Chapter_29.pdf

7/25/2019 Chapter_29.pdf

1/11

1Chapter 29 Cambridge University Press 2010

29Accounting fundamentals

Activity 29.1 (page 533): Mauritius Tourist Flights Ltd

1 Explain to Leroy threereasons why it is important for him to keep accurate

accounting records for his business. [9]

As a limited company, Leroy will have to submit accounts to the government.It is important that accounting records are correct to ensure that the business

does not pay too much corporation tax.

Accounts provide important inormation to aid Leroy in making appropriate decisions, such as the price to charge or tourist ights. Without accurateinormation, Leroy might charge prices that do not provide or prot.

Accounts allow Leroy to measure the perormance o his business and analyseits success/ailure.

o secure nance or purchasing Elviss business, Leroy would need to presentnancial inormation to banks or other potential investors to demonstrate that

his business is nancially sound.

I Leroy wishes to sell his business in the uture, it is necessary to provideaccounts so that he will be able to realise a air price or it.

2 Elvis seems to be window dressing the accounts for his own business in order to make

it seem more successful than it is:

Why is he doing this? [2]

o try and secure a higher price or the business rom Leroy or other potentialbuyers. Window dressing the accounts will exaggerate prots and the nancial

solidity o the business.

Examine briey the ways in which he is doing this. [6]

Te plane has been overvalued. Insuffi cient depreciation has been charged tothe accounts.

Elvis has ignored the realisation principle that revenues should only be recordedwhen the legal title to goods is transerred to the purchaser. He has included in

his prot and loss account revenues not yet earned, thus overstating protability.

Te accounts assume that all debts rom customers will be recovered. Leroysreaction to the accounts suggests that there is evidence o old debts that are

unlikely to be paid; thus, Elvis should include an allowance or bad debts, which

would reduce the prot.

3 In future, how important do you consider Leroys published accounts will be tostakeholders in the business? Explain your answer. [8]


2/11


Accounts are very important to a number o stakeholders.

Suppliers Leroy purchases uel on credit; suppliers must be certain thatthe business is able to repay debts on time. I Leroys business has liquidity

problems, then suppliers will wish to be paid in cash.

Providers o nance as Leroys business expands, he may require externalnance rom banks. Beore making loans, banks will need to see accounts to

assess the liquidity and gearing o the business.

Government and tax authorities to und government projects, tax revenueis necessary; the government must be sure that businesses, such as Leroys, are

paying the correct amount o corporation tax. Te government also has an interest

in protecting its citizens rom raud, thereore accurate accounts are necessary.

ourists the nancial stability o the business will be o concern to touristswho will want to ensure that when they have paid in advance or ights, the

business does not subsequently go bankrupt.

4 Briey explain the benet to company stakeholders of accounts being based on the

same internationally agreed accounting principles. [6]

o make comparisons with competitors, it is necessary that accounts are drawn up

using the same conventions and rules. Otherwise, company stakeholders, such as

managers, may make decisions based on alse assumptions about the perormance

o competitors.

Accounts based on internationally agreed accounting conventions enable potential

shareholders to make inormed decisions about which companies are worth

investing in.

Activity 29.2 (page 536): Calculating gross profit

1 Calculate gross prot for Cosy Corner Retailers Ltd for the nancial year ending

31 March 2009. Show all of your workings.

1,500 items sold for $5 each; opening stocks were valued at $500; purchasesa

totalled $3,000; closing stocks were $1,000.[5]

Revenue = 5 1,500 = $7,500

Cost o sales = opening stock + purchases closing stock

= 500 + 3,000 1,000 = $2,500 Gross prot = 7,500 2,500

= $5,000

Explainb tworeasons why you think it is important for any business to make a prot. [6]

Prot is the reward to an entrepreneur or investment. Without making aprot, owners would withdraw their investment and close the business.

Prot is needed to nance growth. Prots are re-invested into the business topurchase the xed assets needed to help the business grow.

2 Cambridge Boxes Ltd sold 3,500 units in the last nancial year ending 31 December2008. Te selling price was $4. Opening stocks were 200 boxes. Te business


3/11


purchased 4,000 boxes during the year. All boxes cost the company $2 each. Calculate

the value of closing stocks and the companys gross prot in 2008. [5]

Gross prot = turnover cost o sales

urnover = 4 3,500 = $14,000

Closing stock = opening stock + purchases sales [all gures in units]

= 200 + 4,000 3,500 = 700 units.

Value o closing stock = 2 700 = $1,400

Cost o sales = 2 3,500 = $7,000

Gross prot = 14,000 7,000 = $7,000

Activity 29.3 (page 537): Calculating profits

1 Calculate the missing values UZfor the different types of prot for Rodrigues

raders. [5]

Gross prot (U) = revenue cost o sales = 12,000 4,000 = $8,000

Operating prot (V) = gross prot overheads = 8,000 3,000 = $5,000

Prot beore tax (X) = operating prot interest = 5,000 1,000 = $4,000

Prot afer tax (Y) = prot beore tax tax = 4,000 800 = $3,200

Retained prot (Z) = prot afer tax dividends = 3,200 1,200 = $2,000

2 State threestakeholders in this business who would be interested in these prot

gures. [3]

banksshareholders Rodrigues and three riendsgovernmentemployees three electricianslocal community

3 For each stakeholder group identied, explain why the prots of this business are

important. [9]

Stakeholder Importance of profit

Banks will want their loan to be repaid i the business is not

making a prot, then it will struggle to repay the loan

Shareholders Rodrigues andriends

affect dividends available or distribution to shareholdersaffect value o the businesssource o nance or uture growth

Government taxationjobs

Employees job security wage negotiations

Local community jobs created by protable businessesincrease in spending in the local community associatedwith employment


4/11


Activity 29.4 (page 540): Understanding balance sheets

Copy this table and indicate in which category the following items would appear on a

company balance sheet. [10]

Non-current

(fixed)tangible

assets

Non-current

(fixed)intangible

assets

Current

assets

Current

liabilities

Non-current

liabilities

Share-holders

equity

Companycar

x

Work inprogress

x

Four-yearbank loan

x

Money

owed tosuppliers

x

Issued sharecapital

x

Dividendsowed toshareholders

x

Value opatents

x

Paymentsdue romcustomers

x

Retainedearnings

x

Cash inbank

x

Activity 29.5 (page 543): Mauritius Telecom

1 What is meant by the following terms? [12]

accounts receivableMauritius elecom has sold its services on credit to customers. Tis is the

money owed to M or services supplied.

inventoriesTis is stock which is not yet sold. It might include telecommunications

equipment, e.g. telephones that M has purchased or produced or sale to

customers. It may also include raw materials and work-in-progress.


5/11


current assetsTese are assets which will no longer be held in 12 months time. Tey include

stock, debtors and cash/bank deposits.

non-current liabilities . Tese are Ms long-term liabilities and, thereore, are not due to be settled in

the next 12 months. Tis gure could include bank loans, debentures and other

medium-to long-term orms o nance, such as hire purchase and commercial

mortgages.

2 Explain why it is important to stakeholders of Mauritius elecom to be provided with

two years of balance sheet values in the published accounts. ry to make references to

some of the data in your answer. [6]

wo years o data will help identiy change in the nances o M. A balance sheet

is just a snapshot and can, thereore, be misleading. With two years o data, it

is possible to identiy whether the nancial position o the rm is improving ordeteriorating. Tis is important to stakeholders, such as suppliers, nanciers,

shareholders and managers.

Te balance sheets or 2006 and 2007 indicate a number o important changes:

Tere has been a substantial increase in xed assets (non-current assets). Tismay have been unded through shareholder equity: either retained prots or

share capital. Tis is suggested by the increase in shareholder equity rather than

long-term liabilities.

Te value o the business has grown. Tis is indicated by the increase inshareholder equity.

M has a satisactory level o liquidity. Current assets are greater than currentliabilities, suggesting that the business will not have diffi culty paying short-term

debt.

However, stakeholders may be concerned about the substantial increases indebtors and current liabilities. Debtors may deault on payments and become

bad debts.

Stakeholders, such as banks, will be interested in the gearing and liquidity o thebusiness. M is nanced primarily through shareholder unds rather than debt

nance.

3 Research: use the internet to research the latest years accounts from Mauritiuselecom http://www.mauritiustelecom.com (or another plc of your choice). Read the

Chairmans Statement, the Report of Directors, and the Auditors report. How useful

do you think these reports would be to:

shareholdersworkers in the companyany other stakeholder group?

Explain your answers. [12]

Te Chairmans Statement gives a general overview o the achievements o

the company and its uture prospects, taking into account signicant external


6/11


inuences. For example, in 2007 it highlights growth in EBIDA (earnings beore

interest, tax, depreciation and amortisation) o 8%, growth in broadband customer

numbers, and some o the key challenges aced in the communications market.

Te Report o Directors outlines the duties o directors, including saeguarding the

companys assets. Te report gives background inormation on the business and

outlines key results rom the year.

Stakeholder Commentary

Shareholders Te Auditors Report is important as it conrms that the accountsare a air representation o Ms nancial state. I there wereconcerns about the viability o the business, they would be statedby auditors. For example, Liverpool FCs parent company KFCannounced losses in 200809 due to debts o over 400m. Teirauditors, KPMG, stated that renancing the debt was a materialuncertainty which may cast signicant doubt on the groups andparent companys ability to continue as a going concern.

Te Chairmans Statement is, o course, biased and likely to present apositive gloss on the perormance and prospects o the business. It is nomore than a brie overview o past perormance and uture prospects.Investors need to analyse the accounts thoroughly themselves.

Employees Te reports in 2007 emphasise the need to boost productivityand control costs and create more exible working conditions.Employees can learn a little about the uture direction o thebusiness and will be able to identiy some o the signicant changesplanned in the uture. It will give some indication o their jobsecurity. I M communicates effectively with employees, therewould be little o signicance to employees in the reports that they

had not already been told.Other Customers may be interested in the details on broadband access and

Ms plans or the uture.

Suppliers may nd reassurance in the reports as to the continuedtrading viability o the business.

Activity 29.6 (page 548): Has BP plc got enough liquidity topay its short-term debts?

1 Calculate BPs current ratio. [3]

Current ratio = current assets current liabilities

Current assets = inventories + debtors + cash = $68,136m

Current liabilities = creditors + short term loans = $58,546m

Current ratio = 68,136m 58,546m = 1.16

2 Calculate BPs acid-test ratio. [3]

Acid test = liquid assets current liabilities

Liquid assets = current assets inventories = $41,582m

Acid test = 41,582m 58,546m = 0.71


7/11


3 Comment on BPs liquidity. [6]

BP has a relatively low current ratio as it only has $1.16 o current assets orevery $1 o short-term debt.

Te acid-test ratio is below 1 and this indicates a potential lack o liquidity, thatis there is an increased risk o BP not being able to pay its short-term debts i

payment was demanded. A ratio o 1:1 is considered to be healthy.

However, it is necessary to compare ratios over time and with other rms in theindustry to make a more considered judgement o BPs liquidity.

4 Why would it be useful to BPs stakeholders to have liquidity ratio results for the

previous year and for other oil companies? [8]

It would be useul to identiy trends in BPs liquidity. I liquidity is deteriorating,this will be o concern to stakeholders, such as trade creditors, nancial

institutions and potential investors.

Comparisons with other oil companies will help establish i BPs liquidity is normal or the industry. In some industries, it may be quite normal to operatewith a low or high liquidity ratio.

Activity 29.7 answer provided on Students CD-ROM.

Revision case study 1 (page 550): Highfield Leisure Ltd

1 What is meant by the following terms? [12]

cost of salesopening stock + purchases closing stock

Tis is the direct cost o purchasing the goods that were sold during the

accounting period.

retained earnings reservesTis is the accumulated retained prot o the business over time. It is not

literally a reserve o cash, as retained prots will usually have been re-invested

into the business.

shareholders equity Tis is the investment made into the business by shareholders. It includesshare capital invested into the business through the purchase o shares and the

accumulated retained prot.

operating prot . Tis is gross prot less overheads. It is the prot made on the normal trading

activities o the business. It is recorded beore deducting interest payments on

borrowing and does not include unearned income.


8/11


2 Calculate the missing values: U, V, X, Y, Z. [5]

U: Gross prot = sales turnover cost o sales = 320m 120m = $200m

V: Pre-tax prots = operating prot interest = 85m 5m = $80m

X: otal assets = xed assets + current assets = 80m + 10m + 25m + 0.5m =

$115.5m

Y: Share capital = total equity and liabilities (current liabilities + non-current

liabilities + retained earnings) = 112m (25m + 46.5m + 10.5) = $30m

Z: otal equity and liabilities = current liabilities + non-current liabilities +

share capital + retained earnings = 30m + 40m + 30m + 15.5 = $115.5m

3 Using the data in any way you consider appropriate, including the use of ratios,

analyse the changing protability and liquidity of this business. [12]

Relevant calculations include:

Ratio 2009 2008 Commentary

Gross prot margin:gross prot turnover 100

200 320= 62.5%

230 330= 69.7%

Although sales have allen, thecost o sales has increased. Tus,the GPM has been reduced. Teincrease in cost o sales will be oconcern to Higheld Leisure asit will make it more diffi cult tocompete.

Net prot margin:net prot turnover 100

50 320= 15.6%

85 330= 25.6%

Tis is a signicant all in theNPM. Higheld Leisure has ailedto control its overheads.

Current ratiocurrent assets current liabilities

35.5 30= 1.18

37 25= 1.48

Although the current ratio hasallen, this is not necessarily aproblem. Higheld Leisure hasreduced its stock holding; as itoperates sports centres, one mightexpect there to be relatively lowlevels o stock held. Holdingless stock may represent a moreeffi cient use o resources.

Acid test:liquid assets current liabilities

25.5 30= 0.85

22 25 =0.88

Te acid test is on the low side.Liquid assets are less than short-term debt and Higheld Leisure

may have a shortage o workingcapital. Te cash position o thebusiness has deteriorated andthere has been an increase indebtors. Tis could be the resulto offering more generous creditterms or there could be bad debts.

4 Evaluate how managers might improve

protability

liquidity of this business. [12]


9/11


In answering this question, account must be taken o the impact o increased

competition.

Protability:

Increase price the problem or Higheld Leisure is that increasing price couldlead to a signicant drop in demand because o the new competitors that have

entered the market.

Reduce direct costs reducing direct labour would reduce the cost o sales,but could have a negative impact on the quality o customer service. As it is in

the leisure industry, it may not be possible to increase productivity through

automation. Cutting wages will reduce labour costs, but may lead to poor

motivation and poor customer service.

Reduce overhead costs Higheld Leisure should try and reduce costs, suchas administration costs. I it has a head offi ce, it might be possible to relocate

to reduce rent and local taxes. Te leisure centres may be diffi cult to relocate

they need to be accessible to centres o population.

Liquidity:

Increase loans this would provide an injection o capital into the business.However, interest costs would reduce prot.

Sell xed assets i Higheld Leisure has unproductive xed assets, these couldbe sold; the only reason or holding assets is to generate revenue. However, it

can be diffi cult to realise the true value o an asset i sold quickly. Assets can be

sold and leased back i needed; this will improve liquidity, but negatively affect

prot.

Sell stock Higheld Leisure has already reduced stock levels, so there may be arisk o negatively affecting the customer i stocks become too low.

Hold interest-bearing bank accounts Higheld should ensure that cash is heldin interest-bearing bank accounts so as to maximise interest earned.

Monitor accounts receivable Higheld Leisure should monitor its accountsreceivable to ensure that customers are billed properly and payments are made

promptly. However, care must be taken not to alienate customers and drive

them to competitors.

Negotiate credit terms Higheld should negotiate longer credit terms so as tohold on to cash or as long as possible.

5 Evaluate the usefulness of the ratios calculated to the main users of accounting

information. [10]

Managers:

Ratios give an indication o the perormance and effi ciency o the business.Over time, they enable managers to identiy trends.

Poor ratio results identiy problems that managers need to address; HigheldLeisures protability ratios highlight that action must be taken to deal with the

threat o competition.

Ratios can be used to support applications or nance.


10/11


Shareholders / potential investors:

Ratios provide a means or evaluating the perormance o a business and thequality o its management.

Tey can help guide decisions about investment.

Suppliers:

Ratios will indicate whether it is sae to offer credit to customers. I a customerhas poor liquidity, then it will be advisable to only sell or cash.

Evaluation may consider:

Have accounts been window dressed? Are ratios rom other years and other similar

businesses available?

Revision case study 2 (page 551): Shivanis first balance sheet

1 Draw up a correct version of Shivanis balance sheet with correct headings, makingsure that it nally balances. [10]

Balance sheet for Shivani Beauty Salon Ltd as at 31/3/2010

($000)

ASSETS Non-current assets:

Equipment Current assets:

Stock o materials Accounts receivable

CashTOTAL ASSETS

EQUITY & LIABILITIES Current liabilities: Accounts payable Overdraf Non-current liabilities:

Loan

Shareholders equity:

Share capital Retained earningsTOTAL EQUITY AND

LIABILITIES

25

153

144

53

20

10

6

44

Essay2 a Explain the distinction between gross prot, operating prot and retained prot. [9]

Gross prot = turnover cost o sales. It is prot afer deducting direct costs rom

turnover.

Operating prot = gross prot expenses. It is the prot a business earns on its

normal operations beore interest and taxation. It is also called net prot.


11/11


Retained prot is prot lef over afer deducting corporation tax and any dividend

payable to shareholders. It is, thereore, the prot remaining or re-investment into

the business.

b Te owner of a chain of sports-equipment shops is worried about her businesss

declining gross prot margin and net prot margin. Evaluate threedecisions the

owner could take to attempt to increase these prot margin ratios. [16]

Increase price price elasticity o demand will be signicant in determining thesuccess o this decision. I demand is price elastic, then sales will all and prots

will decline despite the increase in the prot margin. Price elasticity o demand

will be affected by the number o substitute products available in the market.

o increase price without causing a all in demand, it may be necessary to offer

an improved customer experience in the shops. However, that may add to costs

and, thereore, prot margins will not be improved.

Reduce direct costs reducing the cost o sales without reducing turnover

would increase the gross prot margin. Tis could be done by negotiating withthe current suppliers o sports equipment to reduce the price paid. Te shops

could buy in bulk to obtain discounts; however, this could lead to an increase

in storage costs and the outow o cash to pay or equipment could lead to

liquidity problems. Alternatively, the shops could look or cheaper suppliers o

equipment.

Reduce overhead costs this could be achieved by reducing staffi ng. However,this would be opposed by employees and cause conict. A reduction in staffi ng

levels could also have a negative impact on customer service and, thereore,

damage sales. Wages could be cut, but this would demotivate staff, lead to

increased labour turnover and possibly reduce the quality o customer service.

I customer service declines, then customers may go elsewhere to buy their

sports equipment. Overheads could also be reduced by cutting promotion, but

this has the associated risk o causing a decline in sales.

Evaluation may consider:

o increase margins, the owner must either increase revenue without increasing costs

or reduce costs without reducing revenue. Simply increasing the quantity o sales is

insuffi cient to increase protability due to the impact o increased sales on costs.

Documents

Chapter_29.pdf