Case study for Chapter 5

This case study draws upon material covered in Chapters 2, 3, 4 and 5.

Fergus and Flora are both in their early fifties. Until recently Fergus was employed as a structural
engineer, but has had to give up his job due to stress and ill health. Flora continues to be
employed as a full-time hospital administrator. Both are very keen amateur painters with a lifelong interest in the arts. Having given up his employment, Fergus starts to think about how he
could turn this interest into a profitable business. He rejects the idea of trying to become a fulltime professional artist. Although he has had some success in selling a few of his watercolours
via exhibitions in the local public library, he is realistic about his talent, or lack of it, and knows
that he can never hope to make more than a few pounds out of his hobby.

Fergus and Flora have almost finished paying off their mortgage and have some money set aside
in savings for their retirement. Fergus starts working on a plan to use the money to start an art
gallery business. They live next door to a farm, and adjoining their land is a small barn that has
not been used for many years. The barn is now just a shell of a building, but Fergus thinks that it
could be converted for use as a gallery. The farmer is amenable to selling it, and he obtains
planning permission for the buildings change of use. Fergus, with Floras agreement, uses their
savings of 90 000 to buy the barn, and to carry out the necessary work of converting it. He does
quite a bit of the work himself, and uses contacts in the building trade to obtain supplies at trade
prices. Nevertheless, the project runs over budget, and the business has to borrow a further 30
000 from the bank, secured on the property. The borrowing is on the basis that no capital
repayments will be required for the first three years of the loan. Interest payable for the loan is
200 per month.

Fergus plans to stage one exhibition in each month of the year, excluding September (when he
and Flora like to take their annual holiday) and January. He makes discreet enquiries about rival
galleries commission charges and decides that he can reasonably charge his artists 40% of the
selling value of their work as commission. He also sells greetings cards, posters and a small range
of pottery whenever the gallery is open.

Ferguss initial capital contribution to the business comprises the barn and a second-hand
computer system. The cost of the barn including conversion is 120 000. Ferguss capital

Use with Business Accounting and Finance 3rd edn (ISBN 9781408018378)
Catherine Gowthorpe, 2011 published Cengage Learning EMEA

contribution in respect of the barn is 90 000, and there is a long-term loan (the mortgage) of 30
000. Fergus bought the computer system, including software, for 1500 and transferred it straight
into the business. The start date of his business is 1 January 20X4, and it trades as The Hayseed
Gallery. After only a couple of months Fergus realises that he will have to buy a van for the
business. Some of the art work he is exhibiting is of generous dimensions, and he finds that he
needs transport to get the work from the artists studios to the galleries. On 31 March 20X4 the
business buys a second hand van for 6 000.

Fergus keeps costs tightly under control. He does not plan to spend more than he can help on
staff, but he finds that its necessary to have a part-timer in for three afternoons per week so as to
free up his time for visiting artists and doing routine administration tasks.

On average at each exhibition, Fergus exhibits work with a total sales value of 11 500.
Generally, hes happy to let the artists set the price of their own work, but he doesnt like to
exhibit work thats priced at over 1000 per piece because he doesnt think many people are
willing to spend four figure sums on art. At the outset he hoped to sell about 40% of the work at
each exhibition, but he has been pleasantly surprised to find that in most exhibitions he is selling
well over 50% by value of the work on show. In fact, the exhibition in November was a sell-out.

At the end of his first years trading Fergus feels reasonably happy with the state of his business.
True, he has had to negotiate a flexible overdraft facility with the bank, and at times he has come
very close to the overdraft limit of 5000. However, he feels hes built up some useful contacts
over the year and the gallery has had some good write-ups in the local press. When he sits down
to discuss things with Flora, however, he finds that she has a rather different perspective on the
business:

Well, I can see its a nice little hobby, but thats all it is, and I cant see it really developing into
something profitable. Your business bank accounts been at around zero, at best, all year, and
youve not taken a penny out in drawings. Weve put all our savings into this venture, and Id be
very surprised if its going to be profitable in the longer term. You should have done some serious
budgeting at the beginning, so at least wed know whether things are on track or not. At this rate
Ill have to shelve my plans for early retirement - somebodys got to keep the cash coming in.

Use with Business Accounting and Finance 3rd edn (ISBN 9781408018378)
Catherine Gowthorpe, 2011 published Cengage Learning EMEA

Fergus is really taken aback. He has to admit that he doesnt actually know whether the business
is profitable or not. Hes just happy to have finished the year with a few pounds in the bank. As
he tells Flora:

After all, it is just the first year, and it takes time to build up a business. I think youre being a bit
hasty in supposing that its never going to make money. I never thought for a moment I was
going to make a fortune doing this, but Im much happier than I was when I was at work fulltime. Surely that counts for something? Tell you what, Ill go and see Simon [the accountant] on
Monday and Ill get him to do some accounts for me. Then we can have a look and see how much
profit Ive made this year. Im sure theres no need to worry its early days yet.

Fergus gathers up a list of balances from his bookkeeping records, as follows:

Commission earned on sales of artwork

27 650

Purchases of cards, posters etc.

4 570

Amounts due to artists in respect of sales

1 660

Mortgage loan

30 000

Capital introduced

91 500

Heating and lighting costs

951

Interest paid

2 400

Land at cost

40 000

Building at cost

80 000

Sales of cards, posters etc

3 600

Private view expenses

2 850

Building repairs and maintenance

660

Advertising

3 244

Mailshot expenses

3 454

Staffing costs

2 663

Motor vehicle running costs

1 566

Motor vehicle at cost

6 000

Computer at cost

1 500

Trade receivables

580

Telephone charges

997

Insurance

752

Use with Business Accounting and Finance 3rd edn (ISBN 9781408018378)
Catherine Gowthorpe, 2011 published Cengage Learning EMEA

Cash at bank

648

Inventory of cards, posters etc

2 206

Other expenses

1 575

Notes:
1. The total cost of the barn including conversion costs is 120 000. Fergus estimates that 40
000 of this relates to land, which, of course, is not to be depreciated. Simon advises Fergus
that the remainder of the total cost, 80 000, should be depreciated on the straight line basis
over an estimated useful life of 100 years.
2. The computer and software will probably need replacing after about 5 years. Neither the
hardware nor the software are likely to have any value at all at the end of five years. Simon
advises the use of the straight line method of depreciation for the computer.
3. Simon tells Fergus that its often best to depreciate motor vehicles using the reducing balance
method of depreciation. He proposes to depreciate the van at the rate of 20% per year on the
reducing balance basis, charging only 9 months depreciation in the first year to reflect the fact
that the van was bought three months into the financial year.
4. Simon estimates that his own fees for accountancy and tax advice will come to 650 for the
20X4 financial year.
5. Fergus has not received the last quarters bill for phone charges. He estimates that these will
amount to 223 for the quarter ending 31 December 20X4.
6. Of the insurance charge of 752, 200 relates to the 20X5 financial year.

Required:

a) prepare a income statement for Fergus for the year ending 31 December 20X4 and a
statement of financial position at that date;
b) comment upon the profitability of Ferguss business. Is Flora correct in her view that the
business is essentially a hobby that will never be profitable?
c) advise Fergus on ways in which he could seek to improve the profitability of his business.

Use with Business Accounting and Finance 3rd edn (ISBN 9781408018378)
Catherine Gowthorpe, 2011 published Cengage Learning EMEA