IBDL level 1

Understanding Financial Information

and Accounting

Managerial Accounting and the

Budgeting Process
(Case studies)
1

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LECTURE LINKS
LECTURE LINK 7-1

Managerial Accounting and the Budgeting Process

In addition to the balance sheet, income statement, and cash flow statement, managers need other forms
of financial informationespecially for the budgeting process. They also need this information to help
make decisions such as when to replace a machine, whether to hire extra people, how much wages can be
raised, and if advertising should be increased or decreased. Detailed reports are needed on such things as
departmental costs, special projects, cash flow, financial analyses, taxes, and labor costs. These reports,
which are a part of managerial accounting, do not have to be standardized but can be tailored to the firms
individual needs.

BUDGETING AND BUDGETARY CONTROL

Two of the primary functions of management are planning and control. When these two functions are
combined with the accounting techniques we have studied, they provide one of managements most
useful tools: the budgeting process. This process, in turn, involves both budgeting and budgetary control.
Budgeting is simply stating in dollars-and-cents terms what the firm wants to accomplish in a given
period of time. Most individuals have some informal plan at the beginning of the month as to how they
are going to spend their money. They know, in general, what their expected income is and what expenses
they must use that money for.
Businesses must use more formal plans, but they follow the same procedure an individual does
determine how much revenue will come into the firm, divide that revenue among the expenses, and
determine the expected profit or loss from operations. In essence, the firm is preparing a planned
income statement when it sets up a budget.
The starting point in budgeting is estimating expected revenue, which is the total amount of goods or
services that company expects to sell. For management to get an accurate figure, the firms sales
department must give a realistic estimate of probable sales. This figure will be a blend of past sales
figures, expected business conditions, and company objectives. For example, if 1,200,000 units are to be
sold, and the expected price per unit is $7.00, the total revenue should be $8,400,000.
Next, expected expenses are calculated by the departments in the firm that will be involved. The
production department should submit a plan showing how much it will cost to produce those items,
including such costs as raw materials, wages, electricity, and maintenance. The marketing department
should develop a plan for sales activities such as advertising, personal selling, and sales promotion. Then
administrative, depreciation, and other costs must be computed.
After all the firms departments have submitted their estimates, management can calculate the projected
net income by subtracting total expected expenses from expected revenues.
At this point, management adds its plans and projections to the raw figures and begins fine-tuning the
budget. The departmental budgets may be sent back for further work and the first few steps repeated until

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a comprehensive budget acceptable to all is created. Each department then develops a departmental
budget based on the figures in the comprehensive budget.
The budgeting process does not end here. The only thing you have at this point is a plan, stated in
monetary terms, of what you expect to do during the next year. Unless budgetary control is added, the
budget becomes useless. Budgetary control involves comparing actual performance against planned
performance and taking corrective action if differences are found.
For instance, the production department budget may call for spending $490,000 each month to produce
one months output of 100,000 units. If, at the end of the month, the chief accountant finds that $505,000
has been spent, he or she knows that actual expenses are exceeding planned expenses by $15,000 and can
notify the production manager to take corrective action. (CRITICAL THINKING EXERCISE 12-1,
Budgetary Control, gives the student the ability to practice budgetary control.)
With this information, the manager can investigate the problem. Are raw materials being wasted? Was
there an increase in the cost of these materials? On the basis of the results of this investigation, a change
may be made in production methods or a new supplier may be found. If it is found that the original budget
was not realistic, the budget itself may be changed to show realistic goals. In this way, management
makes adjustments in order to meet the goals it has set. Budgets and budgetary control are excellent
planning and control tools.

DETERMINING COSTS AND SETTING PRICES

The income statement shows an item called cost of sales or cost of goods sold, which includes
various costsmaterial, labor, and overhead. Analyses that are more detailed can be made to relate these
costs to each product, and costs can be compared with the income from the sales of that product. This
shows what the present cost/profit situation is at a given level of sales. Another study is usually made to
find out what the situation would be if sales increased or decreased.
Each company has its own approach to cost accounting. Some emphasize quality, others price. Cost
analysis provides a basis for determining which approach to follow. All involve a trade-off of value
against cost.

DECIDING ON CAPITAL INVESTMENTS

Managers must make daily and long-term capital investment decisions. Daily decisions may be made on
whether to use machine A or machine B for a given operation. Should a salesperson visit customer X on
this trip or the next? Should Joness order be produced today to assure on-time delivery, or can it wait?
Capital investment decisions are concerned with changes in fixed assets that affect longer periods of time.
Should a manual operation be replaced with a machine? Should a piece of equipment be replaced, rebuilt,
or discarded? Many of these decisions involve large sums of money and have long-term effects on the
company. Special consideration must therefore be given to such decisions, including such factors as
interest charges and the unavailability of money for other purposes, called opportunity cost.
These and other capital investment studies consume much time and involve many people. They also
involve the use of detailed accounting records to obtain costs for their analysis.

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LECTURE LINK 7-2

Auditing the Audit Process

The independent audit once occupied a lofty spot in corporate reporting. It was perceived as the ultimate
business reality check that ensured a companys financial statements were accurate and prepared
according to Generally Accepted Accounting Principles (GAAP). Unfortunately, accounting scandals at
companies such as Enron, WorldCom, Tyco, and Global Crossing questioned the legitimacy and accuracy
of the once respected process. The fallout, however, had much more severe repercussions in the industry.
The scandals led to the demise of one of the largest and most respected accounting firms in the United
States, Arthur Andersen. The company was convicted of obstruction of justice for its actions in the Enron
case. The accounting misdeeds also inspired the U.S. Congress and the U.S. Securities and Exchange
Commission (SEC) to impose vast new reporting and auditing requirements on businesses.
The Sarbanes-Oxley Act of 2002 attempts to regulate financial markets and prevent financial fiascos such
as Enron and WorldCom from cheating unsuspecting investors. The legislation enacted several key
reforms:
(1)

The law prevents public company auditors from serving as business consultants to firms
they audit. However, auditors can provide a tax preparation role at such companies.

(2)

The Public Company Accounting Oversight Board was created to oversee public company
accounting.

(3)

Roles and duties for audit committees of public companies were to be expanded.

(4)

Executives of publicly-held companies are required to sign off on their firms financial
statements and vouch for the effectiveness of financial controls.

The roles and duties for audit committees within companies were crafted by the Securities and
Exchange Commission. The new rules require accounting firms to follow specific dos and donts in what
kinds of non-audit services they can provide firms that they audit. For example:
(1)

Audit firms must disclose how much money they were paid from audit and non-audit
services provided to a client.

(2)

The top two accounting partners working for a particular client must rotate off the account
after a five-year period and wait at least five years before returning to that audit
assignment.

(3)

Outside auditors may not join the client firm and oversee the auditing firms work until
after a one-year cooling off period.

(4)

Auditors are also barred from offering other services such as the design and installation of
financial information systems, appraisal services, actuarial services, investment banking
services, legal advice, and management and human resource functions.

A result of the new rules set forth by Congress and the SEC is that the role of internal auditors within a
company had to be beefed up. In fact, most would argue that when it comes right down to it, the
financial and operations policing of company operations should be an inside job, done by an internal
auditor. Internal auditors need to keep an eye on a companys controls not just its financial

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Operations. In the case of the WorldCom disclosures, it was Cynthia Cooper, an internal auditor at
the company, who blew the whistle on the firm for inflating its profits to the tune of $3.8 billion.
The Sarbanes-Oxley Act and administrative regulations from the SEC (discussed above) has led to a
surge in demand for people trained in the internal-audit field. William Bishop III, president of the
Institute of Internal Auditors (IIA), said job postings on the organizations website have more than
doubled in the year since the law was passed. Bishop also notes that a company with $3 billion to $4
billion in revenues typically now employs about 16 internal auditors.
If you are interested in pursuing a career in the internal-audit field, its important to keep a few points in
mind. The main goal of the internal audit is to make sure the systems already in place within the
company are working correctly. The internal auditor also must know the company inside-and-out but
still have enough independence to give honest feedback and advice when its needed. Finally, guts also
help. Anyone considering a career in internal auditing should have the guts to speak out and most
importantly the ability to tell the truth.i

LECTURE LINK 7-3

The Power of the Internal Auditor

The largest bankruptcy in U.S. history was the 2002 collapse of telecom giant WorldCom. The companys
downfall was caused by a fraudulent $11 billion accounting scheme. The unlikely heroine at the center of
this story is an internal auditor who wouldnt stop asking questions.
Cynthia Cooper admits that she was literally scared to death during the process of uncovering
WorldComs fraudulent activities. In the course of a routine internal audit into the obscure area of line
cost expenses, Cooper uncovered something that didnt look right. Other executives told her she was
wasting her time and the departments resources by pursuing the audit. But she never allowed herself to
be intimidated. It was the urging to move onto something else that encouraged her to keep looking. Her
department eventually discovered $3.8 billion in fraudulent accounting involving line feesfees
WorldCom paid to other telephone companies for the right to use their lines.
Cooper said there was a spider web of entries used to disguise the fraud, and after her auditing staff traced
them backward and forward, they still couldnt understand what was happening. When she confronted
former controller David Myers about the entries, he was honest and said there was no support to back up
the accounting.
According to Cooper, the internal audit department never considered backing down once they began the
investigation. We were at a crossroads, Cooper said of the internal auditing team. The decision to
come forward was easy, but doing the right thing doesnt come without a cost. The role of whistleblower
isnt one she relishes.
The WorldCom debacle eventually sent several executives to prison. Bernie Ebbers, former chief
executive officer and co-founder, was sentenced to 25 years after being found guilty of fraud and
conspiracy for his role in the accounting scheme. This is the harshest sentence ever given in a white-collar

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criminal case. Scott Sullivan, the former chief financial officer who testified against Ebbers, received
five years. Cooper has trouble reconciling those sentences.
Cooper now runs Cynthia Cooper Consulting Company and spends a great deal of time speaking on the
events surrounding the WorldCom scandal. Small decisions matter. Make sure your moral compass is
pointed at true North. Never allow yourself to be intimidated.ii

LECTURE LINK 7-4

Its the Earnings That Count

Marvin Morriss firm, In-Person Payments, runs payment centers in inner city stores that allow people
without checking accounts to pay their bills. His long-standing approach to profit management: when he
made enough money, hed hire somebody. Marketing and expansion efforts were also financed using this
bootstrapping approach.
Morriss company has been a financial success, with revenues of nearly $18 million and 3,000 stores in
20 states. But when he approached venture capitalists to fund his expanding enterprise, he was surprised
at the bargain basement valuation calculated by the venture capitalists. The VC were impressed with InPersons ability to grow so quickly with so little capital, and they liked the companys mainly Hispanic
customer base, a fast-growing segment of the population.
What they didnt like was the companys low EBITDA, or earnings before interest, taxes, depreciation,
and amortization. EBITDA is basically the firms net earnings from normal operations. Morris had always
used revenue as his measuring system, and revenue was growing quickly. But most venture capitalists
look at the bottom line, the companys earnings after operating expenses are deducted. That figure lets
investors determine a companys profitability, regardless of industry or accounting method.
To get a better EBITDA, Morris needed to cut expenses. He cut $100,000 from his marketing budget and
dismissed nearly half of his staff. The company even negotiated a lower rate on its phone service.
The increase in earnings was almost immediate. The company went from running at breakeven to posting
$1.4 million in EBITDA in one year. Investors were also impressed. He has attracted venture capitalists
willing to invest up to $3.5 million to expand In-Person Payments nationally.iii

LECTURE LINK 7-5

Using the Statement of Cash Flows

Rather than studying the income statement, many investors are choosing to look beyond that list of a
companys revenues and expenses to the cash flow statement. And because cash flow is key to financing
many takeovers and leveraged buyouts, understanding and profiting from acquisitions often means
understanding figures such as operating cash flow and free cash flow.
Companies do not go out of business because they report net losses. They fade away because they run out
of cash. Monitoring your ability to generate cash flow is critical to success. To maximize long-term value,

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a company must continually evaluate its consistent capacity for generating cash. Commercial lenders
realize that it is cash flow, not net income, which will repay their loans.
The true definition of cash flow is unclear. It is one of the most over used and least agreed upon terms in
corporate finance. Cash flows can be divided into three primary categories:

Cash flows from operating activities.

Cash flows from investing activities.

Cash flows from financing activities.

Cash flow is often a better measure of company health than earnings, analysts say, because
earnings can be puffed up or hidden through accounting changes or other manipulations that dont reflect
the true state of a companys business. When times are tough, companies can fool around with tax rates
and make timing adjustments. Due to such manipulations, many analysts rate the usefulness of cash flow
statements far above earnings statements.
In todays competitive environment, it is vital for the owner/operator to monitor current and future cash
flow requirements. Careful tracking of cash flow is especially important for industries facing seasonal
fluctuations, such as the retail industry. These companies must prepare projections of cash inflows and
outflows, preferably on a monthly basis, but certainly no less than on a quarterly basis. A forecast of the
companys monthly balance sheet is also important to show its financial position and available assets,
such as accounts receivable and inventory, which can be used as collateral for working capital loans.
Based on these projections, periods of negative cash flow will be highlighted and anticipated. To lessen
the effect of periods of negative cash flow, many factors should be considered, including the companys
business cycle and its ability to fund the negative cash flow period.
In anticipation of these down times, its necessary to pay particular attention to cash-producing assets,
such as accounts receivable, and cash-flow-draining liabilities, such as accounts payable. Steps to speed
up time for collections of receivables might include reducing the time between the sale and mailing the
invoice to the customer or changing sales terms to cash on delivery. It may also be worthwhile to meet
with the companys banker to review the cash flow requirements of the company and obtain a seasonal
line of credit to cover the negative cash flow periods.
Cash flow can be used in different ways for different types of companies:

For developing companies, cash flow and free cash flow are usually negative, because the
company is burdened with low sales and one-time expenses necessary to build the business.
Matching the cash being lost in a cash flow statement to the assets on hand to pay bills can
predict how long the company can survive.

Minding cash flow is especially crucial in energy and real estate companies, whose bottom
line often is obscured by heavy depreciation and depletion allowances.

Companies that recently have made takeovers often have depressed earnings because they
must write off massive amounts of goodwill carried on their balance sheet. The goodwill
comes from paying a premium over a companys book value to buy the company.

Monitoring cash flows is crucial to a companys success. As owners and financial statement users become
more familiar with the concept and use of cash flow ratios, their decision-making process will improve
greatly and become more focused on the cash flow impact of their decisions.

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LECTURE LINK 7-6

Knowing the Numbers

Employees at Setpoint know more about their companys finances than most investors do. Setpoint is a
custom-manufacturing company with 30 employees and a little more than $6 million in sales. Most of its
revenues come from designing and building factory-automation equipment, a highly competitive
business.
In the shop, a spacious, well-lit room, ten employees work on half a dozen machines. Off to one side is a
large whiteboard on a wall next to a canteen area. Scribbled across the board are about 20 rows and 10
columns of numbers forming a table, with a few dollar signs sprinkled here and there. Setpoints CEO,
Joe Knight, says, Thats our board. Its how we trace our projects and figure out whether or not were
making money. Knight can explain what all the numbers mean, but more surprisingly, so can individual
workers.
One worker explained how the GPgross profitis calculated and how much he and other workers had
earned the previous week on each project. He pointed out the column showing each projects GP per hour
and explained the importance of keeping that number in mind. He said he also watched the ratio of overall
GP to OEoperating expensessince thats how you know if the company was making money. He
added that he like to see it running at about 2.0.
CEO Knight explained that the people on the shop floor all had it down like that. It was their scoreboard.
It was the way they could tell if they were winning or losing.
The whiteboard began in November 1998 when Knight was still the Chief Financial Officer. Setpoint had
been on a growth binge and was pushing the limits of its credit line. The banks loan officer was breathing
down his neck. Wed had three months of losses, and we were running the company on our credit line,
but Id told the bank wed break even in November and get back to profitability by December. Then I got
the numbers for the first week of November, and they were awful. We just had too many projects that
were losing money.
Knight didnt have the board back then, but he was using the same system on a spreadsheet. Knight
handed it out to everybody and then talked to Steve Nuetzman, the lead engineer. Knight remembers
saying Look at this, Steve. Were losing money again. If we dont do something, were going to max out
our credit line, and then were really going to be in trouble with the bank.
Nuetzman got the message. On the following Monday, when Knight looked at the spreadsheet for the
previous week, he was stunned to see that the situation had been turned completely around. Virtually no
work had been done on the money-losing projects. Instead people had focused almost all their attention
on the projects with higher gross-profit margins, so the company had made money for the week.
I went right over to Nuetzman and congratulated him. I was pretty excited because it meant Id be able to
go to the bank and say, See, I said we could turn it around, and we did. How many companies can find
out theyre losing money in the first week of November and turn it around like that? Not many.
According to Nuetzman, it wasnt a big idea, really. We just looked at the projects we had and realized
we could shuffle resources around. They got the delivery dates on the less profitable projects extended
and turned them over to contract labor. Then they put their high-powered internal resources on the most
profitable projects.

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The accounting system was developed by Joe Cornwell and Joe VanDenBerghe, who cofounded
Setpoint in 1992 and, with Knight, developed its management system. In order to create a projectmanagement system that worked, they realized theyd have to delve into the accounting processes, which
plays a major role in the way projects are tracked.
Cornwell eventually introduced unconventional accounting ideas. I didnt agree with the textbook about
the way you should do things. For example, they said you should treat labor as a variable cost. Well, you
cant treat labor as variable ... Its stupid to treat your regular employees as a variable cost, because the
cost doesnt vary in reality. You cant hire and fire people as the work comes in and goes out. Even if you
were a hard, cruel bastard, you couldnt do it. Nobody would come to work for you if you did.
Cornwell, VanDenBerghe, and Knight decided early that Setpoint would be an open-book company. To
get employee involvement, they put great emphasis on financial training and sharing information. Then in
1998 a project engineer hit upon an idea to communicate the numbers. Instead of the weekly spreadsheet,
why not put the same information up where everybody could see it? Thus the board was born. iv

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