TEST BANK for Contemporary Accounting 8th Edition. Mike Bazley, Phil Hancock by digitaldownload87

Contemporary Accounting 8e Mike Bazley, Phil Hancock (Test Bank All Chapters, 100% Original Verified, A+ Grade) Chapter 1 – Introduction to accounting TRUE/FALSE 1. An objective of accounting is to provide information to predict and evaluate the going concern of an entity. ANS: T PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

2. Accounting information is always quantitative and objective. ANS: F PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

3. Stewardship is the term used to refer to management’s role in protecting an entity’s economic resources from theft, fraud and wastage. ANS: T PTS: 1 AACSB: TOP: For what purpose is accounting used?

Knowledge, Analytical

4. Management is an external user of accounting information. ANS: F PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

5. The balance sheet is an example of a management accounting report. ANS: F PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

6. The statement of comprehensive income is an example of a financial accounting report. ANS: T PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

7. The difference between management accounting and financial accounting is that management accounting focuses on external users whereas financial accounting focuses on internal users. ANS: F PTS: 1 AACSB: TOP: For what purpose is accounting used?

Knowledge, Analytical

8. Management has the responsibility of selecting accounting policies. ANS: T PTS: 1 AACSB: TOP: Economic consequences of accounting information.

Knowledge, Analytical

9. Where an Accounting Standard exists, accounting policies must comply with the Accounting Standard. ANS: T PTS: 1 AACSB: TOP: Economic consequences of accounting information.

Knowledge, Analytical

10. The economic consequences of accounting information are limited to the compensation schemes paid to managers. ANS: F PTS: 1 AACSB: TOP: Economic consequences of accounting information.

Knowledge, Analytical

11. Political costs create incentives for managers to select accounting policies that increase reported profits. ANS: F PTS: 1 AACSB: TOP: Economic consequences of accounting information.

Knowledge, Analytical

12. Triple bottom line reporting confirms the maximisation of profit as the major objective of listed companies. ANS: F PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

13. A triple bottom line report refers to the publication of economic, environmental and corporate governance information in an integrated report. ANS: F PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge

14. Because triple bottom line reports are voluntary, the provision of an independent verification of the reports should enhance the reliability of the information provided. ANS: T PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

15. The GRI indicators are established by the committee without any input from stakeholders. ANS: F PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

16. The audit of a triple bottom line report is normally completed by the financial auditor. ANS: F PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Accounting information: A. is helpful for financing decisions but not for marketing decisions. B. is useful for profit-making entities but is not needed for not-for-profit entities. C. must follow accounting principles provided by management. D. is useful for all economic organisations. ANS: D PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

2. The primary purpose of accounting is to: A. help people make decisions about economic activities. B. provide information that management can use to convince shareholders that management deserves high salaries. C. provide employment to persons who have a knack for dealing with numbers. D. minimise the amount of profit that a firm has earned. ANS: A PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

3. Accounting is likely to involve: A. qualitative and financial information. B. quantitative and financial information. C. quantitative and non-financial information. D. qualitative and non-financial information. ANS: B PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

4. For the individual, accounting has at least three functions. They are: A. planning, buying and selling. B. planning, decision support and spending. C. saving, controlling and buying. D. planning, controlling and decision support. ANS: D PTS: 1 TOP: What is accounting

AACSB:

Knowledge, Analytical

5. The difference between management accounting and financial accounting is: A. management accounting focuses on external users whereas financial accounting focuses on internal users. B. management accounting focuses only on the control function whereas financial accounting focuses on the reporting function. C. management accounting focuses on internal users whereas financial accounting focuses on external users. D. management accounting focuses on the reporting function whereas financial accounting focuses on the control function. ANS: C PTS: 1 AACSB: TOP: For what purpose is accounting information?

Knowledge, Analytical

6. Examples of internal and external users of information are: A. creditors and investors. B. managers and unions. C. creditors and unions. D. banks and government authorities. ANS: B PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

7. The basic difference between managerial accounting and financial accounting is that: A. the financial accounting system relies on accounting information whereas managerial accounting does not. B. financial accounting relies on information gathered from sources outside the business whereas managerial accounting relies on internally generated information.

C. financial accounting is concerned with providing information to outsiders, whereas managerial accounting is concerned with providing information to managers for their use in directing the activities of the organisation. D. managerial accounting information is useful to not-for-profit organisations, but financial accounting information is not. ANS: C PTS: 1 AACSB: TOP: For what purpose is accounting information?

Knowledge, Analytical

8. Which of the following is an example of a stakeholder of a business? A. An owner B. An investor C. A manager D. All of the above ANS: D PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

9. Financial accounting is the process of: A. preparing and reporting accounting information for external decision makers. B. preparing and reporting accounting information for internal decision makers. C. enacting generally accepted accounting principles. D. preparing and reporting accounting information to lenders. ANS: A PTS: 1 AACSB: TOP: For what purpose is accounting information?

Knowledge, Analytical

10. Management accounting is the process of: A. preparing and reporting accounting information for external decision makers. B. preparing and reporting accounting information for an organisation’s internal decision makers. C. enacting generally accepted accounting principles. D. preparing and reporting accounting information to lenders. ANS: B PTS: 1 AACSB: TOP: For what purpose is accounting information?

Knowledge, Analytical

11. Match the type of accounting information to the term that best describes it. Information prepared for external decision makers A. Financial accounting B. Financial accounting C. Managerial accounting D. Managerial accounting

Information prepared for internal decision makers Financial accounting Managerial accounting Financial accounting Managerial accounting

ANS: B PTS: 1 AACSB: TOP: For what purpose is accounting information used?

Knowledge, Analytical

12. Information contained in external financial reports can be useful to a firm’s: Suppliers A. No B. No C. Yes D. Yes

Employees No Yes No Yes

ANS: D PTS: 1 Who uses accounting information?

AACSB:

Knowledge, Analytical TOP:

13. Match the type of accounting information to the term that best describes it. Information prepared for suppliers’ use A. Managerial accounting B. Managerial accounting C. Financial accounting D. Financial accounting

Information prepared for creditors’ use Financial accounting Managerial accounting Financial accounting Managerial accounting

ANS: C PTS: 1 AACSB: TOP: For what purpose is accounting information?

Knowledge, Analytical

14. Which one of the following groups is not generally regarded as an external user of the accounting information of an entity? A. Employees B. Customers C. Management D. Lenders ANS: C PTS: 1 AACSB: TOP: Who uses accounting information?

Knowledge, Analytical

15. A possible limitation of accounting information is that accounting information: A. can only be used by bankers. B. is relevant depending on the needs of users. C. does not report in money terms. D. relates to past information ANS: D PTS: 1 AACSB: TOP: Limits on the usefulness of accounting information

Knowledge, Analytical

16. The selection of appropriate accounting policies for a company is the responsibility of: A. the body that sets Accounting Standards. B. the company secretary. C. the internal auditors of the company. D. the management of the company. ANS: D PTS: 1 AACSB: TOP: Economic consequences of accounting information

Knowledge, Analytical

17. What is meant by the term economic consequences of accounting policy choice? A. The selection of accounting policies is expensive and time-consuming. B. Accounting numbers affect the financial positions of various users.

C. Accounting policies are selected to minimise the position of creditors. D. The creation of accounting standards consumes a large amount of resources. ANS: B PTS: 1 AACSB: TOP: Economic consequences of accounting information

Knowledge, Analytical

18. In a firm that offers a bonus scheme based on accounting profit, managers can, in most cases, be expected to adopt a: A. profit-decreasing accounting policy. B. profit-increasing accounting policy. C. dividend-increasing accounting policy. D. liability-increasing accounting policy. ANS: B PTS: 1 AACSB: TOP: Economic consequences of accounting information

Knowledge, Analytical

19. Debt covenants primarily protect the interests of which of the following parties? A. Shareholders B. Creditors C. Employees D. Companies ANS: B PTS: 1 AACSB: TOP: Economic consequences of accounting information

Knowledge, Analytical

20. Triple bottom line reporting A. reinforces profit as the primary objective of companies. B. recognises the legal and non-legal obligations of a company to all legitimate stakeholders in a company. C. is mandatory in Australia. D. is where a result is produced for financial, social and environmental benefit. ANS: B PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

21. Arguments in favour of triple bottom line reporting include: A. enhanced all-round company credibility from greater transparency. B. that it facilitates the implementation of an environmental strategy. C. enhanced communication with stakeholders. D. all of the above. ANS: D PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

22 The Global Reporting Initiative: A. refers to an institution based in Sweden. B. is the most widely cited benchmark for the determination of the content of a triple bottom line report. C. was established as a private, profit-making initiative. D. is a set of reporting obligations agreed as part of the Kyoto agreement. ANS: B PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

23 . Which of the following would not form part of social reporting under the GRI 3? A. Number of female employees. B. Number of indigenous employees. C. Donations to charities. D. Greenhouse gas emissions. ANS: D PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

24. Which of the following would not be part of environmental reporting under the GRI 3? A. Greenhouse gas emissions B. Amount of recycled paper C. Child labour D. Biodiversity management ANS: C PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

25. Which of the following reports are not reports specifically on sustainability issues? A. Sustainability report B. Annual report C. Triple bottom line report D. Stakeholder impact report ANS: B PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

26. Which of the following disclosures would you expect to be included by a company in a triple bottom line report? A. Greenhouse gas emissions B. Donations to charities C. Percentage of female staff in senior management positions D. All of the above ANS: D PTS: 1 TOP: Triple bottom line reporting

AACSB:

Knowledge, Analytical

27. Accounting firms generally provides the following services: A. audit, assurance and taxation. B. audit, budgeting and management consulting. C. audit, budgeting and cost accounting. D. internal audit, budgeting and management consulting. ANS: A PTS: 1 TOP: Careers in accounting

AACSB:

Knowledge, Analytical

28. Managers may select accounting policies for which of the following reasons? A. To provide useful information to users B. To avoid violating debt contracts C. To influence compensation plans D. All of the above are correct ANS: D PTS: 1 AACSB: TOP: Economic consequences of accounting information

Knowledge, Analytical

SHORT ANSWER 1. What is the role of accounting information in business? ANS: Accounting information helps decision makers. It aids managers by providing quantitative information about the entity to help them in planning, operating and evaluating the entity’s activities. Accounting information helps external decision makers by providing them with financial statements containing economic information about the performance and financial position of the entity. PTS: 1 AACSB: accounting information used?

Knowledge, Communication

TOP:

For what purpose is

2. Distinguish managerial accounting from financial accounting. Your answer should include a brief discussion of differences in the types of information provided to users as well as differences in the identity of users of financial and managerial accounting information. ANS: Financial accounting is used primarily by external users such as shareholders and creditors and by senior management as a means of evaluating performance. Financial accounting is presented in summary form and must follow generally accepted accounting principles (GAAP). GAAP ensures that information is consistent from period to period and comparable across entities. Managerial accounting is used internally by senior management, functional and division managers and middle managers. Managerial accounting information is frequently presented with detailed information for day-to-day decisions. The information provided does not have to conform to GAAP or need not be consistent between periods or comparable across entities. Rather, it focuses on the information needs of managers. It is critical that managerial accounting information be provided in a timely manner. PTS: 1 AACSB: accounting information used?

Knowledge, Communication

TOP:

For what purpose is

PROBLEM 1. Doug Murphy, a newly hired accountant, wanted to impress his boss, so he stayed late one night to analyse the office supplies expense. He determined the cost by month, for the past 12 months, of each of the following: computer paper, copy paper, fax paper, pencils and pens, note pads, postage, corrections supplies, stationery, and miscellaneous items. Why do entities, such as companies, not include information of this nature in published (general purpose) financial statements? ANS: Entities provide information to external users to make decisions. The primary decision makers external to the business are creditors, bankers, analysts, shareholders, and potential shareholders. These users need to know that the company can repay its debts, earn a profit, and pay dividends. The cost by month for each item of office supplies does not provide any additional information that would be helpful for any external users. In addition, the time and expense necessary to create the additional detail would outweigh the benefits of the final product. PTS: 1 AACSB: Knowledge, Communication, Analytical purpose is accounting information used?

TOP:

For what

CASE 1. In October 2002, Duke Power, the regulated electricity utility of the United States (US) corporation Duke Energy, agreed to pay $25 million to its customers to settle allegations by regulators in North and South Carolina that it had underreported net earnings by about $123 million between 1998 and 2002. The under reporting of net earnings by Duke Energy was allegedly undertaken in order to avoid having to cut its electricity rates. Required: Explain what is meant by the term ‘economic consequences’ and relate this to the underreporting of net earnings by Duke Energy. ANS: Economic consequences: wealth effects, resulting from accounting policy choices, impacting, for example, managers, the firm, shareholders and/or debtholders. Given Duke Energy’s status as a regulated electricity utility, and the explanation for the underreporting, from an economic consequences perspective the entity’s choice of accounting policies lies with political costs ( p 17). Further, ultimately if large companies attract lower political costs its managers will be rewarded (p 17). PTS: 1 AACSB: Knowledge, Communication, Analytical TOP: Economic consequences of accounting information

Chapter 2 – Types of organisations and the financial reporting framework TRUE/FALSE 1 Mutual agency refers to the fact that each member of the partnership form of business entity can bind the other(s) in contract within the scope of normal operations. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

2. There are several advantages to forming a partnership, including the ease with which it can be formed and the limited rules and regulations that apply to it. However, as for a company, one of the regulations is that a partnership must prepare financial statements in accordance with Accounting Standards if it is deemed to be a reporting entity. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

3. Although partnerships may have a tax advantage over companies in that it is the partners that are taxed and not the partnership, a disadvantage of partnerships is that they have unlimited liability. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

4. All companies can raise funds through the general public but not all companies have limited liability. ANS: F PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

5. If a company has sales of $8 million, assets of $4 million and 60 employees, then it may be classified as a small proprietary company. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

6. All limited-by-shares companies must have ‘Ltd’ in their names, but a private company is distinguishable from a public company because it has ‘Pty’ as well as ‘Ltd’ in its name. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

7. Two companies were formed on 1 January 20X3, with the names Pluto Pty Ltd and Neptune NL. From the names of the companies, it is clear that the former is a proprietary company and the latter is a mining company. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

8. There are several differences between the financial statements of a company and those of a partnership, not least of which is the disclosure of taxation on the balance sheet as a liability. For a company, the disclosure is a single amount as it is the company that is liable and not the owners. For a partnership, the amount of taxation is split and reported separately in accordance with each partner’s liability. ANS: F PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

9. The reason why company shareholders may have the advantage of limited liability rests with the entity principle in accounting, not the legal status of the company. ANS: F PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

10. The partnership form of business organisation exists where two or more carry on a business in common with a view to profit. ANS: T PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

11. Accounting Standards set by the Australian Accounting Standards Board (AASB) apply to both the private and public sectors in Australia. ANS: T PTS: 1 AACSB: TOP: The framework for setting accounting standards

Knowledge, Analytical

12. Due process is primarily concerned with producing Accounting Standards that meet managers’ objectives. ANS: F PTS: 1 TOP: The standard setting process

AACSB:

Knowledge, Analytical

13. The Corporations Act 2001 requires that financial statements include a directors’ report, a directors’ statement and an auditor’s report. ANS: T PTS: 1 TOP: The Corporations Act

AACSB:

Knowledge, Analytical

14. The directors’ report included with a company’s financial statements contains an opinion on whether the balance sheet and income statement present a ‘true and fair’ view. ANS: F PTS: 1 TOP: The Corporations Act

AACSB:

Knowledge, Analytical

15. Half-yearly reports contain more detailed information than annual reports. ANS: F PTS: 1 TOP: The Corporations Act

AACSB:

Knowledge, Analytical

16. A conceptual framework can be defined as a set of interrelated objectives and fundamentals that is expected to lead to consistent standards, and that prescribes the nature, function and limits of financial accounting and reporting. ANS: T PTS: 1 TOP: What is a conceptual framework?

AACSB:

Knowledge, Analytical

17. One of the objectives of a conceptual framework is that it is considered to be a defence against politicisation. ANS: T PTS: 1 AACSB: TOP: Objectives of a conceptual framework

Knowledge, Analytical

18. A general-purpose financial report is primarily directed toward the common information needs of a wide range of users. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

19. Users of general-purpose financial reports include investors, financial advisors, employees, lenders, suppliers and customers. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

20. A reporting entity is an entity for which there are users who rely on financial statements as their major source of information about the entity. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

21. General-purpose financial reports provide the information that is required for both internal and external user group needs. ANS: F PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

22. Accrual accounting refers to the method of measuring profit on the basis of cash flow, rather than when revenues and expenses occur. ANS: F PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

23. The going concern assumption assumes that an entity will continue to operate successfully into the foreseeable future. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

24. An asset must have physical qualities that can be measured reliably. ANS: F PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

25. A liability must always be a legal obligation that arises from past events. ANS: F PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

26. Equity is the residual interest in the assets of the entity after deduction of all its liabilities. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

27. Revenue means the gross inflows arising from normal operations plus all gains during the accounting period. ANS: F PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

28. The elements of financial statements are always measured using the historical cost method. ANS: F PTS: 1 AACSB: TOP: Measurement of the elements of financial statements

Knowledge, Analytical

29. The Australian Financial Reporting Council is not able to directly influence the content of the AASB’s accounting standards, but has the capacity to do so given its control of the budget and priorities of the AASB. ANS: T PTS: 1 AACSB: TOP: The framework for setting accounting standards

Knowledge, Analytical

30. The political nature of standard setting refers to the fact that, for example, preparers may lobby the standard setters to promote their own self-interest rather than the decision-making usefulness of general purpose reports. ANS: T PTS: 1 AACSB: TOP: The political nature of accounting standard setting

Knowledge, Analytical

31. The fundamental element equity does not require recognition criteria, because it represents the residual interest in assets, after deducting liabilities. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

32. In accordance with the IASB Conceptual Framework, income includes both revenue and gains. ANS: T PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

33. The external auditor is responsible for preparing the general-purpose financial reports of a company. ANS: F PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

34. The responsibilities of the Australian Financial Reporting Council include advising the government on the process of setting accounting standards. ANS: T PTS: 1 AACSB: TOP: The framework for setting accounting standards

Knowledge, Analytical

35. In Australia the overriding responsibility for the preparation and presentation of general-purpose reports resides with the directors of a company. ANS: T PTS: 1 TOP: The corporations act

AACSB:

Knowledge, Analytical

36. An external auditor seeks to provide reasonable assurance that the financial statements of a company are true and fair, not a guarantee that every error in the financial statements of the entity has been detected. ANS: T PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following is not true of sole traders? A. They are one-owner businesses. B. They are not normally reporting entities. C. They are separate legal entities. D. They usually have limited funds at their disposal. ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

2. Which of the following is not true for a partnership? A. Creditors can supply goods on credit to a partnership. B. Debtors can purchase goods on credit from a partnership. C. Partnerships have to pay their tax yearly. D. Partnerships can enter contracts on behalf of the partnership. ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

3. Which of the following statements regarding partnerships is incorrect? A. There are no legal formalities required to form a partnership and it can be an oral agreement. B. Partnerships have unlimited liability not subject to the amount contributed by each partner. C. The partnership is subject to income tax, not the individual partners. D. Each partner has the authority to enter contracts on behalf of the partnership, provided the contracts relate to normal operations. ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

4. Which of the following would not be considered a disadvantage of forming a partnership? A. Limited life B. Unlimited liability C. Ease of formation D. Mutual agency

ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

5. Jack and Jill Repairers is founded by partners Jack, Jill and Jolly. Jack, Jill and Jolly contributed $3000, $5000 and $8000 respectively. For the year ending 20X2, Jack and Jill Repairers produced a profit of $12,000. If the profits are distributed in accordance with the initial investment which of the following is true? A. Jack gets $2250 and Jill gets $6000. B. Jack gets $3750 and Jolly gets $6000. C. Jack gets $2250 and Jill gets $3750. D. Jack gets $2250 and Jolly gets $8000. ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

6. Which of the following items of information would not be found in the balance sheet of a partnership? A. Assets B. Liabilities C. Dividends payable D. Distribution of profits to partners ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

7. Which of the following is true of companies? All companies: A. are limited liability companies. B. are separate legal entities. C. have a limited life. D. are bound by the contracts signed by shareholders. ANS: B PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

8. A large proprietary company must have its financial statements audited and lodged with the: A. Australian Securities Exchange. B. Australian Securities and Investments Commission. C. Financial Reporting Council. D. Australian Accounting Standards Board. ANS: B PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

9. Which of the following types of business organisation has a legal identity separate from those of the owners? A. Sole proprietorships B. Companies C. Partnerships D. All of the above. ANS: B PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

10. Limited liability is a feature of what form(s) of business organisation? A. Company B. Sole proprietorship C. Partnership D. Both a company and a partnership ANS: A PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

11. It can be determined that Alpha Pty Ltd is a proprietary company as its records show that: A. no approach has been made to the public for funds. B. it has fewer than 50 employees. C. it is a family company. D. it has ‘Pty Ltd’ in its name. ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

12. Gamma Pty Ltd would be a small proprietary company as its records show: A. assets of $15m, sales of $26m and 40 employees. B. assets of $6m, sales of $26m and 60 employees. C. assets of $15m, sales of $9m and 55 employees. D. assets of $4.5m, sales of $12m and 45 employees. ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

13. An advantage that a company typically has over a partnership is: A. mutual agency. B. access to greater amounts of capital. C. avoidance of moral hazard. D. smaller size. ANS: B PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

14. The advantages of the corporate form of business organisation do not include: A. ready transferability of shares. B. limited liability. C. mutual agency. D. continuity of existence. ANS: C PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

15. Which one of the following is not an advantage of a company? A. Separate legal entity B. Access to capital C. Continuous existence D. No regulation ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

16. In which section of a balance sheet would a general reserve be found? A. Current Assets B. Current Liabilities C. Non-current Assets D. Shareholders’ Equity ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

17. Equity on the balance sheet of a sole proprietorship is normally referred to as: A. owner’s equity. B. shareholders’ equity. C. reserves. D. ordinary shares. ANS: A PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

18. A small proprietary company is one that has: A. less than $25 million sales and fewer than 50 employees. B. less than $5 million liabilities and fewer than 50 employees. C. less than $5 million expenses and less than $12.5 million assets. D. less than $10 million equity and less than $12.5 million assets. ANS: A PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

19. Which of the following items does not appear on the balance sheet of a partnership? A. Debtors B. Equipment C. Creditors D. Income tax payable ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

20. The ability of a partner to enter into a contract on behalf of all partners is called: A. voluntary association. B. mutual agency. C. the partnership agreement. D. unlimited liability. ANS: B PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

21. The separation of ownership and control is normally a characteristic of: A. companies. B. partnerships. C. sole traders. D. partnerships and companies. ANS: A PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

22. The factors that should be considered before forming the partnership and company forms of entity would include: A. income taxation implications. B. the liability of the equity participants for the debts of the business. C. the scale/magnitude of the operations involved and the access to finance. D. all of the above. ANS: D PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

23 Due process involves: A. the maximum opportunity to comment on proposed accounting standards. B. the selection and discussion of emerging issues of accounting. C. a process of fast-tracking the implementation of accounting standards. D. adequate consultation between the FRC and the AASB before an accounting standard is issued. ANS: A PTS: 1 AACSB: TOP: The framework for setting accounting standards

Knowledge, Analytical

24. The principle purpose of an audit is to: A. assure investors of the wealth of the entity. B. assure investors of the future profitability of the entity. C. express an opinion on the truth and fairness of the entity’s financial statements. D. detect fraud by the entity’s employees. ANS: C PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

25. If the conceptual framework sets out the concepts that underlie the preparation and presentation of financial statements for external users, which of the following questions is the conceptual framework not attempting to answer? A. Who are the users of general-purpose financial reports? B. Which entities should prepare special-purpose financial reports? C. How should the elements of the financial statements be measured and displayed? D. What are assets, liabilities, income, expenses and equity? ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

26. Objectives of a conceptual framework include: A. providing a defence against lobby groups. B. fewer and more consistent Accounting Standards. C. improved communication. D. all of the above. ANS: D PTS: 1 AACSB: TOP: Objectives of a conceptual framework

Knowledge, Analytical

27. Which of the following statements is incorrect? A. Compliance with the conceptual framework is non-mandatory in general purpose financial statements. B. Compliance with Accounting Standards is mandatory in general purpose financial statements.

C. Compliance with the conceptual framework is mandatory in general purpose financial statements. D. Accounting Standards are more specific than the conceptual framework. ANS: C PTS: 1 AACSB: TOP: The framework for setting accounting standards

Knowledge, Analytical

28. Which of the following sets of entities are not likely to meet the definition of a reporting entity? A. Small proprietary companies, large proprietary companies and partnerships B. Small proprietary companies and sole traders C. Large proprietary companies, sole traders and partnerships D. Small proprietary companies and large professional accounting practices ANS: B PTS: 1 TOP: The Conceptual Framework

AACSB:

Knowledge, Analytical

29. An example of a reporting entity is likely to be a: A. public company. B. partnership. C. family trust. D. small proprietary company. ANS: A PTS: 1 TOP: The Conceptual Framework

AACSB:

Knowledge, Analytical

30. Which of the following are likely to be reporting entities? I. II. III. IV.

BHP Billiton The corner store An unincorporated business with 10 employees A large proprietary company with over 500 employees and 200 creditors

A. I only B. I and IV only C. II, III and IV only D. I, III and IV only ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

31. Which one of the following groups is not generally regarded as an external user of the accounting information of an enterprise? A. Employees B. Customers C. Management D. Lenders ANS: C PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

32. FeelGood Limited has been set up specifically for the building of an inner-city women’s refuge. When the building has been erected and becomes operational (estimated time four months), the company will be liquidated. Which basic assumption underlying the preparation of general-purpose financial reports will not apply in preparing the reports for FeelGood Limited? A. The business entity principle. B. The principle of duality.

C. The going-concern principle. D. The period assumption. ANS: C PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

33. Assets are best defined as a: A. resource owned by the entity as a result of current event, from which future economic benefits are expected to flow. B. resource owned by the entity as a result of past event, from which future economic benefits are expected to flow. C. resource controlled by the entity as a result of past event, from which future economic benefits are expected to flow. D. resource controlled by the entity as a result of a future event, from which future economic benefits are expected to flow. ANS: C PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

34. Which of the following is not a primary characteristic of the accounting definition of an asset? A. The capacity to provide benefits to the entity B. Control but not necessarily ownership C. Representing past events D. The ability to be reliably measured ANS: D PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

35. Which of the following is not an asset? A. Equipment B. Accounts receivable C. Accounts payable D. Inventory ANS: C PTS: 1 TOP: The conceptual framework

36. Which of the following elements does not require recognition criteria in order to decide whether it should be recognised in the financial statements? A. Assets B. Revenues C. Equity D. Expenses ANS: C PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

37. In terms of the conceptual framework, an asset is recognised on a balance sheet if it: A. is capable of reliable measurement and it is probable that the asset will be realised. B. is owned by the entity and is capable of reliable measurement. C. results from a past event and is owned by the entity. D. provides future economic benefits. ANS: A PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

38. Which one of the following is not an asset? A. Inventory B. Accounts receivable C. Revenue D. Cash ANS: C PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

39. Which of the following is not a liability? A. Accounts payable B. Loan payable C. Investment by owner D. Unearned revenue ANS: C PTS: 1 TOP: The conceptual framework

40. Which of the following is not an attribute of a liability? A. Present obligation to transfer resources to another entity. B. The transfer is unavoidable by the entity. C. The transfer results in reduced economic benefits to the entity making the transfer. D. The event creating the responsibility has not yet occurred. ANS: D PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

41. Which of the following accounts is a liability? A. Interest Expense B. Interest Payable C. Interest Revenue D. Interest Receivable ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

42. Liabilities are: A. resources under an organisation’s legal control. B. obligations owed by an organisation to its creditors. C. the amount of investment made by owners in a business. D. the profits earned by a corporation. ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

43. Which of the following accounts is not a liability? A. Wages Payable B. Prepaid Rent C. Accounts Payable D. Notes Payable ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

44. Revenues result when a business: A. creates resources by selling goods or services. B. borrows money. C. receives money from owners of the business. D. pays its employees. ANS: A PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

45. Expenses result when a business: A. pays a supplier for goods purchased last month. B. consumes resources during the production and sale of goods or services. C. distributes money to owners. D. hires employees. ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

46. Torger Associates sold business services to another organisation for cash. As a result, Torger’s assets increased. Which accounting term best describes the concept involved in the other part of this transaction? A. Liability B. Revenue C. Financing activity D. Dividends ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

47. Which of the following types of entities would not fit the category of a profit-making entity? A. Sole proprietorship B. Partnership C. Charitable institution D. Company ANS: C PTS: 1 TOP: Types of organisations

AACSB:

Knowledge, Analytical

48 The present obligation to make a future sacrifice that is an essential criteria of the definition of a liability under the IASB Conceptual Framework: A. can only arise from legal obligations. B. may arise out of moral or constructive obligations. C. meets the definition of an expense. D. may vary in different countries. ANS: B PTS: 1 TOP: The conceptual framework

AACSB:

Knowledge, Analytical

49 According to the Corporations Act, an external auditor must: A. have appropriate tertiary qualifications. B. satisfy ASIC that he/she is capable of performing the duties of an auditor. C. satisfy ASIC that he/she is a fit and proper person to be registered as an auditor. D. all of the above. ANS: D PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

50. The role of an auditor is to: A. review accounting systems and internal controls. B. detect fraud. C. ensure that every transaction is correct. D. ensure that there is no fraud and that all transactions are correct. ANS: A PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

51. The auditor’s report: A. expresses an opinion as to the truth and fairness of the financial statements. B. states that the reporting entity is in a sound financial position. C. is prepared by internal auditors. D. includes forecasts of future profits. ANS: A PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

52. The relationship between the task undertaken by auditors and the understanding of the users is called: A. the experience gap. B. the auditor’s report. C. the expectations gap. D. the information gap. ANS: C PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

53. What is the audit expectation gap? A. The auditors’ ensuring that financial statements are prepared in accordance with accounting standards. B. The difference between what an auditor is required to do and what is expected by users. C. The auditors’ ensuring that they meet the requirements of an audit. D. The auditors’ providing a true and fair view of the financial statements. ANS: B PTS: 1 TOP: External audits

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. What is a conceptual framework from the perspective of financial reporting? ANS: The Financial Accounting Standards Board (FASB) in the US defined the conceptual framework as a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting. The IASB Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users. The framework establishes that the purpose of financial reporting is to provide external users with useful information. PTS: 1 AACSB: TOP: What is a conceptual framework?

Knowledge, Analytical

2. Describe four objectives of a conceptual framework. ANS: Four objectives of a conceptual framework: 1.

Fewer accounting standards. A conceptual framework is designed to enable the resolution of accounting problems faced by the preparers of general purpose reports, thus reducing the need for an accounting standard to be issued for every occasion.

More consistent accounting standards. A conceptual framework also guides the development of accounting standards by regulatory authorities. Thus, the resulting standards should be consistent with each other, leading to improved reporting quality.

Improved communication. Improved communication between stakeholders (regulators, preparers, and users) results from the fact that the concepts that comprise the conceptual framework, including the fundamental concepts of the financial statements – assets, liabilities, income and expenses – are common to all parties.

Defence against politicisation. The politicisation of the standard setting process is reduced, as standards are grounded in the conceptual framework i.e., the framework acts as a buffer against the self-serving interests of various stakeholders involved in the standard setting process.

PTS: 1 AACSB: Knowledge, Analytical TOP: The objectives of a conceptual framework 3. Outline the nature and purpose of general-purpose financial reports. ANS: Nature of GPFRs: typically statements of comprehensive income, financial positions, changes in equity, cash flows and the notes. Purpose of GPRs: to meet the common financial information needs of a diverse set of external users who do not have the authority to have their specific information needs met. PTS: 1 AACSB: TOP: The conceptual framework

Knowledge, Analytical

4. Under what circumstances does an entity represent a ‘reporting entity’ for the purposes of the Australian conceptual framework? ANS: A reporting entity is one for which there are users who rely on the (general purpose) financial statements as their major source of financial information about the entity. PTS: 1 AACSB: TOP: The conceptual framework

Knowledge, Analytical

5. Describe the purpose of the external auditor in financial reporting. ANS: The purpose of the external auditor is to express an independent opinion on whether the financial statements provide a true and fair view of the company’s financial position, performance and cash flows. That is, the external audit is designed to add credibility to general purpose reports. PTS: 1 AACSB: TOP: External audits

Knowledge, Analytical

6. What is the expectation gap associated with the external audit? ANS: The expectation gap refers to the gap between user expectations’ of the duties and responsibilities of the external auditor and the role fulfilled by the auditor in fact. PTS: 1 AACSB: TOP: External audits

Knowledge, Analytical

PROBLEMS 1. Explain what is meant by the term limited liability as it relates to the shareholders of a corporation; and explain why shareholders are able to gain the benefit of limited liability whereas sole traders cannot. ANS: The limited liability of shareholders refers to the fact that the members’ liability for the debts of the company is limited to the issue price of the shares held. Shareholders are able to gain the benefit of limited liability because a corporation is a separate legal entity. The debts of a company are at law those of the company, not the shareholders. However, in the case of a sole trader, the business is not a separate legal entity from the sole traders. Legally, the debts of a sole tradership are those of the owner, and, the assets of the business part of the individual’s pool of resources all of which are available to settle the debts. PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

2. Describe three advantages of a company over a partnership and a sole trader. ANS: • Separate legal entity – from the owners, which, in the case of limited liability companies, leads to reduced risk for equity holders. • Limited liability – by shares or guarantee, whichever applies. • Greater access to capital (equity and debt). • Ease of transfer of ownership. • Absence of mutual agency, with respect to partnerships. • Professional management. • Continuous existence. PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

3. R2 and E2 have been working as employees in the fashion industry. They are considering forming a partnership designing fashion clothing, trading under the RE2 label. Advise the individuals on the advantages and the disadvantages of forming a partnership. ANS: Advantages: • Ease of formation, compared to a company. • Limited rules and regulation, compared to a company. • Access to capital and expertise greater than in the case of sole trader. • There may be income taxation advantages, arising out of the sharing of profits. Disadvantages • Limited life – a partnership can be brought to an end at any time through, for example, the death, withdrawal or bankruptcy of a partner. • Unlimited liability – each partner is jointly and severally liable for the debts of the business, and that liability is unlimited. • Mutual agency – each partner is an agent of the other(s) when acting within the scope of the normal operations of the business. Mutual agency is essential to the efficient functioning of the business, but also has serious implications vis-a-vis each partner’s liability under the partnership. PTS: 1 AACSB: TOP: Types of organisations

Knowledge, Analytical

4. Required: (a) Does the deposit of silver meet the definition of an asset to Vanessa according to the IASB Conceptual Framework? Why?/Why not? (b) Under what circumstances may the deposit of silver be recognised in the balance sheet of Vanessa according to the IASB Conceptual Framework? ANS: (a) The metal deposit would appear to meet the three essential characteristics of the definition of an asset: future economic benefits (viability/profitability); control (the deposit may be deployed in the pursuit of the company’s objectives and the company has the exclusive legal right to mine vis-a-vis regulating/denying the access of others); and the past event (discovery). (b) Recognition criteria: The case study details suggest that it is probable that the future economic benefits will flow to the entity. The use of the present value measurement method may raise the question/discussion of the reliability of the value that has been placed on the asset, but the case details are not definitive vis-a-vis the reliability of the method. PTS: 1 AACSB: TOP: The conceptual framework

Knowledge, Analytical

5. Vanessa raised a $15,000,000 loan to fund the exploration that led to the discovery of the deposit of silver. Discuss whether the loan meets the definition and recognition criteria of a liability to Vanessa during the term of the loan, according to provisions of the IASB Conceptual; Framework.

ANS: The $15,000,000 loan clearly meets the definition and recognition criteria. Vanessa has an existing legal obligation to another entity arising out of a past event. It is probable that the loan will lead to an outflow (sacrifice) of economic benefits; and the figure can be measured reliably. PTS: 1 AACSB: TOP: The conceptual framework

Knowledge, Analytical

ESSAY 1. The opportunity for interested parties to participate in the development of accounting standards lies in the ‘due process’. Discuss. ANS: Accounting standards refer to regulations that are to be followed by preparers in the preparation of general purpose financial statements, where applicable. The standards deal, for example, with issues such as accounting for inventory, property, plant and equipment, long-term construction contracts, agriculture assets and leases. The development of the standards takes place within a regulatory framework, which includes a ‘due process’. The due process reflects a participatory (democratic) approach to the development of regulation. Therefore, it should engender greater stakeholder ‘ownership’ and acceptance of the final product, including a greater willingness to comply on the part of the regulated (preparers). The due process is also an important conduit of communication between the regulatory authority and stakeholders. Diversity of opinion has the capacity to enhance the quality of the final product. The process also has the capacity to allow the regulatory authority to gain a measure of the implications that proposed regulation may hold for wealth effects. PTS: 1 AACSB: TOP: The standard setting process

Knowledge, Analytical, Communication

2. Describe the role that the following organisations play in relation to Australian accounting standards: (i) the Financial Reporting Council; and (ii) the Australian Accounting Standards Board ANS: (i) Financial Reporting Council (FRC). The organisation has the oversight responsibility of the AASB. Specifically, the FRC is responsible for the priorities, business plan, budget and staffing arrangements of the AASB. However, it is not able to influence the AASB’s technical deliberations. (ii) Australian Accounting Standards Board. The organisation’s responsibilities, which are specified in S227 (a) of the Australian Securities and Investments Commission Act, include the following: – developing a conceptual framework, not having the force of an accounting standard, for the purpose of evaluating proposed accounting standards. – developing and issuing accounting standards which have the force of law. – formulating accounting standards for other purposes – participating in and contributing to the development of a single set of accounting standards for worldwide use. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: The framework for setting accounting standards.

Chapter 3 – Ethics and corporate governance TRUE/FALSE 1. Deontologists judge the moral correctness of actions by only looking at the consequences of such actions. ANS:

PTS:

AACSB:

Knowledge TOP:

Ethics and accounting

2. For accountants to use judgement in providing advice would be unethical. ANS:

PTS:

AACSB:

Knowledge TOP:

Ethics and accounting

3. It is ethical for an accountant to minimise the amount of tax his client is required to pay. ANS:

PTS:

AACSB:

Knowledge TOP:

Ethics and accounting

4. Effective corporate governance may reduce agency costs. ANS: T PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

5. Corporate governance is a new phenomenon that has grown out of recent corporate collapses. ANS: F PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

6. A company is classified as a separate legal entity, which often gives rise to a separation of powers, which in turn is a primary reason for ensuring there are effective corporate governance systems in place. ANS: T PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

7. The appointment of an audit committee is an example of internal corporate governance, whereas the ability of one company to take over another is an example of external corporate governance. ANS: T PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

8. Good governance is only relevant to the for-profit sector, not the not-for-profit sector. ANS: F PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

9. Corporate governance includes mechanisms, such as the board of directors, which exist to provide some assurance to equity investors that the management of a company is being held accountable for their actions, thus minimising agency costs. ANS: T PTS: 1 TOP: Board of directors

AACSB:

Knowledge, Analytical

10. The ASX principles and recommendations are mandatory on the top 200 listed companies. ANS: F PTS: 1 AACSB: TOP: Enforcement of corporate governance

Knowledge, Analytical

11. The role of the board of directors is to represent shareholders and debtholders. ANS: F PTS: 1 TOP: Board of directors

AACSB:

Knowledge, Analytical

12. An audit committee is a sub-committee of the board of directors, and part of the corporate governance structure of a company. ANS: T PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

13. The major thrust for the creation of an audit committee is to add credibility to the financial reporting process. ANS: T PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

14. Australian regulation requires the automatic rotation of the lead audit partner every seven years. ANS: F PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. According to Josephson (1992), characteristics of an ethical person include: A. honesty, caring and listening to clients’ orders. B. promise-keeping, not listening to client’s orders and respectfulness. C. loyalty, fairness and caring. D. honesty, coolness and being smart. ANS: C PTS: 1 TOP: What are ethics?

AACSB:

Knowledge, Ethics, Analytical

2. According to Josephson (1992), people do not behave in an ethical manner because of: A. faulty reasoning and loyalty. B. self-righteousness and greed. C. self-deception and fidelity. D. self-protection and faulty reasoning. ANS: D PTS: 1 TOP: What are ethics?

AACSB:

Knowledge, Ethics, Analytical

3. In a utilitarian ethical framework, moral correctness is based on the premise that: A. the underlying nature of an action determines its correctness. B. the consequences of an action determine its correctness. C. the nature of an action and its consequences determines its correctness. D. all of the above are correct. ANS: B PTS: 1 TOP: Ethics and accounting

AACSB:

Knowledge, Ethics, Analytical

4. Ethical behaviour in business will be achieved if: A. the strict letter of the law is applied. B. a course in ethics is undertaken. C. judgement is used, based on rules and morals. D. None of the above is correct. ANS: C PTS: 1 TOP: Ethics and accounting

AACSB:

Knowledge, Ethics, Analytical

5. Which of the following factors could weaken corporate governance? A. The appointment of independent directors to the audit committee B. Stipulating the maximum number of directorships a director can commit to C. Ensuring continuity of all directors over a long period to enhance familiarity with the company’s policies and procedures D. Ensuring the CEO is not the chairman of the board of directors ANS: C PTS: 1 TOP: Board of directors

AACSB:

Knowledge, Analytical

6. Which of the following is considered to be an example of good corporate governance according to the ASX principles? A. The appointment of a board of directors consisting of the company CEO, three company executives and one independent director. B. The appointment of an audit committee consisting of the audit partner and an independent auditor, and the company CEO and one company director. C. A board of directors that has intimate knowledge of the company’s activities since their appointment 10 years ago when the company was formed. D. Rotating the lead external audit partner every five years. ANS: D PTS: 1 AACSB: TOP: Enforcement of corporate governance

Knowledge, Analytical

7. Which of the following statements is incorrect? A. Corporate governance can provide assurances that management is accountable for their actions. B. The external auditor is responsible for the preparation of a company’s financial statements. C. Audit committees are now compulsory for the top 500 companies. D. An audit committee may be responsible for reviewing policies on internal control procedures. ANS: B PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

8. Which of the following would not be considered a function of an audit committee? A. The responsibility for appointing the members of the committee B. Overseeing the appointment of the internal auditor C. Overseeing the appointment of the external auditor D. Overseeing a company’s risk management practices ANS: A PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

9. Which of the following statements regarding audit committees is incorrect? A. Audit committees review internal control procedures. B. Audit committees oversee the appointment and relationship of the external auditor. C. Audit committees oversee the appointment of the internal and external auditors. D. Audit committee members must be employees of the company. ANS: D PTS: 1 TOP: The audit committee

AACSB:

Knowledge, Analytical

10. Corporate governance: A. refers to the governance of not-for-profit entities. B. is concerned with promoting corporate fairness, transparency and accountability. C. is a recent phenomenon in the conduct of company affairs. D. will improve the company’s financial performance. ANS: B PTS: 1 TOP: What is corporate governance?

AACSB:

Knowledge, Analytical

11. Which of the following recommendations are not associated with the principles of good corporate governance issued by the ASX Corporate Governance Council? A. A board of directors should have a majority of independent directors. B. The CEO should not be the chairman. C. There should be a separate nominations and remuneration committee for directors. D. All audit committee members should be accountants. ANS: D PTS: 1 AACSB: TOP: The ASX Corporate Governance Council

Knowledge, Analytical

12. The fundamental characteristic of the corporate form of business organisation that gives rise to the need for governance mechanisms is: A. the separation of ownership and control. B. mutual agency. C. the lack of separation of ownership and control. D. the abuses by professional managers. ANS: A PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

13. External corporate governance refers to: A. the board of directors. B. the audit committee. C. the discipline of the market place. D. triple bottom line reporting. ANS: C PTS: 1 AACSB: TOP: What is meant by corporate governance?

Knowledge, Analytical

14. ASX Ltd needs to appoint a new director from 1 January 20X7. Which of the following persons would meet the requirements for an independent director in accordance with the ASX principles? A. John who holds substantial shares in the company. B. Jill who is a major supplier of office supplies to the company. C. Jordan who was an employee of the company up until 31 December 20X5. D. Bill who was the auditor for the company from 1 January 19X7 until 31 December 20X3. ANS: D PTS: 1 TOP: Board of directors

AACSB:

Knowledge, Analytical

15. The majority of studies on board composition and firm performance and risk show that an increase in the number of independent directors on a board will: A. reduce the financial performance of a form. B. increase the financial performance of a firm. C. have no impact on the financial performance of a firm. D. increase the risk of a firm. ANS: C PTS: 1 TOP: Board of directors

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Explain what is meant by the term ‘corporate governance’. ANS: Corporate governance consists of mechanisms such as the board of directors and audit committees that exist to provide some assurance to the absentee owners that the management of a company are accounting for their actions and to minimise agency costs in respect of management. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: What is meant by corporate governance? 2. Describe the nature and general role of an audit committee. ANS: An audit committee is a subcommittee of a board. The audit committee, as the name suggests, is, generally speaking, responsible for ensuring the integrity of the financial statements; i.e., that the statements have been reliably prepared and verified. The committee is answerable to the board in that respect; i.e., the responsibility ultimately vests with the board as a whole. PTS: 1 AACSB: TOP: The audit committee

Knowledge, Analytical, Communication

The meaning of ‘ethical behaviour’ regarding the notion of ‘morality.’ Were the managers being honest and acting with integrity?

The role of ethics in business, including, perhaps, the question of whether there is a conflict between self-interest and ethical behaviour. Were the managers deriving higher benefits from engaging in behaviour which allowed the entity to increase its rates?

Josephson’s (1992) causes of unethical behaviour: self-deception, self-indulgence, self-protection, self-righteousness, faulty reasoning. Did the managers believe their strategy would go undetected?

The correctness, or otherwise, of management’s actions may also be addressed from the utilitarianism and deontological frameworks. Were the managers aware that their strategy would benefit shareholders but at the expense of customers?

PTS: 1

AACSB:

Ethics

TOP:

Ethics in business and accounting

ESSAY 1. Discuss the role of the board of directors in Australia and the key issues discussed in the literature about the board of directors impacting its effectiveness. ANS: Role of the board: to represent and create value for shareholders. The duties of the board include appointing and overseeing the performance of the CEO, ensuring that the company meets its legal and statutory obligations and managing risks. Corporate governance literature suggests that the following variables are important in relation to board effectiveness: • The number of independent directors on the board. The argument is that independent (non-executive) directors are more able to defuse agency conflicts between internal managers and absentee owners. • The determinants of director independence, which include matters associated with the independence of the selection process and the absence of family, financial, employment and other contractual relationships. • Duality of leadership. The question here is whether the CEO should be the chairman of the board or whether the position should be drawn from the non-executive directorship. Most codes suggest separation of these two roles. • Size of the board. • Qualifications of the directors – directors should possess the appropriate skills to allow the board to discharge its duties effectively. • Number of board memberships of directors. There is a view that some directors belong to too many boards and do not have the necessary time to properly carry out their duties. • Length of time. There is some suggestion that directors should be rotated to avoid the problems of apathy/complacency and familiarity with management. • The adequacy of the board’s duties and responsibilities. • Board diligence with respect to performing its duties and responsibilities. PTS: 1 AACSB: TOP: Board of directors

Knowledge, Analytical, Communication

Chapter 4 – Wealth and the measurement of profit TRUE/FALSE 1. The wealth of an entity is determined by what it controls and what it owes. ANS: T PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

2. Choosing a measurement system affects profit but does not affect wealth. ANS: F PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

3. Profit represents an increase in wealth. ANS: T PTS: 1 TOP: Profit and wealth

4. Profit measures the flow of resources into and out of the business over time. ANS: T PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

5. Historic cost is the cost incurred by an individual or enterprise in acquiring an item, measured at the time of the originating transaction. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

6. The written down cost of an asset represents the cost of an asset after accumulated depreciation. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

7. Historical cost is often referred to as the most relevant method of measurement. ANS: F PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

8. Net realisable value is based on an expected selling price in a forced sale. ANS: F PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

9. The net realisable value is the estimated proceeds of sales less, where applicable, all further costs to the stage of completion, and less all costs to be incurred in marketing, selling and distribution to customers. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

10. The value of the expected earnings from using an item, discounted at an appropriate rate to give a present-day value, is the economic value. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

11. The common measurement method adopted in most countries is that of historic cost. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

12. The fair value of an asset is more reliable where there exists a liquid market for the asset, than when no liquid market exists. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

13. Where an asset is exchanged between a willing seller and a willing buyer and the exchange price is below the market price due to fact that the parties involved are related, the resulting exchange price is referred to as fair value. ANS: F PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

14. Fair value arises in circumstances where the price is based on an orderly transaction between a willing seller and a willing buyer. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

15. Economic value is considered to be an ideal approach to measuring value, but may lack reliability due to the fact that the measure relies on estimates. ANS: T PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following statements is true of profit and wealth? A. Profit is money and wealth is savings. B. Profit is a non-static measure and wealth is a static measure. C. Profit and wealth are non-circular. D. Profit and wealth are not related. ANS: B PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

2. Which of the following statements is incorrect? A. Profit is a non-static measure and wealth is a static one. B. Profit is the difference between wealth at the start and at the end of the period. C. Profit represents the sum of all gains . D. Profit represents an increase in wealth. ANS: C PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

3. Jane buys a 1957 FJ Holden at time T0 for $100,000. At time T1, the car is valued at $180,000. Jane’s profit and wealth at T1 are: A. $100,000 and $80,000 respectively. B. $80,000 and $180,000 respectively. C. $80,000 and $100,000 respectively. D. $80,000 and $80,000 respectively. ANS: B PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

4. James had $80,000 in the bank. He used some of this cash to buy a new car for $67,000 on 1 January 20X7. He subsequently modified the car, at no cost, and sold it for $78,000 on 1 March 20X7. What profit did James make from the sale of the car? A. $3000 B. $8000 C. $11,000 D. $14,000 ANS: C PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

5. Peter has the following assets at various dates. He has no liabilities and earned no other income over this two-year period. Date Asset 1 Asset 2 Asset 3

1/1/X5 $44,000 $24,000 $66,000

1/1/X6 $41,000 $29,000 $61,000

1/1/X7 $46,000 $39,000 $59,000

Which of these statements is correct? A. Peter’s wealth increased by $10,000 over this two-year period. B. Peter’s profit was $3000 for the year ended 1 January 20X7. C. Peter’s wealth was $134,000 at 1 January 20X7. D. Peter’s loss was $8000 for the year ended 1 January 20X6. ANS: A PTS: 1 TOP: Profit and wealth

AACSB:

Knowledge, Analytical

6. Historic cost refers to: A. the cost of selling an item. B. the cost to replace an item C. the purchase consideration of an item, plus incidental costs. D. economic value. ANS: C PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

7. When calculating costs associated with the sale of an item, which of the following are included in the net realisable value? A. Marketing, manufacturing and selling costs. B. Manufacturing, selling and distribution costs. C. Marketing, selling and distribution costs. D. Marketing and distribution costs.

ANS: C PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

8. Aaron sold his large lounge chair to his friend for $1000. He incurred costs of $100 for advertising, $120 for hiring a van to transport the chair to the buyer, and $200 for a speeding fine. What is the net realisable value? A. $1100 B. $1120 C. $1220 D. $1420 ANS: C PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

9. Tom purchased an item for $5050 in 20X6. He sold the item to a complete stranger for $7000 in 20X7 and incurred a sum of $250 for advertising it. Which of the following statements is true? A. Historical cost is $5050. B. Fair value is $7000. C. Net realisable value is $6750. D. All of the above. ANS: D PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

10. James had $80,000 in the bank. He used some of this cash to buy a new car for $67,000 on 1 January 20X7. James subsequently modified the car and sold it for $78,000 on 1 March 20X7. The modifications cost James $10,000. The historical cost of the car is: A. $67,000. B. $68,000. C. $78,000. D. $88,000. ANS: A PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

11. For which of the following accounts would the use of historical cost normally be a greater limitation than for the other three? A. Cash B. Accounts Receivable C. Plant and Machinery D. Prepaid Rent ANS: C PTS: 1 AACSB: TOP: Alternative systems of valuation and chapter 2

Knowledge, Analytical

12. For which of the following accounts would the limitation ‘use of estimates and allocations’ not be a concern? A. Inventory B. Cash C. Equipment D. Accounts Receivable ANS: B PTS: 1 AACSB: TOP: Alternative systems of valuation and chapter 2

Knowledge, Analytical

13. Which of the following statements about the limitations of financial statements is false? A. Many of the numbers reported in financial statements result from estimates. B. Financial statements report primarily the current value of assets. C. Some important factors may not be reported in a firm’s financial statements. D. Certain types of resources are not reported in the financial statements. ANS: B PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

14. Current accounting practice in Australia is to initially record property, plant and equipment at: A. economic value. B. cost. C. net realisable value. D. replacement cost. ANS: B PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

15. Where an asset is measured on the basis of the discounted net cash flows that are expected to be generated by the future use of the item, the resulting measure is referred to as: A. fair value. B. net realisable value. C. historic cost. D. economic value. ANS: D PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

16. Where an asset is measured at fair value, the figure involved: A. is more likely to be reliable if a liquid market for the asset exists than if no liquid market exists. B. reflects an historical value. C. is the same as replacement cost. D. is fair and reasonable. ANS: A PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

17. The replacement cost of an asset: A. is the same as historical cost. B. is sometimes called ‘current cost’. C. is the same as economic value. D. should always be used where the asset is to be replaced. ANS: B PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

18. James had $80,000 in the bank. He used some of this cash to buy a new car for $67,000 on 1 January 20X7. James subsequently modified the car and sold it for $78,000 on 1 March 20X7. The modifications cost James $9000, and he paid a total of $250 to advertise the car for sale. James made a profit on the sale of the car of: A. nil. B. $1750. C. $2000 D. $11,000

ANS: C PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

19. James had $80,000 in the bank. He used some of this cash to buy a new car for $67,000 on 1 January 20X7. James subsequently modified the car and sold it for $78,000 on 1 March 20X7. The modifications cost James $10,000, and he paid a total of $250 to advertise the car for sale. James’ wealth after the sale of the car was: A. $80,000. B. $80,750. C. $148,000. D. $158,000. ANS: B PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

20. Where an asset is measured using economic value, the figure involved: A. may lack reliability. B. represents the discounted value of expected future earnings from the use of the asset. C. represents a measure of current value. D. all of the above. ANS: D PTS: 1 TOP: Alternative systems of valuation

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Distinguish between the terms ‘wealth’ and ‘profit’. ANS: Wealth refers to the monetary value of an entity at a point in time i.e., the net assets of an entity. Profit, refers to the increase in wealth between two consecutive points in time. PTS: 1

AACSB:

Knowledge, Analytical

TOP: Profit and wealth

2. Explain what is meant by the term written-down value, and how the measure differs from the historic cost of an asset. ANS: Written-down value refers to the cost of an asset less accumulated depreciation in the books of an entity at a point in time. Historic cost on the other hand refers to the cost incurred by an entity in acquiring an item at the time of the originating transaction. PTS: 1 AACSB: TOP: Alternative systems of valuation

Knowledge, Analytical, Communication

PROBLEM 1. Assume that you bought a new computer from Computers Plus for $3200 in August 20X0. In January 20X1 your computer is in need of repair. You have been advised that it will cost $275 to repair the computer. You could sell the computer for $500 if you have it repaired and $100 if you do not have it repaired. The new price for a similar computer in January 20X1 is $3050. (a) What is the historic cost of the computer to you?

(b) What is the net realisable value of the asset to you in January 20X1 if you: (i) have the computer repaired? (ii) do not have the computer repaired? (c) What is the replacement cost of the computer in January 20X1? (d) Assuming the computer is repaired, do you consider the figure for the replacement cost an appropriate measure of the future economic benefits that will be derived from the continued use of the computer? Why/Why not? ANS: (a) $3200; (b) (i) $500 – $275 = $225, (ii) $100; (c) $3050. (d) The new price replacement cost ($3050) is likely to overstate the future economic benefits that will be derived from the use of the asset, due largely to changing technology. Written down replacement cost would provide a more appropriate measure in that respect. PTS: 1 AACSB: systems of valuation

Knowledge, Analytical

TOP: Alternative

2. Assume that the following information relates to you at today’s date. You have $120 cash in hand; $3350 deposited in a bank account; a motor vehicle valued at $13,000; jewellery and other miscellaneous items valued at $3200; and a friend owes you $100. You owe $1500 to a relative who lent you the money to purchase the vehicle. What is the amount ($) of your wealth, given the foregoing information? ANS: $120 + $3350 + 13000 + $3200 + $100 – $1500 = $18,270. PTS: 1

AACSB:

Knowledge, Analytical

TOP: Profit and wealth

3. In the season 2001–02 Manchester United (England) paid a transfer fee of USD $58.1 million to Leeds United (England) for the services of soccer star Rio Ferdinand. (a) What factors may Manchester United have taken into consideration in arriving at the value of Ferdinand’s services to the club? (b) What would be the advantages and disadvantage of using economic value to arrive at the transfer fee? ANS: (a) The factors would ultimately centre on the earnings that would accrue to the club on the basis of the player’s status and contribution to the overall success of the club. The earnings would include the following: membership fees, gate takings, sponsorships and sales of club merchandise. (b) The advantage of using economic value lies with the fact that it attempts to measure the net cash flows that will accrue from the future economic benefits that represent the asset. The disadvantages of the measurement model lie with the difficulties associated with estimating future net earnings, and arriving at an appropriate discount rate. The problem of forecasting future earnings would be compounded in this instance given the risks of ‘ownership’ associated with a human (as opposed to a non-human) asset vis-a-vis injury

and illness, which spill over to the recognition criteria (the probability that the benefits will accrue and the question of reliable measurement), notwithstanding the club’s efforts to control for those variables. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Alternative systems of valuation and chapter 2 4. In August 2005, Western Australia’s biggest meat processor, E G Green & Sons, suspended trading with debts estimated at $20 million. The company was at that time facing either (i) liquidation, or (ii) trading out of difficulty and continuing as a going concern. (a) Identify five of the major groups of stakeholders who would be directly impacted by the suspension in the entity’s operations. (b) What method(s) of valuing the firm’s non-monetary assets may have been appropriate under both scenarios? Support your discussion by identifying the reasons for your choice of methods. ANS: (a) Stakeholders: shareholders, lenders, employees, customers and suppliers. (b) Liquidation: The value of all of the assets in the event of liquidation is value in exchange – reflected in the net realisable value (cash equivalent) of the assets. Liquidation involves realising all assets and paying out the various claimholders. Continuing in business: Note: this question may be addressed from varying perspectives, including the nature and purpose of the assets held, regulation, the objectives of the user and the measurement model employed. In the case of assets whose value to the business is in exchange (marketable securities, non-current assets held for sale) then generally speaking NRV is the appropriate measure. However, technically, regulation has a role to play here. For example, under historical cost, inventory held for distribution in the normal course of business is required to be measured at the lower of cost or market – AASB 102 Inventories. This is discussed in chapter 8. For those assets whose value to the business is in their continued use (e.g., buildings, plant and equipment) then the value of the assets is possibly best reflected in the carrying amount, assuming that does not exceed recoverable amount, and that the historic cost model prevails; the recoverable amount; or, depending on the circumstances, written down replacement cost. Economic value should not be ruled out of the discussion, but due to the problems inherent in the use of the method, it is unlikely to be used (finance leases are an exception vis-a-vis, AASB 117 Leases). With respect to land, it is common practice, under modified historical cost, to value the asset at a figure approaching fair value. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Alternative systems of valuation and chapter 2

5. Pod Fashion buys and sells shoes. At 1 January 20X0 the business held 500 pairs of shoes, valued at $10 a pair. During January the business sold 410 pairs of the shoes at $40 cash per pair. The average cost of selling the shoes was $10 cash per pair. The replacement cost of the shoes at 31 January 20X0 was $12 a pair. Further, due to market competition, the expected selling price of the shoes in the foreseeable future will be $38 a pair at an average cost of $10 per pair. (a) Calculate the wealth of Pod Fashion at 1 January 20X0 and 31 January 20X0, assuming that the $10 value for shoes at 1 January represents both the historic cost, replacement cost and net realisable value at that date. (b) Calculate the profit Pod Fashion made for the month of January 20X0, using the historic cost, replacement cost and net realisable value methods. ANS: (a) Shoes Cash (b)

Profit

Historic cost T0 T1 4100 900 0 12,300 4100 13,200 9100

PTS: 1 AACSB: systems of valuation

Replacement cost T0 T1 4100 1080 0 12,300 4100 13,380 9280

NRV T0 4100 0 4100

Knowledge, Analytical

TOP: Alternative

T1 2520 12,300 14,820 10,720

Chapter 5 – Presentation of financial position and the worksheet TRUE/FALSE 1. Liquidity refers to the ease with which assets can be converted to cash in the normal course of business. ANS: T PTS: 1 TOP: The purpose of the balance sheet

AACSB:

Knowledge, Analytical

2. The historical cost assumption requires that an asset that is used for personal use and not for business use should be recorded at cost in the business balance sheet. ANS: F PTS: 1 TOP: Definition of the balance sheet

AACSB:

Knowledge, Analytical

3. The business entity assumption requires that an asset that is used for personal use and not for business use should not be recorded in the business balance sheet. ANS: T PTS: 1 TOP: Definition of the balance sheet

AACSB:

Knowledge, Analytical

4. A balance sheet provides information on the liquidity of the entity. ANS: T PTS: 1 TOP: The purpose of the balance sheet

AACSB:

Knowledge, Analytical

5. An operating cycle may exceed 12 months and be longer than an accounting cycle. ANS: T PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

6. A mortgage payable that had only 12 months left before due for repayment would be reclassified from a non-current liability to a current liability. ANS: T PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

7. A piece of equipment purchased for resale within the entity’s operating cycle would be classified as a current asset. ANS: T PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

8. Current assets are always classified according to their nature and not their function. ANS: F PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

9. To be classified as a current liability, a debt must be expected to be paid within the current accounting period or within the entity’s operating cycle, whichever is the longer.

ANS: T PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

10. In the situation where an entity is insolvent, equity holders will be paid only whatever remains after all liabilities are paid. ANS: T PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

11. The balance sheet equation can be represented as: Assets – Liabilities = Equity ANS: T PTS: 1 TOP: The balance sheet equation

AACSB:

Knowledge, Analytical

12. The ‘net assets’ of a business is equal to current assets plus current liabilities. ANS: F PTS: 1 TOP: The balance sheet equation

AACSB:

Knowledge, Analytical

13. In relation to the format of a balance sheet, large and complex organisations will summarise assets under broad headings. ANS: T PTS: 1 AACSB: TOP: Influences on the format of the balance sheet.

Knowledge, Analytical

14. If assets increase, then, applying the principle of duality, we must increase liabilities, decrease another asset or increase owners’ equity. ANS: T PTS: 1 TOP: A simple balance sheet.

AACSB:

Knowledge, Analytical

15. The worksheet illustrates the basics underlying double-entry bookkeeping. ANS: T PTS: 1 TOP: The worksheet.

AACSB:

Knowledge, Analytical

16. A double-entry error will cause an imbalance in the worksheet which is twice the amount recorded. ANS: T PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

17. If a worksheet does not balance and the imbalance is not caused by a transposition, single-entry or double-entry error, then it must be an addition or subtraction error. ANS: T PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

18. An addition or subtraction error will cause the worksheet to be out of balance by half the amount of the transaction. ANS: F PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following statements is incorrect? A. A balance sheet reports assets, liabilities and equity at a point in time. B. The exclusion of an asset from the business balance sheet because it is for private use is due to the going concern assumption. C. The average period between the purchase of merchandise and the conversion of this merchandise back into cash is the operating cycle. D. In order for a resource to be classified as an asset of the entity, the benefits must accrue to the entity. ANS: B TOP: Chapter 5

PTS: 1

AACSB:

Knowledge, Analytical

2. A balance sheet is a statement that shows the resources controlled and the obligations owed by an entity: A. in the previous financial year. B. for the financial year. C. for the accounting period. D. at a point in time. ANS: D PTS: 1 TOP: Definition of the balance sheet

AACSB:

Knowledge, Analytical

3. Which of the following best describes the purpose of the balance sheet? A. To summarise assets and liabilities for the accounting period. B. To report the inflows and outflows of cash. C. To balance current period revenues with those of the previous period. D. To report assets, liabilities and owner’s equity as of a specific date. ANS: D PTS: 1 TOP: The purpose of the balance sheet.

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

4. The most liquid type of asset is: A. bills receivable. B. cash. C. investment in listed shares. D. inventory. ANS: B PTS: 1 TOP: Elements of the balance sheet

5. Which of the following best represents examples of liquid assets? A. Cash and office equipment. B. Cash and accounts receivable. C. Cash and inventory. D. Cash and prepaid assets. ANS: B PTS: 1 TOP: Elements of the balance sheet

AACSB:

Analytical

6. Which statement below is true about a company’s operating cycle? A. It may not exceed one year. B. It must be one year.

C. It may be longer than a year. D. It is always longer than a year. ANS: C PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

7. Non-current assets are best described as: A. assets that extend benefits beyond the coming financial year or operating cycle. B. tangible assets that extend benefits beyond the coming year or operating cycle, whichever is longer. C. assets that are depreciated for a maximum of 40 years. D. assets that provide economic benefits over the coming year. ANS: A PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

8. Gibson, Inc. a retailer, reports the following information: Accounts Payable Cash Retained Profits Buildings

$600 7000 7800 17,600

Accounts Receivable Loan Payable Inventory Office Supplies

$5200 4400 10,200 1600

What is the most likely amount for the firm’s current assets? A. $41,600 B. $24,000 C. $22,400 D. $13,800 ANS: B TOP: Chapter 5

PTS: 1

AACSB:

Analytical

9. Which of the following is classified as a liability? A. Wages expense. B. Accounts payable. C. Owners’ drawings. D. Retained profits. ANS: B PTS: 1 TOP: Elements of the balance sheet

AACSB:

Analytical

10. Amounts owed by a business enterprise to external parties are described as: A. assets. B. liabilities. C. equities. D. revenue. ANS: B PTS: 1 TOP: Elements of the balance sheet

AACSB:

11. Owners’ equity is: A. the owners interest in the assets of the firm. B. only profits retained in the business.

Knowledge, Analytical

C. the contributions by the proprietor plus all profits retained by the business. D. only contributions by the proprietor. ANS: C PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

12. How many of the following headings would be found on the balance sheet: Unearned revenue, Non-current assets, Current liabilities, Equity, Accounts receivable, Owner’s equity, Inventory, Wages expense, and Interest income. A. Five B. Six C. Seven D. Eight ANS: C TOP: Chapter 5

PTS: 1

AACSB:

Analytical

13. Which of the following equations is correct? A. Assets = Liabilities + Owners’ Equity – (Income – Expenses) B. Assets + (Income + Expenses) = Liabilities + Owners’ Equity C. Assets + Liabilities + Owners’ Equity = Income – Expenses D. Assets – Liabilities = Owners’ Equity + (Income – Expenses) ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

14. Which of the following is not a valid expression of the balance sheet equation? A. Assets = Liabilities + Owners’ Equity B. Assets – Liabilities = Owners’ Equity C. Assets – Owners’ Equity = Liabilities D. Liabilities + Assets = Owners’ Equity ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

15. An entity’s owners’ equity is one-third of its total assets. Its liabilities total $100,000. What is the amount of its total assets? A. $100,000 B. $150,000 C. $200,000 D. $300,000 ANS: B PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

16. An entity’s owners’ equity is one-third of its total liabilities. Its assets total $200,000. What is the amount of its owners’ equity? A. $50,000 B. $66,667 C. $150,000 D. $300,000 ANS: A PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

17. The purchase of an asset for cash will: A. not affect total assets, liabilities, and owners’ equity. B. increase total assets and increase total liabilities. C. increase total assets and increase total owners’ equity. D. increase total assets. ANS: A PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

18. When an organisation purchases a machine for cash, which of the following is true? A. Total assets increase. B. Total liabilities decrease. C. Total expenses increase. D. Total equity stays the same. ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

19. The Davis Company purchases a new delivery truck by making a 10% cash down payment and signing a note payable for the balance. How will assets, liabilities and owner’s equity be affected by this transaction? Assets A. decrease B. increase C. increase D. no change

Liabilities increase increase decrease increase

ANS: B PTS: 1 TOP: The balance sheet equation

Owners’ Equity no change no change increase decrease AACSB:

Analytical

20. On 31 May 20X7, after many months of planning, Macy opened a bike shop by investing $10,000 of his own money. On May 31 he spent 20% of it to pay the rent for three months from 1 June 20X7 on a store location, and the balance on furnishings and fixtures that had been delivered and set up the night before. A friend had loaned Macy $6000, all of which he used to purchase inventory on 31 May, prior to opening. If Macy prepared a balance sheet as at 31 May 20X7, what would be the balances for total assets and total liabilities? Total Assets A. $10,000 B. $14,000 C. $16,000 D. $16,000

Total Liabilities $6000 $6000 $6000 $10,000

ANS: C PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

21. Blanche started a business by contributing $24 000 cash and a truck valued at $40,000. The company then purchased equipment by paying the $24 000 cash as a down payment (which accounted for half its purchase price), and financed the other half by signing a note payable at the bank. After the above transactions, Blanche’s company balance sheet is: Assets A. $64,000 B. $88,000

Liabilities $0 $0

Owner’s Equity $64,000 $88,000

C. $88,000 D. $112,000

$24,000 $24,000

ANS: C PTS: 1 TOP: The balance sheet equation

$64,000 $88,000 AACSB:

Analytical

22. George Corporation had the following transactions during the month of August: 1. Owners started the company by investing $400,000 in cash. 2. Purchased $200,000 of equipment by making a $100,000 cash down payment and signed a 90-day note payable for the balance. 3. Purchased land for $500,000, signing a note payable for the full amount. 4. Earned $60,000 of services revenue (of which $40,000 was received in cash with the balance on accounts receivable). What are total assets for George Corporation at the end of August? A. $1,060,000 B. $1,100,000 C. $1,140,000 D. $1,160,000 ANS: A PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

23. Chocolate Heaven, Inc. had a balance of $200,000 in shareholders’ equity at 31 December 20X6. During 20X7, the company recorded a net profit of $50,000, distributed dividends of $30,000, and borrowed $10,000. What was the company’s shareholders’ equity at 31 December 20X7? A. $200,000 B. $210,000 C. $220,000 D. $230,000 ANS: C PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

24. The accounting records of Margo Catering show the following balances at 31 December 20X7: Cash $600 Notes Payable $200 Office Equipment 2400 Owners’ Equity 1000 Accounts Receivable 400 Retained Profits 900 Accounts Payable 800 Expenses 3400 Total assets as of 31 December 20X7 are: A. $3000 B. $3400 C. $4400 D. $5300 ANS: B PTS: 1 TOP: Elements of the balance sheet

AACSB:

Analytical

25. Which one of the following statements is generally true regarding the relationship between the items mentioned? A. An increase in assets will always cause an increase in owners’ equity. B. A decrease in assets will always cause a decrease in liabilities. C. An increase in revenues normally increases owners’ equity. D. Expenses decrease revenues.

ANS: C PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

26. When a liability is paid, which of the following is true? A. Total assets and total liabilities remain the same. B. Total assets and total owner’s equity decrease. C. Total assets decrease by the same amount that total liabilities increase. D. Total assets and total liabilities decrease. ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

27. The Club of Winston Churchill has the following items disclosed on its balance sheet. The only item missing is owner’s equity: Accounts receivable

$25,000

Motor vehicles

Cash Bank overdraft Loan payable Office Building

40,000 15,000 150,000 90,000

Notes Payable Goodwill Prepaid Rent Plant & Equipment

What are the values of the club’s total assets and net assets? A. Total assets $293,500 and net assets $113,500 B. Total assets $293,500 and net assets $110,000 C. Total assets $308,500 and net assets $98,500 D. Total assets $238,500 and net assets $110,000 ANS: A PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

28. The Club of Winston Churchill has the following items disclosed on its balance sheet as at 30/6/20X2: Accounts receivable Cash at bank Bank overdraft Loan payable Office Building

$25,000 40,000 15,000 150,000 90,000

Motor vehicles Notes Payable Goodwill Prepaid rent to 31/12/20X2 Plant & equipment

$30,000 15,000 25,000 3500 80,000

What is the value of the club’s current assets? A. $25,000 B. $65,000 C. $68,500 D. $93,500 ANS: C PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

29. On a balance sheet, assets are usually classified as: A. Current Assets, Fixed Assets, Plant and Equipment, and Intangible Assets. B. Current Assets, Long Term Assets, Plant and Equipment, and Intangible Assets. C. Current Assets, Fixed Assets and Long-term Investments. D. Current Assets and Non-current Assets.

ANS: D PTS: 1 TOP: Elements of the balance sheet

AACSB:

Knowledge, Analytical

30. What is the value of total assets if current assets equal $2200, current liabilities equal $1500, non-current liabilities equal $800 and shareholders’ equity equals $2500? A. $2200 B. $3700 C. $4800 D. $7000 ANS: C PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

31. During an accounting period, total assets decreased by $5m while owner’s equity increased by $8m. The change in total liabilities during this period must have been a: A. $3m increase. B. $3m decrease. C. $13m increase. D. $13m decrease. ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

32. Bart Corporation reports these balances in its accounting system. Determine the balance of the Retained Profits account. Accounts Payable Land and buildings Notes Payable Equipment Cash Accounts Receivable Inventory

$40 320 16 140 80 120 72

Loan Payable Supplies Inventory Owners’ Equity Interest Payable Retained Profits

$100 8 220 4 ?

AACSB:

Analytical

A. $360 B. $580 C. $620 D. $780 ANS: A PTS: 1 TOP: The balance sheet equation

33. Double-entry bookkeeping is based on a rule known as: A. accrual accounting. B. going concern principle. C. the principle of duality. D. the business entity principle. ANS: C PTS: 1 TOP: A simple balance sheet

AACSB:

Knowledge, Analytical

34. When applying the principle of duality to the balance sheet equation, an increase in assets will not normally result in: A. an increase in liabilities. B. an increase in another asset.

C. an increase in owners’ equity. D. a decrease in another asset. ANS: B PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

35. Which of the following is not a characteristic of a worksheet? A. It is set out in the form of the balance sheet equation. B. It provides a vehicle for recording accounting transactions. C. It requires the use of a computerised system to ensure accuracy. D. It applies the principles of double-entry bookkeeping. ANS: C PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

36. Two transactions are recorded incorrectly in a worksheet. The first error is a transaction of $1000 which is recorded twice on the assets side of the worksheet. The second error is a transaction of $500 recorded only on the assets side of the worksheet. What will be the difference between the assets side of the worksheet and the liabilities + owners’ equity side of the worksheet? A. $500 B. $1500 C. $2000 D. $2500 ANS: D PTS: 1 TOP: The worksheet

AACSB:

Analytical

37. Which of the following errors will not cause an imbalance in the worksheet? A. A single-entry or double-entry error. B. Not recording a transaction or recording a transaction twice. C. A subtraction or transposition error. D. An addition or subtraction error. ANS: B PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

38. A common error encountered when examining a worksheet that does not balance is the discovery that the error is mathematically divisible by nine. This type of error is commonly referred to as: A. an addition or subtraction error. B. a single-entry error. C. a transposition error. D. a double-entry error. ANS: C PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

39. During an accounting period, a transaction occurred involving the purchase of equipment for $9000. On reviewing the worksheet, it was discovered that the transaction had not been recorded. The most likely reason that the omission was picked up is: A. the worksheet did not balance by $9000. B. the imbalance was divisible by 9. C. the omission was picked up by a diligent bookkeeper. D. the worksheet did not balance by $4500. ANS: C PTS: 1 TOP: The worksheet

AACSB:

Knowledge, Analytical

40. A Ltd sold a car for $75,000 which it had recorded in its accounts at $60,000. The effect on A Ltd’s accounts is: Assets A. increase B. decrease C. increase D. no change

Liabilities no change decrease no change decrease

ANS: A PTS: 1 TOP: The balance sheet equation

Equity increase increase no change no change AACSB:

Analytical

AACSB:

Knowledge, Analytical

41. The worksheet is a form of: A. journal. B. financial statement. C. working paper. D. ledger. ANS: C PTS: 1 TOP: The worksheet

42. Aria was trying to determine the amount of total equity in her music business. An exclusive list of accounts is listed below: Piano Cash Office equipment Bank overdraft Profit for the period

$12,000 $2000 $4000 $2000 $2000

Based on this information, the total owner’s equity in Aria’s business was: A. $2000 B. $10,000 C. $14,000 D. $16,000 ANS: D PTS: 1 TOP: The balance sheet equation

AACSB:

Analytical

SHORT ANSWER 1. What is meant by the concept of duality? Illustrate your answer with respect to the following three transactions (events): • Entity paid wages for services provided in the preceding fortnight. • Entity issued shares for land. • Entity paid $30,000 cash for equipment to be used in the business ANS: The concept of duality refers to the fact that all events (transactions) have a two-fold effect on the accounting equation. With respect to three examples provided: (i) wages: decrease assets (cash), decrease owners equity (increase in expenses); (ii) equity issue: increase assets (land); increase owners’ equity (share capital); (iii) equipment: decrease assets (cash) and increase assets (equipment).

PTS: 1 AACSB: TOP: The balance sheet equation

Knowledge, Analytical

2. Briefly describe four sources of the common types of errors that may be made in recording transactions (events) in the worksheet. ANS: (i) single-entry error i.e., the incomplete application of the principle of duality; (ii) double-entry errors i.e., duality is applied incorrectly; (iii) errors of addition and subtraction; and (iv) errors of transposition. PTS: 1 AACSB: TOP: The worksheet

Knowledge, Analytical, Communication

3. What is the operating cycle of a business? How does this impact the classification of assets into current and non-current categories? ANS: Operating cycle: refers to the time between the acquisition of materials entering into a process and the realisation of the materials as cash or an instrument that is readily convertible into cash (e.g., a financial asset, such as accounts receivable). The concept plays an important part in distinguishing current and non-current assets, in that assets that are expected to be realised or are held for sale or consumption in the normal course of the entity’s operating cycle represent current assets. All assets other than current assets are classified in non-current assets. PTS: 1 AACSB: TOP: Elements of the balance sheet

Knowledge, Analytical, Communication

4. What role does the business entity principle play in accounting for the transactions, assets and liabilities of an entity? ANS: The business entity principle holds that the business is a separate entity from the owner, all business transactions are entered into from the perspective of the business, the assets are considered to be the resources of the business entity and the liabilities and owners’ equity claims on those assets. PTS: 1 AACSB: TOP: Definition of the balance sheet

Knowledge, Analytical, Communication

5. At 30 June 2011, the non-current asset section of the balance sheet of Qantas included leasehold aircraft and engines valued at cost, $4947 million, written-down value $3159 million. (a) Explain how the definition and recognition criteria of assets would be met in order for Qantas to report the aircraft as assets in the balance sheet? (b) How is written-down value calculated? ANS: (a) Definition: future economic benefits – revenue from the provision of transport; control

– the aircraft are fundamental to the company’s objectives/operations, and the lease agreements must vest in the company the capacity to deny and/or regulate the access of others, including, all other things being equal, the lessor; past event – striking of lease agreement. Recognition: Qantas would need to have determined that it was probable that economic benefits would accrue to the organisation (demand for its services), and the monetary measure placed on the aircraft would need to be reliable (without undue error or bias). (b) Written-down value: cost less accumulated depreciation (amortisation). PTS: 1 AACSB: TOP: Elements of the balance sheet

Knowledge, Analytical

6. What are the three components of the balance sheet? Briefly discuss each. ANS: The three components of the balance sheet are assets, liabilities, and owners’ equity. Assets are an entity’s economic resources that will provide future benefits to the entity. Examples include cash, accounts receivable, inventory, land, and equipment. Liabilities are the economic obligations of an entity. Examples include accounts payable, wages payable, and salaries payable. Owner’s equity is the owners’ current investment in the assets of the entity. The owners’ equity is a residual interest, because creditors have first claim to the assets of the entity. PTS: 1 AACSB: TOP: Elements of the balance sheet

Knowledge, Analytical, Communication

PROBLEM 1. Identify the impact of the following events on the balance sheet equation. a The owner pays $3000 into the business bank account. b The business acquires equipment for $8000, paying a $3000 deposit, with the balance payable in 90 days. c The business provides services for $850 cash. d Paid salaries and wages $2300. e The business provides a potential customer with a quote of $900 for the provision of services. f The business purchases supplies for $385 cash. ANS: a: increase assets (cash); increases owners equity (capital). b: increase assets (equipment); decrease assets (cash); increase liabilities. c: increase assets (cash); increase owner’s equity (revenue). d: decrease assets (cash); decrease owner’s equity (expense). e: no effect on the balance sheet equation. f: increase assets (supplies); decrease assets (cash). PTS: 1

AACSB:

Analytical

TOP: Balance sheet equation

2. X Ltd sold 2000 computers in June 20X0. The terms of sale included a 12-month warranty. The warranty provides that X Ltd will meet the cost of repairs that are associated with faulty parts attributable to manufacture. Past experience indicates that 10% of computer sales lead to warranty claims at an average cost of $70 for parts and $100 for labour, per computer. Discuss whether the warranty commitment would meet the definition and recognition criteria of a liability to the firm at 30 June 20X0. ANS: Definition: the warranty commitment represents an existing legal obligation involving a future outflow of economic benefits, to another entity (customers), arising out of a past event (sale). Recognition: The details of the case suggest that outflow is probable (‘past experience indicates …’); and the measurement is reliable ((2000) (0.10) ($170)) = $34,000. PTS: 1 AACSB: TOP: Elements of the balance sheet

Analytical, Communication

3. Xavier Plata operates a small manufacturing business, trading under the name of Plata Products. The following list of financial data relates to the business as at 30 June 20X0. Cash Receivables Inventories Prepaid insurance Intangibles

131,950 70,300 13,026 1500 8750

Plant & equipment (net) Accounts payable Salaries payable Interest-bearing, long-term Borrowings Contributed capital Retained profits

183,000 8500 1450 155,000 198,626 44,950

Additional information • Receivables will be collected within 12 months of 30 June 20X0. • 30% of the figure for interest-bearing borrowings is payable within 12 months of 30 June 20X0. Required Prepare a fully classified balance sheet for Plata Products as at 30 June 20X0.

ANS: Plata Products Balance Sheet As at June 30 20X0 Current Assets Cash Receivables Inventories Prepayments Total current assets Non-current assets Plant & equipment Intangibles Total non-current assets

131,950 70,300 13,026 1500 216,776

183,000 8750 191,750

Total assets Current liabilities Accounts payable Salaries payable Interest-bearing borrowings Total current liabilities Non-current liabilities Interest-bearing borrowings Total non-current liabilities Total liabilities Net Assets Equity Contributed equity Retained profits Total owners’ equity

PTS: 1 AACSB: of the balance sheet

408,526

8500 1450 46,500 56,450

108,500 108,500 164,950 243,576 198,626 44,950 243,576 Analytical

TOP: Influences on the format

CASE 1. In June 2002 WorldCom, a US telecommunications firm, announced that it had misreported financial information in previous accounting periods – to the sum of USD $3.9 billion – by recording routine operating expenses as capital expenditure. Discuss (a) The impact of the treatment on the financial statements. (b) The possible reasons for management’s accounting policy choice. (c) Whether any party is likely to suffer from the misrepresentation. ANS: (a) The treatment would have the effect of understating expenses and as a result overstating profits; and overstating assets and equity. (b) Possible reasons: • from the perspective of the economic consequences literature (chapter 1), the policy may be linked to: (i) management’s compensation plans vis-a-vis remuneration tied to performance bonuses and/or share prices; (ii) debt contracts vis-a-vis restrictive debt covenants associated with the debt to equity (assets) ratio and EBIT ratio. • Management’s desire to misrepresent profits in order to meet market expectations, possibly driven by forecast growth targets. (c) Parties likely to suffer from the misrepresentation would include those who have used the associated information for the purposes of making decisions associated with the allocation of scarce resources e.g., shareholders and analysts (decisions to hold or sell shares); lenders; employees; and suppliers. Ultimately, senior executives, directors and auditors vis-a-vis reputation and potential financial losses from civil proceedings. PTS: 1 AACSB: TOP: Chapter 5/Chapter 1

Ethics, Communication, Analytical

ESSAY 1. The balance sheet includes information on the resources, financial structure, solvency and adaptability of a reporting entity. Discuss. ANS: Issues for discussion Balance sheet: a general purpose financial statement designed to provide information on the following: • Resources (assets) under the control of the entity at the reporting date. The statement would include the measurement and classification of assets – by nature and grouping vis-a-vis solvency. • Financial structure identifies the basis for funding the resources – the mix of debt and equity. • Solvency: the capacity of the entity to met its financial commitments in the short and long-term. • Reporting entity: an entity where there exists users who in their own right do not have the authority to access financial information to meet their information needs and as such they are dependent users e.g., shareholders, customers, suppliers and employees. PTS: 1 AACSB: Knowledge, Communication TOP: Definition and purpose of the balance sheet

Chapter 6 – Presentation of financial performance and the worksheet TRUE/FALSE 1. The statement of comprehensive income shows the results of operations over a period of time, and the balance sheet shows the financial condition of a business at a specific date. ANS: T PTS: 1 AACSB: TOP: Financial performance measurement

Knowledge, Analytical

2. The statement of comprehensive income reports revenues and expenses for the period but does not report income. ANS: F PTS: 1 AACSB: TOP: Financial performance measurement

Knowledge, Analytical

3. The statement of comprehensive income reflects the financial position of the business for the accounting period. ANS: F PTS: 1 AACSB: TOP: Financial performance measurement

Knowledge, Analytical

4. Income has the effect of increasing assets and increasing owners’ equity. ANS: T TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

5. An expense is a decrease in assets or an increase in liabilities, and will result in a decrease in owners’ equity. ANS: T TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

6. An essential characteristic of an expense is a decrease in economic benefits. ANS: T TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

7. Unexpired costs are found on the statement of comprehensive income. ANS: F TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

8. Capitalising a cost for the period instead of recording it as an expense of the period will understate profit for the period. ANS: F TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

9. Profitability means having enough funds on hand to pay debts as they fall due. ANS: F TOP: Chapter 6

PTS: 1

AACSB:

Knowledge, Analytical

10. The net profit figure is often referred to as the ‘bottom line’ and is the residual of income after deducting expenses for the period. ANS: T PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

11. Where the expenses of an entity exceed income for a period, a loss results. ANS: T PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

12. Drawings by owners are an expense. ANS: F TOP: Expenses

PTS: 1

13. Gross profit is the sales revenue received, less the cost of the goods sold from ordinary operating activities. ANS: T PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

14. The statement of changes in equity includes transactions with owners. ANS: T PTS: 1 AACSB: TOP: The statement of changes in equity

Knowledge, Analytical

15. Earnings management enhances the decision usefulness of financial reporting. ANS: F PTS: 1 TOP: Earnings management

AACSB:

Knowledge, Analytical

16. Revenue is recognised under the historical cost accounting model when it has substantially been earned and the entity has the cash or a substantial claim to cash. ANS: T TOP: income

PTS: 1

AACSB:

Knowledge, Analytical

17. The essential difference between an asset and an expense revolves around whether the economic benefits involved lie in the future or the past. ANS: T TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. The statement of comprehensive income shows financial information: A. at a point in time. B. over a period of time. C. at the time of the originating transaction. D. at the time of sale of an item.

ANS: B PTS: 1 AACSB: TOP: statement of comprehensive income

Knowledge, Analytical

2. The balance sheet shows the position of the entity: A. at a point in time. B. when it is insolvent only. C. when it is making profits. D. for a specified period of time. ANS: A TOP: Chapter 5

PTS: 1

AACSB:

Knowledge, Analytical

3. What information does a statement of comprehensive income not show? A. Net Profit B. Revenues C. Liabilities D. Tax Expense ANS: C PTS: 1 AACSB: TOP: Statement of comprehensive income

Knowledge, Analytical

4. Which one of the following statements is true? A. The statement of comprehensive income shows the financial position of an entity as of a specific date. B. The statement of comprehensive income shows the financial position of an entity for a specific period of time. C. The balance sheet shows the financial position of an entity at a specific date. D. The balance sheet shows the financial position of an entity for a specific period of time. ANS: C PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

5. A single statement of comprehensive income reports which of the following? A. Assets and liabilities. B. Cash inflows and cash outflows. C. Income and expenses. D. Retained earnings and dividends. ANS: C PTS: 1 AACSB: TOP: Statement of comprehensive income

Knowledge, Analytical

6. A single statement of comprehensive income: A. measures comprehensive income. B. reports net profit or loss for the period. C. is used by external decision makers. D. does all of the above. ANS: D PTS: 1 AACSB: TOP: Statement of comprehensive income 7. Income and expenses are reported on a(n): A. statement of comprehensive income. B. balance sheet. C. liability statement. D. asset statement.

Knowledge, Analytical

ANS: A PTS: 1 AACSB: TOP: Statement of comprehensive income

Knowledge, Analytical

8. Which of the following accounts would not be affected by a credit sale? A. Inventory B. Cost of Goods Sold C. Cash D. Sales Revenue ANS: C TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

9. Revenue has the effect of: A. increasing assets and decreasing liabilities. B. increasing assets and owner’s equity. C. increasing assets and decreasing owner’s equity. D. leaving the entire balance sheet unchanged. ANS: B TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

10. Revenues indicate: A. the sales price of goods and services sold during a period. B. how much cash was received from sales during a period. C. the cost of resources consumed in producing and selling goods and services sold during a period. D. the net profit earned during a period. ANS: A TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

11. Jeremy received $50 as a gift and $120 from his a job as a waiter. He then spent $15 on a silver ring. What is Jeremy’s revenue? A. $50 B. $120 C. $170 D. $155 ANS: B TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

12. Jeremy received $50 as a gift and $120 from his a job as a waiter. He then spent $15 on a silver ring. What is Jeremy’s income? A. $50 B. $120 C. $170 D. $155 ANS: C TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

13. During the first month of operations, Kelly’s Tax Service provided services and billed customers in the amount of $6000. By the end of the first month, $3600 had been collected and it was expected that the other $2400 would be collected during the following month. On Kelly’s statement of comprehensive income for the first month, what amount of revenue should be reported? A. $0 B. $2400 C. $3600 D. $6000 ANS: D TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

14. Which of the following transactions for July represents revenue for the month? A. Collected $1000 in advance for architectural services to be provided in August. B. Completed architectural services for $30,000, payable in seven days. C. Borrowed $60,000 from the bank, repayable over two years. D. Collected cash of $5000 from an account receivable outstanding since February. ANS: B TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

15. Which of the following is an essential characteristic of an expense? A. Decreases in future economic benefits. B. Contribution to owners. C. Increases in assets or reduction in liabilities. D. Increase in future economic benefits. ANS: A TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

16. Which of the following can Tim not recognise as an expense assuming all relate to his business? A. Payment of interest on a loan of $100. B. A suspicion that John will not return the $26 that he borrowed from Tim. C. Payment of electricity for the month of $50. D. Use of water to which Tim will be invoiced in two months. ANS: B TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

17. Which of the following would not result in the recording of an expense? A. Receipt of a bill from the telephone company. B. Recording of wages paid to managers. C. Drawings by the owner for personal expenses. D. Receipt of a bill for electricity used. ANS: C TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

18. Leslie started a computer software firm by investing $16,000 of her own money. She spent three-quarters of it on furniture, fixtures and operating supplies for the business. After borrowing $12,000 from First National Bank, she spent one-third of the funds on computer hardware. At that point in time what balances should be recorded in her accounting system for total assets and total expenses?

Total Assets A. $28,000 B. $12,000 C. $16,000 D. $28,000

Total Expenses $16,000 $16,000 $0 $0

ANS: D PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

19. Which of the following transactions is not an expense? A. Replacing an asbestos roof with a new tiled roof. B. Replacing tyres of a motor vehicle. C. Regular maintenance of equipment. D. The installation of new light globes. ANS: A TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

20. Which of the following pairs of items would normally be classified as expenses? A. Ordinary dividends and salaries paid. B. Salaries paid and interest paid on loans. C. Discount received and interest paid on loans. D. Amortisation of goodwill and loan payable. ANS: B TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

21. Which of the following transactions for July represents an expense for the month? A. Paid $15,000 in advance as first payment for a new computing system. B. Purchased inventory on account for resale in August. C. Paid cash of $2000 to the bank for July interest on loan. D. Borrowed $80,000 from the bank, repayable over four years. ANS: C TOP:

PTS: 1 Expenses

AACSB:

Knowledge, Analytical

22. Charging an interest cost as an expense when it should be capitalised as an asset will result in: A. an overstatement of total assets. B. the understatement of net profit for the next period. C. an overstatement of interest expense for the next period. D. the understatement of net profit for the current period. ANS: D TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

23. Which of the following statements relating to expenses is not true? A. Expenses result in an increase in owner’s equity. B. Expenses may arise through immediate cash payments or through promises to pay cash in the future for services received. C. Expenses result from costs incurred normally to earn revenue. D. Cash may be paid out before expenses are incurred. ANS: A TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

24. If the accounting period were the year ending 31 December 20X6, which of the following costs would not be reported as an expense for that period? A. Wages paid on 1 January 20X7 for the previous fortnight. B. Goods for resale bought and not sold on 31 December 20X6. C. Electricity bill paid on 2 January 20X7 for the previous quarter. D. Creditor paid on 3 January 20X7 for advertising in December 20X6. ANS: B TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

25. Ian bought some goods in May 20X6 for $600 and sold them in August 20X6 for $950. For the financial year ending on 30 June 20X6, which of the following statements is correct? A. Ian has expenses amounting to $600. B. Ian has revenues amounting to $950. C. Ian has a profit of $350. D. Ian has assets of $600. ANS: D PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

26. Using the equation Income – Expenses = Profit, what could cause an increase in profit? A. An increase in income. B. An increase in income and decreases in expenses. C. A decrease in expenses. D. Any of the above. ANS: D TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

27. During May, the Friendly Resort had income of $10,000 and expenses of $4000. The owner withdrew $800 cash from the business during the month. If Owners’ Equity on 31 May was $18,000, Owners’ Equity on 1 May must have been: A. $23,200 B. $12,000 C. $12,800 D. $24,000 ANS: C TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

28. Cisco Company has the following account balances in its accounting system at year end: Advertising Revenue Salaries & Wages Expense Rent Expense Machinery Insurance Expense Interest Income Interest Expense

$120 68 24 40 14 8 10

The net profit (or loss) for the period is: A. $52 B. $(28) C. $12 D. $4

ANS: C PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

29. The Stealth Company reports the following information for 20X6: Assets Liabilities

1 January 20X6 $60,000 $12,000

31 December 20X6 $70,000 $14,000

Assume that owners invested $3000 during 20X6 and that withdrawals were $12,000. Net profit for 20X6 must have been: A. $12,000 B. $14,000 C. $16,000 D. $17,000 ANS: D PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

30. You are inspecting the statement of comprehensive income of a company. It reports a profit of $75,800. From this information, you can conclude that: A. the owners have a rather small investment in the firm. B. the company is a merchandising firm. C. there have been financing and investing activities during the period but no operating activities. D. the value of resources received from sales exceeds the value of resources consumed. ANS: D PTS: 1 AACSB: TOP: The statement of comprehensive income

Knowledge, Analytical

31. Determine the profit earned by a business owner who recorded the following transactions during May: 1. 2. 3.

Sold $5000 of merchandise that had cost the company $3500. Paid $200 cash for rent for the months of May and June. Used $100 of supplies during May.

A. $1500 B. $1300 C. $1200 D. $5000 ANS: B PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

32. What effect do revenues and expenses eventually have on Owners’ Investment? Revenues A. Decrease B. Decrease C. Increase D. Increase ANS: D PTS: 1 TOP: Income and expenses

Expenses Decrease Increase Increase Decrease AACSB:

Knowledge, Analytical

33. The Flying High Company recorded a net profit for the 20X6 year but paid no dividends. Comparing the balance sheet at the end of 20X6 with the one at the beginning of 20X6, which of the following must be true? A. Current assets would be higher. B. Non-current assets would be higher. C. Liabilities would be higher. D. Shareholders’ equity would be higher. ANS: D PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

34. Net profit is: A. the excess of income over expenses that a business records during a period. B. the excess of expenses over revenues that a business records during a period. C. the amount of revenue that a business reports during a period. D. the amount of resources created by a business during a period. ANS: A PTS: 1 TOP: The income statement

AACSB:

Knowledge, Analytical

35. At the end of an accounting period, the amount of net profit earned by a company is transferred to the balance sheet and reported under which one of the following categories? A. Assets B. Liabilities C. Shareholders’ equity D. The amount of net profit is not transferred to the balance sheet. ANS: C PTS: 1 AACSB: TOP: The statement of comprehensive income

Knowledge, Analytical

36. In relation to income, revenue and expenses, which of the following statements is incorrect? A. Revenue is the inflows from ordinary activities while income is revenue plus all gains. B. The difference between revenue and cost of goods sold is referred to as gross profit (loss). C. Income and expenses do not impact the equation Assets = Liabilities + Owners’ Equity. D. Income increases equity while expenses decrease it. ANS: C PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

37. Merchandise inventory costing $10,000 was sold to customers on credit for $15,000. What amount of revenue and cash flow resulted from the sale of the inventory? Revenue A. $5000 B. $10,000 C. $15,000 D. $5000 ANS: C TOP: Income

Cash Flow $15,000 $10,000 $0 $0 PTS: 1

AACSB:

Knowledge, Analytical

38. At year end, Elliott counted the office supplies on hand, which amounted to $1500. The firm had $900 of supplies on hand at the start of the year, and had purchased $6000 of supplies during the year. What was the total office supplies expense for the year?

A. $6900 B. $3600 C. $5400 D. $4500 ANS: C TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

39. The Boaters News magazine sold five-year subscriptions during 20X6 totalling $75,000. Assume that all subscriptions were effective from 1 January 20X6 and that the calendar year is the accounting period. At 31 December 20X6, in addition to the cash which of the following should be reported on Boaters News’ financial statements? A. Revenue of $75,000 and an asset of $75,000. B. Revenue of $15,000 and equity of $60,000. C. Revenue of $15,000 and liabilities of $60,000. D. Revenue of $15,000 and an asset of $60,000. ANS: C PTS: 1 TOP: Chapters 5 and 6

AACSB:

Knowledge, Analytical

40. Physicians, Inc. subscribes to three magazines and pays $140, $90 and $76 respectively, on 1 July 20X6. The subscriptions are for one year and are recorded in Prepaid Subscriptions when paid. At 31 December 20X6, what amount is recorded for ‘magazine expense’ and what is the balance of the Prepaid Subscription account? Magazine Expense A. $153 B. $306 C. $25.50 D. $25.50 ANS: A PTS: 1 TOP: Chapters 5 and 6

Prepaid Subscriptions $153 $306 $153 $306 AACSB:

Knowledge, Analytical

41. Chamber’s Tube & Rim Company reported Retained Profits of $20,000 at year end 20X6. The accompanying statement of comprehensive income reported $10,000 in income for 20X6 and $20,000 in expenses. The beginning 20X6 balance of Retained Profits must have been: A. $50,000. B. $40,000. C. $30,000. D. $20,000. ANS: C PTS: 1 AACSB: TOP: Statement of comprehensive income

Knowledge, Analytical

42. A cost ought to be recognised as an asset when: A. it is probable that it will provide future economic benefits. B. it may provide future economic benefits. C. it involves drawings by the owner. D. the cash has been paid. ANS: A TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

43. On 1 January, Erin, a manufacturer of fine furniture, entered into an agreement with a customer to make a chair that was to be made to meet the unique specifications of the customer. The customer paid a $20 deposit on the chair at that date. Erin finished making the chair on 31 January. The customer took delivery on that day, and agreed to pay Erin the outstanding balance of $3860 in two instalments on 28 February and 31 March. When would Erin normally recognise the revenue as having been earned, from a historical cost accounting perspective? A. 1 January B. 31 January C. 28 February D. 31 March ANS: B TOP: Income

PTS: 1

AACSB:

Knowledge, Analytical

44. A statement of changes in equity reports on: A. all owner changes in equity that took place during a financial reporting period. B. only contributions from owners. C. only distributions to owners. D. net profit and only contributions from owners. ANS: A PTS: 1 TOP: Statement of changes in equity

AACSB:

Knowledge, Analytical

45. Which of the following items do not appear in the statement of changes in equity? A. Dividends paid to shareholders. B. Total comprehensive income. C. Fair value changes of cash flow hedges. D. Shares issued during the period. ANS: C PTS: 1 TOP: Statement of changes in equity

AACSB:

Knowledge, Analytical

46. Company XYZ recorded net profit of $150m for the period. In addition it recognised the following changes in fair values for the period: Available-for-sale securities +$10m Cash flow hedges - $5m Land +$85m What would be the amount of total comprehensive income for the period? A. $90m B. $95m C. $150m D. $240m ANS: D PTS: 1 AACSB: TOP: Statement of comprehensive income

Knowledge, Analytical

47. A company sells inventory on credit for $10,000 which originally cost $4000. Which of the following would not be a result of recording this transaction in the worksheet? A. An increase in total assets and revenue. B. An increase in total assets, revenue and expenses. C. An increase in revenue and expenses, but no effect on total assets. D. An increase in profit.

ANS: C TOP: Chapter 6

PTS: 1

AACSB:

Knowledge, Analytical

48. The ‘Get Out There’ Tour Company had equity of $60,000 at the beginning of the year. After a successful tourist season, dividends of $50,000 were paid and equity at the end of the year was $185,000. The profit for the year was: A. $125,000 B. $175,000 C. $185,000 D. $235,000 ANS: B PTS: 1 TOP: Income statement

AACSB:

Knowledge, Analytical

49. A drawing by an owner has the effect of: A. increasing assets and decreasing owner’s equity. B. decreasing assets and owner’s equity. C. decreasing assets and increasing owner’s equity. D. leaving the entire balance sheet unchanged. ANS: B TOP: Expenses

PTS: 1

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Distinguish between the concepts income and revenue. Support your answer by using an example to demonstrate the difference. ANS: Income involves increases in economic benefits during the accounting period from inflows or enhancements or savings in outflows that result in an increase in OE, other than contributions from owners. Revenue, on the other hand, is a subset of income and refers to inflows derived from an entity’s core business e.g., in the case of a motor vehicle dealer, revenue generated from the sale of motor vehicles. Assuming the motor dealer’s core business does not include trading in marketable securities, then any gains (enhancements and/or inflows) made by the entity on such investments would fall within the definition of income, but not revenue. PTS: 1 TOP: Income

AACSB:

Knowledge, Analytical, Communication

2. Distinguish between the concepts expense and asset. Support your answer by using an example to demonstrate the difference. ANS: Assets represent future economic benefits (over which the entity has control, arising out of a past event). Expenses, on the other hand, represent the loss or consumption of (decrease in) benefits. An example: an entity expends $50,000 today on (i) plant and equipment that will be deployed in carrying out the entity’s operations in the future; (ii) salaries and wages earned by employees in the preceding fortnight. With respect to item (i) the $50,000 represents an investment in future benefits; with respect to item (ii) the benefits of the expenditure have already been consumed. Expenses may also arise from an increase in liabilities.

PTS: 1 TOP: Expenses

AACSB:

Knowledge, Analytical, Communication

3. Describe the nature and impact of factors that may play a role in influencing the format and content of the income statement/statement of comprehensive income? ANS: The type of activities in which an entity engages e.g., provision of goods or services. The provision of goods as opposed to services, for example, gives rise to cost of goods sold as a significant category of expense, and the notion of gross profit. The authority of the user to have his/her particular need for financial information met. An income statement prepared for management may be more detailed than that prepared for external users such as shareholders, and employees. The objective of the user. For example, in Australia, the measurement rules employed may differ according to whether the statement is being prepared for the taxation department for the purposes of measuring income taxation as opposed to a prospective major lender. The type of business. For example, where an entity meets the definition of a ‘reporting entity’, regulation also has an important role to play in determining the format and content of general purpose reports. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Factors affecting the format of the income statement PROBLEM 1. The core business of Greenmango Ltd involves the sale of anti-virus software. The following took place during the financial year ended 30 June 20X0. The company earned $25,000,000 from the sale of software; $3,000,000 from update downloads; and $50,000 in interest from investing on the short-term money market. The company also received a $2000 discount arising out of the early settlement of a liability; and issued shares in exchange for $500,000 cash during the year. (a) Discuss whether the foregoing five financial items would meet the definition of income to the company during the year? Give reasons for your answer. (b) Which, if any, of the items would meet the definition of revenue to the company for the year? Give reasons for your answer. ANS: (a) Income involves increases in economic benefits during the accounting period from inflows (earnings from the sale of the software and downloads, and interest) or enhancements or savings in outflows (the discount) that result in an increase in OE, other than contributions from owners (the proceeds from the sale of the shares). All but the $500,000 contributions from the owners in the foregoing examples fall within the definition of income. (b) Revenue, a subset of income, derives from inflows from an entity’s core business, and would include the inflows from the sale of software ($25,000,000) and the downloads ($3,000,000). While the $50,000 interest represents an inflow, assuming that investing on the short-term money market is not part of the entity’s core business, then the inflow is income (a gain) but not revenue. PTS: 1

AACSB:

Knowledge, Analytical

TOP: Income

2. Greenmango Ltd incurred expenditure on the following items during the year ended 30 June 20X0: (i) dividends to shareholders. (ii) salaries and wages earned by employees. (iii) the acquisition of plant and equipment for use in the business. (iv) the maintenance of plant and equipment. (v) advertising. (vi) registration and insurance of the company’s fleet of motor vehicles. Would the expenditure on the foregoing items meet the definition of (i) expenses, (ii) assets, or (iii) none of the above? Give reasons for your answers. ANS: Dividends to shareholders (item (i)) are a distribution of profit, not an expense. The expenditure has the same effect on the accounting equation as an expense – asset and shareholders’ equity decreasing – but is not of the nature of an expense. Items (ii) and (iv) represent past consumption of benefits at the point of expenditure. Advertising (item (v)) is incurred to promote future sales, and, therefore, generate future benefits. However, the expenditure is typically expensed, which reflects conservatism, and the difficulty of identifying the future economic benefits or indeed if there will be any. Item (iii) involves future benefits – assets; and, similarly, item (vi), at the point of expenditure. PTS: 1

AACSB:

Knowledge, Analytical

TOP: Expenses

3. The following balances were taken from the accounting records of Singapore Enterprises Ltd as at 30 June 20X1. Cash Accounts receivable Supplies inventory Plant & equipment Accounts payable Capital 1 July 20X0 Drawings Fees revenue Supplies expense Selling expenses Borrowing expenses General & administrative expenses Income tax expense

$6000 11,000 4500 71,000 2000 49,250 6000 189,000 98,000 8000 1750 12,000 22,000

(a) Prepare a statement of comprehensive income for the business for the year ended 30 June 20X1. (b) Prepare a classified balance sheet for the business as at 30 June 20X1. ANS: (a) Singapore Enterprises Ltd Statement of comprehensive income for the year ended 30 June 20X1. Fees revenue Supplies expense

$189,000 98,000

Selling expenses Borrowing expenses General & administrative expenses Total expenses Net profit before tax Income tax expense Net Profit after tax Other comprehensive income Total comprehensive income

8000 1750 12,000 119 750 69,250 22,000 47,250 0 47,250

(b) Singapore Enterprises Ltd Balance Sheet as at 30 June 20X1 Current assets Cash Accounts receivable Inventory Total current assets

$6000 11,000 4500

Non-current assets Plant & equipment Total non-current assets

71,000

21,500

71,000

Total assets

92,500

Current liabilities Accounts Payable Total current liabilities Total liabilities

2000 2000 2000

Net assets

90,500

Owners equity Capital Total comp income

49,250 47,250 96,500 6000

Less Drawings Total equity

90,500

REF Chapters 4 and 5 PTS: 1

AACSB:

Knowledge, Analytical

TOP: Chapters 5 and 6

4. Colombo commenced business as a sole proprietor providing computer repair services on 1 June 200X. Colombo contributed land and buildings at $120,000, equipment at $19,000 and cash of $13,000. Transactions during June were as follows:

June

Leased vehicle for use in the business and paid 6 months lease $4200. Purchased supplies of parts for use in the repair of computers for $1500 cash. Completed computer repairs $1000 cash. Completed computer repairs for customer for $600 cash. Paid advertising expenses $400. Revenue of $1900 cash earned Colombo withdrew $200 cash and $100 of the computer parts supplies for personal use. Paid wages to assistant $500. Cash revenue earned $350. Petrol expenses paid $85. Computer supplies used during the month $850.

4 6 8 11 17 19 21 23 30

(a) Complete a worksheet for the month of June, including any final adjustments. Record all property, plant and equipment in a single column of that name. (b) Prepare the statement of comprehensive income for June and the balance sheet at 30 June 200X. ANS: (a) Trans June 1 4 6 8 11 17 19 21 23 30

Cash 13,000

Assets P, P & E prepayments 139,000

- 4200 - 1500 1000 600 -400 1900 -200 -500 350 -85

Liabilities supplies

Owner’s equity capital P&L 152,000

4200 1500 1000 600 -400 1900 -100

-300

-850 9965

139,000

-700 3500

550

(b) Colombo Statement of comprehensive income for June 200X Repair fees Expenses Advertising Wages Supplies Petrol

3850 400 500 850 85

151,700

-500 350 -85 -850 -700 1315

Lease - vehicle

700

Net Profit

2535 1315

Other comprehensive income Total comprehensive income

0 1315

Colombo Balance sheet as at 30 June 200X Current assets Cash Supplies Prepayments Total current assets Non-current assets Property, plant & equipment Total non-current assets Total assets Total liabilities Net assets Owner’s equity Contributed equity Drawings Net profit Total owner’s equity

PTS: 1

9965 550 3500 14,015 139,000 139,000 153,015 0 153,015 152,000 -300 1315 153,015

AACSB:

Knowledge, Analytical

TOP: Chapters 5 and 6

Chapter 7 – Debtors, creditors, accruals and prepayments TRUE/FALSE 1. A debtor arises when a business sells goods or services to a third party on credit terms. ANS: T TOP: Debtors

PTS: 1

AACSB:

Knowledge, Analytical

2. The absence of bad debts is an indicator that the credit policy may be too strict, and can result in the loss of profits. ANS: T PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

3. A prepayment is an asset when it has future economic benefits that are controlled by the business. ANS: T PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

4. A prepayment is recorded on the balance sheet as a current asset, but the proportion of the payment that relates to benefits unexpired at the end of the period is recorded as an expense. ANS: F PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

5. The future benefit of a prepayment will be in a form other than cash. ANS: T PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

6. Payments in advance are commonly called prepayments. ANS: T PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

7. When a prepayment is made and it is known that the future benefit will expire in the same period, then the worksheet must always record the transaction as an asset first and then make an adjusting entry at the end of the period to record an expense. ANS: F PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

8. A credit sale of a business where the revenue is not collected due to the debtor not paying is a bad debt. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

9. The direct write-off method can mean that assets may be overstated in one year and understated the next.

ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

10. A contra debtor’s account is the allowance for doubtful debts, which shows the estimated total of future bad debts. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

11. Allowance for Doubtful Debts is a contra account to debtors. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

12. Bad debts have the effect of reducing assets and reducing profits, which results in a reduction of equity. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

13. Management prepares and examines an aged debtor list, which analyses each debt in order to reach a decision on the probability of receipt of payment. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

14. The direct write-off method for accounting for bad debts is preferred over the allowance for doubtful debts method, as the latter creates a negative or contra asset which is not considered a ‘real’ account under accrual accounting. ANS: F TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

15. Under the allowance for doubtful debts method, the net amount of assets will not change when recording a transaction that determines that a specific debtor will not pay. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

16. The failure to allow for uncollectable accounts will cause the owners’ equity to be overstated. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

17. Trade credit is the finance provided by suppliers from selling goods on credit. ANS: T PTS: 1 TOP: Management of creditors

AACSB:

Knowledge, Analytical

18. If an accrual for interest has been recorded in the previous period and the payment is made in the current period, then an adjustment decreasing liabilities (accruals) will need to be made in the current period. ANS: T TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

19. Debtors and prepayments are classified as current assets at the reporting date because they will be realised or consumed within the next operating cycle. ANS: T TOP: Chapter 7

PTS: 1

AACSB:

Knowledge, Analytical

20. The key to the effective management of debtors relies on maximising the benefits from selling goods on credit, not minimising the losses from bad debts. ANS: F PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

21. Working capital is the residual of current assets after deducting current liabilities. ANS: T PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

22. Accounting for bad debts under the direct write-off method involves a reduction of debtors and a reduction in owners’ equity. ANS: T TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

23. The key difference between creditors and accruals as two separate types of liabilities centres on whether the amounts involved are certain or otherwise. ANS: T TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following bases of accounting measurement recognises revenues when resources are created as part of an organisation’s operating activities? A. Cash B. Financing C. Investing D. Accrual ANS: D TOP: Chapter 7

PTS: 1

AACSB:

Knowledge, Analytical

2. Under accrual-basis accounting, sales made on credit are usually reported as: A. liabilities. B. revenue. C. cash from operating activities. D. a contra account to sales revenue. ANS: B TOP: Chapter 7

PTS: 1

AACSB:

Knowledge, Analytical

3. Which of the following statements is incorrect? A. A debtor arises when a business sells goods or services to a third party on credit terms. B. The absence of bad debts is an indicator that the credit policy may be too strict and can

result in the loss of profits. C. The higher the number of debtors and amount of inventories, the lower the working capital requirements. D. The failure to allow for uncollectable accounts will cause the owners’ equity to be overstated. ANS: C PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

4. An item that is a cash payment in the current period and an expense of the next period is: A. a prepayment. B. not adjusted. C. an accrued expense. D. part expense, part accrued expense. ANS: A PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

5. A prepayment is an asset when: A. there is no further future economic benefit accruing to the business. B. there may be some future economic benefit accruing to the business. C. it has future economic benefits that are controlled by the business. D. it has future economic benefits for the owner’s private residence. ANS: C PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

6. A prepayment is recorded on the: A. balance sheet as an asset. B. statement of comprehensive income as revenue. C. balance sheet as a liability. D. statement of comprehensive income as an expense. ANS: A PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

7. A prepayment consumed during a period is: A. an item that is an expense of a given period but not necessarily a cash payment for that period. B. an item that may be a cash payment for that period and also an expense for that period. C. an item that that may be expensed in the current period. D. any of the above. ANS: D PTS: 1 TOP: Prepayments

AACSB:

Knowledge, Analytical

8. When goods are sold at a profit on credit, the effect of the sale on the accounting equation is: A. an increase in liabilities and an increase in assets. B. an increase in expenses and a decrease in equity. C. a decrease in equity and an increase in liabilities. D. an increase in assets and an increase in equity. ANS: D PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

9. A credit sale results in increases in which of the following pairs of items on the financial statements? Statement of comprehensive income A. Sales Revenue B. Accounts Receivable C. Sales Revenue D. Accounts Receivable ANS: C PTS: 1 TOP: Management of debtors

Balance Sheet Cash Cash Accounts Receivable Sales Revenue AACSB:

Knowledge, Analytical

10. Which of the following transactions would cause a decrease in the Accounts Receivable account? A. A credit sale B. A collection of cash from a previous credit sale C. A cash sale D. A credit purchase ANS: B PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

11. The collection of an account receivable will: A. increase total assets and increase total owners’ equity. B. not affect total assets and increase total owners’ equity. C. decrease total assets and decrease total liabilities. D. not affect total assets liabilities and owners’ equity. ANS: D PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

12. Owens Office Supplies collected $300 that had previously been recorded in Accounts Receivable. Recording this event in the accounting system caused: A. assets to increase. B. assets to decrease. C. total assets to remain the same. D. revenues to increase. ANS: C PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

13. Which of the following methods of handling bad debts often potentially leads to an overstatement of assets? A. Percentage of credit sales method B. Aging of debtors’ method C. Direct write-off method D. Allowance for doubtful debts ANS: C TOP: Bad debts

PTS: 1

14. Allowance for Doubtful Debts is: A. a liability account. B. an expense account. C. a contra liability account. D. a contra asset account.

AACSB:

Knowledge, Analytical

ANS: D TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

15. Failure to record bad debt expense at year end will result in an: A. overstatement of assets. B. understatement of net profit. C. overstatement of expenses. D. understatement of liabilities. ANS: A TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

16. An increase in the Allowance for Doubtful Debts will: A. reduce the cash account. B. reduce total assets. C. increase total liabilities. D. increase shareholders’ equity. ANS: B TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

17. The Allowance for Doubtful Debts is classified on the: A. statement of comprehensive income as an expense. B. statement of comprehensive income as revenue. C. balance sheet as a liability. D. balance sheet as a deduction to an asset. ANS: D TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

18. On 15 July 20X8 Sammy Corporation’s Gross Accounts Receivable had a balance of $2300 and the Allowance for Doubtful Debts had a balance of ($220). A specific account of $80 was written off on 16 July 20X8. If no other relevant transactions had taken place, what is the amount of net receivables after the write-off? A. $1920 B. $2160 C. $2080 D. $2220 ANS: C TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

19. The balance of an allowance for doubtful debts was ($10,000) at the start of a year and ($16,000) at the end of that year. During the year, accounts totalling $9000 were written off as bad debts. What was the bad debts expense for the year? A. $7000 B. $9000 C. $10,000 D. $15,000 ANS: D TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

20. XYZ Company had an Accounts Receivable account balance of $300,000 and Allowance for Doubtful Debts account balance of $12,500 prior to writing off a bad debt of $3000. The estimated net realisable value of Accounts Receivable before and after the write-off were, respectively: A. $12,500 and $309,500. B. $287,500 and $284,500. C. $287,500 and $287,500. D. $300,000 and $297,000. ANS: C TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

21. The bookkeeper at Kupertino Company is recording information into the accounting system to recognise the estimated amount of bad debt expense for the fiscal period. This entry into the accounting system will affect which of the account balances below? Allowance for Doubtful Debts A. Yes B. Yes C. No D. No ANS: A TOP: Bad debts

PTS: 1

Bad Debts Expense Yes No Yes No AACSB:

Knowledge, Analytical

22. Firms should ideally recognise the expense related to uncollectable accounts: A. during the period of sale. B. when accounts are written off. C. when customers declare bankruptcy. D. never; there is no expense related to uncollectable accounts. ANS: A TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

23. Creditors are: A. amounts owing at a point in time, the amounts of which have been paid. B. amounts owing at a point in time, the amounts of which are known. C. amounts owing at a point in time, the amounts of which are not known. D. none of the above. ANS: B TOP: Creditors

PTS: 1

AACSB:

Knowledge, Analytical

24. Accrued expenses result when: A. goods are purchased on credit. B. expenses are recognised after cash is paid. C. expenses are recognised before cash is paid. D. the bookkeeper has made an error. ANS: C TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

25. What is the net effect on the balance sheet if J Trees purchases inventory of raw materials on credit terms? A. No effect. B. An increase in liabilities and equity. C. An increase in assets and liabilities. D. An increase in assets and equity. ANS: C TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

26. If a careless bookkeeper fails to accrue wages payable at the end of the accounting period, which of the following will be true of the financial statements? A. Net profit will be understated. B. Retained profits will be overstated. C. Liabilities will be overstated. D. Assets will be overstated. ANS: B TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

27. When wages are accrued in the current month, what is the transaction in the period in which the wages are paid? A. Increase Wages Expense and decrease Cash at Bank. B. Increase Wages Expense and increase Wages Payable. C. Decrease Wages Payable and decrease Wages Expense. D. Decrease Wages Payable and decrease Cash at Bank. ANS: D TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

28. If an adjustment to record the accrual of interest is omitted from the accounting system, which of the following effects will not occur? A. Total expenses will be understated. B. Net profit will be overstated. C. Liabilities will be understated. D. Cash will be overstated. ANS: D TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

29. If an end-of-period adjusting entry is made to accrue wages, it means that: A. the company pays its employees monthly. B. employees have earned wages since the end of the last payroll period, but have not been paid. C. the account Wages Payable will be decreased. D. the company has already distributed payroll cheques. ANS: B TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

30. Hilde Company reported Accounts Receivable of $40,000 at the beginning of 20X8. It reported a balance of $28,000 at the end of 20X8. From this information, assuming there were no accounts written off as bad debts during the year, it is possible to determine that during 20X8: A. credit sales were higher than cash collected from customers. B. credit sales were less than cash collected from customers.

C. the firm was doing a poor job of collecting its receivables. D. credit sales decreased from the previous year. ANS: B PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

31. The Philamono Bean Company reported the following Accounts Receivable balances for 20X8: Beginning of the year $84,000 End of the year 90,000 Given that there were no bad debts written off during the year, this information means that: A. credit sales exceeded cash collections from customers during the year. B. cash collections from customers exceeded credit sales during the year. C. the firm did an excellent job of collecting its receivables. D. credit sales increased during the current year over the previous year. ANS: A PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

32. What are the two methods of accounting for bad debts? A. Receivable reduction and bad debt methods. B. Direct write-off and allowance methods. C. Allowance and bad debt methods. D. Direct write-off and receivable reduction methods. ANS: B TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

33. Assuming that the allowance for doubtful debts method of accounting for bad debts is used, when a customer’s account is determined to be a bad debt, which of the following will occur? A. Bad Debts expense is increased, Allowance for Doubtful Debts is decreased B. Allowance for Doubtful Debts is reduced, Accounts Receivable is reduced C. Allowance for Doubtful Debts is reduced, Bad Debts expense is reduced D. Allowance for Doubtful Debts is reduced, Accounts Payable is increased ANS: B TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

34. Working capital represents: A. the excess of current assets over current liabilities. B. the amount of long-term liabilities. C. the excess of assets over liabilities. D. the use of accounts payable as trade credit. ANS: A PTS: 1 TOP: Management of debtors

AACSB:

Knowledge, Analytical

35. The net figure for debtors after deducting the allowance for doubtful debts account: A. represents the expected cash to be collected. B. is a contra account. C. understates the realisable value of debtors. D. overstates the realisable value of debtors. ANS: A TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

36. George, a sole trader, sells goods on credit, and uses the direct write-off method for recording bad debts. The balance for debtors at the end of the financial year ended 31 December 20X8 was $12,000. There was $1000 of bad debts that were written off in the year ended 20X9. From an accrual perspective, in the year ended 20X8 which of the following is incorrect? A. Profit and equity were overstated. B. Profit and assets were overstated. C. Debtors and assets were overstated. D. Profit and liabilities were overstated. ANS: D TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

37. The balance of the accounts receivable balance of XYZ Pty Ltd was $23,000 at the beginning of the financial year ended 30 June 20X7 and $27,000 at the end of the period. The total credit sales for the company for the financial year was $132,000. Bad debts write-off totalled $5500. What was the total of the cash received from accounts receivable during the year? A. $118,500 B. $122,500 C. $128,000 D. $133,500 ANS: B TOP: Bad debts

PTS: 1

AACSB:

Knowledge, Analytical

38. The bookkeeper down at the Good Time Saloon was having too good a time and forgot to accrue interest expense at year end. This will result in an: A. understatement of liabilities, and an overstatement of net profit and owners’ equity. B. understatement of liabilities, and an understatement of net profit and owners’ equity. C. overstatement of assets, net profit and owners’ equity. D. understatement of assets, net profit and owners’ equity. ANS: A TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

39. The lazy bookkeeper down at the Lazy R Ranch forgot to record the reduction of prepaid rent during 20X6. The result of this error is that: A. net profit for 20X6 is understated, the balance in owners’ equity is understated, and assets are understated. B. net profit for 20X6 is overstated, the balance in owners’ equity is overstated, and assets are correctly stated. C. net profit for 20X6 is overstated, the balance in owners’ equity is overstated, and assets are overstated. D. net profit for 20X6 is understated, the balance in owners’ equity is understated, and assets are overstated. ANS: C TOP: Accruals

PTS: 1

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. What is accrual accounting? ANS: Under accrual accounting, an entity records its revenues and related expenses in the same accounting period that it provides the goods or services to a customer. That is, it records the revenue and related expense in the same period that it earns the revenue. The collection or payment of cash does not impact the determination of when to recognise the revenue or expense. PTS: 1 TOP: Chapter 7

AACSB:

Knowledge, Analytical, Communication

2. What is the nature of the allowance for doubtful debts account and how does it arise? ANS: The allowance for doubtful debts account is a contra asset – it is deducted from the aggregate of accounts receivable to provide the cash equivalent balance of the receivables at reporting date. The account is the product of the application of accrual accounting and serves the purpose of ensuring that the associated doubtful debts expense is recognised in the year in which revenue is earned. PTS: 1 TOP: Bad debts

AACSB:

Knowledge, Analytical, Communication

PROBLEM 1. The accountant for Tiny Tots has compiled the following information about the company and its accounts: Cash Revenues Accounts Payable Wages Payable (a) (b) (c) (d)

$1500 4000 4500 2500

Prepaid Rent Expenses Equipment Notes Payable

$1000 2000 10,000 1000

What is the total amount of assets belonging to Tiny Tots? What is the total amount that Tiny Tots owes to creditors? Using the accounting equation, what is the amount of Owner’s Equity reported on Tiny Tots balance sheet? How much net profit did Tiny Tots have for the year?

ANS: (a) Cash Prepaid Rent Equipment Total Assets (b) Accounts Payable Wages Payable Notes Payable Total Liabilities

1500 1000 10,000 12,500

4500 2500 1000 8000

12,500 8000 4500

(d) Revenues Expenses Net Income PTS: 1

4000 2000 2000 AACSB:

Knowledge, Analytical

TOP: Chapter 7

2. Pele runs a soccer coaching school. During the year ended 30 June 20X7, coaching fees of $54,800 were received in cash. Fees due but not received or recorded at 30 June 20X7 totalled $1000. Fees received in advance at 30 June 20X7 totalled $800. Cash expenses paid during the year ended 30 June 20X7 totalled $32,000. Accrued expenses due but not paid at 30 June 20X7 totalled $2850. (a)

Calculate the profit for the year ended 30 June 20X7 using both the cash and accrual approaches.

(b)

Explain why the accrual approach to measuring profit is considered to be better than the cash approach.

ANS: (a) Cash profit: $54,800 – 32,000 = $22,800. Accrual profit: ($54,800 + 1000 – 800) – ($32,000 + 2850) = $20,150. (b)

The accrual approach to measuring profit provides a better measure of operating performance (and financial position) within a given accounting period, and promotes comparability across time and between entities.

PTS: 1

AACSB:

Knowledge, Analytical

TOP: Chapter 7

3. Clarinet Trading is involved in the purchase and sale of musical instruments. It sells goods at cost plus 45%. The transactions entered into by the entity during the last three months of the financial year ended 30 June 20X7 included the following. April

Purchased musical instruments for resale on credit for $85,000. Sold musical instruments for cash $23,000 and credit $14,000. Paid wages $4000. Owner withdrew $1000 cash for personal use.

May

Purchased equipment for $18,000 for use in the business. Paid a cash instalment of $10,000 at acquisition; the balance is payable in September 20X7. Received $10,000 in cash from accounts receivable. Sold musical instruments for cash $7450 and credit $9700. Paid $14,000 in cash off accounts payable and received discount of $205. Owner withdrew musical instruments for personal use $3500.

June

Sold musical instrument for cash $5800 and credit $9300. Received advice that $800 of accounts receivable was not collectable and the figure was written off. Received $2000 cash for musical instruments which will be provided to the customers concerned in July 20X7.

(a)

Record the foregoing transactions on the worksheet provided. Total the columns.

(b)

Calculate the cost of the musical instruments sold by the business for the three months ended 30 June 20X7.

ANS: ASSETS trans

Cash

April purchases cash sales credit sale Wages drawings May equipment

Acs receivable

Equipment

85,000

Acs payable

OE Loan

Capital

23,000 14,000 - 4000

14,000 -4000 -1000

discount drawings June cash sales credit sale bad debt revenue Total

P&L

85,000

23,000

receivables cash sale credit sale payables

(b)

Inventory

LIABILITIES Unearned revenue

- 1000

-10 000 10,000 7450

18,000

8000

- 10,000 7450 9700

9700 -14 000

-14,000 -205

205

-3500

5800

5800 9300 -800

9300 - 800 2000 19,250

+81,500

+22,200

+18,000

2000 2000

+70,795

+8000

-4500

+64,655

Sales (cost) = 1.45 cost. Sales = $23,000 + 14,000 + 7450 + 9700 + 5800 + 9300 = 69,250. $69,250/1.45 Cost = $47,758.

PTS: 1

AACSB:

Knowledge, Analytical

TOP: Chapter 7

4. Nankeen commenced business providing cleaning services on 1 June 20X7, by contributing equipment at $4000, a commercial van at $23,000 and cash of $2300. Transactions during June were as follows: June

4 4 6 8 11 14 17 19 21 21 23 25 26 26 28 30

Leased premises and paid two months rent $700 in advance. Purchased office supplies for $300, paying $100 in part payment. Billed customer for cleaning services $280. Cash received for cleaning services $410. Purchased additional equipment for $800 cash. Hired a cleaning assistant at an agreed wage of $300 per week. Paid vehicle maintenance $300. Revenue of $485 earned from provision of service to customer on credit. Paid balance on office supplies purchased on credit on 4 June. Nankeen withdrew $500 cash for personal use. Paid wages to assistant $300. Revenue earned for cleaning services on account $230. Received cash of $250 from accounts receivable. Petrol expenses paid $85. Received cash of $180 from accounts receivable after allowing for a $10 discount. Office supplies used $85.

(a)

Complete a worksheet for the month of June including any final adjustments. Record all physical non-current assets in a single column titled, plant & equipment. Total the columns on completion of the worksheet.

(b)

Prepare the statement of comprehensive income for the month of June, and a classified balance sheet as at 30 June 20X7.

. ANS: (a) trans June

Cash 1 4 4 6 8 11 17 19 21 23 24 26 28

ASSETS Plant & equipment

2300 -700 -100

LIABILITIES Office Supplies

Acs Rec

Pre payments

Accruals

OE Acs Pay able

27,000

Capital 29,300

700 300

200 280

410 -800 -300

280 410

800 -300 485

485 -200 -500 -300

-200 -500 -300 230

230 -250

250 -85 180

-85 -180 -10

-85

Rent Wage

-350 155

P&L

+27,800

+215

+555

300 =300

+350

(b) Nankeen Statement of comprehensive income For the month of June 20X7 $ $ Cleaning fees Expenses Vehicle maintenance Wages Cleaning supplies Petrol expenses Discount expense Rent Net loss Other comprehensive income Total comprehensive income

1405 300 600 85 85 10 350 1430 (25) 0 (25)

---

+28,800

-10 -85 -350 -300 -25

Nankeen Balance sheet As at 30 June 20X7

Current assets Cash Acs receivable Cleaning supplies Prepayments Total current assets

$155 555 215 350 1275

Non-current assets Plant and equipment* Total non-current assets

27,800 27,800

TOTAL ASSETS

29,075

Current liabilities Accruals Total current liabilities TOTAL LIABILITIES

300 300 300

Net assets

$28,775

Owners’ equity Contributed equity Retained profits (-25 – 500)

29,300 (525) $28,775

* Plant & equipment consists of a vehicle valued at $27,000. The balance of the asset is made up of cleaning equipment. PTS: 1

AACSB:

Knowledge, Analytical

TOP: Chapter 7

CASE 1. The following financial statements have been prepared for Clearview for the month of June 20X7. The financial statements have been prepared using accrual accounting, except to the extent evident in the information provided. The business is a sole proprietorship. Trading commenced on 1 June 20X7. The business offers a window cleaning service on both cash and credit terms. Forty per cent of the work completed in June was on credit. Customers are given 30 days to pay. The proprietor invested cash of $2500 and a vehicle valued at $27,000 at 1 June 20X7. Clearview Statement of comprehensive income For the month of June 20X7

Cleaning fees Expenses Vehicle expenses

$1405 -180

Wages for casual employee Advertising fees Various insurances Cleaning supplies Discount expense Lease on premises

-500 -50 -100 -85 -10 -450 -$1375

Net profit Other comprehensive income Total comprehensive income

30 0 30 Clearview Balance sheet As at 30 June 20X7

Current assets Cash Acs receivable Supplies Prepayments Total current assets Non-current assets Plant and equipment at cost Total non-current assets

$385 325 470 350 1530

27,800 27,800

TOTAL ASSETS Current liabilities Accrued wages Total current liabilities TOTAL LIABILITIES

29,330

300 300 300

Net assets Owners’ equity Contributed equity Retained profits (30 – 500 drawings)

29,030

$29,500 -470

= 29,030

Discuss the performance of the business for the period as revealed by the foregoing financial statements, paying particular attention to the entity’s profitability and cash position. ANS: Key issues for discussion: • Profitability and solvency are key determinants of business success. • The profit for the month is 2% of revenue. This figure is low given the small scale of the business (lack of volume in turnover). The figure for revenue is disproportionately low relative to expenses. The figures suggest that the problem may lie with revenue and/or the magnitude of certain expenses i.e., wages and the lease on the premises. • Wages: The figure is high relative to revenue – 57% of revenue. If the rates for the casual employee are appropriate, then what of the individual’s level of productivity regarding the turnover in cleaning hours (jobs) and, therefore,

• •

•

revenue earned. Lease on premises: Given the nature and size of the business, one might question whether such an item of expenditure is necessary at all. Vehicle expenses: Despite the reference to accrual accounting, the information provided suggests that the figure does not include depreciation. Plant and equipment is reported at cost. Therefore, profit is in fact lower, probably a loss in fact. Revenue: Is the rate charged for the window cleaning service appropriate? The whole question of the relation between revenue and cost structure is in question. Note, the proprietor may be undercutting the market vis-a-vis competitors, given the recent entry into the market. Cash position: the business closed the month with a surplus cash balance. However, this is attributable to the cash contribution of the owner at the commencement of the month. The figures provided suggest that if the current trend continues the cash surplus may not be sustained into the future. The net cash flow from operating activities for the month was negative: Cash flow from operating activities Cash from customers (1405 – 325) Operating expenses ($1375 - $300 (wages)) Prepaid supplies Prepayments Net cash outflow

•

$1080 -1075 -470 -350 -$815

There may be more cash tied up in cleaning supplies than is necessary – a just-in-time policy may assist the cash position in the future. Further, there are no accounts payable at 30 June, suggesting that supplies are paid for in cash. The cash position may also be assisted in the future by arranging credit terms for the materials, involving a time frame that is compatible with the operating cycle of the business vis-a-vis the credit terms offered to customers.

The collection of accounts receivable would appear to be reasonable to date. Total credit sales for month ($1405) (0.4) = $562. Balance outstanding $352. PTS: 1 TOP: Chapter 7

AACSB:

Knowledge, Analytical, Communication

Chapter 8 – Inventories and work in progress TRUE/FALSE 1. The just-in-time technique aims to minimise the costs of holding inventory. ANS: T PTS: 1 TOP: Inventory management

AACSB:

Knowledge, Analytical

2. The costs of holding inventory will vary depending on the type of business; generally, however, holding excessive amounts of inventory will increase storage costs but decrease debt to finance the inventory held. ANS: F PTS: 1 TOP: Inventory management

AACSB:

Knowledge, Analytical

3. Holding excessive inventory undermines the liquidity and profitability of an entity. ANS: T PTS: 1 TOP: Inventory management

AACSB:

Knowledge, Analytical

4. Goods, other property and services: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) to be used up in the production of goods, other property or services for sale, including consumable stores and supplies, are all various types of inventory. ANS: T TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

5. Consumable goods for use within the production process are not classified as inventory under current assets in the balance sheet. ANS: F TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

6. Products and services that are at an intermediate stage of completion form part of the work in progress. ANS: T TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

7. Goods that have been through the complete production or assembly cycle and are ready for resale to the customer are finished goods. ANS: T TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

8. The time spent by a barrister briefing a client prior to a court hearing would constitute ‘work in progress’ for the law firm. ANS: T PTS: 1 AACSB: TOP: The nature of business and inventory valuation

Knowledge, Analytical

9. The cost of an item is important in considering whether it should be classified as inventory or not. ANS: F PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

10. Items purchased for incorporation into the manufacture or assembly of goods are referred to as raw materials, but they do not constitute inventory until the manufacturing or production process is complete. ANS: F PTS: 1 AACSB: TOP: The nature of business and inventory valuation

Knowledge, Analytical

11. The nature of the business will determine if the purchase of 500 litres of paint constitutes inventory or not. ANS: T PTS: 1 AACSB: TOP: The nature of business and inventory valuation

Knowledge, Analytical

12. It is most likely that a manufacturing firm will have inventory that constitutes raw materials, work in progress and finished goods. ANS: T PTS: 1 AACSB: TOP: The nature of business and inventory valuation

Knowledge, Analytical

13. The perpetual method of valuing inventory is more effective in detecting inventory theft than the periodic system. ANS: T PTS: 1 TOP: Methods for recording inventory

AACSB:

Knowledge, Analytical

14. The method of accounting for inventory where an accurate record of purchases is kept and an annual inventory count is conducted to establish the cost of goods sold during a period is the periodic method. ANS: T PTS: 1 TOP: Methods for recording inventory

AACSB:

Knowledge, Analytical

15. Cost of goods sold can be determined by adding purchases to closing inventory and deducting opening inventory. ANS: F PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

16. After calculating that the closing inventory balance was $27,000, a physical stocktake revealed that inventory was actually $17,000. This means that cost of goods sold must be $10,000. ANS: F PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

17. When calculating cost of goods sold, an error was made which understated closing inventory. The effect will be to understate profit for the period. ANS: T PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

18. When calculating cost of goods sold, an error was made which overstated closing inventory. The effect will be to overstate profit for the period. ANS: T PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

19. When calculating cost of goods sold, an error was made which overstated opening inventory. The effect will be to understate profit for the period. ANS: T PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

20. When calculating cost of goods sold, an error was made which understated opening inventory. The effect will be to overstate profit for the period. ANS: T PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

21. Under AASB 102, where the purchase price (cost) of an item of inventory is $248 and the net realisable value is $256, inventory should be adjusted to reflect the net realisable value. ANS: F PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

22. The absorption costing method determines the cost of inventories and includes a share of both variable and fixed costs, the latter being allocated on the basis of normal operating capacity. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

23. If AASB 102 determines that the cost of inventory consists of the cost of purchase, the cost of conversion and other costs, then this eliminates the use of the variable-cost method of valuing inventories for external reporting. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

24. Technological changes are likely to cause a downward movement in inventory values, whereas changes in taste are more likely to cause an upward movement in inventory values. ANS: F PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

25. Different valuation rules affect inventory values and therefore cost of sales and profits. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

26. LIFO is a method of inventory valuation based on the assumption that the last goods bought are the first sold. Closing inventory is therefore assumed to consist of the cost of the earliest units purchased. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

27. FIFO is a method of inventory valuation based on the artificial assumption that the first goods bought are the first sold. Closing inventory is therefore assumed to be that purchased most recently. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

28. The inventory turnover ratio is: cost of goods sold/average inventory. ANS: T PTS: 1 TOP: Inventory turnover ratio

AACSB:

Knowledge, Analytical

29. The net realisable value of inventory represents selling price less the costs involved in completing and selling the inventory. ANS: T PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

30. ABC Ltd purchased an item inventory at a cost of $27,000. The item was damaged during storage. The company could sell the item in its damaged state for $23,000, and in doing so incur selling costs of $1000. The net realisable value of the item of inventory is $23,000. ANS: F PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. If an item of inventory is counted twice in the annual stocktake, then: A. current profit will be understated. B. beginning inventory for the next period will be understated. C. current cost of goods available for sale will be understated. D. current cost of goods sold is understated. ANS: D PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

2. Why is the method of valuing inventory important? A. Inventory valuation is based on the actual flow of goods. B. Inventories always account for over 50% of the total assets and therefore have a considerable impact on a company’s financial position. C. Companies desire to use the inventory valuation method that minimises the cost of goods sold expense. D. The inventory valuation method chosen determines the value on the balance sheet and the cost of goods sold expense in the statement of comprehensive income. ANS: D PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

3. Which of the following is not an aspect of efficient inventory management? A. Holding too few items of inventory risks losing profitable sales. B. Holding excessive amounts of inventory requires large storage space and adds to the cost of the business.

C. The costs of holding inventory will vary depending on the type of business. D. Holding large amounts of inventory can reduce debt as there will be no requirement to finance it. ANS: D PTS: 1 TOP: Inventory management

AACSB:

Knowledge, Analytical

4. Efficient inventory management is least likely to be assessed by: A. determining the amount of wastage of inventory. B. evaluating the inventory turnover ratio. C. calculating the number of times during a period that inventory has been turned over. D. looking at the revenue generated from inventory sales. ANS: D PTS: 1 TOP: Inventory management

AACSB:

Knowledge, Analytical

5. Inventories do not include goods and services: A. held for sale. B. used up in production. C. sold to customers. D. consumed in production. ANS: C TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

6. Inventory should normally be classified on the balance sheet as: A. a current asset. B. shareholders’ equity. C. property, plant, and equipment. D. an intangible asset. ANS: A TOP: Definitions

PTS: 1

AACSB:

Knowledge, Analytical

7. You would expect to see the account Work-in-Progress Inventory reported on the balance sheet of a: Manufacturing firm A. Yes B. No C. Yes D. No

Merchandising firm No No Yes Yes

ANS: A PTS: 1 AACSB: TOP: The nature of business and inventory valuation

Knowledge, Analytical

8. The cost of inventory becomes an expense in the period when: A. the inventory is purchased. B. the inventory is sold. C. payment is received for inventory sold. D. the purchaser obtains ownership of the inventory. ANS: B PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

9. When goods sold are automatically recorded into an inventory recording system, this inventory system is known as the: A. periodic method. B. cost of goods sold method. C. closing and opening stock method. D. perpetual method. ANS: D PTS: 1 TOP: Methods for recording inventory

AACSB:

Knowledge, Analytical

10. The practice of recording inventory and conducting a physical inventory count at the end of the accounting period, which highlights spoilage and theft, is called: A. the periodic inventory system. B. the average cost inventory system. C. the perpetual inventory system. D. merchandising inventory. ANS: C PTS: 1 TOP: Methods for recording inventory

AACSB:

Knowledge, Analytical

11. Hilton owns a store that operates on a periodic inventory method. He starts the year with $12,000 of goods, makes purchases of $40,000 and finishes the year with $8000 of inventory. What is the cost of the goods sold? A. $36,000 B. $40,000 C. $44,000 D. $52,000. ANS: C PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

12. Which of the following is not included in the calculation of the cost of goods sold? A. Closing inventory B. Purchases C. Freight out costs D. Beginning inventory ANS: C PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

13. The cost of goods sold is calculated as: A. opening inventory plus purchases plus theft less closing inventory. B. opening inventory plus purchases less closing inventory. C. opening inventory less purchases plus theft less closing inventory. D. sales less net profit. ANS: B PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

14. When calculating cost of goods sold, an error was made which understated closing inventory. What effect will this have on assets and on profits? A. Assets will be understated and profit for the period will be understated. B. Assets will be overstated and profit for the period will be overstated.

C. Assets will be understated and profit for the period will be overstated. D. Assets will be overstated and profit for the period will be understated. ANS: A PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

15. Gross profit is best described as: A. shown in the profit statement of a service enterprise. B. sales revenue less cost of goods sold. C. sales revenue less cost of goods sold and other expenses. D. cost of goods sold less expenses. ANS: B PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

16. Different inventory valuation methods do not affect: A. profit. B. cost of sales. C. liabilities. D. assets. ANS: C TOP: Chapter 8

PTS: 1

AACSB:

Knowledge, Analytical

17. The net realisable value of inventory is: A. the cost of goods sold. B. the purchase cost of inventory. C. the selling price less any costs of sale. D. the selling price less cost of completion and any costs of sale. ANS: D PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

18. The cost of a block of wood is $28 but the net realisable value is $24. Under the valuation rule in accounting standards, the block of wood is recognised at: A. $24 or $28. B. $24. C. $28. D. $32 ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

Consider the following information and answer questions 19 to 21 below. Goods in inventory at start of year Purchases, quarter 1 Purchases, quarter 2 Purchases, quarter 3 Purchases, quarter 4 Goods sold during the year: 3000 units

Units 1600 800 1000 1200 800 5400

Cost per unit $1.20 $1.40 $1.60 $1.80 $2.00

Total costs $3072 $1120 $1600 $2160 $1600 $9552

19. Using the last-in, first-out periodic method, the value of closing inventory is: A. $4400. B. $4192. C. $1840. D. $3460. ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

20. Using the first-in, first-out periodic method, the value of closing inventory is: A. $4192. B. $3450. C. $2510. D. $4400. ANS: D PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

21. Using the weighted-average-cost method, the value of closing inventory is: A. $4400 B. $4192 C. $4245 D. $5040 ANS: C PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

22. Which of the following methods results in the higher value for cost of goods sold in times of rising inventory prices? A. First-in, first-out B. Weighted average cost C. Last-in, first-out D. None of the above ANS: C PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

23. First-in, first-out is the same as: A. weighted average cost. B. last-in, last-out. C. last-in, first-out. D. first-in, last-out. ANS: B PTS: 1 TOP: Valuing inventory

24. Assuming that there are inflationary trends in the economy, the inventory amount shown in the balance sheet, if based on LIFO, would normally be: A. lower than the FIFO value. B. equal to current market value. C. higher than the FIFO value. D. higher than current market value. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

25. Which inventory measurement method would have the most recent costs in cost of goods sold? A. First-in, first-out (FIFO) B. Last-in, first-out (LIFO) C. Weighted average D. Work-in-progress ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

26. The inventory valuation method that results in the recognition of the oldest inventory costs on the balance sheet and statement of comprehensive income, respectively, is: BS Position SOCI Performance A. FIFO LIFO B. FIFO FIFO C. LIFO LIFO D. LIFO FIFO ANS: D PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

27. When the price of inventory is decreasing, which of the following is true regarding the three best-known inventory valuation methods? A. The LIFO method will yield the smallest amount for cost of goods sold. B. The weighted-average method will yield the largest amount for closing inventory. C. The FIFO method will yield the highest amount for closing inventory. D. Both LIFO and FIFO will yield a smaller tax obligation than weighted-average. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

28. The So-Big Company sells hot-dogs. Inventory information for a recent week is shown below: Units Unit Cost Total Cost Beginning inventory 2 $6 $12 Purchase 4 8 32 Purchase 6 10 60 If five units were sold during the week, what is the cost of goods sold if the LIFO periodic method is used? A. $68 B. $54 C. $50 D. $36 ANS: C PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

29. The So-Big Company sells hot-dogs. Inventory information for a recent week is shown below in chronological order: Units Unit Cost Total Cost Beginning inventory 2 $6 $12 Purchase 4 8 32 Sales 3 Purchase 6 10 60 Sales 2

What is the cost of goods sold if the LIFO perpetual method is used? A. $68 B. $54 C. $50 D. $36 ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

30. Schultz-Stein Company has the following inventory information for a recent year: Beginning inventory January purchase July purchase October purchase Ending inventory

$500

(10 units with an average cost of $50 each) 10 units @ $48 each 30 units @ $52 each 20 units @ $48 each 25 units

The cost of ending inventory, using the weighted-average periodic method, is: A. $1250. B. $1240. C. $1237.50. D. $1220. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

31. An advocate of the LIFO inventory method would maintain that: A. current costs are matched with current selling prices. B. the lowest possible costs are always shown in the ending inventory. C. the oldest inventory is relieved of its cost before the newer purchases. D. the highest possible costs are always shown in the ending inventory. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

32. Davenport Merchandising Company uses the FIFO periodic method of cost assignment. The following data are available:

Beginning inventory Purchase Purchase Ending inventory

Date 1 Jan 13 Mar 20 Jun 31 Dec

Units 400 800 1200 200

Unit Cost $24 28 32

Total Cost $9600 22,400 38,400

The value of the ending inventory will be: A. $2400. B. $4800. C. $5866. D. $6400. ANS: D PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

33. Gamma Bomber Parts uses the FIFO periodic costing method. The following data are available:

Beginning inventory Purchase Purchase Sales during the year

Units 20 20 16 25

Unit Cost $4000 4800 3600

Total Cost $80,000 96,000 57,600

The cost of goods sold should be: A. $104,000. B. $100,800. C. $129,600. D. $132,800. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

34. J. Q. Adams Co. had beginning inventory of 50 units with a total cost of $1000. During the period, J. Q. Adams first purchased 20 units for $800 and then 30 units for $1800. The company uses the LIFO periodic method of costing inventory. If a physical count of ending inventory showed 45 units, at what amount would they be valued on the balance sheet? A. $1620 B. $900 C. $2400 D. $3600 ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

35. Which of the following is false concerning the lower-of-cost-or-net realisable value rule when it is applied to the valuation of inventory? A. Inventory must be written up (increased) if the net realisable value of ending inventory is greater than the cost of ending inventory as estimated using the LIFO method. B. Inventory must be written down (decreased) if the net realisable value of ending inventory is less than the cost of ending inventory as estimated using the average cost method. C. Inventory must be written down (decreased) if the current market cost of ending inventory is less than the cost of ending inventory as estimated using the FIFO method. D. Writedowns (decreases) are more common in times of rising prices when FIFO is used. ANS: A PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

36. The balances for the opening and closing inventory of XYZ Ltd for the financial year were $40,000 and $50,000 respectively. Sales for the year totalled $3 million, and cost of goods sold was $600,000. The ratio for inventory turnover for the year was approximately: A. 66.67:1 B. 13.33:1 C. 1.25:1 D. 5:1 ANS: B PTS: 1 TOP: Inventory turnover ratio

AACSB:

Knowledge, Analytical

37. The balances for the opening and closing inventory of ABC Ltd for the financial year were $40,000 and $50,000 respectively. Sales for the year totalled $2.5 million. Purchases of inventory for the year totalled $700,000. What was the gross profit figure for the year? A. $690,000 B. $1,800,000 C. $1,810,000 D. $2,500,000 ANS: C PTS: 1 AACSB: TOP: Determining the cost of goods sold-periodic

Knowledge, Analytical

38. Which of the following items of expenditure would not be included under the variable cost method of measuring inventory: A. direct materials. B. fixed manufacturing overheads. C. direct labour. D. variable manufacturing overheads. ANS: B PTS: 1 TOP: Valuing inventory

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Distinguish between the periodic and perpetual methods of recording inventories. ANS: The periodic method of recording inventory refers to the situation where an accurate record of purchases is kept and an annual inventory count is conducted to establish the quantity of closing inventory and from there the cost of goods sold during a period. Under the perpetual inventory method, on the other hand, the record of inventory is updated every time a sale occurs, and, thus, continuous balance of inventory held is known – as is the cost of goods sold. PTS: 1 AACSB: TOP: Methods for recording inventory

Knowledge, Analytical, Communication

2. Describe the difference between absorption costing and variable costing. Support your answer with reference to the following costs: • managing director’s salary. • machine operator’s wages. • cost of raw materials. • factory supervisor’s salary. ANS: Variable costing involves costing closing inventory using only variables costs incurred in producing the items concerned. In relation to the four types of expenses identified, the salaries of the managing director and the supervisor unlike the remaining two expenses are fixed not variable costs. Thus, they would be excluded from the variable costing method. Where absorption costing is applied, items of inventory are measured on the basis of the variable costs involved and an allocation of fixed costs. Thus, all four costs identified would be factored into the application of absorption costing. PTS: 1 AACSB: TOP: Valuing inventory

Knowledge, Analytical, Communication

3. Describe the LCM rule as it applies to the valuation of closing inventory, and name three different methods of calculating the cost of inventory. ANS: The acronym LCM stands for the lower of cost and market. The rule as the name suggests requires that closing inventory is measured at whichever is lower at the date of reporting, the cost or the market price of the item. Market price refers to net realisable value. Three different methods of determining cost: first-in-first-out, last-in-first-out and weighted average (specific identification and standard costing are also relevant here). Note: AASB 102 Inventories: in respect of not-for-profit entities, inventories held for distribution are required to be measured at the lower of cost and current replacement cost. PTS: 1 AACSB: TOP: Valuing inventory

Knowledge, Analytical, Communication

4. How would the composition of the inventory reported in the balance sheet of a retail organisation, such as Woolworths, be similar to that of a manufacturing entity, and in what way(s) would it differ? ANS: The inventory of both types of entity would be similar in that one would expect them to both hold finished goods and supplies for consumption in the process of carrying out the entity’s operations. However, they would differ to the extent that the inventory of a manufacturing entity would also typically include stocks of raw materials and work-in-progress. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: The nature of business and inventory valuation PROBLEM 1. The inventory of Lusitania Ltd contains the following items at 30 June 20X7.

Item Type A B C D E (a) (b)

Quantity 60 25 10 40 30

Cost 3 8 25 6 7

Total Cost $ 180 200 250 240 210

Market 4 5 21 6 5

Determine the ending inventory value at 30 June 20X7, applying the lower cost and market rule to the individual items. What would the application of the LCM rule rather than cost have on the financial statements of the company?

ANS: (a) Item Type A B C D E Total

Quantity 60 25 10 40 30

Total Cost $ 180 200 250 240 210 1080

Cost 3 8 25 6 7

Market 4 5 21 6 5

LCM Rule $ 180 125 210 240 150 905

(b) Cost of goods sold would be higher by $175 under the LCM than if the inventory had been measuring at cost. Thus, the ensuing profit figures (gross and net) will be $175 lower under LCM – leading to a lower equity figure in the balance sheet. Similarly, the closing inventory figure in the balance sheet will be lower under the LCM rule than had the inventory been measured at cost. PTS: 1 AACSB: TOP: Valuing inventory

Knowledge, Analytical

2. During the year ended 30 June 20X7 Excelsior Soccer sold 1800 soccer balls at $12.50 each. The entity uses the periodic method of recording inventory. Beginning inventory on 1 July 20X6 amounted to 200 balls at a cost of $1200. Purchases during the year were made in the following order: 580 units @ $6.20 100 units @ $6.80 300 units @ $7.00 100 units @ $7.10 (a)

Calculate the 30 June 20X7 closing inventory figure using the following assumptions regarding the flow of costs (round to the nearest $): • FIFO, periodic method. • LIFO, periodic method. • Weighted average, periodic method.

(b)

Prepare partial statements of comprehensive income for each method to the gross profit stage.

ANS: (a) No items

Sold Closing

200 580 1100 300 100 2280 1800 480

@ $6.00 6.20 6.80 7.00 7.10

Total $ 1200 3596 7480 2100 710 $15,086

FIFO 100 300 80 480 LIFO 200 280 480

@ 7.10 7.00 6.80

Total $

@ $6.00 6.20

Total $

Weighted average @ $15,086/2 280 = $6.62 480 x $6.62 = $3176

710 2100 544 3354

1200 1736 2936 Total $

(b) Statement of comprehensive income for year ended 30 June 20X1 FIFO LIFO Weighted average Sales $22,500 $22,500 $22,500 Opening inventory 1200 1200 1200 Purchases 13,886 13,886 13,886 15,086 15,086 15,086 Closing inventory 3354 2936 3176 Cost of goods sold 11,732 12,150 11,910 Gross profit 10,768 10,350 10,590 PTS: 1 AACSB: TOP: Valuing inventory

Knowledge, Analytical

Chapter 9 – Non-current assets and depreciation TRUE/FALSE 1. The future benefits of a non-current asset are difficult to determine, due to the uncertainty of measuring the unexpired benefit. ANS: T TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

2. Depreciation spreads the original cost of a non-current asset over its useful life, but it cannot be considered a precise measure as it is based on forecasts of future outcomes. ANS: T TOP: Deprecation

PTS: 1

AACSB:

Knowledge, Analytical

3. A major difference between current and non-current assets is that the future benefits of current assets will expire in a short period of time, whereas the future benefits of all non-current assets will decline over a longer period. ANS: T PTS: 1 AACSB: TOP: The difference between non-current and current assets

Knowledge, Analytical

4. An expenditure is material if its omission or misstatement could influence economic decisions of users. ANS: T PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

5. Ongoing repairs to a machine used in the production process are considered part of the cost of the machine. ANS: F PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

6. The cost of a non-current asset consists of the purchase consideration, plus all incidental costs incurred in getting the asset into a location and ready for use, and all costs that enhance the future economic benefits of the asset beyond those initially expected at acquisition. ANS: T PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

7. Residual value can be defined as the estimated disposal (sale) value of an asset when it is no longer useful to the entity. ANS: T PTS: 1 AACSB: TOP: The useful life of non-current assets

Knowledge, Analytical

8. When technology is changing rapidly, depreciation of an asset will help maintain an entity’s operating capacity. ANS: F PTS: 1 AACSB: TOP: The useful life of non-current assets

Knowledge, Analytical

9. Depreciation refers to the systematic allocation of the depreciable amount of a depreciable asset over its useful life. ANS: T PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

10. The expensing of an item that should have been capitalised as an asset will understate profits. ANS: T PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

11. The reducing-balance method is an alternative method to the units-of-output method, and may be a better reflection of the actual usage of most assets, such as plant and equipment. ANS: T PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

12. If two entities use different methods of depreciation, then users need to make adjustments for this when comparing the financial statements of the entities. ANS: T PTS: 1 AACSB: Knowledge, Analytical TOP: Accounting policies for depreciation and implications for users 13. A machine was purchased for $30,000 with a life expectancy of five years and a zero residual value. Under the straight-line method, the depreciation expense would be calculated at 20% per annum of the cost. ANS: T PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

14. Because goodwill is unidentifiable, it cannot be recognised as an asset. ANS: F PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

15. Whether an asset should be reported as current or non-current, depends on whether the asset is in the form of cash or will be realised or consumed within the ensuing operating cycle of the entity. ANS: T PTS: 1 AACSB: TOP: The difference between non-current and current assets.

Knowledge, Analytical

16. From the Hicksian economic viewpoint, profit is the amount which an individual can consume over a period and still be as well off at the end of the period as he/she was at the beginning of the period. ANS: T TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

17. Depreciation expense has the effect of reducing profit, equity and assets. ANS: T PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

18. The accumulated depreciation account, unlike the allowance for doubtful debts, is not a contra account. ANS: F PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

19. Depreciation is concerned with allocation not valuation. ANS: T PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

20. The fundamental difference between identifiable and unidentifiable intangible assets is whether the assets are separable from the business. ANS: T PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following would not explain the difference between current and non-current assets? A. The future benefit of current assets will generally be used up within the entity’s operating cycle. B. An expenditure is classified as a non-current asset if it is considered to be material. C. An asset is classified as non-current if it is intended to be used within the business for a considerable period of time. D. The nature and intention of the business can help determine whether an expenditure should be classified as a non-current asset. ANS: B PTS: 1 AACSB: TOP: The difference between non-current and current assets

Knowledge, Analytical

2. The expensing of an office fan in the year purchased may be justified on the basis of: A. full disclosure. B. matching. C. consistency. D. materiality. ANS: D PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

3. The cost of a non-current asset includes: A. all reasonable and necessary costs. B. production costs only. C. manufacturing costs only. D. marketing and selling costs only. ANS: A PTS: 1 TOP: The cost of a non-current asset

4. An expenditure that extends the life of an asset or enhances its value is a(n): A. capital expenditure, recorded as an asset. B. operating expenditure, recorded as an expense. C. investing expenditure, recorded as an expense. D. financing expenditure, recorded in shareholders’ equity.

ANS: A PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

5. Chan bought a second-hand car for $12,500. The original cost of the car was $18,000. He made several modifications to the car to make it go faster. These modifications cost him $3000. What will be the cost of the car when he decides to sell it (ignoring any depreciation charges)? A. $21,000 B. $15,500 C. $12,500 D. $18,000 ANS: C PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

6. Jamboree Ltd has acquired land for tree farming. The cost of the land was $230,000 and an additional amount of $45,000 was spent on land improvements. The land improvement cost should be: A. included in the cost of the land. B. subject to depreciation. C. deducted from the cost of the land. D. charged as an expense in the year of acquisition. ANS: A PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

7. The following costs were incurred in the purchase of new office equipment. Cash price Sales tax Insurance during transit Installation

$22,000 3300 200 500

What amount should be recorded as the cost of the office equipment? A. $22,000 B. $25,300 C. $25,500 D. $26,000 ANS: D PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

8. Which of the following is incorrect? Depreciation is calculated: A. on a systematic allocation basis. B. over the asset’s estimated useful life. C. to prevent losses. D. on a depreciable asset. ANS: C PTS: 1 TOP: Depreciation

AACSB:

9. Which of the following assets is not depreciated? A. Buildings B. Motor vehicles C. Land D. Equipment

Knowledge, Analytical

ANS: C PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

10. Which of the following is the main reason for depreciating non-current assets? A. To show consumption of economic benefits. B. To enable a business to continue production. C. To lessen the losses suffered by businesses. D. To set aside funds for the replacement of assets. ANS: A PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

11. The expired cost of a depreciable asset is referred to as: A. residual value. B. carrying value. C. accumulated depreciation. D. depreciable cost. ANS: C PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

12. Where an entity exists in a rapidly changing environment, depreciation of a non-current asset will: A. show the consumption of economic benefits during a given period. B. ensure operating capacity is maintained. C. provide sufficient funds to replace the asset. D. be inappropriate. ANS: A PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

13. The cost of fixed assets recognised as being consumed during a fiscal period is: A. plant expense. B. depreciation expense. C. interest expense. D. cost of goods sold. ANS: B PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

14. When a company reports depreciation expense on the statement of comprehensive income: A. it is based on allocations of cost rather than on the current value of the asset. B. the firm is reporting that asset’s decline in current value during the period. C. the shortest possible estimated useful life and lowest possible estimated residual value are usually chosen. D. the company is ignoring the going-concern concept. ANS: A PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

15. The using-up process or utilisation of intangible assets is referred to as: A. depreciation. B. depletion. C. dilution. D. amortisation.

ANS: D PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

16. How is accumulated depreciation reported in the financial statements? On the Under the category of A. balance sheet assets B. balance sheet liabilities C. statement of comp income revenues D. statement of comp income expenses ANS: A PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

17. If a firm’s depreciation expense doubles in a period which of the following will increase as a result of this event? Net profit Cash flow A. Yes Yes B. Yes No C. No Yes D. No No ANS: D PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

18. Accumulated depreciation, as used in accounting, represents: A. funds (or cash) set aside to replace the asset being depreciated. B. earnings retained in the business that will be used to purchase another plant asset when the present asset becomes fully depreciated. C. an expense that is shown in the statement of comprehensive income. D. the portion of the cost of a plant asset written off as an expense since the asset was acquired. ANS: D PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

19. If a firm’s depreciation expense is cut by 25% in a period which of the following will decrease as a result of this event? Net profit Cash flow A. Yes Yes B. Yes No C. No Yes D. No No ANS: B PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

20. A business ended the year with a cash balance of $40,000. During the year, the following transactions took place: Cash purchase of a new computer $5000 Depreciation expense 1500 Accumulated depreciation 1500 Assuming no other transactions took place, the cash at the beginning of the year was: A. $45,000. B. $48,000.

C. $46,500. D. $35,000. ANS: A PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

21. Depreciation affects profit in which of the following ways? A. Decreases profit, because it decreases a non-current asset. B. Increases profit, because it is an acquisition of a non-current asset. C. Profit decreases, because depreciation is an expense item. D. Profit increases, because depreciation is an expense item. ANS: C PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

22. The expensing of a depreciable item when it should have been capitalised will result in: A. understated net profit for the current period. B. understated net profit for the succeeding period. C. overstated depreciation expense for the succeeding period. D. overstated total assets at end of current period. ANS: A PTS: 1 TOP: The cost of a non-current asset

AACSB:

Knowledge, Analytical

23. Depreciation and amortisation: A. reduce net profit and cash flow from operating activities. B. reduce net profit but increase cash flow from operating activities. C. reduce net profit but have no direct effect on cash flow from operating activities. D. have no direct effect on net profit or cash flow from operating activities. ANS: C TOP: Chapter 9

PTS: 1

AACSB:

Knowledge, Analytical

24. The carrying value of plant assets is: A. the cost of the assets less accumulated depreciation. B. an indicator of the market value of the assets. C. cost less residual value. D. not reported in the financial statements. ANS: A PTS: 1 TOP: Depreciation

AACSB:

Analytical

25. A building was purchased for $100,000 and used for four years of its estimated 10-year life. It has no residual value and the straight-line method is used. The carrying value of the building after the four years’ usage would be reported on the balance sheet at: A. $20,000. B. $40,000. C. $60,000. D. $80,000. ANS: C PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

26. Consider the following information and answer the question(s) below. Estimated Residual Machine Date Cost life value 1 30 Sept 20X5 $8500 12 years $ 0

Depreciation method Reducing-balance (Assume rate = 0.105) What is the total accumulated depreciation at 30 June 20X7 for machine 1? A. $1786 B. $1492 C. $682 D. $1827 ANS: B PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

27. Mendips Ltd net profit would be understated if in the first year, the residual value were excluded when determining the depreciation expense using: Straight-line Reducing balance A. Yes No B. Yes Yes C. No No D. No Yes ANS: A PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

28. On 1 July 20X7, Gumi Company purchased equipment at a cost of $22,000. The equipment has an estimated residual value of $3000 and is being depreciated over an estimated useful life of eight years under the reducing-balance method of depreciation, at a rate equal to one-and-a-half times the straight-line depreciation rate. For the six months ended 31 December 20X7, Gumi Company recorded one-half year’s depreciation. What should the depreciation expense be (rounded to the nearest dollar) on the equipment for the year ended 31 December 20X8? What is the written-down book value at 31 December 20X8? A. Depreciation expense $2063, written-down book value $19,937. B. Depreciation expense $3158, written-down book value $18,842. C. Depreciation expense $3738, written-down book value $16,199. D. Depreciation expense $5791, written-down book value $14,146. ANS: C PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

29. Flamingo Corporation purchased a machine for $300,000 on 1 January 20X7. The estimated life is 10 years. What is the book value on the 31 December 20X9 balance sheet, assuming that straight-line depreciation is used and the estimated residual value is zero? A. $300,000 B. $210,000 C. $120,000 D. $60,000 ANS: B PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

30. On 1 January 20X7, the local Red Cross affiliate acquired new blood-processing equipment costing $400,000. The equipment has an estimated useful life of 10 years and an estimated residual value of $50,000. After making all necessary calculations and entries on 31 December 20X8, what are the accumulated depreciation to date and carrying value of the equipment? (Assume that the straight-line method is used.) Accumulated depreciation Carrying value as of as of 31 December 20X8 31 December 20X8 A. $70,000 $330,000 B. $70,000 $280,000 C. $35,000 $330,000 D. $80,000 $320,000 ANS: A PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

31. Which of the following statements is true of the straight-line and/or reducing-balance methods (using the theoretical rate) of depreciation? A. The two methods yield different amounts of total depreciation expense over the useful life of the asset. B. The two methods yield the same amount of total depreciation expense over the useful life of the asset. C. The straight-line method is applied to assets that wear and tear faster in the earlier years. D. The reducing-balance method is applied to assets that generate more revenue in later years. ANS: B PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

32. Compared to straight-line depreciation, reducing-balance depreciation: A. results in lower net profit in earlier years and higher net profit in later years. B. is used more often on the statement of comprehensive income than is the straight-line method. C. leads to higher book values for depreciable assets than does the straight-line method. D. allocates larger portions of cost to later periods than to earlier ones. ANS: A PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

33. When a plant asset is sold, the gain or loss on disposal is computed as the difference between: A. fair market value and accumulated depreciation. B. selling price and accumulated depreciation. C. fair market value and selling price. D. selling price and carrying value. ANS: D PTS: 1 TOP: Sale of non-current assets

AACSB:

Knowledge, Analytical

34. Slow Trucking owned a truck that cost $30,000 when it was purchased on 1 January 20X7. It had accumulated depreciation of $18,000 at 31 December 20X8. Slow originally estimated that the truck would have a residual value after using it for four years of $3000. It sold the truck for $22,500 cash on 1 January 20X9. The amount of gain (loss) on the sale of the truck was: A. $4500 gain. B. $19,500 gain. C. $1500 loss. D. $10,500 gain.

ANS: D PTS: 1 TOP: Methods of depreciation

AACSB:

Knowledge, Analytical

35. An example of an intangible asset classification on a balance sheet is: A. rights held for a radio licence to the Himalayas. B. shares in BHP Limited. C. improvements to electric cables. D. interest on debentures due to be paid in 2010. ANS: A PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

36. Which of the following is not an identifiable intangible asset? A. A patent B. Copyright C. Goodwill D. A brand name ANS: C PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

37. A pair of identifiable and unidentifiable assets is: A. patents and copyrights. B. brand names and goodwill. C. copyright and franchises. D. research and development and patents. ANS: B PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

38. Which of the following would not be included in property, plant and equipment? A. Equipment B. Buildings C. Goodwill D. Land ANS: C PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

39. The excess of the cost of acquisition of a company over the fair value of its net identifiable assets is known as: A. surplus. B. amortisation. C. goodwill. D. abatement. ANS: C PTS: 1 TOP: Intangible assets

AACSB:

40. Which of the following is not an intangible asset? A. Goodwill B. Patent C. Copyright D. Land

Knowledge

ANS: D PTS: 1 TOP: Intangible assets

AACSB:

Knowledge

41. Sonya’s Fabrics purchased display equipment two years ago on 1 January for $10,000. Its expected useful life was five years, and its residual value $1000. To record the depreciation for the current year just ended, what would be the accounting entry, using the straight-line method? A. Increase both Depreciation Expense and Accumulated Depreciation by $2000. B. Increase Depreciation Expense and decrease Equipment, both by $1000. C. Increase Depreciation Expense and increase Accumulated Depreciation by $1800. D. Decrease both Depreciation Expense and Accumulated Depreciation by $1000. ANS: C PTS: 1 TOP: Depreciation

AACSB:

Knowledge, Analytical

42. An asset has a cost of $80,000, estimated residual value of $20,000 and estimated useful life of five years. What is the amount of the depreciation expense for the first year, assuming the reducing-balance method is used and the annual rate is 30%? A. $12,000 B. $16,000 C. $18,000 D. $24,000 ANS: D PTS: 1 TOP: Methods of depreciation

AACSB:

Analytical

43. A computer system, which cost $9000 with a carrying value of $2000, is sold for $1700. Which of the following adjustments is correct? A. Accumulated depreciation is decreased by $2000. B. The asset (computer) is decreased by $2000. C. A loss on sale of $300 is recognised. D. Accumulated depreciation is reduced by $7300. ANS: C PTS: 1 TOP: Sale of non-current assets

AACSB:

Knowledge, Analytical

44. The useful life of an asset for accounting purposes refers to: A. the period of time over which an asset is considered to be of use to an entity. B. the expected life of the asset based on engineering estimates. C. the maximum physical life of the asset. D. the shortest of the physical and economic lives of the asset. ANS: A PTS: 1 AACSB: TOP: The useful life of non-current assets

Knowledge, Analytical

45. Goodwill: A. is the collective name for the unidentifiable assets of an entity. B. may not be recognised as an asset. C. is the collective name for identifiable assets. D. includes trademarks and brand names. ANS: A PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

46. Which of the following assets cannot be included as unidentifiable intangibles? A. Customer relations B. Size of the market controlled C. Copyright ownership D. Superior management skills ANS: C PTS: 1 TOP: Intangible assets

AACSB:

Knowledge, Analytical

PROBLEM 1. Grey Egret Ltd purchased an item of equipment at a total cost of $85,000 on 1 October 20X7. The equipment was expected to have residual value of $20,000 at the end of its five-year useful life to the firm. The company’s financial year ends on 30 June. (a) Calculate the annual depreciation expense for the year ended 30 June 20X8 and 20X9, assuming that the equipment was depreciated using the straight-line method. (b) Calculate the annual depreciation expense for the year ended 30 June 20X8 and 20X9, assuming that the equipment was depreciated using the reducing balance method, at a rate of 26% per annum. (c) Show how the item of equipment would appear in the balance sheet of Grey Egret Ltd at 30 June 20X9 assuming the straight-line method is used. ANS: (a) Year ended 30 June 20X8: $85,000 – 20,000 / 5 = $13,000 per annum. Pro-rata $13,000 x 0.75 = $9750. Year ended 30 June 20X9: $13,000. (b) Year ended 30 June 20X8: $85,000 x 0.26 x 0.75 = $16,575. Year ended 30 June 20X9: $85,000 – 16,575 x 0.26 = $17,790. (c) Balance sheet extract as at 30 June 20X9 Non-current assets Equipment $85,000 Accumulated depreciation (22,750) $62,250. PTS: 1 AACSB: TOP: Methods of depreciation

Knowledge, Analytical

2. On 1 January 20X7 Pacioli Traders purchased machinery for use in the business. The purchase price of the machinery was $80,000 cash. The business paid an additional $4000 cash to have the machinery freighted from Sydney to Perth. A further $3500 cash was paid to install the machinery. The machine was expected to have a useful life of 10 years and a residual value of $4000. The financial year of the business ends on 30 June. The entity depreciates all machinery using the straight-line method. The machinery was sold on 1 July 20X9 for $70,000 cash. (a) Record the transactions dealing with the purchase of the asset at 1 January 20X7 on the worksheet provided. (b) Record the depreciation of the machinery at 30 June 20X8 and 30 June 20X9 on the worksheet provided. (c) Record the sale of the machinery at 1 July 20X9 on the worksheet provided.

ANS: Trans (a) 1 Jan

Cash -80,000 -4000 -3500

Mach’y 80,000 4000 3500

(b) 30 /6/X8 30 /6/X9 (c) 1/7/X9

70,000

-87,500

Acc depr

Capital

P&L

-4175 -8350

12,525

-4975

Calculations depreciation: $87,500 – 4000 = $83,500 depreciable amount. $83,500 / 10 years = $8350 per annum. Year ended 30 June 20X8 = $8350/2 = $4175. PTS: 1 AACSB: TOP: Methods of depreciation

Knowledge, Analytical

CASE 1. Albifrons Chat Ltd purchased an expensive new item of machinery for use in its manufacturing process. The machine was manufactured on the site of the vendor. Albifrons assumed responsibility for the cost of removing the new machine and restoring the site on which the plant was originally built by the vendor. The obligation was a term of the original agreement for acquiring the asset from the vendor. While it was clear to the company that the net invoice price before GST and the cost of freighting the machine from Melbourne to the company’s manufacturing plant in Sydney were to be capitalised as part of the cost of the asset, there was some uncertainty surrounding the treatment of the items listed in (i) to (vi) below. All items of expenditure were considered to be material in amount. Discuss whether you consider the items should be capitalised or otherwise using the guidance provided on the matter in paragraph 16 of AASB 116 Property, Plant and Equipment, as the basis of your analysis. The paragraph appears as an exhibit below item (vi). (i) Government sales tax (GST) on the machine. (ii) Wages paid to employees for time spent in (i) removing the machine that the newly acquired item replaced, and (ii) subsequently preparing the site for the installation of the new machine. (iii) The cost of removing the new machine and restoring the sight. The task was outsourced by Albifrons to a Melbourne based firm. (iv) Estimated fees for the removal of the new machine and the restoration process to be conducted by a third party on behalf of Albifrons. (v) Costs of testing whether the machinery was functioning properly subsequent to installation at the company’s Sydney plant. The samples produced during the testing process were subsequently sold. The cost of selling the samples amounted to 10% of the revenue obtained. (vi) Costs of marketing the new line of inventory that will be produced with the machine.

Exhibit AASB 116 Property, plant and equipment Elements of Cost The cost of an item of property, plant and equipment comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management; and (c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. ANS: (i) The GST figure falls within the ambit of 16 (a), and, therefore, may be capitalised. (ii) The wages represent a cost directly attributable to bringing the asset to a condition necessary for it to be capable of operating … re., 16 (b). Therefore, the cost may be capitalised. (iii) The cost of removing and restoring the site falls within the ambit of 16 (c). The provision would appear to provide that only the initial estimate of the costs may be capitalised. Capitalisation would be subject to that proviso. (iv) The fees paid to the consulting firm may also be capitalised if they represent a cost directly attributable to bringing the asset to the point where it is capable of operating ‘in the manner intended by management’ (S16 (b)). Thus, they may be capitalised. (v) The costs of testing also fall within the ambit of bringing the asset to the point where it is capable of operating ‘in the manner intended by management’ (S16 (b)). The net revenue derived from the sale of the samples has the effect of ameliorating the costs of testing. Thus, the net expenditure may be capitalised. (vi) The marketing costs fall outside the ambit of each of the sub-sections of paragraph 16. The most relevant section is sub-section (b), and from that perspective the costs are not directly attributable to bringing the asset to the condition necessary, etcetera. PTS: 1 AACSB: TOP: The cost of non-current assets.

Knowledge, Analytical

Chapter 10 – Financing and business structures TRUE/FALSE 1. The effect that the collapse of an airline has on the tourist industry is seen to be industry-specific and therefore a business risk. ANS: T TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

2. Working capital is represented by current assets less current liabilities for short-term working capital, whereas long-term working capital is total assets less total liabilities. ANS: F PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

3. Business risk is industry-specific, whereas financial risk is more firm-specific. ANS: T TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

4. Financing through creditors can result in opportunity costs where discounts are not taken up by the entity. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

5. Trade credit is widely used as a source of finance but the importance and use of trade credit varies from industry to industry and within industries. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

6. Financing through trade credit requires less security than financing through factoring. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

7. A bank overdraft is normally securitised over assets, either as a fixed charge over specific assets or as a floating charge over all assets; factoring is secured over specific assets being debtors; creditors generally require no security. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

8. Where an overdraft facility has been offered, the bank sees this as a semi-permanent source of finance, and prefers to see the account consistently overdrawn, as it will receive more fees through overdraft charges, thus reducing the risk of the finance. ANS: F PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

9. The purchase of an asset using loan finance and the leasing of an asset under a finance lease will both result in ownership of the asset being transferred at the time of acquisition/beginning of lease and not when all payments have been made. ANS: F PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

10. Under a hire-purchase agreement, ownership of the asset remains with the financier until all payments have been received. ANS: T PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

11. A major difference between accounting for an operating lease and a finance lease, in the books of the lessee, is that a finance lease will create an asset and a liability, whereas an operating lease will be treated as an expense. ANS: T PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

12. AKP enterprises have negotiated a lease for a photocopier. The useful life of the asset is eight years. The lease is non-cancellable and provides that the term of the lease is over three years with the present value of the lease payments being 55% of the fair value. Title will not pass at the end of the lease period. Using the criteria in AASB 117, the lease would definitely constitute a finance lease. ANS: F PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

13. A major discriminator between an operating lease and a finance lease is whether the risks and rewards of ownership have been substantially transferred to the lessee. ANS: T PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

14. Debentures are essentially the same as a long-term loan except that debentures are particular to limited companies and have a fixed interest rate. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

15. An entity that can only raise equity finance through one owner’s contributions and retained profits is a sole proprietorship. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

16. Partnerships may have more ability to raise equity finance than sole proprietorships, as partnerships tend to have more people to contribute funds, but limited companies have a wider range of equity options than partnerships. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

17. In an entity that is highly geared, the effect of a decrease in profits or an increase in interest rates will have a greater negative impact on returns to shareholders than it will on an entity that is not so highly geared. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

18. A choice between debt finance and equity finance will result in a trade-off between risk and return. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

19. A factoring company is a finance company that specialises in providing a service for the collection of payments from debtors. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

20. The principal sources of revenue for a factoring company are the interest earned on the finance provided and the fees for managing the collection of debt. ANS: T PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

21. The sole source of equity finance for a company is contributed equity. ANS: F PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

22. The notion of substance over form may result in certain types of preference shares being classified as debt not equity. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

23. Classifying preference shares as debt not equity, would alter the gearing (leverage) of a company. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

24. The mix of debt finance and equity finance for a given entity is known as gearing. ANS: T PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following terms best describes a firm-specific risk that an entity faces, as opposed to an industry-specific risk? A. Investment risk B. Financial risk C. Market risk D. Business risk

ANS: B TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

2. Working capital is: A. loan capital. B. total assets less total liabilities. C. current assets less current liabilities. D. quick assets less current liabilities. ANS: C PTS: 1 TOP: Short-term finance

3. The term ‘working capital’ is used to describe the: A. amount of equity (ownership) capital in the firm. B. portion of capital actively employed in generating revenues. C. amount of debt (borrowed) capital in the firm. D. cushion of current assets over current liabilities. ANS: D PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

4. Which of the following must be known in order to determine the firm’s total amount of working capital? Current assets A. Yes B. Yes C. No D. No

Current liabilities Yes No Yes No

ANS: A PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

5. What is the total working capital for the following company? Cash Debtors Creditors Land Equipment Long-term loan

$10,000 $40,000 $30,000 $100,000 $70,000 $40,000

A. $10,000 B. $20,000 C. $50,000 D. $150,000 ANS: B PTS: 1 TOP: Short-term finance

AACSB:

6. Which of the following is not an example of short-term finance? A. Trade credit B. Factoring

Knowledge, Analytical

C. Finance lease D. Bank overdraft ANS: C PTS: 1 TOP: Short-term finance

AACSB:

Knowledge, Analytical

7. An example of a source of medium-term finance is: A. hire purchase. B. debentures. C. factoring. D. equity finance. ANS: A PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

8. Which of the following is not a characteristic of a finance lease? A. It is generally non-cancellable. B. The lessee guarantees that the lessor will receive a specific residual value from the sale of the asset at the end of the lease term. C. It is like a rental agreement. D. The lessee has the right to use the leased asset. ANS: C PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

9. The major accounting difference between a finance lease and an operating lease is that finance leases: A. involve larger amounts of funds. B. are for longer periods of time. C. involve the recognition of assets and liabilities. D. are cancellable. ANS: C PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

10. When a firm leases a resource for most of its useful life and controls the resource as though it had been purchased, the lease is treated as: A. an operating lease. B. a finance lease. C. a primary lease. D. a producing lease. ANS: B PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

11. If a lessee enters into a finance lease agreement, it will record: A. an asset only. B. a liability only. C. an asset and a liability. D. an expense only. ANS: C PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

12. The Shifting Sands Company has negotiated to lease a piece of equipment. The equipment has a useful life of 10 years. The lease is non-cancellable but there is only a minor penalty if the lessee returns the equipment before the expiry of the lease. The lease terms provide that the lease is over five years and the present value of the minimum lease payments is 60% of the fair value of the asset at the commencement of the lease. Shifting Sands records the lease payments as an expense in the statement of comprehensive income. Based on this information, which of the following statements is correct? A. Assets and liabilities are understated as the lease should be a finance lease. B. Assets and liabilities are not affected as the lease is an operating lease. C. The non-cancellable nature of the lease determines that it should be a finance lease. D. There is insufficient information to determine whether the lease is a finance or an operating lease. ANS: B PTS: 1 TOP: Medium-term finance

AACSB:

Knowledge, Analytical

13. Raffles Ltd had retained profits of $10,000 on 1 January 20X7 and $30,000 on 31 December 20X7. If a profit of $60,000 was earned during the year, then the amount declared and/or paid in dividends during the period would be: A. $20,000. B. $30,000. C. $40,000. D. $50,000. ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

14. FF Ltd declared and paid $150,000 in dividends during 20X7. Closing retained profits at 31/12/X7 was $860,000. What was opening retained profits at 1/1/X7, if FF Ltd made a loss of $180,000 for the year ended 31/12/X7? A. $530,000 B. $860,000 C. $890,000 D. $1,190,000 ANS: D PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

15. When a holder of preference shares has the right to receive all previously omitted dividends before ordinary shareholders receive any dividends, the preferred share is known as: A. participating preferred. B. cumulative preferred. C. compensating preferred. D. ex post rights preferred. ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

16. A preference share is preferred because: A. it has a higher claim on dividends and assets than ordinary shares. B. it is preferred by shareholders as a potentially better investment. C. preferred shareholders have more voting rights than ordinary shareholders. D. it has a higher claim on assets in liquidation than creditors do.

ANS: A PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

17. Which of the following statements is incorrect? A. Preference shares usually have a fixed dividend and rate higher than ordinary shares in a situation where a company goes into liquidation. B. A redeemable preference share with a fixed redemption date is classified as equity. C. A non-redeemable cumulative preference share gives the right to be paid current or accumulated dividends before ordinary shareholders. D. A non-redeemable cumulative preference is normally classified as equity. ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

18. Which of the following statements is incorrect? A. A redeemable preference share that is redeemable by the holder is classified as equity if it is not probable that redemption will occur. B. A redeemable preference share with a fixed redemption date is classified as debt. C. Sole proprietorships, partnerships and limited companies can all raise equity finance from owners’ contributions but only limited companies can issue ordinary shares. D. A company distributes profits in the form of dividends, which is a reduction in retained profits, whereas distributions of profits by partnerships and sole proprietors are reductions in owners’ equity. ANS: A PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

The following information applies to questions 19 and 20. Kucinta Manufacturing Company started operations with the following capital: Partners’ contribution of cash Cash obtained from a group of creditors Loan obtained from the local bank

$25,000 $15,000 $5000

19. What is the amount of equity financing for this partnership? A. $30,000 B. $25,000 C. $45,000 D. $20,000 ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

20. What is the amount of debt financing for this partnership? A. $5000 B. $45,000 C. $20,000 D. $15,000 ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

21. When a company obtains financial resources from owners, it is termed: A. debt. B. operating.

C. equity. D. risk-free. ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

22. The following amounts of capital were obtained to start operations of Yuppie Manufacturing at the beginning of 20X8: Owners’ contribution of cash Owners’ contribution of machinery & equipment Loan from the owner

$80,000 46,000 18,000 $144,000

What is the amount of equity financing for this firm? A. $18,000 B. $62,000 C. $98,000 D. $126,000 ANS: D PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

23. Deep Lake Lodging Company was established at the beginning of 20X7 with the following capital: Partners’ cash contributions Cash obtained from a group of creditors Loan obtained from the local bank Total

$46,000 30,000 10,000 $86,000

What is the amount of equity financing for this firm? A. $10,000 B. $40,000 C. $46,000 D. $76,000 ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

24. Which of the following provide resources to an organisation in exchange for future returns? Owners A. No B. No C. Yes D. Yes

Creditors Yes No Yes No

ANS: C TOP: Chapter 10

PTS: 1

AACSB:

Knowledge, Analytical

25. Which type of shares has a higher claim on dividends and assets than ordinary shares? A. Voting B. Preference C. Senior D. Favoured

ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

26. Which of the following represent capital that has been earned by the profitable operation of a company? Paid-in capital A. Yes B. Yes C. No D. No

Retained profits Yes No Yes No

ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

27. Retained profits can best be described as: A. cash receipts minus expenses after adjustments. B. net profit minus expenses after adjustments. C. undistributed profits. D. net profit minus cash disbursements after adjustments. ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

28. The term ‘retained profits’: A. is representative of the cash that the corporation has available to pay dividends as of the balance sheet date. B. is found among the assets on the balance sheet of any profitable corporation. C. refers to an item whose value is always as large as, or larger than, that of cash on the balance sheet. D. refers to an account balance found on the balance sheet of a corporation that has paid dividends of lesser amount than profits since the beginning of the corporation. ANS: D PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

29. Wilmington Fisheries had a Retained Profits account balance on 1 January 20X2 of $12,000. During 20X2, the firm had net profit of $7200 and paid a $3600 cash dividend. What is the 31 December 20X2 Retained Profits balance? A. $12,200 B. $15,600 C. $19,600 D. $21,200 ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

30. Dividends on ordinary shares are: A. expensed when paid. B. expensed when incurred. C. expensed at year end. D. a reduction of retained profits. ANS: D PTS: 1 TOP: Long-term finance

31. Blue Nose Cold Storage Company was incorporated on 1 January 20X5. Since then, the following shares have been issued: Preference shares, 5%, $25 Ordinary shares, $20

8000 shares 10,000 shares

On 31 December 20X7, the company declared and paid a total of $50,000 in dividends. This was the first dividend declared by the firm. That is, until this date no dividends had been declared or paid during the first two years of operations. If the preference shares are cumulative, what is the most that will be available out of the $50,000 dividend for payment to the ordinary shareholders? A. $20,000 B. $30,000 C. $40,000 D. $50,000 ANS: A PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

32. Identify the correct statement below. A. Bank overdrafts are classified as long-term loans in Australia. B. Commitments are disclosed on the statement of comprehensive income because they affect net profit but not cash flow. C. Finance leases are accounted for as if the leased items had been purchased. D. The expense associated with operating leases is reported on the cash flow statement under the category of investing activities. ANS: C TOP: Chapter 10

PTS: 1

AACSB:

Knowledge, Analytical

33. A shareholder makes an investment in a company. The net effect of this contribution is an increase in: A. share capital only. B. both assets and share capital. C. both assets and liabilities. D. both liabilities and share capital. ANS: B PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

34. Davis Computer Company has total liabilities of $50,000, total assets of $280,000 and paid-up capital of $120,000. What is the amount of retained earnings and/or reserves? A. $20,000 B. $110,000 C. $140,000 D. $160,000 ANS: B PTS: 1 TOP: Long-term finance

AACSB:

35. The sources of equity finance for a company are: A. contributed equity. B. retained profits. C. general reserves. D. all of the above.

Knowledge, Analytical

ANS: D PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

36. Where preference shares are redeemable at the discretion of the issuer, and shareholders have not been advised of the company’s intention to redeem the shares: A. meet the definition of a liability. B. represent debt. C. are recognised as equity. D. are recognised as a financial liability. ANS: C PTS: 1 TOP: Long-term finance

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Describe the nature and importance of working capital to a business entity. ANS: Working capital is represented by the excess of currents assets over current liabilities; and is the basis of funding the day-to-day operations of an entity. Thus, it is an important determinant of solvency. PTS: 1 AACSB: TOP: Short-term finance

Knowledge, Analytical

2. Describe the nature of trade credit, factoring and bank overdrafts as sources of short-term finance. ANS: Trade credit refers to the short-term funding of goods (services) by the suppliers of the goods (services). The period of time involved and amount of credit depends on a number of factors, including the terms of trade of the industry, the creditworthiness of the business and its importance to the supplier. Factoring refers to the realisation of accounts receivable prior to the due date through a third-party factoring entity who assumes responsibility for collecting the accounts receivable when they accrue. The factoring entity charges interest for the service, based on the finance provided, and a fee for managing the collection of the receivables. A bank overdraft is a financing facility that may be drawn upon, up to a certain amount, to meet the needs of the borrower as and when required. Interest is only charged when the facility is used. PTS: 1 AACSB: TOP: Short-term finance

Knowledge, Analytical, Communication

3. Describe the nature and major sources of equity finance. ANS: Equity finance is long-term permanent finance associated with the ownership of a business entity. The two major sources of the finance are contributed equity and retained profits. PTS: 1 AACSB: TOP: Long-term finance

Knowledge, Analytical

4. Distinguish between an operating lease and a finance lease and describe how the separate classes of lease are accounted for in the books of the lessee. ANS: An operating lease is a strict rental agreement. A finance lease, on the other hand, arises where leasing is used as a means of financing the ‘acquisition’ of the asset concerned. Where a lease is classified as an operating lease, the lease instalments are simply treated as expenses to the lessee. However, where a finance lease is involved, the lessee is required to recognise, at the inception of the lease, an asset and liability equal to the present value of the minimum lease payments*; all future lease instalments are separated between interest and principal; and the leased asset is amortised. *

Note: AASB 117 Leases, provides for the measurement of the asset (liability) at the fair value of the asset, or, if lower, the PV of the minimum lease payments, each determined at the inception of the lease. PTS: 1 AACSB: TOP: Medium-term finance

Knowledge, Analytical, Communication

5. Explain the concept of leverage. Why is this concept important for management? ANS: Leverage is the practice of using borrowed funds and amounts received from preferred shareholders in an attempt to earn an overall return that is higher than the cost of these funds. This is important because the total return should be larger than the cost. PTS: 1 AACSB: Knowledge, Analytical TOP: Financing structures and financial risk 6. Why do companies manage their working capital? ANS: Companies manage their working capital because they want to keep an appropriate amount on hand. This means that they want to have enough on hand to finance their day-to-day operations plus have a reserve on hand for the unexpected. If a company has too little working capital it risks not having enough liquidity. If a company has too much working capital the company risks not putting its assets to their best use, resulting in decreased profitability. PTS: 1 AACSB: TOP: Short-term finance

Knowledge, Analytical, Communication

PROBLEM 1. On 1 January 20X3, the Harglo Construction Company leased a bulldozer from ASIS Sales Corporation. The lease meets the criteria for classification as a finance (capital) lease and requires Harglo to make annual payments of $30,000 at the end of each of the next 10 years with the first payment due on 31 December 20X3. The present value of the lease payments is $200,000 based on an interest rate of 8%. How would the lessee record: (a) The inception of the lease on 1 January 1 20X3?

(b) The first lease payment on 31 December 20X3? (c) Depreciation on the bulldozer for 20X3, assuming the straight-line method is used over the life of the lease, and zero residual value? ANS: (a) Increase Leased Property by $200,000 and increase Obligation Capital Lease by $200,000 to record acquisition of bulldozer under lease from AIS Sales Corporation. (b) Increase Interest Expense by (8%  $200,000) $16,000, decrease Capital Lease Obligation by $14,000, and decrease Cash by $30,000 to record lease payment for bulldozer. (c) Increase Amortisation Expense by [($200,000 – 0)/10] $2000 and increase Accumulated Amortisation: Leased Property by $20,000 to record annual amortisation on leased bulldozer. PTS: 1 AACSB: TOP: Medium-term finance

Knowledge, Analytical

2. On 1 March 20X3, the Red Dour Inn Company purchased a motel for $1,000,000, paying 25% in cash and financing the remainder with a 20-year, 12% mortgage that requires monthly payments of $8258.14. How would the Red Dour Inn record: (a) The acquisition of the building on 1 March 20X3? (b) The first mortgage payment on 1 April 20X3? (c) The second mortgage payment on 1 May 20X3? ANS: (a) Increase Motel by $1,000,000.00, decrease Cash by (1,000,000  25%) $250 000.00, and increase Mortgage Payable by $750,000.00 to record purchase of motel with $250,000 cash payment and a 20-year, 12% mortgage. (b) Increase Interest Expense by ($750,000  1%) $7500.00, decrease Mortgage Payable by ($8258.14 – $7500.00) $758.14, and decrease Cash by $8258.14 to record monthly mortgage payment. (c) Increase Interest Expense by [($750,000 – $758.14)  1%] $7492.42, decrease Mortgage Payable by ($8258.14 – $7492.42) $765.72, and decrease Cash by $8258.14 to record monthly mortgage payment. PTS: 1 AACSB: TOP: Long-term finance 1

Knowledge, Analytical

CASE 1. The following is an excerpt from a 2002 press release by the US corporation, Pacific Gas and Electric (PG&E). Accounting for PG&E NEG Synthetic Leases The Corporation announced on Feb. 21 that it was initiating a thorough review of the accounting treatment of several synthetic leases used to finance power plant development at the PG&E NEG (National Energy Group). The review confirmed that payments to the independent equity owners during construction reduced the investor’s equity below the minimum requirement to maintain these leases off balance sheet. As a result, the Corporation’s statements now include these financings on balance sheet. The change in accounting treatment resulted in no restatement of prior year earnings, a less than $1 million impact on earnings for the fourth quarter 2001, an increase in total assets and liabilities of $118 million in 1999, $861 million in 2000, and $1.058 billion in 2001. Additional information Synthetic leases involve the use of a special purpose entity (SPE) who holds title to the asset(s) (in this instance, power plants) and raises the debt to finance the assets. The assets are then leased to a single lessee – here, PG&E. The accounting objective of synthetic leases is to finance the acquisition of an asset and at the same time keep the corresponding debt off the balance sheet of the acquiring company. The SPE typically leases the property to the lessee at rates below those of a traditional lease. Prior to 31 January 2003, the presumption in favour of consolidating an SPE could be avoided if the following two conditions were met: (i) there was an minimum acceptable outside equity investment in the SPE. The SEC determined, minimum acceptable outside equity investment was 3% of total capital; and (ii) the independent owner had control over the SPE. Control was defined as a majority voting interest. The independent equity owner in the case of PG&E was an independent third-party lessor. Required: Discuss the accounting and ethical issues involved in the case. ANS: The issues that may be discussed include the following: Accounting issues: • broadly, the accounting issues concern the strategy of keeping debt off balance sheet, and the consequences of doing so for the various stakeholders involved. • Favourable financial consequences for shareholders of PG&E include: the cost savings associated with the reduced leasing fees – which is obviously acceptable to the independent equity holder; the reduced cost of capital that might ensue from PG&E’s lower leverage level; avoidance of any adverse economic consequences that might ensue from existing debt contracts in the event that the debt was brought on balance sheet. • With respect to the issue of consolidation, the practice was within USGAAP at the time, subject to the consolidation conditions being met. • The implications of the synthetic lease arrangement, per se, for the decision-usefulness criterion of general purpose reporting by PG&E. The decision usefulness criterion is underpinned by the first principles – substance over form,

relevance and reliability. From the perspective of the decision-usefulness basis for consolidation and accounting for leases, these principles were ‘defined’, in this instance, by regulation. • The issue of transparency (disclosure) for all concerned. Ethical issues: • Debtholders: off balance sheet financing may hold adverse consequences for debtholders, where transparency does not prevail. Adverse consequences for debtholders favour shareholders. This issue may elicit discussion concerning the question of whether management’s first duty is to shareholders; and the broader issue of self-interest as a fundamental attribute of market economies/capitalism. • Evaluating PG&E management’s actions in terms of good and bad consequences reflects a utilitarian approach to ethics. • The actions of management may be evaluated from a deontological perspective. • A lack of transparency prevailed when the leases were left off balance sheet i.e., when conditions for doing so no longer prevailed? This raises the question of the role of the external auditor in this matter. PTS: 1 AACSB: TOP: Medium-term finance

Knowledge, Analytical, Ethics

Chapter 11 – Internal control of cash, statement of cash flows and other issues TRUE/FALSE 1. Investing all cash to maximise returns to the business is a more effective management of cash than ensuring cash is available to pay debts as they fall due. ANS: F PTS: 1 TOP: Cash and cash equivalents

AACSB:

Knowledge, Analytical

2. Instead of paying cash for the purchase of land and buildings, an entity issued shares in exchange. This transaction would be correctly reflected as an investing activity on the cash flow statement. ANS: F PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

3. The most common classification for interest paid and received on a cash flow statement is under operating activities. ANS: T PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

4. When calculating the net cash flows from operating activities, an increase in debtors needs to be subtracted from the profit figure. ANS: T PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

5. An increase in debtors and an increase in inventory will need to be subtracted from operating profit in the calculation of net cash flows from operating activities. ANS: T PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

6. Depreciation is an arbitrary allocation of the cost of an asset and as such it is not a cash item and is not reported on the cash flow statement, but it still needs to be deducted from operating profit in the calculation of net cash flows from operating activities. ANS: F PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

7. Dividends received are most commonly classified as an operating activity, but dividends paid are normally classified as a financing activity on the cash flow statement. ANS: T PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

8. On a cash flow statement, the payment of taxation is considered an operating activity and the payment of dividends is normally classified as a financing activity. ANS: T PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

9. Where a parent entity is required to prepare consolidated accounts, it can only consolidate those subsidiaries that it controls. ANS: T PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

10. With regard to an economic entity, control is established when one entity has the power to govern the financial or operating policies of another entity. ANS: F PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

11. When preparing consolidated financial statements, it is necessary to eliminate inter-company income and expense transactions. ANS: T PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

12. Eliminating the Investment in Subsidiary account from the books of the parent entity and the Shareholders’ Equity account in the subsidiaries books allows the net assets of the parent and the subsidiary to be combined to represent the net assets of the economic entity. ANS: T PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

13. A company’s taxable income is the amount of profit determined by the tax commissioner on which the current income tax liability is determined. ANS: T TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

14. Temporary differences occur when an income or expense item enters into the calculations of accounting profit and taxable income in different periods. ANS: T TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

15. Given a situation in which a company depreciates an asset using the straight-line method, but the tax rules stipulate that the asset should be depreciated using the reducing-balance method, this will, under normal circumstances, initially give rise to a future tax benefit to the entity. ANS: F TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

16. Tax expense is the amount an entity remits to the tax department, and is determined by adjusting the tax-payable figure for increases/decreases in deferred tax payable. ANS: F TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

17. If taxable income is $120,000, accounting profit is $130,000, interest receivable is $10,000, interest is recognised for tax when received and the tax rate is 40%, then we know that tax payable is $48,000, tax expense is $52,000 and a deferred tax liability of $4000 will be recorded in the balance sheet. ANS: T TOP: taxation

PTS: 1

AACSB:

Knowledge, Analytical

18. If taxable income is $220,000, accounting profit is $200,000, interest payable is $20,000, interest is recognised for tax when paid and the tax rate is 40%, then we know that tax payable is $88,000, tax expense is $80,000 and a deferred tax asset of $8000 will be recorded in the balance sheet. ANS: T TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

19. Accounting for income tax gives rise to temporary differences, which arise when the tax value and the carrying value of assets and liabilities differ. ANS: T TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

20. Income tax is considered to be a direct tax, whereas the goods and services tax is a value-added tax and as such is an indirect tax. ANS: T PTS: 1 TOP: Goods and services tax

AACSB:

Knowledge, Analytical

21. In relation to a goods and services tax, when an entity has higher taxable sales than taxable acquisitions, then the entity will recognise a liability to the Australian Tax Office. ANS: T PTS: 1 TOP: Goods and services tax

AACSB:

Knowledge, Analytical

22. Where a goods and services liability exceeds the goods and services asset, the difference will be the amount the entity is owed by the Australian Tax Office. ANS: F PTS: 1 TOP: Goods and services tax

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following would be considered the least effective management of cash? A. Protect cash and ensure cash is available to pay debts as they fall due. B. Protect cash and enable accurate reporting of cash. C. Enable accurate reporting of cash D. Ensure cash is available to pay debts as they fall due and allow idle cash to be invested. ANS: C PTS: 1 TOP: Cash and cash equivalents

AACSB:

Knowledge, Analytical

2. A cashier is employed at the Square Eyes Movie Theatre Complex in downtown Flatscreen. The cashier is responsible for the collection of cash in return for issuing a movie ticket, including acceptance of payment for tickets on credit card and by discount vouchers. While credit sales and full cash payments are recorded on the computer at the time of sale, the vouchers received need to be cross-checked with the discounted tickets recorded on the computer at the time of sale. This procedure is carried out at the end of every week by an employee of the company, but not by the cashier, who has argued that it would be more efficient for the cross-check to be done at the end of every day by the cashier who has issued the discounted tickets, as that person would be most familiar with what tickets had been sold. Based on this information, which of the following statements is correct regarding the current procedure? A. It is an inefficient use of time and staff resources. B. It shows a lack of trust of the cashier. C. It effectively separates individual responsibilities. D. It prevents the cashier from stealing cash. ANS: C PTS: 1 TOP: Cash and cash equivalents

AACSB:

Knowledge, Analytical

3. Cash flows from operating activities is a negative amount. From this fact you know that: A. the company’s cash balance decreased during this period. B. the company’s cash flows from operations are less than its net profit. C. the company’s operations used more cash resources than they generated. D. the company’s accounts receivable balance is increasing quickly. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

4. Activities that obtain funds from investors and creditors to start and sustain a business are called: A. reporting activities. B. investing activities. C. financing activities. D. operating activities. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

5. The methods an organisation uses to obtain financial resources from financial markets and the ways in which it manages those resources are: A. operating activities. B. financing activities. C. investing activities. D. marketing activities. ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

6. Which of the following is not one of the items reported on a cash flow statement? A. Reporting activities B. Operating activities C. Financing activities D. Investing activities ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

7. The cash flow statement is designed to fulfil all of the following purposes except: A. to predict cash flows. B. to evaluate employee performance. C. to relate net profit to changes in cash. D. to evaluate firm performance. ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

8. Which of the following best describes the purpose of the cash flow statement? A. To identify the cash balance at the end of the year B. To report the inflows and outflows of cash. C. To balance current period revenues with those of the previous period. D. To report assets, liabilities and owners’ equity as of a specific date. ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

9. Which of the following is a fundamental purpose of the cash flow statement? To report the To report the inflows of cash outflows of cash A. Yes Yes B. Yes No C. No Yes D. No No ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

10. The cash flow statement is designed to report: A. how the previous period’s statement of comprehensive income relates to the current period’s statement. B. only the sources and uses of cash during the current period. C. the cash from operating, financing and investing activities of the firm during the current period. D. the effects of the current period’s statement of comprehensive income on the current period’s balance sheet. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

11. Which financial statements cover a period of time? A. Statement of comprehensive income and balance sheet. B. Balance sheet and cash flow statement. C. Statement of comprehensive income and cash flow statement. D. Cash flow statement and statement of assets, liabilities and owners’ equity. ANS: C TOP: General

PTS: 1

AACSB:

Knowledge, Analytical

12. Joyce Ltd had cash sales of $80,000 in January. Accounts Receivable decreased by $10,000 during January and there were no credit sales and no bad debts. How much cash was collected from customers in January? A. $60,000 B. $70,000

C. $80,000 D. $90,000 ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

13. Sales on credit for the year totalled $125,000. The following information is also available: Accounts Receivable balance Beginning of year $25,000 End of year 30,000 Bad debts written off during the year: $10,000 How much cash was collected from customers during the year? A. $70,000 B. $130,000 C. $110,000 D. $155,000 ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

14. Car Locks Company reported 20X2 sales of $640,000. The following information is also available: Accounts Receivable balance Beginning of year $80,000 End of year 50,000 Bad debts written off during the year: $40,000 On a cash flow statement (direct format), what amount would be reported for ‘Cash collected from customers’ for the year? A. $510,000 B. $630,000 C. $610,000 D. $720,000 ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

15. Which of the following has a different effect on net profit than it does on cash flow? A. Payment for wages B. Cash sale to customer C. Amortisation of a patent D. Payment for rent ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

16. O’Reilly, Inc., had the following transactions during the month of July: 1. Sold merchandise for $50,000 cash 2. Paid wages of $3000 3. Sold equipment for $10,000 4. Paid $6000 cash for utilities What was the cash flow from operating activities?

A. $51,000 B. $41,000 C. $47,000 D. $54,000 ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

17. The following information is given for Ollufsen Co. Ltd for 20X2: Net profit Depreciation expense Gain on sale of non-current assets Decrease in inventory Acquisition of building Cash received on loan receivable Increase in loans payable Increase in accounts payable Loan made to another company Proceeds from sale of plant assets

Knowledge, Analytical

30,000 4000 6000 1000 4000 3500 2000 800 2500 40,000

From this information, what is the net cash inflow from operating activities for 20X2? A. $29,800 B. $35,800 C. $43,000 D. $69,000 ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

18. The following information is given for Ollufsen Co. Ltd for 20X2: Net profit Depreciation expense Gain on sale of non-current assets Decrease in inventory Acquisition of building Payment of dividends Cash received on loan receivable Increase in loans payable Increase in accounts payable Loan made to another company Proceeds from sale of plant assets

Knowledge, Analytical

30,000 4000 6000 1000 4000 1200 3500 2000 800 2500 40,000

From this information and assuming dividends paid are treated in financing, what is the net cash inflow from financing activities for 20X2? A. $2000 B. $1800 C. $1200 D. $800 ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

19. In 20X8, Price Pty Ltd collected $80,000 from customers, paid wages to employees of $10,000, and received dividends of $12,000. What was the net cash flow from operating activities for 20X8?

A. $58,000 B. $70,000 C. $80,000 D. -$12,000 ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

20. The following information is extracted from a set of financial statements: Opening balance Closing balance Cash $16,000 $20,000 Debtors 10,000 15,000 Creditors 24,000 25,000 Inventory 30,000 35,000 Sales 0 50,000 Cost of goods sold 0 30,000 The net cash flow from operating activities based only on the above information is: A. $11,000 B. $20,000 C. $29,000 D. $33,000 ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

21. The Hambone Soup Store reported the following information for its most recent fiscal year: Accounts payable increased by $39,000; inventory decreased by $27,000; net profit was $66,000; and depreciation expense was $15,000. On the cash flow statement, net cash flow from operating activities should be reported at: A. $15,000. B. $69,000. C. $117,000. D. $147,000. ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

22. Which of the following is subtracted from net profit to arrive at cash from operations? A. Depreciation B. An increase in wages payable C. An increase in prepaid rent D. A decrease in accounts receivable ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

23. Use the following information to calculate the cash from operating activities: Net profit $3308 Depreciation expense 712 Increase in accounts receivable 500 Decrease in inventory 640 Increase in accounts payable 132 Decrease in wages payable 75

Decrease in income tax payable

140

A. $2797 B. $4077 C. $4243 D. $5077 ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

24. At the end of April 20X7, the Blue Water Company sent out statements to customers for April charges totalling $100,000. During April, the company received $85,000 from customers for water bills incurred during March. Blue’s employees earned $35,000 during April, but by month end only $30,000 had been paid. Determine the net cash flow from operations and net profit from operations for the month of April. Net profit Net cash flow A. $65,000 $85,000 B. $70,000 $55,000 C. $65,000 $55,000 D. $50,000 $70,000 ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

25. Which of the following would be considered a cash inflow or outflow from investing activities? A. Purchase of shares in another company. B. Payment of an overdue creditors account. C. Interim dividend declared and paid. D. Loan interest paid. ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

26. You are considering starting a new business. In general, which of the following types of activities would have to occur before operating activities could begin? Investing activities Financing activities A. Yes Yes B. Yes No C. No Yes D. No No ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

27. Which of the following statements is correct concerning investing activities? A. They involve obtaining and managing financial resources. B. They use financial resources to acquire items to sell in the normal course of activities. C. They use financial resources to acquire the assets a company needs to produce and sell its products. D. They involve buying and selling a company’s own shares. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

28. The receipt of dividends on an investment will be reported in a cash flow statement as: A. a cash outflow for financing activities.

B. a cash inflow for investing activities. C. a cash inflow from operating activities. D. either B or C ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

29. Which of the following events is properly classified as an investing activity? A. Purchase of equipment. B. Borrowing money from creditors. C. Selling goods to customers. D. Running the factory. ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

30. Which of the following is a cash flow from an investing activity? A. Payment for advertising. B. Cash receipt from a customer for a previous credit sale. C. Cash received from sale of equipment. D. Payment of dividends. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

31. Which of the following is an investing activity? A. Purchase of a patent. B. Payment of cash dividends. C. Payment of interest. D. Purchase of inventory. ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

32. Cash received from the sale of long-term assets is reported as: A. operating activities. B. financing activities. C. an adjustment to shareholders’ equity. D. investing activities. ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

33. Activities that involve the production or delivery of goods for sale or the providing of services for sale should be listed under which classification on a cash flow statement? A. Operating activities B. Investing activities C. Financing activities D. Refunding activities ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

34. Activities that obtain funds from investors and lenders to start and sustain a business are called: A. reporting activities. B. investing activities.

C. financing activities. D. operating activities. ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

35. What type of activity is the paying off of a bank loan? A. Operating B. Financing C. Investing D. Either A or B ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge

36. Which item would be included in cash flows from financing activities? A. Payments to suppliers B. Receipts from customers C. Repayment of loan D. Purchase of a non-current asset ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

37. Which item would not be included in cash flows from operating activities? A. Salaries paid B. Cash proceeds from disposal of a non-current asset C. Cash sales D. Receipts from customers ANS: B PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

38. Which of the following would not normally be classified as an operating activity on a cash flow statement? A. Dividends received B. Interest received C. Dividends paid D. Interest paid ANS: C PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

39. Payments to employees would be classified on the cash flow statement as a(n): A. operating activity. B. investing activity. C. financing activity. D. operating expense. ANS: A PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

40. In 20X7, North Lakes Co. Ltd purchased machinery for $20,000, loaned $8000 to another company, borrowed $4000, and sold investments for $10,000. What was the net cash flow from investing activities for 20X7? A. $(20,000)

B. $(28,000) C. $(24,000) D. $(18,000) ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

41. Big Deals, Inc., had the following cash flows during March: Paid for inventory $2000 Paid wages to employees 4000 Received from cash sales 10,000 Paid for equipment 6000 Received a loan 7000 What was the cash flow from investing activities? A. $5000 inflow B. $8000 outflow C. $12,000 outflow D. $6000 outflow ANS: D PTS: 1 TOP: The statement of cash flows

AACSB:

Knowledge, Analytical

42. Which of the following statements regarding consolidated accounts and economic entities is incorrect? A. An economic entity consisting of a parent and subsidiaries is a separate legal entity having the legal rights and obligations of a company. B. For an entity to be considered a subsidiary, the parent entity must control both the financial and operating policies of the subsidiary. C. Consolidated accounts are prepared by combining similar accounts of the parent entity and its subsidiaries after eliminating inter-company transactions. D. Consolidated accounts display the operations of the parent entity and all of its controlled entities. ANS: A PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

43. A controls B and B controls C. During 20X7, C sold $100 of goods to A, $90 to B and $2000 to other parties. B sold $100 of goods to C and $500 to other parties (not including A). A sold goods of $50 to B, $300 to outside parties. What is the total revenue reported by C? A. $90 B. $190 C. $2000 D. $2190 ANS: D PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

44. A controls B and B controls C. During 20X7, C sold $100 of goods to A, $90 to B and $2000 to other parties. B sold $100 of goods to C and $500 to other parties (not including A). A sold goods of $50 to B, $300 to outside parties. What is the total consolidated revenue for 20X7? A. $340 B. $2500

C. $2800 D. $3140 ANS: C PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

45. When preparing consolidated accounts for a parent company and a subsidiary company, the eliminations are made to: A. the investment account. B. the intercompany sales. C. inter-company debtors and creditors. D. all of the above. ANS: D PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

46. Consolidated financial statements are prepared only when: A. the parent and subsidiary companies are in the same industry. B. the parent and subsidiary companies are operating as totally separate entities. C. the parent controls the subsidiary company. D. the parent owns 50% of the subsidiary company. ANS: C PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

47. Consolidated financial statements: A. report the combined economic activities of two or more corporations owned by the same shareholders. B. report to ASIC a shortened version of financial statements reported to the public. C. report the combined financial statements of only controlled entities that are 100% owned. D. report the combined financial statements of only entities where the parent owns more than 50% of the voting shares.. ANS: A PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

48. Consolidated statements encompass the principle that: A. a company cannot have a debt to itself. B. an entity’s ownership of its own shares is neither an asset nor shareholders equity. C. all companies in a group are viewed as a single economic entity. D. All of the above are correct. ANS: D PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

49. A Ltd and B Ltd are parent and subsidiary companies within a group. A Ltd has accounts receivables of $30,000 and B Ltd has accounts receivables of $20,000. Of B Ltd’s receivables, $5000 is a receivable from A Ltd. The consolidated balance sheet should show accounts receivable of: A. $20,000 B. $20,000 C. $45,000 D. $50,000 ANS: C PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

50. The Accounts Receivable balances of a parent company and its two controlled entities are as follows: P1 Co. S1 Co. S2 Co. Accounts Receivable $100,000 $20,000 $30,000 If all of S1 Co.’s credit sales are to S2 Co., then what is the amount of Accounts Receivable on the consolidated balance sheet? A. $100,000 B. $120,000 C. $130,000 D. $150,000 ANS: C PTS: 1 TOP: Consolidated accounts

AACSB:

Knowledge, Analytical

51. Which of the following statements regarding tax-effect accounting is incorrect? A. The tax-effect method of accounting for income tax determines that temporary differences may arise, resulting in the recognition of either a liability or an asset. B. The tax-effect method for calculating income tax expense is where the taxable income is multiplied by the tax rate. C. A tax loss can only be carried forward as a future tax benefit if it is probable that the entity will earn taxable income in the future. D. A deferred tax liability will occur where taxable income is less than accounting profit in the current period. ANS: B TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

52. AKP Ltd uses the accrual-basis method of accounting for accounting profit. In the current accounting period, they have recognised income for interest not yet received. Taxable income is determined on a cash basis. Based on this information, which of the following statements is correct? A. Taxable income will be greater than accounting profit, and will give rise to a deferred tax liability. B. Taxable income will be less than accounting profit, and will give rise to a deferred tax liability. C. Taxable income will be greater than accounting profit, and will give rise to a deferred tax benefit. D. Taxable income will be less than accounting profit, and will give rise to a deferred tax benefit. ANS: B TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

53. AKP Ltd depreciates a non-current asset using the straight-line method. Tax law stipulates that the asset should be depreciated using the reducing-balance method at 1.5 times the straight line rate. Under normal circumstances, which of the following statements is correct? A. After year 1, the tax base of the asset exceeds the accounting base and will give rise to a deferred tax liability. B. After year 1, the tax base of the asset is less than the accounting base and will give rise to a deferred tax liability. C. After year 1, the tax base of the asset exceeds the accounting base and will give rise to a deferred tax asset. D. After year 1, the tax base of the asset exceeds the accounting base and will give rise to a tax asset. ANS: B TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

54. Sporter Enterprises has incurred a tax loss in the current period. Under tax law, which of the following statements is not correct? A. A deferred tax asset can be recognised if it is probable that Sporter will earn taxable income in the future. B. Assuming all relevant tax laws have been adhered to, Sporter can carry the loss forward to reduce taxable income in future periods. C. A deferred tax liability is created, as Sporter will have to pay tax on taxable income in the future. D. Sporter cannot carry the loss forward as a deferred tax asset if is probable that future taxable income will not be earned. ANS: C TOP: Taxation

PTS: 1

AACSB:

Knowledge, Analytical

55. In following the trail of a woollen coat sold to a customer for $525, it was determined that the bale of wool from which the coat was made was sold by a farmer to a manufacturer for $80, and the manufacturer produced the coat and on-sold it to a wholesaler of garments, charging $150. The wholesaler then charged a retailer $200. Assuming that GST is still to be calculated at 10% on each of the above transactions, which of the following statements is incorrect? A. The farmer will remit $8 and the manufacturer $7 to the ATO at the end of the period. B. The total amount of GST that will be paid to the ATO is $52.50, which is the amount the retailer will remit to the ATO. C. The wholesaler will remit $5 to the ATO and has recorded $20 as a liability. D. Assuming no other expenses, the retailer made a profit of $272.50 on the sale of the coat. ANS: B PTS: 1 TOP: Goods and services tax

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Briefly describe what information is contained in the Statement of Cash Flows ANS: The cash flows from operating activities section lists the cash received and paid in selling products or performing services. The cash flows from investing activities section lists the cash received and paid for assets such as property, plant and equipment. The cash flows from financing activities section lists the cash received and paid for borrowings and owners’ equity. This information is combined to show the net change in cash for the period.

PTS: 1 AACSB: TOP: The statement of cash flows

Knowledge, Analytical, Communication

2. Why is the statement of cash flows important? ANS: It shows the changes in a company’s cash during an accounting period by listing the cash inflows and outflows from its operating, investing, and financing activities during the period. The statement provides information about a company’s ability to remain solvent, and pay its bills. It summarises the cash activities during the period, and provides information that cannot be obtained from the statement of comprehensive income or the balance sheet. It is possible for an entity to have a profit and yet have cash flow problems which are highlighted in the statement of cash flows. Conversely an entity may have incurred a loss but still have cash available. PTS: 1 AACSB: TOP: The statement of cash flows

Knowledge, Analytical, Communication

3. How is the statement of cash flows organised? ANS: The statement is organised into three sections: operating activities, investing activities, and financing activities. Operating activities include buying, selling, and delivering goods for sale, as well as providing services. Investing activities include lending money and collecting on the loans, investing in other companies, and buying and selling property, plant and equipment. Financing activities include obtaining capital from the owner and providing the owner with a return on the investment, as well as obtaining capital from creditors and repaying the creditors. PTS: 1 AACSB: TOP: The statement of cash flows

Knowledge, Analytical, Communication

4. Consolidated general purpose reports are prepared where one company controls another company. What is meant by the term ‘control’ under those circumstances? ANS: Control refers to the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. PTS: 1 AACSB: TOP: Consolidated accounts

Knowledge, Analytical

5. Which duties associated with handling and accounting for cash should ideally be separated in order to promote the internal control of the asset? ANS: • The duties of receiving and paying cash. • The duties of recording cash receipts and cash payments • Handling cash and recording cash. • The approval of cash payments and the authorisation of the payments. PTS: 1 AACSB: TOP: Cash and cash equivalents

Knowledge, Analytical

PROBLEM 1. (a) Classify the following transactions according to whether they relate to operating, investing or financing activities or none of those categories for the purposes of preparing a statement of cash flows. 1.

Received cash of $14,000 from the sale of equipment previously used in carrying out the entity’s operations. 2. Paid cash of $11,000 to accounts payable for inventory previously purchased on credit. 3. Received $45,000 cash from accounts receivable. 4. Paid cash dividends to shareholders $54,000. 5. Issued shares in exchange for land $105,000. 6. Paid insurance in advance $9000 cash. 7. Purchased vehicles for use in the business for $48,000 cash. 8. Deposited $12,000 into a short-term deposit, redeemable at call. 9. Issued $85,000 in shares in exchange for cash. 10. Borrowed $40,000 in cash repayable in five years. (b) Calculate the cash flow from operating activities based on the foregoing 10 transactions. ANS: (a) Operating

2. 3. 6.

Investing

1. 7.

Financing

4. 9. 10.

Non investing and financing transaction 5.

Movement within cash and cash equivalents 8

(b) Cash inflow Acs receivable

45,000

Cash outflow Acs payable Insurance

11,000 9000

Net cash flow from operating activities

25,000

PTS: 1 AACSB: TOP: The statement of cash flows

Knowledge, Analytical

2. The following information about Thompson Corp. applies to the entity for the year ended 30 June 20X7. Payment to suppliers $150,000 Receipts from owners 405,000 Receipts from long-term borrowing 250,000 Payment of rates 130,000 Payment of wages 125,000 Purchase of other companies’ shares 80,000

Retirement of long-term borrowing Receipts from customers Payment for equipment Depreciation on equipment Average total assets

165,000 500,000 190,000 90,000 1,200,000

(a) What was Thompson Corp.’s cash flow from operating activities? (b) What was Thompson Corp.’s cash flow from investing activities? (c) What was Thompson Corp’s cash flow from financing? ANS: (a) Cash flow from operations: Receipts from customers Payment to suppliers Payment of rates Payment of wages

$500,000 -150,000 -130,000 -125,000 $95,000

(b) Cash flow from investing: Purchase of other companies’ shares Payment for equipment

$(80,000) (190,000) $(270,000)

PTS: 1 AACSB: TOP: The statement of cash flows

$405,000 250,000 -165,000 $490,000 Knowledge, Analytical

3. Following are the balance sheets of Valentine Ltd and Saint Pty Ltd as at 30 June 20X7. On 1 October 20X6, Valentine purchased all of the issued shares of Saint for $125,000. At 30 June 20X7 Saint owed Valentine $6000 which forms part of the accounts payable and receivable of the respective companies. Balance sheets Valentine Ltd Saint Pty Ltd Current assets Cash at bank Accounts receivable Other Total current assets

13,000 28,000 22,000 63,000

9000 14,000 9000 32,000

Non-current assets Property, plant & equipment Investment in Saint Pty Ltd Total non-current assets

260,000 125,000 385,000

120,000 ---------120,000

TOTAL ASSETS

448,000

152,000

Current liabilities Accounts payable Total current liabilities Non-current liabilities Borrowings Total non-current liabilities

32,000 32,000

11,000 11,000

210,000 210,000

16,000 16,000

242,000

27,000

206,000

125,000

TOTAL LIABILITIES NET ASSETS Shareholders’ equity Share capital Retained profits Total shareholders’ equity

160,000 100,000 46,000 25,000 206,000 125,000 Complete the worksheet for the consolidation of the balance sheets of the parent and subsidiary. ANS: Valentine Ltd

Saint Pty Ltd

Current assets Cash at bank Accounts receivable Other Total current assets

13,000 28,000 22,000 63,000

9000 14,000 9000 32,000

Non-current assets Property, plant & equipment Investment in Saint Pty Ltd Total non-current assets

260,000 125,000 385,000

120,000 --------120,000

TOTAL ASSETS

448,000

152,000

Current liabilities Accounts payable Total current liabilities

32,000 32,000

11,000 11,000

Non-current liabilities Borrowings Total non-current liabilities

210,000 210,000

16,000 16,000

226,000 226,000

TOTAL LIABILITIES

242,000

27,000

263,000

NET ASSETS

206,000

125,000

206,000

Shareholders’ equity Share capital Retained profits Total shareholders’ equity

160,000 46,000 206,000

100,000 25,000 125,000

Balance sheets

Eliminations

-6 000

-125,000

Consolidation

22,000 36,000 31,000 89,000

380,000 ---------380,000 469,000

-6000

-100,000 -25,000

37,000 37,000

160,000 46,000 206,000

PTS: 1 AACSB: TOP: Consolidate accounts

Knowledge, Analytical

CASE 1. The operating net profit before income tax of Fraxinus Ltd for the year ended 30 June 20X7 – the entity’s first year of operation – was $8,000,000. The figure was derived using the accrual approach to measuring profit. The company determines tax based on a cash basis. Taking into consideration the additional information provided below, you are required to: (a) Calculate the accounting income taxation expense for the company for the financial year. (b) Calculate the taxable income of the company for the financial year. (c) Calculate the income taxation payable to the ATO for the financial year. (d) Assuming that the difference between (a) and (c) are attributable to temporary differences, calculate the amount of the deferred tax liability and deferred tax asset arising out of the difference between the accounting profit (income taxation expense) before taxation and taxable income (income taxation liability). Additional information 1. Prepaid expenses at 30 June 20X7 $25,000. 2. Accrued expenses at 30 June 20X7 $32,500. 3. Cash received from customers for the year $94,975,000. 4. Accounts receivable outstanding at 30 June 20X7 $325,000 (gross). 5. Provision for doubtful debts $20,000. 6. Revenue received in advance at 30 June 20X7 $300,000 7. Depreciation for accounting purposes $4,000,000 8. Depreciation as a taxation deduction $5,000,000. 9. The company income taxation rate is 30%. ANS: (a) Accounting income taxation expense: $8,000,000 x 30% = $2,400,000. (b) Taxable income Accounting net profit before tax Prepaid expenses Accrued expenses Acs receivable Doubtful debts expense Revenue received in advance Depreciation differential

$8,000,000 -25,000 32,500 -325,000 20,000 300,000 -1,000,000 7,002,500

(c) Income taxation payable: $7,002,500 x 30% = $2,100,750. (d) Deferred tax liability: $405,000 Prepaid expenses Acs receivable Depreciation differential

25,000 x 30% 325,000 x 30% 1,000,000 x 30%

7500 97,500 300,000 405,000

Deferred tax asset: $105,750 Accrued expenses Doubtful debts expense Revenue received in advance

PTS: 1 TOP: Taxation

AACSB:

32,500 x 30% 20,000 x 30% 300,000 x 30%

Knowledge, Analytical

9750 6000 90,000 105,750

Chapter 12 – Financial statement analysis TRUE/FALSE 1. The owners of an entity are regarded as equity investors whether they are sole traders, partnerships or shareholders in a multinational corporation, whereas preference shareholders may be classified as equity or debt investors depending on the characteristics of the shares. ANS: T PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

2. The owners of a small entity, such as a sole tradership, have greater access to the entity’s accounting information than the equity participants of a large entity such as a public company. However, for the purposes of financial statement analysis, the accounting information needs of equity participants are the same. ANS: T PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

3. Of all the user groups identified for financial statement analysis, it is the equity investor who is most interested in information on management efficiency. ANS: T PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

4. As a user group, lenders can be classified as short, medium, or long-term lenders, and all three have an interest in the net realisable value of assets. However, it is generally only certain long-term lenders who have a particular interest in the net realisable value of specific assets. ANS: T PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

5. If financial statement analysis is to be effective, it requires that the information needs of the person or group for whom the analysis is being done are clearly identified. ANS: T PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

6. The most common information needs of users of financial statement analysis relate to profitability, liquidity and risk. ANS: T PTS: 1 TOP: Common information needs

AACSB:

Knowledge, Analytical

7. The social environment in which an entity operates includes factors such as concern for the natural environment and ensuring full employment, and is directly relevant to an analysis of business performance. ANS: T PTS: 1 AACSB: TOP: The context of financial statement analysis

Knowledge, Analytical

8. External sources can provide relevant information when industry trends and business risk are being analysed. ANS: T PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

9. Effective financial analysis relies on internal sources of information such as the financial statements and notes to the accounts, as well as external sources such as the financial press and trade journals. ANS: T PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

10. Consistency implies that the measurement and display of transactions and events need to be carried out in a consistent manner throughout an entity, and over time for that entity, but does not imply there is consistency between entities. ANS: F PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

11. Although the financial statements are important sources of information for financial analysis, it is true to say that they lose some relevance in assessing the entity’s current position, due to the historical nature of the information involved. ANS: T PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

12. Financial analysis is only useful if it is measured relative to something else, such as past periods and similar entities in the same industry. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

13. Measuring profits against sales over a period of time provides information on the increasing/decreasing profitability of the entity, and can determine whether the entity is increasing/decreasing its efficiency in each sale made. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

14. If profit has increased over a period of time relative to sales, and owners’ investments have not increased at the same rate, then it would be reasonable to conclude that management has been efficient in increasing returns to shareholders. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

15. Solvency and profitability are important aspects of financial statement analysis, as an entity can be in the position of not being able to repay debt, which could result in liquidation, even though the entity is making profits. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

16. An entity has debt finance that exceeds its equity finance by 20%. Under the traditional ‘best-practice’ approach used by Australian banks and financial institutions, it would be considered that the debt finance is too high. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

17. Trend analysis is a financial analysis technique for comparing the relationship between different items over a period of time. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

18. Trend analysis is a technique commonly used in financial statement analysis to assess a business’s growth prospects. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

19. Index number trends are calculated relative to a base year at 100, and all other numbers are set according to that index. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

20. Ratio analysis is a technique used for analysing financial statements, but it is only useful if it is based on items from the same financial statement; that is, if the items being compared are either all from the statement of comprehensive income or all from the balance sheet. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

21. Asset turnover, return on assets, and debt to total assets are all examples of long-term solvency ratios. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

22. If a company has a debt to equity ratio of 1.48, it means that for every $1 of equity, the company has $1.48 in liabilities. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

23. When measuring short-term solvency, the current ratio compares current assets to current liabilities, but inventory is normally excluded when calculating the quick ratio. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

24. After analysing a company’s financial statements over a five-year period, it was determined that the current ratio was as follows: 1.6:1 (20X9); 1.5:1 (20X8); 1.1:1 (20X7); 0.95:1 (20X6). From this information we can conclude that the company has been increasing the amount of cash at bank.

ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

25. A company has no prepayments and has a current ratio of 0.98:1 and a quick ratio of 0.95:1. This indicates that the company cannot pay its debts if called upon to do so. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

26. Under the efficient markets hypothesis (EMH), it is possible that individual shares may be underor over-priced. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

27. An implication of the EMH is that managers will choose accounting policies in order to influence reported net profit. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

28. Unlike ordinary shareholders, preference shareholders are more likely to be interested in the extent to which profit is safe, rather than in profit growth, due to the fact that the return on their investment is typically fixed. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

29. A secured lender is exposed to a higher level of financial risk than an unsecured lender. ANS: F PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

30. The statement of cash flow is considered a source of internal information for the financial analysis of an entity’s solvency and its capacity to continue as a going concern. ANS: T PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

31. Comparability, as a qualitative characteristic of useful information, calls for consistency in the application of accounting policy choice. ANS: T PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

32. The ‘true and fair view’ of the auditor with respect to the financial statements of an entity, asserts that the financial assertions contained in the report are accurate in detail. ANS: F PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

33. Trend analysis involves choosing a base year and plotting the trend in key outcome indicators, such as sales and profits, in subsequent years.

ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

34. The accounts receivable and inventory turnover ratios are important in evaluating the short-term efficiency of an entity. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

35. General purpose reporting by corporations contributes to the efficiency of the share market and, ultimately, the allocation of scarce resources. ANS: T PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following is a technique for analysing financial statement data? A. Trend analysis B. Financial ratio analysis C. Vertical analysis D. All of the above. ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

2. Lenders can be classified as short, medium or long-term lenders. In regard to financial statement analysis for lenders, which of the following statements is incorrect? A. All lender groups are interested in the profitability of the entity. B. Short-term lenders are particularly interested in the net realisable value of specific assets. C. All lender groups are interested in the capacity of the entity to repay its debt. D. Long-term lenders are particularly interested in how well their interest is covered by the profits being made. ANS: B PTS: 1 TOP: Users’ information needs

AACSB:

Knowledge, Analytical

3. Financial statement analysis must be: A. viewed in the wider context of the industry and the political and social environments. B. targeted to the needs of the users of the analysis. C. as good as the base information on which the analysis is made. D. All of the above are correct. ANS: D PTS: 1 AACSB: TOP: The context of financial statement analysis

Knowledge, Analytical

4. What are some of the factors that are directly relevant to an analysis of business performance? A. Size and riskiness of the business. B. Economic, social and political environment. C. Industry trends and effects of changes in technology. D. All of the above. ANS: D PTS: 1 AACSB: TOP: The context of financial statement analysis

Knowledge, Analytical

5. Comparing the performance of an entity with the industry norms is complicated by: A. not all businesses in the industry being the same. B. different businesses using different accounting methods. C. business being diversified. D. all of the above. ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

6. Which of the following statements concerning the comparison of financial information between firms is not true? A. The selection of industry norms based on averages is problematic. B. The financial and business risks of firms differ. C. Firms use similar accounting policies. D. The size of the business influences the operating results. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

7. Which of the following is not typically part of the annual report published by a company for investors and other decision makers? A. Financial statements B. Notes to the financial statements C. Budgets prepared by management D. The audit report ANS: C TOP: Chapter 12

PTS: 1

AACSB:

Knowledge, Analytical

8. For financial information to be useful for analysis, it must be both relevant and reliable. Other required qualitative characteristics are: A. predictability and conservatism. B. timeliness and cost. C. understandability and comparability. D. consistency and creativity. ANS: C PTS: 1 TOP: Projections and predictions

AACSB:

Knowledge, Analytical

9. When evaluating the return on a shareholder’s investment, it is necessary to consider the return relative to: A. the shareholders’ funds. B. the industry average. C. the rate of inflation. D. earnings per share. ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge

10. The statements of comprehensive income of LMA Ltd reveal the following information:

Profit before tax Sales

20X3 $30,000 120,000

20X2 $25,000 90,000

20X1 $20,000 75,000

Based on this information, which of the following statements is incorrect? A. Profit has increased in 20X3 by 20% over 20X2, 66.7% from 20X1 to 20X2, and 50% from 20X1 to 20X3. B. Profit in 20X3 has decreased from 20X2 and 20X1 for each sale made. C. The information shows that in 20X2 management was more efficient in creating profits from the sale of goods compared to the other years. D. Sales have increased in 20X3 by 33.4% over 20X2, 20% from 20X1 to 20X2, and 60% from 20X1 to 20X3. ANS: A TOP: Chapter 12

PTS: 1

AACSB:

Analytical

11. The use of debt to increase a company’s return on equity is: A. financial leverage. B. financial lift. C. measured by the debt to equity ratio. D. liquidity. ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

12. As the proportion of debt increases in a firm’s capital structure, what can we say with certainty about the firm’s risk and financial leverage? A. Both remain the same. B. Both decrease. C. Both increase D. Leverage increases and risk may increase. ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

13. Which of the following analysis techniques selects a base year, sets it at 100 and then calculates the change in subsequent years as a percentage of the base year? A. Common-size statements B. Percentage changes C. Index number trends D. Trend analysis ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

14. The analysis technique that shows each item on the financial statements as a percentage of one item on that statement is known as: A. trend analysis. B. comparative financial statements. C. common size financial statements. D. working capital schedule. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

15. The current ratio indicates the: A. funds employed by the shareholders of the company. B. amount of readily liquid current assets for each dollar of urgent liabilities.

C. amount of current assets to meet each dollar of current liabilities. D. profitability of the business. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

16. Profit is not relevant when calculating: A. return on equity. B. price/earnings ratio. C. earnings per share. D. debtors turnover. ANS: D PTS: 1 TOP: Techniques of analysis

17. Inventory turnover in days indicates: A. the average number of days to purchase inventory. B. the average number of days to convert inventory into cash. C. the average number of days taken to sell the inventory. D. the overall earning power of the inventory. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

18. Which of the following assets would be used in calculating the current ratio but not normally in determining the quick ratio? A. Debtors B. Cash C. Short-term investments D. Inventory ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

19. Profit from ordinary operations divided by sales is: A. working capital. B. income from operations. C. net profit margin. D. return on assets. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

20. Gross profit margin measures the: A. efficiency of management in turning over the company’s goods at a profit. B. efficiency of the use of assets in generating assets. C. effectiveness of investments in inventories. D. effectiveness of the collection of debtors’ accounts. ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

21. The conclusion that a company was able to generate 79.5c of net profit for every dollar of sales reflects which of the following? A. Operating leverage B. Return on assets

C. Net profit margin D. Asset turnover ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

22. The ratio of cost of goods sold to inventory is known as: A. inventory turnover. B. asset turnover. C. accounts receivable turnover. D. return on sales. ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

23. Given a high value, which of the following ratios best indicates that a company is controlling its product costs? A. Gross profit margin B. Operating profit margin C. Return on assets D. Return on equity ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

24. Inventory turnover: A. is the ratio of inventory to sales. B. measures the success of a company in converting its investment in inventory into sales. C. is the ratio of sales to inventory. D. measures the success of the company’s purchasing department. ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

Use the following information to answer questions 25 and 26.

Accounts receivable Inventory Operating revenues Cost of goods sold Operating income Gross profit

Wannamaker’s Wonders $159,000 384,000 1,060,000 559,000 360,000 501,000

Delano’s Deals $126,000 254,000 768,000 235,000 305,000 533,000

25. What are the inventory turnovers for Wannamaker’s and Delano’s? A. 2.76 and 3.02 B. 0.93 and 1.20 C. 1.46 and 0.93 D. 1.30 and 2.18 ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

26. What are the debtor’s turnovers for Wannamaker’s and Delano’s? A. 6.67 and 6.10 B. 3.51 and 1.86 C. 1.63 and 2.42 D. 3.15 and 4.23 ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

27. Which of the following is a measure of short-term solvency? A. Debt to assets ratio B. Assets to equity ratio C. Current ratio D. Dividend payout ratio ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

Use the following information to answer questions 28 and 29. Kestal Ltd reported sales of $500,000 for the year ending 31 December 20X7. The net profit before interest and tax was $120,000, and the net profit after tax was $90,000. The average of total assets was $1,000,000. The average shareholders’ equity was $700,000. 28.What is the asset turnover for 20X7? A. 2 B. 0.5 C. 0.7 D. 11.11 ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

AACSB:

Knowledge, Analytical

29. What is the return on equity for 20X7? A. 9% B. 12% C. 12.9% D. 17.1% ANS: C PTS: 1 TOP: Techniques of analysis

30. Thorpedo Ltd reported a return on assets of 15% for 20X4. It also acquired a licence for cash by paying $1m at the end of 20X4. This licence is expected to generate net profits of $0.1m per year and the asset is not amortised. Assuming the 20X5 results mirror 20X4 and the licence did increase net profit by $0.1m. What is the effect on Thorpedo Ltd’s return on assets for 20X5? A. A decrease B. An increase C. No change D. Cannot be determined ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

31. Return on equity is a measure of: A. financial leverage. B. firm value. C. company performance. D. liquidity. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

32. If an investor (shareholder) discovers by analysing financial statements that she ‘lost 5 cents for each dollar invested in the company’, which ratio did she examine? A. Debt to equity B. Debt to assets C. Return on equity D. Financial leverage ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

33. A company has the following accounts: I Paid up capital II Reserves III Retained profits IV Dividends payable Return on equity is net profit divided by: A. I only B. I and II Only C. I, II and III D. 1, II, III and IV ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

34. The financial structure of an entity can be assessed using the: A. current ratio. B. quick asset ratio. C. times interest earned. D. debt to equity ratio. ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

35. A price earnings ratio shows: A. the earnings yield based on market values. B. the amount the market is willing to pay for $1 of profits C. the comparison between earnings of different companies. D. the profitability of ordinary shares ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

36. A clear distinction between return on assets and return on equity is that return on assets: A. must always be a smaller percentage than is return on equity. B. is a measure of management’s investment decisions that excludes any consideration of

how the investments were financed. C. is of greater interest to investors than is return on equity. D. measures operating leverage while return on equity measures financial leverage. ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

37. The ratio that shows the percentage of a company’s assets financed by equity is the: A. rate of return on ordinary shareholders’ equity. B. return on assets ratio. C. asset turnover ratio. D. equity ratio. ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

38. The following information was taken from the annual report of Blake Company: Net profit Interest Total assets Total liabilities

$400 $50 $5000 $3400

What are the return on assets (ROA) and return on equity (ROE)? ROA ROE A. 0.25 0.09 B. 0.09 0.25 C. 0.08 0.25 D. 0.05 0.08 ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

39. Which of the following companies, whose ROE and ROA are given, is probably the most valued by shareholders? ROA ROE

Co. A 10.5% 5.4%

Co. B 6.2% 10.6%

Co. C 9.0% 11.5%

Co. D 8.0% 13.5%

A. Co. A B. Co. B C. Co. C D. Co. D ANS: D PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

40. Which of the following would be an appropriate interpretation of a current ratio of 1.76? A. The company earned $1.76 for every dollar of assets. B. The company has $1.76 of current assets for every dollar of current liabilities. C. The company’s debt is 176% of its capital structure. D. The company has $1.76 of current assets for every dollar of total assets. ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

41. Return on equity for Delta company is 7%. This means that: A. Delta will pay a dividend of $0.07 on each ordinary share. B. The market value of Delta’s ordinary shares will increase. C. Delta earned $0.07 for each dollar of equity. D. The book value of Delta’s ordinary shares will increase by 7%. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

42. The conclusion that a company ‘earned 12.5c of profit for every dollar invested in assets’ by the company reflects which of the following? A. Operating leverage B. Return on assets C. Profit margin D. Asset turnover ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

43. A low debtors turnover ratio could indicate that: A. few customers are defaulting on their debts. B. the company is making collections from its customers very quickly.. C. the company is making collections from its customers very slowly. D. a small proportion of the company’s sales are credit sales. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

44. A low debtors turnover in days could indicate that: A. few customers are defaulting on their debts. B. the company is making collections from its customers very quickly. C. the company is making collections from its customers very slowly. D. a small proportion of the company’s sales are credit sales. ANS: C PTS: 1 TOP: Techniques of analysis

AACSB:

Analytical

45. A higher than normal price/earnings ratio could mean: A. the company’s shares are undervalued. B. the market is expecting future EPS to be higher. C. the market is expecting future EPS to be lower. D. shareholders are receiving a high return. ANS: B PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

46. A lower than normal price/earnings ratio could mean: A. the company’s shares are undervalued. B. the market is expecting future EPS to be higher. C. the company’s shares are overvalued. D. shareholders are receiving a high return. ANS: A PTS: 1 TOP: Techniques of analysis

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. For what purpose is horizontal analysis used by management? Is this information provided to shareholders? If so, in what form? If not, why? ANS: Horizontal analysis is used to track the relative behaviour in changes of percentages of financial statement items from one period to the next. It can flag increases or decreases that need to be examined more closely by management. It helps with controlling expenses. In annual reports, management provides horizontal analysis as supplemental information by showing trends over longer periods of time. PTS: 1 AACSB: Techniques of analysis

Knowledge, Analytical, Communication

TOP:

2. What is the best way to assess solvency? Explain. ANS: Evaluating leverage best assesses solvency. A company should earn a profit that is greater than the cost of capital. This can be assessed by evaluating the debt-to-equity ratio to determine the company’s ability to repay principal, the times interest earned ratio to determine the company’s ability to pay interest, and the debt service ratio, which evaluates the company’s ability to pay both interest and principal. PTS: 1 AACSB: TOP: Techniques of analysis

Knowledge, Analytical, Communication

3. Charmaine Company has a return on assets of 12% and a return on ordinary shareholders’ equity of 15%. What causes the difference in the two returns? ANS: The return on assets considers the investment by creditors and all shareholders. The return on ordinary shareholders’ equity provides a return on the investment by ordinary shareholders only. Because most companies have total assets that exceed ordinary shareholders’ equity, the return on assets will normally be lower than the return on shareholders’ equity. This occurs because the company is able to earn a higher return from assets than the cost of debt used to finance part of the assets. The beneficiaries of this are the shareholders. PTS: 1 AACSB: TOP: Techniques of analysis

Knowledge, Analytical

4. What situations could cause a decrease in the current ratio, but an increase in the quick ratio? If this happens, is management to be commended or is a problem evident? Explain. ANS: The current ratio is comprised of current assets divided by current liabilities. Since the quick ratio does not contain inventory or prepaid items, it is always less than the current ratio. The current ratio will decrease when total current liabilities increase or when total current assets decrease. The increase in the quick ratio must be larger than a decline in the other current assets, to create this situation. For example an entity has current assets of $20,000 including inventory of $5000 so the CR = 2 and the QR = 1.5. If inventories are to be written down by $2000 due to a change in consumer tastes at the same time as the bank overdraft decreased by say $900 the current ratio

would decline to 1.98 but the quick ratio would increase to 1.64. In this case it could be that the decline in the value of inventory indicates a problem that needs to be monitored. PTS: 1 AACSB: TOP: Techniques of analysis

Knowledge, Analytical

PROBLEM 1. The following financial data relate to Bandara Pty Ltd for the years ended 30 June 20X7 and 30 June 20X6. Financial item 30 June 20X7 30 June 20X6 Net credit sales $630,000 $490,000 Cost of goods sold 290,000 250,000 Cash 18,000 12,000 Debtors 70,000 60,000 Inventory 130,000 150,000 Current liabilities 105,000 81,000 Additional information The debtors figure at 30 June 20X5 was $78,000 (net). The inventory figure at 30 June 20X5 was $130,000. The company provides its credit customers 30 days to pay. The average inventory turnover for the industry in which the company operates is 101 days. (a) Calculate the following ratios for the years ended 30 June 20X7 and 30 June 20X6: – current ratio; – quick ratio; – debtors’ turnover (times and in days); and – inventory turnover (times and in days). (b) Comment on the short-term solvency, including the efficiency of the business, given the ratio results obtained in answering part (a). ANS: (a) Formulae Current assets Current liabilities Quick assets Current liabilities Net sales Average debtors Days in year Debtors turnover Cost of goods sold Average inventory Days in year Inventory turnover

20X7 18 + 70 + 130 105 218 – 130 105 630 70 + 60/2 365 9.69 290 103 + 150/2 365 2.29

ratio 2.08:1 0.84:1 9.69 37.67 2.29 160

20X6 12 + 60 + 150 81 222 – 150 81 490 60 + 78/2 365 7.10 250 150 + 130/2 365 1.79

ratio 2.78:1 0.89:1 7.10 51.41 1.79 204

PTS: 1 (b) Taking the results for the current ratio at face value, while the ratio has declined between the two years (2.78 – 2.08), the figure is strong. However, the quick asset ratio suggests a tighter margin of

coverage. Whether this is a problem would depend on the entity’s access to say a bank-overdraft facility. Taking into consideration the composition of the current assets, the entity has a comparatively large amount of funds tied up in inventory. The inventory turnover ratio, while it has improved, suggests that the inventory figure is higher than it ought to be. The turnover of inventory is considerably slower than that of the industry as a whole. This is a matter of concern for management. Notably, the debtors turnover figure has improved considerably – it is much closer to the entity’s terms of credit than it was in the previous year. This reflects favourably on the strength of the current and quick ratios, and management efficiency in that respect. PTS: 1 AACSB: TOP: Techniques of analysis

Knowledge, Analytical

2. The following information relates to Dante Pty Ltd for the years ended 30 June 20X7 and 20X6: 20X7 20X6 $ $ Total assets 6,020,000 5,470,000 Owners’ equity 3,250,000 3,200,000 Annual sales 6,100,000 3,154,350 Net profit (after tax) 810,000 475,200 Weighted average number of ordinary shares issued 10,234,518 10,046,430 Required: (a) Calculate the net profit margin, asset turnover, earnings per share and debt to total assets ratios for Dante Ltd for the 30 June 20X7. (b) Describe four qualitative factors that ought to be taken into consideration in order to put the foregoing analysis in context? ANS: (a) Formulae Net profit Sales Sales Average total assets Net profit – pref divi Average ord shareholders equity Net profit – pref divi Weighted average number of Ord shares issues Total liabilities Total assets

20X7 810 6 100 6 100 6 020 + 5 470/2 810 3 250 + 3 200/2 810 000 10 234 518 + 10 046 430/2 6 020 – 3250 6 020

ratio 0.13:1 1.06:1 0.25:1

0.08:1 0.46:1

(b) Qualitative factors: (i) how these figures compare with previous years; (ii) industry averages; (iii) with respect to the performance figures, any forecast figures; (iv) industry trends and effects of changes in technology; (v) other factors: business size; business risk, the economic, social and political environment, effects of price changes. PTS: 1 AACSB: TOP: Techniques of analysis

Knowledge, Analytical

Chapter 13 – Worksheet to debits and credits TRUE/FALSE 1. An increase in assets and an increase in liabilities is the same as saying assets have been debited and liabilities have been credited. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

2. The worksheet approach and the T account approach to recording transactions are not really comparable, as the worksheet approach uses increases and decreases whereas the T account approach uses debits and credits. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

3. The owner of an entity pays cash into the company bank account. The effect of this is to record an increase to cash on the left-hand side of the worksheet and an increase to equity on the right-hand side of the worksheet. This is the same as recording a debit on the left-hand side of the T account Cash and a credit on the right-hand side of the T account Owners’ Equity. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

4. When using an extended trial balance approach to recording end-of-period adjustments, there is a risk of errors and omissions as this approach will only result in the recording of one side of the transaction. ANS: F PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

5. Increases in assets involved debits and increases to equity and liabilities involve credits under the ledger-based approach to recording transactions. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

6. A trial balance is prepared to check on the arithmetical accuracy of the ledger. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

7 Decreases in assets are credited, and increases in liabilities are debited. ANS: F PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

8. An accounting journal is a book of original entry that is prepared to record transactions in chronological order. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

9. The recording of transactions in the worksheet and ledger both revolve around the principle of duality and the accounting equation. ANS: T PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following statements about double-entry bookkeeping is true? A. The double-entry principle is referred to as accrual accounting. B. The total amount debited must equal the total amount credited. C. If one account is increased, then another account must be decreased. D. The total number of accounts debited must equal the total number of accounts credited. ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

2. Which of the following accounts normally has a debit balance? A. Liabilities B. Owners’ Equity C. Revenues D. Expenses ANS: D PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

3. Which of the following does not normally have a credit balance? A. Asset B. Liability C. Equity D. Revenue ANS: A PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

4. As used in accounting, what do the terms ‘debit’ and ‘credit’ mean? A. Bad and good things, respectively, that happen to a business. B. Increases and decreases, respectively. C. Left and right sides, respectively, of an account. D. First and second, respectively. ANS: C PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

5. Which of the following accounts would be increased by a debit entry? A. Accounts Receivable B. Owners’ Equity C. Accounts Payable D. Sales ANS: A PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

6. A credit entry is used to record increases to: A. Accounts Receivable. B. Accounts Payable. C. Wages Expense. D. Cash. ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

7. The ledger accounts for accumulated depreciation and allowance for doubtful debts: A. would normally hold credit balances. B. would normally hold debit balances. C. represent expenses. D. represent liabilities. ANS: A PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

8. The recording of transactions in the ledger always involves: A. same number of debit and credit entries. B. same dollar amounts of debits and credits. C. the original recording of the transaction. D. plenty of work for accountants. ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

9. An accounting journal: A. is an original book of entry in accounting records. B. records transactions on a chronological basis. C. provides the information for recording in the ledger. D. all of the above. ANS: D PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

10. On 1 August XYZ Ltd issued $240,000 shares to shareholders in exchange for cash of $100,000 and land of $140,000. This transaction would be recorded in the ledger as: A. a debit to cash and land and a credit to share capital. B. a credit to cash and land and a debit to share capital. C. an increase to cash and land and a decrease to share capital. D. a decrease to cash, and an increase to land and share capital. ANS: A PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

11. If an entity paid $200 for two months rent in advance on 1 June and recorded it all as rent expense on that date, which of the following would be the necessary adjusting entry at 30 June? A. Debit rent expense $100 and credit prepaid rent $100 B. Debit prepaid rent $100 and credit rent expense $100 C. Debit rent expense $200 and credit prepaid rent $200 D. Debit prepaid rent $200 and credit rent expense $200 ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

12. If an entity paid $200 for two months rent in advance on 1 June and recorded it all as prepaid rent on that date, which of the following would be the necessary adjusting entry at 30 June? A. Debit rent expense $100 and credit prepaid rent $100 B. Debit prepaid rent $100 and credit rent expense $100 C. Debit rent expense $200 and credit prepaid rent $200 D. Debit prepaid rent $200 and credit rent expense $200 ANS: A PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

13. The balance sheet lists final account balances for which of the following elements of financial statements? A. Assets and liabilities. B. Income and expenses. C. Assets, liabilities and owner’s equity. D. Income, expenses and profit and loss. ANS: C PTS: 1 AACSB: Knowledge, Analytical TOP: Final accounts 14. Income and expenses affect the profits made by an entity. Which of the following statements best describes how this fact is consistent with the accounting equation and the debit and credit rule? A. Income increases equity and so should be a debit and expenses decrease equity and so should be a credit B. Income increases equity and so should be a credit and expenses decrease equity and so should be a debit C. Income decreases equity and so should be a debit and expenses increase equity and so should be a credit D. Income and expenses both affect equity and so both should be a credit if they are increasing ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

15. XYZ receives $1000 in June for rent from a client for the month of July. How should this be recorded by XYZ assuming a balance date of 30 June? A. Debit cash $1000 and credit accounts receivable $1000 B. Debit cash $1000 and credit unearned revenue $1000 C. Debit unearned revenue $1000 and credit cash $1000 D. Debit cash $1000 and credit prepaid rent $1000 ANS: B PTS: 1 TOP: The traditional approach

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Discuss the role that journals, the ledger, debits and credits and the trial balance play in the traditional approach to recording transactions (events). ANS: The journals and ledger play an important part in the process (system) of recording and classifying the economic events associated with the operations of an entity. The journals precede the ledger in that process and provide a chronological summary of the economic events. The information contained in journals is entered into the ledger, which is structured around the accounting equation. The double-sided nature of the accounting equation is also reflected in the ledger, with assets being recorded on the left-hand (debit) side of the ledger, and liabilities and equity on the right-hand

(credit) side of the ledger. A trial balance provides a summary of the ledger account balances at a point in time, and is undertaken to assess the arithmetical accuracy of the ledger – accounting equation at that time. PTS: 1 AACSB: TOP: The traditional approach

Knowledge, Analytical, Communication

PROBLEM 1. The following transactions relate to Murali Traders for the year ended 30 June 20X7 – the first year of operation. a. The owner invested $10,000 into a business bank account. b. Purchased equipment for $6000 cash. d. Purchased inventory for $45,000 on credit, of which $39,000 had been paid for at year end. d. Sold goods for $69,000 on credit. The balance outstanding at the year-end was $4000; the balance was received in cash. e. Paid operating expenses $3000. f. The balance of closing inventory at year end was valued at $4000 cost. (a) Record the foregoing transactions using the traditional T accounts. (b) Extract a trial balance at 30 June 20X7. ANS: (a) Transaction a Transaction d

Balance b/d

Cash 10,000 Transaction b 61,000 Transaction c Transaction e Balance c/d 71,000 23,000 Capital Transaction a

Transaction b

Transaction c

Balance b/d

Transaction c Balance c/d

6000 39,000 3000 23,000 71,000

10,000

Equipment 6000

Inventory 45,000 Transaction f Balance c/d 45,000 4000 Acs payable 39,000 Transaction c 6000 45,000 Balance b/d

41,000 4000 45,000

45,000 45,000 6000

Acs receivable 65,000 Transaction d Balance c/d 65,000 4000

Transaction d

Balance b/d

61,000 4000 65,000

Profit and loss 3000 Transaction d 41,000 21,000 65,000 Balance b/d

Transaction e Transaction f Balance c/d

65,000

65,000 21,000

(b) Trial balance as at 30 June 20X7 debit Cash Capital Equipment Inventory Acs payable Acs receivable Profit and loss

credit 23,000 10,000 6000 4000 6000 4000 21,000 37,000

37,000 PTS: 1

AACSB:

TOP: pp 300–6

2. Prepare general journal entries for the following independent events. (i) Issued 50,000 ordinary shares at a $1.20 issue price in exchange for land whose fair value was equal to value of the shares. (ii) Issued $10,000,000 5% debentures at par and for cash. (iii) Paid a $120,000 cash dividend on ordinary shares. (iv) Sold goods for $50,000 cash. (v) Purchased inventory for $45,000 on credit. ANS: (i)

(ii)

(iii)

(iv)

(v)

Dr Cr

Land Paid-up capital

Dr Cr

Cash Debentures

Dr Cr

Ordinary dividend paid Cash

120,000

Dr Cr

Cash Sales (profit & loss)

50,000

Dr Cr

Inventory Acs payable

45,000

PTS: 1 AACSB: TOP: The traditional approach

60,000 60,000 10,000,000 10,000,000

120,000

50,000

45,000 Knowledge, Analytical

Chapter 14 – Internal users, internal information, and planning and control TRUE/FALSE 1. A major requirement of managers is to have detailed and timely information that enables them to monitor results and compare with plans and budgets, in order to take appropriate action for the future direction of the company. ANS: T PTS: 1 TOP: Management’s information needs

AACSB:

Knowledge, Analytical

2. A company’s results are judged against some expectations, which may be rough plans or detailed budgets. ANS: T PTS: 1 TOP: Management’s information needs

AACSB:

Knowledge, Analytical

3. Bankers have a statutory right of access to internal accounting information. ANS: F PTS: 1 TOP: External users’ information needs

AACSB:

Knowledge, Analytical

4. The Customs and Excise Department and the Australian Taxation Office have a statutory right of access to internal accounting information. ANS: T PTS: 1 TOP: External users’ information needs

AACSB:

Knowledge, Analytical

5. In order for a banker to make judgements about the future needs and prospects of an entity in deciding whether to lend money, additional detailed information in the form of future cash flows may be required. ANS: T PTS: 1 TOP: External users’ information needs

AACSB:

Knowledge, Analytical

6. Detailed financial information is only generally available to managers and a limited number of external users, as it normally contains sensitive information that may be detrimental to the company if made publicly available. ANS: T PTS: 1 TOP: Management’s information needs

AACSB:

Knowledge, Analytical

7. If bankers are to make judgements about the future needs and prospects of the entity, they are likely to require information on projected cash flow statements, statements of comprehensive income and details of any other loans the company may have. ANS: T PTS: 1 TOP: External users’ information needs

AACSB:

Knowledge, Analytical

8. In supplying external users with additional accounting information, there is a need to balance the costs and benefits of supplying that information, but this does not apply to internal users such as managers because the information is already available and does not incur any additional costs.

ANS: F PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

9. Organisational size and structure are major influences on the information needs of managers. ANS: T PTS: 1 AACSB: TOP: Effects of organisational size and structure

Knowledge, Analytical

10. The determination of objectives and expressing how they are to be attained are together referred to as the planning process. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

11. A desired outcome of setting objectives in the planning process is to create criteria for assessing alternative business options. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

12. A major difference between strategic and operating decisions is that the former focus on the long-term policies of the firm, whereas operating decisions focus on the short-term use of resources. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

13. Strategic decisions are decisions that focus on the efficient use of the resources available to the firm in the short term. ANS: F PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

14. Short-term operating decisions can be translated into a budget, which is a plan of action expressed in monetary terms that compels management to look ahead and coordinate their activities. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

15. In a dynamic economic environment, there is often the need to revise operating decisions in order to meet long-term objectives, but this will not impact on strategic decisions as these are related to policy changes and are not affected by operating decisions. ANS: F PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

16. The monitoring process allows corrective action to be planned and taken after comparing actual performance with a predetermined plan. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

17. A reporting system that supports the responsibility accounting approach will communicate relevant information on the comparison between actual and budgeted performance. This report highlights the cause of variances between actual and budgeted performance. ANS: F PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

18. If actual costs were to exceed budgeted costs for a period, the variance would be considered favourable. ANS: F PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

19. On comparing actual performance with the budget, the Light Globe Company determined that there was a favourable variance in sales and an unfavourable variance in the cost of goods sold. This means that both actual sales and costs were higher than expected. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

20. Planning and random variances can generally be controlled, but operating variances cannot be controlled. ANS: F PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

21. Operating, random and planning variances are all examples of divergence from actual performance compared to budgeted performance. ANS: T PTS: 1 TOP: The planning and control process

AACSB:

Knowledge, Analytical

22. A control system is limited in its application, as it depends on the motivation of individuals. ANS: T PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

23. The efficiency and effectiveness of a control system can be affected by the costs associated with running the system. ANS: T PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

24. The cost–benefit approach is often used to evaluate the net benefits of alternative accounting information systems. ANS: T PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

25. Many benefits associated with an information system are qualitative in nature. ANS: T PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

26. The contingency theory accepts that different types of organisation require different types of accounting information for effective functioning. ANS: T PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following is not an external user of financial information? A. Shareholders B. Management C. Suppliers of goods and services D. Government ANS: B TOP: Chapter 14

PTS: 1

AACSB:

Knowledge, Analytical

2. The purpose of financial accounting is to provide information for decision making. What is the purpose of management accounting? A. To enable managers to ask for higher salaries. B. To maximise a company’s profits. C. To provide information for decision making. D. To create a value chain. ANS: C TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

3. The basic difference between management and financial accounting is that: A. the financial accounting system relies on accounting information, whereas management accounting does not. B. financial accounting relies on information gathered from sources outside the business, whereas management accounting relies on internally generated information. C. financial accounting is concerned with providing information to outsiders, whereas management accounting is concerned with providing information to managers for their use in directing the activities of the organisation. D. None of the above is correct. ANS: C TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

4. How are financial accounting information and management accounting information similar? A. They are both used by managers. B. They are both used in decision making. C. They both involve quantitative and non-quantitative aspects. D. All of the above are correct. ANS: D PTS: 1 TOP: Managements’ information needs

AACSB:

Knowledge, Analytical

5. Traditional management accounting information: A. gives managers the only information they need to make decisions. B. integrates production and marketing concerns with accounting. C. is the same in every company. D. assists managers in their roles.

. ANS: D PTS: 1 TOP: Managements’ information needs

AACSB:

Knowledge, Analytical

6. Which of the following characteristics of information is desired by management? A. Regular B. Timely C. Detailed D. All of the above. ANS: D PTS: 1 TOP: Managements’ information needs

AACSB:

Knowledge, Analytical

7. To be useful to management, accounting information must: A. be prepared in accordance with general-purpose financial reports. B. have the potential to affect decisions and influence behaviour. C. be completely accurate. D. be in the form of financial statements. ANS: B PTS: 1 TOP: Managements’ information needs

AACSB:

Knowledge, Analytical

8. Which of the following factors influence the information available to the management of an organisation? A. Size of the organisation B. Needs of management C. Organisation structure D. All of the above ANS: D TOP: Chapter 14

PTS: 1

AACSB:

Knowledge, Analytical

9. Accounting information systems should be installed in an organisation when: A. the financial controller decides they should. B. benefits exceed the costs to an organisation. C. another organisation in the same industry installs such a system. D. the CEO decides they should. ANS: B PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

10. The primary difference between planning and control decisions is that: A. the former must follow the latter. B. planning decisions involve investing decisions, whereas control decisions focus on financing and operating decisions. C. planning is future-oriented, while control decisions are past and present-oriented. D. planning decisions involve components of the transformation process, whereas control decisions do not. ANS: C PTS: 1 TOP: The planning and control system

AACSB:

11. Planning and control decisions are similar in that both: A. tend to have a short-run focus. B. focus on achieving the organisation’s goals.

Knowledge, Analytical

C. increase the risk to owners and creditors. D. involve the setting of goals. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

12. Decisions that require managers to evaluate the accomplishments of their organisation, and to make changes if the organisation is not meeting its goals, are usually referred to as: A. regulatory decisions. B. implementation decisions. C. planning decisions. D. control decisions. ANS: D PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

13. Decisions that require managers to identify goals and to develop strategies are usually referred to as: A. authoritative decisions. B. performance decisions. C. planning decisions. D. managed decisions. ANS: C PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

14. Which of the following is not true of the control process? The control process: A. is a part of the planning and control process. B. involves monitoring action. C. involves allocating resources for acquisitions of plant and equipment. D. contains a corrective activity. ANS: C PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

15. The proper sequence for the planning and controlling process is: A. set objectives, set goals, develop plans, implement plans, evaluate performance, modify goals or plans as needed. B. develop plans, set objectives, set goals, implement plans, evaluate performance, modify goals or plans as needed. C. set goals, set objectives, develop plans, implement plans, evaluate performance, modify goals or plans as needed. D. set goals, develop plans, set objectives, implement plans, evaluate performance, modify goals or plans as needed. ANS: C PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

16. Planning is the process of: A. ensuring that a reasonable profit is made each year. B. creating a map for achieving corporate goals and objectives. C. setting goals and objectives. D. ensuring that assets are properly used. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

17. Which of the following is part of the planning process? A. Deciding on the objectives. B. Detailing how the plans are to be achieved. C. Ensuring that the plans will be achieved. D. All of the above. ANS: D PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

18. Which of the following is essential for management before it decides whether the business is succeeding or failing? A. Accounts receivable. B. A set of objectives. C. A large organisation. D. More current assets than non-current assets. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

19. Decisions that require managers to evaluate the accomplishments of their organisation and to make changes if the organisation is not meeting its goals are usually referred to as: Planning decisions A. No B. No C. Yes D. Yes

Control decisions No Yes No Yes

ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

20. Strategic decisions are decisions that: A. relate to the efficient use of available resources. B. allow the determination of the long-term policies of the firm. C. result in huge amounts of profit for the firm. D. correct the current situation of the company. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

21. Strategic planning differs from operational planning in that strategic planning: A. involves day-to-day activities. B. is done by middle management. C. often involves large investments. D. would be involved in determining production levels for the next week. ANS: C PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

22. Operating decisions are undertaken to: A. optimise the use of resources available to the firm in the long term. B. compare actual versus predetermined performance. C. result in profits in the long term. D. identify efficient use of scarce resources in the short term.

ANS: D PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

23. Evaluation of performance involves: A. modifying goals and objectives to agree with actual performance. B. comparing planned performance results with actual results. C. determining who to blame if actual results are lower than planned performance results. D. determining which employees should be promoted. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge, Analytical

24. The section of a business that has an individual in control of costs and revenues is: A. a division. B. a responsibility centre. C. a program budget. D. a control centre. ANS: B PTS: 1 TOP: The planning and control system

AACSB:

Knowledge

25. The identification of the origin of controllable costs and income allows at least one manager to be responsible for the costs, and: A. results in minimising costs and maximising profits. B. results in more efficient operations. C. makes the manager accountable for each item on a performance report. D. all of the above are correct. ANS: D PTS: 1 TOP: The planning and control system

AACSB:

Knowledge

26. Under contingency theory, the degree of competition refers to the: A. environmental factor. B. technological factor. C. organisational factor. D. structural factor. ANS: A PTS: 1 TOP: The control system

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Distinguish managerial accounting from financial accounting. Your answer should include a brief discussion of differences in the types of information provided to users as well as differences in the identity of users of financial and managerial accounting information. ANS: Financial accounting is used primarily by external users such as shareholders and creditors and by top management as a means of evaluating performance. Financial accounting is presented in summary form and must follow generally accepted accounting principles (GAAP). GAAP ensures that information is consistent from period to period and comparable across companies.

Managerial accounting is used internally by top management, functional and division managers and middle managers. Managerial accounting information is frequently presented with detailed information for day-to-day decisions. The information provided does not have to conform to GAAP or be consistent between periods or comparable across companies. Rather, it focuses on the information needs of managers. It is critical that managerial accounting information be provided in a timely manner. PTS: 1 TOP: Introduction

AACSB:

Knowledge, Analytical, Communication

2. One important use of managerial accounting information is performance evaluation. List and discuss the three major ways managers can identify and detect behaviour for performance evaluation purposes. For each major way, suggest two specific examples within the context of a consulting company. ANS: The three major categories are: direct observation of behaviour, outcome measurement, and corporate culture. Examples for a consulting company are listed below (other answers are possible): Direct observation of behaviour: • Proper telephone etiquette • Professional attire when meeting with clients Outcome measurement: • Profits • Customer satisfaction (via surveys) Corporate culture: • Courtesy and professionalism in dealing with clients • Clear, direct communication with colleagues. PTS: 1 AACSB: TOP: Managements information needs

Knowledge, Analytical, Communication

3. Name three ways that accounting information can assist managers who make marketing decisions. ANS: Accounting information can assist managers who make marketing decisions by: (Note: This is not an exhaustive list.) • • • • • •

providing managers with product cost information. helping sales representatives negotiate prices with customers. telling marketing managers how profitable new products are. telling managers the buying patterns of their customers. allowing marketing managers to monitor the selling and expense account activity of their sales representatives. accounting for advertising and promotion costs for individual products.

PTS: 1 TOP: Chapter 14

AACSB:

Knowledge, Analytical

4. Name three ways that accounting information can assist managers who make production decisions. ANS: Accounting information can assist managers who make production decisions by: (Note: This is not an exhaustive list.) • • • •

providing managers with product cost information used to monitor and control costs. identifying cost drivers and calculating the costs associated with each cost driver. providing information about the costs of production such as materials and labour. providing information about the costs and benefits of alternative production processes.

PTS: 1 TOP: Chapter 14

AACSB:

Knowledge, Analytical

5. Describe the four major stages involved in planning and controlling an organisation. ANS: The four major stages: (i) Setting objectives – to define the parameters of an organisation and set its future direction, and for the basis of evaluating the success or otherwise of the entity as a whole. (ii) Making strategic decisions – such decisions determine the long-term policies of the firm that facilitate the entity achieving its objectives. (iii) Making operating decisions – decisions concerning pricing and output and that focus on the efficient use of the resources available to the firm in the short term. (iv) Monitoring and corrective actions – are the major components of the control activities of any organisation. Monitoring involves comparing actual performance with pre-determined targets. It provides the basis from which corrective action can be planned and implemented. PTS: 1 AACSB: TOP: The planning and control system

Knowledge, Analytical, Communication

6. What is meant by responsibility accounting? ANS: Responsibility accounting is where an entity is structured into strategic business units and the performance of these units is measured in terms of accounting results. PTS: 1 AACSB: TOP: The planning and control system

Knowledge, Analytical

CASE 1. Ordinary Office Products, Inc., a retail office supply company, has a single outlet in a large metropolitan area. The company has a policy of delivering any size order, even a bottle of Liquid Paper, to any customer, regardless of the distance. Management believes that without this delivery policy the company will not be able to maintain its market share. Since delivery costs are considered a selling expense and not a product cost, the company has a positive gross margin. That is, the company appears to be making money on its sales. The problem is that the company has shown an operating loss for each of the past three years and is on the verge of having its bank financing withdrawn. Management has been attempting to solve its profitability problems by increasing sales of its delivered merchandise. (a) What recommendation would you make to the company’s management to attempt to rectify this situation? (b) How would better managerial accounting information have helped Ordinary Office Products? ANS: (a) The company should be strongly encouraged to modify or abandon its delivery policy. It is obviously not possible to make a profit on the delivery of a bottle of Liquid Paper over any distance, since the cost of the delivery would always exceed both the sales price of the merchandise and the product margin. A recommendation should be made to consider requiring a minimum order for a delivery to be made. The short-term effect may be the loss of some customers or sales volume, but the long-term effect should be an increase in profitability. The new policy could also include charging customers for deliveries of less than some specified dollar purchase. (b) Better managerial accounting information could have helped the company by reporting all of the variable and fixed costs associated with a delivered item, including the cost of the truck and driver used to deliver the merchandise. Cost should also have been measured for the cost of preparing sales orders, invoices and all other activities associated with the sale of the merchandise. If the company’s management had been aware of all of the costs related to each sale, they would have been more likely to take corrective action sooner. Instead, the company attempted to solve its financial problems by increasing sales volume for delivered products which actually aggravated an already bad situation. The futility of the approach used by management of increasing sales of delivered merchandise would have been obvious if the total costs had been known. PTS: 1 TOP: Chapter 14

AACSB:

Knowledge, Analytical

Chapter 15 – Capital investment decisions TRUE/FALSE 1. The accounting rate of return (ARR) is a traditional method of project evaluation, which involves dividing either the average net profit by the average book value of the investment, or the average net profit by the total initial investment value. ANS: T PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

2. The payback period is a method used to assist in making decisions about capital investments, and looks at the time required to recover the initial investment. ANS: T PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

3. The payback period provides some assessment of risk, with a longer payback period indicating a lower risk for the project. ANS: F PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

4. Capital investment decisions include mutually exclusive projects where the acceptance of one project results in the rejection of another project or projects. ANS: T PTS: 1 TOP: Comparison of IRR and NPV

AACSB:

Knowledge, Analytical

5. An entity is contemplating investing in a long-term project. A comparison of two mutually exclusive projects reveals that Project A involves an initial outlay of $6000 with cash inflows of $2600 for years 1–5, whereas Project B requires a cash outlay of $4500 with cash inflows of $1300 for years 1–5. Based on this information, the IRR for Project A is higher than the IRR for Project B. ANS: T PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

6. An alternative approach to using the algebraic equation for calculating the internal rate of return is to use trial and error. ANS: T PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

7. The internal rate of return is the rate of return that discounts the cash flows of a project so that the present value of cash inflows equals the present value of expected profits. ANS: F PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

8. A common characteristic of the internal rate of return and the accounting rate of return is that both use the concept of a rate of return.

ANS: T PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

9. A problem with calculating the internal rate of return is that it relies on the estimation of future cash flows, which can be inaccurate, thus making the IRR less reliable. ANS: T PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

10. For a project that has an initial outflow of $10,000 and equal inflows of $3400 for four years, the NPV at a minimum rate of return of 20% will be $(1198) and should not be accepted. ANS: F PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

11. For mutually exclusive projects, the IRR and NPV can give different rankings, but for independent conventional cash flow projects the rankings will be the same. ANS: T PTS: 1 TOP: Comparison of IRR and NPV

AACSB:

Knowledge, Analytical

12. Where two projects have the same investment outlays and project lives but different net cash inflows, the IRR and NPV may give different rankings. ANS: T PTS: 1 TOP: Comparison of IRR and NPV

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. In which of the following situations would it not be useful to apply the concepts and techniques used in capital investment decisions? A. A company is considering the purchase of a new machine that would reduce the cost of direct labour in the production process. B. A company is comparing the profitability and capital investments of two district offices to determine which one has the best current return on investment. C. A company is reviewing the past performance of two investment projects to determine which project had the best five-year return on the investment made. D. A company is evaluating the potential investment in research and development expenses to develop a new product line. ANS: B TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

2. Which of the following does not affect a capital investment decision? A. Cash flows B. Accrual-basis net profit C. Risk D. All of the above affect capital investment decisions. ANS: B PTS: 1 TOP: Discounted cash flow techniques

AACSB:

Knowledge, Analytical

3. What is a disadvantage of using the accounting rate of return? A. It links long-term decision making to profit as the measure of success. B. It is easy to understand. C. It uses accounting measures of profit rather than cash flows. D. None of the above. ANS: C PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

4. Which of the following is not an advantage of the accounting rate of return method? A. It is easy to understand. B. It includes the time value of money. C. It is simple to calculate. D. The profit ratio is familiar to managers. ANS: B PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

5. The accounting rate of return does not consider: A. cost of investment. B. profitability. C. the time value of money. D. depreciation. ANS: C PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

6. Guerdon Ltd is reviewing a project that has an initial outlay of $3m. The project will generate a cash inflow of $2m per annum. The project is expected to have a useful life of six years and a zero salvage value. This company uses straight-line depreciation. What is the accounting rate of return on the total investment? A. 15% B. 20% C. 33% D. 50% ANS: D PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

The following information applies to questions 7 and 8. Phil’s Fish Shack Ltd wants to purchase machinery costing $20,000. The machinery is expected to have a life of 2 years and a zero residual value at the end of that time. The company uses a discount rate of 10 per cent. The net cash inflows for each year are forecast to be: Year 1 Year 2

$12,000 $16,000

7. What is the accounting rate of return on the total investment? A. 10% B. 20% C. 60% D. 70% ANS: B PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

8. What is the accounting rate of return based on the average book value of the investment? A. 40% B. 60% C. 100% D. 120% ANS: A PTS: 1 TOP: Accounting rate of return

AACSB:

Knowledge, Analytical

9. Based on the following information, what is the payback period for the two investment projects? Select the best combination. Year 0 1–3 4–6

Project A $(18,000) $2000 per annum $5000 per annum

Payback period Project A A. 6.4 years B. 5.4 years C. 6.5 years D. 5.4 years

Project B $(22,000) $3000 per annum $5000 per annum

Payback period Project B 5.6 years 4.6 years 5.5 years 5.6 years

ANS: D PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

10. The payback period is: A. the length of time required for cash inflows from the project to recover the initial investment. B. the length of time required for profits from the project to equal the original cash outlay. C. the length of time required for the cash flows from the project to be expressed as a percentage of the original capital. D. none of the above. ANS: A PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

11. Ridge NL is considering investing in a new project. Given the following information, which project would Ridge choose if a maximum payback period of 5.8 years is set?

Initial investment Cash flows Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Project A $160,000

Project B $180,000

25,000 25,000 25,000 25,000 25,000 25,000 25,000

25,000 30,000 35,000 30,000 25,000 20,000 15,000

A. Project B, as the payback period is less than 5.8 years. B. Both projects, as the payback periods are less than 5.8 years.

C. Project A, as the payback period is less than 5.8 years. D. Neither project, as both payback periods exceed 5.8 years. ANS: D PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

12. Guerdon Ltd is reviewing a project that has an initial outlay of $3m. The project will generate a cash inflow of $2m per annum. The project is expected to have a useful life of six years and a zero salvage value. This company uses straight-line depreciation. What is the payback period? A. 0.67 years B. 1.5 years C. 2.0 years D. 6 years ANS: B PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

13. Which of the methods of evaluating capital investment projects does not consider all of the future cash flows related to a project? A. Net present value (NPV). B. Internal rate of return (IRR). C. Payback method. D. All are correct. ANS: C PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

14. What is an advantage of the payback method of reviewing capital investments? A. It is based on accounting information. B. It considers the timing of all cash flows. C. It is based on non-cash flow information. D. It provides some assessment of risk. ANS: D PTS: 1 TOP: Payback period

AACSB:

Knowledge, Analytical

15. The ____ value of an amount is the value of that amount at a later date. A. Present B. Fair C. Future D. Prospective ANS: C TOP: General

PTS: 1

AACSB:

Knowledge, Analytical

16. What is the internal rate of return for a project that has an initial outlay of $65,000 and expected cash inflows of $9456 per year for eight years? A. 3% B. 3.5% C. 4% D. 6.8% ANS: B PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

17. Using the tables provided, calculate or estimate the internal rates of return (IRR) that are the closest to those listed for the two projects. Year 0 1 2

Project A $(25,000) $ 14,405 $ 14,405

Project B $(80,000) $ 47,334 $ 47,334

Present value of $1 to be received after N periods:

Interest rate 7% 8% 9% 10% 11% 12% 13% IRR Project A A. 0.0% B. 11.5% C. 10.0% D. 11.0%

N periods 1 2 $0.9346 $0.8734 .9259 .8573 .9174 .8417 .9091 .8264 .9009 .8116 .8929 .7972 .8850 .7831 IRR Project B 11.5% 12.0% 12.0% 13.5%

ANS: C PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

18. Using the tables provided, calculate the IRR of two investments and select the best combination of answers. Year 0 1

Project A $(120,000) $ 130,800

Project B $(50,000) $57,250

Present value of $1 to be received after N periods: N periods Interest rate 7% 8% 9% 10% 11% 12% 13% 14%

1 $0.9346 .9259 .9174 .9091 .9009 .8929 .8850 .8733

2 $0.8734 .8573 .8417 .8264 .8116 .7972 .7831 .7695

IRR Project A A. 9% B. 9% C. 9% D. 0.10%

IRR Project B 12% 7% 14% 0.12%

ANS: C PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

19. Which of the following is not an advantage of IRR? A. It uses the concept of a rate of return, which is familiar to many managers. B. It incorporates the time value of money by not treating cash received in different years as equal. C. There is only one IRR for every investment. D. It uses cash flows and not profits, and the payment of cash outflows is more closely aligned with cash inflows than profits would be. ANS: C PTS: 1 TOP: Internal rate of return

AACSB:

Knowledge, Analytical

20. Net present value (NPV) is an important concept used to analyse capital investment projects. NPV can best be described as: A. the amount that should be used to discount the future cash flows to the present, and then compared with the current investment. B. the amount that must be invested now to earn a particular future value. C. the difference between the future cash inflows and the discounted cost of the investment. D. the difference between the discounted future cash inflows and the cost of the investment. ANS: D PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

21. A positive net present value indicates that: A. the IRR is less than the discount rate. B. the cost of capital is greater than the present value of the future cash inflows. C. the projected return on the investment is expected to exceed the cost of capital plus the cost of the initial investment. D. the IRR is less than the cost of capital. ANS: C PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

22. Companies evaluating capital investment projects frequently use net present value analysis to make decisions about which projects are likely to be the most profitable. Cash flows are projected for future periods and then discounted to the present. A common rate to use when discounting these cash flows is the: A. internal rate of return. B. weighted cost of capital. C. prime rate of interest. D. accounting rate of return. ANS: B PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

23. Phil’s Fish Shack Ltd wants to purchase machinery costing $20,000. The machinery is expected to have a life of two years and a zero residual value at the end of that time. The company uses a discount rate of 10%. The net cash inflows for each year are forecast to be: Year 1 Year 2

$12,000 $16,000

Interest rate 7% 8% 9% 10%

N periods 1 2 $0.9346 $0.8734 .9259 .8573 .9174 .8417 .9091 .8264

What is the approximate net present value of the investment? A. $4131 B. $5452 C. $8000 D. $20,000 ANS: A PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

24. Which of the following statements is true concerning the future value of an investment? A. The difference between the future and present values of an investment is the annuity. B. The future value of an investment is expected to be larger than its present value. C. The future value of an investment is expected to be smaller than its present value. D. The future value of an investment is always smaller than its present value. ANS: B TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

25. Which of the following statements is true concerning the present value of an investment? A. The difference between the future and present values of an investment is the annuity. B. The present value of an investment is expected to be larger than its future value. C. The present value of an investment is expected to be smaller than its future value. D. The present value of an investment is always larger than its future value. ANS: C TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

26. The difference between future value and present value is: A. cost. B. annuity. C. apportionment. D. interest. ANS: D TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

27. The Orgonne Milling Company is contemplating the purchase of new equipment. The machinery is expected to generate increased sales of $50,000 per year over its five-year life. Excluding the cost of the machinery, additional costs are expected to be $15,000 per year. If the firm requires a minimum 12% return on its investment, what is the maximum price the company can pay for this equipment? (PV annuity at 12% for five years is 3.604)

A. $180,200 B. $175,000 C. $126,140 D. $54,072 ANS: C PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

28. The Sparks Sailboat Company has just acquired new manufacturing equipment. No down payment was made, but four year-end payments of $2400 will be required to pay for the machine. If 8% is the appropriate rate, at what amount should Sparks Sailboat Company record the new equipment on its books? (PV annuity at 8% for four years is 3.312, five years is 3.992) A. $7056 B. $7949 C. $9581 D. $13,060 ANS: B PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

29. The ____ value of an amount is the value of that amount on a particular date prior to the time the amount is paid or received. A. present B. current C. contemporary D. coetaneous ANS: A TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

30. Using the tables provided, calculate the net present value (NPV) of each of the following projects and select the best answer from the choices given. The applicable discount rate is 11%. Year 0 1 2 3 4

Project A $(25,000) 8000 8000 8000 8000

Project B $(80,000) 30,000 30,000 30,000 30,000

Present value of $1 to be received after N periods:

Interest rate 10% 11% 12% NPV Project A A. $24,820 B. $(180)

1 $0.9091 .9009 .8929 NPV Project B $93,072 $93,072

N periods 2 3 $0.8264 $0.7513 .8116 .7312 .7972 .7118

4 $0.6830 .6587 .6355

C. $(180) D. $24,820

$13,072 $13,072

ANS: C PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

31. An entity is contemplating investing in a long-term project. A comparison of two mutually exclusive projects reveals that Project A has an initial outlay of $10,000 with cash inflows of $3400 for years 1–5; Project B has a cash outlay of $4500 with cash inflows of $1400 for years 1–5. If the minimum rate of return is 20%, which of the following statements is incorrect? A. The internal rate of return suggests that Project A would be accepted and Project B would not. B. The net present value suggests that Project A would be accepted and Project B would not. C. The net present value for Project B is a negative amount. D. If the projects were not mutually exclusive, the net present values would suggest that both projects should be selected. ANS: D PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

32. You have an opportunity to purchase the Kuppajo Cafe, a busy shop near your office. The owner is asking $49,000. After satisfying yourself as to the accuracy of the firm’s past financial statements, you note that it generated $12,000 per year in net cash flow. You believe you could operate the business for 4 years and sell it for $30,000. What is the maximum amount you would be willing to pay for the business if you wished to earn at least a 10% return on your investment?

Interest rate 10% 11% 12%

N periods 1 $0.9091 .9009 .8929

2 $0.8264 .8116 .7972

3 $0.7513 .7312 .7118

4 $0.6830 .6587 .6355

A. $33,467 B. $58,528 C. $68,690 D. $95,096 ANS: B PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

33. The Bee Family Fun Centre is for sale at an asking price of $400,000. The audited financial statements show that the business generates approximately $43,000 per year in net cash flow. You believe you could operate the business for 3 years and sell it for $500,000. What is the maximum amount you would be willing to pay for the business if you wished to earn at least a 10% return on your investment?

Interest rate 10% 11% 12%

N periods 1 $0.9091 .9009 .8929

2 $0.8264 .8116 .7972

3 $0.7513 .7312 .7118

4 $0.6830 .6587 .6355

A. $629,000 B. $500,000 C. $482,582 D. $375,655 ANS: C PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

34. A business is for sale at $100,000. Discounting the expected cash inflows and expected cash outflows (except the purchase price) at 12% yields an amount of $94,741. Based on this information: A. the minimum price you should pay for the business is $94,741. B. at a purchase price of $100,000, the business is projected to earn just a little more than 12%. C. a higher discount rate would make this business opportunity more attractive. D. the investment opportunity should be rejected if a 12% return is required. ANS: D PTS: 1 TOP: Net present value

AACSB:

Knowledge, Analytical

35. Which of the following will increase future value relative to present value? A. A higher interest rate B. A shorter period C. More safety D. Less risk ANS: A TOP: Chapter 15

PTS: 1

AACSB:

Knowledge, Analytical

36. Which of the following combinations of interest rate and number of periods is needed for calculation of the present value of an investment that involves an annual interest rate of 12% for 3 years with monthly compounding? Number of periods A. 3 B. 6 C. 12 D. 36 ANS: D PTS: 1 TOP: Appendix at book website

Interest rate 12% 6% 3% 13% AACSB:

Knowledge, Analytical

37. A series of equal amounts received or paid over a specified number of equal time periods is known as an: A. allotment. B. apportionment. C. annuity. D. allowance. ANS: C PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

38. An annuity is a series of: A. equal amounts paid or received over a specified number of unequal time periods. B. unequal amounts paid or received over a specified number of equal time periods. C. equal amounts paid or received over an unspecified number of equal time periods. D. equal amounts paid or received over a specified number of equal time periods. ANS: D PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

39. Which of the following best expresses the concept of compound interest? A. Calculating interest on an annuity. B. Earning interest on interest already earned. C. Making complicated interest calculations. D. Making more than one interest payment. ANS: B PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

40. Earning interest in one period on interest earned in an earlier period is known as: A. simple interest. B. compound interest. C. combined interest. D. composite interest. ANS: B PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

41. If you placed $1000 in a savings account today, how much would you have one year from now if the bank paid 8% interest? A. $1800 B. $1080 C. $1008 D. $1000 ANS: B PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

42. Which of the following formulas would you use to correctly calculate the future amount of an investment of $600 that was earning interest at 8% annually for three years? A. $600  1.08  1.08  1.08 B. $600  1.08  3 C. 3  $600  0.08 D. (1.08  3)  $600 ANS: A PTS: 1 TOP: Appendix at book website

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Describe the accounting rate of return (ARR) and payback period methods of evaluating capital projects, including the formula and decision criterion associated with each method. ANS: ARR: the rate of return is measured using average net profit (after depreciation and tax expenses). The denominator is either the average book value of the investment (formula 1); or the total initial investment value (formula 2). The decision criterion is to accept projects with a rate of return higher than some minimum desired rate of return. Where projects are competing or mutually exclusive, the project with the highest rate of return is accepted provided it is above the minimum desired rate of return. Payback period: An important issue when considering any long-term investment is how long it will take for the initial investment to be recouped. The payback period is the time within which recovery of the initial investment is expected. It is calculated by dividing the amount of the initial investment by the net cash flow. The payback period is a measure of risk: the longer the payback period the higher this risk. As a decision criterion, all other things being equal, if two competing investments offered similar expected benefits, the project with the shorter payback period would be preferred. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Accounting rate of return an payback period 2. Describe the major disadvantages of using the accounting rate of return (ARR) and payback period methods as bases for evaluating capital projects. ANS: Disadvantages ARR: • It applies the same weighting to profits in all years and ignores the time value of money. • It uses accounting measures and not cash flows. Accounting measures are important in assessing managerial performance. However, cash flows are important in investment evaluations as it is cash that are used to pay wages, supplies, and so on. • The two different formulas can result in different decisions. Disadvantages payback period: • It does not take into consideration a project’s cash flows after the payback period and can therefore result in the selection of less profitable investments if used in isolation. • It ignores the time value of money and treats all cash flows as equal, irrespective of the year in which they occur. This problem can be overcome by using the discounted payback period, in which cash flows are discounted to reflect the time value of money. However, the disadvantage identified above remains. PTS: 1 AACSB: TOP: Accounting rate of return

Knowledge, Analytical, Communication

PROBLEM 1. Harglo Construction is considering purchasing a radio antenna for broadcasting to service trucks over the airwaves, rather than using telephone lines. The antenna is expected to reduce cash operating costs by $2000 the first year, $2500 the second year, and $3000 the third year. The antenna will cost $6000, will last 3 years (due to technological advances), and will have no residual value at the end of its life. Harglo’s minimum acceptable rate of return is 8%.

(a)

Compute the net present value of the investment in the antenna.

(b)

If Harglo’s cost of capital was 12%, would this proposal be acceptable?

ANS: (a) Future Amount Net cash inflows: Year 1 Year 2 Year 3 Cash outflow: Now Net present value (b) Net cash inflows: Year 1 Year 2 Year 3 Cash outflow: Now Net present value

$2000 2500 3000

Present Value of $1 Factor x x x

0.9259 0.8573 0.7938

Present Value = = =

$1851.80 2143.25 2381.40 (6000.00) $ 376.45

$2000 2500 3000

x x x

0.8929 0.7972 0.7118

= = =

$1785.80 1993.00 2135.40 (6000.00) $ (85.80)

(b) No, the project is not acceptable at 12%. PTS: 1 AACSB: TOP: Net present value

Knowledge, Analytical

2. The Sloopy Jeans Company is considering the purchase of a machine that would increase the company’s cash inflows by $12,000 per year for six years. Operation of the machine would increase the company’s cash payments by $400 in each of the first three years, $800 the fourth year, and $1000 in the fifth and sixth years. The machine costs $50,000 and would have a residual value of $2000 at the end of the sixth year. (a) (b)

Compute the payback period for this machine. Compute the net present value of the investment in the machine, assuming a minimum acceptable rate of return of 16%.

ANS: (a)

Year 1 Year 2 Year 3 Year 4 Year 5

Amount Unpaid at Beginning of Year

Net Cash Inflow Expected

Amount Left Unpaid at Year-End

$50,000 38,400 26,800 15,200 4000

$11,600 11,600 11,600 11,200 11,000

$38,400 26,800 15,200 4000 --

Payback period = 4.36 years (4 years + $4000/$11,000)

(b) Cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 6

$11,600 x 0.8621 = 11,600 x 0.7432 = 11,600 x 0.6407 = 11,200 x 0.5523 = 11,000 x 0.4761 = 11,000 x 0.4104 = 2000 x 0.4104 =

Cash outflows: Initial investment Net present value

$10,000.36 8621.12 7432.12 6185.76 5237.10 4514.40 820.80

(50,000.00) $(7188.34)

PTS: 1 AACSB: Knowledge, Analytical TOP: Net present value and payback period 3. The Tearess Company can accept either Proposal A or Proposal B (but not both), or it can reject both investment proposals. Proposal A requires an investment of $7000 and promises increased net cash inflows of $2600 for five years. Proposal B requires an investment of $7000 and promises increased net cash inflows of $3000 in each of the first three years, $2000 in the fourth year and $2200 in the fifth year. The company’s minimum acceptable rate of return is 20%. Prepare an analysis to determine which (if either) of the proposals should be selected for investment. ANS: Investment Proposal A Cash inflows: $2600  2.9906 = Cash outflows: Initial investment Net present value

$7775.56 (7000.00) $ 775.56

Investment Proposal B Cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5 Cash outflows: Initial investment Net present value

$3000 x 0.8333 = 3000 x 0.6944 = 3000 x 0.5787 = 2000 x 0.4823 = 2200 x 0.4019 =

$2499.90 2083.20 1736.10 964.60 884.18 (7000.00) $1168.98

Therefore, accept Investment Proposal B, because it has the higher positive net present value. PTS: 1 AACSB: TOP: Net present value

Knowledge, Analytical

4. First Time Cinema, Inc., is a small company that produces movies for artists who have little prior experience in the film industry. Because of the high risk associated with these projects, the company will not accept projects that have a payback period of more than three years. The company is considering three projects and requests your assistance in evaluating their potential given their projected cash flows. Year 0 1 2 3 4 5

Project 1 $(150,000) $ 50,000 $ 100,000 $ 1000 $ 1000 $ 1000

Project 2 $(25,000) $ 19,000 $ 1000 $ 10,000 $ 10,000 $ 10,000

Project 3 $(100,000) $ (20,000) $ 40,000 $ 40,000 $ 40,000 $ 450,000

(a) Calculate the payback period for each project. (b) Which project(s) would you accept? Why? (c) Discuss any reasons why you are satisfied or dissatisfied with the results of your analysis above. ANS: (a) Payback period: Project 1: 2 years

Year 1 = Year 2 = Total

$ 50,000 100,000 $150,000 = Investment

Project 2:

2.5 years

Year 1 = Year 2 = Year 3 = Total

$ 19,000 1000 5000 (1/2 year) $ 25,000 = Investment

Project 3:

4 years

Year 1 = Year 2 = Year 3 = Year 4 = Total

$(20,000) 40,000 40,000 40,000 $100,000 = Investment

(b) Projects 1 & 2; Based solely on the payback method, Projects 1 & 2 would be accepted, because they both meet the three-year criterion. (c) There is little reason to be satisfied with the results of this method, particularly under the circumstances described in this problem. There is some comfort in selecting Project 1, because the investment is recovered quickly, which reduces risk. There are many reasons to be dissatisfied. First, although the payback period for Project 2 is longer, a much larger percentage of the money is recovered in year 1 than for Project 1 (the one selected). If the time value of money were considered, cash received in earlier periods has more value than the same dollars received later. Second, Project 3 was not selected because its payback period was two years longer than Project 1. The payback method ignores cash flows past the payback period, so

the $450,000 expected to be received in year 5 is not considered at all. Project 3 is actually the most profitable investment, even though it has the longest payback period. Even without calculating, it is apparent that the large cash flow received in year 5 for Project 3 would be sufficient compensation to the company for the additional risk assumed. PTS: 1 AACSB: TOP: Payback period

Knowledge, Analytical

5. Second Time Cinema, Inc., is a small company which produces movies for artists who have some prior experience in the film industry. Because of the high risk associated with these projects, the company will not accept projects that have an Accounting Rate of Return of less than 25%. The company is considering three projects and requests your assistance in evaluating their potential given their projected cash flows. All of the initial investments are assets which have an estimated life of five years and will be depreciated on a straight-line basis. Year 0 1 2 3 4 5

Project 1 $(150,000) $ 170,000 $ 60,000 $ 34,000 $ 34,000 $ 34,000

Project 2 $(25,000) $ 6000 $ 33,000 $ 9000 $ 7000 $ 5000

Project 3 $(100,000) $ (20,000) $ 20,000 $ 20,000 $ 85,000 $ 140,000

(a) Calculate the ARR (on initial investment) for each project. (b) Which project(s) would you accept? Why? (c) Discuss any reasons why you are satisfied or dissatisfied with the results of your analysis above. ANS: (a) ARR: Project 1: 24.27% Average cash flow = ($170,000 + $60,000 + $34,000 + $34,000 + $34,000) ÷ 5 = $66,400 Average depreciation = $150,000 ÷ 5 = $30,000 ARR = ($66,400 - $30,000) ÷ $150,000 = 24.27% Project 2: 28.00% Average cash flow = ($6000 + $33,000 + $9000 + $7000 + $5000) ÷ 5 = $12,000 Average depreciation = $25,000 ÷ 5 = $5000 ARR = ($12,000 - $5000) ÷ $25,000 = 28.00% Project 3: 29.00% Average cash flow = (-$20,000 + $20,000 + $20,000 + $85,000 + $140,000) ÷ 5 = $49,000 Average depreciation = $100,000 ÷ 5 = $20,000 ARR = ($49,000 - $20,000) ÷ $100,000 = 29.00% (b) Projects 2 & 3; Based solely on ARR, Projects 2 & 3 both meet the 25% requirement. (c) There is little reason to be satisfied with the results of this method, particularly under the circumstances described in this problem. ARR is used by some companies because accounting numbers are more easily determinable and may be the best measures available.

There are many reasons to be dissatisfied. First, although the ARR for Project 2 is slightly less than Project 3, a much larger percentage of the cash flow is received in years 1 and 2 than for Project 3 (the one selected using ARR). Second, Project 1 would not be selected using ARR because its ARR was 22.27%, which is less than the 25% hurdle rate stipulated (perhaps arbitrarily) by the company’s management. The ARR method ignores the timing of cash flows, so the $140,000 expected to be received in year 5 for Project 3 is given the same weight as the $20,000 negative cash flow in year 1. Project 1 is actually the most profitable investment, even though it has the smallest ARR. Even without calculating, it is apparent that the large cash flow received in year 1 for Project 1 would be sufficient compensation to the company to substantially lower the risk assumed. PTS: 1 AACSB: TOP: Accounting rate o return

Knowledge, Analytical

6. A company is considering two projects with the following cash flows: (Albright, 12, p.4) Year Project A Project B 0 $(526,677) $(74,809) 1 $ 180,000 $ 30,000 2 $ 180,000 $ 30,000 3 $ 180,000 $ 30,000 4 $ 180,000 $ 30,000 5 $ 180,000 -0Present value of $1 to be received after N periods: N Periods Interest Rate 1 2 3 4 5 19% 0.8403 0.7062 0.5934 0.4987 0.4190 20% 0.8333 0.6944 0.5787 0.4823 0.4019 21% 0.8264 0.6830 0.5645 0.4665 0.3855 22% 0.8197 0.6719 0.5507 0.4514 0.3700 Present value of an annuity of $1 for N periods: N Periods Interest Rate 1 2 3 19% 0.8403 1.5465 2.1399 20% 0.8333 1.5278 2.1065 21% 0.8264 1.5095 2.0739 22% 0.8197 1.4915 2.0422

4 2.6386 2.5887 2.5404 2.4936

5 3.0576 2.9906 2.9260 2.8636

(a) Assuming a discount rate of 20% and no taxes, compare these projects using Net Present Value (NPV). Which project would you accept? Why? (b) Calculate the Internal Rate of Return (IRR) of each project using the partial tables provided. Which project would you accept relying solely on the IRR to make your decision? (c) Considering both IRR and NPV, which project would you accept? Why?

ANS: (a) NPV: Project A = $11,631; Project B = $2852; Select Project A, which has the highest NPV. $ 180,000

Project A: Cash flow PV of annuity @ 20% PV of cash flows Initial Investment NPV

 2.9906 * $ 538,308 (526,677) $ 11,631

Project B: Cash flow PV of annuity @ 20% PV of cash flows Initial Investment NPV

$ 30,000  2.5887 * $ 77,661 (74,809) $ 2852

* Note: Project A is 5 years; Project B is 4 years. (b)

IRR: Project A = 21%; Project B = 22%; Select Project B, which has the highest IRR. Project A: Initial Investment ÷ Annual cash flow = $526,677 ÷ $180,000 = 2.9260 = factor In the 5-year column, this corresponds to an interest rate of 21% Project B: Initial Investment ÷ Annual cash flow = $74,809 ÷ $30,000 = 2.4936 = factor In the 4-year column, this corresponds to an interest rate of 22%

(c) Considering both NPV and IRR, you would probably accept Project A with its higher NPV, since this would add the most to the company’s profits. If there were other projects available with high returns, Project B may look more attractive, since it does not use as much of the available capital and is somewhat less risky, since it is a four-year, rather than a five-year project. There are many qualitative considerations as well (such as the type of project and how it fits into the overall company) that students may propose in their answer. However, qualitative reasons for selecting one project over the other are not anticipated in this question. PTS: 1 AACSB: Knowledge, Analytical TOP: Net present value and internal rate of return

Chapter 16 – Cost information and decision making TRUE/FALSE 1. In multi-product firms, it is necessary to set up a system to account for costs and to identify direct and indirect costs. ANS: T PTS: 1 AACSB: TOP: Costs in multi-product (service) firms

Knowledge, Analytical

2. The selling price of products is determined by market forces but can also be dependent on the price of the product, particularly where there is little or no competition. ANS: T PTS: 1 AACSB: TOP: Management’s needs for information

Knowledge, Analytical

3. The basic difference between management and financial accounting is that the financial accounting system relies on accounting information whereas management accounting does not. ANS: F PTS: 1 TOP: Cost assignment process.

AACSB:

Knowledge, Analytical

4. Direct costs are sometimes referred to as prime costs, and indirect costs as overhead costs. ANS: T PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

5. Product costs are held as assets until sold, whereas period costs are expensed in the period in which they are incurred. ANS: T PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

6. Costs that change in response to changes in the level of activities are referred to as fixed costs. ANS: F PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

7. Absorption costing is a method of allocating direct and indirect costs of production to a cost object. ANS: T PTS: 1 TOP: Costing methods

AACSB:

Knowledge, Analytical

8. The overhead costs for product Y are estimated to be $160,000 and the activity level is estimated to be 80,000 machine hours. The actual costs are found to be $180,000 and the actual machine hours are 85,000. Under absorption costing this will necessitate an entry to the statement of comprehensive income to record a period cost of $10,000. ANS: T PTS: 1 TOP: Variable versus absorption costing

AACSB:

Knowledge, Analytical

9. Indirect costs are not included in the calculation of the overhead absorption rate as it is generally thought to be too complex to share these costs equitably. ANS: F PTS: 1 TOP: Costing methods

AACSB:

Knowledge, Analytical

10. In traditional-based costing, overheads are apportioned based on one volume measure, whereas in activity-based costing, overheads are apportioned according to cost drivers. ANS: T PTS: 1 TOP: Activity-based costing systems

AACSB:

Knowledge, Analytical

11. With advanced manufacturing technology, indirect costs tend to predominate over direct costs. ANS: T PTS: 1 TOP: Activity-based costing systems

AACSB:

Knowledge, Analytical

12. Absorption costing includes a proportion of fixed costs in the inventory value, whereas variable costing does not. ANS: T PTS: 1 TOP: Costing methods

AACSB:

Knowledge, Analytical

13. When production exceeds sales, absorption costing shows a higher profit than variable costing because a portion of fixed costs are charged to inventories and thereby deferred to future periods. ANS: T PTS: 1 TOP: Variable versus absorption costing

AACSB:

Knowledge, Analytical

14. When sales exceeds production, absorption costing shows a higher profit than variable costing because a portion of fixed costs are charged to inventories and thereby deferred to future periods. ANS: F PTS: 1 TOP: Variable versus absorption costing

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Management requires information about the cost of products for all of the following reasons except to: A. ascertain the relative profitability of products. B. control costs. C. estimate rate of depreciation for equipment. D. aid planning. ANS: C PTS: 1 AACSB: TOP: Management’s needs for information about costs

Knowledge, Analytical

2. Management accounting is concerned with: A. the company as a whole, rather than with its segments. B. providing information to internal decision makers. C. meeting the requirements of generally accepted accounting principles. D. recording the financial history of an organisation. ANS: B PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

3. Costs that would be included in the factory overhead account would normally not include: A. depreciation on plant and equipment. B. indirect materials. C. direct materials. D. factory gas and electricity. ANS: C PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

4. Indirect costs for an electrician would not include: A. factory rent. B. protective clothing. C. depreciation of tools. D. the electrician’s salary. ANS: D PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

5. Period costs are: A. costs that are unlikely to represent future benefits. B. costs that are recognised in the accounting period in which they are incurred. C. costs for which the future benefits cannot be reliably measured. D. All of the above are period costs. ANS: D PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

6. Which of the following are not production costs? A. Direct materials B. Indirect labour C. Selling expenses D. Indirect materials ANS: C PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

7. Costs directly associated with specific goods are: A. product costs. B. period costs. C. prepaid costs. D. past period costs. ANS: A PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

8. Work-in-progress includes all of the items below except: A. cost of materials. B. cost of labour. C. selling costs. D. overhead costs. ANS: C TOP: Chapter 16

PTS: 1

AACSB:

Knowledge, Analytical

9. The primary difference between a product cost and a period cost is that: A. product costs are associated with specific goods, and period costs are not. B. product costs are incurred by manufacturers, and period costs by service providers. C. only product costs are recorded as expenses. D. period costs become part of cost of goods sold but product costs do not. ANS: A PTS: 1 TOP: Cost assignment process

AACSB:

Knowledge, Analytical

10. Service departments often provide service to: A. revenue-producing departments only. B. other service departments only. C. both revenue-producing and service departments. D. shareholders. ANS: C PTS: 1 TOP: Absorption (full) costing

AACSB:

Knowledge

11. Adel Department Store incurred $8000 of indirect advertising costs for its operations. The following 20X1 data were collected for its three departments: Shoe Clothing Automotive Direct advertising costs $7000 $10,000 $3000 Newspaper ad space 62% 20% 18% Sales $160,000 $120,000 $120,000 How much of the indirect advertising costs would have been allocated to the Shoe Department if newspaper ad space were the allocation base? A. $4340 B. $4960 C. $5600 D. $7000 ANS: B PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

12. Adel Department Store incurred $8000 of indirect advertising costs for its operations. The following 20X1 data were collected for its three departments: Shoe Clothing Automotive Direct advertising costs $7000 $10,000 $3000 Newspaper ad space 62% 20% 18% Sales $160,000 $120,000 $120,000 How much of the indirect advertising costs would have been allocated to the Clothing Department if direct advertising costs were the allocation base? A. $1600 B. $2000 C. $4000 D. $8000 ANS: C PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

13. Adel Department Store incurred $8000 of indirect advertising costs for its operations. The following 20X1 data were collected for its three departments:

Direct advertising costs Newspaper ad space Sales

Shoe $7000 62% $160,000

Clothing $10,000 20% $120,000

Automotive $3000 18% $120,000

How much of the indirect advertising costs would have been allocated to the Automotive Department if sales were the allocation base? A. $1200 B. $1600 C. $2400 D. $8000 ANS: C PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

14. Which of the following is not normally a method of allocating overhead costs to products? A. Cost per machine hour B. Cost per direct labour dollar C. Cost per direct labour hour D. Cost per unit sold ANS: D PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

15. The overhead absorption rate is determined by using: A. estimated costs. B. marginal costs. C. average costs. D. historical costs. ANS: A PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

16. The application of overhead costs to products involves the use of: A. exact figures. B. fixed costs only. C. variable costs only. D. estimates. ANS: D PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

17. If the allocated overhead using a predetermined overhead rate is less than the actual overhead costs, the difference is: A. expensed to the statement of comprehensive income. B. recognised as income in the statement of comprehensive income. C. recognised as part of inventory on the balance sheet. D. expensed to the cost of goods sold. ANS: A PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

18. Brumpy Ltd uses a predetermined overhead rate in applying overhead costs to product, using direct labour costs for cost centre A and machine hours for cost centre B. The estimates for 20X6 are: Cost centre A Cost centre B Direct labour costs $100,000 $ 35,000 Production overheads 140,000 150,000 Direct labour hours 16,000 5000 Machine hours 1000 20,000 What are the predetermined overhead rates for cost centres A and B? A. $140 and $7.50 B. $1.40 and $7.50 C. $8.75 and $30 D. $1.40 and $4.29 ANS: B PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

19. Java Ltd manufactures two products, A and B. The manufacturing processes for the two products are very similar. The following are excerpts from the product data for these two products for 20X6: Product A Product B Units produced 5000 7000 Direct labour hours per unit 1 2 Number of set-ups 10 40 Number of orders 15 60 Machine hours 3 1 Overhead costs total $285,000. What is the cost per unit for each of A and B in respect of overhead costs using absorption costing, if costs are absorbed on the basis of direct labour hours? A. $15 and $30 B. $1 and $2 C. $16.96 and $23.75 D. $38.86 and $12.95 ANS: A PTS: 1 TOP: Traditional-based costing systems

AACSB:

Knowledge, Analytical

20. Which of the following is true of activity-based costing? A. Overhead is allocated using direct labour hours. B. Record keeping is less than under functional-based costing. C. Overhead is allocated using only activity measures. D. Overhead may be allocated using activity and volume-based measures. ANS: D PTS: 1 TOP: Activity-based costing

AACSB:

Knowledge, Analytical

21. The Blizzard Company manufactures skiing equipment. They make six different types of skis and this requires reconfiguring the machinery to new settings for the production of each of the six models. Under activity-based costing, which of the following would be the most appropriate basis on which to apportion the set-up costs for each model? A. Direct labour hours B. Direct machine hours C. Number of set ups D. Number of orders

ANS: C PTS: 1 TOP: Activity-based costing

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Knowledge, Analytical

22. Silver Streak Ltd manufactures two products, P and Q. The following data have been collected for the 20X2 period: P Q Units produced 5000 7000 Machine hours per unit 6 2 Number of set ups 15 25 Direct labour costs per unit $20 $25 Direct material cost per unit $25 $15 Overhead costs for both products are as follows: Setting-up $50,000 Machine costs $100,000 Total $150,000 Calculate the total unit cost for both products using the traditional-based cost system and the activity-based cost system. Assume both products use machine hours under the traditional-based system. Based on your calculations, which of the following statements is incorrect? A. Total unit cost under the traditional-based system are $46.82 for Q. B. Under the traditional-based cost system, product P would be under-priced compared to the activity-based system. C. Set-up costs are $1250 per set-up and machine costs are $2.27 per machine hour. D. Total production costs are $311,850 for 5000 units of P as per the activity-based system. ANS: B TOP: Chapter 16

PTS: 1

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Knowledge, Analytical

23. Absorption costing would be based on which of the following? A. Both fixed and variable costs of production. B. Fixed portion of production costs only. C. Variable portion of production costs only. D. None of the above. ANS: A PTS: 1 TOP: Absorption (full) costing

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Knowledge, Analytical

24. In a manufacturing operation that produces more than one product, the method of cost allocation chosen can have a major impact on which of the following? A. The total cost of raw materials. B. The unit cost of each product. C. Conversion costs. D. The method of allocation has no impact because the total manufacturing costs will still be the same. ANS: B PTS: 1 TOP: Costing methods

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Knowledge, Analytical

25. Which of the following statements is not true of absorption costing? A. When sales equal production, absorption costing yields the same profit as variable costing. B. When production exceeds sales, absorption costing shows a lower profit than variable costing does.

C. When sales exceed production, absorption costing shows a lower profit than variable costing does. D. Absorption costing allocated both fixed and variable overheads to product cost. ANS: B PTS: 1 AACSB: TOP: Measuring profit and valuing inventory

Knowledge, Analytical

26. Consider the plant layout shown below:

This layout would likely encourage manufacturing personnel to: A. specialise in one process. B. be cross-trained in more than one process. C. act in the best interests of shareholders. D. act in the best interests of customers. ANS: A TOP: Chapter 16

PTS: 1

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Knowledge, Analytical

27. PVMC PVMC is a small local hospital in southern Sydney. It has four divisions: family medicine, emergency medicine, medical testing, and the pharmacy. PVMC employs five physicians; their names and details of their work are shown below: % of time % of time % of time % of time spent spent spent spent in family in emergency in medical in the Name Salary medicine medicine testing pharmacy R. Montalban $60,000 50% 30% 15% 5% J. Lawrence 80,000 10% 40% 30% 20% B. Grief 75,000 10% 10% 10% 70% C. Brown 90,000 40% 60% 0% 0% S. Braxton 40,000 0% 20% 80% 0%

The graph below shows the breakdown of patients treated in each area:

PVMC uses activity-based costing to allocate physician salary costs to the four divisions. Each division is a cost pool; the cost driver is the percentage of time spent in each division. Of PVMC’s four divisions, which will have the greatest total allocation of salaries? A. Family medicine B. Emergency medicine C. Medical testing D. Pharmacy ANS: B PTS: 1 TOP: Activity-based costing

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Knowledge, Analytical

28. PVMC PVMC is a small local hospital in southern Sydney. It has four divisions: family medicine, emergency medicine, medical testing, and the pharmacy. PVMC employs five physicians; their names and details of their work are shown below: % of time % of time % of time % of time spent spent spent spent in family in emergency in medical in the Name Salary medicine medicine testing pharmacy R. Montalban $60,000 50% 30% 15% 5% J. Lawrence 80,000 10% 40% 30% 20% B. Grief 75,000 10% 10% 10% 70% C. Brown 90,000 40% 60% 0% 0% S. Braxton 40,000 0% 20% 80% 0% The graph below shows the breakdown of patients treated in each area:

PVMC uses activity-based costing to allocate physician salary costs to the four divisions. Each division is a cost pool; the cost driver is the percentage of time spent in each division. Of PVMC’s four divisions, which will have the greatest salary cost per patient? A. Family medicine B. Emergency medicine

C. Medical testing D. Pharmacy ANS: A PTS: 1 TOP: Activity-based costing

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Knowledge, Analytical

29. Veronica’s Clothing Manufacturers supplies the following information. Direct materials cost is $3.00 per unit; direct labour is $4.50 per unit. Variable overhead is $1.50 per unit; fixed overhead is $2.00 per unit. Secretarial salaries are $7.00 per unit and advertising amounts to $4.00 per unit. What is the total manufacturing cost per unit under absorption costing? A. $7.50 B. $9 C. $11 D. $22 ANS: C PTS: 1 TOP: Absorption (full) costing

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Knowledge, Analytical

30. Veronica’s Clothing Manufacturers supplies the following information. Direct materials cost is $3.00 per unit; direct labour is $4.50 per unit. Variable overhead is $1.50 per unit; fixed overhead is $2.00 per unit. Secretarial salaries are $7.00 per unit and advertising amounts to $4.00 per unit. What is the total manufacturing cost per unit under variable costing? A. $7.50 B. $9 C. $11 D. $22 ANS: B PTS: 1 TOP: Variable versus absorption costing

AACSB:

Knowledge, Analytical

31. Knowledge of unit costs is necessary to companies for many reasons. Which of the following are uses of unit cost information? I. II. III.

Valuation of inventories Controlling costs Setting selling prices

A. I only B. I and II only C. I and III only D. I, II, and III ANS: D PTS: 1 AACSB: TOP: Managements’ needs for information about costs

Knowledge, Analytical

SHORT ANSWER 1. In a manufacturing operation, costs can be divided into product costs and period expenses. (a) Explain the difference between product costs and period expenses. (b) Give two examples of costs classified as product costs. (c) Give two examples of costs classified as period expenses.

ANS: (a) Product costs, which become part of cost of goods sold, are the dollar amounts of materials, labour, and other resources consumed directly in producing goods. These costs are product-related costs that are reported as part of inventory or cost of goods sold, depending on whether the unit remains in ending inventory or has been sold. Thus, manufacturing costs are assets until goods are sold and become expenses. Period expenses (or period costs) are other operating expenses consumed as part of the administrative and selling activities during the fiscal period. Period costs are expenses of the period in which they occur. (b) Examples of product costs are direct material, direct labour, and manufacturing overhead such as indirect factory labour, equipment depreciation, and shop supplies. (c) Examples of period expenses are administrative and selling expenses such as office salaries, interest expense, sales commissions, and office supplies. PTS: 1 AACSB: TOP: Absorption (full) costing

Knowledge, Analytical, Communication

2. How is the variable cost approach used in managerial accounting? What are the advantages and disadvantages of this method? ANS: Variable costing facilitates certain types of decisions, such as breakeven and target profit decisions. It is also popular in making decisions about product pricing. Proponents of variable costing argue that it is theoretically wrong to inventory fixed costs because most fixed costs will be incurred whether any products are produced during a period or not. Proponents also argue that management could manipulate profit under absorption costing by manipulating the level of production. Variable costing is useful in decisions related to profit-maximisation because any sale that more than covers its variable cost contributes to covering fixed cost and profits. Critics of variable costing argue that in the long run companies must make sales that are sufficiently profitable to do more than just cover variable costs. Sales must be sufficient to cover fixed costs and make a profit or the company will not survive. Also, customers may come to expect these lower prices in the future. PTS: 1 AACSB: TOP: Variable versus absorption costing

Knowledge, Analytical, Communication

3. Manufacturing costs flow through an accounting system as products physically move through a factory. (a) (b)

Describe the movement of costs from raw materials to costs of goods sold in relation to the physical movement through the factors. Explain how manufacturing costs can sometimes be classified as assets rather than expenses.

ANS: (a) Raw materials are acquired and placed into a raw materials inventory account. When raw materials are removed from inventory and placed into production, their costs are added to

labour and overhead costs to become Work in Process inventory. The cost of completed goods is transferred to cost of goods sold when the units are sold. (b) When the cost of materials, labour and overhead are in inventory (raw materials, work in process or finished goods inventory), the costs are assets. The assets do not become expenses until the units are sold. PTS: 1 AACSB: TOP: Traditional-based costing systems

Analytical, Communication

4. Your friend, Bumble Beasley, just graduated from State University with a degree in business. He is planning to start his own consulting firm, and has asked you for accounting advice. Specifically, he has the following questions: (a) What kinds of overhead costs will I likely incur in my operation? (b) Should my general ledger contain a ‘work in process’ account? (c) Would you recommend a large, expensive office to impress my clients? Respond to Bumble’s questions. ANS: (a)

Bumble’s overhead will likely include the following items: office rent electricity

office supplies custodial costs

(b)

Bumble’s ledger will not likely include a ‘work in process’ account. Since he is operating a service business, he probably won’t have to account for partially completed units at the end of each accounting period.

(c)

Definitely not. Office rent would be considered a fixed cost. If Bumble rents a large, expensive office, but cannot locate clients due to his inexperience as a consultant, he is likely to run into financial difficulty.

PTS: 1 AACSB: TOP: Chapter 16/Chapter 17

Knowledge, Analytical

5. Explain the difference in the way that fixed manufacturing overhead is treated under variable costing and absorption costing. ANS: Under absorption costing, fixed manufacturing overhead costs per unit of production are included in the total unit cost of inventory items. Thus, the value of the beginning and ending inventories is calculated by multiplying the number of units by the unit cost which includes both fixed and variable manufacturing costs. If production exceeds sales during the period, part of the fixed manufacturing overhead costs are capitalised into the inventory and deferred until the inventory items are sold (that is, when sales exceed production in a later period). Under variable costing, fixed manufacturing overhead costs are treated as an expense of the current period, and not as part of inventory cost. Thus, the value of the beginning and ending inventories is calculated by multiplying the number of units by the unit cost which includes only variable manufacturing costs.

PTS: 1 AACSB: TOP: Costing methods

Knowledge, Analytical, Communication

PROBLEM 1. Opulent Baked Goods, Inc. makes two kinds of breads, Plain and Fancy. The owner has asked you to determine the cost of the two products so that he may know how to reasonably price his baked goods. The plain bread can be prepared and baked in large batches, while the fancy bread is made one loaf at a time. He has provided the following information about the manufacturing (baking) process for the 200,000 loaves of each of the two products for the year.

Ingredients (materials) Direct labour hours Labour cost @ $ 9.00/hour Baking time Number of mixes Recipe alterations

Plain Bread $140,000 5000 hours $45,000 10,000 hours 400 1

Fancy Bread $250,000 4000 hours $36,000 11,000 hours 10,000 3

Overhead costs (annual budget amounts):

Indirect labour (unit) Mixing of batches (batch) Recipe alterations (product) Building expenses (facility)

Estimated Cost $36,000 $94,000 $40,000

Estimated Activity 9000 direct labour hours 10,400 mixes 4 alterations allocated as a percentage of $640,000 total overhead

(a) Calculate the predetermined overhead rate per unit using ABC allocation methods. Calculate the rate for each separate activity and then calculate the total. The facility level overhead is calculated after other levels, with allocation in proportion to the total of other overhead allocations to each product. (b) Calculate product cost per unit for each of the two products (Plain and Fancy). ANS: (a)

Indirect labour Mixing of batches Recipe alterations Building expenses

Estimated Cost $36,000 $94,000 $40,000 $640,000

Estimated Activity 9000 hours 10,400 mixes 4 times % of total OH

Rate $4/hr. $9.04/mix $10,000 ea. percent

Indirect labour  Rate Total allocated

Plain Bread 5000 hours  _$4/hour $20,000

Fancy Bread 4000 hours  $4/hour $16,000

Mixing of batches Number of mixes

400

10,000

 Rate Total allocated

Recipe alterations Recipe alterations  Rate Total allocated

 $9.04/mix $3616 (round to $3600)

 $9.04/mix $90,400

1 _$10,000 ea. $10,000

3 _$10,000 ea. $30,000

$33,600 126,720 **

$136,400

Building expenses Total before building $640,000  19.8% $640,000  80.2% Total Overhead

$160,320

513,280** $649,680

Direct costs Ingredients (materials) Labour cost @ $9.00/hour

$140,000 45,000

$250,000 36,000

Total cost # of units

$345,320 200,000 units

$935,680 200,000 units

$1.73/unit

$4.68/unit

(b) Cost per unit ** Note: $33,600 + $136,400 = $170,000 $33,600 ÷ $170,000 = 19.8% $136,400 ÷ $170,000 = 80.2% PTS: 1 TOP: Chapter 16

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Knowledge, Analytical

2. Hardware Products manufactures a wide variety of products in its plant located in Boston, Massachusetts. Listed below are some of the manufacturing and administrative activities identified by management. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Employees who will be working on a particular product line go through a week-long training program either when they are first hired or when they change positions. The warehouse workers count and shelve all incoming raw materials in the warehouse when they are received. Small, high-priced parts are kept in a special fire-proof and theft-proof vault. Depreciation is calculated monthly for each machine used in the factory. Certain sensitive products are inspected by the receiving department upon receipt. Others are inspected on a random basis as a group. Products are packaged in the finishing department with a shrink-wrap machine. A specialised cleaning service has been hired for their ability to clean factory areas for companies with non-stop processes. Machine setups are performed each time production is begun for a new product. The shop foreman’s cost associated with approving overtime and reviewing weekly timecards for each factory employee. Engineers design new products.

(a) Identify a cost driver for each of the activities to be used to apply costs to the products. (b) Name one traceable cost that would be applied using the cost driver identified in Part a. ANS: (a) Cost Driver 1.

No. of units

2. 3. 4. 5. 6. 7. 8. 9. 10.

No. of units rec’d No. of units stored Machine hours No. of inspections No. of units Floor space No. of setups No. of employees No. of new products

PTS: 1 TOP: Chapter 16

AACSB:

(b) Traceable Cost Training materials and indirect labour (training facilitators) Indirect labour, supplies Depreciation of safe Depreciation of equipment Indirect labour, testing equip Packing materials, labour Cleaning service charges Indirect labour and materials Indirect labour, supplies Indirect labour, computer Knowledge, Analytical

ESSAY 1. Big River College, a small, private college, is trying to categorise its costs in an effort to reduce the overall costs of running the college. The students who attend the college are considered its ‘product’. Required: (a) What are some of the costs which should be classified as direct? Name at least three direct costs and explain the reason for the classification. (b) What are some of the costs which should be classified as indirect? Name at least three indirect costs and explain the reason for the classification. (c) If the college is trying to decide whether or not to offer a particular course in summer school, what are some of the relevant costs which should be considered? (d) Discuss some of the non-financial issues which should be considered in relation to the summer school course. ANS: (a) Costs at Big River College which should be classified as direct would be the salaries paid to professors, food for student cafeterias, and classroom instructional materials. All of these expenses can be directly related to ‘producing’ educated students and would increase or decrease in more or less direct proportion to the number of students. (b) Indirect costs at Big River College would be such costs as the cost of the financial aid office, the career development office, and the salary of the College Dean. Although these costs are related to the student ‘product’, they cannot be allocated in a logical manner. They support the instructional effort, but are not related specifically or directly to the number of students. (c) The costs relevant to a summer school class would be those costs which would increase if the course were offered. The professor’s summer school stipend, the benefits and payroll taxes related to the salary, the cost of electricity for the classroom and any instructional materials would be relevant. Fixed costs or other costs which would occur with or without the course would not be relevant.

(d) Non-financial factors the college should consider would be the effect on overall student (customer) satisfaction, the effect on student retention, and the effect on faculty morale. Also, offering the summer school class could negatively impact enrolments in classes offered during the regular term or positively impact enrolments in courses for which the summer school class is a prerequisite. The availability of summer school classes may improve the reputation of the college in the community. The summer school classes would be offered at a time when many people in the community (like teachers) are able to take the classes. PTS: 1 TOP: Chapter 16

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Knowledge, Analytical

2. How is the absorption cost method used in managerial decisions? What are the advantages and disadvantages of this method? ANS: The absorption cost approach is the only inventory costing method allowed for external reporting of financial statements under GAAP. Absorption costing is used internally by managers for long-term as well as short-term pricing decisions. Proponents of absorption costing argue that in the long run companies must make sales that are sufficiently profitable to do more than just cover variable costs. Sales must be sufficient to cover fixed costs and make a profit or the company will not survive. It can also be argued that variable costing of inventory does not fully reflect the total cost of producing that inventory, especially for products for which direct costs, such as direct labour and materials, are a very small percentage of the cost of production. Critics of the absorption-costing method argue that it is theoretically wrong to inventory fixed costs because most fixed costs will be incurred whether any products are produced during a period or not. Critics also argue that management could manipulate profit under absorption costing by manipulating the level of production. Variable costing is sometimes more useful in decisions related to profit-maximisation because any sale that more than covers its variable cost contributes to covering fixed cost and profits. PTS: 1 AACSB: TOP: Absorption (full) costing

Knowledge, Analytical, Communication

Chapter 17 – Cost behaviour and cost-volume-profit analysis TRUE/FALSE 1. Cost-volume-profit (CVP) analysis is a technique that examines the interrelationship between cost, volume and profit at constant activity levels. ANS: F TOP: Introduction

PTS: 1

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Knowledge, Analytical

2. A dependent variable represents the cost of an activity, while the independent variable represents the level of the activity. ANS: T PTS: 1 TOP: Cost functions

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3. Fixed costs such as rent, rates, and administration salaries are normally also classified as overhead costs. ANS: T PTS: 1 TOP: Fixed and variable costs

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4. Fixed costs are constant over all levels of activity. ANS: F PTS: 1 TOP: Fixed and variable costs

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5. Discounts, increased prices and diminishing returns are all reasons why a variable cost function will not necessarily behave in a linear fashion. ANS: T PTS: 1 TOP: Cost functions

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Knowledge, Analytical

6. The relevant range of activity relates to the levels of activity that the firm has experienced in past periods. ANS: T PTS: 1 TOP: Cost functions

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7. A firm sells a product for $250. Variable costs are $100 per unit and total fixed costs are $120,000. The break-even point will be 800 units. ANS: T PTS: 1 TOP: Cost-volume-profit analysis

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Knowledge, Analytical

8. To calculate the break-even point, that is, where neither a profit nor a loss is made, the formula Sx = VCx + FC + P can be used, but only if P is equal to zero. ANS: T PTS: 1 TOP: Cost-volume-profit analysis

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Knowledge, Analytical

9. The contribution margin of every unit of goods or services sold after the break-even point has been reached will contribute to profit. ANS: T PTS: 1 TOP: Cost-volume-profit analysis

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Knowledge, Analytical

10. The contribution margin is equal to sales revenue less fixed costs. ANS: F PTS: 1 TOP: Cost-volume-profit analysis

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Knowledge, Analytical

11. If the break-even point is 300 units and the contribution margin is $30 per unit, then every unit sold above 300 will contribute $30 to profit. ANS: T PTS: 1 TOP: Cost-volume-profit analysis

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12. The contribution margin ratio is equal to the contribution margin divided by sales, and shows the proportion of each sales dollar available to cover fixed costs and contribute to profit. ANS: T PTS: 1 TOP: Cost-volume-profit analysis

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MULTIPLE CHOICE 1. What will fixed costs do when activity increases but remains within the relevant range of activity? A. Increase B. Remain the same C. Decrease D. Display an erratic behaviour ANS: B PTS: 1 TOP: Fixed and variable cost

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2. Paul’s Ltd is considering increasing its production by 5%. If production increases, what is the most likely impact on costs? A. Administrative wages will increase. B. Factory casual labour will increase. C. Power costs will decrease. D. Depreciation charges will increase. ANS: B PTS: 1 TOP: Fixed and variable cost

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3. Under the assumptions used in cost-volume-profit analysis, as volume increases: A. fixed costs increase in proportion to the increase in volume. B. variable costs per unit remain the same. C. fixed costs per unit remain the same. D. variable costs per unit increase in proportion to the increase in volume. ANS: B PTS: 1 TOP: Cost-volume-profit analysis

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4. All of the following are assumptions made in cost-volume-profit analysis except: A. the cost of materials can change at different levels of volume. B. fixed costs are constant over the volume of production being considered. C. mixed costs can be separated into their variable and fixed components. D. the various components of unit variable cost remain constant during the period of analysis. ANS: A PTS: 1 AACSB: TOP: CVP analysis: Assumptions and limitations

Knowledge, Analytical

5. Unit costs help managers make decisions about: A. continuing to offer a product for sale. B. resource allocation. C. product pricing. D. all of the above. ANS: D TOP: Chapter 17

PTS: 1

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Knowledge, Analytical

6. A break-even point occurs when: A. variable costs equal fixed costs. B. sales revenue equals the total of variable and fixed costs of production. C. assets equal liabilities. D. contribution margin equals all variable costs. ANS: B PTS: 1 TOP: Cost-volume-profit analysis

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Knowledge, Analytical

7. The break-even point is the point at which the total contribution margin is equal to total: A. sales. B. variable costs. C. fixed costs. D. fixed and variable costs. ANS: C PTS: 1 TOP:Cost-volume-profit analysis

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8. Able Company sells a product for $50 per unit, its variable costs are $35 per unit and its total fixed costs are $45,000. What is Able’s break-even point? A. 900 units. B. 1286 units. C. 3000 units. D. 6000 units. ANS: C PTS: 1 TOP: Cost-volume-profit analysis

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9. Which of the following shows a combination of costs that would normally be fixed and variable costs for a production plant? A. Costs of building and costs of equipment. B. Land purchase costs and costs of equipment. C. Cost of building and costs of materials. D. Land purchase costs and general manager’s salary. ANS: C PTS: 1 TOP: Fixed and variable costs

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10. Arches Manufacturing Company provides the following information: Costs Direct labour $16,000 Direct materials 20,000 Direct labour hours 4000 Manufacturing overhead 36,000 Variable selling expenses 12,000 Number of units produced 800 What is the total unit cost of one unit of finished product? A. $87 B. $90 C. $95 D. $105 ANS: D PTS: 1 TOP: Fixed and variable costs

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11. Heath Ltd owns and operates a textile manufacturing plant. Garments are sold for $40 each. The fixed plant and equipment costs are $51,600 per annum. Producing each garment incurs $15 of labour costs and $7.80 of material costs. What is the break-even point for Heath Ltd? A. 1290 garments B. 1602 garments C. 2064 garments D. 3000 garments ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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12. Heath Ltd owns and operates a textile manufacturing plant. Garments are sold for $40 each. The fixed plant and equipment costs are $51,600 per annum. Producing each garment incurs $15 of labour costs and $7.80 of material costs. To make a profit of $4000, Heath Ltd must produce (to the nearest integer): A. 1390 garments. B. 1727 garments. C. 2224 garments. D. 3233 garments. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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13. Heath Ltd owns and operates a textile manufacturing plant. Garments are sold for $40 each. The fixed plant and equipment costs are $51,600 per annum. Producing each garment incurs $15 of labour costs and $7.80 of material costs. Heath Ltd’s contribution margin per garment is: A. $40. B. $32.20. C. $25. D. $17.20. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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14. Heath Ltd owns and operates a textile manufacturing plant. Garments are sold for $40 each. The fixed plant and equipment costs are $51,600 per annum. Producing each garment incurs $15 of labour costs and $7.80 of material costs. If Heath Ltd is considering advertising costs of $4300, how many garments must be sold to break even? A. 1397 garments B. 1736 garments C. 2236 garments D. 3250 garments ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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15. Heath Ltd owns and operates a textile manufacturing plant. Garments are sold for $40 each. The fixed plant and equipment costs are $51,600 per annum. Producing each garment incurs $15 of labour costs and $7.80 of material costs. If Heath Ltd’s cost of plant and equipment increases, which of the following is true? A. The contribution margin increases. B. Variable costs increases. C. The break-even point increases. D. No change occurs. ANS: C PTS: 1 TOP: Cost-volume-profit analysis

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16. Jany Ltd produces 20,000 golf balls. Each golf ball sells for $8, and it costs $2000 to produce the golf balls. The cost of the fixed plant and equipment needed to produce the golf balls is $1500 per period. The break-even point for Jany Ltd is (to the nearest integer): A. 190 golf balls. B. 200 golf balls. C. 210 golf balls. D. 220 golf balls. ANS: A PTS: 1 TOP: Cost-volume-profit analysis

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17. A company has net profit of $10,000, sales price per unit of $25 and fixed costs of $40,000. The company would like to increase profits by 50%. What percentage increase in sales volume would be needed to achieve this goal? A. 20% B. 10% C. 12.5% D. Answer cannot be determined from the information given. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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18. Sweet Things, Inc. had the following results for the year ended 31 December 20X2. Volume was 60,000 units in 20X2. Sales $120,000 Direct labour 6000 Direct materials 18,000 Fixed manufacturing overhead 50,000 Variable selling expenses 6000 Fixed administrative expenses 10,000 Net profit $30,000

If volume increased to 70,000 units, what should Sweet Things, Inc. have expected net profit to be in 20X3? A. $35,000 B. $45,000 C. $46,000 D. $50,000 ANS: B PTS: 1 TOP: Cost-volume-profit analysis

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19. Sweet Things, Inc. had the following results for the year ended 31 December 20X2. Volume was 60,000 units in 20X2. Sales $120,000 Direct labour 6000 Direct materials 18,000 Fixed manufacturing overhead 50,000 Variable selling expenses 6000 Fixed administrative expenses 10,000 Net profit $30,000 What is Sweet Things, Inc.’s break-even sales volume in dollars? A. $80,000 B. $90,000 C. $100,000 D. $120,000 ANS: A PTS: 1 TOP: Cost-volume-profit analysis

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20. A company’s current sales are $400,000 at a volume of 10,000 units. Fixed costs are $120,000 and variable costs are $30 per unit. What is the company’s break-even sales volume in units? A. 3000 B. 4000 C. 10,000 D. 12,000 ANS: D PTS: 1 TOP: Cost-volume-profit analysis

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21. If fixed costs for a company are $65,000 and variable costs are 20% of sales, what do total sales need to be to achieve a target net profit of $35,000? A. $80,000 B. $100,000 C. $125,000 D. $500,000 ANS: C PTS: 1 TOP: Cost-volume-profit analysis

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22. The point where profit equals the total of fixed and variable costs is called the: A. break-even point. B. target net income. C. margin of safety. D. contribution margin. ANS: A PTS: 1 TOP: Cost-volume-profit analysis

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23. The sales price is $60 per unit, variable costs are $25 per unit, and fixed costs are $175,000. What level of sales, in units, would achieve a target profit of $350,000? A. 10,000 units B. 14,000 units C. 15,000 units D. 21,000 units ANS: C PTS: 1 TOP: Cost-volume-profit analysis

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24. If a company is currently operating at its break-even point, which of the following statements is true? (Income tax considerations are ignored.) A. If fixed costs increase, net profit will decrease by the contribution margin ratio times the amount of the increase in fixed costs. B. If sales increase by 20%, net profit will also increase by 20%, assuming that fixed costs are not equal to zero. C. If variable costs double, net profit will decrease by 50%. D. Net profit will increase by the increase in number of units sold times the contribution margin per unit. ANS: D TOP: Chapter 17

PTS: 1

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Knowledge, Analytical

25. Winter Sales, Inc. sells many kinds of winter sports equipment, primarily through telemarketing. Its sales staff are paid 15% of all sales dollars generated. In order to decrease the uncertainty of this arrangement for its staff and increase loyalty, the company is considering a change in the method of payment. The company would like to pay its 100 employees $1000 per month plus 10% of sales. Using cost-volume-profit analysis, what volume of sales dollars does the company need to exceed per month to make this new method more profitable for the company than the old method? A. $100,000 B. $1,000,000 C. $2,000,000 D. Answer cannot be determined from the information given. ANS: C PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

26. On a break-even graph, the break-even point is the point on the graph where the: A. revenue line crosses the fixed-cost line. B. revenue line crosses the line that represents fixed costs plus variable costs. C. revenue line crosses the contribution margin line. D. total cost line crosses the contribution margin line. ANS: B PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

27. The amount that is available to be contributed to fixed costs after deducting variable expenses from sales is called the: A. profit-volume ratio. B. break-even point. C. contribution margin ratio. D. contribution margin. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

28. If a company’s sales price for its product is $40, its variable cost percentage is 30%, its sales are $200,000, and its fixed costs are $100,000, what will be its contribution margin per unit? A. $10 B. $12 C. $28 D. $30 ANS: C PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

29. Jany Ltd produces 20,000 golf balls. Each golf ball sells for $8, and it costs $2000 to produce the golf balls. However, Jany Ltd is considering switching to golf clubs, which have a contribution margin of $10. The cost of the fixed plant and equipment needed to produce the golf balls is $1500. Jany Ltd expects to sell 1000 golf clubs per period at $100 each. Which of the following is true? A. Golf balls are more profitable per unit than golf clubs. B. The contribution margin for golf balls is $2.10 larger than that for golf clubs. C. Total revenue from golf clubs will be higher than that from golf balls. D. Every golf club sold contributes $2.10 more to the profit than each golf ball. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

30. Which of the following situations would be most likely to violate cost-volume-profit assumptions about variable costs? A. As volume doubles, direct labour costs also double. B. As volume decreases, per-unit material costs remain constant. C. The company’s raw material supplier typically allows volume discounts when larger amounts of the raw material are purchased. D. Fixed costs per unit decrease as volume increases. ANS: C PTS: 1 AACSB: TOP: CVP analysis: Assumptions and limitations

Knowledge, Analytical

31. Which of the following situations would be most likely to violate cost-volume-profit assumptions about fixed costs? A. When production volume increases beyond the capacity of the plant, a second shift will be added instead of building a new plant. B. As volume decreases, per-unit fixed manufacturing overhead remains constant. C. The company’s raw material supplier typically allows volume discounts when larger amounts of the raw material are purchased. D. Fixed costs per unit decrease as volume increases. ANS: B PTS: 1 AACSB: TOP: CVP analysis: Assumptions and limitations

Knowledge, Analytical

32. Refer to the graph above. Line A (the solid black line) is: A. the cost line. B. the revenue line. C. the profit line. D. the loss line. ANS: B PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

33. Refer to the graph above. Area B (the area between the solid black line and the dashed black line) is: A. the revenue area. B. the cost area. C. the profit area. D. the loss area. ANS: C PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

34. Refer to the graph above. Line C (the dashed black line) is: A. the profit line. B. the loss line. C. the break-even line. D. the total cost line. ANS: D PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

35. Refer to the graph above. Point D (the point where the two lines cross) is: A. the break-even point. B. the contribution margin point. C. the firm’s total fixed costs. D. none of the above. ANS: A PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

36. Refer to the graph above. Area E (the area between the two lines) is: A. the profit area. B. the loss area. C. the break-even area. D. Answer cannot be determined from the information given. ANS: B PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

37. Extra Extra Newspaper Company had the following results in 20X6. Sales (5000 units) Variable costs

$100,000 65,000 $35,000 Fixed costs 21,000 Net profit $14,000 What is Extra Extra’s contribution margin ratio? A. 10.5% B. 35% C. 65% D. $35,000 ANS: B PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

38. Extra Extra Newspaper Company had the following results in 20X6. Sales (5000 units) Variable costs

$100,000 65,000 $35,000 Fixed costs 21,000 Net profit $14,000 What is Extra Extra’s contribution margin per unit? A. 35 cents B. 70 cents C. $7 D. $13 ANS: C PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

39. Extra Extra Newspaper Company had the following results in 20X6. Sales (5000 units) Variable costs

$100,000 65,000 $35,000 Fixed costs 21,000 Net profit $14,000 What is Extra Extra’s breakeven sales in units? A. 1500 units B. 1615 units C. 2000 units D. 3000 units ANS: D PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

40. Extra Extra Newspaper Company had the following results in 20X6. Sales (5000 units) Variable costs

$100,000 65,000 $35,000 Fixed costs 21,000 Net profit $14,000 How many additional units does Extra Extra have to sell to double current profit? A. 2000 units B. 3000 units C. 4000 units D. 5000 units ANS: A PTS: 1 TOP: Cost-volume-profit analysis

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Breakeven point analysis is one of the most common uses of cost-volume-profit analysis. What is the breakeven point and why is it useful for managers to know what it is for their company? ANS: The breakeven point is the level of sales at which total contribution margin equals total fixed costs. It is also the point at which sales are just sufficient to cover all costs, fixed and variable. Net income at the breakeven point is equal to zero. It is useful for managers to know the breakeven point because it reveals the volume of sales that must be exceeded for a company to be profitable. If the breakeven volume is an unattainable goal because of market conditions, managers will know that they will have to either reduce costs, increase prices, increase market share, or abandon the operation. The level of sales in excess of the breakeven point (the margin of safety) provides managers with a measure of the risk associated with the operation. PTS: 1 AACSB: TOP: Cost-volume-profit analysis

Knowledge, Analytical

2. List and explain two assumptions about costs and activities that are made in cost-volume-profit analysis. ANS: 1. Variable costs per unit are assumed to remain the same. Thus as volume increases, total variable costs increase in direct proportion to the change in volume. 2. Fixed costs are assumed to be fixed over the relevant range of production. If volume increases within that range, fixed costs are assumed to remain the same. PTS: 1 AACSB: Knowledge, Analytical TOP: CVP analysis: Assumptions and limitations 3. Explain how the cost-volume-profit (CVP) assumptions about fixed costs may be violated. Give two examples of situations that may cause these assumptions to be violated. ANS: Total fixed costs are assumed to be fixed over the relevant range of production and for a given period of time. Some fixed costs are fixed for a relatively small range. These costs may increase in increments and are referred to as step-pattern costs. An example may be the cost of production supervisors which is related to direct labour but does not change in direct proportion to changes in volume. Also, anything that causes fixed costs to change in the short term, such as an unexpected machine repair cost, would violate the CVP assumptions about fixed costs. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: CVP analysis: Assumptions and limitations 4. Discuss the concept of the ‘relevant range’ as it applies to cost-volume-profit analysis. ANS: The relevant range is the range over which fixed costs are assumed to be constant. The relevant range is the range of normal operating volumes over which fixed costs will not need to increase because operating capacity has not been exceeded. This is an important concept because it means that management cannot assume that CVP relationships can be maintained at all levels of sales volume. At some point, as production levels increase, new machinery will need to be purchased to increase capacity, and new plant may even need to be built. PTS: 1 AACSB: TOP: Cost-volume-profit analysis

Knowledge, Analytical, Communication

PROBLEM 1. Projected Profit A company can determine its projected profit by using the following equation: profit = total income – (total fixed costs + total variable costs) Based on market research, CSO Corporation feels its product will sell for $200 / unit. At that price, CSO can sell 150 units per month. Currently, CSO incurs the following costs on a per unit basis: direct material, $10; direct labour, $60; variable overhead, $20. Its total fixed costs per month are $3300. (a) Refer to Projected Profit. How many units must CSO sell each month to break even (i.e., to earn neither a profit nor a loss)?

(b) Refer to Projected Profit. What is CSO’s cost per unit if it produces 600 units per month? ANS: (a) $3300 / ($200 - ($10 + $60 + $20)) = $3300 / $110 = 30 units (b) ($3300 / 600) + $10 + $60 + $20 = $95.50 PTS: 1 AACSB: TOP: Cost-volume-profit analysis

Knowledge, Analytical

2. A company had the following results for 2005: Sales (15,000 units) Variable expenses Fixed expenses Net profit

$300,000 180,000 80,000 $40,000

Answer the following questions independently. (a) What are the company’s breakeven sales in dollars? (b) What are the company’s breakeven sales in units? (c) What is the company’s contribution margin in dollars? (d) What is the company’s contribution margin ratio? (e) How many additional units must be sold to increase net profit from the current $40,000 to $100,000? ANS: (a) $200,000 Breakeven sales dollars = $80,000 fixed costs ÷ 40% contribution margin ratio = $200,000. Contribution margin ratio = ($300,000 - $180,000) ÷ $300,000 = .40 (b)

10,000 units Breakeven sales units = $80,000 fixed costs ÷ $8 contribution margin per unit = 10,000 units. Contribution margin per unit = ($300,000 – 180,000) / 15,000 = $8 per unit

(c)

$120,000 Contribution margin = Sales - variable costs = $300,000 - $180,000 = $120,000

(d)

40% Contribution margin ratio = ($300,000 - $180,000) ÷ $300,000 = .40

(e) 7500 units Additional sales units = Additional profit ÷ contribution margin per unit = ($100,000 - $40,000) ÷ $8 = 7500 units. 15,000 current sales + 7500 additional units = 22,500 units needed for a profit of $100,000. PTS: 1 AACSB: TOP: Cost-volume-profit analysis

Knowledge, Analytical

CASE 1. In the 1970s the US corporation Lockheed Aircraft Corporation paid USD $12.5 million in ‘fees’ to All Nippon Airways (ANA) to secure the sale of 21 Tristar aircraft. Carl Kochian, the president of Lockheed at that time, defended his actions with reference to the following: • • •

That the figure involved was negligible to Lockheed. The revenue was desperately needed to stabilise the company’s financial situation. Securing the contract saved the jobs of thousands of Lockheed workers and thousands of dollars for the company’s shareholders.

Bribery was common and expected in Japan in the 1970s. Kochian did not initiate the payment. He was asked to make the payment. Required: Discuss the accounting and ethical issues involved in this case. ANS: Accounting issues include: • the figure involved represented an avoidable cost; • negligibility acknowledged, there would be an opportunity cost involved; once incurred– • the expenditure represented an expense, in effect, an indirect expense; • given the payment involved a bribe (although, at that time, not illegal, per se) the critical issue would be that of transparency, and, therefore, how the expenditure should be classified when recognised; • assuming Lockheed’s cost structure did not factor in a margin for such items of expenditure, the fees would mitigate the profit on the sale of the aircraft; • the tax deductibility of the expenditure. Ethical issues involved: • the tax deductibility of the expenditure; • in edifying his action, Kochian adopted a utilitarian approach to ethical behaviour – pointing to the ‘good’ consequences of his actions – overlooking, however, the adverse consequences, for example, for the company’s competitors, specifically, the stakeholders involved. • Kochian’s action may be evaluated from a deontological perspective. • There is a cultural dimension to what is acceptable (common practice) business behaviour involved. PTS: 1 AACSB: TOP: Chapter 3/Chapter 17

Knowledge, Analytical, Ethics

Chapter 18 – Accounting for decision making: with and without resource constraints TRUE/FALSE 1. Incremental or differential costs are the increases in costs or benefits between alternative opportunities available to an entity. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

2. Sunk costs are costs that have been incurred, or whose payment cannot be avoided; they are irrelevant to future decisions. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

3. Avoidable costs are those costs that will not be incurred if a particular decision is taken, therefore avoidable costs are relevant to decision making. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

4. Unavoidable costs will be incurred regardless of the decision made and are therefore relevant to decision making. ANS: F PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

5. Opportunity costs are economic measures and therefore not relevant to accounting decision making. ANS: F PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

6. An opportunity cost is the maximum benefit that could be obtained from a resource if it were to be used for some other purpose. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

7. When making comparisons using relevant cost and benefit analysis with traditional analysis based on actual costs, the result will depend on the particular circumstances of the firm making the decision. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

8. Relevant costs are those costs that relate to the future and are additional costs that will be incurred or result from a decision. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

9. Fixed costs are irrelevant to a decision if they remain the same regardless of the decision. ANS: T PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

10. In deciding whether to close a department or division, the general rule to follow is that if the department/division makes a positive contribution, then it should not be closed, where the contribution is at least equal or greater than the income less the variable costs. ANS: T PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

11. In a situation where a division has variable costs and avoidable fixed costs, and these costs combined exceed income, then based only on the financials the division should be closed. ANS: T PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

12. A department generates income of $20,000 and has variable costs of $14,000 and avoidable fixed costs of $7500. This indicates that the costs directly attributable to the department exceed its income and the department should be closed. ANS: T PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

13. When there are resource constraints, the objective that should be applied is to establish the optimum output within the constraints to maximise contribution and thus profits. ANS: T PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

14. Where an entity faces resource constraints, the appropriate selection of what to produce should be based on the contribution per unit of resource constraint, as this will optimise output and profits. ANS: T PTS: 1 TOP: Decision making with constraints

AACSB:

Knowledge, Analytical

15. The contribution is also known as the internal opportunity cost, and reflects the cost of using the resource within the organisation itself due to competing opportunities. ANS: T PTS: 1 AACSB: TOP: Contribution per unit and opportunity cost

Knowledge, Analytical

16. The potential to damage customer loyalty or employee morale is a qualitative factor that needs to be considered in decision analysis. ANS: T PTS: 1 TOP: Qualitative factors

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Sunk costs are: A. costs of replacing an item today. B. costs incurred and no longer recoverable. C. costs of an item discounted at an appropriate rate. D. equivalent to the historical cost of an item. ANS: B PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

2. The selection of a special order will improve net profit when the order’s income exceeds: A. the direct labour cost of the order. B. the replacement cost of the order. C. the incremental cost of the order. D. the opportunity cost of the order. ANS: C PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

3. Which of the following is not a relevant cost or benefit when determining a contribution margin? A. Income B. Cost of goods sold C. Unavoidable costs D. Net sales ANS: C PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

4. James is considering replacing his worn-out machines. Which of the following is not a relevant cost for James when considering various available options? A. Costs of electricity consumed by current machines. B. Changes in costs of labour needed to operate the new machines. C. Costs of delivering the new machine. D. Costs of replacing old machines. ANS: A PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

5. With respect to a decision, a relevant cost is: A. one that does not change if the decision to go ahead is made. B. one that changes if the decision to go ahead is made. C. one that does not change if the decision not to go ahead is made. D. All costs currently incurred by the organisation are relevant. ANS: B PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge

6. The Jack received $560 from his grandmother. He decided to shop for a gift for himself and spent $7 for his bus fares. Jack decided to purchase a new bike for $560. For the same amount, he could have purchased a model GH-200 aeroplane that he adored and that would have provided $120 more benefit than the new bike. Jack was also considering a trip to Melbourne to visit his aunt, although he was not too keen about it. He was also interested in pursuing a course leading to a private pilot’s licence, although he is a bit scared of heights. One month later, the price of the bike

Jack purchased from Hut Ltd had gone down by $100. The bike had cost Hut Ltd $260 of labour and $170 of plant and equipment. The differential benefit of the aeroplane is: A. $7. B. $120. C. $430. D. $560. ANS: B PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

7. The unavoidable cost is: A. $7. B. $120. C. $430. D. $560. ANS: A PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

8. The opportunity cost is most likely to be the cost of: A. the aeroplane. B. the trip to Melbourne. C. Hut Ltd’s plant and equipment. D. the private pilot’s licence. ANS: A PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

9. The replacement cost for the bike is: A. $100. B. $430. C. $460. D. $560. ANS: C PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

10. The variable and fixed costs for producing the bike are: A. $560 and $260 respectively. B. $260 and $170 respectively. C. $170 and $560 respectively. D. $170 and $260 respectively. ANS: B PTS: 1 AACSB: TOP: Costs and benefits relevant to decision making

Knowledge, Analytical

11. The following information relates to the production cost of product PX 244. Selling price Raw materials Labour Fixed overheads

$55 $12 $18 $16

What is the contribution per unit of PX 244? A. $9 B. $25 C. $37 D. $43 ANS: B PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

Consider the following information and answer the question(s) below.

Product X Product Y

Sales 12,000 units 16,000 units

Selling price $5 per unit $4 per unit

Labour cost $3 per unit $3.50 per unit

Advertising cost $400 $200

Machinery costs $5000 $6200

12. Which of the following is true? Product X: A. contributes more to profit than Product Y. B. has higher variable costs than Product Y. C. produces lower profits than Product Y. D. has higher fixed costs that Product Y. ANS: A PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

13. The contribution margins for Product X and Product Y are: A. $1.50 and $2.50 respectively. B. $2.00 and $0.50 respectively. C. $2.00 and $2.50 respectively. D. $3.00 and $3.50 respectively. ANS: B PTS: 1 AACSB: TOP: Fixed and variable costs and the contribution approach

Knowledge, Analytical

14. The breakeven in units for Product X and Product Y are: A. 12,000 and 16,000 respectively. B. 2700 and 12,800 respectively. C. 2500 and 12,400 respectively. D. 200 and 400 respectively. ANS: B PTS: 1 AACSB: Knowledge, Analytical TOP: Fixed and variable costs and the contribution approach/Chapter 17 15. Constraints restricting a manufacturing firm’s ability to meet the demand for its products or services could include all of the following except shortage of: A. qualified sales staff. B. labour skills. C. space for machinery. D. raw materials. ANS: A PTS: 1 TOP: Decision making with constraints

AACSB:

Knowledge, Analytical

16. Which of the following can be constraints for manufacturers? I. Market size for the firm’s product II. Current productive capacity of the firm III. Depreciation of buildings owned by the firm A. II only B. I and II only C. I and III only D. I, II and III ANS: B PTS: 1 TOP: Decision making with constraints

AACSB:

Knowledge, Analytical

17. The following information has been provided for three products:

Estimated sales Estimated labour hours per product Contribution per product

Product A 200 1 $4

Product B 200 2 $8

Product C 200 5 $10

The labour availability is limited to 600 hours at these costs and before overtime payments are necessary. The optimum mix of these products given the constraints would be: A. 120 units of C B. 200 units of B + 40 units of C C. 200 units of A and 200 units of B D. 200 units of A and 80 units of C ANS: C PTS: 1 AACSB: TOP: The contribution approach with one scarce resource.

Knowledge, Analytical

18. Finefurniture Ltd has the opportunity to purchase componentry in sufficient quantities at $5.50 per chair. Currently Finefurniture Ltd makes the components for 7000 chairs at the following costs: Timber Labour Variable overhead Fixed overhead

$16,000 12,000 8000 30,000

A saving of 20% of fixed overhead would occur if the components were bought in. Should the component be bought in, and why? A. No, increased cost of $0.36 per chair. B. No, increased cost of $1.50 per chair. C. Yes, cost savings of $1 per chair. D. Yes, cost savings of $0.50 per chair. ANS: D PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

19. X Ltd has the operating capacity to produce either product A or B:

Expected sales Selling price/unit Manufacturing cost Variable/unit Fixed Labour cost Variable/unit

Product A 10,000 $9

Product B 15,000 $7

$3 $30,000

$2 $30,000

From the information above, which product should X Ltd manufacture and why? A. Product A, lower breakeven B. Product B, lower breakeven C. Product B, higher profit D. Product A, higher profit ANS: C PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

20. Company A prints and distributes licensed T-shirts, which wholesale at $16 each. A major retail chain store has asked to be supplied with 3000 T-shirts at $14 each; these shirts would carry the store’s brand name. To process the order, Company A would need to reconfigure the printing program to print the brand name. This would cost $4000 and would not be reusable. There would be no other additional costs. The current cost structure is: T-shirts Labour Variable overhead Fixed overhead

$6 $3 $2 $3

Should the special order be accepted, and why? A. Yes, additional profit of $3 per shirt is made. B. Yes, new equipment is purchased. C. Yes, additional profit of $1.67 per shirt is made. D. No, a loss of $4000 is incurred. ANS: C PTS: 1 AACSB: TOP: Make or buy decisions

Knowledge, Analytical

Apply the following information provided by Ausco Products to questions 21 and 22. Product X Product Y Product Z Estimated sales (units) 200 400 200 Estimated labour hours per unit 1 2 5 Contribution per unit $4 $8 $10 21. The total labour availability is limited to 1000 hours at these costs. Which products should Ausco Products produce? A. Product X only. B. Product Y only. C. Product Z only. D. Product X and Y. ANS: D PTS: 1 AACSB: TOP: The contribution approach with one scarce resource

Knowledge, Analytical

22. If the market will only accept a total of 400 units of any of the 3 products, which product should Ausco Products produce? A. Product X and Z. B. Product Y only. C. 300 units of Product Y and 100 units of Product Z. D. 200 units of Product Y and 200 units of Product Z. ANS: D PTS: 1 AACSB: TOP: The contribution approach with one scarce resource

Knowledge, Analytical

23. The following information has been supplied regarding three products.

Sales Variable costs Materials Labour (@$1 per hour) Total variable costs Contribution per unit Estimated demand per unit Labour hours per unit

A $ 24

B $ 48

C $ 13

Total $ 85

3 7 10 14 700 7

2 10 12 36 800 10

3 2 5 8 600 2

8 19 27 58 200 19

Assuming that the current restriction on labour is 7000 hours, what is the total cost of labour per unit that needs to be considered before management can decide whether to employ additional labour or not? (Hint: First calculate the contribution per unit of labour and determine which products will be produced at the current available hours.) A. $1 B. $4.60 C. $3.60 D. $2 ANS: B PTS: 1 AACSB: TOP: Contribution per unit and internal opportunity costs

Knowledge, Analytical

24. The Northern Division of CPP Corporation supplies parts to its Southern Division. These parts are also available in the market from other suppliers. Northern Division is operating at 80% capacity, with a variable cost per unit of $6. Because of a personality conflict between the two division managers, however, Southern has elected to buy the part from outside suppliers at $7 per unit. As a result of this action, CPP Corporation will be: A. better off. B. worse off. C. forced to close Northern Division. D. forced to close Southern Division. ANS: B PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

25. A supplier of components for the automotive industry has the opportunity to purchase a job lot of parts which it would normally manufacture. The purchase price is $80,000. The production costs for the same number of units are: Materials Labour

$20,000 $24,000

Variable overheads Fixed overheads

$16,000 $100,000

Should the parts be purchased and why? A. Yes, because it saves $80,000. B. Yes, because it saves $20,000. C. No, because it costs $100,000. D. No, because it costs $20,000. ANS: D PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

Pronto Ltd manufactures photo frames and photo albums. 15,000 units of photo frames could be purchased for $5.00 each. The per-unit costs of production for these frames are: Materials Labour Variable overheads Fixed overheads

$2.00 $3.50 $1.50 $3.00

26. Should the frames be purchased instead of being made? A. No, because it saves $1.50 per unit. B. No, because it saves $0.50 per unit. C. Yes, because it saves $2.00 per unit. D. Yes, because it saves $5.00 per unit. ANS: C PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

27. Pronto is considering whether to make or buy the photo frames. The costs that are irrelevant to this decision are: A. opportunity costs. B. variable costs. C. available costs. D. fixed costs. ANS: D PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

28. If the frames were purchased and later sold by Pronto at normal prices, the overall profits would: A. decrease relative to those from making the frames. B. increase relative to those from making the frames. C. remain the same as those from making the frames. D. increase for the first 3 months and decrease thereafter. ANS: B PTS: 1 TOP: Make or buy decisions

AACSB:

Knowledge, Analytical

29. The following information is available for the three products produced by Pitts Ltd:

Estimated sales Estimated labour hours per product Contribution per product

Product A 200 1

Product B 200 2

Product C 200 2

$10

The labour availability is limited to 400 hours at these costs and before overtime payments are necessary. If the market will only accept a total of 200 units of any of the three products, which product should Pitts produce? A. Product A and C B. Products A and B C. Product B D. Product C ANS: D PTS: 1 AACSB: TOP: The contribution approach with one scarce resource

Knowledge, Analytical

30. Which of the following is not a qualitative factor considered by an organisation? A. Employee wages B. Employee–employer relations C. Long-term retainability of employees D. Employee-related benefits ANS: A PTS: 1 TOP: Qualitative factors

AACSB:

Knowledge, Analytical

31. Qualitative factors in the make or buy decisions include: A. quality. B. reliability of supplies. C. after-sales service. D. all of the above. ANS: D PTS: 1 TOP: Qualitative factors

AACSB:

Knowledge, Analytical

32. Which of the following statements about qualitative factors is not true? A. Qualitative factors are easily quantified in terms of costs and revenue. B. The natures of qualitative factors in decision making vary with circumstances related to the opportunities under consideration. C. Qualitative factors stem from non-financial objectives. D. Qualitative factors should be considered by management when making a decision. ANS: A PTS: 1 TOP: Qualitative factors

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. How might a manager identify the relevant costs or revenue for a particular decision? ANS: The manager must first answer two questions: (1) what activities are necessary to carry out the decision, and (2) by how much will the costs or revenues be affected if the company undertakes the activities? No costs incurred prior to making the decision are relevant. Those costs are sunk and are eliminated from the decision process. Future costs that the company will incur for activities that are not necessary to carry out the decision are not relevant. A specific cost is relevant only if the total amount that the company will incur is affected by the decision.

PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Costs and benefits relevant to decision making 2. What are incremental costs, and when are they relevant costs? ANS: Incremental costs are cost increases resulting from a higher volume of activity or from the performance of an additional activity. They are always relevant when the higher volume of activity or the additional activity is not necessary for all of the activities. PTS: 1 AACSB: Knowledge, Analytical TOP: Costs and benefits relevant to decision making 3. What are avoidable costs, and when are they relevant costs? ANS: Avoidable costs are the costs that the company would incur to perform an activity at a given level, but that the company could avoid if it reduces or discontinues the activity. Avoidable costs are relevant costs when one of the alternative solutions under consideration is the reduction or elimination of the activity. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Costs and benefits relevant to decision making 4. What are opportunity costs, and when are they relevant costs? ANS: Opportunity costs are the profits that a company foregoes by following a particular course of action. These costs are relevant to the alternative that would cause the profits to be foregone, and are added to the other costs of that alternative. PTS: 1 AACSB: Knowledge, Analytical, Communication TOP: Costs and benefits relevant to decision making PROBLEM 1. The Transporter Company produces material-handling equipment for use in commercial manufacturing. As part of its operations, Transporter has three distinct product lines: belts, conveyors, and elevators. The company is currently considering the elimination of the belt product line. The belt line’s sales average $850,000 annually. Annual variable manufacturing costs and variable selling costs total $320,000 and $140,000, respectively. Annual fixed costs total $450,000, of which $120,000 are considered to be unavoidable. (a)

Prepare an analysis to determine the profit increase or decrease that would result if production of belts is discontinued.

(b)

Should the company drop the belt line?

ANS: (a) THE TRANSPORTER COMPANY Relevant Costs and Revenues for the Decision to Drop the Belt Product Line

Sales revenue Avoidable costs: Variable manufacturing Variable selling Fixed costs Total avoidable costs Profit

Drop $0

Continue Producing $850,000

$0 0 120,000 0 ($120,000)

$320,000 140 000 450,000 $(910,000) $( 60,000)

(b) To cease making belts the firm will be $60,000 worse off unless: • they expand production of other lines • introduce a new line • reduce fixed costs The firm also needs to think about customers who may go elsewhere for all items if they delete belts. Can the belts be reconfigured to reduce variable costs?. PTS: 1 AACSB: Knowledge, Analytical TOP: Fixed and variable costs and the contribution approach 2. The Multiproducts Company currently purchases a component for $30 each. The company has excess capacity and is considering the possibility of making the component. The Cost Accounting Department estimates that the following costs would be incurred to make each unit of the component: Direct materials Direct labor Variable overhead Total manufacturing cost

$8 10 8 $26 per unit

Additionally, if Multiproducts decides to make the component, additional foremen, custodial personnel, and material handlers are required at a total cost of $150,000 per year. (a) (b)

Assuming the company uses 40,000 components annually, prepare an analysis to determine if the company should make or buy the component. At what annual volume of components would the company change its make or buy decision?

ANS: (a) MULTIPRODUCTS COMPANY Relevant Costs for the Make or Buy Decision To Make Annual volume 40,000 Relevant costs: Direct materials $320,000 Direct labour 400,000

To Buy 40,000

Variable overhead Additional fixed costs for foremen, custodians, and material handlers Component purchase cost Total relevant costs

320,000 150,000 $1,200,000 $1,200,000

$1,190,000

When the Multiproducts Company uses 40,000 components, the total annual cost saved by making the components is $10,000 ($1,200,000 - $1,190,000). (b)

Variable costs of making the component = $26.00 per unit, while the cost to purchase the component is $30 per unit. To obtain this $4 per unit variable cost savings, the Multiproducts Company must incur $150,000 of additional fixed cost for salaries of foremen, custodial personnel, and materials handlers. Thus, the company incurs less cost to make the components than to buy them when the savings in variable costs exceeds the additional fixed cost. This occurs as long as more than $150,000/$4 per unit = 37,500 units are needed. The company should begin buying the components if annual needs drop below 37,500 units.

PTS: 1 AACSB: TOP: Make or buy decisions

Knowledge, Analytical

3. For many years, Condor Company has produced a small part that it uses in the production of its standard line of equipment. The company’s cost of producing one part, based on a production level of 50,000 parts per year, is: Cost Per Part $8.00 5.00 10.00 12.00 $35.00

Direct materials Direct labour Variable overhead Fixed overhead Total

An outside supplier has offered to supply the part to Condor for $29 per part. Condor has determined that 40% of the fixed overhead represents salaries and other costs which can be eliminated if the parts are purchased. Required: Prepare an analysis to determine whether Condor should accept the supplier’s offer. ANS: CONDOR COMPANY Relevant Costs for the Make or Buy Decision

Expected annual requirement (units) Relevant costs: Direct materials Direct labour Variable overhead Avoidable fixed overhead

To Make

To Buy

50,000

$400,000 250,000 500,000 240,000

0 0 0 0

Component purchase cost Total relevant costs Relevant costs per unit

$1,390,000

$1,450,000 $1,450,000

$27.80

$29.00

Therefore, continue to make the part. The annual cost savings will be $60,000 ($1.20  50,000 parts) or ($1,450,000 - $1,390,000) PTS: 1 AACSB: TOP: Make or buy decisions

Knowledge, Analytical

4. The Moony Company, which makes and sells two products, boys’ and girls’ bikes, has $30,000 to spend on advertising. The company has estimated that using the $30,000 to advertise boys’ bikes would increase sales of that product by 1000 units. Moony is uncertain, however, how many additional girls’ bikes could be sold by spending $30,000 on that product. Boys’ bikes have a contribution margin of $40 per unit and girls’ bikes have a contribution margin of $30 per unit. Required: Prepare an analysis to answer each of the following independent questions. (a)

If spending $30,000 on girls’ bikes would increase its sales by 1200 units, which product should be advertised?

(b)

By how many units would sales of girls’ bikes have to increase to justify spending the $30,000 on girls’ bikes instead of boys’ bikes?

ANS: (a) THE MOONY COMPANY Analysis of Product Mix Decision

Contribution margin per unit Sales volume increase resulting from additional advertising (units) Additional contribution margin

Boys’ Bikes $ 40

Girls’ Bikes $ 30

x 1000 $ 40,000

x 1200 $36,000

Spend the advertising on boys’ bikes. (b) Additional contribution margin on boys’ bikes Contribution margin per unit on girls’ bikes Additional girls’ bikes

$40,000 ÷ $30 13,434

units

PTS: 1 AACSB: Knowledge, Analytical TOP: Fixed and variable costs and the contribution approach 5. Hartly Company manufactures three products: A, B, and C. A B Selling price $180 $270 Less variable expenses: Direct materials 24 72 Direct lab or 97 86

C $240 32 140

Variable overhead Total variable expenses Contribution margin

5 126 $ 54

4 162 $108

8 180 $ 60

The same raw material is used in all three products. The company has only 5000 pounds of material on hand and will not be able to obtain any more for several weeks. Management is trying to decide on which products to concentrate on next week to fill its backlog of orders. Material cost is $8.00 per pound. There are no beginning or ending inventories except the raw materials on hand mentioned above. (a) Compute the amount of contribution margin that will be obtained per pound of materials used for each product. (b) Which orders would you recommend that the company work on next week, the orders for A, B, or C? Show your computations. ANS: (a) A = $18; B = $12; C = $15 Contribution margin per pound = Contribution margin ÷ number of pounds A = $54 ÷ 3 pounds = $18 per pound B = $108 ÷ 9 pounds = $12 per pound C = $60 ÷ 4 pounds = $15 per pound Material usage per unit = Direct material cost ÷ cost per pound A = $24 ÷ $8 = 3 pounds B = $72 ÷ $8 = 9 pounds C = $32 ÷ $8 = 4 pounds (b) A; A has the highest contribution per pound. Thus if all 5000 pounds of raw material are used to produce A, profit will be maximised assuming 1667 units of A can be sold. PTS: 1 AACSB: Knowledge, Analytical TOP: The contribution approach with one scarce resource

Chapter 19 – Budgets TRUE/FALSE 1. ‘Budgetary slack’ can be referred to as dysfunctional behaviour where managers deliberately understate or overstate elements of a budget such as sales or costs in order to achieve budget. ANS: T PTS: 1 TOP: The purpose of budgets

AACSB:

Knowledge, Analytical

2. Formulating guidelines for overall activity levels and policies on performance criteria, and communicating this information to the preparers of budgets, are all part of the budget process. ANS: T PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

3. Participative budgeting is where an entity is structured into strategic business units and the performance of these units is measured in terms of accounting results. ANS: F PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

4. A situation where the involvement of lower-level managers in the budget process is merely ‘window dressing’, that is, they appear to be involved but in fact are not, is referred to as ‘pseudoparticipation’. ANS: T PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

5. Responsibility accounting is where an entity is structured into strategic business units and the performance of these units is measured in terms of accounting results. ANS: T PTS: 1 TOP: The purpose of budgets

AACSB:

Knowledge, Analytical

6. For control and planning purposes, an annual budget is normally broken down into quarterly, monthly and weekly periods, which are dependent on the needs of the organisation and the state of the economy. ANS: T PTS: 1 TOP: The budget period

AACSB:

Knowledge, Analytical

7. A production budget is prepared on the basis of determining the production level needed to satisfy sales demand and ensure that the inventory levels are sufficient for the period. Therefore production is equal to sales plus closing inventory less opening inventory. ANS: T PTS: 1 TOP: Sales and production budgets

AACSB:

Knowledge, Analytical

8. 16 000 units of Product A are produced in the period. This requires two units of material X for production. If closing inventory of material X is 4000 units and opening inventory is 6000 units, then 32 000 units of material X was purchased in the period.

ANS: F PTS: 1 TOP: Sales and production budgets

AACSB:

Knowledge, Analytical

MULTIPLE CHOICE 1. Which of the following is not a reason for implementing a budget? A. For planning purposes. B. As a form of communication. C. To assist in preparing a balance sheet. D. For coordinating functions. ANS: C PTS: 1 TOP: Purpose of budgets

AACSB:

Knowledge, Analytical

2. A detailed plan that describes the use of financial and operating resources over a specific period of time in the future is a(n): A. business plan. B. budget. C. statement of comprehensive income D. balance sheet. ANS: B TOP: Introduction

PTS: 1

AACSB:

Knowledge, Analytical

3. Well-designed budgets: A. lead to desired changes in behaviour and minimise any undesired behaviour that results from the measurement process. B. will ensure greater profitability. C. are static. D. will achieve all of the above.= ANS: A PTS: 1 TOP: Purpose of budgets

AACSB:

Knowledge, Analytical

4. Positive behaviour flows when : A. there is no budget to worry about. B. the goals of the entity and individual are aligned in the budget. C. the budget is obviously unachievable, but presents a tremendous challenge. D. budgets contain a maximum of slack. ANS: B PTS: 1 TOP: Purpose of budgets

AACSB:

Knowledge, Analytical

5. Which of the following information is not required for preparation of a budget? A. Credit sales B. Materials purchased C. Costs of labour D. The location of the company’s headquarters ANS: D TOP: Chapter 19

PTS: 1

AACSB:

Knowledge, Analytical

6. The best way to achieve more accurate and achievable budgets is to: A. have the budget committee monitor actual results on a frequent basis so that quick punitive action can be taken when actual results do not comply with budgeted expectations. B. have the budget prepared by top executives only. C. have all employees participate in the preparation of the budget. D. let it be known that budget variances will not be tolerated. ANS: C PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

7. Which of the following people are not involved in preparing a budget? A. The board of directors B. Shareholders C. Sales directors D. Production managers ANS: B PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

8. Responsibility accounting reports are used: A. to determine which manager should be blamed if actual results do not comply with budgeted expectations. B. to evaluate a department manager’s effectiveness in generating revenues or controlling expenses. C. to determine if the actual cost of the product is in line with costs of competitors. D. only when actual results are below budgeted expectations. ANS: B PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

9. Which of the following is not an element of a sound budgeting culture? A. Must expend all the budget before year end. B. Regular budgets. C. Responsibility accounting. D. Continuous review of budgets. ANS: A PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

10. Budgets are developed in RKH Corporation by soliciting input from responsible employees once a year. This technique is best described as: A. perpetual budgeting. B. participative budgeting. C. responsibility accounting. D. committee budgeting. ANS: B PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

11. Which of the following describes responsibility accounting? A. It assigns departmental performance goals to department managers. B. It requires performance evaluation based on factors a manager can control. C. It periodically produces reports that assist in evaluating managers’ performance. D. All of the above. ANS: D PTS: 1 TOP: The budget process

AACSB:

Knowledge, Analytical

12. Four months into the new budget it is learned that there will be a major increase in the cost of raw materials. The most appropriate action is to: A. leave the master budget intact. B. revise the master budget to incorporate the cost increase in raw materials. C. hold the purchasing department responsible for not anticipating the cost increase. D. No action is necessary. ANS: B PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

13. The master budget normally consists of a budgeted: A. statement of comprehensive income and statement of cash flows. B. statement of cash flows and balance sheet. C. balance sheet, statement of comprehensive income and statement of cash flows. D. balance sheet and statement of comprehensive income. ANS: D PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

14. The first step in the master budgeting process is to prepare: A. the sales budget. B. the production budget. C. a cash budget. D. a pro forma balance sheet. ANS: A PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

15. A cash budget is one in which: A. credit sales and cash sales are recorded. B. cash sales and cash expenses are recorded. C. cash sales and all expenses are recorded. D. credit sales and all expenses are recorded. ANS: B PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

16. A collection of individual functional budgets is known as a: A. pro forma financial statement. B. flexible budget. C. static budget. D. master budget. ANS: D PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

Use the information below to answer questions 17, 18 and 19. RTU Ltd sells goods to customers on cash and credit terms. If customers purchase goods on credit, they are allowed exactly one month to pay. RTU Ltd’s customers purchased goods worth $5000 in July, with $2050 being cash sales. Goods worth $2600 were sold by RTU Ltd in August, and they received 90% of this amount in cash. A further $4500 of goods was sold, all on credit, by RTU Ltd in September.

17. All credit customers paid the amounts owing by the due date. How much credit sales did RTU Ltd have for July? A. $2050 B. $5000 C. $2950 D. $6540 ANS: C PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

18. How much total cash did RTU receive in August? A. $5450 B. $2600 C. $2050 D. $5290 ANS: D PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

19. All customers took the maximum allowed time to pay. All credit customers paid the amounts owing by the due date. How much cash did RTU receive in September? A. $260 B. $2340 C. $4500 D. $4760 ANS: A PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

20. The Bowden Company has furnished the following information: Forecast sales for 1st quarter Forecast sales for 2nd quarter Cash sales = 10% of total sales

$200 000 250 000

Collection schedule: In quarter sold In next quarter

75% 25%

What are Bowden Company’s forecast total cash collections for the second quarter? A. $212 500 B. $237 500 C. $238 750 D. $250 000 ANS: C PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

21. Hamilton Manufacturing Company has furnished the following information: Purchases during 1st quarter all on account Cash payments for materials during 1st quarter Accounts Payable balance at the end of 1st quarter

$18 000 22 000 6000

Note: The Accounts Payable account is used only for direct materials.

What was the balance in Hamilton’s Accounts Payable account at the beginning of the 1st quarter? A. $2000 B. $10 000 C. $22 000 D. $28 000 ANS: B PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

22. A typical non-cash expense would be: A. depreciation expense. B. payment of wages accrued in a prior month. C. payment of materials purchased in a prior month. D. All of the above are cash expenses. ANS: A TOP: General

PTS: 1

AACSB:

Knowledge, Analytical

23. Which of the following information is not shown by a cash budget? A. Cash inflow. B. When cash is likely to be received. C. When cash will be deposited into banks. D. Cash outflow. ANS: C PTS: 1 TOP: Preparation of the master budget

AACSB:

Knowledge, Analytical

24. The production budget is equal to: A. expected sales in units plus beginning inventory minus desired ending inventory. B. beginning inventory plus net purchases minus ending inventory. C. net purchases plus desired ending inventory. D. expected sales in units plus desired ending inventory minus beginning inventory. ANS: D PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

25. Bowden Company forecasts sales for the third quarter at 10,000 units. The desired ending inventory for the second quarter is 2000 units and for the third quarter 3000 units. How many units must be produced in the third quarter? A. 9000 units B. 11 000 units C. 12 000 units D. 13 000 units ANS: B PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

26. Hamilton has budgeted total manufacturing overhead costs for the year as $125 000, based on 20 000 direct labour hours. The ratio of variable manufacturing overhead costs to fixed manufacturing overhead costs is 2:1. In a given month, 2000 direct labour hours are budgeted for production. How much overhead is budgeted? A. $6250 B. $12 500

C. $18 750 D. $25 000 ANS: B TOP: General

PTS: 1

AACSB:

Knowledge, Analytical

27. The Marginal Manufacturing Company manufactures one product. Sales and production details are as follows: Estimated sales of Zebras Unit selling price Materials used in manufacture of Zebras: Material Units required A 2 units

9000 $50 Opening inventory 4000 units

Closing inventory 6000 units

What are the estimated sales revenue of Zebras and the number of units of A that are purchased in the current month? A. $900 000 and 16 000 units. B. $450 000 and 20 000 units. C. $450 000 and 18 000 units. D. $450 000 and 16 000 units ANS: B PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

28. The Marginal Manufacturing Company manufactures a product called Saver. Each unit of Saver requires 10 kilos of a material called Lostit. The budget calls for production of 7500 units of Saver for the month of July. The ending inventory of Lostit is forecast at 3500 kilos for the month of July and 4000 kilos for the month of June. If the cost of Lostit is $2 per kilo, what is the cost of purchases in monetary terms during the month of July? A. $15 000 B. $75 000 C. $149 000 D. $151 000 ANS: C PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

29. The Sutcliff Manufacturing Company manufactures a product called Zyklon. Each unit of Zyklon requires 2 kg of Zinses. The budget calls for production of 8000 units of Zyklon during the third quarter. The ending inventory of Zinses is forecasted at 3000 kg for the second quarter and 2000 kg for the third quarter. How many kilograms of Zinses must be purchased during the third quarter? A. 8000 kg B. 14 000 kg C. 15 000 kg D. 16 000 kg ANS: C PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

30. The direct materials budget: A. identifies the quantity of direct materials that will be used to meet production needs during the specified time period. B. identifies the quantity of direct materials that must be purchased to meet production needs during the specified time period. C. uses this formula: beginning inventory plus net purchases minus ending inventory. D. is equal to direct materials needed for production plus beginning inventory minus desired ending inventory. ANS: B PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

31. A typical production budget consists of: A. a direct materials budget, a direct labour budget, and a manufacturing overhead budget. B. a direct materials budget, a direct labour budget, manufacturing overhead budget, and an administrative expense budget. C. a direct materials budget and a direct labour budget. D. a manufacturing overhead budget. ANS: A PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

32. The production of each TV set requires 1.5 direct labour hours. The average cost of each direct labour hour is $10.50. If scheduled production for May is 2000 TVs, what will be the total budgeted cost of direct labour? A. $3000 B. $21 000 C. $31 500 D. None of the above are correct. ANS: C PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

33. Each of Pallet, Inc.’s production workers can produce four wooden pallets per hour. During the month of June, Pallets, Inc. has forecast sales of 100 000 pallets. The beginning inventory was 10 000 pallets, and desired ending inventory is 25 000 pallets. How many hours of direct labour must be budgeted to meet production needs? A. 25 000 B. 21 250 C. 33 750 D. 28 750 ANS: D PTS: 1 TOP: Sales and production budget

AACSB:

34. In preparing the sales budget, the preparer should consider: I. expected demand for the firm’s products. II. current production capacity. III. planned staffing levels. A. I only B. I and II only C. II and III only D. I, II and III

Knowledge, Analytical

ANS: D PTS: 1 TOP: Sales and production budget

AACSB:

Knowledge, Analytical

SHORT ANSWER 1. Why do entities budget? ANS: The budgeting process compels planning, adds order to the planning process, enables managers to identify and avoid potential operating problems, motivates employees, co-ordinates functions within an organisation, acts as a form of communication and creates a benchmark for evaluating the entity’s performance. PTS: 1 AACSB: TOP: Purpose of budgets

Knowledge, Analytical, Communication

2. What are the typical types of budgets of a manufacturing company? ANS: The budgets of a manufacturing company include a sales budget, a production budget, a direct materials purchases budget, a direct labour budget and a factory overhead budget. It also includes a selling expenses budget, a general and administrative expense budget, a capital expenditures budget, a cash budget, a projected statement of comprehensive income and a projected balance sheet. PTS: 1 AACSB: TOP: Preparation of the master budget

Knowledge, Analytical, Communication

3. What is a sales budget, and how is it generated? ANS: The sales budget is a schedule showing the number of units of output (e.g.., inventory) that an entity expects to sell each month and the related revenues that the entity expects to generate from each month’s sales. The sales figures are based on a marketing analysis and past sales figures. PTS: 1 AACSB: TOP: Preparation of the master budget

Knowledge, Analytical, Communication

4. What is the manufacturing company’s production budget, and how is it generated? ANS: The production budget is a schedule showing how many units the company should produce during each period to satisfy the expected sales for the period and to end the period with the desired finished goods inventory. The expected sales for the period come from the sales budget. The production estimates will form the basis for estimated figures, and the estimated ending finished goods inventory will go into the projected balance sheet. PTS: 1 AACSB: TOP: Production and sales budgets

Knowledge, Analytical, Communication

5. What is ‘responsibility accounting’ and how does it contribute to positive budgeting culture? ANS: Responsibility accounting assigns responsibility for the performance of a company’s departments to the department managers. Responsibility accounting requires that each department manager’s performance be evaluated on costs or revenues directly under the manager’s control. Responsibility accounting contributes to a positive budgeting culture by increasing the knowledge that managers have of the costs and revenues that affect their particular department or function. A thorough understanding of an organisation’s cost structure is required to create an accurate budget. PTS: 1 AACSB: TOP: The budget process

Knowledge, Analytical, Communication

PROBLEM 1. Southern Mills is a textile manufacturing company in eastern Tennessee. Every year the company prepares a complete set of budgets. The budgeting process begins with information supplied by the Sales and Marketing department. The balance in Accounts Receivable at the beginning of the year was $900 000. The marketing department has predicted unit sales to be as follows: January February March

1 480 000 sq. yds. 2 120 000 sq. yds. 1 300 000 sq. yds.

Selling price for the fabric is $2.00 per square yard. Cash sales account for 25% of sales. Collections on account (non-cash sales charged to accounts receivable) are received 60% in the month of the sale and 40% in the following month. Required: (a) Prepare a Sales budget for Southern Mills for the first three months of the year. (Show totals for the quarter.) (b) Prepare a Schedule of Expected Cash Collections for the first three months. (c) Calculate the balance in Accounts Receivable as of the end of March. ANS: (a)

Sales in units Selling price/unit Total sales

January 1 480 000 $ 2.00 $2 960 000

Month February March 2 120 000 1 300 000 $ 2.00 $ 2.00 $4 240 000 $2 600 000

Total 4 900 000 $ 2.00 $9 800 000

(b)

Cash sales (25%) This month (60%) Next month (40%) December A/R Total

Schedule of expected cash collections January February March Total $ 740 000 $1 060 000 $ 650 000 $2 450 000 1 332 000 1 908 000 1 170 000 4 410 000 888 000 1 272 000 2 160 000 900 000 900 000 $2 972 000 $3 856 000 $3 092 000 $9 920 000

$ 900 000 9 800 000 9 920 000 $ 780 000 (40% of March credit sales)

PTS: 1 AACSB: TOP: Preparation of the master budget

Knowledge, Analytical

2. Southern Mills is a textile manufacturing company in eastern Tennessee. Every year the company prepares a complete set of budgets. The budgeting process begins with information supplied by the Sales and Marketing department. The balance in inventory at the beginning of the year was 500 000 square yards of fabric. The company plans to have inventory at the end of the month equal to 50% of the following month’s sales. The marketing department has predicted unit sales (in square yards of fabric) to be as follows: January February March April

1 480 000 sq. yds. 2 120 000 sq. yds. 1 300 000 sq. yds. 2 400 000 sq. yds.

Required: (a) Prepare a Production budget for Southern Mills for the first three months of the year. (Show totals for the quarter.) (b) Calculate the balance in inventory as of the end of March. ANS: (a)

Sales in units Ending inventory Total needs Less: Beginning inventory Units to produce

January 1 480 000 1 060 000 2 540 000

Month February 2 120 000 650 000 2 770 000

March 1 300 000 1 200 000 2 500 000

Total 4 900 000 1 200 000 6 100 000

500 000 2 040 000

1 060 000 1 710 000

650 000 1 850 000

500 000 5 600 000

(b)

Balance in ending inventory = 50% of April sales = 1 200 000

Proof:

Beginning inventory Plus: Production Less: Sales Ending inventory

PTS: 1 AACSB: TOP: Production and sales budgets

500 000 5 600 000 4 900 000 1 200 000 Knowledge, Analytical

3. Southern Mills is a textile manufacturing company in eastern Tennessee. Every year the company prepares a complete set of budgets. The budgeting process begins with information supplied by the Sales and Marketing department.

Variable manufacturing costs, for which direct labour hours is the cost driver, are expected to be $2 120 800. Fixed manufacturing overhead is expected to be $2 400 000 for the quarter. The fixed expenses include monthly depreciation expense of $100 000. Budgeted direct labour hours are as follows: January February March

14 320 hours 21 200 hours 17 500 hours

Required: (a) Prepare an overhead budget for each month in the first quarter and for the total quarter. (b) Prepare a schedule of cash disbursements for manufacturing overhead. ANS: (a) and (b) Overhead application rate = variable overhead ÷ labour hours = $2 120 800 ÷ (14 320 + 21 200 + 17 500) = $2 120 800 ÷ 53 020 = $40.00 per direct labour hour

Direct labour hours Overhead rate Variable expense Fixed overhead Total overhead Less: Non-cash Cash disbursements

Manufacturing Overhead Budget Month January February March 14 320 21 200 17 500 _ $40 _ $40 _ $40 $ 572 800 $ 848 000 $ 700 000 800 000 800 000 800 000 $1 372 800 $1 648 000 $1 500 000

Total 53 020 _ $40 $2 120 800 2 400 000 $4 520 800

100 000 $1 272 800

300 000 $4 220 800

PTS: 1 AACSB: TOP: Preparation of the master budget

100 000 $1 548 000

100 000 $1 400 000

Knowledge, Analytical

CASE 1. Mr Sparks is the CEO of a large manufacturing company. He believes strongly that he is the keeper of all the knowledge of what is best for the company. Mr Sparks has traditionally prepared all of the budget estimates himself and then communicated the results to his department managers. In the past several years, however, he has begun to notice that the department managers rarely manage to stay within their budgets and have many excuses for their failures. Mr Sparks has also noticed an increase in his employee turnover, particularly at the managerial level. Required: (a) Explain what is meant by the term ‘participative budgeting’ and how the term relates to the current situation. (b) How would you recommend that Mr Sparks change the budgeting procedures to gain more support from the department managers? (c) How does participative budgeting contribute to a positive budgeting culture?

ANS: (a) Participative budgeting allows managers to participate in developing the budgets. It allows individuals at various levels of a company to participate in determining the company’s goals and plans for achieving those goals. In the current situation it would mean that the budgets would not be ‘top-down’; that is, would not be developed by upper management and imposed on the rest of the organisation. Budgets would be ‘bottom-up’ and involve all levels of the organisation. (b) In order to increase support for the budget, Mr Sparks should learn more about his business from his managers and include their suggestions in the budget. Each department should be responsible for the initial preparation of their departmental budget. Any changes should involve the managers’ suggestions and input. If the managers are involved in developing the goals through the budgeting process, they will be more likely to work toward achievement of the results. (c) Participative budgeting contributes to a positive budgeting culture in two ways. First, it signals that employee judgement is valued by senior managers and generally results in a higher degree of employee acceptance of the budget than if the budget is dictated by senior managers. Second, information gained through communications with the people who are closest to the day-to-day operations contributes to more accurate forecasts. PTS: 1 AACSB: TOP: The budget process

Knowledge, Analytical, Communication

Chapter 20 – Performance measurement and the balance scorecard TRUE/FALSE 1. A manager is responsible for all costs of producing product X but does not set the selling price. This means the manager is responsible for a cost centre. ANS: T PTS: 1 TOP: Responsibility accounting

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Knowledge, Analytical

2. Agricola Ltd is a diversified entity that has several central departments to service its various operating divisions. These include payroll, accounting and finance, and legal departments. As the divisions have no alternative but to use these ‘in-house’ services, the charges are referred to as ‘uncontrollable’ charges. ANS: T PTS: 1 TOP: Responsibility accounting

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Knowledge, Analytical

3. The rate of return on assets is an appropriate performance measure for an investment centre. ANS: T PTS: 1 TOP: Responsibility accounting

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4. A report that shows variances between actual and budgeted performance for a particular centre is referred to as a charge report. ANS: F PTS: 1 TOP: Responsibility accounting

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5. Participation by responsible managers in the setting of budgets enhances the probability of effective planning and control within an organisation. ANS: T PTS: 1 TOP: Responsibility accounting

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6. A major strength of financial measures is that they provide a standardised measure in monetary terms, whereas non-financial measures are difficult to measure and therefore are rarely used in performance assessment systems. ANS: F PTS: 1 AACSB: TOP: Measuring and rewarding performance

Knowledge, Analytical

7. A balanced scorecard is a measurement system that incorporates financial measures that tell the result of actions already taken and operational measures that are the drivers of future financial performance. ANS: T PTS: 1 TOP: The balanced scorecard

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Knowledge, Analytical

8. Economic value is the economist’s way to measure profit. ANS: F PTS: 1 AACSB: TOP: Measuring and rewarding performance

Knowledge, Analytical

9. A key performance indicator that measures which direction a firm should be taking is termed a strategic KPI. ANS: T PTS: 1 TOP: The balanced scorecard

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Knowledge, Analytical

10. An operating KPI measures whether a business is moving in the right direction. ANS: T PTS: 1 TOP: The balanced scorecard

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11. A driver KPI measures factors that will cause a change, whereas an outcome KPI measures the result of a change. ANS: T PTS: 1 TOP: The balanced scorecard

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12. An internal business process perspective of a balanced scorecard system addresses the question ‘What do we need to do to develop our employees?’ ANS: F PTS: 1 TOP: The balanced scorecard

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Knowledge, Analytical

13. The economic value added (EVA) is a method of measuring how effectively a company achieves the objective of creating shareholder value. ANS: T PTS: 1 AACSB: TOP: Measuring and rewarding performance

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14. Non-financial measures of performance assess items such as customer satisfaction and employee morale. ANS: T PTS: 1 TOP: The balanced scorecard

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15. Non-financial indicators of performance are easier to measure than financial indicators. ANS: F PTS: 1 TOP: The balanced scorecard

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16. The equation for calculating economic value added (EVA) is as follows: EVA = before-tax profit + interest - (cost of capital x total capital employed). ANS: F PTS: 1 AACSB: TOP: Measuring and rewarding performance

Knowledge, Analytical

17. In the context of performance measurement, drivers are the indicators that measure the items that will cause a change in the outcome measures. ANS: T PTS: 1 TOP: The balanced scorecard

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18. The four dimensions of the balanced scorecard are: the financial perspective; the monetary perspective; the customer perspective; and the learning and growth perspective.

ANS: F PTS: 1 TOP: The balanced scorecard

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19. The financial perspective of a balanced scorecard contains driver measures such as return on assets and return on shareholders’ equity. ANS: F PTS: 1 TOP: The balanced scorecard

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20. It is primarily the non-financial measures in the internal business process and learning and growth perspectives of the balanced scorecard that drive future financial performance. ANS: T PTS: 1 TOP: The balanced scorecard

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MULTIPLE CHOICE 1. Which of the following is an example of a performance measure that is appropriate for an investment centre but not a profit centre or cost centre? A. Quality of service B. Income from operations C. Rate of return on assets D. Gross profit margin ANS: C PTS: 1 TOP: Responsibility accounting

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2. In assessing the performance of a manager of a profit centre, which of the following would be an appropriate measure? A. Net profit margin B. Income from operations C. The centre’s budget with actual performance D. All of the above ANS: D PTS: 1 TOP: Responsibility accounting

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Knowledge, Analytical

3. Which of the following statements regarding performance assessment is incorrect? A. Measures should focus on the areas over which a manager has no capacity to influence the outcome. B. Assessment should be to reward good performance. C. Negative and positive feedback should be given within a reasonable timeframe. D. Measures should assist the entity in achieving the objectives of the entity. ANS: A PTS: 1 TOP: Responsibility accounting

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4. An objective or outcome of performance assessment in an organisation is not to: A. reward good performance. B. encourage behaviour consistent with an entity’s goals. C. allow an entity to understand the goals of a manager. D. provide feedback on each centre’s contribution to the achievement of an entity’s goals.

ANS: C PTS: 1 TOP: Responsibility accounting

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5. Which of the following factors under management’s control distinguishes an investment centre from a profit centre? A. Selling prices B. Output quantity C. Controllable costs D. Investment in assets ANS: D PTS: 1 TOP: Responsibility accounting

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6. Of the following statements regarding strengths and weaknesses of measures, which statement does not apply to non-financial measures? A. Takes into account the human element. B. Readily available. C. Less susceptible to manipulation. D. Setting inappropriate targets can result in ineffective and inefficient performance. ANS: D PTS: 1 AACSB: TOP: Measuring and rewarding performance

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7. Benefits of the balanced scorecard include: I integral to the development of an entity’s strategy. II focuses on major performance indicators, and measures achievement. III provides managers with complex information, and prevents information overload by limiting the number of measures used. IV requires cooperation of all those involved in selecting the indicators, and takes considerable time and effort. A. I and II B. I, II and III C. II, III and IV D. I, II, III and IV ANS: C PTS: 1 TOP: The balanced scorecard

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8. Which of the following examples would not normally be considered a strategic KPI? A. The amount invested in capital investments. B. Setting the level of debt used to fund assets. C. Comparing actual to budgeted sales. D. Determining the amount to be budgeted for research and development. ANS: C PTS: 1 TOP: The balanced scorecard

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9. Which of the following would not be categorised as an outcome KPI? A. Increase in profit from last year. B. Increased customer numbers resulting from an advertising campaign. C. Implementing staff training to increase output. D. Increased return on shareholders’ equity.

ANS: C PTS: 1 TOP: The balanced scorecard

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10. A business introduced employee training for all production staff, and discovered that product quality improved, which resulted in an increase in sales and ultimately profit. Based on this information, which of the following statements would be the least correct? A. Employee training is a learning and growth perspective. B. Improved product quality is an internal process perspective. C. Increased sales was the real driver of the increased profits. D. Increased sales and profits are the outcomes of improved employee skills. ANS: C PTS: 1 TOP: The balanced scorecard

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Knowledge, Analytical

11. In asking the question ‘What do we need to do within the core processes of our business in order to develop our employees?’ an entity is looking at which main perspective of a balanced scorecard system? A. Learning and growth perspective B. Internal business process perspective C. Customer perspective D. Financial perspective ANS: A PTS: 1 TOP: The balanced scorecard

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12. The Friendly Bank has been offering online banking facilities for several months, and wants to determine whether customer usage has increased over the period since the inception of the facilities. Which of the following KPIs would be the most appropriate to achieve the bank’s outcome? A. Site response time B. Sessions per active online customer C. Profit per customer D. Percentage decrease of in-house banking ANS: B PTS: 1 TOP: The balanced scorecard

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13. The Petrol House service station has introduced a balanced scorecard. The company wants to measure the amount of repeat business from customers. Which of the following measures would be most representative of this objective? A. Profit per new customer. B. Percentage of a day’s sales per customer. C. Percentage of a day’s sales to new versus existing customers. D. Profit per existing customer. ANS: C PTS: 1 TOP: The balanced scorecard

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14. For each of the following industry-specific KPIs indicate whether it is a financial, customer, internal process or learning and growth perspective. 1 2 3 4

Manufacturing: Banking: Retail: Insurance:

Sales from new outlets Customer satisfaction with the bank’s products Percentage of stock not available when the customer asks Number of staff training sessions

A. (1) internal process, (2) learning and growth, (3) financial, (4) customer B. (1) financial, (2) customer, (3) internal process, (4) learning and growth C. (1) financial, (2) internal process, (3) customer, (4) learning and growth D. (1) customer, (2) learning and growth, (3) financial, (4) internal process ANS: B PTS: 1 TOP: The balanced scorecard

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15. The Big Bed Furniture chain has identified as one of its major KPIs the average number of items bought per customer visit. In identifying this KPI, which of the following perspectives is Big Bed most likely to be targeting? A. Financial B. Customer C. Process D. Learning and growth ANS: B PTS: 1 TOP: The balanced scorecard

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16. Fast Forward Pty Ltd. has been expanding into new markets in recent months. The CEO wishes to know what the sales revenue is from these new markets. This KPI is considered to be a: A. financial perspective. B. customer perspective. C. process perspective. D. learning and growth perspective. ANS: A PTS: 1 TOP: The balanced scorecard

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17. The Demons fast food outlet provides intensive training for new staff, and ongoing training for existing staff. A focus of the ongoing training is to improve customer satisfaction. The training is considered to be a: A. financial perspective. B. customer perspective. C. process perspective. D. learning and growth perspective. ANS: D PTS: 1 TOP: The balanced scorecard

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Knowledge, Analytical

18. The store manager of the Red Shoe has asked the store’s staff to make a record of customer requests for stock that is unavailable. Determining the percentage of stock that is unavailable when customers ask for it would normally be considered to be a: A. financial perspective. B. customer or financial perspective. C. process or customer perspective. D. learning and growth perspective. ANS: C PTS: 1 TOP: The balanced scorecard

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19. The Orange Bank measures each business unit’s contribution to the bank’s total revenue on a monthly basis. Which of the following classifications would best describe this KPI? A. Strategic and outcome B. Strategic and driver

C. Operating and outcome D. Operating and driver ANS: A PTS: 1 TOP: The balanced scorecard

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20. Over the past two years, the Orange Bank has closed numerous country branches and significantly reduced staff numbers. In the same period, the bank has posted record profits and paid its top executives significant salary increases. However, the bank has also received a significant increase in customer complaints. In an attempt to redress the situation, the bank has decided to improve its image, and one major focus is to determine the average waiting time for calls to be answered. Which of the following would best describe this KPI? A. Strategic and outcome B. Strategic and driver C. Operating and outcome D. Operating and driver ANS: B PTS: 1 TOP: The balanced scorecard

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21. The finance director of AKP Ltd has observed that outstanding debtors have significantly increased in the past two months. An examination of possible causes has determined that part of the problem may be the new computerised invoicing system, which, due to input errors, has sent a number of accounts to wrong addresses. The director has asked the credit department to determine how many accounts have been sent to wrong addresses. This indicator would be classified as: A. strategic and outcome B. operating and driver C. strategic and driver D. operating and outcome ANS: B PTS: 1 TOP: The balanced scorecard

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22. The economic value added (EVA) method of assessing performance involves: A. after tax profit. B. cost of capital. C. total capital employed. D. all of the above. ANS: D PTS: 1 AACSB: TOP: Measuring and rewarding performance

Knowledge, Analytical

23. The balanced scorecard: A. has equal financial and non-financial measures. B. includes financial and non-financial measures. C. is the same as triple bottom line reporting. D. reports on corporate governance. ANS: B PTS: 1 TOP: The balanced scorecard

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24. The balanced scorecard: A. demonstrates how an entity can improve outcome measures. B. provides a view of a firm’s performance from four perspectives.

C. includes driver measures. D. all of the above. ANS: D PTS: 1 TOP: The balanced scorecard

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25. Which of the following statements about performance measurement is not correct? A. Drivers are measures of the items that will cause a change in outcome measures. B. Improved customer satisfaction is a driver of repeat business. C. The EVA performance measure is financial in nature. D. Cost management is an outcome measure. ANS: D PTS: 1 TOP: The balanced scorecard

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Use the data below to answer the next 2 questions for EVA Ltd. Net profit before tax $100 000 Tax rate 30% Total assets $500 000 Total debt $300 000 Total equity $200 000 Interest $24 000 The interest rate on the debt is 8% and shareholders expect to earn 12%. 26. The weighted average cost of capital is? A. 8.16%. B. 9.6%. C. 10.4% D. 12% ANS: A PTS: 1 AACSB: TOP: Measuring and rewarding performance

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27. The economic value added for EVA Ltd is? A. $29 200 B. $53 200. C. $83 300 D. $100 000 ANS: B PTS: 1 AACSB: TOP: Measuring and rewarding performance

Knowledge, Analytical

SHORT ANSWER 1. Levels within an organisation are often categorised according to the types of responsibilities placed on managers. When a responsibility centre is considered a cost centre, (a) over which aspects of the statement of comprehensive income does the manager have control? (b) over which aspects of the statement of comprehensive income does the manager not have control? (c) on what kinds of measures is the centre’s management evaluated?

ANS: (a) In a cost centre, the manager has control of expenses within the centre such as a department or manufacturing plant. (b) In a cost centre, the manager cannot control selling prices, manage marketing campaigns, purchase or dispose of equipment or other property without approval from divisional or corporate-level management. (c) Managers are evaluated in a cost centre on their ability to control costs. Measurement is often made in relation to a budgeted amount. Measurements may include quality measures such as defect rate and percentage of on-time deliveries. PTS: 1 AACSB: TOP: Responsibility accounting

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2. Levels within an organisation are often categorised according to the types of responsibilities placed on managers. When a responsibility centre is considered an investment centre, (a) over which aspects of the statement of comprehensive income does the manager have control? (b) over which aspects of the statement of comprehensive income does the manager not have control? (c) on what kinds of measures is the centre’s management evaluated? ANS: (a) In an investment centre the manager has control of most costs, revenues and assets. (b) Investment centre managers do not have control of expenses that occur outside of their particular division, certain allocated corporate expenses and certain assets which may be acquired at the group or corporate level. (c) Investment centre managers are evaluated using profitability measures such as profit margins, as well as measures of efficient asset utilisation such as asset turnover and returns on assets such as ROI. PTS: 1 AACSB: TOP: Responsibility accounting

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PROBLEM 1. For each responsibility centre described below, indicate the type of responsibility level that is the most appropriate. Select one (or more) of the following levels. If you select more than one level, explain your reasoning. Responsibility levels are: CC = Cost centre 1. 2.

3. 4.

PC = Profit centre

IC = Investment centre

A manufacturing plant that has no responsibility for sales. A division of the corporation that handles a single product line and whose division manager has the authority to purchase manufacturing equipment, advertise, and make decisions about changes to the product line. All legal matters are handled by the corporate office. Also, computer systems are centralised and charged to the divisions based on actual usage. A manufacturing plant that has responsibility for sales of the product it manufactures. The corporate accounting department that controls the majority of its operating budget including salaries, but not including office rent.

ANS: 1. CC 2. PC or IC If the division has identifiable operating assets, it could be treated as an investment centre; if not, it would be a profit centre. 3. PC 4. CC PTS: 1 AACSB: TOP: Responsibility accounting

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ESSAY 1. People constantly use information to evaluate their environment and help them make important decisions. One such evaluation method used by corporations is called the ‘Balanced Scorecard’. (a) Explain the philosophy behind the ‘Balanced Scorecard’ approach to a firm’s evaluation of its corporate strategy. (b) Name each of the four performance categories of key performance criteria used in conjunction with the ‘Balanced Scorecard’ method. (c) For each of the four categories named in part b, list one performance measure that would be used in that category. ANS: (a) The balanced scorecard approach measures key performance criteria together on a single report to be consistent with the organisation’s strategic goals. The balanced scorecard prevents managers from improving only one aspect of performance while simultaneously allowing other important aspects of performance to decline. The performance measures encourage managers to consider how their company appears in the eyes of shareholders as well as customers while maintaining a longer-term perspective. (b) & (c) 1. 2. 3. 4.

The four performance categories and examples of measures of each are as follows: Financial: ROI and profit percentage measures Customer: On-time deliveries and response time to inquiries Learning and growth: Percentage of sales from new products and patents received Internal business: Cycle time, scrap rate, manufacturing lead time, and employee turnover rates

PTS: 1 AACSB: TOP: The balanced scorecard

Knowledge, Analytical, Communication

2. Sallie’s Cleaning service is a large commercial cleaning service with two divisions. The Office Division services businesses by cleaning their offices once a day during non-business hours. The Residential Division offers cleaning services to individuals in their homes, usually on a weekly basis, although other arrangements can be made. Sallie’s competition is very aggressive, especially for the Office Division. In the past the division managers have been evaluated primarily on sales volume. Although the divisions operate as independent businesses, the corporate president would like to increase the accountability of the division managers by making them also responsible for expenses. Since the company has no manufacturing operations and capital investments are minimal, the president does not intend to account for assets assigned to the divisions.

(a) What kind of responsibility centre should the president establish? (b) What measurements should be used to evaluate the performance of the division managers? (c) Discuss the effect that this change is likely to have on the performance of the division managers. ANS: (a) Since the divisions will be held accountable for sales and expenses, they should be treated as profit centres. It would not be appropriate to treat the divisions as investment centres since they are not responsible for asset acquisitions. Even though the divisions are not investment centres, corporate management may want to hold the divisions accountable for inventory control for the inventory of cleaning supplies. (b) Measures that could be used for division managers include sales volume, net profit, labour hours per job, number of customer complaints, cost of cleaning supplies, employee turnover rates, and number of new customers. (c) The new change will make managers more aware of division profitability, controlling expenses, and other measures related to the corporation’s strategic plan. However, if too much emphasis is placed on current profits, the managers may be motivated to neglect long-term ‘investments’ in expenses related to such things as employee training. PTS: 1 AACSB: TOP: Responsibility accounting

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3. Kaplan and Norton’s Balanced Scorecard has principally been applied to for-profit organisations. In such applications, the scorecard’s four perspectives (financial, customer, learning and growth, and internal business) are highly appropriate. However, Kaplan and Norton also acknowledge the applicability of the Balanced Scorecard to not-for-profit organisations; they state, though, that the four traditional perspectives may need to be altered in such situations. Required: Suppose you were the manager of a not-for-profit shelter for the homeless. Suggest at least three perspectives you would need to consider in developing performance evaluation metrics for your organisation. For each perspective, identify two or three specific performance measures you would include in your organisation’s Balanced Scorecard. ANS: Answers to this question are likely to exhibit a high degree of variability. The main issue is getting students to think ‘outside the box’ about the shelter’s stakeholders and what’s important to them. Some suggestions appear below: Perspective: donors  percentage growth in total donations  funding sources by percentage  ratio of costs to donations  ability to improve clients’ quality of life Perspective: volunteers  perceived relevance of their work  staff turnover  perceived level of appreciation by management

Perspective: regulatory agencies  number of clients served  staff qualifications  ability to meet health and safety standards Perspective: clients (the homeless)  range of available services  convenient and adequate hours of operation  attitudes of volunteers PTS: 1 AACSB: TOP: The balanced scorecard

Knowledge, Analytical