29

Accounting fundamentals
Activity 29.1 (page 533): Mauritius Tourist Flights Ltd
1

Explain to Leroy three reasons why it is important for him to keep accurate
accounting records for his business. [9]

As a limited company, Leroy will have to submit accounts to the government.

It is important that accounting records are correct to ensure that the business
does not pay too much corporation tax.
Accounts provide important information to aid Leroy in making appropriate
decisions, such as the price to charge for tourist flights. Without accurate
information, Leroy might charge prices that do not provide for profit.
Accounts allow Leroy to measure the performance of his business and analyse
its success/failure.
To secure finance for purchasing Elviss business, Leroy would need to present
financial information to banks or other potential investors to demonstrate that
his business is financially sound.
If Leroy wishes to sell his business in the future, it is necessary to provide
accounts so that he will be able to realise a fair price for it.

Elvis seems to be window dressing the accounts for his own business in order to make
it seem more successful than it is:
Why is he doing this? [2]

To try and secure a higher price for the business from Leroy or other potential
buyers. Window dressing the accounts will exaggerate profits and the financial
solidity of the business.

Examine briefly the ways in which he is doing this. [6]

The plane has been overvalued. Insufficient depreciation has been charged to
the accounts.
Elvis has ignored the realisation principle that revenues should only be recorded
when the legal title to goods is transferred to the purchaser. He has included in
his profit and loss account revenues not yet earned, thus overstating profitability.
The accounts assume that all debts from customers will be recovered. Leroys
reaction to the accounts suggests that there is evidence of old debts that are
unlikely to be paid; thus, Elvis should include an allowance for bad debts, which
would reduce the profit.

In future, how important do you consider Leroys published accounts will be to

stakeholders in the business? Explain your answer. [8]

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Accounts are very important to a number of stakeholders.

Suppliers Leroy purchases fuel on credit; suppliers must be certain that
the business is able to repay debts on time. If Leroys business has liquidity
problems, then suppliers will wish to be paid in cash.
Providers of finance as Leroys business expands, he may require external
finance from banks. Before making loans, banks will need to see accounts to
assess the liquidity and gearing of the business.
Government and tax authorities to fund government projects, tax revenue
is necessary; the government must be sure that businesses, such as Leroys, are
paying the correct amount of corporation tax. The government also has an interest
in protecting its citizens from fraud, therefore accurate accounts are necessary.
Tourists the financial stability of the business will be of concern to tourists
who will want to ensure that when they have paid in advance for flights, the
business does not subsequently go bankrupt.
4

Briefly explain the benefit to company stakeholders of accounts being based on the
same internationally agreed accounting principles. [6]
To make comparisons with competitors, it is necessary that accounts are drawn up
using the same conventions and rules. Otherwise, company stakeholders, such as
managers, may make decisions based on false assumptions about the performance
of competitors.
Accounts based on internationally agreed accounting conventions enable potential
shareholders to make informed decisions about which companies are worth
investing in.

Activity 29.2 (page 536): Calculating gross prot

1

Calculate gross profit for Cosy Corner Retailers Ltd for the financial year ending
31 March 2009. Show all of your workings.
a 1,500 items sold for $5 each; opening stocks were valued at $500; purchases

totalled $3,000; closing stocks were $1,000. [5]

Revenue
= 5 1,500 = $7,500
Cost of sales = opening stock + purchases closing stock
= 500 + 3,000 1,000 = $2,500
Gross profit = 7,500 2,500
= $5,000
b Explain two reasons why you think it is important for any business to make a profit. [6]

Profit is the reward to an entrepreneur for investment. Without making a

profit, owners would withdraw their investment and close the business.
Profit is needed to finance growth. Profits are re-invested into the business to
purchase the fixed assets needed to help the business grow.

Cambridge Boxes Ltd sold 3,500 units in the last financial year ending 31 December
2008. The selling price was $4. Opening stocks were 200 boxes. The business

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purchased 4,000 boxes during the year. All boxes cost the company $2 each. Calculate
the value of closing stocks and the companys gross profit in 2008. [5]
Gross profit = turnover cost of sales
Turnover = 4 3,500 = $14,000
Closing stock = opening stock + purchases sales [all figures in units]
= 200 + 4,000 3,500 = 700 units.
Value of closing stock = 2 700 = $1,400
Cost of sales = 2 3,500 = $7,000
Gross profit = 14,000 7,000 = $7,000

Activity 29.3 (page 537): Calculating prots

1

Calculate the missing values UZ for the different types of profit for Rodrigues
Traders. [5]
Gross profit (U) = revenue cost of sales = 12,000 4,000 = $8,000
Operating profit (V) = gross profit overheads = 8,000 3,000 = $5,000
Profit before tax (X) = operating profit interest = 5,000 1,000 = $4,000
Profit after tax (Y) = profit before tax tax = 4,000 800 = $3,200
Retained profit (Z) = profit after tax dividends = 3,200 1,200 = $2,000

State three stakeholders in this business who would be interested in these profit
figures. [3]

banks
shareholders Rodrigues and three friends
government
employees three electricians
local community

For each stakeholder group identified, explain why the profits of this business are
important. [9]
Stakeholder

Importance of prot

Banks

will want their loan to be repaid if the business is not

making a profit, then it will struggle to repay the loan

Shareholders
Rodrigues and
friends

affect dividends available for distribution to shareholders

affect value of the business
source of finance for future growth

Government

taxation
jobs

Employees

job security
wage negotiations
jobs created by profitable businesses
increase in spending in the local community associated

Local community

with employment

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Activity 29.4 (page 540): Understanding balance sheets

Copy this table and indicate in which category the following items would appear on a
company balance sheet. [10]
Non-current
(xed)
tangible
assets
Company
car

Non-current
(xed)
intangible
assets

NonCurrent Current
current
assets
liabilities liabilities

Shareholders
equity

Work in
progress

Four-year
bank loan

Money
owed to
suppliers

Issued share
capital

Dividends
owed to
shareholders
Value of
patents

Payments
due from
customers

Retained
earnings

Cash in
bank

Activity 29.5 (page 543): Mauritius Telecom

1

What is meant by the following terms? [12]

accounts receivable
Mauritius Telecom has sold its services on credit to customers. This is the
money owed to MT for services supplied.

inventories
This is stock which is not yet sold. It might include telecommunications
equipment, e.g. telephones that MT has purchased or produced for sale to
customers. It may also include raw materials and work-in-progress.

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current assets
These are assets which will no longer be held in 12 months time. They include
stock, debtors and cash/bank deposits.

non-current liabilities.
These are MTs long-term liabilities and, therefore, are not due to be settled in
the next 12 months. This figure could include bank loans, debentures and other
medium-to long-term forms of finance, such as hire purchase and commercial
mortgages.

Explain why it is important to stakeholders of Mauritius Telecom to be provided with

two years of balance sheet values in the published accounts. Try to make references to
some of the data in your answer. [6]
Two years of data will help identify change in the finances of MT. A balance sheet
is just a snapshot and can, therefore, be misleading. With two years of data, it
is possible to identify whether the financial position of the firm is improving or
deteriorating. This is important to stakeholders, such as suppliers, financiers,
shareholders and managers.
The balance sheets for 2006 and 2007 indicate a number of important changes:
There has been a substantial increase in fixed assets (non-current assets). This
may have been funded through shareholder equity: either retained profits or
share capital. This is suggested by the increase in shareholder equity rather than
long-term liabilities.
The value of the business has grown. This is indicated by the increase in
shareholder equity.
MT has a satisfactory level of liquidity. Current assets are greater than current
liabilities, suggesting that the business will not have difficulty paying short-term
debt.
However, stakeholders may be concerned about the substantial increases in
debtors and current liabilities. Debtors may default on payments and become
bad debts.
Stakeholders, such as banks, will be interested in the gearing and liquidity of the
business. MT is financed primarily through shareholder funds rather than debt
finance.

Research: use the internet to research the latest years accounts from Mauritius
Telecom http://www.mauritiustelecom.com (or another plc of your choice). Read the
Chairmans Statement, the Report of Directors, and the Auditors report. How useful
do you think these reports would be to:
shareholders
workers in the company
any other stakeholder group?

Explain your answers. [12]

The Chairmans Statement gives a general overview of the achievements of
the company and its future prospects, taking into account significant external

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influences. For example, in 2007 it highlights growth in EBITDA (earnings before

interest, tax, depreciation and amortisation) of 8%, growth in broadband customer
numbers, and some of the key challenges faced in the communications market.
The Report of Directors outlines the duties of directors, including safeguarding the
companys assets. The report gives background information on the business and
outlines key results from the year.
Stakeholder

Commentary

Shareholders

The Auditors Report is important as it confirms that the accounts

are a fair representation of MTs financial state. If there were
concerns about the viability of the business, they would be stated
by auditors. For example, Liverpool FCs parent company KFC
announced losses in 200809 due to debts of over 400m. Their
auditors, KPMG, stated that refinancing the debt was a material
uncertainty which may cast significant doubt on the groups and
parent companys ability to continue as a going concern.
The Chairmans Statement is, of course, biased and likely to present a
positive gloss on the performance and prospects of the business. It is no
more than a brief overview of past performance and future prospects.
Investors need to analyse the accounts thoroughly themselves.

Employees

The reports in 2007 emphasise the need to boost productivity

and control costs and create more flexible working conditions.
Employees can learn a little about the future direction of the
business and will be able to identify some of the significant changes
planned in the future. It will give some indication of their job
security. If MT communicates effectively with employees, there
would be little of significance to employees in the reports that they
had not already been told.

Other

Customers may be interested in the details on broadband access and

MTs plans for the future.
Suppliers may find reassurance in the reports as to the continued
trading viability of the business.

Activity 29.6 (page 548): Has BP plc got enough liquidity to

pay its short-term debts?
1

Calculate BPs current ratio. [3]

Current ratio = current assets current liabilities
Current assets = inventories + debtors + cash = $68,136m
Current liabilities = creditors + short term loans = $58,546m
Current ratio = 68,136m 58,546m = 1.16

Calculate BPs acid-test ratio. [3]

Acid test = liquid assets current liabilities
Liquid assets = current assets inventories = $41,582m
Acid test = 41,582m 58,546m = 0.71

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Comment on BPs liquidity. [6]

BP has a relatively low current ratio as it only has $1.16 of current assets for
every $1 of short-term debt.
The acid-test ratio is below 1 and this indicates a potential lack of liquidity, that
is there is an increased risk of BP not being able to pay its short-term debts if
payment was demanded. A ratio of 1:1 is considered to be healthy.
However, it is necessary to compare ratios over time and with other firms in the
industry to make a more considered judgement of BPs liquidity.

Why would it be useful to BPs stakeholders to have liquidity ratio results for the
previous year and for other oil companies? [8]

It would be useful to identify trends in BPs liquidity. If liquidity is deteriorating,

this will be of concern to stakeholders, such as trade creditors, financial
institutions and potential investors.
Comparisons with other oil companies will help establish if BPs liquidity is
normal for the industry. In some industries, it may be quite normal to operate
with a low or high liquidity ratio.

Activity 29.7 answer provided on Students CD-ROM.

Revision case study 1 (page 550): Higheld Leisure Ltd
1

What is meant by the following terms? [12]

cost of sales
opening stock + purchases closing stock
This is the direct cost of purchasing the goods that were sold during the
accounting period.

retained earnings reserves

This is the accumulated retained profit of the business over time. It is not
literally a reserve of cash, as retained profits will usually have been re-invested
into the business.

shareholders equity
This is the investment made into the business by shareholders. It includes
share capital invested into the business through the purchase of shares and the
accumulated retained profit.

operating profit.
This is gross profit less overheads. It is the profit made on the normal trading
activities of the business. It is recorded before deducting interest payments on
borrowing and does not include unearned income.

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Calculate the missing values: U, V, X, Y, Z. [5]

U: Gross profit = sales turnover cost of sales = 320m 120m = $200m
V: Pre-tax profits = operating profit interest = 85m 5m = $80m
X: Total assets = fixed assets + current assets = 80m + 10m + 25m + 0.5m =
$115.5m
Y: Share capital = total equity and liabilities (current liabilities + non-current
liabilities + retained earnings) = 112m (25m + 46.5m + 10.5) = $30m
Z: Total equity and liabilities = current liabilities + non-current liabilities +
share capital + retained earnings = 30m + 40m + 30m + 15.5 = $115.5m

Using the data in any way you consider appropriate, including the use of ratios,
analyse the changing profitability and liquidity of this business. [12]
Relevant calculations include:
Ratio

2009

2008

Commentary

Gross profit margin:

gross profit
turnover 100

200 320
= 62.5%

230 330
= 69.7%

Although sales have fallen, the

cost of sales has increased. Thus,
the GPM has been reduced. The
increase in cost of sales will be of
concern to Highfield Leisure as
it will make it more difficult to
compete.

Net profit margin:

net profit
turnover 100

50 320
= 15.6%

85 330
= 25.6%

This is a significant fall in the

NPM. Highfield Leisure has failed
to control its overheads.

Current ratio
current assets
current liabilities

35.5 30
= 1.18

37 25
= 1.48

Although the current ratio has

fallen, this is not necessarily a
problem. Highfield Leisure has
reduced its stock holding; as it
operates sports centres, one might
expect there to be relatively low
levels of stock held. Holding
less stock may represent a more
efficient use of resources.

Acid test:
liquid assets
current liabilities

25.5 30
= 0.85

22 25 =
0.88

The acid test is on the low side.

Liquid assets are less than shortterm debt and Highfield Leisure
may have a shortage of working
capital. The cash position of the
business has deteriorated and
there has been an increase in
debtors. This could be the result
of offering more generous credit
terms or there could be bad debts.

Evaluate how managers might improve

profitability
liquidity of this business. [12]

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In answering this question, account must be taken of the impact of increased

competition.
Profitability:
Increase price the problem for Highfield Leisure is that increasing price could
lead to a significant drop in demand because of the new competitors that have
entered the market.
Reduce direct costs reducing direct labour would reduce the cost of sales,
but could have a negative impact on the quality of customer service. As it is in
the leisure industry, it may not be possible to increase productivity through
automation. Cutting wages will reduce labour costs, but may lead to poor
motivation and poor customer service.
Reduce overhead costs Highfield Leisure should try and reduce costs, such
as administration costs. If it has a head office, it might be possible to relocate
to reduce rent and local taxes. The leisure centres may be difficult to relocate
they need to be accessible to centres of population.
Liquidity:
Increase loans this would provide an injection of capital into the business.
However, interest costs would reduce profit.
Sell fixed assets if Highfield Leisure has unproductive fixed assets, these could
be sold; the only reason for holding assets is to generate revenue. However, it
can be difficult to realise the true value of an asset if sold quickly. Assets can be
sold and leased back if needed; this will improve liquidity, but negatively affect
profit.
Sell stock Highfield Leisure has already reduced stock levels, so there may be a
risk of negatively affecting the customer if stocks become too low.
Hold interest-bearing bank accounts Highfield should ensure that cash is held
in interest-bearing bank accounts so as to maximise interest earned.
Monitor accounts receivable Highfield Leisure should monitor its accounts
receivable to ensure that customers are billed properly and payments are made
promptly. However, care must be taken not to alienate customers and drive
them to competitors.
Negotiate credit terms Highfield should negotiate longer credit terms so as to
hold on to cash for as long as possible.
5

Evaluate the usefulness of the ratios calculated to the main users of accounting
information. [10]
Managers:
Ratios give an indication of the performance and efficiency of the business.
Over time, they enable managers to identify trends.
Poor ratio results identify problems that managers need to address; Highfield
Leisures profitability ratios highlight that action must be taken to deal with the
threat of competition.
Ratios can be used to support applications for finance.

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Shareholders / potential investors:

Ratios provide a means for evaluating the performance of a business and the
quality of its management.
They can help guide decisions about investment.
Suppliers:
Ratios will indicate whether it is safe to offer credit to customers. If a customer
has poor liquidity, then it will be advisable to only sell for cash.

Evaluation may consider:

Have accounts been window dressed? Are ratios from other years and other similar
businesses available?

Revision case study 2 (page 551): Shivanis rst balance sheet

1

Draw up a correct version of Shivanis balance sheet with correct headings, making
sure that it finally balances. [10]
Balance sheet for Shivani Beauty Salon Ltd as at 31/3/2010
($000)
ASSETS
Non-current assets:
Equipment
Current assets:
Stock of materials
Accounts receivable
Cash
TOTAL ASSETS
EQUITY & LIABILITIES
Current liabilities:
Accounts payable
Overdraft
Non-current liabilities:
Loan
Shareholders equity:
Share capital
Retained earnings
TOTAL EQUITY AND
LIABILITIES

25
15
3
1
44

5
3
20

10
6
44

Essay
2 a Explain the distinction between gross profit, operating profit and retained profit. [9]

Gross profit = turnover cost of sales. It is profit after deducting direct costs from
turnover.
Operating profit = gross profit expenses. It is the profit a business earns on its
normal operations before interest and taxation. It is also called net profit.

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10

Retained profit is profit left over after deducting corporation tax and any dividend
payable to shareholders. It is, therefore, the profit remaining for re-investment into
the business.
b The owner of a chain of sports-equipment shops is worried about her businesss

declining gross profit margin and net profit margin. Evaluate three decisions the
owner could take to attempt to increase these profit margin ratios. [16]

Increase price price elasticity of demand will be significant in determining the

success of this decision. If demand is price elastic, then sales will fall and profits
will decline despite the increase in the profit margin. Price elasticity of demand
will be affected by the number of substitute products available in the market.
To increase price without causing a fall in demand, it may be necessary to offer
an improved customer experience in the shops. However, that may add to costs
and, therefore, profit margins will not be improved.
Reduce direct costs reducing the cost of sales without reducing turnover
would increase the gross profit margin. This could be done by negotiating with
the current suppliers of sports equipment to reduce the price paid. The shops
could buy in bulk to obtain discounts; however, this could lead to an increase
in storage costs and the outflow of cash to pay for equipment could lead to
liquidity problems. Alternatively, the shops could look for cheaper suppliers of
equipment.
Reduce overhead costs this could be achieved by reducing staffing. However,
this would be opposed by employees and cause conflict. A reduction in staffing
levels could also have a negative impact on customer service and, therefore,
damage sales. Wages could be cut, but this would demotivate staff, lead to
increased labour turnover and possibly reduce the quality of customer service.
If customer service declines, then customers may go elsewhere to buy their
sports equipment. Overheads could also be reduced by cutting promotion, but
this has the associated risk of causing a decline in sales.

Evaluation may consider:

To increase margins, the owner must either increase revenue without increasing costs
or reduce costs without reducing revenue. Simply increasing the quantity of sales is
insufficient to increase profitability due to the impact of increased sales on costs.

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