Financial Concepts B Nov 2012 Model Answers

FINANCIAL CONCEPTS B – NOV 2012 MODEL ANSWERS

(a)Any two of the following:

 A breakeven chart can only apply to a single product or a single mix of a group of products

 Assumes fixed costs are constant at all levels of output

 Assumes that variable costs are the same per unit at all levels of output

 Assumes that sales prices are constant at all levels of output

 Assumes that production and sales are the same (stock levels are ignored)

 It ignores the uncertainty in the estimates of fixed costs and variable cost per unit2 marks

(b)Fixed costs are those costs that do not vary with the volume of sales or production, but remain constant over a period of time and the relevant range e.g. rent of a building must be paid, irrespective of the volume of sales or units of production 3 marks

Variable costs do vary with the volume of sales or production in a direct relationship, the bigger the volumes the higher the variable cost. e.g. the amount of material used to manufacture a product will be a variable cost 3 marks

*marks to be awarded for other correct examples of fixed and variable costs

(c)The banker will be interested in the viability of a new business venture or an extension of an existing business to see if it is going to be profitable and economically viable over the long run 2 marks

The interest paid on a loan by a company is part of the fixed costs of a business and the banker needs to check if the business will be capable of generating enough sales to pay the extra interest costs 2 marks

(d) Contribution required to breakeven:K63,000

Volume of sales:12,000 units

Required contribution per unit:63,000/12,000=K5.252 marks

Variable cost per unit=K7.00

Required sales price per unit=K12.251 mark

(a)(124,800 – 64,290)

=60,5101 mark

(b)These are:

 An excessive investment in working capital, which reduces the return on capital employed

 Excessive stock levels, which could lead to high costs of storage, and losses due to deterioration of stocks or obsolescence

 Excessive levels of debtors, which could lead to high levels of bad debts, if late payers are not chased for the debts they owe. 4 marks

(c)Total assets=K800,000/2.5=K320,0002 marks

Current assets=K320,000/2.0=K160,0002 marks

Current liabilities=K160,000/1.8=K88,8892 marks

Quick assets=K88,889 x 1.2=K106,6672 marks

Stock=K160,000 –K106,667

=K53,3332 marks

(a)To maximize shareholder wealth in the long term2 marks

(b)Sole trader/proprietorship; partnerships and limited companies3 marks

(c)Management who do not own their company might pursue strategies that are in their own interest rather than in the best interests of shareholders, leading to a lack of goal congruence 4 marks

(d)

 A business will have a need for working capital. The working capital requirements for the minimum needs in terms of debtors (accounts receivables) and stock levels will be of a permanent nature, whilst a varying need for working capital can arise due to seasonal/cyclical increases in turnover. This need for working capital will normally be financed by means of short term funds such as a bank overdraft 3 marks

 A business can have a borrowing need for fixed assets such as property, plant and equipment. This is a long term borrowing need and will normally be financed by means of long term loans

3 marks

(a)Stocks and debtors will increase and/or trade creditors will be reduced. The current ratio should therefore be higher 2 marks

(B)Current assets/Current ratio=Current liabilities

Current tax increase is K10,399(K95,399-K85,000)

Thus current liabilities is revised to K139,349(K128,950+K10,399)

Thus current ratio is 1.24(K172,793/139,349)2 marks

(C)Economic order quantity; buffer stocks and lead times; just-in-time inventory policies3 marks

(d)The conservative approach to financing policies means that the management do not mind taking unnecessary risk in terms of not being able to obtain short term funds, or not being able to pay it back, therefore they finance the business mostly by means of long term funds. A very small component of the fluctuating current assets will be financed by short term funds such as overdrafts. At times when fluctuating current assets are low, there will be surplus cash which the company will be able to invest in marketable securities 6 marks

(a)Depreciation is a way of spreading the economic benefits to be obtained from a fixed asset over the expected useful life of the asset. It is therefore a way of spreading the cost of asset, less its expected residual value, over the full life of the asset, and thereby charge the consumption of the asset’s value to the years in which the asset provides benefits to the business. Charging depreciation is an application of the accruals or matching concept of accounting 4 marks

(b)Any of:

 Freehold land

 Investment properties

 Intangible fixed assets with an indefinite life2 marks

(c)With high gearing, profits available to shareholders rise or fall at a faster rate than with low-geared companies 2 marks

(d)Operating Review

 Operating results for the period

 Dynamics of the business

 Investments for the future

 Profit for the year, recognized gains/losses etc

 Dividends, Earnings per share

 Accounting policies3 marks

Financial Review

 Capital structure and treasury policy

 Funds

 Current liquidity

 Going concern

 Balance sheet values3 marks

(e)

 It is part of the Annual Financial Statements and provides focus on the quality of cash flow management by the company during the accounting period under review 2 marks

 It helps to assess the ability of the company to generate positive future net cash flows2 marks

 Assessing whether the company can generate funds to meet its financial commitments, pay dividends and the need for loan capital 2 marks

(a)Time period that cash is tied up in current assets such as stock and debtors2 marks

(b)Any four of:

 Costs associated with too much stock include: storage costs; handling costs; security and maintenance costs; financing costs. The costs associated with holding too little stock include: higher purchase costs as a result of the need to acquire stocks quickly; higher transportation costs in order to secure fast delivery; production scheduling costs and production stoppages as a result of having insufficient stocks to complete production runs 4 marks

(c)The operating cash cycle may be reduced by

 Reducing the level of stock held, or1 mark

 Reducing the level of trade debtors, or1 mark

 Increasing the level of trade creditors, or1 mark

 Some combination of the above.1 mark

However, problems may be encountered when trying to do this in practice. Reducing stock levels can release cash to help eliminate the bank overdraft and can also help to reduce stock carrying costs. However, stock re-order costs will rise as more frequent orders will have to be made (2 marks). In addition, there is a risk that the range and quantity of stock held will not be able to meet customer demand, resulting in lost sales and lost customer goodwill (2 marks). Reducing the level of trade debtors can also release cash but again this may result in lost sales and lost customer goodwill, which may outweigh any benefits received (2 marks). A discount for early settlement is one way of reducing the level of trade debtors but will, again, be a cost to the business (2 marks). Delaying payments to trade creditors may be possible although this may lead to loss of early settlement discounts and loss of supplier goodwill. 2 marks

(a)Total fixed costs:

K per month

Salaries=5,500

Interest paid=2,000

Rent=1,500

Total=9,0002 marks

Variable costs per wrapper:

Labour=1,000

Materials=850

Other=250

Total=2,1002 marks

Therefore, Breakeven =Total Fixed Costs/(SP/unit-VC/unit)

=9,000/(3,000-2,100)

=10 wrappers4 marks

Units required to make K18,000 profit:

=(9,000+18,000)/(3,000-2,100)

=30 wrappers4 marks

INCOME STATEMENT

Sales (30 units x K3,000)90,0002 marks

Variable costs (30 units x K2,100)63,0002 marks

Contribution27,000

Fixed costs9,0002 marks

Profit18,0002 marks

(a)The major benefit of an audit is that it provides an independent opinion o the truth and fairness of the information in the financial statements. A key point is that an auditor’s opinion is independent, and well informed.

The need to subject financial statements to such scrutiny is useful in a number of ways.

At the most basic level, the audit provides a check on the work carried out to produce the financial statements. As in any task, the need to have work checked can improve the quality of the work, as it encourages a degree of care which will contribute towards minimizing errors.

The fact that auditors must be professionally qualified means that the financial statements are likely to conform with generally accepted accounting practice.

Furthermore, as the activities of auditors are subject to monitoring and regulation, a further level of assurance is inherent in the process.

If the auditor discovers that misstatement has occurred, the preparers of the financial statements will be asked to correct the misstatement. Thus the results which are finally published will be more reliable.

The audit can also act as a deterrent to carrying out improper practices (e.g. fraud or misstatement of figures). Although the audit is not intended to detect fraud, it is reasonable to conclude that the incidence of fraud would be higher if no audit was conducted.

Overall, these benefits increase the reliability of financial statements which will in turn increase the confidence of users. Such reliability and confidence are key factors in promoting economic stability and growth.

Mark allocation:up to 2 for each valid point, to a maximum of 6 marks

(b) In considering what is meant by the term ‘fairly presented’, it is often useful to clarify that it does NOT mean ‘correct’. Nor does an unqualified audit opinion provide a guarantee that the audit opinion can be relied on. The main reason for this is that the conduct of the audit, like accounting in general is based on the concept of materiality. Thus, ‘fairly presented’ means that the financial statements are free from material misstatement.

In addition, ‘fairly presented’ means that:

The financial statements provide a faithful representation of the transactions carried out by the entity;

Assets and liabilities are properly classified;

There is satisfactory disclosure to enable users to understand the financial statements (this refers to both the nature and the amount of information);

Appropriate accounting policies have been selected;

The selected accounting policies have been properly applied; and

The information is relevant, reliable, understandable and comparable.

Not ‘correct’/not a guarantee 2 marks each4

For other comments, 1 mark per valid point to a maximum of 4, total 8

(c)It is advisable to read the auditor’s report first as this will have the following advantages:

 It will confirm whether the financial statements have been audited or not

 It will confirm which portion of the financial statements has been subject to audit. This is done by specifying the pages in the financial statements that are covered by the auditor’s report.

 It will confirm if the auditor’s opinion is qualified or unqualified. This is of great importance to the banker, as the auditor’s qualified opinion might point towards potential risk involved if credit were to be granted to the company. Banks often have special requirements in their credit policies referring to the procedures to be followed when dealing with qualified auditor’s report.

2 marks eacha total of 6 marks

A qualification examined by the Institute of Bankers in MalawiPage 1