Solution Manual For Business Accounting & Finance, 6th Edition by Catherine Gowthorpe Chapter 1-20

INSTRUCTOR’S MANUAL Chapter 1: The role of accounting in business

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

Teaching Notes Introduction In this opening chapter we introduce the most common forms of business organization in the UK, and we discuss the reasons why people in business need accounting information, the nature of accounting information and the role of the accountant. The chapter concludes with a section on accounting ethics. It assumes no prior knowledge of the area and so is very suitable as an introduction for For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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students who are new to the study of business. If students can be persuaded to read the section ‘Special notes for the suspicious’ they may find it helpful. Where only limited course contact time is available lecturers may choose to set this chapter as background reading. Whichever approach is taken, lecturers could advise students to revise this chapter before embarking on Chapter 7 which covers accounting for limited companies.

It would be possible to proceed to cover Chapter 20 next if this would better suit your lecture plan.

The coverage of ethics, which was a new feature in the 5th edition of the book, has been augmented for the 6th edition. There is now a section (1.12) on ‘How to be ethical’, which includes the real-life case of Royal Mail Group v Jhuti. The website material for Chapter 1 also includes a case study based on the real-life case of the audit of British Home Stores. Unlike other case studies, this one does not contain any student questions. It is intended to serve as additional reading material.

However, it could form the basis of a seminar discussion.

Learning outcomes After reading the chapter and completing the exercises at the end, students should: •

Understand the differences between the sole trader, partnership and company forms of business organization, and know, in outline, about some of the sources of business finance available to commercial organizations.

•

Know in outline about some important features of the business environment including the various ways in which tax is charged on businesses.

•

Understand why accounting information is produced.

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Be able to identify the principal groups in society who need and use

•

accounting information, and to know about the principal characteristics and features of accounting information.

Know about the functions that accountants perform in the production of

•

accounting information.

Understand the importance of ethics for the professional accountant.

•

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction – emphasizes the need for accounting information

Slide 4

Forms of business organizations

Slide 5

Contrasting sole traders, partnerships and limited companies

Slide 6

Finance for business (this is just a brief introduction in this chapter – proceed to Chapter 20 if you would like to cover financing in more detail at this stage)

Slide 7

Short-, medium- and long-term finance – this slide includes the table from Section 1.4 of the book.

Slide 8

Fundamentals of taxation. This could be omitted if preferred.

Slides 9 – 11

The need for accounting information – a slide each for sole trader, partnership and limited company. You could emphasize the similarities and differences between the three forms of business organization in

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this respect, e.g. registration for VAT. Slide 12

Separation of ownership and management – this shows Figure 1.1 from the book.

Slides 13

Users of accounting information

Slide 14

Key characteristics of useful financial information

Slide 15

Enhancing characteristics of financial information

Slides 16 to 17

Introducing the distinctions between financial accounting/reporting and management accounting

Slides 18 to 21

Introducing the topic of accounting ethics. The principles, threats to principles and consequences of ethical breaches.

Slide 22

Organization of the rest of the book. You may choose to re-order the content of this slide depending upon the order in which you are covering the chapters. It would be quite feasible to start with Chapter 10 if you prefer to cover management accounting first.

Slide 23

Summary

Video The following video on professional ethics may be useful for students. At nearly 35 minutes, it is likely to be too long to incorporate into a lecture, but it could form part of students’ own study. www.youtube.com/watch?v=G5PODQZpp-4

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Case Study The Chapter 1 case study serves as an additional reading, and as such has no questions associated with it. This case study differs from most others in the book in that it outlines a real-life case of ethics and disciplinary action, topics which are touched on in the final section of the chapter.

The full report of the case can be found on the FRC website: www.frc.org.uk/getattachment/433f3df8-d0ef-456b-8a26-aeb55f65489b/BHSParticulars-of-Fact-and-Acts-of-Misconduct.pdf

Exercises The end-of-chapter exercises are a mix of multiple-choice questions and discussion questions. Questions 1.8 (Arnold Tapwood), 1.9 (Geoffrey), 1.13 (Podgorny & Weaver) and 1.14 (Burnip Chemicals) could all be used as the basis for discussion in seminars. Students can test their knowledge using the 18 multiple-choice questions available on the student section of the website.

There are five additional exercises in the student section of the website, and five additional exercises in the lecturer section.

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Answers to Lecturers’ End-of-Chapter Exercises 1.16 The only correct statement is a): a limited company must submit information on a regular basis to Companies House.

1.17 The most appropriate way of financing the build-up of Easter egg stocks, out of those listed, is via an overdraft. The correct answer is b).

1.18 The correct answer is a) objectivity.

1.19 The correct answer is d) self-interest.

1.20 Marie has been correctly informed; shareholders in a company are not personally liable for the debts of the company. This is a great advantage over the alternative form of business organization, the partnership.

However, it is also correct to say that there are some penalties attached to limited company status. It is more administratively complicated to form a limited company than it is to form a partnership. However, the difficulties should not be overstated; a company registration specialist would set up a limited company for around £150 £200. Once a company is established there is an ongoing obligation to submit financial information on a regular basis to Companies House.

The additional administrative responsibilities in a limited company are, in most cases, far outweighed by the very substantial benefit of limited liability.

1.21 Statement a) is correct: the stewardship function requires directors of limited companies to act at all times in the best interests of the company.

1.22 Shareholders in a company are entitled to receive a copy of the annual financial statements, but they are not given any access in law to the company’s management accounting information. Therefore, the finance director should not send a copy of the sales budget, or, indeed, any other information about the company.

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Similarly, unless a shareholder is also appointed as a director, they have no right to take any part in the management of the business. Therefore, the finance director should also refuse to put the suggested item on the agenda for the next board meeting.

1.23 a)

Mohsin, as a potential lender to the company, will be principally concerned with the ability of the business to make regular repayments of the loan, and to meet regular interest payments. He will need to know whether the profit of the company is sufficient to cover the interest on the loan. Also, he will be interested in the company’s other borrowings: has it overstretched itself?

b)

Annual accounting statements lose relevance progressively as they become out of date. The statements which the company has provided are fifteen months old.

A great deal can happen to a company in fifteen months, and more recent, relevant information will be required to assist Mohsin in his decision. The company may not be able at this point to supply the annual accounts for the year ended 31 December 20X2, because they are not yet finalized. However, it would be reasonable to expect that they would be available before too long.

c)

Mohsin is entitled to request whatever information he likes. He is not obliged to make the loan to the company and if the directors refuse to give him additional information Mohsin will almost certainly refuse to make the loan. Lenders and potential lenders are often in a strong position to request information such as monthly management accounting information.

1.24 Greg has been prosecuted and found guilty of the crime of assault, and now has a criminal record. The relevant ethical principle in this case is professional behaviour.

A professional accountant should comply with relevant laws and regulation and should avoid any action that discredits the profession. Although he has not committed any financial crime, Greg has discredited the profession. The For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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consequences for him are possible disciplinary action. He could be further fined by his professional body, or possibly even excluded from membership. Even if he is allowed to remain a member of the professional body, he may find that there are consequences for his future employment prospects, as he may have to declare his criminal record in future job applications.

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INSTRUCTOR’S MANUAL Chapter 2: The statement of financial position

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

Teaching Notes Introduction In this opening chapter of the section on financial accounting, students are introduced to the three principal financial statements, using Example 2.1 of JJ Hair Studio. The three statements are introduced at this stage to demonstrate how they articulate, but the statement of profit or loss and statement of cash flows are not covered in detail until later in the book.

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The remainder of the chapter concentrates on the key terminology used in preparing a statement of financial position, the accounting equation and the preparation of the statement of financial position from a list of balances. Towards the end of the chapter an example considers the significance of the information conveyed by a statement of financial position. The aim of the chapter is to enable students to understand how a statement of financial position is prepared. This involves them learning how to prepare the statement and understanding its significance.

Learning outcomes After reading the chapter and completing the related exercises, students should be able to: Understand how the statement of financial position relates to the other

•

principal financial statements.

Understand the terminology used in a statement of financial position, and

•

some of the principal conventions used in presenting it, and in preparing financial statements in general.

Be able to draw up a statement of financial position for a sole trader from a

•

list of account balances and explanatory notes.

Be able to understand and comment on the basic information conveyed by a

•

statement of financial position.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes (a little abbreviated)

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Slide 3

Introduction

Slide 4

Introduces Example 2.1 by summarizing the transactions for January

Slides 5 to 7

These three slides present the statement of cash flows, statement of profit or loss and statement of financial position that reflect the JJ Hair Studios transactions and position.

Slides 8 to 10

These slides set out the definition of elements in the statement of financial position. You will note that these are not exactly as set out in the Framework, but the definition of assets and liabilities contain some of the same terminology. This means that students will be able to assimilate the full definitions of elements.

Slide 11

Sets out the accounting equation in three different forms. You could use the video suggestion (below) at this point.

Slide 12

Uses Example 2.3 to illustrate the accounting equation in its three different forms.

You could insert a slide or slides here using some of the end-of-chapter exercises to test students' understanding, e.g. Exercise 2.3 (Brian), Exercise 2.4 (Basil), Exercise 2.5 (Brenda).

Slides 13 to 16

Four slides demonstrating the process of drawing up a statement of financial position using Example 2.5 in the book

Slide 17

Changing the value of capital

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Slide 18

Communicating meaning – a few comments about the significance of the 10 February Kitchen Kit position

Slide 19

Qualitative characteristics of financial information – could be explained by reference to the Kitchen Kit position at 10 February

Slide 20

Encouragement to students to try Self-test question 2.4

Slide 21

Summary with encouragement to students to try plenty of questions

Video There is a brief video here: www.youtube.com/watch?v=56xscQ4viWE This video explains the accounting equation in under 5 minutes. Please note that the video uses the term ‘equity’ instead of ‘capital’ so you will need to be sure that students understand that there is a difference in terminology.

I have suggested slotting in this video after Slide 11. You could also use it to introduce a seminar.

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Exercises The chapter contains four self-test questions and there are numerous end-ofchapter exercises. At this stage students are likely to be concerned with getting the figures right and most of the exercises are geared that way. However, Exercises 2.13 and 2.23 require students to comment on the messages conveyed by the statement of financial position. Students can test their knowledge using the 10 multiple-choice questions available on the student section of the website.

There are seven additional questions in the student section of the website, and five additional questions in the lecturer section.

Excel exercises An Excel spreadsheet is available for Exercise 2.12 (Dan). Full instructions are provided on the spreadsheet.

An Excel spreadsheet is also provided for Student question 6 (Hana).

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Answers to Lecturers’ End-of-Chapter Exercises 2.16 Adrian Restaurant tables

NON-CURRENT ASSET

Wages owed to waiter

CURRENT LIABILITY

Bank account containing £3,850

CURRENT ASSET

Tax bill due to HMRC

CURRENT LIABILITY

Restaurant premises

NON-CURRENT ASSET

Mortgage (i.e. loan from bank to buy restaurant premises)

NON-CURRENT

Food supplies in kitchen fridges

CURRENT ASSET

Amounts due to baker for bread supplied over the last month

CURRENT LIABILITY

LIABILITY

2.17 Bernie The assets in Bernie’s business total £91,000 (£63,000 + £28,000) 2.18 Bjork The assets in Bjork’s business total £128,000 (£97,000 + £31,000) 2.19 Bashir The correct answer is b) £27,329 (£79,403 + £16,276 − £68,350)

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2.20 Benedict Benedict: the total for non-current assets = £1,183,850 Explanation: Liabilities = £426,663 + £100,000 = £526,663 Capital = £1,373,424 Assets = £1,900,087 therefore non-current assets = £1,183,850 2.21 Carmela Carmela’s business: Statement of financial position at 18 October 20X6 £ ASSETS Non-current assets Machinery Office computer Current assets Inventory Trade receivables Bank Cash

£

12,722 1,060 13,782 17,721 16,303 6,993 120 41,137 54,919

CAPITAL AND LIABILITIES Capital Non-current liabilities Loan from sister Current liabilities Trade payables Amounts owed to HMRC

45,855 1,800 6,868 396 7,264 54,919

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2.22 Diana Transaction 1: Increase capital (£2,000), increase bank (£2,000) Transaction 2: Increase bank (£600), decrease trade receivables (£600) Diana’s business: Statement of financial position at 30 August 20X1 £ ASSETS Non-current assets Current assets Inventory Trade receivables (1,200 − 600) Bank account (1,000 + 2,000 + 600) Petty cash

£ 13,500

10,300 600 3,600 600 15,100 28,600

CAPITAL AND LIABILITIES Capital (20,200 + 2,000) Current liabilities Trade payables

22,200 6,400 28,600

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2.23 Erik Erik’s business: Statement of financial position at 30 November £ ASSETS Non-current assets Freehold premises Shop fittings etc Current assets Inventory Cash

£

16,800 8,300 25,100 10,300 600 10,900 36,000

CAPITAL AND LIABILITIES Capital Non-current liabilities Loan from mother Current liabilities Trade payables Payables - due to HMRC for VAT Bank overdraft

26,200 2,000 3,200 800 3,800 7,800 36,000

Erik seems to have an immediate cash problem. He must pay the £2,200 owed to Ornamental Glass Products Ltd without delay. If he does not the company may take legal action against him to cover the debt. Paying the bill would take him £2,000 over his overdraft limit.

It may be possible for Erik to put some more capital into the business in the form of cash, or possibly to borrow some more money from a relative. However, the fact that he is asking your advice about increasing the overdraft limit suggests that these options may not be open to him. Erik’s best course of action may be to request an increase in overdraft limit. The bank manager may require him to prepare a

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business plan, and they would need to be convinced that there was a good chance of the overdraft being repaid.

This would be a good time, in any case, for Erik to take stock of where his business is going and establish whether it has a reasonable chance of succeeding in the longer term.

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INSTRUCTOR’S MANUAL Chapter 3: The statement of profit or loss Contents: • Teaching Notes •

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction In this chapter students are introduced to the basic layout of a statement of profit or loss for a sole trader, Mary, and to the key terminology used in its preparation.

Much of the chapter is concerned with the preparation of the statement of profit or loss for a sole trader, but towards the end of the chapter an example of a service For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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business is introduced. The chapter also covers the accounting treatment of adjustments required in respect of returns, discounts and delivery charges. The case study combines knowledge and skills derived from both Chapters 2 and 3 in preparing both a statement of profit or loss and a statement of financial position for a sole trader. The aim of the chapter is for students to understand how a statement of profit or loss is prepared.

Please note that the sixth edition of the book contains extensive changes in respect of Chapters 3 and 4. Some of the content of the previous Chapter 4 has been brought into Chapter 3 (including the accounting treatment of returns, discounts and delivery charges).

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: Understand the terminology used in a statement of profit or loss and some

•

of the principal conventions used in presenting it.

Be able to draw up a statement of profit or loss for a sole trader from a list of

•

account balances and explanatory notes.

Understand the treatment of complexities such as discounts and return of

•

goods. Combine skills learned from studying Chapters 2 and 3 to draw up a set of financial statements comprising a statement of profit or loss and a statement of financial position.

Notes on PowerPoint slides Slide 1

Chapter title

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Slide 2

Learning outcomes, slightly abbreviated

Slide 3

Introduction

Slide 4

Statement of profit or loss: terminology

Slide 5

Categories of commercial activity Refer to the suggested video below

Slide 6

Statement of profit or loss for a sole trader – sets out the basic elements of a statement of profit or loss – refer to Section 3.3 in the chapter

Slides 7 and 8

Trading account Example 3.1 (Mary)

Slide 9

Movements in inventory – explanation of inventory movements

Slides 10 to 12

Movements in inventory example – using Example 3.2 from the chapter

Slide 13

Calculating cost of sales – shows an extract from Section 3.5

Slides 14 and 15

Example of calculating cost of sales using data from Example 3.3

Slide 16

Calculating net profit – presents basic layout from Section 3.6

Slide 17

Typical business expenses

Slide 18

Returns of goods - description

Slide 19

Returns of goods – Example 3.5 (Imran) from chapter

Slide 20

Discounts – description of trade and financial discounts

Slides 21 and 22

Financial discounts – Example 3.6 (Fernando) from chapter

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Slide 23

Delivery charges - description

Slides 24 and 25

Delivery charges – Example 3.8 (Brooklyn) from chapter

Slide 26

Statement of profit or loss accounting in a service business – students can be directed to Example 3.10 (Tony)

Slide 27

Introduces the idea of preparing both statement of profit or loss and statement of financial position

Slide 28

Summary

Video The suggested video is: www.youtube.com/watch?v=hrSUq4wcd0g This is one of the Accounting Stuff series of videos. Students may find this approach appealing. The video is over 11 minutes long, so you may want to recommend it to students as an adjunct to the lecture. If you include it in the lecture, it could be inserted around slide 5. You may need to explain the alternative terminologies for the main accounting statements at this point.

Case study The case study for this chapter examines the preparation of the statement of profit or loss and the statement of financial position from a list of balances for Jimmy Bowden, a sole trader.

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Exercises As well as three self-test questions within the chapter, there are sixteen end-ofchapter exercises. Students can test their knowledge using the eleven multiple choice questions on the student section of the website. Also available in that section are five further questions with solutions. The lecturer-only section of the website contains seven more questions with solutions.

Excel exercises A spreadsheet is available for Exercise 3.9 (Norbert). Full instructions on completing the spreadsheet are provided.

A spreadsheet is also available for Student Question 3 (Venus).

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Answers to Lecturers’ End-of-Chapter Exercises 3.11 Jin–Ming a) Working: breakdown of purchases figure: Total purchases given in question

£14,880

Purchase of 12 large trampolines at cost price = 12 × £330

3,960

Therefore, purchase of standard trampolines

10,920

At a purchase price of £260 each for standard trampolines, £10,920/£260 = 42 standard trampolines purchased during the year.

Jin-Ming: Trading account for the year ended 31 December 20X6 £ Revenue: 30 standard @ £400 17 large @ £550

£ 12,000 9,350

£

21,350 Cost of sales: Opening inventory at 1 January 20X6 Standard: 6 @ £260 Large: 5 @ £330 Purchases Less: closing inventory at 31 December 20X6 Standard: 18* @ £260

1,560 1,650 3,210 14,880 18,090 (4,680) (13,410) 7,940

Gross profit for year

* opening inventory units – standard trampolines: Add: purchases (refer to workings) Less closing inventory (missing figure) = number of units sold in the year The missing figure is 18.

6 42 48 (x) 30

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b) Gross profit on large trampolines: Gross profit on one large trampoline = £550 − £330 = £220 Gross profit on sale of 17 large trampolines: £220 × 17 = £3,740 Gross profit on standard trampolines: Gross profit on one standard trampoline = £400 − £260 = £140 Gross profit on sale of 30 standard trampolines: £140 × 30 = £4,200 Total gross profit, therefore, = £3,740 + £4,200 = £7,940

3.12 Jodie i) Jodie: Trading accounts for March, April and May March

April

May

£

£

£

89,907

31,241

40,270

Opening inventory

93,882

34,920

82,860

Add: Purchases

3,074

65,747

18,911

(34,920)

(82,860)

(75,918)

62,036

17,807

25,853

27,871

13,434

14,417

Revenue

Cost of sales:

Less: Closing inventory

Gross profit

ii) Relevant points include: a) The difficulty of making any kind of plan where the business conditions are volatile as in this case.

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b) The need for fluctuating amounts of cash, often at very short notice. Jodie probably needs a fairly understanding bank manager. If she has to borrow large amounts at short notice on overdraft, borrowing costs are likely to be high. c) The need to be responsive at all times to offers from manufacturers. Assuming that she is a sole trader (although she may employs staff to, for example, heft the electric blankets and dishwashers around the warehouse), Jodie may find it difficult to get any time away from the office. d) Storage space is a problem where the volume of inventory fluctuates. A small warehouse incurs fewer costs, but if it is full to capacity, Jodie may have to turn down advantageous business opportunities to buy in new inventory. A larger warehouse would solve that problem, but its costs would be higher. She could hire extra space to cover temporary gluts in inventory levels but this is likely to be expensive. e) There is always a risk that Jodie will not be able to sell the inventory to retailers.

If manufacturers are dumping a large volume of surplus inventory into the intermediate market it may be because there is a shortfall in demand by consumers for it. The manufacturers are passing on the risk to Jodie who may not be able to withstand the effects of just one poor purchasing decision. Jodie’s is a high-risk business.

(It depends on the nature and the prior experience of the group of students as to how far this discussion extends. The principal objective of the question is to get students to recognize the link between the figures in the trading account and the underlying business reality, i.e. to understand that the figures really mean something and convey information which is both useful and interesting. The question strays away from financial reporting and into some elements of management and finance issues. How much students are able to contribute to the

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discussion may depend upon the order in which they have studied the contents of this book).

3.13 Olivia Olivia: Extract from statement of profit or loss for year ended 31 August 20X5 £

£

£

Revenue

193,306

Less: returns

(1,836)

Cost of sales

191,470

Opening inventory Add: purchases Less: returns

16,399 144,315 (63) 144,252 160,651

Less: closing inventory

(17,041) (143,610)

Gross profit

47,860

The correct answer is c).

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3.14 Ophelia Ophelia: Extract from statement of profit or loss for year ended 30 June 20X9 £

£

Revenue

£ 83,722

Less: returns

(426)

Cost of sales

83,296

Opening inventory Add: purchases

5,799 65,277

Add: special packaging charges

604

Less: returns

(291) 65,590 71,389

Less: closing inventory

(5,904) (65,485)

Gross profit

17,811

The correct answer is d).

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3.15 Mahbub Working 1: 20X1 commission income Total commission earned in 20X2: £115,900 This is 25% higher than in 20X1, i.e. £115,900 is 125% of the commission earned in 20X1. We need to find the figure which is equivalent to 100% where 125% is £115,900. For this we can use the following formula: 20X1 income = 100/125 × £115,900 = £92,720

Mahbub: Statements of profit or loss for year ended 31 December 20X2

Income: commissions (Working 1)

20X2

20X1

£

£

115,900

92,720

Premises

16,506

13,370

Staff costs

29,900

28,807

Administration costs

15,981

12,773

62,387

54,950

53,513

37,770

Expenses

Net profit

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3.16 Nellie £

Category

Inventory at 1 June 20X6

2,672

Trading account

Stall rental and service charge

3,844

Statement of profit or loss

Bank interest received

320

Statement of profit or loss

Sundry expenses

313

Statement of profit or loss

Saturday assistant’s wages

1,200

Statement of profit or loss

Repairs income

1,801

Statement of profit or loss

Purchases

42,640

Trading account

Trade payables

2,497

SFP: current liabilities

Accountant’s fees and other administration

862

Statement of profit or loss

Insurance

574

Statement of profit or loss

Cash at bank

3,422

SFP: current assets

Drawings

14,257

SFP: capital

Repairs expenses

1,742

Statement of profit or loss

Motor expenses

1,252

Statement of profit or loss

Sales of boots

63,060

Statement of profit or loss

Capital at 1 June 20X6

6,060

SFP: capital

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Non-current assets: display stands

960

SFP: non-current assets

Inventory at 31 May 20X7

2,904

Trading account and SFP: current assets

Nellie: Statement of profit or loss for the year ended 31 May 20X7 £ Revenue

£ 63,060

Less: cost of sales Opening inventory

2,672

Add: purchases

42,640 45,312

Less: closing inventory

(2,904) (42,408)

Gross profit

20,652

Boot repairs: income

1,801

Boot repairs: expenses

(1,742) 59

Other income: bank interest received

320

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21,031 Expenses Stall rental and service charge

3,844

Motor expenses

1,252

Saturday assistant’s wages

1,200

Insurance

574

Accountant’s fees and other

862

administration Sundry expenses

313 (8,045)

Net profit

12,986

Nellie: Statement of financial position at 31 May 20X7 £

£

ASSETS Non-current assets

960

Current assets

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Inventory

2,904

Cash

3,422 6,326 7,286

CAPITAL AND LIABILITIES Capital Opening capital balance 1 June 20X6

6,060

Add: net profit for the year

12,986 19,046

Less: drawings Closing capital balance 31 May 20X7

(14,257) 4,789

Current liabilities Trade payables

2,497 7,286

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Solutions to Case Study Questions 1) First, prepare the statement of profit or loss and the statement of financial position for the business. The list which Jimmy has provided is a jumbled mixture of statement of profit or loss items and statement of financial position items, so a useful preliminary step is to identify a category for each item depending on whether it goes in the trading account, the rest of the statement of profit or loss or the statement of financial position. For statement of financial position items, the terminology used in Chapter 2 can be used: •

Non-current assets

•

Current assets

•

Current liabilities

•

Non-current liabilities

•

Capital

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£ Revenue

Category

143,520

Trading account

Opening inventory

9,274

Trading account

Non-current assets

3,823

Opening capital balance 1 March 20X4

19,776

Bank

1,685

Rental expense

16,500

Statement of financial position: non-current assets Statement of financial position: capital Statement of financial position: current assets Statement of profit or loss

Insurance

2,023

Statement of profit or loss

Electricity

2,056

Statement of profit or loss

Trade payables

8,229

Statement of financial position: current liabilities

Trade receivables

1,800

Drawings

23,153 118

Statement of financial position: current assets Statement of financial position: capital Statement of profit or loss

103,221

Trading account

Income from repairs services

4,389

Statement of profit or loss

Repairs service expenses – bicycle parts Administration, finance and sundry expenses Assistant’s wages

1,317

Statement of profit or loss

2,278

Statement of profit or loss

8,902

Statement of profit or loss

Closing inventory

16,337

Trading account AND statement of financial position: current assets

Bank interest received Purchases

Note that closing inventory always appears in both the trading account and the statement of financial position as a current asset. Inventory which remains unsold at the statement of financial position is deducted, as we have seen, in arriving at the

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cost of sales figure. However, it is also an asset of the business because it can be sold to make money in the next following accounting period.

Having categorized all the items, the next stage picks out those which appear in the trading account, and prepares the trading account. Then, immediately below it, the rest of the statement of profit or loss items are listed, ending with net profit.

Remember that a heading with the name of the business (in this case Jimmy simply uses his own name – this is common amongst sole traders) and a description of the financial statement is always required.

Jimmy Bowden: Statement of profit or loss for the year ended 28 February 20X5 £ Revenue

£ 143,520

Less: cost of sales Opening inventory Add: purchases

9,274 103,221 112,495

Less: closing inventory

(16,337) (96,158)

Gross profit

47,362

Repairs service: income

4,389

Repairs service: expenses – bicycle parts

(1,317) 3,072

Other income – bank interest received

118 50,552

Expenses Rental expense

16,500

Insurance

2,023

Electricity

2,056

Administration, finance and sundry expenses

2,278

Assistant’s wages

8,902 (31,759)

Net profit

18,793

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Once all the balances have been put into the statement of profit or loss the remainder should all relate to the statement of financial position, which can then be prepared.

Jimmy Bowden: Statement of financial position at 28 February 20X5 £

£

ASSETS Non-current assets

3,823

Current assets Inventory

16,337

Trade receivables

1,800

Bank

1,685 19,822 23,645

CAPITAL AND LIABILITIES Capital Opening capital balance 1 March 20X4

19,776

Add: net profit for the year

18,793 38,569

Less: drawings

(23,153)

Closing capital balance 28 February 20X5

15,416

Current liabilities Trade payables

8,229 23,645

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Remember, the capital account shows the resources committed to the business by the owner. The balance on the capital account increases or decreases in the following ways: Capital introduced PLUS Profits retained in the business MINUS Drawings MINUS Any losses made by the business

Jimmy Bowden’s capital account, as shown in his statement of financial position at 28 February 20X5 has been increased by the amount of net profit for the year (calculated in the statement of profit or loss) and has been decreased by the drawings he has made from the business.

2. Having prepared the statement of profit or loss and statement of financial position for Jimmy’s business, it is now possible to address his questions about the profitability of the business.

A logical first step is to take the table of figures he provided for 20X4 and slot in the equivalent figures for 20X5:

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20X5

20X4

Bicycle revenue for the year

143,520

164,728

Gross profit on bicycle sales

47,362

49,418

Profit on repairs service

3,072

3,422

Total expenses

31,759

27,263

Interest received

118

260

18,793

25,837

Net profit

From this information a report with recommendations can be constructed by the business adviser, as follows:

18th March 20X5 Report to Jimmy Bowden on business profitability based on the financial statements at 28 February 20X5 There has been a substantial decline in revenue, gross and net profits between 20X4 and 20X5. The fall in sales is over £20,000, which represents a decline of almost 13%.

There has been a small drop in profitability in the repairs service, but this is a fairly insignificant part of the business.

Total expenses have increased from £27,263 to £31,759, an increase of 16.5%. A more detailed comparison of expenses would be useful in order to pinpoint the specific expenses which have risen. There may be a need for better control of business expenses.

Net profits have fallen from £25,837 to £18,793. The decline is significant and an action plan should be drawn up to address the problems the business faces.

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The business is not under immediate threat. The bank balance at 28 February 20X5 is £1,685 and there are no long-term borrowings. But trade payables total £8,229 and there could be problems if they start to press for immediate payment. However, because of the good record of profitability in the past, the bank is likely to grant overdraft facilities if they are required. The level of drawings from the business of a little over £23,000 is not justified by the present level of profitability. Closing inventory is much higher than opening inventory, because of the shortfall in Christmas sales.

Recommendations 1. Mr Bowden could consider a campaign of local advertising. This could be allied to an inventory clearance sale at discounted prices.

2. The current level of business profitability does not support drawings at the level of £23,000 per year. Mr Bowden should plan for a lower level of personal expenditure until business profitability improves.

3. Business expenses should be considered item by item to identify areas where savings might be possible.

4. If other measures fail, the possibility of moving to new shop premises nearer the centre of town could be considered. Suitable premises should be identified and a business plan and budget drawn up on the basis of the likely increase in sales and expenses if the move were to be made.

Signed: Business adviser

Summary This case study pulls together some of the basic content of Chapters 2 and 3.

Students should ensure that they thoroughly understand how the figures in the

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financial statements fit together before attempting the more complex of the questions at the end of the chapter.

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INSTRUCTOR’S MANUAL Chapter 4: Applying accounting conventions Contents: • Teaching Notes •

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter introduces students to a range of further complexities encountered in the preparation of the statement of profit or loss, and to some important accounting conventions. The chapter divides into three principal sections. In the first section adjustments for returns, discounts and delivery charges are considered. The For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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applicability of these adjustments in service businesses is discussed. The second section on conventions examines going concern, recognition and accruals. Finally, the chapter looks at adjustments that may be required in respect of the valuation of inventory and trade receivables, including both specific and general allowances for doubtful debts.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: Understand and be able to apply some of the important conventions in

•

accounting in preparing the statement of profit or loss and the statement of financial position.

Know about the measurement of inventory and trade receivables, and the

•

need for allowances against them, and be able to make appropriate adjustments to the statement of profit or loss and the statement of financial position.

Know about the measurement of provisions, a type of liability.

•

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes (slightly abbreviated)

Slide 3

Introduction

Slide 4

Accounting conventions – going concern – brief introductory explanation

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Slide 5

Accounting conventions – recognition – brief introductory explanation

Slide 6

Accounting conventions – accruals – brief introductory explanation (refer to the video below)

Slides 7 and 8

Example 4.4 (Gregory), including Figure 4.1 from the book that demonstrates the issue diagrammatically

Slides 9 and 10

Introduce and explain some issues relating to inventory measurement

Slide 11

Illustrates the effects on the trading account of valuing inventory at (i) cost; (ii) net realizable value. These figures are taken from Example 4.6 (Taruni).

Slide 12

Introduces some valuation issues in respect of trade receivables

Slide 13

Looks at the accounting effect of writing off a bad trade receivable. This should help emphasize that the accounting equation still holds good.

Slides 14 and 15

These slides demonstrate the accounting treatment involved in making an allowance for a trade receivable.

Again, the emphasis should be on the fact that the accounting equation still holds good.

Slide 16

Another type of liability: introducing provisions.

Outlines the three conditions for recognizing a provision.

Slides 17 to 20

Explain Example 4.9 (Scone & Co)

Slide 21

How to account for a provision

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Slide 22

Warranty provisions

Slides 23 to 25

Explain Example 4.12 Street Domestics

Slide 26

Summary

Video This brief video (4 minutes) which compares accrual and cash accounting may be useful to students. It could be used as part of the presentation (slides 6, 7 and 8) if there is time. www.youtube.com/watch?v=LU_6amWC6H8

Case study This chapter is fairly long and covers several different adjustments. The case study draws together several of the adjustments into one example. As well as demonstrating the application of the accounting adjustments, and the articulation between statement of profit or loss and statement of financial position, this extended case study allows students to appreciate the potentially devastating impact on a business where credit is over-extended. Richard’s redrafted statement of financial position at 30 September 20X4 shows a business that is insolvent; a statement of financial position with a negative capital account has not yet been encountered in the book. The case study discussion suggests some possible solutions which may help to bail out Richard and his business.

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Exercises There are nineteen end-of-chapter exercises. Students can test their knowledge using the ten multiple choice questions on the student section of the website. Also available in that section are eight further questions with solutions. The lectureronly section of the website contains six more questions with answers.

Excel exercises Exercise 4.6 (Ursula) is available in Excel.

Also available in Excel is Student Question 4 (Linley).

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Answers to Lecturers’ End-of-Chapter Exercises 4.11 Paolo Paolo: Statement of profit or loss for the year ended 31 March 20X2 £

£

£

Revenue

118,242

Less: discounts allowed

(88) 118,154

Cost of sales Opening inventory

5,918

Add: purchases

43,947

Add: cost of printing

17,291

Less: discounts received

(133)

Less: purchase returns

(1,774) 59,331 65,249

Less: closing inventory

(4,261) 60,988 57,166

Interest received

204 57,370

Expenses Electricity (£3,072/6)

512

Broadband

1,671

Mobile phone

419

Marketing

2,663

Travelling expenses

3,914

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Accountancy and tax advice

800

Office sundry expenses

977 10,956 46,414

Tutorial note: the cost of printing is integral to the inventory supplied by Paolo and so must appear in the trading account.

4.12 Peregrine The figure for gas expense for inclusion in Peregrine’s accounts for the year ended 31 December 20X6 is calculated as follows: £ January & February £841 × 2/3

561

March – May

790

June – August

654

September – November

752

December

300 3,057

The correct answer is c).

4.13 Paula Insurance £ Insurance for 7 months to 31 May 20X3 (given)

2,660

Insurance for period 1 June 20X3 to 31 October 20X3 − 5

1,925

months = 5/12 × £4,620 4,585

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Broadband and phone £ Bills received for the period 1 November 20X2 to 31 July

2,017

20X3 Bill received after year end

696 2,713

Total of Paula's business expenses for the year ended 31 October 20X3: 4,585 + 2,713 + 36,470 = £43,768.

The correct answer is b).

4.14 Sylvester Workings 1. Sylvester will pay in bonus the higher of: 10 per cent of consultancy fees billed: 10% × £239,000 = £23,900 and £24,500.

Therefore, each consultant will be entitled to £24,500 in bonus. A total accrual of £49,000 will be required in respect of salaries.

2. Landline and broadband charges for 10 months = £4,200. An accrual for two months is required, as follows: 2/10 × £4,200 = £840

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Sylvester: Statement of profit or loss for the year ended 31 January 20X7 £

£

£

Consultancy fees

239,000

Expenses Staff consultants’ salaries

47,090

Add: Accrual

49,000 96,090

Secretarial assistant’s salary

14,441

Premises expenses – office rental

12,750

Premises expenses – other

4,419

Landline and broadband Add: Accrual

4,200 840 5,040

Mobile phone

2,419

Entertainment expenses

3,007

Membership subscriptions

1,136

Less: prepaid

(366) 770

Administration costs

3,422

Sundry expenses

1,620

Accrual for accountant’s fees Electricity

400 5,187 (149,565)

Net profit

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89,435

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4.15 Umberto Umberto’s statement of financial position at 31 August 20X1 includes the following extract in relation to trade receivables: Trade receivables Less: allowance (1.5% × £366,000)

£366,000 (5,490) £360,510

Umberto’s statement of financial position at 31 August 20X2 includes the following extract in relation to trade receivables: Trade receivables Less: allowance (1.5% × £390,000)

£390,000 (5,850) £384,150

Effect on statement of profit or loss: Allowance against trade receivables at 31 August 20X1

5,490

Used up against bad trade receivable

(650)

Unused allowance

4,840

Allowance required against trade receivables at 31 August 20X2

5,850

Additional charge to statement of profit or loss required

1,010

So, in Umberto’s statement of profit or loss for the year ended 31 August 20X2 there will be an additional expense: Increase in allowance against doubtful trade receivables

£1,010

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4.16 Inventory valuation The fundamental rule in relation to inventory valuation is that inventory should be valued at the lower of its cost and its net realizable value. Cost is the amount of the original purchase price of the inventory including any incidental costs incurred by the purchaser such as import duties. Net realizable value is the amount for which the inventory could be sold, less any incidental expenses of sale.

4.17 Spelman & Quaker Ltd A provision should be recognised because it is more likely than not that a payment will be made, because of an obligation arising from a past event. The amount of £150,000 is known, and therefore all three requirements to recognize a provision are met. The full amount of the payment should be provided.

The correct answer is d).

4.18 Anstruther & Cellardyke The required provision is calculated as follows:

175,600 × 0.5% × £105 = £92,190

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4.19 Brisco and Fish The effect on profit of accepting Ethan’s or Jed’s proposals are as follows:

Ethan

Jed

£

£

Draft profit

375,000

Draft profit

Less: provision

(50,000)

No provision

Less: accrual for electricity

(2,000)

Less: accrual for electricity

(1,000)

Less: allowance for doubtful

(8,000)

Less: allowance for doubtful

(2,000)

debt

375,000 -

debt

Revised profit

315,000

372,000

It is not possible to say, on the information given, which of the partners is right. The profit calculated in accordance with Ethan’s proposals is a good deal lower than Jed’s. It could be argued that it is preferable to take this very cautious approach, but actually accounting conventions and practice do not require excessive caution.

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Solutions to Case Study Questions 1. If the amount owed by Charlie cannot be recovered it will be treated as a bad receivable in Richard’s accounts. The appropriate accounting treatment is to deduct the amount that cannot be recovered from the trade receivables balance, thus reducing assets, and from profit for the period. The latter adjustment directly affects the capital account.

The effect, in summary, will be as follows:

Profit for the nine months to 30 September 20X4 currently stands at £41,756. If the amount due from Charlie of £50,600 is deducted a loss arises: £41,756 − 50,600 = £8,844 Loss

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In the statement of financial position, the receivable of £50,600 is deducted from the total trade receivables of £93,242, leaving a revised trade receivables balance of £42,642. The redrafted statement of financial position is as follows:

Richard: Redrafted statement of financial position at 30 September 20X4 £

£

ASSETS Non-current assets

8,311

Current assets Inventory

19,870

Trade receivables

42,642 62,512 70,823

CAPITAL AND LIABILITIES Capital Opening capital balance 1 January 20X4

64,084

Add: loss for the year

(8,844) 55,240

Less: drawings

(61,760)

Closing capital balance 30 September 20X4

(6,520)

Current liabilities Trade payables

51,760

Accruals

1,722

Bank overdraft

23,861 77,343 70,823

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2. Note that the statement of financial position now shows a negative capital account.

The business is insolvent and Richard is in very deep trouble. There is no money available to pay the trade payables and the overdraft limit is virtually reached. The future looks bleak for the business, and for Richard.

Can the business survive this disaster? Looking at the original set of accounting statements before the adjustment is made for the bad trade receivable amount, we can see that the business is basically profitable. If it could be refinanced there is no reason for it not to continue to be a viable concern. The original statement of financial position before adjustment suggests that Richard’s spending has got out of hand: the high level of drawings of £61,760 is not sustainable. Even if new sources of finance were to be found, Richard would need to curtail his spending by a significant amount.

How likely is it that further finance would be available? If Richard had any personal assets these could be sold to raise much-needed cash for the business. What we know of Richard’s personal life suggests that he is short of assets; he cannot borrow on the security of a house because the family home is now owned by Hermione. If the business is to survive Richard needs urgently to explore other options. Some possibilities might be: •

A personal loan. It is possible that the bank may be prepared to lend Richard some money. However, even if this is the case, there are likely to be stringent conditions attached to any loan.

•

A personal loan from a private source. Richard’s mother originally lent him the money to start the business. It is possible that she may be willing to make further loans. There may be other relatives or friends who will stand by Richard in his difficulties.

•

Financial assistance from Richard’s supplier in Italy. For many years Giovanni has been supplying goods to Richard for distribution in the UK. If Richard goes out of business, Giovanni loses his UK outlet and it may be difficult and For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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expensive to establish another. Giovanni may be prepared to, say, go into partnership with Richard in order to keep the distribution outlet open. As the business is basically profitable, it could be to Giovanni’s personal benefit to put money into the venture to keep it afloat.

•

Legal action against Charlie for recovery of the amount owed. This should probably be attempted in any case, but the reports of Charlie’s former business activities and the fact that he cannot currently be found indicate that it will probably be very difficult to recover any cash.

If Richard cannot obtain fresh finance for the business, it will not be able to meet its liabilities. Because he is a sole trader, he is personally liable for the debts incurred by the business, and it is quite likely that he will become personally bankrupt. In the circumstances, his panic seems completely justified.

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INSTRUCTOR’S MANUAL Chapter 5: Depreciation and amortization

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter introduces students to the adjustments required for depreciation and amortization. Depreciation is introduced as an example of the accruals/matching convention (thus building on Chapter 4) and several examples illustrate the impact For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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of depreciation and amortization on the figures in the statement of profit or loss and statement of financial position. Students often find the statement of financial position adjustments especially hard to understand, so the first example, Quickwash, is explained in detail. The chapter also introduces the distinction between tangible and intangible non-current assets and discusses several examples of the latter. Part of Section 5.3 of the chapter examines the issue of accounting for the benefits derived by a business from its staff. A real-life example, Manchester United plc, illustrates a point often raised in this context – accounting for player registrations.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: Understand the application of the accruals convention of accounting to

•

produce adjustments for depreciation and amortization.

Understand the distinction between tangible and intangible non-current

•

assets.

Be able to incorporate adjustments for depreciation and amortization into a

•

statement of profit or loss and statement of financial position.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes for the chapter

Slide 3

Brief introduction and link to the previous lecture

Slide 4

Explains the principle of depreciation – the principle is

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illustrated and explored in the subsequent examples Slides 5 to 8

Explaining depreciation – these slides introduce the basic facts of Example 5.1 (Quickwash) and explain how to calculate depreciation over the three years' of the asset's useful life

Slide 9

Describes the straight-line method of depreciation, pointing out that there are other approaches (one of them, reducing balance, is dealt with later on in the lecture)

Slides 10 to 13

Impact of depreciation on the financial statements: The first three slides in this sequence show the impact of depreciation on the Quickwash financial statements in each of the three years of ownership of the asset, and then (in Slide 13) the impact is summarized. It is important to emphasize (because students tend to get very confused about this) that the amount left at the end of the three-year period of ownership is the amount of the originally estimated residual value.

Refer to note on video material below.

Slide 14

Intangible assets and amortization: Provides examples of non-current assets

Slide 15

Accounting for amortization: This slide uses a brief version of Example 5.4 (Bright and Shoesmith) to demonstrate the calculation and effect of amortization of a patent with a four-year life

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Slide 16

Another method of depreciation – reducing balance method: The method is explained on this slide. Reducing balance and straight-line are the only methods covered in this book – if there is time to spare you could mention that other methods may be permissible.

Slides 17 to 20

Example 5.6 (Boris) demonstrates the calculations involved. Slides 17-20 show the presentation in three consecutive years.

Slide 21

Land and buildings

Slide 22

The role of judgement in estimating depreciation: This is a good point at which to introduce the ideas of judgement and approximation in accounting. There is a brief reference to accounting manipulation in the lower part of the slide – this could be built on by specific reference to, for example, creative accounting.

Slide 23

Accounting for the sale of a non-current asset is introduced very briefly here (Example 5.7)

Slide 24

Buying and selling assets during the year: At this stage, do not place too much emphasis on this aspect – typically students struggle to understand the basic principles, and they will need to work through the earlier sections of the chapter carefully before they are ready for this complication

Slides 25 to 27

Explains revaluation using Example 5.10 (Basal Instruments Ltd)

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Slide 28

Summary

Video This video, from Accounting Stuff, may be helpful, either for students to view on their own, or as part of the lecture. If you use it as part of the lecture, you could insert it after Slide 8, as reinforcement of the Quickwash example. (Note: the example in the video uses a somewhat more complicated example, with a depreciation rate of 8.33 per cent, so it’s probably best to start with Quickwash, which is more straightforward.) www.youtube.com/watch?v=iruD9KTNnNc

Case study The case study for this chapter is The Hayseed Gallery. This involves accounting for depreciation, but it also draws upon knowledge and skills accumulated by studying Chapters 2, 3 and 4. It is a useful exercise, therefore, in testing students' ability to assimilate and make sense of their study to date. It also requires students to comment upon the profitability of the business, thus making use of the analysis skills acquired to date, especially from their study of Chapter 3 (The statement of profit or loss). The final requirement asks students to advise Fergus on ways in which he could see to improve the profitability of his business. It therefore encourages students to think about this exercise not just as an accountancy exercise but also as a business scenario. This exercise is based on a real-life small business case known to the author.

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Exercises There are twenty-three end-of-chapter exercises. In addition, students can test their knowledge and understanding using the twelve multiple choice questions on the student section of the website. Also available in that section are seven questions with suggested solutions. The lecturer only section of the website contains seven more questions with suggested solutions.

Excel exercises Exercises 5.5 (Vincenzo) and 5.11 (Zoe) are available as Excel files.

Student Question 1 (Oriana) is also available as an Excel file.

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Answers to Lecturers’ End-of-Chapter Exercises 5.14 Victor Cost of the new machine

£13,750

Less: expected scrap value in six years' time Depreciable amount

(250) 13,500

Spread evenly over six years this gives an annual depreciation charge of £13,500/6 = £2,250.

The correct answer is b).

5.15 Virginia Basic cost of two new vans (2 × £9,570)

£19,140

Cost of modifications to two vans (2 × £1,830)

3,660

Total cost

22,800

Spread evenly over six years: £22,800/6 = £3,800 per year.

In the year ended 31 December 20X2 Virginia has owned the vans for four complete months (September, October, November and December). Therefore, the depreciation charge for the vans is £3,800 × 4/12 = £1,267.

The correct answer is a).

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5.16 Valda a) The total charge for depreciation for the year ended 31 December 20X7 is as follows: £

Buildings (364,000 − 50,000)* × 1%

3,140

Fixtures and fittings – fully depreciated so no charge to depreciation Car no 1: (15,300 − 5,000) /4

2,575

Car no 2: (17,660 − 5,000) /4

3,165 8,880

*Note: remember that land is not a depreciable asset.

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b) The presentation of non-current assets in Valda’s statement of financial position at 31 December 20X7 is as follows:

£

£

Non-current assets Land at cost

Buildings at cost (364,000 − 50,000)

50,000

314,000

Less: accumulated depreciation (six years @ 3,140)

(18,840)

Carrying amount

295,160

Fixtures and fittings at cost

16,777

Less: accumulated depreciation

(16,777) 0

Cars at cost (15,300 + 17,660)

32,960

Less: accumulated depreciation (refer to

(19,795)

working) Carrying amount

13,165

Total non-current assets

358,325

Working: depreciation on cars

Car 1: Purchased on 1 January 20X4: cost

15,300

Depreciation for four years of ownership (20X4, 20X5, 20X6 and 20X7) 4 × £2,575

10,300

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Car 2: Purchased on 1 January 20X5: cost

17,660

Depreciation for three years of ownership (20X5, 20X6 and 20X7) 3 × £3,165

9,495

Total accumulated depreciation at 31 December 20X7: £10,300 + 9,495 = £19,795

5.17 Wally Carrying amount of machines at 31 March 20X6

£181,221

Addition of new machine

14,800

Depreciable amount

£196,021

Depreciation charge for the year: £196,021 × 10% = £19,602.

The correct answer is d).

5.18 Xavier After seven years of straight-line depreciation the carrying amount of the machine is: Cost

£73,730

7 years × £7,373

(51,611)

Carrying amount

22,119

The profit on sale is the excess of sale proceeds over carrying amount: £30,000 − £22,119 = £7,881.

5.19 Xan If Xan exchanges a non-current asset at carrying amount of £13,338 for an asset of cash at £15,000, he increases the overall asset value of the business. The profit on sale of £1,662 increases the total profit for the period; this is added on to Xan’s capital, and therefore the transaction results in an increase in capital. There is no effect on liabilities.

The correct answer is c).

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5.20 Zak i) Workings: depreciation a) Cleaning equipment Depreciation is over ten years, so the charge for the year is: 6,400 × 10% = £640

b) Office fixtures and fittings at cost Depreciation is over ten years, so the charge on cost looks as though it should be: 1,700 × 10% = 170. However, only £40 of undepreciated cost remains (£1,700 − 1,660) and so the depreciation charge for the year will be £40.

c) Vans The carrying amount of vans at 1 April 20X1 is: Cost

22,419

Less: accumulated depreciation

(14,490)

Carrying amount

7,929

The depreciation charge for the year ended 31 March 20X2 is therefore: £7,929 × 25% = £1,982 (to the nearest £)

Zak: Statement of profit or loss for the year ended 31 March 20X2 £ Revenue

£ 107,614

Expenses Staff costs

63,491

Cleaning materials

5,177

Premises rental

7,462

Electricity and other premises costs

2,444

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Sundry office expenses Accountancy and tax advice

799 1,200

Interest paid

390

Depreciation – cleaning equipment

640

Depreciation – office fixtures and fittings

40

Depreciation – vans

1,982 (83,625)

Net profit

23,989

Zak: Statement of financial position at 31 March 20X2

£

£

ASSETS Non-current assets Cleaning equipment at cost

6,400

Less: accumulated depreciation (1,920 + 640)

(2,560) 3,840

Office fixtures and fittings at cost

1,700

Less: accumulated depreciation (1,660 + 40)

(1,700) –

Vans at cost

22,419

Less: accumulated depreciation (14,490 + 1,982)

(16,472) 5,947 9,787

Current assets Sundry inventory

1,408

Trade receivables

13,796

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15,204 24,991 CAPITAL AND LIABILITIES Capital Capital at 1 April 20X1

21,410

Add: profit for the year

23,989

Less: drawings

(32,479) 12,920

Current liabilities Bank overdraft

10,447

Trade payables

1,624 12,071 24,991

ii) If Zak takes out a £40,000 mortgage the business will incur additional interest charges of £40,000 × 8% = £3,200. Premises rental is currently £7,462, so Zak could, potentially, save money. However, there are other factors to take into account: •

Zak must find a further £11,730 (Purchase price £51,730 − 40,000 mortgage loan). He has no spare cash in the business, so would have to find this additional amount from his own resources, or through borrowing. Borrowing will cost extra money in interest which should be considered when looking at the overall viability of the scheme.

•

Zak has drawn more out of the business (by a substantial margin) than it has generated in profit in the year. Although he has not yet reached the business overdraft limit of £20,000, he cannot continue to draw at his current level, unless profits improve.

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In order to provide informed advice, we would need to know more about Zak’s personal circumstances. Based on the information provided it would seem unwise to take on the risk of a substantial mortgage.

5.21 Purpose of adjustments for depreciation Adjustments are made in respect of depreciation in order to match the cost of using up assets with the sales generated from the use of the assets. The depreciation adjustment is an important example of the matching (or accruals) convention in accounting.

Depreciation is a monetary estimate of the amount of an asset that has been used up in an accounting period. Business managers must determine the likely length of an asset’s useful life to the business and must also estimate any value that will remain at the end of its useful life. Then, they must determine how much of the value of the asset (cost less remaining value at the end of the asset’s useful life) will be used up in a given year. Often, this estimate is done on a straight-line basis: that is, the depreciable amount is divided by the number of years of estimated useful life, to give a fixed annual depreciation charge.

5.22 Difference between depreciation and amortization As noted in the answer to 5.21, depreciation is the amount of an asset that has been used up in an accounting period. This term is applied, by convention, to the using up of tangible non-current assets. Amortization is the word used to describe the using up of intangible non-current assets.

5.23 Accruals convention The accruals convention, also known as the 'matching' convention, requires that the effects of transactions and other events are recognized when they actually occur, and not when the transaction is settled in cash. It is important to match revenue For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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with the expenditure that generates it, as explained in Chapter 4. Depreciation is an estimate of the amount of a non-current asset that has been used up in an accounting period, and, applying the accruals convention, it is charged as part of expenses and matched against the revenue that the use of the asset has helped to generate.

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Solutions to Case Study Questions a) Workings 1. Building depreciation: £80,000/100 years = £800 per year 2. Computer and software depreciation: £1,500/5 years = £300 per year 3. Van depreciation: £6,000 × 20% = £1,200 × 9/12 = £900 4. Accruals for statement of financial position: £650 (accountancy) + £223 (phone and broadband) = £873

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The Hayseed Gallery: Statement of profit or loss for the year ended 31 December 20X4 £

£

Sales: commissions

27,650

Sales: cards etc.

3,600

Cost of sales Opening inventory

-

Purchases of cards etc.

4,570

Less: closing inventory

(2,206) (2,364)

Gross profit

28,886

Expenses Staffing costs Insurance (£752 − 200)

2,663 552

Motor vehicle running costs

1,566

Telephone and website charges (£997 + 223)

1,220

Advertising

3,244

Mailshot expenses

3,454

Private view expenses

2,850

Building repairs and maintenance

660

Heating and lighting costs

951

Accountant’s fees

650

Depreciation – building (working 1)

800

Depreciation – computer and software (working 2)

300

Depreciation – van (working 3)

900

Other expenses

1,575

Interest paid

2,400 23,785

Net profit

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5,101

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The Hayseed Gallery: Statement of financial position at 31 December 20X4 £

£

ASSETS Non-current assets Land at cost

40,000

Building at cost

80,000

Less: depreciation

(800) 79,200

Computer and software at cost

1,500

Less: depreciation

(300) 1,200

Van at cost

6,000

Less: depreciation

(900) 5,100 125,500

Current assets Inventory

2,206

Trade receivables

580

Prepayment

200

Cash at bank

648 3,634 129,134

CAPITAL AND LIABILITIES Capital Capital introduced

91,500

Add: profit for the year

5,101 96,601

Non-current liabilities Loan

30,000

Current liabilities Amounts due to artists

1,660

Accruals (working 4)

873 2,533

Net current assets 129,134

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b) Fergus’s business has made a profit of £5,101. For a new business start-up, making a profit of any size in the first year of operation could be regarded as an achievement. But no tax has yet been paid, and this will further reduce profit. Even before tax, Fergus’s profits amount to less than £100 per week. Considering the amount of work that he has put into the business, and the commitment he has made with his and Flora’s savings, this does not appear to be much of a return. Cash flow has been a minor problem during the year, with the need to utilize an overdraft facility from time to time. At the moment, even if Fergus wanted to take some drawings out of the business, the cash is simply not there to do so. At 31 December 20X4 he owes artists over £1,600 but he only has £648 in the bank, and the phone and broadband bill will have to be paid shortly.

Loan repayments of £2,400 are a significant drain on the business’s resources. And in just two more years, the business will have to start making repayments of capital as well, which will be a further drain on cash.

It would seem that Flora may well be right: the business probably cannot be regarded as a really profitable venture. Perhaps it will never be much more than a hobby.

c) We are told in the case details that Fergus has tried to keep a tight control over costs. Advertising and mailshot expenses total well over £6,000 but are probably necessary in order to keep a steady flow of potential customers coming to the gallery. Conventionally, exhibitions have a private view for artists and selected guests. It is usual to provide refreshments at these events – a glass of wine or mineral water per guest, and sometimes some snacks. Fergus has spent £285 on average per exhibition on these expenses and this is probably quite a modest sum.

There are no items of expense that seem out of the ordinary, and there is probably little scope to economize on costs.

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Fergus could try to increase revenue, although it is noticeable that actual revenue has rather exceeded his expectations: he has sold on average over 50 per cent of work exhibited, compared to the 40 per cent he expected. He could perhaps experiment with pushing the gallery’s exhibitions upmarket by exhibiting works costing over £1,000. However, he may be correct in his perception that more expensive items simply will not sell. Another possibility would be to raise his commission levels. Currently, he charges artists 40 per cent of the selling value of their work. If he were to raise this percentage, he might be able to increase the gallery’s profitability. On the other hand, the relationship he has built up with artists is important and could be endangered if he seeks to make substantial increases in commission levels.

It seems clear that Fergus will have to think hard about plans for increasing profitability. Flora is not happy in her role as sole provider, and if the gallery turns in a second year of only moderate profits, she may become even more convinced that the business is not a truly viable proposition. Fergus and Flora need to thoroughly discuss the issues arising from the business start-up and to reach agreement on a plan for developing the business. If they are unable to agree, the business is likely to be a continuing source of discord.

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INSTRUCTOR’S MANUAL Chapter 6: The statement of cash flows

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter starts by emphasizing the distinction between profit and cash in business. First, the working capital cycle is examined, and some common features of working capital mismanagement are listed and explained. The distinction between For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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profit and cash is exemplified by examining the impact of several different types of transaction on profit and cash. The rest of the chapter is primarily concerned with learning how to prepare a simple statement of cash flows for a sole trader business.

The principal example used is that of Isobel Buchanan's business, which is featured in Example 6.1. It would probably be helpful to students to have the basic data from the example to hand, so it is suggested that they are asked to bring their textbooks to the lecture, or alternatively, a copy of the data can be provided as a lecture handout.

The indirect method of cash flow preparation is demonstrated first, and then the direct method is also explained. The chapter concludes by looking at the high profit/no cash paradox. This reinforces the material covered earlier in the chapter, but also demonstrates that a profitable business can run into problems because of cash shortages. The case study for the chapter is a comprehensive example which examines both the preparation and interpretation of a statement of cash flows.

Learning outcomes After reading the chapter, and completing the related exercises, students should: •

Understand the distinction between profit and cash

•

Be able to draw up a statement of cash flows for a small business

•

Understand some of the messages conveyed by the statement of cash flows

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

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Slides 4 and 5

The distinction between profit and cash: Students sometimes have difficulty appreciating that some categories of expense, for example, do not involve the movement of funds around the business.

Considerations of cash flow provide an opportunity to briefly revisit adjustments for depreciation and accruals. Slide 5 shows an extract from Table 6.1.

Note that Self-test question 6.1 requires students to think about the impact of various transactions on cash and profit.

Refer to video note below.

Slides 6 to 11

There are six slides in total that explain the preparation of a statement of cash flows using Example 6.1 (Isobel)

Slide 12

Direct and indirect approaches to cash flow

Slide 13

The 'direct method' explained using Example 6.3 (Isobel) to use relatively familiar figures

Slide 14

The high profit/no cash paradox This is included as an introduction to Example 6.5 in the chapter which will have to be left for home study by students

Slide 15

Statements of cash flow in large businesses. This slide includes some of the salient details from Example 6.6 (Pfizer Inc.) in the chapter. This allows students to understand that what they have learned in the simple Isobel example is widely applicable.

Slide 16

Summary

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Video The suggested video to accompany this lecture is Leila Gharani introducing the cash flow statement: www.youtube.com/watch?v=hMBN6yTIDb0 This is over 13 minutes long, so it would take up around a quarter of a standard lecture slot. You could use this as a substitute for Slides 4 and 5 in the presentation above, or as an addition to the lecture.

Students should find the video easy to understand, but because it is North American they may need some additional explanations. The example used in the presentation is Microsoft – figures from its 10K in 2018 – the 10K form could be explained here.

Case study The case study, Delroy Desmond, provides a comprehensive example involving the preparation of a statement of cash flows for an established business. The business portrayed is successful and profitable but is suffering some problems with customers’ perceptions of quality. This provides the opportunity to use the statement of cash flows to help provide additional information about what is going on in the business, and to provide some advice tailored to the circumstances.

Unfortunately, as in any example that requires the preparation of a statement of cash flows, quite a lot of numerical information must be provided, and so the case study is fairly long. However, if students succeed in working through and understanding it, they should be well placed to tackle all of the end-of-chapter exercises.

Exercises There are fourteen end-of-chapter exercises, including four that require preparation of a full statement of cash flows (6.6 Henrietta, 6.7 Ishmael, 6.12 Hamid, 6.13 India).

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Students can test their knowledge using the ten multiple-choice questions available on the student section of the website. Also available in that section are five questions with suggested answers, three of which require preparation of full statement of cash flows. The lecturer-only section of the website also contains a further seven questions with suggested answers. Three of these require preparation of a full statement of cash flows.

Excel exercises Spreadsheets are available for Exercises 6.6 (Henrietta) and 6.7 (Ishmael). Full instructions are supplied.

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Answers to Lecturers’ End-of-Chapter Exercises 6.8 Flynn Impact of transactions on Flynn’s business Transaction

Impact on cash etc.

Impact on profits

Purchase of inventory for

There is a cash outflow of

No immediate impact on

cash of £1,300

£1,300 and an increase in

profits. When the goods

inventory of £1,300.

are sold, they will form part of cost of sales.

Sale of a non-current

Cash increases by £900.

Profits for the year

asset with a written down

Non-current assets

increase by £600.

value of £300

decrease by £300 (i.e. the

The sale proceeds are

written down value).

£900

There is a net increase in assets of £600 balanced by an increase in capital (via profits for the year) of £600.

Sale on credit for £3,500

Trade receivables are

The sale is recognized

increased immediately.

immediately, and revenue

Provided that the amount

in the statement of profit

owed is settled, cash will

or loss increases by

be increased at some

£3,500.

point in the near future.

Payment made in respect

There is a cash outflow of

There is no impact on

of a trade payable

£6,350; trade payables are

profits from this

outstanding, for electricity

reduced by the same

transaction. When the

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bill of £6,350

amount.

trade payables were originally recorded a charge of £6,350 in respect of electricity expense was recognized.

Drawings of £800

Cash and capital are both

There is no impact on

reduced by £800.

profit. Effectively, Flynn is taking £800 of his own capital out of the business.

Purchase of vehicle for

Non-current assets are

No immediate impact on

£10,000

increased by £10,000 and

profits. Each year there

cash is reduced by

will be a charge of 25 per

£10,000.

cent; in this first year, the depreciation charge will be £2,500 so profits will be reduced by that amount.

6.9 Grant The net cash inflow from operating activities in Grant’s business for the year ended 30 April 20X1 is calculated as follows: £

£

Operating profit

16,632

Add back: depreciation

6,650 23,282

Inventory − decrease (26,750 − 27,997)

1,247

Trade receivables − increase (12,704 − 11,940)

(764)

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Trade payables − increase (11,667 − 9,975)

1,692 2,175

Net cash inflow from operating activities

25,457

The correct answer is d).

6.10 Gunter The profit on sale of the asset is calculated as follows:

£ Proceeds of sale

£ 2,660

Less: carrying amount at date of sale Cost

17,700

Accumulated depreciation: £15,930 + 6/12 ×

(16,815)

(17,700 × 10%) 885 Profit on sale of asset

1,775

Profits increase by £1,775. Cash increases by the amount of the sale proceeds of £2,660. Statements 3 and 5 are correct, and so the correct answer is d).

6.11 Gary Gary’s net cash outflow from investing activities for the year ended 31 December 20X6 should exclude any cash flows relating to financing activities because these are presented under the financing heading in the statement of cash flows.

Investing cash flows include the following: £ Purchase of office equipment

(5,800)

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Proceeds of sale of old machine

500

Net cash outflow from investing activities

(5,300)

The correct answer is a).

6.12 Hamid Hamid: cash flow statement for the year ended 31 May 20X4 i) Indirect method £

£

Operating profit

68,910

Add back: depreciation

7,662 76,572

Decrease in inventory – (26,980 − 27,420)

440

Increase in trade receivables – (44,349 – 42,760)

(1,589)

Decrease in trade payables - (23,730 – 28,459)

(4,729) (5,878)

Cash generated from operations

70,694

Interest paid

(506)

Interest received

634

Net cash inflow from operating activities Purchase of non-current assets (£82,610 – 38,750)

70,822 (43,860)

Net cash outflow from investing activities

(43,860)

Capital returned to owner (drawings)

(23,250)

Repayment of loan (cash outflow)

(5,000)

Net cash outflow from financing activities

(28,250)

Net decrease in cash

(1,288)

Cash at beginning of period

6,642

Cash at end of period

5,354

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ii) Direct method £ Cash receipts from operating activities

435,911

Cash payments from operating activities

(365,217)

Net cash inflow from operating activities

70,694

After this point, the part of the statement which deals with non-operating cash movements is exactly the same as for the indirect method.

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6.13 India India: Cash flow statement for the year ended 31 December 20X7 £

£

Operating profit

35,160

Add back: depreciation

26,600 61,760

Increase in inventory – (144,200 – 138,750)

(5,450)

Increase in trade receivables – (155,410 – 140,600)

(14,810)

Increase in trade payables – (272,600 – 251,800)

20,800 540

Cash generated from operations

62,300

Interest paid

(6,650)

Net cash inflow from operating activities

55,650

Purchase of non-current assets (342,000 – 275,000)

(67,000)

Net cash outflow from investing activities

(67,000)

Capital returned to owner (drawings)

(62,200)

Increase in bank loan

15,000

Net cash outflow from financing activities

(47,200)

Net decrease in cash

(58,550)

Cash at beginning of period

24,400

Cash (overdraft) at end of period

(34,150)

6.14 Ilyas In both 20X5 and 20X6 Ilyas’s business has generated operating cash inflows, and the figures suggest improved operating performance. Net cash generated by operating activities has increased by 18.6 per cent in the 20X6 financial year.

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Both years show a net cash outflow from investing activities, which suggests that the business has been investing in non-current assets. The amount of investment is much higher in 20X6 than it was in 20X5, and this may indicate a planned programme of business expansion.

There is a net cash inflow from financing activities in both years, meaning that the business has increased its long-term capital, perhaps in the form of investment by owner or in loans, or a combination of the two. In 20X5 financing produced net cash inflows of £50,800, which may have been specifically in order to finance the investment activity in 20X6.

There is a significant increase in cash and cash equivalents in both years. The business may be building up a fund of cash to make further significant investments in the future.

The information given is very limited. A review of the full accounts for the business might provide confirmation of the analysis above.

Note: later in the book, in Chapters 8 and 9, analysis of financial statements will be considered in much more detail.

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Solutions to Case Study Questions 1) Dezzie’s: Statement of cash flows for the year ending 31 March 20X4 £

£

Operating profit Add back: depreciation on buildings

78,578

Note 1

2,000

1

Depreciation on fixtures and fittings

1,829

1

Depreciation on delivery vehicles

4,763

1

Profit on sale of delivery vehicle

(520)

1 8,072 86,650

Less: increase in inventory (6,186 – 5,630)

(556)

2

Add: decrease in trade receivables (5,914 – 7,419)

1,505

2

Add: increase in payables (8,510 – 6,340)

2,170

2 3,119

Cash generated from operations Interest received Interest paid

89,769 280

3

(4,617)

3 (4,337)

Net cash inflow from operating activities

85,432

Cash flows from investing activities Purchase of non-current assets (103,000 + 2,039 +

(120,222)

4

2,120

4

15,183) Proceeds of sale of non-current asset

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Net cash outflow from investing activities

(118,102)

Cash flows from financing activities Capital returned to owner (drawings)

(53,000)

5

Mortgage loan

73,750

6

Net cash inflow from financing activities

20,750

Net decrease in cash

(11,920)

Cash at beginning of period

15,160

7

Cash at end of period

3,240

7

2) Explanation of the cash inflows and outflows 1. The starting point is operating profit. We must then add back all the items in the statement of profit or loss which do not involve cash movements. In Dezzie’s case these are the depreciation charges for buildings, fixtures and fittings and delivery vehicles. We must also adjust for the profit on the sale of the delivery vehicle of £520. (NB: there is a cash movement involved in the sale of the vehicle but we will take that into account – at the value of the cash actually received – later on in the statement of cash flows.)

2. The changes in inventory, receivables and payables must be calculated and recorded in this part of the statement. Comparing these elements in the two statement of financial positions we can see that: a) Inventory has increased by £6,186 – 5630 = £556. This is the amount of the cash outflow in respect of this item. b) Trade receivables have decreased by £5,914 – 7,419 = £1,505; this means there has been a release of cash (effectively, a cash inflow). c) Trade payables have increased by £8,510 – 6,340 = £2,170. This means that the business is managing to obtain a slightly increased level of credit from its suppliers; this is equivalent to an inflow of cash.

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3. Interest paid and received: these figures are taken from the statement of profit or loss.

4. The total cash outflow on non-current assets is calculated by taking the actual capital expenditure from the notes on movements in non-current assets.

Actual capital expenditure was:

Land and buildings

103,000

Fixtures and fittings

2,039

Motor vehicles

15,183

Total

120,222

These are outflows of cash from the business.

The sale of an asset, on the other hand, produces an inflow of cash to the business.

The correct amount to include in the statement of cash flows is the actual proceeds of sale received; in this case, £2,120.

5. Drawings are an outflow of cash from the business.

6. The mortgage loan received is an inflow of cash into the business in this year.

7. The net inflow or outflow of cash which is calculated in the statement of cash flows should equal the change in the balance of cash between the two year-ends. In Dezzie’s case there has been a net outflow of cash of £11,920. The final section of the statement of cash flows ‘proves’ this figure by calculating the difference between cash at bank at 1 April 20X3 and at 31 March 20X4.

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3) Financial implications of following the consultant’s advice Delroy’s business has suffered a net outflow of cash in the course of the year. The statement of cash flows shows where the outflows have occurred. The principal items of outflow are, of course, the expenditure on new non-current assets. Delroy obtained a mortgage loan for some of the major expenditure on new premises but financed part of it (£103,000 – 73,750 = £29,250) from the business’s own resources.

In addition, over £15,000 was spent on acquiring new delivery vehicles and a further £2,000 on fixtures and fittings. The second largest item of cash outflow is Delroy’s own drawings, which have increased substantially (£42,500 increasing to £53,000).

However, Delroy’s business is profitable, and it has generated net cash inflows from operating activities of £89,769.

Delroy accepts the consultant’s analysis of the operating problems the business faces. The accounting information suggests that Delroy is happy to make investments in bricks and mortar but is quite prepared to skimp on the furnishing of his restaurants. We can see from the figures that the fixtures and fittings are quite old (this shows up in the relatively high figures for accumulated depreciation), and that only around £2,000 was spent on new fixtures and fittings. Customers have obviously noticed Delroy’s cost-cutting approach to these matters and are not happy about the appearance of the restaurants.

It appears that Delroy will be obliged to invest more money in restaurant fit out, new tables and so on, in order to keep the customers happy. He should be advised to conduct a thorough appraisal of the restaurant fittings and decoration, possibly in conjunction with an interior design expert (given that Delroy obviously has a blind spot in all matters relating to the appearance of his restaurants).

Over £15,000 has been spent on new delivery vehicles; this investment may address some of the problems noted by the customers of bikes breaking down and long waits for delivery. However, there could also be a problem with staffing, and it For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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certainly appears to be the case that Delroy’s managers are less effective than they should be. Delroy will have to arrange to employ higher paid staff. The obvious implication for cash and profits is that staffing expenses will increase. Also, he may have to spend extra cash on making existing staff redundant and could face legal problems if the staff consider themselves to have been unfairly dismissed.

However, if Delroy can sort out his staffing problems there are potential gains to be made in: •

Increased customer satisfaction (leading to word-of-mouth recommendations, and an increased rate of return visits)

•

Better control of the delivery service, resulting in fewer complaints

•

Improved quality of service within the restaurants

All of these factors could lead to increased revenue, and/or reduced costs.

Delroy’s restaurants are profitable and bring in substantial sums of cash. The second restaurant has been open for only part of the year (we do not know from the details how long it has been open), and it could be expected to produce higher revenue and profits in the year ending 31 March 20X5. Delroy should prepare forecasts for at least the next following year, to show how much cash is likely to be available for spending on restaurant improvement and additional/replacement staffing.

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INSTRUCTOR’S MANUAL Chapter 7: Financial reporting by limited companies

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter examines, in outline, the regulations relating to limited companies and the role of company directors, especially in relation to financial reporting. Limited liability and the potentially problematical position of unsecured creditors are For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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examined in the early part of the chapter by means of an example. Students will build upon the knowledge and skills derived from Chapters 2 to 6 to learn how to draw up a set of financial statements for a simple limited company. Towards the end of the chapter additional regulatory requirements for listed companies are covered briefly.

The regulation of limited companies and the information needs of interested parties were introduced in Chapter 1 The Role of Accounting in Business. It may be beneficial to students to revise the content of this chapter before embarking on Chapter 7.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: • Understand in outline the regulations relating to accounting by companies.

• Understand the roles of directors in respect of company financial reports.

• Be able to draw up a set of financial statements for a simple limited company.

• Understand the need for additional financial and non-financial reporting by listed companies.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

Characteristics of the limited company, summarizing the content of Section 7.1

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Slide 5

Limited liability: This slide sets out the basic advantages and drawbacks of limited liability. Students can be reminded at this point to study Example 7.1 (Tommy) carefully as it illustrates the pitfalls for an unsecured creditor of trading with a limited company that is on the verge of failure.

Slide 6

Information needs of company creditors – reinforces the point made in Slide 5

Slide 7

Information needs of company shareholders: This is a good opportunity to reinforce the point that, where there is a separation between ownership and management of a company, the shareholders do not have access to the same kind of information as the directors (this was also covered in Chapter 1).

This slide introduces the notion of stewardship.

Slide 8

Information needs of people other than shareholders and creditors – another reminder of Chapter 1

Slide 9

Regulation of company accounting and other issues: This slide introduces the Companies Acts, CA 2006 in particular. Obviously, with such a large Act, it is difficult to summarize the contents, but the bulleted list here gives students something to think about.

Slide 10

Types of company: Introduces the distinction between private and public companies

Slide 11

Company constitutional arrangements: This slide covers various important items. It will

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introduce some students to new terminology, e.g. preference shares.

Slide 12

The role of directors: Students may have some misconceptions about what a company director does, and this is a good opportunity to address misunderstandings.

Slide 13

The role of directors in respect of financial statements: Students should understand that all directors of a company share these responsibilities – not just the finance director.

Slide 14

Publication of financial information: Students' attention can be directed to Table 7.1 which sets out the current criteria for small companies and micro-entities.

Slide 15

Accounting requirements: It is important to distinguish between compliance with UK standards and international standards. This gives lecturers an opportunity, if they wish, to address the issue of differences in terminology, and to direct students to the glossary of terminology.

This is the point where, if applicable, you can add some information about local GAAP in your country.

Slide 16

Accounting for limited companies: This slide lists the components of a set of financial statements of a limited company. It offers students an opportunity to identify which are new elements and to reassure themselves that they have already covered some of these components.

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Slide 17

Presentation under CA 2006: This slide emphasizes the point about compliance with different sets of accounting standards.

Slide 18

Statement of changes in equity: Because students are meeting this for the first time, it may be worth spending some time on the layout.

However, please note that the SOCIE is covered only in outline in the book – principally so that students will know what it is when they see an example in a set of financial statements.

Slide 19

Accounting for listed companies: additional requirements: This is the point where students really have to get to grips with the fact that the annual report is vastly more complex than the financial statements they have encountered in Chapters 2 to 6. There is no substitute, in my opinion, for looking at the real thing, and students should be encouraged to access reports via company websites, and to engage with their content.

Easier said than done – students are usually unwilling to do this!

Slide 20

Accounting for limited companies: non-financial information: This could be illustrated with a handout from a real annual report.

Slide 21

The Strategic Report: Again, this could be illustrated with a real example handed out in the lecture.

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Slide 22

Corporate reporting on the internet: Again, students should be encouraged to engage with real companies' websites, and to explore the content.

This could be linked to a coursework assessment.

Slide 23

Corporate governance: If there is time this is a good place to talk about the collapse of Carillion (refer to the video suggestion below).

Slide 24

UK Code of Corporate Governance – a brief introduction to the main points covered.

Slide 25

Summary

Video The chapter refers to the collapse of Carillion and its failures in corporate governance (Real-Life Example 7.7). The following brief video is an interview between Sky News and an unnamed representative of the Institute of Directors: www.youtube.com/watch?v=azFCVs8omuo At 3 minutes 40 seconds it could easily be incorporated into the lecture after Slide 24. The man from the IoD mentions the issue of directors’ remuneration and the clawback of bonuses. Also, the role of shareholders in holding companies to account is briefly explored. The interviewer raises a point about short-selling which you may like to expand upon in your lecture.

Case studies Case Study 1, Daley Limited, illustrates a private limited company where shares are all held by members of a family. It aims to provide a fairly realistic account of a problematic business decision that is likely to split the board down the middle.

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Preparation of draft financial statements is required in order to inform decision making. The case brings in references to the power of directors and shareholders, the standard statement of financial position and statement of profit or loss formats, and also requires some, fairly limited, analysis of the accounting figures. (Chapters 8 and 9 will take analysis of statements much further.)

Students are likely to find the second requirement in Case Study 1 quite challenging.

Some guidance has been supplied to help them get on the right track.

Case Study 2 focuses upon corporate governance, and the case of JD Sports & Fashion plc, a FTSE-100 company. In the 2022/23 financial year, the company overhauled its corporate governance arrangements to comply with the UK Corporate Governance Code. The case study requires students to look at the corporate governance aspects of the annual report.

Exercises There are eighteen end-of-chapter exercises. Students can test their knowledge using the ten multiple-choice questions available on the student section of the website. Also available in that section are six questions with suggested answers. The lecturer-only section of the website contains a further five questions with suggested answers.

Excel exercise A spreadsheet is available for Exercise 7.7 Brighton Magnets Ltd. This helps students to get used to the format of limited company accounts. Full instructions are supplied.

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Additional chapters on the book’s website A supplementary chapter on German accounting (7A) was added to the fifth edition of the book. This is, of course, likely to be of most interest to students using this book in Germany. However, it could be of interest to any student who is interested in learning more about different international accounting systems. The chapter contains end-of-chapter exercises and suggested answers.

A supplementary chapter on corporate governance (7B) has been added to the sixth edition of the book. This follows requests from lecturers for the inclusion of more information than the outline provided in the printed book Chapter 7. The chapter contains end-of-chapter exercises and suggested answers, and also a case study focusing on the role of the company.

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Answers to Lecturers’ End-of-Chapter Exercises 7.13 Which statements are correct?

Statement 1 is false: the audit report of a company is required to state whether, in the opinion of the auditor, the accounts present a true and fair view. It is not required to state that the accounts are correct.

Statement 2 is false: private limited companies are obliged to file certain information with the Registrar of Companies which is then placed on public record.

Statement 3 is true: a public limited company must have an authorized share capital of at least £50,000.

Statement 4 is false: the minimum number of shareholders in a private limited company is one.

Statement 5 is true: each ordinary share does confer the right to a vote.

Statement 6 is true: a listed company must present its financial statements in accordance with international financial reporting standards.

Statements 3, 5 and 6 are correct, so d) is the correct answer.

7.14 Joan Joan owns shares in Western Gadgets Limited with a nominal value of £1,500.

Because the shares are denominated in 25p units, she owns a total of £1,500/25p shares = 6,000. She is entitled to receive a total of 4.5p (2p interim and 2.5p final) in dividend: 6,000 × 4.5p = £270.

The correct answer is a).

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7.15 Parlabane Limited Parlabane Limited’s total dividend payable is: 42,500 × 2p = £850 Jonah owns 13,000 shares, so his share of the dividend is: 13,000 × 2p = £260.

The correct answer is a).

7.16 Derek The total dividend receivable by Derek is: Ordinary shares (total dividend per share = 2.7p + 3.7p = 6.4p): 6.4p × 3,250

£208

Preference dividend (for half a year only) £1,000 × 8% divided by 2

40 £248

The correct answer is d).

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7.17 Downside Green Limited Downside Green Limited: statement of financial position at 31 December 20X1 £

£

ASSETS Non-current assets Intangible assets

80,000

Tangible assets

1,082,184

Investments

24,860 1,187,044

Current assets Inventories

841,740

Trade receivables

916,278

Cash in hand

260 1,758,278

Total assets

2,945,322

CAPITAL AND LIABILITIES Equity Share capital Reserves

100,000 1,850,824 1,950,824

Non-current liabilities Long-term loan

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100,000

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Current liabilities Overdraft

7,746

Trade payables

868,462

Other payables

18,290 894,498

Total liabilities Total equity and liabilities

994,498 2,945,322

7.18 This is an open-ended question and answers could vary substantially depending upon the views of the student answering it. However, some of the following points may be relevant: 1. Increased scrutiny by auditors of statements in the corporate governance section of the Annual Report.

2. Improvements in the appointment and training of non-executive directors.

3. Drawing from a wider pool in appointments of non-executive directors. For example, women and minorities tend to be under-represented on boards of large companies.

4. Changes in legislation/regulation. At the moment, the rule is ‘comply or explain’ which could be argued as being relatively weak.

5. A little outside the scope of corporate governance, but still within companies’ legislation in the UK, there could be a move towards higher levels of capital maintenance in order to protect creditors.

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Solutions to Case Study Questions Case Study 1 – Daley Limited Workings:

1. Cost of sales: £ Opening inventory

2,107,232

Add: purchases

13,720,216 15,827,448

Less: closing inventory

(2,238,400) £13,589,048

2. Administrative expenses £ Directors’ remuneration Other administrative expenses

556,400 3,088,192 £3,644,592

3. Tangible non-current assets £ Office building at carrying amount

3,390,008

Retail units at carrying amount

13,598,800

Vehicles, fixtures etc. at carrying amount

3,235,760 £20,224,568

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4. Other payables Payable for corporation tax:

£1,274,101

5. Retained earnings £ Retained earnings at 1 January 20X5

14,461,144

Profit for the year

2,962,899

Less: dividends

(468,000)

Retained earnings at 31 December 20X5

£16,956,043

The draft financial statements are as follows: Daley Limited: draft statement of profit or loss for the year ended 31 December 20X5 £ Revenue

22,350,400

Cost of sales (working 1)

(13,589,048)

Gross profit

8,761,352

Selling and distribution costs

(803,760)

Administrative expenses (working 2) Other operating income

(3,644,592) 234,800

Operating profit

4,547,800

Finance costs

(310,800)

Profit before taxation

4,237,00

Tax

(1,274,101)

Profit for the year

2,962,899

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Daley Limited: draft statement of financial position at 31 December 20X5 £

£

ASSETS Non-current assets Tangible assets (working 3)

20,224,568

Current assets Inventory

2,238,400

Trade receivables

691,288

Cash at bank

76,360 3,006,048 23,230,616

EQUITY AND LIABILITIES Equity Share capital

150,000

Retained earnings (working 5)

16,956,043 17,106,043

Non-current liabilities

4,000,000

Current liabilities Trade payables Other payables (working 4)

850,472 1,274,101 2,124,573 23,230,616

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2. Advice to Joe Daley Initial financial analysis The draft accounts show that operating profit margin has dropped further this year, to 20.3 per cent (£568 475/2 793 800 × 100), which may help to convince the other directors that radical action needs to be taken. The proposed scheme involves borrowing a further £2,000,000. At a 4 per cent rate of interest this would increase interest charges by £80,000 each year. The other directors need to be convinced that the proposal will increase profits by at least that much. However, the additional charges constitute only about 1.8 per cent of the operating profit in the draft accounts, and it may be helpful to point this out at the meeting.

The board vote It seems likely from their initial response that Carol and Nasser will vote in favour of the proposal, but the other three directors appear to be very much opposed to it. It will almost certainly be very difficult to win them round. It is Joe’s proposal so he will vote for it. Therefore, if the proposal is taken to a vote, it seems likely that it will result in an even split of 3:3. Joe can use his casting vote, but this is likely to create a great deal of ill feeling. The three directors most involved in the company’s day-today running will be split (Joe and Nasser voting for the motion and Gervase against), and this may create further problems.

The continuing decline in profit margins probably means that something will have to be done soon, and it may be that a radical change, such as the one proposed by Joe, is called for. However, if effective change is to be brought about, any proposal really needs the active support of most, if not all, of the directors.

Relevance of individual’ shareholdings What is the relevance of the individuals’ shareholdings? The directors each have an equal vote on the board, but their shareholdings are not the same (this is quite a For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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common arrangement). The individuals’ shareholdings could be significant in a vote on re-appointment of directors, because the proportion of shares held makes a difference to the voting. Suppose Gervase, Eric and Edward feel so strongly that Joe is taking the company in the wrong direction, that they try to vote him off the board?

(A simple majority – i.e. 50 per cent - of votes is required to vote a director off the board). Between them they hold 49 per cent of the shares. Provided that Carol and Nasser will vote with Joe, his position is safe (just).

It may be relevant to query Edward’s and Eric’s retirement arrangements. How soon will they give up taking any active part in the business? Will they pass on their shares to their children? If they were to do this, presumably Eric would transfer all of his holding to Gervase, giving him a total of 34 per cent of the shares, and Edward would split his holding equally between his children Joe and Carol (this would leave Joe with 41.5 per cent, Carol with 17.5 per cent and Nasser with his existing 7 per cent). No one individual would control the company, although Joe and his sister would control a majority of the shares.

Summary of Joe’s position Joe is in a very difficult position. Unless he can persuade at least one of the dissenting directors to his way of thinking, the issue is likely to split the board and may leave a residue of ill feeling, whether he exercises his casting vote or not. He may need to think of a less radical plan to take the business forward or accept suggestions by other directors on how to address the problem of declining profitability. In the worst-case scenario, he may need to wait until he inherits sufficient shares to place him in a more secure position.

The case study illustrates a very typical family company scenario. The original founders of a business are often very reluctant to let go of something which they have spent their working lives building. Their children may become impatient and may try to reduce the parents’ involvement. This type of business arrangement can For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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lead to lasting conflict and very serious consequences on both a personal and business level.

The business illustrated is a limited company, with uneven shareholdings amongst six members of the same family. Democratic arrangements for voting at board level may not reflect percentage shareholdings. Some of the directors participate more fully in business activities than others. However, it is worth reiterating that all directors are equally responsible in law.

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Case study 2 – JD Sports & Fashion plc Andrew Higginson was appointed as Chair of JD Sports & Fashion plc (JD Sports) in July 2022, approximately halfway through the company’s financial year. He stated in the 2023 Annual Report:

‘There was a significant ‘governance deficit’ in a listed business of JD’s size’.

Several aspects of JD Sports’ corporate governance arrangements required updating. The separation of the roles of chief executive is a fundamental aspect of corporate governance according to the UK’s Corporate Governance Code. Although it is more common in the USA to combine the two roles, it is unusual in the UK, and especially for a company of the size and economic significance of JD Sports. Finally, in 2022/23 JD Sports made separate appointments.

The new Chair also stated:

‘Starting with the combination of Chair and CEO roles, the business had not raised standards of Governance to the expected norms of a FTSE 100 business. The Non-Executive Directors, whilst bringing much relevant experience, had a lack of Plc experience’.

Pages 112-3 in the Annual Report list the non-executive directors. Most were appointed during the 2022-23 financial year. A committee structure was established, and by the year end in January 2023, the company appeared to be compliant with the Code. Page 123 of the 2023 Annual Report lists all the specific areas where the company was not compliant and explains the actions that have been taken to address the problems.

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INSTRUCTOR’S MANUAL Chapter 8: Understanding financial reports: trend analysis

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter, and the following Chapter 9, are of particular importance in achieving the book’s aim of fostering understanding of accounting statements. All of the previous chapters in this section of the book have dealt to some extent with the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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interpretation of accounts (often gross or net profit analysis or simple comparison of figures). This chapter explores analysis in considerably greater detail. First, the usefulness of financial reports is briefly revised. Then the chapter proceeds to examine simple comparison of figures, horizontal and trend analysis and vertical and common size analysis. It can be difficult to make valid comparisons between businesses, and in the later part of the chapter some of the problems are examined.

Author’s note: some extracts from Burberry plc's financial information are used in the chapter. In addition, some of the exercises and case studies use real data.

Lecturers and reviewers are generally supportive of the use of real data in the book.

However, the use of real data presents some problems: the financial statements of limited companies, and especially those of listed companies, are usually highly complex. It is important not to demotivate students at this level by presenting them with very complicated statements. The approach that I have taken, therefore, is to use fairly limited extracts and to simplify those extracts where I feel it is appropriate.

I have not included data from the notes to the financial statements.

I think it is appropriate to encourage students from an early stage to look carefully at published financial information, but this needs some careful guidance from the lecturer.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: • Understand the potential usefulness of financial reports to various interest groups.

• Understand the principal features of the analysis of trends in financial statements.

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• Be able to perform an analysis based on horizontal and/or vertical analysis of financial statements.

• Understand the problems that can arise in comparing businesses with each other.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slides 4 to 6

Usefulness of financial reports: These three slides cover the typical questions that investors, potential investors and creditors would like to have answered.

It could be pointed out that not all of the questions can be answered fully by conventional financial statements (because of their orientation towards events that have already taken place, for example).

Slides 7 and 8

Analytical techniques: changes in figures: These slides use the example of Ilse (Example 8.1) from the chapter to compare three years’ worth of sales figures. The objective is to show that a simple comparison can provide some useful information (for example, it could be helpful to know that the percentage increase in sales improves in the second

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year). However, a simple comparison of this type may be of limited usefulness, and it would be helpful to have more contextual information.

Slide 9

Some problems with horizontal analysis: The chapter includes numerical examples illustrating the two key points on this slide.

Slide 10

Analytical techniques: vertical analysis and common size analysis

Slides 11 and 12

Slide 11 presents some data from Example 8.4 (Bore & Hole Limited), showing a common size analysis of an income statement, and Slide 12 sets out some comments on the analysis.

Slide 13

Comparing businesses with each other: Examples in the chapter illustrate these points in more detail and could be used in a lecture if there is time.

Slide 14

Introduces the notion of segment analysis

Slide 15 and 16

This slide provides some figures from Example 8.9 which analyzes some of Burberry plc's segment reporting (refer to the video suggestion below).

Slide 17

Summary

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Video The suggested video material builds upon the real-life example (Example 8.9) in the chapter: Burberry plc. The video is the preliminary annual results presentation of 18 May 2023, which can be found at: Burberry | Burberry Preliminary Results (emincote.com)

How much of the video you use is up to you and how much time you have available.

Watching even a short extract from the preliminary results presentation should serve as a good introduction to the real-life aspects of the study of financial figures.

You can point out to students that most larger listed companies include links to such material on their websites. If they are studying one particular company, they may find the results presentations help to bring the figures alive.

Case studies Case Study 1 for the chapter uses extracts from the five-year summary of results of PageGroup plc, a well-known recruitment firm that operates internationally. Also provided is some data from the 2022 Annual Report about the changing geographical sources of the company's gross profitability. These additional disclosures are a little different from anything included in the chapter and their inclusion will help to make the point to the students that companies can disclose a wide range of additional information. The case study requirement is to perform vertical and horizontal analyses of the performance data provided, and also to say something about the additional information and the future prospects of the business. The case study should set the students thinking, and also, I hope, encourage them to find out more about this particular business by accessing the company's website themselves.

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Case study 2 is a brief case study featuring extracts from the Elementis plc 2022 Annual Report. Students are required to write a brief report on the revenue and profitability of the business over a five-year period.

Exercises There are ten end-of-chapter exercises. Students can test their knowledge of the chapter using the ten multiple-choice questions available on the student section of the website. Also available in that section are four questions with suggested solutions. One of these uses real data; the company analyzed is easyJet plc, a successful company listed on the London Stock Exchange. The lecturer-only section of the website includes a further four questions with suggested solutions. One of these questions uses real data from a listed company, Balfour Beatty plc, an infrastructure services business.

Excel exercise A spreadsheet is available for Exercise 8.5 (Causeway Ferguson plc). This helps students to complete the calculations required for the horizontal trend and common size analysis. Full instructions are supplied, the last one of which asks students not to forget to provide the required commentary on the key features.

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Answers to Lecturers’ End-of-Chapter Exercises 8.7 Rasheda Note: gross profit margin is gross profit as a percentage of sales. Profitability metrics will be explained in more detail in Chapter 9.

The increase in Rasheda’s sales between 20X7 and 20X8: 214,656 – 206,400 × 100 = 4% 206,400 If sales increase by 4 per cent again in 20X9 the sales figure will be: (214,656 × 4%) + 214,656 = £223,242.

A gross profit percentage of 36.5 per cent is expected for 20X9, so gross profit is expected to be: £223,242 × 36.5% = £81 483.

The correct answer is c).

8.8 Reva Reva’s increase in sales between 20X4 and 20X5 is calculated as follows: 696,400 – 585,702 × 100 = 18.9% 585,702 This is higher than the average increase reported by the survey.

Reva’s gross profit margin (gross profit as a percentage of sales) for 20X5 is: 279,953 × 100 = 40.2% 696,400 This is higher than the average gross profit margin reported by survey respondents.

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The correct answer is a).

8.9 Isaac Prentiss Limited Isaac Prentiss Limited: horizontal analysis of extracts from the financial statements: 20X4 to 20X8 Percentage changes from previous year: 20X8

20X7

20X6

20X5

%

%

%

%

Revenue

15.1

13.3

6.2

4.2

Operating profit

19.3

13.9

9.9

2.0

Finance costs

35.4

2.3

3.5

13.2

Non-current assets

26.8

15.3

12.2

9.7

Borrowing

35.0

5.6

10.2

3.2

Report Revenue and operating profit have increased over the last five years, with larger increases in more recent years. However, there has been a very large increase in finance costs over the last year. Finance costs of £245,000 amount to a large proportion of operating profit (£303,000), which is a worrying sign. Borrowing has increased sharply in the last year (by 35 per cent) and non-current assets have also increased (by 26.8 per cent). When a business invests in new non-current assets it can take time for the benefits to feed through to the statement of profit or loss. It For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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could be, therefore, that the revenue and profit figures for 20X9 will be significantly higher than this year.

Although a shareholder who is not a member of company management has no right of access to information beyond the usual financial statements, it may be worth asking Burgess for some additional information about sales and profitability in 20X9, the current year. Because Prentiss is the major shareholder, the company’s managing director is likely to be willing to discuss the affairs of the company with him.

8.10 Starkey Willmott Limited Starkey Willmott Limited: vertical analysis of statement of financial position at 31 March 20X5 based on non-current assets = 100.0% £

£

%

ASSETS Non-current assets

704,710

100.0

Current assets Inventory

369,440

52.4

Trade receivables

416,700

59.1

Cash at bank

81,450

11.6 867,590 1,572,300

223.1

Share capital

50,000

7.1

Retained earnings

931,400

132.1

EQUITY AND LIABILITIES Equity

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981,400

139.2

Long-term liabilities

200,000

28.4

Current liabilities

390,900

55.5

1,572,300

223.1

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Solutions to Case Study Questions Case Study 1 – PageGroup plc

1. Horizontal analysis of five-year summary of key information: percentage increases year-on-year

2022

2021

2020

2019

%

%

%

%

Revenue

21.1

26.0

(21.1)

6.7

Gross profit

22.6

43.8

(28.7)

5.0

Operating profit

16.4

989.6

(88.3)

3.0

Vertical analysis of five-year summary of key information

2022

2021

2020

2019

2018

%

%

%

%

%

Revenue

100.0

100.0

100.0

100.0

100.0

Gross profit

54.0

53.4

46.8

51.7

52.3

Operating profit

9.9

10.3

1.3

8.9

9.2

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2. Analysis of the geographical breakdown of gross profit and revenue for 2019 and 2018

2022

2022

2021

2021

Revenue - % of

Gross profit -

Revenue - % of

Gross profit -

total

% of total

total

% of total

Territory

%

%

%

%

EMEA

53.7

50.0

52.9

49.2

Asia Pacific

16.0

18.1

17.2

20.4

Americas

14.2

18.0

13.4

15.8

UK

16.1

13.9

16.5

14.6

TOTAL

100.0

100.0

100.0

100.0

3. Discussion of performance PageGroup is clearly a profitable business. The vertical analysis of the five-year summary of key information shows, overall, an improved performance. Gross profit has improved in 2022 compared to 2018. There is a drop in performance, in all metrics, in 2020, which would be expected because of the effects of the response across the globe to COVID-19. PageGroup prepares its financial statements to 31 December each year, so the 2020 figures reflect over nine months of performance that had been adversely affected. The 2021 figures, however, show that recovery from the downturn was rapid.

The vertical analysis shows that gross profitability had improved between 2018 and 2022, with the expected drop in 2020. Overall, if past growth is an indicator of prospects for success in the future, then PageGroup’s outlook appears very good.

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The key performance indicator section of the 2022 Annual Report contains the following commentary on performance:

‘Gross profit increased … resulting in a record year for the Group and for 27 individual countries. This was driven by strong trading conditions and the success of our strategic investments made over recent years.’

The geographical breakdown of gross profit shows that PageGroup operates in many different locations across the globe. This factor is likely to provide the group with some protection against regional downturns in trade. The analysis shows especially strong performance in the Asia Pacific and Americas territories.

Profitability in the UK is declining and is lower than in the other regions.

This is what the Chair of the Board had to say about performance in the different regions of the business:

‘All of our regions grew against 2021, our previous record year, with 3 of our 4 regions delivering a record year. In our largest region EMEA, gross profit was up 26%, with particularly strong growth in our Large, High Potential market of Germany. Here, our Technology-focused Interim business delivered an exceptional performance, up 46% on 2021. Asia Pacific grew 5% against the prior year, with conditions becoming more challenging in the second half, due to the COVID-19 lockdowns and restrictions in Greater China. Elsewhere in the region, South East Asia, Japan and India all delivered record years, up 22%, 10% and 39% respectively. The Americas was our fastest-growing region in 2022, with North America up 24% and Latin America up 30%. The UK grew 17%, with stronger growth in Page Personnel of 57%, whilst Michael Page grew 4%’.

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The business appears to be generally confident about its prospects, although the Chair does note potentially difficulties and uncertainties:

‘As we enter 2023, a high degree of macro-economic and geo-political uncertainty remains across the majority of our markets. However, against this backdrop, we continue to see high levels of candidate shortages and vacancies, along with strong fee rates and salary levels.’

Conclusion PageGroup is a highly profitable and successful business. It experienced a downturn, like most other businesses, in 2020 but has recovered well and rapidly since then. Its geographical coverage helps to protect the business against regional downturns in trade and local difficulties. Its prospects for the future look promising.

Note: by the time you are working on this case study, there will be more information available about PageGroup. You will be able to access further trading statements and accounts via the PageGroup website, in order to bring the above analysis up to date.

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Case Study 2 – Elementis Solution and discussion

Report on the revenue and profitability of Elementis plc over the period 2018-2022

The company’s revenue dropped significantly in the middle of the five-year period in 2020, a drop which was probably attributable to the economic consequences of the response to COVID-19. By 2021, revenue had risen again and was almost at the same level as in 2019. Revenue achieved in 2022 was higher still at £921.4m, some 10% higher than the level achieved in 2018. However, the most recent two years have been subject to price inflation in most sectors of most economies, and so the apparent improvement may be less impressive than it seems initially.

In terms of profitability, the business is not currently doing well, compared to earlier years. Losses were made in 2020 which was probably to be expected given the circumstances. However, in 2022, the most recent period, an even greater loss (4.5% of revenue) was made.

Shareholders have not received a dividend since 2019, which may be a cause for concern.

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INSTRUCTOR’S MANUAL Chapter 9: Understanding financial reports: using accounting ratios

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter continues the work on financial statement analysis that was started in Chapter 8. It starts with a brief introduction to ratio analysis techniques and For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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proceeds to examination the calculation and uses of ratios under five headings: performance ratios, liquidity ratios, efficiency ratios, investor ratios and lending ratios. Data from a single example is used to illustrate the calculations. The case study for the chapter includes an extended example of analysis using both trend and ratio techniques.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: • Understand the usefulness of accounting ratios in financial analysis.

• Be able to calculate a range of accounting ratios.

• Be able to use their knowledge of accounting ratios to assist in the analysis of financial statements.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

Financial ratio analysis techniques: Five categories are used to group the ratios discussed in the chapter and these are briefly listed and explained.

Slides 5 to 7

Performance ratios: gross and net profit margin

Slide 8

Example 9.1 (Bilton Burgess) statement of financial position information

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Slides 9 and 10

Performance ratios: Return on equity Return on capital employed

Slide 11

Liquidity ratios: Current ratio and quick ratio

Slide 12

Efficiency ratios 1: Non-current asset turnover ratio

Slide 13

Efficiency ratios 2: Inventory turnover in days

Slide 14

Efficiency ratios 3: Inventory turnover

Slide 15

Efficiency ratios 4: Trade receivables turnover

Slide 16

Efficiency ratios 5: Trade payables turnover

Slide 17

Investor ratios 1: Dividend per share

Slide 18

Investor ratios 2: Dividend cover

Slide 19

Investor ratios 3: Earnings per share

Slide 20

Investor ratios 4: Price/earnings ratio

Slide 21

Investor ratios 5: Price/earnings ratio – comparisons

Slide 22

P/E ratios – real company examples

Slide 23

Lending ratios: Gearing

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Slide 24

Example 9.6: interest cover

Slide 25

The effects of gearing

Slide 26

Summary

NB: most of the slides are concerned with the mechanics of ratio calculation. It is often difficult to get students to see beyond the calculation and to explore the meaning of the ratios. The chapter introduction advises students that ratio calculation is a means to the end of understanding, and not an end in itself.

Alternatively, one of the case studies for the chapter could be used in a seminar following the lecture to show how the ratios can be used to help comprehend a company’s performance and position.

Video The real-life example (Example 9.8) used in Chapter 9 focuses on Sainbury’s 2022 Annual Report. Students might find it helpful to build upon this by watching part, or all, of a Sainsbury’s results presentation. The link below is to Sainsbury’s firstquarter webcast of results by the company’s chief executive and chief financial officer (first quarter to end June 2023). This relates to a later period than that referred to in the chapter. There is 45 minutes of presentation here. Extracts could be used as part of a lecture or in a seminar to stimulate discussion.

Webcast | Sainsbury’s Q1 Trading Statement 2023/24 - Analyst Q&A Call (openexchange.net)

Students will need to register their details to access this presentation. Those who do not wish to do this can instead access a pdf of the slides from the presentation: J Sainsbury plc Q1 2324 Presentation (sainsburys.co.uk)

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Case studies There are four case studies for this chapter.

Case Study 1 contains a lot of information about the 2023 Annual Reports of Sainsbury’s and Tesco. Students are required to calculate some ratios, to write a brief report on the analysis of the two companies, briefly comment upon comparability issues, and to discuss a recommendation to a potential investor. This is a time-consuming and relatively complex case study, based wholly on real-life material. Students should find it challenging, but hopefully worth the effort.

Case Study 2 is also based on real-life material but is shorter and more limited in scope than Case Study 1. It draws upon the results of Persimmon plc for the 2022 financial year and provides some food for thought about the housebuilding industry in the UK. The case requires students to access the more recent half-year results to see how the company is performing beyond the 2022 annual report.

Case Study 3 is mostly fictional, although the tensions between the principal individuals involved are based on a real-life case. Three years’ worth of data about an unlisted company are provided, and the case study requires calculation of both horizontal and vertical trend data, and of many of the accounting ratios covered in the chapter. In order to make the case look realistic, there is quite a lot of circumstantial detail, and the case is quite lengthy. Students may well need some help to thoroughly understand it.

Case Study 4 is a briefer, real-life case study. It presents some figures from the 2023 annual report of JD Sports & Fashion plc and requires the calculation of ratios and a brief report. Students are encouraged to access the annual report in order to add some relevant background to their report.

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Exercises There are thirty-nine end-of-chapter exercises. Many of these are very brief questions which accustom students to the calculation of ratios. However, there are also some longer questions requiring analysis and comment. Students can test their knowledge of the chapter using the fourteen multiple-choice questions available on the student section of the website. Also available in that section are five longer questions requiring analysis and comment. The lecturer-only section of the website contains a further five questions, one of which uses information extracted from a listed company, Card Factory plc.

Note: where questions and case studies feature real-life financial data, the data are usually simplified extracts from the financial statements. The reason for this approach should be fairly obvious – the financial statements of listed companies tend to be very much more complicated than the examples used in a basic accounting textbook. Students are usually reluctant to study financial analysis, and they do not need to be further put off by financial statements containing financial instruments, deferred tax and so on. Those who are interested should definitely be encouraged to go to the corporate website and to look at the full statements, but it should be emphasized to all students that the information they are being given in these exercises is simplified.

Excel exercise A spreadsheet is available for Exercise 9.19 (Cryer Roussillon). This helps students to calculate the accounting ratios required. Full instructions are supplied, the last one of which asks students not to forget to provide the assessment of how the company is doing. I find that students often need a nudge to actually do the analysis rather than simply calculating the ratios.

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Answers to Lecturers’ End-of-Chapter Exercises 9.21 Sinclair Salter Limited Return on total capital employed: Profit before finance costs and tax Shareholders’ equity + Long-term borrowing

=

289.6 1,270.0 + 900.0

= 13.3% The correct answer is b).

9.22 Sinclair Salter Limited Pre-tax return on shareholders’ equity: Profit after finance costs and before tax Shareholders’ equity = 196.6 1,270 = 15.5% The correct answer is a).

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9.23 Sinclair Salter Limited Post-tax return on shareholders’ equity: Profit after finance costs and taxation Shareholders’ equity

= 136.6 1,270 = 10.8% The correct answer is c).

9.24 Shirley

Gross profit margin

20X3 377.6 × 100 976.9

20X2 360.9 × 100 899.6

Operating profit margin

= 38.7% 275.1 × 100 976.9

= 40.1% 262.3 × 100 899.6

Return on shareholders’ equity

= 28.2% 256.4 80.0 + 1,465.0

= 29.2% 245.8 80.0 + 1,285.6

Return on total capital employed

= 16.6% 275.1 80.0 + 1,465.0 + 319.0

= 18.0% 262.3 80.0 + 1,285.6 + 276.0

= 14.8%

= 16.0%

Each of the four measures of performance calculated above show a deterioration between 20X2 and 20X3.

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9.25 Tadcaster Terrier Limited Current assets = 88,700 + 85,210 = £173,910 Current liabilities = 90,450 + 16,790 = £107,240 Current ratio = 173,910 107,240

= 1.62:1

The correct answer is a).

9.26 Turnbull Taffy Limited Projected working capital figures at 31 March 20X7: 31.3.X6

31.3.X7

£

+/–%

£

Inventory

67,400

–10%

60,660

Trade receivables

42,660

–15%

36,261

Cash at bank

6,050

+50%

9,075

Trade payables

58,760

–5%

55,822

i) Current ratio at 31 March 20X6 67,400 + 42,660 + 6,050 58,760

= 1.98:1

Quick ratio at 31 March 20X6 42,660 + 6,050 58,760

= 0.83:1

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ii) Current ratio (projected) at 31 March 20X7 60,660 + 36,261 + 9,075 55,822

= 1.9:1

Quick ratio (projected) at 31 March 20X7 36,261 + 9,075 55,822

= 0.81:1

9.27 Uriah Westwood plc Uriah Westwood plc is likely to have few non-current assets appearing in the statement of financial position. The principal asset of an advertising agency is the staff who work for it, and they do not appear on the statement of financial position.

The non-current asset turnover ratio is, therefore, likely to be a high figure relatively speaking.

Ulverstone Thunderbird has a lot of non-current assets; its non-current asset turnover ratio is, conversely, likely to be a low figure, relatively speaking.

(Tutorial note: students who are having some difficulty appreciating the point might like to carry out the calculation: Revenue for both companies is around £10 million. Assume that Ulverstone Thunderbird has non-current assets at a carrying amount of £8,800,000 and assume that Uriah Westwood has non-current assets at a carrying amount of £978,798.

Carry out the non-current asset turnover calculation for both companies, then think about it.)

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9.28 A sole trader Inventory turnover in days is calculated as follows: Average inventory Cost of sales

× 365 days

Inventory at 31 December 20X7 was £605,000. On 31 December 20X8 it was £605,000 × 110% = £6,655,500. Average inventory for the calculation is therefore: (605,000 + 665,500)/2 = 635,250 Inventory turnover in days, then, is

635,250 × 365 = 91 days 2,560,800

9.29 Another sole trader 20X9 Average inventory = 1,605.3 + 1,565.7 2

= 1585.5

Inventory turnover

1,585.5 × 365 19,400.0

= 29.8 days

Average inventory = 1,396.4 + 1,605.3 2

= 1500.85

Inventory turnover

= 28.3 days

20X8

1,500.85 19,360

× 365

Inventory turnover in days has worsened slightly in that inventory is kept on the premises, on average, for slightly longer in 20X9 than in 20X8.

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9.30 A company Trade receivables turnover is calculated as follows: Average trade receivables Revenue

× 365

In this example only closing trade receivables is given, and therefore an average figure cannot be worked out.

Revenue on credit = £1,703,698 × 70% = £1,192,589 218,603 1,192,589

× 365 = 66.9 days

The correct answer is c).

9.31 Whybird Note that the correct figures are revenue after returns have been deducted, and trade receivables after allowances have been deducted.

20X5 20,676

× 365 days = 42.1 days

179,330

20X4 20,820

× 365 days = 42.8 days

177,380

The ratio has improved slightly from 20X4 to 20X5; that is, trade receivables are being settled slightly more quickly.

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9.32 Wiswell Limited

20X3

20X2

Average inventory:

Average inventory:

145,550 + 160,370 = 152,960 2 Inventory turnover in days:

136,200 + 145,550 = 140 875 2

Average inventory × 365 days Cost of sales 152,960 × 365 = 54.3 days 1,027,435 Trade receivables turnover in days: Trade receivables Revenue on credit

140,875 × 365 = 50.6 days 1,016,316

× 365 days

226,485 × 365 days = 42.7 days 1,936,000 Trade payables turnover in days:

209,063 × 365 days = 40.6 days 1,877,200

Trade payables × 365 days Purchases on credit 160,479 × 365 days = 56.2 days 1,042,255

151,742 × 365 days = 54.0 days 1,025,666

The inventory turnover ratio shows that inventory is being kept on the premises for longer in 20X3. In most circumstances, an increase in this ratio would not be regarded as favourable.

It is taking longer to collect trade receivables in 20X3 than in 20X2. The company may need to examine its credit control procedures carefully.

The company is taking a longer period of credit from its suppliers. While this helps to balance out the unfavourable changes in the inventory and trade receivables For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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ratios, it may create problems. It is taking nearly two months to pay suppliers, and they may be unhappy about the situation.

9.33 Worsley Bacup plc Dividend per share 250,800 2,200,000

= 11.4p

The correct answer is b).

9.34 Worsley Bacup plc Dividend cover 640,700 250,800

= 2.55

The correct answer is d).

9.35 Worsley Bacup plc Earnings per share 640,700 2,200,000

= 29.12p

The correct answer is b).

9.36 Worsley Bacup plc The company’s market capitalization is: £7.66 × 2,200,000 = £16,852,000.

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9.37 Watkinson Chapel plc First, calculate earnings per share: Profit after tax attributable to ordinary shareholders Number of shares in issue = 243,700 1,000,000

= 24.37p

P/E ratio = price divided by earnings per share: Price per share = Market capitalization Number of shares = 3,430,000 1,000,000

= £3.43

Price Earnings per share = 343p 24.37p

= 14.1

The correct answer is d).

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9.38 Better Belter Limited i) Gearing ratio Debt Equity = 300,000 776,400

= 38.6%

ii) Interest cover Profit before interest and taxation Interest = 35,000 24,000

= 1.46 times

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Solutions to Case Study Questions Case Study 1 – Tesco and Sainsbury

1. Relevant accounting ratios The following table compares relevant ratios for the two companies: Sainsbury

Tesco

2023

2022

2023

2022

Gross profit

(2,004/31,491)

(2,366/29,895)

(3,661/65,762)

(4,633/61,344)

margin

× 100 = 6.4%

× 100 = 7.9%

× 100 = 5.6%

× 100 = 7.6%

Operating

(562/31,491) ×

(1,156/29,895)

(1,525/65,762)

(2,560/61,344)

profit margin

100 = 1.8%

× 100 = 3.9%

× 100 = 2.3%

× 100 = 4.2%

(1,156/322) =

(1,525/618) =

(2,560/551) =

3.6

2.5

4.6

Interest cover* (562/309) = 1.8

Pre-tax return

(327/7,253) ×

(854/8,423) ×

(1,000/12,230)

(2,033/15,644)

on equity

100 = 4.5%

100 = 10.1%

× 100 = 8.2%

× 100 = 13.0%

*Interest cover has been calculated as (operating profit/finance costs). A valid approach would be to take net finance costs (finance costs less finance income) as the lower part of the fraction.

2. Report comparing the performance of Sainsbury and Tesco While both companies are major UK food retailers, it is worth pointing out that Tesco is a much larger company in terms of revenue and equity.

Sainsbury revenue in 2023 was only 47.9 per cent of Tesco. Also, Tesco derives a substantial part of its revenue from outside the UK, whereas Sainsbury is an almost entirely UK-based business.

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Comparing the 2022 and 2023 performance of the two companies, both have turned in poorer performance at gross and operating profit level. Sainsbury’s gross profit margin is slightly better than Tesco’s in 2023, but its performance at operating profit margin level is worse. Interest cover has deteriorated in both companies between the years, and now stands at a low level. Pre-tax return on equity has declined in both companies. The earnings per share in both companies has fallen in 2023.

Sainsbury has increased the number of stores by a net of two stores and has actually reduced its square footage. Tesco, on the other hand, has expanded the number of stores by 1.2% although it, too, has reduced its overall square footage.

In summary, Tesco appears to be out-performing Sainsbury’s at the moment, although both businesses face pressures as demonstrated by Sainsbury’s chair’s statement and the reference by Tesco’s chair to ‘circumstances outside our control’. Sainsbury operates only in the UK and Ireland, whereas a portion of Tesco’s revenues (around 8%) are earned outside of the UK. The greater geographical spread may help to diversify risk.

3. Factors impacting comparability There are factors that impact the comparability of the two sets of financial statements. The figures may not have been prepared or presented in exactly the same way - for example, there may be differences between classification of costs and expenses in cost of sales in the two companies. Such differences could affect the key gross profit margin ratio. The two companies may be

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applying International Financial Reporting Standards in slightly different ways (some of the standards offer a choice of accounting treatment). In addition, there are some differences in the nature of the information presented.

Voluntary disclosures are unaudited and do not have to comply with an accounting standard.

Also, there are business factors that undermine the comparability of the two companies. As noted earlier in the report, Tesco is very much larger than Sainsbury. Usually, a larger company can take advantage of ‘economies of scale’ – for example, the ability to source products at lower prices because of the high volumes ordered. Also, Tesco's geographical profile is different.

Tesco's strategy exposes it to greater risks in some respects - operating in overseas markets is likely to be riskier because of e.g. foreign exchange risks, and the risk of making misjudgements because of lack of knowledge of local conditions. On the other hand, Tesco is protected by its diversity of operations. If one market is doing badly, others may be doing well, and the effects offset each other.

4. Advice to Reiner Reiner shares an attitude towards investment which is quite common: he would like to obtain good returns, but to minimize the risk of loss. Each investor must aim to find the appropriate balance between risk and return.

Because Reiner is relatively more risk-averse than some investors he should confine his investment activities to investments in solid, well-established companies. He should realize, however, that investment in shares always

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carries some risk, even where the companies are well-established, like Sainsbury and Tesco.

It makes sense to diversify risk as far as possible. Reiner might consider investing in both companies because of the difference in their profiles.

Tesco’s greater size and diversity in operations may mean that it is not so vulnerable to adverse economic consequences.

It is impossible to guarantee that Reiner will not lose money on his investments in shares. Apart from company-specific issues there is the risk of more general downward movements in markets. If Reiner wants to invest in shares, he must be able to accept the risks involved. If he cannot accept the risks, he should probably put the money into a managed fund, or even a cash ISA if he is really not prepared to take any risk. Also, he should be prepared to undertake, or pay for, more thorough analysis than is presented here.

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Case Study 2 – Persimmon plc Report on the performance of Persimmon plc Accounting ratios 2022

2021

Gross profit margin

22.7%

28.8%

Operating expenses as a percentage of

4.0%

3.6

19.0%

26.6%

sales Operating profit margin

Year-on-year changes calculated from the five-year record 2022

2021

2020

2019

%

%

%

%

Unit sales

2.2

7.2

(14.4)

(3.6)

Revenue from

7.1

10.2

(8.5)

(3.5)

4.9

2.8

6.9

0.06

house sales Average selling price

The company is profitable, although less profitable than previously. Although the average unit selling price of a house has increased between 2021 and 2022, gross profitability has declined, suggesting that costs are rising more steeply than prices.

The decline in performance adversely affects operating margin as well. Persimmon has no apparent problems with cash flow; finance income exceeds finance costs comfortably in both 2021 and 2022.

The company suffered a setback in terms of sales of houses in 2020 and it has not yet returned to its previous sales levels.

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The chair’s statement refers to adverse economic factors, notably a diminution in demand arising from higher mortgage rates. Elsewhere, the report refers to shortages in both building materials and labour. On the positive side, it mentions that high build quality has been achieved. This is a particular issue for Persimmon as, in previous years, the company had been subject to a great deal of criticism because of its poor build quality. From the beginning of 2019, the company instituted a customer care improvement plan, and this appears to have paid off.

First half performance in 2023 Persimmon’s first half results (to the end of June 2023) were published on 9 August 2023. (Persimmon Half Year 2023 Results Announcement (persimmonhomes.com))

The half year results statement included the following information:

2023 first half

2022 first half

4,249

6,652

New home average selling price

£256,445

£245,597

Total group revenue

£1.19bn

£1.69bn

Underlying new housing gross margin

21.5%

31.0%

Underlying operating margin

14.0%

27.0%

New home completions

The chair’s pessimism in their statement in the 2022 Annual Report appears to be borne out in practice. Although the average selling price of a new home has continued to increase into 2023, all other metrics in the table above show a significant downturn.

Conclusion Although Persimmon is a profitable company, it currently faces significant challenges, with a drop in sales volumes and profitability.

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Case Study 3 – An unlisted company Analysis Horizontal trend analysis Because there are three years of figures available it is possible to carry out, to a limited extent, horizontal trend analysis, as follows:

Fitton Parker Limited: horizontal trend analysis for 20X3, 20X2 and 20X1 %age change over

%age change

previous year

over previous year

20X3

20X2

Revenue

21.5%

18.1%

Cost of sales

24.0%

19.7%

Gross profit

16.6%

15.2%

Selling and distribution costs

26.4%

16.0%

Administrative expenses

6.5%

(3.3%)

Directors’ remuneration

0%

0%

Finance costs

27.5%

23.0%

Non-current assets

4.3%

(11.9%)

Inventory

23.8%

23.0%

Trade receivables

25.0%

27.3%

Trade payables

36.7%

10.7%

Overdraft

0.6%

(5.2%)

What does the horizontal trend analysis show?

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There is a general trend towards increases in most items. The increase in revenue is substantial but although there is a corresponding increase in gross profit, the increase is not as great. It looks as though gross profit margin may be declining.

Selling and distribution costs have risen a lot between 20X2 and 20X3, but administrative costs appear to be firmly under control. Also, the directors have not increased their own remuneration in the three-year period.

Investment in non-current assets has been modest, but all current asset and current liability items have increased substantially. The overdraft remains at a fairly constant level, but trade payables have increased by a large percentage (over 36 per cent) in 20X3, suggesting that the business is relying to an increasing extent on the interest-free source of credit offered by trade payables. This is cheaper than increasing the overdraft (because interest has to be paid on an overdraft) but there is a danger of alienating suppliers if they are not paid promptly.

Vertical analysis Vertical analysis of the statements of profit or loss is based upon revenue = 100%.

Vertical analysis of the statements of financial position is based upon equity = 100%.

The vertical analysis produces the following results:

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Fitton Parker Limited: vertical analysis of statements of profit or loss for the years ended 31 March 20X3, 20X2 and 20X1 20X3

20X2

20X1

%

%

%

Revenue

100.0

100.0

100.0

Cost of sales

(67.5)

(66.2)

(65.3)

Gross profit

32.5

33.8

34.7

Selling and distribution costs

(12.9)

(12.4)

(12.6)

Administrative expenses

(5.7)

(6.4)

(7.9)

Directors’ remuneration

(10.0)

(12.2)

(14.4)

Operating profit/ (loss)

3.9

2.8

(0.2)

Finance costs

(0.9)

(0.8)

(0.8)

Profit/ (loss) before taxation

3.0

2.0

(1.0)

Tax

(0.6)

(0.5)

–

Profit for the year

2.4

1.5

(1.0)

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Fitton Parker Limited: vertical analysis of statements of financial position at 31 March 20X3, 20X2 and 20X1 20X3

20X2

20X1

%

%

%

Non-current assets

89.1

100.6

125.2

Inventory

57.0

54.2

48.3

Trade receivables

72.2

68.0

58.5

–

1.0

–

Trade payables

48.8

42.0

41.6

Overdraft

11.0

12.9

14.9

Non-current liabilities

58.5

68.9

75.5

Share capital

46.2

54.4

59.6

Retained earnings

53.8

45.6

40.4

Cash

What does the vertical analysis show?

The vertical analysis of the statements of profit or loss confirms the suspicion that the gross profit margin is declining. Administrative expenses are declining as a percentage of sales. This may be because of very good controls over costs and a deliberate attempt to keep administrative expenses to a minimum. However, savings on such costs can be taken too far, and the business may be operating at a less than optimal efficiency.

The operating profit margin is low, as is the margin of profit for the year to revenue.

Although there has not been a loss since 20X1, profits are not impressive, and even at their highest level in 20X3, there would not be much scope for paying a dividend.

Inventory and trade receivables have increased as a percentage of equity, with a particularly high increase in trade receivables between 20X1 and 20X2. Trade payables, as noted in the horizontal analysis, have also increased substantially.

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Ratio analysis Performance: Gross and operating profit margin were discussed in the vertical analysis section.

Because Louise is looking to invest as an ordinary shareholder, she will probably be most interested in the return on equity: Profit before tax, and after interest Equity 20X3 Return on equity

18,023 × 100 97,368 = 18.5%

20X2 9,642 × 100 82,695 = 11.7%

20X1 (4,188) × 100 75,459 = (5.6%)

The overall return has increased rapidly.

Liquidity Information is available to calculate two ratios: current ratio and quick ratio 20X3 Current ratio:

Current assets

20X2

20X1

125,765 58,187

101,830 45,385

80,615 42,640

= 2.2

= 2.2

= 1.9

125,765 – 55,450 58,187

101,830 – 44,791 45,385

80,615 – 36,425 42,640

= 1.2

= 1.3

= 1.0

Current liabilities Quick ratio: Current asset – inventory Current liabilities

Neither liquidity ratio appears to give any cause for concern. Although the figure for payables is very much higher in 20X3 than it was in 20X2 it is covered quite adequately by current assets.

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Efficiency ratios Three will be calculated: non-current asset turnover, inventory turnover (in days) and trade receivables turnover (in days). Trade payables turnover cannot be calculated because no figures for purchases are available.

20X3

20X2

20X1

Non-current asset turnover:

596,860 86,790

491,383 83,250

415,985 94,484

Revenue

= 6.88

= 5.90

= 4.40

Non-current assets Inventory turnover: Inventory × 365 Cost of sales

55,450 × 365 402,964 = 50.2 days

44,791 × 365 325,089 = 50.3 days

36,425 × 365 271,588 = 49.0 days

70,315 × 365 596,860 = 43.0 days

56,233 × 365 491,383 = 41.8 days

44,190 × 365 415,985 = 38.8 days

Trade receivables turnover: Trade receivables Revenue × 365

Non-current asset turnover shows an increasing rate. Inventory turnover at 50 days may indicate that inventory is being managed inefficiently, but we would need to know more about the business activities to be able to conclude on this point.

It is gradually taking the business longer to collect trade receivables, although even at 43 days (assuming that trade receivables are allowed 30 days to pay), there is unlikely to be a serious problem.

Note that the investor ratios are mostly irrelevant because of lack of information.

No dividend has been paid in any of the years, and, of course, it would not be possible to calculate P/E ratio because the company is unlisted and so there is no market price for shares.

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Gearing In the circumstances it is relevant to calculate gearing since the business has longterm borrowings of significant size: 20X3 Gearing: Debt

20X2

20X1

57,000 57,000 + 97 368 × 100

57,000 57,000 + 82,695 × 100

57,000 57,000 + 75,459 × 100

= 36.9%

= 40.8%

= 43.0%

Debt + equity

Although debt remains constant at £57,000, equity gradually increases because of retained profits, so debt becomes relatively less important. Nevertheless, it is still significant at 36.9 per cent.

1. Points for Louise to consider in making an investment decision The business appears to be growing fairly rapidly with increasing revenue and noncurrent asset turnover. Current assets and liabilities are growing, but there do not appear to be any immediate liquidity problems. However, it is not a particularly profitable business. Louise is being invited to buy into about 18 per cent of the shares of a business with equity at 31 March 20X3 of £97,368. Her ‘share’ of equity would be £97,368 × 18% - approximately £17,500 in exchange for £30,000 in cash. If the equity value in the statement of financial position approximates at all closely to current values, it does not appear to be a very good bargain.

Also, a conscientious financial adviser should be pointing out to Louise that this type of investment is almost certainly not appropriate for someone in her position.

Investing in shares is risky and should really be undertaken only by people who are in a fairly sound financial position, and who could afford to lose all the money.

Investment in a private limited company is especially risky. Usually, it is difficult, sometimes impossible, to get the money out again if it is needed for some other purpose. As Patrick points out, at least by investing in listed company shares, Louise For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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would be able to turn her investments into cash again comparatively easily (although she might well lose money on such investments).

It is up to Louise to make her own informed decision on the investment; she should try not to be influenced by either Ben or by her father.

2. Reservations about the information/more information required Ben asks Barney for the company figures towards the end of 20X4, but Barney is only able to provide figures up to 31 March 20X3. Nine months or so after the year end of 31 March 20X4 it would be reasonable to expect 20X4 accounts to be available. If they are not yet available it may indicate some serious administrative problems within the business. There would be good grounds for serious doubts if the accounts had been prepared but Barney was unwilling to provide them. The question could be easily resolved by checking the latest filing at Companies House.

Also, the information Barney provides is limited to the basic statement of profit or loss and statement of financial position. Although Barney assures Ben that the audit report is fine, he does not include it in the information; nor are the notes to the accounts or the directors’ report made available. This looks a little suspect.

Louise, or any other potential investor, would need to know a great deal more about the prospects of the business and the directors’ plans for expansion in order to make an informed decision.

As noted earlier, Louise is being invited to invest £30,000 for 18 per cent of a business which is worth, at book values, only around £17,500. The directors would no doubt argue that she would be buying into their expertise and the future prospects of the business, but, again, Louise would need to know a great deal more about these factors before she could commit to the investment. The other directors are not offering Louise a directorship and she will not, therefore, have much, if any, control over her investment.

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Case Study 4 – JD Sports and Fashion plc 1) Accounting ratios 2023

2022

Gross profit margin

47.8%

49.1%

Operating profit margin

5.0%

8.4%

Profit margin

4.4%

7.6%

Interest cover

7.4

10.8

Pre-tax return on capital employed

16.7%

28.0%

Workings: 2023

2022

Gross profit margin (4,839.7/10,125.0) ×

Gross profit margin: (4,208.0/8,563.0) ×

100

100

Operating profit margin (509.8/10,125.0)

Operating profit margin (721.2/8,563.0) ×

× 100

100

Profit margin (440.9/10,125.0) × 100

Profit margin (654.7/8,563.0) × 100

Interest cover (509.8/68.9)

Interest cover (721.2/66.5)

Pre-tax ROCE (440.9/2,633.4) × 100

Pre-tax ROCE (654.7/2,339.6) × 100

2) Report on the performance of JD Sports & Fashion plc in 2023 The accounting ratios calculated in part 1 show a deteriorating performance in the company between 2022 and 2023. On all measures, the company’s performance is worse.

The gross profit margin has deteriorated only by a small amount, relatively speaking, but performance is much worse further down the statement of profit or loss.

However, a review of the chair’s statement in the 2023 Annual Report suggests that 2023 was unusual. There have been several significant changes in the business’s

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board. A new chair was appointed in the 2022/23 financial year, followed very quickly by a new chief executive. The chief financial officer also stepped down during this period, and there were changes to the non-executive structure of the board. The new chief executive, by the 2023 year end, had been in post for only four or five months and so had not had time to make many changes. However, the directors had decided, by the 2023 year end, to exit some of the fashion businesses with which the company is involved.

The operating profit figure is after deduction of expenses. In the 2022/23 financial year, additional expenses were incurred as a result of strategic business decisions.

The operating profit margin for 2023 (and the profit before tax) are quite likely to be unrepresentative of the group’s underlying performance, and the two sets of figures, for 2023 and 2022, are not strictly comparable.

Fundamentally, the business remains profitable. The interest cover ratio, although it has worsened, does not give cause for concern, and the return on capital employed is likely to be quite acceptable to shareholders.

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INSTRUCTOR’S MANUAL Chapter 10: Management and cost accounting information

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Question (case study and questions on the website)

Teaching Notes Introduction This chapter introduces the section of the book on management accounting.

Management accounting was briefly introduced in Chapter 1, and it may be helpful if students revise that chapter before starting their study of this section of the book.

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information in business organizations. In addition, it helps to establish some of the features of cost and management accounting and introduces some useful terminology. It is a relatively short chapter that could be set as background reading where available lecture time is short.

Learning outcomes After reading the chapter and completing the related exercises, students should: Understand in principle the nature and purpose of management and cost

•

accounting.

Know about some of the principal features of management and cost

•

accounting information.

Appreciate the usefulness of management and cost accounting in helping

•

management to make decisions and to plan, control and monitor business activity.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

What is cost and management accounting?

This briefly introduces some of the factors that make management accounting different from financial accounting and reporting (refer to the suggested video below).

Slide 5

Characteristics of management reports: This slide shows Figure 10.2. If there is time,

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Example 10.1 (Duckworths) could be used to illustrate some of the key characteristics.

Slide 6

Features of management and cost accounting information

Slide 7

Provides the CIMA definition of management accounting. This slide also provides the CIMA definition of cost accounting, and at this point you could comment upon the interchangeability of the two terms in practice.

Slide 8

This slide outlines the process of management.

Slide 9

Includes the real-life examples of businesses' objectives from the chapter.

Slide 10

Summary

Video The suggested video explains the differences between financial and management accounting and could be slotted in after Slide 4. This video is over 9 minutes long, but as this is an introductory chapter with relatively few PowerPoint slides, its inclusion could work well. www.youtube.com/watch?v=qISkyoiGHcI Case study The aim of the Calder Calloway Cards Ltd case study is to demonstrate the need for management information. It also provides an example of how information needs may change as a business grows. Once students have thoroughly understood the

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study, they should be well-placed to attempt the end-of-chapter and website questions. This case could be set as a seminar exercise or for group work.

Exercises There are six end-of-chapter exercises, all of which are designed to get students thinking about management information needs. A preface to the exercises notes that: ‘the intention is that the questions should be answered in fairly general terms, drawing upon both common sense and imagination. Students have to try to think their way into the situations described in order to specify the kind of management information that would be useful’. Any of the questions could be used to form the basis for discussion in a seminar group.

Students can test their knowledge of the chapter using the five multiple-choice questions available on the student section of the website. Also available in that section are two further discussion-type questions with suggested solutions. The lecturer-only section of the website contains a further two discussion questions.

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Answers to Lecturers’ End-of-Chapter Exercises 10.4 Cyclostyle Limited The items of information listed below could be useful to the directors in making the decision. Note that many of the items are expressed in the form of questions which will have to be answered in order to obtain the type of information necessary to inform the decision making process.

•

Machine capacity: how much can each machine produce? How do these output figures compare with the existing machine? Will the production capacity of the business be significantly increased or decreased if one of these machines is purchased? If an increased production capacity is anticipated can this be utilized within the business? If the production capacity is decreased compared to the existing machine how will the shortfall in capacity be covered?

•

How reliable are the machines? Are there any available statistics on reliability? Is one machine significantly more reliable than the other?

•

How much are regular maintenance and repair costs likely to be? Are any problems anticipated in obtaining spare parts?

•

What will be the useful life of each machine to Cyclostyle? Is there likely to be a significant figure for sale proceeds at the end of the useful life of the machine?

•

The purchase of either of the machines will require financing. What financing options are available? How much will interest costs be? What length of financing arrangement is appropriate?

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10.5 Preedy Price Limited This is a major business decision. Preedy Price need to consider the following factors before reaching a decision:

Financial The proposal involves manufacturing 20,000 items prior to the launch of the new products in Shield and Flagg’s stores. This will require a very large input of working capital. How is this working capital to be financed? Will Shield and Flagg help to finance it, or will it be necessary for Preedy Price Limited to obtain financing? What will be the costs of financing it?

The risk of the items not selling. Will Shield and Flagg buy (and pay for) the initial order of 20,000 (i.e. will they bear the risk)? If the inventory is supplied on a sale or return basis, Preedy Price Limited bears the risk that the inventory cannot be sold.

In this case the impact would almost certainly be so significant that the business would go under.

What profits could be expected from this venture? How much would the items cost to produce and what could they be sold for?

Non-financial There may be a risk of damaging the company’s reputation for exclusivity. The buyers of the existing range of Preedy Price garments pay high prices for an exclusive product. They will be less willing to pay for the name and the product if Preedy Price is selling similar items at low prices in the mass market. They may have to choose between limited market exclusive products on the one hand and mass market products on the other; it may not be possible to be involved in both markets.

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If Preedy Price Limited allows Shield and Flagg’s factories to produce goods under their label how will Preedy Price make sure that the quality is sufficiently high? Will they, in fact, have any control over the production process?

10.6 Denver’s restaurant business i) Moving premises Denver needs to know more about the following factors: •

Information about likely levels of demand. There is no point in expanding the capacity of the restaurant if there is insufficient demand. Empty tables cost money.

•

The location on Cross Street - if this is a more favourable location (e.g. nearer the centre of town with good parking provision), the business could do better. However, Denver will need to do some serious investigation to see whether the Cross Street location offers any significant advantages.

•

Financial implications of the sale of his house - Denver needs a realistic estimate of the amount he can raise by selling his house in order to assess the level of mortgage he needs to buy the Cross Street property. He then needs to look carefully at his projected cash flow in the newly located business to ensure that he will be able to meet the regular repayments of mortgage and interest.

•

The need for more objective evidence – there is a risk that if Denver moves to a bigger restaurant he may lose part of his existing clientele (especially if they have been coming to his restaurant because it’s small and has an intimate atmosphere).

ii) Changes to the menu From the way Denver talks about his menu, it sounds as though he does not have a very clear idea about which items are less profitable. He appears to need more relevant management information on this point. This could be obtained by carefully For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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costing out each item offered to assess its profitability. Once he knows how relatively profitable each item is then he is in a position to make some decisions.

However, he needs to consider other factors too: if customers flock to his restaurant because he cooks a particular dish so perfectly, he would be foolish to drop it from the menu. The key to the decision making, as always, is in obtaining sufficient relevant and accurate information. Denver should not make major decisions based on a hunch about which items are more profitable than others.

iii) Extending opening hours This is a decision which requires very careful research and consideration. Denver needs to consider factors like: •

Competitors -do his competitors open for weekend lunch? If they don’t it may be because they have assessed the level of demand and have decided that it’s not worth opening, or they may be overlooking a good business opportunity. Denver could attempt to assess likely demand by asking his existing customers if they eat out at lunchtimes, and whether or not they would eat at his restaurant if it were open.

•

Cost - how much will it cost to open the restaurant for the extra sessions?

There will be staff to pay (regardless of the number of customers) and extra heating and lighting costs.

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Solutions to Case Study Questions

The situation outlined in the case study is by no means unusual. The founder of a company who remains in control through a period of growth is often unwilling to accept that the nature of the business has changed. The approach to business management which worked so successfully when the business was small may not be appropriate once it has grown past a certain point. The investors, Walter and Jennifer, have managed to persuade Paco to bring in additional management expertise, but the new directors clearly face a struggle if they are to bring Paco round to their way of thinking about management information.

1) Tracey and Karim’s point of view In order to illustrate the need for management information in the company we will look at the four proposals made by the new directors:

1. Introduce a commission scheme for the sales force based on the extent to which their actual performance exceeds budget performance.

A system of commission to reward the sales force can often be an effective way of motivating staff to increase sales. However, management needs to be sure that the scheme is set up in such a way that: •

It does not cost more than the additional profit which can be generated from extra sales.

•

It is fair to all staff and sets achievable targets (if the targets are too high staff are likely to be demotivated).

This proposal will require a decision based on an informed analysis of the existing costs involved in running the sales force and upon future projected figures. Various

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types of commission scheme are possible, and a range of options could be considered.

2. Concentrate sales efforts on the more profitable ranges of cards.

We know from the details in the case that the company’s gross profit margin has been falling. It might make sense to concentrate on the more profitable ranges of cards, but, as Tracey points out, in order to do so the directors need to know which ranges are most profitable. There is no management information on this point, making it very difficult to plan and make realistic decisions for the future. This is a good example of the need for detailed costing information.

3. Invest in some new printing equipment.

This is another proposal which involves a decision. There may be several possible courses of action here, and information will be needed on all of them before an informed decision can be made. The directors really need to know quite a lot about: •

The costs of running the existing production facility

•

The extent and cost of the wastage which appears to be taking place

•

Projected costs of alternative production facilities

Until and unless this type of information is made available the directors will find it impossible to reach a properly informed decision.

4. Employ designers to work full-time for the company This is another proposal which involves the directors in decision making. As Karim says, they need to compare the costs of employing designers with the costs of buying in work from freelance designers. There are several aspects to this type of decision, not all of which are related to cost. For example, employing a team of designers might lead to a stronger corporate approach to design. On the other

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hand, the designs might become predictable and repetitive over time if they are being produced by the same team.

These proposals all involve, to a greater or lesser extent, decision making. Managers and directors of businesses need relevant information to feed into the decision making process, so that they can make fully informed appraisals of alternative courses of action. It is quite clear that the directors of Calder Calloway do not have information to hand which will permit them to do this. Their ability to plan and to control the business is severely constrained because of the lack of management information.

In short, management information can help managers in planning, controlling and decision making.

2) Paco’s point of view Is there anything to be said for Paco’s point of view? He does not appear to accept the need for any formalized source of management information and thinks he can continue to run the business by instinct as he did in its early days. This is not a realistic approach.

However, Paco’s views have some validity in that the cost of provision of management information is an important factor. Managers need to have enough relevant information upon which to base their decisions, but the process of providing information must, itself, be controlled. Sometimes organizations are criticized for having excessive bureaucracies and too much paperwork. Sometimes, accountants get the blame for being responsible for pushing too much paper around the organization.

Calder Calloway, however, is an organization that clearly lacks relevant information, and Paco should be persuaded to implement some systems which will provide what is necessary in order to plan, control and make decisions effectively.

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A final, very important, point In their enthusiasm to get started in their new jobs and to make a positive impact on the company both Tracey and Karim have produced lists of ideas for consideration.

This is premature; they are rushing into action without considering the longer-term strategy of the business. What are the objectives of the business? What are its priorities in the mid- to long-term? What strategic decisions need to be made in order to achieve the objectives? These issues need to be thrashed out and decided at board level – the directors are ultimately responsible for deciding on where the business should be going. Then, and only then, is it appropriate to consider the detailed aspects such as those suggested by Tracey and Karim.

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INSTRUCTOR’S MANUAL Chapter 11: Costing: overview and basic techniques

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

Teaching Notes Introduction This chapter introduces costing. It provides an overview of the costing or products and services and introduces students to some of the terminology.

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This is a relatively short lecture. Depending upon time available, and other course organization issues, it might be possible to present the Chapter 10 lecture followed immediately by this lecture within a single lecture slot.

The chapter starts with a brief introduction to the idea of attaching costs to cost objects, and then proceeds rapidly to identify the principal components of cost.

Example 11.1 introduces direct materials, direct labour, direct expense and indirect production overheads. The related lecture slides (below) also use this example, as it pins the ideas to a specific (but straightforward) production context.

More costing terminology is introduced: absorption costing, job costing, product costing and batch costing. Examples are provided that illustrate the application of this terminology.

FIFO and AVCO follow, again with some quite specific examples. The chapter then proceeds to consider some labour costing issues, and then concludes.

Learning outcomes After reading the chapter and completing the related exercises, students should: •

Recognize and understand a range of basic costing terminology

•

Be able to classify costs into direct and indirect costs

•

Understand the build-up of materials, labour and production overhead into full production cost.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

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Slide 3

Introduction – refers to the CIMA definition of cost accounting

Slides 4

Costing in business: This covers the definition of cost object and costing is contextualized into some of the management function described in Chapter 10.

Slide 5

Product costing: The three basic elements, distinguishing between direct and indirect inputs (refer to video suggestion below)

Slides 6 to 9

These slides explain, in an abbreviated form, the content of Example 11.1

Slide 10

Summary of product costing

Slide 11

Brief introduction to various approaches to costing: The chapter’s examples could be used to expand the lecture content (i.e. 11.3, 11.4, and 11.5)

Slide 12

Materials costing – FIFO and AVCO

Slide 13

Introduces some issues in relation to labour costs

Slide 14

Summary

Video The following is a video on direct and indirect costs which could be used as part of the lecture – perhaps after Slide 5. www.youtube.com/watch?v=PT4zQYdQIz4

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Exercises There are eight end-of-chapter exercises. Students can test their knowledge of the chapter using the five multiple-choice questions available on the student section of the website. Also available in that section are three longer questions with suggested solutions. The lecturer-only section of the website includes a further two questions with suggested solutions.

Excel exercise Exercise 11.2 (Art Kit Supplies) is available as an Excel exercise.

Student Question 2 (Wellingborough Cravats Ltd) is available as an Excel exercise.

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Answers to Lecturers’ End-of-Chapter Exercises 11.5 Xiang Products Depreciation of factory work benches

Indirect production overheads

Bank interest charges

Other indirect overheads

Administration salaries

Other indirect overheads

Sundry factory expenses

Indirect production overheads

Factory insurance

Indirect production overheads

Supervisor’s salary

Indirect production overheads

Assembly operatives’ wages

Direct labour

Managing director’s salary

Other indirect overheads

Production office computer depreciation

Indirect production overheads

Purchase of silicone chips

Direct materials

Factory rental

Indirect production overheads

Depreciation of sales representatives’

Other indirect overheads

cars Purchase of circuit boards

Direct materials

Factory cleaning

Indirect production overheads

11.6 Brisbane Pinker Limited Brisbane Pinker Limited: cost statement for the year ended 31 December 20X2 £

£

Direct materials Plastics

63,570

Metal

21,444

Dyes and paint

2,490 87,504

Direct labour

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Plastics machine: operators’ wages

35,249

Metal moulding machine: operators’ wages

32,222

Finishing operative’s wages

20,240 87,711

Prime cost

175,215

Production overheads Depreciation of factory building

1,500

Machinery depreciation

3,950

Factory canteen costs

12,234

Factory insurance

6,960

Factory power

8,370

Factory cleaning

6,440

Security guard to factory

8,290

Sundry factory expenses

4,284 52,028

Production cost

227,243

Other overheads Selling department sundry expenses

1,899

Sales department salaries

39,434

Distribution costs

18,777

Administrative salaries

41,496

Depreciation of office fixtures and fittings

1,929

Depreciation of office building

1,100

Stationery and other office admin. supplies

2,937

Telephone charges

4,338

Other administrative expenses

6,422 118,332

Total costs

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345,575

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11.7 Wensleydale Woollen Waistcoats Limited Inventory card for code 78X4A for June 20X2: Deliveries into

Transfers to production

Balance

inventory Date

Kg

£

£

Kg

£

£

1 June 2 June 6 June

8 50

2.10

2.00

16.00

105.00

20 June

40

2.062

82.50

Kg

AVCO £

£

38

2.00

76.00

30

2.00

60.00

80

2.0625

165.00

40

2.0625

82.50

5

The value of the issue to production on 20 June under the AVCO convention of valuation is £82.50.

The correct answer is a).

11.8 Ravenna & Michele Limited Working 1: Cost of material J booked to Job No. X4721 Deliveries into

Transfers to production

Balance

inventory Date

Kg

£

£

Kg

£

£

1 Sept 8 Sept

30.0

14.20

426.00

Kg

£

28.7

410.41

58.7

836.41

18 Sept

20.6

14.30

294.58

38.1

541.83

21 Sept

8.1

14.30

115.83

30.0

426.00

21 Sept

13.3

14.20

188.86

16.7

237.14

The total value of the transfer to Job No. X4721 on 21 September is: £115.83 + 188.86 = £304.69

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Job No: X4721 Component code: 1187AB6 Quantity: 100 units £

£

Direct materials Material J: (see working 1)

304.69

Material Q: 3.7kg @ £2.75 per kg.

10.18 314.87

Direct labour Grade IV labour: 16 hours @ 8.28 per hour

132.48

Grade VIII labour: 8 hours @ £10.21 per

81.68

hour 214.16 Prime cost

529.03

i) Prime cost for 100 components is £529.03. ii) Cost per single component therefore = £5.29.

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INSTRUCTOR’S MANUAL Chapter 12: Costing: accounting for overheads

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction The content of this chapter follows on directly from that of Chapter 11. This chapter covers some of the more complex issues in accounting for production overheads, including and introduction to activity-based costing (ABC). The first part of the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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chapter covers the allocation and apportionment of overhead expenses, and the calculation and usage of overhead absorption rates. The final section of the chapter is concerned with ABC which is explained via a comprehensive but fairly straightforward example.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: • Be able to calculate and apply suitable overhead absorption rates.

• Understand some important issues in relation to the costing of services.

• Understand the nature of activity-based costing (ABC) and be able to apply its principles to straightforward costing examples.

• Be able to contrast ABC with traditional costing methods, and to understand the benefits and problems associated with ABC.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes (slightly abbreviated)

Slide 3

Introduction

Slide 4

Production overheads: allocation and introduction of idea of apportionment

Slide 5

Common approaches to apportionment: An extract from Example 12.2 (Choremaster) showing typical apportionment methods for particular types of cost.

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Slides 6 and 7

Continues with Example 12.2 (Choremaster)

Slide 8

Overhead absorption: Introductory slide –continuing Example 12.2 (Choremaster). Refer to Section 12.2 of the chapter.

Slide 9

Shows methods of calculating overhead absorption rates (refer to video suggestion below).

Slides 10

Briefly summarizes some of the chapter content on the costing of services.

Slide 11

ABC – sets out basic principles

Slides 12 to 17

ABC: These slides present aspects of Example 12.7 (Sallis Weller Limited).

Slide 18

Pros and cons of ABC are briefly presented here.

Slide 19

Summary

Video The following video is about overhead allocation. The example used is relatable and is nicely explained. The figures used are easy to follow and the fairness/unfairness of allocation methods is demonstrated well. www.youtube.com/watch?v=vMdxzH5IUQ4

The video runs to just under 9 minutes. It could be used just after Slide 9 to provide a change in pace and consolidation of learning via a different example.

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Case study The case study, Entwistle, is a detailed example of the application of the techniques covered in the first half of Chapter 12. It covers allocation and absorption of production overheads including the results of adopting different approaches. This case study can be used to develop and consolidate students' understanding of the principles set out in the chapter.

Exercises There are fourteen end-of-chapter exercises. Students can test their knowledge of the chapter using the five multiple-choice questions available on the student section of the website. Also available in that section are two longer questions with suggested solutions. The lecturer-only section of the website includes a further two questions with suggested solutions.

Excel exercises Example 12.1 (Jersey Brookfield & Co) is available in spreadsheet form.

Student Question 1 (Amis Brevel Biscuits Ltd) is available in spreadsheet form.

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Answers to Lecturers’ End-of-Chapter Exercises 12.9 Bedford Bowler Bedford Bowler Limited: apportionment of production overheads for the year ended 31 December 20X4 Cost centre Basis

Factory rental

Total

Machining

Assembly

Packaging

£

£

£

£

Floor area

21,105

8,375

5,695

7,035

Actual

5,500

–

–

5,500

Cleaners’ wages

1:1:1

17,991

5,997

5,997

5,997

Factory rates

Floor area

6,930

2,750

1,870

2,310

Electricity – factory

Actual

8,280

3,905

1,892

2,483

Supervision

No.

21,456

5,960

10,728

4,768

Call outs

4,472

2,795

1,677

–

Machinery

Net book

12,250

7,000

5,250

–

depreciation

value 97,984

36,782

33,109

28,093

Packaging machine – leasing charges

employees Machinery maintenance and repair

12.10Oakshield Carver Limited i) Machining cost centre: Overhead absorption rate based on machine hours £297,000 80,000

= £3.71

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ii) Assembly cost centre: Overhead absorption rate based on units of production £136,000 115,000

= £1.18

iii) Finishing cost centre: Overhead absorption rate based on direct labour hours £121,500 9,000

= £13.50

iv) Packaging cost centre: Overhead absorption rate based on units of production £76,000 115,000

= £0.66

12.11 Oakshield Carver (continued) Total production cost of one unit of production: £ Materials

14.20

Direct labour

18.00

Prime cost

32.20

Machining dept: 2 × £3.71

7.42

Assembly dept: 1 × £1.18

1.18

Finishing dept: 1.5 × £13.50

20.25

Packaging dept: 1 × £0.66

0.66

Production cost

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£61.71

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12.12 Bushey Travel Principal categories of cost: 1. Computer and systems costs. Computer maintenance, upgrades and virus protection are vital features in a business that relies so heavily on computers.

Costs will include information systems and maintenance staff.

2. Premises costs, such as rent, business rates, water rates, electricity.

3. Other staffing costs relating to call centre activities.

4. Telephone and internet charges.

12.13 Combe Cullen Systems i) Overhead absorption rate based on machine hours Estimate of production overheads for 20X3: £168,970 Total machine hours = 11,000 Rate per machine hour = £168,970 = £15.36 per hour 11,000 ii) Overhead per unit using ABC system Cost per unit of cost driver: Activity

Cost amount £

Machining

Overhead Machine hours

= 63,030 11,000

£5.73 per machine hour

Assembly

Overhead Labour hours

= 43,020 9,000

£4.78 per labour hour

Packing

Overhead Labour hours

= 31,000 4,000

£7.75 per labour hour

Materials

Overhead No. of orders

= 9,990 111

£90 per order

ordering

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Materials issue

Overhead No. of issues

= 12,000 150

£80 per issue

Machine set up

Overhead No of hours

= 5,940 33

£180 per hour

Quality inspection

Overhead = 3,990 No of inspections 35

£114 per inspection

Allocation of overhead between product A and product B: Product A

Product B

£

£

Machining

6,000 × £5.73

34,380 5,000 × £5.73

28,650

Assembly

3,000 × £4.78

14,340 6,000 × £4.78

28,680

Packing

2,000 × £7.75

15,500 2,000 × £7.75

15,500

Materials ordering

86 × £90

7,740 25 × £90

2,250

Materials issues

103 × £80

8,240 47 × £80

3,760

Machine set up

25 × £180

4,500 8 × £180

1,440

Quality inspection

10 × £114

1,140 25 × £114

2,850

85,840

83,130

Total

iii) Production cost of one unit of each product under ABC system A Total production overhead Number of units planned for production

B

£85,840

£83,130

6,000

5,000

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Production overhead per unit

£14.31

£16.63 Prime cost per unit

12.50

16.00

Production cost per unit

26.81

32.63

Production cost of one unit of each product under the old costing system

Prime cost per unit

£12.50

Production overhead for one machine hour

£16.00 15.36

15.36 Production cost per unit

27.86

29.36

iv) Under both systems the production cost of A is less than the production cost of B. However, there is a greater difference between A and B under the ABC system of costing: A’s cost is lower under ABC whereas B’s cost is higher. Although product A involves a much higher number of materials orders and issues and higher machine set up costs, this is more than offset by the key factor which is the much lower number of labour hours involved in the assembly of product A. Because the company has traditionally absorbed production costs via machine hours, the much lower input of labour hours into A’s assembly has been ignored. One of the advantages of the ABC system is that it is much more ‘fine-tuned’ in this respect.

However, it should be noted that a great deal of work has been involved in collecting and analyzing the data relating to production. Some might argue that the benefit of the more accurate cost provided by ABC is more than offset by the high cost of collecting the relevant data.

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12.14 Queen’s Move plc The business engages in two principal activities: removals and storage.

Removals In respect of removals, the main cost pools are likely to centre on: 1. The provision of haulage services 2. The logistics and administration of the service Haulage service costs would include: •

Premises costs (for housing the fleet of vehicles)

•

Staff costs (vehicle drivers and removers)

•

Fuel and other costs such as tax and insurance relating to the vehicle fleet

Logistics and administration costs would include: •

Office premises costs

•

Staff costs

•

Computer software, hardware, internet and phone charges

The principal cost driver is the booking of a removal by a customer. This is the key factor which links resource consumption to output.

Storage The main cost pools relating to the storage side of the business relate to the physical space involved and its insurance and security. Premises and staffing constitute the principal items of cost, and there will also be costs relating to booking systems, insurance and security.

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The main factor relating consumption of resources to output in the form of a cost driver is the occupation of space by goods stored. This could be related to the initial order by a customer but may also be time-related (for example, if bookings are made by the week, one week’s storage could be the basic unit for the cost driver).

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Solutions to Case Study Questions a) Overhead apportionment Basis

Total

Cutting

Assembly

£

and

and

turning

finishing

£

£

Factory rental

Floor area

75,000

52,500

22,500

Factory insurance

Floor area

7,600

5,320

2,280

Cleaning

Floor area

8,900

6,230

2,670

Canteen

No of employees

11,100

3,552

7,548

Floor area

9,500

6,650

2,850

Actual

22,500

15,200

7,300

Machinery maintenance

No of call-outs

16,464

14,112

2,352

Machinery depreciation

Net book value

30,000

25,000

5,000

Canteen depreciation

No of employees

3,500

1,120

2,380

Supervisors’ wages

Actual

57,936

29,716

28,220

Other factory costs

Floor area

23,000

16,100

6,900

265,500

175,500

90,000

Factory rates Electricity

The total production overhead apportioned to the cutting and turning cost centre is £175,500.

The total production overhead apportioned to the assembly and finishing cost centre is £90,000.

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b) i) Overhead absorption rate on the basis of machine hours: Cutting and turning

Assembly and finishing

Production overhead

175,500

90,000

Machine hours

22,500

5,000

Overhead absorption rate

£7.80

£18.00

ii) Overhead absorption rate on the basis of labour hours: Cutting and turning

Assembly and finishing

Production overhead

175,500

90,000

Labour hours

12,500

25,000

Overhead absorption rate

£14.04

£3.60

c) Machine hours The details of the number of machine hours spent on each product are given in the case study (be careful not to get machine hours confused with labour hours).

Greenhouse Dept C&T

2 hours ×

Garden chair £

Dept

15.60

C&T

£7.80 A&F

0.5 hours ×

2.50 hours ×

19.50

£7.80 9.00

A&F

£18.00 Total

£

0.50 hours ×

9.00

£18.00 £24.60

Total

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£28.50

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If 5,000 greenhouses and 5,000 garden chairs are produced and sold the total overhead absorbed will be: Greenhouses: 5,000 × £24.60

= 123,000

Garden chairs: 5,000 × £28.50

= 142,500

Labour hours The labour hours spent in each department on greenhouses and garden chairs are given in the prime cost details in the case study.

Greenhouse

Garden chair

Dept C&T

1 hour ×

£

Dept

14.04

C&T

£14.04 A&F

1.5 hours ×

21.06

£14.04

2 hours ×

7.20

A&F

£3.60 Total

£

3 hours ×

10.80

£3.60 £21.24

Total

£31.86

If 5,000 greenhouses and 5,000 garden chairs are produced and sold the total overhead absorbed will be: Greenhouses: 5,000 × £21.24

= 106,200

Garden chairs: 5,000 × £31.86

= 159,300

(Tutorial note: This example demonstrates that whichever method of overhead absorption is selected, the total amount of overhead absorbed remains the same.

The only difference is the way in which the total overhead is allocated to products.)

d) For this part of the case, we use the overhead absorption information calculated in part c) together with the prime cost information given in the case study.

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Greenhouse (per unit) Overhead

Overhead

absorption –

absorption –

machine hours

labour hours

£

£

Selling price

85.00

85.00

Less: prime cost

(32.00)

(32.00)

Less: overhead absorbed

(24.60)

(21.24)

Gross profit

28.40

31.76

NB: Gross profit %age

33.4%

37.4%

Garden seat (per unit) Overhead

Overhead

absorption –

absorption –

machine hours

labour hours

£

£

Selling price

103.00

103.00

Less: prime cost

(45.00)

(45.00)

Less: overhead absorbed

(28.50)

(31.86)

Gross profit

29.50

26.14

NB: Gross profit %age

28.6%

25.4%

Tutorial note: It is important to remember that there is no definitively correct way of absorbing production overheads. From the figures given above, the greenhouses certainly appear to be relatively more profitable than the garden seats. However, the gross profit and gross margin per unit depend to some extent on the basis of overhead absorption used.

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Because of this variability, figures based upon the absorption method of accounting (i.e. including production overheads) are not likely to be reliable for decision making which involves questions such as: • How much more profitable is one product than another?

• Which product should we concentrate on producing?

• How much of product X should we produce?

Students should be aware that absorption costing, while it is useful for information and for stock valuation, should be treated with some caution as a tool for decision making. e) The cutting and turning department relies more heavily on mechanized processes and for this reason it may be more appropriate to use an overhead absorption rate based on machine hours in respect of overheads allocated and apportioned to this cost centre. The assembly and finishing department, by contrast, is much more heavily reliant upon manual processes, and so the use of an overhead absorption rate based on labour hours may make more sense in this cost centre. f) The effect on product cost would be as follows: Overheads absorbed, per unit of product Greenhouse Dept C&T

2 machine

Garden seat £

Dept

15.60

C&T

hours × £7.80 A&F

2 labour hours

2.5 machine

19.50

hours × £7.80 7.20

A&F

× £3.60 Total

£

3 labour hours

10.80

× £3.60 £22.80

Total

£30.30

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Effect on total production cost per unit and on gross profit per unit: Greenhouse

Selling price

Garden seat

£

£

85.00

103.00

Prime cost

32.00

45.00

Production overhead absorbed

22.80

30.30

Production cost per unit

54.80

75.30

Gross profit

30.20

27.70

NB: Gross profit %age

35.5%

26.9%

Tutorial note: If we compare these with the equivalent calculations in part d) we can see that using different overhead absorption rates for the two departments produces a gross profit per unit that lies between those calculated earlier. Because this approach steers a middle course by using machine hours for one cost centre and labour hours for the other, it may be most appropriate in the circumstances.

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INSTRUCTOR’S MANUAL Chapter 13: Pricing

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

Teaching Notes Introduction This relatively brief chapter examines the issues involved in setting selling prices.

Pricing tends to be accorded relatively low importance in textbooks at this level, but it is hoped that this chapter will help students to see that pricing is of prime importance in business. The chapter starts by examining the economist’s model of demand and the fundamental relationship between price and quantity. Problems in For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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applying the economic model to the real world are noted, and the effect of advertising, fashion and reputation. The chapter proceeds to examine the special competitive conditions of monopoly, oligopoly and cartel. Then the pricing decision is examined in more detail. Market-based and cost-based pricing solutions are discussed. Also, in a new section for the third edition, product life cycle issues and price skimming are explained. The chapter concludes by examining some special cases (e.g. tendering and discounting). Four brief studies examine pricing in the context of very different types of business.

Learning outcomes After reading the chapter, and completing the related exercises, students should: •

Understand the interaction between supply and demand and the interdependence of price and quantity.

•

Understand the various additional factors that play a part in pricing decisions.

•

Understand the interface between pricing and costing, with especial reference to cost-plus pricing.

•

Be able to apply knowledge of pricing issues across a range of industries and commercial activities.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes, slightly abbreviated

Slide 3

Introduction

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Slide 4

The relationship between price and quantity: The sets of lines describe different price/quantity relationships.

Slides 5

Elasticity and inelasticity: Students could be asked to think of examples of the different conditions (refer to the video below).

Slide 6

Problems with applying the economic model

Slide 7

Competition in the market: Describes the three conditions of monopoly, oligopoly and cartel. Students should also take note of ‘price setter’ and ‘price taker’, as these descriptions are used elsewhere in the chapter.

Slide 8

How do producers decide on prices?

Slide 9

Cost-plus pricing: disadvantages

Slide 10

Cost-plus pricing: Example 13.3 is used to illustrate full cost-plus pricing.

Slide 11

Accepting low prices: Also noted in the previous chapter on marginal costing for decision making.

Slide 12

Special cases: Tendering, highly restricted supply of unique products, target pricing, discounting and auction are noted

Slide 13

More issues in pricing decisions – product life cycle and price skimming

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Slide 14

Example 13.6 (Glock Systems) to demonstrate th product life cycle: A pared-down version of the example is demonstrated on this slide.

Slide 15

Pricing in context: This includes the headings from Section 13.6 of the chapter. Lecturers could briefly outline the pricing issues, and then set Section 13.6 for students to read.

Slide 16

Summary

Video Here is a video about elasticity/inelasticity of demand by Jacob Clifford: www.youtube.com/watch?v=HHcblIxiAAk&t=43s It is around 6 minutes long. If you do not want to use all of it, the first couple of minutes conveys the message. It could be slotted into the presentation at around Slide 5.

Case study The case study for this chapter is based upon the real-life examination of the retail grocery market in New Zealand. Students are required to read the executive summary of the recent (2022) Market Study into the Retail Grocery Sector, produced by the New Zealand Commerce Commission. The first two requirements ask students to read and précis the problems in the market and the Commission’s recommendations. There is a third requirement to compare the New Zealand grocery retail market with that of the country in which students are located.

Indicative word limits are given for the three requirements, but these could be altered.

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Exercises There are ten end-of-chapter exercises. Students can test their knowledge of the chapter using the five multiple-choice questions available on the student section of the website. Also available in that section are three further questions with suggested solutions. The lecturer-only section of the website contains a further three questions with suggested solutions.

Excel exercise Exercise 13.5 (Belvedere, Bharat and Burgess) is available as an Excel file.

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Answers to Lecturers’ End-of-Chapter Exercises 13.7 Ainsley Witt Fixed costs per unit:

£125,000 2,400

= £52.08

Cost-plus calculation: £ Variable materials cost per unit

22.00

Variable labour costs per unit

54.00

Royalty per unit

1.00

Fixed costs per unit

52.08

Total costs per unit

129.08

Profit mark-up: £129.08 x 23%

29.69

Selling price

158.77

This is £8.77 higher than the current selling price.

13.8 Burke and Harpur Burke’s point of view is market-led – he is concerned about the effect that apparently high prices will have in deterring possible clients. He cannot be sure that word will get out about this high charge: Mrs Higgs may not be the type of person to discuss her legal bills with anyone else. However, he is probably correct to recognize the risk.

Harpur’s priority appears to be to cover costs. £890 of the bill relates to the tax specialist’s fees and some sundry charges. Given that these can no doubt be For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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supported by evidence, they should almost certainly be included on the bill. The point of contention relates to the proportion of the time charges which should also be included. The fact that Mrs Higgs is able to afford the charges does not mean that she will necessarily pay them without complaint.

Because the partners are trying to establish themselves in the face of competition from other more established firms, Burke’s point of view should probably prevail here. However, the business will eventually fail if it cannot cover its costs. Accepting such a large undercharge on a bill should be the exception, not the rule. The partners should discuss the proposed charge of £1,500 in more depth – why has Burke suggested this particular figure? Could it perhaps be pitched higher especially given that £890 relates to identifiable separate charges?

13.9 Plumber and biscuit manufacturer a) A plumber (sole trader) Plumbers often bill on the basis of an hourly rate, plus, sometimes, a fixed fee callout charge. These charges would usually have to be competitive in relation to the local market. However, if there is a shortage of plumbing services, market forces would allow prices to increase. Costs in this type of business are relatively low (the main ‘cost’ is the proprietor’s own labour) and so cost-plus pricing would probably not be appropriate. It might be possible to justify higher charges if the quality of service (e.g. rapid response, call-out during the night) were particularly good. b) A biscuit manufacturer As in the case of the toothpaste manufacturer examined in the chapter, demand for this product is relatively elastic. However, a competitive edge could be gained by effective advertising, and it may be possible to establish a product with a premium image which permits the charging of slightly higher prices than competitors. If competition is particularly intense in the biscuit market, it may not be possible to

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increase prices much at all. If heavy marketing of the product is required in order to keep market share, margins may have to be reduced.

13.10 The argument is that regulation against cartels interferes with the operation of a free market and the economists’ demand/supply model.

The regulation undoubtedly does interfere with the operation of a free market: that is its intent. The real points at issue are whether such interference is desirable and, if it is desirable, how far the interference should go. Only a thorough libertarian is likely to argue for no interference at all in the operation of markets, and from most other points of view, it then becomes a matter of extent. Taking the capital markets as an example: these markets (for example, the London Stock Exchange) are able to function only in conditions of comparatively heavy regulation. There are regulations relating to the issue of shares, the amount of information that must be made publicly available in advance of a share issue, and on a regular basis in the form of annual reports. Other regulations relate to the audit of financial reports, publication of price-sensitive information and profit warnings. If capital market regulation were absent, it is probable that the market would cease to exist.

Competition legislation exists to ensure that markets are not distorted by cartels. It can therefore be argued that regulation against cartels, rather than interfering with the operation of a free market, is designed to ensure that a free market can function effectively.

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Solutions to Case Study Questions 1. There are only two major retail grocers in New Zealand: Foodstuffs and Woolworths.

Although the report notes the existence of other competitors at the fringes of the market, such competitors do not provide choices for all consumers, and have a limited impact only. The market in New Zealand is therefore a duopoly.

The ComCom discovered that most consumers continue to shop with one of the two main retail grocers. Competition between the two retail grocers is ‘muted’ and does not reflect competition. Prices are, therefore, higher than they would be if there was a truly competitive market, and prices appear high by international standards.

The two major retailers are each other’s closest competitors, and they have wellknown and similar competitive strategies. They can easily monitor each other’s prices and quickly respond to any changes. The ComCom expects that competition would be more intense if there were more large-scale grocery retailers. However, there are high barriers to entry into this market. There is a lack of suitable sites for development of rival grocery stores. This arises from a range of problems: restrictive planning laws, costs, delays and uncertainty related to planning, and the existence of restrictive covenants in land purchases and leases (this means, for example, imposing a restriction in a lease in allowing competitors to operate in nearby sites).

Another difficulty is that of obtaining competitively priced wholesale supplies of grocery products. The two large retailers are in a position to negotiate good terms with suppliers. The report notes, however, that new, smaller, competitors would be disadvantaged, for example, because they lack the resources to negotiate volume discounts.

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The report finds that the two major retailers achieve higher profitability than would be expected. An estimated reasonable Return on Average Capital Employed (ROACE) is 5.5% but the actual returns are well over 12%. Prices charged to consumers do appear to be relatively higher than those paid elsewhere in the world. New Zealand consumers consider that they pay more than they would in other countries.

As well as being potentially unfair to consumers, the current position is unfair to suppliers because there is an imbalance in bargaining power. Because there are only two major retailers, there is limited competition for suppliers’ products. Also, because of the lack of other customers, suppliers are in a weak bargaining position.

They cannot afford to antagonize the two major retailers due to the threat of having their products removed from the retailers’ shelves.

2. The report identifies a key recommendation to improve conditions for entry and expansion into the NZ grocery market. Two main areas are identified: •

Freeing up sites for retail grocery stores

•

Improving access to groceries for resale

In order to free up sites, amendments will have to be made to planning laws to ensure that more land is made available and to limit the grounds on which new developments can be declined. It would also be necessary to restrict, or make unenforceable, restrictive covenants that impede the development of competition.

The report suggests that improving access to supplies for new entrants to the market could be achieved by requiring one or both major retailers to voluntarily offer supply of goods to new entrants at wholesale prices. This would allow new entrants to gradually develop their own direct relationship with suppliers.

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Related to this last suggestion, the report recommends a mandatory grocery code of conduct and sharpening up regulation relating to unfair contract terms. The code of conduct would require competitors to act in good faith, and would require access to a timely, independent and affordable dispute resolution process.

A further set of recommendations relates to improving consumers’ ability to make informed decisions on purchasing. Pricing and promotions should be simple and easy to understand, and retailers should co-operate with price comparison websites. New rules should be introduced in order to ensure a standard presentation and format for unit pricing.

Finally, the report recommends the establishment of a new grocery sector regulator.

Also, a review should be taken (three years after the implementation of the new recommendations) to assess effectiveness in practice.

3. Answers to this requirement will depend upon students’ location.

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INSTRUCTOR’S MANUAL Chapter 14: Marginal costing and decision making

Contents: • Teaching Notes •

Answers to Lecturers’ Exercises from the book (see electronic pdf book appendix for Answers to Students’ Exercises and self-assessment questions from the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter opens with a discussion of relevant costs and revenues, introducing the notion of opportunity cost. The chapter then proceeds to explain the distinction between fixed, variable and semi-variable costs before introducing marginal costing For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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and cost–volume–profit analysis. Break-even charts and calculations are demonstrated, and the chapter proceeds to examine different types of special decision: accepting contracts, major increases in activity levels and limiting factors.

Finally, the limitations of analysis based on marginal costing are examined.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: •

Understand the principal factors involved in decision making, including the importance of relevant costs.

•

Understand the nature and classification of costs as variable, fixed or semivariable.

•

Be able to use cost–volume–profit analysis to establish a break-even point and to assist in business decision making.

•

Understand the issues involved in making decisions in special circumstances.

•

Understand the limitations of marginal costing for decision making.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

Issues in decision making: Introduces the terms 'relevant costs', 'relevant revenues' and 'opportunity cost'. Includes principles of decision making – sets out six important fundamental principles.

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Slide 5

Variable, fixed and semi-variable costs : Stepped costs are also referred to, in order to reinforce the point that fixed costs remain fixed only up to a point.

Slides 6 to 9

Variable costs, fixed costs, stepped costs and semivariable costs: Each of these four classifications is represented graphically (refer to video suggestion below).

Slide 10

Marginal costing: Describes marginal cost in economic and accounting terms, and also contribution.

Slide 11

Contribution: A very simple example of a contribution calculation (Example 14.13).

Slide 12

Break-even: Provides an example showing the break-even point (this is the example from Section 14.3.2 in the book).

Slide 13

Cost–volume–profit analysis: Introduces the notion of CVP analysis.

Slides 14 and 15

Break-even charts

Slides 16 to 18

Break-even analysis using formulae: Example 14.8 (Mulberry Piggott Ltd) from the chapter is used to demonstrate the calculation of break-even.

Slide 19

Target profit: Example 14.8 is extended.

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Slide 20

Cost–volume–profit graph: The calculations are demonstrated graphically.

Slide 21

Margin of safety: Briefly demonstrated by, again, using the Mulberry Piggott example.

Slide 22

Special decisions: accepting contracts: The decision on whether or not to accept a contract at a special price is explored in greater detail in Example 14.11 (Solidago Solanum Limited).

Slides 23 and 24

Special decisions: major increases in activity levels: A brief excerpt from Example 14.12 (Spindrift and Schooner Limited) is used to demonstrate the point about comparison between incremental revenue and incremental costs.

Slides 25 to 27

Special decisions: limiting factors: Excerpts from Example 14.13 (Crosby and Crossthwaite Limited) are used to illustrate this type of special decision.

Slides 28 and 29

Make-or-buy decisions

Slide 30

Limitations of analysis based on marginal costing

Slide 31

Summary

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Video The suggested video looks at restaurant costs: www.youtube.com/watch?v=pv5cwM5vmeg Restaurant costs are one of the examples used in Section 14.2.5 of the chapter. The video helps students to understand the nature of restaurant costs and why restaurants tend to be low-margin businesses.

Case study The case study, A&A Wright, examines some of the practical difficulties of decision making in a small family business. The father, one of the original founders, is sceptical about the use of management accounting information. The son is keen to implement a more structured approach to financial management of the business.

The latter clearly understands the basic decision rule about the acceptance of special contracts but is perhaps overlooking the importance of other factors in the decision. The conflict between father and son exemplifies some of the problems frequently encountered in family businesses.

Exercises There are twenty-five end-of-chapter exercises, including exercises relating to all the special decisions included in the chapter: acceptance of contracts at special prices, major increases in activity levels and limiting factors. Students can test their knowledge of the chapter using the ten multiple-choice questions available on the student section of the website. Also available in that section are seven further questions with suggested solutions. The lecturer-only section of the website contains a further eight questions with suggested solutions.

Excel exercise Exercise 14.14 (Juniper Jefferson Ltd) is available in Excel.

Student Question 4 (Garth Goredale Ltd) is available in Excel.

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Answers to Lecturers’ End-of-Chapter Exercises 14.16 Darlene Fabrik The definition of opportunity cost, according to CIMA, is: ‘The value of the benefit sacrificed when one course of action is chosen in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action’.

In this case, the amount of the original purchase cost is irrelevant as it does not represent the value of the benefit sacrificed. The amount of depreciation that has taken place is also irrelevant. The machine is no longer required for its original purpose, so the potential benefit foregone is best represented by the amount for which the machine could now be sold. The £50,000 cost of a similar new machine is not appropriate, because the machine in question is not new. The benefit foregone is the amount for which the machine in its current condition could be sold: £38,000.

14.17 Colby Overland i) Colby Overland Limited: graph of coach costs The following points are plotted: Activity level (no of passengers)

Cost £

0

0

1

14,000

40

14,000

41

28,000

80

28,000

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81

42,000

120

42,000

121

56,000

160

56,000

Cost (£)

Colby Overland Limited: graph of hotel costs:

60,000 50,000 40,000 30,000 20,000 10,000 0

0 100 200 Number of passengers

Two points are plotted: At zero passengers: cost = £0 At 160 passengers: cost = 160 × £280 = £44,800

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50,000 Costs (£)

40,000 30,000 20,000 10,000 0

0 100 200 Number of passengers

ii) The cost of coaches is a stepped cost; the hotel cost is a variable cost.

14.18 Various businesses Type of business Milk delivery business

Examples of fixed and variable costs Variable costs Petrol or diesel Cost of milk Fixed costs Road tax on delivery vehicles Depreciation of delivery vehicles

Coffee bar

Variable costs Coffee and other catering supplies Casual staff employment costs

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Fixed costs Rental of premises Depreciation of cappuccino machine Stationery manufacturer

Variable costs Cost of paper Direct labour costs (perhaps) Fixed costs Paper cutting machinery annual maintenance inspection Factory cleaning costs

Cross channel ferry operator

Variable costs Fuel costs Cost of fizzy drinks for vending machine Fixed costs Ship dry dock inspection costs Booking office staff salaries

14.19 Vernon Limited Vernon Limited: budget statement for August 20X7 £ Sales: 120 xylophones × £1,500

180,000

Variable costs Direct materials: 120 xylophones × £300

(36,000)

Direct labour: 120 xylophones × £450

(54,000)

Contribution

90,000

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(54,000)

Fixed costs Net profit

36,000

14.20 Finch Fletcher Limited i) Points plotted on break-even chart: Production

Fixed costs

Total costs

Total revenue

£

£

£

0

172,000

172,000

0

1 200

172,000

316,000 (£172,000 +

£420,000 (1,200 × £350)

level

[1,200 × £120])

Finch Fletcher Limited: break-even chart for the year ended 31 March 20X3:

ii) Reading from the chart, the break-even point in units appears to be about 750 units, equivalent to about £250,000 in sales value.

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iii) Using the break-even formula: Selling price per unit

350

Variable costs per unit

120

Contribution per unit

230

Break-even point (in units)

Break-even point in sales value

=

Fixed costs Contribution per unit

=

£172,000 230

=

748 units (to nearest whole unit)

= 748 units × £350 = £261,800

14.21 Fallon Frodsham Limited

Production

Variable costs

Total revenue

£

£

0

0

0

150

1,095,000 (150 × £7,300)

1,950,000 (150 × £13,000)

level

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A vertical line has been drawn from the 150 unit point on the horizontal (x) axis. The maximum level of fixed costs the company can incur without making a loss is measured by the solid part of the line (i.e. the distance between the variable cost line and the revenue (or total costs) line. If we plot horizontal lines from each end of the solid line (shown as heavy dashes above) we can estimate the total of fixed costs.

On the vertical (y) axis the distance between the two horizontals is about £2,000,000 – £1,200,000 = £800,000 (approximately).

Applying the break-even formula to the problem: Break-even point in units lies at the point where total costs = total revenues.

At 150 units total revenues = 150 × £13,000 =

£1,950,000

Therefore, total costs =

£1,950,000

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Total costs = Fixed costs + Variable costs Fixed costs = Total costs – Variable costs Fixed costs = £1,950,000 – 1,095,000 = £855,000.

14.22 Gulf Gadgets Limited Variable costs per unit will increase by 10 per cent: £78 + (78 × 10%) = £85.80 £ Selling price per unit

187.00

Variable costs per unit

(85.80)

Contribution per unit

101.20

Break-even point

Fixed costs Contribution per unit =

65,000 101.20

=

642 units

The correct answer is c).

14.23 Gecko Grimsby For 20X3: £ Selling price per unit (£1,320 × 110%)

1,452.00

Variable costs per unit (£321 × 110%)

(353.10)

Contribution per unit

1,098.90

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Fixed costs are also expected to increase by 10 per cent in 20X3: £85,750 × 110% = £94,325 Target sales in units

Fixed costs + Target profit Contribution per unit =

50,000 + 94,325 1,098.90

= 131 The correct answer is a).

14.24 Gospodin Grimshaw Limited Selling price per unit

15.00

Variable costs per unit

(5.50)

Contribution per unit

9.50

Break-even point in units

=

Fixed costs Contribution per unit

=

87,900 9.50

=

9,253

Expected sales in units Therefore, margin of safety in units

15,000 15,000 – 9,253 = 5,747

Expressed in sales value: 5,747 × £15 = £86,205 The correct answer is b).

14.25 Ince Pargeter Limited Incremental sales: £15 × 10,000

150,000

Less: incremental variable costs 10,000 × £5.63

(56,300)

Less: incremental fixed costs £390,000 – 283,000

(107,000)

Incremental loss

(13,300)

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On the face of it the decision appears straightforward because the extra 10,000 units ordered per annum would produce an incremental loss.

It may, nevertheless, be worth considering the expansion of production facilities.

Much depends on whether the company really could obtain additional orders to use up some or all of the additional capacity. The sales director would need to be really sure that he could obtain the additional orders.

14.26 Jackson Demetrios Limited i) Type A

Type B

Type C

£

£

£

175

160

165

Wood

(37)

(35)

(35)

Plastics

(16)

(15)

(18)

Screws and fixings

(2)

(2)

(2)

Variable labour costs

(18)

(16)

(16)

Contribution per unit

102.00

92.00

94.00

Machine hours required per

2.5 hours

2.0 hours

2.1 hours

£40.80

£46.00

£44.76

3rd

1st

2nd

Selling price per unit Variable materials costs

unit Contribution per unit of limiting factor Order of ranking

The directors should be advised to manufacture as much as possible of desk Type B. Demand for Type B = 1,600 units – this would use 1,600 × 2 = 3,200 machine hours.

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The remaining machine hours would be used for Type C: 4,000 – 3,200 machine hours = 800 hours. Production of C would be: 800/2.1 = 380 units (rounding down to nearest whole unit).

ii) If this production plan is adopted the overall contribution to fixed costs will be: Desk Type B

1,600 units × £92.00 = £147,200

Desk Type C

380 units × £94.00 = £35,720

Total contribution

£182,920

Tutorial note: this analysis works only if demand for each product is independent. If, for example, a typical business customer buys a mixture of the different types of desk, then he or she will expect to be offered the choice of models. If the choice of models is reduced to two (Types B and C), this could deter some customers.

14.27 Jellaby Insurance Ltd

The main advantage to the proposal is cost saving. It has the scope to add around 20% to annual operating profit. There may be other advantages to be gained from employing fewer people. The work of the HR department could presumably be reduced and there may be savings available in occupying less office space. It is not clear whether or not such savings are taken into account in the finance director’s cost savings estimate. Much more detail would need to be submitted to the board of directors in support of the proposal.

There are potential disadvantages to the proposal. One difficulty that has been encountered in practice when call centre operations are moved, is that the new centre may be too remote. If the call centre operators work in a different time zone to the UK, and if the operators are less than completely skilled in English, problems

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may arise. The specialist company mentioned is based in the UK, but that does not mean that its call centres are.

Another potential problem is quality. Jellaby’s existing call centre staff are, presumably, well trained to handle insurance queries and claims. Jellaby would need some assurance that the outsourced operator is equally experienced in dealing with insurance-related matters. If the quality of service deteriorates as a result of this move, it could have a serious adverse impact on Jellaby’s business.

Presumably, Jellaby has spare capacity on hand so that increases in call volumes can be dealt with successfully. Jellaby’s directors would need assurances about the ability of the outsourced operator to handle sudden increases in volume of calls.

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Solutions to Case Study Questions a) In calculating contribution as the basis for deciding on whether or not to accept an order, Vinnie’s general approach to the business problem is fine, in principle.

Because the business does not have costing systems it has obviously been difficult for him to establish totals for variable and fixed costs. In consequence, he has had to use estimates, and, of course, these may be quite inaccurate. His basic conclusion, that there will be a positive contribution to fixed overheads from the Jay Johnson contract, appears to be supported by the calculations.

b) The figures show that the business is certainly profitable, but not very profitable.

Net profit as a percentage of sales is only about 6 per cent. Also, the margin of safety at current level of sales appears small. It is possible to calculate an estimated margin of safety based on Vinnie’s figures.

Break-even point in units = =

=

Fixed costs Contribution per unit £591,400 650 910 (to nearest unit).

Actual sales in 20X7 were 1,030 ranges, a margin of safety of 120 units, or 11.7 per cent of actual sales.

Arthur and Vinnie should perhaps be looking at the overall profitability of the business as well as thinking about negotiating special prices on contracts. It may be that costs are not very well controlled. Costs are perhaps higher because of inefficiencies in the production process. Vinnie mentioned the very high cost of heating, and if the factory building is of a poor standard there may be other high costs in maintenance, cleaning and insurance.

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c) Although A & A Wright is, clearly, a profitable business, it appears to be facing several problems. Arthur plans to have Vinnie take over the business, but he is not finding it easy to let Vinnie have any say in running it. Arthur is probably going to find it harder than he anticipated to let his son take over completely. In family businesses like this one, relationship problems can create major obstacles to the smooth running of the business. The case study describes a classic succession problem; the father unwilling to admit that his son may be right, and the son equally reluctant to allow that his father might just know a thing or two about running a business.

Is Vinnie correct? If we try to decode what Vinnie is saying, it is actually about a great deal more than the acceptance or non-acceptance of the contract; the subtext is one of impatience with his father’s approach to running the business. Vinnie wants to introduce a more systematic approach to management, using accounting figures to help make business decisions. He also sees, as perhaps his father cannot, that the factory itself has become a liability. Because he has a Business Studies’ education he feels, rightly, that he knows a great deal and is capable of generating good ideas. What he obviously lacks is the experience of making real business decisions.

What about Arthur’s view? Arthur is impatient with Vinnie’s use of figures as an aid to decision making. He dismisses the notion of ‘positive contribution to fixed overheads’ with contempt. However, he does have a point: there are other factors apart from the figures to consider. If the business sells at such a large discount what impact will there be on other sales? If Leonard of Leonard’s Kitchens discovers that Jay Johnson, a new customer, is getting a £250 discount, he will no doubt feel entitled to object to receiving a £30 discount. Accepting this contract may mean a general drop in the selling prices that A & A Wright can command.

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Where do Arthur and Vinnie go from here? They have some major problems to tackle, none of which can be solved unless they can find some way of working harmoniously together. One approach would be to take some advice to help them build a strategy for the business that they can both agree on, perhaps by employing the services of a management consultant (but imagine what Arthur would say about that suggestion!). If they do not employ outside help, they will have to solve the problems themselves. However, their relationship appears to be deteriorating fast, and they may find themselves unable to resolve the problems on their own.

d) If the order from Jay Johnson was accepted, and led to a general fall in selling prices to £1,050 per range, what would be the effect on the business? Contribution would fall to approximately £420 per range, and the break-even point would become higher. We can estimate a new break-even point based upon lower contribution: Break-even point in units

=

£591,400 420

=

1,408 units (to nearest whole unit).

This level of sales is clearly impossible under current circumstances; even if 1,408 sales could be sold in theory, the factory capacity at 100 units per month is a limiting factor. If the order were accepted, and if it led to a general fall in prices, the business could be in serious trouble, and might even go under.

Note: The case study illustrates the following points about decision making: •

Calculations of break-even, contribution and so on, can be very useful in providing input to business decisions.

•

There are always other factors to consider. The correct decision may seem obvious on paper, but matters are rarely so clear in practice.

•

Making business decisions is really difficult, especially where human factors play a major role (and that is often the case).

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INSTRUCTOR’S MANUAL Chapter 15: Capital investment decisions

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter provides a comprehensive introduction to capital investment appraisal.

After a brief discussion of such topics as capital budgeting and capital rationing, the bulk of the chapter is concerned with explaining the calculation of four investment For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

1

appraisal techniques: accounting rate of return, payback, net present value and internal rate of return. The calculations are all explained by reference to a common example. The principles and calculation involved in compounding and discounting are thoroughly explained. Towards the end of the chapter, the strengths and weaknesses of the four techniques are discussed.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: •

Understand the need for control over capital investment decision making.

•

Understand and be able to apply two simple methods of capital investment appraisal: payback and accounting rate of return.

•

Understand the time value of money.

•

Understand and be able to apply more complex methods of capital investment appraisal: net present value and internal rate of return.

Understand some of the limitations of capital investment appraisal

•

techniques.

Notes on PowerPoint slides The number of slides for this chapter is relatively large. You can save time by explaining the calculations for machine A only.

Slide 1

Chapter title

Slide 2

Learning outcomes (the suggested video below could be run after this)

Slide 3

Introduction

Slide 4

Capital investment in context

Slide 5

Capital rationing

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Slide 6

Capital investment appraisal in practice: Identifies the four approaches that will be covered in the lecture.

Slides 7 and 8

Example 15.2 (Proctor Hedges Limited): Example 15.2 includes quite a lot of detail. These two slides contain the basic numbers only.

Slide 9

Accounting rate of return: Sets out the formula.

Slides 10 and 11

Calculating average expected return (accounting profit): Slide 10 makes the required adjustment for depreciation. Slide 11 calculates average profit for each of the two machines.

Slide 12

Calculating average capital employed

Slide 13

Accounting rate of return: The calculation for Machines A and B based on Slides 10 and 11.

Slides 14 and 15

Payback: Slide 14 sets out cash flow and cumulative cash flow for machine A. Payback is reached somewhere between years 2 and 3. Slide 14 shows the calculation to the nearest whole month. Slide 15 repeats the calculations for machine B. Where time is short slide 15 could be dispensed with, as the method has already been demonstrated.

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Slides 16 and 17

The time value of money: The application of the discount factor formula is briefly explained. Students may find it helpful if they have already read through the compounding and discounting section in the chapter.

Slides 18 and 19

Net present value: The net present value calculations for A and B are set out. Slide 19 could be dispensed with where time is short.

Slide 20

Internal rate of return

Slide 21

Choosing between projects: This demonstrates that the four methods may not give consistent results. In this case the inconsistent result is supplied by the NPV calculations, but students should note that the NPVs are very similar.

Slides 22 to 25

Strengths and weaknesses of the four investment appraisal techniques covered in the chapter

Slide 26

Summary

Video The suggested video for this session is ‘Capex vs Opex: what’s the difference?’ by Simplicity Consultancy. The video runs to 6.5 minutes and could be included straight after the learning outcomes in Slide 2. www.youtube.com/watch?v=dLyKfxkkA1s

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Case studies There are three case studies available on the book's website:

Case Study 1, Lawson Pollard, examines some of the dysfunctional behavioural effects that could arising in conditions of capital rationing.

Case Study 2, Ortega Ruiz, examines competing approaches to capital investment decision making. Both cases involve calculations.

Case Study 3 is a brief study to test understanding of a document produced by The King’s Fund, summarizing the UK’s Department of Health and Social Care capital budget.

Exercises There are seventeen end-of-chapter exercises. Students can test their knowledge of the chapter using the ten multiple-choice questions on the student section of the website. Also available in that section are four further long questions with suggested solutions. The lecturer-only section of the website contains a further five long questions with suggested solutions.

Excel exercise Exercise 15.9 (Outhwaite Benson Ltd) is available as an Excel file.

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Answers to Lecturers’ End-of-Chapter Exercises 15.10 Montfort Spelling plc i) ARR calculations Average expected return (accounting profit) Average capital employed

× 100 = ARR%

Depreciation calculations (in £000): Broughton Town:

630 − 35 5

= £119 per year

Carey City:

540 − 30 5

= £102 per year

Accounting profit calculations: Broughton Town

Carey City

Year

£000

£000

1

250 – 119 = 131

242 – 102 = 140

2

275 – 119 = 156

250 – 102 = 148

3

280 – 119 = 161

260 – 102 = 158

4

295 – 119 = 176

270 – 102 = 168

5

310 – 119 = 191

280 – 102 = 178

Total profit

815

792

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The average profit per year generated is: Broughton Town: £815,000 5

=

£163,000

=

£158,400

Carey City: £792,000 5

Average capital employed calculations: Time

Broughton Town

Carey City

£000

£000

0

630

540

5

35

30

Average

630 + 35 = 332.5 2

540 + 30 = 285 2

Broughton Town: ARR = £163,000 332,500

× 100 = 49.0%

Carey City: ARR = £158,400 285,000

× 100 = 55.6%

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ii) Payback period Broughton Town:

Time

Cash flow

Cumulative cash flow

£000

£000

0

(630)

(630)

1

250

(380)

2

275

(105)

3

280

175

4

295

470

5

310

780

5 (sale of assets)

35

815

Cumulative cash flow reaches the zero position sometime during the third year.

Payback to the nearest month is: 2 years + (105/280 × 12 months) = 2 years and 4 months (to nearest whole month).

Carey City: Time

Cash flow

Cumulative cash flow

£000

£000

0

(540)

(540)

1

242

(298)

2

250

(48)

3

260

212

4

270

482

5

280

762

5 (sale of assets)

30

792

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Cumulative cash flow reaches the zero position sometime during the third year.

Payback to the nearest month is: 2 years + (48/260 × 12 months) = 2 years and 2 months (to nearest whole month).

iii) The Carey City projections produce a higher ARR and a shorter payback period, and so this project looks like the more acceptable. However, there may be many other factors to be taken into account in reaching a decision.

15.11 The compounding factor for an investment over 6 years at 8 per cent per year is:

(1.08)6 = (1.08) × (1.08) × (1.08) × (1.08) × (1.08) × (1.08) = 1.587.

The correct answer is a).

15.12 The compounding factor is: (1.17)6 = 2.565 2.565 × £1,900 = £4,874 (to the nearest £).

The correct answer is c).

15.13 The discounting factor is:

1 = 0.419 5 (1.19) The correct answer is a).

15.14 The correct discount factor (from tables) is: 0.592.

PV of £85,000 receivable at the end of year 4, assuming a constant discount rate of 14 per cent is: £85,000 × 0.592 = £50,320

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The correct answer is a).

15.15 Nuria Collezione Limited

i) In year 1 estimated sales are 6,000 waistcoats.

5,000 will produce net cash inflows of £4 per unit

20,000

1,000 will produce net cash inflows of £3 per unit

3,000 23,000

In year 2 estimated sales of 2,000 waistcoats will produce net cash inflows of £3 per unit = £6,000.

Time

Cash flow

Discount factor

Discounted cash

(from table)

flow

£

£

0

(28,000)

1

(28,000)

1

23,000

0.885

20,355

2

6,000

0.783

4,698

2 (sale of machine)

10,000

0.783

7,830

TOTAL

4,883

ii) Estimated sales in year 1: 5,000 waistcoats producing net cash inflows of £4 each = £20,000.

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Time

Cash flow

Discount factor

Discounted cash

(from table)

flow

£

£

0

(28,000)

1

(28,000)

1

20,000

0.885

17,700

1 (sale of machine)

13,000

0.885

11,505

TOTAL

1,205

15.16 i) NPV at 8 per cent cost of capital: Time

Cash flow

Discount factor

Discounted cash

(from table)

flow

£

£

0

(1,650,000)

1

(1,650,000)

1

480,000

0.926

444,480

2

450,000

0.857

385,650

3

390,000

0.794

309,660

4

360,000

0.735

264,600

5

450,000

0.681

306,450 60,840

ii) IRR =9.43%

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15.17 Oppenheim Orgreave Limited i) Option 1 Time

Cash flow

0

£ (76,000)

1

Discount factor (from table)

Discounted cash flow

1

£ (76,000)

(82,000) + 113,000 = 31,000

0.893

27,683

2

(82,000) + 113,000 = 31,000

0.797

24,707

3

(82,000) + 113,000 = 31,000

0.712

22,072

4

(82,000) + 113,000 = 31,000

0.636

19,716

5

(82,000) + 113,000 + 9,000 = 40,000

0.567

22,680 40,858

Option 2 Time

Cash flow

0

£ 0

1

Discount factor (from table)

Discounted cash flow

1

£ 0

(105,000) + 113,000 = 8,000

0.893

7,144

2

(105,000) + 113,000 = 8,000

0.797

6,376

3

(105,000) + 113,000 = 8,000

0.712

5,696

4

(105,000) + 113,000 = 8,000

0.636

5,088

5

(105,000) + 113,000 = 8,000

0.567

4,536 28,840

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Option 3 Time

Cash flow

0

£ 0

1

Discount factor (from table)

Discounted cash flow

1

£ 0

(30,000) + (77,000) +113,000 = 6,000

0.893

5,358

2

(30,000) + (77,000) +113,000 = 6,000

0.797

4,782

3

(30,000) + (77,000) +113,000 = 6,000

0.712

4,272

4

(30,000) + (77,000) +113,000 = 6,000

0.636

3,816

5

(30,000) + (77,000) +113,000 = 6,000

0.567

3,402 21,630

ii) It seems that the directors will have to accept one of these options because the poor existing service is damaging sales and the company’s reputation.

The highest NPV is offered by option 1. This option would ensure that the company had complete control over the vehicles and drivers, and so it would be completely responsible for the quality of the service. However, this would be an advantage only if the company were able to ensure that the service was, in fact, of high quality.

Much would depend upon the quality of the vehicle booking systems, the attitudes of the drivers and whether managers would be able to supervise the system properly. It might be argued that the business of the company is to sell furniture, not to run a delivery service. Managers might be inclined to see the provision of delivery as a nuisance.

Option 2 offers the next highest NPV. This option would have the advantage of devolving much of the responsibility for deliveries onto a third party. However, it would also mean that if the haulier failed to deliver a good quality service, Oppenheim’s would continue to lose sales and reputation. The directors would have For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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to be sure that the haulier they selected would deliver a high-quality service. If they have any doubts on this aspect, they should probably control the delivery service in house.

Option 3 gives the lowest NPV. Although the costs of employment etc. are slightly lower under this option (£77,000 rather than £82,000 – presumably because some element such as maintenance or insurance is covered by the leasing company), leasing the vans costs more, overall, than purchasing them outright. Responsibility for running the service would rest with Oppenheim’s.

There does not seem to be any particular benefit to selecting option 3 over option 1.

The choice really lies between options 1 and 2. The choice the directors make will probably depend upon whether they consider that it is important to control all aspects of the delivery service in-house, or whether they would prefer to devolve that responsibility onto an outside contractor. The difference between the NPVs of options 1 and 2 is not very large, about £12,000 over 5 years, so the decision will probably be made based on other factors.

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Solutions to Case Study Questions

Case study 1 – Lawson Pollard a) NPV calculations

Year

Discount

Realistic

Discounted

Optimistic

Discounted

factors

cash flows -

cash flows -

(12%)

realistic

optimistic

£000

£000

£000

£000

0

1

(7,800)

(7,800)

(7,800)

(7,800)

1

0.893

1,380

1,232.34

1,680

1,500.24

2

0.797

1,470

1,171.59

1,770

1,410.69

3

0.712

1,530

1,089.36

1,860

1,324.32

4

0.636

1,590

1,011.24

1,950

1,240.20

5

0.567

1,650

935.55

2,040

1,156.68

6

0.507

1,710

866.97

2,130

1,079.91

7

0.452

1,770

800.04

2,220

1,003.44

8

0.404

1,830

739.32

2,310

933.24

9

0.361

1,890

682.29

2,400

866.40

10

0.322

1,950

627.90

2,490

801.78

10 (sale of

0.322

180

57.96

300

96.60

plant) Total

1,414.56

3,613.50

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Both the realistic and the optimistic projections produce a positive NPV. The realistic ratio of positive cash flows to initial investment is:

9,214.56 7,800

= 1.18

The optimistic ratio of positive cash flows to initial investment is: 11,413.50 7,800

= 1.46

The optimistic plan, naturally, produces a higher ratio than the realistic plan.

However, would it be high enough? If Donna produces a better proposal for the plastics division it is likely to be preferred.

b) The company’s approach to capital investment decisions is highly competitive and it places divisional managers under a lot of pressure. Ernie, the chief executive, encourages this approach on the grounds that it acts as an incentive to management teams. This argument does have some force, and indeed, the circumstances in the case demonstrate a positive strength of the approach - Doug has been goaded by fear of competition into genuinely considering ways to improve the management and operational effectiveness of his division. However, there are several weaknesses in the approach: •

It may mean that one or two divisions are starved of capital funding simply because their managers have poorer presentational skills.

•

It may encourage managers to exaggerate the figures in their bids in order to be able to compete with other divisions.

•

It has led to collusion between divisional managers in the past; this type of collusion may not be in the best overall interests of the company.

•

Senior management should really be looking at capital funding bids with a view to assessing the extent to which they address the strategic

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16

objectives of the business. The competitive bidding system may reward the best bids, but it has resulted in the cardboard division operating inefficiently with fully depreciated machinery and demoralized local management. Surely senior management did not intend this situation to develop?

c) Doug is proposing to put forward a bid for funding based upon quite unrealistic estimates of future performance. Where local managers are placed under a great deal of pressure, they may react by exaggerating performance, both present and future. This is a step on the road towards outright fraudulent reporting. At the very least, Doug’s proposal might be regarded as somewhat unethical. Doug, himself, would no doubt argue that he has been forced into this position because of senior management’s system of allocating capital funds. He might also argue that, in trying to secure funding for his division, he is ensuring that people keep their jobs (including himself, of course), and that ‘the end justifies the means’.

The approach to capital budgeting in this business is flawed. A system of competitive bidding has resulted in a senior manager in the business trying to subvert the process by projecting figures which are unrealistically optimistic. This cannot be in the best long-term interests of the company. Senior managers should be wary of instituting systems which encourage this type of behaviour.

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17

Case study 2 – Ortega Ruiz a) NPV calculations Gina Time

Cash flow

0

£ (340,000)

1

Discount factor (from table) 1

Discounted cash flow £ (340,000)

(15,000) + 85,000

0.901

63,070

2

85,000

0.812

69,020

3

85,000

0.731

62,135

4

85,000

0.659

56,015

5

85,000

0.594

50,490

5

50,000

0.594

29,700

Total

(9,570)

Gary Note that the expenses of travelling to visit machinery manufacturers are regarded as sunk costs for the purposes of capital investment appraisal. They are not, therefore, considered in the NPV and IRR calculations.

Time

Cash flow

0

£ (260,000)

1

1

Discounted cash flow £ (260,000)

60,000

0.901

54,060

2

80,000

0.812

64,960

3

80,000

0.731

58,480

4

80,000

0.659

52,720

5

80,000

0.594

47,520

5

20,000

0.594

11,880

Total

Discount factor (from table)

29,620

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18

b) IRR calculations Gina IRR is 9.7% Gary IRR is 14.9%

c) The directors clearly cannot agree on a set of criteria for capital spending decisions because they have quite different approaches to business decision making. Emilio prefers to work on instinct; his decisions are not informed by any consideration of detail. Gonzalo, on the other hand, prefers a more structured approach.

Emilio ‘feels’ that Gina’s entrepreneurial proposal should be accepted, but the figures do not bear this out. Using the company’s cost of capital of 11 per cent, the project produces a negative net present value. The IRR of the project is actually fairly close (at over 10 per cent) to the cost of capital, and it is possible that the directors might want to consider it further. Perhaps some market research on the potential market for chocolate bars with fillings could be undertaken.

Gary’s proposal produces a positive net present value and an IRR that is substantially in excess of the company’s cost of capital. Emilio’s reaction against this project seems to be based partly upon his perception of Gary’s management skills.

However, Gary took over the division only a couple of years ago, and it may be that problems with ageing machinery have had an adverse effect on the division’s profitability during that period. It may be unfair to blame Gary for a problem over which he has no control.

If the directors wish to retain the pastille-making operations, they will have to make the decision to replace the machinery sooner or later. Emilio thinks that the existing machinery has another couple of years of life in it, but perhaps it would be sensible to have the condition of the machinery assessed by an expert engineer. The For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

19

directors must decide on whether they intend to retain pastille making as a key part of the company’s operations. If so, it is likely to be in the best interests of the company overall to invest sooner rather than later.

Gonzalo is correct in maintaining that the two projects are not strictly comparable, and in his view that they should be examined in the context of the long-term strategic plan. His remarks suggest that such a plan actually exists, so the directors have presumably thought about some key issues relating to the development of the business.

The directors should try to reach agreement about the criteria for capital spending.

They probably need more detailed information in order to be able to assess the validity of capital expenditure proposals. At Emilio’s insistence, proposals for consideration by the directors are kept to a bare minimum. There are some merits in this approach; it forces managers to be concise and to concentrate on the really important facts. However, it means that the directors are not likely to be fully informed about the thinking behind the proposals. It is clear in this case that the directors need to thoroughly rethink their approach to capital investment decision making.

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Case Study 3 – NHS 1. Just under 6% 2. £2.2 billion 3. Some NHS buildings and equipment fell into increasing disrepair, with rising numbers of patients experience safety incidents caused by estate or infrastructure failures.

4. £11.3 billion

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21

INSTRUCTOR’S MANUAL Chapter 16: Budgets

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction This chapter provides a comprehensive introduction to budgeting. The introduction to the chapter refers back to the functions of management identified in Chapter 10 and the case study from that chapter is briefly revisited in order to illustrate the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

relationship between strategic objectives, long-range planning and the annual budget. The budget process is explained by reference to a manufacturing business example. The benefits conferred by effective budgeting are listed and briefly discussed, and then some of the behavioural problems associated with budgeting are explained. A long example provides a comprehensive illustration of the steps involved in setting various budgets (production, raw materials, cash and so on) for a manufacturing business. The chapter contains a spotlight study and a case study which examine various aspects of budgeting. Included in the case study is an illustration of the use of budgets for monitoring purposes.

Learning outcomes After reading the chapter, including the case studies and completing the related exercises, students should: •

Understand the role of budgeting in planning and controlling business organizations.

•

Know about the stages involved in setting a budget.

•

Be able to prepare straightforward budget statements.

•

Understand the issues involved in evaluating actual outcomes against budget plans.

•

Be able to discuss some of the behavioural and other issues involved in budgeting.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction, including a definition of the budget

Slide 4

The relationship between strategy and budget-

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setting Slides 5 and 6

Relationship with key strategic objectives: These slides use some of the information from Example 16.1 – the case study for Chapter 10, Calder Calloway Cards, revisited.

Slide 7

Principal types of budget: annual budget, rolling budget, incremental budgeting and ZBB

Slide 8

The budget process: Introduces idea of responsibility accounting.

Slide 9

Principal types of budget: This is Figure 16.1 in the chapter

Slide 10

The budget process: Example 16.2 (Arbus Arbuthnot plc) can be used to illustrate a six-stage budget process in a manufacturing organization.

Slides 11 to 20

Ten slides demonstrating the development of a budget. The example used is written specifically for the slides and is not in the chapter. Having worked through this example (Durka), students should be able to work through the more complex Example 16.3 (Macey Nelson).

The Durka example is based on a trading business and is therefore simpler. A handout is produced below these notes setting out the information from some of these slides.

Slide 21

Monitoring outcomes

Slide 22

Benefits of effective budgeting:as discussed in

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Section 16.6.1 of the chapter.

Some problems with budgeting – as discussed in Section 16.6.2 of the chapter.

Slide 23

A radical alternative – beyond budgeting – is briefly presented on this slide. Also refer to Example 16.5 and video material below.

Slide 24

Summary

PowerPoint example: Durka Durka is a sole trader, selling tyre pressure gauges to car spares suppliers. Planned sales in units for the next three months are: January 1,800 February 2,000 March 2,100

Durka’s opening statement of financial position at 1 January is as follows: £

£

ASSETS Non-current assets

10,000

Current assets Inventory

3,000

Trade receivables

4,000

Bank account

2,100 9,100

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19,100

CAPITAL AND LIABILITIES Capital

15,900

Current liabilities Payables for inventory

3,000

Payables for expenses

200 3,200 19,100

1. Trade receivables at each month end = 50 per cent of sales for that month 2. Inventory and payables for inventory at end March = 50 per cent of cost of sales for March 3. Payments for purchases of inventory: January – £6,300, February – £7,000, March – £7,350 4. Payables for expenses at each month end = £200 5. Selling price per unit = £5 6. Cost price per unit = 35 7. Expenses = £1,500 per month, including £100 of depreciation

Video The suggested video material is an introduction to Beyond Budgeting: www.youtube.com/watch?v=WdZg0yi_5kU

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The twelve principles are covered in twelve related videos which you could ask students to watch in their own time, or you may be able to incorporate some of this material into a seminar.

The introduction could be slotted in at the end of the lecture, after Slide 24.

Case studies Case Study 1, Pete, provides a test of students' understanding of budgeting. The scenario provides information about a planned small business start-up and requires students to produce a budget cash flow statement, budget statement of profit or loss for the first year of trading and a budget statement of financial position at the end of year one.

Case Study 2, Piers, covers some similar ground, but requires students to extract information from a conversation. The case study requirement is to prepare budget cash flow, statement of profit or loss and statement of financial position.

Exercises There are sixteen end-of-chapter exercises. Students can test their knowledge of the chapter using the ten multiple-choice questions available on the student section of the website. Also available in that section are three longer questions with suggested solutions, including a comprehensive question requiring preparation of budget statement of profit or loss, cash flow and statement of financial position, plus a spreadsheet question. The lecturer-only section of the site includes a further five longer questions with suggested solutions. One of these is a comprehensive question requiring preparation of budget statement of profit or loss, cash flow and statement of financial position.

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Excel exercises Exercises 16.6 and 16.7 (Skippy) are available in Excel format.

Student exercise 1 (Harris Leader Ltd) is available in Excel format.

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Answers to Lecturers’ End-of-Chapter Exercises 16.9 Budgeting: some potential problems

The budget may not have the beneficial effects expected by senior management if the budget process is mishandled.

Ideally, budgets should motivate staff to produce better performance. However, if the process is authoritarian and is seen to comprise a set of targets handed down from on high, middle managers and other staff may feel resentful, and that senior management does not understand the business activity, resource constraints and so on. If the budget sets unrealistic targets staff are likely to become demotivated and disinclined to even try to achieve the outcomes sought by senior management.

A related problem occurs where blame for failing to achieve an outcome is incorrectly attributed. This is likely to lead to quite justified resentment on the part of staff and further demotivation.

The effects described above can be avoided to some extent by involving staff in the creation of budgets. However, there are dangers in this approach too. Where staff have close involvement, they may try to set themselves easy targets by building in ‘slack’ in the targets. This approach clearly would not work in the long-term interests of the organization.

The budget process should not take too much for granted. Sometimes an incremental approach is adopted, for example, taking last year’s budget and adding on 5 per cent. This is an easy way of setting the budget but it is not likely to encourage the best efforts and results. A related problem arises where managers feel that, in order to ensure the highest possible expenditure allowance for the coming year, they have to spend absolutely all of the current year’s allowance,

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whether or not the expenditure is strictly justified in the best interests of the organization.

All of the adverse effects described are essentially issues related to human behaviour. A budget cannot simply be regarded as a set of figures in isolation; it has profound implications for the way human beings act within the organization.

16.10 Hildebrandt St. Martins Limited.

First, we need to work out the budget production of finished goods for December 20X4: Units Opening inventory of finished goods

12,360

Production (balancing figure)

10,465

Transfers out of inventory (sales)

(9,350)

Closing inventory of finished goods

13,475

Then, we can work out the raw materials purchase requirements: £ Opening inventory of raw

18,000kg × £3

54,000

material Purchases (balancing

56,790

figure) Transfer to production

10,465 (above) × 2kg × £3

(62,790)

Closing inventory of raw

16,000kg × £3

48,000

material

The correct answer is a).

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16.11 Colney Brighouse Limited

Production budget – tables: Opening

Production –

Transfers out

Closing inventory –

inventory –

units –

of production

units

units

balancing

(for sales) –

figure

units

January

7,500

13,000

(13,000)

50% × 15,000 = 7,500

February

7,500

15,500

(15,000)

50% × 16,000 = 8,000

March

8,000

17,000

(16,000)

50% × 18,000 = 9,000

Opening

Production –

Transfers out

Closing inventory –

inventory –

units –

of production

units

units

balancing

(for sales) –

figure

units

Production budget – chairs:

January

19,000

24,500

(28,000)

50% × 31,000 = 15,500

February

15,500

33,000

(31,000)

50% × 35,000 = 17,500

March

17,500

35,500

(35,000)

50% × 36,000 = 18,000

16.12 Corby Thirlwell Limited i) Two advantages of the system of rolling budgeting •

Annual budgeting requires a very significant input of management time in one sustained exercise. A rolling budget system involves adding one additional month to the budget at a time, which means that the work involved in budgeting is spread evenly over the year.

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• A rolling budget system allows management to respond in a timely fashion to changes that will, for example, affect demand for the company’s product. ii) Budget statement of profit or loss for the month of June 20X7 £ Sales Cost of sales ( = production cost)

3,250 × £65

211,250

3,250 × £44.43

(144,398)

Gross profit

66,852

Administrative overheads

(12,479)

Selling and distribution overheads

(10,220)

Sales commission

3,250 × £1.50

Net profit

(4,875)

39,278

16.13 Participative approach to budgeting

Participation in the budget setting process by staff at varying levels of an organization has the following advantages: •

If staff feel that they have had a say in setting the budget, they are more likely to consider that they are an integral part of the budget process, and thus are more likely to work towards meeting it.

•

Staff at lower levels of the organization may be able to see problems and constraints that are not visible to more senior managers. They may be able to signal the problems in advance so that they can be dealt with before a budget is finalized.

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However, there are drawbacks to participation: •

The more people who participate the more cumbersome the budget setting process is likely to be. It is important not to deflect attention from the day to day running of the business in favour of an activity like budget setting.

•

If the participative effort is no more than paying lip service to the idea of participation by senior management, more junior staff are likely to become disillusioned with the process very quickly. A pseudo-participative budget may be counterproductive and may lead to resistance and lack of cooperation on the part of staff in meeting budget targets.

•

More junior managers may be motivated, especially where pay and bonuses are dependent upon performance, to use the participative process to set themselves easy targets.

16.14 Roxanne Sales receipts in January 20X9 will be as follows: £ 40% × January sales: 40% × £28,000

11,200

40% × December sales: 40% × £30,000

12,000

20% × November sales: 20% × £28,000

5,600 28,800

The correct answer is a).

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16.15 Silas Working 1 – cash receipts Each month cash received comprises 75 per cent of current month sales (made for cash) plus 25 per cent of the previous month’s sales (made on credit). Budgeted receipts are therefore:

Month

75% of current month’s sales

25% of previous month’s sales

Total

£

£

£

April

1,125

–

1,125

May

3,375

375

3,750

June

6,188

1,125

7,313

July

6,750

2,062

8,812

August

9,000

2,250

11,250

September

9,000

3,000

12,000

October

9,000

3,000

12,000

November

7,875

3,000

10,875

December

9,000

2,625

11,625

January

5,625

3,000

8,625

February

6,750

1,875

8,625

March

7,875

2,250

10,125 106,125

At the end of March 25 per cent of March’s sales are still to be paid for: 10,500 × 25% = £2,625. This amount will be included in trade receivables in the year end budgeted statement of financial position.

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Working 2 – purchases There are no payments for purchases in the first month. At the end of March, March’s purchases are still to be paid for, and the full amount (£6,000) will be included as a creditor in the year end budgeted statement of financial position.

Working 3 – depreciation Computer: £2,500 × 25% = £625 Till and fixtures and fittings: (£3,500 + 1,000) × 10% = £450

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i) Silas: budgeted cash flow forecast for the year ending 31 March Month

Receipts (working 1)

April

May

June

July

Aug

Sept

Oct

Nov

Dec

Jan

Feb

Mar

Total

£

£

£

£

£

£

£

£

£

£

£

£

1,125

3,750

7,313

8,812 11,250 12,000 12,000 10,875 11,625

8,625

8,625 10,125

106,125

0

2,250

3,750

6,750

6,375

6,375

67,125

Payments Purchases Rent

1,500

Insurance

1,200

Wages

Drawings

6,750

6,750

5,625

1,500

6,000 1,200

150

150

150

750

150

600 750

1,500

Subscriptions Sundry admin

7,500 1,500

150

Water rates

7,500

1,500

Phone

Business rates

7,500

1,500 150

150

150

150

150

150

150

150

150

150

150

150

150

1,800 300

200

200

200

200

200

200

200

200

200

200

200

200

2,400

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

12,000

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Total payments

5,550

4,500

5,250

9,600

8,850

9,000 10,350

8,250

Opening balance

6,000

1,575

825

2,888

2,100

4,500

9,150 11,775 15,150 14,550 15,450

Add: receipts

1,125

3,750

7,313

Less: payments

(5,550) (4,500) (5,250) (9,600) (8,850) (9,000) (10,350) (8,250) (8,250) (9,225) (7,725) (7,125)

Closing balance

1,575

825

2,888

7,500

8,250

8,812 11,250 12,000 12,000 10,875 11,625

2,100

4,500

7,500

9,225

8,625

7,725

7,125

8,625 10,125

9,150 11,775 15,150 14,550 15,450 18,450

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93,675

ii) Silas: budgeted statement of profit or loss for the year ending 31 March £

£

Revenue

108,750

Less: cost of sales Opening inventory

42,000

Add: purchases

73,125 115,125

Less: closing inventory

(42,045) 73,080

Gross profit

35,670

Expenses: Rent

6,000

Insurance

1,200

Phone

600

Water rates

750

Business rates

1,500

Wages

1,800

Subscriptions

300

Sundry admin and other expenses

2,400

Depreciation: computer (working 3)

625

Depreciation: fixtures & till (working 3)

450 (15,625)

Net profit

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20,045

iii) Silas: budgeted statement of financial position at 31 March £

£

ASSETS Computer at cost

2,500

Less: accumulated depreciation

(625) 1,875

Fixtures and fittings, and till

4,500

Less: accumulated depreciation

(450) 4,050 5,925

Inventory

42,045

Trade receivables (working 1)

2,625

Cash at bank

18,450 63,120 69,045

EQUITY AND LIABILITIES Capital introduced

55,000

Profit for the year

20,045

Less: drawings

(12,000) 63,045

Current liabilities: trade payables (working 2)

6,000 69,045

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16.16 i) If trade receivables take two months, not one, to be settled, the estimated cash at bank balance at the end of March drops to £16,200 from £18,450 (the difference of £2,250 is 25 per cent of the estimated February sales of £9,000). The bank account is not budgeted to be overdrawn at any point during the year, although the balance at the end of July drops to £38. ii) If admin expenses double to £400, the estimated cash at bank balance at the end of March drops to £16,050 from £18,450 (the difference of £2,400 is the additional £200 per month in expenses, multiplied by 12 months). No overdraft results. iii) If both the change to trade receivables collection and to admin expenses take place, the estimated cash at bank balance at the end of March drops to £13,800, and an overdraft of £763 appears at the end of July.

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Solutions to Case Study Questions Case Study 1 – Pete 1) Working Sales receipts can be estimated as follows from the information given in notes 1 and 2: Month

Calculation

£

1

55 customers per day for 26 days × £4.50 average spend

6,435

2

55 customers per day for 26 days × £4.50 average spend

6,435

3

55 customers per day for 26 days × £4.50 average spend

6,435

4

60 customers per day for 26 days × £4.50 average spend

7,020

5

60 customers per day for 26 days × £4.50 average spend

7,020

6 - 12

65 customers per day for 26 days × £4.50 average spend

7,605

Cost of sales is, in each case, estimated at 28 per cent of sales revenue (if gross profit percentage is 72 per cent, cost of sales percentage is therefore 28 per cent).

From this, and the information and assumptions given, it is now possible to prepare the cash flow forecast and the budget statement of profit or loss and statement of financial position (on the following page).

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Pete: cash flow forecast for first year of trading Month

Receipts (sales)

1

2

3

4

5

6

7

8

9

10

11

12

Total

£

£

£

£

£

£

£

£

£

£

£

£

6,435

6,435

6,435

7,020

7,020

7,605

7,605

7,605

7,605

7,605

7,605

7,605

86,580

1,802

1,802

1,802

1,966

1,966

2,129

2,129

2,129

2,129

2,129

2,129

2,129

24,241

Payments Cost of sales (28% x sales) Legal fees

3,000

3,000

Launch party

2,300

–

–

–

–

–

–

–

–

–

–

–

2,300

Advertising

1,000

–

400

–

–

200

–

–

–

–

–

–

1,600

Wages

233

233

234

233

233

234

233

233

234

233

233

234

2,800

Rental

5,000

–

–

5,000

–

–

5,000

–

–

5,000

–

–

20,000

Business rates

2,600

2,600

Water rates

72

72

71

72

72

71

72

72

71

72

72

71

860

Power, heat, light

–

–

400

–

–

400

–

–

400

–

–

400

1,600

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Phone charges

–

–

200

–

–

200

–

–

200

–

–

200

800

500

–

–

–

–

–

–

–

–

–

–

–

500

–

–

–

–

600

–

–

–

–

–

–

600

1,200

Drawings

2,000

2,000

2,000

2,000

2,000

2,000

2,000

2,000

2,000

2,000

2,000

2,000

24,000

Total payments

15,907

4,107

7,707

9,271

4,871

5,234

9,434

4,434

5,034

9,434

4,434

5,634

85,501

Opening balance

5,000 (4,472) (2,144) (3,416) (5,667) (3,518) (1,147) (2,976)

195

2,766

937

4,108

Add: receipts

6,435

7,605

7,605

7,605

7,605

Insurance Accountant’s fees

6,435

6,435

7,020

7,020

7,605

7,605

7,605

Less: payments

(15,907) (4,107) (7,707) (9,271) (4,871) (5,234) (9 434) (4,434) (5,034) (9,434) (4,434) (5,634)

Closing balance

(4,472) (2 144) (3,416) (5,667) (3,518) (1,147) (2 976)

195

2,766

937

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4,108

6,079

Pete: Budget statement of profit or loss for first 12 months of trading

£ Sales

86,580

Less: cost of sales

(24,241)

Gross profit

62,339

Expenses (excluding depreciation)

(37,260)

Depreciation: £13,000/5

(2,600)

Net profit

22,479

Pete: Budget statement of financial position at the end of year 1 £ ASSETS Non-current assets at cost

13,000

Less: accumulated depreciation

(2,600)

Non-current assets at carrying amount

10,400

Cash at bank

6,079 16,479

CAPITAL AND LIABILITIES Capital at beginning of year

15,000

Add: profit for the year

22,479 37,479

Less: drawings

24,000 13,479

Liabilities Loan: Dave

3,000 16,479

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2) The bottom line of the cash flow statement shows us the maximum amount that Pete would need to borrow. The largest negative figure occurs in month 5 – £5,667.

However, it is possible that revenue will be less than expected and/or expenses will be higher, in which case the maximum negative figure could be substantially worse.

It would be sensible to look at 'what if' scenarios, identifying the worst likely figures in each category of income and expense in order to identify the maximum borrowing required.

Even if the estimates turn out to be accurate, the business will have increased its cash resource by only a little over £1,000 in the first year of business. There are some non-recurring set-up costs, like the legal expenses in month 1, but much of the expenditure is recurring and so future years' profits and net cash inflow may not improve by very much. Pete's budget profit for the year is £22,479, but he will have drawn more than that (£24,000) out of the business. It is worth bearing in mind, too, that in real life Pete would have to save enough cash to pay income tax on the profits of the business.

Pete's prospects of success depend upon how he defines 'success'. His business is budgeted to produce both a positive cash inflow and a net profit in its first year, which might well be regarded as a success. However, he is taking on a lot of risk in starting a new business venture, and it may be that the return does not justify the risk involved.

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Case Study 2 – Piers 1) Piers – cash flow forecast for six months ending 30 September: April

May

June

July

August

Sept

£

£

£

£

£

£

2,500

Receipts Weddings

–

3,000

2,500

2,500

2,500

Corporate events

–

–

–

6,000

6,000

–

3,000

2,500

8,500

8,500

2,500

Payments Marquee

28,000

Furniture

8,000

Advertising

1,000

Stationery etc.

400

Labour (working 1)

–

400

2,000

2,000

400

400

Truck hire (working 1)

–

550

2,750

2,750

550

550

37,400

950

4,750

4,750

950

950

40,000

2,600

4,650

2,400

6,150

13,700

Receipts

–

3,000

2,500

8,500

8,500

2,500

Payments

(37,400)

(950)

(4,750)

(4,750)

(950)

(950)

2,600

4,650

2,400

6,150

13,700

15,250

Opening balance

Closing balance

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Working 1: payments for labour and truck hire It is assumed that labour and truck hire must be paid for immediately. The following number of events are scheduled to take place: •

May – 1 wedding. £400 for labour and £550 for truck hire

•

June – 1 wedding + 4 evening events = 5 events in all. Each event costs £400 in labour (total £2,000) and £550 for truck hire (total £2,750)

•

July – 1 wedding + 4 evening events = 5 events in all. Total for labour and truck hire is the same as for June

•

August – 1 wedding. £450 for labour and £550 for truck hire

•

September – 1 wedding. £450 for labour and £550 for truck hire

2) Piers – Budget statement of profit or loss for six months ending 30 September £

£

Sales (3,000 + 2,500 + 8,500 + 8,500 + 2,500)

25,000

Expenses Advertising

1,000

Labour (400 + 2,000 + 2,000 + 400 + 400)

5,200

Truck hire (550 + 2,750 + 2,750 + 550 + 550)

7,150

Stationery

400

Depreciation – marquee (working 1)

3,000

Depreciation – furniture (working 2)

1,000 17,750

Net profit

7,250

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Working 1 Depreciation of marquee: Depreciable amount = cost – residual value = £28,000 – 4,000 = £24,000 Over four years on the straight-line basis: £24,000/4 = £6,000 per year. For six months the charge is £3,000.

Working 2 Depreciation of furniture: Depreciable amount = £8,000 (Piers estimates no residual value) Over four years on the straight-line basis: £8,000/4 = £2,000 per year. For six months the charge is £1,000.

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Piers – Budget statement of financial position at 30 September £

£

ASSETS Non-current assets Marquee at cost

28,000

Less: accumulated depreciation

(3,000)

Net book value

25,000

Furniture at cost

8,000

Less: accumulated depreciation

(1,000) 7,000

Non-current assets at carrying amount

32,000

CURRENT ASSETS Cash at bank

15,250 47,250

CAPITAL Capital introduced

40,000

Profit

7,250 47,250

3) Other expenses Piers has assumed that his parents will store the marquee at their home, free of charge, and that they will let him use their phone for business purposes. Piers’ parents will, presumably, want him to make other arrangements in the longer term.

Therefore, in order to assess the viability of the business, he should take reasonable storage and telephone expenses into account, even if he will not have to pay them immediately.

He has made no allowance for insurance. If one of his workers has an accident while putting up or taking down the marquee, Piers could be personally liable and the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

uninsured loss is potentially very large. If the marquee collapsed on the wedding guests, the liability could be even greater. Piers must recognize the need to insure his business against this type of risk.

Piers is proposing to ignore ‘all that tax nonsense’. This is extremely unwise. He should make proper arrangements to deduct income tax from his employees’ wages and to account fully for National Insurance obligations. In all probability, he will need to employ an accountant to help with this aspect of the business, and to make sure that adequate records are kept for income tax, and possibly VAT, purposes.

The budget statement of profit or loss and statement of financial position take six months’ depreciation into account. However, Piers’ business is likely to be highly seasonal in nature (who wants to hire a marquee for a January wedding in the UK?).

The six-month period between April and September is likely to be his busiest period, and he may get no other business outside these months. If that is likely to be the case, he should perhaps consider a full year’s depreciation in the draft accounts. If he were to do this, his budget profit would fall by £4,000 (£3,000 for the marquee and £1,000 for the furniture).

4) The budget statement of profit or loss shows a profit of £7,250 for the six-month period. This represents a profit margin of 29 per cent, which might be considered quite a good return. However, once the seasonal nature of the business is considered, plus the other expenses in c) that Piers has not yet considered, the business proposition looks less promising. If a reasonable allowance were to be made for the expenses in c), Piers might find that his budget profit is an extremely small figure (and indeed, it may even turn into a loss). In order to plan the business properly he needs to consider the full range of costs. Only then will he be able to assess whether the proposition is viable. If he can significantly increase the volume

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of business that he does over the summer months (for example, one or more weddings each week), then the proposition could be profitable.

At the moment, Piers has not spent enough time thinking through the financial implications and taking into account all the relevant costs.

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INSTRUCTOR’S MANUAL Chapter 17: Accounting for control

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Question (the case study is on the website)

Teaching Notes Introduction This chapter introduces standard costing. Responsibility accounting is described, and the processes involved in establishing standard costs are briefly covered. Most of the chapter is taken up with describing the calculation of variances. Price and volume variances are demonstrated for sales, materials and labour. Overhead For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

1

variances are covered in outline only in this chapter, as it is felt that the more detailed analysis of overhead variances is beyond the scope of the book.

Non-specialist students may experience difficulty in understanding budget flexing.

Also, the variance calculations themselves often cause some confusion. In order to make the chapter as easily comprehensible as possible, a reconciliation is provided for the principal examples in the form of a standard cost operating statement.

Towards the end of the chapter typical explanations for the occurrence of variances are listed and discussed.

Learning outcomes After reading the chapter, including the case studies, and completing the related exercises, students should: •

Know about a classification of control mechanisms within organizations.

•

Know about some of the problems of control in firms.

•

Understand the use of a standard costing system in a manufacturing environment.

•

Be able to compare actual results against flexed budgets.

•

Understand and be able to analyze some of the possible reasons for variances that emerge from the comparison of actual with standard costs.

Understand the pros and cons of standard costing systems.

•

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes (slightly abbreviated).

Slide 3

Introduction

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Slide 4

Identifying and attributing variances: This slide provides straightforward explanations of the terms favourable and adverse in relation to variances. It is related to Section 17.1 of the chapter and introduces the idea of responsibility accounting.

Slides 5

Standard costing: This slide describes, in outline, what is involved in a standard costing system (refer to video suggestion below).

Slides 6 to 8

Example 17.2: These slides show the salient details from the Zamboni & Zeuss example in the chapter.

Slide 9

Flexing the budget: Slide 9 shows the flexed budget. Production and selling overheads are assumed not to vary with changes in selling volume so only simple price variances occur. A later example in the chapter covers fixed and variable overhead variances in a little more detail.

Slides 10 to 16

Variance calculations for: • Sales profit volume variance • Sales price variance • Direct materials price variance • Direct materials quantity variance • Direct labour rate variance • Direct labour efficiency variance • Production overhead variance • Selling and administrative overhead variance

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3

All calculations are as shown in the chapter.

Slide 17

Standard cost operating statement: The reconciliation in the statement between original budgeted net profit and actual net profit should help students to appreciate how the variances fit together.

The statement is exactly as shown in the chapter.

Slide 18

Investigating the reasons for variances: Two possible criteria are listed.

Slide 19

Principal reasons for the occurrence of variances: Three examples are given, but there are many more in the chapter.

Slide 20

Standard costing: issues and problems – presented in outline here.

Slide 21

Summary

Video The suggested video examines standard cost setting and would fit in immediately after Slide 5: www.youtube.com/watch?v=MngSBslv6Fc The video is a little over 4 minutes long, so it should be feasible to include in most presentations.

Case study The case study for the chapter, Francis and Follett Limited, is split into two parts.

The first part’s requirements are to prepare a flexed budget and to calculate all relevant variances for updating a given standard cost operating statement. Once updated, the statement contains information on variances for a three-month period. The most obvious area for investigation is the direct materials price For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

4

variance, and part two of the case study extends the scenario to cover the weaknesses in financial and business controls that have allowed a purchasing fraud to happen.

Exercises There are twenty end-of-chapter exercises. Students can test their knowledge of the chapter using the ten multiple-choice questions available on the student section of the website. Also available in that section are four longer questions with suggested solutions. The lecturer-only section of the site includes a further five longer questions, with suggested solutions.

Excel exercises Exercises 17.3 to 17.8 (Edwards and Sheerness Limited) are available in Excel format.

Student Question 2 (Quayle Products plc) is available in Excel format.

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5

Answers to Lecturers’ End-of-Chapter Exercises 17.12 Dorchester Slugg Limited August 20X8: budget flexed for 4,500 units: £ Sales: 4,500 units × £18

81,000

Direct materials: 4,500 × (7kg × £1)

(31,500)

Direct labour: 4,500 × (0.5 hours × £6.00)

(13,500)

Production overhead

(10,000) 26,000

Selling and administrative overhead

(4,000) 22,000

17.13 Dillinger Thompson Limited January 20X9: budget flexed for 3,600 units: £ Sales: 3,600 units × £22.00

79,200

Direct materials: 3,600 × (1 square metre × £6.50)

(23,400)

Direct labour: 3,600 × (0.5 hours × £7.80)

(14,040)

Production overhead

(24,000) 17,760

Selling and administrative overhead

(6,000)

Net profit

11,760

The correct answer is a).

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6

17.14–17.19 Estella Starr Limited: general information for the answers to Questions 17.14 to 17.19: Flexed budget for 830 units: £ Sales: 830 units × £217.00

180,110

Direct materials: 830 × (16 metres × £4.00)

(53,120)

Direct labour: 830 × (4 hours × £6.30)

(20,916)

Production overhead

(62,300) 43,774

Other overheads

(10,600)

Net profit

33,174

Comparison of original budget, flexed budget and actual: Original

Flexed

budget

budget

£

£

£

Sales

195,300

180,110

177,620

Direct materials

(57,600)

(53,120)

(51,045)

Direct labour

(22,680)

(20,916)

(20,418)

Production overhead

(62,300)

(62,300)

(61,400)

52,720

43,774

44,757

Other overheads

(10,600)

(10,600)

(8,950)

Net profit

42,120

33,174

35,807

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Actual

7

17.14 Sales profit volume variance Flexed budget net profit

33,174

Original budget net profit

42,120 8,946 (A)

The correct answer is b).

17.15 Sales price variance Actual volume of sales at actual selling price: 830 × £214

177,620

Actual volume of sales at standard selling price: 830 × £217

180,110 2,490 (A)

The correct answer is b).

17.16 Direct materials price variance Actual quantity of materials used at actual price: 830 × 15 metres = 12,450 × £4.10 Actual quantity of materials used at standard price: 12,450 × £4.00

51,045 49,800 1,245 (A)

The correct answer is b).

17.17 Direct materials quantity variance Actual quantity of materials used at standard price: 12,450 × £4.00

49,800

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8

Standard quantity of materials used at standard price: 830 × 16 metres = 13,280 × £4.00

53,120 3,320 (F)

The correct answer is a).

17.18 Direct labour rate variance Actual hours at actual wage rate: 830 × 4.1hrs = 3,403 × £6.00

20,418

Actual hours at standard wage rate: 3,403 × £6.30

21,438.9 1,020.9 (F)

The variance is £1,021 (F) to the nearest £.

The correct answer is c).

17.19 Direct labour efficiency variance Actual hours at standard wage rate: 3,403 × £6.30

21,438.9

Standard hours at standard wage rate: 830 × 4hrs = 3,320 × £6.30

20,916 522.9 (A)

The variance is £523 (A) to the nearest £ The correct answer is a).

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9

17.20 Feltham Finch Limited i) Variable production overhead variance:

Actual variable production overhead

8,476

Flexed budget variable production overhead

8,512 36 (F)

ii) Fixed production overhead expenditure variance:

Actual fixed production overhead

24,160

Flexed budget fixed production overhead

23,104 1,056 (A)

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10

Solutions to Case Study Questions PART 1 i) Francis & Follett Limited: Flexed budget for 1,650 units for March 20X4: £ Sales: 1,650 units × £103

169,950

Costs: Direct materials: 1,650 units × (12 metres × £2.50 per metre)

(49,500)

Direct materials: 1,650 units × 1 bag of metal components ×

(7,425)

£4.50 Direct materials: 1,650 units × 1 packaging box × £3.50

(5,775)

Direct labour: 1,650 units × (2.5 hours × £6.00 per hour)

(24,750)

Variable production overheads: 1,650 units × (1.5 machine

(9,900)

hours per unit × £4) Fixed production overheads: 1,650 units × (1.5 machine hours

(24,750)

per unit × £10) 47,850 Selling and administration overheads

(16,600)

Net profit

31,250

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11

Summary of original budget, flexed budget and actual statements: Original

Flexed

budget

budget

£

£

£

Sales

164,800

169,950

169,950

Direct materials: wood

(48,000)

(49,500)

(54,351)

Direct materials: components

(7,200)

(7,425)

(7,425)

Direct materials: packaging

(5,600)

(5,775)

(5,775)

Direct labour

(24,000)

(24,750)

(23,760)

Variable production overheads

(9,600)

(9,900)

(10,050)

Fixed production overheads

(24,000)

(24,750)

(23,960)

46,400

47,850

44,629

(16,600)

(16,600)

(16,420)

29,800

31,250

28,209

Selling and administration

Actual

overheads Net profit

ii) Calculation of variances: Sales volume profit variance Flexed budget net profit

31,250

Original budget net profit

29,800

Sales volume profit variance

1,450 (F)

There are no variances for: sales price or for direct materials (components and packaging).

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12

Direct materials price variance:

Actual quantity at actual price 12.2 metres was used for each of 1,650 units: actual quantity used is 12.2 metres × 1,650 = 20,130 metres.

54,351 20,130 metres × price actually paid (£2.70)

Actual quantity at standard price 20,130 metres × standard price (£2.50)

Direct materials price variance

50,325

4,026 (A)

Direct materials quantity variance:

Actual quantity at standard price Actual quantity used (already worked out) – 20,130 metres Standard price per metre: £2.50

50,325

Actual quantity at standard price = 20,130 × £2.50

Standard quantity at standard price Standard quantity: 12 metres × 1,650 units = 19,800 metres Standard price per metre: £2.50

49,500

Standard quantity at standard price = 19,800 × £2.50

Direct materials quantity variance

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825 (A)

13

There is no variance for direct labour rate (because the actual rate of £6.00 is the same as the budget).

Direct labour efficiency variance:

Actual hours at standard rate Actual hours used: 1,650 units × 2.4 hours = 3,960 hours Standard rate per hour - £6.00

23,760

Actual hours at standard rate = 3,960 × £6.00

Standard hours at standard rate Standard hours: 1,650 units × 2.5 hours = 4,125 hours Standard rate per hour - £6.00

24,750

Standard hours at standard rate = 4,125 × £6.00

Direct labour efficiency variance

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990 (F)

14

Variable overhead variance:

Actual expenditure

10,050

Overhead absorbed at standard machine hours 1,650 units at 1.5 hours of machine time (standard rate) = 2,475 hours.

9,900

At the absorption rate of £4.00 per hour: £4.00 × 2,475 150 (A)

Variable overhead variance

Fixed overhead variance: 23,960

Actual expenditure

Expenditure absorbed

Standard machine hours used in production x absorption rate: 1,650 ×

24,750

1.5 machine hours × £10 790 (F)

Fixed overhead variance

Selling and administration overhead variance Actual expenditure

16,420

Originally budgeted

16,600 180 (F)

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15

We can now insert the variance figures for March into the quarterly statement:

Francis & Follett Limited: standard cost operating statements for the quarter ending 31 March 20X4: January

February

March

£

£

£

Budget net profit (original)

28,350

29,800

29,800

Sales profit volume variance

1,450

1,450

1,450

Flexed budget net profit

29,800

31,250

31,250

–

–

–

(3,904)

(3,934)

(4,026)

(360)

(413)

(825)

–

–

–

Direct labour efficiency variance

990

990

990

Variable overhead variance

(592)

(460)

(150)

Fixed overhead variance

776

750

790

Selling and administration overhead

210

(26)

180

26,920

28,157

28,209

Sales price variance Direct materials price variance Direct materials quantity variance Direct labour rate variance

variance Actual net profit

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16

PART 2 The second part of the case demonstrates the importance of investigating all variances thoroughly, and of tracking variances from period to period to see if they indicate persistent problems. Francis & Follett has not previously had a standard costing budgetary system and it seems likely that the identification of this problem has emerged because of the tighter control which is now being exercised over the company’s activities. Therefore, one important control is already in place.

Purchasing frauds of the type described here occur relatively frequently but are difficult to detect. At Lambert’s, Judith is responsible for many aspects of the administration of the business, and so she has been able to carry out the fraud successfully over a long period. Collusion between employees of different companies makes detection even more difficult. At Francis & Follett, Perry has been an employee for a long time, and throughout a period of growth. It is quite likely that his activities are not tightly controlled and that he has had a high level of autonomy in decision making about purchases.

Note: The costs of such a fraud can be substantial. In this case, 20p was added to the price of a metre of wood; each unit of product requires 12 metres, so the additional cost would be 12 × 20p = £2.40 per unit. Even though, presumably, not all of the timber would be purchased from Lambert’s, the amount of cash siphoned off by the criminals could have been very significant indeed over a period of years.

In conclusion, the case study demonstrates how useful a system of full budgetary control can be, and how important it is for management to keep a tight control over the activities of the business.

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17

INSTRUCTOR’S MANUAL Chapter 18: Performance measurement

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case study and questions on the website)

Teaching Notes Introduction This chapter introduces the ways in which performance is measured and reported within the firm. The chapter first examines different sizes of firm, making the point that performance measurement and reporting is important in all sizes of business.

The chapter examines divisional organization in large businesses and discusses the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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advantages and drawbacks of centralization and decentralization. Assessment of divisional performance is explained in respect of cost centres, profit centres and investment centres. Example 18.4 (Delta) provides an example of a divisional profit statement. Example 18.6 (Bartolemi plc) explains some of the problematic issues that arise in determining divisional net profit. The issue of transfer pricing is touched on but is not explained at great length as an in-depth treatment is felt to be beyond the scope of the book. The concluding part of the chapter deals with nonfinancial performance measurement, including an explanation of the balanced scorecard.

Learning outcomes After reading the chapter, including the case study, and completing the related exercises, students should: •

Understand why large organizations often use divisional structures.

•

Be able to argue the advantages and disadvantages of divisionalization.

•

Understand the nature of financial performance measurement in divisions.

•

Appreciate the importance of non-financial performance measures within organizations.

Understand the 'balanced scorecard' approach to financial and non-financial

•

performance measurement, including ESG perspectives.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

Performance reporting within organizations

Slide 5

Measuring and reporting performance in different sizes of business

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Slide 6

Characteristics of management information (these could be compared and contrasted with the characteristics of information provided for use outside the firm)

Slide 7

Divisional responsibility

Slide 8

Decentralization and its advantages

Slide 9

Centralization and its advantages

Slide 10

Assessing divisional performance

Slide 11

Scope of divisional control – Figure 18.1 in the chapter

Slide 12

Cost centre explanation

Slide 13

Profit centre explanation

Slide 14

Example of a divisional performance statement for a profit centre – this is extracted from Example 18.4 (Delta)

Slide 15

Investment centre explanation; calculation of ROI

Slide 16

Advantages and problems of using ROI

Slide 17

Non-financial performance measures – example of the assessment of quality and service standards

Slides 18 and 19

The balanced scorecard (refer to video suggestion below)

Slide 20

The balanced scorecard – recent developments

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Slide 21

Summary

Video The suggested video explains the balanced scorecard using a series of drawings: www.youtube.com/watch?v=M_IlOlywryw

It is 4 minutes long and would fit in between Slides 18 and 19. Note that this video illustrates the original balanced scorecard key perspectives.

Case study The case study, Smallheath Carraldo, examines some of the problems that arise when a large business splits its activities into divisions. The problems are exacerbated in the case by the fact that divisional managers are rewarded by a mixture of salaries and bonuses, the latter dependent upon ROI. The case should involve students in consideration of some of the behavioural aspects of performance measurement.

Exercises There are thirteen end-of-chapter exercises. Students can test their knowledge of the chapter using the ten multiple-choice questions on the student section of the website. Also available in that section are three further long questions with suggested solutions. The lecturer-only section of the website contains a further three long questions with suggested solutions.

Excel exercises Exercise 18.4 (Perkora Bains) is available in Excel format.

Student Question 1 (Warkworth Sunter plc) is available in Excel format.

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Answers to Lecturers’ End-of-Chapter Exercises 18.8 Principal drawbacks to divisional organization Divisionalization results from a decentralized approach to management. Typically, divisions are created within businesses along functional or geographical lines, and each division is allowed a certain degree of autonomy. The level of autonomy can vary substantially from one business to another: a highly decentralized business, for example, is likely to grant its divisional managers control over both the setting of sales prices and the determination of investment strategy.

Unfortunately, divisionalization can lead to less than optimal outcomes. Divisional managers are usually highly motivated, because they have control over the activities of a whole business unit. Usually, this is advantageous to the business as a whole, but sometimes problems of goal congruence emerge. Divisional managers may take decisions which benefit their own division, but at a cost to the wellbeing of other divisions or the organization as a whole. Disputes between divisions over transfer pricing, for example, can be damaging to the business as a whole.

Divisionalization may not be the most cost-effective method of organising business organizations if functions are duplicated across the organization. For example, if each division in a business has its own marketing and accounting departments, there is likely to be a considerable level of overlap in what they do. It may be more efficient and cost-effective to run single centralized service departments.

There can be a problem for senior managers in retaining a sufficient level of control over the organization’s activities. This is more of a problem where divisions are run as investment centres with a high degree of autonomy.

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18.9 Florian Space Products Any two of each of the following sets of factors would be valid.

Arguments supporting the finance director’s views: •

Central management retains control over important activities such as pricesetting and investment.

•

Florian Space Products has previously run its operations on a unified basis.

Division into cost centres would constitute less of a risk for the company than an immediate division into remote investment centres. This could constitute a cautious approach to divisionalization, which could be followed in the future by permitting greater autonomy to the divisions.

•

Central management would retain control over price setting. The example does not make it clear whether there are any sales intra-company, but if there are, constitution of the divisions as cost centres would mean that any transfer pricing issues could continue to be addressed at a head office level.

This would cut down on the chances of discord between divisional managers.

Arguments supporting the marketing director’s views: •

Divisional managers are more likely to be committed and highly motivated if they have control over many aspects of their divisions’ operations.

•

Divisional managers should be well-informed about the business environment in which their divisions operate. In many cases, they are likely to be better informed than remote senior managers and are better able to respond flexibly and rapidly to changing circumstances.

•

If the divisions are treated as investment centres, the ROI performance measurement can be used as a means of comparison and also as a motivator for divisional managers.

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18.10 A divisional performance statement for an investment centre identifies contribution, controllable profit, divisional profit before allocation of head office costs and divisional profit before tax.

18.11 Spall Spelling Spall Spelling: Division D’s performance statement £ Sales

272,600

Less: variable costs (47,000 + 63,700)

110,700

Contribution

161,900

Less: Controllable fixed costs (36,000 × 25%) + (72,400 × 85%)

(70,540)

Controllable profit

91,360

Less: Non-controllable fixed costs (36,000 × 75%) =

(72,400 × 15%) 37,860

Divisional profit before allocation of head office costs

53,500

Head office cost allocation

(43,200)

Divisional profit before tax

10,300

18.12 True or false?

Statements 1 and 3 are FALSE. Statements 2 and 4 are TRUE.

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18.13 Breton Tallis Four performance measurements were asked for in the question. The following lists contain six for each goal, but there are, of course, other possibilities not mentioned here.

Goal: rapid development of new plastics: •

Number of new patents registered in the period

•

Staff retention in research and development department

•

Number of new products launched

•

Number of new staff appointments in relevant departments

•

Sales of new product lines

•

Customer perceptions of new product lines

Goal: creation of conditions in which innovative design can flourish: •

Retention rates and appointments of staff responsible for design

•

Number of industry design awards entered and number and type of prizes awarded

•

Customer perceptions of product design qualities

•

Design staff satisfaction with their employment

•

Number of new designs produced

•

Number of new designs entering production

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Solutions to Case Study Questions

1) The big problem facing Khaleb and the Components division is lack of profitability as measured by ROI. Any strategy adopted by the division or by the company as a whole must tackle this fundamental problem. It seems likely that ROI for the division will improve to some extent because of the improvements to the non-current asset base that were made by Lara. However, the division is a very long way from achieving the level of ROI targeted by the company. Specific problems that cannot be addressed at divisional level include the following: 1. There appears to be a significant transfer pricing problem. The contribution margin of products sold to other divisions is far smaller than that achievable on sales to outsiders. The component cost to Chem and Pharma divisions is highly advantageous and produces significant cost savings for them.

Although it is possible to tackle transfer pricing problems by negotiation between divisions, this option may not be open to Khaleb. He is new to the business and probably lacks bargaining power. His fellow divisional heads will be very reluctant to accept higher transfer prices, in part at least because of the adverse effect it will have on their own bonuses. Renegotiation of transfer prices on a significant scale will probably require intervention at a senior level. Khaleb needs to begin the process of lobbying head office management to review the position.

2. The ROIs of the three divisions may not be strictly comparable. Components has acquired a lot of new non-current assets recently, and its asset base may be relatively higher than that of the other two divisions. The improvements that might be expected to the return part of the equation (because better non-current assets should produce better returns) may not have fully emerged yet, and in any case, we know from the case that non-current asset

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capacity is not fully utilized. It is important when comparing ROI that like is compared with like.

3. The company appears to take a very simplistic approach to performance appraisal, relying wholly on ROI. The assessment of performance probably needs to be managed in a more subtle way, but any changes to performance assessment need to be determined at head office level. Khaleb may be able to exert some influence in any debate on the best way to assess performance but as a divisional manager he has no power to insist on any revision to the company’s appraisal systems.

4. The problems inherent in the use of the ROI measurement have particular impact in the context of SCI because of the key role played by ROI in the awarding and calculation of bonuses. It is rarely a good idea to award performance-related bonuses based on a single measure of performance.

Even if Khaleb manages his division spectacularly well, Components’ ROI is so far away from target that he does not stand to benefit personally. Lara, his predecessor, was clearly not well regarded in the company, but this assessment of her may prove to have been unfair. The non-current asset replacement programme that she instituted was a step in the right direction, but it would not have paid off for her personally for a very long time, if ever.

Khaleb may find that he grows discouraged because the odds are stacked against his division.

5. Sales volumes, it appears, are not as high as they could be. Extra productive capacity is available if additional sales volumes can be achieved, but there is a problem in that sales staff are not well-motivated and, in any case, tend to lack experience. It may be that Khaleb can tackle this problem, at least in part, at divisional level, if he has the authority to alter the basis of employment contracts. If he can improve sales’ staff remuneration and incentives, the division could probably perform much better. However, if conditions of employment are uniform throughout the company (i.e. if they For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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are under senior management control), the problem can be addressed only at head office level.

6. The bonus system is very limited in its application. There may be benefits to be gained across the company by extending performance-related bonuses to senior divisional managers such as Ester.

2) SCI’s senior management probably needs to undertake a fundamental review of the company’s operations, and of its performance review and incentive systems. This could involve the following steps: 1. Immediate review of transfer pricing arrangements to ensure that they are equitable to all of the divisions. Khaled’s division appears to be at a significant disadvantage.

2. Review of the whole performance review system. The reliance on a single measure (ROI) is potentially very damaging to the interests of the company as a whole. Performance measurement should be more complex and should ideally involve consideration of a range of both financial and non-financial indicators. The company could consider implementing a Balanced Scorecard system. In order to do this properly, a full re-appraisal of business strategy would probably be in order, and this might be of great help in challenging increased competition.

3. It may be appropriate to agree a set of specific targets for Khaled’s division that are geared to improving its current position, and to rewarding the staff accordingly. Where the position of the divisions is unequal, as in this case, staff in the struggling division can easily become demotivated. Targets need to be set with a view to encouraging and rewarding improvements in performance.

4. The performance bonus system could probably be extended to a greater number of senior managers in the divisions so as to encourage better For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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performance. Also, if employment contracts are under central control, senior managers need to reconsider the incentives that they provide.

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INSTRUCTOR’S MANUAL Chapter 19: The management of working capital

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case study and questions on the website)

Teaching Notes Introduction This chapter focuses specifically on working capital. The chapter starts by describing the elements of working capital and it illustrates the movement of working capital around the business in Figure 19.1. Example 19.1 looks at the differing components of working capital in three real-life businesses, illustrating the point that the For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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differences in this respect between different types of company can be very substantial. The rest of the chapter examines the management of inventory, trade receivables, cash, overdrafts and trade payables.

Learning outcomes After reading the chapter and completing the exercises at the end, students should: Be able to identify the principal components of working capital and to

•

understand the potential consequences of the mismanagement of each of the components.

Understand and be able to apply simple techniques used in the management

•

of inventory.

Understand the problems and opportunities involved in offering credit to

•

customers, and the techniques involved in managing trade receivables.

Understand some of the important issues relating to the management of

•

cash and of trade payables.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

This slide shows Figure 19.1 – the movement of cash around the business. The problems of too much, or too little, of each principal element could be explained at this point in the lecture, depending upon time available.

Refer to video suggestion below.

Slide 5

This slide explains asset and liability components in practice.

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Slide 6

The management of inventories: Explains the data required for EOQ.

Slide 7

The EOQ formula: Shows the graph in Figure 19.2 for EOQ which can be used to explain the rationale for the formula.

Slides 8 and 9

These slides show Example 19.3 (Bullfinch Supplies Limited) from the chapter.

Slide 10

The management of trade receivables: Shows the benefits and drawbacks of offering credit terms to customers

Slide 11

The credit control function – explaining what credit controllers do

Slide 12

Example 19.5 (Perceval Holland Limited) can be used to explain to students what the issues are in assessing overdue balances.

Slide 13

The management of cash, overdrafts and trade payables: This slide explains the operating cycle

Slides 13 to 17

These slides use some of the data from Example 19.7 to demonstrate the calculation of the operating cycle components and finally (on Slide 17) the operating cycle itself.

Slide 18

Managing cash and overdrafts

Slide 19

Managing trade payables

Slide 20

New payment technologies

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Slide 21

Summary

Video The suggested video is a Deutsche Bank production about working capital management: www.youtube.com/watch?v=bHK77lbdyWA. It is, naturally, geared towards selling bank services but it does explain the basics of working capital management very quickly (it runs to 3 and a half minutes) and in a visually attractive way. It could be slotted in at around Slide 4.

Case study A new short case study has been included for the 6th edition. This reprises some of the content of Example 19.2 in the print book. It asks students to conduct a brief vertical analysis of recent Annual Report figures for Land Securities and Imperial Brands, both of which are in the FTSE-100 at the time of writing. The second requirement is to identify features of the assets in the companies that are characteristic of their activities. Students are encouraged to look up the relevant annual reports.

Exercises There are twenty-one end-of-chapter exercises, which test understanding of significant points within the chapter. Students can test their knowledge using the ten multiple-choice questions available on the student section of the website. Also available in that section are three further questions with suggested solutions. The lecturer-only section of the website contains three more questions, also with suggested solutions.

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Excel exercise Exercise 19.12 (Linwood Lees Limited) is available in Excel format.

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Answers to Lecturers’ End-of-Chapter Exercises 19.13 Keeping inventory too low The correct answer is (c).

19.14 Companies X and Y Company Y is more likely to be a manufacturing business. Typically, manufacturing requires the use of significant amounts of plant and equipment. Company Y has a much larger amount of property, plant and equipment than Company X. Also, it would be expected that a manufacturing business would have relatively high levels of inventory; Company Y has a large amount of inventory, whereas Company X's inventory balance is negligible.

19.15 Tutbury Limited Applying the EOQ model, the economic order quantity (Q) is as follows: Q=

2×D×O H

Q=

2 × 4.000 × £32.00 £13.75

Q = 136 units (to nearest whole unit)

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19.16 Wells Xavier Limited Applying the EOQ model, the economic order quantity (Q) is as follows: Q=

2×D×O H

Q=

2 × 10 000 × £23.50 £12.70

Q = 192 units (to nearest whole unit)

19.17 Benefits of employing a credit controller A credit controller has specific responsibility for running credit checks on customers.

Unless a named individual has this responsibility, it is possible that, for example, junior staff might inappropriately allow credit terms to a customer. The credit controller also has responsibility for regular reviews of customers' credit terms, making changes and advising more senior members of the financial management team on bad and doubtful receivables which may require allowances. Also, an important aspect of the credit controller's work is chasing up unpaid, overdue receivables and keeping control over the list of aged receivables.

19.18 Minimizing risks of non-payment of receivables An effective credit controller can play a key role in minimizing the risks of nonpayment (also refer to the answer to Exercise 19.17) by, firstly, ensuring that credit terms are offered only to those customers who are likely to pay up, and by chasing overdue amounts on a systematic and timely basis. Also, factoring arrangements can improve a business's cash flow by bringing forward in time the receipt of receivable amounts. However, it should be noted that factors typically exclude doubtful receivable amounts from the balances covered by the factoring For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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arrangements, and so the onus remains on the business to collect problematical receivable amounts.

19.19 Snaresbrook and Debden Limited Age analysis of trade payables at 30 June 20X4: report from financial controller Assuming that the amounts due in the category 31–60 days are evenly spread over that period, well over 70 per cent of trade payables are still within the payable period allowed on average by our suppliers. However, more detailed and precise information would be needed to confirm this statement. Only 17.4 per cent of the total of the payables balances remain unsettled after 60 days, and it is unlikely that action will be taken against the company in respect of much of this amount.

However, there is definitely one case where there is a dispute with a supplier, and there may be others. In respect of the disputed amount of £4,300, we must take all reasonable steps to settle the dispute in order to avoid having to defend the company in a court action. This would be expensive and wasteful of staff and management time. A visit to the supplier's credit control department by a member of our staff could help to resolve the dispute in a timely and efficient fashion.

The profile of amounts owing is little changed from June 20X3, although it is noted that no amounts were outstanding for over 90 days a year ago, whereas currently 3.7 per cent of our balances by value are outstanding for over 90 days. It may be worth investigating our payments systems to ensure that payments are made on a timely basis.

The format of this report requires some amendment. The average credit period permitted by our suppliers is 45 days, and so it would be very helpful to be able to quantify the amount and proportion of total balances that are outstanding for up to 45 days. Currently, there is no quantification of the amounts outstanding for longer than the period permitted by the company's suppliers. This information should be For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

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made available as a matter of priority. It is important to avoid alienating our suppliers and risking exceeding our credit limits with them. If we inadvertently allow significant amounts to go unpaid, then it may impact on the company's ability to purchase goods and services. Also, any amount due over 90 days is likely to be significantly overdue and we need more detailed information. It is recommended that the monthly report is accompanied by a detailed listing of all amounts that are seriously overdue.

19.20 Theydon Limited The company's operating cycle is 77.8 days + 66.4 days – 108.4 days = 35.8 days.

On average, the company's suppliers allow it 37 days credit; the average trade payables period at 108.4 days is substantially in excess of this, and it may be that the company has lost the goodwill of its suppliers. Although a long trade payables period can be advantageous in that it provides a source of interest-free finance, suppliers can be pushed too far, and they may start demanding immediate payment and/or cutting off supplies.

The average receivables period tells a similar story, but from the opposite point of view. The company allows 30 days credit, but this is being exceeded by a substantial margin. It is likely that working capital management requires improvement in this respect also; if the company does not currently employ a credit controller it should consider doing so in order to shorten the receivables period. If cash is received more quickly, then it can be paid out to settle trade receivables more quickly, thus easing the relationships with suppliers.

The average inventory turn period is over 2.5 months. There may be good reasons for this – stocking up for the new season, for example. However, the business would need to take care that it keeps inventory moving quickly enough. Fashion clothing

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may soon become obsolescent, and the company must avoid the situation where it is left holding large quantities of unsaleable goods.

19.21 Tucker and Ali Limited Operating cycle: 20X8

20X7

£m

£m

A. Average inventory

3.2 × 365 = 38.0 days

3.1 × 365 = 36.7 days

turnover period

30.7

30.8

B. Average trade

4.4 × 365 = 42.7 days

4.2 × 365 = 40.0 days

receivables turnover

37.6

38.3

C. Average trade

5.2 × 365 = 77.2 days

5.0 × 365 = 70.7 days

payables period

24.6

25.8

period

Operating cycle:

3.5 days

6.0 days

A+B–C

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Report to the directors of Tucker and Ali Limited Tucker and Ali's operating cycle is very short indeed, indicating a relatively low need for cash. This may help to explain why the company's cash balances are actually very modest at both year ends. There has been some deterioration between 20X7 and 20X8 in the company's inventory and trade receivables turnover periods. The period on average over which inventory remains on the premises has risen by 1.3 days. This is a small difference, and it may well arise from a deliberate policy of keeping more inventory, perhaps in order to avoid situations where customers have to wait for goods. However, the inventory turnover period requires careful monitoring and control.

The average trade receivables turnover period has increased by 2.7 days. Again, there may be good reasons for this increase – perhaps certain customers have been given more favourable treatment. On the other hand, it could arise from lack of efficiency in the credit control department, or circumstances such as, for example, the absence of the credit controller due to illness.

The average trade payables period has changed by 6.5 days, the biggest difference of all between the two years. This would appear to be an important element of the company's working capital management approach, and of course, suppliers are a very useful source of interest-free finance. However, it is important, for the sake of continuing good relationships with suppliers, not to extend this period too far. If suppliers typically grant 30 days credit, Tucker and Ali is already exceeding that limit by a very substantial margin. It may not be worth the risk of losing supplier goodwill.

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Solutions to Case Study Questions

1. Vertical analysis Land Securities £m

Imperial Brands £m

31 March 2023

%

30 September 2022

%

6

0

17,777

57.4

9,658

88.1

1,887

6.1

770

7.0

2,373

7.7

10,434

95.1

22,037

71.2

Inventories

118

1.1

4,140

13.4

Trade and other receivables

365

3.3

2,543

8.2

Other current assets

4

0

388

1.3

Cash

45

0.4

1,850

6.0

532

4.9

8,921

28.8

TOTAL ASSETS

10,966

100.0

30,958

100.0

EQUITY

7,072

64.5

7,473

24.1

3,249

29.6

12,346

40.0

Current liabilities

645

5.9

11,139

36.0

TOTAL LIABILITIES

3,894

35.5

23,485

75.9

EQUITY AND LIABILITIES

10,966

100.0

30,958

100.0

ASSETS Non-current assets Intangible assets Property, plant and equipment/investment property Investments and other noncurrent assets Current assets

LIABILITIES Non-current liabilities

Note: vertical analysis columns may not add up exactly, because of rounding.

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2. Features of company asset information Land Securities: a) Most of the company’s assets are comprised under the heading of investment properties (88.1% of total assets). This is consistent with Land Securities’ principal activity of holding real estate. b) The company holds very little in inventories. These are properties held for trading, and presumably it is intended to dispose of them within twelve months of the date of the Annual Report. c) Cash and trade receivables are low, relative to the amounts held by Imperial Brands.

Imperial Brands: a) Intangible assets is the largest single asset category. Note 11 to the financial statements further categorizes intangible assets as goodwill, intellectual property and product development, supply agreements and software. b) Inventories comprise 13.4% of total assets. This includes supplies of leaf tobacco and work-in-progress and finished goods. It would be expected to have a relatively high level of inventory in this type of business. c) There is a large amount of cash (6% of total assets). Note 17 to the financial statements shows a breakdown into cash (£703m) and short-term deposits and other liquid assets (£1,147m). Cash in 2021 was not as high at £1,287m.

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INSTRUCTOR’S MANUAL Chapter 20: Financing the business

Contents: •

Teaching Notes

•

Answers to Lecturers’ End-of-Chapter Exercises from the book (Answers to exercises and Answers to self-test questions are at the end of the book)

•

Solutions to Case Study Questions (case studies and questions on the website)

Teaching Notes Introduction In this chapter students are introduced first to some of the key financial issues involved in starting up a small business, including the importance of constructing a reasoned business plan, and the most common reasons for business failure. The For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage

1

chapter proceeds to examine stages in business growth and expansion, including sources of finance for the growing business. The latter part of the chapter is concerned with sources of finance for large business.

Learning outcomes After reading the chapter and completing the exercises at the end, students should: •

Understand the key issues involved in financing a business start-up.

•

Know about some of the most important sources of small business finance.

•

Understand the problems and opportunities presented by business growth, and some of the financing issues related to growth.

•

Know about sources of finance for larger businesses.

•

Know how the UK stock market operates, and the advantages and disadvantages of operating as a listed company.

Notes on PowerPoint slides Slide 1

Chapter title

Slide 2

Learning outcomes

Slide 3

Introduction

Slide 4

Financing the small business

Slide 5

Sources of finance – new business start-up

Slide 6

The business plan – description of typical contents

Slide 7

Why do businesses fail?

Some of the most common reasons are cited here.

Slide 8

Stages in business growth and expansion

Slide 9

Sources of finance for the growing business

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Slide 10

Sources of finance for large businesses: Many of the sources of finance already mentioned may be suitable, but only larger businesses in the form of listed companies have access to finance via the issue of shares.

Slide 11

Rights of shareholders

Slide 12

Benefits of limited company status (this is to some extent revision of Chapter 1)

Slide 13

The London Stock Exchange (refer to video suggestion below)

Slide 14

Organization of the London Stock Exchange

Slide 15

Stock Market indices

Slide 16

Flotation and other types of share issue

Slides 17 and 18

To list or not to list? Benefits and drawbacks of listing.

Slide 19

Summary

Video The suggested video, lasting under 5 minutes, is about the London Stock Exchange.

It may be helpful to students to see some of the terminology introduced in the lecture being used in context. www.youtube.com/watch?v=3drfsSWFmlE

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Case studies Case Study 1 is Gropius & Garner Productions plc, which examines the factors in the decision of a company to float its shares on the London Stock Exchange. The case aims to illustrate some of the important aspects of larger company financing and the practical difficulties involved in making such a momentous decision for a company.

Case Study 2 is a brief case study which introduces the topic of private equity. The objective of this case is simply to make students aware of this important type of financing. The case study requirements are quite general in nature and there is scope for many different, valid, answers. This could make an interesting seminar exercise.

Exercises There are fifteen end-of-chapter exercises, which require students to think about sources of finance, risk, the business plan, and types of business expenditure.

Students can test their knowledge using the ten multiple-choice questions available on the student section of the website. Also available in that section are four further discussion type questions, with suggested solutions. The lecturer-only section of the website contains four more discussion type questions, also with suggested solutions.

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Answers to Lecturers’ End-of-Chapter Exercises 20.10 Norman and Naylor Partners The business problems and risks facing Sam include the following: 1. Sally wishes to take out her share of the business in cash. This amounts to half of the value of the business; the value no doubt includes goodwill. There is a problem in the valuation of goodwill in this type of business. An expert business valuer will probably have to be appointed to determine the most appropriate value.

2. The amount of cash involved is likely to be substantial. Essentially, Sam will be buying Sally’s share of the business. Is there enough cash available to pay for this? If not, Sam may have to borrow money (if he can) or may have to make an arrangement with Sally whereby she is paid in instalments over a period of several years.

3. It might be possible for Sam to take on a new partner to replace Sally. The new partner would buy up Sally’s share of the business. However, this strategy would have to be carefully handled. If Sam is to take on a new partner, it must be someone he can get along with, and, preferably, someone who will replicate the skills that Sally brought to the original partnership.

4. If Sally’s skills cannot be easily replicated the business may suffer and even collapse. If Sam decides to manage the business on his own, he becomes a sole trader; he may find that the task is simply too large for one person.

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20.11Lionel i) Lionel will need the following information: •

Business profitability (this will be evidenced in the annual accounts of the partnership).

•

Business valuation; he will need to see evidence of the valuation of £1,200,000. He may decide to obtain his own valuation of the business.

•

Business prospects; Lionel may already know quite a lot about the reputation and the client base of the partnership. He needs to find out as much additional information as he can through formal discussions with the existing partners, and through informal means (for example, by asking business contacts for their opinions of the partnership).

Important elements of risk in Lionel’s decision include: •

The risk that he will not be able to make as much money from involvement in the partnership as he makes from his salaried employment (being a partner is likely to be much riskier than being an employee).

•

The risk that he will be induced to pay too much for his share in the partnership. He needs to ensure that the business prospects are genuinely good, and that goodwill, in particular, has not been overvalued.

•

The risk that he will not fit in well with the existing, established, partners. His style of business may be rather different from theirs and this may lead to disputes.

ii) Lionel may be able to raise bank finance in order to fund his investment in the partnership, especially if Lionel is able and willing to provide a personal guarantor for the borrowing, or to secure it on assets in his personal possession. However,

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bank finance may not be available for the whole amount of £300,000 that Lionel requires, and he may have to make up the shortfall from other sources.

If Lionel owns assets, he may be able to either sell the assets to raise cash or to use them as collateral for a loan. For example, if he owns a house free of mortgage, he may be able to raise the cash through a new mortgage.

Lionel may be able to borrow from friends or family, either for the full amount or for part of it.

It is possible that Lionel may be able to come to some arrangement with the other partners to pay in only an agreed proportion of the £300,000. Any shortfall could be made up gradually over a period of time out of Lionel’s share of the profits of the business.

20.12 Lucinda and Lister i) Sources of finance Investment in new vehicles: buying the limos outright involves a substantial capital outlay and it might be preferable to lease the vehicles. However, if the directors want to borrow to finance outright purchase of the new limos, they may well be able, as an established business, to obtain a bank loan quite easily. If they do not wish to take the risk of borrowing, they may be able to lend their own savings to the company.

Investment in other costs of expansion by using existing resources: if there is spare cash available in the business, using it to finance, or partly finance, the expansion might be a good use for the money.

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Financing via a flexible overdraft facility: the directors would need to prepare a cash flow budget to identify any points in the year at which short-term overdraft finance might be required to cover shortfalls.

ii) Additional costs The principal costs involved will be the acquisition of new vehicles, and the employment of additional drivers. Also, the expansion might involve some further, related costs, such as additional administrative costs (because more bookings would be made, and more paperwork would be involved, and additional premises costs.

The limos have to be securely kept in garage premises when not in use, and it might be necessary to expand the space available.

iii) Risks associated with the expansion and its financing The directors face the risk that they have misjudged the market. If they invest in expansion and the demand for services is less than they thought it would be, they may severely damage the future prospects of the business. Another risk is that, if they borrow money to expand, interest rates may rise and could become a greater burden than anticipated.

20.13 Amery Chorlton plc The company has in issue 16,000,000 shares (£4,000,000/25p), each valued at 98p.

The company’s market capitalization is: 16,000,000 × 98p = £15,680,000

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20.14 Willoughby Wooster plc The rights issue gives the holder of 30,000 shares the right to buy 30,000/2 shares = 15,000 shares. Each new share costs £2.70, so the total amount payable to take up the rights is: 15,000 × £2.70 = £40,500. The correct answer, therefore, is a).

20.15 A friend has left some investments in a will i) Where more than half of a company’s shares are quoted on the stock market, it may become a target for a takeover. A takeover involves a person or organization buying up shares in the target company; if sufficient shares are bought (usually this means over 50 per cent of the total issued share capital) the takeover is successful and the buyer now controls the company. A hostile bid is one which is rejected by the target company’s directors.

In this case (Turtlehammer plc), the share price has risen on speculation only – there has been no formal announcement of a takeover bid. If the speculation has any factual basis, Tatiana could expect to see an announcement of a bid very soon. The share price may rise again following such an announcement. Much will depend on the price which the competitor company is prepared to offer for the shares. Where the bid is hostile, the target company’s directors advise the company’s shareholders not to accept it. However, the decision on whether to buy or sell shares is entirely up to the individual shareholder.

This could be good news for your friend. If the share price rises her holding of shares will increase in value; if they sell the shares when the price is high, they could make money. However, your friend might decide to hold onto the shares in the expectation of further rises in price.

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ii) The rise in price of the shares of Teddington Tilmain plc is good news for your friend, especially if the price stays at or around its new level. If the company is expanding its business by obtaining new contracts, and is under good management, the price could continue to rise.

iii) A rights issue is an offer of additional shares to existing shareholders at a price below the current market value. The terms of the Tolson Tortellini rights issue mean that for every four shares your friend holds they will be able to buy one extra share at a price of £2.30. This could be good news for your friend. If the company is raising extra cash to invest in a potentially profitable new project, and if the project does indeed turn out well, the share price could rise. On the other hand, companies sometimes issue additional shares via rights issues when they are in trouble and would find it difficult to borrow extra cash. Your friend needs to look at the background to the issue. Examining more detailed financial press reports would be a good starting point.

The Financial Times and other sources of financial news can be very useful to the investor and anyone else who is interested in companies, the stock markets and the economy. However, shareholders are entitled to receive the annual financial statements of their company (whether it is quoted or not), and shareholders in quoted companies will also receive interim financial statements. In addition, your friend will be able to obtain useful information from the companies’ websites.

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Solutions to Case Study Questions

Case Study 1 - Gropius & Garner Productions plc In order to assess the advantages and drawbacks of the proposed flotation, it would be sensible first to assess the financial impact of the deal.

Would the company be at risk of becoming a takeover target?

A company is usually only at risk of becoming a takeover target if more than 50 per cent of the voting shares are available for purchase. This deal involves the issue of a further 200,000 shares. Added to the existing 700,000 shares, this gives a prospective total of shares in issue of 900 000. How many of the shares will retained by the current directors?

Holdings now (before flotation)

700,000

To be sold on flotation

(300,000)

Retained after flotation

400,000

So, the directors will hold 400,000 of 900,000 shares, i.e. less than half of the issued share capital. If another person or company wished to take over Gropius & Garner it would be technically possible to do so. Judy’s concerns are, therefore, realistic in the circumstances.

In total, 500,000 shares will be sold. If the corporate finance advisers’ estimates are approximately correct, this would mean that 500,000 × £10.50 could be raised, i.e. £5,250,000.

The sale of the shares belonging to the directors will raise 300,000 × £10.50 = £3,150,000 and new capital raised for investment in children’s programming will be 200,000 × £10.50 = £2,100,000.

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Is it unreasonable of Bernard and Amelia to want to sell their shares?

Flotation on the stock market is a common way for founders of companies to turn part or all of their investment into cash. As both Bernard and Amelia are thinking ahead to retirement, the proposal to float the company makes perfect sense from their point of view. It is not unreasonable of them to propose this step.

How much money will the four directors make from selling their shares?

Bernard holds 40 per cent of the shares currently in issue, and so he will be entitled to 40 per cent of the proceeds of the directors’ shares: 40% × £3,150,000 = £1,260,000.

Amelia holds 30 per cent of the shares currently in issue, and so she will be entitled to 30 per cent of the proceeds: 30% × £3,150,000 = £945,000.

Sigmund and Karl-Heinz each hold 15 per cent of the shares currently in issue, and so will each be entitled to: 15% × £3,150,000 = £472,500.

Clearly, all the directors (except Judy) stand to make substantial sums out of the flotation. All will retain large holdings of shares in the business, and so they could potentially make more money out of selling more shares in the future.

Is Bernard correct?

Because Bernard stands to gain a substantial sum of cash from selling part of his shareholding he is, perhaps, not very likely to dwell on the potential drawbacks of the flotation. However, Judy has pointed out one significant potential drawback in the form of a future takeover bid. If the company were taken over, the existing management might not be able to hold onto their lucrative directorships. Even if they did, they would find that they no longer have complete control over the company’s activities.

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Other possible drawbacks include: •

Increased public attention is not always welcome. Following flotation, the company would find itself subject to much more media interest than before.

•

The company would have to start producing interim financial statements as well as a full annual report, and there are various other forms of additional regulation which would come into play. A listed company incurs additional costs in complying with regulations.

•

There might be pressure from the City to produce better and more consistent results.

Most of these drawbacks are unavoidable. The company could help to minimize the possibility of takeover by floating rather fewer shares than originally intended. If 400,000 of 900,000 shares were to be made available, this would leave a majority in the hands of the four shareholder/ directors. The company could, of course, still be vulnerable if one or more of the four were persuaded to sell all or part of their shareholding.

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Case Study 2 – private equity 1. Private equity: brief summary

(Note: there are numerous sources of information on private equity. The brief summary below is from www.forbes.com/advisor/investing/private-equity/ but there are many other possible sources).

The private equity market offers an alternative to conventional methods of raising capital. Private equity has become more and more attractive to both business and private investors. ‘In the third quarter of 2021, private equity deal value reached a new record, topping $787 billion for the year’.

PE funds typically invest in established businesses that are underperforming or that have growth potential that is not being exploited. PE funds may buy up the entire company or a substantial part of it, sufficient to have the authority to install new management where appropriate. Typically, after a period of intensive management, the investment will be sold on again, or possibly floated on the stock market via an Initial Public Offering (IPO). The private equity fund thus realizes its investment and potentially makes a significant profit on the deal.

These investments are usually risky and are open only to established investment companies or people with a high net worth who are apprised of the risks and are able to sustain potential losses.

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2. Three large businesses that are owned and managed by private equity

1. Morrisons supermarket chain in the UK. In October 2021 Morrison’s existing shareholders approved a takeover offer from a US private equity group (Clayton, Dubilier and Rice). This deal was worth £7bn.

2. Also in 2021, Clayton, Dubilier and Rice acquired Wolseley UK, a leading specialist distributor of plumbing and infrastructure supplies.

3. Blackstone and the Benetton family paid £42.7bn in 2022 to privatize the Italian infrastructure group Atlantia.

The third example, Atlantia, comprised the highest value PE transaction in 2022, according to a report by PwC, the accounting firm. For those who would like to read more on the subject, the 2023 PwC report on private equity trends is worth a look: www.pwc.de/en/private-equity/private-equity-trend-report.html

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