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HOMEWORK1: Introduction To Accounts

1. What is the accounting equation?

Total Assets = Total Liabilities

2. Give the names used in accounts to describe:

a) Items that a company owns - ASSETS

b) Items that a company owes - LIABILITIES

c) Amounts due to a company's shareholders SHAREHOLDERS FUNDS; for


individual company accounts this is same as EQUITY

3. Give definitions for the following accounting terms:

a) Net assets - are total assets minus total liabilities. This is shown specifically
in UK-style balance sheets and rarely heard of in the US. Net Assets is
usefully if you are focussing on Equity and return on equity measures.

b) Current assets - are assets that a company means to sell or collect, usually
within a 1-year timeframe

c) Current liabilities - are amounts that the company owes that it will pay or
deliver within the next 1 year

d) Net current assets - are current assets minus current liabilities- used to
assess the liquidity of a company

e) Reserves - are amounts that the company has generated or received which
it has not paid out to shareholders

4. A set of scales helps us visualise a set of accounts. What important point does it
ensure always applies?
Using a set of scales to represent a set of accounts emphasises the fact that a
set of accounts should always balance.

5. What is the difference between and give examples of:

a) "Current assets" and "fixed assets"?


Current assets are cash or convertible into cash within 1 year (stocks,
customer balances, prepayments)
Fixed assets are usually to be used up converting other assets into
saleable assets and not sold - if they are to be sold, not within the next
year.

b) Current liabilities" and "long term liabilities"?

FINANCIAL MARKETS EDUCATION: ACCOUNTING FUNDAMENTALS


These are mirror terms of the above for liabilities, where the 1-year rule
applies. Equity is also a long-term liability, where the expected time of
repayment isnever! People often dont call equity a liability and treat it
as though it is a special type of account. This only serves to confuse
many people accounting is very simplethere are only asset or liability
accounts.

6. Give the name used:

a) By accountants in the UK to describe "Accounts receivable"?


Debtors

b) By accountants in the US to describe "Creditors"?


Accounts payable

c) By accountants in the UK to describe "Inventory"?


Stocks

d) By accountants in the US to describe "Shares"?


Stocks!

7. Which financial statement reconciles:

a) The retained earnings number from one year to the next


Profit and Loss statement (In US, Income Statement does not record
dividends which cause a movement in Retained Earnings another
statement is used to include this)

b) The cash balance from one year to the next


The cash flow statement however try as you like, you can rarely see this
working with the reported financial statements of major companies

8. Newtons third law of motion states: For every action, there is an equal and
opposite reaction. This sounds similar to an accounting principal we discussed:

Every accounting entry has an equal and opposite entry Accountants call this
Double Entry

2

HOMEWORK 02: Preparing Accounts Solution
ASSETS LIABILITIES

Fixed Accounts Prepaym Share Retained Accounts


Date Transaction Cash Asset Inventories receivable ent Capital Earnings Loan Capital Payable Accruals
1/1/1998 2,500 4,000 1,000 500 2,000 3,500 875 4,000 1,000 625
To 31/12/1998 a) 500 (500)
To 31/12/1998 b) 17,500 17,500
To 31/12/1998 b) (17,500) (17,500)
To 31/12/1998 c) 20,000 20,000
To 31/12/1998 c) (10,000) (10,000)
To 31/12/1998 c) 20,000 (20,000)
To 31/12/1998 d) 12,000 12,000
To 31/12/1998 d) (6,000) (6,000)
To 31/12/1998 d) 11,200 (11,200)
To 31/12/1998 e) (1,000) (1,000)
To 31/12/1998 e) (625) (625)
To 31/12/1998 f) (1,000) (1,000)
To 31/12/1998 g) (5,000) 5,000
----------- ---------- ----------- ------------- ---------- ------------- ------------- ------------- ------------- --------
9,075 4,000 2,500 800 7,000 3,500 16,875 3,000 0 0
----------- ---------- ----------- ------------- ---------- ------------- ------------- ------------- ------------- --------

Total Total
assets = 23,375 Liabilities = 23,375

HOMEWORK 03: Accruals Solution

Fixed Accounts Share Retained Loan Accounts


Date Note Cash Asset Inventories receivable Prepayment Capital Earnings Capital Payable Accruals

31/12/1998 9,075 4,000 2,500 800 7,000 3,500 16,875 3,000 0 0


31/12/1998 1 (2,000) (2,000)
31/12/1998 2 (500) 500
31/12/1998 3 (2,000) (2,000)
31/12/1998 3 (2,500) (2,500)
31/12/1998 4 (4,000) 4,000
31/12/1998 5 (1,500) 1,500
31/12/1998 6 (250) (250)
31/12/1998 7 (1,000) 1,000
31/12/1998 8 200 (400) (200)

-------------------- ------------- ------------- ------------- ------------------------ ----------- ------------- -------------


9,075 2,000 2,700 150 2,500 3,500 2,925 3,000 0 7,000
-------------------- ------------- ------------- ------------- ----------- ------------- ----------- ------------- -------------

Total 16,425 Total 16,425



NOTE:

The phrases matching, recognition, accruals principal are synonymous.


Some people treat them as though they mean different things. However,
sometimes one phrase sounds more appropriate than another

1. The cost (or cost less expected residual value) of the truck should not be
expensed in the period it is bought but matched over its useful life to
the company. Annual charge is $2,000.

2. Interest should not be expensed when the cash flow occurs. It should be
matched to the time when the benefit was received. The benefit here
is benefit of receiving cash upfront via a loan.

3. Lets take this as 2 entries. Firstly we know that the prepayment asset
from previous year will have expired so we have to expense the asset
matching it over time up to 30th June 1998.

Secondly, we need to expense/ match the rent expense over the time it
relates to up to end of the year. As this inherently affects the balance on
the prepayment asset account it implicitly affects our recognition of the
asset on the prepayment account.

Note that we had already recognised the asset in part g) of Homework


2.

4. The tax on 1998s profit wont be paid until 1999. However, they must be
expensed in 1998 to match the expense with the profits made in that
year.

5. Dividends are paid after the period to which they relate. However, the
expense should be matched to the period of the profits they are paid
out of. Note in US-style income statements this item is not shown as an
expense, but as a movement of the Retained Earnings reserves
elsewhere.

6. When a company goes bust owing money, the prudent thing to do is not
expect to get any money or have your products returned. Although in
this circumstance it may not have become apparent that the customer
went bust until after the end of the financial year it would be prudent to
assume that the conditions that made the customer go bust had probably
already taken hold before the end of the year. As such we should
match the expense in the period in which it occurred.

7. It sounds as if the company will end up owing money, hence it must owe
money already! Auditors have basic tests on whether such liabilities are
just possible or are actually probable. The company should recognise a
liability as the misdemeanour occurred in the past. As there is no asset
associated with these that we can recognise we must expense this,
matching the expense with the period in which it occurred.

8. A standard trick to massage end of years sales upwards is to accelerate


sales invoicing even for goods not yet shipped. This is not easy to spot,
but isnt that rare. The goods need to be recognised as assets again by
making an adjustment to the accounts and the profit needs to be
adjusted and matched with the correct time period of the sale which
would be in 1999.

This would be an example of an automatically reversing accounting entry


because the auditors arent disputing that a sale was made, just when it
was made. Therefore the asset would be removed and profit recorded
immediately after the adjustments above are recorded.

Even more bizarre; company accounts normally have 12 accounting


periods per year (1 per month!). The reversal of the profit and
restatement of the nets as assets on the accounts would often be
recorded in period13!

HOMEWORK 04: Balance Sheets Solution
US Balance Sheet
As at 12/31/98 As at 12/31/97

Cash and equivalents 9,075 2,500


Accounts Receivable* 150 500
Inventories 2,700 1,000
Prepaid expenses and other current assets 2,500 2,000
Property, plant and equipment 8,000 8,000
Less accumulated depreciation (6,000) (4,000)
------------- -------------
2,000 4,000

------------- -------------
Total Assets 16,425 10,000
------------- -------------

Accounts Payable 0 1,000


Accruals 7,000 625
Current maturities of notes and loans 1,000 1,000

Long-term debt 2,000 3,000

Common Stock 3,500 3,500


Retained Earnings 2,925 875

------------- -------------
Total Liabilities 16,425 10,000


UK Style Balance Sheet As at 31/12/98 As at 31/12/97

Tangible Fixed Assets 2,000 4,000

Current Assets
Debtors* 2,650 2,500
Stocks 2,700 1,000
Cash and equivalents 9,075 2,500
------------- -------------
Current Assets 14,425 6,000

Creditors: amounts falling due in less than one year


Trade creditors 0 (1,000)
Accruals (7,000) (625)
Short-term debt (1,000) (1,000)
------------- -------------
Total current liabilities -8,000 -2,625

Creditors: amounts falling due in more than one year


Long-term debt -2,000 -3,000

------------- -------------
Net Assets 6,425 4,375
------------- -------------

Ordinary Share Capital 3,500 3,500


Profit and Loss Account 2,925 875
------------- -------------
Equity Shareholders Funds 6,425 4,375


Analytical Balance Sheet

As at 31/12/98 As at 31/12/97

WCR (1,650) 1,875

FIXED ASSETS 2,000 4,000


------------- -------------
Capital Employed 350 5,875
------------- -------------

NET DEBT (6,075) 1,500

EQUITY 6,425 4,375


------------- -------------
Invested Capital 350 5,875
------------- -------------

* Debtors and accounts receivable arent exactly the same. Debtors would include prepayments.

HOMEWORK 5: Profit and loss Statements Solutions

These questions ask you to continue from Homework 2,3 and 4 based upon
Newark Nets (NN).

1. Where should you allocate the costs of materials you sell in a profit and loss
statement?

a) Other incomes and expenses


b) Interest income and expense
c) Cost of sales
d) Administrative expenses
e) Taxation

c) is the correct answer.


Cost of materials form part of the core cost of sales used to generate a
gross profit.

2. Where should you allocate the depreciation costs in a company that has no
production in a Profit and Loss statement?

a) Other incomes and expenses


b) Interest income and expense
c) Cost of sales
d) Administrative expenses
e) Taxation

d) is the correct answer.


Depreciation is a normal expense of a business. In the case of a service
company, depreciation of the photocopier cant normally be directly
allocated/matched against a specific sale, so forms part of a selling,
general or administrative expense.

3. Where should you allocate the expense of a one-off fine in a Profit and Loss
statement?

a) Other incomes and expenses


b) Interest income and expense
c) Cost of sales
d) Administrative expenses
e) Taxation

a) is the correct answer.


One-off costs are not considered normal. What is classed as normal/one-
off is subjective. One-off items go under other although this is often

reported with many different names meaning same thing, such as
exceptional items.

4. Which line(s) in the Profit and Loss statement is affected by discovery that a
customer has gone bust whilst still owing money to the company?

a) Other incomes and expenses


b) Interest income and expense
c) Cost of sales
d) Administrative expenses
e) Sales

e) is the correct answer.


You would have to adjust sales to recognise the loss of revenue.
However the cost cannot be recouped. Potentially, you could reclassify
the cost of sales as an other/exceptional item. However, some level of
bad debts is unusually considered normal in most companies.

5. Which line(s) in the Profit and Loss statement is affected by discovery that an
order recorded as a sale by the company actually wasnt completed by the end
of the year?

a) Other incomes and expenses


b) Interest income and expense
c) Cost of sales
d) Administrative expenses
e) Sales

c)e) is the correct answer.


Known by accountants as a cut-off error, the sales and cost of sales need
to be reversed to match the profit with the correct period.

6. Using the following format, create a Profit and loss Statement for 1998 for
Newark Nets

Year ended 31/12/98


Sales 31,350
Cost of sales (15,800)
-------------
Gross Profit 15,550
Admin Expenses (6,500)
-------------
Operating profit 9,050
Other (1,000)
-------------
Profit before interest and tax 8,050
Interest expense (500)
-------------
Profit before tax 7,550
Taxation (4,000)
-------------
Net profit 3,550
Dividends (1,500)
-------------
Retained Earnings 2,050
-------------

HOMEWORK 6: Cash Flow Statements
Solutions

These questions ask you to continue from Homework 2, 3, 4 and 5 based upon
Newark Nets (NN).

1. Which of the following isnt an accruals adjustment for the US-style cash flow
statement?

a) CapEx
b) Movement in interest accrual
c) Movement in tax accrual
d) Depreciation charge

The correct answer is a)


CAPEX is not a profit or loss number, it is already a cash number. Note
net income includes the accruals/matching expenses for tax and interest,
hence needs adjusting to get an operating cashflow. These can be
adjusted within the payables or other line.

2. Which of the following is an accruals adjustment for the UK-style cash flow
statement?

a) CapEx
b) Movement in interest accrual
c) Movement in tax accrual
d) Depreciation charge

The correct answer is d)


In a UK cashflow statement there are lines for interest, tax and CAPEX
hence no accruals adjustment needed for them. Note we start with
operating profit that is free from tax and interest rate.

3.Using the following format, create a US-style cash flow statement for 1998 for
Netwark Nets

Year ended 31/12/98


Operating
Net Income (profit) 3,550
Change in account receivables 350
Change in account payables (1,000)
Change in inventories (1,700)
Change in other operating assets/liabilities 4,375
Add back depreciation 2,000
-------------
Operating cash flow 7,575

Investing
CAPEX 0

Financing
Debt repayments (1,000)
Dividends 0
-------------
Net inflow/(outflow) 6,575
-------------


4.Using the following format, create a UK-style cash flow statement for 1998 for
Netwark Nets

Year ended 31/12/98


Operating
Operating profit 9,050
Change in debtors (150)
Change in creditors (1,000)
Change in stocks (1,700)
Change in other operating assets/liabilities 0
Add back depreciation 2,000
-------------
Operating cash flow 8,200

Financing
Interest paid/received (625)
Dividends 0
-------------
Returns on investments and servicing of finance

Taxation 0

Investing
CAPEX 0

Capital Raising
Change in debt (1,000)

-------------
Net inflow/(outflow) 6,575
-------------