Business Accounting And Finance by Tony Davies And Ian Crawford – Solution Manual

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BUSINESS ACCOUNTING

AND FINANCE

TONY DAVIES

and

IAN CRAWFORD

 

Chapter 1 The importance of accounting

and fi nance

Questions

Q1.1 (i) How many diff erent types of business entity can you think of?

(ii) In what respect do they diff er fundamentally?

Q1.2 (i) Why are accountants required to produce fi nancial information?

(ii) Who do they produce it for and what do they do with it?

Q1.3 Describe the broad regulatory, professional, and operational framework of accounting.

Q1.4 What are conceptual frameworks of accounting?

Q1.5 (i) What are accounting concepts?

(ii) What purpose do they serve?

Q1.6 What is the UK Statement of Principles (SOP)?

Q1.7 (i) What is accountancy?

(ii) What is an accountant?

(iii) What do accountants do?

Q1.8 What do accountants mean by SSAPs and FRSs, and what are they for?

Q1.9 What are IASs and IFRSs and why are they important?

Q1.10 (i) What is fi nancial management?

(ii) How does fi nancial management relate to accounting and perhaps other disciplines?

Q1.11 How do fi nancial statements ensure accountability for the reporting of timely and accurate

information to shareholders is maintained?

Discussion points

D1.1 The managing director of a large public limited company stated: ‘I’ve built up my business

over the past 15 years from a one man band to a large plc. As we grew we seemed to spend

more and more money on accountants, fi nancial managers, and auditors. During the next

few months we are restructuring to go back to being a private limited company. This will be

much simpler and we can save a fortune on accounting and auditing costs.’ Discuss.

(Hint: You may wish to research Richard Branson and, for example, Virgin Air, on the Internet

to provide some background for this discussion.)

D1.2 The managing director of a growing private limited company stated: ‘All these accounting

concepts and standards seem like a lot of red tape to me, and we’ve got fi nancial accountants

and management accountants as well as auditors. Surely all I need to know at the end of the

day is how much have we made.’ Discuss.

D1.3 Is accounting objective? Discuss with reference to at least six diff erent accounting concepts.

Exercises

Exercises E1.1 to E1.10 require an essay-type approach. You should refer to the relevant sections in

Chapter 1 to check your solutions.

Level I

E1.1 Time allowed – 15 minutes

Discuss the implications of preparation of the income statement if there were no accounting

concepts.

E1.2 Time allowed – 30 minutes

At a recent meeting of the local branch of the Women’s Institute they had a discussion about what sort

of organisation they were. The discussion broadened into a general debate about all types of organisation,

and someone brought up the term ‘business entity’. Although there were many opinions,

there was little sound knowledge about what business entities are. Jane Cross said that her husband

was an accountant and she was sure he wouldn’t mind spending an hour one evening to enlighten

them on the subject. Chris Cross fi shed out his textbooks to refresh his knowledge of the subject and

came up with a schedule of all the diff erent business entities he could think of together with the detail

of their defi ning features and key points of diff erence and similarity.

Prepare the sort of schedule that Chris might have drafted for his talk and identify the

category that the Women’s Institute might fall into.

E1.3 Time allowed – 30 minutes

Mary Andrews was an accountant but is now semi-retired. She has been asked by her local comprehensive

school careers offi cer to give a talk entitled: ‘What is an accountant and what is accounting,

and what are its use and its purpose?’.

Prepare a list of bullet points that covers everything necessary for Mary to give a comprehensive

and easy-to-understand presentation to a group of sixth-formers at the school.

Level II

E1.4 Time allowed – 30 minutes

Accounting standards in general are reasonably clear and unambiguous.

Are there any major areas where accountants may disagree in balance sheet accounting?

E1.5 Time allowed – 30 minutes

Financial statements are produced each year by businesses, using prescribed formats.

Should major plcs be allowed to refl ect their individuality in their own fi nancial statements?

E1.6 Time allowed – 45 minutes

Professionals in the UK, for example, doctors, solicitors, accountants etc., normally work within partnerships.

Many tradesmen, such as plumbers, car mechanics, carpenters, and so on, operate as sole

traders. Software engineers seem to work for corporations and limited companies.

Consider the size of operation, range of products, fi nancing, the marketplace and the

geographical area served, to discuss why companies like Microsoft and Yahoo! should operate

as plcs.

E1.7 Time allowed – 60 minutes

Bill Walsh has just been appointed Finance Director of a medium-sized engineering company, Nutsan

Ltd, which has a high level of exports and is very sensitive to economic changes throughout the UK

and the rest of the world. One of the tasks on Bill’s action list is a review of the accounting and fi nance

function.

What are the senior fi nancial roles that Bill would expect to be in place and what are the

important functions for which they should be responsible?

E1.8 Time allowed – 60 minutes

Wembley Stadium II (the Football Association’s replacement for the original iconic Wembley Stadium)

was planned to open in 2003 but due to numerous problems fi nancing the construction, problems

in the general day-to-day operations, and changes of contractor, it fi nally opened in March 2007.

There were many crises reported in the press during the course of the project and the development

fi nally cost over £1 billion.

You are required to research into the Wembley Stadium II project using the BBC, Financial

Times , and the other serious newspapers, and the Internet, and summarise the fi nancial

aspects of the project that you gather. You should focus on the attitudes expressed by the

general public, Government ministers, and the Football Association management, and consider

examples of bias, non-timeliness, and lack of transparency.

E1.9 Time allowed – 60 minutes

Conceptual frameworks of accounting have been developed over many years and in many countries.

Explain how these culminated in the publication of the UK Statement of Principles (SOP) in

1999, and discuss the implications of each of the eight chapters.

E1.10 Time allowed – 60 minutes

The International Accounting Standards Board (IASB) decreed the adoption of the International

Financial Reporting Standards (IFRSs) by all listed companies within the European Union mandatory

with eff ect from 1 January 2005.

Discuss the practical and political issues surrounding this decision.

 

 

Chapter 2 Classifying and recording

fi nancial transactions

 

Questions

Q2.1 What are the four basic business transactions and what are their corresponding debit and

credit accounting entries under the convention of double-entry bookkeeping?

Q2.2 (i) Name each of the books of account and ledgers in an accounting system.

(ii) What are they used for?

Q2.3 Describe the use and purpose of the fi ve main accounting adjusting entries.

Q2.4 (i) At a specifi c point in time, what does a company’s trial balance show?

(ii) What may the trial balance not show?

Q2.5 How may the fi nancial performance of a company be ascertained from its trial balance?

Q2.6 How may the fi nancial position of a company be ascertained from its trial balance?

Q2.7 How may the cash position of a company be ascertained from its trial balance?

Q2.8 Why is the profi t made during an accounting period not necessarily equal to the cash fl ow

during that period?

Q2.9 In what ways do businesses adjust their accounts for accruals and prepayments?

Q2.10 What is the relevance of the accounting period?

Discussion points

D2.1 ‘Managers who are non-accounting specialists don’t need to learn about bookkeeping, debits

and credits, etc.’ Discuss.

D2.2 Computerised accounts and information systems have speeded up the recording of accounting

data and the presentation of information. What are the other advantages over manual

accounting systems and what are the disadvantages?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E2.1 Time allowed – 30 minutes

Extracts from the ledgers of Hall Ltd have provided the following information for 2009 and 2010.

£

Sales revenue 2009 11,000

Sales revenue 2010 12,000

Purchases 2009 7,100

Purchases 2010 8,300

Expenses 2009 2,500

Expenses 2010 2,800

Inventories 1 January 2009 600

Inventories 31 December 2009 700

Inventories 31 December 2010 800

Obsolete inventories included in 31 December 2010 inventories 200

You are required to prepare a basic income statement for the years ended 31 December 2009

and 2010.

E2.2 Time allowed – 30 minutes

(a) Explain why there are always problems at the year end in the assessment of the costs

associated with electricity, gas and telephone.

(b) Using the information below, prepare the appropriate year-end accounting entries.

Electricity charges account balance at 15 December 2010: £10,000

Gas charges account balance at 20 December 2010: £5,000

Estimated consumption

Electricity 16 December to 31 December 2010: £300

Gas 21 December to 31 December 2010: £150

E2.3 Time allowed – 30 minutes

Arthur Moment set up a table-making business, Forlegco, on 1 July 2010. He had £10,000 available

to invest, which is the amount he estimated was required for setting up costs. In the fi rst month of

trading Forlegco entered into the following transactions:

£

£10,000 from Arthur Moment 10,000

Purchase of hand tools for cash 2,000

Purchase of lathe, power saw and drill on one month’s credit 6,000

Purchase of printing and stationery – invoice received for half the order 100

The total order is £200, and it was all delivered in July and used

Purchase of advertising fl yers for cash 2,000 at 50p each, of which 1,000 will be used in July, and 500

in August and September

Purchases of timber, glue and varnish, from Woodco, payable within the month £1,500 – half of this

inventory will be on hand at 31 July 2010

Sales of tables to Gardenfurnco for settlement one month later (10 tables at £700 each)

You are required to present these transactions in T account format, and then prepare a trial

balance for Forlegco for 31 July 2010.

E2.4 Time allowed – 30 minutes

From the trial balance for Forlegco for 31 July 2010 (Exercise E2.3)

(i) Prepare a simple income statement for the month of July 2010.

(ii) Has Forlegco made a profi t in July?

(iii) If Forlegco has not made a profi t, why not?

E2.5 Time allowed – 30 minutes

From the trial balance for Forlegco for 31 July 2010 (Exercise E2.3) prepare a simple balance

sheet at that date.

E2.6 Time allowed – 30 minutes

From the trial balance for Forlegco for 31 July 2010 (Exercise E2.3) prepare a simple statement

of cash fl ows for the month of July 2010.

E2.7 Time allowed – 30 minutes

You are required to prepare the appropriate correcting entries in a company’s accounts at 31

December 2010 for the following:

(i) A cheque paid for rent amounting to £2,400 has been entered into the car hire account

in error.

(ii) A cheque for £980 was received from a customer in full settlement of a balance of

£1,000, but no accounting entry for the discount has been made.

(iii) A cheque paid for insurance on the company cars amounting to £1,200 has been entered

in the cost of motor cars account in error.

(iv) An invoice from a builder for £3,500 has been entered in the buildings cost account, but

in fact it related to redecoration of the reception area of the offi ce and should be treated

as a building repair.

Level II

E2.8 Time allowed – 60 minutes

David (Dai) Etcoak decided to set up a drinks wholesale business, Etcoakco, on 1 December 2009. He

had £100,000 available to invest, which is the amount he felt was required to set up the business. In

the fi rst month of trading Etcoakco entered into the following transactions:

£

£100,000 from Dai Etcoak 100,000

Purchase for cash the freehold of a shop 50,000

Purchase for cash the shop fi ttings 7,000

Purchase of a labelling machine payable one month later 20,000

Cash expenses on printing and stationery 400

Purchases of inventory, from Gasco, of bottles of pop, payable three months later

(25,000 bottles at £1.25 each) 31,250

Sales of bottles of Etcoak to Boozah for settlement one month later

(10,000 bottles at £2.30 each) 23,000

Sales of bottles of Etcoak to Disco30, receivable in the month

(12,000 bottles at £2.30 each) 27,600

You are required to:

(i) look at these transactions in detail and then present them in T account format, and

(ii) state any assumptions you have made particularly relating to how you have valued

inventories transactions.

Also:

(iii) Do you think £100,000 was enough money or too much to invest in the business?

(iv) What alternative courses of action are open to Dai?

 

Chapter 3 Balance sheet

 

Questions

Q3.1 (i) What are the three main fi nancial statements?

(ii) What is their purpose?

(iii) What does the statement of changes in equity show?

Q3.2 Consider two ways of looking at the profi t of a business: an increase in the book wealth of the

company; and the net result of the company’s trading operations (revenue less expenses).

What do these terms mean, and is the result diff erent using the two approaches?

Q3.3 Explain the format and structure of the balance sheet of a typical limited company.

Q3.4 Explain what assets, liabilities and shareholders’ equity are, and give some examples of the

items included in each of these categories.

Q3.5 Illustrate the diff erence between current liabilities and non-current liabilities by giving some

examples of each.

Q3.6 (i) What accounting convention is generally used in the valuation of non-current assets?

(ii) What additional costs may sometimes be included within non-current assets costs and

to which assets may these be applied?

Q3.7 Why are current assets and non-current assets shown under diff erent balance sheet classifi cations?

Q3.8 Describe what is meant by intangible assets and give some examples of how they may be

valued.

Q3.9 What factors infl uence the accurate valuation of a company’s trade receivables?

Q3.10 Why should a potential investor exercise caution when analysing the balance sheets of potential

companies in which to invest?

Discussion points

D3.1 ‘Surely the purchase of non-current assets is expenditure just like spending on stationery or

photocopy expenses so why should it appear as an entry in the balance sheet?’ Discuss.

D3.2 ‘It has often been said that the value of every item in a balance sheet is a matter of opinion

and the cash and bank balances are the only numbers that can truly be relied upon.’

Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E3.1 Time allowed – 30 minutes

Mr IM Green – Manager Ian admired the sign on the door to his new offi ce, following his appointment

as manager of the human resources department. The previous manager left fairly suddenly to join

another company but had left Ian with some papers about the costs of his department, which showed

a total of £460,000 together with a list of items of expenditure. This seemed rather a high fi gure to

Ian for a department of fi ve people. Ian’s boss muttered something to him about capital expenditure

and revenue expenditure, but this was an area about which Ian had never been very clear. The list left

with Ian by his predecessor was as follows:

£

Legal fees 42,000

Five personal computers 15,000

Specialist HR software 100,000

Three laser printers 10,000

Salaries 158,000

Employee benefi t costs 16,000

Pension costs 14,000

Building repairs 25,000

Equipment repairs 8,000

Health and safety costs 20,000

Staff recruitment fees 10,000

Training costs 20,000

Subsistence and entertaining 10,000

Offi ce furniture 12,000

460,000

Assume that you are the fi nance manager whom Ian has asked for advice and provide him

with a list that separates the items into capital expenditure and revenue expenditure.

E3.2 Time allowed – 30 minutes

The balances in the accounts of Vertico Ltd at 31 July 2010 are as follows:

£000

Accrued expenses 95

Bank overdraft 20

Accounts receivable 275

Plant and equipment 309

Inventories of fi nished products 152

Computer system 104

Petty cash 5

Equity share capital 675

Accounts payable 293

Final payment on computer system due 1 September 2011 52

Loan for a factory building 239

Buildings 560

Raw materials 195

(i) An important number has been omitted. What is that?

(ii) Using the data provided and the missing data prepare a balance sheet for Vertico Ltd as

at 31 July 2010.

E3.3 Time allowed – 45 minutes

You are required to prepare a balance sheet for Trainer plc as at 31 December 2010 using the

trial balance at 31 December 2010 and the additional information shown on the next page.

Debit Credit

£000 £000

Bank balance 73

Ordinary share capital 320

Land and buildings at cost 320

Plant and machinery at cost 200

Cumulative depreciation provision (charge for year 2010 was

£20,000)

80

Inventories 100

Revenue 1,000

Cost of sales 600

Operating expenses 120

Depreciation 20

Bad debts written off 2

Accounts receivable 100

Accruals 5

Accounts payable 130

1,535 1,535

Additional information: the company will be paying £20,000 for corporation tax on the 2010 profi t

during 2011.

E3.4 Time allowed – 45 minutes

The following information relates to Major plc at 31 December 2010 and the comparative numbers

at 31 December 2009.

2009 2010

£000 £000

Accruals 800 1,000

Bank overdraft 16,200

Cash at bank 600

Plant and machinery at cost 17,600 23,900

Debenture loan (interest at 15% per annum) 600 750

Plant and machinery depreciation 9,500 10,750

Proposed dividends 3,000 6,000

Ordinary share capital 5,000 5,000

Preference share capital 1,000 1,000

Prepayments 300 400

Retained earnings 3,000 10,100

Inventories 5,000 15,000

Tax payable 3,200 5,200

Accounts payable 6,000 10,000

Accounts receivable 8,600 26,700

Prepare a balance sheet in the format adopted by most of the leading UK plcs showing the

previous year comparative fi gures.

From the trial balance of Gremlins plc at 31 March 2010 identify the assets and expenses

(debit balances) and income, liabilities and equity (credit balances). Confi rm that the trial

balance is in balance, then prepare a balance sheet for Gremlins Ltd as at 31 March 2010.

£000

Depreciation on offi ce equipment and furnishings (administrative expenses) 156

Bank overdraft 609

Accountancy and audit fees 30

Electricity paid in advance 45

Computer system (net book value) 441

Advertising and promotion 135

Share premium account 240

Interest received 15

Plant and equipment (net book value) 927

Amount for fi nal payment on factory machine due March 2012 252

Accounts receivable 1,110

Goodwill 204

Twelve-year lease on factory 330

Rents received 63

Prepaid expenses 885

Interest paid 120

Offi ce electricity 66

Retained earnings at 1 April 2009 513

Inventories of materials at 31 March 2010 585

Telephone 87

Distribution costs 162

Other offi ce utilities 72

Cost of goods sold 1,659

Administrative salaries 216

Sales department salaries 267

Furniture and fi xtures (net book value) 729

Revenue 3,267

Offi ce rent 165

Finished products at 31 March 2010 84

Debenture loan 750

Accounts payable 1,257

Bank and cash 51

Share capital 1,560

Level II

E3.6 Time allowed – 60 minutes

Prepare a balance sheet as at 31 December 2010 for Gorban Ltd based on the following trial

balance, and the further information shown below.

Equity share capital 200,000

Retained earnings 108,968

Building at cost 130,000

Machinery at cost 105,000

Provision for depreciation as at 31 December 2010 30,165

Provision for doubtful debts at 31 December 2010 1,725

Accounts payable 35,112

Accounts receivable 42,500

Bank balance 67,050

Loan 20,000

Inventories as at 31 December 2010 51,420

395,970 395,970

You are given the following additional information, which is not refl ected in the above trial balance.

(a) The authorised and issued share capital is divided into 200,000 shares at £1 each.

(b) Wages unpaid at 31 December 2010 amounted to £1,173.

(c) Inventories at 31 December 2010 were found to have been undervalued by £48,000.

(d) The provision for doubtful debts is to be increased by £1,870.

(e) Additional machinery was purchased on 31 December 2010 for cash at a cost of £29,368.

(f) The company issued 50,000 £1 ordinary shares at par on 31 December 2010.

(g) A customer owing £10,342 went into liquidation on 9 January 2011 – a bad debt which had not

previously been provided for.

(h) The loan was repaid on 31 December 2010.

E3.7 Time allowed – 60 minutes

You are required to prepare a balance sheet as at 31 December 2010 from the following summary

of Pip Ltd’s fi nancial position at 31 December 2010.

Brands worth £10,000 (directors’ opinion)

Reputation in the local area £10,000 (directors’ opinion)

Inventories at cost £50,000 and resale value £85,000, with obsolete inventories £5,000 within the

£50,000

Bank overdraft facility £20,000 agreed by the bank manager

Cash in the offi ce £1,000

Cash in the bank number one current account £10,000

Overdraft on the bank number two current account £10,000, per the bank statement

Land and buildings at cost £100,000

Plant and equipment at cost £150,000

Plant and equipment cumulative depreciation £50,000

Plant and equipment market value £110,000

Accounts payable £81,000

Invoices outstanding by all customers £50,000, including an invoice of £5,000 owed by a customer

in liquidation (Pip Ltd has been advised by the receiver that 1p in the £1 will be paid to creditors)

Past profi ts reinvested in the business £110,000

Ordinary shares issued £100,000 (authorised ordinary shares £200,000)

 

Chapter 4 Income statement

 

Questions

Q4.1 How would you defi ne the profi t (or loss) earned by a business during an accounting period?

Q4.2 Outline an income statement showing each of the main category headings using the business

functions format.

Q4.3 (i) Which accounting or fi nancial reporting standard contains provisions relating to the

format of the income statement?

(ii) What are the requirements that are relevant to the formats of the income statement of a

limited company?

Q4.4 The income statement and the balance sheet report on diff erent aspects of a company’s fi nancial

status. What are these diff erent aspects and how are they related?

Q4.5 (i) Why are the methods used for the valuation of the various types of assets so important?

(ii) Describe the three main categories of asset that are most relevant to asset valuation.

Q4.6 What is depreciation and what are the problems encountered in dealing with the depreciation

of non-current assets?

Q4.7 Describe three of the most commonly used methods of accounting for depreciation.

Q4.8 Describe four of the most commonly used methods of valuing inventory.

Q4.9 How does the valuation of trade receivables impact on the income statement of a business?

Q4.10 Profi t does not equal cash, but how can the one be reconciled with the other for a specifi c

accounting period?

Discussion points

D4.1 ‘My profi t for the year is the total of my pile of sales invoices less the cash I have paid out during

the year.’ Discuss.

D4.2 ‘The reason why companies make a provision for depreciation of their non-current assets is

to save up enough money to buy new ones when the old assets reach the end of their lives.’

Discuss.

D4.3 Why is judgement so important in considering the most appropriate method to use for valuing

inventories? What are the factors that should be borne in mind and what are the pros and

cons of the alternative methods?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E4.1 Time allowed – 30 minutes

Mr Kumar’s chemist shop derives income from both retail sales and from prescription charges made

to the NHS and to customers. For the last two years to 31 December 2009 and 31 December 2010 his

results were as follows:

2009 2010

£ £

Sales and prescription charges to customers 196,500 210,400

Prescription charges to the NHS 48,200 66,200

Purchases of inventories 170,100 180,600

Opening inventories at the start of the year 21,720 30,490

Closing inventories at the end of the year 30,490 25,300

Wages 25,800 27,300

Mr Kumar’s drawings* 20,500 19,700

Rent and property taxes 9,400 13,200

Insurance 1,380 1,620

Motor vehicle expenses 2,200 2,410

Other overheads 14,900 15,300

*Note that Mr Kumar’s drawings are the amounts of money that he has periodically taken out of the business for

his own use and should be shown as a deduction from the profi ts earned by the business rather than an expense

in the income statement.

Rent for the year 2009 includes £2,400 paid in advance for the half year to 31 March 2010, and for

2010 includes £3,600 paid in advance for the half year to 31 March 2011. Other overheads for 2009

do not include the electricity invoice for £430 for the fi nal quarter (included in 2010 other overheads).

There is a similar electricity invoice for £510 for 2010. Depreciation may be ignored.

(i) Prepare an income statement for the two years to 31 December.

(ii) Why do you think that there is a diff erence in the gross profi t to sales % between the two

years.

(iii) Using Mr Kumar’s business as an example, explain the accruals accounting concept

and examine whether or not it has been complied with.

E4.2 Time allowed – 30 minutes

Discuss the concepts that may apply and practical problems that may be encountered when

accounting for:

(i) the acquisition of desktop personal computers, and

(ii) popular brands of products supplied by retailers

with specifi c comments regarding their depreciation reported in the income statement and

their net book values reported in the balance sheet.

E4.3 Time allowed – 30 minutes

A friend of yours owns a shop selling CDs and posters for the 12- to 14-year-old market.

From the following information advise him on the potential problems that may be encountered

in the valuation of such items for balance sheet purposes:

(a) greatest hits compilation CDs have sold consistently over the months and cost £5,000 with a

retail value of £7,000

(b) sales of specifi c group CDs, which ceased recording in the previous year, have now dropped off to

zero and cost £500 with a total retail value of £700

(c) specifi c band CDs, which are still constantly recording and selling in the shop every week cost

£1,000 with a total retail value of £1,400

(d) specifi c artist posters are currently not selling at all (although CDs are), and cost £50 with a retail

value of £100.

E4.4 Time allowed – 30 minutes

The Partex company began trading in 2008, and all sales are made to customers on credit. The company

is in a sector that suff ers from a high level of bad debts, and a provision for doubtful debts of 4%

of outstanding accounts receivable is made at each year end.

Information relating to 2008, 2009 and 2010 is as follows:

Year to 31 December

2008 2009 2010

Outstanding accounts receivable at 31 December* £88,000 £110,000 £94,000

Bad debts to be written off during year £4,000 £5,000 £4,000

*before bad debts have been written off

You are required to state the amount that will appear:

(i) in the balance sheet for trade receivables, and

(ii) in the income statement for bad debts.

E4.5 Time allowed − 45 minutes

Tartantrips Ltd, a company in Scotland, operates several ferries and has a policy of holding several

in reserve, due to the weather patterns and conditions of various contracts with local authorities. A

ferry costs £5 million and has an estimated useful life of 10 years, at which time its realisable value is

expected to be £1 million.

Calculate and discuss three methods of depreciation that the company may use:

(i) sum of the digits

(ii) straight line

(iii) reducing balance.

E4.6 Time allowed − 60 minutes

From the following fi nancial information that has been provided by Lazydays Ltd, for the

year ended 31 March 2010 (and the corresponding numbers for the year to 31 March 2009),

construct an income statement, using the format adopted by the majority of UK plcs, including

comparative fi gures.

2010 2009

£ £

Administrative expenses 22,000 20,000

Depreciation 5,000 5,000

Closing inventories 17,000 15,000

Distribution costs 33,000 30,000

Dividends paid 32,000 30,000

Dividends received from non-related companies 5,000 5,000

Interest paid 10,000 10,000

Interest received 3,000 3,000

Opening inventories 15,000 10,000

Purchases 99,000 90,000

Redundancy costs 5,000 –

Sales revenue 230,000 200,000

Taxation 25,000 24,000

(a) Depreciation is to be included in administrative expenses

(b) Redundancy costs are to be regarded as an exceptional item to be included in administrative

expenses

Level II

E4.7 Time allowed − 60 minutes

Llareggyb Ltd started business on 1 January 2010 and its year ended 31 December 2010. Llareggyb

entered into the following transactions during the year.

Received funds for share capital of £25,000

Paid suppliers of materials £44,000

Purchased 11,000 units of a product at £8 per unit, which were sold to customers at £40 per unit

Paid heating and lighting costs for cash £16,000

Further heating and lighting costs of £2,400 were incurred within the year, but still unpaid at

31 December 2010

Mr D Thomas loaned the company £80,000 on 1 January 2010 at 8% interest per annum

Loan interest was paid to Mr Thomas for January to June 2010

8,000 product units were sold to customers during 2010

Customers paid £280,000 to Llareggyb for sales of its products

Rent on the premises £60,000 was paid for 18 months from 1 January 2010, and local business

property taxes of £9,000 were also paid for the same period

Salaries and wages were paid for January to November 2010 amounting to £132,000 but the

December payroll cost of £15,000 had not yet been paid as at 31 December 2010

A lorry was purchased for £45,000 on 1 January 2010 and was expected to last for fi ve years after

which it was estimated that it could be sold for £8,000

The company uses the straight line method of depreciation.

Prepare an income statement for Llareggyb Ltd for the year ended 31 December 2010.

E4.8 Time allowed − 60 minutes

From the trial balance of Retepmal Ltd at 31 March 2010 shown below prepare an income

statement for the year to 31 March 2010 and a balance sheet as at 31 March 2010 using the

formats used by most UK companies.

£

Premises (net book value) 95,000

Accounts receivable 75,000

Purchases of inventories 150,000

Retained earnings at 31 March 2009 130,000

Inventories at 31 March 2009 15,000

Furniture and fi xtures 30,000

Sales revenue 266,000

Distribution costs 40,000

Administrative expenses 50,000

Accounts payable 54,000

Motor vehicles (net book value) 40,000

Cash and bank 35,000

Equity share capital 80,000

Additional information:

(a) Inventories at 31 March 2010 were £25,000.

(b) Dividend proposed for 2010 was £7,000.

(c) An accrual for distribution costs of £3,000 was required at 31 March 2010.

(d) A prepayment of administrative expenses of £5,000 was required at 31 March 2010.

(e) Corporation tax estimated to be payable on 2009/2010 profi t was £19,000.

(f) Annual depreciation charges on premises and motor vehicles for the year to 31 March 2010 are

included in administrative expenses and distribution costs, and in the cumulative depreciation

provisions used to calculate the net book values of £95,000 and £40,000 respectively, shown in

the trial balance at 31 March 2010.

The furniture and fi xtures balance of £30,000 relates to purchases of assets during the year to

31 March 2010. The depreciation charge in administrative expenses and the corresponding depreciation

provision are not included in the trial balance at 31 March 2010. They are required to be

calculated on a straight line basis for a full year to 31 March 2010, based on a useful economic life of

eight years and an estimated residual value of £6,000.

 

Chapter 5 Statement of cash fl ows

Questions

Q5.1 (i) How would you defi ne cash generated by a business during an accounting period?

(ii) Which International Accounting Standard (IAS) deals with cash fl ow?

Q5.2 Give an example of a statement of cash fl ows showing each of the main categories.

Q5.3 Give an example of the supporting analyses and notes that are prepared in support of the

main statement of cash fl ows.

Q5.4 Describe the ways in which both the direct method and the indirect method may be used by

a business to derive cash generated from operations during an accounting period.

Q5.5 (i) Which cash analysis is used to link the statement of cash fl ows to the income statement?

(ii) How does it do that?

Q5.6 (i) Which cash analysis is used to link the statement of cash fl ows to the balance sheet?

(ii) What are the links?

Q5.7 Why is cash so important, compared to the other assets used within a business?

Q5.8 (i) What questions does the statement of cash fl ows aim to answer?

(ii) How far does it go towards answering them?

Discussion points

D5.1 Why is the information disclosed in the income statement and the balance sheet not considered

suffi cient for users of fi nancial information? What is so important about cash fl ow that

it has an International Accounting Standard, IAS 7, devoted to it?

D5.2 ‘Forget your income statements and balance sheets, at the end of the day it’s the business’s

healthy bank balance that is the measure of its increase in wealth.’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E5.1 Time allowed – 60 minutes

Candice-Marie James and Flossie Graham obtained a one-year lease on a small shop which cost

them £15,000 for the year 2010, and in addition agreed to pay rent of £4,000 per year payable one

year in advance. Candyfl oss started trading on 1 January 2010 as a fl orist, and Candice and Flossie

bought a second-hand, white delivery van for which they paid £14,500. The business was fi nanced

by Candice and Flossie each providing £9,000 from their savings, and receipt of an interest-free loan

from Candice’s uncle of £3,000. Candice and Flossie thought they were doing OK over their fi rst six

months but they weren’t sure how to measure this. They decided to try and see how they were doing

fi nancially and looked at the transactions for the fi rst six months:

Cash transactions:

£

Cash sales of fl owers 76,000

Rent paid 4,000

Wages paid 5,000

Payments for other operating expenses 7,000

Purchases of inventories of fl owers for resale 59,500

Legal expenses paid for the lease acquisition 1,0

Chapter 5 Statement of cash fl ows

E5.2 Time allowed – 60 minutes

Using the information from Exercise E5.1 prepare a statement of cash fl ows for Candyfl oss

for the fi rst six months of the year 2010, using the indirect method.

E5.3 Time allowed – 60 minutes

Jaff rey Packaging plc have used the following information in the preparation of their fi nancial statements

for the year ended 31 March 2010.

£000

Dividends paid 25

Issue of a debenture loan 200

Reduction in inventories 32

Corporation tax paid 73

Interest paid 28

Operating profi t for the year 450

Cash and cash equivalents 31 March 2010 376

Purchase of factory equipment 302

Dividends payable at 31 March 2010 25

Interest received 5

Depreciation charge for the year 195

Purchase of a new large computer system 204

Sale of a patent (intangible non-current asset) 29

Increase in trade and other receivables 43

Reduction in trade and other payables 62

Cash and cash equivalents 1 April 2009 202

You are required to prepare a cash generated from operations statement for Jaff rey Packaging

Ltd using the indirect method, and a statement of cash fl ows for the year ended 31 March 2010

in compliance with the provisions of IAS 7, and also an analysis of cash and cash equivalents

for the same period.

In addition, at 30 June 2010:

The business owed a further £4,000 for the purchase of fl owers and £1,000 for other operating

expenses.

Customers had purchased fl owers on credit and the sum still owed amounted to £8,000.

One customer was apparently in fi nancial diffi culties and it was likely that the £1,500 owed would

not be paid.

Inventories of fl owers at 30 June 2010 valued at cost were £9,500.

They estimated that the van would last four years, at which time they expected to sell it for £2,500,

and that depreciation would be spread evenly over that period.

(i) Prepare a statement of cash fl ows for Candyfl oss for the fi rst six months of the year

2010 using the direct method.

(ii) Prepare an income statement for Candyfl oss for the fi rst six months of the year 2010,

on an accruals basis.

(iii) Why is the profi t diff erent from the cash fl ow?

(iv) Which statement gives the best indication of the fi rst six months’ performance of

Candyfl oss?

E5.4 Time allowed – 60 minutes

From the income statement for the year ended 31 December 2010 and balance sheets as at

31 December 2009 and 31 December 2010, and the additional information shown below,

prepare a statement of cash fl ows for Medco Ltd for the year to 31 December 2010 .

Income statement 2010

£

Operating profi t 2,500

Interest paid (100)

Profi t before tax 2,400

Income tax paid (500)

Profi t for the year 1,900

Balance sheet as at 31 December 2010 2009

£ £

Non-current assets 28,000 20,000

Current assets

Inventories 6,000 5,000

Trade and other receivables 4,000 3,000

Investments 5,100 3,000

Cash and cash equivalents 2,150 5,000

Total current assets 17,250 16,000

Total assets 45,250 36,000

Current liabilities

Borrowings and fi nance leases (6,000) (2,000)

Trade and other payables (4,000) (6,000)

Current tax liabilities (500) (400)

Dividend (proposed) (600) (450)

Total current liabilities (11,100) (8,850)

Non-current liabilities

Borrowings and fi nance leases (2,000) (1,000)

Total liabilities (13,100) (9,850)

Net assets 32,150 26,150

Equity

Ordinary share capital 14,000 10,000

Share premium account 6,000 5,000

Retained earnings 12,150 11,150

Total equity 32,150 26,150

During the year 2010 the company:

(a) acquired new non-current assets that cost £12,500

(b) issued new share capital for £5,000

(c) sold non-current assets for £2,000 that had originally cost £3,000 and had a net book value of

£2,500

(d) depreciated its non-current assets by £2,000

(e) paid an interim dividend of £300,000 during the year and proposed a fi nal dividend of £600,000.

Level II

E5.5 Time allowed – 90 minutes

Llareggyb Ltd started business on 1 January 2010 and its year ended 31 December 2010. Llareggyb

entered into the following transactions during the year.

Received funds for share capital of £25,000

Paid suppliers of materials £44,000

Purchased 11,000 units of a product at £8 per unit, which were sold to customers at £40 per unit

Paid heating and lighting costs for cash £16,000

Further heating and lighting costs of £2,400 were incurred within the year, but still unpaid at

31 December 2010

Mr D Thomas loaned the company £80,000 on 1 January 2010 at 8% interest per annum

Loan interest was paid to Mr Thomas for January to June 2010

8,000 product units were sold to customers during 2010

Customers paid £280,000 to Llareggyb for sales of its products

Rent on the premises £60,000 was paid for 18 months from 1 January 2010, and local business property

taxes of £9,000 were also paid for the same period

Salaries and wages were paid for January to November 2010 amounting to £132,000 but the

December payroll cost of £15,000 had not yet been paid as at 31 December 2010

A lorry was purchased for £45,000 on 1 January 2010 and was expected to last for fi ve years after

which it was estimated that it could be sold for £8,000

The company uses the straight line method of depreciation.

You are required to:

(i) prepare a balance sheet for Llareggyb Ltd as at 31 December 2010.

(ii) prepare a statement of cash fl ows for Llareggyb Ltd for the year ended 31 December

2010.

(Note: you may use the profi t or loss fi gure calculated in Exercise E4.7 to complete this

exercise.)

E5.6 Time allowed – 90 minutes

The balance sheets for Victoria plc as at 30 June 2009 and 30 June 2010 are shown below:

Victoria plc

Balance sheet as at 30 June

£000 £000

2009 2010

Non-current assets

Cost 6,900 9,000

Depreciation provision 900 1,100

Total non-current assets 6,000 7,900

Current assets

Inventories 2,600 4,000

Trade and other receivables 2,000 2,680

Cash and cash equivalents 200 –

Total current assets 4,800 6,680

Total assets 10,800 14,580

Current liabilities

Borrowings and fi nance leases – 600

Trade and other payables 2,000 1,800

Current tax liabilities 300 320

Dividend payable 360 480

Total current liabilities 2,660 3,200

Non-current liabilities

Borrowings and fi nance leases 1,000 1,000

Total liabilities 3,660 4,200

Net assets 7,140 10,380

Equity

Ordinary share capital 4,000 5,500

Share premium account – 1,240

Retained earnings 3,140 3,640

Total equity 7,140 10,380

The following information is also relevant:

  1. During the years 2009 and 2010 Victoria plc disposed of no non-current assets.
  2. Interim dividends were not paid during the years ended 30 June 2009 and 2010.
  3. Non-current liabilities borrowing is a 10% £1m debenture and loan interest was paid on

10 February in each year.

You are required to:

(i) Calculate:

(a) profi t before tax for the year ended 30 June 2010

(b) operating profi t for the year ended 30 June 2010

(ii) Prepare for Victoria plc for the year to 30 June 2010 a statement of cash generated from

operations using the indirect method, and a statement of cash fl ows for the year ended

30 June 2010 in compliance with IAS 7, and also an analysis of cash and cash equivalents

for the same period.

E5.7 Time allowed – 90 minutes

Sparklers plc have completed the preparation of their income statement for the year ended

31 October 2010 and their balance sheet as at 31 October 2010. During the year Sparklers sold some

non-current assets for £2m that had originally cost £11m. The cumulative depreciation on those assets

at 31 October 2009 was £7.6m.

You have been asked to prepare a statement of cash fl ows for the year ended 31 October

2010 in compliance with IAS 7. The directors are concerned about the large bank overdraft

at 31 October 2010, which they believe is due mainly to the increase in trade receivables as

a result of apparently poor credit control. What is your assessment of the reasons for the

increased short-term borrowings?

Sparklers plc

Income statement for the year ended 31 October 2010

£m £m

2010 2009

Operating profi t 41.28 18.80

Interest paid (0.56) −

Interest received 0.08 0.20

Profi t before tax 40.80 19.00

Income tax expense (10.40) (6.40)

Profi t for the year 30.40 12.60

Dividends:

Preference paid (0.20) (0.20)

Ordinary: interim paid (4.00) (2.00)

fi nal proposed (12.00) (6.00)

Retained profi t for the year 14.20 4.40

Sparklers plc

Balance sheet as at 31 October 2010

2010 2009

£m £m

Non-current assets

Tangible at cost 47.80 35.20

Depreciation provision (21.50) (19.00)

Total non-current assets 26.30 16.20

Current assets

Inventories 30.00 10.00

Trade and other receivables 54.20 17.80

Cash and cash equivalents − 1.20

Total current assets 84.20 29.00

Total assets 110.50 45.20

Current liabilities

Borrowings and fi nance leases 32.40 −

Trade and other payables 22.00 13.60

Dividends payable 12.00 6.00

Income tax payable 10.40 6.40

Total current liabilities 76.80 26.00

Non-current liabilities

Debenture loan 1.50 1.20

Total liabilities 78.30 27.20

Net assets 32.20 18.00

Equity

Ordinary share capital − £1 ordinary shares 10.00 10.00

Preference share capital − £1 preferences shares 10% 2.00 2.00

Retained earnings 20.20 6.00

Total equity 32.20 18.00

E5.8 Time allowed – 90 minutes

Dimarian plc’s income statement for the year ended 31 December 2010, and its balance sheets as at

31 December 2010 and 2009, are shown below. Dimarian plc issued no new ordinary shares during

the year.

During 2010 Dimarian plc spent £100,000 on non-current assets additions. There were no noncurrent

assets disposals during 2010.

Dimarian plc

Income statement for the year ended 31 December 2010

Figures in £000

Revenue 850

Cost of sales (500)

Gross profi t 350

Distribution costs and administrative expenses (120)

230

Other operating income 20

Operating profi t 250

Interest paid (30)

220

Interest received 10

Profi t before tax 230

Income tax expense (50)

Profi t for the year 180

Retained profi t 1 January 2010 230

410

Proposed dividends (80)

Retained earnings 31 December 2010 330

Dimarian plc

Balance sheet as at 31 December 2010

Figures in £000 2010 2009

Non-current assets

Tangible 750 800

Intangible 40 50

Total non-current assets 790 850

Current assets

Inventories 50 60

Trade and other receivables 190 200

Cash and cash equivalents 20 10

Total current assets 260 270

Total assets 1,050 1,120

Current liabilities

Borrowings and fi nance leases 20 10

Trade and other payables 70 80

Dividends payable 80 70

Income tax payable 50 30

Total current liabilities 220 190

Non-current liabilities

Debenture loan 100 300

Total liabilities 320 490

Net assets 730 630

Equity

Share capital 260 260

Share premium account 50 50

Revaluation reserve 90 90

Retained earnings 330 230

Total equity 730 630

You are required to prepare:

(i) An indirect statement of cash fl ows for the year to 31 December 2010.

(ii) A statement of cash fl ows for the year ended 31 December 2010, in the format required

by IAS 7.

(iii) An analysis of cash and cash equivalents for the years ended 31 December 2009 and

31 December 2010.

 

 

Chapter 6 Corporate governance

 

Questions

Q6.1 (i) How was the UK Corporate Governance Code developed?

(ii) Why was it considered necessary?

Q6.2 Refer to the Johnson Matthey section on corporate governance in their annual report and

accounts 2010, shown on pages 192–206, and illustrate their areas of compliance (or not)

under the UK Corporate Governance Code (as distinct from the previous Combined Code of

Practice).

Q6.3 (i) Which areas of the business do auditors’ opinions cover?

(ii) What happens if there is any fundamental uncertainty as to compliance?

Q6.4 Explain the implications of the ‘expectation gap’ with regard to external auditors.

Q6.5 Explain the obligations of directors of limited companies in terms of their duty of care, their

fi duciary duty, and the Corporate Manslaughter and Corporate Homicide Act (2007).

Q6.6 If the severity of the penalty is determined by the seriousness of the off ence, describe the half

dozen or so most serious off ences under the Company Directors (Disqualifi cation) Act 1986

(as amended by the Enterprise Act 2002), which relate to directors of limited companies.

Q6.7 Outline the general responsibilities of a director of a limited company with regard to the

company, its shareholders and other stakeholders.

Q6.8 What are the key actions that a director of a limited company may take to ensure compliance

with his or her obligations and responsibilities?

Discussion points

D6.1 Discuss, and illustrate with some examples, how far you think the UK Corporate Governance

Code goes to preventing the kind of corporate excesses we have seen in the recent past.

D6.2 ‘I pay my auditors a fortune in audit fees. I look upon this almost as another insurance premium

to make sure that I’m protected against every kind of fi nancial risk.’ Discuss.

D6.3 ‘Everyone who embarks on a career in industry or commerce aspires to become a director

of their organisation, because then all their troubles are over! Directors just make a few

decisions, swan around in their company cars, and pick up a fat cheque at the end of each

month for doing virtually nothing.’ Discuss.

D6.4 In an age of increasingly sophisticated computer systems is the traditional role of the auditor

coming to an end?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E6.1 Time allowed – 30 minutes

Discuss why users of fi nancial statements should have information on awards to directors of

share options, allowing them to subscribe to shares at fi xed prices in the future.

E6.2 Time allowed – 30 minutes

Outline the basic reasons why there should be openness regarding directors’ benefi ts and ‘perks’.

E6.3 Time allowed – 30 minutes

Can you think of any reasons why directors of UK plcs found that their contracts were no

longer to be open-ended under the new regime of corporate governance?

E6.4 Time allowed – 60 minutes

William Mason is the managing director of Classical Gas plc, a recently formed manufacturing

company in the chemical industry, and he has asked you as fi nance director to prepare

a report that covers the topics, together with a brief explanation, to be included in a section

on corporate governance in their forthcoming annual report and accounts.

Level II

E6.5 Time allowed – 60 minutes

After the birth of her twins Vimla Shah decided to take a couple of years away from her career as

a company lawyer. During one of her coff ee mornings with Joan Turnbull, Joan confi ded in her

that although she was delighted at her husband Ronnie’s promotion to commercial director of his

company, which was a large UK plc in the food industry, she had heard many horror stories about

problems that company directors had encountered, seemingly through no fault of their own. She was

worried about the implications of these obligations and responsibilities (whatever they were) that

Ronnie had taken on. Vimla said she would write some notes about what being a director of a plc

meant, and provide some guidelines as to the type of things that Ronnie should be aware of, and to include

some ways in which Ronnie might protect himself, that may all off er some reassurance to Joan.

Prepare a draft of what you think Vimla’s notes for Joan may have included.

E6.6 Time allowed – 60 minutes

Li Nan has recently been appointed managing director of Pingers plc, which is a company that supplies

table tennis equipment to clubs and individuals throughout the UK and Europe. Li Nan is surprised

at the high fi gure that appeared in last year’s accounts under audit fees.

Li Nan is not completely familiar with UK business practices and has requested you to prepare

a detailed report on what the audit fees cover, and to include the general responsibilities

of directors in respect of the external audit.

E6.7 Time allowed – 60 minutes

Use the following information, extracted from Tomkins plc report and accounts for 2000, as

a basis for discussing the users of fi nancial information’s need for information on directors’

remuneration.

Basic salary Benefi ts in kind Bonuses

G Hutchings, executive director £975,000 £45,000 £443,000

G Gates (USA), non-executive director nil, but has a 250,000 US$ consultancy agreement

R Holland, non-executive director £23,000 Nil Nil

E6.8 Time allowed – 60 minutes

Explain what is meant by insolvency and outline the responsibilities of receivers appointed

to insolvent companies.

 

Chapter 7 Financial statements analysis

 

Questions

Q7.1 (i) Who is likely to carry out a business performance review?

(ii) Describe what may be required from such reviews giving some examples from diff erent

industries and diff ering perspectives.

Q7.2 (i) Outline how the business performance review process may be used to evaluate the position

of a dot.com company like Amazon UK.

(ii) What are the limitations to the approach that you have outlined?

Q7.3 How is ratio analysis, in terms of profi tability ratios, effi ciency ratios, liquidity ratios, investment

ratios and fi nancial structure ratios used to support the business review process?

Q7.4 Why should we be so careful when we try to compare the income statement of a limited company

with a similar business in the same industry?

Q7.5 (i) Why does profi t continue to be the preferred basis for evaluation of the fi nancial performance

of a business?

(ii) In what ways can cash fl ow provide a better basis for performance evaluation, and how

may cash fl ow be approximated?

Discussion points

D7.1 In what ways may the performance review process be used to anticipate and react to change?

D7.2 ‘Lies, damned lies, and statistics.’ In which of these categories do you think ratio analysis sits,

if at all?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E7.1 Time allowed – 30 minutes

The information below relates to Priory Products plc’s actual results for 2009 and 2010 and their

budget for the year 2011.

2009 2010 2011

£000 £000 £000

Cash and cash equivalents 100 0 0

Overdraft 0 50 200

Loans 200 200 600

Ordinary share capital 100 200 400

Retained earnings 200 300 400

You are required to calculate the following fi nancial ratios for Priory Products for 2009,

2010, and 2011:

(i) debt / equity ratio (net debt to equity)

(ii) gearing (long-term loans to equity and long-term loans) .

From the fi nancial statements of Freshco plc, a Lancashire-based grocery and general

supplies chain supplying hotels and caterers, for the year ended 30 June 2010, prepare

a report on performance using appropriate profi tability ratios for comparison with the

previous year.

Freshco plc

Balance sheet as at 30 June 2010

2010

£m

2009

£m

Non-current assets 146 149

Current assets

Inventories 124 100

Trade receivables 70 80

Cash and cash equivalents 14 11

Total current assets 208 191

Total assets 354 340

Current liabilities

Trade payables 76 74

Dividends payable 20 13

Income tax payable 25 20

Total current liabilities 121 107

Non-current liabilities

Debenture loan 20 67

Total liabilities 141 174

Net assets 213 166

Equity

Share capital 111 100

General reserve 14 9

Retained earnings 88 57

Total equity 213 166

Freshco plc

Income statement for the year ended 30 June 2010

2010

£m

2009

£m

Revenue 894 747

Cost of sales (690) (581)

Gross profi t 204 166

Distribution costs and administrative expenses (121) (84)

Operating profi t 83 82

Net interest (2) (8)

Profi t before tax 81 74

Income tax expense (25) (20)

Profi t for the year 56 54

Retained profi t brought forward 57 16

113 70

Dividends for the year (20) (13)

93 57

Transfer to general reserve (5) –

Retained profi t carried forward 88 57

Additional information:

(i) Authorised and issued share capital 30 June 2010, £222m £0.50 ordinary shares (£200m,

2009).

(ii) Total assets less current liabilities 30 June 2008, £219m. Trade receivables 30 June 2008,

£60m.

(iii) Market value of ordinary shares in Freshco plc 30 June 2010, £3.93 (£2.85, 2009).

(iv) Non-current assets depreciation provision 30 June 2010, £57m (£44m, 2009).

(v) Depreciation charge for the year to 30 June 2010, £13m (£10m, 2009).

Freshco plc

Cash generated from operations for the year ended 30 June 2010

2010

£m

2009

£m

Profi t before tax 81 74

Depreciation charge 13 10

Adjust fi nance costs 2 8

Increase in inventories (24) (4)

Decrease/(increase) in trade receivables 10 (20)

Increase in trade payables 2 9

Cash generated from operations 84 77

Freshco plc

Statement of cash fl ows for the year ended 30 June 2010

2010

£m

2009

£m

Cash fl ows from operating activities

Cash generated from operations 84 77

Interest paid (2) (8)

Income tax paid (20) (15)

Net cash generated from operating activities 62 54

Freshco plc

Statement of cash fl ows for the year ended 30 June 2010 (continued)

2010

£m

2009

£m

Cash fl ows from investing activities

Purchases of tangible assets (10) (40)

Net cash outfl ow from investing activities (10) (40)

Cash fl ows from fi nancing activities

Proceeds from issue of ordinary shares 11 0

Proceeds from borrowings 0 7

Repayments of borrowings (47) 0

Dividends paid to equity shareholders (13) (11)

Net cash outfl ow from fi nancing activities (49) (4)

Increase in cash and cash equivalents in the year 3 10

Using the fi nancial statements of Freshco plc from Exercise E7.2, for the year ended 30 June

2010, prepare a report on performance using appropriate liquidity ratios for comparison

with the previous year .

E7.4 Time allowed – 60 minutes

Using the fi nancial statements of Freshco plc from Exercise E7.2, for the year ended 30 June

2010, prepare a report on performance using appropriate investment ratios for comparison

with the previous year .

E7.5 Time allowed – 60 minutes

Using the fi nancial statements of Freshco plc from Exercise E7.2, for the year ended 30 June

2010, prepare a report on performance using appropriate fi nancial ratios for comparison

with the previous year .

E7.6 Time allowed – 60 minutes

Using the fi nancial statements of Freshco plc from Exercise E7.2, for the year ended 30 June

2010, prepare a report on performance using appropriate effi ciency ratios for comparison

with the previous year .

E7.3 Time allowed – 60 minutes

Level II

E7.7 Time allowed – 60 minutes

The summarised income statement for the years ended 31 March 2009 and 2010 and balance sheets

as at 31 March 2009 and 31 March 2010 for Boxer plc are shown below:

Boxer plc

Income statement for the year ended 31 March

Figures in £000 2009 2010

Revenue 5,200 5,600

Cost of sales (3,200) (3,400)

Gross profi t 2,000 2,200

Expenses (1,480) (1,560)

Profi t before tax 520 640

Boxer plc

Balance sheet as at 31 March

2009

£000

2010

£000

Non-current assets 4,520 5,840

Current assets

Inventories 1,080 1,360

Trade receivables 680 960

Cash and cash equivalents 240 –

Total current assets 2,000 2,320

Total assets 6,520 8,160

Current liabilities

Borrowings and fi nance leases – 160

Trade payables 360 520

Income tax payable 240 120

Dividends payable 280 384

Total current liabilities 880 1,184

Non-current liabilities

Debenture loan 1,200 1,200

Total liabilities 2,080 2,384

Net assets 4,440 5,776

Equity

Ordinary share capital 4,000 5,200

Retained earnings 440 576

Total equity 4,440 5,776

Required:

(i) Calculate the following ratios for the years 2009 and 2010:

(a) gross profi t percentage of sales

(b) profi t before tax percentage of sales

(c) return on capital employed

(d) collection days

(e) payables days

(f) inventory turnover

(g) current ratio

(h) quick ratio.

(ii) Comment on Boxer plc’s fi nancial performance over the two years and explain the importance

of eff ective management of working capital (net current assets).

The chief executive of Laurel plc, Al Chub, wants to know the strength of the fi nancial position

of Laurel’s main competitor, Hardy plc. Using Hardy’s fi nancial statements for the past

three years he has asked you to write a report that evaluates the fi nancial performance of

Hardy plc and to include:

(i) a ratio analysis that looks at profi tability, effi ciency and liquidity

(ii) an identifi cation of the top fi ve areas which should be investigated further

(iii) details of information that has not been provided, but if it were available would

improve your analysis of Hardy’s performance.

Hardy plc

Balance sheet as at 31 March 2010

2008

£m

2009

£m

2010

£m

Non-current assets 106 123 132

Current assets

Inventories 118 152 147

Trade receivables 53 70 80

Cash and cash equivalents 26 29 26

Total current assets 197 251 253

Total assets 303 374 385

Current liabilities

Trade payables 26 38 38

Other payables 40 52 55

Total current liabilities 66 90 93

Non-current liabilities

Debenture loan 38 69 69

Total non-current liabilities 38 69 69

Total liabilities 104 159 162

Net assets 199 215 223

Equity

Share capital 50 50 50

Retained earnings 149 165 173

Total equity 199 215 223

Hardy plc

Income statement for the year ended 31 March 2010

2008

£m

2009

£m

2010

£m

Revenue 420 491 456

Cost of sales (277) (323) (295)

Gross profi t 143 168 161

Distribution costs and administrative expenses (93) (107) (109)

Operating profi t 50 61 52

Net interest (3) (7) (9)

Profi t before tax 47 54 43

Income tax expense (22) (26) (23)

Profi t for the year 25 28 20

Dividends (12) (12) (12)

Retained profi t for the year 13 16 8

E7.9 Time allowed – 120 minutes

Locate the website for HSBC Bank plc on the Internet. Use their most recent annual report

and accounts to prepare a report that evaluates their fi nancial performance, fi nancial position

and future prospects. Your report should include calculations of the appropriate ratios

for comparison with the previous year .

E7.10 Time allowed – 120 minutes

Locate the websites for Tesco plc and Morrisons plc on the Internet. Use their most recent

annual report and accounts to prepare a report that evaluates and compares their fi nancial

performance and fi nancial position. Your report should include calculations of the

appropriate ratios for comparing the two groups, and an explanation of their diff erences

and similarities .

 

Chapter 8 Annual report and accounts

Questions

Q8.1 (i) Why, and for whom, do the annual reports and accounts of limited companies have to

be prepared?

(ii) Where do they have to be fi led?

(iii) Who are the main users of the information contained in the annual report and accounts?

(iv) How do they use the information?

Q8.2 (i) Why do you think that the directors, chairman, chief executive and fi nance director of a plc

each need to provide a statement or report for inclusion in the annual report and accounts?

(ii) What purpose do these reports serve and in what ways do they diff er?

Q8.3 (i) Describe the key elements of Johnson Matthey’s fi nancial review that are included in

their report and accounts for 2010, and what these indicate about the performance of

the business.

(ii) Why do you think that about a third of this report is devoted to fi nancial risk management?

(iii) What does risk management mean?

(iv) What are the fi nancial risks faced by Johnson Matthey?

Q8.4 Describe the technique of horizontal analysis and how it may be used to evaluate, explain

and compare company performance.

Q8.5 Describe the technique of vertical analysis and how it may be used to evaluate, explain and

compare company performance.

Q8.6 (i) What were the inadequacies in fi nancial statement reporting that IFRS 8, Operating

Segments, sought to address and how did it do this?

(ii) What are the practical problems that companies face associated with their compliance

with IFRS 8?

Q8.7 (i) Why do you think that sustainability reporting has become increasingly important in

terms of corporate awareness, and with regard to the awareness of the non-business

community?

(ii) Examine the annual reports and accounts of a number of large UK plcs to critically evaluate

and compare their sustainability reporting with that provided by Johnson Matthey

in its 2010 report and accounts.

Q8.8 (i) How does infl ation distort accounting information that has been prepared under the

historical cost convention?

(ii) In what ways has the accountancy profession considered some alternative approaches

to try and deal with the problem of infl ation?

Q8.9 (i) Explain what is meant by a value added statement.

(ii) In what ways may a value added statement be used to measure fi nancial performance?

(iii) What are the disadvantages in using value added statements?

(iv) Why do you think the levels of popularity they enjoyed in the 1980s have not been

maintained?

Q8.10 What information included in the annual report and accounts of UK public listed companies

(plcs) may infl uence prospective investors and in what ways? How impartial do you think

this information is?

Discussion points

D8.1 ‘The annual reports and accounts prepared by the majority of UK plcs serve to ensure that

shareholders, and other stakeholders, are kept very well informed about the aff airs of their

businesses.’ Discuss.

D8.2 ‘In the global competitive world in which we live, company directors should be able to exercise

their full discretion as to the amount of information they disclose in their annual reports

and accounts. If they are not allowed this discretion in disclosure, their companies may be

driven out of business by their competitors, particularly foreign competitors who may not

have the restriction of such extensive reporting requirements.’ Discuss.

D8.3 ‘The main reason that companies increasingly include sustainability reports in their annual

reports and accounts is to change the views of users and regulators about the activities in

which their businesses are engaged, in order to pre-empt and avoid any negative or harmful

reactions.’ Discuss this statement by drawing on examples of the type of businesses to which

this might apply.

(Hint: You may wish to research British Gas, as well as Johnson Matthey Plc, to provide

material for this discussion.)

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E8.1 Time allowed – 60 minutes

Refer to note 1 in Johnson Matthey Plc’s notes on the accounts in their annual report and accounts

2010 and identify the geographical analysis by origin for 2010 and 2009 for:

(a) total revenue

(b) non-current assets.

(i) Present each of the data from (a) and (b) in both pie chart and bar chart format .

(ii) What do the charts you have prepared tell you about Johnson Matthey’s revenue and

non-current assets for 2010 and 2009?

E8.2 Time allowed – 60 minutes

(i) Use the fi ve-year record of Johnson Matthey (see page 339 ) to prepare a horizontal

analysis of the income statement for the fi ve years 2006 to 2010 , using 2006 as the

base year .

(ii) What does this analysis tell us about Johnson Matthey’s fi nancial performance over

that period?

E8.3 Time allowed – 60 minutes

(i) Use the fi ve-year record of Johnson Matthey (see page 339 ) to prepare a horizontal

analysis of the balance sheet for the fi ve years 2006 to 2010 , using 2006 as the base

year .

(ii) What does this analysis tell us about Johnson Matthey’s fi nancial position over that

period?

Level II

E8.4 Time allowed – 60 minutes

(i) Use the fi ve-year record of Johnson Matthey (see page 339 ) to prepare a vertical analysis

of the income statement for the fi ve years 2006 to 2010 .

(ii) What does this analysis tell us about Johnson Matthey’s fi nancial performance over that

period?

E8.5 Time allowed – 60 minutes

Note 1 in the Johnson Matthey Plc notes on the accounts in their annual report and accounts 2010

provides a segmental analysis for the years 2010 and 2009.

Prepare a horizontal analysis from this information , with 2009 as the base year , and use it to

explain the appropriate elements of fi nancial performance and the changes in the fi nancial

position of the business .

E8.6 Time allowed – 60 minutes

Refer to the fi nancial statements included in Johnson Matthey’s report and accounts 2010

to calculate the appropriate ratios for comparison with the previous year , and include them

in a report on the profi tability of the group (see Chapter 7 ) .

E8.7 Time allowed – 60 minutes

Refer to the fi nancial statements included in Johnson Matthey’s report and accounts 2010

to calculate the appropriate ratios for comparison with the previous year , and to give your

assessment of the company’s sources and uses of cash , and include them in a report on the

group’s cash position (see Chapter 7 ) .

E8.8 Time allowed – 60 minutes

Refer to the fi nancial statements included in Johnson Matthey’s report and accounts 2010 to

calculate the appropriate ratios for comparison with the previous year , and include them in a

report on the working capital of the group (see Chapter 7 ) .

E8.9 Time allowed – 60 minutes

Refer to the fi nancial statements included in Johnson Matthey’s report and accounts 2010 to

calculate the appropriate ratios for comparison with the previous year , and include them in

a report on the investment performance of the group (see Chapter 7 ) .

E8.10 Time allowed – 60 minutes

Refer to the fi nancial statements included in Johnson Matthey’s report and accounts 2010

to calculate the appropriate ratios for comparison with the previous year , and include them

in a report on the fi nancial structure of the group (see Chapter 7 ) .

E8.11 Time allowed – 90 minutes

The notes and fi ve-year income statement extracts from the fi nancial statements of an alcoholic

drinks group are shown below.

You are required to use these to carry out an appropriate analysis and provide a report on

the likely explanations of diff erences in performance over the fi ve years .

Notes:

■ The group sells alcohol-based products to consumers and operates in nearly every major country

throughout the world.

■ Local and global competition is intense in many markets.

■ Brands have been sold during the fi ve years.

■ New products are invariably variants on the group’s basic products of beers, wines and spirits.

■ The group share price had been relatively static due to the maturity of the market and the pattern

of profi ts.

■ Other investment income shown in the fi ve-year analysis related to an investment in a French luxury

goods group.

■ Soon after year six the group merged with another international food and drinks business, which

also had an extensive portfolio of own and purchased brands.

■ After the merger several brands were sold to competitors.

■ After the merger many of the directors left the group’s management team.

■ Exchange rates over the fi ve-year period in several of the group’s markets were quite volatile.

■ The group had £1.4 billion of brands in its balance sheet.

Five-year income statement

Year 5 Year 4 Year 3 Year 2 Year 1

£m £m £m £m £m

Sales revenue 4,730 4,681 4,690 4,663 4,363

Gross profi t 961 943 956 938 1,023

Other investment income 113 47 89 (48) (24)

Operating profi t 1,074 990 1,045 890 999

Finance cost (99) (114) (130) (188) (204)

Profi t before tax 975 876 915 702 795

Income tax expense (259) (251) (243) (247) (242)

Profi t after tax 716 625 672 455 553

Minority interests (31) (30) (31) (22) (29)

Profi t for the year 685 595 641 433 524

Dividends (295) (302) (279) (258) (237)

Retained earnings 390 293 362 175 287

Earnings per share 35.1p 29.4p 31.8p 22.9p 28.1p

Interest cover 10.8 8.7 8.0 4.7 4.9

Dividend cover 2.2 2.0 2.3 1.8 2.3

E8.12 Time allowed – 90 minutes

The BOC Group is a company in the chemical industry , and is in the same industrial sector

as Johnson Matthey Plc . Locate the website for BOC Group plc on the Internet . Review their

most recent annual report and accounts and prepare a report that compares it with Johnson

Matthey Plc’s report and accounts for the same year . Your report should include comments

that relate to specifi c points that have been covered in Chapter 8 , and also the diff erences

and the similarities between the two companies .

Chapter 9 The nature of costs

 

Questions

Q9.1 (i) What are the main roles of the management accountant?

(ii) How does management accounting support the eff ective management of a business?

Q9.2 (i) What are the diff erences between fi xed costs, variable costs and semi-variable costs?

(ii) Give some examples of each.

Q9.3 (i) Why do production overheads need to be allocated and apportioned, and to what?

(ii) Describe the processes of allocation and apportionment.

Q9.4 (i) Which costing system complies with the provisions outlined in IAS 2?

(ii) Describe the process used in this technique.

Q9.5 What is marginal costing and how does it diff er from absorption costing?

Q9.6 What are the main benefi ts to be gained from using a system of marginal costing?

Discussion points

D9.1 ‘Surely an accountant is an accountant! Why does the function of management accounting

need to be separated from fi nancial accounting and why is it seen as such an integral part of

the management of the business?’ Discuss.

D9.2 ‘Do the benefi ts from using marginal costing outweigh the benefi ts from using absorption

costing suffi ciently to replace absorption costing in IAS 2 as the basis for inventory valuation

and the preparation of fi nancial statements?’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E9.1 Time allowed – 45 minutes

Bluebell Woods Ltd produces a product for which the following standard cost details have been provided

based on production and sales volumes of 4,300 units in a four-week period:

Direct material cost £0.85 per kg

Direct material usage 2 kg per unit

Direct labour rate £4.20 per hour

Direct labour time per unit 42 minutes

Selling price £5.84 per unit

Variable production overheads £0.12 per unit

Fixed production overheads £3,526 per four-week period

Prepare an income statement for the four-week period using:

(i) absorption costing

(ii) marginal costing.

E9.2 Time allowed – 45 minutes

A manufacturing company, Duane Pipes Ltd, uses predetermined rates for absorbing manufacturing

overheads based on the budgeted level of activity. A total rate of £35 per direct labour hour has been

calculated for the Assembly Department for March 2011, for which the following overhead expenditure

at various diff erent levels of activity have been estimated:

Total manufacturing overheads

£ Number of direct labour hours

465,500 12,000

483,875 13,500

502,250 15,000

You are required to calculate the following:

(i) the variable overhead absorption rate per direct labour hour

(ii) the estimated total fi xed overheads

(iii) the budgeted level of activity for March 2011 in direct labour hours

(iv) the amount of under- or over-recovery of overheads, and state which, if the actual

direct labour hours were 13,850 and actual overheads were £509,250

and

(v) outline the reasons for and against using departmental absorption rates as opposed to

a single blanket factory-wide rate.

Level II

E9.3 Time allowed – 75 minutes

Square Gift Ltd is located in Wales, where the national sales manager is also based, and has a sales

force of 15 salesmen covering the whole of the UK. The sales force, including the national sales manager

all have the same make and model of company car. A new car costs £16,000, and all cars are

traded in for a guaranteed £6,000 when they are two years old.

The salesman with the lowest annual mileage of 18,000 miles operates in the South East of England.

The salesman with the highest annual mileage of 40,000 miles operates throughout Scotland.

The annual average mileage of the complete sales team works out at 30,000 miles per car.

The average salesman’s annual vehicle running cost is:

£

Petrol and oil 3,000

Road tax 155

Insurance 450

Repairs 700

Miscellaneous 300

Total 4,605

Annual vehicle repair costs include £250 for regular maintenance.

Tyre life is around 30,000 miles and replacement sets cost £350.

No additional repair costs are incurred during the fi rst year of vehicle life because a special warranty

agreement exists with the supplying garage to cover these, but on average £200 is paid for repairs

in the second year – repair costs are averaged over the two years with regular maintenance and

repairs being variable with mileage rather than time.

Miscellaneous vehicle costs include subscriptions to motoring organisations, vehicle cleaning

costs, parking, and garaging allowances.

Analyse the total vehicle costs into fi xed costs and variable costs separately to give total

annual costs for:

(i) the lowest mileage per annum salesman

(ii) the highest mileage per annum salesman.

You may ignore the cost of capital and any possible impacts of tax and infl ation.

(Hints:

– Assume that insurance costs are the same for each area.

– Assume that miscellaneous operating costs are fi xed.

– Repairs are based on amount of mileage.)

E9.4 Time allowed – 75 minutes

Rocky Ltd manufactures a single product, the budget for which was as follows for each of the months

July and August 2010:

Total Per unit

£ £

Revenue (6,000 units) 60,000 10.00

Production cost of sales:

Variable overhead 45,000 7.50

Fixed overhead 3,000 0.50

48,000 8.00

Revenue less production cost 12,000 2.00

Selling and distribution costs (fi xed) 4,200 0.70

Administrative expenses (fi xed) 3,000 0.50

Profi t 4,800 0.80

Actual units produced, sold, and levels of inventories in July and August were:

July August

Opening inventories – 900

Production 5,300 4,400

Sales 4,400 5,000

Closing inventories 900 300

Prepare income statements for each of the months July and August, assuming that fi xed

production overhead is absorbed into the cost of the product at the normal level shown in

the monthly budget.

(Hint: This is the absorption costing approach.)

E9.5 Time allowed – 75 minutes

Using the data for Rocky Ltd from Exercise E9.4, prepare income statements for each of

the months July and August, assuming that fi xed production overhead is not absorbed

into the cost of the product, but is treated as a cost of the period and charged against

sales.

(Hint: This is the marginal costing approach.)

E9.6 Time allowed – 75 minutes

Using your answers to Exercises E9.4 and E9.5, explain why the profi t for July and August is

diff erent using the two costing methods, and support your explanation with an appropriate

reconciliation of the results.

 

Chapter 10 Managing costs

Questions

Q10.1 How may cost/volume/profi t (CVP) analysis be used to determine the break-even point of a

business?

Q10.2 Are the assumptions on which CVP analysis is based so unrealistic that the technique should

be abandoned?

Q10.3 (i) What are the principles on which activity based costing (ABC) is based?

(ii) How does ABC diff er from traditional costing methods?

Q10.4 (i) Is throughput accounting (TA) an alternative to traditional costing methods?

(ii) What may be some of the real benefi ts from the use of TA?

Q10.5 Describe the process of life cycle costing, together with some examples that illustrate its aims

and benefi ts.

Q10.6 (i) Describe the various approaches to target costing.

(ii) Critically evaluate the diff erences between target costing approaches and traditional

cost-plus pricing.

Q10.7 The kaizen philosophy includes a wide range of practices and techniques concerned with

achievement of continuous improvement. Describe the role of three of these and how you

think they may support the implementation of kaizen in a business within a service industry.

Q10.8 How may benchmarking be used to add value to a business?

Q10.9 (i) Describe what is meant by cost of quality, giving examples within each of the categories

of cost of quality you have outlined.

(ii) Explain how quality costing may be used to achieve business performance improvement.

Q10.10 (i) What does fi nancial performance not tell us about the health of a business?

(ii) Give examples, from each of the key areas of business activity, of non-fi nancial measures

that may fi ll these gaps.

Q10.11 (i) Why has the balanced scorecard become such an essential part of so many business

management toolkits in recent years?

(ii) How can the balanced scorecard be used to achieve improved business performance?

Discussion points

D10.1 Is activity based costing (ABC) a serious contender to replace the traditional costing methods?

What are some of the drawbacks in implementing this?

D10.2 ‘Many companies benchmark every element of every process, at great cost, but seem to lose

sight of what they are trying to achieve.’ Discuss.

D10.3 Kaizen is probably the Japanese business tool that has had the most signifi cant impact on

performance improvement in the West.’ Why should that be so?

D10.4 The balanced scorecard is a recently developed technique, but it also appears to be the grouping

together of a number of well-established principles and techniques. In what ways does it

represent a new technique?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E10.1 Time allowed – 15 minutes

Break-even sales revenue £240,000

Marginal cost of sales £240,000

Sales revenue for January £320,000

What is the profi t?

E10.2 Time allowed – 15 minutes

Sales revenue for January £120,000, on which profi t is £10,000

Fixed cost for January £30,000

What is the sales revenue at the break-even point?

E10.3 Time allowed – 15 minutes

Selling price £15

Marginal cost £9

Fixed cost for January £30,000

Sales revenue for January £120,000

What is the sales revenue at the break-even point and what is the profi t for January?

E10.4 Time allowed – 30 minutes

Seivad Ltd plans to assemble and sell 20,000 novelty phones in 2010 at £30 each. Seivad’s costs are

as follows:

Variable costs:

materials £10 per phone

labour £7 per phone

overheads £8 per phone

Fixed costs: £70,000 for the year

You are required to calculate:

(i) Seivad Ltd’s planned contribution for 2010.

(ii) Seivad Ltd’s planned profi t for 2010.

(iii) The break-even sales revenue value.

(iv) The break-even number of phones sold.

(v) The margin of safety for 2010 in sales revenue value.

(vi) The margin of safety for 2010 in number of phones sold.

and

(vii) If fi xed costs were increased by 20% what price should be charged to customers for

each phone to enable Seivad Ltd to increase the profi t calculated in (ii) above by 10%,

assuming no change in the level of demand?

E10.5 Time allowed – 60 minutes

Atlas plc, a large UK manufacturer and supplier of business equipment, had total sales revenue for

2010 of £50m. Its profi tability has suff ered over the past couple of years through competition, lack of

innovation, high inventories levels, slow introduction of new products, and high levels of rework in

production. The managing director has proposed the implementation of a quality costing system to

identify the problems in each department and to develop action plans for improvement.

In the sales and marketing department a number of areas have been identifi ed for action. A reduction

in the volume of sales orders has revealed that £4m of sales revenue has been lost to competitors’

products. The budget for the year had been based on earning a profi t before tax of 12% of sales

revenue, but the actual profi t for the past year was 4% of sales revenue, due to higher costs. The

marketing department has discovered that the company’s competitors on average have been able

to price products at an average premium of 10% over Atlas due to superior quality and the fact that

Atlas has been forced to reduce prices to maintain sales levels. 15% of sales orders completed by

Atlas salesmen have errors (which does not please the customers at all), resulting in delivery delays,

invoicing, pricing and quantity errors. Delays in payments from customers have resulted in accounts

receivable levels increasing by £2.5m mainly because of invoicing errors resulting from incorrect

sales orders.

We are told that costs of production are 65% of sales revenue, and the number of people in the

sales team is 84 and the average annual gross cost per person is £27,000. Rework and error correction

costs have been estimated at 25% of original costs, and Atlas’s borrowing costs are 9% per

annum.

(i) Based on the information provided, what is the total cost of quality for the sales and

marketing department in value and as a percentage of total sales revenue, and

(ii) in which quality cost categories should they be categorised?

(iii) What actions would you recommend to provide a significant reduction to these

costs?

Level II

E10.6 Time allowed – 45 minutes

It is a morning in February and Marsha Ighodaro picks up the keys of her brand new Mini Cooper

from the BMW dealer in a town situated some 29 miles from the village in which she lives. She drives

away in the car she has dreamt about since fi nally choosing and ordering it fi ve weeks earlier (she

has very quickly rationalised her acceptance of the red model instead of the British racing green she

originally wanted). It’s a cold morning and so she turns on the heater control. Alas, nothing happens!

The heater doesn’t work.

Fortunately, these days, such failures rarely occur. But how may a manufacturing company

ensure that the complete product off ering, such as a Mini Cooper, provides the required

level of quality and delivery on each of the assemblies making up the product to meet the

expectations of the customer, at a cost he or she is willing to pay?

E10.7 Time allowed – 45 minutes

The managing director of Flatco plc has agreed with his budget committee that a profi t before tax of

20% of sales revenue should be achievable for 2011. The sales and marketing department have already

agreed to a target of 10% increase in sales revenue for 2011 over 2010. The managing director

has suggested that a percentage improvement should be targeted for costs in all areas of the company

that will provide a 20% profi t before tax. (The Flatco plc income statement for the year 2010 is shown

in Fig. 4.4 in Chapter 4 , page 122 .)

(i) Calculate the required percentage cost reduction on the assumption that same percentage

is applied throughout the company.

(ii) How fair do you think this is as a method of target setting?

(iii) How may each department assess whether such targets are achievable or not?

(iv) What impacts may such targets have on the eff ectiveness of each of the departments

within Flatco?

E10.8 Time allowed – 60 minutes

Abem Ltd produces three products, using the same production methods and equipment for each.

The company currently uses a traditional product costing system. Direct labour costs £8 per hour.

machine hour. Estimated cost details for the next month for the three products are:

Hours per unit

Materials

per unit

£

Labour

hours

Machine

hours

Volumes

(units)

Product A ½ 1½ 20 750

Product B 1½ 1 10 1,975

Product C 1 3 25 7,900

An ABC system is being considered by Abem Ltd, and it has been established that the total production

overhead costs may be divided as follows:

%

Costs relating to set-ups 35

Costs relating to machinery 20

Costs relating to materials handling 15

Costs relating to inspection 30

100

The following activity volumes are associated with the production for the period.

Number of

set-ups

Number of

movements

of materials

Number of

inspections

Product A 70 10 150

Product B 120 20 180

Product C 480 90 670

670 120 1,000

Required:

(i) Calculate the cost per unit for each product using the traditional method of absorption

costing.

(ii) Calculate the cost per unit for each product using ABC principles.

(iii) Comment on any diff erences in the costs in your answers to (i) and (ii).

 

Chapter 11 Relevant costs, marginal costs,

and decision-making

 

Questions

Q11.1 Why is decision-making so important to organisations?

Q11.2 What are short- and long-range decisions, and control decisions?

Q11.3 What are the seven steps used in the decision-making process?

Q11.4 Use some examples to illustrate and explain what are meant by relevant costs, sunk costs and

opportunity costs.

Q11.5 In what ways may marginal costing provide a better approach to decision-making than

absorption costing?

Q11.6 What are the key factors that should be considered in make versus buy decisions?

Q11.7 How should limiting factors be considered if a business is seeking to maximise its profi ts?

Q11.8 (i) What are scarce resources?

(ii) What factors does an entity need to consider to make optimising decisions related to

product mix?

Q11.9 Outline the fi ve main approaches to sales pricing decisions.

Q11.10 How may risk analysis be applied to sales pricing decisions?

Q11.11 What is a decision tree and what is its relevance as an aid to decision-making?

Discussion points

D11.1 ‘What is all the fuss about decision-making? Surely it’s simply a question of adding up a few

accounting numbers and the decision makes itself.’ Discuss.

D11.2 ‘The selling price of a product is the amount that the average customer will pay.’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E11.1 Time allowed – 45 minutes

Eifi on plc manufactures two products, A and B. The company’s fi xed overheads are absorbed into

products on a machine hour basis, and there was full absorption of these costs in 2010. The company

made a profi t of £1,344,000 in 2010 and has proposed an identical plan for 2011, assuming the same

market conditions as 2010. This means that Eifi on plc will be working to its capacity in 2011 at the

existing production level with machine hours being fully utilised. Last year’s actual data are summarised

below:

2010 A B

Actual production and sales (units) 12,000 24,000

Total costs per unit £93.50 £126.00

Selling price per unit £107.50 £175.00

Machine hours per unit 7 3.5

Forecast demand at above selling prices (units) 18,000 30,000

Fixed costs £1,680,000

Required:

(i) Explain the relevance of limiting factors in the context of product mix decisions.

(ii) Prepare a profi t maximisation plan for 2011 based on the data and selling prices shown

for 2010.

(iii) Discuss the limitations of cost-plus pricing and how companies may overcome these in

practice.

E11.2 Time allowed – 45 minutes

Phil Atterley Ltd is considering the promotion of a new product, which will provide a unit contribution

of £2. The sales manager, Stan Palbum, has undertaken market research, which has indicated

that if the promotion is undertaken at a cost of £65,000, there is a 70% chance of selling 500,000

units over the following three years, and a 30% chance of selling 300,000 units. Market research has

also shown that if the product is not promoted then there is a 40% chance of selling 500,000 units,

and a 60% chance of selling 300,000 units over the same time period. Stan is unsure as to whether or

not it is worthwhile promoting the product.

You are required to:

(i) Prepare a decision tree to represent the expected outcomes from promoting or not

promoting the new product.

(ii) Recommend to Stan whether or not he should advise the company to promote the new

product.

(iii) Outline some further fi nancial and non-fi nancial factors that Phil Atterley Ltd may consider

in making this decision.

(iv) Briefl y explain what improvements you would suggest to the information about sales

over the next three years, and how this may be used to refi ne the decision-making

process.

Level II

E11.3 Time allowed – 60 minutes

Hurdle Ltd makes and sells wooden fencing in a standard length. The material cost is £10 per length

which requires one half-hour of skilled labour at £10 per hour (which is in quite short supply).

Hurdle Ltd has no variable overheads but has fi xed overheads of £60,000 per month. Each length

of fencing sells for £28, and there is a heavy demand for the product throughout the year.

A one-off contract has been off ered to Hurdle Ltd to supply a variation to their standard product.

(a) The labour time for the contract would be 100 hours.

(b) The material cost would be £600 plus the cost of additional special components.

(c) The special components could be purchased from an outside supplier for £220 or could be made

by Hurdle Ltd for a material cost of £100 and labour time of four hours.

You are required to advise the company:

(i) whether the special component should be manufactured by Hurdle Ltd or purchased

from the outside supplier

(ii) whether the contract should be accepted

and

(iii) how much should be charged to the customer to enable Hurdle Ltd to make a 20%

mark-up on the cost of the contract.

(Hint: Do not forget to include opportunity costs in the total costs of the contract.)

E11.4 Time allowed – 60 minutes

Muckraker Ltd prepares four types of peat mix for supply to garden centres. Muckraker’s output has

increased in successive months and demand continues to increase. For example, total peat production

increased from 2,580 kg April to June to 3,460 kg in the third quarter. Muckraker has now reached

a crisis because output cannot be increased by more than another 5% by the current workforce, who

are working fl at out, and which cannot be increased. In the third quarter of its year Muckraker’s

fi nancial data are as follows:

Peat A Peat B Peat C Peat D

Peat production kg 912 1,392 696 460

Selling price per kg £8.10 £5.82 £4.96 £6.84

Cost data per kg

Direct labour (£10 per hour) £0.98 £0.65 £0.50 £0.85

Direct materials £3.26 £2.45 £2.05 £2.71

Direct packaging £0.40 £0.35 £0.30 £0.35

Fixed overheads £1.96 £1.30 £0.99 £1.70

Total costs £6.60 £4.75 £3.84 £5.61

Fixed overheads are absorbed on a direct labour cost basis. Another company, Bogside Products,

has off ered to supply 2,000 kg of peat B at a delivered price of 80% of Muckraker’s selling price.

Muckraker will then be able to produce extra peat A in its place up to the plant’s capacity.

Should Muckraker Ltd accept Bogside Products’ off er?

E11.5 Time allowed – 60 minutes

Ceiling Zero plc has manufactured six CZ311 aircraft for a customer who has now cancelled the

order. An alternative buyer, Coconut Airways, would be prepared to accept the aircraft if certain

agreed modifi cations were completed within one month. The Ceiling Zero contracts manager has

prepared a costs schedule as a basis for establishing the minimum price that should be charged to

Coconut Airways:

£000 £000

Original cost of manufacture of six CZ311 aircraft

Based on direct costs 100% overheads charge 6,400

less: Deposit retained when order cancelled 1,000

5,400

Costs of modifi cation

Direct materials 520

Direct labour 200

720

Fixed overheads at 75% of direct costs of modifi cation [0.75 × 720] 540

Administrative expenses at 25% of direct costs [0.25 × 720] 180

Total costs 6,840

The contracts manager has suggested an additional mark-up of 25% 1,710

Suggested minimum price to Coconut Airways 8,550

Two types of material were used in the original aircraft manufacture:

■ Melunium could be sold as scrap for £400,000, but it would take 60 hours of labour at £100 per

hour to prepare the melunium for sale. The department required to carry out this work is particularly

slack at the moment.

■ Polylindeme could be sold for £300,000 and would also require 60 hours of preparation by the

same department at the same rate per hour. Alternatively, polylindeme could be kept for a year and

used on another contract instead of metalindeme which would cost £400,000. To do this, a further

120 hours of labour at £150 per hour would be required in addition to the 60 hours above.

The materials used in the modifi cations for Coconut Airways were ordered last year at a cost of

£840,000. The delivery was late and the realisable value fell to £200,000. Because of this the suppliers

of the materials have given Ceiling Zero a discount of £320,000. Ceiling Zero cannot use this

material on any other contracts.

The direct labour for the modifi cations is a temporary transfer from another department for four

weeks. That department usually contributes £1,000,000 per week to overhead and profi ts. 75% of

that level could be maintained if a special piece of equipment were hired at a one-off cost of £300,000

to compensate for the reduction in the labour force.

If the aircraft were not sold, the specifi cations, plans and patents could be sold for £350,000.

Additional interim managers would need to be hired at £180,000 for the modifi cations, included

in overhead costs. The fi xed overhead rate included straight line depreciation (included in overheads

at £140,000), staff expenses, and lighting. Hand tools will be used for the modifi cations. No other

overheads are aff ected by the modifi cations.

Ceiling Zero’s normal profi t mark-up is 50%. The contracts manager has reduced this to 25% because

it is felt that this is probably what Coconut Airways would be willing to pay.

You are required to redraft the contract manager’s schedule to give a more meaningful price

and to explain all assumptions and alterations.

E11.6 Time allowed – 60 minutes

Use the data for Muckraker Ltd from Exercise E11.4 to calculate the most profi table combination

of output of peats A, B, C and D from subcontracting 2,000 kg of one of the products

at a price of 80% of its selling price and producing extra quantities of another product up to

Muckraker’s total capacity.

You should assume that demand for Muckraker’s products will be suffi cient to meet

the extra output, and that Muckraker’s levels of quality and delivery performance will be

maintained.

E11.7 Time allowed – 90 minutes

Mr Threefi ngers Ltd manufactures three DIY tools, the Rimbo, the Cutzer and the Brazer. The numbers

for the fi nancial year just ended are as follows:

Rimbo Cutzer Brazer Total

£ £ £ £

Revenue 100,000 80,000 120,000 300,000

(Units sold) (10,000) (4,000) (10,000)

Variable costs 60,000 50,000 70,000 180,000

Contribution 40,000 30,000 50,000 120,000

Fixed costs 34,000 36,000 40,000 110,000

Profi t/(loss) 6,000 (6,000) 10,000 10,000

£10,000 of the fi xed costs of producing Cutzers are costs which would be saved if their production

ceased.

Mr Threefi ngers Ltd is considering a number of options:

(a) Cease production of Cutzers.

(b) Increase the selling price of Cutzers by 15%.

(c) Reduce the selling price of Cutzers by 10%.

(d) Resurrect a tool which was popular 10 years ago, the Thrad, on the following basis:

– use the resources released by ceasing production of Cutzers

– incur variable costs of £48,000 and extra fi xed costs of £12,000, for sales of 20,000 units

– sales of 20,000 Thrads, according to market research, could be made at a price of £5 each.

(i) Evaluate the options (a) to (d), stating any assumptions that are made to support your

calculations.

(ii) What other factors should be considered by Mr Threefi ngers Ltd in its decision on

which option(s) to adopt?

(iii) Which option(s) would you recommend and why?

 

Chapter 12 Short-term planning – the

operating budget

 

Questions

Q12.1 (i) Why do businesses need to prepare budgets?

(ii) What are they used for?

Q12.2 If there are diff erences between budgets prepared for planning purposes and budgets prepared

for control purposes, what are these diff erences?

Q12.3 Describe and illustrate the diff erences between qualitative and quantitative forecasting

techniques.

Q12.4 (i) Give some examples of the forecasts that are required to be able to prepare the complete

master budget.

(ii) What are the most suitable techniques for each of these forecasts?

Q12.5 Draw a fl ow diagram to illustrate the budget preparation process.

Q12.6 Explain and illustrate the way in which a business may approach the strategic management

process.

Q12.7 (i) What are the internal and external sources of funding for a business?

(ii) How may a business use the budget process to assess its future funding requirements?

Q12.8 How does the assignment of individual budget responsibility contribute to improved

organisational performance?

Q12.9 Discuss the ways in which a budget may be used to evaluate performance.

Q12.10 Outline some of the major problems that may be encountered in budgeting.

Q12.11 Performance is frequently measured using residual income (RI) and return on investment

(ROI). However, these measures are often criticised for placing too great an emphasis on

short-term results, with the possible eff ect of damaging longer-term performance.

(i) Discuss the issues involved in the long-term versus short-term confl ict referred to

above.

(ii) Suggest some of the ways in which these issues may be reconciled.

Discussion points

D12.1 ‘Once I know what the forecast sales revenue is for next year I can tell you how much profi t

we will make within fi ve minutes, so there’s no need for this annual time-wasting and costly

budgeting ritual.’ Discuss.

D12.2 ‘The area of budgeting is a minefi eld of potential problems of confl ict.’ How can these problems

be usefully used as a learning experience to ultimately improve the performance of the

business?

D12.3 You are the general manager of a newly formed subsidiary company. The group managing

director has declared that he has targeted your company to make a profi t of £250,000 in its

fi rst year. What assumptions, decisions and policies are concerned with preparing a budget

by working backwards from a starting point of budgeted profi t?

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E12.1 Time allowed – 15 minutes

Earextensions plc set up a new business to assemble mobile phones from kits. They planned to make

and sell one model only and expected to sell 441,200 units between January and June in their fi rst

year of trading. February, March and April volumes were each expected to be 20% above the preceding

month and May, June and July volumes were expected to be the same as April. The selling price

was £50 each.

Cost prices for the parts used in making a phone were as follows:

Electronic assembly Keypad Case

£23.30 £1 £2

Operators and assemblers were employed to make the phones with the following hourly rates and

standard times used in production:

Assemblers Operators

Hourly rate £10 £8

Standard minutes 3 1.5

Production overheads were forecast at £4.1m, which were incurred on an equal monthly basis and

absorbed into product costs on the basis of direct labour hours.

At 31 December the numbers of units in inventory were estimated at:

Finished product Quantity Materials Quantity

zero Electronic

assembly 10,000

Keypad 30,000

purchased in December

Case 20,000

Materials inventory levels at the end of each month were planned to be 50% of the following month’s

usage. Finished product inventory levels at the end of each month were planned to be 20% of the following

month’s sales.

Earextensions plc have budgeted selling costs and administrative expenses of £4.5m for the six

months. The fi rst three months were evenly spread at 60% of the total and the second three months

evenly spread at 40% of the total. Production overheads included total depreciation of £50,000 budgeted

for six months. Financing costs over the six months were expected to be in line with sales at

0.2% of sales value.

Earextensions plc prepared an estimated opening balance sheet for its new subsidiary at 31 December

as follows:

£ £

Non-current assets 495,000

Inventories 303,000

Trade receivables –

Cash 355,000 1,153,000

Trade payables 303,000

Loans 450,000

Share capital 400,000

Retained earnings – 1,153,000

Trade receivables were expected to be paid in the second month following the month of sale and

trade payables were planned to be paid in the third month following the month of purchase. Direct

labour, production overheads, and selling and administrative costs are all paid in the month in which

they are incurred. There was no further planned capital expenditure during the fi rst six months.

You are required to prepare a phased sales budget in units and values for the six months

January to June.

E12.2 Time allowed – 30 minutes

Using the information from Exercise E12.1 prepare a phased fi nished product inventories

budget and a phased production budget in units for the six months January to June.

Level II

E12.3 Time allowed – 30 minutes

Using the information from Exercise E12.1 prepare a unit gross margin budget and a phased

direct labour budget for the six months January to June.

E12.4 Time allowed – 30 minutes

Using the information from Exercise E12.1 prepare a phased materials inventories,

materials usage and purchases budget in units and values for the six months January to

June.

E12.5 Time allowed –30 minutes

Using the information from Exercise E12.1 prepare a phased selling costs and administrative

expenses budget, and fi nancial budget for the six months January to June, and a phased income

statement budget, using absorption costing, for the six months January to June.

E12.6 Time allowed – 30 minutes

Using the information from Exercise E12.1 prepare a fi nished product valuation budget for

the six months January to June.

E12.7 Time allowed – 30 minutes

An extract from the fi nancial results for 2010 for three of the operating divisions of Marx plc is shown

below:

Division Chico Groucho Harpo

Average net operating assets £7.5m £17.5m £12.5m

Operating profi t £1.5m £1.4m £2.0m

Administrative expenses £0.8m £0.3m £0.65m

Divisional cost of capital per annum 7% 5% 10%

Required:

(i) Calculate the ROI for each division for 2010 .

(ii) Calculate the RI for each division for 2010.

(iii) Each division is presented with an investment opportunity that is expected to yield a

return of 9%.

(a) Which division(s) would accept and which division(s) would reject the

investment opportunity if divisional performance is measured by ROI, and

why?

(b) Which division(s) would accept and which division(s) would reject the invest ment

opportunity if divisional performance is measured by RI, and why?

E12.8 Time allowed – 60 minutes

Using the information from Exercise E12.1 prepare a trade payables budget and a trade receivables

budget, and a phased cash budget for the six months January to June.

E12.9 Time allowed – 60 minutes

Using the information from Exercise E12.1 prepare a phased balance sheet budget for the

six months January to June.

E12.10 Time allowed – 60 minutes

Blord Ltd manufactures bookcases recommended to customers with a lyrical and romantic nature.

Each bookcase retails for £75.

Blord Ltd

Balance sheet as at 30 June 2009

Assets £

Non-current assets

Buildings at cost 100,000

Depreciation provision (20,000)

Equipment at cost 60,000

Depreciation provision (25,000)

Total non-current assets 115,000

Current assets

Inventories of raw materials (96,000 metres of timber) 192,000

Inventories of fi nished goods (15,000 units) 583,575

Trade receivables 300,000

Cash and cash equivalents 58,000

Total current assets 1,133,575

Total assets 1,248,575

Liabilities

Current liabilities

Trade payables 760,000

Net assets 488,575

Equity

Share capital 250,000

Retained earnings 238,575

Total equity 488,575

The buildings are depreciated at 4% of cost and equipment is depreciated at 20% on a reducing balance

basis. 60% of the buildings and all the equipment is used in the manufacturing process.

Blord Ltd have estimated that next year sales volumes will be:

Quarter 1 70,000

Quarter 2 80,000

Quarter 3 85,000

Quarter 4 90,000

The company makes 80% of its sales direct to the public for cash, which is received when the sales are

made. 20% of the company’s sales are made to trade wholesalers on one month’s credit. It is expected

that sales will be made evenly throughout each quarter.

You are required to:

(i) prepare the sales budget for Blord Ltd for the year ending 30 June 2010

(ii) calculate the phased quarterly cash infl ows expected from its customers over the

budget year.

E12.11 Time allowed – 60 minutes

In order to satisfy customer demand the directors of Blord Ltd have decided that there should be

an inventory of fi nished goods at the end of each quarter equivalent to 20% of the budgeted sales

volumes for the following quarter. It is anticipated that sales volumes in both the fi rst and second

quarters of the next year will be 95,000, and the third quarter is expected to be 100,000.

You are required to prepare a production budget for each of the four quarters for the year

ending 30 June 2010.

E12.12 Time allowed – 60 minutes

Each of Blord Ltd’s bookcases is constructed from 8 metres of timber, which the company currently purchases

for £2 per metre. The company does not expect the cost of timber to rise over the next fi nancial year.

In order to ensure a smooth fl ow of production the company has introduced a policy for next year

to ensure there is 15% of the timber required for the next quarter’s production in inventory at the end

of each of the preceding quarters. The timber supplier allows Blord Ltd one month’s credit.

It takes 1.5 hours of direct labour to manufacture a bookcase and the company currently pays a

standard wage rate of £12 per hour. In addition, it is estimated that a variable production overhead

will be incurred at the rate of £2.50 per direct labour hour.

Blord Ltd anticipates that the total manufacturing fi xed overheads will be £380,000 for the year,

which include depreciation of equipment. Blord Ltd absorbs manufacturing fi xed overheads into each

product on the basis of direct labour hours.

It is anticipated that each quarter’s selling and administration costs will be £1,950,000.

You are required to prepare:

(i) the unit gross profi t budget

(ii) materials purchases and the materials usage budget

(iii) the phased quarterly cash payments expected to be made to the timber supplier, for the

year ending 30 June 2010.

E12.13 Time allowed – 60 minutes

Use the information from E12.10 and E12.12 to prepare the direct labour budget for the year

ending 30 June 2010 and the phased quarterly cash outfl ows.

E12.14 Time allowed – 60 minutes

Use the information from E12.10 and E12.12 to prepare the manufacturing overhead budget

for the year ending 30 June 2010 and the phased quarterly cash outfl ows.

E12.15 Time allowed – 60 minutes

Use your solutions to E12.10 to E12.14 to prepare a phased quarterly cash fl ow budget for

the year ending 30 June 2010 using the direct method.

E12.16 Time allowed – 60 minutes

Use your solutions to E12.10 to E12.15 to prepare a phased quarterly income statement budget

for the year ending 30 June 2010 and a balance sheet as at 30 June 2010.

 

 

Chapter 13 The control budget and variance

Analysis

Questions

Q13.1 How is standard costing used in the preparation of budgets?

Q13.2 (i) What are the benefi ts of using standard costing?

(ii) What type of standard may best ensure that those benefi ts are achieved?

(iii) How are standards used to achieve those benefi ts?

Q13.3 Describe and illustrate the technique of fl exible budgeting.

Q13.4 (i) What is management by exception?

(ii) How is variance analysis used to support this technique?

Q13.5 (i) Outline the main variances that may be reported using the bases of absorption costing

and marginal costing.

(ii) What do these variances tell us about direct labour, direct materials and overhead costs?

Q13.6 Describe the main reasons why usage and effi ciency variances may occur and illustrate these

with some examples.

Q13.7 What are mix and yield variances?

Q13.8 (i) Explain some of the problems associated with traditional variance reporting.

(ii) What are planning and operational variances?

Discussion points

D13.1 ‘We set the budget once a year and then compare the actual profi t after the end of the fi nancial

year. If actual profi t is below budget, then everyone needs to make more eff ort to ensure

this doesn’t happen the following year.’ Discuss.

D13.2 ‘The standard-setting process is sometimes seen as management’s way of establishing targets

that demand better and better manufacturing performance.’ To what extent do you think that

is true, and if it is true how eff ectively do you think the standard-setting process achieves that

objective?

D13.3 To what extent do you think that the techniques of fl exed budgets and variance analysis complicate

the otherwise simple process of comparing the various areas of actual performance

against budget?

D13.4 ‘Traditional variance analysis tends to focus on cutting costs and increasing output in a way

that is detrimental to product and service quality and the longer-term viability of the business.’

Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

F13.1 Time allowed – 60 minutes

Nilbog Ltd makes garden gnomes. It uses standard costs and has budgeted to produce and sell

130,000 Fishermen (their top-of-the-range gnome) in 2010. Nilbog’s budget for the year is phased

over 13 four-week periods, and production and sales revenues are spread evenly in the budget.

Budgeted standard costs and selling prices for the Fisherman are:

£

Direct materials 3 cubic metres at £3.60 per cubic metre 10.80

Direct labour 2 hours at £6.60 per hour 13.20

Variable overheads 2 hours at £2.40 per hour 4.80

Fixed overheads 2 hours at £4.80 per hour 9.60

Standard cost of one Fisherman 38.40

Standard profi t 9.60

Standard selling price 48.00

The actual results for period fi ve, a four-week period, were:

Revenue 9,000 Fishermen at £48 each

Production 9,600 Fishermen

Purchase of direct materials 30,000 cubic metres at a cost of £115,200

Direct materials usage 28,000 cubic metres

Direct labour cost £142,560 for 22,000 hours

Variable overhead £44,000

Fixed overhead £100,000

There was no work-in-progress at the start or at the end of period fi ve. Finished goods and materials

inventories are valued at standard cost.

You are required to prepare a fl exed budget and an operating statement for Nilbog Ltd for

period fi ve, showing the profi t for the period and all standard variances with their detailed

calculations, together with an explanation of their likely causes.

F13.2 Time allowed – 90 minutes

Cyclops plc is an electronics business that manufactures television sets, and uses a standard costing

system. The TV cabinets division of Cyclops manufactures, for sale within the company, the plastic

cases for one of their most popular models, the F24. The results for the F24 for October 2010 were

as follows:

Actual Budget

Sales units 61,200 40,800

£ £

Revenue 348,840 244,800

Direct labour 133,280 81,600

Direct materials 114,240 81,600

Variable overheads 27,200 16,320

Contribution 74,120 65,280

Fixed overheads 25,000 20,400

Profi t 49,120 44,880

The budget had been prepared for 2010 using standard costs for that year.

Sales volumes were increasing and just prior to October the TV cabinets division expected around

50% increase in sales volumes for the month. The division had unused capacity to take up this

expected increase in volume. Vimla Patel had recently been appointed as commercial manager and

she proposed a 30p selling price reduction per unit, which was eff ective from 1 October.

Melanie Bellamy, Cyclops’s purchasing manager had negotiated a 4% discount on the standard

prices of raw materials purchased and used from October. The production manager, Graham Brown,

had been having problems with quality due to the learning curve and some operators who were still

receiving training. Training had been completed by the end of September. This meant some increase

in operator pay rates but the planned productivity rate was maintained and there was less materials

wastage in October. The variable costs of utilities increased in October, primarily due to electricity

and gas price increases.

Graham Brown was able to keep inventory levels of materials and fi nished product at the same

level at the end of October as at the beginning of October.

You are required to:

(i) prepare an operating statement that provides an analysis of the variances between

actual and budget for October on a marginal costing basis, highlighting the performance

of each of the managers

(ii) give full explanations of why the variances may have occurred

(iii) and (iv) prepare the same analysis and explanations as (i) and (ii) above using absorption

costing

(v) explain whether absorption costing provides the best basis for assessment of manager

performance.

Level II

E13.3 Time allowed – 90 minutes

White Heaven Ltd manufactures a bathroom basin, the Shell and uses standard costing based on a

monthly output of 50,000 units. White Heaven uses two grades of direct labour and two items of raw

material.

Variable overheads include:

■ indirect labour costs of material handlers and stores persons

■ maintenance labour costs

■ general production overheads.

Fixed overheads include:

■ supervisory salaries

■ other overheads such as

– factory rent

– electricity standing charges

– gas standing charges.

The ideal standard cost of a Shell is as follows:

Direct labour 1 hour at £7.20 per hour grade A

0.75 hours at £6.00 per hour grade B

Direct materials 5 kg at £2 per kg clay

3 kg at £4 per kg glaze

Indirect labour 0.25 hours at £5.00 per hour

Maintenance 0.05 hours at £10.00 per hour

Variable overheads 15% of direct materials cost, plus

10% of direct labour cost

Supervisory salaries £95,000 per month

Other fi xed overheads £109,000 per month

In June 2010 adjustments were agreed as the basis for the following month’s attainable standard

costs:

■ Grade A labour rates increased by 40p, grade B by 30p and indirect and maintenance labour by 20p

per hour.

■ Grade B labour hours increased by 0.05 hours because of process delays due to a tool change problem.

■ Turnover of operators has meant recruiting some inexperienced, untrained operators:

10% of grade A operators with 50% effi ciency

25% of grade B operators with 60% effi ciency

■ The clay is to be upgraded in quality with the supplier imposing a 10% surcharge.

■ The glaze will be purchased in larger batches with a 12.5% discount but resulting in an increase in

variable overheads to 20% of materials cost for this type of material.

For the July output of 49,000 Shells you are required to calculate:

(i) the ideal standard cost for one Shell

(ii) the attainable standard cost for a Shell for July 2010

(iii) the total variance between the ideal and attainable standards.

E13.4 Time allowed – 90 minutes

White Heaven Ltd (see Exercise E13.3) actually produced 49,000 Shells during July 2010 and the

actual costs for the month were as follows:

Direct labour 52,000 hours at £7.60 per hour grade A

43,500 hours at £6.30 per hour grade B

Direct materials 247,000 kg at £2.16 per kg clay

149,000 kg at £3.60 per kg glaze

Indirect labour 12,000 hours at £5.20 per hour

Maintenance 2,250 hours at £10.20 per hour

Variable overheads £251,000

Supervisory salaries £97,000

Other fi xed overheads £110,000

You are required to:

(i) calculate the variances between actual costs for July 2010 and the attainable standard

(ii) prepare an operating statement that summarises the variances

(iii) reconcile the total actual cost for July with the expected total attainable cost

(iv) comment on the likely reasons for each of the variances.

E13.5 Time allowed – 90 minutes

Millennium Models Ltd manufactured an ornamental gift for the tourist trade. The standard variable

cost per unit is:

Materials £0.85 per kg

Unit material usage 2 kg

Direct labour rate £4.20 per hour

Standard labour per unit 42 minutes

Selling price per unit £5.84

Fixed overhead is recovered on the basis of units produced at the rate of £0.82 per unit and Millennium

Models planned to sell 4,300 units in November 2010.

In November 2010 Millennium Model’s actual performance was:

Units manufactured and sold 4,100

Sales revenue £24,805

Materials used 6,600 kg at £0.83 per kg

1,900 kg at £0.89 per kg

Direct labour paid 2,975 at £4.50 per hour

Overheads incurred £3,800

You are required to:

(i) prepare an actual to budget profi t reconciliation for November 2010 including an

analysis of sales, materials and labour variances

(ii) calculate the fi xed overhead expenditure and fi xed overhead volume variances for

November 2010.

E13.6 Time allowed – 90 minutes

Using the information about Millennium Models Ltd from Exercise E13.5:

(i) explain what you think are the advantages and disadvantages of the implementation of

a standard costing system by Millennium Ltd

(ii) explain how the analyses of variances may have helped Millennium Models Ltd control

the business

(iii) prepare a report that explains the variance analysis you have carried out in Exercise E13.5

above and provides explanations of Millennium’s performance.

E13.7 Time allowed – 90 minutes

The Stables is a small holiday let business in Wales.

The standard variable cost for each holiday let unit (HLU) for one holiday is:

Direct materials (food, cleaning materials, and repairs) £120

Direct labour 15 hours at £10 per hour £150

Variable overhead 5 hours at £1 per hour £5

Budgeted costs and sales for the 2010 season are:

Number of holidays 50

Price per holiday £400

Fixed overhead £2,080

The actual outcome for one HLU for 2010 was:

Number of holidays 52

Total revenue £19,760

Direct materials £5,928

Direct labour (780 hours at £9 per hour) £7,020

Variable overhead £260

Fixed overhead £1,950

You are required to:

(i) Prepare a budgeted income statement for one HLU for 2010.

(ii) Prepare an actual income statement for one HLU for 2010.

(iii) Prepare a fl exed budget for one HLU that refl ects the amount of actual business for

2010.

(iv) Prepare a detailed variance analysis for one HLU and identify possible reasons for each

of the variances.

(v) Summarise the variances in an operating statement that reconciles the diff erence

between the budgeted profi t and the actual profi t achieved by one HLU in 2010.

(vi) Outline some of the problems with traditional variance analysis and explain how the

identifi cation of planning variances may assist in more accurate reporting of operational

variances.

 

Chapter 14 Financing the business, and

the cost of capital

 

Questions

Q14.1 (i) What are the main sources of long-term, external fi nance available to an organisation?

(ii) What are their advantages and disadvantages?

Q14.2 What are the advantages and disadvantages of convertible loans?

Q14.3 Why may leasing be considered as a long-term source of fi nance?

Q14.4 What are the implications for a company of diff erent levels of gearing?

Q14.5 What are the advantages and disadvantages for a company in using WACC as a discount factor

to evaluate capital projects?

Q14.6 Describe the ways in which the costs of debt and equity capital may be ascertained.

Q14.7 How does risk impact on the cost of debt and equity?

Q14.8 What is the b factor, and how may it be related to WACC?

Q14.9 How may a company’s return on equity (ROE) be related to its fi nancial structure?

Q14.10 In what way is company growth of such interest to shareholders?

Q14.11 Business performance may be evaluated to determine ways in which it can be improved

upon. If managers are capable of delivering improved performance how can EVA be used to

support this?

Discussion points

D14.1 The former owner and manager of a private limited company recently acquired by a large plc,

of which he is now a board member, said: ‘This company has grown very quickly over the past

few years so that our sales revenue is now over £20m per annum. Even though we expect our

revenue to grow further and double in the next two years I cannot see why we need to change

our existing fi nancing arrangements. I know we need to make some large investments in new

machinery over the next two years but in the past we’ve always operated successfully using

our existing bank overdraft facility, which has been increased as required, particularly when

we’ve needed new equipment. I don’t really see the need for all this talk about additional

share capital and long-term loans.’ Discuss.

D14.2 In the long run does it really matter whether a company is fi nanced predominantly by ordinary

shares or predominantly by loans? What’s the diff erence?

D14.3 The marketing manager of a large UK subsidiary of a multinational plc: ‘Surely the interest

rate that we should use to discount cash fl ows in our appraisal of new capital investment

projects should be our bank overdraft interest rate. I don’t really see the relevance of the

weighted average cost of capital (WACC) to this type of exercise.’ Discuss.

D14.4 ‘Economic value added (EVA) is nothing more than just fl avour of the month.’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E14.1 Time allowed – 30 minutes

A critically important factor required by a company to make fi nancial decisions, for example the evaluation

of investment proposals and the fi nancing of new projects, is its cost of capital. One of the elements

included in the calculation of a company’s cost of capital is the cost of equity.

( i) Explain in simple terms what is meant by the ‘cost of equity capital’ for a company.

The relevant data for Normal plc and the market in general are given below.

Normal plc

Current price per share on the London Stock Exchange £1.20

Current annual dividend per share £0.10

Expected average annual growth rate of dividends 7%

b beta coeffi cient for Normal plc’s shares 0.5

The market

Expected rate of return on risk-free securities 8%

Expected return on the market portfolio 12%

(ii) Calculate the cost of equity capital for Normal plc, using two alternative methods:

(a) the Capital Asset Pricing Model (CAPM)

(b) a dividend growth model of your choice.

E14.2 Time allowed – 30 minutes

Normal plc pays £20,000 a year interest on an irredeemable debenture, which has a nominal value of

£200,000 and a market value of £160,000. The rate of corporation tax is 30%.

You are required to:

(i) calculate the cost of the debt for Normal plc

(ii) calculate the weighted average cost of capital for Normal plc using the cost of equity

calculated in Exercise E14.1 (ii) if Normal plc has ordinary capital of 300,000 £1 shares

(iii) comment on the impact on a company’s cost of capital of changes in the rate of corporation

tax

(iv) calculate Normal plc’s WACC if the rate of corporation tax were increased to 50%.

Level II

E14.3 Time allowed – 30 minutes

Lucky Jim plc has the opportunity to manufacture a particular type of self-tapping screw, for a client

company, that would become indispensable in a particular niche market in the engineering fi eld.

Development of the product requires an initial investment of £200,000 in the project. It has been

estimated that the project will yield cash returns before interest of £35,000 per annum in perpetuity.

Lucky Jim plc is fi nanced by equity and loans, which are always maintained as two thirds and one

third of the total capital respectively. The cost of equity is 18% and the pre-tax cost of debt is 9%. The

corporation tax rate is 40%.

You are required to:

(i) calculate the cost of the debt for Normal plc

(ii) calculate the weighted average cost of capital for Normal plc using the cost of equity

calculated in Exercise E14.1 (ii) if Normal plc has ordinary capital of 300,000 £1 shares

(iii) comment on the impact on a company’s cost of capital of changes in the rate of corporation

tax

(iv) calculate Normal plc’s WACC if the rate of corporation tax were increased to 50%.

If Lucky Jim plc’s WACC is used as the cost of capital to appraise the project, should the project

be undertaken?

E14.4 Time allowed – 30 minutes

You are required to compute the MVA for 2009, 2010 and 2011 from the estimated information

for a large supermarket group.

2011 2010 2009

Number of shares 6.823m 6.823m 6.776m

Share price 261p 169p 177p

Adjusted net assets £5,000m £4,769m £4,377m

E14.5 Time allowed – 60 minutes

Yor plc is a fast-growing, hi-tech business. Its income statement for the year ended 30 September 2010

and its balance sheet as at 30 September 2010 are shown below. The company has the opportunity to

take on a major project that will signifi cantly improve its profi tability in the forthcoming year and for

the foreseeable future. The cost of the project is £10m, which will result in large increases in sales,

which will increase profi t before interest and tax by £4m per annum. The directors of Yor plc have

two alternative options of fi nancing the project: the issue of £10m of 4% debentures at par, or a rights

issue of 4m ordinary shares at a premium of £1.50 per share (after expenses).

Regardless of how the new project is fi nanced, the directors will recommend a 10% increase in

the dividend for 2010/2011. You may assume that the eff ective corporation tax rate is the same for

2010/2011 as for 2009/2010.

Yor plc

Income statement for the year ended 30 September 2010

£m

PBIT 11.6

Finance costs (1.2)

Profi t before tax 10.4

Income tax expense (2.6)

Profi t for the year 7.8

Retained earnings 1 October 2009 5.8

13.6

Dividends (3.0)

Retained earnings 30 September 2010 10.6

Yor plc

Balance sheet as at 30 September 2010

£m

Non-current assets

Tangible 28.8

Current assets

Inventories 11.2

Trade and other receivables 13.8

Cash and cash equivalents 0.7

Total current assets 25.7

Total assets 54.5

Current liabilities

Trade and other payables 9.7

Dividends payable 1.6

Income tax payable 2.6

Total current liabilities 13.9

Non-current liabilities

6% loan 20.0

Total liabilities 33.9

Net assets 20.6

Equity

Share capital (£1 ordinary shares) 10.0

Retained earnings 10.6

Total equity 20.6

The directors of Yor plc would like to see your estimated income statement for 2010 / 2011,

and a summary of the equity and debt at 30 September 2011, assuming:

(i) the new project is fi nanced by an issue of the debentures

(ii) the new project is fi nanced by the issue of new ordinary shares

To assist in clarifi cation of the fi gures, you should show your calculations of:

(iii) eps for 2009 / 2010

(iv) eps for 2010 / 2011, refl ecting both methods of fi nancing the new project

(v) dividend per share for 2009 / 2010

(vi) dividend per share for 2010 / 2011, refl ecting both methods of fi nancing the new

project

Use the information you have provided in (i) and (ii) above to:

(vii) calculate Yor plc’s gearing, refl ecting both methods of fi nancing the new project, and

compare with its gearing at 30 September 2010

(viii) summarise the results for 2010 / 2011, recommend which method of fi nancing Yor plc

should adopt, and explain the implications of both on its fi nancial structure.

E14.6 Time allowed – 90 minutes

Sparks plc is a large electronics company that produces components for CD players and iPods. It is

close to the current year end and Sparks is forecasting profi t after tax at £60m. The following two

years’ post-tax profi ts are each expected to increase by another £15m, and years four and fi ve by

another £10m each.

The forecast balance sheet for Sparks plc as at 31 December is as follows:

£m

Non-current assets 500

Current assets

Inventories 120

Trade and other receivables 160

Total current assets 280

Total assets 780

Current liabilities

Borrowings and fi nance leases 75

Trade and other payables 75

Total current liabilities 150

Non-current liabilities 150

Total liabilities 300

Net assets 480

Equity

Share capital (£1 ordinary shares) 220

Share premium account 10

Retained earnings 250

Total equity 480

Sparks plc has a large bank overdraft of £75m on which it pays a high rate of interest at 15%. The

board would like to pay off the overdraft and obtain cheaper fi nancing. Sparks also has loan capital

of £150m on which it pays interest at 9% per annum. Despite its high level of debt Sparks is a profi table

organisation. However, the board of directors is currently planning a number of new projects

for the next year, which will cost £75m. These projects are expected to produce profi ts after tax of

£8m in the fi rst year and £15m a year ongoing for future years.

The board has discussed a number of fi nancing options and settled on two of them for further

consideration:

(1) a one for four rights issue at £3.00 a share to raise £150m from the issue of 50m £1 shares

(2) a convertible £150m debenture issue at 12% (pre tax) that may be converted into 45m ordinary

shares in two years’ time.

The equity share index has risen over the past year from 4,600 to the current 5,500, having reached

6,250. Sparks plc’s ordinary shares are currently at a market price of £3.37. Gearing of companies in

the same industry as Sparks plc ranges between 25% and 45%. In two years’ time it is expected that

all Sparks debenture holders will convert to shares or none will convert.

The rate of corporation tax is 50%. Repayment of the bank overdraft will save interest of £5.625m

a year after tax.

The board requires some analysis of the numbers to compare against the current position:

(i) if they make the rights issue

(ii) if they issue debentures

(iii) if the debentures are converted .

The analysis should show:

(a) the impact on the balance sheet

(b) the impact on the profi t after tax

(c) earnings per share

(d) gearing

(e) which option should be recommended to the board and why.

 

 

Chapter 15 Investment appraisal and the

capital budget

 

Questions

Q15.1 (i) What is capital investment?

(ii) Why are capital investment decisions so important to companies?

Q15.2 Outline the fi ve main investment appraisal methods.

Q15.3 Describe the two key principles underlying DCF investment selection methods.

Q15.4 What are the advantages in the use of NPV over IRR in investment appraisal?

Q15.5 What are the factors that impact on capital investment decisions?

Q15.6 (i) What is meant by risk with regard to investment?

(ii) How does sensitivity analysis help?

Q15.7 Describe how capital investment projects may be controlled and reviewed.

Discussion points

D15.1 ‘I know that cash and profi t are not always the same thing but surely eventually they end

up being equal. Therefore, surely we should look at the likely ultimate profi t from a capital

investment before deciding whether or not to invest?’ Discuss.

D15.2 ‘This discounted cash fl ow business seems like just a bit more work for the accountants to

  1. Cash is cash whenever it’s received or paid. I say let’s keep capital investment appraisal

simple.’ Discuss.

D15.3 ‘If you don’t take a risk you will not make any money.’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E15.1 Time allowed – 30 minutes

Global Sights & Sounds Ltd (GSS) sells multi-media equipment and software through its retail outlets.

GSS is considering investing in some major refurbishment of one of its outlets, to enable it to

provide improved customer service, until the lease expires at the end of four years. GSS is currently

talking to two contractors, Smith Ltd and Jones Ltd. Whichever contractor is used, the improved customer

service has been estimated to generate increased net cash infl ows as follows:

Year £

1 75,000

2 190,000

3 190,000

4 225,000

Smith:

The capital costs will be £125,000 at the start of the project, and £175,000 at the end of each of years

1 and 2.

Jones:

The capital costs will be the same in total, but payment to the contractor can be delayed. Capital payments

will be £50,000 at the start of the project, £75,000 at the end of each of years one, two and

three, and the balance of capital cost at the end of year four. In return for the delayed payments the

contractor will receive a 20% share of the cash infl ows generated from the improved services, payable

at the end of each year. In the interim period, the unutilised capital will be invested in a short-term

project in another department store, generating a cash infl ow of £60,000 at the end of each of years

one, two and three.

It may be assumed that all cash fl ows occur at the end of each year.

The eff ects of taxation and infl ation may be ignored.

You are required to advise GSS Ltd on whether to select Smith or Jones, ignoring the time

value of money, using the appraisal basis of:

(i) accounting rate of return (ARR), and

(ii) comment on the appraisal method you have used.

Using the information on Global Sights & Sounds Ltd from Exercise E15.1, you are required

to advise GSS Ltd on whether to select Smith or Jones, ignoring the time value of money,

using the appraisal basis of:

(i) payback, and

(ii) comment on the appraisal method you have used.

E15.2 Time allowed – 30 minutes

E15.3 Time allowed – 60 minutes

Rainbow plc’s business is organised into divisions. For operating purposes, each division is regarded

as an investment centre, with divisional managers enjoying substantial autonomy in their selection of

investment projects. Divisional managers are rewarded via a remuneration package, which is linked

to a return on investment (ROI) performance measure. The ROI calculation is based on the net book

value of assets at the beginning of the year. Although there is a high degree of autonomy in investment

selection, approval to go ahead has to be obtained from group management at the head offi ce

in order to release the fi nance.

Red Division is currently investigating three independent investment proposals. If they appear

acceptable, it wishes to assign each a priority in the event that funds may not be available to cover all

three. The WACC (weighted average cost of capital) for the company is the hurdle rate used for new

investments and is estimated at 15% per annum.

The details of the three proposals are as follows:

Project A

£000

Project B

£000

Project C

£000

Initial cash outlay on non-current assets 60 60 60

Net cash infl ow in year 1 21 25 10

Net cash infl ow in year 2 21 20 20

Net cash infl ow in year 3 21 20 30

Net cash infl ow in year 4 21 15 40

Taxation and the residual values of the non-current assets may be ignored.

Depreciation is straight line over the asset life, which is four years in each case.

You are required to:

(i) evaluate the three investment proposals with regard to divisional performance, using

ROI and RI

(ii) evaluate the three investment proposals with regard to company performance, using a

DCF approach

(iii) explain any divergence between the two points of view, expressed in (i) and (ii) above,

and outline how the views of both the division and the company can be brought into

line.

Level II

Using the information on Global Sights & Sounds Ltd from Exercise E15.1, you are

required to advise GSS Ltd on whether to select Smith or Jones, using the appraisal

basis of:

(i) net present value (NPV), using a cost of capital of 12% per annum to discount the cash

fl ows to their present value, and

(ii) comment on the appraisal method you have used.

E15.4 Time allowed – 30 minutes

Using the information on Global Sights & Sounds Ltd from Exercise E15.1, you are

required to advise GSS Ltd on whether to select Smith or Jones, using the appraisal

basis of:

(i) discounted payback, using a cost of capital of 12% per annum to discount the cash

fl ows to their present value, and

(ii) comment on the appraisal method you have used.

E15.5 Time allowed – 30 minutes

Using the information on Global Sights & Sounds Ltd from Exercise E15.1, you are

required to advise GSS Ltd on whether to select Smith or Jones, using the appraisal

basis of:

(i) internal rate of return (IRR), and

(ii) comment on the appraisal method you have used.

E15.7 Time allowed – 45 minutes

In Exercise E15.1 we are told that a 20% share of the improved cash infl ow has been agreed with

Jones Ltd.

You are required to:

(i) calculate the percentage share at which GSS Ltd would be indiff erent, on a

fi nancial basis, as to which of the contractors Smith or Jones should carry out

the work

(ii) outline the other factors, in addition to your fi nancial analyses in (i), that should be

considered in making the choice between Smith and Jones.

You are required to:

(i) calculate the sales that need to be achieved in each of the fi ve years to meet the

proposed targets

(ii) comment briefl y on four aspects of the proposals that you consider merit further

investigation.

You may ignore the possible eff ects of taxation and infl ation.

E15.9 Time allowed – 90 minutes

Lew Rolls plc is an international group that manufactures and distributes bathroom fi ttings to major

building supply retailers and DIY chains. The board of Rolls is currently considering four projects to

work with four diff erent customers to develop new bathroom ranges (toilet, bidet, bath, basin and

shower).

Rolls has a limit on funds for investment for the current year of £24m. The four projects represent

levels of ‘luxury’ bathrooms. The product ranges are aimed at diff erent markets. The lengths of time

to bring to market, lives of product and timings of cash fl ows are diff erent for each product range.

The Super bathroom project will cost £3m and generate £5m net cash fl ows spread equally over

fi ve years.

The Superluxury bathroom project will cost £7m and generate £10m net cash fl ows spread equally

over fi ve years.

The Executive bathroom project will take a long time to start paying back. It will cost £12m and

generate £21m net cash fl ows, zero for the fi rst two years and then £7m for each of the next three

years.

The Excelsior bathroom project will cost £15m and generate £10m net cash fl ows for two

years.

For ease of calculation it may be assumed that all cash fl ows occur on the last day of each year.

Projects may be undertaken in part or in total in the current year, and next year there will be no

restriction on investment. Lew Rolls plc’s cost of capital is 10%.

You are required to:

(i) calculate the NPV for each project

(ii) calculate the approximate IRR for each project

(iii) advise on the acceptance of these projects on the basis of NPV or IRR or any other

method of ranking the projects.

(iv) What are the advantages of the appraisal method you have adopted for Lew

Rolls plc?

(v) What other factors should be used in the fi nal evaluations before the recommendations

are implemented?

E15.10 Time allowed – 90 minutes

A UK subsidiary of a large multinational group plc is considering investment in four mutually exclusive

projects. The managing director, Indira Patel, is anxious to choose a combination of projects that

will maximise corporate value.

At the current time the company can embark on projects up to a maximum total of £230m. The

four projects require the following initial investments:

£20m in project Doh

£195m in project Ray

£35m in project Mee

£80m in project Fah

The projects are expected to generate the following net cash fl ows over the three years following

each investment. No project will last longer than three years.

Project

Year

Doh

£m

Ray

£m

Mee

£m

Fah

£m

1 15 45 15 20

2 30 75 25 25

3 180 60 100

The company’s WACC is 12% per annum, which is used to evaluate investments in new projects.

The impact of tax and infl ation may be ignored.

Advise Indira with regard to the projects in which the company should invest on the basis of

maximising corporate value, given the limiting factor of the total funds currently available

for investment.

 

Chapter 16 Working capital management

Questions

Q16.1 Describe how a company’s fi nancing of its investment in operations may be diff erent from its

fi nancing of its investment in non-current assets.

Q16.2 (i) Explain the diff erences between working capital (WC) and working capital requirement

(WCR).

(ii) What are the implications for companies having either negative or positive WCs or

WCRs?

Q16.3 Outline the policy options available to a company to fi nance its working capital requirement

(WCR).

Q16.4 Outline the processes and techniques that may be used by a company to optimise its inventories

levels.

Q16.5 (i) Explain what is meant by economic order quantity (EOQ).

(ii) Describe some of the more sophisticated inventory management systems that the EOQ

technique may support.

Q16.6 Describe the areas of policy relating to the management of its customers on which a company

needs to focus in order to minimise the amount of time for turning sales into cash.

Q16.7 Outline the processes involved in an eff ective collections and credit management system.

Q16.8 Describe the policies and procedures that a company may implement for eff ective management

of its suppliers.

Q16.9 (i) What is meant by overtrading?

(ii) What steps may be taken by a company to avoid the condition of overtrading?

Q16.10 Describe

(i) a review of the operating cycle, and

(ii) an appropriate action plan that may be implemented to improve the short-term cash

position of a business.

Q16.11 (i) For what reasons may some companies require increases in long-term cash resources?

(ii) What sources are available to these companies?

Discussion points

D16.1 If working capital is the ‘lubricant’ of a company’s investment in its operations that enables

its investment in non-current assets to be most eff ectively exploited, how does the company

choose the best method of lubrication and how often should this oil be changed?

D16.2 ‘Management of working capital is simply a question of forcing suppliers to hold as much

inventory as we require for order and delivery at short notice, and extending payment as far

as possible to the point just before they refuse to supply, and putting as much pressure as possible

on customers by whatever means to make sure they pay within 30 days.’ Discuss.

D16.3 ‘A manufacturing company that adopts a policy of minimising its operating cycle may achieve

short-term gains in profi tability and cash fl ow but may suff er longer-term losses resulting

from the impact on its customer base and its ability to avoid disruption to its production

processes.’ Discuss.

Exercises

Solutions are provided in Appendix 3 to all exercise numbers highlighted in colour.

Level I

E16.1 Time allowed – 30 minutes

Oliver Ltd’s sales revenue budget for 2010 is £5,300,000. Oliver Ltd manufactures components for

television sets and its production costs as a percentage of sales revenue are:

%

Raw materials 40

Direct labour 25

Overheads 10

Raw materials, which are added at the start of production, are carried in inventory for four days

and fi nished goods are held in inventory before sale for seven days. Work in progress is held at levels

where products are assumed to be 25% complete in terms of labour and overheads.

The production cycle is 14 days and production takes place evenly through the year. Oliver Ltd

receives 30 days’ credit from suppliers and grants 60 days’ credit to its customers. Overheads are

incurred evenly throughout the year.

E16.2 Time allowed – 45 minutes

Coventon plc’s income statement for the year ended 30 June 2010, and its balance sheet as at 30 June

2010 are shown below. The chief executive of Coventon has set targets for the year to 30 June 2011,

which he believes will result in an increase in PBT for the year. The marketing director has forecast

that targeted collection days of 60 would result in a reduction in sales of 5% from 2010 but also a

£30,000 reduction in bad debts for the year. The same gross profi t percentage is expected in 2011 as

2010 but inventories days will be reduced by 4 days. The CEO has set further targets for 2011: savings

on administrative expenses and distribution costs of £15,000 for the year; payables days to be rigidly

adhered to at 30 days in 2011. One third of the loan was due to be repaid on 1 July 2010, resulting in

a proportionate saving in interest payable. (Note: Coventon plc approximates its payables days and

inventories days using cost of sales at the end of the year rather than purchases for the year.)

Coventon plc

Income statement for the year ended 30 June 2010

£000

Revenue 2,125

Cost of sales (1,250)

Gross profi t 875

Distribution and administrative costs (300)

Operating profi t 575

Finance costs (15)

Profi t before tax 560

Income tax expense (125)

Profi t for the year 435

Retained profi t 1 July 2009 515

950

Dividends (125)

Retained profi t 30 June 2010 825

Coventon plc

Balance sheet as at 30 June 2010

£000

Non-current assets

Intangible 100

Tangible 1,875

Total non-current assets 1,975

Current assets

Inventories 125

Trade receivables 425

Prepayments 50

Cash and cash equivalents 50

Total current assets 650

Total assets 2,625

Current liabilities

Borrowings and fi nance leases 50

Trade payables 100

Accruals 150

Dividends payable 125

Income tax payable 125

Total current liabilities 550

Coventon plc

Balance sheet as at 30 June 2010

£000

Non-current liabilities

Loan 250

Total liabilities 800

Net assets 1,825

Equity

Share capital 1,000

Retained earnings 825

Total equity 1,825

You are required to calculate the following:

(i) operating cycle days for 2009 / 2010

(ii) operating cycle days for 2010 / 2011

(iii) the expected value of inventories plus trade receivables less trade payables as at

30 June 2011

(iv) the PBT for 2010 / 2011.

E16.3 Time allowed – 45 minutes

Trumper Ltd has recently appointed a new managing director who would like to implement major

improvements to the company’s management of working capital. Trumper’s customers should pay by

the end of the second month following delivery. Despite this they take on average 75 days to settle

their accounts. Trumper’s sales revenue for the current year is estimated at £32m, and the company

expects bad debts to be £320,000.

The managing director has suggested an early settlement discount of 2% for customers paying

within 60 days. His meetings with all the company’s major customers have indicated that 30% would

take the discount and pay within 60 days; 70% of the customers would continue to pay within 75 days

on average. However, the fi nance director has calculated that bad debts may reduce by £100,000 for

the year, together with savings of £20,000 on administrative costs.

Trumper Ltd has a bank overdraft facility to fi nance its working capital on which it pays interest

at 12% per annum.

The managing director would like to know how Trumper may gain from introducing early

settlement discounts, if it is assumed that sales revenue levels would remain unchanged.

The managing director would also like suggestions as to how the company may reduce its

reliance on its bank overdraft, perhaps through better management of its trade receivables,

and whether the bank overdraft is the best method of fi nancing its working capital.

Level II

E16.4 Time allowed – 45 minutes

Josef Ryan Ltd has experienced diffi culties in getting its customers to pay on time. It is considering

the off er of a discount for payment within 14 days to its customers, who currently pay after 60 days.

It is estimated that only 50% of credit customers would take the discount, although administrative

cost savings of £10,000 per annum would be gained. The marketing director believes that sales would

be unaff ected by the discount. Sales revenue for 2006 has been budgeted at £10m. The cost of shortterm

fi nance for Ryan is 15% per annum.

What is the maximum discount that Josef Ryan Ltd may realistically off er?

E16.5 Time allowed – 45 minutes

Worrall plc’s sales revenue for 2009 was £8m. Costs of sales were 80% of sales revenue. Bad debts

were 2% of sales. Cost of sales variable costs were 90% and fi xed costs were 10%. Worrall’s cost of

fi nance is 10% per annum. Worrall plc allows its customers 60 days’ credit, but is now considering

increasing this to 90 days’ credit because it believes that this will increase sales. Worrall plc’s sales

manager estimated that if customers were granted 90 days’ credit, sales may be increased by 20%,

but that bad debts would increase from 2% to 3%. The fi nance director calculated that such a change

in policy would not increase fi xed costs, and neither would it result in changes to trade payables and

inventories.

Would you recommend that Worrall plc increase customer credit to 90 days?

E16.6 Time allowed – 45 minutes

Chapman Engineering plc has an annual sales revenue of £39m, which are made evenly throughout

the year. At present the company has a bank overdraft facility on which its bank charges 9% per

annum.

Chapman Engineering plc currently allows its customers 45 days’ credit. One third of the customers

pay on time, in terms of total sales value. The other two thirds pay on average after 60 days.

Chapman believes that the off er of a cash discount of 1% to its customers would induce them to pay

within 45 days. Chapman also believes that two-thirds of the customers who now take 60 days to pay

would pay within 45 days. The other third would still take an average of 60 days. Chapman estimates

that this action would also result in bad debts being reduced by £25,000 a year.

(i) What is the current value of trade receivables?

(ii) What would the level of trade receivables be if terms were changed and 1% discount

was off ered to reduce collection days from 60 days to 45 days?

(iii) What is the net annual cost to the company of granting this discount?

(iv) Would you recommend that the company should introduce the off er of an early settlement

discount?

(v) What other factors should Chapman consider before implementing this change?

(vi) Are there other controls and procedures that Chapman could introduce to better manage

its trade receivables?

E16.7 Time allowed – 60 minutes

Sarnico Ltd, a UK subsidiary of a food manufacturing multinational group, makes sandwiches for sale

by supermarkets. The group managing director, Emanuel Recount, is particularly concerned with

Sarnico’s cash position. The fi nancial statements for 2010 are as follows:

Income statement for the year ended 30 September 2010

£m £m

Revenue 49

less: Cost of sales

Opening inventories 7

add: Purchases 40

47

less: Closing inventories 10 37

Gross profi t 12

Expenses (13)

Loss for the year (1)

Balance sheet as at 30 September 2010

£m

Non-current assets 15

Current assets

Inventories 10

Trade receivables 6

Total current assets 16

Total assets 31

Current liabilities

Bank overdraft 11

Trade payables 4

Total current liabilities 15

Non-current liabilities

Loans 8

Total liabilities 23

Net assets 8

Equity

Ordinary share capital 3

Retained earnings 5

Total equity 8

We may assume that trade receivables and trade payables were maintained at a constant level

throughout the year.

(i) Why should Emanuel Recount be concerned about Sarnico’s liquidity?

(ii) What is the ‘operating cycle’?

(iii) Why is the operating cycle important with regard to the fi nancial management of

Sarnico?

(iv) Calculate the operating cycle for Sarnico Ltd.

(v) What actions may Sarnico Ltd take to improve its operating cycle performance?

E16.8 Time allowed – 60 minutes

Refer to the balance sheet for Flatco plc as at 31 December 2010, and its income statement for the

year to 31 December 2010 shown at the beginning of Chapter 16 .

A benchmarking exercise that looked at competing companies within the industry revealed that

on average collection days for 2010 were 33 days, average payables days were 85 days, and average

inventories days were 32 days. The exercise also indicated that in the best-performing companies

in the industry the time that customers took to pay was 24 days, with payables days at 90 days and

inventories days at 18 days.

You are required to calculate the range of values of savings that Flatco may achieve in

2011 (assuming the same activity levels as 2010) if it were to implement the appropriate

measures to achieve average performance or if it improved enough to match the best

performers.

You may assume that sales revenue is more or less evenly spread throughout the year.

The average bank interest paid and earned by Flatco plc is 9% per annum.

 

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