• Should the business expand its product range?
• Should the business move into new markets?
• Does the business need to borrow money?
• Can the business afford to buy a new factory or machine?
• Should the business take over another company?
• How can the business increase its profit?
• Can the business increase its dividends to shareholders?

(a) In medieval times, accounting was all about keeping track of resources, such as livestock, grain or money. Shareholders and limited companies did not exist. Today, shareholders own companies while managers run them. Shareholders, therefore, need reports on how the companies are performing. Profit has become more important as it helps to determine the dividends (i.e., cash payments) that shareholders will receive. Consequently, keeping track of assets has become less important.

(b) Germany and the UK are important developed countries in western Europe. However, Germany has a different industrial environment from the UK with banks being relatively more important as a source of business finance. Bank loans are often secured on company assets. As a consequence, in Germany there is a greater focus on assets (i.e., the statement of financial position) than in the UK. This is because the principal concern of banks is to make sure their loans are safe and the interest will be repaid.

• Financial reporting is the reporting of financial information usually to the external users. This is normally done in the form of financial statements such as the income statement, statement of financial position and statement of cash flows.
• Reporting Entity is the business or other enterprises in the case of the IASB this is usually listed companies.
• Providing resources to the entity This varies, for example, the shareholders provide funds by way of cash, loanholders funds by way of loans.

For sole traders, the main users will probably be the sole traders themselves, the tax authorities and perhaps banks. The sole traders will wish to assess their business performance in order to make business decisions. The tax authorities will use the business's profits as the basis for calculating tax. The banks will be interested in the security of their loans. Partnerships will be broadly similar to sole traders. However, in partnerships a key additional question is the distribution of profit and equity between the partners. Finally, large limited companies will need to provide shareholders with information to make share-trading decisions. In addition, profit will be used as a basis for calculating shareholders’ dividends (i.e., cash payments to the shareholders; their reward for investing money in a company).

Expenses are the costs incurred in running a business.

Assets are items owned.

Liabilities are items owned.

Therefore, we have the following:

Equity is a liability because of the entity concept. Essentially, a business owes the equity to the owners.

Note. To aid understanding the balancing off process is italicised. IS = Income Statement.

Note. The nature of Mary Symonds’ business is that she does not really have ordinary sales and purchases of goods. Instead, we have consultancy fees and purchases of various items.

We must, therefore, adjust expenses in the final accounts for amounts owing (accruals) and also for amounts prepaid (prepayments). We must also be careful to adjust the purchases and revenue figures so that they reflect actual financial performance. In particular, we must be careful to adjust purchases for opening and closing inventory. This is so that we can arrive at the inventory that has actually been sold. The reason, therefore, we adjust for inventory, accruals, prepayments, and depreciation is to arrive at the ‘true’ figures for income earned and expenses incurred.

Notes:

1. Business rates £300, advertising £550, auditors’ fees £250, debenture interest £41,200.
2. Retained earnings: Earnings for year £135,500 less £30,000 Dividends.

Opening tax payable + amount incurred for year = amount paid + closing tax payable

Opening and closing tax payable come from the opening and closing statements of financial position (current liabilities), respectively, while the tax charge for the year is in the income statement. The amount paid is the balancing figure.

Notes:

1. The revenue and cost of sales, on average, have risen by 10%. However, there is a steep increase in administrative and distribution expenses. The cause for this should be investigated.
2. In the statement of financial position, tangible non-current assets have risen by 95.8%. This is presumably planned capital expenditure and probably does not need further enquiry.
3. The reasons for the sharp fall in all the current assets needs to be investigated.
4. Why have long-term liabilities increased substantially?

We can perform our analysis in two stages: profitability and liquidity. For profitability, there is no doubt that on the two key measures, return on capital employed and net profit, Beta far outstrips Alpha. In both cases, Beta is twice as profitable as Alpha. Beta's dividend is also covered four times as opposed to Alpha's two. For liquidity, Alpha is stronger than Beta. However, even so, Beta's short-term solvency is not under threat. With a quick ratio of 1.3, Beta can still pay off its trade payables with ease. All things being equal, therefore, we would expect the share price of Beta, fuelled by its profitability, to be the highest. The higher P/E ratio may reflect the higher share price of Beta which has risen in anticipation of more steeply rising profits.

The ratios below are calculated from the accounts. There is insufficient data for average values for return on capital employed and the efficiency ratios, the year end figure is therefore taken from the statement of financial position data. This is indicated by a single asterisk. Except where indicated, all calculations are in £000s.

Brief comments: Turn-a Screw is the more profitable of the two companies. Both the return on capital employed and net profit ratios are significantly higher than Fix-it-Quick.

(b) Efficiency Ratios

Brief comments: Both companies are very quick at collecting money from trade receivables (only about 14 days). However, they both take over four times as long to pay their trade payables. Turn-a-Screw's inventory turnover is slower than Fix-it-Quick's.

Finally, the asset turnover ratio for both is comparatively low.

(c) Liquidity Ratios

Brief comments: Neither company is particularly liquid. The current ratio is just over one for each, with current liabilities just being covered by current assets. However, the quick ratio is under 1. Therefore, if all current trade payables wanted their money at once, there would be insufficient trade receivables and cash.

(d) Gearing

Brief comments: Fix-it-Quick is slightly more highly geared than Turn-a-Screw. However, in both cases almost one pound in three comes from third party borrowing.

(e) Investment Ratios

^†Calculations in pence.

Brief comments: Both companies have comparable dividend yields, price earnings and dividend cover. However, the earnings per share of Turn-a-Screw is significantly higher. Turn-a-Screw also has a much higher interest cover.

Overall Comment: There are many similarities between the two companies. However, Turn-a-Screw is relatively more profitable and looks a better investment.

1.0 Terms of Reference

Mr Pocket has requested a report on the financial results of Sunbright Enterprises, using appropriate ratio analysis.

2.0 Introduction

The income statements and statements of financial position of Sunbright Enterprises were used to calculate three profitability ratios, four efficiency ratios, two liquidity ratios, a gearing ratio and five investment ratios. The calculations underpinning these ratios are presented in the Appendix. In calculating these ratios, it is assumed that there have been no major changes in accounting policies. The main results are discussed below.

3.0 Profitability

Over the last five years there has been a sharp decline in all three ratios. Return on capital employed has slumped from 29.6% in 2008 to 9.4% in 2012. Gross profit and net profit have similarly fallen from 40% to 25%, and from 8.1% to 3.3%, respectively. The business appears to be in great difficulty.

4.0 Efficiency

The trade receivables and trade payables collection periods have both increased. However, whereas trade receivables are taking marginally more time to pay (increase from 20.6 to 23.9 days), trade payables are now having to wait much longer. This may be indicative of the cash flow problems the business appears to have. The inventory turnover ratio has declined markedly from 49.7 times to 26.7 times. However, inventory is still turned over twice per month. The asset turnover has gradually fallen from 3 times in 2006 to 1.95 times in 2011. This shows that the business is being run less efficiently.

5.0 Liquidity

The current ratio has steadily declined. In 2008, there were twice as many assets as liabilities (1.94). But now there are barely enough assets to cover liabilities (1.00). Given the steady downward trend in liquidity, this situation is alarming. In addition, the quick ratio is declining rapidly. There has been a particularly sharp decline over the last year. Should short-term trade payables demand payment at once, Sunbright Enterprises will not have the resources to cope.

6.0 Gearing

The gearing ratio has declined steadily from 33% in 2008 to 28% in 2012. This is positive. In other words, out of every £1, 28 pence has been borrowed. This is reasonably low. Sunbright Enterprises could, therefore, solve its short-term liquidity problems by borrowing.

7.0 Investment

The dividend cover and interest cover ratios have slumped from a coverage of 4.8 and 17.1 times in 2008 to 1.3 times and 5.4 times in 2012, respectively. However, perhaps in an effort to bolster confidence, the dividend has been increased so that dividend yield has actually increased from 9%to 12.3%. This is generally better than one could get in the building society. Earnings per share (EPS) reflect the general slump in profitability.

EPS has fallen sharply from 48.4 pence to 14.7 pence. Perhaps surprisingly the share price has not dropped as rapidly as one might expect. Therefore, the price/earnings ratio has held up surprisingly well at 6.5.

8.0 Recommendations and Conclusions

Sunbright Enterprises is struggling. Its profitability is falling rapidly and it has liquidity problems. While it is paying a high dividend, it is a very risky investment. A short-term solution to liquidity problems would be to borrow using loan capital. However, there appear to be deeper structural problems. In my view, the share price is still artificially high and I would not invest.

Appendix: Calculation of Ratios

The ratios below are calculated from the accounts. For the efficiency ratios and ROCE, where available, the average of two years is taken for years 2008–2012. For 2008, only one year's data is available. This is indicated by an asterisk. Except where indicated calculations are in £000s.

2 Efficiency Ratios

3 Liquidity Ratios

4 Gearing

5 Investment Ratios

^†calculation in pence

If a conceptual framework were to be successfully developed then it would be possible to set accounting statements with reference to the conceptual framework and to use it to solve accounting problems. Unfortunately, the development of the conceptual framework has been dogged by controversy. Critics argue it has been largely unsuccessful. While it has produced the ‘decision-making model’ (i.e., the objective of accounting is to provide users with information so that they can make economic decisions), there is still no agreement on an appropriate measurement model.

For example, suppose the historical cost of property, plant and equipment was £100,000 and the property, plant and equipment were depreciated over 10 years, with a profit of £20,000. Profit after depreciation would then be the profit of £20,000 less the depreciation of £10,000 (£100,000 ÷ 10), equals £10,000. However, if property, plant and equipment were revalued, say to £150,000, depreciation would rise to £15,000 and profit after depreciation would fall to £5,000 (£20,000 profit less £15,000, i.e., £150,000 ÷ 10).

The practice of revaluing property, plant and equipment is not universal internationally, because very few countries revalue their property, plant and equipment. Some countries, like the US, prefer to adopt unmodified historical cost accounting when accounting for property, plant and equipment. Revaluations are, however, permitted under IFRS.

(i) Income Statement

This gives the annual financial performance. This is of key importance in determining how the company has performed and is the key factor influencing the share price of a public limited company.

(ii) Statement of Financial Position

Although it does not provide a market valuation of the company, it does allow one to judge the liquidity and the gearing.

(iii) Statement of Cash Flows

Cash is king. So this statement allows a good assessment of how well the company is generating cash and how cash-rich it is.

(iv) Chairman's Statement

Provides the company's view of events in a narrative, story-like fashion. Users must be careful to look for bias, but it does provide a quick, relatively understandable overview.

(v) Business Review

Provides a stylised and structured look at the year's activities. Essential, in order to gain an overview of the company.

(vi) Historical Summary

Puts the results in a historical context. Enables trends over time to be established.

Notes:

1. We could adopt a less prudent sales policy, sales then increase to £900,000.
2. Closing inventories could be valued at £65,000.
3. The depreciation could be based on 15 years not ten years. Property, plant and equipment at cost must be £600,000 (as depreciation was £60,000 in the original profit and loss having been written off over ten years). If we write it off over 15 years, then depreciation falls to £40,000. There is also this year's depreciation on the £15,000 interest payable capitalised of £1,000. Thus, depreciation is £40,000 + £1,000 = £41,000.
4. We have taken a generous estimate for the interest payable that can be capitalised. This is half of £30,000 (i.e., £15,000).

   So overall, we have creatively increased our profits from a net loss of £12,000 to a profit of £177,000.

1. Sources of finance. These are ranked first because they dictate the nature of accounting in the UK.
2. Objectives. These determine the true and fair view goal which the UK's accounting system should try to achieve.
3. Regulation. This sets out the detailed statutory and standards framework and is thus very important.
4. Users. The needs of the users dictate the orientation of the detailed framework.
5. Accounting profession. This provides the judgement and interpretation which allow the system to work.
6. Spheres of influence. The twin influences of the US and the European Union shape the UK's approach to accounting.
7. Culture. A nebulous and intangible impact. However, perhaps the ideal of fairness in the UK influences the ‘true and fair’ concept.
8. Taxation. This is not an important influence in the UK.

   The ranking of these divergent forces will vary from country to country and also from person to person!

• Objectives. Although listed companies in the UK and France follow IFRS, listed companies represent only a small proportion of business enterprises in those countries. Most non-listed companies, partnerships and sole traders follow nationally-determined accounting principles. Yes, the UK and US are broadly concerned with economic reality (true and fair); and in France the concern is more with planning and control. However, French listed companies are now becoming more economic reality orientated as they follow IFRS for their group accounts.
• Users. Yes, in the UK and US shareholders, albeit primarily institutional investors in the UK and private investors in the US, are most important. In France, it is the government and taxation. Shareholders are, however, growing in importance in France.
• Sources of finance. Yes, in the UK and US shareholders provide the finance; in France, it is predominantly banks. However, in France equity is becoming more important.
• Regulation. Yes, in the UK and US standards are very important. In terms of detailed national legislation each country varies (UK Companies Acts; US SEC's 10K for listed companies, in France, Le Plan Comptable). However, in the UK and France listed companies now follow IFRS.
• Taxation. Yes, in UK and US (apart from LIFO inventory valuation method in US) does not influence financial accounts. In France it does.
• Accounting profession. Yes, strong and influential in UK and US; weak and relatively uninfluential in France.

Culture and spheres of influence are not very relevant here. So overall, the answer is yes!

• Up to 1965 it was the Institute of Cost and Works Accountants
• 1972, renamed Institute of Cost and Management Accountants
• 1987, renamed Chartered Institute of Management Accountants.

(a) Direct costs are those costs (such as direct materials or direct labour) that can be directly charged to a product or service. They represent a key element in the overall cost of a product or service.

(b) Indirect costs (often called period costs) are those costs such as production overheads, selling and distribution costs or administrative costs that cannot directly be charged to a product or service. They are more difficult to recover into the cost of a product or service than direct costs.

(c) Fixed costs are overheads that do not vary with the level of production or revenue. When making short-term operational decisions (such as making more or less of a product) these costs will not vary. They are, therefore, irrelevant to the decision.

(d) Variable costs are overheads that do vary with the level of production or revenue. They should, therefore, be taken into account when making a short-term operational decision. They are relevant to the decision.

(e) Standard costs are costs of a product or service that are estimated in advance. When the actual cost of the product is known it is compared with the standard cost. Any differences are known as variances and can be investigated.

Over the last generation, however, there has been a marked shift in the economic base of developed countries. Manufacturing industry is less dominated by direct labour. Service industries (such as those concerned with finance, marketing, transport, and the Internet), have grown in importance. These industries do not employ huge quantities of direct labour, do not manufacture products nor have large capital investments in machinery. Traditional product costing thus becomes less appropriate. In these industries, new methods of recovering overheads are needed. Thus, we have activity-based costing, which strives to recover overheads according to their relationship with activities, rather than volume-driven production measures. Activity-based costing identifies factors that influence cost and seeks to recover costs using these factors.

We can solve this using the formula below. It should, however, be noted that there are many alternative permissible formulas.

(ii) Activity-Based Costing

(iii) Comments

There is a big difference on the cost of the Conversion, which is a low-volume product.

The Conversion costs are £165.15 using activity-based costing, but £144.60 using traditional cost recovery. In particular, inspections and stores requisitions are costly. This would make an important difference when setting a selling price.

For the maximum bonus take all the revenue and all the discretionary costs in different quarters (for example, quarters 2 and 4).

Peter's bonus will thus be 10% of quarter 4's result (a profit of £95,500) and is, therefore, £9,550.

For the minimum bonus spread the costs evenly.

Peter's bonus is nil because he has failed to make a profit of more than £8,000 in any quarter. He will, therefore, try to adopt the first scenario, even if it has dire consequences for the firm.

This is fine, in theory. However, in practice, individuals often feel threatened by such detailed monitoring. This is particularly true if the original standards have not been set very accurately or without consultation. If the original standards are too lax, individual employees may not need to try too hard to meet the standards. If the original standards are too harsh, then the individual employees may consistently miss the targets and become demotivated.

Helpnotes

    *The sales price variance is £3,200 unfav. The overall cost variances are direct materials variance £9,200 fav., labour cost variance £11,960 fav., £320 unfavourable variable overheads cost variance, and £2,000 unfav., fixed overheads variance.

  **Remember, fixed costs remain unchanged whatever the level of activity, we do not, therefore, flex them.

Note this is simply the flexed profit (£36,160) less the original budget (£26,500) = £9,660 Fav.

(iv) Sales variances 3,500 more widgets were sold than anticipated causing the sales quantity variance. However, each widget sold for £0.20 less than anticipated creating the adverse sales price variance.

Material cost. We paid £9,200 less than expected. This may be due to more competitive prices or decreased quantity used. We need more information on this.

Labour cost. We paid £11,960 less than expected. Either we paid less per hour or we used fewer hours than expected. We need more information.

Variable overheads. This was £320 Unfavourable. We either incurred more overheads or recovered more into our products. We need to look at how we recovered variable overheads.

Fixed overheads These were £2,000 more than expected. We need to know why.

(iv) The actual profit for Supersonic is £125,500 (£686,500 − £561,000) more than budgeted. Supersonic has actually sold 4,000 assembly mountings less than anticipated, creating an unfavourable sales quantity variance of £31,950. By contrast, there is a favourable sales price variance of £91,200 as each assembly mounting has sold for £20.00 not £18.80.

On the cost variances, there is an unfavourable direct materials price variance (£15,000) as the sheets are more expensive than anticipated. However, less sheets were used than anticipated, possibly because they were of better quality. There is thus a favourable quantity variance of £84,000. The labour price variance of £25,500 is favourable since Supersonic paid £7.50 per hour rather than the budgeted £8.00. However, perhaps because an inferior quality of labour was used, the number of hours increased creating an unfavourable quantity variance of £28,000. For variable overheads, less overheads than anticipated were incurred creating a favourable price variance of £4,900. As more labour hours were used, more overheads were recovered into the product causing an unfavourable quantity variance.

Finally, fixed overheads were more than anticipated.

It seems that all the divisions are making a positive contribution, except for miscellaneous. However, the car division is actually the most profitable. Certainly, Riskmore should consider shutting down the miscellaneous division and increase profits to £55,000 (contributions from Car [£55,000], Home [£35,000] and Personal [£15,000] = £105,000 less fixed costs of £50,000). Perhaps it should also focus even more on the car division. However, Riskmore should be careful that shutting the miscellaneous division will not have a knock-on effect on the other divisions.

The short way of doing this is by just dividing the contribution by the number of labour hours. Therefore, Kiosk 1 (£55 ÷ 35) = £1.57; Kiosk 2 (£115 ÷ 55) = £2.09

Alternatively, we could calculate in full.

To maximise contribution over 70 hours, fully open Kiosk 2 and use remaining hours for Kiosk 1. This is because there is a higher contribution for each labour hour for Kiosk 2.

Total contribution for both kiosks is therefore £138.50 (i.e., Kiosk 1 £23.55 plus Kiosk 2 £114.95).

We can calculate the overall contribution and then divide by the number of labour hours used.

(ii) Contribution per labour hour

(iii) Labour hour to make each unit

(iv) Therefore, to use the available 1,500 hours, we need to allocate them up to the maximum revenue in the order France, Germany, UK and US. This order reflects the order of decreasing contribution per labour hour and will give maximum total contribution.

*This is calculated by deduction. So far for France, Germany and the UK we have used 1,375 hours. We have 125 hours left of the 1,500 hours available. Each product for the US takes 0.26 labour hours. Therefore, we can make 481 US board games.

(i) Contribution per unit (i.e., sales less variable cost per unit)

However, strategic management accounting is not without its critics. Some see it as a step too far. These critics fail to see the accounting input or the particular skills that management accountants can offer. They view strategic management accounting rather as a collection of techniques and ideas borrowed from other disciplines with little relevance to the day-to-day work of the management accountant.

By contrast, external growth is a much faster way to expand. You effectively take over existing businesses and utilise their resources. However, taking over other businesses can be risky. It is important to evaluate them carefully so that, like any purchase, you know what you are buying. Although the potential gains of external growth are great, the risks can be high. This is especially true when expanding overseas.

(i) You would target the following groups: age over 40 (particularly 60+); those living in the North and South (particularly the South); females; viewers of BBC; and readers of the Daily Mail.

(ii) You would need more information about the interconnectedness of these groups. For instance, could we narrow down the target market to females over 40, living in the South?

(iii) By targeting the Mail and Express we will maximise our target audience. It is not worth using television advertising, because the majority of the targeted customers watch BBC, which does not take advertising.

*Cash flows are simply cash inflows less cash outflows. Profit is cash flow less depreciation, which is £7,500 per year (initial capital outlay £30,000 ÷ 4 years) for Ready, and £3,750 per year (initial capital outlay £15,000 ÷ 4 years) for Steady and Go. Therefore, for Ready year 1 profit is £12,000 cash flow less £7,500 depreciation = £4,500.

Here we calculate when the cumulative cash flows cover the initial capital outlay. Ready is the best project under this criterion.

(ii) Accounting rate of return

Using this criterion we would choose Steady and Go as they have higher returns.

(iii) Net present value

Ready has a NPV of £3,451 which is less than the combined NPVs of Steady and Go of £4,745 (£2,302 and £2,443). We would, therefore, choose to invest our £30,000 in Steady and Go.

(iv) Profitability index

This shows that Steady and Go have a higher profitability index. We would invest in them.

(v) Internal rate of return (IRR)

Choose a 20% discount rate to arrive at a negative NPV.

Calculate IRR, using formula:

Therefore, as Choosewell's cost of capital is 9%, which is less than these rates, we could undertake all the projects if funds were not limited at £30,000. As we have to choose either Ready or Steady and Go, we would choose Steady and Go as they have the highest IRRs.

Overall, we would probably choose Steady and Go because they were best using accounting rate of return, net present value, profitability index and IRR. If we were just looking for a very quick return we might choose Ready as it has marginally the best payback period.

(i) Deciding which stadium and which rate using net present value

The Superbowl stadium makes the best returns. Manpool should build it as long as it can borrow funds at 5% or 8%, but not at 10 %.

(ii) Internal rate of return (IRR)

We can calculate the IRR by looking for discount rates that give a positive and negative NPV. For both Bowl and Superbowl, 5% gives a positive NPV, while 10% gives a negative NPV. Then, we use the formula (in £000s):

Therefore, if borrowing money at 5% (option (a)), both stadiums would be financially viable. However, if we could borrow money at 8% (option (b)) we should only consider Superbowl. Under option (c) borrowing at 10 %, we should build neither stadium. Overall, Superbowl looks the best project as it has the highest IRR and better NPVs.

Calculate cash flows and accounting profit before interest and taxation.

(i) Payback

When do the cumulative cash outflows reach £700,000?

After four years cash flows are £632,844. Therefore it is 4 years + (£67,156/£157,139) = 4.43 years

(ii) Accounting rate of return

*Note, we exclude the final cash inflow from our calculations.

(iii) Net present value (NPV)

The NPV is £62,597 at 10% so we can go ahead with the project.

(iv) Profitability Index

Using Myopia's cost of capital, we have:

Its profitability index is, therefore, 1.09. The project can be accepted.

(v) Internal rate of return (IRR).

To calculate the IRR, we need discount rates which give positive and negative NPVs. We use the formula:

Therefore, as Myopia has a cost of capital of 10% it would be worthwhile undertaking the project.

It is an important concept because when assessing future capital investment you need to take into account the weighted average cost of capital. It is futile to invest in a project with an investment return of 10%, when you must borrow money at 15% to fund it. Firms strive for an optimal cost of capital.

Thirty days credit, therefore, maximises contribution because the revised contribution of £98,833 is the highest.