# ACCOUNTING THEORY & PRACTICE

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"ACCOUNTING THEORY & PRACTICE"

ACCOUNTING THEORY
AND PRACTICE
Professional 1
December 2002

EXAMINER’S REPORT/

Professional 1 – Accounting Theory and Practice                       December 2002

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).

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Professional 1 – Accounting Theory and Practice                          December 2002

(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
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

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Professional 1 – Accounting Theory and Practice                  December 2002

£000
*Creditors: amounts falling due within one year
Tax                                                    230
Dividends                                              125
Amounts due on leases                                   75
509

Workings
(i) Debtors                      £000
B/F                                660
Sales                            4,090
Less written off                   (20)
Balance C/F Balance sheet          740

(ii) Cost of sales                      £000
Direct operational costs incurred      2,682
Goodwill amortisation                     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

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Professional 1 – Accounting Theory and Practice                       December 2002

(vi)
Equipment                 Vehicles
Cost     Deprec          Cost     Deprec
£000      £000           £000       £000
B/F                  765         306         1,625         650
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.

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Professional 1 – Accounting Theory and Practice                      December 2002

(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

    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.

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Professional 1 – Accounting Theory and Practice                            December 2002

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
       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.

(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
Interest paid                                        (15)
(9)

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Professional 1 – Accounting Theory and Practice                          December 2002

(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)

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Professional 1 – Accounting Theory and Practice                       December 2002

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.

£000
Site 1
Contract value                                     800
Total cost
Cost to completion                             (300)
Total profit                                       100

Sales in year 800 * 50% =                          400

Expenses paid                                      400
Cost of sales 700* 50% =                           350
50
Less part excess cash received                     (50)
0

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
Outstanding debtors                                 80

Expenses paid                                      600
Cost of sales (equal to turnover)                  500
WIP                                                100

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Professional 1 – Accounting Theory and Practice                               December 2002

Site 3
Sales value                                       1,500
Total cost -
Cost to completion                               (305)
Expected loss                                        (80)

Sales in year 1,500 * 80% =                       1,200
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)

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Professional 1 – Accounting Theory and Practice                       December 2002

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.

(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 – 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.

(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.

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Professional 1 – Accounting Theory and Practice                      December 2002

(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
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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