Solutions Manual for Contemporary Accounting 8th Edition By Mike Bazley, Phil Hancock by StudyGuide

Solutions Manual for Contemporary Accounting 8th Edition By Mike Bazley, Phil Hancock

Contemporary Accounting 8e Mike Bazley, Phil Hancock (Solutions Manual All Chapters, 100% Original Verified, A+ Grade)

Chapter 1 Introduction to accounting Review questions 1 a

To help control the level of expenditure, to assist in planning future levels of expenditure, to help raise additional finance (e.g. mortgages, hire-purchase and so on) and to help decide the best way to spend their money. b To control the activities of the organisation, to plan future activities, to assist in raising finance and to report upon the activities and performance of the entity to interested parties. 2 Numerous examples are acceptable. Ideas such as exclusion of certain items (e.g. good reputation, brand names, technical know-how) and how accounting reflects the past can be used to provoke discussion.

Problems for discussion and analysis 1 a The name of the auditing firm is Deloitte. b From note 1P (iv) it is reported that Woolworths does provide share based payments to employees. It operates an ESP where employees receive an interest-free loan that can be used to buy shares in Woolworths. c Yes, the same note states that the cost of equity settled share based payment plans are recognised as an expense over the vesting period. 2 In general, students will need to be aware of the contents of the AASB Framework and the more recent IASB Conceptual Framework. Accordingly, responses should include at least the following points: a Employees are interested in the generation of cash flows and whether the entity is achieving its objectives. This information is available from general purpose financial reports (GPFRs) which also contain non-financial information on the future direction of the entity. b Investors are interested in the amount and timing of profitability, the generation of cash flows, whether the company is achieving its objectives and its future direction. This information is available from GPFRs, ASX extracts and media releases. c Regulators are interested in whether the reporting entity is operating in the interests of its members, whether the entity is achieving its objectives, and if it is operating economically and efficiently. They are also interested in ensuring that reporting entities are complying with various rules and regulations, i.e. AAS, AASB, Corporations Act 2001, ASX. Additionally, regulators are concerned with the efficiency of the law and will therefore monitor reports to ensure that regulation complies with public expectation. This information is available from GPFRs and other reports to meet specific regulatory requirements, i.e., Corporations Act 2001, ASX. d Suppliers of goods and services are primarily interested in whether the entity is solvent. In addition, they are concerned with profitability and cash flows, and whether the entity is achieving its objectives. This information is available from the statement of comprehensive income and the balance sheet. e Customers are interested in the ability of the entity to continue a future supply of goods and services, the level at which they will be provided and the likely cost of provision. Ongoing supply depends on profitability and cash flows. In addition, they may be Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 1: Introduction to accounting

concerned with non-financial issues, such as externalities (pollution, land degradation and so on). 3 This question should promote lively debate about the advantages and disadvantages of mandating the publication of social and environmental information. Costs versus benefits need to be considered. What requirements are to be mandated? Are these to be audited? The UK now requires companies to report on environmental and social matters in the Operating and Financial Review but this need not be audited. 4 The G100 definition is very descriptive and gives details of what triple bottom line (TBL) reporting should contain in very broad terms. The ICANZ definition indicated what the report should cover but also contained some potential benefits from the production of a TBL. The benefits range from micro for the firm and users of its stakeholders through to macro benefits for human welfare. This question will provoke lively debate about the relationship between publishing a TBL report and influencing behaviour. 5 Changing the law for directors will have the following possible implications: a Which stakeholders should be considered most important? b Potential increased risks for directors would act as a disincentive and therefore make attracting directors more difficult. A legal requirement for disclosure provides a clear signal as to the importance of this information. Of course if disclosure is to be mandated, then the next issue is what disclosures should be required? The second alternative is to rely on companies voluntarily disclosing such information and many companies now do this. However, not all companies will disclose and when they do it may be difficult to compare companies. There is argument that where competitors are providing information, non-disclosers are also likely to start providing such information. 6 You are employed by the client, but there are certain obligations to regulatory bodies, such as ASIC and the ASX, which cannot be deliberately disobeyed. 7 • Information on costs, including goods purchased, wages, rents, electricity and other overheads, so prices can be set to cover all costs and return a profit to the owner. • Information on cash flows – weekly or even daily. • Information on inventory levels so goods can be ordered in time to be available before all items are sold. Daily and weekly, depending on items. • Competitor pricing policy. • Opportunity costs. What could you earn with your money invested elsewhere and what is the cost of wages you could earn by working as an employee? This is an issue that should be considered at some stage, preferably before making the decision to buy the supermarket. 8 What is the amount per band member? What are the opportunity costs of taking the job, i.e. what does the band give up? Any costs to incur, such as hiring equipment, transport to the venue? Tax implications should also be considered. 9 a Some examples are: selling price, costs of manufacture, set up costs, marketing costs, patent costs, expected life for the product. b Some examples are: size of market, competitors, technical specifications. Potential costs which may arise given the risk of hang gliders, does the company need to consider special insurance protection – is it available? This is not the company’s core business. What skills does it have in this industry? Costs of relocating to Sydney. 10 • Information about competitors. • Any proposed changes to zoning in the area which may affect the business. • If a lease, when is the lease due for renewal? • Information about suppliers. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 1: Introduction to accounting

• •

Any new competitors likely to enter the area? Market research may be necessary but this depends on how long the business has been established and how successful it has been. • Any new developments or road construction in the area. 11 There is no ‘right’ answer to this problem as until the yacht charter business was purchased there was no separate business entity. However, there is clearly a need for Tom to prepare a statement of expenditure as an individual. Some additional questions to promote discussion are: If there had been no problem with the purchase of the boat building business, what would you have done with the $1000 paid to the accountant? Would you have a different answer if Tom was already in an established business looking for areas to expand or to diversify into? Should Tom even consider investing in a business of which he has no knowledge? 12 • Financial issues – cost of building, machinery, training costs, purchase of components, personnel (wages, annual leave, superannuation and so on), provision for any tax on externalities, projected revenue, life of the project. • Health and safety issues – location of plant, emissions of toxic substances. • Social and legal issues – location of plant, disposal of waste products, procurement of necessary licences for construction. • Market research – demand, price, competition. Note: if nuclear-powered Frisbees are made and/or tested on site then the above issues will need to be expanded (e.g. community reaction, strict health and safety regulations, adequate containment of nuclear materials, as well as the impact these may have on future legislation, adherence to Consumers Protection Act and so on). 13 The solution to this problem should focus on the tentativeness which attaches to all economic measurements. Students should appreciate the difference between intrinsic values of an item (such as the official exchange price of a bar of gold) versus the extrinsic effects on economic value produced by conditions or events in the environment (as demonstrated in this problem). a Discussion of the economic worth of the project to be measured might take into account (1) estimated future rental income offset by estimated expenses to maintain and operate the hotel, (2) the expected exchange price if the hotel building were to be sold to an outside party, or (3) an accumulation of the costs incurred. It is not clear that the costsincurred measure is the best from an economic point of view – even though admittedly it is the simplest and most easily quantifiable. Before the decision of the lower court any of the above measures could be justified depending on expectations about the outcome of the court decision. However, following the decision of the lower court the use of measure (3) may seem more prudent. b Students should have some indication of the difficulty of making qualitative versus quantitative measurements. Quantitative measurements in business affairs are typically subject to several assumptions which must be made before such measurements become substantive or reliable. No one economic measurement is perfect. The question, in other words, is the degree of reliability which can be placed upon any one individual measure. c The loss in the case described falls to the owners of the Coastal Development Company. Discussion should bring out that a company is nothing more than a creation of the law and in reality cannot sustain an economic loss. The owners of the company are the real economic party at interest. But those who might have stayed in the hotel also lost, although those who retained their views and the character of the neighbourhood gained, as did the general public through the protection of the sand dunes. The local shire council may ultimately lose as it is likely the Coastal Development Company will sue the shire for the losses incurred. If successful, then the ratepayers in the shire area must ultimately pay. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 1: Introduction to accounting

14 a Thug Possessions 6 large brown furs 2 small brown furs 5 small black furs 34 morsels of meat Rock fridge

Exchange rates 50 morsels of meat each 30 morsels of meat each 15 small brown furs at 30 morsels of meat per fur 3 small brown furs at 30 morsels each Taxed at 1 rock for every 10 morsels

Equivalent morsels of meat 300 60 450 34 90 934 93 rocks

Exchange rates 50 morsels of meat each 20 large brown furs at 50 morsels of meat each 27 small brown furs at 30 morsels of meat per fur 2 large brown furs at 50 morsels each (equivalent to 1 large black fur) Taxed at 1 rock for every 10 morsels

Equivalent morsels of meat 100 1000 810 22 100 2032 203 rocks

Olga Possessions 2 large brown furs 10 large black furs 9 small black furs 22 morsels of meat Rock fridge

b Thug should pay taxes equivalent to 93 rocks and Olga should pay the equivalent of 203 rocks. They could either collect the rocks themselves or pay Ugg by means of furs and morsels of meat equivalent to the amounts of tax they owe. (Tutors should discuss other possible solutions and alternative measurements, e.g. the rock fridge is shown at two different amounts. Discuss the concept of decline in value through use.)

Chapter 2 Types of organisations and the financial reporting framework Review questions 1 A sole trader has one owner whereas a partner has at least two. Partners are jointly and severally liable for the debts of partnership, there needs to be separate accounts kept of the transactions relating to each partner, agreements need to be reached regarding profit shares and so on. All partners are bound by the requirements of the Partnership Act. 2 The liability of the owners (shareholders) is limited to the amount paid on their shares. 3 Legal status, membership of company, dividends vs. drawings, limited liability, audit, filing of accounts and so on. 4 As the terms imply, the principal difference between limited, unlimited and no-liability companies is in the amount of the shareholders’ obligation to contribute towards the debts of the company when the company is unable to meet those debts itself. • For a limited liability company, shareholders’ liability is restricted to the amount paid for the shares. • Members of an unlimited liability company are liable for all debts of the company. • No-liability companies are restricted to mining companies. Shareholders of these companies are not required to contribute the unpaid value of the issued shares if the company is liquidated 5 Presumably it is to encourage people to invest in this industry which is very high risk but offers enormous benefits to the country if successful. 6 Students should raise and discuss the following points dealt with in the text: Advantages: • ease of formation • limited rules and regulations • provision of capital and expertise • taxation advantages. Disadvantages: • limited life • unlimited liability • mutual agency. 7 Two-dollar companies, as the name suggests, are companies that have a nominal ($2) share capital. They are generally small private companies with the minimum number of members permitted (i.e. one or two members). 8 The term ‘due process’ refers to procedures which are designed to allow all interested parties the opportunity to comment on a proposed accounting standard prior to its adoption. The steps in this process are: • identify technical issues • add issues to the AASB agenda • research and consider issues • consult with stakeholders and issue an exposure draft or discussion paper • issue an accounting standard or other pronouncement such as an Interpretation. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 2: Types of organisations and the financial reporting framework

9 Points raised by students on the various influences on external reporting for companies in Australia should include: • international financial reporting standards as issued by the IASB are now issued as Accounting Standards by the AASB and must be complied with by all reporting entities • Corporations Act 2001 • ASX listing requirements, where applicable. 10 It is a set of interrelated concepts that define the nature, subject, purpose and broad content of general-purpose financial reporting. It is an attempt to establish the foundations from which general-purpose financial statements can be prepared. 11 It is an entity which has users who require general-purpose financial reports (GPFRs) to assist them in making decisions about the allocation of scarce resources. Such users are unable to demand information and receive it from the entity as would normally be the case if they were a banker or large creditor. 12 The users of general-purpose financial reports are those users who cannot demand and receive information from an entity. For example, the Reserve Bank would be able to demand and receive any information from a bank in Australia; therefore the Reserve Bank does not rely on general-purpose financial reports to assist in its supervision of the banks. However, most users, whether they are shareholders, employees, customers or analysts, are unable to demand and receive financial information from an entity. (Tutors may ask students how successful they would be if they approached BHP for financial information.) Users require general-purpose financial reports to assist them with a range of decisions, for example, to buy or sell shares in the entity, to provide goods to the entity, to buy goods from the entity and so on. 13 Students need to understand that while legal ownership will normally provide control, it is not always the case, e.g. a leased asset. Tutors should discuss the rights and obligations of lessors and lessees in a finance lease. The lease allows you to demonstrate that the accountant is concerned with the economic substance of transactions, rather than the legal form. 14 This is a point of view expressed by some authors. A conceptual framework provides definitions of key elements, establishes objectives for financial reporting and is an attempt by the profession to improve its image to outsiders. In doing so, the profession hopes to reduce threats of government intervention into the regulation of the accounting profession. If the conceptual framework simply maintains the status quo then the above argument has some merit. SAC 4 in Australia had the potential to alter current practice and therefore not maintain the status quo. It was strongly opposed by business in Australia. 15 Conservatism is often used to describe an approach to accounting whereby assets, income and revenues should not be overstated and expenses and liabilities should not be understated. It is sometimes associated with prudence and is acceptable provided there is no deliberate overstatement of expenses and liabilities or understatement of assets and income and revenues. 16 Reliable and irrelevant financial information – e.g. amounts to the exact dollars and cents for any items in the financial statements. Unreliable and relevant information – estimates of probability of success from research and development expenditure, extent of reserves underground for mining companies, value of internally-generated goodwill. 17 The purpose of an external audit is to add credibility to general-purpose financial reports so that users can be assured that the reports are a true and fair representation of the economic activities of the reporting entity.

Chapter 2: Types of organisations and the financial reporting framework

18 The expectation gap refers to the difference between what an auditor is legally required to do in auditing general-purpose financial reports and what is expected by users of financial statements. Example: an auditor is required under the Corporations Act to report an incident of fraud or illegal acts discovered during the course of an audit. This requirement may raise the expectation among individual shareholders that, if an auditor reports no such acts, then no fraud or illegal act has been perpetrated. The law, on the other hand, requires the auditor to exercise due care when forming his or her opinion but does not require the auditor to detect fraud. 19 An audit adds credibility to general-purpose financial reports, however, the preparation and presentation of the reports remains the responsibility of the directors of public companies. It would therefore be incorrect to conclude that public financial statements would not be true and fair merely because they were not audited. 20 The unqualified audit report should provide a greater level of confidence with respect to that company. If all other things are equal then the one with the audit report would be preferred.

Problems for discussion and analysis 1 a

Note 1B states that the accounts are prepared on the basis of historical cost basis except for derivative financial instruments, financial instruments held for trading and availablefor-sale, which are valued at fair value. b The auditors are Deloitte. c The auditors were paid $2.153 million for the audit and $660 000 for other non-audit services. As the amount for non-audit services is significantly less than the audit fee it therefore does not present a problem for audit independence. 2 a Asset – something of value that belongs to you. b Liability – an amount you owe someone. c Equity – your interest in a business. d Expense – cost of running a business. e Income – amount received for selling assets and goods and services. 3 a Mike and Phil Income statement for year ending 30 June 20X9 $

Sales Less: cost of goods sold Less: Selling expenses Depreciation expenses Financial expenses General expenses Net profit

b Profit share Mike Phil

36 320 90 800 54 480 90 800

7 316 4 322 1 827 12 035

210 000 163 000 47 000

25 500 21 500

× 21 500 = $8600 × 21 500 = $12 900

Chapter 2: Types of organisations and the financial reporting framework

4 a With no agreement, share profit equally. Steve and Lee each receive $75 000. b Share according to capital investment: Steve 55.6% × 150 000 = $83 400 Lee = $66 600 c $150 000 – 45 000 = $105 000 Steve = 105 000 × 0.4 = $42 000 Lee = $63 000 d $150 000 – 135 000 = 15 000 Steve = $7500 Lee = $7500 e 150 000 – (45 000 + 135 000) = loss $30 000 Steve and Lee each have a loss of ($15 000) 5 $276 000 Plan a b

50/50

Andrew Glen $138 000

40.54%/59.46% $111 892 66.7%/33.3% $184 092 c less $37 000 and $149 375 d 62.5%/37.5% less $37 000 + $44 500 e $150 000 and 50/50 as above + 20% 276 000 – 150 000 *bonus to Glen if – 37 000 – 25 200 f net profit < $187 × 0.5 000 = $31 900 * Bonus to Glen based on NP – salary payments only.

$162 000 Norman Dale $138 000

Andrew Glen $81 000

Norman Dale $81 000

$164 108 $91 908

$65676 $108 054

$96 324 $53 946

$89 625

$78 125

$46 875

$44 500

–$12 500

$31 900

162 000 – 150 000 – 37 000 – 2 400 × 0.5 = –$13 700

–$13 700

6 Students should understand the meaning of a present obligation, sacrifice of future economic benefits and that it must be as a result of a past event. 7 Make sure students understand the meaning of future economic benefits, control and that it must be as a result of a past event. 8 No. As the probability of having to sacrifice $100 000 is only 35 per cent, this fails the recognition criterion of probable and should not be recognised in the balance sheet. If the amount is material then disclosure of this possible liability in the notes is recommended. 9 a The article raises an interesting issue about whether a football player is an asset. Consider whether in this case the definition of an asset is satisfied. Manchester United controls the services of a player because of the contract it would have in place. The future economic benefits relate to the value of the player’s services and his resale value by way of the transfer payment, which is paid when a player moves from one club to another. The future economic benefits are the value of the playing services and the merchandise based on the player. The past event would be the signing of the contract. Before being recorded on the balance sheet, an item that meets the definition of an asset must also satisfy the recognition criteria. It must be probable that the future economic benefits will flow to the entity and there must be a cost or other value which can be reliably measured. The present value of the player salary payments over the contract period could be an amount which could be used to report the value of the player. The probability of the

Chapter 2: Types of organisations and the financial reporting framework

economic benefits flowing to the club depends on a number of issues, including player age, risk of injury and performance on the field. Students should understand that it is the player’s services which the club controls during the contract period and not the player himself. Clearly the player who plays for the local club does not provide the same economic benefits to the club in terms of drawing large crowds to the game. The player may be important for the local team to win but huge sums of money are not involved. The local club probably does not produce a set of financial statements. b No set answer. 10 We begin by examining the transaction in the context of the definition and recognition criteria for liabilities: Present obligation Yes, there is a present obligation that arises when a frequent flyer takes a flight with an appropriate airline. Sacrifice of future economic benefits Yes there is a sacrifice of FEBs which would include the incremental costs incurred when someone flies free, including meals, baggage handling and so on. It could be argued that when a passenger purchases an airline ticket that he or she is in effect buying a portion of a future ‘free’ trip. Past event The past event is the flight that provides frequent flyer points to a member. Probable that there will be a sacrifice of future economic benefits Yes, in fact it is highly likely that frequent flyer members will use points at some stage and so it is certainly probable. Reliable measurement The liability for free tickets would need to be calculated based on an estimation of the portion of free tickets that are likely to be redeemed. If this argument is pursued, a portion of the revenue of each ticket sold to a ‘frequent traveller’ would need to be deferred. Airlines can use past experience to estimate the amount of points that are likely to be redeemed. Airlines would argue that there is little or no cost in free tickets as otherwise empty seats are filled. The liability for free tickets would need to be calculated based on an estimation of the portion of free tickets that are likely to be redeemed and an estimation of the additional cost. The most significant cost would result if the award booking resulted in a fare-paying passenger choosing to fly with a competitor. Most airlines now use the deferred revenue approach following the release of IFRIC 12 on customer loyalty programs which require a portion of the cost of a ticket to be deferred and recognised as unearned revenue. This obligation is then settled when the frequent flyer uses points to take a free flight. 11 The management of companies are interested in the standard-setting process because it may affect the way they have to report the performance and financial position of the company. Tutors should discuss the economic consequences of standard-setting and why management may have a vested interest in the outcome of standard-setting. 12 The due process allows for any interested parties to make comment on proposed accounting standards. However, experience shows that managers and accountants are most active in making submissions to the AASB. User groups such as the Securities Institute and the Australian Shareholders Association do also comment on proposed standards.

Chapter 2: Types of organisations and the financial reporting framework

13 There are far more onerous reporting requirements for public companies and in particular listed public companies. All companies have to submit financial statements to their shareholders. For reporting entities they must prepare: • a statement of comprehensive income • a statement of financial position or balance sheet • a statement of changes in equity • a statement of cash flows. Notes to the financial statements: • a director’s report • an auditor’s report. Public companies have the ability to raise funds from the public, therefore their level of reporting requirements are stringent. The ASX imposes additional reporting requirements on listed companies due to the depth of their shareholding. Proprietary companies are smaller and their members are considered to be better informed. Small proprietary companies have less stringent regulation imposed as they have a very limited number of shareholders who have no requirement for extensive financial reports and verification. They are frequently family businesses. If they are not a reporting entity then they are not required to produce a GPFR but can produce a special purpose financial report which does not include all the details in a GPFR and need not comply with all accounting standards. 14 This question refers to the ‘expectation gap’ of what the actual role of an audit is and what users believe an audit should be. Students should therefore discuss the role of the audit and the way the auditor goes about gathering information to help form an opinion about the financial statements. The discussion should also address the issue of the cost of an audit versus the need to gather enough evidence and to do enough testing to be able to arrive at a reasonable assurance. The cost of checking everything would be prohibitive and so sampling is used. Discuss the issue of tendering for an audit and the implications of this on audit quality. 15 The amount of fees a practice derives from one client is one potential measure of audit independence. If Dorro accepts the engagement then the new client will represent one third of the fees for his practice. If Dorro employs more staff based on the new work and incurs other costs then his practice becomes more reliant on the fees from the new client. The argument is that the client may then be able to exert pressure on Dorro and such pressure can impede his independence. Of course a counter argument is that the professionalism of Dorro will mean that he will not succumb to any undue pressure from the new client, even if this means losing the client. 16 a Yes. The company should recognise a liability as it is probable that there will be a sacrifice of future economic benefits and the amount can be reliably estimated. b No. While it is probable that the company will have to pay money from the claim, we are not told about the amount and if this cannot be reliably estimated then a liability would not be recognised. A note in the financial statements should be included if the amount is likely to be material. c This would not be a liability as there is no present obligation to sacrifice future economic benefits to an external party. You might ask students would the answer be different if they had a contact with a provider to carry out the overhaul? When a company incurs the costs of maintenance the amount involved may be added to the asset cost and subsequently depreciated.

Chapter 2: Types of organisations and the financial reporting framework

17 Solutions to the case study should cover the following points: a Organisation Partnership: – easily formed by simple agreement with a minimal cost – not subject to requirements of corporations law – no requirement for preparation of financial statements – not taxed as an entity thereby providing tax planning opportunities – withdrawal or death of either partner will result in dissolution Company: – a company has a continuous life – the company offers limited liability whereas both partners would be jointly or severally liable for the debts of the partnership – no mutual agency – ease of transfer of ownership of shares of the company – the company is a taxpayer in its own right and would pay franked dividends – separate legal entity Bev and Daniel would probably find the limitation of liability of a company attractive in view of their large debt and the business’s lack of past success. The major disadvantage in choosing a company would be its additional regulation and costs. b Generally companies are better placed to raise finance compared to partnership or sole traders, however, in the case of a small company with a limited capital base, this would probably not be a significant advantage. In these circumstances, financiers frequently request personal guarantees from directors and shareholders of small companies. c A whole range of ideas should be raised, such as knowledge of the particular business sector, tax planning, inventory and cash management and marketing and financial planning. d There are a number of possibilities, however, given the large debt Bev and Daniel will incur, a loan from a large bank or financial institution would be the most likely source of funds. Security in the form of a mortgage over the assets of the business and possibly the personal assets of Bev and Daniel (or a personal guarantee) would be required. 18 Option a Borrow $3m at 10 per cent Interest $300 000 per annum As this is tax deductible the after tax cost is (1 – 0.36) × 300 000 or $192 000 each year. The $3m must be repaid in five years. Option b Converting to a public company and issuing shares will raise the required cash if the market considers the price of $5 appropriate. If the family is to retain control then they will need to purchase at least 50 per cent of the shares for an outlay of $1.5m. As a public company there will be increased regulations and shareholder expectations concerning dividends. Therefore it is wrong to assume this is a costless option. Option c Issuing preference shares will raise the $3m and will impose a dividend cost of $180 000 each year on the company. This is not tax deductible as the preference shares are considered as equity and not debt. This is because the company has complete discretion as to whether the shares are to be redeemed.

Chapter 2: Types of organisations and the financial reporting framework

Recommendation: Options (a) and (b) impose cash flow obligations on the company and cash flows have been a problem. I recommend the company investigate the reasons for the cash flow problems. Option (c) is preferred to Option (a) as it is less costly and does not require the company to repay the principal at any specified time. The choice then is Option (b) or (c). While Option (b) appears less costly it will create greater scrutiny of the company by shareholders and create demands for dividend payments. Therefore Option (c) is perhaps the best option for the company, provided it can remedy the cash flow problems in order to service the dividend. 19 a Optimistic estimate: Net profit Less salaries Share Bob Phil

Year 1 75 000 35 000 40 000

Year 2 85 000 35 000 50 000

Year 3 95 000 35 000 60 000

24 000 16 000

30 000 20 000

36 000 24 000

Year 1 55 000 35 000 20 000

Year 2 65 000 35 000 30 000

Year 3 75 000 35 000 40 000

12 000 8 000

18 000 12 000

24 000 16 000

Year 1 45 000 35 000 10 000

Year 2 50 000 35 000 20 000

Year 3 65 000 35 000 30 000

6 000 4 000

12 000 8 000

18 000 12 000

Total 90 000 60 000

b Most probable estimate: Net profit Less salaries Share Bob Phil

Total 54 000 36 000

Pessimistic estimate: Net profit Less salaries Share Bob Phil

Total 36 000 24 000

d Bob’s share of profit Optimistic Probable Pessimistic

Amount 90 000 54 000 36 000

Probability 0.2 0.6 0.2

EV 18 000 32 400 7 200 57 000

Based on the analysis in (d), if Bob can receive $80 000 then this appears like a good price. The expected profits over the next three years are well below the $100 000 set by Bob. The expected value of $57 600 has not been discounted to a present value which makes the offer of $80 000 today even more attractive. The share of profits is after deduction of the $20 000 per annum salary to Bob. If he added the three years’ salary to the profit then the amount exceeds $100 000. Therefore, it is important that Bob realises he is giving up both his share of profits and the salary.

Chapter 2: Types of organisations and the financial reporting framework

a Cash received for next year’s services The cash flows received from customers cannot yet be recognised as revenues because the definition of revenues (para. 7 of AASB 118) has not been satisfied. Although the cash flows received have increased assets, this increase in assets has not resulted in an increase in equity. Rather, it is the liabilities which have increased. The definition of liabilities (para. 4.4b of the Conceptual Framework) indicates that, in this case, New Incentives Ltd has a present obligation, as a result of the payment received, to sacrifice future economic benefits to supply services to the customers. In the absence of any information to the contrary, this liability meets the recognition criteria in paragraph .4.4b of the Conceptual Framework. Advertising expenditures: These expenditures must meet the definition of assets (para. 4.4a of the Conceptual Framework) and the recognition criteria (para. 4.38 of the Conceptual Framework) before the proposed accounting treatment is acceptable. In principle, advertising expenditures can satisfy the definition of assets because the expectation is that they will give rise to future benefits (e.g. increase or maintenance of sales levels), are controlled by the entity (it is New Incentives Ltd that is the only subject of the advertising), and result from a past event (the screening of television). However, it is much less likely that the expenditures will satisfy the recognition criteria because the ability to identify the specific benefits of any advertising program are notoriously difficult (although this will very much depend on the discernible facts of any given case).

b Facts – Tom has a new job after looking for six months – Tom has been asked to adopt two ‘favourable’ accounting treatments of certain cash receipts and expenditures – Management bonuses are tied to reported profits Four possible courses of action – Action one: comply with boss’s instruction – Action two: record transactions in accordance with the Conceptual Framework – Action three: try to convince boss that the Conceptual Framework should be complied with – Action four: resign from the position of accountant (There may be many other courses of action raised, including reporting the proposal (or eventual action) to the Board of Directors or the ASIC.) Evaluation Action one: – breaches all the ethical principles noted above but will gain approval from boss – managers more likely to achieve bonuses – may encourage boss to impose further manipulation of accounts – could harm the interests of shareholders and creditors Action two: – compliance with ethical principles – disapproval by managers/boss may lead to Tom being overruled anyway, or fired – shareholders’ and creditors’ interests protected

Chapter 2: Types of organisations and the financial reporting framework

Action three: – may succeed and problem resolved – may not be able to convince boss and so could be overruled or fired – gives boss an opportunity to change her mind Action four: – lose job and income – integrity intact – problem remains for someone else Choose a plan of action – take a poll of the class but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts.

Chapter 3 Ethics and corporate governance Review questions 1 The challenge is how to achieve ethical behaviour in business. How do we develop ethical behaviour – through education and training? How do we change certain attitudes, which can result in employees stealing from their employer and justifying their action on the basis that the company is making huge profits? The challenge facing the accounting profession is the same – perhaps the difference is that members of the accounting profession have to show a certain understanding of the profession’s code of ethics before being admitted as a full member. Furthermore, they are then bound by the code of ethics as they go about their work. Is it possible to develop a code of ethics for business people? How would it be enforced? 2 Discussion should focus on the total costs of unethical behaviour. Take McKinley Tabor as an example. His initial unethical actions brought about increases in his personal wealth and could be argued was in his self-interest. However, in the end the costs of his actions outweighed his gains and his self-interest would have been best served by remaining ethical. 3 The role of the board of directors is to represent the shareholders of the company, make decisions and endeavour to add value for the shareholders. The board is one way in which the management of the company is held accountable for its actions. 4 The issues concerning a board of directors and its role in corporate governance include the size of the board and the number of independent directors. Should the CEO also chair the board? What qualifications should directors have? Should there be restrictions on the number of boards on which directors can sit? Should there be a time limit on the length of service on a board?

Problems for discussion and analysis 1 The corporate governance report for Woolworths is available at www.woolworthslimited.com.au (click on ‘annual report’). The notes below are based on the 2011 annual report and are meant as a guide only. It is important for students to discuss whether making statements about ethical decision making, for example, provides sufficient assurances to shareholders. Strengths: • Very detailed and transparent. Meets and exceeds most of the best practice guidelines. • There are nine on the board of directors (BOD) and all except for the CEO and CFO are claimed to be non-executive and independent, which conforms with best practice recommendations. The board size is also not too large and is within the range of what some researchers have found is desirable. • BOD members are able to seek independent advice at the company’s expense. • The roles of chairman and CEO are held by different people. • Has a corporate governance committee that is responsible for the appointment of members to the BOD. • Has an active audit committee (AC) comprised of non-executive directors with financial skills. The AC has wide ranging responsibilities. The AC requires the lead audit partner to be rotated every five years and has a policy of not appointing the firm’s auditors to the

Chapter 3 Ethics and corporate governance 16

BOD at any time. The AC can also seek independent advice at the company’s expense. The AC also reviews all on-audit services provided by the external auditor. • Has a people policy committee made up of non-executive directors which is responsible for the establishment and review of the remuneration of the company’s senior executives. Improvements: • There are few areas where the company needs to improve, but one area not mentioned is whether the non-executive members of the BOD meet independently at any time. Another area could be in terms of directors’ access to information. 2 Students should use their own words, such as honesty, morally right, fairness, integrity, accountability and so on. 3 The government can regulate against fraud and it is a criminal offence with a gaol term for offenders. The issue relates more to the capacity of law enforcement agencies to apprehend the perpetrators of fraud. As a white collar crime it was once viewed as much less serious than other forms of crime, but attitudes have since changed as evidenced by the public opinion towards individuals associated with companies, such as ABC Learning, Enron and Worldcom, and individuals like Bernie Madoff in the USA. 4 Facts – You (the accountant) are preparing the tax return for Jim’s Towing Service. – Jim is the sole owner of the business. – Jim does not appear to be declaring his cash-based income for tax purposes. Stakeholders – Jim – Australian Taxation Office (ATO) – Other taxpayers Problem – What action should you (the accountant) take with respect to the undeclared income? Values and principles – Professional principles at issue here include the public interest (APES 110–100.1), integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290), and technical and professional standards (APES 110–130). There is also the principle of fairness to all taxpayers. These principles would all seem to suggest that, from the accountant’s perspective, Jim’s behaviour is unacceptable. – However, the principles above are in some conflict with the principle of confidentiality (APES 110–140 – or is there a legal or professional duty to disclose Jim’s actions?) and the accountant’s need to maintain a client and make an income. – Also consider the legal requirements. Tax penalties apply when there is a ‘tax shortfall’, which is the difference between tax payable determined in accordance with the law (‘proper tax’) and the amount that would be payable as determined by the taxpayer (‘statement tax’). Relevant provisions are ITAA36 s222A – 226ZB. Penalty tax may be applied under s.227 and the Commissioner has power to remit the penalty in whole or part. Where the ‘tax shortfall’ is caused by intentional disregard of the law (i.e. tax evasion), a penalty of 75 per cent applies; s.226J, compounding for repeat offences and where the taxpayer hinders the Commissioner. Alternatively, taxpayers may be prosecuted under the Tax Administration Act, ss.8A–8ZN, and face heavy penalties or imprisonment; or under s.29B of the Crimes Act, which also carries a penalty of imprisonment.

Chapter 3 Ethics and corporate governance 17

Four possible courses of action – Action one: ignore the non-disclosure – Action two: try to convince Jim to disclose the cash income in his return – Action three: inform the ATO that Jim has not declared all his income – Action four: resign from the position of accountant to Jim’s business Evaluation Action one: – Not in keeping with most of the professional principles (including APS 6) or with fairness to other tax payers. – May encourage Jim to make even more unacceptable demands upon you in the future. – Jim may be audited by the ATO and the non-disclosure of the cash revenues would be discovered. There may be fines or other penalties imposed upon Jim and you (and the profession) would be brought into disrepute. Action two: – You may be able to convince Jim to disclose his cash revenues (by, for instance, pointing out the costs of his behaviour should it be discovered) and the problem then goes away. – Consistent with paragraph 7.4 and 7.5 of APES 220: 7.4 Where a Member finds that a Client or Employer has filed returns or submissions in previous years (with which the Member may or may not have been associated) that contain materially false or misleading information or omit material information, the Member should discuss the matter with the Client or Employer and advise them of their responsibilities. 7.5 In the event of a Member subsequently becoming aware that information previously provided to a Revenue Authority by the Member, which the Member had no reason to believe at the time to be incorrect, is false or misleading, the Member should recommend that the Client or Employer make an appropriate disclosure or, alternatively, the Member should obtain authority from them to make the disclosure on their behalf. [Source: Accounting Professional and Ethical Standards Board, APES 220 Taxation Services, March 2011, p. 8, http://www.apesb.org.au/attachments/Revised%20APES%20220%20Taxation%20Services%20%28March%202011 %29%20-%20Final.pdf]

– Jim may refuse to make the disclosures and the problem remains – Jim may sack you (the accountant) – loss of income and problem remains Action three: – potentially breaking principle of confidentiality to client – not giving Jim the opportunity to change his behaviour – likely to lose Jim as a client Action four: – you lose client but the problem has not been resolved – see paragraph 7.6 of APES 220: 7.6 A Member in Public Practice who (a) knows that a Client or the Member on behalf of the Client has filed a return or submission materially understating a tax liability to a Revenue Authority, and (b) finds the Client unwilling to correct such understatement, Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 3 Ethics and corporate governance 18

shall consider the Firm’s policies and procedures established in accordance with paragraphs 28-35 Acceptance and Continuance of Client Relationships and Specific Engagements of APES 320 Quality Control for Firms in determining whether to continue acting for the Client in a professional capacity. [Source: Accounting Professional and Ethical Standards Board, APES 220 Taxation Services, March 2011, p. 8, http://www.apesb.org.au/attachments/Revised%20APES%20220%20Taxation%20Services%20%28March%202011 %29%20-%20Final.pdf]

Choose a plan of action – Take a poll of the class but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts. 5 a Michael should advise his client that the ATO should be notified. Note: some students would expect nothing to be done, as a monetary error by a government department in their favour seems acceptable conduct. The discussion could centre on why it would be ethically correct to obtain a monetary advantage from a government department and not from a friend. b The captain knows the error has been made. He knows he is not legally entitled to the money. It can be assumed that this is akin to stealing as he is taking money that rightfully does not belong to him. c Michael’s responsibility is to act professionally. His first course of action is to inform his client that the error should be reported. If the captain is unwilling to do this then Michael should state quite clearly that he cannot act on his client’s behalf. Further, Michael should let the captain be aware that he believes it is his duty to report the matter. 6 a Were the transactions unethical? – Legal considerations: Jan Skully’s actions have most likely breached several sections of corporations law. For instance, s232 which requires directors not to abuse their special position for self-gain; also Part VII 11 of the Act, on conduct in relation to securities, particularly ss995–998 which outlaw misleading or deceptive conduct of the type given in the case facts. There are also common law considerations, such as Skully breaching her fiduciary duties as a director. – Ethical considerations: Skully’s actions are inconsistent with a number of ethical principles, such as honesty, a duty of care to protect the uninformed and not to abuse her position of trust. As a member of a professional accounting body, Skully would not have complied with the principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290) and ethical behaviour (APES 110–150) – that is, bringing the profession into disrepute. Her actions will have benefited her (and her family?) in the short-term but the transfer of funds from other companies and the ramping of the share price of Extraordinary Products Ltd has eventually led to losses to the other shareholders (assuming they exist) of Skully’s related companies and the shareholders in Extraordinary. Her actions would also result in a general decline in public confidence in the share market. b How could the scheme have been prevented? – As the founder and chairperson of Extraordinary Products Ltd, Skully may well have had a very dominant position on the Board and may have seen the company as ‘her’ company. This would have made it difficult to control her actions. – Some possible preventative measures might include: Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 3 Ethics and corporate governance 19

• A strong board of directors made up of a substantial proportion of non-executive directors • Policies in which all director share transactions must be declared to, and approved by, the board of directors • Policies prohibiting insider trading • Internal auditing which reviews changes in the share register and the internal auditor reports to the whole Board (or audit committee) • A policy of disclosure in the financial report of all related party transactions along the lines of AASB 124 Many of these suggestions have been incorporated in the Corporate Governance Best Practice Guidelines issued by the ASX. Details are provided in Chapter 12. 7 Any increase in regulation comes at a cost and we should therefore consider whether the cost of regulating corporate governance structures would provide greater benefits. To some extent the legislative reaction, such as Sarbanes-Oxley in the US, was to be seen to be doing something in the light of the spectacular company collapses, because the research on corporate governance does not provide any conclusive evidence about ideal size of boards, number of independent directors and so on. By using the best practice approach, the market can then penalise companies if it feels the corporate governance practices of the company are inadequate. 8 The arguments in favour of a majority of independent directors relate to the ability of external directors to more effectively monitor the performance of the company and its management than internal directors, who will be less objective in the assessment of the company’s performance. External directors will be less susceptible to manipulation from the CEO than internal directors. There is also the argument that firms with better corporate governance will be more attractive to investors and thus enjoy a share price premium. Those who argue against this view believe that external directors do not add to the economic discipline already imposed on managers by product and factor markets, the managerial labour market and the market for corporate control. Some argue that given the large number of directorships held by many directors they do little more than provide outside contacts and advice for senior management. Internal directors have intimate knowledge about the company and are able to make more informed decisions for the benefit of the company. Research results on this issue are mixed but the majority of papers tend to report no association between independent directors and firm performance. Presumably the need for independent directors to hold separate meetings is to enable them to debate issues openly which may be difficult with internal directors present, particularly the CEO. This is particularly true if they wish to discuss the performance of the CEO. 9 It is important for audit committees to have the ability to seek independent advice on issues to enable them to properly discharge their duties. Such advice may be on legal or accounting matters if the members of the audit committee do not have the required expertise. If the committee has to seek funding permission from the CEO, then this is a limiting factor. Members of the management team should only attend meetings when invited. This may be appropriate from time to time so the committee can ask relevant questions about the company, such as about issues to do with internal control procedures. They would attend meetings to provide information but would certainly not hold any voting rights.

Chapter 3 Ethics and corporate governance 20

Ethics case study a

There are clearly important social issues involved in this case and students will have strong views. Many have argued that it was unacceptable behaviour by the company in moving its registered office to Holland and then cancelling the $1.9b scheme. Should the company be liable for the illnesses suffered by previous employees? The definition of a liability includes constructive and moral obligations. Does James Hardie have a moral obligation to assist previous employees? The case raises interesting issues about the recognition and disclosure of liabilities of this type. It may be useful to have students think about current company activities that may at some future date create obligations on a company as community norms change, research reveals dangers of products and so on. A triple bottom line (TBL) report should at the very least disclose details about the situation and indicate possible costs to the company. How far should such disclosures go in admitting responsibility of the company is also worthy of discussion. Some companies are reluctant to report activities or events which may be construed as an admission of guilt and used against the company in court. However, if TBL reports only report positive information, then their value is likely to be undermined. b The controversy surrounding James Hardie and asbestos-related diseases continues in 2012. The courts issued penalties for 10 former executives and directors. In May 2012, the High Court ruled that seven former directors misled investors about a compensation fund for asbestos victims. The company has now moved its head office from the Netherlands to Ireland at a time when news was surfacing that the next wave of asbestos-related diseases are hitting home handymen (it has been discovered that asbestos found its way into underfelt laid beneath carpet back in the 1970s). Here is a link to the James Hardie website devoted to asbestos compensation: http://www.ir.jameshardie.com.au/jh/asbestos_compensation.jsp

Chapter 4 Wealth and the measurement of profit Review questions 1 Answers should encapsulate the idea of the static nature of a stock measure, and the way in which that differs from the dynamic nature of measures covering periods of time. 2 The alternatives and the drawbacks identified were: – original cost: identification of original cost as cost to whom – historic cost: reductions in value, increases in prices – replacement cost: specialist items, changes in technology leading to non-replacement – economic value: problems of forecasting the future, the choice of appropriate discount rates – net realisable value: do we want to sell, whether it is a forced sale or at open market value – fair value: what is the fair value when the market for an asset is illiquid? 3 Answers should show an understanding that assets are used up over time and that this fact is not reflected merely by stating an asset at cost. The example used in the chapter is the car. We have found that students can understand the idea of written-down cost if they are directed towards examples with which they are familiar. 4 Historic cost: normally technology will lower prices as better alternatives become available. In this situation unadjusted historic cost will overstate the asset worth. Replacement cost: changes in technology will lead to two effects. The asset is likely to be replaced with a technologically superior asset and so the replacement cost of the asset held will be difficult to establish even if it is still appropriate. Economic value: as this is based on future cash flows from the asset, the economic value is likely to be reduced. Net realisable value and fair value: once again these are likely to reduce with a change in technology.

Problems for discussion and analysis 1 a

Note 1K states that for short life retail stocks the average cost method is used. For long life retails stocks the retail inventory method is used. This method involves using the mark up from cost to estimate the cost of inventory on the shelves at the end of the period. b The cost method used for other plant and equipment is as per note 1G. c An asset is impaired when its recoverable amount is below its carrying value. Recoverable amount is described as the higher of the fair value less costs to sell and value in use. 2 This exercise is designed to have students consider their own position and how they approach the measurement of their wealth. Tutors should see if students have considered all relevant items, e.g. insurance or superannuation policies, amounts owing for telephone, electricity and so on. What measurement base did they use? Why? 3 The figure should be based on the benefits the player will earn for the club. This will include consideration of the player’s ability to help the club win more games, which in turn will increase attendances at games, membership of the club, sponsorship for the club and so on. Now that there is a market for players, clubs are obviously influenced by what other clubs are prepared to pay, which represents a form of market value for a player. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 4: Wealth and the measurement of profit

4 a b c 5 a

$12 000 $13 000 $1000 with no repairs, $3000 if repairs are made. The calculation of the opening wealth here is straightforward as the historic cost, replacement cost, and net realisable value can be judged to be effectively the same. However, the question is designed to raise problems in terms of the wealth at the end of the period as here the historic cost of the beds is $200 per bed, the replacement cost is $240 and the net realisable value is $260, assuming that there is a market at the price of $280 less $20 costs. The answers using historic cost, replacement cost and net realisable value are as follows:

Beds Cash

Bed Cash

Historic cost Start $ 80 000 0 80 000

End $ 20 000 84 000 104 000

Beds Cash

Replacement cost Start End $ $ 80 000 24 000 0 84 000 80 000 108 000

Net realisable value Start End $ $ 80 000 26 000 0 84 000 80 000 110 000

Profit calculations: These are done using the formula Wealth 1 – Wealth 0 as illustrated in the chapter, as this is the only way of calculating profit the students have been exposed to up to this point. Historic cost $104 000 – $80 000 = $24 000 Replacement cost $108 000 – $80 000 = $28 000 Net realisable value $110 000 – $80 000 = $30 000 b The point that needs to be illustrated is that, depending on the valuation basis used, the profit changes. Students should be encouraged to identify what the profit per bed is likely to be next year, i.e., based on the conditions at the end of the year, it is likely to be only $20 per bed. This is arrived at by taking the selling price prevailing at the end of the year of $280, less the costs per bed of advertising, delivery and so on of $20, making a net selling price of $260, and then taking off the cost of beds at the end of the period, i.e. $240. Therefore, if they sold the same number of beds next year they would only make $6000 (assuming they bought all those beds at the current price). You may wish to illustrate the effect on that profit of having 100 beds in stock which were bought at $200. The point being made is that, in this situation, none of the profit figures is a guide to the future. As far as their usefulness as a measure of performance goes, the conclusion that should be reached is that none is superior, as we can only measure performance by comparison.

Chapter 4: Wealth and the measurement of profit

6 This question is designed to allow students to think through the alternatives and for the tutor to tease out some of the underlying assumptions and test the students’ understanding. It also serves to reinforce the idea that if accounting is to reflect economic reality it is unlikely to be able to do so using only one cost/value measure. Freehold shop – this could be economic value or historic cost. Students’ attention should be drawn to the problems inherent in calculating the economic value of a business that has not started and to the problems with historic cost in changing economic conditions. This may lead to the conclusion that net realisable value based on open market value may be more appropriate. Hanging display rail for clothes – this is likely to have limited, if any usefulness to the new business, therefore it is likely to be sold. Under this assumption net realisable value is likely to be appropriate. A two-year-old car which is essential for the business – the fact that it is essential for the business would seem to rule out NRV while the fact that it is two years old would suggest that original cost is inappropriate. This leaves as possible choices economic value which may be difficult to ascertain, replacement cost of a similar vehicle, written-down cost and historic cost. In the case of the latter it is important that students are made aware which historic cost is appropriate, i.e. cost to the restaurant business, not cost to the clothes shop. New restaurant tables and chairs – in this case replacement cost is likely to equal historic cost so either of these would be acceptable, as would economic value. In the case of net realisable value the tutor can use this as an opportunity to explain that there are costs associated with sale which will mean that this value is lower than the price paid for the tables and chairs. This is of course exacerbated by the fact that they are now second-hand. Cash register – like the car and the freehold property this can be used in the new business, so net realisable value is unlikely to be appropriate. The example is chosen because, unlike the freehold shop and the car, the market for used cash registers is not as visible, therefore establishing replacement cost of a used cash register would not be as easy. This example can also be used to illustrate the problems associated with establishing historic cost and written-down cost – what is the economic life of a cash register? Quantity of fashion garments that were not sold in the closing down sale – the basis that looks obvious is net realisable value. However, students’ attention should be drawn to the fact that these were not sold in the closing down sale, so open market value may not be appropriate even if it could be established. 7 Elite football player – economic value, which would be the discounted value of expected future payments to the player. Need the discount rate and contractual payments which may vary dependent on success or injury. Use the same method initially and after one year. 2011 Holden Commodore – use replacement cost initially and after one year (recognising that the car would be a year older and the replacement cost has probably declined). Sydney Opera House – possibly replacement cost would be the appropriate value. This would require information about expected costs to rebuild the Opera House. Economic value is possible but probably not as appropriate. Use method initially and one year later. Prime Minister – does the country insure its Prime Minister? If he or she is killed or dies while in office then the country may be obliged to make certain payments to his or her estate. Economic value would be the most appropriate and requires information about discount rates and estimates of cash payments involved. Net realisable value and replacement costs are not appropriate. Block of land – you wouldn’t need to insure land as it can’t be destroyed or stolen. Would use net realisable value initially and after one year.

Chapter 4: Wealth and the measurement of profit

The trademark ‘Coca-Cola’ – would use economic value assuming the future cash flows and discount rate can be reliably measured. Would use the same method initially and after one year. Have students discuss the case of the football player and the Prime Minister. What are the similarities and differences? 8 a A banker would be interested in the resale value of the machinery should the borrower be unable to service the loan. Hence net realisable value of $10 000 is most relevant for the bankers. b Tutors should bring out the relevance of the going concern concept versus the liquidation value. Shareholders are interested in the future and the value of a firm as a going concern, so economic value (value in use) or replacement cost may be appropriate. Historic cost may be relevant in assessing accountability of directors. c Management should be interested in economic value (value in use) or replacement costs in looking at the performance of a going concern. 9 a It seems inappropriate to carry the software at cost when it is obviously of little value as it is out of date. A more reasonable value would be to reduce the value to net realisable value. b To value the software at net realisable value will mean a loss in value is recorded. This provides information to the users of the accounts that is relevant and useful. The issue of reliability of the measure of NRV would also need to be considered. The issue of valuing stock at the lower of cost and NRV is covered in Chapter 8. c If historic cost is used then the income statement will not record any loss due to decline in value of the software. Some would then argue that profit is overstated and so are assets in the balance sheet. 10 a The changes in net worth are: Historic cost $1800 Replacement cost $4000 Net realisable value $4000 The purpose of this case is to make students examine the differences between economic reality and accounting practice. The discussion should focus on the use of historic cost for small trading companies and net realisable value for superannuation plans together with the view that replacement cost might well be more appropriate to members or owners. It should be noted that accounting practice actually uses modified historic cost (i.e. depreciation is accounted for). The arguments with reference to historic cost are: • It provides a background story to management’s stewardship/accountability. • Historic cost is objective. • Rapid technological changes have defeated the worst effects of inflation and in practice there is little difference between historic cost and replacement cost. • Historic cost is easily ascertained. • The use of historic cost is based on the traditional realisation principle i.e. if an asset is to be used, any difference between its market price and its historic cost is irrelevant. Historic cost is based on actual, not possible, transactions. • Use of other valuation methods will distort the income statement of a business entity. • Historic cost is based on the matching principle. • Historic cost provides details of past transactions which enables future decisions to be made with greater certainty. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 4: Wealth and the measurement of profit

•

The best understood concept of profit is the excess of selling price over historical cost. • Changes in market prices can be disclosed as supplementary data. • There is insufficient evidence to justify rejection of historical cost accounting. The arguments surrounding replacement cost are: • Objectivity is relative; where market prices are easy to obtain, replacement costs are more objective as historic cost has a greater range of valuation choices, such as weighted average, FIFO, the use of net realisable value or historic cost in the valuation of inventories, and so on. • Replacement cost accounts for inflation. • The determination of periodic income should be based on what actually happens in the current year rather then what might occur. Replacement cost accurately reflects market dynamics. • Replacement cost (like net realisable value) is a reflection of what it would cost to enter the market-place and not what it used to cost. • Replacement cost enables the separation of holding and operating gains and recognises revenue as it is earned. • Current replacement cost is useful in evaluating the strength of the entity as a continuing concern. • Current replacement cost is more relevant (but not necessarily more reliable). The arguments surrounding the use of net realisable value are: • Historic cost does not accurately reflect the value of an entity to its members and other interested parties. • NRV gives a proper account of stewardship as comparisons of the capital maintenance of the entity can be made. • Measuring the net realisable value is a useful measure of solvency and economic performance. • Net realisable value can be better incorporated in the return on investment. • Net realisable value represents a common-sense approach and accords with the general practice of individuals who tend to measure the current cash equivalent when calculating their own wealth. b Net realisable value, though distinction should be made between sales in an orderly market and ‘fire sales’. Tutors should try and bring out the different interests of these users and indicate that often the same value will satisfy these interests. For example, economic value would be of interest to both shareholders and management in assessing the performance of the company. 11 a The use of net market value for self-generating and regenerating assets (SGARAs) allows users to be informed of the increase in value as a result of growth and reproduction. Have students discuss whether it is appropriate to use net market value for agriculture but not for a retailer such as Woolworths. Under IFRS AASB 141, agriculture requires these assets to be measured at fair value. b SGARAs are different from non-living assets because they change biological form over their lives through growth and other means, resulting in changes in future economic benefits. The future economic benefits embodied in SGARAs may also change in the absence of changes in biological form, because their prices change. Measuring a SGARA at its current value ensures that the effect of both biological changes and price changes are recognised in financial reports. Measuring SGARAs at net market value permits Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 4: Wealth and the measurement of profit

comparisons of SGARAs having substantially the same characteristics, regardless of their purpose, and when, by whom and how they were acquired. It also provides a relevant basis for assessing stewardship of the entity’s management or governing body by indicating the effects of the decisions to buy, sell or hold SGARAs. The cost method does not allow the entity to report growth in assets until they are harvested and sold which, in the case of some products, may be many years.

Ethics case study a What is the appropriate way to record this transaction? The boss, Ted Johnson, seems to be proposing the following treatment: Dr Plant and Equipment $1 000 000 Cr Cash $500 000 Cr Gain on Acquisition $500 000 However, such a treatment is not in accordance with AASB 116. Property, plant and equipment cost is defined in para. 6 of AASB 116 as ‘the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other IFRSs.’ Consequently, it is the fair value of the assets given rather than the fair value of the assets acquired that is important here. The fair value of the cash given up is $500 000, not $1 000 000. The journal entry (in accordance with AASB 116) should be: Dr Plant and Equipment $500 000 Cr Cash $500 000 No gain can be recognised. b What should Jane do? Facts – Jane is the accountant at Salisbury Ltd – Plant and equipment was purchased for $500 000 cash but Jane’s boss, Ted Johnson, wants her to record the asset at $1 000 000 with a resulting $500 000 gain recognised in the profit and loss statement. – Salisbury Ltd is likely to report a loss (particularly if the profit on acquisition is not recognised) – If a loss is reported, Salisbury Ltd will breach its contract with a bank resulting in the possible loss of the overdraft facility. – Salisbury Ltd intends to use the asset and has no intention to sell it. Stakeholders – Ted Johnson – Salisbury Ltd’s bank – Salisbury Ltd’s shareholders Problem – How should Jane record the acquisition of the plant and equipment? Values and principles – Professional principles at issue here include integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290), technical and professional standards (APES 110– 100), competence and due care (APES 110–130). These principles would all point to Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 4: Wealth and the measurement of profit

compliance with accounting standards and recording the acquisition as per AASB 116 (see the answer to (a) above). – However, the principles above are in some conflict with Jane’s duty to follow the instructions of her boss and a duty not to put at risk her own job or those of the other employees by making the company breach its bank contract. Two possible courses of action – Action one: comply with Ted Johnson’s instruction. – Action two: record the acquisition as per AASB 116. Evaluation Action one: – Breaches the professional ethical principles listed above and does not comply with APS 1. It also means not being honest with the bank and Salisbury Ltd’s shareholders. – May save Salisbury Ltd from breaching its contract. – Ted Johnson’s accounting treatment may be qualified by the auditors and result in a breach of the bank contract anyway; this could lead to possible costs to Ted and Jane (as well as the company), such as disciplinary action or even being sacked. – Salisbury Ltd may still suffer financial problems, therefore putting the bank and shareholders’ money at even greater risk (the new property and plant cannot be seen as protection because there is no independent evidence that its value really is $1 000 000). – Could protect Jane and other employees’ jobs (at least in the short term). Action two: – Complies with professional ethical principles and APES 110. – Bank and shareholders gain a ‘true and fair view’. – Puts Salisbury Ltd and its employees at risk. – May be able to continue overdraft facility after costly renegotiation. – Ted Johnson will not have been obeyed – he may seek to take disciplinary action against Jane. Choose a plan of action – Take a poll of the class but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts.

Chapter 5 Presentation of financial position and the worksheet Review questions 1 It is a list of assets, less liabilities, with the owners’ equity being the residual figure. It is a snapshot at one point in time and is therefore only relevant to that point in time. 2 • Future economic benefits • Control by the entity • Past transaction or past event 3 Answers should show that students understand that liabilities are present obligations which result in the entity having to sacrifice future economic benefits, while equity is the owners’ interest in the residual of the assets of the entity after the deduction of its liabilities. 4 Current – prepaid insurance, prepaid rent, land held for sale. Non-current – mining equipment, specialised machinery, aircraft. 5 The answer should show an understanding that both sides of the balance sheet equation must always be equal. 6 The difference between the balances of the two sides of the worksheet is exactly divisible by nine. 7 a Decrease the bank column by $200 and decrease the owners’ equity column by $200. b Reduce the bank column by $27 500 and open up a new asset column for the new asset, vehicle, and put $27 500 in that column. c No entry. d Decrease the bank column by $1760 and record a decrease in the profit and loss column of $1760. e Decrease the bank column by $1000 and record a decrease in the profit and loss column of $1000. f Increase the liability account electricity payable by $100 and charge $100 as an expense in the profit and loss column. g No entry until the goods are delivered to the customer, as orders can be cancelled. 8 Is there a future benefit to be obtained or has the benefit expired? If there is a future benefit then we have an asset; if the benefit has been used or consumed then we have an expense. 9 In situations where the answer to the question posed above is not clear cut, students should re-examine the definition and recognition criteria for an asset. If it is not probable that future economic benefits controlled by the entity do exist and can be reliably measured, then we should record an expense.

Problems for discussion and analysis 1 a

Total assets $21 094.5 million; total current assets $6593 million; total non-current assets $14 501.5 million. b Property, plant and equipment is $8620.3 million and represent about 40 per cent of total assets.

Chapter 5: Presentation of the financial position and the worksheet

Total liabilities are $13 248.7 million, total current liabilities $8288.3 million, total noncurrent liabilities $4960.4 million. d Borrowings are $3373.8 million and represent about 25 per cent of total liabilities. 2 Current assets = TA – NCA = 200 000 – 50 000 = 150 000 Current liabilities = TL – NCL = 250 000 – 25 000 = 225 000 Owners’ equity = 200 000 – 250 000 = –50 000 It is unlikely an entity can continue to pass the going concern test with negative owners’ equity but it can happen. (Orbital Engine Company in 2002 had negative equity.) 3 Assets Liabilities Owners equity

20X6 $100 000 $50 000 $50 000

20X7 $160 000 $100 000 $60 000

a Total assets 20X7 $160 000 b Total liabilities 20X6 $50 000 4 20X8: TA = $186 000, NCL = $103 000, TL = $126 000 20X9: CA = $110 000, TA = $196 000, CL = NIL, OE = $96 000 5 Students should raise the following: a The depositing of $2000 into the business’ bank account has created an asset of the business. The right to use the owner’s car has created a future benefit for the business. The value of the car to the business is the car’s replacement cost of $9000, not its original cost. b This question raises the problem of when the earning process is complete; when do we have a sale? Students should discuss the recognition principle as it applies to revenue. c The point being demonstrated in this example is that in the first case, an expense (the rebate) of $200 is being incurred while in the second, the return of the goods amounts to a reversal of a previous sale, the consequences of which are the exchange of one asset for another and the loss of the profit. In the matter of spending $280 to rectify the faulty goods, students should consider whether an additional future benefit is created. Discuss the concept of net realisable value. 6 a Decrease asset cash $769, increase asset desk and chair $769. b Decrease asset cash $549, increase asset prepaid expenses $549. c No entry. d Decrease asset cash $4999, increase asset computer $4999. Decrease asset computer $4999, increase cash $4999. e Decrease asset cash $100, decrease capital drawings $100. f No entry. g Increase asset cash $48 000, increase revenue sales $48 000.

Chapter 5: Presentation of the financial position and the worksheet

7 Balance sheet Assets Current assets Cash Accounts receivable Inventory Non-current assets Office equipment Motor vehicles Loan to director Liabilities Current liabilities Accounts payable Bank overdraft

Total current assets

Total non-current assets Total assets

Total current liabilities Total liabilities

1 700 1 250 30 125 3 600 17 200 21 000

42 250 32 500

33 075

41 800

74 750

NET ASSETS Owners’ equity

74 875

74 750 125

Total owners’ equity

125

125 125

The business has assets only slightly greater than liabilities and generally this would means it will struggle to pass the going concern test. It is unlikely creditors would allow the entity to continue to operate. 8 Note: the question has been set up so that there is a situation where the current liabilities exceed the current assets in order to allow an explanation of how dangerous this can be in terms of risk. The business in the example is likely to be a retailer, as there is no manufacturing capacity in the non-current assets, and thus an opportunity is provided for the tutor to explore with the students the expected differences in the structure of assets and liabilities between different industries. The balance sheet is on the next page.

Chapter 5: Presentation of the financial position and the worksheet

Balance sheet Assets Current assets Cash Stock of goods held for resale Non-current assets Office furniture Delivery van Fixtures and fittings Freehold land and buildings Liabilities Current liabilities Bank overdraft

Total current assets

Total non-current assets Total assets

Total current liabilities

Non-current liabilities Mortgage on land and buildings Total non-current liabilities Total liabilities

1 000 13 000 4 600 3 200 15 200 64 000

20 700 58 000

14 000

87 000

101 000

20 700 58 000

Net assets Owners’ equity

78 700 22 300

Total owners’ equity

22 300

Chapter 5: Presentation of the financial position and the worksheet

9 Balance sheet $

Assets Current assets Cash Accounts receivable Inventory Non-current assets Fixtures and fittings Plant and equipment Freehold land and buildings Liabilities Current liabilities Accounts payable Salaries payable Non-current liabilities Bank loan

Total current assets

Total non-current assets Total assets

Total current liabilities Total non-current liabilities Total liabilities

3 000 16 000 8 000 2 500 7 000 20 000

12 000 600 30 000

27 000

29 500

56 500

12 600 30 000

Net assets Owners’ equity

42 600 13 900

Total owners’ equity

13 900

Chapter 5: Presentation of the financial position and the worksheet

10 Debbie Ltd Balance sheet as at 30 June 20X1 Current assets Accounts receivable Inventory Non-current assets Plant and equipment (net) Land and buildings (net) Current liabilities Bank overdraft Accounts payable Salaries payable

Total current assets

Total non-current assets Total assets

Total current liabilities

Non-current liabilities Long term loan (19/12/20X9) Total non-current liabilities Total liabilities Net assets

17 300 13 100 22 000 110 000

11 900 45 600 1000 100 000

30 400

132 000

162 400

58 500 100 000

Total owners’ equity

158 500 3900 3900

Those accounts not listed in the balance sheet include: salaries expense, sales, interest expense and cost of goods sold. These are in the statement of comprehensive income.

Chapter 5: Presentation of the financial position and the worksheet

11 ABC Ltd Balance sheet as at 30 June 20X1 Current assets Cash Accounts receivable Inventories Non-current assets Land Plant and equipment Current liabilities Accounts payable 90 day bank bill payable Tax payable Non-current liabilities Long term loan payable

Net assets

Total current assets

Total non-current assets Total assets

Total current liabilities Total non-current liabilities Total liabilities

126 000 50 000 88 000 364 000 234 000

26 000 80 000 10 000 45 000

264 000

598 000

862 000

116 000 45 000

Total owners’ equity

161 000 701 000 701 000

Those accounts not listed in the balance sheet include: sales discount, vehicle expenses, cost of goods sold, tax expense. These should be in the statement of comprehensive income. 12 This question has been designed to illustrate the business entity principle, the fact that a balance sheet represents a snapshot at one point in time, and some of the difficulties encountered in deciding what should be included in a balance sheet. Students should, therefore, be encouraged to debate the issues before moving on to the next question. We will now examine each item in turn and point out some of the main arguments. At the end of the discussion of each item we will indicate the decisions on which the answer to question 11 is based. a As some future benefit is likely and the business is a retailer, this is likely to be a business asset and should be included in the balance sheet. (Include.) The business owns the shop and it has an obligation in respect of the mortgage, in this case as a non-current liability. Note: it is assumed that a mortgage would only be taken out for a period greater than 12 months. (Include.) b Once again there is likely to be a future benefit to the business, therefore we have a business asset. The next question is which figure to include. The realisation principle should be brought out in the discussion of this asset. (Include at $16 000.) c At the date of the balance sheet the business did not control the asset nor had it any right to its use as all that had happened at that date was an order had been placed which could easily be cancelled. The legal situation regarding contract law can be explored in this example providing a link with other subjects being studied. (Do not include.) d The issues brought out here are whether cost or value is to be included and whether the fact that the asset was acquired prior to opening the shop is relevant. (Include at $3000.)

Chapter 5: Presentation of the financial position and the worksheet

The principle being illustrated is the business entity. In the case of the Falcon used by the spouse this is not a business asset. The Escort is different as it is being used in the business exclusively and giving the business some benefit. Tutors may wish to explore how it would be treated if it was used for the business as well as for family use to illustrate that these decisions are not always so clear cut. (Include Escort at $8000. Do not include the Falcon and treat the purchase of the Falcon as a drawing by the owner.) f In this case the future benefit to be obtained is difficult to judge and may not exceed the rental. The item is not therefore classified as an asset of the business, rather it is an asset of the business renting it to Transom. (Do not include.) g In this case Transom owns (controls) the cash register and is likely to get a benefit in the future from its use. (Include.) h Transom owes money to the bank, and the bank can demand immediate repayment. (Include as a liability.) i In this case Transom has incurred a cost but there is no future benefit because Transom cannot sell defective seat belts. Tutors might like to explore the question of whether anything could be included in the balance sheet if Transom was able to return these to its supplier or pursue court action against the supplier. (Do not include.) Note: in the following answer these are assumed not to be included in the stock of goods for resale on the shelves.

13 Transom Trading

Bank Inventory O/Bal 192 000 8 000 a. –116 000 b. –16 000 16 000 c d. –3000 e. –7000

Assets Fixtures and Motor fittings vehicles

Liabilities Cash register

Building

Overdraft Mortgage

176 000

60 000

-400 –1200 13 000 –12 000

49 400

Capital 200 000

Income statement

n/a 3000 –7000 8000

8000 f. g. h. i.

Equity

–400 1200 13 000 12 000 –12 000 24 000

–12 000 3000

8000

1200

176 000 261 600

13 000

60 000

201 000

–12 400 261 600

Chapter 4: Presentation of the financial position and the worksheet 37

Transom Trading Balance sheet as at 31 December 20X1 $ Assets Current assets Cash Inventory

49 400 24 000 Total current assets

Non-current assets Freehold shop Shop fittings Ford Escort Cash register

73 400

176 000 3000 8000 1200 Total non-current assets TOTAL ASSETS

Liabilities Current liabilities Bank overdraft

188 200

261 600

13 000

Total current liabilities Non-current liabilities Mortgage loan Total non-current liabilities Total liabilities Net assets Owners’ equity Capital Retained earnings

60 000

13 000 60 000

73 000 188 600

201 000 –12 400 Total owners’ equity

188 600

14 a

There is likely to be a future benefit, therefore we have an asset. It is not a non-current asset as there is no intention to use it in the business. It is likely to be converted into cash and is part of the operating cycle therefore a current asset. (Include at cost to the business $7000.) b There is likely to be a future benefit therefore we have an asset. It is a non-current asset as there is an intention to use them in the business, i.e. their benefit is expected to be greater than 12 months. (Include at cost $1400.) Tutors may wish to explore the fact that in many cases these are not included in business accounts on the basis of materiality and cost/benefit of keeping track of them. c There is likely to be a future benefit, therefore we have an asset. It is a non-current asset as there is an intention to use it in the business. (Include at cost of $240 each, i.e. $480.) (May be excluded on materiality grounds.)

Company Accounting (7th edition) – Solutions Manual

Chapter 5: Presentation of the financial position and the worksheet

d Assuming these are the business premises there is likely to be a future benefit, therefore we have an asset. It is a non-current asset as there is an intention to use it in the business. (Include at cost $80 000.) e Here the situation is less clear; there is likely to be a future benefit, therefore we have an asset. It is a non-current asset as there is an intention to use it in the business. However, tutors should discuss the appropriate measurement of the future economic benefits. (Whether to include is a matter of judgement, materiality and the reliability of the measurement of future economic benefits.) f There is likely to be a future benefit, therefore we have an asset. Although there is an intention to use these parts in the business, they are essentially part of the operating cycle of the business and should be treated as current assets. (Include at cost $1580.) g As with item (f) above, the question of the cost is important to discuss in terms of what future benefit is likely to accrue to the business. (Include at $400.) h There is likely to be a future benefit, therefore we have an asset. It is a non-current asset as there is an intention to use it in the business. The discussion should explore whether the cost of having the crane fitted should be included and the point should be made that the business will derive a future benefit from having a crane on its breakdown truck. (Include at cost of $7200.) i The business has no legal right to the car at this point in time. It does, however, have a right to payment of the bill of $600. (The maximum amount that can be included therefore is $600.) What needs to be explored with students is the effect of uncertainty on whether an asset should be included or not, i.e. will the debt be collected? j This is a difficult situation as the ownership of the car rests with Fred, but the business is obtaining a benefit because the car is used mainly for the business. The question of whether it is in fact an asset of the business or of Fred’s can be explored in more detail. Note that in the last example there was a similar situation, except that in that case the car was being used exclusively for the business and in our answer we classified it as a business asset. Clearly if we tried to apply a legal definition of ownership, the asset belongs to Fred. Tutors should explore the concept of control of the asset in terms of the IASB Framework. k The question that arises is whether there is a future benefit, and if so what that benefit is. How can this benefit be measured without a sale taking place? How does this fit in with our asset definition? In other words, is Fred’s estimate right and what are the effects of uncertainty? l In this case the business owes the bank money, which needs to be repaid in the short term. Therefore we have a current liability. m In this case the business has a liability, as it owes money to the mortgage provider. As mortgages tend to be for a long term and in view of the fact that 75 per cent of the amount originally borrowed is still outstanding it is reasonable to classify this as a noncurrent liability. 15 a Balance in Dr Fang’s equity account: October $119 800 November $123 200 December $121 850 b Drawings are not an expense of the business but a withdrawal of capital by the owner. There is not enough information on trading operations to calculate drawings accurately. Net assets or owner’s equity has increased by $3400 from October to November, and decreased by $1350 from November to December, which indicates profits/losses and possible drawings.

Chapter 5: Presentation of the financial position and the worksheet

15 c Dr Fang Balance sheet as at 31 December Current assets Cash Accounts receivable Prepaid insurance Non-current assets Building Land Surgery equipment Current liabilities Accounts payable Wages payable

Total current assets

Total non-current assets Total assets

Total current liabilities Non-current liabilities Mortgage payable Total non-current liabilities Total liabilities Net assets Total owners’ equity

3 000 8 050 600 80 600 33 000 38 300

3 000 4 800 33 900

11 650

151 900

163 550

7 800 33 900

41 700

121 850 121 850

Chapter 5: Presentation of the financial position and the worksheet

16 Mickey Ltd Balance sheet as at 30 June 20X1 Current assets Bank Accounts receivable Inventory Loan receivable (1/7/20X1) Other current assets Total current assets Non-current assets Loan receivable (30/6/20X3) Fixtures and fittings Plant and equipment Land and buildings Total non-current assets Total assets Current liabilities Accounts payable Salaries payable Tax payable Other current liabilities Total current liabilities Non-current liabilities Debentures payable Loan payable (31/12/20X3) Total non-current liabilities Total liabilities Net assets Total owners’ equity

10 000 15 700 27 200 10 000 700 100 000 7 200 3 600 120 000

63 600

230 800

10 300 6 200 12 300 1 200 137 000 100 000

294 400

30 000

237 000

267 000 27 400 27 400

17 ABC Co. Ltd Balance sheet Assets Current assets Debtors Inventory Prepaid rent Non-current assets Motor vehicles Plant & equipment Land Buildings Total assets

$ 10 000 20 000 2 000 20 000 15 000 50 000 100 000

32 000

185 000 217 000

Liabilities and owners’ equity Current liabilities Bank overdraft Creditors

12 000 90 000

102 000

Owner’s equity Capital Retained earnings

80 000 35 000

115 000

Total liabilities and owners’ equity

217 000

Chapter 5: Presentation of the financial position and the worksheet

18 Firesafe Company Balance sheet as at 30 May 20X1 Current assets Bank Accounts receivable Incendiary plastic containers Incendiary chemicals Total current assets Non-current assets Plant and equipment Motor vehicles Land and buildings Total non-current assets Total assets Current liabilities Accounts payable Bank overdraft Loan payable(29/5/20X2) Total current liabilities Non-current liabilities Loan payable (30/06/20X8) Total non-current liabilities Total liabilities

$ 200 17 800 2 500 17 500 37 000 18 500 62 500

23 000 7 300 17 000 50 000

38 000

118 000

156 000

47 300 50 000

Net assets Total owners’ equity

19 a

97 300 58 700 58 700

A banker considering an application for a loan is interested in the ability of the company to pay its debts. He or she wants to make loans which will be repaid on time and in full at the agreed maturity date. He or she therefore looks closely at the amount of cash and other assets (such as accounts receivable) which will soon be converted to cash. He or she compares these assets with the amount of existing liabilities of the company which fall due in the near future. On this criterion, XYZ Company appears far superior to ABC Company; its cash and receivables total $26 000, which is more than three times the $12 000 of unsecured loan and accounts payable combined. ABC Company, on the other hand, has only $7200 of cash and accounts receivable compared with unsecured loans and accounts payable of $52 800. ABC Company may be insolvent or close to it. XYZ Company appears to have greater debt-paying ability in the short term. A banker is also interested in the amount of the owners’ equity, as this ownership capital provides protection between the banker and any losses of the business. Here, XYZ Company also looks much the better of the two, as the owner’s equity of $34 200 is more than twice the $12 000 owed to present creditors. ABC Company shows only $8400 of owner’s equity compared with $52 800 of liabilities, or about one dollar of owners’ equity for each six dollars of creditors’ claims. b As an investor you would probably be willing to pay a higher price to XYZ for the business than you would for the business of ABC. Although the total assets of ABC Company are greater, these assets have been supplied in large part by creditors. The equity you would acquire by buying ABC Company is only $8400 whereas by buying XYZ Company you would acquire an equity of $34 200. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 5: Presentation of the financial position and the worksheet

Since the information indicates that both companies are new and that the cost of the assets shown on the balance sheet approximates current market value, we can assume that the owners’ equity is a good indication of the fair market value of the net assets (assets minus liabilities). An investor would be interested in the earnings prospects of the companies, but as both companies are new it is difficult to estimate the profitability of either. Furthermore, no income statements or other information on profit potential are provided in the case study. c If the existing owners agreed to be responsible for existing liabilities the decision would probably change. ABC Company’s assets are greater than XYZ Company’s. Future earnings potential would, of course, be an important factor unless the new owner planned to liquidate the business and sell the assets. 20 The essential characteristics of an asset according to the Conceptual Framework are: • Future economic benefits – although the site has no further use for coal mining it has the potential to generate future economic benefits as a rubbish disposal site and perhaps it has other uses. The site is of value to other entities and therefore is a saleable commodity for No More Coal Mining Venture. • Control – the question indicates that No More Coal Mining controls and owns the land in question. • Past event or past transaction – it has secured ownership and control through a past transaction. Presumably it purchased the site. Therefore the site meets the frameworks test of an asset and should be recognised on the balance sheet of No More Coal Mining if it is probable the future economic benefits are to eventuate and can be reliably measured. Presumably the company would wish to sell or lease the site if it has no further use for the land. Therefore the probable test is satisfied. At what value should the asset be recorded? Students should discuss the various options: • The current book value or cost • The $8.8 million • The $11.0 million • Other options may include a revalued amount Do these options provide an attribute which is reliable? 21 a ‘Off balance sheet’ means exactly that: items of debt are not recorded on a balance sheet when perhaps they should be. The Enron case was an example of arranging debt through special purpose entities which were not included in the consolidated balance sheet for Enron. (We discuss consolidated statements in Chapter 11.) Certain lease arrangements may also create obligations for an entity which may not be captured on the balance sheet. The annual report for Woolworths reports significant amounts of operating lease commitments that are not reported as an asset and liability on the balance sheet because under current accounting standards it is not required. We discuss leases in Chapter 10. b An advantage of keeping a debt and the associated asset off the balance sheet means the company’s financial risk may be perceived to be lower because of a lower debt to equity ratio. We discuss financial risk and various ratios in Chapter 12. c Collapses of entities like Enron, ABC Learning, Worldcom and HIH are not good for the image of the accounting profession. The very term ‘off balance sheet’ conjures up an impression of some item that is not reported on a balance sheet when in fact it should be. Clearly, users will lose faith in statements like the balance sheet when entities like Enron cast doubt on the usefulness of such statements.

Chapter 5: Presentation of the financial position and the worksheet

22 This is a difficult problem and is probably best given to MBA students. It involves the historic cost concept, going concern concept, business entity concept and the duality concept. It also introduces accrual accounting. a, b Green Trees Playgroup Balance sheet Current assets Cash Accounts receivable Inventory Prepaid expenses Total current assets

at 30 June 20X1 $

at 31 December 20X1 $

5 974 690 412 825 7 901

1 535 – 412 – 1 947

Non-current assets Land Buildings Equipment Total non-current assets Total assets

8 400 33 600 14 625 56 625 64 526

8 400 33 600 14 625 56 625 58 572

Current Liabilities Accounts payable Loan Total current liabilities

712 7 455 8 167

– –

Non-current liabilities Mortgage loan

28 350

36 517 28 009

28 350 30 222

33 750

(5 741) 28 009

(3 528) 30 222

Net assets

Total liabilities

Owners’ equity Capital Retained profits/ (Accumulated losses)

Chapter 5: Presentation of the financial position and the worksheet

Six months to 30 June 20X1 $

Six months to 31 December 20X1 $

–

5 974

Receipts Investment in Business Loan – Shire Council Mortgage loan Fees Collection of receivables Total Receipts

33 750 7 455 28 350 17 724 – 87 279

– – – 26 880 690 27 570

Payments Land, buildings Furniture, equipment Cash expenses Payment of accounts payable Repayment of Shire Council loan Salaries Electricity Food supplies Interest and miscellaneous Total Payments Net Receipts/ (Payments) Closing cash

42 000 14 625 24 680 – – – – – – 81 305 5 974 5 974

– – – 712 7 455 13 768 1 344 5 880 2 850 32 009 (4 439) 1 535

Movements in Cash Opening cash

Six months to 30 June 20X1 $

Six months to 31 December 20X1 $

Increases /

(Decreases)

Cash items: Cash fees Cash operating costs

17 724 (24 680)

26 880 (23 842)

Non-cash items: Fees receivable Inventory adjustment Prepaid expenses Accounts payable

690 412 825 (712)

– – (825) –

(5 741)

2213

–

(5 741)

(3 528)

Movements in retained profits / (accumulated losses)

Profit / (Loss) for the six months: Opening retained profits / (accumulated losses) Closing retained profits / (accumulated losses)

Chapter 5: Presentation of the financial position and the worksheet

Notes: tutors may wish to point out: • Mrs Wright’s personal loan of $26 280 is irrelevant • Period end adjustments need to be made at 30 June 20X1 for: – Fees receivable: $690 – Supplies on hand: $412 – Accounts payable: $712 – Prepaid insurance: $825 • At the end of the second six month period the prepaid insurance of $825 is charged to the income statement c The offer of $58 875 is irrelevant to a going concern. Assets are originally reported at cost, which is reduced by depreciation in later periods. Depreciation should be recorded on the buildings and equipment but not on the land. This would result in a corresponding increase in accumulated losses at 30 June and 31 December 20X1. d The discussion should bring out the following points: • Green Trees projects a profit of $2213 for the six months to 31 December 20X1 • No depreciation has been charged in estimating the profit • The annualised rate of return on $33 750 invested in the business is 13 per cent which is reasonable • Is Mrs Wright’s salary of only $8250 realistic? • The business’s cash position shows a serious deterioration. Are alternative sources of cash available? • As it stands the operation is at best marginal – perhaps the business’s fee base is too small

Ethics case study a Impact of the classification? • A material impact – $500 000/$2 000 000 = 25 per cent • Decrease in current liabilities; increase in non-current liabilities for the current year b Reasons? • May be an attempt to hide a liquidity problem • Would improve the current and quick ratios used by lenders for assessing the extension of short-term credit c Are any parties likely to suffer? • Short-term/trade creditors who may extend credit on the basis of the reported liquidity in the balance sheet • Long-term creditors if the liquidity situation is made worse as a result of the reclassification (e.g. more trade creditors result) • Shareholders – may lose their investment if the firm goes bankrupt d What would you do? • Point out to the manager that the $500 000 loan due in nine months meets the definition of a current liability in paragraph 69 of AASB 101 and so does not qualify as a noncurrent liability under the definition in the same paragraph. As AASBs are binding on corporations under the Corporations Act, Centura Ltd should not reclassify the loan. Remind the manager of the penalties if s/he breaches the law or commits fraud.

Chapter 6 Presentation of financial performance and the worksheet Review questions Note: many of the answers relate to past versus future benefits. Experience has shown that if the distinction between these two is reinforced at every opportunity students are very soon comfortable with the difference between assets and expenses and can relate to new and unusual situations. 1 The answer should note that expenses are consumptions, or losses of service potential or future economic benefits. 2 The answer should point out that a cost can be incurred which will result in both an asset, i.e. something that has a future benefit, or an expense, i.e. something where the benefit has been used up. 3 The intention here is to reinforce the idea that costs of one period may be expenses of another period. Examples could include prepayments, non-current assets, accruals and so on. 4 To provide a guide to the way in which a business has performed over a period of time. For example, it will be used by owners and other users for making decisions in respect of continued investment in that entity and help them to form a judgement of managers’ performance. 5 Comprehensive income provides information about the total changes in assets and liabilities for a period irrespective of whether they are recognised through the income statement or direct to equity. 6 When the cost does not relate to the business, e.g. the purchase of private assets through the business bank account. 7 They are both important and provide different information about an entity. It really depends on what a user requires as to which statement is the most important. 8 a Cash and owners’ equity. b Cash and income (revenue). c Supplies asset and accounts payable. d Cash and electricity expense. e Cash, land and loan payable.

Problems for discussion and analysis 1 a The revenue from operating activities for 2011 was $54 142.9 million. b The gross profit for 2011 was $14 093.2 million. For 2010 it was $13 393.6 million. The gross profit increased by $699.6 million or 5.2 per cent. c For 2011 the profit before tax was $3014.9 million and in 2010 it was $2870.63 million. This is an increase of $144.3 million or 5 per cent. One of the main reasons was the increase in gross profit for the year. d The total comprehensive income for the year ended 30 June 2011 was $1907.4 million and for 2010 was $2141.5 milion.

Chapter 6: Presentation of financial performance and the worksheet

2 a

6 7 8

Owners’ equity 1 January

= $132 400 – $68 300 = $64 100 b Owners’ equity 31 December = $333 000 – $128 300 = $204 700 c Profit = $204 700 – $64 100 = $140 600 a TL = $50 000, TE = $26 000 b TA = $26 900, Net Loss = $1000 c OE = $16 000, TR = $13 000 d TL = $25 000, OE = $25 000, TR = $15 000, TE = $12 000 a NCA $120 000; NCL $90 000; TL $120 000; TE $112 300 b NCA $147 100; TA $165 300; CL $22 000; TE $93 500 c CA $17 400; TL $92 800; OE $10 900; NP $50 d NCA $65 080; NCL $40 380; OE $42 770; TE $155 400 e CA $23 460; TA $133 660; CL $11 960; TR $40 800 f CA $1300; TA $37 700; TL $10 400; TE $100 350; NP$33 450 This question is designed to investigate the way in which decisions are made about how to deal with monies and goods withdrawn from a business by the owners. In the first situation all we have is the partners withdrawing cash from the business with no apparent input. This can therefore be treated as a withdrawal rather than a business expense. Similar logic applies to the second situation. The salaries raise a more difficult issue. If we apply the concept of accounting for a separate business entity then there is no reason why the salary paid to the owner should be treated any differently from other salaries. It is, however, worth exploring why in practice this is often not done. The reasons for this are largely practical, relating to tax regulations rather than the underlying theoretical debate about the way in which by adjusting the owners’ salary, the performance measure can be manipulated. In the case of the cash withdrawal, the case is more obvious as this is a personal transaction rather than a business transaction. You may wish to explore whether it would have been included in the income statement had it been a business transaction. Record one half of the insurance amount paid as a prepaid asset at 30 June. Owners’ equity at 30 June 20X1 = $134 645 + $5000 – $56 737 + $34 692 = $117 600 It would not be correct to say the entity incurred a loss of $269, as the owner withdrawing funds from a business is not an expense but represents an appropriation of profit. It is not wise for an owner to continually withdraw more than the business is earning in profit, but if this only happens on rare occasions then it need not be seen as critical.

Chapter 6: Presentation of financial performance and the worksheet

9 Balance sheet Assets

Liabilities and owners’ equity Current liabilities Accounts payable Bank overdraft

14 020 2 300

Non-current liabilities Mortgage

23 000

Total liabilities Non-current assets Equipment Motor vehicles Land & buildings

3 200 23 230 125 000

Total assets

151 430

112 110 151 430

Statement of comprehensive income Sales Less Cost of goods sold Gross profit Less expenses Insurance 932 Salaries 1 236 Electricity + telephone 9 560 Wages 38 900 Net profit Other comprehensive income Total comprehensive income * No depreciation has been recorded.

23 000

63 138 48 972

Total liabilities and owner’s equity

16 320

39 320

Owners’ equity Capital Plus: Net profit 151 430

$ 132 000 32 400 99 600

50 628 48 972* 0 48 972

Chapter 6: Presentation of financial performance and the worksheet

10 Balance sheet as at 30 June 20X2 Assets

Current assets Cash Debtors Inventory

10 000 50 000 100 000

Liabilities and owners’ equity Current liabilities Creditors

37 600

Non-current liabilities Loan

80 000

37 600

160 000

Total liabilities Non-current assets Machinery Motor vehicles Office equip’t

80 000 117 600

Owners’ equity 80 000 40 000 12 500

Total assets

132 500 292 500

Capital Less Drawings

200 000 6 478 193 522

Less Retained earnings

(18 622)

Total liabilities and owners’ equity

174 900

292 500

Statement of comprehensive income for year ending 30 June 20X2 Sales

$ 127 800

Less Cost of goods sold

84 070

Gross profit Less Expenses Rent Wages Motor vehicle Electricity Rates Advertising Net loss Other comprehensive income Total comprehensive income

43 730 5 000 42 100 8 230 2 500 2 500 2 022

62 352 (18 622) 0 (18 622)

11 a

The process of selling materials is complete and the receipt of monies is reasonably certain which satisfies the recognition principle. (Include $52 000 as sales.) b The process is complete and the payments received. (Include sales of $144 000.) c In this case the problem is not whether to include the office conversion in sales but how much to include. The answer will depend on what assumptions are made about whether the $48 000 invoiced in 20X0 had been included in full or in part in the 20X0 accounts. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 6: Presentation of financial performance and the worksheet

Assuming $48 000 was in 20X0 accounts, provided the earnings process is complete and the recognition principles are satisfied, we would include $32 000 as sales. d The question here is what should be included as the cost of goods sold. The students need to understand that the timing of the payment is not relevant to the decision on whether an expense is included in the profit and loss account. (Include cost of $28 000.) e As these houses had been started and completed during the period all these materials are an expense of the period. (Include $36 000 as cost of materials.) f As these houses had been started and completed during the period all these wages are an expense of the period. (Include $40 000 as wages.) g This point should be used to illustrate the problems that arise when a trading cycle does not fit neatly into one year. In this case we need to make some assumptions in order to proceed. There are a number of possibilities available and some of these are discussed briefly below. The easiest way to deal with the situation and the one which causes least problems to the students is to assume that the wages paid in 20X0 and the materials used in 20X0 were charged in 20X0. This we have done for our answer to Problem 8. Another method is to allocate the total costs over the two years on the basis of work invoiced. What is important is to explore these possibilities with the students and to use the example to illustrate the difficulty of the latter method if we try to apply it at the end of 20X0 when the costs to completion are uncertain. (Include wages $12 000 and materials $14 000.) h The wages are for the year and are an expense of this period. (Include wages $16 000.) i Once more, a difficult situation to deal with. If we apply the concept of accounting for a separate business entity then there is no reason why the salary paid to the owner should be treated any differently from other salaries. It is, however, worth exploring why in practice this is often not done. The reasons for this are largely practical, relating to tax regulations rather than the underlying theoretical debate about the way in which by adjusting the owners’ salary the performance measure can be manipulated. In the case of the cash withdrawal, the case is more obvious as this is a personal transaction rather than a business transaction. You may wish to explore whether, had it been a business transaction, it would have been included in the profit and loss account. (Include salary of $18 000 as expense.) j In the first three of these cases the question is how much to include, not whether the expenses should be included. We have included one quarter (January to March 20X1) at previous year rates and three quarters (April to December 20X1) at 20X1 rates.

Registration Insurance Repairs

Jan – March $480 × 3/12 = 120 $800 × 3/12 = 200

April – Dec $600 × 9/12 = 450 $960 × 9/12 = 720

Total 570 920 1 200

The others are more controversial as there is a need to establish what is a business expense and what is not. Consider the situation of the wife’s car first – from the information provided there is nothing to indicate that she is involved in the business in any way, so her car expenses could be said to be personal. On the other hand, the owner is clearly involved in the business and uses his car 80 per cent of the time for business and half the repairs relate to that car.

Chapter 6: Presentation of financial performance and the worksheet

Registration Insurance Repairs

Jan – May $160 * 5/12 * 80% = 53 $200 * 5/12 * 80% = 67 $1 600/2 * 80%

June – Dec $200 * 7/12 * 80% = 93 $240 * 7/12 * 80% =112

Total 146 179 640

k The TV rental is unlikely to be a business expense. In the case of the rent and electricity we can assume these are legitimate business expenses. The rent should be based on one quarter from the previous year’s payment and three quarters from 20X1, but as there is no change in the rent over the two years the expense is the same, i.e. $800. For the electricity, which is normally paid in arrears, we should take one-third of the bill paid 1 February for January (108/3 =$36) the May to November payments (90+90+120=300) and make an estimate for the amount due for November and December. Two-thirds of the last bill would be a reasonable estimate (120 * 2/3=80) or two-thirds of the February payment as this would be an estimate covering the same time frame from 12 months earlier (108 * 2/3=72). Once again it is more important to explore the problem with students than to come to an answer. (On our assumptions we have included rent of $800 and electricity of $416 made up of 1/3 of $108 + 2 × $90 + 1 × $120 + 2/3 of $120.)

Chapter 6: Presentation of financial performance and the worksheet

12 Re-cover Upholstery Repairs worksheet Cash + Office + Office + Vehicle equip. supp.

Jan 1

10 000

4 4 6 6 7 8 11 12

-350 –100 500

13 13 14 15 16 17 18 21 23 24 25 28 31 Adj Rent Wages Total

–1 000 600 –200

20 000

+ Sewing + Account + + Prepai = Note machine receive. d Rent Payable

24 000

350

850 5 000 NO

+ Equity

750

500 1 000

4 000

1 200

–750 –300

600

–750

300

700 –550 400 1 000 –70 –550 100

300

–60 pe –10 po –130 el 700 1 200 –300 700 –550 w 1 600

1 200 –1 000

+ 20 000

300

–70 pe –550 w 600 –850 –350 –471

500

–850

–350 + 24 000

+ 5 000

+ 2 900

+ =

–

471 4 000

+ Profit & Loss

10 000 20 000 24 000

ENTRY

700

10 130

1 000

+ Account Payable

771

53 700

3 859

Company Accounting (8th edition) – Solutions Manual

Chapter 6: Presentation of financial performance and the worksheet

Re-cover Upholstery Repairs Statement of comprehensive income for the period ending 31 January Sales revenue Expenses Electricity Office supplies Petrol Postage Rent Wages Net profit Other comprehensive income Total comprehensive income

$ 6 900

130 850 130 10 350 1 571

3 041 $3 859 0 $3 859

Re-cover Upholstery Repairs Balance sheet as at 31 January $

Current assets Cash Office supplies Account receivable Total current assets Non-current assets Office equipment Vehicle Sewing machine Total assets Current liabilities Account payable Note payable Total liabilities

10 130 300 2 900

Total non-current assets

Total current liabilities

20 000 24 000 5 000

771 4 000

13 330

49 000

4 771

Net assets

62 330

4 771 57 559

Owners’ equity I. Cover, Capital Profit Less I. Cover, Drawings

54 000 3 859 Total owners’ equity

57 859 300

57 559

Company Accounting (8th edition) – Solutions Manual

Chapter 6: Presentation of financial performance and the worksheet

13 a Boat worksheet Day

Cash

+ Boats (Stock)

10 000

20 000

–500

–7 400

–2 900

+ Rent

+ Furniture

= Loans

+ Equity

+ Profit & Loss

Ref

10 000 20 000 500 7 400 2 900 No

entry

–300

adver

5 500

sales

3 200

sales

–15 000

–20

clean

–300

adver

–800

adver

–500

15 000

500 No

entry

1 200

sales

19 000

sales

–8 000

–180

Clean

–300

adver

–3 000

8 000

–3 000 No

Repay loan

entry

–900

rep.

9300

9 300

sales

–180

elect

–1 000

rent

Adj

Rent

Adj

Boats

Bal.

27 920

–1 000 –30 400 + nil

–30 400 + nil

+ 2900

= 17 000

+ 10 000

+ 3 820

Chapter 6: Presentation of financial performance and the worksheet

b Joe’s Boats Statement of comprehensive income for the period ending 31 March 20XX Sales revenue Cost of boats sold Gross profit Expenses Advertising Cleaning Electricity Rent Repairs Net profit Other comprehensive income Total comprehensive income

$ 38 200 30 400 1 700 200 180 1 000 900

7 800

3 980 $3 820 0 $3 820

c Joe’s Boats Balance sheet as at 31 March 20XX Current assets Cash Non-current assets Furniture Total assets Current liabilities Loan Total liabilities Net assets Owners’ equity Capital Profit

Total current assets Total non-current assets

Total current liabilities

Total owners’ equity

27 920 2 900

17 000

10 000 3 820

27 920 2 900

17 000

30 820

17 000 13 820

13 820

Chapter 6: Presentation of financial performance and the worksheet

14 a Toy business worksheet Day

Transaction

June1

Equity Rent June 2 Shop fittings Stock June 3 No entry June 4 Telstra June 5 Office equip. June 6 Caterers June 6 Advert June 7 Wages June 7–12 Sales June 12 No entry June 12 Cash June 12 Cash June 12 Wages June 14 Cash refund June 14–19 Sales June 15 Wages June 16 Creditors June 21–26 Sales June 21 Wages June 23 Stock June 28–29 Sales June 28 Insurance June 28 Wages Balances Rent Advert Goods sold Balance © Cengage Learning Australia 2010

Cash $ 150 000 –600

Assets + Shop fittings $

Office equip.

–1 250

+ Inventory $

+ Equity Owners’equity $ 150 000

58 000 5 600

–3 100

600

27 000

–30 000

+ Prepaids $

= Liabilities Creditors = Profit & Loss $

500

27 000 28 000 5 600 500

–300 3 456 –5 600 –500 –1 000 –375 6 320 –200 –28 000 5 321 –775

–5 600 –500

–28 000

1 289 –1 200 –950 92 536

27 000

5 600

+ 2 300 –600 –500

92 536

27 000

5 600

+ 1 200

23 000

81 000

= 50 000

16 300 64 700

= 50 000

1 200 +

–750 –3 100 –500 –300 3 456

–1 000 –375 6 320 –200 5 321 –775 1 289 –950 8 436 –600 –500 –16 300 –8 964

150 000

Company Accounting (8th edition) – Solutions Manual

Chapter 6: Presentation of financial performance and the worksheet

b Statement of comprehensive income for month ending 30 June $

Sales revenue Cost of goods sold Gross profit

16 011 16 300 –289

Expenses: Advertising Catering Rent Telephone Wages Total expenses

1 000 3 100 600 750 3 225

8 675 (8 964) 0 (8 964)

Net Loss for period Other comprehensive income Total comprehensive income

Balance sheet as at 30 June Assets Current assets Cash Inventory Prepaids Total current assets Non-current assets Shop fittings Office equipment Total non-current assets Total assets Liabilities Creditors Total current liabilities Total liabilities

92 536 64 700 1 200

27 000 5 600

50 000

Net assets Owners’ equity Capital Loss Total owners’ equity

158 436

32 600 191 036

50 000 50 000 141 036

150 000 (8 964)

141 036

Company Accounting (8th edition) – Solutions Manual

Chapter 6: Presentation of financial performance and the worksheet

15 a Mandy Plover worksheet Date

Bank

July 1

2 3 4 15 15

30 000 –3 000 –275 –50 –475 –1 000 –1 380

Prepaid Rent

Fixtures & Fittings

ASSETS = LIABILITIES + OWNERS EQUITY Computer Supplies Accounts Prepaid Receivable Lease Rent

Accounts Payable

3 000

1 000

Capital 30 000

Profit & Loss –275 –50 –475

17 500

1 380

No entry –750 225 –2 000 –17 500 300

15 16 16 18 22 23 29 –750 29 300 31 340 Balance 3 985 3 000 1 000 17 500 Adjustment Rent –1 000 Lease Supplies* Adjusted 3 985 2 000 1 000 17 500 Balance *Assumed to last for one year, therefore 1 380 × 1/12 = 11

17 500 2 750

–225

2 750 –750 2 000

–17 500

30 000

300 –780 –750 300 3 450 3 720

30 000

–1 000 –1 000 –115 1 605

–780

1 380

-115 1 265

3 110 4 855

2 000

–1 000 4 855

1 000

Company Accounting (8th edition) – Solutions Manual

Chapter 6: Presentation of financial performance and the worksheet

b Mandy Plover Statement of comprehensive income for month ending 31 July Revenue Less Expenses Wages Rent Motor Vehicle Lease Telephone Electricity Fee Office Equipment Bad Debts Supplies Net Profit Other comprehensive income Total comprehensive income

1 500 1 000 1 000 275 50 475 780 115

$ 6 800

5 195 1 605 0 1 605

Mandy Plover Balance sheet as at 31 July Assets

Current assets Bank Accounts receivable Supplies Prepaid rent Prepaid lease rent

3 985 4 855 1 265 2 000 1 000

13 105

Non-current assets Fixtures and fittings Computer

1 000 17 500

18 500

Total assets

Liabilities and owners’ equity Owners’ equity Capital Retained earnings

31 605

$ 30 000 1 605

31 605

For the month of July, Mandy has made a profit of $1605. However, this figure is overstated for the following reasons: • No expense recorded for electricity or telephone as no account has been received as at 31 July • No depreciation recorded for the computer or the signs • No allowance made for any further bad debts • Based on the investment of $30 000, Mandy is receiving the following return: 1605 × 12 30 000

× 100

= 64.2 per cent per annum

Chapter 6: Presentation of financial performance and the worksheet

The other issue Mandy must consider is whether her wages of $750 per fortnight represent what she could earn elsewhere. If in fact her wages are understated at $750 per fortnight or $20 000 per annum, then her return on investment is overstated. Finally, the effect of the lease of the BMW must be considered. For July the impact on profit has only been $1000 but in future months the impact will be $2000 per month. If Mandy continues to earn the same profit each month then the following figures show the impact of the BMW: Net profit for July Add back BMW lease cost x 12 for full year Less full year cost of BMW

$1 605 $1 000 $2 605 x 12 $31 260 –$24 000 $7 260

Return on investment: $7 260 $30 000

16 a

× 100

= 24.2 per cent In summary then, Mandy’s business looks very promising. However, further analysis is required after a few more months of business to enable a more accurate assessment of the financials. Perhaps Mandy could earn a higher return by investing her money in shares and working for someone else, but then she loses her independence and perhaps the car. Even if she continues in her own business she could improve the return on her investment by choosing to lease a less expensive motor vehicle. Alternative treatments raised by students may include: • Rent – at this stage there is a future benefit, so set up an asset and review at end of month. Alternatively as the accounts are being done at the end of the month at that point in time the benefit is used up so the rent could be charged to the profit and loss account directly. (Charged directly to profit and loss in the worksheet on the next page.) • Advertising – students may argue that advertising creates a future benefit, however, the future benefit is too uncertain to treat it as an asset. • Wages – the area of contention is whether this is a business expense or a withdrawal by the owner. (Included as business expense under business entity principle.) • Purchases of stock – this can be put under an inventory column, and each sale can reduce the inventory figure with a corresponding expense figure. Alternatively, the total cost of goods sold can be calculated at the end of the period. This is the approach taken in the suggested solution.

Chapter 6: Presentation of financial performance and the worksheet

b Jill’s Office Chairs worksheet Day 1

Transaction

Equity Car Rent Equipment 2 Chairs 5 Advert 9 Sales Delivery 11 Sales Delivery 14 Wages 16 Chairs 21 Repairs 23 Sales Delivery 24 Advert 27 Sales Sales Delivery 28 Wages Sales Telephone Electricity Balances Rent Chairs Sold Balance

Cash

Assets + Car

10 000 –240 –1 600 –7 000 –400 1 200 –144 5 400 –600 –300 –1 400 –300 1 800 –80 –400 1 350 700 –200 –300 +500 –60 –80 7 846 7 846

+ Rent

4 000

+ Furniture $

+ Inventory

= Liabilities = Profit & Loss $

4 000

240

4 000

+ +

240 –240

10 000 4 000 1 600

7 000

–400 1 200 –144 5 400 –600 –300

1 400

+ Equity + Owners’ equity

+ +

1 600 1 600

8 400 –8 400

= =

–300 1 800 –80 –400 1 350 700 –200 –300 +500 –60 –80 8 086 –240 –8 400 –554

14 000 14 000

Chapter 6: Presentation of financial performance and the worksheet

c Jill’s Office Chairs Balance sheet at the end of the period $

Assets Current assets Cash Total current assets

7 846

Non-current assets Car Furniture Total non-current assets Total assets

4 000 1 600

7 846

5 600 13 446

Liabilities Total liabilities

Nil

Net assets

13 446

Owners’ equity Capital Loss Total owners’ equity

14 000 (554)

13 446

Jill’s Office Chairs Statement of comprehensive income for the period $ Sales revenue Cost of goods sold Gross profit Expenses: Advertising Car repairs Delivery Electricity Rent Telephone Wages Total expenses Net Loss for period Other comprehensive income Total comprehensive income

$ 10 950 8 400 2 550

800 300 1 024 80 240 60 600

_____ 3 104 (554) 0 (554)

d Comments on the performance of the business should include: Profitability: • The investment of $14 000 has yielded a loss of $544 in the first month of operations Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 6: Presentation of financial performance and the worksheet

•

The gross margin is very low especially when the cost of delivery of $1024 is considered • Both wages and advertising are comparatively high • Depreciation has yet to be charged on the car and furniture Cash position: • The cash position has deteriorated during the month • The cash resources of the business are marginal – on day five the closing cash balance was only $760 • There is no stock on hand at the end of the period; its replacement will strain cash resources 17 Waterloo Ltd Statement of comprehensive income for the year ended June 30 20X5

20X5 $million 130

Profit for the year Other Comprehensive income Unrealised gain (loss) on revaluation of land Unrealised gain (loss) for the year on available-for-sale financial assets

25 (8)

Unrealised gain (loss) on cash flow hedges Gains (losses) on foreign currency translation of investments in foreign operations Reclassification of translation losses to profit or loss Other comprehensive income total for the year, net of tax

(15) 25

Total comprehensive income for the year

142

(15) 12

Waterloo Ltd Statement of changes in equity for the year ended June 30 20X5

Balance at 1 July 20X4 Total comprehensive income for the year Dividends paid during the year Shares issued during the year Balance at 30 June 20X4

Share capital $m 500

550

Reserves $m 100 12

Retained earnings $m 200 130 (50)

112

280

Total $m 800 142 (50) 50 942

18 As electricity usage is fairly constant on a month-to-month basis, CitiPower is able to estimate the electricity consumption of its customers for the period between the date of the last meter reading and the commission’s year end. 19 The bank would record the receipt of the $1050 as an asset and show $1000 payable to Diners Club International and $50 as revenue (this is part of a bank’s normal activities and so it is revenue). From the R & I Bank’s point of view, the transaction is complete and the $50 revenue has been earned.

Chapter 6: Presentation of financial performance and the worksheet

In due course the R & I Bank will remit the $1000 to Diners Club International, which will record $1000 as an asset and record a liability to the traveller of $1000. 20 Although the problem states DEF Ltd sold goods to XYZ Ltd in November, it is clear that no sale has taken place. In essence, DEF Ltd has used the goods as collateral for the asset it acquires under a hire purchase agreement. Therefore, DEF Ltd should record the receipt of cash and the creation of a liability to XYZ Ltd. DEF Ltd will have no revenue for 20X0. 21 Does the receipt of the $8000 create a present obligation (liability) beyond the current accounting period? Swallow Ltd must allow brokers to use its name and its referral system plus arrange seminars. This does not appear to create a liability for Swallow Ltd (except for the costs incurred to arrange seminars) and hence the $8000 is more appropriately recognised as revenue in the period the agreement is signed. Investors will need to make their own judgement as to what will happen when the market becomes saturated. 22 Before advice could be given the alternatives need to be costed: Stay as they are Income Paul Debbie Son Interest

$ 30 000 7 000 2 600 15 000 54 600

Chapter 6: Presentation of financial performance and the worksheet

Buy news agency Sales Newspapers etc. Books Stationery Confectionery Sundry sales Expenses Newspapers etc. Books Stationery Confectionery Sundry sales Phone Wages etc. Rent Rates Insurance Electricity etc Security Advertising Fees Subscriptions Vehicle Depreciation Last year’s profit before tax

780 000 60 000 87 500 27 600 10 000

965 100

663 000 36 000 52 500 13 800 7 000

772 300

3 000 28 820 4 000 15 000 12 750 7 300 2 700 3 450 3 620 1 500 2 300 3 820

88 260

860 560 104 540

Based on last year’s figures there is a $49 940 ($104 540–$54 600) improvement. The figures do not include the $12 000 interest payable on the loan, assuming Paul uses the $250 000 legacy and only borrows $120 000 to purchase the newsagency. The figures do not include stamp duty, and as Paul and Debbie are new to the business, some suppliers may need payment before delivery. Also working capital would be required. Given the investment of $370 000 and an increase of earnings of $37 940, after interest (based on last year’s figures), this represents an approximate return of 10 per cent. This return is greater than the six per cent from leaving the money in the bank. The advice would also depend on the likely increase in the resale value of the newsagency. It should be noted that if credit was available from suppliers, and given this would mainly be a cash business, there should be a positive cash flow, which could be invested in the short term. b This is an ethical issue. It would appear the son has not been consulted. As he is a third year apprentice it could be assumed he likes his trade and may be unwilling to change. Perhaps he may consider an offer if there were some financial advantages, such as a share of the business. c There are many factors the Cruits should consider. A few are listed below and students should be able to identify others. – a newsagency is a seven-day-a-week business and as the turnover is nearly $20 000 per week it would require long working hours from the family. What is the opportunity cost of working such long hours? The expenses of running the business do

Chapter 6: Presentation of financial performance and the worksheet

not include any allowance for payment to the Cruits. Is the $37 940 enough to compensate them for the extra hours work and worry? – how secure is the lease of the premises and can it be transferred? – is there likely to be any new and local competition? – what training have the Cruits had in the running of a business? – are there any new capital works in the district that could affect the flow of pedestrian traffic? – are the Cruits familiar with the requirements of the Goods and Services Tax? – under existing legislation the Cruits, through working for their present employers, would have monies accumulating in a superannuation scheme. 23 NSA Income statement for the year ended 30 June 20X2

Revenues Membership fees Newsletter subscriptions Publication sales Government grant Annual National Sailing Championship, 20X1 profit Total revenues Expenses Printing and mailing publications Committee meeting expense Annual National Sailing Championship advance IBM publishing system Administrative salaries and expenses Miscellaneous Total expenses Excess/(Deficit) of revenues over expenses

Original estimation $

Adjustments

Revised

76 680 8 668 3 168 14 400

(8 640) (720) (13 680)

68 040 7 948 3 168 720

908 103 824

______ (23 040)

908 80 784

24 640 13 120

(2 880)

21 760 13 120

2 880 7 200 45 724 6 680 100 244

(2 880) (7 200) – – (12 960)

– – 45 724 6 680 87 284

3 580

(10 080)

(6 500)

There is no one correct solution. Tutors should raise the following points in the discussion: • The receipt of the government grant creates a present obligation (liability) for the NSA. This should not be recognised as revenue until the clean-up programme is implemented, except to the extent of expenses already incurred. Therefore only $720 is recognised as revenue in 20X2. • The IBM publishing system has future economic benefits and is therefore an asset and not an expense for 20X2. No depreciation has been provided for 20X2/X3. (Discuss this point.) • The $8640 membership fees for 20X2/X3 should be recognised as revenue in that year. The fees paid in advance create a present obligation (liability) for NSA at 30 June 20X2. The free T-shirt cost is irrelevant as this will be recognised as an expense in 20X2/X3 when the above fees are recognised as revenue.

Chapter 6: Presentation of financial performance and the worksheet

•

• •

•

The membership directory is difficult. The benefits of the directory appear to be consumed over two years. Hence we could argue that the cost of $5760 should be spread evenly over two years. Alternatively the cost of 1875 directories ($5400) could be allocated to 20X1/X2 and the cost of 125 directories ($360) allocated to 20X2/X3. The solution has assumed the former treatment. To convert the $8668 subscriptions revenue from cash to accruals basis, we need to deduct $720. The advance of $2880 is not an expense of 20X1/X2 as it is highly probable that the 20X2 championship will derive enough profit to reimburse NSA for the $2880. The $2880 is an account receivable and an asset. (Tutors should discuss that a conservative approach would treat the $2880 as an expense in 20X1/X2 and the subsequent reimbursement as revenues.) The $908 profit for the 20X1 championship should conceptually be shown as revenue in 20X1. However, it may be difficult to reliably measure this amount by 30 June 20X1 and hence it is left as revenue for 20X2. If we were to delete the $908 revenue we should replace it with an estimate of profit for the 20X2 championship. The excess has been replaced by a deficit, which would not be welcomed by the management committee. It is recommended that an accounting manual be established with policies for the treatment of the above items plus any others.

Ethics case study Facts – Sales staff at Ellenmere are paid a bonus on basis of car sales. – Your best friend, James, is a car salesman at Ellenmere. – His most recent sale would qualify James for the bonus. – You approve all sales transactions. – You tell James he qualifies for the bonus. James is overjoyed because he can now afford special treatment for his daughter’s rare disease. – You discover that James’ sales customer’s earnings are overstated and that they do not qualify for approval. James would lose the sale and the bonus Stakeholders – James – James’ daughter – the customer – Ellenmere Problem – Should you approve the sale? Values and principles – Professional principles at issue here include integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110– 290), competence and due care (APES 110–130). These principles would all point to honesty, compliance with company policy and nonapproval of the sale. – However, in contrast are friendship with James and the principle of avoiding harm to James’ daughter. Does the daughter’s suffering outweigh the professional ethical principles (or does the end justify the means)?

Chapter 6: Presentation of financial performance and the worksheet

Three possible courses of action – Action one: do not approve the sale. – Action two: further investigate the financial condition of the customer. – Action three: approve the sale on the basis of the available evidence. Evaluation Action one: – professional ethical principles are maintained and the company’s policies complied with – sale and bonus are not achieved – James’ daughter continues to suffer – customer unable to obtain the car (at least in the short-term) Action two: – you may be able to satisfy yourself that the customer is of sufficient financial soundness that the sale can be approved – possibly confirm inability of customer to pay the bill – either way, you will still need to make an approval decision, but at least you are more informed Action three: – sale and bonus go through – James’ daughter receives treatment – customer may default – Ellenmere would lose money – you may be disciplined or sacked if the breach of policy is discovered or the customer defaults – failure to comply with company policy and professional ethical principles Choose a plan of action – Take a poll of the class, but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts. In particular, if students choose Action two it is worthwhile asking them how they would actually obtain the information they are after.

Chapter 7 Debtors, creditors, accruals and prepayments Review questions 1 It is necessary to identify debtors and creditors because the accounts are to do with measuring economic activity rather than the timing of receipts and payments of cash. 2 Creditors are amounts owing at a point in time, the amounts of which are known. Creditors arise when goods or services are supplied to an enterprise and for which no payment has been made at the date of receipt of the goods or services. 3 The direct write-off method only recognises a bad debt when it is determined a debtor is not expected to pay. The allowance method estimates the expected amount of bad debts in the amounts owing from debtors and recognises an expense at that point in time rather than waiting until a debt is determined to be uncollectable. 4 ‘Prepayment’ is when payment for a service is made in advance. Examples could be rent, insurance and interest. 5 When goods or services are paid for in advance by the enterprise. They differ in that in the case of prepayments the exact amount is known and has been paid although the services have yet to be received, whereas in the case of an accrual, the service has been received but has not been paid for and we have to estimate the amount due. 6 They have no direct effect but often the debtor is the other side of the sales entry. Another effect could be when the debtor fails to pay and the amount has to be charged to the profit and loss account as a bad debt. 7 Small businesses where most transactions are cash based and where there is very little investment in non-current assets. Sporting and not-for-profit organisations, where members are mainly concerned with cash payments and receipts.

Problems for discussion and analysis 1 a

Trade and other receivables are $637.8 million for the consolidated column. Students may ask why the Woolworths Ltd column is $1091.9 million. Let them know it is to do with amounts owed from subsidiary companies, which is one of the transactions that must be eliminated in the preparation of consolidated statements discussed in Chapter 11. b Trade and other payables are $4804.9 million consolidated. Woolworths Ltd is $7385 million. Same discussion as in part (a). c Trade and other payables account for nearly 51 per cent of total liabilities. The use of creditors by Woolworths is discussed in Chapter 12. 2 a Assume electricity is billed every three months. We can estimate the next bill based on the last quarter amount or based on an average of the year or based on the same quarter last year with an allowance for increase in the cost of electricity. An important issue is whether use of electricity is seasonal. Is more used in winter or summer? b Council rates are normally billed for 12 months. Best to estimate based on last year’s amount plus an allowance for any known increases. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 7: Debtors, creditors, accruals and prepayments

Telephone accounts are likely to be more constant than electricity. Therefore, use the last bill amount and allow for any increase in charges. If there is any seasonality to the telephone usage then allow for this in the estimate. d Water rates are normally billed once a year and are therefore similar to council rates. If the rates include usage of water then this is likely to be higher in summer in a place such as Perth and allowance should be made for this. e Income taxes can be based on an estimate of the relevant year’s income with allowances for any known change in tax rates. 3 Cash collections month one $400 000 × 0.95 = $380 000 Cash collections month two $200 000 × 0.95 = $190 000 from month one sales $480 000 from month one $433 333 × 0.95 = $411 667 from month two Cash collections month three $96 000 from month one $216 667 × 0.95 = $205 833 from month two $520 000 from month two $293 333 × 0.95 = $278 667 from month three Cash collections month four $104 000 from month two $146 667 × 0.95 = $139 333 from month three $352 000 from month three $333 333 × 0.95 = $316 667 from month four Cash collections month five $70 400 from month three $166 667 × 0.95 = $158 333 from month four $400 000 from month four $416 667 × 0.95 = $395 833 from month five Cash collected in month four = $912 000 Cash collected in month five = $1 024 566 4 January Cash sales = $170 000 Credit sales= $170 000 Cash collected from credit sales: $170 000 × 0.45 less 2% = $74 970 Total = $244 970 February Cash sales = $132 000 Credit sales = $132 000 Cash collected from Jan credit sales: $170 000 × 0.35 = $59 500 Cash collected from Feb credit sales: $132 000 × 0.45 less 2% = $58 212 Total = $249 712 March Cash sales = $167 000 Credit sales = $167 000 Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 7: Debtors, creditors, accruals and prepayments

Cash collected from Jan credit sales: $170 000 × 0.16 = $27 200 Cash collected from Feb credit sales: $132 000 × 0.35 = $46 200 Cash collected from March credit sales: $167 000 × 0.45 less 2% = $73 647 Total = $314 047 April Cash sales = $149 000 Credit sales = $149 000 Cash collected from Feb credit sales: $132 000 × 0.16 = $21 120 Cash collected from March credit sales: $167 000 × 0.35 = $58 450 Cash collected from April credit sales: $149 000 × 0.45 less 2% = $65 709 Total = $294 279 May Cash sales = $156 000 Credit sales = $156 000 Cash collected from March credit sales: $167 000 × 0.16 = $26 720 Cash collected from April credit sales: $149 000 × 0.35 = $52 150 Cash collected from May credit sales: $156 000 × 0.45 less 2% = $68 796 Total = $303 666 June Cash sales = $112 000 Credit sales = $112 000 Cash collected from April credit sales: $149 000 × 0.16 = $23 840 Cash collected from May credit sales: $156 000 × 0.35 = $54 600 Cash collected from June credit sales: $112 000 × 0.45 less 2% = $49 392 Total = $239 832 5 a Record in the inventory column and in a creditor column. Balance sheet – increase assets and liabilities. Statement of comprehensive income – no effect. b Record an asset and reduce the asset bank. Balance sheet – increase one asset and reduce another. Statement of comprehensive income – no effect. c Increase the asset bank and reduce the asset debtors. Balance sheet – increase one asset and reduce another. Statement of comprehensive income – no effect. d Reduce a liability, the loan, and reduce the asset bank. Balance sheet – reduce an asset and a liability. Statement of comprehensive income – no effect. e This is more open to discussion about how to deal with research expenditure. The question is whether or not there is a future benefit and how certain that benefit is. Reduce the asset bank and either record an expense or an asset. Balance sheet – reduce one asset and perhaps increase another. Statement of comprehensive income – either record an expense or no effect. f Record an asset debtor and record revenue in the profit and loss. Balance sheet – increase the asset debtor. Statement of comprehensive income – record sale as revenue. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 7: Debtors, creditors, accruals and prepayments

Record a reduction in the liability, creditors, and reduce the asset bank. Balance sheet – reduce an asset and a liability. Statement of comprehensive income – no effect. h Reduce the asset bank and record an expense in the P&L. Balance sheet – reduce the asset bank. Statement of comprehensive income – charge the expense wages. i Reduce the asset bank and record an expense in the P&L. Balance sheet – reduce the asset bank. Statement of comprehensive income – charge the expense wages. j Reduce the asset bank and charge the interest expense to P&L. Balance sheet – reduce an asset. Statement of comprehensive income – charge the expense interest. k Reduce the asset bank and reduce the liability accruals. Balance sheet – decrease an asset and a liability. Statement of comprehensive income – no effect. l Record an asset prepayments and reduce the asset bank. Balance sheet – increase one asset and reduce another. Statement of comprehensive income – no effect. m Record an asset in the bank and increase the owner’s equity. Balance sheet – increase an asset and the owner’s equity. Statement of comprehensive income – no effect. n Reduce an asset stock and reduce the owners’ equity. Balance sheet – reduce an asset and reduce the owners’ equity. Statement of comprehensive income – no effect. o Reduce the asset debtors and charge the bad debt as an expense. Balance sheet – reduce an asset. Statement of comprehensive income – charge bad debt as an expense. 6 a No entry. b No entry. c Increase the overdraft by $14 563 and reduce creditors by $14 563. Balance sheet – increase one liability and reduce another. Statement of comprehensive income – no effect. d Reduce the asset cash at bank and increase prepaid insurance if paid in advance (otherwise insurance expense). Balance sheet – reduce one asset and increase another if prepaid. Statement of comprehensive income – no effect unless not prepaid in which case record an expense. e Reduce the asset bank and record an expense. Balance sheet – reduce an asset. Statement of comprehensive income – record an expense. f Increase the overdraft by $100 and record an expense of $100. Balance sheet – increase the liability bank overdraft. Statement of comprehensive income – increase interest expense. g Record an asset land, reduce asset cash at bank and increase a liability mortgage payable. Balance sheet – increase one asset land, reduce asset cash at bank and increase a liability mortgage payable. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 7: Debtors, creditors, accruals and prepayments

Statement of comprehensive income – no effect. h Reduce the asset cash at bank and record an expense in the P&L. Balance sheet – reduce the asset cash at bank. Statement of comprehensive income – charge the expense salaries. i Increase asset equipment and increase a liability accounts payable. Balance sheet – reduce the asset equipment and increase liability accounts payable. Statement of comprehensive income – no effect. j Increase asset cash at bank $300, increase debtors $400 and record revenue $700. Balance sheet – increase assets cash at bank and debtors. Statement of comprehensive income – record revenue. k Reduce the asset bank and reduce owners’ equity. Balance sheet – decrease an asset and owners’ equity. Statement of comprehensive income – no effect. l Record an asset truck and increase owners’ equity. Balance sheet – increase one asset and owners’ equity. Statement of comprehensive income – no effect. m Decrease asset cash at bank and decrease the liability creditors. Balance sheet – increase an asset and decrease a liability. Statement of comprehensive income – no effect. n No entry. 7 a June 1 1 2 4 6 9 12 15 17 18 20 23 25 26 27 29 30

Record an increase in the bank and owners’ equity accounts of $6000 Record shop equipment and accounts payable of $1750 Record inventory $450 and decrease in bank of $450 Record increase in inventory $100 and decrease cash at bank $100 No entry Increase inventory $300 and decrease cash at bank $300 Increase debtors $200 and record revenue of $200 Increase cash at bank $300 and record revenue $300 Decrease cash at bank $209 and record expenses $209 Increase inventory $150 and decrease cash at bank $150 Increase debtors $200 and record revenue of $200 Increase cash at bank $600 and record revenue $600 Record inventory $1000 and increase creditors $1000 Increase cash at bank $1000, debtors $1000 and record revenue $2000 Record inventory $900 and decrease in bank of $900 Increase cash at bank $980, record an expense discount $20 and reduce debtors $1000 Decrease cash at bank $600 and record wages expense $600

Chapter 7: Debtors, creditors, accruals and prepayments

b Day

Transaction

June 1 Capital June 1 Shop equip. June 2 Inventory June 4 Inventory June 9 Inventory June 12 Sales June 15 Sales June 17 Expenses June 18 Inventory June 20 Sales June 23 Sales June 25 Inventory June 26 Sales June 27 Inventory June 29 Debtors June 30 Wages Goods sold Balances

Bank $

Assets + Shop equipment

+ Inventory

+ Debtors

6 000

1 750

–450 –100 –300

150

600

1 000

1 000 –900 980 –600 1 750

–1 700 1 200

Liabilities Creditors

Profit & loss

+ +

200 300 –209

300

300 600

1 000

500

2 750

6 000

2 000

–1 000 +

Equity Owners’ equity $

200

1 000

900

1 750

450 100 300

300 –209 –150

6 171

–20 –600 –1 700 871

6 000

Chapter 7: Debtors, creditors, accruals and prepayments

Billy Bond Statement of comprehensive income for June 20X0 $

Sales Cost of goods sold Gross profit Other expenses: Discount Telephone Wages Electricity

$ 3 400 1 700 1 700

20 123 600 86

829 871 0 871

Net profit Other comprehensive income Total comprehensive income

Billy Bond Balance sheet as at 30 June 20X0 Assets Current assets Bank Debtors Inventory Total current assets Non-current assets Shop equipment Total non-current assets Total assets Liabilities Current liabilities Creditors Total current liabilities Total liabilities Net assets Equity

Capital Profit & loss Total equity

$ 6 171 500 1 200 1 750

2 750

7 871 1 750

2 750

6 000 871

9 621

2 750 6 871

6 871

Chapter 7: Debtors, creditors, accruals and prepayments

8 a May 1 3 6 8 14 16 18 21 23 24

30 31

Record the $3000 in the bank and as owners’ equity Reduce bank and record fixed asset van Record inventory and creditor Record prepayment and reduce bank Record increase in inventory and creditors Increase in bank and revenue in P&L Record debtor and revenue Record expense and reduce bank Record revenue and debtor This is something the students have not been exposed to so it is useful to let them discuss in detail how they would treat the transaction so they can work out the principles involved. Reduce creditor by $700, bank by $682 and record as quasi-revenue the discount of $18 in the P&L. Once again this is new, so the students need to be encouraged to discuss this. In this case, asking the question ‘what is the future benefit to be received?’ often unlocks the problem for students. Increase bank by $360, reduce debtor by $400 and charge $40 to P&L as a bad debt. Reduce bank and charge salary as an expense. As far as the goods returned are concerned, once again this is new so the students need to be encouraged to discuss this. The question revolves around whether revenue should have been recognised in the first place, i.e. had a sale taken place at all. It can be argued that if Wheels can establish they had not ordered the goods then no sale should have been recorded, in which case revenue has to be reduced by the $80 and the creditor also has to be reduced by $80. Note: it is important that this is taken into account when calculating the cost of goods sold as it is our experience that it is often overlooked.

Note: no stock count was done at the end of the month but all goods were sold at a price based on the cost price plus one third. This introduces the idea of arriving at the amount of stock using sales less mark-up, a technique that is often used to produce regular accounts in the retail sector. b The obvious answer relates to the prepayment in respect of rent for the quarter, however, the question should be used to prompt students to think of other services and payments necessary to run the business. Examples are electricity and other utilities, business rates, telephones, advertising, bank charges and so on.

Chapter 7: Debtors, creditors, accruals and prepayments

c Barbie’s Bikes worksheet Assets Day 1 3 6 8 14 16 18 21 23 24 30

Transaction Capital Van Spokes Rent Olympic Sales Sales Petrol Sales Spokes Discount Debtors Bad debt Salary

31 Returns Goods sold Rent Balances

Bank $

3 000 –800

+ Van

+ Stock

800

Creditors

+ + Profit & loss

300

600

–682 360 –400

160

–40 80

3 000

–80 +

200 400 –20 600

–682 –18

–360 –40

+ 800

+ Owners’ equity

400

–840

Equity

700

–20

1 538

Liabilities

120

300

200

+ Debtors

$ 700

–120

Prepaids

520

300

−

–40 –400 –80 –840 -40 202

3 000

Chapter 7: Debtors, creditors, accruals and prepayments

Barbie’s Bikes Statement of comprehensive income for May 20X0 $

Sales Cost of goods sold Gross profit Other expenses Rent Bad debts Salary Petrol Discount Net Loss Other comprehensive income Total comprehensive income

$ 1 120 840 280

40 40 400 20 -18

482 -202 0 -202

Barbie’s Bikes Balance sheet as at 31 May 20X0 Assets Current assets Bank Debtors Prepayments Inventory Total current assets Non-current assets Van Total non-current assets Total assets Liabilities Current liabilities Creditors Net assets Equity

Total liabilities

Capital Profit & loss

Total equity

$ 1 538 520 80 160 800

300

2 298 800

300

3 000 (202)

9 Debtors Balance 31/12/X8 Add: Credit Sales Less: Cash receipts Balance 31/12/X9

X $1 022 111 $1 078 333 $187 000

3 098

300 2 798

2 798

Chapter 7: Debtors, creditors, accruals and prepayments

From this we can write X + $1 022 111 – $1 078 333 = $187 000 ∴ X ≈ –$243 222 10 Creditors balance 30 June 20X7 Deduct net purchases for the year Add payments for the year Balance as at 30 June 20X6

= = = =

$200 376 $2 975 345 $3 000 124 $225 155

11 Revenue Revenue

= + – = + = =

Lessons paid in advance at 30/6/X8 Cash receipts for 20X8/X9 Lessons paid in advance for 20X9/X10 20 × 20 × $5 + 30 × 10 × $7.50 25 650 – (500 × $5 + 250 × $7.50) 2 000 + 2 250 + 25 650 – 4 375 $25 525

12 Revenue $2 500 000 ∴X

= + – = = =

Unearned fees at 30/6/20X7 Cash receipts for 20X7/X8 Unearned fees as at 30/6/X8 X + $2 631 819 – $480 636 $2 500 000 – $2 631 819 + $480 636 $348 817

13 In this problem the ‘true’ solution depends on events that cannot be foreseen at the end of the accounting period. The preferred approach would be to record a proportion of the retainer as revenue in the 20X0 financial year on the basis that the retainer represents a payment to secure the lawyer’s ‘readiness to serve’ and this readiness extends beyond the end of the financial year. This proposition could be based on time, e.g. 1 August to 31 December equals five months, therefore 5/12 could be apportioned to revenue in the current period. The balance represents a present obligation (liability) to provide advice for the next seven months. 14 a Transaction 3 cash – $900 Transaction 5 A. Partridge capital – $2500 Transaction 7 cash and A. Partridge capital – $2000 Transaction 9 Debtors and A. Partridge capital – $4350

Chapter 7: Debtors, creditors, accruals and prepayments

b Flying High Financial Services Statement of comprehensive income for the month ended 31 January 20X3 Fees earned Operating expenses Rent expense Salaries expense Auto expense Supplies expense Miscellaneous expense Total operating expenses Net profit Other comprehensive income Total comprehensive income

$13 100

$2 500 2 000 1 250 1 050 350 7 150 $5 950 0 $5 950

c Flying High Financial Services Balance sheet as at 31 January 20X3 Assets Cash Accounts receivable Supplies Liabilities Accounts payable

Total assets

Owner’s equity A. Partridge capital Less drawings Add net profit Total liabilities and owners’ equity

11 250 4 350 275

$15 875

425 12 500 3 000 5 950

15 450 $15 875

15 It could be argued that no revenue is derived until the tour has been completed. On the other hand, the travel agency’s service can be said to be completed or at least substantially completed on the basis that the agency’s job is to arrange the tour. However, until the charter takes place, the agent has a present obligation (liability) to either provide the charter or give a refund. The introduction of the possibility of a refund adds strength to this argument. In concluding, students should consider the recognition principle (Key concept 6.3): • Is the earning process substantially complete and measurable? • Is the receipt of payment for the service reasonably certain? 16 a The credit unions with the lowest loan delinquency rate in all years are the largest credit unions with assets in excess of $200m. b • One explanation would be that the larger the credit union, the more money they can spend on evaluating loan applicants and thus they are better able to eliminate high-risk borrowers. • Another explanation could be that the larger credit unions attract better quality borrowers with less risk of default. • The data is consistent with the above two explanations because as the size of credit unions increases, the loan delinquency rates decline. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 7: Debtors, creditors, accruals and prepayments

17 a

The main assets of financial institutions are loans to customers. It dominates their assets and hence a small percentage loss could result in large dollar losses. Information on doubtful debts is important for all commercial entities but it is critical for financial institutions. Given the size of the asset loans it is vital for users to be able to assess the quality of the loans portfolio of a financial institution. Allowance for doubtful debts: Opening balance 1/1/20X2 Add: increases to allowance

$400 000 $110 000 $510 000 X $430 000

Less: write-off to allowance Closing balance 31/12/20X2

From above we can determine X to be $80 000. Opening balance 1/1/20X3 Add: increases to allowance Less: write-off to allowance Closing balance 31/12/20X3

$430 000 $116 000 $546 000 Y $460 000

From above we can determine Y to be $86 000. b It appears that the credit union is over-providing for bad debts. Instead of averaging 1 per cent of total losses the losses are closer to 0.2 per cent:

20X2

$80 000 $40 000 000

= 0.2%

20X3

$86 000 $43 000 000

= 0.2%

If in fact the allowance should only be based on 0.2 per cent of total loans then it means that: • net profit has been understated, and • total assets and members equity has been understated. However, the problem with the receivables for the credit union is that many loans will be repayable over long periods of time significantly greater than one year. Therefore, the real losses from bad debts for loans made in 20X2 may not be known for several years. Perhaps the allowance for doubtful debts should be reviewed and amended. A reduction to 0.2 per cent would be not warranted given the comments in (b). Assume allowance reduced to 0.5 per cent of outstanding loans. Required balance at 31/12/X3 $230 000 $460 000 Actual balance at 31/12/X3 Difference $230 000 The adjustment is achieved by adding $230 000 to the allowance for doubtful debts account (which reduces the balance of this negative asset) in the worksheet and adding $230 000 to the profit and loss column. Effectively this increases net profit and net assets.

Chapter 7: Debtors, creditors, accruals and prepayments

18 a

The write-off of the $50m will be to the allowance for doubtful debts account, which does not impact on profit (the bottom line) as the allowance levels of the bank are adequate to take the $50m write-off. Charges to the allowance account do not impact current profit. b If the bank used the direct write-off method the $50m would reduce profit as it would be an expense when it was written off. However, if the bank used only the direct write-off method, it would not be creating an expense as it does under the allowance method each time it increases the allowance account. Therefore, it is a matter of timing and this is the reason an allowance account is used to achieve a better timing of bad debts expensing and to ensure that receivables and revenue (profit) are not overstated. 19 a This means that in estimating the result for BankWest for the half year to 31 December 2002, the analysts at Macquarie are allowing $15.6 million extra charge for bad debts above what would be regarded as normal for the bank and thus are expecting a profit result that will be $15.6 million lower due to extra bad debt allowances. b Housing loans are generally regarded as a lower risk than lending for commercial purposes, such as business loans. The house provides a more reliable form of security than the value of a business and so a growth in commercial lending at the expense of home lending places the bank in a higher risk position. c The article demonstrates that analysts are often very aware of circumstances confronting listed entities, particularly high profile entities. Therefore, inappropriate accounting policies, such as not providing sufficient amounts for possible loan losses, will be quickly detected by analysts and will result in negative publicity for the offending entity. 20 a This refers to the amount set aside in the allowances for loan losses and loses expected on other receivables the bank has among its assets. It shows that in comparison to its peers it has a lower percentage of its risk weighted assets in its allowance account. It is not important that students understand risk weighted assets apart from a general understanding that some assets are riskier than others and the Reserve Bank expects a higher allowance amount for such assets. b As the banks operate in a similar environment you would expect the amount of allowances to be comparable, especially in the context of the article after CBA revealed it did have disclosure to ABC Learning and Allco Finance. If they had significant exposures to different assets, such as the sub-prime assets in the US, then you would expect different levels of allowances. 21 (Note to instructors: The number in the text book on page 212 is missing) a The allowance for bad loans is the bank’s estimate of the amount of current loan that it will not collect and thus profits are lower by the $23 million increase in the allowance b The allowance is an estimate of the amount of uncollectible loans in the banks portfolio of loans. The negative amount is entered into the allowance account in the worksheet with a corresponding entry into the profit and loss column of the worksheet. It is an accounting entry and involves no cash and therefore there is no cash set aside when the allowance is created. c The CEO is referring to the fact that in a strong economy fewer borrowers default on loan payments and so the estimate of expected loan losses as reflected in the balance of the allowance for bad loans is low in comparison to recessionary years. Hence the low base refers to a low balance in the account.

Chapter 7: Debtors, creditors, accruals and prepayments

Ethics case study a Effects on profit of change in doubtful debts expense: – Original percentages: $10 000 000 $5 000 000 $2 500 000 $1 000 000 $600 000

–

2% 6% 20% 35% 80%

= = = = =

$200 000 $300 000 $500 000 $350 000 $480 000 $1 830 000

$1 830 000/$19 100 000 = 9.58 per cent of receivables. New percentages: $10 000 000 $5 000 000 $2 500 000 $1 000 000 $600 000

1.5% 4% 18% 30% 60%

= = = = =

$150 000 $200 000 $450 000 $300 000 $360 000 $1 460 000

$1 460 000/$19 100 000 = 7.64 per cent of receivables. Overall, the effect on expenses would be a drop of $370 000 between the original and new percentages. b Relaxing credit policies may attract more sales but it will also expose the company to a greater risk of default on credit sales. This problem will be exacerbated by the downturn in the economy which means that, on average, customers will tend to have more difficulty meeting their commitments. The company may thus find itself in even bigger difficulties than before because it will need higher working capital to finance expanded operations but will face higher credit risk. The proposed change to the allowance will increase short-term profitability but does not change the underlying financial condition of the company. c Ethical issues associated with John’s plan include: – Non-compliance with s294 of the Corporations Act, which explicitly requires a reasonable assessment of the uncollectable debtors. The poor economic conditions suggest that it would be reasonable to increase the allowance, rather than decrease it as planned. – Non-compliance with professional ethical principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290) and competence and due care (APES 110–130). – Lack of honesty to company bankers, shareholders and the financial press. – The long-term consequences of the plan expose all stakeholders to greater risks (including bankruptcy). – Encourages poorer customers to buy products which they may not really be able to afford.

Chapter 8 Inventories and work in progress Review questions 1 Inventory includes items the business intends to sell for a profit. For a retailer like Woolworths, it includes all items in the Woolworths stores. For a car manufacturer like Toyota, it includes partially completed cars as well as completed cars. 2 Raw materials, work in progress, finished goods. 3 Increase in cost of goods sold figure and decrease in profit. 4 The physical stocktake allows an entity to establish how much of inventory it has compared to what the perpetual system states. This allows losses from theft and spoilage to be measured. 5 If the net realisable value is less than cost then to use cost would overstate the future benefits; on the other hand, if it is higher, to include the higher figure would mean that unrealised profits would be included in the profit for the period. 6 The answer here should bring out the distinction between directly variable costs and other costs attributable to getting the product to its ‘present state and condition’. 7 The question asks the student to look at FIFO, LIFO and average costs. The effects in times of rising prices are tabulated below: Method FIFO

Balance sheet Up to date value

LIFO AVERAGE

Out of date value understated Understated value mid point

Income statement Out of date values Overstated profit Up-to-date values Understated value mid point profit

8 Some useful examples are high technology versus more traditional industries, retail consumables versus furniture retailers.

Problems for discussion and analysis 1 Have students discuss the problems with determining the NRV. 2 Sales at retail $220 000 ∴ Sales at cost =

x $220000

= $176 000 Opening stock + purchases – ending stock = sales at cost $50 650 + $146 000 – x = $176 000 x = $20 650 3 Sales at retail is $786 000 Therefore sales at cost = 4/5 × $786 000 Cost of goods sold = $628 800 Opening inventory + purchases – purchase returns – ending inventory = cost of goods sold $10 000 + X – $27 000 = $628 800 X = $645 800 4 Sales at retail is $198 000 Therefore sales at cost = ⅔ × $198 000 Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 8: Inventories and work in progress

Cost of goods sold = $132 000 Opening inventory + purchases – purchase returns – ending inventory = cost of goods sold $60 000 + $100 000 – $8 000 – x = $132 000 $152 000 – x = $132 000 ∴ x = $20 000 ∴ Ending inventory is $20 000 5 Sales at retail value $490 000 which is 130 per cent of cost, therefore cost is 100/130 $490 000 = $376 923 Therefore, closing inventory = opening inventory + purchases – sales at cost = $27 400 + $376 000 – $376 923 = $26 477 6 December 6 December 10 December 13 December 20 December 24

Cost of sales = 3 @ $56 Cost of sales = 1 @ $56 + 4 @ $58 Cost of sales = 2 @ $58 + 4 @ $44 Cost of sales = 2 @ $44 + 1 @ $50 Cost of sales = 5 @ $50

= $168 = $288 = $292 = $138 = $250

Inventory 1 @ $56 + 6 @ $58 Inventory 2 @ $58 + 6 @ $44 Inventory 2 @ $44 Inventory 11 @ $50 Inventory 6 @ $50

7 The company has 200 tins remaining at the end of May. a FIFO periodic: Closing inventory = 100 × $8 + 100 × $8.50 = $1650 FIFO perpetual: Tins manufactured Opening stock May 3 4 7 12 14 16 18 20 23 25 27 30

750 400

Cost per tin $ 8.00 8.10

200 1 000

7.90 8.05

300

8.20

800

8.00

300

8.50

100

8.00

Tins sold 600 700 600 700 600 450

Closing stock $ 6 000 9 240 4 440 395 8 445 3 622.50 6 082.50 410 6 810 2 000 4 550 850 1 650

= $404 = $380 = $88 = $550 = $300

Chapter 8: Inventories and work in progress

b LIFO periodic: Closing inventory = 200 × $ 8 = $1600 LIFO perpetual: Tins manufactured Opening Stock May 3 4 7 12 14 16 18 20 23 25 27 30 Total

750 400

Cost per tin $ 8.00 8.10

200 1 000

7.90 8.05

300

8.20

800

8.00

300

8.50

100

8.00

Tins sold 600 700 600 700 600 450

3 850

Closing stock $ 6 000 9 240 4 400 400 8 445 3 622.50 6 082.50 410 6 810 2 000 4 550 850 1 650 3 650

Weighted average periodic: Weighted average price per unit = total unit costs for all purchases + OS total number of tins = $31 080 $3850 = $8.07 Closing stock = 200 × 8.07 = $1614

Chapter 8: Inventories and work in progress

Weighted average perpetual: Tins manufactured Opening stock May 3 4 7 12 14 16 18 20 23 25 27 30 Total

750 400

Cost per tin $ 8.00 8.10

200 1 000

7.90 8.05

300

8.20

800

8.00

300

8.50

100

8.00

Tins sold

600 (Av = 8.03) 700 (Av = 8) 600 (Av = 8.05) 700 (Av = 8.11) 600 (Av = 8.01) 450 (Av = 8.28)

3 850

Closing stock $ 6 000 9 240 4 416.50 400 8 450 3 622.50 6 082.50 405.50 6 805.50 2 002.50 4 552.50 828 1 628 3 650

Note that the average price in the table is rounded to two decimal places. 8 Phijen

Opening stock 7/1/20X0 2/2/20X0 4/4/20X0 26/5/20X0 17/8/20X0 19/9/20X0 10/10/20X0 11/12/20X0

Purchase Purchase Purchase Purchase Purchase Purchase Purchase Purchase

Sales Ending stock Average cost

Amount (kg) 77 000 200 000 180 000 250 000 250 000 200 000 350 000 100 000 175 000 1 782 000 (1 600 000) 182 000

197 200 1 782 000

11.066c

Unit price (cents) 10 9 15 6 7 9 12 17 20

Total $ 7 700 18 000 27 000 15 000 17 500 18 000 42 000 17 000 35 000 197 200

Chapter 8: Inventories and work in progress

FIFO periodic Ending inventory: 175 000 @ 20c 7 000 @ 17c

$35 000 $1 190 $36 190

Cost of materials sold: Cost of materials available for sale – ending inventory = $197 200 – $36 190 = $161 010 b LIFO periodic Ending inventory: 77 000 @ 10c 105 000 @ 9c

$7 700 $9 450 $17 150

Cost of materials sold: $197 200 – $17 150 = $180 050 c Weighted average Ending inventory: 182 000 @ 11.066c = $20 140 Cost of materials sold: $197 200 – $20 140 = $177 060 9 a Snorkel sets purchased during the year plus opening inventory = 328 Less sales = 328 – 293 Ending inventory = 35 i FIFO periodic: 35 snorkel sets at $43 each = $1505 ii LIFO periodic: 26 snorkel sets at $42 + 9 sets at $38 = $1434 iii Weighted average periodic: Average cost = 12 906/328 = $39.35 Ending inventory = 35 × $39.35 = $1 377.25

Chapter 8: Inventories and work in progress

b i

FIFO periodic: Swimworld Statement of comprehensive income for year ending 31 December 20X0 Sales Less Opening inventory + Purchases – Closing inventory Cost of goods sold

1 040 11 866 1 505

Gross profit

$ 23 440

11 401 12 039

LIFO periodic: Swimworld Statement of comprehensive income for year ending 31 December 20X0 Sales Less Opening inventory + Purchases – Closing inventory Cost of goods sold

1 040 11 866 1 434

Gross profit

iii

$ 23 440

11 472 11 968

Average cost periodic: Swimworld Statement of comprehensive income for year ending 31 December 20X0 Sales Less Opening inventory + Purchases – Closing inventory Cost of goods sold Gross profit

10 a

1 040 11 866 1 377

$ 23 440

11 529 11 911

Ending inventory: 1887 units on hand. i FIFO 730 1157 1887

@ $4.55 @ $4.40 units

$3 321.50 $5 090.80 $8 412.30

Chapter 8: Inventories and work in progress

LIFO

605 1 282 1 887

iii

1 887

@ $4.00 units

$3 600.00 $5 128.00 $8 728.27

Weighted average @ $4.3976

b Sales: 5 300 units @ $8 Beginning inventory Purchases Ending inventory Cost of goods sold Gross profit

$8 298.27 LIFO

FIFO

$42 400.00 3 600.00 28 005.54 31 605.54 8 728.00 $22 877.54 $19 522.46

$42 400.00 3 600.00 28 005.54 31 605.54 8 412.30 $23 193.24 $19 206.76

Weighted average $42 400.00 3 600.00 28 005.54 31 605.54 8 298.27 $23 307.27 $19 092.73

11 a b c 12 a

iii i i and vi The ending inventory figure in the balance sheet as at 30 June 20X0 will be understated by $10 000. This will be balanced by an understatement of the equity by the same amount. b The statement of comprehensive income will report a $10 000 lower profit and this will result in the understatement of the equity in the balance sheet as mentioned in (a) above. 13 a None, as inventory is determined by count. b None, as inventory is determined by count. c Understated. d Overstated. e Overstated. f Understated. g Understated, in that the liability should have been recorded in 20X1. h None, as although the liability is now recorded in 20X2 when it should have been recorded in 20X1, the balance of accounts payable will be correct. i None, as the overstated net profit in 20X1 is offset by the understatement of net profit in 20X2. 14 a None, as inventory is determined by count. b None, as inventory is determined by count. c Understated. d Overstated. e Overstated. f Understated. g Understated, in that the liability should have been recorded in 20X0. h None, as although the liability is now recorded in 20X1 when it should have been recorded in 20X0, the balance of accounts payable will be correct. i Overstated. j None, as the overstated net profit in 20X0 is offset by the understatement of net profit in 20X1. 15 The balance showing in the inventory account should be reduced by the value of the shortfall of goods. The loss is treated either as an expense in the statement of comprehensive income or Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 8: Inventories and work in progress

a part of the cost of goods sold. For management purposes it is desirable to identify the amount of inventory shortages separately. 16 LIFO does not assume anything about the physical flow of the merchandise and in an inflationary environment the ending inventory may be valued at prices prevailing several years ago. Proponents of LIFO base their primary arguments on the matching concept by arguing that the gross margin should reflect the difference between sales revenue and the current cost of the goods sold. 17 In developing a response to Joanne’s concerns, you should probably first emphasise the practical need for an assumption concerning the flow of cost of goods purchased and sold. That is, when identical goods are frequently purchased, it may not be practical to specifically identify each item of inventory. If all the identical goods were purchased at the same price, it wouldn’t make any difference for financial reporting purposes which goods we assumed were sold first, second and so on. However, in most cases, goods are purchased over time at different prices, and hence, a need arises to determine which goods are sold so that the price (cost) of those goods can be matched against the revenues to determine operating profit. Next, you should emphasise that accounting principles allow for the fact that the physical flow of the goods may differ from the flow of costs. Specifically, accounting principles allow for three cost flow assumptions: first-in, first-out; last-in, first-out (only in the USA); and average. Each of these methods has advantages and disadvantages. One primary advantage of the last-in, first-out method is that it better matches current costs (the cost of goods purchased last) with current revenues. Therefore, the reported operating profit is more reflective of current operations and what might be expected in the future. Another reason that the last-in, first-out method is often used is that it tends to minimise taxes (only allowed to be used for tax purposes in the USA) during periods of price increases. Since for most businesses prices tend to increase, the LIFO method will generate lower taxes than will the alternative cost flow methods. The preceding explanation should help Joanne better understand LIFO and its impact on the financial statements and taxes. 18 In the case of the motorcycle dealer, the economics of the operation would clearly be better represented by using a FIFO method of inventory valuation (a method of specific identification would be better still), however, FIFO would achieve a reasonable approximation of this. The car parts dealer, on the other hand, would be best suited by applying the LIFO method of valuation. 19 The answer below is based on both an absorption costing approach and a variable costing approach although the question is deliberately not explicit about which should be used. Point of production Pre-cutting room Cutting room Machine room Packaging Despatch Overall

Variable Material only Direct staff Materials Direct staff Arguably no cost None None

Absorption Material + storeworker’s wages Direct staff + supervisor Materials Direct staff + supervisor Cost of part-timer None Production manager

Obviously some of the above are debatable and such debate should be encouraged as it provides the student with a feel of the problems encountered in real life.

Chapter 8: Inventories and work in progress

20 a

FIFO: 20X0

20X1

20X2

Cost of goods sold 2 300 750 475 3 525 Inventory 525 500 250 1 275 Cost of goods sold 1 275 875 875 825 3 850 Inventory 50 1 250 1 300 Cost of goods sold 1 300 1 250 875 263 3 688 Inventory 612 875 1 487

@ @ @

$ 24.06 24.38 25.00

$ 55 338 18 285 11 875 85 498

@ @ @

25.00 25.31 25.62

13 125 12 655 6 405 32 185

@ @ @

25.62 25.62 26.26

@ @

26.26 26.56

@ @ @

26.56 26.88 26.88

@ @

26.88 26.88

32 185 22 418 22 418 21 665 98 686 1 313 33 200 34 513 34 513 33 200 23 520 7 069 98 302 16 451 23 520 39 971

Chapter 8: Inventories and work in progress

LIFO:

20X0

20X1

20X2

iii

Cost of goods sold 250 500 1 000 750 1 025 3 525 Inventory 1 275 Cost of goods sold 1 250 875 875 850 3 850 Inventory 1 275 25 1 300 Cost of goods sold 875 875 875 1 063 3 688 Inventory 1 275 25 187 1 487

@ @ @ @ @

$ 25.62 25.31 25.00 24.38 24.06

$ 6 405 12 655 25 000 18 285 24 662 87 007

24.06

30 676

@ @ @ @

26.56 26.26 25.62 25.62

33 200 22 978 22 418 21 777 100 373

@ @

24.06 25.62

30 676 641 31 317

@ @ @ @

26.88 26.88 26.88 26.56

23 520 23 520 23 520 28 233 98 793

@ @ @

24.06 25.62 26.56

30 676 641 4 967 36 284

Average: 20X0 20X1 20X2

Cost of goods sold Inventory Cost of goods sold Inventory Cost of goods sold Inventory

3 525 1 275 3 850 1 300 3 688 1 487

@ @ @ @ @ @

$ 24.517 24.517 25.684 25.684 26.502 26.502

$ 86 422 31 259 98 883 33 389 97 739 39 408

Note: It should be pointed out to students that a lot of effort can be saved by simply applying the equation beginning inventory + purchases = COGS + closing inventory.

Chapter 8: Inventories and work in progress

b FIFO: 20X2

Cost of goods sold

1 487 1 888 3 375

@ @

$ 26.88 27.19

Inventory

500

27.19

Cost of goods sold

2 388 187 25 775

$ @ 27.19 @ 26.56 @ 25.62 @ 24.06

$ 64 930 4 967 641 18 647 _____ 89 185

Inventory

500

@ 24.06

12 030

LIFO: 20X2

21 a

$ 39 971 51 335 91 306 _____ 13 595

Tutors should discuss the lowering of cost of goods sold and hence the increase in profit in 20X2 for LIFO compared to FIFO. This is contrary to the other three years and is despite the fact that costs still increased in 20X2. This is due to the lowering of the ending stock levels and as a result the lower unit cost flowing through cost of goods sold under LIFO. Have goods been stolen? Sales Estimated gross profit 30/130 × $1 550 000 Actual gross profit Estimated deficit

Has cash been stolen or any sales not accounted for? Cost of goods sold Estimated gross profit at 30% Actual gross profit Estimated deficit

$ 1 550 000 357 692 342 500 15 192 $ 1 207 500 362 250 342 500 19 750

Both approaches to measuring estimated gross profit reveal a shortfall of either $15 192 or $19 750. No, it is not possible to determine if theft has occurred by staff or customers. However, something is wrong. b No, it is not possible to determine if cash or goods or both were stolen. c It is fair to say that a perpetual inventory system would normally improve internal control over inventories. However, the cost of the system at $21 000 is high and unnecessary given the deficit calculated under (a) above is at most $19 750. In addition, only the more expensive items would be monitored by the system. d By spending $21 000 on advertising, Joan would increase gross profit by $48 462. The campaign should therefore be immediately undertaken.

Chapter 8: Inventories and work in progress

22 a

First-in, first-out method: 1 000 1 000 1 600 400 4 000

iii

units at $16.00 units at $14.95 units at $14.50 units at $14.25 units

$16 000 $14 950 $23 200 $5 700 $59 850

Last-in, first-out method:

3 875 125 4 000

units at $12.20 units at $13.00 units

$47 275 $1 625 $48 900

Average cost method:

4 000

units at $13.58*

$54 320

*($339 500 ÷ 25 000) = $13.58 b Sales Cost of merchandise sold* Gross profit *Cost of merchandise available for sale Less ending inventory Cost of merchandise sold

FIFO $552 000 $279 650 $272 350 $339 500

LIFO $552 000 $290 600 $261 400 $339 500

Average cost $552 000 $285 180 $266 820 $339 500

$59 850 $279 650

$48 900 $290 600

$54 320 $285 180

i The LIFO method is often viewed as the best basis for reflecting profit from operations. This is because the LIFO method matches the most current cost of merchandise purchases against current sales. The matching of current costs with current sales results in a gross profit amount that many consider to best reflect the results of current operations. For Elvin Company, the gross profit of $261 400 reflects the matching of the most current costs of the product of $290 600 against the current period sales of $552 000. This matching of current costs with current sales also tends to minimise the effects of price trends on the results of operations. The LIFO method will not match current sales and the current cost of merchandise sold if the current period quantity of sales exceeds the current period quantity of purchases. In this case, the cost of merchandise sold will include a portion of the cost of the beginning inventory, which may have a unit cost from purchases made several years prior to the current period. The results of operations may then be distorted in the sense of the current matching concept. This situation occurs rarely in most businesses because of consistently increasing quantities of year-end inventory from year to year. While the LIFO method is often viewed as the best method for matching revenues and expenses, the FIFO method is often in harmony with the physical movement of merchandise in a business, since most businesses tend to dispose of commodities in the order of their acquisition. To the extent that this is the case, the FIFO method approximates the results that will be attained by a specific identification of costs. The average cost method is, in a sense, a compromise between LIFO and FIFO. The effect of price trends is averaged, both in determining net profit and in determining inventory cost. Which inventory costing method best reflects the results of operations for Elvin Company depends upon whether one emphasises the importance of matching revenues and expenses (the LIFO method) or whether one emphasises the physical flow of Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 8: Inventories and work in progress

merchandise (the FIFO method). The average cost method might be considered best if one emphasises the matching and physical flow of goods concepts equally. ii The FIFO method provides the best reflection of the replacement cost of the ending inventory for the balance sheet. This is because the amount reported on the balance sheet for merchandise inventory will be assigned costs from the most recent purchases. For most businesses, these costs will reflect purchases made near the end of the period. For example, Elvin Company’s ending inventory on 31 December 20X2 is assigned costs totalling $59 850 under the FIFO method. These costs represent purchases made during the period of August through December. This FIFO inventory amount ($59 850) more closely approximates the replacement cost of the ending inventory than either the LIFO ($48 900) or the average cost ($54 320) figures. iii The advantages of the perpetual inventory system include the following: • A perpetual inventory system provides an effective means of control over inventory. A comparison of the amount of inventory on hand with the balance of the subsidiary account can be used to determine the existence and seriousness of any inventory shortages. • A perpetual inventory system provides an accurate method for determining inventories used in the preparation of interim statements. • A perpetual inventory system provides an aid for maintaining inventories at optimum levels. Frequent review of the perpetual inventory records helps management in the timely reordering of merchandise, so that loss of sales and excessive accumulation of inventory are avoided. An analysis of Elvin Company’s purchases and sales, as shown below, indicates that the company may have accumulated excess inventory from May to August because the amount of monthend inventory increased materially, while sales remained relatively constant for the period. Month

Purchases

Sales

April May June July August September October November December

3875 units 4125 5000 5000 3400 — 1600 1000 1000

2000 units 2000 2500 3000 3500 3500 2250 1250 1000

Increase (decrease) in inventory 1875 units 2125 2500 2000 (100) (3500) (650) (250) 0

Inventory at end of month

Next month’s sales

1875 units 4000 6500 8500 8400 4900 4250 4000 4000

2000 units 2500 3000 3500 3500 2250 1250 1000 —

It appears that during April through July, the company ordered inventory without regard to the accumulation of excess inventory. A perpetual inventory system might have prevented this excess accumulation from occurring. The primary disadvantage of the perpetual inventory system is the cost of maintaining the necessary inventory records. However, computers may be used to reduce this cost. 23 a The fact that a number of accounting managers from California, where the errors occurred, were fired suggests that the errors may have been deliberate and may be related to achieving target profit figures. Another possible explanation could be the employees did not have adequate accounting skills.

Chapter 8: Inventories and work in progress

b Shareholders who purchased shares during the period of the overstated earnings may have paid too much while those who sold may have received more than they otherwise would have. Clearly the managers who lost their jobs suffered. The company’s reputation may have been negatively impacted, affecting future sales and hence shareholders. c The issue about the auditor would depend very much on whether they were negligent in conducting the audit. As discussed in Chapter 2, the auditor does not do a 100 per cent check and therefore there is no guarantee that they will discover all errors. Given the size of the errors were material, there is more onus on the auditor to uncover such errors. It is possible the auditor may face charges over the failure to uncover the errors.

Ethics case study a Implications of the proposed plan: – relative to beginning inventory, the unit prices of ending inventory will be lower – under LIFO the latest purchased inventory is expensed first, and the oldest inventory is assumed to be held in ending inventory – this means that, in this case, the lower cost items will be expensed, thus increasing profit relative to that which would have been reported if Troy’s plan was not adopted. b Positive consequences of the plan for Elsi Mate Ltd and its shareholders: – all other things being equal, the company should be able to refinance its loans and maintain a lower interest cost – the low interest costs and refinancing may help the company to trade out of its difficulties – the low interest costs and resulting higher profits may mean higher dividends for shareholders (or maybe higher share prices than would otherwise be the case, assuming the market is uninformed from other sources about Elsi Mate Ltd’s difficulties). Negative consequences: – the company may be left with inventory that it cannot shift (higher storage costs, risk of obsolescence and so on). This could create further cash flow problems for the company leading to bankruptcy (losses for creditors and shareholders) – a failure to disclose the ‘true’ situation now may encourage creditors to continue to lend money but not solve the company’s problems. As such, creditors’ and investors’ losses may be greater in the long run than if action were taken now to address the problems or wind-up the company. c Is the plan ethical? Some issues here include: – Compliance with accounting standards. The use of LIFO is not consistent with AASB 102 and consequently APS 1 para. 10 and the principle of technical and professional standards CPC B6. The USA is one of the few jurisdictions where LIFO is permitted. – Non-compliance with other professional ethical principles. The plan does not sit well with the principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290) and competence and due care (APES 110–130). – The proposed plan lacks honesty and, given unknowns about the company’s ability to trade out of its difficulties, may also impose greater losses on creditors and shareholders than if the plan was not undertaken.

Chapter 9 Non-current assets and depreciation Review questions 1 Technological advances, past experience, the factors that cause the asset to wear out. Note: it is important to emphasise that at best this is only an estimate. 2 Broadly the criteria are: has there been an enhancement of the future benefits as a result of incurring the cost? Specifically we ask if the cost was reasonable and necessary to get the asset to its location and condition ready for use. 3 These are alternative terms which are often used interchangeably to describe the figure arrived at after taking the accumulated depreciation away from the historic cost. 4 Generally expenses are more certain in amount and it is easier to identify what has been used up as it is all used up in one period. 5 An intangible asset is an item that meets the definition of an asset but doesn’t have any physical characteristics and is not held for investment purposes. Examples are patents, trademarks, brand names and goodwill. 6 Materiality is an important accounting concept and is related to whether or not an item will make a difference to an investor’s decision. 7 a Other income and other expenses sections. b The cost and accumulated depreciation should be removed from the accounts when the asset is no longer useful and is removed from service. Presumably, the asset will then be sold, traded in or discarded. 8 This should be recorded as a capital expenditure. It is part of the cost to prepare the van for use.

Problems for discussion and analysis 1 a i $37.2 million (Note 2) ii $700.9 million (Note 2). You may want to discuss how this is so much larger than part (i). The answer is that Woolworths has the use of most of its shops under operating leases (Note 22), which do not result in assets on the balance sheet. b Straight line basis (Note 1 G ii) c Intangible assets are $5236.6 million as at 26 June 2011 These consisted of goodwill, brand names, liquor licences and other. Goodwill is the excess purchase price over the fair value of the net assets of an acquired entity paid by the acquirer. 2 Widget life = eight years Residual value = $20 000 Cost = ? After four years, carrying value must be $84 000 ($88 000 – $4000). We can therefore determine the depreciation amount per year for the last four years as: 84000 − 20000

= 16000

Chapter 9: Non-current assets and depreciation

Cost = 8 × $16 000 + $20 000 = $148 000 3 First year 10% of $154 000 = $15 400 20% of $154 000 = $30 800

a b

Second year 10% of $154 000 = $15 400 20% of $123 200* = $24 640

*$154 000 – $30 800

4 a $185 000 ($220 000 – $35 000) b $220,000 as this is the fair value of the new machine. 5 a Straight-line method = $23 000 – $2000 6 = $3500 pa = $17 500 (5 × $3500) b $1000 loss ($12 500 – $11 500) c Reducing-balance method: Year one = $23 000 × 25% = $5750 Year two = $17 250 × 25% = $4312 Year three = $12 938 × 25% = $3234 Total depreciation = $13 296 Carrying value = $23 000 – $13 296 = $9704 A sale at $11 500 yields a gain of $1796 6

7 a

= ∴

Plant at 31 December 20X8 Add purchases Less cost of plant sold Plant at 31 December 20X9 Cost of plant sold is

= ∴

Accumulated depreciation at 31 December 20X8 Add depreciation for 20X9 Less depreciation eliminated Accumulated depreciation at 31 December 20X9 X = $225 000

$ 2 000 000 500 000 X 2 100 000 400 000 750 000 500 000 X 1 025 000

Plant sold: Cost Accumulated depreciation

400 000 225 000

carrying value Add gain on disposal Sale proceeds

175 000 50 000 225 000

Cost of machine: Invoice amount Transport Site works Insurance Total

Chapter 9: Non-current assets and depreciation

b 8 a

b 9 a

Repair due to damage not included as it was not reasonable or necessary. i Straight-line method = $33 500 − $1000 = $3250 per annum 10 = $6500 for two years. ii Reducing-balance percentage = 1 – 10√(1000/33 500) = 1 – 0.704 = 29.6% Year one = $33 500 × 29.6 % = $9916 Year two = $23 584 × 29.6 % = $6981 The reducing-balance method will have the greatest impact on profits in the early years and the situation reverses in later years. Cost of old plant = $2000 (must be the same as the new plant acquired as the amount in plant remains the same). Accumulated depreciation = $1500 ($12 400 + $1 500 – $12 400) Carrying value = $2000 – $1500 = $500 Amount received for old plant = $500 – loss of $100 = $400 Cost = ($75 000 × 2) + ($5000 × 2) + ($1000 × 2) + $500 + $400 + $3750 = $166 650 Straight-line = $166 650 = $8332.5 pa 20 Reducing-balance = $166 650 × 0.10 = $16 650 Year two = $166 650 – $16 650 × 0.10 = $15 000 Year three = $166 650 – $31 650 × 0.10 = $13 500

10 a–d

Depreciation expense: Year

20X2 20X3 20X4 Total

a Straight-line method $ 105 000 105 000 105 000 315 000

b Units-of-production method $ 131 250 105 000 78 750 315 000

c Declining-balance method $ 226 678 75 518 12 804 315 000

Calculations: Straight-line method: ($340 000 – $25 000) ÷ 3 = $105 000 each year Units-of-production method: ($340 000 – $25 000) ÷ 18 000 hours = $17.50 per hour 20X2: 7500 hours @ $17.50 = $131 250 20X3: 6000 hours @ $17.50 = $105 000 20X4: 4500 hours @ $17.50 = $78 750 Declining-balance method: 20X2: $340 000 × 2/3 = $226 678 20X3: ($340 000 – $226 678) × 2/3 = $75 518 Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 9: Non-current assets and depreciation

20X4: ($340 000 – $226 678 – $75 518 – $25 000*) = $12 804 * carrying value should not be reduced below the residual value of $25 000. 11 Note: in this answer the interest on the machine bought by instalments has been dealt with on a separate line. This is because the students will be dealing with this for the first time and this is thought to be a clearer presentation. Bert’s Business Statement of comprehensive income Sales Cost of sales Gross profit Expenses Rent Wages Interest Dep’n car Dep’n machine Net profit Other comprehensive income Total comprehensive income

1 800 6 000 300 1 200 2 100

Bert’s Business Balance sheet $

Assets Current assets Bank Inventory

Total current assets Non-current assets Cars Less depreciation Machines Less depreciation Total non-current assets Total assets Net assets Equity Capital Profit

Total equity

$ 30 000 17 000 13 000

11 400 1 600 0 1 600

$ 5 400 2 000

4 000 1 200 6 500 2 100

7 400

2 800 4 400

13 000 1 600

7 200 14 600 14 600

14 600

Chapter 9: Non-current assets and depreciation

11 Assets Month/ transaction 1

Interest 2 3

4 5–7

8–12

Capital Car Machine Machine + Stock Sales Rent Wages Sales Stock Instalment Sales Stock Sales Wages Rent Instalment Sales Stock Wages Rent Dep’n Car Dep Mach

Balance Stock sold Rent accrual Balances

Bert’s Business worksheet Bank

$ 9 000

Car

(Car, accum. dep’n) $

4 000

–4 000 –1 000

Machines

(Machine accum. dep’n) $

Materials

4 000 2 500

–3 000 3 000 –600 –1 500 4 000 –8 000 –900 4 000 –2 000 5 000 –1 500 –600 –900 14 000 –6 000 –3 000 –600

3 000

Creditors

$ 9 000 4 000

1 800

–300

−900

14 000

(2 100)

4 000

−

1 200

6 500

−

2 100

+ −

19 000 17 000

5400

4 000

−

1 200

6 500

−

2 100

2 000

5 000 –1 500 –600

6 000

Owners’ equity

4 000

−2 100

5 400

3 000 –600 –1 500 4 000

8 000 2 000

−1 200

Profit & loss

+ =

600 600

+ – – +

–3 000 –600 –1 200 –2 100 18 600 17 000 600 1 000

13 000

Chapter 9: Non-current assets and depreciation

12 Depreciation schedule for Fairhead Company Type of asset

Date of acquisition

Building A Machinery Office equipment Delivery equipment Building B Building C New delivery equipment Building E

1/7/X3 1/1/X4 1/7/X5 1/4/X4 1/1/X8 1/1/X8 1/4/X8 1/7/X8

New office equipment

1/10/X8

Cost

Residual value

Amount to be depreciated

$ 252 000 29 000 14 000 40 000 32 000 * 40 000** 27 000 36 000 (28 000 + 8 000 cost of building D) 7 500

12 000 1 000 1 500 4 000 0 0 1 800 0 500

40,000 x 160,000 = 32,000 200,000 50,000 * * Building C Cost = x 160,000 = 40,000 200,000

Useful life Years

Accumulated depreciation 31/12/20X7 $

Depreciation expense 20X8 $

240 000 28 000 12 500 36 000 32 000 40 000 25 200 36 000

20 7 5 4 20 20 4 20

54 000 16 000 6 250 33 750 – – – –

12 000 4 000 2 500 6 250*** 1 600 2 000 4 725 900

7 000

350

* Building B Cost =

*** Assume residual value now zero as it is retained for emergency use. An alternative may be to spread the estimated residual value of $4000 over the period the equipment is expected to be available for emergency use.

Chapter 9: Non-current assets and depreciation

13 a

Land is normally not depreciated as it is assumed not to wear out. The building should be depreciated and a stronger case can be made for the use of the straight-line method than the reducing-balance method. b In this case it would seem that for the cars they should be depreciated over four years as they are unlikely to do 60 000 kilometres. The vans, on the other hand, should be traded in after three years purely on the basis of kilometres travelled. The question then is do we use up more future benefit in the earlier years than in later years? An argument can be put up suggesting that the wearing out process is even over the life of the assets and the incidence of repair costs is greater in later years. This argument would indicate that straight-line is the more appropriate method of depreciation. However, if we look at the total costs of using the vehicles, one could argue that by using the reducing-balance method the repair costs in later life would be compensated by the additional depreciation in earlier years so achieving a matching of costs and revenues over the assets’ life. c Type one: depreciate over five years; if the contract is not renewed, asset has little value. No particular method is clearly more appropriate. Type two: the facts suggest the reducing-balance method would be the choice. The same argument as outlined for vehicles is appropriate. Type three: it may be that the appropriate method is usage related in this case. Apart from that, there is no strong reason for one method rather than another, although as the first year has lower production than later years, it would be difficult in terms of wearing out to argue for the reducing-balance method. 14 Tutors may wish to deal with this problem by having students view the construction of the factory extensions as if it were carried out by an independent firm. Make sure you mention materiality. In these circumstances the construction cost would include all items listed with the exception of g (cost of major errors) and i (claims not covered by workers’ compensation insurance). Such costs are not reasonable and necessarily incurred in this construction. (These could arguably be included under some circumstances.) The contractor would build an interest cost into the price as well as recovery for overheads and so on, comparable to the overheads of Multiplex’s own overhead costs. A marginal cost approach would not include h and possibly f. 15 The point illustrated by this question is that the cost of a non-current asset includes all reasonable and necessary costs incurred to place the asset in a position and condition ready for use. A case could certainly be raised to include items a, b, and c in the cost of the new machine. So far as the trade-in of the machine is concerned, normal practice would be to treat the difference between the trade-in and carrying values of the machine as a gain on disposal. 16 In considering this question students should look at the definition of an asset under the Framework. Before an item qualifies for inclusion in the financial statements it must be probable that future economic benefits will eventuate. Such future economic benefits must be controlled by the entity and be able to be reliably measured. In this case, although past experience has shown that the equipment lasted for five years, does the customer have the right to terminate the lease before the completion of five years? Consideration should be given to the costs of dismantling and removing the equipment. Tutors may like to discuss the issue of cancelling the lease; if the lease cannot be cancelled a stronger case exists for capitalising the service costs, which are not immaterial.

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17 a Sydney Building $408,000 × 5%

Melbourne 408,000 + 40,000 − 8,000 40

= $20 400 Fixtures $40,000 × 40%

= $11 000 40,000 − 5,000 5

= $16 000 Equipment $34,000 × 25%

= $7 000 34,000 − 2,000 8

= $8 500

18 a

19 a

= $4 000

From the above table we determine that the brother in Melbourne has added the building renovation to the asset and used straight-line depreciation for all three assets. The brother in Sydney has expensed the $40 000 renovation cost and used reducingbalance method at double the straight-line rate for all three assets. The Sydney brother expensed the full cost in one year. The Melbourne brother added the cost to the building and as a result it will be spread over 40 years. It is difficult to say which is correct. The amount is material at 10 per cent of the cost of the building. If the renovation increases the future economic benefits of the building or extends the life then it should be added to the cost of the asset. If not, it should be expensed. The case study is meant to highlight to students the difference between underlying profitability and reported profits. Assuming both brothers use the same depreciation methods for their assets, then based on the profit and loss statements, it is difficult to differentiate between the two shops. In the straight-line method, the life of the asset appears in the denominator of the formula and, if the number increases, the resultant calculation (with no change to the numerator) will be lower. The deprecation amount is the result of this calculation. In the reducing-balance method, the life of the asset is used in the formula to determine the rate to apply to the depreciable amount. The longer the life, the lower the rate, hence the lower the depreciation amount in the early years of the asset’s life. While the total depreciation may be the same at the end of the asset’s life, the spread through the life will be different. A longer life means it takes more years to claim the amount of tax deductions allowable for depreciation. This means, given the time value of money, the present value of the tax savings arising from depreciation deductions will be less when the time to claim the deductions is longer. Remember, the total tax deduction from depreciation remains the same but the amount can now only be claimed as a tax deduction over a longer period of time. Depreciation is the systematic allocation of the cost or revalued amount of a tangible non-current asset over its useful life. Amortisation is similar but relates to intangible assets with a finite life. Depreciation is not an attempt to measure the fair value of an asset. The written down value of an asset is simply the cost or revalued amount less accumulated depreciation. It is not meant to represent what an asset can be sold for, except by chance.

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The StarHub result would have only been $1.3 million profit without the change to depreciation. The friend needs to understand that depreciation is an accounting policy and changes to the depreciation have no impact on the cash flows of StarHub. The friend should be looking at all the other aspects of the company and not purchase based on the increase in profit.

Ethics case study a Who does Kylie ultimately report to? Points to discuss include: – In terms of ‘line management’, Kylie reports to Adam Lake but she also, as division controller, has to report to the company-wide controller. This immediately creates a conflict in this case – her responsibilities to Adam reflect his division’s interests but these are not in keeping with her responsibilities to the company controller whose interests are those of the entire company. – If the phrase ‘report to’ is defined more widely to mean to whom is she ‘responsible’, then the question is even more complex because other stakeholders are involved. For instance, many would argue that the company should be run to maximise shareholder value. Is there a hierarchy of Kylie’s responsibilities to stakeholders – i.e., do the interests of the shareholders (perhaps as evidenced by the instructions of the Board or company controller) override the interests of Adam and his division? b Should Kylie agree to Adam’s plan? Kylie’s problem illustrates a classical ethical conflict between compliance with the rules/policy (deontology) versus consideration of the consequences (utilitarianism). When making her decision, Kylie must give due thought to both perspectives. Some points to discuss include: – As implied in part (a), Kylie has a duty to comply with the company’s policies. As controller, she is, at least in part, responsible for implementing them. – Kylie also has a duty of loyalty to her boss, Adam, and the division, but does this loyalty outweigh the responsibilities to shareholders? – If the plan is not adopted, then an important customer may be lost and the division’s performance will fall. The loss of the customer could also cause losses to the company overall. – The manufacturer of the machinery may resent Adam’s abrupt dictation of terms and consequently not agree to the invoicing plan (or maybe even withdraw their services). – The breach of company policy, if discovered, could lead to disciplinary action for Adam and Kylie. It could also result in some financial problems for the company – what are the reasons why the chairman of the budget committee is so adamant that the capital expenditures will not be considered? – The breach of policy is not in keeping with the ethical professional principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290) and competence and due care (APES 110–130). – If the policy is breached this time, Adam may be encouraged to ask Kylie to make further breaches in the future. Having complied once, it will become much more difficult for her to refuse next time.

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What should Kylie do? Some possible alternatives include: – Refuse to comply with Adam’s instruction – this complies with company policy and relevant ethical principles, but loss of the customer could result (with its attendant financial consequences); this action sours Kylie’s working relationship with Adam. – Comply with Adam’s instruction – this breaks company policy and is inconsistent with ethical principles but it maintains the customer and assists the division to meet its performance targets. However, the machine manufacturer may not agree to the payment terms. Also, the breach of policy may be discovered and result in disciplinary action against Adam and Kylie. This option may also create short-term financial hardship for the company if it is experiencing cash flow problems. – Adam and Kylie could prepare a special submission to the budget committee highlighting the importance of the customer to overall company performance. If the budget committee refuses to entertain the proposal, Adam and Kylie could take the matter to the CEO or board of directors. Such an option would be in keeping with company policies and may have the desired outcome.

Note: this case is also an opportunity to consider how a company’s policies and performance measures can lead to dysfunctional behaviour.

Chapter 10 Financing and business structures Review questions 1 Debt finance creates a present obligation and must be repaid. Interest is also required to be paid. Equity finance does not create an obligation to repay for the entity and payment of dividends is optional. 2 Drawings are the amount withdrawn from a business by a sole proprietor or a partner. Dividends are amounts paid to shareholders in a company. 3 Highly geared companies have a large proportion of debt finance compared to equity finance in their capital structure. 4 All forms of short-term finance may involve security over some assets of the company or its directors. Factoring – security over debtor. Bank overdraft – may be secured or security over some assets may be required. Trade credit – often no security required but in small business this may be required. 5 See answer to Question 4 above. 6 A lease is a contractual relationship between two parties in which the lessee enjoys the right to use an asset in exchange for a series of lease payments to the lessor. Example: a milk bar may lease refrigeration equipment from the manufacturer of that equipment for the purposes of storing and selling frozen goods. 7 Equity finance is the finance provided by the owners as follows: Companies – shareholders Partnership – partners Sole proprietorship – the owner 8 Factoring is when a business sells its debtors to an entity that specialises in collecting monies from others. In return, the business gets immediate access to cash but pays a fee for doing this. 9 Information would include profitability, cash flows, assets and liabilities, management expertise and so on. 10 A hire purchase agreement is a way of financing the purchase of an asset and at the end of the hire purchase period; the hirer becomes the legal owner whereas this is not the specific aim of a lease. 11 A debenture is a debt instrument and is normally for a medium- to long-term period.

Problems for discussion and analysis 1 a b c d

$13,248.7 million (balance sheet). 62.8% in 2011; 57.7% in 2010 based on total liabilities to total assets. 168.8% in 2011;136.5% in 2010 61.7% in 2011;45.3% in 2010

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2 First we should determine the payments involved with each option. Loan: Year 1

Total

Principal payment $6 000 $6 000 $6 000 $6 000 $6 000 $30 000

Interest payment $6 000 $4 800 $3 600 $2 400 $1 200 $16 000

Present value at 20% $9996 $7495 $5549 $4049 $2887 $29 976

Total payment = $46 000 Hire purchase: $799 × 12 = $9588 per annum Total payment = 5 × $9588 = $47 940 Present value at 20 per cent = 9588 × 2.9906 = $28 674 The cost of each option is very similar although the hire purchase is slightly higher in nominal terms. However, the loan involves larger payments in the first two years and the present value of the cost of the loan at 20 per cent is higher. Note: we deal with present values in Appendix 2 and Chapter 15 so you may choose not to discuss the present values of these two options at this stage. The above analysis is simplistic and ignores tax issues and the present value of the hire purchase option is an approximation as it is based on an annual payment when in fact the payments are monthly. However, based on this analysis, the cost of each option is similar in both nominal and present value terms. Other issues, such as how easy it is to set up each option and any costs associated with set up, will help decide which is the best option. 3 First we should determine the payments involved with each option. Loan: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total

Principal payment $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $1 000 000 $10 000 000

Interest payment $60 000 $54 000 $48 000 $42 000 $36 000 $30 000 $24 000 $18 000 $12 000 $6 000 $330 000

Present value at 6% $999 993 $938 050 $879 911 $825 358 $774 151 $726 109 $681 011 $628 539 $592 600 $561 740 $7 607 462

Total payment = $13 300 000 Hire purchase: $398 000 × 4 = $1 592 000 per annum Total payment = 10 × $1 592 000 = $15 920 000 Present value at 6 per cent = 1 592 000 × 11.4699 = $18 260 080 The cost of each option in Problem 2 was very similar but in this question, the cost of the hire purchase option both in nominal and present value terms is much higher.

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Note: we deal with present values in Appendix 2 and Chapter 15 so you may choose not to discuss the present values of these two options at this stage. The above analysis is simplistic and ignores tax issues and the present value of the hire purchase option is an approximation as it is based on an annual payment when in fact the payments are quarterly. However, based on this analysis the cost of the loan is much cheaper and is to be recommended. Other issues, such as how easy it is to set up each option and any costs associated with set up, need to be considered but are not likely to alter this decision. 4 a The bank overdraft is a facility that can be used as and when required and interest is only charged when it is used. Therefore, if Bettause Ltd knows that it needs money for a fixed period of time then the bank loan may be appropriate. On the other hand, if the finance is only required to meet occasional short-term cash flow needs, then the overdraft would be more suitable. The bank loan and overdraft both have the same rate of interest, however the rate on the overdraft is variable while the term loan rate may be fixed. If the company thinks interest rates may rise then the term loan may be the better option. The bank overdraft carries with it a charge in the form of interest and often a fee for setting up the facility. The bank may also charge an annual fee for the overdraft facility. We need to know what security the bank requires. b The bank loan is an alternative to the bank overdraft for short-term finance requirements. However, such loans should generally only be used when finance is required for a known period of time. Ideally, that period should relate to the life of the asset or the purpose for which the finance is to be used. Compared to an overdraft facility, which can be used as and when needed, a loan is more permanent. Repayment of the loan is negotiated at the time the loan is taken out, and is generally at fixed intervals. Loans are often secured in the same way as overdrafts and, if the repayment conditions are not met, the lender will take action to recover the outstanding amount. Bank loans are often granted for a specified purpose and limitations may be imposed regarding the use of the loan and the raising of other finance while the loan is outstanding. Unlike an overdraft, the cost of this form of finance is known in advance as interest accrues from the time the business borrows the money – irrespective of the fact that it may not use it straight away. As stated in (a) above, Bettause Ltd’s expectations of future movements in interest rates will be another relevant factor in the decision. c The issuing of shares to the bank will have the advantage of saving interest payments and the liability to repay the principle but this would be replaced by an expectation of dividends. The fact that the bank would hold 50 per cent of the shares also means that the bank has an equal vote in the business. This may be unacceptable to other shareholders and to management. 5 The statement refers to the fact that as a result of the sub-prime crisis, the banks did not trust the balance sheets of competitors and so either would not lend to other banks through the interbank market or would only do so at a significant cost. This is why governments in many countries provided funds to banks so they could continue to lend to business. At the same time equity markets were in free fall and so companies could not try and raise funds through share issues as the probability of success was very low and the discount that would have to be offered was prohibitive for most. The governments were the main source of funds as banks, such as the Bank of Scotland and Lloyds, were in significant trouble and without help would have not survived. Car manufacturers in the US, such as GM and Ford, also needed government assistance.

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6 Some of the information/questions needed are: • Copies of the income statements and cash flows for the past three to five years. • Why are receivables and inventory so large? They are the major assets of the business and may not be very useful as security by the bank if they include large amounts of obsolete items and uncollectable accounts. • What will the loan be used for and what type of security does this offer? For example, if the money is to purchase land and buildings then this type of asset offers the bank more security than, for example, increasing the working capital. • This business has a large amount of equity but 76 per cent of the assets are receivables and inventory which is a huge investment in working capital and is an indication that the business may not be well managed. 7 a From the balance sheet we can determine the following: Total liabilities = $56 200 = 46.8 per cent Total assets = $120 000 This means the company is moderately geared with large current liabilities, large amounts of inventory and some cash. The company’s main assets, beside the inventory, are equipment and vehicles and such assets are not great security for potential lenders. Furthermore, the company has very little retained profits which may mean the company has profitability problems. Alternative sources of finance for the company are difficult to identify. Factoring is not appropriate, as there are no debtors. The bank overdraft is already high but this can be eliminated by using the available cash and so the use of the overdraft is one possibility, but this is an expensive form of debt to use to finance the acquisition of machinery and a van. Trade creditors are also a high cost and so trade credit is not possible and not the best form of finance to use. In general, the use of short-term debt is not the best option. Perhaps if the company raises additional equity so that it can finance half the cost of the new van and machine, the bank may be willing to lend the other half with security over the new assets. b The company is already moderately geared but can offer the existing equipment and vehicles as additional security. Retained profits are low, so unless the future looks bright, the company may find it will have to pay a high rate of interest to negotiate additional bank loans. Another option is to consider leasing the van and machinery. 8 Working capital is current assets less current liabilities. It is important for the operations of the business to have adequate working capital. Many new businesses fail to properly plan for the working capital required to provide cash to pay the bills, offer credit to customers and allow it to hold inventories. It is important for businesses to have sufficient funding, whether it is equity or long-term debt, to ensure the business can maintain its working capital at required levels without getting into difficulties. Insufficient working capital can result in an inability to pay wages, creditors and so on, and can lead to the failure of an entity. This is why the ASX places significance on this type of disclosure. 9 a This is likely to be an operating lease as the lease term is only for 50 per cent of the useful life and the present value of the lease payments is only 65 per cent of the fair value of the asset and so the lessor retains the substantial risks and rewards. b If the lease is non-cancellable then this lease could be a finance lease because the lease term is equal to the expected life of the asset in the business. The real question is which party is still exposed to the majority of the risks and rewards associated with ownership of Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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the asset. The absence of a guaranteed residual suggests the risks remain with the lessor and therefore should be treated as an operating lease. c The guaranteed residual shifts the risks to the lessee and therefore it should be treated as a finance lease assuming the lease is non-cancellable. d The only difference with part (a) is the major risk that the asset’s residual will in fact fall somewhere between $4000 and $6000 and this risk is with the lessee. This pushes the lease more in the direction of a finance lease. e This is clearly an operating lease. 10 a The $15 485 million of operating leases would result in the recognition of more assets and liabilities on the balance sheet. It won’t be this amount but the important issue to discuss is there will be a significant increase in both items. b The ratio of debt to equity will increase, which suggests the company is a higher risk, but the reality is the company will be exactly the same and underlying cash flows will not be impacted. Woolworths might need to renegotiate lending covenants but in an efficient market its lending costs should not change. c Companies with large fixed assets like Qantas, Westfield and Toll Holdings. 11 a Projected income statement for year one: $

Sales Less

Cost of sales Gross profit Less expenses Lease expense Rent Electricity Wages Depreciation – equipment Refurbishment amortisation Interest (see cash budget)

12 000 24 000 3 000 2 000 900 8 000 4 000 300 1 520

Projected cash budget for year one: Cash receipts Investment Sales

$ 40 000 36 000

Deficit

76 000 4 900

Cash payments $ Lease 30 000 Equipment 20 000 Refurbishment 3 000 Fish 12 000 Rent 2 000 Electricity 900 Wages 8 000 Drawings 5 000 80 900

Cash requirements At commencement of business Cash outlays (lease, equipment, refurbishment) Less investment

$ 36 000

$53 000 $40 000 $13 000

19 720 4 280

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Assumption: Overdraft ranges from $13 000 at the beginning of the year to $4900 at the end of the year. ∴ Interest = $13 000 + $4900 = $1520 2 b If Ben takes the loan in year one then there would be additional interest of 10 per cent of $20 000, or $2000. Therefore the net profit of the business would be $2280. However, Ben still has $20 000 in his personal account and if he is able to invest this at 10 per cent, for example, then this will yield $2000. c Ben’s profit in the second year under the same scenario in part (a) will be the same except for the interest in the overdraft. Cash flows in year two will be: 13,000 + 47,000

x17%

Receipts Sales

$ 36 000

36 000

Payments Fish Rent Electricity Wages Drawings

$ 12 000 2 000 900 8 000 5 000 27 900

Surplus $8100. Assumption: The cash surplus arises evenly over the year at $675 per month. The overdraft is approximately $4900 at the beginning of the year and therefore interest would be $4900 × 17 per cent ÷ 12 or about $100 per month. Therefore, it is possible for the business to pay the interest and reduce the overdraft to nil at the end of the year. ∴ Interest = $4900 + 0 = $2450 2 = $2450 × 17 per cent = $416 Ben’s profit in year two under scenario (a) is: Add Year 1 overdraft interest Less Year 2 overdraft interest

$4 280 $1 520 $5 800 $416 $5 384

d Ben’s profit in year two under scenario (b) is as follows: Year 1 profit Add back overdraft interest Year 1 Loan interest Year 1

Less Year 2 overdraft interest Year 2 loan interest $20 000 × 16% Adjusted profit

$2 280 $1 520 $2 000 $5 800 $416 $3 200 $2 184

Interest on the loan has been calculated at the base rate of 16 per cent. The loan is assumed to be interest only with principle to be repaid in full at maturity.

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Remember, under this option Ben still has $20 000 invested in his own personal account.e The company’s profit is higher under scenario (a), but when we consider the return Ben earns on his investment we get the following results. ROI = Year one a

4 280 = 10.7 per cent 40 000 b 2 280 = 11.4 per cent 20 000 Year two a 5 384 = 13.5 per cent 40 000 b 2 184 = 11 per cent 20 000 The returns on Ben’s investments are higher for scenario (a), but we haven’t factored in that in scenario (b), Ben retains $20 000 in his own personal account which gives him more flexibility and more security. We need to consider tax factors before making a final decision, but it appears that scenario (b) may be better for Ben.

Ethics case study a How should the transaction with Close Encounters Ltd be recorded? The principal issue here is whether the transaction is a sale of goods by New Horizons Company (NH) to Close Encounters Ltd (CE) or whether it is, in substance, a financing arrangement. The terminology used by the contracting parties suggests that the form is that of a sale. This would result in an immediate addition to profit of $1 million dollars (and a shift from a loss to a small overall profit) and an increase in assets of the same amount. This appears to be the desired outcome for NH in its attempt to stop the bank appointing an official manager. However, there are several facts which strongly support the view that the transaction is a financing arrangement: – the put option, which will allow CE to sell the goods back to NH (the $100 000 ‘profit’ on that second transaction is effectively interest expense to NH) – the related party relationship between NH and CE (CE is run by Jack’s brother-in-law) – the goods will not physically leave NH’s warehouse. In the light of these facts, the accounting principles of relevance and faithful representation (IASB Conceptual Framework and AASB 101) suggest that the substance of the transaction (a financing arrangement) should be reported. Under the Conceptual Framework, the arrangement gives rise to a liability which NH should record on receipt of the $2 million. The area of debate at this point is whether the Conceptual Framework liability recognition criteria have been met – in particular, is it probable that the put option will be exercised? Given the facts, a strong presumption is that the answer will be in the affirmative. b Can the bank still appoint an official manager if a sale is recorded? The answer to this question will depend upon the exact contractual terms of the bank loan. The facts of the case are not detailed enough on this point to resolve the question. However, some discussion points might include:

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Is the contract tied to reported accounting numbers (e.g. profit)? If so, the bank may not be able to appoint an official manager if there is no technical breach. – The bank, in response, may seek to use the argument in part (a) above. – What is the role of the external auditor? Is Jack’s plan ethical? One positive aspect of the plan is that it may help the company trade out of its difficulties. However, the general background facts of the case must raise serious doubts about the probability that the company will remain a going concern. On the negative side: – By adopting the plan, Jack may cause greater losses to all stakeholders than would have occurred if the firm was placed in official management now. – The plan seeks to promote form over substance and so honesty is threatened. – The plan is inconsistent with the professional ethical principles of integrity (APES 110– 110), objectivity (APES 110–120), independence (APES 110–290) and perhaps technical and professional standards (APES 110–100) as noted from the UIG meeting on 17 June 2003.

Chapter 11 Internal control of cash, statement of cash flows and other issues Review questions 1 • • •

Separation of duties of receiving and paying cash. Separation of duties of recording cash receipts from cash payments. Separation of handling of cash and the recording of cash movements in the accounting records. 2 Information provided by statements of cash flows includes: • new issues of shares • debt raised or repaid during the year • assets acquired (or disposed of) during the year and the source of funding of such purchases • ability of the firm to meet its debts or pay dividends • cash flows from operating, investing and financing activities. 3 Consolidated financial statements are reports which show the financial position and results of an economic entity comprising of a parent entity and all other entities that are controlled by the parent entity. The purpose of consolidated financial statements is to portray the parent and controlled entities as if they were a single economic entity to enable users of financial statements to judge how well the parent entity has performed in pursuing its goals. 4 A subsidiary or controlled entity is one where the operating and financial policies are controlled by another entity. 5 Investing in another company is done for the same reasons that a company invests in any asset. It hopes to make a return on its investment. Another reason is to gain control of a supply chain of infrastructure or assets. 6 ‘Control’ is the ability of one entity (parent) to dominate the decision making of another entity in relation to its operating and financial operating policies, so that the second entity operates in conjunction with the parent entity in pursuing the objectives of the parent. 7 • Transactions between entities that are part of an economic entity. • Amounts owing by or to members within the economic entity. • The investment the parent entity holds in its controlled entities. 8 There are many reasons, such as different depreciation rates for tax and accounting, or the fact that tax only allows bad debts as a deduction, while doubtful debts are an expense for accounting purposes. 9 The staff member must be ringing up an incorrect amount and pocketing the difference or not ringing up an entry at all and pocketing all the money. He could install a visible screen so customers act as a check and he can then use phantom shoppers to observe. 10 For an individual there are costs involved in dealing on credit as this requires record keeping and this imposes costs. For a business, dealing in cash creates more risk of theft and losses because cash is the most difficult asset to control and it poses the greatest temptation to those prone to steal.

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Problems for discussion and analysis 1 a Cash increased by $806.2 million. b Tax of $841.5 million was paid (cash flow statement). c Deferred tax asset of $580.6 million (see Note 5) Deferred tax liability of $70.2million (see Note 5 ). The DTA and DTL have been offset and the net amount of $510.4 million reported as deferred tax assets on the balance sheet. 2 The important point in this question is that profitability and cash flow are distinct from each other. Revenues and expenses in the profit and loss statement will ultimately be translated into cash receipts and cash payments. A satisfactory profit does not guarantee sufficient liquidity because of time lag between the time a transaction is entered and its ultimate translation into cash. Consideration should also be given to balance sheet transactions (for example, major capital projects) which may result in cash outflows, the benefit of which may not be reflected in profit terms until a much later point in time. 3 The issue with a sporting club is that often members are involved in many aspects of the running of the club, so that the fees to belong to the club are minimised. The more sophisticated the controls, the greater the cost to the club. Here are a few suggestions: • The club could purchase a cheap cash register and ask members who work behind the bar to ring up amounts sold. This will provide some degree of control and create some uncertainty in the minds of those who may be stealing money. The use of a visual screen that allows members to see amounts being recorded acts as check on the bartender. The club could make members aware of the problem and encourage all members to be more observant when being served at the bar in the future. • The club could arrange the staffing of the bar so that some members serve while others are responsible for handling the cash. • Have a bar manager and a committee who are responsible for running of the bar. This reduces the number of members working behind the bar and, by having different roster arrangements, the bar takings can then be compared. This may result in cash shortfalls associated with times when certain individuals are working the bar. 4 a The reduction in salaries payable would be deducted from net profit to arrive at the net cash flow from operating activities. b i The $1000 would be a cash inflow in the investing activities and the gain on sale would be subtracted from net profit to arrive at the net cash flow from operating activities. ii No effect c The increase in creditors would be added to net profit to arrive at the net cash flow from operating activities. d This would result in a cash inflow for financing activities of $240 000. e This would be reported as a non-cash financing and investing activities. 5 a Balance sheet: Decrease in asset less accumulated depreciation $5000 Decrease in equity $2000 Increase in cash $3000 Statement of comprehensive income: Increase in expenses $2000 Decrease in profit $2000

Chapter 11: Internal control of cash, cash flow statement and other issues 113

Cash flow statement: Investing activities Cash inflow $3000 b Balance sheet: Increase in assets $70 000 Increase in equity $70 000 Statement of comprehensive income: No effect Cash flow statement: No effect c Balance sheet: Increase in asset $10 000 Decrease in accumulated depreciation $30 000 Increase in equity $40 000 Statement of comprehensive income: No effect Cash flow statement: No effect d Balance sheet: Increase in cash $120 000 Increase in equity $120 000 Statement of comprehensive income: No effect Cash flow statement: Financing activities Cash inflow $120 000 e Balance sheet: Decrease in cash $80 000 Decrease in loans $80 000 Statement of comprehensive income: No effect Cash flow statement: Financing activities Cash outflow $80 000

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Transaction Received cash from customers

Activity Operating

Paid employees for wages

Operating

Signed a four-year lease agreement for a motor vehicle Paid interest Issued debentures

Non-cash or financing Operating Financing

Issued ordinary shares

Financing

Sold long-term investments Paid cash dividends

Investing Financing

Redeemed debentures

Financing

Issued preference shares

Financing

Sold equipment for a gain Purchased buildings Purchased patents Loss on disposal of a non-current asset

Investing Investing Investing Investing

Increase in inventory

Operating

a b c d e f g h i

l m n o

7 a

Investing activities

(80 000)

Investing activities No effect Non-cash financing and investing activity

30 000

Financing activity Financing activity Operating activities

(5 000) (20 000) (5 000)

c d e f g

8 Cash flow from operating activities: Net profit + Increase in accounts receivable Decrease in creditors Increase in salaries payable Increase in wages payable Increase in inventory Decrease in prepaid expenses Cash flow from operating activities = Net profit +

(6 783) (9 553) 686 1 (9 426) 507 ($24 568)

9 Cash flow from operating activities: Net profit + Depreciation – Increases in accounts receivable – Increases in inventory – Increase in prepaid rent + Increase in accounts payable

11 000 15 000 (2 000) (7 000) (3 000) 2 000 $16 000

Chapter 11: Internal control of cash, cash flow statement and other issues 115

10 a

$80 000; consolidated sales should be $8 820 000 ($8 150 000 + $750 000 – $80 000). ii $80 000; consolidated cost of inventory sold should be $5 360 000 ($5 000 000 + $440 000 – $80 000). b $1 950 000 ($8 820 000 – $5 360 000 – $875 000 – $635 000) Sales – cost of inventory sold – selling expenses – admin expenses. 11 a Agree. Stephanie has made one employee responsible for the cash drawer in accordance with the internal control principle of assignment of responsibility. b Disagree. It is commendable that Stephanie has given the employee a specific responsibility and is holding that employee accountable for it. However, after the cashier has counted the cash, another employee (or perhaps Stephanie) should remove the cash register tape and compare the amount on the tape with the cash in the drawer. Also, Stephanie’s standard of no mistakes may encourage the cashiers to overcharge a few customers in order to cover any possible shortages in the cash drawer. c Disagree. Stealing is a serious issue. An employee who can justify taking a box of chicken can probably justify ‘borrowing’ cash from the cash register. 12

Assets Current assets Bank Accounts receivable Total current assets Non-current assets Plant and equipment (net of depreciation) Investment in Lee Ltd Total non-current assets Total assets Liabilities Current liabilities Accounts payable Total liabilities Net assets Equity Paid-up capital Retained earnings Total equity

Bazz Ltd $

Lee Ltd $

Elimination $

Consolidation $

180 000 100 000 280 000

50 000 150 000 200 000

–10 000(2)

230 000 240 000 470 000

300 000

320 000 620 000 900 000

______ 300 000 500 000

320 000(1)

– 600 000 1 070 000

400 000 400 000 500 000

180 000 180 000 320 000

–10 000(2)

570 000 570 000 500 000

400 000 100 000 500 000

300 000 20 000 320 000

–300 000(1) –20 000(1)

400 000 100 000 500 000

600 000

Chapter 11: Internal control of cash, cash flow statement and other issues 116

Assets Current assets Bank Debtors Inventory Total current assets Non-current assets Plant and equipment (net of depreciation) Investment in Phil Ltd Debentures Goodwill on consolidation Total non-current assets Total assets Liabilities Current liabilities Creditors Taxation Total current liabilities Non-current liabilities Debentures Total non-current liabilities Total liabilities Net assets Equity Paid-up capital Retained earnings Total equity

Jan Ltd $

Phil Ltd $

2 000 33 000 12 000 47 000

1 000 27 000 63 000 91 000

47 000

57 000

200 000

100 000

247 000 294 000

157 000 248 000

36 000 10 000 46 000

53 000 60 000 113 000

150 000 150 000 196 000 98 000

113 000 135 000

80 000 18 000 98 000

100 000 35 000 135 000

Elimination $

–13 000(2)

Consolidation $ 3 000 47 000 75 000 125 000 104 000

–200 000(1) –100 000(3) 65 000(1)

65 000 169 000 294 000

–13 000(2)

76 000 70 000 146 000

–100 000(3)

50 000 50 000 196 000 98 000

–100 000(1) –35 000(1)

80 000 18 000 98 000

14 Year ending 30 June 20X4 20X5 20X6 20X7 20X8

Tax payable $ 22 500 22 500 22 500 22 500 30 000

Deferred tax payable $ 1 500 1 500 1 500 1 500 –6 000

Tax expense $ 24 000 24 000 24 000 24 000 24 000

Chapter 11: Internal control of cash, cash flow statement and other issues 117

15 Year ending 31 Dec

Profit before depn & tax

Taxable profit after tax depn

Tax payable

Taxable profit after acctng depn

Tax expense

20X4 20X5 20X6 20X7 Total

100 000 100 000 100 000 100 000 400 000

80 000 80 000 100 000 100 000 360 000

40 000 40 000 50 000 50 000 180 000

90 000 90 000 90 000 90 000 360 000

45 000 45 000 45 000 45 000 180 000

Differences between tax payable and tax expense (5 000) (5 000) 5 000 5 000 0

Tutors should discuss how after four years, columns two and four have the same totals as columns three and five and column six has a nil balance. 16 The major fault with the Bellevue produce company was that Inaba had total control of keeping the records and doing the banking. There was no separation of duties and this case demonstrates the problems that can arise when this fundamental principle of internal control is neglected. It is not always possible for a small business to employ different people to carry out different tasks. In these businesses, it is imperative that the business proprietor oversees what the bookkeeper is doing. One thing the owner could do is to use the services of an accountant to periodically check on the work of the bookkeeper by carrying out an audit. The owner should also have some idea of the profitability of the business. The fake entries would have resulted in lower profits and this should be a warning signal to the owner. It is difficult to imagine how Inaba could do what she did for so long without prompting some concern from the owner about the lack of profits and lower cash balances. 17 • The increase in accounts receivable should be deducted from net profit in the cash flows from operating activities section. • The gain from sale of investments should be deducted from net profit in the cash flows from operating activities section. • The increase in accounts payable should be added to net profit in the cash flows from operating activities section. • Cash paid for dividends should be deducted from cash received from the sale of ordinary shares in the cash flows from financing activities section. • The correct amount of cash at the beginning of the year, $70 700, should be added to the increase in cash. • The final amount should be the amount of cash at the end of the year, $101 300.

Chapter 11: Internal control of cash, cash flow statement and other issues 118

A correct statement of cash flows would be as follows: The Future Zone Inc Statement of cash flows for the year ended 31 December 20X3

Cash flows from operating activities Net profit per statement of comprehensive income Add: Depreciation Increase in accounts payable

Deduct: Increase in accounts receivable Increase in inventories Gain on sale of investments Decrease in accrued expenses Net cash flow from operating activities Cash flows from investing activities Cash received from sale of investments Less: Cash paid for purchase of land Cash paid for purchase of equipment Net cash flow used for investing activities Cash flows from financing activities Cash received from sale of common stock Less: Cash paid for dividends Net cash flow provided by financing activities Increase in cash Cash at the beginning of the year Cash at the end of the year

$49 000 4 400 $11 500 18 300 7 000 1 600 $85 000 $90 000 150 100

$100 500 53 400 $153 900

38 400

240 100 $107 000 36 800

$115 500

(155 100)

70 200 $30 600 70 700 $101 300

18 The company has a potential cash flow problem brought about by the following factors: • Use of short-term borrowings $1450m to fund investment in long-term assets $1800m. This is an unwise practice as the benefits of investing in non-current assets flow to the company over the long term. However, the short-term borrowings must be repaid in the short term. • The cash flow from operating activities has decreased from $468m to $272m. The increase in interest and payments to suppliers are the main reasons for this decrease. Is the company paying too much for its materials from suppliers? • Is it wise to continue to pay a constant level of dividends $200m given the cash flow problem? Students should discuss the implications for a company if dividends are decreased. What does this signal to the capital market? • Can the company obtain the cash required to meet short-term commitments? It currently has a negative cash balance (i.e. bank overdraft) of $20m. Suggestions: • Replace short-term borrowings with either long-term borrowings or equity. • Review payments to suppliers. Is the company paying too much? Do prices need to be increased? • Consider implications of reducing dividends. 19 a The main factors would appear to be: • lower profits • increases in inventory and debtors levels • use of short-term debt to finance the acquisition of non-current assets.

Chapter 11: Internal control of cash, cash flow statement and other issues 119

b The company is required to reduce its overdraft to within the limit of $12 000. This only requires a payment of $500. However, the company also has the following liabilities due soon for payment: Creditors $14 000 Wages + interest $2 000 Tax $2 500 This means the company requires about $22 000 cash in order for it to continue in business. Some suggestions follow which don’t have to be mutually exclusive: • sell some inventory • offer incentives to debtors to pay the amounts due or factor the debtors • additional loans. At present the company’s debt to total assets is: 143500 = 50% 287000 34500 = 49%. The land is shown at 70000 valuation but there may still be some scope for further borrowing using the land as security. The term loan is presumably secured against the other non-current assets, which would 75000 give a ratio of = 57.7%. 130000 • perhaps the company could issue more shares. These are some of the options the company could pursue and there are, no doubt, others.

The land is already mortgaged and the ratio is

Ethics case study In this case the new ratio cash flow per share (CFPS) shows a substantial increase from the previous year (presumably the comparative year’s ratio is given). However, earnings per share (EPS) has declined slightly over the same period. Given the facts, there is nothing that is prima facie unethical about the introduction of the new ratio even though, on the surface, it gives a contradictory signal to that provided by EPS. Users of financial statements are interested in both cash flows and earnings. Consequently, the users of Woppet Enterprises Ltd’s financial reports might welcome and appreciate the additional information. The contradictory signal between EPS and CFPS may simply illustrate the timing differences which arise between accrual and cash flow accounting systems. What we would hope is that sufficient information and comparative figures are disclosed along with the new ratio to help the users interpret it. Instructors may like to extend the question, however, by asking students to consider the scenario in which Jane Golly uses her inside knowledge to attempt to cover a trend of declining profits.

Chapter 12 Financial statement analysis Review questions 1 The groups identified in the chapter are equity investors, i.e. shareholders and their representatives, lenders, employees, auditors and management. The common needs identified were past and future profitability, information relating to financial risk and solvency, return on investment and risk. 2 The purpose of the analysis; size of business; risk of the type of business; economic, social and political environment; industry trends; technological change; price rises and their effects. 3 An overview of the year just gone and some predictions for the future. Note: this statement may be biased. 4 The parts of the annual report, in addition to the chairman’s statement, would include the directors’ report, balance sheets, performance and cash flows, accounting policies statement, notes to the accounts and auditors’ report. You would look at all the other parts of the annual report so that no important information is missed. 5 Here we are looking for an understanding of the relationships between current assets and their liquidity and current liabilities as a short-term measure. In the long term we are looking for a measure of the relationship between debt financing and equity financing. Note: we believe that it is important that students are encouraged to understand the relationships involved and not concentrate on calculating ratios, which they frequently don’t understand and cannot interpret, because they have not fully understood why a ratio is calculated or the relationships the ratio expresses. 6 Timeliness, use of historic costs, use of summarised information, multiplicity of acceptable bases, changes in bases, identification of symptoms not causes. 7 When you compare similar entities, the following steps need to be taken to make the comparisons meaningful. Make sure you look at accounting policies, size and location of operations and make necessary adjustments for differences. 8 External and internal sources to a business are relevant when analysing it’s financial statements. External factors like interest rates, exchange rates and the state of the economy affect all firms to some extent. Internal factors as disclosed in the financial statements and the director’s report are also very relevant to any analysis.

Problems for discussion and analysis 1 a

The two major liabilities were trade and other payables at $5512.8 million and borrowings of $3373.8 million.

Chapter 12: Financial statement analysis 121

Ratio Current ratio

Group 6593 = 8288 8288.3 2856.5 = 8288

.80

Gross profit margin

14093 = 54143

26%

Debt to equity

1342487

Quick ratio

.34

= 7846

171%

2 a

Non-current liabilities to equity ratio = 0.5/1 Equity = $200 000 and therefore non-current liabilities = $100 000 As total assets = $400 000, current liabilities must = $400 000 – $300 000 or $100 000 Current ratio = 1.5/1 and so current assets must = $150 000 b Non current assets = $400 000 – $150 000 = $250 000 3 Debt/total assets = 0.3, total assets are $300 000: Total liabilities = $90 000 Current liabilities = $90 000 – $40 000 = $50 000 Current ratio = 2/1, therefore, current assets = 2 × $50 000 = $100 000 4 a Current assets i Current ratio = Current liabilities $4,362 $6, 251 Current year: = 0.55 Preceding year: = 1.47 $7,914 $4, 257 Quick assets Current liabilities $2,847 $5, 033 Current year: = 0.36 Preceding year: = 1.18 $7,914 $4, 257 b The liquidity of Skippy Ltd has declined significantly over this time period. Both the current and quick ratios have declined by more than half from the preceding year. A review of the current assets and liabilities reveals that cash and marketable securities have dropped significantly, while short-term borrowings were made during the current year. The combined effect reduced Skippy’s liquidity position. Skippy may have been making investments which required cash and short-term borrowings, which placed a temporary squeeze on liquidity. 5 a

ii Quick ratio =

Inventory turnover:

Cost of goods sold Average inventory

Current year:

$2,010,000 = 6.0 ($310,000 + $360,000)/ 2

Preceding year:

$2,400,000 = 8.0 ($290,000 + $310,000)/ 2

Chapter 12: Financial statement analysis 122

Inventory turnover in days

Current year

Preceding year

365 inventory turnover

365 6 = 60.83 days

365 8 45.6 days

b The inventory position of the business has deteriorated. The inventory turnover has decreased and the number of days to turnover inventory has increased. The sales volume has declined while the inventory levels have grown, resulting in the deteriorating inventory position. 6 Sales Gross profit Net profit

20X1 100 100 100

20X2 106.25 110 102.5

20X3 112.5 115 105

20X4 131.25 132.5 95

20X5 162.5 165 112.5

The trends for sales and gross profit are increasing while the net profit has remained relatively stable with a slight upward movement. This means that expenses have been increasing despite the increase in sales and this has eroded most of the increase in gross profit over the period. 7 Item Sales Gross profit Net profit

20X2 100 100 100

20X3 101 105 96

20X4 102 106 93

20X5 100 107 88

20X6 101 88 65

The trend analysis shows that over the five year period sales have remained reasonably constant and gross profit increased steadily up until 20X6 when it suddenly declined. The net profit trend was steadily declining in all years but again showed a more significant decline in 20X6. For some reason in 20X6 the company’s gross margin was squeezed and this had a significant impact on net profit. The reason for this needs to be established together with an explanation for the steady decline in net profit in the first four years despite an increase in gross profit. Possible explanations for the drop in the gross margin in 20X6 could include an increase in the cost of goods sold where the company couldn’t increase selling prices by the same margin, or perhaps the company had to lower selling prices. The declining net profit margin means the company needs to review operating expenses. 8 The company could use the cash in the bank to reduce the creditors to an amount of $8000. The current ratio would then be: 12 500 or 1.56 8 000

Chapter 12: Financial statement analysis 123

9 a

Declining profitability as measured by: 20X4 10%

Net profit margin

20X5 8.3%

20X6 6.25%

Increase in sales is offset by increase in materials costs: Material costs/sales Return on shareholders funds Pre-tax return on total assets (assume 30% tax)

37.5%

38.9%

47.75%

10%

7.5%

6.25%

7 050 90 000 = 7.8%

5 550 90 000 = 6.1%

5 737 105 000 = 5.5%

This trend may be levelling out. b Debt retired for equity in 20X6 has improved the ability to cover fixed charges in 20X6. Times interest earned Debt/equity ratio

5 50%

4 50%

4.12 40%

All the additional investment has gone into work in progress. This indicates that the equity increase was made to acquire working capital since short-term sources had been exhausted. Notice that there is no long-term finance. c • Perhaps attempt to retire short-term debt in favour of long-term debt, which is generally less expensive and provides more flexibility. • Attempt to speed up work in progress to release funds for further investment. • Need to examine costs of materials: can these be reduced? If not, can the company increase its prices? Lower profit on increased sales is not a good sign. However, there may be problems in the economy (e.g. a recession) or competitive pressures which prevent price rises. 10 a Profitability: Ratio Net profit margin Return on assets (assume tax rate of 30%) Return on equity

20X1 3 500 87 000 = 4% 4 200 143 000 = 2.9% 3 500 115 000 = 3%

20X2 –8 000 78 000 = –10% –6 400 142 500 = –4.5% –8 000 112 000 = –7%

20X3 –2 000 85 000 = –2.3% –950 139 750 = –0.7% –2 000 108 000 = –1.8%

20X4 3 000 90 000 = 3.3% 3 700 140 250 = 2.6% 3 000 118 500 = 2.5%

Bigboy Catering Ltd had very low profitability in 20X1 and then suffered losses for 20X2 and 20X3 before returning to a small profit in 20X4. We have no industry ratios to compare Bigboy Catering Ltd with, but profitability is low, although 20X4 did show an improvement. Other operating expenses declined in 20X4 from 15.9 per cent to 10.5 per cent and it was one of the reasons profitability improved in 20X4. b

Ratio Current ratio Quick ratio Debt to equity Times interest

20X1 0.6 0.02 24% 4.5

20X2 0.6 0 29% –3

20X3 0.5 0 28% –0.33

20X4 1.85 0.2 10% 4

Chapter 12: Financial statement analysis 124

covered

Bigboy Catering Ltd is in a much stronger position in 20X4 than it was at any time in the previous three years. We need industry information to make some assessment of the current position of the company, but it has a low debt position. Its main problem is a large amount of inventory and very little other current assets and with only $3000 in cash. c The company has very low profitability, as reflected in the low rates of return to assets and shareholders in all years including 20X4. Therefore, the company needs to improve its profitability. Suggest a review of selling prices to see if these can be increased and assess if total sales can be increased by a marketing campaign. Also need to review major expense areas of food and beverage and wages to assess if these can be curtailed by perhaps changing suppliers or reducing employees. The company has large amounts of non-current assets and as a result the asset turnover figures are very low – 0.6 in 20X4. This means the company is not generating large sales given the amount invested in assets. Does the company require all the non-current assets or can some be sold? 11 a Katrina Ltd Current Assets Current Liabilities

Quick ratio

Current Assets − Stock Current Liabilities

Inventory turnover Cost of Goods Sold Average Stock

In days Accounts receivable turnover Credit Sales Average Accounts Re ceivable

In days Operating cycle

Catherine Ltd

768,000 180,000

840,000 310,000

= 4.3

= 2.7

768,000 − 560,000 180,000

840,000 − 300,000 310,000

= 1.2

= 1.7

1,200,000 520,000 + 560,000 / 2

1,100,000 420,000 + 300,000 / 2

= 2.22

= 3.06

365 2.22

365 3.06

= 164.4 days

= 119.3 days

1,100,000 130,000 + 100,000 / 2

1,500,000 130,00 + 110,000 / 2

= 9.6

= 12.5

365 9.6

365 12.5

= 38 days 164.4 + 38 = 202.4 days

= 29.2 days 119.3 + 29.2 = 148.5 days

Chapter 12: Financial statement analysis 125

b Catherine Ltd has a better liquidity position. It has the shortest operating cycle and the better quick ratio; although Katrina Ltd has a higher current ratio it is mainly due to very high levels of stock, which is unfavourable. c Return on assets: Net profit + aftertax int erest Average total assets

Katrina Ltd

Catherine Ltd

352,000 1,954,000 +1,854,000 / 2

428,000 2,020,000 + 2 / 20,000 / 2

352,000 1,904,000

18.5%

Asset turnover: Katrina Ltd Catherine Ltd

= Profit margin:

1 952 000 1 904 000

1 900 000 2 070 000

102.5%

92%

352 000 1 952 000

428 000 1 900 000

= 18% 22.5% Catherine Ltd has a higher ROA due to a higher profit margin. d Return on ordinary shareholder equity: Katrina Ltd 310,000 Net profit = 1,384,000 Average Shareholders Equity

22.4%

Catherine Ltd =

400,000 1,430,000

28%

Asset turnover: Katrina Ltd Catherine Ltd

1 952 000 1 904 000 102.5%

1 900 000 2 070 000 92%

1 954 000 1 434 000 136%

2 120 000 1 480 000 143%

310 000 1 952 000 15.9%

400 000 1 900 000 21%

Leverage:

Net profit margin:

428,000 2,070,000

20.7%

Chapter 12: Financial statement analysis 126

Catherine Ltd has a higher ROE, mainly due to the higher profit margin. The financial leverage has also contributed to the higher ROE. e

Debt/equity:

= Interest Expense Average Total Liabilities

Net profit + Interest Interest Expense

Catherine Ltd

520,000 1,434,000

640,000 1,480,000

60,000 520,000

40,000 640,000

36.3%

11.5%

= 43.2%

370,000 60,000

Katrina Ltd

6.2

6.25% 440,000 40,000

Both companies have similar return on assets but Catherine Ltd has much better return on shareholders’ equity. This is due to the lower cost of debt for Catherine Ltd compared to Katrina Ltd. Average cost of interest is 6.25 per cent compared to 11.5 per cent. Catherine Ltd’s doesn’t appear overly risky as the interest average ratio is 11 compared to 6.2. Window dressing is where the company manipulates certain ratios by engaging in certain strategies at year end. For example, let’s assume both companies take the cash available at year end and use this to reduce amounts owing to creditors: Pay current liabilities Current ratio

Quick ratio

Katrina Ltd

Catherine Ltd

768,000 − 80,000 180,000 − 83,000

840,000 − 220,000 310,000 − 220,000

688,000 100,000

620,000 90,000

6.88 (was 4.3)

6.9 (was 2.7)

208,000 − 80,000 180,000 − 80,000

540,000 − 220,000 310,000 − 220,000

= =

128,000 100,000

1.28 (was 1.2)

X X

320,000 90,000

3.6 (was 1.7)

Instructors should take particular note of the problems students experience in reading published annual reports.

Chapter 12: Financial statement analysis 127

12 a Common-size statements: Apple Ltd

20X1 $000s 100 70 30 18 12 3 9 3 6 1 5

Sales Cost of goods sold Gross profit Operating expenses Net profit before tax and interest Interest Net profit after interest and before tax Net profit after tax and interest Dividends Retained profit

20X2 $000s 100 71 29 18 11 2 9 2 7 2 5

20X3 $000s 100 76 24 14 10 3 7 4 3 1 2

20X4 $000s 100 75 25 13 12 4 8 3 5 1 4

20X5 $000s 100 79 21 16 5 4 1 1 0 1 (1)

b Short-term solvency: i Current ratio: 20X1 42 318 28 038 = 1.5

Current assets Current liabilities

20X2 54 528 31 194 = 1.75

20X3 121 200 81 480 = 1.5

20X4 127 083 76 896 = 1.65

20X5 176 121 117 585 = 1.5

ii Quick ratio: Current assets – stock Current liabilities

20X1 42 318 – 20 031

20X2 31 494

20X3 68 109

20X4 52 260

20X5 76 515

28 038

31 194

81 480

76 896

117 585

= 0.8

= 0.84

= 0.68

= 0.65

While the current ratio has remained steady at around 1.5, the quick ratio has declined from around 0.8 to 0.65. This decline is due to an increase in stock levels. Therefore we now look at efficiency ratios. iii Inventory turnover: Cost of goods sold Average stock Divide by 365 to convert to days

20X1 N/A

20X2 82 525 21 533 = 3.83

20X3 197 197 38 063 = 5.18

20X4 208 775 63 957 = 3.26

20X5 294 475 87 215 = 3.38

365 3.83 = 95.3 days

365 5.15 = 70.4 days

365 3.26 = 111.97 days

365 3.38 = 108 days

Chapter 12: Financial statement analysis 128

iv Debtors’ turnover: Average debtors

20X1

20X2

20X3

20X4

20X5

N/A

116.232 21 141 = 5.5

259 470 42 481 = 6.1

278 340 54 628 = 5.1

372 753 57 877 = 6.4

365 5.5 = 66.4 days

365 6.1 = 59.8 days

365 5.1 = 71.6 days

365 6.4 = 57 days

Divide by 365 to convert to days

The efficiency ratios are quite variable although the stock turnover has increased from as low as 70.4 days to around 108 days in the last two years. This is an unfavourable trend and the build up in stock levels is a cause for concern. The collection of debtors has varied from 57 to 71.6 days and is reasonably constant. We need information on the industry to be able to assess how Apple Ltd compares to its competitors. v

Operating cycle:

Stock turnover + Debtors’ turnover in days

20X2

20X3

20X4

20X5

161.7 days

130.2 days

183.57 days

165 days

The operating cycle varied from 130.2 days to a high of 183.57 days. The increased stock levels partially explain the increase in the operating cycle. The company will be more profitable if it can operate with an operating cycle closer to 130 days as achieved in 20X3. Profitability ratios: i Gross profit margin: Gross profit Sales

20X1 28 179 93 930 = 30%

20X2 33 707 116 232 = 29%

20X3 62 273 259 470 = 24%

20X4 69 585 278 340 = 25%

20X5 78 278 372 753 = 21%

The gross profit margin has declined significantly and is a cause for concern. Is Apple Ltd paying too much for its goods or not charging enough for the sale of its products? ii Net profit margin: Net profit Sales

20X1 5 913 93 930 = 6.3%

20X2 7 911 116 232 = 6.8%

20X3 8 466 259 470 = 3.3%

20X4 16 455 278 340 = 5.9%

20X5 1 714 372 753 = 0.5%

There has been a large drop in the net profit margin from around 6 per cent to 0.5 per cent in 20X5. Much of this is explained by the drop in the gross profit margin, but have other expenses also increased?

Chapter 12: Financial statement analysis 129

iii Operating expenses: 20X1 17 022 93 930 = 18.1%

Sales

20X2 21 398 116 232 = 18.4%

20X3 36 830 259 470 = 14.2%

20X4 35 130 278 340 = 12.6%

20X5 59 881 372 753 = 16.1%

These ratios show that initially operating expenses are around 18 per cent of sales then decline to a low of 12.6 per cent and increase again in 20X5 to 16.1 per cent. What is the reason for this variation? iv Interest expense: 20X1 2 727 93 930 = 2.9%

Sales

20X2 2 652 116 232 = 2.3%

20X3 7 707 259 470 = 3%

20X4 10 167 278 340 = 3.7%

20X5 14 082 372 753 = 3.8%

Interest expense has remained reasonably constant and is not a cause for concern. v

Return on assets:

Net profit + After tax cost of interest

20X1 N/A

Average total assets

20X2

20X3

20X4

20X5

9 767 75 309

13 861 127 651

23 572 176 609

11 571 218 421

= 13%

= 10.9%

= 13.3%

= 5.3%

As expected from the previous ratio the return on assets is around 13 per cent and then drops to 5.3 per cent in 20X5. vi Return on equity: Net profit after interest and tax Average ordinary shareholders’ equity

20X1 N/A

20X2

20X3

20X4

20X5

7 911 30 558

8 466 45 955

16 455 62 085

1 714 69 543

= 25.9%

= 18.4%

= 26.5%

= 2.5%

The shareholders’ return has significantly decreased in 20X5 due to the large decline in net profit after tax and interest. The decline in return on shareholders’ equity is much greater than the decline in return on assets because lenders still received the same level of interest. Solvency ratios: i Debt to equity ratios: Total liabilities Total shareholders’ equity

20X1 42 831 24 909

20X2 46 671 36 207

20X3 116 721 55 704

20X4 112 326 68 466

20X5 185 429 70 621

= 172%

= 130%

= 210%

= 164%

= 263%

Chapter 12: Financial statement analysis 130

The amount of debt has significantly increased despite the repayment of $22 million in loans during 20X5. Also, given that some of the freehold properties were revalued in 20X5, the shareholders’ equity to some extent reflects current values. This makes the increase in debt to equity to 263 per cent even more worrying. However, we need to obtain industry figures for levels of debt. Can Apple Ltd service this level of debt? We now look at interest coverage rates. ii Interest coverage ratio: Net profit before interest and tax Interest

20X1

20X2

20X3

20X4

20X5

11 157 2 727 = 4.09

12 309 2 652 = 4.64

25 443 7 707 = 3.3

34 455 10 167 = 3.4

18 397 14 082 = 1.3

The interest coverage ratio has declined from 4.09 to 1.3 and increases concerns about the impact of an increase in interest rates on Apple Ltd – it could place the company into liquidation. Unless profits increase, the company is in for trouble. Recommendations • Review operating expenses and reasons for decline in gross profit margin. • Reduce stock levels. • Reduce levels of debt by replacing some debt with equity. Issue more shares. Consider preference shares. c

Limitation of analysis: • no information on industry statistics • no information about share price and amount of unissued shares • unable to determine how much freehold property has been revalued in 20X5 • no information available about economic conditions • no information about cash flows, accounting policies used.

13 Profitability: ROR on ordinary shareholders funds

20X6 693 902 4 970 202

20X5 = 14%

433150 4 908 150

20X4 = 8.8%

423 250 4 900 000

= 8.6%

Indicates an increasing profitability almost on a par with the industry. 20X6 Net profit margin Gross profit margin

20X5 13.2% 38%

20X4 15% 41%

17% 39%

A fairly constant gross profit margin with a falling net profit margin indicates a rising level of expenses, such as depreciation, wages, interest and so on. These should be analysed further. In this case, a large part of the trend is due to increased interest charges on long-term debt. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 12: Financial statement analysis 131

20X6 Times interest covered

20X5 5

20X4 10

This is a potentially dangerous situation since profitability is not quite good enough to offset the higher charges incurred to obtain funds. Short-term solvency: 20X6 Current ratio Quick ratio

20X5 1.49 0.65

20X4 1.84 0.75

2.25 0.90

Short-term solvency is contracting. This may be serious depending on how efficiently funds can be generated.

Accounts receivable turnover Inventory turnover Operating cycle

20X6

20X5

20X4

75 days 152 days 227 days

72 days 268 days 340 days

68 days 304 days 372 days

Cash generation has improved greatly but still lags behind the norm for the industry (150 day operating cycle). Increases here can make allowances for the lower levels of liquid funds held. Receivables turnover has deteriorated, particularly given that credit terms are net 45 days. A review of credit procedures may be warranted and perhaps action on long-outstanding receivables. Leverage: Debt/Tangible net assets

20X6 1.42

20X5 0.76

20X4 0.64

Increases in long-term debt have gone into long-term investment – this is an essentially healthy situation. However, the returns from this investment are not yet great enough to offset the interest burden. Debt / Total assets

20X6 49%

20X5

32%

20X4 29%

The firm has increased debt levels beyond those for the industry. This is a cause for concern. Summary While Jayco Ltd’s profitability is still consistent with that of the industry, its increased debt levels and deteriorating liquidity are a cause for concern. Jayco Ltd needs to examine the collection of debtors. However, the increase in share price is evidence of market confidence in Jayco Ltd and its ability to service the higher levels of debt.

Chapter 12: Financial statement analysis 132

14 a Profitability: Return on equity Return on assets (assume tax rate of 30%)

20X4

17 000 100 000 = 17% 30 500 266 000 = 11.5%

20X5

8 000 97 000 = 8.2% 22 200 274 000 = 8.1%

20X6

– 500 93 750 = –0.5% 16 500 284 500 = 5.8%

Summary Profitability of the company has been declining over the past three years. There is no point in calculating any more profitability ratios as they will all show the same trend. Need to find out why this is happening and what can be done. Therefore examine the income statement in more detail: i Sales are on the decline. 200 000 in X4 to 165 000 in X6. ii 20X4 110 000 200 000 = 55%

Gross profit Sales

20X5

96 000 180 000 = 53.33%

20X6

90 000 165 000 = 54.55%

Gross profit percentage has not changed significantly and therefore is not the cause of the company’s problem. iii Net profit (before tax) Sales

20X4 35 000 200 000 = 17.5%

20X5 20 000 180 000 = 11.11%

20X6

20X4 40 000 200 000 = 20%

20X5 40 000 180 000 = 22.22%

20X6 46 000 165 000 = 27.88%

= 7.5%

= 8.89%

= 12.12%

6 000 165 000 = 3.64%

This is the problem area! iv Selling and distribution Sales

v Finance expenses Sales

This indicates that either: • the company has to try and reduce its operating expenses, or • the company must endeavour to increase sales – need for a marketing campaign.

Chapter 12: Financial statement analysis 133

Short term solvency: i Current ratio 20X4 69 000 41 000

20X5 77 000 42 000

20X6 87 000 34 000

= 1.7 :1

= 1.8 :1

= 2.6 :1

20X4

20X5

20X6

ii Quick ratio Current assets – stock and prepayments 26 000 41 000

= .6 :1

30 000 42 000

35 000 34 000

= .9 :1

= 1.03 :1

Summary The current and quick ratios appear to be adequate, however, the company has no ready cash with which to pay: a accrued wages and interest ($2000) b tax ($2500) c dividends ($3000) d excess of bank overdraft ($500) and no investment to sell. Therefore the short-term solvency problem is cause for concern, even though neither of the ratios indicate a problem. This is because the fall in profitability will be accompanied by a fall in cash funds from operations. Efficiency: i COGS Average Stock

Stock turnover 3.65 days Turnover Rates

20X4

20X5

20X6

= 90 000 (36 000 + 41 000)/2

84 000 (41 000 + 44 000)/2

75 000 (44 000 + 49 000)/2

= 2.34

= 1.98%

= 1.61%

156 days

185 days

226 days

A deterioration in stock turnover may indicate obsolete stock indicating inefficient management of stock levels. ii Average collection period: Average Debtors x 365 Credit Sales

20X4

20X5

20X6

26 000 x 365 200 000

28 500 x 365 180 000

34 000 x 365 165 000

= 47 days

= 58 days

= 75 days

Chapter 12: Financial statement analysis 134

A deterioration in average collection period may indicate a high proportion of bad debts as well inefficient management in either or both of the credit control department and the collections department. iii Previously noted the increase in operating expenses as a proportion of sales. Recommendations • The company must be able to generate sufficient funds from trading to meet liabilities as they fall due and to create an adequate dividend flow. It is therefore imperative that the company embark on a vigorous marketing campaign to increase the volume of sales to a viable level. • Stock levels should be reduced to a quantity sufficient to cover normal sales for the maximum delivery time for each line. Any obsolete or damaged stock should be disposed of as it represents idle working capital and incurs storage charges. Reducing stock levels back to $41 000 will release funds of $8000 to meet pressing commitments. Further reductions in stock levels may also be possible even with expanded sales. • Debtors should be analysed to determine whether the provision for bad debts is adequate. A collection policy should be established and enforced. A collection period of 30 days should result in a debtors balance of $13 560 at the present level of sales. X x 365 = 30 165 000 ∴ X = 13 560

The present balance of debtors is $37 000, therefore the company could generate cash of $23 440 (37 000 – 13 560) by reducing the level of outstanding accounts from 82 days to 30 days. Reducing debtors to 60 days would reduce working capital needs by $10 000. This would be sufficient to overcome the company’s immediate liquidity problems Summary Efficient Distributors Ltd should be able to generate sufficient funds to meet their immediate obligations and should also be able to embark on a marketing campaign to improve sales, and therefore future funds, from operations as well as profitability. b Limitations of analysis: – use of historic costs – use of aggregate information – year end data may not be representative of figures during the year – lack of disclosure in annual reports – we have no bases to compare this company with. c Additional information that would assist analysis: – information of comparable companies to allow comparison – information about the economy – share price information – audit report – directors’ report and statement – any other relevant public information about the company.

Chapter 12: Financial statement analysis 135

Ethics case study a and b Facts – Allendale Ltd (AL) employs 500 people. – AL borrowed $20 million from a bank. The loan is subject to restrictive covenants. – If the covenants are broken, the loan is immediately repayable. – Competitive pressures are reducing AL’s profit margin. – The recoverable amount of an asset is lower than its carrying amount and a bad debt has not yet been recognised in the accounts – if both are recognised, then AL breaches its loan covenant and goes into bankruptcy. Stakeholders – AL’s employees – AL’s bank – AL’s shareholders – AL’s suppliers Problem – Should the write-down of the asset to recoverable amount and the bad debt be recognised? (Another way to look at the case is the broader issue of how to avoid bankruptcy. Even so, a decision still has to be made about how the items are to be treated.) Values and principles – Professional principles at issue here include integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290), technical and professional standards (APES 110– 100, AASB 102 and competence and due care (APES 110–130). These would all imply making adjustments to the accounts. – However, Tom has a duty of care to protect his employees, shareholders and suppliers (at least in the short-run) by not recognising the adjustments. Of course, in the long-run he may end up doing more damage to them, depending upon the financial condition of AL. He also has a conflicting duty to avoid harm to the bank. Three possible courses of action – Action one: do not make the adjustments. – Action two: make the adjustments. – Action three: make the adjustments but attempt to renegotiate the bank loan. (AL would have to produce detailed plans for recovery and budgets to support its case.) Evaluation Action one: – not in keeping with professional ethical principles or requirements of AASB 102 (the boats are inventory and the lower of cost and net realisable value rule applies) and APES 110 – may avoid breaching the loan covenant and so keep in business (at least in the short-run) – possibility that the auditor will discover the questionable items and demand write-down or issue a qualified audit report.

Chapter 12: Financial statement analysis 136

Action two: – in keeping with professional ethical principles and requirements of AASB 102, APES 110 – technical breach of loan with the result that AL goes bankrupt and employees lose their jobs, suppliers lose a source of revenue, and shareholders lose their investment. The bank may even lose some of its money. Action three: – as for Action two – depending on general financial condition of AL, may be able to convince the bank to renegotiate the loan, although this may increase interest costs and result in additional restrictions on AL’s actions. Choose a plan of action – Take a poll of the class but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts.

Chapter 13 Worksheet to debits and credits Review questions 1 Journals are a chronological list of all accounting transactions in a period of time and they identify the debit and credit effects on an account. A ledger is the detailed record of changes to a particular asset, liability, equity, income or expense account. 2 Journal entries identify the accounts affected by the entry, the debit and credit entries and details of the transaction. If an error is detected in the ledger accounts or the trial balance it can be traced back to the journals and source documents. 3 The worksheet approach combines all income and expense account balances under one profit and loss account, whereas the traditional approach lists all accounts separately. 4 The answers need to show an understanding of the trial balance as being equivalent to the first balance on the worksheet and the extended trial balance as including the end of year adjustments. 5 The answers should show the students’ understanding of these adjustments as being the same as would be used on the worksheet to put through year-end entries. 6 The cash basis of accounting does not attempt to recognise expenses in the period in which they are consumed (as opposed to being paid) or income when it is earned (as opposed to receiving the cash). As such, adjusting entries are not required under the cash basis of accounting.

Problems for discussion and analysis 1 Transaction Purchased office furniture on credit

A vehicle is donated to the business by the owner A building is purchased with 50% paid in cash and the remaining 50% from a short-term loan

Goods that have been sold on credit were returned (ignore the cost of goods sold)

Received payment for an outstanding account receivable

Account Office furniture Accounts payable Vehicles Capital Building Cash Short term loan Sales returns Accounts receivable Cash Account

Effect Increasing

Account Debit

Increasing

Credit

Increasing Increasing Increasing Decreasing Increasing

Debit Credit Debit Credit Credit

Increasing

Debit

Decreasing

Credit

Increasing Decreasing

Debit Credit

Chapter 13: Worksheet to debits and credits 138

Sold goods for cash (ignore the cost of goods sold) Recorded the cost of goods sold for cash

Purchased goods on credit

Paid 6 months insurance in advance

Paid land rates in arrears

Recorded interest revenue due to be received at the end of the period

Collected bill receivable plus interest

receivable Cash Sales Cost of goods sold Inventory Inventory Account payable Pre-paid Insurance Cash Accrued Rates1 Cash Interest receivable Interest income Cash Bill receivable Interest income

Increasing Increasing Increasing

Debit Credit Debit

Decreasing Increasing Increasing

Credit Debit Credit

Increasing

Debit

Decreasing Decreasing

Credit Debit

Decreasing Increasing

Credit Debit

Increasing

Credit

Increasing Decreasing

Debit Credit

Increasing

Credit

This assumes that the land rates had been accrued for the period the expense related to. If rates were not accrued then the debit would be to Rates expense and the effect would be to increase the expense account.

2 Date June 3

Transaction Paid electricity

Cash basis Accrual basis Electricity 480 debit Accrued 480 dr. expense electricity Cash 480 credit Cash 480 cr. An account for electricity is generally received after the use of the electricity. Under an accrual basis, an estimate of electricity use would be journalised to the expense account at the end of the period, raising a liability (accrued electricity) at the same time. At the time of payment of the account, the liability would then be debited. 5 Purchased No entry Inventory 2 500 dr. inventory Accounts payable 2 500 cr. Refer to the entry on June 15. This highlights the timing difference of transactions between the cash basis and accrual basis of accounting. 7 Sold goods on No entry Accounts 12 000 dr. credit receivable Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 13: Worksheet to debits and credits 139

Sales revenue 12 000 cr. As for above explanation, but also highlights that credit transactions are not recorded under a cash basis. 9 Prepaid insurance Insurance 6 000 dr. Prepaid 6 000 dr. for June to expense insurance October Cash 6 000 cr. Cash 6 000 cr. Highlights the benefits of the accrual basis in matching expense to consumption and that expenses may be overstated under a cash basis, as the insurance does not all relate to June. 12 Paid salary Salary expense 2 500 dr. Salary expense 2 500 dr. expense Cash 2 500 cr. Cash 2 500 cr. Consumption of expense has occurred therefore there is no difference. 15 Paid account Inventory 2 500 dr. Accounts payable 2 500 dr. payable from June 5 Cash 2 500 cr. Cash 2 500 cr. Assumes that the cash paid out is for receipt of the inventory, otherwise no cash transaction would have occurred. Refer June 5 transaction. 22 Purchased Furniture 8 500 dr. Furniture 8 500 dr. furniture for cash Cash 8 500 cr. Cash 8.500 cr. No difference. 26 Purchased No entry Inventory 3 400 dr. inventory on credit Accounts payable 3 400 cr. Refer explanation for June 5 transaction. 31 Adjusting entry for No entry Insurance 1 200 dr. June insurance expense Prepaid 1 200 cr. Insurance Entry aligns consumption of the insurance.. 31 Accrued June No entry Salary expense 1 800 dr. salary Salary payable 1 800 cr. Ensures that the expense is recorded in the period the service (salary) is used.

Chapter 13: Worksheet to debits and credits 140

3 General Journal Account

Debit

Sales revenue

Credit 6 500

Unearned revenue

6 500

Adjustment to record revenue received but not earned Salary expense

4 300

Salary payable

4 300

Adjustment to record June salaries earned but not yet paid Interest expense

1 500

Interest payable

1 500

Adjustment to record interest due but not yet paid Trial Balance June X0 Debit Credit $ $ Cash 49 680 Accounts receivable 33 700 Inventory 27 840 Land and buildings 188 000 Accounts payable 22 000 Salary payable 4 300 Interest payable 1 500 Unearned revenue 6 500 Loan 28 000 Capital 80 000 Sales 268 920 Cost of goods sold 45 000 Advertising expense 16 000 Electricity expense 7 700 Rent expense 12 000 Salary expense 29 800 Interest expense 1 500 411 220 411 220

Chapter 13: Worksheet to debits and credits 141

4 Balance sheet as at 30 June 20X0 Current assets Cash at bank Debtors Inventory Total current assets Non-current assets Equipment Land & buildings Total non-current assets Total assets Current liabilities Creditors Taxation Salaries payable Dividends payable Total current liabilities Non-current liabilities Debentures payable Total non-current liabilities Total liabilities Net assets Owners’ equity Capital Retained profits Total owners’ equity

6 500 10 000 7 300 137 000 270 000

7 500 10 000 2 000 6 000 250 000

23 800

407 000 430 800

25 500 250 000 275 500

130 800 24 500

$155 300

5 Balance sheet as at 30 June 20X0 Current assets Receivables Pre-paid insurance Inventory Total current assets Non-current assets Land & buildings Vehicles Equipment Total non-current assets Total assets Current liabilities Bank overdraft Creditors Short-term loan payable Taxation1 Dividends payable Total current liabilities Total liabilities Net assets Owners’ equity

13 450 750 63 230 120 000 27 300 7 600

10 000 29 600 15 000 10 000 13 500

77 430

154 900 232 330

78 100 78 100

$154 230

Chapter 13: Worksheet to debits and credits 142

50 000 $1 ordinary shares fully paid 50 000 $1 preference shares fully paid General reserve Retained profits Total owners’ equity

50 000 50 000 27 000 27 230

$154 230

Students may consider the Taxation balance to be an expense but in this question it is a liability because the trial balance only shows permanent account balances in order to prepare a balance sheet. 6 The question in Chapter 13 should have referred students to Problem 16 in Chapter 6 and not Problem 17. Jill’s business Trial Balance Debit $ 7 846 4 000 1 600 554

Credit $

Cash Cars Furniture Profit and loss Capital 14 000 Total 14 000 14 000 7 Mandy Plover General Journal Account

Debit $ 30 000

Jul-01 Cash Capital

Credit $ 30 000

Capital contribution to open the business Pre-paid rent

2 000

Rent expense

1 000

Cash

3 000

Paid three months rent in advance Telephone & fax expense

275

Cash

275

Telephone & fax connection fee Electricity expense

Cash

Chapter 13: Worksheet to debits and credits 143

Payment of electricity connection fee Office equipment rent expense

475

Cash

475

Rental costs for office equipment payable in advance 2

Fixtures & fittings

1 000

Cash

1 000

Paid advertising for fixed sign 3

Computer

17 500

Account payable

17 500

Purchase of computer on credit 4

Supplies (expected to last 12 months) Supplies expense

1 265 115

Cash

1 380

Purchase of supplies 15

Account receivable

2 750

Sales

2 750

Credit sales 15

No entry for contract with Widget company

Salary

750

Cash

750

Paid salary 16

Cash

225

Account receivable

225

Payment from account receivable 16 Pre-paid Motor Vehicle Lease

1 000

Motor Vehicle Lease expense

1 000

Cash

2 000

Payment of car lease in advance 18 Account payable

Chapter 13: Worksheet to debits and credits 144

Cash

17 500

Paid account payable for computer 22 Cash

300

Service income

300

Receipt of payment for tax services at Widget 23 Bad debts expense

780

Account receivable

780

Write off uncollectable debtor 29 Salary

750

Cash

750

Paid salary 29 Cash

300

Service income

300

Payment for tax services at Widget 31 Cash

340

Account receivable

3 110

Service income

3 450

Provided services for cash and on account Cash

Date

Particulars

Jul-01

Capital Pre-paid rent Telephone & fax Electricity Office equipment rent expense Fixtures & Fittings Supplies Supplies expense Salary expense Account receivable Motor Vehicle lease

2 4 15 16 16

Debit $ 30 000

225

Credit $ 3 000 275 50 475 1 000 1 265 115 750 1 000

Balance Debit Credit $ $ 30 000 27 000 26 725 26 675 26 200 25 200 23 935 23 820 23 070 23 295 22 295

Chapter 13: Worksheet to debits and credits 145

18 22 29 29 31

Date

Motor Vehicle lease expense account payable Service income Salary expense Service income Service income

Jul-15 Service revenue 16 Cash 23 Bad debts 31 Service revenue

Particulars

Jul-04

Cash

Date

Particulars

Jul-01

Cash

Date

Particulars

Jul-03

300 340

Debit $ 2 750

Credit $ 225 780

3 110 Supplies Debit $ 1 265 Pre-paid rent Debit $ 2 000

21 295 3 795 4 095 3 345 3 645 3 985

Balance Debit $ 2 750 2 525 1 745 4 855

Credit $

Balance Credit Debit $ $ 1 265

Credit $

Balance Credit Debit $ $ 2 000

Credit $

Pre-paid Motor Vehicle lease

July 16 Cash

Date

750

Accounts Receivable

Particulars

Date

300

1 000 17 500

Particulars

Account payable

Debit $ 1 000

Balance Credit Debit $ $ 1 000

Computer equipment Debit $ 17 500

Credit $

Balance Credit $

Debit $ 17 500

Credit $

Chapter 13: Worksheet to debits and credits 146

Date

Particulars

July 2

Cash

Fixtures & Fittings Debit $ 1 000

Particulars

Jul-03 18

Computer equipment Cash

Particulars

Jul-01

Cash

Date

Particulars

Jul-15 22 29 31

Account receivable Cash Cash Cash Account receivable

Date

Jul-01

Date

Particulars

Cash

Particulars

Credit $

Account Payable

Date

Balance Credit Debit $ $ 1 000

Balance Debit Credit Debit Credit $ $ $ $ 17 500 17 500 17 500 0

Capital

Balance Debit Credit Debit Credit $ $ $ $ 30 000 30 000

Sales Debit $

Balance Credit Debit $ $ 2 750 300 300 340 3 110

Telephone

Debit $ 275

Balance Credit $

Electricity

Debit $

Credit $ 2 750 3 050 3 350 3 690 6 800

Debit $ 275

Credit $

Balance Credit $

Debit $

Credit $

Chapter 13: Worksheet to debits and credits 147

Jul-01

Cash

Date

Particulars

Jul-01

Date

Office equipment rent expense

Debit $ 475

Cash

Jul-23

Particulars

Debit $ 750 750

Account receivable

Jul-4 Cash

Date

Supplies

Debit Credit $ $ 115

Debit $ 780

Balance Debit $ 475

Credit $

Balance Credit $

Bad Debts expense

Particulars

Date Particulars

Credit $

Salary expense

Jul-15 Cash Jan-00 Cash Date

Debit $ 750 1 500

Credit $

Balance Credit $

Debit $ 780

Credit $

Balance Debit Credit $ $ 115

Motor Vehicle expense Particulars Balance

Jul-16 Cash

Debit Credit $ $ 1 000

Chapter 13: Worksheet to debits and credits 148

Mandy Plover Trial Balance Jul-31

Debit Credit $ $ Cash at bank 3 985 Accounts receivable 4 855 Pre-paid rent 2 000 Pre-paid motor vehicle lease 1 000 Supplies 1 265 Fixtures & fittings 1 000 Computer 17 500 Accounts payable 0 Capital 30 000 Sales 6 800 Telephone & fax expense 275 Electricity 50 Office equipment 475 Salary 1 500 Bad debts 780 Rent expense 1 000 Supplies expense 115 Motor vehicle expense 1 000 36 800 36 800

Chapter 13: Worksheet to debits and credits

8 J Smith worksheet Assets Transaction 1 Capital 2 Goods 3 Shop fittings 4 Returns 5 Sales 6 Paid acc. 7 Receipts 8 Wages 9 Telecom 10 Rent Balances

Day Jan 2 Jan 2 Jan 3 Jan 3 Jan 3 Jan 5 Jan 6 Jan 8 Jan 9 Jan 10

Cash $

+ Inventory $

20 000 –3 400

–1 000 190 –200 –50 –100 15 440

+ Furniture & fittings $

3 400

1 450 –450

Debtors

200

3 400

1 000

–1 000

Owners’ equity $ 20 000

20 000

$ 1 450 –450

–200

Creditors

Equity Profit & loss

200 –10 –200 –50 –100 –160

Note: insufficient information has been given to allow students to complete end of period adjustments for inventory sold and depreciation. End of period adjustments are not shown.

149

Chapter 13: Worksheet to debits and credits

Cash

Inventory

Trans 1 Trans 7

$ 20 000 190

Balance b/d

______ 20 190 15 440

Trans 2 Trans 6 Trans 8 Trans 9 Trans 10 Balance c/d

$ 3 400 1 000 200 50 100 15 440 20 190

Balance b/d

$ 450 1 000 1 450

Trans 4 Balance c/d

Creditor (Alco) $ 450 1 000 1 450

Balance c/d

3 400 3 400

Debtor (Jones)

$ 1 450 ____ 1 450 1 000

Trans 3

$ 3 400 3 400 3 400

Trans 2

Furniture & fittings

Trans 4 Trans 6

150

Trans 5

$ 200

Trans 7

$ 200

Equity Trans 3

$ 1 450 ____ 1 450

Balance c/d

$ 20 000 20 000

Profit and Loss Trans 7 Trans 8 Trans 9 Trans 10 Balance b/d

$ 10 200 50 100 260 160

Trans 1 Balance c/d

___ 260

J. Smith Trial Balance Cash Inventory Furniture & fittings Profit and loss Equity

$ 200 160

Debit $ 15 440 3 400 1 000 160 _____ 20 000

Credit $

20 000 20 000

Trans 1 Balance b/d

$ 20 000 20 000 20 000

Chapter 13: Worksheet to debits and credits

9 B Bloggs worksheet Assets Transaction

Day

Cash $

1 Capital 2 No entry 3 Goods 4 Equip. 5 Rent 6 Sales 7 Sales 8 Returns 9 Goods 10 Sales 11 Payments 12 Vehicle 13 Payment 14 Phone 15 Electricity 16 Insurance 17 Cash 18 Sales 19 Interest 20 Sales 21 Rent Balances

Jan 1 Jan 2 Jan 3 Jan 4 Jan 3 Jan 5 Jan 8 Jan 10 Jan 11 Jan 15 Jan 17 Jan 18 Jan 19 Jan 19 Jan 19 Jan 20 Jan 24 Jan 26 Jan 27 Jan 29

+ Prepaids $

Inventory $

Vehicles $

Equipment $

+ Debtors

= Creditor

Equity + Profit & Loss $

+ Owners’ Equity $

25 000

25 000 16 500

–1 000

1 000

2 000

9 750 –13 560 6 760 –16 500

2 000 9 750 –630

–630

13 560

–16 500 27 600 –3 000

27 600

–3 000 –175 –150 –1 800 2 000

1 800

–100 5 330 12 555

16 500 3 000

3 000

–1 000 1 800

–2 000 13 750

30 060

27 600

3 000

13 120

27 600

6 760

–175 –150 13 750 –100 5 330 –1 000 35 535

25 000

151

Chapter 13: Worksheet to debits and credits

Cash Trans 1 Trans 7 Trans 10 Trans 17 Trans 20

Balance b/d

$ 25 000 9 750 6 760 2 000 5 330 ______ 20 190 12 555

Trans 5 Trans 9 Trans 11 Trans13 Trans 14 Trans 15 Trans 16 Trans 19 Balance c/d

Pre-paids Trans 5 Trans 16 Balance b/d

$ 1 000 1 800 ____ 1 800

Trans 21 Balance c/d

Vehicles Trans 12 Balance b/d

$ 27 600 ____ 27 600

Balance c/d

$ 1 000 13 560 16 500 3 000 175 150 1 800 100 12 555

$ 1 000 1 800

$ 27 600

Creditors Trans 11 Trans 13 Balance c/d

$ 16 500 3 000 27 600

Inventory Trans 3 Trans 9

$ 16 500 13 560

Balance b/d

30 060

Balance c/d

30 060

Trans 8 Trans 17 Balance c/d

$ 630 2 000 13 120

Debtors Trans 6 Trans 18

$ 2 000 13 750

Balance b/d

13 120

Equipment Trans 4

$ 3 000

Balance b/d

3 000

152

Balance c/d

$ 3 000

Equity Trans 3 Trans 4 Trans 12 Balance b/d

$ 16 500 3 000 27 600 27 600

Balance c/d

$ 25 000

Profit and Loss Trans 8 Trans 14 Trans 15 Trans 20 Trans 21 Balance b/d

$ 630 175 150 100 1 000 35 535

Trans 6 Trans 7 Trans 10 Trans 19 Balance c/d

$ 2 000 9 750 6 760 13 750 5 330

Balance b/d

35 535

Trans 1

$ 25 000

Balance b/d

25 000

Chapter 13: Worksheet to debits and credits

B Bloggs Trial Balance Cash Inventory Prepaids Debtors Vehicles Equipment Creditors Profit and loss Equity

Debit $ 12 555 30 060 1 800 13 120 27 600 3 000

_____ 88 135

153

Credit $

27 600 35 535 25 000 88 135

10 Part

Accounts

Electricity expense Accrued electricity Accrual of $5 000 of electricity expense for November and December Insurance expense Prepaid insurance The use of 1/24 of the prepaid insurance for the year Interest expense Interest payable Two months of interest accrued for interest payment on debentures to be paid on 31 January No entry

b c

d e

This is a difficult entry and you may want to advise students not to attempt this part. If we assume the entity recorded the receipt of cash as follows then there is no adjusting entry required: Cash Discounts Unearned revenue If, however, the entity credited sales and none of the goods had been delivered as at 31 December then the following adjusting entry is required: Sales Unearned revenue

Debit $ 5 000 120 1 667

92 000 23 000

115 000

Credit $ 5 000 120 1 667

115 000

Chapter 13: Worksheet to debits and credits

154

11 Cash Bal 1 2 3 4 5 6

–4 000

Bal

2 000

+ Account Rec’ble 9 600

1 600 8 000

+ Invent.

+ Vehicle

+ Premises

13 200 2 800

2 400

14 400

800

= Account Payable 5 600 2 800

–2 800 –800

+ Rates Payable

10 400

16 000

+ 2 400

14 400

Trial Balance Sales Rates and taxes Wages Cash at bank Accounts receivable Inventory Delivery vehicles Premises Rates and taxes payable Accounts payable Mortgage Capital

Debit $

2 000 800 2 000 10 400 16 000 2 400 14 400

______ 48 000

5 600

+ Capital

10 000

20 000 8 000

2 000

–2 800

+ Mortgage

+ 2 000

Credit $ 2 400

2 000 5 600 10 000 28 000 48 000

10 000

28 000

+ P&L 2 400 Sales –2 000 Rates –800 Wages –400

Chapter 13: Worksheet to debits and credits

12 Accounts a b c d e f g h i j k

Building

Cash Mortgage payable Depreciation expense – machines Accumulated depreciation – machines Investment – 100 Ravan shares @ $13.50 Cash Vehicle Capital account Cash at bank Capital account Depreciation expense – building Accumulated depreciation – building Cash Discount on debentures Debentures Land Cash Accounts payable Purchases returns Drawings H Black Cash Interest expense – debentures Cash

Debit $ 100 000 2 000 1 350 3 000 4 000 1 000 95 000 5 000 50 000 25 200 6 000

Credit $ 20 000 80 000 2 000 1 350 3 000 4 000 1 000 100 000 50 000 25 200 6 000

155

Chapter 13: Worksheet to debits and credits

13 Accounts a

Cash Paid up capital

Debit $ 5 000

Credit $ 5 000

Issue of 5000 shares for $1 each b

Shares in ABC

Profit and loss

To record dividends payable, balance of profit transferred to RE Retained earnings

10 000

Equipment Exchanged equipment for 5000 $2 shares in ABC

10 000 12 500

Dividends payable Retained earnings

General reserve Transfer to a general reserve Debentures payable Interest payable Cash at bank

5 000 7 500 6 000 6 000 100 000 4 000 104 000

Repayment of debentures and interest

156

Chapter 13: Worksheet to debits and credits

Cash

i ii iii iv v Bal

5 000

Shares in ABC Ltd

10 000

Equipment

Interest payable

5 000 –4 000

Divids payable

Retained earnings

There is no sense in balancing the worksheet as it doesn’t make any sense without opening balances.

7 500 –6 000

6 000

–100 000

General reserve

Capital

P&L

5 000

–10 000

–104 000

Debentures payable

–12 500

157

Chapter 13: Worksheet to debits and credits

14 Accounts a b c

d e

Cash

Paid up capital Issued 25 000 $1 shares paid to 80 cents Legal services expense Paid up capital Issued 200 $2 shares for legal advice Profit and loss Cash Retained profits To record the payment of $5000 dividend to preference shareholders, $3000 to ordinary shareholders and the transfer of the balance of the profit and loss account to retained profits Cash Debentures payable Issue of $1 000 000 of 5% debentures at par Either: Equipment Paid up capital or: Equipment Paid up capital If the fair value of the shares is $2 then the first entry is correct but if the fair value of the shares cannot be reliably determined then the second entry is correct. Accounting standards require the FMV of the assets given to be used unless this cannot be reliably measured, in which case the FMV of the asset acquired can be used.

Debit $ 20 000 400 123 000

1 000 000

20 000 19 500

Extended Trial Balance as at 30 June Account title Trial balance Adjustments Extended Trial Balance Debit $ Credit $ Debit $ Credit $ Debit $ Credit $ Cash at bank 7 100 7 100 Accounts receivable 4 800 4 800 Interest receivable (a) 100 100 Bill receivable 3 500 3 500 Supplies 4 000 (b) 600 3 400 Prepaid rent 2 800 (c) 900 1 900 Equipment 50 000 50 000 Accounts payable 5 400 5 400 Salary payable (d) 1 000 1 000 Unearned revenue 6 000 (e) 4 000 2 000 Capital 49 900 49 900 Sales revenue 15 100 (e) 4 000 19 100 Interest income (a) 100 100 Salary expense 3 100 (d) 1 000 4 100 Rent expense (c) 900 900 Insurance expense 700 700 Supplies expense (b) 600 600 Telephone expense 400 400 76 400 76 400 6 600 6 600 77 500 77 500 Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Credit $ 20 000 400 8 000 115 000

1 000 000

20 000 19 500

158

Chapter 13: Worksheet to debits and credits

159

General Journal

Debit $ 100

Interest receivable Interest income

100

Supplies expense

600

Supplies c

600

Rent expense

900

Prepaid rent d

900

Salary expense

1 000

Salary payable e

1 000

Unearned revenue

4 000

Sales revenue 16

Credit $

4 000

Hourglass Organisation Trial Balance as at 30 June 20X3 Debit Credit $ $ Cash at bank 1 400 Debtors 2 500 Supplies inventory 390 Equipment 6 700 Creditors 2 400 Salaries payable 310 Mortgage payable 2 300 G Hourglass, Capital 7 200 G Hourglass, Drawings 4 420 Service revenues 13 800 Salary expense 5 100 Rent expense 3 200 Other expenses 2 300 26 010 26 010

Chapter 13: Worksheet to debits and credits

Balance

Petty cash

Cash at bank

+ Inventories + Accounts receivable

250

3 400 +

22 400 +

+ Provision + Prepaid for doubtful insurdebts ance

20 000 +

(1 300) +

+ Motor vehicle

+ Accum. depn. motor vehicle

+ Furniture + Accum. depn. furniture

16 000 + (6 400) +

4 400 +

(600)

Accounts payable

+ Rent payable

19 800 +

14 500

Profit and loss

11 850

(1)

(4)

14 500

cost of goods sold

–3200

dep. exp.

–300

rent. exp

150

ins. exp.

–200

bad debs exp.

(4)

–22 400

cost of goods sold

23 520

300

150

(5)

(200)

Opening Stock Adjustment

–22 400

250

3 400 +

14 500 +

20 000 +

(1 500) +

150 +

16 000 + (9 600) +

4 400 +

(820)

19 800 +

300

+ J Lion Capital less drawings (2)

(3 200)

Iii

Balance

160

+ K Jaguar Capital less drawings (3)

21 300 + 28 900

Chapter 13: Worksheet to debits and credits

The Tiger Partnership Income statement for the period ending 30 June 20X7 Sales Commission received Operating revenue Less: Loss on sale of motor vehicle Less: Discount allowed Net operating revenue Opening inventory Purchases Less: Closing inventory C.O.G.S. Gross profit Expenses Rent General office expenses Cartage on sales Travelling expenses Insurance Bad debt expense Salaries Depreciation expense M/vehicles Furniture Net loss

$ 135 750 1 250 137 000 1 000

2 900 133 100 22 400 124 500 146 900 14 500

132 400 700

3 600 1 750 850 3 600 450 1 050 9 500 3 200 220

24 220 $23 520

161

Chapter 13: Worksheet to debits and credits

The Tiger Partnership Balance sheet as at 30 June 20X7 Current assets Petty cash Cash at bank Account receivable Less: Prov. for doubtful debts Pre-paid insurance Inventories Total current assets Non-current assets Motor vehicles Less: Accumulated depreciation Furniture Less: Accumulated depreciation Total non-current assets Total assets Current liabilities Account payable Rent payable Total current liabilities Total liabilities Net assets Owners’ equity J Lion, Capital K Jaguar, Capital Less: J Lion, Drawings Less: K Jaguar, Drawings Net loss Total owners’ equity

20 000 1 500

16 000 9 600 4 400 820

162

250 3 400 18 500 150 14 500

36 800

6 400 3 580

19 800 300 20 100

31 000 (3 700) (2 100) (23 520)

9 980 46 780

20 100

$26 680

25 000

$26 680

Ethics case study 1 I.M. Devious has stolen cash by processing cash received to fictitious account receivables. The entries I.M. Devious would have prepared are: Debit Account Receivable $34 000 Credit Sales $34 000 The correct entries should have been: Debit Cash $34 000 Credit Sales $34 000 2 It is difficult to determine exactly when the fraud would have been stolen as this is dependent on the internal controls Phil has in place. At some point there would need to be a follow-up on the outstanding accounts and the fictitious receivables would have been discovered at that time. The fraud may also have been discovered if one of the customers that had remitted the funds had requested a receipt.

Chapter 13: Worksheet to debits and credits

163

3 There is no definitive answer to this question but it should produce some discussion. Some of the possible points for this discussion include: • Phil would need to bring fraud charges against I.M. Devious. The problem would be in finding I.M. Devious and recovering the stolen money. • In relation to Carl, there are several steps that Phil could take: demote him to a less senior role; suggest he undergo further studies; provide internal mentoring; or fire him.

Chapter 14 Internal users, internal information, and planning and control Review questions 1 Answers should reflect the fact that the accounts are normally at least three months old when they are published. Students should be encouraged to analyse the usefulness of an out-of-date balance sheet and a statement of comprehensive income and the situation of a business that is experiencing difficulties. Although managers require up-to-date information, they have access to more information on a day-to-day basis than external users. So, for example, they would know the current orders and be able to compare these with similar periods in the previous years, they would have a ‘feel’ for production levels, inventory levels and so on, even though this information may be qualitative rather than quantitative in nature. 2 Level of detail, need for overview, monitoring and control information, different reporting frequencies required, strategic level information. 3 Examples in the chapter included information on customers and debtors, costs and aged debtors. Students should be encouraged to look at the other information in the financial accounting system to see if it would be helpful for managers in terms of monitoring, planning or control. 4 Because some external users can exert pressure, for example, a banker or a major shareholder. 5 Information about the future, as repayment of any monies lent is likely to come from future profitability. 6 This information tends to be more up-to-date and detailed as compared to published accounting information. Users of accounting information, such as banks, need timely information for their decision making. This type of information has this quality and is more detailed, which can also be useful. It should be said, however, that there will not be many situations where users will be able to obtain such information from organisations.

Problems for discussion and analysis 1 a

Students should discuss just who is an average investor? What are their needs? Ask students how well they understand all the information in the Woolworths accounts. They will probably all agree that the skills required to fully comprehend the information in an annual report far exceed those of an average investor. b The users who would gain the most from reading the accounts are those users with accounting skills, such as security analysts and accountants. 2 Managers will use a range of information that is not restricted to what appears in the published annual report. Managers are keen for the annual report to show their company in a good position as this reflects well on them as managers. However, in running the business they will use a far greater range of information than what is published in the annual report. Some of this information is discussed in the remaining chapters of this book. Managers would be using it to plan future activity levels, order inventories, employ labour and so on, whereas bankers are more interested in an overview of where the business is likely to go and perhaps also as a monitoring tool, although it is doubtful that such a level of sophistication is applied to the majority of enterprises. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 14: Internal users, internal information, and planning and control

3 a

165

On the face of it, you may not need much financial information as you are not judged on profitability over which you have little control, as selling prices and buying prices are fixed. You do have some control over the costs in the form of wage bills so you may require information about that area and your daily cash takings, and some idea of inventory turnover to control for pilferage of goods or cash. b Here you would need the information contained in the projections that provide the profit target so that you could attempt to improve on the profit either by increasing sales or by adjusting the staffing of your outlet to reduce the costs and thereby increase the profit. Other issues such as profit by product and changes in sales mix could also be explored. c Some of the additional information you would need could include cost by product, potential sales volume by product, price elasticity of demand and competitor prices. d Here the question moves the student into a senior management position which would need information for control purposes, such as profitability by branch, turnover by branch, branch cash flows and so on. Think of a ship – the strategic decisions are those which have a significant bearing on the direction the ship is cruising in, while the operating decisions affect the speed and how the ship is cruising in that direction on a day-to-day basis. Have students give examples from places where they have worked. The main difference between the models is that the engineer’s model is a physical model which generates automatic responses while the accountant’s model is dependent on humans for corrective responses. A number of limitations can be identified, primarily due to this essential difference in the systems. Firstly, with the accountant’s control model, there tend to be time lags in the reporting of variances because of the nature of accounting systems, and secondly, people, rather than the mechanical system, will have to be motivated to respond to variances, identify the cause of the variance and take corrective action. This is an ideal situation to focus on how students will react to setting their own targets, having targets set for them, and then relating this to a business situation. For example, what pass mark would they set for an examination they are about to sit? How would students react to a tutor setting a pass mark of 80 per cent? Setting a low pass mark themselves which they can easily achieve is motivating, while on the other hand they may feel demotivated when having to attempt to obtain a pass mark of 80 per cent that a lecturer has set. You can then relate these comments to setting input and output budgets in a business situation. The main point to pursue is that the accounting information system (AIS) should be designed taking into consideration the environment in which the organisation operates. For example: the type of production process – process as compared to job costing; the degree of competition – monopolistic market conditions; the size of the organisation – a sole trader as compared to a multinational; these factors will influence the design of the AIS. In the case of a monopolist, it is likely their planned sales prices will be based on costs and revenues at output levels where they can maximise profits without reference to competitors’ prices (as they do not exist). If precise objectives are not set organisations will tend to drift along not knowing where they are going. Planning will be hazardous as planners are not aware of what is required from them and there is no basis for establishing whether or not the organisation is succeeding. The major problems associated with setting objectives relate to the fact that different people involved in the organisation will have varying goals, e.g. shareholders and employees, and these objectives may conflict.

Chapter 14: Internal users, internal information, and planning and control

166

9 There is no single answer to this problem. The investigation would normally comprise of processes that would be systematically followed until the fundamental reasons for the decline in profitability are identified. However, as a minimum, students should include the following processes and information required in their answers. • Industry review: how is the organisation performing in relation to the industry? Information available could include recent government statistics, industry reports and stock exchange reports. • Review of the organisation: when did the decline in profitability begin? Information could be obtained from recent annual reports and management accounts. • Review of individual business units: which business units are performing below expectation (i.e. identify the specific nursing home or department within a nursing home that is performing poorly)? The major source of information would be monthly management accounts or cost centre reports. • Review of activities/performance of individual managers/directors responsible for underperforming business units. Information required here would be detailed cost reports and statistics of the individual business units. A detailed review of transactions may be required at this level. Should the business be structured as cost or profit centres? Are the sisters-in-charge the right people to be managing the nursing homes? 10 a The accounting and reporting information system should cover: • a cash forecasting facility • an inventory system capable of identifying sales by period and season • an inventory control system that is triggered by minimum stock levels being reached and which automatically generates order quantities based on a maximum stock level (JIT would be ideal) • a debtor system that automatically generates an ageing analysis of outstanding accounts • marketing management can be improved by reviewing the inventory movement history files • the provision of historical sales information to the marketing department – this information should also be provided to the Management Information System (MIS) • the provision of a purchases budget to the purchasing department • the refusal of supply to customers who do not meet the firm’s credit standards. b Benefits to Giggling Brothers will be twofold: removal of interdepartmental friction within the firm and a strategic advantage by the provision of historical data to enable management planning and future decisions. Planning is broadly divided into two areas: • Strategic – allows focus on long-term planning and forecasting. This suggests the use of a MIS. • Operational – aims to reduce or solve the above problems leading to increased productivity and efficiency and a reduction in cash flow problems and staff friction. These indicate the use of a spreadsheet and a standard accounting package.

Chapter 14: Internal users, internal information, and planning and control

167

If the students are aware of project evaluation and the use of net present values, this can be brought into the discussion. For an analysis, the components below need to be considered: Cost components: Hardware Software Training Maintenance Staff Benefits: Increased productivity Reduced inventory levels Easing of cash flow problems Reduction of collection costs Improved staff morale Market improvement d The design and specification should be coordinated by a systems analyst who will consult with key staff of Giggling Brothers. Additionally, Giggling Brothers may need to provide a steering committee if a custom-made solution is implemented. e Evaluation of competitors is commonly productive.

Ethics case study Is John acting in an ethical manner? • It is difficult to mount a strong case that John is acting in an ethical manner. Although he might personally gain from the decision (his motives are not disclosed) and some property owners in Mandurah might get higher property values, there are some significant negatives to his actions. • By not revealing all the relevant information, John is failing to show respect to the management and shareholders of Energisers Ltd. In other words, he is being dishonest. This behaviour is inconsistent with the professional ethical principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290), and competence and due care (APES 110–130). • His failure to reveal the fact that property taxes are 100 per cent higher in Mandurah would impose significant costs on the company (and reduced returns to its owners) if Mandurah was the site chosen on the basis of his recommendation. The problem would be exacerbated by the fact that property prices will increase in Mandurah as a result of the plant, thus pushing property taxes higher again (assuming they are based on some form of market prices). • His dishonesty also imposes costs on the people of Rockingham who might have benefited by employment and business opportunities if the plant was situated there (of course, these benefits will go to Mandurah). • It is also likely that the higher property taxes of Mandurah will eventually be revealed with the result that John’s competence and ethics will be seriously called into question.

Chapter 15 Capital investment decisions Review questions 1 Simple interest = $900 × 4½ ×

46 365

= $5.10 (including both days) Alternatively: 45 = $900 × 4½ × 365

= $4.99 (excluding one day) 2 a $1000 invested at 5 per cent for five years amounts to $1276.28 5

$1000 × (1.05) = $1000 × 1.27628 (from Table 1, Appendix 2) b $200 at 10 per cent for 15 years amounts to $835.45 15 $200 × (1.10) = $200 × 4.17725 (from Table 1, Appendix 2) N.B. Compare the sizes of the factors, 1.27628 and 4.17725 3 a $1250 invested at 6.5 per cent compounded annually for six years amounts to $1824.52 6

$1250 × (1.065) = $1250 × 1.45962 (from Table 1 Appendix 2) b $6500 invested at 7.75 per cent compounded semi-annually for four years amounts to $8811.60 8 $6500 × (1.03875) = $6500 × 1.35563 (from Table 1, Appendix 2) 4 a $1000 × 1/(1.10)3 = $1000 × 0.75131 (from Table 2, Appendix 2) = $751.31 b $1500 × 1/(1.10)10 = $1500 × 0.38554 (from Table 2, Appendix 2) = $578.31 5 $125 × factor = $330 Factor = 2.64 From Table 1, Appendix 2 using the 2.5 per cent factor (as the amount is compounded quarterly and so we divide the 10 per cent by four) we get about 40 periods which is 10 years. 6 $1000 × factor = $2100 Factor = 2.1 after seven years From Table 1, Appendix 2 the interest rate for seven years that has the factor of 2.1 is between 10% and 12%. By interpolation the rate is approx 11.2%

Chapter 15: Capital investment decisions

169

7 Net saving = labour – maintenance = $25 000 – $10 000 = $15 000 p.a. for 10 years Outlay = $100 000 100 Therefore we are looking for PV annuity factor of 15 = 6.667

From Table 4, Appendix 2, factors for 8 per cent and 10 per cent are 6.710 and 6.1445 for 10 periods. Therefore the IRR is close to 8 per cent (6.667 approx. 6.710) 8 Look for factor of $100/$75 = 1.3333 for 10 years in Table 1, Appendix 2 Rate = 3 per cent approx. 9 Factor of 1.5 for 10 years implies rate of about 4.1 per cent (you need to interpolate to get to this order of accuracy). Assume 4 per cent. $1000 × factor for six years = $1000 × 1.26532 (Table 1, Appendix 2) = $1265.32 10 $400 a year for 15 years plus $600 a year for years 11 to 15 = $20 000 Future value of annuity of $400 for 15 years + FV of annuity of $600 for five years at 12 per cent = $18 723.80 Future value of annuity of $400 for 15 years + FV of annuity of $600 for five years at 15 per cent = $23 077.20 Using interpolation the interest rate is 12.9 per cent. 11 $4000 × 400 (11.4699) (from Table 4, Appendix 2) = $8587.96 12 a 100 (2.07893) Table on FV of $1 at year 15 (Table 1)

100 (5.5256) Table on FV of $1 annuity (years 1– 5) (Table 3)

PV of $100 now PV of $100 p.a. 5 years 5% $100 × 4.3295 (Table 4) PV of $200 years 6–15 $200 × 7.7217 (Table 4) × (1.05)–5 $200 × 7.7217 × 0.78352

(1.62889) Table on FV of $1 (to take to year 10) (Table 1)

200 (12.5779) Table on FV of $1 annuity at year 10 (Table 3) = $3 623.53 $100.00 432.95 1 210.02 $1 742.97

13 Looking for rate to give factor of $10 000/$500 = 20 in Table 3, Appendix 2 for 15 years. At 4 per cent the factor is 20.0236. Thus 4 per cent is close. 14 FV of annuity of $1000 five years 6 per cent = $5627 (use Table 3) FV of $5627 10 years later at 4 per cent = $5627 × 1.48024 (use Table 1) = $8329.31 FV of annuity of $1200 10 years 4 per cent = $14 407.32 (use Table 3) Therefore FV of fund = $8329.31 + 14407.32 = $22 736.63

Chapter 15: Capital investment decisions

15 a $81 000/7.7217 = $10 490 b Year 1 2 3 4 5 6 7 8 9 10

(use Table 4, Appendix 2)

Principal outstanding $ 81 000 74 560 67 800 60 700 53 250 45 420 37 200 28 570 19 510 10 000

Interest (5%) 4 050 3 730 3 390 3 040 2 660 2 270 1 860 1 430 980 490

Principal repayment $ 6 440 6 760 7 100 7 450 7 830 8 220 8 630 9 060 9 510 10 000

Principal outstanding $ 74 560 67 800 60 700 53 250 45 420 37 200 28 570 19 510 10 000 0

Note: rounding errors. c Check: • After four years $10 490 × 5.0757 = $53 240 (use Table 4, Appendix 2) • After seven years $10 490 × 2.7232 = $28 570 (use Table 4, Appendix 2) 16 $500 × 0.74725 + $1000 × 0.41726 = $790.88 PV (use Table 2, Appendix 2) FV = $790.88 × 1.79084 = $1416.34 (use Table 1, Appendix 2) Answer = $1416.34 17 $1000 × 0.86383 + $1000 × 0.53032 = $1394.15 PV (use Table 2, Appendix 2) 2000/1394 = 1.4347 factor For r = 5 per cent, seven and eight years factors are 1.40710 and 1.47746 (Table 1, Appendix 2) Payment at about seven years, two months 18 Total payments are $240 over two years (i.e. $10 per month) Factor in annuity table = $200/$10 = 20 for 24 periods From Table 4, Appendix 2 the rate is approximately 1.5 per cent per month (factor at 24 periods for 1.5 per cent is 20.03041)

Problems for discussion and analysis 1 $3 556.17 calculated as follows: W = $1000 R=? m=4 p=1 i = 0.03 W = RS m/p i gives R = $230.03 A = RA n i gives A = $3 556.17

170

Chapter 15: Capital investment decisions

171

2 Amount to be borrowed = $27 000 – $6000 = $21 000 $21 000 to be paid back over six periods at $4 200 per period. Table 4 ____1___ Let 1 – (1 + R) n = X R 21 000 = 4200 X=5 Look at Table 4 and we can see from six periods the rate is between 5 and 6 per cent. By interpolation this rate is approximately 5.5 per cent per period on approximately 33 per cent per annum. 3 The amount to be financed is $6000. There are four interest additions before the first $2000 is paid. This can be set up from Table 1 as follows: $6000 (Table 1) – $2000 = X X = five payments of $2000 at the same interest in Table 1. This can be set up as follows: $2000 (Table 4) $6000 (Table 1) – $2000 = $2000 (Table 4) By substitution, for example 10 per cent $6000 (1.4641) – $2000 = $2000 (3.79079) = $6785 = $7582 ∴ need a higher interest rate. 12 per cent is too high, by interpolation the rate is approximately 11.5 per cent on 23 per cent PA. 4 a From Table 2, five periods at 5 per cent = 5.5256 Let X = the annual amount $30 000 = 5.5256X X = $5429.27 b To calculate call amount required X ∴ = [(1.025X + X) (1.035) + X] × 1.045 …etc. = 5.8236X ∴ X = $30 000 = $5151 5.8236 ∴ Option (b) is best. 5 a Present value of annual net cash flows ($20 000 × 4.16*) $83 200 Amount to be invested $91 280 Net present value ($8080) *Present value of an annuity of $1 at 15 per cent for seven periods from Table 4, Appendix 2. b The rate of return is less than 15 per cent because there is a negative net present value. Amount to be invested c Present value factor for an annuity of $1 = Annual net cash flow $91280 = $20000 = 4.564 Internal rate of return = 12 per cent (from Table 4, Appendix 2)

Chapter 15: Capital investment decisions

6 a

172

NPV @ 5 per cent Project 1 = –$5000 + 500(1.05)–1 + 500(1.05)–2 + 500(1.05)–3 + 500(1.05)–4 + 5500(1.05)–5 = $1 082.37 Project 2 = $710.58 Project 3 = $1 309.74 Rank 3, 1, 2 NPV @ 10 per cent At 10 per cent NPV equals zero for all projects, implying equal ranking. NPV @15 per cent Project 1 = –$838 Project 2 = –$579 Project 3 = –$996 Rank 2, 1, 3 20 000 =

6 000 7 000 12 000 3 000 12 000 + + + + 2 3 1 + r (l + r) (l + r) (l + r) 4 (l + r) 5

However, no project accepted as all have negative NPVs. b IRR equals 10 per cent at 5, 10 and 15 per cent discount rates implying equal ranking at all rates. 7 a Accounting rate of return: Average net profit = $6000 – Depreciation 20000 −2000 =6000 − 5 = $6000 – $3600 Average investment = $20 000 + $2000 2 = $2400 = $11 000 Total investment = $20 000 • Accounting rate of return on average investment: =

•

2400 11 000

= 21.8 per cent Accounting rate of return on total investment: =

2 400 20 000

= 12 per cent b Payback period: 20 000/6000 = 3⅓ years c Internal rate of return: By trial and error, r = 17.23 per cent d Net present value: NPV = –20 000 + 6000(1.10)–1 + 6000(1.10)–2 + 6000(1.10)–3 + 6000(1.10)–4 + 8000(1.10)–5

Chapter 15: Capital investment decisions

173

NPV = 3 986.56 Answers based on different net cash inflows: Accounting rate of return: Average net cash inflows = $7600 Average net profit = $7600 – $3600 = $4000 i Accounting rate of return on average investment: $4000 $11 000 = 36.36 per cent ii Accounting rate of return on total investment 4 000 20 000

= 20 per cent Payback period: (6000 + 7000 + 7 000/12 000) = 27/12 years Internal rate of return: 20 000 =

6 000 6 000 6 000 6 000 8 000 + + + + 1 + r (l + r) 2 (l + r) 3 (l + r) 4 (l + r) 5

By trial and error, r = 26.32 per cent Net present value: –1

–2

–3

–4

NPV = –20 000 + 6000(1.10) + 7000(1.10) + 12 000(1.10) + 3000(1.10) + –5

8 a

12 000(1.10) NPV = 9 754.54 i Cash payback period for both projects: three years (the year in which accumulated net cash flows equal $380 000). ii Net present value analysis: Net cash flow Year 1 2 3 4 5 Total Amount to be invested Net present value

Present value of $1 at 20% 0.833 0.694 0.579 0.482 0.402

Plant expansion $100 000 130 000 150 000 130 000 170 000 $680 000

Retail store expansion $150 000 120 000 110 000 110 000 190 000 $680 000

Present value of net cash flow Plant Retail store expansion expansion $83 300 $124 950 90 220 83 280 86 850 63 690 62 660 53 020 68 340 76 380 $391 370 $401 320 380 000 380 000 $11 370 $21 320

b The report can take many forms and should include, as a minimum, the following points: • both projects offer the same total net cash flow. • both projects offer the same cash payback period. • because of the timing of the receipt of the net cash flows, the retail store expansion offers a higher net present value

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174

• both projects provide a positive net present value. This means both projects would be acceptable, since they exceed the minimum rate of return. 9 While it is possible to use tables, the answers have been determined using an Excel spreadsheet. Financial calculators can also be used. a $943.72 per month b $991.89 per month The 7.5 per cent loan provides the lowest outlay of money despite the fact that interest commences from the first day of the month compared to the end of the month in the second case. 10 a Project A: 130000 Payback = 40000 = 3.25 years NPV = –13 000 + 400 000 × 3.3521 (Appendix 2) = $4084 Project B: 60000 Payback = 30000 = 2 years NPV = –60 000 + 30 000 × 3.3844 (Appendix 2) = $53 532 Project C: 40000 Payback = 12000 = 3.3 years NPV = –40 000 + 12 000 × 5.0187 (Appendix 2) = $20 980 Project D: 25000 Payback = 9000 = 2.78 years NPV = –25 000 + 9000 × 3.7844 (Appendix 2) = $9060 Project E: 15000 Payback = 4500 = 3.3 years NPV = –15 000 + 4 500 × 2.2832 (Appendix 2) = ($4726) The following table summarises the results: A B C D E

Projects

NPV $4 084 $53 532 $20 980 $9 060 ($4 726)

Payback 3.25 years 2 years 3.3 years 2.78 years 3.3 years

Chapter 15: Capital investment decisions

175

From the table it is clear that B is accepted and E is rejected. Of the remaining projects, C offers the larger NPV but the payback exceeds the company’s three year limit. Therefore, using both NPV and payback the company would select project D as the second investment. b From the above analysis we can see that if the company only used NPV it would select project C before D and be some $11 920 better off. The difference is significant and the payback periods are only about six months different. There is a good argument for the selection of C before D and the use of payback would effectively mean the selection of a lower profitability investment. 11 a i Analysis of cash flows: Year 0 Outlay Less sale of machine Total outlay

$11 000 (500)

Years 1–4

Savings in labour and materials – Maintenance costs - Depreciation Tax outflow

$10 500 390 x 12 100 x 12

= =

$4 680 -$1 200 -$2700

After tax savings Add depreciation After tax cash inflow

Year 4 Disposal of machine

$780 pa -$312 $468 pa $2700 $3168 pa

$200

NPV = –10 500 + 3 168 x PVF (15,4) + 200 PVF 15, Year 4 = –10 500 + 3 168 × 2.8549 + 200 × .57175 = –10 500 + 9 044+ 114 = −$1 342 10500 Payback = = 3.3 years 3168 The company should not purchase the machine, as it has a negative NPV. 12 a Proposal A: 4-year cash payback period, as follows: 1 2 3 4

Year

Net cash flow $160 000 160 000 160 000 120 000

Cumulative net cash flows $160 000 320 000 480 000 600 000

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Proposal B: 3-year cash payback period, as follows: 1 2 3

Year

Net cash flow $200 000 160 000 160 000

Cumulative net cash flows $200 000 360 000 520 000

Proposal C: 2-year, 8-month cash payback period, as follows: Year Net cash flow Cumulative net cash flows 1 $80 000 $80 000 2 60 000 140 000 8 months* 40 000 180 000 *The cash flow required for investment payback in year three is $40 000, which is two-thirds ($40 000 ÷ $60 000) of year three’s cash flow. Thus, eight months (two-thirds of 12 months) are needed to accumulate an additional $40 000.

Proposal D: 3-year, 3-month cash payback period, as follows: Year Net cash flow Cumulative net cash flows 1 $100 000 $100 000 2 100 000 200 000 3 40 000 240 000 3 months* 10 000 250 000 *The cash flow required for investment payback in year four is $10 000, which is 25 per cent ($10 000 ÷ $40 000) of year four’s cash flow. Thus, three months (25% of 12 months) are needed to accumulate an additional $10 000.

b Proposal A: 8 per cent average rate of return, determined as follows: $120000 ÷ 5 $24000 = = 8% ($600000 + $0) ÷ 2 $300000 Proposal B: 24 per cent average rate of return, determined as follows: $312000 ÷ 5 $62400 = = 24% ($520000 + $0) ÷ 2 $260000 Proposal C: 30.8 per cent average rate of return, determined as follows: $138500 ÷ 5 $27700 = = 30.8% ($180000 + $0) ÷ 2 $90000 Proposal D: 11.2 per cent average rate of return, determined as follows: $70000 ÷ 5 $14000 = = 11.2% $125000 ($250000 + $0) ÷ 2 c

Of the four proposed investments, only proposals B and C meet the company’s requirements, as the following table indicates:

Proposal A B C D

Cash payback period 4 yrs 3 yrs 2 yrs, 8 months 3 yrs, 3 months

Average rate of return (%) 8 24 30.8 11.2

Accept for further analysis X X

Reject X X

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d Proposal B: Year 1 2 3 4 5 Total Amount to be invested Net present value

Present value of $1 at 10% 0.909 0.826 0.751 0.683 0.621

Net cash flow

Present value of $1 at 10% 0.909 0.826 0.751 0.683 0.621

Net cash flow

$200 000 160 000 160 000 160 000 152 000 $832 000

Present value of net cash flow $181 800 132 160 120 160 109 280 94 392 $637 792 520 000 $117 792

Proposal C: Year 1 2 3 4 5 Total Amount to be invested Net present value

Present value index =

$80 000 60 000 60 000 60 000 58 500 $318 500

Present value of net cash flow $72 720 49 560 45 060 40 980 36 329 $244 649 180 000 $64 649

Total present value of net cash flow Amount to be invested

$637792 = 1.23* $520000 $244649 Present value index of Proposal C: = 1.36* $180000 *Rounded. f Based on the net present value, the proposals should be ranked as follows: Proposal B: $117 792 Proposal C: $64 649 g Based upon the present value index (the amount of present value per dollar invested), the proposals should be ranked as follows: Proposal C: 1.36 Proposal B: 1.23 h The present value indexes indicate that although proposal B has the larger net present value, it is not as attractive as proposal C in terms of the amount of present value per dollar invested. Proposal B requires the larger investment. Thus, management should use investment resources for proposal C before investing in proposal B.

Present value index of Proposal B:

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Ethics case study Jenny’s responsibilities include: – loyalty to her boss – maximising shareholder value (note complexity of ‘costs’ – a conflict between minimising the financial costs of the alternatives for building the manufacturing facilities versus minimising the unknown, but not unsubstantial, costs from any future damages claims by employees, the local community and environmental groups) – duty to avoid harm to others (employees/local community/the environment) – Jenny’s desire for promotion. Possible courses of action include: – Do nothing (she may get a promotion but this option exposes nearly everyone else to risk (e.g. the company getting sued, employees/local community/environment subject to injury/pollution). – She (and her team?) could attempt to convince her boss to add the missing information. She could do this by pointing out to him the risks the company will face from additional costs from future damages actions. (This may be successful but could result in her incurring her boss’ wrath.) – She (and her team?) could take her concerns to a higher authority in the company after having approached her boss. Similar consequences are possible to the previous option.

Chapter 16 Cost information and decision making Review questions 1 The following summarises the main reasons why firms determine product costs. • To aid planning. The determination of the costs of products will be useful in predicting the future (budgeted) costs of these products in the planning process. • To control costs. The costs of products need to be determined so that they can be compared with budgeted costs. • For valuing inventories at the end of the accounting period. It follows that these values will be influential in determining income. • To aid the setting of selling prices. In a number of situations the costs of the products will be a basis for setting prices, e.g. where the market price does not predominate over the pricing decision, as in the case of a monopoly or an oligopoly. • To ascertain the relative profitability of products so that organisations can make decisions regarding the mix of products. 2 The following are typically categorised as direct costs in a multi-product firm: • direct labour • direct materials • components specifically purchased for the production of products • any other costs that are directly traceable to products and services. The following are examples of indirect costs in a multi-product firm: • supervision • inspection • maintenance • personnel services. 3 Period costs are costs that relate to the current period in question. They are therefore viewed as costs that cannot be justifiably carried forward to future periods because they do not represent future benefits or the future benefits are so uncertain as to defy measurement. Therefore, period costs will be recognised in the profit and loss account in the accounting period when they are incurred. 4 Variable costing only includes costs that are directly attributable to products. It is argued that the inclusion of overhead costs, which have to be absorbed into the product using some arbitrary basis, can distort product costs. This is seen as the main advantage of variable costing. It could also be argued that the costs involved in installing and maintaining a variable costing system are less costly vis-à-vis an absorption costing system. The main disadvantage of variable costing is that overheads are not included into product costs, although it is apparent that if activities classified as overheads were not employed then it is unlikely a firm would be able to satisfactorily produce the products. In addition, if variable costing were to be used for inventory valuations the inventories would clearly be undervalued.

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Problems for discussion and analysis 1 Profit under absorption costing will be higher compared to variable costing when production exceeds sales. This creates an incentive for managers to produce more than perhaps what is required. This may result in increased costs of storage and other potential losses from holding excess inventory. 2 Variable costing focuses on the variable costs of production and therefore highlights the importance of the contribution margin. This potentially makes for improved decision making as it focuses on the variable costs of production and not the fixed costs. However, by focusing on the variable costs there may be a tendency to ignore the fixed costs. 3 The company could use this information to offer reward schemes to the more profitable customers. For example, customers with deposits of over $100 000 will receive a reduction of 0.5 per cent on loans and no account-keeping fees on their accounts. It also enables Metway to charge different fees for different services, such as cash withdrawals over the counter versus an ATM. 4 Note to instructors: the following was omitted from the question: Required: a What is the predetermined overhead rate? b What is the applied overhead for 20X4? c Was overhead over-applied or under-applied, and by how much? d What is the unit cost for the year? Answer: a Predetermined overhead rate = $900 000/120 000 = $7.50 per DLH b Applied overhead = $7.50 × 117 000 = $877 500 c Applied overhead $877 500 893 250 Actual overhead Underapplied overhead $(15 750) d Unit cost for the year: Direct costs $1 350 000 Overhead costs $877 500 Total $2 227 500 Units ÷ 150 000 Unit cost $14.85 5 a The predetermined overhead rate: Cost Centre X based on direct labour cost basis: $140 000/$100 000 = $1.40 per $ of direct labour cost Cost Centre Y based on machine hour basis: $150 000/20 000 hrs = $7.50 per machine hour b The total production cost for BNH: Direct material Direct labour Overheads X $1.40 × $32 000 Y $7.50 × 13 000 hrs

X $ 20 000 32 000 44 800 96 800

Y $ 40 000 21 000 97 500 158 500

Chapter 16: Cost information and decision making

$ 96 800 158 500 255 300

Total cost of production X Y

Unit cost of product BNH: Total cost of production/No. of units $255 300/20 000 units = $12.77 per unit d The over-absorbed or under-absorbed overhead for 20X1: X

Actual cost Absorbed overheads: X $144 200 × $1.40 Over-absorbed overhead Y Actual cost Absorbed overheads: Y 18 000 hrs × $7.50 Under-absorbed overhead X over-absorbed Y under-absorbed Total over-absorbed

$ 160 000 201 880 41 880 $ 138 000 135 000 3 000 41 880 (3 000) 38 880

6 Calculations:

Traceable department costs Indirect labour Indirect material Total (traceable)

S1 $

P1 $

P2 $

44 000 8 000 52 000

18 000 10 000 28 000

23 500 13 000 36 500

Non-traceable department costs Rates Insurance (building) Maintenance Depreciation Electricity Total (non-traceable)

Floor space (sq m) Value of equipment ($) Expected machine hours Expected direct labour hours

S1 400 48 000 500

$ 7 500 5 200 14 600 32 800 12 000 72 100 P1 800 180 000 4 400 8 800

P2 1 400 100 000 1 200 12 500

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Allocation of non-traceable costs Rent S1 4/26 P1 8/26 P2 14/26 Insurance S1 4/26 P1 8/26 P2 14/26 Maintenance S1 5/61 P1 44/61 P2 12/61 Depreciation S1 48/328 P1 180/328 P2 100/328 Electricity S1 5/61 P1 44/61 P2 12/61

S1 $

P1 $

1 154

2 308

800

1 600

1 197

10 531

4 800

18 000

984

Traceable dept. costs Non-traceable costs as allocated: Dept. overheads

8 656

P2 $

Total $

4 038

7 500

2 800

5 200

2 872

14 600

10 000

32 800

8 934

41 095

2 361 22 071

12 000 72 100

S1 $ 52 000 8 934 60 934

P1 $ 28 000 41 095 69 095

P2 $ 36 500 22 071 58 571

Total $ 116 500 72 100 188 600

Direct method: Departmental overheads Re-allocation of service department costs to production departments – to P1 (60%) – to P2 (40%) Total

S1 $ 60 934 (60 934) 0

P1 $ 69 095

P2 $ 58 571

36 561

24 374 82 945

105 655

a Departmental charge rate ($)

P1 $24.0125 per machine hour

$6.6356 per direct labour hour

Plant-wide charge rate $8.8545 per direct labour hour

7 Discussion should focus on the differences of financial and management accounting information and the fact that management, regardless of the type of organisation, requires current, frequent and detailed information to make decisions regarding cost control, cost forecasting, selling prices, profitability, product mix and so on. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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Determining the cost of products can aid in predicting future (budgeted) costs; identifying unprofitable products, identifying the right mix of products. b Management accounting is not limited to manufacturing firms. Determining costs for individual dishes can identify the most cost-effective dishes, and determine accurate pricing. c Management accounting information is based on historical and future costs. It is useful in non-profit organisations for external reporting (controlling bodies), planning and control, thereby assisting management in determining if the organisation is effectively meeting its objectives. d Expenditure and performance are irrelevant if the product mix is not maximised and costs are not accurately apportioned. e Market and product knowledge need to be considered, however, accurate costing will enable a realistic price to be set to achieve a planned profit level. f Supervision of major constructions will be short-lived if they are grossly over budget. Timely and accurate information on current and projected costs is essential. 8 a Cost drivers: 1000000 Welding = 800000 = $1.25 per weld 800000 Assembly = 400000 = $2 per DLH 500000 Inspection = 20000 = $25 per IH Application of costs to models ABC and XYZ: February 20X1 Welding (1.25) Assembly (2) Inspection (25) Total

ABC

No. 30 000 15 000 600

Cost $ 37 500 30 000 15 000 82 500

No.

ABC $ 200 000 400 000 37 500 30 000 15 000 682 500

XYZ $ 250 000 450 000 50 000 40 000 25 000 815 000

1 500 $455

1 630 $500

40 000 20 000 1 000

Costs per unit: Direct materials Direct labour Welding Assembly Inspection Total No. of units produced Cost per unit

XYZ

Cost $ 50 000 40 000 25 000 115 000

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Total overhead applied is $82 500 + $115 000 = $197 500. Actual overhead credited is $190 000. Therefore the overhead was over-applied by $7500. The $7500 is added to the profit and loss statement for the period. 9 a Cost drivers: Construction 3 000 000 = $30 per DLH 100 000 Inspection 1 000 000 = $50 per TTI 20 000 Testing 500 000 = $62.50 per TTT 8 000 Mustang Direct materials Construction Inspection Testing Total cost

(4000 × $30) (800 × $50) (200 × $62.50)

$ 160 000 120 000 40 000 12 500 332 500

Jaguar (6 000 × $30) (1 200 × $50) (300 × $62.50)

$ 120 000 180 000 60 000 18 750 378 750

b Overhead applied was 120 000 + 180 000 + 40 000 + 60 000 + 12 500 + 18 750 or $431 250. Actual overhead was $440 000. Overhead under-applied by $8750. 10 a i Variable costing:

Sales Less variable costs of sales ($10 000 per car) Contribution Less fixed costs (factory) Selling and administration Net profit

April $ 13 500 000

May $ 17 550 000

June $ 9 450 000

5 000 000 8 500 000

6,500 000 11 050 000

3 500 000 5 950 000

(500 000) (86 000) 7 914 000

(500 000) (91 000) 10 459 000

(500 000) (86 000) 5 364 000

Chapter 16: Cost information and decision making

Absorption costing:

Sales (units × $27 000) Opening inventory + production ($10,833 per car) Less: Closing inventory ($10,833 per car) Cost of goods sold Gross profit Less: Selling and administration Net profit

April $ 13 500 000

May $ 17 550 000

June $ 9 450 000

0 6 500 000 6 500 000

1 083 300 8 500 000 9 583 300

2 708 250 7 000 000 9 708 250

1 083 300

2 708 250

5 958 150

5 416 700

6 875 050

3 750 100

8 083 300

10 674 950

5 699 900

(86 000) 7 997 300

(91 000) 10 583 950

(86 000) 5 613 900

b The difference in profit each year is the difference between the opening and closing inventory figures under the absorption costing method. 11 a

Variable costing:

Sales Less variable costs of sales ($1.5 per unit) Contribution

20X1 $ 144 000 54 000 90 000

20X2 $ 200 000 75 000 125 000

Less fixed costs (factory) Selling and administration Net profit

(67 500) (10 000) 12 500

(67 500) (10 000) 47 500

Total profit for the three years

$132 500

Absorption costing: 20X1 $ 144 000

20X2 $ 200 000

20X3 $ 240 000

– 174 000 174 000

66 000 105 000 171 000

21 000 159 000 180 000

66 000 108 000 36 000

21 000 150 000 50 000

– 180 000 60 000

(Under)/over-absorption of overhead Selling and administration Net profit

19 500 (10 000) 45 500

(15 000) (10 000) 25 000

12 000 (10 000) 62 000

Total profit for the three years

$132 500

Sales (units × $4) Opening inventory ($3 per unit) + Production ($3 per unit) Less: Closing inventory ($3 per unit) Cost of goods sold Gross profit

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b The inventory change in units over the three years: Opening inventory Closing inventory Change in inventory Change in inventory × absorption rate ($1.5)

20X1 – 22 000 22 000

20X2 22 000 7 000 (15 000)

20X3 $7000 – (7 000)

$33 000

$(22 500)

$(10 500)

This represents the differences in the three years profits under the two methods. For management decision making, the relevant costs to be accounted for are future incremental costs. The marginal costs of the product by their very nature are incremental. In contrast, fixed costs, it is assumed, will remain constant over activity levels and are therefore unavoidable costs. It follows that variable costing should be used for decision making. Absorption costing using absorption methods includes fixed overheads and therefore would not be appropriate for decision-making purposes.

12 a Indirect materials Indirect labour Power (machine hr) Rent, etc. (area) Heat, etc. (area) Insurance (building area) Insurance (machines book value)

Punching 12 000 24 000

Stamping 14 000 30 000

Assembly 10 000 14 000

Maintenance 8 000 36 000

Inspection 4 000 10 000

Total 48 000 114 000

17 920 38 400 9 600

22 400 25 600 6 400

15 680 51 200 12 800

6 400 1 600

56 000 128 000 32 000

9 600

6 400

12 800

1 600

32 000

20 000

14 000

6 000

40 000

b It is likely that in manufacturing environments different production cost centres will have differing operating characteristics. For example, one cost centre may be highly mechanised while another may be labour intensive. It is these differing activities, it is assumed, which will drive the overhead costs. In such circumstances it is therefore appropriate to employ separate overhead rates for each cost centre reflecting the main activity of the centre. If a single factory-wide overhead absorption rate were to be used it is likely that product costs will be distorted because the application of overheads to products is not a fair reflection of the costs incurred in manufacturing the product. However, there is evidence that the majority of small and medium-size manufacturing firms do employ a single overhead rate. The reason given for this is that the costs of installing and maintaining an accounting information system that computes individual cost centre rates is complex and expensive. This problem clearly relates to the question of cost and benefits of particular accounting information systems which cannot be ignored in the consideration of whether to use a single factory-wide overhead rate or a separate rate for each cost centre.

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13 a

187

Overhead rate = $6 990 000/272 500 = $25.65 per DLH* Overhead assignment: Y-5: $25.65 × 250 000/1 000 000 = $6.41* Z-9: $25.65 × 22 500/200 000 = $2.89* *Rounded numbers used throughout. Unit gross margin: Price Cost Gross margin

Y-5 $15.93 10.68* $5.25

Z-9 $12.00 6.02** $5.98

*Direct costs + Overhead = ($4.27 + $6.41) **Direct costs + Overhead = ($3.13 + $2.89) b

Pools

Setup Machine Receiving Engineering Material handling

Driver

Runs Machine hrs. Orders Engineering hrs. Moves

Pool rate $240 000/300 = $800 per run $1 750 000/185 000 = $9.46/per MHr $2 100 000/1 400 = $1500/per order $2 000 000/10 000 = $200/per eng. hour $900 000/900 = $1000/per move

Overhead assignment: Setup costs

$800 × 100 $800 × 200 Machine costs $9.46 × 125 000 $9.46 × 60 000 Receiving costs $1 500 × 400 $1 500 × 1 000 Engineering costs $200 × 5 000 $200 × 5 000 Material-handling costs $1 000 × 500 $1 000 × 400 Total overhead costs Units produced Overhead cost per kg Direct cost per kg Unit cost Selling price Less unit cost Unit gross margin

Y-5 $80 000 1 182 500 600 000 1 000 000 500 000 $3 362 500 ÷ 1 000 000 $3.36 4.27 $7.63 $15.93 7.63 $8.30

Z-9 $160 000 567 600 1 500 000 1 000 000 400 000 $3 627 600 ÷ 200 000 $18.14 3.13 $21.27 $12.00 21.27 $(9.27)

No. The cost of making Y-5 is $7.63, much less than the amount indicated by functionalbased costing. The company can compete by lowering its price on the high-volume product. The $10 price offered by competitors is not out of line. The concern about selling below cost is unfounded.

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d The $12 price of compound Z-9 is well below its cost of production. This explains why Pearson has no competition and why customers are willing to pay $15, a price that is probably still way below competitors’ quotes. e The price of Y-5 should be lowered to a competitive level and the price of Z-9 increased so that a reasonable return is being earned.

Ethics case study a Choice of direct labour hours? – For pricing purposes, the choice of overhead application base has a significant impact on defence department contracts. Given the contractual terms, as the level of cost varies, the price that Digital Electronics Ltd can demand from the defence department also varies. On the other hand, the price for the Sarich Corporation contract is fixed in advance. – Consequently, although the controller’s choice of machine hours might lead to the most accurate ‘costing’ of the contracts for internal purposes, the general manager’s choice of direct labour hours leads to the ‘best pricing’ from Digital Electronics Ltd’s perspective of the defence contract. This is because it allows for a higher recovery of the overhead costs and should lead to higher profitability in the short term. b The ethical issues? – No definition of the term ‘appropriate application base’ is provided. We do not know if the government gets to periodically ‘audit’ the application base. – From the point of view of Digital Electronics Ltd’s shareholders, there is an expectation that the employees, including the controller, should act to maximise shareholder value. The defence department contract was negotiated, presumably, between willing and able parties and if the defence department was concerned about the price, it should have clearly defined the application base in the contract. – However, in terms of the professional ethical principles of integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290) and competence and due care (APES 110–130), the general manager’s choice of allocation base would not be appropriate. These principles must be balanced against the values of confidentiality (APES 110–140) and loyalty to the employer. – Given the above points, there does not seem to be an overriding duty for the controller to pass on the information to another party. However, although the general manager’s choice may lead to an increase in profits in the short term, it could be detrimental in the medium to long term if the defence department decides that Digital Electronics Ltd’s prices are not competitive. If this happens, Digital Electronics Ltd could lose the contract. The controller could try to use this argument to convince the general manager to stay with machine hours as the application base for the defence contract.

Chapter 17 Cost behaviour and cost-volume-profit analysis Review questions 1 Independent variables in the context of cost functions are normally activities that drive costs. In the example in this chapter, relating to the cost of petrol for a journey, the activity that ‘drives’ the cost is the amount of kilometres travelled. The cost of petrol for a journey will be dependent upon the kilometres travelled (the independent variable). It is likely that the dependent variable, the cost, will be dependent on more than one variable. For example, the speed that a vehicle travels will also be influential on the petrol consumed, and therefore the cost of a journey. However, it is argued that for cost accounting purposes it is too complex to include more than one independent variable. When there is more than one independent variable the most influential variable in relation to the movement of costs should be chosen as this will be the main cost driver. For teaching purposes we would encourage lecturers to ask students to identify a number of different activities and their associated costs, and then to discuss what are the associated independent variables that drive the costs of these activities. 2 A linear fixed cost is one that remains constant for all levels of activity. A curvilinear variable cost is one that initially increases slowly as activity increases and then at higher levels as activity increases more steeply. For example, the cost of labour on a per-hour basis may increase as more hours are worked because of penalty rates. 3 The future may not be the same as the past due to changes in technology, work practices and so on. 4 There are a number of problems associated with CVP analysis in multi-product firms. There may be interdependencies between the production of two or more products. For example, the demand for one product may be affected by the demand for another product, e.g. butter and margarine. If the sales mix and the profit margins of the two products are different this causes problems; while overall sales volume targets may be achieved, total contribution will vary depending on whether the higher or lower margin product dominates the sales mix. Fixed costs can present another problem. If fixed costs are shared between products, a method of allocating and apportioning these costs to individual products must be introduced. The nature of allocation and apportioning of such costs tends to be arbitrary and can therefore lead to distorting the costs associated with products. Lastly, if resources are scarce there will be a constraint on the firm’s capacity to produce all products it wishes to sell. There is a need, therefore, to allocate resources to products, taking account of constraints that will determine the level of output of each of the firm’s products. 5 The contribution margin is sales less variable costs. Therefore, once sales are above breakeven point, all fixed costs are covered and each sale beyond this point produces profit equal to the contribution margin, as by definition the variable costs are covered. 6 The problem illustrates that the $10 000 advertising would increase sales by $30 000 and thus produce a contribution margin of $30 000 × 0.3 or $9000. As the contribution is less than the cost of advertising, it shows very quickly that the proposal will produce a loss.

Chapter 17: Cost behaviour and cost-volume-profit analysis

Problems for discussion and analysis 1 Sales Variable costs Fixed costs $ $ $ 2 000 1 400 *600 3 000 *1 400 600 *4 000 1 000 *600 4 000 *3 000 600 * = the money values required to be included.

Total costs $ 2 000 *2 000 1 600 *3 600

Profit $ *0 1 000 2 400 400

Contribution $ *600 *1 600 *3 000 *1 000

Sales Variable costs Fixed costs $ $ $ 7 249 1 436 *5 814 3 642 *1 876 1 028 *9 253 8 321 *0 634 *315 236 * = the money values required to be included.

Total costs $ 7 250 *2 904 8 321 *551

Profit $ *–1 738 932 83

Contribution $ *5 813 *1 766 *932 *319

3 a

b c

4 a b

c 5 a

Contribution margin =

300 000 500 000 = 60 per cent If variable costs are $6 per widget then selling price must be $10. Sx = VCx + FC + P 55 000 × $10 = $6 × 55 000 + 200 000 + P 550 000 = 330 000 + 200 000 + P P = 20 000 Contribution margin = 45 – 30 = $15 90 000 Break-even = 15 = 6000 Profit = 300 × 15 = $4500 Contribution margin = 5.50 – 3.50 = 2 Break-even = 5000 2 = 2500 Sales = 5000 +7000 2 = 6000 Sales Less variable costs Contribution Less fixed costs Net profit

$ 33 000 21 000 12 000 5 000 7 000

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6 a

Contribution margin = 42 – 22 = $20 4000 Break-even = 20 = 200 b Profit 240 jobs = 40 × 20 = $800 190 jobs = –10 × 20 = –$200 c Contribution = 45 – 22 = $23 New break-even = 4000 23 = 174 jobs 7 a i Break-even point: S(x) = VC(x) + FC 240(x) = 120(x) + 36 000 x = 300 units ii Maximum profit where output is 1000 units. S(x) = VC(x) + FC + P 240(1000) = 120(1000) + 36 000 + P 240 000 = 120 000 + 36 000 + P P = $84 000 iii Profit at the sales level of 800 units: 240(800 = 120(800) + 36 000 + P 192 000 = 96 000 + 36 000 + P P = $60 000 b i The new break-even point: Direct materials $40 + 20 per cent of $40 = $48. Direct labour 10 hours at $10 per hour = $100. Therefore total variable costs will be $148. Fixed costs 36 000 – 12 000 = $24 000. S(x) = VC(x) + FC 240(x) = 148(x) + 24 000 x= 261 units (to the nearest whole number) ii The new profit at the estimated sales level of 800 units: 240(800) = 148(800) + 24 000 + P 192 000 = 118 400 + 24 000 + P P = $49 600 At this point, students should be asked to comment on these results and on the advantages of CVP analysis with reference to this problem. 8 a Contribution margin = 21 – (14.75 + 0.42) = $5.83 Break-even sales = 16 000 5.83 = 2744 b Sales $84 000 Less variable costs $60 680 Contribution $23 320 Depreciation $16 000 Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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Net profit each year $7320 c The investment is profitable and the sales exceed the break-even number of 2744 bins. The total profit over the 10 years based on the above figures would be $73 200. The depreciation of $4 per unit is based on the equipment, $160 000/10 years/4 000 units and so the new bins will provide a positive contribution to the other fixed overheads of the company if the expected sales level of 4000 units is achieved each year. 9 a Selling price = $50 Variable costs = $30 Fixed costs = $900 Contribution margin = 50 – 30 =$20 Break-even = 900 20 = 45 b Profit = 15 × $20 = $300 Could use the equation to arrive at the same answer: Sx = VCx + FC + P 60 × 50 = 60 × 30 + 900 + P 3000 = 1 800 + 900 + P P = $300 Profit is $300 c New break-even = 1150 20 = 57.5 Profit = 22 5 × $20 = $450 Sx = VCx + FC + P 80 × 50 = 80 × 30 +1 150 + P 4000 = 2400 + 1 150 + P P = 450 By spending the $250, the profit has increased from $300 to $450 (if 80 attend) and therefore the promotion should proceed. 10 Trousers $ 54 000

Skirts $ 48 000

Monthly rent Material Labour Selling costs Administration costs Depreciation on plant Total cost

550 18 000 12 750 300 1 000 120 32 720

550 16 800 5 100 240 1 000 120 23 810

Profit

21 280

24 190

Income

Break-even point for trousers is 88 units @ $45 selling price.

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Break-even point for skirts is 52 units @ $60 selling price. The company makes a slightly higher profit ($2910) by selling skirts and, given a lower break-even than trousers, it is recommended the company produces skirts. 11 a The amount of trousers Cords Pty Ltd sell each month. Using the break-even equation where x is the number of pairs of trousers to earn a profit of $22 080 each month: S(x) = VC(x) + FC + P 36(x) = 20(x) + 52 800 + 22 080 16(x) = 74 880 x = 4680 pairs of trousers b Fixed costs have now increased to ($52 800 + $6 000) $58 800. The break-even point, using the break-even equation: 34(x) = 20(x) + 58 800 14(x) = 58 800 x = 4200 pairs of trousers The break-even point before the changes in price and advertising expenditure was: 36(x) = 20(x) + 52 800 x = 3300 pairs Profit on sales of 5800 pairs of trousers: 34(5,800) = 20(5 800) + 58 800 + P P = $22 400 Comments regarding the sales director’s proposals: – small increase in profits of $320 (1.4 per cent) – much higher break-even point and therefore the proposal is riskier than previous operating level – what is the likelihood that sales will, indeed, increase to 5800 units (24 per cent increase)? Assumptions: – all variable costs remain unchanged and are proportional to volume within this range of activity – fixed costs do not change – capacity is available – efficiency does not change, e.g. no economies of scale – business environment not changing (e.g. government policy, competitors). c i Required profit 15 per cent increase on $22 080 × 1.15 = $25 392 34(x) = 20(x) + 58 800 + 25 392 14(x) = 84 192 x = 6014 pairs of trousers (to the nearest whole number) ii Assuming that the sales director’s policies were not adopted: 36(x) = 20(x) + 52 800 + 25 392 x = 4887 pairs of trousers

Chapter 17: Cost behaviour and cost-volume-profit analysis

12 a Total revenue and costs (000) $450 400 350 300 250 200 150 100 50 0

5 10 Units (000)

b Profit or loss: $200 150 100 50 0 0 5 10 15 20 25 30 35 Units (000) –50 –100 –150 –200 c Break-even point in units: 30x – (150 000 + 20x) = 0 30x – 150 000 – 20x = 0 10x = 150 000 x = 15 000 units Break-even point in dollars = 15 000 × $30 = $450 000 Proof: Revenues (15 000 × $30) $450 000 Costs ($150 000 + (15 000 × $20)) –$450 000 Profit 0

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13 a

195

Contribution margin = 250 – 185 = $65 Break-even

250 000 65 = 3 846.15 or 3847 b P = 5000 × 250 – (5000 × 185 + 250 000) = 1 250 000 – 1 175 000 = $75 000 c New profit = 8 100 × 250 – (8 100 × 175 + 450 000) = 2 025 000 – (1 417 500 + 450 000) = $157 500 This is a significant increase in profit and provided the predicted sales and cost estimates are achievable, then the company should proceed. d Sales of 4000 units are now below the new break-even of $250 000/55 or 4545 units. If the company continues to produce and sell 4000 units it obtains $220 000 of contribution towards fixed costs and will incur a loss of $30 000. Stopping production is a major decision and if fixed costs continue it would not be a wise decision. The company would only consider stopping production if it avoided more than $220 000 of fixed costs and the it viewed the recession as long term. The issue to discuss with students is the role of fixed costs in this decision and the company’s position in the market. If the company did stop production it may lose customers to competitors and it may be hard to attract them back.. 14

Selling price Variable cost Contribution margin Share of fixed costs

Sport $ 100 60 40 36 000

Drama $ 70 50 20 45 000

Comedy $ 200 100 100 9 000

Break-even points: x = FC/C Sport Drama Comedy = 90 000/40 90 000/20 90 000/100 = 2250 units 4500 units 900 units b Average unit contribution margin: $0.4 × 40 + 0.5 × 20 + 0.1 × 100 = $36 c Break-even unit sales volume: =

90000 = 2 500 units (1000 sports, 1250 drama, 250 comedy) 36

d Unit sales volume needed to attain after-tax profit of $27 000 = 15 a

90000 + 45000 = 3750 units (1500 sports; 1875 drama; 375 comedy) 36

Original figures: Sx = VCx + FC 90x= 60x + 180 000 30x= 180 000 x = 6000 Break-even is 6000 car alarms. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

Chapter 17: Cost behaviour and cost-volume-profit analysis

Revised figures: Sx = VCx + FC 90x= 50x + 280 000 40x= 80 000 x = 7000 Break-even is 7000 car alarms. b Original: Sx = VCx + FC + P 80 000 × 90 = 80 000 × 60 + 180 000 + P 720 000 = 480 000 + 180 000 + P P = 60 000 Profit is $60 000. Revised: Sx = VCx + FC + P 8 000 × 90 = 8000 × 50 + 280 000 + P 720 000 = 400 000 + 280 000 + P P = 40 000 Profit is $40 000. c 90x = 60x + 180 000 + y (original) 90x = 50x + 280 000 + y (revised) From original: y = 90x – 60x – 180 000 = 30x – 180 000 Substitute into revised: 90x = 50x + 280 000 + 30x – 180 000 x = 10 000 At 10 000 units both produce the same profit of $120 000. d Original: 80 × 15 000 = 60 × 15 000 + 180 000 + P 1 200 000 = 900 000 + 180 000 + P P = 120 000 Profit is $120 000. Revised: 80 × 15 000 = 50 × 15 000 + 280 000 + P 1 200 000 = 750 000 + 280 000 + P P = 170 000 ∴ profit is $170 000. The company achieves a higher profit under the revised figures. Therefore, it should reduce the selling price by $10 per unit. This of course is provided it can’t sell enough units at the old price to earn a profit in excess of $170 000. This would require sales of: 90x = 50x + 280 000 + 170 000 x = 11 250 units

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16 Golden Bakeries Ltd Statement of comprehensive income for year ended 30 June 20X3 Sales in kg Revenue from sales Variable costs Raw materials Direct labour Factory overhead Commissions Total variable costs Contribution margin Direct operating expenses Advertising Licences Total direct operating expenses Product contribution

Bread rolls 400 000 $2 000

Donuts 100 000 $800

Fudge cakes 100 000 $400

Total 600 000 $3 200

660 180 54 100 –994 1 006

320 80 24 80 –504 296

200 40 12 40 –292 108

1 180 300 90 220 –1 790 1 410

100 100 –200 $806

60 40 –100 $196

40 30 –70 $38

200 170 –370 $1 040

Common fixed expenses Factory overhead Sales salaries & benefits G&A salaries & benefits Total fixed expenses

270 120 200 –590

Net profit before taxes

$450

The analysis indicates that fudge cakes provide a positive contribution of $38 000. If the bakery stopped making the fudge cakes and no other changes were made to the sales in other products then the net profit would decline by $38 000.

Ethics case study a Accounting issues: – Which costs are relevant? The case is unclear about what will happen to variable selling and administration costs if the order is taken – e.g. we are told that the customer will pay all freight costs but will some administration costs still be incurred? Part (b) below analyses the proposal assuming (i) variable selling and administration costs are still incurred and (ii) they are avoided. – Will the order make a positive contribution to the business? See the analysis in part (b), but also consider the qualitative factors – e.g. keeping the customer’s business; the propriety of making the payment to the customer’s friend; giving overtime to staff when they need it. Ethical issues: – The main ethical issue seems to be whether the $5000 payment to the Hong Kong customs official is appropriate. Bribery is frowned upon in Australia but may be an ‘accepted’ practice in some other countries. This issue is an example of the philosophical position of ‘ethical relativism’ which essentially argues that one country (for example) cannot object to the moral practices of another country because the two countries simply have ‘different’ moral systems (a form of ‘we agree to disagree’). Although ethical relativism is a widely Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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held view, there are also many people who object to it. Opponents of ethical relativism (and empirical research exists to support them) point out that there are, in fact, ethical principles which are common to all societies – namely the principles of responsible care (duty to avoid harm), justice (treat like cases alike, the sharing of power), and respect for people (duty to be truthful, to empower others). Apparent differences in cultures are mainly differences in the emphasis given by countries to these three fundamental principles rather than substantive moral differences. Therefore, if we reject bribery in our country because it is dishonest (does not show respect for people, is not just), then we cannot suddenly accept it when we decide to do business in another country. The fundamental ethical principles are still broken no matter which country we are in. Bribery is also illegal in Hong Kong. b Assuming variable selling and administrative costs will still be incurred: The contribution margin for a standard unit = $50 – 25 – 12 = $13 We are told that the selling price for the special order is the contribution margin plus 20 per cent. Selling price for special order/unit = $13 × 1.2 = $15.60 Analysis of special order: Revenue $15.60 × 1 000 units = $15 600 less Variable costs $37.00 × 1000 units = 37 000 less Additional fixed costs = 5 000 Loss = $26 400 The order is not a profitable one (this was obvious early on when the proposed selling price was less than the variable costs per unit). However, given that the customer is a ‘very important one’, the order may still go ahead to help cement future business with the customer. It would also give the workers some additional funds for Christmas which will help employee relations. On the other hand, there remains the question of whether the $5000 payment should be made. Assuming variable selling and administration costs will be avoided: Contribution margin per standard unit = $50 – 25 = $25 Selling price for special order/unit = $25 × 1.2 = $30 Analysis of special order: Revenue $30.00 × 1000 units = $30 000 less Variable costs $25.00 × 1000 units = 25 000 less Additional fixed costs = 5 000 Profit/Loss = $ Nil This time the order breaks even but it might still be accepted for the reasons given above.

Chapter 18 Accounting for decision making: with and without resource constraints Review questions 1 Accrual accounting methods primarily evolved from the need to report historical events for internal and external users of accounting information. The relevant costs and revenues associated with decision making, in contrast, relate to the future rather than the past. It is therefore not surprising that a number of the concepts underlying the accrual accounting method are not appropriate to decision making that is forward looking. However, it should be said that past costs can be useful in predicting future costs. The costs of producing a particular product in a past period will be very useful information in predicting the costs of producing the same product in the future. 2 Fixed costs in the majority of cases will be unavoidable; that is, they will be incurred whether or not an opportunity is accepted or rejected. However, in some cases fixed costs are avoidable; that is, they will only be incurred if an opportunity is accepted. For example, a firm has the opportunity to increase its product range, however, an additional building would have to be rented for production purposes. The cost of the building, by its nature, is a fixed cost and is also an avoidable cost. In these circumstances this cost would therefore be relevant in the decision whether or not to increase the range of products. 3 The shortage of resources, although an effective short-term constraint, can invariably be overcome in the long term as the firm can take action to eliminate the constraint. A good example is the case of shortages of particular skills of labour. For example, a proprietor of a garage may be restricted as to the amount of work that can be taken on due to a lack of skilled motor mechanics; however, the proprietor can overcome this constraint in the long term by training non-skilled labour to perform the task. 4 The internal opportunity cost reflects the cost of using the resource within the organisation itself due to competing opportunities. 5 If a resource is scarce a firm may be constrained in terms of output. This is the case when there are competing opportunities for a scarce resource within a firm. The use of the scarce resource on one opportunity (project) may mean that another opportunity cannot be undertaken even though it would have generated a positive contribution in cash-flow terms. It is this contribution foregone which is described as the internal opportunity cost. The determination of the internal opportunity cost can be a very useful tool in the decision making and the planning process of an organisation. The management of a firm, by knowing the contribution from the next best opportunity, could quickly determine the additional contribution if the constraint were to be relieved. In addition, the firm would know how much it is willing to pay to relieve a constraint. For example, if labour is in short supply this constraint could be relieved by the firm offering overtime to its present workforce; if the internal opportunity cost of labour is $5 the firm could offer an overtime premium up to this amount and by doing so generate a positive contribution. 6 The cost of employing a scarce resource may be greater than the cost associated with purchasing the resource. The use of a scarce resource involves not only the purchase price but also the contribution foregone by not being able to accept other opportunities. That is, the use Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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of the scarce resource on one project may mean that another project cannot be undertaken although it would have generated a positive contribution to fixed costs and profits. In such cases the cost of a resource includes the external (purchase price) and internal opportunity cost.

Problems for discussion and analysis 1 a

Check on the number of units that can be manufactured at full capacity: Capacity at 90 per cent = 40 000 units; therefore 100 per cent capacity is equal to 40 000 × 100/90 = 44 444 units (to the nearest round number). Therefore the company could increase their capacity by another 4444 units if they so wished. Variable cost per unit: Total costs – Fixed costs = Total variable costs $800 000 – $192 000 = $608 000 Therefore variable cost per unit = $608 000/40 000 units = $15.2 per unit. Contribution per unit if special order is accepted: $16 – $15.2 = $0.80 × 2000 units = $1600 Calculators Ltd should accept the special order, assuming that fixed costs are irrelevant, because it would increase their total contribution by $1600. b The company, due to its limited capacity, can only make 4444 additional units. Assuming that Kodix will only accept a contract for not less than 5000 pocket calculators, Calculators Ltd can: • Sell the 5000 units to Kodix and reduce their other sales of units that sell for $22 by 556 units; this would result in a total contribution of

Sales to Kodix (5 000 x $0.80) Other sales (40 000 – 556) 39 444 units x ($22 – 15.20) $6.8

Contribution $ 4 000.00 268 219.20 272 219.20

•

Reject the order from Kodix and sell 40 000 at $22 per unit; the total contribution for this option would be: $6.8 per unit x 40 000 units = $272 000 In purely financial terms, the first option above is preferable to Calculators Ltd by ($272 219.20 – $272 000) $219.20. It should be noted that there is possibly another option for the company to increase its capacity. However, it is likely that fixed costs would increase, but we have no available information to assess this possible option. It should also be noted that the decision is based on the assumption that the sale of the calculators by Kodix would not affect Calculators Ltd’s market share.

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2 Fixed costs, we are told in the question, will be constant whatever the volume of sales; it follows that fixed costs will be irrelevant to the decision as to which products should be produced and sold. The decision whether or not to sell a product will depend on which ones make a positive contribution. Variable costs of products (to the nearest $): A $36 000 × 2/3 = $24 000 B $38 000 × 2/3 = $25 333 C $34 000 × 2/3 = $22 667 Contribution of product range: Sales Variable costs Contribution

A $ 32 000 24 000 8 000

B $ 50 000 25 333 24 667

C $ 45 000 22 667 22 333

Total $ 127 000 72 000 55 000

It can be seen in the above table that product A makes a positive contribution of $8000 and therefore should not be dropped from the company’s product range. If this product were to be discontinued, as the managing director suggests, it follows the company’s profits would be reduced by $8000. 3 7021 Variable cost per unit, to make Cost per unit, to buy

Additional cost to buy Production in units per annum Additional total costs to buy Less fixed costs saved by buying Additional total cost of buying Less C.M. of new product if Agro buys Total additional costs of buying 7021

21 25 4 10 000 $40 000 $20 000 (1/4 $80 000) $20 000 10 000 $10 000

Agro should continue to make part 7021. Or, Variable cost per unit Fixed cost per unit Loss of extra Cont margin Per unit cost

Make $21 $8 $1 $30

Buy $25 $6 $31

Or, Variable cost per unit Extra fixed cost per unit Loss of extra Cont margin Total

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We need to look at the contribution margin per labour hour and per cell. Wild One $15 3 $5

CM DLH CM per DLH

Bold One $18 4 $4.5

Wild One has the highest contribution margin per DLH and should be produced. We can verify this as follows: Wild One 4 000 15 $60 000

Total production possible with 12 000 DLH CM per unit Total contribution

Bold One 3 000 18 $54 000

5 a Contribution margin per unit Extra sales from advertising Extra total CM

Product 1 $10 8 000 $80 000

Product 2 $16 9 000 $144 000

Therefore, XYZ Ltd should advertise Product 2. b CM DLH CM/DLH

Product 1 $10 2 $5

Product 2 $16 4 $4

XYZ Ltd would now advertise Product 1 as it yields a higher CM per direct labour hour. The company can produce the 48 000 units of Product 1 and the 60 000 units of Product 2. 6 a and b The offer is for $12 a bottle which results in a contribution margin of $2.15. Therefore, it is worthy of consideration by the company. However, the acceptance of the offer would mean that 1000 current sales would be lost. This may result in a longer-term loss of customers and, given that the current offer is a one-off, it may not be advisable to accept the offer. The company should respond by offering to supply 5000 bottles. 7 a Assuming the production division only produces 50 000 units if the assembly division buys from outside, then the following would be the result for the production division: Units produced Variable costs per unit Fixed costs Profit per unit

50 000 $10 $200 000 $1

The company’s profit will decline by 50 000 × $2 or $100 000 if the production division reduced production to 50 000 units. Of course, if the production division can sell the other 50 000 units elsewhere for more than $12, then this may be a worthwhile decision for the company. b If the production division simply reduces production by 50 000 units then the company is worse off as the assembly division is now paying the same as it is at present and the profit of the production division is $100 000 lower and there are no cost savings effected elsewhere. This is detrimental for shareholders and would be a poor decision by management. At present the production division makes a profit on the 50 000 units it sells to others and covers the variable costs on the units it sells to the assembly division. The Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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production division will be better off if the units are sold to the assembly division for $12 per unit as each unit will be contributing $2 to fixed costs. Of course, if the production division can sell the 100 000 units to external customers and the assembly division can buy the 50 000 units from an external supplier at $12 then the company will be better off. 8 a We will assume that fixed costs are unavoidable. The relevant costs of the make or buy decision:

Cost of buying in Relevant costs of making

BC100 $ 7.75 5.50

Extra cost of buying in Saving if bought in

2.25

Decision

Make

BC200 $ 2.00 2.25 0.25 Buy in

b Qualitative factors that may be influential in the make or buy decision are as follows: • the opportunity cost of the use of spare capacity • reliability of suppliers • control over quality. 9 a Profit = Sx – (VCx + 500 000) = 100 000 × $10 – (100 000 × $5.50 + 500 000) = 1 000 000 – 1 050 000 = $ –50 000 If the company stops production it will lose $100 000 and so would be in a worse position. However, it can’t continue to operate and make losses. It must either increase sales revenues and/or decrease costs. Can fixed costs be reduced? Can variable costs be reduced? Can the selling price be increased without affecting the level of sales? Will a marketing campaign increase sales? b If the company accepts the offer, profit would increase by 150 000 × $3.50 (contribution margin) or $525 000. This means the company’s loss would become a profit of $475 000. Mikel Ltd should accept the offer. 10 The offer from Dorro Ltd would result in an increase in costs of $20 – $17 or $3 per radio for a total increase in costs of $60 000. The sales of transistors results in the following profit: Profit = Sx – (VCx + FC) = 10 000 × $10.10 – 10 000 × $9 = 101 000 – 90 000 = $11 000 Philco would suffer a net decrease in profit of $49 000 if it accepts the offer and so it should reject the offer and continue to make the circuit boards. 11 a Profit = Sx – (VCx + FC) = 100 000 × $200 – (100 000 × $100 + 7 500 000) = 20 000 000 – 17 500 000 = $2 500 000

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b Profit = Sx – (VCx + FC) = 125 000 × $185 – (125 000 × $100 + 7 500 000) = 23 125 000 – 20 000 000 = $3 125 000 Based on the increase in profit the company should proceed with the drop in sales price provided it is confident of the higher sales level at the lower price. c The special offer would add 20 000 × $80 (contribution margin) to the profit in (a) above. This would result in an increase in profit of $1 600 000. Therefore, the total profit when added to the profit in (a) is $4 100 000. Based on the figures, the company should accept the offer from Low Price Stores Ltd and not drop its selling price to $185. Discuss the potential implications for TVS Ltd of selling units at lower than the normal retail price. 12 a Products Selling price

A $ 20

B $ 28

C $ 8

D $ 36

E $ 16

F $ 40

Costs Direct materials Direct labour Total variable cost Contribution

4 4 8 12

4 6 10 18

1.2 2.4 3.6 4.4

2.4 8.8 11.2 24.8

2.8 3.6 6.4 9.6

1.6 3.2 4.8 35.2

Labour hrs per unit Contribution per labour hour ($)

6.4 1.875

7 2.57

4 1.1

9 2.75

5 1.92

12 2.93

Ranking

Optimal production plan: Contributio n $ F 2 900 12 34 800 101 964 D 1 100 9 9 900 27 225 B 1 200 7 8 400 21 588 E 900 5 4 500 8 640 A *1 000 6.4 6 400 12 000 64 000 171 417 Less fixed costs 10 000 Profit 161 417 *The number of units of product A that can be produced will be restricted to 1000 units due to the constrained labour hours. Product

Quantity in units

Labour hours per unit

Cumulative

Note: fixed costs are unavoidable and are therefore irrelevant in the decision. b i Internal opportunity cost – direct labour hours $2.40 can be interpreted in the following ways as the: • contribution a firm would forego by losing one hour of labour • contribution gained if the firm could release one more hour • maximum the firm would be willing to pay to release one more hour.

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ii The additional contribution if one more machine could be released. Therefore, it is also the maximum additional cost that the company would be willing to pay to secure one more machine hour. It can also be interpreted as the contribution the company would forego by losing a machine hour. 13 We need to establish if each product is contributing to the fixed cost. Sales Variable costs

Scout 250 000 (160 000)

Trouper 150 000 (113 000)

Contribution

90 000

37 000

If the company stops making Scouts and Troupers and does not increase production and sales of Hound dog then it will be in a worse situation as shown by the revised profit and loss statement: $ 320 000

Sales Less cost of goods sold

390 000 (70 000)

Less operating costs

62 000 (132 000)

As can be seen from the statement, a decision to stop producing Scouts and Troupers without replacing them or increasing sales and production of Hound dog is disastrous. The reason is that now Hound dogs have to absorb all the fixed costs and the only saving from cutting Scouts and Troupers are the variable costs. If we add back to the loss the contribution to fixed costs from Scouts and Troupers we get the following result: Add

(132 000) 127 000 (10 000)

The $5000 loss is in effect the current overall loss of the company if you add together the three models of shoes. So while the company still has an overall loss, it is much smaller than the loss of $132 000 which will result if Scouts and Troupers were cancelled with no increase in sales and production of Hound dog. More information is needed about alternative uses for the productive facilities if Scouts and Troupers are cancelled. Can more Hound dogs be sold? Are other models possible? Can we reduce plant size? 14 a The management’s statement of the profitability of Mox and Tox includes fixed costs that we are told will not be expected to change from the present total costs of $2000. Therefore, fixed costs are unavoidable; that is they will be incurred whether or not the firm manufactures and sells both products. It follows that in the decision regarding the optimal production plan, fixed costs are irrelevant and should therefore be ignored.

Chapter 18: Accounting for decision making: with and without resource constraints

b Calculation of contribution per unit:

Selling price Variable costs Contribution

Mox

Tox

$ 1.5 0.7 0.8

3.0 1.8 1.2

Present plan: $ Contribution Mox $1.2 x 1 000 units Tox $0.8 x 2 000 units

1 200 1 600

Total contribution Less fixed costs Profit

2 800 2 000 800

Abandon production of Mox and buy in 1000 units for $2800: $

15 a

Contribution Mox $3 x 1 000 units – $2 800 Tox (as above) Cox ($1 – $0.6) 0.4 x 1 000 units

200 1 600 400

Total contribution Less fixed costs Profit

2 200 2 000 200

The present programme is the most profitable and therefore it is strongly suggested that no changes are implemented. Contribution per labour hour:

Sales

1.0

2.0

Variable costs: Labour Materials Total variable cost per unit

0.20 0.55 0.75

0.50 0.90 1.40

Contribution per unit Labour hours per unit Contribution per labour hour

0.25 0.2 $1.25

0.60 0.5 $1.2

Ranking

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Chapter 18: Accounting for decision making: with and without resource constraints

Optimum mix of X and Y: Product

Quantity in units

X Y

Labour hours per unit

1 100 1 160

Total

0.2 0.5

Contribution $ 275 696 971

220 580 800

Less fixed costs Profit

600 371

b Contribution of Y

Sales Less variable costs: Labour Materials ($0.9 – ($0.9 x 20%)) Total variable costs

2.0 0.50 0.72 1.22

Contribution per unit Labour hours per unit Contribution per labour hour

0.78 0.50 $1.56

The ranking now changes; Y will be preferred to X. Optimum mix of X and Y: Quantity in units

Product Y X

Labour hours per unit

1 200 1 000

0.5 0.2

Total

Contribution $ 936 250 1 186

600 200 800

Less fixed costs Profit

600 586

c Contribution per labour hour

1.1

Y $ 2.2

Variable costs: Labour Materials Total variable cost per unit

0.24 0.55 0.79

0.60 0.90 1.50

Contribution per unit Labour hours per unit Contribution per labour hour Ranking

0.31 0.2 $1.55 1

0.70 0.5 $1.4 2

Sales

X $

207

Chapter 18: Accounting for decision making: with and without resource constraints

Optimum mix of X and Y: Product X Y

Quantity units

Labour hours per unit

1 000 800

0.2 0.5

Total 200 400 600

208

Contribution $ 310 560 870

Less fixed costs Profit

600 270

Note: although product X is ranked before product Y the optimum mix only includes the manufacture of 1000 units of X; this is because the minimum quantity of Y that must be sold is 800 units. d Income under all scenarios: a $371

b $586

c $270

The limitations of the analysis: • Costs and revenues are assumed to behave in a linear fashion; this will not necessarily be the case. • The projections for next year assume certainty; in reality all the variables are uncertain. • It is assumed that there are no inventories and all production is therefore sold when produced. • No qualitative factors have been considered in the analysis although these factors may be influential in the decisions. 16 Each item will be considered separately before an amended statement is produced for the revenue and costs of Abrasive Toothpaste. i Direct labour: If labour was transferred from another department there would be an opportunity cost of using labour on this contract of: $5 000 x 20% = $1 000 x 12 months An incremental cost for hiring machine 40% of the labour would be recruited externally: – wages $50 000 x 40% – advertising

$ 12 000 4 000 20 000 3 000 39 000

ii Supervisors: One supervisor would have to be recruited Reg Raven would be kept on at $15 000 p.a.; but the company would not have to pay Reg his pension of $5 000 p.a. until he retires. This $5 000 therefore would be a saving if this opportunity is accepted

$ 15 000

10 000 25 000

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iii Ingredient X Ingredient X could be resold for ($17 000 × 2) $34 000 less 10 per cent ($3 400) = $30 600 Or: The ingredient could be retained for other users thereby saving purchases of: $34 000 less 25 per cent ($8500) = $25 500 The opportunity cost of using Ingredient X to produce Abrasive is the higher of these two opportunities; that is $30 600. Note the original cost of Ingredient X is a sunk cost and is therefore irrelevant to the decision. iv Ingredient Y Ingredient Y would have to be purchased if Abrasive is to be manufactured; thus the cost of manufacturing Abrasive is an incremental cost of $7 000. v Ingredient P Existing inventories could be sold for $4000 less 10 per cent i.e. $3600. Or: the inventories could be further processed saving purchases of $5000. Note under this option the labour cost will be nil because labour is currently available but idle. The opportunity cost will be higher of the two options i.e. $5000. In addition, half of Ingredient P would have to be purchased externally for ($9 000/2) $4500. The total cost of using Ingredient P is therefore $9500. It should be noted the original cost of the inventory is a sunk cost and therefore is irrelevant in establishing the cost of manufacturing Abrasive. vi Ingredient Z This ingredient is in inventory; the original cost is a sunk cost. If it is not used to manufacture Abrasive it will cost the company $500 to dispose of the ingredient; therefore if it is used the company will gain $500. vii Variable overheads Variable costs are avoidable and are therefore relevant to the decision. viii Fixed overheads The only relevant fixed costs are those that are incremental i.e. $2000. Research and development costs $20 000: these are sunk costs and it follows that they are irrelevant to the decision. Amended statement of revenue and costs – Abrasive Toothpaste: Sales Less costs: Direct labour Supervisors Ingredient X Ingredient Y Ingredient P Ingredient Z Variable overhead Fixed overhead Profit

$ 39 000 25 000 30 600 7 000 9 500 (500) 10 000 2 000

$ 160 000

122 600 37 400

The company will make a profit of $37 400 if it manufactures and sells Abrasive Toothpaste.

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17 Selling price Variable costs Contribution Ranking

Hobart

Perth

10.00 5.00 5.00 2

10.00 5.10 4.90 3

Perth – excluding service to Hobart 10.00 4.00 6.00 1

Based on the contribution margin, the decision would be to relocate to Perth and service Hobart using local manufacturer. The $50 000 salary of the Hobart manager is a fixed cost and it is offset by the royalty payment of $50 000. There would also be a reduction in fixed costs of $35 000, which is the rent in Hobart and the part-time assistant in Hobart. This adds to the attractiveness of this option. The above analysis assumes that unit production capacity is certain. Ranking may alter if production of 40 000 units in Perth reduces significantly. Other factors to be considered include satisfying the Hobart market and maintaining product quality and reliability, the availability of appropriately skilled personnel in Perth, the market potential and the strategic objectives of the firm.

Ethics case studies 1 a

Stakeholders: – significant number of workers (1000) – townspeople of Winjarra (including small businesses in the town) – local trade union – shareholders of Orbital Machines Ltd – residents/businesses in nearby small city. Students could be asked to indicate what is the interest (or ‘stake’) of each of these groups in the facts. b Quantitative factors include: – relocation costs of machinery and other assets to the small city – costs of building a new factory (net of any salvage value from the old factory) – wage costs in Winjarra are 25 per cent higher than in the small city – free land plus no local rates and taxes for five years – ability to compete efficiently in local markets – costs of training new workforce. Qualitative factors include: – Will the new workforce be as efficient as the Winjarra workforce? – What will happen to future wage rates and local rates and taxes? – Location of the small city (and parcel of land) – will it increase supply and distribution costs? – What happens if the contract with Ford Motor Company is cancelled? – What happens to the people of Winjarra? Students should be asked to weight the various considerations as a determinant of their decision making.

Chapter 18: Accounting for decision making: with and without resource constraints

2 a

211

Some ethical issues include: – The managers’ duty to maximise shareholder value. What would shareholders expect management to do? Abandon the Winjarra workers? At what cost are shareholders prepared to help out the Winjarra workers and town? – To what extent should Orbital Machines Ltd be a ‘responsible’ corporate citizen? Does it have a duty of care to employees and a town which have served it loyally for 10 years? There are several possible actions Orbital Machines Ltd could investigate: Is it able to continue some manufacturing in Winjarra? Is it able to retrain its Winjarra employees for other work and/or find them alternative employment by attracting another company to the town? Can it organise a buy-out of the Winjarra factory by the existing employees on the condition that the factory is put to some alternative use? What Joe should do? – It is difficult to know what direct action Joe can take because the information he has received, although persuasive, is not by itself proof that the two suppliers have actually colluded. The professional principles of objectivity (APES 110–120) and independence (APES 110–290), as well as the more fundamental ethical principle of fairness, would suggest that Joe should keep an open mind until he has gathered more evidence. This will be difficult to do because the suppliers, if they have colluded, are unlikely to have a written agreement to that effect. – Joe may contact each of the suppliers to ask why they have raised their prices. He does not need to mention Jane’s friend because the raising of the price was already known by the company. Any further action would depend on the plausibility of the responses Joe receives from the suppliers. No matter what the outcome, Joe would be justified in pointing out to the suppliers that they have not followed appropriate tendering practice. Having made their tenders, they cannot unilaterally change the terms later on. – Joe may wish to discuss his suspicions with his manager after making further enquiries. They may want to seek out further suppliers if time permits. – There are also questions about whether the suppliers have breached relevant trade practices legislation. However, there are problems in obtaining sufficient evidence and whether the costs of pursuing the suppliers would be excessive. Several parties are affected including: – Forpark Ltd – additional costs will be incurred to internally manufacture the slides. These costs would have been avoided had the suppliers not changed their prices (colluded?). On the other hand, Forpark Ltd will at least now have direct control over the quantity and quality of slides produced. – Forpark’s shareholders – all other things being equal, the additional cost will ultimately lead to less profits and less dividends. – Forpark’s employees – changes to the production activities may lead to more overtime or perhaps new people being employed if additional capacity is needed as a result of internally producing the slides. – The slide suppliers – as a result of their price change (collusion?), both suppliers have lost business and probably lost the trust of Forpark Ltd’s management. Information about their alleged collusive activity could also spread to other potential purchasers of the suppliers’ product, therefore making it more difficult for the suppliers to attract sales.

Chapter 19 Budgets Review questions 1 It will depend on the type and size of the organisation. In a participative budget process the parties involved should be the managers responsible for a section/department and should start with them. The budget should then be passed to supervisors and ultimately the board for review/change and approval. 2 Often budgets will mean different things to different people in an organisation. For example, management may introduce budgets primarily to enhance planning within the organisation. But the introduction of the budget may be seen from a negative perspective by operatives who feel controls are being imposed on them. 3 The idea of participative budgeting is that if employees are involved in the budget process they will have more ownership of the budget and are more likely to work to achieving the budget. 4 In manufacturing organisations it is extremely important that there is coordination between the sales and the production function. The main reason for this is that the production cycle, that is the time taken to produce goods for sale, can be relatively long. If, for example, a firm was to amend its sales budget halfway through a budget period, the personnel responsible for production need to know this so they can plan and make provisions to ensure the products are available for sale. This may involve ordering additional inventories of material, amending production schedules and possibly introducing overtime or shift working, all of which takes time to plan and implement. 5 An important aspect of cash budgets is that cash surpluses and deficits can be identified in advance. By identifying surpluses at an early stage in the planning process a firm is in a good position to plan the investment of such funds. The time period that funds can be invested is critical in maximising the returns from investments. Knowing, for example, that the firm will have a cash surplus for two months prior to the payment of a large creditor, such as the Australian Tax Office, means that the company will be able to arrange to deposit cash over this period to obtain the maximum returns. If no cash budget existed, these cash surpluses would only be identified when they occur. It is likely that in these circumstances the rate of return on deposits will be less due to not identifying the surpluses earlier and not knowing how long the surpluses will exist. By identifying cash deficits at the planning stage, a firm will be in a good position to arrange financing for the deficit. Certainly a bank, for example, would look more favourably on an application for an overdraft after having some insight into the future cash position of a firm. 6 The time period for a budget will normally be one year. The reason for a year would appear to relate to the periodic reporting requirements regulated by company law. Companies, for example, are required, with a few exceptions, to publish accounts annually. It should be recognised that there is a link between the information content of management budgets and published annual accounts. For example, a company’s budget will normally detail a sales budget for a period while the published accounts will show sales for the year. The budget can therefore be usefully utilised as a control mechanism by management in the reporting of external results. For internal management control purposes, an annual budget will normally be Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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broken down into discrete quarterly, monthly or even shorter periods. Breaking the budget down into shorter periods facilitates a more effective control device. 7 The master budget will normally represent a summary of the individual functional budgets of the organisation as a whole. It conventionally consists of the budgeted profit and loss account and balance sheet for the organisation. This budget is extremely useful for management as it clearly sets out the short-term objectives and targets for the forthcoming budget period and is in a form that is easy to comprehend. It also provides a basis for coordinating the individual functional budgets; these functional budgets will normally include the sales, production, administration, distribution and cash budgets.

Problems for discussion and analysis 1 What is the purpose of the budget? What period will the budget cover? Who will be responsible for monitoring the budget? What steps will be taken if actual performance departs from the budget? Is the budget set at the start of the period and then ignored? 2 The main reasons that organisations introduce budgets are: • To compel management to look ahead and set short-term targets. By looking ahead, management is then in a good position to anticipate potential problems. • To encourages greater coordination of the functions within the organisation. For example, a production budget can only be constructed with knowledge of the forthcoming period’s sales and desired inventory levels. • To force management to formally communicate their objectives and strategies in the forthcoming periods. Communications are also enhanced in the organisation when budgets are compared periodically with actual expenditure. Discussions through this control mechanism will invariably occur regarding future actions. • To provide a basis for identifying those responsible for differing functions within an organisation and a basis for measuring their performance. • If a company wishes to implement control mechanisms, then the budget is an important part of these mechanisms. Budgets in such cases will act as a benchmark that can be compared with actual performance of managers and operatives. • As a medium for which expenditure is authorised. If expenditure is contained within a budget it implies that it has been approved by top management and no further approval is required. • To motivate employees. In this sense the budget is once again being primarily used as a target to motivate employees to reach certain levels of attainment. The arguments against introducing budgets are: • Budgets are time consuming. • Conditions change very quickly which can make budgets obsolete. • They end the politics associated with the setting of budgets between competing units. • Funds being allocated in response to market pressures. • Information technology allows rapid production of financial information for companies to use. • It avoids the demotivating impact that budgets have in some organisations.

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3 AKP Ltd Schedule of collections from sales for the three months ending 31 May March $ 48 000

Receipts from cash sales Cash sales (10% × current month’s sales) March sales on account Collected in March ($432 0001 × 60%) Collected in April ($432 000 × 30%) Collected in May ($432 000 × 10%) April sales on account Collected in April ($531 0002 × 60%) Collected in May ($531 000 × 30%) May sales on account Collected in May ($454 5003 × 60%) Total cash collected

259 200

April $ 59 000

129 600 318 600

307 200

507 200

May $ 50 500

43 200 159 300 272 700 525 700

$480 000 × 90 per cent = $432 000 2 $590 000 × 90 per cent = $531 000 3 $505 000 × 90 per cent = $454 500 4

Cash inflows Part-time job

March $

April $

May $

June $

850

250 750 600

750 600

Cash outflows Guild fees Rent Food Electricity Entertainment Deposit Concert ticket Total cash outflows

130

750 600 89 130

1 730

1 480

125 1 694

1 980

Net cash flow

(880)

(630)

(844)

(1 130)

Cash balance B/F

2 637

1 757

1 127

283

Cash balance C/F

1 757

1 127

283

(847)

130 500

Based on the budget, Jenny will be in deficit of $847 by the end of June. She must arrange a loan, reduce her expenditure in certain areas (cancel the travel plans) or earn more income. She can do a combination of all of these options.

Chapter 19: Budgets

5 Sivraj worksheet for six months to 31 December Assets Transaction

Cash $

JULY Sales Purchases Wages Overheads AUGUST Sales Purchases Wages Overheads SEPTEMBER Sales Purchases Wages Overheads OCTOBER Sales Purchases Wages Overheads NOVEMBER Sales Purchases Wages Overheads DECEMBER Sales Purchases Wages Overheads

16 000 40 000 –60 000 –30 000 –23 000

Balance Debtors Creditors Dep'n COGS

–2 000

Balance

–2 000

Non-current assets $

= Accum. depn $

Inventories $

Debtors $

Liabilities Creditor

Equity

Profit & loss $

24 000

–30 000 –23 000 50 000

60 000

50 000 –20 000 –30 000 –23 000

–30 000 –23 000 50 000

20 000

70 000 –20 000 –30 000 –23 000

–30 000 –23 000 70 000

20 000

120 000 –20 000 –30 000 –23 000

–30 000 –23 000 120 000

20 000

170 000 –20 000 –30 000 –23 000

–30 000 –23 000 170 000

20 000

24 000

(1 200)

–30 000 –23 000

200 000

100 000

60 000

(1 200)

182 000 100 000

60 000

20 000

100 000

60 000

40 000

–1 200 –240 000

–240 000 +

Share capital $ 40 000

40 00

60 000

50 000 –60 000 –30 000 –23 000

40 800

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Chapter 19: Budgets

6 a

Production budget in units: Sales Less opening inventory

X 18 8 10

Y 50 15 35

Z 30 6 24

Plus closing inventory Production

10 20

15 50

6 30

b Total budgeted cost of materials used in production of X, Y and Z:

Products X (20 units) Y (50 units) Z (30 units) Units of material Cost of material per unit

60 – 150 210 $3

40 50 90 180 $2

– 100 30 130 $4

Total cost of materials purchased for production

$630

$360

$520

Less opening inventory Purchases

210 25 235 21 214

180 23 203 17 186

130 15 145 10 135

Cost per unit of material

Total cost of purchases

$642

$372

$540

The total cost of materials purchased: Units to be purchased Production Plus closing inventory

7 a

Production budget in units: Sales Less opening inventory Plus closing inventory

P 276 12 264 33

Q 12 7 5 6

R 33 12 21 15

297

Production

216

Chapter 19: Budgets

b Total budgeted cost of materials used in production of P, Q and R: F

149 22 – 171 $76

– 33 252 285 $8

$12 996

$2 280

Less opening inventory Purchases

171 8 179 22 157

285 45 330 102 228

Cost of material per unit Total cost of purchases

$76 $11 932

$8 $1 824

Products P (297 units) Q (11 units) R (36 units) Units of material Cost per unit of material Total cost of materials used in production

The total cost of materials purchased: Units to be purchased Production Plus closing inventory

8 a

Total budgeted cost of materials used in production of chicken and fish pies: Chicken pies (22 500) Fish pies (13 125) Kg of material Cost per unit of material

Pastry 11 250 9 844 21 094 $2

Chicken 2 250 – 2 250 $7

Fish – 1 969 1 969 $10

Veges 9 000 7 875 16 875 $0.90

Total cost of materials purchased for production

$42 188

$15 750

$19 690

$15 188

The total cost of materials pastry, chicken, fish and vegetables purchased: Pastry

Chicken

Fish

Veges

Less opening inventory Purchases

21 094 600 21 694 745 20 949

2 250 100 2 350 100 2 250

1 969 90 2 059 50 2 009

16 875 200 17 075 125 16 950

Cost per unit of material Total cost of purchases

$2 $41 898

$7 $15 750

$10 $20 090

$0.90 $15 255

Units to be purchased: Production Plus closing inventory

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Chapter 19: Budgets

b Production budget in units: Sales Less opening inventory Plus closing inventory Production

Chicken 20 000 2 000 18 000 4 500 22 500

Fish 12 000 1 500 10 500 2 625 13 125

9 Art and Craft Direct Ltd Cost of goods sold budget for the month of June

Finished goods inventory, 1 June Work in process inventory, 1 June Direct materials Direct materials inventory, 1 June Direct materials purchases Cost of direct materials available for use Less direct materials inventory, 30 June Cost of direct materials placed in production Direct labour Factory overhead Total manufacturing costs Total work in process during the period Less work in process inventory, 30 June Cost of goods manufactured Cost of finished goods available for sale Less finished goods inventory, 30 June Cost of goods sold

$2 900 $8 190 130 320 $138 510 9 150 $129 360 142 300 69 100

340 760 $343 660 1 350

10 a Cash budget for July to September Joe’s estimates Cash inflows Sales receipts Cash outflows Inventory Expenses Total cash outflows Net cash flow Cash balance brought forward Cash balance carried forward

July $

August $

September $

80 000

100 000

150 000

105 000 31 000

119 000 31 500

112 000 31 700

136 000 (56 000)

150 500 (50 500)

143 700 6 300

5 000

(51 000)

(101 500)

(51 000)

(101 500)

(95 200)

$10 030

342 310 $352 340 10 290 $342 050

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219

Cash budget for July to September Debbie’s estimates Cash inflows Sales receipts Cash outflows Inventory Expenses Total cash outflows Net cash flow Cash balance brought forward Cash balance carried forward

July $

August $

September $

80 000

90 000

200 000

140 000 30 900

210 000 32 000

280 000 33 000

170 900 (90 900)

242 000 (152 000)

313 000 (113 000)

5 000

(85 900)

(237 900)

(85 900)

(237 900)

(350 900)

In order to maintain a cash balance of $5000 at the end of each month, the business will need to borrow the following amounts. July August September Total

Joe’s estimates $56 000 $50 500 ($6 300) $100 200

Debbie’s estimates $90 000 $152 000 $113 000 $355 900

b Suggest the owner request further sales estimates from others, as the variations in the two estimates are significant. The business will need to arrange a loan if the minimum cash balance is to be maintained at $5000. The size of the loan depends on which estimates of sales are used. Advise the owner to seek the cheapest source of finance and arrange a loan for $150 000 with standby additional facilities available if requested. The use of a bank overdraft may be necessary in view of the widely divergent cash flow projections. 11 a BBQ Essentials Sales budget for the month ending 31 May 20X3 Product and area Basic

Deluxe:

Sydney Hobart Perth Sydney Hobart Perth

Total

Total Total revenue from sales

Unit sales volume

Unit selling price $

Total sales $

3 500 2 800 4 000 10 300

550 500 600

1 925 000 1 400 000 2 400 000 5 725 000

1 800 1 500 2 900 6 200

1 300 1 200 1 500

2 340 000 1 800 000 4 350 000 8 490 000 14 215 000

Chapter 19: Budgets

b BBQ Essentials Production budget for the month ending 31 May 20X3 Units

Expected units to be sold Plus desired inventory, 31 May 20X3 Total Less estimated inventory, 1 May 20X3 Total units to be produced

Basic model 10 300 1 200 11 500 1 500 10 000

Deluxe model 6 200 500 6 700 400 6 300

c BBQ Essentials Direct materials purchases budget for the month ending 31 May 20X3 Direct materials

Required units for production Basic Deluxe Plus desired inventory, 31 May 20X3 Total Less estimated inventory, 1 May 20X3 Total units to be purchased Unit price Total direct materials to be purchased

Grates (units)

Stainless steel (lbs.)

Burner subassemblies (units)

Shelves (units)

20 0001 37 8005

250 0002 409 5006

10 0003 25 2007

20 0004 18 9008

800 58 600

1 900 661 400

800 36 000

480 39 380

1 000

2 500

600

400

57 600 × $15.00

658 900 × $3.00

35 400 × $72.00

38 980 × $7.00

$864 000

$1 976 700

$2 548 800

$272 860

10 000 × 2 grates = 20 000 grates 10 000 × 25 lbs. = 250 000 lbs. 3 10 000 × 1 sub-assembly = 10 000 sub-assemblies 4 10 000 × 2 shelves = 20 000 shelves 5 6 300 × 6 grates = 37 800 grates 6 6 300 × 65 lbs. = 409 500 lbs. 7 6 300 × 4 sub-assemblies = 25 200 sub-assemblies 8 6 300 × 3 shelves = 18 900 shelves 2

Total

$5 662 360

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Chapter 19: Budgets

d BBQ Essentials Direct labour cost budget for the month ending 31 May 20X3 Hours required for production Basic1 Deluxe2 Total Hourly rate Total direct labour cost 1

12 a

Prefabrication department

Forming department

Assembly department

5 000 3 780 8 780 × $12.00

7 500 9 450 16 950 × $10.00

15 000 15 750 30 750 × $9.00

$105 360

$169 500

$276 750

Total

$551 610

This line is calculated as 10 000 basic units from the production budget multiplied by the hours per unit in each department estimated for the basic. 5000 = 10 000 × 0.50; 7500 = 10 000 × 0.75; 15 000 = 10 000 × 1.50 2 This line is calculated as 6300 deluxe units from the production budget multiplied by the hours per unit in each department estimated for the deluxe. 3780 = 6300 × 0.60; 9450 = 6300 × 1.50; 15 750 = 6300 × 2.50 i Sales budget: A 16 200 $14.35

B 11 800 $12.20

Total revenue

$232 470

$143 960

$376 430

Sales units Price per unit Revenue

Production budget: (in units) Sales Plus closing inventory Less opening inventory Production in units

iii

16 200 8 100 24 300 5 100 19 200

11 800 6 600 18 400 2 600 15 800

Purchases budget in terms of components: Total components used in production Products A (19 200 units) B (15 800 units)

96 000 47 400 143 400

38 400 63 200 101 600

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Chapter 19: Budgets

Purchases

Closing inventory Plus production

46 000 143 400 189 400

19 500 101 600 121 100

Less opening inventory Components

38 000 151 400

13 500 107 600

Purchases budget in dollars: Components to be purchased Price per component

X 151 400 $0.68

Y 107 600 $0.24

Total cost of purchases

$102 952

$25 824

The total labour hours and cost for the period: Product A B

Production (units) 19 200 15 800

Hours per unit 2 1

Total hours 38 400 15 800

Rate per hour ($) 4.50 4.00

Contribution per unit: Sales price

$ 14.35

Variable costs Component X 5 units × $0.68 Component Y 2 units × $0.24 Labour 2 hours × $4.50

3.40 0.48 9.00

Total variable costs Contribution per unit B Sales price

12.88 1.47 $ 12.20

Variable costs: Component X 3 units × $0.68 Component Y 4 units × $0.24 Labour 1 hour x $4

2.04 0.96 4.00

Total variable costs

7.00

Contribution per unit

5.20

Total cost $ 172 800 63 200 236 000

222

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vii

223

The profit and loss for the period: A

Contribution per unit Number of units sold

$1.47 16 200

$5.20 11 800

Total contribution Less overheads Profit

$23 814

$61 360

Total $

85 174 25 000 60 174

b How useful are these budgets for planning, decision making and control? – All those responsible for functions within the organisation must clearly coordinate their individual budgets with others. The budgets prepared for Borough Equipment Ltd illustrate the importance of coordination between these functions. For example, those responsible for the labour budget will know the hours required for the forthcoming period and can therefore plan to ensure this requirement is available. – These budgets will act as a medium to communicate the short-term objectives of the company to management and operatives. – The budgets represent targets which responsible personnel can work to during the period and possibly also provide a means to motivate personnel. Decision making: – The functional budgets give management the opportunity to make decisions within the defined objectives of the company. – From the production of these budgets, it may be felt that certain aspects of the budgets need to be amended before they become operational. The budget in this context gives management the opportunity to examine the overall effect of operating decisions. For example, operating decisions regarding the range of products to be made and sold would normally be made prior to the completion of the functional and master budgets. But these decisions, when considered as a whole within the budgeting framework, may be reconsidered and amendments made to the range. Control: – The budget may be used as a source for the control of authorising of expenditure. The fact that the total expenditure for components X and Y is shown in the budget for the forthcoming six month period implies this level of expenditure has been endorsed by top management and therefore requires no further authorisation from them. – These budgets provide a basis for responsibility accounting. – Budgets can also act as a basis for comparing actual performance with a plan, and this comparison can then lead to identification of variances from the plan which may initiate management action to ensure that in future periods such deviations do not occur.

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224

13 a Month 0 $

Month 1 $

Month 2 $

Month 3 $

Cash inflows Sales receipts 75 000 90 000 110 000 Cash outflows Wages 3 000 6 000 6 000 6 000 Rent 8 000 8 000 8 000 8 000 Utilities 2 000 2 000 Insurance 10 000 Administration 800 800 800 Equipment 45 000 Inventory 60 000 72 000 88 000 96 000* Interest 1 500** Total cash outflows 116 000 96 800 104 800 112 800 Net cash flow (116000) (21 800) (14 800) (2 800) Cash balance B/F 100 000 (16 000) (37 800) (52 600) Cash balance C/F (16 000) (37 800) (52 600) (55 400) * Assume sales for month 4 will be $120 000. ** Assume the long-term loan is granted at the start. The business will also require a bank overdraft sometime in month 3 to meet the cash shortfall. This will result in an increase in interest costs in month 4.

b At a turnover level of $175 000, the following is an estimate of the cash flow per month: Month 12 $

Cash inflows Sales receipts 175 000 Cash outflows Wages 6 000 Rent 8 000 Utilities 2 000 Insurance Administration 800 Equipment Inventory 140 000 Interest 1 500* Total cash outflows 158 300 Net cash flow 16 700 * Assume bank overdraft no longer required given positive net cash flow position at this stage.

The net cash flow of $16 700 suggests the business can be successful in the long term. From the NCF we need to deduct $4500 for depreciation and $833 for the insurance expense per month, but the business will still be producing a profit of approximately $11 367 per month assuming no other costs increase (see part c). This would equate to a per annum profit of about $136 000 and this is a very good return on the investment of $100 000. However, there has been no allowance for a salary to Alan unless this is included in staff costs. Nevertheless, the business appears to have potential over the longer term, although initially the cash position is very unfavourable. The bank would be more likely to provide the loans if it was confident of the increase in turnover and the resultant profit.

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The cash budget for month 12 assumes the only cost that increases is the cost of inventory purchases. It is possible that wages will need to increase, as more staff are required to cope with the increased sales. Administration costs will also increase as a result of having more staff. Other overheads such as rates, utilities and interest are also likely to increase. 14 There are many errors and questions in relation to these projections. Statement of comprehensive income: • Cost of sales $185 000 should be included and not inventory costs $225 000. This item if it means cash paid for inventory should be included as a cash outflow. • Purchase of shelves and counters should not be shown as an expense. It is a cash outflow creating an asset. Only the depreciation should be rounded in the P & L. • Only salaries are an expense and not dividends. The two must be separated and the dividends are a distribution of profit. • The depreciation expense of $30 000 shown in the cash flows should be included as an expense in P& L. • No tax is reported. Cash in and out: • Depreciation is not a cash flow and should be deleted. • If $6000 rent was prepaid in June, then it is not a cost outflow in the next six months. However, additional rent will need to be paid. • Cash payments for inventories should be included, not the cost of sales. • Cash outflow for shelves and counter have not been included. • Cash flow is probably negative. Balance sheet: • No inventory shown and yet it appears as though this should be $40 000. • The shelves and counters included in the fixtures? • Balance sheet not prepared in good form. • Are all liabilities included? Recommendation: • No loans be advanced until a proper set of accounts is submitted for consideration.

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226

15 Cash budget for three months ending June 20X1 April

May

June

$ 16 000

$ 53 300

$ 81 700

Cash sales Debtors Sale of obsolete inventory Total inflows of cash

20 100 142 000

12 600 134 000

162 100

15 000 148 000 9 500 172 500

Cash outflows Purchases Overheads Selling and distribution Advertising Tax payment Capital equipment Purchase of property Total outflows of cash

58 000 10 000 4 200 – – 52 600

71 000 10 000 4 200 6 300 – 52 600

124 800

144 100

80 000 10 000 4 200 7 700 3 880 – 150 000 255 780

37 300

28 400

(109 180)

53 300

81 700

(27 480)

Opening balance

Net inflow (outflow) Closing balance (Cash inflow – cash outflow)

146 600

The following is an outline of the points that should be covered in the report. The company’s cash position from trading activities appears to be healthy. If capital expenditure were to be ignored, the company’s trading activities would generate net inflows of $105 900 (53 300 + 52 600), $134 300 (81 700 + 52 600) and $122 520 (150 000 – 27 480) respectively for the months of April, May and June. From the cash surpluses from trading activities it would appear that the firm can afford, in cash terms, to finance the purchase of the new inventory-handling equipment. However, it seems that some additional finance will have to be raised to finance the proposed purchase of property. The nature of the finance to be raised to fund the purchase of the property will depend on a number of factors, for example, the cost of finance from differing sources of capital and the firm’s current capital structure. This information is not available, so no recommendation can be made regarding this issue. The firm could improve its trading cash flows by reducing the credit given to customers and delaying payment for purchases. However, there is often a cost to this strategy. For example, if the credit period was reduced for customers to pay their debts it is likely that sales would decrease as customers may trade with another company that gives them a greater period to pay. The cost associated with delay in payments to suppliers includes the possible erosion of goodwill between the supplier and the company, which could have significant consequences. For example, there may be an occasion where the company requires supplies delivered more quickly than normal – the supplier may not be very accommodating because of the previous delays in payments.

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Ethics case study a Problems for Jetco: – The sales people’s strategies help maximise the salaries/bonus expense but do not maximise Jetco’s profits. The unit commission rate does not provide sufficient incentives to seek sales above the 1000 units minimum. – The strategies also delay (as well as reduce) cash inflows from customers, which may cause short-term liquidity problems. b What should Roger do? Stakeholders – Sue – Other sales staff – Jetco shareholders Problem – What to do about the information on sales staff strategies? (Another way to look at the case is to ask how can the reward system be redesigned so that it maximises shareholder value?) Values and principles – Professional principles at issue here include integrity (APES 110–110), objectivity (APES 110–120), independence (APES 110–290), and competence and due care (APES 110–130). These combined with the duty to maximise shareholder value imply that Roger should reveal what he knows so that the reward system can be redesigned. – In contrast, Roger needs to consider his friendship with Sue (loyalty), the principle of confidentiality and whether there would be an adverse financial or morale impact on all sales staff (duty to avoid harm to others). Three possible courses of action – Action one: do not report the information to others. – Action two: pass on the information to management. – Action three: attempt to reveal the information surreptitiously, e.g. Roger could suggest to management that it might be time to conduct some sort of benchmarking exercise in which performance (including sales and sales salaries/bonuses) are carefully reviewed, perhaps as part of next year’s budget preparation. Evaluation Action one: – maintains Sue’s friendship and confidentiality but not in keeping with the other ethical principles or shareholders’ interests – it could be discovered (although the probability of this happening might be low) that Roger knew of the sales people’s strategies – we are told that he could lose his job if this happens. Action two: – loses Sue’s friendship and breaks her confidentiality but is in keeping with other ethical principles and shareholders’ interests – depending upon management’s reaction to the information, there could be morale or other problems with the sales staff if they are not consulted on any changes to the reward system.

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Action three: – by attempting to pass on the information surreptitiously it may appear to Sue and the other sales staff that any changes came by coincidence from management rather than from information supplied by Roger – a review of the budget projections and policies as part of some benchmarking exercise may allow the opportunity for all parties to be involved and to be consulted about any changes – however, there is still a risk that Sue may think that Roger broke her confidence and this could threaten their friendship. Choose a plan of action – Take a poll of the class but emphasise the requirement that class members present a plan of action and that they properly justify that plan by reference to principles and consequences. It is often helpful to ask students if they would be comfortable having their actions publicly disclosed on television or before the courts.

Chapter 20 Performance measurement and the balanced scorecard Review questions 1 Responsibility accounting is where an entity is structured into strategic business units and performance of these units is measured in terms of accounting results. It recognises various decision centres throughout an organisation and traces costs (or costs and revenues) to individual managers who are primarily responsible for making decisions and controlling the cost and revenues of their centres which are called ‘responsibility centres’. 2 A cost centre manager is not responsible for making decisions concerning sales or the amount of fixed assets invested in the centre. 3 Driver KPIs are the factors which lead to improvements in the entity’s performance while outcome KPIs measure how effective the drivers have been in bringing about improvements in performance. 4 A balanced scorecard is a set of key performance indicators that provide senior management with a fast but comprehensive view of the business. It includes financial measures that tell the results of actions already taken. It also complements the financial measures with operational measures relating to customer satisfaction, internal processes, and innovation and learning. The operational measures are the drivers of future financial performance which is assessed in the financial perspective. 5 The four perspectives are: Financial – how do we look to our owners? Customers – how do we look to our customers? Internal processes – what do we need to do with the core processes in the business to meet the needs of our customers and owners? Learning and growth – to achieve the objectives how do we develop our employees, work practices and technologies? 6 A balanced scorecard can indicate the underlying causes of financial performance from innovation and learning, customer, internal and financial perspectives. In addition, a balanced set of measures helps managers consider trade-offs between short-term and long-term financial performance. 7 Financial – return on assets, costs per customer. Customer – customer satisfaction, loan amounts per customer. Internal processes – approval time for loans, cost of borrowing money. Learning and growth – employee morale, number of employees attending training courses.

Problems for discussion and analysis 1 Responsibility accounting is where an entity is structured into strategic business units and performance of these units is measured in terms of accounting results. It recognises various decision centres throughout an organisation and traces costs (or costs and income) to individual managers who are primarily responsible for making decisions and controlling the cost and income of their centres, which are called responsibility centres. By using Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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responsibility accounting and creating responsibility centres, it is then possible to assess how well managers control costs or make a profit, and rewards can be based on this assessment. It is not fair or appropriate to assess and reward someone based on factors over which they have no control. Have students consider the position of a CEO of a large company like Wesfarmers and discuss how the reward for a CEO should be structured. a Kellee only has control over some of the costs of the department but cannot control the amount paid to staff. However, she can influence the workload and hence the number of staff. Suggest a cost centre. b Does Leigh’s school have control of the marketing or is this done centrally? Suggest a profit centre. c As with Leigh’s school, we need to know who controls the marketing. Suggest an investment centre. Students should be able to justify the measure they suggest. Some possible measures include: • Growth in membership • Member satisfaction • Staff satisfaction • Cost management • Achieving profit targets a Full-time salaries per student, part-time salaries per student, actual cost to budget, staff evaluations, staff morale. b Net profit, profit per customer, customer satisfaction, employee morale. c Net profit, return on assets, return on shareholder equity. This example raises a conflict between decisions that may be in the best interests of shareholders but not necessarily of the manager. Accepting the project will increase the wealth of the firm and hence its shareholders. However, the divisional manager will not receive any additional bonus as the return does not exceed 25 per cent so the bonus is not providing any incentive for the manager to accept the project. a Cost of capital = 0.4 × 0.06(1 – 0.3) + 0.6 × 0.12 = 0.088 EVA = $50 000 – 500 000 × 0.088 = $50 000 – 44 400 = $ 5600 b The company has created value for shareholders and this should enhance the company’s share price. However, it is important to measure the EVA on a regular basis. a Cost of capital = 0.4 × 0.06(1 – 0.3) + 0.6 × 0.12 = 0.088 EVA = $40 000 – 500 000 × 0.088 = $40 000 – 44 400 = –$ 4400 b The company has not created value for shareholders in 20X6 and in fact they have destroyed shareholder value by $4400. Cost of capital = 0.25 × 0.06(1 – 0.3) + 0.75 × 0.12 = 0.1005 EVA = 2 × ($512 234 + 30 365) – 4 366 301 × 0.1005 = $1 085 198 – 438 813 = $646 385

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We have multiplied the profit by two as it is profit for a half year only and we are charging a full year against the capital. Woolworths has clearly created value in the period based on the EVA of $646 385 000. 9 Driver KPIs are the factors which lead to improvements in the entity’s performance while outcome KPIs measure how effective the drivers have been in bringing about improvements in performance. Operating KPIs measure factors which a business needs to do on a regular basis to ‘keep the ship moving in the right direction’, the ‘business as usual’ measures. Strategic KPIs measure factors which help determine the direction in which the business is moving. • Financial: return on investment = strategic outcome • Customer: time to serve customer = operating outcome • Internal process: time to make coffee = operating driver • Learning and growth: number of employees completed training program = strategic driver 10 Editorial comments in the Australasian financial and business press, the ratio of new clients signed to client terminations and the average number of complaints lodged are all measures that indicate the market profile and client acceptance of Eggleton Limited in the Australasian business community. The annual budget allowance by Eggleton Limited for expenditure on corporate and service promotion would not be directly relevant to assessing the market profile and client acceptance of Eggleton Limited in the Australasian business community. 11 Note to instructors: the following is a guide. There is not only one interpretation. The important issue is for students to justify the classification they choose. a Strategic, driver. b Operating, driver. c Strategic, outcome. d Strategic, driver. e Operating, driver. f Strategic, outcome. g Strategic, outcome. 12 a Customer. b Financial. c Internal process. d Learning and growth. e Customer or internal process. f Customer or financial. g Learning and growth. h Customer. 13 Financial – return on investment, cost reduction. Customer – repeat business, amount of tips, customer satisfaction. Internal process – quality of coffee, time taken to serve customer. Learning and growth – number of employees completed training, employee satisfaction. 14 a High profits or massive losses make headlines, and it is perfectly apparent from scanning the business pages of any newspaper that profitability remains the principal measure by which the success or failure of a business is judged. There are a number of arguments in favour of this: i The techniques of measuring profit are extremely well established and codified in standards of accounting practice. Even where different approaches are possible the issues are well publicised.

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ii Profit is the net result of the success of marketing activities and the control of costs: as such it measures the two principal areas of concern for most commercial organisations. iii It ‘can be applied to any profit-seeking activity, whatever the nature of goods or services being produced and/or sold. It could therefore be used as a basis for comparison of apparently disparate activities.’ (Coates, Rickwood and Stacey, Control and Audit in Management Accounting, CIMA, 1993.) iv It can be related to aspects of output (for example sales) or input (profit per machine/per employee and so on), or (in the form of ROI) to overall investment in a business. v It is helpful for management in deciding which parts of a business should be allocated resources and for investors in deciding where their capital should be placed. b In spite of its widespread use as a performance measure, profitability does have a number of limitations: i Not all organisations have profitability as their main objective; for example government bodies and charities. Most organisations have subsidiary objectives of varying degrees of importance, and success or failure in achieving these may not be reflected in the profit measure. ii Unless supplemented by additional measures, profit does not adequately indicate the impact of external factors such as inflation, exchange-rate movements and general economic conditions. The impact may vary widely between different types of business: a company that makes a loss in certain conditions may nevertheless have performed better than another that makes a profit, if viewed in the light of external conditions. iii Even for financial reporting purposes, the profit figure is subject to a certain amount of manipulation that may mislead the financially unsophisticated. For internal reporting purposes, there is the further problem of which profit figure to use – operating profit, trading profit, profit before or after interest and tax, and so on. iv A company may be profitable and yet have severe cash flow problems: profitability is not necessarily an indicator of continued success. v The profit measure may encourage managers and investors to take a short-term view. Managers may cut essential costs like training or research to show a profit in the short term. Investors may demand that profits are paid out as dividends when long-term interests require that the money be reinvested to fund future growth. vi Focusing on a bottom line figure that is perhaps satisfactory overall may encourage complacency. Areas where further improvements could be made may be neglected if other areas have performed better than expected, giving a satisfactory net result. c Many companies are discovering the usefulness of non-financial indicators (NFPIs such as quality measures, numbers of complaints, non-productive hours, system down time and so on.) However, there are a number of problems associated with such measures: i Too many measures could be reported, overloading managers with information that is not useful (or comes to be regarded as not useful) or that sends conflicting signals. ii It is difficult to judge which non-financial measures are the most important. iii The ultimate goal of commercial organisations remains the maximisation of profit. An over-concentration on non-financial measures may lead to the neglect of this criterion. iv Some non-financial aspects of performance are very difficult to measure objectively. For example, a measure of customer complaints does not indicate that all customers who did not complain were entirely satisfied. Contemporary Accounting (8th edition) – Solutions Manual © 2013 Cengage Learning Australia Pty Limited.

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15 Accounting has been successful because it is the only model of the firm’s operations which can express inputs and outputs in the same units of measurement, i.e. money. As a result, the information systems of firms are usually dominated by the accounting system. However, this has lead to a simplistic use of the accounting measurements when setting targets and measuring the firm’s performance. The pursuit of short-term profit can be detrimental to a firm’s operations, particularly when these profit measurements are so easily manipulated. Non-financial indicators include: i Production statistics (e.g. average time spent on a process). ii Sales and marketing statistics (e.g. percentage of enquiries converted to orders). iii Quality statistics (e.g. percentage of units needing rework). NFPIs also include qualitative analyses, but these are not so easy to use as statistical data. A general principle of control (and quality) is to quantify as much as possible. The advantage of NFPIs over accounting indicators include the following: i They are easy to calculate. ii They are more readily available than financial information. iii They are more directly comparable with results of previous periods (e.g. they do not suffer from inflation). iv They are more easily understood by non-financial managers. v They are less likely to be manipulated. However, NFPIs cannot replace accounting measurements. Concentration on achieving a relatively small number of production statistics has caused harm to companies that have lost track of the need to make profits. NFPIs can sometimes give conflicting signals as to the organisation’s efficiency. Assuming that the goal of most organisations should be to make a long-run profit as well as adequate short-run profits, a strategic overview of the firm’s performance needs to be taken at all stages. This is best done by using a combination of financial and non-financial indicators. 16 BSC

Triple bottom line measures

a b c

Internal process Financial Customer

d e

Innovation and learning Financial

Customer

g h

Internal process Internal process

Innovation and learning

Waste material produced by BestWest as a percentage of total materials used. BestWest operating surplus for the year ending 30 June 20X0. Number of people attending a BestWest workshop promoting the use of environmentally-friendly packaging. Number of BestWest employees completing a fitness program intended to improve the physical and mental well-being of agency employees. Percentage of total BestWest revenue received from corporate philanthropists (e.g. Gill Bates the CEO of MacroHard Software) due to the sound environmental management policies promoted by the agency within the business community. Community satisfaction with BestWest that is attributable to the agency’s reputation of being a good ‘corporate’ citizen. Tonnes of waste paper recycled by BestWest in the year ending 30 June 20X0. Percentage reduction in BestWest energy consumption (as measured in Giga Joules and cost per full-time employee) due to the agency’s adherence to the targets set in the State Government’s Energy Smart policy. The total number of BestWest employees on occupational stress-related sick leave as at 30 June 20X0.

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If (a) employees are trained to improve their soldering capabilities, (b) the manufacturing process is redesigned, and (c) the right suppliers are selected, then the number of defective units produced will decrease; if the number of defective units produced decreases, then customer satisfaction will increase; if customer satisfaction increases, then market share will increase; if market share increases then sales will increase; if sales increase, then profits will increase. Each consequence of the if-then sequence (the ‘then’ outcome) can be tested to see if the outcome is as expected. For example, if workers are trained to solder better, do defects actually decrease? If defects decrease, do we observe an increase in customer satisfaction? Does market share then increase? Thus, the consequences are observable but only if they are measured. Of course, it should be mentioned that not only outcomes must be measured but also those factors that lead to the outcomes (the performance drivers). Was the process redesigned? How many hours of soldering training are needed, and were they provided? Were suppliers selected so that we now have a higher-quality circuit board? Note also that the number of defects acts as both a lag measure and a lead measure. First, it measures the outcome for training, supplier selection, and process redesign. Second, it also drives customer satisfaction (which must be measured by surveys). Targets indicate the amount of performance driver input and the improvement expected. For example, the company may budget 100 hours of soldering training, 300 hours of supplier evaluation, and two new process changes, and then expect a 50 per cent reduction in the number of defects (the outcome). Suppose that the outcome is only a 10 per cent reduction in defects. Comparing the 50 per cent to the 10 per cent reduction achieved reveals a problem. Double-loop feedback provides information regarding both the validity of the strategy and the effectiveness of implementation. If the targeted levels were not achieved for the performance drivers, then it is possible that the outcome was not achieved because of an implementation problem. If, however, the targeted levels of the performance drivers were achieved, then the problem could lie with the strategy itself. Maybe training to solder better has little to do with reducing defects (it may not be as much of a problem as first thought). Or, perhaps the current suppliers are not really a root cause for the production of defects.

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b Financial

Customer

Process Supplier selection

Profits increase

Revenues increase

Customer satisfaction increases

Market share increases

Defects decrease

Redesign process

Infrastructure Soldering training

18 a 20X2 96 000/40 000 = 2.4/hour (velocity) i 60/2.4 = 25 minutes (cycle time) 76 000/40 000 = 1.9/hour (velocity) ii 60/1.9 = 32 minutes* (cycle time) 76 000/40 000 = 1.9 iii 5000/50 000 = 10% iv N/A v N/A vi vii 5 000/76 000 = 6.6%* viii 2 000/76 000 = 0.026/unit* 100 hours ix $150 x 2 × 20 = 40 xi *Rounded.

20X4 2.4/hour 25 minutes 88 000/40 000 = 2.2/hour 60/2.2 = 27 minutes* 88 000/40 000 = 2.2 2 000/50 000 = 4% ($125 – $100)/$125 = (20%) (6 – 3)/6 = (50%) 2 000/88 000 = 2.3%* 8 000/88 000 = 0.091/unit* 400 hours $140 6 × 20 = 120

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Strategic objectives Financial Reduce unit cost Develop new customers Increase total revenues Customer Increase customer acquisition Process Decrease process time Decrease defective units Decrease inventory Learning and growth Increase employee capabilities

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Measures Unit cost – outcome New customers per unit sold – outcome Percentage change in revenues – outcome Number of new customers – outcome Cycle time/velocity – driver Number of defects – outcome Number of scrapped units – outcome Days of inventory – driver Output per hour – driver Training hours – driver Suggestions – driver

All measures have shown improvement over the two-year period. This provides evidence of the strategy’s viability, assuming that the measures are tied to the strategy as they appear to be. What is lacking are the targets for the various measures. Knowing the targets for the two-year period would significantly enhance the value of the feedback. It is important to emphasise that comparing targets to actuals allows for an assessment both of implementation success and strategy viability (double-loop feedback). It is important to understand that one cause can have more than one effect and that an effect can have more than one cause. Because of this, a strategy can have several causeand-effect branches. Based on the available information, we can express the strategy as follows: If training is increased, then employee productivity and participation will increase; if employee productivity and participation increase, then product quality and process time will improve; if process time decreases and if the product quality improves, then inventory will decrease and costs will decrease (including post-purchase costs); if inventory decreases, then costs will decrease; if costs decrease, then customer sacrifice decreases (selling prices and post-purchase costs lowered); if selling prices and post-purchase costs are lowered, then the number of customers can be increased; if the number of customers increases, then market share will increase; if market share increases, then revenues will increase. The measures reveal a lot about the strategy; in fact, if the measures are properly specified, they should tell the whole story of the strategy. The measures allow us to infer the strategic objectives and the underlying relationships of these objectives. It is important that students discuss the measures and appreciate that some measures can be both outcomes and drivers. For example, new customers are an outcome of what is done internally to attract new customers and it is also a driver of more revenues in the financial measures. The solution shows the number of defective units as an outcome but it can also be a driver of lower costs and therefore, higher revenues.

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Ethics case study a There are many examples of successful CEOs of large organisations, such as Michael Chaney, formerly at Wesfarmers, Bill Gates at Microsoft and Rupert Murdoch at News Ltd. While they receive very high remuneration, the shareholders have also benefited from high share prices and good dividends. What makes a good leader is an area in which there has been much research. Can a team be successful without a good leader? Conversely, can a good leader be successful without a good team? This should provoke some lively discussion with students. b It would seem reasonable to a majority of people, even in a capitalist society, that while there should be adequate reward for CEOs of large companies, reward beyond certain levels becomes difficult to justify. On 19 September 2003 Richard Grasso, Chairman of the New York Stock Exchange, resigned over salary and one-off payments of US$140 million after a large outcry about the size of the payment. The argument about self-interest should provoke good discussion. Do we all act in selfinterest? How realistic is it to think it is possible to manage what is self-interest and what is good for the group or community? The objective is to develop an environment in which actions by managers are best for them and the company. Professional ethical principles of integrity (APES 110–110) would require actions that are in the best interests of shareholders, even if this meant acting against what may be in the best interest of the individual. It is worth noting that in Australia there are new rules requiring shareholders to approve the remuneration report. If more than 25% of shareholders reject the report in two consecutive years there is an automatic vote on whether there should be an election of directors. In 2012, a number of CEO’s from companies like BHP Billiton and Rio Tinto have declined to receive any bonuses.