Year 12 Accounting

1. Year 12 Accounting Chapter 17 Budgeting

2. Budgets • So far this text has dealt only with historical transactions, concentrating on how to identify, record and report events that have already occurred. This is a logical starting point to analyse business performance, as without information on what has already happened, we are unable to identify areas that may need to be improved. However, it is also important to keep an eye on the future. • Budgeting is the process of preparing reports that estimate or predict the financial consequences of likely future transactions.

3. Reports • A small business owner could prepare a budget on just about any area of business performance, ranging from how many sales are made in a month, to how much will be spent on advertising, and how many returns will be made. In this course, we will concentrate on three general-purpose budgets: • The Budgeted Cash Flow Statement, which shows all expected future cash inflows and cash outflows, the actual cash balance at the start of the period, and the expected cash balance at the end of the period.

4. Reports 2. The Budgeted Profit and Loss Statement, which shows all expected future revenues and expenses, and the expected Gross profit, Adjusted gross profit and Net profit. 3 Budgeted Balance Sheet, which shows all expected assets, liabilities and owner’s equity at some point in the future.

5. Sales • Accounting reports are interconnected, with transactions reported in one affecting items reported in another, and this is no different for budgets. This means it is essential that the preparation of budgeted reports begin with an accurate estimate of budgeted sales. • First, Sales is the main revenue item in the Budgeted IncomeStatement, and generates significant cash inflows (either as Cash sales or as Receipts from debtors if credit sales are involved). Second, the level of sales will be crucial in estimating the expenses that vary with the number of units sold (like Cost of Sales and Wages), and their corresponding cash outflows. Third, the level of sales will affect how much stock is purchased, which will in turn affect cash paid to creditors.

6. Balance Sheet • The Balance Sheet does not report sales directly, but because it uses figures derived from the other two reports, its accuracy is also dependant on an accurate estimate of sales. • (At the very least, the expected Bank figure will come straight from the Budgeted Cash Flow Statement, and the expected Net profit or loss will be determined in the Budgeted IncomeStatement).

7. The Budgeting Process • It has been said that failing to plan is planning to fail, so the preparation of budgeted reports should be one of the first steps in starting a new business. However, budgeting should be a continuous process; budgets should be compared against actual reports to allow problems to be identified, decisions should be made based on that assessment, and then new budgets should be prepared for the next period. This budgeting process is shown in Figure 17.1 p. 390. • A budget has limited value if it is not used to make decisions to improve business performance in the future. In addition, it makes little sense to develop a budget for one period without preparing another budget for the next period.

8. The Budgeting Process • The information presented in the budgeted reports should be based on the historical data, but allowances must be made for changes and the effect of new business decisions. • (Obviously, a brand new business will not have any historical data on which to rely – this makes budgeting harder for new businesses, but no less important.)

9. Budgeted Cash Flow Statement • In order to survive, a small business must have sufficient cash to meet its obligations. • In order to do this, the business must generate sufficient cash inflows, chiefly through its cash sales and receipts from debtors. The Budgeted Cash Flow Statement attempts to predict all future cash inflows and cash outflows, and thus the estimated cash balance at the end of the budgeted period, to assist the owner in assessing the firm’s ability to meet its obligations over the budget period. • Remember that the Cash Flow Statement classified the inflows and outflows as Operating, Investing and Financing activities, and these classifications must also be present in the Budgeted Cash Flow Statement.

10. Operating Activities • Operating activities: all cash flows related to the firms day-to-day trading activities.

11. Operating Activities • By preparing the Budgeted Cash Flow Statement, the owner will be forewarned if the operating cash flows are expected to be negative. Owners can then take steps to address the cash shortage before it occurs by: • implementing strategies to increase expected inflows. These may include: • increasing sales (via promotions, greater advertising, discounting prices) • increasing receipts from debtors (via offering discounts, contacting slow payers, sending reminder notices). • implementing strategies to decrease expected outflows. These may include: • deferring payments to creditors • cutting back on cash paid for expenses.

12. Operating Expenses • The owner must be particularly mindful of reducing cash paid for expenses, as the benefits the expenses provide are vital in the earning of sales (and hence the generation of cash inflows); cutting expenses may actually make the cash situation worse rather than better.

13. Investing and Financing Activities • Investing activities: all cash flows relating to the purchase or sale of non-current assets.

14. Investing and Financing Activities • Financing cash flows: all cash flows that are the result of changes in the firm’s financial structure.

15. Denzel Washing Machines • Reading skills are essential in budgeting questions; you will find most of the answers in the question itself if you look hard enough. • Note not all the transactions are reported in the Budgeted Cash Flow Statement, because not all involve cash. In this example, Credit sales and Credit purchases (including the GST on the transaction), Cost of Sales, Stock Loss, Depreciation of Office Equipment, and Drawings of Stock have all been excluded.

16. Consecutive Budgets • The budget above relates only to one month taken in isolation, but it would be wise for a business to prepare budgets for consecutive months to show the effect of monthly variations. That is, separate budgets for March, April, May etc. could be prepared and presented side-by-side to show trends in inflows and outflows from month to month. Such a budget may appear as is shown in Figure 17.3.

17. Consecutive Budgets • This type of budget allows the owner to identify monthly and even seasonal trends, and can be very useful for identifying when to undertake a particular cash activity (such as the purchase of a non-current asset or repayment of a loan). • In general, more frequent budgets will be more accurate, and therefore more useful as benchmarks for comparison. In addition, they will allow for the earlier detection of problems.

18. You! • Review Questions 17.3. • All of them!

19. USES OF THE BUDGETED CASH FLOW STATEMENT Planning • The Budgeted Cash Flow Statement aids planning by allowing the owner to prepare in advance for an expected cash surplus or cash deficit. Should the budget predict an overall cash deficit, the owner might: • defer the purchase of non-current assets, or use credit facilities or a loan for their purchase • defer loan repayments • take less cash drawings • make a cash capital contribution • organise (or extend) an overdraft facility.

20. USES OF THE BUDGETED CASH FLOW STATEMENT • Should the budget predict an overall cash surplus, the owner might use the extra cash to: • purchase more/newer non-current assets • increase loan repayments • increase cash drawings (this sounds good) • expand trading activities by increasing advertising, employing more staff etc. • Alternatively, a business starting a period with a bank overdraft may choose to do nothing, and let the expected cash surplus bring their bank balance back into the black.

21. USES OF THE BUDGETED CASH FLOW STATEMENT Decision Making • In addition, the Budgeted Cash Flow Statement aids decision-making because it sets a benchmark for the assessment of the firm’s actual cash performance. By comparing budgeted and actual cash flows, the owner can identify problems areas, and then act to correct the situation. • Specifically, the owner could assess: • debtor collection procedures • creditor payment policies • the level of cash drawings.

22. CALCULATING CASH FLOWS • Schedule of receipts from debtors • In the example in 17.2, we reported Receipts from Debtors in the Budgeted Cash Flow Statement rather than Credit Sales, as we were interested only in reporting cash flows. This distinction is very important; the credit sale and receipt of the cash may even take place in different reporting periods. In some cases, it may be necessary to calculate how much will be received from debtors during the budget period from credit sales made in previous periods (and in some cases, the current period).

23. CALCULATING CASH FLOWS • Based on the information in the Debtors Ledger, owners can estimate what percentage of debtors pay within a month of the sale, within two months and so on, thereby allowing them to calculate the expected receipts from debtors for the budget period. This calculation is facilitated by the preparation of a Schedule of Receipts from Debtors. • If we were preparing a Budgeted IncomeStatement, we would not have to make any calculations, as we already have information relating to expected sales revenue for each month. However, in order to prepare a Budgeted Cash Flow Statement, we need to calculate expected Receipts from Debtors. • First we must calculate how much of the total sales figure is cash sales, and how much is made on credit. This is shown in Figure 17.4.

24. CALCULATING CASH FLOWS • Note that we have used the sales plus the GST, as both amounts will eventually be cash inflows. • The cash sales figures for October to December can go straight into the Budgeted Cash Flow Statement (as Operating inflows) as they represent cash flows in the months when the sale is made (Cash sales for July to September are outside the budget period, and so are excluded.) Remember that of the cash received, part is cash sales (10/11), and part is GST received (1/11); each must be reported separately in the Budgeted Cash Flow Statement (see page 395).

25. CALCULATING CASH FLOWS • However, we need to calculate how much cash will be received in October to December as a result of credit sales in earlier months. This requires more information about the repayment patterns of the firm’s debtors. • In the textbook’s example, the owner expects 25% of debtors to pay in the month after the sale. These debtors receive a 5% discount. Of the remainder, 60% of debtors pay two months after the sale, and 15% pay in the third month after sale. • Based on this information, we can prepare a Schedule of receipts from debtors like the one shown in Figure 17.5.

26. CALCULATING CASH FLOWS • If we examine the amount owing for credit sales made in September, we can see how the calculations were made. Based on the analysis of when debtors pay, 25% of the September credit sales figure ($19 360) less the 5% discount will be collected in the month after the sale, i.e. in October.

27. Budgeted Cash Flow Statement • If we add up all the figures in the columns for October, November and December, we can calculate estimated Receipts from debtors for each month. This information can now be reported in the Budgeted Cash Flow Statement, along with the cash sales (and GST) figures we had already calculated. • See p. 395. • Note that for Receipts from debtors, there is no separate GST amount, because the GST was recognised when the credit sale occurred. It is only for cash sales that we must identify the sales component and the GST component separately.

28. Schedule of payments to creditors • This technique can also be applied to calculate payments to creditors, with Credit Purchases substituting for credit sales. Once again, we require information on how frequently creditors are paid so that we can calculate when, and how much, creditors will be paid during the budget period. • You! • Review Questions 17.5. • Questions 3 & 4.

29. BUDGETED PROFIT AND LOSS STATEMENT • A Budgeted Profit and Loss Statement attempts to predict revenues and expenses for the budget period. • Cash vs. Profit • Cash and profit are different measures of performance, and therefore the items reported in the Budgeted IncomeStatement will not necessarily be the same as those reported in the Budgeted Cash Flow Statement. Whereas the Budgeted Cash Flow Statement reports expected cash inflows and cash outflows over the budget period, the Budgeted IncomeStatement reports expected revenues earned and expected expenses incurred over the budget period.

30. BUDGETED PROFIT AND LOSS STATEMENT • As some cash items are not revenues or expenses, they will be omitted from the IncomeStatement. • Strictly speaking, cash sale from an NCA represents revenue. However, it is only the overall profit (or loss) on the disposal that is reported in the Budgeted IncomeStatement.

31. BUDGETED PROFIT AND LOSS STATEMENT • The Budgeted IncomeStatement will include some revenues and expenses that are not reported as cash flows:

32. BUDGETED PROFIT AND LOSS STATEMENT • Some of the items will be affect both budgets, but the amounts may differ:

33. BUDGETED PROFIT AND LOSS STATEMENT • See Denzel’s Washing Machines example on p. 402. • Uses of Budgeted Incomestatements: • the level of sales (and the effectiveness of advertising) • the mark-up achieved • the level of stock loss (to assess stock management procedures) • expense control • staff performance. • You! • Review Questions 17.6 • Q1.

34. BUDGETED BALANCE SHEET • The Budgeted Balance Sheet attempts to predict the firm’s assets, liabilities and owner’s equity at some point in the future. • See example p. 404. • Uses of the Budgeted Balance Sheet: • By detailing the expected carrying value of non-current assets at some time in the future, it helps the owner prepare for their replacement. When used in conjunction with the Budgeted Cash Flow Statement, it can also be used to plan for the repayment of loans, and to set the level for drawings for the coming period. In addition, it can assist decision-making by setting a benchmark for indicators that assess liquidity and stability (stability is not assessed). Specifically, it will allow the owner to calculate the budgeted Working Capital ratio, which can be used to assess liquidity.

35. Account Reconstruction • The example illustrated how ledger accounts can be used to calculate closing balances for the Budgeted Balance Sheet. However, this is not the only use of ledger accounts in the budgeting process. If we already know the closing balance, we can actually work backwards to calculate other figures which may be necessary to complete the Budgeted Cash Flow Statement, or the Budgeted Profit and Loss Statement. • Where only some information is known, we can use our knowledge of ledger accounts and double entry accounting to calculate missing or unknown figures by reconstructing the relevant ledger account. Reconstructing a ledger account involves three steps: • Step 1 Identify the entries we would expect to see in a particular ledger account. • Step 2 Match these entries with figures that are known. • Step 3 Complete the ledger account to calculate the figures that are not known.

36. Account Reconstruction • See Kings Sportswear example p. 406. • Note the Study Tips. • The data is sufficient to prepare the Budgeted IncomeStatement as Credit Sales is known ($80 000), and the Budgeted Balance Sheet can be prepared as Debtors at the end is known ($15 000). However, the Budgeted Cash Flow Statement cannot be prepared, as Receipts from Debtors is unknown. We do not have sufficient information to prepare a Schedule of Receipts from Debtors, but we can reconstruct the Debtors Control account.

37. Account Reconstruction • Note particularly the Stock Control account. • Note that although Cost of Sales may involve two entries in the ledger, it would only be reported as a single figure. Note also the links between the Creditors Control and Stock Control accounts relating to credit purchases and purchase returns.

38. Account Reconstruction • This list is by no means exhaustive – any ledger account could be reconstructed to calculate a missing figure, for any of the three general-purpose budgets. The only restriction is that we need to know three of the ‘big four’ pieces of information. For debtors and creditors, this means at least three of: • 1 opening balance • 2 closing balance • 3 credit sales/credit purchases • 4 receipts from debtors/payments to creditors. • For stock, it means three of: • 1 opening balance • 2 closing balance • 3 cost of sales • 4 purchases (cash or credit). • If we know only one or two of the big four, we have insufficient information to reconstruct the account.

39. VARIANCE REPORTS – CASH AND PROFIT • A Variance Report compares actual and budgeted figures, highlighting any significant differences (which are known as variances), so that problems can be identified and corrected. It is prepared once the actual figures are available, but before the next budget. • In this course, we will prepare two Variance Reports: • Cash Variance Report • Profit Variance Report

40. Cash Variance Report • A Cash Variance Report compares actual and budgeted cash flows. In appearance, it is very similar to a Budgeted Cash Flow Statement, but is has additional columns for actual figures, and the calculation of the variance. Figure 17.8 shows the Cash Variance Report for Denzel Washing Machines for March 2016. • Avariance is simply the difference between the budgeted figure and actual figure. Whether it is favourable or unfavourable depends – in the Cash Variance Report – on its effect on cash. A variance is favourable (F) if it means cash will be higher than expected in the budget; a variance is unfavourable (U) if it means cash will be lower than expected in the budget.

41. Cash Variance Report • Note that in our example, the variance in the Loan – AXC Bank is reported as favourable because cash will increase more than expected. The fact the liabilities will also increase does not affect its classification in the Cash Variance Report. • Note also payments to creditors is classified as favourable, even though it could mean the balance owed to creditors is higher than expected. • Assuming the variances are not caused by poor estimates, then the Cash Variance Report is a valuable aid to decision-making. The unfavourable variances should be investigated, and their cause identified. This will allow the owner to take corrective action. In our example, Denzel Washing Machines may be concerned at the unfavourable variance in Receipts from debtors; does it indicate a decline in credit sales, poor collection policies, or something else?

42. Profit Variance Report • In the same way that a Cash Variance Report compares actual and budgeted cash flows, a Profit Variance Report can be prepared to compare actual and budgeted revenues and expenses. • Variances in this report are classified as favourable or unfavourable depending on their effect on profit. In the Budgeted IncomeStatement, a variance is favourable (F) if it means profit will be higher than expected in the budget; a variance is unfavourable (U) if it means profit will be lower than expected in the budget.

43. You! • Read Summary. • Do minimum five end of chapter exercises. • Read Chapter 18 Where Are We Headed?