Accounting Problem Book 2011

 

2011   

Principles of Accounting  Problem book  book  V.V. Dobrynskaya, V.V. Poleshchuk

International College of Economics and Finance

 

Introduction to Accounting Problem 1

You are to complete the gaps Assets

Liabilities

Capital

₤ 

₤ 

₤ 

(a) (b)

12,500 28,000

1,800 4,900

? ?

(c)

16,800

?

12,500

(d)

19,600

?

16,450

(e)

?

6,300

19,200

(f)

?

11,650

39,750

Problem 2

Distinguish from the following list the items that are liabilities from those that are assets: (a) (b)

Office machinery Loan from C Shirley

(d) (e)

Motor vehicles We owe for goods

(c)

Fixtures and fittings

(f)

Bank balance

Problem 3

State which of the following are shown sho wn under the wrong classification for J White‟s business:  business:   Assets

Liabilities

Loan from C Smith

Stock of goods

Cash in hand

Debtors

Machinery Creditors

Money owing to bank

Premises Motor vehicles

Problem 4

Mr. S sets up a new business. Before he actually sells anything, he has bought motor vehicle ₤2,000, premises ₤5,000, stock of goods ₤1,000. He did not pay in full for his stock of goods and still owes ₤400 in respect of them. He had borrowed ₤3,000 from B. After the evens just described, and before before trading starts, he has ₤100 cash in hand and ₤700 cash in bank  

 

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Required: 

Calculate the amount of his capital.

Problem 5

Draw up a balance sheet from the following as at 31 December 19X8: Capital Debtors

23,750 4,950

Motor vehicles

5,700

Creditors

2,450

Fixtures

5,500

Stock of goods

8,800

Cash at bank

1,250

Problem 6

Complete the columns to show the effects of the following transactions:  Effect upon  Assets

Liabilities

Capital

(a) We pay a creditor ₤70 in cash. cash . (b) Bought fixtures ₤200 paying paying by cheque. (c) Bought goods on credit ₤275. ₤275 . (d) The proprietor introduces another ₤500 cash into the firm. firm . (e) Mr. X lends the firm ₤200 in cash. cash . (f) A debtor pays us ₤50 by cheque. cheque.

Problem 7

C.S. has the following items in his balance sheet as on 30 April 19X8: Capital ₤20,900; Creditors ₤1,600;  ₤1,600;   Fixtures ₤3,500;  ₤3,500;  Motor vehicle ₤4,200;  ₤4,200;  Stock of goods ₤4,950;  Debtors ₤3,280;  ₤4,950; ₤3,280; Cash at bank ₤6,450;  ₤6,450; Cash in hand ₤120.  ₤120.  During the first week of May 19X8: (a) He bought extra stock of goods ₤770 on credit. (b) One of the debtors paid him ₤280 in cash.  cash.  (c) He bought extra fixtures by cheque ₤1,000.  ₤1,000.   Required: Draw up a balance sheet as on 7 May 19X8 after the above transactions have been completed.

 

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Problem 8

The following are transactions of the business for a period. You are required to state the effect of each on the balance sheet items. Be detailed where the capital is affected, showing the type of effect: (a) Bought stock in trade on credit terms for ₤1,200. ₤1,200. (b) The owner paid a trade creditor ₤1,500 for some s ome stock in trade bought on credit recently. Since the owner did not have the business bank account cheque book with him, he drew a cheque on his personal account. (c) Stock in trade, which had cost ₤1,700, was sold on credit for ₤2,500.  ₤2,500.  (d) The owner withdrew withdrew ₤500 by drawing a cheque on the business bank account, payable to himself. (e) Paid wages of ₤750 by cheque.  cheque.  (f) Paid bank interest of ₤100 by having amount charged on the business bank account. (g) (g) Received a ₤2,000 cheque from a trade debtor.  debtor.   (h) (h) Paid a trade creditor ₤1,200 by a cheque drawn on the business bank account. Problem 9

Explain: (a) What is a revenue? (b) What is an expense? (c) What is a profit? (d) The owner pays himself a regular ₤100 from the business account each week, is it an   expense? (e) Why is the purchase of some stock in trade not an expense? Problem 10

Explain and provide comments: (a) Why is it necessary to put a date in the heading of the balance sheet? (b) Jim just bought a new motor van. Will this have an effect on the balance sheet of his  business? (c) Comment : “Why is it that my capital is shown with the liabilities in the balance sheet of my business? Surely it is an asset”.  asset”.  (d) Which of the following would you expect to find among the items of the balance sheet: - The fact that the business owes money  

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- The fact that the owner has very good business skills - The fact that the demand for the output of the business is expected to increase greatly in the future leading to a large increase in profits. - The fact that the assets of the business are highly specialized and in the main part could only be used for the current purposes. (e) The total of the balance sheet tells the owner how much his business is worth. (f) The amount of equity on the balance sheet tells the owner how much his business is worth.

Problem 11

Consulting Agency Balance Sheet as of October 31, 19X3 ASSETS

LIABILITIES

Cash

₤1,400   ₤1,400

Notes Receivable

₤11,000   ₤11,000

Advertising Expense

₤300   ₤300

Interest Expense

₤2,000   ₤2,000

Land

₤31,500   ₤31,500

Office supplies

₤800   ₤800

Salary Expense Office furniture

₤3,300  ₤3,300  ₤4,700   ₤4,700

Accounts Receivable Note Payable

₤1,600  ₤1,600  ₤20,000   ₤20,000

Accounts Payable

₤3,000   ₤3,000

Utilities Expense

₤1,100   ₤1,100

Total Assets

₤44,300  

OWNER‟S EQUITY  EQUITY  Equity

₤8,900   ₤8,900

Total Liabilities & Equity

₤44,300  

The bookkeeper of Consulting Agency prepared the Balance Sheet of the company while the accounting was ill. The Balance Sheet contains a lot of errors. In particular, the bookkeeper knew that the Balance Sheet should balance, that‟s why he put in the owner‟s equity the amount needed to achieve this balance. But in reality the equity data is not correct. Required: (a) Prepare the correct Balance Sheet as of October 31, 19X3. (b) Identify the accounts listed in the balance sheet made by the bookkeeper that should not  be  be  presented on the true Balance Bal ance Sheet. (c) Explain why you excluded some accounts from the correct Balance Sheet.

Problem 12

Harold Davies is the owner of a small building firm. He does not understand the item “balance sheet” and asks you to explain to him whether whet her the following items should be on his

 

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 balance sheet. Indicate the nature of the item (e.g., current asset, long-term liability, not applicable) and give the reason for your answer. (a) Inventory of sand and cement (b) Air compressor purchased for cash (c) Air compressor hired for three weeks (d) Wages paid to labourer (e) Lorry used for transporting materials (f) Diesel fuel in lorry fuel tanks (g) Washing machine bought for Mrs. Davies (h) Bank overdraft (i) Petty cash in hand (j) ₤2,000 owing to an uncle uncle who says Harold need not pay until five years later

Problem 13

King Pharmaceuticals plc has just spent £50 million on developing a new medicine that is expected to yield substantial profits over the next four years. Use this example to help explain the distinction between the terms 'relevance' and 'reliability' when preparing financial statements for shareholders. Why are 'relevance' and 'reliability' seem to be important qualitative characteristics of accounting information? You should structure your answer well. Your answer should not exceed 250 words.

 

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Double-Entry Bookkeeping Problem 14

The transactions of Wheels Repair Shop for January 19X9 are shown below: January 3  –   Debby Star opened a bank account under the name of her new business and deposited ₤30,000 in cash. January 4  –   She rented a temporary shop and paid ₤300 for the January rent, issued cheque. January 5 –  5  –  Rented   Rented automotive tools and equipment until the firm could purchase its own. Rent in the amount of ₤80 was paid for January, issued cheque. January 5  –   Purchased motorcycle parts and supplies described on invoice from the Southern Supply Company for ₤400 on account. January 10 –  10 –  Purchased   Purchased land as a prospective building site for ₤10,000. Paid ₤4,000 in cash and issued a one-year note payable for the balance. January 12 –  12  –   Made repairs on George Shipman‟s motorcycle for ₤40. ₤40. Shipman asked that a charge account be opened in his name. He promised to settle the account within 30 days. This arrangement was authorized by service manager. January 26 –  26  –   Made repairs on Jay Munson‟s motorcycle for ₤180. ₤180. A charge account was opened in his name. January 29 –  29  –  Purchased   Purchased motorcycle parts and supplies from Delco Supply House for ₤250 on account  account  January 29 –  29 –  Paid the Southern Supply ₤300 on account (cheque)  (cheque)   January 31 –  31 –  Paid electricity and water bills of ₤80 for January  January   January 31 –  31 –  Paid ₤1,700 in salaries for the month  month   January 31 –  31 –  Made motorcycle repairs for various cash customers for ₤4,800   January 31 –  31  –   Debby Star withdrew ₤300 in cash in anticipation that t hat at least as much income had been earned January 31 –  31 –  Purchased automotive tools and equipment for cash ₤4,000. The list price was 5,000. January 31  –   Paid a premium of ₤600 on a 12 months insurance policy, it becomes effective on February 1, 19X9. January 31 –  31 –  Received  Received a cheque for ₤10 from George Shipman.  Shipman.  Required:

(a) Analyze the transactions using extended accounting equation formula

 

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(b) Journalize the transactions (c) Post to the ledger (d) Prepare a trial balance sheet / footing (e) Explain adjusting entries

Problem 15 Bill Cashing sets up practice as an architect, transferring ₤20,000 of his own money on 1 June

2003 from this personal bank account into a new business bank account with NatMid Bank  plc to represent the opening capital of the business. The following transactions took place during June 2003: June 1 –  1 –  Paid  Paid rent for office for June ₤400 by cheque. June 1 –  1 –  Purchased  Purchased office equipment for ₤2,000, from Equipit Ltd on credit. June 1 –  1 –  Purchased  Purchased office supplies, costing ₤300 from W Brown on credit. June 1 –  1 –  Employed an office junior at a monthly wage of ₤500.  ₤500.  June 5 –  5 –  Surveyed a property for A Bond and sent out and invoice for ₤200.  ₤200.   June 7 –  7 –  Decided to transfer his own car to the business at a value of ₤4,000.  ₤4,000.  June 9 –  9 –  Bought  Bought petrol for the car ca r costing ₤20, paying by cheque.  cheque.   June 12 –  12  –   Took a client, P Brosnan, to lunch at a cost of ₤40, paying by cheque, and was asked to prepare plans for a new factory, for which work he estimated he would earn ₤5,000.   ₤5,000. June 16 –  16 –  Carried  Carried out another property sur vey vey for A Bond and invoiced him for ₤240.  ₤240.  June 20 –  20 –  Took another possible client to lunch at a cost of ₤60, paying by cheque, but found that he would not be able to undertake work for that client. June 23 –  23 –  Bought  Bought further office supplies from W Brown on cr edit cr edit for ₤100.  ₤100.  June 30 –  30 –  Paid  Paid the office junior her monthly wage. June 30- Sent a cheque to Equipit Ltd for ₤2,000.  ₤2,000.   June 30 –  30 –  Sent a cheque to W Brown for office supplies for ₤300.   June 30 –  30 –  Banked a cheque received from A Bond for ₤200.   June 30 –  30 –  Drew  Drew out ₤500 from the bank for personal living expenses.  expenses.   Required:

Enter these transactions in Bill Cashing‟s accounting records, and test the arithmetical accuracy of your work by preparing a trial balance when you have completed the necessary entries.

 

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Problem 16

The following transactions took place during May 19X6:   May 1 –  1 –  Started  Started firm with capital in cash of ₤250. May 2 –  2  –  Bought   Bought goods on credit from the following persons: D ₤54; C ₤87; K ₤25; B ₤76; L ₤64. May 4 –  4 –  Sold  Sold goods on credit to: CB ₤43; BH ₤62; HS ₤176. May 6 –  6 –  Paid  Paid rent by cash ₤10 May 9 –  9 –  CB  CB paid us his account by cheque ₤43. May 10 –  10 –  HS  HS paid us ₤150 by cheque. May 12 –  12 –  We  We paid the following by cheque: K ₤25; D ₤54. May 15 –  15 –  Paid  Paid carriage by cash ₤23. May 18 –  18 –  Bought  Bought goods on credit from C ₤43; B ₤110. May 21 –  21 –  Sold  Sold goods on credit to BH ₤67. May 31 Paid rent by cheque ₤18. Required: Enter these transactions in a company‟s accounting records, and then balance off the accounts

and extract a trial balance as at 31 May 19X6.

Problem 17

B‟s Trial Balance as on 31 December 19X6 Dr

Cr

₤ 

₤ 

Sales Purchases Salaries

14,629 2,150

Motor expenses

520

Rent

670

Insurance

111

General expenses

105

Premises

1,500

Motor vehicles

1,200

Debtors

1,950

Creditors

 

18,462

1,538

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Cash at bank

1,654

Cash in hand

40

Drawings

895

Capital

_____

5,424

25,424

25,424

Stock at 31 December 19X6 was ₤2,548. Required: Using the trial balance of B that was extracted after one year‟s trading, prepare a trading and  profit and loss account for the year ended 31 December 19X6 and a balance sheet as on 31 December 19X6.

Problem 18

The following transactions took place during March 19X6:   March 1 –  1 –  Started business with ₤800 in the bank.  bank.   March 2 –  2 –  Bought goods on credit from the following persons: K ₤76; M ₤27;  ₤27;  B ₤56.  ₤56.  March 5 –  5 –  Cash sales ₤87.  ₤87.  March 6 –  6 –  Paid wages in cash ₤14.  ₤14.  March 7 –  7 –  Sold goods on credit to: H ₤35; L ₤42; J ₤72.  ₤72.   March 9 –  9 –  Bought goods for cash ₤46  ₤46  March 10 –  10 –  Bought goods on credit from M ₤57; B ₤98.   March 12 –  12 –  Paid wages in cash ₤14.  ₤14.  March 13 –  13 –  Sold goods on credit to: L ₤32; J ₤23.  ₤23.  March 15 –  15 –  Bought shop fixtures on credit from B Ltd ₤50.  ₤50.   March 17 –  17 –  Paid  Paid M by cheque ₤84. March 18 –  18 –  We returned goods to B ₤20.  ₤20.  March 21 –  21 –  Paid  Paid B Ltd a cheque for ₤50.  ₤50.  March 24 –  24 –  J paid us his account by cheque ₤95. ₤95. March 27 –  27 –  We returned goods to K ₤24.  ₤24.  March 30 –  30 –  J lent us ₤60 by cash.  cash.  March 31 –  31 –  Bought a motor van paying by cheque ₤400.  ₤400.   Required:

Enter these transactions in a company‟s accounting books, and then balance off the accounts and extract a trial balance as at 31 March 19X6.

 

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Problem 19

C‟s Trial Balance as on 30 on 30 June 19X8 Dr

Cr

₤ 

₤ 

Sales Purchases Rent Lighting and heating expense Salaries and wages

28,794 23,803 854 422 3,164

Insurance

105

Buildings

50,000

Fixtures

1,000

Debtors

3,166

Sundry expenses

506

Creditors Cash at bank

1,206 3,847

Drawings

2,400

Motor vans

5,500

Motor running expenses

1,133

Capital

_____

65,900

95,900

95,900

Stock at 30 June 19X8 was ₤4,166. Required:

From the trial balance of C after his first fi rst year‟s trading, prepare a trading and profit and loss account for the year ended 30 June 19X8 and a balance sheet as on 30 June 19X8.

 

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Adjustments Problem 20

The following trial balance was extracted from the accounts of a business as at 31 st December 19X7: Dr

Cr

₤ 

₤ 

Sales

150,000

Sales return

3,000

Purchases

70,000

Carriage in

1,000

Stock as at 1st January 19X7

10,000

Wages

20,000

Administration expenses

25,000

Insurance

1,000

Selling & distribution expenses

10,000

Purchase returns Drawings

500 10,000

Capital

50,000

Premises

20,000

Equipment

20,000

Debtors

15,000

Creditors

10,000

Cash

5,500

_____

₤210,000   ₤210,000

₤210,000   ₤210,000

At the year end (31st December) the following information is available: (1) ₤1,000 of the wages relate to the next accounting period. (2) ₤2,000 is owed for administration expenses relating to 19X7. (3) Equipment is to be depreciated by ₤4,000. (4) Closing stock is estimated to have cast ₤8,000. Required:

(a) Enter the records in the Trial balance. (b) Indicate which data from trial balance relates to the Balance sheet. (c) Prepare a profit and loss statement for the year ended 31st December 19X7.

 

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(d) Explain the role of adjustments you made.

Problem 21

Mr. Big has been trading for some years as a wine merchant. The following list of balances has been extracted from his ledger as at 30 th April 19X7, the end of his most recent financial year. ₤  Capital

83,887

Sales

259,870

Trade creditors

19,840

Returns out

13,407

Provision for doubtful debts Discounts allowed

2,306

Discounts received

1,750

Purchases Returns inwards

 

512

135,680 5,624

Carriage outwards

4,562

Drawings

18,440

Carriage inwards

11,830

Rent, rates and insurance

25,973

Heating and lighting

11,010

Postage, stationery and telephone

2,410

Advertising

5,980

Salaries and wages Bad debts

38,521 2,008

Cash in hand

534

Cash at bank

4,440

Stock as at 1st May 19X6

15,654

Trade debtors

24,500

Fixtures and fittings –  fittings –  at cost

120,740

Provision for depreciation on fixtures and fittings –  fittings –  as  as at 30t  April 19X7

63,020

Deprecation

12,074

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The following additional information as at 30 th April 19X7 is available: (1) Stock at the close of business was valued at ₤17,750. (2) Insurances have been prepaid by ₤1,120. (3) Heating and lighting is accrued by ₤1,360. (4) Rates have been prepaid by ₤5,435. (5) The provision for doubtful debts is to be adjusted so that it is 3% of trade debtors. Required: Prepare Mr. Big‟s trading and profit and loss account for the year ended 30 th April 19X7 and a  balance sheet (in vertical verti cal format) as at that date.

Problem 22

The following trial balance was extracted from the books of Charles as the close of business on 28 February 19X7. Dr

Cr

Purchases and sales

₤  11,280

₤  19,740

Cash at bank

1,140

Cash in hand

210

Capital account 1st March 19X6

9,900

Drawings

2,850

Office furniture

1,440

Rent

1,020

Wages and salaries

2,580

Discounts Debtors and creditors

690 4,920

Stock 1st March 19X6

2,970

Provision for doubtful debts 1 st March 19X6 Delivery van

360 2,490

270 2,400

Van running costs

450

Bad debts written off

810 ₤32,760   ₤32,760

₤32,760   ₤32,760

th

The following additional information as at 28  February 19X7 is available: (1) Stock at 28th February 19X7 ₤3,510.  

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(2) Wages and salaries accrued at 28th February 19X7 ₤90. (3) Rent prepaid at 28th February 19X7 ₤140. (4) Van running costs owing at 28th February 19X7 ₤60. (5) Increase the provision for doubtful debts by ₤60. (6) Provide for depreciation as follows: Office furniture ₤180; Delivery van ₤480. Required: Draw up the trading and profit and loss account for the year ending 28 th  February 19X7

together with a balance sheet as on 28th February 19X7, using vertical formats throughout.

Problem 23

The balance The  balance sheet of Johnson‟s Joh nson‟s shop as at 1st October 19X7 was as follows: ₤ 

₤ 

 Fixed assets

45,000

Shop fittings Delivery van

12,000 4,000 61,000

At 1 October 19X7

Current assets

Cash in hand

₤ 

Capital

Shop premises

Stock in trade

₤ 

51,000

Current liabilities

14,000 2,000 16,000

Trade creditors

12,000

Bank overdraft

14,000 26,000

₤77,000   ₤77,000

₤77,000   ₤77,000

The following in a summary of the transactions which took place during the year to 30 th  September 19X8: (1) Sales were made, all for cash, of ₤145,000. The stock in trade sold cost ₤83,000. (2) Stock in trade was bought, all on credit, for ₤78,000. (3) Cash of ₤113,000 was taken from the till (cash register) and paid into the bank. (4) The trade creditors were paid ₤73,000 by cheque. (5) Johnson borrowed ₤30,000 from Black which was paid into the bank. The loan is for 5 years. (6) Wages of ₤17,000 were paid by cash. (7) Rates of ₤2,900 were paid by cheque. (8) Additional shop fittings costing ₤9,000 were bought and paid for by cheque (9) The bank charged overdraft interest of ₤2,000 direct to the account. (10) Sundry expenses of ₤6,000 were paid in cash.  

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(11) Electricity bills of ₤1,600 were paid by cheque. (12) The owners of the business withdrew ₤9,000 in cash. At 30th September 19X8 you discover the following: (13) Interest ₤2,500 due to Black for the year was unpaid. (14) Shop fittings are to be depreciated at 10% per annum on the total at the year end; the delivery van is to be depreciated by 20% per annum of the total at the year end. (15) The rates payments during the year included ₤1,000 in respect of the period 1.10.19X8 to 31.3.19X9. (16) The electricity bill for the quarter to 30.9.19X8 for ₤500 was unpaid. Required:

Prepare a balance sheet (in vertical format) as at 30th September 19X8 and a profit and loss account for the year to that date.

Problem 24 Adagio plc. is a wholesale supplier of musical instruments to the retail and educational

sectors. The bookkeeper has extracted the following balances from the accounting records for the year ended 31st May 2010. The totals of the debit and credit balances did not agree, and the balancing figure was placed in a suspense account. £000   £000 Freehold property, at cost

3,600

Plant, equipment and vehicles, at cost

2,060

Provision for depreciation at 1 st June 2009 Freehold buildings Plant, equipment and vehicles Purchases

13,100

Sales

21,180

Distribution and selling costs

2,300

Administration costs

1,240

Directors remuneration

1,110

Inventories at 1st June 2009

1,320

Trade creditors Trade debtors

 

440 1,080

972 1,834

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Bank balances Ordinary share capital (£1 shares, fully paid)  paid)   Retained earnings at 1st June 2009 Loan interest paid 10% loan, repayable in 2015 Suspense account (debit balance) The following information is available.

95 3,300 222 30 500 1,005

(1) The accountant of Adagio plc. has now reviewed the accounting records and has discovered the following errors which require adjustment: (i) On 31st  May 2010 stocks were valued at £1,280,000. This figure fi gure has been credited to the  purchases account but no n o other entries have been be en made. (ii) A motor vehicle was sold for cash on 1 st  June 2009 for £15,000. The cash received has  been recorded in the cash book but no other entries have been made. The motor vehicle originally cost £40,000 on 1st June 2008.  2008.  (iii) A debtor balance of £130,000 was eliminated from the trade debtors balance as it was considered to be irrecoverable. No other entries have been made. (iv) A directors‟ bonus of £390,000 was calculated o n the basis of expected profits and was added to the directors‟ directors‟ remuneration  remuneration account but no other entries were made. (2) No provision has been made at the year-end for the following: (i) Depreciation on plant, equipment and vehicles at 10% on the straight line method. There are no fully depreciated assets in this category. (ii) Depreciation at 5% on cost of freehold buildings which represent 25% of the cost of freehold property. Depreciation charges and profits or losses on asset disposals are allocated 50% to cost of sales and 25% each to distribution costs and administration costs. (3) Directors‟ remuneration is allocated as 80% to administration and 20% to selling costs. Bad debts written off are treated as selling costs. (4) Provision is required at the year-end for: (i) outstanding loan interest, (ii) auditors‟ remuneration of £80,000, (treated as administration costs),  costs),   (iii) corporation tax for the year of £600,000  £600,000   (5) The company has paid insurance premiums of £20,000 relating to periods after the year   end. Insurance is included in administration costs.

 

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Required:

(a) Prepare a profit and loss account for Adagio plc. for the year ended 31 st May 2010 and a  balance sheet as at that date da te in a form suitable for the d directors. irectors. (b) During the year the company company had paid £40,000 training costs which were included in administration costs. The human resources director has argued that this should not be seen as an expense but as an asset. Briefly discuss her proposal.

Problem 25

The draft accounts prepared for the directors of Snodrop plc. for the year ended 31 December 1999 show a profit before taxation of £573,580. In the course of subsequent checking, the following errors and omissions were found: (1) During the year the company had acquired an additional factory unit at an annual rent of £64,000, payable quarterly in advance commencing on 31 March 1999. By 31 December 1999 four quarterly payments had been made. The total paid during the year had been treated as capital expenditure and included in fixed assets. No depreciation had been provided on the factory unit. (2) Some goods were included in the closing stock valuation at their selling price of £9,750. The gross profit margin on these goods was 30%. (3) A delivery vehicle held as a fixed asset had been sold during the year for £5,200. The original cost was £16,000 and, at 1 January 1999, depreciation of £9,600 had been provided. The proceeds of sale had been credited to sales account. The company depreciates delivery vehicles at 20% per year using straight-line basis. Its policy is to provide for depreciation in the year of purchase but not in the year of sale. (4) The brought forward balance of £1,700 for the accrued telephone charges at 1 January 1999 had been omitted when calculating the year‟s telephone charge. (5) £9,820, being the total of returns inwards for the year, had been credited to purchases and debited to trade creditors. (6) At 1 January 1999 there was a provision for doubtful debts of £29,320. Snodrop plc. Snodrop  plc. has a  policy of making a 3% provision provis ion for doubtful debts based bas ed on closing trade tr ade debtors. debtors . The entry for 31 December had not been made and the trade debtors then totaled £1,260,500.  £1,260,500.   (7) Items included in closing stock at £7,900, and which would normally be sold for £10,200, were in a damaged state and were worth only £6,850.  £6,850.  

 

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(8) A legal action brought against the company during 1999 for damage to property was decided shortly after the balance sheet date and, as a result, it will have to pay costs and damages totaling £24,000. No provision had been had  been made in the accounts for this event. (9) Salaries paid for October 1999 of £24,530 had been incorrectly recorded as £42,530. There was a compensating error affecting trade creditors which meant that the end of year trial balance agreed. Required: (a) Calculate the correct figure for Snodrop plc. for profit before taxation for 1999. Show each adjustment separately and indicate which entries in the draft trading and profit and loss account are affected. If you consider that any of the above information does not affect profit explain clearly why this is the case. (b) Identify, and briefly explain, the reasons for your adjustments relating to (1), (2), (6) and (8) above. Refer to accounting concepts where relevant.

Problem 26 Ko-Furn Limited is an office furniture manufacturer. The following is a list of balances

extracted from its accounting records at 31 December 2009: Dr

Cr

000$

000$

Land, at valuation

240

Buildings: cost

500

Buildings: accumulated depreciation at 1.1.09 Equipment: cost Equipment: accumulated depreciation at 1.1.09 Vehicles: cost

180 392 152 568

Vehicles: accumulated depreciation at 1.1.09

264

Inventory at 1.1.09

214

Trade receivables

366

Provision for doubtful debts at 1.1.09 Prepayment at 1.1.09

16 12

Accrual at 1.1.09 Cash Trade payables

 

18 408 248

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Share capital: ordinary 50c shares

50

Share premium

350

Retained earnings

606

Sales

2,924

Purchases

976

Wages and salaries Distribution costs

540 200

Other administrative expenses

360

Corporation tax

12

Disposal account

20

Dividend paid

40 4,828

4,828

You are given the following information: (1) Ko-furn prices its furniture using a normal 30% mark-up policy. A stock count carried out at 31 December 2009 valued stock at selling price of $325,000. This included two  board tables at normal selling price of $20,800 each, which the directors have decided should be reduced in price to $5,000 each. (2) The land was valued at $600,000 at 31 December 2009. The directors decided to reflect the revalued amount in the balance sheet. (3) On 1 February 2009, the company sold a vehicle for $20,000. While the proceeds of sale were credited to the Disposal account, no other entries were made in the books of account in relation to this transaction. The vehicle had cost $88,000 in August 2006. The company charges a full year‟s depreciation in the year of acquisition and no depreciation in the year of disposal. (4) The company‟s depreciation policy is as follows:  follows:   Land:

nil

Buildings:

4% straight line

Equipment:

40% reducing balance

Vehicles:

25% straight line.

(5) Trade receivables at 31 December 2009 include a debt of $16,000 from a customer recently declared bankrupt. The company has decided to maintain the provision for doubtful debts at 4% of remaining trade receivables. (6) The balance of prepayments at 1.1.09 refers to insurance charges. Prepaid insurance, included in general distribution costs at 31 December 2009 amounted to $24,000.  

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(7) The balance of accruals at 1.1.09 refers to electricity charges. After the year end, the company received an electricity invoice for $30,000 covering the period 1 November 2009 to 31 January 2010. Electricity charges are included in other administrative expenses. (8) Corporation tax for the year ended 31 December 2009 is estimated to be $190,000. (9) The company issued 100,000 additional shares at 50c each on 30 December 2009 for $140,000. This transaction has not been recorded in the accounting records. Required: Prepare an income statement for the year ended 31 December 2009 and a balance sheet at that date, in good style, for the directors.

 

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Accounting for Current Assets Problem 27

 Bought

Sold

January

10 at ₤30 each  each  

April

8 for ₤46 each  each 

March

10 at ₤34 each  each  

December

12 for ₤56 each  each 

September

20 at ₤40 each  each  

Required:

(a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii)  AVCO methods on a perpetual inventory basis. (b) Draw up the trading account for the year showing the gross profits that would have been reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods.

Problem 28

 Bought

Sold

January

24 at ₤10 each  each  

June

30 for ₤16 each  each 

April

16 at ₤12.50 each  each 

November

34 for ₤18 each  each 

October

30 at ₤13 each  each  

Required:

(a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii)  AVCO methods on a perpetual inventory basis. (b) Draw up the trading account for the year showing the gross profits that would have been reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods.

Problem 29

An evaluation of a physical stock count on 30 th  April, 19X2 in respect of the financial year ending on that date at Cranfleet Commodities has produced a figure of ₤187,033. The firm‟s firm‟s book-keeper  book-keeper has approached you, as the accountant, for assistance in dealing with the following matters to enable him to arrive at a final figure of closing stock for inclusion in the annual accounts: (1) 320 components included at their original cost of ₤11 each can now be bought in for only ₤6 each due to over production by the manufacturer. This drop in price is expected to be only temporary and the purchase price is expected to exceed its original figure within 12 months.

 

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Cranfleet Commodities intends to continue selling the existing stock at the present price of ₤15 each. (2) It has been discovered that certain items which had cost ₤5,657 have been damaged. It will cost ₤804 to repair them after which they can be sold for ₤6,321. (3) On one stock sheet a sub-total of ₤9,105 has been carried forward as ₤1,095. (4) 480 units which cost ₤1.50 each have been extended at ₤15.00 each. (5) The firm has sent goods with a selling price of ₤1,500 (being cost plus 25%) to a customer on a sale or return basis. At 30 th April 19X2, the customer had not signified acceptance, but the goods have not been returned, and consequently had not been included in the physical stock count. (6) Included in stock were goods bought on credit for ₤4,679 from Byfleet Enterprises. At 30th  April 19X2, Cranfleet Commodities had not paid this account. (7) Byfleet Enterprises had also sent some free samples (for advertising purposes only). These have been included in stock at their catalogue price of ₤152. Required: Taking account of such of the above facts as are relevant, calculate a closing stock figure for

inclusion in the 19X2 annual accounts of Canfleet Commodities, giving reasons for the action you have taken in each individual case.

Problem 30

The draft accounts of Trayderrs plc for the year ended 31 st December 1998 show a net profit  before tax of ₤543,350 and closing stock at cost of ₤316,740 following a physical stock count. During the audit of the accounts the following matters have come to light: (1) Stock costing ₤25,000 has been omitted from the closing stock figure. (2) Items included in stock at ₤10,200, and which would normally be sold for ₤18,350, were in a damaged state and were worth only ₤7,600. (3) Trayderrs plc received an order on 27th December 1998 to supply goods at a total price of ₤52,000. The goods, which had cost ₤34,000, were moved on the following day from the warehouse to the packing department and were dispatched on 3rd  January 1999 when the customer was invoiced. Trayderrs plc had included the order in sales for 1998 and had excluded the goods from closing stock. (4) 3,100 items costing ₤21 each were recorded on the stock sheets in error as 1,300 items at ₤12 each.

 

23

 

(5) Stock costing ₤10,000 was lost in a fire in the warehouse during the year. The company‟s insurers have agreed to pay Trayderrs plc ₤11,200 in respect of its insurance claim. No entry has yet been made in the accounting records. (6) Included in purchases is ₤41,500 for goods purchased in December and which were received into the warehouse on 5th January 1999. (7) Stock costing ₤18,000 has in error been treated as a fixed asset and depreciation of 10% of cost has been provided for. (8) Returned stock costing ₤825 has been treated in the accounting records as a return inward instead of a return outward. (9) An item is included in the closing stock valuation at its selling price of ₤8,200. The gross  profit margin on this item is 40%. 4 0%. Required:

(a) Calculations to show the correct figure for Trayderrs plc for (i)

stock at 31st December 1998, and

(ii) net profit before tax for 1998. (b) Your answer to the following questions posed by the purchasing director of Trayderrs plc: “Prices are rising all the time and I think we should change our stock valuation method from FIFO to LIFO or average cost. What do you think about this? Can we do it?”  

Problem 31

On 30th  April 2009 the closing balance on the creditors control account of Dyson Ltd is ₤2,900. The total of the list of balances from the creditors ledger is ₤3,990. Further investigation reveals the following errors: (1) An invoice of ₤600 for goods purchased was included in the creditors ledger but was not recorded in the purchases day book. (2) A cash payment of ₤400 to a supplier recorded in the cash book was not recorded in the creditors ledger. (3) A cash payment of ₤560 was correctly recorded in the creditors ledger but was recorded as ₤650 in the cash book. (4) An invoice for ₤250 was not recorded in either the purchase day book or the creditors ledger. Required:

Show the corrected total of the list of creditors ledger balances and the corrected balance on the creditors control account at 30 th April 2009.  

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Problem 32

Waits opened a business bank account with ₤16,000 on 1st April 2009. During April he issued cheques totaling ₤72,760 and banked cheques totaling ₤80,060. These transactions were entered into his cash book up to 30 th April 2009. On receiving his bank statement for April he discovered the following: (1) A cheque for ₤4,800, which was banked (and included in the receipts above), had been returned by the bank marked “No funds available”. No adjustment has been made in the cash  book. (2) Bank charges debited on the bank statement for April amounted to ₤600. No entries for these have been made in the cash book. (3) Cheques totaling ₤16,860 recorded in the cash book and sent to suppliers were not  presented to the bank until u ntil May 2009. (4) Cheques totaling ₤12,100 had been entered into the cash book but not credited by the bank until May 2009. Required: Calculate the corrected bank balance which should appear in the business cash book at 30 th 

April 2009 and prepare a bank reconciliation statement at 30 th April 2009.

Problem 33

Miss Leung runs a business selling holidays. At 31 January 2010, the balance on the creditors control account was $8,700. The total of the list of balances in the creditors ledger was $11,720. The following information has come to light: (i) an invoice of $750 was not recorded in the purchase day book (ii) a cash payment of $1,680 was correctly recorded in the cash book but was recorded as $1,860 in creditors ledger. (iii) A cash payment of $1,200 to a supplier was recorded in the cash book but was not recorded in the creditors ledger. (iv) A credit note for a price reduction from a supplier of $1,800 was recorded in the purchase day book but not recorded in the creditors ledger. (v) In January, the company paid a refund of $200 to a customer for a price reduction. This was wrongly treated as a payment to a supplier and entered in the Creditors Control Account. Required:

Show the corrections to the: (a) list of creditors ledger balance at 31 January 2010 and  

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(b) creditors control account at 31 January 2010.

Problem 34

In preparing the trial balance, you notice that the debit side exceeds the credit side by $970. Upon investigation, you identify the following mistakes: (1) Goods returned to suppliers amounts to $250 have been entered as a debit in the goods returns outward account by mistake. (2) A cash payment for $560 has been entered in the cash book as $650. (3) A computer purchased for $2,000 as at office machine has been entered as debit in the  purchases account. (4) A credit note for $220 given to a customer has been credite d twice in the customer‟s account. (5) A cheque for $780 from a customer has been entered in the cash book and subsequently  banked before the year end. However, no other entry has been made to the customer‟s account. Required: Explain how each of the above mistakes should be dealt with by means of a suspense account.

 

26

 

Accounting for Fixed Assets Problem 35

A company started in business on 1 st January 19X1. Bought two motor vans for ₤1,200 each on 1st January 19X1. Bought one motor van for ₤1,400 on 1st July 19X1. Required:

Write up the motor vans account and the provision for depreciation account for the year ended 31st December 19X1. Depreciation is at the rate of 20 per cent per annum, using the basis of one month‟s ownership needs one month‟s month‟ s depreciation.

Problem 36

A company maintains its fixed assets at cost. Depreciation provision accounts for each asset are kept. At 31st December 19X8 the position was as follows: Total cost

Total depreciation

to date

to date

Machinery

52,590

25,670

Office furniture

2,860

1,490

(1) The following additions were made during the financial year ended 31st December 19X9: Machinery ₤2,480, office furniture ₤320. (2) Some old machines bought in 19X5 for ₤2,800 were sold for ₤800 during the year. (3) The rates of depreciation are: Machinery 10 per cent, office equipment 5 per cent, using the straight line basis, calculated on the assets in existence at the end of each financial year irrespective of date of purchase. Required:

Show the asset and depreciation accounts for the year ended 31 st  December 19X9 and the  balance sheet entries at that t hat date.

Problem 37

A firm buys a fixed asset for ₤10,000. The firm estimates that the asset will be used for 5 years. After exactly 2½ years, however, the asset is suddenly sold for ₤5,000. ₤ 5,000. The firm always  provides a full year‟s depreciation in the year of purchase and no depreciation in the year of of disposal. Required:

 

27

 

(a) Write up the relevant accounts including disposal account but not profit and loss account for each of Years 1, 2 and 3: (i) Using the straight line depreciation method (assume 20% p.a.); (ii) Using the reducing balance depreciation method (assume 40% p.a.);

(b) What is the purpose of deprecation? In what circumstances would each of the two methods you have used be preferable? (c) What is the meaning of the net figure for the fixed asset in the balance sheet at the end of Year 2? (d) If the asset was bought at the beginning of Year 1, but was not used at all until Year 2 (and it is confidently anticipated to last until Year 6), state under each method the appropriate depreciation charge in Year 1, and briefly justify your answer.

Problem 38

A company depreciates its plant at the rate of 20% per year, straight line method, for each month of ownership. Details: 19X4 bought plant costing 900 on January 1  bought plant costing costin g 600 on October 1 19X6 bought plant costing 550 on July 1 19X7 sold plant which had been bought for 900 on 1st January 19X4 for the sum of 275 on 30th September 19X7. Required:

Draw up: (a) the Plant account (b) the Provision for depreciation account (c) Disposal account (d) extracts from the Balance sheet at the end of each year.

Problem 39

Explain: (a) How is the consistency concept applied to depreciation? (b) Since the calculation of depreciation is based on estimate, why bother to make this calculation?

 

28

 

Problem 40

At the beginning of the financial year commencing on 1 st  April 19X5, a company had a  balance on plant account of £372,000 and on provision for depreciation of plant account of £205,400.   £205,400. The company‟s policy is to provide depreciation using the reducing balance method applied to the fixed assets held at the end of the financial year at the rate of 20 % per annum. On 1st September 19X5 the company sold for £13,700 some plant which it had acquired on 31 October 19X1 at a cost of £36,000. Additionally, installation costs totalled £4,000. During 19X3 major repairs costing £6,300 had been carried out on this plant and, in order to increase the capacity of the plant, a new motor had been fitted in December 19X3 at a cost of £4,400. A further overhaul costing £2,700 had been carried out during 19X4.  19X4.   The company acquired a new replacement plant on 30th  November November 19X5 at a cost of £96,000, inclusive of installation charges of £7,000.  £7,000.  Required:

Calculate the following: (a) the balance of plant at cost at 31 st March 19X6 (b) the provision for depreciation of plant at 31 st March 19X6 (c) the profit or loss on disposal of the plant.

Problem 41

On 1 January 1998 Ay Ltd bought some factory equipment for £100,000. There was no estimated residual value and the equipment is being depreciated using the decreasing-balance method at the rate of 20% per year. At the end of 2000 the market value of the equipment is expected to be £40,000 due to a more advanced design having appeared on the market. The equipment is as efficient in operation as originally anticipated and there is no intention of replacing it during the next few years. Required:

(a) Referring to accounting concepts and to the above information, explain whether or not the annual charge for depreciation of the equipment needs amending and what the charge for 2000 should be.

Problem 42 st

The Cirrus Company Ltd has the following balances on its books at 31  December 19X0:

 

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Dr

Cr

₤ 

₤ 

50p ordinary shares

20,000

6% preference shares of ₤1 each  each 

14,000

Purchases

240,000

Sales Stock at 1st January 19X0

310,000 20,000

Director‟s fees  fees 

6,000

Undistributed profit at 1st January 19X0

35,700

10% Debentures (due 19X4)

20,000

Debenture interest paid Discounts allowed

1,000 500

Administrative expenses

18,400

Salesman‟s salaries  salaries 

18,500

Selling and marketing expenses Heating and lighting

4,000 2,500

Rent and rates

1,700

Debtors

14,000

Provision for doubtful debts at 1st January 19X0

300

Creditors

9,700

Land and buildings at cost

65,000

Vans at cost less depreciation

19,800

Cash in hand Bank balance (overdraft)

400 _____ 411,800

2,100 411,800

The following additional information is given: (1) The stock at 31st  December 19X0 has been valued at ₤32,000. Further investigation reveals that this includes some items originally purchased for ₤3,000 which have been in stock for a long time. They need modifications, probably costing about ₤600, after which it is hoped that they will be saleable for between ₤3,200 and ₤3,500. Other items, included in the total at their cost price of ₤5,000, have been sent to an agent and are still at his premises awaiting sale. It cost ₤200 for transport and insurance to get them to the agent's premises and this amount is included in the selling and marketing expenses.

 

30

 

(2) The balance on the vans account (₤ (₤19,800) is made up as follows: Vans at cost (as  at 1st January 19X0)

₤30,000

 Less: Provision for depreciation to 1 st January 19X0

₤13,800 ₤16,200

Addition during the year

₤3,600

₤19,800 Depreciation is provided at 25% per annum on the reducing balance method. The addition during the year was invoiced as follows: Recommended retail price Signwriting on van

₤3,000 ₤450

Undersealing

₤62

Petrol

₤16

 Number plates

₤12

License which expired 31st December 19X0

₤60

₤3,600 (3) The directors, having sought at the advice of an independent evaluator, wish to revalue the land and building at ₤80,000. (4) The directors wish to make a provision for doubtful debts of 2.5% of the balances of debtors at 31st December 19X0. (5) Rent and rates prepaid at 31 st December 19X0 amounted to ₤400, and salesmen's salaries owing at that date were ₤443. (6) The directors have proposed an ordinary dividend of 5p per share, and the full preference dividend. (7) Ignore taxes. (8) Debenture interest is paid semi-annually. Required: 

(a) Explain very carefully the reasons for the adjustments you have made in respect of items 1, 2 and 3 above. Show your workings (b) Prepare P&L account for Cirrus Company Ltd the year ended 31st  December 19X0, and the Balance sheet as at that date. (b) Explain your treatment of debenture interest and proposed dividends.

 

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Problem 43

A recent article mentioned that there is currently “a bewildering choice” of accounting treatments for goodwill and other intangible assets some of which are inconsistent with the way tangible assets are reported. The balance sheet summary of a well-known successful multinational group of companies is given below to illustrate how one organization chooses to report brand names and goodwill that it has purchased: ₤ millions  millions   Fixed assets

Intangible assets

3,840

Tangible assets

1,725

Investments  Net current assets Long-term liabilities

735

6,300

1,000

7,300

(4,197)

3,103

Share capital and reserves Equity share capital Share premium account

535 667

Revaluation reserve

94

Goodwill reserve Profit and loss account

(3,579) 5,386

3,103

Intangible assets are brands stated at fair value on acquisition. The negative figure for goodwill reserve is in respect of purchased goodwill written off. Required:

(a) Explain the nature of intangible assets and why the method of reporting them seems to be more problematic than for tangible assets. (b) For purchased goodwill, consider the method used in the above balance sheet. What are its good and bad points? Explain one other method that might be used. Which do you personally  prefer and why? (c) For purchased brand names, consider the method used in the above balance sheet. What are its good and bad points? Explain one other method that might be used. Which do you  personally prefer and why? wh y?

 

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Problem 44

Raj Ltd purchased a machine on 1 st January 1999 for ₤100,000. Transporting the machine to its factory cost ₤1,600 and ₤1,000 was spent on installing it. Maintenance of the machine cost ₤750 in 1999 and the expenditure on maintenance increased by ₤200 in each of the following four years. The machine was expected to last until 31 st  December 2006 with a scrap ( or   residual) value at that date of ₤6,600. The company uses the straight-line method of depreciation. It provides provides for a full year‟s depreciation in the year of acquisition and none n one in the year of sale.  The machine was sold for ₤34,000 on 30th June 2003. Required:

Explain  briefly what you understand by the term “depreciation” as used by accountants. In what circumstances would straight-line be the most appropriate method to use for an asset? Give the following calculations: (i) the depreciation charge for 1999; (ii) the profit or loss on sale of the machine in 2003. Problem 45

According to a survey of investment analysts, more than half of them believe that all internally generated intangible assets should be capitalized on a company‟s balance sheet. Discuss the advantages and problems of reporting these assets.

Problem 46

“We live in a society where the real wealth creators are often the intangible assets yet few companies include include these assets in their balance sheets”. Why is this? Explain the issues involved.

Problem 47

Given that amongst the most significant assets of professional football clubs are its footballers, it has become more common in recent years for such companies to account for the cost of players on their balance sheets. Other clubs, however, account for their players as expenses on their Profit and Loss accounts. Required:

Express the arguments behind these two alternative treatments, using any principles or conventions you are applying in your explanation and explaining any terms you use.  

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Problem 48 

The following is an extract from the accounting policies of Manchester United plc (a leisure company) as reported in its annual report and accounts for the year ended 31 st July 2000: Depreciation “Depreciation is provided on tangible fixed assets at annual rates appropriate to the estimated useful lives of the assets, as follows: Reducing Balance

Straight Line

Nil

Nil

1.33%

75 years

Assets in the course of construction

Nil

Nil

Computer equipment and software

33%

3 years

20%-25%

4-5 years

15%

7 years

Freehold land Freehold buildings

Plant and machinery General fixtures and fittings

“During the year the depreciation method was changed [from reducing balance] to the t he straight line basis…”  basis…”  Required:

(a) Explain briefly what you understand by the two methods of depreciation referred to in the above extract. (b) What effect is the change in accounting policy likely to have on the profit and loss account and the balance sheet?

Problem 49

The annual accounts of Sen Manufacturing Ltd. are being prepared for the year ended 31 March 2002 and the closing trial balance includes the following figures: £  Freehold land and factory buildings

£ 

2,800,000

Depreciation of factory buildings at 01.04.01

750,000

Land revaluation reserve

400,000

Plant and machinery at cost

1,900,000

Depreciation of plant and machinery at 01.04.01 Motor vehicles at cost Depreciation of motor vehicles at 01.04.01

1,150,000 153,000 36,000

The following information has been supplied:

 

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(1) The figure for freehold land and factory buildings comprises land at valuation (£1,200,000) and buildings at cost (£1,600,000). The land originally cost £800,000 and was  professionally  professionall y revalued rev alued in 1997 and the revaluation reserve created. It was revalued again in March 2002 and the revised figure of £1,050,000 is to be included in the accounts.  accounts.   (2) Factory buildings include expenditure in 2001 on constructing a new warehouse (£220,000), maintenance of buildings (£60,000) and redecoration (£20,000).  (£20,000).   (3) Factory buildings owned at 31 March 2002 are to be depreciated for the year at 3% of cost. (4) Plant and machinery includes £528,850 for plant constructed by Sen Manufacturing‟s staff during the year and completed on 30 September 2001. The cost is made up as follows: Materials Labour Allocation of company overheads

£325,000   £325,000 122,000 75,000

Delivery of components to the factory

4,000

Insurance on the machine for the year to 31 May 2002 Design costs and engineers‟ engineers‟ fees  fees 

1,200 1,650

(5) Plant and machinery also includes £450,000 being the cost of a machine purchased some years ago. It had a written down value at 1 April 2001 of £40,000 and was sold on the following day for £30,000. The proceeds have been debited to cash and credited in error to sundry income account. No adjustment has been made yet to correct this error. (6) All plant and machinery owned at 31 March 2002 is to be depreciated for the year at 20% of cost. (7) The figure for motor vehicles includes £9,000 paid to Speedy Motors for a new vehicle costing £17,800 from which was deducted £8,800 for an old vehicle taken in part exchange. The old vehicle cost £23,000 in April 1998 and three years‟ depreciation, using the decreasing  balance method and an annual rate of 30%, is included in the depreciation figure in the trial  balance. (8) All motor vehicles owned at 31 March 2002 are to be charged depreciation at the rate of 30% using the decreasing-balance method. Required:

(a) Prepare a table with eight columns using a separate column for each of the seven balances shown in the trial balance extract and head the final column “Profit”. For each item numbered from (1) to (8) above, show on the table which of the seven balances needs correcting, and

 

35

 

how (+ or - ), and show the correct balances at 31 March 2002. For each adjustment, show in the final column by how much the figure of profit for the year will be affected (+ or - ). (b) Prepare the fixed assets section of Sen Manufacturing Ltd‟s balance sheet as at 31 March 2002 in good style. (c) Your answer to the following questions put to you by a colleague: “What is the purpose of having a land revaluation reserve? Why haven‟t the other fixed assets  been revalued? Also, can you explain to me why you asked me to obtain all the detailed information listed under item (4)?”  (4)?” 

 

36

 

Accounting in Joint-Stock Companies Problem 50

GWR Ltd started in business on 1 st  January 19X6. Its issued share capital was 100,000 ordinary shares of ₤1 each and 50,000 10 per cent preference shares of ₤1 each. Its net profits for the first two years of business were: 19X6 ₤42,005; 19X7 ₤34,831. Preference dividends were paid for each of these years, whilst ordinary dividends were  proposed as 19X6 12 per cent and 19X7 9 per cent. Corporation tax, based on the profits of these two years, was: 19X6 ₤13,480; 19X7 ₤11,114. Transfers to general reserve took place as: 19X6 ₤6,000; 19X7 ₤4,000.  Required:

Draw up profit and loss appropriation accounts for each of the years ended 31 st  December 19X6 and 19X7.

Problem 51

Badwa plc. has an authorized capital of 500,000 ordinary shares of ₤0.50 each. At the end of its financial year, 31st May 19X9, the following balances appeared in the company‟s books:  books:   ₤  Issued capital: 400,000 shares fully paid

200,000

Freehold land and buildings at cost

320,000

Stock in trade

17,800

10% debentures

30,000

Trade debtors

6,840

Trade creditors

8,500

Expenses prepaid

760

Share premium

25,000

General reserve

20,000

Expenses outstanding

430

Profit and loss account balance (1 st June 19X8)

36,200

Bank overdraft

3,700

Fixtures, fittings and equipment

 

at cost

54,000

 provision for depreciation depreciat ion

17,500

37

 

The com pany‟s trading and profit and loss accounts had been prepared  prepared   and revealed a net  profit of ₤58,070. However, this figure and certain balances shown above needed adjustment in view of the following details which had not been recorded in the company‟s books. (1) It appeared that a trade debtor who owed ₤300 would not be able to pay. It was decided to write his account off as a bad debt. (2) An examination of the company‟s stock on 31st  May 19X9 revealed that some items shown in the accounts at a cost of ₤1,800 had deteriorated and had a resale value of only ₤1,100. (3) At the end of the financial year some equipment which had cost ₤3,600 and which had a net book value of ₤800 had been sold for ₤1,300. A cheque for this amount had been received on 31st May 19X9. Required:

(a) A statement which shows the changes which should be made to the net profit of ₤58,070 in view of these unrecorded details. (b) The directors proposed to pay a final dividend of 10% and to transfer ₤50,000 to general reserve on 31st  May 19X9. Prepare the profit and loss appropriation account for the year ended 31st May 19x9 and two extracts from fro m the company‟s balance sheet as at 31 st May 19X9, showing in detail: (i) the current assets, current liabilities and working capital (ii) the items which make up the shareholders‟ funds. (c) The directors are concerned about the company‟s liquidity position. Propose three transactions which will increase the company‟s working capital. State which balance sheet items will change as a result of each transaction and whether the item will increase or decrease in value. Problem 52

LMS Ltd has an authorized capital of ₤200,000, consisting of 160,000 ordinary shares of ₤1 each and 40,000 8 per cent preference shares of ₤1 each. Of these 120,000 ordinary shares had  been issued and all the preference p reference shares when the t he business first started star ted trading. The business has a financial year end of 31 st  December. The first three years of business resulted in net profit as follows: 19X7 ₤27,929; 19X8 ₤32,440; 19X9 ₤36,891. Dividends were paid each year on the preference shares. Dividends on the ordinary shares were proposed as follows: 19X7 8 per cent; 19X8 10 per cent; 19X9 11 per cent.

 

38

 

Corporation tax, based on the profits of each year, was: 19X7 ₤8,331; 19X8 ₤10,446; 19X9 ₤12,001. Transfers to reserves were made as: General reserve 19X7 ₤3,000; 19X8 ₤4,000, and Foreign exchange reserve 19X9 ₤2,000.  Required:

Show the profit and loss appropriation accounts for each of the years 19X7, 19X8 and 19X9. Problem 53

The stockholders‟ equity section of the balance sheet of P Corporation Corpora tion as December 31, 2004, appears as follows: Stockholders‟ Equity amounts in thousand, except share amounts 7% Preferred stock, $100 par; 100,000 shares authorized; 40,000

$4,000

shares issued Common stock, $1 par; 1,000,000 shares authorized; 600,000

$600

shares issued, of which 50,000 are held in treasury Additional paid in capital: From issuance of preferred stock

$480

From issuance of common stock

$1,410

Retained earnings

$4,500 … 

Total stockholders‟ equity  equity 

$10,715

Required:

Answer the following questions related to P Corporation. (a) What was the average issue price of the preferred stock as of December 31, 2004? (b) How many shares of common stock are outstanding? (c) What journal entry was made when the common stock was issued? (d) What is the amount of the total dividend requirement on preferred stock annually? (e) Assuming that there are no dividends in arrears, if the company declared a total cash dividend of $580,000, what would be the dividend per share for the preferred and common stock? (f) Assume the company‟s common stock is selling for $80 per share. What journal entry would be made if the company issues a 10% common stock dividend? (g) Compute basic earnings per share if the company‟s net income was $1,560,000 during 2004. Assume no new shares were issued during the year.  

39

 

(h) Refer to the original data. Assume the company declares a 3-for-2 stock split. How many shares of common stock would be outstanding after the split?

Problem 54

The balance sheet of C Ltd is as follows: ₤ 

 Assets

Sundry net assets

₤1,200,000   ₤1,200,000

Share capital

₤1 ordinary shares fully paid  paid 

400,000

 Reserves

General reserve

500,000

Profit and loss account (unappropriated profit)

300,000 ₤1,200,000   ₤1,200,000

The directors decide to make a 1 for 5 bonus issue. This will be followed by 1 for 3 rights issue. Rights shares will be offered at a price of ₤1.60 per share. Required:

Show the revised balance sheet of C Ltd after both share issues have taken place.

Problem 55

Meta Ltd has the following share capital and reserves as at 20th August 19X5: ₤  1,500,000 ordinary shares of 25p, each fully paid

375,000

Share premium

225,000

Retained profit

200,000 800,000

The directors resolve to use the reserves to issue fully-paid bonus shares at par in the ratio of two shares for every three currently held. Required:

(a) Show the revised balance sheet (“capital and reserves” section only) after the above transactions have been carried out. (b) Assuming that the market value of each share has tended to stay around 50p ex div (i.e. excluding any dividend expected in the very near future) and the total annual dividend has  been ₤75,000, what would you expect the market price of each share to be after the bonus issue?  

40

 

Problem 56

The S Ltd commenced operations on 1st January 19X6. For the first four years the following results were achieved: Year ended 31

Trading profit (loss)

Profit (loss) on sale

Profit on revaluation

of fixed asset

on land use

₤ 

₤ 

December ₤  19X6

(100,000)

19X7

80,000

19X8

90,000

30,000

19X9

60,000

(10,000)

40,000

Required:

State, for each year, the maximum dividend company could pay (assuming a maximum dividend is paid whenever possible)

Problem 57

Refer to Problem 56 above. Assume that S Ltd issued 300,000 ₤1 Preference Shares with a 10% fixed rate on dividend at the commencement of business. Required:

State, for each year, maximum dividend the company could pay its ordinary shareholders if: (i) the preference shares were non-cumulative, and (ii) the preference shares were cumulative.

Problem 58

A major international company recently reported the worst results in its century-long history with a 90% fall in net income and the chairman was reported to be worried about keeping his  job. However, the total dividend dividen d proposed for the year was 4 4% % up on the previous year‟s. Required:

Give possible reasons for the dividend increase. How would you check whether the increase is legal?

Problem 59

Wonda plc. has an issued share capital of two million ₤1 shares. The directors are considering whether the company should buy back and cancel 10% of its issued share capital at the current market price of 220 pence per share.  

41

 

(i) Why would the directors of a company like Wonda plc. wish it to buy back and cancel some of its shares? (ii) How do you consider the buyback should be reflected in the balance sheet of Wonda plc.? (iii) Would you expect the share price of Wonda plc. to remain at 220 pence after the share  buyback? Explain your answer.

Problem 60

“This is certainly the record dividend payment of o f the year: O‟Mara plc is paying 75 pence for each ₤1 share! It represents 80% of the company‟s earnings for the year. Even the big banks are not that generous!”  generous!”  Required:

Comment on the above quotation which has been adapted from an article in a national newspaper and explain whether you consider that the company has necessarily been generous to its shareholders. Specify what further information you would need for your answer, if any, and what use you would make of it. Problem 61

Your aunt has held 1,000 ordinary shares in a quoted company for several years. She has very little understanding of financial matters. She has asked you to write her a short note to explain the following: (1) why the company has only paid a dividend of approximately 30% of the profit after tax; (2) why the company is making a 1 for 1 scrip (or bonus) issue and what effect this is likely to have on the market value of each share. Required:

Explain to your aunt: (a) the factors which determine a company‟s dividend;  dividend;   (b) the purpose, the effect on the balance sheet and the effect on the market value of each share of a 1 for 1 scrip issue.

Problem 62

In a recent article on a leading engineering company, a financial journalist drew attention to the fact that, according to its recent balance sheet, the net asset value per share was £4.15  yet the company‟s ordinary shares had been quoted on the stock exchange at around £7.80 for the  past few months.  

42

 

Required: 

Give reasons that might explain why the two figures are different.

Problem 63

The country of Yugalia has experienced a financial crisis over the past year and, for the typical company, share price has been below net asset value per share yet the company has reported a profit. Required: 

Do these apparent anomalies necessarily imply that there is something wrong with financial reporting in Yugalia? Explain the issues involved.

Problem 64

Wizz.com, an online consumer information provider, has seen its share price treble in value over the past eight months. It has been in business for five years and has never earned a profit. Last year ‟s ‟s prepre-tax loss was £32 million on a turnover of £23 million. Required: 

How can the shares of a company with such a poor profitability record and a negative  price/earnings ratio be b e in such demand?

 

43

 

Cash Flow Statement Problem 65

Roseanne owns shares in Inchem plc, a large chemicals company with world-wide interests, and she is worried because the share price has shown a downward trend over the past two years. Roseanne has asked you to explain what the cash flow statement can tell her about the company‟s progress and current position.  position.   She has supplied you with the following information taken form Inchem‟s recent annual reports: Cash flow statement for the year ended 31 st December

 Net cash flow from operating activities activ ities

1997

1998

£m   £m

£m   £m

757

1,006

(171)

(356)

(151)

(126)

(623)

(935)

(4,366)

(234)

2,124

74

(225)

(225)

(2,655)

(796)

2,937

(50)

282

(846)

Returns on investment and servicing of finance: Interest paid Corporation tax paid Capital expenditure: Acquisition of fixed assets other than subsidiary undertakings Acquisitions and disposals of subsidiary undertakings Acquisitions Disposals Equity dividend paid

Financing: Increase (decrease) in debt Increase (decrease) in cash

 

44

 

 Note:  Net cash inflow from operating operatin g activities: Operating profit

378

405

Depreciation

434

402

Stocks decrease

18

62

Debtors increase

(31)

(86)

Creditors (decrease) increase

(42)

223

 Net cash inflow from operating activities acti vities

757

1,006

Required:

(a) An analysis of the above figures to assist Roseanne in understanding Inchem plc‟s financial performance in 1998 and its financial position at the year end. Indicate what additional information you require to help you with your analysis and what use you would make of it. (b) Explain to Roseanne what use published financial reports are in explaining share price movements and indicate what other information might be useful.

Problem 66

C Willis Profit and Loss Account for the year ended 31st December 19X8 £  Gross profit

£  29,328

 Add Discounts received

298

 Add Profit on sale of motor van

570

868 30,196

 Less Expenses

Motor expenses

1,590

Wages

8,790

General expenses

2,144

Bad debts

340

Increase in bad debt provision

120

Depreciation: Motor van

1,090

14,074 16,122

 

45

 

Balance Sheet at 31st December 19X7 £ 

1X98 £ 

£ 

£ 

Fixed assets Motor vans at cost

11,200

 Less Depreciation to date

4,160

7,200 7,040

2,980

4,220

Current assets Stock

10,295

17,150

Debtors less provision*

5,190

3,380

Bank

1,568

2,115

17,053

22,645

 Less Current liabilities

Creditors

2,770

14,283

2,920

19,725

21,323

23,945

6,000

5,000

15,323

18,945

 Less Long-term liability

Loan form P Bond

Capital Opening balance b/d

12,243

15,323

 Add Net profit

14,080

16,122

26,323

31,445

 Less Drawings

11,000

15,323

12,500

18,945

* Debtors 19X7 £5,490 5,490 –   –  provision   provision £300 Debtors 19X8 £3,800 3,800 –   –  provision   provision £420.  Note: The motor van was sold for £2,300 during 19X8. Required:

Draft a cash flow statement for C Willis for the year ended 31 st December 19X8

Problem 67

The directors of Alexay plc are concerned about the substantial increase in the company's  bank overdraft in 1999. 1999 . The summarised balance sheets of the company at 31st December were:

 

46

 

Fixed assets (net of depreciation)

1998

1999

£000

£000   £000

1,315

2,090

Current assets Stock at cost

290

670

Trade debtors

385

610

675

1,280

Bank overdraft

72

440

Trade creditors

345

210

Corporation tax

185

275

602

925

Current liabilities

 Net current assets

73

355

1,388

2,445

290

480

1,098

1,965

Issued share capital (1£ shares)  shares) 

520

620

Share premium

330

380

-

500

248

465

1,098

1,965

 Less: creditors falling due after more than

one year

Share capital and reserves

Revaluation reserve for land Profit and loss account

The summarised profit and loss account for Alexay plc for the year ended 31 st  December 1999 was: £000   £000 Sales

3,900

Cost of sales

2,600

Gross profit

1,300

Administration expenses

460

Depreciation

115

Interest payable

59

 Net profit before corporation corpora tion tax

 

634 666

47

 

Corporation tax

170

 Net profit after corporation corporati on tax

496

Dividends

279

Retained profit for the year

217

 No fixed assets were disposed dispo sed of during the year ended end ed 31st December 1999. Required:

(a) Calculate the net cash flow from operating activities for 1999. (b) Prepare a cash flow statement in good style for 1999. (c) Calculate and comment on the following for 1999: (i) current ratio (ii) gearing ratio (iii) interest cover (d) Reply to the following queries put to you by one of the directors of Alexay plc: "Can you please explain to me how we have a healthy profit yet our bank overdraft has reached a record level? Surely there must be something wrong with the profit calculations, isn't there?"

Problem 68

The directors of N plc are extremely concerned about new trend in company's market share  price. The following information has been extracted from the books for the year to 31 December 1999: Profit and Loss Account

1998

1999

£000

£000

Sales revenues

93,000

200,000

Profit before taxation

9,500

20,400

(3,200)

(5,200)

6,300

15,200

(100)

(100)

(1,000)

(2,000)

(3,000)

(6,000)

2,200

7,100

Taxation Profit after taxation Dividends:  preference ordinary: interim (paid) final (proposed) Retained profit for the year

 

48

 

Balance Sheets as at 31 December 1998

1999

£000

£000

Plant, machinery, equipment, at cost

17,600

23,900

Accumulated depreciation

9,500

10,750

8,100

13,150

Stocks

5,000

15,000

Trade debtors

8,600

26,700

Prepayments

300

400

Cash at bank and in hand

600

-

14,500

42,100

Bank overdraft

-

16,200

Trade creditors

6,000

10,000

Accruals

800

1,000

Taxation

3,200

5,200

Dividends

3,000

6,000

13,000

38,400

Working capital

1,500

3,700

Total assets less current liabilities

9,600

16,850

600

750

9,000

16,100

Ordinary shares of £l each  each 

5,000

5,000

10% preference shares of £l  £l  each

1,000

1,000

Profit and loss account

3,000

10,100

9,000

16,100

Fixed assets

Current Assets

Creditors: amounts due within 1 year

Creditors: amounts due after more than 1 year 15% debentures Share capital

 

49

 

 Note: During the year to 31 st December 1999, fixed assets originally costing £5,500,000 were sold for £1,000,000. The accumulated The  accumulated depreciation on these assets as at 31 st December 1998 was £3,800,000.  £3,800,000.  Required:

(a) Prepare a statement that helps to the directors to understand the liquidity position and overall financial performance of the company in 1999.  b) Explain Ex plain what use this report r eport is in understanding u nderstanding share price movements and indicate in dicate what other information might be useful. Refer to your statement, where appropriate, to illustrate your point.

Problem 69

The balance sheets of R Lester are as follows: 31.12.19X7 £ 

£ 

31.12.19X8 £ 

£ 

£ 

£ 

Fixed assets Equipment at cost

28,500

 Less Depreciation to date

11,450

26,100 17,500

13,010

13,090

Current assets Stock Debtors  Less Bad debts provision

Cash and bank balances

18,570

16,250

8,470 420

14,190 8,050

800

13,390

4,060

3,700

30,680

33,340

4,140

5,730

Less Current liabilities Creditors Working capital

26,540

27,610

43,590

40,700

Opening balances b/d

35,760

33,590

 Add Net profit

10,240

11,070

 Add  Cash introduced

_____

600

46,000

45,260

Financed by: Capital

 

50

 

 Less Drawings

Loan from J Gorsey

12,410

8,560

33,590

36,700

10,000

4,000

43,590

40,700

 Notes: Equipment with a book value of £1,350 was sold for £900. Depreciation written off equipment during the year was £2,610. Required:

Prepare a cash flow statement for R Lester for the year ended 31 st December 19X8.

Problem 70

The following are the financial statements of Eccles Foods plc for the two years ended 31 st  March 2009 and 2010:

Balance sheets as at 31 st March

2010

2009

£m   £m

£m   £m

Tangible

431

410

Intangible

19

23

Investments

82

64

532

497

Fixed assets

Current assets Inventories

482

401

Debtors

290

251

3

7

775

659

Cash

Creditors falling due within 1 year Total assets less current liabilities

(422)

353

(367)

292

885

789

(181)

(213)

704

576

385

247

Creditors falling due after 1 year Loan stock

Capital and reserves Called-up share capital of £1 each

 

51

 

Share premium account Retained earnings

-

50

319

279

704

576

Profit and loss accounts for the year ended 31st March 2010

2009

£m   £m

£m   £m

Turnover

1,240

990

Cost of sales

(902)

(704)

Gross profit

338

286

Distribution costs

(98)

(81)

Administrative expenses

(73)

(56)

Operating profit

167

149

 Net interest paid

(3)

(9)

Exceptional item

(4)

__

Profit before taxation

160

140

Taxation

(90)

(80)

70

60

(30)

(20)

40

40

Profit after taxation Dividend paid Retained profit for the year

The following further information is available: (1) Tangible fixed assets: Cost

Accumulated

 Net

Depreciation £m   £m

£m   £m

£m   £m

As at 1st April 2009

621

211

410

Additions, at cost

82

82

Disposals

(30)

(13)

(17)

Depreciation for the year

___

44

(44)

As at 31st March 2010

673

242

431

The assets were disposed of cash proceeds of £10 million. Any profit or loss arising is included in operating profit for the year. (2) Intangible fixed assets:

 

52

 

The value of goodwill has fallen during the year and the resulting write down of book value was treated as an exceptional item in the profit and loss account. (3) Fixed asset investments: Additional shares were purchased for cash. No other changes occurred during the year. The interest received during the year on these investments was £5 million, this amount is included in net interest paid. (4) Creditors falling due within one year are as follows: 2010

2009

£m   £m

£m   £m

Trade

110

130

Taxation

90

80

Bank overdraft

222

157

422

367

(5) On 1st May 2009 80 million £1 ordinary shares were issued at £1.10 each. On 1st October 2009 the share premium account was utilized in making a bonus issue of ordinary shares. Required:

(a) Prepare a cash flow statement for Eccles Foods plc for the year ended 31st March 2010 (b) “A cash flow statement provides information on the financial performance of a company which is not immediately available from the balance sheet or profit and loss account”.  account”.   Identify two such items from the cash flow statement of Eccles Foods plc and explain how they illustrate the above statement.

Problem 71

The balance sheets of Easy Fix Ltd as at 31 December 2008 and 2009 and a summary of the  profit and loss account for fo r the year ended 31 December Decembe r 2009 are given below: belo w: Balance Sheet as at 31 December 2008

2009

£‟000   £‟000

£‟000   £‟000

Land and buildings

37,000

50,000

Plant and machinery

16,5000

19,500

6,000

6,000

59,500

75,500

Fixed assets

Investment at cost

 

53

 

Current assets Stocks

11,400

10,500

Debtors

12,000

10,400

Cash at bank

4,700

0

28,100

20,900

Bank overdraft

0

1,500

Trade creditors

8,800

9,600

Corporation tax

4,000

3,000

12,800

14,100

10% Debentures

10,000

12,800

 Net assets

64,800

69,500

30,000

40,000

-

5,000

Revaluation reserve

3,000

8,000

Profit and loss account

31,800

16,500

64,800

69,500

Current liabilities

Capital and Reserves 1£ ordinary shares  shares  Share premium

Summary Profit and Loss Account for the Year Ended 31 st December 2009 £000   £000 Loss before tax (after depreciation on plant and machinery of £4,000,000 £4,000,000  

(12,300)

Tax

(2,500)

Profit after tax

(14,800)

Dividends Retained loss for the year

(500) (15,300)

You are given the following information: (1) During the year several machines machi nes were disposed of for £3,200,000. The machines has a total original cost of £4,000,000 and had a total net book value at the date of disposal of £2,000,000.   £2,000,000. (2) During the year, a right issue was made. (3) Included in the loss before tax was and investment investm ent income of £1,250,000 and an interest  payment of £5,100,000  £5,100,000  

 

54

 

Required:

(a) Prepare a cash flow statement, together with the reconciliation statement of operating  profit and cash balance, balanc e, for Easy Fix Ltd for the year ended 31 Decembe Decemberr 2009 (b) Discuss the advantages and disadvantages of such statements.

Problem 72

Dolente Ltd is a small company which designs, manufactures and sells innovative electronic instruments. The directors of the company have discussed the financial statements prepared for the year ended 31st March 2010 and have made the following remarks. “We are surprised to see that we have a loss for the year as our bank balance seems to be healthy and has increased from the 2009 figure”.  figure”.   The following are the financial statements of Dolente Ltd for the two years ended 31 st March 2010. 2010 Balance sheets as at 31 st March

£000   £000

2009 £000   £000

£000   £000

£000   £000

Fixed assets

862

820

Tangible

134

128

Intangible

996

948

Current assets

520

488

Inventories

280

302

Trade debtors

38

46

Prepayments

306

214

Bank

1,144

1,050

Creditors falling due within 1 year

(800)

Total assets less current liabilities

344

(820)

230

1,340

1,178

(462)

(426)

878

752

Ordinary shar es es of £1 each  each 

700

600

Share premium

90

50

Retained earnings

88

102

878

752

Creditors falling due after 1 year Loans

Capital and reserves

 

55

 

Profit and loss account for the year ended 31st March 2010 £000   £000 Turnover

2,480

Cost of sales

(2,004)

Gross profit

476

Distribution costs

(290)

Administrative expenses

(134)

Operating profit

52

Interest payable

(46)

Exceptional items

(20)

Loss before taxation

(14)

Taxation

-

Loss for the year

(14)

The following further information is available: (1) Tangible fixed assets: Cost

Accumulated

 Net

depreciation As at 1st April 2009

£000   £000

£000   £000

£000   £000

1,242

422

820

Additions, at cost

164

Disposals

(60)

164

Depreciation for the year As at 31st March 2010

1,346

(26)

(34)

88

(88)

484

862

The assets were sold for cash proceeds of £10,000. Any profit or loss arising aris ing is included in the operating profit for the year. (2) Intangible fixed assets: These are patents on innovative electronic instruments. £000   £000 As at 1st April 2009

128

Purchases

40

Amortization (in operating profit)

(14)

Exceptional write down

(20)

As at 31st March 2010

134

(3) Prepayments all relate to expenses charged against operating profits.

 

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(4) Creditors falling due within one year 2010

2009

£000   £000

£000   £000

Trade creditors

786

650

Accrued interest

14

10

-

160

800

820

Taxation

(5) On 1st May 2009 100,000 £1 ordinary shares were issued at £1.40 each.  each.   Required:

(a) Prepare a cash flow statement for Dolente Ltd for the year ended 31st March 2010. (b) Using the information provided by the cash flow statement, comment on the remarks of the directors on the results for the year.

 

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Ratio analysis Problem 73

Karen has been told that Wahib & Wills plc is a fast growing company and she seeks your advice on whether or not to buy shares in the company. She has provided you with the following summarized information taken from the recent annual accounts of Wahib & Wills  plc: Profit and loss account

₤000   ₤000

Turnover

7,200

Gross profit

2,160

 Net profit

300

Dividend

150

Balance sheet Fixed assets

2,680

Stock

360

Trade debtors

240

Cash at bank

200

Trade creditors

840

Share capital (₤1 shares fully paid) paid ) Profit and loss account

2,400 240

The share price of Wahib & Wills plc is currently 160 pence and it has been around this level for the past few months. The trade association to which Wahib & Wills plc belongs compiles statistics taken from the annual accounts of its members, and from other sources, and you have obtained the following recently prepared data which give the industry average for seven statistics as: Gross profit margin

50%

Current ratio

2.54

Quick (liquid) ratio

1.87

Debtors collection period (days)

28

Stock holding period (days)

36

Trade credit period (days)

54

Price/earnings ratio

10

Required:

 

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(a) Compute comparable ratios to those listed above for Wahib & Wills plc. All calculations must be clearly shown.  (b) Make use of your calculations in (a) above to comment on the firm‟s financial position.  position.  

Problem 74

The chairman of Badwa plc, which owns a chain of hotels, is concerned about recent comments in the financial press to the effect that the company is too highly geared. The following figures appear in the company‟s recent balance sheet:   ₤  Called up share capital

1,000,000

Share premium account

4,800,000

Profit and loss account

6,100,000

8% Debentures

13,990,000

Total assets less current liabilities

25,890,000

The chairman feels that the accounts do not portray the company‟s true financial fin ancial position. In  particular, he makes the following f ollowing points: (1) The company‟s freehold property was bought five years ago for ₤18 million which is also its current book value. The market value is now ₤32 million. (2) The reputation of Badwa plc is as asset in itself. Customers are attracted to the hotels  because of their reputation for quality and service. The chairman reckons that the reputation must be worth at least ₤13 million. (3) Stock includes ₤400,000 for fine wines at cost; their current replacement cost is ₤600,000. (4) Amongst the fixtures and fittings are works of art that cost ₤1,200,000 and whose book value is ₤300,000. They are currently worth ₤1,000,000.

Required:

(a) Give reasoned arguments to indicate what values you would like to see in the balance sheet of Badwa plc for each of the four items referred to above. If any are controversial, explain why this is so. (b) Redraft the balance sheet extract incorporating you suggestions in (a) above and calculate the gearing ratio before and after any changes you have made. (c) Is high gearing necessarily a bad thing? Do you consider that increasing asset values in a  balance sheet sh eet is likely to lead to less criticism crit icism by the financial finan cial press pres s of a company‟s co mpany‟s gearing? gearin g? Explain your reasoning carefully.

 

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Problem 75 

Although MX plc. has a large cash balance, it offered its shareholders the choice of whether to have the final dividend for the year ended 31 st March 1999 in shares (a scrip dividend) or in cash. The majority opted for shares and the necessary accounting entries were made in the  published accounts for fo r 1999. Required:

For each of the following ratios, state whether it is higher, lower or unchanged as compared with ratios calculated to reflect a 100% cash dividend and explain briefly why this is so. (a) Return on shareholders‟ equity  equity  (b) Return on net assets (c) Current ratio (d) Creditors turnover ratio (e) Gearing ratio (f) Dividend cover.

Problem 76

The summarized balance sheet of G Ltd is given below: Total assets less current liabilities

2,300

Financed by: Share capital, 25p shares

400

Share premium account

360

Revaluation reserve

300

Profit and loss account

440

10% debenture loan, 2006

800 2,300

Required:

Explain briefly the nature of the share premium account and how it arises, and calculate the following: (i) (i) the company‟s gearing ratio  ratio   (ii) the maximum dividend per share that company could legally declare assuming that it has sufficient cash.

Problem 77

The following statistics relates to Gandee plc for 2001:

 

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Profit before interest and tax

£120,000   £120,000

Retained profit for the year

£20,000   £20,000

Dividend for the year

£19,200   £19,200

Interest cover

5

Dividend cover

4

Required:

What was the tax charge for 2001? Give three possible reasons why the directors of Gandee  plc have chosen not to distribute d istribute all the after tax profit of the year as dividend. divide nd.

Problem 78

The following information relates to two companies in the same industry whose financial year end is the same: Cax plc

Dox plc

₤1,680,000   ₤1,680,000

₤1,680,000   ₤1,680,000

10.50%

16.00%

Return on net assets

?

12.00%

Asset turnover ratio

1.6

?

Profit before interest and tax Operating profit margin

Required:

Calculate the return on net assets for Cax plc and the asset turnover ratio for Dox plc. Give  possible reasons for the th e differences in the three thr ee ratios for the two companies. compani es.

Problem 79

Company

A

 B

C

₤000   ₤000

₤000   ₤000

₤000   ₤000

Ordinary shares

600

400

50

12% debentures

___

200

550

600

600

600

The return on capital employed was 20 per cent for each firm in 19X4 and in 19X5 was 10  per cent. Corporation tax in both years was assumed to be 55 per cent, and debenture interest is as allowable expense against corporation tax. Required:

(a) Calculate the percentage return on the shareholders‟ capital for each company for 19X4 and 19X5. Assume that all profits are distributed. (b) Use your answer to explain the merits and the dangers of high gearing.

 

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Problem 80 

Adrian Frampton was considering the purchase of one of two businesses. However Frampton had only been provided with limited information about the businesses, as follows: Summarised financial information for the year ended 31 st December 19X9:  Business

 Business

 X

Y

Cost of goods sold

₤400,000

₤600,000

Administrative expenses

₤50,000

₤60,000

Average stock at cost

₤40,000

₤50,000

Working capital as at 31st December 19X9

₤90,000

₤250,000

Selling and distribution expenses

₤15,000

₤35,000

Proprietor‟s capital at 1st January 19X9

₤200,000

₤350,000

Gross profit percentage mark-up on cost

20

25

Additional information: (1) Average stock had been calculated by using the year‟s opening and closing stocks. Subsequently it was discovered that Business Y had overvalued its stock on 31 st  December 19X9 by ₤10,000. (2) Business X‟s administrative expenses included a payment for rent of ₤15,000 ₤15,000 which covered a three-year period to 31 December 19X1. (3) A sum of ₤2,500 was included in the administrative expenses of Business Y in respect of a holiday taken by the owner and his family. (4) Cash drawings for the year ended 31 December 19X9 were: ₤ 

(5)

Business X

20,000

Business Y

25,000

The owners of the businesses had stipulated the following prices for their businesses: ₤  Business X

190,000

Business Y

400,000

Required:

(a) Based on the information available prepare comparative trading and profit and loss accounts for the year ended 31st December 19X9.

 

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(b) Using the information provided and the accounting statements prepared in (a), calculate relevant accounting ratios in order to give Frampton a basis for assessing the performances of the two businesses. Comment on the results. (c) What additional information is needed in order to assess more accurately (i) the liquidity of the businesses (ii) the future prospects of the businesses?

Problem 81

John Jones is considering purchasing shares in one of two companies and has extracted the following information from the balance sheet of each company: Company A plc

Company B plc

₤000 

₤000 

₤1 ordinary shares

600

1,000

8% ₤1 preference shares

400

Authorised share capital

Issued share capital ₤1 ordinary shares

300

8% ₤1 preference shares

200

800

Reserves Share premium

300

400

Retained earnings

400

200

Loan capital 10% debentures (19X0) 12% debentures (19X6)

200 400

Required:

(a) Define the term “gearing” stating clearly what is meant by a low gearing ratio.  ratio.  (b) Calculate the gearing factor for each company (c) Explain to John Jones the significance of gearing to an ordinary shareholder in each of the companies above. (d) Assuming for each company a trading profit of ₤200,000 before interest and an ordinary dividend of 15 per cent complete the profit and loss appropriation account for a year for each company. You should ignore taxation.

 

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Problem 82 

Durham Limited had an authorized capital of ₤200,000 dividend into  100,000 ordinary shares of ₤1 each and 200,000 8% preference shares of 50p each. The following balances remained in the accounts of the company after the trading and profit and loss accounts had been  prepared for the year ended end ed 30th April 19X9:

Premises at cost

Dr

Cr

₤ 

₤ 

86,000

General reserve

4,000

Ordinary shares: fully paid

100,000

8% Preference shares: fully paid

50,000

Electricity Cash at bank

100 13,100

Profit and loss account balance 1st May 19X8 Debtors and creditors

14,500 20,000

 Net profit (year ended 30 th April 19X9) Machinery and plant at cost

12,900 16,500

60,000

Provision for depreciation on machinery and  plant Stock

40,000 60,000

Provision for doubtful debts Insurance Preference share dividend paid

4,000 900 2,000 242,000

242,000

The Directors have recommended: (1) a transfer of ₤5,000 to general reserve; (2) an ordinary dividend of ₤0.15p per share; and (3) a provision for the unpaid preference share dividend. Required:

(a) Prepare the profit and loss appropriation account for year ended 30 th April 19X9. (b) Prepare the balance sheet as at 30 th  April 19X9, in a form which shows clearly the working capital and the shareholders‟ funds.  funds.  (c) Identify and calculate:

 

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(i) one ratio indicating the firm‟s profitability;  profitability;   (ii) two ratios indicating the firm‟s liquidity position.  position.   (d) Make use of your calculations in (c) above to comment on the firm‟s financial position.  position.   (e) Name two points of comparison which are not available from the information above in this question but which could make your comments in (d) above more meaningful.

Problem 83

The summarised accounts of Hope Ltd for the year 19X8 and 19X9 are given below: Trading and Profit and Loss Accounts for the year ended 31 December 19X8

19X9

₤000

₤000

Sales

200

280

 Less Cost of sales

150

210

Gross profit

50

70

Administration expenses

38

46

Debenture interest

_

4

 Net profit

12

20

 Less

Balance Sheet as at 31 December 19X8

19X9

19X8

19X9

₤000

₤000

₤000

₤000

Ordinary share capital

100

100

Fixed assets, at cost

Profit and Loss Account

30

41

 Less Depreciation

110

140

Stock

20

30

Debtors

25

28

Bank

_

5

155

203

8% Debentures

50

Creditors

15

Bank

10

12

 _

_

155

203

Stock at 1st January 19X8 was ₤50,000. Required:

(a) Calculate the following ratios for 19X8 and 19X9: (i) Gross profit : Sales (ii) Stock turnover

 

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(iii) Net profit : Sales (iv) Quick („acid test‟)  test‟)  (v) Working capital (vi) Net profit : Capital employed (b) State the possible reasons for and significance of any changes in the ratios shown by your calculations. Problem 84 

Answer the following questions put to you by a friend: “Do you think the the shares in Rahman and Shah plc are worth buying at the present price of 150  pence? I see from the balance sheet that the net assets per share are 220 pence. Why are the two figures different?”  different?” 

 

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Consolidated Financial Statements Problem 85

On 1st January 1999 Huge plc purchased all the issued share capital of Medium Ltd for ₤25.2 million which was paid for by a new issue of ₤1 shares in Huge plc at ₤1.40 each. The tangible net assets included in the balance sheet of Medium Ltd had a fair value to Huge plc at that time of ₤17 million. Medium Ltd sells a well-known branded product which Huge plc valued at ₤6 million and which is to be included in the accounts at that figure. Required:

(a) Show how the takeover of Medium Ltd will affect the balance sheet of Huge plc. (b) Show how the consolidated balance sheet of the Huge plc group will be affected by the takeover of Medium Ltd. (c) What is an asset? How would you decide whether a brand name should be permitted to appear on a company‟s balance sheet?  sheet?   (d) Give reasons why some companies might wish to include brands on their balance sheet whereas others might not. (e) A director of Huge plc argues that, unlike most other fixed assets, the brand acquired on the takeover of Medium Ltd should not be depreciated as its value is likely to be maintained or even increased over time. Comment on this view and explain whether or not you agree with it.

Problem 86

Axe plc acquired 75% of the ordinary share capital of Bee Ltd by issuing 40,000 new ₤1 ordinary shares to the shareholders of Bee Ltd. At that date the net assets of Bee Ltd, according to its balance sheet, were ₤80,000. The fair value of Bee Ltd‟s net assets was found to be ₤100,000. The market value of each share in Axe plc was ₤2.20. The company has no other subsidiaries. Required:

Give calculations for the Axe plc group of: (a) goodwill on consolidation (b) minority interests (c) the change in share capital, reserves and net assets of the group following the acquisition. What figure would be shown in Axe plc‟s own balance sheet in respect of the investment in Bee Ltd?

 

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Alternative Methods of Accounting Problem 87

Angelina commenced business on 1st January with ₤10,000. Her transactions in the first year (all for cash) were as follows: ₤  1 January

Purchased 3 KXs

9,000

31 December

Sold 2 KXs

13,000

Purchased 2 KXs

8,400

Paid expenses

2,000

Her accountant has prepared the following profit and loss account for the first year of  business: ₤  Sales Purchases  Less closing stock

13,000 17,400 (11,400)

6,000

Gross Profit

7,000

 Less expenses

2,000

 Net profit for the year

5,000

The general price level rose during the year by 5%. Angelina recalls reading, during her undergraduate studies, that the purpose of income calculation is to give an indication of the amount which one can consume without impoverishing oneself. She has interpreted this to mean that, if she withdraws ₤5,000, the capital of the business will be maintained at its original level. Required:

Is Angelina correct in assuming she can withdraw ₤5,000 and still keep her original capital intact? Explain your assumptions carefully and give calculations to support you answer.

Problem 88

“During the “During  the last year general price inflation in the economy was 2% and the replacement cost of our factory machinery increased by 30%. Would it be sensible to account for such changes in the annual accounts?”  accounts?”  Required:

 

68

 

Explain what the effect on company profit and and return on shareholders‟ equity might be if such adjustments were made. Would such general and specific inflation adjustments merely serve to confuse rather than inform users of accounts?

 

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Introduction to Costing Problem 89

Porter company manufactures a number of furniture products. The accountant of the company unfortunately is on vacation. There is a need to prepare the data for cost analysis and  planning. Selected costs are given giv en below. belo w. You are just ju st appointed app ointed for internship in accounting department and asked for help. (a) Wood is used in the manufacturing of the tables at a cost of £100 per table. (b) The tables are assembled by workers, at a cost of £40 per table. (c) Workers assembling the tables are supervised by a factory fac tory supervisor who is paid £25,000  per year. (d) Electrical costs of £2 per machine-hour machine -hour are incurred in the factory in the manufacturing department. Four machine-hours are required to produce the table. (e) The depreciation cost of the machines in the manufacturing department totals to £10,000  per year. (f) The salary of the president of Porter is £100,000 per year. (g) Porter spends £250,000 to advertise its products. (h) Salespersons are paid at a commission of £30 for each table sold. (i) Instead of producing the tables, Porter could rent its factory space out at a rental income of £50,000 per year. Required:

Fill in the table below. Item

VC

FC

Period

Direct

Direct

Manufac.

Material

Labour

Overheads

Direct

Indirect

Sunk

Opportunity

(a) (b)

Problem 90

The following information has been taken from the ledger accounts of Klear-Seal Company for the year ended December 31, 19X5: $ Selling expenses

140,000

Raw materials inventory, January 1

90,000

Raw materials inventory, December 31

60,000

 

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Utilities, factory

36,000

Direct labor cost

150,000

Depreciation, factory

162,000

Purchases of raw materials

750,000

Sales

2,500,000

Insurance, factory

40,000

Supplies, factory

15,000

Administrative expenses

270,000

Indirect labor

300,000

Maintenance, factory

87,000

Work in process inventory, January 1

180,000

Work in process inventory, December 31

100,000

Finished goods inventory, January 1

260,000

Finished goods inventory, December 31

210,000

Management wants to organize these data into a better format so that statements can be  prepared for the year. Required:

(a) Prepare a schedule of cost of goods manufactured for 19X5. (b) Compute the cost of goods sold for 19X5. (c) Using data as needed from (a) and (b), prepare an income statement for 19X5.

 

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Job-Order Costing Problem 91

Hogle Company is a manufacturing firm that uses job-order costing. On January 1, 19X5, the company‟s inventory balances were as follows:  follows:  $ Raw materials

20,000

Work in process

15,000

Finished goods

30,000

The company applies overhead cost to jobs on the basis of machine-hours worked. For 19X5, the company estimated that it would work 75,000 machine-hours and incur $450,000 in manufacturing overhead cost. The following transactions were recorded for the year: (a) Raw materials were purchased on account, $410,000. (b) Raw materials were requisitioned for use in production, $380,000 ($360,000 direct and $20,000 indirect). (c) The following costs were incurred for employee services: direct labor, $75,000; indirect labor, $110,000; sales commissions, $90,000; and administrative salaries $200,000. (d) Sales travel costs were incurred, $17,000. (e) Utility costs were incurred in the factory, $43,000. (f) Advertising costs were incurred, $180,000. (g) Depreciation was recorded for the year, $350,000 (80 percent relates to factory operations, and 20 percent relates to selling and administrative activities). (h) Insurance expired during the year, $10,000 (70 percent related to factory operations, and the remaining 30 percent relates to selling and administrative activities). (i) Manufacturing overhead was applied to production. Due to greater than expected demand for its products, the company worked 80,000 machine-hours during the year. (j) Goods costing $900,000 to manufacture were completed during the year. (k) Goods were sold on account to customers during the year at a total selling price of $1,500,000. The goods cost $870,000 to manufacture. Required:

(a) Prepare journal entries to record the transactions above. (b) Post the entries in (a) to T-accounts T-accounts (don‟t forget to enter the opening balances in the inventory accounts).

 

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(c) Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. (d) Prepare an income statement for the year.

 

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Allocation of overheads: Traditional Approach and Activity-Based Costing Problem 92

Dinghy Products Ltd makes two products, masts and booms. There are two production departments, Turning and Finishing. There is also a sales administration office and a storeroom for parts and materials. The following information is available. Turning

Finishing

Office

Storeroom

Fl Floor oor space (m²)  (m²) 

300

150

10

40

Issues of parts and materials per month

20

5

Direct labour hours per mast

3

4

Direct labour hours per boom

4

3

The following are the budgeted output and costs for a month: Output of masts

200

Output of booms

800

Factory rent

£1,000   £1,000

Salary of storeman (all storeroom costs)

£1,300   £1,300

Salary of office clerk (all office costs)

£1,500   £1,500

There are the only indirect costs of production and a direct labour hour basis of absorption should be used for the two production departments. Required:

Calculate the indirect cost of producing a mast and a boom.

Problem 93

The following information is available for a factory which houses the assembly, finishing and machining departments: Assembly

Finishing

Machining

Department

Department

Department

Floor areas

40,000 sq ft

35,000 sq ft

25,000 sq ft

 Number of employees

150

100

50

 NBV of machines

$1,800,000

$1,200,000

Nil

During the month of January 2007, the factory incurred the following indirect overheads: Rent

$50,000

Heating and Electricity

$25,000

Indirect labour

$70,000

 

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The management have decided to allocate the above indirect overheads using the following  bases: floor areas for both rent and heating and electricity, and number of employees for indirect labour cost. As the machining department‟s task is to look after the machines in the assembly and finishing department, the management feel that it should be re-allocated to the assembly and finishing department based on the NBV of machines. Required:

Calculate the allocation overheads to the assembly and finishing departments based on the information available above.

Problem 94

The indirect costs incurred by the business on behalf of all departments taken together are given below: Cost item

Total cost this month, £ 

Indirect materials

36,000

Indirect labour

40,000

Rent

1,000

Insurance

1,600

Depreciation

2,000

Total

80,600

The costs must be apportioned (shared) over the departments because there is insufficient information to permit allocation of costs as a whole. The following table sets out relevant information about each department which will be used in the process of determining an overhead cost rate: Assembly

Finishing

Maintenance

Direct materials used for production

£400,000

£500,000

not applicable

 Number of employees

10

25

5

Floor area

100 sq m

200 sq m

100 sq m

Value of machinery

£30,000

£50,000

£20,000

64,000

not applicable

 Number of direct labour hours 55,000 worked on production

 

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Required:

Calculate the overhead cost allocated to the product. Suppose to produce the product you need to spend 2 hours in assembly department and 3 hours in finishing department.

Problem 95

Aerodec, Inc., manufactures and sells two products, X and Y. Annual sales in units, labour time per unit, and total manufacturing time per year are provided below: Total Hours Product X: 2,000 units x 5 hours

10,000

Product Y: 10,000 units x 4 hours

40,000

Total hours

50,000

Costs for materials and labour for one unit of each product are given below: Product X

Y

Direct materials

$25

$17

Direct labour (at 6$ per hour)

$30

$24

Manufacturing overhead costs total $800,000 each year. The breakdown of these costs  between the company‟s six activity centers is given given below. The cost driver for each activity center is shown in parentheses. Expected Number of Events or Transactions Activity Center and Cost Driver

Traceable

Total

Costs

Product

Product

X

Y

Labour related (direct labour-hours) labour-hours )

$80,000

50,000

10,000

40,000

Machine setups (number of setups)

$150,000

5,000

3,000

2,000

Quality inspections (number of inspections)

$160,000

8,000

5,000

3,000

Production orders (number of orders)

$70,000

400

100

300

Material receipts (number of receipts)

$90,000

750

150

600

General factory (machine-hours)

$250,000

40,000

12,000

28,000

$800,000 Required:

(a) Aerodec, Inc., has six activity centers. Classify the activity in each of Aerodec‟s activity centers as either a unit-level, batch-level, product-level, or facility-level activity.

 

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(b) Assume that the company applies overhead cost to products on a basis of direct labourhours. (i) Compute the predetermined overhead rate that would be used. (ii) Determine the cost to manufacture a unit of each product, using the predetermined overhead rate computed in (b)(i). (c) Assume that the company uses activity-based costing to compute overhead rates. (i) Compute the predetermined overhead rate per event or transaction for each of the six activity centers listed above. (ii) Using the rates developed in (c)(i), determine the amount of overhead cost that should be assigned to a unit of each product. (iii) Determine the cost ot manufacture a unit of each product and compare this cost to the cost computed in (b) (ii).

Problem 96

Clinton Ltd is a small company, which was established a year ago to produce and sell two  products, A and B, within withi n a local area. Two local l ocal competitors also produced A, but b ut B was a new development and there was no competitor in the market. Although their prime costs are very different, each product requires the same number of machine hours to produce one unit. The finance director has based the selling prices upon the manufacturing cost plus a mark-up of 25% to cover non-manufacturing costs and profit. The following figures apply: A

B

700

1,400

£ 

£ 

Prime cost

80.00

9.00

Overhead (8 machine hours)

152.40

152.40

232.40

161.40

Mark-up (25% of cost)

58.10

40.35

Selling price

290.50

201.75

Budgeted output (units)

As the other producers of A maintained their previous selling price of £380 per unit, the company has had no difficulty in attaining the desired sales of 700 units of A. B also sold well and the target of selling 1,400 units has been achieved. The company achieved full recovery of overheads.

 

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The management director has just heard that both competitors have announced their intention to stop producing A. However, one of them has also declared that they will be starting to  produce B and will offer it for sale sal e at £160 per unit, undercutting Clinton‟s selling price of B. The management director has sought your advice and after some investigation you have established the following additional information (i)

The production process comprises two distinct cost centers, Assembly and Finishing.

(ii)

The machine hours required to produce each product are:

Machine hours in:

A

B

Assembly

6

2

Finishing

2

6

8

8

Total

The aggregate overhead budgeted and spent in the first year, £320,000 is attributable as follows: £000   £000 Assembly

240

Finishing

80

Total

320

Required:

(a) Explain with supporting calculation how the finance director‟s allocation of £152.40 £152.40 overhead cost per unit of both products would have been arrived at. Comment on this method and its potential effects on business decisions. (b) Prepare product costs and selling prices using an alternative allocation of overheads to A and B, and support your method with reasoned arguments. Offer your suggested explanation for the competitors‟ behavior and advise the managing director. (c) Briefly discuss the issue of, and methods for, allocating non-manufacturing overheads to  products.

 

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Absorption and Variable Costing Problem 97

Palit Ltd. commenced business on 1 April 1993 and purchased equipment for £170,000 to manufacture product NPQ as from that date. The results for the year to 31 March 1994 and the budget for the following year are as follows: 1993/4

1994/5

Actual

Budget

 NPQs produced (units)

2,000

2,200

 NPQs sold (units)

1,500

2,000

£ 

£ 

160

160

Cost of raw materials purchased

70,000

77,000

Direct wages

50,000

55,000

Variable

10,000

11,000

Fixed

30,000

30,000

50,000

50,000

Unit selling price of NPQs

Manufacturing expenses:

Selling and administrative expenses

 No stock of materials and work in progress are held at any time. The NPQ manufacturing equipment is expected to last until 31 March 1998 and it will then be sold for an estimated sum of £30,000. The straight-line straight-line method is to be used for depreciation. Annual accounts for the year ended 31 March 1994 and a budget for the following year are now being prepared and you are asked to advise on how to value stocks of finished goods. The directors of Palit Ltd. are keen to use a method which will be helpful to management in understanding how the business is progressing. The following alternative bases have been suggested: (i) 

absorption costing

(ii) 

variable costing

Required:

(a) Using absorption costing, draw a profit and loss account for Palit Ltd. for the year ended 31 March 1994 and a budgeted profit and loss account for the following year. (b) Using variable costing, draw a profit and loss account for Palit Ltd. for the year ended 31 March 1994 and a budgeted profit and loss account for the following year.

 

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(c) Discuss the two stock valuation bases and give advice to the directors of Palit Ltd. on which to use for management information purposes and why.

Problem 98

Coase Ltd is a single-product manufacturing company which uses a marginal costing system for internal management reports. The company‟s annual profit and loss accounts for external reporting purposes are based on full absorption costing. The following data refer to the years ended 30th June 2007 and 2008: 2007

2008

£ 

£ 

Selling price

90

Marginal cost per unit Direct materials

21

23

Direct labour

19

22

Marginal factory overheads

8

10

Marginal selling and administrative administrativ e expenses

2

3

170,000

180,000

Units

Units

Opening stock

1,500

2,000

Closing stock

2,000

1,500

Sales

20,000

25,000

Fixed factory overheads

The normal volume used for the purpose of absorption costing is 28,000 units in both years. The company uses the first-in first-out assumption for the calculation of cost of sales. Required:

(a) Prepare internal management profit statement for the year ended 30 th  June 2008 using marginal costing. (b) Prepare a draft profit and loss account for the year ended 30th  June 2008 using full absorption costing. (c) Give calculations showing why the profits for 2008 are not the same in your answers to (a) and (b) above. Explain your answer.

Problem 99

John Smith, a friend of yours, has been trading for the past two years producing and selling skids. Although his accountant has drawn up accounts for his he feels they do not give an

 

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accurate picture of the business performance for decision-making purposes. He has asked you to look at his records and to draw up alternative profit and loss accounts for each of the past two years. The selling price for skids has been £9 per unit for the past two years and the following information is available: 1997

1998

Units

Units

Sales

1,500

2,000

Production

1,900

1,800

£ 

£ 

Factory variable

5,700

5,400

Factory fixed

3,800

3,330

Administration fixed

2,000

2,200

Selling variable

1,800

2,400

Costs:

John Smith commenced business in 1997 with no stock and he uses FIFO for stock valuation  purposes. Required:

(a) Produce profit and loss accounts for 1997 and 1998 using absorption costing. (b) Produce profit and loss accounts for 1997 and 1998 using variable costing. (c) Assume now that if John Smith decided to spend £600 in 1998 on improved quality control procedures in the factory then sales volume for the year would rise by 5%. Explain which costing method would give the more useful measure to indicate the profitability of the decision. Make use of the data in this question to illustrate your explanation.

Problem 100

Gladstown Manufacturing has added two new products to its range. Its accountant has  produced the following summarised financial statement showing the profit earned on these  products for the first year using absorption costing. cost ing. Beta

Delta

£ 

£ 

Materials

25,000

7,500

Direct labour

60,000

30,000

 

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Production overheads

120,000

60,000

Cost of sales

205,000

97,500

Sales

250,000

105,500

Gross profit

45,000

8,000

Other overheads

20,500

9,700

 Net profit / (loss)

24,500

(1,700)

Units

Units

Sales

25,000

7,500

Closing stock of finished goods

2,000

1,250

There is concern that Delta is showing a loss and it has been suggested that the use of marginal (variable) costing would give a fairer picture of the financial results. Further analysis shows that one-third of the production overhead charged to each product varies according to the level of production whereas two-thirds of the charge is product-related and is fixed. 75% of the other overheads are company overheads that have been allocated to the products and 25% vary with the level of sales of each product. Required:

(a) Redraft the absorption costing statement in more detail showing such matters as the cost of goods produced, stocks, fixed overheads and variable overheads, (b) Prepare a statement showing the contribution and net profit of each product using marginal (variable) costing. (c) Explain why the net profit figures are different under the two methods.

 

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Cost-Volume-Profit Analysis Problem 101

Drake Ltd‟s cost and revenues for revenues  for the current year are expected to be: £  Direct labour

6,000

Direct materials

7,000

Factory indirect expenses: Variable Fixed

4,500 500 5,000

Administration expenses

1,200

Selling and distribution expenses

600

Finance expenses

200 £20,000   £20,000

It was expected that 2,000 units would be manufactured and sold, the selling price being £11 each. Suddenly during the year two enquiries were made at the same time which would result in extra production being necessary. They were: (A) An existing customer said that he would take an extra 100 units, but the price would have to be reduced to £9 per unit on this extra 100 units. The only costs that would be involved would be in respect of variable costs. (B) A new customer would take 150 units annually. This would mean extra variable costs and also an extra machine would have to be bought costing £1,500 which would last for 5 years  before being scrapped. It would have no scrap value. Extra running costs of this machine would be £600 per annum. annum. The units are needed for an underdeveloped country and owing to currency difficulties the highest price that could be paid for the units was £10 per unit. Required:

On the information above, and assuming that there are no alternatives open to Drake Ltd, should the company accept or reject these orders? Draft the memo that you would give to the managing director of Drake Ltd.

 

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Problem 102

Greatsound Ltd manufactures and sells compact disc players, the cost of which is made up as follows: £  Direct material

74.80

Direct labour

18.70

Variable overhead

7.50

Fixed overhead

30.00

Total cost

131.00

The current selling price is £187.  £187.   Greatsound Ltd. works a day shift only, at present producing 120,000 compact disc players  per annum, and has no spare spar e capacity. Market research has shown that there is a demand for an additional 60,000 compact disc  players in the t he forthcoming year. However, these additional sales would have a selling sellin g price of £150 each. One way of achieving the extra production required is to work a night shift. However, this would increase fixed costs by £2,500,000 and the labour force would to be paid an extra 20 per cent over the day shift rate. The company supplying the materials to Greatsound Ltd. has indicated that it will offer a special discount of 10 per cent on total purchases if the annual purchases of materials increase  by 50 per cent. The selling price and all other cots will remain the same Required:

Assuming that the additional purchases will only be made if the night shift runs, you are required to: (a) advise Greatsound Ltd whether it should proceed with the proposal to commence the night shift, based on financial considerations. (b) calculate the minimum increase in sales and production required to justify the night shift. (c) give four other matters which should be taken into consideration when making a decision of this nature.

Problem 103

Xebec Ltd manufactures three perfumes, Silk, Musk and Opia. The selling prices and the variable costs per unit of each product are as follows:

 

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Silk

Musk

Opia

£ 

£ 

£ 

Selling price

15

20

30

Variable cost

10

14

20

Xebec‟s fixed costs are £150,000 £150,000 per year. There is a shortage of the raw material called Essence which is used in all three products. Silk uses 2 kilos, Musk uses 1 kilo and Opia uses 3 kilos of Essence per unit of output. Only 120,000 kilos of Essence will be available for the year. In addition, market constraints are expected to restrict the production and sales of each  product for the year to: Units Silk

40,000

Musk

8,000

Opia

15,000

Required:

Calculate the mix of sales which would enable Xebec Ltd to maximize profits, and calculate the profit for the year which would be achieved by that sales mix.

Problem 104

A summary of Pareto Company‟s profit statement for last las t year is presented below. Exept as noted, the cost and sales relationship for the current year is expected to follow the same  pattern. The company is operating operatin g at full capacity. £  Sales (1,000,000 bottles at £0,50)

500,000

Variable costs

300,000

Fixed costs

100,000

Total costs

400,000

Profit

100,000

Required:

(a) What is the break-even point in units? (b) What is the margin of safety in units? (c) If an extension to the factory is built it would add £50,000 to the fixed costs and increase  production capacity capaci ty by 60 per cent. Variable costs per unit are also expected ex pected to increase incre ase by 10  per cent. The management managemen t of the th e company compan y feels that t hat it should earn at least £10,000 each ea ch year

 

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on the new investment. Calculate whether the proposed extension provides sufficient capacity for the company to maintain existing profits and earn the minimum required on the new investment, assuming that all of the increased capacity can be sold.

Problem 105

Mento Company manufactures and sells a single product. The company‟s sales sales and expenses for the last quarter follow: Total

Per Unit

Sales

$450,000

$30

less Variable expenses

$180,000

$12

Contribution margin

$270,000

$18

less Fixed expenses

$216,000

 Net income

$54,000

Required:

(a) What is the quarterly break-even point in units sold and in sales dollars? (b) Without resorting to computations, what is the total contribution margin at the break-even  point? (c) How many units would have to be sold each quarter to earn a target net income of $90,000? Use the unit contribution method. Prove your answer by preparing a contribution income statement at the target level of sales. (d) Refer to the original data. Compute the company‟s margin of safety (MS) in both dollar and percentage terms. (e) What is the company‟s contribution contribution margin ratio (CM ratio)? If sales increase by $50,000  per quarter, by how much would you expect quarterly quarterl y net income to increase? (Do not prepare an income statement; use CM ratio to compute your answer).

Problem 106

A building company constructs a standard unit which sells for £30,000. The company‟s costs can be readily identifiable between fixed and variable costs. Budgeted data for the coming six months include the following:

January

Sales

Profit

(in units)

(£)   (£)

18

70,000

 

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February

20

100,000

March

30

250,000

April

22

130,000

May

24

160,000

June

16

40,000

You are told that the fixed costs for the six months have been spread evenly over the period under review to arrive at the monthly profit projections. Required:

(a) Prepare a graph for the total sales, costs and output for the six months under review that shows: (i) the break-even point in units and revenue; (ii) total fixed costs; (iii) the variable cost line; (iv) the margin of safety for the total budgeted sales. (b) The company is worried about the low level of sales. The sales director says that if the selling price of the unit was reduced by £5,000 the company would be able to sell 10% more units. All other costs would remain the same, you are told. Determine whether the company should reduce the selling price to attract new sales in order to maximize profit. Clearly show any workings. (c) Evaluate whether the assumption that costs are readily identifiable as either fixed or variable throughout a range of production is realistic. Give examples of any alternative classification.

Problem 107

You are provided with the following information relating to the sales, estimated demands and  production costs for each e ach bench, table and chair. Bench Estimated selling price

Table

Chair

£60   £60

£7 £71 1

£45   £45

Maximum demand

In units

1,800

1,500

3,000

Raw materials

- timber

£10   £10

£12   £12

£2  £2 

- metal fittings

£3  £3 

£4 £4  

£7  £7 

-

-

£6  £6 

£2  £2 

£2 £2  

£1  £1 

- fabric Packing

Each bench, table or chair involves in two separate stages of processing.

 

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1. 

The timber is machined, finished and assembled. Metal fittings are fixed.

2. 

The products are painted and varnished to packaging in polythene and cardboard.

Labour costs are based on the following estimated time (in minutes) required for each  processing stage: Stage 1

Stage 2

Benches

180

20

Tables

150

60

Chairs

60

40

Stage 1

Stage 2

4

3

The following rates for labour are applied:

£ per hour  

There are a maximum of 10,500 hours of labour available for stage 1. Required:

(a) Advise the management the maximum output for each product and the total contribution of the proposed optimal production plan. (b) Explain clearly the basis method used in (a). (c) Identify two factors that should be considered before a final decision is made.

 

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Budgeting Problem 108

The following figures have been taken from the budget of Solaja Ltd, a company in the retail trade, for the year to 31 December 1998: January

February

March

April

5,000

6,000

7,000

5,000

£ 

£ 

£ 

£ 

Distribution

4,500

4,700

5,200

4,500

Administration

3,000

3,600

4,400

3,000

Depreciation

1,000

1,000

1,500

1,500

Sales (units)

Expenses:

The following additional information is available: (1) The selling price is £6 per unit. It will increase to £6.70 per unit for all sales in April and subsequent months. 25% of budgeted sales revenue is expected to be received in the month of sale and 70% in the following month. 5% of all sales are expected to lead to bad debts. (2) The budgeted number of units of stock held at the end of each month is equal to the  budgeted sales for the following fo llowing month. (3) The purchase price of stock has been £3.50 per unit since October 1997 and this is expected to increase to £4 per unit for all purchases in February and subsequent months. (4) 60% of all purchases are paid in the month of purchase and 40% in the following month. (5) All expenses are paid in the month in which they are incurred. (6) Solaja Ltd plans to buy new fixed assets for £43,000 paying a deposit of £15,000 in February. The balance will be paid in monthly instalments of £2,000 commencing in March. (7) The chairman has suggested that he might be willing to lend up to £12,000 to the company for a maximum of four months to avoid asking the bank for an overdraft. (8) The business is seasonal and, as indicated in the above budget, results in April are expected to be similar to those in January. There is a three month cycle so the results in May and June are expected to be similar to those in February and March respectively. (9) Summarised balance sheet at 31 December 1997: £  Fixed assets (at book value)

12,500

Stock at cost

17,500

Debtors (after bad debt provision)

29,400

 

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Cash at bank

2,000

Creditors

(7,000)

Share capital and reserves

54,400

Required:

(a) A monthly cash budget for Solaja Ltd for January, February, March and April and the total for the four months presented in the form of a table. (b) A budgeted balance sheet at 30 April 1998. (c) Your comments on the impact on the company if it were to borrow up to £12,000 from the chairman to help finance the purchase of the new fixed assets.

Problem 109

The management director of Pumpkin Ltd was reviewing the results of the company for the financial year ended 31 March 19X0. The following summarized information was available:  Balances as at 1 April 19X9

£  

Issued ordinary share capital: £1 fully paid shares  shares  

150,000

Share premium account

100,000

Balance of retained earnings

 Balances as at 31 March 19X0 19X0

40,000

£  

 Net profit for the year 19X9/X0

70,0000

Fixed assets

300,000

Bank overdraft

150,000

Other net current assets

210,000

 Note: There were no other accounts with balances. The balances as at 1 April 19X9 had remained unchanged throughout the year.

The management director was pleased that the company had made a good profit, but he was rather concerned that a healthy bank balance at the beginning of the year had now become a large bank overdraft. Consequently he asked the company accountant to prepare forecast information for 19X0/X1 in order that the cash situation could be improved. The following information was prepared by the accountant: (1) Company sales –  sales –  March  March 19X0

 

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£  Cash sales

30,000

Credit sales

65,000

In each month April to September (inclusive) the sales per month would be: £  Cash sales

40,000

Credit sales

70,000

All credit sales are settled the month after the sale. (2) All goods purchased are from a single supplier. The goods are purchased on credit and each month‟s purchases are paid for three months after the month of purchase. The following purchase schedule had been prepared for the first 9 months of 19X0:  January

February

March

£60,000   £60,000

£58,000   £58,000

£61,000   £61,000

Purchases Purchases in April, May and June £55,000 in each month  month 

Purchases in July, August and September £45,000 in each month  month   Note: the company had successfully negotiated lower prices from its supplier commencing 1 July 19X0. (3) Dividends would be paid as follows: (i) Final ordinary dividend of 5p per share payable on 31 May 19X0 in respect of financial year 19X9/X0. (ii) Interim ordinary dividend of 2p per share payable on 31 July 19X0 in respect of financial year 19X0/X1. (4) Selling and distribution expenses are expected to be 6 per cent of a given month‟s total sales. They are paid one month in arrears. (5) Administration charges would be incurred as follows: 19X0 February, March, April

£10,000 per month  month 

19X0 May to September (inclusive)

£13,500 per month  month 

Administration charges are settled two months after the month in which they were incurred. (6) The company had decided to make a bonus issue of shares of one share for every three held. The issue would be made on 30 April 19X0. The bonus shares would not qualify for the final dividend of 19X9/X0, but would qualify for the interim dividend to be paid on 31 July 19X0.

 

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Required:

(a) Comment on the liquidity of the company as at 31 March 19X0 and explain to the managing director why a company can apparently make a good profit but have no cash in  bank. (b) Prepare a cash budget for each of the four months ending 31 July 19X0. (c) Comment on the forecast bank balance as shown by your cash budget. Identify ways in which the bank overdraft could be reduced over the last five months of 19X0.

Problem 110

The management of Hooke plc have been informed that the union representing the direct  production workers at one of o f their factories, where whe re a standard product is produced, p roduced, intends int ends to call a strike. The accountant has been asked to advise the management of the effect the strike will have on cash flow. The following data has been made available: (1) Week 1

Week 2

Week 3

Budgeted sales

400 units

500 units

400 units

Budgeted production

600 units

400 units

Nil

(2) The strike will commence at the beginning of week 3 and it should be assumed that it will continue for at least four weeks. Sales at 400 units per week will continue to be made during the period of the strike until stocks of finished goods are exhausted. Production will stop at the end of week 2. The current stock level of finished goods is 600 units. (3) The selling price of the product is J60 and the budgeted manufacturing cost is made up as follows: J Direct materials

15

Direct wages

7

Variable overheads

8

Fixed overheads

18

Total

48

(4) Direct wages are regarded as a variable cost. Direct wages are paid one week in arrears. (5) The company operates a full absorption costing system and the fixed overhead absorption rate is based upon a budgeted fixed overhead of J9,000 per week. Included in the total fixed overheads is J700 per week for depreciation of equipment. During the period of the strike

 

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direct wages and variable overheads would not be incurred and the cash expecded on fixed overheads would be reduced by J1,500 per week. It should be assumed that all relevant overheads are paid for immediately the expense is incurred. (6) The current stock of raw materials cost J7,500: it is intended that these stocks should increase of J11,000 by the end of week 1 and then remain at this level during the period of the strike. All direct materials are paid for one week after they have been received. (7) All sales are on credit. 70% of the sales value is received in cash from the debtors at the end of the first week after the sales have been made and the balance at the end of the second week. (8) The current amount outstanding to material suppliers is J8,000 and direct wage accruals amount to J3,200. Both of these will be paid in week 1. The current balance owing from debtors is J31,200, of which J24,000 will be received during week 1 and the remainder during week 2. The current balance of cash at the bank and in hand is J1,000. Required:

(a) Prepare a cash budget for weeks 1 to 6 showing the balance of cash at the end of each week together with a suitable analysis of the receipts and payments during each week. (b) Comment upon any matters arising from the cash budget which you consider should be  brought to management‟s attention.

 

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Variance Analysis Problem 111

Cleanahull Ltd operates a small boat cleaning service. Boats are cleaned using a special machine that requires a skilled operator and are finished using unskilled labour. Cleanahull has produced a standard cost schedule as all boats go through the same process. Overheads are absorbed using standard labour hours. The materials come in packs; each boat cleaned should use one pack of materials. Cleanahull budgets to clean 288 boats per month. Standard cost for cleaning a boat: £  Skilled labour: 2 hours at £8 per hour  

16

Unskilled labour: 1 hour at £5 per hour  

5

Materials: 1 pack at £3 per pack  

3

Variable overheads: 3 hours at £2 per hour  

6

Fixed Fixe d overheads: 3 hours at £10 per hour  

30

Total standard cost

60

Profit mark-up at 30% cost

18

Price charged

78

Actual results for May 2008: £  Sales: 330 boats cleaned

£  26,400

Less costs Skilled labour: 594 hours

5,049

Unskilled labour: 396 hours

1,881

Materials:350 packs

1,190

Variable overheads

1,815

Fixed overheads

8,500

Total costs for May

18,435

Profit for May

7,965

Required:

(a) Prepare an operating statement, reconciling budgeted and actual profit for Cleanahull Ltd Ltd for May 2008 showing two variances for sales and each cost category. (b) Prepare a brief report to the owner of Cleanahull Ltd commenting on the performance in May 2008 suggesting possible reasons for any unexpected results.

 

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Problem 112

Smith Plc. manufactures and sells a range of small household products. The following information relates to the “Adam” for the month of July.  July.   Budgeted volume

6,000 units

Budgeted selling price

£6,00 per unit  unit 

Budgeted variable cost

£2 per unit  unit 

Budgeted fixed overheads for July

£6,000

During July 8000 “Adams” were actually sold for £40,000. £40,000. Required:

(a) Compute the following variances for product “Adam: for July:  July:  (i) Sales price variance; (ii) Sales contribution volume variance; (iii) Sales margin volume variance. (b) Explain and reconcile the difference between your answers to (ii) and (iii).

Problem 113

Thatcher Ltd uses a standard costing system. The standard cost card for direct materials used in production of product NUM is as follows: 8 kgs @ £0.40 per kg = £3.20 per  unit  unit Budgeted production in April 2007 was 850 units. The relevant data for actual production of product NUM for April 2007 was as follows: Actual production

870 units

Materials purchased

8,200 kgs at a cost of £3,444  £3,444 

Materials issued to production 7150 kg Required:

(a) Calculate the total materials variance for April 2007. (b) Calculate the materials price variance and materials efficiency variance for April 2007.

 

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Investment appraisal Problem 114

The government of Nopia is considering operating a series of toll roads which will be operated by companies in the private sector. Contracts to run the toll roads will be for five years at which time contracts will be put out to competitive tender again. As the finance director of QFE plc, a transport operator, you are interested in bidding for one of the first series of contracts. It is anticipated that you will need to pay the government of Nopia an initial fee of £15 million to acquire the right to operate the toll road plus an annual f ee f ee of £1.5 million payable at the end of the year 1, increasing by 15% per year thereafter. In addition, the government will take 20% of all revenues generated by the toll road. Operating costs to monitor traffic and collect tolls are expected to be £3 mi llion in year 1 and will then increase by 10% per year. Based on current estimates of usage there will be 112 million miles of vehicle travel per year for each of the five years. The government of Nopia will allow QFE plc to set the toll fee which will be based on the number of miles a vehicle travels on the toll road. Once set, the toll per mile will remain constant for the duration of the contract. Given the risk profile of this project QFE pls will require a return of 12% per year on its investment. Assume all cash flows, apart from the initial fee, will occur at the end of the year concerned. Required:

(a) As finance director of QFE plc what is the minimum toll per mile you would be prepared to charge? (b) Assume the government of Nopia is prepared to accept an alternative to the initial fee of £15 million. The alternative is to pay five equal annual instalments to the government commencing immediately. What is the maximum QFE plc should be prepared to pay per year to avoid the initial fee of £15 million? million? (c) Assume that the government now states that the toll charge must fall by 4% per year from the end of year 1. How would this effect your recommendation in part (a) above? All calculations should be expressed in millions and rounded to two decimal places.

 

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Problem 115

Part 1 The international division of a large Bulgarian wine producing company is considering starting operations in the UK market. It has commissioned market research on the UK wine market which cost 23,000 Bulgarian Leva (abbreviated BGL). The findings result in a recommendation: to enter this new market the Bulgarian firm needs a marketing campaign. This initial investment is estimated to cost BGL 3 million. The research has also estimated that, following the campaign, the revenues net of cash expenses for UK sales over the next ten years will be: BGL Year 1

450,000

Year 2

500,000

Year 3

620,000

Year 4

700,000

Year 5

700,000

Year 6

700,000

Year 7

700,000

Year 8

700,000

Year 9

700,000

Year 10

700,000

Assume that all cash flows arise at the end of the year. All figures are in real terms. The real discount rate is 6%. Thanks to funds from the European Union to promote trade with new members, the project is exempt from taxes. Required:

Should the company enter the UK market? Provide the relevant calculations to illustrate your answer. Explain and discuss. Part 2 At the end of year 3, an internal assessment of the project and of the revenues from the UK market shows that the sales have been more successful than expected. The company has had a total net cash flow over the previous three years of BGL 2.5 million (instead of the expected BGL 1.57 million). However, the UK market has become more competitive and it is felt that a new marketing campaign is necessary if the company intends to stay in that market. New adverts and  promotions would cost BGL 1.4 1 .4 million. The real discount rate and the tax treatment of the

 

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 project remain the same. However, because of increased competition the estimates of revenues net of cash expenses in real terms, for the remaining seven years, have to be adjusted downwards to the following: BGL Year 1

620,000

Year 2

510,000

Year 3

300,000

Year 4

300,000

Year 5

300,000

Year 6

300,000

Year 7

300,000

Required:

(a) Should the company continue with sales in the UK? Provide the relevant calculations to illustrate your answer. Explain and discuss. (b) Should the initial success of the project in the first three years be taken into account in the decision at the end of Year 3? Why? Part 3 At the same time of the re-assessment of the UK market, at the end of year 3, the domestic division of the firm proposes an alternative investment, completely independent of the first one. They are considering entering the bottle production market to supply glass bottles to the growing Bulgarian wine industry. The project would require exactly the same initial investment as the new marketing campaign  –   BGL 1.4 million  –   to buy the necessary machinery. The company depreciates its fixed assets using the straight-line method. Capital allowances are equal to depreciation for this Bulgarian company. The estimated revenue net of cash expenses for the following seven years would be: BGL Year 1

620,000

Year 2

530,000

Year 3

430,000

Year 4

420,000

Year 5

420,000

Year 6

420,000

Year 7

420,000

 

98

 

It is customary for this division, dealing with the domestic market, to state projects‟ cash flows in nominal terms. Moreover, this project, as a domestic one, is subject to a tax rate of 20%. The inflation rate is 3% per year. The real discount rate is the same. Required:

Compare this project with the project in part 2. Which project should the firm choose if it can only undertake one? Provide the relevant calculations to illustrate your answer. Explain and discuss.

Problem 116

Hayek Plc. is considering investing in either project P or project Q: Time

Project P

Project Q

(years)

£ 

£ 

Equipment cost

0

100,000

100,000

Expected annual profit/loss

1

34,000

4,000

2

24,000

4,000

3

14,000

12,000

4

4,000

16,000

5

(36,000)

4,000

5

20,000

20,000

Estimated resale value of equipment

Hayek Plc depreciates equipment on the straight-line basis. Profits and losses are earned evenly throughout the year. Required:

(a) Calculate the payback period for each project and on this basis advise Hayek Plc which  project to invest in. (b) Briefly explain two disadvantages of payback period as a method of investment appraisal.

Problem 117

The directors of Welch plc are considering which of the following projects to invest in: Year

Alpha

Beta

Gamma

£ 

£ 

£ 

Initial capital investment

0

50,000

50,000

50,000

Expected cash inflows

1

30,000

30,000

20,000

2

20,000

20,000

20,000

 

99

 

Scrap proceeds

3

6,000

6,000

10,000

4

4,000

4,000

10,000

4

10,000

0

10,000

Welch plc uses the straight-line method of depreciation. Required:

(a) Calculate the payback period of each project. (b) Calculate the average accounting rate of return of each project. (c) Based on your calculations in (a) and (b), advise the directors which project they should invest in.

Problem 118

As a member of the f inance inance director‟s team at Londy plc. Londy  plc. you have been asked to approve ap prove at investment proposal recently received from the company‟s subsidiaries, Franly Ltd, whose directors consider that the project should be supported as it yields a forecast profit of £460,000 over its anticipated five year life. The following financial information has been provided to support the proposal: Five year forecast profit and loss account for years ending on 31 May 2002

2003

2004

2005

2006

£000   £000

£000   £000

£000 £000

£000   £000

£000   £000

1,500

2,000

2,500

2,000

1,000

Less: Cost of sales

900

1,200

1,500

1,200

600

Gross profit

600

800

1,000

800

400

Less: Depreciation

240

240

240

240

240

Wages

150

170

170

170

150

Overheads

200

270

320

220

120

Forecast not profit/loss

10

120

270

170

(110)

Sales

 Notes: (1) Closing stock (in £000s) is expected to be as follows:  follows:   2002

2003

2004

2005

2006

100

150

100

50

0

The project will commence on 1 June 2001 with no opening stock. (2) Franly Ltd uses the straight-line method of depreciation. The value of the machinery needed for the project is expected to be £300,000 and the end of its five year life.

 

100

 

(3) The wages figure includes £48,000 for a manager and £27,000 for a supervisor who are already employed by Franly Ltd. If the project goes ahead, the company will need to hire an additional supervisor at a cost of £25,000 per year. If the project does not proceed, the existing manager and supervisor will remain in their present posts. (4) 10% of the overhead charge varies with the value of sales revenue and 90% in an allocation of group overheads. (5) The equipment will be paid for on 1 July 2001. The required amount of materials and components for the year‟s production will be paid for at the beginning of the year conce rned. All other cash flows will occur at the end of the year. (6) Londy plc. uses the discounted cash flow method for project appraisal and the discount rate to be used for this project is 10% per year. Required:

(a) Based upon the above information, advise the finance director whether or not the project should be accepted. (b) If it were possible to lease the equipment by paying five equal annual instalments, the first  being on 1 June 2001, what is the maximum Franly Ltd should be willing to pay? Explain your answer. (c) Explain to the directors of Franly Ltd why the discounted cash flow approach to project evaluation is often preferred to the forecast profit approach and discuss any limitations the method may have.

Problem 119

Parsons plc. is considering an investment proposal for recycling waste production materials into a product, which can be sold to the packaging industry. The company‟s accountant has rejected the project on the basis that it results in a forecast loss of £890,000 over its expected five-year fiveyear life. The company‟s board of directors are concerned about the carbon footprint of the company and are looking for ways to improve its environmental impact and have agreed that a maximum loss of half a million pounds over a five year period is acceptable. They have requested you to re-examine the financial consequences of the product. You are provided with the following financial information about the project: (1) The accountant‟s forecast is as follows based on the project commencing on 1st  January 2009. Five year forecast profit and loss account for years ending on 31 December

 

101

 

2009

2010

2011

2012

2013

£000   £000

£000   £000

£000   £000

£000   £000

£000   £000

Sales

1,300

2,000

2,200

2,200

2,200

Less: Cost of sales

1,100

1,300

1,450

1,500

1,500

Gross profit

200

700

750

700

700

Less: Depreciation

320

320

320

320

320

Labour costs

175

195

205

195

195

Overheads

150

325

300

300

300

(445)

(140)

(75)

(115)

(115)

Forecast loss

The following additional information is made available: (2) The recycling process uses up waste materials which have no resale value. At present, disposal of the production waste is arranged by paying an annual fee to a local waste disposal company. If the project is undertaken, these costs will no longer be incurred. The yearly estimated estima ted cost of waste disposal (in £000s) is as follows:  follows:   2009

2010

2011

2012

2013

80

80

80

80

160

(3) The process will require the purchase of additional materials which are included as cost of sales in the company accountant‟s forecast. The project commenced commence d with no opening stock,  but the forecast includes the following projected closing stock of materials (in £000s) at 31st  December: 2009

2010

2011

2012

2013

100

200

150

50

0

The materials needed for the year will be purchase and paid for on the first day of the year. (4) On 1st January 2009 the company will purchase and pay for special recycling machinery. The scrap value at 31st  December 2013 is estimated at £50,000. Parsons plc uses the straight line method of depreciation which results in a charge of £320,000 £320,000 per annum. (5) 80% of the overhead charge is an allocation of existing company fixed overheads and 20% represents the overheads incrementally incurred on the new recycling project. (6) In August 2008, the company spent £20,000 on commissioning a report investigating the environmental impact of its waste products. (7) Each year‟s labour costs include £55,000 for the environmental manager and £25,000 for a  production supervisor. Both are already employed by Parsons plc. If the project does not  proceed, these two employees will remain in their present posts. The remaining labour costs reflect additional workers needed for the process.

 

102

 

(8) The board of Parsons wish you to use the discounted cash flow method for the project appraisal and the discount rate to be used for this project is 12% per year. Assume all cash flows occur at the year end, unless otherwise indicated. Required:

(a) Based upon the above information, advise the finance director whether or not the recycling  project should be accepted. State any assumptions and use a tabular format for your calculations. All figures to the nearest £000. (b) In the context of project evaluation, what do you understand by the term “sensitivity analysis”? Give (without calculations) two examples of sensitivity sensit ivity analysis considerations for the recycling projects.