114 Accounting Notes Final 29-03-201820190411-19917-1ivhrz9

A
Accounting Notes
Subject Code: 9706
2018-9 Edition
Article: 114
Muhammad Nauman Malik

FCMA, MS Accounting (Gold Medalist), MBA (Finance), PIPFA, DCMA, B.Com (Gold Medalist)
Keynesian Institute of Management & Sciences (KIMS)
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Title A Level Accounting Notes

Author Muhammad Nauman Malik
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CONTENTS
SECTION 1 AS LEVEL – FINANCIAL ACCOUNTING 4
CHAPTER 1.1 BAD & DOUBTFUL DEBTS 5
CHAPTER 1.2 ACCOUNTING FOR NON-CURRENT ASSETS 8
CHAPTER 1.3 BANK RECONCILIATION STATEMENT 15
CHAPTER 1.4 ACCOUNTING CONCEPTS 16
CHAPTER 1.5 CAPITAL AND REVENUE 22
CHAPTER 1.6 SUSPENSE ACCOUNT 23
CHAPTER 1.7 CONTROL ACCOUNTS 25
CHAPTER 1.8 ACCOUNTS FROM INCOMPLETE RECORDS 29
CHAPTER 1.9 FINANCIAL STATEMENTS OF PARTNERSHIP 30
CHAPTER 1.10 PARTNERSHIP CHANGES 35
CHAPTER 1.11 RATIO ANALYSIS – AS LEVEL 40
SECTION 2 AS LEVEL – COST ACCOUNTING 51
CHAPTER 2.1 INVENTORY VALUATION 52
CHAPTER 2.2 LABOUR COSTING 57
CHAPTER 2.3 ABSORPTION COSTING 61
CHAPTER 2.4 MARGINAL & ABSORPTION COSTING 69
CHAPTER 2.5 BREAK-EVEN & PROFIT VOLUME ANALYSIS 72
CHAPTER 2.6 MARGINAL COSTING DECISION MAKING 76
CHAPTER 2.7 ACCOUNTING FOR LIMITING FACTORS 83
CHAPTER 2.8 BUSINESS PLANNING 85
SECTION 3 AS & A2 LEVEL – COMMON TOPICS 88
CHAPTER 3.1 PARTNERSHIP DISSOLUTION 89
CHAPTER 3.2 FINANCIAL STATEMENTS OF COMPANIES 92
CHAPTER 3.3 ISSUE OF SHARES & DEBENTURES 102
CHAPTER 3.4 STATEMENTS OF CASH FLOWS 114
CHAPTER 3.5 BUSINESS FINANCING 118
SECTION 4 A2 LEVEL – FINANCIAL ACCOUNTING 132
CHAPTER 4.1 ACCOUNTS OF NON PROFIT ORGANISATIONS 133
CHAPTER 4.2 INTERNATIONAL ACCOUNTING STANDARDS 139
CHAPTER 4.3 AUDITING 148
CHAPTER 4.4 RATIO ANALYSIS - SUPPLEMENT 154
CHAPTER 4.5 PURCHASE OF BUSINESS 160
CHAPTER 4.6 ACCOUNTING FOR JOINT VENTURES 163
CHAPTER 4.7 CONSIGNMENT 166
CHAPTER 4.8 COMPUTERIZED ACCOUNTING 169
CHAPTER 4.9 MANUFACTURING ACCOUNTS 174
SECTION 5 A2 LEVEL – COST ACCOUNTING 178
CHAPTER 5.1 ACTIVITY BASED COSTING 179
CHAPTER 5.2 BUDGETING 184
CHAPTER 5.3 STANDARD COSTING 192
CHAPTER 5.4 CAPITAL INVESTMENT APPRAISAL 201
Section 1 4 AS Level – Financial Accounting
SECTION 1 AS LEVEL – FINANCIAL ACCOUNTING

SECTION 1 AS LEVEL – FINANCIAL ACCOUNTING 4
CHAPTER 1.1 BAD & DOUBTFUL DEBTS 5
CHAPTER 1.2 ACCOUNTING FOR NON-CURRENT ASSETS 8
CHAPTER 1.3 BANK RECONCILIATION STATEMENT 15
CHAPTER 1.4 ACCOUNTING CONCEPTS 16
CHAPTER 1.5 CAPITAL AND REVENUE 22
CHAPTER 1.6 SUSPENSE ACCOUNT 23
CHAPTER 1.7 CONTROL ACCOUNTS 25
CHAPTER 1.8 ACCOUNTS FROM INCOMPLETE RECORDS 29
CHAPTER 1.9 FINANCIAL STATEMENTS OF PARTNERSHIP 30
CHAPTER 1.10 PARTNERSHIP CHANGES 35
CHAPTER 1.11 RATIO ANALYSIS – AS LEVEL 40
CHAPTER 1.1 BAD & DOUBTFUL DEBTS

QUESTION 1
Distinguish between the accounting treatment of a bad debt and a doubtful debt. [2]
NOVEMBER 2000 P2 Q1 (a)
OR
Explain the difference between the accounting treatment of a bad debt and a doubtful debt [2]
MAY 2009 P2 Q2 (a)(iii)
SOLUTION
Mark Scheme
 a bad debt should be written off when it becomes bad, whereas
 a provision is set up to cover doubtful debts. [2]
Suggested Solution
 Bad debts are credited to trade receivables’ account(s) whereas for doubtful debts a separate
provision account is kept.
 Bad debt is a confirmed loss (irrecoverable debt) whereas doubtful debt is an expected loss.
QUESTION 2
State two reasons for maintaining a Provision for Doubtful Debts Accounts [2]
NOVEMBER 1997 P1 Q2 (b)
OR
Explain why a trader might decide to set up a Provision for Doubtful Debts. [2]
OR
Explain why a provision for doubtful debts may be necessary. [3]
MAY 2015 P21 Q2 (e)
OR
Explain why he should include the provision for doubtful debts in his accounts. [3]
NOVEMBER 2015 P23 Q1 (d)
OR
At present Ross does not make any provision for doubtful debts.
REQUIRED
Advise Ross whether or not he should create a provision for doubtful debts. Justify your answer.[4]
NOVEMBER 2017 P22 Q1 (c)
SOLUTION
Mark Scheme
 To avoid overstating trade receivables (1)
 To avoid overstating profit for the year (1)
 To apply the prudence concept (1)
 To apply the matching concept (1)
 To reflect the true and far view (1)
 To anticipate that some customers may not pay and become bad debts (1)
[Max 3 marks]
Suggested Solution
Provision for doubtful debts should be created
 to show trade receivables at more realistic value
 to prepare for likely losses
 to avoid overstatement of profit for the year
 to apply prudence concept
 To apply matching principle
QUESTION 3
Describe two factors that a business should consider when determining the amount to be provided for in a
Provision for Doubtful Debts. [2]
OR
State three factors that the directors should consider when creating a provision for doubtful debts [3]
NOVEMBER 2011 P21 Q2 (e)
OR
Describe two factors Jeremiah might consider when deciding the amount to be provided for in the provision
for doubtful debts account. [2]
MAY 2009 P2 Q2 (a)(ii)
SOLUTION
Mark Scheme
 Past experience
 Specific knowledge about each individual customer
 The state of the economy
 Consistency concept
 Industry average
 Length of time
 Size of trade receivables
 Comparing with previous years or with competitors.
(3 × 1 mark) [3]
Suggested Solution
 Nature of industry
 Past experience relating to collection from customers
 The economic conditions
 Amount and age of trade receivables (ageing schedule).
 Knowledge of previous trends or policies of competitors.
 Specific information about each customer
 Present market and industry conditions.
QUESTION 4
Kim has provided for doubtful debts at a rate of 2% and would like to change the existing rate of the provision
to 5%.
REQUIRED
Explain why this change might be necessary. [5]
MAY 2015 P22Q2 (d)
SOLUTION
Mark Scheme
 increase in credit sales/more credit customers/increase in trade receivables
 deteriorating economic situation
 less efficient credit control procedures
 state of aged trade receivables’ list
 past experience
 Marker note: no marks for prudence/matching/accruals [Max 5]
Suggested Solution
 increase in credit sales
 inefficient credit control procedures
 entering new markets
 ageing of trade receivables
 past experience.
 deteriorating economic situation

 increase in bad debts
QUESTION 5
The owner of a business is considering introducing a system of credit control.
Explain the benefits this may bring to the business. [4]
SOLUTION
Mark Scheme
 Improved cash flow (1 + 1 for development)
 Reduction in bad debts (1 + 1 for development) [4]
Suggested Solution
 Improved and early collection from trade receivables
 Reduction in bad debts
 Reduction in collection expenses
JOURNAL ENTRIES
1 Bad Debts 
Trade receivables 
(Entry to write off Trade receivables as bad)
2 Income statement
Provision for doubtful debts 
(Entry to create/increase provision) 
3 Provision for doubtful debts
Income statement 
(Entry to record decrease in provision) 
(4a) Cash 
Trade receivables 
(Entry to record recovery of cash from a customer previously written off as bad
debt)
(4b) Trade receivables 
Bad Debts Recovery 
(Entry to reverse previously written off bad debts)
OR
(4) Cash 
Bad Debts Recovery 
(Bad Debts Recovery recorded)
CHAPTER 1.2 ACCOUNTING FOR NON-CURRENT ASSETS

QUESTION 1
Explain what is meant by a non-current asset? [4]
MAY 1997 P1 Q4 (c)
SOLUTION
Mark Scheme
Fixed assets are those assets that are purchased for long-term use within the business and not intended
to be sold in near future e.g. machinery, premises, furniture, motor vehicles etc. However, purpose of
keeping these assets is very important as, e.g. for Northside Motors Ltd motor vehicles held for business
use are treated as fixed assets.
Suggested Solution
Non-current assets are those assets that are purchased for long-term use within the business and not
intended to be sold in near future e.g. machinery, premises, furniture, motor vehicles etc. However, purpose
of keeping these assets is very important as, e.g. for a motor vehicle showroom motor vehicles held for
business use are treated as non-current assets.
QUESTION 2
Explain the term ‘depreciation’ and give one example. [5]
OR
State what is meant by depreciation of non-current assets. [1]
MAY 2016 P22 Q3 (a)
SOLUTION
Mark Scheme
Depreciation is an expense used to spread the net cost of a fixed asset over its useful life.
If, for example, a motor vehicle costing $10 000 is expected to last for five years after which its scrap value
will be $1 000, then its net cost will be $(10 000 – 1 000) = $9 000.
Using straight-line depreciation, an annual charge of $9 000/5 - $1 800 would be made in the income
statement.
There are various correct answers, too numerous to show here. [max. 5]
Suggested Solution
Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset. It
recognizes the fact that assets with finite lives lose value over time through the passing of time and/or wear
and tear from its use.
Depreciation Accounting deals with the allocation of costs of non-current assets over their useful lives. More
simply depreciation is recorded as an expense in the Income Statement to spread the initial price of the
assets over their useful lives to match the revenue the asset is generating.
For example a machine costing $50 000 has an estimated life of 5 years and has a residual/scrap value of
$10 000 then its total depreciable amount will be ($50 000 – $10 000) = $40 000. Under straight-
$40 000
line method of depreciation an annual depreciation charge of $8 000 ( ) would be made in the Income
5 years
Statement.
QUESTION 3
State four factors which must be taken into account when deciding how much depreciation to charge. [4]
MAY 2010 P22 Q2 (c)
SOLUTION
Mark Scheme
 Cost or Market value
 Useful life
 Residual value at end of useful life
 Expected length of ownership
 Rate of usage
 Method of depreciation
 Type of asset
 Machine hours
Any correct 4 for (4)
Suggested Solution
Whichever method or rate is used to calculate depreciation, we must always consider the following:
 the original cost of asset
 the probable/estimated useful economic life of the asset
 the approximate residual value at the end of its life
 estimated amount of expenditure on repairs during the asset’s useful life
 possibility of obsolescence etc
QUESTION 4
Explain the function of depreciation. [2]
MAY 2000 P2 Q3 (a)
OR
Explain why businesses provide for depreciation on their non-current assets. [6]
OR
Explain why Helen needs to depreciate her non-current assets. [3]
MAY 2014 P23 Q2 (a)
OR
Explain why a business should depreciate its non-current assets [4]
MAY 2015 P23 Q1 (c)
OR
Explain why a business depreciates its non-current assets. [3]
MAY 2016 P31 Q3(c)
OR
Explain why a company should provide for depreciation on its non-current assets. [4]
MAY 2017 P22 Q1(c)
SOLUTION
Mark Scheme
 Depreciation is a fall in value of a non-current asset (1) due to wear and tear and other factors
 Depreciation represents that part of the cost of an asset that is consumed during the accounting
period (1).
 The provision for depreciation annually is intended to spread the cost over the useful life of the
asset.
 This follows the matching (accruals) concept (1) as matches costs with revenue generated by the
assets (1)
 Depreciation is not a movement of cash from the business.
 Depreciating the value of a non-current asset avoids overstating the net assets of the business (1)
 This ensures that the statement of financial position shows a true and fair view (1).
 Profit is not overstated. (1) 1 mark per valid point
Suggested Solution
Depreciation represents that part of the cost of an asset that is used up during the accounting period. In
other words it is a process by which cost is spread over the useful life of the asset and charged to Income
statement.This is charged under matching concept. The value of an asset reduces due to reasons like
physical deterioration, obsolescence, inadequacy etc. Depreciating the value of a non-current asset helps
the business to include a charge for use of a non-current asset and include them in the statement of financial
position at a true and fair view.
QUESTION 5
State three causes of depreciation. [3]
MAY 2010 P22 Q2 (a)
OR
State three causes of depreciation. [3]

May 2013 P21 Q2 (c)
OR
State three causes of depreciation of motor vehicles. [3]
MAY 2014 P23 Q2 (b)
OR
State four possible causes of depreciation of non-current assets [4]
OR
State three causes of depreciation of non-current assets. [3]
MAY 2016 P22 Q3 (b)
SOLUTION
Mark Scheme
 Wear and tear
 Obsolescence
 Passage of time
 Depletion
 Technological innovation
 Usage
 Economic reasons
No marks for methods. Any three correct for (3) [3]
Suggested Solution
The following are the main causes of depreciation:
 Wear and tear [physical using up like corrosion, rot, rust and decay];
 Obsolescence [change of fashion or new substitutes or inventions];
 Inadequacy or superfluous [business operation increased hence non-current assets inadequate]
QUESTION 6
State three causes of depreciation and give an example of a non-current asset for which these cause might
be appropriate. [3]
MAY 2010 P22 Q2 (b)
SOLUTION
Mark Scheme
 Wear and tear: Machinery, vehicles
 Obsolescence: Computers, any technological equipment
 Time: Lease
 Depletion: Quarry, oil well etc.
No marks for methods. Any three correct for (3) [3]
Suggested Solution
 Wear and Tear: Furniture and fixtures may physically deteriorate due to factors like corrosion, rot,
rust and decay.
 Obsolescence: With the improvement in technology older version of computers or machines may
become obsolete.
 Inadequacy: An internal telephone exchange with twenty lines may be inadequate when business
expands and new lines are needed.
QUESTION 7
Explain why Land is less likely to have depreciation provided for it than other non-current assets. [2]
MAY 2000 P2 Q3 (b)
SOLUTION
Normally land has unlimited life so there is nothing within land to depreciate unless it has value due to the
existence of natural resources, then it may be subject to depletion (depreciation) when land erodes or
minerals extracted from land etc.
QUESTION 8
Discuss the difference between depreciation & funds set aside for replacement of non-current assets [3]
MAY 2000 P2 Q3 (c)
SOLUTION
Depreciation is charged to spread the cost of the asset over its useful life. It is a non-cash expense. It is
simply an accounting item so does not provide any cash for the replacement of non-current assets.
When cash is invested in a profitable manner to provide funds for the replacement of non-current assets
then it is known as funds for replacement of non-current assets.
QUESTION 9
Name three methods of depreciation. [3]
MAY 2000 P2 Q3 (d)
OR
Identify two alternative methods of providing for depreciation. [2]
MAY 2013 P21 Q2 (b)
SOLUTION
Mark Scheme
 Reducing balance method (1)
 Revaluation (1)
or any other valid method [2]
Suggested Solution
 Straight line
 Depletion units
 Reducing balance
 Machine hours
 Sum of years’ digits
 Revaluation
 Units of production (any three)
QUESTION 10
Discuss the suggestion that it should be possible for a business to change the method of depreciation used
every year, depending on circumstances. [3]
MAY 2000 P2 Q3 (d)
SOLUTION
The depreciation methods should be applied consistently from one year to other (consistency concept).
Methods of depreciating the assets can only be changed if the new method is expected to give a fairer
value for non-current assets as allowed by SSAP I2 (FRS 10), however the method must not be changed
repetitively.
QUESTION 11
State an accounting concept which is applied when depreciation is provided. [1]
MAY 2014 P22 Q2 [d (i)]
OR
State and explain two accounting concepts that apply to depreciation. [4]
OR
Identify and explain one accounting concept relating to depreciation. [3]
OR
Explain two accounting concepts which are being applied when depreciation is provided. [4]
SOLUTION
Mark Scheme
 Consistency (1) using the same depreciation method each year (1) to assist comparisons of
performance between years. (1)
 Prudence(1) reducing the cost of the asset to net book value so not overstating asset worth (1)
and charging depreciation as an expense to reflect asset use and so not overstating profits (1).
 Accruals / matching (1) matching wear and tear of the asset via use against the reduction in value
(1). Matches the cost of the asset (1) with the income generated from its use (1).
(max 3 marks for one concept only)
Suggested Solution
 The matching principle requires that the actual cost of these assets be allocated to the accounting
periods in which the company will benefit from their use.
 As most non-current assets lose value over time so prudence concept requires that the accounts
of a business should show a fair view of the financial position so it is necessary to record this loss
in value.
 Consistency concept requires that same depreciation method should be used over the useful life
of the asset.
QUESTION 12
SMC is considering changing the depreciation method for equipment to reducing balance method. Explain
the possible reasons why the business is considering this change. [7]
MAY 2014 P22 Q2 [d (ii)]
SOLUTION
Mark Scheme
 Straight line depreciation is easy to calculate (1) and therefore there is less chance of errors (1)
whereas reducing (diminishing) balance depreciation is more complex.
 Reducing (diminishing) balance depreciation is appropriate for assets that have a heavier fall in
value in earlier years (1) and is therefore appropriate for equipment (1).
 Reducing (diminishing) balance depreciation has a higher depreciation charge in earlier years
(1) which more accurately reflects the profit (1) – prudence (1) and matches costs to revenues (1)
– matching / accruals (1).
 Straight-line depreciation is an equal charge each year (1). As equipment gets older maintenance
costs increase (1) and with reducing (diminishing) balance method depreciation will decrease (1)
therefore ensuring a more even charge (1) over the life of the asset.
(Maximum 7 marks) [7]
Suggested Solution
Straight line method is though relatively easy and simple to use. Under this method depreciation rate and
amount remain constant in each year of asset’s life as depreciation rate (%) is always applied on original
cost of asset. This method is best rated for those assets, which provide equal benefit to the business for
each year of their useful lives. Examples include building and furniture. Moreover in straight line method
annual cost of repairs increases as the asset gets older whereas the annual depreciation charge remains
constant. Hence, the total of income statement charge on account of depreciation and repairs increases
every year which reduces annual profit progressively.
On the other hand, reducing (diminishing) balance depreciation is more complex and difficult to use. This
method is very useful for calculating depreciation on assets like Equipment, which operate faster, produce
more, incur low maintenance costs and perform more accurately when they are new. Under this method,
the annual cost of repairs increases as the asset gets older whereas the annual depreciation charge
decreases each year. Hence, the total income statement charge on account of depreciation and repairs
remains more or less the same each year so will not affect annual profit/loss in a significant manner during
the asset’s life.
QUESTION 13
Explain why it is appropriate to use the reducing (diminishing) balance method for motor vehicles. [3]
MAY 2012 P23 Q2 (d)
OR
State why the reducing balance method of depreciation is more appropriate for non-current assets like
motor vehicles [4]
SOLUTION
Mark Scheme
Motor vehicles tend to fall in value more in the early years. (1) They lose value the minute they are registered
for use. Repair and maintenance costs increase as the motor vehicle gets older (1). The straight line method
of depreciation depreciates the vehicle at the same amount each year which does not balance up the
increasing repair and maintenance costs in later years. (1) However, the reducing balance method
depreciates the motor vehicle more in the earlier years and less in later years. The reducing balance method
therefore depreciates the asset less in later years which balances with the increasing repair and
maintenance costs thus providing a fairer matching of costs with income generated (1).
1 mark to a maximum of 4 [4]
Suggested Solution
The reducing balance method is suited to non-current assets such as motor vehicles. As vehicles, in the
early years, have lower maintenance costs but give more benefits than in later year. So in early years more
depreciation is charged due to greater benefits and less is charged in the later years. Moreover increasing
costs are offset by decreasing depreciation charge.
QUESTION 14
Explain why machinery is usually depreciated using the straight line method while motor vehicles are
usually depreciated using the reducing balance method. [4]
MAY 2014 P23 Q2 (d)
SOLUTION
Mark Scheme
Assets suffer wear and tear, etc. and lose their value at different rates (1). This might depend on the degree
of use of the asset. Vehicles tend to lose more value in the early years of use (1); hence the reducing
balance method is more appropriate. Buildings tend to lose value (1) more consistently over their lifetime;
therefore, the straight line method tends to be more appropriate (1).
Suggested Solution
Non-Current Assets have different attributes and their useful life for the business depends on various
factors. As vehicles perform more accurately when they are new but also tend to lose more value in the
early years of use; therefore the reducing balance method is more appropriate.
Buildings, on the other hand, perform and give benefits to the business more consistently and therefore
tend to lose value more consistently over their lifetime; hence, the straight line method tends to be more
appropriate.
QUESTION 15
Briefly outline the advantages and disadvantages of each of these three methods of calculating
depreciation. [6]
NOVEMBER 1997 P1 Q5 (A)
Solution
Straight line is easier to calculate and is more reliable for the assets whose efficiency or productivity
remains constant over their lives. It is not useful for those assets, which are more efficient and productive
in the earlier years of their lives.
Reducing balance is more useful for assets, which operate faster, perform more accurately, and produce
more when they are new. Therefore more depreciation should be allocated in early years and when it is
added to low maintenance cost in early years as compared to later years it gives more equitable amount of
expenses connected with use of assets. Moreover it has the drawback that it is difficult to compute and
asset value is not fully depreciated to the scrap value.
Revaluation Method
Normally used for calculating depreciation of items such as loose tools and farmers’ livestock where it is
difficult to estimate with any certainty the rate at which the asset will depreciate.
Under the system each year the asset is valued at the end of the accounting period and the value is
compared with that in the beginning of the year. The fall is treated as depreciation for that period.
Sometimes the value of the non-current assets may be inflated by new purchases of assets and these
purchases need to be taken into consideration for calculating depreciation.
Value of asset at the new assets Value of asset at

Formula Depreciation = + –
beginning purchased the end
Asset Account
Year $ Year $
First date Balance b/f (Cost at year start) xxxx Date of Sale Asset disposal ( Cost of disposal) xxxx
Date of Pur. Bank/Vendor (asset bought) xxxx Last date Balance c/d (Cost at end) xxxx
xxxx xxxx
Provision for Depreciation Account

Year $ Year $
Last date Disposal ( Total depn on disposal) xxxx 1st date Balance b/f (Total depn at start) xxxx
Last date Balance c/d (Total depn at end) xxxx Last date Income statement (Current depn) xxxx
xxxx xxxx
Asset disposal account

Year $ Year $
Date of sale Asset a/c ( Cost of asset sold) xxxx Date of sale Asset a/c (trade in allowance) xxxx
Date of sale Income Statement: Profit (*) xxxx Date of sale Prov. for depn (depn on disposal) xxxx
____ Date of sale Income Statement: Loss (*) xxxx
xxxx xxxx
[4]
CHAPTER 1.3 BANK RECONCILIATION STATEMENT

QUESTION 1
Give three reasons why the bank column balance in the cash book does not always agree with the balance
shown in the bank statement at the same date. [6]
MAY 2011 P23 Q2 (d)
SOLUTION
Mark Scheme
Two marks for valid explanation to a maximum of 6 marks
Standard practice to enter the following in the cash book after receipt of the bank statement:
 Direct debits
 Standing orders
 Bank charges
 Interest on overdrafts
 Cheques dishonoured
Timing differences
 Money lodged with the bank near the end of the month
 Cheques paid but not yet presented for payment
 Cheques received but not yet credited by the bank
 Errors in recording by the bank and/or the business [6]
Suggested Solution
 Cheques paid but not yet presented for payment (un-presented cheques)
 Cheques received but not yet credited by the bank (un-credited cheques)
 Errors in recording by the bank and/or the business
 Items recorded by the bank but omitted from the cash book unless bank statement is received e.g.
Direct credits, direct debits, standing orders, bank charges, dishonoured cheques etc.
QUESTION 2
Describe advantages of preparing bank reconciliation statement.
SOLUTION
 Bank reconciliation is necessary for the accuracy of the accounting records and for the company’s
financial statements.
 If the bank reconciliation is performed by someone other than the authorized check signers and
record keepers, the company can improve its internal control over cash.
 It gives us a true figure for cash at bank to be shown in the balance sheet.
 It helps to detect frauds and errors
 It helps to discover cheques which have become stale.
CHAPTER 1.4 ACCOUNTING CONCEPTS

QUESTION 1
When Mr. X received his Income statement and Balance Sheet from his accountant, he had some questions
to ask. Accordingly he wrote the following letter to the accountant.
Letter written by Mr. X to his accountant

1 New Lane
Ledford
1 February 1998
John & Co
Registered Accountant
2-Tikery Street
Ledford
Dear John,
I know that I have little understanding of accounting matters, and have always preferred to leave such things
to you. I have recently looked at the accounts that have been prepared for the year ended 31 December
1997 and I am writing to ask you to help me understand the following points.
1. My equipment is shown at a lower figure than I expected. I know that I could get more than the
book value if I sold it. My balance Sheet isn’t showing the true worth of my business.
2. I notice that my capital has increased substantially by the year-end. I am thinking of making some
improvements to my home at a cost of about $20 000. Rather than take out a personal loan from
the bank, I would like to withdraw some of my capital – after all, it does all belong to me, doesn’t it?
3. Last time we spoke, I remember you said that my business has built up a large amount of goodwill.
Surely this is worth something – why isn’t it shown in the Balance Sheet?
I think I should get to know more about my accounts, so could you please explain the above points to me
– and in words that I can understand.
Regards
Terry X
REQUIRED
Draft a reply to the questions in Mr. X’s letter of 1 February 1998. Refer to generally accepted accounting
principles as appropriate.
Write you reply in sentence form with supporting figures. (Up to 4 marks may be awarded for clear
presentation and quality of English.) [25]
MAY 1998 P3 Q3
SOLUTION
Mark Scheme
To: Terry X
From: John and Co. Registered Accountants
Subject: Reply to the accounting queries
Sir,
The following is the brief discussion of the points raised by you in the query.
1. In Balance Sheet non-current assets including equipment should be reported in balance sheet at
cost less total depreciation provided. Although equipment has a market value higher than its book
value, even then it should not be shown at price it would fetch if sold. As business is a Going
Concern (assumption of infinite life) so there is no compulsion of selling the non-current assets
in near future, likewise by their definition non-current assets are not expected to be sold in near
future so the equipment should not be valued at estimated selling price. Moreover “ Cost
Concept” states that non-current assets should be recorded at cost. Lastly if equipment has
realisable value more than its book value it may be revalued but for doing the revaluation process
there should be a proper policy for revaluing non-current assets.
2. Although capital within the business legally belongs to you but for accounting purposes, your
business is treated as an independent entity distinct from you (Entity concept). So withdrawal
of huge sums of money out of the business for your personal needs may put your business in a
liquidity problem. Before making such a decision, you should keep in mind needs and funding
requirements of your business in near future. Lastly if the proposed interest rate on bank loan is
less than the rate of return you are getting from your business, then you should go definitely for
the bank loan.
3. A business should not include goodwill in the Balance Sheet as nothing has been paid for it and its
actual worth is difficult to be quantified in monetary terms (Money measurement concept). Moreover
IAS38 states that inherent, or non-purchased goodwill cannot appear in the Balance Sheet,
however if goodwill arises because of purchasing another business (purchased goodwill) then it
may be shown as an intangible non-current asset in the Balance Sheet.
Regards,
John
John & Co.
QUESTION 2 MAY 2001 P3 Q2

The managing director, who is not an accountant, has seen the accounts produced by the accountant
and is not satisfied with the profit figure. He has sent the accountant the following memo with three
suggestions for action to increase the profit. The accountant explains to the managing director that there
are rules to be followed in the preparation of company accounts and tells the managing director about a
Statement of Standard Accounting Practice (SSAP 2) which is about the disclosure of accounting policies
and names four fundamental accounting concepts which must be followed.
MEMORANDUM
From: Managing Director
To: Accountant
I believe the profit shown in the Income statement could be improved if you amend the accounts as
follows:
1. You have calculated depreciation on the factory machinery at the rate of 30 % on net book
value and yet you have used the rate of 15 % for office equipment. You should use the rate
of 15 % for factory machinery as that will not only increase profit but will have the merit of
being consistent.
2. You have valued some of the inventory at cost, but other inventory at net realisable value
when that is less than cost. Cost can be ascertained with certainty but it seems to me that
net realisable value does not represent any identifiable figure in the inventory records. For
the sake of consistency you should value all inventory at cost. Besides, if the inventory has
not been sold yet, no loss has been incurred at the date of the accounts in respect of the
inventory you have included at net realisable value.
3. You have included a provision for unrealised profit on finished goods in the accounts. The
factory has made the profit and full credit for it should be included in the accounts. You should
therefore delete the provision.
REQUIRED
(a) (i) Name the four fundamental accounting concepts mentioned in SSAP2.
(ii) State what is meant in SSAP2 by ‘accounting policies’. [6]
(b) State with reasons whether the accountant should carry out the instructions contained in the
managing director’s memo. [15]
SOLUTION
Mark Scheme
(a) (i) (1) Going concern concept
(2) Consistency concept
(3) Accrual concept
(4) Prudence concept.
(ii) Accounting policies are specific accounting bases judged by business enterprises to
be most appropriate to their circumstances and adopted by them for the purpose of
preparing their financial statements. For example methods of charging depreciation,
methods for providing doubtful debts.
(b)
To: Managing Director
From: Accountant
Subject: Reply to memorandum
Sir:
The response to your queries is given below one by one.
1. Different non-current assets have different lives and are depreciated by using different
rates, so it is not surprising to have two different depreciation rates for two different
assets. Moreover, consistency concept means applying same accounting methods from
year to year for same class of financial statement item rather to use same depreciation
rate for all non-current assets. So there is no need to depreciate factory machinery @
15%.
2. If inventory comprises more than one item then lower of cost or net realisable value
should be calculated individually for each item. (Separate Valuation concept), so
consistency concept does not apply here, However, in one respect consistency concept
is not applied, as at one year the inventory may be shown at cost only and in next year
at lower of cost and net realisable value, but as it is prudent to recognise the loss which
is likely to incur in near future in advance by valuing inventory at lower of cost or NRV,
so it can be said to be consistently prudent to consistently take the lower figure for
calculating inventory value.
3. To be prudent, profit should not be anticipated unless it is being realised or earned, as

inventory has not yet been sold so it will be imprudent to include profit in the inventory
value, so inventories should be valued at lower of cost or market. Moreover, as total
profits have been segregated into factory and trading profits so there is no need to inflate
the inventory value, as this must be shown at cost which has actually been incurred on
it (cost of production) or market value if it is lower.
QUESTION 3
(a) Define prudence. [2]
(b) Discuss how the concept of prudence might be relevant when considering:
(i) Goodwill
(ii) The valuation of Inventory in Trade [6]
NOVEMBER 2001 P2 Q4
SOLUTION
Mark Scheme
(a) It states that when alternative treatments are possible, the one selected should be the one, which
gives the most cautious presentation of the business financial position or results.
(b) (i) Goodwill is different from other assets, as it cannot be sold unless the whole business is
subject to sales, moreover it normally has no objective monetary value, and so it is prudent
to write it off from the books. Besides it should be written off as purchased goodwill would
progressively be replaced by the goodwill created by the new management of the
business.
(ii) Prudence concept states that losses being provided for as soon as they are recognised.
Inventory is likely to be sold in near future so by valuing inventory at lower of cost or net
realisable value business can prudently show its profits and assets as inventory and profits
are not overvalued.
QUESTION 4
Define the prudence concept. State three examples of how this has been applied in the financial statements.
[6]
SOLUTION
Mark Scheme
1 Assets should not be overstated (1)
2 Liabilities should be understated (1)
3 Revenue should not be bought into the financial statements until realised (1)
(Up to 3 points for the definition)
1 Inventory (1)
2 Provision for doubtful debts (1)
3 Depreciation (1)
(Up to 3 points for examples)
[6]
Suggested Solution
Prudence is a key accounting principle which makes sure that assets and income are not overstated and
liabilities and expenses are not understated. The examples of Prudence may include the valuation of
inventory at lower of cost or market, writing off of receivables as bad debts and providing for doubtful debts
etc.
QUESTION 5
Explain the following concepts:
(i) Matching [3]
(ii) Materiality [3]
MAY 2014 P21Q1 (d)
SOLUTION
Mark Scheme
(i) Matching ensures that all income (1) and expenditure (1) are recognised in the financial (1) period
in which they occur. The timing of payment (1) is irrelevant, i.e. if goods are sold in year one but
not paid for until year two, then the sale is recognised in year one (1).
[Max 3]
(ii) Materiality allows that if the amount of a transaction is insignificant 1, then the accepted treatment
of that transaction may be disregarded (1). For example, the purchase of an stapler, which may
last for several years, would tend to be treated as revenue rather than capital expenditure, and the
stapler itself would not be included in non-current assets (1).
Materiality is decided on the following factors:
1 Will the cost of using the normal treatment of an item outweigh the benefit obtained? (1)
2 Will the disclosure of an item (e.g., the stapler mentioned above) make any difference to the
decisions made by the person reading the financial statement? (1)
[Max 3]
Suggested Solution
(i) Matching concept implies that all incomes accounted for when they are earned and expenditures
are recognised when they are incurred. This further states that these expenses are matched
against the incomes of the relevant period.
(ii) Materiality concept allows disregarding the accepted accounting treatment of an item which has
insignificant amount. For example, the purchase of a paper weight of $5 will though be used for a
period more than one year should be treated as revenue expenditure because of its insignificant
value.
QUESTION 6
Define and explain different accounting concepts applied in accounting.
SOLUTION
Business entity
This convention states that, for accounting purposes, a business is to be treated as an independent entity,
distinct from its owner (or owners). The financial statements of a business should provide information about
the business only and should not provide information about the owner’s private financial affairs. It is
important to note the following points:
Since owner and business are treated as separate entities, it is possible for one of them to owe money to
the other. In fact it is very likely that a business will owe money to its owner (capital).
If a business is owned by just one person (a sole trader) or by a small group of people (a partnership), then
the law does not recognises any distinction between the business and its owner(s). On the other hand, a
company is legally distinct from the shareholders who own it. Nonetheless, for the accounting purposes, a
business is always treated as an independent entity, regardless of its legal status.
Money measurement
This convention states that financial accounting is concerned only with items which can be quantified and
expressed in monetary terms. The main effect of this convention is that business assets to which a monetary
value cannot reasonably be attributed (e.g. the skill of the workforce) are normally ignored in the financial
statements, even though those assets might be great worth to the business concerned.
Going concern
Under the going concern convention, it is assumed that a business will continue to operate for the
foreseeable future unless there is good reason to think otherwise. The balance sheet and income statement
are drawn up on the assumption that there is no intention or necessity to liquidate or curtail significantly the
scale of operation. If a business is a going concern, some of its assets may have useful lives stretching into
future years and the going concern convention allows the treatment of those assets in the financial
statements to take into account the length of their useful lives.
Matching
The matching convention states that expenses should be matched against the revenue to which they relate.
In other words, revenue and the expenses incurred so as to earn that revenue should be recognised in the
same accounting period.
Example
Unsold goods (Closing inventory). Any revenue derived from selling goods must be matched against the
expense of purchasing those goods only. The cost of any goods bought during an accounting period but
remaining unsold at the end of that period should be matched against the following period’s sales (assuming
that the goods are sold in the following period).
Conservatism (or Prudence) Principle

The principle states that an accountant should provide for all possible losses as soon as they are known to
exist even though the amount at which they will materialise is uncertain. On the other hand, revenues and
profits are not to be anticipated but are taken into account only when they are realised. The justification for
this principle is that accountants are cautious people. The natural optimism of businessmen needs to be
countered by the pessimism of the accountants. It is felt that where doubt exists, it is better to err on the safe
side.
Consistency Principle
There are many different ways in which items may be treated in the accounts. Each company should select
the most suitable methods and treatments which will give a fair picture of the activities of the business.
Once a suitable method is selected for an accounting treatment, the same method is used in every
accounting period. The aim is to provide records and information that can be compared. If there is no
consistency in accounting treatment, that is, if one method is used in one year and another method in the
next year, this would lead to distortion of financial reports.
The Accrual Concept

Account profit is the difference between revenues and expenses rather than between cash receipts and
payments. Revenue is recognised as soon as it is earned irrespective of whether cash has been received
or not. Similarly any expense incurred for the benefit of a particular accounting period is taken as cost for
that period whether cash has been paid or not. This concept is well justified in that receipts and payments
are to a degree random as to timing, whereas the earning of revenue or the consumption of a resource can
be accurately related of specific time periods.
Materiality Principle
Accounting is concerned with the measurement of profit and capital and the presentation of the results to
interested parties. In essence it is a summarising process. Too much detail in the annual accounts and the
view is obscured. Insignificant items are merged with other and are not shown separately. The principal is
concerned with accuracy in accounting, in particular with materiality of information contained in accounting
records and materiality of accounts. The question as to what may be considered “material” would depend
on judgment and circumstances of the particular case.
For example, if a business buys a $1 jar of coffee use and some of the coffee remains unused at the end
of the accounting period in which it is bought, strict observance of the matching convention requires that
part of the $1 should be regarded as a prepayment and should be shown in the following period’s income
statement. The materiality convention would overrule this and allow the entire $1 to be shown as an
expense in the income statement of the period in which the coffee is bought.
Historic cost/Cost concept

The historic cost convention states that assets should be shown in the balance sheet at their historic cost
to the business (i.e. their original cost) or at a value which is based upon historic cost. The current market
value of assets is ignored. For example, if a building which was bought for $150 000 five years ago has
now increased in the value to $200 000, the historic cost convention requires that the building should
continue to be shown on the balance sheet at its original cost of $150 000.
The main advantage of this convention is that the historic cost of an asset is a fact, whilst any other valuation
is only an estimate or an opinion. The historic cost convention increases the objectivity (and therefore the
reliability) of financial statements but may reduce their relevance to some users.
Substance over form

This convention states that the accounting treatment of an item should reflect its economic substance rather
than its legal form. For example, if a business buys a motor vehicle on hire purchase terms, the legal
position is that the business does not become the owner of the vehicle until the last installment has been
paid. The substance of the transaction is that the business owns the asset from the outset, and this is the
way that the transaction will be represented in the financial statements of the business.
CHAPTER 1.5 CAPITAL AND REVENUE

QUESTION 1
Advise Shostakovich Limited on why the distinction between capital and revenue expenditure is important
when preparing financial statements. [6]
OR
State the difference between capital and revenue expenditure. [2]
SOLUTION
Mark Scheme
 Capital expenditure is entered in the Statement of Financial Position (1) as a non-current asset
(1) with only the depreciation for the asset (1) being included in the Income Statement (1).
 Capital expenditure is charged over consecutive accounting periods (1) in accordance with the
matching/accruals concept (1).
 If there was incorrect classification and the Capital Expenditure was included in the Income
 Statement then the profit for the year would be understated (1) and the asset value in the Statement
of Financial Position would be understated (1).
 Revenue expenditure should be entered in the Income Statement (1) as an expense (1).
 If this expenditure was placed in the Statement of Financial Position ‘profit for the year’ would be
overstated (1) and the asset total in the Statement of Financial Position would be overstated (1).
This would contravene the prudence concept (1).
(max. 3 marks for each type) [6]
Suggested Solution
Capital expenditures are recorded as non-current assets in the Statement of Financial Position whereas
‘revenue expenditures’ are entered in the Income Statement as expenses.
If a Capital Expenditure is wrongly included in the Income Statement as an expense (revenue expenditure)
then the profit for the year and the asset value in the Statement of Financial Position would be overstated.
However, cost of capital expenditure is charged to the income statement as depreciation expense.
QUESTION 2
Define the term ‘revenue expenditure’. [2]
SOLUTION
Mark Scheme
Revenue expenditure is money spent on the day-to-day running expenses of the business on resources
that will generally be used up within one year.
Suggested Solution
A revenue expenditure is a cost that is expensed in the accounting year in which it is incurred. In other
words, the cost will be matched with the revenues of the accounting year in which the expenditure took
place.
CHAPTER 1.6 SUSPENSE ACCOUNT

QUESTION 1
Explain three reasons why it is necessary for a Trial Balance to ‘balance’. [3]
MAY 1997 P1 Q1 (c)
SOLUTION
 According to double entry concept every debit has a corresponding credit with the same amount
so if all accounting entries are correctly recorded in journals and posted to ledgers, Trial Balance
should balance.
 Equality of Trial Balance also proves accounting equation i.e. total of assets equals to totals of
equity and liabilities.
 The total of debit balances in various accounts should be the same as the total of credit balances
of various accounts. Hence, Trial Balance is a list of ledger balances that should balance.
QUESTION 2
State the use of a suspense account. [1]
NOVEMBER 2016 P22 Q3 [a(i)]
SOLUTION
Mark Scheme
A suspense account is used to balance the trial balance where errors exist in the double entry book keeping
system (1).
Suggested Solution
If two sides of a trial balance do not agree due to errors then a suspense account is opened to balance the
trial balance.
QUESTION 3
State the six types of errors not affecting agreement of trial balance.
OR
State the six types of errors not revealed or disclosed by a trial balance.
SOLUTION
1. Error of omission: This occurs where a transaction has been completely omitted from the books
Example: A sale invoice to D. Riley was completely omitted from the books.
2. Error of Commission: This arises where one half of a transaction has been entered in wrong account
but to the correct type of account
Example: $400 paid to P. Collins was debited to the account of J. Collins.
3. Error of principle: This is similar to the error of commission and arises when a transaction is recorded
without due regards to the fundamental accounting principle. This occurs when an entry is made in
entirely the wrong type of account.
Example: A machine purchased for $10 000 has been debited to purchases account.
4. Complete Reversal of Entries: This arises when we debit the account which should be credited and
credit the account which should be debited.
Example: Rent paid $300 wrongly recorded as rent received.
5. Error of original entry: This occurs where the same wrong amount is posted to the debit of one
account and the credit of another. Although the accounts to which we enter are correct, but the amount
entered is incorrect.
Example: Goods returned from P. Wedge $639 were recorded in the accounts as $369.
6. Compensating/Compensatory Error: This is not a single error. Rather these are two or more than
two errors which cancel themselves out. So an error in one account is exactly matched by an equal but
opposite error in another a/c.
CHAPTER 1.7 CONTROL ACCOUNTS

QUESTION 1
State two reasons for preparing control accounts
OR
State three advantages of preparing Control Accounts [3]
NOVEMBER 1998 P2 Q4(a)
OR
Outline three reasons for keeping control account [6]
OR
Give three reasons for preparing control accounts. [3]
OR
State three reasons for keeping control accounts. [3]
MAY 2008 P2 Q2 (c)
OR
State three advantages of keeping control accounts. [6]
MAY 2010 P23 Q2 (c)
OR
Explain two advantages of using a sales ledger control account. [4]
NOVEMBER 2011 P22 Q2(c)
OR
State three advantages to a business of maintaining a sales ledger control account. [3]
OR
State three benefits and one limitation of preparing a sales ledger control account. [4]
OR
State four advantages to a business of preparing a sales ledger control account. [4]
SOLUTION
Mark Scheme
Benefits
 Accuracy (1)
It identifies the ledger or ledgers in which errors have been made when there is a difference in Trial
Balance. (1).
 Prevention of fraud (1)
Segregation of duties helps in the prevention of fraud because members of staff who complete the
control accounts are not involved in completing the sales ledger (1).
 Availability of management information (1)
It provides a total of trade receivables and trade payables to be used in the trial balance and
financial statements (1).
 Division of Labour
It facilitates the division of labour within the accounting function
(Any two points – 2 each) [4]
Limitation
 Doesn’t identify errors of commission, omission or original entry (1)
Teacher's Solution
Benefits
(i) Trade receivables and payables figures for inclusion in trial balance & balance sheet can be easily
& quickly found.
(ii) Corresponding records of control account items in the subsidiary books act as check on frauds and
misappropriations, which can easily be detected.
(iii) Mistakes and errors in trade receivables and payables control accounts can easily and quickly be
detected and corrected by comparing totals of subsidiary books with the amounts shown in control
accounts.
(iv) Act as independent check on the arithmetical accuracy of the total of Sales ledger and purchase
ledger balances.
Limitations
(i) The arithmetical accuracy of the total of sales ledger balances cannot be checked in the absence
of double entry system.
(ii) Mistakes, errors and frauds in Mary’s accounts cannot be easily detected and corrected in the
absence of internal checks as mentioned above.
(iii) Control accounts cannot check individual trade receivables and trade payables balances.
QUESTION 2
State why a Sales Ledger Control Account may have both a debit and a credit closing balance [1]
OR
State three possible reasons why a trade receivable's account might have a credit balance [3]
MAY 2008 P2 Q2 (b)
OR
State three reasons why there might be a credit balance on a customer’s account in the sales ledger. [3]
MAY 2017 P21 Q3 (c)
SOLUTION
Mark Scheme
 Overpayment
 Payment in advance
 Credit note issued
 Deposit received etc.
1 mark each to maximum [3]
Teacher's Solution
 Advance payments from customers
 Over/duplicated payments by customers
 Return of goods after full payment.
 A contra has been put through but the customer has ignored it.
QUESTION 3
(i) Explain the purposes of the journal. [2]
(ii) State two examples of transactions which would be recorded in the journal, other than the purchase
of non-current assets on credit. [2]
MAY 2014 P22Q2(a)
OR
State two types of entries, other than the correction of errors, which would usually be recorded in the general
journal [2]
MAY 2016 P22 Q1(c)
SOLUTION
Mark Scheme
(i) It is used to record the double entry (1) of non-routine transactions (1) [2]
(ii) correction of errors (1)

Opening entries (1)
Purchase and sale of non-current assets (1)
Non-regular transactions (such as year-end transfers) (1)
Calculating opening capital (1)
Write off bad debts (1)
Depreciation (1)
Award 1 mark per correct example: (maximum 2 marks) [2]

SOLUTION
Suggested Solution
(i) Journal or General Journal is used to record the double entries of less frequent transactions which
are not entered in special journals.
(ii) Rectification of errors, Opening entries, Closing entries, sale of non-current assets on credit,
Adjusting entries like writing off of bad debts, provisions for doubtful debts & depreciation etc.
QUESTION 4
State two types of errors that will not be identified by producing a sales ledger control A/c. [2]
SOLUTION
Mark Scheme
1 Error of omission (1)
2 Error of commission (1)
3 Compensating error (1)
4 Error of original entry (1)
Suggested Solution
 Error of principles
 Error of commission
 Error of omission
 Error of original entry
 Complete reversal of entries
 Compensating error
QUESTION 5
Meena is considering charging interest on the full account balances of her customers who do not pay
promptly.
REQUIRED
Advise Meena whether or not she should take this course of action. Justify your answer. [3]
MAY 2017 P21 Q3 (d)
SOLUTION
Mark Scheme
 May improve trade receivables collection period.
 Improve cash flows
 Meena may lose customers
 May need tighter credit control which may increase cost
Decision (1 mark)
Justification (2 marks)
Suggested Solution
Charging of interest will expedite payments from trade receivables resulting in improved cash flows and
reduction in receivables collection period. On the darker side Meena may lose her customers. Meena
should also consider market and industry trends before making the final decision.
Sales Ledger Control Account

Current yr $ Current yr $
First date Balance b/f (Dr.) xxxxx First date Balance b/f (Cr.) xxxxx
Last date Sales (credit) xxxxx Last date Sales Returns xxxxx
Last date Interest on overdue accounts xxxxx Last date Discounts allowed xxxxx
Last date Cash refunds to customers xxxxx Last date Bad debts xxxxx
Last date Bank (dishonoured cheques) xxxxx Last date Bank/ cash from receivables xxxxx
Last date Balance c/d (Cr.) xxxxx Last date Purchases ledger control xxxxx
(contra)
xxxxx Last date Balance c/d (balancing fig.) xxxxx
xxxxx xxxxx
Purchase Ledger Control Account

Current yr $ Current $
yr
First date Balance b/f (Dr.) xxxxx First date Balance b/f (Cr.) xxxxx
Last date Purchases Returns xxxxx Last date Purchases (credit) xxxxx
Last date Discount received xxxxx Last date Interest on overdue accounts xxxxx
Last date Bank (payment to suppliers) xxxxx Last date Cash refunds from payables xxxxx
Last date Sales ledger control (contra) xxxxx Last date Balance c/d (Dr.) xxxxx
Last date Balance c/d (Cr) xxxxx _____
xxxxx xxxxx
Treatment of Two Balances in the Balance Sheet

The following equations would help you to determine the amounts to be included in the balance sheet for
trade receivables and trade payables.
• Sales ledger control a/c (Dr) + Purchases ledger control a/c (Dr) = Trade Receivables
• Purchases ledger control a/c (Cr) + Sales ledger control a/c (Cr) = Trade Payables
CHAPTER 1.8 ACCOUNTS FROM INCOMPLETE RECORDS

QUESTION 1
State five reasons why making a profit does not necessarily mean having more cash [5]
SOLUTION
Mark Scheme
 Sales on credit and purchases on cash.
 Expenses paid in advance.
 Income earned but still receivable.
 Repayment of loan.
 Purchase of non-current assets for cash.
 Redemption of shares or debentures.
QUESTION 2
Explain the difference between mark-up and margin. [2]
MAY 2009 P2 Q2 B (a)
SOLUTION
Mark Scheme
 Mark-up is the percentage added to cost to find selling price. (1)
 Margin is the percentage deducted from the selling price to find the cost price. (1)
Or any other correct answer. [2]
Suggested Solution
Gross Profit
 Mark-up is defined as Gross profit as a % of cost of sales and is calculated as × 100.
Cost of Sales
 Markup is added to cost to find out the selling price.
Gross Profit
 Margin is defined as Gross profit as a % of sales and is calculated as ×100.
Net Sales
 Margin is deducted from the selling price to determine the cost price.
QUESTION 3
State three benefits of keeping full double entry accounting records for a business. [3]
SOLUTION
Mark Scheme
 Assists with the preparation of the trial balance
 Assists with the preparation of the financial statements
 Reduces the risk of errors
 Reduces the risk of fraud
 Improves the accuracy of accounting records
 Balances on individual accounts are available throughout the year.
(1 mark for a valid point up to a maximum of 3)
Suggested Solution
 Individual transactions will be recorded and can be located easily.
 Matters are not forgotten or overlooked
 Accuracy of the accounts can be checked at regular intervals.
 Balances available at all times
 Financial statements can be easily prepared
 The accounts can be presented to the bank in order to obtain a loan or overdraft facility.
 Less risk of errors and fraud
 Easier to refer to previous transactions
 Easier to make business decisions
CHAPTER 1.9 FINANCIAL STATEMENTS OF PARTNERSHIP

QUESTION 1
State two reasons why partners often have separate Capital Accounts and Current Accounts. [3]
NOVEMBER 1997 P1 Q3 (B)
OR
Sate two advantages to the partners of keeping Current accounts in addition to Capital accounts. [2]
MAY 2000 P2 Q2 (c)
OR
Explain, briefly, why partnerships may keep both capital accounts and current accounts. [4]
OR
Explain two reasons why a partner might wish to keep separate capital and current accounts. [6]
OR
State why partnerships maintain separate capital accounts for each partner. [1]
MAY 2016 P21 Q1 (d)
OR
State why partnerships maintain separate capital accounts for each partner. [1]
MAY 2016 P23 Q1 (d)
OR
State three reasons why partnerships maintain separate capital accounts and current accounts for each
partner. [3]
MAY 2016 P22 Q2 (d)
SOLUTION
Mark Scheme
 To keep capital invested separate from profit and drawings
 To help avoid the possibility of partners overdrawing
 To reward the partner who has invested more capital with interest on the amount invested
 To identify partners’ drawings in order to calculate interest on drawings
Max 3 marks [3]
Suggested Solution
 Separate Capital accounts show original investment made by the partners on long-term basis.
 Separate capital account also facilitates the crediting/payment of interest on capital account
balances.
 Current accounts show increase or decrease (changes) in partner’s capitals due to business
operations like drawings, interest on drawings, share of residue profits, interest on capital and
partnership salaries.
 Lastly, separate current account roughly specifies a limit up to which drawings may be made.
QUESTION 2
(i) State two reasons why the partners are charged interest on drawings. [2]
(ii) State two reasons why the partners receive interest on capital. [2]
NOVEMBER 2014 P22 Q2 (e (i&ii))
SOLUTION
Mark Scheme
(i) To try to limit partners’ drawings (1)
Reward partner with lower drawings (1)
Ensure cash is retained in the business (1)
Maximum 2 [2]
(ii) Reward the partner for business investment (1)
Encourage partners to introduce more capital (1)
Reward partners for the lost opportunity cost of capital invested (1)
Maximum 2 [2]
Suggested Solution
(i) To ensure that cash is retained and reinvested within the business
To restrict partners’ drawings
To reward partner with lower drawings
(ii) To reward the partner for business investment
To encourage partners to introduce more capital
To reward partners for the lost opportunity cost of capital invested
QUESTION 3
Explain how a debit balance may arise on a partner’s current account. [2]
MAY 2012 P41 Q2 (a)
OR
State two reasons why a partner may have an overdrawn current account [1]
MAY 2016 P21 Q1 (c & d)
SOLUTION
Mark Scheme
A debit balance on a current account arises when a partner has withdrawn more money than he is entitled
to and is therefore in debt to the partnership. [2]
Suggested Solution
 A debit balance on a current account arises when a partner has withdrawn more money than he is
entitled to and is therefore in debt to the partnership.
 An overdrawn current account balance may also be due to running of partnership business in
continued losses
QUESTION 4
State four disadvantages a partnership has compared with a Limited company. [4]
MAY 1999 P2 Q2 (a)
SOLUTION
 First and foremost shareholders of a company enjoy limited liability whereas liability of the partners
for debts of their firm is unlimited.
 Companies have more opportunities to raise capital as compared to partnership and consequently
also enjoy economies of scale.
 A company enjoys perpetual existence as it continues in spite of death or insolvency of
shareholders, whereas death or insolvency of partner(s) dissolves the partnership.
 A shareholder can transfer his shares without the consent of other shareholders but a partner
cannot do so.
QUESTION 5
State three advantages for existing partners of trading as a partnership rather than as sole traders [3]
OR
Before forming a partnership both Henry and Robin were sole traders. State four advantages of a
partnership compared to a sole trader. [8]
MAY 2011 P21 Q1 (c)
OR
State three advantages to Kim of forming a partnership. [3]
MAY 2015 P22 Q2(c)
OR
State three advantages to a sole trader of forming a partnership. [3]
MAY 2016 P22 Q2 (c)
SOLUTION
Mark Scheme
The advantages are:
 More capital is available
 Different partners may have different skills that are beneficial to the business
 The management of the business can be shared
 The business is more efficient
 There are more ideas
 The responsibility is shared, so less stress
 Losses can be shared
 Holiday / sickness cover
2 marks for each valid comment. [8]
Suggested Solution
The advantages of a partnership compared to a sole trader are:
 availability of additional capital
 sharing of managerial responsibilities resulting in shared workload and less stress
 spread of risk as losses will be shared
 different skills of different partners may be beneficial to the business
 more ideas from more partners
QUESTION 6
State two items which may be included in a partnership agreement (other than the share of profit)
(i) which will affect the appropriation account [2]
(ii) which will not affect the appropriation account. [2]
OR
State three items that may appear in a partnership agreement. [3]
SOLUTION
Mark Scheme
Affect appropriation account
 Interest on capital
 Partners’ salaries
 Interest on drawings
1 mark × 2 [2]
Will not affect appropriation account
 Interest on loans
 Amount of fixed capital
 Annual limit on
drawings
1 mark × 2
Suggested Solution
Items affecting appropriation account
 Interest on capital
 Partners’ salaries
 Bonuses to partners
 Interest on drawings
Items not affecting appropriation account

 Interest on partners’ loans
 Amount of fixed capital
 Rent on partner’s owned building
 Annual limit on drawings
QUESTION 7
State three financial rules, which apply to a partnership, if no partnership agreement has been drawn
up. [3]
OR
State four provisions which would apply in the absence of a partnership agreement. [4]
MAY 2017 P22 Q3 (a)
SOLUTION
Mark Scheme
 Share profits and losses equally (1)
 Partners are not entitled to salaries (1)
 Partners are not charged interest on their drawings (1)
 Entitled to contribute equally to the capital of the partnership (1)
 Partners are not entitled to interest on the capital they have contributed (1)
 Partners are entitled to interest at 5% per annum on loans they make to the partnership (1)
Max 4
Solution:
(i) Equal shares in capital, profits and losses.
(ii) No interest on capital and drawings.
(iii) 5% interest is allowed on partners’ loans.
QUESTION 8
Suggest two reasons why the partners may have decided to have Loan Accounts as well as Capital
Accounts. [3]
SOLUTION:
Mark Scheme
(i) To enjoy high rate of return than capital
(ii) To ensure to have fixed returns even in case of losses.
(iii) Partners’ loans could be repaid before partners’ capitals.
Name of partnership
Appropriations a/c
for the year ended------------------------
$ $
Net profit (after all income statement expenses) xxx
Add Interest on drawings A xxx
B xxx xxx
xxx
Less Interest on capital A xxx
B xxx
Partner’s salary, bonus, commission xxx (xxx)
xxx
Profit share A xxx
B xxx xxx
Partner’s Capital accounts
Fixed Capital accounts Fluctuating Capital accounts

↓ ↓
Two separate accounts are kept for each Only one single capital a/c is kept for
& every partner to record transaction partners to record transactions relating to
relating to him i.e. Capital account & them.
current account
Partner’s Capital accounts (when fluctuating)

A ($) B ($) A ($) B ($)
Transfer to loan xxx xxx Balance b/f xxx xxx
Drawings xxx xxx Assets (additional capital) xxx xxx
Interest on drawings xxx xxx Profit share xxx xxx
Loss share xxx xxx Interest on capital xxx xxx
Balance c/d xxx xxx Interest on partner’s loan xxx xxx
Partner’s bonus xxx xxx
Partner’s salary xxx xxx
Partner’s commission xxx xxx
____ ____ Other payables to partners xxx xxx
xxx xxx xxx xxx
Balance b/d xxx xxx
Partner’s Capital accounts (when fixed)

A ($) B ($) A ($) B ($)
Transfer to loan Xxx xxx Balance b/f xxx xxx
Balance c/d Xxx xxx Assets (additional capital) xxx xxx
Xxx xxx xxx xxx
Balance b/d xxx xxx
Partner’s Current accounts

A ($) B ($) A ($) B ($)
Balance b/f (Dr) xxx xxx Balance b/f (Cr) xxx xxx
Drawings xxx xxx Profit share xxx xxx
Interest on drawings xxx xxx Interest on capital xxx xxx
Loss share xxx xxx Interest on partner’s loan xxx xxx
Balance c/d xxx xxx Partner’s bonus xxx xxx
Partner’s salary xxx xxx
____ ____ Partner’s commission xxx xxx
xxx xxx xxx xxx
Balance b/d xxx xxx
CHAPTER 1.10 PARTNERSHIP CHANGES

QUESTION 1
Explain the meaning of Goodwill. [2]
OR
Explain the term goodwill. [4]
OR
State what is meant by goodwill. [1]
NOVEMBER 2016 P21Q1 [b (i)]
OR
State what is meant by ‘goodwill’. [1]
MAY 2017 P32 Q4 (a)
SOLUTION
Mark Scheme
Goodwill is the amount paid for the acquisition of a business in excess of the acquired business’ separable
net assets at fair value
Suggested Solution
Goodwill is an intangible non-current asset. It arises from the factors like advantageous location, good
reputation, quality products & customer loyalty of the concerned business. Mathematically, it represents the
value of the business in excess of the book value of its net assets.
QUESTION 2
State two reasons why goodwill has arisen? [4]
MAY 2013 P22 Q2 (c)
OR
Explain the meaning of goodwill and suggest two reasons how it may arise. [5]
MAY 2014 P21 Q2(c)
OR
State three factors which affect the value of goodwill [3]
NOVEMBER 2016 P21Q1[b(ii)]
SOLUTION
Mark Scheme
 Reputation (1)
 customer base/monopoly (1)
 location (1)
 quality product (1)
 skilled workforce (1) Max 3 [3]
Suggested Solution
 advantageous location of the business premises
 access to sources of supply e.g. large quotas
 effectiveness of publicity
 nature and reputation of firm’s products and services
 growth element
 less or negligible competition
 efficient and contended workforce
 good after sale services
 operating in an industry which does not allow new entrants with ease
QUESTION 3
Explain how goodwill should be treated in the books of partnership. [4]
MAY 2014 P21Q2(d)
SOLUTION
Mark Scheme
As this is not purchased goodwill (1) it is not shown in the books of account (1) and must be written off
against the capital accounts (1) of the partners in their profit sharing ratios (1). [4]
Suggested Solution
Accounting standards do not allow showing any non-purchased goodwill in the books of account as an
asset. This must be written off against the capital account balances of the partners in their new profit sharing
ratios.
QUESTION 4
Identify two situations where the capital accounts of partners may be adjusted for goodwill .[2]
NOVEMBER 2016 P23Q2[a(iii)]
SOLUTION
Mark Scheme
 On the introduction of a new partner. (1)
 On the retirement of an existing partner. (1)
 On a change in the profit sharing ratio. (1) Max 2
Suggested Solution
 On admission of a new partner.
 On retirement or death of an existing partner.
 On a change in the profit sharing agreement
QUESTION 5
Discuss the treatment of goodwill in partnership accounts, with particular reference to retiring and incoming
partners. [6]
SOLUTION
Mark Scheme
Good will is taken into account on the retrial of a partner, who must be credited with his share of Goodwill.
An incoming partner must compensate the existing partners for his acquired share of Goodwill. In this
situation Goodwill may be raised in the books of account as an asset, but it is considered prudent to adjust
individual capital accounts in order to compensate each partner when partners retire form or join a
partnership.Etc. 2 for each point to a maximum of (6)
Suggested Solution
If the business has generated goodwill in the past, then it is only that the old partners are given credit for
that goodwill in their old profit-sharing ratios.
In that case an incoming partner may be asked to bring some amount for his share in goodwill in addition
to his capital investment whereas an outgoing partner receives his share of goodwill in addition to his capital.
So on admission or retirement of a partner value of goodwill is determined and credited to old partners’
capitals in their old profit-sharing ratios. Then goodwill is normally written off by debiting new partners’
capitals in new profit-sharing ratios
QUESTION 6
Identify one advantage of writing off Goodwill after immediately after it arises. [1]
SOLUTION
As goodwill normally has no objective value so it cannot be sold individually unless business is subject to
sale. So writing off of goodwill enables to show true and fair value of business assets. Moreover, it is prudent
to write off goodwill as it is progressively replaced by the goodwill created by the new management of
business.
QUESTION 7
State two reasons why assets are revalued on the change of a partnership [2]
NOVEMBER 2016 P23Q2[a(ii)]
SOLUTION
Mark Scheme
To give the benefit of the change in value of the business to the existing partners and any partner who may
be retiring. (1)
So that the statement of financial position on the entry of the new partner shows a true and fair view.(1)
Suggested Solution
When a new partner takes admission in a firm, it is desirable for him as well as the existing partners to opt
for revaluation. It helps to assess true and fair values of assets and liabilities and as a result actual worth
of investment of each partner. Likewise in case of retirement of an existing partner, revaluation may become
necessary to find out the real and fair value of investment of retiring partner.
QUESTION 8
Suggest one reason why Poppy and Rose might have decided to change the partnership agreement. [2]
MAY 2011 P43 Q2 (e)
SOLUTION
Mark Scheme
 Years of inflation had made their salaries unrealistic.
 Change in balance of workload between partners
Other reasonable answer 1 × 2 [2]
Suggested Solution
Change in workload or managerial role of partners within the partnership.
QUESTION 9
Outline four advantages to Mhairi of forming a partnership with Aiden. [8]
MAY 2012 P22 Q2 (d)
SOLUTION
Mark Scheme
The advantages are:
 More capital is available;
 Different partners may have different skills that are beneficial to the business;
 The management of the business can be shared;
 The business is more efficient
 There are more ideas
 The responsibility is shared, so less stress
 Losses can be shared;
 Liquidity is improved.
Two marks per valid point to maximum of 8. [8]
Suggested Solution
The advantages of forming a partnership are:
 availability of more capital;
 sharing of risks and responsibilities of business ownership;
 easy formation than a corporate form of business;
 different skills and ideas of different partners may be more beneficial to the business;
 subject to limited government regulations
QUESTION 10
Identify non-financial factors, which a sole trader should consider when making his decision of forming
partnership. [5]
MAY 1996 P1 Q4(C)
SOLUTION
Sole trader should remember that after forming the partnership the business is no longer under his control
and new partner John may disagree on policy matters and he will be legally bound by the acts of the new
partner and can be held individually responsible for all of the partnership debts.
QUESTION 11
Identify two possible advantages and two possible disadvantages to Brian and Clive of admitting Dilip to
the partnership on the retirement of Alan. [4]
OR
State two possible advantages to Alex and Barry of the admission of a new partner [2]
SOLUTION
Mark Scheme
Advantages:
 Wider pool of knowledge/expertise.
 Greater resources (capital etc.).
 Share of losses when these arise.
Disadvantages:
 All responsible for debts and errors of new partner.
 Can slow decision making process.
 Share of profits. [4 marks]
(Maximum 2 for adv. & 2 for disadv.)
Suggested Solution
Advantages:
 Increased amount of capital will be available
 Risks and responsibilities of business ownership are shared
 Widerpoolofskills and expertise
 Reduction in workload of existing partners
Disadvantages:
 Sharing of profits among more partners.
 Can slow decision making process
 Each partner is legally bound by the acts of all the other partner
QUESTION 12
Why do partnerships decide to become limited companies? [5]
November 1996 P1 Q4 (b)
OR
The partners are now considering changing their business from a partnership to a limited company. Explain
to the partners the meaning of the term ‘limited liability’. [3]
SOLUTION
Mark Scheme
Liability for the debts of the business (1) is limited (1) to the amount of capital invested by each partner
(1) [3]
Suggested Solution
In a partnership, the limited partners have limited liability, while the general partner has unlimited liability.
The limited liability feature implies that the partner's personal assets cannot be used to satisfy the creditor
claims in the event of the partnership's insolvency.
QUESTION 13
Assess the impact of Alice’s retirement on the partnership’s statement of financial position. [4]
SOLUTION
Mark Scheme
 Reduced cash flow after paying Alice to leave the business in view of the current overdraft
 Having to raise additional finance to pay Alice off

 Impacts on profitability having to raise additional capital
 Lower capital investment in the business
 Difficult to raise additional finance to pay to Alice due to the current overdraft [4]
Suggested Solution
 Liquidity problems especially in the presence of bank overdraft
 Difficulty in arranging cash to pay to Alice
 Cash will have to be raised from some outside souse to pay to Alice.
 Arranging new finance may be difficult and costly
QUESTION 14
Describe what financial provision a partnership should make for the death or planned retirement of a
partner. [2]
November 1996 P2 Q1 (b ii)
Solution:
Partnership should decide about mode and time for payment of deceased or retired partners’ share in the
firm after revaluation, goodwill adjustments other adjustments including profit share.
QUESTION 15
Explain why partners may value goodwill and revalue the assets when one partner retires. [3]
MAY 2017 P23 Q1 (c)
SOLUTION
Mark Scheme
All partners, including the partner who is retiring are rewarded for their efforts in building up the
business. It is only fair that the retiring partner is compensated in this way.
Suggested Solution
Goodwill adjustments are made to reward the partners including retiring partner in recognition of their efforts
in building up the reputation of business. It is in an effort to compensate the retiring partner for his efforts.
Revaluation adjustments are made to determine the true worth of retiring partner’s total investment in the
partnership
CHAPTER 1.11 RATIO ANALYSIS – AS LEVEL

QUESTION 1
Profitability ratios are one type of ratio.
Name two other types of ratio that a business might use. [2]
MAY 2000 P2 Q1 [f (i)]
SOLUTION
 Utilisation of resources ratios.
 Financial (Solvency) ratios.
 Investment ratios.
QUESTION 2
State three possible reasons for the reduction in gross profit percentage of a retailer. [3]
MAY 2000 P2 Q1 (e)
OR
Give three reasons why the gross profit of a business may be less than the expected margin on sales. [3]
OR
State five possible reasons for the apparent decrease in her gross profit ratio. [5]
MAY 2001 P2 Q3 (a)
OR
The prices of food and drink sold had been planned to obtain a gross margin of 70%. The actual margin
was only 50%. State two reasons why these figures may differ? [4]
MAY 2013 P21 Q1 (c)
SOLUTION
Mark Scheme
The obtained gross profit margin is worse than planned margin. This could be due to the following reasons.
 Price cut to dispose off old inventories.

 Lower sales volume of higher margin items
 High sales volume of lower margin items.
 Increase in purchase price without corresponding increase in sales price.
 Decrease in sales price does not correspond with increase in sales value.
 Increase in import duties on imported raw material.
 Price reducing policy due to competition.
 Price ceiling imposed by government.
 Stolen inventory not deducted from purchases.
 Undervaluation of closing inventory or overvaluation of opening inventory
 Loss of bulk purchases discounts because of purchases in smaller quantities than expected.
 Withdrawal of government subsidies on purchased items (Any five)
Teacher's Solution
 Price cuts for disposing off old inventory.
 Price reducing policy due to competition.
 Loss of bulk purchases discounts because of purchases in smaller quantities than expected.
 Decrease in sales price does not correspond with increase in sales volume
 Increase in purchase prices without corresponding increase in sales price.
 Withdrawal of government subsidies on purchased items
 Over valuation of opening inventory / under valuation of closing inventory.
QUESTION 3
Discuss three actions which the club could take to improve the gross margin. [6]
NOVEMBER 2017 P32 Q1 [b(ii)]
SOLUTION
Mark Scheme
 Consider market (1) – provide higher quality food (1) to appeal to target market (1).
 Seek cheaper suppliers/seek discounts from suppliers/buy in bulk (1) to reduce cost of sales (1).
 Increase the prices for items served in the restaurant.(1) Should earn higher revenue (1).
 Reduce food wastages (1). This should increase the gross margin (1)
2 marks × 3 points (1 mark for stating and 1 mark for developing) [6]
Suggested Solution
 Bulk buying with higher trade discounts.
 Increase in selling prices
 Change of suppliers with cheaper rates
 More sales of higher margin items
QUESTION 4
State six possible reasons for the decrease in the ratio of net profit to sales [6]
NOVEMBER 2008 P2 Q2 (B)
SOLUTION
Mark Scheme
 Inventory wastage
 Inventory pilferage
 Sales price reduced
 Purchase price increased
 Opening inventory overstated
 Closing inventory understated
 Theft from till
 Sales mix altered
 Increased carriage in
 Increased expenses
 More bad debt Etc.
Any six points to a maximum of 6
Suggested Solution
 Net profit to sales ration may decrease due to any of the following reasons.
 Decrease in sales price does not correspond with increase in sales volume.
 Price reducing policy due to competition
 Increase in purchase prices without corresponding increase in sales price.
 Price cuts for disposing off old inventory.
 Overstatement of opening inventory or understatement of closing inventory
 More administrative and marketing expenses
QUESTION 5
Jackie and Kim provided the following accounting ratios:
Year ended 30 April 2011 Year ended 30 April 2012

Percentage of gross profit to sales 21% 24%
Percentage of net profit to sales 10% 11%
REQUIRED
Suggest two reasons for the change in the percentage of gross profit to sales. [4]
MAY 2012 P21Q2 (d)
SOLUTION
Mark Scheme
 Higher sales price with cost of sales staying same or rising less than sales price.
 Lower cost of sales with sales price staying same or falling less than cost of sales.
 More efficient use of inventory with less spoilage, wastage and theft.
NOTE: increase in sales volume is incorrect.
1 mark per point, one for development to maximum of 4 [4]
Suggested Solution
 Increase in sales price with no or relatively low increase in cost of sales.
 Decrease in cost of sales with no or relatively low decrease in sales price.
 Bulk purchases resulting in more trade discounts and reduced purchase costs.
QUESTION 6
Jackie and Kim provided the following accounting ratios:
Year ended 30 April 2011 Year ended 30 April 2012
Percentage of gross profit to sales 21% 24%
Percentage of net profit to sales 10% 11%
REQUIRED
Suggest two reasons for the change in the percentage of net profit to sales. [4]
MAY 2012 P21Q2 (e)
SOLUTION
Mark Scheme
 Lower overhead costs such as rent, rates, heat and light.
 Increased efficiency (lower costs)
 Higher gross profit margin with overheads remaining the same or less than percentage increase in
GP to sales.
1 mark per point, one for development to maximum of 4 [4]
Suggested Solution
 Better control on operating expenses.
 Increase in gross profit margin with no or relatively low increase in operating expenses.
QUESTION 7
How owner of a business can use the figure for return on capital employed to assess the performance of
his business. [3]
SOLUTION
Mark Scheme
 Allows investor to make decisions between alternatives
 Allows comparison with similar businesses
 Allows comparison with less risky investments, e.g. Bank
One mark per relevant point to maximum of 3 [3]
Suggested Solution
 He can compare this with the other businesses in the same industry
 He can compare the ratio with the past year to determine the reasons of significant changes (if any)
 ROCE can also be compared with alternative investment opportunities
QUESTION 8
Explain what is meant by mark up. [2]
MAY 2015 P21 Q2 (a)
SOLUTION
Mark Scheme
Mark up expresses the gross profit (1) as a percentage of cost price of the goods sold (1).
Suggested Solution
Mark up represents the gross profit as a percentage of cost price of the goods sold (cost of sales).
QUESTION 9
Explain what the non-current asset turnover measures. [4]
MAY 2015 P21 Q2 (d)
SOLUTION
Mark Scheme
It shows the efficiency of assets to generate income (1). It shows how much every dollar of non- current
assets (1) generates in sales revenue (1). A higher value indicates better utilisation of resources (1). [4]
Suggested Solution
It determines that how efficiently and effectively business is using its assets to generate its revenue. It
shows how much sales revenue is generated for every dollar of amount invested in non- current assets. A
higher value signifies better utilisation of resources.
QUESTION 10
State four ways in which Klingsman could improve his working capital [4]
MAY 2011 P23 Q1 (e)
SOLUTION
Mark Scheme
 Injection of cash/additional capital
 Long term loan
 Sales of surplus non-current assets
 Reduction in drawings
 Factor debt
 Effective inventory management to reduce damage to inventory
Any four suitable points for 1 mark each [4]
Suggested Solution
 Sales of surplus non-current assets
 Borrowing on long term basis
 Injection of additional capital by the owner
 Reduction in drawings
 Bringing in a new partner
QUESTION 11
Explain why the liquid ratio is a more reliable indicator of liquidity than the current ratio. [2]
MAY 2011 P23 Q1 (f)
SOLUTION
Mark Scheme
 Inventory is regarded as the least liquid asset
 A buyer has to be found
 Some goods may prove to be unsaleable
 The quick ratio shows if the business would have any surplus liquid funds if all the current liabilities
were paid immediately
Any two suitable points 1 mark each [2]
Suggested Solution
The liquid ratio shows the availability of liquid funds to settle all of the current liabilities immediately. Liquid
ratio excludes closing inventory from the calculation as it is considered as the least liquid current asset. The
exclusion of inventory from the calculation may be justified on the ground that some goods in inventory may
prove to be unsaleable or it sometimes becomes difficult to find a buyer for some inventory items.
QUESTION 12
A shareholder at the Annual General Meeting said that the purchase of the new factory would cause non-
current asset turnover to fall, with an adverse effect on shareholder confidence.
Advise the directors whether or not they should be concerned about the shareholder’s comment. Justify
your answer. [5]
SOLUTION
Mark Scheme
 The ratio may indeed fall in the short term as non-current assets increase. (1)
 Once the new factory is established sales revenue or profit should rise too. (1)
 The ratio may actually rise in due course. (1)
 Shareholders are more interested in profits and dividends. (1)
 The disclosure of the purchase enables users of the financial statements to make informed
comparisons. (1)
 Directors do not need to be greatly concerned. (1)
 The directors should be concerned (1) as shareholders may sell their shares (1), which may reduce
the market price of their shares (1).
 Shareholder confidence may fall (1).
 New shareholders may not be attracted to buy shares in the future (1).
 The shareholders may dismiss the directors. (1)
Decision (1)
Justification Max 2 for positive + Max 2 for negative
Suggested Solution
The non-current assets turnover ratio may fall in the short term as new factory will not start working at full
capacity immediately.
Once factory becomes fully operational then there should be an increase in revenues and profits.
Increase in revenues and profits are more relevant for shareholders than non-current assets ratio.
Increase in revenues will also increase the non-current assets turnover ratio in the long term.
Purchase of a new factory should also boost the shareholders’ confidence as it indicates the company is
growing.
Though this does not seem to be big issue but as it is raised in the annual general meeting so should be
addressed seriously by the directors.
The dissatisfaction of shareholders may adversely affect their confidence. The shareholders may elect new
directors. They may sell their shares in the company and due to negative impact in the market new
shareholders may not be inclined to buy the company’s shares.
QUESTION 13
State two organisations or groups of people, other than the proprietors of the business, who might use
these ratios. [2]
MAY 2000 P2 Q1 [f (ii)]
OR
State four user groups who might be interested in accounting ratios. [4]
MAY 2008 P2 Q1 [d (ii)]
SOLUTION
Mark Scheme
Interested parties might be:
 Bank manager
 Directors
 Competitors
 Customs and excise
 Trade payables
 Investors/Shareholders
 Employees
 Trade receivables
 NOT Stakeholders
 The media (Newspapers, TV etc)
Allow ONE group only of members of the firm
One mark each to a maximum of [4]
Suggested Solution
 Lenders
 Management
 prospective and existing shareholders
 tax Authorities
 stock brokers
 lenders
 employees
 trade payables
 trade receivables
 directors
 Government, etc.
QUESTION 14
Identify three possible users of accounting ratios other than the directors of the company. State what
information the users would obtain from the ratios. [9]
SOLUTION
Mark Scheme
 Shareholders and potential shareholders (1)
Interested in: sales and profit trends (1) future performance (1) profit available for distribution (1)
yield on investment (1) ease of payment of dividends from profits (1) management of funds (1)
 Trade payables (1)

Interested in: working capital (1) acid test (1) profitability (1) order of claim in event of liquidation
(1)
 Lenders (1)
Interested in: purpose for which loan needed (1) security of loans (1) profit trends (interest) (1)
current ratio (1) book values of non-current assets compared to saleable value (1) order of claim in
event of liquidation (1)
 Government bodies (1)

Interested in: wages (income tax) (1) profits (corporation tax) (1) VAT returns (1) forecasts of future
expansion (1)
 Employees and Trade Unions (1)

Interested in: profits earned this year (1) potential and past profits (1) future prospects (1) dividends
(1)
Marks awarded are one for each user to a maximum of 3 and a maximum of two for the
information required by each of those users.
In (b), correct answers outside the AS syllabus will be accepted. Above answers are not
exclusive. [max 9]
Suggested Solution
User group Class of ratio Reason for the interest
Profitability, Interested in servicing of their loans by the enterprise, i.e., regular
Bankers and
Liquidity and payment of interest & repayment of principal amount on
Lenders
Investment scheduled dates.
They are interested in the profitability and safety of their
Profitability and
Investors investment and would like to know whether the business is
Investment
profitable, has growth potential and is progressing on sound lines.
Government may use profit as a basis for taxation, grants and
Government Profitability
subsidies
Profitability, Employees will be concerned with job security, bonus and
Employees Liquidity and continuance of business and wage bargaining.
Activity
Customers will seek reassurance that the business can survive in
Customers Liquidity
the short term and continue to supply
Interested in receiving their payments as and when become due
Suppliers Liquidity and would like to know its ability to honour its short term
commitments.
Profitability, Liquidity Management is interested in all aspects i.e. both financial
Management
& Activity performance and financial condition of the business.
QUESTION 15
Comment briefly on the advantages of using ratios. [3]
MAY 2004 P2 Q1 (c)
OR
State & explain one advantage of using ratio analysis as a means of evaluating performance. [2]
OR
Explain briefly one use of accounting ratios. [3]
OR
State two reasons for calculating ratios. [2]
MAY 2008 P2 Q1 (d)
OR
Explain two ways in which ratios may be used to assess the performance of companies. [4]
OR
State three benefits to a business of using ratios. [3]
MAY 2016 P22 Q1 (e)
OR
State three uses of ratio analysis to a trader. [3]
MAY 2017 P23 Q3 (d)
OR
State two advantages of ratio analysis to a user of the financial statements. [2]
SOLUTION
Mark Scheme
(i) Trend analysis: compare the trend of each company’s performance.(l) Trends indicate if a
company’s performance is improving, stagnant or in decline.(l)
(ii) Inter-company comparison.(l) Comparison with the average performance of other companies in
the same trade or with other firms of a similar type provides a useful measure of how efficiently a
company is performing (1)
(iii) Set targets for the next period.
(iv) Help to compare with industry averages. [4]
Suggested Solution
In general, ratios are used for making the following comparison.
(i) Comparing one year with another (Trend analysis)
The financial performance of a business for a given year and its financial position at the end of that
year may be judged by calculating a set of ratios and comparing the results with the Equivalent
ratios for the same business in previous year. Any perceived trends may be categorised as
favourable, adverse or stagnant.
(ii) Comparing one business with another

The ratios calculated for a business in a given accounting year may be compared with those
calculated for another business in the same year or with industry average or with market leader
(this comparison is only valid if all the businesses are in the same trade). This comparison helps to
evaluate that how efficiently the company is performing.
(iii) Help in Decision making

Ratios help the management in decision-making and also point out problem areas. Ratios also
highlight issues of performance that can be investigated.
QUESTION 16
State six shortcomings or dangers in using ratio analysis. [6]
MAY 2003 P2 Q2 (c)
OR
Comment briefly on the disadvantages of using ratios. [3]
MAY 2004 P2 Q1 (c)
OR
State and explain one disadvantage of using ratio analysis as a means of evaluating performance. [2]
OR
State two limitations of the uses of ratios [4]
MAY 2013 P23 Q2 (c)
OR
Explain five limitations of using ratios as indicator of business performance. [10]
OR
Explain three limitations of ratio analysis. [6]
MAY 2016 P21 Q2(c)
OR
State two limitations of using ratio analysis to analyse the performance of a business. [2]
MAY 2017 P22 Q2(a)
SOLUTION
Mark Scheme
 Reliability – information from which ratios are prepared may not be reliable as there could be
errors.
 Seasonal variations – date of accounts may affect ratios; for example a toy-maker might have low
inventory during the month before his busy season but have many trade receivables at that time.
 Timing – by their nature, final accounts are almost out-of-date by the time they are published.
 Monthly fluctuations – these cannot be ascertained from yearly accounts.
 Cosmetic accounting – Despite regulation it is still possible to alter ratios by, for example,
undertaking a robust debt collection exercise or delaying inventory purchases thus “modifying”
ratios for the year end.
 Comparability – Comparisons between businesses are only valid if they are of the same type and
size. Use of different accounting policies also limit comparisons.
 Non-financial matters – such items as staff loyalty, level of competition and customer base cannot
be measured by ratios.
 The ratios do not show the cause of the changes.
 Economic – changes may be due to a downturn or inflation.
Award marks to the first five answers, giving one for a brief description and one for
expansion in each case.
(Maximum 10 marks)
Suggested Solution
The following are the important limitations of accounting ratios.
(i) No ideal ratio
No fixed standard can be laid down for ideal ratios.
(ii) Limited Use
Ratios are limited only on the information, which has been recorded, in the books of accounts.
(iii) Ratios are only indicators
They should not be taken as final regarding good or bad financial position of the business. Other
things will have to be seen. Moreover they do not indicate the reasons of poor performance.
(iv) Different Ways to interpret ratios
Ratios have to be interpreted and different people may interpret the ratios in different ways.
(v) Based on historical figures
Ratios are based on historical figures (not adjusted for inflation) so the conclusions drawn from
them may be misleading and unrealistic.
(vi) Comparability
They can only be used to compare like with like. Inter-firm comparison is made more difficult as
firms may use different accounting methods and techniques.
(vii) Dependent upon quality of input
The accuracy and reliability of ratios depend upon the quality of the information from which they
are calculated.
(viii) Don’t predict future
Ratios are based upon what has happened rather than what will happen.
(ix) Non-Financial Factors
Only concerned with financial data, ignores non-financial aspects such as staff morale, quality of
management etc
QUESTION 17
Name five external users of accounting information & state their interest in the information. [10]
SOLUTION
1 Trade payables (suppliers)
Need to know the organisation’s ability to pay its debts and continue to supply
2 Providers of finance to the business (e.g. banks).
Need to know that business can pay interest/repay loans/grant finance.
3 Trade unions.
Need to know financial situation as a means of discussing working conditions and pay/job security.
4 Financial analysts (e.g. stockbrokers)
Need information to help advise clients
5 Government and its agencies
Interested in allocation of resources also to provide a basis for national statistics Inland revenue for
taxation purposes.
6 The public
Need information regarding jobs and may be local suppliers
7 Trade receivables (customers)
Interested in continuity of business for supply of goods/services
8 Competitors
To compare to their own business.
9 (Potential) investors
Need to know whether the investment is worthwhile.
10 Auditors
Need to examine the accounts.
Maximum two marks per user, one for title and one for their interest to a maximum of ten
marks [10]
Suggested Solution
External users are those groups or persons who are outside the organization for whom accounting function
is performed.
1 Trade payables (suppliers)

They are interested to know the financial soundness before granting credit from the point of view
of security and further credit.
2 Investors
The prospective investors need to know that business can pay interest/repay loans/grant finance.
3 Government
Government keeps a close watch on the firms which yield good amount of profits. The state and
central Governments are interested in the financial statements to know the earnings for the purpose
of taxation. To compile national accounts the accounting is essential.
4 Trade receivables (customers)

Customers have interest in the accounting information for assessing the financial position of a
business, especially, when they have a long term involvement with, as it enables to maintain a
steady source of business.
5 Regulatory Authorities
The accounting information is needed for them to ensure that it is in accordance with the rules and
regulations and that it protects the interests of the stake holders who rely on such information.
6 Research Scholars
Accounting information, being a mirror of the financial performance of a business organization, is
of immense value to the research scholar who wants to make a study into the financial operations
of a particular firm.
7 Financial Institutions
Bank and financial institutions that provide loan to the business are interested to know credit-
worthiness of the business.
(1) Income Statement Ratios

(i) Gross Profit Ratio (Margin) Gross Profit
= × 100
Net Sales
(ii) Mark Up Gross Profit

= × 100
Cost of Sales
(iii) Net Profit Ratio Profit after interest

= × 100
Sales (Revenue)
(iv) Operating Expenses Ratio Operating Expenses

= × 100
Sales (Revenue)
NPBI
= × 100
Capital Employed
(v) Return on Capital Employed [Capital Employed = Issued Shares + Reserves + Long
Term Liabilities (Non-Current Liabilities)]
Net Profit after tax and Preference Dividends

(vi) Return on Equity = × 100
Equity
(3) Turnover/Efficiency Ratios

Net Sales
(i) Non-current Assets Turnover = × 100
Total Net Book Value of Non−Current Assets
Cost of Sales
(ii) Inventory Turnover Rate (times) = (answer given in times)
Average Inventory
(iii) Average Inventory
Inventory Turnover Rate (days) = × 365
Cost of Sales
(iv) Trade Receivables

Trade receivables Collection Period = × 365
Credit Sales
(v) Trade Payables

Trade payables Payment Period = × 365
Credit Purchases
(4) Liquidity Ratios

Current Assets
(i) Current ratio/Working Capital Ratio =
Current Liabilities
Current Assets− Inventory

(ii) Quick/Acid Test/Liquid Ratio =
Current Liabilities
Section 2 51 AS Level – Cost Accounting
SECTION 2 AS LEVEL – COST ACCOUNTING

CHAPTER 2.1 INVENTORY VALUATION 52
CHAPTER 2.2 LABOUR COSTING 57
CHAPTER 2.3 ABSORPTION COSTING 61
CHAPTER 2.4 MARGINAL & ABSORPTION COSTING 69
CHAPTER 2.5 BREAK-EVEN & PROFIT VOLUME ANALYSIS 72
CHAPTER 2.6 MARGINAL COSTING DECISION MAKING 76
CHAPTER 2.7 ACCOUNTING FOR LIMITING FACTORS 83
CHAPTER 2.8 BUSINESS PLANNING 85
CHAPTER 2.1 INVENTORY VALUATION

QUESTION 1
Explain the meaning of the FIFO, LIFO and AVCO in connection with the valuation of inventory: [3]
NOVEMBER 2000 P3 Q3
SOLUTION
(i) FIFO
This is a method under which issues are priced at the cost of the earliest delivery available in
inventory.
(ii) LIFO
This is a method of pricing the issue of materials using the purchase price of the latest units in
inventory.
(iii) AVCO
This pricing method calculates a weighted average price for all units in inventory and issues are
priced at this average cost.
QUESTION 2
State one advantage and one disadvantage of using the FIFO and AVCO methods of inventory
valuation: [4]
MAY 2013 P23 Q3 (c)
OR
Explain two advantages and one disadvantage of using the AVCO method of inventory valuation. [6]
NOVEMBER 2016 P21 Q4 (g)
SOLUTION
Mark Scheme
Advantages (FIFO)
 Relatively easy to calculate.
 Realistic – Inventory is bought and sold in order.
 Inventory values are based on actual prices paid for Inventory.
 Closing Inventory valuation is based on most recent prices paid.
 Acceptable under IAS.
Disadvantages (FIFO)
 The price at which Inventory is issued to production is likely to be out of date.
 When the prices of Inventory rise, the FIFO method values the Inventory at the highest (latest
prices). This would reduce cost of sales and therefore increase profit.
 This would mean more tax would have to be paid.
(2 × 1 marks)
Advantages (AVCO)
 It is logical since all identical units of Inventory are given an equal value.
 Fluctuations in the purchase price of Inventory are evened out so the impact on costs and profit is
reduced.
 It conforms to the IAS.
 Averaged prices used to value closing inventory likely to be closer to latest prices
 Avoids identical items being charged to a job at different prices
Disadvantages (AVCO)
 The average cost has to be recalculated every time the price of purchased Inventory changes.
 The average cost might not be the same as the actual cost paid.
 If Inventory prices are rising rapidly, the average cost will be lower than the replacement price.
(2 x 1 marks)
Suggested Solution
Advantages (FIFO)
 It is relatively easy and simple to use.
 It is more realistic as goods are bought and sold in the order of purchase.
 Inventory values are based on actual prices paid for the goods.
 Closing Inventory valuation is a close approximation to market value as it is based on most recent
prices paid.
 It is acceptable valuation method under IAS 2.
Disadvantages (FIFO)
 The price at which Inventory is issued to production is likely to be out of date.
 When the prices of Inventory rise, the FIFO method values the Inventory at the highest (latest
prices). This would reduce cost of sales and therefore increase profit. This would mean more tax
would have to be paid.
Advantages (AVCO)
 It is logical since all identical units of Inventory are assigned equal per unit cost.
 It is best rated method in periods of price fluctuations as these are evened out so the impact on
costs and profit is reduced.
 It is acceptable valuation method under IAS 2.
Disadvantages (AVCO)
 The average cost has to be recalculated every time a new inventory is purchased at different price.
 The average cost might not be the same as the actual cost paid.
 If Inventory prices are rising rapidly, the average cost will be lower than the replacement price.
QUESTION 3
Brahms currently uses FIFO to value his inventory. He is considering changing the method to show a lower
profit each year. State two reasons why he should not do this. Make reference to any relevant accounting
principles, concepts and conventions. [4]
MAY 2013 P23 Q3 (c)
SOLUTION
Mark Scheme
1 Needs to be consistent
2 Window dressing of accounts not allowed
3 Comparing results from one year to the next meaningless
4 Falsely manipulating of accounts/true and fair view
Any two answers for 2 marks each to a maximum of 4 [4]
Suggested Solution
Brahms should be consistent in applying different accounting methods (consistency concept). This is also
important as if he falsely manipulates the accounts by changing valuation method it will not only distort true
and fair view but comparison of current year results with of the last year will be meaningless.
QUESTION 4
How the inventory should be valued in the final accounts. Give reasons for your advice. [6]
SOLUTION
Mark Scheme
 Inventories should be valued at the lower of cost and net realisable value.
 IAS states companies should either use the FIFO or AVCO method of inventory valuation.
 Whichever method is used should be used consistently – Consistency concept.
 Prudence concept states that companies should choose the lowest value when valuing their assets.
(3 × 2 marks) (1 plus 1 for development) [6]
Suggested Solution
According to “Prudence concept” inventory should be valued at lower of cost and net realisable value.
International Accounting standard 2 (IAS 2) states companies should either use the FIFO or AVCO method
for inventory valuation. However according to “Consistency concept” whichever method is selected should
be used consistently.
QUESTION 5
Goods in inventory of Marshall Klingsman, a sole trader, at 30 April 201at, valued at cost $15 000, were
found to be damaged.
REQUIRED
(i) Explain two differences between cost and net realisable value.
(ii) Discuss the accounting treatment of the damaged inventory. [4]
MAY 2011 P23 Q1 (c)
SOLUTION
Mark Scheme
(i) The cost comprises the cost of purchase plus other costs incurred in bringing the inventory to its
present location and condition.
Net realisable value is the estimated selling price less estimated selling costs
(ii) Inventory should never be valued at more than cost.
Valuing inventory at cost observes the principles of realisation, matching and prudence.
Any 2 relevant points for 2 marks each [4]
Suggested Solution
(i) Cost means expenditures, which have been incurred in the normal course of business in bringing
the product or service to its present location and condition. Cost includes import duties, transport
and handling charges less trade discounts.
Net realisable value is the actual or estimated selling price less;

 all further costs to completion; and
 all costs to be incurred in marketing, selling and distributing.
(ii) Inventory should be valued at lower of cost and net realisable value. This treatment is in compliance
with prudence and matching concepts.
QUESTION 6
IAS relate to standards to be used in accounting. IAS 2 sets standards regarding inventories and long-term
contracts. Using your knowledge of IAS2define the following:
(i) Cost [3]
MAY 2001 P2 Q1, MAY 2012 P21 Q1 (c)
(ii) Net realisable value [3]
MAY 2001 P2 Q1, MAY 2012 P21 Q1 (b), NOVEMBER 2016 P23 Q2 [a (i)]
(iii) Cost of purchase [3]
MAY 2001 P2 Q1
(iv) Cost of conversion [3]
MAY 2001 P2 Q1
SOLUTION
Mark Scheme
Cost is expenditure incurred in the normal course of business to bring the product to its present location
and condition and includes import duties, transport and handling costs less trade discounts.
1 mark per valid point to a max of 1 x 3
NRV is the actual or estimated selling price (less trade discount) but before cash discount less all further
conversion costs and costs incurred in marketing, selling and delivering the goods to the customer.
1 mark per valid point to a max of 1 x 3
Suggested Solution
(i) Cost
Cost means expenditures, which have been incurred in the ordinary course of business in bringing
the product or service to its present location and condition. Cost includes import duties, transport
and handling charges less trade discounts.
(ii) Net realisable value

Net realisable value is the actual or estimated selling price less;
 trade discount) but before cash discount
 all further costs to completion; and
 all costs to be incurred in marketing, selling and distributing the goods to the customer.
(iii) Cost of Purchase

It is the cost of acquiring the inventory, including any VAT or other duties payable in connection with
the inventory and not reclaimable by the business. Also included is the cost of having the inventory
delivered from supplier’s premises (carriage inwards) plus any further freight costs incurred in
moving the inventory to its present location.
(iv) Cost of Conversion

Conversion cost includes costs, which are specifically attributable to units of production, i.e., direct
labour, direct expenses and sub-contracted work, production overheads and other overheads, if
applicable.
QUESTION 7
Explain three reasons why a business cannot normally use the latest selling price of its products to value
the inventory. [6]
SOLUTION
Mark Scheme
 Inventory must be valued at the lower of cost (1) and net realisable value (1).
 The accounting concept of prudence (1) must be applied when valuing inventory.
 Prudence states that profits and asset values must not be overstated (1).
 The use of the selling price would overstate profit for the year (1) and the current asset/net asset
value of the business would be overstated (1). [6]
Suggested Solution
 As per IAS 2, inventory must be valued at the lower of cost and net realisable value.
 The use of the selling price (which is usually higher than cost) would not only overstate profit for
the year but also the current asset/net asset value of the business.
 The application of fundamental accounting concept of prudence concept requires that profits and
asset values must not be overstated.
QUESTION 8
There had been little control over the movement of inventory. Staff had valued the inventory actually in the
warehouse at the end of the year at $24 000 whereas as per financial statements it was $74 800.
Discuss three possible reasons for the difference between the warehouse inventory valuation and the
calculated value of inventory. [6]
SOLUTION
Mark Scheme
Reasons for closing inventory to be different than as per records:
 Inventory has been stolen / damaged (1) due to little control. (1)
 Inventory is obsolete (1) so has no value in reality but might in the inventory records. (1)
 Sales have been omitted in the records (1) i.e. Inventory has been sent out on consignment
or a sale or return basis so not yet sold. (1)
 Purchases of inventory have been recorded twice. (1) or not all inventory was counted. (1)
 Sales returns were amended in the records (1) but the purchases returns were not. (1)
1+1 mark for development
max 6 [6]
Suggested Solution
 Goods lost by theft/fire
 Goods sent on sale or return or on consignment and are with the customers so not part of physical
count.
 Sales of inventory were omitted from the books
 Mistakes in physical count
 Purchase returns was not accounted for
 Outdated or damaged inventory value was not reduced to its net realisable value.
CHAPTER 2.2 LABOUR COSTING

QUESTION 1
Define and explain Piece Work Wage System and Time Wage System (Pay on Time Basis) for calculation
of wages
SOLUTION
The labour cost may be calculated in the following ways.
Piece Work Wage System

Piecework is the oldest form of performance related pay. This is also called ‘payment by result’. Under this
system an employee is paid a uniform "piece rate" for each unit produced or service rendered irrespective
of how long it takes.
This wage system is best adapted to pay standardized operations in which quantity is preferred to quality
and where the output produced by employees can easily be counted or calculated.
Formula
The piece work system determines the employee’s wages by using the following formula.
Total Labour Cost = Number of Units Produced x Wage rate per Unit
Time Wage System (Pay on Time Basis)

This is the oldest system of calculating labour remuneration. This system calculates labour pay based on
the number of hours or days worked by employees, regardless of the volume of output they have produced.
However if hours in excess of the agreed amount are worked i.e. overtime hours, they may be paid at a
different and higher rate.
This system of wage payment is found in practice in those industries and for those jobs where output quality
is of prime importance e.g. artistic pieces or where the speed of production is beyond the control of the
employee as when the production is automatic. This system is very easy and simple to follow.
Formula
The time wage system determines the employee’s wages by using the following formula.
Total (Total Hours Worked × Basic (Overtime Hours Worked × Overtime

= x
Wages wage rate per hour) premium per hour)
QUESTION 2
Describe the advantages of using Piece Work Wage System for calculation of wages
SOLUTION
Advantages
The following are the notable advantages of piece work system
 It stimulates employees to produce more as remuneration is directly proportional to the production
volume.
 Under this method, the calculation of the wage cost becomes very easy due to constant per unit
cost. The constant per unit cost is very useful for planning and tendering purposes.
 The workers handle the production facilities in a very careful way to avoid any production stoppages
and breakdown in machines.
 Close monitoring and strict supervision is not very much needed as workers are themselves
interested in increasing production as this method correlates efforts and rewards.
 Under this method, meritorious workers are rewarded more for their better skills and performance.
On the other hand meager workers are panelized which induce them to improve their performance.
Disadvantages
The following are the important disadvantages of piece work system.
 The piece work system is unnecessarily competitive in which workers usually receive less than
they would under the time wage system.
 The system is usually opposed by the trade unions as this system creates greed and damaging
rivalries born out of jealousy among the workers.
 Inferior products are produced as quantity is stressed over quality. This raises the need of a rigid
system of inspection and quality control to maintain the quality standards.
 It forces the pace of work which may cause excessive wastage of materials, loss to production
facilities and may also ruin their own health.
 Under this system the workers may feel insecure as no minimum amount of wages is guaranteed.
QUESTION 3
Describe the advantages of using Time based wage system for calculation of wages
SOLUTION
Time based wage system offers the following advantages
 Time wage system is simple and easy to calculate wages as time spent on different tasks is very
easy to ascertain.
 Time wage system assures regular income and workers have a sense of economic security as
there is no link between wages and output i.e. wages are paid irrespective of output and the workers
are not supposed to complete a particular task for getting their wages.
 When workers are assured of wages on time basis then they pay full attention to improve the quality
of output as they are in no hurry in completing the task.
 As workers are in no hurry in completing the task, they will avoid over speeding and will properly
handle the equipment without wastage and damage of production facilities. This is more
advantageous for organizations that use costly inputs for quality outputs.
 Where the production is not standardized, the productivity of each worker cannot be measured
precisely in terms of units. In such circumstances, this system is the best system of wage payment.
 In most organisations the production is the joint efforts of all the members in the group. It is very
difficult to determine output separately for each worker as jobs are linked to one another. In such
case wages of the workers should be paid on time basis.
 This system promotes internal amity because labour unions recognise this system in the interest
of workers as it does not distinguish between workers on the basis of their performance.
 Time wage system is more suitable for the beginners, average and below average workers because
they may not be able to reach a particular level of production.
Disadvantages
The following are some of the important drawbacks of time wage system.
 This method does not correlate effort and reward. It fails to distinguish between efficient and
inefficient workers because the payment of wages is related to time and not output.
 Since wages are not related to output, workers may be producing at slower rate. If every worker is
paid at the same rate irrespective of output, the efficient workers are little motivated to produce at
a level higher than the average standard.
 This method encourages a slowdown tendency amongst employees at work and efficient workers
may also follow slow workers because there is no distinction between them. This may encourage
the workers to work overtime when production targets are not met.
 As wages are not related to output, organisations find it difficult in determining labour cost per unit.
The difficultly in estimating exact labour cost in advance makes it difficult to prepare quotations and
budgets to do planning.
 As under time wages system efficient workers are not given incentives to produce goods at a good
pace the responsibility mostly lies on greater and firm management to get the required output.
 Time wage system increases the total payroll cost for all contractual hours whether spent for
producing goods or for idle time.
QUESTION 4
Define overtime and state how overtime wages are calculated?
SOLUTION
When a business is not able to complete its work within normal or routine working hours then it may asks
it workers to work for extra hours. The work for these additional hours is called overtime for which wages
are paid at higher rates.
Overtime premium paid over and above the basic wage rate is treated as indirect labour cost. However, if
overtime is undertaken at the special request of a customer or to complete an order before normal routine
time, then it should be included in direct labour cost of that particular order.
(hours worked x basic rate (overtime hours worked x
Total wages = +
per hr) overtime premium per hr)
QUESTION 5
Define and explain any two bonus or incentive plans for calculation of wages
SOLUTION
Businesses often pay bonuses to their employees to enhance their efficiency and productivity. The
increased productivity helps the businesses to meet their production targets in lesser amount of time. As a
result, the businesses pay such workers’ wages at basic rate plus a portion of wages for the time saved.
Time saved may be calculated as agreed or allowed time for the work less actual time taken.
An effective bonus scheme also boosts employees’ morale as additional rewards are given for extra efforts.
However, despite of paying these bonuses, an effective bonus scheme results in reduced per unit cost and
higher per unit profit.
Different bonus schemes are used by different businesses out of which Halsey premium plan and Rowan
bonus plan are very popular. F. A Halsey, an American engineer suggested his plan in 1891 to fix a standard
time for each task and pay employees hourly wages for actual time worked plu a bonus equal to one half
of the time saved. Another bonus plan was developed by J. D. Rowan in 1901 which was quite similar to
Halsey plan except a different proportion of time is used in the calculation of bonus.
Time Allowed−Time Taken

Halsey plan = ( × Time Rate)
2
Time Taken
Rowan Plan = ( × Time Saved × Time Rate)
Time Allowed
QUESTION 6
One of the directors stated that new staff should have been employed. This would have resulted in fewer
overtime payments although extra training costs would have been incurred.
The director believed that 7 800 hours would have been worked at a cost of $10.80 per hour.
REQUIRED
Advise the directors whether or not they should have taken this action. Support your answer with
calculations where appropriate. [6]
MAY 2017 P32 Q5 (d)
SOLUTION
Mark Scheme
The suggestion appears sound (1) because the actual labour costs are higher (1) by $11 390 (2)* than
labour costs under the suggestion.
* ($95 630 (1)–$84 240 (1))=$11 390
But inexperienced staff might make more errors (1) leading to an increase in the adverse materials usage
variance. (1).
Although labour costs are saved there will be higher training costs (1) which will impact on
production/profit (1).
Decision (1) Justification (5)
Suggested Solution
The suggestion to hire new staff seems to be a profitable option because the actual labour costs of $95
630 are higher than the suggested labour costs of $84 240. However there are both advantages and
limitations of hiring new staff which are discussed below.
Advantages
 Passionate to work: New fresh staff will be much active and vigorous to work when compared to
the experienced employees.
 Optimists: The new staff with open mind will accept the assigned roles and responsibilities
because they do not have experience to urge for a particular role.
 High Productivity: The new staff will try to excel and will try to impress with their initial results.
This will improve the productivity of organization.
 Easy to manage: It is easy to manage new staff. They are bound to each policy designed by the
organization.
 Versatility: One cannot grow with same old way of techniques, there should be a change in
process. The new staff may lack experience but not lack of knowledge.
 Cost to company is low: The hiring of new staff will reduce labour cost. Few companies enforce
security deposit, in the event the employee does not complete the prohibition period, the total
training cost will be recovered from that amount.
Disadvantages:
 Lack of Stability: Many of the young employees join for a company and once they find any other
good opportunity they will switch to other companies. Since the effort and time invested in providing
benefits and training will be a huge loss for the employers
 Lack of skills: For some specific roles the organisations need experienced staff so that they can
handle the task in a professional manner. The new inexperienced staff may cause damage to the
company’s resources resulting in adverse efficiency variance.
 Discipline Issues: Not all, but most of them are unaware of work culture environment. They do
not turn up on time, they do not strictly follow the HR rules. Many of them try to take leaves more
than they are provided with. They may damage the work force environment due to lack of maturity
about work culture.
 Frustration: The new staff may lose patience and get frustrate when something went wrong. In
critical times, the older employees would manage it perfectly because of their experience in
particular field.
 Lack of experience: They do not have much awareness about business. Every situation is new to
them, they may have bookish knowledge but when coming to practical it needs experience. So the
burden automatically increases, since they have no idea of what consequences occur to the
organization.
 They find difficulty to accept feedback: There will be heap of instructions and guidelines for the
new employees. Most of them receive negative feedback, they find it difficult to accept it. This is
also one of the cons of hiring them.
CHAPTER 2.3 ABSORPTION COSTING

QUESTION 1
State what is meant by overhead costs. [2]
NOVEMBER 2016 P23 Q4 (f)
SOLUTION
Mark Scheme
 a cost incurred which cannot be traced directly (1) to a product, service or department (1)
 an indirect cost (1) (max 2)
Suggested Solution
Overhead costis an indirect cost which cannot be traced directly to a product, service or department
QUESTION 2
Explain the following terms in relation to overheads.
1 Allocation [2]
NOVEMBER 2014 P22 Q3
2 Apportionment [2]
3 Absorption [2]
OR
State what is meant by allocation. [1]
SOLUTION
Mark Scheme
1. Allocation – Directly attributable costs (1) are allocated to the relevant department. (1)
2. Apportionment – Costs that cannot be directly attributed to a department (1) are apportioned on
an equitable basis. (1)
3. Absorption – Total costs (1) that have been allocated and apportioned to a department are
absorbed into products on the basis of the product’s use of the overheads. (1) [6]
Suggested Solution
1. Allocation Allocation represents charging an overhead expensesdirectly to a cost unit or
cost centre when an indirect expense is incurred directly or specifically for a
that particular cost unit or cost centre.
2. Apportionment Indirect expenses which are incurred for the whole factory and cannot be
identified separately for different departments then these expenses are
apportioned (divided) among different departments on same fair and
reasonable base.
3. Absorption Total costs that have been allocated and apportioned to a department are
absorbed into products on the basis of the product’s use of the overheads.
QUESTION 3
Explain why overhead costs are re-apportioned from service cost centres. [2]
SOLUTION
Mark Scheme
So that each unit of production (1) contains a share of total overhead costs.(1) [2]
Suggested Solution
Overhead costs are re-apportioned (allotted) from service cost centresso that each unit of production
contains a share of total overhead costs.
QUESTION 4
Manufacturing businesses classify costs by function. State three functional groups of costs [3]
MAY 2014 P23 Q3 (f)
SOLUTION
Mark Scheme
 Manufacturing costs (1)
 Selling costs (1)
 Distribution costs (1)
 Administration costs (1)
 Finance charges and other costs (1)
1 mark for each functional group (max. 3) [3]
Suggested Solution
 Manufacturing costs
 Selling costs
 Distribution costs
 Administration costs
 Finance charges and other costs
QUESTION 5
Explain why estimated figures are used to calculate overhead absorption rates. [3]
MAY 2015 P22 Q3 (e)
SOLUTION
Mark Scheme
The total expected cost of production (1) must be known in advance (1) to enable selling prices to be
calculated (1) and to ensure that expected overhead costs are fully recovered (1). Actual figures are not
available (1).
[max 3]
Teacher's Solution
In order to determine selling price through cost plus pricing approach, businesses need to estimate and
include total cost of production in the selling price. As amount of actual overheads cannot be accurately
determined until the relevant period ends so businesses have to use estimated overheads. This also
ensures that expected overhead costs are fully recovered.
QUESTION 6
State two alternative methods the business could use to absorb their overheads. [2]
NOVEMBER 2010 P23 Q3 (d & e)
SOLUTION
Mark Scheme
 Single factory rate
 Machine hour rate
 Unit cost
 % prime cost
 % direct labour cost
 % direct material cost
 Activity based costing
(2 x 1 mark) [2]
Suggested Solution
Estimated FOH
1) Direct Material Cost base = × 100
Estimated material cost
Estimated FOH
2) Direct Labour cost base = × 100
Estimated labour cost
Estimated FOH
3) Prime cost base = × 100
Estimated prime cost
Estimated FOH
4) Units of Production base =
Estimated units of output
Estimated FOH
5) Machine hours base =
Estimated machine hours
Estimated FOH
6) Direct labour hours base =
Estimated direct labour hours
QUESTION 7
State one advantage and one disadvantage to Chester Limited of using a single overhead absorption rate.
[4]
MAY 2014 P23 Q3 (a)
OR
The directors are considering changing from departmental overhead absorption rates to one factory-wide
rate. Advise the directors whether or not they should make this change. Justify your answer. [4]
MAY 2016 P22 Q4 (c)
SOLUTION
Mark Scheme
Advantage
 Easier and cheaper to calculate (1)
 Avoid the necessity to allocate and apportion costs into departments. (1)
Disadvantage
 Less accurate as some products may require more labour hour / machine hours in each
department.
 Where different products spend differing amounts of time in departments (1) there is a danger that
product costs will be under or overstated. (1)
[4]
Suggested Solution
This rate is used for the whole factory and is assigned to all cost units irrespective of the departments in
which they were produced
Advantage: Easier and time saving to calculate as it does not require allocating and
apportioning costs to different cost centers or departments.
Disadvantage: Where business produces different products which spend differing amounts of time
in departments there is a danger that product costs will be under or overstated.
QUESTION 8
Assembly department absorbs overheads on the basis of direct labour hours whereas Finishing department
uses machine hours’ base for absorbing overheads
Give reasons for the two different methods used [2]
NOVEMBER 2003 P2 Q3
OR
State the reason for using different methods of calculating the overhead recovery rate. [2]
NOVEMBER 2007 P2 Q3
SOLUTION
Mark Scheme
Assembly department is labour intensive (1)
Finishing department is capital intensive (accept machine intensive) (1) Marks [2]
Teacher's Solution
Assembly department is labour intensive
Finishing department is capital intensive (2)
QUESTION 9
Explain why Mandar Ltd absorbs its overheads using direct labour hours. [5]
NOVEMBER 2010 P23Q3(d)
SOLUTION
Mark Scheme
 Overheads tend to be related to time.
 The company may be labour intensive
 Using a departmental labour rate is appropriate if different grades of labour are used in each
department.
(2 × 2 marks – 1 for point and 1 for development / 1 further mark for evaluation point) [5]
Suggested Solution
As Assembly department is based on labour intensive operations so direct wages base (related to labour)
is more appropriate. Moreover, it is better to absorb overheads in relation to time rather than cost. This
becomes more important if different grades of labour are used in different department.
QUESTION 10
Explain what is meant by the under and over-absorption of overheads. [4]
MAY 2010 P43 Q3 (c)
OR
Explain how the under absorption of overheads in Machining department and over absorption of overheads
in Assembly department could have occurred. [4]
MAY 2012 P22 Q3 (d)
OR
Explain what is meant by over and under absorption of overheads and how each will arise. [4]
OR
Explain the reason for the over or under absorption of overheads calculated for each production department
in part (c). [2]
OR
State two reasons for the under absorption or over absorption of overheads, calculated in part (c), for each
department [4]
MAY 2015 P22 Q3 (d)
OR
Explain the meaning of Overhead over absorption and overhead under absorption [6]
SOLUTION
Mark Scheme
Over-absorption of overheads:
 Over absorption of overheads means that the absorbed overheads were more than the actual
overhead expenditure incurred. (1)
 More hours are actually worked than forecast
Under-absorption of overheads:
 the amount of overheads absorbed into production was less than the amount of actual overheads
incurred. (1)
 the number of direct labour hours worked was less than estimated.
Suggested Solution
Over-absorption of overheads shows the actual overheads were more than the absorbed overheads
resulting in increase in overall costs. This could be due to overspending or due to over estimation of hours
by the concerned department.
Under-absorption of overheads shows that the actual overheads were less than the absorbed overheads
resulting in reduction in overall costs. This could be due to better control on expenses or due to under
estimation of labour hours by assembly department.
QUESTION 11
Explain how over absorption and under absorption of overheads can affect the profit of a manufacturing
business. [6]
MAY 2016 P22 Q3 (d)
SOLUTION
Mark Scheme
Over absorption of overheads
It will mean that too much overhead is charged to the product (1). This means that a higher price is charged
to the customer (1) leading to increased profits (1).
Or
Over absorption of overheads could also lead to a higher selling price (1) leading to lower demand (1) and
lower profits (1).
Under absorption of overheads
It could lead to insufficient overhead being charged to a product (1). This means a lower price is charged
to the customer (1) which fails to cover costs and reduces profit (1).
Or
Under absorption of overheads could also lead to a lower selling price (1) leading to higher demand (1) and
higher profits (1). [6]
Overall Max 3 [3]
Suggested Solution
If overheads are over absorbed, this means that fewer actual overhead costs were incurred than expected,
so that more cost is applied to cost objects than were actually incurred. This means that the recognition of
expense is reduced in the current period, which increases profits.
If overheads are under absorbed, this means that more actual overhead costs were incurred than expected,
with the difference being charged to expense as incurred. This usually means that the recognition of
expense is accelerated into the current period, so that the amount of profit recognized declines.
QUESTION 12
Explain the problems associated with using predetermined overhead absorption rates in calculating the
price of a product. [6]
MAY 2012 P22 Q3 (e)
OR
Discuss the problems associated with using predetermined overhead absorption rates. [2]
MAY 2012 P23 Q3 (e)
SOLUTION
Mark Scheme
Use of estimated data which could be inaccurate, leading to under/over absorption
Over–absorption, too much overhead charged to production, overpriced and uncompetitive, fall in demand
and subsequent loss of revenue/reduction in profit.
Under–absorption, insufficient overhead charged to production, lower price to customer, costs not covered
and subsequent reduction in profits.
(2 × 3 mark) [6]
Suggested Solution
The use of predetermined overhead absorption rate can cause particular problems where there is a fixed
cost, because the volume of activity for the period ahead has to be estimated as well as the amount of
overheads. As a result there could be over or under absorption of over absorption of overheads. The use
of predetermined overhead absorption rate may also result in over or underpricing of products and affecting
profits of the business.
QUESTION 13
State the effect on profits if the factory does not operate at full capacity. [4]
May 2012 P23 Q3 (e)
SOLUTION
Mark Scheme
If the factory actual activity is less than the budgeted activity it faces under absorption of overhead. Not
enough overhead is charged to each unit of production – this may affect pricing decisions which may
influence profitability.
If the factory actual activity is higher than the budgeted activity it faces over absorption of overhead – too
much overhead may be charged – this may affect pricing decisions which may influence demand and
revenue for the product.
1 mark each for mention of under or over absorption.
2 marks each to a max of 4 for any other valid comment. [4]
Teacher's Solution
Factory overheads will be under recovered (Under absorbed) if the actual activity level of factory is less
than the budgeted activity. This under recovery of overheads may influence profitability as products would
be underpriced.
Factory overheads will be over recovered (over absorbed) if the actual activity level of factory is more than
the budgeted activity. This over recovery of overheads may demand and revenue for the product as
products would be overpriced.
QUESTION 14
Anna has a manufacturing business with two production departments and two service departments. She
makes circuit boards for electronic games using batch costing.
REQUIRED
Explain what is meant by ‘batch costing’. [2]
SOLUTION
Mark Scheme
Method of costing that you apply to the production of a number of identical items. (1) The cost per unit is
found by dividing the total batch cost by the number of units in the batch. (1) [2]
Suggested Solution
Batch costing is a form of specific order costing. It is applied when a group of like units are produced in
batches. Costs are ascertained for the whole batch and then per unit cost is determined by dividing the total
batch cost by the number of units in the batch.
QUESTION 15
State and explain the terms ‘cost centre’ and ‘cost unit’ as used in absorption costing.
SOLUTION
Cost Center
This is a production or service location, function, activity or item of equipment in relation to which costs are
ascertained. Cost center may include a single expensive machine, a group of these machines and may be
extended to individual departments or even the whole factory may be treated as cost center in some cases.
As in cost centers the head of that segment (center) being held accountable for expenses, they are
established in large organizations to identify responsibility and to control costs.
There are two types of cost Center:
(i) Production Cost Centers

Production cost centers are the cost centers directly involved in production activities. Examples
include moulding, machining, assembly shaping, welding, binding and cutting etc.
(ii) Service Cost Centers

Service Cost Centers are those cost centers which are incidental to the production process,
although necessary for it to take place. Examples are canteen, personnel, stores, boiler house and
maintenance etc.
Notice that the service cost centers are incidental to production in the sense that the products or
cost units are not produced by them. Service cost centers are, however, often just as important and
necessary to the carrying out of production as the production cost centers are.
Any costs which are incurred or charged to service cost centers must be apportioned subsequently
to production cost centers which is then incorporated in the cost of the product produced.
Cost unit
We cannot have costs unless there are things to be costed. Cost unit is a unit of production (or a unit of
service provided) which absorbs the cost center’s overhead costs.
Often the cost units are the final products which are manufactured by the organization, e.g. vehicle for
vehicle manufacture, operation in a hospital is a cost unit i.e. the cost per operation is calculated
The cost unit is not necessarily restricted to the final product of the organization, however. If the final cost
unit is either big or complex the costing system may be organized so that the costing of intermediate parts
or sub-assemblies may take place. In these cases, each part which is costed may be treated as a cost unit.
Where small units of output are produced, it is usual to combine the output into batches so that the cost
unit does not have a cost which is so small as to be immeasurable. Examples include thousands of pens
may be a cost unit for a pen manufacture company and tonnes of newspapers for newspaper publishers.
QUESTION 16
State and explain different costing systems.
SOLUTION
Costing Systems/Methods
As there are various costing systems are available so organizations should choose a costing system or
method keeping in mind the nature of their business. There are two broad categories of product costing
methods.
(i) Specific order costing

This applies to businesses where work consists of separate jobs, batches or contracts (contract costing
is not part of Cambridge A level syllabus). As the jobs or contracts are significantly different from each
other so each job, batch or contract are taken as cost units. So cost unit may be a single unit or may
comprise of a batch of say 100 units (in case of batch costing). Operations under specific order costing
are undertaken to comply with the specific instructions and orders of customers.
(ii) Continuous costing

Continuous costing sometimes known as unit costing is used for businesses where a product or service
results from a sequence of continuous or repetitive operations or processes. Continuous costing
comprises of service/function and process costing (not part of Cambridge AS level syllabus)
In continuous costing management decides in advance about the quantity, size, colour, shape and
quality of goods produced without identifying the customers who would buy the goods.
Note
The general fundamental principles of cost ascertainment are the same in every system of cost accounting,
but the methods of collecting and presenting the costs may vary with the type of product manufactured or
services offered by organizations.
QUESTION 17
State and explain Job order costing, Batch order costing and unit costing
SOLUTION
Job costing
Job order costing is used by organizations which manufacture products or render services against specific
instructions to ascertain costs. The work is usually carried out in company’s workshop or factory in such a
way that the continuously identifiable unit moves through the production process and on which clearly
defined tasks are performed to the order of customers.
As each job has a unique nature so it becomes essential to analyze and segregate costs for each job or
order separately.
In a job-order costing system, direct materials costs and direct labor costs are usually "traced" directly to
jobs. Overhead is applied to jobs using a predetermined rate. Actual overhead costs are not "traced" to
jobs.
Typical examples of job order costing include
(i) Designers and builders -“requires different specification”
(ii) Accounting and law firms -“requirements differ significantly”
(iii) Vehicle repair shops- “each repair requires different parts replacement and labour hours”
Features
There are certain unique features of job order costing which are as follows.
(i) It is possible to physically identify each job separately.
(ii) Each job is of relatively short duration.
(iii) The production is always against customers' orders and not for inventories.
(iv) Each job has unique features and needs special treatment.
(v) There is no uniformity in the flow of production from department to department.
(vi) Each job is assigned a separate number.
(vii) A separate job cost card or job cost sheet is maintained to identify expenses incurred on
each job.
(viii) Each job requires careful routing and scheduling as there is normally no pre-determined flow
line for the work to follow.
(ix) it is suitable in a production environment where each new order is different from the earlier
or succeeding order.
Batch costing
A batch is a cost unit which consists of a group of identical items which maintains its identity throughout the
all stages of production. Batch costing, a variant of job costing, is used when the production consists of
limited repetition work and a definite sizeable number of units are produced in one batch and kept in
inventories for sales. Batch costing normally arises in situations where most of the cost for each batch is
fixed (for example, the cost for setting up machinery to produce a batch of goods is independent of batch
size) and is much larger than the unit variable cost of each article. In these circumstances, the average cost
per unit falls dramatically as the batch size increases. Where batch costing is used, the fixed and variable
elements of cost are normally identified and reported separately.
Typical examples of industries using batch order costing include garments manufacturer, shoe
manufacturer, spare parts and components manufacturers etc.
The costing procedure in batch order costing is similar to that followed for job order costing. Each batch is
assigned a number and separate costs are maintained for each batch. However in this case instead of a
job, batch constitutes the cost unit for which costs are compiled.
Unit Costing
It is used by manufacturing concerns engaged in production of exclusively one product or a few grades of
the same product e.g. in industries such as cement, paper, bricks work, steel etc. It is also known as single
costing. Businesses listed above use continuous costing to determine the cost of production of a single unit
of product or service. As mentioned earlier may be one single item or may be a large number of items are
regarded as one unit.
CHAPTER 2.4 MARGINAL & ABSORPTION COSTING

QUESTION 1
Explain why the profit found when using absorption costing differs from the profit found in marginal costing.
[4]
OR
Explain why profit calculated using marginal costing would be different to that calculated using absorption
costing. [4]
MAY 2013 P22 Q3 (f)
OR
Explain why the absorption costing statement produces a different profit figure to the marginal costing
statement. [4]
OR
Explain why there is a difference in the marginal costing profit with the absorption costing profit.
[4]
MAY 2015 P23 Q3 (f)
SOLUTION
Mark Scheme
 Absorption costing will produce a different profit figure to marginal costing whenever opening and
closing inventory differ. (1)
 Absorption costing values inventory at total production cost including a portion of fixed costs. (1)
 Marginal costing values inventory at variable cost only, treating fixed costs as period costs. (1)
 When closing inventory is higher than opening inventory, absorption costing will produce the higher
profit. (1) When closing inventory is lower than opening inventory, marginal costing will produce the
higher profit. (1) (Max 4) [4]
 Fixed overheads are treated as a period cost under marginal costing (1) but as part of the cost of
production under absorption costing (1). As a result, the fixed overheads are written off in
the period’s income statement (1) rather than being carried forward as part of the inventory as is
the case in absorption costing (1). [4]
Suggested Solution
The difference between profits calculated in marginal and absorption costing is purely a result of timing of
the matching of fixed overheads with products.
In marginal costing fixed costs are charged in full against the profit in which they are incurred (period costs)
while in absorption costing, as inventories are valued at full production costs (fixed + variable). So cost of
sales in a period will include same fixed overheads incurred in a previous period (i.e. in opening inventory
values) and will exclude some fixed overheads incurred in the current period but carried forward in closing
inventory values as a charge to the subsequent periods (product costs).
Lastly the overall effect of the positive and negative differences in profits over the business life is zero,
provided the allocation process is applied consistently. Finally, it may be said that when inventory levels are
decreasing profit under absorption costing is lower and vice-e-versa for the contrary.
QUESTION 2
Explain the reason why valuing inventory on a marginal cost basis produces a different profit figure than
valuing it on an absorption cost basis. [4]
MAY 2014 P22 Q3 (f)
SOLUTION
Mark Scheme
In the marginal cost statement, inventory is valued at variable cost (1) resulting in a higher cost of sales
(1) and fixed costs are treated as a period cost (1).
In the absorption cost statement, the inventory value includes an element of fixed overhead (1) resulting
in a lower cost of sales (1). Some of the fixed overheads are carried forward to the next accounting period
(1).
(Maximum 4 marks) [4]
Suggested Solution
In the marginal cost statement, inventories are valued at variable cost. If closing inventory is more than
the opening inventory then it results in a higher cost of sales compared to absorption costing. In this case
fixed costs are treated as a period cost.
In the absorption cost statement, an element of fixed overhead is included in the value of inventories. If
closing inventory is more than the opening inventory then it results in a lower cost of sales compared to
marginal costing. In this way, some of the fixed overheads are carried forward to the next accounting period
through inventories.
QUESTION 3
Rajesh has been advised to change from absorption costing to a marginal costing system.
REQUIRED
Advise Rajesh whether or not he should change. Justify your answer. [5]
NOVEMBER 2016 P23 Q4 (h)
SOLUTION
Mark Scheme
Reasons to change to marginal costing:
 simple and quick to operate
 no apportionment of fixed costs
 fixed costs are treated as period costs and so remain unchanged at different activity levels
 no over/under absorption of overhead costs to calculate
 no further adjustment needed in the income statement for over/under absorption
 closing inventory is realistically valued at variable production cost
 allows easy calculation of profit when changes in activity occur
 great aid in decision making/pricing/make or buy situation. (max 2)
Reasons to keep absorption costing:

 it shares fixed production costs to units of production, which is fair as these costs are incurred in
order to make the output
 it is easier to determine profitability of several products as they include a share of fixed overheads.
 it values closing inventory fairly (max 2)
[5]
Teacher's Solution
Reasons to change to marginal costing:
 Simplicity: simple to understand and operate and it can be combined with other forms of costing
(e.g. budgetary costing and standard costing) without much difficulty.
 Customer profitability: Marginal costing can help determine which customers are worth keeping
and which are worth eliminating.no apportionment of fixed costs
 Internal inventory reporting: Since a firm must include indirect costs in its inventory in external
reports, and these can take a long time to complete, marginal costing is useful for internal inventory
reporting.
 Outsourcing: Marginal costing is useful for deciding whether to manufacture an item in-house or
maintain a capability in-house, or whether to outsource it.
 Short-term profit planning: Marginal costing can help in short-term profit planning and is easily
demonstrated with break-even charts and profit graphs. Comparative profitability can be easily
assessed and brought to the notice of the management for decision-making.
 Cost control: Marginal costing makes it easier to determine and control costs of production. By
avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on
achieving and maintaining a uniform and consistent marginal cost as fixed costs are treated as
period costs and remain unchanged at different activity levels
 No over/under absorption : In marginal costing there is no need to calculate over/under

absorption and no further adjustment needed in the income statement for over/under absorption
 Accurate overhead recovery rate: This method of costing eliminates large balances left in
overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.
Reasons to keep absorption costing:

 Fixed overhead costs are included in production costs, which is fair as these costs are incurred in
order to make the output
 It is easier to determine profitability of several products as they include a share of fixed overheads.
 it values closing inventory fairly
 it is used to prepare financial accounts
 It shows less fluctuation in in net profit as variation in sales occur while the production stays the
same
 This method is accepted by Inland Revenue and international accounting standards as inventory
is not undervalued;
 Higher income when production is above sale
QUESTION 4
Differentiate between Marginal & Absorption Costing
SOLUTION
Difference between Marginal & Absorption Costing
 In marginal costing inventories are valued at variable production cost whereas in absorption costing
inventories are valued at total cost of production.
 In marginal costing fixed costs are charged in full against the profit in which they are incurred (period
costs) while in absorption costing, as inventories are valued at full production costs (fixed +
variable). So cost of sales in a period will include same fixed overheads incurred in a previous
period (i.e. in opening inventory values) and will exclude some fixed overheads incurred in the
current period but carried forward in closing inventory values as a charge to the subsequent periods
(product costs).
 Marginal costing is often used in decision making situations whereas absorption costing is used for
external reporting.
 Absorption costing can be used for inventory valuation under SSAP 9 whereas marginal costing
cannot be.
CHAPTER 2.5 BREAK-EVEN & PROFIT VOLUME ANALYSIS

QUESTION 1
Explain the term contribution. [2]
NOVEMBER 1996 P2 Q2B (I)
SOLUTION:
Contribution shows how much income is being earned to help pay for the organisations’ (or products’) fixed
costs and profit.
This is calculated as: Contribution = Sales – Variable Costs
QUESTION 2
State the meaning of C / S ratio. [1]
MAY 2017 P21 Q4 (c)
SOLUTION
Mark Scheme
It shows how much contribution is earned from each $1 of sales revenue (1)
Suggested Solution
It represents contribution to sales ratio. It is the percentage of sales, service revenues or selling price that
remains after all variable costs and variable expenses have been covered. In other words, the contribution
margin ratio is the percentage of revenues that is available to cover a company's fixed costs and profit.
QUESTION 3
Break-even analysis has been described as a useful tool for the accountant.
REQUIRED
Define the break-even point. [2]
MAY 2010 P22 Q3 [a (i)]
OR
State what is meant by break-even point. [1]
MAY 2016 P21 Q4 (a)
SOLUTION
Mark Scheme
The answer may be any one of the following:
 the point at which a product makes neither a profit or a loss
 total costs equal total revenue
 total contribution equals fixed costs.
Max 1 mark [1]
Suggested Solution
It shows the output level (units produced or services rendered) at which total revenues just equals to total
costs or point at which profit or loss is zero.
QUESTION 4
Define and explain margin of safety. [4]
OR
Define the margin of safety. [2]
MAY 2010 P22 Q3 [a (i)]
OR
Explain the significance of this difference to a business. [2]
MAY 2017 P21 Q4 (d)
OR
(d) Define the term ‘margin of safety’. [2]
(e) Explain the usefulness of margin of safety to a company. [4]
NOVEMBER 2017 P23 Q4 (d & e)
SOLUTION
Mark Scheme
Definition
 Margin of safety is the distance between break-even point and expected level of activity. 2
 It shows the amount by which actual can fall short of expected it is a measure of risk. 2
 It can be expressed in units or as a percentage of sales (1).
Usefulness
Margin of safety provides an assessment of risk (1) by indicating the extent to which expected
output can fall (1) before a loss is made (1). It shows the ability to withstand adverse trading
conditions (1).
Suggested Solution
Definition
Margin of safety is the difference in units (value) between the budgeted (actual) sales and the breakeven
sales and it is sometimes expressed as a % of the budgeted (actual) sales volume (revenue).
Usefulness
This informs management of the risk of loss to which a business is subjected by changes in sales
volume.
A high margin of safety indicates the soundness of business i.e., the break-even point is much
below the actual sales so that even if there is a fall in sales, there will still be a profit. A small
margin, on the other hand, indicates a not-too-sound position.
Margin of safety is also of immense use in making inter-firm comparisons.
QUESTION 5
State three fixed costs a business typically incurs. [3]
SOLUTION
Mark Scheme
 Depreciation
 Admin costs
 Rent
 Insurance
 Advertising/marketing
 Rates
 Indirect wages
 Loan interest
 Or other suitable alternative.
(Any three examples – 1 mark each) [3]
Suggested Solution
Common examples of fixed costs include rents, salaries of permanent employees, insurance and
depreciation.
QUESTION 6
Explain what is meant by the term 'stepped costs'. [2]
SOLUTION
Mark Scheme
Stepped costs occur when a business increases capacity. As a result of expansion overheads such as
insurance, rent and rates and bank interest payments are likely to increase. On a break even chart these
increases would result in a horizontal fixed cost line moving to a higher level beyond the output at which
increased capacity occurs.
(2 × 1 mark) [2]
Suggested Solution
Step cost is a cost that does not change steadily, but rather at discrete points. In other words it increases
to a new level in step with the significant changes in activity or usage. For example, supervision costs are
fixed for a given range of production volume, but increased production often requires additional work shifts
leading to added supervisory costs in a lump-sum fashion.
QUESTION 7
State four assumptions, which are made using break-even charts
MAY 1998 P2 Q2 (e)
OR
State four assumptions made when using break-even charts. [4]
OR
State four assumptions made when using break-even analysis. [4]
MAY 2010 P23 Q3 (e)
OR
State three assumptions the accountant must make when preparing a break-even chart. [3]
SOLUTION
Mark Scheme
 All variable costs per unit remain constant.
 Fixed costs do not change within the relevant range.
 Deals with only a single product or a constant sales mix.
 Total costs and total revenue are linear.
 Costs can be accurately classified into fixed or variable.
 Chart applies to the relevant range only.
 Chart covers only the short-term.
 All units produced are sold i.e. there is no inventory.
 It assumes that the selling price is constant at all levels of output.
(1 per assumption) Max 3 [3]
Suggested Solution
 Every unit produced is sold.
 Business sells all its products at constant selling price.
 Costs can be classified as variable and fixed and there is no semi variable costs
 Variable cost per unit remains the same.
 Fixed costs in total remain unchanged.
 Business produces only one type of product.
 Sales mix remains constant.
QUESTION 8
State four assumptions, which are made using break-even charts. State one limitation of each assumption
MAY 1998 P2 Q2 (e)
OR
State two limitations of break-even analysis [2]
OR
Sate two assumptions, which may be made when using break-even analysis, and state one limitation of
each assumption. Your answer should take the form of the example given below. [4]
OR
State three limitations of a break-even analysis. [3]
MAY 2017 P21 Q4 (f)
OR
State two limitations of break-even analysis. [4]
SOLUTION
Mark Scheme
Assumption Limitation
FC remains fixed Rent etc may increase
VC always in same proportion to sales Economies of scale may occur
SP is constant Competition may force lower prices
Sales mix does not change Demand forces changes
B/E based on one product Few produce only one product
Cost mix constant Labour intensive becomes capital intensive
Costs either fixed or variable Some are semi-variable
Technology/efficiency does not change Firms constantly aim to improve
No outside influences We live in a real world
Etc
Limitations must follow on from assumptions Any two pairs for(4)
Suggested Solution
(i) Fixed cost is assumed to be constant at different levels of activity, however fixed costs tend to
increase in steps with change in activity level.
(ii) Per unit variable cost is supposed as constant whereas each unit produced or sold may not
necessarily incur same variable cost.
(iii) Another assumption is to take sales price per unit constant whereas in order to increase sales
volume, it may be necessary to give extra discounts or reduce the selling price.
(iv) Break-even analysis assumes that all units are sold whereas in actual practice many units
may remain be unsold.
(v) It is based on the assumption of trading of one product only whereas there are many
organisations, which produce or sell more than one product.
QUESTION 9
State two benefits of break-even analysis. [4]
SOLUTION
Mark Scheme
 Calculate the break-even point
 Helps with short term decision making
 Easy to understand
 Less complicated than absorption costing
 Quick method of calculating to show impact of decision on profits
2 marks each for benefits
Accept other valid answers
Suggested Solution
 break-even charts and graphs are easy to view, comprehend and interpret.
 helps the management the decision making process.
 can be used to show the level of profit at a given level of output, and to set targets for achieving
profits.
 the margin of safety can be established.
 may be used to consider the consequences of changes for a particular product.
CHAPTER 2.6 MARGINAL COSTING DECISION MAKING

QUESTION 1
State three situations where marginal costing would help in making a short term decision [3]
OR
State three further reasons why a business might use a marginal costing system [6]
OR
State three short-term decisions, other than limiting factor decisions, where marginal costing would be
useful. [3]
MAY 2017 P23 Q4 (f)
SOLUTION
Mark Scheme
Situations where marginal costing is useful:
 Making decisions on allocation (1) of scarce/limited resources (1)
 Accept orders below normal selling price (1) if spare capacity (1)
 Determine the selling prices (1) of entering into a new market (1)
 The use of sensitivity analysis (1) if there is a change in output/cost structure (1)
 Accept or reject orders (1) below normal selling price (1)
 Whether to close down a department/discontinue a product (1) positive/negative contribution (1)
 To ascertain the additional overhead (1) in producing one extra unit (1)
 To ascertain the required turnover (1) to achieve a target profit (1)
Max 3 marks [3]
Suggested Solution
 Cost control: Marginal costing makes it easier to determine and control costs of production. By
avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on
achieving and maintaining a uniform and consistent marginal cost.
 Simplicity: Marginal costing is simple to understand and operate and it can be combined with other
forms of costing (e.g. budgetary costing and standard costing) without much difficulty.
 Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of
production in marginal costing, units have a standard cost.
 Short-term profit planning: Marginal costing can help in short-term profit planning and is easily
demonstrated with break-even charts and profit graphs. Comparative profitability can be easily
assessed and brought to the notice of the management for decision-making.
 Accurate overhead recovery rate: This method of costing eliminates large balances left in
overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.
 Maximum return to the business: With marginal costing, the effects of alternative sales or
production policies are more readily appreciated and assessed, ensuring that the decisions taken
will yield the maximum return to the business.
 Helps to determine the most profitable product mix when business has limited resources.
 Helps to accept or reject orders below normal selling price if spare capacity available.
 Acceptance or rejection of orders below normal selling price.
 Helps inn decision to continue or close down a department loss making department.
 Helps in make or buy decisions
 Helps to determine break-even point
 Helps to determine margin of safety
 Ascertains the required turnover to achieve a target profit.
QUESTION 2
Evaluate the limitations of marginal costing. [4]
SOLUTION
Mark Scheme
Marginal costing should only be used for short term decision making (1)
However, it is necessary to split all costs into fixed and variable (1) which may be difficult (1) Difficult to use
if more than one product is sold (1) as it is difficult to split fixed overheads over several products (1)
Max 4 marks [4]
Suggested Solution
 Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since
all costs are variable in the long run. Hence such classification sometimes may give misleading
results. Furthermore, in a firm with many different kinds of products, marginal costing can prove
less useful.
 Accurately representing profits: Since the closing inventory consists only of variable costs and
ignores fixed costs (which could be considerable), this gives a distorted picture of profits to
shareholders.
 Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed, leading to
distortions.
 Recovery of overheads: With marginal costing, there is often the problem of under or over-
recovery of overheads, since variable costs are apportioned on an estimated basis and not on
actual value.
 External reporting: Marginal costing cannot be used in external reports, which must have a
complete view of all indirect and overhead costs.
 Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate
picture in the presence of increasing costs or increasing production.
QUESTION 3
Discuss the suggestion that Direct Labour might be classified as a Fixed Cost. [2]
NOVEMBER 2000 P2 Q4
SOLUTION
Mark Scheme
(i) Direct labour is usually regarded as being a variable cost in labour intensive work. In highly
automated industries it may be regarded as a fixed cost.
(ii) For control purposes, direct labour is regarded as a variable cost so that standard of efficiency or
production can be maintained, however labour turnover rate may increase as a result. So a trade-
off between the two should be made.
QUESTION 4
The directors of Sparkle have discovered that $7 500 fixed production overhead was incorrectly analysed
as direct materials.
REQUIRED
Explain the effect that this error will have on contribution and profit when using marginal
costing. [4]
[4]
MAY 2014 P22 Q3 (g)
SOLUTION
Mark Scheme
The marginal cost of producing one unit of Esprit will reduce (1) resulting in an increase in contribution (1).
The profit for the year will stay the same (1) because fixed production overheads will increase (1). [4]
Suggested Solution
Due to treatment of fixed factory overheads as direct material cost, the marginal cost of producing one unit
of Esprit will increase resulting in decrease in contribution. However, the profit for the year will remain the
same because fixed production overheads will decrease.
QUESTION 5
Zumbi Limited manufactures three products, Ess, Tee and Ewe. Zumbi Limited has the opportunity to
purchase unlimited quantities of product Ewe from an outside supplier at a cost of $30per unit.
REQUIRED
Discuss the advantages and disadvantages to the company if it purchases Ewes from the outside supplier.
[6]
SOLUTION
Mark Scheme
Advantages
 Enables Zumbi to meet maximum demand for Ewe. (1)
 Enables Zumbi to meet maximum demand for Ess. (1)
 Zumbi may be able to use the space saved to make another profitable product. (1)
Disadvantages
 Quality of product may not be as good as own (1)
 Supplier may not be reliable (1)
 May not be able to save all the costs (1)
 Fixed costs will now be shared among less products (1)
[Max 6]
Suggested Solution
Advantages
 Enables Zumbi to use the spare capacity to meet maximum demand for Ewe.
 Enables Zumbi to use the spare capacity to meet maximum demand for Ess.
 Zumbi may be able to find an alternative use for resources made idle by a decision to
purchase from outside supplier.
Disadvantages
 Quality and reliability of goods to be bought may not be as good as own
 Supplier may not be reliable on deliveries
 Possible high costs of closing down the productions line (process)
 May not be able to save all the costs
 Fixed costs will now be shared among less products
QUESTION 6
ABG Ltd has received an enquiry for an additional order of 3 000 units of Gamma at a special reduced price
of $50 per unit. Identify three factors which ABG Ltd should consider when deciding whether to accept this
additional order for Gamma. [6]
OR
Sally considered the quoted price and has asked for a discount of 5%.
REQUIRED
Advise Anna whether or not she should allow Sally the discount. Justify your answer. [5]
OR
Advise the directors whether or not they should accept the new contract with Bart and increase the selling
price. Justify your answer by explaining two benefits and two limitations. [7]
OR
Additional information
In February 2017, Ted was approached by an existing customer for an extra order of 5000 units.
The budgeted production for 2017 was already set at the maximum production capacity. Ted considered
whether or not to source the extra 5000 units from an external supplier at a cost of $28 per unit.
REQUIRED
Advise Ted whether or not he should have accepted the extra order. Justify your answer. [4]
SOLUTION
Mark scheme
 Customers paying full price will be annoyed to discover others paying less.
 Other customers may also start demanding discount which would reduce overall profit.
 Possible business will be taken elsewhere.
 Reaction of competitors needs consideration – price wars.
 Will acceptance of the offer take up capacity that could be better used for future full price business?
 An over reliance on special orders is not a long term solution and the company should put priority
on achieving full price orders.
 Less reliant on only one customer
 The order will help ensure the workforce is kept busy.
 May lead to further orders from Sally.
3 x 2 marks [6]
SUGGESTED SOLUTION
Reasons for proceeding
 Additional profit of $13 520 will be earned
 Better utilisation of spare capacity
 Increase in customer base
 Negligible effect on fixed costs
Reason for not proceeding
 Reaction of competitors needs consideration – price wars.
 An over reliance on special orders is not a long term solution and the company should put priority
on achieving full price orders.
 Customers paying full price will be annoyed to discover others paying less.
Questions to be answered
 will the acceptance of one order at a lower price lead other customers to demand lower price as
well
 is this special order the most appropriate way to use the spare capacity
 will the special order lock-up capacity which could be used for future full price business
 is it absolutely certain that fixed costs will not change
 the degree of risk of following price cutting approach by the competitors.
QUESTION 7
Angelicus and co. manufactures three different qualities of lock, Domestic, Commercial and Industrial. The
company’s results for the year ended 31 March 2003 were as follows.
Domestic Commercial Industrial Total
Sales (units) 120 000 45 000 56 250 221 250
$000 $000 $000 $000
Sales (total value) 240 180 450 870
Total costs
Direct material 108 66 84 258
Direct labour 60 30 150 240
Variable overheads 24 54 120 198
Fixed overheads 54 33 42 129
246 183 396 825
Profit (Loss) (6) (3) 54 45
REQUIRED
Advise whether Angelicus should cease production of Domestic and Commercial locks. Give your reasons.
[6]
MAY 2003 P2 Q3(c)
OR
It had been proposed that the three-drawer cabinet be discontinued, as it was making a loss. State whether
this proposal should have been agreed, giving your reasons [5]
MAY 2006 P2Q3(a)
OR
The table at the beginning of the question shows that both the Household and the Business models
appear to be making a loss. Explain why Fernando should not cease production of these two types of
refrigerator. [6]
MAY 2007 P2Q3 (c)
OR
Advise Anna whether or not she should close this factory giving both financial and non-financial reasons
for your answer. [4]
SOLUTION
Mark Scheme
Non-financial reasons
If Anna doesn’t fulfil the existing orders the customers will not be happy/loss of reputation.
Could have a knock on effect for other orders of other products.
Can workforce be used elsewhere if they don’t make these orders/lay off workers.
Morale of employees in existing factory.
Financial reasons
The orders provide a positive contribution towards fixed costs.
At present current level of demand is below break even point so factory operates at a loss.
Demand may increase in the future and make the new factory profitable.
How accurate are the fixed costs
1 mark for Advice and 3 marks for reasons [4]
Each of the three products had a positive contribution, and the business as a whole was showing a profit.
If any production line was closed then
maximum [5]
Teacher's Solution
Financial reasons
 The production lines should not be closed unless they have a negative contribution as the fixed
costs allocated to it would have to be split between the other two production lines and the profit
would turn to a loss.
 The production line (running in losses) may be attracting customers to the profitable one.
 The methods used to apportion the expenses should be the fairest methods
 The possibility of improving the performance of the least profitable or loss making department.
Non-financial reasons
 Non-monetary factors like negative effect on the customers’ and suppliers’ in the future operations
of the remaining business are also important.
 Loss of staff morale and overall reputation of the business due to displacement of staff of
department subject to closure should also be considered
 It must be remembered that not all the expenses apportioned to the department will disappear
when the department is closed as fixed costs burden of remaining products may increase
QUESTION 8
Alberta Limited produces one product, plates, for which the following information is available.
Alberta limited is now considering extending the product range by adding two products cups and saucers.
Explain the implications for the local community if Alberta Limited decides to extend its product range. [6]
MAY 2009 P2 Q3 (c)
SOLUTION
Mark scheme
 Additional employment available
 Increased pollution
 Work for local suppliers
 Training for new employees
 Other suitable answers
Any three appropriate answers for 2 marks each [6]
Suggested Solution
If Alberta Limited decides to extend its product range then this would create additional employment
opportunities for the local community. Moreover, more diversified products would be available in local
market. This would also open new market for local suppliers of raw materials. However, increased pollution
due to extension of product range would be injurious to the health of local community.
QUESTION 9
Rahel has to meet the forecast demand in April as she has contracts with her customers. In order to achieve
this she has two alternatives.
1 Ask the workers to work overtime.
2 Buy in the products from another supplier.
REQUIRED
Advise Rahel which option she should choose. Justify your answer. [5]
MAY 2016 P21 Q3 (h)
OR
The company has two possible options to enable it to achieve the budgeted production.
Option 1 Pay existing staff overtime. This will be paid at a rate of $5.75 per hour.
Option 2 Buy in the required products from an external supplier at a cost of $50 per unit.
(c) (i) Evaluate the options available to the company to achieve the budgeted production.
Support your answers with calculations. [10]
(ii) Recommend which option the company should choose. Justify your answer. [3]
SOLUTION
Mark scheme
Overtime
Disadvantages Advantages
Workers may refuse Will meet demand
Positive contribution but less than the Quality is maintained via in house production (1)
outsourcing option
Possibility of lower quality Quality is maintained via in house production (1)
Additional other costs
There would be no delivery implications
Buy-in
Disadvantages Advantages
Doesn’t know quality / reliability of supplier Will meet demand
May be more expensive May obtain better price
May allow competition into market

Need to consider the reliability of supply and
delivery (1)
Higher risk but larger financial returns which
would also increase profit (1)
Suggested Solution
Overtime
Benefits
 Ability of workers is well known to the business
 Quality of work done by labour is also well known
 Production will meet the demand
Drawbacks
 Workers may refuse
 Efficiency of workers may be affected
 Additional other costs such as power etc will also be incurred
Buy-in from another supplier
Benefits
 Demand will be met
 Customers would remain loyal with the business
Drawbacks
 Doesn’t know quality or reliability of supplier
 No knowledge of price
 May allow competition into market
CHAPTER 2.7 ACCOUNTING FOR LIMITING FACTORS

QUESTION 1
Explain what is meant by the term key factor. [2]
MAY 1999 P2 Q4
SOLUTION
Anything which is scarce and limits the growth of an entity e.g., limited sales demand, limited material
supply, limited labour availability, shortage of cash etc.
QUESTION 2
Outline two disadvantages that might be encountered if the planned production pattern was adopted to
counter problem of limiting factor. [4]
MAY 2006 P4 Q3
SOLUTION
Mark scheme
 Will workers be made redundant?
 Will skills of work force diminish during the year?
 Can the workers be recruited when ‘normal’ production resumes?
 Will machinery deteriorate?
 Is there a danger that ceasing production of CCTV cameras might affect the sales of other
cameras?
Two marks per point.
1 mark for identification plus one further mark for development. [4]
Suggested Solution
 Workers working for product with lowest contributions may have to be made redundant.
 Redundant workers may have to be recruited on the resumption of ‘normal’ production.
 Machinery engaged in production of effected product may deteriorate.
 Discontinuation of production of effected product might affect the sales of other cameras and future
sales of effected product when normal production resumes.
QUESTION 3
The directors of S Limited have been informed that only $39 000 worth of direct materials would be available
in December 2017.
Due to an increased demand, the directors do not want to discontinue any of the products and wish to
produce a minimum of 1 000 units of each.
Advise the directors of S Limited whether or not they should produce a minimum of 1000 units of each
product. Justify your answer. [7]
SOLUTION
Mark scheme
Advantages
 The company has a better chance of fulfilling customers’ orders. If the shortage is only short term
there is less chance of losing customers in the long term.
 Fewer dissatisfied customers.
 Less chance of idle resources.
Disadvantages
 Products may be dependent on each other
 Customers may cease purchasing some products if some are unavailable
 Company makes a budgeted loss if minimum demand is met
 If the shortage is long term the company will always be operating at a loss.
 Competitors may exploit the material shortage.
1 for decision (3 for advantages and 3 for disadvantages)
SUGGESTED SOLUTION
Advantages
 If the shortage is only short term then there are less chance of losing customers in the long term.
 As company continues to supply all products so minimum requirements of most customers would
be satisfied.
 Through rotation, company can make a better plan to fulfil most of the customers’ orders.
 Company would be in a better position to use its idle resources as products may be dependent on
each other
Disadvantages
 Through producing a minimum of 1000 units of each product, the company would not be able to
comply the most optimum production plan resulting in relatively lower amount of profit.
 If the shortage is long term the company will always be operating at a loss.
 Competitors may increase their customer base if they are not affected by the material shortage in
the same manner.
QUESTION 4
Give two examples of a limiting factor. [4]
SOLUTION
The factors which limit production or sales volume may include:
 Shortage of material
It arises due to non-availability of required quality of material; crop failure, legal or trade restrictions
arising from quotas etc.
 Shortage of labour
It may be of general nature or of a specific type of labour, overtime restrictions etc
 Shortage of plant capacity
It may be due to non-availability of machines or machine hours, machine breakdown, lack of finance
to expand production facilities
 Shortage of factory space
It refers to lack of physical space to accommodate production facilities
 Shortage of finance
It may be of general nature or of a specific type of fund or at reasonable cost
 Lack of market demand which may be due to ineffective or insufficient advertising, inefficient sales
team, decrease in products, availability or availability of better or cheap substitutes, shortage of
delivery vans etc
QUESTION 5
Suggest the ways to have an optimum use of a limiting factor.
SOLUTION
 Is it possible to obtain units of limiting or scarce factor (e.g.) material, labour from an alternative
source
 T what extend is the demand for each product dependent upon the availability of others, the process
which is being curtailed or discontinued because of shortage of a key factor.
 Degree of risk of temporary discontinuance of a product will lead to loss of market share and would
it be preferable to continue to produce all products within the constraints imposed by the limiting
(key) factor even if it results in temporary reduction in profits
 Is it possible to minimize loss of profit by increasing selling prices or reducing production costs.
 Is it possible to utilize the scare resources more efficiently by re-designing production, changing
specification, reduction wastage etc.
CHAPTER 2.8 BUSINESS PLANNING

QUESTION 1
Explain the advantages and uses of budgets. [7]
MAY 2003 P4 Q3 [d(i)]
OR
State three benefits which may be obtained from the preparation of budgets. [3]
MAY 2005 P4 Q2 (c)
OR
State three advantages of using budgets [3]
MAY 2011 P43 Q3 (e)
OR
Explain two reasons why a business prepares a budget. [4]
SOLUTION
Mark Scheme
 Budgets formalise management plans (1).
 Budget preparation ensures that all functions of a business are properly co-ordinated (1).
 Budgets may indicate possible future shortages of resources so that remedial measures may be
taken in in good time, or other functional budgets modified (1 – plus 1 for example of amplification).
 Participation by management at all levels in budget preparation induces sense of commitment by
all of them to the budget (1).
 Budgets bring together plans for different departments
 The preparation of budgets for individual departments, functions etc. is a form of responsibility
accounting (1).
 Budgets provide information for on-going control of business activities (1).
 Budgets help to predict shortages of cash/labour/materials
(Other points may be acceptable.) [7]
Suggested Solution
Budgets have the following advantages
 They compel management to look ahead for the company as a whole instead of focusing its
attention solely on daily problem solving.
 Mangers of different departments are forced to work together in order to integrate their individual
plans. This enhances inter-departmental communication, coordination and spirit of teamwork.
 Budgets can be used as yardsticks to compare with actual performance in order to highlight the
strengths and weaknesses of an organisation.
 As managers set the budgets for their own department, they will be more aware of the responsibility
they bear to achieve the goals set.
 Participation in setting a budget makes a person psychologically involved in the company. Often
the employee becomes more committed and motivated to achieve the target set.
 Budgets establish targets for the operating departments to follow.
QUESTION 2
State two advantages & two disadvantages to a company of using a budgetary control system. [4]
MAY 2013 P41 Q3 (d)
OR
(i) State three advantages of budgetary control. [3]
(ii) State three disadvantages of budgetary control. [3]
OR
State three advantages and three disadvantages of a system of budget preparation. [4]
MAY 2017 P22 Q4 (e)
OR
State three financial benefits of a system of budgetary control. [3]

SOLUTION
Mark Scheme
Advantages
 requires planning/co-ordination/communication between departments
 Facilitates profit maximisation
 Enhanced cash management
 Facilitates working capital requirement planning
 Enables capital expenditure planning
 can be a motivator
 causes more efficient use of resources
 leads to cost control.
 Assists with planning for the future
 Helps to monitor performance
 Compares budget and actual, identifying variances, determine causes and taking corrective action
 Can act as motivation for employees
 Enables delegation to departments
 Assists with decision making
 Helps with responsibility accounting
 Helps with accounting by exception
Other sensible comment rewarded. Any two × 1 mark
Disadvantages
 poor data lead to poor decisions
 without consultation budgets can be a demotivator
 if undemanding can lead to underachievement
 Budgets could be inaccurate
 Budget are time consuming and expensive to create and monitor
 Could lead to conflict between departments regarding the allocation of resources
 Can discourage innovation
Suggested Solution
Budgetary control offers several advantages to managers. Some of these are:
 Budgetary control coordinates activities across departments.
 Budgetary control translates strategic plans into action. It specifies the resources, revenues, and
activities required to carry out the strategic plan for the coming year.
 Budgetary control provides an excellent record of organizational activities.
 Budgetary control improves communication with employees.
 Budgetary control improves resources allocation, because all requests are clarified and justified.
 Budgetary control provides a tool for corrective action through reallocations.
 Budgetary control helps to control costs.
 Budgetary control assists with planning for the future
 Budgetary control helps to monitor performance
 Budgetary control compares budget and actual, identifying variances, determine causes and taking
corrective action
 Budgetary control enables delegation to departments
 Budgetary control assists with decision making
 Budgetary control helps with responsibility accounting
 Budgetary control helps with accounting by exception
However, budgets control can also create problems.

The disadvantages of budgets are:
 The major problem occurs when budgetary control is applied mechanically and rigidly.
 Budgetary control can de-motivate employees because of lack of participation. If the budgets are
arbitrarily imposed top down, employees will not understand the reason for budgeted expenditures,
and will not be committed to them.
 Budgetary control can cause perceptions of unfairness.
 Budgetary control can create competition for resources and politics.
 A rigid budgetary control reduces initiative and innovation at lower levels, making it impossible to
obtain money for new ideas.
 Budgets could lead to conflict between departments
Section 3 88 AS & A2 Level – Common Topics
SECTION 3 AS & A2 LEVEL – COMMON TOPICS
CHAPTER 3.1 PARTNERSHIP DISSOLUTION 89

CHAPTER 3.2 FINANCIAL STATEMENTS OF COMPANIES 92
CHAPTER 3.3 ISSUE OF SHARES & DEBENTURES 102
CHAPTER 3.4 STATEMENTS OF CASH FLOWS 114
CHAPTER 3.5 BUSINESS FINANCING 118
CHAPTER 3.1 PARTNERSHIP DISSOLUTION

QUESTION 1
State three possible reasons why the partners may have decided to dissolve the partnership. [3]
MAY 2012 P41 Q2 (b)
OR
State three other reasons why a partnership may be dissolved apart from a decline in Profit. [6]
OR
State two reasons why a partnership may be dissolved. [2]
MAY 2017 P21 Q2 (c)
SOLUTION
Mark Scheme
A partnership may be dissolved
 as the partners are constantly in disagreement and can no longer work together.
 as the partnership is no longer liquid and further trading would increase the debt.
 as the partnership is no longer profitable
 as a partner wishes to set up on his own, or a partner dies or retires.
 due to insolvency of one of the partners.
1 mark per point [3 Max]
Suggested Solution
A partnership may dissolve in the following cases:
 Mutual agreement of the partners to dissolve the business
 Completion of a project for which the partnership was formed
 Expiry of the agreed term of the partnership if it was formed for a pre-determined period
 Death or retirement of all the partners or all except one partner
 Disagreement between the partners
 Formation of a limited company to take care of the partnership business
 When the partnership business is no longer profitable
QUESTION 2
Discuss three problems, which may arise in a partnership but would not occur in a limited company. [6]
SOLUTION
Mark Scheme
 Unlimited liability of owners (partners)
 Responsibilities of/control by partners
 Agreements on share of profits/losses
 Agreements on death/dissolution etc
2 marks each to max (6)
Suggested Solution
Partnership has the following drawbacks when compared with company.
 Each partner is personally liable to trade payables for all debts incurred by the partnership. This
means that if trade payables cannot be paid from partnership assets, they may seek to have their
claim satisfied from the personal assets of the individual partners in contrast to companies where
shareholders enjoy limited liability.
 Each partner acts as an agent of the partnership with authority to bind the partners and partnership
to contracts with other parties, which may affect negatively the personal interest of the other
partners, whereas personal commitments of a company’s shareholders have no bearing on other
shareholders.
 A partnership dissolves with any change in the personnel of its membership or on the expiry of a
period (when formed for a specific period) or on the completion of a project (when formed for that
particular project). So partnership has a limited time span in comparison to company, which
normally enjoys perpetual succession.
QUESTION 3
Explain what would happen if the dissolution of the partnership resulted in a debit balance on a partner’s
capital account. [3]
MAY 2017 P21 Q2 (d)
SOLUTION
Mark Scheme
This means that the partner owes money to the partnership (1)
The partner must use his personal funds to repay the partnership bank account (1) in order that
funds owing to other partners may be repaid (1)
Suggested Solution
This represents amount owing by the partner to the firm. The partner will have to pay this owing amount
from his personal resources to enable the partnership to settle the outstanding amount to the other partners.
QUESTION 4
Amit has recently advised the partners that he is having financial difficulties. He has asked Wang and Susi
for the payment of the balance on his interest free loan account as soon as possible.
REQUIRED
Advise Wang and Susi whether or not they should agree to Amit’s request. Justify your answer. [5]
MAY 2017 P22 Q3 (c)
OR
Trueman asks Ramadhin and Statham for an early repayment of his loan to the partnership.
REQUIRED
Advise the partners whether or not they should make an early repayment. Justify your answer. [4]
MAY 2017 P23 Q1 (f)
SOLUTION
Mark Scheme
 Depends on the agreement on the initial loan
 May need additional capital
 Partnership has insufficient liquid assets at present
 May have to take loan / overdraft which will be charged interest
 Current loan is free of interest (for May 2017 P22 Q3 (d)]
 Interest would reduce the future profit (for May 2017 P22 Q3 (d)]
 Current interest rate on loan is quite high (for May 2017 P23 Q1 (f)]
 It may be able to take a loan to repay at a lower interest thereby increasing the profit of the
remaining partners (for May 2017 P23 Q1 (f)]
 May require security for loan
1 mark for decision and 4 marks for justification.
Suggested Solution
Repayment of Amit’s loan depends on the agreement on the initial loan. The Partnership has insufficient
liquid assets at present so may need additional funds.
In order to arrange funds for the repayment of Amit’s loan, an additional loan has to be arranged which may
require collateral. The additional interest on new loan borrowed may reduce the profit.
QUESTION 5
Explain the difference between a realisation account and a revaluation account. [2]
SOLUTION
Mark Scheme
Realisation account is used to close the books of account (1) on the dissolution of a partnership
Revaluation account is used to record changes in the value of assets and liabilities on changes in a
partnership (1)
Suggested Solution
Revaluation account is a nominal account carrying only increase and decrease in the value of assets and
liabilities from last balance sheet date to current values. It is prepared at the time when there is change
in profit sharing ratio between existing partners or when new partner is admitted into the partnership firm or
when any one or more partner retires or dies.
Realisation account is prepared at the time of dissolution of partnership firm. It is prepared to close all
assets and liabilities which exist at the date of dissolution. The balance on Realisation account represents
profit or loss on dissolution of business.
CHAPTER 3.2 FINANCIAL STATEMENTS OF COMPANIES

QUESTION 1
State five advantages and disadvantages of limited liability companies over sole traders or partnership [5]
SOLUTION
Mark Scheme
 If the company goes out of business the shareholders cannot be held personally liable for the
company debts.
 The death or retirement of a director of a limited company need not affect the business.
However,
 Annual accounts must be professionally audited.
 Companies must file annual return and accounts with the Registrar of Companies.
 There is much more "red tape" than with sole traders or partnerships.
 Each shareholder must be sent a copy of the company's annual audited accounts.
Any other relevant answers. Any 5 points. (5)
Suggested Solution
The main advantages of limited companies over other forms of business organisations are as follows.
 The shareholders enjoy limited liability. Private property of the shareholders is not liable to settle
the business obligations.
 Company, as a separate legal entity, continues to exist despite changes in the ownership by transfer
of shares. A company therefore enjoys perpetual succession.
 The shares of a company can easily be transferred to other persons without the consent of other
shareholders.
The main disadvantages of forming a limited company

 Compliance with the Companies Act imposes an increased administrative burden on the company.
 Tighter government regulations and more extensive public disclosure.
 A company’s affairs are less private than those of a sole trader or partnership, since company
accounts are made available for public inspection.
QUESTION 2
State two advantages and two disadvantages of Partnership and a private limited company. [8]
MAY 2015 P23 Q2 (c)
OR
Hamid and Patel are now considering forming a partnership rather than continuing to trade on a
consignment basis.
REQUIRED
Advise whether or not Hamid and Patel should enter into a partnership with each other. Justify your answer.
[4]
OR
Following the closure of the joint venture, Greaves and Hurst have received more orders and are
considering forming a partnership.
REQUIRED
Advise Greaves and Hurst whether or not they should form a partnership. Justify your answer by discussing
advantages and disadvantages of forming the partnership. [6]
MAY 2017 P31 Q3 (d)
SOLUTION
Mark Scheme
Partnership:
Advantages:
 Possibly more capital
 Shared risk and workload
 greater access to skills and customer base
 Continuity
 Long-term relationship
 Formalised agreement
Disadvantages:
 Unlimited liability
 Need to earn more profit than a sole trader to support partner.
 Possible disputes between partners.
 Trust and reliability considerations between two of them
 Decision making is more difficult
 Partners bound by agreement
[1 mark per valid point to max of 4]
Private limited company:
Advantages:
 Limited liability
 Shared workload
Disadvantages:
 Possible disputes between shareholders
 Not all shareholders may take part in running the business
[1 mark per valid point to max of 4] [8]
Suggested Solution
Partnership:
Advantages:
Disadvantages:
 liability of the partners for debts of their firm is unlimited.
 limited life as death or insolvency of partner(s) dissolves the partnership.
 possible disputes between partners
Private limited company:

Advantages:
 limited liability of shareholders
 shared workload
Disadvantages:
 possible disputes between shareholders
 all shareholders may not take part in running the business
QUESTION 3
Anjali and Bailey trade as partners. They share profits and losses in the ratio 3 : 2.
REQUIRED
Explain whether or not Anjali and Bailey made the correct decision to form a limited company. Justify your
answer. [5]
MAY 2016 P32 Q3 (c)
SOLUTION
Mark Scheme
The partnership had an overdraft (1) and had more trade payables than trade receivables.(1) If the value
the inventory was sold the partnership had a negative working capital. (1)
Given that partnership had unlimited liability and limited companies have limited liability, (1) it seems the
prudent action was to form a limited company, in order to protect the partners assets. Each gets preference
shares with fixed rate of dividend (1). Have voting rights (1)
May raise more capital (1) Shares may gain value (1)
However, may lose control (1), shares may lose value (1) profits may not be enough to pay preference
dividend (1)
(1) for decision + 1 per valid point, max 4 [5]
Suggested Solution
Anjali and Bailey’s partnerships have low working capital. The partnership had overdrafts and its trade
payables were more than trade receivables. In the absence of inventory or in case of its sales then
partnership had a negative working capital.
As partnerships have unlimited liability and limited companies have limited liability, it seems to be a prudent
action to form a limited company, in order to protect the personal assets of partners.
QUESTION 4
Explain the function of an Appropriation Account in:
(i) a partnership
(ii) a Limited Company [6]
MAY 2005 P2 Q2 (a)
SOLUTION
Mark Scheme
(i) In a partnership, the appropriation account shows how the net profit of the business is split among
the partners, taking into account interest on capital, interest on drawings, and salaries. There is no
profit retained at the year end.
(ii) In a limited company, the appropriation account shows how the net profit of the business is
distributed among the shareholders but also into reserves such as general reserve and retained
profits. Frequently profits are brought forward from last year and carried forward to next year.
Maximum 3 for each section, to maximum [6]
Teacher's Solution
(i)  Appropriation account of a partnership only shows how profits of a firm are distributed
among the partners on account of interest on capital, salaries etc.
 There is no last year profit or loss to be adjusted to current year profit.
(ii)  Appropriation account of a company not only shows the distribution of profits among
the shareholders as dividend but also retention of profits as reserves.
 Last year profits/losses are adjusted to current year profits/losses.
QUESTION 5
Explain three differences between a provision and a reserve. [6]
SOLUTION
Teacher's Solution
 Provisions are amounts written off or unknown future losses or to strengthen financial position of
the business.
 Provisions are created by debiting retained by way of providing for depreciation diminution or
renewals of assets or for any known liability the amount of which cannot be accurately determined,
whereas reserves are created for meeting Profit and Loss a/c, whereas reserves are created by
debiting Profit and Loss appropriation a/c.
 Provision cannot be distributed among the shareholders as dividends whereas reserves can be.
 A provision is created irrespective of the fact whether there is profit or loss whereas reserves can
be created only when there are sufficient profits.
QUESTION 6
Explain, briefly, the difference between a liability and a provision. [3]
SOLUTION
Mark Scheme
The amount of a liability may be determined with some accuracy (1) e.g. rent accrued at the year-end (or
other relevant example) (1) whereas the amount of a provision is not readily determinable (1).
Any three to a maximum of [3]
Suggested Solution
A liability is a present obligation as a result of past events and its amount may be determined with some
level of accuracy. Examples include trade payables for goods, accrued expenses etc. A provision is a liability
of uncertain timing or amount as is not readily determinable with substantial accuracy. Examples of
provisions include warranty obligations; legal or constructive obligations to clean up contaminated land or
restore facilities; and a retailer’s policy to refund customers.
QUESTION 7
On 30 April 2010 Frog Log plc’s statement of financial position (balance sheet) showed the following
reserves:
 Share premium
 Revaluation reserve
 Capital redemption reserves
 General reserve
 Retained earnings
State whether each reserve given above is a revenue reserve or a capital reserve. [5]
MAY 2011 P43Q1(b)
SOLUTION
Share premium capital reserve
Revaluation reserve capital reserve
Capital redemption reserves capital reserve
General reserve revenue reserve
Retained earnings revenue reserve
QUESTION 8
State what is meant by the term ‘revaluation reserve’. [1]
SOLUTION
Mark Scheme
A revaluation reserve arises when non-current assets are revalued at an amount greater than their current
net book value.
Suggested Solution
A revaluation reserve arises when a company revalues its non-current assets at a value which is higher
than their current book value.
A share premium account can be used in a number of ways
 to pay up un-issued ordinary shares to existing ordinary shareholders as bonus shares.
 to write off preliminary expenses
 to write off expenses incurred in the issue of shares and debentures.
 to provide for any premium payable on the redemption of shares and debentures.
QUESTION 9
Explain how share premium arises. [2]
SOLUTION
Mark Scheme
A share premium arises when a share is sold for more than its nominal value (1). The difference between
the selling price and the nominal value is called the share premium (1).
Suggested Solution
A share premium arises when a company issues shares for a price which is higher than their nominal value.
The excess of selling price over the face value is called share premium.
QUESTION 10
Explain share premium and state how it may be used. [4]
OR
State two uses of a share premium account. [2]
SOLUTION
Mark Scheme
Share premium is the amount above the face value of a share at which it may be issued. Example: a $1
share may be issued at $1.05. The $1 is credited to the share capital account whilst the $0.05 is credited
to the share premium account. It is a capital reserve and may be used as follows:
 to pay up unissued shares as fully paid bonus shares.
 to write off preliminary expenses on formation of the company
 to write off expenses incurred in share issues.
 to provide any premium pay able on redemption of shares or debentures.
Up to 4 points (4)
Suggested Solution
A share premium arises when a company issues shares for a price which is higher than their nominal value.
A share premium account can be used in a number of ways
 to pay up un-issued ordinary shares to existing ordinary shareholders as bonus shares.
 to write off preliminary expenses
 to write off expenses incurred in the issue of shares and debentures.
 to provide for any premium payable on the redemption of shares and debentures.
QUESTION 11
Describe the treatment of a proposed final dividend in the financial statements. Give the reason for this
treatment. [4]
MAY 2012 P41 Q1 (c)
OR
State how a proposed final dividend should be dealt with in the accounts. [2]
OR
Explain how proposed dividends are treated in the published accounts. [3]
MAY 2013 P41 Q2 (e)
OR
State how a proposed dividend would be treated in the financial statements. [2]
SOLUTION
Mark Scheme
 Proposed dividends are a non-adjusting event (1)
 They are not included in the financial statements for the current year (1)
 They are shown as a note to the accounts for that year (1)
 They are still subject to approval by shareholders (1) [3]
Suggested Solution
The proposed final dividend of current year needs shareholders’ approval at the Annual General Meeting
and accordingly is not provided for in the financial statements and can only be disclosed by way of a note
to the financial statements. This implies that current year’s interim dividend and last year’s final dividend
paid during the current year (provided the latter has been approved by the shareholders) will be included
in the current year’s financial statements.
QUESTION 12Only for A2 (Paper

3)
State three items, which should be contained in the directors’ report, which accompanies the financial
statements of a company. [3]
OR
A public limited company is required to publish a Report of the Directors.
List five items which appear in the Report of the Directors. [10]
MAY 2011 P42 Q2 (d)
SOLUTION
Mark Scheme
 Review of business during the year. (1) Position of business at end of year.(1)
 Principal activities of the company during the year.(1)
 Significant changes in the business activities during the year. (1)
 Particulars of important events affecting the company since the end of the financial year.(1)
 An indication of likely future developments in the business of the company.(1)
 Amounts of recommended dividends.(1)
 Proposed transfers to reserves.(1)
 Names of directors and their holdings of shares and debentures in the company.(1)
 Directors’ remuneration, pensions, share options
 Political and charitable donations
(Any three; maximum 3 marks) [3]
Suggested Solution
The Directors’ Report should contain the following:
 The state of affair of the company (review of business performance during the year).
 Statement of company’s principal activities with significant changes.
 An indication of research and development activities of the business.
 A statement of political and charitable donations
 Proposed transfers to reserves
 Amounts of recommended dividends
 Details of directors’ remuneration
 Names of directors and their holdings of shares and debentures in the company
 A statement of principal risks and uncertainties which the company is facing
 A statement of details of annual general meeting (AGM)
QUESTION 13 Only for A2 (Paper 3)
State five matters which should be included in the directors’ report. Give one reason why each of matters
you have identified is important. [10]
SOLUTION
Mark Scheme
1. A review of the business during the year and its position at the end of the year. (1)
The income statement and balance sheet do not provide information which cannot be expressed
in monetary terms (concept of money measurement). (1)
2. The principal activities carried on by the company during the year and significant changes in those
activities. (1) the accounting statements cannot explain the activities carried on by the company/frs
3 does not give adequate information about new and discontinued activities. (1)
3. Particulars of important events that have occurred after the end of the financial year and which
affect the company.(1) post balance sheet events occur after the directors have approved the
financial statements and may affect the balance sheet or income statement (adjusting events) or
may affect the business after the balance sheet date (non-adjusting events). (1)
4. Recommended dividends. (1) these must be approved by the members of the company at the
annual general meeting. (1)
5. Names of directors of the company and their interests in shares or debentures of the company.(1)
shareholders are entitled to know who have been stewards of their interests during the year and
the extent of each director’s commitment to the company as share or debenture holders.(1)
6. Donations to political parties or charities during the year.(1) shareholders may not wish their money
to be used for political purposes, or may wish that some of the profits be used for charitable
purposes. (1) .
7. Arrangements for promoting the health, safety and welfare at work of the employees (1)
shareholders are entitled to be re-assured that the company is abiding by current legislation
concerning health and safety and that it is concerned with the welfare of its employees (good labour
relations). (1)
8. Information about research and development being carried on by the company. (1)this helps to
assess the future prospects of the company. (1)
9. An indication of the future developments in the company’s business. (1) an indication of likely future
growth (1) and/or diversification (1) or disposing of non-core activities. (1)
10. Significant changes in fixed assets during the financial year. (1) shareholders are informed of any
material differences between the balance sheet values of fixed assets and their current market
values. (1)
(1 mark for each matter and one for each comment on its significance. Maximum 10 marks.)
[10]
Suggested Solution
1. A review of the development of the company’s business during the year and its position at the end
of the year.
Reason: The income statement and Balance Sheet only provide information which can be
expressed in monetary terms (money measurement concept). They cannot describe
the conditions under which the company has traded etc.
2. The principal activities carried on by the company during the year and significant changes in those
activities.
Reason: The accounting statements prepared for FRS 3 cannot explain the activities carried on
by the company or give complete information about new and discontinued activities.
3. Details of recommended dividends.
Reason: These must be approved by the shareholders of the company at the annual general
meeting.
4. Names of the directors of the company, their remuneration, pension details and their interests in
shares or debentures of the company.
Reason: Shareholders are entitled to know who have been stewards of their interests during the
year and the extent of each director’s commitment to the company as a shareholder or
debenture holder.
5. Donations to political parties or charities during the year provided total of these donations is more
than $200.
Reason: Shareholders may not wish their money to be used for political purposes, or may wish
on the other hand, that some of the profits be used for charitable purpose.
6. Details of any significant changes in non-current assets during the financial year.
Reason: Shareholders are informed of any material differences between balance sheet values
of non-current assets and their market value and their additions and disposals.
QUESTION 14
State how an upward revaluation of an existing non-current asset is recorded in the financial statements of
a company. [3]
SOLUTION
Mark Scheme
It increases the value of non-current assets in the statement of financial position. (1)
It increases / creates the revaluation reserve in the statement of financial position. (1)
It reduces the accumulated depreciation. (1)
It is recorded in the statement of changes in equity. (1)
Suggested Solution
An upward revaluation of an existing non-current asset is credited to a capital reserve called revaluation
reserve.
It increases the value of the non-current asset to reflect the true and fair view of the financial position of the
business.
It reduces the accumulated depreciation in the statement of financial position.
It increases the shareholders’ equity and is recorded in the statement of changes in equity and also shown
as part of equity in the statement of financial position.
QUESTION 15
Explain why the company should not use its revaluation reserve to pay dividends to shareholders. [4]
SOLUTION
Mark Scheme
The revaluation reserve is a capital reserve. Capital reserves are not allowed to be used for the payment
of a cash dividend. (1) The creation of a revaluation reserve is not a cash transaction as no cash has been
generated for the payment of dividends. (1)
The capital reserve will increase the asset value of the company and the shareholders interest and is in the
accounts to reflect a true and fair view of the company accounts.(1) Cash gain can only be realised if the
asset is sold. (1)
Suggested Solution
The revaluation reserve is a capital reserve. This arises when a non-current asset, usually land or building,
is revalued upward to reflect an increase in the market value of the asset. This increases the shareholders’
equity and accounted for to reflect the true and fair view of the financial position of the business.
This is an unrealizable gain until the concerned asset is sold so the revaluation reserve cannot be paid out
as cash dividends as no cash is received on upward revaluation of non-current assets.
QUESTION 16
State two objectives of financial statements of a limited company. [2]
MAY 2017 P31 Q1 (a)
SOLUTION
Mark Scheme
Provide information about the financial position (1) and financial performance (1), and cash flows (1) of an
entity. Useful to a wide range or users in making economic decisions. (1) Max 2
Suggested Solution
Financial statements of a limited company provide information about its
1 financial position and solvency through statement of financial position (balance sheet)
2 financial performance which is primarily provided in an income statement through comparison of
incomes with expenses
3 movements of cash flows through cash flow statement
4 changes in equity items including shares, reserves and profits through statement of changes in equity
5 overall position and future prospects which may be very helpful for users of financial statements in
making different solutions
QUESTION 17
Suggest two reasons why the balance on a retained earnings account may be lower than the profit for the
year. [2]
MAY 2017 P21 Q1 (b)
SOLUTION
Mark Scheme
 Previous loss brought forward (1)
 Payment of dividends (1)
 Bonus issue of shares (1)
Max 2
Suggested Solution
 Loss brought forward from previous years
 Payment of ordinary or preference dividends
 Bonus issue of shares out of retained profits
 Transfer to general reserves
Financial Statements in CIE Exams
Name of Company
Income Statement for the year ended - 
$
Sales xx xxx
Cost of Sales (x xxx)
Gross profit xx xxx
Administration expenses xx xxx
Distribution expenses xx xxx (x xxx)
Operating profit xx xxx
Interest on loans and debentures (x xxx)
Profit after interest xx xxx
Corporation’s tax (x xxx)
Profit attributable to equity holders xx xxx
Statement of Changes in Equity

For the year ended 
Ordinary Preference Share Revaluation General Retained Total
Share Share Premium Reserves reserves Earnings Equity
capital capital
$000 $000 $000 $000 $000 $000 $000
Balance at year start xx xxx xx xxx xx xxx xx xxx xx xxx xx xxx xx xxx
Current year profit ----- ----- ----- ----- ----- xx xxx xx xxx
New issue of shares xx xxx xx xxx xx xxx ----- ----- ----- xx xxx
Revaluation of Assets ----- ----- ----- xx xxx ----- ----- xx xxx
Transfer to reserves ----- ----- ----- ----- xx xxx (x xxx) -----
Dividends paid ----- ----- ----- ----- ----- (x xxx) (x xxx)
Balance at year end xx xxx xx xxx xx xxx xx xxx xx xxx xx xxx xx xxx
Name of Company
Balance Sheet as at 
Non-current assets Cost ($) Depn. ($) NBV($)
Land, premises and buildings xx xxx xx xxx xx xxx
Furniture, fittings and fixtures xx xxx xx xxx xx xxx
Machine, plant and equipment xx xxx xx xxx xx xxx
Motor vehicles xx xxx xx xxx xx xxx
xx xxx xx xxx xx xxx
Current Assets
Closing inventory xx xxx
Trade receivables xx xxx
Cash at bank/ Cash in hand xx xxx
Prepaid expenses/ accrued income xx xxx
xx xxx
Current Liabilities
Trade payables xx xxx
Accrued expenses/ Pre received incomes xx xxx
Debentures and loans payable within one year xx xxx
Debenture/loan interest payable xx xxx
Tax payable xx xxx (x xxx) xx xxx
xx xxx
Non-current liabilities
Debentures and loans payable after one year (x xxx)
xx xxx
Equity
Ordinary shares capital xx xxx
6% preference shares capital xx xxx xx xxx
Share premium/ Revaluation reserves xx xxx
General Reserves / assets replacement reserves xx xxx
Retained profits xx xxx xx xxx xx xxx
CHAPTER 3.3 ISSUE OF SHARES & DEBENTURES

QUESTION 1
Abdul is considering forming a company by issuing ordinary and preference shares.
REQUIRED
(e) State one advantage and one disadvantage of ordinary shares to:
(i) the company [2]
(ii) a shareholder. [2]
(f) State one advantage and one disadvantage of preference shares to:
(i) the company [2]
(ii) a shareholder. [2]
MAY 2015 P41 & P42 Q3 (e & f)
SOLUTION
Mark Scheme
(e) (i) Advantage – dividends need not be paid if profits are insufficient (1)
Disadvantage – ordinary shareholders control the company as they have the vote (1) [2]
(ii) Advantage – entitled to vote at the AGM/may earn a higher dividend as profits increase
(1)
Disadvantage – Ordinary shareholders must stand any losses on a winding-up/may not
receive any dividend at all if profits insufficient. The dividend is variable and based on
profits (1) [2]
(f) (i) Advantage – fixed dividend assists cash flow management (1)
Disadvantage – may be treated as financing costs if shares are redeemable/rate of
interest on overdraft/capital may be lower than rate of dividend payable on shares. No
control over the amount of dividend as it is fixed. (1) [2]
(ii) Advantage – preference shares receive their dividend, usually at a fixed rate, in priority to
the ordinary shareholders. Receive the dividend before ordinary shareholders (1).
Disadvantage – preference dividend is a fixed amount (1) [2]
Suggested Solution
(e) (i) Advantage – dividends need not be paid if profits are insufficient
Disadvantage – sharing of management control as ordinary shareholders control
have the voting rights
(ii) Advantage – entitled to vote at the annual general meeting may earn a higher
dividend in periods of high profits
Disadvantage – may not receive any dividend in the periods of low or no profits
ordinary shareholders only receive what residue is left after paying
to all lenders and preference shareholders on winding-up of
company.
(f) (i) Advantage – an allowable expense for tax purposes if shares are redeemable
Disadvantage – No control over the amount of dividend as it is fixed.
(ii) Advantage – preference shareholders receive the dividend before ordinary
shareholders.
Disadvantage – do not receive higher dividends in the periods of higher profits as
preference dividend is a fixed amount.
QUESTION 2
Describe three different types of preference share. [6]
SOLUTION
Mark Scheme
(i) Cumulative, where dividends, if not paid one year, will be added to the following year’s
dividends.
(ii) Non-cumulative, where dividends, if not paid one year, are lost.
(iii) Redeemable, which may be bought back by the Company.
(iv) Participating, which receive a share of the profits Etc
1 for name, 1 for description to maximum (6)
Suggested Solution
(i) Redeemable preference shares may be issued by accompany with the condition that the amount
subscribed may be refunded to the shareholders at the option of the company.
(ii) Participating preference shares entitle holders, not only to a fixed dividend rate but also to an
additional distribution of profits in good trading years.
(iii) Non-participating preference shares, shareholders’ right to dividend is ordinarily limited to a

specified amount and mostly preference shares are non-participating in nature.
(iv) Cumulative preference shares are entitled to be paid any arrears of their dividend before ordinary
shares receive any dividends whereas preference shares that do not have this cumulative right
called non-cumulative.
QUESTION 3
State the major differences between ordinary shares, preference shares and debentures. [6]
OR
Explain two differences between ordinary shares and preference shares. [4]
OR
Explain two differences between ordinary shares and preference shares. [4]
MAY 2017 P22 Q1 (d)
OR
Identify two differences between ordinary shares and cumulative preference shares. [2]
NOVEMBER 2017 P21 Q3 [a (i)]
SOLUTION
Mark Scheme
Ordinary shares Voting rights
Share of profits
No fixed dividend
Part owners of business
Own reserves
Unpaid ordinary dividends do not accumulate
etc.
Preference shares No voting rights (usually)

Fixed dividend
Part owners of business
Don't own reserves
Unpaid cumulative preference dividends accumulate
etc.
Debentures No voting rights

Fixed interest
Lenders to business
etc. 2 each to maximum (6)
Teacher's Solution
 Ordinary shares represent ownership whereas preference shares and debentures are debts of the
business.
 Ordinary shareholders have voting rights whereas preference shareholders & debenture holders
do not have the voting rights.
 Debentures earn interest at a fixed rate. Preference shares earn dividend at a fixed rate whereas
ordinary shares receive dividends; the amount of which varies from year to year and depends upon
profit & company’s policy.
QUESTION 4
State two differences between ordinary shares and debentures [2]
NOVEMBER 1999 P2 Q1 [b (iii)]
OR
OR
Explain one difference between debentures and ordinary shares. [2]
SOLUTION
Mark Scheme
Ordinary shares Debentures
Variable returns Fixed returns
Owners Trade payables
Receive dividend Receive interest
Voting rights No voting rights
Not repaid Must be repaid
Any 2 differences 2 marks
Suggested Solution
 Interest on debentures is paid at a fixed rate whereas rate and amount of ordinary dividend paid to
ordinary shareholders may vary from year to year.
 Ordinary shareholders are owners of the company, whereas debenture holders are long-term
lenders.
 Companies are legally bound to pay fixed amount of interest on debentures every year otherwise
companies operations can be ceased, whereas payment of ordinary dividend to ordinary
shareholders is dependent upon profits and company’s policy.
QUESTION 5
Explain one benefit to Wembo and Bob of receiving:
(i) ordinary shares
(ii) cumulative preference shares. [2]
SOLUTION
Mark Scheme
Ordinary shares
The dividend on ordinary shares is variable and dependent on the levels of profit (1) so has greater reward
when the profits are high. (1)
Possible involvement of Wembo and Bob in managing the company through voting rights (1)
Max (1)
Preference shares
Whereas cumulative preference shares have a fixed dividend of $4200 per year, (1) which if profits are low
one year will be paid the next. (1) So limited risk. (1)
Suggested Solution
Ordinary shares
Wembo and Bob will be entitled to vote at the annual general meeting and may also earn a higher dividend
in periods of high profits
Cumulative preference shares receive dividends at fixed rate and amount of $4 200. They also have low
risk as are entitled to be paid any arrears of their dividend before ordinary shares receive any dividends
QUESTION 6
NOVEMBER 1999 P2 Q1 [b (iii)]
OR
OR
Explain one difference between debentures and ordinary shares. [2]
SOLUTION
Mark Scheme
Ordinary shares Debentures
Variable returns Fixed returns
Owners Trade payables
Receive dividend Receive interest
Voting rights No voting rights
Not repaid Must be repaid
Any 2 differences 2 marks
Suggested Solution
 Interest on debentures is paid at a fixed rate whereas rate and amount of ordinary dividend paid to
ordinary shareholders may vary from year to year.
 Ordinary shareholders are owners of the company, whereas debenture holders are long-term
lenders.
 Companies are legally bound to pay fixed amount of interest on debentures every year otherwise
companies operations can be ceased, whereas payment of ordinary dividend to ordinary
shareholders is dependent upon profits and company’s policy.
QUESTION 7
Adam is considering investing some of his retirement proceeds in a limited company. He is considering
acquiring either participating preference shares or convertible loan stock.
Explain the terms ‘participating preference shares’ and ‘convertible loan stock’. [6]
MAY 2013 P41 Q1 (d)
SOLUTION
Mark Scheme
Participating Preference Shares
 Fixed rate of dividend if sufficient profit. (1)
 Arrears paid in later years if dividend not paid. (1)
 Dividend paid before ordinary share dividend. (1)
 Capital returned to investor prior to ordinary shareholder on winding up. (1)
Convertible loan stock
 Fixed interest rate. (1)
 Right to convert to shares at agreed price on agreed date. (1)
 Therefore usually lower interest rate than debentures. (1)
 Risk that market price may be lower than agreed price. (1)
1 mark for each valid point – maximum 3 for each term. [6]
Suggested Solution
Participating Preference Shares entitle the bearer to a certain minimum dividend as well as an additional
dividend based on some predetermined condition. The dividend paid may be higher than the fixed minimum
dividend depending upon company performance. In any case, these dividends must be paid before any
dividends are paid on ordinary shares, and if a company is unable to pay dividends on participating
preference shares, stockholders have the right to force the liquidation of the company.
Through convertible loan stocks, a stockholder (lender) may exchange, at any time after a waiting period,
for ordinary shares in the company issuing the loan stock. This conversion is under specified conditions
and with a pre-determined conversion rate.
The number of shares one receives for each loan stock is determined when the convertible loan stock is
issued. A convertible loan stock usually carries lower interest rate than debentures.
QUESTION 8
Explain what do you understand by:
(i) Rights issues;
(ii) Bonus issues. [4]
OR
Explain what is meant by a ‘rights issue’. [3]
SOLUTION
Mark Scheme
 A bonus issue of shares is a capitalisation of reserves (1)
 A rights issue generates cash for the business (1) [2]
Teacher's Solution
(i) Right issue is a right given to existing ordinary shareholders of the company to buy a certain number
of shares as a proportion to the number of shares, which they already have at a price in between
the face price and market price.
(ii) Bonus issue is a free issue of ordinary shares to replace cash dividends to existing shareholders
as a proportion to their shareholdings at the time of issue.
QUESTION 9
State one similarity and one difference between a rights issue and a bonus issue of shares. [2]
MAY 2011 P41 Q2 (d)
SOLUTION
Mark Scheme
Similarity – both are issues of shares to existing shareholders 1
Difference – rights issues are for cash; bonus issue does not involve any consideration but is a
capitalisation of reserves 1 [2]
Suggested Solution
Similarity Both are issued to existing ordinary shareholders
Difference Rights issues are issued for cash whereas bonus issue does not involve any cash inflow
QUESTION 10
Explain the difference between a rights issue and a bonus issue. [4]
MAY 2011 P42 Q1 (c)
OR
State the difference between a bonus issue of shares and a rights issue of shares. [2]
OR
State three differences between a rights issue and a bonus issue. [3]
NOVEMBER 2017 P21 Q3 [a (ii)]
SOLUTION
Mark Scheme
A rights issue generates cash for the business whereas bonus issue is a free issue of shares (1)
The company’s net assets are increased as a result of a rights issue but unchanged with a bonus issue (1)
Shareholders may or may not exercise their rights, but will automatically receive their bonus shares (1)
Shareholders can sell the bonus shares while in a rights issue shareholders may sell their rights. (1)
Max 3 [3]
Max 1 bonus, max 1 rights [2]
Suggested Solution
Rights issue Bonus issue
Issue is made to maintain the proportional ownership Issue is made when company makes profit but
of the existing shareholders. does not have sufficient amount of cash to pay
cash dividends.
Shares are issued at a price which is normally in Shares are issued without charging a price.
between the face price and market price.
As issued for a price so shareholders not necessarily As they are free shares so all the shareholders
subscribe for the shares. took up bonus shares.
As a result of rights issue net assets of the business Bonus issue has no effect on net assets of the
increase. business.
QUESTION 11
(i) Identify the reserves which directors should select to make the bonus issue of $100 000. [2]
(ii) Explain a reason for their selection. [2]
MAY 2011 P42 Q1 (d)
SOLUTION
Mark Scheme
(i) Share premium 1
Revaluation reserve 1
(ii) To keep reserves in the most flexible/distributable form 2 or
To use capital reserves before revenue reserves 2
[4]
Suggested Solution
(i) Share premium of $750 000 ($1 000 000 – $250 000)
Revaluation reserve 0f $250 000 ($250 000 – Nil)
(i) To keep the remaining reserves after bonus issue in the most flexible/distributable form
QUESTION 12
Explain two advantages that a company hopes to gain by using a rights issue to raise additional
capital. [5]
NOVEMBER 2009 P42Q1 (c)
SOLUTION
Mark Scheme
 Cheaper than public issue (0–3)
 Does not dilute the power base of the company (0–3)
1 mark for identification plus up to two further marks for development
[max. 5]
Suggested Solution
 control may be retained by existing shareholders as right issue is made in proportion to existing
shareholdings
 raises cash for the company
 cheaper than a normal share issue because of low administrative and advertising costs
 keeps reserves available for future dividends
 beneficial for existing shareholders in that the right issue is made at a discount to the current market
price
QUESTION 13
Explain what is meant by a bonus issue and also explain whether it would help the expansion plans for the
business. [4]
SOLUTION
Mark Scheme
 A bonus issue would result in 1 share for each 5 held being given to the existing shareholders. (1)
 This is a bookkeeping exercise and a reserve is debited (1) and no cash is raised. (1)
 Therefore, the expansion plans of Aston plc would not be assisted. (1) [4]
Suggested Solution
A bonus issue is a free issue of ordinary shares to the existing ordinary shareholders in proportion to their
present shareholdings. The proposed plan would result in 1 new share for each 5 held being given to the
existing shareholders. This is simply a bookkeeping exercise and a reserve is debited without receiving any
cash on the issue. As a result, it would not help Aston plc in the expansion plans for the business.
QUESTION 14
State three advantages and one disadvantage to a limited company of making a bonus issue of
shares. [4]
MAY 2017 P23 Q2 (b)
SOLUTION
Mark Scheme
Advantages:
 Can be issued instead of paying dividends and so cash flow is not reduced.
 Keeps existing shareholders satisfied as there is no dilution of ownership (shares issued
in proportion to existing holdings).
Disadvantages:
 No capital raised from selling the shares
(1 mark for a valid point up to a max of 4 marks)
Suggested Solution
Advantages:
 Bonus issue allows the company to declare a dividend without using up cash
 There is no dilution of ownership (shares issued in proportion to existing holdings) so shareholders
remain satisfied.
 The cost of issue of bonus shares is the minimum because no underwriting commission, brokerage
etc
 Shareholders need not pay tax on the bonus shares as they pay on cash dividends.
 Shareholders have an option to convert the shares into cash.
Disadvantages
 If the rate of dividend fluctuates, i.e., cannot be maintained, the market value of shares may go
down.
 If the rate of profit is not increased, the rate of dividend may be decreased.
 No cash flow arises on bonus issue
QUESTION 15
The directors are considering making a further issue of bonus shares rather than paying a cash dividend.
Advise the directors which course of action they should take. Justify your answer. [4]
MAY 2017 P31 Q1 (d)
SOLUTION
Mark Scheme
Responses may include:
Bonus issue
 Shareholders may be expecting a cash bonus each year.
 Stop giving return to shareholders may be a negative signal about the performance of the
company
 Company retains cash for other investment opportunities
 The interest of shareholders is not diluted by receiving the proportionate number of bonus
 shares
 Transfer from reserves
Cash dividend
 Company maintains the practice of giving out cash returns to shareholders constantly
 Company may have liquidity problem in paying out cash dividend
 Short term benefit (cash) vs long term benefit (shares value increase).
Accept any reasonable alternatives
Advice 1 mark and 3 max for relevant points
For each valid point, 1 mark for basic explanation and 2 marks for developed explanation
Suggested Solution
In the initial growth phase of a company, preserving cash is of utmost importance while satisfying the return
desires of its shareholders takes precedence when the company is mature. A company has various means
at its disposal to satisfy its objectives and one of these is the type of dividend pay-out. A company can
either choose or is forced to (because of cash constraints) to pay a cash or bonus issue to replace cash
dividend. Each carries its own advantages and disadvantages which are discussed below.
Bonus Issue
 Bonus issue allows the company to declare a dividend without using up cash that may be needed to
finance the profitable investment opportunities within the company.
 Sometimes a company may declare the bonus issue to increase the trading activity and reduce the
market price of the share to make it more attractive to investors.
 The bonus issue does not affect the book value of shareholders’ wealth of the company and therefore
it has no value for them.
 Sometimes, bonus issue is the only way to satisfy the shareholders when a company faces stringent
cash difficulty or where certain restrictions to pay dividend in cash are put under loan agreement.
 The cost of issue of bonus shares is the minimum because no underwriting commission, brokerage
etc.
 Bonus issue is specifically beneficial for the investors who believe in the long term story of the company
and want to increase their investment in the same.
 The company doesn’t receive any cash upon issuing bonus shares. So, the company’s ability to raise
money by follow-on offerings is reduced.
Cash dividend
 A cash dividend is a payment made by a company out of its earnings to investors in the form of cash.
 Cash dividends are beneficial, in that they provide shareholders with regular income on their
investment.
 Cash dividend is specifically beneficial for the investors who believe in the short term story of the
company.
 The receivers of cash dividends must pay tax on the value of the distribution, lowering its final value.
QUESTION 16
Name three types of capital reserve. [6]
MAY 2011 P41 Q1 (d)
OR
Name one capital reserve. [1]
OR
Give an example of a revenue reserve and a capital reserve. [2]
NOVEMBER 2014 P41Q1 (d)
OR
State one example of a capital reserve [1]
MAY 2016 P21 Q1 (f)
SOLUTION
Mark Scheme
Capital Reserves
 Share premium account 2
 Capital redemption reserve 2
 Revaluation reserve 2 [6]
Revenue Reserves
 General reserve
Suggested Solution
Capital reserves
 Share premium
 Capital redemption reserve
 Revaluation reserve
Revenue Reserves
 General reserve
 Asset Replacement reserve
QUESTION 17
Give two characteristics of each of the following:
(i) revenue reserves;
(ii) capital reserves. [8]
MAY 2011 P41 Q1 (e)
OR
Explain the difference between a capital reserve and a revenue reserve. [4]
MAY 2016 P21Q1 (e)
OR
Explain the difference between a capital reserve and a revenue reserve. [4]
MAY 2017 P21Q1 (g)
SOLUTION
Mark Scheme
Revenue reserve –
 created by debiting retained earnings
 may be used to pay cash dividends
 may be set aside for specific purpose
 strengthen the financial position of the company
Capital reserve –
 not created out of profits
 not used for cash dividends
 may be used for bonus issues
 help protect creditors
 They usually represent gains that have not been realised [8]
Characteristics of Revenue reserve –
Capital Reserve:
 It is created out of capital profits.
 It may arise during the period prior to incorporation.
 It is not created by retaining profit.
 It can be used for payment of dividend only when certain conditions of Companies’ Act are satisfied.
 It is created to meet capital loss or for compliance of legal requirements or accounting practices.
 It usually represents gains that have not been realised
 It is not distributable as cannot be used for cash dividends
 It may be used for bonus issues
Revenue Reserve
 It is created out of revenue profits.
 It cannot arise during the pre-incorporation period
 It is created by retaining profit.
 It can be used for payment of dividends without any precondition.
 It usually represents gains that have not been realised.
 It is created to strengthen the financial position or to meet unforeseen contingencies.
 It may be distributable as dividends
QUESTION 18
What are the General Reserves and why are they created in accounting? [5]
SOLUTION
General Reserves are profits of a company after payment of tax, which are not distributed among the
shareholders as dividends. There is no specific reason for making these reserves rather they are created
to provide for unforeseen emergencies or to strengthen the financial position of the business.
QUESTION 19
Explain what is meant by keeping reserves in their most flexible form. [3]
SPECIMEN 2016 P3 Q3 (a)
SOLUTION
Mark Scheme
This means using capital reserves before revenue reserves in order to maintain distributable reserves so
that maximum future dividends can be paid.
Developed explanation (2–3 marks)
Basic explanation (1 mark)
QUESTION 20
Explain why companies usually leave the reserves in the most useful form following the issue of the bonus
shares. [4]
MAY 2001 P3 Q3 (b)
SOLUTION
Capital Reserves are inflexible reserves as they can only be used for some certain purposes (i.e., for
meeting capital losses and capital expenses) whereas revenue reserves are more flexible in nature as they
can be used for meeting revenue as well as capital expenses and losses. So by utilising the capital reserves
for bonus issue, revenue reserves will be left unused which can be used more freely in comparison to
capital reserves as mentioned above.
QUESTION 21
Explain for what purposes the following balances may be used:
(i) the share premium account [2]
(ii) the retained earnings. [2]
MAY 2013 P43 Q1 (f)
OR
Explain share premium and state how it may be used. [4]
SOLUTION
Mark Scheme
(i) The share premium account may be used
1 to pay up new shares issued as fully paid bonus shares (1)
2 to write off expenses of a share issue (1) [2]
(ii) The retained earnings may be used
1 to pay dividends (1)
2 pay up fully paid bonus shares (1)
3 to fund a reduction or repayment of capital (1)
4 for transfers to capital redemption reserve (1) [Max 2]
Suggested Solution
(i) The share premium account may be used
 to pay up new shares issued as fully paid bonus shares
 to write off expenses and any commission paid on the issue of share
(ii) The retained earnings may be used
 to pay cash dividends
 to issue fully paid bonus shares
 to fund a reduction or repayment of capital
 to provide for prior year adjustments
QUESTION 22
Give one reason why a company might want to buy its own shares. [3]
MAY 2011 P41 Q2 (b)
OR
State by what means a company may purchase its own shares. [3]
MAY 2011 P41 Q2 (c)
SOLUTION
Mark Scheme
 To buy out a shareholder/group of shareholders
 Because a previous need for capital/funds has passed
 To make use of spare cash
 Other reasonable answer 1 reason to max 3 [3]
Suggested Solution
 To make use of surplus cash
 To prevent a hostile takeover of the company
QUESTION 23
State by what means a company may purchase its own shares. [3]
MAY 2011 P41 Q2 (c)
SOLUTION
Mark Scheme
 By using proceeds of a new share issue 1
 By capitalising distributable profits 1
 By using a combination of the two 1 [3]
Suggested Solution
 Out of proceeds from new issue of shares
 Out of profits i.e. by capitalising distributable profits
 Partly out of proceeds of new issue of shares and partly by capitalising distributable profits
QUESTION 24
Chandra wishes to invest the $60 000 which he received from the partnership. He is considering acquiring
a debenture or convertible loan stock.
REQUIRED
Explain what is meant by a debenture and convertible loan stock highlighting the major difference between
them. [5]
MAY 2015 P43 Q2 (c)
SOLUTION
Mark Scheme
Debentures are bonds which record a long term loan to be redeemed at a fixed future date (1) to the
company at a fixed interest rate. (1) Interest will be paid whether the company is profitable or not. (1)
Likewise holders of convertible loan stock have made a long term loan to the company. (1) The major
difference is that these holders have the right to exchange the stock for ordinary shares in the company at
a predetermined price at a specified future date. (1)
Teacher's Solution
Debentures are secured long-term loans for the company. They have to be redeemed by the company at
a fixed future date. Interest is paid on debentures at a fixed rate whether the company makes profit or not.
Convertible loan stocks are also a long term loan to the company. They also carry a fixed rate of interest.
Its major difference with debentures is that the holders of convertible loan stocks have the right to exchange
their stock for ordinary shares in the company at a predetermined price at a specified future date.
QUESTION 25
In what circumstances would loan stockholders wish to exercise their right to convert loan stock into ordinary
shares? [3]
MAY 2011 P43 Q1(c)
SOLUTION
Mark Scheme
When the market value of the share is higher than the price given in their option to convert 2
In this case when market value is higher than $3 a share 1 [3]
Suggested Solution
If at the time of conversion, the offered price of $3 for conversion is less than the market price of the shares,
it could be advantageous to exercise the option.
QUESTION 26
Differentiate between provisions and reserves [3]
MAY 2011 P43 Q1(c)
SOLUTION
Mark Scheme
Difference between Provisions and Reserves
Provisions Reserves
 Provisions are amounts set aside out of  Reserves are created either to provide for
profit to provide for the diminution unknown liabilities the amounts of which
(decrease) in the value of assets or to are also not certain or to strengthen the
provide for any known liability the amount financial position of a company
of which cannot be ascertained with
substantial accuracy.  Changes in reserves are shown in the
 Changes in provisions are shown in statement of changes in equity.
income statement.  Reserves can be distributed among the
 Provisions cannot be distributed among shareholders
the shareholders
CHAPTER 3.4 STATEMENTS OF CASH FLOWS

QUESTION 1 ,
FRS1 requires the preparation of an annual Cash Flow Statement. State two advantages of preparing a
Cash Flow Statement [2]
MAY 1999 P2 Q3 (a)
OR
Explain two reasons why a business may prepare a cash flow statement. [4]
MAY 2006 P4 Q1 (d)
OR
State one reason why the directors of a limited company would prepare a cash flow statement [2]
NOV 2008 P4 Q2 (c)
OR
State two reasons why a business might prepare a statement of cash flows [4]
NOV 2010 P42 Q2 (d)
OR
State two purposes for which Swiftsureplc would use a statement of cash flows [4]
SOLUTION
Mark Scheme
 It is a legal requirement for some limited companies
 Shows why cash and profits are not the same
 Shows internally generated cash and cash from external sources
 Links balance sheets
 Shows how efficiently or inefficiently cash has been used throughout the year
 Cash is important to survival – shows how cash is generated and used
 Completes the picture given by financial statements
 To give information on cash flows to management
 To give information on cash flows to other interested parties e.g. bank
Other sensible answers are acceptable
Each point maximum two marks.
1 mark for identification and a further mark for development. [4]
2 × 2 marks each [4]
Suggested Solution
(i) A cash flow statement has to be prepared by each company as the international accounting
standard 1 states that a company must prepare a statement of cash flows previously known as
cash flow statement in addition to other main financial statements.
(ii) It reconciles profitability and liquidity by explaining the difference between the net income and cash
provided by operating activities of an enterprise.
(iii) A cash flow statement can be used to assess the timing, amount and predictability of future cash
flows and it can be used as the basis for budgeting and business-planning.
(iv) It shows sources and uses of cash in an objective manner. On the other hand, reported net income
is heavily influenced by a firm's accounting practices.
(v) It shows the ability of a business to generate cash from internal and external sources.
QUESTION 2
Explain the benefits of preparing a Cash Flow Statement in addition to an income statement. Your
explanation should include a comparison of the bases on which they are prepared. [17]
SOLUTION
The Cash Flow Statement sets out the sources and uses of cash (and near cash items) over a period. It is
important to recognise that, while profitability is an essential ingredient of success, it is by no means
sufficient. Even though profits may be high, a business may face liquidity problems. It is because of the fact
that income statement is prepared on an accrual and prepayment basis and also contains non-cash items
like depreciation, bad debts etc. Moreover, it contains only revenue items (incomes & expenses) and omits
capital items. While the cash flow statement is prepared on cash basis and contains only cash items.
Moreover, it has both capital and revenue items.
Although Cash Flow Statement as a part of financial statements does not normally provide additional
information already provided to users, rather, it normally provides a selection, reclassification and
summarisation of information already shown in the income statement and Balance Sheet. Forming a link
between two Balance Sheets through Cash Flow Statement does this. As we know that Income statement
determines the profitability of the business in terms of “profit or loss” which business makes. Balance sheet
shows the financial position of the business as what business owns and what it owes.
Briefly put, the survival of a business depends not so much on profits as on its ability to pay its debts when
they fall due. Such payments might include Income statement items (expenses), but also capital payments
for new non-current assets and the repayment of loan capital when it falls due e.g. on redemption of
debentures.
From these examples, it may be apparent that a company’s performance and prospects depend not so
much on the profits earned in a period but more realistically on liquidity (Cash flow). A cash flow statement
goes towards meeting this criticism on income statement.
In addition to an income statement and Balance Sheet Cash Flow Statement assesses the reasons for
differences between reported profits and cash flows. It determines whether liquid funds generated are
sufficient and whether they have been raised and applied in an appropriate way. Lastly cash flow statement
also shows ways in which financing occurs.
QUESTION 3
Explain why a cash flow statement is important to shareholders. [8]
SOLUTION
Mark Scheme
Cash flow statements are important to shareholders because they show
 the ability of a business to generate cash internally (1)
 how much cash has been raised externally (1)
 the causes of change in liquidity (2) or cash inflows (1) cash outflows (1)
 viability (1) whether business can generate cash to service finance, pay tax and maintain its fixed
assets (1) going concern (1)
 stability of business (1) reliance upon internal sources (1) external sources (1) for financing
 profitability and liquidity reconciled (1) shareholders may confuse profitability with liquidity (1)
 indication of future cash flows (1); capital investment (expansion of activities) and its effect on future
cash flows (1)
(1 mark per point + 1 for development) max [8]
Suggested Solution
Cash flow statement is intended to show information that is not available from examining the Income
statement and Balance Sheet. It is intended to fill in gaps in the available published information, between
opening and closing Balance Sheets. In simple words, a Cash Flow statement is nothing more than a
summary of a company’s cash book for the accounting period under review. This shows sources and uses
of cash during the year. Although a cash flow statement shows only historic data, it should help shareholders
to assess a company’s ability to;
(i) generate sufficient cash to fund its day-to-day operation.
(ii) repay loans as they fall due and make payments of loan interest.
(iii) replace and improve non-current assets as necessary.
(iv) make the required payments of tax and maintain an acceptable level of dividend.
(v) the reason for the difference between profit and cash from operations.
A cash flow statement provides information, which is both reliable (since preparation of the statement
involves little, if any, subjectivity) and also relevant to the needs of shareholders and many users. The
information provided is fairly easy to understand and it is generally agreed that cash flow statement is
worthy and useful addition to a company published accounts.
QUESTION 4
Explain how cash flow statements differ from cash budgets. [8]
OR
Explain the difference between a cash budget and a cash flows statement. [4]
OR
Explain the difference between a statement of cash flows and a cash budget. [2]
SOLUTION
Mark Scheme
Cash Flow Statement Cash budget
Based on historical data (1) Based on future plans (1)
An account of the directors' stewardship For internal use (1)
of funds (1)
Cannot (legally) be manipulated (1) May be adjusted to reflect management policy (1)
A legal requirement for some companies (1) Desirable for management purposes (1)
It may be produced for budgeting purposes (1) Often gives rise to the principal budget factor (1)
Suggested Solution
Cash flow statements are similar to cash budgets in the content that they show sources and uses of cash
but they are different in many respects some of which are given below.
 Cash flow statements are published for external use and they are part of a company’s published
accounts whereas cash budgets are only used for internal purposes.
 Cash flow statements are based on historic data and shows sources and uses of cash for previous
year whereas a cash budget shows the same for a coming period.
 There is no set format of cash budgets but a cash flow statement has to be prepared in compliance
with IAS 7.
 Cash flow statements show reasons for changes in cash for a whole year whereas companies may
prepare cash budgets for any time period to show changes in cash.
 A company is bound to prepare a cash flow statement on annual basis whereas there is no such
compulsion for a cash budget.
 A statement of cash flows is prepared for a specific period whereas a cash budget is usually
presented in columnar format for more than one time period.
Max 2
QUESTION 5
Explain the difference between cash and profit. [2]
SOLUTION
Mark Scheme
Cash is the actual amount of money physically held by a business, whereas profit is calculated as excess
of incomes over expenses and does not represent actual amount of money.
QUESTION 6
Explain why Winston has an overdraft at the end of 2012, despite making a profit for the year. [5]
MAY 2013 P43 Q2 (c)
SOLUTION
Mark Scheme
Notes regarding overdraft v profit
The business has made a profit for the year. However, this has not generated enough cash (1) to
cover the following major items of expenditure:
• purchase of new non-current assets ($200) (1)
• repayment of loan ($150) (1)
• drawings ($400) (1)
This has resulted in the bank overdraft for the year (1). [5]
Suggested Solution
The reasons for having an overdraft at the end of 2012, despite making a profit for the year are given below.
 purchase of new non-current assets for $200 000
 repayment of loan amounting to $150 000
 cash drawings amounting t0 $400 000
Cash Flow Statement for the year ended - - - - - - - - - - - - - - - - - -
$ $
Cash flows from Operating activities
Profit before interest and income taxes xx xxx
Add Depreciation charge for the year xx xxx
Add Amortisation of goodwill, patents or intangible assets xx xxx
Add Loss on sale of non-current assets xx xxx
Less Gain on sale of non-current assets (x xxx)
Less Investment income (x xxx)
Less Interest paid (x xxx)
Less Taxes paid on income (usually corporation tax) (x xxx) (x xx x)
Operating profit before working capital changes xx xxx
Add Decrease in inventories xx xxx
Less Increase in inventories (x xxx)
Add Decrease in receivables xx xxx
Less Increase in receivables (x xxx)
Add Increase in payables xx xxx
Less Decrease in payables (x xxx) (x xxx)
Net cash from operating activities xx xxx
Cash flows from Investing Activities
Cash receipts from disposal of property, plant and equipment xx xxx
Receipts from investments disposal (other than cash equivalents) xx xxx
Collection of principal on loans made to other entities xx xxx
Interest and dividends received xx xxx
Cash payments to acquire property, plant and equipment (x xxx)
Loans to other entities (including suppliers or customers) (x xxx)
Payments to acquire investments (other than cash equivalents) (x xxx)
Net cash flow from investing activities xx xxx
Cash flows from Financing Activities
Cash proceeds from issuing equity and debt instruments xx xxx
Capital contributions (applies to unincorporated businesses) xx xxx
Payments to repay amounts borrowed & finance lease liabilities (x xxx)
Payments for the repurchase/ redemption of shares (x xxx)
Cash Drawings (applies to sole proprietorship & partnership) (x xxx)
Dividends paid or returns of capital (x xxx)
Net cash flow from financing activities xx xxx
Net increase (decrease) in cash and cash equivalents xx xxx
Cash and cash equivalents at the beginning of the year xx xxx
Cash and cash equivalents at the end of the year xx xxx
CHAPTER 3.5 BUSINESS FINANCING

QUESTION 1
The Company needs to improve its premises but the bank refuses either to allow a further increase in
overdraft or to grant a loan.
State six other possible sources of finance [6]
MAY 2003 P2 Q1 (c)
SOLUTION
Mark Scheme
Mention of any 6 of the following, for 1 mark each:
 Factoring
 Leasing
 Hire purchase (H.P.)
 Trade payables
 Money lenders - friends/relatives
 Mortgage/credit union
 Another (merchant) bank
 Shareholders etc.
[6]
Suggested Solution
 Further investment by the owner.
 Borrowing from other banks.
 Personal borrowing from friends, relatives.
 Buying on hire purchase.
 Buying on finance lease.
 Mortgage.
QUESTION 2
In May 2003 the directors of Omicron Ltd plan to build an additional factory. This requires initial capital
expenditure of $600 000 and is expected to start producing revenue and be profitable in three years’ time.
The directors are considering raising the additional funds for the project by one of the following methods.
1. The issue of 12% debentures 2006/2008 at par.
2. A rights issue of ordinary shares at $4 per share.
3. An issue of ordinary shares to the public at $4 per share.
The present rate of ordinary dividend would be maintained on all the old and new shares for the foreseeable
future.
REQUIRED
Discuss each of the methods of raising the capital, and state with reasons which method the directors
should choose. [10]
MAY 2003 P4 Q1 (d)
OR
K Limited is considering purchasing additional plant and equipment costing $30 000. This could be financed
by one of the following:
Bank loan
Issue of ordinary shares
REQUIRED
Advise the directors which method of finance they should choose. Justify your answer. [5]
OR
The directors of F Limited wish to purchase a new retail store for $400 000. They are considering two
different ways to raise the finance for this investment.
1 Issue a further $400 000 8% debentures (2026–2028).
2 Make a rights issue of 320 000 ordinary shares of $1 each at a price of $1.25.
REQUIRED
Advise the directors which method of raising the finance you would recommend. Give reasons for your
answer. [4]
OR
Profits have been constant for a number of years.
At the Annual General Meeting, the directors were confident that following the expansion next year the
ordinary shareholders will see an increase in dividends as profits for the year were expected to increase by
20%.
However, one of the ordinary shareholders expressed concerns that the Earnings per share would fall
following the rights issue on 1 January 2017. He proposed that a further expansion planned for two years’
time should be financed by a long-term loan instead.
REQUIRED
Recommend whether the directors should finance the future expansion with loans or rights issues. Justify
your choice using relevant calculations. [9]
SOLUTION
Mark Scheme
(i) A long-term loan would be a suitable form of financing for non-current assets (1). The lender would
need to convince that the company can meet the interest and repayment obligations. Interest on
the debentures would amount to $72000 per annum (1). This would be a prior charge on profit (1).
The debentures could be redeemed as soon as the new factory becomes profitable (1) so that all
the additional benefits from the investment would accrue to the existing shareholders (1).
(ii) The success of the rights issue depends upon all the new shares being subscribed for by the
existing shareholders (1). The required additional capital would be raised by the issue of an
additional 150000 shares (1). The additional dividend would amount to $60000 (1). The control of
the company by the existing shareholders will not be diminished by the addition of new
shareholders (1). All the additional benefits from the investment would accrue to the existing
shareholders (1).
(iii) A public issue of shares to them would be a more permanent form of capital than an issue of
debentures (1). A public issue may be more successful than a rights issue which is limited to
existing shareholders (1). The control of the company by the existing shareholders would be
diminished by the addition of new shareholders (1). Profits would have to be shared between the
existing and the new shareholders (1).
Recommendation: The additional capital should be raised by a rights issue (1). It should be
attractive to the shareholders (1) and will not involve sharing control (1) or profit (1) with outsiders.
(At least 2 marks must be reserved for recommendation.)
[10]
Teacher's Solution
(i) As debentures are a long-term loan and it can be redeemed on or before a specified date, which is
shown as part of its description. Debenture holders are not owners of the company in the same
way as shareholders are. Debenture interest of $72 000 ($600 00012%) is an allowable expense
for tax purposes. If company’s makes huge profits, additional profit after paying debentures holders
at a fixed rate will be available for ordinary shareholders.
(ii) In right issue, shares are offered to existing shareholders, not to the general public. If we issue 150
000 shares, required additional capital would be raised. The offer price of the rights issue is usually
advantageous to the shareholders and the company saves the expense and inconvenience of
preparing a full prospectus as for a public issue. Another advantage of a right issue is control of the
company remains with the existing shareholders however the dividend of $60 000 (if proposed at
present rate) is not an allowable expense for tax purposes.
(iii) An issue of ordinary shares is a more permanent form of capital than other forms. If the shares are
offered to public generally then they may result in loss of control of existing shareholders on
company’s management. Dividend paid to them is not an allowable expense for tax purposes;
however payment of dividend is not binding for companies as the payment of interest. A public
issue may be more successful than a rights issue. Moreover issuing of shares will not increase
gearing.
On the basis of above discussion, rights issue seems to be more advantageous for the company as it
ensures control of company remains with the existing shareholders and may also result in increased
existing shareholders’ commitment and loyalty towards the company.
QUESTION 3
5% debentures are due for repayment in the next two years. The directors of Bayliss Limited are considering
the following two options to raise the necessary finance to repay the $80 000.
1 Issue 160000 ordinary shares of $0.50 each.
2 Issue a further debenture of $80 000.
REQUIRED
(i) Discuss the impact of each option on the future profits of Bayliss Limited. [4]
(ii) Advise the directors which option they should choose. Give reasons for your decision. [7]
MAY 2016 P21 Q1 (d)
SOLUTION
Mark Scheme
(i) Ordinary shares
Dividends paid to ordinary shareholders do not affect profit (1) they reduce retained
earnings (1) in the statement of changes in equity (1). Does not appear in the income
statement (1).
Debenture
Interest paid to debenture holders is charged to the income statement (1) reducing the
profit for the year (1).
Max 2 marks for each option. Overall max 4 marks. [4]
(ii) Decision (1)

Interest on the debentures must be paid whether the company makes a profit or a loss (1).
Ordinary share dividends are paid at the discretion of the directors (1).
Debentures are a non-current liability (1) and weaken the statement of financial position
and increase gearing (1) whereas ordinary shares are part of the permanent capital of the
company (1).
Reasons Max 2 marks [3]
Suggested Solution
(i) An issue of ordinary shares is a more permanent form of capital than other forms. If the shares are
offered to public generally then they may result in loss of control of existing shareholders on
company’s management. Dividend paid to them is not an allowable expense for tax purposes;
however payment of dividend is not binding for companies as the payment of interest. A public
issue may be more successful than a rights issue.
(ii) As debentures are a long-term loan and it can be redeemed on or before a specified date, which is
shown as part of its description. Debenture holders are not owners of the company in the same
way as shareholders are. Debenture interest of $72 000 ($600 00012%) is an allowable expense
for tax purposes. If company’s makes huge profits, additional profit after paying debentures holders
at a fixed rate will be available for ordinary shareholders.
(iii) On the basis of above discussion, issue of ordinary shares seems to be more advantageous for
the company as it ensures control of company remains with the existing shareholders and dividend
is only payable if company makes profits and also depends upon the dividend policy of directors.
QUESTION 4
Patel wishes to expand his business and is undecided about taking out a five year loan or asking the bank
for an overdraft.
REQUIRED
State one advantage and one disadvantage of each option. [6]
MAY 2015 P21 Q1(c)
SOLUTION
Mark Scheme
Five year loan
Advantage:
 Fixed rate of interest
 Helps plan cash flow
Disadvantage:
 May pay more interest if rates fall
 Interest payable for whole period
 May be secured on assets
Bank overdraft
Advantage
 No interest charged if not used
 Can be paid off whenever you like
Disadvantage
 Higher rate of interest than loan
 Can be called in by the bank at any time
1 mark for each advantage and disadvantage.
1 mark x 2 for development.
Suggested Solution
Five year loan
Advantage:
Fixed rate of interest
Helps to plan cash flow in a better way
Will be available for a long period
Disadvantage:
Interest payable for whole period
May be secured on assets
Bank overdraft
Advantage
No interest is charged if not used
Can be paid off whenever business prefers
Disadvantage
Higher rate of interest than loan
Can be called in by the bank at any time
QUESTION 5
The partnership has recently purchased new premises and needs new equipment costing over $100 000.
REQUIRED
Identify two methods of raising extra finance and state one advantage and one disadvantage of each
method. [6]
NOVEMBER 2007 P2 Q1
OR
The partnership is considering expansion and will need to purchase additional non-current assets at a cost
of $60 000.
REQUIRED
(i) Discuss two possible sources of finance which could be used to fund the purchase of the additional
non-current assets. [6]
(ii) Recommend the most appropriate source of finance for the partnership. Justify your answer. [2]
NOVEMBER 2016 P22Q1 (f)
SOLUTION
Mark Scheme
(i) Partner introduces additional capital
Each partner brings in more cash. Control retained, doesn’t need to be repaid.but assumes partners
have more cash to invest.
(ii) Bring in a new general partner.

Eases workload but less share of profits. The partner would however expect a share of the profits
and the ownership would be diluted which could lead to conflict.
(iii) Form private limited company.

Smaller share of profit and possibly no easing of workload.
(iv) Long-term loan.

Has to be paid back with interest at either a fixed or variable rate, allows forward planning but must
be paid.May require security / collateral to cover the possibility of loan default.
(v) Partner’s loan
(vi) Sale of unused non-current assets
(vii) Hire purchase Etc.

One mark for method, one for each valid point to maximum of three per suggestion.
(max 3 marks per source) Marks [6]
NOVEMBER 2016 P22Q1 (f)1 mark for a decision about the source of funding and max 1
mark for any justification of the outcome. [2]
Suggested Solution
(i) Non-current borrowing from bank
Advantage: It will provide ease in working capital condition and business can plan for the
future as the repayment of such borrowing can be done over a longer period.
Moreover Maneesh will keep all future profit earned
Disadvantage: High rate of interest.
(ii) Additional capital by partners

Advantage: No outsider’s influence on the business and interest payment can be saved.
Disadvantage: Capital is limited to personal resources.
(iii) Admission of a new partner

Advantage: It will bring in additional expertise and will provide ease in working load
Disadvantage: Reduction in future profit shares of Maneesh as he will lose 10% of profits earned.
.
QUESTION 6
The directors of a company want to raise finance to use during 2013.
Their options are:
1. to take out a loan repayable over 5 years with interest at 6% per annum
or
2. to make a rights issue of one ordinary share for every 2 shares held, at a 5% discount on the current
market price.
REQUIRED
Explain one disadvantage of each of the possible methods of raising the finance. [6]
SOLUTION
Mark Scheme
Loan – annual interest has to be paid out of profits before appropriations to the shareholders. It may be
secured on non-current assets which cannot be sold for the length of the loan. 3
Rights issue - usually the market price of the shares drops after a rights issue and not all shareholders will
chose to take up the rights so not all the desired money will be raised. 3 [6]
Suggested Solution
On loans, fixed amount of interest has to be paid irrespective of profit or loss made by the company. In
addition, if the loan is secured on non-current assets then these assets cannot be sold unless loan is being
paid off.
Rights issue usually results in reduction in market value of shares. It is possible that all shareholders do
not take up their rights and as a result required funds could not be raised.
QUESTION 7
(i) The directors of a limited company wish to raise funds to expand the business. State two sources
of finance they could use. [2]
(ii) State the advantages and disadvantages to the company of the two sources of finance you have
chosen. [6]
SOLUTION
Mark Scheme
(i) Ordinary shares; Preference shares; Debentures; Long term loans; Factoring; Disposal of non-
current assets no longer used.
(1 mark each for any two) [2]
(ii) Ordinary Shares:

Advantages: They company does not have to pay a dividend if profits are low. Dividends
vary with profits.
Disadvantages: Ordinary shareholders have a vote at annual general meetings. In a private
company they can change the balance of control.
Preference Shares:
Advantages: The shareholders have no right to vote at AGM. The dividends are fixed.
Disadvantages: Low or no profits, dividends may have to be paid or provided.
Debentures/Long term loans:
Advantages: Fixed rates of interest, repayment date known.
Disadvantages: Interest needs to be paid even if no profit made, security may be required by
the lender. (2 × 3 marks to max 6) [6]
QUESTION 8
(i) Discuss two possible sources of finance which could be used to fund the purchase of the additional
non-current assets in a partnership. [6]
(ii) Recommend the most appropriate source of finance for the partnership. Justify your answer. [2]
SOLUTION
Mark Scheme
(i) Possible options could include:
Loan Has to be paid back with interest at either a fixed or variable rate. May require
security / collateral to cover the possibility of loan default. Spreads the cost of
purchasing the asset over the life of the asset.
New partner Would introduce capital which doesn’t need to be repaid. The partner would
however expect a share of the profits and the ownership would be diluted which
could lead to conflict.
(max 3 marks per source) [6]
(ii) 1 mark for a decision about the source of funding and max 1 mark for justifying the
outcome. Based on the answer to part (e) (i). [2]
Suggested Solution
(1) Non-current borrowing from bank
Advantage: It will provide ease in working capital condition and business can plan for the
future as the repayment of such borrowing can be done over a longer period.
Disadvantage: High rate of interest.
(2) Additional capital by partners
Advantage: No outsider’s influence on the business and interest payment can be saved.
Disadvantage: Capital is limited to personal resources.
(3) Admission of a new partner
Advantage: It will provide ease in working load
Disadvantage: Reduction in future profit shares of the existing partners.
(ii) Injection of additional capital by partners seems to be most appropriate source of finance for the
partnership as it doesn’t need to be repaid. Moreover no outsider’s influence on the business and
interest payment can be saved.
QUESTION 9
A club wishes to buy a new boat for use by members. It will cost $12 500.
(d) Suggest three ways the club could raise the finance to purchase the new boat. [3]
(e) State one advantage and one disadvantage of each method you have suggested. [6]
MAY 2014 P23 Q1 (d & e)
SOLUTION
Mark Scheme
(d) 1 Use funds from the deposit account
2 Bank loan
3 Ask members for donations
4 Fund raising events
1 mark per valid suggestion (3) [3]
(e) Answers will be based on methods selected. For those above:
1 Advantage: Immediate funds available.
Disadvantage: No cash reserves for the club. Loss of interest.
2 Advantage: Funds available from bank for full amount.
Disadvantage: Interest will have to be paid. May require security.
3 Advantage: No interest payable.
Disadvantage: May not raise enough money, so other / additional method will be needed.
4 Advantage: No interest payable.
Disadvantage: May not raise enough money, so other / additional method will be needed.
1 mark for advantage and 1 for disadvantage (max. 6) [6]
Suggested Solution
1 Use of funds from the deposit account
Advantage: Immediate availability of funds.
Disadvantage: No cash reserves will be left. Interest income on deposit will be lost
2 Bank loan
Advantage: Funds available from bank for full amount.
Disadvantage: Bank loans usually require security. Interest will have to be paid.
3 Ask members for donations
Advantage: No fixed interest charges.
Disadvantage: May not generate required funds so some other source may be required.
QUESTION 10
A club is considering modernising the pavilion which will cost $75 000.
REQUIRED
(i) Compare and contrast two sources of finance which the club could use. [4]
(ii) Advise the club members which source of finance would be most appropriate. Justify your answer.
[3]
MAY 2016 P31 Q1 (d)
SOLUTION
Mark Scheme
(i) Sponsorship
Use funds from bank account as well as another source of finance.
Debentures
2 marks for each comparison point.[4]
(ii) 1 mark for decision and 2 marks for justification of the decision based on (d)(i).[3]
Suggested Solution
2 Bank deposit and bank loan
Advantage: Funds available from bank for full amount.
Disadvantage: Bank loans usually require security. Interest will have to be paid.
3 Sponsorship
(ii) A combination of the above sources may be more beneficial for the club. For instance, Fund raising
events or sponsorships may be arranged. In case these sources do not generate required funds
then bank balance may be used. In case, there is still some deficiency then a loan may be arranged.
QUESTION 11
Barkis& Co. Ltd require more funds to purchase an additional machine to complete further orders. Three
methods of doing so have been discussed. Give one advantage and one disadvantage of each method.
(i) a rights issue;
(ii) an issue of shares to the public;
(iii) an issue of debentures. [6]
MAY 2002 P2 Q3 (d)
SOLUTION
Mark Scheme
Rights issue
A Saves on expense of a full public share issue.
B May bring in less cash than a full public share issue.etc.
Issues of shares to the public
A May be sold at a premium and bring in large cash fund.
D Costs a great deal of money and no guarantee that all will be sold.etc.
Issue of debentures
A No control given to debenture holders.
B Interest must be paid even if business is making a loss etc.
One advantage and one disadvantage for each to maximum (6)
Teacher's Solution
(i) Rights Issue:
Advantage: Control on company's affairs remains with the existing shareholders.
Disadvantage: Dividend paid to them is not an allowable expense for tax purposes. A
dilution in the list price of the ordinary shares may occur.
(ii) Issue of Shares to Public:
Advantage: Control not being lost or transferred to debenture holders.
Disadvantage: Management control cannot be with the existing shareholders.
(iii) Issue of Debentures:

Advantage: Debenture interest is an allowable expense for tax purposes.
Disadvantage: Debenture interest has to be paid whether or not company makes a
profit.
QUESTION 12
Sanghera Manufacturing plc produces office desks in two versions, standard and superior. The directors of
Sanghera Manufacturing plc wish to raise additional finance for investment.
REQUIRED
Identify two possible sources of finance the directors could use and explain one advantage and one
disadvantage of each method you have chosen. [6]
SOLUTION
Mark Scheme
The possible sources of finance may include share issue, debentures, bank loan, disposal of surplus
non-current assets, debt factoring [2]
 Public issue
 expensive
 needs underwriting to ensure success
 requires prospectus
 dilutes control
 no legal necessity to pay dividend in a bad year
 Right issue
 no dilution of control
 generally cheaper
 Debenture issue/loan
 interest is always payable
 may require security/floating charge
 needs to be paid back/redeemed
 interest is charged against profit
 no votes in general meeting
 Disposal of non-current assets

 no loss of control within ownership
 no costs/bank charges
 immediate cash
 but may lead to insufficient assets as business grows
 Debt factoring
 immediate cash
 there is a cost associated with factoring and not all of the debt will be collected
[Max 6]
Teacher's Solution
(i) Public issue of shares, rights issue, debentures issue, bank loan, disposal of surplus non-current
assets, debt factoring.
(ii) Public issue

Advantages
 Reduce gearing level
 no legal obligation to pay dividend in the years of low or no profitability
Disadvantages
 Expensive
 dilutes control of existing owners
Right issue
Advantages
 no dilution of control of existing owners
 Enjoy voting rights
Debenture issue/loan
Advantages
 charging of interest against profit which is admissible expense for tax purposes
 trading on equity
Disadvantages
 need to be redeemed (repaid)
 interest is always payable regardless of profitability
 no voting rights in general meeting
 may require security / floating charge
QUESTION 13
During the next financial year it is anticipated that plant modernisation will be required and that additional
capital will have to be raised. The directors are considering four options:
1 Issue of 10% debentures.
2 New share issue.
3 Rights issue.
4 Bonus issue
REQUIRED
Explain the advantages and disadvantages of each option and recommend the most appropriate
option. [11]
MAY 2012 P43 Q2 (c)
SOLUTION
Mark Scheme
Bonus issue:
Not a feasible option 1 since cash will not be raised 1
Issue of 10% debentures:
Interest payments must be made even if the company makes a loss 1 but if the company makes higher
profits than anticipated they will not be required to increase the interest payments 1.
Cash will be required for the redemption 1
New share issue:
The issue of new shares could affect control 1.
Dividends would only be paid if sufficient profits are available 1.
Rights issue:
The issue would not affect control 1. Dividends would only be paid if sufficient profits are available 1.
Conclusion with a reason 2 [11]
Suggested Solution
Public issue
Advantages
 Reduce gearing level
 no legal obligation to pay dividend in the years of low or no profitability
Disadvantages
 Expensive
 dilutes control of existing owners
Right issue
Advantages
 no dilution of control of existing owners
 Enjoy voting rights
Disadvantage:
 Dividend paid to them is not an allowable expense for tax purposes.
 A dilution in the list price of the ordinary shares may occur.
Debenture issue/loan
Advantages
 charging of interest against profit which is admissible expense for tax purposes
 trading on equity
Disadvantages
 need to be redeemed (repaid)
 interest is always payable regardless of profitability
 no voting rights in general meeting
 may require security / floating charge
Disposal of non-current assets

Advantages
 no loss of control within ownership
 no fixed costs involved
 will generate immediate cash
Disadvantages
 may affect business operations
 may become insufficient as business grows
Bonus issue:
Issue of bonus shares should not be considered as it does not involve any cash inflow as bonus shares are
issued free of price to existing shareholders.
QUESTION 14
Your friend Brian has just inherited $10 000 and would like to invest in Frame-Patel plc. He is undecided
whether to invest in ordinary shares (the current market price is $1.70 per share) or in 7 1/2% debentures
that can be purchased at par value.
REQUIRED
Discuss the merits and disadvantages of the two investments in Frame-Patel plc and advise Brian which
one to choose. Give reasons for your choice. [5]
MAY 2009 P4 Q1 (d)
OR
An investor, Bevin, is considering acquiring ordinary shares in M plc. He has been advised that the directors
intend to raise extra funds by issuing a further 5% debenture (repayable 2027).
REQUIRED
Advise Bevin whether or not he should make the intended investment. Justify your answer. [6]
NOVEMBER 2017 P31 Q3 [d (ii)]
SOLUTION
Mark Scheme
 Debentures are safer investment for Brian (0–3)
 Debentures will currently give a greater yield (0–3)
 The issue of the debentures will increase the gearing. (1)
 A greater proportion of profits will be paid to these holders lowering availability to Bevin. (1)
 Bevin may not receive dividends in years of low profits. (1)
 The market value, however, has risen and this may continue. (1)
 Interest payment and capital repayment on the debenture has to be paid regardless of the level of
profits (1). This could affect possible dividend payment to Bevin. (1)
 Bevin should not invest (1) without further information. (1)
 Ordinary shares may give greater rewards (dividends) in the future (0–3)
 Potential for greater capital growth with ordinary shares (0–3)
 Ordinary shares give ownership rights (0–3) [max 4]
1 mark for advice based on analysis [1]
Suggested Solution
Investment in ordinary shares
(i) Investments in ordinary shares of Frame-Patel plc will give Brian ownership rights, as after
becoming ordinary shareholder he will be entitled to attend and cast his vote in general meetings
of the company.
(ii) If company makes large profits, then Brian will have a chance to be rewarded in the form of higher
dividends greater capital growth with ordinary shares.
Investment in debentures
(i) The fixed interest rate offered on debentures to Brian is higher than the dividend yield presently
earned on ordinary shares.
(ii) Debentures are safer investment for Brian as debenture holders have a higher priority for getting
repayment of their investment if a company is liquidated (wound up) than preference shareholders
and ordinary shareholders.
(iii) Moreover dividends on ordinary and preference shares cannot be paid unless the fixed interest on
debentures is provided for.
(iv) Interest on the debentures must be paid whether the company makes a profit or a loss.
(v) Debenture interest is an allowable expense for tax purposes.
(vi) If company’s makes huge profits, additional profit after paying debentures holders at a fixed rate
will be available for ordinary shareholders.
(vii) If company’s makes low profits, the payment of ordinary dividend could be at risk.
(viii) The issue of debentures will increase the gearing level.
(ix) Needs to be redeemed after the agreed time period
QUESTION 15
Advise Sunil whether or not he should apply for a loan rather than maintain an overdraft. Justify your
answer. [3]
SOLUTION
Mark Scheme
Advice (1). Justification (2)
If overdrawn balance is expected every month for the next year (1) then a loan is recommended (1)
An agreed loan should be cheaper than a long term overdraft.(1) [3]
Suggested Solution
A long term loan should be more appropriate tool of financing if overdraft balance is expected throughout
the year as the interest on a loan tends to be lower than an overdraft.
QUESTION 16
Recommend to the managing committee of the club whether or not they should proceed with the purchase
of the premises. Justify your answer by discussing both advantages and disadvantages of the
purchase. [7]
SOLUTION
Mark Scheme
Advantages
 Purchases of premises seems to be cheaper than renting in long-term.
 Potential investment which could be sold in the future.
 Club may be able to rent out room(s) to other community groups, etc. to bring in income
 No worries about rent rises
(1) mark × 3 points. Max 3
Disadvantages
 Club will responsible for maintenance
 Club will bear the running cost of the building
 Club will need to pay off the loan / interest
 Are projections of life membership income achievable?
(1) mark × 3 points. Max 3
Recommendation (1)
Suggested Solution
Advantages
 Certainty of securing a long term business location
 An investment that will potentially increase in value
 Helps to avoid any sudden, large rent increases
 Ability to customise the premises without the landlord’s consent
 Increase the value of the business and the net wealth of the business owner
 The unused area of the building space may be sublet to generate some additional revenue
Disadvantages
 High initial cost -- this amount invested might be used for more important business
purposes.
 Owning a property also comes with responsibilities like responsibility for maintenance,
fixtures and fittings, decoration and security.
 Any fall in the value of the property will decrease your capital.
 It is usually harder to relocate the business, because selling business premises is a complex and
sometimes lengthy process.
 Payment of loan interest and repayment of loan are also important factors.
QUESTION 17
Discuss two disadvantages to the company of the issue of the debentures. [4]
SOLUTION
Mark Scheme
 The issue of the debentures had an adverse (1) effect on the income gearing and gearing ratios.
 The company is now seen to be more risky (1).
 The company may be perceived as being less attractive to investors (1)
 The company has had to pay additional finance costs (1). This has reduced profits available to
distribute to shareholders (1). This may have a negative effect on its liquidity. (1)
 The company has a significant repayment commitment (1) and annual interest payment (1) for
which the directors need to plan if profits fall. (1)
 Debentures may be secured on the assets of the company (1) which may mean the asset is sold
to repay it if necessary. (1)
1 for comment + 1 for development
2 marks x 2 points
Suggested Solution
The issue of the debentures will adversely affect gearing and the income gearing ratio. With the increase
in gearing level, the company will be more risky. The issue of debentures resulted in additional finance
costs, which has had to be paid whether or not company makes a profit. This also reduced profits available
to distribute to shareholders.
Issue of debentures may also negatively affect company’s liquidity. The company has to make an effective
plan with regard to repayment of debentures and annual interest payment.
Issue of debentures does not involve any sharing of management control. Moreover, debenture interest is
an allowable expense for tax purposes
QUESTION 18
Advise Sunil whether or not he should apply for a loan rather than maintain an overdraft. Justify your
answer. [3]
SOLUTION
Mark Scheme
Advice (1). Justification (2)
If overdrawn balance is expected every month for the next year (1) then a loan is recommended (1)
An agreed loan should be cheaper than a long term overdraft.(1) [3]
Suggested Solution
A long term loan should be more appropriate tool of financing if overdraft balance is expected throughout
the year as the interest on a loan tends to be lower than an overdraft.
Section 4 132 A2 Level – Financial Accounting
SECTION 4 A2 LEVEL – FINANCIAL ACCOUNTING

CHAPTER 4.1 ACCOUNTS OF NON PROFIT ORGANISATIONS 133
CHAPTER 4.2 INTERNATIONAL ACCOUNTING STANDARDS 139
CHAPTER 4.3 AUDITING 148
CHAPTER 4.4 RATIO ANALYSIS - SUPPLEMENT 154
CHAPTER 4.5 PURCHASE OF BUSINESS 160
CHAPTER 4.6 ACCOUNTING FOR JOINT VENTURES 163
CHAPTER 4.7 CONSIGNMENT 166
CHAPTER 4.8 COMPUTERIZED ACCOUNTING 169
CHAPTER 4.9 MANUFACTURING ACCOUNTS 174
CHAPTER 4.1 ACCOUNTS OF NON PROFIT ORGANISATIONS

QUESTION 1
Explain three differences between the financial statements of a not-for-profit organisation and the financial
statements of a public limited company. [6]
MAY 2011 P42 Q2 (c)
OR
State two differences between the financial statements of a not for profit organisation and those of a limited
company. [2]
MAY 2016 P32 Q1 (a)
OR
Identify four terms used only in the financial statements of a not-for-profit organisation with the
corresponding terms used in the financial statements of a profit-making business. [4]
SOLUTION
Mark Scheme
Not-for-profit organisation Public limited company
Has balance sheet Has statement of financial position
Shows accumulated fund Shows share capital and reserves
Has income and expenditure account Has income statement
Shows surplus or deficit Shows profit or loss
Limited access to financial statements General access to financial statements
Has receipts and payments account Has statement of cash flow
2 for any pair [max 6]
Suggested Solution
Public limited company Not-for-profit organisation
(i) Prepares income statement Prepares income and expenditure account
(ii) Excess of total incomes over total expenses Excess of total incomes over total expenses is
is called profit called surplus
Excess of total expenses over total incomes Excess of total expenses over total incomes is
is called loss called deficit
(iii) Shows share capital and reserves Shows accumulated fund
(iv) Financial statements are published and Financial statements are not published
available for general view
(v) Prepares statement of cash flows Prepares receipts and payments account
QUESTION 2
Distinguish between the terms ‘capital’ and ‘accumulated fund’. [2]
MAY 2016 P31 Q1 (a)
OR
Distinguish between the capital of a sole trader and the accumulated fund of a non-profit-making club or
society. [2]
SOLUTION
Mark Scheme
The capital of a sole trader is his own investment (1)
The accumulated fund is the surplus funds gained by the club from the members. (1)
The capital is increased by profits. (1) The fund is increased by surpluses. (1)
Capital is reduced by losses or drawings. (1) The fund is decreased by deficits. (1)
Suggested Solution
In a trading organization, term capital is used to represent the amount invested by owner within the
business. As there are no owner(s) in non-profit organisations so accumulated fund replaces capital in this
case and represents the accumulation of surpluses over a number of years. Drawings by a sole trader
reduce his capital but as there is no owner in a non-profit organisation so accumulated fund is not affected
by drawings. Capital increases through profits and reduces by losses & drawings whereas surpluses are
added in accumulated funds and deficits are subtracted.
QUESTION 3
In a Trading organisation, what are the equivalents of the ‘Receipts and Payments Account’ and the
‘Accumulated Fund’ in a non-profit making organisation? [2]
MAY 1999 P2 Q1 (a)
SOLUTION
Cash book is equivalent of Receipts and Payments account and Capital is equal to Accumulated fund in
Profit making organisations.
QUESTION 4
State the main difference between the Surplus in an Income and Expenditure Account and the Profit in an
income statement. [1]
MAY 1999 P2 Q1 (a)
SOLUTION
Profit is available for distribution among the owners whereas surplus (relates to non-profit organisations)
cannot be distributed amongst its members.
QUESTION 5
Distinguish between a Receipts & Payments A/c and an Income & Expenditure A/c. [4]
NOVEMBER 2003 P2 Q1 (e(ii))
SOLUTION
Mark Scheme
Receipts & Payments A/c records all cash/cheque transactions through the year; 2
Income & Expenditure A/c takes into account accruals & prepayments. 2 (4)
Suggested Solution
In general Receipts and Payments account may be called abridged cash book as all the cash transactions
of the whole year are recorded in it in a summarised form. On the other hand the Income and Expenditure
Account may be linked with the income statement of a business concern. The major differences between
the two accounts are shown below.
Receipts and Payments Accounts Income and Expenditure Account

It begins with an opening and ends with a closing There is no opening or closing balance. However,
balance of cash and bank (though sometimes they it ends with surplus or deficit of the period
are merged) concerned.
It records all amounts received or paid whether It includes revenue items only
relate to capital or revenue items.
It includes cash items only It also includes non-cash incomes or expenses of
revenue nature.
It includes all cash and bank receipts and payments, It includes both cash and non-cash revenue items
whether they are related to current, past or future related to the current year only.
year.
QUESTION 6
State two advantages and two disadvantages of using a receipts and payments account instead of an
income and expenditure account, in a non-trading organisation. [4]
SOLUTION
Mark Scheme
Advantages
 Show cash position
 Easy to record
Disadvantages
 Capital and revenue expenditure not separated
 Depreciation ignored
Any two sensible advantages and disadvantages acceptable.
Not more than two of each. [4]
Suggested Solution
Advantages
 It provides a summary of cash transactions for a financial period.
 It shows cash position at start and at the end of the accounting period
 It is easy to maintain and understand.
Disadvantages
 It includes all capital & revenue receipts and payments which are not separated.
 It ignores the fact that there may be many receipts or payments which are of capital nature or
related to preceding or coming years.
 It ignores non-cash items (e.g. depreciation or subscription written off etc)
 It shows no records of assets and liabilities other than cash or bank balances
QUESTION 7
State three reasons why, for most clubs, a Receipts and Payments Account is not always a satisfactory
record of the club’s activities.
MAY 2006 P2 Q2 (c)
SOLUTION
Mark Scheme
(i) The receipts and payments account shows no records of assets other than the bank balance
and any assets bought or sold during the year. This is unsatisfactory as a club may have assets
worth thousands of dollars.
(ii) No depreciation of fixed assets is provided for.
(iii) No record of liabilities other than possibly bank balance, so no way of telling if club is in debt, other
than by asking treasurer.
(iv) No knowledge of surplus or deficit for year which would help in determining subscriptions for year
etc.
Any three to maximum [3]
Suggested Solution
Provision of only Receipts and Payments account to members can be unsatisfactory for the members as it
includes all capital & revenue receipts and payments but ignores the fact that there may be many receipts
or payments which are of capital nature or related to preceding or coming years. Moreover it also ignores
non-cash items (e.g. depreciation) so to show the performance of the business for a particular year, Income
and Expenditure should be provided to the members. Lastly the receipts and payments account shows no
records of assets and liabilities other than the bank.
QUESTION 8
State two accounting methods of treating donations received by the Club. [4]
SOLUTION
Mark Scheme
As income in the l & E account or 2
shown separately in the balance Sheet, 2
Suggested Solution
Donations may be treated as an income in the Income and Expenditures account. Alternatively it may also
be shown as a special fund in the balance sheet.
QUESTION 9
Explain why a club may capitalise donations received from its members. [2]
MAY 2016 P31 Q1 (c)
SOLUTION
Mark Scheme
 Variable amount received
 Not part of regular income
 Maybe allocated to specific projects in the future
Any 2 points 1 mark each. [2]
Suggested Solution
As donations are not received on regular basis and their amounts vary from year to year so clubs capitalise
the donations amounts. In addition, donations may be treated as an income in the Income and Expenditures
account. However if donation is received for a specific purpose then it may be shown as a special fund in
the balance sheet.
QUESTION 10
State three differences between a donation and a member subscription received by a not-for-profit
organisation. [3]
SOLUTION
Mark Scheme
Donation Member subscription
Voluntary Basis Member’s obligation
From Members and non-members From members only
Irregular payment Regular payment, i.e. monthly or annually
Can be ear marked for specific purpose e.g. For daily running of the organisation e.g.
Buy new equipment Paying for day to day expenses
Can be capitalised Cannot be capitalised
(1 mark) × 3 differences [3]
Suggested Solution
Donation Member subscription
Voluntary basis (not of binding on donors) Members’ obligation
May be from both members and non-members From members only
Irregular payment Regular payment, i.e. monthly or annually
May be for a specific purpose or for general For daily running of the organization
purpose
May be treated as revenue or capital item, Only treated as a revenue item (income)
depending upon the nature
QUESTION 11
Discuss whether or not the treasurer should invest the fund (donated amount) for the club-house in a
separate long-term savings account. Justify your answer. [5]
SOLUTION
Mark Scheme
Yes (1)
The donation was for a specific purpose (1) and so should not be paid into the current account (1) in case
it is not used for that purpose.
It is for future use (1) and so can be used to earn interest in the interval. (1)
It will ensure that the members appreciate the amount of funds available for current running costs (1) and
what are reserved for a special purpose. (1)
Any payments made for the purpose of expanding the facilities will be paid from this account (1) and so
ensuring members know about any ongoing developments. (1)
Decision (1), Justification Max 5
Suggested Solution
 As donation is received for a specific long term purpose so should be invested in long term saving
account.
 This investment will create a source of income for the organization.
 It would diversify the incomes of the organization and reduces its dependency on conventional
earning sources.
 The interest on long term saving account may help to “smooth out” the overall income stream.
QUESTION 12
The treasurer had suggested increasing cafe prices and the rate of lifetime subscriptions but the club
committee refused to do this.
Instead, the committee decided to raise the ordinary subscriptions by 50%.
Suggest three additional ways in which the club could try to minimise or eliminate the deficit in future years.
[6]
SOLUTION
Mark Scheme
 Increase membership
 Increase subscriptions
 Encourage life subscriptions
 Social events
Or other relevant suggestions
(3 × 2 marks for analysis) (1 plus 1 for development) [6]
Suggested Solution
 Increase annual subscription or reduce annual subscription charge to attract more potential
members.
 Use clubhouse extensively for social events and other functions
 Parking fee may be introduced
 life subscriptions may be encouraged
QUESTION 13
State two reasons why the members of a not-for-profit organisation do not receive a dividend [2]
SOLUTION
Mark Scheme
Making a profit is not the main reason for clubs (1) They provide facilities for the members (1). The club is
owned by the members (1) providing they have paid a subscription for membership (1). Any surplus is used
to improve the facilities and provide other benefits for the members (1).
[2]
Teacher's Solution
A not-for-profit organisation is a legal entity which nobody owns. It has trustees or members, who run the
organization but cannot sell their "trusteeship or membership". It is not allowed to distribute profits to
anyone, no matter how much money it makes. In these organisations 100% of the money (surplus) earned
is re-invested in the organisation to finance the main cause of the organisation.
QUESTION 14
Explain why the club transfers life membership fund to the income and expenditure accounts over 10 years.
[4]
OR
Explain the accounting treatment of the life subscriptions. [2]
SOLUTION
Mark Scheme
The life membership is payment of a lump sum (1). The subscription received is debited to the bank/receipts
and payments account and credited to the life membership fund (1). In accordance with the matching
concept (1) it will inflate the surplus if it is all entered in the income and expenditure account in the year in
which it is paid. (1) An amount is transferred annually to the income and expenditure account. (1) The
remaining balance in the fund is shown in the statement of financial position. (1)
Also the club owes those members the benefit of membership for a number of years (1) not just the year of
joining. (1) [4]
Teacher's Solution
In case of life membership, the members are generally required to make only one payment in a
lump sum which enables them to become the members for whole of their lives.
As 'life membership fees' is a substitute for 'annual membership fees', therefore, it is debited to
bank account and credited to a separate life fee fund and fair proportion be credited to income in
subsequent years as the organisation is supposed to provide membership facilities for the rest of
their lives.
This treatment is also in compliance with the matching concept. The life fee should be spread
over a suitable time period for which club is expecting to provide services to the life members.
The suitable time period may be determined through dividing the life fee by the annual
membership fee.
QUESTION 15
Gurmukh, a retired gentleman, is considering joining the club and seeks your advice on whether or not he
should pay an annual subscription or the life membership.
Advise Gurmukh whether or not he should become a life member. Justify your advice. [5]
SOLUTION
Mark Scheme
Beneficial if live longer than 10 years. (1) Otherwise not beneficial. (1)
Does he have funds available to pay $1000? (1)
Saves ‘trouble’ of renewing every year. (1)
Avoids any increases in subscriptions over the period (1)
There may be other benefits for life membership. (1)
If he wishes to resign before the ten-year period, he may not get any refund. (1)
Decision. (1)
Max. 4 + Decision 1 [5]
Teacher's Solution
If Gurmukh has $1 000 to pay life fee he would not be required to pay membership fee again in his life
irrespective of changes in annual membership rates. As Gurmukh is a retired personnel so it can only
benefit him on financial grounds if he lives for a period more than one year. Clubs usually offers special
benefits for life members which could also be there. However, life fee, once paid is not recoverable or
refundable.
On the basis of above discussion, Gurmukh may become life member if he has ample funds like $1 000and
his health conditions are good.
CHAPTER 4.2 INTERNATIONAL ACCOUNTING STANDARDS

QUESTION 1
Advise the directors whether or not they should apply the International Accounting Standards when
preparing the published accounts. Justify your answer. [4]
OR
State four reasons why the business should comply with International Accounting Standards when financial
statements are being prepared. [4]
MAY 2017 P32 Q3 (1)
SOLUTION
Mark Scheme
The directors should apply the international standards (1)
 Financial statements need to be understandable by different interested stakeholders;
 Financial statements need to be relevant for decision making (1)
 Financial statements need to be reliable (1)
 Financial statements need to be comparable (1)
 Accounting policies adopted are appropriate (1)
 Accounting concepts/assumptions are adhered to, i.e. Prudence, accrual, going concern and
consistency (1)
 To ensure fair representation and to show true and fair view (1)
 Form the basis of auditor’s opinion (1)
 The external auditor will qualify the audit report Or if international standards are not complied with
(1)
Accept any reasonable alternative
(1 mark) × 4 valid points
Teacher's Solution
The international accounting standards should be applied by the directors as they offer the following
benefits.
 They reduce the confusing variations in the accounting treatments while preparing financial
statements.
 They describe the accounting principles, the valuation techniques and the method of applying
accounting principles so to ensure true and fair view.
 Where important information is not statutorily required, accounting standards calls for its disclosure
 Accounting standards facilitate comparison of financial statements of companies in the same
industry situated in different parts of the world.
 Accounting standards help in resolving conflict of financial interest among various stakeholders.
 Accounting standards help the auditors in case of preparation of financial statements and any
deviation can be disclosed in the reports so that users are aware of such deviations.
QUESTION 2
State how a proposed final dividend should be dealt with in the accounts. [2]
OR
Explain how proposed dividends are treated in the published accounts. [3]
MAY 2013 P41 Q2 (d)
OR
Explain the treatment of the final dividend proposed on 1 April 2014. [4]
OR
State how a proposed dividend would be treated in the financial statements. [2]
OR
Explain how the proposed final dividend should be treated in the financial statements for the year ended 31
December 2016. [2]
SOLUTION
Mark Scheme
The proposed dividend is not a liability at the statement date and is therefore accounted for in the next
period (1). It is disclosed by way of a note in the accounts for the current year (1) [2]
Suggested Solution
Under IAS 1, the final dividend is not accounted for in the financial statements unless it is approved by the
ordinary shareholders in the annual general meeting.
It is however disclosed as a note to the accounts as non-adjusting event. This is included in the next year
financial statements.
QUESTION 3
Give two examples of cost of purchase and two examples of cost of conversion. [4]
MAY 2013 P43 Q3 (e)
SOLUTION
Mark Scheme
Cost of purchase – purchase price
import duty
transport costs
handling costs
other directly attributable costs
Any 2 for 1 mark each
Cost of conversion –direct labour
direct materials
production overheads
Any 2 for 1 mark each [4]
Suggested Solution
Cost of purchase – Purchase price, carriage inwards, import duty, handling costs other costs
directly attributable to purchased items.
Cost of conversion –direct labour, other direct expenses, production overheads
QUESTION 4
G Limited adopted the Weighted Average Cost (AVCO) method to ascertain the value of inventories in
2016. The purchase price has been increasing over recent years. The directors are now considering
changing to First in, First out (FIFO) method to value inventory in 2017.
REQUIRED
Advise the directors whether or not the method of valuing inventory should be changed.
Justify your answer. [4]
May 2017 P31 Q4 (e),
SOLUTION
Mark Scheme
Responses could include:
 FIFO and AVCO are accounting methods in costing inventories permitted by the international
accounting standard (IAS 2); to adopt which method is the accounting policy of the business
 Business should select and apply its accounting policies consistently
 Financial statements should contain relevant and reliable information
 Business shall change an accounting policy only if the change (1) is required by the accounting
standards; or (2) results in the financial statements providing reliable and more relevant
information about the effects of transactions.
 The cost of goods has an increasing trend. FIFO method attracts a higher inventory value and
therefore a higher gross profit.
 The directors cannot change the method if its purpose is only to improve the profitability.
Accept any reasonable alternative
(1 mark) for recommendation
(1 mark) × 3 valid reasons
Suggested Solution
IAS 2 allows both FIFO and AVCO to value inventories. The business should, however, select that method
which gives more relevant and reliable information about the state of the transaction.
Consistency concept requires that accounting methods, once chosen, should be used with consistency.
The businesses may, however, are allowed to change the change the accounting method if it is requirement
of an IAS or change is expected to provide reliable and more relevant information about the effects of
transactions.
The directors, therefore, should not change the AVCO method to FIFO to have a higher inventory value
and therefore a higher gross profit.
QUESTION 5
The first audit report was qualified. Included in current assets was inventory valued at cost price of $1
million. This had become damaged and now could only be sold for $750 000 after repairs costing $200 000.
REQUIRED
Explain, with reference to the relevant International Accounting Standard, the necessary adjustment that
must be made to the financial statements. [8]
SOLUTION
Mark Scheme
IAS 2 (1) requires inventory to be valued at the lower of cost and net realisable value (1).
Net realisable value is the selling price less the costs to make the goods saleable and reach their point of
sale (1).
The inventory has been valued at cost (1) of $1 million but the net realisable value is only $750 000 (1) –
$200 000 (1) = $550 000 (1).
The value of the inventory must therefore be reduced by $450 000 (1).
This is in accordance with the application of the prudence concept (1) to avoid overstatement of assets /
profits (1).
This must be reflected in the accounts by charging this reduction to the income statement which will reduce
profit (1) and reducing the value of the inventory in the statement of financial position (1) for them to show
a true and fair view (1). Max 8
Suggested Solution
As per IAS 2, inventory must be valued at the lower of cost and net realisable value. This treatment avoids
overstatement of inventory and helps to recognize a loss of reduction in inventory’s value as soon as it
arises. Net realizable value is the estimated selling price less costs to make the inventory ready for sale.
The cost of inventory is 1 million whereas the net realisable value is only $550 000 ($750 000 – $200 000).
This requires reduction in the value of inventory by $450 000 ($1 000 000 – $550 000). This adjustment will
result in reduction of reported profits by $450 000 in the income statement. Inventory value in the balance
sheet should also be reduced by the same amount to show a true and fair view.
QUESTION 6
IAS 10 (events after the statement of financial position date) identifies two types of event as adjusting
events and non-adjusting events.
REQUIRED
State the difference between adjusting and non-adjusting events. Explain their treatment in the financial
statements. [4]
NOVEMBER 2011 P42 Q2(c),
OR
Explain the difference between an adjusting event and a non-adjusting event. [4]
Explain, with reference to IAS 10, how this event should be dealt with in the financial statements. [2]
SOLUTION
Mark Scheme
Adjusting event is one which requires the accounts of the year to be adjusted (1) as a result of the
conditions of the event existing at the statement of financial position date (1).
A non-adjusting event does not require the statements to be adjusted but a note is added (1) as the
conditions leading to the event were not present at the statement of financial position date (1). [4]
Suggested Solution
Adjusting event: Adjusting events refer to situations where the events after balance sheet date provide
new evidence of conditions that exist at the balance sheet date, and result in adjustment to the financial
statements.
Non-adjusting event: Non-adjusting events represent events that are indicative of conditions that arose
after the balance sheet date. As a result, they should be reflected in the financial statements of the following
accounting period, but not adjusted for in the financial statements of the current accounting period.
However, if it is considered that these events are relevant and material and that users of the financial
statements need the information for making economic decisions, these events can be disclosed in notes to
the accounts. Otherwise, users of financial statements would be deprived of material information.
QUESTION 7
State if the following items are adjusting or non-adjusting events. Justify your answer. [4]
1 There was a flood at the company's premises on 29 July 2011 resulting in a material uninsured loss
of $215 000.
2 On 14 August 2011 the company declared its final dividend for the year ended 30 June 2011 of
$0.03 per share.
SOLUTION
Mark Scheme
Flood is non-adjusting as condition did not exist at statement of financial position date. (1) No adjustment
required. (1) Dividend declared after statement of financial position date. (1) [4]
Suggested Solution
This is a non-adjusting event as its condition did not exist at the reporting date (date of statement of financial
position). It will be disclosed by way of note to the financial statement. However it will be recorded in the
financial statements of the following year.
QUESTION 8
Explain the treatment in the financial statements for the year ended 31 December 2016 of the purchase of
the second factory on 7 January 2017. [3]
SOLUTION
Mark Scheme
This is a non-adjusting event (1) as per IAS 10 (1), which is material / significant to the business (1). Thus
it is disclosed in the notes to the financial statements for 2016. (1) It will be recorded in the 2017 financial
statements. (1)
[max 3] [3]
Suggested Solution
This is a non-adjusting event as its condition did not exist at the reporting date (date of statement of financial
position). It will be disclosed by way of note to the financial statement. However it will be recorded in the
financial statements of the following year.
QUESTION 9
State the IAS which deals with property, plant and equipment and identify five items which a company can
add to the cost price of an asset. [6]
SOLUTION
Mark Scheme
IAS16 (1)
 import duties and taxes
 site preparation
 delivery and handling costs
 installation and assembly
 costs of testing/inspection fees
 regularly replaced parts
any five × (1) each [6]
Suggested Solution
IAS16 deals with property, plant and equipment
The items which a company can add to the cost price of an asset may include import duties, installation
costs, delivery charges, handling charges, inspection and testing costs, delivery and handling costs.
QUESTION 10
The equipment operates in a factory which the company recently built. The figure for non-current assets
includes the amounts paid to the seller of the land, the supplier of the building materials, and the building
contractor who supplied the labour.
REQUIRED
Name one (1) additional cost involved in building the factory which is included in non-current assets. [2]
SOLUTION
Mark Scheme
 Legal costs
 Architect’s fees
Any reasonable answer accepted [2]
Suggested Solution
 Legal costs
 Commission of property agent
 Architect’s fees
QUESTION 11
IAS 23 sets out the required accounting treatment for borrowing costs.
REQUIRED
Explain how the directors should deal with the interest on a loan taken out to acquire a ‘qualifying
asset’. [5]
MAY 2012 P42 Q1 (c)
SOLUTION
Mark Scheme
A qualifying asset is an asset that takes a substantial period of time to get ready for use or sale. 1
The interest related to the acquisition should be capitalised 1 as soon as preparation starts. 1
Capitalisation ceases when the activities required for the preparation are complete. 1
All such assets should be treated in the same way 1 [5]
Suggested Solution
A qualifying asset is an asset for which activities to prepare the asset for its intended use or sales are in
progress. The borrowing costs related to its acquisition should be capitalised as soon as such activities
start. Capitalization of borrowing costs ends when all such activities are complete.
QUESTION 12
IAS 36 sets out the accounting procedures to ensure that assets are carried on the statement of financial
position at no more than their recoverable amount.
Explain the accounting treatment to ensure that this is achieved. [3]
MAY 2012 P42 Q1 (c & d)
SOLUTION
Mark Scheme
If the carrying value is greater than the recoverable amount the asset is impaired. 1
Write down asset to recoverable amount on statement of financial position. 1
Amount of loss treated as an expense in income statement. 1 [3]
Suggested Solution
When the carrying amount of an asset is more than its recoverable value then it has to be reduced to its
recoverable amount. This reduction in the asset’s value is an impairment loss. The impairment loss is
recorded as an expense in the income statement. Once an impairment loss is recognized, the asset should
be valued in the balance sheet at its recoverable value.
QUESTION 13
(i) Suggest two possible reasons for impairment loss. [4]
(ii) Name the IAS which deals with impairment losses. [2]
SOLUTION
Mark Scheme
(i) Technological change (2)
Economic downturn (2)
Damage to asset (2)
Fall in market value (2)
Change in demand (2) [Max 4]
(ii) IAS36 [2]
Suggested Solution
(i) Decline in market value
Increases in market interest rates
Obsolescence or physical damage
Negative changes in technology, markets, economy, or laws
(ii) IAS36 - Impairment of Assets
QUESTION 14
Explain the term ‘impairment’ with reference to IAS 36. [4]
OR
Explain what is meant by impairment. [2]
NOVEMBER 2014 P42 Q1 [e(i)]
OR
Explain the term impairment and the treatment of impairment in the financial statements. [4]
OR
Explain the term impairment and the treatment of impairment in the financial statements. [4]
SOLUTION
Mark Scheme
When the carrying amount of property, plant and equipment exceeds the recoverable amount impairment
has occurred. (1) It is accounted for by reducing the value of the asset by the impaired amount (1) and
writing off this amount to the income statement. (1)
The recoverable amount is the higher of the net realisable value and the value in use. (1) [2]
Suggested Solution
When the carrying amount of an asset is more than its recoverable value then it has to be reduced to its
recoverable amount. Recoverable amount is the higher of net realizable value and value in use.
This reduction in the asset’s value is an impairment loss. The impairment loss is recorded as an expense
in the income statement. Once an impairment loss is recognized, the asset should be valued in the balance
sheet at its recoverable value.
QUESTION 15
Aston is considering investing in a limited company. He does not understand some of the accounting
terminology.
REQUIRED
Explain the following terms in accordance with IAS 37:
(i) Provision
(ii) Contingent liability
(iii) Contingent asset [6]
NOVEMBER 2014 P41Q1(e)
SOLUTION
Mark Scheme
(i) A provision is a liability (1) of uncertain timing and amount. (1)
(ii) A contingent liability is a possible liability from a past event (1) whose existence will be confirmed
by the occurrence or non-occurrence of an uncertain event. (1)
(iii) A contingent asset is a possible asset from a past event (1) whose existence will be confirmed by
the occurrence or non-occurrence of an uncertain event. (1) [6]
Suggested Solution
(i) A provision is a liability of uncertain timing and amount.
(ii) A contingent liability is a possible liability which arises from a past event whose existence will be
confirmed by the occurrence or non-occurrence of an uncertain future event not wholly within the
control of enterprise.
(iii) A contingent asset is a possible asset which arises from a past event whose existence will be
confirmed by the occurrence or non-occurrence of an uncertain future event not wholly within the
control of enterprise.
QUESTION 16
The directors of Rezwan Limited expect that the value of goodwill acquired from Nimra may reduce over a
period of years.
REQUIRED
Explain, making reference to IAS 36 and 38, how any reduction will be calculated and state the accounting
adjustments which will be made in future financial statements. [8]
MAY 2014 P43 Q1 (f)
SOLUTION
Mark Scheme
Under IAS 38 (Intangible assets), Rezwan should identify the useful life of the goodwill (1) acquired from
Nimra. Rezwan must then amortise the goodwill on the straight line basis (1) over this useful life and charge
the annual amount to its Income Statement (1). The amortisation period should be reviewed annually and
changes made in the amortisation in line with this review (1).
Under IAS 36 (Impairment of assets) each year Rezwan should also compare the carrying value of the
goodwill (i.e. its net book value after amortisation) (1) with its recoverable amount (its value in use) (1) and
if the carrying value exceeds the recoverable amount show the impairment loss (1) as an additional expense
in its income statement (1). [8]
Suggested Solution
As this goodwill arises on purchase of business so under IAS 38 (Intangible assets), Rezwan Ltd can show
it as an intangible non-current asset in the Statement of Financial Position. Rezwan must then amortise the
goodwill on the straight line basis over the estimated useful life of goodwill. This is done by transferring an
equal charge from goodwill to its Income Statement. The amortisation period should be reviewed annually
and changes made in the amortisation in line with this review.
Under IAS 36 (Impairment of assets) each year Rezwan should also compare the carrying value of the
goodwill (i.e. its net book value after amortisation) with its recoverable amount (its value in use). If the
recoverable amount is less than the carrying value then an impairment loss is shown as an additional
expense in its income statement.
QUESTION 17
Explain why the goodwill may increase in the statement of financial position of a limited company. [4]
SOLUTION
Mark Scheme
Only purchased goodwill is shown in the financial statements. (2)
Goodwill has increased so expansion must have involved the purchase of another business. (2) [4]
Suggested Solution
Under International Financial Reporting Standards only purchased goodwill can be shown in the financial
statements. The increase in the value of goodwill therefore represents goodwill arising on purchase of
another business.
QUESTION 18
The directors of Corbiereplc have discovered the following.
1 Inventories have all been valued at cost at $73 100 on 30 September 2015.
Included in this valuation are some items which originally cost $5 000 but have been damaged.
They would normally sell for $10000. The items could be repaired at a cost of $3 000 and then sold
for $6 500.
2 On 13 October 2015 a flood resulted in the loss of inventory valued at $17 500.
3 The directors proposed a final dividend of $0.05 per share. No dividends were paid during the year.
REQUIRED
Explain your treatment of the points listed above. [6]
SOLUTION
Mark Scheme
1. Inventory is valued at lower of cost and net realisable value (1) to avoid inventory being overstated
(1) and to recognize a loss as soon as it arises. (1) [Max 2]
2. The flood occurred after the date of the financial statements (1). The condition did not exist at this
date and the event is therefore non-adjusting as per IAS10 (1). The event should be disclosed as
a note (1). [Max 2]
3. Proposed dividends are disclosed as a note (1) but are not shown in the financial statements
(1). [6]
Suggested Solution
1 As per IAS 2, inventory is valued at lower of cost and net realisable value. This is to comply with
prudence and matching concepts. This treatment avoids overstatement of inventory and helps to
recognize a loss of reduction in inventory’s value as soon as it arises.
2 The flood occurred (on 13 October) after the date of the financial statements (30 September) when
no condition existed relating to the fire event. As per IAS 10, this is non-adjusting event and should
only be disclosed as a note without making any adjustment in the financial statements.
3 Proposed dividend (unless approved by the shareholders) is treated as a non- adjusting event
under IAS 10. It is only disclosed as a note to the statement of financial position but not shown
within the financial statements.
CHAPTER 4.3 AUDITING

QUESTION 1
List five duties which the auditor would carry out during an audit. [5]
November 2016 P32 Q4 (a)
OR
Explain the role of an external auditor. [4]
May 2017 P31 Q2 (c)
SOLUTION
Mark Scheme
 Checking financial data (1).
 Examining accounts (1) and systems (1).
 Reviewing accuracy of records (1) and reports (1).
 Reviewing security of assets (1).
 Recommending changes after review (1).
 providing reassurance to shareholders that the accounts are true records of the business activities
 expressing his / her opinion whether the financial statements give a true and fair view
 carrying out checks to ensure that the directors have acted in the best interest of the shareholders
 Ensuring procedures are adhered to (1).
 Produce audit report (1). Max 5 [5]
Suggested Solution
The auditors are appointed to act as an independent check on the reliability of the company’s accounting
records. The auditors are required to carry out their duties objectively.
 They should inquire of management and others to gain an understanding of the organization itself,
its operations, financial reporting, and known fraud or error
 They must ensure that the accounts comply with current accounting standards and the
requirements of Companies Acts.
 They should perform analytical procedures on expected or unexpected variances in account
balances or classes of transactions
 They should test documentation supporting account balances or classes of transactions
 They should observe the physical inventory count
 The overriding requirement is that auditors must ensure the accounts present a true and fair picture
of the company’s financial affairs and that they are free from significant errors.
 The auditors are required to report to shareholders as part of the annual report giving their judgment
as to whether or not the financial statements meet these criteria.
 At the completion of the audit, the auditor may also offer objective advice for improving financial
reporting and internal controls to maximize a company’s performance and efficiency.
QUESTION 2
State three characteristics of an auditor’s report [3]
SPECIMEN 2016 P3 Q3 (d)
SOLUTION
Mark Scheme
 a report to shareholders
 prepared by an independent person
 prepared by a suitably qualified person
 prepared following an inspection of the company’s books
 contains the auditor’s stated opinion as to whether the financial statements give a true and fair
view.
Accept any reasonable alternative. (1 mark) × three characteristics
QUESTION 3
Assess the effect that auditor’s report will have on shareholders. [4]
SPECIMEN 2016 P3 Q3 (e)
SOLUTION
Mark Scheme
 Shareholders will know that they cannot rely on the financial statements as they do not give a true
and fair view.
 They will know that the statement of financial position does not show the true assets and liabilities
of the company.
 They will know that the underlying share value is lower than they previously thought.
 The market value of their shares may fall.
 Potential investors are likely to be deterred from investing.
 Shareholders may not have the required knowledge of auditing and audit reports and they may not
care. They may simply be interested in the dividends the company pays.
 Shareholders may question whether the qualification of the audit report is the result of a
disagreement between the directors and the auditors.
 Accept any reasonable alternative.
QUESTION 4
How can one ensure that the financial statements represent a true and fair view of the company’s financial
affairs? Analyse the importance to the shareholders of the auditors providing a true and fair view of the
company’s accounts. [6]
November 2016 P32 Q4 (d)
SOLUTION
Mark Scheme
True and fair view means that the statements are free from misstatements (1) and faithfully represent the
financial performance and position of Soames Limited (1). The shareholders of Soames Limited will have
confidence (1) since the report will confirm the accuracy of the statements (1) and the professional opinion
should be trusted due to the expertise (1) and independence (1) of the auditor. [6]
Teacher's Solution
The phrase ‘true and fair view’ in auditing refers to the auditor’s opinion regarding the quality of information
given in financial statements. “Fair” in this context implies that financial statements are free from material
misstatements and “True” entails true representation of the performance and financial position of the
business. They are also important for tax computations, for management decisions and quotations from
lending institutions. Thus, it can clearly be seen why independence and objectivity are important in the
statements. This can be linked back to the four basic concepts on presenting this information: going
concern, accruals (matching), consistency, and prudence. However, a true and fair view is not a guarantee,
but an opinion.
QUESTION 5
Explain what is meant by a qualified audit report. [2]
OR
Assess the implications of a qualified audit report. [5]
SOLUTION
Mark Scheme
A qualified audit report which indicates that the auditor is not satisfied (1) that the financial statements
audited present a true and fair view. (1) This is a safeguard of the shareholders’ interests (1) as it signals
that the statements are incorrect in the opinion of the external independent examiner. (1) This may also put
potential shareholders off investing in the business (1)
Teacher's Solution
A qualified audit report is issued after an audit is done by a professional auditor that suggests that
misstatements (i-e non-compliance with accounting standards/accounting principles, misstatement in
account balances and disclosures), individually or in the aggregate, are material, but not pervasive, to the
financial statements. Auditors who deem audits as qualified opinions are safeguarding the shareholders’
interest by advising them that the information within the audit is not complete or the accounting
methods used by the company do not follow IAS.
QUESTION 6
The audit report was signed by Aamir, the brother of the finance director of Soames Limited. Aamir was an
unqualified auditor.
Evaluate the validity of this audit report. [4]
SOLUTION
Mark Scheme
An unqualified auditor should not have signed the audit report (1) as he is related to a director and therefore
not independent (1) and does not have the required expertise as he is unqualified (1). The report is therefore
invalid and the directors must re-appoint a qualified, independent auditor (1).
Teacher's Solution
The auditors’ responsibility is to express an independent opinion on financial statements. Independence
of the internal auditor means independence from parties whose interests might be harmed by the
results of an audit. As Aamir is the brother of the finance director of Soames Limited and in addition to that
he was an unqualified auditor so the audit report signed by him will not be valid. Therefore the company
must re-appoint a new qualified and independent auditor.
QUESTION 7
Explain the term stewardship. [2]
OR
Explain the term ‘stewardship’. [2]
NOVEMBER 2017 P32 Q3 [a(i)]
SOLUTION
Mark Scheme
Stewardship is the responsibility which managers have for the management of resources (1) within a
business on behalf of the owners. (1) [2]
Teacher's Solution
Stewardship is the careful and responsible management of something entrusted to one's care such as an
organization or property.
QUESTION 8
Explain what is meant by stewardship with regard to the role of the directors. [2]
MAY 2017 P32 Q3 (b)
OR
Explain how directors carry out their role of stewardship within a limited company. [2]
SOLUTION
Mark Scheme
 The directors manage the company on behalf of the owners (shareholders) (1).
 They are accountable and report to the owners (shareholders) (1).
 They maintain proper accounting records. (1)
 Responsible for the preparation of financial statements. (1)
 Manage the business on a day to day basis. (1)
 Safeguard the assets. (1)
Teacher's Solution
The directors act as stewards on behalf of the shareholders. They are responsible for ensuring that the
resources of the company are managed to best effect on behalf of the shareholders. To this end directors
are responsible for ensuring that proper books of account are prepared, and that an annual report is
published including financial statements which present a true and fair picture of the company’s affairs. The
law also requires directors to include a report on their management of the company as part of the report.
QUESTION 9
Explain the purpose of an end of year audit. [2]
OR
Explain the purpose of an end of year audit. [2]
NOVEMBER 2017 P32 Q3 [a(iii)]
SOLUTION
Mark Scheme
An end of year audit is the process of checking the financial records of a business (1) by an independent
person (1), in order to ensure that the records show a true and fair view of the business and comply with
IAS/Companies Acts. (1) used to prepare an audit report expressing an opinion
max 2 marks [2]
Teacher's Solution
A financial statement audit is the examination of an entity's financial statements and accompanying
disclosures by an independent auditor. The result of this examination is a report by the auditor, attesting to
the fairness of presentation of the financial statements and related disclosures. The auditor's report must
accompany the financial statements when they are issued to the intended recipients.
QUESTION 10
Jack, Julia's brother, is the sole trader of a small business. He has asked his sister if his accounts should
be audited.
REQUIRED
Discuss the advantages and disadvantages to Jack of having his accounts audited. [5]
MAY 2017 P32 Q3 (e)
SOLUTION
Mark Scheme
Advantages
 increase the credibility/reliability of accounts
 maybe helpful if Jack wants to apply for a bank loan/investment from 3rd parties
 help identify weaknesses in the internal procedures
Disadvantages
 high cost of audit fee
 no segregation of ownership and management in Jack’s business
 no need for audit as sole trader
Max 3 marks for the advantages and Max 2 marks for the disadvantages
Teacher's Solution
Advantages of Audit
 Audited accounts are readily accepted by Government authorities like Tax authorities and banks.
 By auditing the accounts errors and frauds can be detected and rectified in time.
 Audited accounts are lot more reliable than the accounts which have not been audited.
 For accessing finance from financial institutions like Banks, previous years audited accounts are
evaluated for determining repayment capability.
 Regular audit of account create fear among the employees in the accounts department and
exercise a great moral influence on clients staff thereby restraining them from commit frauds and
errors.
 In the event of loss of property by fire or on happening of the event insured against, Audited
accounts help in the early settlement of claims from the insurance company.
 To determine the value of the business in the event of purchase or sales of the business, audited
account will be the treated as the base for the evaluation.
Disadvantages of Audit
 The payment of audit fees brings extra cost burden to the organization.
 During an audit the auditor requires the attention several company staff and therefore causes
disruption.
 An audit does not assure future viability of the organization audited
 An audit does not assure the effectiveness and efficiency of management.
 Auditors express opinion and therefore does not give total assurance of the true fair presentation
of annual reports.
QUESTION 11
Explain why the audit report of a limited company is addressed to the company’s shareholders and not its
directors. [2]
MAY 2016 P31 Q2 (d)
SOLUTION
Mark Scheme
Auditor is appointed by shareholders, not directors
The auditor is accountable to shareholders
1 mark for each valid point. Max 2
Teacher's Solution
As auditors are appointed by shareholders in the annual general meeting (AGM) so they are required to
work to serve the requirements of shareholders and not the directors.
QUESTION 12
State three points covered in a director’s report.
SOLUTION
Companies are also required to publish a directors’ report in addition to other fundamental statements.
Directors’ report is prepared to supplement the information given in the financial statements. The publication
of directors’ report helps the users of the financial statements to form an assessment of the past and future
performance of the business.
The directors’ report usually contains
(i) names of the persons who were directors of the company at any time during the last financial year;
(ii) principal activities of the company during the year and significant changes in those activities;
(iii) the amount (if any) of dividends recommended by the directors;
(iv) a fair review of the company’s business to help shareholders in assessing the performance of the
directors during the current year;
(v) the principal risks and problems which the company is facing;
(vi) a report on the position of the company’s business at the year-end;
(vii) the main s factors and trend which are likely to affect the future performance and position of the
company’s operations;
(viii) the information about any policies of the company relating to
(a) environmental issues
(b) company’s employees
(c) social issues
(ix) additional explanations relating to the amounts included in the financial statements; and
(x) a statement that all necessary communication between directors and auditors was undertaken and
none of them are unaware of any relevant audit information.
QUESTION 13
Differentiate between the Duties of Management and Auditors
SOLUTION
Management Auditors
Management’s responsibility is to prepare financial The auditors’ responsibility is to express an
statements. independent opinion on these statements.
It is the duty of management to adopt and maintain The auditors’ duty is limited to point out material
strong and sound accounting system and internal flaws, significant deficiencies and gaps in controls
control. observed by them during the audit process.
The management has direct access and control on The auditors’ knowledge and control on the detail
the detail of accounting transactions, assets, of accounting transactions is limited to that
liabilities and equity items. acquired in and needed for the audit process.
Management is responsible to ensure the true and The auditors can only make draft or suggest
fair presentation of financial statements as required improvements regarding the form or content of the
in Companies Act and International Accounting accounting statements.
Standards.
CHAPTER 4.4 RATIO ANALYSIS - SUPPLEMENT

QUESTION 1
Explain what is meant by the gearing of a company and how it may affect the ordinary shareholders. [5]
MAY 2000 P3 Q2 (b)
OR
Explain what you understand by gearing. [2]
MAY 2017 P31 Q4 [c (i)]
SOLUTION
Mark Scheme
Gearing is the proportion of long term debt (1) to equity and long term debt (1) expressed as a
percentage.
Max 2
Suggested Solution
Gearing is the proportion of company’s long-term funds, which have been provided by lenders. There are
several ways to calculate this, but a frequently used method of its calculation is as follows:
Preference share capital+Long term loans
Gearing =
All share capitals and reserves+Long term loans
A company with more loans and preference shares is known as “high-geared” company and represents a
risky investment for the ordinary shareholders. In good years they get very healthy returns but in a difficult
year, they may not get dividends as they receive only residue of profits after payments of interests &
preference dividends. Furthermore if company liquidates there may be insufficient funds to repay the
ordinary shareholders after the loans and preference shares have been repaid and vice-e-versa for the
ordinary shareholders in low-geared companies.
QUESTION 2
The following statistics have been prepared by a local bank. They relate to similar businesses in the same
district as Lopez Ltd.
 Dividend yield
 Dividend cover
 Dividend per share
 Earnings per share (EPS)
 Price earnings ratio
REQUIRED
Explain what each of the five ratios indicates? [5]
MAY 2007 P4 Q2 (c)
SOLUTION
Mark Scheme
 Dividend yield is dividend as percentage of market price of share (1)
 Dividend cover signifies that how many times the company can cover the dividend (1)
 Dividend per share calculates how much each share is paid in dividends (1)
 Earnings per share (EPS) represents profits attributable to each share (1)
 Price earnings ratio relates the market price to the earnings per share (1)
Suggested Solution
 Dividend yield shows ordinary dividend as percentage of market price of ordinary shares
 Dividend cover indicates that how many times the company’s profits after tax and preference
dividends can cover payment of ordinary dividend
 Dividend per share is ordinary dividend paid on each ordinary share.
 Earnings per share is the profit after tax and preference dividends attributable to each ordinary
share
 Price Earnings ratio relates the market price of an ordinary share to the earnings per share
QUESTION 3
Suggest three ways Riffatulah could improve his working capital cycle and reduce his bank overdraft. [3]
SOLUTION
Mark Scheme
 Improve credit control for trade receivables/trade payables.
 Use factoring.
 Reduce inventory levels.
 Sell surplus non-current assets (if any).
 Take additional bank loan.
 Introduce additional capital
 Reduce drawings.
Any three × 1 mark [3]
Suggested Solution
 Improved (strict) credit terms for credit customers
 Negotiate more relaxed credit terms from the credit suppliers
 Use of debt factoring
 Reduction in inventory levels
 Sale of surplus non-current assets (if any)
 Take additional bank loan
 Additional capital invested by the owner
 Reduction in owner’s drawings
Uses of Ratio analysis
Ratio analysis helps a business in a number of ways, some of which are given below:
 Ratios help in analysing the performance trends over a long period of time.
 They also help a business to compare the financial results to those of competitors.
 Ratios assist the management in decision making.
 They also point out problem and week areas along with the strength areas.
 Ratios help to develop relationships between different financial statement items.
 Ratios have the advantage of controlling for differences in size. For example, two businesses may
be quite different in size but can be compared in terms of profitability, liquidity, etc. by the use of
ratios.
Limitations of ratio analysis
Analysis of financial statements is a powerful mechanism to ascertain strengths and weaknesses in the
operations and financial position of an enterprise. However, it suffers from certain limitations, which should
be kept in mind while making the analysis. Some of the major limitations are listed below.
 Ratio analysis requires a proper comparison i.e. a ratio is of no use unless it is compared to last
year’s or other firms’ figures, etc.
 Comparison with last year’s or with competitors may well result in distortion and invalid
comparisons because firms can use different accounting policies and methods.
 Ratios are based on historical figures (not adjusted for inflation) so the conclusions drawn from
them may be misleading & unrealistic.
 Accounting ratios are usually retrospective, based on previous performance and conditions
prevailing in the past. They may not necessarily be valid for making forward projections.
 Outside influences e.g. conditions of national/world economy can affect ratios. For instance in an
economic downturn; retailers are usually the first to suffer; whereas manufacturers feel the effects
later.
 The accuracy and reliability of ratios depend upon the quality of the information, which has been
recorded, in the financial statements. Moreover accounting data is limited to information having a
monetary value.
 Ratios are only indicators; they should not be taken as final regarding good or bad financial position
of the business. Other things will have to be seen. Moreover they do not indicate the reasons of
poor performance.
 Ratios have to be interpreted as the causes of changes in ratios are not revealed and different
people may interpret the ratios in different ways. The sophistication in the use is dependent upon
the personal skills, experience and judgmental power of the analyst.
 Each industry has different standards for different ratios to be adhered to.
Users of Financial ratios

User group Class of ratio Reason for the interest
Interested in servicing of their loans by the enterprise,
Bankers and Profitability, Liquidity and
i.e., regular payment of interest & repayment of principal
Lenders Investment (A2)
amount on scheduled dates.
They are interested in the profitability and safety of their
Profitability and Investment investment and would like to know whether the business
Investors
(A2) is profitable, has growth potential and is progressing on
sound lines.
Government may use profit as a basis for taxation,
Government Profitability
grants and subsidies
Profitability, Liquidity and Employees will be concerned with job security, bonus
Employees
Activity and continuance of business and wage bargaining.
Customers will seek reassurance that the business can
Customers Liquidity
survive in the short term and continue to supply
Interested in receiving their payments as and when
Suppliers Liquidity become due and would like to know its ability to honour
its short term commitments.
Management is interested in all aspects i.e. both
Profitability, Liquidity and
Management financial performance and financial condition of the
Activity
business.
Earnings per share

Earnings per share (EPS) are the earnings returned on the initial investment amount. Earnings per share
is generally considered to be the single most important variable in determining a share's price. It is also
a major component of the price-to-earnings valuation ratio.
An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net
income) in the calculation. Two companies could generate the same EPS number, but one could do
so with less equity (investment) - that company would be more efficient at using its capital to generate
income and, all other things being equal would be a "better" company.
Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number.
It is important not to rely on any one financial measure, but to use it in conjunction with other measures.
Dividend per Share

Dividend per share (DPS) is the total dividends paid out over an entire year (including interim and final
dividends but not including special dividends) divided by the number of outstanding ordinary shares issued.
Special dividends are dividends which are only expected to be issued once so are not included. Dividend
per share (DPS) is a simple and intuitive number.
It is the amount of the dividend that shareholders have (or will) receive for each share they own. Dividend
per share is also used to calculate the dividend yield ratio.
This is an important ratio as most companies avoid dividend cuts unless their financial condition demands
it or there has been some other change in the business or its capital structure. As a result of this, having a
growing dividend per share can be a sign that the company's management believes that the growth can be
sustained.
Ordinary shareholders prefer high dividend per share as this is taken to be a sign that the management is
confident that the high level of dividends can be maintained or improved on. This results in higher dividend
yield but lower dividend cover.
Dividend yield ratio

Unlike preference shares, there is no stipulated dividend for ordinary shares. Instead, dividends paid to
holders of ordinary shares are set by management, usually in relation to the company's earnings. There is
no guarantee that future dividends will match past dividends or even be paid at all. Historically, a higher
dividend yield has been considered to be desirable among investors.
A high dividend yield can be considered to be evidence that a share is under-priced or that the company
has fallen on hard times and future dividends will not be as high as previous ones. Similarly a low dividend
yield can be considered evidence that the share is overpriced or that future dividends might be higher.
The dividend yield tells the investor how much he is earning on an ordinary share from the dividend alone
based on the current market price.
Dividend Cover
This ratio measures that how many times the ordinary dividends could have been paid out of the available
profit. This shows the likelihood that the company can continue paying the current rate of ordinary dividend.
Dividends cover may reflect the directors’ conservative dividend policyas it suggests that much of the profit
available to pay dividends is being reinvested within the business or in other case there is decrease in
business’ profits, but the directors wanted to pay dividends at consistent rate to satisfy the shareholders’
expectations.
On the other hand low dividend cover may indicate a reckless or aggressive dividend policy as it implies
that a lower proportion of earnings are being re-invested in the business. As a result company may face
difficulty in paying dividends at the same or even at higher rates in the coming years.
A high figure is good since it indicates that the company is making sufficient profits to sustain the payment
of future dividends as this would imply a larger percentage of earnings are being retained and re-invested
in the business. On the other hand a low cover might indicate that future dividends are at risk if profitability
declines. The companies need to strike a balance between the dividend payment and the profits retained
within the business.
Price Earnings ratio

The P/E ratio of a share is used to measure how cheap or expensive its share price is. The lower the P/E,
the less you have to pay for the shares, relative to what you can expect to earn from it.
It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves,
regularly, as a marker of business problems and opportunities. By relating price and earnings per share for
a company, one can analyse the market's valuation of a company's shares relative to the wealth the
company is actually creating.
One reason to calculate P/Es is for investors to compare the value of shares, one share with another. If one
share has a P/E twice that of another share, it is probably a less attractive investment. But comparisons
between industries, between countries, and between time periods may be dangerous. To have faith in a
comparison of P/E ratios, one should compare comparable shares.
The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Companies
with high P/E ratios are more likely to be considered "risky" investments than those with low P/E ratios,
since a high P/E ratio signifies high expectations. Comparing P/E ratios is most valuable for companies
within the same industry.
Income Gearing
This ratio determines the ability of a company to meet its fixed interest charges out of its operating profits.
For instance an income gearing ratio of 0.20 indicates that 20% of operating profits would be used in making
payment of interest.It is a very good ratio to measure the gearing effect of debts on profits. A high geared
business pays more interest and will result in low interest cover.
The higher ratio indicates that the company is loaded by fixed finance charges and the greater the risk that
the operating profit will be insufficient to cover interest payments. However too low ratio may reveal unused
debt facility. This should be at least over 1 as an interest cover ratio below 1 suggests the business is not
generating adequate revenue to meet interest expense.
Present and prospective long-term lenders are mainly interested in this ratio so as to determine that how
adequately the loan interest payments are covered by the profits available for such expense.
Ordinary shareholders and directors are also interested to ascertain the ability of the business to handle
the fixed interest charges moreover a change in the ratio could have a significant effect on profits available
to pay dividends to them.
Working Capital Cycle

Working capital cycle also known as operating cycle or cash cycle is the time required to purchase or
manufacture inventory, sell the product and collect the cash. So it shows the time lag between the flow of
cash out of the business on account of purchases and back into it again as a result of normal trading
operations i.e. collection from customers.
For example, a departmental store purchases inventory for cash and then sells it for cash. The relatively
short time that the inventory remains an asset of the departmental store (no collection or payment period)
represents a very short operating cycle. In another example, a car manufacturer purchases raw material
and then incurs labour and overheads to convert this material into finished cars. A car dealer buys the cars
on credit and then pays the manufacture after sometime. Compared to the departmental store the car
manufacturer has much longer working capital cycle.
Working capital cycle can be shortened by reducing average inventory levels, speeding up collection from
accounts receivables and by delaying payments to accounts payables. A business should not over invest
in working capital. A longer cash cycle ties up a bigger investment in working capital. It is therefore useful
to monitor the length of cash cycle, and changes in it, to judge whether a business has an excessive working
capital level or perhaps whether working capital is inadequate which may lead to liquidity problems.
A short working capital cycle is preferred as it indicates the business is well managing its working capital
and lower value of working capital to be financed from other sources. On the other hand the longer the
working capital cycle, the larger will be the funds tied up.
Net working assets to sales

Net working assets to sales ratio gives us a glimpse of the liquidity position from yet another side. The other
liquidity measures like current and quick ratios use balance sheets figures only whereas in net working
assets to sales ratio the on-going operations of the business are considered by including yearly sales
revenue from the income statement. This ratio is considered as a prime indicator of a company's ability to
expand its operations without taking on additional debt as with the increase in sales working assets
requirements also increase.
The ratio provides an insight into the likely amount of additional working assets funding required from a
given increase in sales. For instance if the ratio is 20% this means that the company will require net working
assets of 20 cents for every increase of $1 in sales. As increase in working assets requirements needs
finance so management tries to minimise the level of net working assets in relation to sales.
This ratio is a useful measure of the amount of money that is tied up in funding the day-to-day trading
activities of the business as it includes only those current assets and current liabilities that vary in direct
proportion to sales turnover. It is possible to have a stable 'current' or 'quick' ratio while this ratio is falling.
This would happen if sales were increasing rapidly without corresponding increase in net working assets.
This low ratio may indicate 'overtrading’ (excessive sales volume in relation to lower working assets
investment in the business)’. This may also indicate that the business relies extensively upon credit granted
by suppliers or the bank as a substitute for an adequate margin of operating funds.
The lower ratio is usually preferred as it indicates that more of the working assets have been financed by
short term funds resulting in lower amount of net working assets. On the other hand the larger the ratio, the
more finance will be needed to fund larger requirements of net working assets in relation to sales.
FORMULAS
Net Profits after Preference Dividends
(i) Earnings per Share (EPS) =
Number of issued Ordinary Shares
Ordinary Dividend paid
(ii) Dividend per Share =
Number of Ordinary Shares
Market Price Per Share
(iii) Price Earnings Ratio (PER) =
Earnings Per Share
Ordinary Dividend paid and Proposed
(iv) Dividend Yield Ratio =
Market Price of Shares
Profit before Interest and Tax(PBIT)
(v) Interest Cover Ratio =
Interest Expense
Interest Expense
(vi) Income Gearing =
Profit before Interest and Tax(PBIT)
Profit Available to pay Ordinary Dividend
(vii) Dividend Cover Ratio =
Ordinary dividends paid
Net Working Assets
(viii) Net working assets to sales = × 100
Sales (Revenue)
Net Working Assets = Inventories plus Trade receivables less Trade payables)
= Receivables turnover (days) + Inventory turnover (days)
(ix) Working Capital Cycle (days)
 Payables turnover (days)
Fixed Cost Capital
(x) Gearing = × 100
Total Capital
Non Current Liabilities + Preference Share Capital ×100
=
Ord. Capital+ Reserves+Non Current Liabilities+Pref. Capital
CHAPTER 4.5 PURCHASE OF BUSINESS

QUESTION 1
State the meaning of the term ‘capital account’. [2]
SOLUTION
Mark Scheme
The account which records the introduction (1) or withdrawal (1) of funds / assets of a person into the
business.
Suggested Solution
Capital account records the injection of funds within the business or withdrawal of funds out of
the business by the owner. It may also incorporate changes within the owner’s capital through
business operations like profits etc.
QUESTION 2
Explain briefly one possible reason why the partners decided to change their business into a limited
company. [2]
MAY 2007 P4 Q1 (e)
OR
After the first year’s successful trading as a partnership the partners were advised to consider incorporating
their business. Both partners are close to retirement age and have family.
REQUIRED
Discuss two advantages to the partners of incorporating their business. [4]
SOLUTION
Mark Scheme
 Limited liability
 Access to greater sources of finance
 Ownership is transferable
 More legal formalities. Greater expense to maintain.
 Since the partners are close to retirement it is advisable to incorporate
Any other sensible reason acceptable
1 mark for identification 1 further mark for development
Suggested Solution
 The liability that each shareholder has for company debts is only limited to the amount paid for his
or her shares.
 Company may find it easier to raise finance through loans, issue of shares and debentures
 Continuity of the business
 Partners have to work in the business where shareholders may only invest
 Shares can easily be transferred by shareholders to other individuals or entities.
 On the other side a company has to comply with a number of statutory regulations. It has to audit
its accounts annually and also has to publish audited accounts on annual basis.
 A company’s affairs are less private than those of a sole trader or partnership, since company
accounts are made available for publication.
 Separation of ownership and control makes it difficult for ordinary shareholders to take concerted
action to oust bad management group.
 Compliance with the Companies Act imposes an increased administrative burden on the company.
This also involves occurrence of higher overheads on accounting and secretarial services.
QUESTION 3
Explain why the directors of Rezwan Limited are prepared to pay more for the assets acquired than their
book value. [6]
MAY 2014 P43 Q1 (e)
SOLUTION
Mark Scheme
 Rezwan Limited pays 14% in excess of the net book value (1 of)
 Goodwill is $280 000 – $245 450 = $34 550 (1 of)
 Goodwill is included in Rezwan’s statement of financial position after acquisition (1)
 Rezwan is paying a substantial amount in excess of the statement of financial position value of the
land and buildings (1)
 Rezwan Limited is paying for the reputation (1) location (1) future profits (1) customer base (1)
one mark per valid point – [Max 6]
Suggested Solution
Rezwan Limited, as the acquiring business pays, goodwillforthe reputation, advantageous location,
customers’ loyalty, quality products etc.
As this Goodwill is included in Rezwan’s statement of financial position after acquisition.
QUESTION 4
On 1 July 2013 Clemens, August and Bleeker converted their partnership into a limited company.
The company issued ordinary shares of $1 each to Clemens and August at a premium of 10% and issued
$1 non-redeemable 5% preference shares to Bleeker at par.
REQUIRED
Explain how each partner will receive a return on their investment in the new company. [6]
MAY 2014 P43 Q2 (f)
SOLUTION
Mark Scheme
 Future profits will be distributed as dividends. (1)
 The directors need to declare dividends out of distributable profits. (1)
 Bleeker’s dividend on preference shares will be a fixed amount (1) and will take priority over
dividends on ordinary shares. (1)
 Dividends on ordinary shares need not be for the full amount of the remaining distributable profits.
(1)
 If there are no profits C & A are unlikely to receive dividends. (1) [6]
Suggested Solution
All partners will become shareholders in the new company. As a result, all of them will receive their return
in the form of dividends.
As Bleeker owns preference shares in the new company so he will receive preference dividends at a fixed
rate. In addition this dividend payment will take priority in preference to the ordinary dividend.
Clemens and August will own ordinary shares. The ordinary dividend amount may vary from year to year
and is declared by the directors out of distributable profits. In the absence of any distributable profits the
shareholders may not receive any dividend. In addition, directors usually do not distribute all the profits as
dividend.
QUESTION 5
A company had considered the possibility of settling the purchase of a partnership completely by a cash
payment.
Suggest two advantages and two disadvantages for the partners of a cash settlement for their assets. [4]
SOLUTION
Advantages
(1) Cash settlement will enable the partners to consider a wide range of alternative investment
opportunities.
(2) There is no risk of decrease in the market value of shares.
Disadvantages
(1) Topper Ltd is an established company presumably engaged in activity known to the partners so
was safe to invest.
(2) The partners will lose control on management of new business.
QUESTION 6
Describe how your calculations of goodwill would have been different if Shindig Ltd had purchased the
partnership assets only, instead of the partnership business. [5]
MAY 2004 P4 Q1(b) (ii)
SOLUTION
Mark Scheme
 Shindig Ltd would not have purchased Goodwill.(1) The purchase of assets does not give rise to
payment for Goodwill (1) Goodwill is only relevant when a company acquires a business as a going
concern. (1)
 The settlement would more likely to have been made in cash. (1)
 The partnership business would not have been terminated (1) [5]
Suggested Solution
Goodwill normally arises when a whole business is purchased as a going concern however if assets of a
business are sold independently to different businesses then this may not give rise to goodwill. This may
mean that partnership business might still be in operation after selling the assets to the Shindig Ltd.
Moreover if assets are sold independently to other businesses then they are normally sold for cash.
QUESTION 7
Profit for the year ended 31 December 2016 of Armfield was $80 000 and Bonetti was $120 000.
The profit for the year of the partnership for the year ending 31 December 2017 is expected to be $200
000. The partners agreed to share the profits and losses equally.
REQUIRED
Discuss whether or not the merger of the two businesses has been beneficial to each partner. [5]
SOLUTION
Mark Scheme
Based purely on profitability Armfield benefits by $20 000 (1) – Bonetti is worse off by $20 000. (1)
Only one year’s results available so difficult to form opinion. (1)
Disadvantages include sharing of profits, possible disagreements and therefore delays to decision making
process. (1)
Advantages include more capital, more expertise. (1)
Suggested Solution
As only one year’s data is available so is difficult to make a safe decision. Based on available data Armfield
would be better off in terms of increased profits by $20 000 whereas Bonetti will be worse off by $20 000 in
the form of reduction in his profits.
The advantages are:
 different skills may be beneficial to the business
 Holiday / sickness cover
The disadvantages are:
 Sharing of profits
 Delayed decision making
 Possible disputes
 sharing of managerial responsibilities
CHAPTER 4.6 ACCOUNTING FOR JOINT VENTURES

QUESTION 1
Ahmed and Bashmir have separate garage businesses and have agreed to form a joint venture to buy and
sell second hand cars.
Evaluate whether or not Ahmed should have entered into the joint venture with Bashmir. Justify your answer.
[3]
MAY 2016 P31 Q2 (e)
OR
Explain two benefits to Greaves and Hurst of forming a joint venture. [4]
MAY 2017 P31 Q3 (a)
SOLUTION
Mark Scheme
Yes or No (1) Max 1 for decision
Reasons for Yes
 Made a profit
 More customers or business
 More experience
 Separate from own business.
 Identify share of profit for each
 Shared responsibility
Identification 1 + development 1. Max. 2 benefits.
Max 2 for reasons
OR
Reasons for No
 Tarnish the reputation
 Poor choice of business associate
Max 2 for reasons [3]
Suggested Solution
The points favouring forming the joint venture may include having a pool of diversified skill, reduced
investments because of pooling of funds; to enter into new markets and sharing of risk as each party
diversifies risk.
The points against forming the joint venture may include loss of reputation due to poor choice of business
associate and no enactment is directly applicable on joint ventures.
QUESTION 2
Compare Partnerships and Joint Ventures.
SOLUTION
Partnerships and joint ventures are similar in the sense that both are aimed at earning profit with at least
two owners and with capital investment by each member.
Joint ventures are usually preferred over partnerships to enjoy greater tax flexibility and to avoid legal
requirements and other complications associated with the formation of partnerships. The main differences
between the partnerships and joint ventures are as follows
Partnerships Joint Ventures
Partnership always has a name of There is no need to give a name to the
Name
business to operate with. joint venture businesses
The persons running the business The persons running the business
Parties involved
affairs are called partners. affairs are called co-venturers.
Partnership business is of continuous As formed for a specific project so
Continuity/ scope nature and is not limited to a specific automatically comes to an end after
project. completion of the venture.
Each party is individually or jointly Liability of the members is limited to

Liability liable for the acts of partnership as a the particular venture.
whole and of the other partners.
Partnerships Joint Ventures
Location of Partnership business may be located Joint ventures are generally local
Business on different and distant places. based ventures.
A minor can be admitted into the A minor cannot be a party to a joint
Position of a Minor partnerships but for benefits only. venture as by law he is incompetent to
enter into a legal contract.
Application of the Partnership Act, 1912 is applicable No enactment is directly applicable
Act
The number of partners ranges from 2 Minimum number of owners is two (2)
Number of Members to 20 unless business is in service but there is no limit on maximum
sector and fulfils certain conditions. number of owners or members.
Partners are usually not allowed to The parties to a joint venture can
Conducting other
carry on a similar business to that of freely carry on a business of similar
businesses
the partnership. nature.
Though registration of partnership is There is no need of registration in
Registration
preferable but not necessary. case of joint ventures.
Profits and losses are calculated on Profits (losses) are calculated on
Calculation of profit annual basis. project basis. However, calculation
or loss may be made after a year or on interim
basis if the venture continues for a
period longer than one year
Basis of Accounting Partnerships usually follow accrual Joint ventures usually follow cash
basis of accounting basis of accounting.
QUESTION 3
Differentiate between Consignment and Joint Ventures
SOLUTION
The main differences between Consignments and joint ventures are as follows
Consignments Joint Ventures
Nature of Business In consignment, no new business is The joint venture is a new separate
formed as it is simply an extension of business formed on temporarily basis.
existing business.
Scope of activities Consignments are only related with Joint ventures may involve in many
the sale of movable items. activities besides sale of goods like
construction, underwriting of shares,
film making etc.
Number of parties In consignment, there are two parties In joint ventures there are two or more
which are called consignor and than two parties involved called co-
consignee. venturers
Relationship In consignment, the consignor and A joint venture is like a temporary
between parties consignee are related to each other partnership so parties to a joint
as principal and agent where venture are related to each other as
consignee is the agent of consignor. partners. As a result each party acts
as an agent of the other party.
Consignments Joint Ventures
Consignor as a principal has the full As in joint venture each party in a joint
authority to control the consignment venture acts as an agent of the other
Powers and rights of
business whereas the consignee as party so enjoys equal rights and
parties
an agent follows the instructions from powers to run and manage the
the consignor. business affairs.
In consignment operations, consignor Both parties in joint venture enjoy the

Ownership is the owner and the consignee as an ownership rights in the business.
agent has no rights of ownership.
In consignment, it is the responsibility In joint ventures, all the parties
Capital contribution of consignor to arrange all the funds contribute capitals within the business
required for consignment.
In consignment all profits belong to the As a joint venture is like a temporary
Profit and loss consignor (principal) whereas the partnership so profits and losses are
sharing consignee is only entitled to receive shared between the parties in agreed
his commission. ratio.
As a consignment is a principal/agent As a joint venture is like a temporary
Governing rules relationship so is governed by the Law partnership so is governed by the
of Agency. Partnership Act.
In consignments, accounts are In joint ventures, there are four
Accounting Methods
prepared by using only one method. methods to do accounting.
The agency relationship between As joint venture is formed for a
Continuity of consignor and consignee continues particular venture so its completion
Business relations unless terminated by any of the ends the business relationship
parties. between the parties.
It is the responsibility of consignee to In case of joint ventures there is no
prepare an ‘Account Sale’ for the need to prepare an ‘Account sales’ by
Account Sales
consignor to give detailed information any of the party to the joint venture.
relating to consigned goods
CHAPTER 4.7 CONSIGNMENT

QUESTION 1
Hamid and Patel are now considering forming a partnership rather than continuing to trade on a
consignment basis.
REQUIRED
Advise whether or not Hamid and Patel should enter into a partnership with each other. Justify your answer.
[4]
SOLUTION
Mark Scheme
Yes.
Hamid and Patel should enter into partnership.
 Partnership has unlimited liability as do sole traders (1)
 shared responsibility(1) / shared liability to debts (1)
 shared workload (1)
 greater access to skills (1) and customer base (1)
 trust and reliability considerations between two of them (1)
No.
Hamid and Patel should not enter into partnership.
 practical issues such as speed of communication for decision making between countries (1) e.g.
time differences
 trust and reliability considerations between two of them (1)
 restricted trading opportunities.
(1) decision max 3 for justification
[4]
Suggested Solution
Hamid and Patel should enter into partnership due to
Hamid and Patel should not enter into partnership due to

 liability of the partners for debts of their firm is unlimited.
 limited life as death or insolvency of partner(s) dissolves the partnership.
 possible disputes between partners
 practical issues such as speed of communication for decision making between countries
e.g. time differences
QUESTION 2
Differentiate between Consignment and Sale
SOLUTION
Consignment Sale
1 Transfer of Consignor remains the owner of the In case of sale of goods, the title of
ownership goods consigned unless they are sold ownership is transferred to the buyers.
by the consignee. Therefore physical
transfer of goods does not constitute as
sale in case of consignment.
2 Return of goods The goods on consignment can be The goods sold usually cannot be
returned back to the seller except for
returned to the consignor if they remain
unsold. specific reasons e.g. due to some
defect in goods or not according to
sample.
3 Loss or damage As ownership remains with the Once goods are sold the risk of
of goods consigner so any damage or loss to the subsequent loss or damage is
goods is borne by him. This is true transferred to the buyer even if goods
despite the transfer of goods to the are not physically transferred to the
consignee. buyer.
4 relationship In consignment, the consignor and In an ordinary sale the relationship
consignee are related to each other as between the two parties is that of a
principal and agent where consignee is buyer (trade receivable) and of a seller
the agent of consignor. (trade payable).
5 Expenses In consignment, all expenses even In case of sales, expenses after sale
after delivery made by the consignee are to be borne by the buyer unless
relating to the consigned goods are otherwise agreed between him and the
ultimately borne by the consignor. seller.
6 Forwarding Pro-forma invoice is the forwarding Sales invoice is the forwarding
document document document
7 Physical In case of consignment it is necessary In a sale, the transfer of physical
transfer of to deliver the goods to the consignee. possession (delivery) is not necessary
goods as the goods may be delivered at a
later date.
A comparison of entries between entries in the books of Consignor and Consignee

Transaction Books of Consignor Books of Consignee
To record goods sent on Consignment Account
No entry
consignment Goods on Consignment
To record return of goods sent on Goods on Consignment A/c
No entry
consignment Consignment Account
To record payment of expenses Consignment Account
No entry
incurred by consignor Bank Account
To record expenses Consignment Account Consignor Account
incurred/paid by consignee Consignee Account Bank Account
To record commission payable Consignment Account Consignor Account
to consignee Consignee Account Commission Account
To record sales made by Consignee Account Bank/ Receivable
consignee Consignment Account Consignor Account
To record receipt of cash Bank Account Consignor Account
(advance payment) from Consignee Account Bank Account
consignee
To record payment of cash by Consignee Account Bank account
consignor to consignee Bank Account Consignor Account
Transaction Books of Consignor Books of Consignee
To record profit on consignment Consignment Account
No Entry
Income statement
To record loss on consignment Income statement
Consignment Account No Entry
To record bad debts, if consignee Consignment Account Consignor Account
doesn’t get del credere Consignee account Consignment Receivable
commission
To record bad debts when del- Bad debts Account
No Entry
credere commission is agreed Consignment Receivable
No entry Commission Account
To record transfer of bad debts Bad debts Account

when del-credere commission is
agreed
To record inventory held on Inventory on consignment
No entry
consignment Consignment Account
QUESTION 3
State why an advertising campaign paid for by an agent would not be included in the valuation of inventory.
[2]
SOLUTION
Mark Scheme
Advertising is not a purchase / production cost (1)
Advertising is not part of bringing a product to its existing location or condition (1)
Its inclusion would contravene IAS 2. (1) [4]
Suggested Solution
Under IAS 2 advertising cost should not be included in the inventory valuation as it is not incurred on
purchasing or producing inventory items. As per IAS 2 only those costs may be included in inventory
valuation which are incurred on preparing the inventory to its present location or condition.
CHAPTER 4.8 COMPUTERIZED ACCOUNTING

QUESTION 1
Differentiate between Hardware & Software
SOLUTION
Computer hardware refers to the machine used to run the whole computer system. It comprises of computer
itself, processor, monitor, keyboard and other peripheral devices including printers, scanners, external
disks, networking cables etc.
Software represents the set of instructions given to computers to carry out their tasks. This not only
comprises of the package of instruction used to run the operating system but may also include some other
software packages as mentioned below.
(a) General Purpose Software

These packages include word processor, spreadsheets, graphic software and data basis used for
multiple purposes as required by the end user.
(b) Customised Software

These are also called application packages & are designed to serve a specific purpose. They are
however, not expected to do any task other than for which they were acquired.
Businesses may acquire individual modules to perform a specific task. For instance; an inventory module
records only movements relating to inventory items. On the other hard a complete accounting suite
(package) will comprise of several modules to serve all accounting needs of the business as mentioned
earlier is this chapter. This type of suite, if contains integrated packages, will make it possible for the
business to enter a transaction only once and leave the rest for the system to perform including posting to
ledger accounts and production of different reports.
QUESTION 2
What steps would you take to shift from manual accounting to computerized accounting system?
SOLUTION
For a running business, switching to computerised accounting is a bit more difficult and time consuming
compared to a new business to ensure that the computer system starts with the information that matches
your current records.
The transition from manual to computerised accounting system involves a process with few simple steps
given as follows. Once your computerised system is fully operational, you will soon wonder that how you
were able to survive without accounting software.
1 Assessment of needs
In the first step, the main purpose (purposes) of switching to computerised accounting should be
determined with a list of all the tasks expected from the use of software should be prepared.
2 Acquisition of computer equipment
3 High speed internet connection
High speed internet connection is also the main requirement to have online access to your data.
This is also needed to avail online backing up of your data.
4 Selection of suitable software
Decide between buying the existing commercial software or developing it in-house on customized
basis on the basis of cost, functionality, user friendliness and specific business requirements each
option of accounting software.
5 Use of trial version before buying a software
6 Installation of suitable accounting software
7 Determination of date to start computerised accounts which should be on the very next day after
the end of an accounting period. In this case closing balances of last year would be entered into
the accounting program as opening balances.
8 Verify and finalise the data in manual records before transferring to computerized system.
9 Use of Templates and preparation of the standard chart of accounts of the software to meet with
their specific business requirements.
11 Run parallel systems for a short period of time
12 Discontinuation of Manual system
Once the reports prepared in both manual and computerised systems match each other, then it
would be time to good bye manual accounting. Business should then concentrate solely on
computerised system.
13 Back up your accounting data on online basis or on disks’ on regular basis
QUESTION 3
The treasurer currently maintains the records using a manual book-keeping system and is now considering
transferring the records to a computerised accounting system.
REQUIRED
Recommend to the treasurer whether or not he should introduce a computerised accounting system. Justify
your answer analyzing both benefits and limitations to the club. [9]
MAY 2016 P32 Q1
SOLUTION
Mark Scheme
Benefits
 Small organisation so may be purchased for relatively low cost. (1)
 Cost saving then continues. (1)
 Time saving (1) so can spend more time on other aspects of business. (1)
 Can be used for different aspects (e.g. payroll, invoicing, inventory control etc.). (1) Integrated
system. (1)
 Can use tailor made package. (1
 Reduces storage space (1) as uses less paper.
 Reduced manual input (1) so reduced errors. (1).
 Reduction in staff reducing wages cost (1).
 Can use IT to advertise the club to gain new members (1).
 Can use system to pay subscriptions on line (1).
 Password restricts access to data (1)
Limitations
 Initial cost of the system (1).
 Computer could crash/virus (1) which could lead to loss of information. (1)
 Requirement to back up information. (1)
 Training costs of staff. (1)
 Greater security needed (1) to prevent fraud and data loss. (1)
 Cost of updating hardware and software. (1)
 Expensive maintenance and repairs. (1).
 Workers may be resistant to change or retraining (1).
 Staff fear for job security (1).
 System can be hacked and data stolen (1)
Award 1 mark for a decision and max 4 for benefits and max 4 marks for limitations [9]
Suggested Solution
Computerised accounting has the advantage of automatically posting to both ledger accounts affected by
a transaction, and therefore should eliminate some types of error, including arithmetical ones. It helps to
reduce storage space as uses less paper.
However, there will still be the possibility of errors of omission and errors of original entry due to
incorrect data inputting. Computer system could crash which could lead to loss of information.
Advantages of Computerised Accounting

 Fast Speed
If the computerised accounts are fully integrated then data needs to be entered once only in
contrast to manual accounts where two or even more entries are needed. Multitasking and fast
processing are also possible in computerised programs.
 Low running Cost
Costs relating to a computerised system have reduced significantly in recent times due to reduced
costs of hardware and software.
 Increased Accuracy
We know that data needs to be entered once in computerised systems so the correct entry of
original data makes it unlikely to have subsequent errors unless there are errors in writing the
programs.
 Easy production of documents
The use of computers makes the generation of different documents like invoices, cheques,
purchase orders, debit or credit notes, statement of accounts etc very easy.
 Availability of timely information and reports
Through the use of computers, all accounts and reports are constantly updated and instantly
available as and when required by different users at different places at the same time.
 Easy transfer of documents
In computerised accounts invoices, statements of accounts and other documents can easily be
sent through email. This reduces the need of physical sources needed to transfer them from one
place to another.
 More secure and backing up of accounting data on online basis or on disks’ on regular basis
 Staff motivation and comfort
 Reduces management’s frustration through timely production of reports and availability of
information
 Ability to finalise Tax return
The computer software can easily be tailored to automatically calculate and finalise the amounts of
GST or VAT returns.
 The ability to deal multiple currencies
Disadvantages of Computerised Accounting

 High Capital expenditure
Installing a computerised accounting system can be expensive. The cost of the equipment and the
software can be high. It is also quite likely that the hardware and the software will have to be
upgraded regularly. However, costs have fallen markedly in recent times.
 Garbage In Garbage Out (GIGO)
If the data originally entered was incorrect then the output would also be inaccurate. This concept
is called GIGO i.e. Garbage In (input) Garbage Out (output). In many cases it becomes very difficult
to trace the actual reason of the error especially if paper documents are not available.
 Security threats
Another risk associated with the use of accounting software is loss of data due to viruses, hacking
attacks or spying through internet. It is therefore necessary to have adequate security measures
while doing computerised accounting.
 Danger of Computer fraud
The accounting software makes it easier to alter and manipulate the data so increases likelihood
of frauds.
 Need for additional Software to view or transfer report. This

 Training of personnel
When introducing a computerised accounting system, it is almost inevitable that staff will need
training. From time to time staff will need training updates, which will add to the costs.
 Issues with general purpose software
If business is using general purpose or non-customised accounting software then there would be
numerous fields and templates not needed by the business. This issue and poorly designed or
inappropriate software may create more confusion and chaos.
 Period of transition from manual to computerized system may place an additional strain on
staff and on the business’s resources.
In nutshell, we can determine through the above discussions that the advantages of computerised
accounting outweigh its disadvantages. We would not probably find a business switched to computerised
accounting reverts back to the paper based manual accounting system.
QUESTION 4
Differentiate between Manual and Computerised Accounting.
SOLUTION
The differences between the two systems are given below
Manual Accounting Computerised Accounting
In manual accounts each transaction In computerised accounts, speed is
has to be entered at least twice or enormous as data needs to be
(i) Speed thrice. entered once only and then software
automatically processes data and
creates reports.
The computerised systems are lot
expensive as for running computer
programs business needs
In terms of cost, manual accounting is computers, printer, software and
(ii) Costs more economical as it only requires other system related expenses like
papers, pen and some stationery. training, maintenance cost, updating
cost etc. This may cost in millions
depending upon the complexity of
organisation.
In manual accounting, cost of hiring In computerised accounts, the cost
Staff qualified and trained accountants to of staff may also be costly as staff
(iii)
requirements keep a record of business acquainted with computer software
transactions is very high. and basic accounting is needed
In manual accounting as all In computerised accounts,
calculations are done manually so calculations are automatically made
(iv) Calculations
there are more chances of resulting in reduced errors and
arithmetical mistakes and errors. increased efficiency.
In manual accounts data entered in Once the data is entered in journals,
Ledger day books is transferred to the debit the computer program will
(v)
Accounts and credit sides of ledger accounts automatically transfer it to the ledger
through manual posting. accounts without any human effort.
Trial balance is also prepared In computerised accounting trial
Trial Balance
(vi) manually at the end of the period with balance is produced automatically at
all ledger accounts’ balances. any point of time.
In manual accounts, both adjusting In computerised accounts, once
Recording of entries in journals and their posting to adjusting entries are made in
(vii)
Adjustments ledgers are done manually on one by journals, the software automatically
one basis. posts them in the ledgers.
In manual accounts, financial Financial statements can be

statements like income statement prepared automatically in
and balance sheets are prepared at computerised accounts at any point
Financial the end of the period by using of time. The financial statements are
(viii)
Statements information given in the trial balance updated after each and every new
with additional information given as entry made in the system. However,
adjustments. this option is not available in the
manual accounting system.
Generation of multiple reports in Computerized accounting allows
manual accounting is very time easy and timely generation of
Generation of
(ix) consuming task which may ultimately different reports. This would help the
Reports
result in wastage of resources, managers to perform their work in
incorrect reports and staff frustration. most efficient manner.
Manual accounting can work
The use of UPS, stand-by
independent of the computer
Continuity of generators, and modern back-up
(x) machines so the accountants
work devices help the system to work with
continue to work even when the
continuity.
computer machines are not working.
Data stored in a computer system
In case of manual accounts, the risk can be backed up in a number of
of data loss is very likely. If important ways like on compact disk (CD),
documents are lost or damaged then USB flash drive, and external hard
(xi) Back-ups
they have to be recreated. Though drive or even online. Many
photocopies can be made but this organisations back-up their data on
could be costly and time consuming. daily basis to avoid the possibility of
data loss.
CHAPTER 4.9 MANUFACTURING ACCOUNTS

QUESTION 1
Explain the following terms.
Direct costs [2]
Indirect costs [4]
Prime cost [2]
Production cost [2]
SOLUTION
Mark Scheme
(i) Direct costs – can be directly traced to a product unit. (1)
Examples – Direct materials (1)
Direct labour (1)
Direct expenses (1)
Maximum 1 for example [2]
(ii) Indirect costs – cannot be economically (1) traced to a product unit. (1)
Examples – Indirect wages (1)
Indirect materials (1)
Depreciation of factory machinery (1)
Insurance (1)
Power (1)
Other suitable examples
Maximum 2 for examples [4]
(iii) Prime cost – total of all direct expenses. (1) Must refer to total.
Direct materials + direct labour (+ direct expenses) (1) [2]
(iv) Production cost – total cost of producing the goods in the factory. (1)
Must refer to total
Prime cost + factory overheads ± work in progress adjustment (1)
Must include work in progress [2]
Suggested Solution
(i) Direct costs are the manufacturing costs which can be directly traced to a product unit.
Examples of direct costs include direct materials, direct labour etc.
(ii) Indirect costs are the manufacturing costs which cannot be economically traced to a product unit.
Examples of indirect costs include indirect wages, indirect materials, factory building expenses like
rent, factory machine expenses like depreciation etc.
(iii) Prime cost is simply the total of all direct expenses and is calculated as
Direct materials + direct labour + direct expenses
(iv) Production cost is the total cost of producing the goods in the factory. This is calculated as Prime
(direct) cost + Factory (indirect) overheads ± opening/(closing) work in progress
QUESTION 2
Explain one reason why a manufacturing business might continue to manufacture goods despite the fact
that it may be cheaper to purchase the goods from an outside supplier. [3]
MAY 2008 P4 Q2(f)
SOLUTION
Mark Scheme
 to keep resources working
 to cover fixed costs
 to maintain customer confidence etc.
1 for identification plus 2 for development
Suggested Solution
A manufacturing business might prefer to manufacture goods instead of buying the goods from an outside
supplier due to the following reasons.
 to ensure quality output
 to avoid bottlenecks in delivery of goods
 to cover fixed costs
 to maintain customers’ confidence etc.
QUESTION 3
The price at which the product could be bought from an outside supplier is expected to increase.
It is now proposed to transfer finished goods at production cost plus 20%.
REQUIRED
Advise the directors whether or not the mark-up should be increased. Justify your answer. [5]
MAY 2016 P32 Q2 (e)
OR
Explain why a mark-up is added to the factory cost of production. [3]
SOLUTION
Mark Scheme
The company manufactures because it can produce goods cheaper than buying them for resale (1). This
mark-up increases the cost of sales (1) and therefore reduces the gross profit (1) and is added back in the
income statement (1) leaving net profit unchanged (1). Since the bought in price has risen, the transfer
price accordingly should rise, too (1) so the proposal to increase the mark-up to 20% should be adopted
(1). Increasing mark-up may lead to staff gaining higher bonus (1) and therefore improving morale (1) and
possibly productivity and profit (1) may not change (1) because increase overall cost of manufacture (1)
which may affect selling price (1) which makes goods uncompetitive (1) and may result in lost sales/lower
profit (1).
Manufacturing department is a profit centre (1) and it is a better way to measure the performance of the
manufacturing department (1). Better control of manufacturing cost (1). Transferred price is compared with
market price (1).
1 for advice/decision + 1 per valid point, max 4 [5]
Suggested Solution
Factory profit is the difference between cost of producing the goods and the cost at which the same goods
could be bought from an outside supplier. Factory profit is added to cost of production so results in increase
in cost of sales and reduction in gross profit. However, as factory profit is added back to net profit, so net
profit remains unaltered.
The production department is a profit centre so adding mark up to the factory cost of production helps in
determining its contribution in the overall profits.
Due to increase in the bought in price of finished goods, the transfer price should be increased accordingly
provided production cost remains the same. Therefore, the proposal to increase the mark-up to 20% should
be adopted.
QUESTION 4
Explain what is meant by the term transfer price. [2]
SOLUTION
Mark Scheme
Transfer price is the price of goods calculated in the manufacturing account and completed (1) and
transferred to the income statement (1). It often includes an additional percentage for factory profit (1) and
this is included in the inventory of finished goods as unrealised profit (1).
Max 2
Suggested Solution
Transfer price in manufacturing accounts represents the cost at which the manufactured goods could be
bought from an outside supplier. To calculate transfer price, Factory profit is added to cost of production so
results in increase in cost of sales and reduction in gross profit. However, as factory profit is added back to
net profit, so net profit remains unaltered. This also results in overstatement of inventory of finished goods
which is adjusted through provision for unrealised profit in the balance sheet.
QUESTION 5
Explain your treatment of finished goods in the inventory valuation of a manufacturing concern. [2]
OR
Explain why it is important for Richard to create a provision for unrealised profit. [4]
MAY 2017 P32 Q1 (d)
SOLUTION
Mark Scheme
To remove unrealised profit from income statement (1) otherwise profits are overstated (1) by amount of
unrealised profit.
In accordance with the prudence concept (1), to ensure inventories are not overvalued (1) and are valued
at cost and not cost plus a mark-up (1). [Max 4]
Suggested Solution
Under prudence concept value of an inventory should not include an element of profit so factory profit needs
to be removed from the value of finished goods inventory as it has not yet been earned or realized.
QUESTION 6
Explain why a business might create a provision for unrealised profit. [3]
MAY 2016 P32 Q2 (c)
SOLUTION
Mark Scheme
The finished goods at the year-end are valued at cost plus the profit margin. (1) Unrealised profit should
not be anticipated (1) and the profit element should be removed from the inventory by creating a provision
for unrealised profit. (1) IAS 2 (1) Lower of cost and net realisable value (1) Prudence /Not overstating
profits/assets (1) [3]
Suggested Solution
The finished goods inventories are valued at cost plus the profit margin. IAS 2 clearly states that inventories
must be valued at lower of cost or NRV. Inventories should not include profit element as these profits are
not yet realized. As a result, provision for unrealised profit is created to remove the profit element from the
inventory of finished goods.
QUESTION 7
State three examples of how the prudence concept has been applied in the preparation of Bart’s
manufacturing account and income statement. [3]
MAY 2012 P22 Q1 (c)
SOLUTION
Mark Scheme
Examples
1 Value of opening and closing inventory at lower of cost or net realisable value.
2 Depreciation of non-current assets charges the estimated amount of the asset consumed against
profit.
3 Any other valid point, provision for depreciation, accruals/prepayments.
One mark per valid point.
Not provision for unrealised profit – must apply to Bart’s accounts. [3]
Suggested Solution
Prudence concept may be applied in manufacturing accounts by
1 valuing inventories at lower of cost or net realisable value.
2 providing doubtful debts in the books of accounts
3 charging depreciation against profit
Manufacturing Account
For the year ended ------------
$ $
Raw /Direct material cost
Opening inventory xxxx
Add: Purchases xxxx
xxxx
Closing inventory of direct material xxxx xxxx
Direct wages xxxx
Direct expenses (license fee, Royalties etc.) xxxx
Prime Cost xxxx
Factory overheads
Indirect factory wages xxxx
Indirect materials xxxx
Other factory overheads (All factory expenses other than direct xxxx xxxx
expenses)
Total Manufacturing Cost xxxx
Add Opening work in process xxxx
xxxx
Less Closing work in process xxxx
Cost of Production xxxx
Factory profit xxxx
Market value of goods produced xxxx
Trading Account For the year ended ------------

$ $
Sales xxxx
Cost of sales
Finished goods: opening xxxx
Add Cost of Production xxxx
xxxx
Less Finished goods: closing xxxx xxxx
Gross Profit on trading xxxx
Add Factory profit xxxx
Decrease/ (Increase) in provision for unrealised profit xxxx xxxx
Overall Gross Profit xxxx
Balance Sheet As at ---------- $ $

Current Assets
Inventories: Raw Materials xxxx
Work in-process xxxx
Finished goods xxxx
Less Provision for unrealised profit xxxx xxxx
Section 5 178 A2 Level – Cost Accounting
SECTION 5 A2 LEVEL – COST ACCOUNTING
CHAPTER 5.1 ACTIVITY BASED COSTING 179

CHAPTER 5.2 BUDGETING 182
CHAPTER 5.3 STANDARD COSTING 192
CHAPTER 5.4 CAPITAL INVESTMENT APPRAISAL 201
CHAPTER 5.1 ACTIVITY BASED COSTING

QUESTION 1
“The idea behind this method of costing is that it is the cause of a cost which is important and not whether
it is fixed or variable.”
REQUIRED
Identify the costing method described in the quotation. [1]
SOLUTION
Mark Scheme
Activity Based Costing
Suggested Solution
Activity Based Costing
QUESTION 2
State what is meant by the terms ‘cost driver’ and ‘cost pool’. [2]
NOV 2017 P31 Q6 (f)
SOLUTION
Mark Scheme
Cost driver – the separate activities of each department
Cost pool – an account collecting the cost of each activity
Teacher's Solution
Cost drivers are commonly used for the allocation of production overhead to units of production, as
required by several accounting frameworks.
A cost pool is a grouping of individual costs, typically by department or service center.
QUESTION 3
State two similarities in use between standard costing and activity based costing. [2]
SPECIMEN 2016 P3 Q6 (e)
SOLUTION
Mark Scheme
Responses could include:
 both seek to control costs
 both can help set selling prices.
(1 mark) × two valid points [2]
QUESTION 4
Explain three differences between activity based costing and absorption costing. [6]
MAY 2016 P31 Q5 (d)
Advise Chetna which method she should use. Justify your answer. [3]
MAY 2016 P31 Q5 (e)
SOLUTION
Mark Scheme
(d) Activity based costing uses cost drivers and cost pools whereas, absorption costing uses direct
labour hours or machine hours
Activity based costing is expensive to set up whereas, absorption costing is easy to set up
Activity based costing is more realistic than absorption costing.
Absorption costing is more easily understood than activity based costing.
Any three points of comparison 2 marks each. [6]
(e) The change in selling price is not significant in either case. However, the reduction in the
selling price of Standard (1) may increase the number of units sold and vice versa for
Superior (1)
1 mark for decision
Max 2 for comments [3]
Teacher's Solution
(d) The following are the main differences between Conventional (traditional) Costing and Activity
Based Costing
Conventional (traditional) Costing Activity Based Costing

1 Before producing products it identifies Before producing products it identifies relevant
relevant costs activities
2 Its main focus is on the determination of total The focal point of ABC is on the activities performed
costs which have been incurred and/or on the products produced
3 Cost unit is used to allocate and accumulate Cost drivers are used to identify the factors
costs influencing costs of a particular activity
4 Indirect overheads are charged to products Indirect manufacturing overheads are charged to
on the basis of departmental overhead rate products on the basis of relevant cost drivers.
5 There is only one cost pool as overheads are There are multiple cost pools as one cost pool is
pooled and accumulated on departmental used for each activity.
basis
6 Once the costs of all departments are In ABC, overheads of service departments are not
ascertained then the costs of service allocated and redistributed to production
departments are allotted to production departments.
departments to determine total overheads.
7 It unrealistically assumes that fixed It is more realistic as it assumes that fixed
overheads remain constant regardless of overheads may vary in proportion to the changes in
changes in output level. output level.
8 A single overhead rate is used for the whole There is separate overhead rate for each activity.
department
9 Marketing and distribution costs are treated In ABC, Marketing and distribution costs are traced
as period costs. to certain products and customers
10 In conventional costing all costs are assumed On the contrary, ABC recognises that costs
to be unit level costs and are allocated on the incurred on activities can either be directly related
basis of production volume. to the units of output, batches of output, facilities,
specific product or even to the customers.
(e) Though both methods are numerically accurate and are used in practice but each method results
in a different cost figure so will generate different gross profit. These two methods are only different
with the different allocation of overheads to different cost objects. Accurate costing of cost objects
is very critical as numerous decisions including the determination of sales price are based on it.
The accurate costing of products also helps in planning to push the sales of one product and drop
the sales of other products.
The choice of using conventional costing or Activity Based Costing usually involves a trade-off
between simplicity and accuracy. The first one is though easy to apply but does not give accurate
cost information whereas Activity Based Costing is difficult to use but is more accurate and realistic
in nature.
Product Variety and Process Complexity also create problems as a result hard-to-make products
show big profits and easy-to-make products show losses. Though change in selling price is not
significant in either case. However, the reduction in the selling price of Standard may increase the
number of units sold and vice versa for Superior. As a result, activity based costing should be used
to show and earn realistic profit.
QUESTION 5
Explorer Limited produces two products, Y and Z, and has always used absorption costing to allocate
overheads to each product. The directors are now considering adopting activity based costing (ABC).
REQUIRED
Compare how overheads are apportioned using absorption costing and ABC. [4]
MAY 2016 P32 Q5 (a)
SOLUTION
Mark Scheme
Activity based costing is based on the activities required to produce the item. (1) Costs are collected into
cost pools (1) and apportioned to products based on cost drivers (1).
Under absorption costing costs are apportioned to cost centres (1) using a suitable basis for apportionment
(1), e.g. direct labour hours, machine hours or units (1)
2 marks for each method [4]
Teacher's Solution
The traditional method of costing relied on the arbitrary addition of a proportion of overhead costs on to
direct costs to attain a total product cost. The traditional approach to cost allocation relies on three basic
steps.
1. Accumulate costs within a production or non-production department.

2. Allocate non-production costs to production departments.
3. Allocate the resulting production department costs to various products, services or
customers.
In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each
organisational activity. Costs are then collected into cost pools. They then assign these costs to products,
services or customers (referred to as cost objects) causing that activity.
QUESTION 6
Explorer Limited produces two products, Y and Z, and has always used absorption costing to allocate
overheads to each product. The directors are now considering adopting activity based costing (ABC).
REQUIRED
Advise the directors whether or not ABC should be adopted. Justify your answer. [2]
MAY 2016 P32 Q5 (e)
SOLUTION
Mark Scheme
Since costs are only assigned to the products that require the activity (1) it is more realistic (1) activity based
costing should be adopted (1).
Not using ABC (1) – More time consuming (1), requires specialist knowledge (1)
1 for advice + 1 for justification. [2]
Teacher's Solution
Traditional costing system faces problems with cost allocations due to lack of commonality in overhead
costs. Product Variety and Process Complexity also create problems as a result hard-to-make products
show big profits and easy-to-make products show losses. In view of this, the directors should adopt activity
based costing.
QUESTION 7
List down the benefits and drawbacks of activity based costing method. [10]
OR
State two reasons why a business may use ABC for allocating overhead costs. [2]
MAY 2017 P31 Q6 (e)
SOLUTION
Mark Scheme
The benefits of ABC
 Avoids apportioning overheads using a basis that may not be relevant. e.g. machine hours for
administration costs
 Considers batch sizes which are ignored by absorption costing.
 Fairer / more accurate / meaningful allocation of overhead costs.
 Provides good understanding of what drives the cost.
 Uses multiple cost drivers so recognises complexity of manufacturing.
 If the activity (cost driver) changes then the relevant effect on the cost can be assessed so costs
are controlled. E.g. how much will costs increase if there is another batch run?
 Useful for decision making (profitability / pricing / discontinue lines).
 Accurate and reliable cost information.
Drawbacks
 ABC is often of little benefit if there is only one product because the overhead cost per unit will be
the same.
 There are still cost pools that are not caused by one particular cost driver but by several e.g.
marketing
 The costs for implementing such a system for a small business often outweigh the benefits
 The level of accuracy may be immaterial for management decisions
Teacher's Solution
Advantages
 Allows the company or the business institution to have the most accurate costing of the
products/services, thereby allowing the company to have known the cost which is friendly to both
the manufacturer and to the consumer.
 Easier to be understood. This method or approach does not require a deeper way of understanding.
It is never hard to be understood since this is focusing on the reality how the process is being
undertaken.
 The unit cost is properly utilized rather than its total cost.
 Is helpful in the integration of continues improvement programs for the company.
 Benchmarking is being facilitated.
 Performance management and scorecards are being supported.
Limitations
 If the overhead costs are high for reasons such as volume, there are very limited benefits to be
reaped from activity based costing.
 It also is not very efficient if the overhead costs of the business only represent a very small portion
of the costs.
 ABC method of costs may not be best if the overhead waste is perceived to be relatively low. This
is because it can be very costly to implement activity based costing into a business. Experts must
be brought in for an extended period of time, and other measures may be necessary for the ABC
to be effective.
 There is a long time period that is involved in using an activity based costing method in a business.
 ABC requires many different departments and individuals to collect and input data. Even the
smallest flaw in this information can damage the entire process and the outcome would be tainted.
This is one of the biggest risks that are taken on when using this method.
QUESTION 8
The directors of S Limited are considering using production units rather than direct labour hours as the
basis of absorbing fixed overheads.
REQUIRED
Advise the directors whether or not they are correct to absorb fixed overheads on the basis of direct labour
hours. Justify your answer. [4]
SOLUTION
Mark Scheme
Both methods represent the basis of production. (1) Will a change of method allow managers to control
production more efficiently or set selling prices more accurately? (1)
Production is not labour intensive and all units produced are identical. (1)
Therefore either method would be acceptable. (1)
Suggested Solution
Units of production base may be appropriate in this case as company is producing only one type of product
which is identical in nature. Moreover, Production is not labour intensive so company may switch from
labour hours base to units of production base provided change in method is expected to calculate more
accurate value of production overheads.
CHAPTER 5.2 BUDGETING

QUESTION 1
Explain the advantages and uses of budgets. [7]
MAY 2003 P4 Q3 [d(i)]
OR
State three benefits which may be obtained from the preparation of budgets. [3]
MAY 2005 P4 Q2 (c)
OR
State three advantages of using budgets [3]
MAY 2011 P43 Q3 (e)
OR
Explain two reasons why a business prepares a budget. [4]
SOLUTION
Mark Scheme
 Budgets formalise management plans (1).
 Budget preparation ensures that all functions of a business are properly co-ordinated (1).
 Budgets may indicate possible future shortages of resources so that remedial measures may be
 Participation by management at all levels in budget preparation induces sense of commitment by
 Budgets bring together plans for different departments
 The preparation of budgets for individual departments, functions etc. is a form of responsibility
accounting (1).
 Budgets provide information for on-going control of business activities (1).
 Budgets help to predict shortages of cash/labour/materials
(Other points may be acceptable.) [7]
Suggested Solution
Budgets have the following advantages
 They compel management to look ahead for the company as a whole instead of focusing its
attention solely on daily problem solving.
 Mangers of different departments are forced to work together in order to integrate their individual
plans. This enhances inter-departmental communication, coordination and spirit of teamwork.
 Budgets can be used as yardsticks to compare with actual performance in order to highlight the
strengths and weaknesses of an organisation.
 As managers set the budgets for their own department, they will be more aware of the responsibility
they bear to achieve the goals set.
 Participation in setting a budget makes a person psychologically involved in the company. Often
the employee becomes more committed and motivated to achieve the target set.
 Budgets establish targets for the operating departments to follow.
QUESTION 2
State two advantages & two disadvantages to a company of using a budgetary control system. [4]
MAY 2013 P41 Q3(d)
OR
(i) State three advantages of budgetary control. [3]
(ii) State three disadvantages of budgetary control. [3]
NOVEMBER 2016 P22 Q4(d)
OR
State three advantages and three disadvantages of a system of budget preparation. [4]
MAY 2017 P22 Q4(e)
SOLUTION
Mark Scheme
Advantages
 requires planning/co-ordination/communication between departments
 can be a motivator
 causes more efficient use of resources
 leads to cost control.
 Assists with planning for the future
 Helps to monitor performance
 Compares budget and actual, identifying variances, determine causes and taking corrective action
 Can act as motivation for employees
 Enables delegation to departments
 Assists with decision making
 Helps with responsibility accounting
 Helps with accounting by exception
Disadvantages
 poor data lead to poor decisions
 without consultation budgets can be a demotivator
 if undemanding can lead to underachievement
 Could lead to conflict between departments regarding the allocation of resources
 Can discourage innovation
Suggested Solution
Budgetary control offers several advantages to managers. Some of these are:
 Budgetary control coordinates activities across departments.
 Budgetary control translates strategic plans into action. It specifies the resources, revenues, and
activities required to carry out the strategic plan for the coming year.
 Budgetary control provides an excellent record of organizational activities.
 Budgetary control improves communication with employees.
 Budgetary control improves resources allocation, because all requests are clarified and justified.
 Budgetary control provides a tool for corrective action through reallocations.
 Budgetary control helps to control costs.
 Budgetary control assists with planning for the future
 Budgetary control helps to monitor performance
 Budgetary control compares budget and actual, identifying variances, determine causes and taking
corrective action
 Budgetary control enables delegation to departments
 Budgetary control assists with decision making
 Budgetary control helps with responsibility accounting
 Budgetary control helps with accounting by exception
However, budgets control can also create problems.

The disadvantages of budgets are:
 The major problem occurs when budgetary control is applied mechanically and rigidly.
 Budgetary control can de-motivate employees because of lack of participation. If the budgets are
arbitrarily imposed top down, employees will not understand the reason for budgeted expenditures,
and will not be committed to them.
 Budgetary control can cause perceptions of unfairness.
 Budgetary control can create competition for resources and politics.
 A rigid budgetary control reduces initiative and innovation at lower levels, making it impossible to
obtain money for new ideas.

 Budgets could lead to conflict between departments
QUESTION 3
State three advantages that may arise from preparing budgets from standard costs. [3]
MAY 2005 P4 Q2 (d)
SOLUTION
Mark Scheme
Standard costing
 facilitates preparation of budgets
 provides basis for calculating variances
 standards must be kept up-to-date
 standard costs are acceptable for inventory valuation.
(Maximum of three points 1 mark for each point) [3]
Suggested Solution
If budgets are prepared form standard costs, they have the following advantages.
 Standard costs especially when regularly updated facilitate preparation of budgets.
 Standards costs are acceptable for inventory valuation under SSAP 9.
 Calculation of variances from budgets prepared from standard costs become easy.
QUESTION 4
Briefly describe how flexible budgets work?
MAY 2001 P2 Q4
OR
Explain what is meant by flexible budgetary control. [3]
MAY 2012 P42 Q3 (a)
OR
State two reasons why a business prepares a flexed budget. [2]
MAY 2017 P31 Q5 (a)
SOLUTION
Mark Scheme
A company sets a budget for a certain level of output (1). if the actual level of activity is higher or lower than
this level (1) the budgeted figures are adjusted/recalculated to the actual level (1) So that meaningful
comparisons can be made. (1)
[3]
Teacher's Solution
Flexible budget recognises the existences of fixed, variable and mixed (semi-fixed, semi variable) costs. It
considers certain items, which will react to changes in the volume of activity and the budget can be “flexed”
to reflect this.
A company sets a budget for a certain level of output. If the actual level of activity is higher or lower than
the original estimate. The flexible budget adjusts to changes in activity level by flexing the data of original
budget in accordance with the actual level.
Flexible budget helps in planning (by preparing a series of budgets based on different volumes of activity)
and as a part of the control process (to ensure “like is being compared to like”).
QUESTION 5
Hiemstra Limited manufactures a single product. It operates a flexible budgetary control system.
REQUIRED
Explain why flexible budgetary control is better than a fixed budget to monitor the costs of a business. [4]
MAY 2012 P42 Q3 (b)
SOLUTION
Mark Scheme
With a fixed budget, the figures are not changed whatever the actual level of output 1. This means that if
the actual level is different from the budget level of activity any comparison between the two will not be any
help to management 1. It will be difficult to identify the reason for any difference 1 or what actions to take
to correct any problems 1
[4]
Suggested Solution
A company sets a budget for a certain level of output. If the actual level of activity is higher or lower than
the original estimate. The flexible budget adjusts to changes in activity level by flexing the data of original
budget in accordance with the actual level.
Fixed budget is a budget based on a single level of activity (e.g., a particular volume of sales or production)
and is not adjusted for changes in the volume of output. Businesses using fixed budgets have no
allowances for possible changes in their budgetary needs. If actual output is different from budgeted output
It will be difficult to identify the reason for any difference or what actions to take to correct any problems
QUESTION 6
Explain a how principal budget factors affect the preparation of budgets. [7]
MAY 2003 P4 Q3 [d(i)]
SOLUTION
Mark Scheme
 budgets formalise management plans (1).
 budget preparation ensures that all functions of a business are properly co-ordinated (1).
 budgets may indicate possible future shortages of resources so that remedial measures may be
 participation by management at all levels in budget preparation induces a sense of commitment by
 the preparation of budgets for individual departments, functions etc. is a form of responsibility
accounting (1).
 budgets provide information for on-going control of business activities (1).
(other points may be acceptable.) [7]
Suggested Solution
In practice, it is unlikely that budgets will be prepared in strict sequence from start to finish. In particular, the
preparation of budgets may be affected by the existence of one or more principle budget factors (limiting
factors). Assume that direct materials is a principal budget factor and this limitation cannot be overcome,
its existence will determine the mix and quality of products and may mean that the company cannot fully
satisfy expected demand in future.
In effect, the principal budget factor becomes the starting point for budget preparation. It could also happen
that an unforeseen limitation may emerge during budget preparation; in this case, budgets would need to
be revised accordingly. Failure to reflect such a resource limitation will render budgets pointless at best and
seriously misleading at the worst.
QUESTION 7
Discuss the advantages to Roland of preparing a cash budget. [3]
MAY 2000 P2 Q4 (a)
OR
State two reasons why management prepares a cash budget. [2]
OR
State two benefits of preparing a cash budget. [2]
NOVEMBER 2016 P32 Q6 [a(ii))
OR
State two benefits of preparing a cash budget. [2]
SOLUTION
Mark Scheme
 Identify and solve cash flow problems (1). E.g. avoid overdrafts
 Identify possible investment opportunities for surplus cash (1).
 Control of cash (1)
 Plan timing of expenditure (1)
 Co-ordination and communication of departmental cash needs (1)
 Motivates staff to achieve departmental objectives (1) Max
2
[2]
Teacher's Solution
 Cash budget will show to Roland the pattern of future cash flows giving information on cash
surpluses, which can be used, or deficits, which have to be funded.
 Short end long-term cash needs can be identified and funded by Roland in an appropriate manner.
 A detailed cash budget will encourage efficiency within Roland business and will ease borrowing
when necessary by showing control being exercised over resources.
QUESTION 8
RengawLtd’s bank overdraft is limited to $40 000. State four actions the directors could take to avoid the
overdraft limit being exceeded. Where possible state the effect of each of the actions on the bank balance.
[11]
NOVEMBER 2004 P4 Q1 (b & c)
SOLUTION
Mark Scheme
Actions to keep bank balance within overdraft limit
 reduce inventory (1) by (82 000 - 32 000) $50 000 (1)
 delay purchase of machine (1) saving $30 000 (1)
 Alternatively hire machine (1) saving most of $30 000 (1)
 increase selling prices by 5% (1) if this can be done without decreasing volume (1) increasing
revenue by $10 000 (1)
 reduce cost of purchases by 5% (1) $6 000 (1) by obtaining discounts (1) or buying from cheaper
suppliers (1)
 delay payment of dividend (1) $8 000 (1)
 give incentives to customers to purchase for cash (1)
 negotiate longer credit from suppliers if possible without loss of confidence (1)
 issue shares (1)
 issue debentures (1)
 renegotiate overdraft (1)
1 mark for identification
1 mark for development
1 mark for effect on bank balance Max [11]
Suggested Solution
The directors could take following actions to avoid overdraft limit being exceeded
 Purchase of machine in November may be deferred, or it may be purchased on credit or on hire
purchase or may be leased. This will reduce cash outflows by $30 000 in November and budgeted
overdraft figure in November and subsequent month.
 Trade receivables may be given an incentive to make early payments but this may involve a loss
of custom and may involve a cost (discount allowed). Moreover efforts may be made to sell more
for cash so if significant numbers of trade receivables pay in the month of sale then overall cash
cycle will be shortened and will cause reduction in overdraft.
 Payments to trade payables may be delayed to cut the cash cycle short. However this may result
in loss of discounts receivable stopping of delivery of goods from suppliers or a requirement from
them to “pay cash with order” in future.
 Check the tendency for overpayment, payments would be tailored to match the resources.
 Cut down expenses, which can possibly be delayed until liquidity position of the business is
restored.
 New preference or debentures issue may be made to improve cash.
 Enhancement of overdraft facility may be negotiated
 Dividend payment may be delayed.
QUESTION 9
Explain one measure that the managers of a business might adopt if they are faced with a cash deficit in
one month of an annual cash budget. [2]
MAY 2008 P4 Q3 (d)
OR
Explain two measures that might be taken to resolve a forecast cash deficit in one month. [4]
OR
The directors wish to eliminate the expected deficit in cash at the end of February. They are considering
paying $15 000 in January for an advertising campaign which is expected to increase sales from February
onwards.
REQUIRED
Suggest two possible actions the directors could take, other than the advertising campaign, to improve the
cash flow. [2]
SOLUTION
Mark Scheme
 do nothing if indeed the cash deficit is only for one month.
 reschedule payments.
 get trade receivables to pay more quickly.
 negotiate temporary overdraft facility.
 other sensible solutions to be rewarded accordingly.
1 mark for recognition plus 1 mark for development [max 4]
Teacher's Solution
 There is no need to do anything as it may only be a short term problem
 Arrange overdraft facilities
 If the overdraft will cause problems then make an attempt to reschedule some of the payments etc.
 Trade receivables may be offered cash discounts for early payments.
 Purchase of non-current assets may be deferred
QUESTION 10
Explain two differences between a cash budget and a cash flow statement. [4]
MAY 2008 P4 Q3 (c)
Or
Explain the difference between a statement of cash flows and a cash budget. [2]
Or
State one difference between a cash budget and a statement of cash flows. [1]
NOVEMBER 2016 P32 Q6 [a (i)]
SOLUTION
Mark Scheme
 A cash budget deals with the future whilst a statement of cash flows deals with historic data (1).
 A cash budget does not deal with non-cash items whereas a statement of cash flows does, e.g.
depreciation (1)
 A cash budget is an internal document whilst a statement of cash flows is published. (1)
Max (1) [1]
Suggested Solution
Cash flow statements are similar to cash budgets in the content that they show sources and uses of cash
but they are different in many respects some of which are given below.
(i) Cash flow statements are published for external use and they are part of a company’s published
financial statements whereas cash budgets are only used for internal purposes.
(ii) Cash flow statements are based on historic data and shows sources and uses of cash for previous
year whereas a cash budget shows the same for a coming period.
(iii) There is no set format of cash budgets but a cash flow statement has to be prepared in compliance
with FRS 1.
(iv) Cash flow statements show reasons for changes in cash for a whole year whereas companies may
prepare cash budgets to show changes in cash on monthly, weekly or yearly basis.
(v) A company is bound to prepare a cash flow statement on annual basis whereas there is no such
compulsion for a cash budget.
QUESTION 11
(i) Name one item which may appear in an income statement which cannot appear in a cash budget.
[1]
MAY 2011 P43 Q3 [f(i)]
(ii) Name one item which may appear in a cash budget which cannot appear in an income statement.
[1]
MAY 2011 P43 Q3 [f(ii)]
SOLUTION
Mark Scheme
(i) Depreciation
Increase in PDD
(ii) Loan repayment
Purchase of non-current (fixed) asset
Any acceptable answer [2]
Suggested Solution
(i) Depreciation, bad debts
Change in Provision for doubtful debts
(ii) Loan repayment

Purchase, sale of a non-current asset
QUESTION 12
Explain what is meant by a master budget. [2]
SOLUTION
Mark Scheme
A master budget is the consolidation of all of the prepared budgets (1). It consists of a budgeted income
statement and statement of financial position (1). [2]
Suggested Solution
A master budget is a set of interconnected budgets of sales, production costs, purchases, incomes, etc.
and it also includes pro forma financial statements.
QUESTION 13
Differentiate between Standard Cost and Budget
SOLUTION
Both ‘Standard costing’ and a ‘Budgetary control system’ aim at the same objective-managerial control.
This gets support by the fact that both use predetermined costs for the coming period. Periodical reports
are also prepared for both systems to compare budgeted or standard costs with actual costs to pinpoint
favourable or adverse areas. On this basis many people believe that the two are the same and cannot
function independently.
A standard provides cost estimation per unit of activity whilst a Budget provides the cost expectation for the
total activity. Standard Costs represent target costs that should be attained if certain performances are
achieved. As standard costs are expressed on per unit basis so they help in building flexible budgeting
and feedback system (the comparison of actual performance with planned performance).
The principle difference between budgets and standard costs lies in their scope. Budgets estimate
requirements in terms of workforce, finances, sales etc for forth coming activity. They act as a guidepost
which keeps the business on a charted course to attain a given objective. Standards on other hand estimate
individual costs to be incurred within effective and efficient working conditions.
Usually both systems of standard costing and budgetary control are operated together as both are
interrelated, but it must be emphasized that they are not interdependent. Both systems can be operated
independently but as both facilitate each other so it would be difficult to operate one of them in the absence
of other system.
QUESTION 14
Differentiate between forecasting and Budgeting
SOLUTION
Forecasts are projections of what is likely to happen usually over multiple years based on past and current
conditions. Budgets are the estimates of future financial conditions over a specified period, reflecting what
an organisation has set itself as a target for what should happen based on targets, efforts and plans to
improve the present conditions.
Though forecasts and budgets look alike, forecasting is a bit more general and helps in preparation of
budgets, while budgeting a bit more specific to financial conditions. In other words a budget is a plan
whereas a forecast is a prediction of future events and conditions. When it is first established a budget will
also be a forecast - i.e. forecast and plan ought to coincide.
CHAPTER 5.3 STANDARD COSTING

QUESTION 1
Explain the term standard costing. [2]
MAY 2016 P32 Q6 (a)
OR
Explain what is meant by ‘standard costing’. [2]
SOLUTION
Mark Scheme
Standard costing is the preparation and use of budgeted, predetermined or expected costs (1) to calculate
variances (1), prepare budgets (1). [2]
Suggested Solution
Standard costing system is a tool for planning budgets, managing and controlling costs. It evaluates cost
management performance through variance analysis.
QUESTION 2
Explain four ways in which standard costing may be helpful to management. [7]
OR
State four advantages, which may result from, using standard costs [4]
MAY 2004 P4 Q2 (f)
OR
Explain two reasons why a system of standard costing might be introduced into a business. [4]
OR
State four advantages of using a standard costing system [8]
MAY 2010 P43 Q3 (f)
OR
Explain the purpose of standard costing. [4]
MAY 2012 P41 Q3 (a)
OR
Describe how standard costing would be useful to Peter Parfitt. [4]
OR
State three advantages to the company of operating a standard costing system. [3]
MAY 2017 P32 Q5 (e)
SOLUTION
Mark Scheme
Advantages of using standard costs
 Standard cost can be used to facilitate the preparation of realistic budgets
 Variances between budgeted and actual activity may identified/explained
 Differences between actual expenditure and budgeted expenditure is easy to identify
 Enables management to understand why actual performance differs from budgets
 Responsibility for variances may be allocated to persons involved
 Workforce aware of being monitored so could encourage them. (1)
 Standard costs facilitate the preparation of estimates for new products\quotations for jobs.
 Enables responsibility accounting.
(1 mark for each point. Maximum 4 points) [4]
Suggested Solution
The following are the advantages of using standard costing
 Standard costing helps management in the planning and control of the business.It act as a control
device by highlighting those activities those do not conform to plan, and thus alerting decision-
makers to those situations that may be ‘out of control’ and in need of corrective action.
 It makes budgets easier to prepare
 It makes budgets more realistic
 It aids setting of selling price.
 It aids decision making
 It helps with controlling resources.
 It provides a benchmark to measure actual performance
 It provides a ‘yardstick’ against which actual performance may be measured.
 It identifies areas where savings could be made.
 It enables the use of responsibility accountingby allocating responsibility for variances to different
managers.
 It facilitates the preparation of budgets.
 It simplifies the task of tracing costs to products for inventory valuation purposes
 It permits management by exception which means that the management’s attention is concentrated
on the important deviations from standards and budgets.
QUESTION 3
Explain one reason why the following variances calculated in (a) might have arisen:
(i) Sales price
MAY 2009 P4 Q3 (c)
(ii) Sales volume
MAY 2009 P4 Q3 (c), MAY 2012 P41 Q3 (a)
(iii) Material price
MAY 2009 P4 Q3 (c), MAY 2012 P41 Q3 (a), NOVEMBER 2016 P31 Q5 (c), MAY 2017 P32 Q5 (c)
(iv) Material usage
MAY 2009 P4 Q3 (c), SPECIMEN 2016 P3 Q6 (d), NOVEMBER 2016 P31 Q5 (c), MAY 2017 P32 Q5 (c)
(v) Labour rate
MAY 2009 P4 Q3 (c), MAY 2012 P41 Q3 (a), NOVEMBER 2015 P41 Q3 (c), SPECIMEN 2016 P3
Q6 (d), NOVEMBER 2016 P31 Q5 (c)
(vi) Labour efficiency
MAY 2012 P41 Q3 (a), NOV 2015 P41 Q3 (c), NOV 2016 P31 Q5 (c), MAY 2017 P31 Q5 (e)
SOLUTION
(i) Sales Price Variance:
 Change in market conditions
 price cuts
 imposition of sales tax
 change in material prices or wage costs.
(ii) Sales Volume Variance:
 high sales prices by business in comparison to competitors;
 change in customers’ taste and preferences;
 increase in competition level in the market;
 poor sales forecasts;
 poor marketing of products;
 less aggressive advertising or marketing strategies
 deficient product design emerging from poor engineering
(iii) Material Price Variance:
 standard price set unrealistically;
 unpredictable increase of market prices;
 change of supplier with worse terms;
 buying superior quality than planned;
 losing trade (quantity) discounts by paying in smaller quantities;
 change in market conditions e.g. inflation, increase in duties like import duties, change in
interest rates etc
(iv) Material Usage Variance:

 Use of superior or inferior quality than planned
 change in production techniques
 greater or lower rate of scrap (wastage) than expected
 hire of higher or lower grade (skill) of workers
 errors in allocating material to jobs.
 extra hours meant staff were demotivated/tired
 inefficient use of material
(v) Labour Rate Variance
 hiring of lower grade (skill) of workers than planned;
 unplanned decrease in overtime or bonus payments;
 unexpected decrease in wage rates may be due to market conditions;
 increase in supply of labour due to unemployment or for other reasons
(vi) Labour Efficiency Variance
 Use of high or low grade of labour
 use of superior or inferior material
 poor or good supervision
 change in production process (techniques)
 introduction of new equipment or tools
 lack of or improved staff training
QUESTION 4
Variable Overhead Expenditure Variance
 Increase or decrease in general price level
 Effects due to seasonal variations
 Poor budgeting
 Wrong classification of variable overheads as fixed overheads or vice-e-versa
Variable Overhead Efficiency Variance
 age level or health conditions of workers
 hiring of higher or lower skilled labour than planned
 change in production process (techniques) or technology
 effects of learning curve after hiring new or inexperienced workers
Fixed Overhead Expenditure Variance
 Increase or decrease in general price level
 Effects due to seasonal variations
 Good or poor cost management
 Wrong classification of variable overheads as fixed overheads or vice-e-versa
Fixed Overhead Volume Variance
 Increase or decrease in production volume
 Increase or decrease in demand level
 Change in labour productivity
 Loss of production due to strike, inventory outs, machine breakdowns or other reasons
Fixed Overhead Volume Efficiency Variance
 age level or health conditions of workers
 change in production process (techniques) or technology
 effects of learning curve after hiring new or inexperienced workers
Fixed Overhead Volume Capacity Variance
 hours worked higher or lower than budget
 unplanned increase or decrease in overtime hours due to change in demand
 change in demand level for company's products
 introduction of new equipment or tools
QUESTION 5
Discuss possible links between two pairs of variances calculated above. [6]
OR
Explain how any two of the material & labour variances may be connected. [2]
OR
Explain how a raw materials usage variance might be connected to a direct labour efficiency variance. [6]
MAY 2009 P4 Q3 (d)
OR
A company operates a standard costing system. State with reasons what effects might be observed if:
(i) raw material is of a higher quality than usual. [6]
(ii) directlabour has a lower skill level than usual. [6]
OR
In March the company bought raw materials which were of a lower quality than usual. Explain how the
purchase of lower quality raw materials had affected the variances. [8]
OR
Advise the directors whether this purchase of lower quality materials has benefitted the business. [6]
SOLUTION
Mark Scheme
If a favourable material usage variance is evident then fewer materials have been used than was planned
then this generally means that more highly skilled workers have been employed or that training has been
undertaken in this particular part of the business; the workers have taken less time to produce the goods.
[0–6]
If an adverse material usage variance is evident then more materials have been used than was planned
then this generally means that less skilled workers have been and they have therefore taken longer to
complete their work than had been anticipated. [0–6] [max 6]
Suggested Solution
(i) Due to purchase of better quality material, the material price variance is likely to be adverse due to
purchases at higher rate. However, as better quality of materials would result in less wastage &
spoilage so material usage variance is likely to be favourable. In addition, due to use of better
quality material, labour efficiency may improve resulting in favourable efficiency variance.
(ii) The use of low skilled labour would be cheaper resulting in favourablelabour rate variance.
However, the Labour efficiency and Material usage variances are likely to be adverse due to slow
speed, improper handling of production facilities and by making more mistakes in using material.
QUESTION 6
State which costing method is best suited to the following situations:
(i) a company wishes to calculate a break-even point. [2]
(ii) a customer requires a quote for the manufacture of a large, one-off item. [2]
(iii) goods are produced in a sequence of continuous manufacturing operations. [2]
(iv) production costs need to contain an element of the costs of support or service departments. [2]
(v) a price is needed for one item out of a set of identical items. [2]
SOLUTION
Mark Scheme
(i) Marginal costing
(ii) Job costing
(iii) Process costing

(iv) Absorption costing
(v) Batch or unit costing
5 × 2 marks [10]
Suggested Solution
(i) Marginal costing
(ii) Absorption costing
(iii) Job costing
(iv) Batch or unit costing
(v) Process costing
QUESTION 7
For each event listed below identify which variance would be affected and give one example of a variance
which might arise. State whether the effect would be favourable or adverse.
(i) Theft of raw materials
(ii) Changing suppliers making raw materials more expensive
(iii) Giving sales discounts for bulk buying
(iv) Investment in more reliable machinery
(v) Use of higher grade raw materials
(vi) Decrease in overtime hours. [12]
MAY 2013 P43 Q3 (d)
SOLUTION
Mark Scheme
(i) Materials usage
(ii) Materials price
(iii) Sales price
(iv) Labour efficiency
(v) Materials price
OR
Materials usage
(vi) Labour rate [12]
Suggested Solution
(d) (i) Materials usage variance Adverse
(ii) Materials price variance Adverse
(iii) Sales price variance Adverse
(iv) Labour efficiency variance Favourable
OR
Materials usage variance Favourable
(v) Materials price variance Adverse
OR
Materials usage variance Favourable
(vi) Labour rate variance Favourable
QUESTION 8
Suggest reasons why the cost per unit could change with the increase in sales for:
(i) direct material
(ii) direct labour. [4]
SOLUTION
Mark Scheme
(i) Direct Material costs – quantity discounts (1) / savings on carriage inwards (1)
(ii) Direct labour – more hours worked leading to overtime rates (1) / shortage of labour leading to higher
wage rates (1) [4]
Suggested Solution
Direct material costs per units usually decreases with the increase in the units of sales and production due
to bulk buying discount, reduction in carriage costs on per unit basis.
Direct labour cost per unit may increase due to increase in the units of production due to increase in
overtime cost or non-availability of labour with required skill at current labour rate.
QUESTION 9
In an attempt to control costs, Khalid is considering to:
1 Stop the quality assurance checks usually made during the production process.
2 Find a cheaper supplier for materials to make the blankets.
3 Keep the selling price at $40 per blanket.
REQUIRED
Recommend to Khalid which option or options he should choose. Justify your answer. [5]
MAY 2016 P32 Q6 (e)
SOLUTION
Mark Scheme
 If quality assurance checks are stopped then need to employ a workforce with more skills (1) as
long as the cost does not exceed the benefit (1).
 If quality check is stopped, cost saved (1) but may affect product (1) may lead to less sales/profit
(1).
 Cheaper materials of poorer quality (1) may increase the adverse material variance (1) and labour
efficiency (1) and lead to less sales/profit (1).
 Reputation of the business may also suffer (1). Cheaper supplier reduces costs (1), but quality
must be maintained otherwise adverse effect on sales/profit (1)
 Keeping the selling price at $40 will not have a direct effect on costs (1).
1 mark for recommendation + max 4 marks for comments [5]
Suggested Solution
If business stops the quality assurance checks usually made during the production process then cost may
reduce but it may affect quality of product resulting in ultimate reduction of sales and profits. This would
then be supplemented by more skilled labour force as long as the cost does not exceed the benefit.
Cheap or low quality materials may lead to adverse material and labour efficiency variance and will reduce
sales/profit. Reputation of the business may also suffer.
Keeping the selling price at $40 per blanket will not have a direct effect on costs
QUESTION 10
Discuss different types of standard as used in standard costing.
SOLUTION
Current Standards:
 Based on current working conditions (current inefficiencies, current wastages etc).
 The disadvantage is that they do not attempt to improve on current efficiency levels.
Basic Standards:
 Kept unaltered for a long period of time
 may be out of date as do not account for changes in technology and efficiency levels of workers.
 Used to show changes in efficiency or performance over a long period of time.
 Least useful and least common type of standard
Ideal/Perfect/Unattainable standards:
 Based on perfect working conditions i.e. they assume that there are no wastages, no inefficiencies,
no breakdown, no idle time, no spoilage etc.
 Have unfavourable motivational impact on workers as they know that reported variances will always
be adverse.
 Useful in determining that where actual performance falls short of the ideal.
Attainable/Efficiency Standards:
 They assume that a standard amount of work will be done efficiently.
 They make allowance for normal wastages of material, normal idle time of labour, normal machines
breakdowns but still present employees with a reasonable challenge to achieve the standard.
QUESTION 11
List down the factors which must be taken into account in the setting of standards
SOLUTION
 The expected level of activity. If set at an unrealistically high level then they may not act as an
incentive if workers consider that the standards are unachievable. An unrealistically high level of
activity may also cause under-costing of products.
 A sound method of budgetary control is desirable.
 Requires the support of management and the approval of the workforce. A series of
induction/training courses for staff and employees would be helpful.
 The degree of sophistication/complexity must be appropriate to the type of business and the needs
for management information.
 Standards should be based on a level of performance which is reasonably achievable by an
experienced and properly motivated workforce when using the most appropriate production
methods.
QUESTION 12
Explain Fixed and flexible budgets
SOLUTION
Fixed Budget
A fixed or static budgetis based on a projected level of output, prior to the start of the period. In other words
it shows the expected results for a single activity level. However the term “fixed budget” does not mean that
budget is kept unaltered. Revision to fixed budgets may be made if situation requires so. The term “fixed”
means that the budget is not designed to change with changes in activity level. Once sales and expenses
are estimated, they become the relevant benchmarks.
Though a fixed budget is very useful for planning and control purposes. However, problems may arise due
to use of fixed budgets for performance evaluation. Specifically, when the actual output varies from the
anticipated level, variances are likely to arise. These variances can be quite misleading as e.g. if a business
greatly exceeded the sales goal, it is reasonable to expect costs to also exceed planned levels especially
the variable costs which are directly related to volume. We know it is a good thing to produce and sell more
than planned, but the variances resulting from the higher costs can appear as a bad thing! The opposite
occurs when volume is less than anticipated. How ludicrous would it be to fault the manager of the business
for having cost overruns?
Flexible Budget
It is essential for proper cost control to compare actual and budgeted performance for the same level of
activity; the flexible budget serves the purpose by comparing like with like. The flexible budget responds to
changes in activity by adjusting or flexing for changes in activity levels. It recognises that failing to meet
sales goals should be accompanied by a reduction in variable costs. Certainly it would make no sense to
congratulate a manager for holding costs down in this case. A flexible budget is one that reflects expected
costs as a function of business volume; when sales rise so do certain budgeted costs, and vice versa.
If a business actually produced and sold 50 000 units, then management should compare actual costs and
revenues for 50 000 units to what the business should have spent to make 50 000 units, not to what the
factory should have spent on 45 000 units or 55 000 units or any other output level.
QUESTION 13
The management of the company is evaluating a plan to retrain the existing workers to improve their
efficiency.
REQUIRED
Discuss the disadvantages to EF plc if they proceed with this plan. [3]
MAY 2017 P31 Q5 (f)
SOLUTION
Mark Scheme
 Resistance
 Training costs
 Loss in production while training
 May not help if real cause of variances is not found
Max 3
Suggested Solution
 Once fully trained, staff may leave for better paid jobs
 Financial cost of training may be high
 Work time is lost when staff are being trained
 Quality of training must be high for it to have a positive effect
CALCULATION OF VARIANCES
(i) Sales price variance $

Actual volume × Actual price xxxx
Actual volume × Standard price (xxx)
Sales price variance [favourable/(adverse)] xxxx
(ii) Sales volume variance

Actual volume × Standard price xxxx
Budgeted volume × Standard price (xxx)
Sales volume variance [favourable/(adverse)] xxxx
(iii) Material Price variance

Actual material price × Actual material quantity xxxx
Standard material price × Actual material quantity (xxx)
Material Price variance [adverse/(favourable)] xxxx
(iv) Material usage variance

Actual material quantity × Standard material rate xxxx
Standard material quantity × Standard material rate (xxx)
Material usage variance [adverse/(favourable)] xxxx
(v) Labour Rate Variance

Actual labour hours × Actual labour rate xxxx
Actual labour hours × Standard labour rate (xxx)
Labour Rate Variance [adverse/(favourable)] Xxxx
(vi) Labour Efficiency Variance

Actual labour hours × Standard labour rate xxxx
Standard labour hours × Standard labour rate (xxx)
Labour Efficiency Variance [adverse/(favourable)] xxxx
(vii) Total Variable overhead variance

Actual hours × Actual rate xxxx
Standard hours × Standard rate (xxx)
Total variable overhead variance [adverse/(favourable)] xxxx
(viii) Variable overhead expenditure variance $

Actual hours × Actual rate xxxx
Actual hours × Standard rate (xxx)
Variable overhead expenditure variance [adverse/(favourable)]
(ix) Variable overhead efficiency variance

Actual hours × Standard rate xxxx
Budgeted Hours × Standard rate (xxx)
Variable overhead efficiency variance [adverse/(favourable)] xxxx
(x) Total Fixed overhead variance $

Actual hours × Actual rate per hour xxxx
Flexed budgeted hours × Standard rate per hour (xxx)
Total Fixed overhead variance [adverse/(favourable)] xxxx
(xi) Fixed overhead expenditure variance $
Actual hours × Actual rate per hour xxxx
Original budgeted hours × Standard rate per hour (xxx)
Fixed overhead expenditure variance [adverse/(favourable)] xxxx
(xii) Fixed overhead volume variance

Flexed budgeted hours × Standard rate per hour xxxx
Fixed overhead volume variance [favourable/(adverse)] xxxx
(xiii) Fixed overhead efficiency variance

Actual hours × Standard rate per hour xxxx
Flexed budgeted hours × Standard rate per hour (xxx)
Fixed overhead efficiency variance [adverse/(favourable)] xxxx
(xiv) Fixed overhead capacity variance

Actual hours × Standard rate per hour xxxx
Fixed overhead capacity variance [favourable/(adverse)] xxxx
CHAPTER 5.4 CAPITAL INVESTMENT APPRAISAL

QUESTION 1
State the advantages and disadvantages of using the following methods:
(i) Accounting rate of return (ARR) [4]
MAY 2004 P4 Q3
(ii) Payback period, [4]
MAY 2004 P4 Q3, NOVEMBER 2016 P31 Q6 (e), MAY 2017 P32 Q6 (c)
(iii) Internal rate of return (IRR) [4]
MAY 2004 P4 Q3
(iv) Net present value [2]
SOLUTION
Mark Scheme
Accounting rate of return
Advantages
 profitability of a project may be compared with present profitability of business
 it is relatively easy to calculate
Disadvantages
 average annual profit may not be typical of any year
 timing of cash inflows and outflows is ignored
 it ignores the payback risk factor
 it ignores the time value of money
 ‘profit’ is subjective (provisions for depreciation, bad debts etc.)
 no commonly accepted method of calculating capital employed
 ignores duration of project
Payback period
Advantages
 it is relatively easy to calculate
 calculation of net cash flows is less subjective than calculation of profitability
 where competing projects are being considered, the risk factors may be compared as risk
may be reduced by preferring early cash flows/short term projects
 short payback periods benefit business’s liquidity and facilitate faster growth
 useful as a first screening tool
 better for liquidity–prefers early cash flows
Disadvantages
 life expectancy of project is ignored
 different projects may have similar payback periods but different patterns of cash flows
 time value of money may be ignored
Internal rate of return

Advantages
 indicates return actually to be expected from expenditure
 may assist in ranking different proposals
 often used in businesses
 recognises time value of money
Disadvantages
 more difficult to calculate than npv
 npv is usually more useful in ranking different projects
Net Present Value

Advantages
 time value of money used (1),
 easy to understand (1),
 greater importance
 given to earlier cash flows (1).
Disadvantages
 difficult to predict cash flow (1),
 length of project difficult to predict (1),
 cost of capital may change during project (1). max 1 .[2]
Suggested Solution
The advantages and disadvantages of different appraisal methods are given below:
(i) Accounting Rate of Return
Advantages
 Easy to calculate
 Easy to understand
Disadvantages
 Time value of money ignored
 Based on profit which is subjective (based on accounting policies)
 Ignore duration of project
 Timings ofcash receipts and payments is ignored
(ii) Payback Method

Advantages
 Easy to calculate and understand
 Based on cash flows (more objective than profits)
 Useful for risky proposals (shorter payback is preferred)
 Useful in liquidity crises
Disadvantages
 Ignores the time value of money unless discounted payback is calculated
 Ignores all cash flows which arise after the payback period
 Ignores the size of investment and its overall cost/benefit
(iii) Internal Rate of Return

Advantages
 Based on time value of money
 Indicates return actually to be expected from the expenditure
 Based on cash flows (more objective than profits)
Disadvantages
 Calculation is rarely precise
 Unable to cope with a change in the cost of capital during the proposal’s life
 Reinvestment assumed to occur at a project’s IRR
(iv) Net Present Value

Advantages
 time value of money used
 easy to understand
 greater importance given to earlier cash flows
Disadvantages
 difficult to predict cash flow
 length of project difficult to predict
 cost of capital may change during project
QUESTION 2
State two limitations of each of the following:
(i) accounting rate of return [2]
(ii) the payback period [2]
(iii) the net present value. [2]
MAY 2010 P42 Q3 (c)
SOLUTION
Mark Scheme
Limitations
(i) ARR
 ignores timing of cash flows
 ignores risk
 average profit and average capital may be difficult to estimate
(ii) Payback
 ignores length of project life
 ignores timing of cash flows
(iii) NPV complex calculations

 cash flows are estimates
 difficulties in deciding on cost of capital [6]
Suggested Solution
(i) Accounting Rate of Return:
 It ignores time value of money i.e. It makes no distinction between two projects of the same
average profits, one of which given most of its profit at an early stage and the other gives
most of its profit at a later stage.
 It is based on profit which is quite subjective as is based on varying accounting policies
and methods, so it is better to use cash flows, which does not contain the same amount of
subjectivity.
 It ignores timings of cash receipts and payments.
 It is not adjusted for the greater risk to longer term forecasts.
(ii) Payback Period:

 It does not take into account the time value of money unless discounted payback is
calculated which is discussed later in the chapter
 It ignores all cash flows which arise after the payback period
 It ignores the life expectancy of the project
 Its accept/reject criterion is arbitrary and varies from business to business.
(iii) Net Present Value:

 Determination or selection of discount rate involves subjectivity as it may be different for
different organizations.
 It involves complex calculations
 There may be uncertainties about the estimated life of the project.
 It ignores the possibility that cost of capital may change during the expected life of the
project.
QUESTION 3
Distinguish between the payback method of investment appraisal and the net present value method. [4]
SOLUTION
Mark Scheme
Payback does not consider the time value of money (1) whereas net present value does (1)
Payback calculates the time it takes to cover the initial cost of the investment and does not consider the net
cash flow after the payback period (1).
Net present value considers the discounted cash flows for the whole life of the investment (1)
Suggested Solution
 Payback does not consider the time value of money whereas net present value does
 Payback considers the net cash flow only within the payback period whereas net present value
considers the cash flow for the whole life of the project.
 Payback ignores timings of cash flows but Net present value does.
QUESTION 4
Explain briefly what you understand by the internal rate of return (IRR) of a project. [2]
OR
Explain what you understand by the internal rate of return (IRR).Identify how IRR could be used to appraise
this proposal. [3]
MAY 2012 P43 Q3 (e)
SOLUTION
Mark Scheme
The internal rate of return is the rate which gives a zero net present value. (1)
Discount rates below the IRR will result in a feasible project and vice versa. (1) [2]
If NPV is lower. 1 the proposal should be rejected 1 and vice versa 1Since the NPV is negative at 10% 1
the IRR is lower than the cost of capital 1. [Max 3]
Suggested Solution
The internal rate of return is the discount rate at which net present value is zero. In other words it is the
discount rate at which present value of inflows is equal to present value of outflows. If cost of capital is lower
than the internal rate of return then the proposal should be rejected and vice versa. The negative NPV
reveals that the IRR is lower than the cost of capital.
QUESTION 5
Suggest why Clegg requires the new machine to produce an IRR of at least 22% if it already produces a
positive NPV. [4]
SOLUTION
Mark Scheme
 A positive NPV suggests that expenditure may be considered subject to other conditions
 Being favourable (1)
 If IRR is less than the present R.O.C.E. of 22% the project will dilute the present profitability. (1)
 This may be a reason for not proceeding with the expenditure regardless of the favourable NPV.
(1)
 IRR greater than22% will enhance profitability. (1) [4]
Suggested Solution
Although projects having positive net present value should be considered provided other factors and
conditions are favourable. Clegg requires IRR of at least 22% perhaps due to the reason that 22% is present
rate of return on capital employed. So, projects having an IRR of less than present ROCE of 22% may
dilute the present profitability. So, this may be a reason for not proceeding with the expenditure regardless
of the favourable net present value.
QUESTION 6
State and explain two advantages that Discounted Cash Flow has over Payback as a method of capital
investment appraisal. [4]
NOVEMBER 2001P2Q3 (a)
SOLUTION
1. Discounted cash flow techniques recognise that $1 received now is worth more than $1 received
afterwards. (Time value of money) whereas payback ignores this.
2. Discounted cash flow techniques recognise cash flows for the entire life of the project, whereas
payback period ignores cash flows after payback period.
QUESTION 7
In what ways might investment decisions be affected by non-financial factors? [4]
NOVEMBER 2001P2Q3 (a)
OR
Identify four other factors other than NPV which may be used to determine the acceptability of the project.
[4]
OR
State three non-financial factors Alexander should consider when choosing between Product X and Product
Y. [3]
OR
Discuss which factors, other than those you have considered in (f), Tisha should consider when making her
decision. [4]
MAY 2017 P32 Q6 (g)
SOLUTION
Mark Scheme
 Environmental issues.
 Political issues.
 Is initial finance available – or can it be raised?
 Cash flow patterns
 How reliable is forecast for long term projects?
 Are existing projects being affected?
 Workers availability required skills
 Is there sufficient space to carry out the work?
 Opportunity cost.
 Current economic conditions
 Current interest rate
 Which one is closest to current ROCE
 Source of capital/funding
 Quality of output
 Training time/costs
Any other reasonable point to be given credit.
1 mark for each point to maximum 4. [4]
Suggested Solution
 Delivery and installation time of assets to be bought.
 Can quality of output be maintained or not.
 Whether or not the workforce would need training to use the assets.
 New assets may be dangerous to use.
 Environmental issues.
 Compatibility with existing projects
 Reliability of project’s forecast in long run
 Workers availability with required skills
 Political stability
 Current economic conditions
QUESTION 8
The directors of Drake plc could finance the new project by issuing new ordinary shares and not using a
bank loan.
REQUIRED
(f) Explain how financing the new project from the proceeds of issuing new ordinary shares would
affect the accounting rate of return (ARR). [6]
MAY 2014 P41 Q3 (f), MAY 2014 P42 Q3 (f)
(g) State and explain two other sources of finance for the project. [4]
MAY 2014 P41 Q3 (g), MAY 2014 P42 Q3 (g)
SOLUTION
Mark Scheme
(f) Interest would not be charged to the project (1), therefore the profits should be higher (1). This
will result in a higher accounting rate of return (1).
ARR = 195 455 / 5 = 39 091 (1) of / 100 000 (1) = 39.09% (1) of. [6]
(g) Preference shares fixed dividend (1) in priority to ordinary shareholders (1).
Debenture secured on the asset (1). Interest charged may be at a lower rate than on the bank
loan (1). Interest is charged before dividend is paid to ordinary and preference shareholders (1).
Sale of surplus non-current assets (1) as long as this does not affect trading (1).
Venture capitalist could invest (1) but would require a return on his investment (1)
Accept other reasonable alternatives. [Max 4]
Suggested Solution
(f) If project is not financed through loan then interest would not be charged to the project, therefore
the profits should be higher. This will result in a higher accounting rate of return
(g) Preference shares: Preference dividends are paid at fixed rate. Preference dividend and capital
amounts are paid in priority to ordinary shareholders. Preference dividend on redeemable
preference shares is a chargeable expense against profits for tax purposes.
Debentures: These are usually secured on the asset. Interest charged may be at a lower rate than
on the bank loan. Interest is charged before dividend is paid to ordinary and preference
shareholders. Interest is also a chargeable expense against profits for tax purposes.
QUESTION 9
Explain to the directors which is the more valid method of investment appraisal.
Give reasons. [4]
SOLUTION
 Decision (1) Reasons (3) Max
 NPV takes account of time value and money (1)
 NPV takes account of the cost of capital (1)
 Accounting profit is subjective (1)
[4]
Suggested Solution
Net present value as it takes account of time value and money. It is based on cash flow which is more
objective than accounting profit. Moreover it takes account of the cost of capital.

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A

Muhammad Nauman Malik

Title A Level Accounting Notes

Published by Read & Write Publications

Composed by M. Salman, Sharjeel, Hayaat, Shahab, Naveed, Waqas, Awais

SECTION 1 AS LEVEL – FINANCIAL ACCOUNTING

CHAPTER 1.1 BAD & DOUBTFUL DEBTS

 deteriorating economic situation

CHAPTER 1.2 ACCOUNTING FOR NON-CURRENT ASSETS

State three causes of depreciation. [3]

Value of asset at the new assets Value of asset at

Provision for Depreciation Account

Asset disposal account

CHAPTER 1.3 BANK RECONCILIATION STATEMENT

CHAPTER 1.4 ACCOUNTING CONCEPTS

Letter written by Mr. X to his accountant

John & Co.

QUESTION 2 MAY 2001 P3 Q2

3. To be prudent, profit should not be anticipated unless it is being realised or earned, as

Conservatism (or Prudence) Principle

The Accrual Concept

Historic cost/Cost concept

Substance over form

CHAPTER 1.5 CAPITAL AND REVENUE

CHAPTER 1.6 SUSPENSE ACCOUNT

CHAPTER 1.7 CONTROL ACCOUNTS

(ii) correction of errors (1)

Award 1 mark per correct example: (maximum 2 marks) [2]

Sales Ledger Control Account

Purchase Ledger Control Account

Treatment of Two Balances in the Balance Sheet

CHAPTER 1.8 ACCOUNTS FROM INCOMPLETE RECORDS

CHAPTER 1.9 FINANCIAL STATEMENTS OF PARTNERSHIP

Items not affecting appropriation account

Fixed Capital accounts Fluctuating Capital accounts

Partner’s Capital accounts (when fluctuating)

Partner’s Capital accounts (when fixed)

Partner’s Current accounts

CHAPTER 1.10 PARTNERSHIP CHANGES

 Having to raise additional finance to pay Alice off

CHAPTER 1.11 RATIO ANALYSIS – AS LEVEL

 Price cut to dispose off old inventories.

Year ended 30 April 2011 Year ended 30 April 2012

 Trade payables (1)

 Government bodies (1)

 Employees and Trade Unions (1)

(ii) Comparing one business with another

(iii) Help in Decision making

1 Trade payables (suppliers)

4 Trade receivables (customers)

(1) Income Statement Ratios

(ii) Mark Up Gross Profit

(iii) Net Profit Ratio Profit after interest

(iv) Operating Expenses Ratio Operating Expenses

Net Profit after tax and Preference Dividends

(3) Turnover/Efficiency Ratios

(iv) Trade Receivables

(v) Trade Payables

(4) Liquidity Ratios

Current Assets− Inventory

SECTION 2 AS LEVEL – COST ACCOUNTING

CHAPTER 2.1 INVENTORY VALUATION

Net realisable value is the actual or estimated selling price less;