abe dip 1 -financial accounting june 2005

7/28/2019 ABE Dip 1 -Financial Accounting JUNE 2005

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THE ASSOCIATION OF BUSINESS EXECUTIVES

DIPLOMA PART 1

Accounting

morning 7 June 2005

1 Time allowed: 3 hours.

2 There areTHREE sections to the examination:

Section ATEN compulsory multiple choice questions,each question carries one mark. (10 marks)

Section BONE compulsory question. (30 marks)

Section C Four questions,TWO of which should beanswered.(Each question carries 30 marks) (60 marks)

3 No books, dictionaries, notes or any other written materials areallowed in this examination.

4 Calculators are allowed providing they are not programmable andcannot store or recall information. Electronic dictionaries andpersonal organisers are NOT allowed. All workings should beshown.

5 Candidates who break ABE regulations, or commit any misconduct,

will be disqualified from the examinations.

6 Question papers must not be removed from the Examination Hall.

Acct


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Section A

Question 1 (compulsory)

Answer ALL of the following multiple choice questions.

Write the number of the question and the letter which you considerto be the correct answer, for example 1 D.

You must write only ONE answer to each question.

1 An increase in which one of the following is a source offinance?

A Liabilities.B Assets.

C Expense.D Sales.

2 A company started out with 100,000 share capital and100,000 cash and then:

Bought fixed assets for 50,000 and paid cash;Bought stock for 50,000 and paid cash;Sold half the stock for 45,000 for cash;Incurred expenses of 10,000.

Ignoring depreciation, what is the net profit or loss beforetax and dividends?

A 15,000 lossB 10,000C 25,000D 35,000

3 If a company has a negative net worth, this means that:

A Total debt exceeds shareholders funds;B Total liabilities exceed total assets;C Current liabilities plus long term debt exceed current

assets;D The share price has collapsed and the assets of the

company are worthless

2


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4 Net profit is

A the increase in cashB sales less all expenses including purchasesC sales less all expenses other than purchasesD gross profit less expenses

5 Your warehouse staff found some damaged stock duringthe year-end stock take. Stock worth 10,000 had to bedestroyed. What will be the effect on the accounts?

A The gross profit margin will fall.B The book value of the business will rise because

unsaleable stock has been disposed of.C Since this years closing stock is next years opening

stock, the effect on the accounts over two years willbe zero.

D Cost of goods sold will fall.

6 The cost of goods sold is

A purchasesB salesC sales minus cost of salesD stock at start plus purchases minus stock at end

7 If wages accrued in a prior accounting period are paid incash, what happens to net working capital and profit aftertax?

A Net working capital decreases and profit after taxdecreases.

B Net working capital is unchanged and profit after taxdecreases.

C Net working capital is unchanged and profit after taxis unchanged.

D Net working capital increases and profit after tax isunchanged.

3 P.T.O.


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8 When a company pays a dividend, which one of thefollowing happens as a consequence?

A The amount owed by debtors is decreased.B The amount owed to trade creditors is decreased.C Equity is decreased.D Profit after tax is decreased.

9 Which of these items does not appear in the Profit andLoss Account?

A DiscountsB Furniture and FittingsC WagesD Rents Received

10 A retailers performance ratios are as follows:

2004 2003Turnover m 13.3 14.1Gross profit % 54.7 54.4Net profit % 7.8 0.75Stock days on hand 80 136Debtor days on hand 22 22Creditor days on hand 59 58

How would you explain the improvement in profitability in2004?

A An improvement in the management of tradereceivables.

B Tighter cost control, leading to a reduction inexpenses.

C A change in the mix of sales in favour of higher priceditems.

D An improvement in stock control leading to quickerstock turnover.

4


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6

Section B

Candidates must answer Question 2 (compulsory)

Q2 Jones Ltd is a trading company. The following amountswere extracted from the books of account on31 December 2004.

Trial Balance Dr Cr

Share Capital 500,000Land and Buildings 400,000Motor Vehicles 125,000Equipment 85,000Long term Investments 75,000

Stock (as at 1.1.2004) 19,500Sales 670,000Purchases 550,000Debtors 120,000Short term deposit 20,000

Creditors 148,000Loan (Repayable 2020) 50,000Bank 4,400Depreciation (as at 1.1.2004)

Land and Buildings 70,000Motor Vehicles 30,000Equipment 10,000

Returns In 6,500Returns Out 7,600Carriage In 650Carriage Out 1,200Provision for Doubtful Debts(as at 1.1.2004) 3,000

Wages and Salaries 34,750Rates and Rent 19,000Insurance 6,500

Telephone and Postage 4,600Discounts Received 2,500Discounts Allowed 4,500Motor vehicle expenses 6,600Repairs to Buildings 16,700

1,495,500 1,495,500


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Notes

1. Closing stock at 31.12.2004 was 28,500.2. The item Repairs to Buildings 16,700 includes

6,700 for redecoration costs and 10,000 for anextension to create a new store room.

3. Wages and salaries of 2,900 were outstanding at31.12.2004.

4. Rates paid in advance at 31.12.2004 were 3,000.5. Provision for Doubtful Debts is to be provided for at

3% of year-end debtors.6. Depreciation is to be charged on year-end balance at:

Motor Vehicles 20% reducing balance methodLand & Buildings 5% straight line methodEquipment 10% straight line method

Required:

(a) Prepare a trading, profit and loss account for the yearending 31 December 2004 and a balance sheet as atthat date. (25 marks)

(b) (i) What is the historical cost convention?(ii) Under what circumstances would it be

inappropriate to use the historical costconvention? (5 marks)

(Total 30 marks)

7 P.T.O.


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Section C

Answer any TWO questions from this section

Q3 The Lancaster Co Ltd is an unquoted company engaged inthe highly competitive textile industry. Its summarisedfinancial statements for the two most recent years at31 December are as follows:

Profit & loss account for the year 2003 2004000 000

Sales 42,000 44,300Cost of sales 22,680 24,800Distribution and admin cost 17,200 19,380Net profit before tax 2,120 120

Corporation tax 650 30Net profit after tax 1,470 90Dividends paid and proposed 480 460

Retained profits 990 (370)

Balance sheet at 31 December 2003 2004000 000

Net fixed assets 4,370 3,100InvestmentsStocks 7,750 7,250Debtors 3,700 4,350Cash and bank balances 800 170

12,250 11,770

Current taxation 650 30Dividends 330 320Creditors 5,550 5,800

6,530 6,150

Net Current Assets 5,720 5,620 10,090 8,720

Less loans 1,000

9,090 8,720

Called up capital (1 shares) 6,100 6,100Reserves 2,990 2,620

9,090 8,720

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9 P.T.O.

Note that the expense figures above include (000):

2003 2004Depreciation for the year 480 550Interest payable 156

Ratios for 2002 are as follows:1. Profitability:

Return on capital employed % 22.69Return on sales % 4.09Gross profit on selling price % 50.00

2. Liquidity:Working capital ratio 2.00Acid test ratio 1.14

3. Efficiency:Net assets turnover 3.63

Debtors days 22.124. Capital Structure:

Gearing % 10.99Dividend cover 3.46EPS pence 56.25

Note: 1 = 100p

Required:

(a) Calculate the above ratios, for each year, that may behelpful in judging the profitability, liquidity andefficiency performance of the company for the years to31 December 2003 and 2004. (20 marks)

(b) Present your interpretation of the results obtainedfrom (a) above. (10 marks)

(Total 30 marks)


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Q4 A company holds stocks of material B. During the year to31 December 2004 the following movements in and out ofstock are recorded.

Units Price BalanceOpening stock 1.1.04 103 2.03 103Issue 1.3.04 50 53Purchase 1.4.04 103 3.03 156Purchase 1.6.04 103 3.50 259Issue 1.7.04 150 109Purchase 1.9.04 103 3.75 212

Required:

(a) Calculate and explain the make-up of closing stockunder the LIFO basis. (12 marks)

(b) Calculate and explain the make-up of closing stockunder the FIFO basis. (12 marks)

(c) Under what circumstances is it appropriate to use theLIFO basis for valuing stock? (6 marks)

(Total 30 marks)

Q5 The adoption of specific accounting policies impacts onthe financial statements, and therefore any financialanalysis conducted upon them.

Discuss this statement with reference to accountingpolicies on stock and depreciation, providing examples. (30 marks)

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Q6 (a) Assume that a company sends ten employees throughits training programme, which costs 150,000.Discuss the accounting treatment of this expenditure.

What fundamental accounting concepts are involved? (15 marks)

(b) Innovations plc sells a product with a five year partsand labour warranty. In what ways could it treat theexpenses that it expects to incur as a result of theproduct warranty? What fundamental accountingconcepts are involved? (15 marks)

(Total 30 marks)

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Diploma Part 1

Accounting

Examiners Suggested Answers

Question 1

1 A2 B3 B4 D5 A6 D7 C8 C

9 B10 D


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Question 2

(a) Jones LtdTrading, Profit and Loss Account for year ending 31 December 2004

Sales 670,000Returns In (6,500)

663,500

Cost of Sales:Opening Stock 19,500Purchases 550,000Returns Out (7,600)Carriage In 650

543,050Closing Stock (28,500)

534,050

Gross Profit 129,450

Other Income:Discounts Received 2,500

131,950

Expenses:

Carriage Out 1,200Wages & Salaries 34,750Add accrual 2,900 37,650

Rates and Rent 19,000Less prepayment 3,000 16,000

Insurance 6,500Telephone & Postage 4,600

Discounts Allowed 4,500Car Expenses 6,600Repairs to Buildings 16,700Less extension 10,000 6,700

Provision for Doubtful Debts 600Depreciation: Land & Buildings 20,500

Motor Vehicles 19,000Equipment 8,500

132,350

Net Profit/(Loss) (400)

======


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Jones LtdBalance Sheet as at 31 December 2004

Fixed Assets Cost Accum. Depr. NBV

Land and Buildings 410,000 90,500 319,500Motor Vehicles 125,000 49,000 76,000Equipment 85,000 18,500 66,500

620,000 158,000 462,000======= =======

Long Term Investments 75,000

Current AssetsClosing Stock 28,500Debtors 120,000Less Provision for Doubtful Debts (3,600)Prepayment: Rates 3,000Short-term Deposit 20,000

167,900

Current LiabilitiesCreditors 148,000Accrual: Wages 2,900Bank Overdraft 4,400

(155,300)

Net Current Assets (Working Capital) 12,600

Total Assets less Current Liabilities 549,600

Long Term LiabilitiesLoan (50,000)

Net Assets 499,600

=======

Share Capital 500,000Profit/(Loss) (400)

499,600=======


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(b) (i) The historical cost convention is the basis usually adopted byaccountants in preparing financial statements for valuing assets,liabilities, revenues and income. The basis enables assets to becarried in the balance sheet at their original cost, less depreciationwhere appropriate.Alternative accounting bases are possible although not commonlyused. Examples of relevant alternatives to the historical cost

accounting basis include the liquidation or break-up valuation of acompany. Assets are valued at the amount receivable from a quicksale rather than the historical or replacement cost.

(ii) It is inappropriate to use the historical cost convention on liquidationof a company.

Question 3

(a) Lancaster Co Ltd ratios

Year to 31 December 2003 2004

1. Profitability:(a) Return on cap. empl. % 23.72 1.28(b) Return on equity % 17.10 1.01(c) Return on sales % 3.50 0.20(d) Gross profit on sales % 46.00 44.02(e) Gross profit on cost % 85.19 78.63

2. Liquidity:

(a) Working capital ratio 1.88 1.91(b) Acid test ratio 0.77 0.74

3. Efficiency:(a) Net assets turnover 4.38 4.71(b) Stock turnover 3.48 3.31(c) Debtors turnover 14.74 11.01(d) Debtors coll. days 24.77 33.16

4. Capital Structure:(a) Gearing % 9.91 0.00(b) Debt/equity ratio % 11.00 0.00

(5) Coverage:(a) Debt interest 14.59 0.00(b) Dividend 3.06 0.20

(6) Quoted:(a) EPS pps (pence per share) 61.25 3.75(b) PE ratio 0.00 53.33(c) Dividend yield % 3.06 9.58


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(b) ProfitabilityAs can be seen from the ratios, profitability has fallen dramatically over theyear, particularly in the case of return on capital employed (ROCE), less soin the case of the gross profit margin.

LiquidityLiquidity has improved marginally. However, we would need to know

greater detail about the nature of the business and industry before beingable to comment on the appropriateness of the current level. The level ofdetail given in the question does not enable us to determine whetherliquidity is moving in the right direction or not.

EfficiencyA mixed message is given by the ratios on efficiency.Net asset turnover issue has improved while stock turnover and debts haveworsened.

GearingCapital gearing has changed quite significantly during the year. Thecompany has moved to a 0 geared capital structure and is now entirelyreliant on equity funding.

Similarly, operating gearing has moved to 0.

Investor ratiosThe earnings per share largely follows the decrease in profitability.

Question 4

(a) At the end of the year there are 212 units in stock. However, as can beseen, under the LIFO assumption this balance must comprise the followingpurchases:

1.9.04 103 at 3.751.4.04 56 at 3.031.1.04 53 at 2.03

The issue of 50 items on 1 March 04 was made from opening stock,reducing the year end quantity to 53. The issue on 1 July 04 is made fromthe purchases of 1 June 04 (103) and from that of 1 April 04 (50), leaving abalance of 47 from this purchase for stock.

(b) Had the FIFO method been used the final stock would have been valued asfollows:

1.4.04 6 at 3.031.9.04 103 at 3.751.6.04 103 at 3.50

The effect of using the LIFO method of valuation is, in this case, to valuethe stock at 664, whilst the FIFO method gives a value of 693.


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(c) Because the LIFO method gives a lower stock value in periods of inflation,and as a result lower profit figures, it is often claimed to be a useful way ofaccounting for the impact of rising prices on the cost of replacing stock.However, the side effect is that the value placed on stock appearing in thebalance sheet is unlikely to reflect the current cost of stock held. Over aperiod of time the value will become increasingly out of date. As can beseen in the example above, the closing stock includes some units

purchased in 2004 at a cost of 2.03 compared with a final price of 3.75.For many countries the LIFO method is not acceptable to the taxauthorities and has been deemed unsuitable.

Question 5

The way in which stock is measured is the first accounting policy that will bediscussed. The amount of stock sold during a period will affect the calculationof net profit, while the amount of stock left at the end of a period will have animpact on the financial position.

A number of different assumptions are used for stock measurements whichhave to be used consistently each year. These assumptions are

First In, First Out (FIFO) Earliest stock held is the first to be sold. Last In, First Out (LIFO) Latest stock held is the first to be sold. Weighted Average Cost (AVCO) This is based on the average cost of the

stocks to be used.

First in/first out

First in, first out means exactly what it says. The first items you bring intoinventory will be the first ones sold as product. First in, first out is based onthe principle that most businesses tend to sell the first goods that come intoinventory.

Suppose you buy five widgets at 10 apiece on 3 January and purchaseanother five widgets at 20 apiece on 7 January. You then sell five widgets on30 January. Using first in, first out, the five widgets you purchased at 10would be sold first. This would leave you with the five widgets that youpurchased at 20, which would leave the value of your inventory at 100.

Last in/first out

This method is based on the assumption that the most recent units purchasedwill be the first units sold. The advantage of LIFO, is that typically the lastunits purchased would have been purchased at the highest price and that byconsidering the highest priced items to be sold first, a business is able toreduce its short-term profit.

Suppose you purchase five widgets at 10 apiece on 4 January and five more

widgets at 20 apiece on 2 February. You then sell five widgets on 20 February.The value of your inventory, using LIFO, would be 50, since the most recentwidgets purchased, at a total value of 100 on 2 February, were sold. You wereleft with the five widgets valued at 10 each.


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Weighted average

Weighted average measures the total cost of items in inventory that areavailable for sale divided by the total number of units available for sale.Typically this average is computed at the end of an accounting period.

Suppose you purchase five widgets at 10 apiece and five widgets at 20

apiece. You sell five units of product. The weighted average method iscalculated as follows:

Weighted Average Cost per Widget =Total Cost of Goods for Sale at Cost divided byTotal Number of Units Available for Sale

Five widgets at 10 each = 50Five widgets at 20 each = 100Total number of widgets = 10Weighted Average = 150/10 = 15

15 is the average cost of the 10 widgets

The second accounting policy that impacts the financial statement isdepreciation. The concept of depreciation is relatively simple to understand.For example, if a car has been purchased for a business, the car loses value theminute it is driven out of the dealership. Each year that the car is owned, itloses some value, until the car finally stops running and has no value to thebusiness. Measuring the loss in value of an asset is known as depreciation.

There are a number of different depreciation methods that can be used. Again,due to the consistency convention, whichever method is chosen needs to beused throughout the life of the asset.

The straight-line method is the most common method of depreciating assets.To calculate the amount of annual depreciation using the straight-line methodrequires the initial cost of the asset, its estimated useful life and its residualvalue at the end of the period. For example, if the car is purchased for20,000, is expected to be used for 4 years and have a residual value of5,000, using the straight-line method for determining depreciation:

Annual Depreciation each year for 4 years is

= (20000 5000)/4= 3,750

The second method for depreciation is called the Reducing Balance Method.This method applies a fixed percentage rate of depreciation P to the writtendown value of the asset each year. This will have an effect of higher annualdepreciation charges in the earlier years and lower charges in the later years.


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Using the information from the car example above, the fixed percentage to beapplied can be calculated from the following formula:

P = (1 nSqRoot(R/C)) * 100%

Where R = residual value of asset, C = cost of the asset, n = number of yearslife with the business and P = %

P = (1 4SqRoot(5,000/20,000)) * 100%

P = 29%

So, using the Reducing Balance method, the annual depreciation figure to beused is:

Cost of Car 20,000

Year 1 Depreciation (29%) 5,800

Written Down Value 14,200






Residual Value 5,082

From the examples given, it can be seen how important the accounting policiesused are and the impact that they have on the financial statements.

Question 6

(a) It would be PRUDENT (conservative) to put no value on the trainingexpense in the balance sheet, but treat it all as expenditure when incurred.

However the MATCHING concept proposes that cash expenditure ismatched against cash received. Training is an investment which givesbenefit into future periods, which means an alternative treatment is to puta value on the training expense in the balance sheet, and subsequently toreduce the value as the cash is recovered from the consulting assignmentsof the new employee.

A further refinement would be to estimate the likely refunds of the trainingexpenditure from the prematurely resigning employee. The MATCHINGconcept suggests that this future benefit could be combined with the


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training expenditure to reduce its cost. In practice the PRUDENCE conceptis the rule likely to dominate, and the benefits of the refunds cannot beanticipated.

(b) MATCHING and PRUDENCE both suggest that anticipated future warrantyexpenditures be estimated as a liability. The benefit of the sale is thenreduced by the (expected) cash paid for repairs, irrespective of the fact that

it is not incurred in the same accounting period as the sale. TheQUANTITATIVE boundary rule that only data capable of being easilyquantified should be included is likely to be overruled in practice by thePRUDENCE concept.

abe dip 1 -financial accounting june 2005

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