Accounting for non financial manager exam reviewer summarized lectures with sample computations

Analysis of Short-Term Decisions
CONTRIBUTION MARGIN APPROACH
revenues
less
vc mfg
less
vc s&a
total vc

= rev – total vc
less
less

contribution
margin

1,000,000 favourable

700,000 unfavourable

300,000 favourable

fc mfg
fc s&a
total fc

OI

= CM – Total fixed costs = operating
income

FULL ABSORPTION COSTING
revenues

1,000,000 favourable

less

COGS
gross margin

➔ V&F

less

S,G & A exp
total sg&a exp

Prodn Costs

700,000 unfavourable
➔ V&F
S&A Exp
300,000 favourable

operating income

differential costs and revenues.
→those that change as a result of a decision. Variable costs are normally differential costs, and fixed costs are normally
not differential costs.
In making a decision, the only elements that are relevant are those that are differential to the decision.

With the differential cost information, the decision maker is now in a position to make an informed decision. The answer
may still be negative because of other qualitative factors. For example, Gery’s may perceive that lowering the cost to
this customer would have knock-on effects with other customers, who would also negotiate for lower prices. Or Gery’s
may consider that additional contribution of $5,000 not to be worth the effort of the additional production.
Capacity Issues:
If there is insufficient spare capacity, then either more capacity would have to be added (at an additional cost) or sales
to “regular” customers would have to be sacrificed, with an associated loss of contribution margin.
Using unused capacity is, effectively, free. Where there is no unused capacity, then capacity has to be created and this
always has a cost.

We should also recognize the potential drawback associated with failing to supply the regular customers with the
products they normally buy from Gery’s. There are few things more expensive in the business world than a dissatisfied
customer. Unfortunately, it is very difficult to put an accurate dollar value on dissatisfaction and, for that reason, it is
frequently omitted from the calculation.
Sunk Costs:
One of the costs that is always irrelevant is a sunk cost. A sunk cost is one that has already happened or has been
committed, so that it is unavoidable.
Sunk costs are typical when the financial accounting model uses matching to spread a cost incurred in one period to
future periods where the use is to continue.
Depreciation is the most frequently found sunk cost.
Committed Costs:
A committed cost is one that the organization is obliged to incur, even though it has not yet been spent.
An example of a committed cost is the rent payable on a lease, or the salary of an employee on a five-year
employment contract.
Such costs may be treated exactly the same way as are sunk costs.
Short-Term vs. Long-Term:
➔ The shorter the timespan of the decision, the more likely that the differential cost and revenue will be the
appropriate way to make the decision.
➔ As timespans get longer, the choices available to the organization become wider, and the marginal approach to
cost will give way to something nearer to a full-cost model.
➔ In the longer term, fixed costs must be covered by contribution from the various activities of the company, and full
costs have a role to play in establishing the fair share each product or service must generate.
Short-term Decisions and the Functional Manager:
Many of the costs in a human resources department are either fixed costs, or committed costs. As such, when a
decision is made to change management practice, those costs are unlikely to go away. The costs merely remain
unchanged, making some potential cost savings illusory.
Summary
In the short term, capacity constraints and unused capacity are unalterable; but as the decision horizon becomes longer,
it will be possible to raise or lower capacity to deal with capacity constraints and unused capacity.
Full costs tend to give inappropriate short-term signals for decisions; but as the decision horizon gets longer, full costs
become more appropriate measures of the relevant costs. In the very long term, all costs, fixed and variable, must be
covered by revenues, or the organization will fail.
By now we have covered several different ways how to classify costs that organizations incur, such as direct and indirect
or variable and fixed. The chosen cost classification depends on the purpose of labelling costs, such as raw materials,
rent, or depreciation.

Sources of Capital
decision activities:
raising capital, and

investing capital.

Common Shares:
➔ The double entry principle tells us that for every investment in an asset, there must have been a source of capital
of the same value.
➔ All organizations will have some capital provided by the owners to get the company going.
➔ In a sole proprietorship, this is owner’s equity. In a partnership, this is owners’ equity
➔ In a corporation (a limited liability company), this is common stock (otherwise known as common shares or
ordinary shares).
➔ We shall concentrate on corporations, as they are the most important type of business structure.
➔ The share certificate is an acknowledgement that the investor owns, literally, a share in the business.
➔ The nature of the residual interest makes common shares a relatively high-risk investment for shareholders and,
by counter argument, a relatively low-risk source of capital for the company.

Net Income and Dividends:
➔ When a company generates sales revenue, its first obligation is to pay expenses that were incurred. What is left
over is net income, which is beneficially owned by the shareholders.
➔ They do not always get their hands on it, however, due to the existence of dividend policies, which are under the
control of the board of directors.
➔ Companies are owned by their shareholders, but they are frequently run by others. Called directors.
➔ In smaller (typically family-owned) businesses, the shareholders may be the directors.
➔ In larger companies, publicly traded on a stock exchange, the directors are elected by the shareholders to manage
the company, but the shareholders themselves play no part in the day-to-day management of the company.
➔ Directors’ choices are to pay the net income to the shareholders as a dividend(1. Investors); to retain the net
income in the company for reinvestment(2 Directors’); or to pay some as dividend, and retain the rest for
reinvestment(3).
➔ Dividend cover ratio = net income ÷ dividend
➔ dividend payout ratio = Dividend / Net Income x 100%
➔ Share price increases are frequently referred to as “capital growth”.

Stock Splits:
➔ the total value of the company remains unchanged, as does the balance sheet value of the common shares. The
number of common shares, however, is increased. value of each individual share should fall in proportion to the
rate of the split.

Stock Dividends:
➔ wishes to pay a dividend, but has insufficient liquidity to pay the dividend in cash, may pay a stock dividend.
➔ shareholders can sell these in the stock market, turning their stock dividend into a cash dividend.

➔ the market value of the new shares issued is deducted from retained earnings and added to common stock

Retained Earnings:
➔ are profits made by the company, but not distributed as dividends to shareholders.
➔ The company that always pays out 100% of its net income as dividend will maintain its common equity at the
same level
➔ The company that pays out less than 100% of its net income as dividend will grow.
➔ The amount ploughed back will be invested in new assets, and total company assets will increase.
➔ Where retained earnings are significant, the market value of the common shares is likely to be much higher than
the amount originally contributed to the company for the shares.
Preferred Shares:
➔ A preferred share is a share that has some preferential right attached to it. (right to receive a dividend before the
common shareholders, usually at the expense of losing voting rights.)
Variations on the theme of preferred shares, include:
➔ Redeemable: a redeemable preferred share is required or allowed to be repaid at some future time. Common
shares are not redeemable;
➔ Convertible: a convertible preferred share is one that is allowed or required to be exchanged for common shares
at some future time;
➔ Cumulative: a cumulative preferred share is one that allows unpaid preferred dividends to accumulate, and only
after all arrears of preferred dividends are paid can common shareholders get any dividend;
➔ Participating: a participating preferred share is one that enjoys the regular dividend preference at a set rate, and
is also entitled to a further dividend on a par with the dividend paid out to common shareholders;
➔ Capital preference: in a winding up of the company, a preferred share may carry the right to repayment of its
nominal amount before the common shareholders;
➔ Voting preference: some preferred shares carry a right to outvote common shares in company meetings

Equity Capital: In order, preferred shares listed first, followed by common shares, then retained earnings.
➔ pool of capital with two important features:
First, it does not have to be repaid (with the exception of redeemable preferred shares). This means that it is low risk
for the company. There is never a threat to the liquidity situation from having to repay the capital.
Second, it is rewarded through the payment of dividends, and dividends do not have to be paid if the directors are
against them. Again, this is a low risk for the company. But note that for the investor it is a high risk as the entire
amount, invested into the company, can be lost in case of bankruptcy.

➔ Contributed surplus: this is the excess amount received for shares over their nominal value
➔ Accumulated other comprehensive income: It refers to those revenues, expenses, gains, and losses that generally
accepted accounting principles exclude from net income.

Cost of Equity:
➔ Equity has a cost to the company.
➔ The company’s profits are the source of investors’ rewards: they can be paid to the investor as they are earned in
the form of a dividend
➔ The return to the shareholders is a combination of dividends received and growth in share price.

Debt:
➔ Debt is a creditor relationship.
➔ Debt has an interest obligation and a repayment obligation, and so it is much riskier for the company.
There are several features of debt that need to be described, and we shall do that under these headings:
Level;

Interest;

Repayment;

Security.

Debt Level: The level of debt is commonly expressed as a ratio.
Debt-to-equity ratio: = total debt / total equity x 100%

(potentially infinitely large)

Debt-to-assets ratio: = total debt / total assets x 100%

(cannot exceed 100%)

➔ The higher the level of debt, the greater the risk of default.
➔ debt-to-equity ratios of more than 100% are regarded as excessive.
➔ debt-to-asset ratios of more than 50% are regarded as excessive
Debt Interest:
➔ When a company borrows, there is a contractual relationship that provides interest payments.
➔ The interest is normally expressed as an annual percentage rate on the amount outstanding.
➔ high-risk source of capital for the company, but a low-risk investment for the lender.
➔ company’s ability to service its debt interest is measured by the interest cover ratio;
o Operating income (income before taxes and interest) divided by interest expense (interest earned ratio)
➔ The smaller the interest cover ratio, the higher the risk that interest cannot be paid.
➔ it is a tax-allowable expense, unlike a dividend.
➔ After-tax interest rate = nominal interest rate × (1-tax rate)
➔ If the nominal interest rate is 10%, and the marginal tax rate is 40%, then the after-tax interest rate is 6%.
Debt Security:
➔ lender will reduce risk exposure by taking a legal charge against some assets of the company(Mortgage).
Mortgagors limit their risk further by lending (typically) 80% or less of the Assest’s value. If the mortgagee
defaults, the house may be seized and sold to pay off the debt. This reduces the risk for the lender.
Debt Reporting:
➔ When the debt is recorded in the balance sheet, it is required that the interest rate, the repayment terms, and any
security be disclosed, too. (has to take place in the “notes to the accounts”)

Debt, Risk, and Financial Leverage:
1. Equity capital has a cost to the company represented by shareholder’s expectations of a return.

2. Debt has a cost to the company represented by interest paid. Because interest is a “tax allowable” expense, its
net cost is the gross amount of interest less the tax savings it causes.

The Weighted Average Cost of Capital:
If the company is financed partly by equity and partly by debt, then its cost of capital will be a weighted average of the
cost of equity and the cost of debt, weighted according to their relative proportions on the balance sheet. This is called
the weighted average cost of capital.

Financial Leverage:
➔ If a company uses a judicious amount of debt to finance its investments, it can engage in financial leverage.
➔ cost of common stock as its cost of capital, which is normally a relatively high cost.
➔ If cost of debt is lower than the cost of equity, its cost of capital overall will fall.
➔ debt capital is cheaper than equity capital {the combined result of lower risk and the tax effect}.
➔ Typically, debt ratios greater than 50% (which is equivalent to a debt-to-equity ratio of 100%) are regarded as the
limit for prudent investors.
➔ Borrowings increases the earnings for the common shareholders, but also increases their volatility.(effects)
In a levered company any change in operating income magnifies the change in return on equity. The return on equity
has become more variable.
Business incubators or accelerators provide support for the start of new businesses by providing resources and services
as well as by sharing business experience and networks.
In the first financing stage of new ventures, the seed funding stage, typically business angels come on board, whereas
venture capital firms join for the growth phase.
Summary:
In capital structure, there is a fundamental choice between debt and equity financing.
Equity is lower risk, but higher cost;

debt is higher risk, but lower cost.

A reasonable level of debt will minimize the cost of capital, as this will make the company more profitable for the
equity shareholders. At extremely high levels of debt, there is a risk of bankruptcy, so high levels of debt are to be
avoided.
Minimizing the cost of capital is important, as we shall see in the next chapter: it is a constraint on what projects the
company can invest in.

Long-Term Decision Making or Capital Budgeting Decisions
Long-term decisions are those such as buying new equipment, moving to new premises, and launching new products.
These decisions are critically important as they commit the organization to a particular way of doing things over a
number of years. Additionally, the long-term decisions tend to involve large amounts of money.
By making such decisions in a more structured and thoughtful way, we try to avoid committing significant amounts of
money to a direction that will not help the organization achieve its long-term objectives.

three main decision analysis techniques:
payback; →fails to consider what happens after the investment is repaid!
the return on investment;
present value
All proposals must provide the same quality and quantity of information, including the following:
a strategic analysis;
the amount of the investment;
the effect on revenues, costs and profits;
the effect on cash flows; and
a consideration of the risk.
Strategic Analysis:
➔ strategy is chosen to achieve objectives.
➔ Operational activities are initiated to give effect to the strategy.
Long-term decisions should be ways of moving that strategy forward.
A proposal that does so is worthy of further consideration, and a proposal that militates against the strategy should be
rejected.
Strategy could include ideas such as being a “least cost” manufacturer. For that strategy proposals that increase
production efficiency are appropriate.
Strategy could equally well be based on consumer satisfaction through product differentiation. In that case, a proposal
that increases the range of products, or their suitability to meeting the needs of customers, would be ideal.
Strategy & Ethics
Capital projects frequently have strong ethical implications. Assessing whether or not a proposal contravenes ethical
standards is part of deciding whether or not to proceed with the economic analysis.
Management’s decision to block this shareholder resolution involves considering the ethics of capitalism, the ethics of
the ecological lobby, and the ethical position of the company. In the view of the dissenting shareholders, Exxon Mobil
may be perceived as having allowed the economic aspects to take precedence over the ethical dimension.
Economic Analysis:
Most proposals (or projects, as they are often called) will call for an investment of a substantial amount of cash at the
beginning, and they will generate cash and earnings over a period of years.
The key to any decision-analysis technique is that it should measure whether the future returns justify the investment.
➔ depreciation expense is not relevant to a payback calculation, as it is not represented by a cash flow.
1 Payback:
The payback technique is quick and easy, but it fails to consider:
1. What happens after payback is complete, and;
2. The pattern of cash flows within the payback period.

Payback period = Initial Investment / Cashflows

2 Return on Investment:
ROA = (operating income ÷ total assets) × 100%
ROI = (operating income from the investment ÷ investment)×100%

Return on Average Investment

➔ In general, either ROI or ROAvI ratio will be compared with some sort of standard or expectation, to be
regarded as acceptable.
➔ superior to payback as it uses the estimated income from all six years of the project’s life.
➔ still a deficient technique because it does not consider the pattern of cash flows over the life of the project any
more than the payback does.

3 Present Value:
➔ it represents the value today of a sum of money
➔ The assessment of a project should be based on its cash flows;
➔ To make them comparable, we first need to discount a future cash flow back to the present time by allowing for
the interest effect. This calculates its present value;
➔ When the present values of all the cash flows from a project are added, a project with a positive net present value
will increase the value of the firm,
➔ while a project with a negative net present value will decrease the value of the firm.
The present-value approach underpins techniques with the following names:
➔ present value;
➔ net present value;
➔ discounted cash flow;
➔ discounting;
➔ internal rate of return.
Discounting:
If a present amount can grow to a larger future amount through the process of compound interest, then a future
amount can be expressed as its present equivalent by eliminating the interest opportunity.
Discounting uses the inverse of the compound interest factor, the formula is
PV = FV×(1 / (1 + i)n)
Annuities:

Or, if you prefer:

PV = FV / (1 + i)n.

A series of cash flows that is the same each year for a period of time is called an annuity.
PV of an annuity = annual amount × annuity discount factor

Weighted Average Cost of Capital: See Excel
Uncertainty:
Proposals that involve brave new ventures (introduction of new products, excursions into new markets) offer the least
reliability and the greatest levels of uncertainty. Such proposals are often the most lucrative, as well as being the
riskiest.
Sensitivity Analysis:

Summary:
Long-term decisions have to be carefully vetted to make sure they move the company forward toward its strategic
objectives.
Such decisions may be assessed using payback, return on investment, and present value. Of these, present
value is far more rigorous than the others.
Because these projects are about the future, there is risk involved, and that is another dimension to be considered in
making the decision.

Accounting and Personal Finance
◼ Calculate financial situation
◼ Analyze financial situation
◼ Develop and update a personal financial plan
◼ How to use debt to your advantage
◼ Good debt vs bad debt
◼ Compound interest and effect on your personal financial plan
◼ General principles of investing
The Financial Planning Process Five Steps (Plan)
1. Determine your financial situation
2. Setting financial goals
3. Identify and evaluate alternative courses of action
4. Create a financial action plan
5. Adjustments to cash flow in order to meet your short-term and long-term objectives

Step 1 – Determine your financial situation
How often should a net worth evaluation be performed?
There is no specific timeline, but it is recommended to be performed at a minimum once a year.
– If an individual’s net worth is increasing it implies that they are on the right track to fund their short-term and longterm goals.
–

If an individual’s net worth is decreasing, it should bring awareness that expenses should be decreased.

Assets such as:
–

Cash, bank accounts, savings accounts, investments, property, vehicles & other

–

Exclude assets such as clothing and household equipment

Deduct, Liabilities such as:
–

Car loans, credit card balances, lines of credit, mortgages,

–

Amounts owing to friends/family

Assets – Liabilities = Net worth (either positive or negative)

Cash Flow Analysis
i)

Cash flow positive (Your income exceeds your expenses)
– This is great, continue on the same course!

i)

Cash flow neutral (Your income equals your expenses)
– Look into decreasing some expenses.

i)

Cash flow negative (Your expenses exceeds your income)
– Try and reduce discretionary expenses.

Step 2 – Set Financial Goals
Examples of short-term goals:
–

Save for a trip to Europe

–

Pay off your credit card debt

–

Buy a used car

Examples of long-term goals:
–

Buy a condo or house

–

Save for retirement

–

Pay off your student loan

Step 3 – Identify and evaluate alternative courses of action:
Basic tenet of personal finance is that you should spend less than you earn on an after-tax basis.

Therefore, there is an opportunity cost. Which is deciding to forego current wants to help you achieve your short-term
and long-term goals.
Positive cash flow – Where income is higher than expenses
–

Ensure you are saving at least 10% of your after-tax income.

–

If funds continue to grow (his savings) consider investing funds for the short-term and long-term goals to
ensure his savings exceed inflation

Negative cash flow – Where expenses are higher than your income
–

Increase income

–

Decrease expenses

–

Change nothing (eventual bankruptcy, credit will be non-existent for 7 years).

Step 4 – Create a Financial Action Plan
–

All individuals who are trying to improve their financial situation need to establish an action plan in order to
provide structure in achieving their goals.

–

Focus on the short-term goals such as paying high interest credit card debt first

–

Once all high-interest debt has been eliminated ensure you are cash flow positive

–

Cash flow positive will enable you to eliminate low-interest debt such as student debt.

–

Start saving for S/T and L/T goals in conjunction with repayment of low-interest debt

Step 5 – Management of Personal Cash Flow
For an action plan to achieve its goals, monitoring and revisions as time passes is critical.
Technology can assist you in tracking your income and expenses.
–

Consider applications that can be downloaded onto your smartphone

Track expenses manually
–

Tedious

–

Benefit of ‘feeling’ the expenses as you incur them.

Accounting and Investing
➔ Wealth gives you the opportunity to spend.
o If you spend it on consumption, the wealth disappears.
o If you purchase a physical asset that has a long life (i.e. a house or diversified investments) you have
something for the future.
Investing is the process of deferring consumption to increase your wealth!
➔ Purchase investments for the long-term.

Some Considerations of Investing
Risk and Return
–

The higher the risk, the higher the expected level of return you should achieve.

–

A Guaranteed Investment Certificate (GIC) is as stated guaranteed and therefore your rate of return is small

–

Investing in a marketable security is not guaranteed and therefore your rate of return is expected to be much
higher

Time Horizon and Balance
–

Only invest money you do not expect to need in the short-term

–

Purchase of individual securities is not recommended

–

A balanced portfolio of 60% equity and 40% fixed income should help you weather the storm.

Chapter 18 – Elements of Taxation for Individuals and Small Businesses
◼ Treatment of various types of income
o
o
o

o

Canada has a graduated rate tax system→ This means the more you earn in any given year, the higher
your marginal (and average) tax rate.
Employment, self-employment, rental and interest income -Every dollar that is earned increases your
taxable income
Dividends:
▪ Eligible dividends are preferred since the dividend tax credit mechanism gives them preferential
treatment. (i.e. a higher tax deduction)
▪ Non-eligible dividends are usually dividends paid out by private corporations to their owner
managers that have only been taxed at the small business tax rates (Approx. 15%)
Capital Gain (Capital Loss)
▪ Refers to the gain or loss realized on the disposal of capital property (only 50% of gain is taxable)

◼ How to start a business
◼ Different types of business structures
o

o

o
o

Sole Proprietorship
▪ Activity is summarized on a Statement of Business or Professional Activities T2125 on that
individual’s personal tax return
▪ Proper set of books and records are required to be kept for 7 years
▪ Liability exposure could be an issue
Partnership
▪ General Partnership
– All partners are joint and severally liable
▪ Limited Partnership
– 1 general partner, 1 or more limited liability partners
▪ Limited Liability Partnership – Provincially regulated
Small Business Corporation -Separate legal entity from its shareholders and directors

◼ Legal issues in structuring your business
◼ Understand marginal tax rates

o
o
o

Sales Tax Reporting – (Monthly, Quarterly or Annually)
GST, HST, QST (all consumption taxes)
Required to withhold and remit on behalf of your employees (monthly)

◼ Employer payroll(monthly) and sales tax requirements (Monthly, Quarterly or Annually)
o
o
o
o
o
o

Consist of federal, provincial taxes
Canada Pension Plan (CPP) both employer + employee portions
Quebec Pension Plan (QPP) both employer + employee portions
Employment Insurance (EI) both employer + employee portions
WSIB remittances
Employer Health Tax (if certain conditions are met)

All Individuals, Corporations and Trusts are obligated to file a tax return on a yearly basis
–

Individuals by April 30th (June 15th if you or your spouse are self-employed)

–

Corporations any fiscal year end the directors choose

Notices of Assessments, Interest and Penalties
–

Notice of assessments are issued by the Canada Revenue Agency

–

Right to appeal if individual does not agree

–

If late filing, interest and penalties will accrue

–

Interest and penalties are not tax deductible

◼ Owner manager remuneration – sole-proprietorship vs. corporation
◼ Capital gains exemption on sale of Qualified Small Business Corporation
◼ Tax evasion vs. tax avoidance
o

o

Income Tax Evasion
▪ Conscious decision to ignore income tax laws to avoid paying taxes
▪ ‘Cash’ deals
▪ Avoid sales taxes, federal and provincial taxes
Income Tax Avoidance
▪ Is a method of income tax planning
▪ Technically in compliance with the Income Tax Act

Tax Planning for the Business
–

Ensure that all possible deductions are taken

–

Deductible for accounting and tax are different (Consult a tax professional for more details)

–

Buy capital assets before the end of your fiscal year. Dep’n is always at 50%

–

Start as a sole-proprietor

–

Once your business is deemed to be profitable consider incorporation

–

Losses in a sole-proprietorship will offset other sources of income earned during the calendar year

–

Seek the advice of a lawyer for regulatory or liability concerns when incorporating or entering into a partnership

–

Maintain adequate books and records for at a minimum 7 years

–

Maximize use of employer provided benefit programs

–

Consider deducting RRSP contributions to a year whereby you will be in a higher marginal tax rate

–

Spousal RRSP plans (avoid attribution rules)

–

Lifelong Learning Plan (LLP)

–

Tax Free Savings Accounts (TFSA)

…