Accounting Principles. Question Paper, Answers and Examiners Comments. Level 3 Diploma January 2013

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1 Accounting Principles Question Paper, Answers and Examiners Comments Level 3 Diploma January

2 Copyright of the Institute of Credit Management Institute of Credit Management The Water Mill, Station Road, South Luffenham, Oakham, Leicestershire LE15 8NB Bookshop Tel: Education Tel: Switchboard Tel: Fax:

3 Accounting Principles questions, answers and examiners comments UNIT 02 LEVEL 3 DIPLOMA IN CREDIT MANAGEMENT JANUARY 2013 Instructions to candidates Answer any FIVE questions. All questions carry equal marks. Time allowed: 3 hours All ledger accounts must be prepared in continuous balance format Final accounts must be prepared in vertical format Where appropriate, VAT is to be calculated at 20% Questions start on the next page A good paper including a range of questions to cover the syllabus and which gave the more able the chance to gain high marks - highest = 83. The paper really tested the less well prepared (lowest mark 6). Candidates generally appeared prepared to deal with the mix of numerical and written questions and the overall standard achieved was in line with expectations. The majority of candidates appeared to have sufficient time to complete the questions, with one candidate attempting 6 questions, another answering all 8 questions set which clearly wasted time. However approx 10% of candidates only attempted 3 or 4 of the set questions, which does affect the marks awarded. Candidates are encouraged to attempt the required 5 questions so that they can be awarded marks for their ability. Candidates should also attempt all parts of each question which some candidates did not; this restricted the marks they could achieve. Some candidates still do not include their workings which doesn t allow the examiner to award any marks whilst one or two still use T account format when the study text and exam paper make it clear that the continuous balance format is a requirement. 3

4 1. a) Read the following cutting from the financial press, and then answer the questions which follow: Profits Warning at Leading Cars: From Ivor Pound, Financial Correspondent The share price of Leading Cars plc, the car retailing group, dipped sharply in January to 456p from its high of 587p last month following a profits warning from the company. TASK How might the following users of these accounts be affected if Leading Cars plc does, in fact, make a loss? Shareholders Managers Suppliers. (6 marks) b) When preparing final accounts it is important to distinguish between capital and revenue expenditure. TASK i) Define capital expenditure using two appropriate examples. (3 marks) ii) Define revenue expenditure using two appropriate examples. (3 marks) iii) Explain why it is important to classify these types of expenditure correctly in the accounting system. (4 marks) iv) Show the relevant double entries for the following expenditure: A business purchases a new air conditioning system costing 15,000 paying by cheque, receiving a cash settlement discount of 5% for immediate payment The businesses employees are used to install the new air conditioning system. Included in total wages is the cost of 1,000 for labour costs Plumbing and other materials cost of 1,500 was included in total purchases. (4 marks) Total 20 marks Question aims To test the candidate s ability to: Describe the requirements of the different users of accounting information and their application of the data Describe the difference between capital and revenue expenditure and give examples of both. 4

5 Suggested answer a) Shareholders: As there has been a profits warning they will want to understand that their money is safe and that there is a prospect of the company returning to previous levels of profit and paying dividends In the worst case scenario, shareholders could loose their investment if the company makes a loss or becomes insolvent. Managers Managers, and employees are interested in information about the stability and profitability of their employer They need to assess the likelihood of future employment as they might lose their jobs if Imperial Cars continues to make a loss Firms that operate profitably are more likely to offer job security including promotion/advancement Managers might also be concerned about the ability of the firm to offer pay increases and/or bonuses in the future They will also be interested in the ability of the firm to continue to offer retirement benefits. Suppliers These are people the business owes money to and they will be concerned about the ability of Leading Cars to make payment within agreed credit terms Suppliers might lose their money and future business/trading opportunities with the firm If Leading Cars is their major customer, then the suppliers will be concerned about the long term survival of the business, as failure of this business will ultimately affect the trading success/profitability of their own firm. b) i) Capital expenditure results in the acquisition of fixed assets, or an improvement in their earning capacity Capital expenditure can be defined as expenditure incurred on the purchase, alteration or improvement of fixed assets, e.g. land and buildings; motor vehicles; fixtures and fittings; plant and machinery; computers) Fixed assets are permanent assets of the business, which will be used for a number of years to generate profit and thus the funds to buy these assets will be tied up for a long time If expenditure improves a fixed asset i.e. by making it superior to what it was when it was first owned by the business (e.g. building an extension to a warehouse) then it is treated as capital expenditure Included in capital expenditure are costs such as Delivery of fixed assets; Installation of fixed assets; Improvements (but NOT repair) of fixed assets; Legal costs of buying property; Carriage inwards on machinery bought. 5

6 ii) Revenue expenditure is for the purpose of the trade of the business or to maintain the existing earning capacity of fixed assets Revenue expenditure is expenditure incurred on running expenses i.e. the day-to-day expenses of a business, e.g. the cost of petrol or diesel for a motor vehicle or repairs to a building This is because the expenditure is used up in a short time, and does not add to the value of the fixed assets Included in revenue expenditure are the costs of maintenance and repairs of fixed assets; administration of the business; selling and distribution of the goods or products in which the business trades. iii) Revenue expenditure is charged as an expense to the profit and loss account, provided that it relates to the trading activity and sales of that particular period, which reduces the net profit Capital expenditure is charged to the balance sheet and results in the addition of fixed assets to the business Depreciation reduces the fixed asset value, and is treated as revenue expenditure, although no cash transaction takes place Getting the classification wrong will affect the reported profits as well as the asset values (and capital account) in the financial statements If expenditure is treated as revenue expenditure, then it reduces the profit immediately by the amount spent. However, if this is treated as capital expenditure, then the reported profits are higher as the expense is shown as an asset on the balance sheet Following the dual-entry concept, if the fixed asset values are over-stated (i.e. because revenue expenditure is treated as capital expenditure) then the profits will also be over-stated If the expenditure also affects items in the trading account, then the gross profit figure will also be incorrect. iv) This is capital expenditure and should increase fixed assets because it is an addition to the property. Dr Fixed Assets (air conditioning) 15,000 Cr Bank account 14,250 Cr Cash discount received 750 Wages should be reduced by 1,000 and Materials reduced by 1,500 Dr fixed assets (air conditioning) 2,500 Cr wages 1,000 Cr purchases 1,500 6

7 This was a popular choice, with a good range of marks being achieved. Part a) Although some candidates were clearly not prepared for a question which required them to explain how a profits warning would affect users of the accounts, more able candidates gave fully developed explanations. Weaker candidates did not answer the question as set, for example incorrectly explaining how managers would need to review budgets and cash flow by arranging overdraft facilities and how Leading Cars would need to change to cheaper supplies. Part (b) Should have been expected and many candidates were able to correctly define both capital and revenue expenditure giving two valid examples. However, the majority of candidates did not fully appreciate the need to classify these correctly so that both gross and net profits and fixed assets are correctly stated in the financial statements. The final part of this question required candidates to apply concepts already covered when dealing with capital expenditure. Although more able candidates showed correct entries, weaker candidates did not recognise that the 750 discount would be deducted from the payment, showing the gross figure of 15,000 as a credit to the bank account. Weaker candidates were also confused by the mis-posting of wages and purchases by showing these as debit entries to each account and then credit to the bank account in error. As the payment had already been in the relevant costs, the correct entries increase (debit) fixed assets and reduce (credit) costs. 7

8 2. a) The following balances were extracted from the books of Graham Weston, a sole trader, as at 31October 2012: Trade creditors 2,065 Stock held at 31 October ,073 Wages owing 225 Premises 27,400 Cash 500 Trade debtors 5,127 Furniture and fittings - cost 5,000 Furniture and fittings - accumulated depreciation 1,925 Motor vehicles - cost 10,000 Motor vehicles - accumulated depreciation 3,900 Plant and machinery - cost 20,000 Plant and machinery - accumulated depreciation 6,160 Bank overdraft 1,875 Insurance paid in advance 50 5 year loan from Loamshire Finance Co 7,500 Drawings 10,800 Net profit for the year ended 31 October ,970 Capital? No provision for depreciation has yet been made for the year ending 31October Depreciation is to be provided using reducing balance method as follows: Motor vehicles 25% per annum Plant and machinery Furniture and fittings 15% per annum 20% per annum 8

9 TASK a) i) Prepare the balance sheet for Graham Weston as at 31 October Note: An amended trial balance is not required. ii) What is the meaning of the words as at for the balance sheet heading? (11 marks) (1 mark) b) Graham Weston keeps referring to the motor vehicle as my car. His accountant has told him that the car does not belong to him but to the firm. He replies that of course it belongs to him, and furthermore, if the firm went bankrupt he would be able to keep the car. Use the appropriate accounting concept to help explain to Graham whose approach is correct. (3 marks) c) Graham Weston informs you that his business will use depreciation as a means to set aside cash each year so that it eventually has the funds to purchase a replacement car when this becomes necessary. i) Comment briefly on the above statement. (2 marks) ii) Use an appropriate accounting concept to help explain why a business will provide for depreciation. (3 marks) Question aims To test the candidate s ability to: Construct a balance sheet for a sole trader business including both accruals and prepayments, from information in a trial balance State the purpose of a balance sheet Explain the reasons for a depreciation provision Calculate and include depreciation in the balance sheet of a business Identify and explain relevant accounting concepts. Suggested answer Starts on next page Total 20 marks 9

10 a) Workings - full trial balance not required for information only Trade creditors 2,065 Stock held at 31 October ,073 Wages owing 225 Premises 27,400 Cash 500 Trade debtors 5,127 Furniture and fittings cost 5,000 Furniture and fittings accumulated depreciation 1,925 Motor vehicles cost 10,000 Motor vehicles accumulated depreciation 3,900 Plant and machinery - cost 20,000 Plant and machinery accumulated depreciation 6,160 Bank overdraft 1,875 Insurance paid in advance 50 5 year loan from Loamshire Finance Co 7,500 Drawings 10,800 Net profit for the year ended 31 October ,970 Capital = balancing figure 45,330 81,950 81,950 Motor vehicles Cost 10,000 3,900 = 6,100 x 25% Plant and machinery Cost 20,000 6,160 = 13,840 x 15% Furniture and fittings Cost 5,000 1,925 = 3,075 x 20% = 1,525 = 2,076 = 615 4,216 10

11 i) Balance sheet for Graham Weston as at 31 October 2012 Fixed assets Cost Depreciation NBV Premises 27, ,740 Furniture and fittings 5,000 2,540 2,460 Motor vehicles 10,000 5,425 4,575 Plant and machinery 20,000 8,236 11,764 46,199 Current Assets Stock 3,073 Debtors 5,127 Prepayments 50 Cash 500 8,750 Current Liabilities Creditors 2,065 Accruals 225 Bank overdraft 1,875 (4,165) Working capital/net current assets 4,585 50,784 Long-Term Liabilities Loan from Loamshire Finance Co (7,500) Net Assets 43,284 Financed by: Capital Account (Graham Weston) Opening capital (missing figure) 45,330 Add: net profit (12,970-4,216) ,084 Less: drawings (10,800) 43,284 ii) The balance sheet is a statement of the assets, liabilities and capital of a business at a particular moment in time, i.e. 31 October The balance sheet does not reflect a financial period, but only shows the value of assets, liabilities and capital at a particular date. 11

12 b) Business Entity concept. This refers to the fact that final accounts record and report on the activities of one particular business. They do not include the assets and liabilities of those who play a part in owning or running the business The owner and the business are treated as two separate entities. The business affairs are kept completely separate from those of the owner As the car is shown on the firm s balance sheet, it is an asset of Graham s firm, not a personal asset As Graham is a sole trader he has unlimited liability, which means should he be unable to pay the debts of the firm, then his personal assets may well be used to cover any shortfall. c) i) Depreciation is a non-cash expense, i.e. unlike the other expenses in the profit and loss account, no cheque is written out, or cash paid, for depreciation In cash terms, depreciation causes no outflow of money and is not a method of providing a fund of cash which can be used to replace the asset at the end of its life In order to do this, it is necessary to create a separate fund into which cash is transferred at regular intervals, known as a reserve account This technique is often known as a sinking fund and it needs to be represented by a separate bank account e.g. deposit account, which can be drawn against when the new fixed asset is to be purchased. This is not, however, a common practice. ii ) Depreciation is an application of the accruals (matching) concept because we are recording the timing difference between payment for the fixed asset and the asset s loss in value Depreciation is an estimate of the amount of loss in the value of fixed assets over an estimated time period As a fixed asset will be used by the business in the generation of profits for a number of years, the full cost is not charged to the profit and loss account in a single year i.e. when it is bought, only a proportion of the cost of the asset is charged to the profit and loss account and matched against the revenue which it helps to generate Fixed assets lose value as time goes by largely as a result of wear and tear. This loss in value is known as depreciation and in business accounts it is necessary to record the amount of this loss in value in order to present a realistic view of the business The balance sheet must reflect as accurately as possible the value of fixed assets in accordance with the prudence concept so that profits and asset values are not overstated. This was another reasonably popular question choice, with the full range of marks being achieved. Part a) required the preparation of a balance sheet from given information, although the trial balance required a calculation of working capital = balancing figure of 45,330 only attempted by a few candidates. The majority of candidates did recognise that both sides of the balance sheet should equal the same amount, but did not realise that the profit figure would need to be adjusted for the current year s total depreciation ( 4,216). Weaker candidates did not adjust the depreciation figure for fixed assets, showing the total from the trial balance in error, and thus losing valuable marks. Despite being told that the bank was overdrawn, some candidates treated this as a current asset in error. 12

13 Only more well prepared candidates correctly identified and explained the business entity concept, although many recognised the business and owner are treated as two separate entities. Only a few candidates explained the effect of unlimited liability on the owner s personal assets. Part c) was also only answered fully by the more able candidates. Weaker candidates applied the consistency concept which is not appropriate here as it an approach for applying depreciation, not matching cost with wear and tear. As a result, some candidates wasted time explaining the difference between reducing balance and straight line depreciation and/or which should be used for the motor vehicle. 13

14 3. a) i) Explain what is meant by the term accounting equation. (2 marks) ii) Identify the components of the equation. (1 mark) iii) State how the accounting equation is affected by the following transactions: The owner of a business pays a cheque for 10,000 (for initial capital) into the bank A Mercedes is bought for the business for 45,000 paying by cheque The business pays by cheque a supplier s invoice for 3,500 The bank agrees to lend the business 20,000 and transfers the money into the business bank account. (4 marks) b) You have received the following statement of account from F. Ramsey & Son who are VAT registered traders. However, their book-keeper has not had any formal training and so the information and layout provided may not be wholly correct. TASK W Hoddle Limited Black Pool Road Manchester 31 December 2012 Statement Of Account F. Ramsey & Son 31 North Street, Liverpool Date 2012 Reference Dr Cr Balance 1 December B/F Dr December December December Cheque and discount December December December , Cash discount 5% if paid within one month of the date of this statement i) Explain the transactions which gave rise to the entries dated: 12 December 14 December 20 December. (4 marks) ii) Calculate the amount of cash discount W. Hoddle Ltd will receive if they pay the above account on 18 January (1 mark) iii) Explain why it is good practice to reconcile entries in a purchase ledger account and a statement from a supplier. (3 marks) iv) Explain why the purchase ledger and suppliers statement are unlikely to agree. (5 marks) Total 20 marks 14

15 Question aims To test the candidate s ability to: Understand the concepts behind the workings of the double entry system, using the accounting equation Use a supplier s statement to identify purchase invoices; returns and discounts Calculate cash discount Explain the procedures to be adopted in order to reconcile the entries in a purchase ledger account and a statement from a supplier. Suggested answer a) i) The accounting equation Is the basis used to record financial information and will always balance because the principal is that for each financial transaction there are two entries (the double entry system) i.e. a debit and a corresponding credit entry Involves the balance sheet, as it shows the net amount of what the firm owns (assets less liabilities) on one side, and the funding used to by those assets (capital) on the other side Every business transaction will change the balance sheet and the equation, because each transaction has a dual effect on the accounts. ii) The three components are assets - liabilities = capital Accept assets + expenses = liabilities + capital + income. iii) The owner of a business pays a cheque for 10,000 (for capital) into the bank Both sides of the equation increase Debit bank account 10,000 Credit capital account 10,000 A Mercedes is bought for the business for 45,000 paying by cheque The equation is unchanged as the transaction cancels itself out Debit Fixed Assets (Vehicle Account) 45,000 Credit Bank Account 45,000 The business pays by cheque a supplier s invoice for 3,500 Both assets and liabilities decrease Debit Suppliers Account (purchase ledger) 3,500 Credit Bank Account 3,500 The bank agrees to lend the business 20,000 and transfers the money into the business bank account Both assets and liabilities increase Debit Bank Account 20,000 Credit Bank Loan Account 20,000 b) i) Use the Statement provided to explain the transactions which gave rise to the entries 12 December = goods sold on credit by F. Ramsey & Son to W. Hoddle Ltd Accept: Invoice received (by W. Hoddle Ltd) for supplies on credit from F. Ramsey & Sons. 15

16 14 December = payment received by F. Ramsey & Son from W. Hoddle Ltd, including settlement discount allowed to W. Hoddle Ltd Accept: Payment made to F. Ramsey & Son which cleared the balance brought forward on 1 st December. Settlement discount = 21.78; cheque = December = goods returned by W. Hoddle Ltd to F. Ramsey & Son Credit note issued by F. Ramsey & Son. ii) 1,080 = 900 x 5% = VAT iii) The statement is the suppliers (F. Ramsey & Son) record of transactions that have taken place with a customer and should contain the same information as the customer s ledger (W. Hoddle Ltd), in a similar format In a small firm it is relatively easy to check that goods as ordered have been supplied but it is important that there is some mechanism in place to verify that the goods have been received before an invoice from a supplier is entered in to the purchase ledger and authorised for payment W. Hoddle Ltd should check the statement from F. Ramsey & Son with their own records of the transactions that have taken place using the purchase ledger In most instances the reconciliation of the two sets of figures will be straightforward as invoices, credit notes and other documentation will carry dates and reference numbers, which make for easy referencing by both firms The entries in the statement and the purchase ledger account can then be reconciled and agreed for payment. iv) Reconciliation does not mean that every invoice the supplier has listed on the statement is in order, and should be paid. There may be reasons for differences, and action should be taken to rectify these differences before payment is made. These differences could arise as follows: Goods have been sent back to the supplier shortly before the statement date, and the supplier has not yet issued a credit note The supplier may have offered a specific trade discount but the suppliers accounts department have not been notified, and the goods have been invoiced at normal price Payments may have been made after the statement date so that the supplier has not included this in the latest statement Goods from an order may not yet have been delivered to the customer i.e. marked to follow but the supplier has included these on the invoice and on the statement There may be items on the statement that do not relate to the firm at all Settlement discount may have been taken when it is outside the terms agreed and therefore has been disallowed 16

17 Invoices and credit notes may have been issued but not yet received, i.e. timing differences Invoices and credit notes may have gone missing i.e. not received at all. This was not a particularly popular question choice, although more able candidates did achieve good marks. Part a) relied on the relationships assets - liabilities = capital although weaker candidates used current assets and liabilities = working capital, which was not required. Candidates were required to explain what is meant by this equation, although weaker candidates tried to explain and give examples for each element of the accounting equation which was not required. Candidates were then required to apply the accounting equation and to recognise the double entry transactions which had taken place. Although more able candidates gave fully correct answers, the less able simply repeated the information provided linking it to the accounting equation and not identifying the Debit and Credit entries. Some candidates used the cumulative figures provided, and were not able to identify the new transactions taking place at each stage. Part b) had not previously been examined in this way, and although more able candidates were able to fully explain the transactions, weaker candidates did not appear to have read the initial information stating that the layout might not be wholly correct and confused invoices with payments and credit notes with invoices, thus gaining few marks. The calculation of cash discount also confused many candidates who did not exclude the VAT element and so calculated 1,080 x 5% = 54 instead of the actual net figure of 900 x 5% = 45. Part c) required candidates to apply a standard requirement for the credit manager i.e. the reconciliation of the purchase ledger with supplier s statement, and then identify reasons for disagreement. Again, only the very well prepared candidates gained good marks for this part of the question, with weaker candidates confusing the two aspects of the question, and thus gaining few marks overall. 17

18 4. Byron Beasley Limited manufactures components for the motor vehicle industry. The following is a summary of some of its accounting ratios as at 31 December 2011 and 31 December Current ratio 1.7 : : 1 Quick ratio 0.8 : : 1 Stock turnover 63 days 59 days Debtors ratio 63 days 52 days Creditors ratio 78 days 71 days Interest cover 6.2 times 7 times TASK a) State the formulae which will have been used to calculate each ratio. (3 marks) b) Explain the meaning and purpose of these ratios. (9 marks) c) Identify and comment on possible reasons for any changes in the ratios for Byron Beasley Limited. (3 marks) d) Calculate and explain the cash operating cycle. (2 marks) e) Discuss what actions Byron Beasley Limited could take to improve the cash operating cycle. (3 marks) Total 20 marks Question aims To test the candidate s ability to: Analyse the financial statements of a given organisation and evaluate their reliability as a key indicator of performance: State the formulae for a number of accounting ratios Assess the performance of the business based on calculated ratios Explain the importance of working capital and calculate the cash operating cycle for a business. Suggested answer a) Current ratio Quick ratio Stock turnover Debtors ratio Creditors ratio Interest cover Current assets Current liabilities Current assets - stock Current liabilities Average stock x 365 Cost of sales Debtors x 365 Credit Sales Creditors x 365 Purchases Profit before interest and tax Interest payments 18

19 b) Current ratio This measures the relationship between current assets and current liabilities i.e. working capital. These figures are usually taken from the balance sheet. Although there is no ideal working capital ratio 2:1 is often accepted i.e. there are 2 of current assets for each 1 of current liabilities. This indicates how well a firm can meet its day-to-day liabilities. Quick ratio This is also known as the acid test which uses current assets and current liabilities from the balance sheet, but stock is omitted. This is because stock is the most illiquid of assets i.e. it has to be sold, turned into debtors and then the cash collected from the debtors. The balance between liquid assets (debtors and cash/bank) and current liabilities should ideally be 1: 1 i.e. 1 of liquid assets to each 1 of current liabilities. At this ratio a business is expected to be able to pay its current liabilities from its liquid assets. A figure below 1: 1 indicates that the company would have difficulty in meeting pressing demands from creditors. Stock turnover This ratio uses information from the Trading Account. Average stock is usually found by making the simple average of the opening and closing stocks i.e. (Opening Stock + Closing Stock 2 Stock turnover is the number of days stock held on average. As Byron Beasley Limited manufacture components for the motor vehicle industry they may hold large volumes of stock items. Debtor s ratio This calculation shows how long, on average, debtors take to pay for goods sold to them by the business. Some businesses make the majority of their sales on credit, but others will have a lower proportion of credit sales. As the company manufacture components for the motor vehicle industry it would be anticipated that the majority of their sales are on credit terms. The debt collection time should be compared with terms offered to contextualise the result and should be compared with the previous year to show how efficient the firm is at collecting the money that is due. Results can also be compared with other businesses in the same sector for benchmarking. Creditor s ratio This measures the speed at which a firm pays its creditors (i.e. suppliers) and should be compared to the credit terms given. Efficient management of payment to creditors is that it should be longer than the time taken to collect payment from debtors. Firms should take full use of the credit period given, but while creditors can be a useful temporary source of finance, delaying payment too long, may cause problems. 19

20 Interest cover This indicates the number of times the profit before interest and tax can cover the interest payable. This is a useful ratio for lenders, as banks will usually specify a required ratio (usually 3 times) when dealing with any loan agreement. Although the ratio may show that there is sufficient profit to cover the interest due, this does not necessarily mean that there is cash available to pay the interest, so that the liquidity ratio must also be considered. However, there is no information to indicate whether loans have been paid and/or increased during the year, which will affect the interest cover. c) The current ratio (working capital) has improved (2012 = 1.7; 2011 = 1.5) which is below the average of 2:1, but the quick (liquidity) ratio has got worse (2012 = 0.8; 2011 = 1.1) and is also now below the average of 1:1. This suggests a possible build up of stocks held for re-sale. The stock turnover has increased (2012 = 63 days; 2011 = 59 days) which also points to an increase in stocks and/or a decrease in sales. The debtors ratio (2012 = 63 days; 2011 = 52 days) shows that debtors are being allowed to take a considerably longer period of credit. The creditors ratio (2012 = 78 days; 2011 = 71 days) shows that this company is taking longer to pay its debts. The interest cover is decreasing (2012 = 6.2 times; 2011 = 7 times) which is above the average of 3 times. This may be an indicator that there may be insufficient profits in the future, and the firm may have difficulty in paying interest. Overall there is deterioration in liquidity and control of working capital as well as interest cover. It appears there may be: Overstocking i.e. money is tied up un-necessarily in unsold stock which could lead to loss of sales Poor stock control, which could mean that some of the stock included in the balance sheet figure may be un-saleable or obsolete A relaxation of credit control procedures as it now takes on average 11 days longer to collect debts due, which may lead to bad debts increasing. d) Calculate and explain the cash operating cycle Stock turnover + Debtor Collection time Creditor payment time = = 48 days = = 40 days. This is a further use of ratios to calculate the period of time between payments for goods received into stock and the collection of cash from customers in respect of their sale. The shorter the length of time between the initial cash outlay and the ultimate collection of cash, the lower the value of working capital to be financed by the business. 20

21 e) Whilst the cash operating cycle is the same for both years, it might be appropriate for the firm to consider actions which will reduce the cycle by either: Reducing stocks, which will lower the number of days that stock is held but this might mean that a poorer service is offered to customers, who might take their business elsewhere. The firm might also consider investing in a stock management system to improve stock control. Speeding up the rate of debtor collection i.e. allowing debtors less time to pay, but this may also cause customers to seek alternative suppliers who are offering better credit terms. Alternatively there may be an option to offer discounts for early settlement, or to charge interest on overdue accounts. Slowing down the rate of creditor payments i.e. taking longer to pay the creditors, but this may be difficult, as suppliers might decline to supply goods unless immediate payment is forthcoming i.e. may ask for cash with order. This could have a detrimental effect on the firm s credit rating and other suppliers might also refuse to supply goods. Ratio analysis is a very common type of question and was popular with some well developed answers which achieved good marks. However, weaker candidates appeared to be confused by the lack of financial statements and were confused by the fact that the actual ratios had already been calculated. Part a) required the relevant formula for each ratio and whilst many gained max marks here, the ratio for interest cover caused most difficulty. Part b) and c) should have been anticipated and again, many gave good explanations although weaker candidates gave very basic comments and did not achieve the development required. Only the more well prepared candidates fully recognised the reasons for the changes in the ratios over the two years. Part c) and d) required candidates to apply and discuss the cash operating cycle and again whilst many did well, weaker candidates did not calculate the cycle for both years, and thus their explanation about how the cycle could be improved was not fully correct. 21

22 5. a) Explain the main similarities and differences between ordinary shares and debenture loans. (6 marks) b) You have been provided with the following selected balances of Filo plc as at 31 December 2012, together with the additional information which follows: Retained profits as at 31 December ,000 Stocks held at 1 January ,000 Purchases 1,462,000 Turnover 2,456,000 Returns inwards 108,000 Returns outwards 37,000 Carriage inwards 14,700 Wages and salaries 136,000 Rent and business rates 14,000 General distribution expenses 28,000 General administrative expenses 24,000 Discounts allowed 36,000 Bad debts 5,000 Loan interest 12,000 Motor expenses 16,000 Interest received on bank deposits 6,000 Other income 7,000 Motor vehicles at cost 146,000 Equipment at cost 27,000 Ordinary share dividends paid 120,000 TASK Stocks held at 31 December ,000 Wages and salaries accrued amount to 12,000 Rent and business rates prepaid amount to 1,700 Depreciate motor vehicles 20% and equipment 10% on cost Ordinary share dividend proposed 42,000 Accrue auditors remuneration of 11,000 Accrue corporation tax for the year on ordinary profits 364,000. Prepare a trading, profit & loss and appropriation account for internal use. (14 marks) Total 20 marks 22

23 Question aims To test the candidate s ability to: Explain and describe the terminology used in the preparation of statutory accounts for limited companies Use an extract of a trial balance to construct a trading, profit and loss and appropriation account, including adjustments for accruals, prepayments and depreciation Suggested answer a) Ordinary shares Also known as equity shares, they are the ultimate risk takers Shareholders are owners of the company who are normally entitled to vote at general meetings of the company e.g. to elect directors and appoint auditors Shareholders may receive a dividend annually, at a rate decided by the company s directors. The dividend varies each year depending on the profit, and is an appropriation of the profit. If the company is not profitable enough a dividend may not be paid. They are last to be repaid the value of their shares in the event of the company going into liquidation Shareholders funds are Non-repayable except on the liquidation of the company Their rights are outlined in the Articles of Association Dividends are non-deductible from company profits i.e. for tax purposes. Debenture loans These are long-term loans, which are usually secured against the assets of the company Debenture holders have no voting rights Receive a fixed rate of interest which constitutes a charge against income when calculating the profit They have priority over preference dividends (and thus over ordinary shareholders) They are repaid before either preference or ordinary shareholders in the event of liquidation as they are usually secured creditors They are normally repayable after a fixed period of time Their rights are specified at the time of issue of the loan agreement Interest is deducted from profits for tax purposes. 23

24 b) Filo plc -Trading, profit and loss and appropriation account for the year ended 3 December 2012 Trading account Sales 2,456,000 Less: Returns inwards (108,000) Less: Cost of sales Opening stock at 1 January ,000 Add: purchases 1,462,000 Less: returns outwards (37,000) 1,425,000 Add carriage inwards 14,700 1,523,700 Less: Stock at 31 December 2012 (102,000) 2,348,000 1,421,700 Gross profit 926,300 Add: other operating income 7,000 bank interest received 6,000 13,000 Less operating costs Wages and salaries (136, ,000) 148,000 Rent and business rates (14,000-1,700) 12,300 General distribution expenses 28,000 General administrative expenses 24,000 Discounts allowed 36,000 Bad debts 5,000 Motor expenses 16,000 Auditors remuneration 11,000 Depreciation: motor vehicles 29, ,300 equipment 2,700 (312,200) Profit before interest and tax 627,100 Less: loan interest (12,000) Profit before taxation 615,100 Corporation tax 364,000) Profit for the year 251,100 Less: ordinary share dividends paid 120,000 proposed 42,000 (162,000) 89,100 Retained profits brought forward 102,000 Retained profits carried forward OF 191,100 Note: This answer is in accordance with the ICM Study Text. However, some students may be aware that the rules have changed with regard to how dividends are shown on the accounts. As they are not paid out until after they have been agreed at the AGM they should be accrued. 24

25 This was a popular question choice and many of the candidates who attempted this question found it manageable and achieved high marks. Part a) required an understanding of the differences and similarities between ordinary share capital and debenture loans. As anticipated only the very well prepared candidates achieved max marks for this part of the question. For part b) candidates were required to prepare the trading, profit and loss account and the adjustments were done accurately by the more able candidates. Some still had difficulty dealing with opening/closing stock reversing these figures. Common errors included: Including the 108,000 returns inwards as part of operating costs (expenses) and not deducting from sales Treating carriage inwards 14,700 as expenses not cost of sales 37,000 returns outwards either treated as + rather than deduction from cost of sales and/or treating this as sales returns Including the 12,000 loan interest as part of expenses and not recognising the profit should be calculated before interest and tax A few candidates treated PBIT as Gross Profit in error. The appropriation account was only prepared accurately by the more able, as weaker candidates ignored the 120,000 dividend paid. The retained profit b/f 102,000 was also ignored by less able candidates. 25

26 6. a) Claire Hamilton runs an ironing service, and now wishes to buy a more reliable motor vehicle for her business. TASK Explain two advantages and two disadvantages of these two alternatives: i) Hire purchase. (4 marks) ii) Leasing. (4 marks) b) Revamp Furniture Ltd prepare annual figures to 31 May and have provided you with the following management figures for month 7, and the cumulative budget for the year 2013: Budget trading and profit and loss account for the year ended 31 May 2013 Period 7 Cumulative Whole Year Budget Actual Variance Budget Actual Variance Budget Latest forecast Sales ,500 3,420 (80) 6,000 6,200 Direct cost of sales Factory overheads Administration & selling costs (42) 1,960 1, ,500 3, (11) (1) ,320 1,147 Total costs (54) 3,220 3, ,520 5,747 Operating profit (11) Profit: sales % 8% 14.3% 8% 7.9% 8% 7.3% TASK i) For each item of income and expenditure, explain what this information tells the directors of Revamp Furniture Ltd about their business profits. (10 marks) ii) Explain the circumstances when an auditor might issue a qualified opinion on the financial statements. (2 marks) Total 20 marks 26

27 Question aims To test the candidate s ability to: Explain the advantages and disadvantages of medium-term debt finance for a sole trader Understand the process of monitoring and analysing budgets using variance analysis Explain why and when an auditor might issue a qualified opinion. Suggested answer a) i) Hire purchase Hire purchase is actually two agreements, one for hire and the other an option to purchase at the end of the term by paying an additional amount. Purchase is usually via a secured loan that is paid back monthly across the agreed period, usually 3-5 years. Monthly payments are therefore much higher than when leasing. Advantages of Hire purchase Hire Purchase is a method of acquiring assets without having to invest the full amount in buying them. Typically, a hire purchase agreement allows the hire purchaser sole use of an asset for a period after which they have the right to buy them, often for a small or nominal amount. The benefit of this system is that companies gain immediate use of the asset without having to pay a large amount for it or without having to borrow a large amount. Hire purchase is cheaper than an, unsecured, personal loan because the ownership of the car is retained by the finance company, i.e. it is secured, and if you don t make your monthly payments then they will simply take the vehicle back. However, you will still have to pay any outstanding installments, plus any interest due. Hire purchase is relatively quick as it is offered directly by most dealers and manufacturers and is agreed to more easily than personal loans Deposits are lower than with personal loans If you intend to own and retain the same car for more than 4 or 5 years, than hire purchase is cheaper over the long term than leasing because there are no further payments once you own it completely. Disadvantages of Hire Purchase Often the finance company will expect all of the VAT for the whole value of the car to be paid with the first installment, whereas with leasing the upfront payment is only the equivalent of three months payments: The monthly payment required is always much higher You are paying interest on the full value of the car, even if you don t intend to retain it for longer than 2-4 years There are often hidden fees and so you would need to shop widely before being sure you have a good deal The termination fee is significant if your circumstances change and you don t want the car anymore. You are not the owner of the car from day one so you can not modify or sell it. 27

28 ii) Leasing Leasing is a contract between the leasing company, the lessor, and the customer (the lessee). The leasing company buys and owns the asset that the lessee requires. The customer hires the asset from the leasing company and pays rental over a pre-determined period for the use of the asset. There are two types of leases: Finance Leases Under a finance lease the rental covers virtually all of the costs of the asset therefore the value of the rental is equal to or greater than 90% of the cost of the asset. The leasing company claims writing down allowances, whilst the customer can claim both tax relief and VAT on rentals paid Operating Leases The lease will not run for the full life of the asset and the lessee will not be liable for its full value. The lessor or the original manufacturer or supplier will assume the residual risk. This type of lease is normally only used when the asset has a probable resale value, for instance, aircraft or vehicles. The most common form of operating lease is known as contract hire. Essentially, this gains the customer the use of the asset together with added services. A very common example of an asset on contract hire would be a fleet of vehicles. Advantages of Leasing Car leasing provides the option of making no down payment, although you must still make the first month's payment and any registration fees. Some promotional lease deals require a down payment to get the deal. Since monthly lease payments are lower than with buying, you get to drive a new vehicle every two to four years, depending on the term length of your lease. Most people like to lease for a term that coincides with the length of the manufacturer's warranty coverage so that if something goes wrong with the car, the repairs are always covered. Most car leases require little or no down payment, which makes getting into a new car more affordable and frees up your cash for other things. However, you can choose to make a down payment, or trade in your old vehicle, to lower your monthly payment amount. With leasing, the headaches of selling a used car are eliminated. When your lease ends, you simply turn it back to the leasing company and walk away, unless you decide to buy it or trade it. Disadvantages of Leasing If you must terminate your lease before the end of your contract, the cost is usually very high, much higher than might be expected. The trade-off for low monthly lease payments is that you typically do not build ownership or trade-in value in your leased vehicle. However, it is fairly common that the market value of a vehicle at lease-end is higher than the purchase option price specified in the lease contract, which means you may have some equity trade value. If you exceed the mileage allowance in your lease contract, you will be charged for the extra miles at a specified per-mile rate. A large mileage excess could result in a hefty charge, even at a reasonable per-mile rate. 28

29 If you return a leased vehicle at lease-end with excessive dents, scratches, or unrepaired accident damage, you will be charged because those damages reduce the vehicle's value. Most lease companies clearly specify what is considered "excessive" so that you'll know if you should get it repaired before returning your vehicle. Get the repairs done yourself before you return the vehicle and avoid being charged. b) i) Sales for Period 7 were significantly above budget by favourable 100,000. However, the cumulative to date figures show that sales had in fact been below budget. The increase for Period 7 has reduced this adverse variance/shortfall to 80,000. If this trend continues then by the end of the year, overall sales should exceed budget by 200,000. However, additional strategies to increase sales may be required if overall profit margins are to be maintained at 8%. Direct Cost of Sales are naturally higher when sales are higher and it is possibly easier to understand the trend by calculating direct costs as a %age of Sales i.e. Direct costs x 100. Sales Budget Actual Period 7 280/500 x % 322/600 x % Cumulative to date 1960/3500 x % 1951/3420 x % Forecast for year 3500/6000 x % 3850/6200 x % The forecast for direct costs was original set at 56%, but this has increased to 57.05% and is now predicted to be 62.10%. This is now forecast for the year as a whole as adverse by 350,000, i.e. additional direct costs are anticipated. However, period 7 direct costs are not consistent with this trend showing an adverse variance of 42,000, and the directors may need to investigate the variance further to establish if this is related to some peculiarity in sales mix or as a result of savings from bulk buying, which has reduced costs. Factory overheads were un-favourable in period 7, adverse by 11,000) although cumulative the variance shows a favourable figure of 20,000. Overall the forecast for the year shows an adverse variance of 50,000, i.e. additional costs not included in budget. Again the directors may need to investigate this trend, as the budget may not have included inflationary increases correctly. Administration and selling costs are also adverse by 1,000 with a cumulative favourable variance of 20,000. This predicts an overall favourable variance of 173,000. It would appear that considerable economies are planned and have already commenced. Operating profits have improved for Period 7 by a favourable figure = 46,000 although the cumulative figure is still adverse by 11,000. This shows an overall improving trend but the forecast for the year remains as adverse 27,000 i.e. profits will not be as high as anticipated. This is confirmed by the Profit margin, which has fallen from the budget figure of 8% to an overall margin of 7.3%. The directors would be advised to request more frequent variance reporting (maybe weekly) so that tighter control on costs can be maintained. 29