Accounting Problem Book 2011

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Principles of Accounting

Problem book

V.V. Dobrynskaya, V.V. Poleshchuk

2011

International College of Economics and Finance



2

Introduction to Accounting

Problem 1

You are to complete the gaps

Assets₤

Liabilities₤

Capital₤

(a) 12,500 1,800 ?

(b) 28,000 4,900 ?

(c) 16,800 ? 12,500

(d) 19,600 ? 16,450

(e) ? 6,300 19,200

(f) ? 11,650 39,750

Problem 2

Distinguish from the following list the items that are liabilities from those that are assets:

(a) Office machinery (d) Motor vehicles

(b) Loan from C Shirley (e) We owe for goods

(c) Fixtures and fittings (f) Bank balance

Problem 3

State which of the following are shown under the wrong classification for J White‟s business:

Assets Liabilities

Loan from C Smith Stock of goods

Cash in hand Debtors

Machinery Money owing to bank

Creditors

Premises

Motor vehicles

Problem 4

Mr. S sets up a new business. Before he actually sells anything, he has bought motor vehicle

₤2,000, premises ₤5,000, stock of goods ₤1,000. He did not pay in full for his stock of goods

and still owes ₤400 in respect of them. He had borrowed ₤3,000 from B. After the evens just

described, and before trading starts, he has ₤100 cash in hand and ₤700 cash in bank



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Required:

Calculate the amount of his capital.

Problem 5

Draw up a balance sheet from the following as at 31 December 19X8:

Capital 23,750

Debtors 4,950

Motor vehicles 5,700

Creditors 2,450

Fixtures 5,500

Stock of goods 8,800

Cash at bank 1,250

Problem 6

Complete the columns to show the effects of the following transactions:

Effect upon

Assets Liabilities Capital

(a) We pay a creditor ₤70 in cash.

(b) Bought fixtures ₤200 paying by cheque.

(c) Bought goods on credit ₤275.

(d) The proprietor introduces another ₤500 cash into the firm.

(e) Mr. X lends the firm ₤200 in cash.

(f) A debtor pays us ₤50 by cheque.

Problem 7

C.S. has the following items in his balance sheet as on 30 April 19X8:

Capital ₤20,900; Creditors ₤1,600; Fixtures ₤3,500; Motor vehicle ₤4,200; Stock of goods

₤4,950; Debtors ₤3,280; Cash at bank ₤6,450; Cash in hand ₤120.

During the first week of May 19X8:

(a) He bought extra stock of goods ₤770 on credit.

(b) One of the debtors paid him ₤280 in cash.

(c) He bought extra fixtures by cheque ₤1,000.

Required:

Draw up a balance sheet as on 7 May 19X8 after the above transactions have been completed.



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Problem 8

The following are transactions of the business for a period. You are required to state the effect

of each on the balance sheet items. Be detailed where the capital is affected, showing the type

of effect:

(a) Bought stock in trade on credit terms for ₤1,200.

(b) The owner paid a trade creditor ₤1,500 for some stock in trade bought on credit recently.

Since the owner did not have the business bank account cheque book with him, he drew a

cheque on his personal account.

(c) Stock in trade, which had cost ₤1,700, was sold on credit for ₤2,500.

(d) The owner withdrew ₤500 by drawing a cheque on the business bank account, payable to

himself.

(e) Paid wages of ₤750 by cheque.

(f) Paid bank interest of ₤100 by having amount charged on the business bank account.

(g) Received a ₤2,000 cheque from a trade debtor.

(h) Paid a trade creditor ₤1,200 by a cheque drawn on the business bank account.

Problem 9

Explain:

(a) What is a revenue?

(b) What is an expense?

(c) What is a profit?

(d) The owner pays himself a regular ₤100 from the business account each week, is it an

expense?

(e) Why is the purchase of some stock in trade not an expense?

Problem 10

Explain and provide comments:

(a) Why is it necessary to put a date in the heading of the balance sheet?

(b) Jim just bought a new motor van. Will this have an effect on the balance sheet of his

business?

(c) Comment : “Why is it that my capital is shown with the liabilities in the balance sheet of

my business? Surely it is an asset”.

(d) Which of the following would you expect to find among the items of the balance sheet:- The fact that the business owes money



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- The fact that the owner has very good business skills

- The fact that the demand for the output of the business is expected to increase greatly

in the future leading to a large increase in profits.

- The fact that the assets of the business are highly specialized and in the main part

could only be used for the current purposes.

(e) The total of the balance sheet tells the owner how much his business is worth.

(f) The amount of equity on the balance sheet tells the owner how much his business is worth.

Problem 11

Consulting Agency Balance Sheet as of October 31, 19X3

ASSETS LIABILITIES

Cash ₤1,400 Notes Receivable ₤11,000

Advertising Expense ₤300 Interest Expense ₤2,000

Land ₤31,500 Office supplies ₤800

Salary Expense ₤3,300 Accounts Receivable ₤1,600

Office furniture ₤4,700 Note Payable ₤20,000

Accounts Payable ₤3,000

Utilities Expense ₤1,100 OWNER‟S EQUITY

Equity ₤8,900

Total Assets ₤44,300 Total Liabilities & Equity ₤44,300

The bookkeeper of Consulting Agency prepared the Balance Sheet of the company while the

accounting was ill. The Balance Sheet contains a lot of errors. In particular, the bookkeeper

knew that the Balance Sheet should balance, that‟s why he put in the owner‟s equity the

amount needed to achieve this balance. But in reality the equity data is not correct.

Required:

(a) Prepare the correct Balance Sheet as of October 31, 19X3.

(b) Identify the accounts listed in the balance sheet made by the bookkeeper that should not be

presented on the true Balance Sheet.

(c) Explain why you excluded some accounts from the correct Balance Sheet.

Problem 12

Harold Davies is the owner of a small building firm. He does not understand the item

“balance sheet” and asks you to explain to him whether the following items should be on his



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balance sheet. Indicate the nature of the item (e.g., current asset, long-term liability, not

applicable) and give the reason for your answer.

(a) Inventory of sand and cement

(b) Air compressor purchased for cash

(c) Air compressor hired for three weeks

(d) Wages paid to labourer

(e) Lorry used for transporting materials

(f) Diesel fuel in lorry fuel tanks

(g) Washing machine bought for Mrs. Davies

(h) Bank overdraft

(i) Petty cash in hand

(j) ₤2,000 owing to an uncle who says Harold need not pay until five years later

Problem 13

King Pharmaceuticals plc has just spent £50 million on developing a new medicine that is

expected to yield substantial profits over the next four years. Use this example to help explain

the distinction between the terms 'relevance' and 'reliability' when preparing financial

statements for shareholders. Why are 'relevance' and 'reliability' seem to be important

qualitative characteristics of accounting information?

You should structure your answer well. Your answer should not exceed 250 words.



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Double-Entry Bookkeeping

Problem 14

The transactions of Wheels Repair Shop for January 19X9 are shown below:

January 3 – Debby Star opened a bank account under the name of her new businessand deposited ₤30,000 in cash.

January 4 – She rented a temporary shop and paid ₤300 for the January rent, issued

cheque.

January 5 – Rented automotive tools and equipment until the firm could purchase its

own. Rent in the amount of ₤80 was paid for January, issued cheque.

January 5 – Purchased motorcycle parts and supplies described on invoice from the

Southern Supply Company for ₤400 on account.

January 10 – Purchased land as a prospective building site for ₤10,000. Paid ₤4,000 in

cash and issued a one-year note payable for the balance.

January 12 – Made repairs on George Shipman‟s motorcycle for ₤40. Shipman asked

that a charge account be opened in his name. He promised to settle the account within 30

days. This arrangement was authorized by service manager.

January 26 – Made repairs on Jay Munson‟s motorcycle for ₤180. A charge account

was opened in his name.

January 29 – Purchased motorcycle parts and supplies from Delco Supply House for

₤250 on account

January 29 – Paid the Southern Supply ₤300 on account (cheque)

January 31 – Paid electricity and water bills of ₤80 for January

January 31 – Paid ₤1,700 in salaries for the month

January 31 – Made motorcycle repairs for various cash customers for ₤4,800

January 31 – Debby Star withdrew ₤300 in cash in anticipation that at least as much

income had been earned

January 31 – Purchased automotive tools and equipment for cash ₤4,000. The list price

was 5,000.

January 31 – Paid a premium of ₤600 on a 12 months insurance policy, it becomes

effective on February 1, 19X9.

January 31 – Received a cheque for ₤10 from George Shipman.

Required:

(a) Analyze the transactions using extended accounting equation formula



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(b) Journalize the transactions

(c) Post to the ledger

(d) Prepare a trial balance sheet / footing

(e) Explain adjusting entries

Problem 15

Bill Cashing sets up practice as an architect, transferring ₤20,000 of his own money on 1 June

2003 from this personal bank account into a new business bank account with NatMid Bank

plc to represent the opening capital of the business. The following transactions took place

during June 2003:

June 1 – Paid rent for office for June ₤400 by cheque.

June 1 – Purchased office equipment for ₤2,000, from Equipit Ltd on credit.

June 1 – Purchased office supplies, costing ₤300 from W Brown on credit.

June 1 – Employed an office junior at a monthly wage of ₤500.

June 5 – Surveyed a property for A Bond and sent out and invoice for ₤200.

June 7 – Decided to transfer his own car to the business at a value of ₤4,000.

June 9 – Bought petrol for the car costing ₤20, paying by cheque.

June 12 – Took a client, P Brosnan, to lunch at a cost of ₤40, paying by cheque, and

was asked to prepare plans for a new factory, for which work he estimated he would earn

₤5,000.

June 16 – Carried out another property sur vey for A Bond and invoiced him for ₤240.

June 20 – Took another possible client to lunch at a cost of ₤60, paying by cheque, but

found that he would not be able to undertake work for that client.

June 23 – Bought further office supplies from W Brown on cr edit for ₤100.

June 30 – Paid the office junior her monthly wage.

June 30- Sent a cheque to Equipit Ltd for ₤2,000.

June 30 – Sent a cheque to W Brown for office supplies for ₤300.

June 30 – Banked a cheque received from A Bond for ₤200.

June 30 – Drew out ₤500 from the bank for personal living expenses.

Required:

Enter these transactions in Bill Cashing‟s accounting records, and test the arithmetical

accuracy of your work by preparing a trial balance when you have completed the necessary

entries.



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Problem 16

The following transactions took place during May 19X6:

May 1 – Started firm with capital in cash of ₤250.

May 2 – Bought goods on credit from the following persons: D ₤54; C ₤87; K ₤25; B

₤76; L ₤64.

May 4 – Sold goods on credit to: CB ₤43; BH ₤62; HS ₤176.

May 6 – Paid rent by cash ₤10

May 9 – CB paid us his account by cheque ₤43.

May 10 – HS paid us ₤150 by cheque.

May 12 – We paid the following by cheque: K ₤25; D ₤54.

May 15 – Paid carriage by cash ₤23.

May 18 – Bought goods on credit from C ₤43; B ₤110.

May 21 – Sold goods on credit to BH ₤67.

May 31 Paid rent by cheque ₤18.

Required:

Enter these transactions in a company‟s accounting records, and then balance off the accounts

and extract a trial balance as at 31 May 19X6.

Problem 17

B‟s Trial Balance as on 31 December 19X6

Dr

₤

Cr

₤

Sales 18,462

Purchases 14,629

Salaries 2,150

Motor expenses 520

Rent 670

Insurance 111

General expenses 105

Premises 1,500

Motor vehicles 1,200

Debtors 1,950

Creditors 1,538



10

Cash at bank 1,654

Cash in hand 40

Drawings 895

Capital _____ 5,424

25,424 25,424

Stock at 31 December 19X6 was ₤2,548.

Required:

Using the trial balance of B that was extracted after one year‟s trading, prepare a trading and

profit and loss account for the year ended 31 December 19X6 and a balance sheet as on 31

December 19X6.

Problem 18

The following transactions took place during March 19X6:

March 1 – Started business with ₤800 in the bank.

March 2 – Bought goods on credit from the following persons: K ₤76; M ₤27; B ₤56.

March 5 – Cash sales ₤87.

March 6 – Paid wages in cash ₤14.

March 7 – Sold goods on credit to: H ₤35; L ₤42; J ₤72.

March 9 – Bought goods for cash ₤46

March 10 – Bought goods on credit from M ₤57; B ₤98.

March 12 – Paid wages in cash ₤14.

March 13 – Sold goods on credit to: L ₤32; J ₤23.

March 15 – Bought shop fixtures on credit from B Ltd ₤50.

March 17 – Paid M by cheque ₤84.

March 18 – We returned goods to B ₤20.

March 21 – Paid B Ltd a cheque for ₤50.

March 24 – J paid us his account by cheque ₤95.

March 27 – We returned goods to K ₤24.

March 30 – J lent us ₤60 by cash.

March 31 – Bought a motor van paying by cheque ₤400.

Required:

Enter these transactions in a company‟s accounting books, and then balance off the accounts

and extract a trial balance as at 31 March 19X6.



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Problem 19

C‟s Trial Balance as on 30 June 19X8

Dr

₤

Cr

₤

Sales 28,794

Purchases 23,803

Rent 854

Lighting and heating expense 422

Salaries and wages 3,164

Insurance 105

Buildings 50,000

Fixtures 1,000

Debtors 3,166

Sundry expenses 506

Creditors 1,206

Cash at bank 3,847

Drawings 2,400

Motor vans 5,500

Motor running expenses 1,133

Capital _____ 65,900

95,900 95,900

Stock at 30 June 19X8 was ₤4,166.

Required:

From the trial balance of C after his first year‟s trading, prepare a trading and profit and loss

account for the year ended 30 June 19X8 and a balance sheet as on 30 June 19X8.



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Adjustments

Problem 20

The following trial balance was extracted from the accounts of a business as at 31 st December

19X7:Dr

₤

Cr

₤

Sales 150,000

Sales return 3,000

Purchases 70,000

Carriage in 1,000

Stock as at 1st January 19X7 10,000

Wages 20,000

Administration expenses 25,000

Insurance 1,000

Selling & distribution expenses 10,000

Purchase returns 500

Drawings 10,000

Capital 50,000

Premises 20,000

Equipment 20,000

Debtors 15,000

Creditors 10,000

Cash 5,500 _____

₤210,000 ₤210,000

At the year end (31st December) the following information is available:

(1) ₤1,000 of the wages relate to the next accounting period.

(2) ₤2,000 is owed for administration expenses relating to 19X7.

(3) Equipment is to be depreciated by ₤4,000.

(4) Closing stock is estimated to have cast ₤8,000.

Required:

(a) Enter the records in the Trial balance.

(b) Indicate which data from trial balance relates to the Balance sheet.

(c) Prepare a profit and loss statement for the year ended 31st December 19X7.



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(d) Explain the role of adjustments you made.

Problem 21

Mr. Big has been trading for some years as a wine merchant. The following list of balances

has been extracted from his ledger as at 30 th April 19X7, the end of his most recent financial

year.

₤

Capital 83,887

Sales 259,870

Trade creditors 19,840

Returns out 13,407

Provision for doubtful debts 512

Discounts allowed 2,306

Discounts received 1,750

Purchases 135,680

Returns inwards 5,624

Carriage outwards 4,562

Drawings 18,440

Carriage inwards 11,830

Rent, rates and insurance 25,973

Heating and lighting 11,010

Postage, stationery and telephone 2,410

Advertising 5,980

Salaries and wages 38,521

Bad debts 2,008

Cash in hand 534

Cash at bank 4,440

Stock as at 1st May 19X6 15,654

Trade debtors 24,500

Fixtures and fittings – at cost 120,740

Provision for depreciation on fixtures and fittings – as at 30t April 19X7 63,020

Deprecation 12,074



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The following additional information as at 30th April 19X7 is available:

(1) Stock at the close of business was valued at ₤17,750.

(2) Insurances have been prepaid by ₤1,120.

(3) Heating and lighting is accrued by ₤1,360.

(4) Rates have been prepaid by ₤5,435.

(5) The provision for doubtful debts is to be adjusted so that it is 3% of trade debtors.

Required:

Prepare Mr. Big‟s trading and profit and loss account for the year ended 30th April 19X7 and a

balance sheet (in vertical format) as at that date.

Problem 22

The following trial balance was extracted from the books of Charles as the close of business

on 28 February 19X7.

Dr

₤

Cr

₤

Purchases and sales 11,280 19,740

Cash at bank 1,140

Cash in hand 210

Capital account 1st March 19X6 9,900

Drawings 2,850

Office furniture 1,440

Rent 1,020

Wages and salaries 2,580

Discounts 690 360

Debtors and creditors 4,920 2,490

Stock 1st March 19X6 2,970

Provision for doubtful debts 1st March 19X6 270

Delivery van 2,400

Van running costs 450

Bad debts written off 810

₤32,760 ₤32,760

The following additional information as at 28th

February 19X7 is available:(1) Stock at 28th February 19X7 ₤3,510.



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(2) Wages and salaries accrued at 28th February 19X7 ₤90.

(3) Rent prepaid at 28th February 19X7 ₤140.

(4) Van running costs owing at 28th February 19X7 ₤60.

(5) Increase the provision for doubtful debts by ₤60.

(6) Provide for depreciation as follows: Office furniture ₤180; Delivery van ₤480.

Required:

Draw up the trading and profit and loss account for the year ending 28th February 19X7

together with a balance sheet as on 28th February 19X7, using vertical formats throughout.

Problem 23

The balance sheet of Johnson‟s shop as at 1st October 19X7 was as follows:

₤ ₤ ₤ ₤

Fixed assets Capital

Shop premises 45,000 At 1 October 19X7 51,000

Shop fittings 12,000

Delivery van 4,000 61,000

Current assets Current liabilities

Stock in trade 14,000 Trade creditors 12,000

Cash in hand 2,000 16,000 Bank overdraft 14,000 26,000

₤77,000 ₤77,000

The following in a summary of the transactions which took place during the year to 30th

September 19X8:

(1) Sales were made, all for cash, of ₤145,000. The stock in trade sold cost ₤83,000.

(2) Stock in trade was bought, all on credit, for ₤78,000.

(3) Cash of ₤113,000 was taken from the till (cash register) and paid into the bank.

(4) The trade creditors were paid ₤73,000 by cheque.

(5) Johnson borrowed ₤30,000 from Black which was paid into the bank. The loan is for 5

years.

(6) Wages of ₤17,000 were paid by cash.

(7) Rates of ₤2,900 were paid by cheque.

(8) Additional shop fittings costing ₤9,000 were bought and paid for by cheque

(9) The bank charged overdraft interest of ₤2,000 direct to the account.(10) Sundry expenses of ₤6,000 were paid in cash.



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(11) Electricity bills of ₤1,600 were paid by cheque.

(12) The owners of the business withdrew ₤9,000 in cash.

At 30th September 19X8 you discover the following:

(13) Interest ₤2,500 due to Black for the year was unpaid.

(14) Shop fittings are to be depreciated at 10% per annum on the total at the year end; the

delivery van is to be depreciated by 20% per annum of the total at the year end.

(15) The rates payments during the year included ₤1,000 in respect of the period 1.10.19X8 to

31.3.19X9.

(16) The electricity bill for the quarter to 30.9.19X8 for ₤500 was unpaid.

Required:

Prepare a balance sheet (in vertical format) as at 30th September 19X8 and a profit and loss

account for the year to that date.

Problem 24

Adagio plc. is a wholesale supplier of musical instruments to the retail and educational

sectors. The bookkeeper has extracted the following balances from the accounting records for

the year ended 31st May 2010. The totals of the debit and credit balances did not agree, and

the balancing figure was placed in a suspense account.

£000

Freehold property, at cost 3,600

Plant, equipment and vehicles, at cost 2,060

Provision for depreciation at 1st June 2009

Freehold buildings 440

Plant, equipment and vehicles 1,080

Purchases 13,100

Sales 21,180

Distribution and selling costs 2,300

Administration costs 1,240

Directors remuneration 1,110

Inventories at 1st June 2009 1,320

Trade creditors 972

Trade debtors 1,834



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Bank balances 95

Ordinary share capital (£1 shares, fully paid) 3,300

Retained earnings at 1st June 2009 222

Loan interest paid 30

10% loan, repayable in 2015 500

Suspense account (debit balance) 1,005

The following information is available.

(1) The accountant of Adagio plc. has now reviewed the accounting records and has

discovered the following errors which require adjustment:

(i) On 31st May 2010 stocks were valued at £1,280,000. This figure has been credited to the

purchases account but no other entries have been made.

(ii) A motor vehicle was sold for cash on 1st June 2009 for £15,000. The cash received has

been recorded in the cash book but no other entries have been made. The motor vehicle

originally cost £40,000 on 1st June 2008.

(iii) A debtor balance of £130,000 was eliminated from the trade debtors balance as it was

considered to be irrecoverable. No other entries have been made.

(iv) A directors‟ bonus of £390,000 was calculated on the basis of expected profits and was

added to the directors‟ remuneration account but no other entries were made.

(2) No provision has been made at the year-end for the following:

(i) Depreciation on plant, equipment and vehicles at 10% on the straight line method. There

are no fully depreciated assets in this category.

(ii) Depreciation at 5% on cost of freehold buildings which represent 25% of the cost of

freehold property.

Depreciation charges and profits or losses on asset disposals are allocated 50% to cost of sales

and 25% each to distribution costs and administration costs.

(3) Directors‟ remuneration is allocated as 80% to administration and 20% to selling costs.

Bad debts written off are treated as selling costs.

(4) Provision is required at the year-end for:

(i) outstanding loan interest,

(ii) auditors‟ remuneration of £80,000, (treated as administration costs),

(iii) corporation tax for the year of £600,000

(5) The company has paid insurance premiums of £20,000 relating to periods after the year

end. Insurance is included in administration costs.



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Required:

(a) Prepare a profit and loss account for Adagio plc. for the year ended 31 st May 2010 and a

balance sheet as at that date in a form suitable for the directors.

(b) During the year the company had paid £40,000 training costs which were included in

administration costs. The human resources director has argued that this should not be seen as

an expense but as an asset. Briefly discuss her proposal.

Problem 25

The draft accounts prepared for the directors of Snodrop plc. for the year ended 31 December

1999 show a profit before taxation of £573,580. In the course of subsequent checking, the

following errors and omissions were found:

(1) During the year the company had acquired an additional factory unit at an annual rent of

£64,000, payable quarterly in advance commencing on 31 March 1999. By 31 December

1999 four quarterly payments had been made. The total paid during the year had been treated

as capital expenditure and included in fixed assets. No depreciation had been provided on the

factory unit.

(2) Some goods were included in the closing stock valuation at their selling price of £9,750.

The gross profit margin on these goods was 30%.

(3) A delivery vehicle held as a fixed asset had been sold during the year for £5,200. The

original cost was £16,000 and, at 1 January 1999, depreciation of £9,600 had been provided.

The proceeds of sale had been credited to sales account. The company depreciates delivery

vehicles at 20% per year using straight-line basis. Its policy is to provide for depreciation in

the year of purchase but not in the year of sale.

(4) The brought forward balance of £1,700 for the accrued telephone charges at 1 January

1999 had been omitted when calculating the year‟s telephone charge.

(5) £9,820, being the total of returns inwards for the year, had been credited to purchases and

debited to trade creditors.

(6) At 1 January 1999 there was a provision for doubtful debts of £29,320. Snodrop plc. has a

policy of making a 3% provision for doubtful debts based on closing trade debtors. The entry

for 31 December had not been made and the trade debtors then totaled £1,260,500.

(7) Items included in closing stock at £7,900, and which would normally be sold for £10,200,

were in a damaged state and were worth only £6,850.



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(8) A legal action brought against the company during 1999 for damage to property was

decided shortly after the balance sheet date and, as a result, it will have to pay costs and

damages totaling £24,000. No provision had been made in the accounts for this event.

(9) Salaries paid for October 1999 of £24,530 had been incorrectly recorded as £42,530.

There was a compensating error affecting trade creditors which meant that the end of year

trial balance agreed.

Required:

(a) Calculate the correct figure for Snodrop plc. for profit before taxation for 1999. Show each

adjustment separately and indicate which entries in the draft trading and profit and loss

account are affected. If you consider that any of the above information does not affect profit

explain clearly why this is the case.

(b) Identify, and briefly explain, the reasons for your adjustments relating to (1), (2), (6) and

(8) above. Refer to accounting concepts where relevant.

Problem 26

Ko-Furn Limited is an office furniture manufacturer. The following is a list of balances

extracted from its accounting records at 31 December 2009:

Dr Cr

000$ 000$

Land, at valuation 240

Buildings: cost 500

Buildings: accumulated depreciation at 1.1.09 180

Equipment: cost 392

Equipment: accumulated depreciation at 1.1.09 152

Vehicles: cost 568

Vehicles: accumulated depreciation at 1.1.09 264

Inventory at 1.1.09 214

Trade receivables 366

Provision for doubtful debts at 1.1.09 16

Prepayment at 1.1.09 12

Accrual at 1.1.09 18

Cash 408

Trade payables 248



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Share capital: ordinary 50c shares 50

Share premium 350

Retained earnings 606

Sales 2,924

Purchases 976

Wages and salaries 540

Distribution costs 200

Other administrative expenses 360

Corporation tax 12

Disposal account 20

Dividend paid 40

4,828 4,828

You are given the following information:

(1) Ko-furn prices its furniture using a normal 30% mark-up policy. A stock count carried out

at 31 December 2009 valued stock at selling price of $325,000. This included two board

tables at normal selling price of $20,800 each, which the directors have decided should be

reduced in price to $5,000 each.

(2) The land was valued at $600,000 at 31 December 2009. The directors decided to reflect

the revalued amount in the balance sheet.

(3) On 1 February 2009, the company sold a vehicle for $20,000. While the proceeds of sale

were credited to the Disposal account, no other entries were made in the books of account in

relation to this transaction. The vehicle had cost $88,000 in August 2006. The company

charges a full year‟s depreciation in the year of acquisition and no depreciation in the year of

disposal.

(4) The company‟s depreciation policy is as follows:

Land: nil

Buildings: 4% straight line

Equipment: 40% reducing balance

Vehicles: 25% straight line.

(5) Trade receivables at 31 December 2009 include a debt of $16,000 from a customer

recently declared bankrupt. The company has decided to maintain the provision for doubtful

debts at 4% of remaining trade receivables.

(6) The balance of prepayments at 1.1.09 refers to insurance charges. Prepaid insurance,included in general distribution costs at 31 December 2009 amounted to $24,000.



21

(7) The balance of accruals at 1.1.09 refers to electricity charges. After the year end, the

company received an electricity invoice for $30,000 covering the period 1 November 2009 to

31 January 2010. Electricity charges are included in other administrative expenses.

(8) Corporation tax for the year ended 31 December 2009 is estimated to be $190,000.

(9) The company issued 100,000 additional shares at 50c each on 30 December 2009 for

$140,000. This transaction has not been recorded in the accounting records.

Required:

Prepare an income statement for the year ended 31 December 2009 and a balance sheet at that

date, in good style, for the directors.



22

Accounting for Current Assets

Problem 27

Bought Sold

January 10 at ₤30 each April 8 for ₤46 each March 10 at ₤34 each December 12 for ₤56 each

September 20 at ₤40 each

Required:

(a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii)

AVCO methods on a perpetual inventory basis.

(b) Draw up the trading account for the year showing the gross profits that would have been

reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods.

Problem 28

Bought Sold

January 24 at ₤10 each June 30 for ₤16 each

April 16 at ₤12.50 each November 34 for ₤18 each

October 30 at ₤13 each

Required:

(a) Calculate the closing stock-in-trade that would be shown using (i) FIFO, (ii) LIFO, (iii)

AVCO methods on a perpetual inventory basis.

(b) Draw up the trading account for the year showing the gross profits that would have been

reported using (i) FIFO, (ii) LIFO, (iii) AVCO methods.

Problem 29

An evaluation of a physical stock count on 30 th April, 19X2 in respect of the financial year

ending on that date at Cranfleet Commodities has produced a figure of ₤187,033.

The firm‟s book-keeper has approached you, as the accountant, for assistance in dealing with

the following matters to enable him to arrive at a final figure of closing stock for inclusion in

the annual accounts:

(1) 320 components included at their original cost of ₤11 each can now be bought in for only

₤6 each due to over production by the manufacturer. This drop in price is expected to be only

temporary and the purchase price is expected to exceed its original figure within 12 months.



23

Cranfleet Commodities intends to continue selling the existing stock at the present price of

₤15 each.

(2) It has been discovered that certain items which had cost ₤5,657 have been damaged. It will

cost ₤804 to repair them after which they can be sold for ₤6,321.

(3) On one stock sheet a sub-total of ₤9,105 has been carried forward as ₤1,095.

(4) 480 units which cost ₤1.50 each have been extended at ₤15.00 each.

(5) The firm has sent goods with a selling price of ₤1,500 (being cost plus 25%) to a customer

on a sale or return basis. At 30th April 19X2, the customer had not signified acceptance, but

the goods have not been returned, and consequently had not been included in the physical

stock count.

(6) Included in stock were goods bought on credit for ₤4,679 from Byfleet Enterprises. At 30th

April 19X2, Cranfleet Commodities had not paid this account.

(7) Byfleet Enterprises had also sent some free samples (for advertising purposes only). These

have been included in stock at their catalogue price of ₤152.

Required:

Taking account of such of the above facts as are relevant, calculate a closing stock figure for

inclusion in the 19X2 annual accounts of Canfleet Commodities, giving reasons for the action

you have taken in each individual case.

Problem 30

The draft accounts of Trayderrs plc for the year ended 31 st December 1998 show a net profit

before tax of ₤543,350 and closing stock at cost of ₤316,740 following a physical stock count.

During the audit of the accounts the following matters have come to light:

(1) Stock costing ₤25,000 has been omitted from the closing stock figure.

(2) Items included in stock at ₤10,200, and which would normally be sold for ₤18,350, were

in a damaged state and were worth only ₤7,600.

(3) Trayderrs plc received an order on 27th December 1998 to supply goods at a total price of

₤52,000. The goods, which had cost ₤34,000, were moved on the following day from the

warehouse to the packing department and were dispatched on 3rd January 1999 when the

customer was invoiced. Trayderrs plc had included the order in sales for 1998 and had

excluded the goods from closing stock.

(4) 3,100 items costing ₤21 each were recorded on the stock sheets in error as 1,300 items at

₤12 each.



24

(5) Stock costing ₤10,000 was lost in a fire in the warehouse during the year. The company‟s

insurers have agreed to pay Trayderrs plc ₤11,200 in respect of its insurance claim. No entry

has yet been made in the accounting records.

(6) Included in purchases is ₤41,500 for goods purchased in December and which were

received into the warehouse on 5th January 1999.

(7) Stock costing ₤18,000 has in error been treated as a fixed asset and depreciation of 10% of

cost has been provided for.

(8) Returned stock costing ₤825 has been treated in the accounting records as a return inward

instead of a return outward.

(9) An item is included in the closing stock valuation at its selling price of ₤8,200. The gross

profit margin on this item is 40%.

Required:

(a) Calculations to show the correct figure for Trayderrs plc for

(i) stock at 31st December 1998, and

(ii) net profit before tax for 1998.

(b) Your answer to the following questions posed by the purchasing director of Trayderrs plc:

“Prices are rising all the time and I think we should change our stock valuation method from

FIFO to LIFO or average cost. What do you think about this? Can we do it?”

Problem 31

On 30th April 2009 the closing balance on the creditors control account of Dyson Ltd is

₤2,900. The total of the list of balances from the creditors ledger is ₤3,990. Further

investigation reveals the following errors:

(1) An invoice of ₤600 for goods purchased was included in the creditors ledger but was not

recorded in the purchases day book.

(2) A cash payment of ₤400 to a supplier recorded in the cash book was not recorded in the

creditors ledger.

(3) A cash payment of ₤560 was correctly recorded in the creditors ledger but was recorded as

₤650 in the cash book.

(4) An invoice for ₤250 was not recorded in either the purchase day book or the creditors

ledger.

Required:

Show the corrected total of the list of creditors ledger balances and the corrected balance onthe creditors control account at 30th April 2009.



25

Problem 32

Waits opened a business bank account with ₤16,000 on 1st April 2009. During April he issued

cheques totaling ₤72,760 and banked cheques totaling ₤80,060. These transactions were

entered into his cash book up to 30 th April 2009. On receiving his bank statement for April he

discovered the following:

(1) A cheque for ₤4,800, which was banked (and included in the receipts above), had been

returned by the bank marked “No funds available”. No adjustment has been made in the cash

book.

(2) Bank charges debited on the bank statement for April amounted to ₤600. No entries for

these have been made in the cash book.

(3) Cheques totaling ₤16,860 recorded in the cash book and sent to suppliers were not

presented to the bank until May 2009.

(4) Cheques totaling ₤12,100 had been entered into the cash book but not credited by the bank

until May 2009.

Required:

Calculate the corrected bank balance which should appear in the business cash book at 30 th

April 2009 and prepare a bank reconciliation statement at 30 th April 2009.

Problem 33

Miss Leung runs a business selling holidays. At 31 January 2010, the balance on the creditors

control account was $8,700. The total of the list of balances in the creditors ledger was

$11,720. The following information has come to light:

(i) an invoice of $750 was not recorded in the purchase day book

(ii) a cash payment of $1,680 was correctly recorded in the cash book but was recorded as

$1,860 in creditors ledger.

(iii) A cash payment of $1,200 to a supplier was recorded in the cash book but was not

recorded in the creditors ledger.

(iv) A credit note for a price reduction from a supplier of $1,800 was recorded in the purchase

day book but not recorded in the creditors ledger.

(v) In January, the company paid a refund of $200 to a customer for a price reduction. This

was wrongly treated as a payment to a supplier and entered in the Creditors Control Account.

Required:

Show the corrections to the:(a) list of creditors ledger balance at 31 January 2010 and



26

(b) creditors control account at 31 January 2010.

Problem 34

In preparing the trial balance, you notice that the debit side exceeds the credit side by $970.

Upon investigation, you identify the following mistakes:

(1) Goods returned to suppliers amounts to $250 have been entered as a debit in the goods

returns outward account by mistake.

(2) A cash payment for $560 has been entered in the cash book as $650.

(3) A computer purchased for $2,000 as at office machine has been entered as debit in the

purchases account.

(4) A credit note for $220 given to a customer has been credite d twice in the customer‟s

account.

(5) A cheque for $780 from a customer has been entered in the cash book and subsequently

banked before the year end. However, no other entry has been made to the customer‟s

account.

Required:

Explain how each of the above mistakes should be dealt with by means of a suspense account.



27

Accounting for Fixed Assets

Problem 35

A company started in business on 1st January 19X1. Bought two motor vans for ₤1,200 each

on 1

st

January 19X1. Bought one motor van for ₤1,400 on 1

st

July 19X1.Required:

Write up the motor vans account and the provision for depreciation account for the year ended

31st December 19X1. Depreciation is at the rate of 20 per cent per annum, using the basis of

one month‟s ownership needs one month‟s depreciation.

Problem 36

A company maintains its fixed assets at cost. Depreciation provision accounts for each asset

are kept. At 31st December 19X8 the position was as follows:

Total cost

to date

Total depreciation

to date

Machinery 52,590 25,670

Office furniture 2,860 1,490

(1) The following additions were made during the financial year ended 31st December 19X9:

Machinery ₤2,480, office furniture ₤320.

(2) Some old machines bought in 19X5 for ₤2,800 were sold for ₤800 during the year.

(3) The rates of depreciation are: Machinery 10 per cent, office equipment 5 per cent, using

the straight line basis, calculated on the assets in existence at the end of each financial year

irrespective of date of purchase.

Required:

Show the asset and depreciation accounts for the year ended 31st December 19X9 and the

balance sheet entries at that date.

Problem 37

A firm buys a fixed asset for ₤10,000. The firm estimates that the asset will be used for 5

years. After exactly 2½ years, however, the asset is suddenly sold for ₤5,000. The firm always

provides a full year‟s depreciation in the year of purchase and no depreciation in the year of

disposal.

Required:



28

(a) Write up the relevant accounts including disposal account but not profit and loss account

for each of Years 1, 2 and 3:

(i) Using the straight line depreciation method (assume 20% p.a.);

(ii) Using the reducing balance depreciation method (assume 40% p.a.);

(b) What is the purpose of deprecation? In what circumstances would each of the two

methods you have used be preferable?

(c) What is the meaning of the net figure for the fixed asset in the balance sheet at the end of

Year 2?

(d) If the asset was bought at the beginning of Year 1, but was not used at all until Year 2 (and

it is confidently anticipated to last until Year 6), state under each method the appropriate

depreciation charge in Year 1, and briefly justify your answer.

Problem 38

A company depreciates its plant at the rate of 20% per year, straight line method, for each

month of ownership. Details:

19X4 bought plant costing 900 on January 1

bought plant costing 600 on October 1

19X6 bought plant costing 550 on July 1

19X7 sold plant which had been bought for 900 on 1st January 19X4 for the sum of 275 on

30th September 19X7.

Required:

Draw up:

(a) the Plant account

(b) the Provision for depreciation account

(c) Disposal account

(d) extracts from the Balance sheet at the end of each year.

Problem 39

Explain:

(a) How is the consistency concept applied to depreciation?

(b) Since the calculation of depreciation is based on estimate, why bother to make this

calculation?



29

Problem 40

At the beginning of the financial year commencing on 1st April 19X5, a company had a

balance on plant account of £372,000 and on provision for depreciation of plant account of

£205,400.

The company‟s policy is to provide depreciation using the reducing balance method applied

to the fixed assets held at the end of the financial year at the rate of 20 % per annum.

On 1st September 19X5 the company sold for £13,700 some plant which it had acquired on 31

October 19X1 at a cost of £36,000. Additionally, installation costs totalled £4,000. During

19X3 major repairs costing £6,300 had been carried out on this plant and, in order to increase

the capacity of the plant, a new motor had been fitted in December 19X3 at a cost of £4,400.

A further overhaul costing £2,700 had been carried out during 19X4.

The company acquired a new replacement plant on 30th November 19X5 at a cost of £96,000,

inclusive of installation charges of £7,000.

Required:

Calculate the following:

(a) the balance of plant at cost at 31 st March 19X6

(b) the provision for depreciation of plant at 31st March 19X6

(c) the profit or loss on disposal of the plant.

Problem 41

On 1 January 1998 Ay Ltd bought some factory equipment for £100,000. There was no

estimated residual value and the equipment is being depreciated using the decreasing-balance

method at the rate of 20% per year.

At the end of 2000 the market value of the equipment is expected to be £40,000 due to a more

advanced design having appeared on the market. The equipment is as efficient in operation as

originally anticipated and there is no intention of replacing it during the next few years.

Required:

(a) Referring to accounting concepts and to the above information, explain whether or not the

annual charge for depreciation of the equipment needs amending and what the charge for

2000 should be.

Problem 42

The Cirrus Company Ltd has the following balances on its books at 31st

December 19X0:



30

Dr

₤

Cr

₤

50p ordinary shares 20,000

6% preference shares of ₤1 each 14,000

Purchases 240,000

Sales 310,000

Stock at 1st January 19X0 20,000

Director‟s fees 6,000

Undistributed profit at 1st January 19X0 35,700

10% Debentures (due 19X4) 20,000

Debenture interest paid 1,000

Discounts allowed 500

Administrative expenses 18,400

Salesman‟s salaries 18,500

Selling and marketing expenses 4,000

Heating and lighting 2,500

Rent and rates 1,700

Debtors 14,000

Provision for doubtful debts at 1st January 19X0 300

Creditors 9,700

Land and buildings at cost 65,000

Vans at cost less depreciation 19,800

Cash in hand 400

Bank balance (overdraft) _____ 2,100

411,800 411,800

The following additional information is given:

(1) The stock at 31st December 19X0 has been valued at ₤32,000. Further investigation

reveals that this includes some items originally purchased for ₤3,000 which have been in

stock for a long time. They need modifications, probably costing about ₤600, after which it is

hoped that they will be saleable for between ₤3,200 and ₤3,500. Other items, included in the

total at their cost price of ₤5,000, have been sent to an agent and are still at his premises

awaiting sale. It cost ₤200 for transport and insurance to get them to the agent's premises and

this amount is included in the selling and marketing expenses.



31

(2) The balance on the vans account (₤19,800) is made up as follows:

Vans at cost (as at 1st January 19X0) ₤30,000

Less: Provision for depreciation to 1st January 19X0 ₤13,800

₤16,200

Addition during the year ₤3,600

₤19,800

Depreciation is provided at 25% per annum on the reducing balance method. The addition

during the year was invoiced as follows:

Recommended retail price ₤3,000

Signwriting on van ₤450

Undersealing ₤62

Petrol ₤16

Number plates ₤12

License which expired 31st December 19X0 ₤60

₤3,600

(3) The directors, having sought at the advice of an independent evaluator, wish to revalue the

land and building at ₤80,000.

(4) The directors wish to make a provision for doubtful debts of 2.5% of the balances of

debtors at 31st December 19X0.

(5) Rent and rates prepaid at 31st December 19X0 amounted to ₤400, and salesmen's salaries

owing at that date were ₤443.

(6) The directors have proposed an ordinary dividend of 5p per share, and the full preference

dividend.

(7) Ignore taxes.

(8) Debenture interest is paid semi-annually.

Required:

(a) Explain very carefully the reasons for the adjustments you have made in respect of items

1, 2 and 3 above. Show your workings

(b) Prepare P&L account for Cirrus Company Ltd the year ended 31st December 19X0, and

the Balance sheet as at that date.

(b) Explain your treatment of debenture interest and proposed dividends.



32

Problem 43

A recent article mentioned that there is currently “a bewildering choice” of accounting

treatments for goodwill and other intangible assets some of which are inconsistent with the

way tangible assets are reported. The balance sheet summary of a well-known successful

multinational group of companies is given below to illustrate how one organization chooses to

report brand names and goodwill that it has purchased:

₤ millions

Fixed assets

Intangible assets 3,840

Tangible assets 1,725

Investments 735 6,300

Net current assets 1,000 7,300

Long-term liabilities (4,197) 3,103

Share capital and reserves

Equity share capital 535

Share premium account 667

Revaluation reserve 94

Goodwill reserve (3,579)

Profit and loss account 5,386 3,103

Intangible assets are brands stated at fair value on acquisition. The negative figure for

goodwill reserve is in respect of purchased goodwill written off.

Required:

(a) Explain the nature of intangible assets and why the method of reporting them seems to be

more problematic than for tangible assets.

(b) For purchased goodwill, consider the method used in the above balance sheet. What are its

good and bad points? Explain one other method that might be used. Which do you personally

prefer and why?

(c) For purchased brand names, consider the method used in the above balance sheet. What

are its good and bad points? Explain one other method that might be used. Which do you

personally prefer and why?



33

Problem 44

Raj Ltd purchased a machine on 1st January 1999 for ₤100,000. Transporting the machine to

its factory cost ₤1,600 and ₤1,000 was spent on installing it. Maintenance of the machine cost

₤750 in 1999 and the expenditure on maintenance increased by ₤200 in each of the following

four years. The machine was expected to last until 31st December 2006 with a scrap (or

residual) value at that date of ₤6,600. The company uses the straight-line method of

depreciation. It provides for a full year‟s depreciation in the year of acquisition and none in

the year of sale.

The machine was sold for ₤34,000 on 30th June 2003.

Required:

Explain briefly what you understand by the term “depreciation” as used by accountants. In

what circumstances would straight-line be the most appropriate method to use for an asset?

Give the following calculations:

(i) the depreciation charge for 1999;

(ii) the profit or loss on sale of the machine in 2003.

Problem 45

According to a survey of investment analysts, more than half of them believe that all

internally generated intangible assets should be capitalized on a company‟s balance sheet.

Discuss the advantages and problems of reporting these assets.

Problem 46

“We live in a society where the real wealth creators are often the intangible assets yet few

companies include these assets in their balance sheets”. Why is this? Explain the issues

involved.

Problem 47

Given that amongst the most significant assets of professional football clubs are its

footballers, it has become more common in recent years for such companies to account for the

cost of players on their balance sheets. Other clubs, however, account for their players as

expenses on their Profit and Loss accounts.

Required:

Express the arguments behind these two alternative treatments, using any principles or conventions you are applying in your explanation and explaining any terms you use.



34

Problem 48

The following is an extract from the accounting policies of Manchester United plc (a leisure

company) as reported in its annual report and accounts for the year ended 31st July 2000:

Depreciation

“Depreciation is provided on tangible fixed assets at annual rates appropriate to the estimated

useful lives of the assets, as follows:

Reducing Balance Straight Line

Freehold land Nil Nil

Freehold buildings 1.33% 75 years

Assets in the course of construction Nil Nil

Computer equipment and software 33% 3 years

Plant and machinery 20%-25% 4-5 years

General fixtures and fittings 15% 7 years

“During the year the depreciation method was changed [from reducing balance] to the straight

line basis…”

Required:

(a) Explain briefly what you understand by the two methods of depreciation referred to in the

above extract.

(b) What effect is the change in accounting policy likely to have on the profit and loss account

and the balance sheet?

Problem 49

The annual accounts of Sen Manufacturing Ltd. are being prepared for the year ended 31

March 2002 and the closing trial balance includes the following figures:

£ £

Freehold land and factory buildings 2,800,000

Depreciation of factory buildings at 01.04.01 750,000

Land revaluation reserve 400,000

Plant and machinery at cost 1,900,000

Depreciation of plant and machinery at 01.04.01 1,150,000

Motor vehicles at cost 153,000

Depreciation of motor vehicles at 01.04.01 36,000

The following information has been supplied:



35

(1) The figure for freehold land and factory buildings comprises land at valuation

(£1,200,000) and buildings at cost (£1,600,000). The land originally cost £800,000 and was

professionally revalued in 1997 and the revaluation reserve created. It was revalued again in

March 2002 and the revised figure of £1,050,000 is to be included in the accounts.

(2) Factory buildings include expenditure in 2001 on constructing a new warehouse

(£220,000), maintenance of buildings (£60,000) and redecoration (£20,000).

(3) Factory buildings owned at 31 March 2002 are to be depreciated for the year at 3% of

cost.

(4) Plant and machinery includes £528,850 for plant constructed by Sen Manufacturing‟s staff

during the year and completed on 30 September 2001. The cost is made up as follows:

Materials £325,000

Labour 122,000

Allocation of company overheads 75,000

Delivery of components to the factory 4,000

Insurance on the machine for the year to 31 May 2002 1,200

Design costs and engineers‟ fees 1,650

(5) Plant and machinery also includes £450,000 being the cost of a machine purchased some

years ago. It had a written down value at 1 April 2001 of £40,000 and was sold on the

following day for £30,000. The proceeds have been debited to cash and credited in error to

sundry income account. No adjustment has been made yet to correct this error.

(6) All plant and machinery owned at 31 March 2002 is to be depreciated for the year at 20%

of cost.

(7) The figure for motor vehicles includes £9,000 paid to Speedy Motors for a new vehicle

costing £17,800 from which was deducted £8,800 for an old vehicle taken in part exchange.

The old vehicle cost £23,000 in April 1998 and three years‟ depreciation, using the decreasing

balance method and an annual rate of 30%, is included in the depreciation figure in the trial

balance.

(8) All motor vehicles owned at 31 March 2002 are to be charged depreciation at the rate of

30% using the decreasing-balance method.

Required:

(a) Prepare a table with eight columns using a separate column for each of the seven balances

shown in the trial balance extract and head the final column “Profit”. For each item numbered

from (1) to (8) above, show on the table which of the seven balances needs correcting, and



36

how (+ or - ), and show the correct balances at 31 March 2002. For each adjustment, show in

the final column by how much the figure of profit for the year will be affected (+ or - ).

(b) Prepare the fixed assets section of Sen Manufacturing Ltd‟s balance sheet as at 31 March

2002 in good style.

(c) Your answer to the following questions put to you by a colleague:

“What is the purpose of having a land revaluation reserve? Why haven‟t the other fixed assets

been revalued? Also, can you explain to me why you asked me to obtain all the detailed

information listed under item (4)?”



37

Accounting in Joint-Stock Companies

Problem 50

GWR Ltd started in business on 1st January 19X6. Its issued share capital was 100,000

ordinary shares of ₤1 each and 50,000 10 per cent preference shares of ₤1 each.Its net profits for the first two years of business were: 19X6 ₤42,005; 19X7 ₤34,831.

Preference dividends were paid for each of these years, whilst ordinary dividends were

proposed as 19X6 12 per cent and 19X7 9 per cent.

Corporation tax, based on the profits of these two years, was: 19X6 ₤13,480; 19X7 ₤11,114.

Transfers to general reserve took place as: 19X6 ₤6,000; 19X7 ₤4,000.

Required:

Draw up profit and loss appropriation accounts for each of the years ended 31 st December

19X6 and 19X7.

Problem 51

Badwa plc. has an authorized capital of 500,000 ordinary shares of ₤0.50 each. At the end of

its financial year, 31st May 19X9, the following balances appeared in the company‟s books:

₤

Issued capital: 400,000 shares fully paid 200,000

Freehold land and buildings at cost 320,000

Stock in trade 17,800

10% debentures 30,000

Trade debtors 6,840

Trade creditors 8,500

Expenses prepaid 760

Share premium 25,000

General reserve 20,000

Expenses outstanding 430

Profit and loss account balance (1st June 19X8) 36,200

Bank overdraft 3,700

Fixtures, fittings and equipment

at cost 54,000

provision for depreciation 17,500



38

The com pany‟s trading and profit and loss accounts had been prepared and revealed a net

profit of ₤58,070. However, this figure and certain balances shown above needed adjustment

in view of the following details which had not been recorded in the company‟s books.

(1) It appeared that a trade debtor who owed ₤300 would not be able to pay. It was decided to

write his account off as a bad debt.

(2) An examination of the company‟s stock on 31st May 19X9 revealed that some items

shown in the accounts at a cost of ₤1,800 had deteriorated and had a resale value of only

₤1,100.

(3) At the end of the financial year some equipment which had cost ₤3,600 and which had a

net book value of ₤800 had been sold for ₤1,300. A cheque for this amount had been received

on 31st May 19X9.

Required:

(a) A statement which shows the changes which should be made to the net profit of ₤58,070

in view of these unrecorded details.

(b) The directors proposed to pay a final dividend of 10% and to transfer ₤50,000 to general

reserve on 31st May 19X9. Prepare the profit and loss appropriation account for the year

ended 31st May 19x9 and two extracts from the company‟s balance sheet as at 31st May 19X9,

showing in detail:

(i) the current assets, current liabilities and working capital

(ii) the items which make up the shareholders‟ funds.

(c) The directors are concerned about the company‟s liquidity position. Propose three

transactions which will increase the company‟s working capital. State which balance sheet

items will change as a result of each transaction and whether the item will increase or

decrease in value.

Problem 52

LMS Ltd has an authorized capital of ₤200,000, consisting of 160,000 ordinary shares of ₤1

each and 40,000 8 per cent preference shares of ₤1 each. Of these 120,000 ordinary shares had

been issued and all the preference shares when the business first started trading.

The business has a financial year end of 31st December. The first three years of business

resulted in net profit as follows: 19X7 ₤27,929; 19X8 ₤32,440; 19X9 ₤36,891.

Dividends were paid each year on the preference shares. Dividends on the ordinary shares

were proposed as follows: 19X7 8 per cent; 19X8 10 per cent; 19X9 11 per cent.



39

Corporation tax, based on the profits of each year, was: 19X7 ₤8,331; 19X8 ₤10,446; 19X9

₤12,001.

Transfers to reserves were made as: General reserve 19X7 ₤3,000; 19X8 ₤4,000, and Foreign

exchange reserve 19X9 ₤2,000.

Required:

Show the profit and loss appropriation accounts for each of the years 19X7, 19X8 and 19X9.

Problem 53

The stockholders‟ equity section of the balance sheet of P Corporation as December 31, 2004,

appears as follows:

Stockholders‟ Equity amounts in thousand, except share amounts

7% Preferred stock, $100 par; 100,000 shares authorized; 40,000

shares issued

$4,000

Common stock, $1 par; 1,000,000 shares authorized; 600,000

shares issued, of which 50,000 are held in treasury

$600

Additional paid in capital:

From issuance of preferred stock $480

From issuance of common stock $1,410

Retained earnings $4,500

…

Total stockholders‟ equity $10,715

Required:

Answer the following questions related to P Corporation.

(a) What was the average issue price of the preferred stock as of December 31, 2004?

(b) How many shares of common stock are outstanding?

(c) What journal entry was made when the common stock was issued?

(d) What is the amount of the total dividend requirement on preferred stock annually?

(e) Assuming that there are no dividends in arrears, if the company declared a total cash

dividend of $580,000, what would be the dividend per share for the preferred and common

stock?

(f) Assume the company‟s common stock is selling for $80 per share. What journal entry

would be made if the company issues a 10% common stock dividend?

(g) Compute basic earnings per share if the company‟s net income was $1,560,000 during2004. Assume no new shares were issued during the year.



40

(h) Refer to the original data. Assume the company declares a 3-for-2 stock split. How many

shares of common stock would be outstanding after the split?

Problem 54

The balance sheet of C Ltd is as follows:

Assets ₤

Sundry net assets ₤1,200,000

Share capital

₤1 ordinary shares fully paid 400,000

Reserves


Profit and loss account (unappropriated profit) 300,000

₤1,200,000

The directors decide to make a 1 for 5 bonus issue. This will be followed by 1 for 3 rights

issue. Rights shares will be offered at a price of ₤1.60 per share.

Required:

Show the revised balance sheet of C Ltd after both share issues have taken place.

Problem 55

Meta Ltd has the following share capital and reserves as at 20th August 19X5:

₤

1,500,000 ordinary shares of 25p, each fully paid 375,000

Share premium 225,000

Retained profit 200,000

800,000

The directors resolve to use the reserves to issue fully-paid bonus shares at par in the ratio of

two shares for every three currently held.

Required:

(a) Show the revised balance sheet (“capital and reserves” section only) after the above

transactions have been carried out.

(b) Assuming that the market value of each share has tended to stay around 50p ex div (i.e.

excluding any dividend expected in the very near future) and the total annual dividend has

been ₤75,000, what would you expect the market price of each share to be after the bonusissue?



41

Problem 56

The S Ltd commenced operations on 1st January 19X6. For the first four years the following

results were achieved:

Year ended 31

December

Trading profit (loss) Profit (loss) on sale

of fixed asset

Profit on revaluation

on land use

₤ ₤ ₤

19X6 (100,000)

19X7 80,000

19X8 90,000 30,000

19X9 60,000 (10,000) 40,000

Required:

State, for each year, the maximum dividend company could pay (assuming a maximum

dividend is paid whenever possible)

Problem 57

Refer to Problem 56 above. Assume that S Ltd issued 300,000 ₤1 Preference Shares with a

10% fixed rate on dividend at the commencement of business.

Required:

State, for each year, maximum dividend the company could pay its ordinary shareholders if:

(i) the preference shares were non-cumulative, and

(ii) the preference shares were cumulative.

Problem 58

A major international company recently reported the worst results in its century-long history

with a 90% fall in net income and the chairman was reported to be worried about keeping his

job. However, the total dividend proposed for the year was 4% up on the previous year‟s.

Required:

Give possible reasons for the dividend increase. How would you check whether the increase

is legal?

Problem 59

Wonda plc. has an issued share capital of two million ₤1 shares. The directors are considering

whether the company should buy back and cancel 10% of its issued share capital at thecurrent market price of 220 pence per share.



42

(i) Why would the directors of a company like Wonda plc. wish it to buy back and cancel

some of its shares?

(ii) How do you consider the buyback should be reflected in the balance sheet of Wonda plc.?

(iii) Would you expect the share price of Wonda plc. to remain at 220 pence after the share

buyback? Explain your answer.

Problem 60

“This is certainly the record dividend payment of the year: O‟Mara plc is paying 75 pence for

each ₤1 share! It represents 80% of the company‟s earnings for the year. Even the big banks

are not that generous!”

Required:

Comment on the above quotation which has been adapted from an article in a national

newspaper and explain whether you consider that the company has necessarily been generous

to its shareholders. Specify what further information you would need for your answer, if any,

and what use you would make of it.

Problem 61

Your aunt has held 1,000 ordinary shares in a quoted company for several years. She has very

little understanding of financial matters. She has asked you to write her a short note to explain

the following:

(1) why the company has only paid a dividend of approximately 30% of the profit after tax;

(2) why the company is making a 1 for 1 scrip (or bonus) issue and what effect this is likely to

have on the market value of each share.

Required:

Explain to your aunt:

(a) the factors which determine a company‟s dividend;

(b) the purpose, the effect on the balance sheet and the effect on the market value of each

share of a 1 for 1 scrip issue.

Problem 62

In a recent article on a leading engineering company, a financial journalist drew attention to

the fact that, according to its recent balance sheet, the net asset value per share was £4.15 yet

the company‟s ordinary shares had been quoted on the stock exchange at around £7.80 for the past few months.



43

Required:

Give reasons that might explain why the two figures are different.

Problem 63

The country of Yugalia has experienced a financial crisis over the past year and, for the

typical company, share price has been below net asset value per share yet the company has

reported a profit.

Required:

Do these apparent anomalies necessarily imply that there is something wrong with financial

reporting in Yugalia? Explain the issues involved.

Problem 64

Wizz.com, an online consumer information provider, has seen its share price treble in value

over the past eight months. It has been in business for five years and has never earned a profit.

Last year ‟s pre-tax loss was £32 million on a turnover of £23 million.

Required:

How can the shares of a company with such a poor profitability record and a negative

price/earnings ratio be in such demand?



44

Cash Flow Statement

Problem 65

Roseanne owns shares in Inchem plc, a large chemicals company with world-wide interests,

and she is worried because the share price has shown a downward trend over the past twoyears. Roseanne has asked you to explain what the cash flow statement can tell her about the

company‟s progress and current position.

She has supplied you with the following information taken form Inchem‟s recent annual

reports:

Cash flow statement for the year ended 31 st December

1997

£m

1998

£m

Net cash flow from operating activities 757 1,006

Returns on investment and servicing of finance:

Interest paid (171) (356)

Corporation tax paid (151) (126)

Capital expenditure:

Acquisition of fixed assets other than subsidiary

undertakings (623) (935)

Acquisitions and disposals of subsidiary undertakings

Acquisitions (4,366) (234)

Disposals 2,124 74

Equity dividend paid (225) (225)

(2,655) (796)

Financing:

Increase (decrease) in debt 2,937 (50)

Increase (decrease) in cash 282 (846)



45

Note:

Net cash inflow from operating activities:

Operating profit 378 405

Depreciation 434 402

Stocks decrease 18 62

Debtors increase (31) (86)

Creditors (decrease) increase (42) 223

Net cash inflow from operating activities 757 1,006

Required:

(a) An analysis of the above figures to assist Roseanne in understanding Inchem plc‟s

financial performance in 1998 and its financial position at the year end. Indicate what

additional information you require to help you with your analysis and what use you would

make of it.

(b) Explain to Roseanne what use published financial reports are in explaining share price

movements and indicate what other information might be useful.

Problem 66

C Willis

Profit and Loss Account for the year ended 31st December 19X8

£ £

Gross profit 29,328

Add Discounts received 298

Add Profit on sale of motor van 570 868

30,196

Less Expenses

Motor expenses 1,590

Wages 8,790

General expenses 2,144

Bad debts 340

Increase in bad debt provision 120

Depreciation: Motor van 1,090 14,074

16,122



46

Balance Sheet at 31st December

19X7 1X98

£ £ £ £

Fixed assets

Motor vans at cost 11,200 7,200

Less Depreciation to date 4,160 7,040 2,980 4,220

Current assets

Stock 10,295 17,150

Debtors less provision* 5,190 3,380

Bank 1,568 2,115

17,053 22,645

Less Current liabilities

Creditors 2,770 14,283 2,920 19,725

21,323 23,945

Less Long-term liability

Loan form P Bond 6,000 5,000

15,323 18,945

Capital

Opening balance b/d 12,243 15,323

Add Net profit 14,080 16,122

26,323 31,445

Less Drawings 11,000 15,323 12,500 18,945

* Debtors 19X7 £5,490 – provision £300

Debtors 19X8 £3,800 – provision £420.

Note: The motor van was sold for £2,300 during 19X8.

Required:

Draft a cash flow statement for C Willis for the year ended 31 st December 19X8

Problem 67

The directors of Alexay plc are concerned about the substantial increase in the company's

bank overdraft in 1999.

The summarised balance sheets of the company at 31st

December were:



47

1998 1999

£000 £000

Fixed assets (net of depreciation) 1,315 2,090

Current assets

Stock at cost 290 670

Trade debtors 385 610

675 1,280

Current liabilities

Bank overdraft 72 440

Trade creditors 345 210

Corporation tax 185 275

602 925

Net current assets 73 355

1,388 2,445

Less: creditors falling due after more than

one year

290 480

1,098 1,965

Share capital and reserves

Issued share capital (1£ shares) 520 620

Share premium 330 380

Revaluation reserve for land - 500

Profit and loss account 248 465

1,098 1,965

The summarised profit and loss account for Alexay plc for the year ended 31 st December

1999 was:

£000

Sales 3,900

Cost of sales 2,600

Gross profit 1,300

Administration expenses 460

Depreciation 115

Interest payable 59 634

Net profit before corporation tax 666



48

Corporation tax 170

Net profit after corporation tax 496

Dividends 279

Retained profit for the year 217

No fixed assets were disposed of during the year ended 31st December 1999.

Required:

(a) Calculate the net cash flow from operating activities for 1999.

(b) Prepare a cash flow statement in good style for 1999.

(c) Calculate and comment on the following for 1999:

(i) current ratio

(ii) gearing ratio

(iii) interest cover

(d) Reply to the following queries put to you by one of the directors of Alexay plc:

"Can you please explain to me how we have a healthy profit yet our bank overdraft has

reached a record level? Surely there must be something wrong with the profit calculations,

isn't there?"

Problem 68

The directors of N plc are extremely concerned about new trend in company's market share

price. The following information has been extracted from the books for the year to 31

December 1999:

Profit and Loss Account 1998

£000

1999

£000

Sales revenues 93,000 200,000

Profit before taxation 9,500 20,400

Taxation (3,200) (5,200)

Profit after taxation 6,300 15,200

Dividends:

preference (100) (100)

ordinary: interim (paid) (1,000) (2,000)

final (proposed) (3,000) (6,000)

Retained profit for the year 2,200 7,100



49

Balance Sheets as at 31 December

1998 1999

£000 £000

Fixed assets

Plant, machinery, equipment, at cost 17,600 23,900

Accumulated depreciation 9,500 10,750

8,100 13,150

Current Assets

Stocks 5,000 15,000

Trade debtors 8,600 26,700

Prepayments 300 400

Cash at bank and in hand 600 -

14,500 42,100

Creditors: amounts due within 1 year

Bank overdraft - 16,200

Trade creditors 6,000 10,000

Accruals 800 1,000

Taxation 3,200 5,200

Dividends 3,000 6,000

13,000 38,400

Working capital 1,500 3,700

Total assets less current liabilities 9,600 16,850

Creditors: amounts due after more than 1 year

15% debentures 600 750

9,000 16,100

Share capital

Ordinary shares of £l each 5,000 5,000

10% preference shares of £l each 1,000 1,000


9,000 16,100



50

Note: During the year to 31st December 1999, fixed assets originally costing £5,500,000 were

sold for £1,000,000. The accumulated depreciation on these assets as at 31st December 1998

was £3,800,000.

Required:

(a) Prepare a statement that helps to the directors to understand the liquidity position and

overall financial performance of the company in 1999.

b) Explain what use this report is in understanding share price movements and indicate what

other information might be useful. Refer to your statement, where appropriate, to illustrate

your point.

Problem 69

The balance sheets of R Lester are as follows:

31.12.19X7 31.12.19X8

£ £ £ £ £ £

Fixed assets

Equipment at cost 28,500 26,100

Less Depreciation to date 11,450 17,500 13,010 13,090

Current assets

Stock 18,570 16,250

Debtors 8,470 14,190

Less Bad debts provision 420 8,050 800 13,390

Cash and bank balances 4,060 3,700

30,680 33,340

Less Current liabilities

Creditors 4,140 5,730

Working capital 26,540 27,610

43,590 40,700

Financed by:

Capital

Opening balances b/d 35,760 33,590

Add Net profit 10,240 11,070

Add Cash introduced _____ 600

46,000 45,260



51

Less Drawings 12,410 8,560

33,590 36,700

Loan from J Gorsey 10,000 4,000

43,590 40,700

Notes: Equipment with a book value of £1,350 was sold for £900. Depreciation written off

equipment during the year was £2,610.

Required:

Prepare a cash flow statement for R Lester for the year ended 31 st December 19X8.

Problem 70

The following are the financial statements of Eccles Foods plc for the two years ended 31st

March 2009 and 2010:

Balance sheets as at 31st March 2010

£m

2009

£m

Fixed assets

Tangible 431 410

Intangible 19 23

Investments 82 64

532 497

Current assets

Inventories 482 401

Debtors 290 251

Cash 3 7

775 659

Creditors falling due within 1 year (422) 353 (367) 292

Total assets less current liabilities 885 789

Creditors falling due after 1 year

Loan stock (181) (213)

704 576

Capital and reserves

Called-up share capital of £1 each 385 247



52

Share premium account - 50

Retained earnings 319 279

704 576

Profit and loss accounts for the year ended 31st March

2010

£m

2009

£m

Turnover 1,240 990

Cost of sales (902) (704)

Gross profit 338 286

Distribution costs (98) (81)

Administrative expenses (73) (56)

Operating profit 167 149

Net interest paid (3) (9)

Exceptional item (4) __

Profit before taxation 160 140

Taxation (90) (80)

Profit after taxation 70 60

Dividend paid (30) (20)

Retained profit for the year 40 40

The following further information is available:

(1) Tangible fixed assets:

Cost

£m

Accumulated

Depreciation

£m

Net

£m

As at 1st April 2009 621 211 410

Additions, at cost 82 82

Disposals (30) (13) (17)

Depreciation for the year ___ 44 (44)

As at 31st March 2010 673 242 431

The assets were disposed of cash proceeds of £10 million. Any profit or loss arising is

included in operating profit for the year.

(2) Intangible fixed assets:



53

The value of goodwill has fallen during the year and the resulting write down of book value

was treated as an exceptional item in the profit and loss account.

(3) Fixed asset investments:

Additional shares were purchased for cash. No other changes occurred during the year. The

interest received during the year on these investments was £5 million, this amount is included

in net interest paid.

(4) Creditors falling due within one year are as follows:

2010

£m

2009

£m

Trade 110 130

Taxation 90 80

Bank overdraft 222 157

422 367

(5) On 1st May 2009 80 million £1 ordinary shares were issued at £1.10 each. On 1st October

2009 the share premium account was utilized in making a bonus issue of ordinary shares.

Required:

(a) Prepare a cash flow statement for Eccles Foods plc for the year ended 31st March 2010

(b) “A cash flow statement provides information on the financial performance of a company

which is not immediately available from the balance sheet or profit and loss account”.

Identify two such items from the cash flow statement of Eccles Foods plc and explain how

they illustrate the above statement.

Problem 71

The balance sheets of Easy Fix Ltd as at 31 December 2008 and 2009 and a summary of the

profit and loss account for the year ended 31 December 2009 are given below:

Balance Sheet as at 31 December

2008 2009

£‟000 £‟000

Fixed assets

Land and buildings 37,000 50,000

Plant and machinery 16,5000 19,500

Investment at cost 6,000 6,000

59,500 75,500



54

Current assets

Stocks 11,400 10,500

Debtors 12,000 10,400

Cash at bank 4,700 0

28,100 20,900

Current liabilities

Bank overdraft 0 1,500

Trade creditors 8,800 9,600

Corporation tax 4,000 3,000

12,800 14,100

10% Debentures 10,000 12,800 Net assets 64,800 69,500

Capital and Reserves

1£ ordinary shares 30,000 40,000

Share premium - 5,000

Revaluation reserve 3,000 8,000


64,800 69,500

Summary Profit and Loss Account for the Year Ended 31 st December 2009

£000

Loss before tax

(after depreciation on plant and machinery of £4,000,000 (12,300)

Tax (2,500)

Profit after tax (14,800)

Dividends (500)

Retained loss for the year (15,300)

You are given the following information:

(1) During the year several machines were disposed of for £3,200,000. The machines has a

total original cost of £4,000,000 and had a total net book value at the date of disposal of

£2,000,000.

(2) During the year, a right issue was made.

(3) Included in the loss before tax was and investment income of £1,250,000 and an interest

payment of £5,100,000



55

Required:

(a) Prepare a cash flow statement, together with the reconciliation statement of operating

profit and cash balance, for Easy Fix Ltd for the year ended 31 December 2009

(b) Discuss the advantages and disadvantages of such statements.

Problem 72

Dolente Ltd is a small company which designs, manufactures and sells innovative electronic

instruments. The directors of the company have discussed the financial statements prepared

for the year ended 31st March 2010 and have made the following remarks.

“We are surprised to see that we have a loss for the year as our bank balance seems to be

healthy and has increased from the 2009 figure”.

The following are the financial statements of Dolente Ltd for the two years ended 31 st March

2010.

2010 2009

Balance sheets as at 31st March £000 £000 £000 £000

Fixed assets 862 820

Tangible 134 128

Intangible 996 948

Current assets 520 488

Inventories 280 302

Trade debtors 38 46

Prepayments 306 214

Bank 1,144 1,050

Creditors falling due within 1 year (800) 344 (820) 230

Total assets less current liabilities 1,340 1,178

Creditors falling due after 1 year

Loans (462) (426)

878 752

Capital and reserves

Ordinary shar es of £1 each 700 600

Share premium 90 50


878 752



56

Profit and loss account for the year ended 31st March

2010

£000

Turnover 2,480

Cost of sales (2,004)

Gross profit 476

Distribution costs (290)

Administrative expenses (134)

Operating profit 52

Interest payable (46)

Exceptional items (20)

Loss before taxation (14)

Taxation -

Loss for the year (14)

The following further information is available:

(1) Tangible fixed assets:

Cost Accumulated

depreciation

Net

£000 £000 £000

As at 1st April 2009 1,242 422 820

Additions, at cost 164 164

Disposals (60) (26) (34)

Depreciation for the year 88 (88)

As at 31st March 2010 1,346 484 862

The assets were sold for cash proceeds of £10,000. Any profit or loss arising is included in the

operating profit for the year.

(2) Intangible fixed assets: These are patents on innovative electronic instruments.

£000

As at 1st April 2009 128

Purchases 40

Amortization (in operating profit) (14)

Exceptional write down (20)

As at 31st March 2010 134(3) Prepayments all relate to expenses charged against operating profits.



57

(4) Creditors falling due within one year

2010 2009

£000 £000

Trade creditors 786 650

Accrued interest 14 10

Taxation - 160

800 820

(5) On 1st May 2009 100,000 £1 ordinary shares were issued at £1.40 each.

Required:

(a) Prepare a cash flow statement for Dolente Ltd for the year ended 31st March 2010.

(b) Using the information provided by the cash flow statement, comment on the remarks of

the directors on the results for the year.



58

Ratio analysis

Problem 73

Karen has been told that Wahib & Wills plc is a fast growing company and she seeks your

advice on whether or not to buy shares in the company. She has provided you with thefollowing summarized information taken from the recent annual accounts of Wahib & Wills

plc:

Profit and loss account ₤000

Turnover 7,200

Gross profit 2,160

Net profit 300

Dividend 150

Balance sheet

Fixed assets 2,680

Stock 360

Trade debtors 240

Cash at bank 200

Trade creditors 840

Share capital (₤1 shares fully paid) 2,400

Profit and loss account 240

The share price of Wahib & Wills plc is currently 160 pence and it has been around this level

for the past few months.

The trade association to which Wahib & Wills plc belongs compiles statistics taken from the

annual accounts of its members, and from other sources, and you have obtained the following

recently prepared data which give the industry average for seven statistics as:

Gross profit margin 50%

Current ratio 2.54

Quick (liquid) ratio 1.87

Debtors collection period (days) 28

Stock holding period (days) 36

Trade credit period (days) 54

Price/earnings ratio 10

Required:



59

(a) Compute comparable ratios to those listed above for Wahib & Wills plc. All calculations

must be clearly shown.

(b) Make use of your calculations in (a) above to comment on the firm‟s financial position.

Problem 74

The chairman of Badwa plc, which owns a chain of hotels, is concerned about recent

comments in the financial press to the effect that the company is too highly geared. The

following figures appear in the company‟s recent balance sheet:

₤

Called up share capital 1,000,000

Share premium account 4,800,000

Profit and loss account 6,100,000

8% Debentures 13,990,000

Total assets less current liabilities 25,890,000

The chairman feels that the accounts do not portray the company‟s true financial position. In

particular, he makes the following points:

(1) The company‟s freehold property was bought five years ago for ₤18 million which is also

its current book value. The market value is now ₤32 million.

(2) The reputation of Badwa plc is as asset in itself. Customers are attracted to the hotels

because of their reputation for quality and service. The chairman reckons that the reputation

must be worth at least ₤13 million.

(3) Stock includes ₤400,000 for fine wines at cost; their current replacement cost is ₤600,000.

(4) Amongst the fixtures and fittings are works of art that cost ₤1,200,000 and whose book

value is ₤300,000. They are currently worth ₤1,000,000.

Required:

(a) Give reasoned arguments to indicate what values you would like to see in the balance

sheet of Badwa plc for each of the four items referred to above. If any are controversial,

explain why this is so.

(b) Redraft the balance sheet extract incorporating you suggestions in (a) above and calculate

the gearing ratio before and after any changes you have made.

(c) Is high gearing necessarily a bad thing? Do you consider that increasing asset values in a

balance sheet is likely to lead to less criticism by the financial press of a company‟s gearing?Explain your reasoning carefully.



60

Problem 75

Although MX plc. has a large cash balance, it offered its shareholders the choice of whether

to have the final dividend for the year ended 31st March 1999 in shares (a scrip dividend) or in

cash. The majority opted for shares and the necessary accounting entries were made in the

published accounts for 1999.

Required:

For each of the following ratios, state whether it is higher, lower or unchanged as compared

with ratios calculated to reflect a 100% cash dividend and explain briefly why this is so.

(a) Return on shareholders‟ equity

(b) Return on net assets

(c) Current ratio

(d) Creditors turnover ratio

(e) Gearing ratio

(f) Dividend cover.

Problem 76

The summarized balance sheet of G Ltd is given below:

Total assets less current liabilities 2,300

Financed by:

Share capital, 25p shares 400

Share premium account 360

Revaluation reserve 300

Profit and loss account 440

10% debenture loan, 2006 800

2,300

Required:

Explain briefly the nature of the share premium account and how it arises, and calculate the

following:

(i) the company‟s gearing ratio

(ii) the maximum dividend per share that company could legally declare assuming that it has

sufficient cash.

Problem 77

The following statistics relates to Gandee plc for 2001:



61

Profit before interest and tax £120,000

Retained profit for the year £20,000

Dividend for the year £19,200

Interest cover 5

Dividend cover 4

Required:

What was the tax charge for 2001? Give three possible reasons why the directors of Gandee

plc have chosen not to distribute all the after tax profit of the year as dividend.

Problem 78

The following information relates to two companies in the same industry whose financial year

end is the same:

Cax plc Dox plc

Profit before interest and tax ₤1,680,000 ₤1,680,000

Operating profit margin 10.50% 16.00%

Return on net assets ? 12.00%

Asset turnover ratio 1.6 ?

Required:

Calculate the return on net assets for Cax plc and the asset turnover ratio for Dox plc. Give

possible reasons for the differences in the three ratios for the two companies.

Problem 79

Company A

₤000

B

₤000

C

₤000

Ordinary shares 600 400 50

12% debentures ___ 200 550

600 600 600

The return on capital employed was 20 per cent for each firm in 19X4 and in 19X5 was 10

per cent. Corporation tax in both years was assumed to be 55 per cent, and debenture interest

is as allowable expense against corporation tax.

Required:

(a) Calculate the percentage return on the shareholders‟ capital for each company for 19X4

and 19X5. Assume that all profits are distributed.(b) Use your answer to explain the merits and the dangers of high gearing.



62

Problem 80

Adrian Frampton was considering the purchase of one of two businesses. However Frampton

had only been provided with limited information about the businesses, as follows:

Summarised financial information for the year ended 31st December 19X9:

Business

X

Business

Y

Cost of goods sold ₤400,000 ₤600,000

Administrative expenses ₤50,000 ₤60,000

Average stock at cost ₤40,000 ₤50,000

Working capital as at 31st December 19X9 ₤90,000 ₤250,000

Selling and distribution expenses ₤15,000 ₤35,000

Proprietor‟s capital at 1st January 19X9 ₤200,000 ₤350,000

Gross profit percentage mark-up on cost 20 25

Additional information:

(1) Average stock had been calculated by using the year‟s opening and closing stocks.

Subsequently it was discovered that Business Y had overvalued its stock on 31st December

19X9 by ₤10,000.

(2) Business X‟s administrative expenses included a payment for rent of ₤15,000 which

covered a three-year period to 31 December 19X1.

(3) A sum of ₤2,500 was included in the administrative expenses of Business Y in respect of a

holiday taken by the owner and his family.

(4) Cash drawings for the year ended 31 December 19X9 were:

₤

Business X 20,000

Business Y 25,000

(5) The owners of the businesses had stipulated the following prices for their businesses:

₤

Business X 190,000

Business Y 400,000

Required:

(a) Based on the information available prepare comparative trading and profit and loss

accounts for the year ended 31st

December 19X9.



63

(b) Using the information provided and the accounting statements prepared in (a), calculate

relevant accounting ratios in order to give Frampton a basis for assessing the performances of

the two businesses. Comment on the results.

(c) What additional information is needed in order to assess more accurately

(i) the liquidity of the businesses

(ii) the future prospects of the businesses?

Problem 81

John Jones is considering purchasing shares in one of two companies and has extracted the

following information from the balance sheet of each company:

Company A plc

₤000

Company B plc

₤000

Authorised share capital

₤1 ordinary shares 600 1,000

8% ₤1 preference shares 400

Issued share capital

₤1 ordinary shares 300 800

8% ₤1 preference shares 200

Reserves

Share premium 300 400


Loan capital

10% debentures (19X0) 200

12% debentures (19X6) 400

Required:

(a) Define the term “gearing” stating clearly what is meant by a low gearing ratio.

(b) Calculate the gearing factor for each company

(c) Explain to John Jones the significance of gearing to an ordinary shareholder in each of the

companies above.

(d) Assuming for each company a trading profit of ₤200,000 before interest and an ordinary

dividend of 15 per cent complete the profit and loss appropriation account for a year for each

company. You should ignore taxation.



64

Problem 82

Durham Limited had an authorized capital of ₤200,000 dividend into 100,000 ordinary shares

of ₤1 each and 200,000 8% preference shares of 50p each. The following balances remained

in the accounts of the company after the trading and profit and loss accounts had been

prepared for the year ended 30th April 19X9:

Dr

₤

Cr

₤

Premises at cost 86,000


Ordinary shares: fully paid 100,000

8% Preference shares: fully paid 50,000

Electricity 100

Cash at bank 13,100

Profit and loss account balance 1st May 19X8 14,500

Debtors and creditors 20,000 12,900

Net profit (year ended 30 th April 19X9) 16,500

Machinery and plant at cost 60,000

Provision for depreciation on machinery and

plant 40,000

Stock 60,000

Provision for doubtful debts 4,000

Insurance 900

Preference share dividend paid 2,000

242,000 242,000

The Directors have recommended:

(1) a transfer of ₤5,000 to general reserve;

(2) an ordinary dividend of ₤0.15p per share; and

(3) a provision for the unpaid preference share dividend.

Required:

(a) Prepare the profit and loss appropriation account for year ended 30 th April 19X9.

(b) Prepare the balance sheet as at 30 th April 19X9, in a form which shows clearly the

working capital and the shareholders‟ funds. (c) Identify and calculate:



65

(i) one ratio indicating the firm‟s profitability;

(ii) two ratios indicating the firm‟s liquidity position.

(d) Make use of your calculations in (c) above to comment on the firm‟s financial position.

(e) Name two points of comparison which are not available from the information above in this

question but which could make your comments in (d) above more meaningful.

Problem 83

The summarised accounts of Hope Ltd for the year 19X8 and 19X9 are given below:

Trading and Profit and Loss Accounts for the year ended 31 December

19X8

₤000

19X9

₤000

Sales 200 280

Less Cost of sales 150 210

Gross profit 50 70

Less

Administration expenses 38 46

Debenture interest _ 4

Net profit 12 20

Balance Sheet as at 31 December

19X8

₤000

19X9

₤000

19X8

₤000

19X9

₤000

Ordinary share capital 100 100 Fixed assets, at cost

Profit and Loss Account 30 41 Less Depreciation 110 140

8% Debentures 50

Creditors 15 12 Stock 20 30

Bank 10 Debtors 25 28

_ _ Bank _ 5

155 203 155 203

Stock at 1st January 19X8 was ₤50,000.

Required:

(a) Calculate the following ratios for 19X8 and 19X9:

(i) Gross profit : Sales(ii) Stock turnover



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(iii) Net profit : Sales

(iv) Quick („acid test‟)

(v) Working capital

(vi) Net profit : Capital employed

(b) State the possible reasons for and significance of any changes in the ratios shown by your

calculations.

Problem 84

Answer the following questions put to you by a friend:

“Do you think the shares in Rahman and Shah plc are worth buying at the present price of 150

pence? I see from the balance sheet that the net assets per share are 220 pence. Why are the

two figures different?”



67

Consolidated Financial Statements

Problem 85

On 1st January 1999 Huge plc purchased all the issued share capital of Medium Ltd for ₤25.2

million which was paid for by a new issue of ₤1 shares in Huge plc at ₤1.40 each. Thetangible net assets included in the balance sheet of Medium Ltd had a fair value to Huge plc at

that time of ₤17 million. Medium Ltd sells a well-known branded product which Huge plc

valued at ₤6 million and which is to be included in the accounts at that figure.

Required:

(a) Show how the takeover of Medium Ltd will affect the balance sheet of Huge plc.

(b) Show how the consolidated balance sheet of the Huge plc group will be affected by the

takeover of Medium Ltd.

(c) What is an asset? How would you decide whether a brand name should be permitted to

appear on a company‟s balance sheet?

(d) Give reasons why some companies might wish to include brands on their balance sheet

whereas others might not.

(e) A director of Huge plc argues that, unlike most other fixed assets, the brand acquired on

the takeover of Medium Ltd should not be depreciated as its value is likely to be maintained

or even increased over time. Comment on this view and explain whether or not you agree

with it.

Problem 86

Axe plc acquired 75% of the ordinary share capital of Bee Ltd by issuing 40,000 new ₤1

ordinary shares to the shareholders of Bee Ltd. At that date the net assets of Bee Ltd,

according to its balance sheet, were ₤80,000. The fair value of Bee Ltd‟s net assets was found

to be ₤100,000. The market value of each share in Axe plc was ₤2.20. The company has no

other subsidiaries.

Required:

Give calculations for the Axe plc group of:

(a) goodwill on consolidation

(b) minority interests

(c) the change in share capital, reserves and net assets of the group following the acquisition.

What figure would be shown in Axe plc‟s own balance sheet in respect of the investment in

Bee Ltd?



68

Alternative Methods of Accounting

Problem 87

Angelina commenced business on 1st January with ₤10,000. Her transactions in the first year

(all for cash) were as follows:₤

1 January Purchased 3 KXs 9,000

31 December Sold 2 KXs 13,000

Purchased 2 KXs 8,400

Paid expenses 2,000

Her accountant has prepared the following profit and loss account for the first year of

business:

₤

Sales 13,000

Purchases 17,400

Less closing stock (11,400) 6,000

Gross Profit 7,000

Less expenses 2,000

Net profit for the year 5,000

The general price level rose during the year by 5%.

Angelina recalls reading, during her undergraduate studies, that the purpose of income

calculation is to give an indication of the amount which one can consume without

impoverishing oneself. She has interpreted this to mean that, if she withdraws ₤5,000, the

capital of the business will be maintained at its original level.

Required:

Is Angelina correct in assuming she can withdraw ₤5,000 and still keep her original capital

intact? Explain your assumptions carefully and give calculations to support you answer.

Problem 88

“During the last year general price inflation in the economy was 2% and the replacement cost

of our factory machinery increased by 30%. Would it be sensible to account for such changes

in the annual accounts?”

Required:



69

Explain what the effect on company profit and return on shareholders‟ equity might be if such

adjustments were made. Would such general and specific inflation adjustments merely serve

to confuse rather than inform users of accounts?



70

Introduction to Costing

Problem 89

Porter company manufactures a number of furniture products. The accountant of the company

unfortunately is on vacation. There is a need to prepare the data for cost analysis and planning. Selected costs are given below. You are just appointed for internship in accounting

department and asked for help.

(a) Wood is used in the manufacturing of the tables at a cost of £100 per table.

(b) The tables are assembled by workers, at a cost of £40 per table.

(c) Workers assembling the tables are supervised by a fac tory supervisor who is paid £25,000

per year.

(d) Electrical costs of £2 per machine-hour are incurred in the factory in the manufacturing

department. Four machine-hours are required to produce the table.

(e) The depreciation cost of the machines in the manufacturing department totals to £10,000

per year.

(f) The salary of the president of Porter is £100,000 per year.

(g) Porter spends £250,000 to advertise its products.

(h) Salespersons are paid at a commission of £30 for each table sold.

(i) Instead of producing the tables, Porter could rent its factory space out at a rental income of

£50,000 per year.

Required:

Fill in the table below.

Item VC FC Period Direct

Material

Direct

Labour

Manufac.

Overheads

Direct Indirect Sunk Opportunity

(a)

(b)

Problem 90

The following information has been taken from the ledger accounts of Klear-Seal Company

for the year ended December 31, 19X5:

$

Selling expenses 140,000

Raw materials inventory, January 1 90,000

Raw materials inventory, December 31 60,000



71

Utilities, factory 36,000

Direct labor cost 150,000

Depreciation, factory 162,000

Purchases of raw materials 750,000

Sales 2,500,000

Insurance, factory 40,000

Supplies, factory 15,000

Administrative expenses 270,000

Indirect labor 300,000

Maintenance, factory 87,000

Work in process inventory, January 1 180,000

Work in process inventory, December 31 100,000

Finished goods inventory, January 1 260,000

Finished goods inventory, December 31 210,000

Management wants to organize these data into a better format so that statements can be

prepared for the year.

Required:

(a) Prepare a schedule of cost of goods manufactured for 19X5.

(b) Compute the cost of goods sold for 19X5.

(c) Using data as needed from (a) and (b), prepare an income statement for 19X5.



72

Job-Order Costing

Problem 91

Hogle Company is a manufacturing firm that uses job-order costing. On January 1, 19X5, the

company‟s inventory balances were as follows: $

Raw materials 20,000

Work in process 15,000

Finished goods 30,000

The company applies overhead cost to jobs on the basis of machine-hours worked. For 19X5,

the company estimated that it would work 75,000 machine-hours and incur $450,000 in

manufacturing overhead cost. The following transactions were recorded for the year:

(a) Raw materials were purchased on account, $410,000.

(b) Raw materials were requisitioned for use in production, $380,000 ($360,000 direct and

$20,000 indirect).

(c) The following costs were incurred for employee services: direct labor, $75,000; indirect

labor, $110,000; sales commissions, $90,000; and administrative salaries $200,000.

(d) Sales travel costs were incurred, $17,000.

(e) Utility costs were incurred in the factory, $43,000.

(f) Advertising costs were incurred, $180,000.

(g) Depreciation was recorded for the year, $350,000 (80 percent relates to factory operations,

and 20 percent relates to selling and administrative activities).

(h) Insurance expired during the year, $10,000 (70 percent related to factory operations, and

the remaining 30 percent relates to selling and administrative activities).

(i) Manufacturing overhead was applied to production. Due to greater than expected demand

for its products, the company worked 80,000 machine-hours during the year.

(j) Goods costing $900,000 to manufacture were completed during the year.

(k) Goods were sold on account to customers during the year at a total selling price of

$1,500,000. The goods cost $870,000 to manufacture.

Required:

(a) Prepare journal entries to record the transactions above.

(b) Post the entries in (a) to T-accounts (don‟t forget to enter the opening balances in the

inventory accounts).



73

(c) Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal

entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold.

(d) Prepare an income statement for the year.



74

Allocation of overheads: Traditional Approach and Activity-Based Costing

Problem 92

Dinghy Products Ltd makes two products, masts and booms. There are two production

departments, Turning and Finishing. There is also a sales administration office and astoreroom for parts and materials. The following information is available.

Turning Finishing Office Storeroom

Floor space (m²) 300 150 10 40

Issues of parts and materials per month 20 5

Direct labour hours per mast 3 4

Direct labour hours per boom 4 3

The following are the budgeted output and costs for a month:

Output of masts 200

Output of booms 800

Factory rent £1,000

Salary of storeman (all storeroom costs) £1,300

Salary of office clerk (all office costs) £1,500

There are the only indirect costs of production and a direct labour hour basis of absorption

should be used for the two production departments.

Required:

Calculate the indirect cost of producing a mast and a boom.

Problem 93

The following information is available for a factory which houses the assembly, finishing and

machining departments:

Assembly

Department

Finishing

Department

Machining

Department

Floor areas 40,000 sq ft 35,000 sq ft 25,000 sq ft

Number of employees 150 100 50

NBV of machines $1,800,000 $1,200,000 Nil

During the month of January 2007, the factory incurred the following indirect overheads:

Rent $50,000

Heating and Electricity $25,000

Indirect labour $70,000



75

The management have decided to allocate the above indirect overheads using the following

bases: floor areas for both rent and heating and electricity, and number of employees for

indirect labour cost.

As the machining department‟s task is to look after the machines in the assembly and

finishing department, the management feel that it should be re-allocated to the assembly and

finishing department based on the NBV of machines.

Required:

Calculate the allocation overheads to the assembly and finishing departments based on the

information available above.

Problem 94

The indirect costs incurred by the business on behalf of all departments taken together are

given below:

Cost item Total cost

this month,

£

Indirect materials 36,000

Indirect labour 40,000

Rent 1,000

Insurance 1,600

Depreciation 2,000

Total 80,600

The costs must be apportioned (shared) over the departments because there is insufficient

information to permit allocation of costs as a whole. The following table sets out relevant

information about each department which will be used in the process of determining an

overhead cost rate:

Assembly Finishing Maintenance

Direct materials used for production £400,000 £500,000 not applicable

Number of employees 10 25 5

Floor area 100 sq m 200 sq m 100 sq m

Value of machinery £30,000 £50,000 £20,000

Number of direct labour hours

worked on production

55,000 64,000 not applicable



76

Required:

Calculate the overhead cost allocated to the product. Suppose to produce the product you need

to spend 2 hours in assembly department and 3 hours in finishing department.

Problem 95

Aerodec, Inc., manufactures and sells two products, X and Y. Annual sales in units, labour

time per unit, and total manufacturing time per year are provided below:

Total

Hours

Product X: 2,000 units x 5 hours 10,000

Product Y: 10,000 units x 4 hours 40,000

Total hours 50,000

Costs for materials and labour for one unit of each product are given below:

Product

X Y

Direct materials $25 $17

Direct labour (at 6$ per hour) $30 $24

Manufacturing overhead costs total $800,000 each year. The breakdown of these costs

between the company‟s six activity centers is given below. The cost driver for each activity

center is shown in parentheses.

Expected Number of Events

or Transactions

Activity Center and Cost Driver Traceable

Costs

Total Product

X

Product

Y

Labour related (direct labour-hours) $80,000 50,000 10,000 40,000

Machine setups (number of setups) $150,000 5,000 3,000 2,000

Quality inspections (number of inspections) $160,000 8,000 5,000 3,000

Production orders (number of orders) $70,000 400 100 300

Material receipts (number of receipts) $90,000 750 150 600

General factory (machine-hours) $250,000 40,000 12,000 28,000

$800,000

Required:

(a) Aerodec, Inc., has six activity centers. Classify the activity in each of Aerodec‟s activitycenters as either a unit-level, batch-level, product-level, or facility-level activity.



77

(b) Assume that the company applies overhead cost to products on a basis of direct labour-

hours.

(i) Compute the predetermined overhead rate that would be used.

(ii) Determine the cost to manufacture a unit of each product, using the predetermined

overhead rate computed in (b)(i).

(c) Assume that the company uses activity-based costing to compute overhead rates.

(i) Compute the predetermined overhead rate per event or transaction for each of the

six activity centers listed above.

(ii) Using the rates developed in (c)(i), determine the amount of overhead cost that

should be assigned to a unit of each product.

(iii) Determine the cost ot manufacture a unit of each product and compare this cost to

the cost computed in (b) (ii).

Problem 96

Clinton Ltd is a small company, which was established a year ago to produce and sell two

products, A and B, within a local area. Two local competitors also produced A, but B was a

new development and there was no competitor in the market. Although their prime costs are

very different, each product requires the same number of machine hours to produce one unit.

The finance director has based the selling prices upon the manufacturing cost plus a mark-up

of 25% to cover non-manufacturing costs and profit. The following figures apply:

A B

Budgeted output (units) 700 1,400

£ £

Prime cost 80.00 9.00

Overhead (8 machine hours) 152.40 152.40

232.40 161.40

Mark-up (25% of cost) 58.10 40.35

Selling price 290.50 201.75

As the other producers of A maintained their previous selling price of £380 per unit, the

company has had no difficulty in attaining the desired sales of 700 units of A. B also sold well

and the target of selling 1,400 units has been achieved. The company achieved full recovery

of overheads.



78

The management director has just heard that both competitors have announced their intention

to stop producing A. However, one of them has also declared that they will be starting to

produce B and will offer it for sale at £160 per unit, undercutting Clinton‟s selling price of B.

The management director has sought your advice and after some investigation you have

established the following additional information

(i) The production process comprises two distinct cost centers, Assembly and Finishing.

(ii) The machine hours required to produce each product are:

A B

Machine hours in: Assembly 6 2

Finishing 2 6

Total 8 8

The aggregate overhead budgeted and spent in the first year, £320,000 is attributable as

follows:

£000

Assembly 240

Finishing 80

Total 320

Required:

(a) Explain with supporting calculation how the finance director‟s allocation of £152.40

overhead cost per unit of both products would have been arrived at. Comment on this method

and its potential effects on business decisions.

(b) Prepare product costs and selling prices using an alternative allocation of overheads to A

and B, and support your method with reasoned arguments. Offer your suggested explanation

for the competitors‟ behavior and advise the managing director.

(c) Briefly discuss the issue of, and methods for, allocating non-manufacturing overheads to

products.



79

Absorption and Variable Costing

Problem 97

Palit Ltd. commenced business on 1 April 1993 and purchased equipment for £170,000 to

manufacture product NPQ as from that date. The results for the year to 31 March 1994 andthe budget for the following year are as follows:

1993/4

Actual

1994/5

Budget

NPQs produced (units) 2,000 2,200

NPQs sold (units) 1,500 2,000

£ £

Unit selling price of NPQs 160 160

Cost of raw materials purchased 70,000 77,000

Direct wages 50,000 55,000

Manufacturing expenses:

Variable 10,000 11,000

Fixed 30,000 30,000

Selling and administrative expenses 50,000 50,000

No stock of materials and work in progress are held at any time. The NPQ manufacturing

equipment is expected to last until 31 March 1998 and it will then be sold for an estimated

sum of £30,000. The straight-line method is to be used for depreciation.

Annual accounts for the year ended 31 March 1994 and a budget for the following year are

now being prepared and you are asked to advise on how to value stocks of finished goods.

The directors of Palit Ltd. are keen to use a method which will be helpful to management in

understanding how the business is progressing. The following alternative bases have been

suggested:

(i) absorption costing

(ii) variable costing

Required:

(a) Using absorption costing, draw a profit and loss account for Palit Ltd. for the year ended

31 March 1994 and a budgeted profit and loss account for the following year.

(b) Using variable costing, draw a profit and loss account for Palit Ltd. for the year ended 31

March 1994 and a budgeted profit and loss account for the following year.



80

(c) Discuss the two stock valuation bases and give advice to the directors of Palit Ltd. on

which to use for management information purposes and why.

Problem 98

Coase Ltd is a single-product manufacturing company which uses a marginal costing system

for internal management reports. The company‟s annual profit and loss accounts for external

reporting purposes are based on full absorption costing.

The following data refer to the years ended 30th June 2007 and 2008:

2007

£

2008

£

Selling price 90

Marginal cost per unit

Direct materials 21 23

Direct labour 19 22

Marginal factory overheads 8 10

Marginal selling and administrative expenses 2 3

Fixed factory overheads 170,000 180,000

Units Units

Opening stock 1,500 2,000

Closing stock 2,000 1,500

Sales 20,000 25,000

The normal volume used for the purpose of absorption costing is 28,000 units in both years.

The company uses the first-in first-out assumption for the calculation of cost of sales.

Required:

(a) Prepare internal management profit statement for the year ended 30 th June 2008 using

marginal costing.

(b) Prepare a draft profit and loss account for the year ended 30th June 2008 using full

absorption costing.

(c) Give calculations showing why the profits for 2008 are not the same in your answers to (a)

and (b) above. Explain your answer.

Problem 99

John Smith, a friend of yours, has been trading for the past two years producing and sellingskids. Although his accountant has drawn up accounts for his he feels they do not give an



81

accurate picture of the business performance for decision-making purposes. He has asked you

to look at his records and to draw up alternative profit and loss accounts for each of the past

two years.

The selling price for skids has been £9 per unit for the past two years and the following

information is available:

1997 1998

Units Units

Sales 1,500 2,000

Production 1,900 1,800

£ £

Costs:

Factory variable 5,700 5,400

Factory fixed 3,800 3,330

Administration fixed 2,000 2,200

Selling variable 1,800 2,400

John Smith commenced business in 1997 with no stock and he uses FIFO for stock valuation

purposes.

Required:

(a) Produce profit and loss accounts for 1997 and 1998 using absorption costing.

(b) Produce profit and loss accounts for 1997 and 1998 using variable costing.

(c) Assume now that if John Smith decided to spend £600 in 1998 on improved quality

control procedures in the factory then sales volume for the year would rise by 5%. Explain

which costing method would give the more useful measure to indicate the profitability of the

decision. Make use of the data in this question to illustrate your explanation.

Problem 100

Gladstown Manufacturing has added two new products to its range. Its accountant has

produced the following summarised financial statement showing the profit earned on these

products for the first year using absorption costing.

Beta

£

Delta

£

Materials 25,000 7,500

Direct labour 60,000 30,000



82

Production overheads 120,000 60,000

Cost of sales 205,000 97,500

Sales 250,000 105,500

Gross profit 45,000 8,000

Other overheads 20,500 9,700

Net profit / (loss) 24,500 (1,700)

Units Units

Sales 25,000 7,500

Closing stock of finished goods 2,000 1,250

There is concern that Delta is showing a loss and it has been suggested that the use of

marginal (variable) costing would give a fairer picture of the financial results.

Further analysis shows that one-third of the production overhead charged to each product

varies according to the level of production whereas two-thirds of the charge is product-related

and is fixed. 75% of the other overheads are company overheads that have been allocated to

the products and 25% vary with the level of sales of each product.

Required:

(a) Redraft the absorption costing statement in more detail showing such matters as the cost

of goods produced, stocks, fixed overheads and variable overheads,

(b) Prepare a statement showing the contribution and net profit of each product using

marginal (variable) costing.

(c) Explain why the net profit figures are different under the two methods.



83

Cost-Volume-Profit Analysis

Problem 101

Drake Ltd‟s cost and revenues for the current year are expected to be:

£ Direct labour 6,000

Direct materials 7,000

Factory indirect expenses:

Variable 4,500

Fixed 500

5,000

Administration expenses 1,200

Selling and distribution expenses 600

Finance expenses 200

£20,000

It was expected that 2,000 units would be manufactured and sold, the selling price being £11

each.

Suddenly during the year two enquiries were made at the same time which would result in

extra production being necessary. They were:

(A) An existing customer said that he would take an extra 100 units, but the price would have

to be reduced to £9 per unit on this extra 100 units. The only costs that would be involved

would be in respect of variable costs.

(B) A new customer would take 150 units annually. This would mean extra variable costs and

also an extra machine would have to be bought costing £1,500 which would last for 5 years

before being scrapped. It would have no scrap value. Extra running costs of this machine

would be £600 per annum. The units are needed for an underdeveloped country and owing to

currency difficulties the highest price that could be paid for the units was £10 per unit.

Required:

On the information above, and assuming that there are no alternatives open to Drake Ltd,

should the company accept or reject these orders? Draft the memo that you would give to the

managing director of Drake Ltd.



84

Problem 102

Greatsound Ltd manufactures and sells compact disc players, the cost of which is made up as

follows:

£

Direct material 74.80

Direct labour 18.70

Variable overhead 7.50

Fixed overhead 30.00

Total cost 131.00

The current selling price is £187.

Greatsound Ltd. works a day shift only, at present producing 120,000 compact disc players

per annum, and has no spare capacity.

Market research has shown that there is a demand for an additional 60,000 compact disc

players in the forthcoming year. However, these additional sales would have a selling price of

£150 each. One way of achieving the extra production required is to work a night shift.

However, this would increase fixed costs by £2,500,000 and the labour force would to be paid

an extra 20 per cent over the day shift rate.

The company supplying the materials to Greatsound Ltd. has indicated that it will offer a

special discount of 10 per cent on total purchases if the annual purchases of materials increase

by 50 per cent.

The selling price and all other cots will remain the same

Required:

Assuming that the additional purchases will only be made if the night shift runs, you are

required to:

(a) advise Greatsound Ltd whether it should proceed with the proposal to commence the night

shift, based on financial considerations.

(b) calculate the minimum increase in sales and production required to justify the night shift.

(c) give four other matters which should be taken into consideration when making a decision

of this nature.

Problem 103

Xebec Ltd manufactures three perfumes, Silk, Musk and Opia. The selling prices and the

variable costs per unit of each product are as follows:



85

Silk

£

Musk

£

Opia

£

Selling price 15 20 30

Variable cost 10 14 20

Xebec‟s fixed costs are £150,000 per year.

There is a shortage of the raw material called Essence which is used in all three products. Silk

uses 2 kilos, Musk uses 1 kilo and Opia uses 3 kilos of Essence per unit of output. Only

120,000 kilos of Essence will be available for the year.

In addition, market constraints are expected to restrict the production and sales of each

product for the year to:

Units

Silk 40,000

Musk 8,000

Opia 15,000

Required:

Calculate the mix of sales which would enable Xebec Ltd to maximize profits, and calculate

the profit for the year which would be achieved by that sales mix.

Problem 104

A summary of Pareto Company‟s profit statement for last year is presented below. Exept as

noted, the cost and sales relationship for the current year is expected to follow the same

pattern. The company is operating at full capacity.

£

Sales (1,000,000 bottles at £0,50) 500,000

Variable costs 300,000

Fixed costs 100,000

Total costs 400,000

Profit 100,000

Required:

(a) What is the break-even point in units?

(b) What is the margin of safety in units?

(c) If an extension to the factory is built it would add £50,000 to the fixed costs and increase

production capacity by 60 per cent. Variable costs per unit are also expected to increase by 10 per cent. The management of the company feels that it should earn at least £10,000 each year



86

on the new investment. Calculate whether the proposed extension provides sufficient capacity

for the company to maintain existing profits and earn the minimum required on the new

investment, assuming that all of the increased capacity can be sold.

Problem 105

Mento Company manufactures and sells a single product. The company‟s sales and expenses

for the last quarter follow:

Total Per Unit

Sales $450,000 $30

less Variable expenses $180,000 $12

Contribution margin $270,000 $18

less Fixed expenses $216,000

Net income $54,000

Required:

(a) What is the quarterly break-even point in units sold and in sales dollars?

(b) Without resorting to computations, what is the total contribution margin at the break-even

point?

(c) How many units would have to be sold each quarter to earn a target net income of

$90,000? Use the unit contribution method. Prove your answer by preparing a contribution

income statement at the target level of sales.

(d) Refer to the original data. Compute the company‟s margin of safety (MS) in both dollar

and percentage terms.

(e) What is the company‟s contribution margin ratio (CM ratio)? If sales increase by $50,000

per quarter, by how much would you expect quarterly net income to increase? (Do not prepare

an income statement; use CM ratio to compute your answer).

Problem 106

A building company constructs a standard unit which sells for £30,000. The company‟s costs

can be readily identifiable between fixed and variable costs.

Budgeted data for the coming six months include the following:

Sales

(in units)

Profit

(£)

January 18 70,000



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February 20 100,000

March 30 250,000

April 22 130,000

May 24 160,000

June 16 40,000

You are told that the fixed costs for the six months have been spread evenly over the period

under review to arrive at the monthly profit projections.

Required:

(a) Prepare a graph for the total sales, costs and output for the six months under review that

shows:

(i) the break-even point in units and revenue;

(ii) total fixed costs;

(iii) the variable cost line;

(iv) the margin of safety for the total budgeted sales.

(b) The company is worried about the low level of sales. The sales director says that if the

selling price of the unit was reduced by £5,000 the company would be able to sell 10% more

units. All other costs would remain the same, you are told. Determine whether the company

should reduce the selling price to attract new sales in order to maximize profit. Clearly show

any workings.

(c) Evaluate whether the assumption that costs are readily identifiable as either fixed or

variable throughout a range of production is realistic. Give examples of any alternative

classification.

Problem 107

You are provided with the following information relating to the sales, estimated demands and

production costs for each bench, table and chair.

Bench Table Chair

Estimated selling price £60 £71 £45

Maximum demand In units 1,800 1,500 3,000

Raw materials - timber £10 £12 £2

- metal fittings £3 £4 £7

- fabric - - £6

Packing £2 £2 £1

Each bench, table or chair involves in two separate stages of processing.



88

1. The timber is machined, finished and assembled. Metal fittings are fixed.

2. The products are painted and varnished to packaging in polythene and cardboard.

Labour costs are based on the following estimated time (in minutes) required for each

processing stage:

Stage 1 Stage 2

Benches 180 20

Tables 150 60

Chairs 60 40

The following rates for labour are applied:

Stage 1 Stage 2

£ per hour 4 3

There are a maximum of 10,500 hours of labour available for stage 1.

Required:

(a) Advise the management the maximum output for each product and the total contribution

of the proposed optimal production plan.

(b) Explain clearly the basis method used in (a).

(c) Identify two factors that should be considered before a final decision is made.



89

Budgeting

Problem 108

The following figures have been taken from the budget of Solaja Ltd, a company in the retail

trade, for the year to 31 December 1998:January February March April

Sales (units) 5,000 6,000 7,000 5,000

£ £ £ £

Expenses:

Distribution 4,500 4,700 5,200 4,500

Administration 3,000 3,600 4,400 3,000

Depreciation 1,000 1,000 1,500 1,500

The following additional information is available:

(1) The selling price is £6 per unit. It will increase to £6.70 per unit for all sales in April and

subsequent months. 25% of budgeted sales revenue is expected to be received in the month of

sale and 70% in the following month. 5% of all sales are expected to lead to bad debts.

(2) The budgeted number of units of stock held at the end of each month is equal to the

budgeted sales for the following month.

(3) The purchase price of stock has been £3.50 per unit since October 1997 and this is

expected to increase to £4 per unit for all purchases in February and subsequent months.

(4) 60% of all purchases are paid in the month of purchase and 40% in the following month.

(5) All expenses are paid in the month in which they are incurred.

(6) Solaja Ltd plans to buy new fixed assets for £43,000 paying a deposit of £15,000 in

February. The balance will be paid in monthly instalments of £2,000 commencing in March.

(7) The chairman has suggested that he might be willing to lend up to £12,000 to the company

for a maximum of four months to avoid asking the bank for an overdraft.

(8) The business is seasonal and, as indicated in the above budget, results in April are

expected to be similar to those in January. There is a three month cycle so the results in May

and June are expected to be similar to those in February and March respectively.

(9) Summarised balance sheet at 31 December 1997:

£

Fixed assets (at book value) 12,500

Stock at cost 17,500

Debtors (after bad debt provision) 29,400



90

Cash at bank 2,000

Creditors (7,000)

Share capital and reserves 54,400

Required:

(a) A monthly cash budget for Solaja Ltd for January, February, March and April and the total

for the four months presented in the form of a table.

(b) A budgeted balance sheet at 30 April 1998.

(c) Your comments on the impact on the company if it were to borrow up to £12,000 from the

chairman to help finance the purchase of the new fixed assets.

Problem 109

The management director of Pumpkin Ltd was reviewing the results of the company for the

financial year ended 31 March 19X0. The following summarized information was available:

Balances as at 1 April 19X9 £

Issued ordinary share capital:

£1 fully paid shares 150,000

Share premium account 100,000

Balance of retained earnings 40,000

Balances as at 31 March 19X0 £

Net profit for the year 19X9/X0 70,0000

Fixed assets 300,000

Bank overdraft 150,000

Other net current assets 210,000

Note: There were no other accounts with balances. The balances as at 1 April 19X9 had

remained unchanged throughout the year.

The management director was pleased that the company had made a good profit, but he was

rather concerned that a healthy bank balance at the beginning of the year had now become a

large bank overdraft.

Consequently he asked the company accountant to prepare forecast information for 19X0/X1

in order that the cash situation could be improved.

The following information was prepared by the accountant:(1) Company sales – March 19X0



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£

Cash sales 30,000

Credit sales 65,000

In each month April to September (inclusive) the sales per month would be:

£

Cash sales 40,000

Credit sales 70,000

All credit sales are settled the month after the sale.

(2) All goods purchased are from a single supplier. The goods are purchased on credit and

each month‟s purchases are paid for three months after the month of purchase.

The following purchase schedule had been prepared for the first 9 months of 19X0:

January February March

Purchases £60,000 £58,000 £61,000

Purchases in April, May and June

£55,000 in each month

Purchases in July, August and September

£45,000 in each month

Note: the company had successfully negotiated lower prices from its supplier commencing 1

July 19X0.

(3) Dividends would be paid as follows:

(i) Final ordinary dividend of 5p per share payable on 31 May 19X0 in respect of

financial year 19X9/X0.

(ii) Interim ordinary dividend of 2p per share payable on 31 July 19X0 in respect of

financial year 19X0/X1.

(4) Selling and distribution expenses are expected to be 6 per cent of a given month‟s total

sales. They are paid one month in arrears.

(5) Administration charges would be incurred as follows:

19X0 February, March, April £10,000 per month

19X0 May to September (inclusive) £13,500 per month

Administration charges are settled two months after the month in which they were incurred.

(6) The company had decided to make a bonus issue of shares of one share for every three

held. The issue would be made on 30 April 19X0. The bonus shares would not qualify for the

final dividend of 19X9/X0, but would qualify for the interim dividend to be paid on 31 July19X0.



92

Required:

(a) Comment on the liquidity of the company as at 31 March 19X0 and explain to the

managing director why a company can apparently make a good profit but have no cash in

bank.

(b) Prepare a cash budget for each of the four months ending 31 July 19X0.

(c) Comment on the forecast bank balance as shown by your cash budget. Identify ways in

which the bank overdraft could be reduced over the last five months of 19X0.

Problem 110

The management of Hooke plc have been informed that the union representing the direct

production workers at one of their factories, where a standard product is produced, intends to

call a strike. The accountant has been asked to advise the management of the effect the strike

will have on cash flow.

The following data has been made available:

(1)

Week 1 Week 2 Week 3

Budgeted sales 400 units 500 units 400 units

Budgeted production 600 units 400 units Nil

(2) The strike will commence at the beginning of week 3 and it should be assumed that it will

continue for at least four weeks. Sales at 400 units per week will continue to be made during

the period of the strike until stocks of finished goods are exhausted. Production will stop at

the end of week 2. The current stock level of finished goods is 600 units.

(3) The selling price of the product is J60 and the budgeted manufacturing cost is made up as

follows:

J

Direct materials 15

Direct wages 7

Variable overheads 8

Fixed overheads 18

Total 48

(4) Direct wages are regarded as a variable cost. Direct wages are paid one week in arrears.

(5) The company operates a full absorption costing system and the fixed overhead absorption

rate is based upon a budgeted fixed overhead of J9,000 per week. Included in the total fixedoverheads is J700 per week for depreciation of equipment. During the period of the strike



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direct wages and variable overheads would not be incurred and the cash expecded on fixed

overheads would be reduced by J1,500 per week. It should be assumed that all relevant

overheads are paid for immediately the expense is incurred.

(6) The current stock of raw materials cost J7,500: it is intended that these stocks should

increase of J11,000 by the end of week 1 and then remain at this level during the period of the

strike. All direct materials are paid for one week after they have been received.

(7) All sales are on credit. 70% of the sales value is received in cash from the debtors at the

end of the first week after the sales have been made and the balance at the end of the second

week.

(8) The current amount outstanding to material suppliers is J8,000 and direct wage accruals

amount to J3,200. Both of these will be paid in week 1. The current balance owing from

debtors is J31,200, of which J24,000 will be received during week 1 and the remainder during

week 2. The current balance of cash at the bank and in hand is J1,000.

Required:

(a) Prepare a cash budget for weeks 1 to 6 showing the balance of cash at the end of each

week together with a suitable analysis of the receipts and payments during each week.

(b) Comment upon any matters arising from the cash budget which you consider should be

brought to management‟s attention.



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Variance Analysis

Problem 111

Cleanahull Ltd operates a small boat cleaning service. Boats are cleaned using a special

machine that requires a skilled operator and are finished using unskilled labour. Cleanahullhas produced a standard cost schedule as all boats go through the same process. Overheads

are absorbed using standard labour hours. The materials come in packs; each boat cleaned

should use one pack of materials. Cleanahull budgets to clean 288 boats per month.

Standard cost for cleaning a boat:

£

Skilled labour: 2 hours at £8 per hour 16

Unskilled labour: 1 hour at £5 per hour 5

Materials: 1 pack at £3 per pack 3

Variable overheads: 3 hours at £2 per hour 6

Fixed overheads: 3 hours at £10 per hour 30

Total standard cost 60

Profit mark-up at 30% cost 18

Price charged 78

Actual results for May 2008:

£ £

Sales: 330 boats cleaned 26,400

Less costs

Skilled labour: 594 hours 5,049

Unskilled labour: 396 hours 1,881

Materials:350 packs 1,190

Variable overheads 1,815

Fixed overheads 8,500

Total costs for May 18,435

Profit for May 7,965

Required:

(a) Prepare an operating statement, reconciling budgeted and actual profit for Cleanahull Ltd

for May 2008 showing two variances for sales and each cost category.

(b) Prepare a brief report to the owner of Cleanahull Ltd commenting on the performance in

May 2008 suggesting possible reasons for any unexpected results.



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Problem 112

Smith Plc. manufactures and sells a range of small household products. The following

information relates to the “Adam” for the month of July.

Budgeted volume 6,000 units

Budgeted selling price £6,00 per unit

Budgeted variable cost £2 per unit

Budgeted fixed overheads for July £6,000

During July 8000 “Adams” were actually sold for £40,000.

Required:

(a) Compute the following variances for product “Adam: for July:

(i) Sales price variance;

(ii) Sales contribution volume variance;

(iii) Sales margin volume variance.

(b) Explain and reconcile the difference between your answers to (ii) and (iii).

Problem 113

Thatcher Ltd uses a standard costing system. The standard cost card for direct materials used

in production of product NUM is as follows:

8 kgs @ £0.40 per kg = £3.20 per unit

Budgeted production in April 2007 was 850 units.

The relevant data for actual production of product NUM for April 2007 was as follows:

Actual production 870 units

Materials purchased 8,200 kgs at a cost of £3,444

Materials issued to production 7150 kg

Required:

(a) Calculate the total materials variance for April 2007.

(b) Calculate the materials price variance and materials efficiency variance for April 2007.



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Investment appraisal

Problem 114

The government of Nopia is considering operating a series of toll roads which will be

operated by companies in the private sector.Contracts to run the toll roads will be for five years at which time contracts will be put out to

competitive tender again. As the finance director of QFE plc, a transport operator, you are

interested in bidding for one of the first series of contracts.

It is anticipated that you will need to pay the government of Nopia an initial fee of £15

million to acquire the right to operate the toll road plus an annual f ee of £1.5 million payable

at the end of the year 1, increasing by 15% per year thereafter. In addition, the government

will take 20% of all revenues generated by the toll road.

Operating costs to monitor traffic and collect tolls are expected to be £3 mi llion in year 1 and

will then increase by 10% per year.

Based on current estimates of usage there will be 112 million miles of vehicle travel per year

for each of the five years.

The government of Nopia will allow QFE plc to set the toll fee which will be based on the

number of miles a vehicle travels on the toll road. Once set, the toll per mile will remain

constant for the duration of the contract.

Given the risk profile of this project QFE pls will require a return of 12% per year on its

investment.

Assume all cash flows, apart from the initial fee, will occur at the end of the year concerned.

Required:

(a) As finance director of QFE plc what is the minimum toll per mile you would be prepared

to charge?

(b) Assume the government of Nopia is prepared to accept an alternative to the initial fee of

£15 million. The alternative is to pay five equal annual instalments to the government

commencing immediately. What is the maximum QFE plc should be prepared to pay per year

to avoid the initial fee of £15 million?

(c) Assume that the government now states that the toll charge must fall by 4% per year from

the end of year 1. How would this effect your recommendation in part (a) above?

All calculations should be expressed in millions and rounded to two decimal places.



97

Problem 115

Part 1

The international division of a large Bulgarian wine producing company is considering

starting operations in the UK market. It has commissioned market research on the UK wine

market which cost 23,000 Bulgarian Leva (abbreviated BGL). The findings result in a

recommendation: to enter this new market the Bulgarian firm needs a marketing campaign.

This initial investment is estimated to cost BGL 3 million. The research has also estimated

that, following the campaign, the revenues net of cash expenses for UK sales over the next ten

years will be:

BGL

Year 1 450,000

Year 2 500,000

Year 3 620,000

Year 4 700,000

Year 5 700,000

Year 6 700,000

Year 7 700,000

Year 8 700,000

Year 9 700,000

Year 10 700,000

Assume that all cash flows arise at the end of the year. All figures are in real terms. The real

discount rate is 6%. Thanks to funds from the European Union to promote trade with new

members, the project is exempt from taxes.

Required:

Should the company enter the UK market? Provide the relevant calculations to illustrate your

answer. Explain and discuss.

Part 2

At the end of year 3, an internal assessment of the project and of the revenues from the UK

market shows that the sales have been more successful than expected. The company has had a

total net cash flow over the previous three years of BGL 2.5 million (instead of the expected

BGL 1.57 million).

However, the UK market has become more competitive and it is felt that a new marketing

campaign is necessary if the company intends to stay in that market. New adverts and promotions would cost BGL 1.4 million. The real discount rate and the tax treatment of the



98

project remain the same. However, because of increased competition the estimates of

revenues net of cash expenses in real terms, for the remaining seven years, have to be adjusted

downwards to the following:

BGL

Year 1 620,000

Year 2 510,000

Year 3 300,000

Year 4 300,000

Year 5 300,000

Year 6 300,000

Year 7 300,000

Required:

(a) Should the company continue with sales in the UK? Provide the relevant calculations to

illustrate your answer. Explain and discuss.

(b) Should the initial success of the project in the first three years be taken into account in the

decision at the end of Year 3? Why?

Part 3

At the same time of the re-assessment of the UK market, at the end of year 3, the domestic

division of the firm proposes an alternative investment, completely independent of the first

one. They are considering entering the bottle production market to supply glass bottles to the

growing Bulgarian wine industry. The project would require exactly the same initial

investment as the new marketing campaign – BGL 1.4 million – to buy the necessary

machinery. The company depreciates its fixed assets using the straight-line method. Capital

allowances are equal to depreciation for this Bulgarian company. The estimated revenue net

of cash expenses for the following seven years would be:

BGL

Year 1 620,000

Year 2 530,000

Year 3 430,000

Year 4 420,000

Year 5 420,000

Year 6 420,000

Year 7 420,000



99

It is customary for this division, dealing with the domestic market, to state projects‟ cash

flows in nominal terms. Moreover, this project, as a domestic one, is subject to a tax rate of

20%. The inflation rate is 3% per year. The real discount rate is the same.

Required:

Compare this project with the project in part 2. Which project should the firm choose if it can

only undertake one? Provide the relevant calculations to illustrate your answer. Explain and

discuss.

Problem 116

Hayek Plc. is considering investing in either project P or project Q:

Time

(years)

Project P

£

Project Q

£

Equipment cost 0 100,000 100,000

Expected annual profit/loss 1 34,000 4,000

2 24,000 4,000

3 14,000 12,000

4 4,000 16,000

5 (36,000) 4,000

Estimated resale value of equipment 5 20,000 20,000

Hayek Plc depreciates equipment on the straight-line basis. Profits and losses are earned

evenly throughout the year.

Required:

(a) Calculate the payback period for each project and on this basis advise Hayek Plc which

project to invest in.

(b) Briefly explain two disadvantages of payback period as a method of investment appraisal.

Problem 117

The directors of Welch plc are considering which of the following projects to invest in:

Year Alpha

£

Beta

£

Gamma

£

Initial capital investment 0 50,000 50,000 50,000

Expected cash inflows 1 30,000 30,000 20,000

2 20,000 20,000 20,000



100

3 6,000 6,000 10,000

4 4,000 4,000 10,000

Scrap proceeds 4 10,000 0 10,000

Welch plc uses the straight-line method of depreciation.

Required:

(a) Calculate the payback period of each project.

(b) Calculate the average accounting rate of return of each project.

(c) Based on your calculations in (a) and (b), advise the directors which project they should

invest in.

Problem 118

As a member of the f inance director‟s team at Londy plc. you have been asked to approve at

investment proposal recently received from the company‟s subsidiaries, Franly Ltd, whose

directors consider that the project should be supported as it yields a forecast profit of

£460,000 over its anticipated five year life.

The following financial information has been provided to support the proposal:

Five year forecast profit and loss account for years ending on 31 May

2002 2003 2004 2005 2006

£000 £000 £000 £000 £000

Sales 1,500 2,000 2,500 2,000 1,000

Less: Cost of sales 900 1,200 1,500 1,200 600

Gross profit 600 800 1,000 800 400

Less: Depreciation 240 240 240 240 240

Wages 150 170 170 170 150

Overheads 200 270 320 220 120

Forecast not profit/loss 10 120 270 170 (110)

Notes:

(1) Closing stock (in £000s) is expected to be as follows:

2002 2003 2004 2005 2006

100 150 100 50 0

The project will commence on 1 June 2001 with no opening stock.

(2) Franly Ltd uses the straight-line method of depreciation. The value of the machinery

needed for the project is expected to be £300,000 and the end of its five year life.



101

(3) The wages figure includes £48,000 for a manager and £27,000 for a supervisor who are

already employed by Franly Ltd. If the project goes ahead, the company will need to hire an

additional supervisor at a cost of £25,000 per year. If the project does not proceed, the

existing manager and supervisor will remain in their present posts.

(4) 10% of the overhead charge varies with the value of sales revenue and 90% in an

allocation of group overheads.

(5) The equipment will be paid for on 1 July 2001. The required amount of materials and

components for the year‟s production will be paid for at the beginning of the year conce rned.

All other cash flows will occur at the end of the year.

(6) Londy plc. uses the discounted cash flow method for project appraisal and the discount

rate to be used for this project is 10% per year.

Required:

(a) Based upon the above information, advise the finance director whether or not the project

should be accepted.

(b) If it were possible to lease the equipment by paying five equal annual instalments, the first

being on 1 June 2001, what is the maximum Franly Ltd should be willing to pay? Explain

your answer.

(c) Explain to the directors of Franly Ltd why the discounted cash flow approach to project

evaluation is often preferred to the forecast profit approach and discuss any limitations the

method may have.

Problem 119

Parsons plc. is considering an investment proposal for recycling waste production materials

into a product, which can be sold to the packaging industry. The company‟s accountant has

rejected the project on the basis that it results in a forecast loss of £890,000 over its expected

five-year life. The company‟s board of directors are concerned about the carbon footprint of

the company and are looking for ways to improve its environmental impact and have agreed

that a maximum loss of half a million pounds over a five year period is acceptable. They have

requested you to re-examine the financial consequences of the product.

You are provided with the following financial information about the project:

(1) The accountant‟s forecast is as follows based on the project commencing on 1st January

2009.

Five year forecast profit and loss account for years ending on 31 December



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2009 2010 2011 2012 2013

£000 £000 £000 £000 £000

Sales 1,300 2,000 2,200 2,200 2,200

Less: Cost of sales 1,100 1,300 1,450 1,500 1,500

Gross profit 200 700 750 700 700

Less: Depreciation 320 320 320 320 320

Labour costs 175 195 205 195 195

Overheads 150 325 300 300 300

Forecast loss (445) (140) (75) (115) (115)

The following additional information is made available:

(2) The recycling process uses up waste materials which have no resale value. At present,

disposal of the production waste is arranged by paying an annual fee to a local waste disposal

company. If the project is undertaken, these costs will no longer be incurred. The yearly

estimated cost of waste disposal (in £000s) is as follows:

2009 2010 2011 2012 2013

80 80 80 80 160

(3) The process will require the purchase of additional materials which are included as cost of

sales in the company accountant‟s forecast. The project commenced with no opening stock,

but the forecast includes the following projected closing stock of materials (in £000s) at 31st

December:

2009 2010 2011 2012 2013

100 200 150 50 0

The materials needed for the year will be purchase and paid for on the first day of the year.

(4) On 1st January 2009 the company will purchase and pay for special recycling machinery.

The scrap value at 31st December 2013 is estimated at £50,000. Parsons plc uses the straight -

line method of depreciation which results in a charge of £320,000 per annum.

(5) 80% of the overhead charge is an allocation of existing company fixed overheads and 20%

represents the overheads incrementally incurred on the new recycling project.

(6) In August 2008, the company spent £20,000 on commissioning a report investigating the

environmental impact of its waste products.

(7) Each year‟s labour costs include £55,000 for the environmental manager and £25,000 for a

production supervisor. Both are already employed by Parsons plc. If the project does not

proceed, these two employees will remain in their present posts. The remaining labour costsreflect additional workers needed for the process.



(8) The board of Parsons wish you to use the discounted cash flow method for the project

appraisal and the discount rate to be used for this project is 12% per year. Assume all cash

flows occur at the year end, unless otherwise indicated.

Required:

(a) Based upon the above information, advise the finance director whether or not the recycling

project should be accepted. State any assumptions and use a tabular format for your

calculations. All figures to the nearest £000.

(b) In the context of project evaluation, what do you understand by the term “sensitivity

analysis”? Give (without calculations) two examples of sensitivity analysis considerations for

the recycling projects.

Accounting Problem Book 2011

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