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A2 Unit 3
Further Aspects of Financial Accounting
1 Sources of finance 1
2 Incomplete records 2
3 Partnership final accounts 8
4 Changes in partnerships 15
5 Published accounts of limited companies 21
6 Cash flow statements 26
7 Accounting standards 30
8 Stock valuation 34
A2 Unit 4
Further aspects of Management Accounting
9 Manufacturing accounts 40
10 Costs and contribution 44
11 Break-even analysis 47
12 Absorption and activity based costing 52
13 Overheads and overhead absorption 57
14 Costing in decision-making 62
15 Standard costing and variance analysis 70
16 Capital investment appraisal 73
17 Further aspects of budgeting 79
18 Decision-making and social accounting 85
1
CHAPTER 1 Sources of finance
(b) Rachel will need a bank loan for the equipment for her business.
Its features are:
• a fixed amount over a fixed period
• interest at a fixed or variable rate
• a regular repayment schedule
advantages:
• easy to budget for, as the timing of repayments is known
• the possibility of negotiating the timing of repayments (‘holiday’ may be possible)
• interest rates may be lower than overdraft rates
disadvantages:
• a long-term financial commitment which has to be met
• security normally required – which could include Rachel’s property
(c) Basil will need a commercial mortgage.
Its features are:
• a long-term loan secured on business premises (ie the hotel)
• finance available normally up to 70% of property value (Basil’s deposit of £150,000 will be sufficient)
• interest at a fixed or variable rate
• a regular repayment schedule
advantages:
• easy to budget for, as the timing of repayments is known
• interest rates may be lower than overdraft rates
disadvantages:
• a long-term financial commitment which has to be met
• the property will be required as security
• if the business fails and the bank calls in the loan, Basil will lose his hotel
1.5 Tariq has two distinct financial needs: £80,000 for fixed assets and £70,000 for working capital.
There is no ‘right or wrong’ answer to this question. In an exam situation the examiner will be looking for knowledge of the
different forms of financing and a reasoned conclusion based on a discussion of the relevant advantages and disadvantages of
each form.
(a) asset finance
The first consideration is likely to be whether the finance can be met from internal sources. The question states that Tariq is
already putting in a capital contribution, so further internal financing could be met from a loan from the family – this has the
advantage of being cheap and flexible, but the possible downside is the family wanting a say in the way the business is run. The
other internal source of finance would be funding from cash generated from profits, but as the business is not yet trading this is
not a viable option.
The other options are financing from external sources:
• Bank loan – repayable over the long term, repayments can be budgeted for, repayment schedule may be negotiated to
include ‘holiday’, interest fixed or variable rate; but . . . security will be required, Tariq may lose his house if the business fails.
This is, on balance, probably the favoured option for asset finance.
• Bank mortgage – not applicable as the office will be rented and not available as security.
• Business angel – the finance may be available, but the angel will want a stake in the business and a say in how it is run –
this may be an advantage or a disadvantage depending on Tariq’s expertise and ambitions for ‘going it alone’. The biggest
downside will be the loss of total control, an issue which is often important for the entrepreneur.
1
• Incorporation of the business as a limited company in order to attract external equity finance from a private equity firm – this
is very unlikely in view of the small amount involved. It will also involve a partial loss of control of the business.
(b) working capital finance
The requirement could be met from internal sources, but the same considerations in (a) apply, ie Tariq does not have more
funds himself; also, involving the family could cause problems and financing from profits is not possible in a business start-up
situation.
The only other option is an external source of finance – the bank overdraft, which involves borrowing on a current account up
to a set limit.
The advantages are that it is flexible (the borrowing can be repaid as and when funds are available) and is economical (interest
is only charged when the business borrows). The disadvantages are: an overdraft is repayable on demand (this would happen
if the bank wanted to cancel the overdraft) and security will be required (the danger of the possible sale of Tariq’s house if the
business fails).
2.2 £77,000
2.5
TALIB ZABBAR
CALCULATION OF STOCK LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20-7
£ £
Opening stock 30,500
Purchases 89,500
Cost of stock available for sale 120,000
Sales 160,000
Less Normal gross profit margin (40%) 64,000
Cost of sales 96,000
Estimated closing stock 24,000
Less Actual closing stock 21,500
Value of stock loss 2,500
2005 2005
1 Jan Balance b/d 2,640
2
• Calculating the cash loss:
£
Cash expected to be banked (from control account) 93,532
Cash actually banked 93,322
∴ Cash loss 210
2.8 (a)
2004/05 2004/05
1 Jun Balance b/d 160
(b) Measures to prevent such a loss occurring in the future; any two from:
• Record cash transactions as they occur, eg by using tills that issue receipts.
• Collect cash from tills regularly, and place the cash in a safe in the office.
• Bank cash regularly, so that there is a low level of cash on the premises at any time.
• Pay bills by cheque rather than in cash, so avoiding the need to carry cash when paying creditors.
• Divide duties within the business, ensuring that no one person is responsible for all cash handling.
• Carry out cash checks at regular intervals, eg to ensure that the cash in tills balances against receipts.
• Improve security, eg use of a safe in the office for cash to be banked, keep the office door locked when the
office is empty, use of security cameras.
• Set authorisation limits for employees who pay bills, to ensure that large amounts cannot be paid out without
authority.
(c) Advice to maintain accurate records of cash transactions; any two from:
• Keep a detailed cash book.
• Keep a copy of all receipts issued.
• Use a numbering system for all receipts and invoices.
• Prepare bank reconciliation statements each time a bank statement is received.
• Use margin and mark-up to compare expected sales with actual sales figures.
2.10 (a) £
• receipts from trade debtors 121,000
• less trade debtors at beginning of year 36,000
• add bad debts written off during year 550
• add trade debtors at end of year 35,000
• sales for year 120,550
3
(d) COLIN SMITH
TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 20-5
£ £
Sales 120,550
Opening stock 25,000
Purchases 60,000
85,000
Less Closing stock 27,500
Cost of sales 57,500
Gross profit 63,050
Less expenses:
Expenses 30,200
Provision for depreciation: fixtures and fittings 5,000
Bad debts written off 550
35,750
Net profit 27,300
£ £ £
Fixed Assets Cost Provision for Net
depreciation book value
Fixtures and fittings 50,000 15,000 35,000
Current Assets
Stock 27,500
Trade debtors 35,000
Bank 1,210
63,710
Less Current Liabilities
Trade creditors 30,000
Accrual: expenses 700
30,700
Net Current Assets 33,010
NET ASSETS 68,010
FINANCED BY
Capital
Opening capital* 69,500
Add Net profit 27,300
96,800
Less drawings 28,790
68,010
* Opening capital: £
• assets at 1 July 20-4 102,500
• less liabilities at 1 July 20-4 33,000
• capital at 1 July 20-4 69,500
4
2.11 SANDRINE
TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006
£ £
Sales (working 1) 228,295
Opening stock 4,987
Purchases (working 2) 62,794
67,781
Less Closing stock 5,038
Cost of sales 62,743
Gross profit 165,552
Less expenses:
Wages (working 3) 56,404
Motor expenses 7,920
General expenses 7,963
Loan interest (working 4) 3,000
Provision for depreciation: equipment (working 5) 1,500
vehicles (working 6) 12,000
Loss on sale of equipment (working 7) 3,800
92,587
Net profit 72,965
WORKINGS
£
1 • receipts from trade debtors 163,729
• less trade debtors at beginning of year 3,746
• add trade debtors at end of year 2,988
• add cash sales 65,324
• sales for year 228,295
5
2.13 (a) CINDY TOFE
Bank Reconciliation Statement as at 31 December 2005
£
Balance at bank as per bank statement (668)
Unpresented cheque (291)
(959)
Outstanding lodgement 1,084
Balance at bank as per cash book 125
Tutorial note: the topic of bank reconciliation statements is covered in AQA AS Accounting; the statement starts with
the bank balance, which is overdrawn.
(b)
Dr Bank Account Cr
2005 £ 2005 £
1 Jan Balance b/d 1,726 Payments for year 186,065
Receipts for year 201,784 Drawings (missing figure) 17,320
31 Dec Balance c/d 125
203,510 203,510
2006 2006
1 Jan Balance b/d 125
(c) £
Stock at 31 December 2005 ?
– sales at cost price 2,520 ÷ 1.4 1,800
– sales to F Fearless at cost price 858 ÷ 1.1 780
+ sales returns at cost price 504 ÷ 1.4 360
+ purchases 1,036
– purchases returns 140
Stock valuation at 8 January 2006 2,986
By working up the calculation (adding the minuses and deducting the pluses), the stock valuation at 31 December
2005 is found to be £4,310.
(d)
Dr Disposals Account Cr
2005 £ 2005 £
Vehicle (book value) 12,000 Vehicle (part exchange value)
(missing figure) 11,500
Profit and loss account
(loss on sale) 500
12,000 12,000
6
(e) CINDY TOFE
TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005
£ £
Sales (working 1) 198,506
Opening stock 2,998
Purchases (working 2) 143,102
146,100
Less Closing stock 4,310
Cost of sales 141,790
Gross profit 56,716
Less expenses:
General expenses 1,604 + 5,162 6,766
Wages (working 3) 23,041
Rent (working 4) 4,680
Motor expenses 3,040
Provision for depreciation: equipment 4,000
vehicles (working 5) 17,000
Loss on sale of vehicle 500
59,027
Net loss 2,311
WORKINGS
1 Dr Cash Account Cr
2005 £ 2005 £
1 Jan Balance b/d 142 Expenses 11,022
Receipts (missing figure) 197,833 Bank 186,784
31 Dec Balance c/d 169
197,975 197,975
2006 2006
1 Jan Balance b/d 169
2006 2006
1 Jan Balance b/d 7,219
2006 2006
1 Jan Balance b/d 5,433
7
3 Dr Wages Account Cr
2005 £ 2005 £
Bank 23,110 1 Jan Balance b/d 831
31 Dec Balance c/d 762 Profit and loss account
(missing figure) 23,041
23,872 23,872
2006 2006
1 Jan Balance b/d 762
4 Dr Rent Account Cr
2005 £ 2005 £
1 Jan Balance b/d 160 Profit and loss account
Bank 4,940 (missing figure) 4,680
31 Dec Balance c/d 420
5,100 5,100
2006 2006
1 Jan Balance b/d 420
5 Dr Vehicles Account Cr
2005 £ 2005 £
1 Jan Balance b/d 60,000 Disposals 12,000
Bank 13,500 Profit and loss account
Part exchange 11,500 (missing figure) 17,000
31 Dec Balance c/d 56,000
85,000 85,000
2006 2006
1 Jan Balance b/d 56,000
8
3.6
Dr Partners' Capital Accounts Cr
Mike Bernie Mike Bernie
20-4 £ £ 20-4 £ £
31 Dec Balances c/d 30,000 20,000 1 Jan Balances b/d 30,000 20,000
20-5 20-5
1 Jan Balances b/d 30,000 20,000
20-5 20-5
1 Jan Balances b/d 1,510 830
3.9 (a)
DANIEL AND FREDA, IN PARTNERSHIP
STATEMENT OF AFFAIRS AS AT 31 DECEMBER 2005
£ £
Assets
Premises 40,000
Vehicle 3,750
Office equipment 6,000
Stock 2,400
Debtors 150
Cash at bank 10,950
63,250
Less Liabilities
Creditors 3,250
Capital at 31 December 2005 60,000
9
(b) Although there is no legal requirement for Daniel and Freda to keep their financial records using a double-entry
system, such a system will:
• provide more accounting information to assist with management decisions
• enable tax liabilities – income tax and Value Added Tax – to be calculated easily
• allow better control of the business, eg debtor control
• allow the partners to see their own financial position with the business better, eg capital accounts and current
accounts
• provide more information to a lender – such as a bank – should the partnership require a bank loan or overdraft
A double-entry system will involve more work than a single-entry system. Thus single-entry is cheaper, easier to
maintain, and requires no special training; however, a double-entry system may reduce or eliminate the fees of an
external accountant and is a more complete system.
3.11 (a)
20-5 20-5
1 Apr Balances b/d 10,000 6,000
20-5 20-5
1 Apr Balance b/d – 1,060 1 Apr Balance b/d 1,550 –
10
3.11 (b) SARA AND SIMON PENNY, TRADING AS ‘CLASS CATERERS’
TRADING AND PROFIT AND LOSS ACCOUNT
FOR THE YEAR ENDED 31 MARCH 20-5
£ £
Sales 44,080
Opening stock 2,850
Purchases 11,300
14,150
Less Closing stock 3,460
Cost of sales 10,690
Gross profit 33,390
Less expenses:
Wages 8,020
Rent and rates 4,090
Sundry expenses 1,500
Provision for depreciation: office equipment 800
14,410
Net profit 18,980
Less appropriation of profit:
Salary: Sara 8,000
Interest allowed on partners’ capitals: Sara 1,000
Simon 600
1,600
9,380
Share of remaining profit:
Sara 4,690
Simon 4,690
9,380
Current Assets
Stock 3,460
Trade debtors 4,500
Bank 8,640
16,600
Less Current Liabilities
Trade creditors 7,200
Accrual of expenses 110
7,310
Net Current Assets 9,290
NET ASSETS 16,490
FINANCED BY
Capital Accounts
Sara 10,000
Simon 6,000
16,000
Current Accounts
Sara 1,550
Simon (1,060)
490
16,490
11
3.12 (a)
Dr Partners' Capital Accounts Cr
A Adams J Beeson A Adams J Beeson
20-5 £ £ 20-4 £ £
30 Jun Balances c/d 30,000 20,000 1 Jul Balances b/d 30,000 20,000
20-5 20-5
1 Jul Balances b/d 30,000 20,000
20-5 20-5
1 Jul Balances b/d 1,209 1,349
12
3.12 (b) continued
BALANCE SHEET AS AT 30 JUNE 20-5
£ £ £
Fixed Assets Cost Provision for depreciation Net book value
Vehicle 12,000 5,250 6,750
Fixtures and fittings 4,000 1,200 2,800
16,000 6,450 9,550
Current Assets
Stock 27,750
Trade debtors 6,850
Less provision for doubtful debts 137
6,713
Prepayment of expenses 250
Bank 22,009
Cash 1,376
58,098
FINANCED BY
Capital Accounts
A Adams 30,000
J Beeson 20,000
50,000
Current Accounts
A Adams 1,209
J Beeson 1,349
2,558
52,558
3.14 (a)
Dr Total Debtors Account* Cr
2006 £ 2006 £
1 Jan Balance b/d 317 Cash received from debtors 44,049
Sales (missing figure) 43,915 31 Dec Balance c/d 183
44,232 44,232
2007 2007
1 Jan Balance b/d 183
* also known as sales ledger control account
(b)
Dr Total Creditors Account** Cr
2006 £ 2006 £
Payments to creditors 195,911 1 Jan Balance b/d 4,872
31 Dec Balance c/d 5,163 Purchases (missing figure) 196,202
201,074 201,074
2007 2007
1 Jan Balance b/d 5,163
** also known as purchases ledger control account
13
3.14 (c) MARTIN AND NASSER, IN PARTNERSHIP
TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006
£ £
Sales – cash 332,467
– credit 43,915
376,382
Opening stock 14,003
Purchases 196,202
210,205
Less Closing stock 13,471
Cost of sales 196,734
Gross profit 179,648
Add income: Rent received (working 1) 6,000
185,648
Less expenses:
Wages (working 2) 63,482
General expenses 56,676
Provision for depreciation:
vehicle (working 3) 8,000
machinery (working 4) 10,000
Loss on sale of machinery (working 5) 800
138,958
Net profit 46,690
Workings:
1. Rent received: £7,000 – £500 owing at 1 Jan – £500 paid in advance at 31 Dec = £6,000
2. Wages: £63,156 – £612 accrued at 1 Jan + £938 accrued at 31 Dec = £63,482
3. Vehicle depreciation: £16,000 valuation at 1 Jan – £8,000 valuation at 31 Dec = £8,000 depreciation for year
4. Machinery depreciation: £147,000 valuation at 1 Jan + £12,000 cost of new machine – £4,000* book value of old
machine now sold – £145,000 valuation at 31 December = £10,000 depreciation for year
* £10,000 cost – £6,000 depreciation
5. Loss on sale of machinery: cost £10,000 – £3,200 part exchange value – £6,000 depreciation = £800 loss on sale
14
3.14 (e)
Dr Partners' Current Accounts Cr
Martin Nasser Martin Nasser
2006 £ £ 2006 £ £
31 Dec Drawings 35,660 26,480 1 Jan Balances b/d 3,210 1,304
31 Dec Interest on drawings 230 100 Salary – 3,000
31 Dec Interest on capital 6,000 4,200
31 Dec Share of profit 20,292 13,528
31 Dec Balances c/d 6,388 4,548
35,890 26,580 35,890 26,580
2007 2007
1 Jan Balances b/d 6,388 4,548
(f) The benefits of maintaining separate capital and current accounts are:
• the capital amount remains fixed except for capital introduced or withdrawn
• the current account is a working account dealing with all aspects of the distribution and drawings of profits
• the distinction between the two accounts shows whether or not partners are maintaining their permanent capital
in the business, while the fluctuating current account shows whether or not partners have withdrawn more profit
from the business than they are earning
• the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy to
calculate
However, it should be pointed out that separate capital and current accounts require more work and are, therefore,
more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions. As to which
is used will depend on the size and complexity of the partnership business.
4.1 (a) • Goodwill can be defined as the difference between the value of a business as a whole, and the net value of its
separate assets and liabilities.
• Goodwill is used when changes are made to partnerships, eg the admission of a new partner or retirement of an
existing partner.
• The principle is that the agreed value of goodwill is shared amongst those partners who created the goodwill, and
is then charged to new partners as a premium for joining an established business.
• It is normal practice not to record goodwill on a partnership balance sheet – this follows the concept of prudence.
15
4.5 (a)
Dr Revaluation Account Cr
20-4 £ 20-4 £
31 Aug Capital accounts: 31 Aug Fixed assets (£74,000 – £50,000) 24,000
Reena (4/8) 12,000
Sam (2/8) 6,000
Tamara (2/8) 6,000
24,000 24,000
Dr Goodwill Account Cr
20-4 £ 20-4 £
31 Aug Capital accounts: 31 Aug Capital accounts:
Reena (4/8) 8,000 Reena (1/2) 8,000
Sam (2/8) 4,000 Tamara (1/2) 8,000
Tamara (2/8) 4,000
16,000 16,000
(b)
BALANCE SHEET OF REENA AND TAMARA AS AT 1 SEPTEMBER 20-4
£
Fixed Assets (£50,000 + £24,000) 74,000
Current Assets 10,000
Bank (£25,000 – £22,000) 3,000
87,000
Trade creditors (10,000)
77,000
Capital Accounts
Reena 45,000
Tamara 32,000
77,000
16
4.7 (a)
Dr Revaluation Account Cr
2007 £ 2007 £
28 Feb Fixed assets (£123,000 – £120,000) 3,000 28 Feb Capital accounts:
Ibrahim (3/6) 1,500
Joan (2/6) 1,000
Kelly (1/6) 500
3,000 3,000
Dr Goodwill Account Cr
2007 £ 2007 £
28 Feb Capital accounts: 28 Feb Capital accounts:
Ibrahim (3/6) 37,500 Ibrahim (3/5) 45,000
Joan (2/6) 25,000 Kelly (2/5) 30,000
Kelly (1/6) 12,500
75,000 75,000
(b)
Dr Bank Account Cr
2007 £ 2007 £
28 Feb Balance c/d 72,058 28 Feb Balance b/d 4,590
28 Feb Joan: loan account 15,000
28 Feb Joan: capital account 52,468
72,058 72,058
17
4.9 (a)
JEAN AND DAVID, IN PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 20-4
(b)
Dr Partners' Current Accounts Cr
Jean David Jean David
20-4 £ £ 20-4 £ £
1 Jan Balance b/d – 1,250 1 Jan Balance b/d 2,400 –
31 Dec Drawings 18,600 14,200 31 Dec Salaries 12,000 10,000
31 Dec Balance c/d 1,900 – 31 Dec Interest on capital 500 600
31 Dec Share of profit 5,600 4,000
31 Dec Balance c/d – 850
20,500 15,450 20,500 15,450
20-5 20-5
1 Jan Balance b/d – 850 1 Jan Balance b/d 1,900 –
18
Dr Goodwill Account Cr
2006 £ 2006 £
30 Jun Capital accounts: 1 Jul Capital accounts:
Daniel (1/2) 30,000 Daniel (1/2) 30,000
Freda (1/2) 30,000 Freda (1/3) 20,000
Helen (1/6) 10,000
60,000 60,000
(d)
DANIEL, FREDA AND HELEN, IN PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006
19
4.10 (e)
Dr Partners' Current Accounts Cr
Daniel Freda Helen Daniel Freda Helen
2006 £ £ £ 2006 £ £ £
31 Dec Drawings 41,000 35,000 12,000 31 Dec Salary – – 2,500
31 Dec Interest on drawings 250 80 160 31 Dec Interest on capital 1,500 1,890 1,200
31 Dec Balances c/d 1,950 2,110 – 31 Dec Share of profit 41,700 35,300 6,400
31 Dec Balance c/d – – 2,060
43,200 37,190 12,160 43,200 37,190 12,160
2007 2007
1 Jan Balance b/d – – 2,060 1 Jan Balances b/d 1,950 2,110 –
(f) The benefits of maintaining separate capital and current accounts are:
• the capital amount remains fixed except for capital introduced or withdrawn, and any subsequent capital
transactions such as revaluations and adjustments for goodwill
• the current account is a working account dealing with all aspects of the distribution and drawings of profits
• the distinction between the two accounts shows whether or not partners are maintaining their permanent capital
in the business, while the fluctuating current account shows whether or not partners have withdrawn more profit
from the business than they are earning
• the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy to
calculate
However, it should be pointed out that separate capital and current accounts require more work and are, therefore,
more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions.
The decision to keep separate capital and current accounts is justified in this partnership in view of the complexity of
partners’ transactions.
4.14 (a)
ALI, BAMBI AND CHARLIE: PROFIT OR LOSS ON DISSOLUTION
£
Net book value of assets (excluding bank) 82,020
Less liabilities 23,420
58,600
Business sold to Daphne 40,000
Loss on dissolution 18,600
Capital accounts:
Ali (3/6) 9,300
Bambi (2/6) 6,200
Charlie (1/6) 3,100
18,600
20
4.14 (b)
Dr Partners' Capital Accounts Cr
Ali Bambi Charlie Ali Bambi Charlie
2006 £ £ £ 2006 £ £ £
31 Dec Current account 4,700 31 Dec Balances b/d 40,000 10,000 10,000
31 Dec Share of loss 9,300 6,200 3,100 31 Dec Current accounts 1,700 – 2,300
31 Dec Bambi 720 – 180 31 Dec Ali 720
31 Dec Bank 31,680 – 9,020 31 Dec Charlie 180
41,700 10,900 12,300 41,700 10,900 12,300
Tutorial notes:
• Upon dissolution the capital account of Bambi has a deficit of £900.
• As Bambi is unable to meet this liability, the rule in Garner v Murray applies, and the amount must be paid by Ali and
Charlie in the ratio of their last agreed capital balances, ie Ali £40,000 and Charlie £10,000.
• Thus Ali will pay £720 and Charlie £180.
• The amounts paid to Ali and Charlie from the bank are £31,680 + £9,020 = £40,700; this is the £40,000 paid by
Daphne plus £700 bank balance from the partnership balance sheet.
5.1 The report and accounts – or corporate report – of a public limited company is available to every shareholder and contains
the main elements of financial statements:
• income statement (also known as a ‘statement of comprehensive income’)
• balance sheet (also known as a ‘statement of financial position’)
• cash flow statement
• statement of changes in equity
• notes to the financial statements, including a statement of the company’s accounting policies
• directors’ report
• auditors’ report
5.3 • The directors are responsible for ensuring that the provisions of the Companies Acts 1985 and 2006 which relate to
accounting records and statements are followed.
• In particular the company’s accounting records must:
– show and explain the company’s transactions
– disclose with reasonable accuracy at any time the financial position of the company
– enable the directors to ensure that the company’s income statement and balance sheet give a true and fair
view of the company’s financial position
• A company’s accounting records must contain:
– day-to-day entries of money received and paid, together with details of the transactions
– a record of the company’s assets and liabilities
– details of inventories held at the end of the year
• A company’s financial statements must be prepared in accordance with the Companies Acts and with either UK
accounting standards or international accounting standards.
• The directors must report annually to the shareholders on the way that they have run the company on behalf of the
shareholders.
• Every company director has a responsibility to ensure that the statutory accounts are produced and filed with the
Registrar of Companies.
• The annual accounts must be approved by the company’s board of directors and the copy of the balance sheet filed
with the Registrar of Companies must be signed by one of the directors on behalf of the board.
21
• The directors must prepare a directors report – this must be approved by the board (and the copy to be filed with the
Registrar of Companies signed on behalf of the board by a director, or the company secretary).
• The statutory accounts must be laid before the company at the annual general meeting (and they must be circulated
beforehand to shareholders, debenture holders and any other persons entitled to attend the meeting).
5.6 (a) The published income statement of a limited company does not have to detail every single overhead or expense
incurred. However, IAS 1, Presentation of Financial Statements, requires that certain items must be detailed on the
face of the income statement, including:
• revenue
• finance costs
• tax expense
IAS 1 states that further detail may be needed to give information relevant to an understanding of financial
performance.
The income statement concludes by showing the profit or loss for the period attributable to equity holders.
(b) Retained earnings are profits that have been retained in the company. They belong to the shareholders, but are
represented by assets in the balance sheet and are not a cash balance at the bank available to build a new warehouse
for the company.
(c) Equity is the stake of the ordinary shareholders in the company. It comprises ordinary share capital, plus capital and
revenue reserves.
Non-current liabilities are those liabilities that are due to be repaid more than twelve months from the date of the
balance sheet. Examples include loans and debentures.
22
5.10 This answer may be set out either vertically or horizontally.
23
5.14 (a) Shareholders
They will almost certainly get a dividend; profits are up which is better for dividends and for ploughing back to yield
future dividends; plans for growth will save the company from stagnating.
(c) Employees
The profits mean they are put into a better bargaining position for a pay rise. Employees may also be in a company
share scheme, so a prosperous company will make their shares worth more. The future growth of the company should
mean that their jobs are safe.
5.16
MITHIAN PLC
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-2
£ £
Revenue 2,640,300
Opening inventories 318,500
Purchases 2,089,600
2,408,100
Less Closing inventories 340,600
Cost of sales (2,067,500)
Gross profit 572,800
Overheads:
Distribution expenses (216,320)
Administrative expenses (note 1) (229,080)
(445,400)
Profit/(loss) from operations 127,400
Finance costs (20,000)
Profit/(loss) before tax 107,400
Tax (30,000)
Profit/(loss) for the year attributable to equity holders 77,400
24
MITHIAN PLC
BALANCE SHEET AS AT 31 DECEMBER 20-2
Current Assets
Inventories 340,600
Trade receivables 415,800
Cash and cash equivalents 20,640
777,040
Total assets 1,018,900
Current Liabilities
Trade payables (428,250)
Tax liabilities (30,000)
(458,250)
Net Current Assets 318,790
*560,650
Non-current Liabilities
10% loan stock (200,000)
Total liabilities 658,250
Net Assets 360,650
EQUITY
Issued Share Capital
Ordinary shares of £1 each 200,000
Capital Reserves
Share premium account 40,000
Revenue Reserve
Retained earnings 120,650
TOTAL EQUITY 360,650
Working note 1 £
Administrative expenses 220,180
Bad debts 8,900
229,080
25
CHAPTER 6 Cash flow statements
6.2 Depreciation is added back to profit from operations because depreciation is a non-cash expense, ie no money is paid out
by the business in respect of depreciation charged to the income statement. Thus profit added back to depreciation gives the
amount of cash generated by the trading activities of business: this, together with the changes in net current asset items
(except for cash/bank) and adjustments for any profits/losses on sales of non-current assets, forms the operating activities
section of the cash flow statement.
6.5 Points when assessing the cash flow statement of a company include:
• reasonable cash flow from operating activities
• link changes in net current asset items of inventories, trade receivables and trade payables to changes in profit from
operations – is there a strain on the liquidity of the company?
• link purchase/sale of non-current assets to context of company – expanding or declining?
• where finance has been raised through increases in loans/shares, look to see how the cash has been used – to
finance new non-current assets, or to finance inventories and trade receivables, or other purposes?
• look at change in cash/bank in relation to profit/loss from operations – is the company generating cash?
26
(b) (i) managers
• a cash flow statement highlights information not available from the income statement and balance sheet
• it shows clearly sources and uses of cash over the year
• it shows cash available at the year end for future developments
• it aids decision-making and development of the company
(ii) shareholders
• a cash flow statement demonstrates the ability of the company to generate cash from operating activities
• it shows the liquidity of the business
• it shows clearly the sources and uses of cash over the year
• it shows the investment of the company in capital expenditure
• it shows the amount of dividends paid to shareholders
6.10 (a)
ADAGIO PLC
RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES
£000
Profit/(loss) from operations (2,127)
Adjustments for:
Depreciation for year 3,490
Loss on disposal of non-current assets 58
Decrease in inventories 48
Decrease in trade receivables 986
Decrease in trade payables (1,787)
Cash from operations 668
Interest paid (–)
Income taxes paid (278)
Net cash (used in)/from operating activities 390
(b)
ADAGIO PLC
DRAFT CASH FLOW STATEMENT FOR THE YEAR ENDED 30 APRIL 2004
£000 £000
Net cash from operating activities 390
Cash flows from investing activities
Purchase of non-current assets (1,795)
Proceeds from sale of non-current assets 818
(977)
Cash flows from financing activities
Dividends paid (299)
Net decrease in cash and cash equivalents (886)
27
(c) Using a cash flow statement to judge the financial performance of a company
• The cash flow statement focuses on cash inflows and cash outflows. It concentrates on the liquidity of the
business – it is often a lack of cash that causes most businesses to fail.
• Cash is often described as the ‘life blood’ of a business.
• The cash flow statement uses the money measurement concept – only items which can be recorded in money
terms can be included. This makes it difficult to manipulate, and cash can be seen as an accurate measure of
business success or failure.
This contrasts with the income statement where judgement has to be made about items such as:
– recognition of sales/revenue
– the distinction between capital and revenue expenditure
– depreciation methods and policies
• The cash flow statement shows:
– the cash from operations after interest and tax have been paid
– the investing activities of the business, eg the purchase of non-current assets
– the financing activities of the business, eg an increase/decrease in loans/share capital
• The cash flow statement links profit with changes in cash. Both of these are important: without profit, the
company cannot generate cash (unless it sells non-current assets), and without cash it cannot pay bills as they
fall due.
• The cash flow statement is important in judging financial performance because of its emphasis on:
– liquidity and solvency
– investment in assets
– financing methods
6.11 (a)
HALLS-KROSBY PLC
RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES
£000
Profit from operations 573
Adjustments for:
Depreciation for year 206
Loss on sale of non-current assets (machinery) 18
Increase in inventory (230)
Increase in trade receivables (62)
Decrease in trade payables (46)
Cash from operations 459
Interest paid (–)
Income taxes paid (–)
Net cash (used in)/from operating activities 459
(b) Changes made to original reconciliation statement (question asks for an explanation of three of the changes):
• Depreciation is non-cash and is added back to profit from operations in the cash flow statement.
• Loss on sale of machinery is non-cash and is also added back to profit from operations.
• Receipts from sale of machinery is shown as a receipt in the investing activities section of the cash flow
statement.
• Dividends paid – both ordinary and preference – are shown as payments in the financing activities section of
the cash flow statement.
• Share premium receipts are included with the proceeds of the ordinary share issue in the financing activities
section of the cash flow statement.
28
6.15 (a)
KALSI PLC
RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES
£000
Profit from operations 237
Adjustments for:
Depreciation for year 275
Gain on sale of non-current assets (2)
Increase in inventories (210–200) (10)
Increase in trade receivables (390–250) (140)
Decrease in trade payables (150–160) (10)
Cash generated from operations 350
Interest paid (20)
Income taxes paid (21)
Net cash (used in)/from operating activities 309
(b)
KALSI PLC
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 20-5
£000 £000
Net cash (used in)/from operating activities 309
Cash flows from investing activities
Purchase of non-current assets (110)
Proceeds from sale of non-current assets1 7
Net cash (used in)/from investing activities (103)
Cash flows from financing activities
Proceeds from issue of share capital (40–25) 15
Proceeds from long-term borrowings (200-100) 100
Repayment of debentures (500)
Dividends paid (30)
Net cash (used in)/from financing activities (415)
Net increase/(decrease) in cash and cash equivalents (209)
Cash and cash equivalents at beginning of year 10
Cash and cash equivalents at end of year (199)
Working note
1 Proceeds from sale of non-current assets
Non-current Assets
£ £
Non-current assets (cost) 10,000 Accumulated depreciation 5,000
Gain on sale 2,000 Proceeds (bal fig) 7,000
12,000 12,000
29
(c) From the point of view of the company’s shareholders, the following points are highlighted by the cash flow statement
of Kalsi plc for the year ended 31 March 20-5:
• an excellent cash flow has been generated from operations, £350,000, which is well above the amounts paid
for tax, £21,000, and dividends, £30,000
• There have been increases in inventories and trade receivables – the increase of £140,000 in the latter seems
very large and might indicate that the company is having to offer extended terms to its customers in order to
maintain sales; there has been a small decrease in trade payables
• new non-current assets of £110,000 have been bought – an indication that the company is re-equipping for the
future
• debentures of £500,000 have been repaid – financed mainly from profits and an increased long-term loan of
£100,000; the company’s gearing has reduced and it seems that this is a short/medium-term aim of the
company
• the reduction in borrowed funds will reduce the amount of interest to be paid in future years
• a small share issue has taken place during the year
• the bank balance – cash and cash equivalents – has fallen during the year from a credit balance of £10,000
to an overdraft of £199,000
Conclusion:
The cash flow statement shows that Kalsi plc is a highly profitable company which generates a good cash flow from
operations. There has been an expansion of net current assets but shareholders may be concerned to note the
increase of £140,000 in trade receivables. The debentures have been repaid – partly from profits which explains the
significant fall in cash and cash equivalents. New non-current assets of £110,000 have been purchased. Overall, it
seems that the company is reorganising its financing so as to reduce its reliance on borrowed funds, while at the same
time seeking to develop in the future.
For shareholders, they should hold their existing shares and should consider increasing their holdings as profits and
dividends seem likely to increase in the future.
7.2 Accounting principles are the broad concepts that are applied in the preparation of financial statements.
Examples: going concern, accruals, consistency.
Accounting bases are the methods used for applying accounting principles to financial statements, and are intended to
reduce subjectivity by identifying the acceptable methods.
Example: the use of historic cost or revaluation to value assets.
Accounting policies are the specific principles, bases, conventions, rules and practices applied in the preparation and
presentation of financial statements.
Examples: the use of straight-line or diminishing (reducing) balance method of depreciation for non-current assets.
7.3 (a) IAS 16, Property, Plant and Equipment, defines depreciation as the systematic allocation of the depreciable amount
of an asset over its useful life. (Depreciable amount is the cost or valuation of the asset, less any residual value.)
(b) • IAS 16 states that, initially, PPE are to be measured (recorded) at cost in the balance sheet.
• After acquisition of PPE a company must choose either the cost model or the revaluation model as its
accounting policy – which is then applied to an entire class of PPE.
• Using the cost model, assets are shown in the balance sheet at cost less accumulated depreciation and
impairment losses.
• Using the revaluation model, assets are shown at a revalued amount, being fair value less subsequent
depreciation and impairment losses; revaluations are to be made regularly to ensure that the revalued amounts
do not differ materially from fair values at the balance sheet date.
• Depreciation is to be charged on all non-current assets – with the exception of freehold land, which is shown
at cost.
• Depreciation methods include the straight-line and the diminishing (reducing) balance methods.
30
• A company chooses the depreciation method which best reflects the way in which the asset’s economic
benefits are consumed.
• The depreciation method should be reviewed at least annually in order to consider if the method used is still
the most appropriate one.
STEP 3 If an asset’s carrying amount is greater than its recoverable amount, then the asset is impaired and
should be written down to its recoverable amount.
Terms used:
Carrying amount is the amount at which an asset is recognised after deducting any accumulated
depreciation/amortisation and accumulated impairment losses.
Recoverable amount is the higher of the asset’s
• fair value, less any costs that would be incurred were it to be sold
• its value in use.
Fair value, less costs to sell is the amount at which an asset could be sold for, less any selling costs.
Value in use is the present value of the future cash flows from an asset’s continued use, including cash from its final
sale.
(b) When an asset is impaired it should be written down to its recoverable amount in the balance sheet. The amount of
the impairment loss is shown as an expense in the income statement.
(c) The fork lift truck is impaired: its carrying amount is £20,000 but its recoverable amount is £19,000 (the higher of fair
value less costs to sell of £18,000, and value in use of £19,000). Accordingly, an impairment loss of £1,000 should be
shown as an expense in the income statement.
7.7 The overriding principle of inventory valuation is that inventories should be valued at ‘the lower of cost and net realisable
value’.
Thus two different inventory values are compared:
• cost, which means the purchase price, plus any other costs incurred to bring the product (or service) to its present location
and condition
• net realisable value, which is the estimated selling price less the estimated costs to get the product into a condition
necessary to complete the sale
The lower of these two values is taken, and different items or groups of inventory are compared separately.
31
7.12 (a) Although the selling of the inventory (stock) is an event which happened after the year end, under IAS 10, Events after
the Reporting Period, this is an example of an adjusting event. Such events provide evidence of conditions that
existed at the end of the reporting period; if the amount involved is material, then the amount shown in the financial
statements should be changed. The sale of inventory provides evidence as to the net realisable value of the inventory
reported in the financial statements for the year under review. Under IAS 2, Inventories, inventories are to be valued
at the lower of cost and net realisable value.
(b) A dividend declared or proposed on ordinary shares after the balance sheet date is, under IAS 10, an example of a
non-adjusting event. Such events are conditions that arose after the reporting period; no adjustment is made to the
financial statements – if such events are material, then they are disclosed by way of notes to the accounts. The notes
would explain the nature of the event and, if possible, give the likely financial consequences of the event. The
proposed ordinary dividend cannot be recorded as a liability at 30 September 20-6 as it was not a present obligation
of the company at the financial year end. The details of the proposed dividend will be given in the notes to the financial
statements, including the amount of £75,000.
(c) Under IAS 10, this is an example of a non-adjusting event after the reporting period. Although the employee was
working for Gernroder Limited at the financial year end, the legal proceedings do not relate to conditions that existed
at the end of the reporting period. Instead, the legal proceedings are conditions that arose after the reporting period
and no adjustment is to be made to the financial statements. The amount of £20,000, if material, is to be disclosed by
way of a note which explains the nature of the event and the likely financial consequences of the event.
2 IAS 2, Inventories
Cost is £100,000; net realisable value is £160,000.
Inventories (stocks) are to be valued at ‘the lower of cost and net realisable value’. Therefore this stock should be
recognised as an asset at £100,000 and recorded in the financial statements.
7.15 (a) IAS 2 states that inventories must be valued at the lower of cost and net realisable value.
Cost means the purchase price plus any other costs incurred to bring the product (or service) to its present location
and condition.
Net realisable value is the estimated selling price less the estimated costs to get the product into a condition
necessary to complete the sale.
The lower of these two values is taken, and different items or groups of inventory are compared separately.
(b) 1 This situation – where a customer, who owes money at the balance sheet date, subsequently goes into
liquidation – is covered by IAS 10, Events after the Reporting Period. Adjusting events provide evidence of
conditions that existed at the end of the reporting period. If the amount is material, then the amount shown in
the financial statements should be changed. In this case, the amount of £30,000 needs to be written off as a
bad debt. The book-keeping entries are:
DEBIT Bad debts written off £30,000
CREDIT Trade receivables £30,000
2 The situation described here is covered by IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
A contingent asset is a possible asset arising from past events whose existence will be confirmed only by
uncertain future events not wholly within the control of the company.
It follows from the above definition that the probable inflow of £25,000 from the legal suit is a contingent asset.
IAS 37 states that if a contingent asset is probable, it should be disclosed by way of a note in the financial
statements. It cannot be recognised in the financial statements because it would not be prudent to recognise
income that may never be realised.
32
7.16 (a) 1 IAS 38, Intangible Assets
2 IAS 38, Intangible Assets
3 IAS 16, Property, Plant and Equipment
4 IAS 18, Provisions, Contingent Liabilities and Contingent Assets
5 IAS 2, Inventories
33
(d) Although accounting standards are not laws – ie they are non-statutory – any limited company that fails to apply them
would cast serious doubts on the reliability of its financial statements. It is one of the duties of directors to ensure that
a company’s financial statements are prepared in accordance with the Companies Acts and with accounting
standards. At the same time, the auditors’ report must state whether or not the financial statements have been
prepared in accordance with company law and accounting standards: if they have not, the auditors’ report will be
qualified.
The reasons for using international accounting standards are:
• to provide a framework for preparing and presenting financial statements – the ‘rules’ of accounting
• to ensure that accountants follow the same set of rules
• to reduce the number of different accounting treatments and so make ‘window dressing’ more difficult
• to meet with the duty of the directors to ensure that financial statements comply with accounting standards
• to meet with the auditors’ report requirement to state that the financial statements have been prepared in
accordance with accounting standards
The benefits of international accounting standards are:
• to standardise financial statements internationally – thus a company operating in several countries knows that
the same accounting rules have been applied to all parts of its business
• to reduce the variations of accounting treatments used in financial statements – thus making ‘window dressing’
the accounts more difficult
• to allow users of financial statements to make inter-firm comparisons in the knowledge that all the financial
statements have been prepared using the same standards.
8.3
34
8.4 (a)
35
8.5 (a)
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 20 3.00 60.00 20 3.00 60.00
(b)
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 20 3.00 60.00 20 3.00 60.00
36
8.6 (a)
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 100 4.00 400.00 100 4.00 400.00
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 100 4.00 400.00 100 4.00 400.00
37
(b)
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 200 10.00 2,000.00 200 10.00 2,000.00
20-7 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
Jan 200 10.00 2,000.00 200 10.00 2,000.00
38
Valuation at 30 June 20-7:
£
Product Jay 727.30 (cost price, using FIFO)
Product Kay 1,950.00 (net realisable value)
2,677.30
8.10 (a) Tutorial note: This part of the question requires a calculation of the value of closing stock at 30 April 2007. For clarity,
the answer below is set out in the form of a stores ledger record; however, it can be answered instead by means of
a calculation.
2007 Quantity Cost Total Quantity Cost Total Quantity Cost Total
Cost Cost Cost
£ £ £ £ £ £
1 Apr Balance 1 17,700 17,700
(b) • FIFO will give him a closing stock valuation of £36,800 (2 x £18,400). This higher closing stock under FIFO will
give him a higher profit of £250. This could be an advantage if he is thinking of selling the business in the near
future; the disadvantage is that he will pay more tax.
• However, any change in profit will be only temporary as, over the life of his business, total profits will be the
same under both methods, and there will be no effect on the cash generated by the business.
• The FIFO method is logical and relatively easy to calculate; however, for the low number of items that Tom has
in stock, AVCO is not difficult to calculate.
• To meet the accounting concept of consistency, if he changes to FIFO he will need to adjust his financial
statements to show comparability.
• Both FIFO and AVCO are acceptable for tax purposes and under IAS 2.
Conclusion
Tom is currently using AVCO which, for the low number of items that he has in stock, is relatively easy to calculate.
Although his profits will be higher under FIFO when prices are rising, there will be no effect on the cash generated by
the business. All-in-all, there do not appear to be compelling reasons to make the change.
39
8.12 (a) A stock-take is carried out regularly to check that the quantity of stock held is the same as that recorded in the stock
records. This is done by counting the physical stock on hand against the balance shown by the records, and to identify
any theft or deterioration.
A stock-take is carried out on either a periodic basis or continuously.
(b) Stock reconciliation is the process of comparing the stock-take and the stock record. This process is important
because:
– an accurate stock figure can then be used to value the stock
– it will highlight any discrepancies which can then be investigated
(c) Stock number 146: as the discrepancy here is a small shortfall in the physical stock compared with the stock record,
ie £2 x 2 units = £4, the likely action to be taken by the company accountant will be to authorise the discrepancy for
write-off.
Stock number 523: this is a larger discrepancy, ie £200 x 10 units = £2,000 and needs to be investigated to see if it
has been caused by:
– an error on the stock record
– theft of stock
– damaged stock being disposed of without any record having been made
40
(b) MALCOLM PLC
PROFIT AND LOSS ACCOUNT EXTRACT FOR THE YEAR ENDED 31 DECEMBER 2008
£
Factory gross profit 170,000
Less Increase in provision for unrealised profit 4,000 – 4,800 800
Adjusted factory gross profit 169,200
MALCOLM PLC
BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2008
£
Current asset
Stock of finished goods 24,000
Less Provision for unrealised profit 4,800
Adjusted stock of finished goods 19,200
(c) The amount of the adjustment to the provision for unrealised profit to be shown in the profit and loss account is £6,000.
Workings:
192 x 20/120 = 32
156 x 20/120 = 26
(d) The amount of the adjustment is shown as a deduction from factory profit shown in the profit and loss account.
41
(e) BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2002
£000 £000
Current Assets
Stock – raw materials 75
– work-in-progress 36
– finished goods 192
– less provision for unrealised profit 32
adjusted stock of finished goods 160
271
(c) Provision for unrealised profit is made to reduce the closing stock value of finished goods to cost price. This enables
the balance sheet valuation to comply with IAS 2, Inventories, and the concept of prudence.
* Rates: £6,400 – £400 prepaid = £6,000, apportioned three-quarters to factory, £4,500, and one-quarter to office, £1,500
** Factory machinery depreciation: £400,000 x 10%
42
(b) Closing stock at 31 December 2006:
£
£25,600 x 25 = 5,120
100 + 25
Less provision for unrealised profit 4,700
Increase in provision for unrealised profit 420
(c) £ £
Gross profit on trading 312,400
Factory profit 225,000
Less increase in provision for unrealised profit 420
224,580
Total gross profit 536,980
£27,804 x 20 = 4,634
100 + 20
43
(c) SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005
£ £
Gross profit 570,944
Less Administrative expenses 478,221
Profit from trading 92,723
Factory profit **144,000
Less increase in provision for unrealised profit 662
143,338
Net profit 236,061
** £720,000 x 20%
(ii) S H MATT
BALANCE SHEET EXTRACT AS AT 31 MARCH 2008
£ £
Current Assets
Stock – raw materials 10,980
– work-in-progress 9,946
– finished goods 31,906
less provision for unrealised profit 9,116
adjusted stock of finished goods 22,790
43,716
(b) £
Provision for unrealised profit at 31 March 2008 9,116
Provision for unrealised profit at 31 March 2007 8,536
Increase in provision for unrealised profit 580
In profit and loss account the increase is deducted from the factory profit in order to remove the profit element from
stock so that profit is not overstated.
(c) Any two reasons for transferring goods to the trading account at cost plus a profit:
• Enables the factory to make a notional profit which is added into net profit at a later stage.
• Gives the unit cost of goods manufactured a more realistic value which can be compared with the cost of buying
in completed goods from an outside source.
• By showing a factory profit, the profit from trading activities can be identified separately.
• The factory and the warehouse become separate profit centres which show the contribution of each to the overall
profitability of the business.
44
10.5 The following are example figures; each student’s solution will be different.
(a) Fixed costs: Advertising £200
Room hire £150
Speakers £350
£700
(c) If price charged per delegate is £80, then contribution will be £80 – £25 = £55 per delegate
(d) £
course fees £80 x 30 people 2,400
less variable costs £25 x 30 people 750
equals total contribution 1,650
less fixed costs 700
equals profit for event 950
(b) (i) Contribution per unit before the proposed purchase of the machinery:
£
selling price (per parachute) 44
less variable costs £10 + £16 + £8 34
equals contribution (per parachute) 10
45
(ii) Contribution after the proposed purchase of the machinery: £
materials 10.00
labour £9 per hour x 1.5 hours 13.50
other variable costs 8.00
variable costs per parachute 31.50
Tutorial note:
The increase in profits of £23,000 (£109,000 – £86,000) can also be calculated by reference to the increase in
contribution, as follows:
£
increase in contribution £2.50* x 22,000 parachutes 55,000
less retraining costs 32,000
equals increased profits 23,000
10.10 (a) • Direct costs can be identified directly with each unit of output.
• Indirect costs (overheads) cannot be identified directly with specific units of output.
46
(c) Marginal costing statement £ £
sales £20 x 5,000 compasses 100,000
less variable costs:
direct labour 23,000
direct materials 35,000
other direct costs 9,000
67,000
equals total contribution 33,000
less fixed costs 12,000
equals profit for the period 21,000
11.1
units of fixed costs variable costs total cost sales profit/(loss)*
output revenue
£ £ £ £ £
0 7,500 0 7,500 0 (7,500)
500 7,500 2,500 10,000 5,000 (5,000)
1,000 7,500 5,000 12,500 10,000 (2,500)
1,500 7,500 7,500 15,000 15,000 nil
2,000 7,500 10,000 17,500 20,000 2,500
2,500 7,500 12,500 20,000 25,000 5,000
3,000 7,500 15,000 22,500 30,000 7,500
47
11.4 (a) • contribution sales ratio
contribution (£) = £15* = 0.6 or 60%
selling price (£) £25
* selling price £25 – variable cost £10
48
• forecast profit at maximum output of 40,000 units
£
sales revenue (at £20 each) 800,000
less variable costs (at £10 each) 400,000
equals contribution (to fixed costs and profit) 400,000
less monthly fixed costs 300,000
equals forecast profit for month 100,000
EMAIL
To: General Manager
From: A2 Student
Date: Today
Report
• As can be seen from the workings at current levels of output of 30,000 units per month:
– contribution sales ratio is 60%
– break-even point is 20,000 units
– margin of safety is 33.3%
– forecast profit is £150,000 per month
• If the manager’s suggestion is adopted sales will increase to our maximum output of 40,000
units per month; this will give us:
– contribution sales ratio of 50%
– break-even point of 30,000 units
– margin of safety of 25%
– forecast profit of £100,000 per month
Conclusion
• From the data summarised above it can be seen that the manager’s suggestion would
reduce our contribution sales ratio, increase the break-even point, and reduce the margin of
safety. All of these are all movements in the wrong direction.
• The main point to note is that forecast profit will fall by £50,000 per month to £100,000 per
month, and the volume of output will need to be higher.
• Although the firm would be working at maximum output if the suggestion is adopted, this
does mean that there is no scope to increase output and sales in the future without major
changes to our cost structure. We would not be able to meet requests for additional sales
from our existing customers, and this could cause them to seek all of their supplies from our
competitors.
• For these reasons, it is recommended that the manager’s suggestion is not undertaken.
49
11.5 (a)
Fixed costs Variable costs per
£ unit in pence
Wages 20
Raw materials 30
Salespeople’s wages 10
Administration costs 42,000
Business rates 20,400
Total £62,400 60p
(b) (i) Contribution per unit = selling price per unit – variable costs per unit
(ii) Contribution per unit = £1.00 – £0.60 = £0.40
(iii) Contribution goes, firstly, towards fixed costs and, when they have been covered, secondly, contributes to profit
11.8 (a) A = margin of safety, between 3,500 and 6,000 carpets, ie 2,500 carpets
B = area of loss
C = profit at maximum capacity of 6,000 carpets
D = sales value and total costs, £25,000, at break-even point
(b) Disadvantage of using a break-even graph to identify the break-even point, one from:
• the assumption is made that all output is sold
• the presumption is made that there is only one product
• all costs and revenues are expressed in straight lines
• it is not possible to extrapolate the graph
• the profit or loss shown by the graph is probably only true for figures close to current output levels
• external factors are not considered
11.9 (a) Marginal cost is the cost of producing one extra unit of output.
(c) Marginal cost x 1.2 = £21.00 x 1.2 = £25.20 selling price per unit
50
(d) Break-even in units:
fixed costs (£) = £52,500 = 12,500 units
contribution per unit (£) £25.20 – £21.00
Break-even revenue:
break-even units x selling price per unit = 12,500 units x £25.20 = £315,000
51
CHAPTER 12 Absorption and activity based costing
12.1 (a) • cost units – units of output to which costs can be charged
• cost centres – sections of a business to which costs can be charged
(b) Suggestions to include:
COST UNIT COST CENTRE
• firm of accountants client hour partner in firm
tax department
administration
52
• COOK-IT LIMITED
PROFIT STATEMENT: 10,000 BARBECUES
£ £
Sales (10,000 x £90) 900,000
Direct materials (10,000 x £30) 300,000
Direct labour (10,000 x £25) 250,000
PRIME COST 550,000
Overheads (fixed) 150,000
TOTAL COST 700,000
PROFIT 200,000
12.6 (a)
ACTIVTOYS LIMITED
PROFIT STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-1
53
12.7 (a)
DURNING LIMITED
PROFIT STATEMENT FOR THE MONTH ENDED 30 APRIL 20-4
Working notes:
Closing stock is calculated on the basis of this year’s costs:
marginal costing, variable costs only, ie £0.80 + £1.60 = £2.40 per unit x 2,000 units = £4,800
absorption costing, variable and fixed costs, ie £34,000 ÷ 10,000 units = £3.40 per unit x 2,000 units = £6,800
(b) The difference in the profit figures is caused only by the closing stock figures: £4,800 under marginal costing, and
£6,800 under absorption costing. With marginal costing, the full amount of the fixed production overheads has been
charged in this year’s profit statement; by contrast, under absorption costing, part of the fixed production overheads
(here £10,000 x 20%* = £2,000) has been carried forward in the stock valuation.
* 2,000 units in stock out of 10,000 units manufactured
54
(c) • Using absorption costing, budgeted net profit for June is £75,000 which is £15,000 higher than the £60,000
profit using marginal costing.
• With marginal costing, the full amount of fixed production costs of £930,000 has been charged in this month’s
profit statement; by contrast, with absorption costing, part of the fixed production costs (here, £7.50 x 2,000
units = £15,000) has been carried forward to next month in the stock valuation.
• Profit will always be higher under absorption costing in accounting periods of increasing stock levels.
• However, a higher profit does not mean more money in the bank and, over the longer term, profit is the same
under both methods.
• Under IAS 2, Inventories, Jayne Bonde plc must use absorption costing for its stock valuation, based on the
costs of direct materials, direct labour, direct expenses (if any), and production overheads. Note that non-
production overheads are charged in full to the profit statement to which they relate.
• It seems unlikely that there will be any effect on the shareholders as marginal costing cannot be used for stock
valuation purposes in published accounts.
12.11 (a) Activity based costing is a costing method which charges overheads to output on the basis of activities. The cost per
unit of a product can be calculated based on its use of activities.
The steps to applying activity based costing are:
1. The overhead costs which are incurred by the same activity are grouped together in cost pools, eg the costs
of purchasing goods to be used in production.
2. The cost driver – the factor which influences the costs – is then identified, and the rate for each cost is
calculated, eg the cost of placing a purchase order for goods to be used in production.
3. The rate for each cost is charged to production, based on the use of the activity, eg if a product requires two
purchase orders to be placed, it will be charged with the cost of two activities.
(b) • Today’s capital intensive, low-labour industries are very different from older industries which are labour
intensive, or where production requires the use of heavy machinery. Traditionally, older industries have
charged overheads to output on the basis of direct labour hours, or machine hours. Such methods are not
appropriate for modern, complex methods of production.
• In capital-intensive industries, overheads often form a high proportion of total costs and are complex in nature.
They need to be accounted for in a more sophisticated way than would be the case under absorption costing,
eg absorbing overhead costs under one basis – such as direct labour hours – does not acknowledge the
complex nature of the overheads and production processes.
• Often modern flexible manufacturing methods require short production runs, with the ability to switch from one
product to another at short notice. This is in contrast to older industries where the same product is produced
over a long production run. These differing production methods impact on costs such as setting up equipment,
which will be much larger per unit of output for small production runs than for large ones. Activity based costing
is able to charge the cost of overheads to output on the basis of activities – something which absorption costing
would not do.
12.13 (a) calculation of weekly overheads for set ups and quality inspections
£ £
set ups: product Aye 5 x £250 1,250
product Bee 50 x £250 12,500
13,750
quality inspection: product Aye 5 x £150 750
product Bee 50 x £150 7,500
8,250
TOTAL 22,000
At present the weekly overheads are charged on the basis of labour hours:
£
product Aye (500 hours) 11,000
product Bee (500 hours) 11,000
TOTAL 22,000
55
(b) activity based costing:
£ £
product Aye
5 set ups at £250 1,250
5 quality inspections £150 750
2,000
product Bee
50 set ups at £250 12,500
50 quality inspections £150 7,500
20,000
TOTAL 22,000
(c) • By using activity based costing, there is a more accurate reflection of the cost of the activities of set up and
quality inspection.
• The cost of 50,000 units of product Aye is reduced by £9,000 (ie £11,000 – £2,000), while the cost of 50,000
units of product Bee is increased by £9,000 (ie from £11,000 to £20,000).
• This may well have implications for the viability of product Bee, and for the selling prices of both products.
• With marginal costing, the focus is on the contribution – both by product and in total.
• Fixed production costs are treated as a period cost – ie cost of time (such as a week, as here) rather than being
product related.
Absorption costing
Product Exe Product Wye Total
£ £ £ £ £
sales 200,000 160,000
less direct materials 60,000 40,000
direct labour 20,000 20,000
PRIME COST 80,000 60,000
fixed production costs *18,000 *18,000
TOTAL COST 98,000 78,000
equals profit for the week 102,000 82,000 184,000
* 2,000 direct labour hours for each product per week, so fixed production costs are £36,000 ÷ 2 = £18,000 per product.
• With absorption costing, the focus is on profit – both by product and in total.
• Overhead costs are absorbed by production before profit is calculated.
56
Product Exe Product Wye Total
£ £ £ £ £
sales 200,000 160,000
less direct materials 60,000 40,000
direct labour 20,000 20,000
PRIME COST 80,000 60,000
fixed production costs
set ups 4,000 20,000
inspections 2,000 10,000
TOTAL COST 86,000 90,000
equals profit for the week 114,000 70,000 184,000
• With activity based costing, which is a development of absorption costing, the focus is on identifying the overhead costs for
a particular activity.
• It gives more accurate costing information and shows that smaller batches (as here with product Wye) cost more to produce.
13.3 (a)
OVERHEAD ANALYSIS SHEET
for January 20-8
Accountancy Department Management Department
Budgeted total overheads (£) 22,143 17,251
Budgeted lecturer hours 1,525 1,300
Budgeted overhead absorption rate (£) 14.52 13.27
(b)
OVERHEAD ANALYSIS SHEET
Course: Finance for Managers
Accountancy Department Management Department
Lecturer hours 45 20
Budgeted overhead absorption rate (£) 14.52 13.27
Overhead absorbed by course (£) 653.40 265.40
57
(c) 35 hours x 47 weeks = 1,645 direct labour hours per employee
Machining Dept: 6 employees = 9,870 hours = £5.12 per direct labour hour
Finishing Dept: 3 employees = 4,935 hours = £4.75 per direct labour hour
(d) Depending on the method and type of production, the company is most likely to use overhead absorption rates based
on:
• direct labour hours, or
• machine hours
The OAR selected may vary from one department to another, depending on whether departments are labour-intensive
or machine-intensive. The labour hour rate is a popular method because overheads are absorbed on a time basis.
However, the machine hour is particularly appropriate where expensive machinery is used in a department.
13.8 (a) Direct labour hour: (3 hours x 80 seats) + (3.5 hours x 40 seats)
= 380 direct labour hours per month = £2.63 per hour.
Machine hour: (1 hour x 80 seats) + (2.5 hours x 40 seats)
= 180 machine hours per month = £5.56 per hour.
Alternative methods could be based on a percentage of certain costs, eg direct labour.
(c) See text. The machine hour rate charges most to 'de luxe' model. On balance, direct labour hours may be the best
method to use because the products are more labour-intensive than machine-intensive.
13.10
total day care surgical operating administration
ward ward theatre
£ £ £ £ £
Overheads 112,195 28,750 42,110 32,260 9,075
Administration – 1,650 4,125 3,300 (9,075)
35,560 –
Operating theatre – 20,320 15,240 (35,560) –
112,195 50,720 61,475 – –
13.11
58
13.12 (a)
Fixed overheads for Basis Total New Car Sales Used Car Sales Servicing Administration
four weeks ended
28 April 20-4 £ £ £ £ £
Depreciation of fixed assets Net book
value 8,400 2,100 1,260 4,200 840
Other property overheads Floor space 4,500 1,800 1,350 900 450
59
Staff costs Allocated 35,295 11,080 7,390 9,975 6,850
(b) Budgeted fixed overhead absorption rate for the servicing centre:
£23,575 ÷ 1,025 hours = £23.00 per direct labour hour
13.13 (a) Labour hour method
Expected number of labour hours, 26,000 units x 3 labour hours per unit = 78,000 hours
Tutorial note
• In order to set the same selling price under absorption costing and marginal costing, the cost-plus mark-up will
be different – it will be lower for absorption costing (being a mark-up on total cost), and higher for marginal
costing (being a mark-up on variable cost).
60
13.14 (c)
Fixed overheads for 2006 Basis Total Machining Assembly Maintenance Canteen
£ £ £ £ £
Factory canteen expenses number of
employees 36,000 9,000 18,000 6,000 3,000
61
Machine set-up costs number of
set-ups 40,000 24,000 16,000 – –
Tutorial note: canteen costs are re-apportioned before maintenance because it does not receive any services
from the maintenance department.
(d) Machining department
The method to be used in this department is labour hour, because the department is more labour-intensive than machine-
intensive.
total machining department overheads = £44,860 = approx £1.12 per labour hour
total labour hours 40,000 hours
Assembly department
The method to be used in this department is machine hour, because the department is more machine-intensive than labour-
intensive.
total assembly department overheads = £57,540 = approx £0.96 per machine hour
total machine hours 60,000 hours
(f) • for factory canteen expenses the cost driver will be the number of employees
• for factory machine maintenance the cost driver will be the number of machine hours
• for factory machine set-up costs the cost driver will be the number of machine set-ups
14.1 There are a wide range of marginal costing applications in the service businesses mentioned. For example:
• hotel
– ‘bargain break’ weekends to make use of rooms occupied by business people during the week
– last minute bookings, which are discounted from the normal tariff
• transport
– season tickets
– weekend fares
– cheaper fares after the morning rush
– discounts for categories of people in slack travel months
• cinema or theatre
– standing or cheap tickets released only on the day of the performance
– ‘half-price’ ticket booths on day of performance
– special cheap ticket deals with transport companies
– family tickets
• holiday companies
– discounts for last minute bookings to fill empty places on planes and at hotels
– discounts for early bookings, which help with planning the travel companies’ operations
– special deals with transport companies
– off-peak prices
Consider also the benefits and restrictions/problems for both the customer and the supplier. Often only a limited
number of products are available at special prices, or there are restrictions on the time that they are available. The
major disadvantage for the supplier is that those customers who have paid the full price will be disgruntled when they
learn the lower price paid by others.
62
14.2 In-house manufacture
Marginal cost of manufacture per pump motor: £
direct materials 40.00
direct labour 25.00
variable overheads 20.00
marginal cost 85.00
Therefore, by buying in pump motors from an outside supplier, the company has the potential to increase profits by £40,000
(£372,500 – £332,500).
14.5 (a) Absorption cost per seat (based on sixty seats sold)
£
direct materials £12.50 x 60 750.00
direct labour £10.00 x 60 600.00
direct expenses £2.50 x 60 150.00
fixed overheads 3,500.00
TOTAL COST 5,000.00
63
(d)
MERCIA AIRWAYS
profit statement for flight MA 005
60 seats 60 seats 60 seats
sold + 30 sold + 40 sold
to travel firm to newspaper
£ £ £
Sales revenue for flight:
60 seats at £100 each 6,000 6,000 6,000
30 seats at £45 each – 1,350 –
40 units at £35 each – – 1,400
6,000 7,350 7,400
Less costs:
Direct materials (£12.50 per passenger) 750 1,125 1,250
Direct labour (£10 per passenger) 600 900 1,000
Direct expenses (£2.50 per passenger) 150 225 250
Fixed overheads 3,500 3,500 3,500
PROFIT 1,000 1,600 1,400
Marginal cost £
direct materials (per pair) 20.00
direct labour (per pair) 18.00
MARGINAL COST (per pair) 38.00
64
(b)
THE LAST COMPANY LTD
profit statements
Existing Existing Existing
production production production
12,500 pairs + 2,500 pairs + 5,000 pairs
of boots @ £45 each @ £37 each
£ £ £
Sales revenue (per week):
12,500 pairs at £60 each 750,000 750,000 750,000
2,500 pairs at £45 each – 112,500 –
5,000 pairs at £37 each – – 185,000
750,000 862,500 935,000
Less production costs:
Direct materials (£20 per pair) 250,000 300,000 350,000
Direct labour (£18 per pair) 225,000 270,000 315,000
Fixed overheads 200,000 200,000 200,000
PROFIT 75,000 92,500 70,000
14.10 (a)
65
(b) Break-even point for the ‘People’ range is:
fixed costs (£) = £45,400 = 1,514 units
contribution per unit (£) £30
(c)
(d) • Labour hours are the scarce resource here, with 2,800 hours available.
• To maximise profits, the company should maximise the contribution from each labour hour.
• The preferred order is ‘Animals’ (at £30 contribution per labour hour), ‘Birds’ (at £27.66), and ‘People’ (at £20).
• Optimum production plan:
Therefore production of ‘People’ at 1.5 hours per unit will be 600 units per month. This production plan does
not allow for full production of the ‘People’ range.
£
(b) (i) Ink pen £8.00 – £6.20 = £1.80 contribution x 4,200 units = 7,560
Novelty ruler £2.50 – £0.60 = £1.90 contribution x 8,400 units = 15,960
Total contribution 23,520
(c) • The bought-in goods give a positive contribution of £0.90 for the pen and £1.00 for the ruler; these amounts
will contribute to fixed costs and profit.
• By buying-in goods Drew Armstrong is able to satisfy the demand from customers who will not seek out an
alternative supplier.
• Drew must be sure of the quality of the bought-in goods, the timing of deliveries, and the reliability of the
supplier.
66
(d) See also chapter 18:
• The current staff may be resistant to retraining on the new machine.
• The staff will be demotivated until they know who is to be made redundant and who is to be retrained; some
staff may seek work elsewhere.
• The staff to be retrained may seek a pay rise on account of their increased skills.
• Once retrained, staff will have transferable skills useful to other employers who may seek to recruit them.
• Staff may see increased production as a positive sign that their jobs are safe. They may be concerned about
the effect of the loan interest and repayments for the machine on the financial viability of the business.
14.13 (a) • Fixed costs remain fixed over a range of output levels and vary with time rather than activity levels, eg rent,
insurance.
• Semi-variable costs include both a fixed and a variable element, eg utility bills such as telephone, fuel.
• Variable costs vary directly with output, eg direct materials, royalties, direct labour.
£
(c) selling price £40 per unit x 12,000 units 480,000
less variable costs £12 per unit x 12,000 units 144,000
variable overheads £1.50 per unit x 12,000 units 18,000
equals total contribution for year to 31 May 2007 318,000
(e) Profit statements for each new order for the year ended 31 May 2008
Order JJH Order JHB
6,000 units 8,000 units
£ £
Sales JJH £180,000/6,000 = £30 per unit; JHB £256,000/8,000 = £32 per unit 180,000 256,000
Variable costs £14 x 6,000 (JJH) or 8,000 (JHB) units (84,000) (112,000)
Variable overheads £1.50 x 6,000 (JJH) or 8,000 (JHB) units (9,000) (12,000)
Delivery charges JJH 2% of £180,000; JHB 2.5% of £256,000 (3,600) (6,400)
Machinery modification (19,000) –
Staff retraining (8,000) –
Overseas agent (14,000) (14,000)
Temporary staff – (28,000)
PROFIT FROM EACH NEW ORDER 42,400 83,600
(f) Note that the factory is currently operating at 60 per cent of capacity: current production is 12,000 units, so maximum
capacity is 20,000 units, ie an increase of 8,000 units.
Order JJH
• Although profit on this order is lower than for JHB, future orders “are almost guaranteed”.
• In the year to 31 May 2008, one-off costs of machinery modification and staff retraining are £27,000. Provided
no further such costs are incurred, the profit of subsequent years will be £42,400 + £27,000 = £69,400 from
this order.
• Staff retraining will motivate the staff but will also give them transferable skills useful to other employers who
may seek to recruit them.
• Staff may seek a pay rise once they have been retrained.
• Staff may see increased production as a positive sign that their jobs are safe.
67
• With a selling price of £30 per unit, this order gives a positive contribution, £30 – £15.50 (£14 + £1.50) = £14.50
to delivery charges and fixed costs.
• It utilises spare capacity, but leaves 2,000 further units of spare capacity.
• Although the selling price is £30 instead of the normal selling price of £40, the company is already past the
break-even point with its normal sales.
Order JHB
• This is a ‘one-off’ order which utilises the full capacity of the factory, and so prevents future growth of the
business for the year to 31 May 2008.
• With a selling price of £32 per unit, this order gives a positive contribution, £32 – £15.50 (£14 + £1.50) = £16.50
to delivery charges and fixed costs.
• Profit is higher than for JJH but is likely to be for one year only.
• Temporary staff will need to be employed, helping the local economy, in the short-term.
• For this order, the product will need to be modified – management needs to ensure that the modifications are
within the capabilities of the staff.
Conclusion
The order from JJH is to be preferred provided that there is the likelihood of future orders. This will safeguard the jobs
of current employees and may enable the company to expand in the future. Although profit will be lower than JHB in
the first year, this will be more than made up by the second year order.
14.14 (a)
PRODUCT Caz Jaz
Selling price per unit £42 £45
less Unit variable costs per unit
Caz, materials £18, direct labour £16 £34
Jaz, materials £12, direct labour £24 £36
equals Contribution per unit £8 £9
Direct labour hours per unit 2 hours 3 hours
Contribution per direct labour hour £4 £3
(b) • Labour hours are the scarce resource, with 42,000 hours available.
• To maximise profits, the company should maximise the contribution from each labour hour.
• The preferred order is Caz (at £4 contribution per labour hour) and Jaz (at £3).
• Optimum production plan:
Therefore production of Jaz at 3 hours per unit will be 6,000 units. In summary:
Production plan
Caz 12,000 units
Jaz 6,000 units
68
(c) The shortfall in Jaz is 2,000 units (8,000 – 6,000):
£
Selling price per unit 45.00
less Buying-in price per unit
£38 + *£5.70 delivery charge 43.70
equals Contribution per unit 1.30
* £38 x 15%
This contribution will increase profit by £2,600 (£1.30 x 2,000 units) and will be worthwhile
– to maintain market share
– to retain customers
provided that
– quality can be assured
– delivery dates can be relied upon
14.16 (a)
PRODUCT JHB1 JJH2
Selling price per unit £50 £50
less Unit variable costs per unit
JHB1, labour £32, materials £8 £40
JJH2, labour £16, materials £16 £32
equals Contribution per unit £10 £18
Direct labour hours per unit 4 hours 2 hours
Contribution per labour hour £2.50 £9
Ranking 2 1
• Labour hours are the scarce resource, with 80,000 hours available.
• Optimum production plan:
£
Selling price per unit 50
less Buying-in price per unit 45
equals Contribution per unit 5
This contribution will increase profit by £25,000 (£5 x 5,000 units) and will be worthwhile
– to maintain market share
– to retain customers
provided that
– quality can be assured
– delivery dates can be relied upon
69
(c) Contribution: £
JHB1 10,000 units @ £10 per unit 100,000
5,000 units @ £5 per unit 25,000
JJH2 20,000 units @ £18 per unit 360,000
485,000
less Fixed costs 420,000
equals Profit 65,000
15.1 (a) Standard costing sets a pre-determined/budgeted cost for materials, labour and overheads in advance of production.
Many businesses establish a standard or budgeted cost for their output in advance of production. Standard costs can
then be compared with actual costs and variances calculated.
(b) The main advantages of standard costing are that it can be used:
• to help with decision-making – for example, with price setting
• to assist in planning – for example, to plan the quantity and cost of resources needed for production
• as a means of controlling costs – standard costs are compared with actual costs and variances calculated so
that action can be taken by the responsible manager or department when appropriate
15.4
£ p £ p £ p £ p
material price variance 120.00 FAV 200.00 ADV 500.00 FAV 250.00 ADV
material usage variance 100.00 ADV 400.00 FAV 1,000.00 FAV 100.00 FAV
materials variance 20.00 FAV 200.00 FAV 1,500.00 FAV 150.00 ADV
15.5
£ p £ p £ p £ p
labour rate variance 7.00 ADV 4.00 ADV 15.00 FAV 15.00 ADV
labour efficiency variance 10.00 FAV 9.00 ADV 72.00 ADV 48.00 ADV
labour variance 3.00 FAV 13.00 ADV 57.00 ADV 63.00 ADV
70
(b) • the managers responsible for each section of the business will be asked to explain the reason for any
significant variances of their section
• the buying department should explain the 5p per kilo adverse variance in the cost of materials – perhaps better
quality materials have been purchased, or there has been a price increase, or there has been an adverse
exchange rate fluctuation
• the production department should explain the favourable variance in materials usage – perhaps better quality
materials have been used with less wastage, or the workforce is better trained in using the materials
• the human resources department will need to explain the £1.00 per hour higher labour rate – perhaps there
has been a pay rise; alternatively, overtime rates may have had to be paid, which the production department
will be asked to explain
• the production department should be asked to explain the favourable variance in labour efficiency – perhaps
more use has been made of machines, or the workforce is better trained, or better quality materials have been
used
• it may be that variances are linked, eg more expensive materials have less wastage; skilled employees (on
higher pay rates) work more efficiently
• corrective action may need to be taken in some areas despite the overall favourable variance in total cost
Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.
71
(c) • As the material price variance is adverse this could indicate that the material is of better quality which has led
to a favourable material usage variance because there is less wastage.
• However, the labour efficiency variance is adverse which may have been caused by the workforce spending
longer and taking more care with the product; alternatively a lower grade of labour may have been used which
does not have sufficient skills.
Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.
72
15.13 (a) Sales price variance:
actual quantity x (standard price – actual price)
18,000 units x (£5 – *£6) = £18,000 FAVOURABLE
* £108,000 ÷ 18,000 units
73
net present value
(b)
REPORT
To: Managing Director
From: A2 Accounting Student
Date: Today
74
16.5 (a)
THE CHESTER CARPET COMPANY
Working paper for the financial appraisal of a new machine
for the production department
PAYBACK PERIOD
Year Cash Flow Cumulative
Cash Flow
£ £
0 (65,000) (65,000)
1 17,000 (48,000)
2 25,000 (23,000)
3 31,000 8,000 £23,000* required
4 28,000 36,000
* £31,000 – £8,000
(b)
REPORT
To: General Manager
From: A2 Accounting Student
Date: Today
75
16.6 (a) The net cash flows are:
£
year 0 (110,000)
year 1 20,000
year 2 60,000
year 3 80,000
year 4 80,000
year 5 85,000
payback period
The development costs are recovered in the first half of year 3: £20,000 + £60,000 + (£30,000/£80,000). Thus the
payback period is 2 years and 4.5 months/2 years and 19.5 weeks/2 years and 136.9 days. Note that these assume
even cash flows during the year.
76
(b)
REPORT
To: Managing Director
From: A2 Accounting Student
Date: Today
Payback period:
cost of machinery = £2,400,000 x 365 days =
cash flow per year £1,560,000
Tutorial note: the examiner will also accept the answer given in weeks, 1 year and 28 weeks, and months, 1 year and
6 months.
77
16.9 (a)
Net present value of new machine
current production (units) per year x 120% x profit per unit = cash flow per year
6,000 units per year x 120% x £20 profit (£80 – £60) = £144,000 per year
(b) On the basis of net present value, the new machine should be purchased.
Advantages:
– There is a positive net present value over the four years for which information is given.
– There is a further six years when, subject to economic conditions, cash flow should continue to be generated.
– Payback is 2 years and 157 days, leaving a further 7.5 (approx) years to generate cash flow.
Disadvantages:
– Can purchase of the new machine be justified when the old machine has four years’ economic life remaining?
– Will the quality of the output from the new machine be as good as/better than from the old machine?
– Will Roberta be able to sell the increased output of 1,200 units per year? If not, and output/sales continue at 6,000
units per year, cash flow will be £120,000 per year. This gives a payback of 2 years and 335 days, and a negative
net present value of £440 at the end of year 4.
– Will the market continue for the product over the next ten years?
– The new machine will need financing – is this available?
– Will there be any proceeds from the sale of the old machine?
– The cost of capital is high at 14% – is lower cost finance available?
– Borrowing will increase the gearing of the business and may make it less attractive to investors.
– The estimates of cash flows may be inaccurate.
– Staff may need to be retrained.
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(b) Net present value
(c) On the basis of net present value, Machine A should be purchased and Machine B should be rejected because of its
negative net present value.
Reason:
Machine A has a positive net present value and the initial cost is much less than Machine B. However,
– the net present value is not large and the estimates of revenues and costs may be inaccurate.
– if the cost of capital increases, the positive net present value could disappear.
– will there be any proceeds from the sale of the old machine?
– if Beard Bakeries Ltd needs to borrow to finance the machine, the company’s gearing will increase and may make
the company less attractive to investors.
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17.3 (a)
purchases budget
April June August and October and December February
and May and July September November and January and March
£000 £000 £000 £000 £000 £000
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17.4 (a)
ROBERT ADAMS
Production budget for periods 1 – 3
Tutorial note: the closing stock for each period is one-quarter of the next period’s expected sales.
(d) Debtor collection period = Debtors x 365 days (or 52 weeks or 12 months)
Credit sales
Total sales for periods 1–3 at £1 per football £38,000
14% of sales is £5,320
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17.6 (a)
SU LING LTD
Labour budget for months 1 – 3
Month 1 Month 2 Month 3
Production in units 2,100 2,400 3,000
Labour hours at 6 hours per unit 12,600 14,400 18,000
Labour hours available 15,000 15,000 15,000
Surplus/(shortfall) of labour hours 2,400 600 (3,000)
(c) • The surplus of labour hours in months 1 and 2 could be used to manufacture stock in advance of month 3.
• This additional stock would need to be stored until month 3.
• The costs of manufacturing the stock earlier will have to be paid.
• The management of Su Ling Ltd need to consider whether it is cheaper to manufacture earlier, with its attendant
costs, or whether to pay the higher rate for part-time labour in month 3.
• The main limitation of using the labour budget in this way is that much depends on the accuracy of future sales
forecasts, as this will affect the production budget. If the sales forecasts are over-stated, goods will be
manufactured needlessly and may remain unsold, thus incurring extra storage costs, or have to be scrapped if the
goods have a limited life (eg perishable goods).
17.7 (a)
debtor budget
Jan Feb Mar Apr May Jun Total
£ £ £ £ £ £ £
Opening debtors 65,500 60,550 61,050 65,600 69,500 73,200 65,500
Credit sales 38,300 39,500 42,400 45,000 47,400 44,700 257,300
Receipts (42,400) (38,100) (37,400) (40,600) (43,200) (45,800) (247,500)
Discount allowed (350) (400) (450) (500) (500) (400) (2,600)
Bad debts written off (500) (500) – – – – (1,000)
Closing debtors 60,550 61,050 65,600 69,500 73,200 71,700 71,700
(b)
creditor budget
Jan Feb Mar Apr May Jun Total
£ £ £ £ £ £ £
Opening creditors 42,400 39,130 40,730 41,410 42,830 40,870 42,400
Credit purchases 19,500 22,300 22,500 24,000 22,600 23,400 134,300
Payments (22,600) (20,500) (21,600) (22,300) (24,300) (23,200) (134,500)
Discount received (170) (200) (220) (280) (260) (270) (1,400)
Closing creditors 39,130 40,730 41,410 42,830 40,870 40,800 40,800
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17.10 (a) Difference between cash and profit:
• cash is the actual amount of money held in the bank or as physical cash (eg in a cash till)
• profit is a calculated figure which shows the surplus of income over expenditure for the period; it takes note of
adjustments for accruals and prepayments and non-cash items such as depreciation and provision for doubtful
debts; it does not include capital expenditure (ie the purchase of fixed assets), or owner’s drawings/dividends
(b) Possible reasons for a bank overdraft when profits are being made:
• capital expenditure – the purchase of fixed assets reduces cash, but profit is affected only by the amount of
depreciation on the asset
• increase in debtors – with more goods sold, profits will increase but, until debtors pay, there is no benefit to the
bank balance
• decrease in creditors – if creditors have been paid earlier there will be no effect on profit, but a bank overdraft will
increase
• increase in stock – with more stock purchased there will be an increase in profit as it is sold, but paying for the
stock will increase the bank overdraft
• prepayment of expenses made at the year end – no effect on profit as the prepayment is an expense for next year,
but the bank overdraft will increase
• repayment of a loan – no effect on profits (although loan interest may be reduced), but the bank overdraft will
increase
• drawings/dividends – no effect on profit, but the bank overdraft will increase
(c)
SALES BUDGET
(d)
PRODUCTION BUDGET IN PARTS (UNITS)
Closing stock 20 26 39 39 39
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17.13 (a) production budget (units/surfboards)
Sales 16 16 28 40 40
Closing stock 24 48 60 44 28
Production 40 40 40 24 24
Tutorial notes:
• The selling price of each board increases to £190 from 1 June
• Net cash flow is receipts from sales less payments for expenses
• Drawings have been shown in the bank summary, but could be included amongst the payments
• Other layouts of the cash budget are acceptable in the examination
Tutorial notes:
• Units of closing stock are 8% of sales: at 31.03.2004 312,500 units x 8% = 25,000 units.
• Closing stock at 31.03.2003 had cost £10 per unit (£200,000 ÷ 20,000 units), so purchases for the year ended
31.03.2004 will be £10 x 90% = £9 per unit.
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(b) • The forecast profit – both gross and net – can be calculated and compared with the actual profit of the previous
year.
• The forecast profit shows the effect of changes in the selling price, volume of units sold, the buying price, and in
overhead expenses. Here the forecast profit is reduced by £190,000 from the actual profit of the previous year.
• Management can take action by reviewing their selling and buying prices, and overhead expenses.
• Corrective action can be taken in advance if the forecast operating statements show a loss.
• The actual gross and net profits for the year can be compared with the forecast profits, and any differences can
be investigated.
18.2 (a) Increase in total contribution resulting from the change in paint supplier
Original contribution = (£190 – £140) x 12,000 sheds = £600,000
New paint = (£190 – £118*) x 12,000 sheds = £864,000
* £140 – £22 saving
Increase in total contribution = £264,000
18.4 The suggested answer from the textbook is shown below. The question, however, requires the students to explain
this term in their own words.
‘Social accounting’ is the term used to describe the way in which businesses are accountable and responsible to
society as a whole. Social accounting requires that businesses should not be driven just by the profit motive but
should also consider the wider implications of their decisions. The issues which involve social accounting can be
internal, eg the demands of the workforce, or they can be external. External factors can be economic (providing local
employment), ethical (not selling high nicotine cigarettes to developing countries), political (not selling goods to
oppressive governments), legal (employment law) or environmental (using renewable resources or not polluting the
atmosphere).
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