customs, policies, procedures, institutions, and laws that affect the way
the organization is administered. Governance spells out the rules and procedures
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to be followed in making decisions. Governance also involves the relationships

among the various participants and stakeholders within the organization, such as
the board of directors, the shareholders, the chief executive officer (CEO), and the
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managers. Governance is the joint responsibility of the board of directors and

management.
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• The business model is at the fundamental core of the organization. A company’s

business model is the organization’s system of using its business activities to
transform inputs (the capitals) into outputs and outcomes to fulfil the
organization’s strategic purposes and create value over the short, medium, and
long term. The business model encompasses the various capitals (inputs) and the
organization’s business activities that convert the inputs to outputs, which include
products, services, by-products, and waste.
• The organization’s business activities and outputs lead to outcomes. The
outcomes are the internal and external consequences, both positive and negative,
for the capitals that result from the organization’s business activities and outputs.
The value creation process may preserve, increase, or decrease the organization’s
capitals over time.

• The outcomes are transformed capitals that are depicted in the graphic emerging
from the right side of the process. And for sure hopefully the outputs will be more
than the inputs. The outcomes—the transformed capitals—become inputs to the
ongoing value creation process.
• Information about performance (on the bottom left of the circle) is required for
decision-making. Performance is monitored through setting up measurement and
monitoring systems.
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• Regular review of each component of the value creation process and its
interactions with other components and a focus on the organization’s outlook (on
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the bottom right of the circle) lead to revisions and refinement to make
improvements going forward in the future.
The integrated Report elements:

Content of integrated report:
Principles for Preparation and

a.
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Presentation
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Content of integrated report
An integrated report should include the following eight content elements [not
necessarily in this order], which parallel the items in the graphic depicting the
integrated reporting process, bear in mind that every company has a very different
type of report, since what is important to one company as part of their value
creation is going to be very different compared to other companies.

1) Organizational overview and external environment: What dose the organization

do, and what are the circumstances under which it operates? The report should
provide information about the company’s use of and effects on the capitals and
how the organization’s strategy relates to its ability to create value in the short,
medium, and long term, and significant factors affecting the external environment
and the organization’s response to it. It should also include quantitative
information such as number of employees, revenue, countries in which the
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organization operates, and changes from prior periods.
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2) Governance: How does the organization’s governance structure support its
ability to create value in the short, medium, and long term? The report should
provide information about how regulatory requirements and the skills and diversity
of the organization’s leadership structure influence the design of the governance
structure. It should include information on
a. The organization’s attitude toward risk,
a.
b. Methods of addressing integrity and ethical issues,
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c. How the organization’s culture, ethics, and values are reflected in its use of and
effects on the capitals and on its relationships with key stakeholders, and
d. How compensation and incentives are linked to value creation and to the
organization’s use of and effects on the capitals in the short, medium, and long
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term.
3) Business model: What is the organization’s business model? An integrated report

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should describe the business model, including key inputs, business activities,
outputs, and outcomes.
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4) Risks and opportunities: What are the risks and opportunities that affect the
organization’s ability to create value over the short, medium, and long term, and
how is the organization dealing with them?
5) Strategy and resource allocation: Where does the organization want to go and
how does it intend to get there? The report should identify the organization’s short-
, medium-, and long-term strategic objectives, how it intends to achieve them, how
it plans to allocate resources to implement its strategy, and how it will measure
achievements and outcomes for the short, medium, and long term.
6) Performance: To what extent has the organization achieved its strategic

objectives for the period, and what are its outcomes in terms of effects on the

capitals? The report should contain qualitative and quantitative information about
performance, such as a discussion of quantitative indicators, the organization’s
positive and negative effects on the capitals, the state of key stakeholder
relationships, and linkages between past and current performance and between
current performance and the organization’s future outlook.
7) Outlook: What challenges and uncertainties is the organization likely to
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encounter in pursuing its strategy, and what are the implications for its business
model and future performance? The report should highlight anticipated changes,
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the organization’s expectations about the external environment it expects to face
in the short, medium, and long term, how it will affect the organization, and how
the organization is equipped to respond to the challenges and uncertainties likely
to arise.
a.
8) Basis of presentation: How does the organization determine what matters to
include in the integrated report, and how are those matters quantified or
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evaluated? The report should provide a summary of the frameworks and methods
used to quantify or evaluate material matters and a brief description of the process
used to identify relevant matters, evaluate their importance, and narrow them
down to material matters.
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Guiding Principles for Preparation and Presentation of an Integrated Report:

The following seven principles are the guiding principles for preparing an integrated
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report:
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1) Strategic focus and future orientation: The report should provide information
about the organization’s strategy and the way it relates to the organization’s ability
to create value in the short, medium, and long term, and to its use and effects on
the capitals, so is not so much about what already happen, as we already know
what happen and maybe we can’t do anything about it, but also what is our
strategic focus and what are we going to do in the future
2) Connectivity of information: The report should present a holistic picture of the

combination, interrelatedness, and dependencies between and among the factors
that affect the organization’s ability to create value over time.
3) Stakeholder relationships: An integrated report should provide information

about the nature and quality of the organization’s relationships with its key

stakeholders. The report should include how and to what extent the organization
understands, takes into account, and responds to stakeholders’ legitimate needs
and interests.
4) Materiality: The information disclosed in an integrated report should be about

material matters, that is, matters that substantively affect the organization’s ability
to create value over the short, medium, and long term. The materiality
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determination process involves identifying relevant matters, evaluating their
importance, prioritizing the matters, and determining what information to disclose
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about material matters.
5) Conciseness: An integrated report should be concise. It should include context

that is sufficient to understand the organization’s strategy, governance,
a.
performance, and prospects without including less relevant information.
6) Reliability and completeness: The report should include all material matters,
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both positive and negative, in a balanced way and without material error.
7) Consistency and comparability: The information in the report should be

presented on a basis that is consistent over time, meaning reporting policies are
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followed consistently from one period to the next unless a change is needed to
improve the quality of information reported. The information should also be
presented in a way that enables comparison with other organizations to the extent
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it is material to the organization’s own ability to create value over time.

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Benefits of Adopting Integrated Reporting IR:

• Integrated reporting can impose a form of discipline on a company’s reporting by
ensuring that the company concisely reports material information that shows how
well it is performing in non-financial areas that affect the company’s strategies and
their execution. The result is greater clarity about the relationship between
financial and non-financial performance and how value creation is affected.
• Integrated reporting can help managers gain a better understanding of the
relationship between financial performance and non-financial performance.
Managers are forced to think about when and under what conditions trade-offs
and interdependencies between financial and non-financial performance arise.
Better internal decision-making may result.
• Internal measurement and control systems for producing reliable and timely non-
financial information are improved. Adopting integrated reporting forces

organizations to increase the quality of their information systems, internal controls,

and monitoring systems so that the integrated report can meet standards for
independent assurance by external auditors.
• Greater employee engagement may result.
• Integrated reporting can lower an organization’s reputational risk.
• Customers who care about sustainability may be more committed.
• Better communication about the organization’s performance, position, vision,
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and mission in both financial and non-financial terms can result in deeper
engagement and improved relationships with shareholders and stakeholders.
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• Integrated reporting can communicate a company’s vision of the future and how
it addresses nonfinancial challenges and opportunities, enhancing confidence of
long-term investors in the company’s leadership and its ability to build sustainable
value.
Challenges of Adopting Integrated Reporting:

a.
• Adopting integrated reporting requires support of the board of directors and the
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CEO.
• Non-financial information does not have the same established reporting
standards as financial information has.
• Understanding what is a material issue that should be reported is very
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challenging. Management needs to determine what information its providers of

financial capital will want to know. The judgment of what matters are relevant and
important is firm-specific, and each organization needs to develop a process for
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how relevant and important matters are defined.

• In order to establish the reliability and comparability of integrated reports, an
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assurance opinion is necessary, and it should be in the form of “positive” assurance,

for example, “the company has fairly presented the necessary information” (in the
U.S.) or “the necessary information presents a true and fair view” (internationally).
• Internal controls over non-financial data are not as effective as controls over
financial data. Thus, a lack of data quality may prevent reporting of some non-
financial information, and data quality presents a challenge to the independent
auditor when attempting to provide positive assurance on nonfinancial
information.
• Preparation of an integrated report requires collecting and analysing all
nonfinancial date, structured and unstructured data, which entails investments in
new information systems and data, new processes and control systems, dedicating
resources, and obtaining assurance from third parties.

• Specialists with analytical skills will need to be brought in to make sense of the
data and incorporate it into financial reporting.
• Integrated reporting may cause disclosure of proprietary information and
revelation of competitive information.
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Unit 2. Recognition, measurement, valuation and disclosure

Subunits:
1) Basic accounting principles
2) Assets valuation
3) Valuation of liabilities
4) Equity transactions
5) Revenue recognition
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6) Major differences between US GAAP and IFRS
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1. Basic Accounting Principles
We generally use four basic principles of accounting to record and report
transactions:
1. Measurement principle
2. Revenue recognition principle
3. Expenses recognition principle a.
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4. Full disclosure principle
1. Measurement:
The most commonly used measurements are based on historical cost and fair value.
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1. Historical cost:
Many assets and liabilities are measured on the basis of acquisition price
(Historical Cost). Historical cost has an important advantage is that It is
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generally thought to be verifiable. While one of its disadvantages is that

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historical cost does not provide a good presentation of asset’s or liability’s

current cash value
2. Fair Value:
Fair value in practice mean to be a market-based measure, the advantage of
using fair value is that it can provide better information about the company’s
financial position and its future cash flow prospects, while that the
implementation of fair-value principle depends primly on existence of an
active market, which might not be the case always.

Kieso
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2. Revenue recognition principle:

The revenue recognition principle requires that companies recognize revenue in
the accounting period in which their performance obligation is satisfied. Which
means the revenue is recognized and recorded to the company’s accounting books
when the service is provided, or the item is sold, regardless of the cash collection.
3. Expenses recognition principle:
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Expenses are defined as outflows or other using up of assets or incurring of
liabilities or both, as a result of delivering or producing goods and/or performing
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services.
The expenses recognition principle is based on the matching to revenues basis,
which means that company should recognize expenses following recognition of the
related revenue, so companies should not recognize expenses when they get paid,
a.
while instead when the product or the service actually contributes to the revenue
value, this principle is also referred to as “matching efforts (expenses) with
accomplishment (revenue)
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While not always expenses can be matched, or tied up directly to revenues, for
example:
1- The assets depreciation that are depreciated during the useful life of the asset
which is expected to generate revenue during this period and that’s the logic of it.
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2- Another example of this matching dilemma, is the allocation of the

administration expenses directly to the period, regardless of the revenue
recognition, since it is not directly related to a specific revenue achievement
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Costs are related directly to revenue recognition are classified as product

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costs, such as material, labor, and overhead. While other costs that cannot be
directly connected to a specific revenue classified as period costs, such as
officers’ salaries and other administrative expenses and are expensed as
incurred.

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4. Full disclosure principle: a.
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The full disclosure principle is the general practice of providing information that is
of sufficient importance to influence the judgment and decisions of an informed
user. Bear in mind the costs of preparing and using the information.
Information are available in one of three areas:
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1. The main body of the financial statements:

In order to be recognized in the main body of the financial statements, an item
should meet the definition of a basic element of financial statements, be
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measurable with sufficient certainty, and be relevant and reliable. (FASB C5, P63)
The basic elements of financial statements are assets, liabilities, equity,
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investments by owners, distributions to owners, comprehensive income,

revenues, expenses, gains, and losses.
2. The notes to the financial statements: are used to explain the information
presented in the main body of the statements.
3. Supplementary information: it may be quantifiable information that is high
in relevance, or it may include management’s explanation of the financial
information

2. Assets Valuation
A) Cash
Cash is usually the first item on the balance sheet as it is the most liquid asset:
Items included in cash Items not included in cash
Cash consists of coin and currency Legally restricted deposits
Saving accounts
Checking accounts
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Bank drafts
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Cash equivalents:
Some companies present first line of their balance sheet as “cash and cash
equivalents”, and cash equivalents are very short term and highly liquid
a.
investments such as bonds, usually less than three months from the date the
company acquired that asset, such as CDs Certificate of Deposits less than 3 months
(that has no restrictions in case of withdraw) and money market mutual funds.
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B) accounts receivable
The main issues with respect to receivables are:
1) Valuing the accounts receivable.
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2) Calculating the Allowance for credit losses account under the percentage-of-
sales method and the percentage-of-receivables methods.
3) The factoring of receivables with and without recourse.
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Receivables: balance sheet account, which present money held against customers
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(trade receivables) or others (nontrade receivables), others such as advances to

employees, deposits, etc. it could be oral promise (accounts receivables) or written
promise (notes receivables), also could be for short term (current) [the current
accounts receivables are the majority or most common] or long term (noncurrent),
to remember about the current A/R: because they are expected to be collected
within one year or the company’s operating cycle.
These quick views of classifications to summaries all about receivables definitions.
Will be studying mainly the short-term accounts receivables against customers, and
we are more concerned about the valuation of accounts receivables and the credit
losses balances.
Accounts receivable are reported in the balance sheet at the net realizable value
(NRV), net accounts receivable, which means the net amount of cash that is
expected to be received

Accounts receivable NRV = Gross accounts receivable – Allowance for credit losses
Amounts to be deducted from Gross Accounts Receivables, could be:

a. Allowance for credit losses account
b. Allowance for sales returns
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c. other variable consideration expected. Variable consideration is the term
used to refer to prices of goods or services that are dependent on future
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events.
‫ﻣﺒﺪأ اﻻﺳﺘﺤﻘﺎق اﳌﺤﺎﺳﺒﻲ‬
The recording of accounts receivables using the accrual accounting method is also
coincides with revenue recognition, evaluating the expected credit losses amount
based on estimation, relates to being sure not to overstate the company’s assets,
a.
‫ﻣﺒﺪأ اﻟﺤﻴﻄﻪ واﻟﺤﻈﺮ‬
which is the principle of conservatism
‫مبﻌﻨﻲ اﻧﻪ ﰲ ﻋﺮض اﳌﻴﺰاﻧﻴﻪ ﺑﻴﺘﺨﺼﻢ ﻣﻦ ﺣﺴﺎب اﻻﺻﻞ ﻧﻔﺴﻪ‬
The valuation account is a contra-asset account called “Allowance for credit losses”.
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The allowance account should have a minus (credit) balance, which should
decrease the value of net accounts receivable. The estimated collectible amount is
called “net receivables “.
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Discounts and Initial Recording of the Account Receivable

Receivables should initially be recorded at the net amount of cash the company
expects to be entitled to receive in exchange for the goods or services transferred
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to the customer. Therefore, any trade discounts that are given or any other
discounts that the company expects its customers to take should be subtracted
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before recording the receivable in the books. This reduced amount is also the
amount that should be recognized as revenue on the income statement.
Two types of discounts may be given: trade discounts and cash (or prompt
payment or sales) discounts.
Note: Cash discounts (also called sales discounts or prompt payment discounts) and
trade discounts are applied only to the cost of the product that is purchased. If the
seller pays for the shipping costs and then charges them to the customer, the
discount is not applied to the shipping costs.
Trade Discounts
Trade discounts are discounts that are given for large purchases, to repeat
customers, or for a special offer.

Accounting for Trade Discounts

Accounting for trade discounts is fairly straightforward since the trade discount is
a simple reduction of the selling price. A trade discount may be given to good, long-
term customers, purchasers of large amounts, or as an incentive to win new clients.
When a trade discount is extended, the sales revenue and the receivable are
recorded at the discounted price. If more than one trade discount is given (for
example, a discount for being a long-standing customer and an additional discount
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for a large order), it does not matter which discount is calculated first because the
ending discounted sales amount will be the same no matter which discount is
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calculated first. What is important, though, is that the second discount is not
applied to the entire sale amount, but rather to the reduced amount after the
application of the first discount.
a.
Cash Discounts (Sales Discounts or Prompt Payment Discounts)
A cash discount, also called a sales discount or a prompt payment discount, is a

discount given when a customer pays a receivable in full before a set date. The
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purpose of a cash discount is to encourage early payment of the amount due by
giving a discount if the payment is made before the final due date.
A cash or sales discount offered is noted on the invoice the customer receives. For
example, an invoice might say “Terms: 2/10, n/30.”
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if the customer pays within 10 days

of the invoice date
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However, if the customer does not pay

within 10 days, the full undiscounted
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amount is due within 30 days.
the customer can pay 2% less than the invoiced amount, and the invoice will be
considered paid in full.
Businesses frequently take cash/sales discounts, because the amount of the

discount usually translates to a substantial benefit when the difference between
the full invoiced amount and the discounted amount is regarded as an interest
charge on the discounted amount—an interest charge for taking only 20 additional
days to pay (per the example above, at least).

Accounting for Cash (or Sales) Discounts

Prompt payment discounts are variable, and the receivables should reflect
management’s estimate of the balance of discounts that will be taken based on its
experience with the customer, with similar customers, or with similar transactions.
There are two possible accounting treatments for cash discounts given. The
company can either record receivables at the full amount (the gross method) or
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record them at the discounted amount (the net method). The gross method is used
more frequently in practice.
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Gross Method
Under the gross method, the company recognizes a receivable and revenue equal
to the full (gross) amount of the sale. When receivables are paid within the discount
a.
time period (and thus less than the full amount is paid), an adjusting entry is made
to account for the fact that less than the full amount is paid.
If the customer does not pay within the discount period but rather pays in full by
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the due date, the accounting is very simple because the company records the
receivable at its full amount and that is also the amount of cash that is collected.
The two journal entries will be as follows:

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Dr Accounts receivable 100 To record the sale.

Cr Sales revenue 100
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Dr Cash 100 To record the receipt

Cr Accounts receivable 100 of cash for the sale.
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However, if the customer pays within the time frame required for the discount and
takes the discount, the journal entries to record the sale and the receipt of cash will
be more involved and will look like the following:
Dr Accounts receivable 100 To record the sale.
Cr Sales revenue 100
Dr Cash 98 To record the receipt of

Dr Cash discounts (or sales discounts) given 2 cash and also to recognize
Cr Accounts receivable 100 that only $98 was received.

Even though the full amount of the receivable was not paid, the entire receivable
must be removed from the books, since the customer owes no more money. The
$2 discount amount is debited to an account called cash discounts (or sales
discounts) given, which is a contra-revenue account. The amount of the discount
taken will reduce the revenue account on the income statement, but the
adjustment is made to the discounts given contra-revenue account instead of to
the revenue account itself to enable analysis.
m
Allowance for Discounts – Under the Gross Method
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However, rather than debiting income each time a discount is taken, proper
expense recognition under the gross method requires that the company reasonably
estimate the expected discounts to be taken and set up an allowance account for
discounts. The allowance account is a valuation account and a contra-asset account
a.
that carries a negative balance and reduces the reported receivables on the balance
sheet. The other side of the entry is estimated expense for discounts taken, and
that debit goes to the contra-revenue account, discounts given.
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The company uses the allowance in order to properly value the receivables on the
balance sheet at the end of the period and to avoid overstating them. The
allowance that is set up should be equal to the balance of discounts the company
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expects its customers to take in the future for sales already made. The net of the
accounts receivable balance and the balance in the allowance account for discounts
should be equal to the amount the company expects its customers to pay.
h
When a customer takes the discount, the debit for the discount amount is made to
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the allowance account instead of to the contra-revenue account.

The process of estimating the discounts to be taken and setting up and using the
allowance for discounts is very similar to the process for the allowance for credit
losses account, covered later in this topic.
Net Method
The net method of accounting for cash/sales discounts recognizes the amount of
the potential discount at the time of sale, and each receivable is recorded at its net
amount (after the discount), assuming the customer will take the discount. If the
outstanding balance is not paid within the discount period, the lost discount is
recognized in a separate account such as cash discounts (or sales discounts)
forfeited, which is a revenue account on the income statement. Under the net
method, the journal entries for the sale and the customer’s payment are as follows.

Dr Accounts receivable 98
Cr Sales revenue 98
To record the revenue and the receivable at the net amount.
When the discount period passes for each sale, an additional journal entry is
required to increase accounts receivable and income by the discount amount
m
forfeited, as follows:
Dr Accounts receivable 2
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Cr Cash discounts (or sales discounts) forfeited 2
To record sales discount forfeited on receivable that has passed the discount period.
When the receivable is collected, the following journal entry is recorded:

Dr Cash
Cr Accounts receivable
a. 100
To record receipt of the gross amount of the receivable.

100
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The discounts forfeited account is a revenue account and will increase the revenue
figure on the income statement as each sale passes its discount period.
According to ASC 606-10-32-2, the transaction price is the amount of consideration
am
the company expects to be entitled to in exchange for transferring the promised

goods or services to a customer. Therefore, technically the net method is called for
by the revenue recognition standard. However, the net method may not be
h
practical for most companies because it is quite labor-intensive, requiring analysis

and bookkeeping time to calculate and record sales discounts forfeited on each
ef
receivable that has passed its discount period. If collection periods are fairly short,
any differences between the revenues and receivables that result from the gross
method and the net method will probably be immaterial.
Allowance for Customers’ Sales Return:

Goods could be returned if products are defects or due to customer dissatisfaction,
etc., therefore an allowance for sales returns should be estimated.
And entries are as follow:
1) Recognition of revenue from sale:

Dr. Cash/accounts receivable XXX
Cr. Sales XXX

2) Recognition of allowance for sales returns:

Dr. Sales returns (contra revenue) XXX
Cr. Allowance for sales returns (contra asset) XXX
When a customer returns merchandise or the company grants an allowance, the

company must eliminate or reduce the receivable if the sale has not yet been paid
for or refund the customer’s payment if payment has been received. Two accounts
m
in the chart of accounts are used: sales returns and allowances and allowance for
sales returns and allowances.
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• Sales returns and allowances is a contra-revenue account. It carries a debit
balance and reduces sales revenue on the income statement.
a.
• Allowance for sales returns and allowances is a contra-receivables account. It
carries a credit balance and reduces accounts receivable on the balance sheet.
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The sales returns and allowances account and the allowance for sales returns and
allowances account are used to show the estimated amount of refunds and
allowances the company expects to grant in the future.
am
Both sales revenue and accounts receivable are reduced to the amount of
consideration the company expects to receive.
h
ef

Credit losses on Accounts Receivables:

It is unlikely to collect full amounts from accounts receivables; therefore, we must
recognize an allowance for credit losses, bear in mind matching the expenses
(credit loss expenses) with the revenue (related sales).
The main measurement issue here is that we need to consider the estimation of
the NRV of accounts receivable for the balance sheet presentation and the related
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credit losses account which is the credit loss expenses account for the income
statement presentation. The recognized credit loss expense for the period
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increases the allowance for credit losses. Which is a contra account to accounts
receivable. Accordingly, we can say that the recognition of credit loss expense
decreases the balance of accounts receivable.
a.
The main aim is to measure the accounts receivable net realizable value, to that
there two common methods, in order to measure the credit loss expense and
accordingly the allowance for credit losses:
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(1) (2)
Income statement approach Balance sheet approach
The percentage-of-sales method the percentage-of-receivables method
Main journal entry:
am
Dr. credit loss expense XXX

Cr. Allowance for credit losses XXX
h
Note: Both the percentage of receivables and the percentage of sales methods
are acceptable under U.S. GAAP, as long as the company uses the same method
ef
every year, so the method is consistent from period to period.
However, a third method—the direct write-off method—is not acceptable for U.S.
GAAP. Under the direct write-off method, an individual receivable is written off
only when it actually becomes a credit loss. No allowance account is used under
the direct write-off method and therefore the direct write-off method does not
match revenues and expenses.

Income Statement Approach (Percentage of credit Sales):

In the income statement approach we start by calculating the credit loss expenses
for the period and add it to the allowance of credit losses balance, based on
estimated percentage of expected revenue not to be collected.
Credit sales on income statement X estimated percentage % = credit loss exp.
m
EXAMPLE:
co
A company’s trial balance demonstrates the following amounts:
Gross accounts receivable $50,000
Allowance for credit losses account (beginning balance) 1,000
a.
Sales on credit 100,000
According to previous experience, 1% of the company’s credit sales have been
usually credit losses.
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The credit loss expense recognized for the year is $1,000 ($100,000 × 1%).
The journal entry:
Dr. credit loss expense $1,000
am
Cr. Allowance for credit losses $1,000

The total adjusted balances of allowance for credit losses $2,000 ($1,000 + $1,000)
and credit loss expense $1,000.
Reporting:
h
Net accounts receivable of $48,000 ($50,000 – $2,000) in the balance sheet and
credit loss expense of $1,000 in the statement of income.
ef
Balance sheet presentation:

Accounts receivable, net of allowance for credit losses account of $2,000 $48,000
Or:
- allowance for credit losses account 2,000
Net accounts receivable $48,000

Balance-Sheet Approach (Percentage of Receivables):

In the balance sheet approach, we start by calculating the required ending balance
in the allowance account, based on percentage of accounts receivables ending
balance, and then calculate the credit loss expenses that should be charged to the
period.
A. Single estimated percentage:
m
Ending Balance Gross Accounts receivable on balance sheet X estimated
percentage % = allowance for credit losses account ending balance
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EXAMPLE

Gross accounts receivable
a.
Allowance for credit losses (beginning balance)
$50,000
1,000
That we already have in previous balance

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According to previous experience, 5% of accounts receivable are considered to be
credit losses.
The ending balance of the allowance for credit losses $2,500 ($50,000 × 5%), while
am
remember that the ending allowance balance has already $1,000

So the journal entry: That we need to reach
Dr. credit loss expense $1,500 ($2,500-$1,000)
h

The ending balances of allowance for credit losses account $2,500 ($1,500 +
ef
$1,000) and credit loss expense $1,500.

Reporting:
Or:

B. Multiple estimated percentages:

Usually entities have multiple rates of un-collectability for all accounts. Thus, these
entities prepare an aging schedule for accounts receivable.
EXAMPLE
m
Allowance for credit losses account (beginning balance) 1,000
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Aging period Balance % Estimated Ending
credit losses Allowance
a.
Less than 30 days $30,000 2% $600
30-60 days 5,000 5% 250

61-90 days 10,000 13% 1,300
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Over 90 days 5,000 20% 1,000
Total $50,000 $3,150
am
The ending balance of the allowance for credit losses account $3,150, while
remember that the ending allowance balance has already $1,000
h
So, the journal entry:

Dr. credit loss expense $2,150 ($3,150-$1,000)
ef

The ending balances of allowance for credit losses account $3,150 ($2,150 +
$1,000) and credit loss expense $2,150.
Reporting:
Or:

Write-Off of Accounts Receivable:

At a final step, some customers are unwilling or unable to satisfy their debts. A
write-off of a specific debt is recorded:
Dr. Allowance for credit losses account $XXX
Cr. Accounts receivable $XXX
According to this entry:
m
1) The write-off of debts has no effect on expenses (credit loss expenses).
2) Write-offs do not affect the balance of net accounts receivable because the
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reduction is the same amount from both, accounts receivable and allowance
for credit losses account, so accordingly also no effect on working capital.
a.
Collecting a Previously Written-off Receivable
If a customer pays on an account previously written off.
Dr. Cash $XXX
cm
Cr. Allowance for credit losses $XXX
According to this entry:
Credit loss expense is not affected when an account receivable is written off or
when an account previously written off becomes collectible.
am
Sales / Revenue X % Income Statement approach

Its goal is to match expenses incurred with related revenues
h
Receivables X % Balance Sheet approach

ef
Its goal is to value the ending accounts receivable
The T-account for that Allowance for credit losses account:
√ DR. Allowance for credit losses
XXX Amount written off

XXX
CR.
Beginning balance 1
XXX Collection of previously written-off credit losses 3
as credit loss for the year 2 XXX credit loss expense(amount to be charged) 4
XXX Ending balance 5
1, 2 and 3 will be given in the problem, question will ask for 4 or 5, or both, calculate one of them
based on given information this calculate the last number using simple +/- equation

The allowance for credit losses T-account in form of equation:

Beginning balance of allowance for credit losses XXX
+ credit loss expenses (amount to be charged/recognized) XXX
- Amount written off as credit loss for the year (XXX)
+ Collection of previously written-off credit losses XXX
Ending allowance for credit losses account XXX
m
Under the income statement approach, credit loss expense is a percentage of credit
In other words
sales, and the ending balance of the allowance is calculated using the equation
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above.
Under the balance sheet approach, the ending balance of the allowance is a
percentage of the ending balance of accounts receivable, and credit loss expense
is calculated using the equation above.
Factoring of Accounts Receivable:

a.
Factoring is a transfer or selling of receivables to a third party (a factor) which is a
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commercial finance company, to provide cash immediately using the factored
receivable balance as guaranteed, whom the factor should collect latter.
Example, if we have account receivable balance to be collected in 50 days, we could

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factor it now at a discount price and sort out some cash issue immediately.
Factoring accounts receivables has two forms:

h
Factoring “without recourse” and “with recourse.”

ef
Remember: the seller or the transferor is the company originally owns the
accounts receivable.
The factor is the purchaser or the transferee
Factoring without recourse:

Without recourse means no guarantee given by the seller, as the factor (purchaser)
assumes the risk of any inability to collect the receivables, and he has no obligation
against the seller in case if he couldn’t collect these balances at latter date. That’s
why some companies factor their receivables to transfer the credit loss risk in this
manner. Accordingly, the receivables are no longer reported on the seller’s books,
so if the sale is without recourse, any allowance for credit losses already recorded
for the receivables by the seller needs to be reversed.

Bear in mind that the greater the risk of credit loss, the less cash the selling
company will receive from the factor.
Factoring with recourse:

This means that if any of the receivable accounts does not pay their debt, the seller
will be obliged to cover any credit losses to the factor. The involved parties account
for the transaction as a secured borrowing with a pledge of noncash collateral.
m
Accordingly, the receivables are still on the seller’s books and it must recognize a
liability for cash received from the factor.
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Because of the lower level of risk to the factor in case buying the debt with
recourse, the purchaser will pay more to the seller when buying receivables with
recourse, which means that the factor fee with recourse is less than the factor fee
without recourse.
EXAMPLE a.
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A factor charges a 2% fee plus an interest rate of 18% on all cash advanced to a seller of accounts
receivable. Monthly sales are $50,000, and the factor advances 90% of the receivables submitted
after deducting the 2% fee and the interest.
am
Credit terms are net 60 days. What is the cost to the seller of this arrangement?
Amount of receivables submitted (face value) $50,000

Minus: 2% factor’s fee (% of face value) (1,000)
Minus: 10% reserve (% of face value) (5,000)
h
Amount accruing to the transferor $ 44,000

Minus: 18% interest for 60 days (% of net amount) (1,320)
ef
[$44,000 × 18% × (60 ÷ 360)]

Amount to be received immediately (net proceeds) $ 42,680
The transferor also will receive the $5,000 reserve at the end of the 60-day period, so the total
cost to the transferor to factor the receivables for the month is $2,320 ($1,000 factor fee +
interest of $1,320). Assuming that the factor has approved the customers’ credit in advance (the
sale is without recourse), the transferor will not absorb any credit loss.
The journal entry to record the preceding transaction is:

Dr. /
Cash $42,680 (received amount immediately)
Loss on sale of receivables 1,000 (factoring fee)
Prepaid interest 1,320
Receivable from factor 5,000 (reserve – Held amount)
Cr. Accounts receivable $50,000

% Of face value
m
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Advantages of factoring receivable accounts:
For the factor:
 Receives a high financing fee on the deposit plus the factoring fee, because
a.
the factor often operates more efficiently than its clients as they are
specialized.
For the seller

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 Speed up its collections.
 It can eliminate its credit department and accounts receivable staff.
 Credit losses are eliminated from the financial statements in case of factoring
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without recourse.
 These reductions in costs can offset the fee charged by the factor.
h
A very common form of factoring is the Credit card. The retailer benefits by
immediate receipt of cash and avoidance of credit losses. In return, the credit card
ef
company charges a fee.

C) Inventory
Classification of inventory:
Retailer or wholesaler: Merchandise inventory: goods inventory for resell
(This is will be covered in this section)
Manufacturer: Raw materials: parts and pieces that will make the finished goods
Work-in-process: unfinished production
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Finished goods: completed production
(This will be covered in section D)
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Inventories are classified as current assets in the financial statements, as they are
expected to be converted into cash or sold or consumed in less than one year or
a.
during the normal operating cycle of the business.
Sales revenue – cost of goods sold = gross profit

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Cost Basis of Inventory – valuing the inventory when it is purchased:
(initial measurement)
The cost of inventory includes all costs incurred in getting the inventory ready and
am
available for sale.

The cost of purchased inventories includes:
1) The purchase price of the inventory (net of trade discounts, rebates, etc.)
2) Shipping cost, handling, insurance, freight-in, taxes and tariffs, duties and all
h
other costs related to receiving the inventory.

ef
Dr. Inventory XXX

Cr. Cash XXX
Inventory’s physical count: (Inventory Period-End Physical Count)

This physical count is required by US GAAP for annual reporting purposes.
A period-end inventory physical count done annually is necessary under both the
perpetual and periodic inventory accounting systems.
The amount of inventory reported in the annual financial statements should be
matching the results of the physical count.

Goods included in inventory:

For more accuracy during the inventory physical count, the entity should include
only items considered to be inventory. Items to be counted as inventory include
the following:
1) Goods in transit:
Inventories that on the physical count date are not delivered yet and shipped to its
location (on the way)
m
The owner of the goods, who has the right to count the goods part of his inventory,
and also responsible for any losses or risks during the shipment process, is
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determined by the shipping terms:
a) FOB shipping point – the owner is the buyer when once the seller delivers
the goods to the carrier. Therefore, the buyer must include the goods in
inventory during shipping process.
a.
b) FOB destination – the owner is the seller until the buyer receive the
shipment, accordingly, the seller must include the goods in inventory during
shipping process.
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FOB = Free on Board
2) Goods out on consignment (Consigned Goods):
Consigned goods are transferred by the goods owner (consignor) to an agent
(consignee) for possible sale.
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For the consignor:

1. Goods out on consignment are included in the consignor’s inventory at cost
2. Costs of transporting the goods to the consignee are inventoriable costs, not
h
selling expenses, because they are costs of making the goods available for
sale to the end customer.
ef
3. Records sales only when the goods are sold to another third parties by the
consignee.
For the consignee:
Never records the consigned goods as an inventory.
3) Goods Out on Approval:
Goods out on approval are goods that are currently held by the customer but not
yet purchased, as the customer has some period of time to decide either to
purchase it or return it.
These goods should be recorded at the seller inventory, until either the customer
accepts the goods or the time to return the goods expires, then the sale will be
recognized, and the goods removed from the seller’s inventory.
(Could be such as online markets for example)

Calculations related to Inventory:
COGS is calculated using the following formula:

Beginning finished goods inventory Finished
+ Purchases (for a reseller) or cost of goods manufactured (for a manufacturer)
− Ending finished goods inventory
= Cost of Goods Sold
m
COGM is calculated using the following formula:
Direct Materials Used
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+ Direct Labor Used
+ Manufacturing Overhead Applied
= Total Manufacturing Costs
a.
+ Beginning Work-in-Process Inventory
− Ending Work-in-Process Inventory
= Cost of Goods Manufactured
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Finished
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Inventory Estimation:
An estimate of inventory may be used when it is not feasible to make a certain
h
inventory count, for example, interim reporting purposes or when inventory

records have been destroyed or lost.
ef
Can use the gross profit method for inventory estimation:

Gross profit margin (gross profit percentage):
Gross profit margin % = Gross profit / sales

COGS = sales X (1-Gross profit margin)
Frequency of making inventory entries (updating inventory accounts):

This is to answer how often a company makes the calculation of its ending
inventory and cost of goods sold, there are two inventory systems to cover this
aspect:

(1) The perpetual inventory system: ‫ﻧﻈﺎم اﻟﺠﺮد اﳌﺴﺘﻤﺮ‬

Updates inventory accounts after each purchase or sale. This system is more
suitable for expensive and heterogeneous goods that requires continuous
monitoring of inventory and cost of goods sold accounts, for example vehicles
traders.
Process of the perpetual inventory system are based on:
1) Purchases and other inventory costing items are directly charged to inventory,
m
no use of intermediate or control account such as purchase account.
2) Inventory and cost of goods sold are adjusted at every sales transaction.
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Advantage:
The inventory balance and the cost of goods sold can be determined at any time.
a.
Disadvantage:
The bookkeeping is more complex and expensive, to register every single
transaction when it occurs
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Inventory Physical Count Under the perpetual system:
The physical count is basically used as controlling tool, intending to monitor
misstatements in the records and thefts. The inventory shortages and overages are
recorded in a separate line in the current period income statement.
am
(2) The periodic inventory system: ‫ﻧﻈﺎم اﻟﺠﺮد اﻟﺪوري‬

Inventory and cost of goods sold entries and calculations are updated at the end of
h
the period, such as monthly, quarterly or annually, based on the results of a

physical count.
ef
It mainly works well with goods that are relatively inexpensive and homogeneous,
such as supermarkets, that have no need to continuously monitor their inventory
and cost of goods sold with every single sales transaction.
Process of the periodic inventory system are based on:

1) Purchases and other inventory costing items are tracked during the period in a
separate temporary (intermediate) account (purchases).
2) The beginning inventory balance remains unchanged until the end of the period
when the purchases account is closed into the inventory account.
3) Changes in inventory and cost of goods sold are recorded only at the end of the
period, based on the physical count, as previously mentioned

Inventory Physical Count under the periodic system:

The amounts of inventory and cost of goods sold can be determined based only on
the results of a physical count, so opposite of the inventory under the perpetual
system, the inventory physical count under the periodic system provide
information of:
(a) Cost of goods sold and (b) Inventory shortages and overages.
m
EXAMPLE:
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In January 1st, 20X1, inventory consists of 1,000 units with a cost of $7 per unit. The
following are 20x2 transactions:
April 1st: sold 800 inventory units for $6,400 in cash.
a.
May 1st: purchased 250 inventory units for $7 in cash per unit.

The year-end result of the physical count was 450 inventory units. The following
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are the journal entries under the perpetual and periodic systems:
Perpetual System Periodic System
Inventory sale April 1st
Cash $6,400 Cash $6,400
am
Sales $6,400 Sales $6,400

Cost of goods sold $5,600
(800 × $7)
h
Inventory $5,600
Inventory purchase May 1st
ef
Inventory (250 × $7) $1,750 Purchases $1,750

Cash $1,750 Cash $1,750
st
After the physical count on December 31
No journal entry is needed year-end inventory $3,150
the physical count Inventory (450*7)
equals the amount COGS (difference) 5,600
of inventory on the books Inventory (beginning) $7,000
(1,000 – 800 + 250 = 450). Purchases 1,750
Beginning inventory $7,000
Purchases of inventory 1,750
during the period
Ending inventory (3,150)
Cost of goods sold $5,600

The perpetual and periodic systems have the same result. While, under the periodic
system, the amounts of inventory and cost of goods sold are updated only at the
end of the period (most commonly end of the year) after the physical count.
Inventory Errors:
The most important about the inventory errors is to understand the effect of those
errors and how to correct them, errors generally can happen in one or more of
m
inventory accounts, beginning or ending inventory or purchases, and we need to
understand the effect of these errors on the ending inventory balance and cost of
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goods sold
Best way to calculate for the effect and correction of these errors is through three
steps:
1. Make the calculation including the mistake (the amounts actually used)
should have been used)

a.
2. Make the correct calculation after finding the mistake (the amounts that
3. The difference between step 1 and step 2 = the effect of the error
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Most of the scenarios related to this issue in the exam mainly about the effect of
these errors on ending inventory and on cost of goods sold, and to calculate that
we could use the following formulas:
am
Ending inventory Cost of Goods sold

Beginning inventory Beginning inventory
+ Purchases + Purchases
h
= Cost of goods available for sale = Cost of goods available for sale
− Cost of goods sold − Ending inventory
ef
= Ending inventory = Cost of goods sold
Note: If COGS is overstated, then profits are understated.

If COGS is understated, then profits are overstated.
A self-correcting error:
Is the one that corrects itself in the right time, even if it is not discovered, for
example of self-correcting error is the miscounting of inventory, since the error in
ending inventory will have an effect on two balance sheets and two income
statements, if inventory is correctly counted at the end of the next year then there
will be no carried forward errors as a result of the miscounting, so the error will
eliminate itself in the next ending period right count.

INVENTORY -- COST FLOW METHODS:
1. First-in, First-out (FIFO)

This method assumes that the first goods purchased are the first sold, so
accordingly it assume that the most recently (newest) purchased items are still in
the ending balance inventory, therefore if the goods’ prices are rising (in inflation
time) so the cost of goods sold includes the earliest goods purchased (lowest-price)
m
that will result in a lower cost of goods sold (lower older historical cost) - compared
to LIFO - and therefor higher profit, and on the other hand a higher ending
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inventory (because it includes the newest highest priced items) current cost (or
replacement cost) so the balance sheet has current values.
Under the FIFO method, year-end inventory and cost of goods sold for the period
a.
are the same regardless of whether the perpetual or the periodic inventory
accounting system is used.
cm
am
Advantage of FIFO:
h
The ending inventory approximates current replacement cost

ef
Disadvantage
The current revenues are matched with older costs.
2. Last-in, First-out (LIFO)

This method assumes that the last goods purchased are the first sold, so
accordingly it assume that the oldest purchased items are still in the ending balance
inventory, therefore if the goods’ prices are rising so the cost of goods sold includes
the latest (newest) goods purchased (highest-priced) that will result in a higher cost
of goods sold (current cost or replacement cost) - compared to FIFO – and therefore
lower profit as the income statement has current higher values, and on the other
hand a lower ending inventory balance (because it includes the oldest lowest priced
items – historical cost).

Under the LIFO method, the perpetual and the periodic inventory accounting
m
systems may result in different values for end inventory balance and cost of goods
sold.
co
1) Under the periodic inventory accounting system, the calculation of inventory and
cost of goods sold are made at the end of the period.
2) Under the perpetual inventory accounting system, cost of goods sold is
calculated every time a sale happens and includes the most recent (newest)
purchases.
a.
Under LIFO, management can affect net income with a major late purchase that
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immediately changes cost of goods sold value, while last-minute FIFO purchase has
no such effect because it will be included in the ending inventory.
Under LIFO, if fewer units are purchased than sold that means that Part or all of the
am
beginning inventory is sold.
Advantages of LIFO:
h
1. LIFO matches current costs against current revenues in the year’s income
statement, which provides a better measure of current earnings.
ef
2. In case of inflation and price raises LIFO results in higher COGS, accordingly
lower net income, which results in lower income tax and savings in cash
outflow, so it’s a very good reason to be used for tax purposes
Disadvantages of LIFO:
1. As a down side of using LIFO for tax benefits, the US law forces entities using
LIFO for tax reports, is obliged to use LIFO for financial reporting, which will
lead to report lower earnings than other methods in case of inflation,
obviously that’s not the best reporting decision that management will take
in some cases
2. Since ending inventory on the balance sheet consists mainly of oldest items,
which mean lower value of inventory than it should be in case of price’s rise,

which considered to be a valuation distortion of inventory being evaluated

lower than the current market prices or close to it
3. If entity sales are more than purchases during a period, that means we will
take part of or all of the beginning inventory for example, which was rated
using old price, which will mean to use old cost against current revenue,
which will increase the income for this period.
m
GAAP IFRS
Costing LIFO is an acceptable method. LIFO is prohibited.
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methods
In inflation Period Cost of Goods Ending Inventory Gross Profit (Net
FIFO
LIFO
Lowest
Highest
Sold
a. Highest
Lowest
Income)
Highest
Lowest
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Which Method should be used:
In general, LIFO is preferable under the following circumstances:
• Selling prices and revenues are increasing faster than costs and thus distorting
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net income
• LIFO has traditionally been used, such as in department stores and in industries
where a fairly constant core inventory remains on hand, such as refining, chemicals,
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and glass.
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3. Average Method
The average method tends to balance between FIFO and LIFO as it measures at an
average of the costs incurred to be used for the calculation of ending inventory and
COGS.
The average may be calculated on the periodic basis or as each additional purchase
occurs (perpetual basis).
1) The perpetual inventory accounting system:
To determine a new weighted-average inventory cost after each purchase, this cost
is used for every sale until the next purchase.
Total cost of the purchase

Weighted average cost = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Number of purchased units

2) The periodic inventory accounting system:

The average cost is determined only at the end of the period, which is used to
calculate the ending inventory and the cost of goods sold for the period.
Cost of beginning inventory + Cost of purchases during the period

Weighted average cost = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Units in beginning inventory + Number of units purchased
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4. Specific Identification Method
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Specific identification requires determining COGS and Inventory value of each
particular item, this system is appropriate for low quantity and high valued items,
such as Jewelry, automobiles or heavy equipment, so generally it is more useful
when items are not identical and item by item has its own characteristics and
serialized.
a.
Note: In a period of rising prices, LIFO yields the highest cost of goods sold and thus
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the lowest net income of all the methods, while FIFO results in the lowest cost of
goods sold and the highest net income.
If prices are falling, the opposite will be true.
The resulting cost of goods sold and operating income from the average cost
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method (weighted or moving) will always be in between LIFO and FIFO.
INVENTORY MEASUREMENT IN THE FINANCIAL STATEMENTS:

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Lower of Cost or Market (LCM):

In case of inventory obsolete, damage, or any other market factors price of
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inventory can fall below its original balance sheet cost (over estimation), in this case
the inventory should be written down to a lower value, so at the end of each period,
company should evaluate its inventory to be sure that its utility is more than its
cost at future, the difference (write-down) should be recognized as a loss in a
separate line item or cost of goods sold in the current-period income statement, at
later time reversals of write-downs of inventory are prohibited (according to
GAAP). So, the evaluation is done by comparing the cost of the inventory on the
balance sheet:
1- To its market value (if inventory cost is measured using LIFO or retail method)
2- or to its net realizable value (if inventory is measured by any costing
measurement system other than LIFO or retail method) such as FIFO or Weighted
average.

The value of the inventory reported on the balance sheet should be the lower of its
cost or its net realizable value or the lower of its cost or its designated market value.
While remember that the market value here means the market where to buy the
inventory not where to sell the inventory, so we mean by market value is the current
cost if to be replaced, the cost to replace the inventory.
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If the net realizable value or the designated market value (whichever is appropriate,
depending on the inventory method being used) is lower than the historical cost of
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the inventory, the difference (loss) must be written off. U.S. GAAP does not specify
what account should be debited for the write-down. Two accounts are acceptable:
COGS or a loss account.
a.
1- Inventories measured using LIFO or the Retail Method:
For inventories valued using either LIFO or the Retail method, the inventory should
be measured at the lower of cost or market (abbreviated as LCM), using a
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“designated market value” as the market value.
Market value: LIFO & Retail Method

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Market value is also called designated market value is the middle (not the average)
value of the following three figures:
(1) Ceiling: equal to net realizable value (NRV) (Maximum market value)
Net Realizable Value = estimated selling Price - the Cost to Complete and Dispose
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(2) Current replacement cost: the cost to purchase the inventory immediately
(usually given number in the CMA exam)
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(2) Floor: equal to NRV reduced by an allowance for an approximately normal profit
margin.
Floor = Net Realizable Value (Ceiling) - a Normal Profit Amount

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2- Inventories measured using any method other than LIFO or the Retail Method:
NET realizable value (NRV):
a.
Inventories measured using any method other than LIFO or the Retail Method are
measured at the lower of cost or net realizable value. Net realizable value is
defined as the estimated selling price in the ordinary course of business, minus
reasonably predictable costs of selling, including costs of completion, disposal, and
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transportation.
h am
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Applying LCM or NRV:

If the designated market value (or NRV) is lower than the cost of the inventory on
the balance sheet, the difference (or loss) must be written off to a loss account in
the income statement.
Dr. Inventory Loss or Cost of Goods SoldXXX
Cr. Inventory XXX
LCM (or NRV) rule may be applied directly to each item or to the total of inventory
group, while applying it to each item individually will provide the lowest amount

for ending inventory, because in groups of inventories, it is very likely that a

reduction in one item maybe offset by an increase in another item
Afterwards once inventory is written down, the reduced amount is the new cost
basis for the following period according to GAAP.
GAAP IFRS
Measurem In U.S. GAAP, inventories Inventory is measured (carried) at
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ent measured using any method the lower of cost or net realizable
other than LIFO or the retail value.
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method should also be No calculation of market value
measured at the lower of cost or
net realizable value. (similar to
a.
IFRS)
However, in U.S. GAAP,

inventory valued using LIFO or
the Retail Method is valued at
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the lower of cost or market
value (different to IFRS)
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Reversal of prohibits any reversal of write- previous write-downs of inventory

inventory down. may be recovered up to the
write- original cost of the inventory.
downs Gains cannot be recognized on
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appreciated inventory, but

previous losses can be reversed
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D) Investments
CLASSIFICATION OF INVESTMENTS
Investments in Debt securities and Equity securities:
‫اﳌﻔﻬﻮم اﻟﻌﺎم أوراق ﻣﺎﻟﻴﻪ‬ Only read for information
A security is a share, participation, or other interest in property or in an enterprise

of the issuer or an obligation of the issuer that has the following three
characteristics. (1) It either is represented by an instrument issued in bearer or
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registered form or, if not represented by an instrument, is registered in books
maintained to record transfers by or on behalf of the issuer. (2) It is commonly
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traded on securities exchanges or markets or, when represented by an instrument,
is commonly recognized in any area in which it is issued or dealt in as a medium for
investment. (3) It either is one of a class or series or by its terms is divisible into a
a.
class or series of shares, participations, interests, or obligations.
FASB Codification section (page 1005).
INVESTMENTS IN DEBT SECURITIES:
The debt security:
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A creditor relationship with the issuer (examples, U.S. government securities,
municipal securities, corporate bonds, convertible debt, and commercial paper) the
purpose of the investor: is to gain interests + realizing capital gains when resell,
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Debt Investment Classifications
Category Criteria
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Held-to-maturity Debt securities that the investor has a positive intent and
ability to hold to maturity, note: equity securities
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(ownership) have no maturity.

Trading Debt securities that bought primarily to be sold in the
near term
Available-for-sale Debt securities that are not held-to-maturity or trading
Next table shows each category required accounting and reporting (presentation)
treatment:
Category Valuation Unrealized holding gains and Other income

losses effects
Held-to- Amortized Not recognized
maturity cost
Interest when
Trading Fair value Recognized in net income
earned +
(income statement)
gains and losses
Available-for- Fair value Recognized as other
from sale.
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sale comprehensive income OCI
component of stockholders’
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equity
Only read for info.
premium, if appropriate.
a.
Amortized cost is the acquisition cost adjusted for the amortization of discount or
Fair value is the price that would be received to sell an asset or paid to transfer a
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liability in an orderly transaction between market participants at the measurement
date.
Held-to-Maturity Securities:
Only debt securities can be classified as held-to-maturity, as for sure equity
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securities have no maturity date (it is an ownership form), a debt security is

classified as held-to-maturity only if it has both (1) the positive intent and (2) the
ability to hold those securities to maturity, companies account for held-to-maturity
securities at amortized cost, not fair value, and therefore these securities do not
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increase the volatility of either reported earnings or reported capital as do trading

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securities and available-for-sale securities.

Held-to-maturity securities are presented net of any unamortized premium or
discount. No valuation account is used.
1) Amortization of any discount or premium is reported by a debit (credit) to held-
to-maturity securities and a credit (debit) to interest income.
2) No re measurement to fair value at the end of the reporting period is required.
Income statement presentation:

Realized gains and losses and interest income (including amortization of premium
or discount) are included in earnings.

Example: No calculation required for this study area

Only read for information
X Company purchased $100,000 of 8 percent bonds of entity Y on January 1, 2013, at a discount,

paying $92,278. The bonds mature January 1, 2018 and yield 10%. Interest is payable each July 1
and January 1.
X the investor records the investment as follows:
January 1, 2013 (recording the investment)
Dr. Investments 92,278
Cr. Cash 92,278
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8% BONDS PURCHASED TO YIELD 10%
Bond Carrying
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Cash Interest Discount Amount
Date Received Revenue Amortization of Bonds
1/1/13 $ 92,278
7/1/13 $ 4,000 $ 4,614 $ 614 92,892
a.
1/1/14 4,000 4,645 645 93,537
7/1/14 4,000 4,677 677 94,214
1/1/15 4,000 4,711 711 94,925
7/1/15 4,000 4,746 746 95,671

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1/1/16 4,000 4,783 783 96,454
7/1/16 4,000 4,823 823 97,277
1/1/17 4,000 4,864 864 98,141
7/1/17 4,000 4,907 907 99,048
1/1/18 4,000 4,952 952 100,000
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$40,000 $47,722 $7,722

Cash received = $100,000 X .08 X 6/12 = $4,000
Interest revenue = $92,278 X .10 X 6/12 = $4,614
Bond discount amortization = $4,614 - $4,000 = $614
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Carrying amount of bond = $92,278 + $614 = $92,892

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July 1, 2013 (receipt of first semiannual interest payment)

Dr. Cash 4,000
Dr. Debt Investments 614
Cr. Interest Revenue 4,614
December 31, 2013 (accrue for interest and amortize the discount)
Dr. Interest Receivable 4,000
Dr. Debt Investments 645
Cr. Interest Revenue 4,645
X reports its investment in Y’s bonds in its December 31, 2013, financial statements, as follows:
Balance Sheet Income Statement
Current assets Other revenues and gains
Interest receivable $ 4,000 Interest revenue $ 9,259
Long-term investments
Debt investments (held-to-maturity) $93,537

Available-for-Sale Securities:
Securities that are not classified as held-to-maturity or trading, initially recorded at
cost, reporting available-for-sale securities at fair value at each balance sheet, by
recording the unrealized gains and losses (net of taxes) related to the evaluation of
securities based on the changes in its fair value in a separate account under other
comprehensive income (OCI) for the period, which is shown as a separate
component of stockholders’ equity at the balance sheet, until realized (when the
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security is sold) to be reclassified to the income statement.
Note: companies report available-for-sale securities at fair value on the balance
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sheet but do not report changes in fair value as part of net income because they
are not realized gains or losses until after selling the security, which means that
unrealized gains or losses does not affect the entity’s income statement until it
become real (realized) gains or losses by actually selling them, this approach
reduces the volatility of net income.
Example: a.
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On April 1, Year 1, X Co. purchased 1,000 shares of Y Co. bonds for their fair value. X classified
this investment as available-for-sale securities. On May 1, Year 3, X sold all of its investment in Y
for its fair value on that day. The following are the fair values per share of Y common stock:
Date Fair Value
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April 1, Year 1 $25

December 31, Year 1 32
May 1, Year 3 31
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April 1, Year 1 Journal Entry

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Dr. Available-for-sale securities (1,000 × $25) $25,000

Cr. Cash $25,000
December 31, Year 1 Journal Entry –

At each balance sheet date, available-for-sale securities are re-measured at fair value.
Unrealized holding gains and losses are included in OCI.
Dr. Available-for-sale securities fair value adjustment [1,000 × ($32 – $25)] $7,000
Cr. Unrealized holding gain (OCI item) $7,000
Presentation in X’s December 31, Year 1 financial statements:

Balance sheet: Assets section - Available-for-sale securities (1,000 × $32) $32,000
Equity section: Accumulated OCI 7,000
Statement of comprehensive income: Unrealized holding gain (OCI) 7,000

December 31, Year 2 Journal Entry

Dr. Unrealized holding loss [1,000 × ($27 – $32)] $5,000
Cr. Available-for-sale securities fair value adjustment $5,000
Presentation in X’s December 31, Year 2 financial statements:

Balance Sheet: Assets section - Available-for-sale securities (1,000 × $27) $27,000
Equity section -- Accumulated OCI ($7,000 – $5,000) 2,000
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Statement of comprehensive income -- Unrealized holding loss (OCI) 5,000
May 1, Year 3 Journal Entry
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Dr. Cash (1,000 × $31) $31,000
Dr. Accumulated OCI 2,000
Cr. Available-for-sale securities $27,000
Cr. Realized gain on disposal of available-for-sale securities 6,000
a.
Trading Securities: “Trading” means frequent buying and selling
Companies hold trading securities with the intention of selling them in a short
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period of time usually less than three months, companies use trading securities to
generate profits from short-term differences in price, companies report trading
securities at fair value (net change in the fair value of a security from one period
to another), initially recorded at cost, then adjustment (remeasurement) at fair
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value must be done at each balance sheet, results in unrealized holding gains and
losses to be reported as part of net income (earnings) not other comprehensive
income, exactly as held-to-maturity or available for sale investments, companies
are required to amortize any discount or premium.
h
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Example:
On October 1, Year 1, X Co. purchased 5,000 shares of Z Co. common stock for their fair value. X
classified this investment as trading securities. On March 1, Year 2, X sold all of its investment in
Larson for its fair value on that day. The following are the fair values per share of Z common
stock:
Date Fair Value
October 1, Year 1 $15
March 1, Year 2 20
October 1, Year 1
Dr. Trading securities (5,000 × $15) $75,000
Cr. Cash $75,000

December 31, Year 1

At each balance sheet date, trading securities are re-measured at fair value. Unrealized holding
gains, and losses are reported in earnings.
Dr. Unrealized holding loss [5,000 × ($15 – $13)] $10,000
Cr. Trading securities fair value adjustment $10,000
In X’s December 31, Year 1 balance sheet, the investment in Z is reported in the current assets
section as trading securities.
It is measured at year-end fair value of $65,000 (5,000 × $13).
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March 1, Year 2
Dr. Cash (5,000 × $20) $100,000
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Cr. Trading securities ($75,000 – $10,000) $65,000
Cr. Gain on disposal of trading securities 35,000
a.
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INVESTMENTS IN EQUITY SECURITIES:

The equity security represents ownership interests such as common, preferred, or
other capital stock, they also include rights to acquire or dispose of ownership
interests at an agreed-upon or determinable price, such as in warrants, rights, and
call or put options.
Companies do not treat convertible debt securities as equity securities, also the
redeemable preferred stock (which must be redeemed for common stock) they
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don’t treat it as equity security, and the investor’s gains should be to receive
dividends + realizing capital gains when resell
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The classification of such investments depends on the percentage of the
investment held by the investor:
a.
1. Less than 20 % investor has little or no influence

a. Equity Security that does have a Readily Determinable Fair Value
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Fair Value Through Income Statement
usually publicly-owned and traded on an active secondary market
Sales prices or bid-and-asked quotations are currently available on a securities
exchange or in the over-the counter market and are publicly reported. A security
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may also be included in this classification if it is a mutual fund or similar investment

vehicle that determines and publishes the fair value per share and that fair value is
the basis for current transactions.
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b. Equity Security that does not have a Readily Determinable Fair Value
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Cost Less Impairment

usually privately held and not traded on an active secondary market
The security is privately held and is not traded on any securities exchange or in the
over-the-counter market and thus sales prices or bid-and-asked quotations are not
available.
2. Between 20 % and 50 % investor has significant influence (equity method).
3. More than 50% investor has controlling interest (consolidated statements).

Category Valuation Unrealized Other Income

Holding gains effects
or Losses
Holdings less
than 20%
1. Equity security that Fair value Recognized in
does have a readily net income Dividends declared
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determinable fair value gains and losses
2. Equity Security that Cost Less from sale.
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does not have a readily Impairment
determinable fair value
Holdings between 20% Equity Not recognized Proportionate share
and 50% of investee’s net
Holdings more than

50%
Consolidation
a. income.
Not recognized Not applicable
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Briefly, investors calculate and present information of their investments depending
on the type of security:
Security type Management plan Recognize Valuation method
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unrealized
gains
Debt Hold-to-maturity (no No recognition Amortized cost
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plan to sell)
Trading (planning to sell) Earnings Fair value
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Available-for-sale OCI Fair value

Equity Own less than 20% with Fair value
And little or no influence determinable
fair value
Without Cost Less
determinable Impairment
fair value
Own between 20%-50% Equity method
And significant influence
Own between 50%-100% Consolidation
Presume control method

1- Investments Where the Investor Does Not Have Significant Influence

Equity securities other than those accounted for by the equity method or by
consolidation are those where the investor does not have significant influence.
Such an equity security may or may not have a readily determinable fair value.
Usually a lack of significant influence is indicated by ownership of up to 20% of the
voting stock, although it is possible to lack significant influence with ownership of
20% or more of the voting stock.
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a. Equity Securities with Readily Determinable Fair Values
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Investor does not have significant influence over the investee + the investment has
a readily determinable fair value = fair value through income statement, usually
because it is traded in secondary markets.
Little or no influence is usually indicated by less than 20% investment in the
investee.
a.
When an equity investment that will be accounted for under the fair value through
the income statement method is purchased, it is recorded at the cost of acquisition.
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Then, each time financial statements are prepared, the investments will be valued
at their fair value at the balance sheet date.
Gains and Losses on Equity Securities with Readily Determinable Fair Values
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Unrealized Gain or Loss

As the fair value of the equity security changes during its holding period, the
unrealized gain or loss is reported on the income statement as an unrealized
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holding gain or loss.

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In the case of an increase in the fair value, the journal entry will be:
Dr. Fair value adjustment (valuation account) XXX
Cr. Unrealized holding gain (on income statement) XXX
For a decrease in fair value, the entry will be as follows:

Dr. Unrealized holding loss (on income statement) XXX
Cr. Fair value adjustment (valuation account) XXX

Realized Gain or Loss

When an equity security is sold, the realized gain or loss on the sale is recorded as
follows (assuming the security increased in value while being held):
Dr Cash (including costs of the transaction) XXX sales price
Cr Gain XXX balance
Cr Investment account XXX original acquisition price
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Note that the realized gain or loss is calculated as follows:
Amount received for the sale
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- Acquisition cost (original cost of the security
= Realized gain or loss .
The full amount of the gain or loss during the holding period is reported as “realized
a.
gain or loss” on the income statement. It is not necessary to reverse previously-
recognized unrealized gains or losses on the security that has been sold. When an
investment has been sold, it will simply not be included in calculating the fair value
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of all the remaining equity investments in the portfolio at the end of the period.
The adjustment to the fair value valuation account that is made at the end of the
period for the remaining portfolio as a whole will have the effect of removing the
unrealized gain or loss that had been recognized in previous periods on the sold
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investment. The calculation of the adjustment amount is outside the scope of the
exam.
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b. Equity Securities Without Readily Determinable Fair Values – Method 4

When an equity security is privately held and is not traded on secondary exchanges
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and if there is not an available expedient method to estimate fair value as outlined
in ASC 820, Fair Value Measurement, the equity investment should be carried at
cost and assessed each period for impairment. Additionally, if there is an
observable price change for the shares, the carrying value should be adjusted
upwards or downwards for this observable change.
In order to assess impairment, the company must perform a qualitative
assessment. If the situation and information about the investment indicate that it
is impaired, the company must recognize a loss for the difference between its
assessed fair value and its carrying value.
Note: Because preferred shares have no voting rights, investments in preferred

stock are always accounted for using the fair value method if the shares have a
readily determinable fair value or, if they do not have a readily determinable fair

value, at cost less impairment. Even if an investor owns 100% of the preferred
shares outstanding of a company, the investor has no opportunity to exert
influence over the investee because the investor cannot vote.
Accounting for Dividends When the Investor Does Not Have Significant Influence
Dividends received on equity securities where the investor does not have
significant influence or control and does not consolidate the investment as a
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subsidiary are accounted for the same way whether the equity securities do or do
not have readily determinable fair values.
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Dividends Received
Cash Dividends
Dividend income for equity securities both with and without a determinable fair
a.
value is recognized for any cash dividends declared on common or preferred stock.
The following entry is made on the date of record when the company has a legal
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right to the dividend:
Dr Dividend receivable XXX
Cr Dividend income XXX
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When the dividend is received, the journal entry is:

Dr Cash XXX
Cr Dividend receivable XXX
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Stock Dividends
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Stock dividends do not give rise to any journal entry. Because only additional shares
are received in a stock dividend, only a memorandum entry is used to record the
receipt of the additional shares. This means that no revenue is recognized from the
receipt of a stock dividend.
Note: Stock splits that result in the receipt of additional shares do not result in a
journal entry, either.
Liquidating Dividends
A liquidating dividend is a dividend that the company pays from a source other than
retained earnings, and it occurs when the amount of the accumulated dividends
received by an investor exceeds the investor’s share of the amount of retained
earnings that the investee company has recognized since the investor acquired its

shares. A liquidating dividend is considered a return of the investor’s capital, rather

than a return on the investor’s capital and as such, the investor’s investment
account is reduced by the amount of the dividend that is a liquidating dividend.
Dr. Cash XXX
Cr. Investment XXX
Note: Because the investor compares the total of accumulated dividends received
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with the investor’s share of retained earnings the investee has recognized since the
investor acquired its investment, it is possible that a given dividend will be a
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liquidating dividend for one investor but not a liquidating dividend for another
investor.
2. Equity Method: (this method can’t be applicable for debt securities)
a.
The equity method can be called a “one-line consolidation,” because the net result
on the investor’s income of accounting for an investment using the equity method
is the same as the result of using full consolidation.
cm
However, instead of reporting its share of each separate component of income
(sales, cost of sales, operating expenses, and so forth) in its income statement, the
Investor includes only its share of the investee’s net income in a single line on its
income statement.
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Used when the investor has significant influence over the investee by owning
between 20% and 50% of the outstanding voting stock (Common stock shares).
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Note: It is important to remember that the rules governing the equity method and
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consolidation are based on influence and control, not the percentage of

ownership. The percentages of ownership are only guidelines. If a company owns
80% of another company but does not have significant influence over the other
company, the investment is accounted for using the fair value method or, if the
investment does not have a readily determinable fair value, at cost less
impairment.
ASC 323-10-15-6 provides indicators of “significant influence,” in addition to the

percentage of ownership, as follows:
• The investor is represented on the board of directors of the investee.
• The investor participates in the policy-making processes of the investee.
• There are material intra-entity transactions.

• There is an interchange of managerial personnel between the investor and the

investee.
• There is technological dependency between the entities, for example using the
same systems.
Application of the Equity Method:

(1) Initial Recording at original cost (acquisition):
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Dr. Investment in Company (Balance sheet) XXX
Cr Cash (balance sheet) XXX
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Corporation subsequently adjusts the balance in the investment account for
changes in the investee’s net assets.
a.
(2) Investor’s Share of Investee Profit or Loss:
The investment account will be increased or decreased for the investor’s portion of
the investee’s reported earnings or losses.
cm
Profit:
Dr. Investment in Company (Balance sheet) XXX
Cr. Income from Investment in Company (Income statement) XXX
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Loss:
Dr. Loss from Investment in Company (Income statement) XXX
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Cr. Investment in Company (Balance sheet) XXX

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The investor’s share of the investee’s earnings or losses is recognized only for the
portion of the year that the investment was held under the equity method, as not
necessarily that investor will buy investments from first day to last day of the year.
(3) Dividends Received from Investee:

The investor company decreases its carrying amount for the investment by its
proportionate share of dividends declared and paid. When a dividend is received,
the investor’s net income is not affected because investor already recognized
income from the investment based on the profits of the investee, not the
distribution of profits, while dividends will increase cash and reduce investment.
Dr. Cash XXX
Cr. Investment in Company (balance sheet) XXX

If losses experienced by the investee company exceed the value of the investment
that will cause the balance to become negative, the investor then should stop using
the equity method and begin using the fair value method in order to not recognize
losses greater than their investment value.
Financial Statement Presentation

The investment account is shown in one line on the balance sheet, and the
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earnings or losses from the investment are shown on the income statement as part
of net income, but not as operating income. They are presented as part of the non-
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operating gains and losses line on the income statement below net operating
income, and the components of that line on the income statement are disclosed in
the notes to the financial statements.
Disposal of an Equity Investment
a.
When an investment that was accounted for under the equity method is disposed

of, a gain or loss is recognized for the difference between the carrying amount and
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the selling price.
Changing from the Fair Value or Cost Less Impairment Method to the Equity
Method
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When a fair value or cost method investment qualifies as an equity method

investment because of an additional investment made, the investor adds the cost
of the additional investment to the basis of the previously-held interest and adopts
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the equity method of accounting as of the date the investment qualifies for equity
method accounting. No retroactive adjustment is made.
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3. Consolidation Method: (Used for investments in equity securities only no way

to use it for debt securities)
Consolidated financial statements are usually required for a fair presentation when
one of the companies in a group of companies directly or indirectly has a controlling
financial interest in the other companies. (ASC 810-10-10-1)
A business combination is a position when an acquirer obtains control of a

businesses, controlling financial interest is the direct or indirect ability to determine
the direction of management and policies of the investee, the parent is an entity
that controls one or more subsidiaries, The usual condition for a controlling
financial interest is ownership by one reporting entity, wither direct or indirect
relationship ( when a subsidiary holds a majority interest in another subsidiary) of

more than 50% of the outstanding voting shares of the acquire, while remember
that it is possible for an owner to have control with a smaller ownership percentage
or to have no control with a higher ownership percentage.
The parent company will present the financial statements of the consolidated
companies as being single economic entity (one financial statements), even if the
two entities remain legally separate, the financial statements are more meaningful
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to demonstrate the effects of control over the subsidiaries.
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At the acquisition date, the parent company must recognize and measure
1- Identifiable assets acquired,
2- Liabilities,
3- Any noncontrolling interest (NCI), and
a.
4- Goodwill or a gain from a bargain purchase (difference between purchase value
and the net assets fair value.
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A noncontrolling interest (NCI) is the portion of equity in a subsidiary that is not
related at all to the parent, it is reported in the equity section of the consolidated
balance sheet separately from the parent’s shareholders’ equity, there is no NCI
recognized if the parent holds all the outstanding common stock of the subsidiary.
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Goodwill is recognized only in a business combination. It is an intangible asset

reflecting the future economic benefits arising from those assets, the goodwill
recognized in the parent’s consolidated balance sheet as an intangible asset under
the noncurrent assets section, opposite of a goodwill is an account named gain
from bargain purchase (when amount paid to invest in the subsidiary less than its
net assets fair value only when preparing the consolidated accounts)
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Consolidated Financial Statements:
The consolidation process begins with the parent and subsidiary adjusted trial
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balances separately in a columnar format and an additional column is created for
adjusting or eliminating entries (the trial balance represents balance sheets and
income statements of parent company and each of its subsidiaries).
a.
Steps of preparing consolidated financial statements:
1. Add all line items one by one of assets, liabilities, revenues, expenses, gains,
losses, and other comprehensive income OCI items of a subsidiary to those
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of the parent
2. The periodic net income or loss of a consolidated subsidiary related to the
non-controlling interest NCI is presented separately from the periodic net
income or loss related to the shareholders of the parent accounts, It must be
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adjusted for its proportionate share of (a) the subsidiary’s net income
(increase) or net loss (decrease) for the period, (b) dividends declared by the
subsidiary (decrease), and (c) items of OCI recognized by the subsidiary.
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3. The main adjustments are:

Intercompany transactions: are resulted from conducted business among
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the consolidating entities with each other, this effect must be eliminated in
full (as if it never been occurred) during the preparation of the consolidated
financial statements, while eliminating journal entries for intercompany
transactions must be presented at the consolidated financial statements.
1) Eliminating intercompany receivables and payables.
2) Eliminating the effect of intercompany sales of inventory.
3) Eliminating the effect of intercompany sales of fixed assets.
4) Eliminating the parent’s investment account.
4. Goodwill recognized at the acquisition date is presented separately as an
intangible asset.

E) Fixed assets
Property, plant, and equipment (PPE), also called fixed assets or capital assets,
including lands, buildings and equipment, are tangible property expected to benefit
the entity for more than 1 year, they are held for the production or supply of goods
or services, rental to others, or administrative purposes, and are not acquired for
resale.
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(1) Fixed assets- Initial recording of fixed assets:
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PPE are initially measured at historical cost, which consists of all the costs incurred
to bring the asset to the condition and location necessary to get the asset ready for
a.
use. The historical (initial) cost includes
1) Net purchase price = total purchase price - trade discounts and rebates, purchase
taxes and import duties.

2) The directly related costs of getting the asset ready to use, such as architects’
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and engineers’ fees, site preparation, delivery and handling, installation, assembly,
and testing, also the related interest costs (borrowing costs) related to the
preparation of the asset to get it ready to be used.
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(2) Depreciation:
Depreciation is the process of systematically and rationally allocating the

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depreciable base of fixed assets over its expected useful life, which is a match of
the expense of acquiring the asset with the revenues that it will generate over its
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useful life by spreading the recognition of acquisition expense (which is the

depreciation) over the time period that the asset will be useful (provide revenue),
the depreciation expenses are recognized in the income statement, accumulated
depreciation is a contra-asset account at the balance sheet.
The entry is:
Dr. Depreciation expense $XXX

Cr. Accumulated depreciation $XXX

GAAP IFRS
Revaluation Revaluation Revaluation is a permitted (which means increase the
of assets not value of the fixed asset according to the new fair
permitted. market value) accounting policy election for two
conditions 1- an entire class (grouping of assets of
similar nature and use)
2- requiring revaluation to fair value on a regular
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basis.
The increase in the value is recognized in Other
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Comprehensive Income and carried in the equity
section of the balance sheet as a Revaluation Surplus.
Component component if individual components of a large fixed asset have
a.
depreciation depreciatio different usage patterns and useful lives, then the
n is allowed individual components should be depreciated
but not separately. For example, if the engine on a machine
required. has a 5-year life while the rest of the machine has a
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15-year life, the engine must be depreciated over 5
years and the remaining cost of the machine must be
depreciated over 15 years
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(3) Fixed assets – Net Book Value (NBV):

The carrying amount of an item of PPE is the amount (presented in the balance
sheet), which is equal to the historical cost minus accumulated depreciation.
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Fixed assets (NBV) = Initial cost (historical Cost) - accumulated depreciation

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The historical cost recorded in the fixed asset account initially will remain
unchanged until disposal, unless there are subsequent capitalized expenditures.
The accounting issue of the expenditures for fixed assets subsequent to initial
recognition is to determine whether they should be
1) Capitalized at cost and depreciated in future periods (a capital expenditure)
2) Or simply expensed when they occur (a revenue expenditure).
Capital expenditures provide additional benefits by improving the quality of

services rendered by the asset, extending its useful life, or increasing its output,
these expenditures are added to the value of the asset and are capitalized at cost.

Periodic Expenses (Revenue expenditures) maintain an asset’s normal service

capacity, these costs are recurring, not expected to benefit future periods, and
expensed as they occur, such as routine checkup and maintenance expenses.
Calculation of Depreciation:
The asset’s depreciable base (the amount to be allocated) is calculated as follows:
Depreciable Amount or (Depreciable base) = historical cost – salvage value
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Rule: there is no depreciation for lands as they don’t have estimated useful life.
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Definitions: Estimated useful life: (Service life): is an estimated length of time over
which the asset is expected to be useful, and it’s the same period used to recognize
depreciation expenses of that asset, whereas at the end of the asset’s useful life
a.
the book value of the asset should equal to the expected salvage value.
Estimated salvage value (residual value): is the value expected to be obtained from
disposal of the asset at the end of the asset’s useful life, some companies assume
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salvage value is always $0 at the end of the asset life, also the book value will not
be depreciated below the salvage value.
Depreciable amount (depreciable base): This is the amount to be depreciated over

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the asset’s useful life, calculated as per previous equation.
Depreciation Methods:
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No matter the chosen depreciation method is the basic depreciation entry

mentioned before is always the same, the method will only change the value XXX
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in the journal entry.
❶ Straight-line depreciation (SLD):

This method represents the easiest and simplest depreciation calculation, it
calculates an equal amount of depreciation to be charged to each period of the
asset’s useful life.
Periodic depreciation = Depreciable Amount / Estimated Useful Life
Other depreciation methods result in greater depreciation in the early years of an

asset’s life and lesser depreciation in the latter years.

❷ Accelerated depreciation methods:

Are time-based methods, they result in decreasing depreciation charges over the
life of the asset, the two major time-based methods are declining balance and sum-
of-the-years’-digits.
1) Double Declining balance (DDB)

Use a rate that is maybe 200% of straight-line method, also the percentage is
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applied to the net book value of the asset at the beginning of each year not the
original depreciation base, which means that we must calculate the depreciation
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rate of Y3 for example in order to reach the assets NBV for Y4 if we want to calculate
depreciation of Y4, in other words, calculation of depreciation of any year
dependent on the previous year depreciation and NBV calculation, opposite to all
other methods when we calculate the depreciation of each year regardless of the
other years calculations
a.
The annual depreciation expense = Double declining rate × book value of the
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asset at the beginning of the year
Salvage value is not taken into account when calculating the annual depreciation
charge, but the asset is not depreciated below salvage value, some companies use
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DDB for the first few years then switch to straight-line for the remaining years of
the asset’s life.
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2) The sum-of-the-years’-digits (SYD)

Periodic expenses = depreciable base X (remaining years of useful life / sum of all
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years in useful life)

In the equation the constant depreciable base is used (cost minus salvage value)
multiplied by a declining fraction (a declining rate) (a declining-charge method).
If the number of years too large to calculate the sum of the years number (fraction)
the following equation could be used
The sum the years digits = n (n + 1)/2
N = number of useful life of the asset you can try it now to examine the
equation for 3 or 4 years for example

❸ Units of production method (Usage-centered activity methods):

Under the units of production method, it depends mainly on determining the
number of units that the asset will be able to produce over it’s useful, instead of
using the asset useful time as basis of calculation
Periodic depreciation = depreciable base X (units produced during current period

/ total units of production during the estimated life time)
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Group and composite depreciation methods
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Apply straight-line accounting to a collection of group of assets, similar assets
(group of assets) or dissimilar assets but still combined in one group (composite
assets), depreciated as if they were a single asset, that would be an efficient way
a.
to account for large numbers of depreciable assets.
Depreciation for Tax Purposes:

It is very possible that the depreciation calculation for tax purposes is going to be
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different than the depreciation calculation for book purposes, and this is one of the
areas that causes the deferred tax issue, when we have different tax expense
amount for depreciation and book expense number for the depreciation
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In the U.S., the Internal Revenue Service (IRS) prescribes the method of
depreciation to be used on a company’s tax return, and the method is specific for
tax purposes, so IRS is going to set the useful life and the depreciation method for
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different types of assets for tax purposes, while remember that all of the cost of
the asset is going to be expense anyway, its just when we have different
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depreciation method the time period over which it gets expensed is different, the
amount that is expensed for a given period will be different, but at the end of the
life of the asset one way or another total value will be all expensed.
MACRS, or Modified Accelerated Cost Recovery System, is the most common type
of depreciation required by the U.S. tax laws, although it is not the only acceptable
method a company can use on its tax return. The depreciable base for tax purposes,
is always 100% of the cost of the asset and the other costs required to make it ready
for use. Therefore, any anticipated salvage value at the end of the asset’s life is
never subtracted from the original cost when calculating depreciation for tax
purposes or when calculating the tax basis (book value for tax purposes) when the
asset is sold.

❶ So, we don’t take in account salvage value when calculating depreciation for
tax purposes.
Furthermore, U.S. tax laws require that a portion of a year’s depreciation be taken
in the year the asset is acquired and a portion of a year’s depreciation be taken in
the year the asset is disposed of. The most common portion used is one-half year’s
depreciation in both the first and the last year, regardless of the actual date the
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asset was purchased. Taking one-half year’s depreciation in the first and last year
is called the half-year convention.
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For example, if an asset is being depreciated over a three-year period for tax
purposes, that three-year period begins in the middle of the fiscal year in which the
asset is acquired (July 1 if the company is using a calendar year as its fiscal year)
a.
and it ends in the middle of the year in which the asset is completely depreciated
and/or disposed of. Thus, a three-year asset purchased in 20X1 when the
company’s fiscal year is the same as the calendar year will be depreciated over four
calendar years as follows:
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20X1 ½ of one year’s depreciation
20X2 1 year’s depreciation
20X3 1 year’s depreciation
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20X4 ½ of one year’s depreciation

Note that the above depreciation schedule works out to three full years of
depreciation, even though the depreciation is taken over a period of four tax years.
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❷ So, half-year convention for the acquisition year and disposal year is used for
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tax purposes.
MACRS Tables:
The IRS provides MACRS tables that give the percentage of the original cost to be
depreciated each year
There are several tables, each incorporating a given convention, and the half-year
convention is the most commonly used.
Therefore, when calculating annual depreciation amounts using MACRS tables, the
percentage should be used as given, the same apply for CMA exam if any question
required to calculate depreciation based on MACRS, percentage will be given.

Example: The amount of depreciation to be taken for each year for an asset with
an original cost of $90,000 that is being depreciated as three-year property using
MACRS and the half-year convention will be as follows:
Year 1 33.33% $29,997

Year 2 44.45% 40,005
Year 3 14.81% 13,329
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Year 4 7.41% 6,669
Totals 100.00% $90,000
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Note:
1. We have 4 lines of calculation over 4 years while the asset’s useful life is only
3 years, that due to the half-year convention
2. The $90,000 which is the total value of the asset (100%) had been
value.
a.
depreciated fully for tax purposes whether or not there will be a salvage
So simply because of the half-year convention you will always find one year extra,
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and always depreciate the total value of the asset and never account for salvage
value when for tax purposes.
Straight-Line Depreciation When Used for Tax Purposes:

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Straight-line depreciation can be used for tax purposes, that’s usually specific
assets that are mainly long-term assets, such as real estate, residential buildings,
etc. However, straight-line depreciation for tax purposes is different from straight-
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line depreciation used for financial reporting under U.S. GAAP. If straight-line
depreciation is used for tax purposes, do not subtract the salvage value to
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determine the depreciable base for the depreciation to be reported on the tax
return, even though for financial reporting under U.S. GAAP the salvage value
would be subtracted. The depreciable base for tax purposes is always 100% of the
asset’s cost.
The IRS generally requires assets depreciated on the straight-line basis on the tax
return to be depreciated monthly. If an exam question specifies that a company
uses straight-line depreciation for tax purposes, it will usually state that the asset
was purchased on either January 1 or on June 30/July 1.
1) If the asset was purchased on January 1, take a full year of depreciation in the
year acquired. A three-year asset will be depreciated over only three tax years, not
four tax years.
2) If the asset was purchased on June 30 or July 1, take one-half year of the annual
straight-line depreciation amount in the year acquired and leave one-half year of

depreciation for the final year. A three-year asset will be depreciated over four tax
years.
If the asset was purchased on any date other than January 1, June 30, or July 1,
calculate the monthly straight-line depreciation for the first year and the final year
of the asset’s life as needed. The asset will be depreciated over one tax year more
than its life. For example, a three-year asset that was purchased on October 1 will
be depreciated for three months in the first tax year it is owned and for nine months
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in the fourth tax year.
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What is the best depreciation method to be used?
Entity should choose depreciation method that will accomplish the matching to
revenue accounting principle, matching the depreciation expenses to the revenue
generated from particular asset during the same period, such as:
a.
1. If expected revenues from particular asset are constant over the asset’s
useful life so using the straight-line depreciation would be suitable to
allocate a constant depreciation expenses values.
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2. If revenue will be higher during the beginning period of using the asset so
the accelerated methods will be beneficial for that purpose, and if the
production is lower at the beginning of the asset usage so production
method could be used then to match the low revenue at the beginning of the
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asset life
Impairment of fixed assets:

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Impairment asset: when the carrying amount of the asset may not be recoverable,
such as when the market price has decreased significantly, or the physical condition
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of the asset has a major change adversely, it worth to refer that according to GAAP
the opposite is not true, which means if market price of an asset has increased so
fixed assets value in books are not written up to recognize that increase.
The two-step test for impairment: applicable for fixed assets and intangible assets
1) Recoverability test:
Entity should compare the carrying value of the fixed asset with the sum of the
estimated undiscounted future cash flows expected from the use and the
disposition of the asset, so if the carrying value exceeds the expected sum of the
undiscounted future cash flows so it is not recoverable.
Carrying amount of an asset > total undiscounted cash flows

If the asset’s book value is less than the future cash flows, the asset is not impaired,
and no adjustments are needed
2) If last condition is applicable and the carrying amount is not recoverable, then
the entity should recognize an impairment loss as follow:
Impairment loss = asset’s carrying value – asset’s current fair value
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The recognition should be done immediately in income from continuing
operations.
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The journal entry:

Impairment loss $XXX
Accumulated depreciation $XXX
a.
The adjusted carrying value (asset book value) for impairment loss - which is the
original cost of fixed asset minus accumulated depreciation including the
impairment loss based on the last entry - is used as new depreciation base for
following periods depreciation cost calculations.
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Disposal of fixed Assets (long-lived assets):
When fixed asset is sold
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Gain or loss on disposal = net proceeds – asset’s carrying amount (NBV)
Dr. Cash $XXX amount received

Dr. Accumulated depreciation XXX amount on books
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Dr. /Cr. Loss/Gain on disposal XXX balance

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Cr. Fixed assets XXX historical cost of asset

GAAP IFRS
calculation The amount by which the The impairment process is a one-
carrying amount of the asset step process. The carrying value of
exceeds its fair value (carrying the asset is compared to the
amount of the asset is compared recoverable amount. The
with the sum of future recoverable amount is the higher
undiscounted cash flows of 1) the fair value of the asset, if
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generated through use and sold, minus any costs of sale, or 2)
eventual disposition) the Discounted future cash flows it
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will generate
Reversal of Prohibited. No reversal after If the revaluation is the recovery of
loss impairment made a previously recognized loss when
a.
the asset was impaired, the
revaluation gain is reported on the
income statement to reverse or
recover previous transaction
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Notice from last to points for IFRS:
Revaluation gains happen first to an asset, so gains go to OCI, if subsequent
impairment so losses goes to OCI also to recover previous increase, and extra
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losses will be in income statement.

While if impairment happen first so losses go to income statement, then if
subsequent gain due to revaluation after impairment it will go to income
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statement to recover previous losses.

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F) Intangible assets
Intangible assets:
Assets that are not physical, in other words assets that cannot be touched, for
example patents, copyrights, franchises, trademarks, etc.
Initial Recognition
Intangible external acquired assets like fixed assets are initially recorded at original
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cost paid to acquire that asset, plus any additional costs required to make the asset
ready for use, such as legal fees and all transfer costs of the asset during the
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acquiring process.
Internally developed intangible assets are not recorded or capitalized because it is
originally having no identified value, but instead recording and capitalizing the
a.
additional costs such as registration fees, while research and development
expenses R&D are directly expensed as incurred and therefore can’t be capitalized.
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Amortization Intangibles
(1) The asset has a determined limited life (finite useful life):
It is amortized over that useful life (also known as amortized intangible assets), such
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as Purchased patent, internally developed patents, franchises, trademark, and

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copyrights, and most of it additional costs that could be capitalized with the original
cost of the intangible asset, such as legal fees, registration fees, cost of defending
one of the previously mentioned examples, such as court arguments, and other
related costs.
Journal entry of amortization:

Dr. amortization expenses $XXX
Cr. Accumulated amortization $XXX
The amortizable amount = initial original cost - residual value.
The amortization methods are like the depreciation methods used in the
calculations related to the fixed assets, accordingly the carried forward balances of
an intangible asset with a finite useful life equals its historical cost minus
accumulated amortization and any impairment losses, similarly the impairment
tests used in case of intangible amortized assets are the same that are used for
fixed assets.
(2) The asset with no determinable useful life (indefinite useful life):
That asset is not amortized, but instead it must be tested regularly for impairment
at least annually, known also as nonamortized intangible assets
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Carried forward balances of intangible asset with indefinite useful life
= historical original cost – impairment losses
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Accounting for intangible assets:
1- Patents
a.
for example, new technology or new design
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It’s the exclusive right of granted use by government (usually 20 years in the US).
The amortization period for a patent is the shorter of:
1) Its economic useful life or
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2) Legal life.
A) Purchased patent historical cost to be amortized

B) Internally generated patent only registration and legal fees
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to be capitalized and amortized

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while all other costs are expensed

including R&D.
Most likely that the economic useful life is shorter than the legal life because of
changes in technologies, consumer tastes, and development of substitutes.
Defending the patent legally:

Main issue about the patent are court cases and legal expenses related to defensing
the patent
Company could succeed to defense its while if the company fails to defense its
patent, so court costs are capitalized patent so the court costs should be all
for the remaining life of the patent expenses as incurred + any remaining
and amortized over its useful life value of the patent is also written off as a
loss because if we loss the case it means
Instructor,
(costs goesTarek Naiem,
to the CMA
Balance sheet) 116 of 543
that we don’t really own the patent
(income statement).
2- Trademarks & Trade names:

It is a distinctive sign, word, or symbol
it should be amortized over its useful life but not longer than 40 years.
3- A copyright (©) for example, music composition and literatures (original work)
It is effective for the life of the author plus 70 years
for publishers for example:
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A) for a publisher: a purchased copyright is recorded at its original purchase price
+ additional transfer costs of the purchased rights.
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B) for the writer: own developed copyright can be recorded only at its registration
costs as usual in similar intangible assets developed internally.
4- Franchises best example are the international chain restaurants
according to a written contract

a.
The franchisee will operate a specific business using the franchisor’s name
A) for a finite franchise: the franchisee should capitalize the costs of acquiring the
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franchise and amortize them over the franchise’s useful life.
B) for an indefinite franchise: it should be carried at cost and should not be
amortized but should be tested annually for impairment, as per all other intangible
assets with indefinite life
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5- Goodwill intangible asset – indefinite useful life

Goodwill can be acquired or developed internally, but the only goodwill recognized
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in the accounting records is purchased goodwill, the amount of goodwill purchased

is equal to the difference between the purchase price paid for a business and the
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fair value of the net assets received.
Goodwill = paid price for a business – fair value of its net assets
The purchased goodwill (the one is purchased in a business combination) is the only
recognized in the financial statements (recorded), while internally generated
goodwill not recorded.
Maintaining goodwill:
Developing and maintaining purchased goodwill are expensed as incurred, such as
training employees or hiring employees from the company that was purchased.

Presentation of intangible assets: Disclosure

Two lines for intangible assets on the balance sheet:
1- All intangible assets are presented in one line
2- Only Goodwill is presented in a separate line
As well as the income statement:

Amortization expenses and impairment losses are reported in the continuing
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operations section in two lines:
1- all intangible assets except goodwill
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2- Goodwill
Intangible assets impairment:

The goal of impairment of intangible assets (such as fixed assets) is to be sure that
a.
intangible assets are not overstated (overvalued) in the balance sheet, by being
sure that the intangibles are going to provide as much value as its carrying value on
the balance sheet.
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3 different treatments for intangibles impairment:
1. Definite (limited) life intangibles impairment
2. Indefinite intangibles impairment other than goodwill
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3. Goodwill impairment
1. Definite life intangibles impairment: very similar to the fixed assets

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Company should evaluate an intangible asset whenever there is any indication that
the carrying amount of the asset may not be recoverable
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2 steps process
1- recoverability test: intangible asset to be impaired if
Carrying value (Book value) > sum (total) undiscounted future cash flows
Including its disposal (selling value)
2- impairment step is to write down the book value of the intangible to its fair value
Impairment loss = carrying value – fair value
Fair value = present value (discounted) future cash flows (same amount of future
cash flows but discounted)

2. Indefinite intangibles Not including goodwill:

Indefinite intangibles are not amortized but should be tested on at least an annual
basis for impairment.
3 steps process
1- Qualitative (optional – according to standards entity is allowed, not must use it)
initial qualitative assessment to determine whether it is more likely than not that
the asset is impaired (i.e., probability greater than 50%), if the qualitative results
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indicate that the indefinite life asset is not impaired, then the entity does not need
to calculate the fair value continue the rest of the process.
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2- Quantitative impairment test: if a determination is made that the intangible
asset is impaired after performing the initial qualitative assessment, the asset’s fair
value must be calculated and compared with the carrying value to determine
a.
whether an impairment loss should be recognized.
Carrying value (Book value) > intangible asset fair value (asset to be impaired)
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3- write down the carrying amount of intangible asset to its fair value and loss
should be recognized under the continuing operations section in the income
statement, and as mentioned in the disclosure it should be reported in a separate
line from any goodwill impairment losses.
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3. Goodwill impairment:
Goodwill not amortized but should be tested on at least an annual basis for
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impairment, impairment testing of the goodwill must be done in the context of the
value of the business to which the goodwill is related
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3 steps process
1- Qualitative (optional)
As with other intangible assets that are not being amortized, the company has the
option to first perform a qualitative assessment to determine if it is more likely than
not that the fair value of the reporting unit is more than its carrying amount, then
the company does not need to go further. However, if the company concludes that
it is more likely than not that the fair value of the reporting unit is less than its net
carrying amount, the company proceeds to the quantitative, two-step impairment
test.
2- Quantitative analysis:
Carrying amount of reporting unit’s > Fair value of reporting purchased
net assets including goodwill unit that created the goodwill
Potential loss but not sure yet

If carrying amount < fair value so company can stop here and not go further.
3- 3rd step test
compare implied fair value of the goodwill to the carrying amount of the goodwill
unit’s implied fair value: fair value of the reporting unit’s assets and liabilities as if
the unit were newly acquired in a business combination.
Carrying amount of the goodwill > Goodwill implied fair value = the
fair value of the reporting unit –
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implied fair value of net assets
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Carrying amount of the goodwill is written down to its implied fair value and
impairment loss is recognized in a separate line in income statement, the loss
recognized cannot be greater than the carrying amount of the goodwill, only to
is written off.
GAAP a.
bring goodwill carrying amount to zero maximum and it is said then that goodwill
IFRS
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Developme Generally, development Development costs are capitalized as an
nt costs costs are expensed as intangible asset item if the entity can
incurred. demonstrate the technical feasibility of

(may be capitalized only if a completion of the asset.
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specific U.S. GAAP standard

allows capitalization for that
asset)
Revaluation Revaluation is not Revaluation to fair value of intangible
permitted. assets other than goodwill is a permitted
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accounting policy, for a class of intangible

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assets. can be applied only if the

intangible asset is traded in an active
market.
Reversal of prohibits any reversal of a previously recognized impairment loss
loss write-down. on an intangible asset may be reversed if
the estimates of the recoverable amount
have changed.

3. Valuation of Liabilities
A) Reclassification of Short-term Debt
When a company expects to refinance some or all of its short-term liabilities by
means of new long-term debt or by issuing equity, the amount of the liability to be
refinanced should not be classified as a current liability. Rather, the amount of the
short-term liability that will be refinanced is reclassified as a noncurrent liability
on the balance sheet.
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In order for a company to reclassify its short-term obligations as long-term
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obligations, it must both:
• Have the intent to refinance them, and
• Be able to demonstrate the ability to refinance them.
a.
The ability to refinance the short-term debt can be demonstrated by either:
• Completing the refinancing transaction and converting the short-term
obligations to long-term obligations after the end of the year but before the
financial statements are issued or are available to be issued, or
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• Entering into a financing agreement with another party after the end of the year
but before the financial statements are issued or are available to be issued that will
enable the refinancing to occur. If this requirement is met, the company also must
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be able to show the ability to actually perform the agreement.
Note: If some of the short-term obligations that were intended for refinancing are
actually settled (paid) in the following year before the issuance of the financial
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statements by using short-term assets, the settled amount of obligations must be

shown as short-term obligations on the year-end balance sheet.
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Note: If the company refinances only part of its short-term obligations, it must
continue to show the short-term obligations that were not refinanced as current
liabilities.

B) Warranty liabilities
A warranty is a written promise, guaranteeing to fix or replace a defective product
during a specific period, there are two types of warranties:
1) An assurance-type warranty is a manufacturer’s warranty given along with the

sale of the product that provides assurance only that the product meets agreed-
upon specifications in the contract at the time it is sold, without any additional
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payment being required from the customer. An assurance-type warranty is
included with the product price, and the consideration received from the
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transaction includes the warranty.
Assurance-type warranties that cover only the compliance of the product with
a.
agreed-upon specifications do not constitute a separate performance obligation
under ASC 606, Revenue Recognition, and are accounted for as liabilities under ASC
460, Guarantees.
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2) A service-type warranty is an extended warranty that is usually sold separately
from the product. Service-type warranties provide a service in addition to product
assurance. A service-type warranty may offer protection against wear and tear or
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certain types of damage. A service-type warranty may be offered by the

manufacturer but also may be offered by either the reseller or by a third party.
When a warranty, or a part of a warranty, provides a service in addition to the
assurance that the product complies with agreed-upon specifications, the
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promised service is a performance obligation and the company should allocate the
transaction price to the product and to the service. Service type warranties
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constitute a separate performance obligation under ASC 606, Revenue Recognition,

and a portion of the consideration received from the transaction is allocated to the
warranty and recognized as revenue over the warranty period. ASC 606 is discussed
in detail later.
Classification of Warranties
A warranty that is not sold separately may nevertheless represent a separate
performance obligation under ASC 606 if it provides any service beyond assuring
that the product complies with agreed-upon specifications. A single warranty can
have elements of both an assurance-type and a service-type warranty. If a warranty
includes elements of both and the company cannot reasonably account for them
separately, the company should account for both of the warranties together as a
single performance obligation.
All warranties need to be carefully assessed to determine whether they should be

accounted for as liabilities under ASC 460 or whether they need to be accounted
for as separate performance obligations under ASC 606, or both. To assess whether
a warranty provides a customer with a service in addition to the assurance that the
product complies with agreed-upon specifications, the company should consider
the following factors:
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1) Is the warranty required by law? A warranty required by law should be accounted
for as an assurance warranty. It is not a performance obligation under ASC 606.
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2) What is the length of the warranty coverage period? The longer the coverage
period, the more likely it is that the promised warranty is a performance obligation
because it is more likely that it provides a service in addition to the assurance that
a.
the product complies with the agreed-upon specifications. For example, a “lifetime
warranty” provided at no extra charge with purchase of a product that promises to
repair or replace the product at any time for any reason is likely a separate
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performance obligation that needs to be accounted for under ASC 606, even
though it is not purchased separately.
3) What is the nature of the tasks that the company promises to perform? Specified
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tasks performed in order to provide the assurance that a product complies with
agreed-upon specifications, such as providing a return shipping service for
defective products, probably do not give rise to performance obligations under ASC
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606. However, referring again to a “lifetime warranty,” a promise to repair or

replace the product for any reason at any time during the life of the product goes
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beyond simply assuring that the product complies with agreed-upon specifications
and tends to indicate a separate performance obligation.
Example: A manufacturer of pet accessories promises that its products are

guaranteed for life “even if chewed.” For instance, if a dog chews on its leash and
destroys it at any time, no matter how long it has been in use, the manufacturer
will replace it with a new one with no questions asked. The lifetime guarantee is a
service in addition to the assurance that the product complies with specifications,
so it is a service-type warranty even though it is not sold separately. It should be
accounted for as a separate performance obligation, and a portion of the
consideration from each sale should be allocated to the warranty.

1) Accounting for Assurance-Type Warranties

Per ASC 460-10-25-5, because of the uncertainty surrounding claims under
warranties, warranty obligations are considered contingencies and losses are to be
accrued if the conditions in ASC 450-20-25-2 are met, specifically:
 If it is probable that an obligation has been incurred due to a transaction that
occurred on or before the date of the financial statements, and
 If the amount of the obligation can be reasonably estimated.
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Assurance-type warranties may be current liabilities, or they may be partly current
liabilities and partly noncurrent liabilities.
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 If the term of the warranty extends only into the next accounting period, a
current liability is recorded.
 If the term of the warranty extends beyond the next period, the estimated
liability must be separated into a current portion and a non-current portion.
a.
Because the company does not know exactly how many units will break, or exactly
how much it will cost to fix or replace those units, warranty expense under
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assurance-type warranties is an estimate.
At the end of each period, the company must make a calculation of the amount of
expected warranty claims that will be received in all future periods. This calculation
can be based on a percentage of sales, a cost per unit sold, or can be calculated in
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some other manner. No matter which method is used for calculating the amount
of the estimated warranty expense
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the journal entry to record the liability and the expense for warranties is:
Dr Assurance-type warranty expense XXX
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Cr Assurance-type warranty liability XXX

This entry will match the expense of the future warranty claims with revenues that
were recognized from the sale of those items.
When a warranty claim is received, the company will reduce the liability and not
recognize an expense because the expense was already recognized in the period
when the sale was made. The entry to record actual cost incurred is:
Dr Assurance-type warranty liability XXX
Cr Cash, inventory, accrued payroll, as appropriate XXX
At the end of each year the company must evaluate the balance in the assurance-
type warranty liability account to make certain that it is appropriate. If the amount
is estimated to be too low, additional expense and liability are recognized using the

first entry above. If it is determined that the liability is higher than necessary, a
portion of the first entry is reversed in order to bring the assurance-type warranty
liability account down to its proper estimated value.
Note: As each assurance-type warranty period expires, the company will need to
remove any remaining estimated warranty liability balance attributable to that
warranty period by reversing any remaining amount of the first entry above.
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Candidates should be able to calculate both the warranty expense for a period and
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the remaining warranty liability.
 The assurance-type warranty expense is a simple percentage of sales (or
other calculation) and does not take into account the amount of cost actually
incurred for warranty claims.
a.
 The assurance-type warranty liability is the total assurance-type warranty
expenses recognized in the past (as debits to assurance-type warranty
expense and credits to assurance-type warranty liability) minus all costs
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incurred on warranty claims.
Disclosing Assurance-Type Warranties on the Balance Sheet

Assurance-type warranties are classified as current or non-current on the balance
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sheet based on the remaining time period that the warranty is valid.
1) If the warranty term extends only into the next accounting period, a current
liability is recorded.
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2) If the warranty term extends beyond the next period, the estimated liability must
be separated into a current portion and a long-term portion.
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The warranty liability on the balance sheet is calculated as:

Total warranty expenses recognized (accrued) in the past on warranties that
are still open
- All costs that have been incurred on warranty claims on those warranties
= Warranty liability on the balance sheet .

2) Accounting for Service-Type Warranties

When a warranty such as an optional extended warranty is sold separately from
the product, the warranty is a distinct service because the company promises to
provide the service to the customer in addition to the product. The option to
purchase the warranty separately provides evidence that the warranty is a service
in addition to the product. A service-type warranty is a separate performance
obligation under ASC 606.
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However, a warranty does not need to be sold separately in order to be a separate
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performance obligation. The company should assess all warranties to determine
whether they are assurance-type or service-type warranties. A warranty could even
have elements of both assurance and service.
The seller of a service-type warranty should account for the promised warranty as
a.
a performance obligation. A portion of the transaction price of each sale should be
allocated to that performance obligation.
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The recognition of revenue for the consideration allocated to a service-type
warranty is deferred and is usually recognized on a straight-line basis over the life
of the warranty contract. However, if historical evidence indicates that costs under
the contracts are incurred on some basis other than a straight-line basis, then the
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revenue should be recognized over the contract period in proportion to the

expected costs. If the extended warranty picks up after the manufacturer’s
warranty expires, recognition of the extended warranty revenue does not begin
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until after the manufacturer’s warranty has expired.

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Since service-type warranty revenue is recognized throughout the term of the

contract, expenses incurred in fulfilling the contracts should be expensed as
period costs when incurred.
Thus, consideration received for a service-type warranty is a contract liability on
the balance sheet according to ASC 606, representing the seller’s performance
obligation over the term of the contract. The name of the liability account may be
contract liability or it may be more descriptive, such as service-type warranty
liability.
Dr Cash or accounts receivable ................. Consideration allocated to warranty

Cr Service-type warranty liability .................. Consideration allocated to warranty

The consideration received for the service-type warranty is transferred to revenue

as the contract is performed.
Estimated future costs of service-type warranties are not accrued as liabilities.

Actual costs are expensed as they are incurred.
Example: A manufacturer that sells direct to consumers offers a one-year
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assurance-type warranty against defects for its products and an extended 4-year
service-type warranty for an additional cost.
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When the extended warranty is purchased along with the product, the $5,200
consideration received for both is allocated $5,000 to the product and $200 to the
service-type warranty. The consideration allocated to the product includes the
assurance-type warranty that covers the product for the first year, and the
a.
extended, service-type warranty covers the product from Year 2 through Year 5.

The manufacturer’s entry on the date of the sale for each unit sold is:
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Dr Cash 5,200
Cr Sales revenue 5,000
Cr Service-type warranty liability 200
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Also, on the sale date, the manufacturer estimates that its liability for the
assurance-type warranty will be $100 for each sale during Year 1, the period
covered by the assurance-type warranty, and records its liability for the assurance-
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type warranty as follows:

ef
Dr Assurance-type warranty expense 100

Cr Assurance-type warranty liability 100
The manufacturer processes a claim against the assurance-type warranty during

Year 1 that involves one hour of labor at $20 and parts costing $60:
Dr Assurance-type warranty liability 80

Cr Parts inventory 60
Cr Accrued payroll 20
The manufacturer evaluates the balance in the assurance-type warranty liability

account at each reporting date and adjusts it according to its estimated remaining

liability. The other side of the adjusting entry is either a debit or a credit to
assurance-type warranty expense.
Since the product is under the assurance-type warranty for the first year, the
service-type warranty covers years 2 through 5 (4 years).
At the end of Year 2 following the sale (after expiration of the assurance-type
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warranty) and for each of the three following years, the manufacturer recognizes
one-fourth of the revenue for the service-type warranty on a straight-line basis.
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Entries at the ends of Years 2, 3, 4, and 5 to recognize the revenue from the service-
type warranty for each sale are:
Dr. Service-type warranty liability 50

Cr. Service-type warranty revenue
a. 50
Costs for repairing or replacing items covered by the service-type warranty during
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years 2, 3, 4 and 5 are expensed as incurred, as follows:
Dr Service-type warranty expense XXX Amount incurred

Cr Salaries and wages payable XXX Amount incurred
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Cr Parts inventory XXX Amount incurred

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C) Income taxes
What we want to pay What we must pay
There are two sets of calculations of income in any entity:
Book income (financial income) calculated based on the GAAP standards and
which represents the income reported in the financial statement before applicable
taxes (pre-tax income) and which is different than taxable income (tax income)
which is the basis used to compute the income tax payable to the government, in
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other words what the government says that the entity should pay for in a certain
period, so it is calculated in accordance with the applicable tax law in each country,
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taxable income = taxable revenues – taxable expenses.
Deferred taxes:
a.
Deferred tax is the difference between book income & taxable income
Dr. Income tax expense (want to pay) 90
Dr. Deferred taxes Asset (means Prepaid tax) 10

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Cr Cash (must pay) 100
Dr. Income tax expense (want to pay) 100

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Cr. Cash (must pay) 90

Cr. Deferred tax Liability (means Tax liability) 10
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Possible cases that will cause a difference between financial income and taxable
income, temporary Timing Differences, which will lead to deferred taxes:
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Deferred tax liability:

Book income > taxable income
1) Revenues recognized in the accounting records before it is recognized in as a
taxable income: for example, income of equity securities are recognized when
earned for financial reporting, while for tax purposes only when distributed -
dividends.
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2) An expense item is deductible from taxable income before it is deducted in the
accounting records: for example, when using the Modified Accelerated Cost
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Recovery System (MACRS) for calculating depreciation for tax purposes and using
depreciation method such as straight-line for financial reporting purposes,
depreciation expensed will be greater for tax purposes than for book purposes in
a.
the early years of the asset’s life).
Deferred tax liability DTL = future taxable amount X tax rate

Known also as taxes payable or future taxable amounts
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Deferred tax assets:
Book income < taxable income
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1) Revenues recognized as taxable income before it is recognized in the

accounting records: for example, prepaid rental income and service contract
revenue are recognized for tax purposes when received, while for financial
reporting they are recognized when they are earned
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2) Expenses deducted in accounting records before it is deducted from taxable

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income: for example when expense accrued for financial reporting purposes for
estimated liability for warranties which is accrued on the date of sale and pending
litigation – accrual method of accounting, which is not allowed as a tax deduction
until the amounts are paid – cash bases, also credit loss expense is recognized in
the financial statements under the allowance method, which is different for tax
purposes as credit loss expense is recognized when the debts are determined to be
credit loss using the direct write-off method.
Deferred tax assets DTA = future deductible amount X tax rate

Known also as prepaid taxes or future deductible amounts

Table of temporary timing Differences and Their Results

Included in taxable income Included in book income
first first
Revenues and gains Deferred tax asset Deferred tax liability
Expenses and losses Deferred tax liability Deferred tax asset
So deferred taxes are resulting from taxable (or deductible) temporary differences,
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which results from the differences between the GAAP basis and the tax basis (tax
code) of an asset or liability, as explained in the previous examples, those
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differences exist when items of income and/or expense are recognized in different
periods under GAAP standards compared to the tax code, the effect is that a
taxable or deductible amount will occur in future years when the asset is recovered
a.
(collected) or the liability is settled (paid), therefore the deferred tax valuation is
based on using the enacted tax rate(s) expected to apply when the liability or asset
is expected to be settled or realized, in other words deferred taxes are the
differences between what the company wants to pay based on the income the
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company defines as taxable (book income) and what the company has to pay
calculated by the government according to the tax code, that different could be on
the debit side with the assets or in the credit side with the liabilities
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Presentation on income statement:

Require two tax expenses account on the income statement:
1. Current Income Tax Expense: the amount payable to the government, based
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on taxable income used for the payable tax calculation of the current period.
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Current tax expenses / benefit = taxable income X tax rate.
Current income tax expense is recorded as follows:

Dr. Income tax expense -- current XXX
Cr. Income tax payable XXX
2. Deferred Income Tax Expense or Benefit: The tax effect of timing differences
between book and taxable income, as explained before, this deferred
income tax item may be either a reduction to current income tax expense,
which is a benefit, or an increase to current income tax expense, which is an
expense.

The calculation of the deferred tax is based on the connotation: It is the amount of
change in the total deferred tax asset and liability position of the company during
the period, entity could have both deferred tax liability and asset in the same
period, so total of both items will result to the final deferred tax value for the period
in the direction of the larger amount, wither liability or asset.
Deferred tax expenses or benefit = Beginning Balance of DTA (DTL) - Ending
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Balance of DTA (DTL)
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a.
Total of 1 + 2 equal to Total Income Tax Expense as calculated on the basis of
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financial income according to GAAP and shown on the income statement:
current income tax expenses (amount payable based on taxable income)

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+ deferred tax expenses OR

– deferred tax benefit
Total income tax expense on income statement
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Journal entries:
DTL balance increased during the year
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Income tax expense -- deferred $XXX IS

Deferred tax liability $XXX BS
DTL balance decreased during the year:

Deferred tax liability $XXX BS
DTA balance increased during the year

Deferred tax asset $XXX BS

DTA balance decreased during the year

Deferred tax asset $XXX BS
A Single Period of Creation and Multiple Periods of Reversal with Changing Future
Tax Rates
When the temporary timing difference is created in a single period but will reverse
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over a number of future periods that have different enacted tax rates, the
calculation of the deferred tax amount is fundamentally the same. Instead of
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making one calculation, a separate calculation must be made for each year in which
the temporary timing difference will reverse. The process involves three steps:
1) Determine the amount of the temporary difference and how much of that
a.
difference will reverse in each future period.
2) Multiply each amount of the temporary timing difference that will reverse in
each future period by the enacted tax rate for that future period.
3) Sum all of the results from Step 2 to calculate the amount of increase in the
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balance of the deferred tax asset or liability at the end of the year in which it was
created.
The amount of increase in the asset or liability account representing that particular
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deferred tax item at the end of the year will be equal to the related deferred tax
benefit or expense for the year.
Note: The enacted tax rate is the rate that has been enacted into law by the
government as the rate for the future period in question. If no laws have been
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passed that change the tax rates in the future, assume that the current tax rate will
be the enacted rate for any future periods.
ef

Different cases and Examples:

Single period of creation and single period of reversal:
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a.
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h am
ef

Multiple Periods of Reversal and a Constant Future Tax Rate:
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a.
A Single Period of Creation and Multiple Periods of Reversal with Changing Future
Tax Rates:
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h am
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Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet:

Deferred tax assets and liabilities are to be classified on the balance sheet as either
a net non-current asset or a net non-current liability.
The net amount and whether it is to be presented as an asset or a liability is
determined by subtracting the deferred tax liability amounts from the deferred tax
asset amounts. If the net result is positive (a debit), the net amount is reported on
the balance sheet as a non-current asset. If the net result is negative (a credit), the
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net amount is reported on the balance sheet as a non-current liability.
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Valuation needed:
In case of probability of more likely that some portion of asset will not be realized,
then it is required to use a valuation allowance to reduce the deferred tax asset, in
order to reduce the deferred tax asset to the amount that is more likely than not
to be realized.
DTA Valuation Journal Entry: a.

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DR. Benefit due to loss carry forward XX
Cr. Allowance for deferred tax asset XX
If it is connected to temporary difference, the debit is to Income Tax Benefit
Deferred.
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Permanent difference:
If an income or expense item is recognized only for book purposes or only for tax
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purposes but not both (which is the case in temporary time differences), it is a
permanent difference, which will never generate a deferred tax asset or liability,
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examples: Municipal Bond Interest (Tax exempted), The Dividends-Received

Deduction, Expenses incurred in the process of earning tax-exempt income, Life
insurance premiums paid by the corporation (The life insurance expense is not
deductible and in the same time proceeds are not taxable), and Expenses incurred
as a result of violating the law which involve governmental fines (for book purpose
are expensed but for tax purpose is not allowed to be deducted)

D) Leases
Definition of a Lease:
The agreement between a lessor (the owner of the asset) and a lessee (the entity
that is going to use the asset) that conveys the right to control the use of specific
property for a stand period of time in exchange for consideration.
Control means that the lessee has both:
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1) The right to obtain substantially all of the economic benefits from the use of the
asset, and
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2) The right to direct the use of the asset, such as how it is going to be used, who is
going to use it, etc.
a.
There are two categories of leases:
1. Finance lease: a purchase/sale agreement, where the lessor transfers all the
benefits and risks of ownership of the asset to the lessee
2. Operating lease: rental contract, it does not transfer all the benefits and risks
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of ownership of the asset to the lessee, at the end of the lease contract the
asset will be returned to the lessor.
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Finance lease:
Remember that finance lease is like a purchase as mentioned earlier but it may not
actually be a purchase but it is still very much like a purchase.
A lease is said to be finance lease in ONE at least or more of the following
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cases/criteria: (what differentiate finance lease from operating lease).

1) The lease provides for the transfer of ownership of the asset to the lessee at the
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end of the lease, simply transfer of ownership is a purchase

2) The lease grants the lessee an option to purchase the underlying asset, and the
lessee is reasonably certain to exercise the option to purchase, probably because
that purchase price is less than the expected fair market value in the future, it is
also a purchase case.
3) The lease term is for a major part of the remaining economic life of the asset,
as per FASB the guidance for a major part is 75% or more.
4) The present value of the sum of the lease payments (and any residual value
guaranteed by the lessee not already reflected in the lease payments) is equal to
or greater than substantially all of the fair value of the underlying asset, as per
FASB the guidance for substantially all of the FV is 90% or more
The points 3 and 4, it is not actually a purchase but it is fundamentally a purchase
that the lessee used this leased asset for 80% of its useful life, the present value of
the lease payments is equal to 90% or more of its FV and so it is not actually a
purchase but for all practical purposes the lessee is getting actually all of the
benefits of the ownership of the asset, paying for it fundamentally or using the vast
majority of its useful life.
5) The underlying asset is of such a specialized nature that it is expected to have no
alternative use to the lessor at the end of the lease term, it is done with the contract
and the lessor will not even want to get the asset back, as it is not going to have
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any value to the lessor at the end of the lease period
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Financing Lease Recognition by the Lessee:
The lessee buys the asset from the lessor, through financing the purchase with a
loan from the lessor, and therefore the lessee will:
1) Recognize a right-of-use asset and a lease liability at the start/initially of the lease
a.
in the lessee’s statement of financial position (balance sheet) at
2) the lease liability at the lease commencement date, is measured at the present
value of the lease payments to be made over the lease term. The lease payments
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are discounted using the discount rate for the lease.
a) It is the rate implicit in the lease, if known to the lessee.
b) If not, it is the lessee’s incremental borrowing rate.
The rate implicit in the lease is determined by the lessor.
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3) The asset includes the PV of all future payments as well as any payments already
made and any direct costs incurred.
4) recognize interest expenses as payments are made
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5) recognize amortization of the right of use asset each year, because this asset is
recorded in the lessee books
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So, when there is a finance lease the lessee will have two different types of
expenses, that are going to show up on the income statement, an interest expense
and an amortization expense
Operating Lease Recognition by the Lessee:

When none of the criteria for a finance lease are met, the lessee classifies the lease
as an operating lease and is required to:
1) Recognize a right-of-use asset and a lease liability at the start of the lease in the
lessee’s statement of financial position (balance sheet). The right-of-use asset and
the lease liability are measured the same way as they are measured for a finance
lease.

And so, what is different about the operating lease, is that instead of having two
expenses items 
2) Recognize a single lease cost after the commencement date, calculated so that
the total cost of the lease is allocated on a generally straight-line basis over the
term of the lease, so essentially it is calculating the total lease amount and allocate
it on a straight basis over the term of the lease.
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Single periodic lease expense = Total undiscounted lease payments ($) ÷ Lease term (years)
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Finance and operating leases result in the same accounting for
a) Initial recognition and measurement of the lease liability,
b) Initial recognition and measurement of the right-of-use asset, and
c) Subsequent measurement of the lease liability.
a.
The accounting for subsequent measurement of a right-of-use asset differs under
finance and operating leases.
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Finance lease liabilities and operating lease liabilities must not be presented
together in the same line item. They are presented in the balance sheet or disclosed
in the notes, separately from each other and separately from other liabilities.
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Finance lease right-of-use assets and operating lease right-of-use assets must not
be presented together in the same line item. They are presented in the balance
sheet or disclosed in the notes, separately from each other and separately from
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other assets.
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Leases on the statement of cash flows:

1- payments of the principle portion of a finance lease liability are cash outflows
from financing activities
2- payments of interest on the lease liability and any variable lease payments are
operating activities.
3- if it is operating lease & short-term leases any payments are cash outflows from
operating activities.
Short-term Leases:
For leases having a term of 12 months or less, the lessee may make an accounting
policy decision, by class of underlying asset, not to recognize lease assets and lease

liabilities. If a lessee makes such an election, it should recognize the lease payments
as expenses as it happens on a generally straight-line basis over the lease term.
Example: A one-year lease that includes a renewal option that the lessee is
reasonably certain to exercise cannot qualify as a short-term lease, and the lessee
must record a right-of-use asset and a lease liability.
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So briefly, both types of lease have right of use asset and lease liability accounts,
while the major different between them that under finance lease there are two
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expenses accounts and only one kind of expense under the operating lease
Finance lease Example:

On January 1, Year 1, Cottle, Inc., entered into a 3-year lease of a machine from
a.
Crimson, LLC. Cottle must pay Crimson three annual payments of $100,000 starting
on December 31, Year 1. The machine’s useful life from the lease commencement
date is 5 years. The lease allows Cottle the option to purchase the machine at the
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end of the lease term for $15,000. Cottle is reasonably certain to exercise this
purchase option. Cottle’s incremental borrowing rate is 15%, but the rate implicit
in the lease is 10%, which is known to Cottle.
● The present value factor for an ordinary annuity at 10% for 3 periods is 2.48685,
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and the present value of $1 at 10% for 3 periods is 0.7513.

● The present value factor for an ordinary annuity at 15% for 3 periods is 2.28323,
and the present value of $1 at 15% for 3 periods is 0.65752.
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The lease is a finance lease because it meets the lease classification criterion of
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including a purchase option that the lessee is reasonably certain to exercise. The
rate implicit in the lease of 10% is used to calculate the present value of the lease
payments because Cottle knows this rate.
PV of rental payments ($100,000 × 2.48685) $248,685

PV of purchase option ($15,000 × 0.7513) 11,270 .
PV of lease payments $259,955
Right-of-use asset $259,955

Lease liability $259,955

Operating Lease Example:

Using the scenario in Example 3-10, assume that (1) Cottle concludes that the
contract is an operating lease, (2) the lease does not include a purchase option, (3)
the rental payments are $100,000 at the end of Years 1 and 2 and $160,000 at the
end of Year 3, and (4) the rate implicit in the lease is not known to Cottle.
Because Cottle does not know the rate implicit in the lease, it uses its incremental
borrowing rate of 15% to calculate the present value of lease payments.
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The PV of the rental payments is $267,774 [($100,000 × 2.28323) + ($60,000 ×
0.65752)].
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Lease liability $267,774
a.
Example of Interest Expense and Amortization of Lease Liability:
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h am
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Example of Amortization of Right-of-Use Asset over Useful Life:

In Example 3-10, Cottle is reasonably certain to exercise the option to purchase the
machine. The right-of- use asset therefore is amortized over the useful life of the

machine of 5 years. Annual amortization expense of $51,991 ($259,955 ÷ 5 years)

is recognized by Cottle. The journal entry is
Amortization expense $51,991
In its 12/31/Yr 1 balance sheet, Cottle reports the right-of-use asset at $207,964
($259,955 initial cost – $51,991 accumulated amortization).
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GAAP IFRS
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Finance classify leases as either finance no formal classification between
lease and leases or operating leases finance leases and operating leases
operating
lease there are different treatments almost all leases are accounted for
lease
a.
for finance lease and operating as finance leases with a separate
expense for
amortization expense
interest and
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short term leases are accounted there are short term leases and
for as direct expenses leases for which the underlying
asset is of low value maybe
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accounted for as an operating lease
the right of use asset is measured under IFRS the right of use asset can
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at a historical cost and be revaluated during the term of

revaluation is not permitted the lease (as for fixed assets in
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general)

4. Equity Transactions
Owners’ equity (shareholders’ equity)
Owners’ equity = Assets – Liabilities
So equity is the balancing of the balance sheet for assets and liabilities, and owners’
equity represents what the company owes to the owners of the company, more
formally, owners’ equity is defined as the residual interest in the assets of an entity
after deducting its liabilities, depending on the entity’s form the equity’s accounts
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are different from each other, for example a sole proprietorship will have one
capital account for the owner of this company, while in a partnership company
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there will be many capital accounts, one for each partner.
Owners’ equity consists of the following accounts:
a.
❶Contributed capital:

The fair value of what is received from owners in exchange for the shares, whether
cash or another asset
1. Capital stock account: registering in the balance sheet the par value of sold
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shares, that’s why company might have many capital stock accounts one for
each type of issued shares.
2. Additional-paid-in-capital (APIC) account: the above the par value that is
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received when shares were sold, so balance sheet might have different APIC
accounts, classified by type of shares or by transactions.
❷Retained earnings: “undistributed earnings” that were reinvested.

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❸other comprehensive income: not discussed in this study unit

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Types of equity financing:

Depending the registration of the stock and the characteristics of it
1. Common shares
2. Preferred shares
Common and Preferred Stock:

Basic terms related to stock:
1) Authorized stock: maximum number of shares that a company is allowed to
legally issue.
2) Issued stock: amount of stock authorized that has been issued by the
corporation, it might be held by owners or by the company itself in the form of
“treasury shares”
3) Outstanding stock: is the amount of stock issued that has been sold to
shareholders and they still hold it.
Outstanding shares = issued shares – treasury shares
4) Par value: (stated value) is the stated specific amount of the stock which is
printed on the share itself (not all shares have par value), most of companies they
use a very small amount for the par value, it is only used at the registration of the
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shares, and it does not impact the selling price of the stock, the par value also
represents the legal capital of the company that cannot be distributed
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Common Stock: represents the general form of ownership
It has two types:
a.
Common stock with par value: as the par value is the legal capital of the company
that can’t be distributed as dividends.
Common stock with no par value: the legal capital here is the total amount received
when issued.
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Common shareholders are called residual owners, because if the company is
liquidated, they are going to receive the residual money after paying everybody
else, creditors, preferred shares, etc.
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Common shareholders have the highest risk as company don’t have to pay
dividends (no obligation) and share price may go down
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Rights of common shareholders:

1. Voting: vote to select BODs, merger decisions, and other significant issues at
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annual meetings.
2. Dividend: common shareholders have a right to dividend if it is declared by the
board of directors, as the entity might choose not to declare dividends.
3. Preemptive right: (stock rights) it allows the shareholders to have the right to
purchase the same percentage of a newly additional issued shares in proportion to
their ownership percentage, this way the preemptive rights safeguard a common
shareholder’s ownership and interest proportion.
4. Right of distribution of residual assets in liquidation

In the middle
Preferred stock:
Bonds preferred shares common shares
Like with the common stock preferred share is an equity instrument and included
in the equity section of the balance sheet, it said to be in the middle between debts
and equity since it has features of debt (bonds) and equity (common shares)
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How similar to debts:
1. Generally don’t vote.
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2. The preferred dividends are usually a fixed percentage of a par value (fixed
charge).
3. Preference over common shareholders in a liquidation.
a.
4. Preference over common shareholders in receiving dividends, although payment
of dividend still not an obligation.
5. It may have some characteristics such as callable, convertible and may have
sinking fund requirements.
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How similar to common stock:
1. No commitment against the company in paying dividends.
2. Preferred dividends are paid after interest and tax, so they are not tax deductible.
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3. They are below debt in liquidation.
Two types of preferred dividends:

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❶Noncumulative preferred dividends:

undeclared dividends in a year are lost Cumulative preferred dividends: every year
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it is earned even if it is not paid, so if it is not declared for a year it will be

accumulated and carried forward, which will be called then “dividend in arrears”,
while no legal liability for not paying.
❷cumulative preferred stock: refers to the cumulative dividend in arrears

A cumulative dividends are earned every year no need for declaration, and if not
declared the dividend will accumulates and will be paid in the future (that’s why its
is called divided in arrears)
Company will not be able to pay common dividend before paying all previous and
current cumulative preferred dividends.
Dividends in arrears must be disclosed in financial statements so that potential
investors could make an investment decision in the company or not.

Disclosure of cumulative dividends:

Dividends in arrears are not recorded as a liability but must be disclosed in a note
to the financial statements.
Characteristics that might exist in preferred shares:

1. Can be callable by issuer, buys it back
2. Can be redeemable by shareholders, tell company to buy it back from them.
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3. Can be convertible into common shares.
4. Can be participating in common dividends not only preferred dividends.
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5. In some cases, they can vote, such as preferred cumulative shares if their
dividends haven’t been declared for two, three or some set of years.
a.
Equity Transactions
(1) Issuance of Stock

Dr. Cash (or other asset received) XXX fair value received
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Cr. Common shares XXX par value issued stock
Cr. preferred shares XXX par value issued stock
Cr. Additional paid-in capital –common shares XXX in excess of par
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Cr. Additional paid-in capital –preferred shares XXX in excess of par
Direct costs of issuing stock (underwriting, legal, accounting, tax, registration, etc.)
are not recognized as expenses, while instead, they reduce the net proceeds
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received and additional paid-in capital (contra accounts).

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Dr. APIC XXX Paid Costs

Cr. Cash XXX
Issuing shares NOT for cash:

The transaction should be recorded at the fair market value of the property or the
market value of the stock whichever is more readily determinable
(2) Dividends
Dividends are the distribution of current profits and/or the retained earnings of the
company to its owners, the declaration of dividends reduces total stockholders’
equity.

(A) Cash Dividend the most common form of dividend

Three important dates related to the cash dividends
a. Date of declaration:
The board of directors formally approves a dividend for declaration, and on the
same day the record date and the date of payment are announced, while
remember that the declaration entry reduces the company’s working capital, since
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working capital is current assets minus current liabilities.
Dr. Retained earnings XXX
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Cr. Dividend payable XXX
b. Record date:
a.
All holders of the shares on the date of record are legally entitled to receive the
dividend, no entry required on that date, while company could make entry on
record date to correct the estimation made to the dividend payable on the date of
declaration.
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c. Date of Payment:
The date of payment is the date on which the dividend is paid.
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Dr. Dividends Payable XXX

Cr. Cash XXX
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(B) Property Dividend

When an entity declares a dividend consisting of property rather than cash, this
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property could be inventory, asset, shares in another company, property dividend

might be declared because company need cash for major expansions for example,
in this situation the property is remeasured to fair value as of the date of
declaration, and any gain or loss on the remeasurement is recognized in the income
statement
Dr. Equity – Property name XXX

Cr. Gain XXX
(Different between property balance and its fair value which could be gain or
loss)

And the carrying amount of retained earnings is decreased for the total fair value
of the distributable property.
Dr. Retained Earnings XXX
Cr. Property Dividends Payable XXX
Then the property is distributed as a dividend:

Dr. Property Dividends Payable XXX
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Cr. Equity – Property name XXX
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a.
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(C) Liquidating Dividends

Liquidating dividends are those dividends that are a return of capital rather than a
return on capital, which is the case when the dividend distributed is greater than
the balance of the retained earnings.
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The journal entry if no balance in retained earnings and all dividend is liquidating
dividends (if there is no balance in the Retained Earnings account):
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Dr. APIC XXX

Cr. Cash XXX
While entry could be as follow: in case there is a balance in retained earnings which
we bring it down to zero and then the liquidating dividends are excess of that
balance
Dr. Retained earnings XXX reduced to zero
Dr. APIC XXX liquidating amount
Cr. Cash XXX dividend amount

(D) Stock Dividend and Stock Split
❶ Stock dividend
Involves no distribution of cash or property, while distribution is in the form of
additional shares instead, the total value of the equity of the company is not
changed by a stock dividend, so stock dividends are accounted for as a
reclassification of different equity accounts
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An issuance of shares maximum is 25% of the previously outstanding common
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shares should be recognized as a small stock dividend, are valued at the fair value
of the shares on the date of declaration, and no adjustment is required for any
change in the fair value on the date of issuance.
a.
Dr. Retained earnings XXX Fair value of shares distributed
Cr. Common shares – issuable as a dividend XXXPar value of shares
Cr. Additional paid-in capital – common shares XXXBalancing amount

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An issuance of more than 25% of the previously outstanding common shares should
be recognized as a large stock dividend, and the entry is based on the par value of
the shares.
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Dr. Retained earnings XXX par value

Cr. Common shares – issuable as a dividend XXX par value
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❷ Stock split
Simply the stock split is to reduces the share’s market price, by increasing number
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of issued shares (in doubles, triples, etc.) the company essentially cuts its shares
into smaller pieces, therefor more shares are outstanding and each has a lower
market price, for example in a 2-for-1 stock split, the owner of one share becomes
the owner of two shares, in proportion of total shares owned, but each share will
have a market price that is half what it was before the split, also the par value of
each share of the stock is reduced in the same ratio, no journal entries are made
that’s why the balances of the shareholders’ equity accounts are not changed,
while instead there is a memo entry, a memo will note that there are now twice as
many shares and the par value of each share is lower
Reverse stock split:
A company can also announce a reverse stock split, when the company
consolidates shares so that there are fewer outstanding shares (opposite to stock

split story), which will lead to a higher market value for each share, while the
investor’s total market value will be unchanged.
Retained Earnings
The retained earnings account is the final destination for all income statement
(revenue and expense) accounts. The retained earnings account represents the
accumulated undistributed income of the corporation from its inception.
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In the year-end close, net after-tax income for the year is moved to retained
earnings, so retained earnings increases by the amount of the after-tax net income.
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The retained earnings account is decreased when dividends are paid. Retained
earnings is a permanent balance sheet account, so the balance in it accumulates
from year to year.
Treasury Stock:
a.
Are shares that have been bought back from shareholders by the company, so the
company is the holder of its treasury stock shares, treasury shares do not receive
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dividends, do not vote, and are not classified as outstanding, company could decide
to retire them or sell them later, in this case the company’s entry is to make a
contra-account to the owner’s equity by the treasury stock account.
Reasons of why company would buy treasury stocks:
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1. In case if there is a slow treading transaction of the company’s shares at the

market, so company could temporarily provide a market for its shares
2. Maybe company’s BODs are willing to reconsolidate ownership, so they buy
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treasury stock by the company to resell them to family only and make it
closed company ownership for example
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3. An investment if the company thinks its shares are undervalued, expecting

market value to increase at some point.
4. Treasury stock shares could be used for different purposes, such as a stock
dividend.
Effect of stock splits, stock dividends and treasury stock over the various types of
shares (that are explained earlier in this study section):
Stock split Stock dividend Treasury stock
Authorized stock X X X
Issued stock √ √ X
Outstanding stock √ √ √

5. Revenue Recognition ASC 606

Introduction
FASB and IASB issued a converged revenue recognition standard in 2014 entitled
“Revenue from contracts with customers”
The issue of when revenue should be recognized is complex, the many methods of
marketing products and services make it difficult to develop guidelines that will
apply to all situations.
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IFRS was criticized because it lacked guidance in a number of areas. For example,
IFRS had one general standard on revenue recognition—IAS 18—plus some limited
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guidance related to certain minor topics. In contrast, GAAP had numerous
standards related to revenue recognition (by some counts, well over 100), but
many believed the standards were often inconsistent with one another. Thus, the
accounting for revenue provided a most fitting contrast of the principles-based
(IFRS) and rules based (GAAP) approaches.
a.
Many times, a sale includes multiple components and the seller’s obligations with
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respect to the various components are fulfilled at different times. Additionally,
under previous guidance the same transaction might be accounted for differently
by different entities because of industry-specific guidance.
Under the new guidance, principles for recognizing revenue are consistent
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regardless of industry.
The Objective
h
The objective of the revenue recognition standard in ASC 606 is to provide a single,
comprehensive revenue recognition model for all contracts with customers to
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improve comparability across industries, jurisdictions, and capital markets.
The Principle
The revenue recognition principle is to recognize revenue in the accounting period
in which the performance obligation is satisfied. A performance obligation is
satisfied when the customer obtains control of the asset, and the asset is the good
or service transferred to the customer. Therefore, revenue should be recognized to
depict the transfer of goods or services to customers in an amount that reflects the
consideration that the company expects to be entitled to in exchange for those
goods or services.

Consideration
Performance
m
obligation
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New Revenue Recognition Standard
The new standard, Revenue from Contracts with Customers, adopts an asset-
a.
liability approach as the basis for revenue recognition. The asset-liability approach
recognizes and measures revenue based on changes in control of assets and
liabilities.
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Contract Assets and Liabilities
The revenue model focuses on recognizing revenue when control transfers to the
buyer. The model is based on an asset and liability approach that recognizes
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revenue based on changes in control of assets and liabilities.
Contract Assets
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Contract assets are either unconditional or conditional.

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Unconditional contract assets are unconditional rights to receive consideration

because the company has satisfied its performance obligation to a customer and
thus recognizes revenue. Unconditional rights to receive consideration should be
reported as receivables on the balance sheet.
Dr Accounts receivable XXX Amount of sale
Cr Sales revenue XXX Amount of sale
At the same time, the company records cost of goods sold:

Dr Cost of goods sold XXX Cost of product sold
Cr Inventory XXX Cost of product sold
Conditional contract assets are conditional rights to receive consideration because

the company has satisfied one of, or some of, the performance obligations in the
contract and thus recognizes revenue for the performance obligations that are
satisfied, but it must satisfy another performance obligation or obligations before
it can invoice the customer. Conditional rights to receive consideration should be
reported on the balance sheet as contract assets.
Dr Contract asset XXX Price of obligation A satisfied
Cr Sales revenue XXX Price of obligation A satisfied
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When the company satisfies its complete performance obligation, invoices the
customer, and reports the remainder of the performance obligation satisfied as
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revenue, it also reduces the contract asset and reports the full contract obligation
as a receivable:
Dr Accounts receivable XXX Price of obligations A and B
a.
Cr Contract asset XXX Price of obligation A
Cr Sales revenue XXX Price of obligation B
Contract Liabilities
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A contract liability arises when a company receives consideration from the
customer before it transfers goods or services. The contract liability represents the
company’s obligation to transfer the goods or services. The consideration received
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in advance of fulfillment is recorded as a contract liability.

Dr Cash XXX Amount received
Cr Contract liability XXX Amount received
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When the performance obligation is satisfied, the company records the revenue:
Dr Contract liability XXX Amount received
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Cr Sales revenue XXX Amount received
The company also records cost of goods sold at the same time as it records the
revenue:
Dr Cost of goods sold XXX Cost of product sold
Cr Inventory XXX Cost of product sold
Names for Contract Assets and Contract Liabilities

ASC 606 refers to “contract assets” and “contract liabilities.” However, a company
may use other terms for contract assets and contract liabilities in its statement of
financial position, as appropriate, as long as the terms used provide sufficient

information to enable a user of the financial statements to distinguish between

receivables (unconditional contract assets) and contract assets that are conditional.
a. Five Steps to Revenue Recognition CPTAR

The new revenue recognition standard includes five steps:
1) Identify the Contract with a customer.
2) Identify the separate Performance obligations in the contract.
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3) Determine the Transaction price.
4) Allocate the transaction price to the separate performance obligations in the
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contract.
5) Recognize revenue when or as each performance obligation is satisfied.
a.
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A particular transaction may not require all five steps to be completed, and the
steps may not always need to be applied in the order above. The revenue standard
is not organized according to the five steps, but the five steps are provided as a
methodology for companies to use to determine how to account for a given
transaction.

Following are each of the steps of the revenue recognition process in more detail.
1) Identify the Contract with a customer.
Contract:
Agreement between two or more parties that creates enforceable rights or
obligations.
It is important to understand that the revenue recognition guidance in ASC 606 is
not limited to business transacted under formal written contracts, nor is it limited
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to long-term contracts, but valid contract can be written, oral, or implied from
customary business practice.
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ASC 606 applies to all revenue transactions as long as a valid contract exists, with
the exception of several items listed in ASC 606-10-15-2, including:
1. Leases
a.
Out
2. insurance contracts
3. Financial instruments such as investment securities and derivatives
4. and some nonmonetary exchanges to facilitate sales to customers
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Therefore, the first requirement is to determine whether the contract is within the
scope of Topic 606 or whether it is excluded. After determining that a contract is
not specifically excluded.
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Company applies the revenue guidance to a contract only when the contract meets
all of the following criteria:
1. The contract has commercial substance, (that is the risk, timing, or
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amount of future cash flows of the company will change as a result of

the contract).
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2. The parties have approved the contract

3. Identiﬁcation of the rights of the parties is established
4. Payment terms are identiﬁed
5. It is probable (likely occurring) that the consideration will be collected.
Note: A valid contract to be accounted for under ASC 606 exists only if it creates
enforceable rights and obligations and meets the five conditions above.
The performance obligations in a contract can be satisfied at a point in time or over

time. For example:
• A valid contract can be represented when a customer approaches a cashier in a
retail establishment and pays for a purchase. The performance obligation in such a
contract is satisfied at a point in time.

• A valid contract can be represented by an order for goods to be shipped that is

received from a customer through any of a variety of means and includes payment
by credit card, on account after receiving the invoice, or by some other method
such as cash.
• A valid contract can be represented by a long-term contract, which can be
satisfied at a point in time or over time. Long-term contracts can be construction
contract but can also be, for example, contracts to provide services for an extended
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period. If the customer obtains control of the asset as the asset is being
constructed, the performance obligations in the contract are satisfied over time. If
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the customer obtains control of the asset only at the completion of the contract,
the performance obligation is satisfied at a point in time.
Example:
a.
Facts: On March 1, 2017, Margo Company enters into a contract to transfer a
product to Soon Yoon on July 31, 2017. The contract is structured such that Soon
Yoon is required to pay the full contract price of $5,000 on August 31, 2017. The
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cost of the goods transferred is $3,000. Margo delivers the product to Soon Yoon
on July 31, 2017. Either party can unilaterally terminate the contract without
compensation.
Question: What journal entries should Margo Company make in regard to this
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contract in 2017?
Solution:
No entry is required on March 1, 2017, because neither party has performed on the
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contract.
On July 31, 2017, Margo delivers the product and therefore should recognize
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revenue on that date as it satisfies its performance obligation by delivering the

product to Soon Yoon.
The journal entry to record the sale and related cost of goods sold is as follows.
July 31, 2017
Accounts Receivable 5,000
Sales Revenue 5,000
Cost of Goods Sold 3,000
Inventory 3,000
After receiving the cash payment on August 31, 2017, Margo makes the following
entry.
August 31, 2017
Cash 5,000

2) Identify the separate Performance obligations in the contract.

A performance obligation is a promise in a contract with a customer to transfer a
good or service to that customer. A contract may contain only one performance
obligation, or it may contain multiple separate and distinct performance
obligations. Each distinct performance obligation needs to be identified within the
contract.
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is a promise to provide a distinct product or service to a customer.
A product or service is distinct when a customer is able to
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 benefit from a good or service on its own or
 together with other readily available resources.
The objective is to determine whether the nature of a company’s promise is to
transfer individual goods and services to the customer or to transfer a combined
a.
item (or items) for which individual goods or services are inputs.
3) Determine the Transaction price.

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Amount of consideration that company expects to receive from a customer. In a
contract is often easily determined because customer agrees to pay a fixed amount.
Other contracts, companies must consider:
 Variable consideration
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 Time value of money

 Noncash consideration
 Consideration paid or payable to the customer
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Variable Consideration
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Price dependent on future events.

Might include discounts, rebates, credits, performance bonuses, or royalties.
The variable consideration can be estimated by either of two methods:

Example:
Facts: Peabody Construction Company enters into a contract with a customer to
build a warehouse for $100,000, with a performance bonus of $50,000 that will be
paid based on the timing of completion. The amount of the performance bonus
decreases by 10% per week for every week beyond the agreed-upon completion
date. The contract requirements are similar to contracts that Peabody has
performed previously, and management believes that such experience is predictive
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for this contract. Management estimates that there is a 60% probability that the
contract will be completed by the agreed-upon completion date, a 30% probability
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that it will be completed 1 week late, and only a 10% probability that it will be
completed 2 weeks late.
Question: How should Peabody account for this revenue arrangement?
Solution:
a.
The transaction price should include management’s estimate of the amount of
consideration to which Peabody will be entitled. Management has concluded that
the probability-weighted method is the most predictive approach for estimating

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the variable consideration in this situation:
On time: 60% chance of $150,000 [$100,000 + ($50,000 × 1.0)] = $ 90,000
1 week late: 30% chance of $145,000 [$100,000 + ($50,000 × .90)] = 43,500
2 weeks late: 10% chance of $140,000 [$100,000 + ($50,000 × .80)] = 14,000
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$147,500
Thus, the total transaction price is $147,500 based on the probability-weighted
estimate. Management should update its estimate at each reporting date. Using a
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most likely outcome approach may be more predictive if a performance bonus is

binary (Peabody either will or will not earn the performance bonus), such that
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Peabody earns either $50,000 for completion on the agreed-upon date or nothing
for completion after the agreed-upon date. In this scenario, if management
believes that Peabody will meet the deadline and estimates the consideration using
the most likely outcome, the total transaction price would be $150,000 (the
outcome with 60% probability).
Only allocate variable consideration if it is reasonably assured that it will be entitled

to the amount.
Companies only recognizes variable consideration if
1. they have experience with similar contracts and are able to estimate the
cumulative amount of revenue, and
2. based on experience, they do not expect a significant reversal of revenue
previously recognized.

If these criteria are not met, revenue recognition is constrained. Furthermore, at

the end of each accounting period, the company must update the estimated
transaction price to represent any changes in circumstances.
Example:
Facts: On January 1, Shera Company enters into a contract with Hornung Inc. to
perform asset-management services for 1 year. Shera receives a quarterly
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management fee based on a percentage of Hornung’s assets under management
at the end of each quarter. In addition, Shera receives a performance-based
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incentive fee of 20% of the fund’s return in excess of the return of an observable
index at the end of the year.
Shera accounts for the contract as a single performance obligation to perform
investment-management services for 1 year because the services are
a.
interdependent and interrelated. To recognize revenue for satisfying the
performance obligation over time, Shera selects an output method of measuring
progress toward complete satisfaction of the performance obligation. Shera has
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had a number of these types of contracts with customers in the past.
Question: At what point should Shera recognize the management fee and the
performance-based incentive fee related to Hornung?
Solution:
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Shera should record the management fee each quarter as it performs the
management of the fund. However, Shera should not record the incentive fee until
the end of the year. Although Shera has experience with similar contracts, that
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experience is not predictive of the outcome of the current contract because the
amount of consideration is highly susceptible to volatility in the market. In addition,
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the incentive fee has a large number and high variability of possible consideration
amounts. Thus, revenue related to the incentive fee is constrained (not recognized)
until the incentive fee is known at the end of the year.
Time Value of Money

When contract (sales transaction) involves a significant financing component.
If the customer will make payment over a period greater than one year, the
consideration includes a financing component that should be accounted for using
time value of money concepts and the transaction price should be adjusted.
contract includes a significant financing component, revenue from the contract and
a loan receivable should be presented in the financial statements. The revenue
amount should be the present value of the consideration, discounted at an

interest rate that reflects inflation and the credit risk, including the credit
characteristics of the buyer and any secondary repayment sources.
 The contract revenue is recognized once a performance obligation is
satisfied.
 The interest income on the financing component is recognized separately in
the income statement as interest income over the financing period.
 Company reports as interest expense or interest revenue.
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Example:
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Facts: On July 1, 2017, SEK Company sold goods to Grant Company for $900,000 in
exchange for a 4-year, zero-interest-bearing note with a face amount of
$1,416,163. The goods have an inventory cost on SEK’s books of $590,000.
Questions: (a) How much revenue should SEK Company record on July 1, 2017? (b)
a.
How much revenue should it report related to this transaction on December 31,
2017?
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Solution:
(a) SEK should record revenue of $900,000 on July 1, 2017, which is the fair value
of the inventory in this case.
(b) SEK is also financing this purchase and records interest revenue on the note
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over the 4-year period. In this case, the interest rate is imputed and is determined
to be 12%. SEK records interest revenue of $54,000 (12% × ½ × $900,000) at
December 31, 2017.
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The entry to record SEK’s sale to Grant Company is as follows.

July 1, 2017
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Notes Receivable 1,416,163

Discount on Notes Receivable 516,163
Sales Revenue 900,000
The related entry to record the cost of goods sold is as follows.
July 1, 2017
Cost of Goods Sold 590,000
Inventory 590,000
SEK makes the following entry to record (accrue) interest revenue at the end of the
year.
December 31, 2017
Discount on Notes Receivable 54,000
Interest Revenue (12% × ½ × $900,000) 54,000

Noncash Consideration
Goods, services, or other noncash consideration.
 Companies sometimes receive contributions (e.g., donations and gifts).
 Customers sometimes contribute goods or services, such as equipment or
labor, as consideration for goods provided or services performed.
 Companies generally recognize revenue on the basis of the fair value of what
is received.
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Consideration Paid or Payable to Customers
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 May include discounts, volume rebates, coupons, free products, or services.
 In general, these elements reduce the consideration received and the
revenue to be recognized.
Example:
a.
Facts: Sansung Company offers its customers a 3% volume discount if they
purchase at least $2 million of its product during the calendar year. On March 31,
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2017, Sansung has made sales of $700,000 to Artic Co. In the previous 2 years,
Sansung sold over $3,000,000 to Artic in the period April 1 to December 31.
Assume that Sansung prepares financial statements quarterly.
Question: How much revenue should Sansung recognize for the first 3 months of
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2017?
Solution:
In this case, Sansung should reduce its revenue by $21,000 ($700,000 × 3%)
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because it is probable that it will provide this rebate. Revenue is therefore $679,000
($700,000 - $21,000). To not recognize this volume discount overstates Sansung’s
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revenue for the first 3 months of 2017. In other words, the appropriate revenue is
$679,000, not $700,000.
Given these facts, Sansung makes the following entry on March 31, 2017, to
recognize revenue.
Sales Revenue 679,000
Assuming that Sansung’s customer meets the discount threshold, Sansung makes
the following entry to record collection of accounts receivable.
Cash 679,000

If Sansung’s customer fails to meet the discount threshold, Sansung makes the
following entry to record collection of accounts receivable.
Cash 700,000
Sales Discounts Forfeited 21,000
Sales Discounts Forfeited is reported in the “Other revenues and gains” section of
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the income statement.
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4) Allocate the transaction price to the separate performance obligations in the
contract.
After the contract has been identified and the performance obligations and amount
of consideration have been determined, the company must allocate the transaction
a.
price to the individual performance obligations if the contract contains more than
one performance obligation.
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The allocation is based on the fair value of each performance obligation, and the
best indicator of the fair value of each performance obligation is its standalone
selling price. Therefore, the company shall allocate the transaction price to each
performance obligation identified in the contract by determining the standalone
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price for each individual performance obligation and then allocating the contract
price over those obligations based on the relative standalone price of each
component.
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If a discount is offered to the customer, for example when a bundle of goods or

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services is sold at a lower price than the total price of the individual items in the
bundle, the discount should be allocated proportionally based on the relative
standalone selling prices of the individual goods or services in the bundle.
If, during the performance of the contract, the price of the contract changes, the
change in the price should be allocated to the individual components on the same
basis as the contract price was originally allocated, even if standalone selling prices
of one or more of the performance obligations have changed.
Example:
Facts: Lonnie Company enters into a contract to build, run, and maintain a highly
complex piece of electronic equipment for a period of 5 years, commencing upon
delivery of the equipment. There is a fixed fee for each of the build, run, and

maintenance deliverables, and any progress payments made are nonrefundable. It

is determined that the transaction price must be allocated to the three
performance obligations: building, running, and maintaining the equipment. There
is verifiable evidence of the selling price for the building and maintenance but not
for running the equipment.
Question: What procedure should Lonnie Company use to allocate the transaction
price to the three performance obligations?
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Solution:
The performance obligations relate to building the equipment, running the
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equipment, and maintaining the equipment. As indicated, Lonnie can determine
verifiable standalone selling prices for the equipment and the maintenance
agreements. The company then can make a best estimate of the selling price for
running the equipment, using the adjusted market assessment approach or
a.
expected cost plus a margin approach. Lonnie next applies the proportional
standalone selling price method at the inception of the transaction to determine
the proper allocation to each performance obligation.

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Once the allocation is performed, Lonnie recognizes revenue independently for
each performance obligation using regular revenue recognition criteria.
If, on the other hand, Lonnie is unable to estimate the standalone selling price for
running the equipment because such an estimate is highly variable or uncertain,
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Lonnie may use a residual approach.

In this case, Lonnie uses the standalone selling prices of the equipment and
maintenance agreements and subtracts these prices from the total transaction
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price to arrive at a residual value for running the equipment.

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5) Recognize revenue when or as each performance obligation is satisfied.

A performance obligation is considered satisfied when the promised good or
service (that is, an asset) has been transferred to the customer. An asset is
transferred when or as the customer obtains control of the asset.
Company satisfies its performance obligation when the customer obtains control
of the good or service.
Change in Control Indicators

1. Company has a right to payment for asset.
2. Company has transferred legal title to asset.
3. Company has transferred physical possession of asset.
4. Customer has significant risks and rewards of ownership.

5. Customer has accepted the asset.
Recognizing revenue from a performance obligation over time

Measure progress toward completion
 Method for measuring progress should depict transfer of control from
company to customer.
 Objective of methods is to measure extent of progress in terms of costs,
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units, or value added.
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Example:
Facts: Gomez Software Company enters into a contract with Hurly Company to
develop and install customer relationship management (CRM) software. Progress
payments are made upon completion of each stage of the contract. If the contract
a.
is terminated, then the partly completed CRM software passes to Hurly Company.
Gomez Software is prohibited from redirecting the software to another customer.
Question: At what point should Gomez Software Company recognize revenue
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related to its contract with Hurly Company?
Solution:
Gomez Software does not create an asset with an alternative use because it is
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prohibited from redirecting the software to another customer. In addition, Gomez

Software is entitled to payments for performance to date and expects to complete
the project. Therefore, Gomez Software concludes that the contract meets the
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criteria for recognizing revenue over time.

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Step in Process Description Implementation

1) Identify the A contract is an A company applies the revenue guidance to
Contract with a agreement that creates contracts with customers.
customer. enforceable rights or
obligations.
2) Identify the A performance obligation A contract may be comprised of multiple
separate is a promise in a contract performance obligations.
Performance to provide a product or Accounting is based on evaluation of
obligations in the service to a customer. whether the product or service is distinct
contract. A performance obligation within the contract.
exists if the customer can If each of the goods or services is distinct, but
benefit from the good or is interdependent and interrelated, these
service on its own or goods and services are combined and

together with other reported as one performance obligation.
readily available
resources.
3) Determine the Transaction price is the
In determining the transaction price,
Transaction price. amount of considerationcompanies must consider the following
that a company expects to
factors:
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receive from a customer 1. variable consideration,
in exchange for 2. time value of money,
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transferring goods and 3. noncash consideration, and
services. 4. consideration paid or payable to
customer.
4) Allocate the If more than one The best measure of fair value is what the
transaction price to performance obligation
the separate
performance
exists, allocate the
a.
good service could be sold for on a
standalone basis (standalone selling price).
transaction price based on Estimates of standalone selling price can be
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obligations in the relative fair values. based on
contract. 1. adjusted market assessment,
2. expected cost plus a margin approach,
or
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3. a residual approach.
5) Recognize A company satisfies its Companies satisfy performance obligations
revenue when or as performance obligation either at a point in time or over a period of
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each performance when the customer time. Companies recognize revenue over a
obligation is obtains control of the period of time if one of following criteria are
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satisfied. good or service. met:

1. the customer receives and consumes
the benefits as the seller performs,
2. the customer controls the asset as it is
created,
3. the company does not have an
alternative use for the asset.

b. Special Revenue Recognition Issues

Several special situations are covered by ASC 606. The situations covered that are
relevant for the CMA Exam are:
A. Contract with a Right of Return
B. Consigned Goods
C. Long-term Contracts
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A. Contract with a Right of Return
The company should recognize revenue from the contract at the amount it expects
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to be entitled to receive, which is the revenue only for goods or services not
expected to be returned and refunded.
Rather than adjusting the journal entries recording sales revenue, accounts
a.
receivable, cost of goods sold, and inventory for each individual sale, companies
usually record revenue and accounts receivable for such sales at their gross
amounts and record returns when they occur without reference to any
adjustments. At the end of each reporting period, they analyze the accounts and
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record adjusting entries to reflect estimated returns and allowances. At the end of
the next reporting period, they reverse the previous adjusting entries and
recalculate and record the needed adjusting entries for that reporting period.
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B. Consigned Goods
Consignment involves an entity shipping goods to a distributor while retaining
control of the goods until a predetermined event occurs. Because control has not
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passed to the consignee, the consignor does not recognize revenue upon shipment
or delivery to the consignee. The consignor recognizes revenue only when control
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transfers. Usually the transfer of control occurs and thus the revenue is recognized
when the goods are sold to the final customer.
The two main points in respect to revenue recognition and consigned goods are:
1) The consignor recognizes revenue for the entire selling price for which the
consignee sells the goods, even if some of it is paid to the consignee as a
commission.
2) The consignee recognizes as revenue any commission that it is entitled to receive
only when the goods are sold. The commission will be treated as a selling expense
by the consignor.

Following are the journal entries that both the consignor and consignee will record
in respect to the consigned goods.
Accounting by the Consignor

When the goods are sent to the consignee the consignor makes the following entry:
Dr Goods out on consignment XX original cost (inventory account)
Cr Inventory XX original cost
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Freight costs paid by the consignor to transfer the goods to the consignee are
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inventoriable costs. The entry to record the shipping charges is:
Dr Goods out on consignment XX freight cost (inventory account)
Cr Cash XX freight cost
a.
The next entry the consignor makes will be made after a good is sold and the cash
is received from the consignee. At this point, the consignor needs to make the
following entry:
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Dr Cash XX cash received (expenses not reduction
Dr Commission expense (if applicable) XX commission from revenue)
Dr Cost of goods sold XX inventory cost
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Cr Revenue from consignment sales XX the selling price

Cr Goods out on consignment XX inventory cost
Note that the revenue and cost of goods sold are recognized only after the item
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has been sold to the final customer.

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Accounting by the Consignee

The consignee makes entries only when it sells some of the product held on
consignment.
Dr Cash XX total received

Cr Payable to consignor XX to be remitted to consignor
Cr Commission revenue XX commission entitled to
When the amount due to the consignor is paid, the payable is reduced.
Dr Payable to consignor XX remitted to consignor

Cr Cash XX remitted to consignor

C. Accounting for Long-Term Contracts

Some contracts include performance obligations that require a period of time to
satisfy. as the customer obtains control of the asset. In some cases, the customer
obtains control of the asset at a point in time, usually when all the performance
obligations in the contract have been satisfied, even though the contract requires
time to perform. In other cases, the customer obtains control over time, as the
performance obligations in the contract are being satisfied.
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The most common situation for long-term contracts is construction contracts such
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as airliners and space exploration equipment, or contracts for a group of assets
such as office furniture to be delivered over a period of time.
Recall that according to Topic 606, a company satisfies a performance obligation
a.
over time and recognizes the revenue (and costs) over time if at least one of the
following three criteria is met:
1) The customer simultaneously receives and consumes the benefits provided by

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the company’s performance as the company is performing its obligations under the
contract.
Example: An annual contract to provide a service such as office cleaning or
grounds maintenance. If the benefits of the contract are transferred to the
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customer on a straight-line basis throughout the contract, the customer is invoiced

periodically, and the revenue is recognized as the invoices are issued, usually
monthly. Costs are recognized as they are incurred.
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2) The company’s performance creates or enhances an asset such as work in

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process that the customer controls as the work is being done.

Example: A contract to build a structure on land the customer already owns.
Invoices for progress payments are usually issued to the customer, but the amounts
of the progress billings do not necessarily represent the progress toward
satisfaction of the performance obligations in the contract.
3) The company’s performance does not create an asset with an alternative use to
the company, and the company has an enforceable right to payment for
performance completed to date.
Example: Any asset manufactured or built to the customer’s specifications
that could not be sold to another customer without significant loss to the company
if the customer terminates the contract prior to its completion for any reason other
than the failure of the company to perform.

In situations 2) and 3) above, the accounting is done in a manner similar to what

was called the percentage-of-completion method in legacy GAAP, although that
term is not used in ASC 606. The term is now “over time.”
Note: There are important differences between over-time revenue and profit
recognized on a long-term contract and the legacy percentage-of-completion
method. For example, a contract might be 50% complete as to costs but less than
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50% complete with respect to the elements in the contract to be satisfied. Since
ASC 606 is principles-based rather than rules-based, it may not be appropriate to
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record 50% of the contract revenue as would typically be done under use of the
percentage-of-completion method in legacy GAAP. Management judgment is
necessary.
a.
If the long-term contract does not meet any one of the three criteria for recognizing
revenue over time, the company recognizes revenue and gross profit only when
the performance obligation in the contract have been satisfied and the customer
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has obtained control of the asset, in other words, at a point in time. The accounting
is similar what was formerly called the completed contract method, though again,
that term is not used in ASC 606. The term is now “point in time.”
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Point-in-Time Recognition
When a long-term contract does not meet any of the criteria for over-time
recognition, the contract is recognized on the company’s balance sheet as it is being
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satisfied, but the revenue, cost, and gross profit are recognized at a point in time—
when the customer has obtained control of the asset. The amount of gross profit
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recognized when the customer obtains control of the asset equals the difference
between the contract price (the revenue) and the total cost to complete the
project.
However, if a loss is projected on the contract at any point as it is being satisfied,
that loss must be recognized in full immediately.
Recognition of Losses
At the end of each reporting period, the company determines the final estimated
gross profit or loss on the contract as follows:
Contract price
- Costs actually incurred to date
- Costs estimated to be incurred in the future
= Estimated profit (loss) on the project .

If the cost and gross profit estimates made at the end of the reporting period
indicate that a loss on the entire contract will result, the company must recognize
the entire estimated contract loss in the current period.
Recognizing the Incurrence of Contract Costs

The costs of construction incurred during the work-in-process period are debited
as they are incurred to a contract assets account, construction in process (CIP). The
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CIP account is used whether the costs are paid for in cash, on account, as accrued
wages, or other types of costs.
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Dr Construction in process (CIP) XXX
Cr Cash (or accounts payable or accrued wages) XXX
a.
The CIP account is a temporary “holding” account.
Note: For a given contract, the CIP asset account may be a current asset or a non-
current asset, or both, depending on the facts and circumstances of the contract
with the customer.
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Recognizing Invoice Issuance
Invoices are generally sent periodically to the client as work progresses on the
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contract because progress payments are usually required even though the revenue
will not be recognized until the point in time when the customer obtains control of
the asset. The journal entry to record an invoice issued is:
Dr Accounts receivable XXX
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Cr Billings on construction in process (BCP) XXX

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The BCP account is not a revenue account because revenue is not recognized when
invoices are issued.
Rather, the BCP account is a contract liability account because once an invoice is
issued and the client pays the invoice, the company constructing the asset owes
the customer a building or whatever is being constructed. The BCP account may
also be a contra-asset to the CIP account in the general ledger.
Reporting a Point-in-Time Contract on the Balance Sheet

Even though no revenue or gross profit will be recognized until the customer
obtains control of the asset, the point-in-time contract must be recognized on the
balance sheet to the extent that it represents a net contract asset or a net contract
liability.

• If CIP > BCP, the difference is reported as a contract asset. The line item used is
called costs of in-process point-in-time contracts in excess of related billings or
something similar.
• If CIP < BCP the difference is reported as a contract liability. The line item used is
called billings on in-process point-in-time contracts in excess of related costs or
something similar.
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Recognizing an Estimated Loss
When an estimated loss on a point-in-time contract as a whole is anticipated, the
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amount of the estimated loss must be recognized immediately. Recognizing the
estimated loss is relatively straightforward because no revenue, expense, or gross
profit will have yet been recognized on the contract.
The journal entry to record the estimated loss is:
a.
Dr Loss on long-term contract (income statement)
Cr Construction in process (reduces the asset)
XXX amount of loss
XXX amount of loss
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In subsequent periods, losses on the point-in-time contract will be recognized only
to the extent that the total estimated loss on the contract exceeds losses that have
been previously recognized on the contract.
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Closing Out a Point-in-Time Contract

When the performance obligations in the contract have been satisfied and the
customer has obtained control of the asset, contract revenue is recognized by
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closing out the billings on construction in process (BCP) liability account to revenue
on point-in-time contracts, and contract expense is recognized by closing out the
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construction in process (CIP) asset account to construction expense, as follows:

Dr Billings on construction in Process (BCP) XXX total billings
Cr Revenue on point-in-time contracts XXX total billings
Dr Construction expense XXX total construction costs

Cr Construction in process (CIP) XXX T. construction costs

Over-Time Recognition
When a contract meets any one of the three criteria for recognizing revenue over
time, the contract revenue, cost of sales, and gross profit are recognized as the
company makes progress toward satisfaction of its performance obligations on
the project.
If the contract is a service contract with revenue recognized on a generally straight-
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line basis and costs expensed as incurred, it is simple to account for. Invoices are
issued periodically throughout the term of the contract as the service is provided
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and revenue is recognized as the invoices are issued.
However, if the progress toward full satisfaction of the performance obligations
depends on construction progress, for instance on a building constructed on land
owned by the client, the accounting is more complex.
a.
The construction in process (CIP) contract asset account is used to accumulate costs
and the billings on construction in process (BCP) contract liability account is used
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for invoices, similar to the on point-in-time contracts. However, revenue, costs, and
gross profit are also recognized on the income statement as the contract
progresses. In addition, the amount of gross profit recognized each period is
debited to the construction in process (CIP) asset account along with the
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construction costs incurred, thereby increasing it.
In order to make this recognition, three calculations must be made at the end of
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each period:
1) The amount of the total estimated gross profit on the whole contract as of the
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reporting date.
2) What percentage of the performance obligation has been satisfied.
3) How much revenue, cost, and gross profit on the contract should be recognized
in the currents period.
1) Calculation of Estimated Gross Profit

The first calculation is to determine the estimated gross profit on the contract as
a whole as of the reporting date.
Contract price
- Costs actually incurred to date
- Estimated costs to be incurred in the future
= Estimated gross profit (loss) .

The estimated gross profit (loss) is the amount of gross profit or loss the company
expects from the entire contract as of the reporting date. However, because the
performance obligation in the contract is not yet completely satisfied, the entire
amount of the estimated gross profit should not be recognized in the current
period, nor should the percentage of the estimated gross profit represented by the
percentage satisfied be recognized in the current period, if some has already been
recognized. The amount to recognize in the current period is determined by the
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percentage of the performance obligation that has been satisfied less any amounts
recognized during previous periods.
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2) Calculation of the Progress Toward Satisfaction of the Performance Obligation
The second calculation measures the extent of the entity’s progress as of the
reporting date toward complete satisfaction of the performance obligation in the
contract.
a.
Methods that can be used to determine the extent of this progress include output
measures and input measures. The best method to use depends on the
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circumstances and choosing the most appropriate method requires judgment.
• Output measures recognize revenue on the basis of direct measurements of the
value to the customer of the goods or services transferred to the customer to date,
relative to the remaining goods or services promised. Examples are surveys of
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performance to date, milestones reached, and appraisals of results achieved such

as number of units produced or delivered. When the contract is for a long-term
construction project, an engineering estimation or other method may be used to
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make the determination.

• Input measures measure the efforts or inputs expended—for example,
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resources consumed, costs incurred, labor hours expended, time elapsed, or

machine hours used—toward satisfying a performance obligation relative to the
remaining goods or services promised under the contract.
Note: The cost-to-cost method as presented in the following pages is an example

of an input method and exemplifies the basic calculations only. If an output
measure is used, the calculations would be based on the output measure instead.
The Cost-to-Cost Input Method

When the cost-to-cost method is used to determine the extent of a company’s
progress toward complete satisfaction of a contract, the percentage satisfied is the
ratio between the actual cost incurred to date on the contract and the total cost

estimated for the contract. The total cost estimated for the contract is the actual
cost incurred to date plus the estimated cost to complete as of the reporting date.
The calculation for the percentage satisfied using the cost-to-cost method is as
follows:
Cost Incurred to Date (including prior periods)
Percentage satisfied = ‫ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ‬
Cost Incurred to Date + Estimated Cost to Complete
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the total estimated cost for the contract as of that date.
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an exam question might simply give the total estimated cost for the contract as of
the relevant date. If so, no calculation of the denominator of the formula will be
required.
3) Calculation of the Gross Profit to Recognize This Period

Using the estimated gross profit calculated in Step 1 and the percentage satisfied
calculated in Step 2, the company can now calculate the amount of gross profit that a.
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should be recognized in total to date. The formula is:
Estimated Gross Profit

× Percentage Satisfied .
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= Total Gross Profit to be Recognized to Date
The “total gross profit to be recognized to date” is the amount of gross profit the
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company should have recognized in all periods that the contract has been in
process. In order to determine the amount of profit to recognize in this period, the
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company subtracts gross profit previously recognized from the total gross profit to
be recognized to date, as follows.
Total Gross Profit to be Recognized to Date

- Profit Previously Recognized .
= Gross Profit to Recognize This Period

All of the preceding calculations and formulas can be combined into one formula
for the calculation of gross profit to recognize in the current period under the cost-
to-cost method, as follows:
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In a situation where the level of estimated profit falls from one period to the next,
it is possible that the above formula will result in a negative number. This negative
number is the loss that the company needs to recognize in the current period. If
the contract in total is not expected to result in a loss, however, the loss in the
a.
current period does not eliminate all profit recognized to date on the contract. The
contract as a whole can remain profitable, even when there is a loss in the current
period. If the contract remains profitable, by recording a loss in the current period
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the company is simply “de-recognizing” some of the profit that was recognized in
a previous period or periods.
Recognition of Losses
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At any point during the contract’s fulfillment, the company may estimate that the
entire contract will result in a loss by its completion because costs on the whole
contract will be greater than revenue from the whole contract. Any estimated loss
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on an entire project is recognized in full in the period when it becomes apparent

that there will be a loss.
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Can still use the formula that is given above for the profit (or rather, loss) to
recognize in the current period, as long as they remember that if a loss is estimated
for the contract as a whole, it is as if the performance obligations in the contract
are 100% satisfied.
The actual calculation of the loss to recognize this period will be
Total Estimated Loss - Profit Previously Recognized = Loss to Recognize This Period
For example, if the total estimated loss from the contract (Contract Price -
Estimated Total Cost) is $(100,000) and $150,000 of gross profit has been
previously recognized, the loss to recognize this period is
$(100,000) - $150,000 = $(250,000)

The above formula works as long as the negative numbers are used correctly in the
calculation. The same loss amount can be calculated more simply without using
negative numbers, as follows:
Total Estimated Loss + Profit Previously Recognized = Loss to Recognize This Period
Using the same example, the loss to recognize is

$100,000 + $150,000 = $250,000
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Note: If in the early years of an over-time contract it is estimated that there will be
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a profit, a percentage of that profit will have been recognized previously. If,
however, in later years the amount of estimated profit decreases or becomes an
estimated loss, previously-recognized profit will need to be de-recognized. The
company does this by recognizing a large loss in the period when the estimated loss
becomes known.
Recording Losses on Over-Time Contracts a.

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When a company realizes that an over-time contract will produce an overall loss,
the amount of the estimated loss must be recognized immediately in the period in
which it arises, just as it is for a point-in-time contract.
However, because gross profit may have already been recognized on the contract
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in previous periods, the journal entry is different from the journal entry used to
recognize an estimated loss on a point-in-time contract because for a point-in-time
contract, no profit will have been previously recognized. When an overtime
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contract as a whole is estimated to be ultimately unprofitable, not only does the

ultimate loss (the total estimated loss for the whole contract) need to be
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recognized immediately, but any previously-recognized gross profit on the

contract needs to be reversed, as well. Therefore, if the company has recognized
any gross profit during the contract’s earlier periods, the amount of the loss to
recognize in the period when the estimated loss arises will be larger than the
estimated loss on the whole contract because the company needs to de-recognize
all of the profit recognized earlier and then recognize the total estimated loss.
Reporting Over-Time Contracts on the Balance Sheet

Just as is done for point-in-time contracts, an over-time contract must be
recognized on the balance sheet to the extent that it represents a net contract asset
or a net contract liability.
The contract asset is the CIP account and the contract liability is the BCP account.
The difference between the construction in process (CIP) and the billings on

construction in process (BCP) accounts is reported on the balance sheet as either a

contract asset or a contract liability. Thus, the BCP liability account is netted
together with the CIP asset account for presentation on the balance sheet.
• If CIP > BCP, the difference is reported as a contract asset. The line item used will
be called costs and estimated earnings of in-process over-time contracts in excess
of related billings or something similar.
• If CIP < BCP the difference is reported as a contract liability. The line item used
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will be called billings on in-process over-time contracts in excess of related costs
and estimated earnings or something similar.
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Note: If a company has several projects in process at the same time, costs will
exceed billings on some contracts and billings will exceed costs on other contracts.
The company should segregate the contracts on the balance sheet according to
a.
whether each individual contract is a net asset or a net liability. The asset side of
the balance sheet should include only contracts on which the CIP asset is greater
than the BCP liability, and the liability side should include only contracts on which
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the BCP liability is greater than the CIP asset.
Disclosures for Revenue Recognition

According to ASC 606-10-50-1, disclosures about revenue recognition should
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provide sufficient information to enable users of the financial statements to

understand the nature, amount, timing, and uncertainty of revenue and cash flows
arising from contracts with customers. To achieve that objective, quantitative and
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qualitative information should be disclosed. For example:

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The company is required to provide information about:

1) Revenue recognized from contracts with customers, including the disaggregation
of revenue into appropriate categories, presentation of opening and closing
balances in contract assets and contract liabilities, and significant information
related to performance obligations in the contracts.
2) The significant judgments made and changes in the judgments made in applying
the guidance in ASC 606 to contracts, including judgments that affect the
determination of the transaction price, the allocation of the transaction price, and
the determination of the timing of the revenue.
3) Any assets recognized from the costs to obtain or fulfill a contract with a
customer, including the closing balances of assets recognized to obtain or fulfill a
contract, the amount of amortization recognized, and the method used for
amortization.

6. Major Differences Between US GAAP & IFRS

Because differences and differences between GAAP and IFRS are vast amount of
information, I will copy here the related part from the LOS and go through them
only in a way that matches the LOS, for exam purposes, ignoring (II) expense
recognition with respect to share-based payments and employee benefits.
U.S. GAAP: Generally Accepted Accounting Principles
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Financial Accounting Standards Board (FASB).
IFRS: International Financial Reporting Standards
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International Accounting Standards Board (IASB).

Intangible assets, with respect to development costs and revaluation
a.
GAAP IFRS
Developme Generally, development costs Development costs are capitalized
nt costs are expensed as incurred. as an intangible asset item if the
(may be capitalized only if a specific entity can demonstrate the
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U.S. GAAP standard allows
capitalization for that asset) technical feasibility of completion
of the asset.
Revaluation Revaluation is not permitted. Revaluation to fair value of

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intangible assets other than

goodwill is a permitted accounting
policy, for a class of intangible
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assets. can be applied only if the

intangible asset is traded in an
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active market.
Reversal of prohibits any reversal of write- a previously recognized
loss down. impairment loss on an intangible
asset may be reversed if the
estimates of the recoverable
amount have changed.
Inventories: with respect to costing methods, valuation and write-downs (e.g.,

LIFO)
GAAP IFRS
Costing LIFO is an acceptable method. LIFO is prohibited.
methods

Measurem In U.S. GAAP, inventories Inventory is measured (carried) at

ent measured using any method the lower of cost or net realizable
other than LIFO or the retail value.
method should also be No calculation of market value
measured at the lower of cost or
net realizable value. (similar to
IFRS)
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However, in U.S. GAAP,
inventory valued using LIFO or
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the Retail Method is valued at
the lower of cost or market
value (different to IFRS)
Reversal of prohibits any reversal of write-

inventory
write-
down. a. previous write-downs of inventory
may be recovered up to the
original cost of the inventory.
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downs Gains cannot be recognized on
appreciated inventory, but
previous losses can be reversed
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Leases, with respect to leases of land and buildings

GAAP IFRS
Finance classify leases as either finance no formal classification between
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lease and leases or operating leases finance leases and operating leases
operating
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lease there are different treatments almost all leases are accounted for
for finance lease and operating as finance leases with a separate
lease expense for interest and
amortization expense
short term leases are accounted there are short term leases and
for as direct expenses leases for which the underlying
asset is of low value maybe
accounted for as an operating lease
under IFRS the right of use asset can

be revaluated during the term of

the right of use asset is measured the lease (as for fixed assets in
at a historical cost and general)
revaluation is not permitted
Fixed Assets (long lived assets): with respect to revaluation, depreciation, and
capitalization of borrowing costs
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GAAP IFRS
Revaluation Revaluation Revaluation is a permitted (which means increase
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of assets not the value of the fixed asset according to the new
permitted. fair market value) accounting policy election for
two conditions 1- an entire class (grouping of assets
a.
of similar nature and use)
2- requiring revaluation to fair value on a regular
basis.
The increase in the value is recognized in Other
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Comprehensive Income and carried in the equity
section of the balance sheet as a Revaluation
Surplus.
Component component if individual components of a large fixed asset have
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depreciation depreciation different usage patterns and useful lives, then the
is allowed but individual components should be depreciated
not required. separately. For example, if the engine on a machine
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has a 5-year life while the rest of the machine has a

15-year life, the engine must be depreciated over 5
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years and the remaining cost of the machine must

be depreciated over 15 years
Impairment of assets, with respect to determination, calculation and reversal of

loss
GAAP IFRS
calculation The amount by which the The impairment process is a one-
carrying amount of the asset step process. The carrying value of
exceeds its fair value (carrying the asset is compared to the
amount of the asset is compared recoverable amount. The
with the sum of future recoverable amount is the higher
undiscounted cash flows of 1) the fair value of the asset, if

generated through use and sold, minus any costs of sale, or 2)

eventual disposition) the Discounted future cash flows it
will generate
Reversal of Prohibited. No reversal after If the revaluation is the recovery of
loss impairment made a previously recognized loss when
the asset was impaired, the
revaluation gain is reported on the
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income statement (notice the
increase for reevaluation goes to
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OCI)
Notice from last to points for IFRS:
Re-evaluation gains happen first to an asset, so gains go to OCI, if subsequent
impairment so losses goes to OCI also.
a.
While if impairment first so losses go to income statement, then if subsequent
re-evaluation gain after impairment it will go to income statement.
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a.
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Section B) Planning, Budgeting and Forecasting … 20%

Unit 3. Strategic planning and forecasting techniques
Subunits:
1) Strategic planning
2) Forecasting techniques
Correlation and regression
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Learning curves analysis
Expected Value
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1. Strategic Planning:
a.
Strategic Management sets overall objectives for an entity and guides the process
of reaching those objectives. It is the responsibility of upper management.
Strategic planning is the design and implementation of the specific steps and
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processes necessary to reach the overall objectives, strategic management and
strategic planning are closely related (interrelated) and are a long-term planning.
Strategy:
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Strategy is the formulation (selecting strategies) and implementation (action the

selected strategies) of a set of actions that are taken by company’s managers in
order to increase its performance.
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Strategic planning Competitive advantage Ultimate goal

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The strategies that That can set the To increase profitability

management is selecting company apart from its and sustain profit growth
to create activities competitors
To attain this ultimate goal management should prepare
Business model
Management’s plan of how to fit both the selected set of strategies with the
company’s capital investments

Types of plans:
Effective plans should be coordinated within the company’s units and departments,
so they are in alignment with the company’s larger goals, to avoid the cross-
purposes between the different units and divisions, therefore all plans within the
company should be matching the company’s final main goal.
Concept:
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Top Management Lower level management
Long time frame Shorter time frame
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Less details More details
Less numbers More numbers
Strategic directional role Detailed operational role
1) Strategic plans (long-term plans):
a.
They are broad and general plans that usually cover five years or longer (long term
plans), and are based on the organization’s objectives, strategic plans are led by the
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company’s top management.
Strategic planning is considering the strategies, objectives and goals of the

company, and are not going through the details of specific financial targets, so it is
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said that strategic plans are not detailed nor focused, so strategic plans are
directional instead of operational, which means that company is considered (in
strategic planning in where it wants to go) instead of how to get there.
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In strategic planning management should consider both internal and external

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factors when making strategic planning decisions, internal factors such as current
resources, current products, corporate’s goals and objectives, technology
investments and anything that is in a direct control of the company, including
company’s capacity and capital resources
1- Capacity is the ability of the company to produce its products or services
2- Capital resources are the company’s fixed assets, in the long term
External factors that are also considered when making strategies decisions, are
such as economy, labor market, domestic and international competition,
environment, industry, political risks and all factors that are out of company’s
control, when company’s management consider such factors, they can then decide
a long term plan that would affect the company’s long term future such as dropping

or adding product or product lines or making long term capital investments or

reducing capacity or capital resources, etc.
2) Intermediate and short-term plans:
Intermediate (tactical plans) Short term operational plans

Day-to-day operations
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Period One to five years Up to one year
Developed upper and middle management Middle and lower level
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by managers
Focused on Implementing specific parts of Implementing the tactical plans
strategic plans to achieve operational goals
a.
Operational plans are the primary basis of the budget amounts since budget is
usually prepared for one year (except for capital expenditures budget).
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Other types of plans:
1. Single purpose plan: are developed for a specific purpose / item
2. Standing plans: Intermediate and operational plans are translated into

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policies, procedures, and rules, which are standing plans for repetitive
situations.
1) Policies are general statements that guide thinking and action in decision
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making
2) Procedures are specific directives that define how work is to be done.
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3) Rules are specific, detailed guides that restrict behavior.
3. Contingency plans: (What If? plans) are developed to prepare for possible
future events mostly negative ones, mainly planning to consider external
factors, considering that external factors are beyond the company’s control,
contingency plans could help company to respond quickly and in best
possible manner towards those negative expected events.

Read
Management by Objectives (MBO) G not in H
It is a comprehensive management approach and therefore is relevant to planning
and control.
MBO requires
1) Senior management participation and commitment to the program. These
managers must
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a) Determine the overall direction and objectives for the organization
b) Communicate these effectively in operational or measurable terms
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c) Coordinate subordinates’ objectives with overall objectives
d) Follow up at the end of the MBO cycle period to reward performance and
review problems
2) Integration of objectives for all subunits into a compatible, balanced system
a.
directed toward accomplishment of the overall objectives.
3) Provisions for regular periodic reporting of performance toward attainment of
the objectives.
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4) Free and honest communication between supervisor and subordinate.
5) A commitment to taking the ideas of subordinates seriously on the part of
supervisors.
6) An organizational climate that encourages mutual trust and respect.
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Steps necessary to implement an MBO program include establishing objectives and

action plans (the planning steps) and periodic review and final appraisal (the
control steps).
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Steps in the Strategic Planning Process:

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1) Identifying and specifying the company’s mission, vision, values, and goals.
2) Analyzing the organization’s external competitive advantages in order to identify
opportunities and threats.
3) Analyzing the internal operational environment to identify strengths,
weaknesses and limitations of the organization.
(Both points are referring to SWOT analysis which is abbreviation of strengths and
weaknesses identified by analyzing internal factors, and opportunities and threats
that are identified by analyzing external factors)
4) Formulating and selecting strategies that are consistent with the organization’s
mission and goals identified in the first point, considering optimizing the
organization’s strengths and correct its weaknesses and limitations for the purpose
of taking advantage of external opportunities while countering external threats
(SWOT analysis).

5) Developing and implementing the chosen strategies.
Strategic management
Mission, SWOT analysis Formulating Implementing controls
vision, values Strategy strategy
and goals
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Feedback
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Mentioned earlier that Strategic plans are translated into measurable and
achievable intermediate and operational plans. Thus, intermediate and operational
plans must be consistent with, and contribute to achieving, strategic objectives.
a.
1) Identifying and specifying the company’s mission, vision, values, and goals:
The mission statement includes four components:
1) Mission statement itself which is the “reason to be.”:
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The mission statement summarizes the entity’s reason for existing, and it
should be customer-centered rather than product-centered, so company’s
mission could be we are existing to satisfy our customers’ needs instead of
we are existing to sell X product, the company’s mission statement should
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be very broad to be flexible and easily adapted to changing conditions. For

example, a tourist company’s mission should be (we are here to make your
trips joyful and adventures) instead of we are selling trips to Europe or Africa
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for example, or our mission is to service largest numbers of tourists and so,
also the mission of Starbucks Coffee as an example “to inspire and nurture
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the human spirit – one person, one cup and one neighborhood at a time”,
which proves that effective mission statement consist of a single statement.

2) The vision, or a statement of a desired future state:

What the company is willing to become or achieve in the future and that
vision should be motivating for its employees and driving the strategies that
will be formulated
The difference between a company’s mission and its vision is that a company’s
mission is what it does, whereas its vision is what it wants to achieve (challenge the
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company’s ambitious future).
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a.

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AVON: To be the company that best understands and satisfies the product,
service and self-fulfillment needs of women-globally.
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Charles SCHWAB: Helping investors help themselves.
COLD STONE Creamery: The ultimate ice cream experience

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Disney: To make people happy
3) Statement of values (organizational culture):

It represents employees and managers behavior in doing business, so it is
setting the standards of how the company’s employees work to achieve the
company’s mission and goals, is not only what management say but also
what they do.
4) Statement of goals:
These are the future goals that company wants to achieve while goals are
more precise and measurable, they also should be clearly stated in specific
terms to avoid interpretation of the objectives or the employees, goals can
be very specific in such a way as our next goal is to achieve $ X of revenue or

reduce our expenses or debts by $X, goals also should be well connected to
employees, and to be motivating should be accepted as well by them.
The ultimate goal of any company is to maximize the shareholder’s value, by

continually and consistently increasing company’s profits (high profitability and
sustainable profit growth), which will increase owners’ return on investment, while
profitability will increase if management could achieve superior performance
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(ultimate objective) compared to the competitors performance, which is
considered to be a competitive advantage, accordingly we should understand that
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one of the main goals of management is attaining and maintaining short-term
profitability and long-term profit growth and management should find the balance
between both goals (good example required current spending to achieve future
growth).
a.
Shareholders’ return on investment is represented in capital appreciation of shares’
market value and received dividends
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2) Analyzing external factors: to identify company’s opportunities (use
advantage of external environment) and threats (external factors that considered
to be danger for the company’s profits)
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External environment can be categorized as follows:

a) Macroenvironmental factors (economic, demographic, political, legal, social,
cultural, and technical) and
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b) Microenvironment factors (suppliers, customers, distributors, competitors, and

other competitive factors in the industry).
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Companies could react to or get prepared for external factors but not change (no
control)
Michael Porter’s 5 forces model:
which can help managers analyze competitive forces in the environment to identify
opportunities and threats.
Note:
1. strength of 5 forces can change over time as conditions of the industry
changing
2. when a force is strong that represents pressure / limitation threat
it creates limitations on the company’s ability to raise prices and earn greater
profits
3. a weak competitive force allows the company to raise prices, and therefore
increasing profits, which is representing an opportunity.

It includes an analysis of five forces that are shaping competition within an industry:
1. The intensity of rivalry among established companies within an industry
2. The risk of entry by potential competitors
3. The bargaining power of buyers.
4. The bargaining power of suppliers.
5. The closeness of substitutes to an industry’s products.
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1. The intensity of rivalry among established companies within an industry
Rivalry is the competition among companies in an industry to gain market share
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from one another. Weapons in the competition include prices, product design,
promotional efforts, selling efforts, and service and support after the sale.
many strong intense rivalry lower price decrease profits.

competitors
a. & higher cost Threat
if rivalry is not intense, companies in the industry can raise their prices or reduce
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their costs, and industry profits will increase.
The height of exit barriers can influence the intensity of rivalry among established
companies within an industry.
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If exit barriers are high, companies may find themselves locked into an industry
with declining demand, causing excess capacity that leads to price wars. An
example of a high exit barrier is a large investment in assets that are specific to the
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industry. A company leaving an industry when the industry has overcapacity would
not be able to sell its assets or would have to sell them at a very low price resulting
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in a large loss.
High exit barriers price war & higher cost Losses threat
2. The risk of entry by potential competitors:

Potential competitors are companies not presently in an industry but that could
enter it. The height of barriers to entry, such as costs or regulatory requirements
that make it difficult for new companies to enter an industry, is a major
determinant of the risk of entry by potential competitors.
Entry barrier Risk Return
Risk of entry Risk ‫ ﺧﺪ ﺑﺎﻟﻚ ﻣﻦ اﻟﻔﺮق ﺑﻴﻨﻬﻢ‬Entry Barrier Risk

Economies of scale constitute a high entry barrier as well, since a new competitor
would not have the volume to enable it to compete profitably against the
established players in the industry.
3. The closeness of substitutes to an industry’s products:

The existence of close substitutes for an industry’s product is a threat because it
limits the prices that can be charged for the product. If a product has few or no
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close substitutes, then any company producing or selling it has the opportunity to
raise prices without fear that its customers will switch to a substitute.
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Higher cost
More substitutes lower price less profits more threat
Lower market share
4. The bargaining power of buyers.:
a.
If buyers such as large discount store chains have the ability to bargain down prices
or to demand better product quality and service that would increase
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manufacturers’ costs, an industry can become less profitable. Therefore, powerful
buyers are a threat.
Buyers require
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bargaining high quality Higher cost lower profit Threat

power lower price
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5. The bargaining power of suppliers:

Powerful suppliers are also a threat. If suppliers have the ability to raise the prices
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of inputs such as materials or direct labor (through labor unions, for instance) or to
lower quality, it will raise the costs of companies in the industry.
Powerful raised prices Higher cost lower profit Threat

suppliers. &/or lower quality

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a.
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3) Analyzing internal environment:

The purpose: is to identify strengths and weaknesses within the organization; that
will include assessing the company’s resources and capabilities (internal
environment).
What we can do better than competitors?! But
Competitive Advantage also, to create profit out of it
The primary objective of strategy is to create a sustained competitive advantage,
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because that will lead to superior profitability and profit growth.
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A firm creates competitive advantage when it is able to use its resources and its
capabilities to achieve either a differentiation advantage or a cost advantage (or
both) in order to create profits:
1) A differentiation advantage creates value for a firm’s customers because it
a.
provides their customers with benefits that exceed those provided by the firm’s
competitors, such as Apple
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2) A cost advantage creates the same value and benefits for the firm’s customers
as its competitors do but at a lower cost, also leading to greater profits than the
competition, such as IBM compared to Apple and its compatibles that sells lower
prices that apple but achieves a good market share.
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competitive advantage
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Differentiation advantage cost advantage

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Provide benefits that exceeds competitors provide same benefit at lower cost
Better Cheaper
How to achieve the competitive advantage?! using resources and capability to

employ them
1- Resources: (accounting assets and all other assets of the company)

Tangible resources intangible resources
Including employees, HR, knowledge, company’s assets, etc.
The more difficult a resource is to imitate or replace, the more valuable it is, for
example, if a company has a distinctive competency in a patented product and the
patent expires, the value of its distinctive competency will disappear. Or if a
superior technology comes along that replaces the company’s technology, then its

distinctive competency will become far less valuable such as Nokia and android
system.
2- Capabilities: how to use the resources in a productive beneficial way to

generate profits?
The company’s ability to coordinate its resources and to put them to productive
use, are the result of its organizational structure, processes, and control systems,
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so if the company has better capabilities to use and manage the same resources
that its competitor has so it may don’t need to have special resources, and that will
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represent a distinctive competency.
Four distinctive competencies factors that directly create competitive advantage,

they are called generic distinctive competences, because any company can apply
them:
1. Superior efficiency.
2. Superior quality. a.
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3. Superior innovation.
4. Superior customer responsiveness.
Efficiency: is the relationship between inputs and outputs, the fewer inputs used
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to produce a given output the process is said to be efficient, that will represent a
lower cost which will lead to higher profitability and competitive advantage.
Examples of efficiency components:
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1. Employee productivity which represented by the output per employee

2. Capital productivity is output per unit of invested capital
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Quality: a product has superior quality when customers consider higher utility
(benefit) than the competing products.
Quality indicators: product’s design, styling, features, functions, and the level of
service associated with the product.
Innovation: innovation considered to be one of the most important factors in

competition as it relates to providing something unique to the company, which will
be considered a unique competitive advantage (differentiation) that the
competitor doesn’t have, which will would lead to selling products at premium
prices, or process innovation that would lead to producing at a lower cost than
competitors which will lead in both ways to increased profitability

Innovation
New product New processes

Improve product how we do it?
Customer see this effect Cheaper
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Customer responsiveness: superior responsiveness to customers’ needs or the
time required to deliver a product or perform a service, is also an important aspect,
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whereas these factors differentiate the company from less responsive competitors,
build brand loyalty, and charge a premium price.
Identify customer needs (what they want?) and satisfy those needs (provide it to
them).
a.
To have a competitive advantage all previous 4 factors are around profitability,

which consists of the value customers place on its products, the product’s price and
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the costs of production, generally we want to have those 4 factors, grow them,
improve them over time and maintain them as long as we can, while we can’t
concentrate on one factor and ignore all others, we could concentrate more on
some important factor than others, but we can’t totally ignore all others, so finding
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a balance is a key of success in this case.
Read only to understand the concept of lowering cost

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Company can add value to customers by lowering its cost which will lower the price
and therefore add value to customers, or company could add value as mentioned
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before through superior design, performance, quality and service, a company has
a competitive advantage over its competition if it can create more value for its
customers than its competitors are able to, in order to achieve this company should
look closely through its value chain, which consists of all of its processes,
production, marketing, R&D, customer service, information systems, materials
management and human resources, to find out where it is possible to edit each
one’s role to lower the cost structure and/or creating competitive advantage
through other elements (quality, etc.)
The value chain

Analyzing Financial Performance:

Study and examine the financial reports and financial performance, to evaluate the
contribution of the applied strategies to the company’s profitability; that could be
done through benchmarking company’s current financial results against that of its
competitors as well as against its own historical financial performance from
previous periods.
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a.
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4) Formulating strategies:
Once the company’s external opportunities and threats and internal strengths and
weaknesses have been identified, the next step is to select or choose strategy for
the company, in order to optimize the organization’s strengths and correct its
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weaknesses, and in order to take advantage of external opportunities while

countering external threats, working towards the company’s mission statement.
The company’s management selects a set or group of strategies that will create and
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sustain a competitive advantage, the general classifications of strategies

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considered are:
• Functional-level strategy, to improve operations (effectiveness of operation)

inside the company, which includes areas such as manufacturing, marketing,
materials management, product development, and customer service.
• Business-level strategy, which includes the position of the business in the

marketplace as well as different positioning strategies that could be used,
such as
1. cost leadership: being the cheapest but not the lowest quality
2. focused cost leadership: the cheapest in a designated segment of the market
3. differentiation: being different and unique compared to competitors
4. focused differentiation: different in a designated segment of the market

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• Global strategy or considering how to expand operations outside the home
country, how to go multinational and stay multinational (means to deal with
a.
different cultures, expectations and different consumer tastes:
1. Global standardization: no product customization for different countries
(markets) which will lead to low-cost strategy on a global scale, such as
franchises, Starbucks Coffee utilizes a global brand approach by leveraging
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its global brand image
2. Localization: customized goods or services for each local national market, it
works if added value supports higher price, that’s why we are ready to
produce different goods, such as Domino’s Pizza and McDonalds with regard
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their menus.
3. Transnational: requirements for local responsiveness are high and cost
pressure is strong, because prices wouldn’t increase for special local
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requirements, which means you need to be local and low cost, and it is
difficult strategy to apply, such as Shell, Exxon Mobil, Toyota, Total, etc.
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4. International: when companies don’t have low cost pressure and don’t have
pressure to be locally responsiveness, that’s an ideal situation to produce
one global product and no significant competition, the main related risk
would be when local companies believe they could enter the market to
produce locally in lower cost Coca-Cola, Apple, IBM.
• Corporate-level strategy, involves long term prospective, managers need to

consider how current changes will affect the company’s strategy in the
future, changes in industry, in technology, in customer preferences, trying
to be a proactive to these changes instead of being reactive.

• External options used as strategies for growing companies:

1. Horizontal integration, merge with competitors
2. Vertical integration, merge with supplier
3. Strategic alliances, long-term cooperation
4. Diversification, new industries, considering the inherent risks to this strategy
The strategies answer such questions as:
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1) “Which lines of business will we be in?”
2) “How do we penetrate and compete in the international marketplace?”
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3) “How will this line of business reach its objectives that contribute to achievement
of the overall entity’s mission?”
4) “How do we perform each strategic business unit’s basic processes (materials
handling, assembly, shipping, human resources, customer relations, etc.) as
efficiently as possible?”
a.
We could select or choose different strategies and combine them together in order
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to make a suitable strategic plan that would make everyone works towards the
same direction.
5) Developing and implementing chosen strategies:

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The 5th and final step in strategic planning

Once a set of strategies has been chosen to achieve competitive advantage and
increase performance, the strategies must be actioned or implemented to achieve
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the company’s goals and execute its business model. Implementing the chosen
strategies involves every employee at every level of the entity. Incentive systems
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and employee performance evaluations must be designed so that they encourage

employees to focus their efforts on achieving the entity’s objectives, these are the
means the organization uses to motivate and coordinate its members to work
toward achieving competitive advantage through its distinctive competencies,
which are superior efficiency, superior quality, superior innovation and superior
responsiveness to customers.
Implementation involves considerations about organization design which includes

decisions related to three main point of views:
1. Organizational structure
2. Control systems
3. Corporate culture

Organizational Structure
Specify who should do what, how they should do it, and how to coordinate to
increase efficiency, quality, innovation and responsiveness to customers
The three decisions to be made about organizational structure are:
1- This involves decisions about how to organize the company structure with based
on tall structure hierarchy or short one, organized based on regions, products,
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locations or functions for example
2- allocation of who has responsibility and authority and to which level or extent
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3- increase coordination and integration of all the organization (people work in the
company) they should all work together towards the company’s goals, is the
organization big or small how it work centralized or decentralized.
Control Systems
a.
Strategic control systems are goal-setting, measurement and feedback systems in
order to monitor how well the firm is using its resources to build and perform its
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distinctive competencies and to create incentives to keep its employees focused on
coordination towards company’s main missions and goals, so as plans are executed
at each organizational level, strategic controls and feedback allow management to
determine the degree of progress toward the stated objectives.
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In other words, Provide managers with incentives to motivate employees and

provide feedback (information) to managers on how well the company and its
employees are succeeding in increasing competitive advantage, what’s going well
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or not going well, what needs to be improved, what are the results.
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Organizational Culture
Mainly created by the company’s founder and top management to influence the
values and norms that develop in an organization.
The organization’s norms, guidelines and expectations prescribe the appropriate
behavior by employees in particular situations. Such as, communicating almost
exclusively by email. They are acting as controls to influence the values and norms
that develop in an organization.
In other words, corporate culture includes all of the norms, values, beliefs and
attitudes that people in an organization share, who the organization would be if
the organization was a person? (H) the way we do things, and how we interact with
everyone else employees, suppliers, customers, etc.
While note that different industries and different entities have different types of
cultures (H)

All previous decisions will come down to:
Implementing strategy, which as very important step in strategic planning as

mentioned earlier, since a strategy that is not implemented does not help the
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organization at all and loses its importance and meaning
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Strategic Management Model ‫ﻟﻺﻃﻼع ﻓﻘﻂ‬
a.
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h am
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Other Planning Tools and Techniques

PEST Analysis
PEST analysis is a type of situation analysis. This analysis are used to examine the
impact of some factors on the business:
1) Political factors: external factors, such as trade regulations, wage legislation,
product labeling requirements, industrial health and safety regulations, etc.
2) Economic factors: such as exchange rates, inflation rates, interest rates and
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economic growth, etc.
3) Social factors: which refers to a culture in a country, population growth rate,
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attitudes of citizens towards specific products and services
4) Technological factors: new technology developments, the impact of these
developments on the company’s structured value chain, or the cost structure
Competitive Analysis
a.
It is similar to SWOT analysis in some ways. It involves analyzing the competitive
environment
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• Defining the competitors.
• Analyzing the competitors’ strengths and weaknesses.
• Analyzing the company’s own internal strengths and weaknesses.
• Analyzing customer needs and wants.
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• Studying barriers in the market for both the company and its competitors
Contingency Planning and Scenario Planning

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The widely used approach is called “Scenario Planning” for the kind of analysis that
are based on “what if” analysis, and one of its forms is the Contingency planning,
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which involves considering alternatives that enable an organization to respond

quickly to future events, usually preparing for unexpected negative events which
will make company react better in order to reduce the damage.
In other words, what could go wrong and make the plan of what we are going to
do if that happens, so it is to prepare for an event that hopefully never happens,
but if it does happen then we are ready and responsive and limit the damage

The BCG Growth-Share Matrix
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a.
It is meant to assist corporations in analyzing the life cycles of their product lines in
order to make better decisions about allocation of resources in planning.

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1) Stars: Product is selling in a high market share and a high growth rate, which
represents the best situation we could have, so we need to try and keep our
product life cycle stay in this position as much as we can, such an SBU is profitable
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but needs large amounts of cash for expansion, R&D, and meeting competitors’
attacks. Net cash flow (plus/minus) is modest (small).
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2) Cash cows represents a high market share and low growth rate, products
that are slowly continuously regularly generate cash, are strong competitors and
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cash generators, A cash cow ordinarily enjoys high profit margins and economies
of scale. Financing for expansion is not needed, so the SBU’s excess cash can be
used for investments in other SBUs. However, marketing and R&D expenses should
not necessarily be slashed excessively. Maximizing net cash inflow might
precipitate a premature decline from cash cow to dog.
3) Dogs represents a low market share and low growth rate, and that would
represent the worst-case scenario, it is not growing and there is nothing better we
can do, and these are markets that we want to get out of, products that we don’t
want to keep selling, are weak competitors in low-growth markets. Their net cash
flow (plus/minus) is modest.

4) Question marks is a low market share and a high market growth, then the
question is: can we increase that market share, because if we could increase that
market share it becomes a star, but if the market share stays the same and growth
goes down then that product will enter the dogs stage of its life cycle, so it is an
area of question, maybe we could take the cash generated from the cash cow and
see if we can grow our share in the question mark stage products, are weak
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competitors and poor cash generators in high-growth markets. They need large
amounts of cash.
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Ideally, we want to try and make all stars, but that not going to happen so we can
try always and find solutions and strategies to get out of the question mark and
dogs situations and increase products market shares and growth in order to
a.
generate more stars and cash cows if possible.
Finally based on all previous strategic plans and other tools:

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Companies can pick different tools and different strategies for different parts of the
business or combine between some of them in some areas so trying to put all or
some of these tools together to come up with the best plan that the company can
have
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Characteristics of Successful Strategic Plans:

• Ongoing strategic planning process, it should be integrated into the organization
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as a core business practice that keeps the company focused on its strategic
direction.
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• Integrated strategic plan throughout the organization, all of the different areas of
the business need to be in alignment and operating together, as well the plan
should not focus only on specific areas of the company such as financial results or
marketing programs. Instead, it should address the whole company’s strategy.
• Strategies should be long-term in nature, while also the plan should be flexible
enough to enable the company to respond to new opportunities.
• Employees at all levels should have input into the strategic planning process.
• The strategy should be communicated clearly and often to everyone in the
organization, a good practice in this aspect is view the strategy as a roadmap to
take the firm from vision to reality.
• The implementation and execution of strategy is a key success for this strategy,
so employees and managers should have the tools to properly execute the strategy.

2. Forecasting Techniques:
Forecasting is the attempt to determine what a future result is going to be? So,
projecting and forecasting future is required to determine what values should be
used for our budgeting or some other decision, such as projecting product demand,
inventory levels, cash flows, etc.
Simple question to brief following subject is: how to calculate numbers that goes
into the budget?
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Collecting the Data for a Forecast
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In forecasting, historical data is used in various ways, forecasts are the basis for
business plans, there are two basic forecasting methods categories:
1) Qualitative methods of forecasting rely on the manager’s experience and
intuition.
a.
2) Quantitative methods use mathematical models and graphs.
a) Time series methods, which look only at the historical pattern of one variable

and generate a forecast by extrapolating the pattern using one or more of
the components (or patterns) of the time series, and
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b) Causal forecasting methods, which look for a cause-and-effect relationship
between the variable we are trying to forecast (the dependent variable) and
one or more other variables (the independent variables).
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Forecasting Techniques
It is important to understand that forecasting is the basis for the plans
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1 2 3
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Quantitative Forecasting Methods learning Curves Expected Value

Causal forecasting methods cumulative & Probability
Regression analysis average- time
1- Simple linear regression (calculation) learning model
2- Multiple regression analyses (calculation)
Quantitative forecasting methods:

a- Regression Analysis
Regression analysis, is the process of deriving the linear equation that describes the
relationship between two variables with a nonzero coefficient of correlation, the
causal forecasting is used when we know that the value we are calculating for is
affected by another variable, for example using marketing expenses as a cause to

effect and generate sales volumes, so if there is a cause and effect and a liner
relationship we can use projection of one variable to estimate the other variable.
1) Simple liner regression is used when there is one independent variable.

The simple regression equation is the algebraic formula for a straight line:
y = a + bx + e
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y = the dependent variable (that we are trying to forecast it)
a = the y intercept (fixed constant)
b = the slope of the regression line (variable cost per unit / coefficient)
x = the independent variable (cost drive)
a.
e = estimate in error
Example: A firm has collected observations on advertising expenditures and annual

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sales.
Advertising Sales
($000s) ($000,000s)
71 26.3
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31 13.9
50 19.8
60 2 2.9
35 15.1
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Solving with the least-squares method reveals that expected sales equal $4.2
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million plus 311.741 times the advertising expenditure.

y = $4,200,000 + 311.741 x
The firm can now project the amount it will have to spend on advertising to
generate $32,000,000 in sales.
y = $4,200,000 + 311.741x
$32,000,000 =$4,200,000 +311.741x
311.741X = $27,800,000
x = $89,177
2) Multiple regression is used when there is more than one independent variable,
multiple regression allows a firm to identify many factors (independent variables),
and to weight each one according to its influence on the overall outcome.

1. Should evaluate each independent variable to make sure that there is a

useful cause and effect relationship with the dependent variable
2. The T-value should be 2 or more for every independent variable
T-Value:
Measures the degree to which the dependent variable has a valid long-term
relationship with the independent variable.
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Sales of fast food and cold drinks
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Multiple regression analysis, for example sales
is being function of temperature and number
of people around the area
a. This is more realistic as we can’t imagine

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that only one variable is affecting another
but practically there will be always many
combined factors and variables
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y = a + b1x1 + b2x2 + b3x3 + ….. + e

no calculation is required by LOS for the multiple regression analysis.
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Summarized:
Look for cause and effect linear relationship (within the relevant range) between:
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One dependent variable (we are trying to forecast for) and one independent
variable simple regression analysis
Or one dependent variable and more than one independent variables

multiple regression analysis
Assumptions of the linear regression model:

1) The linear relationship established for x and y is only valid across the relevant
range. The user must identify the relevant range and ensure that (s)he does not
project the relationship beyond it, bear in mind a negative y intercept in the simple
regression equation usually indicates that it is outside the relevant range.

2) Regression analysis assumes that past relationships can be validly projected into
the future.
3) The distribution of y around the regression line is constant for different values
of x, referred to as homoscedasticity or constant variance. This is known as the
ceteris paribus assumption, or that all things must remain equal. Thus, a limitation
of the regression method is that it can only be used when cost patterns remain
unchanged from prior periods.
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Correlation analysis:
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Correlation analysis is the foundation of any quantitative method of forecasting.
Correlation: is the strength of the linear relationship between two variables,
expressed mathematically in terms of the coefficient of correlation (r). It can be
a.
graphically depicted by plotting the values for the variables on a graph in the form
of a scatter diagram, the r value ranges from 1 (perfect direct relationship) to –1
(perfect inverse relationship). The more the scatter pattern resembles a straight
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line, the greater the absolute value of r.
Correlation analysis
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Coefficient of correlation Coefficient of determination

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R Squared
R²
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Measures the relative direction and measures the percentage of

strength of the total linear the change (variance) in the
relationship dependent variable that can
This is going to help us understand be explained by changes in
wither or not independent variable is the independent variable (by
actually can be used an indicator the regression equation)
(relationship) of what sales for so above 50% correlating is
example is going to be meaningful

Coefficient measures:
+1 0 -1 % percentage
Perfect direct No relationship Perfectly inverse Can’t be
relationship relationship minus and
can’t be more
than 100%
Strong direct
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relationship
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R R²
Best coefficient is a strong one which is greater than 0.5 or -0.5
Advantages / benefits:
a. Disadvantages / shortcomings /
limitations:
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1. Quantitative (numerical) which 1. Historical data is required, so if
means it is objective and will lead to historical data are not available then
specific results therefor It can be used can’t use regression analysis
easier to make forecasts, so we can 2- If these historical data changed for
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understand and explain the reasons any reason since then, so it will not
and the results. work to represent the situation that
2. it is well used in budgeting to we are working in now.
compute the fixed and variable portion 3. Analysis valid only within the
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of mixed cost relevant

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4. If the choice of the independent

variable is inappropriate the results
can be misleading

b- Learning Curves:
Learning curve analysis reflects the increased rate at which people perform tasks
as they gain experience, the time required to perform a given task becomes
progressively shorter during the early stages of production, people accomplish a
repetitive task more quickly the more they do it, based on that more often means
more quickly and more efficient, which will bring down costs, and should affect
pricing decisions.
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Learning curves assumptions:
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1. Quantifying learning so the amount of learning curve shown as a % between
50% maximum learning which represents the best can be done and 100% no
learning
a.
2. Doubling of production which assumes that learning takes places every time
production doubles.
It doesn’t need to be calculated by unit of production but instead it could be a
batch, a lot or a production run
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The curve is usually expressed as a percentage of reduced time to complete a task
for each doubling of cumulative production.
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More experienced more efficient

Labor intensive
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Three conditions:
1. Learning curve rate
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2. Doubling
3. Given level of production (number of lots)
From this we can calculate:
1. Total time required – then – average required time per unit
2. Incremental cost
Application:
Two methods of applying learning curve analysis are in common use.
1) The cumulative average-time learning model
(traditional learning curve model) projects the reduction in the cumulative average
time it takes to complete a certain number of tasks, used to calculate the average
time for all units produced from number 16 to 32 for example.

2) The incremental unit-time learning model calculation is not required

projects the reduction in the incremental time it takes to complete the last task,
which means it calculated the time required to produce the last unit only unit
number 4 or 8 or 16 etc.
Cumulative average time learning model:

Evaluates the average time / unit (after calculating the total number that’s why it
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is called cumulative) required to produce a given number of units (a given level of
production)
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Important notes when answering learning curves questions:
Average time / unit: 1. declined by a constant percentage
a.
The completeness of learning curve percentage
Learning rate 50% 100%
Maximum learning No learning

49% learning means 51% declined
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means that required time to produce
two units is less than required time
to produce one unit which is not logic
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& 2. In Double
Incremental total cost according to cumulative average time learning model @ a

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given level of production:

The cost related to labor cost (DLH & VMOH) will apply learning curve rate and
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Doubling
And
Costs not related to labor hours (DM & FMOH) will apply only Doubling
The cumulative model can be used to calculate three things:

1. The average time/unit for the entire quantity produced to date (cumulative
– all units).
2. The total time required for all the units produced to date.
3. The total time required to produce a certain block of units
5,6,7,8 9,10,11,12,13,14,15,16

Two directions to calculate it mathematically:

1- Start total time Calculate knowing # of units proceed Average time
2- Start wz average Total time
time
1- Calculate total time:

a) Calculate the estimated total time required for production, then use the
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estimated total time to calculate the estimated cumulative average time per unit
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Estimated total time required for all units produced =
n
Time required for the first unit × (2 × LC)
LC = Learning curve percentage (in decimal format)
n = Number of doublings of units produced to date
a.
b) Once the total time is known, the estimated cumulative average time per unit
can be calculated by dividing the estimated total time by the total number of units
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produced, as follows:
Estimated cumulative avrage time per unit required for all units produced =
Estimated total time required for all units produced
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total number of units produced
This method works better when the question requires the calculation of the
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estimated total time required for all units produced.

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Example: A plant that manufactures cars is subject to an 80% learning curve. Ten
hours are required to produce the first car of a new model. According to the
cumulative average-time learning model, the estimated total time required to
manufacture the first two cars will be 80% of the total time it would have taken to
produce two cars if no learning had taken place.
If no learning had taken place, then estimated production time for the first two cars
would be 20 hours.
With an 80% learning curve, the estimated total time required to produce two cars
will be 80% of 20 hours, or 16 hours (10 × [2 × 0.8]), which equates to an estimated
cumulative average of 8 hours for each of the first two cars (16 ÷ 2). The
mathematical process is shown for the first three doublings of production.

The first doubling (to produce a total of 2 units):

[Note: Any number raised by the exponent 1 is the number itself.]
1) Estimated total time required for units 1 and 2 = 10 × (2 × 0.80)1 = 10 × 1.6 = 16
hours
2) Estimated cumulative average time per unit for units 1 and 2 = 16 ÷ 2 = 8 hours
The second doubling (to produce a total of 4 units):
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1) Estimated total time required for units 1 through 4 = 10 × (2 × 0.80)2 = 10 × 2.56
= 25.6 hours
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2) Estimated cumulative average time per unit for units 1 through 4 = 25.6 ÷ 4 =
6.4 hours
The third doubling (to produce a total of 8 units):
= 40.96 hours
a.
1) Estimated total time required for units 1 through 8 = 10 × (2 × 0.80)3 = 10 × 4.096
2) Estimated cumulative average time per unit for units 1 through 8 = 40.96 ÷ 8 =
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5.12 hours
And so on.
Notice that with each doubling, multiplying the previous estimated total time by 2
and then by 80% results in the new estimated total time. For example, 25.6
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estimated total hours required for the first 4 units multiplied by 2 and then
multiplied by 80% equals 40.06 hours, the estimated total hours required for the
first 8 units.
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2- cumulative average time per doubling:

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Calculate the estimated cumulative average time per unit for all units produced,
then use the estimated cumulative average time per unit to calculate the estimated
total time required for all units produced:
Estimated cumulative average time per unit (per lot) for all units produced =
n
Time required for the first unit × LC
LC = Learning curve percentage (in decimal format)
n = Number of doublings of all units produced
This method works because the time required to produce the first unit or lot is also
the cumulative average time required for that unit or lot. The total time required
for the first unit or lot divided by the number produced (1) equals the average time

per unit or lot for the first unit or lot. This method begins with the cumulative
average time per unit or lot required to produce the first unit or lot.
Once the estimated cumulative average time per unit is known, the estimated total
time can be calculated by multiplying the estimated cumulative average time by
the number of units produced, as follows:
Estimated total time required for all units produced =
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Estimated cumulative average time per unit for all units produced
× Total number of units produced
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This method works better when the question requires the calculation of the
estimated cumulative average time required per unit for all units produced.
a.
Example: The following doublings refer to the same plant from the previous
example. It manufactures cars and is subject to an 80% learning curve. The time
required to produce the first car is 10 hours.
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The first doubling:
[Note: Any number raised by the exponent 1 is the number itself.]
1) Estimated cumulative average time per unit for units 1 and 2 = 10 × 0.801 = 10
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× 0.80 = 8 hours
2) Estimated total time required for units 1 and 2 = 8 × 2 = 16 hours
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The second doubling:

1) Estimated cumulative average time per unit for units 1 through 4 = 10 × 0.802 =
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10 × 0.64 = 6.4 hours

2) Estimated total time required for units 1 through 4 = 6.4 × 4 = 25.6 hours
The third doubling:

1) Estimated cumulative average time per unit for units 1 through 8 = 10 × 0.803 =
10 × 0.512 = 5.12 hours
2) Estimated total time required for units 1 through 8 = 5.12 × 8 = 40.96 hours
And so on.
Note regarding calculating a block of units:

The difference between the total time for 8 units (lots) and the total time for 4 unit
(lots) is the amount of time needed to produce units (lots) number 5 to 8 (5,6,7,8)
then divide by 4 will give the average time for those 4 units (lots)
Benefits Limitations
1. Ensure that estimates are accurate 1. applicable only for labor intensive
for Life-cycle contracts tasks
2. Development of production plans & 2. assuming that learning rate is
labor Requirements. constant
3. could be an important element of
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calculation in price offers and price
decisions depends on the nature of the
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task
4- calculating more accurate cost
numbers to be used in estimating the
standard costs, and make or buy
decisions of products and calculating
the breakeven point
a.
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3- Expected Value:
When a situation has several possible outcomes, expected value can be used to
determine the outcome to use in a decision model. “Expected value” has a very
specific meaning. It does not mean “forecasted value” or “anticipated value” or
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“budgeted value.”
The expected value of a discrete random variable is the weighted average of all the
possible outcomes using the probabilities of each of the outcomes as the weights.
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The following steps are used to determine the expected value:

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1) Identify the possible quantitative outcomes and assign a probability to each one.
All of the probabilities must be between 0 and 1 (%) and altogether they must add
up to 1. In order to calculate a weighted average, the possible outcomes must be
whole numbers, as well.
2) Multiply each possible quantitative outcome by its assigned probability.
3) Sum the results of Step 2.

The sum of the results of Step 2 is the expected value, which is a weighted average
of the possible outcomes, using each outcome’s probability as its weight. The
expected value is then used as the assumption in the decision model. In forecasting,
the expected value may be used as a forecasted amount.

The expected value is the mean value, also known as the average value. The symbol
for the mean, average, or expected value is μ (mu).
3 methods in assessing probability: H

1. Classical method: each outcome has an equal chance of occurring
2. Relative frequency method: this used when we have past information and
we can make determination
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3. Subjective method: used when isn’t past information so we think what would
be reasonable
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Variance and standard deviation: H calculation isn’t required
Both are measuring the diversity of the possible outcomes
So if we have a small variance and standard deviation that means that all of these
a.
results are very close to the average (expected value), while when they are large
amounts (variance and standard deviation) that means we are having a broader
range of possible outcome.
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Class A both pass grades Class B
are average 75%
73%-77% 30%-100%
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All passed some people really passed

Some people failed
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G
It is associating a dollar amount with each of the possible outcomes of a probability
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distribution.
1) The outcome yielding the highest expected monetary value (which may or may
not be the most likely one) is the optimal alternative.
a) The decision alternative is under the manager’s control.
b) The state of nature is the future event whose outcome the manager is
attempting to predict.
c) The payoff is the financial result of the combination of the manager’s
decision and the actual state of nature.
2) The expected value of an event is calculated by multiplying the probability of
each outcome by its payoff and reaching the total of all results.
Expected value = mean value = average value = expected monetary value
Expected value = weighted (weights = probabilities) average of all possible values

Payoff table: G
Alternative decisions + states of nature = possible outcomes
The difficult aspect of constructing a payoff table:

It is the determination of all possible outcomes of decisions and their probabilities.
Thus, a probability distribution must be established, the assigned probabilities may
reflect prior experience with similar decisions, the results of research, or highly
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subjective estimates.
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The expected value criterion is likely to be adopted by a decision maker who is risk
neutral. However, other circumstances may cause the decision maker to be risk
averse or even risk seeking.
a.
Expected value without perfect information: G

Calculated for each decision
EVwoPI for 1st decision = each expected outcome for 1st decision X Probability of
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each state of nature (PSoN1 + PSoN2)
Example: A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s
inventory, the dealer projects demand for the season as follows:
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Demand Probability
0 yachts 10%
1 yacht 50%
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2 yachts 40%
The cost of carrying each excess yacht is $50,000, and the gain for each yacht sold
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is $200,000. The profit or loss resulting from each combination of decision and
outcome is thus as follows:
Expected Value
Without
States of Nature Perfect Info.
Decision Demand = 0 Demand = 1 Demand = 2 Totals
Stock 0 yachts $0 $0 $0 $0
Stock 1 yacht (50,000) 200,000 200,000 175.000
Stock 2 yachts (100,000) 150,000 400,000 225.000
In this example, a risk-averse decision maker may not wish to accept the risk of
losing $100,000 by ordering two yachts.

The benefit of expected value analysis is that it allows a manager to apply scientific
management techniques to applications that would otherwise be guesswork.
Although exact probabilities may not be known, the use of expected value analysis
forces managers to evaluate decisions in a more organized manner. At the least,
managers are forced to think of all of the possibilities that could happen with each
decision.
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A criticism of expected value is that it is based on repetitive trials, whereas in
reality, most business decisions involve only one trial.
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EXAMPLE: A company wishes to launch a communications satellite, the probability
of launch failure is .2, and the value of the satellite if the launch fails is $0. The
probability of a successful launch is .8, and the value of the satellite would then be
$25,000,000. The expected value is calculated as follows:
.2($0) + .8($25,000,000) = $20,000,000
a.
But $20,000,000 is not a possible value for a single satellite; either it flies for
$25,000,000 or it crashes for $0.
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Expected value with perfect information: G
Perfect information is the certain knowledge of which state of nature will occur, is
the additional expected value that could be obtained if a decision maker knew
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ahead of time which state of nature would occur.
EVwPI for all decision = best outcome of any decision under SoN1 X Probability of
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SoN1 + best outcome of any decision under SoN2 X Probability of SoN2

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Expected value of perfect information: G

EVPI = EVwPI – EvwoPI
That means that we should not spend on market researches more than EVPI in
order to collect perfect information about the state of nature
Perfect information is the certain knowledge of which state of nature will occur.
The expected value of perfect information (EVPl) is the additional expected value
that could be obtained if a decision maker knew ahead of time which state of
nature would occur.
Example: The yacht dealer on the previous example would maximize profits if they
were able to determine exactly what all potential customers intended to do for the

season, the profit that could be obtained with this perfect knowledge of the market
is calculated as follows:
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(.1 x $0) + (.5 * $200,000) + (.4 x $400,000) = $260,000
The difference between this amount and the best choice without perfect
information is the EVPl.
Expected value with perfect information $260,000
Expected value without perfect information
Expected value of perfect information (EVPl)
a. (225,000)
$35,000
The dealer is therefore not willing to pay more than $35,000 for perfect information
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about future demand.
h am
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a.
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Unit 4. Budget concepts, methodologies and preparation

Subunits:
1) Budget concepts
2) Budgeting methodologies
3) Annual profit plan and supporting schedules
4) Top-level planning and analysis
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1. Budget Concepts:
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The budget is developed in advance of the period it covers, and it is based on
forecasts and assumptions. But the budget is not something that is primarily for the
purpose of restricting what can be done. It is intended as a planning tool and is a
guideline to follow in order to achieve the company’s planned goals and objectives.
a.
The Relationship among Planning, Budgeting, and Performance Evaluation:
Planning, budgeting, and performance evaluation are interrelated and inseparable.
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Here is an overview of the process:
1) Management develops the plan, which consists of goals, objectives, and a

proposed plan of action for the future. The plan includes the company’s short-term
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as well as long-term goals and objectives and its business opportunities and risks.
2) The plan developed by management leads to the formulation of the annual profit
plan, also called the budget. The profit plan expresses management’s plans for the
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future in quantitative terms. The profit plan also identifies the resources that will
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be required in order to fulfill management’s goals and objectives and how they will
be allocated.
3) Budgets provide feedback to the planning process because they quantify the
likely effects of plans that are under consideration. This feedback may then be used
by managers to revise their plans and possibly their strategies as well.
4) Once the plans and the budget have been coordinated and the budget adopted
for the coming period, as the organization carries out its plans to achieve the goals
it has set, the master budget is the document the organization relies upon as its
operating plan. By budgeting how much money the company expects to make and
spend.

5) Actual results are compared to the profit plan. The profit plan is a control tool.
Controlling is defined as the process of measuring and evaluating actual
performance of each organizational unit of an enterprise and taking corrective
action when necessary to ensure accomplishment of the firm’s goals and
objectives. The profit plan functions as a control tool because it expresses what
measures will be used to evaluate progress. A regular (monthly or quarterly)
comparison of the actual results—both revenues and expenditures—with the
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profit plan will give the company’s management information on whether the
company’s goals are being met. This comparison should include narrative
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explanations for variances and discuss the reasons for the differences so that mid-
course corrections can be made if necessary.
6) Sometimes, this control will result in the revision of prior plans and goals or the
a.
formulation of new plans, changes in operations, and revisions to the budget.
7) Changed conditions during the year will be used in planning for the next period.
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Advantages of budget:
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1. Planning proactive manner

A budget is a written plan for the future that forces management to evaluate the
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assumptions and the objectives identified in the budgetary process.

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The budget is a planning tool, so that companies that prepare budgets anticipate
problems before they occur, a firm that has no goals may not always make the best
decisions. A firm with a goal in the form of a budget will be able to plan.
2. Coordination and Communication cross purposes

Coordination means balancing the activities of all the individual units of the
company in the best way so that the company will meet its goals and the individual
units of the company will meet their goals. Communication means imparting
knowledge of those goals to all employees.
1) A budget can help tell employees what goals the firm is attempting to
accomplish.
2) If the firm does not have an overall budget, each department might think the
firm has different goals.

3. Control measure performance

Control refers generally to the set of procedures, tools and systems that a company
uses to ensure that progress is being made toward accomplishing its goals and
objectives. Financial control is achieved by comparing actual results to budgeted
financial amounts. Thus, budgets provide the standard against which actual
financial results are compared. Differences between the actual and the budget are
called variances, and variance analysis is performed to determine whether the
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variances are favorable or unfavorable.
The budget is a control tool.
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1) A budget helps a firm control costs by setting cost guidelines.
2) Guidelines reveal the efficient or inefficient use of company resources.
3) A manager is less likely to spend money for things that are not needed if (s)he
knows that all costs will be compared with the budget, while if s(he)will be
a.
accountable if controllable costs exceed budgeted amounts.
4) Budgets can also reveal the progress of highly effective managers.
5) Managers can also use a budget as a personal self-evaluation tool.
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4. Motivation challenging to improve performance
A challenging budget improves employee performance because no one wants to
fail and falling short of achieving the budgeted numbers is perceived as failure. The
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goals quantified in the budget should be demanding but achievable. If goals are so
high that they are impossible to achieve, however, they are de-motivating.
1) A budget helps motivate employees to do a good job.
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a) Employees are particularly motivated if they help prepare the budget.

b) A manager who is asked to prepare a budget for his/her department will work
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hard to stay within the budget.

2) A budget must be seen as realistic by employees before it can become a good
motivational tool.
5. Allocation of resources strategy congruence

The process of developing the operating budgets for the individual units in an
organization includes identifying the resources that each unit will need to carry out
the planned activities.
A budget functions as an aid to planning, coordination, and control. Thus, a budget
helps management allocate resources efficiently and ensure that subunit
objectives are consistent with those of other subunits and of the organization.

Time Frames for Budgets

A profit plan is generally prepared commonly for one year, and the annual profit
plan is subdivided into months or possibly quarters. Usually the profit plan is
developed for the same time period covered by a company’s fiscal year. When the
budget period is the same as the fiscal year, budget preparation is easier and
comparisons between actual results and planned results are facilitated. This
comparison is called a variance report.
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Budget cycle:
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1. Budget guidelines
This may be done by a budget
committee or by senior
management. The initial budget
guidelines govern the preparation
of the profit plan. Information
considered in the development of a.
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the budget guidelines includes the
general outlook for the economy
and the markets the company
serves, strategic objectives and
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long-term plans, expected

operating results for the current
period (since a budget for the coming period is developed toward the end of the
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current period before the current period has been completed), specific corporate
decisions for the coming period (such as corporate downsizing), response to
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environmental requirements, and short-term objectives.
2. Initial budget
Each responsibility center manager prepares an initial budget proposal using
the budget guidelines as well as their own knowledge about their own area (such
as introduction of new products or changes to be made in product design or
manufacturing processes).
3. Negotiation and review

The responsibility center managers submit their initial budget proposals to
the next level up for review. The initial proposals are reviewed for their adherence
to the budget guidelines and to determine whether the budget goals are
reasonable and in line with the goals of the next higher unit and with those of other

units. Any changes that are needed are negotiated between the responsibility
center managers and their superiors. Eventually, all the individual unit budgets are
combined into the consolidated master budget (first draft). The consolidated
master budget will consist of a set of budgeted financial statements: balance sheet,
income statement, and statement of cash flows. The consolidated master budget
is reviewed at the topmost level to determine whether it meets the requirements
without being unachievable, and negotiations begin again for revisions. Finally,
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when the consolidated master budget meets the approval of the budget committee
or senior management, the CEO approves the entire profit plan and submits it to
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the board of directors for final approval.
4. Revision
Even after the profit plan has finally been adopted, it should be able to be
a.
changed if the assumptions upon which it was built change significantly. New
information about internal or external factors may make revision of the profit plan
necessary. In addition, periodic review of the approved budget for possible changes
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or use of a continuous budget that is continually being updated might be advisable.
Although updating the budget provides better operating guidelines, budget
revisions that are too easy or too frequent might encourage responsibility centers
to not take the budgeting process seriously. The budget should be revised only
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when circumstances have changed significantly, and the changes are beyond the
control of the responsibility center manager or the organization.
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5. Reporting variances
A budget is meaningless unless actual results are compared to the planned
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results for the same period. The budget needs to be used to monitor and control
operations to meet the company’s strategic objectives. The comparison between
actual results and planned results is called variance reporting, and it should take
place at every budget unit level. Responsibility center managers should report on
variances within their responsibility centers at the end of each reporting period
(monthly or quarterly) to their superiors, who then compile the reports they
receive into a variance report that is sent to the next level up, and so on. Variance
reporting should include not only the amounts of the variances but also the causes
of the variances that can be identified.
6. Feedback
Variance reports should be used at every level to identify problem areas and
to adjust operations, if necessary

Characteristics of successful budget:

1. Coordinated
The profit plan should be coordinated, and operating activities of diverse
business units should be synchronized. For example, the sales manager will
want to make as many sales as possible, whereas the credit manager will
want to limit credit loss write-offs. A coordinated effort to establish credit
standards that both managers can support should be incorporated into the
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budgeting process
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2. Motivating
The profit plan should be a motivating device. It should help the people in
the organization to work toward the organization’s goals for the
improvement of the company.
a.
3. Applying strategy congruence – aligned with corporate strategy
The development of the profit plan should be linked to corporate strategy.
The development of the profit plan should begin with the company’s short-
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and long-term plans. Linking them gives the managers and employees a
clearer understanding of strategic goals, which leads to greater support for
goals, better coordination of tactics, and ultimately stronger company
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performance. Furthermore, without input from planning, the budget will

usually just recreate the previous year’s results with some minor changes,
making it useless as a planning tool.
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4. Supported by management
The profit plan must have the support of management at all levels. The
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support of top management is critical to gain the support of lower-level

managers.
5. Ownership by lower management and employees

The support of lower-level managers is critical in order to gain the support
of the affected employees.
6. Flexible and not rigid

Budgeting should not be rigid. If revenue decreases are anticipated for the
coming year, an “across the board” cost reduction applied to all areas can
create additional problems. A coordinated effort should be made to find
where making cuts would do the least damage to company operations.
7. Accurate presentation
Budget participants:
1. Board of directors setting the organization’s mission statement
2. Top management forming budget committee
Participating in review, suggestions and approval of
budgets
3. Budget committee lacks details
Setting budget manual and budget calendar
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4. Middle & lower management (SBUs)
Preparing initial budget
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Providing variances reports and feedback
5. Budget controller / department
Technical advisory
Collect budget schedules
a.
Preparing statements
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Budget calendar: schedule of budget processes
The schedule of activities for the development and adoption of the budget. It
includes a list of dates indicating when specific information is to be provided to
others by each information source, because all of the individual departmental
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budgets are based on forecasts prepared by others and the budgets of other
departments, it is essential to have a planning calendar to integrate the entire
process, the budget department is responsible for compiling the budget and
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managing the budget process. However, the budget director and department are
not responsible for actually developing the estimates on which the budget is based
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Budget manual: detailed procedures for preparing and submitting budget parts
Budget manual. Everyone involved in preparing the budget at all levels must be
educated on the detailed procedures for preparing and submitting their part of the
overall budget.
Distribution instructions are vital because of the interdependencies of a master
budget, one department’s budget may be dependent on another’s, and functional
areas must be aggregated from their constituent department budgets. The
distribution instructions coordinate these interdependencies.

Authoritative and participative budget:

Authoritative Participative
Top – Down approach bottom – Up Approach
Self-imposed approach
Advantages
1. Goal and strategic congruence 1. More motivated
2. Better decision-making control 2. Support
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3. Reduced budget cycle time 3. Understanding
4. No budgetary slack 4. More Accuracy
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5. Increases coordination (divisional
objectives)
Disadvantages
a.
1. Lacks commitment 1. Budgetary Slack
2. Reduces acceptance of goals (Padding the budget)

3. Maybe not possible to achieve
4. Less communication between
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management and employees
Budgetary Slack:
Goal congruence is defined as “aligning the goals of two or more groups.” As used
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in planning and budgeting, it refers to the aligning of goals of the individual

managers with the goals of the organization as a whole.
The budgetary slack: is the excess of resources budgeted over the resources
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necessary to achieve organizational goals, setting easy targets for the budget which
represents noncompliance to organization’s strategies, Management may create
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slack by overestimating costs and underestimating revenues.
Positive side: being caution against unforeseen circumstances
Negative results: 1. misrepresents true profits

2. lead to inefficient resources allocation
3. poor coordination in activities
4. inaccuracy planning
Decrease the budgetary slack:

1. Budget should be flexible to accept additional changes
2. Considering all variables
3. Continually review budget process
4. Evaluate the accuracy of budget instead of using budget for management

performance evaluation
Responsibility centers (Strategic business units - SBUs) and controllable costs:

Responsibility center manager should only budget and report variances for
controllable objects
Some costs are controllable by a given manager and some costs are not.
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Controllable costs refer to costs for which the manager has the authority to make
the decisions about how money will be spent. Non-controllable costs refer to costs
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that are ordinarily controlled at a higher level in the organization
Each budgeted cost assigned to a responsibility center should be identified as either
controllable or non-controllable by that responsibility center’s management. For
example, salaries in the accounting system may be segregated in two accounts:
a.
controllable salaries and non-controllable salaries. Each would then be budgeted
by the person who has control over it, and that person would be responsible for
explaining the variances.
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All costs should be included on some manager’s variance report and identified as
the responsibility of that manager on whose report they appear. If an expense is
classified as non-controllable on a given manager’s budget reports, then that
expense should be included as a controllable expense on the report of the higher-
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level manager who makes the decisions that affect that expense.
When budget is used to evaluate manager’s performance:

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Fixed & indirect costs are not necessarily uncontrollable

Variable & direct costs are not necessarily controllable
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Standards Costs:
Standard costs are the estimated manufacturing costs for direct materials, direct
labor, and manufacturing overhead that are predetermined or estimated as they
would occur under the conditions in the budget, in another word standard costs
are predetermined expectations about how much a unit of input, a unit of output,
or a given activity should cost.
Standards are usually based on interviews, analyses and engineering studies that
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identify the time needed for the various activities required to manufacture a
product, the amount of direct materials needed for each product, and the cost for
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each unit of time or unit of direct materials.
• A standard input is the quantity of the input (such as kilograms or the number of
units of direct material or hours of direct labor) required to produce one unit of
output.
a.
• A standard price is the price the company expects to pay for one unit of an input.
• A standard cost is the cost of producing one unit of output. It is the sum of the
products of each standard input multiplied by its standard price.
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 The standard direct material cost per unit of output is the standard material
input allowed for one unit of output multiplied by the standard price per unit
of that direct material input.
 The standard direct labor cost per unit of output is the standard direct labor
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hours allowed for one unit of output multiplied by the standard price per
direct labor hour.
Without standard costs it would be very difficult to budget, since we would not
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know how much it would cost to produce our products. Also, without standard
costs it would be very difficult to evaluate our performance because at the end of
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the year we would not know how much it should have cost to produce what was
produced
A) Reasons for using standard costs:
1. Budget planning and control (used in developing production budget)
2. Financial statements preparation
3. Cost management
4. Pricing decisions
B) Ideal (theoretical) perfection SC Currently attainable (practical) SC

Maximum efficiency / tight (flexible budget)
“Continuous improvement” “Possible results but difficult to
attain”
Challenging and motivation

C) Setting standard costs:

1) Activity Analysis
Activity analysis involves identifying and evaluating all the input factors and
activities that are required to complete a job, a project, or an operation efficiently.
Activity analysis is the most accurate way of determining standard costs if it is
properly executed.
Product engineers specify the components to be used in the manufacturing of a
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product. Industrial engineers analyze the procedures required to complete the
manufacturing process.
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The activity analysis specifies the quantity and the quality of the direct materials,
the required skills and experience of the employees who will produce the product,
and the equipment to be used in producing the product.
2) Historical Data
a.
If a firm cannot justify the high cost of activity analysis, it can use historical data
instead. Data on costs involved in the manufacture of a similar product in prior
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periods can be used to determine the standard cost of an operation, if accurate
data is available. However, a standard cost based on the past may perpetuate past
inefficiencies and does not incorporate continuous improvements.
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3) Benchmarking
Comparing against the current practices of the best-performing divisions within the
same company, the other firms can offer good guidelines even if they are from a
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different industry or country.

Using the best-performing company as a standard can help a firm maintain its
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competitive edge.
1 2 3
Activity analysis historical data benchmarking
Team development
approach
Most accurate “Similar products in prior Comparison
Very expensive periods” - similar unit in the
most easy to prepare company
but: Passing past - similar operation
inefficiencies & does not “competitor”
incorporate “Continuous
improvement”

D) Authoritative and participative standard cost setting:

Authoritative Participative (Grass roots)
Advantages
1. Less complex and time consuming 1. Ownership
2. Will reflect management’s 2. Acceptance and commitment
expectations 3. More detailed information
3. Proper consideration of all factors
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Disadvantages
Less likely to accept set standard costs 1. May not support strategic goals
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that’s why It is demotivating to achieve 2. Costly in terms of time and money
them.
a.
E) Setting standard costs using outside consultants:
1. Consultants may not fully understand manufacturing process
2. Standard costs may contain costs which are not controllable by the unit held
responsible, which will lead for dissatisfaction and suboptimal performance
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2. Budget Methodologies:
Budget Methodologies: Philosophy or approach not format or shapes
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a.
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1. The Annual Master Budget:

The master budget is also called the comprehensive budget. The master budget is
a summarized set of budgeted financial statements, including the budgeted
balance sheet, budgeted income statement, and budgeted statement of cash
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flows.
A projected financial statement can be called a pro forma financial statement;
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however, the master budget is not a pro forma financial statement. The term pro
forma is used to refer to a forecasted financial statement prepared for a specific
purpose (for example, to do “what if” analysis in the process of planning). A
company might prepare many different sets of pro forma financial statements for
the same period in its planning process. A pro forma financial statement is not used
for formal variance reporting as the master budget and the flexible budget are.
However, if an action that was forecasted is implemented, the company would
probably want to compare the actual results with the forecasted, pro forma ones.
But pro forma financial statements are not a part of the formal budgeting process.
They are used for planning and decision-making purposes, and the amounts in
them may be quite different from the amounts in the master budget.

The master budget is a static budget. A static budget is one that is prepared for just
one planned activity level, and the activity level is whatever is projected before the
period begins.
Note: The term activity level or level of activity is used in planning and budgeting
to refer to various activities. It is often used to mean the planned number of units
the company expects to produce or the planned number of direct labor or machine
hours the company expects to use. It can also refer to a planned sales volume or
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any other planned volume.
The master budget is created using both non-financial and financial assumptions,
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which come about as a result of the planning process. For instance, companies
develop budgets for the number of units of each product that they expect to
manufacture and sell, the number of employees they will need, and so forth. The
master budget is a result of both operating decisions and financing decisions.
a.
Operating decisions are concerned with the best use of the company’s limited
resources. Financing decisions are concerned with obtaining the funds to acquire
the resources the company needs.

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A profit plan that is broken down according to responsibility center lines will
provide more feedback and will function as more of a control tool than one that is
not prepared by responsibility center, because each responsibility center manager
will be responsible for meeting his or her responsibility center’s profit plan.
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Ideally, each responsibility center manager will also be responsible for developing
his or her responsibility center’s profit plan. These underlying budgets are used in
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developing the master budget. The master budget is the consolidation of all the
responsibility center budgets. It comprises operating budgets and financial
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budgets.
Operating budgets are used to identify the resources that will be needed to carry
out the planned activities during the budget period, such as sales, services,
production, purchasing, marketing, and R&D (research and development). The
operating budgets for individual units are compiled into the budgeted income
statement.
Financial budgets identify the sources and uses of funds for the budgeted
operations. Financial budgets include the cash budget, budgeted statement of cash
flows, budgeted balance sheet, and the capital expenditures budget.

Key words:
 primly planning tool
 Comprehensive budget including operating and financial budget
 Statistic budget @ one single level of activity
 Annual business plan & annual profit plan
Operating budget obtaining and using current resources
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Financial budget funding operating budget
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 Pro forma financial statements may not provide the type of management
information most useful to decision making
 Master Budget (Static) (constant comparison)
a.
 One level of activity
2. Flexible budget:
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A flexible budget is a budget that is prepared after the actual level of activity is
known. A flexible budget for a production department will be adjusted to the actual
volume of units produced. A flexible budget for an income statement will be
adjusted to the actual volume of units sold.
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The flexible budget is prepared for the actual level of activity using all of the
standard variable costs per unit along with the standard total fixed cost as
determined at the beginning of the year. Essentially, what the flexible budget
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does is answer the question, “If we had known what the actual level of activity
was going to be when we prepared the budget, what would the budget have
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looked like?” In other words, the flexible budget is the budget that would have
been prepared for the actual level of activity for the period.
The flexible budget can be prepared only after the end of a period, when the actual
volume for the period is known. Therefore, a flexible budget would be prepared for
each month or each quarter as well as for the year-end, but only when the actual
volume for that period is known.
The primary advantage of flexible budgeting is that it enables management to focus
its attention on variances caused by factors other than differences between actual
and budgeted volumes.
Note: Flexible budgeting needs to be used with a standard costing system. The two
go together, and one is meaningless without the other.

Contribution margin
At different levels of activities
Control tool when prepared @ actual level as then it is used to calculate
variances and Measure performance
Also, can be used as plan tool when done at different levels of activities within
any range
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While it is primly used as control tool, the control here is mainly for DM, DL and
VMOH not for FMOH costs because it will not differ between two different levels
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of activities within the relevant Range, note that in a flexible budget only the
variable budgeted revenues and costs are adjusted. Only variable revenues and
costs change with changes in volume. Fixed costs are just that: fixed. They do not
change with changes in sales volume, as long as the activity remains within the
a.
relevant range. Therefore, fixed costs in the flexible budget are exactly the same
as the fixed costs in the static budget.
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Preparation of flexible budget:
Revenue / unit XX
- Variable cost / unit (XX) any variable costs whether manufacturing
or
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Nonmanufacturing
Contribution Margin / unit XX means: contribution to cover fixed costs

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- fixed costs (XX) here: it is period costs even fixed

manufacturing costs
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Operating income XX
 Any number of volume levels within the relevant range
 Significant level of uncertainty in unit sales volumes
 Budgeted or standard value at the actual volume
 Contribution margin
3. Project budget:
project budget consists of all the costs expected to attach to a particular project,
such as the design of a new airliner or the building of a single ship, while the project
is obviously part of the company’s overall line of business, the costs and profits
associated with it are significant enough to be tracked separately, a project will
typically use resources from many parts of the organization, e.g., design,

engineering, production, marketing, accounting, and human resources, all indirect

costs and overheads to be allocated to the project must be identified and included.
All of these aspects of the project budget must align with those of the firm’s master
budget, their budgeted amounts must be integrated into the master budget of the
company for the relevant period or periods.
A long-term project budget for the introduction of a new product can also be called
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a life-cycle budget. A life-cycle budget plans incomes and expenses for one specific
product throughout its entire life cycle, from its development through its decline.
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This enables a company to see the cash flows that will result from the product over
its entire life. When all the lifetime development and production costs are set forth
in the life-cycle budget, management can set a price that will cover not only the
company’s costs but also its required return on investment.
 Long term / multi year
a.
 appropriate time frame is over the project’s life cycle
 life-cycle budget
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 pricing
4. Continuous (Rolling) Budget:

A continuous budget, also called a rolling budget, is one that is prepared for a
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certain period of time ahead of the present. For example, a one-year continuous
budget would be prepared at the end of every month for the next twelve months.
Typically, a company continuously extends such a budget for an additional month
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or quarter in accordance with new data as the current month or quarter ends.
 Long range
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 Dynamic
 Revised monthly or quarterly
 Dropping one period and adding another
 Does not coincide with the fiscal year
5. Kaizen Budget:
 Continuous improvement
 Many small improvements
 Assumes innovation and high performance
 Efficiently and with higher quality
 Competitive reductions
 Costs lower
 Improved cost value

6. Activity based budget (ABB):

Activity-based budgeting (ABB) is similar in concept to activity-based costing (ABC).
Activity-based costing is an alternate method of allocating overhead costs to
products.
Activity-based budgets are prepared based on the budgeted overhead costs to
perform the budgeted activities. Activities that drive the costs are identified and a
budgeted level of activity for each of the drivers is determined based on a budgeted
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level of production. A budgeted cost pool (budgeted overhead costs) is developed
for each activity. Budgeted overhead costs per unit of each activity are determined
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by dividing the total budgeted overhead costs for the activity by the total budgeted
units of the activity. Overhead costs are allocated to products on the basis of the
budgeted levels of each activity for each product. The company may have several
a.
different overhead cost pools, each with a different cost driver and a different cost
allocation to the units produced. Thus, several different overhead allocations may
be made to each product.
A traditional budgeting system involves lumping all indirect costs into a single pool
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and allocating them to products based on a (usually arbitrary) driver such as volume
or machine hours.
If activity-based costing is used as the costing system, then the budget should also
be activity-based to enable continuous improvement and also to make
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comparisons between actual results and budgeted results meaningful. Activity-

based budgeting is an extension of the company’s activity-based costing system
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and uses the same activity cost pools to group budgeted costs as the activity-based
costing system uses to group actual costs.
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 Linking of costs to outputs

 focuses on the cost of the processes
 Better identification of resource needs
 Identification of budgetary slack
7. Zero Based Budget (ZBB):

Under ZBB, a manager must build the budget every year from a base of zero. All
expenditures must be justified regardless of variance from previous years, the
objective is to encourage periodic reexamination of all costs in the hope that some
can be reduced or eliminated.

Under zero-based budgeting, the budget is prepared without any reference to, or
use of, the current period’s budget or the likely operating results for the current
period. Every planned activity must be justified with a cost-benefit analysis. Zero-
based budgeting (ZBB) is a budget and planning process in which each manager
must justify his or her department’s entire budget every budget cycle.
So zero-based budgeting is more time consuming and difficult than an incremental
approach to budgeting
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Governmental and non-profitable organizations
 In depth review
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 Justify / Justification
 Decision package
 Questions each activity
 initiated for the first time
a.
 ZBB divides the activities of individual responsibility centers into a series of
packages that are prioritized.
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8. Incremental budget:
Typically, budgets are developed by beginning with the current period’s actual or
current period’s budgeted figures and adjusting them for any changes anticipated
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in the coming period. This process assumes that the budget period will be related
to the current period. The focus is on things that are expected to change during the
coming year. This is called an incremental approach to budgeting.
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VS. ZBB
 Accepts the existing basis as being satisfactory
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9. Life cycle budget:

 Targeting market price
 Life time of product
Value chain – including manufacturing and nonmanufacturing costs

3. Annual Profit Plan and Supporting Schedules

The Master Budget:
Master comprehensive budget:
Comprehensive because it includes operation and financial budget
Static budget because it is at one single level of activity
Also called annual business plan – annual profit plan
The master budget is a summarized set of budgeted financial statements, including
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the budgeted balance sheet, budgeted income statement, and budgeted statement
of cash flows.
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A projected financial statement can be called a pro forma financial statement;
however, the master budget is not a pro forma financial statement. The term pro
forma is used to refer to a forecasted financial statement prepared for a specific
a.
purpose

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Operating budgets are used to identify the resources that will be needed to carry
out the planned activities during the budget period, such as sales, services,
production, purchasing, marketing, and R&D (research and development). The
operating budgets for individual units are compiled into the budgeted income
statement.
The operating budget includes the income statement and all the budgets that
support it, which will be detailed in the following pages, including:

• Sales budget corner stone

• Production budget in units
• Direct materials usage budget
• Direct materials purchases budget production budget in $ (product cost)
• Direct labor budget COGM manufacturing costs
• Manufacturing overhead costs budget
• Ending inventories budget (finished goods and direct materials)
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• Cost of goods sold budget
• Nonmanufacturing budget
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period cost
a.
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Financial budgets identify the sources and uses of funds for the budgeted
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operations. Financial budgets include the cash budget, budgeted statement of cash
flows, budgeted balance sheet, and the capital expenditures budget.
How to finance the operation? Finding the funds
Capital expenditure budget independent

Cash budget
Balance sheet budget
Budgeted statement of cash flow Last budget to be prepared in the financial and
all budgets as it requires two budgeted balance sheets

A) Operating Budget:
1. Sales budget: Corner Stone

The sales budget is the first budget prepared because sales volume affects
production and purchasing levels, operating expenses, and cash flows, thus,
expectations about sales drive the entire budget process, once a firm can estimate
sales, the next step is to decide how much to produce or purchase, sales are usually
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budgeted by product or department. The sales budget also establishes targets for
sales personnel.
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The sales budget, also called the revenue budget, is the starting point for the
massive cycle that produces the annual profit plan (i.e., the master budget).
The sales budget is an outgrowth of the sales forecast. The sales forecast distills
a.
recent sales trends, overall conditions in the economy and industry, market
research, activities of competitors, and credit and pricing policies, all of these
factors must be taken into account when forming expectations about product sales
for the coming budget cycle.
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The sales budget must specify both projected unit sales and dollar revenues.
Budgeted sales quantity XX

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X budgeted sales price XX

= sales budget (budgeted revenue) XX
2. Production budget in units:

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Production budgets are usually stated in units instead of dollars, product pricing is
not a consideration since the goal is purely to plan output and inventory levels and
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the necessary manufacturing activity. when the production budget has been
completed, it is used to prepare three additional budgets:
1) Raw materials purchases, which is similar to the purchases budget of a
merchandising firm
2) Direct labor budget, which includes hours, wage rates, and total dollars
3) Factory overhead budget, which is similar to a department expenses budget
Budgeted sales (units) XX
+ Ending desired finished goods inventory XX
- Beginning finished goods inventory (XX)
= production budget in units XX
X budgeted production cost / unit XX
= production budget in $ XX

3. Direct material (DM) budget:

Consists of two budgets:
A) usage budget. B) purchase budget.
The direct materials budget follows directly from the production budget. It is
concerned with both units and input prices, to minimize raw materials carrying
costs and obsolescence, the purchasing of inputs is tied closely to the projections
contained in the production budget.
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DM usage budget:
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Production budget in units XX
X required DM / unit XX
= DM usage budget in units XX
X DM cost price / unit XX
= DM usage budget in $
DM purchase budget: a. XX
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The purchases budget can follow after projected sales have been set. It is prepared
on a monthly or even a weekly basis, purchases can be planned so that stock outs
are avoided. Inventory should be at an appropriate level to avoid unnecessary
carrying costs.
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DM usage budget in units XX

+ ending desired DM inventory XX
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- beginning DM inventory (XX)

= DM purchase budget in units XX
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X DM purchase cost / unit XX

= DM purchase budget in $ XX
you will need to calculate the number of units that a company needs to produce
(finished goods inventory) or purchase (DM inventory) in order to meet the
demand for that period and the opening beginning inventory required for the next
month. These questions are based on the following formula:
Units needed for use in the current period
+ Units needed for the next month’s beginning inventory (ending inventory)
= Total Units needed this period
− Units on hand at the start of this period (beginning inventory)
= Units needed to be produced or purchased this period
To determine how many units will be needed during the period. Units will be
needed either for production or for ending inventory. This is the line “Total units
needed this period.” There are two sources of these units of inventory. Either the
company will have them in beginning inventory at the start of the period or they
will need to purchase or produce the units.
The basic inventory formula:

Beginning Inventory + Inventory Added – Inventory Removed = Ending
Inventory
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If you have any three of the four amounts, you can calculate the fourth amount
algebraically. Note that sometimes a problem will not specifically give you all of the
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three known amounts you need in order to find the fourth amount. However, it will
always give the information you need to calculate the three known amounts.
 When applied to Finished Goods Inventory costs, the formula is as follows:
Cost of Beginning Inventory + Net Cost of Purchases (for a reseller) or Cost of Goods
a.
Manufactured (for a manufacturer) – Cost of Goods Sold = Cost of Ending Inventory
 For Finished Goods Inventory in units, the formula is as follows:
Units in Beginning Inventory + Net Units Purchased or Manufactured – Units Sold
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= Units in Ending Inventory
 When applied to Direct Materials Inventory costs, the formula is as follows:
Cost of Beginning Inventory + Net Cost of Purchases (minus returns plus shipping-
in costs) – Cost of Materials Used in Production = Cost of Ending Inventory
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If units purchased and units returned are given, those should be used if it is
necessary to calculate Net Units Purchased.
 For Direct Materials Inventory in units, the formula is as follows:
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Units in Beginning Inventory + Net Units Purchased – Units Used in Production =

Units in Ending Inventory
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4. Direct labor (DL) Budget:

The direct labor budget depends on wage rates, amounts and types of production,
numbers and skill levels of employees to be hired, etc.
Production budget in units XX

X required DLH / unit XX
= DL total budgeted hours XX
X budgeted cost / hour XX
= DL budget cost in $ XX

5. Manufacturing overhead (MOH) budget:

Any other factory costs other than DM & DL (which is indirect costs)
The manufacturing overhead budget reflects the nature of overhead as a mixed
cost, i.e., one that has a variable component and a fixed component.
Variable overhead contains those elements that vary with the level of production.
1) Indirect materials
2) Some indirect labor
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3) Variable factory operating costs (e.g., electricity)
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Fixed overhead contains those elements that remain the same regardless of the
level of production.
1) Real estate taxes
a.
2) insurance
3) Depreciation
VMOH budget FMOH budget

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If basis of VMOH is DLH, then: Given total cost of FMOH, then we
DLH / Unit XX divided it on total production budget
X VMOH cost / unit XX in units
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= total VMOH cost budget = FMOH cost budget / unit

only within the relevant range
6. Nonmanufacturing overhead cost budget:

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Noninventoriable costs – expired costs

Period cost – meaning that allocation is directly to the expenses of the period and
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not to the Product cost

The nonmanufacturing budget consists of the individual budgets for R&D, design,
marketing, distribution, customer service, and administrative costs.
The development of separate R&D, design, marketing, distribution, customer
service, and administrative budgets reflects a value chain approach.
The variable and fixed portions of selling and administrative costs must be treated
separately.
1) Some S&A costs vary directly and proportionately with the level of sales. As more
product is sold, sales representatives must travel more miles and serve more
customers.
2) Other S&A expenses, such as sales support staff, are fixed; they must be paid no
matter the level of sales.
3) As the variable portion of S&A costs increases, contribution margin, i.e., the
amount available for covering fixed costs, is decreased.
Variable Fixed
Ex. Sales commission Ex. Given marketing staff house rent
Sales budget in units XX
X percentage XX%
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7. Total manufacturing cost / unit (budgeted cost of manufactured goods) to reach
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COGS:
The cost of goods sold budget combines the results of the projections for the three
major inputs (materials, labor, overhead), the end result will have a direct impact
on the pro forma income statement. Cost of goods sold is the single largest
reduction to revenues for a manufacturer.
a.
Budgeted usage DM cost / unit XX

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+ Budgeted DL cost / unit XX
+ Budgeted VMOH cost / unit XX
+ Budgeted FMOH cost / unit XX
= Manufacturing cost / unit XX
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Or total manufacturing cost XX

% number of produced units XX
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Manufacturing cost / unit XX

As manufacturing costs or production costs are related and allocated to the
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number of produced Units
Cost of goods manufactured XX (Current production cost)

+ Beginning inventory of finished goods cost XX
= Available finished goods for sales XX
- Ending inventory of finished goods cost (XX) balance sheet - inventory
= cost of goods sold (COGS) XX income statement
8. Budgeted income statement:

Based on number of sold units because profit / income is based on sold units
number
Sales revenue XX
- Cost of goods sold (COGS) (XX)

= Gross profit XX
- Nonmanufacturing costs (XX)
= net operating income XX
And like this we reach the final result of the operating budget
Variable Costing and Contribution Margin

Contribution margin is the amount left over from sales after subtracting variable
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basis cost of goods sold.
1) Although it is impermissible for external financial reporting, contribution margin
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is more useful to management accountants because it more accurately reveals the
change in profitability resulting from a given change in output.
2) Absorption costing (required for external reporting) includes certain amounts in
cost of goods sold that do not vary directly with the level of production, such as
a.
straight-line depreciation and property taxes.
Cost of goods sold calculated on a variable-costing basis, on the other hand,
includes only those costs that vary directly with the level of production. The amount
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of sales left over after subtracting variable-basis cost of goods sold is contribution
margin, because costs are accumulated so differently, inventory amounts as well
as cost of goods sold are different under variable costing from what they are under
absorption costing.
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Sales XX
Beginning inventory XX
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Add: Variable manufacturing costs XX

Goods available for sale XX
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Less: Ending inventory (XX)

Variable-basis cost of goods sold (XX)
Less: Variable nonmanufacturing costs (XX)
Contribution margin XX
Contribution margin is the amount available for “contributing” to the covering of

fixed costs and providing a profit (a more discussion of absorption and variable
costing can be found in Study Unit 7 cost allocation).
Note that management can make tradeoffs among elements of selling and
administrative expenses for example that can affect contribution margin.

For example, use of fixed advertising expense will increase contribution margin,
while the same sales level might be reached using variable sates commissions, a
method that would reduce contribution margin.
The breakeven point:

The level of production at which operating income equals zero, i.e., the level at
which all fixed costs plus those variable costs incurred to that point have been
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covered.
Every sales dollar beyond breakeven provides operating profit.
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Total fixed costs
Breakeven point = -------------------------------
Contribution margin per unit
EXAMPLE: A manufacturer has budgeted total fixed costs of $1,240,000 and a
a.
budgeted contribution margin of $6.80 per unit. The breakeven point for the
budget period is 182,353 units ($1,240,000 * $6.80).
NOTE: Breakeven analysis, also called cost-volume-profit analysis (P2)
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“What would the flexible budget have been?” You will be given a set of
circumstances and the question will be related to what the flexible budget would
have given as the budgeted amount. This calculation is made by multiplying the
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standard rate by the actual quantity produced, sold, or whatever is required given
the situation.
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B) Financial Budget:
• Capital Expenditures Budget,
• Cash Budget,
• Budgeted Balance Sheet, and
• Budgeted Statement of Cash Flows.
Capital Expenditures Budget (CAPEX)
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Equipment (long-term assets) purchases (capital expenditures) are technically not
part of the operating budget, but they must be incorporated into the preparation
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of the cash budget and pro forma financial statements, may be prepared more than
a year in advance to allow sufficient time to
1) Plan financing of major expenditures for equipment or buildings or
a.
2) Receive custom orders of specialized equipment, buildings, etc.
A procedure for ranking projects according to their risk and return characteristics
is necessary because every organization has finite resources, these procedures (net
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present value, internal rate of return, payback method, etc.) (P2)
The capital budget has a direct impact on the cash budget and the pro forma
financial statements, for example, principal and interest on debt acquired to
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finance capital purchases require regular cash outflows. The acquired debt also
appears in the liabilities section of the pro forma balance sheet, also the output
produced by the new productive assets generates regular cash inflows. In addition,
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the new assets themselves appear in the assets section of the pro forma balance
sheet.
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Cash budget
The cash budget is usually the last to be prepared and is also probably the most
important part of a company’s budget program, an organization must have
adequate cash at all times. Even with plenty of other assets, an organization with a
temporary shortage of cash can be driven into bankruptcy. Proper planning can
keep an entity from financial embarrassment, it helps prevent not only cash
emergencies but also excessive idle cash.
A cash budget details projected cash receipts and disbursements. It cannot be
prepared until the other budgets have been completed, cash budgeting facilitates
loans and other financing.
Cash Budget Preparation

The cash budget combines the results of the operating budget with the cash
collection and disbursement schedules to produce a comprehensive picture of
where the company’s cash flows are expected to come from and where they are
expected to go.
The completed cash budget can be used to plan outside financing activities. For
example, if the budget shows a cash deficit at some future date, the firm can plan
ahead to borrow the necessary funds or sell stock.
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Dividend policy can also be planned to use the cash budget. Dividend payment
dates should correspond to a time when the firm has excess cash.
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Beginning cash balance XX
+ Receipts / cash inflow:
Collection from customers XX
Credit sales
Cash Sales
Sales of Capital equipment a.
XX
XX don’t forget same month cash sales
XX
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= total available cash XX
- Disbursements / cash outflow: (XX) will never include depreciation
DM purchases (XX)
Payroll (XX)
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MOH costs (XX)

Nonmanufacturing costs (XX)
Capital equipment purchases (XX)
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Income tax (XX)

- Minimum cash balance desired (XX)
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= cash excess / deficit XX

+ Financing and dividends XX
Ending cash balance XX
When cash deficit does not mean inability as it is resulted from company’s
collection policy
The key is to make sure you identify how much of the credit sales are collected in
the month of the sale and how much are collected after the month of the sale. The
same is true for payables: you need to identify when the cash is actually paid.

4. Top-Level Planning and Analysis

SALES FORECASTS AND PRO FORMA FINANCIAL STATEMENTS:
Pro forma is a Latin phrase meaning “according to form.” It can be loosely

translated to mean “as if”, in accounting pro forma means Historical statements
adjusted for the effects of a future transaction …
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Pro Forma in Business ‫ﻓﻬﻢ ﻓﻘﻂ‬-‫ﰲ اﻟﻮاﻗﻊ اﻟﻌﻤﲇ‬
In a business sense, financial statements prepared with the pro forma method are
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made ready ahead of a planned transaction such as an acquisition, merger, change
in capital structure or a new capital investment. These models forecast the
anticipated result of the transaction, with emphasis placed most specifically on
a.
estimated net revenues, cash flows and taxes. Pro forma statements, therefore, in
summary, indicate the projected status of a company in the future based on current
financial statements.
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Sales Forecasts
The sales forecast starts by looking back at historical trends and seeks to determine
a pattern so that next year’s sales can be predicted. One of the most effective ways
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to do this is to plot sales on a graph and use regression analysis to forecast next
year’s sales.
Percent of Sales Method

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After sales are forecasted, future financial statements must be forecasted. The
most common method is the percent of sales method. Under this method, many
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items on the income statement and balance sheets are assumed to increase
proportionately to sales. Other items may be based off historical data (i.e., interest
expense may remain constant due to contracts previously entered into) or be based
off forecasted net sales (i.e., cost of goods sold will be 60% of net sales). The first
financial statement forecasted is generally the income statement.
Pro Forma Income Statement

Financial statements are referred to as pro forma when they reflect projected,
rather than actual, results. The pro forma income statement is used to decide
whether the budgeted activities will result in an acceptable level of income. If the
initial pro forma income shows a loss or an unacceptable level of income,
adjustments can be made to the component parts of the master budget.

Other strategic objectives can also be observed from the pro forma income
statement, such as a target gross margin percentage and the interest coverage ratio
(times interest earned). The adequacy of earnings per share can also be observed
from the pro forma income statement.
Pro Forma Balance Sheet

The pro forma balance sheet is prepared using the cash and capital budgets and
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the pro forma income statement. The pro forma balance sheet is the beginning-of-
the-period balance sheet updated for projected changes in cash, receivables,
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payables, inventory, etc. If the balance sheet indicates that a contractual
agreement may be violated, the budgeting process must be repeated.
Pro Forma Statement of Cash Flows
a.
The pro forma statement of cash flows is normally the last statement prepared.
The pro forma statement of cash flows classifies cash receipts and disbursements
depending on whether they are from operating, investing, or financing activities.
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The direct presentation reports the major classes of gross cash operating receipts
and payments and the difference between them. The indirect presentation
reconciles net income with net operating cash flow. Under GAAP, this reconciliation
must be disclosed, regardless of which presentation is chosen.
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The reconciliation requires balance sheet data, such as the changes in accounts
receivable, accounts payable, and inventory, as well as net income.
All the pro forma statements are interrelated (articulated), e.g., the pro forma cash
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flow statement will include anticipated borrowing. The interest on this borrowing
will appear in the pro forma income statement.
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Financial Projections and Ratio Analysis

Pro forma financial statements are of interest to parties outside the organization
as well as inside.
Banks and stock analysts in particular want to know what the firm believes its
results will be. Projections help the bank assess whether the company anticipates
satisfying the requirements of debt covenants. Typically, a firm’s financing
agreement with its bank requires that its debt ratio remain below a certain
threshold and that its coverage ratios remain above a threshold.

The debt ratio is the portion of the firm’s capital structure that consists of debt, i.e.,
total liabilities divided by total assets. The most common coverage ratio is times
interest earned, i.e., earnings before interest and taxes divided by interest expense.
Projection of satisfactory levels of these ratios provide the bank some assurance
that the firm will remain solvent for the foreseeable future.
Earnings per share (EPS) is probably the most heavily relied-upon performance
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measure used by investors. EPS states the amount of current-period earnings that
can be associated with a single share of a corporation’s common stock. EPS is only
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calculated for common stock because common shareholders are the residual
owners of a corporation. Of the two versions of EPS required for external financial
reporting (basic and diluted), only basic is needed on Part 1 of the CMA exam.
a.
Basic Earnings per Share (EPS) = Income available to common shareholders

(IACS) / whited average number of common shares outstanding
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amounts associated with preferred stock are not available to the common
shareholders and must be removed from the numerator.
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Income Available to Common Shareholders (IACS) = net income – dividends

on preferred stock
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The Popularity of Pro Forma ‫ﻗﺮاءه ﻓﻘﻂ‬-‫ﰲ اﻟﻮاﻗﻊ اﻟﻌﻤﲇ‬

The U.S. Securities and Exchange Commission (SEC) requiring publicly traded
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companies to report and make public U.S. GAAP-based financial results. The SEC
also made it clear that utilizing pro forma results to lie about or grossly misconstrue
GAAP-based results would be deemed fraud and punishable by law if investors
were misled.

Major differences between budget, forecast and proforma financial statements:

Budget Where you if the business says that it is aiming for 5% sales
want to go… growth, this is a target, it is a statement of fact.
Forecast Where you based on the expectation that the business will
are going … recruit a new sales manager, it forecasts that sales
will increase by five percent this year
the managements “best guess” as to what will
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happen if it follows the expected course of action
and among other things recruits a new sales
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manager
Pro Historical a business might be considering the acquisition of
Forma statements another business and is seeking finance. It will issue
pro forma financial statements to show what the
a.
adjusted for
the effects of significant effects on the historical financial
a future information might have been had the acquisition
transaction … occurred at an earlier date
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the pro forma financial statements are essentially
restated historical information and are not
considered to be projections.
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Master Budget Process:
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Section D) Cost Management … 15%

Unit 5. Cost Management Measurement Concepts
Subunits:
1) Cost Management Terminology
2) Cost Behavior and Relevant Range
3) Cost Classification
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4) Capacity levels
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1. Cost Management Terminology:
Management accounting internal reporting
a.
is concerned principally with reporting to internal users. The management
accountant’s goal is to produce reports that improve organizational decision
making. Management accounting is thus future-oriented.
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Financial accounting external reporting based on generally accepted
accounting principles GAAP
is concerned principally with reporting to external users, usually through a set of
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financial statements produced in accordance with GAAP. Financial accounting thus

has a historical focus.
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Cost accounting Both kinds of accounting use the cost accounting

supports both financial and management accounting. Information about the cost
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of resources acquired and consumed by an organization underlies effective

reporting for both internal and external users.
Definitions:
Cost: resource sacrificed to achieve specific objective
Cost pool: costs are collected into meaningful groups, it is preferable for all the
costs in a cost pool to have the same cost driver
Cost object: entity for which measurement of cost is desired, such as product,
service, customer, activity, organization, etc.

Cost Driver: activities that cause costs to increase as the activity increases, used as
the basis to assign costs to a cost object, chosen by management and
the choice has a relation with the cost and benefit
The key aspect of a cost driver is the existence of a direct cause-and-effect
relationship between the quantity of the driver consumed and the amount of total
cost
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The Difference Between Costs and Expenses
Costs and expenses are two different things.
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1) Costs are resources given up achieving an objective.
2) Expenses are costs that have been charged against revenue in a specific
accounting period.
“Cost” is an economic concept, while “expense” is an accounting concept. A cost
a.
need not be an expense, but every expense was a cost before it became an
expense. Most costs eventually do become expenses, such as manufacturing costs
that reach the income statement as Cost of Goods Sold when the units they are
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attached to are sold, or the cost of administrative fixed assets that have been
capitalized on the balance sheet and subsequently expensed over a period of years
as depreciation.
However, some costs do not reach the income statement. Implicit costs such as
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opportunity costs never become expenses in the accounting records, but they are
costs nonetheless because they represent resources given up achieving an
objective.
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Cost system:
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cost accumulation and cost assignment

Collection of cost data in some include encompasses:
organized way 1. Tracing accumulated costs that has
Direct relationship with cost object
2. Allocate accumulated costs that has
Indirect relationship with cost object

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2. Cost Behavior and Relevant Range:
Behavior: Variable costs vs. Fixed costs
Fixed costs
Fixed costs do not change within the relevant range of activity. As long as the
activity level remains within the relevant range, the total amount of fixed costs
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does not change with a change in activity level such as production volume.
However, the cost per unit decreases as the activity level increases and increases
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as the activity level decreases.
Variable costs
a.
Variable costs are incurred only when the company actually produces something.
If a company produces no units (sits idle for the entire period), the company will
incur no variable costs. Direct material and direct labor are usually variable costs.
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Variable costs are costs such as material and labor (production costs) or shipping-
out costs (period costs) that are incurred only when the activity takes place. The
per unit variable cost remains unchanged as the activity increases or decreases
while total variable cost increases as the activity level increases and decreases as
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the activity level decreases.
• As the production level increases, total variable costs will increase, but the
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variable cost per unit will remain unchanged.

• As the production level decreases, total variable costs will decrease, but the
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variable cost per unit will remain unchanged.
Mixed costs
Mixed costs have both a fixed and a variable component. An example of a mixed
cost is a contract for electricity that includes a basic fixed fee that covers a certain
number of kilowatts of usage per month, and usage over that allowance is billed at
a specified amount per kilowatt used. The electricity plan has a fixed component
and a variable component. A mixed cost could also be an allocation of overhead
cost that contains both fixed and variable overheads.
A) Variable costs: varies in total constant per unit

B) Fixed costs: Fixed by nature in total varies / declining per unit

If given fixed cost per unit we should bring it back in total and deal with its
fixed total value at different levels within the relevant range
Relevant Range
The relevant range defines the limits within which per-unit variable costs remain
constant and fixed costs are not changeable. It is synonymous with the short run.
The relevant range is established by the efficiency of a company’s current
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manufacturing plant, its agreements with labor unions and suppliers, etc.
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test
(Total cost/ Different level of activities) = cost / unit
A) if fixed per unit so variable cost
B) if varies per unit
How to separate them?

so mixed cost
a.
cm
High and low method:
Used to compute the fixed and variable portion of mixed costs, which we need to
do when calculating total cost or budgeting for example, so we use the variable
cost per unit and fix the fixed cost at different levels of activities within the relevant
am
range
Total variable cost = highest cost – lowest cost

h
Highest cost – lowest cost

Variable cost / unit = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
ef
Highest activity – lowest activity

Example:
Month Machine Maintenance
Hours costs
April 1000 $2,275
May 1600 $3,400
June 1200 $2,650
July 800 $1,900
August 1200 $2,650
September 1000 $2,275

Variable portion = (May cost – July cost ) / (May driver – July driver) = ($3,400 -
$1,900) / (1,600 – 800) = $1,500 / 800 = $1.875 per machine hour
Fixed portion = total cost – variable cost

= $1,900 – (800 machine hours X $1.875 per hour)
= $1,900 – $1,500
= $400
m
The firm can now use this information to project total cost at any level of activity;
co
e.g., the expenditure of 1,300 machine hours will generate a probable total cost of
$2,837.50 [$400 + (1,300 × $1.875)].
3. Cost Classification:
a.
**********
cm
1- Traceability: Direct costs vs. Indirect costs
Direct costs: are costs that can be traced directly to a specific cost object. A cost
object is anything for which a separate cost measurement is recorded. It can be a
function, an organizational subdivision, a contract, or some other work unit for
am
which cost data are desired and for which provision is made to accumulate and
measure the cost of processes, products, jobs, capitalized projects, and so forth.
Examples of direct costs are direct materials and direct labor used in the production
h
of products.
ef
Indirect costs: are costs that cannot be identified with a specific cost object (not
easily traceable to a cost object or cost pool) typically incurred to benefit two or
more cost pools or cost objects.
In manufacturing, overhead is an indirect material, indirect labor and other indirect
costs (common costs) A common cost is one shared by two or more users.
Manufacturing indirect costs are grouped into cost pools for allocation to units of
product manufactured. A cost pool is a group of indirect costs that are grouped
together for allocation on the basis of the same cost allocation base. Cost pools can
range from very broad, such as all plant overhead costs, to very narrow, such as the
cost of operating a specific machine.

Other indirect costs are nonmanufacturing, or period, costs. Examples are support
functions such as IT, maintenance, security, and managerial functions such as
executive management and other supervisory functions.
Indirect overhead allocation using allocation base (cost driver)

MOH - Indirect cost
Allocation rate = ‫ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ ـ‬
m
Allocation base (Cost driver)
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Reasons for indirect cost allocation to cost objects:
1. External reporting for disclosure purposes to comply with GAAP
2. Reimbursement purposes such as cost-plus contracts
3. Decision making make or buy / invest or no invest
4. Motivate managers and employees
2- Nature of cost: manufacturing costs vs. nonmanufacturing costs a.

cm
A) Manufacturing costs / Product costs / inventoriable costs
Direct material, direct labor and indirect manufacturing overhead costs
Direct materials are those tangible inputs to the manufacturing process that can
am
practicably be traced to the product, e.g., sheet metal welded together for a piece
of heavy equipment, wood in furniture, amount of cloth in clothes.
In addition to the purchase price, all costs of bringing raw materials to the
h
production line, e.g., freight in, are included in the cost of direct materials.
ef
Direct labor is the cost of human labor that can practicably be traced to the
product, e.g., the wages of the welder, carpenter, tailor
Total Labor cost

Normal wages Fringe Benefits Overtime Idle time
(straight-time premium
wage rate)
Direct Labor Cost MOH (Indirect costs)

Manufacturing overhead consists of all costs of manufacturing that are not direct
materials or direct labor.
a) Indirect materials are tangible inputs to the manufacturing process that cannot
practicably be traced to the product, e.g., the welding compound used to put
together a piece of heavy equipment, or staples used in a stapling machine.
b) Indirect labor is the cost of human labor connected with the manufacturing
process that cannot practicably be traced to the product, e.g., the wages of
m
supervisors.
c) Factory operating costs, such as utilities, real estate taxes, insurance,
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depreciation on factory equipment, etc.
Manufacturing costs are often grouped into the following classifications:

1) Prime cost equals DM + DL, i.e., those costs directly attributable to a product.
the finished product.

a.
2) Conversion cost equals DL + MOH, i.e., the costs of converting raw materials into
Never total prime costs and conversion costs

cm
B) Nonmanufacturing costs / period costs / noninventoriable costs / SG&A
/ value chain costs other than manufacturing costs
am
R&D – Design – XXXXXX - XXXXX – Marketing - Distribution - Customer Service

1) Selling (marketing) expenses are those costs incurred in getting the product
from the factory to the consumer, e.g., sales personnel salaries, advertising, and
product transportation.
h
2) Administrative expenses are those costs incurred by a company not directly

related to producing or marketing the product, e.g., executive salaries and
ef
depreciation on the headquarters building.
3- purpose: Product costs vs. period costs/expired costs

Manufacturing costs Nonmanufacturing costs
+ any losses
+ any abnormal spoilage
One of the most important classifications a management accountant can make is

whether to capitalize a cost as part of finished goods inventory or to expense it as
incurred.

1) Product costs (also called inventoriable costs) are capitalized as part of finished
goods inventory. They eventually become a component of cost of goods sold.
Product costs are costs for the production process without which the product could
not be made. Product costs are “attached” to each unit and are carried on the
balance sheet as inventory during production (as work-in-process inventory) and
when production is completed (as finished goods inventory) until the unit is sold.
When a unit is sold, the item’s cost is transferred from the balance sheet to the
m
income statement where it is classified as cost of goods sold, which is an expense.
The main types of product costs are: 1) direct materials, 2) direct labor, and 3)
co
manufacturing overhead (both fixed and variable) which include the indirect
material and indirect labor.
2) Period costs are expensed as incurred, i.e., they are not capitalized in finished
a.
goods inventory and are thus excluded from cost of goods sold, the theory is that
period costs are caused by the passage of time and would occur even if production
was zero.
cm
The number of period costs is almost unlimited because period costs include
essentially everything other than the product costs, since all costs must be either
product costs or period costs. The more commonly-used examples of period costs
include selling, administration, and accounting, but period costs are all the costs of
am
any department that is not involved in production.
This distinction is crucial because of the required treatment of manufacturing costs

h
for external financial reporting purposes.

ef
1) Financial accounting
For external financial reporting, all manufacturing costs (direct materials, direct
labor, variable overhead, and fixed overhead) must be treated as product costs,
and all selling and administrative (S&A) costs must be treated as period costs, this
approach is called absorption costing (also called full costing).
2) Management accounting
For internal reporting, a more informative accounting treatment is often to
capitalize only variable manufacturing costs as product costs, and treat all other \
costs (variable S&A and the fixed portion of both production and S&A expenses) as
period costs, this approach is called variable costing (also called direct costing).

m
Relationship of types of costs:
co
Variable Fixed
Direct
Indirect
Direct
Indirect
a.
cm
h am
ef

Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM):

DM Available for use
+ Beginning
DM inv.
m
Purchased DM
Purchased DM cost
co
- Return & Cost of DM + Beginning Cost of
Discout used WIP inv. Goods Sold
Fright in Direct Labor

a. COGM
(period)

cm
- Ending DM Manufactoring - Ending WIP Finished
inv. over head inv. Goods inv.
Calculating Cost of Goods Sold
am
COGS represent the cost to produce or purchase the units that were sold during
the period.
COGS is calculated using the following formula:
h
Beginning finished goods inventory Finished

+ Purchases (for a reseller) or cost of goods manufactured (for a manufacturer)
ef
Cost of Goods Available for Sale

− Ending finished goods inventory
= Cost of Goods Sold
Calculating Cost of Goods Manufactured

The COGM represents the cost of the units completed and transferred out of work-
in-process during the period. For a manufacturing company this amount will be
part of the cost of goods sold calculation. COGM does not include the cost of work
that was done on units that were not finished during the period.

COGM is calculated using the following formula:

Direct Material Used
+ Direct Labor Used
+ Manufacturing Overhead Applied
= Total Manufacturing Costs
+ Beginning Work-in-Process Inventory
− Ending Work-in-Process Inventory
m
= Cost of Goods Manufactured
co
DM used is calculated using the following formula:
Beginning Direct Materials Inventory
+ Purchases
a.
+ Transportation-In
– Net Returns
– Ending Direct Materials Inventory
Direct Material Used
cm
COGS formula:
Beginning DM inventory XX
am
Purchased DM cost XX
- return and discount (XX)
Net purchase cost XX
+ Freight in cost XX XX
h
= DM available for use XX

- Ending DM inventory (XX)
ef
= Production cost of used DM XX

+ DL cost XX
+ MOH cost XX
= Total manufacturing cost for the period XX
+ Beginning WIP inventory XX
- Ending WIP inventory (XX)
= Cost of Goods manufactured (COGM) XX
+ Beginning finished goods inventory XX
= Goods available for sales XX
- Ending finished goods inventory (XX) Balance sheet
= Cost of Goods Sold (COGS) XX income statement

Cost classification for decision making:
1- Controllable vs. noncontrollable costs:
Controllable costs are those that are under the discretion (control) of a particular
manager.
m
Noncontrollable costs are those to which another level of the organization has
committed, removing the manager’s discretion, such as higher management level.
co
it is not inherent in the nature of a given cost.
For example, an outlay for new machinery may be controllable to the division vice
president but noncontrollable to a plant manager or lower-level manager.
2- Relevant vs. Sunk costs:

Relevant costs include two conditions:
1. Will be incurred in the future a.
cm
2. Differs for each decision option
Sunk costs
Irrelevant costs as it was incurred or committed in the past (Historical costs), so
am
they are unavoidable and will therefore not vary with the option chosen, so
decision maker no longer has discretion over them
h
Historical cost is the actual (explicit) price paid for an asset. Financial accountants
rely heavily on it for balance sheet reporting, because historical cost is a sunk cost,
ef
however, management accountants often find other (implicit) costs to be more

useful in decision making.
3- Differential cost & Incremental cost:

Incremental cost: additional cost inherent in a given decision
Differential cost: differs for each decision option, computed as difference
between two incremental costs.
Example:
A company must choose between introducing two new product lines.
1) The incremental choice of the first option is the initial investment of $1.5 million;
the incremental choice of the second option is the initial investment of $1.8 million.
2) The differential cost of the two choices is $300,000.

4- Outlay vs. Opportunity costs:

Opportunity costs: are implicit costs
Benefit lost (foregone) when choosing one option that precludes receiving benefit
from an alternative option
Outlay costs which is an explicit cost and out of pocket costs, such as actual cash
disbursement
m
Economic costs = implicit costs + explicit costs
co
5- Avoidable vs. committed costs:
Avoidable costs are those that may be eliminated by not engaging in an activity or
by performing it more efficiently. An example is direct materials cost, which can be
saved by ceasing production.
a.
related to production process – if done more efficiently or activity level – when
ceasing production
cm
Committed costs arise from holding property, plant, and equipment. Examples are
insurance, real estate taxes, lease payments, and depreciation. They are by nature
long-term and cannot be reduced by lowering the short-term level of production.
am
Committed costs: past decisions

Only change slowly in response to small changes in capacity
h
long term and can’t be reduced by lowering short term production

Typically, fixed costs, arise from holding property, plant and equipment
ef
Ex. Insurance, real estate taxes, depreciation
6- Engineered Vs. Discretionary:

Engineered costs: observable, direct and quantifiable cause and effect
relationship between input and output Ex. DM and DL
Discretionary costs: budgeting decisions, have no strong input and output
relationship
Uncertainty degree of caution, for example advertising costs and R&D costs
Expression: Management decision to incur in the current period to enable to
achieve objectives other than the filling of orders replaced by customers.

Other costs classification:

1- Joint & separable costs: joint irrelevant while separable costs are relevant
2- Normal & Abnormal spoilage: normal product costs
Abnormal losses allocated to the period costs
3- Rework, Scrap & Waste:
Rework: related to finished goods - should be charged to FOH
control account including OH costs incurred during rework
m
Scrap & Waste: related to raw materials
co
Other costs:
1- Carrying costs: the costs of storing or holding inventory, related to carrying
inventory costs, it includes implicit and explicit costs (Compared to stock out costs)
2- Transferred in costs: related to transferred costs between production
a.
departments
3- Value adding costs: are the costs of activities that cannot be eliminated without
reducing the quality, responsiveness, or quantity of the output required by a
cm
customer or the organization.
am
Different costs for different purposes

h
:‫ﻦ‬lm‫ﻦ ﺟ‬l‫ﺪأ ﻋﺎم ﻟﻬﻮر‬x‫ﻣ‬

Different costs for different purposes
ef
Ex. Product cost

Pricing all costs
Decision making value adding and none value adding costs
Disclosure only manufacturing costs

4. Capacity Levels:
m
Capacity levels (denominator-level capacity choices):
co
A) Supply denominator level concepts:
What the company can supply?
1- Theoretical (Ideal) (perfect) capacity:
a.
Theoretical (ideal) capacity is the maximum capacity assuming continuous
operations with no holidays, downtime, etc.
- This type of capacity will never be close to actual level which means there
will be always over/under allocation if this type is used as a denominator
cm
capacity level.
- Represents largest possible volume of output but unattainable, unrealistic
and unachievable
- Means producing at full efficiency all the time: no idle time, no down time,
am
no machine breakdowns, no maintenance and no waste

- Represents large denominator activity level, which will result in lower OH
cost allocation per unit
h
2- Currently attainable (practical) capacity:

ef
Practical capacity is the maximum level at which output is produced efficiently. It

allows for unavoidable delays in production for maintenance, holidays, etc.
- Highest level of capacity that can be achieved
- Company is not over/under allocating OH costs / unit
- Practical capacity = theoretical capacity – idle time & down time
B) Demand denominator level concepts:

1- Master budget capacity (expected actual capacity):
- Budgeted output based on expected demand for the next period (budgeted
period) typically one year
- Always will result in different allocation base per unit

2- Normal capacity: OH standard costs

- Average of expected customer demand (average of master capacity) say two
to three years
Normal capacity is the long-term average level of activity that will approximate
demand over a period that includes seasonal, cyclical, and trend variations.
Deviations in a given year will be offset in subsequent years.
m
co
a.
cm
h am
ef

m
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a.
cm
h am
ef

Unit 6. Cost accumulation systems

Subunits:
1) Costing techniques
2) Job order costing
3) Activity based costing
4) Process costing
5) Life cycle costing
m
6) Accounting for spoilage
co
1. Costing Techniques:
Product costing involves accumulating, classifying and assigning direct materials,
a.
direct labor, and factory overhead costs to products, jobs, or services. In developing
a costing system, management accountants need to make choices in three
categories of costing methods:
1) The cost accumulation method to use (job costing, process costing, or operation
cm
costing).
2) The method to be used to allocate overhead (allocation) (volume-based or
activity-based).
am
3) The cost measurement method to use in allocating costs to units manufactured

(standard, normal, or actual costing).
All systems (accumulation, allocation or measurement are interrelated)

h
ef

(Product costing systems)
Cost accumulation
Collecting cost data According to manufacturing settings
Job order costing Process costing Operation costing
m
Primly normal costing Primly >>>>>>> standard different DM
cost object >>>>> Job
co
Manufacturing settings: Manufacturing settings: Operation costing
Customized, Unique, Mass production and = DM (different) (Job Costing)
Heterogeneous, few units homogeneous + Conversion cost (Similar)
produced (DL + MOH) (Process costing)
1st Management decision
Volume based
Volume Based (Output)
How to allocate OH cots?
a. ABC
Activity based
cm
(Peanut-butter-costing) Non-volume based
A) Plant wide single rate: single cost pool Transaction-Based Costing
B) Departmental
# of cost pools = # of departments
am
2nd management decision

Cost measurement system?
Actual Normal Standard
h
Actual MOH Budgeted MOH Budgeted MOH

‫ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ــ ـ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ــ‬ ‫ــ ـ ـ ـ ــ ـ ـ ــ ـ ــ ـ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ــ‬ ‫ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ــ ـ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ـ ـ ــ ـ ـ ــ ـ ـ ـ ــ ــ‬
ef
Actual allocation base Budgeted allocation base Budgeted allocation base
Actual allocation rate Budgeted allocation rate Budgeted (predetermined)

X actual allocation base X actual allocation base allocation rate
X budgeted allocation base
X Actual Activity level

DM and DL
Actual Actual Budgeted
(AP X AQ) X Actual Activity (AP X AQ) X Actual Activity level (SP X SQ) X Actual Activity
level level

Cost Measurement Systems:

1) Actual Costing
In an actual costing system, no predetermined or estimated or standard costs are
used. Instead, the actual direct labor and materials costs and the actual
manufacturing overhead costs are allocated to the units produced. The cost of a
unit is the actual direct cost rates multiplied by the actual quantities of the direct
m
cost inputs used and the actual indirect (overhead) cost rates multiplied by the
actual quantities used of the cost allocation bases.
co
Actual costing is practical only for job order costing for the same reasons that
normal costing is practical only for job order costing. In addition, actual costing is
seldom used because it can produce costs per unit that fluctuate significantly. This
fluctuation in costs can lead to errors in management decisions such as pricing of
a.
the product, decisions about adding or dropping product lines, and performance
evaluations.

cm
2) Standard Costing
In a standard cost system, standard, or planned, costs are assigned to units
produced (output). The standard cost of producing one unit of output is based on
the standard cost for one unit of each of the inputs required to produce that output
am
unit, with each input multiplied by the number of units of that input allowed for
one unit of output. The inputs include direct materials, direct labor and allocated
overhead.
h
The standard cost is what the cost should be for that unit of output.
ef
Standard cost per output unit

= standards price per input unit X standard input units allowed for output
unit = SP X SQ
Direct materials and direct labor are applied to production by multiplying the
standard price or rate per unit of direct materials or direct labor by the standard
amount of direct materials or direct labor allowed for the actual output. For
example, if three direct labor hours are allowed to produce one unit and 100 units
are actually produced, the standard number of direct labor hours for those 100
units is 300 hours (3 hours per unit × 100 units). The standard cost for direct labor
for the 100 units is the standard hourly wage rate multiplied by the 300 hours
allowed for the actual output, regardless of how many direct labor hours were
actually worked and regardless of what actual wage rate was paid. The cost
applied to the actual output is the standard cost allowed for the actual output.
Note: In a standard cost system, the standard quantity of an input allowed for the
actual output, not the actual quantity of the input used for the actual output and
the standard price allowed per unit of the input, not the actual price paid per unit
of the input, are used to calculate the amount of the input’s cost applied to
m
production.
co
In a standard cost system, overhead is generally allocated to units produced by
calculating a predetermined, or standard, manufacturing overhead rate (a volume-
based method) that is applied to the units produced on the basis of the standard
amount of the allocation base allowed for the actual output. When a traditional
application rate is =
a.
method of overhead allocation is used, the standard manufacturing overhead
budgeted overhead cost

cm
budgeted activity level of the allocation base.
The predetermined overhead rate is calculated as follows:

The best cost driver to use as the allocation base is the measure that best
am
represents what causes overhead cost to be incurred.

The most frequently-used allocation bases are for a labor-intensive manufacturing
process direct labor hours or direct labor costs. For an equipment-oriented
h
manufacturing process, number of machine hours is the better allocation base.

To apply overhead cost to production:
ef
1 Budgeted Budgeted Activity Level predetermined

Manufacturing ÷ of Allocation Base = overhead rate
Overhead
2 predetermined standard amount of the standard overhead
overhead rate X allocation base allowed = amount for one unit
for producing one unit
of product
3 standard overhead number of units actually standard overhead
amount for one X produced = cost to be applied to
unit all the units produced

Of course, the actual costs incurred will probably be different from the standard
costs. The difference is a variance. The difference is also called an under-applied
or over-applied cost. At the end of each accounting period, variances are
accounted for in one of two basic ways.
• If the variances are immaterial, they may be closed out 100% to Cost of Goods
Sold expense on the income statement.
• If the variances are material, they should be prorated among Cost of Goods Sold
m
and the relevant Inventory accounts on the balance sheet according to the amount
of overhead included in each that was allocated to the current period’s production.
co
Standard costing enables management to compare actual costs with what the costs
should have been for the actual amount produced. Moreover, it permits
production to be accounted for as it occurs. Using actual costs incurred for
a.
manufacturing inputs would cause an unacceptable delay in reporting, because
those costs may not be known until well after the end of each reporting period,
when all the invoices have been received.
cm
The emphasis in standard costing is on flexible budgeting, where the flexible budget
for the actual production is equal to the standard cost per unit of output multiplied
by the actual production volume.
Standard costing can be used in either a process costing or a job-order costing
am
environment.
Note: The standard cost for each input per completed unit is the standard rate per
unit of input multiplied by the amount of inputs allowed per completed unit, not
h
multiplied by the actual amount of inputs used per completed unit.

ef
3) Normal Costing
In a normal cost system, direct materials and direct labor costs are applied to
production differently from the way they are applied in standard costing. In normal
costing, direct materials and direct labor costs are applied at their actual rates
multiplied by the actual amount of the direct inputs used for production.
To allocate overhead, a normal cost system uses a predetermined annual
manufacturing overhead rate, called a normal or normalized rate. The
predetermined rate is calculated the same way the predetermined rate is
calculated under standard costing. However, under normal costing, that
predetermined rate is multiplied by the actual amount of the allocation base that
was used in producing the product, whereas under standard costing, the
predetermined rate is multiplied by the amount of the allocation base allowed for
producing the product.

Normal cost =
SP (budgeted allocation rate) X AQ (actual input units used for actual output)
Normal costing is not appropriate in a process costing environment because it is

too difficult to determine the actual costs of the specific direct materials and direct
labor used for a specific production run. Normal costing is used mainly in job
costing.
m
The purpose of using a predetermined annual manufacturing overhead rate in
normal costing is to normalize factory overhead costs and avoid month-to-month
co
fluctuations in cost per unit that would be caused by variations in actual overhead
costs and actual production volume. It also makes current costs available. If actual
manufacturing overhead costs were used, those costs might not be known until
a.
well after the end of each reporting period, when all the invoices had been
received.
cm
h am
ef

m
co
a.
Example of standard costing, normal costing, and actual costing used for the
same product under the same set of assumptions:
Log Homes for Dogs, Inc. (LHD) manufactures doghouses made from logs. It offers
cm
only one size and style of doghouse. For the year 20X4, the company planned to
manufacture 20,000 doghouses. Overhead is applied on the basis of direct labor
hours.
am
The company’s planned costs were as follows:

Direct materials $45 per doghouse (5 units of DM/doghouse @ $9/ unit)
Direct labor $30 per doghouse (2 DLH/doghouse @ $15/ DLH)
h
Variable overhead $10 per doghouse (2 DLH/doghouse @ $5/DLH

Fixed overhead $260,000, or $13 per doghouse (2 DLH/doghouse @ $6.50
ef
per DLH)
LHD actually produced and sold 21,000 doghouses during 20X4.

LHD’s actual costs incurred were:
Direct materials $882,000: 5.25 units of DM used per doghouse @ $8/unit of
DM
Direct labor $617,400: 2.1 DLH used per doghouse @ $14/DLH
Variable overhead $224,910
Fixed overhead $264,600

Answer
Total Costs Applied Under Standard Costing:
DM cost applied: $9 std. cost/unit of DM × 5 units allowed/house × 21,000 = $945,000
Direct labor applied: $15 std. rate/DLH × 2 DLH allowed/house × 21,000 = $630,000
Variable overhead applied: $5 std. rate/DLH × 2 DLH. allowed/house × 21,000 = $210,000
Fixed overhead applied: $6.50 std. rate/DLH × 2 DLH. allowed/house × 21,000 = $273,000
Total Costs Applied Under Actual Costing:
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Direct materials cost applied: $8 actual rate/DM unit × 5.25 units used/house × 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH × 2.1 DLH used/house × 21,000 = $617,400
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Variable overhead applied: $5.10 actual rate/DLH × 2.1 DLH used/house × 21,000 = $224,910
Fixed overhead applied: $6.00 actual rate/DLH × 2.1 DLH used/house × 21,000 = $264,600
Total Costs Applied Under Normal Costing:
a.
Direct materials cost applied: $8 actual rate/DM unit × 5.25 units used/house × 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH. × 2.1 DLH. used/house × 21,000 = $617,400
Variable overhead applied: $5 est. rate/DLH × 2.1 DLH used/house × 21,000 = $220,500
Fixed overhead applied: $6.50 est. rate/DLH × 2.1 DLH used/house × 21,000 = $286,650
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The costs applied per unit under each of the cost measurement methods were:
Cost Applied per Unit Under Standard Costing:
Direct materials ($9 std. cost/unit of DM × 5 units of DM allowed) $45.00
Direct labor ($15 std. rate/DLH × 2 DLH allowed) 30.00
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Variable overhead ($5/DLH allowed × 2 DLH allowed) 10.00

Fixed overhead ($6.50/DLH allowed × 2 DLH allowed) 13.00
Total cost per unit $98.00
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Cost Applied per Unit Under Actual Costing:

Direct materials ($8 actual cost/DM unit × 5.25 units) $42.00
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Direct labor ($14 actual rate/DLH × 2.1 DLH used) 29.40

Variable overhead ($5.10 actual rate/DLH × 2.1 DLH used) 10.71
Fixed overhead ($6.00 actual rate/DLH × 2.1 DLH used) 12.60
Cost Applied per Unit Under Normal Costing:

Direct materials ($8 actual cost/DM unit × 5.25 units used) $42.00 Actual
Direct labor ($14 actual rate/DLH × 2.1 DLH used) 29.40 Actual
Variable overhead ($5 est. rate /DLH Standard × 2.1 DLH used Actual) 10.50
Fixed overhead ($6.50 est. rate/DLH Standard × 2.1 DLH used Actual) 13.65

Cost Accumulation Systems:

2. Job Order Costing:
Job-order costing is concerned with accumulating costs by specific job.
This method is appropriate when producing products with individual unique
characteristics (e.g., yachts), or when identifiable groupings are possible (e.g.,
jewelry). Units (jobs) should be dissimilar enough to warrant the special record
keeping required by job-order costing. Products are usually custom made for a
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specific customer, audit and legal firms are good examples of job-order costing
environments. As employees work on a particular client or case, they charge their
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time and any other costs to that specific job. At the end of the project, the company
simply needs to add up all of the costs assigned to it to determine the project’s
cost. Performance measurement can be done by comparing each individual job to
a.
its budgeted amounts or by using a standard cost system.
Job-order costing is a cost system in which all of the costs associated with a specific
job or client are accumulated and charged to that job or client. The costs are
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accumulated on what is called a job-cost sheet.
All of the job sheets that are still being worked on equal the work-in-process at that
time. In a job-order costing system, costs are recorded on the job-cost sheets and
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not necessarily in an inventory account. While direct materials and direct labor are
accumulated on an actual basis, manufacturing overhead must be allocated to each
individual job. A predetermined overhead rate is calculated and applied to each
product based either on:
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• Actual usage of the allocation base (as in normal costing)

• Standard usage of the allocation base (as in standard costing)
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Multiple cost allocation bases may be used if different overheads have different
cost drivers. For example, in a manufacturing environment, machine hours for each
job may be used to allocate overhead costs such as depreciation and machine
maintenance, whereas direct labor hours for each job may be used to allocate plant
supervision and production support costs to jobs. If normal costing is being used,
actual machine hours and actual direct labor hours will be used. If standard costing
is being used, the standard machine hours allowed, and the standard direct labor
hours allowed for the actual output on each job will be used.
Note: Under job-order costing, selling and administrative costs are not allocated
to the products in order to determine the COGS per unit. Selling and administrative
costs are expensed as period costs.

Briefly:
Cost objective is the job or unit
Suited for: 1- customized, 2- unique, 3- heterogeneous production, and 4- few units
produced
Job order coting is based mainly on Normal costing and applied OH

Normal costing = budgeted rate X actual allocation base = applied / allocated OH
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costs
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Job-Order Costing steps:
1- The first step in the process is the receipt of a sales order from a customer
requesting a product or special group of products.
a.
2- Costs are recorded by classification, such as direct materials, direct labor,
and manufacturing overhead, on a job cost sheet, which is specifically
prepared for each job.
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a. The physical inputs required for the production process are obtained
from suppliers. The journal entry to record the acquisition of inventory
would be
Raw materials $XX
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Accounts payable $XX
b. Materials requisition forms request direct materials to be pulled from

the warehouse and sent to the production line.
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Work-in-process – Job 1015 $XX

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Raw materials $XX
c. Time tickets track the direct labor that workers expend on various
jobs.
Wages payable $XX
These two major components of product cost are charged to work-in process
(an inventory account) using the actual amounts incurred.
3- Under job-order costing, the third component, manufacturing overhead, is

charged using an estimated rate.

a. The application of an estimated overhead rate is necessary under job-

order costing because the outputs are customized, and the processes
vary from period to period.
b. As indirect costs are paid throughout the year, they are collected in
the manufacturing overhead control account.
Note that work-in-process is not affected when actual overhead costs
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are incurred, and the debits are made to a manufacturing overhead
control account, not work-in-process.
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Manufacturing overhead control $XX
Property taxes payable $XX
Prepaid insurance
a.
$XX
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Accumulated depreciation – factory equipment $XX
c. Overhead costs are applied to (“absorbed” by) each job based on a

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predetermined overhead application rate for the year (such as $5 per

direct labor hour, or machine hour, etc., or based on an activity-based
costing system).
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i) At the beginning of the year, an estimate is made of the total amount

that will be spent for manufacturing overhead during that year.
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ii) This total is divided by the allocation base, such as direct labor hours
or machine hours, to arrive at the application rate.
iii) The amount applied equals the number of units of the allocation
base used during the period times the application rate.
# The credit is to manufacturing overhead applied, a contra-account
for manufacturing overhead control.
Manufacturing overhead applied $XX
iv) By tracking the amounts applied to the various jobs in a separate
account, the actual amounts spent on overhead are preserved in the
balance of the overhead control account.

# In addition, the firm can determine at any time how precise its
estimate of overhead costs for the period was by comparing the
balances in the two accounts. The closer they are (in absolute value
terms), the better the estimate was.
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a.
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d. At the end of the period, the overhead control and applied accounts
are netted.
If the result is a credit, overhead was overapplied for the period. If the
result is a debit, overhead was underapplied.
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# If the variance is immaterial, it can be closed directly to cost of goods

sold.
# If the variance is material, it should be allocated based on the relative
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values of work-in-process, finished goods, and cost of goods sold.

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4- The amounts from the input documents are accumulated on job-cost sheets.
These serve as a subsidiary ledger page for each job.
a. The total of all job-cost sheets for jobs in progress will equal the
balance in the general ledger work-in-process inventory account.
b. Once the job is completed, but before it is delivered to the customer,
the job cost sheet serves as the subsidiary ledger for the finished
goods inventory account.
5- When a job order is completed, all the costs are transferred to finished
goods.
Finished goods Inv. $XX


6- When the output is sold, the appropriate portion of the cost is transferred to
cost of goods sold.
Cost of goods sold $XX
Finished goods Inv. $XX
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3. Activity Based Costing: (Transaction-Based Costing)

Activity-based costing (ABC) is another way of allocating overhead costs to
products, and in ABC the method of allocation is based on cost drivers. As with the
other overhead allocation methods, ABC is a mathematical process. It requires
identification of the costs to be allocated, followed by some manner of allocating
them to departments, processes, products, or other cost objects. ABC can be used
in a variety of situations and can be applied to both manufacturing and
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nonmanufacturing overheads. It can also be used in service businesses.
The Institute of Management Accountants defines activity-based costing as
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“a methodology that measures the cost and performance of activities, resources,
and cost objects based on their use. ABC recognizes the causal relationships of cost
drivers to activities.”
a.
• An activity is an event, task or unit of work with a specified purpose. Examples
of activities are designing products, setting up machines, operating machines,

making orders or distributing products.
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 Resources: is an economic element applied or used to perform
activities, such as: salaries and materials
• A cost object is anything for which costs are accumulated for managerial
purposes. Examples of cost objects are a specific job, a product line, a market, or
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certain customers.
 Intermediate cost objects receive temporary accumulations of costs as the
cost pools move from their originating points to the final cost objects, for
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example, work-in-process is an intermediate cost object, and finished salable

goods are final cost objects.
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• A cost driver is anything (it can be an activity, an event, or a volume of some

substance) that causes costs to be incurred each time the driver occurs (cause-and-
effect relationship).
 Two types of cost drivers:
 Resources cost driver
 Activity cost driver
Measurable factor used to assign costs to activities (resources cost driver) and from
activities to cost objects (activity cot driver)
ABC is a costing approach that assigns costs to cost objects, based on the
consumption of resources caused by activities resources are assigned to
activities and activities are assigned to cost objects based on the activities’ use

Design of an ABC system starts with process value analysis, a comprehensive

understanding of how an organization generates its output.
1) A process value analysis involves a determination of which activities that use
resources are value-adding or nonvalue-adding and how the latter may be reduced
or eliminated.
A value-adding activity contributes to customer satisfaction or meets a need of the
entity. The perception is that it cannot be omitted without a loss of the quantity,
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quality, or responsiveness of output demanded by the entity or its customers.
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Steps in ABC:
1. Identification of activities involved in the production process;
2. Classification of each activity according to the cost hierarchy (i.e. into unit-
a.
level, batch-level, product level and facility level);
Cost Hierarchy
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The first step in activity-based costing involves identifying activities and classifying
them according to the cost hierarchy. Cost hierarchy is a framework that classifies
activities based the ease at which they are traceable to a product.
Unit level activities are activities that are performed on each unit of product.
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Batch level activities are activities that are performed whenever a batch of the
product is produced.
Product level activities are activities that are carried out separately for each
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product.
Facility level activities are activities that are carried out at the plant level. The unit-
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level activities are most easily traceable to products while facility-level activities are
least traceable.
Activity Hierarchy
Product design Product-sustaining
Production setup Batch-level
Machining Unit-level
Inspection & testing Unit-level
Customer maintenance Facility-sustaining
3. Identification and accumulation of total costs of each activity;

Once the activities are designated, the next step in enacting an ABC system is to
assign the costs of resources to the activities. This is termed first-stage allocation.

Once the resources have been identified, resource drivers are designated to
allocate resource costs to the activity cost pools, resource drivers (causes) are
measures of the resources consumed by an activity.
Resource Driver
Production line (electricity & depreciation) Machine hours
Materials management wages Hours worked
Accounting wages Hours worked
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Sales & marketing Number of orders
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Maintenance activity will include all costs of resources consumed by maintenance
such as engineering wages, indirect wages, utilities, depreciation, etc.
a.
4. Identification of the most appropriate cost driver for each activity;
The final step in enacting an ABC system is allocating the activity cost pools to final
cost objects. This is termed second-stage allocation.
Activity Driver
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Product design Number of products
Production setup Number of setups
Machining Number of units produced
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Inspection & testing Number of units produced

Customer maintenance Number of orders
5. Calculation of total units of the cost driver relevant to each activity;

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6. Calculation of the activity rate i.e. the cost of each activity per unit of its
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relevant cost driver;
7. Application of the cost of each activity to products based on its activity

usage by the product.
Briefly activity-based system involves 4 main steps:
1. Activity analysis: Identifying activities that constitute overhead
2. 1st step of allocation
Assigning costs for resources to activity cost pools (activity centers) using
resource cost drivers
3. Calculate activity rates
4. 2nd stage of allocation
Assigning OH costs to cost objects

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a.
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Activity-Based Management
The linkage of product costing and continuous improvement of processes is
activity-based management (ABM). It encompasses driver analysis, activity
analysis, and performance measurement.
Pricing and Product-Mix Decisions
Cost Reduction and Process Improvement Decisions
Design Decisions
Planning and Managing Activities

Benefits of ABC:
1. More accurate product cost which lead to more accurate profitability
measurements
2. Better cost control which helps to improve product
3. Helps to reduce distortions caused by traditional cost allocations (product-
cost cross-subsidization)
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Limitations of ABC:
1. Sometimes finding a specific activity that causes the cost, might not be
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practical
2. General practice of ABC do not conform to GAAP, as sometimes it come to
allocating nonmanufacturing costs to the product cost
3. Very expensive to develop and very time consuming
a.
4. Generates vast amounts of information while too much information can
mislead managers
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Traditional (Volume-Based) Costing System
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Under a traditional (volume-based) costing system, overhead is simply dumped

into a single cost pool and spread evenly across all end products, also called peanut-
butter costing.
Peanut-butter costing results in product-cost cross-subsidization, the condition in
which the miscosting of one product causes the miscosting of other products.
Volume-based systems, as illustrated above, involve

1) Direct labor and direct materials are traced to products or service units.
2) Accumulating costs in general ledger accounts (utilities, taxes, etc.)
3) Using a single cost pool to combine the costs in all the related accounts
4) Selecting a single driver to use for the entire indirect cost pool
5) Allocating the indirect cost pool to final cost objects.
Limitations of traditional costing systems:
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1. Generally, under costs low volume products and over costs high volume
products
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2. Distorted inventory measurement
3. Unrealistic pricing
4. Ineffective resource allocation
5. Incorrect product-line decisions
a.
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4. Process Costing Accounting:

Process cost accounting is used to assign costs to inventoriable goods or services.
It is applicable to relatively homogeneous products that are mass produced on a
continuous basis (e.g., petroleum products, thread, computer monitors).
Assigning an exact amount of materials, labor, and indirect costs to thousands, or
even millions, of individual end products is simply not cost-effective. For this
reason, process costing involves averaging the costs of production and allocating
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them to work-in-process and finished goods.
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Briefly:
Homogeneous products mass production similar process
Due to mass production DL costs are usually small thus DL cost combined with MOH
to constitutes conversion costs
a.
if using actual costing, there will be no over/under applied OH, also it is an inventory
costing system
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The accumulation of costs under a process costing system is by department rather
than by project. There will normally be a work-in-process inventory account for
each department, this reflects the continuous, homogeneous nature of the
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manufacturing process
Unit cost = Process cost / Equivalent units produced
All of the costs incurred during the current period and during all previous periods
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for the units worked on during the period must be allocated to either finished
goods (or to the next department for more work to be done) or EWIP at the end of
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the current period.
The costs in the department, usually materials and conversion costs (DL+MOH) and
sometimes transferred-in costs, that require allocation can come from one of three
places:
1) The costs are incurred by the department during the period. Materials and
conversion costs are accounted for separately.
2) The costs are transferred in from the previous department. Transferred-in costs
include total materials and conversion costs from previous departments that have
worked on the units. Transferred-in costs are transferred in as total costs.
3) The costs were in the department on the first day of the period as costs for the
beginning work-in process (BWIP). They were incurred by the department during
the previous period to begin the work on the units in the current period’s BWIP.

In reality, the categories of costs can be numerous. They may include more than
one type of direct materials, more than one class of direct labor, indirect materials,
indirect labor or other overheads. However, on the CMA exam, generally only two
classifications of costs are tested: direct materials and conversion costs.
Conversion costs include everything other than direct materials—specifically direct
labor and overhead—and are the costs necessary for converting the raw materials
into the finished product.
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Note: Transferred-in costs are the total costs that come with the in-process
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product from the previous department. They are similar to raw materials, but they
include all of the costs (direct materials and conversion costs) from the previous
department that worked on the units. The costs of the previous department’s
“completed units” are the current department’s transferred-in costs, and the
a.
transferred-in costs and work are 100% complete (even though the units
themselves are not complete when received) because the work done in the
previous department is 100% complete.
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At the end of the period all of the costs within the department—including direct
materials, conversion costs, and transferred-in costs, if applicable—must either be
moved to Finished Goods Inventory (or to the next department if further work is
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required) if the work on them in the current department was completed, or they
will remain in Ending WIP if they are not complete (the allocation process will be
explained later). The Ending WIP Inventory for the current period will be the
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Beginning WIP Inventory for the next period.

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When the goods that have been completed and transferred to Finished Goods
Inventory are sold, the costs associated with the units that were sold will end up in
COGS. The costs of the units that have been completed but have not been sold will
remain in Finished Goods Inventory until they are sold.
Thus, the cost of every unit that goes through a particular process in a given period
must be recorded in one of the four following places at the end of the period:
1) Ending WIP Inventory in the department or process
2) The next department in the assembly process
3) Ending Finished Goods inventory
4) Cost of Goods Sold
Items 2 and 3 in the preceding list are classified together as completed units
transferred out of the department. The costs for all units on which the current

process’s work has been completed are transferred either to Finished Goods
Inventory or to the next department or process for further work.
Whether the units have been sold (and the costs are in COGS), are still being
worked on (are in ending WIP for the company) or finished but not sold (in ending
Finished Goods Inventory for the company) is irrelevant to the process in a given
department. The objective of process costing is to allocate costs incurred to date
on products worked on in one department during one period between completed
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units and ending Work-in-Process Inventory for that department.
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a.
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Note: The basic accounting for a process costing system is as follows:

All of the manufacturing costs incurred are debited to a WIP Inventory account.
Manufacturing costs include direct material, direct labor, and factory overhead
consisting of indirect materials, indirect labor and other factory overhead such as
facility costs. Direct materials are usually added to units in process in a different
pattern from the way conversion costs (direct labor and overhead) are added to
units in process, so they are usually accounted for separately.

The costs in WIP then need to be allocated between units completed during the
period and units remaining in ending WIP at the end of the period. Costs for units
completed during the period are transferred to either Finished Goods Inventory or,
if more work is needed on them, to the next department’s WIP inventory. This cost
allocation is done based on a per unit allocation basis. Candidates do not need to
be familiar with the accounting steps in the process, just the process of allocating
the costs, but the information is presented because it may help candidates to see
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what is happening in the process.
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Process costing Steps:
The following will examine the steps in process costing in more detail. It is
important for candidates to be very comfortable with how equivalent units of
production are calculated. Equivalent units of production are used to allocate costs
a.
between completed units transferred out during the period and the incomplete
units remaining in ending work-in-process inventory at the end of the period.
Equivalent units of production, or EUP, are an important concept in process costing
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and one that is likely to be tested.
1- As in job-order costing, the physical inputs required for the production

process are obtained from suppliers.
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Raw materials $XX

Accounts payable $XX
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2- Direct materials are used by the first department in the process and are
added to work-in-process.
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Work-in-process – Department A $XX

Raw materials $XX
3- Conversion costs, which includes direct labor and manufacturing overhead,

are used by the first department (Department A) and are added to work-in-
process.
1) Actual amounts are used.

2) Standard costs are applied at a later stage for purposes of variance analysis.
Work-in-process – Department A $XX
Wages payable (direct and indirect labor) XX
Manufacturing supplies (indirect materials) XX
Property taxes payable XX

Prepaid insurance XX
Accumulated depreciation – factory equipment XX
4- The products can move from one department to the next (from Department
A to Department B).
Work-in-process – Department B $XX
Work-in-process – Department A XX
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5- The second department (Department B) can add more direct materials and
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more conversion costs.
Work-in-process – Department B $XX
Raw materials XX
Work-in-process – Department B
a.
Wages payable (direct and indirect labor)
Manufacturing supplies (indirect materials)
$XX
XX
XX
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Property taxes payable XX
Prepaid insurance XX
Accumulated depreciation – factory equipment XX
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6- If a standard costing system is used, standard costs are applied before

transfer from work-in-process to finished goods, the differences are
accumulated in a direct materials variance and a conversion costs variance
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account.
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7- When processing is finished in the last department, all the costs are
transferred to finished goods.
Finished goods $XX
Work-in-process – Department B XX
8- As products are sold, the costs are transferred to cost of goods sold.
Cost of goods sold $XX
Finished goods XX

Detailed steps in Process costing

A. Equivalent Units of Production – Basics
1- Some units remain unfinished at the end of the period. For each department
to account adequately for costs attached to its unfinished units, the units
must be restated in terms of equivalent units of production (EUP).
1) EUP are the number of complete units that could have been produced
using the inputs consumed during the period, for example, 2 units that are
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each 50% complete make 1 EUP (2 units × 50%).
2) Cost-per-unit can be calculated using EUP.
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2- In all EUP calculations:
3- There are 2 methods for calculating EUP:
a.
1) Under the weighted-average method, the beginning WIP is treated as if it is
started and completed during the current period.

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EUP under weighted average costing:
DM Conversion
Total units completed this period XX XX first line of FIFO
+ Amount added to date on EWIP XX XX last line of FIFO
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EUP under weighted average XX XX

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2) Under the first-in, first-out (FIFO) method, work done in the current period
on units in beginning WIP are included in the calculation.
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For example, units in beginning WIP that are 40% complete at the beginning of
the period will require an additional 60% of work in the current period for those
units to be completed. The 60% of work done in the current period is included
in EUP, while the 40% done in the previous period is not.
EUP computation under FIFO:

DM Conversion
Total units completed XX XX
- BWIP (regardless of % of completion) <XX> <XX>
Units started and completed this period XX XX
+Amount needed to complete BWIP XX XX BWIP ‫ﺔ ال‬x‫ﻣﺘﻤﻢ ~ﺴ‬
+Amount completed on EWIP XX XX EWIP ‫ﺔ ال‬x‫ﻧﻔﺲ ~ﺴ‬
EUP under FIFO XX XX

B. Equivalent Units of Production – Materials

a. Materials can be added at the beginning:
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BWIP = 0 DM
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EWIP = 100% DM
a.
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Units in beginning WIP are already 100% complete with respect to direct
materials
Units in beginning WIP will not produce EUP in the current period since
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materials were added in the previous period.
Units in ending WIP are 100% complete with respect to direct materials when
materials are all added at the beginning of the production process.
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ef
b. Materials can be added evenly throughout the process:

Beginning WIP -- FIFO method
Since we are looking for the amount completed in the current period, we
subtract the completion percentage from 100%. This will give us the
percentage completed in the current period. For example, if there are 1,000
units in beginning WIP that are 30% complete with respect to materials, 70%
(100% – 30%) will be completed in the current period. # EUP from beginning
WIP will be 700 units (1,000 units × 70%).
Units in ending WIP will be complete based on the completion percentage.

For example, if there are 1,000 units in ending WIP that are 60% complete
with respect to materials, 60% were completed in the current period. # EUP
from ending WIP will be 600 units (1,000 units × 60%).

c. Materials added at end of process:
BWIP = 100% DM
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EWIP = 0 DM
a.
Units in Ending WIP are already 100% complete with respect to direct
materials so it will not produce EUP in the current period it will equal zero.
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Units in beginning WIP are 100% complete with respect to direct materials
when materials are all added at the end of the production process.
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C. Equivalent Units of Production – Conversion Costs

a. Since conversion costs are generally added throughout the process.
b. It is important to note both the method used and the completion
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percentage.
1) Beginning WIP -- FIFO method
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Since we are looking for the amount completed in the current period,
we subtract the completion percentage from 100%. This will give us
the percentage completed in the current period. For example, if there
are 1,000 units in beginning WIP that are 20% complete with respect
to conversion costs, then 80% (100% – 20%) will be completed in the
current period.
# EUP from beginning WIP will be 800 units (1,000 units × 80%).
2) Units in ending WIP will be complete based on the completion

percentage. For example, if there are 1,000 units in ending WIP that
are 10% complete with respect to conversion costs, 10% were
completed in the current period.
# EUP from ending WIP will be 100 units (1,000 units × 10%).

:‫ﺧﺘﺼﺎر‬Y‫اﻟﺨﻄﻮات ﺑ‬
Demonstration of steps in process costing:
 Accounting for all units (physical flow of quantities):
BWIP XX ignoring % of completion of WIP

+ Started units this period XX
Total units to account for XX
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Finished or transferred out goods XX
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+ ending WIP XX
+Spoilage (lost) XX
Total units to account for XX
FIFO
a.
 Compute equivalent units of production (EUP) :
Weighted average (WA)
 Compute unit cost = cost / equivalent

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First in first out (FIFO):
- Inventory costing that distinguishes between work done in the prior period
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and work done in the current period

- Assumes units in BWIP inventory are completed and transferred first, and
the EWIP inventory results from goods processed this period
- EUP is separately computed for DM and Conversion costs
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EUP computation under FIFO:

DM Conversion
Total units completed XX XX
- BWIP (regardless of % of completion) <XX> <XX>
Units started and completed this period XX XX
1- If materials are added continually:
+Amount needed to complete BWIP XX XX BWIP ‫ﺔ ال‬x‫ﻣﺘﻤﻢ ~ﺴ‬

+Amount completed on EWIP XX XX EWIP ‫ﺔ ال‬x‫ﻧﻔﺲ ~ﺴ‬

2- If materials are added at the beginning of the process:
+Amount needed to complete BWIP Zero XX

+Amount added to date on EWIP 100% XX
3- If materials are added at the end of the process:
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+Amount needed to complete BWIP 100% XX
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+Amount added to date on EWIP Zero XX
Weighted-Average:
a.
ˆ‫ﺗ‬ Š ˆ‫ﺑ‬
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† ‡ ‹‫ﻟﻠﻔ‬
- BWIP inventory costs are merged with the costs of the units started during
the period to reach a new average cost
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- EUP under weighted average differs from EUP under FIFO by the amount of
EUP in BWIP
So, if there is NO BWIP then EUP weighted average = EUP FIFO
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EUP under weighted average costing:

DM Conversion
Total units completed this period XX XX first line of FIFO
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+ Amount added to date on EWIP XX XX last line of FIFO

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EUP under weighted average XX XX
Always:
EUP under weighted average > EUP under FIFO

As long as there is a BWIP
Because if BWIP = zero

EUP under weighted average = EUP under FIFO

 Compute units cost = process cost / EUP

FIFO:
Current period (only) manufacturing cost:
DM cost $XX / XX (EUP FIFO) = $XX cost/unit
Conversion cost $XX / XX (EUP FIFO) = $XX cost/unit
Total cost / unit (FIFO) $XX
Allocate only the current period manufacturing cost as FIFO distinguish between
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units in BWIP and units started in current period
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Weighted average:
Current period manufacturing cost + BWIP cost:
DM cost ($XX + $XX) / XX (EUP WA) = $XX cost/unit
Conversion cost ($XX + $XX) / XX (EUP WA) = $XX cost/unit
Total cost / unit (WA)
a. $XX
Because WA ignores separation between BWIP and current period as it calculates
average for the two periods, so we allocate the total cost of the two periods as
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well on the average of units
Operation Costing
Operation costing is a hybrid, or combination, of job-order costing and process
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costing. In operating costing, a company applies the basic operation of process

costing to a production process that produces batches of items. The different
batches all follow a similar process, but the direct materials input to each batch are
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different.
Examples of manufacturing processes where operation costing would be
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appropriate are clothing, furniture, shoes and similar items. For each of these
items, the general product is the same (for example, a shirt), but the materials used
in each shirt may be different.
In operation costing the direct materials are charged to the specific batch where
they are used, but conversion costs are accumulated and distributed using a
predetermined conversion cost per unit. Conversion costs are allocated by batch.
An operation costing worksheet would look very much like a process costing
worksheet, except it would require a separate column for each product’s direct
materials, while the worksheet would have one conversion costs column that
would pertain to the conversion of all the products.

5. Life-cycle costing Not GAAP
A life-cycle approach to budgeting estimates a product’s revenues and expenses

over its entire sales life cycle beginning with research and development,
proceeding through the introduction and growth stages into the maturity stage,
and finally into the harvest or decline stage, accordingly, life-cycle costing takes a
long-term view of the entire cost life cycle, also known as the value chain.
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Not GAAP as it includes nonmanufacturing costs in the product costing
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Used as basis for cost planning and product pricing (pricing decisions)
Total cost for a product’s life cycle = manufacturing costs + nonmanufacturing costs
= value chain
a.
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†‡
Life cycle whole life cost ‫اﻟﺴﻨˆ ﻋ• ﻃﻮل‬ ‫ † ˜™ ﻋﺪد‬š‫ﻌ‬œ
†
˜ concepts are associated with target
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costing and target pricing

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Subtracting the desired unit profit margin from the target price to reach target
costing
Market price is known (Given)
Internal and External Reporting Effects

For external financial statement purposes, costs during the upstream phase must
be expensed in the period incurred.
Essentially, life-cycle costing requires the accumulation of all costs over a product’s
lifetime, from inception of the idea to the abandonment of the product, these costs
are then allocated to production on an expected unit-of-output basis.
The internal income statement for a product will report total sales for all periods,
minus all expenses to date.

Traditional financial statements, however, might report that certain products were
extremely profitable because upstream costs were expensed in previous periods,
for example, if a substantial investment is made in the development of a new
product but that product quickly becomes obsolete due to new technology, how
worthwhile was the investment?
Life-cycle costing combines all costs and revenues for all periods to provide a better
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view of a product’s overall performance.
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6. Accounting for spoilage
Spoilage: Output that does not meet the quality standards for salability.
a.
1) Normal spoilage: is the amount expected in the ordinary course of production.
The accounting treatment is to include normal spoilage as a product cost, this is
accomplished by allowing the net cost of the spoilage to remain in the work-in-
process account of the job that generated it.
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a) If the normal spoilage is worthless and must be discarded, no entry is
made.
b) If the normal spoilage can be sold, the entry is
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Spoiled inventory (at fair market value) $XX

2) Abnormal spoilage: is spoilage over or above the amount expected in the

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ordinary course of production.

The accounting treatment is to highlight abnormal spoilage as a period cost so that
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management can address the deficiency that caused it, this is accomplished by
charging a loss account for the net cost of the spoilage.
a) If the abnormal spoilage is worthless and must be discarded, the entry is
Loss from abnormal spoilage $XX
(costs up to point of inspection)
b) If the abnormal spoilage can be sold, the entry is:
Spoiled inventory $XX
Loss from abnormal spoilage (difference) XX
Work-in-process – Job 1015
(costs up to point of inspection) $XX
Will transfer out
numbers cost
Good units completed OK OK

Normal spoilage NO OK
Abnormal spoilage NO NO
 Normal spoilage: cost is charged to product costing

Units are NOT transferrable out instead only its cost to be transferred
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 Normal spoilage allocated to income statement as a product cost
Admitted when goods are sold
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Allocated as percentage of sold goods to match
Example:
a.
Good units completed 16000
Normal spoilage 300 units
Abnormal spoilage 100 units
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Unit cost DM $3.50
Conversion $6.00
$9.50
Request:
am
What is the number of units that would transfer to finished foods inventory?
And related cost of these units?
h
Answer:
Total cost transferred = (16000+300) X $9.50 = $154,850
ef
Number of units transferred = 16000 unit

Cost / unit transferred = $154,850 / 16000 = $9.68 / UNIT

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a.
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Unit 7. Cost allocation

Subunits:
1) Service departments cost allocation
2) Allocation of joint costs
3) Inventory costing choices (absorption and variable costing)
Four criteria are used to allocate costs:
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1) Cause and effect should be used if possible because of its objectivity and
acceptance by operating management.
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2) Benefits received is the most frequently used alternative when a cause-and
effect relationship cannot be determined, however it requires an assumption about
the benefits of costs, for example, that advertising that promotes the company, but
not specific products was responsible for increased sales by the various divisions.
a.
3) Fairness is sometimes mentioned in government contracts but appears to be
more of a goal than an objective allocation base.
4) Ability to bear (based on profits) is usually unacceptable because of its
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dysfunctional effect on managerial motivation.
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1. Service Departments Cost Allocation

Shared services are administrative services provided by a central department to the
company’s operating units. Shared services are usually services such as human
resources, information technology, maintenance, legal, and many accounting
services such as payroll processing, invoicing and accounts payable. Usage of the
services by the individual departments (cost objects) can be traced in a meaningful
way based on a cost driver that fairly represents each one’s usage of the service.
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These shared services, or support departments incur costs (salaries, rent, utilities,
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and so on). For internal decision-making, the costs of shared service departments
need to be allocated to the operating departments that use their services in order
to calculate the full cost of operations or production.
a.
When service departments also render services to each other, their costs may be
allocated to each other before allocation to operating departments.
cm
Three approaches are used to allocate the costs of service departments to other
departments:
1. The direct method
2. The step-down method
am
3. The reciprocal method

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The direct method:

Simplest and most common but least accurate all service department costs are
allocated directly to production departments only, ignoring service rendered
among service departments, Service department costs are allocated to production
departments based on an allocation base appropriate to each service department’s
function.
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a.
Total cost of production departments after allocation
= cost of production departments + cost of service departments
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The Step-down method:

Under the step, or step-down method, some of the costs of services rendered by
service departments are allocated to each other, this method derives its name from
the procedure involved. The service departments are allocated in order, from the
one that provides the most service (the heights percentage of service) to other
service departments down to the one that provides the least, very common for
CMA Exam to be told which service department to start with.
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‹•‫ا‬ †
Š ž‫اﻟﺘﺎ‬ †‡
˜ ‫ﻣˆ ﺑ ﺪي‬
a.

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 Highest percentage / greatest number / greatest dollar service department
cost will be allocated to service department below it + the production cost
as well
am
 Below service departments does not allocate up to higher service

departments but directly only to production department
h
ef
The first shared service department’s costs are allocated to the other shared
service departments and the operating departments. The second shared service
department’s costs (which now include its share of the first shared service
department’s costs) are allocated next to the other shared service departments
(but not to the first shared service department that has already been allocated) and

the operating departments. Once a shared service department’s costs have been
allocated, no costs will be allocated to it from other shared service departments.
A problem on the exam will give the allocation order to use if it is not obvious.
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a.
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The reciprocal method: full recognition

It is also known as the simultaneous solution method, cross allocation method,
matrix allocation method, or double distribution method, Under the reciprocal
method, services rendered by all service departments to each other are recognized.
Most accurate but most complex
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†
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˜ ‫ﺑﻨﻮزع اﻟﻘﺴﻢ‬
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‫ اﻻﻗﺴﺎم اﻻﻧﺘﺎﺟ ﻪ‬+ ‫اﻟﺨﺪ¨ اﻻول‬ †
‫ ﻋ• اﻟﻘﺴﻢ‬ž‫اﻟﺜﺎ‬
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˜ ‫و®ﻌﺪﻳﻦ ﻧﻮزع اﻟﻘﺴﻢ‬
‫ﻠﻔﻪ‬±‫ اﻟﺘ‬²̃‫¯ ﺻﻔ ـ ـ ــﺮ واﻻﻗﺴﺎم اﻻﻧﺘﺎﺟ ﻪ ﺗﺘﺤﻤﻞ اﺟﻤﺎ‬x‫ﻪ ان اﻻﻗﺴﺎم اﻟﺨﺪﻣ ﻪ ﺗ‬œ‫اﻟﻤﻬﻢ † ˜™ اﻟﻨﻬﺎ‬
Š
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It requires the use of matrix algebra with 3 or more service departments,
simultaneous equations
a.
cm
am
To solve a problem using the reciprocal method, “simultaneous” or multiple

equations are used. With two shared service departments, the multiple equations
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are set up as follows:

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The first step is to solve for either “Maintenance Costs to Allocate” or “Cafeteria
Costs to Allocate,” and after that solve for the other number. These calculated
amounts become the amounts that need to be allocated from the maintenance
department and cafeteria to all the other departments, including the other service
departments.

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a.
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ef
Dual Rate allocation:

Two separate rates for fixed costs and variable costs, which is vital for some certain
internal decisions.
Service department cost allocation to SBUs:
The criteria for choosing the cost allocation method to the SBUs:
1. Motivate managers
2. Provide an incentive
3. Provide fair evaluation
4. + use Dual Allocation

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2. Joint Cost Allocation

JOINT PRODUCT AND BY-PRODUCT COSTING
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Joint Processing and the Split-Off Point

When two or more separate products are produced by a common manufacturing
process from a common input, the outputs from the process are joint products.
The main issue with joint products is how to account for the joint costs (those costs
incurred prior to the split off point) and how to allocate the joint costs to the
separate products. Accurate allocation is needed primarily for financial reporting
purposes and pricing decisions. The inventory cost of each unit of each joint
product needs to be determined accurately so that the balance sheet will be
accurate. Since the inventory cost of each unit becomes its cost of goods sold when
it is sold, the amount of cost to be expensed to COGS for each unit sold is needed.

Joint (common) costs are those costs incurred up to the point where the products
become separately identifiable, called the split-off point.
Joint costs include direct materials, direct labor, and manufacturing overhead.
Because they are not separately identifiable, they must be allocated to the
individual joint products, for example Crude oil can be refined into multiple salable
products. All costs incurred in getting the crude oil to the distilling tower are joint
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costs.
At the split-off point, the joint products acquire separate identities. Costs incurred
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after split-off are separable costs.
Separable costs can be identified with a particular joint product and allocated to a
specific unit of output, for example Once crude oil has been distilled into asphalt,
a.
fuel oil, diesel fuel, kerosene, and gasoline, costs incurred in further refining and
distributing these individual products are separable costs.
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Joint costs may include direct materials, direct labor, and overhead. Costs incurred
after the split off point may also include direct materials, direct labor, and
overhead. The costs incurred after the split off point are separable costs and they
are allocated to each product as they are incurred by that product.
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Byproducts are the low-value products that occur naturally in the process of
producing higher value products. They are, in a sense, accidental results of the
production process. The main differentiator between main products and joint
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products is the market value. If the product has a comparatively low market value
when compared to the other products produced, it is a byproduct.
ef
Since joint costs cannot be traced to individual products, they must be allocated.
The methods available for this allocation can be classified in two conceptual
groupings.
1) The physical-measure-based approach employs a physical measure, such as
volume, weight, or a linear measure.
2) Market-based approaches assign a proportionate amount of the total cost to
each product on a monetary basis.
a) Sales-value at split-off method
b) Estimated net realizable value (NRV) method
c) Constant Gross Profit (Gross Margin) Percentage method

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a.
cm
Main product / Joint product High
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Common costs Joint costs Separable by product sales

Costs value
by product Low
Split off point
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Common manufacturing cost / process

DM + conversion cost
Allocation 1- products are identifiable
Is essential for determining 2- we can sell here or add additional separable costs
COGS & valuing inventory
Joint cost allocation methods:

1- Physical measure:
"Average Cost method” - “Quantitative method”, the joint cost allocation is done
based on the weight, volume, or other physical measure of the joint products, such
as pounds, tons, or gallons. In the Average Cost method, the joint cost allocation is
done based on the physical units of output, joint costs are allocated
proportionately among the joint products, so that each product is allocated the

same amount of joint cost per unit of measure, whether that unit is a unit of
physical measure or a unit of output.
The total joint cost is divided by the total number of units of all of the joint products
produced to calculate the average cost per unit. Then that average cost per unit is
multiplied by the number of units of each product produced to find the amount of
cost to be allocated to each product.
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weight, volume or pounds, tons, All outputs must have the
other physical measure gallons, or feet same unit of measurement
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Joint costs are allocated based on production weight or volume @ split off point
a.
cm
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Advantages Disadvantages
1- Easy to use 1- ignores revenue capability of individual products
2- Objective criterion of
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‫ﻳﻌﻧﻲ ﺣﺎﺟﻪ ﺛﻘﻳﻠﻪ ﻭﺳﻌﺭﻫﺎ ﺭﺧﻳﺹ ﺗﻛﻠﻔﺗﻬﺎ ﺣﺗﺑﻘﻰ ﻛﺑﻳﺭﻩ ﻭﺗﺧﺳﺭﻛﺗﻳﺭ ﻭﺍﻟﺣﺎﺟﻪ‬
allocation ‫ﺍﻟﺧﻔﻳﻔﻪ ﻭﺳﻌﺭﻫﺎ ﻏﺎﻟﻲ ﺗﻛﻠﻔﺗﻬﺎ ﺣﺗﺑﻘﻰ ﻗﻠﻳﻠﻪ ﻭﺗﻛﺳﺏ ﺍﻛﺗﺭ‬
2- each product can have its own unique physical measure
ef
(KG, Litter, etc.), can’t be applied in this case
Market based approaches:

2- Sales value at split off point: market-based approach
also called the Gross Market Value method, or simply, just the Sales Value method.
Under the Relative Sales Value at Split off method, joint costs are allocated on the
basis of the sales values of each product at the split off point, relative to the total
sales value of all the joint products.
The formula to allocate the costs between or among the products is as follows, for
each of the joint products:

can be used only if all of the joint products can be sold at the split off point (in
other words, with no further processing). Management may decide it would be
more profitable to the company to process some of the joint products further; but
the Relative Sales Value at Split off method can still be used to allocate joint costs
up to the split off point, as long as sales prices at the split off point do exist for all
of the joint products.
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Note: These allocations are performed using the entire production run for an
accounting period, not units sold. This is because the joint costs were incurred on
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all the units produced, not just those sold. ‫ﺍﻟﺗﻭﺯﻳﻊ ﺑﻧﺳﺏ ﺳﻌﺭ ﺍﻟﺑﻳﻊ ﻟﺣﺟﻡ ﺍﻻﻧﺗﺎﺝ ﻭﻟﻳﺱ ﻟﻠﻣﺑﺎﻉ‬
a.
cm
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1- Easy to calculate 1- market prices may be changing constantly
ef
2- costs are allocated according to the 2- if sales price at split off point not available
individual product’s revenue ‫ ﻳﻌﻧﻲ ﺍﻟﻘﻳﻣﻪ ﺍﻟﺑﻳﻌﻳﻪ‬because of additional processing is necessary
‫ﻟﻠﻣﻧﺗﺞ ﻭﻟﻳﺱ ﻟﻠﻣﺑﺎﻉ‬ for sale (this disadvantage force to work NRV)
3- Net realizable value (NRV):

The Estimated Net Realizable Value (NRV) method can be used if one or more of
the joint products must be processed beyond the split off point in order to be sold.
It may also be used under certain circumstances if one or more of the joint products
may be processed beyond the split off point in order to increase its value above the
selling price at the split off point.
This method is essentially the same as the Relative Sales Value method, and the
allocation is done in the same way, except an estimated Net Realizable Value
(NRV) is used for the product or products.

Note: The Net Realizable Value method is generally used in preference to the
Relative Sales Value at Split off method only when selling prices for one or more
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products at split off do not exist. However, sometimes when sales prices at the split
off do exist for all of the joint products but one or more products can be processed
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further, an exam problem will say to use the Net Realizable Value method to
allocate the joint costs. If a problem says to use the Net Realizable Value method,
use the net realizable values for the products that can be processed further even
though sales prices at split off do exist, but only if the cost to process further is
a.
less than the additional revenue to be gained from the further processing. (if the
cost to process a product further is greater than the additional revenue to be
gained from the further processing, the product will not be processed further.)
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If the problem does not say to use the Net Realizable Value method and sales values
at the split off exist for all products, then use the sales values of all of the joint
products for the allocation, even if one or more of the products can be or will be
processed further.
am
Sell-or-Process-Further Decisions
The joint costs of production are not relevant costs in the decision to process
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further or sell immediately because they are sunk costs (irrelevant costs). In order
to determine whether or not a product should be processed further, the company
ef
should compare the incremental revenues (the increase in the sales price that
results from further processing) with the incremental cost (the increase in costs
related to the additional processing). If the incremental revenue is greater than the
incremental cost, the product should be processed further.
NRV method also allocates joint costs based on the relative market values of the
products.
The significant difference is that, under the estimated NRV method, all separable
costs necessary to make the product salable are subtracted before the allocation is
made.
Joint costs are allocated based on production volume sales value after additional
processing @ split off point

Estimated NRV = final sales value – additional cost (separable cost)

Total cost ‫ﻘﻮل‬œ ‫ﻻزم † ˜™ ﺣﺴﺎﺑﻬﺎ ~ﺴﺘﻌﻤﻞ اﻻرﻗﺎم اﻻﺟﻤﺎﻟ ﻪ ﻟﻼﻧﺘﺎج ¶ﺪﻻ ﻣﻦ ﺳﻌﺮ اﻟﻮﺣﺪە او اﻟﻤﺒ ﻌﺎت وﻟﻤﺎ‬
separable cost + joint cost ‫ﻘﺼﺪ‬œ ¯x‫ﻳ‬ Š
Disadvantages
1- more difficult to calculate
2- based on an estimated value
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4- Constant Gross Profit (Gross Margin) Percentage method:

The constant-gross-margin percentage NRV method is based on allocating joint
costs so that the gross-margin percentage is the same for every product.
1) Determine the overall gross-margin percentage.
2) Subtract the appropriate gross margin from the final sales value of each
product to calculate total costs for that product.
3) Subtract the separable costs to arrive at the joint cost amount.

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a.
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Accounting for Byproducts:

By-products are one or more products of relatively small total value (immaterial)
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that are produced simultaneously from a common manufacturing process with

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products of greater value and quantity.

The first question that must be answered regarding by-products is: Do the benefits
of further processing and bringing them to market exceed the costs?
NRV = Selling price – additional processing costs – selling costs
If the net realizable value is zero or negative, the by-products should be discarded
as scrap.
Regardless of the timing of their recognition in the accounts, by-products usually
do not receive an allocation of joint costs because the cost of this accounting
treatment ordinarily exceeds the benefit.

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Tips to answer questions:
Inventoried
To be deducted from joint cost and
ignore by-product when allocating a. not inventoried
don’t deduct from joint cost but still
ignore by product when allocating
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joint costs joint costs
am
Production method sales method
3. Absorption and Variable Costing

h
Two Ways of Treating Fixed Production Costs

Variable and absorption costing are two different methods of inventory costing.
ef
Under both variable and absorption costing, all variable manufacturing costs (both
direct and indirect) are inventoriable costs. The only two differences between the
two methods are in:
1) Their treatment of fixed manufacturing overhead
2) The income statement presentation of the different costs
For external reporting purposes, the cost of a product must include all the costs of
manufacturing it: direct labor, direct materials, and all factory overhead (both fixed
and variable).
This method is commonly known as absorption costing or full costing.
For internal purposes, decision making is improved by treating fixed overhead as a

period cost so that only costs that are variable in the short run are included in the
cost of the product.
1) Fixed overhead costs are considered as period costs and are deducted in
the period in which they are incurred.
2) This practice is termed variable, or direct costing. Variable costing is the
preferred term because it describes what is really happening – namely that
product costs are based only on variable costs.
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Absorption Costing (GAAP)
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Under absorption costing (sometimes called full or full absorption costing), the
fixed portion of manufacturing overhead is “absorbed” into the cost of each unit of
product.
1) Product cost thus includes all manufacturing costs, both fixed and variable.
a.
2) Absorption-basis cost of goods sold is subtracted from sales to arrive at
gross margin.

3) Total selling and administrative (S&A) expenses (i.e., both fixed and
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variable) are then subtracted from gross margin to arrive at operating
income.
This method is required for external reporting purposes and for tax purposes.
Under absorption costing, fixed factory overhead costs are allocated to the units
am
produced during the period according to a predetermined rate. Fixed

manufacturing overhead is therefore a product cost under absorption costing.
Product costs are inventoried, and they are expensed as cost of goods sold only
h
when the units they are attached to are sold.

Because the fixed factory overhead costs are allocated to the products so we need
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as discussed before the predetermined fixed overhead rate, which is calculated as

follows:
The budgeted activity level of the allocation base is the number of budgeted direct
labor hours, direct labor cost, material cost, or machine hours—whatever is being
used as the allocation base.
Note: Fixed factory overheads are allocated to the units produced as if they were
variable costs, even though fixed factory overheads are not variable costs.
Absorption costing is required not only by U.S. GAAP for external financial reporting
but also by the U.S. taxing authorities for tax reporting.
When absorption costing is being used, the operating income reported by a
company is influenced by the difference between the level of production and the

level of sales. For example, when the level of production is higher than the level of
sales, some of the fixed manufacturing overhead costs incurred during the current
period are included on the balance sheet as inventory at year-end. As a result, the
fixed costs that are in inventory are not included on the income statement as an
expense.
Variable Costing (internal purposes only NOT GAAP)
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Under variable costing (also called direct costing), fixed factory overheads are
reported as period costs and are expensed in the period in which they are incurred.
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Thus, no matter what the level of sales, all of the fixed factory overheads will be
expensed in the period when incurred.
Variable costing does not conform to GAAP. For external reporting purposes,
GAAP requires the use of absorption costing, and therefore variable costing
a.
cannot be used for external financial reporting. However, many accountants feel
that variable costing is a better tool to use for internal analysis, and therefore
variable costing is often used internally.
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Note: It is important to remember that the only difference in operating income
between absorption costing and variable costing relates to the treatment of fixed
factory overheads.
This method (sometimes called direct costing) is more appropriate for internal
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reporting.
1) Product cost includes only the variable portion of manufacturing costs.
2) Variable-basis cost of goods sold, and the variable portion of S&A expenses are
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subtracted from sales to arrive at contribution margin.

a) This figure (sales – total variable costs) is an important element of the variable
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costing income statement because it is the amount available for covering fixed
costs (both manufacturing and S&A).
b) For this reason, some accountants call the method contribution margin
reporting.
3) Contribution margin is an important metric internally but is generally considered
irrelevant to outside financial statement users.
Justification for Variable Costing

Under variable costing, fixed overhead cost is considered a cost of maintaining
capacity, not a cost of producing a product.

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a.
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Absorption (full costing) (conventional): GAAP – External reporting
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It breaks down costs between manufacturing and nonmanufacturing costs
product cost >>

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inventory cost >>

COGS >> DM + DL +
MOH
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all factory costs note that only difference between

(variable and fixed) the two ways is the treatment of
FMOH in absorption: treated as
product cost and inventoriable in
Variable: is a not product cost but
absorption means that produced unit will absorb all production
/ manufacturing costs whatever variable or fixed period cost and non-inventoriable
Main limitation:
That according to absorption costing management can show higher net income by
overproducing and saving fixed manufacturing cost in inventory

Variable (direct) costing: NOT GAAP – management tool

‫ﻁﺭﻳﻘﺔ ﻋﺭﺽ ﻓﻘﻁ‬ ‫ﺇﺳﻣﻬﺎ‬ Contribution margin income statement
It breaks down costs between variable and fixed costs
product cost >>
inventory cost >>
COGS >> DM + DL +
VMOH
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only variable costs
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means that in variable
costing: there is no FMOH
not in Product cost and
accordingly not in
inventory cost (non-
inventoriable)
Effects of Changing Inventory Levels a.

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Because fixed factory overheads are treated differently under absorption and
variable costing, it is virtually certain that variable and absorption costing will result
in different amounts of operating income (or operating loss) for the same period
of time, only when production and sales are equal in a period (meaning there is no
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change in inventory levels and everything that was produced was sold) will there
not be a difference between the operating incomes reported under variable costing
and absorption costing. If sales and production are equal, the fixed factory
overheads will have been expensed as period costs under the variable costing
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method, and the fixed factory overheads will have been “sold” and included in cost
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of goods sold under the absorption costing method.
Whenever inventory changes over a period of time, the two methods will produce
different levels of operating income.

Production = sales
Absorption net operating income = variable net operating income
Production > sales

Inventory
Absorption net operating income > variable net operating income
because some of the fixed factory overheads incurred were inventoried under
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absorption costing
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Production < sales
Inventory
Absorption net operating income < variable net operating income
a.
under the absorption method, some of the fixed factory overhead costs that had
been inventoried in previous years will be expensed in the current period
Generally, the inventory cost in absorption is higher than variable whatever the
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case is, and the best is to think of the two ways as inventory costing with regard
the inventory cost.
When calculating differences between the two ways as mentioned before the only
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different is:
Fixed manufacturing costs
Which is saved in the inventory according to only the absorption costing
h
In case we need to calculate the difference between the two methods instead of
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doing full calculation of operating income under both methods, we already know
that the difference between both methods is the fixed manufacturing overhead, so
we can use the following formula:
Absorption operating income – variable operating income
=
(Ending inventory FMOH absorption – beginning inventory FMOH absorption)
X FMOH/unit
the change in inventory X FMOH

Example:
A firm, during its first month in business, produced 100 units and sold 80 while
incurring the following costs:
Direct materials $1,000
Direct labor 2,000
Variable overhead 1,500
Manufacturing costs used in variable costing $4,500
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Fixed overhead 3,000
Manufacturing costs used in absorption costing $7,500
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The impact on the financial statements from using one method over the other can
be seen in these calculations:
Absorption Variable
a.
Basis Basis
Manufacturing costs $7,500 $4,500
Divided by: units produced ÷ 100 ÷ 100

Per-unit cost $ 75 $ 45
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Times: ending inventory × 20 × 20
Value of ending inventory $1,500 $ 900
The per-unit selling price of the finished goods was $100, and the company incurred
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$200 of variable selling and administrative expenses and $600 of fixed selling and
administrative expenses.
The following are partial income statements prepared using the two methods:
h
Absorption Costing Variable Costing

(Required under GAAP) (For internal reporting only)
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Sales $ 8,000 $ 8,000

Beginning finished goods inventory $0 $0
Plus: variable production costs 4,500 (a) 4,500 (a)
Product Costs
Plus: fixed production costs 3,000 (b)
Goods available for sale $7,500 $4,500
Less: ending finished goods inventory (1,500) (900)
Cost of goods sold $(6,000) $(3,600)
Less: variable S&A expenses (200) (c)
Gross margin (abs.) / Contribution margin (var.) $ 2,000 $ 4,200
Less: fixed production costs Period Costs (3,000) (b)
Less: variable S&A expenses (200) (c)
Less: fixed S&A expenses (600) (d) (600) (d)
Operating income $ 1,200 $ 600

The $600 difference in operating income ($1,200 – $600) is the difference between
the two ending inventory values ($1,500 – $900).
The absorption method carries 20% of the fixed overhead costs ($3,000 × 20% =
$600) on the balance sheet as an asset because 20% of the month’s production
(100 available – 80 sold = 20 on hand) is still in inventory.
This calculation is for illustrative purposes only. The difference in operating income
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is exactly the difference in ending inventory only when beginning inventory is $0.
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Example
a.
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Answer
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a.
Note: (H) In certain situations, it is very easy to calculate the difference between
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the variable and absorption method operating income. Given that the only
difference between the two costing methods is the treatment of fixed factory
overheads, if one of the three situations below applies and the question asks for
the difference in operating income between the two methods, the only calculation
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needed is:
Fixed overhead cost per unit applied to production

× Number of units of change in inventory
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= Difference in operating income between the two methods

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If the inventory level has fallen, the previous year’s fixed overhead cost per unit will
need to be used as the “extra inventory” sold that was produced during the
previous year. If inventory has risen, the current period’s fixed overhead cost per
unit should be used.
The three situations in which the formula above can be used to calculate the
difference in operating income between the two methods are:
(1) Beginning inventory is zero. In many questions there is a statement either that
there is no beginning inventory, or that it is the company’s first year of operations.

(2) The LIFO inventory cost flow assumption is being used and ending inventory is
higher than beginning inventory (in other words, none of the beginning inventory
was sold during the period).
(3) If an inventory cost flow assumption other than LIFO is being used, and (a) the
beginning inventories are valued at the same per-unit fixed manufacturing cost as
the current year planned per-unit fixed manufacturing cost and (b) under- or over-
applied fixed manufacturing overhead is closed out to cost of goods sold only.
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a.
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h am
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Unit 8. Supply Chain Management and Business Process Improvement

A. Supply Chain Management (operational B. Business process improvement
efficiency) 1. Value chain analysis
1. Lean manufacturing 2. Process analysis
2. Enterprise resource planning (ERP) 3. Benchmarking
3. Outsourcing 4. Activity-based management
4. Theory of constraints and throughput 5. Continuous improvement concepts
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costing 6. Cost of quality analysis
5. Capacity management and analysis 7. Efficient accounting processes
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A. supply chain management (operational efficiency):
a.

1. Just in Time (JIT)
Lean system /demand pull system/comprehensive production & inventory system
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Just-in-time system: A comprehensive production and inventory system that
purchases or produces materials and parts only as needed and just in time to be
used at each stage of the production process.
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Just-in-time (JIT) production (Also called lean production)( Lean Resource

Management-which is a new formation of the lean manufacturing that apply to
other activities other than factories) : Demand-pull manufacturing system in which
h
each component in a production line is produced as soon as and only when needed
by the next step in the production line.
ef
CUSTOMER

Just-in-time (JIT) purchasing: The purchase of goods or materials so that they are
delivered just as needed for production.
Just-In-Time Inventory management systems are based on a manufacturing
philosophy that combines purchasing, production and Inventory control into one
function.
The emphasis in lean manufacturing is on cutting out waste in the manufacturing
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process. “Waste” is anything other than the minimum amount of equipment,
materials, parts, and working time that is absolutely essential to add value to the
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customer. Waste is anything that does not add value to the customer or anything
the customer is not willing to pay for.
JIT Goals:
2. With high-quality products

3. At the lowest possible cost a.
1. Meet customer demand in a timely manner
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Objectives The ultimate goal is increased competitiveness and higher profits.
1- Higher productivity & improved quality
2- reduced order costs as well as carrying costs
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3- shorter manufacturing cycle times

4- faster and cheaper setups
5- better due date performance
h
6- more flexible processes are objectives of JIT methods.

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JIT (demand/lean) system

The main Idea of JIT is that nothing is produced until the next process in the
assembly line needs it. This demand-pull feature requires close coordination
between workstations.
JIT (lean) systems are based on a manufacturing philosophy devised by Japanese
industry that affects production, inventory control, and purchasing.
1- JIT is a pull system, i.e., items are pulled through production by current
demand, not pushed through by anticipated demand. One operation
produces only what is needed by the next operation, and components and
raw materials arrive just in time to be used.
2- Demand-driven production allows inventory levels to be minimized.
Counting, handling, and storing inventory are viewed as nonvalue-added,
indeed, carrying inventory is regarded as a symptom of correctable

problems, such as poor quality, long cycle times, and lack of coordination
with suppliers, the dependability of suppliers is crucial.
3- Organizations that adopt JIT systems therefore develop close relationships
with a few carefully chosen suppliers who are extensively involved in the
buyer’s processes.
Implementing JIT:
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a. To implement a JIT inventory or lean production system, the factory is
reorganized around what are called manufacturing cells.
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Cells are sets of machines, often grouped in semicircles, that produce a given
product or product family.
b. Each worker in a cell must be able to operate all machines and, possibly, to
perform support tasks, such as setup activities, preventive maintenance,
a.
movement of work-in-process within the cell, and quality inspection, in such a pull
system, workers might often be idle if they are not multi-skilled.
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Characteristics of JIT:
1. Coordinated work cells
2. Multi-skilled workers
3. Reduced setup times
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4. Reduced manufacturing lead time, time from initial order to finished

goods
5. Reliable suppliers
h
On time deliveries of high quality goods and frequent deliveries of smaller

amount of inventory that’s why it causes a reduction in number of suppliers
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Role of Kanban Developed by the Japanese Toyota Motor.

Kanban means ticket. Tickets (also described as cards or markers) control the flow
of production or parts so that they are produced or obtained in the needed
amounts at the needed times.
Kanban is essentially a visual workflow management system, when a worker sees a
kanban, it acts as authorization to release inventory to the next step. Work cannot
move to the next stage until a kanban indicates that stage is ready for it.
The supplier delivers components to the production line on an “as needed” basis,
signaled by receipt of a card, eliminating storage in the production area.

Advantages / benefits: Limitations:

1. Reduction in carrying inventory cost 1. Increased risk of stock out cost, as it
and increases inventory turn over reduces or eliminate the inventory
2. Improving quality by eliminating buffer
causes of rework, scrap & waste 2. Not appropriate for high-mix
3. Decrease setup times manufacturing environments
4. Lower investments in space
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5. Utilized with Backflush which is less
costly as a costing system
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Traditional (push) systems
In a push system, a department produces and sends all that it can to the next step
for further processing, which means that the manufacturer is producing something
of inventory.
a.
without understanding consumer demand. This can result in large, useless stocks
JIT lot sizes based on immediate need while traditional (push) system lot sizes
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based on formulas
2. Materials requirements planning (MRP)

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Material Requirements Planning (MRP) systems help determine what raw materials
to order for production, when to order them, and how much to order.
Material requirements planning, or MRP, is an approach to inventory management
that uses computer software to help manage a manufacturing process. It is a
h
system for ordering and scheduling of dependent demand inventories, starting

from raw material purchases and going through the production process, MRP is a
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“Push- through” system that manufactures finished goods for inventory based on
demand forecasts.
In MRP systems, a master production schedule indicates the quantities and timing
of each part to be produced. Once the scheduled production run begins,
departments push output through a system, regardless of whether that output is
needed.

Overview (read only)

1- Short-range (tactical or operational) plans must be converted into specific
production targets for finished goods. The raw materials going into the
creation of these end products must be carefully scheduled for delivery.
2- The yearly/quarterly/monthly numbers and styles of finished goods called
for in the demand forecasts included in the operational plans must be turned
into specific dates for completion and availability for shipment to the
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customer. This is the task of the master production schedule (MPS).
3- A materials requirement planning (MRP) system enables a company to
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efficiently fulfill the requirements of the MPS by coordinating both the
manufacture of component parts for finished goods and the arrival of the
raw materials necessary to create the intermediate components.
a. As computers were introduced into manufacturing, it was common for
a.
firms to have a production scheduling system and an inventory control
system. MRP joins the two into a single application.
b. The three overriding goals of MRP are the arrival of the right part in
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the right quantity at the right time.
4- MRP, in effect, creates schedules of when items of inventory will be needed
in the production departments.
a. If parts are not in stock, the system automatically generates a
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purchase order on the proper date (considering lead times) so that

deliveries will arrive on time.
b. The timing of deliveries is vital to avoid both production delays and a
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pileup of raw materials inventory that must be stored.

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Bill of Materials (BOM) (read only)

The MRP system consults the bill of materials (BOM), a record of which (and how
many) subassemblies go into the finished product. The system then generates a
complete list of every part and component needed.
Premises underlying MRP include:

1. Demand forecasts
2. Detailed material order
3. Detailed production order
4. Master production schedule
Quantities and timing of each part to be produced regardless of whether that
output is needed

Benefits: Limitations:
1. Less required coordination between functional areas 1. Potential inventory
2. Predictable raw material needs which represents accumulation
advantage of bulk purchasing and price breaks Workstations may
3. More efficient inventory control receive parts that
4. Additional inventory (in case if something broke in they are not ready to
way in) process
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5. Quick response to new customer demand
6. Increased flexibility in responding to market changes
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7. Reduced (Idle time)
8. Lower setup costs
Manufacturing Resource Planning (MRP II)
a.
While MRP is concerned mainly with raw materials for manufacturing, MRPII’s
concerns are more extensive. MRPII integrates information regarding the entire
manufacturing process, including functions such as production, sales, inventories,

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schedules, and cash flows.
An MRPII system is designed to centralize, integrate and process information for
effective decision making.
However, if a firm wants to integrate information on its non-manufacturing
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functions with the information on its manufacturing functions, it needs an ERP

system.
h
Enterprise Resource Planning (ERP)

ERP is a software platform that is used to plan and keep records of resources,
ef
including
1) Finances,
2) Labor capabilities and capacity,
3) Materials, and
4) Property (assets).
An ERP system would allow a company to determine what hiring decisions might
need to be made or whether a company should invest in new capital assets.

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a.
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3. Outsourcing related to make or buy decision

h
Purchasing goods and services from outside vendors rather than producing these
goods or providing these services.
ef
When a company outsources, an external company performs one or more of its

internal functions.
Benefits Limitations
1. By outsourcing functions to a specialist, 1. Can result in a loss of in-house expertise
management can free up resources to focus 2. Reduce process direct control
on primary operations and strategic revenue 3. Lead to less flexibility
generating activities 4. Creates privacy and confidentiality
2. It may be cheaper and gaining capabilities issues
without incurring overhead costs 5. Giving knowledge away
3. Can improve efficiency
4. Avoiding of obsolescence, for example
continuous developed technologies
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a.
4. Theory of constraints (TOC) & Throughput costing
The basic premise of TOC as applied to business is that improving any process is
best done not by trying to maximize efficiency in every part of the process, but by
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focusing on the slowest part of the process, called the constraint (limitation),
increasing the efficiency of processes that are not constraints merely creates
backup in the system.
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Constraint = bottleneck
Throughput: is product produced and delivered
Throughput time: is the time that elapses between the receipt of the customer’s
h
order and the shipment of the order = manufacturing lead time = manufacturing
cycle time
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Throughput contribution = revenue – DM (Super variable costing/totally variable)

calculation required:
how many units can be produced during a period of time? The throughput
contribution margin will be the throughput contribution margin per unit multiplied
by the number of units that can be produced in a given time.
What we are actually looking for: is in a constraint during this period of time how
much contribution are we able to produce, and the main goal is trying to maximize
the contribution through the constraint
While remember that companies usually produce more than one product, and the
constraint cannot produce enough of each of those individual products to meet
demand, so we have to priorities production of products through this constraint,
and by doing that we are increasing contribution going through the constraint.

Basic principles:
1. Inventory: invested money into physical inventory
2. Operating expenses: money spent to convert inventory into throughput
(including depreciation)
The steps in a TOC analysis are as follows:
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a.
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1) Identifying the constraint (bottleneck)
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The step that has the smallest capacity, were it is that production slows down,
where work-in-process backs up the most.
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2) Determine the most profitable product mix given the constraint.

Or maximizing the contribution of the constraint
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A basic principle of TOC analysis is that short-term profit maximization requires

maximizing the contribution margin through the constraint, called the throughput
margin or throughput contribution.
TOC thus helps managers to recognize that the product they should produce the
most of is not necessarily the one with the highest contribution margin per unit of
product, but the one with the highest throughput margin per unit of time; i.e.,
managers must make the most profitable use of the bottleneck operation.
Throughput costing, sometimes called supervariable costing, recognizes only

direct materials costs as being truly variable and thus relevant to the calculation of
throughput margin. All other manufacturing costs are ignored because they are
considered fixed in the short run.

Even direct labor is considered a fixed cost, which makes sense considering that
many companies have union contracts or paternalistic policies that involve
employing laborers, or at least paying them, even when no work is available.
Throughout costing (super variable costing): Inventory costing system

Sales revenue XX
- DM cost only (XX) = inventory costing = investment cost = materials
Including material handling costs costs in DM, WIP and finished goods inventory
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‫ـــــــ‬ + R&D costs + equipment and building costs
Throughput contribution margin XX
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Only direct materials are considered to be an inventory cost
Operating costs: all other manufacturing costs other than DM (including DL costs)
are considered:
- Fixed costs & - Period costs
a.
As it is difficult to change in the short-run
Therefore, throughput costing is the most less incentive to produce for inventory
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To determine the most profitable use of the bottleneck operation, a manager next
calculates the throughput margin per unit of time spent in the constraint,
profitability is maximized by keeping the bottleneck operation busy with the
product with the highest throughput margin per unit of time.
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3) Maximize the flow through the constraint or maximizing the throughput

contribution
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The short-term, we need to make certain that the constraint is always operating,
TOC encourages a manager to make the best use of the bottleneck operation.
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Exploit the constraint by always producing the right product, which has the highest
contribution through that constraint
Production flow through a constraint is managed using the drum-buffer-rope
(DBR) system.

Drum-Buffer-Rope system (DBR):

Drum = is the constraint itself, it gives the beat that the entire operation needs to
march / run according to
Buffer = mini WIP before the constraint provide as protection against delays that
would delay the drum
Rope = the sequence of processes prior to and including the constraint,
DBR is to keep the process flow running smoothly through the constraint
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4) Increase capacity at the constraint.
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The medium-term step for improving the process is to increase the bottleneck
operation’s capacity.
5) Redesign the manufacturing process for greater flexibility and fast cycle time
(value engineering)
a.
The long-term solution is to reengineer the entire process. In order to elevate the
constraint by adding capacity to it. The firm should take advantage of new
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technology, product lines requiring too much effort should be dropped, and
remaining products should be redesigned to ease the manufacturing process.
Value engineering is useful for this purpose because it explicitly balances product
cost and the needs of potential customers (product functions).
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TOC ABC
h
Short term focus long term focus

Constraint – included explicitly cost driver – determined at all levels
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Optimization of production flow and strategic pricing and profit planning

Short term product mix
Reason of comparison is that most company’s using TOC they also apply ABC

5. Capacity management & analysis Read and understand

Determining the level of activity (output level):
Capacity level influences product costing, pricing decisions, and financial
statements, we could use different capacities for different decision making.
Excess capacity has a cost. Having excess capacity means that a company will either
have to charge higher prices for its products or report lower income on its financial
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statements.
Similarly, producing at full capacity can have a cost in the form of opportunity costs.
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A company that could generate additional sales if it had more capacity needs to
address whether the acquisition of additional capacity is warranted.
Tarek Naiem, CMA, Online course 2019
a.
Capacity Levels
Explained previously in unit 5 of these handouts.
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B. Business process performance
1. Value chain analysis

The value chain is a model for depicting the way in which every function in a
company adds value to the final product, value chain depicts how costs and
customer value accumulate along a chain of activities that lead to an end product
or service, in other words, a value chain is a firm’s overall chain of value-creating
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(value-added) processes.
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Strategic analysis of the business functions, while the business functions in the
value chain are as follow:
a.
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Steps in value-chain analysis:

h
Analysis of which activities that use resources are value-adding or non-value adding
to the customer, and how to reduce or eliminate the non-value adding costs
ef
High value-added activity: if time permitted you would do more of

Low value-added activity: if given option you would prefer to do less of
1. Identifying the activities that add value to the finished product

2. Identify the cost driver for each activity
3. Develop a competitive advantage by adding value to the customer or
reducing the costs of the activity (in other words: reducing cost while
satisfying customer)
Supply chain:
From the initial source to the delivery of the products to consumers, even if those
activities occur in other organizations such as suppliers

Firms seeking to improve performance and reduce costs must analyze all phases of
the supply chain as well as the value chain. Thus, a firm must reduce the cost of,
and increase the value added by, its purchasing function.
Value-chain and supply-chain analysis should be used to meet customer

requirements such as:
1) Cost reduction 2) Efficiency 3) Constant innovation
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4) Continuous improvement of quality to meet customer needs and wants
5) Minimization or elimination of defects
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6) Faster product development and customer response times
Value engineering: Target cost / unit

Value engineering is a means of reaching targeted cost levels. It is a systematic
a.
approach to assessing all aspects of the value chain cost buildup for a product. The
purpose is to minimize costs without sacrificing customer satisfaction.
cost incurrence is the actual use of resources, but locked-in (designed-in) costs will
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result in use of resources in the future because of past decisions. Thus, value
engineering emphasizes controlling costs at the design stage before they are
locked- in.
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Life-cycle costing:
Life-cycle costing is sometimes used as a basis for cost planning and product pricing.
Life-cycle costing estimates a product’s revenues and expenses over its expected
h
life cycle. Emphasis is on the need to price products to cover all costs, not just
production costs.
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2. Process analysis & Business Process Reengineering (BPR)

Process analysis: incremental & constant changes to improve efficiency
linkage of quality, productivity and process improvements
The challenge to a business is to make its processes work effectively and efficiently,
to accomplish the most possible with the least waste. Process analysis is used to
understand the activities included in a process and how they are related to each
other.
Once a process has been analyzed, the information gained from the analysis can be
used to make operating decisions.

Business process reengineering (BPR):

Reengineering: destroy all and build all new contrasted with process improvement
Dramatic improvement not incremental changes
Business process reengineering (BPR) is the fundamental analysis and radical

redesign of business processes within and between enterprises to achieve dramatic
improvements in performance (for example, cost, quality, speed, and service). BPR
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Involves changes that are: fundamental, radical (reinvention), dramatic (heavy
blasting)
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BPR developing controls that are:
1. Automated
2. Self-correcting
3. Minimal human intervention
3. Benchmarking
a.
Benchmarking: a firm identifies best in class levels (best practice analysis) and
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conducts a study to determine how those levels can be adopted and lead to
improved performance, it is an ongoing process of measuring the difference
between the company’s performance of an activity and the performance by the
best efficient global example. The benchmark organization need not be a
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competitor.
Comparison / measuring against the best levels of performance to be competitive,
which is called best in class whether outside or internal benchmarking
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4. Activity based management (ABM)

ef
ABM is linkage of product costing and continuous improvement (Kaizen) of

processes is activity-based management (ABM). ABM redirects and improves the
use of resources to increase the value created for customers and other
stakeholders. It encompasses activity analysis, cost driver analysis, and quality
performance measurement.
 manages activities to improve the value of products or services to customers
and increase the firm’s competitiveness and profitability.
 ABM draws on ABC as its major source of information, so it uses ABC information
for operational ABM to improve efficiency for example, while strategic ABM to
decide which products to develop and which activities to use.
 by identifying resources spent on customers, products, and activities, ABM
improves management’s focus on the firm’s critical success factors and

enhances its competitive advantage by improving operations, reducing costs, or

increasing values to customers.
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a.
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1. Uses continuous improvement 1. Not used for external financial
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2. Eliminates non-value-added reporting

activities 2. Expensive & time consuming
3. Works well with JIT & ABC requires cost-benefit analysis
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5. Continuous improvement concepts Kaizen

ef
The term kaizen is a Japanese word that

means "improvement." As used in
business, it implies "continuous
improvement," or slow but constant
incremental improvements being made
in all areas of business operations.
Small-scale improvements are
considered to be less risky than a major
overhaul of a system or process. The
slow accumulation of small developments in quality and efficiency can, over time,
lead to very high quality and very low costs. Kaizen needs to be a part of the
corporate culture. This can be difficult to maintain and takes years to show results,
but if done properly, it confers a sustained competitive advantage.

Implementing ideal standards and quality improvements is the heart of the kaizen
concept. Kaizen challenges people to imagine the ideal condition and strive to
make the necessary improvements to achieve that ideal.
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a.

cm
am
Ideal standards / quality improvements / Targeting costing
Target price (market price) given – desired profit margin = target cost
Standard cost (ideal standard)
h
Kaizen: is how to manufacture a product for the target cost, which means it includes
ef
reduced cost and a continuous improvement
6. Cost of quality analysis (COQ) (heavy tested)

The costs of quality include not only the costs of producing quality products, but
they also include the costs of not producing quality products. Over the long term,
not producing a quality product is more costly than producing a quality product
because lack of quality causes loss of customers.
four categories of costs of quality: prevention, appraisal, internal failure, and
external failure. The organization should attempt to minimize its total cost of
quality.
Conformance costs: these are the costs making certain that the product is
produced properly in accordance with all production specifications, it includes

prevention (to prevent the defect from occurring) and appraisal (costs to assessing
wither or not the unit was produced properly), which are both financial measures
of internal performance.
1) Prevention attempts to avoid defective output. These costs include preventive
maintenance, employee training, review of equipment design, and evaluation of
suppliers.
2) Appraisal encompasses such activities as statistical quality control programs,
m
inspection, and testing.
co
Nonconformance costs: are the costs that incurred after a defective unit has been
produced, include two costs categories depending on who find the defect, internal
failure (a financial measure of internal performance) and external failure costs (a
financial measure of customer satisfaction).
a.
1) Internal failure (did we find the defect?) costs occur when defective products
are detected before shipment, examples are scrap, rework, tooling changes,
downtime, redesign of products or processes, lost output, and searching for and
cm
correcting problems.
2) The costs of external failure (did the customer finds the defect after he delivered
the product?) or lost opportunity include lost profits from a decline in market share
as dissatisfied customers make no repeat purchases, return products for refunds,
am
cancel orders, and communicate their dissatisfaction to others, thus, external

failure costs are incurred for customer service complaints; rejection, return, repair,
or recall of products or services; warranty obligations; products liability claims; and
h
customer losses, environmental costs are also external failure costs, e.g., fines for
nonadherence to environmental law and loss of customer goodwill.
ef
Cost of quality analysis (COQ)

Conformance costs non-conformance costs
Failure costs
Prevention costs Appraisal costs Before shipped After shipped
Internal failure costs external failure costs
Design engineering Inspection Spoilage Customer support
Process engineering Online product insp. Rework Warranty repair costs
Supplier evaluation Manufacturing insp. Scrap Liability claims
Prevention equip. process inspection Break down
maintenance maintenance
Quality training Product testing
New materials

Total Quality Management (TQM): is a long-term commitment

An approach committed to customer satisfaction and continuous improvement
TQM’s goals are to both reduce costs and improve quality, and code is simple in
achieving these goals is by “Do it right the first time”
The objectives of TQM include:

• Enhanced and consistent quality of the product or service
m
• Timely and consistent responses to customer needs
• Elimination of non-value-adding work or processes, which leads to lower costs
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• Quick adaptation and flexibility in response to the shifting requirements of
customers
a.
7. Efficient accounting processes
Need to look at accounting and finance functions to be certain that they are
efficient, improving accounting processes can increase a company’s ability to
minimize the costs of these processes while also maximizing their usefulness.
cm
Used technique such as:
Process Walk-Throughs: is a demonstration or explanation detailing each step of a
process. The existing processes need to be thoroughly documented before they can
am
be streamlined. Every step, every piece of paper, and every input and output should
be challenged such as how can we do this process better or even do we need this
step at the first place. That should include Identification of Waste and Over-
h
capacity of accounting department and also Identifying the Root Cause of Errors.
According to previous steps we go then to Process Design Once the current process
ef
is fully understood, process design can take place in line with the vision for the new
process. Four important areas where companies can optimize their accounting
processes:
1) Accounts payable,
2) Cash cycle,
3) Closing and reconciliation processes, and
4) Data analysis.
Every process is different, and a creative project team is required in order to

generate a range of alternative solutions. The redesigned process needs to cover
every aspect of the internal customers’ (users’) needs.

Planning and Implementing the Redesign:

A complete redesign of a process or processes has the potential to be very
disruptive, and it requires careful planning.
If the changes are extensive, they will need to be phased in to allow the employees
and the rest of the organization time to adjust to their impact.
Process Training:
m
Redesigning processes requires finding new ways to use the skills of existing
employees and to further enhance those skills through training.
co
a.
cm
h am
ef

m
co
a.
cm
h am
ef

Section C) Performance Management … 20%

Unit 9. Cost and variance measures
Subunits:
1. Variance analysis overview
2. Static and flexible budget variances
3. Direct materials variances
m
4. Direct labor variances
5. Overhead variances
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6. Sales variances
1. Variance Analysis
Variance analysis is the basis of any performance evaluation system using a budget.
a.
Variances are the differences / comparison between the amounts budgeted and
the amounts incurred (or earned in the case of revenues).
cm
On the cost side: variance analysis can’t be done without standard costs.
A favorable variance occurs when actual costs are less than standard costs.
An unfavorable variance occurs when actual costs are greater than standard costs.
h am
ef
Standard costs are also very important in the preparation of the flexible budget
On the revenue side:

A favorable variance occurs when actual revenues are greater than budgeted
revenues.
An unfavorable variance occurs when actual revenues are less than budgeted
revenues.
Whether a variance is favorable or unfavorable depends on how it affects income.
A favorable variance increases income, and an unfavorable variance decreases
income.
Standard Hours to complete 1 unit = 1 Hour

Standard rate (SR) = $6
Total standard cost = SR X SH $6
Actual Hours (AH) = 1.1 Hours

Actual rate (AR) = $6.25
m
Total Actual cost = AR X AH $6.88
co
Actual cost > Standard cost
unfavorable variance is $.88 per unit.
The significance of variances depends not only on their amount but also on their
a.
direction, frequency, and trend, persistent variances may indicate that standards
need to be reevaluated.
cm
Variance analysis is an important tool for the management accountant:
The use of variances:
1. Variance analysis enables management by exception, the practice giving
attention primarily to significant deviations from expectations whether
am
favorable or unfavorable and placing less attention on areas operating as

expected.
2. Variance analysis assigns responsibility, to find explanations and solutions
h
3. Sometimes variances suggest a change in strategy

4. Variances may signify that standards need to be evaluated
ef
5. Variances assist managers in their planning & control decisions

6. Variances used in performance evaluation.
standard cost budgeted cost

Short run represents what costs should expected actual costs /
be target
Long run these costs should be the same

Effectiveness: ‫ ﻓﺎﻋﻠﻳﻪ‬in attaining goals

The degree to which a predetermined objective or target is met
m
And
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Efficiency: ‫ﻛﻔﺎءﻩ‬ in carrying out operations & resources usage
The relative amount of inputs used to achieve a given output level
Operation maybe effective but inefficient or maybe efficient but ineffective
a.
*******************************************************
cm
Variance analysis levels
am
2 3
1
Flexible bugdet and Manufacturing input
static budget variances
sales volume variances and sales variances
h
ef
Master / static budget:

The beginning of variance analysis is the static budget variance, which measures
the difference between the static (master) budget amount and the actual results.
It is the total variance to be explained.

2. Static Budgeting variance

A static budget is prepared before the budget period begins and is not changed. It
is based only on the output planned (single output level or single volume) at the
beginning of the budget period.
The static budget reflects management’s best estimates of, for example, sales,
production, input prices, labor and overhead costs, and selling and administrative
costs.
m
Static budget = standard quantity X standard price = SQ X SP
co
The actual results are prepared after the budget period ends.
The actual results reflect the revenues earned and the costs actually incurred.
a.
Actual results = actual quantity X actual price = AQ X AP
cm

h am
ef
The static budget variance is the difference between the static budget and the
actual results for the period.
Static budget variance = actual results – static budget = (AQ X AP) – (SQ X SP)
Operating income variance
Master / static budget VS. Actual results reveals “operating income variances”
which is assessing effectiveness
Favorable and unfavorable variances
Increasing operating income relative to the decreasing operating income relative to the
Budgeted amount budgeted amount
(The significance of variances F. or UnF. Depends on amount and direction)

The static budget variance consists of a flexible budget variance and a sales volume
variance.
Limitations of Measuring Performance by Static Budget Variances:

• The static budget variance provides useful information, but it does not explain
the cause of the variance.
• focuses on short-term performance instead of long-term success.
m
• Managers should be evaluated on performance measures other than just
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whether or not they have met short-term financial targets.
3rd variances level a.

cm
am
2nd variances level

h
1st variances level

ef

3. Flexible budget
Calculated based on the actual output level, is the budget we would have made at
the beginning of the period if we had perfectly predicted the actual output level
Developed at the end of the period when the actual output is known
Flexible budget involves two comparisons

(Assessing efficiency)
m
Actual Master / Static Budget
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“Flexible Budget Variances” “Sales Volume Variances”
Measures efficiency of the performance Measures efficiency of budgeting sales
Using the organization’s resources volume, accuracy of output forecasting
a.
cm
h am
ef

1) Sales Volume Variances:

The sales-volume variance is the difference between the flexible budget and static
budget amounts if selling prices and costs are constant.
Sales Volume Variance = Flexible Budget Amount – Static Budget Amount
= budgeted contribution margin / unit X Output level or volume difference
Contribution margin is used because fixed (Actual volume – Budgeted volume)
m
costs are the same and variance of FC is zero
Only difference is due to inaccurate forecasting of output units sold, meaning that
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the only reason for this variance is the output level
Components of the Sales-Volume Variance

When more than one product is made, the sales volume variance consists of the
following variances:
a) Sales yield variance
b) Sales mix variance a.
cm
am
Sales volume variance interpretation:

h
A) Significant unfavorable sales volume variance: Could be due to one or more of

the following
ef
1. The overall demand is not growing at the rates that were anticipated
2. Competitors are taking away market share
3. Company did not adapt quickly to changes in customer preferences and
tastes
4. Quality problems led to customer dissatisfaction
5. Budgeted sales targets were set without careful analysis of market
conditions
B) Significant favorable sales volume variance:
The firm need to pursue a more aggressive strategy or operating goal
C) Insignificant sales volume variance: (favorable or unfavorable)
The firm is on track to attain its goals

2) Flexible budget Variances: “operating income flexible budget variance”
The flexible budget variance is the difference between the actual results and the
budgeted amount for the actual activity level. It may be analyzed in terms of
variances related to selling prices, input costs, and input quantities.
Flexible Budget Variance = Actual Results – Flexible Budget Amount
Measures efficiency in internal operations concerning the resources usage
m
efficiency
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Factors contributing to operating income flexible budget variances include:
1. Selling price variance = (Actual Price – budgeted price) / unit X Actual output
quantity (sales volume)
a.
2. Variable costs (DM, DL & VMOH)
Price/rate variances quantity/usage/efficiency variances both
Generally, managers have more control over efficiency variances than price
variances
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Level 3 of analysis helps managers better understand past performance and better
plan for future performance
am
Obtaining budgeted input prices & budgeted input quantities:

(obtaining standard date)
1- Actual input data from past periods:
h
Limitations:
1- Past data can include inefficiencies
ef
2- Past data do not incorporate any expected changes for the budgeted area
2- Data from other companies that have similar process
Limitation:
That data may not be available
3- Standards developed:
Standard is usually expressed on per unit basis
Advantages of using standards:
1- They aim to exclude past inefficiencies, and
2- They aim to take into account changes expected to occur in the budget
period

Standard cost/output unit = standards price/input unit X standard input allowed for output unit
Direct material and Direct labor flexible budget variances:
Direct Material
A direct material variance includes a: total variance
ADM-Flexible DM
m
Quantity or usage
Price Variance
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variance
(AP – SP) X AQ
(AQ – SQ) X SP
a.
when a product Calculate for each Mix Variance Yield Variance
has more than and add all (waspAM – (AQ – SQ) ×
one input together waspSM) × AQ waspSM
cm
The proportion (%) The total volume or

of each input in the the total amount of
mix the mix
Interpreting DM price variance:
am
Responsibility of DM Price variance mainly: Purchasing manager

Production manager when request express deliveries
1. Unexpected price changes and changes in freight in costs
h
2. Negotiation of prices
3. Changing supplier whether to lower or higher price
ef
4. Buying larger quantities and obtaining quantity discount (related to DM

carrying inventory cost)
5. Budgeted / standard DM prices were set inaccurately
Interpreting DM Quantity / Usage / Efficiency variance:

Responsibility of DM Usage variance mainly: production department
Purchasing department when buying inferior material will lead to
unfavorable material usage variance
1. Faulty machines usage or other production factors
2. Using inferior material quality or substitutions
3. Inadequate training or inexperienced employees
4. Poor supervision

Direct Labor total

A direct labor variance includes a: variance
Rate Variance Efficiency variance
m
(AR – SR) X AH (AH – SH) X SR
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when a product Calculate for each Mix Variance Yield Variance
has more than and add all (waspAM – (AQ – SQ) ×
one labor class together waspSM) × AQ waspSM
a. The proportion (%)

of each input in the
The total volume or
the total amount of
cm
mix the mix
A direct labor variance includes a(n)

a) Rate variance (a price variance for direct labor)
am
b) Efficiency variance
when labor rates vary, the following variances can be calculated:
Labor mix variance
h
Labor yield variance

ef
Interpreting DL rate variance:

Responsibility of DL rate variance mainly: personnel department
Production supervisor when choose to use employees with a different skill level
1. Change in labor rates
2. Different labor skills
3. Inaccurate set standards labor rates or undetailed
Interpreting DL efficiency variance:

Responsibility of DL efficiency variance mainly: production department
Purchasing department by buying inferior material
1. Inadequate training or inexperienced employees

2. Hiring under skilled workers

3. Under motivated workers

4. Faulty machines usage will cause breakdowns and work interruptions
5. Different materials
6. Budgeted standard time were set inaccurately
In variances’ formulas rates or prices are per unit and quantities or hours are in total
m
Variance abbreviations:
AQ Actual Quantity
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SQ Standard Quantity
AP Actual Price
SP Standard Price
waspAM Weighted average standard price of the ACTUAL mix
a.
How much one unit of the actual mix (AM) used, should have cost
using the standard price (sp), (wa) of all the materials.
waspSM Weighted average standard price of the STANDARD mix
cm
How much one unit of the standard mix (SM) used, should have
cost using the standard price (sp), (wa) of all the materials.
Always subtract the standard from the actual:

am
Actual – Standard (Budgeted) = Variance
Revenue (Same as the Result)

h
Result in a favorable variance

ef
Result in an unfavorable variance

Expense (opposite of the Result)
Result in an unfavorable variance
Result in a favorable variance
Generally:
 Cannot accurately evaluate performance before understanding causes of
variances
 Do not automatically interpret favorable variance as “good news”, as it relies
on: Emphasizing total company objectives and overall goals, so do not
interpret variances in isolation of each other, as variances often affect one
another

 The focus of variance analysis is to understand why variances arise and how
to use that understanding to learn and to improve performance instead of
playing the blame game, as we must balance between: 1- performance
evaluation and 2- organization learning (which represents the continuous
improvement concept)
Example: ‫ﻦ‬lm‫ﻨﺠ‬l‫ﻣﺜﺎل ﻣﻦ ﻫﻮر‬
m
Consider Webb Company, a firm that manufactures and sells jackets. All units manufactured in
April 2017 are sold in April 2017.
co
Cost Category Budgeted Variable Cost per Jacket
Direct materials costs $60
Direct manufacturing labor costs 16
Variable manufacturing overhead costs 12
Total variable costs $88
Budgeted selling price

Budgeted production and sales
a.
Budgeted fixed costs for production between 0 and 12,000 jackets $276,000
$120 per jacket
12,000 jackets
cm
Actual production and sales 10,000 jackets
Actual Results (Given)

am
Units sold 10,000

Revenue $1,250,000
Variable costs
DM 621,600
h
DL 198,000
VMOH 130,500
ef
Fixed costs 285,000
Cost details Standard Actual

DM 2M X $30/M 22,200 M X $28/M
DL 0.80DLH X $20/H 9000DLH X $22/H

Static Sales Flexible

Budget volume Budget
Variances variance Variance
Actual Master/Stat Master VS. Flexible Master VS. Actual VS.
m
Results ic Budget Actual budget Flexible Flexible
Sales volume 10,000 12,000 (2,000) 10,000 (2,000) 0
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Sales Revenue $1,250,000 $1,440,000 ($190,000) $1,200,000 ($240,000) $50,000
DM 621,600 720,000 (98,400) 600,000 (120,000) 21,600

DL 198,000 192,000 6,000 160,000 (32,000) 38,000
a.
Variable MOH 130,500 144,000 (13,500) 120,000 (24,000) 10,500
Total V. costs (950,100) (1,056,000) (105,900) (880,000) (176,000) (70,100)

cm
Contribution 299,900 384,000 (84,100) 320,000 (64,000) (20,100)
Margin
FMOH
Relevant range (285,000) (276,000) 9,000 (276,000) 0 9,000
am
Net Operating
Income 14,900 108,000 (93,100) 44,000 (64,000) (29,100)
Effectiveness Budgeted operating Efficiency Efficiency
income @ actual level
+
h
Operating income variances

Sales volume variance / Unit
ef
Sales price $120

- Variable manufacturing costs ($88)
Budgeted contribution margin efficiency variance Per Unit $32
X volume variance (Actual sales – budgeted sales) -2,000 Units

Sales volume variance -$64,000

Brief Notes:
Prepare flexible budget: price & variable cost / unit X actual output
Fixed cost in total as budgeted within the relevant range
st
1 comparison flexible vs. Static sales volume variance
As a result of volume variance
2nd comparison flexible vs. actual flexible budget variance
m
Reasons of flexible budget variance:
1. Sales price variance 2. Variable costs variances 3. Fixed MOH Variances
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Direct costs DM & DL
Indirect MOH
1- Direct Material:
Actual Standard Variance
Quantity
Price
22,200
$28
20,000
$30
a. 2,200
($2)
unfavorable
favorable

cm
Quantity variance = (AQ – SQ) X SP = (22,200 - 20,000) X $30 = $66,000 UnF.
Price Variance = (AP – SP) X AQ = ($28 - $30) X 22,200 = ($44,400) F.
Total DM variance = $21,600 UnF.
am
2- Direct Labor:
Actual Standard Variance
Efficiency 9,000 8,000 1,000 unfavorable
h
Rate $22 $20 $2 unfavorable

ef
Efficiency variance = (AH – SH) X SR = (9,000 – 8,000) X $20 = $20,000 UnF.

Price Variance = (AR – SR) X AH = ($22 - $20) X 9,000 = $18,000 UnF.
Total DL variance = $38,000 UnF.
Actual Results Flexible budget Master / Static budget

Given Actual output volume X Given
budgeted rates
Net operating income variance (Effectiveness)

Flexible Budget Variance (Efficiency) Sales Volume variance (Efficiency)
Contribution margin / unit X volume
variance

* DM & DL Mix and Yield variances:

Example
Comprehensive example: The Sunny Grains Cereal Company produces cereal made
up of different grains. The material prices in effect for the fiscal year ending June
30 and the standard kilograms (kg) allowed for each input for the April output of
Sunny Morning cereal are:
m
Standard Price/Kg Standard Kg for Standard Cost
Output
co
Corn $ 10.00 250 $2,500
Wheat $ 8.00 250 2,000
Rice $ 3.00 250 750
750 $5,250
a.
Due to several natural disasters around the world, the price for each input
increased on January 1. The actual material prices and the actual usage for April
cm
were as follows:
Actual Price/Kg Actual Usage Actual Cost

Corn $ 12.00 375 $4,500
am
Wheat $ 8.50 200 1,700

Rice $ 5.50 325 1787.50
900 $7,987.50
h
the following variances and variance components will be calculated:

ef
1) Total variance
2) Materials price variance
3) Materials quantity variance
4) Weighted average standard price of the standard mix (waspSM)
5) Weighted average standard price of the actual mix (waspAM)
6) Mix variance
7) Yield variance

Answer:
1) Total Materials Variance
The total materials variance is the difference between the actual cost and the
standard cost allowed for the actual output.
The actual cost for April $7,987.50.
The standard cost for April $5,250
The total materials variance $2,737.50 unfavorable variance
m
which is broken down into the price and the quantity variances as follows.
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2) Materials Price Variance
price variance for each of the three inputs individually and summing them.
(AP - SP) × AQ
Corn
Wheat
Rice
($8.50 – $8) × 200
($5.50 – $3) × 325 a.
($12.00 – $10.00) × 375 = $ 750
= 100
= 812.50
cm
Total materials price variance $ 1,662.50 Unfavorable
3) Materials Quantity Variance

am
The total materials quantity variance is calculated by using the usage formula (AQ
- SQ) × SP for each of the classes individually and then summing them:
h
Corn (375 – 250) × $ 10.00 = $ 1,250

Wheat (200 – 250) × $ 8.00 = (400)
ef
Rice (325 – 250) × $ 3.00 = 225

Total materials quantity variance $ 1,075 Unfavorable
4) The weighted average standard price of the standard mix (waspSM)

Total Standard Cost ÷ Total Standard Kgs
The total standard kilogram is 750 and the total standard cost is calculated as
follows:
Corn $10.00 × 250 kg = $2,500
Wheat $8.00 × 250 kg = 2,000
Rice $3.00 × 250 kg = 750
Total Standard Cost 750 kg $5,250
The waspSM is $7 per kg ($5,250 ÷ 750).

5) The weighted average standard price of the actual mix (waspAM)
Total Cost using Actual Kg and Standard Price ÷ Total Actual Kg

The total actual kg was 900 and the total standard cost of the actual mix is
calculated as follows:
Corn $10.00 × 375 kg = $3,750
Wheat $8.00 × 200 kg = 1,600
m
Rice $3.00 × 325 kg = 975
Total Cost at Standard Price 900 kg $6,325
co
The waspAM is $7.0277 per kg ($6,325 ÷ 900).
6) Mix Variance
a.
The mix variance is the portion of the total material quantity variance that was
caused by the actual mix having been different from the standard mix. The mix
variance is the difference between the weighted average standard prices of the
cm
actual and the standard mix multiplied by the actual total quantity used of all
inputs. The formula is:
Mix Variance = (waspAM – waspSM) × AQ

am
Mix Variance = ($7.0277 – $7) × 900 = $25 Unfavorable

Therefore, $25 of the $1,075 unfavorable quantity variance arose because the
h
actual mix of grains was not the same as the standard mix of grains.
ef
7) Yield Variance
The yield variance is the portion of the quantity variance that occurred as a result
of having used more or fewer total inputs than the standard total inputs. The mix
of the inputs is not needed to calculate the yield variance--only the total quantity
of inputs used.:
Yield Variance = (AQ – SQ) × waspSM
Yield Variance = (900 – 750) × $7 = $1,050 Unfavorable

Therefore, $1,050 of the $1,075 unfavorable quantity variance occurred because
the company used more material input than it should have for the amount of
output.
Summary, Reconciliation, and Interpretation

The variance in the mix was not a material cause of the $1,075.00 Unfavorable
quantity variance, since it was responsible for only $25.00 of the unfavorable
variance. Rather, the unfavorable quantity variance was primarily caused by a
general inefficiency in the use of the material inputs.
To prove all of the calculations, the sum of the two sub-variances should be
reconciled to the total quantity variance:
Materials mix variance $25 U
m
+ Materials yield variance 1,050 U
= Total materials quantity variance $1,075 U
co
Overhead costs flexible budget variances
Overhead variances aren’t quite that useful as the material and labor variances,
a.
whereas for DM and DL variances management has direct control and therefore
can interpret the reasons of these variances and deal with them, while overhear
expenses, especially the FMOH variances, companies don’t have that much direct
control, and management may not be able to change them in the short term,
cm
specially the fixed OH.
Total Overhead Variance

am
Actual - Applied Actual paid total V&FOH

- Applied total V&FOH
h
Total variable OH
Total fixed OH variance
variance
ef
Actual FMOH - Applied

Actual VMOH - Applied
FMOH
VMOH
FOH spending variance FOH production-volume

VOH spending variance VOH Efficiency variance
(budget variance) variance
(AP – SP) × AQ (AQ – SQ) × SP
A. OH − Budgeted OH B. OH – Applied OH

Total Variable Overhead variance:

Equal to the difference between the actual variable overhead incurred and the
standard variable overhead applied.
= Actual VMOH – Applied VMOH
The standard variable overhead applied is based on the standard input allowed for
actual output.
m
Note: In a standard cost system, the following three items are all the same—they
are just called by different names:
co
1) Variable overhead allowed for production.
2) Variable overhead applied to production.
3) Variable overhead flexible budget.
a. Flexible budget
cm
Applied VMOH
am
AH X AR AH X SR SH allowed for actual output X SR
(AR – SR) × AH
h
It includes the following:

1) The variable overhead spending variance (equal to price variance)
ef
= AH X AR – AH X SR
= (AR – SR) X AH
It determines how much of the total variance was caused by the actual variable
overhead rate per unit of the allocation base actually used being different from the
standard overhead application rate per unit of the allocation base actually used.
2) The efficiency variance (equal to the quantity variance)

It measures the effect on variable factory overhead cost of efficient or inefficient
use of the allocation base used to apply the variable overhead. The variable
overhead efficiency variance is calculated as follows:
= AH X SR – SH X SR
= (AH – SH) X SR
standard input allowed for the actual output
it determines how much of the total variable variance was caused by the actual
number of the allocation base used, being different than the expected number of
the allocation base to be used.
Important notes:
1- If variable overhead is applied on the basis of output, not inputs, no efficiency
variance arises.
m
2- The variable overhead efficiency variance is related to the labor efficiency
variance if overhead is applied to production on the basis of direct labor hours. For
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example, if the labor efficiency variance is unfavorable, the overhead efficiency
variance also is unfavorable because they are based on the same number of input
hours.
Total Fixed Overhead variance

a.
Because of the nature of the FMOH, much less control can be maintained or
effected over these costs, that’s why it does not represent a high priority in
cm
studying variances as not much can be done to control them or change them or fix
the situation.
Note: Fixed manufacturing overhead is unique. Even though fixed overhead does
am
not change in total as the level of production changes, fixed overhead is applied to
production as if it were a variable cost that does change in total as the level of
production changes.
h
Total Fixed Overhead Variance (over- or under-applied fixed overhead)

= Actual FMOH – Applied FMOH
ef
Applied SH X SR
Static Budget = Flexible Budget
Given amount Given amount
FMOH Spending SVariance

(Flexible budget variance)
Note: The total fixed overhead variance is the same as the amount of over- or
under-applied fixed overhead.

1) The fixed overhead spending variance (flexible budget variance)

It is the difference between the actual amount of fixed overhead incurred (given
amount) minus the budgeted amount of fixed overhead (given amount).
= Actual FMOH – Budgeted FMOH
(static budget or flexible budget it is
the same, remember rent is rent no
mater how much is the production)
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The fixed overhead variance is simply attributable to more or less spending by the
production function. Whether the difference is justified should be investigated.
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2) The production-volume variance (idle capacity variance or denominator-level
variance)
It is the difference between the budgeted amount of fixed overhead (static =
a.
flexible) and the amount of fixed overhead applied (standard rate × standard input
allowed for the actual output).
The fixed overhead production-volume variance is caused by a difference between

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the actual production level and the production level used to calculate the budgeted
fixed overhead allocation/application rate.
= Budgeted FMOH – Applied FMOH
(Given) SH X SR
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The point here is that the SR is calculated dividing FMOH budgeted / allocation base
budgeted (budgeted hours / capacity), but that rate is then applied not to budgeted
capacity but to standard input allowed for actual output (different allocation base
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/ different capacity) that’s why the applied FMOH (from cost accounting
perspective) differs from the Budgeted FMOH.
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This variance results when production capacity differs from capacity usage. A
favorable (unfavorable) variance occurs when overhead applied is more (less) than
budgeted fixed costs. For example, the variance is favorable when actual
production exceeds planned production.
EXAMPLE: If fixed cost is expected (budgeted) to be $10,000, and the expected

(denominator) level of activity is 1,000 hours, the standard cost is $10 per hour. If
actual production uses 1,100 hours, $11,000 of fixed overhead is applied to
production (1,100 × $10). The production-volume variance is $1,000 favorable
($11,000 – $10,000).
The production-volume variance is typically not the fault of the production

function. The sales staff often is blamed, or rewarded, for a volume variance. If

sales are greater than expected, production increases, and the variance may be
favorable. An unfavorable volume variance may be caused by low sales (the fault
of the sales staff) or by a production shutdown, perhaps due to a labor strike, power
failure, or natural disaster.
In these cases, the variance is attributable to actions of the general administration
of the entity or to uncontrollable external factors.
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For the difference between actual overhead incurred and the flexible budget
overhead, the total overhead flexible budget variance is needed. The total
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overhead flexible budget variance includes the following three of the four overhead
sub-variances:
1) Variable overhead spending variance.
2) Variable overhead efficiency variance.
3) Fixed overhead spending variance.
a.
The total overhead flexible budget variance does not include the fixed overhead
production-volume variance because the fixed overhead production-volume
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variance is not a comparison between actual and flexible budget costs
also called as
controllable variance
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Example:
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a.
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h am
Variable manufacturing overhead variances:

Flexible budget
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Applied VMOH
8400HrsX$176 8400HrsX$200 1.5X4800X$200

$1,478,400 $1,680,000 $1,440,000
Total VMOH Variance = $38,400 UnF.

VOH Spending variance = ($201,600) Favorable VOH efficient variance = $240,000 UnF.

Efficiency variance interpretations:

1. Inadequate machine maintenance
2. Using under motivated, inexperienced or under skilled workers
Both will result in more use of time cost
Note: if allocation base is output units / number of production units then VMOH
efficiency variance = 0
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Spending variance interpretations:
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Standard cost rates were set inaccurately
Fixed manufacturing overhead variances:
Given amount
a.
Given amount
Applied SH X SR
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$1,832,200 $1,800,000 1.5X4800X$240
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$1,728,000
Total FMOH Variance = $104,200 UnF.

h
FOH Spending variance = $32,200 UnF. FOH production volume variance = $72,000 UnF.
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Production volume variance does not mean that we paid more or less FMOH, but
otherwise that the allocated FMOH cost per unit is different
Production volume variance of FMOH is uncontrollable
Production-volume variance interpretations:

Also known as: “denominator level variance”
“Idle capacity”
“output level overhead variance”
Reasons mainly related to demand and supply factory

FMOH spending variance = FMOH flexible budget variance

= Actual– Budgeted FMOH (Flexible budget amount)
FMOH spending variance interpretations
1. Paying more or less than expected to FOH items
2. Inactive budget procedures
3. Inadequate control of costs
4. Misclassification of cost items
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Usually with VMOH
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a.
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h am
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Example:
OPQ Company applies overhead to production based on machine hours. Before
20X0 begins, the company budgets the following for the year 20X0:
Standard for number of machine hours used/unit produced 5 MH/unit
Budgeted activity level 1,000,000 units
Budgeted fixed overhead $10,000,000
Budgeted variable overhead for budgeted activity level $5,000,000
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Actual overhead incurred during 20X0 was:
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Variable overhead incurred $5,670,000
Fixed overhead incurred 11,000,000
Total overhead incurred $16,670,000
a.
Actual production during 20X0 is 1,200,000 units. The actual number of machine
hours used during 20X0 for the actual production is 6,300,000 hours.
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The following variances will be calculated:
1) Total overhead variance
2) Total variable overhead variance
Variable overhead spending variance
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Variable overhead efficiency variance

3) Total fixed overhead variance
Fixed overhead spending variance
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Fixed overhead production-volume variance

4) Total overhead flexible budget variance
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Answer:
1) Total overhead variance = Actual – Applied
Actual Applied
Standard input allowed
for actual output X SR
5 Hours X 1,200,000 = 6,000,000 Hrs
$15,000,000 /1,000,000/5 = $3 SR
$16,670,000 $18,000,000
Total OH Variance = $(1,330,000) Favorable

2) Variable overhead variance
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6,300,000HrsX$0.9 6,300,000HrsX$1 5X1,200,000X$1
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$5,670,000 $6,300,000 $6,000,000
Total VMOH Variance = $(330,000) Favorable
a.
VOH Spending variance = $(630,000) Favorable VOH efficient variance = $300,000 UnF.

3) Total fixed overhead variance
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Applied SH X SR
Given amount Given amount
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$11,000,000 $10,000,000 5X1,200,000X$2

$12,000,000
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Total FMOH Variance = $(1,000,000) Favorable

FOH Spending variance = $1000,000 UnF. FOH production volume variance = $(2,000,000) F.
4) Total overhead flexible budget variance

1) Variable overhead spending variance $(630,000) Favorable
2) Variable overhead efficiency variance $300,000 Unfavorable
3) Fixed overhead spending variance $1000,000 Unfavorable
$670,000 Unfavorable

4. Sales Variances
Sales Variance
Selling price sales volume
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variance variance
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When there are multiple Sales quantity V.
Sales mix Variance
products Budgeted CM/Unit
a. Market size
variance
market share
variance
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Single Product Sales Variances
Variance analysis is useful for evaluating not only the production function but also
the selling function.
If sales differ from the amount budgeted, the difference could be attributable to
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either the sales price variance or the sales volume variance.

The analysis of these variances concentrates on contribution margins (if available
in the question) because fixed costs are assumed to be constant and also the
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variable costs increases lead to (generally almost) equal price increases so final
effect is the same to the contribution margin.
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For a single product, the sales price variance is the change in the contribution
margin (or unit price) attributable solely to the change in selling price.
Sales price variance = (ACM – SCM) X AQ

= (AP-SP) X AQ
For a single product, the sales volume variance measures the impact of the
difference in sales volume between actual results and the STATIC budget, and here
when we use static budget quantity not flexible budget quantity because simply
flexible budget is using the actual quantity like actual results, so no variance of
quantity (volume) with flexible budget.
Sales volume variance = (AQ – SQ) X SCM
= (AQ – SQ) X SP

For a single product, the sales mix variance is zero, which is discussed below. Thus,
the sales volume variance equals the sales quantity variance.
Exam Tip: If an exam question contains a variance report that includes an operating
income line and if it asks only for the sales volume variance without specifying a
line, the question is probably asking for the “bottom line,” or the sales volume
variance for operating income. The sales volume variance for operating income can
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be calculated in two ways.
1) The first way is to calculate the sales volume variance for either the contribution
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margin or the operating income line. The sales volume variance for the contribution
margin will be the same as the sales volume variance for operating income because
the only difference between the contribution margin line and the operating income
line is fixed costs, and there can be no sales volume variance for fixed costs.
a.
2) The second way is to subtract the static budget operating income from the
flexible budget operating income.
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Multiproduct Sales Variances
When more than one product sold, the sales price variance and sales volume
variance are calculated for each product and then added together.
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The multiproduct sales volume variance consists of: 1) the sales mix variance and
2) the sales quantity variance.
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The sales quantity variance tells us how much of that sales volume variance was
caused by the fact that in total we sold a different number of units from what was
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budgeted.
Sales Mix Variance = (AQ – AP) X waspSM
The sales mix variance is how much of the sales volume variance was caused by
the fact that the mix of the products sold was different than the budgeted mix, the
proportion of product A+B+C was different than it was supposed to be according
to the budget.
Sales Mix Variance = (waspAM – waspSM) X AQ

Example:
New Company, a newly created firm, produces chairs and tables. The budgeted
sales data for the first month of operation are as follows (CM stands for
contribution margin per unit):
Budgeted CM Actual CM Budgeted Units Actual Units

Chairs $ 60 $ 50 150 100
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Tables $ 250 $ 300 60 50
Totals 210 150
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Calculate the following:
1) Total sales variance
2) Sales price variance
3) Sales volume variance
a.
4) Mix Variance
5) Quantity (Yield) Variance
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Answer:
1) Calculate the total sales variance:
Static Budget Total Contribution Margin Variance
The actual contribution margin for both products is:
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Chairs 100 × $50 = $5,000

Tables 50 × $300 = 15,000
Total actual contribution margin $20,000
h
The budgeted contribution margin for both products is:

Chairs 150 × $60 = $9,000
ef
Tables 60 × $250 = 15,000

Total budgeted contribution $24,000
Static budget total contribution margin variance $4,000 UnF.
2) Calculate the sales price variance:

Calculation of the Flexible Budget Variance for the Contribution Margin
∑ (AP – SP) × AQ
Chairs ($50 - $60) × 100 = $(1,000) U
Tables ($300 - $250) × 50 = 2,500 F
Sales price variance (total flexible budget variance) $1,500 F

3) Calculate the Sales Volume Variance

The sales volume variance calculation for the contribution margin
the sales volume variance is calculated individually for each product and then these
amounts are summed.
∑ (AQ – SQ) × SP.
Chairs (100 - 150) × $60 = $(3,000) U
Tables (50 - 60) × $250 = (2,500) U
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Total sales volume variance $(5,500) U
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We need to calculate first:
The weighted average standard price of the actual mix (waspAM)
SP AQ
Contribution margin for actual chairs sold
at the standard contribution margin per unit
Contribution margin for actual tables sold a. $60 × 100 = $6,000

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at the standard contribution margin per unit $250 × 50 = 12,500
Total contribution margin for actual sales

at standard contribution margin per unit 150 $18,500
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Because 150 items were actually sold, the weighted average standard contribution
margin per unit for the actual mix (waspAM) is $123.33 ($18,500 / 150), sure we
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don’t have a product that has that contribution but that’s the weighted average of
the chairs and the tables.
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The weighted average standard price of the standard mix (waspSM)

SP SQ
Budgeted contribution margin for chairs $60 × 150 = $9,000
Budgeted contribution margin for tables $250 × 60 = 15,000
Totals 210 $24,000
Because 210 items should have been sold, the weighted average standard
contribution margin per unit for the standard mix (waspSM) is $114.28

4) Calculate the Sales Mix Variance:

(waspAM – waspSM) × AQ
($123.33 – $114.28) × 150
= $1,357 Favorable sales mix variance
Which means that because the company sold a mix that was actually more heavily
weighted to the higher-contribution item (tables), it received $1,357 more
contribution margin than if the actual quantity sold had been sold in the planned
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mix.
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5) Calculate the Sales Quantity Variance:
(AQ - SQ) × waspSM
(150 – 210) × $114.28
= $(6,857) Unfavorable sales quantity variance
a.
The company’s contribution margin was lower than budgeted by $6,857 because it
did not sell enough of either product we were missing 60 units in total, so the mix
was ok it led to a higher contribution margin, but the company simply didn’t sell
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enough of total products.
Sales quantity variance $(6,857) Unfavorable

Sales mix variance 1,357 Favorable
am
Sales volume variance $(5,500) Unfavorable

h
ef

5. Market Variances
The sales quantity variance is one of the two components of the sales volume
variance for a multiple-product firm. The sales quantity variance for the
contribution margin measures the effect on the contribution margin of the
difference between the total units actually sold of all products and the total units
budgeted to be sold of all products.
The sales quantity variance for the contribution margin can be broken down to
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discover the cause or causes of the variance in the total quantity sold in terms of
market forces. The total level of sales may be different from expected because
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(a) the market was bigger or smaller than expected (Market (sales) Size variance),
or (b) because the company’s share of the market was bigger or smaller than
expected (Market share variance), or both.
Market Size Variance:

a.
cm
am
Market Share Variance:

h
ef
Variance analysis for service companies:

Service companies can have variances such as price, volume, (quantity), mix (if they
provide different types of services) and overhead
If the service company provides both a service and a product, the company should
segregate its service revenue from its product revenue in its accounting system
A service company may have a high fixed overhead costs, in which case of revenue
drops, those large overhead costs might put business in trouble, that’s why it is
important to use comparative reports and variance analysis, so companies in his

situation can detect the problem earlier as possible, which would allow the
company more time to make changes to that fixed costs structure, try to minimize
or if possibly eliminate quickly these fixed costs.
So main distinguish between manufacturing and service companies regarding

variance analysis is mainly a shift in the focus to different costs categories.
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Total number of finished product units
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Productivity: = ‫ــ ــــ ــــ ـــــ ــــ ــــ ــــ ـــــ ــــ ــــ ــــ ـــــ ــــ ــــ ـــ ـــــ ــــ ــــ ــــ ــــ ـــــ ــــ ــــ ــــ ــ‬
Input cost
All costs (DM+DL) = total productivity
a.
Measures ratio of output quantity to input costs for the total production factors
Input cost:
Some costs (DM or DL) = partial productivity

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Measures ratio of output quantity to input costs for a single factor of production
h am
ef

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a.
cm
h am
ef

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a.
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h am
ef

Unit 10. Responsibility Accounting and performance measures

Subunits:
1) Responsibility centers
2) The contribution income statement
3) Transfer pricing
4) Performance measures
5) Balanced scorecard
m
1. Responsibility accounting
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A responsibility center is any part, segment, or subunit of an organization. A
segment may be a division, a product line, a geographical area, or any other
meaningful unit.
a.
Responsibility center accounting is the system that measures plans by budgets and
actions by actual results of each responsibility center (SBU), which consist of
controllable operating activities
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Decentralization: delegate responsibility to SBU managers
Decision Making and Decentralization
The primary distinction between centralized and decentralized organizations is in
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the degree of freedom of decision making by managers at many levels.

1) In a centralized organization, decision making is consolidated so that activities
throughout the organization may be more effectively coordinated from the top.
2) In a decentralized organization, decision making is at as low a level as possible.
h
The premise is that the local manager can make more informed decisions than a
manager farther from the decision.
ef

Responsibility Centers
A decentralized organization is divided into responsibility centers (also called
strategic business units, or SBUs) to facilitate local decision making.
4 Types of responsibility centers (SBUs):

1. Cost center
2. Revenue center
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3. Profit center (revenue & Cost)
4. Investment center (revenue, cost & investments / assets)
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Cost center: e.g., maintenance department and training department they are only
responsible for costs only.
Responsible for the incurrence of costs, any revenue it may earn is immaterial, and
a.
is not the reason that this department exist for the company, cost centers are
measured on their efficiency for the use of the resources of the company.
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Revenue center: are responsible only for generating the revenues and is not
measured by its expenses, instead it is measured by its effectiveness of how much
did it sell. e.g., sales department is responsible for revenues only. It may incur some
costs as well, but it become as a secondary to it.
am
Profit center: e.g., an appliance department in a retail store, is responsible for both
the incurrence of costs (efficiency) and generating revenues (effectiveness).
h
Investment center: is responsible not only for the incurrence of costs and
ef
generating revenues but also for providing a return on an investment. e.g., a branch
office to a home office is responsible for revenues, expenses, and invested capital.
The advantage of an investment center is that it permits an evaluation of
performance that can be compared with that of other responsibility centers or
other potential investments on a return on investment basis, i.e., on the basis of
the effectiveness of asset usage.
Evaluating manager / department:

Whenever an evaluation of a manager or department is made, it is important that
the manager and similarly department be evaluated only on things that they are
able to control (influence), Regardless of being variable or fixed

Controllability:
Degree of influence that specific manager has over costs, revenues and related
items, controllable costs are any costs subject to the influence of a given
responsibility center manager for a given period
Allocation of common costs:

Common costs are costs that are shared by two or more responsibility centers, for
m
example the nonmanufacturing overhead costs such as IT, HR, Accounting, etc. as
we need to allocate the service department costs in order to get these costs out of
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the service departments into the production departments so that we can
determine how it actually cost to produce the product, and we need to be sure to
allocate this costs properly because it will effect the evaluation of each department,
the allocation method should:
a.
 Provide accurate departmental and product costs
 Motivate managers to make their best effort
 Provide a fair evaluation of managers’ performance
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 Provide incentives for managers to make decisions that are consistent with
the company’s goals
 Justify costs for transfer prices or cost-based contracts.
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Considerations for cost allocation:

1. Cause and effect: activities that cause resources to be consumed are
identified, and cost allocations are based upon each responsibility center’s
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usage of the resources.

2. Benefits received: based upon benefit received by each responsibility center.
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3. Fairness or equity: allocation should be based on what is reasonable or what

is fair which is actually a matter of judgment
4. Ability to bear: costs are allocated based upon the ability of the responsibility
center to bear the cost.
Ways of allocating common costs:

There are two main ways in which common costs may be allocated:
1. stand alone cost allocation
allocates costs proportionately among all users on some basis that relates to
each user’s proportion of the entire organization, for example allocating HR
costs to each user’s weight of its employees’ number to the total
organization number.

2. incremental cost allocation

a. ranking the users of the cost object
b. full cost for primary users and
c. last party incremental users will receive the remaining balance of the
common costs), proportionately if there is more than one incremental user
So, the least user is the most to receive discount or least allocated cost
m
Common costs allocation uses:
1. External reporting for disclosure purposes to comply with GAAP
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2. Reimbursement purposes such as cost-plus contract
3. Decision making make or buy / invest or no invest
4. Motivate managers and employees
a.
Reasons of central support cost allocation to departments or divisions:
1. Reminds managers that support costs exist.
2. Reminds managers that profit center earnings must cover some amounts of
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support costs.
3. Motivation to use central support services appropriately.
4. Managers may be indirectly restraining central costs by exerting pressure on
managers control those costs.
h am
ef

2. the contribution income statement

Contribution margin approach to performance evaluation is emphasized in
responsibility accounting because it focuses on controllability
Sales Revenues XX
– variable costs (Variable manufacturing costs & SG&A) (XX)
= Contribution margin XX
It could be calculated per unit or for all revenue for a certain period
m
Sales Revenues XX
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– manufacturing costs (V. & F. Manufacturing costs) (XX)
= Gross margin XX
For external reporting GAAP
a.
Segment: is a product line, geographical area or other meaningful subunit of the
organization
Allocation of central administration costs:

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The purpose is to reach revenue or contribution goals after covering all fixed cots
including common costs
Contribution margin income statement:
Sales XX
am
- Variable manufacturing costs (XX)

= Manufacturing contribution margin XX To cover nonmanufacturing variable costs,
- Variable nonmanufacturing costs (SG&A) (XX) all fixed costs and then flow to profit
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= Contribution margin XX
To cover all fixed costs and then profit
- Controllable fixed costs (controllable by segment manager) (XX)
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= Controllable margin XX Short-term segment manager performance

- Noncontrollable, Traceable fixed costs XX
Depreciation XX
Taxes XX
Insurance XX (XX)
= Segment (product-line) margin XX Measuring the business unit performance
- Noncontrollable, untraceable common costs XX shared by two or more cost objects
= Segment operating income (net income) XX
Noncontrollable, untraceable fixed costs: are allocated to the segment, but they
shouldn’t be used in evaluating the segment, because these are costs that are
incurred at the company level, and would continue even if that segment would

discontinue, such as a sponsored marketing policy decided by the company’s top

management.
Profit Margin Ratio

= net income (or profit) / revenue (or sales)
In order to increase the profit margin a manager must either:
• Increase sales while holding costs constant, or
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• Decrease costs without losing sales, or
• Increase sales at a rate greater than the increase in costs.
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3. Transfer pricing
A transfer price is the price charged by one sub-unit of a company to another sub-
a.
unit of the same company for the services or goods produced by the first sub-unit
and “sold” to the second sub-unit.
The principal challenge is determining a price that motivates both the selling and
the buying manager to pursue organizational goal congruence.
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Goals of transfer pricing system:
Decision maker should consider the following:
am
1. Promote goal congruence

2. Segmental performance evaluation
3. It should consider the motivation of each profit center manager to achieve
their own profit goals plus working towards the success of the company as a
h
whole
4. It must meet legal and external reporting requirements
ef
5. It should be easy to apply, so it should be understandable, easy,

communicated and simple to apply for operating managers.
Don’t consider transfer price as a tax saving tool, most of countries already have
their own special tax laws treating transfer pricing for international companies.
Setting the transfer price:

The choice of a transfer price type is mainly a top management decision
1. Market price: is set as if the selling division were selling to an outside customer
(“arm’s-length” transaction), even though the selling division is really selling to
another division of the same company.

Sometimes no external market exists for a given product or component being

transferred from one segment to another, and thus a market price is not available.
2. Cost of Production Plus Opportunity Cost: it includes the cost of production +
the contribution that the selling department gives up by selling internally rather
than externally.
3. Variable costs: deciding price only at the variable cost of the selling division, and
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it works well enough when the selling department has excess capacity and it just
trying to satisfy the internal demand for goods, is not appropriate if the seller is a
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profit or investment center, because it decreases their profitability.
4. Full cost: it includes the full cost of production all materials, labor, and a full
allocation of overhead
a.
5. Cost plus: the cost of production (defined in the contract) + a fixed dollar amount
(lump sum) or percentage of costs (markup percentage)
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Stop here and think:
The tricky issue under all the cost-based pricing approaches, if it is actual cost that
the company uses, there will be a huge risk for the company as a whole, because
am
the producing department has no motivation to control the costs, because they
know whatever costs they incur they pass on to the purchasing department, while
if companies use standard costs, then there is less incentive for that, as if these
h
departments go over that standards they are not going to be reimbursed for it.
ef
6. Negotiated price: the selling and buying departments agree on a price, it

depends on the ability of both departments to negotiate and make decision,
whether they are able to decide to buy/sell it internally or externally.
7. arbitrary pricing: central management decides on a price to achieve some overall

objective such as tax minimization, it might be easy and simple and might serve the
goal congruence of the company for the top management point of view, but all
involved parties, will not motivated and will give up.
8. Dual-rate pricing: the selling and purchasing department each record the
transaction at different prices.
On one hand it is good from the point that everyone ends up being profitable, as
selling department can use high price and purchasing department could use low

price, but on other hand it might cause a loss for the company as a whole, and for
sure profit for the company will be less than the sum of the profits of the individual
segments.
Dual pricing system is rarely used because the incentive to control costs is reduced
What method should be used:

Top management should consider:
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1. The goal congruence of the company as a whole
2. The capacity of the producing department, as; if the producer is producing
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at a full capacity company will use a different pricing method than if the
producer has an excess of capacity
Transfer pricing and capacity:
a.
If the producing department has excess capacity and can produce what is required
by the other department, the minimum price that they will charge is the variable
cost of production.
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If the producing department does not have excess capacity, they will need to
charge variable cost of production + any lost contribution, otherwise they would
sell to another external party and keep their contribution and profit
am
While remember that also for the buying department the maximum price that they
are willing to pay is the market price, as they are not going to pay more than they
h
could go buy from external supplier for.

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Example:
Blitz Corporation has two divisions, A and B. Division B currently operates at 100%
of its capacity and produces two products: widgets and gadgets. Division B sells
both products to outside customers for $15.00 and $30.00 per unit, respectively.
The variable costs for widgets are $10.00 per unit and fixed costs are $3.00 per unit
at the current production and sales level. For gadgets, the variable costs are $16.00
per unit and fixed costs are $8.00 at the current production and sales level.
Division A, which currently purchases widgets from an outside supplier for $16.00
per unit, would like to purchase 150 widgets from Division B annually. However, if
Division B increases its production of widgets to meet the demand of Division A, it
must stop producing gadgets entirely. Also, to meet stricter quality requirements
of Division A, Division B must increase materials cost by $0.80 per widget, but the

marketing and transportation cost per widget will be reduced by $0.50 per unit.
The total number of units of gadgets produced and sold by Division B is 50 units per
year.
What is the price range within which the transfer price for widgets would satisfy
both divisions?
Solution:
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The transfer price acceptable for the seller, the buyer, and the whole company
should be:
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1) higher than the variable cost (VC) plus the opportunity cost (OC) of forgone
production and sales for the seller (lost contribution margin) per unit. Therefore,
the variable cost plus any opportunity cost of forgone production and sales is the
minimum price that the selling department needs to receive, and
a.
2) lower than the market price of the product per unit. The market price is the
maximum amount the buying department would be willing to pay.
Expressed as a formula:
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VC + OC ≤ Transfer Price ≤ Market Price
The maximum transfer price for a widget is $16.00 = (market price), as it is the
maximum that the purchasing price is willing to pay
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Variable cost for widgets produced by Division B for Division A is $10.30 per unit
($10.00 + $0.80 – $0.50)
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The opportunity cost, or the contribution margin lost on each gadget that Division
B could not produce is $30.00 – $16.00 = $14.00.
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The total contribution margin lost by Division B for the 50 gadgets that would not
be produced if it sells widgets to Division A is $700.00 (50 units × $14.00 per unit).
The opportunity cost/unit given up producing each widget for Division A is $4.67
($700.00 ÷ 150 units).
the minimum transfer price for a widget (VC+OC) of $14.97 ($10.30 variable cost
+ $4.67 opportunity cost).
VC + OC ≤ Transfer Price ≤ Market Price

14.97 ≤ Transfer Price ≤ $16

4. Performance Measures
Performance evaluation
Applying “management by objectives” approach
Looking at ways to measure the effectiveness of a manger or department, keeping
in mind that we always need to be evaluating performance based on controllable
items.
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So, performance measurement goals:
A company needs to measure performance and reward outstanding performance
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in a way that motivates its managers to achieve the company’s strategic objectives
and operational goals.
a.
“Goal congruence” means that individuals and organization segments are all
working toward achieving the organization’s goals.
Organization Goals
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Department Goals
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Team Goals Individual

Goals Goal congruence
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We also need to consider balancing between both-short term and long-term

measures and performance evaluation.
Timing of Feedback
The timing of the feedback is important because feedback that is not received in a
correct time frame is not useful, to correct things in the right time and avoid that
something continuous to go wrong for a longer period of time.

Performance measurement tools
Return on investment ROI Residual Income RI

Both are a kind of addition to the contribution income statement and other
measurements as well
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While remember that organizations should always consider using more than one
tool, so company can get the most accurate picture of what it is going on from
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different perspectives.
Financial measures:
① Return on investment (ROI) – De Pont method
a.
ROI is a key performance measure for an investment center, which is not only

responsible for generating a profit but also for providing a return on investment.
It measures the percentage of return that was provided on the dollar amount of
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the investment for example assets.
ROI (%) = Income (profit) / Investment (assets) of the business unit

Also called accounting / accrual accounting rate of return
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What is income? Unless stated otherwise we should use operating income, and
therefore we need to consider the accounting policies impact income such as the
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inventory measurement methods, the depreciation calculation methods, costing,

how variances are treated, etc. all are impacting income
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What is the investment? It is the assets of the business unit that is been measured,
we should include the assets that are in control under that business unit and that
includes the fixed assets.
 Assets being leased are included
 Idle assets that could be sold or used elsewhere should also be included
So according to answers of both previous questions that might mean that two
companies might calculate for the ROI differently, which needs to be considered if
we are using comparison as measurement.

Advantages of using ROI:

1. Generally, within the manager’s control, thus ROI motivates managers to
achieve goals
2. ROI can achieve goal congruence, as each successful investment SBUS
contributes directly to firm’s success
3. ROI provides fairness of reports as ability to compare performance of units
of different size
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One of the major Disadvantages of ROI:
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It measures return as a percentage rather than as a dollar amount as companies
would be more interested in a dollar amount, think of it as 50% of a $100 is $50
while 10% of a $1000 is a $100, so the return amount is a better indicator and
preferable by companies than the percentage, in other words, a higher rate does
a.
not necessarily mean that company is going to have a higher amount.
When a manger is evaluated using ROI, the manager may make decisions that are
good for short term ROI, but bad for the company in the long term, so companies
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can’t use only ROI.
An investment SBU manager can increase ROI in basically 3 ways:

1. Increase sales
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2. Reduce expenses
3. Reduce assets
That also include increase revenue and costs by the same percentage
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② Residual income (RI)

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RI is absolute amount instead of ratio (percentage)

RI = Income – (required rate of return X investment)
WACC Computed: Cost of investment

Weighted average cost of capital
RI: is the income earned after the unit has paid a charge for the funds it needs to
invest in the unit
RI generally is more likely than ROI as a measure of the subunit manager’s

performance to induce goal congruence ensuring that subunit managers work
towards achieving the company’s goals

Note: Income could be operating income or net income and investment could be
total assets or total assets minus current liabilities
Residual income might be a negative amount, which simply means that actual
achieved division income is less than what was targeted.
Advantages of RI Disadvantages of RI
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Support incentive to accept all projects Because it measures a dollar amount, RI
with ROI greater than minimum rate of is not useful in comparing projects or
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return departments of different sizes.
Remember that different decisions that company makes regarding its accounting
policies and methods (regarding inventory and fixed assets for example), is going
a.
to influence what the result is of all financial performance measures (ROI, RI, etc.),
so when we make comparison we need to consider a like companies or
departments of the same accounting methods.
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5. The Balanced scorecard
Record to evaluate the investment center performance
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(Multiple performance measures)

financial and nonfinancial measures
because to measure a performance is not good enough for a company to measure
it only financially and in dollar amount and meeting budgeting targets and that’s it
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as there are a lot more factors that companies can use as bases for their managers
and departments performance evaluation, that’s why using the balanced scorecard
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Nonfinancial measures focus on performance that should ultimately result in

improved long-term financial performance. Thus, nonfinancial measures are
leading indicators of performance.
in the balanced scorecard >>>>> the perspectives (categories) measured are:
1. Financial measures perspectives – profitability
2. Customer perspective – identify the market segment(s) to target and then

measuring success in those segments
3. Internal process perspective – products and services, operations and

customer service/support
4. Learning and growth – the culture that supports employee innovation,

growth and development as well as organizational capital and information
capital.
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a.
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All four major factors need to be based on the vision and strategy that the company
has, and all should build together to help achieve the goals of the organization, so
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the scorecard used by the business should depend upon its strategy.
And therefore, scorecard measures will be different from one company to another,
as each business should select a few measures (key performance indicators KPIs)
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that are most relevant to its business strategy and track those measures rigorously,
because management will only have a certain amount of time and that time need
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to be used and focused on the measures that are important and that are relevant
to achieving those goals and objectives.

A strategy map: links the 4 perspectives together and provides a way for all
employees to see how their work is linked to the corporation’s goals
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a.
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h am
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o Beginning at the bottom, Learning and growth contributes to the goals of the
internal business process perspectives.
o We make operational improvements made in operations support (business
process perspective) contribute to the company’s ability to fulfill the goals of
customer satisfaction (customer perspective).
o If the customer satisfied and happy that will bring more business increase
profit and increase financial performance (financial perspective).

Difficulties of balanced scorecard: is not easy to develop and its kind of long-term
process
1. It is difficult to use scorecards to make comparisons across business units,
because each business unit has its own scorecard.
2. To implement balanced scorecard performance measurement, it is
necessary to have extensive enterprise resource planning systems to capture
the detailed information required
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3. Nonfinancial data is not a subject to control or audit and so how reliable is
it? Some of it maybe subjective, what we think is happening, we don’t have
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a specific measure that we can quantify and confirm.
Software can be used to provide balanced scorecard performance information to

interested parties. However, installing dedicated balanced scorecard software does
a.
not mean that the balanced scorecard has been implemented. Specialized software
merely tracks the results
of a balanced scorecard
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program. A business
must develop its own
balanced scorecard for
each unit, undertake the
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implementation project,
and follow up on the
results.
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a.
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h am
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Section E) Internal Control … 15%

Unit 11. Governance, Risk & Compliance
Subunits:
1) Corporate Governance
2) Internal controls
3) Components of internal controls
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4) Legal Aspects of Internal Controls
5) External auditors
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a.
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1. Corporate Governance
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Corporate governance includes all of the means by which businesses are directed
and controlled, including the rules, regulations, processes, customs, policies,
procedures, institutions and laws that affect the way the business is administered
(how the company behave to achieve its goals and to make decisions).
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Corporate governance also involves the relationships among the various

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participants and stakeholders in the corporation, such as the board of directors,

the shareholders, the Chief Executive Officer (CEO), and the managers (all external
and internal connections).
Corporate governance is very concerned with what is known as the “agency

problem.”
Different people, That’s mainly why companies
Different priorities need corporate governance.
& different goals
Owner Hire Manager
Shareholder

Agency issues arise from the fact that the owners of the corporation (the
shareholders) and the managers of the corporation (the agents of the
shareholders) are different people. The priorities and concerns of the managers are
different from those of the shareholders. The managers are concerned with what
will benefit them personally and lead to increased salary, bonuses, power, and
prestige. The shareholders’ priorities lie with seeing the value of their investments
in the corporation increase.
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Therefore, corporate governance specifies the distribution of rights and
responsibilities among the various parties with conflicting priorities and concerns
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in an effort to mitigate the agency problem and bring about congruence between
the goals of the shareholders and the goals of the agents.
How is Corporate Governance Related to Risk Assessment, Internal Control and
a.
Risk Management? (why we study corporate governance?)
Strategies of business rely on measuring risk & risk management and that relies on
internal controls. (all are interconnected)
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Internal control and risk management are part of corporate governance
Principles of Good Governance: ‫ﻗﺮاءە‬

1) Board Purpose – The board of directors should understand that its purpose is to
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promote and protect the interests of the corporation’s stockholders while

considering the interests of other external and internal stakeholders such as (e.g.
creditors, employees, etc.).
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2) Board Responsibilities:
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1- monitoring the CEO and other senior executives

2- overseeing the corporation’s strategy and processes, including succession
planning;
3- and monitoring the corporation’s risks and internal controls
3) Interaction – Sound governance requires effective interaction among the board,

management, the external auditor, the internal auditor, and legal counsel.
4) Independence – An “independent” director has no current or prior professional

or personal ties to the corporation or its management other than service as a
director.
5) Expertise and Integrity – The directors should possess relevant business,
industry, company, and governance expertise. The directors should reflect a mix of

backgrounds and perspectives and have unblemished records of integrity. All

directors should receive detailed orientation and continuing education to assure
they achieve and maintain the necessary level of expertise.
6) Leadership – The roles of Board Chair and CEO should be separate.

If the roles are not separate, then the independent directors should appoint an
independent lead director. The lead director and committee chairs should provide
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leadership for agenda setting, meetings, and executive sessions.
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7) Committees – The audit, compensation and governance committees of the
board should have charters, authorized by the board, that outline how each
committee will be organized, the committees’ duties and responsibilities, and how
they report to the board. Each of these committees should be composed of
a.
independent directors only, and each committee should have access to
independent outside advisors who report directly to the committee.
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8) Meetings and Information – The board and its committees should meet
frequently for extended (Á‫وﻧﻤ‬ À ‫ دﻗ ﻘﻪ‬15 ‫ )ﻣﺶ‬periods of time and should have
˜
unrestricted access to the information and personnel they need to perform their
duties.
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9) Internal Audit – All public companies should maintain an effective, full-time

internal audit function that reports directly to the audit committee.
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10) Compensation – The compensation committee and full board should carefully
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consider the compensation amount and mix (e.g., short-term vs. long-term, cash
vs. equity) for executives and directors.
11) Disclosure – Proxy statements and other communications should reflect board
and corporate activities and transactions in a transparent and timely manner.
12) Proxy Access – The board should have a process for shareholders to nominate
director candidates, including access to the proxy statement for long-term
shareholders with significant ownership stakes.
13) Evaluation – The board should have procedures in place to evaluate on an
annual basis the CEO, the board committees, the board as a whole, and individual
directors.

Sources of corporate governance:

Where all policies, procedures, regulations, rules, etc. (which are part of corporate
governance) are coming from:
1- Charter (articles of incorporation)
Bylaws policies procedures
2- BOD
3- CEO
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4- Audit committee
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1- The corporate charter (articles of incorporation): À ‫ﺻﺤ ﻔﺔ‬
‫ﺎت‬ÂÃ‫اﻟ‬
also referred to as its “Articles of
Incorporation” or “Certificate of
Incorporation,” details the
following:
• The name of the corporation. In
many states, the corporate name a.
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must contain the word
“corporation,” or “incorporated,”
or “company,” or “limited,” or an
abbreviation of these. Names of
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companies shouldn’t be similar.

• The length of the corporation’s life, which is usually perpetual (meaning forever).
• Its purpose and the nature of its business.
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• The authorized number of shares of capital stock that can be issued with a
description of the various classes of such stock.
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• Provision for amending the articles of incorporation.

• Whether or not existing shareholders have the first right to buy new shares when
shares are going to be issued.
• The names and addresses of the incorporators, these are the people who setup
†‡
the corporation, whose powers terminate upon filing. ˆ‫اﻟﻤﺆﺳﺴ‬
• The names and addresses of the members of the initial board of directors, whose
powers commence (begin) when corporation is officially existing.
• The name and address of the corporation’s registered agent for receiving service
of process and other notices that the corporation needs to receive.
The persons who sign the articles of incorporation are called the incorporators.
Incorporators’ services end with the filing of the articles of incorporation (when the

company legally and officially exist), and the initial board of directors, named in the
articles of incorporation, takes over.
After the articles of incorporation have been filed and the certificate of
incorporation has been issued by the state (company is officially established), the
following steps must be carried out by the new corporation:
1) The incorporators elect the directors if they are not named in the articles.
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2) The incorporators resign, some of them maybe the directors.
3) The directors meet to complete the organizational structure. At this meeting
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they:
a. Adopt bylaws how it is that the corporation is going to function

o the requirements for annual meetings of shareholders;
a.
o Methods of calling special shareholders’ meetings;
o How directors are to be elected by the shareholders, the number of
directors and the length of their terms;
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o How officers (president, treasury, secretary, etc.) are to be elected by the
board of directors, officer positions and the responsibilities of each officer
position;
o How the shares of the corporation shall be represented (for example, by
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certificates) and how shares shall be issued and transferred;

o Specifications for payments of dividends; and
o How the bylaws can be amended. The directors ordinarily have the power
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to enact, amend or repeal bylaws, but this authority may instead be reserved
to the shareholders.
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Bylaws must conform to all state laws and specifications in the articles of
incorporation.
b. Elect officers (president, treasury, secretary, etc.).
c. Select the corporate bank account and designate by name the persons who are
authorized to sign checks on the account.
d. Consider for ratification any contracts entered into before incorporation, such
as with lawyers and legal accountants.
e. Approve the form of certificate that will represent shares of the company’s stock.
f. Accept or reject stock subscriptions.
g. Comply with any requirements for doing business in other states. For example,
if a corporation files with another state as a foreign corporation located in that
state, it will need to appoint a registered agent in that state.

h. Adopt a corporate seal to be used for corporate documents for which a seal is
required by law.
i. Consider any other business as necessary for carrying on the business purpose of
the corporation.
Amending the Articles of Incorporation

Most state corporation laws permit amendment of the articles, amendments for
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sure should comply to legal requirements and allowances for the corporations.
The BOD usually adopts a resolution containing the proposed amendments in order
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to be approved by a majority of the voting shares.
2- The Board of Directors BOD:

The board of directors’
main responsibility is to
ensure that the
a.

company is operated in
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the best interest of the
shareholders, who are
the owners of the
company.
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Thus, the members of the board of directors represent the owners of the company.
The board’s responsibility is to provide governance, guidance and oversight to the
management of the company, while remember that they are not involved in the
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day to day decisions of the company.

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The board has the following specific responsibilities:

• Selecting and overseeing management (select and remove officers), set
compensation of officers and management
• determine the capital structure
• initiate fundamental changes (because approving and deciding fundamental
changes is require GA)
• declare dividends
• add, amend and repeal bylaws
• the board determines what it expects from management in terms of integrity and
ethics and it confirms its expectations in its oversight activities.
• The board has authority in key decisions and plays a role in top-level strategic
objective-setting and strategic planning.

• Because of its oversight responsibility, the board is closely involved with the
company’s internal control activities.
• Board members need to be familiar with the company’s activities and
environment, just in a level that would help them to perform other responsibilities.
• Board members should investigate any issues they consider important.
It is important for the board members to be independent of the company. An
independent director has no material relationship with the company. In other
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words, an independent director is not an officer or employee of the company and
thus is not active in the day-to-day management of the company.
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BOD duties:
1- governing duties : setting corporate policies
2- fiduciary duty : fiduciary in behalf of other stockholders
3- loyalty duty
a.
: A) disclosure of any deals with the corporate, and
B) not to usurp any corporate opportunity
Honest errors do not result in personal liability, acting in
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good faith
Committees of the Board:
Most boards of directors carry out their duties through committees. Committees
of the board of directors are made up of selected board members and are smaller,
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working groups of directors that are tasked with specific oversight responsibilities.
One of the committees whose membership is prescribed by SEC regulations is the
audit committee. Other usual committees are governance, compensation, finance,
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nominating and employee benefits committees, that they all report back to the
whole board to make decisions when needed.
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Electing and removing directors:

The shareholders elect the members of the board of directors, the length of the
directors’ term of office is set in the corporate bylaws, removing directors as well
is done as necessary and usually requiring the vote of the shareholders.
3- Chief executive officer CEO:

The responsibilities of the CEO are determined by the
corporation’s board of directors, his/her
responsibilities are different from one company to
another, depending on many factors. The CEO should
not serve as chairman of the board of directors
because he should be monitored by the BODs.

4- The Audit Committee:

The SEC first recommended that boards
of directors of corporations have audit
committees in 1972. The Sarbanes-
Oxley Act of 2002 increased audit
committees’ responsibilities to a great
degree.
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Audit Committee Requirements
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Audit committee is a subcommittee of board of directors
Requirements for Audit Committee and Audit Committee Members
1) The audit committee is to consist of at least three members.
2) All members of the audit committee must be independent. This requirement
a.
means that the members of the audit committee may not be employed by the
company in any capacity other than for their service as board members and on any
committee of the board.
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3) at least one member of the audit committee must be a financial expert.
4) All members of the audit committee must be financially literate
5) In addition, the New York Stock Exchange requires a five-year “cooling-off”
period for former employees of the listed company or of its independent auditor
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before they can serve on the audit committee of a listed company.
Responsibilities of the Audit Committee

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1) Selecting and nominating the external auditor, approving audit fees, supervising
the external auditor, and reviewing the audit scope, plan, and results, which will
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help keep independence of external auditor.

2) being intermediary between management, the external auditor and the internal
auditor.
3) review the scope, plan and results of the external and internal audit.
4) review evaluations of internal controls.
5) review the work of the internal auditors.
6) review the interim and annual financial statements.
Authority and Funding of the Audit Committee

Has the authority to investigate any matter.
In the US, the audit committee has the authority to engage independent
counsel and other advisors, as it determines necessary, so they need to be
provided the proper level of funding to pay for what it need to do.

2. Internal Controls
According to the COSO (Committee of Sponsoring Organizations of the Treadway
Commission) publication, Internal Control – Integrated Framework,
“Internal control is a process, effected by an entity’s board of directors,
management, and other personnel, designed to provide reasonable assurance
regarding the achievement of objectives relating to operations, reporting, and
compliance.”
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No guarantees
Possible: internal control involves tradeoffs
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between cots and benefit, as benefit of control
system must exceed its cost
Objectives of internal control: ORC
a.
provide reasonable assurance of 3 achievements:
1- effectiveness and efficiency of Operations
Operations objectives relate to achieving the entity’s mission, include
improving (a) financial performance, (b) productivity, (c) quality, (d)
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innovation, (e) customer satisfaction, and (f) safeguarding of assets,
objectives related to protecting and preserving assets assist in risk
assessment and development of mitigating controls, avoidance of waste,
inefficiency, and bad business decisions relates to broader objectives than
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safeguarding of assets.
2- reliability of financial Reporting
To make sound decisions, stakeholders must have reliable, timely, and
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transparent financial information.

Objectives may relate to 1) Financial and nonfinancial reporting and/or 2)
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Internal or external reporting

3- Compliance with applicable laws and regulations
Entities are subject to laws, rules, and regulations that set minimum
standards of conduct.
While note that compliance with internal policies and procedures is an
operational matter.
Fundamental concepts of internal controls:

1- The purpose of internal control is to help the company achieve its objectives.
2- Internal control is an ongoing process.
3- Internal control is effected (accomplished) by people.
4- Internal control procedures can provide reasonable assurance only—not
absolute assurance and not a guarantee
5- Internal control must be flexible in order to be adaptable to the entity’s structure

to apply to an entire entity or just to a particular subsidiary, and also should be
flexible to be adaptable to all possible changes.
Who is involved for Internal Control?

Everybody in the company has a duty connected to internal controls, so everyone
is involved with the internal control process and requirements instead of one
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officer or one department that is specialized in internal control, while COSO define
the responsibility to maintain and assess internal controls as follows:
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1- The board of directors (BOD): responsible of overseeing the internal control
system, providing governance and guidance making certain that good controls are
in place
2- The CEO has responsibility of internal control system and the “tone at the top”
a.
3- Senior management: delegate responsibility for establishment of specific
internal control policies and procedures to personnel responsible for each unit’s
functions.
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4- Financial officers and their staffs are central to the exercise of control, as their
activities cut across as well as up and down the organization.
5- Internal auditors: play a monitoring role. They evaluate the effectiveness of the
internal controls established by management.
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6- all employees are involved in internal control, because all employees produce
information used in the internal control system or carry out other activities that put
the internal control systems into effect.
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3. Components of Internal Control

COSO (Committee of Sponsoring Organizations for the tread way commission)
CRIME
Interrelated components
E Control Environment (foundation of internal control system)
C Control activities
R Risk assessment
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I Information and communication
M Monitoring
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Internal control (cube) objectives and components:
a. Involving all
Objectives
different
ORC
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parts of
business
units and
activities
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Components
CRIME
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so, all 5 components with all 3 activities are interrelated and relevant to all parts of
the business.
1- Control environment:
Is the foundation of internal control system, this is the most important element of
internal controls because it is the basis on which the other elements are built.
The board of directors and senior management are responsible for establishing
the “tone at the top,” what is the top of the organization think about the control
environment, how they are related and dealing with control requirements, verbally

and by action, in other words if control system is important to management it will

be also important to everybody else.
Control environment:
Attitudes and actions of board of directors (BOD) and top management regarding
the significance of controls
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Control environment principles:
1- management philosophy:
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integrity and ethical values
BOD demonstrates independence from management and exercises
oversight over internal controls.
2- organizational structure:
responsibilities.
a.
management establishes the structures, reporting lines, and authorities and
incompatible duties cannot be combined in the same job function

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for example: book keeping reports to controller while bank deposits report
to treasurer
3- policies and procedures:
policies: general principles of the organization
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procedures: represent the detailed steps in carrying out the policies (Guide
for the policies)
4- objectives and goals:
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develop and retain competent individuals in alignment with objectives.

Objectives and goals must be clear, realistic, well communicated and
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achievable
5- assignment of authority and responsibility:
lines of reporting – segregation of duties
for example, when internal auditor report directly to CEO instead of
controller
2- Risk assessment:
Company has to identify and assess risks that it faces in order to be able to work on
mitigation and reduction of those risks, in other words if company doesn’t know
what risks are, it won’t be able to protect itself from those risks.
Risk: Unforeseen obstacles to the pursuit of organization’s objectives, risks are

internal or external also are quantitative or qualitative

Risk assessment: Process of identifying organization’s vulnerabilities

Risk management: process of designing and operating internal control system that
mitigate risks identified in the risk assessment
Internal control system cannot be effective 100% as it involves tradeoffs between
cost and benefit and since risks can be mitigated and not eliminated
Risk model according to AICPA:
TR = IR X CR X DR
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Total risk = inherent risk X control risk X detective risk
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After the company has identified its entity-level risk and activity-level risk,
internally and externally, then it should perform a risk analysis:
1- to estimate the significance of each risk
2- the likelihood or frequency of each risk’s occurring
a.
3- to consider how each risk should be managed by assessing what actions need to
be taken.
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3- Control activities:
These activities are the policies that are developed to address the risks of the
company, and procedures that ensure the policies will be followed, you could say
that these are the control forms that you have to fill up and all those things you
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have to get permission and authorization for.

Any control implemented must have a greater benefit than the cost of the control
(so it is important to involve a cost-benefit analysis before deciding to implement
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any control activity/tool)

Preventive VS. Detective controls:
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Preventive controls: which try to prevent an error, mistake or problem from

entering the system, sure it is cheaper and easier to
prevent a mistake than trying to fix it it is highly visible
Such as fences, locked doors, security guards and
segregation of duties
Detective controls: calls attention to an error that has already entered the
system but before a negative outcome
Such as petty cash count

Control Activities:
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1. Segregation of duties:
a.
Duties need to be divided among various employees to reduce the risk of

errors or inappropriate activities, generally, no single individual should have
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enough responsibility to be in a position to both perpetrate and conceal
irregularities.
Incompatible duties cannot be combined in the same job function
And it includes separation of 4 basic responsibilities:
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1. Authorization to execute transactions

2. Recording of transactions, this person knows how much of that asset we
should have
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3. Physical Custody of the recorded assets, this person know how much we
actually have
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4. Periodic reconciliation, between physically existing assets to recorded

transaction/balances, which means the reconciliation between what we
should have and what we actually have
2. Independent check and verifications
Involves 2 conditions:
1. No involvement of assets custody
2. Unconnected to original transaction
3. Safeguarding controls:
Includes limit access to assets only to the authorized personnel, whether it
is direct access or indirect access
4. Sequential pre-numbered forms
5. Specific document flow
6. Compensating controls
When not possible to apply previous control activities, then we apply

compensating controls instead.
For example: referring to financing and investment cycle, top management
holds all decisions, transactions and execution, and the solution will be to
use two different people to perform each function.
7. Fraud:
must be intentional, involves collusion (when two or more individuals get
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around controls) and falsification
Ex. Fraudulent financial reporting
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4- Information and communication:
Information needs to be obtained from and communicated to people to allow them
to perform their duties, ongoing basis.
a.
Good information and communication system mean, right information, to right
person and in the right time in order to be able to make a proper decision or action
according to the given information.
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5- Monitoring activities:
Reviewing the controls over a time to make sure that they are still relevant and still
functioning as they were intended, in order to be able to comply to all changes that
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might happen to technology, business, transactions, even people, etc.

As control tools that were working well a year ago or even a month ago, doesn’t
mean those are still the controls that we need to have in place now, or that it is still
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working now, so monitoring must be an ongoing process.

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Limitations of internal controls that we must be aware off:

1- can’t provide absolute assurance, only a reasonable assurance.
2- human judgement in decision-making can be faulty/wrong.
3- breakdowns can occur because of human errors.
4- management maybe able to override internal controls, which will be a problem
with the “ton on the top”, a problem with the control environment
5- collusion, as two or more individuals might be able to get around internal
controls, maybe someone inside and someone outside the company for example.
Transaction Control Activities

• Authorization and approvals. Authorization generally is in the form of an
approval by a higher level of management or of another form of verification, make
sure that documents and transactions have got the right authorization level.

• Verifications. Items are compared with one another or an item is compared with
a policy, and if the items do not match or the item is not consistent with policy,
follow up occurs.
• Physical controls. Equipment, inventories, securities, cash, and other assets are
secured physically in locked or guarded areas with physical access restricted to
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authorized personnel and are periodically counted and compared with amounts in
control records.
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Safeguarding Controls
Physical safeguarding of assets against loss is an important part of a
company’s operations objectives. Loss to assets can occur through
a.
unauthorized acquisition, use, or disposition of assets or through
destruction caused by natural disasters or fire.
Prevention of loss through waste, inefficiency, or poor business
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decisions
Physical protection of assets requires:
• Segregation of duties.
• Physical protection and controlled access to records and documents such
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as blank checks (stored in specific area), purchase orders (prenumbered and

numbers should be logged), passwords (limited password to each individual
according to their authority levels), and so forth.
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• Physical protection measures to restrict access to assets, particularly cash

(kept in a safe controlled by one individual for example until deposited to
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bank) and inventory (should be also limited access to store responsible

person, approvals of acquisition should be obtained, security cameras in
inventory area, security alarms if needed, also security guard, that all could
limit theft of inventory, also regular physical count of inventory is important
tool of controlling inventory).
• Effective supervision and independent checks and verification.
• Controls over standing data. Standing data, such as in a master file containing
prices or inventory items, is often used in the processing of transactions. Controls
need to be put into place over the process of populating, updating, and maintaining
the accuracy, completeness, and validity of the data in the master files.

• Reconciliations. Reconciliations compare two or more data elements and, if

differences are found, action is taken to make the data elements agree. For
example, a bank reconciliation reconciles the balance in the bank account
according to internal records with the balance in the account according to the bank.
Reconciling items are items in transit (outstanding checks and deposits) and are to
be expected. However, differences that cannot be explained by items in transit
must be investigated and corrective action taken. Reconciliations generally address
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the completeness and accuracy of processing transactions.
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• Supervisory controls. determine whether other transaction control activities are
being performed completely, accurately, and according to policy and procedures.
For example, a supervisor may review a bank reconciliation performed by an
accounting clerk to check whether the bank balance as given on the reconciliation
a.
report matches the balance on the statement and whether reconciling items have
been followed up and corrected and an appropriate explanation provided.
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Read-H
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a.
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4. Legal aspects of internal controls

The acts applicable to issuers of publicly traded securities
Internal controls are important and so governments are trying to make certain
that the companies that publicly traded have these internal controls
There are two legislations regarding internal control issues that we need to know
details of are:
a- The foreign corrupt practices act FCPA
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b- Sarbanes-Oxley act SOX
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a. FCPA (Foreign Corrupt Practices Act) 1977
Passed in response to the discovery in the 1970’s that American companies were
making large, questionable or illegal payments to foreign governments, officials or
a.
politicians.

Applicability and responsibility:
1- anti-bribery provision apply to all companies whether or not are publicly traded.
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2- the accounting provisions are applicable only to companies that are under the
regulations of SEC, so those companies that are publicly traded.
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3- the responsibility of compliance with the act is given to the company as a whole,
so is not specific to any person or position but everyone within the organization has
responsibility for compliance with FCPA, however, individuals are personally liable
for their actions
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 Prohibits only corrupt payments to foreign officials with no mention of

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corrupt payments to business owners according to this law

 It is concerned of the valued corrupt payments as according to FCPA the de
minims gifts and hospitality tokens are acceptable
 Foreign official does not include clerical and ministerial governmental
employees as long as the recipient has no discretion in carrying out
governmental function / decision
 What is not prohibited in other foreign country is not prohibited by this law
There are two main provisions of FCPA:

1- anti-bribery provision
2- internal control provision

1- anti-bribery provision
It is illegal to offer or authorize corrupt payments to any foreign official, foreign
party chief or official or a candidate for political office in a foreign country.
Also, it is illegal to do these payments through another party (intermediate party)
Corrupt payment depends on the intentioned of the payee whether it was

successful or not it doesn’t matter.
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2- internal control provision
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Management must develop and implement a system of internal controls, and
management is required to maintain records and books and accounts that
represent transactions properly.
Reason is / or relation of this provision to FCPA is: because if company comply with
a.
internal control provision, it will be much more difficult for a corrupt payment to
be made, because there will be always a question about this payment.
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FCPA penalties:
For an individual for each criminal violation:
A fine of up to $100,000 or imprisonment of up to 5 years or both
For corporates:
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A fine of up to $2,000,000
b. Sarbanes-Oxley act SOX

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Subjects under SOX:

Title I: Public Company Accounting Oversight Board (PCAOB)
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Title II: Auditor Independence

Section 201: Services Outside the Scope and Practice of Auditors
Section 203: Audit Partner Rotation
Section 204: Auditor Reports to Audit Committees
Title III: Corporate Responsibility
Section 302: Corporate Responsibility for Financial Reports
Title IV: Enhanced Financial Disclosures
Section 404: Management Assessment of Internal Controls
Section 407: Disclosure of Audit Committee Financial Expert

Title I: Public Company Accounting Oversight Board (PCAOB)

established the Public Company Accounting Oversight Board (PCAOB), to oversee
the auditing of public companies that are subject to the securities laws.
This board:
1- contains 5 members appointed by SEC
2- includes only members who are financially literate and must be from the private
sector
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3- and only two of the board members can be CPAs
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Responsibilities of PCAOB:
Guidance to the auditors and their auditing of internal controls and financial
statements, among other responsibilities:
1- Registering public accounting firms that audit public companies.
a.
2- establishing standards related to the preparation of audit reports regarding
auditing, quality control, ethics, and independence
3- Conducting inspections of registered public accounting firms with the Sarbanes-
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Oxley Act, the rules of the Board, the rules of the Securities and Exchange
Commission (SEC), and another professional standard.
4- Conducting investigations and disciplinary proceedings and imposing
appropriate sanctions for violations.
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5- Management of the operations and staff of the Board.
Section 201: Services Outside the Scope and Practice of Auditors

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Lists specific non-audit services that create a fundamental conflict of interest for
the accounting firms, services can’t be provided by external auditor to his client.
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Excluded services:
1- bookkeeping services
2- financial information system design and implementation
3- appraisal of valuation services
4- actuarial services
5- internal audit outsourcing services
6- management functions
7- HR services
8- Broker/dealer, investment adviser, or investment banking services.
9- Legal services.
10- Expert services unrelated to the audit.

11- Any other service that the Public Company Accounting Oversight Board
(PCAOB) determines, by regulation, is not permissible.
These all works toward the independence of the external auditor, he can’t keep
records of books and then audit the books
Section 203: Audit Partner Rotation:
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The lead audit partner and the concurring review audit partner must rotate off a
particular client’s audit after 5 years, and they must remain off that audit for 5
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years.
Other audit partners who are part of the engagement team must rotate off after 7
years and remain off for two years if they meet certain criteria.
Specialty partners do not need to rotate off, tax or valuation specialists.
a.
Other partners who serve as technical resources for the audit team and are not
involved in the audit per se are also not required to rotate off the audit.
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Rotate Remain
off after off for
Lead audit partner 5 5
Other audit partners 7 2
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Specialty partners No rotation

Technical resources partners No rotation
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Section 204: Auditor Reports to Audit Committees:

The auditor must report the following in a timely manner to the audit committee:
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1) All critical accounting policies and practices to be used;

2) All alternative treatments of financial information within GAAP that have been
discussed with the issuer’s management; and
3) Other material written communication between the registered public
accounting firm and the management of the issuer, such as any management letter
or schedule of unadjusted differences.
Section 302: Corporate Responsibility for Financial Reports:

Concerned about the corporate’s responsibility for financial statements
each annual or quarterly financial report filed or submitted to the SEC in
accordance with the Securities Exchange Act of 1934 must include certifications by
the company’s principal executive officer or officers and its principal financial
officer or officers.

periodic financial reports should be signed by two officers:

1. Principal executive officer
2. Principal financial officer
They are going to be certifications about financial reporting and also internal
controls, So not only the auditor signing the audit report and financial statements
but also the leading officers of the company
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Financial reporting certification:
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The signing officers certify that:
1. Singing officer has reviewed the report
2. Singed report does not contain untrue statements or omit to state any
material fact
a.
3. Signed report fairly represent actual financial position and results of
operations
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Internal control certifications:
The signing officers certify that:
1. Signing officer is responsible for:

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 Establishing and maintaining internal controls

 Knowing all related significant information to the issuer and its
subsidiaries
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 Evaluating the effectiveness of internal controls as of a date within 90

days prior to issuing the signed report
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 have reported on their findings about the effectiveness of their

internal controls
2. Signing officer has disclosed to audit committee and external auditor:

 Significant deficiencies or material weaknesses in internal controls
 Any fraud incidents whether or not material
 Indicate significant changes in internal controls

Section 404: Management Assessment of Internal Controls:

There are requirements connected to the assessment of internal control for both
management and the external auditor.
Requirements of management:
SEC NO33-8810 guidance for management assessment
Must include in their annual reports a report of management on the company’s
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internal control over financial reporting, SOX requires the report to:
1. Statement of management’s responsibility for internal controls.
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2. Management’s assessment / evaluation of the effectiveness of internal
controls
the report contains an assessment by management of the adequacy of
the company’s internal control over financial reporting (ICFR)
controls such as report of COSO

a.
3. Identification of standards used in evaluating the effectiveness of internal
4. Statement of significant changes in internal controls after evaluation

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Requirements of external auditor:
PCAOB Auditing standard #5 guidance for external auditor
(Public Company Accounting Oversight Board)
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To issue an attestation report on management’s evaluation of internal controls

integrated with the audit report of the financial statements
So, external auditor is to express two opinions:
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One for the audit of the financial statements, regarding:

1. Compliance in accordance with GAAP
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2. Accurate transactions
Another one must report on and attest to management’s assessment of the
effectiveness of the internal controls, regarding:
Significant deficiency or material weaknesses in internal controls, as it would result
in a possible material misstatement in financial statements
Both evaluation and audit are in conjunction and not separate engagement
So, management does assessment (yes, our controls are good) and then the auditor
report on that assessment (yes, we agree with management).

Top-down approach: used by both: Both fundamentally the

SEC NO33-8810 guidance for management assessment same and both use the top-
PCAOB Auditing standard #5 guidance for external auditor down risk-based approach
Top-down begins with a risk assessment of the overall risks to the financial
statements ICFR, to be sure to identify the risks to the financial statements as a
whole, once identified, then those risks are the focus of the testing,
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SEC NO33-8810 guidance for management assessment
The guidance is organized around two broad principles:
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1- management’s evaluation of evidence about the operation of its controls should
be based on its assessment of risk.
2- management should determine whether it has implemented controls that
adequately address the risk that a material misstatement of the financial
a.
statements would not be prevented or detected in a timely manner.
Section 407: Disclosure of Audit Committee Financial Expert:

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Each issuer (of publicly traded security) must disclose whether or not the
company’s audit committee consists of at least on member who is a financial
expert.
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Requires that each member of Audit Committee (which is consists of outside

members of BODs and should include at least one financial expert) should be
independent of the board of directors
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Audit committee is responsible for appointing, compensating and overseeing the

external auditor as well as internal auditors whom they should report to audit
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committee and not to management
Disclosure of the expert:

If, one expert, must disclose that person’s name and his independence
If more than one expert, the company may, but does not need to, disclose their
names.
Definition of expert:
Education and experience as public accountant, auditor or a principal accounting
or financial officer of an issuer of publicly-traded securities, has:
1- an understanding of GAAP and financial statements and the ability to assess the
application of GAAP in connection with accounting for estimates, accruals and
reserves.

2- experience in the preparation or auditing of financial statements of comparable

issuers
3- experience and understating of internal accounting controls and procedures for
financial reporting
4- an understating of the audit committee functions.
5- The external auditors and their report:
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Responsibilities of external auditor:
Only one major responsibility of external auditor is to express an opinion on the
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financial statements.
+ under the PCAOB, external auditor must issue a report on internal controls (if
the engagement is about a publicly traded company).
a.
Focuses on internal control material weaknesses, as internal control deficiencies
can result in material misstatement in the financial statements
PCAOB Auditing Standard AS # 2201:

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The purpose of this opinion with regard the internal controls system, is that
material weaknesses in internal controls will be found before they result in material
misstatement in financial statements and at the same time eliminate procedures
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that are unnecessary

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For example, internal auditor would care why company is paying high rent? So, they
care about efficiency, while external auditor they only care that the financial
statements reports that high rent in a proper way no matter if it is efficient
agreement or not, that’s an example to demonstrate briefly the major difference
between both internal and external auditors.
Types of external auditor’s opinions:

External auditor can express 4 types of opinions with regard the accuracy,
presentation, completeness, and conformance of financial statements to GAAP.
Unqualified opinion  yes  means that the financial statements are correct 
that means there are no qualifications  clear opinion

External auditor will never certify that financial statements are correct in general
but instead they usually report that financial statement fairly represents the
financial position of the company and it is prepared in accordance with GAAP
Qualified opinion  almost  financial statements are almost correct except for
some items that they believe are wrong and needs correction (so it needs
qualifications)  and therefor auditor should mention what should be the right
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number instead
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Adverse opinion  not even close  the financial statements are not even close
to correct  so there are so many mistakes that the financial statements are
considered to be wrong
a.
Disclaimer of an opinion  no idea  auditor is not given an opinion because he
has no idea  because for some reason or another they couldn’t do what they
suppose to do (regarding their tests, etc.)
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How the process goes?!
Company will provide its financial statements  stating that, these are the financial
statements we think are correct  auditor will do tests  and refer back to
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company and say no this is what we believe should be the correct position  and
provide the required adjustments from external auditor’s point of view  if
company will apply all required adjustments  it is unqualified opinion then  if
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company apply adjustments except one or two (for example)  it is a qualified

opinion  if the company refused to make majority of the required adjustments
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 it is an adverse opinion.
So generally, it is the company’s choice as the auditors told them what they needed
to do in order to get unqualified opinion
Unqualified Yes – correct – fairly represent

Qualified Almost – there are exceptions or notes in the auditor’s report
Adverse Not even close
disclaimer No idea – no opinion

Audit risk:
Is the risk that the audit opinion is incorrect, for example when auditor justify that
financial statements are correct were in fact they are not, in this case auditor can
be sued, while if they say it is not correct and it is actually correct they not going to
be sued but for sure they will lose the client
Audit risk is made up of three types of risks:
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Inherent risk:
The risk that is the natural risk in the function being audited, assuming that there
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are no controls
So, it depends on the nature of the activity, the account or the number that it had
been audited, there are much more inherent risks in securities and derivatives than
in cash or inventory for example
Control risk:
a.
The risk that an internal control will not prevent or detect a material misstatement
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in a timely manner.
Detection risk:
The risk that the external auditor will not detect a material misstatement, it
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depends mainly of the auditor’s lists, tests, experience, efforts and amount of work
to be done to reduce that detection risk.
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Inherent risk A risk that there is a mistake

Control risk A risk that client doesn’t detect the mistake
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Detection risk A risk that the auditor doesn’t detect the mistake
Based on all previous, in order to be an audit risk, that there is a misstatement in

financial statements, then the audit risk must include all three types of risks, first
there has to be a 1-mistake, then the client’s 2-controls detect it, and then the 2-
auditor doesn’t detect it as final step

Audit approaches:
The substantive approach:
“Vouching approach” “Direct verification approach”
Testing large volumes of transactions and balances without any particular focus
The balance sheet approach:

Procedures are focused on the balance sheet account with only limited procedures
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on the income statement accounts
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The systems-based approach:
Evaluating the effectiveness of internal control system, and focus audit on areas
where it is considered that system objectives will not be met and reduce testing on
other areas
The risk-based approach:

“The business risk approach” a.
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Audit resources are directed towards those areas that may contain misstatement
whether by omission or error
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Unit 12. Systems Controls and Security Measures

Subunits:
1. Information systems controls
2. Internet security
1. Information systems controls

Objectives of information system control are
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similar to the objectives of overall organizational
controls
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1- promoting effectiveness and efficiency of
operations to achieve company’s objectives
2- maintaining the reliability of financial reporting
a.
3- assuring compliance with laws and regulations as
well as adhering to company’s policies
4- safeguarding assets
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Three major goals of information security:
Availability Confidentiality (Secrecy) Integrity
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Specific threats to information system:

1- errors can occur in system design
2- errors can occur in transmission of data
3- data can be stolen over the internet
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4- data and programs can be damaged

5- viruses, trojan horses and worms can infect a system, that might crash the
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system or lead to a stolen or damaged data

6- physical facilities can be damaged as well
System controls guidelines: (just be familiar with the names)

Information system internal control guidelines are based upon two documents:
1- the report of COSO Committee of sponsoring organizations – internal control
integrated framework
2- COBIT control objectives for information and related technology, published by
ISACF the information systems audit and control foundation

Categories of systems controls:

1- General controls (relate to environment transactions)
1- organization and operation of the computer facility (including,
segregation of duties)
2- general operating procedures (including, written procedures and
manuals)
3- equipment and hardware controls (including, backup procedures)
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4- access controls (including both, physical access and password
access data and programs)
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Segregation of accounting duties:
Most important organizational and operating control
Separation of basic duties and responsibilities in order to minimize to perpetrate
a.
and conceal errors or fraud, for example information system (IS) personnel (design,
programming and maintain computer systems) should be separated from the users
of the systems, also responsibilities within IS should be separated from one another
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Basic responsibilities / functions / duties:

Authorization Record keeping Assets custody

2- application controls
Are specific to individual applications.
They should be designed to prevent, detect and correct errors in
transactions, three main categories are:
1- input controls
2- processing controls
3- output controls
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Input, processing, output and storage controls:
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Any information system (automated or manual) perform 4 basic functions on
information (input, processing, output and storage)
1. Input controls:
a.
Reasonable assurance that data submitted are: Authorized, complete and accurate
Input is the stage with the most human involvement and therefore has the highest
risk of errors occurring.
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These controls depending on whether input is entered in online or batch mode
A) Online input controls:
1 Preformatting forcing data entry to all necessary fields
2 Edit checks prevents (also detect and correct controls) certain types
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of incorrect data (Dropdown menus)

3 Limit checks certain amounts can be restricted to appropriate ranges
4 Check digits algorithm, Ex. Customer codes
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B) Batch input controls:

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1 Management batch released upon management’s review and approval

release
2 Record count batch released when number of records in the batch
matches the number calculated by the user.
3 Financial total batch released when dollar amount of individual items
matches the amount calculated by the user
4 Hash total the sum of a numeric field, that has no meaning by itself,
can serve as a check

2. Processing controls:
Provide reasonable assurance that:
1. All data submitted for processing are processed
2. Only approved data are processed
Controls are built into the application code by programmers:
Validation identifiers are matched against master files to determine
existence Ex. Vendors codes
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Completeness to reject any record with missing data
Sequence check logical order
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3. Output controls:
Assurance that input and processing has resulted in valid output, that output
information is complete and accurate
a.
1. Audit trail: report of all transactions details
2. Error listings: report all transactions rejected by the system
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Classification of information systems controls:
Preventive To try and prevent the error or the fraud before it happens
such as segregation of duties, job rotation, dual access controls,
preformatted input
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Detective Try to uncover the mistake, the error, the fraud, etc. after its
already occurred
Such as batch totals, total of documents had been entered to the
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system
Corrective Used to correct the errors, such as discrepancy reports, upstream
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resubmissions
4. Storage controls:
Dual write routines store data on two separate physical devices
Validity checks data bits structure validity
Storage physical controls store hard drives in physically secure rooms and
storing portable
Media (CD-ROMs) in locked storage areas

3- System development controls:

Steering committee (composed of managers from IT and end user departments) to:
1. Approve development projects
2. Assign resources
3. Ensure that required system developments are aligned with organizational
strategic plan
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Changes to existing systems should be initiated by an end user and authorized by
management or the steering committee
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Steps of information system development:
1. Changes should be made to a working copy of the program
2. Should be tested before placed in production
a.
3. Testing must involve the use of incorrect data
4. Changed program code should be stored in secure library during the testing
5. Unauthorized changes can be detected by code comparison
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4- Physical controls:
1. Physical access: limit access to computer center only to authorized
personnel or operators
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2. Environmental controls: the computer center should be equipped with a

cooling and heating system to maintain a year-round constant level of
temperature and humidity
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5- Logical controls:
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1. Authentication: ‫اﻟﻤﺼﺎدﻗﻪ ﻋ• ﺷﺨﺺ اﻟﻤﺴﺘﺨﺪم‬

IDs Passwords
Unique identifier (user name)
1. Difficult to guess
2. Ideally, passwords are at least 8 characters long, and contain
both uppercase and lowercase and numerals
3. The system should force password to be changed periodically
2. Authorization: ‫ﺻﻼﺣ ﺎت اﻟﻤﺴﺘﺨﺪم‬
a. Users can only access programs and data necessary to their job duties
b. Authority to view data but not to change

Computerized audit techniques:

Testing the computer system:
Three main ways to test the integrity of the system (testing the process of the
information):
1- Test data approach
Auditor creates data that is fed through the computer system that include both
true and false data, so we need to be sure that the false does not make it to the
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real system, one of the main limitations to this method is that it can only evaluate
programs and their processing but not the integrity of input and output, also it can
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only run on a specific program at a specific time.
2- Integrated test facility (ITF)
Used to test large systems that process in real-time, use test data and fictitious data
of some real accounts all processed along side real data, such as creating fake
a.
customer and supplier accounts in between all other real accounts.
3- parallel simulation
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Auditor is using actual client data and running it on a computer system that the
auditor knows to be working correctly, the results are then compared, its mainly
used when the audit requires auditing all the transactions.
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2- Internet security
A minimum level of internet security
includes:
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1- user account management, accounts

and passwords for only authorized people
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to use the system

2- a firewall, Combination of hardware and
software that separate (barrier) an internal
network from an external network, such as internet
3- Anti-virus protection
4- encryption: converts data into a code, protecting against data interception that
results from people stealing our data, so even if they stole it they not able to read
it, unauthorized users without encryption key will be unable to decode the
information

Threats to information systems:

Input manipulation
Program alteration deliberate changes to program applications
Direct file alteration deliberate changes to data in a database to the intruder’s
advantage
Data theft copying critical data such as credit card numbers and
social security information
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Viruses are computer programs that aim to destroy data, they
propagate from One computer to another without user’s
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knowledge, while they mostly spread through e-mail
attachments and downloads
Worm Similar to a virus, but it replicates itself without the use of
a.
a host file
Virus hoax Can cause you to damage your own system by deleting
critical system files that it tells you incorrectly are virus
files, by email for example to advice you to delete some
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files because they are viruses but they are not really virus
Logic bombs they also destroy data while they remain on one single
computer, and often dormant until triggered by some
occurrence
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Trojan horses voluntarily installed on computer by the user because

they are masquerading as programs the user wants
Backdoors IT personnel often design backdoors, while hackers search
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to exploit Backdoors for their own purposes

Theft require proper physical protection of computing
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infrastructure assets
Inherent risk of the internet:

1. Password attacks:
a. Brute-force attack: uses password cracking software
b. Trojan horses: using false website to obtain information (packet
sniffers)
2. A man-in-the-middle attack:
Access to the network during a rightful user’s active session to steal data
3. Denial of service attack (DOS):
Is an attempt to overload network with so many messages so that it cannot
function

Use of data encryption:

Encryption: converts data into a code
Unauthorized users without encryption key will be unable to decode the
information
Flowcharts:
Pictorial symbols used in internal control and systems development
Standardized by ANIS and ISO
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A) Endpoints & connectors:
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Start & end
Connection on the same page / connector
B) Processes: a.
Connection between pages / off-page connector
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Manual input
Decision
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Computer operation / process
Manual operation
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C) Input & output:

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General symbol for input & output (data)
Display on a video terminal (screen)
Document or report
Online storage (magnetic disk)
Offline storage (file) of page storage
Database (magnetic disk)

Routine backup and offsite location:

Organization’s data is more valuable than its hardware as hardware can be replaced
while each organization’s data bundle is unique
Offsite location must be temperature and humidity controlled
Disaster recovery planning: contingency planning

Two major types of contingencies:
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1. The data center is physically available:
Power failure, viruses and hacking incidents
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2. Data center is not available: more serious
Caused by disasters, such as floods, fires, hurricanes, earthquakes, etc. and
this type of contingency require alternate processing facility.
1. Power failures: generators

a.
Dealing with specific types of contingencies:
2. Attacks such as viruses: system must be brought down “gracefully”, to halt

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the spread of the infection, IT must be trained to isolate damage and bring
system back
3. Most extreme contingency:
Flood, fire, earthquakes, etc. which requires alternate processing facility
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called also recovery center, which can take many forms:

a. Hot site: fully operational processing facility that is immediately
available with all required equipment and communication tools (flying
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star site)
b. Warm site: limited hardware, such as communications and networking
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equipment, still need to prepare for operation running, lets say we

have the computers but we don’t have the data.
c. Cold site: lacking most infrastructure but readily available for the quick
installation of hardware

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Section F) Technology and Analytics … 15%

1. Information systems
a) Accounting information systems
b) Database and DBMS
c) Enterprise resource planning systems
d) Enterprise performance management systems
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2. Data governance
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a) Data policies and procedures
b) Life cycle of data
c) Controls against security breaches
3.
a)
b)
Systems Development Life Cycle (SDLC)
Business Process Analysis
a.
Technology-enabled finance transformation
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c) Robotic Process Automation (RPA)
d) Artificial Intelligence (AI)
e) Cloud Computing
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f) Blockchains and Smart Contracts
4. Data analytics
a) Business intelligence
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b) Data mining
c) Simple Regression Analysis
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d) Sensitivity Analysis
e) Data visualization

Information Systems
Introduction of Information systems:
Companies have loads and loads of information, that should be organized for an
easy use, and keeping track of all information and transactions, into all details of
information, every employee, every customer, etc. it is a mass in amount of
information, so we are going to look at systems that would help companies to
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record, organize, process it and use these information, by making it available for
right people in the right time.
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A- Accounting Information Systems
The Value Chain and the Accounting Information System (AIS):
a.
The value chain was discussed earlier in this course. To review, the value chain as
envisioned by Michael Porter looks like the following:
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An organization’s accounting information system (AIS) interacts with every process

in the value chain. The AIS adds value to the organization by providing accurate and
timely information so that all of the value chain activities can be performed
efficiently and effectively. And if we are talking about the value chain so this
information must be also adding value to the customers. For example:
• Just-in-time manufacturing and raw materials inventory management is made
possible by an accounting information system that provides up-to-date information
about inventories of raw materials and their locations.
• Sales information can be used to optimize inventory levels at retail locations.
• An online retailer can use sales data to send emails to customers suggesting other
items they might be interested in based on items they have already purchased.

• Allowing customers to access accounting information such as inventory levels and

their own sales orders can reduce costs of interacting with customers and increase
customer satisfaction.
• A variance report showing a large unfavorable variance in a cost indicates that
investigation and possibly corrective action by management is needed.
• An AIS can provide other information that improves management decision-
making. For instance:
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o It can store information about the results of previous decisions that can be
used in making future decisions.
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o The information provided can assist management in choosing among
alternative actions.
The Supply Chain and the AIS:
a.
A well-designed accounting information system can improve the efficiency and
effectiveness of a company’s supply chain, thus enhancing the company’s
profitability. All of the organizations involved in moving a product or service from
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suppliers to the end-user (the customer) are referred to collectively as the supply
chain.
The supply chain goes outside the organization, dealing with those suppliers that
provide the row materials to the organization, and potentially also dealing with our
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customers and so a good AIS is going to improve the efficiency and effectiveness of
the company’s supply chain as mentioned earlier
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Automated Accounting Information Systems (AIS):

Automated accounting information systems are computer-based systems that
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transform accounting data into information using the fundamental elements of

paper-based accounting systems, but with electronic processing.
Journals and Ledgers:

Transactions are recorded in Journals and ledgers and journal entries are posted to
a General Ledger (GL), so in automated AIS, this is not in a piece of paper, is not an
actual physical journal
General ledger and Chart of Accounts (COA):

The General Ledger (GL): contains a separate account for each type of transaction.
COA: the list of General ledger accounts used by an organization, usually in the
automated AIS the accounts have numbers/codes, so it is easier to keep track of all

transactions and accounts using those codes instead of having names for large
number of accounts
Master and transaction files:

An automated accounting information system stores information in files
 Master files: store permanent information, such as GL account numbers,
customer account numbers and historical data for each customer
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 Transaction files: are used to update master files, and they store detailed
information about business activities, such as detail about sales transactions
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or purchase of inventory
Block codes:
In an automated accounting information system, accounts in general ledger COA
a.
are numbered using block codes, which are sequential codes that have specific
blocks of numbers reserved for specific uses
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Modules:
Special journals are used for a specific kinds of transactions, and in a computerized
system, the journals are known as modules, such as sales invoice, point of sales
modules, bank modules and so on
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Transactions recorded electronically:

In an automated accounting system, transactions are recorded electronically, in
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many different ways maybe input directly by employee, maybe scanned, or maybe
with no interfering from any employee (done automatically) for example when
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customers order something online for the organization, all will go automatically to
the system such as payments through credit cards, sales order, etc.
Transaction codes:
When a transaction is created in a module, the input includes a transaction code
that identifies, for example, a transaction in the order entry modules as a sales
transaction, this code is going to cause that data entered in that transaction to be
recorded in whatever other modules or accounts where it needs to be, so the code
what it is that triggers the order, creating the receivables, creating the revenue,
dealing with inventory, etc.
Codes, both numeric and alphanumeric, are used elsewhere in an automated AIS,
as well.

There is also a type of codes that are sequential codes, such as the invoice number
that will always create and add a new one number with every invoice created,
which is considered a good control tool
This example just to understand the idea
Example: General ledger expense account numbers used for advertising expenses
include a code for the department that initiated the cost. The expense account
number identifies the type of advertising medium, for example television
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advertising, followed by codes indicating the type of advertising expense and the
product advertised.
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Thus, a production expense for a television commercial advertising a specific
kitchen appliance such as a blender is coded to the television advertising account
for commercial production for blenders. As the cost is recorded in the AIS, the cost
a.
is directed to the correct responsibility center code and expense account, as
follows:
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Thus, the full expense account number charged is 5162731 in department 120. That
account number in that responsibility center accumulates only expenses for
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television advertising production costs for blender advertising that have been
committed to by the advertising department.
As a result, the different types of advertising expenses are clearly delineated in the
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general ledger according to responsibility center, type of expense, advertising

medium, type of cost, and product advertised, enabling easier analysis of the data.
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Output of an automated AIS:

The data collected by an AIS is reported on internal reports. The internal reports
are used by accountants to prepare adjusting entries, by management for analysis
and decision-making, and by both accountants and management to produce the
external financial reports needed.
An AIS needs to be designed so that it will be able to produce the reports that users
will need.
Reports from an AIS may be paper reports, screen reports, or reports in various
other forms such as audio reports. They could be regularly scheduled reports or
they could be produced on demand, the most important point of any form of report
is that it needs to be suitable for the user’s needs and easy to understand and use.

Characteristics of good report:

 A report should include a date or dates, is it as of a certain date or for a period
of time and what is this period of time, such as, income statement for the
period from 1st January 2020 to 31st December 2020 for example, otherwise
users will get lost in a mass of reports and wouldn’t connect it to a specific
purpose for a specific period or certain date.
 The report should be consistent over time, so managers and all other users
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can compare information from different time periods.
 The report should be in a convenient format and should contain useful
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information that is easy to identify. Summary reports should contain
financial totals and comparative reports should provide related numbers
such as actual versus budgeted amounts in adjacent columns.
The elements of an automated AIS?

Journals a.
Automated Accounting Information Systems (AIS)
General ledger
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Chart of accounts Master files
Transaction files Block codes
Modules Transaction codes
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Accounting Information System Cycles:

Transaction cycles are grouped business processes for which the transactions are
interrelated. They include:
• Revenue to cash cycle.
• Purchasing and expenditures cycle.
• Production cycle.
• Human resources and payroll cycle.
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• Financing cycle.
• Fixed asset cycle (property, plant, and equipment).
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• General ledger and reporting systems.
a.
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The revenue to cash cycle:

The revenue to cash cycle involves activities
related to the sale of goods and services and
the collection of customers’ cash payments.
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Starts with the
customer order a.
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The purchasing and Expenditures cycle:

obtaining items and services in a timely manner at the
lowest price consistent with the quality required,
managing the inventory, and seeing that payment is made
for items purchased and services received.
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The production cycle:

Conversion of raw materials into finished goods and
the goal is to do that as efficiently as possible, by using
the least possible resources to covert the row
materials into the finished goods that the company is
producing. Computer-assisted design technology and
robotics are often used.
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The production process begins with a request for raw
materials for the production process. It ends with the
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completion of manufacturing and the transfer of finished goods inventory to
warehouses.
a.
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RFID (radio frequency identification systems), RFID can be used to

track components to products and the products themselves along the
production process and the supply chain. Tags containing

electronically-stored information are attached to components and products.
The Human Resources and Payroll cycle:

The human resources management and payroll cycle involves hiring, training,
paying, and terminating employees.
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a.
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The Financing cycle:

The financing process is responsible for acquiring financial resources by borrowing
cash or selling stock and for investing financial resources. It involves managing cash
effectively
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a.
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So, when we talk about the term financing cycle, sounds more like long-term cycle
and package of processes and actions, while this is not entirely true as it is also
including cash management as demonstrated in that financing cycle, is more
about managing companies’ cash and resources, so that those resources are
working as well as it could for the company.

The Fixed Assets System:

The fixed asset management system manages the purchase, valuation,
maintenance, and disposal of the firm’s fixed assets, also called property, plant, and
equipment.
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a.
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The General Ledger and Reporting Systems:
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a.
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So, all cycles, processes and
details we talked about are
together creating the GL
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Remember always that the concept and major objective behind building any
information system, that’s what is all about, why we need to build an information
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system, is not to have a system for the sake of building system, or having a bigger
system than our competitors for example, instead the system is to provide useful
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information, that we need to manage the company and run the company in
efficient and effective way, so all these pieces build together to give the
information needed to manage the company.

B- Data, Database, and Database Management System (DBMS)

Databases
A database is an organized collection of data in a computer
system, Data in the database are combined in one location to
eliminate redundancy, that can be used by different application
programs and accessed by multiple users, such as product list,
customer list, suppliers list, etc.
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The most commonly used type of databases is a relational
database, which is a group of related tables. The data must be
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organized into a logical structure so it can be accessed and used.
Basic Data Structure
a.
Data is stored according to a data hierarchy, and the data is structured in levels.
1. A data field is the first level in the data hierarchy. A field is information that
describes one attribute of an item or entity in the database. A field may also
be called an “attribute,” or a “column.”
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2. A database record is the second level of data. A database record contains all
the information about one item, or entity, in the database.
3. A file, also called a table, is the third level of the data hierarchy. A table is a
set of common records, such as records for all employees.
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4. A complete database is the highest level. Several related files or tables make
up a database. For example, in an accounting information system, the
collection of tables will contain all the information needed for an accounting
application.

Data Base
File / Table
Record
Filed
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Database Keys
Every record in a database has a primary key, and each primary key is unique. The
primary key is used to find a specific record, such as the record for a specific
employee. A primary key may consist of one data field or more than one data field.
a.
For example, in an Employees table, each employee record contains an Employee
ID. The Employee ID is the primary key in the Employees table because position for
example is not a unique primary key as you could have 5 accountants for example
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with the same position in the same department.
some records will also have foreign keys. Foreign keys connect the information in
a record to one or more records in other tables.
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Database Management System (DBMS)

A database management system is a software package that serves as an interface
between users and the database. a set of interrelated, centrally-coordinated data
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files by standardizing the storage, manipulation, and retrieval of data

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Entity relationship modeling:

Database administrators use it to plan and analyze relational database files and
records. The three most important relationship types are: one-to-one, one-to-
many, and many-to-many.

Database management systems

A database management system is a software package that serves as an interface
between users and the database, so the DBMS manages those interrelated,
centrally coordinated data files by standardizing how it is that the information is
stored, manipulated and retrieved, the DBMS is used to create the database,
maintain it, to protect and safeguard the data and most important to be available
for use as necessary.
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perform four primary functions:
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1) Database development. Database administrators use database management
systems to develop databases and create database records.
2) Database maintenance. Database maintenance includes record editing, deletion,
alteration, and reorganization.
a.
3) Database interrogation. Users can retrieve data from a database using the

database management system and a query language in order to select subsets of
records to extract information.
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4) Application development. Application development involves developing queries,
forms, reports, and labels for a business application and allowing many different
application programs to easily access a single database.
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Database Development / creation

The database administrator uses a database management system and a Data
Definition Language (DDL) to create a description of the logical and physical
structure or organization of the database and to structure the database by

specifying and defining data fields, records, and files or tables. The database
administrator also specifies how data is recorded, how fields relate to each other,
and how data is viewed or reported.
The structure of the database includes the database’s schema, subschemas, and
record structures.
• The schema is a map or plan of the entire database—its logical structure. It
specifies the names of the data elements contained in the database and their
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relationships to the other data elements.
• The limited access for an application or a user is called a subschema or a view.
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One common use of views is to provide read-only access to data that anyone can
query, but only some users can update. Subschemas are important in the design of
a database because they determine what data each user has access to while
protecting sensitive data from unauthorized access.
a.
Schema  Design of DB
Subschema  Use of DB
• In defining the record structure for each table, the database administrator gives
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each field a name and a description, determines how many characters the field will
have, and what type of data each field will contain (for example, text, integer,
decimal, date), and may specify other requirements such as how much disk space
is needed.
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The database administrator also defines the format of the input (for example, a
U.S. telephone number will be formatted as [XXX] XXX-XXXX).
The input mask for a data field creates the appearance of the input screen a user
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will use to enter data into the table so that the user will see a blank field or fields
in the style of the format. For example, a date field will appear as XX /XX /XXXX.
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The input mask helps ensure input accuracy.

Once the record structure of the database table is in place, the records can be
created.
Database Maintenance
A data manipulation language (DML) is used to maintain a database and consists
of insert, delete and update statements (commands), users do not need to know
the specific format of the data manipulation commands, such as Structured Query
Language (SQL).
Database Interrogation
Users can retrieve data from a database by using a query language. Structured
Query Language (SQL) is a query language, and it is also a data definition language

and a data manipulation language. SQL has been adopted as a standard language
by the American National Standards Institute (ANSI). All relational databases in use
today allow the user to query the database directly using SQL commands. SQL uses
the “select” command to query a database. However, business application
programs usually provide a graphical user interface (GUI) that creates the SQL
commands to query the database for the user, so users do not need to know the
specific format of SQL commands, since it’s graphics that is easy to be understood
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and used by the normal users.
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Application Development
Database management systems usually include one or more programming
languages that can be used to develop custom applications by writing programs
that contain statements calling on the DBMS to perform the necessary data
a.
handling functions. When writing a program that uses a database that is accessed
with a DBMS, the programmer needs only the name of the data item, and the DBMS
locates the data item in the storage media.
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C- Enterprise Resource Planning Systems
Enterprise Resource Planning (ERP) can help to overcome the challenges of
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separate systems because it integrates all aspects of an organization’s activities—

operational as well as financial—into a single system that utilizes a single database
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ERP systems consist of the following components:

• Production planning, including determining what raw materials to order for
production, when to order them, and how much to order.
• Logistics, both inbound (materials management) and outbound (distribution).
• Accounting and finance.
• Human resources.
• Sales, distribution, and order management.
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Features of ERP systems include:
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1) Integration. The ERP software integrates the accounting, customer relations
management, business services, human resources, and supply chain management
so that the data needed by all areas of the organization will be available for
planning, manufacturing, order fulfillment, and other uses. The system tracks all of
a.
a firm’s resources, including cash, raw materials, inventory, fixed assets, and
human resources, forecasts their requirements, and tracks shipping, invoicing, and
the status of commitments such as orders, purchase orders, and payroll.
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2) Centralized database. The data from the separate areas of the organization
flows into a secure and centralized database rather than several separate
databases in different locations. All users use the same data that has been derived
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through common processes.
3) Usually require business process reengineering. An ERP system usually forces

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organizations to reengineer or redesign their business processes in order to use the

system. Because ERP software is “off-the-shelf” software, customization is usually
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either impossible or prohibitively expensive. Thus, business processes used must

accommodate the needs of the system and many may need to be redesigned.
Extended ERP Systems

Extended enterprise resource planning systems include customers, suppliers, and
other business partners. The systems interface with customers and suppliers
through supply chain management applications that give partners along the supply
chain access to internal information of their suppliers and customers. Suppliers can
access the company’s internal information such as inventory levels and sales
orders, enabling the company to reduce its cycle time for procuring raw materials
for manufacturing or goods for sale. Customers can also view their supplier’s
information about their pending orders.

Advantages of ERP Systems

• Integrated back-office systems result in better customer service and production
and distribution efficiencies.
• Centralization of data provides a secure location for all data that has been derived
through common processes, and all users are using the same data.
• Day-to-day operations are facilitated. All employees can easily gain access to real
time information they need to do their jobs. Cross-functional information is quickly
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available to managers regarding business processes and performance, significantly
improving their ability to make business decisions and control the factors of
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production. As a result, the business is able to adapt more easily to change and
quickly take advantage of new business opportunities.
• Communication and coordination are improved across departments, leading to
greater efficiencies in production, planning, and decision-making.
use system outputs is reduced.

a.
• Data duplication is reduced and labor required to create inputs and distribute and
• Expenses can be better managed and controlled.

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• Inventory management is facilitated. Detailed inventory records are available,
simplifying inventory transactions. Inventories can be managed more effectively to
keep them at optimal levels.
• Trends can be more easily identified.
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• The efficiency of financial reporting can be increased.

• Resource planning as a part of strategic planning is simplified.
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Disadvantages of ERP Systems

• Business re-engineering is usually required to implement an ERP system and it is
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time consuming and requires careful planning.

• Converting data from existing systems into the new ERP system can be time
consuming and costly and, if done incorrectly, can result in an ERP system that
contains inaccurate information.
• Training employees to use the new system disrupts existing workflows and
requires employees to learn new processes.
• An unsuccessful ERP transition can result in system-wide failures that disrupt
production, inventory management, and sales, leading to huge financial losses.
Customers who are inconvenienced by the implementation may leave. Because the
entire business relies on the new ERP system, it is critical that it be completely
functional and completely understood by all employees before it “goes live.”
• Ongoing costs after implementation include hardware costs, system maintenance
costs, and upgrade costs.

D- Enterprise Performance Management

Enterprise Performance Management (EPM), also known as Corporate
Performance Management (CPM) or Business Performance
Management (BPM), is a method of monitoring and managing
the performance of an organization in reaching its
performance goals. It is the process of linking
strategies to plans and execution.
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Enterprise Performance Management
software is available that integrates with an
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organization’s accounting information system,
ERP system, customer relations management
system, data warehouse, and other systems.
a.
It is designed to gather data from multiple
sources and consolidate it to support
performance management by automating the
collection and management of the data needed
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to monitor the organization’s performance in relation to its
strategy.
So, what’s happening here is that the company is making certain that everybody
knows what goals and objectives are, and to be certain that they are communicated
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clearly to managers, so they can be incorporated to their plans and budgets, and
then periodically to be reviewed (performance evaluation), using tools such as Key
Performance Indicators (KPIs), balanced scorecards, strategy maps, etc.
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Some examples of an EPM’s capabilities include:

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• Reports comparing actual performance to goals.

• Reports on attainment of KPIs by department.
• Balanced scorecards, strategy maps, and other management tools.
• Creating and revising forecasts and performing modeling.
• Generating dashboards presenting current information customized to the needs
of individual users.
EPM software can also automate budgeting and consolidations. Tasks that in the
past may have required days or weeks can now be completed very quickly.
Note: EPM software can be on premises or it can be deployed as Software as a

Service (SaaS), otherwise known as “the cloud.” Cloud computing is covered in this
section in the topic Technology-enabled Finance Transformation.
There are three terms that are related to data subject and candidates must be
aware of
Data Warehouse, Data Mart, and Data Lake
1) Data Warehouse
A copy of all of the historical data for the entire organization can be stored in a
single location known as a data warehouse, or an enterprise data warehouse. A
data warehouse is separate from an ERP system because a data warehouse is not
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used for everyday transaction processing.
Managers can use business intelligence tools to extract information from the data
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warehouse. For instance, a company can determine which of its customers are
most profitable or can analyze buying trends.
The data in a data warehouse is a copy of historical data, and are not updated.
Furthermore, information in a data warehouse is read-only, meaning users cannot
change the data in the warehouse.
a.
To be useful, data stored in a data warehouse should:
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1) Be free of errors.
2) Be uniformly defined so every body can access the same data in the same way
3) Cover a longer time span than the company’s transactions systems to enable
historical research.
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4) Easy access, allow users to write queries that can draw information from several
different areas of the database.
Read only
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The process of making the data available in the data warehouse involves the
following:
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1) Periodically, data is uploaded from the various data sources, usually to a staging
server before going to the data warehouse. The data upload may occur daily,
weekly, or with any other established frequency.
2) The datasets from the various sources are transformed to be compatible with
one another by adjusting formats and resolving conflicts. The transformation that
must take place before the data can be loaded into a data warehouse is known as
Schema-on-Write because the schema is applied before the data is loaded into the
data warehouse.
3) The transformed data is loaded into the data warehouse to be used for research,
analysis, and other business intelligence functions.

What Is a Data Warehouse Used For? Read only

Airline: In the Airline system, it is used for operation purpose like crew assignment,
analyses of route profitability, frequent flyer program promotions, etc.
Banking: It is widely used in the banking sector to manage the resources available
on desk effectively. Few banks also used for the market research, performance
analysis of the product and operations.
Healthcare: Healthcare sector also used Data warehouse to strategize and predict
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outcomes, generate patient's treatment reports, share data with tie-in insurance
companies, medical aid services, etc.
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Public sector: In the public sector, data warehouse is used for intelligence
gathering. It helps government agencies to maintain and analyze tax records,
health policy records, for every individual.
2) Data Mart
a.
A data mart is a subsection of a data warehouse that provides users with analytical
capabilities for a restricted set of data. For example, a data mart can provide users
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in a department such as accounts receivable access to only the data that is relevant
to them so that the accounts receivable staff do not need to sift through unneeded
data to find what they need.
A data mart can provide security for sensitive data because it isolates the data
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certain people are authorized to use and prevents them from seeing data that
needs to be kept confidential. Furthermore, because each data mart is used only
by one department, the demands on the data servers can be distributed; one
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department’s usage does not affect other departments’ workloads.

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Data marts can be of three different types:

1) A dependent data mart draws on an existing data warehouse. It takes what’s
already in data warehouse but just kind of representing it.
2) An independent data mart is created without the use of a data warehouse, is

maybe data that comes from the transaction systems.
3) A hybrid data mart combines elements of both, dependent and independent

data marts, drawing some data from an existing data warehouse and some data
from transactional systems.

3) Data Lake
Much of the data captured by businesses is a mass of unstructured data, such as
social media data, videos, emails, chat logs, and images of invoices, checks, and
other items. Such data cannot be stored in a data warehouse because the types of
data are so disparate and unpredictable that the data cannot be transformed to be
compatible with the data in a data warehouse. A data lake is used for unstructured
data.
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A data lake is a massive body of information fed by multiple sources for which the
content has not been processed. Unlike data warehouses and data marts, data
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lakes are not “user friendly.” Data lakes have important capabilities for data mining
and generating insights, but usually only a data scientist is able to access it because
of the analytical skills needed to make sense of the raw information.
a.

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Data Governance
A- Data Policies and Procedures
Corporate governance includes all of the means by which businesses are directed
and controlled, including the rules, regulations, processes, customs, policies,
procedures, institutions, and laws that affect the way the business is administered.
Corporate governance spells out the rules and procedures to be followed in making
decisions for the corporation.
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a.
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Data Governance:
Data governance is similar, but it is specific to data and information technology.
Data governance encompasses the practices, procedures, processes, methods,
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technologies, and activities that deal with the overall management of the data
assets and data flows within an organization. Data governance is a process that
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helps the organization better manage and control its data assets. In a sense, data
governance is quality control for data, as if data is wrong, lost or somewhere input
incorrectly, then the data has no value to the organization, so company need to
make certain that they have the quality data that is going be used, because this
quality data and good data that the organization have will help its managers to
make good decisions, It enables reliable and consistent data, which in turn makes
it possible for management to properly assess the organization’s performance and
make management decisions.
Data governance includes the management of the following.

• Data availability, or the process of making the data available to users and
applications when it is needed and where it is needed.

• Data usability, including its accessibility to users and applications, its quality, and
its accuracy.
• Data integrity, or the completeness, consistency, reliability, and accuracy of data.
• Data security, meaning data protection, including prevention of unauthorized
access and protection from corruption and other loss, including backup
procedures.
• Data privacy, that is, determining who is authorized to access data and which
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items of data each authorized person can access.
• Data integration, which involves combining data from different sources (which
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can be both internal and external) and providing users with a unified view of all the
data.
• System availability, that is, maximizing the probability that the system will
function as required and when required.
a.
• System maintenance, including modifications of the system done to correct a
problem, to improve the system’s performance, to update it, or to adapt it to
changed requirements or a changed environment.
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• Compliance with regulations, such as laws regulating privacy protections.
• Determination of roles and responsibilities of managers and employees.
• Internal and external data flows within the organization.
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IT Governance and Control Frameworks:

IT governance and control frameworks have been developed to provide models, or
sets of standardized guidelines, for the management of IT resources and processes.
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Frameworks provide numerous benefits to an organization.

• They identify specific roles and responsibilities that need to be met.
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• They provide a benchmark for assessing risks and controls.

• Following a framework provides a higher likelihood of implementing effective
governance and controls.
• Frameworks break down objectives and activities into groups.
• Regulatory compliance may be easier to achieve by following effective
governance and control frameworks.
Internal Control – Integrated Framework by COSO, the Committee of Sponsoring

Organizations (remember that this all belong to the company as a whole not only
to the data of the company)
1) The control environment
2) Risk assessment
3) Control activities

4) Information and communication

5) Monitoring
COBIT® by ISACA is an I & T (Information and Technology) framework for the
governance and management of enterprise information and technology.
“Enterprise information and technology” refers to all the technology and
information processing used by the whole enterprise to achieve its goals, no matter
where the technology and information processing occurs in the enterprise. Thus,
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while enterprise I & T includes the organization’s IT department, it is not limited to
the IT department.
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COBIT® was an acronym for Control OBjectives for Information and Related
Technology
Governance vs. Management:
a.
Governance is usually the responsibility of the board of directors under the
leadership of the chair of the board of directors. The purpose of governance is to
ensure that:
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• Stakeholder needs are considered and conditions and options are evaluated in
order to determine balanced, agreed-on enterprise objectives.
• Prioritization and decision-making are used to set direction.
• Performance and compliance are monitored in terms of the agreed-on direction
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and enterprise objectives.
Management is usually the responsibility of the executive management under the

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chief executive officer’s (CEO’s) leadership. The purpose of management is to plan,

build, run, and monitor activities in
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accordance with the direction that it

was set by the body responsible for
governance such as the board of
directors, in order to achieve the
enterprise objectives
Components of a Governance System:

We have first of all to understand that
every company is going to be a little bit
different and so each company needs
to establish and setup a governance
system for this company, and that
includes the following components, or

factors, that contribute to the operations of the enterprise’s governance system

over information and technology (I&T):
• Processes. is a set of practices and activities needed to achieve a specific objective
and produce outputs that support achievement of IT-related goals.
• Organizational structures. the primary decision-making entities within the
enterprise.
• Principles, policies, and frameworks. That guide the day-to-day management of
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the enterprise.
• Information. all the information produced and used by the enterprise. COBIT®
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2019 focuses on the information needed for effective governance of the enterprise.
• Culture, ethics, and behavior. of both the enterprise as whole and the individuals
in it are important factors in the success of governance and management activities.
• People, skills, and competencies. are important for making good decisions, for
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corrective action, and for successful completion of activities.
• Services, infrastructure, and applications. used to provide the governance
system for information and technology processing.
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Goals Cascade:
As mentioned earlier governance would set goals and then management make
certain that they all happen, and there need to be a process to this and this is what
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is called Goals Cascade. Enterprise goals, one of the design factors for a governance
system, are involved in transforming stakeholder needs into actionable strategy for
the enterprise.
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Internal stakeholders:
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• Members of the board of directors, for whom COBIT® provides insight into how
to obtain value from the use of I & T and explains relevant board responsibilities.
• Executive management, for whom COBIT® provides guidance in organizing and
monitoring performance of I & T.
• Business managers, COBIT® helps understanding in how to obtain the I&T
solutions that the company needs and how best to use new technology and
opportunities.
• IT managers, for whom COBIT® provides guidance in how best to structure and
operate the IT department and manage its performance.
• Assurance providers such as auditors, for whom COBIT® helps in managing
assurance over IT, managing dependency on external service providers.
• Risk management, for whom COBIT® helps with identification and management
of IT-related risk.

External stakeholders:
• Regulators, ensure an enterprise is compliant with applicable rules and
regulations and has an adequate governance system in place to manage
compliance.
• Business partners, (Suppliers and customers) to ensure that a business partner’s
operations are secure, reliable, and compliant with applicable rules and
regulations.
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• IT vendors, to ensure that IT vendors’ operations are secure, reliable, and
compliant with applicable rules and regulations.
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Management objectives are prioritized based on prioritization of enterprise goals,
which in turn are prioritized based on stakeholder drivers and needs. Alignment
goals emphasize the alignment of the IT efforts with the goals of the enterprise.
a.
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Performance Management in COBIT® 2019

Performance management includes the activities and methods used to express
how well the governance and management systems and the components of an
enterprise work, and if they are not achieving the required level, how they can be
improved. Performance management utilizes the concepts capability levels and
maturity levels.
Components in enterprise governance over I&T:

Performance management is organized in COBIT® 2019 according to the
components that make up the enterprise’s governance system over information

and technology. Although not all of the components are specifically addressed in
COBIT® 2019 as to performance management issues at this time, to review, the
components include:
• Processes
• Organizational structures
• Principles, policies and frameworks
• Information
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• Culture, ethics, and behavior
• People, skills, and competencies
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• Services, infrastructure, and applications.
Those components for which performance management issues have been
addressed include the following.
Capability levels:
a.
Governance and management objectives consist of several processes, and a
capability level is assigned to all process activities. The capability level is an
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expression of how well the process is implemented and is performing, measuring
the performance, how the company is doing. A process reaches a certain capability
level when all the activities of that level are performed successfully. Capability
levels range from 0 (zero) to 5, as follows:
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B- Data Life Cycle and Records Management

encompasses the period from creation of data and its initial storage through the
time the data becomes out of date or no longer needed and is purged. The stages
of the data life cycle include data capture, data maintenance, data synthesis, data
usage, data analytics, data publication, data archival, and data purging.
The stages do not describe sequential data flows, because data may pass through
various stages several times during its life cycle. Furthermore, data does not have
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to pass through all of the stages. However, data governance challenges exist in all
of the stages and each stage has distinct governance needs, so it is helpful to
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recognize the various stages and some of the governance challenges associated
with each.
a.
The Stages in data life cycle:
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 Data capture creating new data values that have not existed before within
the organization. Data can be captured through external acquisition, data
entry, or signal reception.
1. External acquisition. Data can be acquired from an outside
organization, often through contracts governing how the data may be
used. Monitoring performance with the contracts is a significant
governance challenge.

2. Data entry. Data can be created through entry by human operators or

by devices that generate data. Data governance requires monitoring
the accuracy of the input.
3. Signal reception. Data may be received by transmission, for example
from sensors. Data governance challenges include monitoring the
function of the devices and the accuracy of the data received.
 Data maintenance is the processing of data before deriving any value from
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it, such as performing data integration. A governance issue is determining
how best to supply the data to the stages at which data synthesis and data
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usage occur.
 Data synthesis is the creation of new data values using other data as input.
To “synthesize” something means to combine different things to make
something new. Data synthesis is therefore combining data from different
a.
sources to create new data. Governance issues include concerns about data
ownership and the need for citation, the quality and adequacy of the input
data used, and the validity of the synthesized data.
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 Data usage, which is the application of the data to tasks, whether used in
support of the organization or used by others as part of a product or service
the organization offers. A governance challenge with respect to data usage
is whether the data can legally be used in the ways the users want to use it.
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Regulatory or contractual constraints on the use of the data may exist, and
the organization must ensure that all constraints are observed.
 Data analytics, or the process of gathering and analyzing data in a way that
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produces meaningful information to aid in decision-making. As businesses

become more technologically sophisticated, their capacity to collect data
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increases. However, the stockpiling of data is meaningless without a method

of efficiently collecting, analyzing, and utilizing it for the benefit of the
company. A governance issue with respect to data analytics is ensuring that
the company’s data is accurately recorded, stored, evaluated, and reported.
 Data publication occurs when data is sent outside of the organization or
leaves it in other ways. Periodic account statements sent to customers are
an example of data publication, but data breaches also constitute data
publication. The governance issue is that once data has been released it
cannot be recalled, because it is beyond the reach of the organization. If
published data is incorrect or if a data breach has occurred, data governance
is needed in deciding how to deal with it.
 Data archival is the removal of data from active environments and its storage
in case it is needed again. No maintenance, usage, or publication occurs
while the data is archived, but if it is needed, it can be restored to an

environment where it will again be maintained, used, or published.
 Data purging occurs at the end of the data’s life cycle. Data purging is the
removal of every copy of a data item from all locations within the
organization. Purging should generally be done only of data that has been
previously archived. Data governance considerations include development
and maintenance of data retention and destruction policies that comply with
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all laws and regulations regarding record retention; conformance with
established policies; confirmation that purging has been done properly; and
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documentation of data purged.
Records Management:
Every organization should have a documented policy about record management
a.
that establishes how records are to be maintained, identified, retrieved, preserved,
and when and how they are to be destroyed. The policy should apply to everything
defined by the organization as a “record,” which includes both paper documents
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and data records. The concern for information systems is, of course, data records.
The records management policy should identify the information that is considered
records and the information that is not considered records but that nevertheless
should be subject to the guidance in the policy.
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Factors to be considered in developing a records management policy include:

Generally, we company will need to be certain that it is in compliance with
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everything that it need to be complied with, that’s the concept in this point, such
as being in compliance with:
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• Federal, state, and local document retention requirements. Regulations and

laws provide minimum records retention requirements, but those should not be
regarded as guidance on when records must be destroyed. Decisions may be made
to retain specific records longer than their required minimum periods due to other
factors such as ongoing business use or internal audit requirements.
• Requirements of the Sarbanes-Oxley Act of 2002. prohibits altering, destroying,
mutilating, concealing, or falsifying records, documents, or tangible objects with
the intent to obstruct, impede, or influence a potential or actual federal
investigation or bankruptcy proceeding. Violation is punishable by fines and/or
imprisonment for up to 20 years.
• Statute of limitations information. A statute of limitations is the time period
during which an organization may sue or be sued or the time period within which
a government agency can conduct an examination.

• Accessibility. An important consideration with electronic records is hardware,

software, and media obsolescence. Records can become inaccessible if they are in
an obsolete format, and the records management policy must include a means to
either migrate the records to new versions, or the old hardware and software must
be retained so the records can be accessed. If the records are to be migrated to
new formats, quality control procedures must be in place to ensure none of the
content is lost or corrupted.
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• Records of records. The records management policy should establish the practice
of maintaining an index of active and inactive records and their locations and of
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maintaining logs containing records of all purged data.
C- Controls Against Security Breaches
a.
Cyberattacks:
Cybersecurity:
is the process or methods of protecting
Internet-connected networks, devices, or
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data from attacks, because there is
cyberattack so we need cybersecurity.
Cyberattacks are usually made to access,
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change, or destroy data, interrupt normal

business operations, or as with
ransomware, they may involve extortion
such as trying to get money from the organization.
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Some specific cybersecurity risks include the following:

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• Copyright infringement is the theft and replication of copyrighted material,

whether intellectual property, such as computer programs or textbooks, or
entertainment property such as music and movies.
• Denial of Service (DOS) attacks occur when a website or server is accessed so

frequently that legitimate users cannot connect to it. Distributed Denial of Service
(DDOS) attacks use multiple systems in multiple locations to attack one site or
server, which makes stopping or blocking the attack difficult. Sophisticated
firewalls and network monitoring software can help to mitigate DOS and DDOS
attacks.
• Buffer overflow attacks are designed to send more data than expected to a
computer system, causing the system to crash, permitting the attacker to run
malicious code, or even allowing for a complete takeover of the system. Buffer
overflow attacks can be easily prevented by the software programs adequately
checking the amount of data received, but this common preventative measure is
often overlooked during software development.
• Password attacks are attempts to break into a system by guessing passwords.

Brute force attacks use programs that repeatedly attempt to log in with common
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and/or random passwords
1- Two-factor authentication can also prevent brute force attacks from being
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successful because a password alone will not allow access to the system.
2- Systems should include sophisticated logging and intrusion-detection systems to
prevent password attacks
3- password requirements should be in place to reject short or basic passwords
such as “password” or “123456.”
a.

• Phishing is a high-tech scam that uses spam email to deceive people into
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disclosing sensitive personal information such as credit card numbers, bank
account information, Social Security numbers, or passwords.
1- The best defense against phishing is awareness and common sense.
2- Recipients should be wary about any email that requests personal or financial
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information
3- Should resist the impulse to click on an embedded link.
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• Malware broadly refers to malicious software, including viruses. Spyware can

secretly gather data, such as recording keystrokes in order to harvest banking
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details, credit card information, and passwords.
• Ransomware is particularly dangerous malware that encrypts data on a system

and then demands a ransom (a payment) for decryption. If the ransom is not paid,
the data is lost forever. The most common way that ransomware is installed is
through a malicious attachment or a download that appears to come from a trusted
source.
1- The primary defenses against ransomware are to avoid installing it in the first
place
2- Having data backups.
• “Pay-per-click” abuse refers to fraudulent clicks on paid online search ads (for
example, on Google or Bing) that drive up the target company’s advertising costs.

Furthermore, if there is a set limit on daily spending, the ads are pushed off the
search engine site after the maximum-clicks threshold is reached, resulting in lost
business as well as inflated advertising costs. Such scams are usually run by one
company against a competitor.
• Social Engineering an individual may pose as a trustworthy coworker, perhaps

someone from the company’s IT support division, and politely ask for passwords or
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other confidential information.
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• Dumpster diving is the act of sifting through a company’s trash (Physical) for
information that can be used either to break into its computers directly or to assist
in social engineering.
Defenses Against Cyberattack:
a.
Encryption is an essential protection against hacking. Encryption protects both
stored data and data that could be intercepted during transmission. If a hacker
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gains access to encrypted files, the hacker is not able to read the information.
Ethical hackers are network and computer experts with hacking skills who attempt
to attack a secured system. They use the same methods as are used by malicious
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hackers, but if they find vulnerabilities that could be exploited by a malicious

hacker, they report them to the owner or manager so they can be remedied.
Ethical hacking is called intrusion testing, penetration testing, and vulnerability
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testing.
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Advanced firewalls are firewalls that perform traditional firewall protection but
have other capabilities, as well. Traditional firewalls use packet filtering to control
network access by monitoring outgoing and incoming packets.
Advanced firewalls are called Next Generation Firewalls (NGFW). In addition to the
traditional firewall protection, advanced firewalls can filter packets based on
applications and can distinguish between safe applications and unwanted
applications, this when you are trying to install a program or any file, and you may
not be able to do it

Access Controls
Access controls provide additional defenses against cyberattack. Access controls
include logical access controls and physical access controls.
1) Logical Access Controls

Companies need to have strict controls over access to their proprietary data. Poor
data oversight can leave a company vulnerable to accidents, fraud, and malicious
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parties who manipulate equipment and assets. Logical security focuses on who can
use which computer equipment and who can access data. Logical access controls
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identify authorized users and control the actions that they can perform.
To restrict data access only to authorized users, one or more of the following
strategies can be adopted:
1) Something you know
2) Something you are
3) Something you have a.
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1) Something you know
User IDs and passwords are the most common “something you know” way of
authenticating users. Security software can be used to encrypt passwords, require
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changing passwords after a certain period of time, and require passwords to

conform to a certain structure (for example, minimal length, no dictionary words,
restricting the use of symbols). Procedures should be established for issuing,
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suspending, and closing user accounts, and access rights should be reviewed
periodically.
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2) Something you are

Biometrics is the most common form of “something you are” authentication.
Biometrics can recognize physical characteristics such as:
• Iris or retina of the eyes
• Fingerprints
• Vein patterns
• Faces recognition
• Voices recognition
Biometric scanners can be expensive and are generally used only when a high level
of security is required.

3) Something you have

Some very high-security systems require the presence of a physical object to certify
an authorized user’s identity. The most common example of this “something you
have” authentication is a fob, such as in some banks to transfer cash level of service
for example, a tiny electronic device that generates a unique code to permit access;
for increased security, the code changes at regular intervals. A lost fob may be
inconvenient but not a significant problem because the fob by itself is useless.
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Furthermore, a stolen fob can be remotely deactivated.
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Two-Factor Authentication
Requires two independent, simultaneous actions before access to a system is
granted. The following are examples of two-factor authentication:
1. In addition to a password, some systems require entering additional
a.
information (secondary question) known only to the authorized user, such
as a mother’s maiden name or the answer to another security question
chosen by the authorized person.
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2. Passwords can be linked to biometrics.
3. In addition to a password, a verification code is emailed or sent via text
message that must be entered within a few minutes to complete the login.
4. A biometric scan and a code from a fob are combined to allow access.
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Considerations when evaluating the effectiveness of a logical data security system

include:
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• Does the system provide assurance that only authorized users have access to
data?
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• Is the level of access for each person appropriate to that person’s needs?
• Is there a complete audit trail whenever access rights and data are modified?
• Are unauthorized access attempts denied and reported?
Other User Access Considerations

Besides user authentication, other security controls related to user access and
authentication to prevent abuse or fraud include:
• Automatic locking or logoff policies. Any login that is inactive for a specified
period of time can automatically be logged out in order to limit the window of time
available for someone to take advantage of an unattended system.
• Logs of all login attempts, whether successful or not. Automatic logging of all
login attempts can detect activities designed to gain access to an account by

repeatedly guessing passwords. Accounts under attack can then be proactively

locked in order to prevent unauthorized access.
• Accounts that automatically expire. If a user needs access to a system only for a
short period of time, the user’s access to the system should be set to automatically
expire at the end of that period, thus preventing open-ended access.
2) Physical Access Controls
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Physical access controls are used to secure equipment and premises. The goal of
physical access controls is to reduce or eliminate the risk of harm to employees and
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of losing organizational assets. Controls should be identified, selected, and
implemented based on a thorough risk analysis. Some common examples of
general physical security controls include:
• Walls and fences
• Locked gates and doors
a.
• Manned guard posts

• Monitored security cameras
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• Guard dogs
• Alarm systems
• Smoke detectors and fire suppression systems
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Controlling Physical Access:

Physical access to servers and networking equipment should be limited to
authorized persons.
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1. Keys
2. Card access
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3. Biometric as explained earlier can also be used for protecting the physical
equipment that exist
4. Limit activities that can be performed remotely. For example, changes to
employee pay rates can be restricted to computers physically located in the
payroll department. Thus, even if online thieves managed to steal a payroll
password, they would be prevented from changing pay rates because they
would not have access to the premises.

TECHNOLOGY-ENABLED FINANCE TRANSFORMATION

Using technology to help making finance processes getting better, trying to make
finance processes more effective, more efficient, allow users to make tasks and
steps that add value to the organization, and fewer the actions that are repetitive,
so it is a sort of continues improvement process.
A- Systems Development Life Cycle (SDLC)
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The systems development life cycle was described previously in System Controls
and Security Measures as System and Program Development and Change Controls,
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and it will be briefly reviewed here.
1) Statement of objectives. A written
a.
proposal is prepared, including the need for
the new system, the nature and scope of the
project and timing issues. A risk assessment
Sort of preparation before
is done to document security threats,

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analysis and planning
potential vulnerabilities.
2) Investigation and feasibility study of

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alternative solutions. Needs are identified

and feasibility of alternative solutions are
assessed, including the availability of
required technology and resources. A cost-
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benefit analysis is done.

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3) Systems analysis and planning. The

current system is analyzed to identify its
strong and weak points, and the information needs from the new system, such as
reports to be generated, database needs, and the characteristics of its operation
are determined.
4) Conceptual design. Systems analysts work with users to create the design
specifications and verify them against user requirements.
5) Physical design. The physical design involves determining the workflow, what
and where programs and controls are needed, the needed hardware, backups,
security measures, and data communications.

6) Development and testing. The design is implemented into source code, the
technical and physical configurations are fine-tuned, and the system is integrated
and tested. Data conversion procedures are developed.
7) System implementation and conversion. The site is prepared, equipment is

acquired and installed, and conversion procedures, including data conversion, are
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implemented. System documentation is completed, procedures are developed and
documented, and users are trained.
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8) Operations and maintenance. The system is put into a production environment
and used to conduct business. Continuous monitoring and evaluation take place to
determine what is working and what needs improvement. Maintenance includes
a.
modifying the system as necessary to adapt to changing needs, replacing outdated
hardware as necessary, upgrading software, and making needed security upgrades.
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If follow-up studies indicate that new problems have developed or that previous
problems have recurred, the organization begins a new systems study.
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B- Business Process Analysis

Business process reengineering and redesign, discussed in Section D, Cost
Management, relies on technology to accomplish its objectives. When a business
process needs to be reengineered or redesigned, information systems will need to
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be adjusted, changed, modified or updated, or perhaps redesigned completely.

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Business process analysis is used to analyze a business process to determine the

specific way the process is presently being accomplished from beginning to end, so
trying to monitor what is going on in the business process of the information system
from the beginning to the end, through all the steps and that should provide
information needed to monitor efficiency and productivity, locate process
weaknesses, pinpoint potential improvements, and determine whether the
potential improvements should be carried out, part of this maybe that there are
things that we can do now that we couldn’t do when the system were setup, due
to changes in available conditions or tools
Business process analysis involves the following steps:

1) Determine the process to be analyzed. Processes that influence revenue,
expenses, the end product, and other critical functions are processes that should
be analyzed periodically, as are processes that appear to be underperforming. A

new process just implemented might also be analyzed to determine whether it is
working as intended. Determine the beginning and ending points of the process to
be analyzed, so we are trying to identify specifically what is it that we are looking
at.
2) Collect information about the process that will be needed to analyze it. Go
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through the documentation, interview the people involved, and do any other
research necessary to answer any questions that arise.
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3) Map the process. Business process mapping is visualizing the whole process from
start to finish to better understand the various roles and responsibilities involved.
Mapping makes it easier to see the big picture, what is working and what is not
working, and where the risks are.
a.
A flowchart can be created for this step, or several software solutions, called
business process analysis tools, are available for business process mapping.
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4) Analyze the process. For example, determine the most important components
and whether they could be improved. Look for any delays or other problems and
determine whether they can be fixed. Look for ways to streamline the process so it
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uses fewer resources.
5) Determine potential improvements. Make recommendations for ways to

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improve the process. For example, determine whether incremental changes are
needed and if so, what they are, or whether the process needs to be completely
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reengineered. Business process analysis tools can be an important part of this step,
because they can be used to model changes to the process and prepare visuals.
C- Robotics Process Automation (RPA)

a type of artificial intelligence (see next topic), is not the same thing as the use of
industrial robots. Robotic process automation software automates repetitive tasks
by interacting with other IT applications to execute business processes, that people
are doing already right now, but people don’t necessarily need to be able to do it,
and it can operate around the clock with no human errors. The automation of the
repetitive part of a job frees up employees to do other things. RPA software cannot
replace an employee, but it can increase the employee’s productivity, which should
add more value to the organization.

The RPA software is not part of the organization’s IT infrastructure. Instead, it

interacts with the IT infrastructure, so no change is needed to the existing IT
systems. Thus, RPA allows the organization to automate what would otherwise be
a manual process without changing the existing systems.
RPA allows the organization to automate what would otherwise be a manual
process without changing the existing system, it can be all done more quickly with
no error, so more efficient and more effective
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RPA uses:
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The software robots, also called “clients” or “agents,” can log into applications,
move files, copy and paste items, enter data, execute queries, do calculations,
maintain records and transactions, upload scanned documents, verify information
for automatic approvals or rejections, and perform many other tasks.
mainly all the routine areas.

a.
• Automate portions of transaction reporting and budgeting in the accounting area,
• Automate manual consolidations of financial statements, leaving the accountants

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more time to follow up on items that require investigation, perhaps because of
significant variances.
• Financial institutions can use RPA to automate account openings and closings.
• Insurance companies can use it to automate claims processing.
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• RPA can be used in supply chain management for procurement, automating order
processing and payments, monitoring inventory levels, and tracking shipments.
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Benefits of Robotic Process Automation (RPA):

• Developing a process in RPA software does not require coding knowledge. RPA
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software usually has “drag-and-drop” functionality and simple configuration

wizards that the user can employ to create an automated process.
• It enables employees to be more productive because they can focus on more
advanced and engaging tasks, resulting in lower turnover and higher employee
morale.
• It can be used to ensure that business operations and processes comply with
regulations and standards.
• The tasks performed can be monitored and recorded, creating valuable data and
an audit trail.
• Once an RPA process has been set up, the process can be completed much more
rapidly.
• Robotic process automation can result in cost savings.

• It can help provide better customer service by automating customer service tasks.
RPA can even be used to converse with customers, gathering information and
resolving their queries faster and more consistently than a person could.
• Low-volume or low-value processes that would not be economical to automate
via other means can be automated using RPA.
• Business process outsourcing providers can use RPA tools to lower their cost of
delivery or to offer “robots-as-a-service.”
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• Robots follow rules consistently, do not need to sleep, do not take vacations, do
not get sick, and do not make typographical errors.
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Limitations of Robotic Process Automation (RPA):
• Robots are not infallible. Like any machine, their reliability is not 100%. Poor
quality data input can cause exceptions, and their accuracy can be affected by
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system changes, so they what they are programmed to do, and if something is not

programmed correctly and a little bit wrong, they are going to do it the same way
the incorrectly every single time, they may not recognize that data that’s going in
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isn’t correct, that something is wrong with the form or so, so it is not perfect.
• Robots cannot replicate human reasoning. RPA software can mimic human
behavior in the way it interacts with application user interfaces, but it can only
follow highly methodical instructions, such as when an employee think something
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doesn’t look right, something might be missing or so

• Robots have no “common sense.” If a flaw in the instructions creates an error
that would be obvious to a human, the robot will continue to follow the instructions
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provided without deviation and the error may be replicated hundreds or thousands
of times before it is recognized by a human. Then, correcting all the incidents of the
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error could be very difficult (unless the errors could be corrected using the same
automated tools).
• Because RPA can be used to automate processes in a “noninvasive” manner (in
other words, without changing the IT system), management may be tempted to
deploy RPA without relying on assistance from the IT department. However,
although RPA can be deployed without involving the IT department, doing so may
lead to unexpected problems. The IT department needs to be involved in the effort
so the deployment is stable, so we always need to have to get the right people
involved.
D- Artificial Intelligence (AI)

It is a field in computer science dedicated to creating intelligent machines,
especially computers, that can simulate human intelligence processes. AI uses
algorithms, which are sets of step-by-step instructions that a computer can execute
to perform a task. Some AI applications are able to learn from data and self-correct,
according to the instructions given.
Artificial intelligence is categorized as either weak AI, also called narrow AI, or
strong AI, also called artificial general intelligence (AGI).
Weak AI
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is an AI system that can simulate human cognitive functions but although it appears
to think, it is not actually conscious. A weak AI system is designed to perform a
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specific task, “trained” to act on the rules programmed into it, and it cannot go
beyond those rules.
o Apple’s Siri voice recognition software is an example of weak AI. It has access
to the whole Internet as a database and is able to hold a conversation in a
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narrow, predefined manner; but if the conversation turns to things it is not
programmed to respond to, it presents inaccurate results.
o Industrial robots and robotic process automation are other examples of
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weak AI. Robots can perform complicated actions, but they can perform only
in situations they have been programmed for. Outside of those situations,
they have no way to determine what to do.
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Strong AI
is equal to human intelligence and exists only in theory, so it is not existing in eality.
A strong AI system would be able to reason, make judgments, learn, plan, solve
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problems, communicate, create and build its own knowledge base, and program
itself. A strong AI system would be able to find a solution for an unfamiliar task
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without human intervention. It could theoretically handle all the same work that a
human could, even the work of a highly-skilled knowledge worker.
Applications of AI:
Artificial intelligence is increasingly being used in administrative procedures and
accounting:
Digital assistants powered by AI and speech recognition (such as Siri), machine
vision, and machine learning.
1- Digital assistants
have become standard in smartphones and for controlling home electronics, and
their use has expanded into enterprise applications, as well. Some Enterprise
Resource Planning systems incorporate digital assistants. The Oracle Cloud

application includes functionality for enterprises to create chatbots and virtual

assistants. A chatbot is software that can conduct a conversation via auditory or
text methods. Examples of the use of chatbots are customer service and for
acquisition of information.
2- Machine vision
includes cameras, image sensors, and image processing software. It can automate
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industrial processes such as quality inspections by enabling robots to “see” their
surroundings. Machine vision is also used in non-industrial settings such as
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surveillance and medical applications. It is increasingly being used in administrative
and accounting applications, as well.
• Machine vision can be used to analyze satellite imagery for several purposes.
o Insurance agents can use it to verify property information provided by
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existing clients or identify physical features of properties such as the roof
condition and validate property features such as building size prior to
providing an insurance quote to a new client, thereby reducing inspection
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costs.
o Investment firms can use it to determine economic trends and forecast retail
sales based on the number of cars in a retail parking lot on an hourly basis.
o Financial institutions can monitor the status of construction on projects for
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construction lending purposes.

o Businesses making investments in projects can use it to assess the degree to
which a project is complete for accounting purposes and for monitoring and
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management.
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• Machine vision can be used to automate document data extraction.

o Businesses can assess large numbers of incoming paper documents or forms
to extract the information from them. When documents are fed to the
system, the software can identify each document as to its type and sort the
documents to be forwarded to the appropriate processing group.
o Incoming paper documents can be digitized for review by human employees,
eliminating the need for manual data entry. Instead of doing the manual data
input, the human employees can instead spend their time reviewing and
ensuring the accuracy of fields entered by the machine learning software.
The machine vision can even “read” handwritten text. When the data
extraction is manually done, in many cases the full amount of the data is not
input but only the most important data points are extracted. With machine

vision, the data that results is complete and organized, and greater insights
can be gained from data analytics.
3- Machine learning
is another aspect of artificial intelligence being put to use in the accounting area.
In machine learning, computers can learn by using algorithms to interpret data in
order to predict outcomes and learn from successes and failures. Computers can
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“learn” to perform repeatable and time-consuming jobs such as the following:
• Checking expense reports. Computers can learn a company’s expense
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reimbursement policies, read receipts, and audit expense reports to ensure
compliance. The computer can recognize questionable expense reimbursement
claims and forward them to a human to review.
• Analyzing payments received on invoices. When a customer makes a payment
invoice in the system.

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that needs to be applied to multiple invoices or that does not match any single
• Risk assessment. Machine learning can be used to compile data from completed
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past projects to be used to assess risk in a proposed project.
• Data analytics. Using available data, machines can learn to perform one-time
analytical projects such as how much the sales of a division have grown over a
period of time or what the revenue from sales of a specific product was during a
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period of time.
• Bank reconciliations. Machines can learn to perform bank reconciliations.
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AI and impact on accounting and accountants:

AI-enabled robots will not replace accountants, but they will substantially
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transform what accountants do. When machines are able to do the repetitive work
of calculating, reconciling, transaction coding, and responding to inquiries,
accountants can focus less on tasks that can be automated and more on work such
as advisory services that can be done only by humans, thereby increasing their
worth in an organization. Accountants will need to monitor the interpretation of
the data processed by AI to ensure that it continues to be useful for decision
making. Accountants will need to embrace AI, keep their AI and analytical skills
current, and be adaptive and innovative in order to remain competitive, so for
accountants it is not any more about doing data entry, but to be able to that
information, apply that information, add value to the organization, through that
process of using all of the data.

Considerations in Instituting Artificial Intelligence:

• Processes should be re-imagined where possible, rather than just using the AI to
replicate existing processes.
• Activities to be performed by AI should be those that are standardized and not
often changed.
• Processes that are automated should be fully documented, have full
documentation of how that needs to be done and what was done
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• Data quality, both input and output, must be reviewed. Potential exceptions and
errors requiring human intervention must be identified and investigated.
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E- Cloud Computing
Cloud computing is a method of essentially outsourcing the IT function. It is a way
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to increase IT capacity or add capabilities without having to invest in new
infrastructure or license new software.
The National Institute of Standards and Technology (NIST) of the U.S. Department
of Commerce defines cloud computing as follows:
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“Cloud computing is a model for enabling ubiquitous, convenient, on-demand
network access to a shared pool of configurable computing resources (e.g.,
networks, servers, storage, applications, and services) that can be rapidly
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provisioned and released with minimal management effort or service provider

interaction”.
Thus, cloud computing means the use of business applications offered over the
Internet, such as Google Drive and DorpBox for example, Cloud computing
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resources include data storage, infrastructure and platform (that is, hardware and
operating system), and application software. Cloud service providers offer all three
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types of resources.
Software as a Service (SaaS) is defined by NIST as follows:

“The capability provided to the consumer is to use the provider’s applications
running on a cloud infrastructure. The applications are accessible from various
client devices through either a thin client interface, such as a web browser (e.g.,
web-based email), or a program interface. The consumer does not manage or
control the underlying cloud infrastructure including network, servers, operating
systems, storage, or even individual application capabilities, with the possible
exception of limited user-specific application configuration settings”.
SaaS is software that has been developed by a cloud provider for use (company
can’t manage or control just use it) by multiple businesses (called multi-tenant use),
and all business customers use the same software. Applications available as SaaS
applications include enterprise resource planning (ERP), customer relationship
management (CRM), accounting, tax and payroll processing and tax filing, human
resource management, document management, service desk management, online
word processing and spreadsheet applications, email, and many others.
Platform as a Service (PaaS):
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“The capability provided to the
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consumer is to deploy onto the
cloud infrastructure consumer-
created or acquired applications created using programming languages, libraries,
services, and tools supported by the provider. The consumer does not manage or
a.
control the underlying cloud infrastructure including network, servers, operating
systems, or storage, but has control over the deployed applications and possibly
configuration settings for the application-hosting environment”.

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If a company uses Platform as a Service, the company deploys its own applications
to the cloud using the cloud provider’s operating systems, programming languages,
libraries, services, and tools. PaaS services include operating systems, database
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solutions, Web servers, and application development tools, the program and the
applications does belong to the company and owned by the company and it is run
through the cloud service.
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Infrastructure as a Service (IaaS):

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“The capability provided to

the consumer is to provision
processing, storage, networks,
and other fundamental
computing resources where
the consumer is able to deploy
and run arbitrary software,
which can include operating
systems and applications. The
consumer does not manage or
control the underlying cloud
infrastructure but has control
over operating systems,

storage, and deployed applications and possibly limited control of select

networking components (e.g., host firewalls)”.
A company using Infrastructure as a Service is provided with physical and virtual
processing, storage, networks, and other computing resources. The company can
use the infrastructure to run software and operating systems. Although the
company does not manage or control the cloud infrastructure, it does have control
over the operating systems, storage, and deployed applications it uses, and it may
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have some control over things like configuration of a host firewall. Examples of
Infrastructure as a Service include storage servers, network components, virtual
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machines, firewalls, and virtual local area networks.
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Benefits of Cloud Computing, SaaS, PaaS, and IaaS:

• Users pay for only what they use, either on a periodic basis or on a usage basis.
Thus, cloud computing is scalable. A firm can quickly increase or decrease the scale
of its IT capability, Google and Amazon for example they charge per usage of a GB
per month.

• Since the provider owns and operates the hardware and software, a user
organization may be able to decrease its investment in its own hardware and
software, company doesn’t have to own all these required servers and devices,
which is less costly for sure, and more flexible regarding technology development
and so
• The provider keeps the software updated, so the user organizations do not need
to invest in upgrades or be concerned with applying them, don’t have to maintain
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all programs to be UpToDate anymore as provider is doing it instead
• Applications and data resident in the cloud can be accessed from anywhere, from
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any compatible device, work at home or office (flexibility)
• Technology available in the cloud can be leveraged in responding to new and
existing requirements for external compliance reporting, sustainability and
integrated reporting, internal management reporting, strategic planning,
advanced analytics, and many others.

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budgeting and forecasting, performance measurement, risk management,
• Cloud technology can be used to free up accountants so they can handle more
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higher-value activities and streamline lower-value processes.
• The cloud can enable the CFO to move into a more strategic role instead of
spending time on transactional activities.
• The cloud can provide greater redundancy of systems than an on-site IT
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department may be able to offer.

• The cloud can offer to companies of all sizes the advanced computing power
needed for advanced analytics, something that otherwise only the largest
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companies would be able to afford due to cost. As a result, small to medium-sized

businesses can be better positioned to compete with much larger competitors.
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• Although security is a concern with the cloud, security is a concern with on-site
IT, as well. The cloud frequently can provide stronger infrastructure and better
protection than an on-site IT department may be able to, so security may actually
be enhanced
Limitations, Costs, and Risks of Cloud Computing, SaaS, PaaS, and IaaS:
• Reliability of the Internet is a concern. If the Internet goes down, operations stop.
• The quality of the service given by the provider needs to be monitored, and the
service contract needs to be carefully structured, we need to make certain always
the provider is following new updates and releases
• Loss of control over data and processing introduces security concerns. The cloud
vendor must demonstrate that it has the proper internal controls and security
infrastructure in place.

• Contracting with overseas providers may lead to language barrier problems and
time-zone problems as well as quality control difficulties.
• The ability to customize cloud solutions is limited, and that may hamper
management from achieving all that it hopes to achieve.
• Service provided by automatic backup service providers may be problematic
because timing of automatic backups may not be controllable by the user and may
not be convenient for the user.
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• The cloud cannot overcome weak internal controls. People are the greatest area
of weakness with both internal IT and with cloud technologies. Security awareness
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training, proper hiring procedures, good governance, and protection from malware
continue to be necessary after a company moves to the cloud, just as they are when
the IT is on-site.
• The company’s data governance must be structured to cover the cloud and the
risks inherent in it.
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• Expected cost savings may not materialize. An organization may find that
managing its own IT internally, even with all of its attendant problems, is less
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expensive than using the cloud.
F- Blockchains and Smart Contracts

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1- Blockchains:
The blockchain was initially envisioned as a peer-to-peer system for sending online
payments from one party to another party without using a financial institution.
While online payments are still important, blockchain technology has expanded
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and is now used in many other areas.

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Some terminologies that related with blockchain

Blockchain – A blockchain is a public record of transactions in chronological order,
more specifically “a way for one Internet user to transfer a unique piece of digital
property to another Internet user, such that the transfer is guaranteed to be safe
and secure, everyone knows that the transfer has taken place, and nobody can
challenge the legitimacy of the transfer”.
Thus, a blockchain is a continuously growing digital record in the form of packages,
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called blocks, that are linked together and secured using cryptography. A
blockchain is a system of digital interactions that does not need an intermediary
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such as a financial institution to act as a third party to transactions. The blocks are
maintained via a peer-to-peer network of computers, and the same chain of blocks
(transactions), called a ledger, is stored on many different computers. A blockchain
can be public, private, or a hybrid, which is a combination of public and private, in
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case if someone could figure out to change his record as a matter of playing around
it, everybody’s else record of that transaction remains to be the original one.
Public blockchain - A public blockchain is open to anyone, anyone can contribute
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data to the ledger, and all participants possess an identical copy of the ledger. A
public blockchain is also called a permission less ledger. The public blockchain has
no owner or administrator, but it does have members who secure the network, and
they usually receive an economic incentive for their efforts.
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Private blockchain – A private blockchain, also called a permissioned ledger, allows

only invited participants to join the network. Permissioned ledgers are controlled
by one or more network administrators. All of the members—but only the
members—have copies of the ledger. Private blockchains can be used by a single
entity, for example to manage its value chain.
Hybrid blockchain – A hybrid blockchain is a mix of a public and private blockchain.
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Some processes are kept private and others are public. Participants in public or
private networks are able to communicate with each other, enabling transactions
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between them across networks. A hybrid blockchain can be used by a supply chain
group to control the supply chain.
Node – A node is a powerful computer running software that keeps the blockchain
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running by participating in the relay of information. Nodes communicate with each
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other to spread information around the network. A node sends information to a

few nodes, which in turn relay the information to other nodes, and so forth. The
information moves around the network quickly, so it is a tool of the blockchain
system.

Mining nodes, or “miners” – Miners are nodes (computers) on the blockchain that
group outstanding transactions into blocks and add them to the blockchain.
Distributed ledger – A distributed ledger is a database held by each node in a

network, and each node updates the database independently. Records are
independently constructed and passed around the network by the various nodes—
hey are not held by any central authority. Every node on the network has
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information on every transaction and then comes to its own conclusion as to
whether each transaction is authentic (that is, whether the people are who they
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say they are) and, if the transaction is a payment transaction, whether the sender
has enough funds to cover the payment. The data sent in a transaction contains all
the information needed to authenticate and authorize the transaction. When there
is a consensus among the nodes that a transaction is authentic and should be
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authorized, the transaction is added to the distributed ledger, and all nodes
maintain an identical copy of the ledger.

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Hash – Hashing is taking an input string of any length and giving it an output of a
fixed length using a hashing algorithm. For example, bitcoin uses the hashing
algorithm SHA-256 (Secure Hashing Algorithm 256) on Bitcoin networks. Any input,
no matter how big or small, always has a fixed output of 64 symbols, which is made
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up of 256 bits, the source of the “256” in its name. The fixed output is the hash.
Block – is a record in a blockchain that contains and confirms many waiting

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transactions. It is a group of cryptocurrency transactions that have been encrypted

and aggregated into the block by a miner.
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Nonce - The nonce in a block is a random string of characters that is appended to

the transaction information in the block before the block is hashed and it is used to
verify the block, this is how to be able to confirm that the block is actually the block
that it says.
Confirmation – When a block has been validated on a blockchain, the transactions

processed in it are confirmed. Confirmation means the transactions in the block
have been processed by the network.

Uses of Blockchain
 The first usage of a blockchain was to transfer virtual currency, or
cryptocurrency. A virtual currency is a digital representation of value that
functions as a medium of exchange, a unit of account, and/or a store of
value. It is a piece of computer code that represents ownership of a digital
asset. (such as Bitcoin and it is a convertible virtual currency)
 Private, permissioned blockchains can be used by financial institutions for
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trading, payments, clearings, settlements, and repurchase agreement
transactions (short-term borrowing of securities).
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 Intercompany transactions where different ERP systems are in use can be
streamlined using a blockchain.
 Procurement and supply chain operations on blockchain can be used to
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optimize accounts payable or accounts receivable functions.
2- Smart Contracts:
Blockchain technology can be used for more than payments. Blockchains are being
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used to store all kinds of digital information and to execute contracts automatically.
A contract that has been digitized and uploaded to a blockchain is called a smart
contract.
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According to Nick Szabo, a computer scientist who envisioned smart contracts in

1996, “A smart contract is a set of promises, specified in digital form, including
protocols within which the parties perform on these promises.”
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So basically, it is a normal contract, translating the terms and conditions of that

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normal standard contract, into a computer code, written by blockchain developers

in a computer programming language, and so it’s a set of coded computer functions
with a set of rules, and this computer code is self-executing on a blockchain-based
platform, so if something happens then it executes what it needs to be
Executing a Smart Contract:

When a smart contract is uploaded to a blockchain, the validity of the contract is
checked and the required steps are enabled, after that, it is automatically executed,
so what ever it is need to be happen like people paid or whatever it needs to be
done the contract will be automatically executed.

Following are some examples of the uses of smart contracts on blockchains:

• A blockchain can be used to ensure the authenticity of a product, so a purchaser
of the product can be assured that the product he or she is buying is genuine and
not a counterfeit.
• It can be used to protect intellectual property. For example, artists can protect
and sell music on a blockchain system. Artists who are due royalties from each sale
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of their material can receive the payments due them automatically through a smart
contract as sales are made. They do not need to wait until the end of a period or
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wonder whether the publisher is being truthful about the number of sales made
during the period.
• Blockchain and smart contracts have an important place in supply chain
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management, freight, and logistics, particularly in international transactions.
Blockchain supply chain management does not rely on freight brokers, paper
documents, or banks around the world to move goods and payments. The
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blockchain can provide secure digital versions of all documents that can be
accessed by all the parties to a transaction.
• On-demand manufacturing can be performed by machines that are automated

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and running on a blockchain network. A design would be sent to a locked machine

along with an order for a specific number of units. The contract would be executed,
the machine would be unlocked to produce the correct number of units, the goods
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would be produced, and the machine would be locked again.

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• An insurance contract can be in the form of a smart contract. For example, an

orchard owner is concerned about a freeze that could destroy the year’s fruit crop.
An insurance company offers insurance against a freeze through a self-executing
smart contract. The orchard owner and the insurance company agree to the
contract terms and digitally sign a smart contract that is uploaded to a blockchain.
The orchard owner’s periodic premium payments are automated, and the
blockchain checks a third-party source such as the National Weather Service daily
for a possible freeze event. If a freeze event occurs, payment is sent automatically
from the insurance company to the orchard owner.

Governance for Smart Contracts:

Good governance is important for smart contracts, which require ongoing attention
and may require action and possible revision. Governance standards and
frameworks are needed and appear to be in the early stages of development.
• Governance standards may assign responsibility for smart contract design and
operation and establish mechanisms for dispute resolution.
• Standards may incorporate terms or conditions that smart contracts need to have
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in order to be enforceable.
• Standards could create presumptions regarding the legal character of a smart
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contract, depending on its attributes and manner of use.
• Good governance standards may help address the risks that smart contracts
present.
Benefits of Smart Contracts:
a.
• Smart contracts can authenticate counter-party identities, the ownership of
assets, and claims of right by using digital signatures, which are private
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cryptographic keys held by each party.
• Smart contracts can access outside information or data to trigger actions, for
example, commodity prices, weather data, interest rates, or an occurrence of an
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event, if the weather drops below certain temperature in a certain location that
triggers the payment from the insurance company.
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• Smart contracts can self-execute. The smart contract will take an action such as
transferring a payment without any action required by the counter-parties. The
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automatic execution can reduce counter-party risk and settlement risk.
• The decentralized, distributed ledger on the blockchain prevents modifications

not authorized or agreed to by the parties, the contract gets locked in as to what
the terms of that contract are.
• Smart contracts can enhance market activity and efficiency by facilitating trade
execution.
• Use of standardized code and execution may reduce costs of negotiations.
• Automation reduces transaction times and manual processes.

• Smart contracts can perform prompt regulatory reporting as necessary whatever

that reporting requirements are.
Limitations and Risks of Smart Contracts:

• The operation of a smart contract is only as smart as the information it receives
and the computer code that directs it, so if it is poorly program, if it is not setup
properly, is not going to do what is it that it supposed to do
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• Existing laws and regulations apply to all contracts equally regardless of what
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form a contract takes, so contracts or parts of contracts that are written in code
are subject to otherwise applicable law and regulation.
• A smart contract could introduce operational, technical, and cybersecurity risk, it

has to be protected.
a.
• A smart contract may be subject to fraud and manipulation. For example, smart
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contracts can include deliberately damaging code that does not behave as
promised or that may be manipulated. Oracles may be subject to manipulation or
may themselves be fraudulent and may disperse fraudulent information that
results in fraudulent outcomes.
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Date Analytics
Data analytics
is the process of gathering and analyzing data in a way that produces meaningful
information that can be used to aid in decision making. As businesses become more
technologically sophisticated, their capacity to collect data increases. However, the
stockpiling of data is meaningless without a method of efficiently collecting,
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aggregating, analyzing, and utilizing it for the benefit of the company.
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Data analytics can be classified into four types:
1) Descriptive analytics report past
performance. Descriptive analytics are the
a.
simplest type of data analytics and they
answer the question, “What happened”?
2) Diagnostic analytics are used with

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descriptive analytics to answer the question,
“Why did it happen”? The historical data is
mined to understand the past performance
and to look for the reasons behind success or
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failure. For example, sales data might be

broken down into segments such as revenue
by region or by product rather than revenue
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in total.
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3) Predictive analytics focus on the future using correlative analysis. Predictive

analytics answer the question, “What is likely to happen”? Historical data is
combined with other data using rules and algorithms. Large quantities of data are
processed to identify patterns and relationships between and among known
random variables or data sets in order to make predictions about what is likely to
occur in the future. A sales forecast made using past sales trends is a form of
predictive analytics.
4) Prescriptive analytics answer the question “What needs to happen?” by charting

the best course of action based on an objective interpretation of the data.
Prescriptive analytics make use of structured and unstructured data and apply rules
to predict what will happen and to prescribe how to take advantage of the
predicted events. For example, prescriptive analytics might generate a sales
forecast and then use that information to determine what additional production
lines and employees are needed to meet the sales forecast. In addition to
anticipating what will happen and determining what needs to happen, prescriptive
analytics can help determine why it will happen. Prescriptive analytics can
incorporate new data and re-predict and re-prescribe, as well. Prescriptive
analytics is most likely to yield the most impact for an organization, but it is also
the most complex type of analytics.
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A- Business Intelligence (BI)
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Business intelligence is the combination of architectures, analytical and other tools,
databases, applications, and methodologies that enable interactive access—
sometimes in real time—to data such as sales revenue, costs, income, and product
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data. Business intelligence provides historical, current, and predicted values for
internal, structured data regarding products and segments. Further, business
intelligence gives managers and analysts the ability to conduct analysis to be used
to make more informed strategic decisions and thus optimize performance.
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Data to Action:
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• Data is facts and figures, but data by itself is not information, just random pieces
of data.
• Information is data that has been processed, analyzed, interpreted, organized,
and put into context such as in a report, in order to be meaningful and useful.

• Knowledge is the theoretical or practical understanding of something. It is facts,

information, and skills acquired through experience or study. Thus, information
becomes knowledge through experience, study, or both.
• Insight is a deep and clear understanding of a complex situation. Insight can be
gained through perception or intuition, but it can also be gained through use of
business intelligence: data analytics, modeling, and other tools.
• The insights gained from the use of business intelligence lead to
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recommendations for the best action to take. Strategic decisions are made by
choosing from among the recommendations.
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• The strategic decisions made are implemented and turned into action.
A Business Intelligence system has four main components:

1) A data warehouse (DW) containing the source data.
a.
2) Business analytics, that is, the collection of tools used to mine, manipulate, and
analyze the data in the DW. Many Business Intelligence systems include artificial
intelligence capabilities, as well as analytical capabilities.
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3) A business performance management component (BPM) to monitor and
analyze performance.
4) A user interface, usually in the form of a dashboard.
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Big Data:
Big Data refers to vast datasets that are too large to be analyzed using standard
software tools and so require new processing technologies. Those new processing
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technologies are data analytics.

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Big Data can be broken down into three categories:

1) Structured data is in an organized
format that enables it to be input into
a relational database management
system and analyzed. Examples include DB
the data in CRM or ERP systems, such
as transaction data, customer data,
financial data, employee data, and
vendor data.
2) Unstructured data has no defined

format or structure. It is typically free-
form and text-heavy, making in-depth analysis difficult. Examples include word

processing documents, email, call center communications, contracts, audio and

video, photos, data from radio-frequency identification (RFID) tags, and
information contained on websites and social media.
3) Semi-structured data has some format or structure but does not follow a defined
model. Examples include XML files, CSV files, and most server log files.
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Big Data is characterized by four attributes, known as the four V’s:
1) Volume: Volume refers to the amount of data that exists. The volume of data
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available is increasing exponentially as people and processes become more
connected, creating problems for accountants. The tools used to analyze data in
the past—spreadsheet programs such as Excel and database software such as
Access—are no longer adequate to handle the complex analyses that are needed.
a.
Data analytics is best suited to processing immense amounts of data.
2) Velocity: Velocity refers to the speed at which data is generated and changed,
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also called its flow rate. As more devices are connected to the Internet, the velocity
of data grows and organizations can be overwhelmed with the speed at which the
data arrives. Data analytics is designed to handle the rapid influx of new data.
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3) Variety: Variety refers to the diverse forms of data that organizations create and
collect. In the past, data was created and collected primarily by processing
transactions. The information was in the form of currency, dates, numbers, text,
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and so forth. It was structured, that is, it was easily stored in relational databases
and flat files. However, today unstructured data such as media files, scanned
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documents, Web pages, texts, emails, and sensor data are being captured and
collected. These forms of data are incompatible with traditional relational database
management systems and traditional data analysis tools. Data analytics can capture
and process diverse and complex forms of information.
4) Veracity: Veracity is the accuracy of data, or the extent to which it can be trusted
for decision making. Data must be objective and relevant to the decision at hand in
order to have value for use in making decisions. However, various distributed
processes—such as millions of people signing up online for services or free
downloads—generate data, and the information they input is not subject to
controls or quality checks. If biased, ambiguous, irrelevant, inconsistent,
incomplete, or even deceptive data is used in analysis, poor decisions will result.
Controls and governance over data to be used in decision-making are essential to

ensure the data’s accuracy. Poor-quality data leads to inaccurate analysis and
results, commonly referred to as “garbage in, garbage out.”
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Some data experts have added two additional Vs that characterize data:
5) Variability: Data flows can be inconsistent, for example, they can exhibit
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seasonal peaks. Furthermore, data can be interpreted in varying ways. Different

questions require different interpretations.
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6) Value: Value is the benefit that the organization receives from data. Without the
necessary data analytics processes and tools, the information is more likely to
overwhelm an organization than to help the organization. The organization must
be able to determine the relative importance of different data to the decision-
making process. Furthermore, an investment in Big Data and data analytics should
provide benefits that are measurable.
Data Since:
A field of study and analysis that uses algorithms and processes to extract hidden
knowledge and insights from data. The objective of data science is to use both
structured and unstructured data to extract information that can be used to
develop knowledge and insights for forecasting and strategic decision making.

The difference between data analytics and data science is in their goals:
• The goal of data analytics is to provide information about issues that the analyst
or manager either knows or knows he or she does not know (that is, “known
unknowns”).
• On the other hand, the goal of data science is to provide actionable insights into
issues where the analyst or manager does not know what he or she does not know
(that is, “unknown unknowns”).
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a.

Example: Data science would be used to try to identify a future technology that
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does not exist today but that will impact the organization in the future. Decision
science, machine learning (that is, the use of algorithms that learn from the data in
order to predict outcomes), and prescriptive analytics are three examples of means
by which actionable insights can be discovered in a situation where “unknowns are
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unknown.”
Data and Data Science as Assets:

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Data and data science capabilities are strategic assets to an organization, but they
are complementary assets, (compete each other they go together they work
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together they benefit together, so taking the data one step more not just answer
questions we know but looking at questions that we don’t even know)
• Data science is of little use without usable data.
• Good data cannot be useful in decision-making without good data science talent.
Investing in Data and Data Since:

As with any strategic asset, it is necessary to make investments in data and data
science. The investments include building a modern business intelligence
architecture using the right tools, we need to be certain that we are UpToDate and
current with the hardware and software, and also investing in people with data
science skills, and investing in the training needed to enable the staff to use the
business intelligence and data analytics tools.

Challenges of Managing Data Analytics:

Some general challenges of managing data analytics include data capture, data
curation (that is, the organization and integration of disparate data collected from
various sources), data storage, security and privacy protection, data search, data
sharing, data transfer, data analysis, and data visualization.
In addition, some specific challenges of managing data analytics include:
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• The growth of data and especially of unstructured data
• The need to generate insights in a timely manner in order for the data to be
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useful, and business world moves quick, so we can’t wait three years to get the
information out of that, we need to get that information out quickly
• getting and keeping right people, Recruiting and retaining Big Data talent.
Demand has increased for data engineers, data scientists, and business intelligence
a.
analysts, causing higher salaries and creating difficulty filling positions.
B- Data Mining
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Data mining is the use of statistical techniques to search large data sets to extract
and analyze data in order to discover previously unknown, useful patterns, trends,
and relationships within the data that go beyond simple analysis and that can be
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used to make decisions. It has to be useful, so we’ve got this mass amount of data
and we going to pull out those unknown things, that we didn’t know that they were
existing, and make it useful to the organization, Data mining uses specialized
computational methods derived from the fields of statistics, machine learning, and
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artificial intelligence.
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Data mining is thus an ❶ iterative process. Iteration is the repetition (keep doing
it) of a process in order to generate a sequence of outcomes. Each repetition of the
process is a single iteration, and the outcome of each iteration is the starting point
of the next iteration, simply we do something and we keep doing it till we get some
information out of it, and then we keep doing something different based on the
first outcome, as we have different understanding now after the first outcome, and
so on.
Data mining is a process with defined steps, and thus it is a❷ science. Science is
the pursuit and application of knowledge and understanding through a mass of
data and try to find some sort of order in it.
Data mining is also an ❸ art. In data mining, decisions must be made regarding
what data to use, what tools to use, and what algorithms to use. For example, one
word can have many different meanings. In mining text, the context of words must
be considered. Therefore, instead of just looking for words in relation to other

words, the data scientist looks for whole phrases in relation to other phrases. The
data scientist must make thoughtful choices in order to get usable results.
Context and Generalization: two considerations in data mining

In data mining, the context of words and information must be considered
Data mining involves generalization of pattern from data set, “Generalization” is
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the ability to predict or assign a label to a “new” observation based on a model built
from past experience. We need to notice that it won’t be absolutely accurate, but
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we developing this generalization to get that new unknown data that going to be
useful for the organization.
Data mining is used in predictive analytics:
a.
Basic concepts of predictive analytics include:
(remember that when we say predictive so we are looking to the future, we are
looking to what is going to happen, mostly based on historical data)
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• Classification – Any data analysis involves classification. Data mining is used when
the classification of the data is not known. For example, customers visiting the
company’s website are classified as predicted purchasers or predicted non-
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purchasers.
• Prediction – Prediction is similar to classification, but the goal is to predict the

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numerical value of a variable such as the amount of a purchase rather than (for
example) simply classifying customers as predicted purchasers or predicted non-
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purchasers, so how much they are going to purchase
• Association rules – Also called affinity analysis, association rules are used to find
patterns of association between items in large databases, such as associations
among items purchased from a retail store, or “what goes with what.” For example,
when customers purchase a 3-ring notebook, do they usually also purchase a
package of 3-hole punched paper? If so, the 3-hole punched paper can be placed
on the store shelf next to the 3-ring notebooks. Similar rules can be used for
bundling products.
• Online recommendation systems – In contrast to association rules, which

generate rules that apply to an entire population, online recommendation systems
use collaborative filtering to deliver personalized recommendations to users.

Collaborative filtering generates rules for “what goes with what” at the individual
user level. It makes recommendations to individuals based on their historical
purchases, online browsing history, or other measurable behaviors that indicate
their preferences, as well as other users’ historical purchases, browsing, or other
behaviors. For example, when you see the message “people who purchase this TV
also purchased these Shelves”
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• Data reduction – Data reduction is the process of consolidating a large number
of records into a smaller set by grouping the records into homogeneous groups.
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• Clustering – Clustering is discovering groups in data sets that have similar
characteristics without using known structures (unexpected) in the data. Clustering
can be used in data reduction to reduce the number of groups to be included in the
data mining algorithm.
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• Dimension reduction – Dimension reduction entails reducing the number of
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variables in the data before using it for data mining, in order to improve its
manageability, interpretability, and predictive ability, in this step we eliminating
some variables that are irrelevant, which will help the prediction concept as well.
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• Data exploration – Data exploration is used to understand the data and detect
unusual values. The analyst explores the data by looking at each variable
individually and looking at relationships between and among the variables in order
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to discover patterns in the data. Data exploration can include creating charts and
dashboards, called data visualization or visual analytics (see next item). Data
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exploration can lead to the generation of a hypothesis.
• Data visualization – Data visualization is another type of data exploration.

Visualization, or visual discovery, consists of creating graphics such as histograms
and boxplots for numerical data in order to visualize the distribution of the
variables and to detect outliers. Pairs of numerical variables can be plotted on a
scatter plot graph in order to discover possible relationships. When the variables
are categorized, bar charts can be used. Visualization is covered in more detail later
in this section.

Supervised and Unsupervised Learning in Data Mining:

What we are trying to do here is learn what this data means, so we can extract out
information that is going to help us predict who is going to buy, what they going to
buy, and how much they going to buy, what ever is that we are trying to predict.
Supervised learning algorithms are used in classification and prediction. In order

to “train” the algorithm, it is necessary to have a dataset in which the value of the
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outcome to be predicted is already known, so let’s say we get all data and
information about our past customers (historical data), and we already know which
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purchases they made, and how much was it, and so we use these training data to
train and learn the algorithm what is important and what is not important, what
were the characteristics of all the people who purchased, who purchased a lot or a
little bit, but if we have these historical information as foundation, so we are
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learning from that past information, and then once we have that past information,
we are able to apply it to our current data going forward, to make those predictions
about what customers are going to purchase, what is it that we need to be looking
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for to identify that we have a customer who is ready to purchase, and keep
monitoring that overtime, just because this it what it was two months ago, doesn’t
mean this still what’s going to be happening
The data in the dataset is called labeled data because it contains the outcome value
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(called the label) for each record. The classification or prediction algorithm “learns”
or is “trained” about the relationship between the predictor variables and the
outcome variable in the training data. After the algorithm has “learned” from the
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training data, it is tested by applying it to another sample of labeled data for which
the outcome is already known but is initially hidden (called the validation data) to
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see if it works properly. If several different algorithms are being tested, additional
test data with known outcomes should be used with the selected algorithm to
predict how well it will work. After the algorithm has been thoroughly tested, it can
be used to classify or make predictions in data where the outcome is unknown.
Example: Simple linear regression is an example of a basic supervised learning

algorithm. The x variable, the independent variable, serves as the predictor
variable. The y variable, the dependent variable, is the outcome variable in the
training and test data where the y value for each x value is known.
The regression line is drawn so that it minimizes the sum of the squared deviations
between the actual y values and the values predicted by the regression line. Then,
the regression line is used to predict the y values that will result for new values of
x for which the y values are unknown.
Unsupervised learning algorithms are used when there is no outcome variable to

predict or classify, so we just kind of have to start trying to determine what it is
that going to become that predictor for whatever we are trying to predict for or
forecast into the future. Association rules, dimension reduction, and clustering are
unsupervised learning methods.
Neural Networks in Data Mining:
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Neural networks are systems that can recognize patterns in data and use the
patterns to make predictions using new data. Neural networks are used to learn
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about the relationships in the data and combine predictor information in such a
way as to capture the complicated relationships among predictor variables and
between the predictor variables and the outcome variable.
Neural networks are based on the human brain and mimic the way humans learn;
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humans can learn from experience. Similarly, a neural network can learn from its
mistakes by finding out the results of its predictions.
The results of the neural network’s predictions—the output of the model—
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becomes the input to the next iteration of the model. Thus, if a prediction made
did not produce the expected results, the neural network uses that information in
making future predictions.
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Uses of Neural Networks:

• Picking stocks for investment by performing technical analysis of financial
markets and individual investment holdings.
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• Making bankruptcy predictions. A neural network can be given data on firms that
have gone bankrupt and firms that have not gone bankrupt. The neural network
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will use that information to learn to recognize early warning signs of impending
bankruptcy, and it can thus predict whether a particular firm will go bankrupt.
• Detecting fraud in credit card and other monetary transactions by recognizing
that a given transaction is outside the ordinary pattern of behavior for that
customer, such as when you recognize that you card is blocked because you are
trying to use it in a different country, if you didn’t inform the bank already to change
the data that had been feed to the system.
• Identifying a digital image as, for example, a cat or a dog, such as separate traffic
signs from other pictures on as a confirmation on internet to prove that user is not
a robot user
• Self-driving vehicles use neural networks with cameras on the vehicle as the
inputs.

Challenges of Data Mining:

• Poor data quality. Data stored in relational databases may be incomplete, out of
date, or inconsistent. For example, mailing lists can contain duplicate records,
leading to duplicate mailings and excess costs. Poor quality data can lead to poor
decisions. Furthermore, use of inaccurate data can cause problems for consumers.
• Information exists in multiple locations within the organization and thus is not
centrally located, for example Excel spreadsheets that are in the possession of
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individuals in the organization. Information that is not accessible cannot be used.
• Biases are amplified in evaluating data. The meaning of a data analysis must be
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assessed by a human being, and human beings have biases. A “bias” is a preference
or an inclination that gets in the way of impartial judgment. Most people tend to
trust data that supports their pre-existing positions and tend not to trust data that
does not support their pre-existing positions. Other biases include relying on the
a.
most recent data or trusting only data from a trusted source. All such biases
contribute to the potential for errors in data analysis.
• Analyzed data often displays correlations. However, correlation does not prove
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causation. Establishing a causal relationship is necessary before using correlated
data in decision-making. If a causal relationship is assumed where none exists,
decisions made on the basis of the data will be flawed, so not just because two sets
of data has same pattern and move in same direction there must be a relation
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between them, or that one causes the other one, so we need to make certain that
we are not drawing false conclusions about what causes the other.
• Ethical issues such as data privacy related to the aggregation of personal
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information on millions of people. Profiling according to ethnicity, age, education

level, income, and other characteristics results from the collection of so much
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personal information.
• Data security is an issue because personal information on individuals is frequently
stolen by hackers or even employees.
• A growing volume of unstructured data. Data items that are unstructured do not
conform to relational database management systems, making capturing and
analyzing unstructured data more complex. Unstructured data includes items such
as social media posts, videos, emails, chat logs, and images, for example images of
invoices or checks received.

Steps in Data Mining:

A typical data mining project will include the following steps.
1) Understand the purpose of the project. The data scientist needs to understand
the user’s needs and what the user will do with the results. Also, the data scientist
needs to know whether the project will be a one-time effort or ongoing.
2) Select the dataset to be used. The data scientist will take samples from a large
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database or databases, or from other sources. The samples should reflect the
characteristics of the records of interest so the data mining results can be
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generalized to records outside of the sample. The data may be internal or external.
3) Explore, clean, and preprocess the data. Verify that the data is in usable
condition, that is, whether the values are in a reasonable range and whether there
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are obvious outliers. Determine how missing data (that is, blank fields) should be
handled. Visualize the data by reviewing the information in chart form.
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4) Reduce the data dimension if needed. Eliminate unneeded variables, transform
variables as necessary, and create new variables. The data scientist should be sure
to understand what each variable means and whether it makes sense to include it
in the model.
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5) Determine the data mining task. Determining the task includes classification,
prediction, clustering, and other activities. Translate the general question or
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problem from Step 1 into the specific data mining question.

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6) Partition the data. If supervised learning will be used (classification or

prediction), partition the dataset randomly into three parts: one part for training,
one for validation, and one for testing.
7) Select the data mining techniques to use. Techniques include regression, neural
networks, hierarchical clustering, and so forth.
8) Use algorithms to perform the task. The use of algorithms is an iterative process.
The data scientist tries multiple algorithms, often using multiple variants of the
same algorithm by choosing different variables or settings. The data scientist uses
feedback from an algorithm’s performance on validation data to refine the settings.

9) Interpret the results of the algorithm. The data scientist chooses the best
algorithm and tests the final choice on the test data to learn how well it will
perform.
10) Deploy the model. The model is run on the actual records to produce
actionable information that can be used in decisions. The chosen model is used to
predict the outcome value for each new record, called scoring.
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A data mining project does not end when a particular solution is deployed,
however. The results of the data mining may raise new questions that can then be
used to develop a more focused model.

C- Analytic Tools and Simple Regression Analysis

The purpose of this study in practical, is that we are taking the mass amount of
data, and using it from a practical point of view to be able to use it to make a
prediction, so we are going to use these historical mass amount of data we will be
trying to take related data, just part of that data and try to project for the sales
number lets say in one year or two years in the future
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Use of Data:
This about using the past historical data to forecast what will happen in the future.
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Time Series analysis:
This is when we are looking at trends overtime, a time series can be descriptive or
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predictive
descriptive modeling, in which a time series is modeled to determine its
components, that is, whether it demonstrates a trend pattern, a seasonal pattern,
a cyclical pattern, or an irregular pattern, so we are going to take these series of
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information overtime and we are going to model it to determine what type of
pattern and the components of these information are. The information gained from
a time series analysis can be used for decision-making and policy determination.
predictive. It involves using the information from a time series to forecast future
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values of that series.
Time series forecasting:

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A time series may have one or more of four patterns (also called components) that
influence its behavior over time:
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1) Trend
2) Cyclical
3) Seasonal
4) Irregular
Simple liner regression analysis:

A trend projection is performed with simple linear regression analysis, which
forecasts values using historical information from all available past observations of
the value. The regression line is called a trend line.

The equation of a simple linear regression line is:

ŷ = a + bx
Where:
ŷ = the predicted value of ŷ (sales for example) on the regression line corresponding
to each value of x, the dependent variable.
a = the y-intercept, or the value of ŷ on the regression line when x is zero, also called
the constant coefficient.
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b = the slope of the line and the amount by which the ŷ value of the regression line
changes (increases or decreases) when the value of x increases by one unit, also
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called the variable coefficient.
x = the independent variable, the value of x on the x-axis that corresponds to the
predicted value of ŷ on the regression line.
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The symbol over the “y” in the formula is called a “hat,” and it is read as “y-hat.”
The y-hat indicates the predicted value of y, not the actual value of y. The predicted
value of y is the value of y on the regression line (the line created from the historical
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data) at any given value of x.
Note: The equation of a simple linear regression line graphs as a straight line
because none of the variables in the equation are squared or cubed or have any
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other exponents. If an equation contains any exponents, the graph of the equation
will be a curved line.
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Linear regression is used to calculate the location of the regression line

mathematically. Linear regression analysis is performed on a computer or a
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financial calculator, using the observed values of x and y.
Example of a Trend Pattern in Time Series Analysis:

The chart illustrates the trend pattern of the sales. It indicates a strong relationship
between the passage of time (the x variable) and sales (the y variable) because the
historical data points fall close to the regression line.
The green line what the sales had been over historical period from 20X0 and 20X9
While the red line is the regression line, that’s the formula for the line that goes the
best through that green line historical data, and what we do, is just keep that red
line going into the future, and that’s going to be our projection through the future,
which we know that is not correct or lets say purely accurate, but if we do our
calculation right (draw the right line) and consider other factors constant that
should be fairly close

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Trends in a time series analysis are not always upward and linear like the preceding
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graph. Time series data can exhibit an upward linear trend, a downward linear
trend, a nonlinear (that is, curved) trend, or no trend at all. A scattering of points
that have no relationship to one another would represent no trend at all.
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Example of a Cyclical Pattern in Time Series Analysis:

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The chart illustrates the cyclical pattern of the sales. The fluctuations from year to
year are greater than they were for the chart containing the trend pattern.
However, a long-term trend is still apparent.
It shows a much greater differences than the trend pattern, as you will see few
years up and few years down, but we still have the regression line that goes through
that historical data, and the regression formula for the line is still applicable
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Seasonal Pattern in Time Series Analysis:
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Usually, trend and cyclical components of a time series are tracked as annual
historical movements over several years. However, a time series can fluctuate
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within a year due to seasonality in the business. For example, a surfboard

manufacturer’s sales would be highest during the warm summer months, whereas
a manufacturer of snow skis would experience its peak sales in the wintertime.
Variability in a time series due to seasonal influences is called the seasonal
component.
Note: Seasonal behavior can take place within any time period. Seasonal behavior
is not limited to periods of a year. A business that is busiest at the same time every
day is said to have a within-the day seasonal component. Any pattern that repeats
regularly is a seasonal component.
Seasonality in a time series is identified by regularly spaced peaks and troughs with
a consistent direction that are of approximately the same magnitude each time,

relative to any trend. The graph that follows shows a strongly seasonal pattern.
Sales are low during the first quarter each year. Sales begin to increase each year
in the second quarter and they reach their peak in the third quarter, then they drop
off and are low during the fourth quarter. However, the overall trend is upward, as
illustrated by the trend line.
Example of an Irregular Pattern in Time Series Analysis:
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In this pattern there really isn’t a line, as we can’t draw a line through it that would
work for our prediction, so in irregular pattern this all trend analysis and regression
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overtime may not be really be useful, simply because it does not appear be a
correlation between time and sales
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Line of best fit:

The red line we talked about, is called the best fit line, as the formula is the line
that is the best fit through the past data, which projects to the future, while
remember it is possible that not any of the individual data of past years are on that
line, but they are close to it above and below
Correlation Analysis:
Correlation analysis is used to assess how well a model can predict an outcome, so
if we have high correlation between X and Y then adding another year to our
formula is a good way of predicting next year sales, such as if we predict sales using
number of sales employee or number of stores it depends on the relation between

each of these to the sales value itself, and how each when increase or decrease will
affect the sales number
Some of the most important statistical calculations for determining correlation are:
(you don’t need to calculate these all you need to know is what they measuring,
what value they present and what each of these mean)
1) The correlation coefficient, R
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2) The standard error of the estimate, also called the standard error of the
regression
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3) The coefficient of determination, R²
4) The T-statistic
1- The Correlation Coefficient (R):
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measures the relationship between the independent variable and the dependent
variable. The coefficient of correlation is a number that expresses how closely
related, or correlated, the two variables are and the extent to which a variation in
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one variable has historically resulted in a variation in the other variable.
Mathematically, the correlation coefficient, represented by R, is a numerical

measure that expresses both the direction (positive or negative) and the strength
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of the linear association between the two variables.
Coefficient measures:
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+1 0 -1 % percentage
Perfect direct No relationship Perfectly inverse Can’t be
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(positive) There is no connection relationship minus and

relationship between both (negative) can’t be more
Upsloping Down sloping than 100%
Strong direct
relationship
R R²
The strength:
A high correlation coefficient (R), that is, a number close to either +1 or −1, means
that simple linear regression analysis would be useful as a way of making a

projection. Generally, a correlation coefficient of ±0.50 or higher indicates enough

correlation that a linear regression can be useful for forecasting. The closer R is to
±1, the better the forecast should be.
A moderate correlation coefficient (R), generally defined as ±0.30 to ±0.49,

indicates a lower amount of correlation and questionable value of the historical
data for forecasting, properly not but maybe a little bit of relation
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A low correlation coefficient (R), around ±0.10, indicates that a forecast made from
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the data using simple regression analysis would not be useful.
2- The Standard Error of the Estimate, also called the Standard Error of the
Regression (S) and the Error Term (e):
a.
This recognizes that the line of best fit is not a line of perfect fit, and so we know
that our future predicted value isn’t going to be exactly on that line, it is going to
be near, and so we add an error term to the regression formula.
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y = a + bx + e
and this standard error of the estimate, is the average distance that those observed
past values were from the regression line, so we are simply saying, it is going to be
XX amount of value plus or minus a little bit
am
3- The Coefficient of Determination (R²):

The coefficient of determination is the percentage of the total variation in the
h
dependent variable (y) that can be explained by variations in the independent

variable (x), as depicted by the regression line.
ef
In a simple linear regression with only one independent variable, the coefficient of
determination is the square of the correlation coefficient. The coefficient of
determination is represented by the term R².
R² is expressed as a number between 0 and 1.

• If R² is 1, then 100% of the variation in the dependent variable is explained by
variations in the independent variable, and that means that’s the only one factor
that change the sales is time, which is not going to be the case in real life.
• If R² is 0, then none of the variation in the dependent variable is explained by
variations in the independent variable, so it means that none of the change in sales
is explained by the change in time, and if that’s the case we don’t really need to
continue to testing this relation as there is no connection between the independent
variable and the dependent variable.

The T-Statistic:
The t-statistic, or t-value, measures the degree to which the independent variable
has a valid, long-term relationship with the dependent variable. The t-value for the
independent variable used in a simple regression analysis should generally be
greater than 2. A value below 2 indicates little or no relationship between the
independent variable and the dependent variable, and thus the forecast resulting
from the regression analysis should not be used.
m
Multiple Regression Analysis: (no calculation required)
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When more than one independent variable is known to impact a dependent
variable and each independent variable can be expressed numerically, regression
analysis using all of the independent variables to forecast the dependent variable
is called multiple regression analysis.
a.
Note: Remember that there must be a reasonable basis to assume a cause-and-

effect relationship between the independent variable(s) and the dependent
cm
variable. If there is no reason for a connection, any correlation found through the
use of regression analysis is accidental. A linear relationship does not prove a cause-
and-effect relationship, and correlation does not prove causation.
am
The equation of a multiple regression function is usually written with either all “a”s
or all “b”s as the coefficients, with a subscripted zero to indicate the constant
coefficient and subscripted subsequent numerals to indicate the variable
h
coefficients, such as the following, although any letters could be used:

ŷ = a0 + a1x1 + a2x2 + ... + akxk
ef
Note: The variables and the coefficients in a multiple regression equation could be
identified using any letters. To identify the various components, look for the form
of the equation rather than the specific letters.
• The equation will have one component that stands by itself, and that will be the
constant coefficient.
• The variable coefficients will be next to the independent variables.
• The independent variables may or may not be identified by “x”s.
Just like in simple analysis we still need to make certain that with multiple
regression what we are measuring is actually what we should be measuring, and
that we are measuring these variables that they are connected to each other, so
familiar terms here:

Evaluating the Reliability of a Multiple Regression Analysis:

R² is used as an indicator of the reliability of a multiple regression analysis, as well
as in simple regression analysis as previously explained. In multiple regression
analysis, though, the R² value evaluates the whole regression, including all of the
independent variables used. If R² is above 0.50 or 50%, then the regression is fairly
reliable because the regression can be used to predict that percentage of the total
variation in the dependent variable. The higher the R² is, the better.
m
Multiple regression analysis uses the t-value —actually t-values (plural)— to
co
evaluate the reliability of each individual independent variable as a predictor of the
dependent variable. A separate t-value is calculated for each of the individual
independent variables in the multiple regression, and each independent variable is
evaluated individually.
a.
Goodness of Fit in Regression Analysis:wither we are talking about simple or
multiple regression analysis
cm
The term goodness of fit describes how close the actual values used in a statistical
model are to the expected values, that is, the predicted values, in the model, were
we accurate, or is there is something that was close to being accurate that we are
am
able to use, it’s all about the middle red line, so we can phrase it like this, is the line
that we draw a good line given the information that we have
h
low goodness of fit.

ef
As you see the numbers are all over the graph, yes there are some close points to
the line, but you can’t make a continuous line to the future and be comfortable to

estimate or forecast what sales is going to be, so we are trying to make certain that
the model we are using is accurate and descriptive to what is it that we are trying
to model
high goodness of fit:
m
co
a.
cm
One more measure to be aware of
Confidence Interval in Regression Analysis:
h am
ef
The confidence interval is used in regression analysis to describe the amount of

uncertainty caused by the sampling method used when drawing conclusions about

a population based on a sample. If several samples are drawn from a population

using the same sampling method and a confidence interval at a confidence level of
95% is used, 95% of the interval estimates in the samples can be expected to
include the true parameter of the population, so if we are looking at a period of ten
years for example with certain amount of data, we already know that it is not going
to be absolutely correct, so we are creating confidence interval, which is a kind of
a plus or minus corridor, were we say we are 95% confident that the value will be
m
within this range, kind of graphing that error
co
Benefits of Regression Analysis:
• Regression analysis is a quantitative method and as such it is objective. A given
data set generates specific results. The results can be used to draw conclusions and
make predictions.
a.
• Regression analysis is an important tool for drawing insights, making
recommendations, and decision-making.
cm
Limitations of Regression Analysis:
• To use regression analysis, historical data are required. If historical data are not
available, regression analysis cannot be used.
• Even when historical data are available, the use of historical data is questionable
am
for making predictions if a significant change has taken place in the conditions
surrounding that data.
• The usefulness of the data generated by regression analysis depends on the
h
choice of independent variable(s). If the choice of independent variable(s) is

inappropriate, the results can be misleading.
ef
• The statistical relationships that can be developed using regression analysis may
be valid only for the range of data in the sample.
D- Sensitivity Analysis
Sensitivity analysis can be used to determine how much the prediction of a model
will change if one in put to the model is changed. It can be used to determine which
input parameter is most important for achieving accurate predictions. Sensitivity
analysis is known as “what-if” analysis, for example in multiple regression analysis
it is based on that multiple variables are affecting the variable that we are
forecasting for, so the rule of sensitivity analysis is to determine which one of those
factors is the most important and the has the biggest impact over the independent
variable, that’s simply the concept of the sensitivity analysis, it could be also that
the outcome of these analysis is the opposite to what Tarek Naiem just explained,
meaning that it might come out of this that we identify area that is more risk than
we thought, increasing number of point of sales is not really the reason to increase
sales but it is a totally another variable, maybe number of sales employees, training
or marketing instead, and also if we change that variable a little bit, the result
changes a lot, as the volatility is one of the ways we see the risk that connected to
that input.
In sensitivity analysis we are changing one input at a time, which is making it easy,
m
while in reality multiple variables will change in the same time, rather than one by
one
co
Monte Carlo Simulation Analysis:
which involves changing to multiple variables at the same time, using solutions to
mathematical problems and complexity in it. Monte Carlo simulation can be used
a.
to develop an expected value when the situation is complex and the values cannot
be expected to behave predictably. Monte Carlo simulation uses repeated random

sampling and can develop probabilities of various scenarios coming to pass that can
cm
be used to compute a predicted result.
In CMA we don’t really need to know all details and how it works, all
we need to know is the brief following concept:
am
Sestivity Analysis But both of

them are
trying to
h
changing one variable at a time

reach a
ef
predicted
Monte Carol Simulation result that is
the most
changing multiple variables at a time accurate
possible
Benefits of Sensitivity Analysis and Simulation Models:

• Sensitivity analysis can identify the most critical variables, that is, the variables
that are most likely to affect the end result if they are inaccurate.
• Simulation is flexible and can be used for a wide variety of problems.
• Both sensitivity analysis and simulation analysis can be used for “what-if”
situations, because they enable the study of the interactive effect of variables.

• Both sensitivity analysis and simulation analysis are easily understood.

• Many simulation models can be implemented without special software packages
because most spreadsheet packages provide useable add-ins. For more complex
problems, simulation applications are available, so we don’t need any special
programming skills for that.
Limitations of Sensitivity Analysis and Simulation Models:
m
• The results of sensitivity analysis can be ambiguous when the inputs used are
themselves predictions, when we are trying to predict using a prediction.
co
• The variables used in a sensitivity analysis are likely to be interrelated. Changing
just one variable at a time may fail to take into consideration the effect that
variable’s change will have on other variables.
• Simulation is not an optimization technique. It is a method that can predict how
a.
a system will operate when certain decisions are made for controllable inputs.
• Although simulation can be effective for designing a system that will provide good
performance, there is no guarantee it will be the best performance.
cm
• The results will be only as accurate as the model that is used. A poorly developed
model or a model that does not reflect reality will provide poor results and may
even be misleading.
• There is no way to test the accuracy of assumptions and relationships used in the
am
model until a certain amount of time has passed, till we get some actual results.
Benefits of Data Analytics in General:

h
• The process of cleaning the data preparatory to processing it can detect errors,
duplicate information, and missing values. If the errors and duplicate information
ef
can be corrected and the missing values supplied, the data quality can be improved.
• The results of data analytics done correctly can lead to improved sales revenues
and profits, all of that better forecasting makes for better decisions.
• It can help to reduce fraud losses by recognizing potentially fraudulent
transactions and flagging them for investigation, as we are able that mass amount
of data and find what doesn’t look quite right
• Some easy-to-use data analytics tools are available that average users with little
knowledge of data science are able to make use of to access data, perform queries,
and generate reports. As a result, data scientists can be freed up to do more critical
data analysis projects.
• Forecasting can be vastly improved through the use of data analytics, this is what
we were talking about such as using regression analysis and so

Limitations of Data Analytics in General:

• Big Data is used in data analytics to find correlations between variables. However,
correlation does not prove causation. The fact that two variables are correlated
does not mean that one variable caused the other. Both variables could have been
caused by a third, unidentified, factor, so they are not actually influencing each
other but another factor that influence both of them.
• Big Data can be used to find correlations and insights using an endless number of
m
questions. But if the wrong questions are asked of the data, the answer will be
meaningless even though it may be the “right” answer.
co
• Failure to take into consideration all relevant variables can lead to inaccurate
predictions.
• Data breaches are a risk of using Big Data.
• Customer privacy issues and the risk of the misuse of data obtained from data
analytics are matters for concern.
a.
• In addition to the cost of the data analytics tools themselves, training on the use
of the tools so they are used to their best advantage may entail costs, as well.
cm
• Some easy-to-use data analytics tools are available that average users with little
knowledge of data science are able to make use of to access data, perform queries,
and generate reports. Use of the tools by those without a background in statistical
analysis and data science and without adequate training, though, can cause risks
am
such as data inconsistency, a lack of knowledgeable verification of the results, a

lack of proper data governance, and ultimately, poor decisions, so people might
think they are getting good results and good forecast, but it is not maybe the case.
h
• Selection of the right data analytics tools can be difficult.

ef
Finally,
All of this we got this mass amount of data available to us, what’ve been talking
about, using that data to get information that is useful for a better decision making,
yes a lot of these information are based on projections, and forecasts, but we are
sifting through and mining through all that data, to get the information that going
to help the users make better decisions, that would help the company being
successful as possible, by achieving its goals and objectives, which will add value to
the overall organizational ultimate goals.

E- Data Visualization
Data visualization is making data more understandable and usable data and
predictions from data. Charts, tables, and dashboards can be used to explore,
examine, and display data. Interactive dashboards allow users to access and
interact with real-time data and give managers a means to quickly see what might
otherwise not be readily apparent. The choice of information to include in a
dashboard depends on what a manager needs to see and can include visual
m
presentations such as colored graphs showing, for instance, current customer
orders.
co
Some visualization options are presented in the following pages, and information
on how each can be used is provided, it actually depends on that we need to match
together what we are trying to communicate and whom we are trying to
a.
communicate it to, so we get the right presentation method, even considering
people preferences and comfortability of using one type that another, the most
important of our presentation outcome is to communicate the data in an

understandable and usable manner.
cm
Tables Used in Visualization:
A table can be in any form and include all of the data available or only certain data.
The data table below will be used in all the chart examples that follow.
am
In addition to daily strawberry sales for each of the days of the week for twelve
weeks, the data table below contains the mean (average) for each day of the week
over the twelve-week period.
h
ef

Scatter Plot:
A scatter plot can be used to show all the values for a dataset, typically when there
are two variables. One variable may be independent and the other value
dependent, or both variables may be independent.
A scatter plot can reveal correlations between variables or alternatively, a lack of
correlation. For example, do sales of strawberries correlate with days of the week?
A scatter plot can answer that question.
m
In this case, it appears that strawberry sales do correlate with days of the week.
Sales build from Monday through Saturday and then they drop off on Sunday each
co
week.
a.
cm
h am
ef
Charts Containing Summarized Statistics

Several charts are used to present summarized statistics such as means, maximum
values, and minimum values.

Dot Plot:
A dot plot provides information in the form of dots. A dot plot can be used to
visualize several data points for each category on the x-axis. For example, the
following dot plot shows the minimum, the maximum, and the mean number of
pounds of strawberries sold for each day of the week during the twelve-week
period.
m
co
a.
cm
am
Bar Chart:
h
ef

A bar chart is useful for comparing a statistic across groups. The height of the bar
or the length of it, if the bar is displayed horizontally, displays the value of the
statistic.
The previous bar chart shows the mean number of pounds of strawberries sold per
day over the twelve-week period. Thus, the Monday sales figure is the average of
twelve Mondays, and so forth for each of the days of the week. This chart can be
used to easily visualize which are the heaviest days of the week for selling
m
strawberries in order to place orders at the appropriate times.
co
The following horizontal bar chart is used to show not only the mean sales in
pounds for each day of the week but also the minimum sales and maximum sales
for each day, which are also important information.
a.
cm
h am
ef
Here is the same information presented vertically:

Pie Chart:
A pie chart is in the form of a circle that portrays one value for each category,
marked as pieces of a pie, and what percentage of that value is made up of different
pieces, the size of the “pieces” helps the user to visualize the relative sizes of the
mean sales for each day.
A limitation of the pie chart is that it can present only one value for each category.
m
co
a.
cm
am
So, the pie is the week sales and each section of that pie is the daily average sales
Line Chart:
h
ef

A line chart can be used to visualize several observations for each category, using
one line for each observation. The strawberry sales data are shown on the previous
line chart as the minimum, the maximum, and the mean values for each day of the
week for the twelve-week period.
Bubble chart:
A bubble chart replaces data points with bubbles that vary in size according to the
m
size of the values they depict, thus adding an additional dimension to the chart: the
relative sizes of the values plotted on the chart, so is not what is high and what is
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down in the place on the chart only but also the size of the bubble.
The following bubble chart shows the means of the strawberry sales for each day
of the week.
a.

cm
h am
ef
Histogram:

The previous histogram shows how many days during the twelve-week period the
sales of strawberries were between 1 and 20 pounds, how many days between 21
and 40 pounds were sold, and so forth.
A histogram shows the frequencies of a variable using a series of vertical bars. The
values of the variable may occur over a period of time, or they may be as of a
moment in time, so it demonstrates how often historically did each of these events
happen.
m
A histogram looks similar to a bar graph. However, it is different from a bar graph
in that a bar graph relates two variables to one another, whereas a histogram
co
communicates only one variable.
a.
cm
h am
ef
Boxplot:
A boxplot is another type of chart that is used to display the full distribution of a
variable. A boxplot shows the minimum, the first quartile, the median, the mean,
the third quartile, and the maximum for each day of the week, as well as individual
observations for each day of the week, it a lot more of information here.
In the table that follows, the data on daily strawberry sales for the twelve weeks
have been re-ordered by day from the smallest value to the largest value for that
day. Ordering the data in that way makes apparent the minimum, median, and
maximum values for each day of the week and the approximate values for the first
and third quartiles.

m
co
a.
cm
h am
ef
the boxplot chart may not be appropriate for summering data, as it maybe more
information demonstrated, or may not be able to be understood by everybody,
especially on a higher level of management.
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October 2020 CMA Handouts

Part one - 2020

Part 1: Financial Planning, Performance, and Analytics

Instructor, Tarek Naiem, CMA 1 of 543

a- Regression Analysis ................................................................................................................... 204

Instructor, Tarek Naiem, CMA 2 of 543

3. Absorption and Variable Costing .................................................................................................. 323

Instructor, Tarek Naiem, CMA 3 of 543

2. Internal Controls ........................................................................................................................... 416

Instructor, Tarek Naiem, CMA 4 of 543

Section A) External Financial Reporting Decisions … 15%

1. Basics of Financial Accounting

Primary users Internal managers External users: investors,

Instructor, Tarek Naiem, CMA 5 of 543

Financial reporting objectives:

a.The compliance of the entity to the

Direct Users Indirect Users

Directly affected by the results of a Users with indirect interests such as

1) Investors or potential investors 1) Financial advisers and analysts

3) Employees 3) Regulatory authorities

2) Creditors deficiencies (SWAT analysis), to

Therefore, regarding this aspect we have to look at

Instructor, Tarek Naiem, CMA 7 of 543

GAAP: represent the U.S standards, which is referred to as Generally Accepted

Tarek Naiem, CMA, Online course

Basic Financial Statements are:

2) Income statement, statement of earnings

The notes to the financial statements (such as management discussions and

Instructor, Tarek Naiem, CMA 8 of 543

Relationship among the financial statements:

Accrual accounting: is to record the financial transactions when they occur,

cash will be received in a future period.

cash will be paid in a future period.

To enhance the usefulness of the information provided by the financial statements,

Instructor, Tarek Naiem, CMA 9 of 543

2. Statement of Financial Position (balance sheet)

Assets = Liabilities + Equity

The purposes (use) of balance sheet report:

of the business, and predicting a company’s future cash flows.

3) Can also be used in financial statement analysis to assess the company’s

Instructor, Tarek Naiem, CMA 10 of 543

Elements of the balance sheet: Three conditions

dividends and contributions.

Statement of financial position (Balance sheet) at XX/XX/XXXX

Account receivables current notes payable

Inventory Noncurrent liabilities:

Instructor, Tarek Naiem, CMA 11 of 543

Current and noncurrent assets:

raw materials and work-in-process.

expenses are not convertible to cash.

Instructor, Tarek Naiem, CMA 12 of 543

4) Restricted Cash: An Asset That Could be Either Current or Non-Current

• Petty cash and payroll funds or funds to be paid in dividends

regulations against exportation of money

Instructor, Tarek Naiem, CMA 13 of 543

Deposits held as compensating balances to support borrowing arrangements

Main categories of current liabilities:

recognition standard, ASC 606, to transfer goods or services to a customer

as when the entity expects to satisfy its performance obligations—over time

4) Short-term notes payable (30, 60, 90 days)

Current liabilities do not include:

Instructor, Tarek Naiem, CMA 14 of 543

1) Capital contributions by owners: par value or stated value of issued shares