Faculty of Business and Management

DATE: December, 2021 Time Allowed:

INSTRUCTIONS TO CANDIDATES
MODULE CODE: BAC123
MODULE NAME: Intermediate Accounting
TIME ALLOWED: Hours
MATERIALS PERMITTED: Open Book Examination
MATERIALS PROVIDED: Examination Paper (soft copy)
TOTAL MARKS: 100 Marks
INSTRUCTIONS TO CANDIDATES
(i) This is an Open Book Take Home Examination.
(ii) It is recommended that before beginning to type/write, your name and save the
document under your IDENTIFICATION NUMBER, MODULE CODE AND
MODULE NAME
(iii) Write/Type your student ID number at the bottom of every page (as a footer).
(iv) Read the case provided carefully before beginning to type/write your answers.
(v) Review the grades assigned to each question of the examination and allocate your
time accordingly.
(vi) Review your answers carefully before submitting your examination to the link
provided
(vii) Answer all questions in this paper.

Cavendish University Uganda – Examination December 2021 Page 1 of 22

Case: Miracles of a Middle Management Financial Accountant
In the annual general meeting of GAG Ltd, the directors were perturbed by the way the finance
department dealt with intangible assets; provisions, contingent liabilities, contingent assets and
financial assets. In the contemporary world of business, argued the directors of GAG Ltd, it is
imperative for a middle management accountant to be skilled in all applied accounting practices
and even interpret such practices for better understandability by users of financial information
that he/she provides. The directors were particularly not happy the way intangible assets,
provisions, contingent liabilities, contingent assets and liabilities were or were not recognised in
the financial statement.In Uganda the securities market is shallow. It is in such markets that
financial assetsincluding those of GAG Ltd are traded to raise money for listed companies
including government itself.GAG Ltd has purchased intangible assets which form part of the
reporting problems as they can easily be kept off balancesheet or misreported.

QN.1. Prepare a memo to management of GAG Ltd:

a) Describe how management of GAG Ltd can raise long term finance. (9Marks)

Public Issue of Shares: The company can raise a substantial amount of fixed capital by issue of
shares- equity and preference. In India, however, equity shares are more popular as compared to
preference shares. The issue of shares requires a number of formalities to be completed such as
approval of prospectus by S.E.B.I., appointment of underwriters, bankers, and registrars to the
issue, filing of the prospectus with the registrar of companies, and so on.
Rights Issue of Shares: A Right issue is issue of shares to the existing shareholders of the
company through a Letter of Offer made in first instance to the existing shareholders on pro data
basis. The shareholders have a choice to forfeit this right partially or fully. The company, then
issue this additional capital to public. This is an inexpensive method as underwriting
commission, brokerage are very small. Rights issue prevents dilution of control but it may
conflict with the broader objective of wider diffusion of share capital.
Private Placement of Shares: This is a method of raising funds from a group of financial
institutions and others who are ready to invest in the company.
Issue of Debentures: There are companies who collect long term funds by issuing debentures-
convertible, or, non convertible. Convertible debentures are very popular in the Indian market.
Long Term Loans: The company may also obtain long term loans from banks and financial
institutions like I.D.B.I., I.C.I.C.I., and so on. The funding of term loans by financial institutions
often acts as an inducement for the investors to sub- scribe for the shares of the company. This is,
because, the financial institutions study the project report of the company before sanctioning
loans. This creates confidence in the investors, and they too, lend money to the company in form
of shares, debentures, fixed deposits, and so on.
Accumulated Earnings (Reserves): The Company often resorts to ploughing back of profits
that, is, retaining a part of profits instead of distributing the entire amount to shareholders by way

Cavendish University Uganda – Examination December 2021 Page 2 of 22

of dividend. Such accumulated earnings are very useful at the time of replacements, or,
purchases of additional fixed assets.

b) With clear numerical illustrations differentiate between intangible assets and

tangible assets providing their measurement, recognition and de-recognition
criteria. (7 marks)

Basis Tangible Intangible

Basic Assets that have a The opposite of the
Definition physical existence Tangible Assets is the
and that can be Intangible Assets that don’t
touched and can be have or possess a physical
felt are known as existence, and the same
Tangible Assets. cannot be felt or touched.
Values  Tangible Assets Intangible Assets which
have monetary are incorporeal those have
value, and the same some economic value and
is materially economic life.
present.
Value Tangible assets are Intangible Assets are
Reduction depreciated. amortized
Form Tangible assets Intangible Assets are
possess physical abstract.
presence.
Scrap Tangible assets, Intangibles do not have any
Value when it becomes scrap value.
obsolete, can be
sold in scrap.
Liquidation Tangible assets are Intangible assets don’t
comparatively easy possess liquidation value as
to liquidate. such.
External Creditors and Banks These kinds of assets
usage do accept tangibles cannot be used as collateral
assets as collateral. as creditors, and banks
don’t consider the same.

Cavendish University Uganda – Examination December 2021 Page 3 of 22

IAS 38

IAS 38 sets out the criteria for recognising and measuring intangible assets and requires
disclosures about them. An intangible asset is an identifiable non-monetary asset without
physical substance. Such an asset is identifiable when it is separable, or when it arises from
contractual or other legal rights. Separable assets can be sold, transferred, licensed, etc.
Examples of intangible assets include computer software, licences, trademarks, patents, films,
copyrights and import quotas. Goodwill acquired in a business combination is accounted for in
accordance with IFRS 3 and is outside the scope of IAS 38. Internally generated goodwill is
within the scope of IAS 38 but is not recognised as an asset because it is not an identifiable
resource.

Expenditure for an intangible item is recognised as an expense, unless the item meets the
definition of an intangible asset, and:

 it is probable that there will be future economic benefits from the asset; and
 the cost of the asset can be reliably measured.

The cost of generating an intangible asset internally is often difficult to distinguish from the cost
of maintaining or enhancing the entity’s operations or goodwill. For this reason, internally
generated brands, mastheads, publishing titles, customer lists and similar items are not
recognised as intangible assets. The costs of generating other internally generated intangible
assets are classified into whether they arise in a research phase or a development phase. Research
expenditure is recognised as an expense. Development expenditure that meets specified criteria
is recognised as the cost of an intangible asset.

Intangible assets are measured initially at cost. After initial recognition, an entity usually
measures an intangible asset at cost less accumulated amortisation. It may choose to measure the
asset at fair value in rare cases when fair value can be determined by reference to an active
market.

An intangible asset with a finite useful life is amortised and is subject to impairment testing. An
intangible asset with an indefinite useful life is not amortised, but is tested annually for
impairment. When an intangible asset is disposed of, the gain or loss on disposal is included in
profit or loss.

IAS 16

Objective of IAS 16

The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and
equipment. The principal issues are the recognition of assets, the determination of their carrying

Cavendish University Uganda – Examination December 2021 Page 4 of 22

amounts, and the depreciation charges and impairment losses to be recognised in relation to
them.

Scope

IAS 16 applies to the accounting for property, plant and equipment, except where another
standard requires or permits differing accounting treatments, for example:

 assets classified as held for sale in accordance with IFRS 5 Non-current Assets Held for
Sale and Discontinued Operations

 biological assets related to agricultural activity accounted for under IAS 41 Agriculture

 exploration and evaluation assets recognised in accordance with IFRS 6 Exploration for
and Evaluation of Mineral Resources

 Mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative
resources.

The standard does apply to property, plant, and equipment used to develop or maintain the last
three categories of assets. [IAS 16.3]

The cost model in IAS 16 also applies to investment property accounted for using the cost model
under IAS 40 Investment Property. [IAS 16.5]

The standard does apply to bearer plants but it does not apply to the produce on bearer plants.
[IAS 16.3]

Recognition

Items of property, plant, and equipment should be recognised as assets when it is probable that:
[IAS 16.7] it is probable that the future economic benefits associated with the asset will flow to
the entity, and the cost of the asset can be measured reliably.

This recognition principle is applied to all property, plant, and equipment costs at the time they
are incurred. These costs include costs incurred initially to acquire or construct an item of
property, plant and equipment and costs incurred subsequently to add to, replace part of, or
service it.

IAS 16 does not prescribe the unit of measure for recognition – what constitutes an item of
property, plant, and equipment. [IAS 16.9] Note, however, that if the cost model is used (see
below) each part of an item of property, plant, and equipment with a cost that is significant in
relation to the total cost of the item must be depreciated separately. [IAS 16.43]

IAS 16 recognises that parts of some items of property, plant, and equipment may require
replacement at regular intervals. The carrying amount of an item of property, plant, and

Cavendish University Uganda – Examination December 2021 Page 5 of 22

equipment will include the cost of replacing the part of such an item when that cost is incurred if
the recognition criteria (future benefits and measurement reliability) are met. The carrying
amount of those parts that are replaced is derecognised in accordance with the derecognition
provisions of IAS 16.67-72. [IAS 16.13]

Also, continued operation of an item of property, plant, and equipment (for example, an aircraft)
may require regular major inspections for faults regardless of whether parts of the item are
replaced. When each major inspection is performed, its cost is recognised in the carrying amount
of the item of property, plant, and equipment as a replacement if the recognition criteria are
satisfied. If necessary, the estimated cost of a future similar inspection may be used as an
indication of what the cost of the existing inspection component was when the item was acquired
or constructed. [IAS 16.14]

Initial measurement

An item of property, plant and equipment should initially be recorded at cost. [IAS 16.15] Cost
includes all costs necessary to bring the asset to working condition for its intended use. This
would include not only its original purchase price but also costs of site preparation, delivery and
handling, installation, related professional fees for architects and engineers, and the estimated
cost of dismantling and removing the asset and restoring the site (see IAS 37 Provisions,
Contingent Liabilities and Contingent Assets). [IAS 16.16-17]

Proceeds from selling items produced while bringing an item of property, plant and equipment to
the location and condition necessary for it to be capable of operating in the manner intended by
management are not deducted from the cost of the item of property, plant and equipment but
recognised in profit or loss. [IAS 16.20A]

If payment for an item of property, plant, and equipment is deferred, interest at a market rate
must be recognised or imputed. [IAS 16.23]

If an asset is acquired in exchange for another asset (whether similar or dissimilar in nature), the
cost will be measured at the fair value unless (a) the exchange transaction lacks commercial
substance or (b) the fair value of neither the asset received nor the asset given up is reliably
measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying
amount of the asset given up. [IAS 16.24]

Measurement subsequent to initial recognition

IAS 16 permits two accounting models:

Cost model. The asset is carried at cost less accumulated depreciation and impairment. [IAS
16.30]

 Revaluation model. The asset is carried at a revalued amount, being its fair value at the date of
revaluation less subsequent depreciation and impairment, provided that fair value can be
measured reliably. [IAS 16.31]
Cavendish University Uganda – Examination December 2021 Page 6 of 22
The revaluation model

Under the revaluation model, revaluations should be carried out regularly, so that the carrying
amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS
16.31]

If an item is revalued, the entire class of assets to which that asset belongs should be revalued.
[IAS 16.36]

Revalued assets are depreciated in the same way as under the cost model

If a revaluation results in an increase in value, it should be credited to other comprehensive

income and accumulated in equity under the heading "revaluation surplus" unless it represents
the reversal of a revaluation decrease of the same asset previously recognised as an expense, in
which case it should be recognised in profit or loss. [IAS 16.39]

A decrease arising as a result of a revaluation should be recognised as an expense to the extent

that it exceeds any amount previously credited to the revaluation surplus relating to the same
asset. [IAS 16.40]

When a revalued asset is disposed of, any revaluation surplus may be transferred directly to
retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer
to retained earnings should not be made through profit or loss. [IAS 16.41]

Depreciation (cost and revaluation models)

For all depreciable assets:

The depreciable amount (cost less residual value) should be allocated on a systematic basis over
the asset's useful life [IAS 16.50].

The residual value and the useful life of an asset should be reviewed at least at each financial
year-end and, if expectations differ from previous estimates, any change is accounted for
prospectively as a change in estimate under IAS 8. [IAS 16.51]

The depreciation method used should reflect the pattern in which the asset's economic benefits
are consumed by the entity [IAS 16.60]; a depreciation method that is based on revenue that is
generated by an activity that includes the use of an asset is not appropriate. [IAS 16.62A]

The depreciation method should be reviewed at least annually and, if the pattern of consumption
of benefits has changed, the depreciation method should be changed prospectively as a change in
estimate under IAS 8. [IAS 16.61] Expected future reductions in selling prices could be
indicative of a higher rate of consumption of the future economic benefits embodied in an asset.
[IAS 16.56]

Depreciation should be charged to profit or loss, unless it is included in the carrying amount of
another asset [IAS 16.48].
Cavendish University Uganda – Examination December 2021 Page 7 of 22
Depreciation begins when the asset is available for use and continues until the asset is
derecognised, even if it is idle. [IAS 16.55]

Recoverability of the carrying amount

IAS 16 Property, Plant and Equipment requires impairment testing and, if necessary, recognition

for property, plant, and equipment. An item of property, plant, or equipment shall not be carried
at more than recoverable amount. Recoverable amount is the higher of an asset's fair value less
costs to sell and its value in use.

Any claim for compensation from third parties for impairment is included in profit or loss when
the claim becomes receivable. [IAS 16.65]

Derecognition (retirements and disposals)

An asset should be removed from the statement of financial position on disposal or when it is
withdrawn from use and no future economic benefits are expected from its disposal. The gain or
loss on disposal is the difference between the proceeds and the carrying amount and should be
recognised in profit and loss. [IAS 16.67-71]

If an entity rents some assets and then ceases to rent them, the assets should be transferred to
inventories at their carrying amounts as they become held for sale in the ordinary course of
business. [IAS 16.68A]

Disclosure

Information about each class of property, plant and equipment

For each class of property, plant, and equipment, disclose: [IAS 16.73]

 basis for measuring carrying amount

 depreciation method(s) used
 useful lives or depreciation rates
 gross carrying amount and accumulated depreciation and impairment losses
 reconciliation of the carrying amount at the beginning and the end of the period, showing:
 additions
 disposals
 acquisitions through business combinations
 revaluation increases or decreases
 impairment losses
 reversals of impairment losses
 depreciation
 net foreign exchange differences on translation
 other movements

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Additional disclosures

The following disclosures are also required: [IAS 16.74]

 restrictions on title and items pledged as security for liabilities

 expenditures to construct property, plant, and equipment during the period
 contractual commitments to acquire property, plant, and equipment
 compensation from third parties for items of property, plant, and equipment that were
impaired, lost or given up that is included in profit or loss.

IAS 16 also encourages, but does not require, a number of additional disclosures. [IAS 16.79]

Revalued property, plant and equipment

If property, plant, and equipment is stated at revalued amounts, certain additional disclosures are
required: [IAS 16.77]

 the effective date of the revaluation

 whether an independent valuer was involved
 for each revalued class of property, the carrying amount that would have been recognised
had the assets been carried under the cost model
 the revaluation surplus, including changes during the period and any restrictions on the
distribution of the balance to shareholders.
c) With numerical examples distinguish been contingent assets, contingent liabilities
and provisions as used in financial reporting. (9 marks) Total Mark 25
QN.2. Write a memo with references to GAG Ltd:
i) With clear numerical illustrations discussing the importance of control accounts.

Control Accounts: Meaning, Advantages and Formats

Meaning of Control Accounts:

Control Accounts are the total accounts in the cost ledger which summarizes the totals of
individual accounts (subsidiary ledger). In these accounts, entries are made once at the end of
each accounting period based on the periodical totals of transactions in related subsidiary ledgers
and books.

Control accounts act as a double check on the accuracy of the analysis. The balance of the
control account at any time should equal to the sum of the balances of all individual accounts in
subsidiary ledger.

For example, purchases of individual items of stores appearing in individual accounts in the
stores ledger are totaled and posted in Stores Ledger Control Account in the cost ledger as total
purchases. Thus, Stores Ledger Control Account is stores ledger in a summary form.

Cavendish University Uganda – Examination December 2021 Page 9 of 22

Similarly, a control account is also maintained for each of the other subsidiary ledger. The
objective of opening a control account for cost ledger is to complete the double entry and to
make the cost ledger self-balancing.

Advantages of Control Accounts:

(i) Control accounts provide a summary of transactions recorded in various

subsidiary ledger. Hence these are very useful to management in policy
formulation.
(ii) It makes possible the division of accounting work among ledger keepers,
thereby resulting in specialisation in work.
(iii) It facilitates prompt preparation of profit and loss account and balance sheet at
the end of each period by providing stock figures quickly.
(iv) It provides internal check leading to greater accuracy of records. and
(v) It provides a basis for reconciliation of cost and financial accounts.

Formats of Control Accounts under Non-Integrated Accounting:

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ii) Describe methods used in dealing with incomplete records and their applicability.

Net Worth Method or Statement of Affairs Method

To ascertain profit, from incomplete records, it is necessary to prepare a Statement of Affairs at
the end of the year and also at the beginning of the year, if not already prepared. A Statement of
Affairs is a statement of all assets and liabilities. The difference between the amount of the two
sides is taken as capital. Like the Balance Sheet, the Statement of Affairs has two sides - the
right-hand side for assets and the left-hand side for liabilities. To prepare the statement,
information has to be collected from various sources. Information about assets will be available
from the Cash Book, the Personal Ledger, etc. The value of the Closing Stock will be ascertained
by preparing Stock Sheets and valuing the Stock in Hand, at lower of cost and market value. If
the trader has any other assets also, like furniture, machinery, etc., the value will be ascertained
and included among the assets. The business is likely to have full knowledge of the amounts
owing to outsiders. The difference between the total of assets and liabilities will be capital

Capital = Total Assets - Total Liabilities

For ascertaining profit the capital in the beginning of the year must also be ascertained, if
necessary, by preparing a Statement of Affairs as at the beginning of the year. If the capital at the
end of the year exceeds that at the beginning, we can say that there has been a profit. If, on the
other hand, the capital in the beginning was more than that at the end, there must have been a
loss. However, two adjustments must be borne in mind for ascertaining profit :

Adjustments for Capital Introduced :

If the proprietor brought in some additional capital during the year, it should be deducted from
the capital at the end (since this increase is not due to profit but is due to fresh introduction of
capital); and

iii) Discuss the reasons for the dissolution of a partnership

Usually, general partnerships will dissolve if any partner withdraws, becomes deceased, or
otherwise becomes unable to continue their duties as a partner. Other circumstances that may
lead to partnership dissolution may include:

 Loss of profits or declaration of bankruptcy

 Illegal activities or violations
 Merging of a partnership with a larger entity
 Changes of the business’ registration status (such as switching to a corporation)
 Fulfillment of conditions stated in the partnership agreement (such as the production or
sale of a certain number of products).

Lastly, some limited partnerships may not dissolve automatically if a partner withdraws or
becomes deceased. The company may continue on, especially if the partnership still has
sufficient managerial capacity to keep up with business activities.
Cavendish University Uganda – Examination December 2021 Page 11 of 22
Dissolution by Agreement
Any partnership firm can be dissolved by issuing a notice agreement to all the partners of the
firm. If all the partners are in agreement on dissolution, then the partnership firm can be
dissolved. This type of dissolution is the most common type and is called as voluntary
dissolution.

Dissolution by Notice
If a partnership firm is at will, then any one of the partners of that firm could dissolve it by
issuing a notice to the other Partners. In the notice, the Partner must provide the reasons for the
dissolution of the partnership firm in writing. In this mode of dissolution, the notice stands
effectively from the date of issue if in case it doesn’t hold any predefined date of dissolution of
the firm and therefore the firm gets dissolved once after the date of receipt of the notice.

Insolvency of Partners
If all the partners of the firm are declared as insolvent or even any one of them appear inactive at
an unsound state of mind, then the partnerhsip firm should be mandatorily dissolved.

Commitment to Illegal Business

Under certain circumstances, the activities of the business firm might be declared as illegal
where the law of the land does not permit certain activities of the partnership firm. In such a
case, the partnership firm can be dissolved by agreement of the Partners or through notice to the
Partners.

Death of a Partner
A partnership firm must be dissolved in the event of death of a partner where he upholds the
roles and responsibilities of an acting chairperson amongst the other partners of the business
firm.

Expiry of Term
In case the Partners agreed and the partnership deed of a firm contains a certain date on which
the firm must be dissolved, then such terms must be abided.

Completion of Work or Contract

A partnership firm could be started to accomplish a specified business purpose or contract.
Hence, on completion of the work or contract, the partnership firm can be dissolved as per the
agreement.

Cavendish University Uganda – Examination December 2021 Page 12 of 22

Resignation of Partner
A partnership firm can be dissolved if any one of the registered partners does not have the
interest to continue the business further due to any misunderstandings with other partner or
financial loss.

iv) Comprehensively describe the importance and application of general and cash controls.

Q.N 3.GAG Ltd has nominated and agreed with you to prepare relevant reports using the data
below.

Shs. (000)
Fleet of delivery vehicles, after deducting depreciation 90,000
Furniture and fittings, after deducting depreciation 60,000 Trade
receivables 80,000
Bank deposit 150,000
Creditors 30,000
Ordinary Share Capital 210,000
10% Debentures 100,000
Bank Loans 40,000
On 1 October 2021 management of the company issued additional 30,000 ordinary shares
of Shs. 3,000; and 50,000 13% Debenture of Shs. 1,000 each and received all the cash
duly banked. The manager of GAG Ltd has a personal business named “Gag Ent.” where
he is suspecting that the in-charge officer is stealing her money and provides you with the
data below:
Balances Brought Forward (Shs. ‘000’)
Motor Vehicles 100,000 Cash Balance 100,000
Furniture and fittings, 120,000 Capital ?
Trade receivables 40,000 Additional Capital 160,000
Bank Balance 60,000 Prepaid Insurance 50,000
Inventory at Close 5,000 Umeme Bills Due 30,000
Creditors 80,000 Unpaid Salaries 30,000
Motor Vehicles 190,000 Outstanding Rent 20,000
Bank Loans 140,000 Machinery 250,000
Transactions during the year (Shs. ‘000’)
Sales 670,000 Discount Received 15,000
Purchases 340,000 Discount Allowed 20,000
Transport on Purchases 4,000 Repairs 2,000
General Office Expenses 5,000 Insurance Costs 18,000
Payment – Trade Payables 120,000 Auditing 25,000
Receipts -Trade Receivables 180,000 Interest on Loan 19,000

Required
a) Explain reasons why partnership business Revaluation Accounts. (5marks)

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Revaluation of Assets in Partnership Account
Assets are originally recorded at its original price, but when certain events occurred, such as
1) a new partner is admitted,
2) or a partner leaving the firm and
3) if the partners change their profit or loss sharing ratios, the assets will have to be revalued.

There are two rationales in doing such exercise,

First, the true value of asset is being reflected correctly on the books and

Second, this is to ensure that new partner do not share the profit and loss on revaluation. The
first point is pretty much updating the value of your assets from original price into a more recent
price (or even market price).

b) Discuss the principles of internal control related to cash receipts.

(6marks)

Principles of Internal Control

Internal control as related to cash receipts is based on the following principles:

Principle of Separation
Financial and accounting operations must be separated, i.e., handling of cash and the recording
of the movement thereof should be done by different persons.

Principle of Responsibility
Responsibility for the performance of the job must be clearly stated so that there may be no room
for doubt or confusion subsequently.

Principle of Review
The work should be so arranged that work done by one employee should be promptly checked by
another independent employee.

Principle of Clarification
Clear and well-defined rules should be laid down and practically followed, relating to dealing
with cash, ordering, receiving and issuing goods, etc.

Principle of Documentation
The arrangement of the work should be in such a manner that a written record of the part played
by each employee should be maintained, and the work should pass through several hands in a
well-defined manner.

Cavendish University Uganda – Examination December 2021 Page 14 of 22

 c) Prepare a statement of:
(i) Affairs at start for the manager’s personal business. (2 marks)

(ii) Profit or loss for the year ended 30 November 2021. (8

marks)

GAG ENT LTD.’S

PROFIT OR LOSS STATEMENT

FOR THE YEAR TO 30 JUNE, YEAR 2021

Sales/Revenue 670,000
Less: Cost of Goods sold
Add: Purchases 340,000
Add: Purchases Returns 4,000
Less: closing stock (5,000)
Cost of sales (349,000)
Gross profit 321,000
Add: Discount received 15000
336,000
Less: Operating expenses

General Office Expenses 5,000

Interest on Loan 19,000
Auditing 25,000
Insurance Costs 18,000
Repairs 2,000
Discount allowed 20,000
Total expenses (89,000)
Net profit 247,000

d) Analyse benefits and limitations of equity and debt capital to GAG Ltd.(4Marks)
Total Marks 25

Advantages and Disadvantages of Equity Finance

Rights Shares
A company can get required capital via an issue of rights shares from its existing capital
providers which have almost nil floatation cost. Floatation cost is the cost incurred in raising
funds.
From Company point of view
Cavendish University Uganda – Examination December 2021 Page 15 of 22
Limitations of equity financing
Floatation Cost
Financing through equity is the most difficult way of getting funds to the company. Not only
does it require a lot of statutory compliances but also have other costs like fee of a merchant
banker, other expenses such as brokerage, underwriting fee, and lots of other issue expenses.

High Cost of Funds

Equity finance is considered to be the costly source of finance especially in comparison to debt.
The obvious reason is the higher required rate of return from equity share investors. Since equity
share investment is a high-risk investment, an investor will always expect a higher rate of
returns.

No Tax Shield
The dividends distributed to the shareholders are not a tax-deductible expense. On the contrary,
the interest expense is an eligible expense for tax benefits. A 12% interest rate with 40%
prevailing Tax Rate makes the effective cost of funds to be 7.2% {12% * (1-40%)} in case of
debt. This benefit is not available to the equity source of financing and therefore, it is considered
as a costly source of financing.

Underwriting of Shares
At the time of offering equity shares to the public, the company normally requires the
appointment of underwriters. The job of an underwriter is to assume the risk of subscription.
Underwriters would agree to subscribe the shares to the extent not subscribed by the general
public and will charge a fee for that service. The fee may be in the form of upfront payment or
maybe a discounted equity share price.

Dilution of Control
When a company raises funds via equity, it dilutes the existing shareholder’s control. Percentage
shareholding is reduced when new shareholders are introduced. In the case of debt financing, the
control does not dilute.

No Benefit of Leverage
Debt funding has an indirect benefit available to the existing owners. Since a project with the
higher rate of return (12%) than the cost of debt funds (8%) would enhance the welfare of the
shareholders. It is because the margin of 4% will be distributed to the existing shareholders. If
the project was financed by equity, this additional benefit would not have occurred to the
existing shareholders but would equally distribute between old and new shareholders
Debt Financing
Simply put, debt financing is the technical term for borrowing money from an outside source
with the promise to return the principal plus the agreed-upon percentage of interest.

Benefits of Debt Financing

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Maintain Ownership of Your Business
One might be tempted to get an angel investor for the growing business. This is definitely a way
to infuse cash into it. But, one will need to ask himself if you want outside interference from
investors? If you prefer to call the shots for your business, it makes sense to leverage debt
financing – in other words, borrowing from a bank or other type of lender and paying it back in
the agreed upon timeframe. The bank may charge you interest on what you borrow, but they’re
not going to get involved with how you run your day-to-day operations.
Tax Deductions
Surprising to some, taxes are often a key consideration when pondering whether or not to use
debt financing for your business.
Lower Interest Rates
This is a somewhat difficult advantage of debt financing to understand, but it can actually be
quite valuable. Tax deductions can affect your overall tax rate. In many cases, there can be a tax
advantage to taking on debt.
Limitations of Debt Financing
Paying Back the Debt
Making payments to a bank or other lender can be stress-free if you have ample revenue flowing
into your business.
High Interest Rates
Your parents may be willing to loan you some cash at a next to nothing interest rate, but don’t
expect this from a traditional bank or other lender.
The Effect on Your Credit Rating
What you borrow does affect your credit rating. And, this effect can be negative if you’re
borrowing large sums. This translates into higher interest rates and more risk on the part of
lenders.
Cash Flow Difficulties
Not all businesses sell the same amount each month. In fact, most have periods of time that are
busier than others. However, lenders typically expect payment on any debt financing in equal
monthly installments. This can be a real challenge that can lead to late payments or even defaults
that can harm your credit over the long term.

Q.4.
i) Advise management of GAG Ltd on the importance of cash control. (6
Marks)

Cash Control means managing and monitoring credit and collection policies, cash allocation, and
disbursement policies, accounts payable policies and the invoicing cycle.

Cash Control is an important part of business as it is required for proper cash management,
monitoring and recording of cash flow and analyzing cash balance.

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Cash is the most important liquid asset of the business. A business concern cannot prosper and
survive without proper control over cash.

In accounting, cash includes coins; currency; deposited negotiable instruments such as cheques,
bank drafts, and money orders; amounts in chequing and savings accounts and demand
certificates of deposit.

A certificate of deposit (CD) is an interest-bearing deposit that can be withdrawn from a bank at
will (demand CD) or at a fixed maturity date (time CD).

Cash only includes demand CDs that may be withdrawn at any time without prior notice. Cash
does not include postage stamps, IOUs, time CDs or notes receivable.

A business concern maintains two types of cash accounts in its general ledger – cash and petty
cash. But in the balance sheet, the balances of these two accounts are shown together as cash.

Since most of the transactions of a business concern are cash transactions, cash is considered an

important liquid asset.

Misuse of cash may happen easily through stealing or due to carelessness.

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ii) Prepare control accounts for the manager’s personal business-Gag Ent. (4 Marks)

iii)
ACCOUNTS RECEIVABLE CONTROL
Dr. Cr

Bal b/d 90000 Bal c/d 270000

Sales 180,000

270,000 270000

ACCOUNTS PAYABLE
Dr. Cr
Cash 100,000 Bal B/d
Discount received Umeme Bills Due 30,000
15,000 Unpaid Salaries 30,000
Bal c/d 285,000 Outstanding Rent 120000
Creditors 80,000
Bank Loans 140,000

400,000 400,000

iv) Explain plausible cash controls that can be undertaken in Gag Ent. (5 Marks)

Separation of duties
One of the most important steps your unit can take to protect cash — and you — is to separate
cash handling duties among different people.

 Best practice is to have different people:

o Receive and deposit cash
o Record cash payments to receivable records
o Reconcile cash receipts to deposits and the general ledger
o Bill for goods and services
o Follow up on collection of returned checks
o Distribute payroll or other checks

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 Note: The key to effective cash control while separating duties is to minimize the number
of people who actually handle cash before it's deposited.

 Potential consequences if duties are not separated:

o Concealed errors or irregularities going unchecked
o Lost or stolen cash receipts
o Inaccurate application of cash receipts to department accounts

Accountability, authorization, and approval

Cash accountability ensures that cash is accounted for, properly documented and secured, and
traceable to specific cash handlers.

 When proper cash accountability exists, you can answer the four W's during a process:
o Who has access to cash
o Why they have access to cash
o Where cash is at all times
o What has occurred from the transaction's beginning to end

 Best practices:
o Record cash receipts when received.
o Keep funds secured.
o Document transfers.

Security of assets
Be sure to keep all of your resources physically protected, including your cash handlers. Follow
these practices to promote a safe work environment when working with cash.
Best practices:

 Conduct the proper background checks on prospective cash handlers.

 Follow physical layout standards prescribed by policy.
 Restrict access of cash to as few people as possible.
 Lock cash in a secure location like a safe or locked storage facility.
 Provide combinations, passwords only to authorized personnel.

Review and reconciliation

Your reconciliation activities confirm that you've recorded transactions correctly. Perform
monthly reconciliations of cash receipts and bank account statements to provide good checks and
balances.

 Best practices:
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 o Compare receipts to deposit records.
o Record cash receipts when received.
o Count and balance cash receipts daily.
o Perform periodic surprise cash counts.

 Potential consequences if review and reconciliation activities are not performed:

o Errors, discrepancies, or irregularities not detected
o Lost or stolen cash receipts

v) Prepare GAG Ltd.’s Profit or loss statement for the year to 30 November 2021. (10
Marks) Total Marks 25

GAG ENT LTD.’S

PROFIT OR LOSS STATEMENT

FOR THE YEAR TO 30 JUNE, YEAR 2021

Sales/Revenue 670,000
Less: Cost of Goods sold
Add: Purchases 340,000
Add: Purchases Returns 4,000
Less: closing stock (5,000)
Cost of sales (349,000)
Gross profit 321,000
Add: Discount received 15000
336,000
Less: Operating expenses

General Office Expenses 5,000

Interest on Loan 19,000
Auditing 25,000
Insurance Costs 18,000
Repairs 2,000
Discount allowed 20,000
Total expenses (89,000)
Net profit 247,000

GOOD LUCK

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