answers to practice questions

8/12/2019 Answers to Practice Questions

http://slidepdf.com/reader/full/answers-to-practice-questions 1/81

Answers to Practice Questions



Business Accounting – Answers to Practice Questions

1

Introduction to the second edition

Business Accounting is an accessible, non-technical introduction to financial and

management accounting primarily intended for non-specialist undergraduate and

postgraduate students. The active-learning approach helps students gain an

understanding of the subjectivity inherent in accounting and the ability to evaluate

financial information for a range of business purposes.

This edition of Business Accounting features comprehensive revisions. There are new

chapters on the regulatory and conceptual frameworks, and on the preparation of single

entity and consolidated financial statements under IFRS. The revised chapter onfinancial statement analysis takes a case study approach and has been given a strong

user focus. For more advanced students of financial accounting, there is a new chapter

on ethics, corporate governance and corporate social responsibility. The chapters on

management accounting have been updated and there is a new chapter that discusses

new issues, such as strategic management accounting, market-oriented accounting,

target costing, the balanced score card, accounting for quality and environmental

accounting. Many of the case studies are set in an international context.

Teaching and learning resources include activities in the text and exam-style practice

questions at the end of each chapter. There are also detailed PowerPoint slides with

integrated exercises, a lecture workbook and interactive progress tests on the website.

In addition, there are chapters and associated teaching and learning materials on

subjects not covered in the current edition.




2

Contents

Part I The world of accounting and finance ........................................................... 3

1. Introduction to business accounting .................................................................... 3

2. The importance of cash....................................................................................... 4

Part II Financial accounting ..................................................................................... 7 3. The accounting system ....................................................................................... 7

4. Regulatory framework for financial reporting ..................................................... 10

5. Conceptual framework for financial reporting .................................................... 13

6. Statement of comprehensive income ................................................................ 16

7. Statement of financial position .......................................................................... 22

8. Consolidated statement of financial position ..................................................... 32

9. Financial statement analysis ............................................................................. 34

10. Ethics, governance and corporate social responsibility ................................... 41

Part III Management accounting ........................................................................... 43 11. Importance of cost information ........................................................................ 43

12. Costing for product direct costs ....................................................................... 46

13. Costing for indirect costs ................................................................................. 49

14. Activity-based costing ..................................................................................... 52

15. Marginal costing .............................................................................................. 55

16. Budgetary planning and control ...................................................................... 58

17. Standard costing ............................................................................................. 62

18. Capital investment appraisal ........................................................................... 64

19. Discounting methods of investment appraisal ................................................. 64

20. Issues in management accounting .................................................................. 71




3

Part I The world of accounting and finance

1. Introduction to business accounting

The following narrative answers are indicative of the main points in the chapter.

1. Describe the advantages and disadvantages of the money measurement concept and explainwhy students studying business and management should learn about accounting.

The money measurement concept states that only items that can be measured in monetary terms areincluded in the financial statements. The main advantages are that it makes it easier to aggregate andsummarise transactions, and compare financial statements. In addition, the concept is appropriate asbusiness is about money, and it is easily understood and convenient for internal and external users of

the financial statements. The main disadvantages of the monetary measurement concept are that itlimits the usefulness of information in the financial statements because non-financial items areignored (eg loyalty of workforce, management skills, size of customer base). In addition, the value ofmoney is not stable due to inflation/deflation and, if business has international transactions, the valueof money fluctuates with exchange rates.

The main reason why business and management students should learn about accounting is that it willenhance their future employability. Irrespective of whether they become entrepreneurs and start theirown businesses or find jobs in large, small or medium-sized entities, they will need a basicunderstanding of accounting. This is because they will need to understand the financial and otherquantitative information that accounting provides to help them to control the resources for which theyare responsible, plan how those resources can be most effectively used and decide what course ofaction they should take when a number of options are open.

2. Define the term accounting and explain the difference between the two main branches ofaccounting.

In its broadest sense, accounting can be defined as a service provided to those who need financialinformation. Law (2012, p. 6) is more specific and defines accounting as „the process of identifying,measuring, recording and communicating economic transactions ‟. There are two main branches ofaccounting:

Financial accounting is concerned with classifying, measuring and recording the economictransactions of an entity in accordance with established principles, legal requirements andaccounting standards. It is primarily concerned with communicating a true and fair view of the

financial performance and financial position of an entity to external parties at the end of theaccounting period.

Management accounting is concerned with collecting and analyzing financial and otherquantitative information. It is primarily concerned with communicating information to managementto help effective performance measurement, planning, controlling and decision making. Therefore,the main differences between the two branches of accounting are that financial accounting isguided by a regulatory framework and focuses on meeting the needs of external users (those notinvolved in managing the business), and management accounting is unregulated and focuses onmeeting the needs of internal users. However, both branches of accounting draw on the samedata sources to generate financial information.




4

3. Explain the concept of limited liability and the advantages of a company over an unincorporatedbusiness.

Limited liability means that on liquidation, the liability of the members of a limited liability company orlimited partnership for the debts incurred by the entity is limited to the capital they have invested(including any amount owing). The liability of the members can be limited by shares or limited byguarantee.

Limited liability for the debts of the business is the main advantage that an incorporated business hasover an unincorporated business. An associated advantage is that if one of the members of anincorporated business dies, his or her shares can be transferred to someone else and the businesscontinues, whereas an unincorporated entity has a finite life. The indefinite life of an incorporatedentity is possible because complementary to the concept of limited liability for members is „the notionthat the company is a separate “legal person” distinct from the members and the directors‟ (Mallettand Brumwell, 1994, p. 7).

4. Compare and contrast the advantages and disadvantages of public and private companies.

Once of the main advantages of a public limited company is that it can advertise its shares for sale tothe public and, if it is listed on the stock exchange, its shares can be traded in the stock market.However, a private limited company‟s shares cannot be advertised and can only be offered for saleprivately. One of the main advantages of a private company is that, unlike a public listed company, itis not obliged to comply with stock exchange regulations and most small private companies do nothave to disclose as much financial information as a public company. In addition, the formalities forsetting up a private limited company are less complex than for a public company.

5. Describe the two underlying assumptions that underpin financial accounting and reporting,

providing examples to illustrate your explanations.

The two underlying assumptions are the going concern concept and the accruals concept:

The going concern concept is based on the principle that the entity is a going concern and will

continue in operation for the foreseeable future. Therefore, unless it is known otherwise, it is

assumed that the entity is not intending to close down or significantly reduce its activities (IASB,

2010). If that presumption is not valid, the financial statements will need to show the assets of the

business at their break-up value and any liabilities that are applicable on liquidation. The going

concern assumption is confirmed by IAS 1, Presentation of Financial Statements (IASB, 2011),

which requires management to look at least 12 months ahead to assess this and, if there is

significant doubt over the entity's ability to continue as a going concern, those uncertainties must

be disclosed, together with the basis used.

The accruals concept is the principle that revenue and costs are recognized as they are earned

and incurred not as cash is received or paid (the realization concept), and they are matched with

one another (the matching concept) and dealt with in the income statement of the period to which

they relate (the period concept).




5

2. The importance of cash


1. Define finance and explain why students studying business or management should learn aboutthe management of money.

Finance is „the practice of manipulating and managing money‟. It can also be used to describe „thecapital involved in a project, especially the capital needed to start a new business [or] a loan of moneyfor a particular purpose, especially by a financial house‟ (Law (2010, p. 185). The main reason whybusiness and management students should learn about finance is that it will enhance their futureemployability. Irrespective of whether they become entrepreneurs and start their own businesses orfind jobs in large, small or medium-sized entities, they will need a basic understanding of finance. Thisis because they will need to understand the main sources of finance and how to use cash flowinformation to check that there will be sufficient cash to meet the needs of the entity and to plan theinvestment of any surplus cash.

2. Explain the theory of the finance gap.

Some entrepreneurs who have an idea for a new business or managers who want to expand anexisting business have difficulty in gaining access to the finance they need. A finance gap is thesituation where a business has profitable opportunities, but is unable to raise the funds to exploit them(Jarvis, 2012). It was formally recognised in 1931 by the Macmillan Committee, which reported thatthe financing needs of small business were not well served by the financial services institutions at thattime. The main argument supporting the notion of a finance gap is that the majority of enterprises inthe UK (and elsewhere) are small and medium-sized sole proprietorships, partnerships and privatecompanies, which cannot raise equity finance by selling shares to the public. This is because onlypublic listed companies can raise capital on a stock exchange. This aspect of the finance gap issometimes referred to as the equity gap.

3. Describe the potential sources of long-term finance available to a sole proprietorship or traditionalpartnership.

Long-term finance is used to provide assets that are expected to provide economic benefits to thebusiness in the long-term. There are two potential sources of long-term finance for unincorporatedbusinesses and both can be classified as debt finance. A long-term loan is a suitable form of financefor capital investment in assets that are not acquired for trading purposes but intended to be kept inthe business in the long term, such investment in plant and machinery. A mortgage is a long-term loanfor purchasing land or premises. Mortgages are usually supplied by financial institutions, such asbanks and building societies, for a specified number of years (in the UK the maximum period isusually 25-30 years) at a fixed or variable rate of interest. Repayment may be in instalments or at the

end of the term.




6

4(a)Dudes & Divas Ltd

Cash flow forecast 1 July to 30 September 2012

July August September Total£ £ £ £Cash inflows

Capital 25,000 0 0 25,000Cash sales 10,000 10,000 10,000 30,000Credit sales 0 2,000 2,000 4,000

35,000 12,000 12,000 59,000

Cash outflowsPurchases 0 0 5,000 5,000Overheads 5,000 5,000 5,000 15,000Salaries 1,500 1,500 1,500 4,500Fixtures and fittings 0 0 30,000 30,000

6,500 6,500 41,500 54,500

Net cash flow 28,500 5,500 (29,500) 4,500Cumulative cash b/f 0 28,500 34,000 0

Cumulative cash c/f 28,500 34,000 4,500 4,500

4(b) The forecast cumulative cash position at the end of each month is positive. The cash flowforecast predicts there will be a cash surplus of £4,500 at 30 September 2012.

5(a)Trigg Electronics Ltd

Cash flow forecast 1 January to 30 June 2012

January February March April May June Total£ £ £ £ £ £ £

Cash inflowsRevenue from A 0 0 792 858 858 990 3,498Revenue from B 0 1,300 1,300 1,560 1,560 1,560 7,280

0 1,300 2,092 2,418 2,418 2,550 10,778

Cash outflowsRent and rates 1,500 0 0 1,500 0 0 3,000Electricity 0 120 120 120 120 120 600Telephone and Internet 0 0 50 0 0 50 100Printing, postage and stationery 0 209 216 242 255 248 1,170General expenses 25 25 25 25 25 25 150Tools and equipment 2,500 1,000 500 0 0 0 4,000

4,025 1,354 911 1,887 400 443 9,020

Net cash flow (4,025) (54) 1,181 531 2,018 2,107 1,758Cumulative cash b/f 0 (4,025) (4,079) (2,898) (2,367) (349) 0

Cumulative cash c/f (4,025) (4,079) (2,898) (2,367) (349) 1,758 1,758

5(b) Philip needs to invest capital of £4,079 in January to prevent the business from having a cashdeficit during the first six months.




7

Part II Financial accounting

3. The accounting system

1. Wellworth Fencing LtdCapital account

£ £1 June Bank 50,000

Bank account

£ £1 June Capital 50,000 1 June Lorry 16,000

1 June Lorry insurance 1,4001 June Rent 4,500

2 June Equipment 5,4002 June Purchases 8502 June Advertising 420

Lorry account

£ £1 June Bank 16,000

Lorry insurance account

£ £1 June Bank 1,400

Rent account


Equipment account


Purchases account

£ £2 June Bank 8504 June Timber supplies 120

Advertising account

£ £2 June Bank 420

Timber Supplies Ltd account

£ £4 June Purchases 120




8

2. Lavender & Lace Ltd

Sales account

£ £2 July Cash 1383 July Cash 192

Postage account


Window cleaning account

£ £1 July Cash 10

Stationery account


Parking account

£ £1 July Cash 22 July Cash 23 July Cash 2

Petrol account


Purchases account





9

3. Burton‟s Books Ltd

Bank account

£ £1 October Balance b/f 6,400 2 October Purchases 750

12 October Sales 1,800 3 October Advertising 1,12015 October Jones Ltd 950 16 October Purchases 2,30018 October Jones Ltd 950 18 October Davies Ltd 78030 October Sales 1,450 25 October Purchases 3,400

31 October Balance c/f 3,200

11,550 11,550

1 November Balance b/f 3,200

4. O‟Neill Ltd

O’Neill Ltd account

£ £2 November Sales 850 30 November Cash 1,900

12 November Sales 1,650 30 November Balance c/f 1,90018 November Sales 26021 November Sales 40025 November Sales 640

3,800 3,800

1 October Balance b/f 1,900

5. Hampton Health Food Ltd

Hampton Health Food LtdTrial balance as at 30 June 2012

Debit Credit£ £

Sales 26,200Purchases 36,770Returns inward 900Returns outward 460Discounts allowed 720Discounts received 620Equipment 2,000

Bank 1,500Salaries 1,600Rent 1,400General expenses 390Capital at 1 July 2011 _____ 18,000

45,280 45,280




10

4. Regulatory framework for financial reporting


1. Describe the key elements of the regulatory framework for public and private companies in theUK.

The key elements of the regulatory framework in the UK are:

Company law as represented by the Companies Act 2006 (CA2006) and subsequent statutoryinstruments

National and international accounting standards issued by independent (non-government) bodies

Stock exchange rules, which are issued by an independent regulator.

2. Define the term financial reporting. In addition, explain the need for the regulation of financialreporting and the purpose of the regulatory framework.

Financial reporting refers to the statutory disclosure of general purpose financial information by limitedliability entities via the annual report and accounts. Financial reporting is derived from a complexprocess known as financial accounting, which is concerned with classifying, measuring, and recordingthe economic transactions of an entity in accordance with established principles, legal requirementsand accounting standards. It is primarily concerned with communicating a true and fair view of thefinancial performance and financial position of an entity to external parties. These external partiesinclude existing and potential investors, lenders and creditors, who rely on the directors‟ integrity and

judgement to provide high quality, reliable information for external users. In an ideal world, thedirectors would provide unambiguous and value-free measures of wealth, but the world is not idealand, hence, the need for regulation.

The purpose of the regulatory framework is to guide corporate financial reporting. This helps thepreparers, auditors and users of the statutory information disclosed in the annual report and accounts.The principles and rules help ensure that the financial statements are prepared in a standard way,thus aiding comparison, improving the credibility of the accountancy profession and imposing adiscipline on companies. Regulation also allows suspected cases of fraud or misconduct to beinvestigated and curbs creative accounting.

3. Explain the acronym GAAP and outline the historical reasons why one country‟s GAAP coulddevelop differently from another.

GAAP is the acronym for Generally Accepted Accounting Practice (or Principles) and it refers to the

regulatory framework for financial reporting that applies in a particular jurisdiction. UK GAAPcomprises general rules which have been codified in company law and more detailed regulationswhich are contained in accounting standards. In addition, public companies with a listing on theLondon Stock Exchange must comply with stock exchange rules.

The historical reasons for international differences in GAAP can be summarised as differences inaccounting principles, differences in what is perceived as the objectives of financial reporting, andvarious economic, social and cultural factors. A country‟s GAAP is likely to consist of accountingpractices that have evolved over time and legal requirements that are added to from time to time.Legal requirements arise on a contingency basis. For example, they can arise as a response to anunusual event (eg a financial scandal) or a change in the economic environment. However, it isunlikely that countries will experience the same unusual events and, if they do, the events may notoccur at the same time or lead to the same changes in requirements. Views on the objective of

financial reporting vary because in some countries the focus is on meeting the needs of investors fordecision making and in others it is on providing financial information for creditor protection and




11

taxation. This difference arises because in some countries (eg the UK) the main source of finance isequity finance raised on the stock market, whereas in other countries (eg Germany) it is debt financefrom financial institutions. A further complication is that in some countries there are separate rules for

financial reporting and tax purposes (eg the UK), requiring two sets of financial statements to beprepared. One of the key cultural factors that creates differences is due to different attitudes. In somecountries it is taken for granted that a law should be obeyed, whereas in other countries there is asubtle understanding about which laws are obeyed and the degree to which they are obeyed.

4. Explain what an accounting standard is and discuss the advantages and disadvantages of IFRS.Draw conclusions from your analysis.

An accounting standard is an authoritative statement on how a particular type of transaction or otherevent should be reflected in the financial statements. In the UK, compliance with accountingstandards is normally necessary for the financial statements to give a true and fair view. Ball (2006)classified the advantages of IFRSs into direct and indirect advantages and the disadvantages intoimmediate and longer-term disadvantages:

Direct advantages of IFRSs:

IFRSs provide more accurate, comprehensive and timely financial statement information relative

to the national standards they replace in many countries

There are reduced costs arising from being informed in a timely fashion (mainly benefits small

investors who, unlike investment analysts, do not have access to other sources of information).

The cost of processing financial information is reduced, since no adjustments are needed for

differences in GAAP. This benefits institutions creating standardised financial databases and

should increase the efficiency with which the stock market incorporates the information in prices.

Most assets can be reported using fair value accounting (eg replacement cost, market value, net

realisable value, value in use), which contains more information than historical cost accounting

Companies can compete for capital on equal terms since there are reduced compliance costs for

multinational companies, which only need to prepare one set of accounts.

Transparency is achieved through the use of one global accounting language, which aids inter-

company comparison and reduces information costs and information risk to investors, but only if

IFRSs are implemented consistently

Indirect advantages of IFRSs:

The cost of equity capital is reduced due to higher information quality reducing the risk to

investors.

The cost of debt capital is reduced due to more efficient contracting in debt markets, particularly

due to timelier loss recognition. Corporate governance (the system by which companies are directed and controlled) is improved

due to greater transparency. In particular, timelier loss recognition increases the incentives of

managers to attend to existing loss-making investments and strategies more quickly and to

undertake fewer unprofitable investments (for example, pet projects and trophy acquisitions).

Immediate disadvantages of IFRSs:

It is hard to agree on a global accounting language and whether it should be based on principles

or rules. It will mean that national models of best practice may be lost.

There will be initial training costs for preparers, auditors and enforcers.

Fair value accounting leads to volatility and may reflect estimation noise or managerial

manipulation.




12

Despite some regulatory co-ordination, political and economic forces will lead to inconsistency in

implementation.

Longer-term disadvantages of IFRSs:

Allowing all countries to use the IFRS brand name discards information about reporting quality

differences. There may also be free rider problem where low-quality countries may adopt IFRSs in

name only.

Competition encourages innovation and discourages complacency and bureaucracy and

imposing global standards is risky centralization.

At present IFRSs have a strong common law orientation, but over time the IASB risks becoming a

politicized, bureaucratic UN-style body.

5. Search the ASB‟s website (http://www.frc.org.uk/asb/) to get up-to-date information on the future

of UK GAAP and find articles on the subject in the accountancy press (for example Accountancy Age, Accountancy magazine or Accounting & Business). Then write a brief essay on theadvantages and disadvantages of the new regime. Refer to the above website and othersources.

http://www.frc.org.uk/asb/







13

5. Conceptual framework for financial reporting


1. Explain what a conceptual framework is and the advantages of having such a framework.

A conceptual framework is „a statement of theoretical principles that provides guidance for financialaccounting and reporting‟ (Law, 2010, p. 102). The IASB‟s revised conceptual framework (firstrevisions published in 2010) is called the Conceptual Framework for Financial Reporting. The mainadvantage of a conceptual framework is that it clarifies the conceptual underpinnings of accountingstandards and allows standard setters to develop accounting standards on a consistent basis. It alsoassists preparers, auditors and users of financial statements to understand the approach to standardsetting, and the nature and function of the financial information reported. In addition, a conceptualframework gives guidance to preparers resolving accounting issues that are not specificallyaddressed by an existing IFRS or interpretation.

2. Describe the objective of general purpose financial reporting and the information needs of thethree primary user groups identified in the IASB Framework (2010).

The objective of general purpose financial reporting is „to provide information about the reportingentity that is useful to existing and potential investors, lenders and other creditors in making decisionsabout providing resources to the entity. Those decisions involve buying, selling or holding equity anddebt instruments and providing or settling loans and other forms of credit.‟ [OB2]. This principle formsthe foundation of the Framework and other aspects of the Framework flow logically from it. Theprimary users of general purpose financial reports are existing and potential investors, lenders andother creditors [OB3].

Investors need financial information to help them make investment decisions such as buying,selling or holding equity and debt instruments. These decisions depend on the investment risks

and returns. Returns might include dividends payable on shares, principal and interest paymentsor market price increases in equity and debt instruments.

Lenders need financial information to help them make lending decisions. These decisions dependon the lending risks and returns. They need to assess whether loans can be repaid and whetherthe interest they expect to receive will be paid when it is due. As expectations depend on theirassessment of the amount, timing and uncertainty of payments, they need information that willhelp them assess the prospects for future net cash inflows to an entity.

Creditors need financial information to help them make credit decisions. These decisions willdepend on the credit risks and returns. The latter usually take the form of interest payments. As inthe case of lenders, their expectations depend on their assessment of the amount, timing anduncertainty of receiving the amounts owed to them and therefore they need information that will

help them assess the prospects for future net cash inflows to an entity.

3. Explain the fundamental and enhancing qualitative characteristics of usefulness in the latest issueof the IASB Framework.

Chapter 3 of the IASB Framework (2010) divides the qualitative characteristics of that are likely tomake the financial information useful to users into fundamental and enhancing characteristics.

Fundamental qualitative characteristics:

Relevance – Relevant financial information is capable of making a difference to users‟ decisions.

Financial information is capable of making a difference to decisions if it has predictive value

and/or confirmatory value. These two are interrelated. Materiality is an entity-specific aspect of




14

relevance based on the nature or magnitude (or both) of the items to which the information relates

in the context of an individual entity‟s financial report.

Faithful representation – General purpose financial reports represent economic phenomena in

words as well as numbers. To be useful, the information must not only represent relevant

phenomena but it must also be a faithful representation of the phenomena. Ideally it should be

complete, neutral and free from error. Free from error does not mean perfectly accurate. For

example, an estimate of an unobservable value cannot be perfectly accurate, but it is a faithful

representation if is clearly described as being an estimate and the nature and limitations of the

estimating process are explained, and no errors have been made in selecting and applying an

appropriate process for developing the estimate.

Enhancing qualitative characteristics:

Comparability – The information is more useful if it can be compared with similar information forthe entity in other periods, or similar information for other entities. A comparison requires at leasttwo items. Consistency helps achieve comparability and refers to the use of the same methods forthe same items, either from period to period within a reporting entity or in a single period acrossentities.

Verifiability – The financial information is more useful if it is verifiable. Verifiability helps to assure

users that the information is a faithful representation. It means that different knowledgeable and

independent observers could reach consensus, although not necessarily complete agreement,

that a particular depiction is a faithful representation.

Timeliness – The financial information is more useful if it is timely. Timeliness means that

information is available to users in time to be capable of influencing their decisions.

Understandability – The financial information is more useful if is readily understandable.

Classifying, characterising and presenting information clearly and concisely makes it

understandable. While some phenomena are inherently complex and cannot be made easy tounderstand, to exclude such information would make financial reports incomplete and potentially

misleading. Financial reports are prepared for users who have a reasonable knowledge of

business and economic activities and who review and analyse the information with diligence.

4. Define the three elements of financial position and the two elements of financial performance inthe IASB Framework (2010).

Element of financial position (IASB, 2010, para 4.4):

An asset is a resource controlled by the entity as a result of past events and from which future

economic benefits are expected to flow to the entity. A liability is a present obligation of the entity resulting from past events, the settlement of which isexpected to result in an outflow from the entity of resources embodying economic benefits.

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Elements of financial performance (IASB, 2010, para 4.25):

Income is increases in economic benefits during the accounting period in the form of inflows orenhancements of assets or decreases of liabilities that result in increases in equity, other thanthose relating to contributions from equity participants.

Expenses are decreases in economic benefits during the accounting period in the form ofoutflows or depletions of assets or incurrences of liabilities that result in decreases in equity, otherthan those relating to distributions to equity participants.




15

5. Explain the general recognition criteria relating to the elements of financial statements and outlinethe four measurement methods mentioned in the latest issue of the IASB Framework. In addition,explain the financial capital maintenance and physical capital maintenance concepts...

The general recognition criteria are that the item can be incorporated in the statement of financialposition or statement of comprehensive income if it meets the definition of an element and it alsosatisfies the following conditions:

It is probable that any future economic benefit associated with the item will flow to or from theentity; and

The item has a cost or value that can be measured with reliability (IASB, 2010, para 4.37-38).




16

6. Statement of comprehensive income


1. Describe the general purpose of the statement of comprehensive income. In addition, explain theterms income and expenses as defined by the Conceptual Framework for Financial Reporting(IASB, 2010).

The purpose of the statement of comprehensive income is to provide information to users on thefinancial performance of business over the accounting period. Financial performance is concernedwith the profitability of the entity. Users need information on the entity‟s financial performance toassess potential changes in its economic resources and its capacity to generate cash from itsresources. In addition, users need information to evaluate how effectively any additional resourcesmight be used. There are two elements of financial performance (IASB, 2010, para 4.25):

Income is increases in economic benefits during the accounting period in the form of inflows orenhancements of assets or decreases of liabilities that result in increases in equity, other thanthose relating to contributions from equity participants.

Expenses are decreases in economic benefits during the accounting period in the form ofoutflows or depletions of assets or incurrences of liabilities that result in decreases in equity, otherthan those relating to distributions to equity participants.

2. Explain the accrual basis of accounting by defining the principles involved. Illustrate your answerby taking the example of the cost of sales adjustment in the statement of comprehensive income.

The accrual basis of accounting shows the effects of economic transactions and events in the periodin which those effects occur, even if the resulting cash receipts and payments occur in a different

period. It is based on the accruals concept which is the principle that revenue and costs arerecognized as they are earned and incurred not as cash is received or paid (the realization concept),and they are matched with one another (the matching concept) and dealt with in the income statementof the period to which they relate (the period concept). For example, the cost of sales includespurchases made during the period, irrespective of whether cash has yet changed hands. Cost of salesexcludes the cost of closing inventory to match cost of goods sold during the period with salesrevenue for the period.

3. Missing figures

(a) (b) (c) (d) (e)£ £ £ £ £

Opening inventory 100 50 1,020 232 14,960Purchases 400 680 10,210 1,924 163,570

500 730 11,230 2,156 178,530Closing inventory (50) (210) (1,550) (150) (18,815)

Cost of sales 450 520 9,680 2,006 159,715

(f) (g) (h) (i) (j)£ £ £ £ £

Revenue 10,000 600 17,000 18,150 27,750Cost of sales (6,000) (450) (13,500) (680) (24,590)

Gross profit 4,000 150 3,500 17,470 3,160Expenses (3,500) (100) (3,250) (15,370) (2,420)

Profit for the period 500 50 250 2,100 740




17

4.Uplights Ltd

Statement of comprehensive income

for the year ended 31 December 2012 £Revenue 66,500Cost of sales (W1) (12,000)

Gross profit 54,500Bank interest received 100Rent and rates (24,000)Salaries (21,500)Insurance (2,000)Lighting and heating (500)Telephone and Internet (400)

Advertising (100)

Operating profit 6,100

Income tax expense (2,000)Profit for the period 4,100

Working 1 £Purchases 20,000Closing inventory (8,000)

Cost of sales 12,000




18

5(a)Miphone Ltd

Draft statement of comprehensive income

for the year ended 30 June 2012 £Revenue 75,200Cost of sales (W1) (11,270)

Gross profit 63,930Other income 1,200Salaries (24,000)Rent and rates (18,000)Insurance (7,200)

Advertising (W2) (600)Lighting and heating (W2) (1,160)Telephone and Internet (W2) (740)General expenses (410)

Operating profit 13,020Income tax expense (1,200)

Profit for the period 11,820

Working 1 £Purchases 12,160Closing inventory (890)


Working 2 Trial balance Accrued Prepaid Total£ £ £ £

Advertising 860 (260) 600Lighting and heating 620 540 1,160Telephone and Internet 450 290 740General expenses 250 160 410




19

5(b)

Miphone LtdStatement of comprehensive income

for the year ended 30 June 2012£

Revenue 75,200Cost of sales (W1) (11,270)

Gross profit 63,930Rental income 1,200Salaries (24,000)Rent and rates (18,000)Insurance (7,200)

Advertising (W2) (600)Lighting & heating (W2) (1,160)Telephone & Internet (W2) (740)General expenses (410)

Allowances:Depreciation on plant and equipment (W3) (5,000)

Doubtful receivables (W4) (120)







Working 3 £Plant and equipment at cost 25,000

Allowance for depreciation (÷ 5 years) (5,000)

Working 4 £Trade receivables in trial balance 1,200

Allowance for doubtful receivables (10%) (120)




21

6.Beauty Box Ltd



Gross profit 67,200Interest received 100Salaries (30,000)Rent and rates (15,000)Insurance (3,000)Lighting & heating (1,500)Telephone & Internet (2,000)

Advertising (500) Allowances:

Depreciation on equipment (W2) (4,000)Doubtful receivables (W3) 400



Working 1 £Opening inventory 10,000Purchases 39,700Closing inventory (12,000)


Working 2 £Equipment at cost 20,000

Allowance for depreciation (÷ 5 years) (4,000)

Working 3 £Trade receivables in trial balance 6,000Year 2 doubtful debts (600)

Adjusted trade receivables 5,400

Year 1 doubtful debts (1,000)

Decrease in doubtful debts 400




22

7. Statement of financial position


1. Describe the general purpose of the statement of financial position. In addition, explain the termsasset, liability and equity as defined by the Conceptual Framework for Financial Reporting (IASB,2010).

The purpose of the statement of financial position is to summarize the assets, equity and liabilities onthe last day of the accounting period for which the statement of comprehensive income was prepared.There are three elements of financial position (IASB, 2010, para 4.4):

An asset is a resource controlled by the entity as a result of past events and from which future

economic benefits are expected to flow to the entity.

A liability is a present obligation of the entity resulting from past events, the settlement of which is

expected to result in an outflow from the entity of resources embodying economic benefits. Equity is the residual interest in the assets of the entity after deducting all its liabilities.

2. Explain the going concern basis of accounting by defining the principles involved. Illustrate youranswer by taking the example of the valuation of tangible assets in the statement of financialposition.

The going concern concept is based on the principle that the entity is a going concern and willcontinue in operation for the foreseeable future. Therefore, unless it is known otherwise, it is assumedthat the entity is not intending to close down or significantly reduce its activities (IASB, 2010). If thatpresumption is not valid, the financial statements will need to show the assets of the business at theirbreak-up value and any liabilities that are applicable on liquidation. IAS 1, Presentation of Financial

Statements (IASB, 2011) requires management to look at least 12 months ahead to assess this and, ifthere is significant doubt over the entity's ability to continue as a going concern, those uncertaintiesmust be disclosed, together with the basis used. For example, if an entity were not deemed to be agoing concern, the tangible assets would be valued at their net realisable value (the disposal valueless any direct selling costs), which is likely to be substantially lower than the carrying amount.




23

3. Insert the missing figures in the following examples, remembering that some items will be addedand others will be subtracted.

(a) (b) (c) (d) (e)£ £ £ £ £ASSETSNon-current assets 12,400 22,800 32,000 42,200 54,200Current assets 3,400 3,700 4,200 10,600 11,800

Total assets 15,800 26,500 36,200 52,800 66,000

EQUITY AND LIABILITIESEquityCapital 5,000 6,000 10,000 15,000 10,000Retained earnings 4,800 13,300 22,700 25,800 37,700

9,800 19,300 32,700 40,800 47,700

LiabilitiesNon-current liabilities 5,000 6,000 2,000 10,000 15,000Current liabilities 1,000 1,200 1,500 2,000 3,300

6,000 7,200 3,500 12,000 18,300

Total equity and liabilities 15,800 26,500 36,200 52,800 66,000

Note

In the chapter we showed the amounts for equity and liabilities in the chapter in brackets to remindyou of the accounting equation, which states that assets are always equal to the claims against them.Therefore, assets minus equity and liabilities = 0. It is not necessary to do this in assessments.




24

4.Uplights Ltd


for the year ended 31 December 2012 £Revenue 66,500Cost of sales (W1) (12,000)

Gross profit 54,500Bank interest received 100Rent and rates (24,000)Salaries (21,500)Insurance (2,000)Lighting and heating (500)Telephone and Internet (400)

Advertising (100)

Operating profit 6,100

Income tax expense (2,000)Profit for the period 4,100

Uplights LtdDraft statement of financial position

at 31 December 2012£

ASSETSNon-current assetsProperty, plant and equipment at cost 20,000

Current assetsInventory 8,000Trade and other receivables 2,000

Cash 14,50024,500

Total assets 44,500

EQUITY AND LIABILITIESEquityShare capital 30,000Retained earnings 4,100

34,100

Current liabilitiesTrade and other payables 8,400Current tax payable 2,000

10,400

Total equity and liabilities 44,500

Working 1 £Purchases 20,000Closing inventory (8,000)





25

5(a)Miphone Ltd

Draft statement of comprehensive income


Gross profit 63,930Other income 1,200Salaries (24,000)Rent and rates (18,000)Insurance (7,200)

Advertising (W2) (600)Lighting and heating (W2) (1,160)Telephone and Internet (W2) (740)General expenses (410)



Miphone LtdDraft statement of financial position

at 30 June 2012£

ASSETSNon-current assetsProperty, plant and equipment (at cost) 25,000

Current assetsInventory 890Trade and other receivables (W3) 1,460Cash and cash equivalents 3,260

5,610

Total assets 30,610


26,820

Current liabilitiesTrade and other payables (W4) 2,590

Current tax payable 1,2003,790







26


Advertising 860 (260) 600

Lighting and heating 620 540 1,160Telephone and Internet 450 290 740General expenses 250 160 410

Total accruals/prepayments 990 (260)

Working 3 £Opening trade receivables 1,200Prepayments (W2) 260

Trade and other receivables 1,460

Working 4 £Opening trade payables 1,600

Accruals (W2) 990

Trade and other payables 2,590

5(b)Miphone Ltd

Statement of comprehensive incomefor the year ended 30 June 2012

£Revenue 75,200Cost of sales (W1) (11,270)

Gross profit 63,930Rental income 1,200Salaries (24,000)

Rent and rates (18,000)Insurance (7,200) Advertising (W2) (600)Lighting & heating (W2) (1,160)Telephone & Internet (W2) (740)General expenses (410)

Allowances:Depreciation on plant and equipment (W3) (5,000)

Doubtful receivables (W4) (120)






27

Miphone LtdStatement of financial position

at 30 June 2012

£ASSETSNon-current assets

Property, plant and equipment (W3) 20,000

Current assetsInventory 890Trade and other receivables (W4) 1,340Cash and cash equivalents 3,260

5,490

Total assets 25,490


21,700

Current liabilitiesTrade and other payables (W5) 2,590Current tax payable 1,200

3,790







Working 3 £Property, plant and equipment at cost 25,000

Year 1 depreciation (5,000)Closing carrying amount 20,000


Allowance for doubtful receivables (120)

Adjusted trade receivables 1,080Prepayments 260



Accruals 990


5(c)




28

Miphone LtdStatement of comprehensive income

for the year ended 30 June 2012

£Revenue 75,200Cost of sales (W1) (11,270)

Gross profit 63,930Rental income 1,200Distribution costs (W6) (28,855)

Administrative expenses (W6) (28,375)Operating profit 7,900Income tax expense (1,200)


Miphone LtdStatement of financial position

at 30 June 2012£

ASSETSNon-current assetsProperty, plant and equipment (W3) 20,000

Current assetsInventory 890Trade and other receivables (W4) 1,340Cash 3,260

5,490

Total assets 25,490


21,700

Current liabilitiesTrade and other payables (W5) 2,590Current tax payable 1,200

3,790










29

Working 3 £Property, plant and equipment at cost 25,000Year 1 depreciation (5,000)

Closing carrying amount 20,000


Allowance for doubtful receivables (120)

Adjusted trade receivables 1,080Prepayments 260



Accruals 990


Working 6 Amount Distributioncosts

Administrativeexpenses

Financecosts

£ £ £ £Salaries 24,000 12,000 12,000Rent and rates 18,000 9,000 9,000Insurance 7,200 3,600 3,600

Advertising (W2) 600 600Lighting and heating (W2) 1,160 580 580Telephone and Internet (W2) 740 370 370General expenses 410 205 205

Allowances:

Depreciation: PPE (W3) 5,000 2,500 2,500Doubtful receivables (W4) 120 120

57,230 28,855 28,375 0




30

6.Beauty Box Ltd



Gross profit 67,200Interest received 100Salaries (30,000)Rent and rates (15,000)Insurance (3,000)Lighting & heating (1,500)Telephone & Internet (2,000)

Advertising (500) Allowances:

Depreciation on equipment (W2) (4,000)Doubtful receivables (W3) 400



Beauty Box LtdStatement of financial position

at 30 June 2012£

ASSETSNon-current assets

Property, plant and equipment (W2) 12,000Current assetsInventory 12,000Trade and other receivables (W3) 5,400Cash 15,300

32,700

Total assets 44,700

EQUITY AND LIABILITIESEquity

Share capital 20,000Retained earnings 12,200

32,200Current liabilitiesTrade and other payables 8,000Current tax payable 4,500

12,500





31

Working 1 £Opening inventory 10,000Purchases 39,700

Closing inventory (12,000)Cost of sales 37,700

Working 2 Year Openingcarrying amount

Provision fordepreciation

Closingcarryingamount

£ £ £Equipment 1 20,000 (4,000) 16,000Equipment 2 16,000 (4,000) 12,000

Working 3 £

Trade receivables in trial balance 6,000Year 2 doubtful debts (600)

Adjusted trade receivables 5,400

Year 1 doubtful debts (1,000)

Decrease in doubtful debts 400




32

8. Consolidated statement of financial position


1. Under IFRS 10, control of an investee is achieved when the investor is exposed to or has rights to

variable returns from its involvement with the investee and has the ability to affect those returnsthrough its power over the investee. As a result, control is only achieved if the investor possessesall three of the following elements of control:

Power over the investee by having rights that give the ability to direct its relevant activities

Exposure, or rights, to variable returns from its involvement with the investee

Ability to use its power over the investee to affect the amount of these returns.

In contrast, an investment that offers joint control provides a contractually agreed sharing ofcontrol where strategic decisions about the relevant activities, such as capital expenditure and

approving a business plan, require the unanimous consent of the parties sharing control.

2. IFRS 3 states that goodwill can only recognised in the group accounts as a result of a businesscombination. Goodwill is an asset that represents the future economic benefits arising from assetsacquired in a business combination that cannot be individually separately identified andrecognised, such as the company‟s reputation and loyalty of its workforce and customer base.Goodwill at the date of acquisition is the excess of the fair value of the consideration transferredplus the value of any NCI less the fair value of the identifiable net assets acquired.

3. IFRS 3 requires that a subsidiary‟s identifiable assets and liabilities should be recognised at fairvalue rather than current book value (carrying value) at the date of acquisition. Fair value is the

price that would be received to sell an asset or paid to transfer a liability in an orderly transactionbetween market participants at the measurement date. IFRS 3 requires measurement of asubsidiary‟s assets and liabilities at fair value as it provides a faithful representation of theireconomic value at the date of acquisition.

4. Agro Ltd£000

Fair value of consideration transferred 500(b) NCI at 1 July 2012 (£300k x 20%) 60

Fair value of subsidiary‟s net assets at 1 July 2012 (300)

(a) Goodwill (balancing figure) 260




33

5. Major Ltd

(a) £

Fair value of consideration transferred 60,000Non-controlling interest (£66,250 x 20%) 13,250Fair value of identifiable assets at 1 August 2011 (66,250)

Goodwill (balancing figure) 7,000

(b) Consolidated statement offinancial position at 31 July 2012

MajorLtd £

MinorLtd £

W1£

W2£

W3£

W4£

Group£

ASSETSNon-current assetsProperty, plant and equipment 150,000 82,000 232,000Investment in Minor Ltd 60,000 (60,000) -Goodwill 7,000 (3,500) 3,500

210,000 82,000 (53,000) (3,500) 235,500

Current assets 195,000 92,250 - - 287,250Total assets 405,000 174,250 (53,000) - - (3,500) 522,750

EQUITY AND LIABILITIESEquityOrdinary share capital 250,000 50,000 (40,000) (10,000) 250,000Retained earnings pre-acquisition 16,250 (13,000) (3,250) -Retained earnings post acquisition 32,000 20,000 (4,000) (3,500) 44,500Revaluation reserve 10,000 (2,000) 8,000Non-controlling interest (NCI) 13,250 6,000 19,250

282,000 96,250 (53,000) - - (3,500) 321,750Current liabilities 123,000 78,000 201,000

Total equity and liabilities 405,000 174,250 (53,000) - - (3,500) 522,750

Notes

W1 recognizes goodwill by deducting the parent‟s 80% share of Minor‟s identifiable net assets(£60,000).

W2 recognizes the NCI by deducting its 20% share of Minor's identifiable net assets at the acquisitiondate.

W3 recognizes the NCI's 20% share in Minor's post acquisition profits of £20,000 (£4,000); the NCI‟s20% share in Minor‟s post acquisition revaluation reserve of £10,000 (£2,000); and the NCI's 20%share in Minor's post acquisition profits of £20,000 (£6,000).

W4 accounts for the 50% impairment of goodwill (£3,500).




34

9. Financial statement analysis


1. Explain the purpose of ratio analysis and describe its limitations as a tool for evaluating the

financial statements of a business.

The purpose of ratio analysis is to evaluate the financial performance and stability of an entity. It helpsinternal and external users analyse financial statements by examining ratios that describe thequantitative relationship between two data items. Ratios can be used to perform a trend analysis orthey can be compared with a predetermined budget or previous periods for the same entity. Inaddition, can they can be compared with ratios for competitors or industry benchmarks.

2. Adams Ltd and Eve Ltd

(a) Main profitability ratios

Adams Ltd Eve Ltd

Return on capital employed

Operating profit x 100 29,500 41,500

Capital employed 281,000 596,000

= 10.50% = 6.96%

Capital turnover

Revenue 354,900 706,260

Capital employed 281,000 596,000

= 1.26 times = 1.19 times

Gross profit margin

Gross profit x 100 71,400 156,200

Revenue 354,900 706,260

= 20.12% = 22.12%

Operating profit margin

Operating profit x 100 29,500 41,500

Revenue 354,900 706,260

= 8.31% = 5.88%

(b) Interpretation

Adams Ltd has a better return on capital employed because the company generated

proportionally higher profits from less capital employed, while Eve Ltd generated proportionallylower profits from a larger amount of capital employed. The capital turnover ratio helps explain the

reasons: Adams Ltd turned over the capital employed in the company to generate revenue just

over 1¼ times during the year, whereas capital employed was used slight less frequently during

the year in Eve Ltd. The superior gross profit margin for Eve Ltd suggests that the company has a

lower cost of sales than Adams Ltd. However, the superior operating profit margin for Adams Ltd

suggests the company is controlling its operating costs better than Eve Ltd.




35

3. Ted Baker 2005/06

Note

Ted Baker has chosen to refer to the statement of financial position as the balance sheet anduses the format: Assets – Liabilities = Equity. This explains why the amounts shown for liabilitiesare in brackets. The brief comments in the narrative answers below are not exhaustive, butintended for guidance.

(a) Earnings per share 2005/06 2004/05

Profit for ordinary shareholders 12,919 11,368

Number of ordinary shares 42,237 42,375

= 30.59 pence = 26.83 pence

This is an investment ratio that measures the amount of profit earned by one ordinary share.There was good news for investors, as EPS increased by 3.8p per share in 2005/06.

(b) Return on equity 2005/06 2004/05Profit for ordinary shareholders x100 12,919 11,368

Equity 42,172 36,830= 30.63% = 30.87%

This is a profitability ratio that measures return on shareholders ‟ funds. Unlike ROCE, it excludeslong-term debt. In 2005/06 there was £30.63 operating profit for every £100 capital employed alittle lower than the previous year, but nearly 31% represents a high return compared to a non-risky investment.

(c) Return on capital employed 2005/06 2004/05

Operating profit x 100 18,334 x100 16,405 x 100

Equity + Non-current liabilities 42,922 37,580= 42.71% = 43.65%

This profitability ratio measures the percentage return on total funds (shareholders‟ equity andlong-term debt). It reflects the stewardship of management and their ability to generate revenueand control costs. ROCE was slightly lower in 2005/06 with only £42.71 in operating profit forevery £100 of capital employed compared with £43.65 the previous year. This is disappointing asthe amount of capital employed was higher in 2005/06, but gave proportionately less operatingprofit. ROCE is higher than ROE because it is based on profit before interest and tax andtherefore does not takes account of finance costs.

(d) Operating profit margin 2005/06 2004/05

Operating profit x 100 18,334 x 100 16,405 x100

Revenue 117,832 105,753= 15.56% = 15.51%

This profitability ratio measures the percentage return on revenue based on operating profit. Theresults show a stable performance with approximately £15 of operating profit generated by every£100 of revenue in both years.




36

(e) Acid test ratio 2005/06 2004/05

Current assets - Inventory 23,300 18,365

Current liabilities 24,740 21,929

= 0.94:1 = 0.84:1

This is a liquidity ratio that measures the relationship between the liquid current assets and theshort-term liabilities. It excludes inventory as this takes longer to turn into cash. In 2005/06 therewas £0.94 in liquid assets for every £1 of current liabilities, which is a slight improvement on theprevious year. It does not matter that the ratio is slightly less than 1:1 because the accounts areprepared on a prudent basis and trade payables will be due at different times in the next period. Itis also good financial management to obtain a longer credit period from suppliers than thecompany gives to its to customers. This ratio assures users that the business is a going concern.

(f) Inventory holding period 2005/06 2004/05

Inventory x12 for months 23,475 x 12 22,725 x12

Closing inventory 48,979 43,357= 5.75 months = 6.29 months

This is an efficiency ratio that measures average time between purchase and sale of inventory.There was an improvement in 2005/06, as management was more efficient is selling inventory,taking just under six months (one fashion season). This meant there was little risk of extra storagecosts or obsolescence.

(g) Debt/equity ratio 2005/06 2004/05

Non-current liabilities x100 750 x 100 750 x 100

Equity 42,172 36,830

= 1.78% = 2.04%

This is a gearing ratio that describes the financial structure of the business in terms of thepercentage of long-term debt to total shareholder‟s funds. The company had very low gearing inboth years. In 2005/06 it reduced from approximately £2 of long-term debt for every £100 ofequity to only £1.78 of long-term debt for every £100 of equity. This means there was even lessrisk that the company would be unable to pay interest due on long-term debt in the event of aneconomic downturn.

(h) Interest cover 2005/06 2004/05

Operating profit 18,334 16,405

Interest payable 109 221

= 168.20 times = 74.23 times

This gearing ratio measures the relative safety of interest payments. The increase in 2005/6reflects the lower gearing and confirms interest payable can still be covered many times over.Therefore, there is very low risk to long-term lenders/creditors that the company will not be able topay the interest due.

4. Ted Baker 2007/08 – Investor s‟ perspective

(a) Dividend per share 2007/08 2006/07

Total dividends x 100 for pence 5,079 x100 4,556 x 100

Number of ordinary shares 42,321 42,915

= 12.00 pence 10.62 penceThis investment ratio is also known as dividend net and measures the amount of dividend on one

ordinary share. The results provide good news for shareholders, as the dividend per share has




37

increased by 1.4p per share. This is partly due to an increase in total dividends for 2007/08 andpartly due to a reduction in the number of shares that year.

(b) Dividend yield 2007/08 2006/07 Dividend per share x100 12.00 x 100 10.62 x 100

Average share price 480.00 641.50

= 2.50% = 1.65%

This investment ratio is also known as the yield gross and it measures the dividend per share inrelation to the average price of the share. Shareholders will be pleased as the yield rose by 0.85%in 2007/08 due to the higher dividend per share. However, the yield would have been higher if itwere not for the significantly lower average share price that year.

(c) Earnings per share 2007/08 2006/07

Profit for ordinary shareholders x 100 for pence 15,242 x100 14,416 x 100

Number of ordinary shares 42,321 42,915= 36.02 pence 33.59 pence

This investment ratio measures the amount of profit earned by one ordinary share. There is goodnews for shareholders as the increased profits in 2007/08 improved EPS by 2.43 pence. This ratiois based on total profits and therefore reflects the shareholders‟ total return. EPS is higher thanthe dividend per share, since only part of the profit is distributed as dividends.

(d) Price/earnings ratio 2007/08 2006/07

Average share price 480.00 641.50

Earnings per share 36.0 33.6

= 13.33 years = 19.10 yearsThis investment ratio compares the amount invested in one share with the earnings per share and

reflects the stock market's confidence in how long the current level of EPS will be sustained. Theresults are disappointing for shareholders since the number of years the market believes thecompany has good prospects has dropped by nearly 6 years. Nevertheless, the P/E ratio is stillmore than 13 years, so little cause for concern for existing or potential investors.

(e) Return on equity 2007/08 2006/07

Profit for ordinary shareholders x100 15,242 x 100 14,416 x 100

Equity 55,712 51,281

= 27.36% = 28.11%

This investment ratio measures the return on shareholders‟ funds. The results will bedisappointing for shareholders as the increased equity did not lead to a proportionately higher

total return. In 2007/08 the return was only £27.35 for every £100 of equity compared with £28.11the previous year. Nevertheless, a return of 27.36% is very high compared to the risk-free interestrate of 5.29% and should be attractive to existing and potential investors.

(f) Return on capital employed 2007/08 2006/07

Operating profit x 100 22,142 x100 20,049 x 100

Equity + Non-current liabilities 56,555 51,324

= 39.15% = 39.06%

This is a profitability ratio that measures the percentage return on total funds (shareholders‟ equityand long-term debt). It reflects the stewardship of management and their ability to generaterevenue and control costs. ROCE is stable with approximately £39 in operating profit for every£100 of capital employed in both years. The increased amount of capital employed in 2007/08 did

not lead to proportionately higher operating profit. Nevertheless, existing and potential investorsare likely to consider a return of 39% is favourable compared to the risk-free interest rate of




38

5.29%. Note that ROCE is higher than ROE because it is based on profit before interest and taxand therefore does not take account of finance costs.

(g) Operating profit margin 2007/08 2006/07 Operating profit x 100 22,142 x 100 20,049 x 100

Revenue 142,231 125,648

= 15.57% 15.96%

This profitability ratio measures the percentage return on revenue based on operating profit. Theresults show a stable performance with approximately £15 of operating profit generated by every£100 of revenue in both years.

(h) Capital turnover 2007/08 2006/07

Revenue__________ 142,231 125,648

Equity + Non-current liabilities 56,555 51,324

= 2.51 times = 2.45 times

This profitability ratio measures the number of times capital employed was used during the year toachieve the revenue. The small improvement in 2007/08 shows more efficient use of capitalemployed and this is reflected in the return on capital employed.

5. Ted Baker 2007/08 – short-term lender perspective

(a) Current ratio 2007/08 2006/07

Current assets 57,329 53,397


= 2.24:1 = 2.40:1

This is a liquidity ratio that measures the relationship between current assets and short-termliabilities. In 2007/08 there was £2.24 in current assets for every £1 of current liabilities, whichmeans current liabilities are still easily covered by current assets.

(b) Acid test 2007/08 2006/07

Current assets - Inventory 28,014 25,572


= 1.10:1 = 1.15:1

This liquidity ratio is more stringent than the current ratio because it excludes inventory, as thiscurrent asset cannot be converted into cash at short notice. In 2007/08 there was £1.10 in liquid

assets for every £1 of current liabilities, which means current liabilities are just covered by currentassets. However, the accounts are prepared on a prudent basis and trade payables will be due atdifferent times in the next period. In addition, it is also good financial management to obtain alonger credit period from suppliers than the company gives to its to customers. The results for thisratio should assure lenders and creditors that the liquidity position is stable and the business is agoing concern.

(c) Inventory holding period 2007/08 2006/07

Closing inventory x 12 for months 29,315 x 12 27,825 x 12

Cost of sales 59,560 51,986

= 5.91 months 6.42 months

This is an efficiency ratio that measures average time between purchase and sale of inventory.There was an improvement in 2007/08, as management was more efficient is selling inventory,taking just under six months (one fashion season) rather than just over 6 months. This meant




39

there was little risk of extra storage costs or obsolescence. Lenders and creditors will welcomethis result as it reflects good management of working capital.

(d) Trade receivables collection period 2007/08 2006/07Trade receivables x 12 for months 10,217 x 12 8,543 x 12

Revenue 142,231 125,648

= 0.86 months = 0.82 months

This efficiency ratio measures the average time credit customers took to settle their debts. Theposition is stable with customers taking less than 1 month to pay on average during both years.This suggests efficient credit control, but depends on how long the credit period given tocustomers is. The short trade receivables collection period will give a positive signal to lendersand creditors as it reflects good management of working capital.

(e) Trade payables payment period 2007/08 2006/07

Trade payables x 12 for months 13,361 x 12 11,770 x 12Cost of sales 59,560 51,986

= 2.69 months = 2.72 months

This efficiency ratio measures the average time the company has taken to pay suppliers for goodsand services over the year. The results show little change in 2007/08 and suggest efficient cashmanagement if the period agreed with suppliers is two months. Taking the maximum credit periodprovided will be seen by lenders and creditors as good financial management.

(g) Debt/equity ratio 2007/08 2006/07

Non-current liabilities x100 843 x 100 43 x 100

Equity 55,712 51,281

= 1.51% = 0.08%

This is a gearing ratio that describes the financial structure of the business in terms of thepercentage of long-term debt to total shareholder‟s funds. The company had very low gearing inboth years. Although gearing increased slightly in 2007/08, the company only had £1.51 of long-term debt for every £100 of equity. This means there was very little risk that the company wouldbe unable to pay interest due on long-term debt in the event of an economic downturn.

(h) Interest cover 2007/08 2006/07

Operating profit 22,142 20,049

Interest payable 387 67

= 57.21 times = 299.24 times

This gearing ratio assesses the relative safety of interest payments by measuring the number oftimes interest payable on long-term debt is covered by the available profits. This avoids problemsover different definitions of debt that can be used in the debt/equity ratio. The significant reductionin 2007/08 reflects the higher gearing. Nevertheless, there is no cause for concern for lenders andcreditors as interest payable can still be covered by operating more than 57 times.

The main limitations of the above analysis are:

Ideally, the inventory holding period should be based on average inventory and purchases forthe year. However, average inventory cannot be calculated for 2006/07 because openinginventory is not disclosed for that year. Therefore, closing inventory is used as a proxy so thatboth years can be compared. In addition, cost of sales is substituted for purchases since thelatter is not disclosed for either year. In both cases, the substitute figures are less precise.

It is difficult to interpret the trade receivables collection period and the trade payablespayment period without knowing the average credit periods associated with these ratios.




40

There are no agreed definitions of the terms used, so these ratios should not be comparedwith others based on different definitions.

The analysis is based on comparing two years. It would be more useful if figures were

available to examine the trend over the last five years for example. It would also be useful tocompare these ratios for Ted Baker with competitors or industry benchmarks.

The analysis is based on figures from the financial statements in which there is a substantialdegree of classification and aggregation, and the effect of allocating continuous operations tothe period. A second weakness of the financial statements is that they do not take account ofnon-financial factors such as whether the business has sound plans for the future, a goodreputation, a strong customer base, reliable suppliers, loyal employees, obsolete assets,strong competitors or poor industrial relations.

Finally, the above analysis cannot anticipate the impact of potential changes in the economicenvironment. The lender should treat the analysis as an indication of where further investigationmight be directed to better understand the present and future financial performance and position.




41

10. Ethics, governance and corporate social responsibility


1. Explain why professional accountancy bodies issue codes of ethics for their members.

The Code of Ethics for Professional Accountants states that „a distinguishing mark of the accountingprofession is its acceptance of the responsibility to act in the public interest. Therefore, a professionalaccountant‟s responsibility is not exclusively to satisfy the needs of an individual client or employer‟(IESBA, 2009, para. 100.1). The main advantages of the IFAC Code of Ethics for Professional

Accounts are:

It provides explicit guidance to accountants and aids their understanding of the expectationsplaced upon them in terms of their ethical behaviour.

It lets clients know what they can expect from their professional accountants.

It provides a standard for disciplining professional accountants who adopt poor accountingpractices.

It enhances the reputation of professional accountants.

It promotes a commitment to best practice within the profession.

Abiding by a code may decrease the legal liability of professional accountants frominappropriate actions.

It provides users of the accounts with a standard against which they can compare the ethicalbehaviour of their professional accountants and complain about poor accounting practice.

2. Define the term „corporate governance‟ and explain its importance to investors.

Cadbury (1992, p. 15) defined corporate governance as „the system by which companies are directedand controlled. Boards of directors are responsible for the governance of their companies. Theshareholders‟ role in governance is to appoint the directors and the auditors and to satisfy themselvesthat an appropriate governance structure is in place. The responsibilities of the board include settingthe company‟s strategic aims, providing the leadership to put them into effect, supervising themanagement of the business and reporting to shareholders on their stewardship. The board‟s actionsare subject to laws, regulations and the shareholders in general meeting.‟ A succinct explanation byLaw (2012, p. 113) summarises corporate governance as „the manner in which organizations,particularly limited companies, are managed and the nature of accountability of the managers to theowners‟. Corporate governance is important to investors because it allow them to assess thestewardship of management. This is important because in large companies there is separation ofownership and control, and although the company is owned by the shareholders, the latter appointdirectors to manage the business on their behalf.

3. Obtain information from the FRC‟s website and write a summary explaining its role in regulating

corporate governance in the UK.

The answer should refer to the fact that the FRC is the UK‟s independent regulator responsible forpromoting high quality reporting and CG to foster investment, which is does through the UK CorporateGovernance Code. The FRC‟s Committee on Corporate Governance leads work on corporategovernance. Reference should be made to the Committee's terms of reference and the FRC‟s role ininfluencing EU and global developments, promoting boardroom professionalism and diversity, andencouraging constructive interaction between company boards and institutional shareholders (cf. theStewardship Code for Institutional Investors).




42

4. Obtain a copy of the annual report and accounts for two public limited companies and comparethe information they disclose on corporate governance. Write a summary analysing thedifferences in the wording used and noting any non-compliance with the UK Code of Corporate

Governance.

The answer should cover the following points:

The length of each company‟s corporate governance statement and how easy it is to find

Whether each company has been clear about its adherence to the UK Code and if it has

deviated from it, whether adequate explanations have been given (the „comply or explain‟

aspect of the UK Code)

The usefulness of any additional information provided

An analysis of the language used by each company, noting similarities and differences

Conclusions on how engaged the company appears to be with corporate governance

principles.

5. Select one public limited company and analyse the data provided on corporate governance and

on corporate social responsibility.

The answer should refer to the following:

a) How satisfied an investor might feel that the CG/CSR information indicates that the company

is well run and therefore a „safe‟ investment.

b) Whether the supplier can take comfort that the CG/CSR sections indicate that as a

stakeholder in the business the company recognises that good supplier relationships are

essential to future success.

c) Appropriate CG/CSR statements should provide the customer with the sense that thecompany takes its role in the community seriously and is in business for the longer term.

d) To some extent this overlaps with the customer view, but would suggest the wider context of

how the company is perceived, especially in certain sectors (eg pharmaceuticals, banking and

the oil industry).




43

Part III Management accounting

11. Importance of cost information


1. Explain the purpose of cost accounting and why it is important for managers to have costinformation.

The purpose of cost accounting is to ascertain the cost of the designated cost centres and cost units.Cost is the expenditure on goods and services required to carry out the operations of an organization.

A cost unit is „a unit of production for which the management of an organization wishes to collect thecosts‟ and a cost centre is the area of an organization for which costs are collected for the purpose ofcost ascertainment, planning, decision making and control‟ (Law, 2010, p. 119 and 116). Business is

about money and in order to run a business successfully, managers need to know the cost of runningthe business in order to run it successfully. A total cost statement shows the total cost of 1 cost unit(the product direct costs plus a share of the indirect costs). A mark up can be added to establish theselling price.

2. Describe the main classifications of cost.

Revenue expenditure can be classified by:

The nature of the cost, such as those that can be identified for materials, labour and expenses,and those for materials that can be divided into the different types of raw materials, maintenance

materials, cleaning materials, etc. The function of costs, such as production costs, administration costs, selling and distributioncosts.

Whether they are product costs, which can be identified with the cost unit and are part of thevalue of inventory, or period costs, such as selling costs and administrative expenses, which arededucted as expenses in the current period.

Whether they are direct costs, which can be identified with a specific cost unit, or indirect costs,which cannot be identified with a specific cost unit, although they may be traced directly to aparticular cost centre. Indirect costs must be shared by the cost units. Examples of direct costsare the cost of materials used to make a product; the cost of labour if employees are paidaccording to the number of products made or services provided; the cost of expenses, such assubcontract work. Examples of indirect costs are expenses such as rent and managers‟ salaries.

The behaviour of the cost and whether they are variable costs, which in total change in proportion

with the level of production activity or fixed costs, which are not changed by fluctuations inproduction levels. Direct costs are usually variable and indirect costs are usually fixed. Examplesof direct costs that are fixed are patents, licences and copyright relating to a particular productand some direct expenses such as the hire of a particular piece of equipment to produce aspecific order.




44

3. Classify the following costs:

Production

costs

Administration

costs*

Distribution

costs(a) Factory rent

(b) Insurance of office buildings

(c) Electricity for powering machinery

(d) Electricity for office lighting and heating

(e) Tax and insurance of delivery vehicles

(f) Depreciation of factory machinery

(g) Depreciation of office equipment

(h) Commission paid to sales team

(i) Salaries paid to accounts office staff

(j) Factory manager‟s salary

(k) Delivery drivers‟ salaries

(l) Factory security guards‟ salaries

(m) Piecework wages paid to factory operatives

(n) Salary paid to managing director‟s secretary

(o) Salaries paid to factory canteen staff

(p) Fees paid to advertising agency

(q) Maintenance of machinery

(r) Accounting software

(s) Bonuses for factory staff

(t) Training course for clerical staff.

*Includes selling costs

4. Petra Pots Ltd

(a)Petra Pots Ltd

Total cost (2,000 units)£

Direct costsDirect materials (6,000 + 200) 6,200Direct labour 10,000

Prime cost 16,200Production overheads (1,000+2,000+700+1,500+2,500+2,200+800+900) 11,600

Production cost 27,800Indirect costs

Administration overheads (400 + 800 + 200 + 1,800 + 2,200 + 16,000) 7,000Distribution overheads (500 + 800) 1,300

8,300

Total cost 36,100

(b) Interpretation should demonstrate awareness that total cost is built from a number of key elementsand should explain the terms used.




45

5. Petra Pots Ltd*

Petra Pots Ltd

Total cost (1 unit)£

Direct costsDirect materials 3.10Direct labour 5.00

Prime cost 8.10Production overheads 5.80

Production cost 13.90Indirect costs

Administration overheads 3.50Distribution overheads 0.65

4.15

Total cost 18.05

Profit (Production cost £13.90 x 50%) 6.95Selling price 25.00

*The workings are the same as in question 4, but divided by 2,000.




46

12. Costing for product direct costs


1. Describe the main stages in controlling direct materials.

In a manufacturing business the control of materials used in the production process is essential toensure that production is not delayed due to shortages and that the business does not tie up capitalby storing excess quantities of inventory. The main stages in material control are:

The stores or production department sends a purchase requisition to the purchasing department,

giving details of the quantity and type of materials required.

The buyer in the purchasing department sends a purchase order to the supplier.

The supplier sends the materials with a goods received note, which is checked against the

materials received and the purchase order.

The materials are added to the existing inventory in the stores and the quantity is added to the

inventory level shown on the bin card .

When materials are required, the production department sends a materials requisition to the

stores and the stores issues the materials and deducts the quantity from the inventory level

shown on the bin card . Periodic stocktaking ensures that a physical count of all inventories is

made to confirm that the actual quantities support the levels shown on the bin cards.

In a well-managed business, materials are available in the right place, at the right time and in the rightquantities, and all materials are properly accounted for.

2. Compare and contrast the advantages and disadvantages of the FIFO and CWA methods.

The main advantage of the FIFO cost method is that it is acceptable to financial accountants in the UKand to the HM Revenue and Customs, which means that not only can it be used for managementaccounting purposes, but also for financial reporting and taxation purposes. However, this advantagealso applies to the CWA cost method. The FIFO method is the logical choice if it coincides with theorder in which inventory is physically issued to production (eg materials with a finite life where itmakes sense to issue those that have been stored the longest first). However, the CWA is the logicalchoice if inventory consists of volume and liquid materials where an averaging method makes sensebecause it may not be possible to differentiate between old and new inventory stored in bulkcontainers.

While the FIFO has the benefit of charging the cost of direct materials against profits in the same

order as costs are incurred, the CWA offers the advantage of smoothing out the impact of pricechanges in the statement of comprehensive income. However, the FIFO method is complex and anarithmetical burden, even when a spreadsheet is used. While the cost of direct materials issued toproduction is based on historical prices, the value of inventory at end of period is close to currentprices. On the other hand, the CWA method requires the prices of materials issued to production mustbe recalculated every time a new consignment is received, this can be relatively simple to calculate byentering the quantity and pricing information from the source documents into a spreadsheet orspecialist software package. The CWA method also offers the advantage that it takes account ofquantities purchased and changing prices, including prices relating to previous periods. Nevertheless,the prices of materials issued may not match any of the prices actually paid and the value of closinginventory will lag behind current prices if prices are rising.




47

3. Janet‟s wages are based on piecework and she is paid £5 per piecework hour. Calculate her payfor a 36-hour week in which she produces the following units:

Product Numberof units Time allowanceper unit Total pieceworkhours A 12 0.8 hours 9.6B 30 0.6 hours 18.0C 24 0.5 hours 12.0

39.6

Pay (39.6 hours x £5) £198

4. Perfect Pans Ltd

(a)

(i) FIFO Receipts Issues Inventory balance

December Quantity Price Value Quantity Price Value Quantity Valuekg £ £ kg £ £ kg £

1 500 1,000.002 450 2.00 900.00 50 100.007 550 2.10 1,155 600 1,255.008 50 2.00 100.00 550 1,155.008 450 2.10 945.00 100 210.00

14 600 2.20 1,320 700 1,530.0015 100 2.10 210.00 600 1,320.0015 500 2.20 1,100.00 100 220.0030 500 2.30 1,150 600 1,370.00

31 100 2.20 220.00 500 1,150.00Total 3,475.00

(ii) AVCO Receipts Issues Inventory balance

December Quantity Price Value Quantity Price Value Quantity Valuekg £ £ kg £ £ kg £

1 500 1,000.002 450 2.00 900.00 50 100.007 550 2.10 1,155 600 1,255.008 500 2.09 1,045.83 100 209.17

14 600 2.20 1,320 700 1,529.1715 600 2.18 1,310.71 100 218.45

30 500 2.30 1,150 600 1,368.4531 100 2.28 228.08 500 1,140.38

Total 3,484.62

(b) Assuming that the business needs to choose between the two methods, recommend whichmethod management should adopt, giving at least five reasons.

The answer should include a recommendation. The choice of method should be supported with adiscussion of at least five advantages and disadvantage of the method chosen contrasted with thoseof the method that has been rejected.




48

5. Baked Bean PLC

(a)

(i) FIFO Receipts Issues Inventory balance

September Quantity Price Value Quantity Price Value Quantity Value

tonne £ £ tonne £ £ tonne £

1 1,000 5.00 5,000 1,000 5,000.00

2 1,000 5.50 5,500 2,000 10,500.00

3 750 5.00 3,750.00 1,250 6,750.00

14 250 5.00 1,250.00 1,000 5,500.00

500 5.50 2,750.00 500 2,750.00

15 1,000 6.00 6,000 1,500 8,750.00

16 500 5.50 2,750.00 1,000 6,000.00

250 6.00 1,500.00 750 4,500.00

29 1,000 6.50 6,500 1,750 11,000.0030 750 6.00 4,500.00 1,000 6,500.00

Total 16,500.00

(ii) AVCO Receipts Issues Inventory balance

September Quantity Price Value Quantity Price Value Quantity Value

tonnes £ £ tonnes £ £ tonnes £

1 1,000 5.00 5,000 1,000 5,000.00

2 1,000 5.50 5,500 2,000 10,500.00

3 750 5.25 3,937.50 1,250 6,562.50

14 750 5.25 3,937.50 500 2,625.0015 1,000 6.00 6,000 1,500 8,625.00

16 750 5.75 4,312.50 750 4,312.50

29 1,000 6.50 6,500 1,750 10,812.50

30 750 6.18 4,633.93 1,000 6,178.57

Total 16,821.43

(b) Identify which of the two methods would give the higher profit for the month in this particular case,giving your reasons.

The basic argument is that the higher the value of closing inventory, the higher the profit. Costsreduce revenue and closing inventory reduces the cost of sales for the period. Reference should be

made to the fact that when prices are rising, the value of closing inventory under the FIFO method ishigher than under the CWA method. Under the FIFO cost method, the valuation is closer to currentprices, whereas under the CWA method price increases are smoothed out and the value of closinginventory lags behind the current price. Therefore, the FIFO cost method gives the higher profit underthese circumstances




49

13. Costing for indirect costs


1. Describe the main stages for calculating the total cost per unit under an absorption costing

system.

Absorption costing is the cost accounting system in which the overheads of an organization arecharged to the production by means of the process of absorption. Costs are first allocated orapportioned to the cost centres, where they are absorbed into the cost unit using absorption rates(Law, 2012, p. 2). There are three main stages as follows:

Collect indirect costs in cost centres on the basis of allocation or apportionment

Determine an overhead absorption rate (OAR) for each production cost centre (eg cost per

direct labour hour)

Charge indirect costs to products using the OAR and a measure of the product‟s consumption

of the cost centre‟s cost (eg number of direct labour hours)

Calculate the cost per unit.

2. Explain what it means to allocate, apportion and absorb indirect costs.

In some cases, indirect costs that have been classified by nature can be wholly identified with oneparticular cost centre (eg wages and depreciation on machinery relating to a particular productiondepartment that has been designated as a cost centre). These overheads can simply be allocated tothat cost centre (eg the whole amount of the annual allowance for depreciation on machinery in thatdepartment is allocated to that cost centre). However, indirect costs that are associated with more

than one cost centre must be apportioned over the cost centres benefiting from them (eg factory rentcould be apportioned over the production cost centres on the basis of the proportion of space eachdepartment occupies in the factory).

An overhead absorption rate is calculated in advance of an accounting period and used to charge theindirect costs to the production for that period (Law, 2010). The choice of absorption rate depends onthe basis of apportionment and the resources used. The main rates used are:

The cost unit overhead absorption rate

The direct labour hour overhead absorption rate

The machine hour overhead absorption rate.

3. Discuss the advantages and disadvantages of using an absorption costing system for calculating

the total cost of a product.

The advantages of absorption costing are that it provides a means of sharing the total overheads of abusiness in the manufacturing sector over the various production cost centres and the overheads for aparticular production cost centre over the various products passing through it. It allows productionoverheads to be allocated or apportioned to the cost centres on a fair basis and absorbed into thecost unit using an appropriate using an overhead absorption rate. Non-production overheads areabsorbed into the cost unit by adding a percentage based on the proportion of non-productionoverheads to the total production cost.

However, there are a number of disadvantages. Not only is this cost accounting system is unsuitablefor businesses in the service sector, but a major limitation of absorption costing is that it is based onarbitrary decisions about the basis for apportioning and absorbing the overheads. Normallypredetermined overhead absorption rates are used because the actual figures are not available until




50

the end of the period, but if the predetermined overhead that has been absorbed is higher than theactual overhead, it will result in overabsorption, which reduces expenses in the statement ofcomprehensive income. On the other hand, if the predetermined overhead that has been absorbed is

lower than the actual overhead, it will result in underabsorption, which increases expenses in thestatement of comprehensive income. In addition, general overheads are spread across the productrange with little regard for how the costs are actually generated. Therefore, there is always someconcern that the total cost of each product is not being calculated in the most precise manner. If thebusiness is miscalculating the cost of its products and basing its selling prices on this inaccurateinformation, it could have a dramatic impact on financial performance. For example, if theinaccuracies result in selling prices that are too high, the business could lose market share tocompetitors; if they result in selling prices that are too low, the business will not achieve its plannedprofit.

A further criticism of absorption costing is that assigns indirect costs in proportion to the number ofunits produced (volume), but many resources used in support activities are not related to volume (egmachine set-up, where the cost varies with the complexity of the production process and the diversity

of the product range). This means too large a proportion of the cost of support activities is assigned tohigh volume products that cause little diversity, and too small a proportion is assigned to low volumeproducts that use more support activities.

4. Toy Craft Ltd

(a) Toy Craft Ltd

Production overhead analysisOverhead Total Basis of Machine Assembly Maintenance

apportionment department department department£ £ £ £

Indirect materials 24,500 Allocated 12,000 10,000 2,500Indirect labour 54,500 Allocated 14,000 18,000 22,500Rent and rates 26,000 Area 13,000 10,400 2,600Electricity 4,000 Area 2,000 1,600 400Depreciation on machinery 36,000 Value of machinery 24,000 8,000 4,000Supervisors' salaries 42,000 No. of employees 9,800 29,400 2,800

Subtotal 187,000 74,800 77,400 34,800 Apportioned service costs - Value of machinery 26,100 8,700 (34,800)

Total 187,000 100,900 86,100 -

(b) Machine department OAR

Cost centre overheads = £100,900 = £2.37 per machine hourNo. of machine hours 42,500

(c) Assembly department OAR

Cost centre overheads = £86,100 = £5.74 per direct labour hourDirect labour hours 15,000




51

5. West Wales Windsurfers Ltd

(a)

West Wales Windsurfers LtdProduction overhead analysisBasis of Body Finishing Canteen Totalapportionment* workshop workshop

£ £ £ £Production overheads Allocated 680,000 390,000 160,000 1,230,000

Apportioned service costs No. of employees 100,000 60,000

Total 780,000 450,000

*Students should give a rationale for the basis of apportionment used.

(b) Overhead absorption rates

Body workshop: Total machine hours (30 2,000) + (80 2,500) = 260,000

Cost centre overheads = £780,000 = £3.00 per unitNo. of machine hours 260,000

Finishing workshop: Total direct labour hours (40 2,000) + (40 2,500) = 180,000

Cost centre overheads = £450,000 = £2.50 per unitNo. of direct labour hours 180,000

(c) Predicted production cost per unit

Fun Wave Hot Racer

£ £

Direct costs

Materials 80 50

Labour

Body workshop 150 180

Finishing workshop 80 80

Indirect costs

Body workshop 90 240

Finishing workshop 100 100

Production cost 500 650




52

14. Activity-based costing


1. Discuss the reasons why accountants have developed ABC as an alternative to the traditionalmethod of absorption costing for charging overheads to products or services.

Once of the main criticisms of absorption costing is that this cost accounting system is based onarbitrary decisions about the basis for apportionment and absorption of overheads. In addition,general overheads are spread across the product range with little regard for how the costs areactually generated. Therefore, there is always some concern that the total cost of each product is notbeing calculated in the most precise way. If a business is miscalculating the cost of its products andbasing its selling prices on this inaccurate information, it could have a dramatic impact on financialperformance. For example, if the inaccuracies result in selling prices that are too high, the businesscould lose market share to its competitors; if they result in selling prices that are too low, the business

will not achieve its planned profit.

Absorption costing was developed at a time when the majority of firms were in the manufacturingsector and tended to carry high levels of inventory. Therefore, the valuation of inventory was veryimportant. In addition, direct labour was a major element in the cost of a product and overheads wererelatively small, so inaccuracies in apportioning indirect costs to cost units did not have a significanteffect on the total cost, which is calculated to determine the selling price or to value closing inventory.Today, advanced manufacturing technology (eg computer-controlled processes and robotics) hasdecreased direct labour costs and increased overheads (eg power, maintenance and depreciation onmachinery and equipment). Moreover, just-in time techniques mean little or no inventory is held.

Activity-based costing (ABC) was proposed by Johnson and Kaplan (1987), who questioned therelevance of traditional management accounting practices to modern business. The increased

importance of financial accounting as one of the main branches of accounting and the fact that themajority of firms are now in the service sector means that traditional management accountingtechniques based on the needs of manufacturers are irrelevant to many businesses today. ABC is „asystem of costing… that recognizes that cost are incurred by each activity that takes place within anorganization and that products (or customers) should bear costs according to the activities they use.Cost drivers are identified, together with the appropriate activity cost pools, which are used to chargecost to products‟ (Law, 2010, p. 15). The main assumption is that products (goods or services)consume activities and activities consume resources. This overcomes the problem of finding ameaningful relationship between non-production overheads and the production activity.

2. Describe the four main stages in implementing a system of activity-based costing, defining allterms used.

Activity-based costing (ABC) is a system of costing „that recognizes that costs are incurred by eachactivity that takes place within an organization and that products (or customers) should bear costsaccording to the activities they use. Cost drivers are identified, together with the appropriate activitycost pools, which are used to charge cost to products… An activity cost pool is a collection of indirectcosts grouped according to the activity involved (Law, 2010, p. 15). The implementation of an activity-based costing system involves four main steps:

Identify the main activities in the organization and classify them into activity centres if thereare a large number of different activities. An activity centre is an identifiable unit of theorganization that performs an operation that uses resources. For most organizations the firstactivity will be the purchase of materials. This will involve several sub-activities, such asdrawing up material specifications, selecting suppliers, placing the order, receiving and

inspecting the materials that have been delivered.




53

Identify the cost drivers associated with each activity centre. A cost driver is „any factor suchas number of units, number of transactions, or duration of transactions that drives the costsarising from a particular activity. When such factors can be clearly identified and measured,

they will be used as a basis for allocating costs to cost objects‟ (Law, 2010, p. 117). Forexample, a cost driver for the purchase of materials would be the number of orders placed; forcustomer support, it might be the number of calls answered; for a quality control activity, itmight be the number of hours of inspection conducted. Some activities have multiple costdrivers.

Calculate the cost driver rate, which is the cost per unit of activity. For example, in purchasingit would be the cost per order placed.

Assign costs to the products by multiplying the cost driver rate by the volume of the costdriver units consumed by the product. With purchasing, the cost driver rate will be calculatedon the basis of orders placed. For example, if Product A requires 15 orders to be placed inJanuary, the cost of purchasing activity for Product A will be 15 times the cost driver rate.

3. Write a short report discussing the types of business where ABC might be appropriate and theadvantages and disadvantages of implementing this type of cost accounting system.

Activity-based costing is best suited to businesses that operate in highly competitive markets andwhich have many different products that require complex production processes. In such firms thearbitrary process of absorption costing does not generate sufficiently specific information to aidmanagers in planning, controlling and decision making.

The main advantages of activity-based costing are:

It provides more comprehensive detail about product costs.

It generates data that is more specific and reliable than traditional costing.

Because it does not distinguish between production overheads and general overheads, it

overcomes the problem of finding a meaningful relationship between these non-productionoverheads and the production activity.

It provides better information about the costs of activities, thus allowing managers to makemore informed decisions.

It improves cost control by identifying the costs incurred by specific activities.

The main disadvantages are:

It can be costly and difficult to implement.

Trained and experienced staff are required to operate the system.

Substantial IT costs may be required.

Managers may not find the information useful.

It uses predetermined rates and therefore underabsorption or overabsorption of overheadswill still occur as they do under absorption costing.

Managers should be aware that the different basis for assigning costs to products is likely to result ina different total cost per unit. This can have important consequences for decision making and strategyin the company. More accurate cost information could lead to some products being eliminated andchanges in the market price of other products. Installing the system will require teamwork betweenaccounting, production, marketing and other functions in the company. Therefore, managementshould conduct a cost/benefit analysis before implementing activity-based costing and, unless theexpected benefits are greater than the costs, the firm should not move from absorption costing.




54

4. Continental Communications Ltd

Rate Standard Advanced Total

£ £ £ £Direct costsDirect labour 200,000 100,000 300,000Direct materials 50,000 20,000 70,000Indirect costsProduction 3,000 120,000 30,000 150,000Quality 2,000 16,000 24,000 40,000Delivery 200 16,000 4,000 20,000

Total cost 402,000 178,000 580,000

Number of units produced 100,000 50,000Cost per unit 4.02 3.56

5. Parfums de Paris AG

(a)Sweet Pea Allure

€ € Direct costs

Direct materials 35,000 12,000Direct labour 25,000 16,000Indirect overhead costs

Purchasing 1,800 720Quality control 4,000 3,000Material handling 4,000 2,000

Production cost 69,800 33,720

Litres produced 20,000 4,000Cost per litre €3.49 €8.43

(b) This seems to be a simple production process with little use of technology so it is not the type ofoperation that one would usually recommend adopts activity based costing. The overhead costsare modest compared to the cost of direct materials and direct labour and the company would bebetter advised to concentrate on controlling their direct costs. No information is given on thepackaging costs and the advertising and it would be worthwhile to investigate these. A fairlysimple absorption costing system may be a better approach for this company.




55

15. Marginal costing


1. Describe the purposes of marginal costing and the importance of contribution.

The purpose of marginal costing is to meets the need for detailed information about costs in abusiness where production levels fluctuate. It requires revenue expenditure to be classified intovariable costs or fixed costs according to the behaviour of the cost when the level of production orsales activity changes. A variable cost is „an item of expenditure that, in total, varies directly with thelevel of activity achieved‟ and a fixed cost is „an item of expenditure that remains unchanged, in total,irrespective of changes in the levels of production or sales (Law, 2010, pp. 430 and 194). The variablecosts per unit are usually regarded as the direct costs plus any variable overheads and are assumedto be constant in the short term. Therefore, a characteristic of a variable cost is that it is incurred at aconstant rate per unit; for example, the cost of direct materials will tend to double if output doubles.

Semi-variable costs contain both variable and fixed elements and must be analysed so that thevariable elements can be added to the other variable costs and the fixed elements can be added toother fixed costs.

In marginal costing, only the variable costs are charged to the units. The difference between salesrevenue and the variable costs is not the profit, since no allowance has been made for the fixed costsincurred; it is the contribution towards fixed costs. Contribution is „the additional profit that will beearned by an organization when the breakeven point production has been exceeded. The unitcontribution is the difference between the selling price of a product and its marginal cost of production.This is based on the assumption that the marginal cost and the sales value will be constant (Law,2010, p. 110). Contribution can be calculated for one unit or for any chosen level of sales. The totalcontribution is the contribution per unit multiplied by the number of units produced. Contribution isimportant because once the total contribution exceeds the total fixed costs the business starts making

a profit.

2. Explain the impact of limiting factors and how you would allow for them. Use a worked example toillustrate your answer.

A limiting factor is a constraint that restricts a business from achieving higher levels of profitability (ega shortage of materials or labour, a restriction on the sales demand at a particular price or a limit inthe production capacity of machinery). If the business has more than one product that uses the limitedresource, it could mean that the business can only make a limited number of products andmanagement needs to decide which products to make to obtain the maximum profit. The general ruleis to maximize production of the product with the highest contribution per unit of limiting factor.

The example should show how the contribution per unit of limiting factor has been calculated and howselection will maximise overall profitability.

3. Funfair Engineering Ltd

The report should include the following points:

(a) The total cost per unit increases because some costs are fixed. Therefore, the same total amountof cost has to be shared over fewer units.

(b) Marginal costing focuses on the contribution to fixed costs. In periods of recession, most decision-making is concerned with achieving the best contribution. Although in the long-term it is essential

that fixed costs are recovered, marginal costing can give a new perspective on the problemsconfronted by the businesses.




56

4. Edwards & Co Ltd

(a) Marginal cost statement 1 unit£

Revenue 10.00

Variable costsDirect materials (1.00)Direct labour (5.00)

(6.00)

Contribution 4.00

(b)Marginal cost statement 12,000 units

£

Revenue 120,000Variable costsDirect materials (12,000)Direct labour (60,000)

(72,000)

Contribution 48,000Fixed costs (32,000)


(c) The breakeven point is the level of production, sales volume, percentage of capacity, or salesrevenue at which an organization makes neither a profit nor a loss (Law, 2010, p 65). At this point,total revenue equals total costs (or total contribution equals total fixed costs).

(d) Breakeven analysis

(i) BEP in units

Fixed costs 32,000 = 8,000 unitsContribution per unit 4

(ii) BEP in sales revenue

BEP in units Selling price 8,000 10 = £80,000

(iii) Sales activity to reach target profit

Fixed costs + Target profit 32,000 + 20,000 = 13,000 unitsContribution per unit 4

(iv) Margin of safety

Selected level of activity - BEP in units 13,000 - 8,000 = 5,000 units




57

5. Audiomax Ltd

(a)

Audiomax LtdMarginal cost statement (1 unit)Premier Deluxe Superior

£ £ £Selling price 100 150 240

Variable costs Direct materials (30) (40) (50)Direct labour (30) (50) (120)Direct expenses (10) (25) (24)

(70) 115) (194)

Contribution 30 35 46

(b) Contribution per £1 direct materials

ContributionDirect materials

3030 = £1.00

3540 = £0.88

4650 = £0.92

Ranking 1st 3

r 2

n

Therefore, if direct materials are a limiting factor, maximise production of Premier, followed by Superior;reduce production of Deluxe.

(c) Contribution per £1 direct labour

ContributionDirect labour

3030 = £1.00

3550 = £0.70

46120 = £0.38

Ranking 1st 2

n 3

r

Therefore, if direct labour is a limiting factor, maximise production of Premier, followed by Deluxe;reduce production of Superior.

d) Other considerations (indicative)

The analysis does not take into account that more than one of the two limiting factors identifiedmay arise.

Management may have overlooked other limiting factors (eg constraints on production capacity,constraints on sales capacity, obsolescence of its products through development of newtechnology).

All the revenue and expenditure used in budgets is based on estimates and their utility dependson how realistic they are.

Budgeted figures are only useful if there is frequent monitoring against actual figures and actiontaken to remedy any adverse variances.

Budgeted figures may be difficult to predict for a new business or an existing business in a volatilemarket.




58

16. Budgetary planning and control


1. Describe the main stages in budgetary control and the specific purposes of a system of budgetary

control.

Budgetary control is the process by which financial control is exercised within an organization.Budgets for income and expenditure for each function of the organization are prepared in advance ofan accounting period and are then compared with actual performance to establish any variances.Individual function managers are made responsible for the controllable costs within their budgets, andare expected to take remedial action if the adverse variances are regarded as excessive (Law, 2010,p. 67). The main stages in budgetary control are:

Consult with managers to make assumptions and predictions about markets and business

environment Set financial objectives in the form of detailed budgets for income and expenditure for each

function of the business

Once the budget period begins, continuously compare actual performance against the budget

Revise the budget or take remedial action to ensure financial objectives are achieved

The overall purpose of budgetary control is to help managers plan and control the use of resources ina systematic and logical manner. This helps ensure that they achieve their financial objectives, whichare t

Profit satisficing (making a satisfactory level of profit)

Profit maximisation (making the maximum profit)

The overall purpose of budgetary control is to help managers to plan and control the use of resources.However, there are a number of more specific purposes.

A formal system of budgetary control enables an organization to carry out its planning in asystematic and logical manner.

Control can be achieved only by setting a plan of what is to be accomplished in a specifiedtime period and managers regularly monitoring progress against the plan, taking correctiveaction where necessary.

By setting plans, the activities of the various functions and departments can be co-ordinated.For example, the production manager can ensure that the correct quantity is manufactured tomeet the requirements of the sales team, or the accountant can obtain sufficient funding tomake adequate resources available to carry out the task, whether this is looking after children

in care or running a railway network. A budgetary control system is a communication system that informs managers of theobjectives of the organization and the constraints under which it is operating. The regularmonitoring of performance helps keep management informed of the progress of theorganization towards its objectives.

By communicating detailed targets to individual managers, motivation is improved. Without aclear sense of direction, managers will become demotivated.

By setting separate plans for individual departments and functions, managers are clear abouttheir responsibilities. This allows them to make decisions within their budget responsibilitiesand avoids the need for every decision to be made at the top level.

By comparing actual activity for a particular period of time with the original plan, any variance(difference), expressed in financial terms, is identified. This enables managers to assess theirperformance and decide what corrective action, if any, needs to be taken.

By predicting future events, managers are encouraged to collect all the relevant information,analyse it and make decisions in good time.




59

An organization is made up of a number of individuals with their own ambitions and goals.The budgetary control process encourages consensus by modifying personal goals andintegrating them with the overall objectives of the organization. Managers can see how their

personal aims fit into the overall context and how they might be achieved.

2. Describe the advantages and disadvantages associated with systems of budgetary control.

The main advantages of budgetary control systems are:

All the various functions and activities of the organization are co-ordinated.

Accounting information is provided to the managers responsible for income and expenditurebudgets to allow them to conduct variance analysis.

Capital and effort are used to achieve the financial objectives of the business.

Managers are motivated through the use of clearly defined objectives and the monitoring ofachievement.

Planning ahead gives time to take corrective action, since decisions are based on theexamination of future problems

Control is achieved if plans are reviewed regularly against performance

Authority for decisions is devolved to the individual managers.

The main disadvantages are:

Managers may be constrained by the original budget and not take effective and sensibledecisions when the circumstances warrant it. For example, they might make no attempt tospend less than maximum or make no attempt to exceed the target income.

Time spent on setting and controlling budgets may deflect managers from their primeresponsibilities of running the business.

Plans may become unrealistic if fixed budgets are set and the activity level is not as planned.This can lead to poor control.

Managers may become demotivated if budgets are imposed by top management withoutconsultation or if fixed budgets cannot be achieved due to a lower level of activity beyondtheir control.

3. Explain the difference between a fixed budget and a flexible budget, using an example to illustrate

your answer.

A fixed budget is „a budget that does not take into account any circumstances resulting in the actuallevels of activity achieved being different from those on which the original budget was based.Consequently, in a fixed budget the budget cost allowances for each cost item are not changed for the

variable items‟ (Law, 2010, p. 193). It can be contrasted with a flexible budget, which is „a budget thattakes into account the fact that values for income and expenditure on some items will change withchanging circumstances. Consequently, in a flexible budget the budget cost allowances for eachvariable cost item will change to allow for the actual levels of activity achieved‟ (Law, 2010, p. 195).

Example should show how a flexible budget changes in accordance with activity levels and reflectsthe different behaviours of fixed and variable costs.




60

4. Leisure Magazines Ltd

Answer should be in the form of a report. A variety of approaches can be taken, but a useful method

of analysis is to use the list of features that describe an effective system of budgetary control given inthe chapter. Recommendations will depend on the assumptions made, but should be credible and set

within a business context.

5. John‟s Bikes Ltd

John’s Bikes Ltd

Cash flow budget for 3 months ending 31 March 2014

January February March Total

£ £ £ £

Cash inflowsCapital 25,000 0 0 25,000

Loan 25,000 0 0 25,000

Cash sales 30,000 30,000 30,000 90,000

Credit sales 0 5,000 5,000 10,000

80,000 35,000 35,000 150,000

Cash outflows

Purchases 0 0 10,000 10,000

Rent and rates 24,000 0 0 24,000

Insurance 500 500 500 1,500

Advertising 1,000 0 0 1,000

Telephone and Internet 100 100 100 300

Salaries 6,100 6,100 6,100 18,300

Lighting and heating 200 200 200 600

Interest on loan 125 125 125 375

Equipment 12,000 0 0 12,000

Fixtures and fittings 20,000 0 0 20,000

Drawings 2,500 2,500 2,500 7,500

Subtotal 64,025 7,025 17,025 88,075

Net cash flow 15,975 27,975 17,975 61,925

Cumulative cash b/f 0 15,975 43,950 0

Cumulative cash c/f 15,975 43,950 61,925 61,925




62

17. Standard costing

1. Direct materials price variance = (SP - AP) actual quantity

= (£4 - £3) 5 kilos= £5 favourable

Possible reasons are the use of inferior quality materials, a cheaper supplier or bulk discounts.

2. Direct materials usage variance = (SQ - AQ) standard price

= (1,000 tonnes – 995 tonnes) £50= £250 favourable

Possible reasons are the use of better quality materials with less wastage.

3. Direct materials price variance = (SP - AP) actual quantity

= (£100 - £98) 52 kilos= £104 favourable

Direct materials usage variance = (SQ - AQ) standard price

= (50 kilos – 52 kilos) £100 Note: SQ = 200 kilos= (£200) adverse 4 units

Total direct materials cost variance = price variance + usage variance

= £104 – £200 (favourable price variance but adverse usage variance)= (£96) adverse

Possible reasons are the use of inferior materials leading to higher wastage than planned, use of anew supplier who provides materials with a slightly different specification, leading to higher usage.Higher marks can be achieved for suggesting where the responsibility lies and for makingrecommendations for further action.

4. Direct labour efficiency variance = (SH – AH) standard rate per hour

= (500 hours – 460 hours) £9= £360 favourable

Direct labour rate variance = (SR - AR) actual hours

= (£9 - £11) 460 hours Note: AR = £5,060= (£920) adverse 460 hours

Total direct labour variance = efficiency variance + rate variance= £360 - £920 (favourable efficiency variance but adverse rate variance)= (£560) adverse

Possible reasons are that more highly skilled labour has been employed than planned and their outputhas been greater. Perhaps unplanned bonus payments have been made to encourage higher levelsof productivity. The effect of these actions has led to an overall adverse variance of £560 and higher

marks should be given for suggesting what possible actions can be taken to remedy the situation.




63

5. Aphrodite Ltd

The answer needs to identify the general advantages of a standard costing system and include a

discussion of the processes involved in setting ideal or attainable standards and the information thesystem should produce in terms of variances. For higher marks, the answer should relate to the

particular context (eg by discussing the setting of separate standards for glass and aluminium). It

should also take into account that there are two products, with the deluxe product using more

expensive materials.




64

18. Capital investment appraisal


1. Explain the purpose of capital investment appraisal in general. In addition, explain the purpose ofthe payback period method and the accounting rate of return.

The purpose of capital investment appraisal is to provide information to management that will helpthem decide which of several proposed capital investment projects is likely to yield the highestfinancial return. Capital expenditure is the outlay of a considerable amount of money on a project suchas the purchase of a new non-current asset (eg buying a new factory), the enhancement of anexisting non-current asset (eg extending the existing factory) or investment in a new business venture.

The purpose of payback period method is to calculate the time required before the projected cashinflows for a project equal the investment expenditure so that the project that takes the shortestpossible time can be chosen. Whereas the payback period focuses on cash, the accounting rate of

return is a ratio that focuses on profit. The purpose of the accounting rate of return is to measure therelationship between the profit before interest and tax for a period and the capital employed at the endof that period so that management can choose the project with the highest rate of return.

2. Describe the advantages and disadvantages of the payback period method and the accounting

rate of return.

The main advantages of the simple payback period method are that it is simple to calculate and theresults are easy to understand. In addition, it is useful for comparing risky projects where theprediction of cash flows after the first few years is difficult (eg due to possible changes in the businessenvironment, such as advances in technology that could make a product obsolete in a short time). It isalso useful if short-term cash flows are more important than long-term cash flows or if borrowing orgearing is a concern.

On the other hand, there are a number of disadvantages. It is difficult to estimate the amount andtiming of future cash flows and the method ignores cash flows after the payback period. It also ignoresthe profitability of the project (eg the project with the shortest payback period might be chosen,although an alternative project with a longer payback period might be more profitable). In addition, themethod ignores the size of the investment (eg the project with a smaller initial investment may have ashorter payback period than an alternative project that requires a larger investment but is moreprofitable in the long term). A key disadvantage is that the simple payback period ignores the timevalue of money because it gives net cash flows in later years the same importance as those in Year 1.

The main advantages of the accounting rate of return are that, like the simple payback period method,

the calculations are simple and the results are easy to understand. However, it offers the addedadvantage that the entire life of the project is taken into account. It also useful because it iscompatible with the financial accounting ratio, return on capital employed, which is used to assess thefinancial performance of the business. The main disadvantages of the accounting rate of return arethat, like all ratios, there is no standard definition of terms used in the formula, which renderscomparison with ratios based on other definitions unreliable. A further disadvantage is that the ratio isbased on averages, which can be misleading as they are hypothetical values and the actual figure inany year may be higher or lower. In addition, the method does not take account of the benefit ofearning a larger proportion of the total profit in the early years of the project, the fact that a crucialfactor in investment decisions is cash flow or the timing of profits or cash. Finally, the results aredifficult to interpret because there is no guidance on what is an acceptable rate of return and, like thesimple payback period, the accounting rate of return does not take account of the time value ofmoney.




65

3. Jeffery‟s Boatyard Ltd

Project 1 Project 2

Net cash flow Cumulative Net cash flow Cumulativenet cash flow net cash flowYear £ £ £ £

0 (500,000) (500,000) (500,000) (500,000)1 80,000 (420,000) 90,000 (410,000)2 100,000 (320,000) 110,000 (300,000)3 180,000 (140,000) 190,000 (110,000)4 140,000 0 110,000 05 100,000 100,000 80,000 80,000

(a) Both projects have a payback period of 4 years, so either could be chosen.(b) Project 1 gives the largest cash return over the entire life of the project, but Project 2 is also

worthwhile as the largest cash flows are in early years. This may be more important if liquidityis a problem and the business recognises the importance of the time value of money. Neitherof these factors is incorporated in the simple payback period technique.

(c) Students should refer to the other limitations mentioned in the text and wider reading.

4. Film Animation Ltd

Project A Project B

£ £

Average sales revenue 318,500 358,000

Average costs and expenses (240,500) (264,400)

Average profit before interest and tax 78,000 93,600

Average capital employed 650,000 780,000

Average PBIT 100 78,000 100 93,600 100

Average CE 650,000 780,000

ARR = 12% = 12%

(a) Both projects have an accounting rate of return of 12%. Therefore, on the basis of thistechnique they are identical.

(b) Some businesses may choose Project A, if they can invest the £130,000 not required inanother project that provides a return in excess of 12%.

(c) Students should refer to the limitations mentioned in the text and wider reading.




66

5. Wren Electronics Ltd

(a) Equipment 1 Equipment 2

Year Net cash flow Cumulative Net cash flow Cumulativenet cash flow net cash flow£ £ £ £

0 (50,000) (50,000) (50,000) (50,000)1 5,000 (45,000) 20,000 (30,000)2 17,000 (28,000) 30,000 03 42,000 14,000 20,000 20,0004 30,000 44,000 20,000 40,0005 10,000 54,000 20,000 60,000

Payback period:2 + 28,000 = 2.67

28,000 + 14,000

= 2 years 8 months = 2 years

Ranking 2n

1st

(b)

Depreciation £50,000 - £0 = £10,000 pa

5

Equipment 1 Equipment 2 Year Net cash flow PBIT Net cash flow PBIT

£ £ £ £1 5,000 (5,000) 20,000 10,0002 17,000 7,000 30,000 20,0003 42,000 32,000 20,000 10,0004 30,000 20,000 20,000 10,0005 10,000 0 20,000 10,000

Total 54,000 60,000

Average (÷ 5) 10,800 12,000

ARR:

Av PBIT 100 10,800 100 = 22% 12,000 100 =24% Av CE 50,000 50,000

Ranking 2n 1st

(c) The results of this analysis show that Equipment 2 is likely to be the better investment. Thepayback period method shows that Equipment 2 has the shorter payback period (only 2 yearscompared to 2 years and 8 months for Equipment 1) and the accounting rate of return showsthat Equipment 2 is likely to give a higher return on the capital invested (24% compared to22% for Equipment 1).

(d) Students should refer to the limitations mentioned in the text and wider reading.




68

3. Melrose Events

Year Net cash flow Cumulative

net cash flow

Discount

factor

Present

value£ £ 12% £

0 (10,000) (10,000) 1.000 (10,000)

1 (4,000) (14,000) 0.893 (3,572)

2 (1,000) (15,000) 0.797 (797)

3 3,000 (12,000) 0.712 2,136

4 6,000 (6,000) 0.636 3,816

5 8,000 2,000 0.567 4,536

NPV (3,881)

Simple payback period:

4 years + 6,000

6,000 + 2,000

= 4.75 years

(a) The payback period is 4 years and 9 months and the NPV is a negative £3,881.

(b) The results are contradictory. The payback period suggests that the project is worthwhile, butthe NPV is negative. Kerry should not go ahead with the project because the NPV shows thatwhen the time value of money is taken into account by discounting the predicted net cashflows, the project is not viable.

(c) Kerry should check the basis of her figures carefully to ensure that her estimates are realistic,that all possible future cash flows have been included and she has considered non-financialfactors that may have an impact on the project. Students should refer to the limitationsmentioned in the text and wider reading.




69

4. Stuart‟s Boatyard Ltd

Project 1 Project 2

Discountfactor Cash flow Discountedcash flow Cumulativecash flow Cash flow Discountedcash flow Cumulativecash flowYear 6% £ £ £ £ £ £

0 1.000 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000)1 0.943 80,000 75,440 (424,560) 90,000 84,870 (415,130)2 0.890 100,000 89,000 (335,560) 110,000 97,900 (317,230)3 0.840 180,000 151,200 (184,360) 190,000 159,600 (157,630)4 0.792 140,000 110,880 (73,480) 110,000 87,120 (70,510)5 0.747 100,000 74,700 1,220 80,000 59,760 (10,750)

Discounted payback period:4 years + 73,480

73,480 + 1,220

= 4.98 years

(a) The discounted payback period for Project 1 is just under 5 years, but the investment in Project 2will not be recovered within the life of the project.

(b) Project 1 would be feasible as it has a discounted payback period of just under 5 years. However,the investment would not be recovered until the final month of the project. On the other hand,Project 2 should be rejected as the payback period based on an interest rate of 6% shows thatthe capital would not be recovered. Some students may point out that cumulative net cash flow forProject 1 by the end of year 5 represents a positive NPV for the project, although this decision isnot part of the payback period method.

(c) Students should refer to the limitations mentioned in the text and wider reading.




70

5. Bloomfield Laundry Ltd

The following model answer compares the required interest rate of 15% with a rate of 25%, which

was arrived at by chance. Students may show other interest rates arrived at through trial anderror.

YearDiscount

factorCashflow

Presentvalue

Cumulativecash flow

Discountfactor

Presentvalue

Cumulativecash flow

15% £ £ £ 25% £ £0 1.000 (50,000) (50,000) (50,000) 1.000 (50,000) (50,000)

1 0.870 10,000 8,700 (41,300) 0.800 8,000 (42,000)

2 0.756 25,000 18,900 (22,400) 0.640 16,000 (26,0000

3 0.658 25,000 16,450 (5,950) 0.512 12,800 (13,200)

4 0.572 20,000 11,440 5,490 0.410 8,200 (5,000)

5 0.497 10,000 4,970 10,460 0.328 3,280 (1,720)

NPV 10,460 NPV (1,720)

Discounted payback period:

3 years + 5,950 .

5,950 + 5,490

= 3.52 years

Internal rate of return (IRR) 15 + 10,460 10

10,460 + 1,720

= 23.59%

(a) Using an interest rate of 15% the discounted payback period is just over 3½ years, the NPV is£10,460 and the IRR is 23.59%.

(b) The discounted payback period using an interest rate of 15% is just over 3½ years, whichmakes the project worthwhile. The NPV is positive and shows a likely return of 15% plus£10,460. The IRR shows the return is likely to be 23.59%. These results suggest that theinvestment in the new dryers will be financially viable.

(c) Aunt Laura should check the basis of her figures carefully to ensure that her estimates arerealistic, that all possible future cash flows have been included and that she has considerednon-financial factors that may have an impact on the project. Students should refer to the

limitations mentioned in the text and wider reading.




71

20. Issues in management accounting


1. Describe the target costing process. Explain its advantages over a cost-plus approach to productor service pricing.

The main steps in target costing are:

Develop a product that satisfies the needs of customers. It is essential that any new productor service offers a bundle of attributes that are superior to those of competitors.

Determine an appropriate target price for the product based on customer‟s perceptions of thevalue of its attributes, the price of competing products and the target profit per unit. Thisrequires an assessment of the market price that is appropriate for bundle of attributes it offersand the competition it faces.

Calculate the target cost after allowing for target profit (target price minus target profit). Theentity must provide a return that is appropriate for the level of risk inherent in the business.

Use value engineering and SMA techniques to achieve the target cost per unit.

Under cost-plus pricing, the cost of producing the product or service dictates the selling price of theproduct or service. As markets are now increasingly competitive, prices should be determined throughanalysis of prevailing market forces and the competitiveness of the product or service, rather thanbeing driven by the cost of production or service delivery. In a target costing framework, the sellingprice of a product or service is seen as constrained by the market and the target cost is the goal thatan organisation must achieve to meet its strategic objectives.

2. Explain the purpose of environmental management accounting and explain how it can be used to

assist in the management and control of environmental costs.

Environmental management accounting (EMA) involves the identification, collection, analysis and useof non-financial and financial information for managing the environmental costs and impacts ofbusiness operations. The need for EMA is based on the premise that traditional managementaccounting systems cannot be used to measure environmental issues as they hide environmentalcosts as overheads, thereby obscuring their size and origin. Environmental costs are not typicallyallocated or apportioned in an appropriate manner as they are not made the responsibility of thedepartment or product that causes them. EMA aims to make environmental issues visible in all areasof organisational and operational decision-making and permit them to be managed effectively.

Corporate responses to green pressures largely involve the use of non-accounting expertise and non-financial information systems. Indicative of the current use of „non -accounting‟ methods to tackle

internal environmental issues is the way that many organisations have implemented environmentalmanagement systems (EMS) certified to the ISO 14001 standard (BSI, 2004). Such EMS are typicallystructured as an extension of either existing health and safety or TQM systems, rather than becominga routine part of the finance function.




72

3. Stunt Ltd

(a)

AttributesComponents of cost Safety Style Performance Importance % of total Strategic

10.0% 40.0% 50.0% index cost cost index

Handlebars & steering 40% 20% 40% 0.320 33.33% 0.96Footplate 40% 60% 20% 0.380 50.00% 0.76Wheels & suspension 20% 20% 40% 0.300 16.67% 1.80

Total 100% 100% 100% 1.000 100.00%

With the highest importance index of 38% (0.380), the aluminium footplate component is thelargest provider of the attributes that customers desire, although all three components have animportance level of at least 30%. The importance index of 0.320 for handlebars and steering iscalculated as: (Safety 10% x 40%) + (Style 40% x 20%) + (Performance 50% x 40%) = 0.320.

(b) The strategic cost index (SCI) is calculated as the relative importance of the attribute divided bythe cost of providing that attribute. The strategic cost index of 0.96 for handlebars and steering iscalculated as 0.320 importance index ÷ 0.3333 of total cost = 0.96. Management should redesignor re-engineer products to focus on the attributes with the highest SCI results and consider waysof eliminating attributes with very low SCI scores. The strategic cost index (SCI) results indicatethat the wheels and suspension component provides customers with substantial product benefitsfor a relative inexpensive target cost. On the other hand, the footplate is relative costly comparedto the product attributes it provides customers (a SCI of 0.76 is relatively low).




73

4. Electro Ltd

(a) Cost of quality report

2012 % of 2011 % of£ Revenue £ RevenuePrevention costs

Quality Engineering 770,000 520,000Quality training 1,100,000 700,000Supplier Reviews 200,000 50,000

Total 2,070,000 3.34% 1,270,000 2.24%

Appraisal costsDepreciation of test equipment 370,000 270,000Inspection 150,000 80,000Product testing 670,000 700,000

Total 1,190,000 1.92% 1,050,000 1.85%

Internal failure cost

Retesting 480,000 1,250,000Rework 580,000 770,000

Total 1,060,000 1.71% 2,020,000 3.56%

External failure costsCost of customer complaints department 270,000 480,000Lost contribution from lost sales 823,000 1,790,000Product recall 360,000 920,000Warranty repairs 240,000 320,000

Total 1,693,000 2.73% 3,510,000 6.19%

Total cost of quality 6,013,000 9.70% 7,850,000 13.84%

(b) During the past year the company has significantly increased its spending on prevention costs

and it has increased its spending on appraisal costs. This increased emphasis on prevention andappraisal has caused overall quality costs to decline to 9.70% of annual revenue during 2012(13.84% in 2011). The company has a better distribution of quality costs in 2012 with most of thecompany's quality costs traceable to internal and external failure, rather than to prevention andappraisal. Due to the increased spending on prevention and appraisal activities during 2012,internal failure costs decreased to £1.06 million (£2.02 million in 2011). External failure costs havefallen from £3.51 million in 2011 to just £1.693 million during 2012. If the company continues itsemphasis on prevention activities in future years, appraisal costs and internal failure costs shoulddecline further. As quality is built into products through better engineering and design, and asbetter process control is maintained, then defects should decrease. Thus, internal failures-and theneed to detect these failures through appraisal activities-will also decrease.




74

5. Contain Ltd

(a) The company‟s strategy for 2012 is a cost leadership strategy and it plans to grow by producing

high-quality containers at a low cost delivered to customers in a timely manner. The company‟scontainers are not differentiated and there are ten other manufacturers producing containers withsimilar product attributes. To succeed, the company must achieve lower costs relative tocompetitors through improvements in manufacturing, productivity and efficiency.

(b)

BSC Perspective Possible measures

Financial perspective Operating income from productivity gain – target £150,000Operating income from growth – target £300,000Cost reductions in key areas – increased yield on steel – target £50000

Customer perspective Market share of cost conscious consumers,New customers

Customer satisfactionCustomer retention/repeat customers and number of on-time ordersTime taken to fulfil customer orders

Internal businessprocesses

Yield on steelOrder fulfilment timeOn-time delivery% of defective containers per 1,000 unitsProductivity

Learning and growth % of staff trained in TQM techniquesEmployee retentionEmployee satisfaction

(c) Students should briefly explain the rationale for selecting the measures and comment on the

cause and effect relationship between them.

(d) The potential benefits are that in contrast to traditional performance measurement systems thatsolely focus on the achievement of financial objectives, the BSC combines financial and non-financial performance measures and evaluates short, medium and long-term performancemeasures in a single cohesive report. As a result, the technique focuses on the non-financialobjectives that an organisation must achieve in order to meet its financial objectives. The logic forthis is that non-financial and operational indicators can capture improvements in performance thatshort-term financial measures may not. Thus, BSC provides an appropriate balance and linkbetween non-financial and financial performance measures, as non-financial performanceimprovements must eventually lead to tangible pay-offs. By using a balanced scorecard, thecompany can be sure that any strategic action matches the desired outcomes. A BSC systemallows management to communicate strategy to employees by translating it into performance

measures that they understand and can influence, and it prevents sub-optimal trade-offs andinappropriate cost cutting (eg cutting R&D expenditure during a recession). In addition, BSCoffers the advantage that it concentrates solely on the critical measures of performance.

However, the company should be aware that there is much debate over whether there is a cause-and-effect relationship between the four perspectives in the balanced scorecard. At a conceptuallevel, there is only a logical rather than a causal relationship between non-financial performancemeasures and future financial performance (Norreklit, 2000). For example, the production of highquality products does not always result in increased profit, especially when customers areunwilling to pay for such improvements. Furthermore, in many instances, a loyal and highlysatisfied customer may not be a profitable one, as they may require many hours of costlycustomer service time. It may be confusing to mix subjective performance measures (eg customersatisfaction levels) and objective performance measures (eg. increased revenue) as it may not be

possible to assess the time lag between each cause-and-effect between measurements.




75

A further criticism of the BSC is that if too many performance measures are used, it will produceconfusing and conflicting data. Moreover, since financial measures are normally used to evaluatethe performance of managers, management may attach less importance to improving non-

financial performance. Other limitations include the exclusion of other stakeholder perspectives(eg suppliers and employees), it can be costly to implement in terms of resources andmanagement time, and that it needs to fit the organisation‟s culture.




76

A1. Financial statements for a partnership

1. H&G Tool Hire

H&G Tool HireStatement of comprehensive income for

the year ended 31 December 2013 (extract)£

Profit for the period 95,000Interest on drawings Harry 1,500

George 1,000

97,500Salaries Harry (15,000)

George (10,000)Interest on capital Harry (1,000)

George (3,000)

Balance of profits to be shared 68,500

Harry 60% 41,100George 40% 27,400

68,500

2. H&G Tool Hire

Current accounts

Harry George

£ £Salaries 15,000 10,000Interest on capital 1,000 3,000Share of profits 41,100 27,400

57,100 40,000Interest on drawings (1,500 (1,000)Drawings (35,000) (32,000)

Closing balance 20,600 7,000




77

3. J&B Services

Goodwill working

£Total net assets of the new partnership (£2000,000 x 3) 600,000Net assets + investment by new partner (£120,000 x 2) + £200,000 (440,000)

Goodwill 160,000

Goodwill account

£ £Jarvis 80,000Berry 80,000

Capital account: Jarvis

£ £Opening balance 120,000

Goodwill 80,000

Capital account: Berry

£ £Opening balance 120,000Goodwill 80,000

Capital account: Coyle

£ £Bank 200,000

4. Page & Partners

Statement of comprehensive income forthe year ended 31 December 2012 (extract)

£Profit for the year 131,950Interest on drawings (5%) Page 2,750

Jones 1,000Beattie 1,400

137,100Salaries Page (15,000)

Jones (10,000)Beattie (10,000)

Interest on capital (10%) Page (5,000)Jones (7,500)Beattie (8,500)

Balance of profits to be shared 71,100

Page 33% 23,700Jones 33% 23,700Beattie 33% 23,700

71,100




78

Current accounts Page Jones Beattie

£ £ £

Opening balance 4,500 2,000 5,000

Salaries 15,000 10,000 10,000Interest on capital 5,000 7,500 8,500Share of profits 23,700 23,700 23,700

48,200 43,200 47,200

Interest on drawings (2,750) (1,000) (1,400)Drawings (55,000) (20,000) (28,000)

Closing balance (9,550) 22,200 17,800

5. Mourne, Noonan & Knight

Realisation account

£ £Premises 50,000 Bank: Sale of premises 47,500Stock 48,600 Bank: Sale of stock 41,100Debtors 28,200 Bank: Debtors realised 26,800

Loss on realisation: Mourne 3,800Noonan 3,800Knight 3,800

126,800 126,800

Bank account

£ £Realisation: Premises 47,500 Opening balance 28,700Realisation: Stock 41,100 Creditors 78,300Realisation: Debtors 26,800 Payment to Mourne 5,400

______ Payment to Noonan 3,000115,400 115,400

Capital accounts

Mourne Noonan Knight Mourne Noonan Knight£ £ £ £ £ £

Loss on realisation 3,800 3,800 3,800 Opening balance 8,000 6,000 2,000Knight* 800 600 Current accounts 2,000 1,400 400Bank 5,400 3,000 Mourne* 800

Noonan* 6008,000 7,400 44,700 10,000 7,400 3,800

* Garner v. Murray (1904) requires that losses are shared in the ratio of the partners‟ capital accounts(not their profit-sharing ratios).




79

A2. Costing for specific orders and continuous processes


1. Distinguish between normal loss and abnormal loss, and explain their costing treatments.

The main points are as follows:

Normal loss is „the loss arising from a manufacturing or chemical process through waste,seepage, shrinkage, or spoilage that can be expected, on the basis of historical studies, to be partof that process. It may be expressed as a weight or volume or in other units appropriate to theprocess. It is usually not valued but if it is, a notional scrap value is used‟ (Law, 2010, p. 299). Onthe other hand, abnormal loss is „the loss arising from a manufacturing or chemical processthrough abnormal waste, seepage, shrinkage, or spoilage in excess of the normal loss. It may beexpressed as a weight or volume or in other units appropriate to the process; it is usually valued

on the same basis as the good output‟ (Law, 2010, p. 1).

2. Imprint Ltd

Imprint LtdJob 213 – Wedding invitations

£Materials 30Wages (£5 4 hours) 20

Production overheads (£2.50 4 hours) 10

Production costs 60

General overheads (20%) 1272

Profit (25%) 18

90

3. Townday Building Ltd

Townday Building LtdContract No. 33 – Grove Lane

£

Cost of work done: Work certified 140,000Work not certified 34,000

174,000

Estimated contract profit: Contract price 320,000Estimated total costs 260,000

60,000

Profit at year end: £174,000 £60,000 = £40,150

£260,000

answers to practice questions

Documents