THE ASSOCIATION OF BUSINESS EXECUTIVES DIPLOMA PART 1

Acct

Accounting
morning 7 June 2005
1 2 Time allowed: 3 hours. There are THREE sections to the examination: Section A TEN compulsory multiple choice questions, each question carries one mark. Section B ONE compulsory question. Section C Four questions, TWO of which should be answered. (Each question carries 30 marks) 3 4 (10 marks) (30 marks)

(60 marks)

No books, dictionaries, notes or any other written materials are allowed in this examination. Calculators are allowed providing they are not programmable and cannot store or recall information. Electronic dictionaries and personal organisers are NOT allowed. All workings should be shown. Candidates who break ABE regulations, or commit any misconduct, will be disqualified from the examinations. Question papers must not be removed from the Examination Hall.

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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 consider to 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 of finance? A B C D 2 Liabilities. Assets. Expense. Sales.

A company started out with 100,000 share capital and 100,000 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 before tax and dividends? A B C D 15,000 loss 10,000 25,000 35,000

If a company has a negative net worth, this means that: A B C D Total debt exceeds shareholders funds; Total liabilities exceed total assets; Current liabilities plus long term debt exceed current assets; The share price has collapsed and the assets of the company are worthless

Net profit is A B C D the increase in cash sales less all expenses including purchases sales less all expenses other than purchases gross profit less expenses

Your warehouse staff found some damaged stock during the year-end stock take. Stock worth 10,000 had to be destroyed. What will be the effect on the accounts? A B C D The gross profit margin will fall. The book value of the business will rise because unsaleable stock has been disposed of. Since this years closing stock is next years opening stock, the effect on the accounts over two years will be zero. Cost of goods sold will fall.

The cost of goods sold is A B C D purchases sales sales minus cost of sales stock at start plus purchases minus stock at end

If wages accrued in a prior accounting period are paid in cash, what happens to net working capital and profit after tax? A B C D Net working capital decreases. Net working capital decreases. Net working capital is unchanged. Net working capital unchanged. decreases and profit after tax is unchanged and profit after tax is unchanged and profit after tax increases and profit after tax is

P.T.O.

When a company pays a dividend, which one of the following happens as a consequence? A B C D The amount owed by debtors is decreased. The amount owed to trade creditors is decreased. Equity is decreased. Profit after tax is decreased.

Which of these items does not appear in the Profit and Loss Account? A B C D Discounts Furniture and Fittings Wages Rents Received

10 A retailers performance ratios are as follows: Turnover m Gross profit % Net profit % Stock days on hand Debtor days on hand Creditor days on hand 2004 13.3 54.7 7.8 80 22 59 2003 14.1 54.4 0.75 136 22 58

How would you explain the improvement in profitability in 2004? A B C D An improvement in the management of trade receivables. Tighter cost control, leading to a reduction in expenses. A change in the mix of sales in favour of higher priced items. An improvement in stock control leading to quicker stock turnover.

Section B Candidates must answer Question 2 (compulsory) Q2 Jones Ltd is a trading company. The following amounts were extracted from the books of account on 31 December 2004. Trial Balance Share Capital Land and Buildings Motor Vehicles Equipment Long term Investments Stock (as at 1.1.2004) Sales Purchases Debtors Short term deposit Creditors Loan (Repayable 2020) Bank Depreciation (as at 1.1.2004) Land and Buildings Motor Vehicles Equipment Returns In Returns Out Carriage In Carriage Out Provision for Doubtful Debts (as at 1.1.2004) Wages and Salaries Rates and Rent Insurance Telephone and Postage Discounts Received Discounts Allowed Motor vehicle expenses Repairs to Buildings Dr 400,000 125,000 85,000 75,000 19,500 670,000 550,000 120,000 20,000 148,000 50,000 4,400 70,000 30,000 10,000 6,500 7,600 650 1,200 3,000 34,750 19,000 6,500 4,600 2,500 4,500 6,600 16,700 1,495,500 Cr 500,000

1,495,500

Notes 1. 2. 3. 4. 5. 6. Closing stock at 31.12.2004 was 28,500. The item Repairs to Buildings 16,700 includes 6,700 for redecoration costs and 10,000 for an extension to create a new store room. Wages and salaries of 2,900 were outstanding at 31.12.2004. Rates paid in advance at 31.12.2004 were 3,000. Provision for Doubtful Debts is to be provided for at 3% of year-end debtors. Depreciation is to be charged on year-end balance at: Motor Vehicles 20% reducing balance method Land & Buildings 5% straight line method Equipment 10% straight line method

Required: (a) Prepare a trading, profit and loss account for the year ending 31 December 2004 and a balance sheet as at (25 marks) that date. (b) (i) What is the historical cost convention? (ii) Under what circumstances would it be inappropriate to use the historical cost convention?

(5 marks) (Total 30 marks)

P.T.O.

Section C Answer any TWO questions from this section Q3 The Lancaster Co Ltd is an unquoted company engaged in the highly competitive textile industry. Its summarised financial statements for the two most recent years at 31 December are as follows: Profit & loss account for the year Sales Cost of sales Distribution and admin cost Net profit before tax Corporation tax Net profit after tax Dividends paid and proposed Retained profits Balance sheet at 31 December Net fixed assets Investments Stocks Debtors Cash and bank balances Current taxation Dividends Creditors Net Current Assets Less loans 2003 000 42,000 22,680 17,200 2,120 650 1,470 480 990 2003 000 4,370 7,750 3,700 800 12,250 650 330 5,550 6,530 5,720 10,090 1,000 9,090 6,100 2,990 9,090
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2004 000 44,300 24,800 19,380 120 30 90 460 (370) 2004 000 3,100 7,250 4,350 170 11,770 30 320 5,800 6,150 5,620 8,720 8,720 6,100 2,620 8,720

Called up capital (1 shares) Reserves

Note that the expense figures above include (000): Depreciation for the year Interest payable Ratios for 2002 are as follows: 1. Profitability: Return on capital employed % Return on sales % Gross profit on selling price % 2. Liquidity: Working capital ratio Acid test ratio 3. Efficiency: Net assets turnover Debtors days 4. Capital Structure: Gearing % Dividend cover EPS pence Note: 1 = 100p Required: (a) Calculate the above ratios, for each year, that may be helpful in judging the profitability, liquidity and efficiency performance of the company for the years to (20 marks) 31 December 2003 and 2004. (b) Present your interpretation of the results obtained (10 marks) from (a) above. (Total 30 marks) 2003 480 156 2004 550

22.69 4.09 50.00 2.00 1.14 3.63 22.12 10.99 3.46 56.25

P.T.O.

Q4 A company holds stocks of material B. During the year to 31 December 2004 the following movements in and out of stock are recorded. Opening stock Issue Purchase Purchase Issue Purchase Required: (a) Calculate and explain the make-up of closing stock under the LIFO basis. (b) Calculate and explain the make-up of closing stock under the FIFO basis. (12 marks) 1.1.04 1.3.04 1.4.04 1.6.04 1.7.04 1.9.04 Units 103 50 103 103 150 103 Price 2.03 3.03 3.50 3.75 Balance 103 53 156 259 109 212

(12 marks)

(c) Under what circumstances is it appropriate to use the (6 marks) LIFO basis for valuing stock? (Total 30 marks)

Q5 The adoption of specific accounting policies impacts on the financial statements, and therefore any financial analysis conducted upon them. Discuss this statement with reference to accounting policies on stock and depreciation, providing examples. (30 marks)

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Q6 (a) Assume that a company sends ten employees through its 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 parts and labour warranty. In what ways could it treat the expenses that it expects to incur as a result of the product warranty? What fundamental accounting (15 marks) concepts are involved? (Total 30 marks)

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Diploma Part 1 Accounting Examiners Suggested Answers Question 1

1 2 3 4 5 6 7 8 9 10

A B B D A D C C B D

Question 2
(a) Jones Ltd Trading, Profit and Loss Account for year ending 31 December 2004 Sales Returns In 670,000 (6,500) 663,500 Cost of Sales: Opening Stock Purchases Returns Out Carriage In Closing Stock 19,500 550,000 (7,600) 650 543,050 (28,500) Gross Profit Other Income: Discounts Received Expenses: Carriage Out Wages & Salaries Add accrual Rates and Rent Less prepayment Insurance Telephone & Postage Discounts Allowed Car Expenses Repairs to Buildings Less extension Provision for Doubtful Debts Depreciation: Land & Buildings Motor Vehicles Equipment 1,200 34,750 2,900 19,000 3,000 37,650 16,000 6,500 4,600 4,500 6,600 16,700 10,000 6,700 600 20,500 19,000 8,500 132,350 (400) ====== 534,050 129,450 2,500 131,950

Net Profit/(Loss)

Jones Ltd Balance Sheet as at 31 December 2004 Fixed Assets Land and Buildings Motor Vehicles Equipment Cost 410,000 125,000 85,000 620,000 ======= Accum. Depr. 90,500 49,000 18,500 158,000 ======= NBV 319,500 76,000 66,500 462,000 75,000

Long Term Investments Current Assets Closing Stock 28,500 Debtors 120,000 Less Provision for Doubtful Debts (3,600) Prepayment: Rates 3,000 Short-term Deposit 20,000 167,900 Current Liabilities Creditors Accrual: Wages Bank Overdraft 148,000 2,900 4,400 (155,300) Net Current Assets (Working Capital) Total Assets less Current Liabilities Long Term Liabilities Loan Net Assets Share Capital Profit/(Loss)

12,600 549,600 (50,000) 499,600 ======= 500,000 (400) 499,600 =======

(b) (i)

(ii)

The historical cost convention is the basis usually adopted by accountants in preparing financial statements for valuing assets, liabilities, revenues and income. The basis enables assets to be carried in the balance sheet at their original cost, less depreciation where appropriate. Alternative accounting bases are possible although not commonly used. Examples of relevant alternatives to the historical cost accounting basis include the liquidation or break-up valuation of a company. Assets are valued at the amount receivable from a quick sale rather than the historical or replacement cost. It is inappropriate to use the historical cost convention on liquidation of a company.

Question 3
(a) Lancaster Co Ltd ratios Year to 31 December 1. (a) (b) (c) (d) (e) 2. (a) (b) 3. (a) (b) (c) (d) 4. (a) (b) (5) (a) (b) (6) (a) (b) (c) Profitability: Return on cap. empl. Return on equity Return on sales Gross profit on sales Gross profit on cost Liquidity: Working capital ratio Acid test ratio Efficiency: Net assets turnover Stock turnover Debtors turnover Debtors coll. Capital Structure: Gearing Debt/equity ratio Coverage: Debt interest Dividend Quoted: EPS pps PE ratio Dividend yield (pence per share) % % % % % % 2003 23.72 17.10 3.50 46.00 85.19 1.88 0.77 4.38 3.48 14.74 24.77 9.91 11.00 14.59 3.06 61.25 0.00 3.06 2004 1.28 1.01 0.20 44.02 78.63 1.91 0.74 4.71 3.31 11.01 33.16 0.00 0.00 0.00 0.20 3.75 53.33 9.58

days % %

(b) Profitability As can be seen from the ratios, profitability has fallen dramatically over the year, particularly in the case of return on capital employed (ROCE), less so in the case of the gross profit margin. Liquidity Liquidity has improved marginally. However, we would need to know greater detail about the nature of the business and industry before being able to comment on the appropriateness of the current level. The level of detail given in the question does not enable us to determine whether liquidity is moving in the right direction or not. Efficiency A mixed message is given by the ratios on efficiency. Net asset turnover issue has improved while stock turnover and debts have worsened. Gearing Capital gearing has changed quite significantly during the year. The company has moved to a 0 geared capital structure and is now entirely reliant on equity funding. Similarly, operating gearing has moved to 0. Investor ratios The 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 be seen, under the LIFO assumption this balance must comprise the following purchases: 1.9.04 1.4.04 1.1.04 103 at 3.75 56 at 3.03 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 from the purchases of 1 June 04 (103) and from that of 1 April 04 (50), leaving a balance of 47 from this purchase for stock. (b) Had the FIFO method been used the final stock would have been valued as follows: 1.4.04 1.9.04 1.6.04 6 at 3.03 103 at 3.75 103 at 3.50

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

(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 of accounting 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 the balance sheet is unlikely to reflect the current cost of stock held. Over a period of time the value will become increasingly out of date. As can be seen 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 tax authorities and has been deemed unsuitable.

Question 5
The way in which stock is measured is the first accounting policy that will be discussed. The amount of stock sold during a period will affect the calculation of net profit, while the amount of stock left at the end of a period will have an impact on the financial position. A number of different assumptions are used for stock measurements which have 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 into inventory will be the first ones sold as product. First in, first out is based on the principle that most businesses tend to sell the first goods that come into inventory. Suppose you buy five widgets at 10 apiece on 3 January and purchase another five widgets at 20 apiece on 7 January. You then sell five widgets on 30 January. Using first in, first out, the five widgets you purchased at 10 would be sold first. This would leave you with the five widgets that you purchased 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 purchased will be the first units sold. The advantage of LIFO, is that typically the last units purchased would have been purchased at the highest price and that by considering the highest priced items to be sold first, a business is able to reduce 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 recent widgets purchased, at a total value of 100 on 2 February, were sold. You were left with the five widgets valued at 10 each.

Weighted average Weighted average measures the total cost of items in inventory that are available 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 is calculated as follows: Weighted Average Cost per Widget = Total Cost of Goods for Sale at Cost divided by Total Number of Units Available for Sale Five widgets at 10 each = 50 Five widgets at 20 each = 100 Total number of widgets = 10 Weighted Average = 150/10 = 15 15 is the average cost of the 10 widgets The second accounting policy that impacts the financial statement is depreciation. The concept of depreciation is relatively simple to understand. For example, if a car has been purchased for a business, the car loses value the minute it is driven out of the dealership. Each year that the car is owned, it loses some value, until the car finally stops running and has no value to the business. 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 be used 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 method requires the initial cost of the asset, its estimated useful life and its residual value at the end of the period. For example, if the car is purchased for 20,000, is expected to be used for 4 years and have a residual value of 5,000, 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 written down value of the asset each year. This will have an effect of higher annual depreciation charges in the earlier years and lower charges in the later years.

Using the information from the car example above, the fixed percentage to be applied 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 years life 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 be used is: Cost of Car Year 1 Depreciation (29%) Written Down Value Year 2 Depreciation (29%) Written Down Value Year 3 Depreciation (29%) Written Down Value Year 4 Depreciation (29%) Residual Value 20,000 5,800 14,200 4,118 10,082 2,924 7,158 2,076 5,082

From the examples given, it can be seen how important the accounting policies used 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 training expense in the balance sheet, but treat it all as expenditure when incurred. However the MATCHING concept proposes that cash expenditure is matched against cash received. Training is an investment which gives benefit into future periods, which means an alternative treatment is to put a value on the training expense in the balance sheet, and subsequently to reduce the value as the cash is recovered from the consulting assignments of the new employee. A further refinement would be to estimate the likely refunds of the training expenditure from the prematurely resigning employee. The MATCHING concept suggests that this future benefit could be combined with the

training expenditure to reduce its cost. In practice the PRUDENCE concept is the rule likely to dominate, and the benefits of the refunds cannot be anticipated. (b) MATCHING and PRUDENCE both suggest that anticipated future warranty expenditures be estimated as a liability. The benefit of the sale is then reduced by the (expected) cash paid for repairs, irrespective of the fact that it is not incurred in the same accounting period as the sale. The QUANTITATIVE boundary rule that only data capable of being easily quantified should be included is likely to be overruled in practice by the PRUDENCE concept.