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2011

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

International College of Economics and Finance

Introduction to Accounting
Problem 1 You are to complete the gaps Assets (a) (b) (c) (d) (e) (f) 12,500 28,000 16,800 19,600 ? ? Liabilities 1,800 4,900 ? ? 6,300 11,650 Capital ? ? 12,500 16,450 19,200 39,750

Problem 2 Distinguish from the following list the items that are liabilities from those that are assets: (a) (b) (c) Office machinery Loan from C Shirley Fixtures and fittings (d) (e) (f) Motor vehicles We owe for goods Bank balance

Problem 3 State which of the following are shown under the wrong classification for J Whites business: Assets Loan from C Smith Cash in hand Machinery Creditors Premises Motor vehicles Liabilities Stock of goods Debtors Money owing to bank

Problem 4 Mr. S sets up a new business. Before he actually sells anything, he has bought motor vehicle 2,000, premises 5,000, stock of goods 1,000. He did not pay in full for his stock of goods and still owes 400 in respect of them. He had borrowed 3,000 from B. After the evens just described, and before trading starts, he has 100 cash in hand and 700 cash in bank

Required: Calculate the amount of his capital.

Problem 5 Draw up a balance sheet from the following as at 31 December 19X8: Capital Debtors Motor vehicles Creditors Fixtures Stock of goods Cash at bank 23,750 4,950 5,700 2,450 5,500 8,800 1,250

Problem 6 Complete the columns to show the effects of the following transactions: Effect upon Assets (a) We pay a creditor 70 in cash. (b) Bought fixtures 200 paying by cheque. (c) Bought goods on credit 275. (d) The proprietor introduces another 500 cash into the firm. (e) Mr. X lends the firm 200 in cash. (f) A debtor pays us 50 by cheque. Liabilities Capital

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

Problem 8 The following are transactions of the business for a period. You are required to state the effect of each on the balance sheet items. Be detailed where the capital is affected, showing the type of effect: (a) Bought stock in trade on credit terms for 1,200. (b) The owner paid a trade creditor 1,500 for some stock in trade bought on credit recently. Since the owner did not have the business bank account cheque book with him, he drew a cheque on his personal account. (c) Stock in trade, which had cost 1,700, was sold on credit for 2,500. (d) The owner withdrew 500 by drawing a cheque on the business bank account, payable to himself. (e) Paid wages of 750 by cheque. (f) Paid bank interest of 100 by having amount charged on the business bank account. (g) Received a 2,000 cheque from a trade debtor. (h) Paid a trade creditor 1,200 by a cheque drawn on the business bank account.

Problem 9 Explain: (a) What is a revenue? (b) What is an expense? (c) What is a profit? (d) The owner pays himself a regular 100 from the business account each week, is it an expense? (e) Why is the purchase of some stock in trade not an expense?

Problem 10 Explain and provide comments: (a) Why is it necessary to put a date in the heading of the balance sheet? (b) Jim just bought a new motor van. Will this have an effect on the balance sheet of his business? (c) Comment: Why is it that my capital is shown with the liabilities in the balance sheet of my business? Surely it is an asset. (d) Which of the following would you expect to find among the items of the balance sheet: - The fact that the business owes money 4

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

Problem 11 Consulting Agency Balance Sheet as of October 31, 19X3 ASSETS Cash Advertising Expense Land Salary Expense Office furniture Accounts Payable Utilities Expense 1,400 300 31,500 3,300 4,700 3,000 1,100 44,300 OWNERS EQUITY Equity Total Assets Total Liabilities & Equity 8,900 44,300 LIABILITIES Notes Receivable Interest Expense Office supplies Accounts Receivable Note Payable 11,000 2,000 800 1,600 20,000

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

Problem 12 Harold Davies is the owner of a small building firm. He does not understand the item balance sheet and asks you to explain to him whether the following items should be on his

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

Problem 13 King Pharmaceuticals plc has just spent 50 million on developing a new medicine that is expected to yield substantial profits over the next four years. Use this example to help explain the distinction between the terms 'relevance' and 'reliability' when preparing financial statements for shareholders. Why are 'relevance' and 'reliability' seem to be important qualitative characteristics of accounting information? You should structure your answer well. Your answer should not exceed 250 words.

Double-Entry Bookkeeping
Problem 14 The transactions of Wheels Repair Shop for January 19X9 are shown below: January 3 Debby Star opened a bank account under the name of her new business and deposited 30,000 in cash. January 4 She rented a temporary shop and paid 300 for the January rent, issued cheque. January 5 Rented automotive tools and equipment until the firm could purchase its own. Rent in the amount of 80 was paid for January, issued cheque. January 5 Purchased motorcycle parts and supplies described on invoice from the Southern Supply Company for 400 on account. January 10 Purchased land as a prospective building site for 10,000. Paid 4,000 in cash and issued a one-year note payable for the balance. January 12 Made repairs on George Shipmans motorcycle for 40. Shipman asked that a charge account be opened in his name. He promised to settle the account within 30 days. This arrangement was authorized by service manager. January 26 Made repairs on Jay Munsons motorcycle for 180. A charge account was opened in his name. January 29 Purchased motorcycle parts and supplies from Delco Supply House for 250 on account January 29 Paid the Southern Supply 300 on account (cheque) January 31 Paid electricity and water bills of 80 for January January 31 Paid 1,700 in salaries for the month January 31 Made motorcycle repairs for various cash customers for 4,800 January 31 Debby Star withdrew 300 in cash in anticipation that at least as much income had been earned January 31 Purchased automotive tools and equipment for cash 4,000. The list price was 5,000. January 31 Paid a premium of 600 on a 12 months insurance policy, it becomes effective on February 1, 19X9. January 31 Received a cheque for 10 from George Shipman. Required: (a) Analyze the transactions using extended accounting equation formula

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

Problem 15 Bill Cashing sets up practice as an architect, transferring 20,000 of his own money on 1 June 2003 from this personal bank account into a new business bank account with NatMid Bank plc to represent the opening capital of the business. The following transactions took place during June 2003: June 1 Paid rent for office for June 400 by cheque. June 1 Purchased office equipment for 2,000, from Equipit Ltd on credit. June 1 Purchased office supplies, costing 300 from W Brown on credit. June 1 Employed an office junior at a monthly wage of 500. June 5 Surveyed a property for A Bond and sent out and invoice for 200. June 7 Decided to transfer his own car to the business at a value of 4,000. June 9 Bought petrol for the car costing 20, paying by cheque. June 12 Took a client, P Brosnan, to lunch at a cost of 40, paying by cheque, and was asked to prepare plans for a new factory, for which work he estimated he would earn 5,000. June 16 Carried out another property survey for A Bond and invoiced him for 240. June 20 Took another possible client to lunch at a cost of 60, paying by cheque, but found that he would not be able to undertake work for that client. June 23 Bought further office supplies from W Brown on credit for 100. June 30 Paid the office junior her monthly wage. June 30- Sent a cheque to Equipit Ltd for 2,000. June 30 Sent a cheque to W Brown for office supplies for 300. June 30 Banked a cheque received from A Bond for 200. June 30 Drew out 500 from the bank for personal living expenses. Required: Enter these transactions in Bill Cashings accounting records, and test the arithmetical accuracy of your work by preparing a trial balance when you have completed the necessary entries.

Problem 16 The following transactions took place during May 19X6: May 1 Started firm with capital in cash of 250. May 2 Bought goods on credit from the following persons: D 54; C 87; K 25; B 76; L 64. May 4 Sold goods on credit to: CB 43; BH 62; HS 176. May 6 Paid rent by cash 10 May 9 CB paid us his account by cheque 43. May 10 HS paid us 150 by cheque. May 12 We paid the following by cheque: K 25; D 54. May 15 Paid carriage by cash 23. May 18 Bought goods on credit from C 43; B 110. May 21 Sold goods on credit to BH 67. May 31 Paid rent by cheque 18. Required: Enter these transactions in a companys accounting records, and then balance off the accounts and extract a trial balance as at 31 May 19X6.

Problem 17 Bs Trial Balance as on 31 December 19X6 Dr Sales Purchases Salaries Motor expenses Rent Insurance General expenses Premises Motor vehicles Debtors Creditors 14,629 2,150 520 670 111 105 1,500 1,200 1,950 1,538 Cr 18,462

Cash at bank Cash in hand Drawings Capital Stock at 31 December 19X6 was 2,548. Required:

1,654 40 895 _____ 25,424 5,424 25,424

Using the trial balance of B that was extracted after one years trading, prepare a trading and profit and loss account for the year ended 31 December 19X6 and a balance sheet as on 31 December 19X6.

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

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Problem 19 Cs Trial Balance as on 30 June 19X8 Dr Sales Purchases Rent Lighting and heating expense Salaries and wages Insurance Buildings Fixtures Debtors Sundry expenses Creditors Cash at bank Drawings Motor vans Motor running expenses Capital Stock at 30 June 19X8 was 4,166. Required: From the trial balance of C after his first years trading, prepare a trading and profit and loss account for the year ended 30 June 19X8 and a balance sheet as on 30 June 19X8. 3,847 2,400 5,500 1,133 _____ 95,900 65,900 95,900 23,803 854 422 3,164 105 50,000 1,000 3,166 506 1,206 Cr 28,794

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Adjustments
Problem 20 The following trial balance was extracted from the accounts of a business as at 31st December 19X7: Dr Sales Sales return Purchases Carriage in Stock as at 1st January 19X7 Wages Administration expenses Insurance Selling & distribution expenses Purchase returns Drawings Capital Premises Equipment Debtors Creditors Cash 5,500 210,000 At the year end (31st December) the following information is available: (1) 1,000 of the wages relate to the next accounting period. (2) 2,000 is owed for administration expenses relating to 19X7. (3) Equipment is to be depreciated by 4,000. (4) Closing stock is estimated to have cast 8,000. Required: (a) Enter the records in the Trial balance. (b) Indicate which data from trial balance relates to the Balance sheet. (c) Prepare a profit and loss statement for the year ended 31st December 19X7. 20,000 20,000 15,000 10,000 _____ 210,000 10,000 50,000 3,000 70,000 1,000 10,000 20,000 25,000 1,000 10,000 500 Cr 150,000

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(d) Explain the role of adjustments you made.

Problem 21 Mr. Big has been trading for some years as a wine merchant. The following list of balances has been extracted from his ledger as at 30th April 19X7, the end of his most recent financial year. Capital Sales Trade creditors Returns out Provision for doubtful debts Discounts allowed Discounts received Purchases Returns inwards Carriage outwards Drawings Carriage inwards Rent, rates and insurance Heating and lighting Postage, stationery and telephone Advertising Salaries and wages Bad debts Cash in hand Cash at bank Stock as at 1 May 19X6 Trade debtors Fixtures and fittings at cost Provision for depreciation on fixtures and fittings as at 30th April 19X7 Deprecation
st

83,887 259,870 19,840 13,407 512 2,306 1,750 135,680 5,624 4,562 18,440 11,830 25,973 11,010 2,410 5,980 38,521 2,008 534 4,440 15,654 24,500 120,740 63,020 12,074

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

Problem 22 The following trial balance was extracted from the books of Charles as the close of business on 28 February 19X7. Dr Purchases and sales Cash at bank Cash in hand Capital account 1st March 19X6 Drawings Office furniture Rent Wages and salaries Discounts Debtors and creditors Stock 1st March 19X6 Provision for doubtful debts 1st March 19X6 Delivery van Van running costs Bad debts written off 2,400 450 810 32,760 The following additional information as at 28th February 19X7 is available: (1) Stock at 28th February 19X7 3,510. 14 32,760 2,850 1,440 1,020 2,580 690 4,920 2,970 270 360 2,490 11,280 1,140 210 9,900 Cr 19,740

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

Problem 23 The balance sheet of Johnsons shop as at 1st October 19X7 was as follows: Fixed assets Shop premises Shop fittings Delivery van Current assets Stock in trade Cash in hand 14,000 2,000 16,000 77,000 45,000 12,000 4,000 61,000 Current liabilities Trade creditors Bank overdraft 12,000 14,000 26,000 77,000 Capital At 1 October 19X7 51,000

The following in a summary of the transactions which took place during the year to 30th September 19X8: (1) Sales were made, all for cash, of 145,000. The stock in trade sold cost 83,000. (2) Stock in trade was bought, all on credit, for 78,000. (3) Cash of 113,000 was taken from the till (cash register) and paid into the bank. (4) The trade creditors were paid 73,000 by cheque. (5) Johnson borrowed 30,000 from Black which was paid into the bank. The loan is for 5 years. (6) Wages of 17,000 were paid by cash. (7) Rates of 2,900 were paid by cheque. (8) Additional shop fittings costing 9,000 were bought and paid for by cheque (9) The bank charged overdraft interest of 2,000 direct to the account. (10) Sundry expenses of 6,000 were paid in cash. 15

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

Problem 24 Adagio plc. is a wholesale supplier of musical instruments to the retail and educational sectors. The bookkeeper has extracted the following balances from the accounting records for the year ended 31st May 2010. The totals of the debit and credit balances did not agree, and the balancing figure was placed in a suspense account. 000 Freehold property, at cost Plant, equipment and vehicles, at cost Provision for depreciation at 1 June 2009 Freehold buildings Plant, equipment and vehicles Purchases Sales Distribution and selling costs Administration costs Directors remuneration Inventories at 1st June 2009 Trade creditors Trade debtors 440 1,080 13,100 21,180 2,300 1,240 1,110 1,320 972 1,834
st

3,600 2,060

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

95 3,300 222 30 500 1,005

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

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

Problem 25 The draft accounts prepared for the directors of Snodrop plc. for the year ended 31 December 1999 show a profit before taxation of 573,580. In the course of subsequent checking, the following errors and omissions were found: (1) During the year the company had acquired an additional factory unit at an annual rent of 64,000, payable quarterly in advance commencing on 31 March 1999. By 31 December 1999 four quarterly payments had been made. The total paid during the year had been treated as capital expenditure and included in fixed assets. No depreciation had been provided on the factory unit. (2) Some goods were included in the closing stock valuation at their selling price of 9,750. The gross profit margin on these goods was 30%. (3) A delivery vehicle held as a fixed asset had been sold during the year for 5,200. The original cost was 16,000 and, at 1 January 1999, depreciation of 9,600 had been provided. The proceeds of sale had been credited to sales account. The company depreciates delivery vehicles at 20% per year using straight-line basis. Its policy is to provide for depreciation in the year of purchase but not in the year of sale. (4) The brought forward balance of 1,700 for the accrued telephone charges at 1 January 1999 had been omitted when calculating the years telephone charge. (5) 9,820, being the total of returns inwards for the year, had been credited to purchases and debited to trade creditors. (6) At 1 January 1999 there was a provision for doubtful debts of 29,320. Snodrop plc. has a policy of making a 3% provision for doubtful debts based on closing trade debtors. The entry for 31 December had not been made and the trade debtors then totaled 1,260,500. (7) Items included in closing stock at 7,900, and which would normally be sold for 10,200, were in a damaged state and were worth only 6,850.

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

Problem 26 Ko-Furn Limited is an office furniture manufacturer. The following is a list of balances extracted from its accounting records at 31 December 2009: Dr 000$ Land, at valuation Buildings: cost Buildings: accumulated depreciation at 1.1.09 Equipment: cost Equipment: accumulated depreciation at 1.1.09 Vehicles: cost Vehicles: accumulated depreciation at 1.1.09 Inventory at 1.1.09 Trade receivables Provision for doubtful debts at 1.1.09 Prepayment at 1.1.09 Accrual at 1.1.09 Cash Trade payables 408 248 12 18 214 366 16 568 264 392 152 240 500 180 Cr 000$

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Share capital: ordinary 50c shares Share premium Retained earnings Sales Purchases Wages and salaries Distribution costs Other administrative expenses Corporation tax Disposal account Dividend paid 40 4,828 You are given the following information: 976 540 200 360 12

50 350 606 2,924

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4,828

(1) Ko-furn prices its furniture using a normal 30% mark-up policy. A stock count carried out at 31 December 2009 valued stock at selling price of $325,000. This included two board tables at normal selling price of $20,800 each, which the directors have decided should be reduced in price to $5,000 each. (2) The land was valued at $600,000 at 31 December 2009. The directors decided to reflect the revalued amount in the balance sheet. (3) On 1 February 2009, the company sold a vehicle for $20,000. While the proceeds of sale were credited to the Disposal account, no other entries were made in the books of account in relation to this transaction. The vehicle had cost $88,000 in August 2006. The company charges a full years depreciation in the year of acquisition and no depreciation in the year of disposal. (4) The companys depreciation policy is as follows: Land: Buildings: Equipment: Vehicles: nil 4% straight line 40% reducing balance 25% straight line.

(5) Trade receivables at 31 December 2009 include a debt of $16,000 from a customer recently declared bankrupt. The company has decided to maintain the provision for doubtful debts at 4% of remaining trade receivables. (6) The balance of prepayments at 1.1.09 refers to insurance charges. Prepaid insurance, included in general distribution costs at 31 December 2009 amounted to $24,000. 20

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

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Accounting for Current Assets


Problem 27 Bought January March September Required: (a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii) AVCO methods on a perpetual inventory basis. (b) Draw up the trading account for the year showing the gross profits that would have been reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods. 10 at 30 each 10 at 34 each 20 at 40 each April December Sold 8 for 46 each 12 for 56 each

Problem 28 Bought January April October Required: (a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii) AVCO methods on a perpetual inventory basis. (b) Draw up the trading account for the year showing the gross profits that would have been reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods. 24 at 10 each 16 at 12.50 each 30 at 13 each June November Sold 30 for 16 each 34 for 18 each

Problem 29 An evaluation of a physical stock count on 30th April, 19X2 in respect of the financial year ending on that date at Cranfleet Commodities has produced a figure of 187,033. The firms book-keeper has approached you, as the accountant, for assistance in dealing with the following matters to enable him to arrive at a final figure of closing stock for inclusion in the annual accounts: (1) 320 components included at their original cost of 11 each can now be bought in for only 6 each due to over production by the manufacturer. This drop in price is expected to be only temporary and the purchase price is expected to exceed its original figure within 12 months.

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

Problem 30 The draft accounts of Trayderrs plc for the year ended 31st December 1998 show a net profit before tax of 543,350 and closing stock at cost of 316,740 following a physical stock count. During the audit of the accounts the following matters have come to light: (1) Stock costing 25,000 has been omitted from the closing stock figure. (2) Items included in stock at 10,200, and which would normally be sold for 18,350, were in a damaged state and were worth only 7,600. (3) Trayderrs plc received an order on 27th December 1998 to supply goods at a total price of 52,000. The goods, which had cost 34,000, were moved on the following day from the warehouse to the packing department and were dispatched on 3rd January 1999 when the customer was invoiced. Trayderrs plc had included the order in sales for 1998 and had excluded the goods from closing stock. (4) 3,100 items costing 21 each were recorded on the stock sheets in error as 1,300 items at 12 each.

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(5) Stock costing 10,000 was lost in a fire in the warehouse during the year. The companys insurers have agreed to pay Trayderrs plc 11,200 in respect of its insurance claim. No entry has yet been made in the accounting records. (6) Included in purchases is 41,500 for goods purchased in December and which were received into the warehouse on 5th January 1999. (7) Stock costing 18,000 has in error been treated as a fixed asset and depreciation of 10% of cost has been provided for. (8) Returned stock costing 825 has been treated in the accounting records as a return inward instead of a return outward. (9) An item is included in the closing stock valuation at its selling price of 8,200. The gross profit margin on this item is 40%. Required: (a) Calculations to show the correct figure for Trayderrs plc for (i) (ii) stock at 31st December 1998, and net profit before tax for 1998.

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

Problem 31 On 30th April 2009 the closing balance on the creditors control account of Dyson Ltd is 2,900. The total of the list of balances from the creditors ledger is 3,990. Further investigation reveals the following errors: (1) An invoice of 600 for goods purchased was included in the creditors ledger but was not recorded in the purchases day book. (2) A cash payment of 400 to a supplier recorded in the cash book was not recorded in the creditors ledger. (3) A cash payment of 560 was correctly recorded in the creditors ledger but was recorded as 650 in the cash book. (4) An invoice for 250 was not recorded in either the purchase day book or the creditors ledger. Required: Show the corrected total of the list of creditors ledger balances and the corrected balance on the creditors control account at 30th April 2009. 24

Problem 32 Waits opened a business bank account with 16,000 on 1st April 2009. During April he issued cheques totaling 72,760 and banked cheques totaling 80,060. These transactions were entered into his cash book up to 30th April 2009. On receiving his bank statement for April he discovered the following: (1) A cheque for 4,800, which was banked (and included in the receipts above), had been returned by the bank marked No funds available. No adjustment has been made in the cash book. (2) Bank charges debited on the bank statement for April amounted to 600. No entries for these have been made in the cash book. (3) Cheques totaling 16,860 recorded in the cash book and sent to suppliers were not presented to the bank until May 2009. (4) Cheques totaling 12,100 had been entered into the cash book but not credited by the bank until May 2009. Required: Calculate the corrected bank balance which should appear in the business cash book at 30th April 2009 and prepare a bank reconciliation statement at 30th April 2009.

Problem 33 Miss Leung runs a business selling holidays. At 31 January 2010, the balance on the creditors control account was $8,700. The total of the list of balances in the creditors ledger was $11,720. The following information has come to light: (i) an invoice of $750 was not recorded in the purchase day book (ii) a cash payment of $1,680 was correctly recorded in the cash book but was recorded as $1,860 in creditors ledger. (iii) A cash payment of $1,200 to a supplier was recorded in the cash book but was not recorded in the creditors ledger. (iv) A credit note for a price reduction from a supplier of $1,800 was recorded in the purchase day book but not recorded in the creditors ledger. (v) In January, the company paid a refund of $200 to a customer for a price reduction. This was wrongly treated as a payment to a supplier and entered in the Creditors Control Account. Required: Show the corrections to the: (a) list of creditors ledger balance at 31 January 2010 and 25

(b) creditors control account at 31 January 2010.

Problem 34 In preparing the trial balance, you notice that the debit side exceeds the credit side by $970. Upon investigation, you identify the following mistakes: (1) Goods returned to suppliers amounts to $250 have been entered as a debit in the goods returns outward account by mistake. (2) A cash payment for $560 has been entered in the cash book as $650. (3) A computer purchased for $2,000 as at office machine has been entered as debit in the purchases account. (4) A credit note for $220 given to a customer has been credited twice in the customers account. (5) A cheque for $780 from a customer has been entered in the cash book and subsequently banked before the year end. However, no other entry has been made to the customers account. Required: Explain how each of the above mistakes should be dealt with by means of a suspense account.

26

Accounting for Fixed Assets


Problem 35 A company started in business on 1st January 19X1. Bought two motor vans for 1,200 each on 1st January 19X1. Bought one motor van for 1,400 on 1st July 19X1. Required: Write up the motor vans account and the provision for depreciation account for the year ended 31st December 19X1. Depreciation is at the rate of 20 per cent per annum, using the basis of one months ownership needs one months depreciation.

Problem 36 A company maintains its fixed assets at cost. Depreciation provision accounts for each asset are kept. At 31st December 19X8 the position was as follows: Total cost to date Machinery Office furniture Machinery 2,480, office furniture 320. (2) Some old machines bought in 19X5 for 2,800 were sold for 800 during the year. (3) The rates of depreciation are: Machinery 10 per cent, office equipment 5 per cent, using the straight line basis, calculated on the assets in existence at the end of each financial year irrespective of date of purchase. Required: Show the asset and depreciation accounts for the year ended 31st December 19X9 and the balance sheet entries at that date. 52,590 2,860 Total depreciation to date 25,670 1,490

(1) The following additions were made during the financial year ended 31st December 19X9:

Problem 37 A firm buys a fixed asset for 10,000. The firm estimates that the asset will be used for 5 years. After exactly 2 years, however, the asset is suddenly sold for 5,000. The firm always provides a full years depreciation in the year of purchase and no depreciation in the year of disposal. Required:

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(a) Write up the relevant accounts including disposal account but not profit and loss account for each of Years 1, 2 and 3: (i) Using the straight line depreciation method (assume 20% p.a.); (ii) Using the reducing balance depreciation method (assume 40% p.a.); (b) What is the purpose of deprecation? In what circumstances would each of the two methods you have used be preferable? (c) What is the meaning of the net figure for the fixed asset in the balance sheet at the end of Year 2? (d) If the asset was bought at the beginning of Year 1, but was not used at all until Year 2 (and it is confidently anticipated to last until Year 6), state under each method the appropriate depreciation charge in Year 1, and briefly justify your answer.

Problem 38 A company depreciates its plant at the rate of 20% per year, straight line method, for each month of ownership. Details: 19X4 bought plant costing 900 on January 1 bought plant costing 600 on October 1 19X6 bought plant costing 550 on July 1 19X7 sold plant which had been bought for 900 on 1st January 19X4 for the sum of 275 on 30th September 19X7. Required: Draw up: (a) the Plant account (b) the Provision for depreciation account (c) Disposal account (d) extracts from the Balance sheet at the end of each year.

Problem 39 Explain: (a) How is the consistency concept applied to depreciation? (b) Since the calculation of depreciation is based on estimate, why bother to make this calculation?

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Problem 40 At the beginning of the financial year commencing on 1st April 19X5, a company had a balance on plant account of 372,000 and on provision for depreciation of plant account of 205,400. The companys policy is to provide depreciation using the reducing balance method applied to the fixed assets held at the end of the financial year at the rate of 20 % per annum. On 1st September 19X5 the company sold for 13,700 some plant which it had acquired on 31 October 19X1 at a cost of 36,000. Additionally, installation costs totalled 4,000. During 19X3 major repairs costing 6,300 had been carried out on this plant and, in order to increase the capacity of the plant, a new motor had been fitted in December 19X3 at a cost of 4,400. A further overhaul costing 2,700 had been carried out during 19X4. The company acquired a new replacement plant on 30th November 19X5 at a cost of 96,000, inclusive of installation charges of 7,000. Required: Calculate the following: (a) the balance of plant at cost at 31st March 19X6 (b) the provision for depreciation of plant at 31st March 19X6 (c) the profit or loss on disposal of the plant.

Problem 41 On 1 January 1998 Ay Ltd bought some factory equipment for 100,000. There was no estimated residual value and the equipment is being depreciated using the decreasing-balance method at the rate of 20% per year. At the end of 2000 the market value of the equipment is expected to be 40,000 due to a more advanced design having appeared on the market. The equipment is as efficient in operation as originally anticipated and there is no intention of replacing it during the next few years. Required: (a) Referring to accounting concepts and to the above information, explain whether or not the annual charge for depreciation of the equipment needs amending and what the charge for 2000 should be.

Problem 42 The Cirrus Company Ltd has the following balances on its books at 31st December 19X0:

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Dr 50p ordinary shares 6% preference shares of 1 each Purchases Sales Stock at 1st January 19X0 Directors fees Undistributed profit at 1st January 19X0 10% Debentures (due 19X4) Debenture interest paid Discounts allowed Administrative expenses Salesmans salaries Selling and marketing expenses Heating and lighting Rent and rates Debtors Provision for doubtful debts at 1st January 19X0 Creditors Land and buildings at cost Vans at cost less depreciation Cash in hand Bank balance (overdraft) 65,000 19,800 400 _____ 411,800 The following additional information is given: 1,000 500 18,400 18,500 4,000 2,500 1,700 14,000 20,000 6,000 240,000

Cr 20,000 14,000

310,000

35,700 20,000

300 9,700

2,100 411,800

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

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(2) The balance on the vans account (19,800) is made up as follows: Vans at cost (as at 1st January 19X0) Less: Provision for depreciation to 1st January 19X0 30,000 13,800 16,200 Addition during the year 3,600 19,800 Depreciation is provided at 25% per annum on the reducing balance method. The addition during the year was invoiced as follows: Recommended retail price Signwriting on van Undersealing Petrol Number plates License which expired 31st December 19X0 3,000 450 62 16 12 60 3,600 (3) The directors, having sought at the advice of an independent evaluator, wish to revalue the land and building at 80,000. (4) The directors wish to make a provision for doubtful debts of 2.5% of the balances of debtors at 31st December 19X0. (5) Rent and rates prepaid at 31st December 19X0 amounted to 400, and salesmen's salaries owing at that date were 443. (6) The directors have proposed an ordinary dividend of 5p per share, and the full preference dividend. (7) Ignore taxes. (8) Debenture interest is paid semi-annually. Required: (a) Explain very carefully the reasons for the adjustments you have made in respect of items 1, 2 and 3 above. Show your workings (b) Prepare P&L account for Cirrus Company Ltd the year ended 31st December 19X0, and the Balance sheet as at that date. (b) Explain your treatment of debenture interest and proposed dividends.

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Problem 43 A recent article mentioned that there is currently a bewildering choice of accounting treatments for goodwill and other intangible assets some of which are inconsistent with the way tangible assets are reported. The balance sheet summary of a well-known successful multinational group of companies is given below to illustrate how one organization chooses to report brand names and goodwill that it has purchased: millions Fixed assets Intangible assets Tangible assets Investments Net current assets Long-term liabilities Share capital and reserves Equity share capital Share premium account Revaluation reserve Goodwill reserve Profit and loss account 535 667 94 (3,579) 5,386 3,103 3,840 1,725 735 1,000 (4,197) 6,300 7,300 3,103

Intangible assets are brands stated at fair value on acquisition. The negative figure for goodwill reserve is in respect of purchased goodwill written off. Required: (a) Explain the nature of intangible assets and why the method of reporting them seems to be more problematic than for tangible assets. (b) For purchased goodwill, consider the method used in the above balance sheet. What are its good and bad points? Explain one other method that might be used. Which do you personally prefer and why? (c) For purchased brand names, consider the method used in the above balance sheet. What are its good and bad points? Explain one other method that might be used. Which do you personally prefer and why?

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Problem 44 Raj Ltd purchased a machine on 1st January 1999 for 100,000. Transporting the machine to its factory cost 1,600 and 1,000 was spent on installing it. Maintenance of the machine cost 750 in 1999 and the expenditure on maintenance increased by 200 in each of the following four years. The machine was expected to last until 31st December 2006 with a scrap (or residual) value at that date of 6,600. The company uses the straight-line method of depreciation. It provides for a full years depreciation in the year of acquisition and none in the year of sale. The machine was sold for 34,000 on 30th June 2003. Required: Explain briefly what you understand by the term depreciation as used by accountants. In what circumstances would straight-line be the most appropriate method to use for an asset? Give the following calculations: (i) the depreciation charge for 1999; (ii) the profit or loss on sale of the machine in 2003.

Problem 45 According to a survey of investment analysts, more than half of them believe that all internally generated intangible assets should be capitalized on a companys balance sheet. Discuss the advantages and problems of reporting these assets.

Problem 46 We live in a society where the real wealth creators are often the intangible assets yet few companies include these assets in their balance sheets. Why is this? Explain the issues involved.

Problem 47 Given that amongst the most significant assets of professional football clubs are its footballers, it has become more common in recent years for such companies to account for the cost of players on their balance sheets. Other clubs, however, account for their players as expenses on their Profit and Loss accounts. Required: Express the arguments behind these two alternative treatments, using any principles or conventions you are applying in your explanation and explaining any terms you use. 33

Problem 48 The following is an extract from the accounting policies of Manchester United plc (a leisure company) as reported in its annual report and accounts for the year ended 31st July 2000: Depreciation Depreciation is provided on tangible fixed assets at annual rates appropriate to the estimated useful lives of the assets, as follows: Reducing Balance Freehold land Freehold buildings Assets in the course of construction Computer equipment and software Plant and machinery General fixtures and fittings line basis Required: (a) Explain briefly what you understand by the two methods of depreciation referred to in the above extract. (b) What effect is the change in accounting policy likely to have on the profit and loss account and the balance sheet? Nil 1.33% Nil 33% 20%-25% 15% Straight Line Nil 75 years Nil 3 years 4-5 years 7 years

During the year the depreciation method was changed [from reducing balance] to the straight

Problem 49 The annual accounts of Sen Manufacturing Ltd. are being prepared for the year ended 31 March 2002 and the closing trial balance includes the following figures: Freehold land and factory buildings Depreciation of factory buildings at 01.04.01 Land revaluation reserve Plant and machinery at cost Depreciation of plant and machinery at 01.04.01 Motor vehicles at cost Depreciation of motor vehicles at 01.04.01 The following information has been supplied: 153,000 36,000 1,900,000 1,150,000 2,800,000 750,000 400,000

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(1) The figure for freehold land and factory buildings comprises land at valuation (1,200,000) and buildings at cost (1,600,000). The land originally cost 800,000 and was professionally revalued in 1997 and the revaluation reserve created. It was revalued again in March 2002 and the revised figure of 1,050,000 is to be included in the accounts. (2) Factory buildings include expenditure in 2001 on constructing a new warehouse (220,000), maintenance of buildings (60,000) and redecoration (20,000). (3) Factory buildings owned at 31 March 2002 are to be depreciated for the year at 3% of cost. (4) Plant and machinery includes 528,850 for plant constructed by Sen Manufacturings staff during the year and completed on 30 September 2001. The cost is made up as follows: Materials Labour Allocation of company overheads Delivery of components to the factory Insurance on the machine for the year to 31 May 2002 Design costs and engineers fees 325,000 122,000 75,000 4,000 1,200 1,650

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

35

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

36

Accounting in Joint-Stock Companies


Problem 50 GWR Ltd started in business on 1st January 19X6. Its issued share capital was 100,000 ordinary shares of 1 each and 50,000 10 per cent preference shares of 1 each. Its net profits for the first two years of business were: 19X6 42,005; 19X7 34,831. Preference dividends were paid for each of these years, whilst ordinary dividends were proposed as 19X6 12 per cent and 19X7 9 per cent. Corporation tax, based on the profits of these two years, was: 19X6 13,480; 19X7 11,114. Transfers to general reserve took place as: 19X6 6,000; 19X7 4,000. Required: Draw up profit and loss appropriation accounts for each of the years ended 31st December 19X6 and 19X7.

Problem 51 Badwa plc. has an authorized capital of 500,000 ordinary shares of 0.50 each. At the end of its financial year, 31st May 19X9, the following balances appeared in the companys books: Issued capital: 400,000 shares fully paid Freehold land and buildings at cost Stock in trade 10% debentures Trade debtors Trade creditors Expenses prepaid Share premium General reserve Expenses outstanding Profit and loss account balance (1st June 19X8) Bank overdraft Fixtures, fittings and equipment at cost provision for depreciation 54,000 17,500 200,000 320,000 17,800 30,000 6,840 8,500 760 25,000 20,000 430 36,200 3,700

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The companys trading and profit and loss accounts had been prepared and revealed a net profit of 58,070. However, this figure and certain balances shown above needed adjustment in view of the following details which had not been recorded in the companys books. (1) It appeared that a trade debtor who owed 300 would not be able to pay. It was decided to write his account off as a bad debt. (2) An examination of the companys stock on 31st May 19X9 revealed that some items shown in the accounts at a cost of 1,800 had deteriorated and had a resale value of only 1,100. (3) At the end of the financial year some equipment which had cost 3,600 and which had a net book value of 800 had been sold for 1,300. A cheque for this amount had been received on 31st May 19X9. Required: (a) A statement which shows the changes which should be made to the net profit of 58,070 in view of these unrecorded details. (b) The directors proposed to pay a final dividend of 10% and to transfer 50,000 to general reserve on 31st May 19X9. Prepare the profit and loss appropriation account for the year ended 31st May 19x9 and two extracts from the companys balance sheet as at 31st May 19X9, showing in detail: (i) the current assets, current liabilities and working capital (ii) the items which make up the shareholders funds. (c) The directors are concerned about the companys liquidity position. Propose three transactions which will increase the companys working capital. State which balance sheet items will change as a result of each transaction and whether the item will increase or decrease in value.

Problem 52 LMS Ltd has an authorized capital of 200,000, consisting of 160,000 ordinary shares of 1 each and 40,000 8 per cent preference shares of 1 each. Of these 120,000 ordinary shares had been issued and all the preference shares when the business first started trading. The business has a financial year end of 31st December. The first three years of business resulted in net profit as follows: 19X7 27,929; 19X8 32,440; 19X9 36,891. Dividends were paid each year on the preference shares. Dividends on the ordinary shares were proposed as follows: 19X7 8 per cent; 19X8 10 per cent; 19X9 11 per cent.

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

Problem 53 The stockholders equity section of the balance sheet of P Corporation as December 31, 2004, appears as follows: Stockholders Equity amounts in thousand, except share amounts 7% Preferred stock, $100 par; 100,000 shares authorized; 40,000 shares issued Common stock, $1 par; 1,000,000 shares authorized; 600,000 shares issued, of which 50,000 are held in treasury Additional paid in capital: From issuance of preferred stock From issuance of common stock Retained earnings Total stockholders equity Required: Answer the following questions related to P Corporation. (a) What was the average issue price of the preferred stock as of December 31, 2004? (b) How many shares of common stock are outstanding? (c) What journal entry was made when the common stock was issued? (d) What is the amount of the total dividend requirement on preferred stock annually? (e) Assuming that there are no dividends in arrears, if the company declared a total cash dividend of $580,000, what would be the dividend per share for the preferred and common stock? (f) Assume the companys common stock is selling for $80 per share. What journal entry would be made if the company issues a 10% common stock dividend? (g) Compute basic earnings per share if the companys net income was $1,560,000 during 2004. Assume no new shares were issued during the year. 39 $480 $1,410 $4,500 $10,715 $600 $4,000

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

Problem 54 The balance sheet of C Ltd is as follows: Assets Sundry net assets Share capital 1 ordinary shares fully paid Reserves General reserve Profit and loss account (unappropriated profit) 500,000 300,000 1,200,000 The directors decide to make a 1 for 5 bonus issue. This will be followed by 1 for 3 rights issue. Rights shares will be offered at a price of 1.60 per share. Required: Show the revised balance sheet of C Ltd after both share issues have taken place. 400,000 1,200,000

Problem 55 Meta Ltd has the following share capital and reserves as at 20th August 19X5: 1,500,000 ordinary shares of 25p, each fully paid Share premium Retained profit 375,000 225,000 200,000 800,000 The directors resolve to use the reserves to issue fully-paid bonus shares at par in the ratio of two shares for every three currently held. Required: (a) Show the revised balance sheet (capital and reserves section only) after the above transactions have been carried out. (b) Assuming that the market value of each share has tended to stay around 50p ex div (i.e. excluding any dividend expected in the very near future) and the total annual dividend has been 75,000, what would you expect the market price of each share to be after the bonus issue? 40

Problem 56 The S Ltd commenced operations on 1st January 19X6. For the first four years the following results were achieved: Year ended 31 December 19X6 19X7 19X8 19X9 Required: State, for each year, the maximum dividend company could pay (assuming a maximum dividend is paid whenever possible) (100,000) 80,000 90,000 60,000 30,000 (10,000) 40,000 Trading profit (loss) Profit (loss) on sale of fixed asset Profit on revaluation on land use

Problem 57 Refer to Problem 56 above. Assume that S Ltd issued 300,000 1 Preference Shares with a 10% fixed rate on dividend at the commencement of business. Required: State, for each year, maximum dividend the company could pay its ordinary shareholders if: (i) the preference shares were non-cumulative, and (ii) the preference shares were cumulative.

Problem 58 A major international company recently reported the worst results in its century-long history with a 90% fall in net income and the chairman was reported to be worried about keeping his job. However, the total dividend proposed for the year was 4% up on the previous years. Required: Give possible reasons for the dividend increase. How would you check whether the increase is legal?

Problem 59 Wonda plc. has an issued share capital of two million 1 shares. The directors are considering whether the company should buy back and cancel 10% of its issued share capital at the current market price of 220 pence per share. 41

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

Problem 60 This is certainly the record dividend payment of the year: OMara plc is paying 75 pence for each 1 share! It represents 80% of the companys earnings for the year. Even the big banks are not that generous! Required: Comment on the above quotation which has been adapted from an article in a national newspaper and explain whether you consider that the company has necessarily been generous to its shareholders. Specify what further information you would need for your answer, if any, and what use you would make of it.

Problem 61 Your aunt has held 1,000 ordinary shares in a quoted company for several years. She has very little understanding of financial matters. She has asked you to write her a short note to explain the following: (1) why the company has only paid a dividend of approximately 30% of the profit after tax; (2) why the company is making a 1 for 1 scrip (or bonus) issue and what effect this is likely to have on the market value of each share. Required: Explain to your aunt: (a) the factors which determine a companys dividend; (b) the purpose, the effect on the balance sheet and the effect on the market value of each share of a 1 for 1 scrip issue.

Problem 62 In a recent article on a leading engineering company, a financial journalist drew attention to the fact that, according to its recent balance sheet, the net asset value per share was 4.15 yet the companys ordinary shares had been quoted on the stock exchange at around 7.80 for the past few months. 42

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

Problem 63 The country of Yugalia has experienced a financial crisis over the past year and, for the typical company, share price has been below net asset value per share yet the company has reported a profit. Required: Do these apparent anomalies necessarily imply that there is something wrong with financial reporting in Yugalia? Explain the issues involved.

Problem 64 Wizz.com, an online consumer information provider, has seen its share price treble in value over the past eight months. It has been in business for five years and has never earned a profit. Last years pre-tax loss was 32 million on a turnover of 23 million. Required: How can the shares of a company with such a poor profitability record and a negative price/earnings ratio be in such demand?

43

Cash Flow Statement


Problem 65 Roseanne owns shares in Inchem plc, a large chemicals company with world-wide interests, and she is worried because the share price has shown a downward trend over the past two years. Roseanne has asked you to explain what the cash flow statement can tell her about the companys progress and current position. She has supplied you with the following information taken form Inchems recent annual reports: Cash flow statement for the year ended 31st December 1997 m Net cash flow from operating activities Returns on investment and servicing of finance: Interest paid Corporation tax paid Capital expenditure: Acquisition of fixed assets other than subsidiary undertakings Acquisitions and disposals of subsidiary undertakings Acquisitions Disposals Equity dividend paid (4,366) 2,124 (225) (2,655) Financing: Increase (decrease) in debt Increase (decrease) in cash 2,937 282 (50) (846) (234) 74 (225) (796) (623) (935) (171) (151) (356) (126) 757 1998 m 1,006

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Note: Net cash inflow from operating activities: Operating profit Depreciation Stocks decrease Debtors increase Creditors (decrease) increase Net cash inflow from operating activities 378 434 18 (31) (42) 757 405 402 62 (86) 223 1,006

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

Problem 66 C Willis Profit and Loss Account for the year ended 31st December 19X8 Gross profit Add Discounts received Add Profit on sale of motor van 298 570 868 30,196 Less Expenses Motor expenses Wages General expenses Bad debts Increase in bad debt provision Depreciation: Motor van 1,590 8,790 2,144 340 120 1,090 14,074 16,122 29,328

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Balance Sheet at 31st December 19X7 Fixed assets Motor vans at cost Less Depreciation to date Current assets Stock Debtors less provision* Bank 10,295 5,190 1,568 17,053 Less Current liabilities Creditors 2,770 14,283 21,323 Less Long-term liability Loan form P Bond 6,000 15,323 Capital Opening balance b/d Add Net profit 12,243 14,080 26,323 Less Drawings * Debtors 19X7 5,490 provision 300 Debtors 19X8 3,800 provision 420. Note: The motor van was sold for 2,300 during 19X8. Required: Draft a cash flow statement for C Willis for the year ended 31st December 19X8 11,000 15,323 15,323 16,122 31,445 12,500 18,945 5,000 18,945 2,920 19,725 23,945 17,150 3,380 2,115 22,645 11,200 4,160 7,040 7,200 2,980 4,220 1X98

Problem 67 The directors of Alexay plc are concerned about the substantial increase in the company's bank overdraft in 1999. The summarised balance sheets of the company at 31st December were:

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1998 000 Fixed assets (net of depreciation) Current assets Stock at cost Trade debtors 290 385 675 Current liabilities Bank overdraft Trade creditors Corporation tax 72 345 185 602 Net current assets 73 1,388 Less: creditors falling due after more than one year 1,098 Share capital and reserves Issued share capital (1 shares) Share premium Revaluation reserve for land Profit and loss account 520 330 248 1,098 290 440 210 275 925 670 610 1,280 1,315

1999 000 2,090

355 2,445 480

1,965

620 380 500 465 1,965

The summarised profit and loss account for Alexay plc for the year ended 31st December 1999 was: 000 Sales Cost of sales Gross profit Administration expenses Depreciation Interest payable Net profit before corporation tax 460 115 59 634 666 3,900 2,600 1,300

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Corporation tax Net profit after corporation tax Dividends Retained profit for the year No fixed assets were disposed of during the year ended 31st December 1999. Required: (a) Calculate the net cash flow from operating activities for 1999. (b) Prepare a cash flow statement in good style for 1999. (c) Calculate and comment on the following for 1999: (i) current ratio (ii) gearing ratio (iii) interest cover

170 496 279 217

(d) Reply to the following queries put to you by one of the directors of Alexay plc: "Can you please explain to me how we have a healthy profit yet our bank overdraft has reached a record level? Surely there must be something wrong with the profit calculations, isn't there?"

Problem 68 The directors of N plc are extremely concerned about new trend in company's market share price. The following information has been extracted from the books for the year to 31 December 1999: Profit and Loss Account 1998 000 Sales revenues Profit before taxation Taxation Profit after taxation Dividends: preference ordinary: interim (paid) final (proposed) Retained profit for the year (100) (1,000) (3,000) 2,200 (100) (2,000) (6,000) 7,100 93,000 9,500 (3,200) 6,300 1999 000 200,000 20,400 (5,200) 15,200

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Balance Sheets as at 31 December 1998 000 Fixed assets Plant, machinery, equipment, at cost Accumulated depreciation 17,600 9,500 8,100 Current Assets Stocks Trade debtors Prepayments Cash at bank and in hand 5,000 8,600 300 600 14,500 Creditors: amounts due within 1 year Bank overdraft Trade creditors Accruals Taxation Dividends 6,000 800 3,200 3,000 13,000 Working capital Total assets less current liabilities Creditors: amounts due after more than 1 year 15% debentures 600 9,000 Share capital Ordinary shares of l each 10% preference shares of l each Profit and loss account 5,000 1,000 3,000 9,000 5,000 1,000 10,100 16,100 750 16,100 1,500 9,600 16,200 10,000 1,000 5,200 6,000 38,400 3,700 16,850 15,000 26,700 400 42,100 23,900 10,750 13,150 1999 000

49

Note: During the year to 31st December 1999, fixed assets originally costing 5,500,000 were sold for 1,000,000. The accumulated depreciation on these assets as at 31st December 1998 was 3,800,000. Required: (a) Prepare a statement that helps to the directors to understand the liquidity position and overall financial performance of the company in 1999. b) Explain what use this report is in understanding share price movements and indicate what other information might be useful. Refer to your statement, where appropriate, to illustrate your point.

Problem 69 The balance sheets of R Lester are as follows: 31.12.19X7 Fixed assets Equipment at cost Less Depreciation to date Current assets Stock Debtors Less Bad debts provision Cash and bank balances 8,470 420 8,050 4,060 30,680 Less Current liabilities Creditors Working capital 4,140 26,540 43,590 Financed by: Capital Opening balances b/d Add Net profit Add Cash introduced 35,760 10,240 _____ 46,000 33,590 11,070 600 45,260 5,730 27,610 40,700 18,570 14,190 800 13,390 3,700 33,340 16,250 28,500 11,450 17,500 26,100 13,010 13,090 31.12.19X8

50

Less Drawings

12,410 33,590

8,560 36,700 4,000 40,700

Loan from J Gorsey

10,000 43,590

Notes: Equipment with a book value of 1,350 was sold for 900. Depreciation written off equipment during the year was 2,610. Required: Prepare a cash flow statement for R Lester for the year ended 31st December 19X8.

Problem 70 The following are the financial statements of Eccles Foods plc for the two years ended 31st March 2009 and 2010: Balance sheets as at 31st March

2010 m

2009 m

Fixed assets Tangible Intangible Investments 431 19 82 532 Current assets Inventories Debtors Cash 482 290 3 775 Creditors falling due within 1 year Total assets less current liabilities Creditors falling due after 1 year Loan stock (181) 704 Capital and reserves Called-up share capital of 1 each 385 247 (213) 576 (422) 353 885 401 251 7 659 (367) 292 789 410 23 64 497

51

Share premium account Retained earnings Profit and loss accounts for the year ended 31st March 2010 m Turnover Cost of sales Gross profit Distribution costs Administrative expenses Operating profit Net interest paid Exceptional item Profit before taxation Taxation Profit after taxation Dividend paid Retained profit for the year 1,240 (902) 338 (98) (73) 167 (3) (4) 160 (90) 70 (30) 40

319 704

50 279 576

2009 m 990 (704) 286 (81) (56) 149 (9) __ 140 (80) 60 (20) 40

The following further information is available: (1) Tangible fixed assets: Cost m As at 1st April 2009 Additions, at cost Disposals Depreciation for the year As at 31st March 2010 621 82 (30) ___ 673 (13) 44 242 Accumulated Depreciation m 211 m 410 82 (17) (44) 431 Net

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

52

The value of goodwill has fallen during the year and the resulting write down of book value was treated as an exceptional item in the profit and loss account. (3) Fixed asset investments: Additional shares were purchased for cash. No other changes occurred during the year. The interest received during the year on these investments was 5 million, this amount is included in net interest paid. (4) Creditors falling due within one year are as follows: 2010 m Trade Taxation Bank overdraft 110 90 222 422 2009 m 130 80 157 367

(5) On 1st May 2009 80 million 1 ordinary shares were issued at 1.10 each. On 1st October 2009 the share premium account was utilized in making a bonus issue of ordinary shares. Required: (a) Prepare a cash flow statement for Eccles Foods plc for the year ended 31st March 2010 (b) A cash flow statement provides information on the financial performance of a company which is not immediately available from the balance sheet or profit and loss account. Identify two such items from the cash flow statement of Eccles Foods plc and explain how they illustrate the above statement.

Problem 71 The balance sheets of Easy Fix Ltd as at 31 December 2008 and 2009 and a summary of the profit and loss account for the year ended 31 December 2009 are given below: Balance Sheet as at 31 December 2008 000 Fixed assets Land and buildings Plant and machinery Investment at cost 37,000 16,5000 6,000 59,500 50,000 19,500 6,000 75,500 2009 000

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Current assets Stocks Debtors Cash at bank 11,400 12,000 4,700 28,100 Current liabilities Bank overdraft Trade creditors Corporation tax 0 8,800 4,000 12,800 10% Debentures Net assets Capital and Reserves 1 ordinary shares Share premium Revaluation reserve Profit and loss account 30,000 3,000 31,800 64,800 Summary Profit and Loss Account for the Year Ended 31st December 2009 000 Loss before tax (after depreciation on plant and machinery of 4,000,000 Tax Profit after tax Dividends Retained loss for the year You are given the following information: (1) During the year several machines were disposed of for 3,200,000. The machines has a total original cost of 4,000,000 and had a total net book value at the date of disposal of 2,000,000. (2) During the year, a right issue was made. (3) Included in the loss before tax was and investment income of 1,250,000 and an interest payment of 5,100,000 (12,300) (2,500) (14,800) (500) (15,300) 40,000 5,000 8,000 16,500 69,500 10,000 64,800 1,500 9,600 3,000 14,100 12,800 69,500 10,500 10,400 0 20,900

54

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

Problem 72 Dolente Ltd is a small company which designs, manufactures and sells innovative electronic instruments. The directors of the company have discussed the financial statements prepared for the year ended 31st March 2010 and have made the following remarks. We are surprised to see that we have a loss for the year as our bank balance seems to be healthy and has increased from the 2009 figure. The following are the financial statements of Dolente Ltd for the two years ended 31st March 2010. 2010 Balance sheets as at 31st March Fixed assets Tangible Intangible Current assets Inventories Trade debtors Prepayments Bank Creditors falling due within 1 year Total assets less current liabilities Creditors falling due after 1 year Loans (462) 878 Capital and reserves Ordinary shares of 1 each Share premium Retained earnings 700 90 88 878 600 50 102 752 (426) 752 520 280 38 306 1,144 (800) 344 1,340 000 000 862 134 996 488 302 46 214 1,050 (820) 230 1,178 000 2009 000 820 128 948

55

Profit and loss account for the year ended 31st March 2010 000 Turnover Cost of sales Gross profit Distribution costs Administrative expenses Operating profit Interest payable Exceptional items Loss before taxation Taxation Loss for the year The following further information is available: (1) Tangible fixed assets: Cost 000 As at 1st April 2009 Additions, at cost Disposals Depreciation for the year As at 31st March 2010 1,346 1,242 164 (60) (26) 88 484 Accumulated depreciation 000 422 000 820 164 (34) (88) 862 Net 2,480 (2,004) 476 (290) (134) 52 (46) (20) (14) (14)

The assets were sold for cash proceeds of 10,000. Any profit or loss arising is included in the operating profit for the year. (2) Intangible fixed assets: These are patents on innovative electronic instruments. 000 As at 1st April 2009 Purchases Amortization (in operating profit) Exceptional write down As at 31st March 2010 128 40 (14) (20) 134

(3) Prepayments all relate to expenses charged against operating profits. 56

(4) Creditors falling due within one year 2010 000 Trade creditors Accrued interest Taxation 786 14 800 2009 000 650 10 160 820

(5) On 1st May 2009 100,000 1 ordinary shares were issued at 1.40 each. Required: (a) Prepare a cash flow statement for Dolente Ltd for the year ended 31st March 2010. (b) Using the information provided by the cash flow statement, comment on the remarks of the directors on the results for the year.

57

Ratio analysis
Problem 73 Karen has been told that Wahib & Wills plc is a fast growing company and she seeks your advice on whether or not to buy shares in the company. She has provided you with the following summarized information taken from the recent annual accounts of Wahib & Wills plc: Profit and loss account Turnover Gross profit Net profit Dividend Balance sheet Fixed assets Stock Trade debtors Cash at bank Trade creditors Share capital (1 shares fully paid) Profit and loss account 2,680 360 240 200 840 2,400 240 000 7,200 2,160 300 150

The share price of Wahib & Wills plc is currently 160 pence and it has been around this level for the past few months. The trade association to which Wahib & Wills plc belongs compiles statistics taken from the annual accounts of its members, and from other sources, and you have obtained the following recently prepared data which give the industry average for seven statistics as: Gross profit margin Current ratio Quick (liquid) ratio Debtors collection period (days) Stock holding period (days) Trade credit period (days) Price/earnings ratio 50% 2.54 1.87 28 36 54 10

Required:

58

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

Problem 74 The chairman of Badwa plc, which owns a chain of hotels, is concerned about recent comments in the financial press to the effect that the company is too highly geared. The following figures appear in the companys recent balance sheet: Called up share capital Share premium account Profit and loss account 8% Debentures Total assets less current liabilities 1,000,000 4,800,000 6,100,000 13,990,000 25,890,000

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

Required: (a) Give reasoned arguments to indicate what values you would like to see in the balance sheet of Badwa plc for each of the four items referred to above. If any are controversial, explain why this is so. (b) Redraft the balance sheet extract incorporating you suggestions in (a) above and calculate the gearing ratio before and after any changes you have made. (c) Is high gearing necessarily a bad thing? Do you consider that increasing asset values in a balance sheet is likely to lead to less criticism by the financial press of a companys gearing? Explain your reasoning carefully. 59

Problem 75 Although MX plc. has a large cash balance, it offered its shareholders the choice of whether to have the final dividend for the year ended 31st March 1999 in shares (a scrip dividend) or in cash. The majority opted for shares and the necessary accounting entries were made in the published accounts for 1999. Required: For each of the following ratios, state whether it is higher, lower or unchanged as compared with ratios calculated to reflect a 100% cash dividend and explain briefly why this is so. (a) Return on shareholders equity (b) Return on net assets (c) Current ratio (d) Creditors turnover ratio (e) Gearing ratio (f) Dividend cover.

Problem 76 The summarized balance sheet of G Ltd is given below: Total assets less current liabilities Financed by: Share capital, 25p shares Share premium account Revaluation reserve Profit and loss account 10% debenture loan, 2006 400 360 300 440 800 2,300 Required: Explain briefly the nature of the share premium account and how it arises, and calculate the following: (i) the companys gearing ratio (ii) the maximum dividend per share that company could legally declare assuming that it has sufficient cash. 2,300

Problem 77 The following statistics relates to Gandee plc for 2001: 60

Profit before interest and tax Retained profit for the year Dividend for the year Interest cover Dividend cover Required:

120,000 20,000 19,200 5 4

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

Problem 78 The following information relates to two companies in the same industry whose financial year end is the same: Cax plc Profit before interest and tax Operating profit margin Return on net assets Asset turnover ratio Required: Calculate the return on net assets for Cax plc and the asset turnover ratio for Dox plc. Give possible reasons for the differences in the three ratios for the two companies. 1,680,000 10.50% ? 1.6 Dox plc 1,680,000 16.00% 12.00% ?

Problem 79 Company A 000 Ordinary shares 12% debentures 600 ___ 600 B 000 400 200 600 C 000 50 550 600

The return on capital employed was 20 per cent for each firm in 19X4 and in 19X5 was 10 per cent. Corporation tax in both years was assumed to be 55 per cent, and debenture interest is as allowable expense against corporation tax. Required: (a) Calculate the percentage return on the shareholders capital for each company for 19X4 and 19X5. Assume that all profits are distributed. (b) Use your answer to explain the merits and the dangers of high gearing. 61

Problem 80 Adrian Frampton was considering the purchase of one of two businesses. However Frampton had only been provided with limited information about the businesses, as follows: Summarised financial information for the year ended 31st December 19X9: Business X Cost of goods sold Administrative expenses Average stock at cost Working capital as at 31st December 19X9 Selling and distribution expenses Proprietors capital at 1st January 19X9 Gross profit percentage mark-up on cost 400,000 50,000 40,000 90,000 15,000 200,000 20 Business Y 600,000 60,000 50,000 250,000 35,000 350,000 25

Additional information: (1) Average stock had been calculated by using the years opening and closing stocks. Subsequently it was discovered that Business Y had overvalued its stock on 31st December 19X9 by 10,000. (2) Business Xs administrative expenses included a payment for rent of 15,000 which covered a three-year period to 31 December 19X1. (3) A sum of 2,500 was included in the administrative expenses of Business Y in respect of a holiday taken by the owner and his family. (4) Cash drawings for the year ended 31 December 19X9 were: Business X Business Y (5) 20,000 25,000 Business X Business Y Required: (a) Based on the information available prepare comparative trading and profit and loss accounts for the year ended 31st December 19X9. 190,000 400,000

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

62

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

Problem 81 John Jones is considering purchasing shares in one of two companies and has extracted the following information from the balance sheet of each company: Company A plc 000 Authorised share capital 1 ordinary shares 8% 1 preference shares Issued share capital 1 ordinary shares 8% 1 preference shares Reserves Share premium Retained earnings Loan capital 10% debentures (19X0) 12% debentures (19X6) Required: (a) Define the term gearing stating clearly what is meant by a low gearing ratio. (b) Calculate the gearing factor for each company (c) Explain to John Jones the significance of gearing to an ordinary shareholder in each of the companies above. (d) Assuming for each company a trading profit of 200,000 before interest and an ordinary dividend of 15 per cent complete the profit and loss appropriation account for a year for each company. You should ignore taxation. 400 200 300 400 400 200 300 200 800 600 400 1,000 Company B plc 000

63

Problem 82 Durham Limited had an authorized capital of 200,000 dividend into 100,000 ordinary shares of 1 each and 200,000 8% preference shares of 50p each. The following balances remained in the accounts of the company after the trading and profit and loss accounts had been prepared for the year ended 30th April 19X9: Dr Premises at cost General reserve Ordinary shares: fully paid 8% Preference shares: fully paid Electricity Cash at bank Profit and loss account balance 1st May 19X8 Debtors and creditors Net profit (year ended 30th April 19X9) Machinery and plant at cost Provision for depreciation on machinery and plant Stock Provision for doubtful debts Insurance Preference share dividend paid 900 2,000 242,000 242,000 60,000 4,000 40,000 60,000 20,000 13,100 14,500 12,900 16,500 86,000 4,000 100,000 50,000 100 Cr

The Directors have recommended: (1) a transfer of 5,000 to general reserve; (2) an ordinary dividend of 0.15p per share; and (3) a provision for the unpaid preference share dividend. Required: (a) Prepare the profit and loss appropriation account for year ended 30th April 19X9. (b) Prepare the balance sheet as at 30th April 19X9, in a form which shows clearly the working capital and the shareholders funds. (c) Identify and calculate: 64

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

Problem 83 The summarised accounts of Hope Ltd for the year 19X8 and 19X9 are given below: Trading and Profit and Loss Accounts for the year ended 31 December 19X8 000 Sales Less Cost of sales Gross profit Less Administration expenses Debenture interest Net profit 38 _ 12 46 4 20 200 150 50 19X9 000 280 210 70

Balance Sheet as at 31 December 19X8 000 Ordinary share capital Profit and Loss Account 8% Debentures Creditors Bank 15 10 _ 155 Stock at 1st January 19X8 was 50,000. Required: (a) Calculate the following ratios for 19X8 and 19X9: (i) Gross profit : Sales (ii) Stock turnover 65 _ 203 100 30 19X9 000 100 41 50 12 Stock Debtors Bank 20 25 _ 155 30 28 5 203 Fixed assets, at cost Less Depreciation 110 140 19X8 000 19X9 000

(iii) Net profit : Sales (iv) Quick (acid test) (v) Working capital (vi) Net profit : Capital employed (b) State the possible reasons for and significance of any changes in the ratios shown by your calculations. Problem 84 Answer the following questions put to you by a friend: Do you think the shares in Rahman and Shah plc are worth buying at the present price of 150 pence? I see from the balance sheet that the net assets per share are 220 pence. Why are the two figures different?

66

Consolidated Financial Statements


Problem 85 On 1st January 1999 Huge plc purchased all the issued share capital of Medium Ltd for 25.2 million which was paid for by a new issue of 1 shares in Huge plc at 1.40 each. The tangible net assets included in the balance sheet of Medium Ltd had a fair value to Huge plc at that time of 17 million. Medium Ltd sells a well-known branded product which Huge plc valued at 6 million and which is to be included in the accounts at that figure. Required: (a) Show how the takeover of Medium Ltd will affect the balance sheet of Huge plc. (b) Show how the consolidated balance sheet of the Huge plc group will be affected by the takeover of Medium Ltd. (c) What is an asset? How would you decide whether a brand name should be permitted to appear on a companys balance sheet? (d) Give reasons why some companies might wish to include brands on their balance sheet whereas others might not. (e) A director of Huge plc argues that, unlike most other fixed assets, the brand acquired on the takeover of Medium Ltd should not be depreciated as its value is likely to be maintained or even increased over time. Comment on this view and explain whether or not you agree with it.

Problem 86 Axe plc acquired 75% of the ordinary share capital of Bee Ltd by issuing 40,000 new 1 ordinary shares to the shareholders of Bee Ltd. At that date the net assets of Bee Ltd, according to its balance sheet, were 80,000. The fair value of Bee Ltds net assets was found to be 100,000. The market value of each share in Axe plc was 2.20. The company has no other subsidiaries. Required: Give calculations for the Axe plc group of: (a) goodwill on consolidation (b) minority interests (c) the change in share capital, reserves and net assets of the group following the acquisition. What figure would be shown in Axe plcs own balance sheet in respect of the investment in Bee Ltd?

67

Alternative Methods of Accounting


Problem 87 Angelina commenced business on 1st January with 10,000. Her transactions in the first year (all for cash) were as follows: 1 January 31 December Purchased 3 KXs Sold 2 KXs Purchased 2 KXs Paid expenses 9,000 13,000 8,400 2,000

Her accountant has prepared the following profit and loss account for the first year of business: Sales Purchases Less closing stock Gross Profit Less expenses Net profit for the year 17,400 (11,400) 6,000 7,000 2,000 5,000 13,000

The general price level rose during the year by 5%. Angelina recalls reading, during her undergraduate studies, that the purpose of income calculation is to give an indication of the amount which one can consume without impoverishing oneself. She has interpreted this to mean that, if she withdraws 5,000, the capital of the business will be maintained at its original level. Required: Is Angelina correct in assuming she can withdraw 5,000 and still keep her original capital intact? Explain your assumptions carefully and give calculations to support you answer.

Problem 88 During the last year general price inflation in the economy was 2% and the replacement cost of our factory machinery increased by 30%. Would it be sensible to account for such changes in the annual accounts? Required:

68

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

69

Introduction to Costing
Problem 89 Porter company manufactures a number of furniture products. The accountant of the company unfortunately is on vacation. There is a need to prepare the data for cost analysis and planning. Selected costs are given below. You are just appointed for internship in accounting department and asked for help. (a) Wood is used in the manufacturing of the tables at a cost of 100 per table. (b) The tables are assembled by workers, at a cost of 40 per table. (c) Workers assembling the tables are supervised by a factory supervisor who is paid 25,000 per year. (d) Electrical costs of 2 per machine-hour are incurred in the factory in the manufacturing department. Four machine-hours are required to produce the table. (e) The depreciation cost of the machines in the manufacturing department totals to 10,000 per year. (f) The salary of the president of Porter is 100,000 per year. (g) Porter spends 250,000 to advertise its products. (h) Salespersons are paid at a commission of 30 for each table sold. (i) Instead of producing the tables, Porter could rent its factory space out at a rental income of 50,000 per year. Required: Fill in the table below.
Item VC FC Period Direct Material Direct Labour Manufac. Overheads Direct Indirect Sunk Opportunity

(a) (b)

Problem 90 The following information has been taken from the ledger accounts of Klear-Seal Company for the year ended December 31, 19X5: $ Selling expenses Raw materials inventory, January 1 Raw materials inventory, December 31 140,000 90,000 60,000

70

Utilities, factory Direct labor cost Depreciation, factory Purchases of raw materials Sales Insurance, factory Supplies, factory Administrative expenses Indirect labor Maintenance, factory Work in process inventory, January 1 Work in process inventory, December 31 Finished goods inventory, January 1 Finished goods inventory, December 31

36,000 150,000 162,000 750,000 2,500,000 40,000 15,000 270,000 300,000 87,000 180,000 100,000 260,000 210,000

Management wants to organize these data into a better format so that statements can be prepared for the year. Required: (a) Prepare a schedule of cost of goods manufactured for 19X5. (b) Compute the cost of goods sold for 19X5. (c) Using data as needed from (a) and (b), prepare an income statement for 19X5.

71

Job-Order Costing
Problem 91 Hogle Company is a manufacturing firm that uses job-order costing. On January 1, 19X5, the companys inventory balances were as follows: $ Raw materials Work in process Finished goods 20,000 15,000 30,000

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

72

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

73

Allocation of overheads: Traditional Approach and Activity-Based Costing


Problem 92 Dinghy Products Ltd makes two products, masts and booms. There are two production departments, Turning and Finishing. There is also a sales administration office and a storeroom for parts and materials. The following information is available. Turning Floor space (m) Issues of parts and materials per month Direct labour hours per mast Direct labour hours per boom 300 20 3 4 Finishing 150 5 4 3 Office 10 Storeroom 40

The following are the budgeted output and costs for a month: Output of masts Output of booms Factory rent Salary of storeman (all storeroom costs) Salary of office clerk (all office costs) 200 800 1,000 1,300 1,500

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

Problem 93 The following information is available for a factory which houses the assembly, finishing and machining departments: Assembly Department Floor areas Number of employees NBV of machines 40,000 sq ft 150 $1,800,000 Finishing Department 35,000 sq ft 100 $1,200,000 Machining Department 25,000 sq ft 50 Nil

During the month of January 2007, the factory incurred the following indirect overheads: Rent Heating and Electricity Indirect labour $50,000 $25,000 $70,000

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

Problem 94 The indirect costs incurred by the business on behalf of all departments taken together are given below: Cost item Total cost this month, Indirect materials Indirect labour Rent Insurance Depreciation Total 36,000 40,000 1,000 1,600 2,000 80,600

The costs must be apportioned (shared) over the departments because there is insufficient information to permit allocation of costs as a whole. The following table sets out relevant information about each department which will be used in the process of determining an overhead cost rate: Assembly Direct materials used for production 400,000 Number of employees Floor area Value of machinery 10 100 sq m 30,000 Finishing 500,000 25 200 sq m 50,000 64,000 Maintenance not applicable 5 100 sq m 20,000 not applicable

Number of direct labour hours 55,000 worked on production

75

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

Problem 95 Aerodec, Inc., manufactures and sells two products, X and Y. Annual sales in units, labour time per unit, and total manufacturing time per year are provided below: Total Hours Product X: 2,000 units x 5 hours Product Y: 10,000 units x 4 hours Total hours 10,000 40,000 50,000

Costs for materials and labour for one unit of each product are given below: Product X Direct materials Direct labour (at 6$ per hour) $25 $30 Y $17 $24

Manufacturing overhead costs total $800,000 each year. The breakdown of these costs between the companys six activity centers is given below. The cost driver for each activity center is shown in parentheses. Expected Number of Events or Transactions Activity Center and Cost Driver Traceable Costs Labour related (direct labour-hours) Machine setups (number of setups) Quality inspections (number of inspections) Production orders (number of orders) Material receipts (number of receipts) General factory (machine-hours) $80,000 $150,000 $160,000 $70,000 $90,000 $250,000 $800,000 Required: (a) Aerodec, Inc., has six activity centers. Classify the activity in each of Aerodecs activity centers as either a unit-level, batch-level, product-level, or facility-level activity. 76 50,000 5,000 8,000 400 750 40,000 Total Product X 10,000 3,000 5,000 100 150 12,000 Product Y 40,000 2,000 3,000 300 600 28,000

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

Problem 96 Clinton Ltd is a small company, which was established a year ago to produce and sell two products, A and B, within a local area. Two local competitors also produced A, but B was a new development and there was no competitor in the market. Although their prime costs are very different, each product requires the same number of machine hours to produce one unit. The finance director has based the selling prices upon the manufacturing cost plus a mark-up of 25% to cover non-manufacturing costs and profit. The following figures apply: A Budgeted output (units) 700 Prime cost Overhead (8 machine hours) 80.00 152.40 232.40 Mark-up (25% of cost) Selling price 58.10 290.50 B 1,400 9.00 152.40 161.40 40.35 201.75

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

77

The management director has just heard that both competitors have announced their intention to stop producing A. However, one of them has also declared that they will be starting to produce B and will offer it for sale at 160 per unit, undercutting Clintons selling price of B. The management director has sought your advice and after some investigation you have established the following additional information (i) (ii) The production process comprises two distinct cost centers, Assembly and Finishing. The machine hours required to produce each product are: A Machine hours in: Assembly Finishing Total 6 2 8 B 2 6 8

The aggregate overhead budgeted and spent in the first year, 320,000 is attributable as follows: 000 Assembly Finishing Total Required: (a) Explain with supporting calculation how the finance directors allocation of 152.40 overhead cost per unit of both products would have been arrived at. Comment on this method and its potential effects on business decisions. (b) Prepare product costs and selling prices using an alternative allocation of overheads to A and B, and support your method with reasoned arguments. Offer your suggested explanation for the competitors behavior and advise the managing director. (c) Briefly discuss the issue of, and methods for, allocating non-manufacturing overheads to products. 240 80 320

78

Absorption and Variable Costing


Problem 97 Palit Ltd. commenced business on 1 April 1993 and purchased equipment for 170,000 to manufacture product NPQ as from that date. The results for the year to 31 March 1994 and the budget for the following year are as follows: 1993/4 Actual NPQs produced (units) NPQs sold (units) 2,000 1,500 Unit selling price of NPQs Cost of raw materials purchased Direct wages Manufacturing expenses: Variable Fixed Selling and administrative expenses 10,000 30,000 50,000 11,000 30,000 50,000 160 70,000 50,000 1994/5 Budget 2,200 2,000 160 77,000 55,000

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

79

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

Problem 98 Coase Ltd is a single-product manufacturing company which uses a marginal costing system for internal management reports. The companys annual profit and loss accounts for external reporting purposes are based on full absorption costing. The following data refer to the years ended 30th June 2007 and 2008: 2007 Selling price Marginal cost per unit Direct materials Direct labour Marginal factory overheads Marginal selling and administrative expenses Fixed factory overheads 21 19 8 2 170,000 Units Opening stock Closing stock Sales 1,500 2,000 20,000 23 22 10 3 180,000 Units 2,000 1,500 25,000 2008 90

The normal volume used for the purpose of absorption costing is 28,000 units in both years. The company uses the first-in first-out assumption for the calculation of cost of sales. Required: (a) Prepare internal management profit statement for the year ended 30th June 2008 using marginal costing. (b) Prepare a draft profit and loss account for the year ended 30th June 2008 using full absorption costing. (c) Give calculations showing why the profits for 2008 are not the same in your answers to (a) and (b) above. Explain your answer.

Problem 99 John Smith, a friend of yours, has been trading for the past two years producing and selling skids. Although his accountant has drawn up accounts for his he feels they do not give an 80

accurate picture of the business performance for decision-making purposes. He has asked you to look at his records and to draw up alternative profit and loss accounts for each of the past two years. The selling price for skids has been 9 per unit for the past two years and the following information is available: 1997 Units Sales Production 1,500 1,900 Costs: Factory variable Factory fixed Administration fixed Selling variable 5,700 3,800 2,000 1,800 5,400 3,330 2,200 2,400 1998 Units 2,000 1,800

John Smith commenced business in 1997 with no stock and he uses FIFO for stock valuation purposes. Required: (a) Produce profit and loss accounts for 1997 and 1998 using absorption costing. (b) Produce profit and loss accounts for 1997 and 1998 using variable costing. (c) Assume now that if John Smith decided to spend 600 in 1998 on improved quality control procedures in the factory then sales volume for the year would rise by 5%. Explain which costing method would give the more useful measure to indicate the profitability of the decision. Make use of the data in this question to illustrate your explanation.

Problem 100 Gladstown Manufacturing has added two new products to its range. Its accountant has produced the following summarised financial statement showing the profit earned on these products for the first year using absorption costing. Beta Materials Direct labour 25,000 60,000 Delta 7,500 30,000

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Production overheads Cost of sales Sales Gross profit Other overheads Net profit / (loss)

120,000 205,000 250,000 45,000 20,500 24,500 Units

60,000 97,500 105,500 8,000 9,700 (1,700) Units 7,500 1,250

Sales Closing stock of finished goods

25,000 2,000

There is concern that Delta is showing a loss and it has been suggested that the use of marginal (variable) costing would give a fairer picture of the financial results. Further analysis shows that one-third of the production overhead charged to each product varies according to the level of production whereas two-thirds of the charge is product-related and is fixed. 75% of the other overheads are company overheads that have been allocated to the products and 25% vary with the level of sales of each product. Required: (a) Redraft the absorption costing statement in more detail showing such matters as the cost of goods produced, stocks, fixed overheads and variable overheads, (b) Prepare a statement showing the contribution and net profit of each product using marginal (variable) costing. (c) Explain why the net profit figures are different under the two methods.

82

Cost-Volume-Profit Analysis
Problem 101 Drake Ltds cost and revenues for the current year are expected to be: Direct labour Direct materials Factory indirect expenses: Variable Fixed 4,500 500 5,000 Administration expenses Selling and distribution expenses Finance expenses 1,200 600 200 20,000 It was expected that 2,000 units would be manufactured and sold, the selling price being 11 each. Suddenly during the year two enquiries were made at the same time which would result in extra production being necessary. They were: (A) An existing customer said that he would take an extra 100 units, but the price would have to be reduced to 9 per unit on this extra 100 units. The only costs that would be involved would be in respect of variable costs. (B) A new customer would take 150 units annually. This would mean extra variable costs and also an extra machine would have to be bought costing 1,500 which would last for 5 years before being scrapped. It would have no scrap value. Extra running costs of this machine would be 600 per annum. The units are needed for an underdeveloped country and owing to currency difficulties the highest price that could be paid for the units was 10 per unit. Required: On the information above, and assuming that there are no alternatives open to Drake Ltd, should the company accept or reject these orders? Draft the memo that you would give to the managing director of Drake Ltd. 6,000 7,000

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Problem 102 Greatsound Ltd manufactures and sells compact disc players, the cost of which is made up as follows: Direct material Direct labour Variable overhead Fixed overhead Total cost 74.80 18.70 7.50 30.00 131.00

The current selling price is 187. Greatsound Ltd. works a day shift only, at present producing 120,000 compact disc players per annum, and has no spare capacity. Market research has shown that there is a demand for an additional 60,000 compact disc players in the forthcoming year. However, these additional sales would have a selling price of 150 each. One way of achieving the extra production required is to work a night shift. However, this would increase fixed costs by 2,500,000 and the labour force would to be paid an extra 20 per cent over the day shift rate. The company supplying the materials to Greatsound Ltd. has indicated that it will offer a special discount of 10 per cent on total purchases if the annual purchases of materials increase by 50 per cent. The selling price and all other cots will remain the same Required: Assuming that the additional purchases will only be made if the night shift runs, you are required to: (a) advise Greatsound Ltd whether it should proceed with the proposal to commence the night shift, based on financial considerations. (b) calculate the minimum increase in sales and production required to justify the night shift. (c) give four other matters which should be taken into consideration when making a decision of this nature.

Problem 103 Xebec Ltd manufactures three perfumes, Silk, Musk and Opia. The selling prices and the variable costs per unit of each product are as follows:

84

Silk Selling price Variable cost 15 10

Musk 20 14

Opia 30 20

Xebecs fixed costs are 150,000 per year. There is a shortage of the raw material called Essence which is used in all three products. Silk uses 2 kilos, Musk uses 1 kilo and Opia uses 3 kilos of Essence per unit of output. Only 120,000 kilos of Essence will be available for the year. In addition, market constraints are expected to restrict the production and sales of each product for the year to: Units Silk Musk Opia Required: Calculate the mix of sales which would enable Xebec Ltd to maximize profits, and calculate the profit for the year which would be achieved by that sales mix. 40,000 8,000 15,000

Problem 104 A summary of Pareto Companys profit statement for last year is presented below. Exept as noted, the cost and sales relationship for the current year is expected to follow the same pattern. The company is operating at full capacity. Sales (1,000,000 bottles at 0,50) Variable costs Fixed costs Total costs Profit Required: (a) What is the break-even point in units? (b) What is the margin of safety in units? (c) If an extension to the factory is built it would add 50,000 to the fixed costs and increase production capacity by 60 per cent. Variable costs per unit are also expected to increase by 10 per cent. The management of the company feels that it should earn at least 10,000 each year 85 500,000 300,000 100,000 400,000 100,000

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

Problem 105 Mento Company manufactures and sells a single product. The companys sales and expenses for the last quarter follow: Total Sales less Variable expenses Contribution margin less Fixed expenses Net income Required: (a) What is the quarterly break-even point in units sold and in sales dollars? (b) Without resorting to computations, what is the total contribution margin at the break-even point? (c) How many units would have to be sold each quarter to earn a target net income of $90,000? Use the unit contribution method. Prove your answer by preparing a contribution income statement at the target level of sales. (d) Refer to the original data. Compute the companys margin of safety (MS) in both dollar and percentage terms. (e) What is the companys contribution margin ratio (CM ratio)? If sales increase by $50,000 per quarter, by how much would you expect quarterly net income to increase? (Do not prepare an income statement; use CM ratio to compute your answer). $450,000 $180,000 $270,000 $216,000 $54,000 Per Unit $30 $12 $18

Problem 106 A building company constructs a standard unit which sells for 30,000. The companys costs can be readily identifiable between fixed and variable costs. Budgeted data for the coming six months include the following: Sales (in units) January 18 Profit () 70,000

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February March April May June

20 30 22 24 16

100,000 250,000 130,000 160,000 40,000

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

Problem 107 You are provided with the following information relating to the sales, estimated demands and production costs for each bench, table and chair. Bench Estimated selling price Maximum demand Raw materials In units - timber - metal fittings - fabric Packing 60 1,800 10 3 2 Table 71 1,500 12 4 2 Chair 45 3,000 2 7 6 1

Each bench, table or chair involves in two separate stages of processing. 87

1. 2.

The timber is machined, finished and assembled. Metal fittings are fixed. The products are painted and varnished to packaging in polythene and cardboard.

Labour costs are based on the following estimated time (in minutes) required for each processing stage: Stage 1 Benches Tables Chairs The following rates for labour are applied: Stage 1 per hour 4 Stage 2 3 180 150 60 Stage 2 20 60 40

There are a maximum of 10,500 hours of labour available for stage 1. Required: (a) Advise the management the maximum output for each product and the total contribution of the proposed optimal production plan. (b) Explain clearly the basis method used in (a). (c) Identify two factors that should be considered before a final decision is made.

88

Budgeting
Problem 108 The following figures have been taken from the budget of Solaja Ltd, a company in the retail trade, for the year to 31 December 1998: January Sales (units) 5,000 Expenses: Distribution Administration Depreciation 4,500 3,000 1,000 4,700 3,600 1,000 5,200 4,400 1,500 4,500 3,000 1,500 February 6,000 March 7,000 April 5,000

The following additional information is available: (1) The selling price is 6 per unit. It will increase to 6.70 per unit for all sales in April and subsequent months. 25% of budgeted sales revenue is expected to be received in the month of sale and 70% in the following month. 5% of all sales are expected to lead to bad debts. (2) The budgeted number of units of stock held at the end of each month is equal to the budgeted sales for the following month. (3) The purchase price of stock has been 3.50 per unit since October 1997 and this is expected to increase to 4 per unit for all purchases in February and subsequent months. (4) 60% of all purchases are paid in the month of purchase and 40% in the following month. (5) All expenses are paid in the month in which they are incurred. (6) Solaja Ltd plans to buy new fixed assets for 43,000 paying a deposit of 15,000 in February. The balance will be paid in monthly instalments of 2,000 commencing in March. (7) The chairman has suggested that he might be willing to lend up to 12,000 to the company for a maximum of four months to avoid asking the bank for an overdraft. (8) The business is seasonal and, as indicated in the above budget, results in April are expected to be similar to those in January. There is a three month cycle so the results in May and June are expected to be similar to those in February and March respectively. (9) Summarised balance sheet at 31 December 1997: Fixed assets (at book value) Stock at cost Debtors (after bad debt provision) 12,500 17,500 29,400

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Cash at bank Creditors Share capital and reserves Required:

2,000 (7,000) 54,400

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

Problem 109 The management director of Pumpkin Ltd was reviewing the results of the company for the financial year ended 31 March 19X0. The following summarized information was available: Balances as at 1 April 19X9 Issued ordinary share capital: 1 fully paid shares Share premium account Balance of retained earnings 150,000 100,000 40,000 70,0000 300,000 150,000 210,000

Balances as at 31 March 19X0 Net profit for the year 19X9/X0 Fixed assets Bank overdraft Other net current assets

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

The management director was pleased that the company had made a good profit, but he was rather concerned that a healthy bank balance at the beginning of the year had now become a large bank overdraft. Consequently he asked the company accountant to prepare forecast information for 19X0/X1 in order that the cash situation could be improved. The following information was prepared by the accountant: (1) Company sales March 19X0 90

Cash sales Credit sales 30,000 65,000 Cash sales Credit sales All credit sales are settled the month after the sale. (2) All goods purchased are from a single supplier. The goods are purchased on credit and each months purchases are paid for three months after the month of purchase. The following purchase schedule had been prepared for the first 9 months of 19X0: January Purchases Purchases in April, May and June 55,000 in each month Purchases in July, August and September 45,000 in each month Note: the company had successfully negotiated lower prices from its supplier commencing 1 July 19X0. (3) Dividends would be paid as follows: (i) Final ordinary dividend of 5p per share payable on 31 May 19X0 in respect of financial year 19X9/X0. (ii) Interim ordinary dividend of 2p per share payable on 31 July 19X0 in respect of financial year 19X0/X1. (4) Selling and distribution expenses are expected to be 6 per cent of a given months total sales. They are paid one month in arrears. (5) Administration charges would be incurred as follows: 19X0 February, March, April 19X0 May to September (inclusive) 10,000 per month 13,500 per month 60,000 February 58,000 March 61,000 40,000 70,000

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

Administration charges are settled two months after the month in which they were incurred. (6) The company had decided to make a bonus issue of shares of one share for every three held. The issue would be made on 30 April 19X0. The bonus shares would not qualify for the final dividend of 19X9/X0, but would qualify for the interim dividend to be paid on 31 July 19X0. 91

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

Problem 110 The management of Hooke plc have been informed that the union representing the direct production workers at one of their factories, where a standard product is produced, intends to call a strike. The accountant has been asked to advise the management of the effect the strike will have on cash flow. The following data has been made available: (1) Week 1 Budgeted sales Budgeted production 400 units 600 units Week 2 500 units 400 units Week 3 400 units Nil

(2) The strike will commence at the beginning of week 3 and it should be assumed that it will continue for at least four weeks. Sales at 400 units per week will continue to be made during the period of the strike until stocks of finished goods are exhausted. Production will stop at the end of week 2. The current stock level of finished goods is 600 units. (3) The selling price of the product is J60 and the budgeted manufacturing cost is made up as follows: J Direct materials Direct wages Variable overheads Fixed overheads Total 15 7 8 18 48

(4) Direct wages are regarded as a variable cost. Direct wages are paid one week in arrears. (5) The company operates a full absorption costing system and the fixed overhead absorption rate is based upon a budgeted fixed overhead of J9,000 per week. Included in the total fixed overheads is J700 per week for depreciation of equipment. During the period of the strike 92

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

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Variance Analysis
Problem 111 Cleanahull Ltd operates a small boat cleaning service. Boats are cleaned using a special machine that requires a skilled operator and are finished using unskilled labour. Cleanahull has produced a standard cost schedule as all boats go through the same process. Overheads are absorbed using standard labour hours. The materials come in packs; each boat cleaned should use one pack of materials. Cleanahull budgets to clean 288 boats per month. Standard cost for cleaning a boat: Skilled labour: 2 hours at 8 per hour Unskilled labour: 1 hour at 5 per hour Materials: 1 pack at 3 per pack Variable overheads: 3 hours at 2 per hour Fixed overheads: 3 hours at 10 per hour Total standard cost Profit mark-up at 30% cost Price charged Actual results for May 2008: Sales: 330 boats cleaned Less costs Skilled labour: 594 hours Unskilled labour: 396 hours Materials:350 packs Variable overheads Fixed overheads Total costs for May Profit for May Required: (a) Prepare an operating statement, reconciling budgeted and actual profit for Cleanahull Ltd for May 2008 showing two variances for sales and each cost category. (b) Prepare a brief report to the owner of Cleanahull Ltd commenting on the performance in May 2008 suggesting possible reasons for any unexpected results. 5,049 1,881 1,190 1,815 8,500 18,435 7,965 26,400 16 5 3 6 30 60 18 78

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Problem 112 Smith Plc. manufactures and sells a range of small household products. The following information relates to the Adam for the month of July. Budgeted volume Budgeted selling price Budgeted variable cost Budgeted fixed overheads for July 6,000 units 6,00 per unit 2 per unit 6,000

During July 8000 Adams were actually sold for 40,000. Required: (a) Compute the following variances for product Adam: for July: (i) Sales price variance; (ii) Sales contribution volume variance; (iii) Sales margin volume variance. (b) Explain and reconcile the difference between your answers to (ii) and (iii).

Problem 113 Thatcher Ltd uses a standard costing system. The standard cost card for direct materials used in production of product NUM is as follows: 8 kgs @ 0.40 per kg = 3.20 per unit Budgeted production in April 2007 was 850 units. The relevant data for actual production of product NUM for April 2007 was as follows: Actual production Materials purchased 870 units 8,200 kgs at a cost of 3,444

Materials issued to production 7150 kg Required: (a) Calculate the total materials variance for April 2007. (b) Calculate the materials price variance and materials efficiency variance for April 2007.

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Investment appraisal
Problem 114 The government of Nopia is considering operating a series of toll roads which will be operated by companies in the private sector. Contracts to run the toll roads will be for five years at which time contracts will be put out to competitive tender again. As the finance director of QFE plc, a transport operator, you are interested in bidding for one of the first series of contracts. It is anticipated that you will need to pay the government of Nopia an initial fee of 15 million to acquire the right to operate the toll road plus an annual fee of 1.5 million payable at the end of the year 1, increasing by 15% per year thereafter. In addition, the government will take 20% of all revenues generated by the toll road. Operating costs to monitor traffic and collect tolls are expected to be 3 million in year 1 and will then increase by 10% per year. Based on current estimates of usage there will be 112 million miles of vehicle travel per year for each of the five years. The government of Nopia will allow QFE plc to set the toll fee which will be based on the number of miles a vehicle travels on the toll road. Once set, the toll per mile will remain constant for the duration of the contract. Given the risk profile of this project QFE pls will require a return of 12% per year on its investment. Assume all cash flows, apart from the initial fee, will occur at the end of the year concerned. Required: (a) As finance director of QFE plc what is the minimum toll per mile you would be prepared to charge? (b) Assume the government of Nopia is prepared to accept an alternative to the initial fee of 15 million. The alternative is to pay five equal annual instalments to the government commencing immediately. What is the maximum QFE plc should be prepared to pay per year to avoid the initial fee of 15 million? (c) Assume that the government now states that the toll charge must fall by 4% per year from the end of year 1. How would this effect your recommendation in part (a) above? All calculations should be expressed in millions and rounded to two decimal places.

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Problem 115 Part 1 The international division of a large Bulgarian wine producing company is considering starting operations in the UK market. It has commissioned market research on the UK wine market which cost 23,000 Bulgarian Leva (abbreviated BGL). The findings result in a recommendation: to enter this new market the Bulgarian firm needs a marketing campaign. This initial investment is estimated to cost BGL 3 million. The research has also estimated that, following the campaign, the revenues net of cash expenses for UK sales over the next ten years will be: BGL Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 450,000 500,000 620,000 700,000 700,000 700,000 700,000 700,000 700,000 700,000

Assume that all cash flows arise at the end of the year. All figures are in real terms. The real discount rate is 6%. Thanks to funds from the European Union to promote trade with new members, the project is exempt from taxes. Required: Should the company enter the UK market? Provide the relevant calculations to illustrate your answer. Explain and discuss. Part 2 At the end of year 3, an internal assessment of the project and of the revenues from the UK market shows that the sales have been more successful than expected. The company has had a total net cash flow over the previous three years of BGL 2.5 million (instead of the expected BGL 1.57 million). However, the UK market has become more competitive and it is felt that a new marketing campaign is necessary if the company intends to stay in that market. New adverts and promotions would cost BGL 1.4 million. The real discount rate and the tax treatment of the 97

project remain the same. However, because of increased competition the estimates of revenues net of cash expenses in real terms, for the remaining seven years, have to be adjusted downwards to the following: BGL Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Required: (a) Should the company continue with sales in the UK? Provide the relevant calculations to illustrate your answer. Explain and discuss. (b) Should the initial success of the project in the first three years be taken into account in the decision at the end of Year 3? Why? Part 3 At the same time of the re-assessment of the UK market, at the end of year 3, the domestic division of the firm proposes an alternative investment, completely independent of the first one. They are considering entering the bottle production market to supply glass bottles to the growing Bulgarian wine industry. The project would require exactly the same initial investment as the new marketing campaign BGL 1.4 million to buy the necessary machinery. The company depreciates its fixed assets using the straight-line method. Capital allowances are equal to depreciation for this Bulgarian company. The estimated revenue net of cash expenses for the following seven years would be: BGL Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 620,000 530,000 430,000 420,000 420,000 420,000 420,000 620,000 510,000 300,000 300,000 300,000 300,000 300,000

98

It is customary for this division, dealing with the domestic market, to state projects cash flows in nominal terms. Moreover, this project, as a domestic one, is subject to a tax rate of 20%. The inflation rate is 3% per year. The real discount rate is the same. Required: Compare this project with the project in part 2. Which project should the firm choose if it can only undertake one? Provide the relevant calculations to illustrate your answer. Explain and discuss.

Problem 116 Hayek Plc. is considering investing in either project P or project Q: Time (years) Equipment cost Expected annual profit/loss 0 1 2 3 4 5 Estimated resale value of equipment 5 Project P 100,000 34,000 24,000 14,000 4,000 (36,000) 20,000 Project Q 100,000 4,000 4,000 12,000 16,000 4,000 20,000

Hayek Plc depreciates equipment on the straight-line basis. Profits and losses are earned evenly throughout the year. Required: (a) Calculate the payback period for each project and on this basis advise Hayek Plc which project to invest in. (b) Briefly explain two disadvantages of payback period as a method of investment appraisal.

Problem 117 The directors of Welch plc are considering which of the following projects to invest in: Year Alpha Initial capital investment Expected cash inflows 0 1 2 50,000 30,000 20,000 Beta 50,000 30,000 20,000 Gamma 50,000 20,000 20,000

99

3 4 Scrap proceeds 4

6,000 4,000 10,000

6,000 4,000 0

10,000 10,000 10,000

Welch plc uses the straight-line method of depreciation. Required: (a) Calculate the payback period of each project. (b) Calculate the average accounting rate of return of each project. (c) Based on your calculations in (a) and (b), advise the directors which project they should invest in.

Problem 118 As a member of the finance directors team at Londy plc. you have been asked to approve at investment proposal recently received from the companys subsidiaries, Franly Ltd, whose directors consider that the project should be supported as it yields a forecast profit of 460,000 over its anticipated five year life. The following financial information has been provided to support the proposal: Five year forecast profit and loss account for years ending on 31 May 2002 000 Sales Less: Cost of sales Gross profit Less: Depreciation Wages Overheads Forecast not profit/loss Notes: (1) Closing stock (in 000s) is expected to be as follows: 2002 100 2003 150 2004 100 2005 50 2006 0 1,500 900 600 240 150 200 10 2003 000 2,000 1,200 800 240 170 270 120 2004 000 2,500 1,500 1,000 240 170 320 270 2005 000 2,000 1,200 800 240 170 220 170 2006 000 1,000 600 400 240 150 120 (110)

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

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(3) The wages figure includes 48,000 for a manager and 27,000 for a supervisor who are already employed by Franly Ltd. If the project goes ahead, the company will need to hire an additional supervisor at a cost of 25,000 per year. If the project does not proceed, the existing manager and supervisor will remain in their present posts. (4) 10% of the overhead charge varies with the value of sales revenue and 90% in an allocation of group overheads. (5) The equipment will be paid for on 1 July 2001. The required amount of materials and components for the years production will be paid for at the beginning of the year concerned. All other cash flows will occur at the end of the year. (6) Londy plc. uses the discounted cash flow method for project appraisal and the discount rate to be used for this project is 10% per year. Required: (a) Based upon the above information, advise the finance director whether or not the project should be accepted. (b) If it were possible to lease the equipment by paying five equal annual instalments, the first being on 1 June 2001, what is the maximum Franly Ltd should be willing to pay? Explain your answer. (c) Explain to the directors of Franly Ltd why the discounted cash flow approach to project evaluation is often preferred to the forecast profit approach and discuss any limitations the method may have.

Problem 119 Parsons plc. is considering an investment proposal for recycling waste production materials into a product, which can be sold to the packaging industry. The companys accountant has rejected the project on the basis that it results in a forecast loss of 890,000 over its expected five-year life. The companys board of directors are concerned about the carbon footprint of the company and are looking for ways to improve its environmental impact and have agreed that a maximum loss of half a million pounds over a five year period is acceptable. They have requested you to re-examine the financial consequences of the product. You are provided with the following financial information about the project: (1) The accountants forecast is as follows based on the project commencing on 1st January 2009. Five year forecast profit and loss account for years ending on 31 December

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2009 000 Sales Less: Cost of sales Gross profit Less: Depreciation Labour costs Overheads Forecast loss 1,300 1,100 200 320 175 150 (445)

2010 000 2,000 1,300 700 320 195 325 (140)

2011 000 2,200 1,450 750 320 205 300 (75)

2012 000 2,200 1,500 700 320 195 300 (115)

2013 000 2,200 1,500 700 320 195 300 (115)

The following additional information is made available: (2) The recycling process uses up waste materials which have no resale value. At present, disposal of the production waste is arranged by paying an annual fee to a local waste disposal company. If the project is undertaken, these costs will no longer be incurred. The yearly estimated cost of waste disposal (in 000s) is as follows: 2009 80 2010 80 2011 80 2012 80 2013 160

(3) The process will require the purchase of additional materials which are included as cost of sales in the company accountants forecast. The project commenced with no opening stock, but the forecast includes the following projected closing stock of materials (in 000s) at 31st December: 2009 100 2010 200 2011 150 2012 50 2013 0

The materials needed for the year will be purchase and paid for on the first day of the year. (4) On 1st January 2009 the company will purchase and pay for special recycling machinery. The scrap value at 31st December 2013 is estimated at 50,000. Parsons plc uses the straightline method of depreciation which results in a charge of 320,000 per annum. (5) 80% of the overhead charge is an allocation of existing company fixed overheads and 20% represents the overheads incrementally incurred on the new recycling project. (6) In August 2008, the company spent 20,000 on commissioning a report investigating the environmental impact of its waste products. (7) Each years labour costs include 55,000 for the environmental manager and 25,000 for a production supervisor. Both are already employed by Parsons plc. If the project does not proceed, these two employees will remain in their present posts. The remaining labour costs reflect additional workers needed for the process. 102

(8) The board of Parsons wish you to use the discounted cash flow method for the project appraisal and the discount rate to be used for this project is 12% per year. Assume all cash flows occur at the year end, unless otherwise indicated. Required: (a) Based upon the above information, advise the finance director whether or not the recycling project should be accepted. State any assumptions and use a tabular format for your calculations. All figures to the nearest 000. (b) In the context of project evaluation, what do you understand by the term sensitivity analysis? Give (without calculations) two examples of sensitivity analysis considerations for the recycling projects.

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