"ACCOUNTING THEORY & PRACTICE"
ACCOUNTING THEORY AND PRACTICE Professional 1 December 2002 EXAMINER’S REPORT/ MODEL ANSWERS (Copyright) Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Examiner’s Report – Introduction The standard of competence displayed by candidates in this examination continued to show the level of improvement exhibited at the previous diet. It is still of concern that there is a significant proportion of candidates who are unable to carry out basic calculations, eg depreciation calculations; or to apply basic accounting principles, eg recording provisions as current liabilities and identifying revaluations as cash flows. Many of these techniques and principles should have been learnt at Foundation stage. The conceptual understanding demonstrated in the answer scripts of many students was limited and students were often unable to argue a case. In all ATP examinations students have been required to apply knowledge and understanding rather than regurgitate material from the open learning material. There have been and will continue to be few marks allocated for straight repetition. There appears to be a general weakness of students showing an inability to apply theory to practice. The following question-by-question comments include sections on “the most common errors”; these are given to assist future students preparing for future examinations. Examiner’s Report – Question 1 Overall performance on this question was considerably better than in previous diets. (a) This section was reasonably well done. The element causing the most problems was calculating and then using figures relating to the lease and showing full workings. (b) This section was answered quite badly. Many candidates obviously did not know what multivariate ratio analysis was and were therefore unable to explain the difference from univariate analysis. (c) Most students were able to say something about the ratios given but many students were unable to give any reasons for the differences from the average. Most common errors: Failing to calculate the entries required for the finance lease correctly; Failing to calculate depreciation correctly; Failing to correctly identify the data required for inclusion in the profit and loss account; Not able to calculate missing figures by using opening and closing balances; Unable to define univariate and multivariate ratio analysis; Not clearly laying out workings; a significant number of candidates do not use any headings or references in their workings. If the marker cannot follow workings it is difficult to give marks for workings when the answer is not 100% correct; Not separating the answers to questions 1 (c) (i) from 1 (c) (ii). Page 2 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Model Answer – Question 1 (a) C Plc Profit & Loss Account for year ended 30 June 2002 £000 Turnover 4,090 Cost of sales (see working (ii)) (3,325) Gross profit 765 Administration and distribution costs (62) Profit or loss on ordinary activities before interest 703 Loan finance charges (see working (viii)) (170) Profit or loss on ordinary activities before tax 533 Taxation (see working (iv)) (220) Profit or loss for the financial year 313 Dividends (125) Retained profit for the financial year 188 C plc Balance Sheet as at 30 June 2002 £000 £000 £000 Fixed assets Intangible assets Goodwill (see working v) 100 80 20 Tangible assets Leased equipment 765 459 306 Leased vehicles 1,750 1,000 750 2,515 1,459 1,076 Current assets Stock 35 Debtors 740 Investments 500 Cash at bank and in hand 222 1,497 Creditors: amounts falling due within one year* (509) Net current assets 988 Total assets less current liabilities 2,064 Creditors: amounts falling due after more than one year Amounts due under finance leases (1,126) Provisions for liabilities and charges Provision for legal claim (100) 838 Capital and reserves Called up share capital Ordinary shares 500 Retained profits 338 838 Page 3 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer £000 *Creditors: amounts falling due within one year Trade creditors 79 Tax 230 Dividends 125 Amounts due on leases 75 509 Workings (i) Debtors £000 B/F 660 Sales 4,090 Less received (3,990) Less written off (20) Balance C/F Balance sheet 740 (ii) Cost of sales £000 Direct operational costs incurred 2,682 Goodwill amortisation 20 Bad debt written off 20 Tangible asset depreciation: Equipment 153 Vehicles 350 Provision for legal claim 100 3,325 (iii) Creditors £000 B/F 92 Incurred 2,682 Paid (2,695) Balance C/F balance sheet 79 (iv) Tax £000 B/F (200) Paid 190 (10) Year charge to P & L (220) (230) (v) Goodwill £000 Amortised in year 100/5= 20 Amortisation B/F 60 Amortisation C/F 80 Page 4 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer (vi) Equipment Vehicles Cost Deprec Cost Deprec £000 £000 £000 £000 B/F 765 306 1,625 650 Add purchases 125 Depreciation 153 350 Total 765 459 1,750 1,000 (vii) Retained Profit £000 B/F 150 P&L 188 338 (viii) Amounts due on leases Existing leases brought forward 1/7/01 Less than one More than one year year £000 £000 Balance 1/7/01 473 1,096 Reclassified 52 (52) New leases 23 82 Repaid existing (473) 75 1,126 New Leases Year B/F Interest @ 10% Payments Balance C/F 1 125,000 12,500 -32,976 104,524 2 104,524 10,452 -32,976 82,000 3 85,000 8,200 -32,976 57,224 4 57,224 5,722 -32,976 29,970 5 29,970 2,997 -32,976 -9 (vii) Interest paid £000 Existing leases 157 New leases 13 170 (b) Univariate analysis considers each ratio in turn. The different ratios then need to be looked at together. This needs skill and judgement as each ratio is equal. Multivariate ratio analysis is often used in predicting corporate failure, eg Altman’s Z score. Multivariate analysis uses a limited number of specified ratios which each have a predetermined weighting. The ratios are calculated and then weighted. The weighted figures are then summed to give a score. The score is used to determine how secure a company might be. Page 5 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer (c) Report format. (i) ROCE has increased slightly from 2001 and it is nearly double the industry average. As the finance leases are excluded from long term debts, the assets employed by C plc will be share holders funds only. This will give a much higher ROCE. Asset turnover has decreased in the year; this is probably due to the increase in the finance leases in the year. Turnover is still more than double the average. Although profit margin has increased it is still below the average. As finance leases are not counted as long term debt, the interest on finance leases should be deducted from operating profit; this would give a lower profit margin than would be achieved if profit before interest was used. The very high asset turnover and lower profit margin could be an indication that C plc is setting prices competitively to obtain a higher turnover. This strategy seems to be working as ROCE is well above average. C plc has expanded recently; they may have been giving special deals to customers to increase turnover. Liquidity has improved in the year, but is still below the industry average. C plc may be happy with a lower liquidity as they have a high turnover and can generate cash quickly. Debtors collection has increased by 2 days over the year and now stands at more than two months. C plc needs to try and improve their debt collection, at least reducing to the industry average. C plc may not have been chasing debtors so vigorously as they have been trying to expand sales. C plc has no gearing as finance leases are excluded. If finance leases were to be included the gearing ratio would be 2001 - 63% and 2002 – 43%. New leases were acquired in the year; the amount of finance leases due in more than one year has hardly moved in the period. Shareholders funds have increased along with retained profits, so gearing would have been reduced if finance leases were included as debt. As the five-year leases near completion the gearing would continue to reduce. Gearing will then increase dramatically as all the leases are renewed. The 35% average gearing implies that most other companies either fund the business partly through debt or they include finance leases as long term debt. (ii) Reasons why C plc is different from the industry average: C plc rents all premises and uses finance leases for all its equipment and vehicles – this may not be the norm in the industry. If property was owned there would be higher asset values and a reduction in asset turnover. Other companies may include finance leases as long term debt – this will increase capital employed and reduce ROCE. Page 6 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Gearing may be different because other companies may use loans to purchase assets – these could have a different repayment profile to C plc’s leases. Liquidity is reduced by the inclusion of lease payments due in less than one year under current liabilities. If other companies used long term loans, such as debentures, these would remain as debt and not be moved to current liabilities. Liquidity without including lease payments is 2.8:1. C plc does not revalue leased assets. If other companies revalued fixed assets they would increase shareholders funds and reduce gearing. The other companies may use different accounting policies to C plc, so their results may not be comparable. The other companies are probably not identical to C plc – some may only cover one city; others may also include other services. The industry average has a different year-end – if the business is at all cyclical this may have an effect on the different results. Page 7 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Examiner’s Report – Question 2 It was encouraging to see that the majority of candidates attempting this question were able to prepare a reasonable cash flow statement. There were still a significant number of candidates making basic errors of principle. Very few candidates were able to prepare the reconciliation of net cash flow to movement in net debt. The most common errors were: Including reserve movements as cash flows; Treating the profit and loss account figures for tax and dividends as the cash paid in the year; Not including deferred tax movements in the tax paid calculation; Using either the profit on disposal or the net book value of the investment as the cash received on disposal; Incorrectly calculating asset movements to calculate asset acquisitions; Incorrectly preparing an analysis of changes in net debt instead of the reconciliation of net cash flow to movement in net debt. Model Answer – Question 2 (a) Reconciliation of Operating Profit to net cash inflow from operating activities. £m Operating profit 77 Add depreciation – land and buildings 19 Plant, equipment etc 31 Less gain on disposal of investments (13) Increase in stock (17) Increase in creditors 28 125 Cash Flow Statement for year ended 30 June 2002 £m Net cash inflow from operating activity 125 Returns on investment and servicing of finance (See working 1) (9) Corporation tax paid (see working 3) (12) Capital expenditure (see working 2) (210) Equity dividends paid (see working 4) (27) Net cash flow before financing (133) Management of liquid resources Sale of investments 103 Reduction in cash (30) Workings: Returns on investment and servicing of finance £m (1) Interest received 6 Interest paid (15) (9) Page 8 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer (2) Land & Buildings Plant, equipment etc WIP £m £m £m Balance B/F 696 116 33 Completed/transferred 29 (29) Revalued 70 Depreciation – year (19) (31) Balance C/F (924) (126) (25) Purchases/New works (bal) 148 41 21 (3) £m Tax Balances B/F: Corporation tax 20 Deferred tax 40 Charge to P & L 25 85 Balances C/F Corporation tax (23) Deferred tax (50) Paid 12 (4) Dividends Balance B/F 12 P&L 30 42 Balance C/F (15) Paid 27 (b) Reconciliation of net cashflow to movement in net funds £m £m Decrease in cash in period (30) Cash inflow from current asset investments (103) Less gain on disposal 13 (90) Change in net funds resulting from cashflows (120) Net debt at 30 June 2001 (40) Net debt at 30 June 2002 (160) Page 9 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Examiner’s Report – Question 3 This question was designed to test students’ knowledge of long term contracts. This was the least popular question on the paper and had the lowest average mark. Very few candidates attempting this question showed any real understanding of accounting for long term contracts. The most common errors were: Unable to calculate Debtors, creditors and stock balances relating to the contracts; Incorrectly calculating and then accounting for the loss on contract 3; Not identifying that contract 2 was too new a contract to be able to take any profit; Not summarising the figures calculated into a suitable format. Model Answer – Question 3 £000 Site 1 Contract value 800 Total cost Payments made (400) Cost to completion (300) Total profit 100 Sales in year 800 * 50% = 400 Cash received 500 Excess cash received 100 Expenses paid 400 Cost of sales 700* 50% = 350 50 Less part excess cash received (50) 0 Creditors – Balance excess cash 50 received Site 2 Contract value 5,000 Costs unknown - therefore not prudent to recognise any profits. As contract is profitable recognise turnover and cost of sales. Sales in year 5,000 * 10% = 500 Cash received 420 Outstanding debtors 80 Expenses paid 600 Cost of sales (equal to turnover) 500 WIP 100 Page 10 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Site 3 Sales value 1,500 Total cost - Payments made (1,275) Cost to completion (305) Expected loss (80) Sales in year 1,500 * 80% = 1,200 Cash received 1,050 Outstanding debtors 150 £000 Expenses paid 1,275 Cost of sales 1,580 * 80% 1,264 WIP 11 Less provision for loss (11) 0 Turnover 1,200 Cost of sales 1,264 Loss in year (64) Provision for future losses (16) Total loss (80) Provision for future losses (16) Less utilised against WIP 11 (5) Site 1 Site 2 Site 3 Total £000 £000 £000 £000 Profit & Loss Account Turnover 400 500 1,200 2,100 Cost of sales 350 500 1,280 2,130 Profit/(loss) 50 0 (80) (30) Balance Sheet Debtors – amounts due on contracts 0 80 150 230 Stock – Contract WIP 0 100 0 100 Creditors – receipts in excess of (50) 0 0 (50) amounts due on contracts Provision for future losses on contracts 0 0 (5) (5) Page 11 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Examiner’s Report – Question 4 This question tested knowledge of the time value of money and techniques used. It was badly answered with many candidates unable to clearly express the differences between the two methods asked for. The most common errors were: Explaining CCA instead of CPP; Not identifying differences between the two approaches. Model Answer – Question 4 (a) Deferred tax and pensions costs often cover fairly long time periods, sometimes in excess of ten years. Inflation tends to increase prices year on year; as prices increase the real value of money decreases. Therefore £1 in hand now is worth more than £1 in two years’ time. When estimating expenses we need to include the fair value of the expected costs. If the costs are expected to be incurred in the future then the real value of those items at today’s prices is less. We therefore need to discount future expenses to fair value at today’s prices. If the future expenses were not discounted their effect would be overstated in the accounts. (b) Current purchasing power (CPP) accounting The current purchasing power of an asset is its original cost adjusted for inflation since its acquisition. CPP accounting makes adjustments to income and capital values to allow for the general rate of price inflation. Non-monetary assets are restated using the RPI. Monetary items are not restated. Profit in CPP accounting is measured after allowing for maintenance of equity capital – profit is only recognised after non-monetary assets have been restated. (c) Discounting uses an estimate of the time value of money, the discount rate, to reduce future payments or receipts to their present value. Indexing takes a recognised index of actual price movements, such as the retail price index, and uses it to increase items such as non-monetary asset costs to present day prices. In other words discounting takes estimates and applies estimated discount rates to arrive at a present value figure. Indexing, as used in CPP for example, takes actual expenses and increases them by the average of actual past increases in prices. Page 12 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer Examiner’s Report – Question 5 This was a popular question that was generally well done. The most common errors were: Not giving any examples to illustrate the principles in part (c); Not relating the answer to a public sector organisation. Model Answer – Question 5 (a) Relevant: information that is relevant has the ability to influence decisions of users. Reliable: information that is complete and provides faithful representation, free from bias and material error, to users. Comparable and consistent information needs to be comparable from year to year and with other organisations. To achieve comparability users must be able to identify changes in accounting policies from one year to another. Understandable: the significance of the information must be able to be perceived by the users. (b) “Pervasive role” means that their role is all-encompassing; they underlie all aspects of financial statements. (c) (i) Relevance; information that is relevant has the ability to influence the economic decisions of users and is provided in time to influence those decisions. For example, being able to produce the final accounts of a public sector organisation quickly enough after the year end so that they are still relevant and not out of date. (ii) Reliability; information that can be depended upon to represent faithfully what it either purports to represent or could reasonably be expected to represent. It is free from bias (neutral) and material error. All public sector organisations are required to have their final accounts audited and a statement made whether they represent a true and fair view or present fairly. (iii) Comparability; information needs to be comparable and consistent from year to year. Information also needs to be comparable with other organisations. For example, the application of the Code of Practice when preparing Local Authority financial statements – this will help ensure that the statements are prepared according to current accounting standards and government regulations and will help comparability with other organisations. Using the standard CIPFA classifications enables comparison within the organisation and between organisations. Page 13 of 14 Professional 1 – Accounting Theory and Practice December 2002 Examiner’s Report/Model Answer (iv) Understandability – the significance of the information must be able to be perceived by users. The tax payers should be able to understand the financial information provided by public sector organisations such as local authorities. An example here could be the simplified accounting information provided with the council tax demand. (v) Going concern – an organisation is assumed to be able to continue operating in the future, unless it can be shown otherwise. Most public sector organisations are backed by Government and cannot cease their activities, so they must be going concerns. Going concern is particularly relevant to public sector organisations’ trading accounts such as local government DSO’s. (vi) Accruals – accruals accounting is required to be used by FRS 18. Expenditure and income are recorded in the period that they relate to rather than when they are paid or received. At the period end unpaid invoices are accrued by posting to creditor and charging the expenses to the Income and Expenditure account. This should happen in all public sector organisations using accrual accounting. Examiners note: The above answer uses general examples from several sectors. In the examination the candidate would have been expected to use more specific examples from their own organisation. Examiner’s Report – Summary 1. Standards generally continue to improve. 2. Students must pay more attention to reading questions carefully and answering the question requirements, rather than what they think the examiner should have asked. 3. Students who have been granted exemption from Financial Accounting at Foundation stage, and are embarking on their study of ATP at P1 will be assumed to have the same level of knowledge as students completing Foundation. Students exempt Foundation stage should therefore ensure that they carry out sufficient revision or additional study to bring their knowledge up to this level. 4. All students and college courses must cover all of the syllabus. Students and lecturers should note that all of the syllabus is examinable and the examiner does intend to examine all of the syllabus over a number of examination diets, within the normal constraints of a balanced paper that meets all of the CIPFA published criteria. Page 14 of 14