THEORY: UNIT 2

TOPIC: CAPITAL STRUCTURE OF LIMITED COMPANIES

1. Differentiate between revenue reserves and Capital Reserves
Revenue reserves: An amount of profit voluntarily kept within the business, thus reducing the amount of
profits left available for dividend payments. They may be either specific or general reserve. Capital Reserves:
Capital reserves are created in accordance with the provisions of the company’s act. Company’s act prohibits
transferring of capital reserves to Statement of Comprehensive income and they may not be used to pay cash
dividend to shareholders but they can be used for issuing bonus shares.

2. Explain the following terms, including how each is created:

(i) reserves (ii) provisions (iii) liabilities
Reserves
Revenue reserves are appropriation of retained profit i.e. created after net profit has been calculated. Eg
General reserve. Capital reserves may arise for a specific reason. Eg issuing shares at a premium, or revaluing
a non-current asset, or redeeming own shares without an issue of new shares.
Provisions
Provisions are amounts set aside before arriving at net profit eg for depreciation. Provisions reduce the value
of assets. The reason for the provision will be specific eg for damages in a court case, but the amount of the
provision would be an estimate. Provisions follow the concept of prudence. Provisions enable a true and fair
view to be shown/using matching concepts.
Liabilities
Liabilities are debts that have been incurred by the business and must be paid. Short term (current) liabilities
must be paid back within one year. Eg trade payables to suppliers. Long term liabilities are to be repaid in a
term greater than one year. Eg long term bank loan.

3. Evaluate the decision of redeeming ordinary shares

Advantages of redeeming shares: Company may have excess/large amounts of cash, which they feel would
be best used / no better use than redeeming shares. Less funds will have to be paid out in the future in terms
of dividends. Certain ratios will improve, eg Return on Capital Employed, Earnings per share. (need one) This
will make managers and directors and company look better. The share price will rise as less shares are on the
market.

Disadvantages of redeeming shares: Company may not have surplus funds / excess working capital etc. so
may not afford/ be in a position to redeem. So it will drain on company’s liquid resources. i.e. cash and cash
equivalents. Liquidity ratios will worsen. eg Current ratio, and Acid ratio. Gearing ratio will worsen. as Debts
is a larger percentage of capital employed. The company’s Statement of Financial Position has a smaller equity
base which gives the impression of a smaller company.

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4. Briefly state how the following reserves are 1) created and 2) used:

Created by Used for/utilized examples

Trading profit built up
Retained earnings over the past and present Dividend paid to ordinary shareholders
years
Any, perhaps unspecified, use.
Transfer from retained
General reserve Issue of bonus shares
earnings/ profit
Transfer back to retained earnings
write of preliminary expenses on
formation of the company or issue of
Issue of ordinary shares
Share premium reserve shares
above their nominal value
pay premium on redemption of shares
issue of bonus shares
Transfer from retained
Capital Redemption
earnings when shares are Act as a creditors buffer.
reserve
redeemed
Upward revaluation of Transfer to retained earnings/ income
Revaluation Reserve
non- current asset statement when the asset is sold
Capital Replacement Transfer from retained Spent on property plant and equipment
Reserve earnings Purchase of motor vehicle, Furniture

5. Evaluate, from the viewpoint of the company, whether Sunshine Stores Ltd should issue redeemable
preference shares or irredeemable preference shares.
For redeemable preference shares:
• The company has more flexibility, being able to buy back the shares when it wishes and is in a position to
do so. Buying back the shares will mean less dividends paid out in the future.
• The company may be in a position to pay less tax.
• Irredeemable preference shares cannot be redeemed except on liquidation of the company.
• Irredeemable preference shares might be more attractive to potential investors, who would eventually be
able to get their cash back i.e. the new shares might be easier to place.

For irredeemable preference shares

• The equity section of the company appears bigger and stronger. This may have benefits when trying to
attract investors or raise finance etc.

Other comments Both types of share will:

• Be included as fixed interest debt, so the gearing ratio will be the same.
• Involve paying a fixed dividend (that is actually cumulative).
Decision: Redeemable preference shares appear to offer flexibility and the possibility of a future redemption
when finances allow.

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6. Evaluate the decision of redeeming preference shares
Advantages: Redeemable shares can be bought back from shareholders, so will mean less funds leave the
company in the form of dividends each year leaving more funds in the business for operations or paying
dividends to ordinary shareholders. Buying back debt means that the gearing ratio could improve/reduce.
which reduces risk. Statement of Financial Position looks stronger which could help attract investors. Capital
may not be needed. Return on Capital employed will rise.
Disadvantages: Buying back the shares means a large outflow of funds at this time. Administration costs of
buying back shares are high e.g. staff time, bank fees, postage etc. Preference shareholders may be unhappy
and may not invest in the future.

7. Evaluate the use of ordinary shares as a method of raising further finance.

Case for Ordinary shares
• It is fairly straightforward to ask existing shareholders if they would like to purchase more shares.
• No “outside” parties having any influence on the running of the company, e.g. a place on the board, which
banks may request if they provide funds.
• Shareholders do not have to be paid dividends, which is useful if Company is short of funds.
• No interest has to be paid, so the profits of Company will be higher than taking a bank loan. This will also
help cash flow and liquidity.
• Issue of shares results in lower gearing, which decreases the risk to Company.

Case against Ordinary shares

• Administration costs involved in the issue of ordinary shares would be much greater than the
administration costs of taking out a bank loan.
• A share issue may not be fully subscribed. If Company then turn to a bank for funding, the bank may see
the company as high risk and charge a high interest rate.

Conclusion
Should relate to points made above. For example, ordinary shares are a good source of finance.

8. Evaluation of creating and utilising Capital Redemption Reserve ;

Case for; CRR acts as a creditors’ buffer. Capital base is maintained. CRR is a Capital Reserve so it prevents
directors/shareholders from taking cash/ capital out of the business, leaving little/nothing for creditors in the
event of the company experiencing liquidity/ trading problems. Cannot be transferred back to the Statement
of Comprehensive Income and then used to pay out dividends. Presence of CRR may help a company obtain
credit or investment/ buying of company shares as Statement of Financial Position appears stronger. In certain
circumstances e.g. redemption of shares, the CRR must be created by company law therefore should be of
benefit. CRR can be used for a bonus issue of shares
Case Against; Creating a CRR takes time and money and accounting expertise. Reduces flexibility, as
company may not be able to do what they want to do e.g. redeem shares, if e.g. insufficient funds in revenue
reserves.
Conclusion: Capital Redemption Reserve is worthwhile/ useful/ effective.

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9. Evaluate the decision to issue ordinary shares instead of preference shares, giving advantages and
disadvantages of each type of share from the point of view of the company.
Ordinary shares
Ordinary shares would see an inflow of capital that will help the company’s liquidity position and therefore
help with the future running of the company. Ordinary shares would allow existing shareholders the right
to buy more shares in the company. This would ensure there is no dilution of control if they take up the
rights. However, ordinary shares could be purchased on issue by outside parties if existing shareholders do
not take up their right to buy the newly issued shares. Outside parties could buy these new shares when
second-hand, if they are offered on the open market. Outside parties gaining some control of the company
could be to the benefit or detriment of the company. Ordinary shares only have to pay a dividend when the
company is in a financial position to do so. This would help the company regarding liquidity, cash flow, and
maybe stop
revenue reserves being drained. It would appear that the business is not in a healthy financial position – it
made a trading loss this year. There is little in the revenue reserves that could be used to finance a large
dividend payment. Ordinary shares decrease the gearing ratio and that may make borrowing easier. This
would help the company’s liquidity position, if it is having problems borrowing, or with liquidity.
Decreasing the gearing ratio also reduces risk to company..
Preference shares
Preference shares would see an inflow of capital that will help the company’s liquidity position and
therefore may help with the running of the company. If the company is finding it difficult to raise finance, it
may find preference shares are more likely to be taken up by investors than ordinary shares, who may see a
potentially larger return. Preference shares would see the holders
expecting a regular payment, probably twice a year, at a fixed rate of interest. This should be paid, even if
the company is in a poor financial position. If dividends are not paid, the missed dividend may be carried
over to a future period i.e. the dividends may be cumulative. Preference shares increase the gearing ratio
that may make future borrowing more difficult for the company.
Decision
Good decision by the board to issue ordinary shares.

10. Differentiate between right issue and Bonus issue. Right issue is offered to existing shareholders (not to
the general public) in a ratio based on the shareholders present holding of shares. The book keeping entries
are similar to selling shares to the general public. It can be issued at premium.
Journal entry: Dr. Bank
Cr. Ordinary share capital
Cr. Share premium
Bonus shares are issued to the existing shareholders free of cost. They are issued when there are undistributed
profits in the company. They may be issued utilizing capital reserves and revenue reserves. This is an issue of
shares by means of capitalizing reserves.
Journal entries
Dr Reserve (the reserve that they utilize for bonus issue)
Cr Share capital

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11. Evaluate the decision of issuing bonus shares?
Advantages of Bonus shares:
The issue of bonus share does not use the cash reserves of the company and allows cash resources to be used
elsewhere in the company. Bonus share may be issued instead of the dividend, where there is shortage of
cash. The bonus issue will not affect the voting rights as each shareholder has same position of the overall
share capital. It is easier for an individual shareholder to sell part of his holdings at a lower price. If the company
can sustain its dividend per share each shareholder will receive a larger total dividend.
Disadvantages of bonus shares
Bonus shares bring in no cash for the company. Issue of bonus shares sees share price fall and Shareholders
will be unhappy. Bonus shares will result in more shares eligible for dividends in the future so greater future
payouts, or dividend per share may fall. If bonus shares are paid from revenue reserves this means, there will
be less funds available for future dividends/emergencies. Shares may fall in value in the future due to (e.g.)
economic reasons so shareholders will be unhappy.

12. Evaluate the decision of right issue.

Advantages of Rights Issues
Allows the company to raise funds that can be used for the benefit of the company.
Funds could be used to pay dividends to shareholders who did not receive a final dividend for previous
years who may be unhappy.
Existing shareholders get the first rights to buy the shares, so
- administration costs will be lower than a public issue, if the rights are taken up.
- Existing shareholders do not see a dilution of powers/ownership
The company may appear a “bigger” company as it has a larger capital base.
A successful rights issue shows the shareholders have confidence in the company.
A rights issue helps banks maintain the capital base that is required for banks.
Disadvantages of Rights Issues
Costs of administration.
Rights may not all be taken up. This may mean:
- extra costs of having issue underwritten by e.g. merchant banks.
- new shareholders take up the shares, so existing shareholders see powers diluted.
Shareholders were probably unhappy at not receiving a final dividend for previous year, now they are being
asked to pay up more cash, which will make them even more unhappy.
If the market price of the shares falls below the issue price before the issue, nobody will take up the rights
issue.
Some ratios will now worsen, due to the larger capital base.
E.g. Return on capital employed ,Earnings per share ,Dividends per share Dividend yield
A rights issue may send out a signal to the market that the company is short of funds, so confidence in the
company falls. This may effect the Price Earnings ratio, or even the credit rating of the company.

Conclusion
Company could probably welcome the extra funds, but they run the risk of upsetting the shareholders and
the market with a rights issue.

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13. Evaluate the decision to convert the (8%) Debentures / Bank loan into £1 Ordinary Shares from the
viewpoint of the directors.
Case for Ordinary shares/ For Conversion
• Shareholders do not have to be paid dividends, useful when short of funds. • No interest has to be paid, so
profits of company higher (or smaller losses) which will result in share price rising • Assets no longer offered as
security, so no claims on assets by debenture holders, if debenture not repaid, or company fails. • Share issue
reduces gearing and therefore risk • OR Debenture results in higher gearing which increases risk to company
(and may affect credit rating) • No “outside” parties (i.e. debenture holders) having any influence on running
of company eg place on Board • Statement of financial position will look stronger and may attract investors
Case for Debentures / Against Conversion
• Interest is allowable for tax, so company may be able to retain more funds than if paying dividends. • Keeping
debenture sees no dilution of ownership for existing shareholders. • Debenture issuer may bring expertise and
experience to company, and maybe Board. • Cost of share issue eg fees etc. • The Memorandum of Association
may have to be changed • There may be a fall in dividends per share • Share price may fall
Conclusion: Conversion will benefit the company

14. Evaluate the decision to raise further finance by issuing ordinary shares, rejecting the possibility of
raising funds by the issue of debentures
Case for Ordinary shares / Case Against Debentures
• Shareholders do not have to be paid dividends, useful when short of funds / making a loss. Dividends
could be variable interest on debentures must be paid
• No “outside” parties having any influence on running of company eg place on Board
• No interest has to be paid, so profits of company higher.
• No assets offered as security, so no claims on assets by debenture holders, if debenture not repaid, or
company fails.
• Reduces gearing ratio and therefore risk
• Debenture results in higher gearing which increases risk to company
Case for Debentures / Case Against Ordinary Shares
• Interest is allowable for tax, so company may be able to retain more funds than if paying dividends.
• Debenture issuer may bring expertise and experience to company, and maybe Board.
• No possible dilution of ownership for existing shareholders which means earnings per a share will fall
• May be quicker to issue than ordinary shares
• Costs of arranging debenture may be lower eg no prospectus to issue
Maximum of 8 marks for arguing one side
Conclusion
Should relate to above points made.
E.g. Ordinary shares are a preferable source of finance.

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15. Evaluate the raising of capital for a plc by issuing a debenture instead of taking out a bank loan
Advantages of debentures: Debenture may have a lower rate of interest which would have been fixed on
issue. The bank loan may have a higher rate if there is a period of high or rising interest rates. Interest only
has to be paid on a debenture every 6 months, whereas bank loans require monthly repayments. The
debenture therefore allows the company some breathing space which is useful if trading is seasonal, or going
through a period of low sales. Debenture may be for a longer period of time, which may benefit company,
especially if to finance a long term project. Bank may wish to be involved in decision-making etc. if loan given
e.g. ask for a seat on the board
Advantages of bank loans: Interest rate may be lower. Bank loan is likely to be for shorter period so less
interest may be paid. Monthly repayments may be preferable to larger six-monthly repayments. Bank may
have good relationship with company and give advice etc. Debenture holders may wish to be involved in
decision-making/control e.g. ask for a seat on the board
Conclusion:

16. Evaluate the issue of debenture to raise finance

Case for: Company raises cash required for new investment. Fees are likely to be low compared to an issue
of shares e.g. prospectus, advertising, etc. No capital repayments over the life of the debenture. Interest is
fixed which allows budgeting to take place. Debenture interest is allowed against tax so less corporation tax
is paid on profits. Issuing debentures instead of shares reduces the chance of a takeover
Case Against: There will be some expenses involved in debenture issue e.g. administration, underwriting
etc. When debenture matures, a large capital sum has to be repaid. Interest must be paid on debenture even
when the company makes a loss and interest will reduce the profits. Issue of debenture means gearing ratio
will increase. Debenture holders are likely to insist on a charge over company assets. Debenture holders may
insist on some form of control e.g. a seat on the board
Conclusion: As a source of finance for the new marina, a debenture is probably (not) a good idea.

TOPIC: FINAL ACCOUNT OF LIMITED COMPANIES

17. International Accounting Standard 1 (IAS1) recommends costs to be placed under the headings of cost
of sales, distribution costs, administrative expenses and financial cost. Evaluate the IAS
recommendation
For decision
Allows readers of financial statements to understand a given, uniform presentation.
Allows readers of financial statements to compare companies.
Enables companies to see how various sections of the business are performing i.e. production,
distribution, and administration.
The subdivisions may be helpful in determining internal decision making e.g. price setting, budget
preparation.
Against decision
May add to the complexity of producing and reading financial statements.
There are some items/expenses that may be placed in more than one section, which may make
comparisons invalid.
Decision
Probably a good recommendation to divide up expenses into the given sub-headings.

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 18. Explain the term corporate governance.
Corporate governance is the mechanisms and processes used to control and direct companies in pursuit of
their objectives. This will involve the rights and responsibilities of the board of directors and managers.
Mechanisms may include monitoring the actions, policies and decisions of companies and their agents.
Corporate governance practices will try to align the interests of stakeholders and minimise conflict.

19. “A company’s statement of financial position is more important than statement of comprehensive
income” “evaluate.
For Statement of Financial position;
Statement of Financial position shows items of value firm possesses and may use for running firm over long
time (fixed asset), i.e. it shows the financial strength of the firm. Shows the financial weakness of the business.
The long-term liabilities debt that must be serviced. It shows a book value of the firm. That is the capital and
reserves. Shareholders can see the value of their investment. Some figures in the profit and loss may be an
estimate. Example depreciation, stock valuations
For Statement of Comprehensive income:
Shows how well the business has performed over the trading period. This is very important as Statement of
Financial position may look very healthy, but trading a loss. P&L a/c enable firm to see the relationship
between sales and purchases/production that is the gross profit. It enables the firm to see the relationship
between the gross profit and expense; net profit. Some figures in the Statement of Financial position may be
estimate for example depreciation and stock values.

20. Evaluate the importance of auditor’s report

Case for importance of Auditors’ Report
Auditors are independent scrutineers of the accounts and report that the accounts have been prepared
“correctly” in accordance with International Accounting Standards. Auditors will report that the accounts
give a true and fair view, or do not give a true and fair view. Auditors report on how the Directors have used
the funds invested by shareholders and the auditors’ duty is to the shareholders. Auditors will have audited
the reported profit and this may give tax authorities more confidence that the tax computation is correct.
Professional supervisory bodies exist to give guidelines to auditors, e.g. Auditing Practices Board. Auditors
should be professionally qualified, e.g. Chartered Accountants.
Case against importance of Auditors’ Report
Auditors may not be very independent, going along with the wishes of their clients, in order to keep their
custom. Clients may provide auditors with lucrative non-audit work so auditors will not want to upset
clients by disputing their accounts. Auditors could be misled by the directors and provide an inaccurate
report. Auditors do not guarantee that material fraud has not occurred which means a reduction in the
confidence of an Auditors’ Report. Cases of fraud have been overlooked by a positive Auditors’ Report.
Companies have gone into liquidation soon after being given a positive Auditors’ Report.
Conclusion
The Auditors’ Report can usually be relied on as a confirmation of the financial statements and the financial
position of the company. However, this is not the case in 100% of Reports.

21. Explain how continuing activities and discontinued activities would be disclosed in the Annual Report
available to shareholders, and why it is important to disclose the activities in this way.
Continuing Activities and Discontinued Activities should be shown separately in the financial statements.
This is required by FRS3 / IFRS 5. This will benefit users of accounts because they can see that profits or losses
from the Discontinued Activities will not be expected to be realised in the future. This allows readers to
predict more accurately future expected performance of the company from Continuing Activities. This may
help future potential investors/shareholders/creditors etc. with decision making. E.g. buy more shares/allow
credit.
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 22. Evaluate whether you think it is beneficial to show Net Current Assets (Liabilities) on the Statement of
Financial Position for a company.
FOR: Allows the user to see clearly/easily which is largest of current assets and current liabilities. This enables
the user to judge the net amount of liquid assets If Net Current Liabilities, then clearly the entity has a liquidity
problem. And allows them to take action Helps potential investors to make a decision whether to invest.
Helps suppliers make a decision concerning possible credit to be given.
AGAINST: Net Current Assets only shows an amount in a monetary value. This does not show if this amount
is sufficient. The amount required would be affected by the entity’s size and industry. More useful measures
of liquidity are the Current Ratio and Acid (Quick) Ratio. These could be calculated using either of the two
formats. It may be better to show all the monies put into the entity on the same side of the Statement of
Financial Position / Statement of Financial position i.e. Total Equity and Liabilities.

23. Evaluate the usefulness of accounting recognising exceptional item (eg: discontinued activity) in the
published account. Benefits: This will benefit users of accounts because they can see that the expense of the
exceptional item will not be expected to repeat regularly in the future. Although in the normal line of business
the exceptional item should be disclosed because of its size. This allows reader to predict more accurately
future expected performances. This may help future potential investors; shareholders, creditors etc. with
decision making.
Disadvantages: Adds more figures and details to the accounts so makes them more difficult to understand.
Extra cost in spending extra time and preparing account.
Conclusion: it is beneficial for disclosing exceptional item

24. Evaluate the importance of directors’ report

Case For Directors’ Report
• Report gives information to e.g. shareholders which they could use to make a decision e.g. invest more
funds in the company. Shareholders / readers may be assured the company is acting in an ethical
manner. Other stakeholders e.g. pressure group may use information in the Report to bring about
change in company policy e.g. treatment of disabled. Disclosures may be required under Stock
Exchange regulations, which may be appropriate in the Directors’ Report e.g. legislation pending. The
Director’s Report could be considered part of the corporate governance.
• Information is given to shareholders which allows them to see in some detail how the company is
performing  E.g.company performance/principal activities, review of the position of the business
 Post balance sheet events, future developments  Names of directors, interests of directors 
Employee involvement, disabled employees policy
 Political and charitable donations  Creditor payment policy, creditor payment days
Case Against Directors’ Report
• Report costs personnel time to prepare and money to print etc.
• Directors may use Report to “window dress” the accounts, ie give an inaccurate/unrealistic positive view
of the company,as it is in their interest to do so. There is a time delay before the Directors Report is
published so events may have changed.
Conclusion : Should relate to above points. E.g. Directors’ Report is useful.

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25. Evaluate the importance of sending a copy of the financial statements of a public limited company to
shareholders at the end of the financial year.
FOR Usefulness/ Importance
Legally the shareholders must receive a copy/or have copy made available of the accounts and they can see
how the funds they have invested are being used/ how company is performing . Shareholders may be
happy (or unhappy) with the performance of the company and may decide to buy more (sell) shares.
Accounts are prepared in standard format which allows shareholders to compare the accounts of one
company with another. E.g for investment potential.
AGAINST Usefulness/Importance
Preparing the accounts is time consuming, and time means money. Expenses associated with preparation
and sending eg printing costs and postage. However shareholders could be sent an abridged (smaller)
version of the accounts which are much cheaper.
Some figures are estimates e.g. Depreciation
Some shareholders will not understand the accounts as they have little accounting knowledge .
The accounts may not be totally reliable e.g. due to ‘window dressing’, fraud etc
CONCLUSION Should relate to points made above.
Eg It is important they receive a copy of the accounts.

26. Evaluate the role of the auditor in the corporate governance of a public limited company.
Case for role of auditors
Companies must “comply or explain”. They may be able to justify an alternative approach to corporate
governance in writing. Auditors may have a department or number of staff specialising in corporate
governance. Auditors could advise or prepare the “alternative approach”.
Corporate governance has 5 key areas:
Section A: Leadership – lead by an effective board, who are responsible for success of company, clear
division of responsibilities, with non-executive directors who should challenge. The Chairman is responsible
for the Board. No individual should be able to make all the decisions. An auditor could note in the Audit
Report, or enquire about division of responsibilities. For example, is the Chief Executive Officer also the
Chairman?
Section B: Effectiveness – board should have an appropriate balance of skills, experience, independence,
and knowledge to carry out duties effectively. Appointment to the board should be formal, rigorous and
transparent. There should be induction, self-evaluation, and re-election. An auditor could note in the Audit
Report (or ask) to check that re-election of board members at regular intervals does take place.
Section C: Accountability The board should present a balanced and understandable assessment of the
company’s position and prospects. The board is responsible for risk and internal controls, and should have
sound risk management. The board should maintain an appropriate relationship with the company’s
auditor. An auditor could note in the Audit Report (or ask about): In our opinion, insufficient checks were
made when taking over another company. Risk management was not sound.
Section D: Remuneration Levels of remuneration should attract, retain and motivate directors of the
required quality. However, a company should avoid paying more than is necessary. Director’s remuneration
should be partly linked to individual and corporate performance. No director should be involved in
deciding their own remuneration. An auditor could note in the Audit Report (or ask): One director sits on
the Remuneration Committee and was involved in setting their own remuneration.
Section E: Relations with shareholders The board is responsible for ensuring a satisfactory dialogue with
shareholders takes place, based on mutual understanding of objectives. Investors should be encouraged to
participate at the AGM. An auditor could note in the Audit Report (or ask) about sufficient notice being
given concerning the date of the AGM.

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 Case against the role of auditors
Auditors providing services in relation to corporate governance are likely to be expensive. It is possible they
may not provide value for money.
It may be that a company will benefit from outside corporate governance specialists, as auditors may be
reluctant to challenge a company too strongly for fear of losing audit and other work.
Conclusion:
It is hoped that auditors who provide specialist advice in the area of corporate governance provide a
beneficial service.

TOPIC: RATIO ANALYSIS/ INVESTMENT RATIO

27. At a Board meeting, the Chief Executive stated, “Last year, the dividend per share was 2.5 pence per
share. It is important that the dividend per share increases every year”. Evaluate the statement made
by the Chief Executive.
Agree with statement
Ideally directors would like to reward the shareholders with an ever-increasing dividend per share each year.
This would keep shareholders happy. This would probably keep directors in their posts, including when they
come up for re-election by shareholders.
This may also signify that the company is continually performing increasingly well.
Against the statement
Directors should only pay what they feel is the appropriate amount in dividends. This may be less than they
paid in the previous year. This may be because profits are down in a year, and directors wish to be cautious.
It may be that if dividends are to increase in a year, they are greater than the amount in revenue reserves.
Or, it may be that dividends are getting too large, and the shareholders returns are starting to be unrealistically
high, given the financial position of the company.
Or, it may be that the directors wish to keep some funds in reserve in case of a future downturn, or for an
investment opportunity, or to replace non-current assets etc.
Decision : The statement is unrealistic.

28. “There is only one ratio that is important and worth knowing about, and that is the dividend per share”.
Evaluate the statement
For the statement: Investors are usually interested only in the return on their investment, which is shown
in the dividend per share, which is used to calculate how
much the investor receives. Investors are more concerned with what they actually receive, than how easily
the company can afford to pay the dividend, as shown by the dividend cover.
Against the statement: Investors also have a capital gain when the share price rises, which is partly shown
in the Price/Earnings ratio. Dividend yield shows the return for every pound invested, which is more
important than dividend per share. Earnings per share is an important ratio, as it shows how much profit is
being generated for each share invested. These profits are then used to pay dividends. Other ratios
concerning profitability and liquidity etc. are important, as they show how well the firm is doing.
Conclusion: Dividend per share is not the only important ratio worth knowing about.

29. “A higher share price means shares are better”. Evaluate

A higher share price does not mean a “better” share. The nominal or face value of the share needs to be
considered. Also the total number of shares in the company. Also important is the movement in the value of
the share – is it moving up or down? Very important is the demand and/or future/confidence of the market
in the share – if he/she buys shares now, will he make a profit or a loss on the share. Many factors both inside
the company and outside the company can affect the price of a share.

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30. Evaluate the ways to increase a companys earnings per share
Ways to increase earnings per ordinary share:
Increase net profit.
Numerous ways to do this, under the general headings of increasing revenue and/or decreasing costs. For
example, Bogra could run a marketing campaign to increase revenue and negotiating a discount on purchases
could decrease costs.
This method would be approved by Bogra shareholders and the stock market and is probably the best
method.

Reduce interest payments

Bogra could reduce borrowings, by paying off loans etc. However the company would need to ensure they
have enough liquid funds for this.
This method would be approved by shareholders and the stock market and is a good method.

Reduce taxation
Accountants or the finance department of Bogra could find ways of reducing the tax bill of the company. For
example they could move the company base to a low-tax location. This would not be popular with the public
of the country the company is based in now.

Reduce number of ordinary shares issued.

Bogra could redeem some ordinary shares. However, the company would need to ensure they have the liquid
funds to do this and not drain liquid resources. Those shareholders who have to sell the shares may not like
this approach. It may also make Bogra look a smaller company. It would also increase the gearing ratio.

Decision
Increasing net profits is probably the best way to increase earnings per share.

31. At the Board Meeting, the Chief Executive said, ‘The dividend yield is an important ratio and helps
judge the success of the company’.
Evaluate the importance of the dividend yield ratio in judging the success
Dividend yield is a reflection of the success of the company
Dividend yield is a reflection when judging the success of the company because dividends paid will be higher
when profits are healthy. The company could increase the ratio by increasing the dividends.
Dividend yield is not a reflection of the success of the company
The board of the company could make a decision to increase the dividends paid out to shareholders. This
would make shareholders happy. However, this does not necessarily indicate a successful company but may
just be an indication of the dividends policy of the directors. Dividends yield may be high because the
directors are paying out all of the profits as dividends.
Dividend yield may be high because the share price is low. The low share price may be due to external factors
e.g. government regulations or internal factors e.g. company weaknesses.
Return on capital employed is a better reflection of the performance of the company.
Conclusion
Dividend yield probably is a reflection of the success of the company.
(Candidates may conclude dividend yield is/is not a reflection of the success of the company but must be
supported by an appropriate rationale)

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32. Evaluate the relative importance of liquidity and profitability to a business
Profit most important: Without profit, business would close down in the long. No/low profits may result in
firm unable to attract finance or investors/shareholders. No/Low profits may see share price fall, as investors
lose confidence. If short term liquidity problem, many sources are available as source of finance banks,
shareholders, debt factoring etc.
Liquidity Most important: Liquidity problems result in unable to pay daily bills eg: wages, electricity unable
to pay some bills may result in closure of business eg: tax bill. Unable to pay some bills may mean business
may face discontinuing of services available e.g. electricity cut off. Can survive short term losses if previous
profits have been built up. Firms could have profits in books but lack of
liquidity could force firm to cease trading
Conclusion e.g. It is profit that determines the long-term survival of a business/ Profit more important.

33. At a recently held Annual General Meeting, a shareholder made the following comment. “If we can
increase the return on capital employed ratio, we will be able to attract more shareholders”. Evaluate
the statement made by the shareholder.
For the statement
The return on capital employed (RoCE) is an important ratio for investors and potential investors. The ratio
shows the return before interest and tax on every pound invested in the business.
The higher the RoCE the better the returns for every pound invested in the company. This would make the
company look more attractive to investors.
Investment funds etc will study the ratios before investing in a company and they would like to see RoCE as
high as possible.
Against the statement
There are other ratios which are very important to potential investors as well eg earnings per ordinary share,
price/earnings ratio, dividend per share. These other ratios will also be studied and analysed by potential
investors.
Some investors may not study the ratios, but may make an investment decision based on economic
circumstances. For example the external factors that may affect the holiday industry such as exchange rates,
the trade cycle, or pandemics.
Conclusion
Candidate may conclude that the return on capital employed ratio may or may not attract more shareholders
but must support their answer with valid reasons.

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34. A member of staff comments ‘I think that the dividend cover is the most important ratio of all the
investment ratios’. Evaluate the statement made by the member of staff.

Dividend cover is the most important ratio

Investment ratios are ratios that are of importance to those investing in the company. They show investors
the return they may receive on their investment. They also indicate how well the company is performing.
Dividend cover tells an investor how many times the dividends paid for the year can be covered by the
profit for the year after interest and tax. This is important to investors who can see if they are getting a fair
return on their investment.
If potential investors see that the dividend cover ratio is low, this may encourage potential investors to
invest in the company as they will be expecting good revenue returns.
If potential investors see that the dividend cover ratio is high, this may encourage potential investors to
invest in the company as they will be expecting good capital growth.

Dividend cover is not the most important ratio

There are more important investment ratios than dividend cover. For example, return on capital employed
shows the profits generated before interest and tax as a percentage of capital employed. This shows the
return on every pound invested in the company.
Similarly, the earnings per ordinary share show a return on the sum invested by shareholders of the
company.
Also important is the price/earnings per share ratio. This shows the relationship between the market price
of the share and the earnings per share. This gives an indication of the confidence of the share/stock market
in the company.
The dividend cover ratio is specific for the current year. If this ratio looks particularly high, there may not be
a case to worry about as this year’s dividends could be paid out of previous year’s profits. If this ratio looks
particularly low, it may be that the company is wanting to use cash reserves for future investments, or it
does not have funds to pay a dividend.
Conclusion
Dividend cover is not the most important ratio.
More important ratios are earnings per share and return on capital employed.

35. Evaluate the decision of the directors to reward shareholders by paying a final dividend instead of an
issue of bonus shares.

For paying a final dividend

Shareholders receive cash when the dividend is paid which they can spend how they wish.

If healthy dividends are paid, the market may like this and this may cause the share price of Beddokk
Supermarkets plc to rise.
If bonus shares are issued, there are more shares on the market so the price of the shares may fall.

For issuing bonus shares

Shareholders may be able to look forward to more dividends in the future as they hold more shares.
No funds leave Beddokk Supermarkets plc. The company may have liquidity problems or be short of
cash. If dividends are paid, this will see funds leaving the company.
Conclusion
Some shareholders would prefer to receive cash at the present time when paid a dividend. Some
shareholders would be happy to receive bonus shares now, with larger dividends
in the future.

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TOPIC: MERGER/ TAKEOVER

36. Define the term Goodwill

Goodwill is a sum paid in excess of the fair / agreed value of net assets acquired when purchasing a business

37. Explain two reasons why goodwill might occur

Existing customer base. Supply channels set up. Suitable location. Skilled workers. Reputation of business.
Brand awareness. Loyal staff. Profitable business.

38. Evaluate the possible treatment of purchased goodwill in the books

Goodwill is an intangible non- current asset on the statement of financial position
Correct treatment of goodwill would be to amortize/depreciate/write off over its useful economic life/ over a
lengthy time period e.g. over 20 years.
Cases for:
Likely to derive benefits from the expenditure over a number of years. So spread the cost of this expenditure
over a number of years i.e. matching concept gives a true and fair view of the accounts. To write off
immediately may make profit unrealistically and tax charge would be unfairly low. In line with recommended
practice i.e. FRS 10/IAS 38
against this Treatment: if written off immediately against reserves, the prudence concept is followed.
Conclusion: writing off over a number of years is required and beneficial as it gives a true and fair view of the
accounts.

39. Evaluate merger as a shareholders’ point of view

For Merger: New Company should enjoy benefits of horizontal integration as in same line of business.
Which leads to larger market share which results in increased profits and dividends. New Company could
enjoy economies of scale eg bulk buying. New company should be able to reduce costs eg reduce staff or
close some branches. They probably need a stronger company to take them over to improve position or
guarantee survival.
Reduces risk and reduces competition
Against Merger:
Increased number of shareholders /Dilution of ownership (need one) and voting power. Possible cultural
clash leading to demotivation. Dividends may decrease due to increased number of shareholders.
We do not know what the market price

40. Explain the Factors to be considered when revaluing the following:

Property, plant and equipment: Market value /size/ location of property Condition/depreciation of
plant and equipment.
Motor vehicles : Mileage/age/condition/depreciation of vehicles.
Other inventory : Lowest of cost and net realisable value. Shelf life/condition/market value of inventory.
Number of items.
Trade receivables: Possibility of bad debts. Sales level. Credit policy.
Trade payables: Possibility of discount receivable. Level of purchases/ terms of supplier Availability of cash.
Patent: the number of years remining

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41. Evaluate the appropriateness of revaluing assets and liabilities before a takeover.
AGAINST Revaluations
The larger party may be in a position of strength and abuse this position to revalue assets to their own
advantage ie lower value than true market value. Revaluing assets and liabilities a pointless waste of time
and money because the buyer can agree to pay whatever goodwill they feel is appropriate. Professional
valuers may be required for revaluing and these may charge considerable fees
FOR Revaluations
Even if one party is in a position of strength, the other party does not have to agree to a sale if they do not
like the value put on assets. It is only fair that assets and liabilities are sold for their correct market value, not
some historical book value that may not reflect market value.

42. Evaluate the use of cash to finance the purchase of a company.

For financing using cash
Buyer may be able to afford purchase using cash / be cash rich better to use this cash than to have lying idle.
Memorandum of Association may mean it is not possible to issue more shares, or may need to get approval
from Stock Exchange Council to alter Memorandum and issue more shares. If issue more shares in buying
company instead number of shareholders in buyer rises so dilution of powers of existing shareholders. and
share price falls. and extra dividends may have to be paid in the future. It is quicker/easier/cheaper
Against financing using cash
Use of cash is a drain on liquid resources. May need to take out loan etc. to finance purchase. May not have
enough cash to trade normally and enjoy discounts for early payments etc.
Conclusion Financing purchase of another company using cash is good/ not good idea.

43. Evaluate the use of shares to finance the purchase of a company.

For financing using shares
Does not require any use of cash which would be a drain on liquid resources.
If the market thinks the deal is a good one the value of all shares in buying company will rise, keeping
shareholders happy.
Improves gearing ratio
No need to payback shareholders
No capital repayment required unlike loans
Dividends only need to be paid when profits are healthy unlike interest payments on loans that must take
place
No need to offer collateral

Against financing using shares

If the market thinks the deal is a bad one the value of all shares in buying company will fall, making
shareholders unhappy.
Memorandum of Association may mean it is not possible to issue more shares, or may need to get approval
from Stock Exchange Council to alter Memorandum and issue more shares.
Number of shareholders in buyer rises so dilution of powers of existing shareholders.
More dividends will be paid to a greater number of shareholders which may result in lower dividends per
share
Issuing of shares results in extra costs etc
Conclusion –
Financing purchase of another company is good/ not good idea.

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44. Evaluate whether it is preferable for shareholders to receive shares or cash during a takeover?
Cases for shares:
Larger company must feel that there are benefits from taking over another company. Therefore, there must
be a possibility that the share price will rise in the future. Also the share may pay out regular dividends in the
future.
If inflation is high, the value of cash may soon be reduced to the real terms.
Cases for cash:
Cash may be invested, which may give good returns, or returns that are better than those of shares in the
company taking over.
Cash could be spent straight away to give immediate consumption.
If inflation is not high, cash will holds its value in real terms
Conclusion
The best option will depend upon on a number of factors, such as the performance of the larger company,
the dividend policy, and inflation.

45. Explain why a company would pay for goodwill

Insurance companies have a large number of existing customers whose details will be kept by the company
being taken over/who may not shop around when renewing policy.
The larger company may gain from economies of scale for example marketing economies, only having to
advertise one company, not two.
Managerial expertise being purchased for example senior staff with expertise/experience running a large
company.

46. Evaluate the decision of paying goodwill to purchase a loss making business .
Case FOR paying goodwill:
The company (Selling company) has an existing customer base and brand value
The company has existing links with suppliers and a trained workforce
What was The company may improve in the future/ make future profits
Purchaser may benefit from economies of scale
Purchaser should increase its market share
Purchaser may benefit from trading in a different segment of the computer games market
Good chance that the value of the property will rise in the future , as it has already had to be revalued upwards
once.
The company may have best-selling games in its portfolio and may have patents which will not be shown on
the statement of financial position.
The staff of The company may be skilled, creative etc but this value will not be found on the statement of
financial position.
Case AGAINST paying goodwill:
The company has been making losses recently, buyers should question - “Why?” Is this because they are
inefficient/ badly managed or the games are not very good or the design team are not very creative.
Purchaser may suffer from diseconomies of scale and see profits reduced.
Staff of The company may have outdated skills and may need training.
If professionals are hired calculating goodwill this may be expensive
Conclusion -
Should relate to points made above.

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 TOPIC: STATEMENT OF CASHFLOW
47. Explain the difference between cash budget and cash flow
A statement of cash flow is for the past 12 months and includes mostly exact figures prepared for external
users. A cash budget is for a future period, and involves figures that are mostly estimates prepared for
mainly internal use.

48. Evaluate the usefulness of preparing a Statement of Cash Flows.

Case for usefulness of Statement of Cash Flows “
The statement helps Valetta Motors plc study where the company has generated its cash over the last
financial year and how it is applied. This may help decision-making in the next financial year. The
statement is broken down into three key sectors, net cash flows from operating, investing and financing
activities. The three parts are added together to give an overall figure for an increase or a decrease in cash
for the last financial year. The statement helps to explain why the overall change in the bank balance
might be significantly different (or even contradict) the amount of profit or loss generated. The statement
looks back and uses figures that are nearly all actual figures (except for depreciation and amortisation).
Case against usefulness of Statement of Cash Flows The statement is fairly complicated. It may not be
fully understood by all readers.
It may take time, effort and funding of Valetta Motors plc to produce.
Conclusion
The statement must be produced by Valetta Motors plc and is regarded as a useful tool to inform readers
about liquidity of the company.

49. Evaluate whether a company should sell non-current assets to improve cash flow For statement
The company may be experiencing cash flow problems. Company may be able to find premises to rent
or company may be able to lease back the same building. Property prices may be falling, so now is the
time to sell. Company may not need property of this size to function/surplus asset. Company may be able
to buy another property for a lower price. Can sell the property if no alternative funding is available . Sale
may reduce interest payments on mortgage/loan.
Against statement
It is taking a short term view. Property prices may be rising, so good business would be to hold onto the
asset. Years of rental may eventually be greater than the price for which the property was sold. There will
be other costs associated with finding another location eg staff time, legal fees
Alternative funding may be available eg bank loan. Sale may reduce collateral available if requesting to
take out a new loan.

Conclusion
Company may be better not selling off the property to improve cash flow

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50. There are three sections on a Statement of Cash Flows: Operating Activities, Investing Activities and
Financing Activities. Evaluate in which of the three sections it would be most important to have a positive
cash flow, for any company.
Operating Activities
Very important. The business cannot survive in the long term without cash inflows from operations.
Investing Activities
A negative cash flow could mean that the company is investing for the future, eg. in non-current assets, or
more modern technology. A positive cash flow could indicate that the company is selling off non- current
assets, which may be worrying. A positive cash flow could signify that the company is selling off non-core
business, which may be a good strategy.
Financing Activities
A positive cash flow would be expected during the first year of trading, as the company attracts finance in
order to commence trading. A positive cash flow would be good if the company needs to attract funds in
order to expand. A positive cash flow would be bad if the company needs to attract funds in order to
survive/ meet debts etc. A negative cash flow would be good if the company is paying back debt. A
negative cash flow would be good if it were paying high levels of dividends because they are making high
profits.
Conclusion
Operating activities is probably the most important, as they cannot survive without making cash inflows
from operations.

TOPIC: BUDGETING
51. Evaluate the most appropriate order in which budget should be prepared, giving reasons
Sales first as this is key budget that determines all the other budgets. Then the stock budget at a level
determined by the management. Then production in order to meet sales and required stock level. Then
cash as required to meet production demands as generated by sales.

52. Evaluate the decision to produce a quantity determined by the maximum capacity of the factory instead of
producing a quantity determined by customers’ orders.
For Decision
• Makes full use of factory ie capacity utilisation is 100%, no wastage • Sales may be more. Able to
meet this demand from production or stock. • In the event of production breakdown customers
orders can be met this will maintain customer loyalty. • (output kept in stock do not deteriorate /
perish so money is not lost).
Against Decision
• Stock is building up continually, and this involves a number of costs for example rent insurance and
ties up working capital. • Eventually will run out of storage space, so must find alternative premises or
reduce production. • It is possible that goods could deteriorate in stock for example due to dampness.
(The goods might be perishable.)
• Possible that tastes change and firm left with stock that they cannot sell.
•
53. Explain flexible budget
A flexible budget is a budget that can be changed during the accounting period if output changes. For
example, if the budget was set up on the basis that 1000 units would be made and production turns out to
be 2000, all variable costs would be changed in proportion

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54. Evaluate budgets as a management tool for control.
FOR - Budgets as a management tool for forecasting, planning and control.
Preparing a budget ensures management focus on future possibilities and likely outcomes.
Eg Jolly Pyeman plc may focus on level of sales and expected sales revenues.
Some budgets are under the direct control of management. This will mean that management can
accurately forecast the likely figures. For example, Jolly Pyeman plc has decided the level of inventory is to
be equal to the sales level of the following week. The company will have to plan to ensure it has sufficient
capacity for this level of inventory.
Some costs are under management control, for example rate paid to direct labour.
Budgets allow a business to see how a level of costs impacts on profit, for example direct labour.
This may result in management deciding on an appropriate level of pay rise.
Variances can be analysed and remedial action taken. For example, Jolly Pyeman plc may not be happy
with the forecast level of sales. This may result in a marketing campaign to boost sales.
Budgets may act as a yardstick against which performance may be measured. This helps senior
management in control of other staff of the company. For example, the Production Department has to
meet a production target of 620 000 (o/f) pies in the month of July.
Budgets ensure that different departments are co-ordinated, integrated and controlled. For example the
purchasing, production, and logistics department of Jolly Pyeman plc must be co-ordinated to ensure the
smooth running of the company.
Against
Forecasting may not be accurate. For example, sales for Jolly Pyeman plc are seasonal, affected by the
weather. If the autumn months are mild or warm, sales may not reach the expected levels.
Forecasts may be unrealistic. For example, production targets for staff may be set too high, which will
demotivate staff.
Some costs are out of management control. For example, Jolly Pyeman plc may not be able to control the
wholesale price of meat, or flour. This means that management can only make an informed guess when
preparing figures.
Some figures or costs may not change each year. Therefore drawing up budgets is a waste of time and
money and does not help planning or control. For example, the production figures for Jolly Pyeman plc
may stay the same each year.
Conclusion : Budgets are a useful management tool for forecasting, planning and control.

55. Evaluate the importance of cash budget before starting the business
FOR: Business owners will need to show potential investors eg family and friends, banks business will be
successful and is able to give a return/pay back. The Cash Budget will show if the sales receipts will be
sufficient to cover all outgoings, and when shortages may occur. The budget may allow business managers
to see when alternative arrangements eg overdraft may be required. Also for how long, and how much.
The budget may show where a cash surplus may be present, so allows the firm time to plan what to do
with the surplus eg invest in shares, currencies etc. Budget can act as a method of control. Budget can give
variances which can be analysed and action taken
AGAINST: The budget takes time and money and expertise to draw up. The figures are only predictions and
may be inaccurate or misleading. Eg inaccurate sales figures may be caused by change in demand from
supermarkets Budget maybe inaccurate and may demotivate workers not meeting targets
Cash Budgets are useful.

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56. Evaluate the usefulness of flexible budgets
For flexible budgets: Allows good decision making as “like compared to like” eg similar output levels. May
save time and money by allowing “Management by exception” i.e. action only if a variance. Allow choice
of optimum output eg 2000 units. Meeting the targets leads to motivation of workforce.
Against flexible budgets: Labour time which means money in preparation. Figures are only estimates so
some variances may be misleading/action inappropriate.
Conclusion: flexible budgets are a very useful tool

57. Evaluate the usefulness of budgeting for a new business:

Usefulness of budgets for a new business:
Budgets will focus the attention of the owners onto important areas e.g. cash flow, purchases, production,
sales etc. The budget shows the business the likely outcome/future situation. The owners can plan their
strategy around what the budget may show. The owners can use budgets as a tool of control over the
business. This may allow the business to make changes to their plans if budget figures do not look good.
For example, reduce budgeted expenditure or boost planned sales by an advertising campaign. Or, it may
result in approaching the bank for a loan. Budgets may act as a motivating tool for staff, who must achieve
targets
e.g. sales Once business has started variance analysis, comparing actual figures to the budget, may allow
the business to take corrective action. Budgets help communicate ideas and plans to all members of staff.
This will also help co-ordinate the activities of different departments e.g. purchasing may operate
according to the requirements of production. A framework for responsibility may be created, whereby
managers of budget centres are responsible for achieving budgeted targets. A request for a bank loan or
overdraft is almost certain to be followed up by a demand for budgets by the bank.
Against usefulness of budgets :
Budget figures can only be estimates/guesses as they are for a future period Unexpected events or changes
may happen in the future that were not planned for in the budget. This may make the budget less relevant.
The cost of accountants or the time and cost of accounting staff to prepare the budgets and carry out
variance analysis may outweigh the benefits or savings made by the budget. Unrealistic budget figures are
demotivating for staff, who can never achieve them. Conclusion Budgets are a useful for a new business as
they help in planning and achieving targeted goals.

58. Evaluate the decision of Rejecting finished goods.

Advantages of Rejecting finished goods
By rejecting damaged goods/ goods not perfect, the company are assured that goods in the stores are
of merchantable/ good quality. This will ensure the brand name is not damaged /has a good reputation.
This is particularly important in the fragrance market, where a quality brand name can command a
premium price.
High levels of rejections would mean the inspection process is rigorous /doing its job.
Disadvantages of Rejecting finished goods
Rejected finished goods means resources have been wasted. These would be materials and/or labour.
It also means capital/finance is wasted.
The company should investigate the possible cause of this rejection e.g. poor quality of materials, or
unskilled or untrained labour, faulty machinery etc (need one possibility for maximum of one tick)
Conclusion –
Company should be concerned about the rejection of finished goods as resources are wasted

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59. At the end of Month 1, actual sales of have only been half (50%) of budgeted. Evaluate whether they
should draw up a new set of budgets to replace the existing budgets for next month.
For Decision to draw up new budgets.
Existing budgets are not likely to be accurate so there is little point in sticking with them. Good
budgeting should be flexible, so changes should be made to this ongoing process with regular reviews
taking place. A new business should not draw up a three month budget, as it is likely to be unsure of the
predicted figures, not having any past figures to rely on. A new budget would help planning / changes
eg reduce the purchases for each month. New budgets may have targets staff can reach which will
increase motivation.
Against Decision to draw up new budgets
Will take time and money to draw up new budgets. Variance analysis could be carried out and actions
taken to meet original budgeted figures. The new budget will only be estimates anyway, so may not be
accurate. The only budget directly affected by a lower sales level is trade receivables so there maybe a
need just to draw up trade receivables. This is a new business, and sales may pick up to meet month 2
an3 figures in the original budget, making it accurate.

60. Evaluate, from the point of view the selling company, each of the three payment options, and
recommend the most appropriate option.
Option 1: full cash payments at the day of sales
Advantages :
• Brings in a large amount of cash on the day of the sale. • No need to wait for any payment.
Disadvantages
• May not be helpful in generating sales volume, as many customers cannot afford to pay huge
amount on one day • The total amount of cash from a sale is less than option 3.
Option 2: pay a small amount at the day of purchase and pay the full payment after 1 year.
Advantages
• May be helpful in generating sales volume, as many customers can afford to pay a small amount on
the day of purchase.
Disadvantages
• Does not bring in a large amount of cash on the day of the sale. Company has to wait more than a
year for nearly all of the payment. . No interest is charged. • It is possible that some of the debts will
turn bad before payment is made. and the amount owing may not be fully recovered.
• The total amount of cash from a sale is less than option 3.
Option 3: 10% deposit on the day of sales and monthly payment after one month of sales
Advantages
• May be helpful in generating sales volume, as many customers can afford the deposit of 10% of the
total payment. • Brings in some cash on the day of the sale. • The total amount received from each
customer is the most using this option is more than the other two options.
Disadvantages
• Does not bring in a large amount of cash on the day of the sale. • Company has to wait for payment
over 36 months.
Conclusion
Option 3 brings in the most cash per sale, although company must wait 3 years to collect all of it.
It may be argued that option 1 is the best, as company receive cash on the day of the sale and as % of
customers selecting option 1 is higher than the other 2 options.
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 TOPIC: STANDARD COSTING/ VARIANCE ANALYSIS

61. Explain the stages in establishing a standard cost for a unit of production.
For product, obtain a product specification giving standard quantities for materials and labour Look at
figures for past cost of sales . Standard prices for materials obtained by consulting buyers and suppliers.
Standard labour rates obtained by consulting human resources department and/or unions. Standard
overheads obtained by consulting management / finance department. Standard cost calculated may be
regarded as provisional and may be tested to see if realistic. Standard cost may be revalued if appropriate.

62. Evaluate the effectiveness of management by exception

Management by exception means take action only if the variance is adverse. FOR the use of Management by
Exception: Management by exception sees management only investigating differences against present
tolerances Saves management time as no need to take any action if no variance /unless adverse variance.
Costs may well be reduced if variances are adverse AGAINST the use of Management by Exception: It is
possible that costs could be reduced eg find a cheaper supplier, Standards set could be poor

63. Evaluate the likely effects of a standard costing system on the production workers
POSITIVE EFFECTS: Helps to establish production targets that may be comfortable for workers to achieve
(Eg numerical example) May be basis of possible bonus for production targets met etc. which may see
workers taking home more pay. Anything that benefits the firm will benefit the workers eg for job security,
pay, bonuses, competitive pricing of products etc. Meeting production targets will motivate workers.
NEGATIVE EFFECTS: Helps to establish production targets that may be difficult for workers to achieve (Eg
numerical example). May be basis of possible bonus for production targets met etc. which may see workers
missing targets and taking homeless. Missing production targets will demotivate workers. Workers may
have to work overtime at a higher rate to meet targets. Output may be poor quality in order to meet
targets so need supervisors/ inspectors

64. Evaluate the usefulness of a Standard costing system

For usefulness: Allow performance to be compared with predetermined standards. Variance can be
analysed and action can be taken to control costs. Helps eliminate waste, idle time, inefficiency etc. allows
management by exception, which sees action taken only for larger variances. Helps to estimate
production costs and therefore helps when giving a quotation. Allows target for workers to be set which
may motivate workers when targets are achieved.
Against usefulness: take expertise and time/ money to prepare. Inaccurate standards set may be
misleading and unhelpful. Some variances may be outside the control of the business and time may be
wasted investigating them. Allows target workers to be set which can demotivate if not achieved.
Conclusion: Standard costing is useful.

65. Suggest and explain 2 ways to reduce the labour cost variances Reduce the rate paid. Perhaps by
negotiating with trade unions or by employing low grade workers this could be difficult for the workers to
accept as they would be demotivated and output may fall. And strikes etc. could take place. Ensure workers
work faster eg by training or having reliable machinery etc. workers must work faster (i.e. increase efficiency)
eg by training or improving motivation or having reliable machinery etc. Improve quality of materials which
may result in less wastage and reworking.

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66. Evaluate the usefulness of Variance analysis
For: Allows firm to see likely outcome/future situation. Allows firm to make changes to plans if budget
figures do not look good Examples of above eg reduce planned expenditure or boost planned sales by
advertising Comparing Variance analysis allows firms to take corrective action once business started.
Against: Figures are only estimates/guesses. Unexpected events or changes may happen in the future.
Time and cost of accounting staff to prepare budget/variance analysis etc.
Conclusion it is a useful tool

67. Briefly explain why a fixed overhead figure may change. Give three examples of fixed overheads that
may rise, and explain briefly why they may increase.
Fixed costs do not change with output, but they do change over time. Eg: Rent may be increased each
year/when lease is renewed. Salaries may rise during annual pay review/ in line with inflation.
Depreciation may rise if more non-current assets are purchased in year.

68. “If there is an adverse variance, this must be bad for the business.” Evaluate this statement.
For statement: If this is a cost variance then expenditure has been more than expected. If budget is
realistic, this is bad and may be caused by : Workers not working as hard as they could , Workers being
paid more than a market rate wage, Inefficient machinery, Materials being wasted, Paying more than the
market rate for materials. If this is a sales variance, then revenue is less than expected This could be
caused by: Sales volume being less than expected, Sales price being less than expected
Against statement: Budget set may be unrealistic and actually the business has performed well. There may
be a positive aspect to the adverse variance eg: Material prices have risen on the world market, but our
buyers are still getting a comparatively good price. Adverse variances may be due to production being
greater than expected which is good for the business
Conclusion: Statement is (correct)/not correct

69. Explain why an adverse variance for material would occur. Explain how Material cost variance could
be reduced.
Material usage variance: Could be caused by poor quality materials resulting in a lot of wastage. Action
to solve the problem could be to change supplier or insist on a certain level of quality. Perhaps insert
penalty clauses into supplier’s contracts for quality. Or wastage caused by poor quality labour. So train
labour better, hire better quality labour, or raise wage rates to attract better quality labour or improve
quality control.
Material Price variance: Could be caused by suppliers charging a high price. Action could be Purchasing
department must negotiate a lower price. Or change to supplier with lower price. , buy lower quality
materials, achieve discount by bulk buying, or prompt payment.

70. Evaluate the decision not to charge the extra production costs to the customers.
AGAINST Passing on the increase in production cost: Could absorb rising costs by increasing efficiency.
Customer could be unhappy and not buy and go to a rival supplier. New price could make firm’s price
higher than rivals.
FOR Passing on the increase in production cost : Need to maintain profit margin, this (or mark-up) could
be fixed otherwise business makes losses / goes bankrupt. Cannot keep same selling price for ever will
have to increase price some day Customers may be quite willing to pay the higher price if they still think
they get good value New price may still be below that of rival firms.
CONCLUSION: (Should relate to above eg passing on increased costs is wrong/right)
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 TOPIC: CAPITAL BUDGETING/ INVESTMENT APPRAISAL

71. Explain the following accounting terms:

(i) payback period: the payback period is the length of time taken to recover the initial cost of an
investment.
(ii) accounting (average) rate of return: the accounting (average) rate of return is the profit as a
percentage of the cost of the investment over the life of the investment
(iii) internal rate of return.
( the internal rate of return shows the true return of the investment expressed as a percentage OR
the cost of capital when the net present value is equal to zero

72. Evaluate Payback as methods of appraising an investment.

Payback method –
this method measures the period of time it takes the cash flows of a project to repay the cost of
the investment.
Advantages:
Simple to use and easy to understand the results. Can be used to compare different projects with
different initial costs.
Disadvantages:
Does not take account of the falling value of money over time. May not be suitable for projects that
have uneven cash flows e.g. a project may payback quickly and look attractive, but have little cash
inflows after payback.

73. Evaluate the Internal Rate of Return as a project appraisal method.

Case for IRR: An accurate return can be calculated. Takes account of falling value of money over
time. Can be compared to target value of business to decide whether to invest in project. Can be
calculated fairly easily by computer.
Case against IRR: Calculation of IRR involves use of complicated formula requiring Numerical skill
or calculation may involve much “trial and error” to arrive at the IRR. May need a computer and
computing skills to calculate IRR.
Conclusion: IRR is a good / not a good method of project appraisal.

74. Explain how the profitability index can be useful when evaluating projects.
The profitability index (PI) shows whether a project is worth investing in or not. If the PI is greater
than zero, the project is worth investing in. The PI also allows projects of different initial costs to
be compared. The higher the PI, the better the financial return for the company.

TOPIC: BREAKEVEN ANALYSIS

75. Differentiate between semi-variable cost and variable cost giving examples
Semi Variable costs are expenses that may vary with output, but not directly. AND/OR are
costs that have a fixed element and a variable element and could include: telephone, electricity,
gas, water.
Variable costs are expenses that change directly with output. Examples are direct wages,
direct materials, royalties, sales commission, and fuel

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76. Differentiate between semi-fixed cost and fixed cost.
Fixed costs are cost that does not vary with the level of output. They remain costant regardless
of the output. Examples: Rent, Loan interest, Salaries.
Semi-Fixed costs are cost that remain constant up to a certain level of output, increase when
reached to the level, and again remain constant for a certain levels.

77. Explain the term angle of incidence. What possible relationship exists between fixed and
variable costs where the angle of incidence is narrow?
The angle of incidence equals the angle between the revenue line and the total cost line. Where
the angle is narrow, the revenue line emanates from the zero intersection and the total cost line
emanates from a low cost (fixed cost) at zero activity. Therefore, the relationship will be of
relatively low fixed cost and high variable cost per unit. The narrow angle may also conclude
that profit margins are low

78. Is contribution same as margin of safety? Explain your answer?

Profit is equal to total sales revenue less total costs. Margin of safety is equal to actual sales
revenue less sales revenue required to break even. OR actual output / sales units less output /
sales to break even. Therefore, the two are not the same.

79. Explain the margin of Safety.

It is the excess of actual or budgeted sales over the breakeven sales. The margin of safety shows
the extent to which sales may fall before the firm suffers a loss.

80. Is contribution same as profit?

Contribution is the amount available for covering up the fixed cost. Contribution can be
found using the formulas:
Contribution per unit = selling price per unit - variable costs per unit
OR Total contribution = Sales Revenue - Variable Costs It is a contribution toward paying off
fixed costs. Profit can be found using the following formula: Sales Revenue - Total Costs or Profit
= Total Contribution - Fixed Costs. To calculate profit, you must take account of fixed costs.
Hence Profit is not the same as contribution

81. Explain the Advantages of break-even analysis.

The analysis could be used for decision-making . For example, if a project does not appear to
break- even, the business should not proceed with the project. Break-even analysis is suitable
for computer modelling . By changing variables on a spreadsheet, the business could see the
effect on break-even point and levels of profit / or graphical representations can be produced
easily, which are easier to interpret than columns of figures

82. Explain the Disadvantages of break-even analysis.

The analysis assumes that total fixed costs remain the same for all output levels . This is
unrealistic, as there are likely to be stepped fixed costs, meaning total fixed costs will rise as
output rises.
Break-even analysis assumes that the variable costs per unit remain the same for all levels of
output. This is not likely to happen because, for example, discounts will be received as the
purchase of raw materials increases. It is assumed that sales revenue is a straight line, as the
selling price per item does not change. This may be unrealistic, as discounts may be allowed
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 for sales in bulk.
The analysis assumes all output is sold, which may not always happen. This would affect the
sales revenue figure/line on the graph and the level of profit achieved.
83. Evaluate the effectiveness of breakeven analysis as an aid to business decision
making FOR effectiveness
Breakeven analysis is a tool that allows a business to forecast profit/loss at different output
levels. It helps a business break down costs into fixed or variable. It helps identify margin of
safety and the angle of incidence
AGAINST effectiveness
Cost and revenue figures are only predictions and cannot be assumed as 100% accurate. Eg
in practice, straight lines on graphs are likely to be curves as discounts are given or received
for bulk sales or overtime worked at a higher rate. The breakeven Theory assumes that all
output is sold which is not true. Costs and sales figures are affected by outside influences eg
inflation, boom or recession, seasonal factors, fashions, life styles etc.

84. “it is easier to control fixed costs than variable cost” evaluate this statement.
Case for easier control of FIXED costs : It is possible to decide the length of life of a non-current
asset, thus controlling the depreciation charge per year. It may be possible to negotiate with the
landlord to fix a monthly rent charge. It may be possible to negotiate with the bank over the
interest rate charged on a loan. Fixed costs do not change with output but variable costs do.
Case for easier control of VARIABLE costs.: It is possible to fix direct wages, and someone will
be willing to work for this rate. It may be possible to negotiate with suppliers for the price of raw
materials. Some fixed costs may be impossible to change eg loan interest/repayments, business
rates, depreciation, insurance.

85. Evaluate the change of fixed salary to a

variable rate. If moved to the variable rate
For : Business has profit target and has to take action to achieve these targets. It may not
possible to decrease other costs, especially if fixed eg loan repayment, rent etc. It May not be
possible to increase selling price to increase profit, as it will result in reduced sales . Manager
may be motivated and improve performance / increase output eg train staff better to increase
sales which may result in increased market share also in higher profits for business and higher
pay for the manager.
Against : Manager is concerned only with output so quality may suffer and there may be more
accidents and manager may put workers under more pressure which demotivates. Budgeting
for the managers salary maybe more difficult due to fluctuations in sales and output. A rise in
variable costs may raise the break even point (but remember fixed costs will rise )
If stays on the fixed rate.
For : Managers are professionals and are usually paid a salary and changing to payment by
linking to production may demotivate.
Against : Manager will be de-motivated if forced to take pay cut. This is likely to effect running
of the business in a negative way. They Could try to reduce other costs instead eg shop around
for lower insurance. A reduction in fixed costs may lower the break even point. (but remember
variable costs will rise)

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 TOPIC: MARGINAL COSTING AND ABSORPTION COSTING

86. Evaluate the decision to produce quantity demanded by the maximum capacity of the factory
rather than producing a quantity determined by customers’ order
For: Make full usage of the factory. Utilise 100% of resources. No wastage of costs. Sales may
increase unexpectedly. They would be able to meet up the demand from production or stock.
In case of production breakdown customers order can be met. This will maintain customers’
loyalty.
AGAINST: stock is building up continually and this involves a number of extra costs.
Warehousing, insurance and ties up working capital. Eventually run out of storage space. So
must find alternative premises or reduce production. Possibility of deterioration. Possibility of
out date.

87. Evaluate the decision not to produce all of its product range for a few
weeks. Case For not producing all of the product range
Profits can be maximised, by ranking in order the products with the highest contribution per
unit of limiting factor first.
Profits built up when demand is high, can help cushion the company when demand and
profits are low. It will be possible to build up inventory when demand is low as the
product is not perishable.
Case Against not producing all of the product range
Customers may be annoyed that there is a waiting time for the order. This is especially applicable
for small building/repair jobs which have not planned a schedule in advance. Work may have to
stop on the job, whilst supplies are awaited.
The customer may decide to look elsewhere for supplies. They may not return .
The customer may be looking to buy similar products/ products in the same product range.
Conclusion – Not producing all of the product range may/may not be a good idea.
88. Differentiate between direct costs and Marginal costing
Direct costs are direct materials, direct labour, and other costs directly assignable to a product.
Marginal costing or variable costing is a procedure by which only prime costs plus variable
factory overhead are assignable to a product or inventory; all fixed costs are considered period
costs.

89. Distinguish between period costs and product costs.

Period costs are costs charged against the income of the current period. In Marginal costing, the
fixed factory overhead as well as selling and administrative expenses are treated as period costs.
Expenses that apply to the production of goods are called product costs. Variable
manufacturing costs are typical product costs in Marginal costing and are charged against
income when the units to which they relate are sold.

90. Evaluate the decision to accept an offer by a customer at below the normal sellingprice.
Accept the order only if it gives a positive contribution.
For accepting order
• The order could be accepted on the grounds that the selling price is greater than the
marginal cost of . A positive contribution per item would be made.
• New customer may result in more orders in the future, perhaps at a higher price.

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 For rejecting order
• However in the long term, selling at that price would result in a Net Loss/ not all costs are
covered.
• Existing customers would be unhappy to hear of this low price on offer.
Business reputation may decrease due to biasness among customers.

91. Evaluate which method of stock valuation, marginal costing or absorption costing should be
used Case for Absorption Costing: Sees costs allocated to products. Could be useful for
management when fixing prices or reviewing if a product/project has been profitable in the long
term Recommended by IAS 2. Follows the matching concept i.e. matches costs with revenues earned
for a particular product Case for Marginal Costing: Could be said to help decision making in the
short term when deciding whether to accept an offer price or make or buy or discontinue a
product/profit centre. Sees costs allocated to a time period, so it may be argued that profit for that
time period is more accurate. External accounts are drawn up on the basis of a time period. Follows
the prudence concept as lower figures for profit and closing inventory. Business owners may like
this method as it shows a lower profit so less tax is paid which is probably one of the reasons why
final accounts should not use the method.
Conclusion: Should draw up accounts according to absorption costing method.

92. Evaluate the use of marginal costing in decision making.

For Marginal Costing: Allows seeing whether a contribution is made to paying off fixed costs.
It Can be used in situations when deciding whether to accept an offer or make or buy or to
continue or discontinue production. find the optimal production mix when there is a shortage
of an input. It is Useful for short term decision making. It Complies with the prudence concept.
It Allocates all costs to the time period
Against Marginal Costing
It Does not give the whole picture i.e. overall profit or loss as only considers variable
costs/fixed costs need to be taken into account. It is Not suitable for long term decision
making eg fixing prices, when all costs need to be taken into account.
Conclusion: Marginal costing is useful for short term decision making

93. Explain the Advantages and disadvantages of Absorption costing.

Advantages of absorption costing
• All are costs allocated to products. This could be useful for management when fixingprices.
• If used financial statements would give a true and fair view and be signed off by auditors.
Recommended by IAS 2. This follows the matching concept. Here the revenues of a
product are matched against the costs of the product.
Disadvantage of absorption costing
• All costs are not allocated to the time period in which they are incurred. So it may be
argued that profit for that time period is not accurate as external accounts are drawn up
on the basis of a timeperiod. It Does not follow the prudence concept. The closing
inventory and the profit figures are higher than in marginal costing.
• Absorption costing is not suitable for decision making in the short term. .In the long
term fixed costs need to be covered so absorption costing is suitable for long term
decision making only.

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94. Evaluate Non- financial factors to accept an offer by a customer at below the normal sellingprice.
Non-Financial Factors to Consider:
This could be at a higher price with a greater profit margin. It Enables goods to be sold in a
different market which should raise profile of company. The Contract with supplier may lead to
further business in future perhaps with a keener price or in times of high demand. Selling at the
lower price may upset the existing customers who may demand a lower price or find a different
supplier. (If Goods are purchased instead of producing) Quality of the products supplied may
be better/worse than products produced themselves Workers earn a higher rate if overtime is
paid and this increases motivation.
Case Against considering Non-Financial Factors: Directors’ duty is to the shareholders
who want a return on their investment. Loss making firms will go out of business in the
long term.
(Marginal costing should be used to make these decisions. )

TOPIC: ICT

95. Evaluate how ICT could be used to select the location for the new store and to sell online.
Case for ICT
• Saves time and therefore money, compared to preparing accounts by hand.
• Many accounting packages are available, and these can produce sales invoices, discounts,
aged list of debtors, payroll, cash flow, tax returns and create final accounts etc.
• Electronic Point of Sale ensures a perpetual, up-to-date stock control system for stock levels,
stock valuation, and reordering.
• Some packages are widely used, which allows auditors to be familiar with their use, making
audits more thorough and meaningful. Packages should leave an audit trail.
• Spreadsheets can be used for budgets, job costing, variances etc.
Case against ICT
• Financial cost of hardware, software, staff training, running costs, maintenance etc.
• If staff are not trained, or are unskilled, they can make errors, which the computer may
compound.
• Security risks, especially if the public can access the system to make purchases online. Also
from staff, who may have to be restricted to certain areas. Computer crashes, freezes etc., which
may result in a loss of information. Should conclude that ICT is very advantageous for account

96. Evaluate the use of ICT in break-even analysis.

Case for ICT
• Saves time and therefore money, compared to preparing accounts by hand.
• Spreadsheets can be used for calculations for break-even analysis.
• Spreadsheets can also be used to generate graphical
information. Case against ICT
• Financial cost of hardware, software, staff training, running costs, maintenance etc.
• If staff are not trained or are unskilled, they can make errors, which may lead to
generation of incorrect information.
• Security risks if management or company wish to keep the information confidential.
• Computer crashes, freezes etc which may result in a loss of information and waste of staff
time. Decision :

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97. Evaluate the usefulness to Sunnieside Bakeries plc of information and communication
technology (ICT) in bookkeeping and accounting.
Case for ICT
Saves Sunnieside Bakeries plc time and therefore money, compared to preparing accounts by
hand. The need to have ledgers and books is eliminated, and this saves space as well.
Many bookkeeping/accounting programmes complete the double entry after the first entry is
made. This could reduce errors. They can also produce final financial statements automatically.
Spreadsheets can be used for quick calculations. Also displaying financial and management
accounts in a pre-prepared formats. Flexed budgets could be speedily produced by changing
key variables.
Packages provide an audit trail, so entries can be tracked. This allows auditors to audit the
accounts of Sunnieside Bakeries plc at the year end.
Spreadsheets can also be used to generate graphical information. This may be useful for break-
even analysis.
Packages can complete invoices, purchase orders, requisition notes, delivery notes, etc. The
presentation for Sunnieside Bakeries plc could be a clearer, standard format, which should be
useful.
An Electronic Point of Sale could be used to reduce the need for handling cash, saving time and
money. This could also be linked to inventory giving information regarding levels and re-
ordering etc.
Case Against ICT
High financial cost of hardware, software, staff training, running costs, maintenance etc for
Sunnieside Bakeries plc.
Hardware has a relatively short life, software often needs updating, new staff will need to be
trained, and often outside experts are needed for maintenance issues.
If staff are not trained or are unskilled, they can make errors, which may lead to generation of
incorrect information. These errors will take time and money to discover and correct.
Security risks if management of Sunnieside Bakeries plc wish to keep the information
confidential. Outside hackers could access sensitive information if security controls are weak.
Internal staff could gain access to information they are not meant to view if security controls are
lapsed.
Computer crashes, freezes, power cuts, etc which may result in a loss of information and waste
Sunnieside Bakeries plc staff time. Back-up copies should be kept in case these issues occur
Conclusion
Should conclude that ICT is very advantageous for Sunnieside Bakeries plc.

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