Exam Revision

Question 1

State 2 reasons to explain how profitability could have improved despite a fall in the Gross Profit Margin

Answer 1

Look at what has happened between gross profit and profit in the income statement:

• Other expenses have decreased
• Expense control has been improved
• Assets are being used more efficiently to generate profit (only if ROA increased as well)
• Other revenue and stock gain have increased
• Obsolete assets have been disposed of

Question 2

Explain why Return on Assets is used as an indicator of business profitability

Answer 2

It is used as it measures how efficiently a business has used its assets to earn profit. More efficient use of assets allows the business to generate greater profit

Question 3

Explain how Return on Assets can improve despite a fall in the Net Profit Margin

Answer 3

ROA = NPM x ATO

The asset turnover must have improved, thus indicating that assets have been used more productively by the business to earn revenue (or sales).

Total sales have increased, this could have been achieved via the business selling some assets, thus decreasing total assets available while using the remaining assets more productively to earn revenue.

Question 4

State 2 reasons for the fall in Net Profit Margin

Answer 4

Whole income statement to look at:

• Costs of Sales has increased at a greater rate than selling price of stock
• Other expenses have increased at a greater rate than selling price of stock ( rent, advertising, wages)
• Average mark up decreased possibly due to cost price increases
• Owner could have reduced selling prices while maintaining cost prices

Question 5

Identify 2 other benchmarks that should be considered before making any decisions about the profitability of the business

Answer 5

• Industry Average
• Previous reports
• Budgeted reports
• Similar businesses

Question 6

Define Liquidity

Answer 6

The ability of a business to meet its short term debts as they fall due

Question 7

Distinguish between Profit and Profitability

Answer 7

Profit is calculated by revenues earned less expenses incurred and is reported as a dollar amount

whereas

Profitability is the ability of the business to earn profit compared against a base such as assets, sales or owners investment and is written as a percentage

Question 8

Explain one consequence for a business that is experiencing a decline in its liquidity

Answer 8

One consequence would be suppliers removing credit facilities. This could occur if the business is not able to repay its debts in the form of creditors within the credit terms as they fall due and therefore would lose the ability use credit.

Question 9

Explain the implications of changes in the level of Debt Ratio for the business

Answer 9

Debt ratio is a stability measure which indicates the percentage of the businesses assets which are financed by liabilities

Higher levels of debt generally equated to a higher level of risk. One possible implication of a higher level of debt could be an increase in repayments leading to more pressure on liquid assets of the business.

Additionally increased debt could also lead to interest repayments which would have a negative affect on net profit

With higher levels of debt repayments the business may not be able to meet its short term debts as they fall due thus causing damage to the businesses credit rating.

The ultimate implication would be the business facing total financial collapse due to all these factors.

However,
a possible positive implication would be that the owner f the business would be able to increase their personal return on investment by using borrowed funds to purchase new assets for the business rather than making additional capital contributions.

Question 10

Evaluate the profitability of the firm

Answer 10

Profitability has improved as the business has been using its assets more productively and this has provided an increased return to the owner.

However, as net profit remained constant the increase in ROA must have been brought about by reducing overall assets.

As the debt ratio has increased so much it could be said that newer more efficient assets have been purchased using borrowed funds.

Despite the fact that the ROA has increased, it is still below the industry average, therefore it is not a positive outlook as net profit has not increased

Question 11

State two pieces of non-financial information

Answer 11

• Results of customer satisfaction survey
• Number of sales returns
• Number of Customer complaints

Question 12

Explain how it is possible for the Net Profit Margin to decline yet the Return on Assets to improve

Answer 12

When Net Profit Margin decreases and Return on Assets increases it means that Asset Turnover has increased, meaning that sales have increased meaning that Sales have increased by a greater percentage than the percentage in increase in Assets.

Even though the Asset Turnover has increased, it is the worsening if expense control that has lead to the decrease in Net Profit Margin

OR

Assets may have decreased as non-current assets may have been disposed of for a loss which has seen the total value of assets decrease

Question 13

Explain the effect on Gross Profit Margin in the period if period costing is used instead of product costing

Answer 13

Assuming not all the stock was sold, Gross Profit Margin would be lower as Costs of Goods Sold would represent a higher percentage of Sales as period costing would recognize the full amount as an expense during the period regardless of how many were sold

Question 14

Why are asset accounts not required to be closed?

Answer 14

They are not included in the calculation of profit therefore as they provide a future economic benefit they are balanced so they can be carried forward into the next reporting period

Question 15

Discuss a high Working Capital Ratio

Answer 15

A high WCR indicates that the firm is in a better position to meet its short term debts as they fall due as they have more current assets more every current liability.

However,

WCR is a static measure which does not assess the speed of liquidity

A very high WCR of 5:1 indicates poor management and inefficient use of current assets…

If cash is high it should be used to invest in non-current assets to boost revenue or pay off long term debt to reduce interest repayments.

If there is large stock on hand it is risky as it may expire or become obsolete increasing expenses such as stock write downs.

If the debtors balance is large it may reflect that debtors are not paying their debts which would increase the expense of bad debts.

Question 16

cash surplus but negative operating cash flow

Explain one reason why the owner should be concerned about the firms cash performance for the reporting period

Answer 16

Net Cash Flows from Operations is negative, meaning the business is generating insufficient funds from its Operating activities to meet its other cash requirements. If not for the loan, the bank overdraft would have fallen into overdraft

Question 17

Explain the importance of Net Cash Flows from the Operations to the success of a trading business

Answer 17

If Net Cash Flows from Operations are negative, the firm will be unable to meet its other cash requirements without using other sources of finance, such as loans which must be repaid or capital which is limited to the funds of the owner.

Question 18

Explain one benefit of a cash flow statement

Answer 18

It aids decision-making by classifying sources and uses of funds, allowing the owner to identify whether Net Cash Flows from Operations is sufficient to cover other cash requirements.

It aids decision-making by allowing the firm’s to assess its performance in meeting its cash targets.

It assists in planning for future cash activities by providing a basis for cash targets for the future (in the next Budgeted Cash Flow Statement).

Question 19

*Net profit for the quarter was $3650, although Net Cash from Operating Activities was negative, explain giving one example how this can occur

Answer 19

Only cash inflows and outflows related to day to day trading activities are included in the calculation of Net Cash from Operating Activities, whereas the Net Profit is the result of revenues earned minus expenses incurred

Cash flows from operating activities and net profit measure different information.

For example, Credit sales may be greater than Receipts from debtors which could increase net profit more than operating cash flow

Question 20

Explain the impact of FIFO on Cost of Sales and Net Profit in times of rising prices

Answer 20

FIFO assumes that the older stock is sold first. When prices are rising this older stock will be cheaper, understating Cost of Sales and overstating Net Profit as it is possible some of the stock sold is actually the newer, more expensive stock.

Question 21

Explain how the FIFO method of stock evaluation can overstate the value of stock on hand

Answer 21

FIFO assumes that the older stock is sold first, and that the newer stock is still on hand. When prices are rising, this newer stock will be more expensive, overstating stock on hand as it is possible some of the stock on hand is actually the older, cheaper stock.

Question 22

Referring to one qualitative characteristic, explain the role of source documents in the accounting process

Answer 22

Reliability:
Source documents provide the verifiable evidence of each transaction to ensure that the information in the reports remains accurate and free from error and bias.

Question 23

Explain how a physical stocktake may improve reliability in reports

Answer 23

It will verify the stock on hand as recorded in the stock cards, and in the process detect any stock loss or gain, thus ensuring that the figure reported as Stock Control in the Balance Sheet is accurate and free from bias and error.

Question 24

Explain the perpetual method of stock recording

Answer 24

The perpetual inventory system involves keeping continuous records of stock movements in and out of the business by recording stock transactions in stock cards then conducting a physical stocktake at the end of the reporting period to verify the balances of those stock cards

Question 25

Explain an advantage and disadvantage of the perpetual method of stock recording

Answer 25

One advantage is that stock cards can be used to assess fast and slow moving lines of stock so that the stock mix and can be improved

Stock losses and gains can be detected by verifying stock cards against stocktake

Reordering is assisted by having continuous records of stock on hand

One disadvantage is that this method requires the use of a physical stocktake which can be costly and time consuming

Question 26

Product Cost

Answer 26

It is treated as a product cost, as it is a cost incurred to get the stock into a condition and location ready for sale, and can be allocated to each individual item on a logical basis

Question 27

Period Cost

Answer 27

Although incurred to get stock into a condition and location ready for sale, it cannot be allocated to each individual line of stock on a logical basis as it is incurred per month

Question 28

Pre adjustment trial balance rule

Answer 28

Only concerns revenues and expenses!

Contributions on new assets or liabilities are already included in value!

Question 29

Referring to 1 accounting principle, explain why it is necessary to make balance day adjustments

Answer 29

Reporting Period

To ensure that profit is calculated accurately by comparing revenues earned against expenses incurred in the current Reporting Period

Question 30

Explain how balance day adjustments ensures relevance in reports

Answer 30

By reporting revenues earned and expenses incurred in the current Reporting Period, balance day adjustments ensure that reports contain all information that is useful for decision-making.

Question 31

Explain your treatment of installation on the Van

Answer 31

It is included as part of the cost of the asset, as it is incurred to get the asset into a condition and location ready for USE, and will bring a benefit for the life of the asset.

Question 32

With reference to an accounting principle, explain why it is necessary to depreciate non-current assets

Answer 32

Reporting Period

To ensure that the cost incurred in relation to a non-current asset is reported as an expense in each Reporting Period in which the asset earns revenue, thus ensuring that profit is calculated accurately in the current reporting period

Question 33

Explain why the straight line method should be used to depreciate the shelving

Answer 33

The straight-line method best reflects the revenue earning pattern of the shelving, which will contribute evenly to revenue over its useful life, and this method allocates depreciation expense evenly over the asset’s life.

Question 34

Explain why the reducing balance method should be used to depreciate the sewing machine

Answer 34

The reducing balance method best reflects the revenue earning pattern of the sewing machine, which will contribute more to revenue when it is new and less as it ages. This method allocates more depreciation expense at the start of the asset’s life and less as it ages.

Question 35

Referring to 1 qualitative characteristic, explain one reason why the owner should not change the method of the deprecation used for the shop fittings

Answer 35

Comparability

Changing accounting methods will mean that the reports will not be able to be compared from one Reporting Period to another: it will be unclear whether changes in depreciation expense are the result of changes in financial performance or simply changes in accounting methods.

Question 36

Explain one reason for the loss on the disposal of furniture

Answer 36

The carrying value was overstated, due to under-depreciation. This may have been caused by overstating the residual value or useful life, or because the asset was not in demand due to damage or obsolescence.

Question 37

*The reporting of a profit or loss on disposal of a non current asset proves that while depreciation expense may be relevant it is not reliable

Explain why this statement is correct

Answer 37

Reliability states that all information in reports should be free from bias and as depreciation is calculated upon an assumption it does not fulfill reliability. However, by allocating depreciation we can determine a more accurate profit figure and therefore the information is more useful for decision making, thus making depreciation relevant.

Question 38

Suggest a reason for the profit on disposal of fittings

Answer 38

Over-depreciated asset due to understated residual value or useful life

Question 39

Current Liability

Answer 39

A present obligation of the entity, arising from past events, which the settlement of which is expected to result in an outflow of economic benefits in the next 12 months

Question 40

Current Asset

Answer 40

A resource controlled by an entity from past events which a future economic benefit is expected for, in 12 months or less

Question 41

Revenue

Answer 41

An INFLOW of economic benefit (or saving in outflow) in the form of an INCREASE in ASSETS (or decrease in liabilities) that INCREASES OWNERS EQUITY (except for capital contributions)

Question 42

Expense

Answer 42

An OUTFLOW or consumption of an economic benefit (or reduction in inflow) in the form of a DECREASE in ASSETS (or increase in liabilities) that REDUCES OWNERS EQUITY (except for drawings)

Question 43

Agreed Value

Answer 43

Estimated future economic benefit to be provided by the asset on the date it is contributed to the business

Question 44

Explain with reference to one accounting principle and two qualitative characteristics, the issues involved in determining the value at which the computer system was recorded (historical cost v agreed value)

Answer 44

Usually non-current assets are recorded at their historical cost, which is the original cost at the time of acquisition.

However, this cost was paid by the owner when purchased privately and does not represent the value of the asset at the time it was contributed to the business.

The future economic benefit of the asset should be taken into account, as this would be more relevant to decision-making than the item’s historical cost.

Therefore, the agreed value should be used to satisfy relevance.

Using agreed value would not, however, satisfy reliability, as this value cannot be verified by a source document and may include bias and error

Question 45

Calculate cost of sales from 50% mark up

Sales = 9000

Answer 45

9000/1.5

= 6000

Question 46

Discuss arguments for and against the business operating with control accounts for debtors and creditors

Answer 46

By operating with control accounts, unnecessary detail is removed from the general ledger as there is just one account for each of total debtors and total creditors.

These totals provide ease of reporting as the totals from the control accounts in the general ledger can be transferred to the balance thus ensuring greater relevance as not all accounts have to be listed making the balance sheet more useful for decision making.

It also provides a checking mechanism that can be used to identify recording errors, as the balance of control accounts can be checked against the totals of the subsidiary ledgers via the Debtors Schedule and Creditors Schedule.

However, Shade Designs has just one supplier, so using a control account for creditors would create unnecessary duplication of one creditor’s account and keeping two sets of records is not necessary.

Question 47

Carrying Value

Answer 47

The value of the non-current asset that is yet to be consumed as an expense by the business, including any residual value

Question 48

Residual Value

Answer 48

Estimated value of the non-current asset at the end of its useful life

Question 49

Useful Life

Answer 49

Estimated time for which the non-current asset will be used by the current entity to earn revenue

Question 50

Historical Cost

Answer 50

Original purchase price of the non-current asset

Question 51

Define Accural accounting

Answer 51

Accural accounting is a method of determining profit whereby revenues earned and expenses incurred are compared for a particular reporting period

Question 52

Benefit of reporting adjusted gross profit in the income statement

Answer 52

It allows the management of stock to be assessed from one reporting period to the next

It will highlight the result of a physical stocktake and allow for corrective action to be taken to reduce stock losses, stock gains and stock write downs

Question 53

Discuss the use subsidiary ledgers

Answer 53

Subsidiary ledgers allow for individual information for each debtor or creditor to be recorded separately.

The use of subsidiary ledgers enhances the internal control of the business by providing a crosschecking mechanism.

The balance of each subsidiary ledger at the end of each month can be checked against the Statement of Account received from the supplier and the debtors or creditors schedule within our own business. If there is a discrepancy, an error can be detected and promptly rectified.

As Fabian’s Footballs sells sporting equipment directly to schools and sports clubs, they need to use subsidiary ledgers as they provide an up-to-date record of who owes the business and how much.

However, using subsidiary ledgers requires additional record keeping and may need additional staff and training that can be costly.