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Free Accounting Course: Accounting and Finance for Non-Specialists

Accounting and Finance for Non-Specialists

Budgeting – Chapter 9 Preview


This chapter is concerned with budgets. Budgeting is an activity that most business managers see as one of the most crucial in which they are engaged. We shall consider the purpose of budgets and how they fit into the decision-making and planning process.

We shall also consider how budgets are prepared. Preparing budgets relies on knowledge of the financial statements (balance sheet and income statement (profit and loss account)) that we considered in Chapters 2 and 3.

It also picks up many of the issues relating to the behaviour of costs and full costing, topics that we explored in Chapters 7 and 8, respectively. Lastly, we shall take a look at how budgets are used to help exercise control over the business to try to ensure that its objectives are achieved.


Learning outcomes

When you have completed this chapter, you should be able to:

  • define a budget and show how budgets, corporate objectives and long-term plans are related;
  • explain the interlinking of the various budgets within the business;
  • indicate the uses of budgeting, and construct various budgets, including the cash
  • budget, from relevant data;
  • use a budget to provide a means of exercising control over the business.

Budgets, long-term plans and corporate objectives

We saw in Chapter 1 that it is vital that businesses develop plans for the future. Whatever a business is trying to achieve, it is unlikely to be successful unless its man- agers have clear in their minds what the future direction of the business is going to be. Thus the starting point is to identify, as precisely as possible, the long-term objectives to be pursued. Once this has been done, the various options available to fulfil these objectives should be evaluated. The most appropriate option(s) should be selected and plans developed on the basis of this selection.

Businesses typically produce a long-term plan, perhaps going five years into the future, and a short-term plan normally looking at the following 12 months.

The planning sequence can be shown graphically, as in Figure 9.1. We can see that the overall objectives are first defined; they are then translated into long-term plans of action. These objectives are achieved by successfully working towards short-term plans or budgets.

Accounting and Finance for Non-Specialists-The planning process

The long-term plan would define the general direction of the business over the next five or so years and would deal, in broad terms, with such matters as:

  • the market that the business will seek to serve;
  • production/service rendering methods;
  • what the business will offer to its customers;
  • target levels of profit and returns to shareholders; n financial requirements and financing methods;
  • personnel requirements;
  • bought-in goods and services requirements and sources.

The budget is essentially a business plan for the short term. It is likely to be expressed mainly in financial terms, and is designed to convert the long-term plan into an actionable blueprint for the future. The budget will define precise targets for:

  • sales revenues and expenses;
  • cash receipts and payments;
  • short-term credit to be given or taken; n inventories (stock) requirements;
  • personnel requirements.

Clearly, the relationship between objectives, long-term plans and budgets is that the objectives, once set, are likely to last for quite a long time, perhaps throughout the life of the business (though changes can and do occur). A series of long-term plans identify how the objectives are to be pursued, and budgets identify how the long-term plan is to be fulfilled.

An analogy might be found in terms of someone enrolling on a course of study. His, or her, objective might be to have a working career that is rewarding in various ways. The person might have identified the course as the most effective way to work towards this objective.

In working towards achievement of the objective, passing a particular stage of the course might be identified as the target for the forthcoming year. Here the intention to complete the entire course is analogous to a long-term plan, and passing each stage is analogous to the budget. Having achieved the ‘budget’ for the first year, the ‘budget’ for the second year becomes passing the second stage.

It should be emphasied that planning is the role of management rather than of accountants. The role of the management accountant is simply to provide technical advice and assistance to managers to help them plan.



Guided tour of the book

1 Introduction to accounting and finance

Learning outcomes
What are accounting and finance?
Accounting and user needs
Not-for-profit organisations
Accounting as a service function
The threshold of materiality
Costs and benefits of accounting information
Accounting as an information system
Planning and control
Management and financial accounting
The scope of this book
Has accounting become too interesting?
Why do I need to know anything about accounting and finance?
Business objectives
Key terms
Further reading
Review questions



2 Measuring and reporting financial position

Learning outcomes
The major financial statements – an overview
The balance sheet
The effect of trading operations on the balance sheet
The classification of assets
The classification of claims
Balance sheet formats
The balance sheet as a position at a point in time
Accounting conventions and the balance sheet
Accounting for goodwill and product brands
The basis of valuation of assets on the balance sheet
Interpreting the balance sheet
Key terms Further reading Review questions Exercises

3 Measuring and reporting financial performance

Learning outcomes
The income statement (profit and loss account)
Relationship between the income statement and the balance sheet
The format of the income statement
The income statement – some further aspects
Profit measurement and the recognition of revenue
Profit measurement and the recognition of expenses
Profit measurement and the calculation of depreciation
Profit measurement and inventories (stock) costing methods
Profit measurement and the problem of bad and doubtful debts
Interpreting the income statement
Key terms
Further reading
Review questions

4 Accounting for limited companies

Learning outcomes
Generating wealth through limited companies
Managing a company – corporate governance and the role of directors
Financing limited companies
Raising share capital
Loans and other sources of finance
Restriction on the right of shareholders to make drawings of their claim 119
Accounting for limited companies 122
The directors’ duty to account 126
The need for accounting rules 126
The main sources of accounting rules 126
Directors’ report 127
Auditors 128
Accounting rules and the quality of financial statements 129
Summary 132
Key terms 134
Further reading 134
Reference 135
Review questions 135
Exercises 135

5 Measuring and reporting cash flows

Introduction 139
Learning outcomes 139
The cash flow statement 140
The main features of the cash flow statement 142
Preparing the cash flow statement 149
What does the cash flow statement tell us? 156
Summary 159
Key terms 160
Further reading 160
Review questions 161
Exercises 161

6 Analysing and interpreting financial statements

Introduction 167
Learning outcomes 167
Financial ratios 168
Financial ratio classifications 169
The need for comparison 170
Calculating the ratios 171
A brief overview 173
Profitability 174
Efficiency 180
The relationship between profitability and efficiency 185
Liquidity 187
Financial gearing 189
Investment ratios 195
Trend analysis 203
Ratios and prediction models 205
Limitations of ratio analysis 205
Summary 207
Key terms 208
Further reading 208
Review questions 209
Exercises 209


7 Cost–volume–profit analysis

Introduction 217
Learning outcomes 217
The behaviour of costs 218
Fixed costs 218
Variable costs 221
Semi-fixed (semi-variable) costs 222
Break-even analysis 223
Contribution 228
Margin of safety and operating gearing 228
Profit-volume charts 232
Failing to break even 233
Weaknesses of break-even analysis 233
The popularity of break-even analysis 234
Marginal analysis 235
Accepting/rejecting special contracts 237
The most efficient use of scarce resources 238
Make-or-buy decisions 240
Closing or continuation decisions 242
Summary 244
Key terms 245
Further reading 245
Review questions 245
Exercises 246

8 Full costing

Introduction 249
Learning outcomes 249
The nature of full costing 250
Deriving full costs in a single-product operation 250
Deriving full costs in multi-product operations 251
Activity-based costing (ABC) 267
Uses of full-cost information 272
Criticisms of full costing 274
Summary 274
Key terms 276
Further reading 276
References 276
Review questions 277
Exercises 277

9 Budgeting 280

Introduction 280
Learning outcomes 280
Budgets, long-term plans and corporate objectives 281
Time horizon of plans and budgets 282
Budgets and forecasts 283
The interrelationship of various budgets 284
The uses of budgets 286
The extent to which budgets are prepared 288
Preparing the cash budget 289
Preparing other budgets 293
Using budgets for control 298
Comparing the actual performance with the budget 300
Standard quantities and costs 311
Reasons for adverse variances 312
Investigating variances 313
Compensating variances 315
Making budgetary control effective 316
Limitations of the traditional approach to control through
variances and standards 316
Behavioural aspects of budgetary control 317
Summary 319
Key terms 320
Further reading 320
References 321
Review questions 321
Exercises 321


10 Making capital investment decisions

Introduction 327
Learning outcomes 327
The nature of investment decisions 328
Methods of investment appraisal 329
Accounting rate of return (ARR) 331
Payback period (PP) 336
Net present value (NPV) 340
Why NPV is superior to ARR and PP 347
Internal rate of return (IRR) 348
Some practical points 352
Investment appraisal in practice 356
Summary 359
Key terms 361
Further reading 361
References 361
Review questions 362
Exercises 362

11 Managing working capital

Introduction 367
Learning outcomes 367
The nature and purpose of working capital 368
The scale of working capital 370
Managing inventories (stock) 371
Managing receivables (debtors) 381
Managing cash 389
Managing trade payables (creditors) 396
Summary 398
Key terms 400
Further reading 400
Review questions 401
Exercises 401

12 Financing the business

Learning outcomes
Sources of finance
Internal sources of financing
Long-term sources of internal finance
Short-term sources of internal finance
Sources of external finance
Long-term sources of external finance
Gearing and the long-term financing decision Share issues
The role of the Stock Exchange
Short-term sources of external finance
Providing long-term finance for the small business Summary
Key terms
Further reading
Review questions

Present value table
Glossary of key terms
Relevant websites
Appendix A: Solutions to self-assessment questions
Appendix B: Solutions to review questions
Appendix C: Solutions to selected exercises



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