Principles of accounting

Principles of accounting D Leiwy AC1025 2013 Undergraduate study in Economics, Management, Finance and the Social Sciences This subject guide is for a 100 course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences This is equivalent to Level within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ) For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk This guide was prepared for the University of London International Programmes by: Danny Leiwy, Department of Accounting, The London School of Economics and Political Science It draws on material in the previously published editions of the guide by: Dr Jennifer Ireland, formerly of the Department of Accounting and Finance, The London School of Economics and Political Science This is one of a series of subject guides published by the University We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2013 The University of London asserts copyright over all material in this subject guide except where otherwise indicated All rights reserved No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher We make every effort to respect copyright If you think we have inadvertently used your copyright material, please let us know Contents Contents Introduction The study of accounting Aims of the course Learning outcomes Essential reading Further reading Online study resources Structure of the subject guide How to use the subject guide Examination advice List of abbreviations used in this subject guide 10 Chapter 1: Accounting in context 13 Aims 13 Learning outcomes 13 Essential reading 13 Introduction 13 What is accounting? 14 Accounting theory and practice 17 Accounting information and its uses 17 Financial accounting 18 Management accounting 19 Summary 19 Reminder of your learning outcomes 20 Sample examination question 20 Section 1: Financial accounting 21 Chapter 2: Fundamentals of financial accounting 23 Aims 23 Learning outcomes 23 Essential reading 23 Introduction 23 An introduction to the financial statements 24 Accounting characteristics and concepts, bases and policies 33 Summary 35 Reminder of your learning outcomes 36 Sample examination questions 36 Chapter 3: Data processing 37 Aims 37 Learning outcomes 37 Essential reading 37 Introduction 37 One transaction: two effects 38 Recording transactions: books of prime entry 40 Double-entry book-keeping 44 Trial balance 52 i AC1025 Principles of accounting Getting it right: internal control 55 Summary 57 Reminder of your learning outcomes 57 Sample examination question 57 Chapter 4: Preparing financial statements 59 Aims 59 Learning outcomes 59 Essential reading 59 Introduction 59 Inventory, purchases and sales 60 Accruals and prepayments 64 Bad and doubtful debts 66 Depreciation of non-current assets 70 Disposal of non-current assets 74 Revaluation of land and buildings 76 Summary 77 Reminder of your learning outcomes 77 Sample examination questions 78 Chapter 5: Preparing financial statements 79 Aims 79 Learning outcomes 79 Essential reading 79 Introduction 79 Preparing the statement of financial position and income statement 80 Incomplete information 90 Summary 100 Reminder of your learning outcomes 100 Sample examination question 100 Chapter 6: Preparing financial statements 103 Aims 103 Learning outcomes 103 Essential reading 103 Introduction 103 Different formats for different purposes 104 Preparing company accounts 108 Preparing the cash flow statement 113 Summary 120 Reminder of your learning outcomes 121 Sample examination questions 121 Chapter 7: Using and understanding financial statements 127 Aims 127 Learning outcomes 127 Essential reading 127 Introduction 127 Ratio analysis 128 Writing a report 141 Summary 142 Reminder of your learning outcomes 142 Sample examination question 143 ii Contents Section 2: Management accounting 145 Chapter 8: Fundamentals of management accounting 147 Aims 147 Learning outcomes 147 Essential reading 147 Introduction 147 Planning and coordination 148 Control, communication and motivation 149 Information for decision-making 150 Summary 150 Reminder of your learning outcomes 151 Chapter 9: Cost accounting 153 Aims 153 Learning outcomes 153 Essential reading 153 Introduction 153 Understanding costs 154 Inventory valuation – marginal costing 157 Inventory valuation – full costing 157 Effects of different inventory valuation methods 162 Summary 164 Reminder of your learning outcomes 165 Sample examination questions 166 Chapter 10: Making decisions 169 Aims 169 Learning outcomes 169 Essential reading 169 Introduction 169 Cost-volume-profit analysis 170 Relevant costs 174 Limiting factors 177 Summary 178 Reminder of your learning outcomes 179 Sample examination questions 179 Chapter 11: Making decisions 183 Aims 183 Learning outcomes 183 Essential reading 183 Introduction 183 Capital investments 184 Payback period 184 Accounting Rate of Return (ARR) 188 Summary 189 Reminder of your learning outcomes 190 Sample examination question 190 Chapter 12: Making decisions 191 Aims 191 Learning outcomes 191 Essential reading 191 iii AC1025 Principles of accounting Introduction 191 Discounted cash flow techniques 192 Summary 200 Reminder of your learning outcomes 200 Sample examination questions 201 Chapter 13: Planning for the future 203 Aims 203 Learning outcomes 203 Essential reading 203 Introduction 203 Goals and objectives 204 Budgets and forecasts 205 Working capital management 209 Summary 211 Reminder of your learning outcomes 212 Sample examination question 212 Chapter 14: Budgets for control 213 Aims 213 Learning outcomes 213 Essential reading 213 Introduction 213 Standard costs 214 Behavioural effects of using budgets 215 Variance analysis – an introduction 216 Summary 225 Reminder of your learning outcomes 225 Sample examination question 226 Appendix 1: Suggested solutions to selected Activities and Sample examination questions 227 Chapter 227 Chapter 229 Chapter 232 Chapter 235 Chapter 245 Chapter 258 Chapter 259 Chapter 260 Chapter 10 263 Chapter 11 266 Chapter 12 267 Chapter 13 272 Chapter 14 276 Appendix 2: Sample examination papers 279 Before you start 279 Sample examination paper 280 Extracts from compound interest tables 289 Sample examination paper 290 Appendix 3: Example of 8-column accounting paper 301 iv Introduction Introduction This subject guide has been written for those of you who are studying AC1025 Principles of accounting The course is intended as a broad introduction to the subject, both for non-specialist students, and as a foundation for further study in the area The study of accounting From the outside, accounting can appear to be a purely practical subject It would be very easy to focus on just the applications of techniques and procedures But accounting is more than just a set of calculations; unless we can understand and interpret the figures we produce, the calculations are pointless! Accounting provides information for a wide variety of different users and purposes, and its practices can only be properly understood and assessed in relation to the economic and social environment in which they are applied Therefore there are four aspects to this subject: Techniques for recording, calculating, classifying and reporting of accounting information The legal and institutional background associated with accounting information The economic and administrative problems which the information is required to solve The interpretation of reports prepared using in the light of and The accounting information referred to in need not be financial, although for our purposes in this course it will almost always be The problems referred to in are largely concerned with the planning of, and control over, the use of economic resources They are also concerned with the measurement of income and of various kinds of value changes In order to properly interpret accounting information as in 4, and apply it to the problems in 3, we need to understand the theory and principles which underlie the techniques in The study of accounting is traditionally divided into two parts according to the types of users of the accounting information Financial accounting is primarily concerned with the needs of users outside the business (or other organisation) Therefore it relates to the external control and management of resources (for example, by shareholders of the company in which they have invested their funds, or by banks making loans) A key part of financial accounting is reporting the performance and position of the business to these external users, via the financial statements The form and content of financial statements is usually highly regulated In contrast, management accounting is concerned with the needs of users inside the business Therefore it relates to the internal control and management of resources (for example, by the directors, management or employees of a company) Management accounting statements may be more detailed than those prepared for external users, and not normally need to meet any legal requirements AC1025 Principles of accounting Countries around the world organise their economic and financial activities in different ways so, inevitably, legal requirements, regulation and administrative procedures also vary across countries The syllabus for this course is based on the system pertaining to the UK, but the amount of institutional material that you need to know is kept to a minimum Even though the material in this text is based on the system in the UK, accounting rules and guidelines around the world are becoming more similar (converging) as a result of International Financial Reporting Standards (IFRSs) which are complied with by large companies in most countries This is part of a general drive to harmonise international accounting practices It is important to note that knowledge of UK Statements of Standard Accounting Practice (SSAPs), Financial Reporting Standards (FRSs), and of International Accounting Standards (IASs) and International Financial Reporting Standards (IRFSs), is not part of the syllabus Aims of the course The aims of the course are to: • introduce you to the principles underlying accounting • enable you to apply, interpret and explain key accounting techniques • provide a broad understanding of the theory and practice of financial and management accounting The course is intended both for non-specialist students, and as a foundation for further study in the area Learning outcomes At the end of this course, and having completed the Essential reading and Activities, you should be able to: • distinguish between different uses of accounting information and relate these uses to the needs of different groups of users • explain the limitations of such statements and their analysis • categorise cost behaviour, and prepare and contrast inventory valuations under different costing methods • describe the budgeting process and discuss the use of budgets in planning and control • explain, discuss and apply relevant techniques to aid internal users in decision-making Essential reading Leiwy, D and R Perks Accounting: understanding and practice (Maidenhead: McGraw-Hill, 2013) fourth edition [ISBN 9780077139131] You are strongly advised to buy this textbook, which is referred to in every chapter of this subject guide and has many examples and both self-testing and assessment questions closely related to this course The textbook also has a companion website: www.mcgraw-hill.co.uk/textbooks/leiwy Detailed reading references in this subject guide refer to the edition of the set textbook listed above New editions of this textbook may have been published by the time you study this course You can use a more recent edition; use the detailed chapter and section headings and the index to identify relevant readings Also check the virtual learning environment (VLE) regularly for updated guidance on readings Introduction Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world To help you read extensively, you have free access to the VLE and University of London Online Library (see below) Accounting is an evolving and, at times, controversial subject You are encouraged to stay informed of the current issues in accounting These issues are often reported in the press, so you may this by reading the financial pages of a quality daily, or weekly, newspaper In addition, specialist publications that are worth reading on a regular basis include economia, the official monthly journal of the Institute of Chartered Accountants in England and Wales (ICAEW), Accountancy, formerly the official monthly journal of the ICAEW, and Accountancy Age which is available online at www.accountancyage.com Journals of other professional accountancy bodies in the UK and elsewhere are also suitable Press, comment and other information can also be found at www.accountingweb.co.uk In recent times, accounting for pensions and financial instruments have been regular features in the UK news Your country may have very different accounting issues You may not be able to understand all the technical details, but you should try to understand the main arguments Who you think is right, and why? What may be the real motivations behind the arguments? How the policy-makers respond? What are the causes of accounting scandals that occur? What you think can be done to prevent these scandals, and why? Reference books Nobes, C The Penguin dictionary of accounting (London: Penguin Books, 2006) second edition [ISBN 9780141025254] Owen, G and J Law A dictionary of accounting (Oxford: Oxford Paperbacks, 2010) fourth edition [ISBN 9780199563050] These (or any similar) dictionaries of accounting provide a quick source of reference for any new terms you meet in this course You may find a dictionary particularly useful when you approach this course for the first time, as accounting terminology can sometimes cause unnecessary confusion You should be aware that precise terminology, particularly with respect to financial reporting terms, may differ from one country to another If you not have a dictionary of accounting, you should be able to find the information you need in Leiwy and Perks (2013) which includes a comprehensive glossary (pp.470–75) Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave AC1025 Principles of accounting on your application form You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community It forms an important part of your study experience with the University of London and you should access it regularly The VLE provides a range of resources for EMFSS courses: • Self-testing activities: Doing these allows you to test your own understanding of subject material • Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered • A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material • Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions • Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills • Feedback forms Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php Appendix 2: Sample examination papers b payables control account at 31 January 2010 (Total marks) Question 1(b) The summarised statement of financial position of Ted Baker plc as at 31 January 2009 is as follows: £000 Net assets 62,166 Share capital 2,160 Share premium account 9,137 Revaluation reserves 2,859 Retained earnings 48,010 Total equity 62,166 Required: a explain what is meant by ‘undistributable reserves’ and give two examples of such reserves (1 mark) b calculate the undistributable reserves of the company Briefly explain why the share capital and these reserves provide safety to the company’s creditors (2 marks) c Ted Baker plc distributed £6.93m as dividends to its ordinary shareholders during the year This was 55% of the profit for the period of £12.57m for the financial year What has happened to rest of the profits? (1 mark) d explain what factors would be taken into consideration, by the directors, in determining the company’s dividend policy (2 marks) (Total marks) Question 1(c) Orchard Clinic Ltd operates a 200-bed hospital and offers a number of specialised medical services Orchard Clinic’s hospital facility and equipment are leased on a long-term basis The hospital charges $250 per patient-day On the basis of past cost data, Orchard Clinic has estimated its variable costs as $182.80 per patient day Fixed costs are $182,160 per month The hospital’s administrator has estimated that the hospital will have on average 4,600 patient days per month Required: a How much will the hospital need to charge per patient-day to break even at this level of activity? (2 marks) b Refer to the original data in the question How many patient-days must Orchard Clinics have on average each month to earn a target profit of $60,000 per month? (2 marks) c What is the difference between a linear and a non-linear cost function? Give an example of each type of cost function (2 marks) (Total marks) 291 AC1025 Principles of accounting Question 1(d) Kine Limited produces sports trainers and also sports shirts and baseball hats, all featuring their famous branded logo the Kine Cross (X) Relevant information on contribution, hours of labour to make one unit and the demand for each product appears below Product Contribution/unit Hours of labour Demand (units) Trainers $10 500 t-shirts $6 600 Hats $4 700 Unfortunately, the company only has only 2,000 hours of labour available Required: i Can the total demand be met, and if not, why not? (2 marks) ii What is the optimum production policy? Calculate the total contribution that would arise for each product if this production policy was adopted (4 marks) iii What other factors, if any, would you consider in making this decision? (1 mark) (Total marks) Section B Answer QUESTION from this section and not more than a further one question (You are reminded that four questions in total are to be attempted with at least one from Section C.) Question Ko-Furn Limited is an office furniture manufacturer The following is a list of balances extracted from its accounting records at 31 December 2009: 292 Appendix 2: Sample examination papers Dr Cr £000 £000 Land, at valuation 240 Buildings: cost 500 Buildings: accumulated depreciation at 1.1.09 180 Equipment: cost 392 Equipment: accumulated depreciation at 1.1.09 152 Vehicles: cost 568 Vehicles: accumulated depreciation at 1.1.09 264 Inventory at 1.1.09 214 Trade receivables 366 Provision for doubtful debts at 1.1.09 16 Prepayment at 1.1.09 12 Accrual at 1.1.09 18 Cash 408 Trade payables 248 Share capital: ordinary 50c shares 50 Share premium 350 Retained earnings 606 Sales 2,924 Purchases 976 Wages and salaries 540 Distribution costs 200 Other administrative expenses 360 Corporation tax 12 Disposal account 20 Dividend paid 40 4,828 4,828 You are given the following information: i Ko-furn prices its furniture using a normal 30% mark-up policy An inventory count carried out at 31 December 2009 valued inventory at selling price of £325,000 This included two board tables at normal selling price of £20,800 each, which the directors have decided should be reduced in price to £5,000 each ii The land was valued at £600,000 at 31 December 2009 The directors decided to reflect the revalued amount in the balance sheet iii On February 2009, the company sold a vehicle for £20,000 While the proceeds of sale were credited to the Disposal account, no other entries were made in the books of account in relation to this transaction The vehicle had cost £88,000 in August 2006 The company charges a full year’s depreciation in the year of acquisition and no depreciation in the year of disposal iv The company’s depreciation policy is as follows: Land: nil Buildings: 4% straight line Equipment: 40% reducing balance Vehicles: 25% straight line 293 AC1025 Principles of accounting v Trade receivable at 31 December 2009 include a debt of £16,000 from a customer recently declared bankrupt The company has decided to maintain the provision for doubtful debts at 4% of remaining trade receivables vi The balance of prepayments at 1.1.09 refers to insurance charges Prepaid insurance, included in general distribution costs at 31 December 2009 amounted to £24,000 vii The balance of accruals at 1.1.09 refers to electricity charges After the year end, the company received an electricity invoice for £30,000 covering the period November 2009 to 31 January 2010 Electricity charges are included in other administrative expenses viii Corporation tax for the year ended 31 December 2009 is estimated to be £190,000 ix The company issued 100,000 additional shares at 50p each on 30 December 2009 for £140,000 This transaction has not been recorded in the accounting records Required: Prepare an income statement for the year ended 31 December 2009 and a statement of financial position at that date, in good style, for the directors (25 marks) Question MoFro Limited is in business as a frozen food wholesaler Accounts for the years ended 31 December 2008 and 2009 are as follows: Income statements for the year ended 31 December 2008 £000 2008 2009 £000 £000 2009 £000 Sales 8,943 10,281 Cost of sales 5,367 6,372 Gross profit 3,576 3,909 Expenses: Wages and salaries 1,290 1,431 Distribution expenses 357 378 Advertising 135 27 Office expenses 147 141 Depreciation 459 513 2,388 2,490 1,188 1,419 - 81 1,188 1,338 Taxation 594 669 Profit for the year 594 669 Operating profit Interest paid Profit before tax 294 Appendix 2: Sample examination papers Statement of changes in retained profits for the year ended 31 December 2009 2008 2009 £000 £000 Retained profit brought forward 762 1,059 Profit for the year 594 669 Dividends paid (297) (459) Retained profit at year end 1,059 1,269 Statement of financial position sheets at 31 December 2009 2008 2008 2009 2009 £000 £000 £000 £000 Non-current assets Property (nbv) Equipment (nbv) Vehicles (nbv) 5,400 5,130 810 1,215 540 432 6,750 6,777 Current assets Inventory 1,122 1,500 Receivables 972 1,476 Cash at bank 330 129 Total assets 2,424 3,105 9,174 9,882 810 Liabilities and equity Non-current liabilities: 10% debenture Current liabilities Payables Taxation payable 1,041 654 594 669 Total liabilities 1,635 1,323 1,635 2,133 Equity Ordinary shares 6,480 6,480 Retained profits 1,059 1,269 Total liabilities & equity 7,539 7,749 9,174 9,882 The chief executive has asked for you advice concerning the following: a Investment in new equipment in January 2009 was part of a plan to increase the scale of operations by 25% in 2009 She had hoped this would bring about a proportionate improvement in profit but this has not happened b She was led to believe that the debenture issue, which took place in January 2009, would improve the company’s bank balance She realises that some of the proceeds of the debenture issue went towards buying new equipment but cannot understand where the rest of the proceeds have gone and is worried about the company’s liquidity 295 AC1025 Principles of accounting Required: Write a brief report to the chief executive to help explain what has happened to the company during 2009 and comment on your findings Your report should be based around the discussion of selected ratios, including • two profitability ratios, • two liquidity ratios, • three working capital control ratios and • gearing You are to list these ratios, specifying the formula, in each case Note: Ratios Comments and analysis Total marks (16 marks) (9 marks) (25 marks) Question The statements of financial position of Easy Fix Ltd as at 31 December 2008 and 2009 and a summary of the income statement for the year ended 31 December 2009 are given below: Statement of financial position as at 31 December 2008 2009 £000 £000 Land and buildings 37,000 50,000 Plant and machinery 16,500 19,500 6,000 6,000 59,500 75,500 Inventory 11,400 10,500 Receivables 12,000 10,400 4,700 28,100 20,900 87,600 96,400 10,000 12,800 Bank overdraft 1,500 Trade payables 8,800 9,600 Corporation tax 4,000 3,000 12,800 14,100 22,800 26,900 30,000 40,000 – 5,000 Non-current assets Investment at cost Current Assets Cash at bank Total assets Liabilities and equity Non-current liabilities: 10% debentures Current liabilities Total liabilities Equity £1 ordinary shares Share premium 296 Appendix 2: Sample examination papers Revaluation reserve Retained profits Liabilities & equity 3,000 8,000 31,800 16,500 64,800 69,500 87,600 96,400 Summary Income statement and Statement of movements in retained profits for the Year Ended 31 December 2009 £000 Loss before tax (after depreciation on plant and machinery of $4,000,000) (12,300) Tax (2,500) Profit after tax (14,800) Dividends (500) Retained loss for the year (15,300) You are given the following information: i During the year several machines were disposed of for £3,200,000 The machines had a total original cost of £4,000,000 and had a total net book value at the date of disposal of £2,000,000 ii During the year, a right issue was made iii Included in the loss before tax was an investment income of £1,250,000 and an interest payment of £5,100,000 Required: a Prepare a cash flow statement, together with the reconciliation statements of loss before tax and cash balance, for Easy Fix Ltd for the year ended 31 December 2009 (19 marks) b Discuss the advantages and disadvantages of such statements (6 marks) (Total 25 marks) Section C Answer ONE question from this section and not more than a further one question (You are reminded that four questions in total are to be attempted with at least one from Section C.) Question Coast Ltd commenced business on January making one product only The budgeted cost of one unit of the product is as follows: $ Direct labour 24 Direct material 16 Variable production overhead Fixed production overhead 10 56 The fixed production overhead figure has been calculated on the basis of a budgeted normal output of 48,000 units per annum Budgeted fixed expenses are incurred evenly over the year 297 AC1025 Principles of accounting Selling, distribution and administration expenses are: Fixed Administration expenses $300,000 per annum Variable Selling and Distribution costs 20% of the sales value The selling price per unit is $100 and there was no opening stock at the beginning of January The actual numbers of units produced and sold were: Jan Feb units units Production 3,500 4,000 Sales 3,000 4,200 Actual variable costs per unit and fixed costs were as budgeted The company uses the First-in-first-out approach to value closing inventory Required: a Prepare income statements for each of the months of January and February using the absorption costing approach (11 marks) b Prepare income statements using marginal costing, showing clearly your calculation of contribution, for each of the months of January and February (7 marks) c Reconcile the monthly profits in (a) and (b) What are the relative advantages of marginal costing approach over the absorption costing approach? (7 marks) (Total 25 marks) Question The following is extracted from the standard unit cost card of RNM Ltd for the quarter ended 31 December 2009: $ Selling price per unit 25 Direct materials (2 kgs @ $1 per kg) Skilled labour hour @ $8 per hour Variable overheads Fixed overheads Net profit per unit Budgeted sales 10 10,000 units Variable overheads are determined by using the skilled labour hours while fixed overheads are absorbed on the budgeted sale units For the quarter ended 31 December 2009, the following results were reviewed: $ Sales (9000 units) 298 234,000 Direct materials (16,000kgs) 20,000 Skilled labour (9,500 hours) 71,250 Variable overheads 30,875 Fixed overheads 22,000 Appendix 2: Sample examination papers Required: a Calculate the actual and budgeted profit for the quarter ended 31 December 2009 Reconcile these profit figures by providing the appropriate variances (19 marks) b What explanations would you give to the discrepancies between the actual and the budgeted results? (6 marks) (Total 25 marks) Question Innovative Plc is considering a new project, code named SK3 This project requires an initial investment of £100,000 in a new machine This machine is expected to have an economic useful life of years The company usually depreciates this type of asset at 20% on a reducing balance method Running cost is expected to be £5,000 for the first year, payable at the end of the year, and is increased by 10% p.a thereafter The residual value for the machine is expected to be £30,000 in the fifth year Production can begin as soon as the new machine is installed An initial one-off cost for clearing the existing factory for the machine is estimated to be £10,000 It is estimated that in the first three years of production, the demand for the products is uncertain and it is likely to be dependent on the state of the economy The following table gives the expected demand for the products in each state of the economy: Sales Year Year Year Probability units units Units Boom 0.3 6,000 8,000 10,000 Normal 0.4 4,500 5,000 6,000 Bust 0.3 3,500 3,200 3,000 Economy In year and 5, the demands for the products are likely to be the same as the expected level as in year Each product is priced at £20 each and requires kgs of materials and hours of skilled labour There are 40,000 kgs of materials in stock They have no other use in the company The company can buy or sell these materials in the open market for £1.50 per kg The company has contracted 10,000 skilled labour hours for another production, which has never been commenced According to the contract, the company would have to pay the skilled labour the wages regardless if they work or not on any production The normal wage for skilled labour is £4 per hour The company’s cost of capital has always been 10% Cash flows from sales, purchases of materials and payments to labour are all arising at the end of the year Required: a Determine, with detailed calculation, the net present value of SK3 (17 marks) b Advise the management if SK3 should be undertaken What other factors would you consider, apart from on the financial ground, before you finalise your advice to the management? (8 marks) (Total 25 marks) 299 AC1025 Principles of accounting Notes 300 Appendix 3: Example of 8-column accounting paper Appendix 3: Example of 8-column accounting paper 301 AC1025 Principles of accounting Notes 302 Notes Notes 303 AC1025 Principles of accounting Notes 304 Comment form We welcome any comments you may have on the materials which are sent to you as part of your study pack Such feedback from students helps us in our effort to improve the materials produced for the International Programmes If you have any comments about this guide, either general or specific (including corrections, non-availability of Essential readings, etc.), please take the time to complete and return this form Title of this subject guide: Name Address Email Student number For which qualification are you studying? Comments Please continue on additional sheets if necessary Date: Please send your completed form (or a photocopy of it) to: Publishing Manager, Publications Office, University of London International Programmes, Stewart House, 32 Russell Square, London WC1B 5DN, UK