Finance

Question 1

Accruals concept

Answer 1

Expenses are matched to the revenues that they help generate. Expenses, costs, income and revenue are accounted for when they are earned or incurred not when cash flows in or out of the company.

Question 2

How would the accruals concept be applied to non-current assets and statement of financial position?

Answer 2

Non- current assets – Cost is on the statement of financial position. Each year depreciation is taken off the cost and treated as an expense in the income statement

That part of the cost of the asset has been match with the revenues it has helped to generate in that time period
EG asset £90,000 three year life. £30,000 as an expense each year and the asset on statement of financial position will be £90,000, £60,000, £30,000 and 0.

Question 3

What does absorption costing mean?

Answer 3

Absorption costing is the way a business will be able to obtain the production cost for its output, that is the direct costs plus indirect production overheads.

Question 4

What are product costs?

Answer 4

Product costs are those costs that are attached to the products and therefore included in the inventory (stock) valuation. The product cost will be:
Direct Materials X Direct Labour X Other Direct Expenses X Prime cost X Indirect production costs (overheads) X Product cost X

Question 5

What are direct costs?

Answer 5

Direct costs of a cost object are those that are related to a given cost object (product, department, etc.) and that can be traced to it in an economically feasible way.

Question 6

What are prime costs?

Answer 6

Prime cost is the accumulation of all the direct costs

Question 7

What are the indirect costs?

Answer 7

Indirect costs are related to the particular cost object but cannot be traced to it in an economically feasible way.

Question 8

What are period costs?

Answer 8

Period costs are non-manufacturing costs such as training, advertising and invoice (debt) collection. Period costs are not attached to the products and are not included in the inventory (stock) valuation. All period costs will be recorded as an expense in the current accounting period.

Question 9

What is an asset?

Answer 9

Assets are resources controlled by the entity as a result of a previous transaction that is expected to bring economic benefits (generate profit). Can be divided into non-current (future) and current assets (owned at reporting date).

Question 10

What is a liability?

Answer 10

A liability is an obligation of an entity arising from a past event the settlement of which involves the transfer of resources, (an amount owing by the business). Liabilities can be split into categories: Non- Current – the payment of liability is due after 12 months - Bank loan Current – the payment of the liability is due within the next 12 months -Trade payable

Question 11

Explain the position of a shareholder and the rights and risks.

Answer 11

• Owner with voting rights
• Dividend no guarantee of payment
• No security
• Ltd liability no recourse to assets
• Shares not generally re-purchased
• Will be last for repayment entitled to residue
• Shareholding may appreciate or depreciate in value

Question 12

Accruals concept - how does it translate to profit?

Answer 12

The profit shows the economic reality of how the business is performing An example of accruals principle is the treatment of cost of sales and calculation of gross profit
Opening inventory and purchases are added together and closing inventory deducted.
This ensures quantity sold is matched with quantity purchased and the profit is based on margins and not related to differing quantities The cash represents actual cash flows into and out of an organisation.

Question 13

What is the ratio for ROCE?

Answer 13

operating profit/ equity + non-current liabilities

Question 14

What is the ratio for gross profit margin?

Answer 14

Gross profit/ turnover

Question 15

What is the ratio for operating profit margin?

Answer 15

Operating profit/ turnover

Question 16

What is the ratio for asset turnover?

Answer 16

turnover/ equity + non-current liabilities

Question 17

Explain the pricing mechanism and how the market prices are determined.

Answer 17

The pricing mechanism is governed by the laws of demand and supply. Demand is the amount of a good and service demanded at a particular price. Supply is the amount of a good or service that is supplied at a given price. For demand in general if price increases the quantity demanded will fall. For supply if price increases the amount supplied will increase. The market price is where demand meets supply. Where the price is below this there will be an excess of demand and supplier will enter the market and current supplies will increase production. This will lead to a price fall. If price is above the equilibrium there is an excess supply and manufactures will reduce production until the price rises.

Question 18

Define contribution

Answer 18

Contribution is sales price – variable costs The amount that remains after deducting variable cost from sales revenue
Contribution – fixed cost = profit.

Question 19

Why is it important to consider a products contribution in short term decision making?

Answer 19

The fixed costs must be met in the short term. If spare capacity and no other alternatives projects should be accepted, product lines maintained and components made in house if they make a positive contribution to fixed costs and profits. This is because fixed overheads are related to products on an arbitrary basis and apply to business as a whole rather than one particular product line. A positive contribution will help cover these fixed costs and hence increase the profitability of the business as a whole.

Question 20

What is payback period?

Answer 20

Payback period is simple and unsophisticated investment appraisal technique that involves estimating the length of time it will take for cash flows to cover the initial investment outflow.

Question 21

What is net present value?

Answer 21

The forecast of set of cash inflows and outflows to take place at future dates, discounted to present value. Present value is the discounted value at the present time of cash flow expected to arise in the future.

Question 22

What is an audit?

Answer 22

An audit is an independent examination of the financial statements to establish that they show a true and fair view of the financial performance (profit) and position (value/worth) of the company.
An audit will not guarantee that the financial statements are correct just true and fair.
The scope of the audit does not cover all the information in the annual report, much of the narrative is unaudited.

Question 23

What is the statement of financial position?

Answer 23

It reports the assets, liabilities, and equity of a company at a specific time
The assets which are resources that are controlled by an entity that are expected to bring economic benefits, (generate profits). Example: land and building, inventory The liabilities which are obligations of an entity arising from a past event the settlement of which involves the transfer of resources, (an amount owing by the business). Example loans, trade payables and Equity which represents ”the residual interest in the assets of the entity after deducting all the liabilities” Equity belongs to the owners of the company who are the shareholders

Question 24

What is the income statement?

Answer 24

The income statement details the profit that a company has made over the year. It provides information on the financial performance of the company. It highlights gross profit which indicates how well the core business is performing as it compares sales revenue with the manufacturing costs of producing the product. It then highlights operating profit which deducts costs of administration and distribution from gross profit. Final deduction being for tax

Question 25

What does it mean to have a limited company financially?

Answer 25

If the business has been set up as a limited company. A limited company is a separate legal entity. It is responsible for its own debts. If a limited company cannot pay its debts when they become due it is the company that is bankrupt. The creditors of the company have no recourse to the owners of the business the shareholders.

Question 26

Why is it expected that a new business will have a low asset turnover?

Answer 26

The asset turnover is likely to be depressed when a business starts up or expands. It is on start up or expansion that new assets are purchased. The new assets are at current prices and have had only had 1 year depreciation. The denominator is therefore at a high value. On set up or expansion it takes time for the new assets to generate revenue, there is a time lag between purchasing the new assets and generating revenue so the numerator is low.

Question 27

Why would you want the operating profits to be low?

Answer 27

The operating profit margin is half the gross profit margin. The costs that are deducted from gross profit to arrive at operating profits are administration costs and distribution costs. A well managed company would seek to keep these costs as low as possible to achieve high margins.

Question 28

How can a business be profitable with a loan or overdraft?

Answer 28

Profits of a business are calculated on the accruals principle
Revenues and costs are recognised when they occur and not when cash flows into or out of the business
When a sale is made it is recognised in revenue even if cash has not been received from a customer
Cost of sales matches the quantity sold with the same quantity. When more stock has been bought than sold the excess is carried forward to the next accounting period as closing stock.
When a business first starts to trade it will have to purchase a lot of stock which may not all be sold plus plant and machinery etc. Therefore there will be a lot of expenditure and a negative cash balance.
The purchase of items of plant and machinery are regarded as assets and so will not go into the income statement. The only charge in the income statement for these items is depreciation.
Additionally as stated above only the cost of stock that has actually been sold will be included in the income statement and not all the expenditure

Question 29

How to price an item after calculating the product cost.

Answer 29

Need to cover any period costs such as administration and distribution
Need to add a mark up that provides the business with an acceptable level of profit
Need to look at the market as would tend to be a price taker as a large number of buyers and seller. Were demand and supply would be market price. If the products are priced any higher may not sell
If can may be able to distinguish product or company to obtain a small price increase through premium pricing.
If you could find a single customer- large retail outlet/department store willing to take large quantities may reduce price as will have less selling and admin costs.

Question 30

How does management accounting help run a company?

Answer 30

• Determine the organisation objective
• Identify different strategies to achieve the organisation objective
• Prepare detailed plans for the selected courses of action to achieve the organisation goal
• The plans need to be monitored throughout the process to ensure they are being adhered to
• Review of organisation achievement.
• Organisations goals and strategies may need to be reviewed and revised

Question 31

What is the break-even point?

Answer 31

The break-even point is where total costs = total revenue
Sales Revenue – Variable Costs – Fixed costs = 0
BEP (units) = Fixed costs/contribution
Break-even point is important for a business- need to know how many units you need to sell to be profitable.
If just starting or expanding to a new product line particularly important.
If a business expect to be able to produce or sell the required number of units then should not proceed.

Question 32

What is the margin of safety?

Answer 32

Margin of safety is the excess number of units sold over break-even point.
Margin of safety give the directors confidence that even if sales or production falls slightly a profit can still be maintained.

Question 33

Why do investment appraisal techniques apply discount factors?

Answer 33

Discounting at the cost of capital to a particular company or project to bring cash flows to their net present value allows factors such as risk, opportunity cost and the time value of money to be taken into consideration.
Recognises £1today is worth more than £1 tomorrow in terms of spending power
Compensates for the fact that a project carries a risk and so must ensure the future cash flows not only compensates for deferred consumptions but that its return is put at risk.

Question 34

What is opportunity cost?

Answer 34

Opportunity cost. If a company has an amount of money to invest there will be alternative options, The project chosen should generate a return equal to or greater than the next best alternative project. The discount factor takes this into account

Question 35

What are the variable costs?

Answer 35

Variable costs vary in direct proportion with activity (i.e., change in total in proportion to changes in the related level of total activity or volume).

Question 36

What are the fixed costs?

Answer 36

Fixed costs remain constant over wide ranges of activity (i.e., do not change in total for a given time period despite wide changes in the related level of total activity or volume).

Question 37

What is contribution?

Answer 37

The difference between sales price and variable cost is contribution.

Question 38

How does a ltd company differ from a public ltd company?

Answer 38

A popular business vehicle is to start a business as a limited company.
A business is incorporated it becomes a legal entity in its own right and can sue or be sued.
If the business gets into financial difficulties the creditors do not have recourse to the owners private assets.
The owners liability is limited to the capital they have invested in the company.
The owners of the company are given shares/equity in the company in return for the funds they invest.
These shares in private limited companies cannot be bought and sold on the stock exchange but there can be a private transfer.
The benefits of incorporation are limited liability but the costs include registration and complying with company law which requires annual published accounts.
A plc can sell shares direct to the public and have greater regulation.

Question 39

Problem with cost absorption.

Answer 39

• Management accounting must find the most appropriate cost absorption rate one that matches the product with the most benefited resource.
• But price can vary, between them
• If not matched with an appropriate overhead as it may be less than competitors and while sales may be high the profits margins may be low
• If price is based on costs and costs contain too great a percentage of overheads, the price will be higher than the market price and goods may be unsold.

Question 40

Why should admin and distribution costs not be included in the product cost?

Answer 40

These are period costs and should not be included in product cost. The product cost is used for inventory valuation. Any unsold products are carried forward as an asset to the next accounting period, following the accruals principle.
Period costs are fully used in the period. They should never be carried forward they should be expensed in the year they are incurred and therefore should not be included in product cost.

Question 41

New technology on the market - how should it be priced?

Answer 41

The product should be priced using life cycle costing.
On launch a high price can be charged as it will be a prestige product with high levels of demand and limited supply pushing the price up. Try and recoup research and development cost as well as advertising and marketing costs.
If no new technology comes along and the product remains unique and/or fashionable, high prices may be maintained even if production is increased.
Once new technology has been found or the patent expires, then new suppliers will enter the market and supply will increase pushing price down or out dating the product.
Cost plus pricing is not an option as the company is not initially a price taker. The initial price can only be determined after some market research.