LILIAN LIMITED BALANCE SHEET AS AT 31/12/2008. Financial and Management Accounting April, General Comments

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1 General Comments Financial and Management Accounting April, 2011 The questions, six in all, could be described as popular in view of the fact that all the topics covered were tested in three previous diets. The success rate of 59.6% (114 candidates passing out of 191) is the best performance in recent years. However, the usual deficiencies in the performance of candidates were still visible. These include poor presentation of accounts or financial statements with normal formats ignored. Comments on Question 1 The standard of the question, which falls within the syllabus, can be adjudged above average. Performance was however poor with only 16.3% of the candidates scoring above-average marks. o error was noticed in the question and the answer schematics. Some of the candidates provided answers in journal entries and failed to adhere to the examiner s request for a reconstruction account. Only very few candidates were able to determine correctly the new Ordinary Shares balance after reconstruction. SECTIO A Question 1 LILIA Ltd has been operating unprofitably for many years. The Balance Sheet as at 31st December, 2008 revealed the following: 1 LILIA LIMITED BALACE SHEET AS AT 31/12/2008 Fixed Assets Cost Depreciation BV Goodwill 50,000-50,000 Freehold Land & Building 75,000-75,000 Plant & Machinery 98,500 15,000 83,500 Motor Vehicle 35,000 12,500 22, ,500 27, ,000 Current Assets Stock 75,000 Debtors 68,050 Cash 1, ,100 Current Liabilities Creditor 165,000 Bank Overdrafts 50, ,100 (71,000) 160,000 Financed By: Share Capital Authorised 500,000 Issued 200,000 Ordinary Shares of 1 each fully paid 200, ,000 8% Cumulative Preference Share on 1 each fully paid 2 100, ,000 Less Losses 140, ,000 The following information is provided: a. The dividend on the 8% cumulative preference shares are in arrears for the past five years. b. The Board of Directors has recently been reconstituted and a scheme of reconstruction has been approved by the court which includes the following: i. The Ordinary share capital to be written down to 25 kobo each and then converted into fully paid 1 shares. ii. The preference shareholders have agreed to accept 60,000 ordinary shares of 1 each fully paid at par in place of their preference shares and have waived their rights to the arrears of dividend by agreeing to accept

2 Required: 10,000 ordinary shares of 1 each fully paid at par in full settlement. iii. The property to be revalued at 130,000, the plant and machinery to 60,000, the motor vehicle to 17,500 and stock to 65,000. iv. A provision is to be created in respect of doubtful debts amounting to 6% of debtors. v. The creditors agree to take 10,000 ordinary shares of 1 each fully paid at par in settlement of their claim and to provide 100,000 10% debenture secured by a floating charge. vi. Good will to be written off. a. The Reconstruction Account. b. The Balance Sheet of the reconstructed company. a. Reconstruction Account LILLIA LTD Ordinary Shares issued in place 60,000 Ordinary Share capital 150,000 of Dividend In Lieu of Dividend 10,000 Land & Building 55,000 Plant & Mach Revalued 38,500 Depreciation in P.M w/ off 15,000 Motor Veh. Revaluation 17,500 Depreciation in MV 12,500 Stock Revaluation 10,000 Ordinary Share to 100,000 Creditors Provision for Doubtful Debt 4,083 Goodwill w /off 50,000 Profit & Loss Acct 140,000 Capital Reserve 2, , ,500 3 b. Balance Sheet After Reconstruction Freehold Land & Building 130,000 Plant & Machinery 60,000 Motor Vehicles 17, ,500 Current Assets Stock 65,000 Debtors 68,500 Less Provision 4,083 63,967 Bank 49,900 Cash 1, ,917 Less: Current Liabilities: Creditors 65,000 14,917 22,417 Financed By: Authorised Share Capital 500,000 Issued and Fully Paid (220,000 Ordinary Shares of 1 each) 220,000 Capital Reserve 2, ,417 10% Debentures 100, ,417 Workings Bal b/f ( 50,100) 10% deb 100,000 49,900 Calc of Ord. Shares 200,000 Shares converted at 25 kobo 50,000 Preference Share Replacement 60,000 Dividend Converted 10,000 Issues to Creditors 100, ,000 Comments The popular question on Consolidated Balance Sheet was attempted by 135 candidates and performance was average( 37% pass rate.) 4

3 In view of the frequency of examination of this subject, a better performance was expected. Omitted in the question was the required Balance Sheet date (31st December, 2007). This could lead to ambiguity. The following observations in the answer scripts were made: a. Cheque in transit of 3,000 was improperly treated with many candidates adding this to the consolidated cash balance at the balance sheet date. b. Improper presentation of the Balance Sheet with most of the candidates opting for a T shaped statement. c. Consolidation Schedule normally attracts marks even when not expressly stated by the Examiner. Some of the candidates ignored this and lost marks. Question 2 Captain Ltd purchased 1,450,000 ordinary shares in Major Ltd in 2003 when the General Reserve of Major Ltd stood at 400,000 and there was no balance of unappropriated profit. The Balance Sheets of the two companies as at December 31st, 2007: Captain Major Fixed Assets Building 5,000 1,000 Plant & Machineries 3, Vehicles ,868 1,787 Investments Shares In Major Ltd 1,450-10,318 1,787 Current Assets Stock 1,960 1,425 Due from Major 23 - Debtors 1,462 1,307 5 Cash ,470 2,748 Creditors due within one year Overdraft (1,176) (820) Trade Creditors (887) (1,077) Due to Captain - (20) Tax (540) (218) Dividend (280) - ( 2,883) 587 (2,135) ,905 2,400 Creditors due after 1 year 10% Debenture (4,000) - 15% Debenture - (500) 6,905 1,900 Shareholders Funds Ordinary Shares of 50k each 5,000 1,000 Share Premium General Reserve Unappropriated Profit ,905 1,900 At the Balance Sheet date, the current account of Captain Ltd in Major Ltd was agreed at 23,000 owed by Captain Ltd. However, a 3,000 cheque sent by Captain Ltd on 29/12/07 was not received by the latter until 4th January, Required: Prepare a consolidated Balance Sheet for Captain Ltd and Major Ltd. Captain Limited Consolidated Balance Sheet At 31st December, Fixed Assets Buildings 6,000 Plant 3,939 Vehicles ,655 Goodwill 435 6

4 Current Assets Stock 3,385 Debtors 2,769 Cash 41 6,195 Creditors within one year Overdraft 1,993 Trade Creditors 1,964 Tax 758 Dividend 280 (4,995) 1,200 12,290 Creditors after 1 Year 10% Debentures 4,000 15% Debentures 500 (4,500) 7,790 Financed By: Ordinary Shares of 50k each 5,000 Share Premium 500 Consolidated P & L Consolidated Reserve 1,490 7,267.5 Minority Interest ,790 Consolidated Schedule C in M MI Consolidated Reserve P&L Major Ltd OSC 1, GR P&L ,015 Cost of Acquisition 1,450 Goodwill 435 Captain Reserves 1, , Comments on Question 3 The question on Cash Budgeting was attempted by 154 candidates but only 22.7% of them scored above-average marks. o error was found in the question and the answer schematics. It is evident in the answers provided that most of the candidates are deficient in English as they could not interpret clear transactions for the purpose of computing the Cash Budget. In the second portion which featured mainly the differences between Profitability and Liquidity, most of the candidates demonstrated lack of in-depth knowledge of the terms. Majority included Stability Ratios such as Gearing while listing Liquidity ratios. Question 3 a. Teddytoys Limited is preparing its budget for the quarter starting on 1st July, Stock on hand at the end of June 2010 is expected to be 72,000 and the bank balance was 10,000. In view of pressure on liquid resources, the Directors have decided to reduce the stock level at the end of each month to an amount that is sufficient to cover the next two months. Purchases are paid for at the end of the following month, the amount payable for June 2010 purchases is 36,000. Budget Sales(which provides the gross profit of 33.33% on cost) are: Month July August September Oct ov Dec Budgeted Sales 40,000 42,000 46,000 48,000 52,000 44,000 10% of sales are for cash and of credit sales, 2/3 are paid during the month after sales and the balance during the following month. 7 8

5 Credit sales for the month of May 2010 amounted to 24,600 and in June 26,100. The annual rental for the company s premises is 18,000 payable monthly. Other payments to be made are: July August Sept. Salary, Wages & Commission 4,800 5,100 5,500 Rates Other Expenses 1,600 1,800 2,000 You are required to prepare the company s cash budget for the quarter beginning 1st July, 2010 and show the balance at the end of each month. b. It is widely recognised that, in order to succeed, a business must pay regard not only to its profitability but also its liquidity. i. State briefly what you understand to be the meaning of the term Profitability and Liquidity ii. ame three (3) ratios which can be used for measuring profitability and three (3) ratios for measuring liquidity. Teddytoys Ltd a. Cash Budget For the Quarter Begining 1st July, July August September Receipts Cash Sales 4,000 4,200 4,600 Receipt on Credit sales 25,600 32,700 37,200 29,600 36,900 41,800 Payments Purchases 36,000 24,000 36,000 Rent 1,500 1,500 1,500 9 Salary, Wages & Commission 4,800 5,100 5,500 Rates Other Expenses 1,600 1,800 2,000 44,700 32,400 45,000 Summary Balance b/f 10,000 (5,100) (600) Receipts 29,600 36,900 41,800 39,600 31,800 41,200 Payments 44,700 32,400 45,000 Balance (5,100) (600) (3,800) b. Profitability The relationship between profit and the resources employed in earning it is usually expressed as percentage. The resources aspect of the relationship may comprise total assets or fixed assets plus working capital, i.e. the capital employed.this is relevant for a business which depends on its assets to generate revenue and hence profit. For other businesses which are not asset-reliant, an alternative suitable measure must be adopted. Thus, in a profession such as that of a solicitor or an accountant, profit will be more appropriately related to fee income. A subsidiary measure of profitability is the relationship between gross profit and net profit to sales. Liquidity The degree of safety of a business from failure due to inability to pay its way is referred to as liquidity. As a measure of financial stability, the ability of the business to meet its obligations as they fall due is critical to its survival. This explains why banks, for instance, are mandated to compulsorily keep part of their assets in liquid form as exemplified in the Central Bank - imposed liquidity and acid test ratios. 10

6 Profitability Ratios Liquidity Ratios a. et Profit to Sales a. Current Asset Ratio b. Gross Profit to Sales b. Stock Turnover c. et Profit to Capital Employed c. Debtors Turnover d. et Profit to Total Assets d. Creditors Turnover e. et Profit to Fixed Assets e. Quick Asset Ratio f. et Profit to Shareholders Fund SECTIO B Comments This was the least popular question, as only 22% of the candidates attempted it. The par value of debenture was omitted in the question and this ambiquity must have discouraged most of the candidates while deciding which question to attempt. Performance was average( 39.3% pass rate) The ambiquity should attract the attention of the examiners in future. Question 4 The account of OLUREMMY PLC reveals the following: 1 Ordinary Shares 2,000,000 Reserves 3,000,000 10% Debentures 1,000,000 6,000,000 Market Values of the above are as follows: Ordinary Shares 3.75 each ex div. Debentures Stock 80 The cost of equity is estimated to be 20%, the cost of debt is 7.5% after tax. 11 Required: Calculate the Weighted Average Cost of Capital using: a. Book Value Weights b. Market Value Weights Using Book Value Equity ( Ordinary Shares plus Reserves) 5,000,000 Debt 1,000,000 Total 6,000,000 Proportion 5/6 Equity, 1/6 Debt Combined Cost ( 5/6 x 20%) + (1/6 x 7.5% ) 17.92% Using Market Value Equity 2,000,000 x ,500,000 Debt 1,000,000 x 80/ ,000 8,300,000 Proportions Equity 7,500,000/8,300,000 Debt 800,000/8,300,000 Combined Cost of Capital 7,500,000/8,300,000* 20% 800,000/ 8,300,000 * 7.5% 18.79% Comments on Question 5 Perhaps the most popular question attempted by 96% of the total candidates assessed. The question was however too cumbersome and should have been ideal to carry 30 marks in Section A. In order to compensate the candidates, the answer schematics was remoderated. 12

7 Also noted was an error in the year 3 cash flows in the answer schematic. This was reworked accordingly. In spite of the observations above, performance was excellent with 84.2 % of the candidates scoring marks above the average. Question 5 a. Write short notes on three Investment Appraisal Techniques. Also, mention their advantages and disadvantages. b. OKOROBIAKU Ltd is considering investment in either of 2 projects with the following cash flows: PROJECT A PROJECT B Initial Investment Cash Flows: 1,000,000 1,200,000 Year 1 50, , , , ,000,000 1,000, ,000 50,000 The cost of capital is expected to be 12% for Project A and 15% for Project B. Further information: Present Value Required: 12% 15% Rate at end of year Compute the PV of the two projects and advise on the better option. a. Accounting Rate of Return This is the ratio of average of profits after depreciation to the capital invested. The basic definition has the following variations: i. Profit may be before or after tax. ii. Capital may or may not include working capital. iii. Capital invested may be the initial capital or average capital invested over the life of the project. Advantages i. It is easy to calculate. ii. It is easy to express in percentage term. Disadvantages i. It does not allow for the timing of cash inflows and outflows. ii. It has many variations and therefore could lead to various interpretations. iii. It uses, as a measure of return, the concept of the accounting profit. b. Payback Payback is the period expressed in years which it takes for a project net cash inflows to recoup the original investment. It is a popular technique used alone or in conjunction with others. The decision rule is to accept the project with the shortest payback period. Advantages i. It is simple to calculate and understand. ii. It uses project cashflows rather than accounting profit. iii. It favours quick return projects. iv. It minimises risk

8 Disadvantages i. Payback does not measure overall project worth. ii. It provides only a crude measure of the timing of projects. iii. It does not use the discounting cash flow. Internal Rate of Return (IRR) IRR is also based upon discounted cash flow calculations but measures the value of investment as a percentage return or yield rather than absolute figure in the case of PV calculations. The IRR is the discount rate which equates the present value of cash inflows with the present value of cash outflows, i.e. the rate that gives a zero PV. The IRR is estimated by assuming a linear change in PV between the 2 discount rates. Advantages i. It factors in the time value of money. ii. It is the best measure as it shows whether the project is profitable or not as it is a means of comparing the cost of capital with the return on investment. Disadvantages i. It is complex and cannot be determined directly. ii. It is based on subjective rates which are assumed. et Present Value PV is the value obtained in discounting all cash outflows and inflows associated with a chosen target rate of return or cost of capital. The present value of cash inflows minus the present value of cash inflows is the PV. 15 Advantages i. The time value of money is taken into consideration. ii. Decision is made easy as only projects with positive PV are chosen. Disadvantages i. Profitability of project is not evident. ii. The cost of capital applied may be subjective. PROJECT A Year Cash Flows DF at 12% PV 0 1,000, ,000, , , , , ,000, , , ,000-21,500 PROJECT B Year Cash Flows DF at 15% PV 0 1,200, ,200, , , , , ,000, , , , ,500 Decision: Project B should be accepted as it has a positive PV. Comments On Question 6 The question on Marginal Costing was attempted by 127 candidates and pass rate was 54%. Some errors wer however observed on the question. 16

9 1. Error noticed in the sales volume of Product A. In the original manuscript, it read 12,000 units and the answer scheme was prepared in line with this volume. However, only 1,200 was reflected in the question due to obvious typographic error. This was accordingly adjusted in the answer schematics. The following errors were noticed in the answer scripts of the candidates. i. Most of the candidates did not consider the sales commission as a variable cost and therefore ignored this in the calculation of the contribution per unit. ii. Majority of the candidates did not adhere to the a portion of the requirements which asked for contribution per unit but instead determined the contribution for the total volume. Question 6 KOKOBILO Ltd is planning to expand its scale of operations and the corporate planning department has produced the following estimates for two products for year 2010 each of which uses the same grade of skilled labour. Product A Product B Sales Volume per annum 1,200 10,000 Sales per Unit Cost per Unit Direct Materials Direct Labour( 5 per hour) Variable Overhead 4 3 Fixed Cost 80,000 70,000 The fixed cost represents an allocation of business overheads which KOKOBILO LTD will incur whether or not it decides to proceed with either or both of the above products. Required: Prepare operating statement showing for each product line: a. Forecast contribution per unit. b. Forecast total contribution. c. et Profit assuming the estimated sales volume is achieved. Product A Product B Sales per Unit Cost per Unit Direct Materials Direct Labour Variable Overhead 4 3 Sales Commission a. Forecast Contribution per Unit b. Forecast Total Contribution 1,200* ,000*11 15, ,000 c. et Profit Total Contribution 15, ,000 Fixed Cost 80,000 70,000 Profit -64,700 40,000 In addition, you discover that: Salesmen are entitled to a commission of 5% on each item sold