FORMATION 2 EXAMINATION - AUGUST 2008 NOTES
You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5. (If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.) Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.
PRO-FORMA INCOME STATEMENT BY NATURE, INCOME STATEMENT BY FUNCTION AND BALANCE SHEET ARE PROVIDED
3.5 hours, plus 10 minutes to read the paper.
During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.
The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.
FINANCIAL ACCOUNTING THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FORMATION 2 EXAMINATION - AUGUST 2008
Time allowed: 3.5 hours plus 10 minutes to read the paper.
Answer Question 1 and three of the remaining four questions.
Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.
Outline the information needs of each of the following user groups: (i) Shareholders (ii) Managers (iii) Employees and discuss briefly whether you think those needs are met by a companyʼs published financial statements. (10 marks)
The following trial balance was extracted from the books of Smith plc. at close of business on 31 December 2007. Property: Buildings Plant and equipment Vehicles Retained earnings Ordinary shares €1 each Share Premium account 10% Debentures Provision for depreciation: Buildings Plant and equipment Vehicles Inventories Purchases Sales Trade receivables Trade payables Returns Discounts Provision for doubtful debts Bank Dividends Interest Rent and rates Bad debts Postage and stationery VAT Wages and salaries Motor expenses
Debit € 697,500 562,500 144,000
7,920 14,400 6,750 62,100 5,850 12,600
190,800 12,420 2,561,175 Page 1
156,645 360,000 90,000 135,000
135,000 292,500 38,250
55,440 4,320 9,450 2,520
The following additional information is available:
3. 4. 5. 6. 7.
Inventories on hand at 31 December 2007 were €131,850. Staff constructing a computer room were paid €9,000. This was included in wages and salary costs. Included in purchase was an amount of €13,500 for materials used in this construction. You are to write off €1,980, an amount owing from a customer which has gone into liquidation. The VAT account had been debited €900 for motor expenses. The provision for doubtful debts should be 4% of debtors. The annual charge for rates is €27,000; these are paid up to 30 January 2008. Included in sales is €3,150, which are the proceeds from the disposal of equipment purchased in March 2005 for €5,400. Depreciation is provided on assets held at balance sheet date as follows: a) Buildings: 2% on cost. b) Plant and machinery: 20% on cost. c) Vehicles: 25% on written down value. The issue on approval, on 19 December 2007, of goods costing €3,600 was accounted for as a sale giving a margin of 20%.
REQUIRED: Prepare, for internal use, an income statement for the year ending 31 December 2007 and a draft balance sheet as at that date. Please support all accounting adjustments on the trial balance.
(30 marks) [Total: 40 marks]
Explain the main advantages and disadvantages of using computerised accounting systems compared with manual systems. Your answer should give examples and explanations of types of error which could occur in one system, but should not in the other. It should also give examples and explanations of errors which could occur in both systems. (20 marks) [Total: 20 marks]
Andrew, Bernard and Charles have been in partnership for many years, sharing profits in the ratio 3: 2:1. At 31 December 2006 the partnership balance sheet was: € € € Capital accounts Sundry net assets 500,000 Andrew 200,000 Bernard 160,000 Charles 100,000 460,000 Current accounts Andrew 8,000 Bernard 20,000 Charles 12,000 40,000 €500,000 €500,000 Andrew decided to retire on 30 June 2007. It was agreed that goodwill should be valued at €120,000. Andrew would take €132,000 of net assets out of the business. The balance owing to him would be transferred to a loan account bearing interest at 10% per annum and payable on 30 June each year. Bernard and Charles agreed to (a) eliminate goodwill from the balance sheet of the new partnership; and (b) share profits in the ratio 3:2 (for Bernard and Charles respectively).
The net profit before loan interest for the year to 31 December 2007 was €96,000. There were no drawings by Andrew during the year, but Bernard drew €40,000 and Charles €32,000. REQUIRED: (a) Prepare the balance sheet of the new partnership as at 31 December 2007.
List five terms normally found in a partnership agreement.
(5 marks) [Total: 20 marks]
When Bill Murphy (whose bookkeeping system is not computerised) extracted a trial balance on 30 June 2008, he found that the sum of the debit balances did not equal the sum of the credit balances. The difference was recorded in a suspense account. A draft income statement and balance sheet were prepared using the suspense balance. An investigation into the causes of the difference revealed the following:
(iii) (iv) (v)
The balance of €1,320 on the telephone expense account had been omitted from the trial balance. €9,600 paid for an item of plant purchased 1 January 2008 had been debited to the plant repairs account. Plant is depreciated at 20% per annum on the straight-line basis, with proportional depreciation in the year of purchase. The cash discount totals for the month of June 2008, had not been posted to the nominal ledger accounts. The figures were: Discounts allowed: €620 Discounts received: €730 €670 insurance prepaid at 30 June 2007 had not been brought down as an opening balance in determining the amount in the trial balance. €6,750, the total of the sales returns book for June 2008 had been credited to the purchases returns account. A car held as a non-current asset had been sold during the year for €9,600. The proceeds of the sale were entered in the cash book but had been credited to the sales account in the nominal ledger. The original cost of the car of €24,000 and the accumulated depreciation to the date of sale of €16,000, were included in the motor vehicle account and the accumulated depreciation account. The company depreciates motor vehicles at 25% per annum on the straight line basis with proportionate depreciation in the year of purchase but none in the year of sale.
REQUIRED: (a) Prepare the journal entries necessary to correct the errors made (narratives not required). Post the entries to a suspense account and derive the opening suspense account balance. (12 marks) (b)
Draw up a statement showing the adjustments to the draft profit. Page 3
(8 marks) [Total: 20 marks]
Alpha Ltd and Beta Ltd are both hardware retailers in a large town. You are given the following summarised information. Income statements for year ending 31 March 2008. Alpha Ltd Beta Ltd €ʼ000 €ʼ000 Revenue: Sales 4,300 3,024 Less cost of sales 2,860 2,296 Gross profit 1,440 728 Less Sundry expenses (500) (380) Operating profit 940 348 Interest on debentures (40) (120) Net profit before tax 900 228 Taxation (200) (60) 700 168 Dividends (400) (160) Retained profit 300 8
Non-current assets Machinery at cost less depreciation to date Office equipment at cost less depreciation to date
Motor vehicles at cost Less depreciation to date Current assets Inventory Trade receivables Sundry Bank
Balance sheets as at 31 March 2008 Alpha Ltd. € € 5,000 1,800 3,200 260 80
840 1,600 200 80
Equity and Liabilities Issued share capital Retained earnings Long-term liabilities 10% Debentures
Current liabilities Trade payables Sundry including taxation Bank overdraft Dividends
400 320 400 400
180 160 3,540
€ 5,920 4,640 720 328
200 80 680 1,200 160
1,280 392 120 1,792
2,400 1,940 4,340
400 152 552
560 240 1,120 160
REQUIRED (a) Calculate the following ratios for both companies: (i) Current ratio. (ii) Quick ratio/acid test. (iii) Debtorsʼ collection period in days. (iv) Return on capital employed. Return on ownersʼ equity (before taxation). (v) (vi) Gearing ratio. (vii) Interest cover. (viii) Dividend cover. (ix) Gross profit percentage on sales. (x) Operating profit percentage on sales.
Comment briefly on the relative profitability, liquidity and risk of the two companies.
END OF PAPER
[Total: 20 marks]
FINANCIAL ACCOUNTING THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FORMATION 2 EXAMINATION - AUGUST 2008
SOLUTION 1 (a) (i)
Shareholders. Shareholders will want to access how effectively management is performing its stewardship function. They will want to know how profitably management is running the companyʼs operations and how much profit they can afford to withdraw from the business for their own use. They need information on which to base their decisions as to whether to buy, hold onto or sell their shares. Published accounts are aimed at shareholders, so it is this user group who should be the most satisfied with the information they provide. However, it is not necessarily possible to tell by looking at a set of financial accounts that a company is a ʻgood betʼ for investment. By using ratios such as earnings per share or price to earnings, some conclusions can be drawn about a companyʼs performance, but only by comparison with other companies in the same sector and with previous years.
Managers Managers are appointed by the companyʼs owners to supervise the day to day activities of the company. They need information about the companyʼs financial situation as it is currently and as it is expected to be in the future. This is to enable them to manage the business efficiently and to take effective control and planning decisions.
Information which is prepared for external reporting purposes is not generally useful for decision making purposes. Financial accounts are backward looking, while managers must be forward looking. However, it could be argued that financial accounts were not developed for decision making purposes. The answer lies in timely and relevant management accounts.
Employees Many hold that the employees of a company should have a right to information about the companyʼs profitability and stability, because their future careers and size of their wages and salaries depend on it. Employees will also be interested in less tangible aspects such as employment opportunities.
It has been argued that the company financial statements contain little of direct relevance to employees; the focus is much more on the shareholders. An answer to this criticism lies in the provision of supplementary statements such as employee reports. So far, however, these suggestions have not been extensively taken up.
(b) Revenue Less returns
Smith plc Income statement for the year ended 31 December 2007. €
Cost of sales Inventory 1/1/2007 Purchases Less: Returns
Inventory 31/12/2007 Gross profit Provision for bad debts Debenture interest Depreciation: Buildings Plant & equipment Vehicles Discounts allowed Bad debts Rent and rates Postage and stationery Loss on disposal of equipt. Wages and salaries Motor expenses Dividends:
14,400 111,420 26,438
Retained Balance c/f Balance b/f
540 13,500 152,258 5,400 7,830 59,850 12,600 90 181,800 13,320
142,650 592,380 735,030 135,450
€ 1,269,000 3,105 1,265,895
599,580 666,315 9,450 675,765
447,188 228,577 14,400 214,177 156,645 370,822
Non current assets Property: Buildings Plant and equipment Vehicles
Current assets Inventories Trade and other receivables
Balance sheet as at 31 December 2007 € € Cost Depreciation 720,000 149,400 557,100 401,760 144,000 64,688 1,421,100 615,848 76,500
Provision for doubtful debts Bank Prepayment Total assets
Equity and liabilities Ordinary shares 25c each
135,450 73,440 7,920 2,250
570,600 155,340 79,312 805,252
Share Premium account Retained earnings
Long term liabilities 10% Debentures
Current liabilities Trade and other payables Debenture interest
Types of error which could occur on a manual system which should not occur on a computer system: (i) Miscasting. A list of numbers may be wrongly added. (ii) Misposting. The transfer of a number from one area to another may go wrong. It may result in the number going to the wrong account or the wrong number going to an account (ie transposition error) (iii) Single entry. Only one side of the entry may be made.
Types of error which could occur in both systems: (i) Transposition error at entry of data. Numbers may be entered incorrectly. (ii) Omitted entry. A whole entry may not be posted. (iii) Entry account. A receipt from a debtor may be posted to another debtorʼs account.
Advantages and disadvantages of computerised accounting systems: (i) The automatic posting of entries from books of prime entry to the nominal ledger (ii) The prevention of single entry inputs. (iii) The data is neat and uniform and therefore easily read. (iv) Data can be manipulated in a number of ways and a number of reports such as a trial balance , income statement, balance sheet and cash flow can be produced. (v) A large amount of data can be stored in a small area (vi) A large amount of data can be input and processed very quickly. (vii) A number of users can access the system at the same time.
Disadvantages of a computerised accounting system: (i) The cost of installation and major updates. (ii) Training. Staff may not be familiar with computerised accounting systems or the particular system in operation. This will cost time and money. (iii) Loss of data. If inputs are not saved regularly then a system crash may lose a great deal of work. Regular backups are required in case the system does crash. (iv) Loss of audit trail. As many processes happen automatically within the computer it is difficult to trace transactions through the system. This may require expensive software. (v) Flexibility. Once a system is in place it may not be possible to adapt it as the business changes. A new system may be required which would be costly.
SOLUTION 3 (a)
Capital accounts Bernard Charles
Current accounts Bernard Charles
Loan account Andrew Accrued interest
Bernard and Charles Balance sheet as at 31 December 2007 € € Sundry net assets 128,000 72,000 200,000 20,000 4,000
Workings: Profit before interest Appropriated: Andrew Bernard Charles
Andrew on retirement is owed Capital (200,000 + 60,000) Current (8,000 + 24,000)
Paid out in business assets Loan account (balance)
Profit before interest (2nd half) Loan interest Bernard (3) Charles (2)
Capital accounts On 1/1/07 Goodwill 30/6/07
Eliminate goodwill Capital a/cs 31/12/07
Current accounts On 1/1/07 Profit share: to 30/6/07 1/7 to 31/12/07
Less drawings Balance 31/12/07
24,000 160,000 8,000 €392,000 Pre-change (6 months) €48,000 €24,000 €16,000 €8,000
€392,000 Post-change (6 months) €48,000
260,000 32,000 292,000 132,000 160,000
48,000 8,000 40,000 24,000 16,000
160,000 40,000 200,000 72,000 128,000
100,000 20,000 120,000 48,000 72,000
20,000 16,000 24,000 60,000 40,000 20,000
12,000 8,000 16,000 36,000 32,000 4,000
The net assets of the business at 31/12/07, ignoring accrued interest, are:
Net assets on 1/1/07 Add net profit before interest
Less drawings of Bernard and Charles Assets taken by Andrew Net assets at 31/12/07
Any (i) (ii) (iii) (iv) (v) (vi) (vii)
of the following: The capital to be contributed by each partner The ratio in which profits (losses) are to be shared The rate of interest, if any, to be paid on capital before profits are shared. The rate of interest, if any, to be charged on partners' drawings Salaries to be paid to partners. Arrangements for the admission of new partners Procedures to be carried out when a partner retires or dies.
500,000 96,000 596,000
Dr Telephone expense Cr Suspense account
Dr Plant and equipment Cr Plant repairs Dr Depreciation Cr Plant & Equipment
Dr Discount allowed Cr Suspense account Dr Suspense account Cr discount received
Dr Insurance Cr Suspense account
Dr Sales returns account Cr Suspense account
Dr Purchases returns account Cr Suspense account
Dr Disposals account Vehicles Dr Depreciation vehicles Cr Disposals account Dr Sales Cr Disposals account Dr Disposals account Cr Profit on disposal Opening balance Discounts received
6,750 24,000 16,000
730 670 6,750 6,750 24,000 16,000 9,600
Suspense account 15,380 Telephone (i) Sales returns (v) Purchase returns (v) 730 Discount allowed (iii) Insurance (iv) 16,110
Adjustments to the draft profit. (i) (ii) iii) (iv) (v) (vi)
Telephone Plant & equipment and depreciation (9,600-960) Discounts (730 – 620) Insurance Sales returns adjustment (6,750 X 2) Non current asset disposal (1,600- 9,600)
1,320 6,750 6,750 620 670 16,110
(1,320) 8,640 110 (670) (13,500) (8,000)
SOLUTION 5 (a) (i)
Debtorsʼ collection period
Return on equity
Gross profit margin
Profitability. Both companies show a profit, although Alphaʼs profit margins exceed those of Betaʼs by a significant amount.
(viii) Dividend cover (x)
Operating profit margin
Return on capital employed is virtually identical for both companies but Beta yields a much higher return on ownersʼ equity than Alpha (30.4% against 16.1%). This reflects the fact that Beta is much more highly geared than Alpha (68.5% against 8.4%).
Liquidity Alpha exhibits a very comfortable liquidity position, with current and quick ratios at normal levels for a manufacturing company.
Beta appears to be in a less healthy position, with ratios below the industrial norm. However, this is primarily due to the fact that Beta has such a large bank overdraft. If this is removed from the calculations, Betaʼs current and quick ratios fall to 2.13 : 1 and 1.42 : 1 respectively, which are perfectly acceptable levels.
Excluding the bank overdraft from the calculations is justified on the basis that it may be regarded as a medium-term source of finance.
Risk. Alpha exhibits healthy profit margins, a comfortable liquidity position and low level of gearing. It may therefore be considered a low risk company.
Beta, on the other hand, is highly geared, indicating quite a high degree of risk. Interest costs will be high, reflecting the cost of the overdraft. If profits decline, the company could find itself in trouble. Furthermore, machinery is almost fully depreciated, suggesting that capital investment in fixed assets will be required in the not too distant future. This will put further demands on resources.