MSIN1006 ACCOUNTING FOUNDATION

MSIN 1006 ACCOUNTING FOUNDATION 2013/2014 1

REFERRAL ASSESSMENT_OCTOBER 2014

PART A30 MARKS

QUESTION1

  1. Explain and illustrate the nature and purpose of Net Present Value(NPV) and Accounting Rate of Return (ARR) as two techniques used within investment appraisal. In so doing identify the advantages and disadvantages of each technique.

NetPresent Value Method of investment appraisal

This methoddiscounts inflows and outflows and ascertains the net present valueof the incomes generated by deducting the discounted inflows from thediscounted outflows. If the net present value is positive you shouldinvest if it is negative do not invest. When comparing twoinvestments with a positive NPV pick the one who’s NPV is greatest.

Pv(inflow) –Pv(outflows) = NPV

The following formula can be used:

Where: A = annual inflow

K = Cost of finance

C = Cost of investment

N = Number of years

Examples

Cost of investment = 100,000/=,interest rate = 10%, inflows year 1 = 80,000/= year 2 = 50,000/=

NPV =

= 14,049 positive henceinvest.

Advantages

Takes care of the time value ofmoney

It allows for comparison ofdifferent investments to identify the best investment project.

Disadvantages

It is difficult to calculate

It requires a person to know thediscounting rates of an investment such data may be difficult togather.

2.)Accounting Rate of Return

Thismethod divides the average profit by the initial investment in orderto get a ratio of the expected return. This method allows an investorto compare potential profits of different investments. An investorshould select the investment with the highest ARR.

ARR=expectedreturns/initial investment

Advantages

Easyto calculate and understand.

Easyto compare the best investment

Disadvantage

Itdoes not take care of the time value of money.

Informationgathered using this method may be misleading at times.

Partb) (15 marks)

Victoriaa budding business woman has heard that you can value a companysimply by looking at a company’s balance sheet. That, is to say,the balance sheet tells us about a company’s assets and liabilitiesand this will be the value of a business at that moment in time.

Required

Critiquethe comment Victoria has heard above, and in so doing explain andillustrate the nature and characteristics of assets and liabilitiesand their accounting treatment for balance sheet purposes.

True,the value of a business is shown by the business’ balance sheet ata specific time.

Thebalance sheet of a company is generally grouped into two sections:

  • The first section includes the business assets (Current assets and Fixed asset)

  • The second section includes the business liabilities (Current liability and Non-current liability) and the business capital.

Asset:this refers to property and services owned by the business.

Currentassets are those assets that by nature will not last for more thanone year in the business premises. This may include stock andconsumable products such as office cleaning detergent).

Fixedassets are those assets that will generally last for more than oneyear in the business. This may include company van and land.

Liability:this refers to what the company owes other people.

Currentliability refers to a liability that the business will pay within oneyear.

Fixedliability refers to a liability that will take more than one year tofully repay the debt.

Capital:this refers to the value of investment that the company shareholdershave invested into the business. This may include ordinary andpreference shareholders, profit or loss and debentures.

The sumof Assets =Liability + Capital

Therefore,a company’s value can be determined by the balance sheet.

Question2 (20 marks)

ZeusLimited is thinking aheadabout how to increase its sales during the next year. There are fourmutually exclusive options that it is seeking to evaluate:

Option1: reduce the sellingprice per unit by 10 per cent

Option2: improve the productresulting in an increase in the variable cost per unit of £2.50

Option3: spend £25,000 on asmall advertising campaign

Option4: improve factoryefficiency by purchasing more machinery at a fixed extra annual costof £50,000

Theprevious year saw sales of 10,000 units with the following costdetails:

Variable costs

£200,000

Fixed costs

£50,000

Profit

£50,000

Required:

i)Evaluate each of the four options for the business in terms of:

  • break even in units

  • profitability (assuming the business wishes to achieve the same profit as last year) (10 marks)

ii)Based on your calculations in part i) above, state with reasons whichoption you would recommend for the business. You should also refer toany other relevant contextual information in justifying yourrecommendation. (6 marks)

iii)Explain the limitations of the accountant’s view of variable andfixed cost classification when used in cost-volume-profit analyses.(4 marks

Answers:

  • Evaluation in terms of break even

  • Profitability.

Optionone:

20-Perunit selling price=Sales/Total units sold

300000/10000=30

Newselling price 0.9*30=27

Quantity(Breakeven)=total fixed cost/(Price-Variable cost)

Averagevariable cost. 200000/10000=20

Quanity=50000/(27-20)=7142.857

7143Units

Lastyear profits 50000

Perunit profit =7

50000/7=7142.85

Newsales to retain profit

7143+7143=14286

14286(retain profit)

Option2

Increasevariable cost by 2.5

Quantity(Breakeven)= total fixed cost/(Price-Variable cost)

Newvariable cost 20+2.5=22.5

50000/(30-22.5)=6666.67

6667Units

Retainprofit

50000/7.5=6666.7

6668+6668=13336

=13336units

Option3

Spendadvertising fee of 25000

Newfixed cost is 75000

Quantity(Breakeven)= total fixed cost/(Price-Variable cost)

75000/(30-20)=7500

7500Units

Retainprofit

50000/10=5000

5000+7500=12500

12500

Option4

Improvefactory at affixed cost of 50000 annually

Newfixed cost 100000

Quantity(Breakeven)= total fixed cost/(Price-Variable cost)

100000/(30-20)=10000

10000Units

Retainprofit

50000/10=5000

5000+10000=15000

15000Units

ii)I would select option two. In this option, the number of units of theproducts sold so as to breakeven are relatively small compared to theother options. Option 3 is not very bad because it has a higherprofit per unit and it is appropriate if the company is sure it canbreak even.

iii.)Limitations of the accountants view of variable and fixed costclassification when used in CVP analysis. The following are some ofthe limitations

  1. In most businesses it is difficult to correctly classify costs as fixed costs or variable cost. It is difficult to correctly categorize costs as either fixed cost or variable cost.

  2. Cost of products may differ from time to time such as quantity discounts on stocks purchased. This will lead to same product having different variable costs. Therefore, the assumption that changes in activity are the only factors that affect costs does not hold.

  3. Some units purchased are not sold during a given accounting period. This brings a challenge in determinin6 g their costs and also classification of costs.

  4. When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant. Is assumption is not necessarily true. Some costs may decrease such as packaging and transportation cost.

Question3 (20 marks)

G&ampGLimited is a newcompany, buying and reselling various innovative gizmos and gadgets.It commenced life on 1st January in Year 1. Year 1 has just beencompleted. In January, it issued 200,000 ordinary shares with anominal value of £1.00 each at a premium of £0.50 each. It alsoobtained a 5 year bank loan of £260,000 at an annual interest rateof 16% when it started business. During Year 1, the followingoccurred:

1.In January Year 1, £90,000 was spent on rent of buildings forfifteen months.

2.Inventories totalling £190,000 were purchased on credit during theyear and at the end of the year closing inventories amounted to£24,000. £54,000 was still owed to trade payables at the end of theyear.

3.At the start of Year 1, machinery and equipment had been purchasedfor £40,000, to be used for 5 years. Non-current assets aredepreciated using the reducing balance approach (also known as thedeclining balance approach) using an annual percentage rate that isdouble the percentage rate at straight line method.

4.Various other operating expenses amounted to £3,400 each month, paidwith one month’s delay.

5.Wages and salaries totalled £120,000 and were all paid in full.

6.Inventories were sold on credit and generated total revenue of£560,000, but during the year a debtor owing £14,000 went bankruptand the debt was written off as a bad debt. At the end of the year,the business was still owed £100,000. It was decided to create aprovision for bad debts of 10% of the year end receivables.

7.At the end of Year 1, the bank loan interest was paid.

8.Taxation of Year 1’s profits is estimated as being £20,000. Halfof this sum had been paid midway during Year 1. The remainder ispayable in the next year.

9.£30,000 was paid to the bank as a repayment of the loan taken out atthe beginning of the year.

10.The directors suggested paying no dividends for the year.

Required:

i)Prepare an IncomeStatement for Year 1. (7marks)

ii)Prepare a BalanceSheet as at the end of Year 1. (7marks)

iii)Explain the nature andpurpose of the Dual Aspect concept in recording financialtransaction. You may wish to use illustrations to add substance toyour explanation.

i.)

G&ampG limited

Income statement for the year ended 31/12/year1

$,000,

$,000,

Sales

560,000

560,000

opening inventory

190000

closing inventory

24000

cost of goods sold

166000

gross profit

394000

expenses

bad debts

14000

interest on loan

41600

rent

72000

depreciation

16000

sundry expenses

40800

wages&amp salary

120000

Tax

20,000

total expenses

324400

324400

Net profit

69600

ii) Balance sheet

G&ampG limited

Balance sheet for the year ended 31/12/Year1

$,000,

$,000,

Fixed assets

Machinery and equipment

24000

24000

Current assets

inventories

24,000

Bank

497600

Rent prepayment

18000

Debtors

90000

Provision for debtors

10000

663600

Current liability

trade payables

54000

Tax

10000

bank loan

22000

86000

Non-current liability

bank loan

208000

208000

Capital

Ordinary shares

200,000

premium

100000

Profit

69600

39600

TOTAL

663600

iii.)Purpose of dual aspect concept in recording financial transactions.

Thisis the underlying concept of double entry accounting. Alltransactions undertaken have two aspects one of receiving benefitand the other is of giving benefit.

Anexample of this is:

Supposecompany Alpha pays its staff a salary bonus of $220000. The dualaspect of this is:

  1. There will be an increase in salary expense by $220000

  2. There will be a decrease in cash at bank by $220000

Thisis recorded in the journal entry as

DR. CR

Salaryexpense 220000

Bank220000

Thedual aspect concept is important because:

l.&nbspDualaspect concept helps accountant to complete the accounts and indetecting error.2.It also gives confirmation to the accountant, to post and record eachentry in opposite&nbsp sdes of two affected accounts.3.Every business transaction of financial nature affects the accountingequation through its aspect.

Question4

Parta) (10 marks)

Thefollowing information relates to the activities of the productiondepartment of ApolloLimited for the month ofAugust:

ApolloLimited adds a margin of50 per cent to the total production cost of specific units in orderto cover administration expenses and to provide a profit.

Required:

i)Calculate the total selling price of order number 666 if overhead isabsorbed using the following methods of overhead absorption:

directlabour hours (3 marks)

machinehours. (3 marks)

ii)State which of the two methods you would recommend for the productiondepartment and why. (4marks)

Answer

Directlabor

0.5*16=8

Sellingprice=Overhead +direct materials +wages

Sellingprice=8+40+16

=64

Machinehrs

0.5*40=20

Sellingprice=Overhead +direct materials +wages

Sellingprice=20+40+16

=76

Partb) (20 marks)

Youhave been asked to undertake a specific job by a company calledPoseidon Limited.The job requires you to prepare a statement of cash flows in a formatsuitable for publication, using the indirect method of preparation:

1.Property, plant and equipment: during the year to 30 September 2014,equipment with a book value of £14 million was sold for a sumequivalent to this book value figure. This equipment originally cost£20 million.

2.Loan: during the year to 30 September 2014 part of the loan, £25million, was repaid not through a cash payment but through issuing 25million £1 shares in exchange for that part of the loan.

3.Depreciation: the depreciation charge for the year, included in thecost of sales expenses already charged to the income statement,amounted to £21.5 million.

4.Dividends paid in cash during the period amounted to £16 million.

Required:

i)Using the information provided, prepare a statement of cash flows ina form suitable for publication for the year ended 30 September 2014using the indirect method. (10marks)

ii)The directors of PoseidonLimited wish you towrite a short report summarising the significant cash movementsduring the year and their implications for the future of the company.The report is intended for potential investors and generalstakeholders who are interested in the business.

(10marks

Answers

i.)

Poseidon Limited

Cash flow statement for year ended 30 sept 2014

Indirect method

$,000,000

Net income

31

adjustments

depreciation

21.5

sale o PPE

6

decrease in inventories

26.5

increase in debtors

-4

increase in creditors

28

increase in interest payable

2

decrease in tax payable

-7.5

gain on property

-47

decrease in loan

-25

increase in ordinary share capital

40

increase in share premium

15

reserves

15

43

cash as at 30/sept 2013

4

Cash as at 30/sept 2014

47

ii.)

Reportof Poseidon limited.

Profit:The profits of the company have been increasing steadily. The profitsas at l2014-10-09 was $31m

Sharecapital: the company has steadily increased its capital to $100m upfrom &amp60m. The share premium is know $15m. The company can nowfinance its activities better.

Liability:the company has reduced its major liability by converting the bankloan into ordinary shares. This shows the liability burden is notsevere for the business.

Sales:the company sales have been increasing steadily. This has shown thatthe business will perform better in future.

Assets:The assets of the company are increasing steadily. The new value ofthe company is $179m up from$132m in 2013. This shows the business isin a better position compared to 2013.