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Professional 1
December 2002


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

Examiner’s Report – Question 1

Overall performance on this question was considerably better than in previous

(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

      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).

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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
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
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
Provisions for liabilities and charges
Provision for legal claim                                                       (100)
Capital and reserves
Called up share capital
Ordinary shares                                                                 500
Retained profits                                                                338

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Professional 1 – Accounting Theory and Practice                  December 2002
Examiner’s Report/Model Answer

*Creditors: amounts falling due within one year
   Trade creditors                                         79
   Tax                                                    230
   Dividends                                              125
   Amounts due on leases                                   75

(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

(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
Year charge to P & L          (220)

(v) Goodwill                        £000
Amortised in year 100/5=             20
Amortisation B/F                     60
Amortisation C/F                     80

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Professional 1 – Accounting Theory and Practice                       December 2002
Examiner’s Report/Model Answer

                       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

(viii) Amounts due on leases

     Existing leases brought forward 1/7/01
                   Less than one More than one 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

(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.

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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.

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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
                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.

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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.

    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

    Cash Flow Statement for year ended 30 June 2002

    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)

Returns on investment and servicing of finance
(1) Interest received                                      6
    Interest paid                                        (15)

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Professional 1 – Accounting Theory and Practice                          December 2002
Examiner’s Report/Model Answer

                                 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
Balances B/F:
    Corporation tax                                20
    Deferred tax                                   40
Charge to P & L                                    25
Balances C/F
  Corporation tax                                 (23)
  Deferred tax                                    (50)
Paid                                               12

Balance B/F                                        12
P&L                                                30
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)

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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
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
         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

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
Less part excess cash received                     (50)

Creditors – Balance excess cash                        50

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

Expenses paid                                     1,275
Cost of sales 1,580 * 80%                         1,264
WIP                                                  11
Less provision for loss                             (11)

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

                                            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)

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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.

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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

      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.

      (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

                                        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.

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