Answers To Business Accounting

Answers to Practice Questions
Business Accounting – Answers to Practice Questions
Introduction to the second edition
Business Accounting is an accessible, non-technical introduction to financial and

management accounting primarily intended for non-specialist undergraduate and
postgraduate students. The active-learning approach helps students gain an
understanding of the subjectivity inherent in accounting and the ability to evaluate
financial information for a range of business purposes.
This edition of Business Accounting features comprehensive revisions. There are new
chapters on the regulatory and conceptual frameworks, and on the preparation of single
entity and consolidated financial statements under IFRS. The revised chapter on
financial statement analysis takes a case study approach and has been given a strong
user focus. For more advanced students of financial accounting, there is a new chapter
on ethics, corporate governance and corporate social responsibility. The chapters on
management accounting have been updated and there is a new chapter that discusses
new issues, such as strategic management accounting, market-oriented accounting,
target costing, the balanced score card, accounting for quality and environmental
accounting. Many of the case studies are set in an international context.
Teaching and learning resources include activities in the text and exam-style practice
questions at the end of each chapter. There are also detailed PowerPoint slides with
integrated exercises, a lecture workbook and interactive progress tests on the website.
In addition, there are chapters and associated teaching and learning materials on
subjects not covered in the current edition.
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Contents
Part I The world of accounting and finance ........................................................... 3

1. Introduction to business accounting .................................................................... 3
2. The importance of cash....................................................................................... 4
Part II Financial accounting ..................................................................................... 7

3. The accounting system ....................................................................................... 7
4. Regulatory framework for financial reporting..................................................... 10
5. Conceptual framework for financial reporting .................................................... 13
6. Statement of comprehensive income ................................................................ 16
7. Statement of financial position .......................................................................... 22
8. Consolidated statement of financial position ..................................................... 32
9. Financial statement analysis ............................................................................. 34
10. Ethics, governance and corporate social responsibility ................................... 41
Part III Management accounting ........................................................................... 43

11. Importance of cost information ........................................................................ 43
12. Costing for product direct costs....................................................................... 46
13. Costing for indirect costs ................................................................................. 49
14. Activity-based costing ..................................................................................... 52
15. Marginal costing .............................................................................................. 55
16. Budgetary planning and control ...................................................................... 58
17. Standard costing ............................................................................................. 62
18. Capital investment appraisal ........................................................................... 64
19. Discounting methods of investment appraisal ................................................. 64
20. Issues in management accounting .................................................................. 71
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Part I The world of accounting and finance
1. Introduction to business accounting
The following narrative answers are indicative of the main points in the chapter.
1. Describe the advantages and disadvantages of the money measurement concept and explain
why students studying business and management should learn about accounting.
The money measurement concept states that only items that can be measured in monetary terms are
included in the financial statements. The main advantages are that it makes it easier to aggregate and
summarise transactions, and compare financial statements. In addition, the concept is appropriate as
business is about money, and it is easily understood and convenient for internal and external users of
the financial statements. The main disadvantages of the monetary measurement concept are that it
limits the usefulness of information in the financial statements because non-financial items are
ignored (eg loyalty of workforce, management skills, size of customer base). In addition, the value of
money is not stable due to inflation/deflation and, if business has international transactions, the value
of money fluctuates with exchange rates.
The main reason why business and management students should learn about accounting is that it will
enhance their future employability. Irrespective of whether they become entrepreneurs and start their
own businesses or find jobs in large, small or medium-sized entities, they will need a basic
understanding of accounting. This is because they will need to understand the financial and other
quantitative information that accounting provides to help them to control the resources for which they
are responsible, plan how those resources can be most effectively used and decide what course of
action they should take when a number of options are open.
2. Define the term accounting and explain the difference between the two main branches of
accounting.
In its broadest sense, accounting can be defined as a service provided to those who need financial
information. Law (2012, p. 6) is more specific and defines accounting as ‘the process of identifying,
measuring, recording and communicating economic transactions’. There are two main branches of
accounting:
 Financial accounting is concerned with classifying, measuring and recording the economic
transactions of an entity in accordance with established principles, legal requirements and
accounting standards. It is primarily concerned with communicating a true and fair view of the
financial performance and financial position of an entity to external parties at the end of the
accounting period.
 Management accounting is concerned with collecting and analyzing financial and other
quantitative information. It is primarily concerned with communicating information to management
to help effective performance measurement, planning, controlling and decision making. Therefore,
the main differences between the two branches of accounting are that financial accounting is
guided by a regulatory framework and focuses on meeting the needs of external users (those not
involved in managing the business), and management accounting is unregulated and focuses on
meeting the needs of internal users. However, both branches of accounting draw on the same
data sources to generate financial information.
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3. Explain the concept of limited liability and the advantages of a company over an unincorporated
business.
Limited liability means that on liquidation, the liability of the members of a limited liability company or
limited partnership for the debts incurred by the entity is limited to the capital they have invested
(including any amount owing). The liability of the members can be limited by shares or limited by
guarantee.
Limited liability for the debts of the business is the main advantage that an incorporated business has
over an unincorporated business. An associated advantage is that if one of the members of an
incorporated business dies, his or her shares can be transferred to someone else and the business
continues, whereas an unincorporated entity has a finite life. The indefinite life of an incorporated
entity is possible because complementary to the concept of limited liability for members is ‘the notion
that the company is a separate “legal person” distinct from the members and the directors’ (Mallett
and Brumwell, 1994, p. 7).
4. Compare and contrast the advantages and disadvantages of public and private companies.
Once of the main advantages of a public limited company is that it can advertise its shares for sale to
the public and, if it is listed on the stock exchange, its shares can be traded in the stock market.
However, a private limited company’s shares cannot be advertised and can only be offered for sale
privately. One of the main advantages of a private company is that, unlike a public listed company, it
is not obliged to comply with stock exchange regulations and most small private companies do not
have to disclose as much financial information as a public company. In addition, the formalities for
setting up a private limited company are less complex than for a public company.
5. Describe the two underlying assumptions that underpin financial accounting and reporting,
providing examples to illustrate your explanations.
The two underlying assumptions are the going concern concept and the accruals concept:
 The going concern concept is based on the principle that the entity is a going concern and will
continue in operation for the foreseeable future. Therefore, unless it is known otherwise, it is
assumed that the entity is not intending to close down or significantly reduce its activities (IASB,
2010). If that presumption is not valid, the financial statements will need to show the assets of the
business at their break-up value and any liabilities that are applicable on liquidation. The going
concern assumption is confirmed by IAS 1, Presentation of Financial Statements (IASB, 2011),
which requires management to look at least 12 months ahead to assess this and, if there is
significant doubt over the entity's ability to continue as a going concern, those uncertainties must
be disclosed, together with the basis used.
 The accruals concept is the principle that revenue and costs are recognized as they are earned
and incurred not as cash is received or paid (the realization concept), and they are matched with
one another (the matching concept) and dealt with in the income statement of the period to which
they relate (the period concept).
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2. The importance of cash
1. Define finance and explain why students studying business or management should learn about
the management of money.
Finance is ‘the practice of manipulating and managing money’. It can also be used to describe ‘the
capital involved in a project, especially the capital needed to start a new business [or] a loan of money
for a particular purpose, especially by a financial house’ (Law (2010, p. 185). The main reason why
business and management students should learn about finance is that it will enhance their future
employability. Irrespective of whether they become entrepreneurs and start their own businesses or
find jobs in large, small or medium-sized entities, they will need a basic understanding of finance. This
is because they will need to understand the main sources of finance and how to use cash flow
information to check that there will be sufficient cash to meet the needs of the entity and to plan the
investment of any surplus cash.
2. Explain the theory of the finance gap.
Some entrepreneurs who have an idea for a new business or managers who want to expand an
existing business have difficulty in gaining access to the finance they need. A finance gap is the
situation where a business has profitable opportunities, but is unable to raise the funds to exploit them
(Jarvis, 2012). It was formally recognised in 1931 by the Macmillan Committee, which reported that
the financing needs of small business were not well served by the financial services institutions at that
time. The main argument supporting the notion of a finance gap is that the majority of enterprises in
the UK (and elsewhere) are small and medium-sized sole proprietorships, partnerships and private
companies, which cannot raise equity finance by selling shares to the public. This is because only
public listed companies can raise capital on a stock exchange. This aspect of the finance gap is
sometimes referred to as the equity gap.
3. Describe the potential sources of long-term finance available to a sole proprietorship or traditional
partnership.
Long-term finance is used to provide assets that are expected to provide economic benefits to the
business in the long-term. There are two potential sources of long-term finance for unincorporated
businesses and both can be classified as debt finance. A long-term loan is a suitable form of finance
for capital investment in assets that are not acquired for trading purposes but intended to be kept in
the business in the long term, such investment in plant and machinery. A mortgage is a long-term loan
for purchasing land or premises. Mortgages are usually supplied by financial institutions, such as
banks and building societies, for a specified number of years (in the UK the maximum period is
usually 25-30 years) at a fixed or variable rate of interest. Repayment may be in instalments or at the
end of the term.
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4(a)
Dudes & Divas Ltd
Cash flow forecast 1 July to 30 September 2012
July August September Total
£ £ £ £
Cash inflows
Capital 25,000 0 0 25,000
Cash sales 10,000 10,000 10,000 30,000
Credit sales 0 2,000 2,000 4,000
35,000 12,000 12,000 59,000
Cash outflows
Purchases 0 0 5,000 5,000
Overheads 5,000 5,000 5,000 15,000
Salaries 1,500 1,500 1,500 4,500
Fixtures and fittings 0 0 30,000 30,000
6,500 6,500 41,500 54,500
Net cash flow 28,500 5,500 (29,500) 4,500
Cumulative cash b/f 0 28,500 34,000 0
Cumulative cash c/f 28,500 34,000 4,500 4,500
4(b) The forecast cumulative cash position at the end of each month is positive. The cash flow
forecast predicts there will be a cash surplus of £4,500 at 30 September 2012.
5(a)
Trigg Electronics Ltd
Cash flow forecast 1 January to 30 June 2012
January February March April May June Total
£ £ £ £ £ £ £
Cash inflows
Revenue from A 0 0 792 858 858 990 3,498
Revenue from B 0 1,300 1,300 1,560 1,560 1,560 7,280
0 1,300 2,092 2,418 2,418 2,550 10,778
Cash outflows
Rent and rates 1,500 0 0 1,500 0 0 3,000
Electricity 0 120 120 120 120 120 600
Telephone and Internet 0 0 50 0 0 50 100
Printing, postage and stationery 0 209 216 242 255 248 1,170
General expenses 25 25 25 25 25 25 150
Tools and equipment 2,500 1,000 500 0 0 0 4,000
4,025 1,354 911 1,887 400 443 9,020
Net cash flow (4,025) (54) 1,181 531 2,018 2,107 1,758
Cumulative cash b/f 0 (4,025) (4,079) (2,898) (2,367) (349) 0
Cumulative cash c/f (4,025) (4,079) (2,898) (2,367) (349) 1,758 1,758
5(b) Philip needs to invest capital of £4,079 in January to prevent the business from having a cash
deficit during the first six months.
6
Part II Financial accounting
3. The accounting system
1. Wellworth Fencing Ltd

Capital account
£ £
1 June Bank 50,000
Bank account
£ £
1 June Capital 50,000 1 June Lorry 16,000
1 June Lorry insurance 1,400
1 June Rent 4,500
2 June Equipment 5,400
2 June Purchases 850
2 June Advertising 420
Lorry account
£ £
1 June Bank 16,000
Lorry insurance account

£ £
1 June Bank 1,400
Rent account
£ £
1 June Bank 4,500
Equipment account
£ £
1 June Bank 5,400
Purchases account
£ £
2 June Bank 850
4 June Timber supplies 120
Advertising account
£ £
2 June Bank 420
Timber Supplies Ltd account

£ £
4 June Purchases 120
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2. Lavender & Lace Ltd
Sales account
£ £
2 July Cash 138
3 July Cash 192
Postage account
£ £
1 July Cash 25
2 July Cash 31
Window cleaning account

£ £
1 July Cash 10
Stationery account
£ £
1 July Cash 15
1 July Cash 36
Parking account
£ £
1 July Cash 2
2 July Cash 2
3 July Cash 2
Petrol account
£ £
1 July Cash 18
2 July Cash 18
Purchases account
£ £
2 July Cash 104
3 July Cash 89
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3. Burton’s Books Ltd
Bank account
£ £
1 October Balance b/f 6,400 2 October Purchases 750
12 October Sales 1,800 3 October Advertising 1,120
15 October Jones Ltd 950 16 October Purchases 2,300
18 October Jones Ltd 950 18 October Davies Ltd 780
30 October Sales 1,450 25 October Purchases 3,400
31 October Balance c/f 3,200
11,550 11,550
1 November Balance b/f 3,200
4. O’Neill Ltd
O’Neill Ltd account

£ £
2 November Sales 850 30 November Cash 1,900
12 November Sales 1,650 30 November Balance c/f 1,900
18 November Sales 260
3,800 3,800
1 October Balance b/f 1,900
5. Hampton Health Food Ltd
Hampton Health Food Ltd

Trial balance as at 30 June 2012
Debit Credit
£ £
Sales 26,200
Purchases 36,770
Returns inward 900
Returns outward 460
Discounts allowed 720
Discounts received 620
Equipment 2,000
Bank 1,500
Salaries 1,600
Rent 1,400
General expenses 390
Capital at 1 July 2011 _____ 18,000
45,280 45,280
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4. Regulatory framework for financial reporting
1. Describe the key elements of the regulatory framework for public and private companies in the UK.
The key elements of the regulatory framework in the UK are:
 Company law as represented by the Companies Act 2006 (CA2006) and subsequent statutory
instruments
 National and international accounting standards issued by independent (non-government) bodies
 Stock exchange rules, which are issued by an independent regulator.
2. Define the term financial reporting. In addition, explain the need for the regulation of financial
reporting and the purpose of the regulatory framework.
Financial reporting refers to the statutory disclosure of general purpose financial information by limited
liability entities via the annual report and accounts. Financial reporting is derived from a complex
process known as financial accounting, which is concerned with classifying, measuring, and recording
the economic transactions of an entity in accordance with established principles, legal requirements
and accounting standards. It is primarily concerned with communicating a true and fair view of the
financial performance and financial position of an entity to external parties. These external parties
include existing and potential investors, lenders and creditors, who rely on the directors’ integrity and
judgement to provide high quality, reliable information for external users. In an ideal world, the
directors would provide unambiguous and value-free measures of wealth, but the world is not ideal
and, hence, the need for regulation.
The purpose of the regulatory framework is to guide corporate financial reporting. This helps the
preparers, auditors and users of the statutory information disclosed in the annual report and accounts.
The principles and rules help ensure that the financial statements are prepared in a standard way,
thus aiding comparison, improving the credibility of the accountancy profession and imposing a
discipline on companies. Regulation also allows suspected cases of fraud or misconduct to be
investigated and curbs creative accounting.
3. Explain the acronym GAAP and outline the historical reasons why one country’s GAAP could
develop differently from another.
GAAP is the acronym for Generally Accepted Accounting Practice (or Principles) and it refers to the
regulatory framework for financial reporting that applies in a particular jurisdiction. UK GAAP
comprises general rules which have been codified in company law and more detailed regulations
which are contained in accounting standards. In addition, public companies with a listing on the
London Stock Exchange must comply with stock exchange rules.
The historical reasons for international differences in GAAP can be summarised as differences in
accounting principles, differences in what is perceived as the objectives of financial reporting, and
various economic, social and cultural factors. A country’s GAAP is likely to consist of accounting
practices that have evolved over time and legal requirements that are added to from time to time.
Legal requirements arise on a contingency basis. For example, they can arise as a response to an
unusual event (eg a financial scandal) or a change in the economic environment. However, it is
unlikely that countries will experience the same unusual events and, if they do, the events may not
occur at the same time or lead to the same changes in requirements. Views on the objective of
financial reporting vary because in some countries the focus is on meeting the needs of investors for
decision making and in others it is on providing financial information for creditor protection and
taxation. This difference arises because in some countries (eg the UK) the main source of finance is
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equity finance raised on the stock market, whereas in other countries (eg Germany) it is debt finance
from financial institutions. A further complication is that in some countries there are separate rules for
financial reporting and tax purposes (eg the UK), requiring two sets of financial statements to be
prepared. One of the key cultural factors that creates differences is due to different attitudes. In some
countries it is taken for granted that a law should be obeyed, whereas in other countries there is a
subtle understanding about which laws are obeyed and the degree to which they are obeyed.
4. Explain what an accounting standard is and discuss the advantages and disadvantages of IFRS.
Draw conclusions from your analysis.
An accounting standard is an authoritative statement on how a particular type of transaction or other

event should be reflected in the financial statements. In the UK, compliance with accounting
standards is normally necessary for the financial statements to give a true and fair view. Ball (2006)
classified the advantages of IFRSs into direct and indirect advantages and the disadvantages into
immediate and longer-term disadvantages:
Direct advantages of IFRSs:
 IFRSs provide more accurate, comprehensive and timely financial statement information relative
to the national standards they replace in many countries
 There are reduced costs arising from being informed in a timely fashion (mainly benefits small
investors who, unlike investment analysts, do not have access to other sources of information).
 The cost of processing financial information is reduced, since no adjustments are needed for
differences in GAAP. This benefits institutions creating standardised financial databases and
should increase the efficiency with which the stock market incorporates the information in prices.
 Most assets can be reported using fair value accounting (eg replacement cost, market value, net
realisable value, value in use), which contains more information than historical cost accounting
 Companies can compete for capital on equal terms since there are reduced compliance costs for
multinational companies, which only need to prepare one set of accounts.
 Transparency is achieved through the use of one global accounting language, which aids inter-
company comparison and reduces information costs and information risk to investors, but only if
IFRSs are implemented consistently
Indirect advantages of IFRSs:
 The cost of equity capital is reduced due to higher information quality reducing the risk to
investors.
 The cost of debt capital is reduced due to more efficient contracting in debt markets, particularly
due to timelier loss recognition.
 Corporate governance (the system by which companies are directed and controlled) is improved
due to greater transparency. In particular, timelier loss recognition increases the incentives of
managers to attend to existing loss-making investments and strategies more quickly and to
undertake fewer unprofitable investments (for example, pet projects and trophy acquisitions).
Immediate disadvantages of IFRSs:
 It is hard to agree on a global accounting language and whether it should be based on principles
or rules. It will mean that national models of best practice may be lost.
 There will be initial training costs for preparers, auditors and enforcers.
 Fair value accounting leads to volatility and may reflect estimation noise or managerial
manipulation.
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 Despite some regulatory co-ordination, political and economic forces will lead to inconsistency in
implementation.
Longer-term disadvantages of IFRSs:
 Allowing all countries to use the IFRS brand name discards information about reporting quality
differences. There may also be free rider problem where low-quality countries may adopt IFRSs in
name only.
 Competition encourages innovation and discourages complacency and bureaucracy and
imposing global standards is risky centralization.
 At present IFRSs have a strong common law orientation, but over time the IASB risks becoming a
politicized, bureaucratic UN-style body.
5. Search the ASB’s website (http://www.frc.org.uk/asb/) to get up-to-date information on the future
of UK GAAP and find articles on the subject in the accountancy press (for example Accountancy
Age, Accountancy magazine or Accounting & Business). Then write a brief essay on the
advantages and disadvantages of the new regime. Refer to the above website and other
sources.
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5. Conceptual framework for financial reporting
1. Explain what a conceptual framework is and the advantages of having such a framework.
A conceptual framework is ‘a statement of theoretical principles that provides guidance for financial
accounting and reporting’ (Law, 2010, p. 102). The IASB’s revised conceptual framework (first
revisions published in 2010) is called the Conceptual Framework for Financial Reporting. The main
advantage of a conceptual framework is that it clarifies the conceptual underpinnings of accounting
standards and allows standard setters to develop accounting standards on a consistent basis. It also
assists preparers, auditors and users of financial statements to understand the approach to standard
setting, and the nature and function of the financial information reported. In addition, a conceptual
framework gives guidance to preparers resolving accounting issues that are not specifically
addressed by an existing IFRS or interpretation.
2. Describe the objective of general purpose financial reporting and the information needs of the
three primary user groups identified in the IASB Framework (2010).
The objective of general purpose financial reporting is ‘to provide information about the reporting
entity that is useful to existing and potential investors, lenders and other creditors in making decisions
about providing resources to the entity. Those decisions involve buying, selling or holding equity and
debt instruments and providing or settling loans and other forms of credit.’ [OB2]. This principle forms
the foundation of the Framework and other aspects of the Framework flow logically from it. The
primary users of general purpose financial reports are existing and potential investors, lenders and
other creditors [OB3].
 Investors need financial information to help them make investment decisions such as buying,
selling or holding equity and debt instruments. These decisions depend on the investment risks
and returns. Returns might include dividends payable on shares, principal and interest payments
or market price increases in equity and debt instruments.
 Lenders need financial information to help them make lending decisions. These decisions depend
on the lending risks and returns. They need to assess whether loans can be repaid and whether
the interest they expect to receive will be paid when it is due. As expectations depend on their
assessment of the amount, timing and uncertainty of payments, they need information that will
help them assess the prospects for future net cash inflows to an entity.
 Creditors need financial information to help them make credit decisions. These decisions will
depend on the credit risks and returns. The latter usually take the form of interest payments. As in
the case of lenders, their expectations depend on their assessment of the amount, timing and
uncertainty of receiving the amounts owed to them and therefore they need information that will
help them assess the prospects for future net cash inflows to an entity.
3. Explain the fundamental and enhancing qualitative characteristics of usefulness in the latest issue
of the IASB Framework.
Chapter 3 of the IASB Framework (2010) divides the qualitative characteristics of that are likely to
make the financial information useful to users into fundamental and enhancing characteristics.
Fundamental qualitative characteristics:
 Relevance – Relevant financial information is capable of making a difference to users’ decisions.

Financial information is capable of making a difference to decisions if it has predictive value
and/or confirmatory value. These two are interrelated. Materiality is an entity-specific aspect of
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relevance based on the nature or magnitude (or both) of the items to which the information relates
in the context of an individual entity’s financial report.
 Faithful representation – General purpose financial reports represent economic phenomena in
words as well as numbers. To be useful, the information must not only represent relevant
phenomena but it must also be a faithful representation of the phenomena. Ideally it should be
complete, neutral and free from error. Free from error does not mean perfectly accurate. For
example, an estimate of an unobservable value cannot be perfectly accurate, but it is a faithful
representation if is clearly described as being an estimate and the nature and limitations of the
estimating process are explained, and no errors have been made in selecting and applying an
appropriate process for developing the estimate.
Enhancing qualitative characteristics:
 Comparability – The information is more useful if it can be compared with similar information for
the entity in other periods, or similar information for other entities. A comparison requires at least
two items. Consistency helps achieve comparability and refers to the use of the same methods for
the same items, either from period to period within a reporting entity or in a single period across
entities.
 Verifiability – The financial information is more useful if it is verifiable. Verifiability helps to assure
users that the information is a faithful representation. It means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement,
that a particular depiction is a faithful representation.
 Timeliness – The financial information is more useful if it is timely. Timeliness means that
information is available to users in time to be capable of influencing their decisions.
 Understandability – The financial information is more useful if is readily understandable.
Classifying, characterising and presenting information clearly and concisely makes it
understandable. While some phenomena are inherently complex and cannot be made easy to
understand, to exclude such information would make financial reports incomplete and potentially
misleading. Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyse the information with diligence.
4. Define the three elements of financial position and the two elements of financial performance in
the IASB Framework (2010).
Element of financial position (IASB, 2010, para 4.4):
 An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
 A liability is a present obligation of the entity resulting from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
 Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Elements of financial performance (IASB, 2010, para 4.25):
 Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
 Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants.
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5. Explain the general recognition criteria relating to the elements of financial statements and outline
the four measurement methods mentioned in the latest issue of the IASB Framework. In addition,
explain the financial capital maintenance and physical capital maintenance concepts...
The general recognition criteria are that the item can be incorporated in the statement of financial
position or statement of comprehensive income if it meets the definition of an element and it also
satisfies the following conditions:
 It is probable that any future economic benefit associated with the item will flow to or from the
entity; and
 The item has a cost or value that can be measured with reliability (IASB, 2010, para 4.37-38).
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6. Statement of comprehensive income
1. Describe the general purpose of the statement of comprehensive income. In addition, explain the
terms income and expenses as defined by the Conceptual Framework for Financial Reporting
(IASB, 2010).
The purpose of the statement of comprehensive income is to provide information to users on the
financial performance of business over the accounting period. Financial performance is concerned
with the profitability of the entity. Users need information on the entity’s financial performance to
assess potential changes in its economic resources and its capacity to generate cash from its
resources. In addition, users need information to evaluate how effectively any additional resources
might be used. There are two elements of financial performance (IASB, 2010, para 4.25):
 Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
 Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants.
2. Explain the accrual basis of accounting by defining the principles involved. Illustrate your answer
by taking the example of the cost of sales adjustment in the statement of comprehensive income.
The accrual basis of accounting shows the effects of economic transactions and events in the period
in which those effects occur, even if the resulting cash receipts and payments occur in a different
period. It is based on the accruals concept which is the principle that revenue and costs are
recognized as they are earned and incurred not as cash is received or paid (the realization concept),
and they are matched with one another (the matching concept) and dealt with in the income statement
of the period to which they relate (the period concept). For example, the cost of sales includes
purchases made during the period, irrespective of whether cash has yet changed hands. Cost of sales
excludes the cost of closing inventory to match cost of goods sold during the period with sales
revenue for the period.
3. Missing figures
(a) (b) (c) (d) (e)

£ £ £ £ £
Opening inventory 100 50 1,020 232 14,960
Purchases 400 680 10,210 1,924 163,570
500 730 11,230 2,156 178,530
Closing inventory (50) (210) (1,550) (150) (18,815)
Cost of sales 450 520 9,680 2,006 159,715
(f) (g) (h) (i) (j)

£ £ £ £ £
Revenue 10,000 600 17,000 18,150 27,750
Cost of sales (6,000) (450) (13,500) (680) (24,590)
Gross profit 4,000 150 3,500 17,470 3,160
Expenses (3,500) (100) (3,250) (15,370) (2,420)
Profit for the period 500 50 250 2,100 740
16
4.
Uplights Ltd
Statement of comprehensive income
for the year ended 31 December 2012
£
Revenue 66,500
Cost of sales (W1) (12,000)
Gross profit 54,500
Bank interest received 100
Rent and rates (24,000)
Salaries (21,500)
Insurance (2,000)
Lighting and heating (500)
Telephone and Internet (400)
Advertising (100)
Operating profit 6,100
Income tax expense (2,000)
Profit for the period 4,100
Working 1 £
Purchases 20,000
Closing inventory (8,000)
Cost of sales 12,000
17
5(a)
Miphone Ltd
Draft statement of comprehensive income
for the year ended 30 June 2012
£
Revenue 75,200
Gross profit 63,930
Other income 1,200
Salaries (24,000)
Insurance (7,200)
Advertising (W2) (600)
Lighting and heating (W2) (1,160)
Telephone and Internet (W2) (740)
General expenses (410)
Working 1 £
Purchases 12,160
Closing inventory (890)
Working 2 Trial balance Accrued Prepaid Total

£ £ £ £
Advertising 860 (260) 600
Lighting and heating 620 540 1,160
Telephone and Internet 450 290 740
General expenses 250 160 410
18
5(b)
Miphone Ltd
£
Revenue 75,200
Gross profit 63,930
Rental income 1,200
Salaries (24,000)
Insurance (7,200)
Lighting & heating (W2) (1,160)
Telephone & Internet (W2) (740)
Allowances:
Depreciation on plant and equipment (W3) (5,000)
Doubtful receivables (W4) (120)
Working 1 £
Purchases 12,160

£ £ £ £
Working 3 £
Plant and equipment at cost 25,000
Allowance for depreciation (÷ 5 years) (5,000)
Working 4 £
Trade receivables in trial balance 1,200
Allowance for doubtful receivables (10%) (120)
19
5(c)
Miphone Ltd
£
Revenue 75,200
Gross profit 63,930
Rental income 1,200
Distribution costs (W5) (28,855)
Administrative expenses (W5) (28,375)
Working 1 £
Purchases 12,160

£ £ £ £
Working 3 £
Plant and equipment at cost 25,000
Working 4 £
Allowance for doubtful receivables (10%) (120)
Working 5 Amount Distribution Administrative Finance

costs expenses costs
£ £ £ £
Salaries 24,000 12,000 12,000
Rent and rates 18,000 9,000 9,000
Insurance 7,200 3,600 3,600
Advertising (W2) 600 600
Lighting and heating (W2) 1,160 580 580
Telephone and Internet (W2) 740 370 370
Allowances:
Depreciation: Plant and equipment (W3) 5,000 2,500 2,500
Doubtful receivables (W4) 120 120
57,230 28,855 28,375 0
20
6.
Beauty Box Ltd
£
Revenue 104,900
Gross profit 67,200
Interest received 100
Salaries (30,000)
Insurance (3,000)
Lighting & heating (1,500)
Telephone & Internet (2,000)
Advertising (500)
Allowances:
Depreciation on equipment (W2) (4,000)
Doubtful receivables (W3) 400
Working 1 £
Opening inventory 10,000
Purchases 39,700
Working 2 £
Equipment at cost 20,000
Working 3 £
Year 2 doubtful debts (600)
Adjusted trade receivables 5,400
Year 1 doubtful debts (1,000)
Decrease in doubtful debts 400
21
7. Statement of financial position
1. Describe the general purpose of the statement of financial position. In addition, explain the terms
asset, liability and equity as defined by the Conceptual Framework for Financial Reporting (IASB,
2010).
The purpose of the statement of financial position is to summarize the assets, equity and liabilities on
the last day of the accounting period for which the statement of comprehensive income was prepared.
There are three elements of financial position (IASB, 2010, para 4.4):
 An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
 A liability is a present obligation of the entity resulting from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
 Equity is the residual interest in the assets of the entity after deducting all its liabilities.
2. Explain the going concern basis of accounting by defining the principles involved. Illustrate your
answer by taking the example of the valuation of tangible assets in the statement of financial
position.
The going concern concept is based on the principle that the entity is a going concern and will
continue in operation for the foreseeable future. Therefore, unless it is known otherwise, it is assumed
that the entity is not intending to close down or significantly reduce its activities (IASB, 2010). If that
presumption is not valid, the financial statements will need to show the assets of the business at their
break-up value and any liabilities that are applicable on liquidation. IAS 1, Presentation of Financial
Statements (IASB, 2011) requires management to look at least 12 months ahead to assess this and, if
there is significant doubt over the entity's ability to continue as a going concern, those uncertainties
must be disclosed, together with the basis used. For example, if an entity were not deemed to be a
going concern, the tangible assets would be valued at their net realisable value (the disposal value
less any direct selling costs), which is likely to be substantially lower than the carrying amount.
22
3. Insert the missing figures in the following examples, remembering that some items will be added
and others will be subtracted.
(a) (b) (c) (d) (e)

£ £ £ £ £
ASSETS
Non-current assets 12,400 22,800 32,000 42,200 54,200
Current assets 3,400 3,700 4,200 10,600 11,800
Total assets 15,800 26,500 36,200 52,800 66,000
EQUITY AND LIABILITIES

Equity
Capital 5,000 6,000 10,000 15,000 10,000
Retained earnings 4,800 13,300 22,700 25,800 37,700
9,800 19,300 32,700 40,800 47,700
Liabilities
Non-current liabilities 5,000 6,000 2,000 10,000 15,000
Current liabilities 1,000 1,200 1,500 2,000 3,300
6,000 7,200 3,500 12,000 18,300
Total equity and liabilities 15,800 26,500 36,200 52,800 66,000
Note
In the chapter we showed the amounts for equity and liabilities in the chapter in brackets to remind
you of the accounting equation, which states that assets are always equal to the claims against them.
Therefore, assets minus equity and liabilities = 0. It is not necessary to do this in assessments.
23
4.
Uplights Ltd
for the year ended 31 December 2012
£
Revenue 66,500
Gross profit 54,500
Bank interest received 100
Salaries (21,500)
Insurance (2,000)
Advertising (100)
Uplights Ltd
Draft statement of financial position
at 31 December 2012
£
ASSETS
Non-current assets
Property, plant and equipment at cost 20,000
Current assets
Inventory 8,000
Trade and other receivables 2,000
Cash 14,500
24,500
Total assets 44,500
Equity
Share capital 30,000
Retained earnings 4,100
34,100
Current liabilities
Trade and other payables 8,400
Current tax payable 2,000
10,400
Total equity and liabilities 44,500
Working 1 £
Purchases 20,000
24
5(a)
Miphone Ltd
Draft statement of comprehensive income
£
Revenue 75,200
Gross profit 63,930
Other income 1,200
Salaries (24,000)
Insurance (7,200)
Lighting and heating (W2) (1,160)
Telephone and Internet (W2) (740)
Miphone Ltd
Draft statement of financial position
at 30 June 2012
£
ASSETS
Non-current assets
Property, plant and equipment (at cost) 25,000
Current assets
Inventory 890
Trade and other receivables (W3) 1,460
Cash and cash equivalents 3,260
5,610
Total assets 30,610

Equity
26,820
Current liabilities
Trade and other payables (W4) 2,590
3,790
Working 1 £
Purchases 12,160
25

£ £ £ £
Total accruals/prepayments 990 (260)
Working 3 £
Opening trade receivables 1,200
Prepayments (W2) 260
Working 4 £
Opening trade payables 1,600
Accruals (W2) 990
5(b)
Miphone Ltd
£
Revenue 75,200
Gross profit 63,930
Rental income 1,200
Salaries (24,000)
Insurance (7,200)
Lighting & heating (W2) (1,160)
Telephone & Internet (W2) (740)
Allowances:
Depreciation on plant and equipment (W3) (5,000)
Doubtful receivables (W4) (120)
26
Miphone Ltd
Statement of financial position
at 30 June 2012
£
ASSETS
Non-current assets
Property, plant and equipment (W3) 20,000
Current assets
Inventory 890
Cash and cash equivalents 3,260
5,490
Total assets 25,490

Equity
21,700
Current liabilities
3,790
Working 1 £
Purchases 12,160

£ £ £ £
Working 3 £
Year 1 depreciation (5,000)
Closing carrying amount 20,000
Working 4 £
Allowance for doubtful receivables (120)
Prepayments 260
Working 5 £
Accruals 990
5(c)
27
Miphone Ltd
£
Revenue 75,200
Gross profit 63,930
Rental income 1,200
Distribution costs (W6) (28,855)
Administrative expenses (W6) (28,375)
Miphone Ltd
at 30 June 2012
£
ASSETS
Non-current assets
Current assets
Inventory 890
Cash 3,260
5,490
Total assets 25,490

Equity
21,700
Current liabilities
3,790
Working 1 £
Purchases 12,160

£ £ £ £
28
Working 3 £
Year 1 depreciation (5,000)
Closing carrying amount 20,000
Working 4 £
Allowance for doubtful receivables (120)
Prepayments 260
Working 5 £
Accruals 990
Working 6 Amount Distribution Administrative Finance

costs expenses costs
£ £ £ £
Salaries 24,000 12,000 12,000
Rent and rates 18,000 9,000 9,000
Insurance 7,200 3,600 3,600
Advertising (W2) 600 600
Lighting and heating (W2) 1,160 580 580
Telephone and Internet (W2) 740 370 370
Allowances:
Depreciation: PPE (W3) 5,000 2,500 2,500
Doubtful receivables (W4) 120 120
57,230 28,855 28,375 0
29
6.
Beauty Box Ltd
£
Revenue 104,900
Gross profit 67,200
Interest received 100
Salaries (30,000)
Insurance (3,000)
Lighting & heating (1,500)
Telephone & Internet (2,000)
Advertising (500)
Allowances:
Depreciation on equipment (W2) (4,000)
Doubtful receivables (W3) 400
Beauty Box Ltd

at 30 June 2012
£
ASSETS
Non-current assets
Current assets
Inventory 12,000
Cash 15,300
32,700
Total assets 44,700

Equity
32,200
Current liabilities
12,500
30
Working 1 £
Opening inventory 10,000
Purchases 39,700
Working 2 Year Opening Provision for Closing

carrying amount depreciation carrying
amount
£ £ £
Equipment 1 20,000 (4,000) 16,000
Equipment 2 16,000 (4,000) 12,000
Working 3 £
Year 2 doubtful debts (600)
Year 1 doubtful debts (1,000)
Decrease in doubtful debts 400
31
8. Consolidated statement of financial position
1. Under IFRS 10, control of an investee is achieved when the investor is exposed to or has rights to
variable returns from its involvement with the investee and has the ability to affect those returns
through its power over the investee. As a result, control is only achieved if the investor possesses
all three of the following elements of control:
 Power over the investee by having rights that give the ability to direct its relevant activities
 Exposure, or rights, to variable returns from its involvement with the investee
 Ability to use its power over the investee to affect the amount of these returns.
In contrast, an investment that offers joint control provides a contractually agreed sharing of
control where strategic decisions about the relevant activities, such as capital expenditure and
approving a business plan, require the unanimous consent of the parties sharing control.
2. IFRS 3 states that goodwill can only recognised in the group accounts as a result of a business
combination. Goodwill is an asset that represents the future economic benefits arising from assets
acquired in a business combination that cannot be individually separately identified and
recognised, such as the company’s reputation and loyalty of its workforce and customer base.
Goodwill at the date of acquisition is the excess of the fair value of the consideration transferred
plus the value of any NCI less the fair value of the identifiable net assets acquired.
3. IFRS 3 requires that a subsidiary’s identifiable assets and liabilities should be recognised at fair
value rather than current book value (carrying value) at the date of acquisition. Fair value is the
price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. IFRS 3 requires measurement of a
subsidiary’s assets and liabilities at fair value as it provides a faithful representation of their
economic value at the date of acquisition.
4. Agro Ltd
£000
Fair value of consideration transferred 500
(b) NCI at 1 July 2012 (£300k x 20%) 60
Fair value of subsidiary’s net assets at 1 July 2012 (300)
(a) Goodwill (balancing figure) 260
32
5. Major Ltd
(a) £
Fair value of consideration transferred 60,000
Non-controlling interest (£66,250 x 20%) 13,250
Fair value of identifiable assets at 1 August 2011 (66,250)
Goodwill (balancing figure) 7,000
(b) Consolidated statement of Major Minor W1 W2 W3 W4 Group

financial position at 31 July 2012 Ltd £ Ltd £ £ £ £ £ £
ASSETS
Non-current assets
Property, plant and equipment 150,000 82,000 232,000
Investment in Minor Ltd 60,000 (60,000) -
Goodwill 7,000 (3,500) 3,500
210,000 82,000 (53,000) (3,500) 235,500
Current assets 195,000 92,250 - - 287,250
Total assets 405,000 174,250 (53,000) - - (3,500) 522,750

Equity
Ordinary share capital 250,000 50,000 (40,000) (10,000) 250,000
Retained earnings pre-acquisition 16,250 (13,000) (3,250) -
Retained earnings post acquisition 32,000 20,000 (4,000) (3,500) 44,500
Revaluation reserve 10,000 10,000
Non-controlling interest (NCI) 13,250 4,000 17,250
282,000 96,250 (53,000) - - (3,500) 321,750
Current liabilities 123,000 78,000 201,000
Total equity and liabilities 405,000 174,250 (53,000) - - (3,500) 522,750
Notes
W1 recognizes goodwill by deducting the parent’s 80% share of Minor’s identifiable net assets.
W2 recognizes the NCI by deducting its 20% share of Minor's identifiable net assets at the acquisition
date.
W3 recognizes the NCI's 20% share in Minor's post acquisition profits of £20,000.
W3 recognizes the NCI's 20% share in Minor's post acquisition profits of £20,000.
W4 accounts for the 50% impairment of goodwill.
33
9. Financial statement analysis
1. Explain the purpose of ratio analysis and describe its limitations as a tool for evaluating the
financial statements of a business.
The purpose of ratio analysis is to evaluate the financial performance and stability of an entity. It helps
internal and external users analyse financial statements by examining ratios that describe the
quantitative relationship between two data items. Ratios can be used to perform a trend analysis or
they can be compared with a predetermined budget or previous periods for the same entity. In
addition, can they can be compared with ratios for competitors or industry benchmarks.
2. Adams Ltd and Eve Ltd
(a) Main profitability ratios

Adams Ltd Eve Ltd
Return on capital employed
Operating profit x 100 29,500 41,500
Capital employed 281,000 596,000
= 10.50% = 6.96%
Capital turnover
Revenue 354,900 706,260
Capital employed 281,000 596,000
= 1.26 times = 1.19 times
Gross profit margin
Gross profit x 100 71,400 156,200
Revenue 354,900 706,260
= 20.12% = 22.12%
Operating profit margin
Operating profit x 100 29,500 41,500
Revenue 354,900 706,260
= 8.31% = 5.88%
(b) Interpretation
Adams Ltd has a better return on capital employed because the company generated
proportionally higher profits from less capital employed, while Eve Ltd generated proportionally
lower profits from a larger amount of capital employed. The capital turnover ratio helps explain the
reasons: Adams Ltd turned over the capital employed in the company to generate revenue just
over 1¼ times during the year, whereas capital employed was used slight less frequently during
the year in Eve Ltd. The superior gross profit margin for Eve Ltd suggests that the company has a
lower cost of sales than Adams Ltd. However, the superior operating profit margin for Adams Ltd
suggests the company is controlling its operating costs better than Eve Ltd.
34
3. Ted Baker 2005/06
Note
Ted Baker has chosen to refer to the statement of financial position as the balance sheet and
uses the format: Assets – Liabilities = Equity. This explains why the amounts shown for liabilities
are in brackets. The brief comments in the narrative answers below are not exhaustive, but
intended for guidance.
(a) Earnings per share 2005/06 2004/05

Profit for ordinary shareholders 12,919 11,368
Number of ordinary shares 42,237 42,375
= 30.59 pence = 26.83 pence
This is an investment ratio that measures the amount of profit earned by one ordinary share.
There was good news for investors, as EPS increased by 3.8p per share in 2005/06.
(b) Return on equity 2005/06 2004/05

Profit for ordinary shareholders x100 12,919 11,368
Equity 42,172 36,830
= 30.63% = 30.87%
This is a profitability ratio that measures return on shareholders’ funds. Unlike ROCE, it excludes
long-term debt. In 2005/06 there was £30.63 operating profit for every £100 capital employed a
little lower than the previous year, but nearly 31% represents a high return compared to a non-
risky investment.
(c) Return on capital employed 2005/06 2004/05

Operating profit x 100 18,334 x100 16,405 x 100
Equity + Non-current liabilities 42,922 37,580
= 42.71% = 43.65%
This profitability ratio measures the percentage return on total funds (shareholders’ equity and
long-term debt). It reflects the stewardship of management and their ability to generate revenue
and control costs. ROCE was slightly lower in 2005/06 with only £42.71 in operating profit for
every £100 of capital employed compared with £43.65 the previous year. This is disappointing as
the amount of capital employed was higher in 2005/06, but gave proportionately less operating
profit. ROCE is higher than ROE because it is based on profit before interest and tax and
therefore does not takes account of finance costs.
(d) Operating profit margin 2005/06 2004/05

Operating profit x 100 18,334 x 100 16,405 x100
Revenue 117,832 105,753
= 15.56% = 15.51%
This profitability ratio measures the percentage return on revenue based on operating profit. The
results show a stable performance with approximately £15 of operating profit generated by every
£100 of revenue in both years.
35
(e) Acid test ratio 2005/06 2004/05

Current assets - Inventory 23,300 18,365
Current liabilities 24,740 21,929
= 0.94:1 = 0.84:1
This is a liquidity ratio that measures the relationship between the liquid current assets and the
short-term liabilities. It excludes inventory as this takes longer to turn into cash. In 2005/06 there
was £0.94 in liquid assets for every £1 of current liabilities, which is a slight improvement on the
previous year. It does not matter that the ratio is slightly less than 1:1 because the accounts are
prepared on a prudent basis and trade payables will be due at different times in the next period. It
is also good financial management to obtain a longer credit period from suppliers than the
company gives to its to customers. This ratio assures users that the business is a going concern.
(f) Inventory holding period 2005/06 2004/05

Inventory x12 for months 23,475 x 12 22,725 x12
Closing inventory 48,979 43,357
= 5.75 months = 6.29 months
This is an efficiency ratio that measures average time between purchase and sale of inventory.
There was an improvement in 2005/06, as management was more efficient is selling inventory,
taking just under six months (one fashion season). This meant there was little risk of extra storage
costs or obsolescence.
(g) Debt/equity ratio 2005/06 2004/05

Non-current liabilities x100 750 x 100 750 x 100
Equity 42,172 36,830
= 1.78% = 2.04%
This is a gearing ratio that describes the financial structure of the business in terms of the
percentage of long-term debt to total shareholder’s funds. The company had very low gearing in
both years. In 2005/06 it reduced from approximately £2 of long-term debt for every £100 of
equity to only £1.78 of long-term debt for every £100 of equity. This means there was even less
risk that the company would be unable to pay interest due on long-term debt in the event of an
economic downturn.
(h) Interest cover 2005/06 2004/05

Operating profit 18,334 16,405
Interest payable 109 221
= 168.20 times = 74.23 times
This gearing ratio measures the relative safety of interest payments. The increase in 2005/6
reflects the lower gearing and confirms interest payable can still be covered many times over.
Therefore, there is very low risk to long-term lenders/creditors that the company will not be able to
pay the interest due.
4. Ted Baker 2007/08 – Investors’ perspective
(a) Dividend per share 2007/08 2006/07

Total dividends x 100 for pence 5,079 x100 4,556 x 100
= 12.00 pence 10.62 pence
This investment ratio is also known as dividend net and measures the amount of dividend on one
ordinary share. The results provide good news for shareholders, as the dividend per share has
36
increased by 1.4p per share. This is partly due to an increase in total dividends for 2007/08 and
partly due to a reduction in the number of shares that year.
(b) Dividend yield 2007/08 2006/07

Dividend per share x100 12.00 x 100 10.62 x 100
Average share price 480.00 641.50
= 2.50% = 1.65%
This investment ratio is also known as the yield gross and it measures the dividend per share in
relation to the average price of the share. Shareholders will be pleased as the yield rose by 0.85%
in 2007/08 due to the higher dividend per share. However, the yield would have been higher if it
were not for the significantly lower average share price that year.
(c) Earnings per share 2007/08 2006/07

Profit for ordinary shareholders x 100 for pence 15,242 x100 14,416 x 100
= 36.02 pence 33.59 pence
This investment ratio measures the amount of profit earned by one ordinary share. There is good
news for shareholders as the increased profits in 2007/08 improved EPS by 2.43 pence. This ratio
is based on total profits and therefore reflects the shareholders’ total return. EPS is higher than
the dividend per share, since only part of the profit is distributed as dividends.
(d) Price/earnings ratio 2007/08 2006/07

Average share price 480.00 641.50
Earnings per share 36.0 33.6
= 13.33 years = 19.10 years
This investment ratio compares the amount invested in one share with the earnings per share and
reflects the stock market's confidence in how long the current level of EPS will be sustained. The
results are disappointing for shareholders since the number of years the market believes the
company has good prospects has dropped by nearly 6 years. Nevertheless, the P/E ratio is still
more than 13 years, so little cause for concern for existing or potential investors.
(e) Return on equity 2007/08 2006/07

Profit for ordinary shareholders x100 15,242 x 100 14,416 x 100
Equity 55,712 51,281
= 27.36% = 28.11%
This investment ratio measures the return on shareholders’ funds. The results will be
disappointing for shareholders as the increased equity did not lead to a proportionately higher
total return. In 2007/08 the return was only £27.35 for every £100 of equity compared with £28.11
the previous year. Nevertheless, a return of 27.36% is very high compared to the risk-free interest
rate of 5.29% and should be attractive to existing and potential investors.
(f) Return on capital employed 2007/08 2006/07

Operating profit x 100 22,142 x100 20,049 x 100
= 39.15% = 39.06%
This is a profitability ratio that measures the percentage return on total funds (shareholders’ equity
and long-term debt). It reflects the stewardship of management and their ability to generate
revenue and control costs. ROCE is stable with approximately £39 in operating profit for every
£100 of capital employed in both years. The increased amount of capital employed in 2007/08 did
not lead to proportionately higher operating profit. Nevertheless, existing and potential investors
are likely to consider a return of 39% is favourable compared to the risk-free interest rate of 5.29%.
37
Note that ROCE is higher than ROE because it is based on profit before interest and tax and
therefore does not take account of finance costs.
(g) Operating profit margin 2007/08 2006/07

Operating profit x 100 22,142 x 100 20,049 x 100
Revenue 142,231 125,648
= 15.57% 15.96%
This profitability ratio measures the percentage return on revenue based on operating profit. The
results show a stable performance with approximately £15 of operating profit generated by every
£100 of revenue in both years.
(h) Capital turnover 2007/08 2006/07

Revenue__________ 142,231 125,648
= 2.51 times = 2.45 times
This profitability ratio measures the number of times capital employed was used during the year to
achieve the revenue. The small improvement in 2007/08 shows more efficient use of capital
employed and this is reflected in the return on capital employed.
5. Ted Baker 2007/08 – short-term lender perspective
(a) Current ratio 2007/08 2006/07

Current assets 57,329 53,397
= 2.24:1 = 2.40:1
This is a liquidity ratio that measures the relationship between current assets and short-term
liabilities. In 2007/08 there was £2.24 in current assets for every £1 of current liabilities, which
means current liabilities are still easily covered by current assets.
(b) Acid test 2007/08 2006/07

Current assets - Inventory 28,014 25,572
= 1.10:1 = 1.15:1
This liquidity ratio is more stringent than the current ratio because it excludes inventory, as this
current asset cannot be converted into cash at short notice. In 2007/08 there was £1.10 in liquid
assets for every £1 of current liabilities, which means current liabilities are just covered by current
assets. However, the accounts are prepared on a prudent basis and trade payables will be due at
different times in the next period. In addition, it is also good financial management to obtain a
longer credit period from suppliers than the company gives to its to customers. The results for this
ratio should assure lenders and creditors that the liquidity position is stable and the business is a
going concern.
(c) Inventory holding period 2007/08 2006/07

Closing inventory x 12 for months 29,315 x 12 27,825 x 12
Cost of sales 59,560 51,986
= 5.91 months 6.42 months
This is an efficiency ratio that measures average time between purchase and sale of inventory.
There was an improvement in 2007/08, as management was more efficient is selling inventory,
taking just under six months (one fashion season) rather than just over 6 months. This meant
38
there was little risk of extra storage costs or obsolescence. Lenders and creditors will welcome
this result as it reflects good management of working capital.
(d) Trade receivables collection period 2007/08 2006/07

Trade receivables x 12 for months 10,217 x 12 8,543 x 12
Revenue 142,231 125,648
This efficiency ratio measures the average time credit customers took to settle their debts. The
position is stable with customers taking less than 1 month to pay on average during both years.
This suggests efficient credit control, but depends on how long the credit period given to
customers is. The short trade receivables collection period will give a positive signal to lenders
and creditors as it reflects good management of working capital.
(e) Trade payables payment period 2007/08 2006/07

Trade payables x 12 for months 13,361 x 12 11,770 x 12
Cost of sales 59,560 51,986
This efficiency ratio measures the average time the company has taken to pay suppliers for goods
and services over the year. The results show little change in 2007/08 and suggest efficient cash
management if the period agreed with suppliers is two months. Taking the maximum credit period
provided will be seen by lenders and creditors as good financial management.
(g) Debt/equity ratio 2007/08 2006/07

Non-current liabilities x100 843 x 100 43 x 100
Equity 55,712 51,281
= 1.51% = 0.08%
This is a gearing ratio that describes the financial structure of the business in terms of the
percentage of long-term debt to total shareholder’s funds. The company had very low gearing in
both years. Although gearing increased slightly in 2007/08, the company only had £1.51 of long-
term debt for every £100 of equity. This means there was very little risk that the company would
be unable to pay interest due on long-term debt in the event of an economic downturn.
(h) Interest cover 2007/08 2006/07

Operating profit 22,142 20,049
Interest payable 387 67
= 57.21 times = 299.24 times
This gearing ratio assesses the relative safety of interest payments by measuring the number of
times interest payable on long-term debt is covered by the available profits. This avoids problems
over different definitions of debt that can be used in the debt/equity ratio. The significant reduction
in 2007/08 reflects the higher gearing. Nevertheless, there is no cause for concern for lenders and
creditors as interest payable can still be covered by operating more than 57 times.
The main limitations of the above analysis are:
 Ideally, the inventory holding period should be based on average inventory and purchases for
the year. However, average inventory cannot be calculated for 2006/07 because opening
inventory is not disclosed for that year. Therefore, closing inventory is used as a proxy so that
both years can be compared. In addition, cost of sales is substituted for purchases since the
latter is not disclosed for either year. In both cases, the substitute figures are less precise.
 It is difficult to interpret the trade receivables collection period and the trade payables
payment period without knowing the average credit periods associated with these ratios.
39
 There are no agreed definitions of the terms used, so these ratios should not be compared
with others based on different definitions.
 The analysis is based on comparing two years. It would be more useful if figures were
available to examine the trend over the last five years for example. It would also be useful to
compare these ratios for Ted Baker with competitors or industry benchmarks.
 The analysis is based on figures from the financial statements in which there is a substantial
degree of classification and aggregation, and the effect of allocating continuous operations to
the period. A second weakness of the financial statements is that they do not take account of
non-financial factors such as whether the business has sound plans for the future, a good
reputation, a strong customer base, reliable suppliers, loyal employees, obsolete assets,
strong competitors or poor industrial relations.
Finally, the above analysis cannot anticipate the impact of potential changes in the economic
environment. The lender should treat the analysis as an indication of where further investigation
might be directed to better understand the present and future financial performance and position.
40
10. Ethics, governance and corporate social responsibility
1. Explain why professional accountancy bodies issue codes of ethics for their members.
The Code of Ethics for Professional Accountants states that ‘a distinguishing mark of the accounting
profession is its acceptance of the responsibility to act in the public interest. Therefore, a professional
accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer’
(IESBA, 2009, para. 100.1). The main advantages of the IFAC Code of Ethics for Professional
Accounts are:
 It provides explicit guidance to accountants and aids their understanding of the expectations
placed upon them in terms of their ethical behaviour.
 It lets clients know what they can expect from their professional accountants.
 It provides a standard for disciplining professional accountants who adopt poor accounting
practices.
 It enhances the reputation of professional accountants.
 It promotes a commitment to best practice within the profession.
 Abiding by a code may decrease the legal liability of professional accountants from
inappropriate actions.
 It provides users of the accounts with a standard against which they can compare the ethical
behaviour of their professional accountants and complain about poor accounting practice.
2. Define the term ‘corporate governance’ and explain its importance to investors.
Cadbury (1992, p. 15) defined corporate governance as ‘the system by which companies are directed
and controlled. Boards of directors are responsible for the governance of their companies. The
shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves
that an appropriate governance structure is in place. The responsibilities of the board include setting
the company’s strategic aims, providing the leadership to put them into effect, supervising the
management of the business and reporting to shareholders on their stewardship. The board’s actions
are subject to laws, regulations and the shareholders in general meeting.’ A succinct explanation by
Law (2012, p. 113) summarises corporate governance as ‘the manner in which organizations,
particularly limited companies, are managed and the nature of accountability of the managers to the
owners’. Corporate governance is important to investors because it allow them to assess the
stewardship of management. This is important because in large companies there is separation of
ownership and control, and although the company is owned by the shareholders, the latter appoint
directors to manage the business on their behalf.
3. Obtain information from the FRC’s website and write a summary explaining its role in regulating
corporate governance in the UK.
The answer should refer to the fact that the FRC is the UK’s independent regulator responsible for
promoting high quality reporting and CG to foster investment, which is does through the UK Corporate
Governance Code. The FRC’s Committee on Corporate Governance leads work on corporate
governance. Reference should be made to the Committee's terms of reference and the FRC’s role in
influencing EU and global developments, promoting boardroom professionalism and diversity, and
encouraging constructive interaction between company boards and institutional shareholders (cf. the
Stewardship Code for Institutional Investors).
41
4. Obtain a copy of the annual report and accounts for two public limited companies and compare
the information they disclose on corporate governance. Write a summary analysing the
differences in the wording used and noting any non-compliance with the UK Code of Corporate
Governance.
The answer should cover the following points:
 The length of each company’s corporate governance statement and how easy it is to find
 Whether each company has been clear about its adherence to the UK Code and if it has
deviated from it, whether adequate explanations have been given (the ‘comply or explain’
aspect of the UK Code)
 The usefulness of any additional information provided
 An analysis of the language used by each company, noting similarities and differences
 Conclusions on how engaged the company appears to be with corporate governance
principles.
5. Select one public limited company and analyse the data provided on corporate governance and
on corporate social responsibility.
The answer should refer to the following:
a) How satisfied an investor might feel that the CG/CSR information indicates that the company
is well run and therefore a ‘safe’ investment.
b) Whether the supplier can take comfort that the CG/CSR sections indicate that as a
stakeholder in the business the company recognises that good supplier relationships are
essential to future success.
c) Appropriate CG/CSR statements should provide the customer with the sense that the
company takes its role in the community seriously and is in business for the longer term.
d) To some extent this overlaps with the customer view, but would suggest the wider context of
how the company is perceived, especially in certain sectors (eg pharmaceuticals, banking and
the oil industry).
42
Part III Management accounting
11. Importance of cost information
1. Explain the purpose of cost accounting and why it is important for managers to have cost
information.
The purpose of cost accounting is to ascertain the cost of the designated cost centres and cost units.
Cost is the expenditure on goods and services required to carry out the operations of an organization.
A cost unit is ‘a unit of production for which the management of an organization wishes to collect the
costs’ and a cost centre is the area of an organization for which costs are collected for the purpose of
cost ascertainment, planning, decision making and control’ (Law, 2010, p. 119 and 116). Business is
about money and in order to run a business successfully, managers need to know the cost of running
the business in order to run it successfully. A total cost statement shows the total cost of 1 cost unit
(the product direct costs plus a share of the indirect costs). A mark up can be added to establish the
selling price.
2. Describe the main classifications of cost.
Revenue expenditure can be classified by:
 The nature of the cost, such as those that can be identified for materials, labour and expenses,
and those for materials that can be divided into the different types of raw materials, maintenance
materials, cleaning materials, etc.
 The function of costs, such as production costs, administration costs, selling and distribution costs.
 Whether they are product costs, which can be identified with the cost unit and are part of the
value of inventory, or period costs, such as selling costs and administrative expenses, which are
deducted as expenses in the current period.
 Whether they are direct costs, which can be identified with a specific cost unit, or indirect costs,
which cannot be identified with a specific cost unit, although they may be traced directly to a
particular cost centre. Indirect costs must be shared by the cost units. Examples of direct costs
are the cost of materials used to make a product; the cost of labour if employees are paid
according to the number of products made or services provided; the cost of expenses, such as
subcontract work. Examples of indirect costs are expenses such as rent and managers’ salaries.
 The behaviour of the cost and whether they are variable costs, which in total change in proportion
with the level of production activity or fixed costs, which are not changed by fluctuations in
production levels. Direct costs are usually variable and indirect costs are usually fixed. Examples
of direct costs that are fixed are patents, licences and copyright relating to a particular product
and some direct expenses such as the hire of a particular piece of equipment to produce a
specific order.
43
3. Classify the following costs:
Production Administration Distribution

costs costs* costs
(a) Factory rent 
(b) Insurance of office buildings 
(c) Electricity for powering machinery 
(d) Electricity for office lighting and heating 
(e) Tax and insurance of delivery vehicles 
(f) Depreciation of factory machinery 
(g) Depreciation of office equipment 
(h) Commission paid to sales team 
(i) Salaries paid to accounts office staff 
(j) Factory manager’s salary 
(k) Delivery drivers’ salaries 
(l) Factory security guards’ salaries 
(m) Piecework wages paid to factory operatives 
(n) Salary paid to managing director’s secretary 
(o) Salaries paid to factory canteen staff 
(p) Fees paid to advertising agency 
(q) Maintenance of machinery 
(r) Accounting software 
(s) Bonuses for factory staff 
(t) Training course for clerical staff. 
*Includes selling costs
4. Petra Pots Ltd
(a)
Petra Pots Ltd
Total cost (2,000 units)
£
Direct costs
Direct materials (6,000 + 200) 6,200
Direct labour 10,000
Prime cost 16,200
Production overheads (1,000+2,000+700+1,500+2,500+2,200+800+900) 11,600
Production cost 27,800
Indirect costs
Administration overheads (400 + 800 + 200 + 1,800 + 2,200 + 16,000) 7,000
Distribution overheads (500 + 800) 1,300
8,300
Total cost 36,100
(b) Interpretation should demonstrate awareness that total cost is built from a number of key elements
and should explain the terms used.
44
5. Petra Pots Ltd*
Petra Pots Ltd

Total cost (1 unit)
£
Direct costs
Direct materials 3.10
Direct labour 5.00
Prime cost 8.10
Production overheads 5.80
Production cost 13.90
Indirect costs
Administration overheads 3.50
Distribution overheads 0.65
4.15
Total cost 18.05
Profit (Production cost £13.90 x 50%) 6.95
Selling price 25.00
*The workings are the same as in question 4, but divided by 2,000.
45
12. Costing for product direct costs
1. Describe the main stages in controlling direct materials.
In a manufacturing business the control of materials used in the production process is essential to
ensure that production is not delayed due to shortages and that the business does not tie up capital
by storing excess quantities of inventory. The main stages in material control are:
 The stores or production department sends a purchase requisition to the purchasing department,
giving details of the quantity and type of materials required.
 The buyer in the purchasing department sends a purchase order to the supplier.
 The supplier sends the materials with a goods received note, which is checked against the
materials received and the purchase order.
 The materials are added to the existing inventory in the stores and the quantity is added to the
inventory level shown on the bin card.
 When materials are required, the production department sends a materials requisition to the
stores and the stores issues the materials and deducts the quantity from the inventory level
shown on the bin card. Periodic stocktaking ensures that a physical count of all inventories is
made to confirm that the actual quantities support the levels shown on the bin cards.
In a well-managed business, materials are available in the right place, at the right time and in the right
quantities, and all materials are properly accounted for.
2. Compare and contrast the advantages and disadvantages of the FIFO and CWA methods.
The main advantage of the FIFO cost method is that it is acceptable to financial accountants in the UK
and to the HM Revenue and Customs, which means that not only can it be used for management
accounting purposes, but also for financial reporting and taxation purposes. However, this advantage
also applies to the CWA cost method. The FIFO method is the logical choice if it coincides with the
order in which inventory is physically issued to production (eg materials with a finite life where it
makes sense to issue those that have been stored the longest first). However, the CWA is the logical
choice if inventory consists of volume and liquid materials where an averaging method makes sense
because it may not be possible to differentiate between old and new inventory stored in bulk
containers.
While the FIFO has the benefit of charging the cost of direct materials against profits in the same
order as costs are incurred, the CWA offers the advantage of smoothing out the impact of price
changes in the statement of comprehensive income. However, the FIFO method is complex and an
arithmetical burden, even when a spreadsheet is used. While the cost of direct materials issued to
production is based on historical prices, the value of inventory at end of period is close to current
prices. On the other hand, the CWA method requires the prices of materials issued to production must
be recalculated every time a new consignment is received, this can be relatively simple to calculate by
entering the quantity and pricing information from the source documents into a spreadsheet or
specialist software package. The CWA method also offers the advantage that it takes account of
quantities purchased and changing prices, including prices relating to previous periods. Nevertheless,
the prices of materials issued may not match any of the prices actually paid and the value of closing
inventory will lag behind current prices if prices are rising.
46
3. Janet’s wages are based on piecework and she is paid £5 per piecework hour. Calculate her pay
for a 36-hour week in which she produces the following units:
Product Number Time allowance Total piecework

of units per unit hours
A 12 0.8 hours 9.6
B 30 0.6 hours 18.0
C 24 0.5 hours 12.0
39.6
Pay (39.6 hours x £5) £198
4. Perfect Pans Ltd
(a)
(i) FIFO Receipts Issues Inventory balance

December Quantity Price Value Quantity Price Value Quantity Value
kg £ £ kg £ £ kg £
1 500 1,000.00
2 450 2.00 900.00 50 100.00
7 550 2.10 1,155 600 1,255.00
8 50 2.00 100.00 550 1,155.00
8 450 2.10 945.00 100 210.00
14 600 2.20 1,320 700 1,530.00
15 100 2.10 210.00 600 1,320.00
15 500 2.20 1,100.00 100 220.00
30 500 2.30 1,150 600 1,370.00
31 100 2.20 220.00 500 1,150.00
Total 3,475.00
(ii) AVCO Receipts Issues Inventory balance

December Quantity Price Value Quantity Price Value Quantity Value
kg £ £ kg £ £ kg £
1 500 1,000.00
2 450 2.00 900.00 50 100.00
7 550 2.10 1,155 600 1,255.00
8 500 2.09 1,045.83 100 209.17
14 600 2.20 1,320 700 1,529.17
15 600 2.18 1,310.71 100 218.45
30 500 2.30 1,150 600 1,368.45
31 100 2.28 228.08 500 1,140.38
Total 3,484.62
(b) Assuming that the business needs to choose between the two methods, recommend which
method management should adopt, giving at least five reasons.
The answer should include a recommendation. The choice of method should be supported with a
discussion of at least five advantages and disadvantage of the method chosen contrasted with those
of the method that has been rejected.
47
5. Baked Bean PLC
(a)
(i) FIFO Receipts Issues Inventory balance

September Quantity Price Value Quantity Price Value Quantity Value
tonne £ £ tonne £ £ tonne £
1 1,000 5.00 5,000 1,000 5,000.00
2 1,000 5.50 5,500 2,000 10,500.00
3 750 5.00 3,750.00 1,250 6,750.00
14 250 5.00 1,250.00 1,000 5,500.00
500 5.50 2,750.00 500 2,750.00
15 1,000 6.00 6,000 1,500 8,750.00
16 500 5.50 2,750.00 1,000 6,000.00
250 6.00 1,500.00 750 4,500.00
29 1,000 6.50 6,500 1,750 11,000.00
30 750 6.00 4,500.00 1,000 6,500.00
Total 16,500.00
(ii) AVCO Receipts Issues Inventory balance

September Quantity Price Value Quantity Price Value Quantity Value
tonnes £ £ tonnes £ £ tonnes £
1 1,000 5.00 5,000 1,000 5,000.00
2 1,000 5.50 5,500 2,000 10,500.00
3 750 5.25 3,937.50 1,250 6,562.50
14 750 5.25 3,937.50 500 2,625.00
15 1,000 6.00 6,000 1,500 8,625.00
16 750 5.75 4,312.50 750 4,312.50
29 1,000 6.50 6,500 1,750 10,812.50
30 750 6.18 4,633.93 1,000 6,178.57
Total 16,821.43
(b) Identify which of the two methods would give the higher profit for the month in this particular case,
giving your reasons.
The basic argument is that the higher the value of closing inventory, the higher the profit. Costs
reduce revenue and closing inventory reduces the cost of sales for the period. Reference should be
made to the fact that when prices are rising, the value of closing inventory under the FIFO method is
higher than under the CWA method. Under the FIFO cost method, the valuation is closer to current
prices, whereas under the CWA method price increases are smoothed out and the value of closing
inventory lags behind the current price. Therefore, the FIFO cost method gives the higher profit under
these circumstances
48
13. Costing for indirect costs
1. Describe the main stages for calculating the total cost per unit under an absorption costing
system.
Absorption costing is the cost accounting system in which the overheads of an organization are
charged to the production by means of the process of absorption. Costs are first allocated or
apportioned to the cost centres, where they are absorbed into the cost unit using absorption rates
(Law, 2012, p. 2). There are three main stages as follows:
 Collect indirect costs in cost centres on the basis of allocation or apportionment

 Determine an overhead absorption rate (OAR) for each production cost centre (eg cost per
direct labour hour)
 Charge indirect costs to products using the OAR and a measure of the product’s consumption
of the cost centre’s cost (eg number of direct labour hours)
 Calculate the cost per unit.
2. Explain what it means to allocate, apportion and absorb indirect costs.
In some cases, indirect costs that have been classified by nature can be wholly identified with one
particular cost centre (eg wages and depreciation on machinery relating to a particular production
department that has been designated as a cost centre). These overheads can simply be allocated to
that cost centre (eg the whole amount of the annual allowance for depreciation on machinery in that
department is allocated to that cost centre). However, indirect costs that are associated with more
than one cost centre must be apportioned over the cost centres benefiting from them (eg factory rent
could be apportioned over the production cost centres on the basis of the proportion of space each
department occupies in the factory).
An overhead absorption rate is calculated in advance of an accounting period and used to charge the
indirect costs to the production for that period (Law, 2010). The choice of absorption rate depends on
the basis of apportionment and the resources used. The main rates used are:
 The cost unit overhead absorption rate

 The direct labour hour overhead absorption rate
 The machine hour overhead absorption rate.
3. Discuss the advantages and disadvantages of using an absorption costing system for calculating
the total cost of a product.
The advantages of absorption costing are that it provides a means of sharing the total overheads of a
business in the manufacturing sector over the various production cost centres and the overheads for a
particular production cost centre over the various products passing through it. It allows production
overheads to be allocated or apportioned to the cost centres on a fair basis and absorbed into the
cost unit using an appropriate using an overhead absorption rate. Non-production overheads are
absorbed into the cost unit by adding a percentage based on the proportion of non-production
overheads to the total production cost.
However, there are a number of disadvantages. Not only is this cost accounting system is unsuitable
for businesses in the service sector, but a major limitation of absorption costing is that it is based on
arbitrary decisions about the basis for apportioning and absorbing the overheads. Normally
predetermined overhead absorption rates are used because the actual figures are not available until
49
the end of the period, but if the predetermined overhead that has been absorbed is higher than the
actual overhead, it will result in overabsorption, which reduces expenses in the statement of
comprehensive income. On the other hand, if the predetermined overhead that has been absorbed is
lower than the actual overhead, it will result in underabsorption, which increases expenses in the
statement of comprehensive income. In addition, general overheads are spread across the product
range with little regard for how the costs are actually generated. Therefore, there is always some
concern that the total cost of each product is not being calculated in the most precise manner. If the
business is miscalculating the cost of its products and basing its selling prices on this inaccurate
information, it could have a dramatic impact on financial performance. For example, if the
inaccuracies result in selling prices that are too high, the business could lose market share to
competitors; if they result in selling prices that are too low, the business will not achieve its planned
profit.
A further criticism of absorption costing is that assigns indirect costs in proportion to the number of
units produced (volume), but many resources used in support activities are not related to volume (eg
machine set-up, where the cost varies with the complexity of the production process and the diversity
of the product range). This means too large a proportion of the cost of support activities is assigned to
high volume products that cause little diversity, and too small a proportion is assigned to low volume
products that use more support activities.
4. Toy Craft Ltd
(a)
Toy Craft Ltd
Production overhead analysis
Overhead Total Basis of Machine Assembly Maintenance
apportionment department department department
£ £ £ £
Indirect materials 24,500 Allocated 12,000 10,000 2,500
Indirect labour 54,500 Allocated 14,000 18,000 22,500
Rent and rates 26,000 Area 13,000 10,400 2,600
Electricity 4,000 Area 2,000 1,600 400
Depreciation on machinery 36,000 Value of machinery 24,000 8,000 4,000
Supervisors' salaries 42,000 No. of employees 9,800 29,400 2,800
Subtotal 187,000 74,800 77,400 34,800
Apportioned service costs - Value of machinery 26,100 8,700 (34,800)
Total 187,000 100,900 86,100 -
(b) Machine department OAR
Cost centre overheads = £100,900 = £2.37 per machine hour

No. of machine hours 42,500
(c) Assembly department OAR
Cost centre overheads = £86,100 = £5.74 per direct labour hour

Direct labour hours 15,000
50
5. West Wales Windsurfers Ltd
(a)
West Wales Windsurfers Ltd
Production overhead analysis
Basis of Body Finishing Canteen Total
apportionment* workshop workshop
£ £ £ £
Production overheads Allocated 680,000 390,000 160,000 1,230,000
Apportioned service costs No. of employees 100,000 60,000
Total 780,000 450,000
*Students should give a rationale for the basis of apportionment used.
(b) Overhead absorption rates
Body workshop: Total machine hours (30  2,000) + (80  2,500) = 260,000
Cost centre overheads = £780,000 = £3.00 per unit

No. of machine hours 260,000
Finishing workshop: Total direct labour hours (40  2,000) + (40  2,500) = 180,000
Cost centre overheads = £450,000 = £2.50 per unit

No. of direct labour hours 180,000
(c) Predicted production cost per unit
Fun Wave Hot Racer

£ £
Direct costs
Materials 80 50
Labour
Body workshop 150 180
Finishing workshop 80 80
Indirect costs
Body workshop 90 240
Finishing workshop 100 100
Production cost 500 650
51
14. Activity-based costing
1. Discuss the reasons why accountants have developed ABC as an alternative to the traditional
method of absorption costing for charging overheads to products or services.
Once of the main criticisms of absorption costing is that this cost accounting system is based on
arbitrary decisions about the basis for apportionment and absorption of overheads. In addition,
general overheads are spread across the product range with little regard for how the costs are
actually generated. Therefore, there is always some concern that the total cost of each product is not
being calculated in the most precise way. If a business is miscalculating the cost of its products and
basing its selling prices on this inaccurate information, it could have a dramatic impact on financial
performance. For example, if the inaccuracies result in selling prices that are too high, the business
could lose market share to its competitors; if they result in selling prices that are too low, the business
will not achieve its planned profit.
Absorption costing was developed at a time when the majority of firms were in the manufacturing
sector and tended to carry high levels of inventory. Therefore, the valuation of inventory was very
important. In addition, direct labour was a major element in the cost of a product and overheads were
relatively small, so inaccuracies in apportioning indirect costs to cost units did not have a significant
effect on the total cost, which is calculated to determine the selling price or to value closing inventory.
Today, advanced manufacturing technology (eg computer-controlled processes and robotics) has
decreased direct labour costs and increased overheads (eg power, maintenance and depreciation on
machinery and equipment). Moreover, just-in time techniques mean little or no inventory is held.
Activity-based costing (ABC) was proposed by Johnson and Kaplan (1987), who questioned the
relevance of traditional management accounting practices to modern business. The increased
importance of financial accounting as one of the main branches of accounting and the fact that the
majority of firms are now in the service sector means that traditional management accounting
techniques based on the needs of manufacturers are irrelevant to many businesses today. ABC is ‘a
system of costing… that recognizes that cost are incurred by each activity that takes place within an
organization and that products (or customers) should bear costs according to the activities they use.
Cost drivers are identified, together with the appropriate activity cost pools, which are used to charge
cost to products’ (Law, 2010, p. 15). The main assumption is that products (goods or services)
consume activities and activities consume resources. This overcomes the problem of finding a
meaningful relationship between non-production overheads and the production activity.
2. Describe the four main stages in implementing a system of activity-based costing, defining all
terms used.
Activity-based costing (ABC) is a system of costing ‘that recognizes that costs are incurred by each
activity that takes place within an organization and that products (or customers) should bear costs
according to the activities they use. Cost drivers are identified, together with the appropriate activity
cost pools, which are used to charge cost to products… An activity cost pool is a collection of indirect
costs grouped according to the activity involved (Law, 2010, p. 15). The implementation of an activity-
based costing system involves four main steps:
 Identify the main activities in the organization and classify them into activity centres if there
are a large number of different activities. An activity centre is an identifiable unit of the
organization that performs an operation that uses resources. For most organizations the first
activity will be the purchase of materials. This will involve several sub-activities, such as
drawing up material specifications, selecting suppliers, placing the order, receiving and
inspecting the materials that have been delivered.
52
 Identify the cost drivers associated with each activity centre. A cost driver is ‘any factor such
as number of units, number of transactions, or duration of transactions that drives the costs
arising from a particular activity. When such factors can be clearly identified and measured,
they will be used as a basis for allocating costs to cost objects’ (Law, 2010, p. 117). For
example, a cost driver for the purchase of materials would be the number of orders placed; for
customer support, it might be the number of calls answered; for a quality control activity, it
might be the number of hours of inspection conducted. Some activities have multiple cost
drivers.
 Calculate the cost driver rate, which is the cost per unit of activity. For example, in purchasing
it would be the cost per order placed.
 Assign costs to the products by multiplying the cost driver rate by the volume of the cost
driver units consumed by the product. With purchasing, the cost driver rate will be calculated
on the basis of orders placed. For example, if Product A requires 15 orders to be placed in
January, the cost of purchasing activity for Product A will be 15 times the cost driver rate.
3. Write a short report discussing the types of business where ABC might be appropriate and the
advantages and disadvantages of implementing this type of cost accounting system.
Activity-based costing is best suited to businesses that operate in highly competitive markets and
which have many different products that require complex production processes. In such firms the
arbitrary process of absorption costing does not generate sufficiently specific information to aid
managers in planning, controlling and decision making.
The main advantages of activity-based costing are:
 It provides more comprehensive detail about product costs.

 It generates data that is more specific and reliable than traditional costing.
 Because it does not distinguish between production overheads and general overheads, it
overcomes the problem of finding a meaningful relationship between these non-production
overheads and the production activity.
 It provides better information about the costs of activities, thus allowing managers to make
more informed decisions.
 It improves cost control by identifying the costs incurred by specific activities.
The main disadvantages are:
 It can be costly and difficult to implement.

 Trained and experienced staff are required to operate the system.
 Substantial IT costs may be required.
 Managers may not find the information useful.
 It uses predetermined rates and therefore underabsorption or overabsorption of overheads
will still occur as they do under absorption costing.
Managers should be aware that the different basis for assigning costs to products is likely to result in
a different total cost per unit. This can have important consequences for decision making and strategy
in the company. More accurate cost information could lead to some products being eliminated and
changes in the market price of other products. Installing the system will require teamwork between
accounting, production, marketing and other functions in the company. Therefore, management
should conduct a cost/benefit analysis before implementing activity-based costing and, unless the
expected benefits are greater than the costs, the firm should not move from absorption costing.
53
4. Continental Communications Ltd
Rate Standard Advanced Total

£ £ £ £
Direct costs
Direct labour 200,000 100,000 300,000
Direct materials 50,000 20,000 70,000
Indirect costs
Production 3,000 120,000 30,000 150,000
Quality 2,000 16,000 24,000 40,000
Delivery 200 16,000 4,000 20,000
Total cost 402,000 178,000 580,000
Number of units produced 100,000 50,000

Cost per unit 4.02 3.56
5. Parfums de Paris AG
(a)
Sweet Pea Allure
€ €
Direct costs
Direct materials 35,000 12,000
Direct labour 25,000 16,000
Indirect overhead costs
Purchasing 1,800 720
Quality control 4,000 3,000
Material handling 4,000 2,000
Production cost 69,800 33,720
Litres produced 20,000 4,000

Cost per litre €3.49 €8.43
(b) This seems to be a simple production process with little use of technology so it is not the type of
operation that one would usually recommend adopts activity based costing. The overhead costs
are modest compared to the cost of direct materials and direct labour and the company would be
better advised to concentrate on controlling their direct costs. No information is given on the
packaging costs and the advertising and it would be worthwhile to investigate these. A fairly
simple absorption costing system may be a better approach for this company.
54
15. Marginal costing
1. Describe the purposes of marginal costing and the importance of contribution.
The purpose of marginal costing is to meets the need for detailed information about costs in a
business where production levels fluctuate. It requires revenue expenditure to be classified into
variable costs or fixed costs according to the behaviour of the cost when the level of production or
sales activity changes. A variable cost is ‘an item of expenditure that, in total, varies directly with the
level of activity achieved’ and a fixed cost is ‘an item of expenditure that remains unchanged, in total,
irrespective of changes in the levels of production or sales (Law, 2010, pp. 430 and 194). The variable
costs per unit are usually regarded as the direct costs plus any variable overheads and are assumed
to be constant in the short term. Therefore, a characteristic of a variable cost is that it is incurred at a
constant rate per unit; for example, the cost of direct materials will tend to double if output doubles.
Semi-variable costs contain both variable and fixed elements and must be analysed so that the
variable elements can be added to the other variable costs and the fixed elements can be added to
other fixed costs.
In marginal costing, only the variable costs are charged to the units. The difference between sales
revenue and the variable costs is not the profit, since no allowance has been made for the fixed costs
incurred; it is the contribution towards fixed costs. Contribution is ‘the additional profit that will be
earned by an organization when the breakeven point production has been exceeded. The unit
contribution is the difference between the selling price of a product and its marginal cost of production.
This is based on the assumption that the marginal cost and the sales value will be constant (Law,
2010, p. 110). Contribution can be calculated for one unit or for any chosen level of sales. The total
contribution is the contribution per unit multiplied by the number of units produced. Contribution is
important because once the total contribution exceeds the total fixed costs the business starts making
a profit.
2. Explain the impact of limiting factors and how you would allow for them. Use a worked example to
illustrate your answer.
A limiting factor is a constraint that restricts a business from achieving higher levels of profitability (eg
a shortage of materials or labour, a restriction on the sales demand at a particular price or a limit in
the production capacity of machinery). If the business has more than one product that uses the limited
resource, it could mean that the business can only make a limited number of products and
management needs to decide which products to make to obtain the maximum profit. The general rule
is to maximize production of the product with the highest contribution per unit of limiting factor.
The example should show how the contribution per unit of limiting factor has been calculated and how
selection will maximise overall profitability.
3. Funfair Engineering Ltd
The report should include the following points:
(a) The total cost per unit increases because some costs are fixed. Therefore, the same total amount
of cost has to be shared over fewer units.
(b) Marginal costing focuses on the contribution to fixed costs. In periods of recession, most decision-
making is concerned with achieving the best contribution. Although in the long-term it is essential
that fixed costs are recovered, marginal costing can give a new perspective on the problems
confronted by the businesses.
55
4. Edwards & Co Ltd
(a)
Marginal cost statement 1 unit
£
Revenue 10.00
Variable costs
Direct materials (1.00)
Direct labour (5.00)
(6.00)
Contribution 4.00
(b)
Marginal cost statement 12,000 units
£
Revenue 120,000
Variable costs
Direct materials (12,000)
Direct labour (60,000)
(72,000)
Contribution 48,000
Fixed costs (32,000)
(c) The breakeven point is the level of production, sales volume, percentage of capacity, or sales
revenue at which an organization makes neither a profit nor a loss (Law, 2010, p 65). At this point,
total revenue equals total costs (or total contribution equals total fixed costs).
(d) Breakeven analysis
(i) BEP in units
Fixed costs 32,000 = 8,000 units

Contribution per unit 4
(ii) BEP in sales revenue
BEP in units  Selling price 8,000  10 = £80,000
(iii) Sales activity to reach target profit
Fixed costs + Target profit 32,000 + 20,000 = 13,000 units

Contribution per unit 4
(iv) Margin of safety
Selected level of activity - BEP in units 13,000 - 8,000 = 5,000 units
56
5. Audiomax Ltd
(a)
Audiomax Ltd
Marginal cost statement (1 unit)
Premier Deluxe Superior
£ £ £
Selling price 100 150 240
Variable costs
Direct materials (30) (40) (50)
Direct labour (30) (50) (120)
Direct expenses (10) (25) (24)
(70) 115) (194)
Contribution 30 35 46
(b) Contribution per £1 direct materials
Direct materials 30 = £1.00 40 = £0.88 50 = £0.92
st rd nd
Ranking 1 3 2
Therefore, if direct materials are a limiting factor, maximise production of Premier, followed by Superior;
reduce production of Deluxe.
(c) Contribution per £1 direct labour
Direct labour 30 = £1.00 50 = £0.70 120 = £0.38
st nd rd
Ranking 1 2 3
Therefore, if direct labour is a limiting factor, maximise production of Premier, followed by Deluxe;
reduce production of Superior.
d) Other considerations (indicative)
 The analysis does not take into account that more than one of the two limiting factors identified
may arise.
 Management may have overlooked other limiting factors (eg constraints on production capacity,
constraints on sales capacity, obsolescence of its products through development of new
technology).
 All the revenue and expenditure used in budgets is based on estimates and their utility depends
on how realistic they are.
 Budgeted figures are only useful if there is frequent monitoring against actual figures and action
taken to remedy any adverse variances.
 Budgeted figures may be difficult to predict for a new business or an existing business in a volatile
market.
57
16. Budgetary planning and control
1. Describe the main stages in budgetary control and the specific purposes of a system of budgetary
control.
Budgetary control is the process by which financial control is exercised within an organization.
Budgets for income and expenditure for each function of the organization are prepared in advance of
an accounting period and are then compared with actual performance to establish any variances.
Individual function managers are made responsible for the controllable costs within their budgets, and
are expected to take remedial action if the adverse variances are regarded as excessive (Law, 2010,
p. 67). The main stages in budgetary control are:
 Consult with managers to make assumptions and predictions about markets and business
environment
 Set financial objectives in the form of detailed budgets for income and expenditure for each
function of the business
 Once the budget period begins, continuously compare actual performance against the budget
 Revise the budget or take remedial action to ensure financial objectives are achieved
The overall purpose of budgetary control is to help managers plan and control the use of resources in
a systematic and logical manner. This helps ensure that they achieve their financial objectives, which
are t
 Profit satisficing (making a satisfactory level of profit)

 Profit maximisation (making the maximum profit)
The overall purpose of budgetary control is to help managers to plan and control the use of resources.
However, there are a number of more specific purposes.
 A formal system of budgetary control enables an organization to carry out its planning in a
systematic and logical manner.
 Control can be achieved only by setting a plan of what is to be accomplished in a specified
time period and managers regularly monitoring progress against the plan, taking corrective
action where necessary.
 By setting plans, the activities of the various functions and departments can be co-ordinated.
For example, the production manager can ensure that the correct quantity is manufactured to
meet the requirements of the sales team, or the accountant can obtain sufficient funding to
make adequate resources available to carry out the task, whether this is looking after children
in care or running a railway network.
 A budgetary control system is a communication system that informs managers of the
objectives of the organization and the constraints under which it is operating. The regular
monitoring of performance helps keep management informed of the progress of the
organization towards its objectives.
 By communicating detailed targets to individual managers, motivation is improved. Without a
clear sense of direction, managers will become demotivated.
 By setting separate plans for individual departments and functions, managers are clear about
their responsibilities. This allows them to make decisions within their budget responsibilities
and avoids the need for every decision to be made at the top level.
 By comparing actual activity for a particular period of time with the original plan, any variance
(difference), expressed in financial terms, is identified. This enables managers to assess their
performance and decide what corrective action, if any, needs to be taken.
 By predicting future events, managers are encouraged to collect all the relevant information,
analyse it and make decisions in good time.
58
 An organization is made up of a number of individuals with their own ambitions and goals.
The budgetary control process encourages consensus by modifying personal goals and
integrating them with the overall objectives of the organization. Managers can see how their
personal aims fit into the overall context and how they might be achieved.
2. Describe the advantages and disadvantages associated with systems of budgetary control.
The main advantages of budgetary control systems are:
 All the various functions and activities of the organization are co-ordinated.
 Accounting information is provided to the managers responsible for income and expenditure
budgets to allow them to conduct variance analysis.
 Capital and effort are used to achieve the financial objectives of the business.
 Managers are motivated through the use of clearly defined objectives and the monitoring of
achievement.
 Planning ahead gives time to take corrective action, since decisions are based on the
examination of future problems
 Control is achieved if plans are reviewed regularly against performance
 Authority for decisions is devolved to the individual managers.
The main disadvantages are:
 Managers may be constrained by the original budget and not take effective and sensible
decisions when the circumstances warrant it. For example, they might make no attempt to
spend less than maximum or make no attempt to exceed the target income.
 Time spent on setting and controlling budgets may deflect managers from their prime
responsibilities of running the business.
 Plans may become unrealistic if fixed budgets are set and the activity level is not as planned.
This can lead to poor control.
 Managers may become demotivated if budgets are imposed by top management without
consultation or if fixed budgets cannot be achieved due to a lower level of activity beyond
their control.
3. Explain the difference between a fixed budget and a flexible budget, using an example to illustrate
your answer.
A fixed budget is ‘a budget that does not take into account any circumstances resulting in the actual
levels of activity achieved being different from those on which the original budget was based.
Consequently, in a fixed budget the budget cost allowances for each cost item are not changed for the
variable items’ (Law, 2010, p. 193). It can be contrasted with a flexible budget, which is ‘a budget that
takes into account the fact that values for income and expenditure on some items will change with
changing circumstances. Consequently, in a flexible budget the budget cost allowances for each
variable cost item will change to allow for the actual levels of activity achieved’ (Law, 2010, p. 195).
Example should show how a flexible budget changes in accordance with activity levels and reflects
the different behaviours of fixed and variable costs.
59
4. Leisure Magazines Ltd
Answer should be in the form of a report. A variety of approaches can be taken, but a useful method
of analysis is to use the list of features that describe an effective system of budgetary control given in
the chapter. Recommendations will depend on the assumptions made, but should be credible and set
within a business context.
5. John’s Bikes Ltd
John’s Bikes Ltd

Cash flow budget for 3 months ending 31 March 2014
January February March Total
£ £ £ £
Cash inflows
Capital 25,000 0 0 25,000
Loan 25,000 0 0 25,000
Cash sales 30,000 30,000 30,000 90,000
Credit sales 0 5,000 5,000 10,000
80,000 35,000 35,000 150,000
Cash outflows
Purchases 0 0 10,000 10,000
Rent and rates 24,000 0 0 24,000
Insurance 500 500 500 1,500
Advertising 1,000 0 0 1,000
Telephone and Internet 100 100 100 300
Salaries 6,100 6,100 6,100 18,300
Lighting and heating 200 200 200 600
Interest on loan 125 125 125 375
Equipment 12,000 0 0 12,000
Fixtures and fittings 20,000 0 0 20,000
Drawings 2,500 2,500 2,500 7,500
Subtotal 64,025 7,025 17,025 88,075
Net cash flow 15,975 27,975 17,975 61,925
Cumulative cash b/f 0 15,975 43,950 0
Cumulative cash c/f 15,975 43,950 61,925 61,925
60
John's Bikes Ltd Budgeted statement of comprehensive

income for 3 months ended 31 March 2014
£
Revenue 105,000
Gross profit 85,000
Expenses
Insurance (1,500)
Advertising (1,000)
Salaries (18,300)
Depreciation (W2) (1,750)
(29,450)
Finance costs (375)
Profit before tax 55,175
John's Bikes Ltd

Budgeted statement of financial position at 31 March 2014
£
ASSETS
Non-current assets
Plant, property and equipment (W2) 30,250
Current assets
Inventory 10,000
Trade receivables 5,000
Prepayments 18,000
Cash 61,925
94,925
Total assets 125,175

Equity
80,175
Non-current liabilities
Loan 25,000
Current liabilities
Trade payables 20,000
Carrying
Working 1 £ Working 2 Cost Deprecn amount
Purchases 30,000 £ £ £
Closing inventory (10,000) Equipment (÷ 4 years) 12,000 (750) 11,250
Cost of sales 20,000 Fixtures and fittings (÷ 5 years) 20,000 (1,000) 19,000
PPE (for 3 months) (1,750) 30,250
61
17. Standard costing
1. Direct materials price variance = (SP - AP)  actual quantity
= (£4 - £3)  5 kilos

= £5 favourable
Possible reasons are the use of inferior quality materials, a cheaper supplier or bulk discounts.
2. Direct materials usage variance = (SQ - AQ)  standard price
= (1,000 tonnes – 995 tonnes)  £50

= £250 favourable
Possible reasons are the use of better quality materials with less wastage.
3. Direct materials price variance = (SP - AP)  actual quantity
= (£100 - £98)  52 kilos

= £104 favourable
Direct materials usage variance = (SQ - AQ)  standard price

= (50 kilos – 52 kilos)  £100 Note: SQ = 200 kilos
= (£200) adverse 4 units
Total direct materials cost variance = price variance + usage variance

= £104 – £200 (favourable price variance but adverse usage variance)
= (£96) adverse
Possible reasons are the use of inferior materials leading to higher wastage than planned, use of a
new supplier who provides materials with a slightly different specification, leading to higher usage.
Higher marks can be achieved for suggesting where the responsibility lies and for making
recommendations for further action.
4. Direct labour efficiency variance = (SH – AH)  standard rate per hour
= (500 hours – 460 hours)  £9

= £360 favourable
Direct labour rate variance = (SR - AR)  actual hours

= (£9 - £11)  460 hours Note: AR = £5,060
= (£920) adverse 460 hours
Total direct labour variance = efficiency variance + rate variance

= £360 - £920 (favourable efficiency variance but adverse rate variance)
= (£560) adverse
Possible reasons are that more highly skilled labour has been employed than planned and their output
has been greater. Perhaps unplanned bonus payments have been made to encourage higher levels
of productivity. The effect of these actions has led to an overall adverse variance of £560 and higher
marks should be given for suggesting what possible actions can be taken to remedy the situation.
62
5. Aphrodite Ltd
The answer needs to identify the general advantages of a standard costing system and include a
discussion of the processes involved in setting ideal or attainable standards and the information the
system should produce in terms of variances. For higher marks, the answer should relate to the
particular context (eg by discussing the setting of separate standards for glass and aluminium). It
should also take into account that there are two products, with the deluxe product using more
expensive materials.
63
18. Capital investment appraisal
1. Explain the purpose of capital investment appraisal in general. In addition, explain the purpose of
the payback period method and the accounting rate of return.
The purpose of capital investment appraisal is to provide information to management that will help
them decide which of several proposed capital investment projects is likely to yield the highest
financial return. Capital expenditure is the outlay of a considerable amount of money on a project such
as the purchase of a new non-current asset (eg buying a new factory), the enhancement of an
existing non-current asset (eg extending the existing factory) or investment in a new business venture.
The purpose of payback period method is to calculate the time required before the projected cash
inflows for a project equal the investment expenditure so that the project that takes the shortest
possible time can be chosen. Whereas the payback period focuses on cash, the accounting rate of
return is a ratio that focuses on profit. The purpose of the accounting rate of return is to measure the
relationship between the profit before interest and tax for a period and the capital employed at the end
of that period so that management can choose the project with the highest rate of return.
2. Describe the advantages and disadvantages of the payback period method and the accounting
rate of return.
The main advantages of the simple payback period method are that it is simple to calculate and the
results are easy to understand. In addition, it is useful for comparing risky projects where the
prediction of cash flows after the first few years is difficult (eg due to possible changes in the business
environment, such as advances in technology that could make a product obsolete in a short time). It is
also useful if short-term cash flows are more important than long-term cash flows or if borrowing or
gearing is a concern.
On the other hand, there are a number of disadvantages. It is difficult to estimate the amount and
timing of future cash flows and the method ignores cash flows after the payback period. It also ignores
the profitability of the project (eg the project with the shortest payback period might be chosen,
although an alternative project with a longer payback period might be more profitable). In addition, the
method ignores the size of the investment (eg the project with a smaller initial investment may have a
shorter payback period than an alternative project that requires a larger investment but is more
profitable in the long term). A key disadvantage is that the simple payback period ignores the time
value of money because it gives net cash flows in later years the same importance as those in Year 1.
The main advantages of the accounting rate of return are that, like the simple payback period method,
the calculations are simple and the results are easy to understand. However, it offers the added
advantage that the entire life of the project is taken into account. It also useful because it is
compatible with the financial accounting ratio, return on capital employed, which is used to assess the
financial performance of the business. The main disadvantages of the accounting rate of return are
that, like all ratios, there is no standard definition of terms used in the formula, which renders
comparison with ratios based on other definitions unreliable. A further disadvantage is that the ratio is
based on averages, which can be misleading as they are hypothetical values and the actual figure in
any year may be higher or lower. In addition, the method does not take account of the benefit of
earning a larger proportion of the total profit in the early years of the project, the fact that a crucial
factor in investment decisions is cash flow or the timing of profits or cash. Finally, the results are
difficult to interpret because there is no guidance on what is an acceptable rate of return and, like the
simple payback period, the accounting rate of return does not take account of the time value of money.
64
3. Jeffery’s Boatyard Ltd
Project 1 Project 2
Net cash flow Cumulative Net cash flow Cumulative
net cash flow net cash flow
Year £ £ £ £
0 (500,000) (500,000) (500,000) (500,000)
1 80,000 (420,000) 90,000 (410,000)
2 100,000 (320,000) 110,000 (300,000)
3 180,000 (140,000) 190,000 (110,000)
4 140,000 0 110,000 0
5 100,000 100,000 80,000 80,000
(a) Both projects have a payback period of 4 years, so either could be chosen.
(b) Project 1 gives the largest cash return over the entire life of the project, but Project 2 is also
worthwhile as the largest cash flows are in early years. This may be more important if liquidity
is a problem and the business recognises the importance of the time value of money. Neither
of these factors is incorporated in the simple payback period technique.
(c) Students should refer to the other limitations mentioned in the text and wider reading.
4. Film Animation Ltd
Project A Project B
£ £
Average sales revenue 318,500 358,000
Average costs and expenses (240,500) (264,400)
Average profit before interest and tax 78,000 93,600
Average capital employed 650,000 780,000
Average PBIT  100 78,000  100 93,600  100

Average CE 650,000 780,000
ARR = 12% = 12%
(a) Both projects have an accounting rate of return of 12%. Therefore, on the basis of this
technique they are identical.
(b) Some businesses may choose Project A, if they can invest the £130,000 not required in
another project that provides a return in excess of 12%.
(c) Students should refer to the limitations mentioned in the text and wider reading.
65
5. Wren Electronics Ltd
(a) Equipment 1 Equipment 2

Year Net cash flow Cumulative Net cash flow Cumulative
net cash flow net cash flow
£ £ £ £
0 (50,000) (50,000) (50,000) (50,000)
1 5,000 (45,000) 20,000 (30,000)
2 17,000 (28,000) 30,000 0
3 42,000 14,000 20,000 20,000
4 30,000 44,000 20,000 40,000
5 10,000 54,000 20,000 60,000
Payback period:
2+ 28,000 = 2.67
28,000 + 14,000
= 2 years 8 months = 2 years

nd
Ranking 2 1st
(b)
Depreciation £50,000 - £0 = £10,000 pa

5
Equipment 1 Equipment 2
Year Net cash flow PBIT Net cash flow PBIT
£ £ £ £
1 5,000 (5,000) 20,000 10,000
2 17,000 7,000 30,000 20,000
3 42,000 32,000 20,000 10,000
4 30,000 20,000 20,000 10,000
5 10,000 0 20,000 10,000
Total 54,000 60,000
Average (÷ 5) 10,800 12,000
ARR:
Av PBIT  100 10,800  100 = 22% 12,000  100 =24%
Av CE 50,000 50,000
nd st
Ranking 2 1
(c) The results of this analysis show that Equipment 2 is likely to be the better investment. The
payback period method shows that Equipment 2 has the shorter payback period (only 2 years
compared to 2 years and 8 months for Equipment 1) and the accounting rate of return shows
that Equipment 2 is likely to give a higher return on the capital invested (24% compared to 22%
for Equipment 1).
(d) Students should refer to the limitations mentioned in the text and wider reading.
66
19. Discounting methods of investment appraisal
1. Describe the advantages and disadvantages of using discounted cash flow techniques for capital
investment appraisal.
The main advantage of discounted cash flow methods is that they use the concept of the time value of
money. This is the concept that cash received earlier is worth more than a similar sum received later,
because the sum received earlier can be invested to earn interest in the intervening period (Law,
2010). The net present value and internal rate of return methods take account of the entire life of the
project, but the discounted payback period only considers the project up to the payback period. All
three methods are useful because they allow comparisons to be made with other opportunities.
However, the main disadvantages of discounted cash flow methods are that it is difficult to determine
the appropriate interest rate to use and predict the cash inflows and outflows over the life of the
project. In addition, the calculations are complex and managers may have difficulty in understanding
the results. A final limitation is that these methods do not take account of non-financial factors (eg the
flexibility of the plant and equipment purchased).
2. Compare the net present value method with the internal rate of return.
The net present value ‘is a method of capital budgeting in which the value of an investment is
calculated as the total present value of all cash inflows and cash outflow minus the cost of the initial
investment’ (Law, 2010, p. 293). On the other hand, the internal rate of return is ‘an interest rate that
gives a net present value of zero when applied to a projected cash flow of an asset, liability, or
financial decision’ (Law, 2010, p. 242). Both are discounted cash flow techniques that are based on
the concept of the time value of money. This is the concept that cash received earlier is worth more
than a similar sum received later, because the sum received earlier can be invested to earn interest in
the intervening period (Law, 2010). Although both methods take account of the entire life of the project,
it is difficult to determine the appropriate interest rate to use and predict the cash flows over the life of
the project. In addition, the calculations are complex and managers may have difficulty in
understanding the results. A final limitation is that these methods do not take account of non-financial
factors (eg the flexibility of the plant and equipment purchased). A survey of UK and international
members of CIMA (2009) showed that net present value is the most widely used method.
67
3. Melrose Events
Year Net cash flow Cumulative Discount Present

net cash flow factor value
£ £ 12% £
0 (10,000) (10,000) 1.000 (10,000)
1 (4,000) (14,000) 0.893 (3,572)
2 (1,000) (15,000) 0.797 (797)
3 3,000 (12,000) 0.712 2,136
4 6,000 (6,000) 0.636 3,816
5 8,000 2,000 0.567 4,536
NPV (3,881)
Simple payback period:
4 years + 6,000
6,000 + 2,000
= 4.75 years
(a) The payback period is 4 years and 9 months and the NPV is a negative £3,881.
(b) The results are contradictory. The payback period suggests that the project is worthwhile, but
the NPV is negative. Kerry should not go ahead with the project because the NPV shows that
when the time value of money is taken into account by discounting the predicted net cash
flows, the project is not viable.
(c) Kerry should check the basis of her figures carefully to ensure that her estimates are realistic,
that all possible future cash flows have been included and she has considered non-financial
factors that may have an impact on the project. Students should refer to the limitations
mentioned in the text and wider reading.
68
4. Stuart’s Boatyard Ltd
Project 1 Project 2
Discount Cash flow Discounted Cumulative Cash flow Discounted Cumulative
factor cash flow cash flow cash flow cash flow
Year 6% £ £ £ £ £ £
0 1.000 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000)
1 0.943 80,000 75,440 (424,560) 90,000 84,870 (415,130)
2 0.890 100,000 89,000 (335,560) 110,000 97,900 (317,230)
3 0.840 180,000 151,200 (184,360) 190,000 159,600 (157,630)
4 0.792 140,000 110,880 (73,480) 110,000 87,120 (70,510)
5 0.747 100,000 74,700 1,220 80,000 59,760 (10,750)
Discounted payback period:

4 years + 73,480
73,480 + 1,220
= 4.98 years
(a) The discounted payback period for Project 1 is just under 5 years, but the investment in Project 2
will not be recovered within the life of the project.
(b) Project 1 would be feasible as it has a discounted payback period of just under 5 years. However,
the investment would not be recovered until the final month of the project. On the other hand,
Project 2 should be rejected as the payback period based on an interest rate of 6% shows that
the capital would not be recovered. Some students may point out that cumulative net cash flow for
Project 1 by the end of year 5 represents a positive NPV for the project, although this decision is
not part of the payback period method.
(c) Students should refer to the limitations mentioned in the text and wider reading.
69
5. Bloomfield Laundry Ltd
The following model answer compares the required interest rate of 15% with a rate of 25%, which
was arrived at by chance. Students may show other interest rates arrived at through trial and error.
Discount Cash Present Cumulative Discount Present Cumulative

Year factor flow value cash flow factor value cash flow
15% £ £ £ 25% £ £
0 1.000 (50,000) (50,000) (50,000) 1.000 (50,000) (50,000)
1 0.870 10,000 8,700 (41,300) 0.800 8,000 (42,000)
2 0.756 25,000 18,900 (22,400) 0.640 16,000 (26,0000
3 0.658 25,000 16,450 (5,950) 0.512 12,800 (13,200)
4 0.572 20,000 11,440 5,490 0.410 8,200 (5,000)
5 0.497 10,000 4,970 10,460 0.328 3,280 (1,720)
NPV 10,460 NPV (1,720)
Discounted payback period:

3 years + 5,950 .
5,950 + 5,490
= 3.52 years
Internal rate of return (IRR) 15 +  10,460  10

10,460 + 1,720 
= 23.59%
(a) Using an interest rate of 15% the discounted payback period is just over 3½ years, the NPV is
£10,460 and the IRR is 23.59%.
(b) The discounted payback period using an interest rate of 15% is just over 3½ years, which
makes the project worthwhile. The NPV is positive and shows a likely return of 15% plus
£10,460. The IRR shows the return is likely to be 23.59%. These results suggest that the
investment in the new dryers will be financially viable.
(c) Aunt Laura should check the basis of her figures carefully to ensure that her estimates are
realistic, that all possible future cash flows have been included and that she has considered
non-financial factors that may have an impact on the project. Students should refer to the
limitations mentioned in the text and wider reading.
70
20. Issues in management accounting
1. Describe the target costing process. Explain its advantages over a cost-plus approach to product
or service pricing.
The main steps in target costing are:
 Develop a product that satisfies the needs of customers. It is essential that any new product
or service offers a bundle of attributes that are superior to those of competitors.
 Determine an appropriate target price for the product based on customer’s perceptions of the
value of its attributes, the price of competing products and the target profit per unit. This
requires an assessment of the market price that is appropriate for bundle of attributes it offers
and the competition it faces.
 Calculate the target cost after allowing for target profit (target price minus target profit). The
entity must provide a return that is appropriate for the level of risk inherent in the business.
 Use value engineering and SMA techniques to achieve the target cost per unit.
Under cost-plus pricing, the cost of producing the product or service dictates the selling price of the
product or service. As markets are now increasingly competitive, prices should be determined through
analysis of prevailing market forces and the competitiveness of the product or service, rather than
being driven by the cost of production or service delivery. In a target costing framework, the selling
price of a product or service is seen as constrained by the market and the target cost is the goal that
an organisation must achieve to meet its strategic objectives.
2. Explain the purpose of environmental management accounting and explain how it can be used to
assist in the management and control of environmental costs.
Environmental management accounting (EMA) involves the identification, collection, analysis and use
of non-financial and financial information for managing the environmental costs and impacts of
business operations. The need for EMA is based on the premise that traditional management
accounting systems cannot be used to measure environmental issues as they hide environmental
costs as overheads, thereby obscuring their size and origin. Environmental costs are not typically
allocated or apportioned in an appropriate manner as they are not made the responsibility of the
department or product that causes them. EMA aims to make environmental issues visible in all areas
of organisational and operational decision-making and permit them to be managed effectively.
Corporate responses to green pressures largely involve the use of non-accounting expertise and non-
financial information systems. Indicative of the current use of ‘non-accounting’ methods to tackle
internal environmental issues is the way that many organisations have implemented environmental
management systems (EMS) certified to the ISO 14001 standard (BSI, 2004). Such EMS are typically
structured as an extension of either existing health and safety or TQM systems, rather than becoming
a routine part of the finance function.
71
3. Stunt Ltd
(a)
Attributes
Components of cost Safety Style Performance Importance % of total Strategic
10.0% 40.0% 50.0% index cost cost index
Handlebars & steering 40% 20% 40% 0.320 33.33% 0.96
Footplate 40% 60% 20% 0.380 50.00% 0.76
Wheels & suspension 20% 20% 40% 0.300 16.67% 1.80
Total 100% 100% 100% 1.000 100.00%
With the highest importance index of 38% (0.380), the aluminium footplate component is the
largest provider of the attributes that customers desire, although all three components have an
importance level of at least 30%. The importance index of 0.320 for handlebars and steering is
calculated as: (Safety 10% x 40%) + (Style 40% x 20%) + (Performance 50% x 40%) = 0.320.
(b) The strategic cost index (SCI) is calculated as the relative importance of the attribute divided by
the cost of providing that attribute. The strategic cost index of 0.96 for handlebars and steering is
calculated as 0.320 importance index ÷ 0.3333 of total cost = 0.96. Management should redesign
or re-engineer products to focus on the attributes with the highest SCI results and consider ways
of eliminating attributes with very low SCI scores. The strategic cost index (SCI) results indicate
that the wheels and suspension component provides customers with substantial product benefits
for a relative inexpensive target cost. On the other hand, the footplate is relative costly compared
to the product attributes it provides customers (a SCI of 0.76 is relatively low).
72
4. Electro Ltd
(a) Cost of quality report

2012 % of 2011 % of
£ Revenue £ Revenue
Prevention costs
Quality Engineering 770,000 520,000
Quality training 1,100,000 700,000
Supplier Reviews 200,000 50,000
Total 2,070,000 3.34% 1,270,000 2.24%
Appraisal costs
Depreciation of test equipment 370,000 270,000
Inspection 150,000 80,000
Product testing 670,000 700,000
Total 1,190,000 1.92% 1,050,000 1.85%
Internal failure cost
Retesting 480,000 1,250,000
Rework 580,000 770,000
Total 1,060,000 1.71% 2,020,000 3.56%
External failure costs
Cost of customer complaints department 270,000 480,000
Lost contribution from lost sales 823,000 1,790,000
Product recall 360,000 920,000
Warranty repairs 240,000 320,000
Total 1,693,000 2.73% 3,510,000 6.19%
Total cost of quality 6,013,000 9.70% 7,850,000 13.84%
(b) During the past year the company has significantly increased its spending on prevention costs
and it has increased its spending on appraisal costs. This increased emphasis on prevention and
appraisal has caused overall quality costs to decline to 9.70% of annual revenue during 2012
(13.84% in 2011). The company has a better distribution of quality costs in 2012 with most of the
company's quality costs traceable to internal and external failure, rather than to prevention and
appraisal. Due to the increased spending on prevention and appraisal activities during 2012,
internal failure costs decreased to £1.06 million (£2.02 million in 2011). External failure costs have
fallen from £3.51 million in 2011 to just £1.693 million during 2012. If the company continues its
emphasis on prevention activities in future years, appraisal costs and internal failure costs should
decline further. As quality is built into products through better engineering and design, and as
better process control is maintained, then defects should decrease. Thus, internal failures-and the
need to detect these failures through appraisal activities-will also decrease.
73
5. Contain Ltd
(a) The company’s strategy for 2012 is a cost leadership strategy and it plans to grow by producing
high-quality containers at a low cost delivered to customers in a timely manner. The company’s
containers are not differentiated and there are ten other manufacturers producing containers with
similar product attributes. To succeed, the company must achieve lower costs relative to
competitors through improvements in manufacturing, productivity and efficiency.
(b)
BSC Perspective Possible measures

Financial perspective Operating income from productivity gain – target £150,000
Operating income from growth – target £300,000
Cost reductions in key areas – increased yield on steel – target £50000
Customer perspective Market share of cost conscious consumers,
New customers
Customer satisfaction
Customer retention/repeat customers and number of on-time orders
Time taken to fulfil customer orders
Internal business Yield on steel
processes Order fulfilment time
On-time delivery
% of defective containers per 1,000 units
Productivity
Learning and growth % of staff trained in TQM techniques
Employee retention
Employee satisfaction
(c) Students should briefly explain the rationale for selecting the measures and comment on the
cause and effect relationship between them.
(d) The potential benefits are that in contrast to traditional performance measurement systems that
solely focus on the achievement of financial objectives, the BSC combines financial and non-
financial performance measures and evaluates short, medium and long-term performance
measures in a single cohesive report. As a result, the technique focuses on the non-financial
objectives that an organisation must achieve in order to meet its financial objectives. The logic for
this is that non-financial and operational indicators can capture improvements in performance that
short-term financial measures may not. Thus, BSC provides an appropriate balance and link
between non-financial and financial performance measures, as non-financial performance
improvements must eventually lead to tangible pay-offs. By using a balanced scorecard, the
company can be sure that any strategic action matches the desired outcomes. A BSC system
allows management to communicate strategy to employees by translating it into performance
measures that they understand and can influence, and it prevents sub-optimal trade-offs and
inappropriate cost cutting (eg cutting R&D expenditure during a recession). In addition, BSC
offers the advantage that it concentrates solely on the critical measures of performance.
However, the company should be aware that there is much debate over whether there is a cause-
and-effect relationship between the four perspectives in the balanced scorecard. At a conceptual
level, there is only a logical rather than a causal relationship between non-financial performance
measures and future financial performance (Norreklit, 2000). For example, the production of high
quality products does not always result in increased profit, especially when customers are
unwilling to pay for such improvements. Furthermore, in many instances, a loyal and highly
satisfied customer may not be a profitable one, as they may require many hours of costly
customer service time. It may be confusing to mix subjective performance measures (eg customer
satisfaction levels) and objective performance measures (eg. increased revenue) as it may not be
possible to assess the time lag between each cause-and-effect between measurements.
74
A further criticism of the BSC is that if too many performance measures are used, it will produce
confusing and conflicting data. Moreover, since financial measures are normally used to evaluate
the performance of managers, management may attach less importance to improving non-
financial performance. Other limitations include the exclusion of other stakeholder perspectives
(eg suppliers and employees), it can be costly to implement in terms of resources and
management time, and that it needs to fit the organisation’s culture.
75
A1. Financial statements for a partnership
1. H&G Tool Hire
H&G Tool Hire

Statement of comprehensive income for
the year ended 31 December 2013 (extract)
£
Interest on drawings Harry 1,500
George 1,000
97,500
Salaries Harry (15,000)
George (10,000)
Interest on capital Harry (1,000)
George (3,000)
Balance of profits to be shared 68,500
Harry 60% 41,100
George 40% 27,400
68,500
2. H&G Tool Hire
Current accounts
Harry George
£ £
Salaries 15,000 10,000
Interest on capital 1,000 3,000
Share of profits 41,100 27,400
57,100 40,000
Interest on drawings (1,500 (1,000)
Drawings (35,000) (32,000)
Closing balance 20,600 7,000
76
3. J&B Services
Goodwill working
£
Total net assets of the new partnership (£2000,000 x 3) 600,000
Net assets + investment by new partner (£120,000 x 2) + £200,000 (440,000)
Goodwill 160,000
Goodwill account
£ £
Jarvis 80,000
Berry 80,000
Capital account: Jarvis

£ £
Opening balance 120,000
Goodwill 80,000
Capital account: Berry

£ £
Opening balance 120,000
Goodwill 80,000
Capital account: Coyle

£ £
Bank 200,000
4. Page & Partners
Statement of comprehensive income for

the year ended 31 December 2012 (extract)
£
Profit for the year 131,950
Interest on drawings (5%) Page 2,750
Jones 1,000
Beattie 1,400
137,100
Salaries Page (15,000)
Jones (10,000)
Beattie (10,000)
Interest on capital (10%) Page (5,000)
Jones (7,500)
Beattie (8,500)
Balance of profits to be shared 71,100
Page 33% 23,700
Jones 33% 23,700
Beattie 33% 23,700
71,100
77
Current accounts
Page Jones Beattie
£ £ £
Opening balance 4,500 2,000 5,000
Salaries 15,000 10,000 10,000

Interest on capital 5,000 7,500 8,500
Share of profits 23,700 23,700 23,700
48,200 43,200 47,200
Interest on drawings (2,750) (1,000) (1,400)

Drawings (55,000) (20,000) (28,000)
Closing balance (9,550) 22,200 17,800
5. Mourne, Noonan & Knight
Realisation account
£ £
Premises 50,000 Bank: Sale of premises 47,500
Stock 48,600 Bank: Sale of stock 41,100
Debtors 28,200 Bank: Debtors realised 26,800
Loss on realisation: Mourne 3,800
Noonan 3,800
Knight 3,800
126,800 126,800
Bank account
£ £
Realisation: Premises 47,500 Opening balance 28,700
Realisation: Stock 41,100 Creditors 78,300
Realisation: Debtors 26,800 Payment to Mourne 5,400
______ Payment to Noonan 3,000
115,400 115,400
Capital accounts
Mourne Noonan Knight Mourne Noonan Knight
£ £ £ £ £ £
Loss on realisation 3,800 3,800 3,800 Opening balance 8,000 6,000 2,000
Knight* 800 600 Current accounts 2,000 1,400 400
Bank 5,400 3,000 Mourne* 800
Noonan* 600
8,000 7,400 44,700 10,000 7,400 3,800
* Garner v. Murray (1904) requires that losses are shared in the ratio of the partners’ capital accounts
(not their profit-sharing ratios).
78
A2. Costing for specific orders and continuous processes
1. Distinguish between normal loss and abnormal loss, and explain their costing treatments.
The main points are as follows:
Normal loss is ‘the loss arising from a manufacturing or chemical process through waste, seepage,
shrinkage, or spoilage that can be expected, on the basis of historical studies, to be part of that
process. It may be expressed as a weight or volume or in other units appropriate to the process. It
is usually not valued but if it is, a notional scrap value is used’ (Law, 2010, p. 299). On the other
hand, abnormal loss is ‘the loss arising from a manufacturing or chemical process through
abnormal waste, seepage, shrinkage, or spoilage in excess of the normal loss. It may be
expressed as a weight or volume or in other units appropriate to the process; it is usually valued
on the same basis as the good output’ (Law, 2010, p. 1).
2. Imprint Ltd
Imprint Ltd
Job 213 – Wedding invitations
£
Materials 30
Wages (£5  4 hours) 20
Production overheads (£2.50  4 hours) 10
Production costs 60
General overheads (20%) 12
72
Profit (25%) 18
90
3. Townday Building Ltd
Townday Building Ltd

Contract No. 33 – Grove Lane
£
Cost of work done: Work certified 140,000
Work not certified 34,000
174,000
Estimated contract profit: Contract price 320,000

Estimated total costs 260,000
60,000
Profit at year end: £174,000  £60,000 = £40,150

£260,000
79
4. Pollution Control Ltd
£
Technician’s wages 12,000
Materials 2,500
Overheads 15,500
Total annual cost 30,000
Monthly cost (£30,000) = £2,500

12
Cost per test £2,500 = £10.42

240
5. Chris Paul (Processing) Ltd
Chris Paul (Processing) Ltd

Process 2 – Costs for August
Total cost Completed Equivalent Effective Cost Value of
units units in WIP units per unit WIP
£ £ £
Previous process 910,500 12,200 3,800 16,000 56.91 216,244
costs
Materials introduced 49,500 12,200 3,800 16,000 3.09 11,756
Labour and 701,200 12,200 (50%) 1,900 14,100 49.73 94,488
overheads
1,671.200 109.73 322,488
£
Value of completed units (12,200  £109.73) 1,338,712
Value of WIP (see last column) 322,488
Total cost 1,661,200
80

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Business Accounting – Answers to Practice Questions

Introduction to the second edition

Business Accounting is an accessible, non-technical introduction to financial and

Part I The world of accounting and finance ........................................................... 3

Part II Financial accounting ..................................................................................... 7

Part III Management accounting ........................................................................... 43

Part I The world of accounting and finance

1. Introduction to business accounting

2. The importance of cash

2. Explain the theory of the finance gap.

Part II Financial accounting

3. The accounting system

1. Wellworth Fencing Ltd

Lorry insurance account

Timber Supplies Ltd account

2. Lavender & Lace Ltd

Window cleaning account

3. Burton’s Books Ltd

O’Neill Ltd account

5. Hampton Health Food Ltd

Hampton Health Food Ltd

4. Regulatory framework for financial reporting

The key elements of the regulatory framework in the UK are:

An accounting standard is an authoritative statement on how a particular type of transaction or other

Direct advantages of IFRSs:

Indirect advantages of IFRSs:

Immediate disadvantages of IFRSs:

Longer-term disadvantages of IFRSs:

5. Conceptual framework for financial reporting

Fundamental qualitative characteristics:

 Relevance – Relevant financial information is capable of making a difference to users’ decisions.

Enhancing qualitative characteristics:

Element of financial position (IASB, 2010, para 4.4):

Elements of financial performance (IASB, 2010, para 4.25):

6. Statement of comprehensive income

(a) (b) (c) (d) (e)

(f) (g) (h) (i) (j)

Working 2 Trial balance Accrued Prepaid Total

Working 2 Trial balance Accrued Prepaid Total

Working 2 Trial balance Accrued Prepaid Total

Working 5 Amount Distribution Administrative Finance

7. Statement of financial position

(a) (b) (c) (d) (e)

EQUITY AND LIABILITIES

EQUITY AND LIABILITIES

Working 2 Trial balance Accrued Prepaid Total

EQUITY AND LIABILITIES

Working 2 Trial balance Accrued Prepaid Total

EQUITY AND LIABILITIES

Working 2 Trial balance Accrued Prepaid Total

Working 6 Amount Distribution Administrative Finance

Beauty Box Ltd

EQUITY AND LIABILITIES

Working 2 Year Opening Provision for Closing

8. Consolidated statement of financial position

(b) Consolidated statement of Major Minor W1 W2 W3 W4 Group

EQUITY AND LIABILITIES

W4 accounts for the 50% impairment of goodwill.

9. Financial statement analysis

2. Adams Ltd and Eve Ltd

(a) Main profitability ratios

3. Ted Baker 2005/06