Answers To Practice Questions

Answers to Practice Questions
Business Accounting Answers to Practice Questions
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 on financial 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.
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
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 explain why students studying business and management should learn about accounting. The money measurement concept states that only items that can be measured in monetary terms are included in the financial statements. The main advantages are that it makes it easier to aggregate and summarise transactions, and compare financial statements. In addition, the concept is appropriate as business 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 it limits the usefulness of information in the financial statements because non-financial items are ignored (eg loyalty of workforce, management skills, size of customer base). In addition, the value of money is not stable due to inflation/deflation and, if business has international transactions, the value of money fluctuates with exchange rates. The main reason why business and management students should learn about accounting is that it will enhance their future employability. Irrespective of whether they become entrepreneurs and start their own businesses or find jobs in large, small or medium-sized entities, they will need a basic understanding of accounting. This is because they will need to understand the financial and other quantitative information that accounting provides to help them to control the resources for which they are responsible, plan how those resources can be most effectively used and decide what course of action they should take when a number of options are open.
2. Define the term accounting and explain the difference between the two main branches of accounting. In its broadest sense, accounting can be defined as a service provided to those who need financial information. 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 of accounting: Financial accounting is concerned with classifying, measuring and recording the economic transactions of an entity in accordance with established principles, legal requirements and accounting 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 the accounting period. Management accounting is concerned with collecting and analyzing financial and other quantitative information. It is primarily concerned with communicating information to management to help effective performance measurement, planning, controlling and decision making. Therefore, the main differences between the two branches of accounting are that financial accounting is guided by a regulatory framework and focuses on meeting the needs of external users (those not involved in managing the business), and management accounting is unregulated and focuses on meeting the needs of internal users. However, both branches of accounting draw on the same data sources to generate financial information.
3. Explain the concept of limited liability and the advantages of a company over an unincorporated business. Limited liability means that on liquidation, the liability of the members of a limited liability company or limited 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 by guarantee. Limited liability for the debts of the business is the main advantage that an incorporated business has over an unincorporated business. An associated advantage is that if one of the members of an incorporated business dies, his or her shares can be transferred to someone else and the business continues, whereas an unincorporated entity has a finite life. The indefinite life of an incorporated entity is possible because complementary to the concept of limited liability for members is the notion that the company is a separate legal person distinct from the members and the directors (Mallett and 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 to the public and, if it is listed on the stock exchange, its shares can be traded in the stock market. However, a private limited companys shares cannot be advertised and can only be offered for sale privately. One of the main advantages of a private company is that, unlike a public listed company, it is not obliged to comply with stock exchange regulations and most small private companies do not have to disclose as much financial information as a public company. In addition, the formalities for setting 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).
2. The importance of cash

The following narrative answers are indicative of the main points in the chapter. 1. Define finance and explain why students studying business or management should learn about the management of money. Finance is the practice of manipulating and managing money. It can also be used to describe the capital involved in a project, especially the capital needed to start a new business [or] a loan of money for a particular purpose, especially by a financial house (Law (2010, p. 185). The main reason why business and management students should learn about finance is that it will enhance their future employability. Irrespective of whether they become entrepreneurs and start their own businesses or find jobs in large, small or medium-sized entities, they will need a basic understanding of finance. This is because they will need to understand the main sources of finance and how to use cash flow information to check that there will be sufficient cash to meet the needs of the entity and to plan the investment 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 an existing business have difficulty in gaining access to the finance they need. A finance gap is the situation 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 that the financing needs of small business were not well served by the financial services institutions at that time. The main argument supporting the notion of a finance gap is that the majority of enterprises in the UK (and elsewhere) are small and medium-sized sole proprietorships, partnerships and private companies, which cannot raise equity finance by selling shares to the public. This is because only public listed companies can raise capital on a stock exchange. This aspect of the finance gap is sometimes referred to as the equity gap. 3. Describe the potential sources of long-term finance available to a sole proprietorship or traditional partnership. Long-term finance is used to provide assets that are expected to provide economic benefits to the business in the long-term. There are two potential sources of long-term finance for unincorporated businesses and both can be classified as debt finance. A long-term loan is a suitable form of finance for capital investment in assets that are not acquired for trading purposes but intended to be kept in the business in the long term, such investment in plant and machinery. A mortgage is a long-term loan for purchasing land or premises. Mortgages are usually supplied by financial institutions, such as banks and building societies, for a specified number of years (in the UK the maximum period is usually 25-30 years) at a fixed or variable rate of interest. Repayment may be in instalments or at the end of the term.
4(a) Dudes & Divas Ltd Cash flow forecast 1 July to 30 September 2012 July August September Cash inflows Capital 25,000 0 0 Cash sales 10,000 10,000 10,000 Credit sales 0 2,000 2,000 35,000 12,000 12,000 Cash outflows Purchases 0 0 5,000 Overheads 5,000 5,000 5,000 Salaries 1,500 1,500 1,500 Fixtures and fittings 0 0 30,000 6,500 6,500 41,500 Net cash flow 28,500 5,500 (29,500) Cumulative cash b/f 0 28,500 34,000 Cumulative cash c/f 28,500 34,000 4,500
Total 25,000 30,000 4,000 59,000 5,000 15,000 4,500 30,000 54,500 4,500 0 4,500
4(b) The forecast cumulative cash position at the end of each month is positive. The cash flow forecast 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 Cash inflows Revenue from A Revenue from B Cash outflows Rent and rates Electricity Telephone and Internet Printing, postage and stationery General expenses Tools and equipment Net cash flow Cumulative cash b/f Cumulative cash c/f 0 0 0 1,500 0 0 0 25 2,500 4,025 (4,025) 0 (4,025) 0 1,300 1,300 0 120 0 209 25 1,000 1,354 (54) (4,025) (4,079) 792 1,300 2,092 0 120 50 216 25 500 911 1,181 (4,079) (2,898) 858 1,560 2,418 1,500 120 0 242 25 0 1,887 531 (2,898) (2,367)
May 858 1,560 2,418 0 120 0 255 25 0 400 2,018 (2,367) (349)
June 990 1,560 2,550 0 120 50 248 25 0 443 2,107 (349) 1,758
Total 3,498 7,280 10,778 3,000 600 100 1,170 150 4,000 9,020 1,758 0 1,758
5(b) Philip needs to invest capital of 4,079 in January to prevent the business from having a cash deficit during the first six months.
Part II Financial accounting 3. The accounting system

1. Wellworth Fencing Ltd Capital account 1 June Bank account 50,000 1 June 1 June 1 June 2 June 2 June 2 June Lorry account 16,000 Lorry insurance account 1,400 Rent account 4,500 Equipment account 5,400 Purchases account 850 120 Advertising account 420 Timber Supplies Ltd account 4 June Purchases 50,000
Bank
1 June
Capital
Lorry Lorry insurance Rent Equipment Purchases Advertising
16,000 1,400 4,500 5,400 850 420
1 June
Bank
1 June
Bank
1 June
Bank
1 June
Bank
2 June 4 June
Bank Timber supplies
2 June
Bank
120
2. Lavender & Lace Ltd Sales account 2 July 3 July Postage account 25 31 Window cleaning account 10
Cash Cash
138 192
1 July 2 July
Cash Cash
1 July
Cash
1 July 1 July
Cash Cash
Stationery account 15 36 Parking account 2 2 2 Petrol account 18 18 Purchases account 104 89
1 July 2 July 3 July
Cash Cash Cash
1 July 2 July
Cash Cash
2 July 3 July
Cash Cash
3. Burtons Books Ltd Bank account 6,400 2 October 1,800 3 October 950 16 October 950 18 October 1,450 25 October 31 October 11,550 3,200
1 October 12 October 15 October 18 October 30 October
Balance b/f Sales Jones Ltd Jones Ltd Sales
Purchases Advertising Purchases Davies Ltd Purchases Balance c/f
750 1,120 2,300 780 3,400 3,200 11,550
1 November
Balance b/f
4. ONeill Ltd ONeill Ltd account 850 30 November 1,650 30 November 260 400 640 3,800 1,900
2 November 12 November 18 November 21 November 25 November 1 October
Sales Sales Sales Sales Sales Balance b/f
Cash Balance c/f
1,900 1,900
3,800
5. Hampton Health Food Ltd Hampton Health Food Ltd Trial balance as at 30 June 2012 Debit Credit Sales 26,200 Purchases 36,770 Returns inward 900 Returns outward 460 Discounts allowed 720 Discounts received 620 Equipment 2,000 Bank 1,500 Salaries 1,600 Rent 1,400 General expenses 390 Capital at 1 July 2011 _____ 18,000 45,280 45,280
4. Regulatory framework for financial reporting

The following narrative answers are indicative of the main points in the chapter. 1. Describe the key elements of the regulatory framework for public and private companies in the UK. The key elements of the regulatory framework in the UK are: Company law as represented by the Companies Act 2006 (CA2006) and subsequent statutory instruments 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 financial reporting and the purpose of the regulatory framework. Financial reporting refers to the statutory disclosure of general purpose financial information by limited liability entities via the annual report and accounts. Financial reporting is derived from a complex process known as financial accounting, which is concerned with classifying, measuring, and recording the economic transactions of an entity in accordance with established principles, legal requirements and accounting 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. These external parties include 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, the directors would provide unambiguous and value-free measures of wealth, but the world is not ideal and, hence, the need for regulation. The purpose of the regulatory framework is to guide corporate financial reporting. This helps the preparers, 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 a discipline on companies. Regulation also allows suspected cases of fraud or misconduct to be investigated and curbs creative accounting. 3. Explain the acronym GAAP and outline the historical reasons why one countrys GAAP could develop 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 GAAP comprises general rules which have been codified in company law and more detailed regulations which are contained in accounting standards. In addition, public companies with a listing on the London Stock Exchange must comply with stock exchange rules. The historical reasons for international differences in GAAP can be summarised as differences in accounting principles, differences in what is perceived as the objectives of financial reporting, and various economic, social and cultural factors. A countrys GAAP is likely to consist of accounting practices 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 an unusual event (eg a financial scandal) or a change in the economic environment. However, it is unlikely that countries will experience the same unusual events and, if they do, the events may not occur 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 for decision making and in others it is on providing financial information for creditor protection and 10
taxation. This difference arises because in some countries (eg the UK) the main source of finance is equity finance raised on the stock market, whereas in other countries (eg Germany) it is debt finance from 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 be prepared. One of the key cultural factors that creates differences is due to different attitudes. In some countries it is taken for granted that a law should be obeyed, whereas in other countries there is a subtle 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 other event should be reflected in the financial statements. In the UK, compliance with accounting standards 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 into immediate 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 intercompany 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. 11
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 ASBs 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 the advantages and disadvantages of the new regime. Refer to the above website and other sources.
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5. Conceptual framework for financial reporting

The following narrative answers are indicative of the main points in the chapter. 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 financial accounting and reporting (Law, 2010, p. 102). The IASBs revised conceptual framework (first revisions published in 2010) is called the Conceptual Framework for Financial Reporting. The main advantage of a conceptual framework is that it clarifies the conceptual underpinnings of accounting standards and allows standard setters to develop accounting standards on a consistent basis. It also assists preparers, auditors and users of financial statements to understand the approach to standard setting, and the nature and function of the financial information reported. In addition, a conceptual framework gives guidance to preparers resolving accounting issues that are not specifically addressed by an existing IFRS or interpretation.
2. Describe the objective of general purpose financial reporting and the information needs of the three primary user groups identified in the IASB Framework (2010). The objective of general purpose financial reporting is to provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments and providing or settling loans and other forms of credit. [OB2]. This principle forms the foundation of the Framework and other aspects of the Framework flow logically from it. The primary users of general purpose financial reports are existing and potential investors, lenders and other 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 payments or market price increases in equity and debt instruments. Lenders need financial information to help them make lending decisions. These decisions depend on the lending risks and returns. They need to assess whether loans can be repaid and whether the interest they expect to receive will be paid when it is due. As expectations depend on their assessment of the amount, timing and uncertainty of payments, they need information that will help them assess the prospects for future net cash inflows to an entity. Creditors need financial information to help them make credit decisions. These decisions will depend on the credit risks and returns. The latter usually take the form of interest payments. As in the case of lenders, their expectations depend on their assessment of the amount, timing and uncertainty 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 issue of the IASB Framework. Chapter 3 of the IASB Framework (2010) divides the qualitative characteristics of that are likely to make 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 13
relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entitys 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 for the entity in other periods, or similar information for other entities. A comparison requires at least two items. Consistency helps achieve comparability and refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. 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 to understand, 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 in the 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 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.
Elements of financial performance (IASB, 2010, para 4.25): Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
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5. Explain the general recognition criteria relating to the elements of financial statements and outline the 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 financial position or statement of comprehensive income if it meets the definition of an element and it also satisfies the following conditions: It is probable that any future economic benefit associated with the item will flow to or from the entity; and The item has a cost or value that can be measured with reliability (IASB, 2010, para 4.37-38).
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6. Statement of comprehensive income

The following narrative answers are indicative of the main points in the chapter. 1. Describe the general purpose of the statement of comprehensive income. In addition, explain the terms 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 the financial performance of business over the accounting period. Financial performance is concerned with the profitability of the entity. Users need information on the entitys financial performance to assess potential changes in its economic resources and its capacity to generate cash from its resources. In addition, users need information to evaluate how effectively any additional resources might 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 or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
2. Explain the accrual basis of accounting by defining the principles involved. Illustrate your answer by 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 period in 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 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). For example, the cost of sales includes purchases made during the period, irrespective of whether cash has yet changed hands. Cost of sales excludes the cost of closing inventory to match cost of goods sold during the period with sales revenue for the period.
3. Missing figures (a) 100 400 500 (50) 450 (f) 10,000 (6,000) 4,000 (3,500) 500 (b) 50 680 730 (210) 520 (g) 600 (450) 150 (100) 50 (c) 1,020 10,210 11,230 (1,550) 9,680 (h) 17,000 (13,500) 3,500 (3,250) 250 (d) 232 1,924 2,156 (150) 2,006 (i) 18,150 (680) 17,470 (15,370) 2,100 (e) 14,960 163,570 178,530 (18,815) 159,715 (j) 27,750 (24,590) 3,160 (2,420) 740
Opening inventory Purchases Closing inventory Cost of sales
Revenue Cost of sales Gross profit Expenses Profit for the period
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4. Uplights Ltd Statement of comprehensive income for the year ended 31 December 2012 Revenue Cost of sales (W1) Gross profit Bank interest received Rent and rates Salaries Insurance Lighting and heating Telephone and Internet Advertising Operating profit Income tax expense Profit for the period Working 1 Purchases Closing inventory Cost of sales 20,000 (8,000) 12,000 66,500 (12,000) 54,500 100 (24,000) (21,500) (2,000) (500) (400) (100) 6,100 (2,000) 4,100
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5(a) Miphone Ltd Draft statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Other income Salaries Rent and rates Insurance Advertising (W2) Lighting and heating (W2) Telephone and Internet (W2) General expenses Operating profit Income tax expense Profit for the period 75,200 (11,270) 63,930 1,200 (24,000) (18,000) (7,200) (600) (1,160) (740) (410) 13,020 (1,200) 11,820
Working 1 Purchases Closing inventory Cost of sales Working 2
12,160 (890) 11,270 Trial balance 860 620 450 250 Accrued 540 290 160 Prepaid (260) Total 600 1,160 740 410
Advertising Lighting and heating Telephone and Internet General expenses
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5(b) Miphone Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Rental income Salaries Rent and rates Insurance Advertising (W2) Lighting & heating (W2) Telephone & Internet (W2) General expenses Allowances: Depreciation on plant and equipment (W3) Doubtful receivables (W4) Operating profit Income tax expense Profit for the period 75,200 (11,270) 63,930 1,200 (24,000) (18,000) (7,200) (600) (1,160) (740) (410) (5,000) (120) 7,900 (1,200) 6,700
12,160 (890) 11,270 Trial balance 860 620 450 250 Accrued 540 290 160 25,000 (5,000) 1,200 (120) Prepaid (260) Total 600 1,160 740 410
Working 3 Plant and equipment at cost Allowance for depreciation ( 5 years) Working 4 Trade receivables in trial balance Allowance for doubtful receivables (10%)
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5(c) Miphone Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Rental income Distribution costs (W5) Administrative expenses (W5) Operating profit Income tax expense Profit for the period 75,200 (11,270) 63,930 1,200 (28,855) (28,375) 7,900 (1,200) 6,700
12,160 (890) 11,270 Trial balance 860 620 450 250 Accrued 540 290 160 25,000 (5,000) 1,200 (120) Amount 24,000 18,000 7,200 600 1,160 740 410 5,000 120 57,230 Distribution costs 12,000 9,000 3,600 600 580 370 205 2,500 28,855 Administrative expenses 12,000 9,000 3,600 580 370 205 2,500 120 28,375 Finance costs Prepaid (260) Total 600 1,160 740 410
Working 3 Plant and equipment at cost Allowance for depreciation ( 5 years) Working 4 Trade receivables in trial balance Allowance for doubtful receivables (10%) Working 5
Salaries Rent and rates Insurance Advertising (W2) Lighting and heating (W2) Telephone and Internet (W2) General expenses Allowances: Depreciation: Plant and equipment (W3) Doubtful receivables (W4)
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6. Beauty Box Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Interest received Salaries Rent and rates Insurance Lighting & heating Telephone & Internet Advertising Allowances: Depreciation on equipment (W2) Doubtful receivables (W3) Operating profit Income tax expense Profit for the period 104,900 (37,700) 67,200 100 (30,000) (15,000) (3,000) (1,500) (2,000) (500) (4,000) 400 11,700 (4,500) 7,200
Working 1 Opening inventory Purchases Closing inventory Cost of sales
10,000 39,700 (12,000) 37,700 20,000 (4,000) 6,000 (600) 5,400 (1,000) 400
Working 2 Equipment at cost Allowance for depreciation ( 5 years) Working 3 Trade receivables in trial balance Year 2 doubtful debts Adjusted trade receivables Year 1 doubtful debts Decrease in doubtful debts
21
7. Statement of financial position

The following narrative answers are indicative of the main points in the chapter. 1. Describe the general purpose of the statement of financial position. In addition, explain the terms asset, 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 on the 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 your answer by taking the example of the valuation of tangible assets in the statement of financial position. 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. IAS 1, Presentation of Financial Statements (IASB, 2011) 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. For example, if an entity were not deemed to be a going concern, the tangible assets would be valued at their net realisable value (the disposal value less any direct selling costs), which is likely to be substantially lower than the carrying amount.
22
3. Insert the missing figures in the following examples, remembering that some items will be added and others will be subtracted. (a) ASSETS Non-current assets Current assets Total assets EQUITY AND LIABILITIES Equity Capital Retained earnings Liabilities Non-current liabilities Current liabilities Total equity and liabilities Note In the chapter we showed the amounts for equity and liabilities in the chapter in brackets to remind you 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. 12,400 3,400 15,800 (b) 22,800 3,700 26,500 (c) 32,000 4,200 36,200 (d) 42,200 10,600 52,800 (e) 54,200 11,800 66,000
5,000 4,800 9,800 5,000 1,000 6,000 15,800
6,000 13,300 19,300 6,000 1,200 7,200 26,500
10,000 22,700 32,700 2,000 1,500 3,500 36,200
15,000 25,800 40,800 10,000 2,000 12,000 52,800
10,000 37,700 47,700 15,000 3,300 18,300 66,000
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4. Uplights Ltd Statement of comprehensive income for the year ended 31 December 2012 Revenue Cost of sales (W1) Gross profit Bank interest received Rent and rates Salaries Insurance Lighting and heating Telephone and Internet Advertising Operating profit Income tax expense Profit for the period 66,500 (12,000) 54,500 100 (24,000) (21,500) (2,000) (500) (400) (100) 6,100 (2,000) 4,100
Uplights Ltd Draft statement of financial position at 31 December 2012 ASSETS Non-current assets Property, plant and equipment at cost Current assets Inventory Trade and other receivables Cash Total assets EQUITY AND LIABILITIES Equity Share capital Retained earnings Current liabilities Trade and other payables Current tax payable Total equity and liabilities
20,000 8,000 2,000 14,500 24,500 44,500
30,000 4,100 34,100 8,400 2,000 10,400 44,500
Working 1 Purchases Closing inventory Cost of sales
20,000 (8,000) 12,000
24
5(a) Miphone Ltd Draft statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Other income Salaries Rent and rates Insurance Advertising (W2) Lighting and heating (W2) Telephone and Internet (W2) General expenses Operating profit Income tax expense Profit for the period 75,200 (11,270) 63,930 1,200 (24,000) (18,000) (7,200) (600) (1,160) (740) (410) 13,020 (1,200) 11,820
Miphone Ltd Draft statement of financial position at 30 June 2012 ASSETS Non-current assets Property, plant and equipment (at cost) Current assets Inventory Trade and other receivables (W3) Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Share capital Retained earnings Current liabilities Trade and other payables (W4) Current tax payable Total equity and liabilities
25,000 890 1,460 3,260 5,610 30,610
15,000 11,820 26,820 2,590 1,200 3,790 30,610
12,160 (890) 11,270
25
Working 2 Advertising Lighting and heating Telephone and Internet General expenses Total accruals/prepayments Working 3 Opening trade receivables Prepayments (W2) Trade and other receivables Working 4 Opening trade payables Accruals (W2) Trade and other payables 5(b)
Trial balance 860 620 450 250
Accrued 540 290 160 990
Prepaid (260)
Total 600 1,160 740 410
(260)
1,200 260 1,460 1,600 990 2,590
Miphone Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Rental income Salaries Rent and rates Insurance Advertising (W2) Lighting & heating (W2) Telephone & Internet (W2) General expenses Allowances: Depreciation on plant and equipment (W3) Doubtful receivables (W4) Operating profit Income tax expense Profit for the period 75,200 (11,270) 63,930 1,200 (24,000) (18,000) (7,200) (600) (1,160) (740) (410) (5,000) (120) 7,900 (1,200) 6,700
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Miphone Ltd Statement of financial position at 30 June 2012 ASSETS Non-current assets Property, plant and equipment (W3) Current assets Inventory Trade and other receivables (W4) Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Share capital Retained earnings Current liabilities Trade and other payables (W5) Current tax payable Total equity and liabilities Working 1 Purchases Closing inventory Cost of sales Working 2 Advertising Lighting and heating Telephone and Internet General expenses Total accruals/prepayments 12,160 (890) 11,270 Trial balance 860 620 450 250 Accrued 540 290 160 990 Prepaid (260) Total 600 1,160 740 410
20,000 890 1,340 3,260 5,490 25,490
15,000 6,700 21,700 2,590 1,200 3,790 25,490
(260)
Working 3 Property, plant and equipment at cost Year 1 depreciation Closing carrying amount Working 4 Trade receivables in trial balance Allowance for doubtful receivables Adjusted trade receivables Prepayments Trade and other receivables Working 5 Opening trade payables Accruals Trade and other payables 5(c)
25,000 (5,000) 20,000 1,200 (120) 1,080 260 1,340 1,600 990 2,590 27
Miphone Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Rental income Distribution costs (W6) Administrative expenses (W6) Operating profit Income tax expense Profit for the period Miphone Ltd Statement of financial position at 30 June 2012 ASSETS Non-current assets Property, plant and equipment (W3) Current assets Inventory Trade and other receivables (W4) Cash Total assets EQUITY AND LIABILITIES Equity Share capital Retained earnings Current liabilities Trade and other payables (W5) Current tax payable Total equity and liabilities Working 1 Purchases Closing inventory Cost of sales Working 2 Advertising Lighting and heating Telephone and Internet General expenses Total accruals/prepayments 12,160 (890) 11,270 Trial balance 860 620 450 250 Accrued 540 290 160 990 Prepaid (260) Total 600 1,160 740 410 75,200 (11,270) 63,930 1,200 (28,855) (28,375) 7,900 (1,200) 6,700
20,000 890 1,340 3,260 5,490 25,490
15,000 6,700 21,700 2,590 1,200 3,790 25,490
(260)
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Working 3 Property, plant and equipment at cost Year 1 depreciation Closing carrying amount Working 4 Trade receivables in trial balance Allowance for doubtful receivables Adjusted trade receivables Prepayments Trade and other receivables Working 5 Opening trade payables Accruals Trade and other payables Working 6
25,000 (5,000) 20,000 1,200 (120) 1,080 260 1,340 1,600 990 2,590 Amount 24,000 18,000 7,200 600 1,160 740 410 5,000 120 57,230 Distribution costs 12,000 9,000 3,600 600 580 370 205 2,500 28,855 Administrative expenses 12,000 9,000 3,600 580 370 205 2,500 120 28,375 Finance costs
Salaries Rent and rates Insurance Advertising (W2) Lighting and heating (W2) Telephone and Internet (W2) General expenses Allowances: Depreciation: PPE (W3) Doubtful receivables (W4)
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6. Beauty Box Ltd Statement of comprehensive income for the year ended 30 June 2012 Revenue Cost of sales (W1) Gross profit Interest received Salaries Rent and rates Insurance Lighting & heating Telephone & Internet Advertising Allowances: Depreciation on equipment (W2) Doubtful receivables (W3) Operating profit Income tax expense Profit for the period 104,900 (37,700) 67,200 100 (30,000) (15,000) (3,000) (1,500) (2,000) (500) (4,000) 400 11,700 (4,500) 7,200
Beauty Box Ltd Statement of financial position at 30 June 2012 ASSETS Non-current assets Property, plant and equipment (W2) Current assets Inventory Trade and other receivables (W3) Cash Total assets EQUITY AND LIABILITIES Equity Share capital Retained earnings Current liabilities Trade and other payables Current tax payable Total equity and liabilities
12,000 12,000 5,400 15,300 32,700 44,700
20,000 12,200 32,200 8,000 4,500 12,500 44,700
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Working 1 Opening inventory Purchases Closing inventory Cost of sales
10,000 39,700 (12,000) 37,700
Working 2
Year
Opening carrying amount 20,000 16,000
Provision for depreciation (4,000) (4,000)
Equipment Equipment
1 2
Closing carrying amount 16,000 12,000
Working 3 Trade receivables in trial balance Year 2 doubtful debts Adjusted trade receivables Year 1 doubtful debts Decrease in doubtful debts
6,000 (600) 5,400 (1,000) 400
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8. Consolidated statement of financial position

The following narrative answers are indicative of the main points in the chapter. 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 returns through its power over the investee. As a result, control is only achieved if the investor possesses all 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 of control 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 business combination. Goodwill is an asset that represents the future economic benefits arising from assets acquired in a business combination that cannot be individually separately identified and recognised, such as the companys 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 transferred plus the value of any NCI less the fair value of the identifiable net assets acquired. 3. IFRS 3 requires that a subsidiarys identifiable assets and liabilities sho uld be recognised at fair value 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 transaction between market participants at the measurement date. IFRS 3 requires measurement of a subsidiarys assets and liabilities at fair value as it provides a faithful representation of their economic value at the date of acquisition.
4. Agro Ltd Fair value of consideration transferred NCI at 1 July 2012 (300k x 20%) Fair value of subsidiarys net assets at 1 July 2012 Goodwill (balancing figure) 000 500 60 (300) 260
(b) (a)
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5. Major Ltd (a) Fair value of consideration transferred Non-controlling interest (66,250 x 20%) Fair value of identifiable assets at 1 August 2011 Goodwill (balancing figure) (b) Consolidated statement of financial position at 31 July 2012 ASSETS Non-current assets Property, plant and equipment Investment in Minor Ltd Goodwill Current assets Total assets EQUITY AND LIABILITIES Equity Ordinary share capital Retained earnings pre-acquisition Retained earnings post acquisition Revaluation reserve Non-controlling interest (NCI) Current liabilities Total equity and liabilities Notes W1 recognizes goodwill by deducting the parents 80% share of Minors identifiable net assets (60,000). W2 recognizes the NCI by deducting its 20% share of Minor's identifiable net assets at the acquisition date. W3 recognizes the NCI's 20% share in Minor's post acquisition profits of 20,000 (4,000); the NCIs 20% share in Minors 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). Major Ltd Minor Ltd W1 W2 60,000 13,250 (66,250) 7,000 W3 W4 Group
150,000 60,000 210,000 195,000 405,000
82,000 (60,000) 7,000 (53,000) (53,000) (3,500) (3,500) (3,500)
82,000 92,250 174,250
232,000 3,500 235,500 287,250 522,750
250,000 32,000
50,000 16,250 20,000 10,000 96,250 78,000 174,250
(40,000) (13,000)
(10,000) (3,250) (4,000) (2,000) 6,000 (3,500)
282,000 123,000 405,000
(53,000) (53,000)
13,250 -
(3,500) (3,500)
250,000 44,500 8,000 19,250 321,750 201,000 522,750
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9. Financial statement analysis

The following narrative answers are indicative of the main points in the chapter. 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 helps internal and external users analyse financial statements by examining ratios that describe the quantitative relationship between two data items. Ratios can be used to perform a trend analysis or they can be compared with a predetermined budget or previous periods for the same entity. In addition, can they can be compared with ratios for competitors or industry benchmarks.
2. Adams Ltd and Eve Ltd
(a) Main profitability ratios

Adams Ltd Return on capital employed Operating profit x 100 Capital employed Capital turnover Revenue Capital employed Gross profit margin Gross profit x 100 Revenue Operating profit margin Operating profit x 100 Revenue 29,500 281,000 = 10.50% 354,900 281,000 = 1.26 times 71,400 354,900 = 20.12% 29,500 354,900 = 8.31% Eve Ltd 41,500 596,000 = 6.96% 706,260 596,000 = 1.19 times 156,200 706,260 = 22.12% 41,500 706,260 = 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 proportionally lower 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 1 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.
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3. Ted Baker 2005/06 Note Ted Baker has chosen to refer to the statement of financial position as the balance sheet and uses the format: Assets Liabilities = Equity. This explains why the amounts shown for liabilities are in brackets. The brief comments in the narrative answers below are not exhaustive, but intended for guidance. (a) Earnings per share Profit for ordinary shareholders Number of ordinary shares 2005/06 12,919 42,237 = 30.59 pence 2004/05 11,368 42,375 = 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 Profit for ordinary shareholders x100 Equity 2005/06 12,919 42,172 = 30.63% 2004/05 11,368 36,830 = 30.87%
This is a profitability ratio that measures return on shareholders funds. Unlike ROCE, it excludes long-term debt. In 2005/06 there was 30.63 operating profit for every 100 capital employed a little lower than the previous year, but nearly 31% represents a high return compared to a nonrisky investment. (c) Return on capital employed Operating profit x 100 Equity + Non-current liabilities 2005/06 18,334 x100 42,922 = 42.71% 2004/05 16,405 x 100 37,580 = 43.65%
This profitability ratio measures the percentage return on total funds ( shareholders equity and long-term debt). It reflects the stewardship of management and their ability to generate revenue and control costs. ROCE was slightly lower in 2005/06 with only 42.71 in operating profit for every 100 of capital employed compared with 43.65 the previous year. This is disappointing as the amount of capital employed was higher in 2005/06, but gave proportionately less operating profit. ROCE is higher than ROE because it is based on profit before interest and tax and therefore does not takes account of finance costs. (d) Operating profit margin Operating profit x 100 Revenue 2005/06 18,334 x 100 117,832 = 15.56% 2004/05 16,405 x100 105,753 = 15.51%
This profitability ratio measures the percentage return on revenue based on operating profit. The results show a stable performance with approximately 15 of operating profit generated by every 100 of revenue in both years.
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(e) Acid test ratio Current assets - Inventory Current liabilities
2005/06 23,300 24,740 = 0.94:1
2004/05 18,365 21,929 = 0.84:1
This is a liquidity ratio that measures the relationship between the liquid current assets and the short-term liabilities. It excludes inventory as this takes longer to turn into cash. In 2005/06 there was 0.94 in liquid assets for every 1 of current liabilities, which is a slight improvement on the previous year. It does not matter that the ratio is slightly less than 1:1 because the accounts are prepared on a prudent basis and trade payables will be due at different times in the next period. It is also good financial management to obtain a longer credit period from suppliers than the company gives to its to customers. This ratio assures users that the business is a going concern. (f) Inventory holding period Inventory x12 for months Closing inventory 2005/06 23,475 x 12 48,979 = 5.75 months 2004/05 22,725 x12 43,357 = 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 storage costs or obsolescence. (g) Debt/equity ratio Non-current liabilities x100 Equity 2005/06 750 x 100 42,172 = 1.78% 2004/05 750 x 100 36,830 = 2.04%
This is a gearing ratio that describes the financial structure of the business in terms of the percentage of long-term debt to total shareholders funds . The company had very low gearing in both years. In 2005/06 it reduced from approximately 2 of long-term debt for every 100 of equity to only 1.78 of long-term debt for every 100 of equity. This means there was even less risk that the company would be unable to pay interest due on long-term debt in the event of an economic downturn. (h) Interest cover Operating profit Interest payable 2005/06 18,334 109 = 168.20 times 2004/05 16,405 221 = 74.23 times
This gearing ratio measures the relative safety of interest payments. The increase in 2005/6 reflects 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 to pay the interest due. 4. Ted Baker 2007/08 Investors perspective (a) Dividend per share Total dividends x 100 for pence Number of ordinary shares 2007/08 2006/07 5,079 x100 4,556 x 100 42,321 42,915 = 12.00 pence 10.62 pence This 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 36
increased by 1.4p per share. This is partly due to an increase in total dividends for 2007/08 and partly due to a reduction in the number of shares that year. (b) Dividend yield Dividend per share x100 Average share price 2007/08 12.00 x 100 480.00 = 2.50% 2006/07 10.62 x 100 641.50 = 1.65%
This investment ratio is also known as the yield gross and it measures the dividend per share in relation 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 it were not for the significantly lower average share price that year. (c) Earnings per share Profit for ordinary shareholders x 100 for pence Number of ordinary shares 2007/08 15,242 x100 42,321 = 36.02 pence 2006/07 14,416 x 100 42,915 33.59 pence
This investment ratio measures the amount of profit earned by one ordinary share. There is good news for shareholders as the increased profits in 2007/08 improved EPS by 2.43 pence. This ratio is based on total profits and therefore reflects the shareholders total return. EPS is higher than the dividend per share, since only part of the profit is distributed as dividends. (d) Price/earnings ratio Average share price Earnings per share 2007/08 2006/07 480.00 641.50 36.0 33.6 = 13.33 years = 19.10 years This 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. The results are disappointing for shareholders since the number of years the market believes the company has good prospects has dropped by nearly 6 years. Nevertheless, the P/E ratio is still more than 13 years, so little cause for concern for existing or potential investors. (e) Return on equity Profit for ordinary shareholders x100 Equity 2007/08 15,242 x 100 55,712 = 27.36% 2006/07 14,416 x 100 51,281 = 28.11%
This investment ratio measures the return on shareholders funds. The results will be disappointing 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 28.11 the previous year. Nevertheless, a return of 27.36% is very high compared to the risk-free interest rate of 5.29% and should be attractive to existing and potential investors. (f) Return on capital employed Operating profit x 100 Equity + Non-current liabilities 2007/08 22,142 x100 56,555 = 39.15% 2006/07 20,049 x 100 51,324 = 39.06%
This is a profitability ratio that measures the percentage return on total funds ( shareholders equity and long-term debt). It reflects the stewardship of management and their ability to generate revenue 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 investors are likely to consider a return of 39% is favourable compared to the risk-free interest rate of 37
5.29%. Note that ROCE is higher than ROE because it is based on profit before interest and tax and therefore does not take account of finance costs. (g) Operating profit margin Operating profit x 100 Revenue 2007/08 22,142 x 100 142,231 = 15.57% 2006/07 20,049 x 100 125,648 15.96%
This profitability ratio measures the percentage return on revenue based on operating profit. The results show a stable performance with approximately 15 of operating profit generated by every 100 of revenue in both years. (h) Capital turnover Revenue__________ Equity + Non-current liabilities 2007/08 142,231 56,555 = 2.51 times 2006/07 125,648 51,324 = 2.45 times
This profitability ratio measures the number of times capital employed was used during the year to achieve the revenue. The small improvement in 2007/08 shows more efficient use of capital employed and this is reflected in the return on capital employed. 5. Ted Baker 2007/08 short-term lender perspective (a) Current ratio Current assets Current liabilities 2007/08 57,329 25,573 = 2.24:1 2006/07 53,397 22,289 = 2.40:1
This is a liquidity ratio that measures the relationship between current assets and short-term liabilities. In 2007/08 there was 2.24 in current assets for every 1 of current liabilities, which means current liabilities are still easily covered by current assets. (b) Acid test Current assets - Inventory Current liabilities 2007/08 28,014 25,573 = 1.10:1 2006/07 25,572 22,289 = 1.15:1
This liquidity ratio is more stringent than the current ratio because it excludes inventory, as this current 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 current assets. However, the accounts are prepared on a prudent basis and trade payables will be due at different times in the next period. In addition, it is also good financial management to obtain a longer credit period from suppliers than the company gives to its to customers. The results for this ratio should assure lenders and creditors that the liquidity position is stable and the business is a going concern. (c) Inventory holding period Closing inventory x 12 for months Cost of sales 2007/08 29,315 x 12 59,560 = 5.91 months 2006/07 27,825 x 12 51,986 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 38
there was little risk of extra storage costs or obsolescence. Lenders and creditors will welcome this result as it reflects good management of working capital. (d) Trade receivables collection period Trade receivables x 12 for months Revenue 2007/08 10,217 x 12 142,231 = 0.86 months 2006/07 8,543 x 12 125,648 = 0.82 months
This efficiency ratio measures the average time credit customers took to settle their debts. The position 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 to customers is. The short trade receivables collection period will give a positive signal to lenders and creditors as it reflects good management of working capital. (e) Trade payables payment period Trade payables x 12 for months Cost of sales 2007/08 13,361 x 12 59,560 = 2.69 months 2006/07 11,770 x 12 51,986 = 2.72 months
This efficiency ratio measures the average time the company has taken to pay suppliers for goods and services over the year. The results show little change in 2007/08 and suggest efficient cash management if the period agreed with suppliers is two months. Taking the maximum credit period provided will be seen by lenders and creditors as good financial management. (g) Debt/equity ratio Non-current liabilities x100 Equity 2007/08 843 x 100 55,712 = 1.51% 2006/07 43 x 100 51,281 = 0.08%
This is a gearing ratio that describes the financial structure of the business in terms of the percentage of long-term debt to total shareholders funds . The company had very low gearing in both years. Although gearing increased slightly in 2007/08, the company only had 1.51 of longterm debt for every 100 of equity. This means there was very little risk that the company would be unable to pay interest due on long-term debt in the event of an economic downturn. (h) Interest cover Operating profit Interest payable 2007/08 22,142 387 = 57.21 times 2006/07 20,049 67 = 299.24 times
This gearing ratio assesses the relative safety of interest payments by measuring the number of times interest payable on long-term debt is covered by the available profits. This avoids problems over different definitions of debt that can be used in the debt/equity ratio. The significant reduction in 2007/08 reflects the higher gearing. Nevertheless, there is no cause for concern for lenders and creditors 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 for the year. However, average inventory cannot be calculated for 2006/07 because opening inventory is not disclosed for that year. Therefore, closing inventory is used as a proxy so that both years can be compared. In addition, cost of sales is substituted for purchases since the latter 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 payables payment period without knowing the average credit periods associated with these ratios. 39
There are no agreed definitions of the terms used, so these ratios should not be compared with 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 to compare 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 substantial degree of classification and aggregation, and the effect of allocating continuous operations to the period. A second weakness of the financial statements is that they do not take account of non-financial factors such as whether the business has sound plans for the future, a good reputation, 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 economic environment. The lender should treat the analysis as an indication of where further investigation might be directed to better understand the present and future financial performance and position.
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10. Ethics, governance and corporate social responsibility

The following narrative answers are indicative of the main points in the chapter. 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 accounting profession is its acceptance of the responsibility to act in the public interest. Therefore, a professional accountants 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 expectations placed 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 accounting practices. 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 from inappropriate actions. It provides users of the accounts with a standard against which they can compare the ethical behaviour 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 directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders role in governance is to appoint the directors an d the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the companys strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The boards actions are subject to laws, regulations and the shareholders in general meeting. A succinct explanation by Law (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 the owners. Corporate governance is important to investors because it allow them to assess the stewardship of management. This is important because in large companies there is separation of ownership and control, and although the company is owned by the shareholders, the latter appoint directors to manage the business on their behalf. 3. Obtain information from the FRCs website and write a su mmary explaining its role in regulating corporate governance in the UK. The answer should refer to the fact that the FRC is the UKs independent regulator responsible for promoting high quality reporting and CG to foster investment, which is does through the UK Corporate Governance Code. The FRCs Committee on Corporate Governance leads work on corporate governance. Reference should be made to the Committee's terms of reference and the FRCs role in influencing EU and global developments, promoting boardroom professionalism and diversity, and encouraging constructive interaction between company boards and institutional shareholders (cf. the Stewardship Code for Institutional Investors).
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4. Obtain a copy of the annual report and accounts for two public limited companies and compare the information they disclose on corporate governance. Write a summary analysing the differences 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 companys 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 the company 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).
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Part III Management accounting 11. Importance of cost information

The following narrative answers are indicative of the main points in the chapter. 1. Explain the purpose of cost accounting and why it is important for managers to have cost information. 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 the costs and a cost centre is the area of an organization for which costs are collected for the purpose of cost ascertainment, planning, decision making and control (Law, 2010, p. 11 9 and 116). Business is about money and in order to run a business successfully, managers need to know the cost of running the 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 the selling 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 distribution costs. Whether they are product costs, which can be identified with the cost unit and are part of the value of inventory, or period costs, such as selling costs and administrative expenses, which are deducted 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 a particular cost centre. Indirect costs must be shared by the cost units. Examples of direct costs are the cost of materials used to make a product; the cost of labour if employees are paid according to the number of products made or services provided; the cost of expenses, such as subcontract 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 in production levels. Direct costs are usually variable and indirect costs are usually fixed. Examples of direct costs that are fixed are patents, licences and copyright relating to a particular product and some direct expenses such as the hire of a particular piece of equipment to produce a specific order.
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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 managers salary (k) Delivery drivers salaries (l) Factory security guards salaries (m) Piecework wages paid to factory operatives (n) Salary paid to managing directors 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 costs Direct materials (6,000 + 200) Direct labour Prime cost Production overheads (1,000+2,000+700+1,500+2,500+2,200+800+900) Production cost Indirect costs Administration overheads (400 + 800 + 200 + 1,800 + 2,200 + 16,000) Distribution overheads (500 + 800) Total cost 6,200 10,000 16,200 11,600 27,800 7,000 1,300 8,300 36,100
(b) Interpretation should demonstrate awareness that total cost is built from a number of key elements and should explain the terms used.
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5. Petra Pots Ltd* Petra Pots Ltd Total cost (1 unit) Direct costs Direct materials Direct labour Prime cost Production overheads Production cost Indirect costs Administration overheads Distribution overheads Total cost Profit (Production cost 13.90 x 50%) Selling price 3.10 5.00 8.10 5.80 13.90 3.50 0.65 4.15 18.05 6.95 25.00
*The workings are the same as in question 4, but divided by 2,000.
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12. Costing for product direct costs

The following narrative answers are indicative of the main points in the chapter. 1. Describe the main stages in controlling direct materials. In a manufacturing business the control of materials used in the production process is essential to ensure that production is not delayed due to shortages and that the business does not tie up capital by 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 right quantities, 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 UK and to the HM Revenue and Customs, which means that not only can it be used for management accounting purposes, but also for financial reporting and taxation purposes. However, this advantage also applies to the CWA cost method. The FIFO method is the logical choice if it coincides with the order in which inventory is physically issued to production (eg materials with a finite life where it makes sense to issue those that have been stored the longest first). However, the CWA is the logical choice if inventory consists of volume and liquid materials where an averaging method makes sense because it may not be possible to differentiate between old and new inventory stored in bulk containers. 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 price changes in the statement of comprehensive income. However, the FIFO method is complex and an arithmetical burden, even when a spreadsheet is used. While the cost of direct materials issued to production is based on historical prices, the value of inventory at end of period is close to current prices. On the other hand, the CWA method requires the prices of materials issued to production must be recalculated every time a new consignment is received, this can be relatively simple to calculate by entering the quantity and pricing information from the source documents into a spreadsheet or specialist software package. The CWA method also offers the advantage that it takes account of quantities 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 closing inventory will lag behind current prices if prices are rising.
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3. Janets wages are based on piecework and she is paid 5 per piecework hour. Calculate her pay for a 36-hour week in which she produces the following units: Product A B C Number of units 12 30 24 Time allowance per unit 0.8 hours 0.6 hours 0.5 hours Total piecework hours 9.6 18.0 12.0 39.6 198
Pay (39.6 hours x 5)
4. Perfect Pans Ltd (a) (i) FIFO December 1 2 7 8 8 14 15 15 30 31 Total Receipts Price Issues Price 2.00 2.00 2.10 2.10 2.20 2.20 Inventory balance Quantity Value kg 500 1,000.00 50 100.00 600 1,255.00 550 1,155.00 100 210.00 700 1,530.00 600 1,320.00 100 220.00 600 1,370.00 500 1,150.00
Quantity kg
Value
Quantity kg 450
Value 900.00 100.00 945.00 210.00 1,100.00 220.00 3,475.00
550
2.10
1,155 50 450
600
2.20
1,320 100 500
500
2.30
1,150 100
(ii) AVCO December 1 2 7 8 14 15 30 31 Total
Quantity kg
Receipts Price
Value
Quantity kg 450
Issues Price 2.00 2.09 2.18 2.28
Value 900.00 1,045.83 1,310.71 228.08 3,484.62
550 600 500
2.10 2.20 2.30
1,155 500 1,320 600 1,150 100
Inventory balance Quantity Value kg 500 1,000.00 50 100.00 600 1,255.00 100 209.17 700 1,529.17 100 218.45 600 1,368.45 500 1,140.38
(b) Assuming that the business needs to choose between the two methods, recommend which method management should adopt, giving at least five reasons. The answer should include a recommendation. The choice of method should be supported with a discussion of at least five advantages and disadvantage of the method chosen contrasted with those of the method that has been rejected.
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5. Baked Bean PLC (a) (i) FIFO September 1 2 3 14 15 16 29 30 Total Receipts Price 5.00 5.50 Issues Value 5,000 5,500 Quantity tonne Price Value Inventory balance Quantity Value tonne 1,000 5,000.00 2,000 10,500.00 1,250 6,750.00 1,000 5,500.00 500 2,750.00 1,500 8,750.00 1,000 6,000.00 750 4,500.00 1,750 11,000.00 1,000 6,500.00
Quantity tonne 1,000 1,000
750 250 500 1,000 6.00 6,000 500 250 1,000 6.50 6,500 750
5.00 5.00 5.50 5.50 6.00 6.00
3,750.00 1,250.00 2,750.00 2,750.00 1,500.00 4,500.00 16,500.00
(ii) AVCO September 1 2 3 14 15 16 29 30 Total
Quantity tonnes 1,000 1,000
Receipts Price 5.00 5.50
Issues Value 5,000 5,500 Quantity tonnes Price Value
750 750 1,000 1,000 6.00 6.50 6,000 750 6,500 750
5.25 5.25 5.75 6.18
3,937.50 3,937.50 4,312.50 4,633.93 16,821.43
Inventory balance Quantity Value tonnes 1,000 5,000.00 2,000 10,500.00 1,250 6,562.50 500 2,625.00 1,500 8,625.00 750 4,312.50 1,750 10,812.50 1,000 6,178.57
(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. Costs reduce 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 is higher than under the CWA method. Under the FIFO cost method, the valuation is closer to current prices, whereas under the CWA method price increases are smoothed out and the value of closing inventory lags behind the current price. Therefore, the FIFO cost method gives the higher profit under these circumstances
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13. Costing for indirect costs

The following narrative answers are indicative of the main points in the chapter. 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 are charged to the production by means of the process of absorption. Costs are first allocated or apportioned 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 products consumption of the cost centres 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 one particular cost centre (eg wages and depreciation on machinery relating to a particular production department that has been designated as a cost centre). These overheads can simply be allocated to that cost centre (eg the whole amount of the annual allowance for depreciation on machinery in that department 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 rent could be apportioned over the production cost centres on the basis of the proportion of space each department occupies in the factory). An overhead absorption rate is calculated in advance of an accounting period and used to charge the indirect costs to the production for that period (Law, 2010). The choice of absorption rate depends on the 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 a business in the manufacturing sector over the various production cost centres and the overheads for a particular production cost centre over the various products passing through it. It allows production overheads to be allocated or apportioned to the cost centres on a fair basis and absorbed into the cost unit using an appropriate using an overhead absorption rate. Non-production overheads are absorbed into the cost unit by adding a percentage based on the proportion of non-production overheads to the total production cost. However, there are a number of disadvantages. Not only is this cost accounting system is unsuitable for businesses in the service sector, but a major limitation of absorption costing is that it is based on arbitrary decisions about the basis for apportioning and absorbing the overheads. Normally predetermined overhead absorption rates are used because the actual figures are not available until 49
the end of the period, but if the predetermined overhead that has been absorbed is higher than the actual overhead, it will result in overabsorption, which reduces expenses in the statement of comprehensive 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 the statement of comprehensive income. In addition, general overheads are spread across the product range with little regard for how the costs are actually generated. Therefore, there is always some concern that the total cost of each product is not being calculated in the most precise manner. If the business is miscalculating the cost of its products and basing its selling prices on this inaccurate information, it could have a dramatic impact on financial performance. For example, if the inaccuracies result in selling prices that are too high, the business could lose market share to competitors; if they result in selling prices that are too low, the business will not achieve its planned profit. A further criticism of absorption costing is that assigns indirect costs in proportion to the number of units produced (volume), but many resources used in support activities are not related to volume (eg machine 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 to high volume products that cause little diversity, and too small a proportion is assigned to low volume products that use more support activities.
4. Toy Craft Ltd (a) Toy Craft Ltd Production overhead analysis Total Basis of Machine apportionment department 24,500 Allocated 12,000 54,500 Allocated 14,000 26,000 Area 13,000 4,000 Area 2,000 36,000 Value of machinery 24,000 42,000 No. of employees 9,800 187,000 74,800 - Value of machinery 26,100 187,000 100,900
Overhead
Indirect materials Indirect labour Rent and rates Electricity Depreciation on machinery Supervisors' salaries Subtotal Apportioned service costs Total
Assembly department 10,000 18,000 10,400 1,600 8,000 29,400 77,400 8,700 86,100
Maintenance department 2,500 22,500 2,600 400 4,000 2,800 34,800 (34,800) -
(b) Machine department OAR Cost centre overheads = 100,900 = 2.37 per machine hour No. of machine hours 42,500
(c) Assembly department OAR Cost centre overheads = 86,100 = 5.74 per direct labour hour Direct labour hours 15,000
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5. West Wales Windsurfers Ltd (a) West Wales Windsurfers Ltd Production overhead analysis Basis of Body Finishing apportionment* workshop workshop Allocated 680,000 390,000 No. of employees 100,000 60,000 780,000 450,000
Canteen 160,000
Total 1,230,000
Production overheads Apportioned service costs Total
*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 unit No. 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 unit No. of direct labour hours 180,000
(c) Predicted production cost per unit Fun Wave Direct costs Materials Labour Body workshop Finishing workshop Indirect costs Body workshop Finishing workshop Production cost 80 150 80 90 100 500 Hot Racer 50 180 80 240 100 650
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14. Activity-based costing

The following narrative answers are indicative of the main points in the chapter. 1. Discuss the reasons why accountants have developed ABC as an alternative to the traditional method 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 on arbitrary 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 are actually generated. Therefore, there is always some concern that the total cost of each product is not being calculated in the most precise way. If a business is miscalculating the cost of its products and basing its selling prices on this inaccurate information, it could have a dramatic impact on financial performance. For example, if the inaccuracies result in selling prices that are too high, the business could 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 manufacturing sector and tended to carry high levels of inventory. Therefore, the valuation of inventory was very important. In addition, direct labour was a major element in the cost of a product and overheads were relatively small, so inaccuracies in apportioning indirect costs to cost units did not have a significant effect 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) has decreased direct labour costs and increased overheads (eg power, maintenance and depreciation on machinery 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 the relevance 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 the majority of firms are now in the service sector means that traditional management accounting techniques based on the needs of manufacturers are irrelevant to many businesses today. ABC is a system of costing that recognizes that cost are incurred by each activity that takes place within an organization 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 charge cost 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 a meaningful relationship between non-production overheads and the production activity.
2. Describe the four main stages in implementing a system of activity-based costing, defining all terms used. Activity-based costing (ABC) is a system of costing that recognizes that costs are incurred by each activity that takes place within an organization 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 charge cost to products An activity cost pool is a collection of indirect costs grouped according to the activity involved (Law, 2010, p. 15). The implementation of an activitybased costing system involves four main steps: Identify the main activities in the organization and classify them into activity centres if there are a large number of different activities. An activity centre is an identifiable unit of the organization that performs an operation that uses resources. For most organizations the first activity will be the purchase of materials. This will involve several sub-activities, such as drawing up material specifications, selecting suppliers, placing the order, receiving and inspecting the materials that have been delivered. 52
Identify the cost drivers associated with each activity centre. A cost driver is any factor such as number of units, number of transactions, or duration of transactions that drives the costs arising 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). For example, a cost driver for the purchase of materials would be the number of orders placed; for customer support, it might be the number of calls answered; for a quality control activity, it might be the number of hours of inspection conducted. Some activities have multiple cost drivers. Calculate the cost driver rate, which is the cost per unit of activity. For example, in purchasing it would be the cost per order placed. Assign costs to the products by multiplying the cost driver rate by the volume of the cost driver units consumed by the product. With purchasing, the cost driver rate will be calculated on the basis of orders placed. For example, if Product A requires 15 orders to be placed in January, 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 the advantages and disadvantages of implementing this type of cost accounting system. Activity-based costing is best suited to businesses that operate in highly competitive markets and which have many different products that require complex production processes. In such firms the arbitrary process of absorption costing does not generate sufficiently specific information to aid managers 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-production overheads and the production activity. It provides better information about the costs of activities, thus allowing managers to make more 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 overheads will 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 in a different total cost per unit. This can have important consequences for decision making and strategy in the company. More accurate cost information could lead to some products being eliminated and changes in the market price of other products. Installing the system will require teamwork between accounting, production, marketing and other functions in the company. Therefore, management should conduct a cost/benefit analysis before implementing activity-based costing and, unless the expected benefits are greater than the costs, the firm should not move from absorption costing.
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4. Continental Communications Ltd Rate Direct costs Direct labour Direct materials Indirect costs Production Quality Delivery Total cost Number of units produced Cost per unit Standard 200,000 50,000 3,000 2,000 200 120,000 16,000 16,000 402,000 100,000 4.02 Advanced 100,000 20,000 30,000 24,000 4,000 178,000 50,000 3.56 Total 300,000 70,000 150,000 40,000 20,000 580,000
5. Parfums de Paris AG (a) Sweet Pea Direct costs Direct materials Direct labour Indirect overhead costs Purchasing Quality control Material handling Production cost Litres produced Cost per litre 35,000 25,000 1,800 4,000 4,000 69,800 20,000 3.49 Allure 12,000 16,000 720 3,000 2,000 33,720 4,000 8.43
(b) This seems to be a simple production process with little use of technology so it is not the type of operation that one would usually recommend adopts activity based costing. The overhead costs are modest compared to the cost of direct materials and direct labour and the company would be better advised to concentrate on controlling their direct costs. No information is given on the packaging costs and the advertising and it would be worthwhile to investigate these. A fairly simple absorption costing system may be a better approach for this company.
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15. Marginal costing

The following narrative answers are indicative of the main points in the chapter. 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 a business where production levels fluctuate. It requires revenue expenditure to be classified into variable costs or fixed costs according to the behaviour of the cost when the level of production or sales activity changes. A variable cost is an item of expenditure that, in total, varies directly with the level 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 variable costs per unit are usually regarded as the direct costs plus any variable overheads and are assumed to be constant in the short term. Therefore, a characteristic of a variable cost is that it is incurred at a constant 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 the variable elements can be added to the other variable costs and the fixed elements can be added to other fixed costs. In marginal costing, only the variable costs are charged to the units. The difference between sales revenue and the variable costs is not the profit, since no allowance has been made for the fixed costs incurred; it is the contribution towards fixed costs. Contribution is the additional profit that will be earned by an organization when the breakeven point production has been exceeded. The unit contribution 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 total contribution is the contribution per unit multiplied by the number of units produced. Contribution is important 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 to illustrate your answer. A limiting factor is a constraint that restricts a business from achieving higher levels of profitability (eg a shortage of materials or labour, a restriction on the sales demand at a particular price or a limit in the production capacity of machinery). If the business has more than one product that uses the limited resource, it could mean that the business can only make a limited number of products and management needs to decide which products to make to obtain the maximum profit. The general rule is 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 how selection 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 amount of cost has to be shared over fewer units. (b) Marginal costing focuses on the contribution to fixed costs. In periods of recession, most decisionmaking 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 problems confronted by the businesses. 55
4. Edwards & Co Ltd (a) Marginal cost statement 1 unit Revenue 10.00 Variable costs Direct materials (1.00) Direct labour (5.00) (6.00) Contribution 4.00 (b) Marginal cost statement 12,000 units Revenue 120,000 Variable costs Direct materials (12,000) Direct labour (60,000) (72,000) Contribution 48,000 Fixed costs (32,000) Profit for the period 16,000
(c) The breakeven point is the level of production, sales volume, percentage of capacity, or sales revenue 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 Contribution per unit (ii) BEP in sales revenue BEP in units Selling price (iii) Sales activity to reach target profit Fixed costs + Target profit Contribution per unit (iv) Margin of safety Selected level of activity - BEP in units 13,000 - 8,000 = 5,000 units 32,000 + 20,000 4 = 13,000 units 8,000 10 = 80,000 32,000 4 = 8,000 units
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5. Audiomax Ltd (a) Audiomax Ltd Marginal cost statement (1 unit) Premier Deluxe 100 150 (30) (30) (10) (70) 30 (40) (50) (25) 115) 35
Selling price Variable costs Direct materials Direct labour Direct expenses Contribution
Superior 240 (50) (120) (24) (194) 46
(b) Contribution per 1 direct materials Contribution Direct materials Ranking 30 30 35 40 46 50
= 1.00 st 1
= 0.88 rd 3
= 0.92 nd 2
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 Contribution Direct labour Ranking 30 30 35 50 46 120
= 1.00 st 1
= 0.70 nd 2
= 0.38 rd 3
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 identified may arise. Management may have overlooked other limiting factors (eg constraints on production capacity, constraints on sales capacity, obsolescence of its products through development of new technology). All the revenue and expenditure used in budgets is based on estimates and their utility depends on how realistic they are. Budgeted figures are only useful if there is frequent monitoring against actual figures and action taken to remedy any adverse variances. Budgeted figures may be difficult to predict for a new business or an existing business in a volatile market.
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16. Budgetary planning and control

The following narrative answers are indicative of the main points in the chapter. 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 of an 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, and are 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 in a systematic and logical manner. This helps ensure that they achieve their financial objectives, which are 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 a systematic and logical manner. Control can be achieved only by setting a plan of what is to be accomplished in a specified time period and managers regularly monitoring progress against the plan, taking corrective action 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 to meet the requirements of the sales team, or the accountant can obtain sufficient funding to make 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 the objectives of the organization and the constraints under which it is operating. The regular monitoring of performance helps keep management informed of the progress of the organization towards its objectives. By communicating detailed targets to individual managers, motivation is improved. Without a clear sense of direction, managers will become demotivated. By setting separate plans for individual departments and functions, managers are clear about their responsibilities. This allows them to make decisions within their budget responsibilities and 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 their performance 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. 58
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 and integrating 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 expenditure budgets 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 of achievement. Planning ahead gives time to take corrective action, since decisions are based on the examination 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 sensible decisions when the circumstances warrant it. For example, they might make no attempt to spend less than maximum or make no attempt to exceed the target income. Time spent on setting and controlling budgets may deflect managers from their prime responsibilities 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 without consultation or if fixed budgets cannot be achieved due to a lower level of activity beyond their 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 actual levels 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 that takes into account the fact that values for income and expenditure on some items will change with changing circumstances. Consequently, in a flexible budget the budget cost allowances for each variable cost item will change to allow for the act ual levels of activity achieved (Law, 2010, p. 195). Example should show how a flexible budget changes in accordance with activity levels and reflects the different behaviours of fixed and variable costs.
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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 in the chapter. Recommendations will depend on the assumptions made, but should be credible and set within a business context. 5. Johns Bikes Ltd Johns Bikes Ltd Cash flow budget for 3 months ending 31 March 2014 January February March Cash inflows Capital 25,000 0 0 Loan 25,000 0 0 Cash sales 30,000 30,000 30,000 Credit sales 0 5,000 5,000 80,000 35,000 35,000 Cash outflows Purchases 0 0 10,000 Rent and rates 24,000 0 0 Insurance 500 500 500 Advertising 1,000 0 0 Telephone and Internet 100 100 100 Salaries 6,100 6,100 6,100 Lighting and heating 200 200 200 Interest on loan 125 125 125 Equipment 12,000 0 0 Fixtures and fittings 20,000 0 0 Drawings 2,500 2,500 2,500 Subtotal 64,025 7,025 17,025 Net cash flow 15,975 27,975 17,975 Cumulative cash b/f 0 15,975 43,950 Cumulative cash c/f 15,975 43,950 61,925
Total 25,000 25,000 90,000 10,000 150,000 10,000 24,000 1,500 1,000 300 18,300 600 375 12,000 20,000 7,500 88,075 61,925 0 61,925
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John's Bikes Ltd Budgeted statement of comprehensive income for 3 months ended 31 March 2014 Revenue Cost of sales (W1) Gross profit Expenses Rent and rates Insurance Advertising Telephone and Internet Salaries Lighting and heating Depreciation (W2) Operating profit Finance costs Profit before tax 105,000 (20,000) 85,000 (6,000) (1,500) (1,000) (300) (18,300) (600) (1,750) (29,450) 55,550 (375) 55,175
John's Bikes Ltd Budgeted statement of financial position at 31 March 2014 ASSETS Non-current assets Plant, property and equipment (W2) 30,250 Current assets Inventory 10,000 Trade receivables 5,000 Prepayments 18,000 Cash 61,925 94,925 Total assets 125,175 EQUITY AND LIABILITIES Equity Share capital Retained earnings Non-current liabilities Loan Current liabilities Trade payables Total equity and liabilities
25,000 55,175 80,175 25,000 20,000 125,175 Carrying amount 11,250 19,000 30,250
30,000 (10,000) 20,000
Working 2 Equipment ( 4 years) Fixtures and fittings ( 5 years) PPE (for 3 months)
Cost 12,000 20,000
Deprecn (750) (1,000) (1,750)
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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 a new 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 making recommendations 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 output has been greater. Perhaps unplanned bonus payments have been made to encourage higher levels of 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.
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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 the system 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.
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18. Capital investment appraisal

The following narrative answers are indicative of the main points in the chapter. 1. Explain the purpose of capital investment appraisal in general. In addition, explain the purpose of the payback period method and the accounting rate of return. The purpose of capital investment appraisal is to provide information to management that will help them decide which of several proposed capital investment projects is likely to yield the highest financial return. Capital expenditure is the outlay of a considerable amount of money on a project such as the purchase of a new non-current asset (eg buying a new factory), the enhancement of an existing 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 cash inflows for a project equal the investment expenditure so that the project that takes the shortest possible 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 the relationship between the profit before interest and tax for a period and the capital employed at the end of 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 the results are easy to understand. In addition, it is useful for comparing risky projects where the prediction of cash flows after the first few years is difficult (eg due to possible changes in the business environment, such as advances in technology that could make a product obsolete in a short time). It is also useful if short-term cash flows are more important than long-term cash flows or if borrowing or gearing is a concern. On the other hand, there are a number of disadvantages. It is difficult to estimate the amount and timing of future cash flows and the method ignores cash flows after the payback period. It also ignores the 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, the method ignores the size of the investment (eg the project with a smaller initial investment may have a shorter payback period than an alternative project that requires a larger investment but is more profitable in the long term). A key disadvantage is that the simple payback period ignores the time value 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 added advantage that the entire life of the project is taken into account. It also useful because it is compatible with the financial accounting ratio, return on capital employed, which is used to assess the financial performance of the business. The main disadvantages of the accounting rate of return are that, like all ratios, there is no standard definition of terms used in the formula, which renders comparison with ratios based on other definitions unreliable. A further disadvantage is that the ratio is based on averages, which can be misleading as they are hypothetical values and the actual figure in any year may be higher or lower. In addition, the method does not take account of the benefit of earning a larger proportion of the total profit in the early years of the project, the fact that a crucial factor in investment decisions is cash flow or the timing of profits or cash. Finally, the results are difficult to interpret because there is no guidance on what is an acceptable rate of return and, like the simple payback period, the accounting rate of return does not take account of the time value of money.
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3. Jefferys Boatyard Ltd Project 1 Net cash flow Cumulative net cash flow (500,000) (500,000) 80,000 (420,000) 100,000 (320,000) 180,000 (140,000) 140,000 0 100,000 100,000 Project 2 Net cash flow Cumulative net cash flow (500,000) (500,000) 90,000 (410,000) 110,000 (300,000) 190,000 (110,000) 110,000 0 80,000 80,000
Year 0 1 2 3 4 5
(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 liquidity is a problem and the business recognises the importance of the time value of money. Neither of 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 318,500 (240,500) 78,000 650,000 78,000 100 650,000 ARR = 12% Project B 358,000 (264,400) 93,600 780,000 93,600 100 780,000 = 12%
Average sales revenue Average costs and expenses Average profit before interest and tax Average capital employed Average PBIT 100 Average CE
(a) Both projects have an accounting rate of return of 12%. Therefore, on the basis of this technique they are identical. (b) Some businesses may choose Project A, if they can invest the 130,000 not required in another project that provides a return in excess of 12%. (c) Students should refer to the limitations mentioned in the text and wider reading.
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5. Wren Electronics Ltd (a) Year Equipment 1 Net cash flow Cumulative net cash flow (50,000) (50,000) 5,000 (45,000) 17,000 (28,000) 42,000 14,000 30,000 44,000 10,000 54,000 Equipment 2 Net cash flow Cumulative net cash flow (50,000) (50,000) 20,000 (30,000) 30,000 0 20,000 20,000 20,000 40,000 20,000 60,000
0 1 2 3 4 5 Payback period: 2+
28,000 28,000 + 14,000
= 2.67
= 2 years 8 months Ranking 2

nd
= 2 years 1st
(b) Depreciation 50,000 - 0 5 = 10,000 pa
Year 1 2 3 4 5 Total Average ( 5) ARR: Av PBIT 100 Av CE Ranking
Equipment 1 Net cash flow 5,000 17,000 42,000 30,000 10,000
PBIT (5,000) 7,000 32,000 20,000 0 54,000 10,800
Equipment 2 Net cash flow 20,000 30,000 20,000 20,000 20,000
PBIT 10,000 20,000 10,000 10,000 10,000 60,000 12,000
10,800 100 50,000
= 22%
nd
12,000 100 50,000
=24%
st
(c) The results of this analysis show that Equipment 2 is likely to be the better investment. The payback period method shows that Equipment 2 has the shorter payback period (only 2 years compared to 2 years and 8 months for Equipment 1) and the accounting rate of return shows that Equipment 2 is likely to give a higher return on the capital invested (24% compared to 22% for Equipment 1). (d) Students should refer to the limitations mentioned in the text and wider reading.
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19. Discounting methods of investment appraisal

The following narrative answers are indicative of the main points in the chapter. 1. Describe the advantages and disadvantages of using discounted cash flow techniques for capital investment appraisal. The main advantage of discounted cash flow methods is that they use the concept of the time value of money. This is the concept that cash received earlier is worth more than a similar sum received later, because the sum received earlier can be invested to earn interest in the intervening period (Law, 2010). The net present value and internal rate of return methods take account of the entire life of the project, but the discounted payback period only considers the project up to the payback period. All three methods are useful because they allow comparisons to be made with other opportunities. However, the main disadvantages of discounted cash flow methods are that it is difficult to determine the appropriate interest rate to use and predict the cash inflows and outflows over the life of the project. In addition, the calculations are complex and managers may have difficulty in understanding the results. A final limitation is that these methods do not take account of non-financial factors (eg the flexibility of the plant and equipment purchased).
2. Compare the net present value method with the internal rate of return. The net present value is a method of capital budgeting in which the value of an investment is calculated as the total present value of all cash inflows and cash outflow minus the cost of the initial investment (Law, 2010, p. 293). On the other hand, the internal rate of return is an interest rate that gives a net present value of zero when applied to a projected cash flow of an asset, liability, or financial decision (Law, 2010, p. 242). Both are discounted cash flow techniques that are based on the concept of the time value of money. This is the concept that cash received earlier is worth more than a similar sum received later, because the sum received earlier can be invested to earn interest in the intervening period (Law, 2010). Although both methods take account of the entire life of the project, it is difficult to determine the appropriate interest rate to use and predict the cash flows over the life of the project. In addition, the calculations are complex and managers may have difficulty in understanding the results. A final limitation is that these methods do not take account of non-financial factors (eg the flexibility of the plant and equipment purchased). A survey of UK and international members of CIMA (2009) showed that net present value is the most widely used method.
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3. Melrose Events Year Net cash flow (10,000) (4,000) (1,000) 3,000 6,000 8,000 Cumulative net cash flow (10,000) (14,000) (15,000) (12,000) (6,000) 2,000 Discount factor 12% 1.000 0.893 0.797 0.712 0.636 0.567 NPV Present value (10,000) (3,572) (797) 2,136 3,816 4,536 (3,881)
0 1 2 3 4 5
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, but the NPV is negative. Kerry should not go ahead with the project because the NPV shows that when the time value of money is taken into account by discounting the predicted net cash flows, 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-financial factors that may have an impact on the project. Students should refer to the limitations mentioned in the text and wider reading.
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4. Stuarts Boatyard Ltd Project 1 Discounted cash flow (500,000) 75,440 89,000 151,200 110,880 74,700 Project 2 Discounted cash flow (500,000) 84,870 97,900 159,600 87,120 59,760
Year 0 1 2 3 4 5
Discount factor 6% 1.000 0.943 0.890 0.840 0.792 0.747
Cash flow (500,000) 80,000 100,000 180,000 140,000 100,000
Cumulative cash flow (500,000) (424,560) (335,560) (184,360) (73,480) 1,220
Cash flow (500,000) 90,000 110,000 190,000 110,000 80,000
Cumulative cash flow (500,000) (415,130) (317,230) (157,630) (70,510) (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 2 will 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 that the capital would not be recovered. Some students may point out that cumulative net cash flow for Project 1 by the end of year 5 represents a positive NPV for the project, although this decision is not part of the payback period method. (c) Students should refer to the limitations mentioned in the text and wider reading.
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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 and error. Discount factor 15% 1.000 0.870 0.756 0.658 0.572 0.497 Cash flow (50,000) 10,000 25,000 25,000 20,000 10,000 NPV Present value (50,000) 8,700 18,900 16,450 11,440 4,970 10,460 Cumulative cash flow (50,000) (41,300) (22,400) (5,950) 5,490 10,460 Discount factor 25% 1.000 0.800 0.640 0.512 0.410 0.328 NPV Present value (50,000) 8,000 16,000 12,800 8,200 3,280 (1,720) Cumulative cash flow (50,000) (42,000) (26,0000 (13,200) (5,000) (1,720)
Year 0 1 2 3 4 5
Discounted payback period: 3 years +
5,950 . 5,950 + 5,490 3.52 years 15 + 10,460 10 10,460 + 1,720 = 23.59%
= Internal rate of return (IRR)
(a) Using an interest rate of 15% the discounted payback period is just over 3 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 3 years, which makes 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 the investment in the new dryers will be financially viable. (c) Aunt Laura 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 that she has considered non-financial factors that may have an impact on the project. Students should refer to the limitations mentioned in the text and wider reading.
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20. Issues in management accounting

The following narrative answers are indicative of the main points in the chapter. 1. Describe the target costing process. Explain its advantages over a cost-plus approach to product or service pricing. The main steps in target costing are: Develop a product that satisfies the needs of customers. It is essential that any new product or service offers a bundle of attributes that are superior to those of competitors. Determine an appropriate target price for the product based on customers perceptions of the value of its attributes, the price of competing products and the target profit per unit. This requires an assessment of the market price that is appropriate for bundle of attributes it offers and the competition it faces. Calculate the target cost after allowing for target profit (target price minus target profit). The entity 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 the product or service. As markets are now increasingly competitive, prices should be determined through analysis of prevailing market forces and the competitiveness of the product or service, rather than being driven by the cost of production or service delivery. In a target costing framework, the selling price of a product or service is seen as constrained by the market and the target cost is the goal that an 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 use of non-financial and financial information for managing the environmental costs and impacts of business operations. The need for EMA is based on the premise that traditional management accounting systems cannot be used to measure environmental issues as they hide environmental costs as overheads, thereby obscuring their size and origin. Environmental costs are not typically allocated or apportioned in an appropriate manner as they are not made the responsibility of the department or product that causes them. EMA aims to make environmental issues visible in all areas of 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 nonfinancial information systems. Indicative of the current use of non -accounting methods to tackle internal environmental issues is the way that many organisations have implemented environmental management systems (EMS) certified to the ISO 14001 standard (BSI, 2004). Such EMS are typically structured as an extension of either existing health and safety or TQM systems, rather than becoming a routine part of the finance function.
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3. Stunt Ltd (a) Attributes Performance 50.0% 40% 20% 40% 100%
Components of cost Handlebars & steering Footplate Wheels & suspension Total
Safety 10.0% 40% 40% 20% 100%
Style 40.0% 20% 60% 20% 100%
Importance index 0.320 0.380 0.300 1.000
% of total cost 33.33% 50.00% 16.67% 100.00%
Strategic cost index 0.96 0.76 1.80
With the highest importance index of 38% (0.380), the aluminium footplate component is the largest provider of the attributes that customers desire, although all three components have an importance level of at least 30%. The importance index of 0.320 for handlebars and steering is calculated 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 by the cost of providing that attribute. The strategic cost index of 0.96 for handlebars and steering is calculated as 0.320 importance index 0.3333 of total cost = 0.96. Management should redesign or re-engineer products to focus on the attributes with the highest SCI results and consider ways of eliminating attributes with very low SCI scores. The strategic cost index (SCI) results indicate that the wheels and suspension component provides customers with substantial product benefits for a relative inexpensive target cost. On the other hand, the footplate is relative costly compared to the product attributes it provides customers (a SCI of 0.76 is relatively low).
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4. Electro Ltd (a) Cost of quality report 2012 Prevention costs Quality Engineering Quality training Supplier Reviews Total Appraisal costs Depreciation of test equipment Inspection Product testing Total Internal failure cost Retesting Rework Total External failure costs Cost of customer complaints department Lost contribution from lost sales Product recall Warranty repairs Total Total cost of quality 770,000 1,100,000 200,000 2,070,000 370,000 150,000 670,000 1,190,000 480,000 580,000 1,060,000 270,000 823,000 360,000 240,000 1,693,000 6,013,000 % of Revenue 2011 520,000 700,000 50,000 1,270,000 270,000 80,000 700,000 1,050,000 1,250,000 770,000 2,020,000 480,000 1,790,000 920,000 320,000 3,510,000 7,850,000 % of Revenue
3.34%
2.24%
1.92%
1.85%
1.71%
3.56%
2.73% 9.70%
6.19% 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 and appraisal 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 the company's quality costs traceable to internal and external failure, rather than to prevention and appraisal. 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 have fallen from 3.51 million in 2011 to just 1.693 million during 2012. If the company continues its emphasis on prevention activities in future years, appraisal costs and internal failure costs should decline further. As quality is built into products through better engineering and design, and as better process control is maintained, then defects should decrease. Thus, internal failures-and the need to detect these failures through appraisal activities-will also decrease.
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5. Contain Ltd (a) The companys 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 companys containers are not differentiated and there are ten other manufacturers producing containers with similar product attributes. To succeed, the company must achieve lower costs relative to competitors through improvements in manufacturing, productivity and efficiency. (b) BSC Perspective Financial perspective Possible measures Operating income from productivity gain target 150,000 Operating income from growth target 300,000 Cost reductions in key areas increased yield on steel target 50000 Market share of cost conscious consumers, New customers Customer satisfaction Customer retention/repeat customers and number of on-time orders Time taken to fulfil customer orders Yield on steel Order fulfilment time On-time delivery % of defective containers per 1,000 units Productivity % of staff trained in TQM techniques Employee retention Employee satisfaction
Customer perspective
Internal business processes
Learning and growth
(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 that solely focus on the achievement of financial objectives, the BSC combines financial and nonfinancial performance measures and evaluates short, medium and long-term performance measures in a single cohesive report. As a result, the technique focuses on the non-financial objectives that an organisation must achieve in order to meet its financial objectives. The logic for this is that non-financial and operational indicators can capture improvements in performance that short-term financial measures may not. Thus, BSC provides an appropriate balance and link between non-financial and financial performance measures, as non-financial performance improvements must eventually lead to tangible pay-offs. By using a balanced scorecard, the company can be sure that any strategic action matches the desired outcomes. A BSC system allows 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 and inappropriate cost cutting (eg cutting R&D expenditure during a recession). In addition, BSC offers 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 causeand-effect relationship between the four perspectives in the balanced scorecard. At a conceptual level, there is only a logical rather than a causal relationship between non-financial performance measures and future financial performance (Norreklit, 2000). For example, the production of high quality products does not always result in increased profit, especially when customers are unwilling to pay for such improvements. Furthermore, in many instances, a loyal and highly satisfied customer may not be a profitable one, as they may require many hours of costly customer service time. It may be confusing to mix subjective performance measures (eg customer satisfaction 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. 74
A further criticism of the BSC is that if too many performance measures are used, it will produce confusing and conflicting data. Moreover, since financial measures are normally used to evaluate the performance of managers, management may attach less importance to improving nonfinancial performance. Other limitations include the exclusion of other stakeholder perspectives (eg suppliers and employees), it can be costly to implement in terms of resources and management time, and that it needs to fit the organisations culture.
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A1. Financial statements for a partnership

1. H&G Tool Hire H&G Tool Hire Statement of comprehensive income for the year ended 31 December 2013 (extract) Profit for the period Interest on drawings 95,000 1,500 1,000 97,500 (15,000) (10,000) (1,000) (3,000) 68,500 41,100 27,400 68,500
Harry George Harry George Harry George Harry George 60% 40%
Salaries Interest on capital Balance of profits to be shared
2. H&G Tool Hire Current accounts Harry Salaries 15,000 Interest on capital 1,000 Share of profits 41,100 57,100 Interest on drawings (1,500 Drawings (35,000) Closing balance 20,600
George 10,000 3,000 27,400 40,000 (1,000) (32,000) 7,000
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3. J&B Services Goodwill working Total net assets of the new partnership (2000,000 x 3) Net assets + investment by new partner (120,000 x 2) + 200,000 Goodwill Goodwill account 80,000 80,000 Capital account: Jarvis Opening balance Goodwill Capital account: Berry Opening balance Goodwill Capital account: Coyle Bank 600,000 (440,000) 160,000
Jarvis Berry
120,000 80,000
120,000 80,000
200,000
4. Page & Partners
Statement of comprehensive income for the year ended 31 December 2012 (extract) Profit for the year Interest on drawings (5%) 131,950 2,750 1,000 1,400 137,100 (15,000) (10,000) (10,000) (5,000) (7,500) (8,500) 71,100 23,700 23,700 23,700 71,100
Page Jones Beattie Page Jones Beattie Page Jones Beattie Page Jones Beattie 33% 33% 33%
Salaries
Interest on capital (10%)
Balance of profits to be shared
77
Opening balance Salaries Interest on capital Share of profits
Current accounts Page Jones 4,500 2,000 15,000 5,000 23,700 48,200 (2,750) (55,000) (9,550) 10,000 7,500 23,700 43,200 (1,000) (20,000) 22,200
Beattie 5,000 10,000 8,500 23,700 47,200 (1,400) (28,000) 17,800
Interest on drawings Drawings Closing balance
5. Mourne, Noonan & Knight Realisation account 50,000 Bank: Sale of premises 48,600 Bank: Sale of stock 28,200 Bank: Debtors realised Loss on realisation: Mourne Noonan Knight 126,800 Bank account 47,500 Opening balance 41,100 Creditors 26,800 Payment to Mourne ______ Payment to Noonan 115,400 Capital accounts Knight 3,800 Opening balance Current accounts Mourne* Noonan* 7,400 44,700
Premises Stock Debtors
47,500 41,100 26,800 3,800 3,800 3,800 126,800
Realisation: Premises Realisation: Stock Realisation: Debtors
28,700 78,300 5,400 3,000 115,400
Loss on realisation Knight* Bank
Mourne 3,800 800 5,400 8,000
Noonan 3,800 600 3,000
Mourne 8,000 2,000
Noonan 6,000 1,400
10,000
7,400
Knight 2,000 400 800 600 3,800
* Garner v. Murray (1904) requires that losses are shared in the ratio of the partners capital accounts (not their profit-sharing ratios).
78
A2. Costing for specific orders and continuous processes

The following narrative answers are indicative of the main points in the chapter. 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 part of that process. It may be expressed as a weight or volume or in other units appropriate to the process. It is usually not valued but if it is, a notional scrap value is used (Law, 2010, p. 299). On the other hand, abnormal loss is the loss arising from a manufacturing or chemical process through abnormal waste, seepage, shrinkage, or spoilage in excess of the normal loss. It may be expressed 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 Ltd Job 213 Wedding invitations Materials Wages Production overheads Production costs General overheads Profit (5 4 hours) (2.50 4 hours) (20%) (25%) 30 20 10 60 12 72 18 90
3. Townday Building Ltd
Townday Building Ltd Contract No. 33 Grove Lane Cost of work done: Work certified Work not certified 140,000 34,000 174,000 320,000 260,000 60,000 40,150
Estimated contract profit:
Contract price Estimated total costs
Profit at year end:
174,000 60,000 = 260,000
79
4. Pollution Control Ltd Technicians wages Materials Overheads Total annual cost Monthly cost (30,000) = 12 2,500 = 240 12,000 2,500 15,500 30,000 2,500
Cost per test
10.42
5. Chris Paul (Processing) Ltd Chris Paul (Processing) Ltd Process 2 Costs for August Total cost Completed Equivalent units units in WIP 910,500 12,200 3,800 49,500 701,200 1,671.200 Value of completed units (12,200 109.73) Value of WIP (see last column) Total cost 12,200 12,200 3,800 (50%) 1,900
Effective units 16,000 16,000 14,100
Previous process costs Materials introduced Labour and overheads
Cost per unit 56.91 3.09 49.73 109.73 1,338,712 322,488 1,661,200
Value of WIP 216,244 11,756 94,488 322,488
80

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Business Accounting Answers to Practice Questions

Introduction to the second edition

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

Part I The world of accounting and finance 1. Introduction to business accounting

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

2. The importance of cash

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

Part II Financial accounting 3. The accounting system

Lorry Lorry insurance Rent Equipment Purchases Advertising

16,000 1,400 4,500 5,400 850 420

Bank Timber supplies

Business Accounting Answers to Practice Questions

Stationery account 15 36 Parking account 2 2 2 Petrol account 18 18 Purchases account 104 89

1 July 2 July 3 July

Cash Cash Cash

Business Accounting Answers to Practice Questions

1 October 12 October 15 October 18 October 30 October

Balance b/f Sales Jones Ltd Jones Ltd Sales

Purchases Advertising Purchases Davies Ltd Purchases Balance c/f

750 1,120 2,300 780 3,400 3,200 11,550

2 November 12 November 18 November 21 November 25 November 1 October

Sales Sales Sales Sales Sales Balance b/f

Cash Balance c/f

Business Accounting Answers to Practice Questions

4. Regulatory framework for financial reporting

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

5. Conceptual framework for financial reporting

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

6. Statement of comprehensive income

Opening inventory Purchases Closing inventory Cost of sales

Business Accounting Answers to Practice Questions

Business Accounting Answers to Practice Questions

Working 1 Purchases Closing inventory Cost of sales Working 2

Advertising Lighting and heating Telephone and Internet General expenses

Business Accounting Answers to Practice Questions

Working 1 Purchases Closing inventory Cost of sales Working 2

Advertising Lighting and heating Telephone and Internet General expenses

Business Accounting Answers to Practice Questions

Working 1 Purchases Closing inventory Cost of sales Working 2

Advertising Lighting and heating Telephone and Internet General expenses

Business Accounting Answers to Practice Questions

Working 1 Opening inventory Purchases Closing inventory Cost of sales

Business Accounting Answers to Practice Questions

7. Statement of financial position

Business Accounting Answers to Practice Questions

5,000 4,800 9,800 5,000 1,000 6,000 15,800

6,000 13,300 19,300 6,000 1,200 7,200 26,500

10,000 22,700 32,700 2,000 1,500 3,500 36,200

15,000 25,800 40,800 10,000 2,000 12,000 52,800

10,000 37,700 47,700 15,000 3,300 18,300 66,000

Business Accounting Answers to Practice Questions

20,000 8,000 2,000 14,500 24,500 44,500

30,000 4,100 34,100 8,400 2,000 10,400 44,500

Working 1 Purchases Closing inventory Cost of sales