Solutions Manual

Financial Accounting
An International Introduction
Third Edition

David Alexander Christopher Nobes

www.pearsoned.co.uk/alexander
ISBN: 978-0-273-70928-2

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Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at: http://www.pearsoned.co.uk ----------------------------------First published 2001 This edition published 2007 Pearson Education Limited 2007 The rights of David Alexander and Christopher Nobes to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN: 978-0-273-70928-2 All rights reserved. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6-10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

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Contents
Chapters Feedback on exercises 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Introduction Some fundamentals Frameworks and concepts The regulation of accounting International differences and harmonization The contents of financial statements Financial statement analysis Recognition and measurement of the elements of financial statements Tangible and intangible fixed assets Inventories Financial assets, liabilities and equity Accounting and taxation Cash flow statements Group accounting Foreign currency translation Accounting for price changes Financial appraisal Pages 5 6 7 11 12 13 15 16 20 21 24 27 28 29 31 34 35 40

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

Supporting resources Visit www.pearsoned.co.uk/alexander to find valuable online resources Companion Website for students Self-assessment questions to check your understanding Weblinks to relevant Internet resources to facilitate in-depth independent research Newly updated and improved presentation of double-entry book-keeping principles For instructors Complete, downloadable Instructors Manual PowerPoint slides that can be downloaded and used for presentations Also: The Companion Website provides the following features: Search tool to help locate specific items of content E-mail results and profile tools to send results of quizzes to instructors Online help and support to assist with website usage and troubleshooting

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Feedback on exercises
The suggested feedback on the first two exercises in each chapter was included in the main text as Appendix D. Feedback on the remaining exercises is included here. We have tried to follow a broadly similar approach to that in Appendix D, i.e. giving outline suggestions in the case of discussion questions, but giving numerical feedback in full. The point that these are suggested solutions should be remembered. They can be used in any way that lecturers find useful. However, our own general preference would be to distribute suggested solutions to numerical exercises to students, but to regard the comments on discussion topics as notes to ourselves as lecturers and leaders of tutorials. If our suggested feedback helps to stimulate discussion in a time-efficient way, then we should be well satisfied.

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C H AP T E R 1

Introduction
1.3 Decisions are by definition about the future. You can decide what to eat tomorrow, but you cannot decide what to eat yesterday. Accounting information is usually based on past events. However, current values of certain assets (e.g. some investments) are sometimes used. Information about the past is generally more reliable than estimates of todays values or of future cash flows. Consequently, reporting tends to concentrate on the past. Nevertheless, this is only useful for decisions if it helps with the prediction of the future. Open discussion. We suspect not. It is possible that users can specify the decision that they need to make, though even that is likely to be doubtful. The chances that the average user of financial statements can actually specify the particular information characteristics relevant to his/her own needs seem extremely small. This suggests that the accountant will have to tell the user what the users own needs are. We cannot help much here. Discussion would be beneficial, and note and consider likely contextual explanations for differences. As Exercise 1.5 but more so. Do any national patterns emerge?

1.4

1.5 1.6

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C H AP T E R 2

Some Fundamentals
2.3 Solution to Kings Cross Co.
Applications Assets Land and Buildings Machinery Vehicles Inventory at end of year Debtors Prepayments Cash at bank 110,000 +40,000 150,000 50,000 25,000 30,000 35,000 +3,000 10,000 260,000 Expenses Cost of goods sold Wages Interest Rent, insurance, sundry expenses 90,000 20,000 +2,000 15,000 +1,000 3,000 +1,500 +5,000 +2,500 125,000 90,000 20,000 2,000 5,000 2,500 45,000 22,500 30,000 35,000 3,000 10,000 295,500 Revenues Sales 160,000 160,000 225,000 Loans (10%) Creditors 20,000 50,000 +1,000 +1,500 +2,000 20,000 Sources Capital and Liabilities Share capital Revaluation Retained profits 150,000 5,000 +40,000 +26,000 150,000 40,000 31,000

54,500 295,500

14,500 7,500 134,000 26,000 160,000

Depreciation Profit

160,000

160,000

Note: The fact that a dividend is to be proposed indicates an expectation that an obligation to pay dividends will come into existence at a later date. There is no liability, within the IASB meaning of the word, at the balance sheet date. This argument is not necessarily accepted in other jurisdictions. The note above refers to part (g) in the second edition of the book. Note: Each individual transaction is also balanced in the following sense Changes in assets + changes in expenses = changes in equity/liabilites + changes in revenues

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For transaction (a) this equality is equal to 0+1,000 = 1,000 + 0. For transaction (b) it is equal to -3,000 + 3,000 = 0 + 0. You canuse this equality as an additional control check as it needs to hold for EACH transaction

2.4

This question introduces a more practical treatment of the inventory and cost of goods sold. It has been assumed so far that every time a sale is made the business knows the exact cost of the actual items or units that have been sold. In the context of large-scale operations in the real world this assumption is both impractical and unnecessary. All that is really needed is to determine the cost of the inventory in hand at the beginning and at the end of the year. This can be done in two ways, either by physically counting inventory at each year end date and calculating the cost of those items only, or by keeping continuous inventory records in quantity terms (which can be compared with actual inventory holdings from time to time as and when convenient or necessary to ensure accuracy), and reading off the year-end figures. The logic of this method is to assume that all the purchases in the year are expenses, and during the year to forget about inventory for this purpose. The inventory at the end of the previous year was obviously an asset. This is the same as the inventory at the beginning of the current year, so this too is clearly an asset, to be recorded in the assets section of the balance sheet. The purchases are treated as expenses and recorded in the expenses section of the recording system. At the end of the year we will, so far, have arrived at the wrong answer. Our closing inventory, determined by one of the two methods just described will not in reality be the same as our opening inventory. If the actual closing inventory is higher than the opening inventory this will have been caused by some of the purchases in the year being added to inventory and therefore not sold. Such items need to be removed from expenses and added to assets. If the actual closing inventory is lower than the opening inventory this will have been covered by the total items sold in the year being greater than the total items purchased in the year, the difference being the reduction in inventory levels. Such items need to be removed from assets and added to expenses. We suggest that the most logical and sure way of dealing with this is as follows: opening inventory + purchases = total goods available for sale closing inventory = cost of sales opening goods available for sale + additional goods available for sale = total goods available for sale total goods available for sale which were not sold = total goods (available for sale which were) sold

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual Applications Assets Land and Buildings Plant and Machinery Vehicles Inventory at start of Year Debtors Shares in listed company Cash at bank and in Hand 60,000 40,000 30,000 4,000 6,000 60,000 36,000 Retained profits 24,000 Creditors 25,000 20,000 40,000 25,500 230,500 Revenues 50,000 +20,00 0 25,000 + 4,000 + 6,000 Sales 45,000 10,000 41,000 6,000 8,500 + 500 107,000 Profit 342,500 1,500 500 112,500 37,000 149,500 Dividends from listed investment 2,000 2,000 149,500 147,500 147,500 37,000 + 500 37,500 20,000 20,000 +25,000 20,000 40,000 25,500 235,500 6,000 +37,000 43,000 Sources Capital and Liabilities Share capital 150,000 150,000

193,000

230,500

Expenses Purchases (adjusted to cost of sales) Depreciation

Wages and salaries Salesmens commission Rent, insurance, sundry expenses Cash discounts allowed Audit fees

41,000 6,000 8,500 1,500

149,500 342,500 149,500

Note: at the start, the balance sheet is not balanced. Total assets equal 235,500 while equity and liabilities amount to 193,000. The difference of 42,500 is equal to profit, that is the difference in revenues and expense. Revenues equal 149,500 and expenses equal 107,00. Transactions (a)-(c) result in adjustments to the balance sheet and income statement. Transaction (a) increases profit by 5,000 as it reduces cost of goods sold and increases inventory (asset). Transaction (b) decreases profit by 500 and increases liabilities. Finally, transaction (c) decreases profits due to depreciation expenses of 10,000; it also decreases assets by 10,000. Overall, transactions (a)-(c) decrease profit by 5,500. Also note that transactions (a)-(c) each satisfy the equation Change in assets + change expenses = change in equity/liabilities + change revenues. Note: dividends of company Y do not affect profits of company Y. However, dividends of company Y may affect the profit of another company Z when company Z has shares in company Y as company Z receives the dividends paid by company Y. It is a revenue on company Zs investment company Y. This is what happens in this exercise. Kings Happy Co. is shareholder of a dividend paying company. If Kings Happy Co. decided to pay dividends it would not affect their profit of 37,000. Paying dividends does not affect profit; profits are used to pay dividends.

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2.5

Solution to Kingsad Co.

Sources Capital and Liabilities 100,000 50,000 30,000 25,000 205,000 +50,000 5,000 30,000 +20,000 1,000 +500 150,000 45,000 Share capital Retained profits Revaluation reserve Creditors 100,000 46,000 +13,500 +50,000 30,000 176,000 Revenues 70,000 40,000 10,000 +30,000 20,000 +5,000 500 +1,000 80,000 5,000 40,000 9,500 1,000 135,500 +13,500 149,000 100,000 59,500 50,000 30,000 239,500

Applications Assets Land and Buildings Plant and Machinery Inventory at 1 Jan. Debtors Prepayments

20,000 24,000 500 239,500

Expenses Purchases (adjusted to cost of sales) Depreciation Wages and salaries General expenses Bad debt Profit

Sales Less returns

150,000 1,000

149,000

120,000 325,000

149,000 325,000

149,000

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C H AP T E R 3

Frameworks and concepts

3.3 3.4 An expansion of section 3.1 would be a basis for an answer to the first part of this question. Section 1.1 is also relevant. Section 3.3 is relevant for the second part. See Chapters 1 and 3. Consider the importance of (and conflict between?) relevance, reliability, etc. Specific uses might include profitability and liquidity appraisal, assessment of managers and directors, invest/disinvest decisions, etc. There is certainly a conflict between these two conventions. Perhaps, though, this does not stop them both being beneficial ideals to bear in mind as part of a desirable context for accounting thought and action. Or does it? There is scope for discussion here. There is clearly a trade-off, as mentioned in section 3.4. The last of the old IASCs standards, IASs 39, 40 and 41 (see Table 5.13), all concluded that fair values are more relevant and are reliable enough under certain circumstances. However, this is a modern view, suggesting that the hampering is reducing. There are several possible treatments, for example: Write off the whole amount in 20X1. This could be justified on the grounds of prudence any return being highly speculative. Write off the amount in strict proportion to the expected benefits. This would be supported by the matching convention, i.e. to allocate the expenses over the period of benefit in proportion to that benefit. This would imply expenses of 0 in 20X1 (as benefit does not commence in 20X1), 6,000 in 20X2 and 4,000 in 20X3. The conflict between prudence and matching is usually resolved through compromise, though in areas of real doubt some accountants or rule-makers in some countries believe that prudence should prevail and be given greater emphasis. A reasonable compromise in this case might well be to charge all the 10,000 as an expense in 20X2 any return in 20X3 being much more speculative than those expected in 20X2. This suggested compromise is, however, a highly debatable (indeed subjective!) proposition and its validity would depend on the particular circumstances, advice of advertising and industry experts, earlier treatment of similar items (consistency is an important accounting convention) and also on the materiality of the amounts concerned. If the amounts concerned are small in relation to your results as a whole, then it is pointless to spend time and money in a lengthy and detailed investigation. We should perhaps also consider the users of the accounting reports. For example, a trade creditor will be particularly interested in the asset and liability position. From this point of view, an asset which exists because of the speculative expectation of higher sales next year is not exactly a safe near-cash security. On the other hand, a shareholder will be concerned with the future trend of profits, and application of the matching convention is arguably an essential requirement for showing a fair indication of present profit and current and future trends.

3.5

3.6

3.7

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C H AP T E R 4

The regulation of accounting

4.3 Of the three countries mentioned, the state is most involved in Germany. The Commercial Code (HGB) contains the basic legal rules for financial reporting. Because of Massgeblichkeit, the tax regulations and the decisions of the tax court are relevant, particularly in cases where the Commercial Code is silent or allows choices. Only in 1998 was a standard setter established, and its rules need governmental approval, and only apply to consolidated statements. In the United Kingdom, the Companies Act is of some relevance but private sector standards are more detailed and sometimes use the true and fair view to override the details of the law. The Act is important as part of enforcement of standards, although standards are not legally compulsory. In the United States, there is no Commercial Code or general Companies Act. At first sight, the rules come mainly from the private sector FASB. However, SEC-registered companies have to comply with the regulations of the SEC, a government agency. The SECs rules include Regulations S-X and S-K, and it enthusiastically enforces standards. The FASB is, no doubt, affected by the SECs existence. 4.4 Generally accepted accounting principles include accounting standards and are required by the SEC for the financial reporting of those companies registered with it. This is rigorously enforced. However, this covers only a small proportion of US corporations. The others may have requirements depending on their State of registration. However, generally, there is no requirement for full-scale GAAP. Nevertheless, the US tax system starts from the income as calculated under GAAP. So, many aspects of GAAP are relevant for the generality of companies. 4.5 Partners can share risks and losses. Partners can provide a range of skills and resources. Partners can pool their capital in order to gain economies of scale. Partners can cover for each other during holidays or sickness. The partnership business can continue on retirement or death of a partner, although the exact legal partnership arrangements have to change. Partnerships do not pay tax in their own right, so they avoid double taxation of the same income. On the other hand, undistributed income can build up in a company, having perhaps suffered a lower rate of tax than partners profit would. Unlike partners, the owners of companies have limited liability for the debts of the business. This means that partnerships are more risky, and large partnerships are difficult because all the partners want to be in control. Companies can have thousands of distant owners. Partnerships generally have lesser (or no) audit and financial reporting requirements.

4.6

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C H AP T E R 5

International differences and harmonization

5.3 5.4 The question is phrased in such a way that a suggested answer is difficult. However, there is plenty of relevant material in section 5.3. Of course, classifications are designed to simplify masses of facts into a digestible picture. Naturally, plenty of important detail is lost on the way. It is important to specify the purpose of the classification, what exactly is being classified, and how. Without some form of classification, the world would be full of a large number of apparently unconnected and incoherent individual members of populations. 5.5 5.6 As with Exercise 5.3, the phrasing prohibits a standard answer. The basic thesis is this: (a) In all countries, the government will be interested in the calculation of profit in order to calculate taxable income and prudently distributable profit. (b) Financial reporting rules in a country tend to be driven by large companies because they exercise the greatest influence over the rule-makers. (c) In countries with large numbers of listed companies which have large numbers of nondirector shareholders, there will be a demand for large quantities of published, audited financial information used for making financial decisions. (d) In these countries, the governments accounting/tax rules will be unsuitable for financial reporting, so accounting calculations will have to be done twice. (e) In other countries, a few large international companies may volunteer to use non-tax rules for group accounts. If, for example, the United Kingdom and the United States are countries as described in (c), whereas Germany and Italy are not, the financial reporting will differ. The conclusion would be that a basic split of countries into two groups is not caused by tax differences. The fact that some countries have financial reporting closely linked to tax is not caused by differences in the calculation of taxable income. However, at the next classification level down, we might be looking at a series of countries in all of which the tax rules and the financial reporting rules are closely linked. In that case, differences in tax rules would be likely to cause differences in financial reporting. For example, if tax rules allow the use of LIFO (as in Germany, Japan or Italy) then financial reporting in those countries may be affected by companies choosing that practice. 5.7 The first half of the invented quotation is true in a sense. However, the words are, of course, different in the different national laws. Some of the words are a long way from being a literal translation of the English. This presumably may lead to different interpretations.
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Also, in some laws, the TFV is hedged around with words such as in accordance with GAAP. This may rob it of power. In addition, the override is not implemented in, for example, Germany. All this suggests a lack of harmonization of the aim of financial reporting. Furthermore, it is worth asking: true and fair view for what? Different answers may imply different aims. 5.8 (a) The EU objectives, according to the preamble of the Fourth Directive, refer to creditorprotection and use for tax, as well as protection of shareholders. The achievements include the spread of consolidation along broadly similar lines throughout the EU. As far as the Fourth Directive is concerned it did somewhat harmonize formats (although this may be unimportant) and increase disclosures. Now, of course, the EU is backing the IASB and requiring use of IFRSs by listed companies from 2005. (b) The objectives of the IASB include the issuing of standards and encourage observance of them. The effects differ by type of country (see chapter). In the late 1990s onwards the effects are clear in greatly increased use of IFRSs by large European companies. (c) In the 1980s, the IASC had little practical effect, whereas the EUs efforts (as above) were bearing some fruit. Now, the EU is becoming a regulator and enforcer, leaving the standard setting to the IASB. This makes good sense. 5.9 Possibly the answer up until 2005 was Switzerland and Germany, where many large companies used IFRSs for consolidated statements. The domestic rules of those countries are not much affected, however. There is probably more effect on the National Standards in Norway, Denmark, the Netherlands and the United Kingdom. From 2005, of course, the effects have been greater in all the EU countries, but movements towards IFRS at the national level remain unclear at present.

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C H AP T E R 6

The contents of financial statements

6.3 This is essentially a repeat of Activity 6A in the text. The vertical format seems to present the information in a logical sequence, almost as a narrative, in contrast to the bookkeeping style of the horizontal format. The arguments for by function and by nature are perhaps more even-handed, as discussed in the feedback to Activity 6A. There is the obvious point that complicated financial statements cost more to produce than simple ones, and the benefits to society as a whole of the publication of voluminous data should be expected to exceed the costs to society as a whole. More significantly, perhaps, one should consider the reader of the financial statements. As a general proposition, the expert reader can be expected to benefit from a maximum of data, and to sift the important from the unimportant. However the everyday reader may be actively confused by a mass of data. This creates the further danger that important facts might be embedded in a mass of figures and verbiage, in such a way that many users of the financial statements will fail to appreciate their significance. Data are not synonymous with information! Nevertheless, standard setters tend to concentrate on the expert reader, and there is evidence that inexpert readers make little use of financial statements. Over to you. Reasons are likely to be historical, and may relate to the finance focus/investor focus dichotomy discussed in Chapter 5. If your jurisdiction restricts the possibilities by law, why is this so? The question remains relevant even in the context of the use of IFRS, because IASI does not contain format requirements.

6.4

6.5

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C H AP T E R 7

Financial statement analysis

7.3 Mosca (i) return on capital employed (ii) gross profit margin (iii) current ratio (iv) inventory turnover period (v) debtors collection period (vi) creditors payment period 14,000 = 15.5% 90,000 24,000 = 16.6% 144,000 60,000 = 2.5 :1 24,000 20,000 365 = 61 days 120,000 30,000 365 = 76 days 144,000 24,000 365 = 73 days 120,000 Vespa 4,000 = 4.4% 90,000 20,000 = 14.3% 140,000 65,000 = 13 :1 5,000 10,000 365 = 30 days 120,000 50,000 365 = 130 days 140,000 5,000 365 = 15 days 120,000

In broad terms, Mosca seems to be in the stronger position. As regards the profitability ratios, this is clearly so. As regards the liquidity position, Vespa obviously has the stronger current ratio. This is caused partly by its much lower creditors figure, and partly by its higher debtors figure. Vespa takes an average of 130 days to receive the money from its sales activities, which is definitely not favourable. Mosca has cash available to pay some of its creditors, but has not done so, presumably because there was no need to shorten the 73 day average payback period. 7.4 Ratio calculations for 20X3 are as follows: 465 + 80 2,045 + 800 465 11, 200 11, 200 1,850 + 995 1,950 955 = 19.16% = 4.15% = 3.94 = 2.04

ROCE Profit/sales Asset turnover Current ratio

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Quick ratio Gross profit ratio Days debtors Days creditors Inventory turnover Gearing

1, 230 + 80 955 11, 200 8, 460 11, 200 1, 230 365 11, 200 750 365 8, 460 8, 460 640 800 2,045 + 800

= 1.37 = 24.46% = 40 days = 32 days = 13.22 = 28.12%

Note that some assumptions have been made in these calculations, in order to ensure apparent consistency with the given figures for 20X2. Thus assets have been taken to mean fixed assets plus net current assets, rather than gross assets, and gearing has been calculated as debt over capital employed, not as debt over equity. ROCE has used return, rather than operating return. The figures suggest that little of significance has happened over the year. Profitability has slightly improved, and the other figures are generally satisfactory. 7.5 (a) The current ratio is found by dividing current assets by current liabilities. Quick assets relate current assets less inventory (and less any other relatively slow-moving current asset) to current liabilities. Return on capital employed (ROCE) relates profits generated by the business resources with the total resources provided to the business by owners and non-current lenders. Return on owners equity relates the net profits attributable to the owners with the resources provided to the business by the owners. Debtors turnover relates sales to average debtors, expressed in terms of the number of days it takes debtors to pay, on average. Creditors turnover relates purchases (theoretically, but cost of sales in practice) to average creditors, expressed in terms of the number of days it takes the firm to pay creditors, on average. Gross profit percentage relates gross profit to sales. Net profit percentage relates net profit to sales. Inventory turnover relates average inventory level with cost of sales, expressed in terms of the number of days that goods are held in inventory before sales, on average. (b) It should be noted that the question gave no indication about the relative size of Businesses A and B. Comments about size or significance in what follows should be understood in relative rather than absolute terms. The current and quick assets ratios show that Business A has a higher working capital requirement than B. Relating the current and quick asset ratios together indicates that B has high inventory relative to liabilities (0.8:1) compared with A (0.3:1). A presumably has very significant debtors. This supposition is supported by the debtors payback period being three times greater for A than for B.

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The ROCE shows A as slightly more efficient than B, but ROE (return on equity) shows A significantly higher. This suggests that A has significant long-term borrowings (at an interest rate significantly less than 20%). For B, since ROE and ROCE are nearly the same, then either B has low borrowings or the borrowings are at an interest rate close to 18%. Gross profit percentage indicates a much higher gross profit per euro of sales for A than for B, but net profit percentage is the same for both. Clearly A has very high operating expenses per euro of sales when compared with B. Finally inventory stays unsold in A for over twice as long as in B. In summary, A, relative to B, has low inventory, high debtors, probably high borrowings, sells more slowly but at a higher mark-up and has high running costs compared with sales. Bs high inventory, accentuated further in effect by its lower inventory turnover period, strongly suggest a high sales volume, at a relatively low price as the gross profit percentage makes clear. It seems very likely that A concentrates on personal service smaller scale, high unit return and B concentrates on competitive prices larger scale, smaller unit return. 7.6 Some suggested ratios are as follows: 20X3 ROE ROCE Gearing Current ratio Quick assets Gross profit sales Net profit sales Net operating profit sales Receivables 365 sales Payables 365 cost of sales Inventory 365 cost of sales 20 109 20 + 15 109 + 150 150 259 115 84 50 84 80 200 20 200 20 + 15 200 50 365 200 60 365 120 65 365 120 = 18.3% = 13.5% = 57.9% = 136.9% = 59.5% = 40% = 10% = 17.5% = 91 days = 183 days = 197 days 40 77 40 + 10 77 + 100 100 177 98 60 43 60 100 200 40 200 40 + 10 200 40 365 200 40 365 100 55 365 100 20X2 = 51.9% = 28.2% = 56.5% = 163.3% = 71.7% = 50% = 20% = 25% = 73 days = 146 days = 201 days

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These calculations take the given figures at face value. It is clear, however, that land has been revalued in 20X3, introducing an inconsistency. Removing that revaluation, and then reworking the first three ratios, gives the following for 20X3. ROE ROCE Gearing 20 89 35 239 150 239 = = = 22.5% 14.6% 62.8%

The way that the revaluation largely disguises the increase in gearing is noteworthy. Overall, the picture is of a company with high inventory and payables turnover figures, and also a high receivables turnover. Against this background, gross profit ratio has fallen, presumably to maintain sales, as they have not increased despite the cut in sales margin, and constant operating expenses have led to a sharp decline in earnings and profitability. The position does not look favourable.

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C H AP T E R 8

Recognition and measurement of the elements of financial statements

8.3 8.4 A1 + E1 = L1 + OE0 + R1 Given that the balance sheet and the income statement articulate (i.e. the double-entry system contains a balance), debit balances must be on the left of the answer to Exercise 8.3. If asset and expense were defined independently, there would be a grave risk that some items would appear to fall into both definitions. The definitions need to be mutually exclusive and to capture everything relevant. So, one of them has to be residual. According to the IASBs Framework, the general rule would be to have a clear definition of an asset-that-must-be-recognized. Any payment that has not led to that must be an expense. The disadvantage mainly concerns loss of relevance. If the purpose of financial reporting relates to decisions about the future, past costs are unlikely to be the most relevant data about it. Similar assets will be recorded (and added together) at different costs. Depreciation expenses will be proportions of old costs rather than a current measure of wearing out. Alternatives include economic value, current replacement cost, current purchasing power adjusted and net realizable value. Further, these can be used in combination, as in deprival value. Preferences depend upon the purposes of reporting, and a weighing up of advantages and disadvantages. Sub-section 8.3.3 relates to this question, as do later parts of the book, e.g. section 9.7 and Chapter 16.

8.5 8.6

8.7

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C H AP T E R 9

Tangible and intangible fixed assets

9.3 (a) Machine 1 is an operating lease as there is no transfer of the risks or rewards of ownership because the contract can be terminated any time. (b) Machine 2 involves a total payment of 12,000. Since this is much greater than 8,000, it implies (depending on the discount rate) that rewards of ownership are transferred. So, it is a finance lease. (c) Machine 3 involves a total payment of 7,200 which, on present value terms, will never equate to anything approaching 8,000. Therefore, it is an operating lease. 9.4 Machine 1 will cause a simple expense at the rate of 250 per month, with corresponding reductions in the bank balance. Machine 2 will involve an opening entry: Dr Leasehold machine Cr Lease liability 8,000 8,000

Each payment of 1,500 will contain some interest and some repayment of the liability. Thus: Dr Interest expenses Dr Lease liability Cr Bank X X 1,500

Additionally there will be an annual depreciation charge based on the 8,000 cost figure. Machine 3, being an operating lease like Machine 1, will involve an expense charge of the amounts due. 9.5 Briefly, there is no legal ownership of the tangible asset, but there is legal ownership of the right to use it. There is ownership and control over an economic resource. Are financial statements supposed to be about economic or legal situations? In the end, this question requires a consensus answer, because there is no theoretical one. Users interested in the protection of creditors would note that leased assets cannot be sold by the lessee. Those interested in the comparison of performance would note that the leasing arrangements have similar effects to a purchase, for a going concern. Even the creditors should be worried about the obligations of the lessee. Assuming that an enterprise can keep its research findings secret or legally protected, then it can control the discoveries. There seem to be past transactions. The problem with research is identifying the benefits. In conclusion, it seems reasonable to assume that there is often an asset, but not one reliable enough to be recognized. We hope that students will now better understand Exercise 3.7 and its answer (see earlier).

9.6

9.7

9.8 Arguments for the capitalization of interest:

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(a) Interest on funds borrowed to create an asset is not different in nature from the other costs associated with the asset. If there is a time lag between commencing the development, and receiving earnings from the asset, the interest paid on borrowed funds during this period may fairly be treated as part of the cost of the asset. (b) If interest on borrowings used to develop an asset is charged against revenue before the asset starts to earn, the measurement of income for that period will be distorted as a direct consequence of acquiring the asset. Similarly, unless the full cost of the development is measured and amortized against its earnings when they commence, an overstated profit figure will result. (c) Capitalization of interest will show the true cost of the development for accurate comparison with assets purchased on the open market. Arguments for treating interest as a charge to income without regard to the purpose of the borrowing are: (a) Borrowed funds finance the whole of the activities of the business and cannot be associated with individual assets unless some form of arbitrary allocation is applied. (b) All funds have a cost. Thus it is illogical to capitalize interest on borrowed funds and ignore internally generated funds which may also be used to finance capital developments. (c) Interest is calculated on a time basis and should thus be treated as a period cost. This treatment enables a more accurate indication of past and future cash flows to be derived from the accounts. 9.9 (a) The essential point is that depreciation is an allocation process following the logic of the matching convention. It gives, perhaps, the (historical) cost of the benefit derived from using the asset during the year. (b) The simple, and perhaps only safe, answer is that it is the unallocated part of the original figure. This does not sound very useful from the viewpoint of readers of a balance sheet. NBV is not a value in any economic sense. 9.10 The cost figure should be the total cost of making the fixed asset usable or improving it, excluding all costs of actually using it or repairing it. This gives: 11,000 + 100 + 200 + 500 = 11,800 Note the difference in treatment between the additional component and the replacement parts. 9.11 See text. Note the significance of allocation over the useful life in proportion to the benefit, i.e. the pattern of benefit is crucial. The relevance or otherwise of other ancillary expenses in this particular matching process is also important. 9.12 (a) Annual charge = 12,000 2,000 4 Year 1 = 2,500 Cost Depreciation (40%) NBV 12,000 4,800 7,200

(b)

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

Year 2 Year 3 Year 4

Depreciation (40%) NBV Depreciation (40%) NBV Depreciation (40%) NBV

2,880 = 40% x 7,200 4,320 1,728 = 40% x 4,320 2,592 1,037 = 40% x 2,592 1,555

(c) If reducing balance had been used, then an asset recorded at 1,555 is sold for 2,000, giving a gain of 445. This is a realized gain, and is in a sense merely a correction to the estimated depreciation charges of earlier years. You have recorded too much depreciation expenses in the past. Over the past 4 years you have recorded 10,445 in depreciation expenses whereas you only needed to record 10,000 (the loss in value over the past 4 years). Hence, you may now record a gain of 445. Under the straight line method, in this example, no correction is needed because total depreciation expenses over the past 4 years is precisely equal to decrease in value (i.e. 12,000 2,000 = 10,000).. The effects on reported profit can be summarized as follows: ________________________________________________________ Straight line Reducing balance _________________________________________________________ Year 1 Year 2 Year 3 Year 4 Year 5 Total effect Reduction 2,500 2,500 2,500 2,500 Nil 10,000 Reduction 4,800 2,880 1,728 1,037 445 10,000

Increase

_________________________________________________________ 9.13 Debatable of course, but if the matching convention is accepted at all, then it is surely better to have depreciation vaguely right, rather than not there or precisely wrong. It is clear that the use of an asset is a cost of the business.

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C H AP T E R 1 0

Inventories
10.3 Schedule of number of units held: Beginning of 2005 End of 2005 End of 2006 End of 2007 0 7,000 0 2,000

10.4 Note. Since the question gives no information on dates of purchases or sales, the calculations can only be made on a whole-year basis. 2005 FIFO closing inventory = 7,000 @ 30 = LIFO Closing inventory = 4,000 @ 20 + 3,000 @ 20 = FIFO & LIFO Closing inventory = 0 FIFO Closing inventory = 2,000 @ 25 = LIFO Closing inventory = 2,000 @ 40 = 50,000 80,000 210,000 140,000

2006 2007

Gross profit statements, 2005 () FIFO Sales Opening inventory Purchases Closing inventory Gross profit 600,000 0 460,000 460,000 210,000 250,000 350,000 0 460,000 460,000 140,000 320,000 280,000 LIFO 600,000

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

Gross profit statements, 2006 () Sales Opening inventory Purchases Closing inventory Gross profit FIFO 1,200,000 210,000 440,000 650,000 0 650,000 550,000 ====== 140,000 440,000 580,000 0 580,000 620,000 ====== LIFO 1,200,000

Gross profit statements, 2007 () Sales Opening inventory Purchases Closing inventory Gross profit FIFO 1,170,000 0 655,000 655,000 50,000 605,000 565,000 ====== 0 655,000 655,000 80,000 575,000 595,000 ====== LIFO 1,170,000

Note that the gross profit for 2005 and 2006 added together is the same under both methods. This is because, for that two-year period, opening and closing inventories are both nil. 10.5 (a) All figures in euros. (i) FIFO Sales Cost of sales R 1,200 260 @ 1.25 40 @ 1.50 385 815 R 1,200 200 @ 3.75 100 @ 1.50 900 300 200 @ 1.55 200 @1.70 100 @ 1.75 825 175 200 @ 1.75 200 @ 1.70 100 @ 1.55 845 155 A 1,000 A 1,000

Gross profit (ii) LIFO Sales Cost of sales

Gross profit

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

(b)

Assuming that cost of replacement remains at the latest given purchase price, then under FIFO, R will be unable to replace his volume of pils, whereas A will have more than enough cash to replace his lager. Under LIFO, R will more than be able to replace the volume of pils sold, and A will again be able to easily replace the lager. The key conclusion is clear: when cost levels are rising, FIFO seems to overstate reported profits. The above answer implicitly assumes that purchases on credit are not possible/allowed. Whether this is a justifiable assumption is debatable. However, the point that the book tries to make here is, that overstating profits can harm the financial position of the firm. Since profits may be used to pay dividends, overstating profits may result in dividend payments that are too high (as in this example). The reasoning is similar to the reasoning in the supplemental document on blackboard on depreciation and replacement.

10.6 Essentially, this question requires a verbal description, perhaps with simple illustrations, of the various alternative treatments given in section 10.4 of the chapter. It is essential to understand thoroughly that we are dealing with accounting assumptions and not with investigation or assumption of physical movement of inventory items (except with the unit cost method, of course). Note also that all the various possible reported profits resulting from these methods, however different they may be numerically, are historical cost figures. 10.7 Lower of cost and net realizable value, in the context of inventories, means that each type of commodity or product is separately evaluated at both historical cost (on one of the bases, consistently applied, described in the chapter), and at net realizable value, i.e. the estimated revenues which will arise from disposal in the normal course of business less costs of the disposal process. The lower of the two evaluations is then used in the financial statements. There is, of course, an element of subjectivity in this process especially, but not uniquely, in the net realizable value calculation. The idea of lower of cost and net realizable value is similar to the idea presented in Figure 9.5 for valuing fixed assets. Now, the term net realizable value is used instead of recoverable amount. 10.8 It can certainly be validly argued that failure to use the percentage of completion method, if the four stated conditions are satisfied, would result in a failure to report, or even to attempt to report, the economic substance of position and performance (if that is what financial statements are supposed to do). However, there is always some uncertainty involved (what does reliably estimated mean?). The usual discussion (!).

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C H AP T E R 11

Financial assets, liabilities and equity

11.3 In these circumstances, the authors would think that they had gained. The gain is reliably measurable and could be turned into cash with a telephone call. Note that a distinction between gained and better off does not seem useful. Surely, one is better off, and that must mean one has gained. 11.4 Of course, the quotation contains an error in the sense that receivables are not valued at what the entity is owed. The entity has to estimate how much might not be received. Also, the value of a receipt could reasonably be said to fall the longer one has to wait for it. The determination of discount rates is a notorious problem. 11.5 The Fourth Directive definition refers to those assets intended (by the directors) for continuing use in the business. This is vague and difficult to audit. The IAS 1 definition offers a choice (see section 6.2.1), which is even less precise. It matters because the fixed/current split will affect valuation and income. Although IAS 39 does not have this exact split, it has an analogous one: held-to-maturity, available-for-sale, or trading. 11.6 In US-English, in practice, reserve can be used to mean an allowance against the value of an asset and a liability of uncertain timing or size. In UK-English, it means an element of equity caused by undistributed income, including gains on assets. 11.7 Table 11.6 can be used for the answer to this question. In a high-tax environment, the deductibility of interest is likely to favour debt. 11.8 Let us assume that raising finance does not include retaining profits. Bank loans and overdrafts seem to be excluded from debt securities. Also, a company could slow down payments to creditors. Taking out leases is a way of raising finance, in substance.

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Accounting and taxation

12.3 A reduction by the enterprise, voluntarily or otherwise, in future capital expenditure, or a cancellation by a future government of the front-loaded tax allowances designed to encourage such expenditure, will lead to a reduction in the deferred tax account balance, i.e. to the future outflow of resources necessary within the definition. In practice, within the limited time horizon of many businesses, the expectation of apparently continuous deferral may be genuine, but this is not really the point. In the longrun, the entity must pay the tax postponed, even though new postponements may arise. 12.4 A temporary difference, as discussed in section 12.4 of the text, is the difference between the carrying value of an asset or liability for financial reporting purposes and its value as recorded in the tax records. Such differences, being temporary, will usually eventually reverse. This means that the balance sheet values imply that future tax payments will be necessary (or possibly receipts will be obtainable). This arguably creates an immediate liability. However, in some cases at least (e.g. the revaluation of an asset which does not lead to immediate tax), it is not clear that there is an obligation.

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C H AP T E R 1 3

Cash flow statements

13.3 Remark 1: On the balance sheet, creditors payable within one year represent the liabilities that will result in cash outflows in the next year. At the end of 20X6, dividend payable amounts to 26. Hence, 26 will be paid in cash during 20X7. Also note that this dividend is paid out 20X6 profit. Similarly, dividend payable of 28 at the end of 20X7 is paid out of 20X7 profit. Remark 2: Taxation is a payable within one year. It refers to the taxes that the company needs to pay based on previous years profit. Thus, tax payable of 17 at the end of 20X6 arises from 20X6 profit and tax payable of 19 at the end of 20X7 arsises from 20X7 profit. The reason why is clear. Profit over 20X6 is known at the end of 20X6. From this point onwards, the company knows how much tax it needs to pay. Hence, the tax payable at the end of 20X6. The actual payment of the tax must thus occur in 20X7. Remark 3: The difficult part of the exercise is to determine 20X7 profit. Observe that the following holds: Operating profit - interest on loans Gross Profit - Taxes Net profit Net profit is reinvested in the company as retained profits or it is paid as dividends to the shareholders. Hence, Net profit = dividends payable + change in retained profits. Now you can work backwards to determine operating profit as dividends payable, change in retained profits, taxation, and interest on loans is given in the balance sheets. Cash flow statement for Dot Co., year ended 31 December 20X4 (all figures 000). Operating profit Increase in retained profits Interest on loans Taxation Dividend Net cash inflow from operations Operating profit Depreciation (change in cumulative depreciation: 90-56 = Increase in inventory Increase in debtors Increase in creditors
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10 12 19 28 69

69 34 (8) (7) 9

David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

Interest paid 15% x 80 = Taxes paid We therefore have: Cash inflows from operating activities Cash flows from investing activities: Purchase of fixed assets = change in fixed assets Cash flows from financing activities: Issue of new shares Dividends paid Issue of new debentures Net cash flows Opening cash balance Closing cash balance Reduction in cash

(12) (17) 68

68 (90) 7 (26) 20

1 (21) 11 (10) (21)

Briefly, the broad picture is that significant expenditures on fixed assets (90) have been financed partly out of operating activities (6826), partly out of new share and debenture finance (20 + 7) and partly out of the reduction in the cash balances (21). This is not a worrying situation provided that the fixed asset investment is not set to continue at the same sort of level.

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13.4 Cash flow statement for Dot Co., year ended 31 December 20X4 (all figures 000). Operating profit Increase in retained profits Interest on loans Taxation Dividend Net cash inflow from operations Operating profit Depreciation (90 (5612)) Loss on disposal (30-12) 11 = Increase in inventory Increase in debtors Increase in creditors Interest paid Taxes paid We therefore have: Cash inflows from operating activities Cash flows from investing activities: Purchase of fixed assets Disposal of fixed assets Cash flows from financing activities: Issue of new shares Dividends paid Issue of new debentures Net cash flows Opening cash balance Closing cash balance Reduction in cash 69 46 7 (8) (7) 9 (12) (17) 87 87 (120) 11 7 (26) 20 1 (21) 11 (10) (21) (109) 10 12 19 28 69

The implications of this cash flow statement are not fundamentally different from that in Exercise 13.3. The amount spent on fixed assets, and the net cash flow from operations, are both higher.

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Group accounting
14.3 (a) Cost Shares of net assets 75% (503) Negative goodwill 35 35.25 0.25 3,000 1,000 2,000

(b) Intra-group inventory transfer unrealized profit 331/3 9,000 Reduction in value As accounts unrealized profit Consolidated balance sheet as at 31 December 20X7

$000s Fixed assets Land and buildings Plant and machinery Current assets Inventory Debtors Bank Creditors < 1 year Creditors 120 54 174 50 69 28 147 146 1 175 === Represented by Ordinary 1 euro shares Capital reserves Revenue reserves (36 2 + 75% 19) Minority interest (25% 66) 100 10.25 48.25 158.50 16.50 175 =====

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14.4 Acquisition Plant and machinery Goodwill on acquisition Net current assets 14,000 13,500 (Note 4) 27,500 7,500 35,000 ===== 15,000 (Note 1) 18,000 (Note 2) 2,000 (Note 3) 35,000 ===== Merger 13,000 13,000 7,000 20,000 ===== 15,000 5,000 20,000 =====

Issue ordinary shares ( 1) Share premium Reserves

Notes 1. Based on a one-for-one exchange, A will need to issue a further 6,000 1 shares (i.e. 9,000 + 6,000 = 15,000). 2. Issued at a price of 4 per share, the share premium on the issue of A shares for acquisition accounting purposes will be 3 per share (i.e. 6,000 3 = 18,000). 3. For acquisition accounting purposes (but not for merger accounting) the reserves of M of 3,000 as at the date of acquisition are not group reserves and are set off in the goodwill calculation. 4. Cost of investment (i.e. 6,000 shares at 4 each) Less fair value of net assets acquired (i.e. 8,000 + 2,500) 24,000 (10,500) 13,500

Despite the simplicity of this example the differences are amply illustrated: 1. Under acquisition accounting, a non-distributable share premium account arises. 2. Under merger accounting, the reserves of M at the date of acquisition are regarded as reserves of the group. 3. For acquisition accounting the assets of M are recorded at fair values, whereas for merger accounting purposes book values prevail. 4. Under merger accounting there is no goodwill on consolidation. 14.5 (a) Goodwill may be defined as the difference between the value of a business as a whole, and the aggregate of the value of its separable net assets. The net assets are usually valued at fair value, but sometimes book values are used in some countries. (b) (i) Goodwill is regarded as an asset which is no different from any other.

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(ii) Goodwill will be maintained through normal trading activities, purchased goodwill being substituted by non-purchased goodwill. (iii) Elimination of an asset incapable of valuation (and whose length of life is indeterminate). The preferences require open discussion!

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C H AP T E R 1 5

Foreign currency translation

15.3 It is very easy to demonstrate differences, both in terms of theoretically possible alternatives, and by a survey of European practice. The resulting differences in the published financial statements can sometimes be very large. Whether this situation is likely to continue for a long time is a more open question. Given the deep-seated cultural and historical basis for many national attitudes in this as in other areas, it is perhaps difficult to foresee rapid movement towards significantly greater harmonization, as regards the attitude to the treatment of the gains. Note, however, that IAS 21 does not give a choice of methods; it requires different methods in different circumstances. 15.4 The essential points are as follows: Transactions expressed in foreign currencies are recorded at the rate ruling at the date of the transactions. Unrealized gains and losses between transaction date and balance sheet date are taken directly to the income statement. Most consolidated subsidiaries operate as independent enterprises, so the current rate method is used, using middle market rates on the balance sheet date for the balance sheet, and average rates for the year for the income statement. Gains and losses arising from currency differences in the consolidation process are recognized in the balance sheet in retained earnings, but do not pass through the income statement, and so do not affect earnings for the year. For subsidiaries operating in highly inflationary economies, only monetary items apply the current rate. Other items use historical rates.

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C H AP T E R 1 6

Accounting for price changes

16.3 Stage 1. Convert the historical figures at the beginning of the year into euros of current purchasing power at the beginning of the year.

31.12.X7 000 Fixed assets Cost Less Depreciation Current assets Inventory Debtors Bank Less Current liabilities Creditors Share capital and reserves (balancing figure)

500 220/180 300 220/180

611 366 245 102 200 150 452

100 220/215

300 152 397 ===

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Stage 2. Convert the historical figures at the end of the year into euros of current purchasing power at the end of the year.

31.12.X8 000 Fixed assets Cost Depreciation Current assets Inventory Debtors Bank Less Current liabilities Creditors Share capital and reserves (balancing figure)

500 240/180 400 240/180

666 533 133 153 300 350 803

150 240/235

400 403 536 ===

Stage 3. Update the share capital and reserves figure calculated in Stage 1 from 31.12.X7 euros of current purchasing power into 31.12.X8 euros of purchasing power.

31.12.X8 000 Share capital and reserves are 397 240/220 = Profit for year is 536 433 = 433 === 103

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Stage 4. Prepare the income statements for the year ended 31.12.X8 Historical cost 000 Sales Cost of goods sold opening inventory purchases Less closing inventory Gross profit Expenses Depreciation Loss on net monetary Items Net profit 1,850 100 1,350 1,450 150 1,300 550 300 100 400 150 === 240/230 240/215 240/230 240/235 240/230 240/180 (see note) 112 1,409 1,521 153 1,368 563 313 133 14 460 103 === CPP 000 1,931

The loss on net monetary items is calculated as follows: 000 Net monetary items, 31.12.X7 Net monetary items, 31.12.X8 Increase in year 50 250 200 ===

Since 50 has been held throughout the year, this represents a purchasing power loss of: 50 20 =5 220 The increase of 200 is assumed to have accrued evenly throughout the year, and therefore represents a purchasing power loss of: 200 10 =9 230 Giving a total loss of 5 + 9 = 14. 16.4 For explanation and illustration, see the text. They key point is that replacement cost accounting splits up the historical cost profit into two different elements: the current operating profit and the holding gains. These elements have different causes and different effects, and reporting the split facilitates separate analysis and interpretation. 16.5 An interesting question. Replacement cost accounting, given rising cost levels, leads to a lower operating profit figure, which is more prudent. It also leads to higher asset figures in
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the balance sheet, which is less prudent. These two effects considered together will lead to much lower profitability and return on resource ratios, which perhaps sounds more prudent! 16.6 Arguably, the suggestion would give an income statement with a useful long-run operating perspective (note that this would perhaps be even more relevant if based on future RC rather than on current RC figures) and at the same time a balance sheet of current cash equivalents, i.e. meaningful current market values. Discuss the advantages of both of these. Against this, there would be a loss of internal consistency in the reporting package which seems significant. Discuss this, too. 16.7 In essence, CPP adjustments attempt to update financial measurements for changes in the value of the measuring unit, without altering or affecting the underlying basis of valuation usually, but not necessarily, historical cost. They do it by using general averaged index adjustments, usually, but again not necessarily, by means of a retail price index. 16.8 Note the generality of the wording of the question; no particular valuation mechanism is mentioned. Perhaps, as authors and teachers, we should not give our own views. In the end it may come back to relevance versus reliability. Is a general index relevant to anybody or anything? 16.9 In brief, capital maintenance is the idea that you have to keep what you already have, before you can regard yourself as having gained anything. In an accounting context, this means that the investment, the capital, at the beginning of a period must still exist at the end of the period. Any further increase or excess can be regarded as profit. Capital can be defined and measured in many different ways, leading to a variety of significantly different profit concepts, as outlined in the chapter. 16.10 Deprival value is the loss that an economically rational person would suffer if they were to be deprived of a resource. The implications of this, in terms of whether replacement would occur or not, are set out in section 16.7 of the chapter. It is a theoretical improvement on pure replacement cost. Replacement cost accounting uses replacement cost figures whether an actual replacement is desirable, or even possible. Deprival value uses replacement cost figures when replacement will logically occur, but the opportunity cost foregone (the recoverable amount) when it will not. This arguably increases relevance, but at the cost of more complexity, and usually more subjectivity and therefore perhaps less reliability. So there is scope for debate here.

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16.11 The three measures of profit would be (all figures in euros):

Money Real Maintenance Capital Concept Maintenance Concept Net Assets at 31 December 20X7 (i) (ii) Money Maintenance Real Capital Maintenance (1,000 + 10%)

Maintenance of Specific Purchasing Power

1,400 1,000

1,400

1,400

1,100

(iii)

Specific Purchasing Power (1,000 + 15%) Profit ___ 400 ___ 300

1,150 ___ 250

16.12 This can be argued to almost any level of depth and complexity. Historical cost is arguably relatively simple and relatively reliable, which is not to say that, for example, depreciation and net book value calculations are either easy to explain/understand, or are remotely objective. However, it can be suggested that it is less relevant for many purposes, and that it achieves what simplicity it has by ignoring problems and issues rather than by solving them. There is real scope for discussion here. 16.13 Who knows what you will find? The basic point of fair value is very simple, as described in the text. The detail, both in theory and in practical collaboration, is both complex and ill thought outwhich of course is not a satisfactory position.

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C H AP T E R 1 7

Financial appraisal
17.3 In three words, the problem is different accounting policies. Many examples can be given, as Part 2 has discussed in some detail. Note, however, that if two enterprises treat an apparently similar problem in different ways, then this may be because the economic circumstances and implications are genuinely different. This limitation can be addressed by companies and regulators by moving towards an internationally agreed set of accounting rules. In the meantime, analysts have to try to adjust financial statements to a common benchmark. Another limitation on analysis is that non-financial factors should be taken into account. 17.4 Yes, and no. As a general proposition, it must follow that irrelevant or misleading data will lead to poor or misleading information. The answer to Exercise 17.3 is also relevant here. However, ratios, and comparisons may lead to the cancelling out of errors. Thus trends may be informative even if absolute figures are nonsense in isolation. 17.5 A wide variety of ratios may be calculated. Those attached are a longer list than one is likely to prepare in practice. On the other hand, other ratios may be just as helpful as the ones suggested here. Briefly, it is clear that major changes were budgeted for. A major expansion was intended. Sales were to be encouraged by a planned fall in the gross profit margin. However, a sharp reduction (in percentage terms) in the expenses and overheads of running the business was planned, so that the net profit percentages, and the earnings ratios, would rise substantially. The financing of this rapid expansion was to be achieved partly by a planned reduction (equals worsening) in the working capital position, as evidenced by the current, debtors and creditors ratios, and partly by long-term borrowing as evidenced by the gearing ratio. In the outcome, the plans have been achieved to a considerable extent. The net profit before interest and tax as a percentage of turnover has risen by less than budget, but the asset turnover ratio has risen by more than budget. The net effect of these two movements is that net profit before interest and tax as a percentage of net assets (= ROCE) has risen very significantly, though not quite up to budget. Earnings as a percentage of equity have nearly doubled compared with the previous year. The only area of uncertainty seems to be on the financing side. Gearing has followed the plan, but liquidity ratios are slightly below budget, and an unexpected bank overdraft has appeared. The budgeted dividend has been sharply cut, presumably because of the cash shortage. Gross profit as a percentage of turnover 20X7 Actual 860/2,560 100 = 33.6% 20X8 Budget 1,350/4,500 100 = 30.0% 20X8 Actual 1,530/5,110 100 = 29.9% Administration and distribution costs as a percentage of turnover 20X7 Actual 655/2,560 100 = 25.6%

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20X8 Budget 20X8 Actual

880/4,500 100 = 1,084/5,110 100 =

19.6% 21.2%

Net profit before interest and tax as a percentage of turnover 20X7 Actual 20X8 Budget 20X8 Actual 205/2,560 100 = 470/4,500 100 = 446/5,100 100 = 8.0% 10.4% 8.7%

Net profit before interest and tax as a percentage of net assets 20X7 Actual 20X8 Budget 20X8 Actual 205/1,280 100 = 470/(1,420 + 360) 100 = 446/(1,460 + 360) 100 = 16.0% 26.4% 24.5%

Asset turnover ratio 20X7 Actual 20X8 Budget 20X8 Actual Current ratio 20X7 Actual 20X8 Budget 20X8 Actual Quick assets ratio 20X7 Actual 20X8 Budget 20X8 Actual (685 205)/362 = (1,080 290)/830 = (1,135 325)/935 = 1.3:1 1.0:1 0.9:1 685/362 = 1,080/830 = 1,137/935 = 1.9:1 1.3:1 1.2:1 2,560/1,280 = 4,500/1,780 = 5,110/1,820 = 2.0:1 2.5:1 2.8:1

Debtors average collection period1 20X7 Actual 20X8 Budget 20X8 Actual 305 365/2,560 = 720 365/4,500 = 810 365/5,110 = 43 days 58 days 58 days

Creditors average settlement period2 20X7 Actual 20X8 Budget 20X8 Actual
1 2

175 365/1,770 = 505 365/3,230 = 545 365/3,700 =

36 days 57 days 54 days

Assuming all sales are on credit and that the debtors figure represents trade debtors only. Assuming all purchases are on credit and that the creditors figure represents purchase creditors only (see Workings 1).

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Inventory ratio (using average inventory see Workings 2) 20X7 Actual 20X8 Budget 20X8 Actual Gearing ratio 20X7 Actual 20X8 Budget 20X8 Actual none 360/1,420 100 = 360/1,460 100 = 25.3% 24.7% 1,700/170 = 3,150/250 = 3,580/265 = 10 times 12.6 times 13.5 times

Earnings as a percentage of equity (see Workings 3) 20X7 Actual 20X8 Budget 20X8 Actual Dividend cover 20X7 Actual 20X8 Budget 20X8 Actual Workings 1. Calculation of purchase figures 20X7 20X8 20X8 Actual Budget Actual 000 000 000 Opening inventory Purchases (by difference) 135 210 205 1,770 3,230 3,700 1,905 Less closing inventory Cost of sales 3,440 3,905 119/82 = 248/108 = 229/49 = 1.5 times 2.3 times 4.7 times 110/1,261.5 100 = 250/1,350 100 = 226/1,370 100 = 8.7% 18.5% 16.5%

205 290 325 1,700 3,150 3,580 ==== ==== ==== 000 170 250 265

2. Calculation of average inventory 20X7 Actual (135 + 205)/2 = 20X8 Budget (210 + 290)/2 = 20X8 Actual (205 + 325)/2 =

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3. Calculation of average equity (assuming no shares issued in 20X7) 000 20X7 Actual (1,280 37) + 37/2 = 20X8 Budget 1,280 + 140/2 = 20X8 Actual 1,280 + 180/2 = 1,261.5 1,350 1,370

17.6 (a) Some possible ratio calculations are given below. Note, however that the appropriate return (earnings) figures are distinctly debatable. Current ratio Acid test ratio ROCE ROE e.p.s. Trade debtors turnover Trade creditors turnover Gross profit % Operating profit % Inventory turnover Gearing 54 = 36.7% 147 12 = 8.2% 147 57 = 22.9% 249 33 = 17.5% 188 31 = 0.163 euros 190 4 365 = 2 days 910 60 365 = 30 days 730 180 = 19.8% 910 57 = 6.3% 910 42 365 = 21 days 730 61 = 32.4% 188 56 = 32.6% 172 15 = 8.7% 172 41 = 25.5% 161 24 = 15.0% 160 22 = 0.116 euros 190 4 365 = 2 days 775 60 365 = 35 days 633 142 = 18.3% 775 41 = 5.3% 775 41 365 = 23 days 663 1 = 0.6% 160

(b) The company has a number of features which appear at first sight to be unusual. The most obvious is that there are hardly any debtors. On the other hand the company seems to have over 2 million permanently as cash, as well as positive bank balances. The inventory turnover period is also short. In one sense this demonstrates a remarkably efficient organization. Inventory is sold quickly, sales are paid for very quickly indeed and creditors appear willing to wait for their money. The effect of this on the balance sheet is to produce a total of current assets which is very much lower than the current liabilities, which gives the impression of a very illiquid business.

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David Alexander and Christopher Nobes, Financial Accounting, 3rd Edition, Solutions Manual

However, the positive aspects of this situation surely outweigh the negative ones. Many of the companys activities are being financed, presumably interest free, by the creditors! If we take the given figures literally, it appears that the company buys inventory, sells it and makes its profit 21 days later. It actually receives the sales proceeds 23 days after the purchase, but does not have to pay for its original purchases for another seven days after that. Gearing has risen by 5,400%, but this figure is quite meaningless as it was virtually zero in 20X1. Gearing is still low, there are enormous fixed assets which are presumably available as security for any further required borrowings, and the company has a large and apparently regular positive flow of funds from its trading operations. In reality the company seems to have cash available on tap whenever it wants it. From a profitability point of view, the position also seems very sound indeed. Profit to sales may not be all that high, but the sales volume is clearly great, and profit to capital is good. It is important to note that the ROCE and ROE figures given could be misleading if not interpreted carefully. The ROCE is before tax and the ROE is after tax. Further, the ROE relates to all shareholders. The enquiry here explicitly relates to an ordinary shareholder. A return on ordinary shareholders interest should perhaps be calculated. This might be: 31 = 21.8% 142 As an overall comment, the company, probably in the retail or cash-and-carry sector, seems in a very strong position and there seems no reason at all to rush out and sell ordinary shares.

45 Pearson Education Limited 2007