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Disciplinary and grievance procedures by R Das Gupta

noreply@blogger.com (Unknown) — Mon, 14 Mar 2011 22:14:00 -0700

Disciplinary and grievance procedures

by S R Das Gupta
31 Jan 2001

This article is written specifically for Certified Accounting Technician students preparing for Paper C6 (Managing People). Students are required to answer any four (out of five) questions, each question carrying 25 marks.
This article will focus on disciplinary and grievance procedures in two sections. In the first section, we will cover various aspects of ‘discipline’. The second section will discuss different issues on ‘grievances’.

Section 1 Definition

Discipline may be defined as a safe, healthy and orderly working atmosphere created by the employees with appropriate behaviour and proper attitude and who are following all company rules and policies in an efficient manner.

A past question

There was a whole question on ‘discipline’ in the June 1999 sitting which is reproduced in Figure 1. We will make reference to it later in the article to illustrate some of our points.

Disciplinary actions

Normally in any organisation there will be a set of rules that need to be followed by the employees to ensure the smooth running of its business. Such rules will prescribe what may or may not be done by the employees during the course of their employment. All these rules are implemented not only for meeting company objectives but also to ensure a safe working environment for the employees.

It would be an ideal situation if all rules were always properly followed by all employees. In reality, however, the situation may not be so perfect. There may be occasions of non-compliance, instances of abnormal behaviour or existence of attitude problems. Disciplinary actions are then taken to stop recurring non-compliance and improve the situation. In serious cases, disciplinary proceedings may also be necessary to punish an errant employee. In section (a) of Figure 1, 5 marks were allocated for explaining ‘discipline’.

Figure 1
The accounts manager understands the need to motivate employees, but does not understand what is meant by discipline within the employment context. You have been asked to explain.
Required:

(a) What do you understand is meant by the term ‘discipline’ in the employment context?	(5 marks)
(b) Provide examples of situations where disciplinary action may be required.	(8 marks)
(c) Describe the steps involved in a formal disciplinary procedure.	(12 marks)
	(25 marks)

Consideration for disciplinary actions

Different organisations may have different rules for disciplinary action. Certain employee actions are sure to attract disciplinary proceedings although the level of punishment may differ from organisation to organisation. Severity or seriousness of the infraction is the key factor to decide actual disciplinary action. The more serious the infraction, the more severe the punishment would be. Unless it is a serious offence, the employee’s past performance records would also be taken into consideration before deciding on disciplinary action.

In finalising any disciplinary action, the following key principles must be followed:

· disciplinary proceedings should be based on facts and not hearsay;

· affected employees must be given all reasonable opportunity to explain and defend (if necessary) his/her action. Final action can only be taken after such explanation/defence has been given due consideration by the management;

· no employee should be punished more than the infraction warrants;

· personal bias against an employee should not be used to influence disciplinary action.

Situations requiring disciplinary actions

To save some time in the examination hall, students should remember some of the incidents that would invariably result in disciplinary actions. Please refer to section (b) of Figure 1, where 8 marks were allocated for providing 8 such examples. It is not possible to compile a comprehensive list of all such actions, however we have listed sixteen instances which may be remembered easily from the acronym:

STRICT DISCIPLINE
Sleeping while on duty
Threatening co-workers
Refusing to perform assigned duties
Intoxication
Conviction of criminal offence
Tarnishing company image
Disobedience
Infraction of company policies
Safety procedures ignored
Carrying out illegal/immoral activities in company premises
Irregular attendance
Poor performance
Lying
Improper behaviour
Negative attitude
Embezzlement

Steps taken in disciplinary action

Some countries may have labour laws stipulating the exact steps to be followed when disciplinary actions are necessary. In the absence of any such legal requirement, organisations are at liberty to develop their own internal policies.

Generally such actions are taken in steps to provide the employee an opportunity to rectify the situation. However, the severity of the offence is the key factor in deciding whether the employee is entitled to such progressive steps or if drastic action is necessary. In more serious cases, management will obviously start proceedings at a higher step commensurate with the offence/non-compliance. As an example, management may decide to immediately discharge an employee found to have stolen company property.
Usually the steps are as follows:
(a) Informal discussion. Direct communication between employee and supervisor to highlight and resolve the issue.
(b) Verbal warning/reprimand. Here the supervisor clearly explains the problem and makes it clear to the employee that more serious disciplinary action will follow if it is not corrected within a specified time. (It is important to note that steps (a) and (b) are not documented in company records.)
(c) Official warning. A written warning is issued to the employee.
(d) Suspension or lay-off. If an official warning does not improve the situation, the employee may be placed on suspension (temporary lay-off) for a specific period, without pay.
(e) Demotion. The employee is downgraded to a lower position usually associated with a reduction in pay.
(f) Discharge. The final action comes in the form of retrenchment when the employee is terminated from the company. (Actions under steps (c) to (f) are appropriately documented and a copy is placed in the employee’s personnel file.)
Students should note that 12 marks were allocated in section (c) of Figure 1 for describing these steps. An accounting supervisor should be fairly familiar with company policy on disciplinary matters. With efficient handling of such matters, the supervisor should not only resolve the issue for the company but also earn respect from the rest of the employees.

Section 2 What is grievance?

Disciplinary proceedings are the result of employees not following rules and regulations or not performing according to standards set by the company. The reverse situation is also possible when an employee feels that he is being treated unfairly or inequitably. His grievances may arise due to many factors such as inappropriate interpretation of rules, unfair treatment, personal grudge, non-recognition of work performance, etc.

Unless the employee’s grievance is addressed from the very beginning, it can be a constant source of worry and anger for the employee which in turn may impact on his work performance. Disgruntled employees may be a source of danger not only to the organisation but also to the other employees in the organisation. Such an employee can also cause nuisance value to the company. Therefore grievances should be addressed and resolved at the earliest opportunity.

Management responsibility

Managers should be extremely sensitive in handling grievance situations. Every case of grievance must be treated as an opportunity to improve the working environment and not viewed as a nuisance created by an employee. A clearly defined grievance policy should exist in every organisation. The policy should be made available to all employees.

The policy should allow the employee complete freedom to air his grievances to different levels of management. It should also provide for a fair hearing with assurance of complete privacy where necessary. No action should be taken against the employee simply based on hearsay or unconfirmed reports.
In summary, a grievance policy should be seen by the employees as a right to express their complaints, unhappiness or disputes. This is also their opportunity to work towards prompt and orderly resolution of such issues.

Key principles

In developing a grievance policy the following considerations must be given:

· employees must be accorded at all times an open-door policy without any fear;

· reasonable opportunity must be provided for the employees to adequately express their grievance(s);

· if desired by the employees, permission should be given to be accompanied by a labour union or other representative;

· every employee must be given adequate opportunity to pursue his case until a satisfactory resolution is reached;

· specific time limit must be set for a fair and equitable resolution.

Grievance policy

As a start, the employee should contact his immediate supervisor who should endeavour to amicably resolve the issue. Most grievances can be settled by open, effective and regular communication between the employee and his supervisor. If, unfortunately, the immediate supervisor’s efforts do not satisfy the employee, he should have the right to approach higher levels of management for assistance. Because of the high importance placed on the employee-supervisor relationship to resolve grievances, it is critical that the manager makes his best efforts to first understand and then resolve the complaint. To do this, he must first arrange an interview with the employee. His role in such an interview is usually three-fold:

1 Exploration: to obtain all the details of the complaint with relevant and complete facts and related information.
2 Consideration: to analyse all available information and determine different options available to address the issue;
3 Resolution (response): to arrive at a final decision and communicate same to the employee.
The supervisor’s final resolution should be documented for reference in future actions, if any. If the employee is not satisfied with this resolution and decides to pursue the matter with higher authorities, this documentation would serve a key role in future proceedings.

Figure 2
A grievance occurs when an individual thinks that he or she has been wrongly treated by colleagues or supervisor. An unresolved feeling of grievance often leads to further problems for the organisation. The purpose of a procedure is to resolve the grievance to the satisfaction of all concerned.
Required:

(a) Briefly describe what should be in an organisation’s grievance procedure.	(13 marks)
(b) Describe three stages in a grievance interview within an organisation.	(12 marks)
	(25 marks)

Reproduced in Figure 2 is a question on grievances from the December 1999 sitting. By reading this article, students should be able to answer both sections (a) and (b) comfortably.
In this question, students were not asked to give examples of “further problems” that unresolved grievances may lead to. It is difficult to compile a comprehensive list of potential problems but the following are some of the key dangers that may seriously DISRUPT normal operations of the organisation:
Divulge sensitive information to competitors and external business associates/destroy company records/damage company properties
Instigate fellow workers to engage in undesirable activities
Spread damaging and/or false rumours against the company
Resort to inappropriate behaviour and/or unacceptable attitude
Use company assets for personal benefits
Purposely slow down business activities
Tamper with safety/security equipment

Conclusion

The impact of employee grievances may have a significant and long-lasting negative impact on the organisation. The impact may be even more severe if it is a collective grievance i.e., several employees share the same concern. To avoid any such problem, the manager must handle all cases of grievances with speed and sensitivity. He should not underestimate the situation until it has been resolved to the complete satisfaction of employee(s) and management.

Data and information by Philip Dunn

noreply@blogger.com (Unknown) — Mon, 14 Mar 2011 22:13:00 -0700

Data and information

by Philip Dunn
01 Mar 2002

Accounting Technicians studying Paper B3 Information Technology Processes need to develop knowledge and understanding of the operation of systems and procedures found within an information technology environment. Item (b) in the content elements of the syllabus includes the following reference to information: "attributes of information, data versus information, quality – reliability, accuracy, consistency, completeness and brevity".
The purpose of this short article is to define both data and information, consider the information hierarchy within organisations and outline the attributes of quality information. It may also be of interest to Professional Scheme students studying Paper 2.1 Information Systems.
Data and Information
The terms 'data' and 'information' are commonly used interchangeably but they can be distinguished from each other.
Data is defined as the raw material for data processing and relates to facts, events and transactions.
Data can also be classified as:

quantitative;
qualitative;
discrete;
continuous;
primary;
secondary.

Quantitative data is that capable of being measured numerically, e.g. the standard labour hours required to produce one unit of output.
Qualitative data is that not capable of being measured numerically but may reflect distinguishing characteristics, e.g. the grade of labour used to produce the unit of output.
Data is said to be discrete when it can only take on specific fixed values, e.g. the actual number of vehicles through a car wash per day could be 35 but not 35.3. Whereas continuous data takes on any numerical value and we could, in an eight hour day, measure the throughput of cars as 4.375 per hour i.e. 35 cars / 8 hours.
Data needs to be collected and summarised to the form required by the user.
Primary data is collected for a particular enquiry, for example by observation, employees would be observed performing a 'value adding' activity when establishing a standard time for the activity.
Data collected by a trade association from a number of firms and comprising trade association statistics would become secondary data when used by a firm in the sector making an enquiry of its own.
What then is the distinction between data and information?
Information is defined as 'data that has been processed in such a way that it is meaningful to the end user'.
Within organisations information has a defined hierarchy. This is shown in Figure 1.

Figure 1

Information is classed as:

Strategic � that information relating to the longer term planning and strategic focus of the business.
Tactical � that used in short term planning and decision making within an organisation.
Operational � that relevant to day-to-day decision making.
From bottom up, the following example refers to capital equipment utilisation:
Operational information would include a current week�s report for a cost centre on the capacity of the plant utilised in the period. Such a measure may include:

actual machine hours x 100
budgeted machine hours 1
i.e. the percentage capacity utilised.
Tactical information could include the short-term budget for 12 months and would show the budgeted machine utilisation in terms of machine hours for each item of plant. The total machine hours being predetermined from the production budget for the period.
Strategic Information would relate to the longer- term strategy on the company�s market share, which in turn informs the production plan. This plan would be used to predetermine the level of investment required in capital equipment in the longer term. This process which 'compels planning' would lead to investigating new methods and technology.
Attributes of Information
Quality information is that, which when used, 'adds value'. Research suggests that information should possess numerous attributes which include:

relevant for its purpose;
complete enough for the issue in question;
accurate for the purpose;
from a reputable source;
communicated to the right person;
timely in communication;
communicated in an appropriate channel;
the volume should be manageable;
must be understandable by the end user;
must be cost effective.

The attributes which 'add value' and together underpin quality of information are examined further below.
Relevant for purpose
Information should always be relevant to the issue being considered. It is often the case that memos, reports and schedules contain irrelevant sections which can have an adverse effect on the understanding of the issue by the user.
Completeness
It is desirable that all information required for decision making is made available. There must be close co-operation between the information provider and the end user. Therefore, all factors influencing decision making should be included.
Accurate for purpose
Managers rely on information to effectively manage their 'value-adding' activities. For example, to satisfy the VAT regulations, a VAT invoice must be accurate to the nearest penny. However, the aged debtors list would contain rounding to the nearest '£'.
Reputable source
For information to be used effectively by managers, the users must have confidence in its source.
This would be supported by the fact that the source was reliable in the past and that there is a good and clear channel of communication between the provider and the user of the information.
Communicated to the right person
Where responsibility accounting is used in practice, managers have a clear and defined level of responsibility and must achieve their predetermined objectives.
Managers should therefore receive information to carry out their defined tasks. Such information should be communicated to the right person at the right level within the organisation.
Timely
For effective decisions to be taken, information needs to be reported to management on a timely basis.
For example, a budgetary control or standard costing report containing adverse variances would need to be timely for managers to take immediate corrective action. Likewise if a favourable position was reported 'late', the reward and recognition to employees may be delayed and effect morale.
Communicated in an appropriate channel
For a manager to use information effectively it must be transmitted in the communication process. The process takes many forms and the channel selected must take account of nature, purpose, speed and requirement of the user.
Volume
The detail and volume of the information communicated should be that consistent with the need of the user.
The information should focus clearly on the issue and the main points highlighted and not 'clouded' by superfluous and excessive volume.
Understandable
Managers can only use information to good effect if they understand its purpose.
The level and skill of the manager is important here. Managers need to continually update their skills and therefore, Continuing Professional Development (CPD) is important. For example, for managers to fully understand their role in a responsibility accounting environment and to interpret the management accounting reports they need training.
"Training aids understanding."
The provider also needs to choose the style and language appropriate to the user.
Cost-effective
The costs of providing the information must not outweigh the 'value-added' benefits derived from its use.
An understanding of the underpinning knowledge, principles and concepts outlined above are all relevant to your development as trainee accounting technicians � the providers of information for the effective financial management of business.
Dr Philip E Dunn, Esk Valley Business School

communication is not just sending messages or e-mails, or indeed producing management reports or final accounts : John Bell

noreply@blogger.com (Unknown) — Mon, 14 Mar 2011 22:12:00 -0700

Communication

by John Ball
03 Nov 1999

"What do accountants do?" How many times have ACCA students been asked that question? The answer, of course, is that accountants, and accountancy, is about communication. But communication is not just sending messages or e-mails, or indeed producing management reports or final accounts. It is about understanding the nature of the communication process, especially for the management of people. If people do not communicate then the accountant’s work can never be complete.
Central to the communication process are two fundamental elements of management — understanding the nature of the organisational structure, and the way in which communication flows within that structure. Take the idea of the organisational structure first of all. Everyone knows what an organisation chart is; every accounting practice, factory, shop and office proudly displays such a chart. But what message is it intended to convey?
The organisation chart describes in diagramatic form the structure of the organisation. It is the skeleton upon which every other activity depends, more importantly, it is the framework which explains the communication process. It illustrates to everyone who communicates with whom, how the control system works, who is in control, who has authority and above all, who is responsible. It explains how the organisation is co-ordinated and how individual departments relate. Formal structures are often based on specific tasks, and it is how these tasks are allocated and the authority which they carry which is explained by the organisational structure.
A business organisation may be structured in many different ways, depending upon the environment within which it operates. Traditionally, the structure — and therefore the communication process — is based upon individual departments, although more and more organisations now see the product and the market as more fundamental to structure than individual departments. There are, however, always problems with any communication system. Traditional organisations based on departments often tend to be bureaucratic and slow in distributing information, whilst organisations which are informal and often more aware of the external environment sometimes lack the formality and control of the traditional organisation.
In more formal organisations, especially accounting practices, the organisation chart defines the way that communication and work flows through the organisation. The typical organisation chart assumes a hierarchical structure, reflecting communication flowing downwards from top management to the departments further down the organisation. But of course communication also flows in reverse, instructions received from above have to be acted upon and reported. However, in many modern organisations where conventional communication structures either do not exist or are less formal, communication tends to be horizontal between individuals and departments, rather than the upward or downward flow assumed by so many to be the normal case. Whichever structure is adopted, problems of communication will always occur.
There are, of course, other forms of communication. Teams are very much a modern form, but the role of the committee is still important, again especially within the formal structures of accounting. This is, of course, why committees are still important; because of their formality. Unlike teams (which are often established to tackle individual problems or projects), committees are often permanent, have authority and provide a fixed opportunity to resolve conflict and promote cooperation between departments. They follow well established procedures and provide a well tried way of resolving difficult decisions because all individuals and departments are formally involved in the decision-making process.
Internal communication is not the only form of communication. All organisations interact with the environment, and in people management terms a particular and unique form of external communication arises when new employees are required. How are new employees found? Specialists, such as accountants, may be sought through advertising in specific professional journals, whilst unskilled production operators might be sought through the local employment system or government agency. Whatever new employees are required or whatever recruitment medium is used, the recruiting organisation must ensure that information about the vacancy is clear, concise and positive — and that the organisation itself knows what it requires of the new employee. Employees cost a great deal of money, and if the communication is incorrect or inappropriate the wrong employee can be expensive!

How to approach performance appraisal questions

noreply@blogger.com (Unknown) — Wed, 8 Sep 2010 23:30:00 -0700

How to approach performance appraisal questions

by Steve Scott

28 Apr 2004

Performance appraisal is an important topic in Paper 2.5, Financial Reporting. It has been the subject of many past examination questions and will continue to be examined on a regular basis. This article is intended to give candidates some guidance as to what is expected from a good answer and how to approach such questions. The scenario of a performance appraisal question can take many forms.

Vertical or trend analysis

A company's performance may be compared to its previous period's performance. Past results may be adjusted for the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is that there are no independent benchmarks to determine whether the chosen company's current year results are good or bad. Just because a company's results in say 2003 are better than its results in 2002 - it does not mean the 2003 results are good. It may be that its results in 2002 were particularly poor.

Horizontal analysis

To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.

Industry average comparison

This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company.

The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company's results.

Question scenarios

Most questions on this topic in Paper 2.5 have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many 'clues' in the question - ignore them at your peril. Examples of such circumstance include:

Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:

• goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)

• a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office

• loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

• a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation

• entering into debtor factoring (the sale of debtors to a finance house). This would obviously reduce debtor collection periods, but this would not be through improved credit control procedures

• a general revaluation of fixed assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any

real change in operating capacity or profitability

• a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

Most performance appraisal is based on interpreting various comparative ratios. Questions may vary in their approach, but in most questions there are some marks available for calculating ratios. Some questions will leave it for you to decide which ratios to calculate, other questions may specify which ratios have to be calculated. However, some questions may give you the ratios such that all the marks are for the analysis and interpretation of them. Another common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. Even in questions where there are marks available for calculating ratios, the majority of marks will still be for their interpretation.

Lack of interpretation/analysis

By far the most common complaint by markers is that candidates' comments explaining the movement or differences in reported ratios lack any depth or commercial understanding. A typical comment may be that debtor collection has improved from 60 days to 40 days. Such a comment does not constitute interpretation - it is a statement of fact. To say a ratio has gone up or down is not helpful or meaningful.

What is required from a good answer are the possible reasons as to why the ratio has changed. There may be many reasons why a ratio has changed and no-one can be certain as to exactly what has caused the change. All that is required are plausible explanations for the changes. Even if they are not the actual cause, marks will be awarded. There is no single correct answer to an interpretation question, and remember there may be clues in the scenario that would account for some of the changes in the ratios.

Examination approach

In an examination there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful where the question does not specify which ratios to calculate:

• limit calculations to important areas and avoid duplication (eg stock turnover and stock holding periods)

• it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them

• often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional fixed assets have been purchased without a proportionate increase in sales).

How to approach performance appraisal questions

noreply@blogger.com (Unknown) — Sun, 15 Aug 2010 08:43:00 -0700

How to approach performance appraisal questions

by Steve Scott

Vertical or trend analysis

Horizontal analysis
To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.
Industry average comparison
This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company.
The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company's results.
Question scenarios
Most questions on this topic in Paper 2.5 have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many 'clues' in the question - ignore them at your peril. Examples of such circumstance include:
Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:

goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)
a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office
loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation
entering into debtor factoring (the sale of debtors to a finance house). This would obviously reduce debtor collection periods, but this would not be through improved credit control procedures
a general revaluation of fixed assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any
real change in operating capacity or profitability
a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

The possibilities of what might have happened are almost infinite, but what is important is that where the scenario describes events such as those described above, you take them into consideration when preparing your answer.
Most performance appraisal is based on interpreting various comparative ratios. Questions may vary in their approach, but in most questions there are some marks available for calculating ratios. Some questions will leave it for you to decide which ratios to calculate, other questions may specify which ratios have to be calculated. However, some questions may give you the ratios such that all the marks are for the analysis and interpretation of them. Another common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. Even in questions where there are marks available for calculating ratios, the majority of marks will still be for their interpretation.
Lack of interpretation/analysis
By far the most common complaint by markers is that candidates' comments explaining the movement or differences in reported ratios lack any depth or commercial understanding. A typical comment may be that debtor collection has improved from 60 days to 40 days. Such a comment does not constitute interpretation - it is a statement of fact. To say a ratio has gone up or down is not helpful or meaningful.
What is required from a good answer are the possible reasons as to why the ratio has changed. There may be many reasons why a ratio has changed and no-one can be certain as to exactly what has caused the change. All that is required are plausible explanations for the changes. Even if they are not the actual cause, marks will be awarded. There is no single correct answer to an interpretation question, and remember there may be clues in the scenario that would account for some of the changes in the ratios.
Examination approach
In an examination there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful where the question does not specify which ratios to calculate:

limit calculations to important areas and avoid duplication (eg stock turnover and stock holding periods)
it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them
often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional fixed assets have been purchased without a proportionate increase in sales).

Suggested structure to a typical answer
Comment on company performance in the following areas:

profitability and asset utilisation
liquidity (look for overtrading)
gearing and security of borrowings
prepare a cash flow statement - if specifically requested.

Profitability
The primary measure of profitability is normally considered to be the Return on Capital Employed (ROCE):
(Profit before interest and tax/shareholders funds plus long-term borrowings) x 100
This is probably the most important single ratio, but it is open to manipulation. Secondary ratios indicate why the ROCE has changed:

Gross and net profit margin %:
Profit (gross or net)/sales x 100
Asset utilisation: sales/net assets

For example, an improvement in the ROCE is either because of improved margins or better use of assets. Increases may be due to increases in selling prices or reductions in manufacturing (or purchased) costs. They may also be caused by changes in sales mix or stocktaking errors. A change in the net profit margin is a measure of how well a company has controlled overheads. The asset utilisation ratio (sales/net assets) shows how efficiently the assets are being used.
Liquidity
Current ratio: current assets/current liabilities. Ideally it is thought that this should be between 1.5 and 2 to 1, but it can vary depending upon the market sector (eg retailers have relatively few debtors so the current, and quick, ratios may be meaningless for such businesses).
Quick ratio (or acid test): current assets less stock/current liabilities. This is expected to be at parity, ie 1 to 1. If the above liquidity ratios appear to be outside 'normal ranges' further investigation is required and stock, debtors, and creditor ratios should be looked at. These ratios can be calculated either as time periods (eg 'days') or as turnovers.
Debtor's collection period (in days): (trade debtors/credit sales) x 365
Stock turnover: cost of sales/(average or closing) stock
Creditor's payment period (in weeks): (trade creditors/purchases on credit*) x 52
*Note: you may have to use cost of sales if purchases figure is not available.
Comments on the above ratios
Debtor's collection period - when too high, it may be that some bad debts have not been provided for, or an indication of worsening credit control. It may also be deliberate, eg the company has decided to offer three months' credit in the current year, instead of two as in previous years. It may do this to try to stimulate higher sales.
Stock turnover - generally the higher this is, the better. If it is low, it may be an indication of obsolete stock or poor sales achievement. Sales may have fallen (perhaps due to an economic recession), but the company has been slow to cut back on production, resulting in a build up of stock levels.
Creditor payment period - if this is low, creditors are being paid relatively early or there may be unrecorded creditors. Although the credit period may represent a source of 'free' borrowing, if it is too high it may be an indication of poor liquidity (perhaps at the overdraft limit), and there may be a danger of further or renewed credit being refused by suppliers.
Liquidity problems may also be caused by 'overtrading'. In some ways this is a symptom of the success of the business. It is usually a lack of adequate financing and may be solved by an injection of capital.
Gearing
This is a far more important ratio than most candidates seem to be aware of. Company directors often spend a great deal of time and money to make this ratio appear in line with acceptable levels.
Its main importance is that as borrowings rise, risk increases (in many ways) and as such, further borrowing is difficult and expensive. Many companies have limits to the amount of borrowings they are permitted to have. These may be in the form of debt covenants imposed by lenders or they may be contained in a company's Articles, such as a multiple of shareholders funds.
Measures of gearing
Gearing is basically a comparison of debt to equity. Preference shares are usually treated as debt for this purpose. There are two alternatives: Debt/equity or Debt/debt + equity.
In any comparison of gearing it is important to use the same basis to calculate the gearing percentage in order for any interpretation to be meaningful. A question often asked is what level should a company's gearing be? There is no easy answer to this - a lot will depend on the nature of the industry and composition of the balance sheet assets. For example, companies with large property portfolios often have high levels of gearing without it troubling investors. But companies that have large amounts of intangible assets are not considered to have a desirable type of security to support large borrowings. It is important that the effect of debt is understood.
Example 1
Realm plc is financed by £5 million 10% preference shares, and £5 million equity.
Calculate the return to each provider of finance if Realm plc's profits are:

£1 million
£1.3 million
£700,000

Answer

	£000	£000	£000
	i	ii	iii
Profit	1,000	1,300	700
		(+30%)	(-30%)
Preference shareholders	500	500	500
Equity shareholders	500	800	200
% return on equity	10%	16%	4%
		(+60%)	(-60%)

Note that when profits increase by 30%, the increase in the return to equity shareholders is double this increase (a 16% return is 60% higher than a 10% return). However, the down side is that when profits fall by 30%, the reverse applies. The existence of debt increases the risks (favourable and unfavourable) to the equity shareholders. By contrast, the return to preference shareholders is 10% at all levels profit.
Investment Ratios
Earnings per share
In isolation, this ratio is meaningless for inter-company comparisons. Its major usefulness is as part of the P/E ratio, and as a measure of profit trends.
Price/earnings ratio
This is calculated by dividing a company's (stock) market price by its EPS. Say the price of a company's shares is £2.40, and its last reported EPS was 20p. It would have a P/E ratio of 12. The mechanics of the movement of a company's P/E ratio are complex, but if this company's EPS improved to 24p in the following year, it would not mean that its P/E ratio would be calculated as 10 (£2.40/24p). It is more likely that its share price would increase such that it maintained or even improved its P/E ratio. If the share price increased to say £2.88, the P/E ratio would remain at 12 (£2.88/24p). This demonstrates the real importance of EPS in the way it has a major influence on a company's share price.
Earning yield
This is a relatively 'old' ratio which has been superseded by the P/E ratio. It is in fact its reciprocal. Earnings yield is the EPS/share price x 100. In the above example, a P/E ratio of 12 would be equivalent to an earnings yield of 8.3%.
Dividend yield
This is similar to the above except that the dividend per share is substituted for the EPS. It is a crude measure of the return to shareholders, but it does ignore capital growth which is often much higher than the return for dividends.
Dividend cover
This is the number of times the current year's dividend could have paid out of the current year's profit available to ordinary shareholders. It is a measure of security. A high figure indicates high levels of security. In other words, profits in future years could fall substantially and the company would still be able to pay the current level of dividends. An alternative view of a high dividend cover is that it indicates that the company operates a low dividend distribution policy.
Example 2
Realm plc has 5 million ordinary shares of 25p each in issue. The stock market price of the shares just before its year end is £3.00 each. The dividend yield for companies in the same sector as Realm plc is 5%. Realm plc has paid an interim dividend of £200,000, and its profit after tax is £1,250,000.
Required, calculate:

the final dividend (in pence per share) to be declared such that Realm plc's dividend yield would equal its market sector
Realm plc's P/E ratio
Realm plc's dividend cover.

Answer

A dividend yield of 5% of a share price of £3.00 would be achieved if total dividends for the period were 15p ((15/300) x 100 = 5%). An interim dividend of £200,000 on 5 million shares would be 4p per share. Thus the final dividend would need to be 11p per share.
Profits of £1,250,000 on 5 million shares gives an EPS of 25p (£1,250,000/5 million). The P/E ratio would be calculated as 12 (300p/25p)
Dividends of 15p per share from earnings of 25p per share would give a dividend cover of 1.67 times (25p/15p).

In conclusion, candidates may be required to explain the weaknesses or limitations of ratio analysis. As a summary, it may be useful to read and work through a question from a recent Paper 2.5 examination. The first section of the answer deals with the limitations of ratios.
Example 3
Comparator assembles computer equipment from bought in components and distributes them to various wholesalers and retailers. It has recently subscribed to an inter-firm comparison service. Members submit accounting ratios as specified by the operator of the service, and in return, members receive the average figures for each of the specified ratios taken from all of the companies in the same sector that subscribe to the service. The specified ratios and the average figures for Comparator's sector are shown overleaf.

Ratios of companies reporting a full year's results for periods ended between 1 July 2003 and 30 September 2003

Return on capital employed	22.1%
Net assets turnover	1.8 times
Gross profit margin	30%
Net profit (before tax) margin	12.5%
Current ratio	1.6:1
Quick ratio	0.9:1
Stock holding period	46 days
Debtors' collection period	45 days
Creditors' payment period	55 days
Debt to equity	40%
Dividend yield	6%
Dividend cover	3 times

Comparator's financial statements for the year to 30 September 2003 are set out below:

Profit and loss account	£000
Turnover	2,425
Cost of sales	(1,870)
Gross profit	555
Other operating expenses	(215)
Operating profit	340
Interest payable	(34)
Exceptional item (note (ii))	(120)
Profit before taxation	186
Taxation	(90)
Profit after taxation	96
Dividends	(90)
Net profit for the period	6
Profit and loss reserve - 1 October 2002	179
Profit and loss reserve - 30 September 2003	185

Balance Sheet	£000	£000
Fixed assets (note i)		540

Current Assets
Stock	275
Debtors	320
Bank	nil
	595

Creditors: amounts falling due within one year
Bank overdraft	35
Trade creditors	350
Proposed dividends	30
Taxation	85
	(500)	95

Creditors: amounts falling due after more than one year
8% loan notes		(300)
		335

Share Capital and Reserves
Ordinary shares (25p each)		150
Profit and loss account reserve		185
		335

Notes

The details of the fixed assets are:

	Cost £000	Accumulated depreciation £000	Net book value £000
At 30 Sept 2003	3,600	3,060	540

The exceptional item relates to losses on the sale of a batch of computers that had become worthless due to improvements in microchip design.
The market price of Comparator’s shares throughout the year averaged £6.00 each.

Required:

Explain the problems that are inherent when ratios are used to assess a company's financial performance. Your answer should consider any additional problems that may be encountered when using inter-firm comparison services such as that used by Comparator (7 marks).
Calculate ratios for Comparator equivalent to those provided by the inter-firm comparison service (6 marks).
Write a report analysing the financial performance of Comparator based on a comparison with the sector averages (12 marks).
25 marks

Answer

Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years' ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are:

Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example, return on capital employed is materially affected by revaluations of fixed assets. Comparing this ratio for two companies where one has revalued its fixed assets and the other carries fixed assets at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, stock valuation policies etc.
Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debtor factoring. If one company collects its debts in the normal way, then the calculation of debtor days would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its debtors (ie 'sell' them to a finance company) then the calculation of its debtor days would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as an operating lease rather than a finance lease.
Balance sheet averages: many ratios are based on comparing profit and loss account items with balance sheet items. The above ratio of debtor's days would be a good example. For such ratios to be meaningful, it is necessary to assume that the year-end balance sheet figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example, the level of debtors and stock of a toy manufacturer could vary largely due to the nature of its seasonal trading.
Inflation can distort comparisons over time.
The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also, where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of exceptional items and finance costs.
The use of norms can be misleading. A desirable range for the current ratio may be between 1.5 and 2:1, but all businesses are different. This would be a very high ratio for a supermarket (with few debtors), but a low figure for a construction company (with high levels of work in progress).
Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

They are themselves averages and may incorporate large variations in their composition. Some inter-firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this.
It may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different.
Companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures.
The year-end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

b. Refer to Figure 1 on page 52.
c. Analysis of Comparator's financial performance compared to the sector average for the period to 30 September 2003:
To:
From: A N Allison
Date:

Figure 1: Calculation of specified ratios

	Comparator	Sector average
Return on capital employed ((186 + 34 loan interest/635)	34.6%	22.1%
Net assets turnover (2,425/635)	3.8 times	1.8 times
Gross profit margin (555/2,425 x 100)	22.9%	30%
Net profit (excluding exceptionals) margin (306/2,425 x 100)	12.6%	not available
Net profit (before tax) margin (186/2,425 x 100)	7.7%	12.5%
Current ratio (595/500)	1.19:1	1.6:1
Quick ratio (320/500)	0.64:1	0.9:1
Stock holding period (275/1,870 x 365)	54 days	46 days
Debtors' collection period (320/2,425 x 365)	48 days	45 days
Creditor payment period (350/1,870 x 365)(based on cost of sales)	68 days	55 days
Debt to equity (300/335 x 100)	90%	40%
Dividend yield (see below)	2.5%	6%
Dividend cover (96/90)	1.07 times	3 times

The workings are in £000 (unless otherwise stated) and are for Comparator's ratios.
The dividend yield is based on a dividend per share figure of 15p (£90,000/(150,000 x 4)) and a share price of £6.00. Thus the yield is 2.5% (15p/£6.00 x 100%).
Operating performance
The return on capital employed of Comparator is impressive being more than 50% higher than the sector average. The components of the return on capital employed are the asset turnover and profit margins. In these areas, Comparator's asset turnover is much higher (nearly double) than the average, but the net profit margin after exceptionals is considerably below the sector average. However, if the exceptionals are treated as one off costs and excluded, Comparator's margins are very similar to the sector average.
This short analysis seems to imply that Comparator's superior return on capital employed is due entirely to an efficient asset turnover (ie Comparator is making its assets work twice as efficiently as its competitors). A closer inspection of the underlying figures may explain why its asset turnover is so high. It can be seen from the note to the balance sheet that Comparator's fixed assets appear quite old. Their net book value is only 15% of their original cost. This has at least two implications: they will need replacing in the near future and the company is already struggling for funding; and their low net book value gives a high figure for asset turnover. Unless Comparator has underestimated the life of its assets in its depreciation calculations, its fixed assets will need replacing in the near future. When this occurs its asset turnover and return on capital employed figures will be much lower. This aspect of ratio analysis often causes problems and to counter this anomaly some companies calculate the asset turnover using the cost of fixed assets rather than their net book value as this gives a more reliable trend. It is also possible that Comparator is using assets that are not on its balance sheet. It may be leasing assets that do not meet the definition of finance leases and thus the assets and corresponding obligations have not been recognised on the balance sheet.
A further issue is which of the two calculated margins should be compared to the sector average (ie including or excluding the effects of the exceptionals). The gross profit margin of Comparator is much lower than the sector average. If the exceptional losses were taken in at trading account level, which they should be as they relate to obsolete stock, Comparator's gross margin would be even worse.
As Comparator's net margin is similar to the sector, it would appear that Comparator has better control over its operating costs. This is especially true as the other element of the net profit calculation is finance costs, and as Comparator has much higher gearing than the sector average, one would expect Comparator's interest to be higher than the sector average.
Liquidity
Here Comparator shows real cause for concern. Its current and quick ratios are much worse than the sector average, and indeed far below expected norms. Current liquidity problems appear to be due to high levels of trade creditors and a high bank overdraft. The high levels of stock are also noteworthy and they may be indicative of further obsolete stock (the exceptional item is due to obsolete stock). The debtors' collection figure is reasonable, but at 68 days, Comparator takes longer to pay its creditors than do its competitors. While this is a source of 'free' finance, it can damage relations with suppliers and may lead to a curtailment of further credit.
Gearing
As referred to above, gearing (as measured by debt/equity) is more than twice the level of the sector average. While this may be an uncomfortable level, it is currently beneficial for shareholders. The company is making an overall return of 34.6%, but only paying 8% interest on its loan notes. The level of gearing may become a serious issue if Comparator becomes unable to maintain the finance costs. The company already has an overdraft and the ability to make further interest payments could be in doubt.
Investment ratios
Despite reasonable profitability figures, Comparator's dividend yield is poor compared to the sector average. From the profit and loss account it can be seen that total dividends are £90,000 out of available profit for the year of only £96,000 (hence the very low dividend cover). It can also be noted that the interim dividend must have been £60,000 as the proposed dividend is only £30,000. Perhaps this indicates a worsening performance during the year, as normally final dividends are higher than interim dividends. Considering these factors, it is surprising the company's share price is holding up so well.
Summary
The company compares favourably with the sector average figures for profitability. However, Comparator's liquidity and gearing position is quite poor and gives cause for concern. If it is to replace its old fixed assets in the near future, it will need to raise further finance. With already high levels of borrowing and poor dividend yields, this may become a serious problem for Comparator.
Yours faithfully
A N Allison
Steve Scott is examiner for Paper 2.5

How to approach performance appraisal questions

noreply@blogger.com (Unknown) — Sun, 15 Aug 2010 08:43:00 -0700

How to approach performance appraisal questions

by Steve Scott

Vertical or trend analysis

goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)
a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office
loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation
entering into debtor factoring (the sale of debtors to a finance house). This would obviously reduce debtor collection periods, but this would not be through improved credit control procedures
a general revaluation of fixed assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any
real change in operating capacity or profitability
a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

limit calculations to important areas and avoid duplication (eg stock turnover and stock holding periods)
it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them
often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional fixed assets have been purchased without a proportionate increase in sales).

Suggested structure to a typical answer
Comment on company performance in the following areas:

profitability and asset utilisation
liquidity (look for overtrading)
gearing and security of borrowings
prepare a cash flow statement - if specifically requested.

Gross and net profit margin %:
Profit (gross or net)/sales x 100
Asset utilisation: sales/net assets

£1 million
£1.3 million
£700,000

Answer

	£000	£000	£000
	i	ii	iii
Profit	1,000	1,300	700
		(+30%)	(-30%)
Preference shareholders	500	500	500
Equity shareholders	500	800	200
% return on equity	10%	16%	4%
		(+60%)	(-60%)

the final dividend (in pence per share) to be declared such that Realm plc's dividend yield would equal its market sector
Realm plc's P/E ratio
Realm plc's dividend cover.

Answer

A dividend yield of 5% of a share price of £3.00 would be achieved if total dividends for the period were 15p ((15/300) x 100 = 5%). An interim dividend of £200,000 on 5 million shares would be 4p per share. Thus the final dividend would need to be 11p per share.
Profits of £1,250,000 on 5 million shares gives an EPS of 25p (£1,250,000/5 million). The P/E ratio would be calculated as 12 (300p/25p)
Dividends of 15p per share from earnings of 25p per share would give a dividend cover of 1.67 times (25p/15p).

Ratios of companies reporting a full year's results for periods ended between 1 July 2003 and 30 September 2003

Return on capital employed	22.1%
Net assets turnover	1.8 times
Gross profit margin	30%
Net profit (before tax) margin	12.5%
Current ratio	1.6:1
Quick ratio	0.9:1
Stock holding period	46 days
Debtors' collection period	45 days
Creditors' payment period	55 days
Debt to equity	40%
Dividend yield	6%
Dividend cover	3 times

Comparator's financial statements for the year to 30 September 2003 are set out below:

Profit and loss account	£000
Turnover	2,425
Cost of sales	(1,870)
Gross profit	555
Other operating expenses	(215)
Operating profit	340
Interest payable	(34)
Exceptional item (note (ii))	(120)
Profit before taxation	186
Taxation	(90)
Profit after taxation	96
Dividends	(90)
Net profit for the period	6
Profit and loss reserve - 1 October 2002	179
Profit and loss reserve - 30 September 2003	185

Balance Sheet	£000	£000
Fixed assets (note i)		540

Current Assets
Stock	275
Debtors	320
Bank	nil
	595

Creditors: amounts falling due within one year
Bank overdraft	35
Trade creditors	350
Proposed dividends	30
Taxation	85
	(500)	95

Creditors: amounts falling due after more than one year
8% loan notes		(300)
		335

Share Capital and Reserves
Ordinary shares (25p each)		150
Profit and loss account reserve		185
		335

Notes

The details of the fixed assets are:

	Cost £000	Accumulated depreciation £000	Net book value £000
At 30 Sept 2003	3,600	3,060	540

The exceptional item relates to losses on the sale of a batch of computers that had become worthless due to improvements in microchip design.
The market price of Comparator’s shares throughout the year averaged £6.00 each.

Required:

Explain the problems that are inherent when ratios are used to assess a company's financial performance. Your answer should consider any additional problems that may be encountered when using inter-firm comparison services such as that used by Comparator (7 marks).
Calculate ratios for Comparator equivalent to those provided by the inter-firm comparison service (6 marks).
Write a report analysing the financial performance of Comparator based on a comparison with the sector averages (12 marks).
25 marks

Answer

Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years' ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are:

Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example, return on capital employed is materially affected by revaluations of fixed assets. Comparing this ratio for two companies where one has revalued its fixed assets and the other carries fixed assets at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, stock valuation policies etc.
Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debtor factoring. If one company collects its debts in the normal way, then the calculation of debtor days would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its debtors (ie 'sell' them to a finance company) then the calculation of its debtor days would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as an operating lease rather than a finance lease.
Balance sheet averages: many ratios are based on comparing profit and loss account items with balance sheet items. The above ratio of debtor's days would be a good example. For such ratios to be meaningful, it is necessary to assume that the year-end balance sheet figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example, the level of debtors and stock of a toy manufacturer could vary largely due to the nature of its seasonal trading.
Inflation can distort comparisons over time.
The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also, where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of exceptional items and finance costs.
The use of norms can be misleading. A desirable range for the current ratio may be between 1.5 and 2:1, but all businesses are different. This would be a very high ratio for a supermarket (with few debtors), but a low figure for a construction company (with high levels of work in progress).
Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

They are themselves averages and may incorporate large variations in their composition. Some inter-firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this.
It may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different.
Companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures.
The year-end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

b. Refer to Figure 1 on page 52.
c. Analysis of Comparator's financial performance compared to the sector average for the period to 30 September 2003:
To:
From: A N Allison
Date:

Figure 1: Calculation of specified ratios

	Comparator	Sector average
Return on capital employed ((186 + 34 loan interest/635)	34.6%	22.1%
Net assets turnover (2,425/635)	3.8 times	1.8 times
Gross profit margin (555/2,425 x 100)	22.9%	30%
Net profit (excluding exceptionals) margin (306/2,425 x 100)	12.6%	not available
Net profit (before tax) margin (186/2,425 x 100)	7.7%	12.5%
Current ratio (595/500)	1.19:1	1.6:1
Quick ratio (320/500)	0.64:1	0.9:1
Stock holding period (275/1,870 x 365)	54 days	46 days
Debtors' collection period (320/2,425 x 365)	48 days	45 days
Creditor payment period (350/1,870 x 365)(based on cost of sales)	68 days	55 days
Debt to equity (300/335 x 100)	90%	40%
Dividend yield (see below)	2.5%	6%
Dividend cover (96/90)	1.07 times	3 times

Relevant costs for decision-making

noreply@blogger.com (Unknown) — Thu, 15 Jul 2010 04:09:00 -0700

Relevant costs for decision-making

by Bev Jay
27 May 2004

Commercial organisations usually make decisions with the objective of maximising the present value of future cash flows. In order to ensure that the right opportunities are taken to do this, we need to be able to measure the relevant costs for decision-making. In examination questions (unlike real life) we can assume that future costs and benefits are known with certainty and therefore we only have to apply the principles correctly.

What is a relevant cost or benefit?
A relevant cost or benefit is one that will be affected by the decision. This means that the following can be disregarded as they are irrelevant in the decision-making process:

Fixed overheads. These will be incurred regardless of the decision.
Notional costs. For example, notional rent - these costs are only a book exercise and do not represent a real cash flow.
Past or sunk costs. These have already happened, so they cannot be affected by a future decision. It is vital to note that relevant costs are always future costs.
Book values. Similar to sunk costs. For example, the price paid for stock in the past is not a relevant cost to the decision.

Many of the above are included in examination questions and should be rejected by candidates. It is important to state that they are not relevant for decision-making rather than to simply omit them. Marks are often available for this information.
Opportunity costs
A company often has a choice of options. For example, does it choose to use a scarce resource for Contract A instead of Contract B? If it does choose Contract A then Contract B will be deprived of the resource that could have generated a contribution for the company. This is an example of an opportunity cost, a relevant cost for decision-making. By definition, an opportunity cost is one which measures the cost of sacrificing one course of action in favour of another.
In examination questions, the more difficult aspects of a question include opportunity costs. It is important that candidates take their time and employ a logical approach in order to gain maximum marks.
The examination approach
Using the data in the illustration below, we can now apply the above principles in the manner expected by the examiner. It is vital that during the examination your work is clear, cross-referenced, and logical. Markers seek out marks to the best of their ability. However, this is difficult if markers are presented with illegible scribbles and calculations which are not referenced.
Always read the question carefully and make sure that you are comfortable with the requirement. In this illustration you are required to show all the relevant costs in a cost schedule and more importantly you are also required to explain why the costs are relevant. It is logical to deal with each of the costs separately, using the headings given in the illustration. For each cost element, summarise in your own words what the note is telling you before you pronounce a cost as relevant or otherwise.
Illustration
The managing director of Parser Limited, a small business, is considering undertaking a one-off contract. She has asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a profit. The following schedule has been prepared:

Costs for special order	Notes	£
Direct wages	1	28,500
Supervisor costs	2	11,500
General overheads	3	4,000
Machine depreciation	4	2,300
Machine overheads	5	18,000
Materials	6	34,000
		98,300

Notes

Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job. They could be transferred from another department to undertake the work on the special order. They are fully occupied in their usual department and sub-contracting staff would have to be brought in to undertake the work left behind.
Sub-contracting costs would be £32,000 for the period of the work. Other sub-contractors who are skilled in the special order techniques are also available to work on the special order. The costs associated with this would amount to £31,300.
A supervisor would have to work on the special order. The cost of £11,500 is made up of £8,000 normal payments plus a £3,500 additional bonus for working on the special order. Normal payments refer to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his normal work amounting to £2,500. It is not anticipated that any replacement costs relating to the supervisors' work on other jobs would arise.
General overheads comprise an apportionment of £3,000 plus an estimate of £1,000 incremental overheads.
Machine depreciation represents the normal period cost, based on the duration of the contract. It is anticipated that £500 will be incurred in additional machine maintenance costs.
Machine overheads (for running costs such as electricity) are charged at £3 per hour. It is estimated that 6,000 hours will be needed for the special order. The machine has 4,000 hours available capacity. The further 2,000 hours required will mean an existing job is taken off the machine resulting in a lost contribution of £2 per hour (before overheads are charged)
Materials represent the purchase costs of 7,500kg bought some time ago. The materials are no longer used and are unlikely to be wanted in the future except for the special order. The complete stock of materials (amounting to 10,000kg), or part thereof, could be sold for £4.20 per kg. The replacement cost of material used would be £33,375.

Because the business does not have adequate funds to finance the special order, a bank overdraft of £20,000 would be required for the project duration of three months. The overdraft would be repaid at the end of the period. The company uses a cost of capital of 20% to appraise projects. The bank's overdraft rate is 18%.

The managing director has heard that for special orders such as this, relevant costing should be used that also incorporates opportunity costs. She has approached you to create a revised costing schedule based on relevant costing principles.

Required
Produce a revised costing schedule for the special project based on relevant costing principles. Fully explain and justify each of the costs included in the costing schedule.

Direct wages
Summary: There are two options. We can take the workers from their usual department, where it would cost £32,000 to replace them. Or we could hire sub-contractors to do the special order at a cost of £31,300.
Both of these costs are future costs that will be affected by the decision and are therefore relevant. The choice between the two alternatives is relatively straightforward - either incur a £32,000 cost or a £31,300 cost. As an accountant you will want to minimise costs and will choose to hire the sub-contractors at £31,300.
Supervisor costs
Summary: The supervisor's normal salary is £8,000 and this will be paid whether or not we take on the special contract. This is a fixed cost to the business and is unaffected by the decision. However, the £3,500 additional bonus is relevant as it is dependent on the decision to take the special contract. In addition, if we take the special contract we will not have to pay the £2,500 incentive payment. Therefore, the net relevant cost to the business is £3,500 less £2,500 = £1,000.
General overheads
Summary: Regardless of the decision, general fixed overheads remain constant. The apportioned rent, rates, power etc, will be incurred whether the special contract is undertaken or not. Therefore, these are not relevant costs and can be ignored for decision-making purposes. However, incremental overheads are extra overheads, incurred as a direct result of undertaking the special project. These could include additional costs for power or premises. They are relevant costs to the project of £1,000.
Machine depreciation
Summary: The machine depreciation has been charged at £2,300 which is what the accountant would normally charge for depreciation for this period of time. The accountant will charge this time-based depreciation if we use the machine for the special contract and also if we do not. It is only a book value and does not represent a true cash flow to the business. Therefore it is not a relevant cost. However, if we do take the special contract and use the machine, we will incur maintenance costs of £500. These future costs are a direct result of the decision and should be included within the costs.
Machine overheads
Summary: Taking the special contact will mean that the machine will run for 6,000 hours and as each hour incurs a running cost of £3, the relevant future cost will be £18,000. In addition, there is an opportunity cost. If we choose to take the contract we will have to choose not to work on an existing job as machine hours are a scarce resource and we only have enough hours free to do one job. Therefore, a relevant cost to the special contract will be the benefit forgone from choosing the special contract over the existing job. This cost if the lost contribution of £2 per hour for 2,000 hours. We will lose £4,000 contribution is we take the special contract. The total relevant cost therefore is £18,000 plus £4,000 = £22,000.
Materials
Summary: The 7,500kg of materials is already in stock. We do not know how much it cost and if we did it would not be useful as this is a sunk cost and therefore irrelevant. Neither is the replacement cost of £33,375 relevant as it is not a future cost that will be incurred as a result of the decision (if we already have it we will not need to buy it). However, this would be relevant if the material was in constant use by the company.
There is an opportunity cost, as we have two courses of action to choose from. We can either use the material for the special contract or we can sell it and receive £4.20 per kg. The relevant cost is 7,500 x £4.20 = £31,500 as this represents the benefit sacrificed by choosing to take the contract rather than selling the materials.
Overdraft interest
Summary: If the company chooses to undertake the special project it will incur finance charges for the three month duration. This is a future cost due to the decision being made and therefore should be included as a relevant cost. £20,000 x 18% x 3/12 = £900.

Revised cost schedule for the special contract

Costs for special order	Notes	£
Direct wages	1	31,300
Supervisor costs	2	1,000
General overheads	3	1,000
Machine depreciation	4	500
Machine overheads	5	22,000
Materials	6	31,500
Interest charges	7	900
		88,200

We have now worked through an entire exam standard question answering it in a format that will maximise the marks awarded. In the examination, candidates may feel less confident of their ability, but it is important to follow the above layout to produce a well-organised and logical answer.
Bev Jay is a marker for CAT Paper 7

Performance measurement

noreply@blogger.com (Unknown) — Thu, 15 Jul 2010 04:09:00 -0700

Performance measurement

by Steve Jay
08 Apr 2004

The new CAT Paper 7 contains much more detail on performance measurement than the old Paper C2. This article considers some of the performance measures introduced in the new syllabus.

Decentralisation and the need for performance measurement
Decentralisation is the delegation of decision-making responsibility. All organisations decentralise to some degree, some do it more than others. Decentralisation is a necessary response to the increasing complexity of the environment that organisations face and the increasing size of most organisations. Nowadays it would be impossible for one person to make all the decisions involved in the operation of even a small company, hence senior managers delegate decision-making responsibility to subordinates.
One danger of decentralisation is that managers may use their decision-making freedom to make decisions that are not in the best interests of the overall company (so called dysfunctional decisions). To redress this problem, senior managers generally introduce systems of performance measurement to ensure - among other things - that decisions made by junior managers are in the best interests of the company as a whole. Example 1 details different degrees of decentralisation and typical financial performance measures employed.
Example 1

Responsibility structure	Manager's area of responsibility	Typical financial performance measure
Cost centre	Decisions over costs	Standard costing variances
Profit centre*	Decisions over costs and revenues	Controllable profit
Investment centre*	Decisions over costs, revenues, and assets	Return on investment and residual income

* These two structures are often referred to as divisions - divisionalisation refers to the delegation of profit-making responsibility.
What makes a good performance measure?
A good performance measure should:

provide incentive to the divisional manager to make decisions which are in the best interests of the overall company (goal congruence)
only include factors for which the manager (division) can be held accountable
recognise the long-term objectives as well as short-term objectives of the organisation.

Traditional performance indicators
Cost centres
Standard costing variance analysis is commonly used in the measurement of cost centre performance. It gives a detailed explanation of why costs may have departed from standard. Although commonly used, it is not without its problems. It focuses almost entirely on short-term cost minimisation which may be at odds with other objectives, for example, quality or delivery time. Also, it is important to be clear about who is responsible for which variance - is the production manager or the purchasing manager (or both) responsible for raw material price variances? There is also the problem with setting standards in the first place - variances can only be as good as the standards on which they are based.
Profit centres
Controllable profit statements are commonly used in profit centres. A proforma statement is given in Example 2.
Example 2: Controllable profit statement

		£	£
Sales	(external)	XXX
	(internal)	XXX
			XXX
Controllable divisional variable costs			(XXX)
Controllable divisional fixed costs			(XXX)
Controllable divisional profit			XXX
Other traceable divisional variable costs			(X)
Other traceable divisional fixed costs			(XXX)
Traceable divisional profit			XXX
Apportioned head office cost			(XXX)
Net profit			XXX

The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing the performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division.
Investment centres
In an investment centre, managers have the responsibilities of a profit centre plus responsibility for capital investment. Two measures of divisional performance are commonly used:
1 Return on investment (ROI) =
controllable (traceable) profit %
controllable (traceable) investment
2 Residual income = controllable (traceable) profit - an imputed interest charge on controllable (traceable) investment.
Example 3 demonstrates their calculation and some of the drawbacks of return on investment.

Example 3
Division X is a division of XYZ plc. Its net assets are currently £10m and it earns a profit of £2.2m per annum. Division X's cost of capital is 10% per annum. The division is considering two proposals.
Proposal 1 involves investing a further £1m in fixed assets to earn an annual profit of £0.15m.
Proposal 2 involves the disposal of assets at their net book value of £2.3m. This would lead to a reduction in profits of £0.3m.
Proceeds from the disposal of assets would be credited to head office not Division X.
Required: calculate the current ROI and residual income for Division X and show how they would change under each of the two proposals.
Current situation
Return on investment
ROI = £2.2m = 22%
£10.0m
Residual income
Profit £2.2m
Imputed interest charge
£10.0m x 10% £1.0m
Residual income £1.2m
Comment: ROI exceeds the cost of capital and residual income is positive. The division is performing well.
Proposal 1
Return on investment
ROI = £2.35m = 21.4% £11.0m
Residual income
Profit £2.35m
Imputed interest charge
£11.0m x 10% £1.1m
Residual income £1.25m
Comment: In simple terms the project is acceptable to the company. It offers a rate of return of 15% (£0.15m/£1m) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting proposal 1. This would be a dysfunctional decision. Residual income increases if proposal 1 is adopted and this performance measure should lead to goal congruent decisions.
Proposal 2
Return on investment
ROI = £1.9m = 24.7% £7.7m
Residual income
Profit £1.90m
Imputed interest charge
£7.7m x 10% £0.77m
Residual income £1.13m
Comment: In simple terms the disposal is not acceptable to the company. The existing assets have a rate of return of 13.0% (£0.3m/£2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting proposal 2. This would be a dysfunctional decision. Residual income decreases if proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions.
Relative merits of ROI and Residual income
Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow £100 and invest it at a 25% rate of return or borrow £1m and invest it at a rate of return of 15%?
Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of £15 per annum after borrowing costs. The bigger investment would give a net return of £50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth.
Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth. Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance.
Problems common to both ROI and Residual income
The following problems are common to both measures:

Identifying controllable (traceable) profits and investment can be difficult.
If used in a short-term way they can both overemphasise short-term performance at the expense of long-term performance. Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to rejection of projects by managers (see Example 4).
If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery (see Example 4).
Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern businesses, multi-faceted measures of performance are necessary.
Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.

Example 4
PQR plc is considering opening a new division to manage a new investment project. Forecast cashflows of the new project are as follows:

Year	0	1	2	3	4	5
Forecast net cash flow £m	(5.0)	1.4	1.4	1.4	1.4	1.4

PQR's cost of capital is 10% pa. Straight line depreciation is used.
Required: Calculate the project's net present value and its projected ROI and residual income over its five-year life.

NPV

Year	0	1	2	3	4	5
Forecast net cash flow £m	(5.0)	1.4	1.4	1.4	1.4	1.4
Present value factors at 10%	1.00	0.91	0.83	0.75	0.68	0.62
Present value	(5.0)	1.27	1.16	1.05	0.95	0.87
NPV = £0.30m

ROI

Year	1	2	3	4	5
1 Opening investment at net book value	5.0	4.0	3.0	2.0	1.0
2 Forecast net cash flow £m	1.4	1.4	1.4	1.4	1.4
3 Straight line depreciation	(1.0)	(1.0)	(1.0)	(1.0)	(1.0)
4 Profit	0.4	0.4	0.4	0.4	0.4

ROI (4 ÷ 1 x 100)	8%	10%	13%	20%	40%

Residual income

Year	1	2	3	4	5
Profit (as above)	0.4	0.4	0.4	0.4	0.4
Imputed capital charge (opening investment x 10%)	0.5	0.4	0.3	0.2	0.1
Residual income	(0.1)	0.0	0.1	0.2	0.3

Comment: this example demonstrates two points. Firstly, it illustrates the potential conflict between NPV and the two divisional performance measures. This project has a positive NPV and should increase shareholder wealth. However, the poor ROI and residual income figures in the first year could lead managers to reject the project. Secondly, it shows the tendency for both ROI and residual income to improve over time. Despite constant annual cashflows, both measures improve over time as the net book value of assets falls. This could encourage managers to retain outdated assets.
Non-Financial Performance indicators
In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial and non-financial indicators. The most well-known of these approaches is the balanced scorecard proposed by Kaplan and Norton. This approach attempts to overcome the following weaknesses of traditional performance measures:

Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional performance.
Single factor measures are capable of distortion by unscrupulous managers (eg by undertaking proposal 2 in Example 3).
They can often lead to confusion between measures and objectives. If ROI is used as a performance measure to promote the maximisation of shareholder wealth some managers will see ROI (not shareholder wealth) as the objective and dysfunctional consequences may follow.
They are of little use as a guide to action. If ROI or residual income fall they simply tell you that performance has worsened, they do not indicate why.

The balanced scorecard approach involves measuring performance under four different perspectives, as follows:

Perspective	Question
Financial success	How do we look to shareholders?
Customer satisfaction	How do customers see us?
Process efficiency	What must we excel at?
Growth	Can we continue to improve and create value?

The term 'balanced' is used because managerial performance is assessed under all four headings. Each organisation has to decide which performance measures to use under each heading. Areas to measure should relate to an organisation's critical success factors. Critical success factors (CSFs) are performance requirements which are fundamental to an organisation's success (for example innovation in a consumer electronics company) and can usually be identified from an organisation's mission statement, objectives and strategy. Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key performance indicators should be:

specific (ie measure profitability rather than 'financial performance', a term which could mean different things to different people)
measurable (ie be capable of having a measure placed upon it, for example, number of customer complaints rather than the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor.

Example 5 demonstrates a balanced scorecard approach to performance measurement in a fictitious private sector college training ACCA students.
Example 5

Perspective	Critical Success Factor	Key Performance Indicators
Financial success	Shareholder wealth	Dividend yield % increase in share price
	Cashflow	Actual v budget Debtor days
Customer satisfaction	Exam success	College pass rate v national average Premier college status Tutor grading by students
	Flexibility	Average number of course variants per subject (eg full-time, day release, evening)
Process efficiency	Resource utilisation	% room occupancy Average class size Average tutor teaching load (days)
Growth	Innovation products Information technology	% of sales from < 1 year old Number of online enrolments

The balanced scorecard approach to performance measurement offers several advantages:

it measures performance in a variety of ways, rather than relying on one figure
managers are unlikely to be able to distort the performance measure - bad performance is difficult to hide if multiple performance measures are used
it takes a long-term perspective of business performance
success in the four key areas should lead to the long-term success of the organisation
it is flexible - what is measured can be changed over time to reflect changing priorities
'what gets measured gets done' - if managers know they are being appraised on various aspects of performance they will pay attention to these areas, rather than simply paying 'lip service' to them.

The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This can prove difficult where the organisation has no previous experience of performance measurement. Benchmarking with other organisations is a possible solution to this problem.
Allowing for tradeoffs between KPIs can also be problematic. How should the organisation judge the manager who has improved in every area apart from, say, financial performance? One solution to this problem is to require managers to improve in all areas, and not allow tradeoffs between the different measures.
Steve Jay is examiner for Paper 7

Partnership accounts

noreply@blogger.com (Unknown) — Thu, 15 Jul 2010 04:08:00 -0700

Partnership accounts

by Neil Stein
16 Jan 2000

This article concentrates on the preparation of partnership financial statements.
There are no material differences between UK and international practice in partnership accounts apart from minor variations in terminology and format. This article uses international terminology. For students taking the UK paper the conversion is:

International term	UK equivalent
Income statement	Profit and loss account
Statement of division of profit	Appropriation account

Differences between sole traders' accounts and partnership accounts

If you can handle the financial statements of sole traders, with adjustments for accruals, prepayments, depreciation and the like, it is an easy matter to add the requirements for partnership accounts. The differences are:

Balance sheet

there is a separate capital account for each partner instead of just the one required for a sole trader
we often maintain a separate current account for each partner, recording drawings and profit shares. If this is done, the capital account is only used for 'capital' transactions such as the introduction of extra long-term capital by partners.

Income statement - the division of the net profit among the partners has to be shown. There are several possibilities:

profit is shared in agreed proportions
as (a), but partners are credited with a 'salary' to allow for the work they put into the partnership
as (a) or (b), but partners are credited with 'interest on capital' to allow for differences in the amounts of fixed capital partners have contributed.

It is important to note that partners' salaries and interest on capital are not charges in the main part of the Income statement. They are simply part of the process of dividing up the profit among the partners. The division is shown in the statement of division of profit. This may be presented in a tabular format as shown in the next section.

Preparing partnership financial statements

Income statement

The main part of the income statement is prepared exactly as for a sole trader.
Points to watch:

Do not put partners' salaries or interest on capital into the main income statement. They belong only in the division of profit statement section.
Do not include drawings anywhere in the income statement or statement of division of profit. Drawings are debited to partners' current accounts.

Statement of division of profit

The easiest format to adopt here is a simple columnar presentation. See Figure 1 below (figures invented). Points to watch:

One partner may guarantee that another partner's total profit share is not less than a certain minimum amount. To deal with this, make a transfer from one column to another in the tabulated statement.
Changes to the profit-sharing arrangements or changes in partnership personnel part way through the year. You have to divide the profit on a time basis between the periods, then apply the details given to the apportioned profits. Remember to take half a year's salary for a half-year period. Your table then shows the total profit shares for the year calculated for the two periods involved.
Change in partnership personnel part way through the year, with an agreement that certain expenses charged in the income statement relate to one part of the year only. This is a variation on (b) above and always causes problems for candidates. What you have to realise is that for the partners not bearing the expense, the profit is that shown by the income statement plus the special expense. You have to split that increased profit among the partners, then deduct the special expense from the partners who are to bear it.

Figure 1: statement of division of profit

	A	B	C	Total
	$	$	$	$
Salaries	20,000	15,000	-	35,000
Interest on capital	4,000	3,000	2,000	9,000
Share of balance 3:2:1	90,000	60,000	30,000	180,000
	114,000	78,000	32,000	224,000

P, after having been a sole trader for some years, entered into partnership with Q on 1 July 20X2, sharing profits equally. The business profit for the year ended 31 December 20X2 was $340,000, accruing evenly over the year apart from a charge of $20,000 for a bad debt relating to trading before 1 July 20X2, which it was agreed P should bear entirely.
How is the profit for the year to be divided between P and Q?

	P $000	Q $000
A	245	95
B	250	90
C	270	90
D	255	85

Decide what you think the answer should be, and then read on.
Discussion
A little clear thinking is required. The profit excluding the $20,000 is to be used, then $20,000 deducted from P's share.Thus we have:

	P $000	Q $000
6 months to 30 June 20X2	180
6 months to 31 December 20X2	90	90
	270	90
less: bad debt	20
	250	90

The answer is B. If you didn't get it right, re-read note (c).
d the question states that there is no partnership agreement and tells you nothing about profit shares. In this case, assume the following (Partnership Act 1890 provisions):

no partnership salaries
no interest on capital
profit shared equally among the partners
but
if any partner has loaned money to the partnership (as opposed to introducing capital), the loan carries interest at 5 per cent per year, charged in the income statement. Questions rarely bring in this point, because it makes the question easier.
e Interest on drawings - partners sometimes agree that interest should be charged on drawings made. In reality, partners will agree the amount of drawings the business can stand rather than charge interest. If the point should come up, calculate the total interest due from all partners and add that to the net profit in the statement of division of profit. Then deduct each partner's interest charge from the individual shares at the end of the statement.

Balance sheet
Each partner has to have a capital account and, probably, a current account in the balance sheet. The easiest way to present these is to use columns. See Figure 2 (figures invented).
Figure 2
Capital accounts

	A	B	C
	$	$	$
Balance at 1 January	40,000	30,000	20,000
Capital introduced	20,000	10,000	-
Balance at 31 December	60,000	40,000	20,000	120,000

	A	B	C
	$	$	$
Balance at 1 January	14,800	16,100	12,400
Profit share (the total from the division of profit statement)	68,000	49,000	46,000
	82,800	65,100	58,400
Drawings	(70,000)	(60,000)	(60,000)
Balance at 31 December	12,800	5,100	(1,600)	16,300

If a partner has a debit balance, as does C here, it is easy to include it in the tabulation as shown. There is no need to complicate matters by putting C's account on the assets side of the balance sheet.
A practice question
Here is a practice question to test your understanding. Try to complete it for yourself, then take a look at the discussion and answer below.
Alamute and Brador have been in partnership for several years, compiling their financial statements for the year ended 31 March and sharing profits in the ratio 60:40 after allowing for interest on capital account balances at 5 per cent per year. Extracts from their trial balance at 31 March 20X3 are given in Figure 3.
Figure 3: extract from Alamute and Brador trial balance

		Reference to notes	$
Capital accounts:	Alamute		50,000
	Brador		50,000
Current accounts	Alamute		3,800 credit
	Brador		2,600 debit
Drawings:	Alamute		48,400
	Brador		36,900
Office equipment	cost	1	48,300
	accumulated depreciation, 1 April 20X2		12,800
Inventory, 1 April 20X2		2	15,600
Trade receivables		3	68,400
Allowances for receivables, 1 April 20X2		3	3,800
Sales revenue			448,700
Purchases			184,600
Rent paid		4	30,000
Salaries			88,000
Insurance		5	4,000
Sundry expenses			39,400

Notes to Figure 3

Office equipment should be depreciated at 20% per year on the reducing balance basis.
Closing inventory amounted to $21,400.
Debts of $2,400 are to be written off, and the allowance for receivables is to be adjusted to 5% of trade receivables.
Rent paid of $30,000 is the amount for the nine months to 31 December 20X2. From that date the rent was increased by 10%.
Insurance paid in advance amounted to $1,500.

Required:

Prepare the partnership's trading and income statement and statement of division of profit for the year ended 31 March 20X3 (9 marks)
Write up the partners' current accounts for the year ended 31 March 20X3
(3 marks) (12 marks in total).

Discussion
This is quite a simple question, but care is needed on several points:

The drawings figures are given. They go into the current accounts and do not appear in theincome statement or statement of division of profit.
Note 3 gives details of receivables. The charge in the income statement is:

		$	$
Debts written off			2,400
Movement in allowance
	Original allowance	3,800
	New allowance required 5% x (68,400 - 2,400)	3,300	(500)
			1,900

Note 4 explains the rent. $30,000 is the cost for nine months. That means $10,000 per quarter. The fourth quarter must therefore be $11,000, giving a total of $41,000.

a Alumute and Brador
Income statement for the year ended 31 March 20X3

Sales revenue

448,700

Cost of sales:

opening inventory

15,600

purchases

184,600

200,200

less: closing inventory

21,400

(178,800)

Gross profit

269,900

Less:

expenses

salaries

88,000

rent (30,000 + 11,000)

41,000

insurance (4,000 + 1,500)

2,500

sundry expenses

39,400

depreciation (35,500 x 20%)

7,100

receivables expense (2,400 - 500)

1,900

(179,900)

Net profit

90,000

Statement of division of profit

	Alamute	Brador	Total
	$	$	$
Net profit			90,000
Interest on capital	2,500	2,500	(5,000)
			85,000
Balance of profit 60:40	51,000	34,000	(85,000)
	53,500	36,500	-

b Current accounts

	Alamute	Brador		Alamute	Brador
	$	$		$	$
Balance	-	2,600	Balance	3,800	-
Drawings	48,400	36,900	Share of profit	53,500	36,500
Balance	8,900	-	Balance	-	3,000
	57,300	39,500		57,300	39,500

Neil Stein is former examiner for Paper 1.1

Incomplete records

noreply@blogger.com (Unknown) — Thu, 15 Jul 2010 04:07:00 -0700

Incomplete records

by Neil Stein
26 Aug 2004

Examiners like questions on incomplete records because they provide the opportunity to test a variety of bookkeeping and accounting techniques.
The two main instances in which incomplete records can be found are where:

there are no records at all
some records exist and information is available to calculate missing figures.

No records at all
It is still possible to calculate a profit or loss figure by using the fact that the profit of a business must be represented by more assets. We list and value the opening and closing net assets, then calculate the profit as the difference between the two:
Profit = Closing net assets - Opening net assets
Allowance must be made for proprietor's drawings and extra capital introduced, so the formula becomes:
Profit = Closing net assets - Opening net assets + Drawings - Capital introduced
There is little scope here for a major question, but it could form the basis of a two-mark multiple-choice question.
Incomplete records
This a more common scenario, both in exam questions and in practice. There are standard techniques for calculating missing figures:

Opening capital
Missing figures for sales and purchases
Missing figures for cash.

Opening capital
We need to have the opening capital of the business at the beginning of a period to provide a starting point - the capital in the balance sheet account. Questions will usually give us a list of opening assets and liabilities, and we use this to arrive at the opening capital.
Missing figures for sales and purchases
If we know the opening and closing debtors of a business, and the cash received from customers, we can calculate sales. All we need to do is set up a sales ledger total account (see Figure 1).

Figure 1: Sales ledger total account (figures invented)

	£		£
Opening debtors	38,600	Cash received	218,650

Sales (balancing figure)	221,250	Closing debtors	41,200
	259,850		259,850

If any three of these figures is known, the fourth can be calculated.

All we are doing here is using the sales ledger control account format, but instead of proving the accuracy of the sales ledger, we are calculating what the sales must have been in order for the other figures to be what they are. The same technique may be used to calculate credit purchases. If the sales figure is given we can calculate the cash received.
There is another way to calculate sales, purchases or stock figures, and that is to use the trading account format. We normally set up the trading account as (figures invented):

		£	£
Sales			100,000
Less:	cost of sales
	opening stock	10,000
	purchases	78,000
		88,000
	less: closing stock	13,000	75,000
gross profit			25,000

Suppose the closing stock has been destroyed by fire, along with all the stock records. Then we wouldn't have the closing stock total to include in our trading account. However, we can calculate it if we know the gross profit percentage on sales - or, of course, the mark-up on cost of sales.
In the example above, gross profit is 25 per cent of sales. If we are told this, we can insert the gross profit of £25,000 and so calculate the missing stock figure as a balancing item. We can also find a missing purchases figure, or even a missing sales figure.
Suppose we are given:

		£	£
Cost of sales
	opening stock	10,000
	purchases	78,000
		88,000
	less: closing stock	13,000	75,000

We are also told that gross profit percentage on sales is 25 per cent. If gross profit is 25 per cent on sales, cost of sales must be 75 per cent of sales. The sales total is therefore:
£75,000 x 100/75 = £100,000.
Whenever the gross profit percentage is given in an incomplete records question, you know that this technique is needed.
Missing figures for cash
We may be given details of cash receipts and payments plus details of opening and closing balances, but with one figure missing, often the proprietor's drawings. We can calculate the missing figure by setting up a cash account to find the balancing item required.
Here are the incomplete records techniques:

Construct	To calculate
1 Opening assets and liabilities	Opening capital
2 Sales or purchases ledger total accounts	Any missing figure
3 Trading account (gross profit percentage must be given)	Any missing figure
4 Cash account	Any missing figure

There is only one way to develop fluency in incomplete records questions, and that is to practise as many questions as you can. Here are three short exercises:

The net assets of Altese, a trader, at 1 January 2003 amounted to £128,000. During the year to 31 December 2003, Altese introduced a further £50,000 of capital and made drawings of £48,000. At 31 December 2003, Altese's net assets totalled £184,000. Using this information compute Altese's total profit for the year ended 31 December 2003.
Senji does not keep proper accounting records, and it is necessary to calculate her total purchases for the year ended 31 January 2004 from the following information:

		£
Trade creditors
	31 January 2003	130,400
	31 January 2004	171,250
Payments to suppliers		888,400
Cost of goods taken by Senji for her personal use		1,000
Refunds received from suppliers		2,400
Discounts received		11,200

Compute the figure for purchases for inclusion in Senji's financial statements.
Aluki fixes prices to make a standard gross profit percentage on sales of 331/3%. The following information is available for the year ended 31 January 2004 to compute her sales total for the year:

		£
Stock
	1 February 2003	243,000
	31 January 2004	261,700
Purchases		595,400
Purchases returns		41,200

Calculate the sales figure for the year ended 31 January 2004.

Answers

	£
Opening capital	128,000
Capital introduced	50,000
	178,000
less: Drawings	48,000
	130,000
Closing capital	184,000
Profit is therefore	54,000

See Figure 2.

Figure 2: Purchases total account

	£		£
Payments to suppliers	888,400	Balance brought forward	130,400
Discounts received	11,200	Goods taken by Senji	1,000
Balance carried forward	171,250	Refunds from suppliers	2,400
		Purchases (balancing figure)	937,050
	1,070,850		1,070,850

		£	£
Cost of sales
	Opening stock		243,000
	Purchases	595,400
	less: Returns	41,200	554,200
			797,200
	less: Closing stock		261,700
			535,500
Sales figure is therefore: £535,500 x 3/2 =			803,250

These three examples are quite elementary, but they illustrate techniques that you will find in nearly all incomplete records questions.
Neil Stein is examiner for Paper 1.1

IAS 10 and FRS 21, events after the balance sheet date

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IAS 10 and FRS 21, events after the balance sheet date

by Neil Stein
15 Mar 2007

Events after the balance sheet date and before financial statements are issued can have important effects on the financial statements. For example, the bankruptcy of a major customer would normally be evidence that the trade receivable should be written off or an allowance made as at the balance sheet date.
There is another type of event after the balance sheet date - one that does not affect the position at the balance sheet date, but which still needs disclosure in some way to prevent users being misled. An example of such an event might be a material fall in the market value of investments.

General provisions

Events after the balance sheet date are divided into two types, corresponding to the two examples just given. The definition in IAS 10 is:
Events after the balance sheet date are those events, both favourable and unfavourable, that occur between the balance sheet date and the date when the financial statements are authorised for issue.

Two types of events can be identified:
(a) those that provide evidence of conditions that existed at the balance sheet date (adjusting events after the balance sheet date); and
(b) those that are indicative of conditions that arose after the balance sheet date (nonadjusting events after the balance sheet date).
Material adjusting events require changes to the financial statements.
Examples of such events given in IAS 10 and FRS 21 are:
(a) the resolution of a court case, as the result of which a provision has to be recognised instead of the disclosure by note of a contingent liability;
(b) evidence of impairment of assets:
(i) bankruptcy of a major customer;
(ii) sale of inventories at prices
suggesting the need to reduce the balance sheet figure to the net value actually realised.
Nonadjusting events do not, by definition, require an adjustment to the financial statements, but if they are of such importance that non-disclosure would affect the ability of users of the financial statements to make proper evaluations and decisions, the enterprise should disclose by note:
- the nature of the event;
- an estimate of its financial effect, or a statement that such an estimate cannot be made.
Examples of such events given in IAS 10 and FRS 21 are:
(a) decline in market value of investments;
(b) announcement of a plan to discontinue part of the enterprise;
(c) major purchases and sales of assets;
(d) expropriation of assets by government;
(e) destruction of a major asset by fire etc;
(f) a major business combination after the balance sheet date;
(g) sale of a major subsidiary;
(h) major dealings in the company's ordinary shares;
(i) abnormally large changes in asset prices or foreign exchange rates;
(j) changes in tax rates with a significant effect on current and deferred tax assets;
(k) entering into significant commitments or contingent liabilities;
(l) commencing major litigation arising solely out of events after the balance sheet date.

Further provisions of IAS 10 and FRS 21

(a) Authorisation for issue of financial statements
An enterprise should disclose the date when the financial statements were authorised for issue and who gave that authorisation. If the owners or others have the power to amend the financial statements after issue, that fact should be disclosed.
(b) Going concern
If the management decides after the balance sheet date that it is necessary to liquidate the enterprise, the financial statements should not be prepared on a going concern basis.
(c) Dividends
Proposed dividends may no longer be recognised as liabilities if, as will normally be the case, they are proposed or declared after the balance sheet date.
The disclosure of proposed dividends may be given in one of two ways:
(a) by note
(b) on the face of the balance sheet as a separate component of equity.

How to approach performance appraisal questions

noreply@blogger.com (Unknown) — Thu, 15 Jul 2010 04:06:00 -0700

How to approach performance appraisal questions

by Steve Scott
28 Apr 2004

Vertical or trend analysis
A company's performance may be compared to its previous period's performance. Past results may be adjusted for the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is that there are no independent benchmarks to determine whether the chosen company's current year results are good or bad. Just because a company's results in say 2003 are better than its results in 2002 - it does not mean the 2003 results are good. It may be that its results in 2002 were particularly poor.
Horizontal analysis
To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.
Industry average comparison
This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company.
The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company's results.
Question scenarios
Most questions on this topic in Paper 2.5 have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many 'clues' in the question - ignore them at your peril. Examples of such circumstance include:
Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:

goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)
a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office
loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation
entering into debtor factoring (the sale of debtors to a finance house). This would obviously reduce debtor collection periods, but this would not be through improved credit control procedures
a general revaluation of fixed assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any
real change in operating capacity or profitability
a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

limit calculations to important areas and avoid duplication (eg stock turnover and stock holding periods)
it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them
often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional fixed assets have been purchased without a proportionate increase in sales).

Suggested structure to a typical answer
Comment on company performance in the following areas:

profitability and asset utilisation
liquidity (look for overtrading)
gearing and security of borrowings
prepare a cash flow statement - if specifically requested.

Gross and net profit margin %:
Profit (gross or net)/sales x 100
Asset utilisation: sales/net assets

£1 million
£1.3 million
£700,000

Answer

	£000	£000	£000
	i	ii	iii
Profit	1,000	1,300	700
		(+30%)	(-30%)
Preference shareholders	500	500	500
Equity shareholders	500	800	200
% return on equity	10%	16%	4%
		(+60%)	(-60%)

the final dividend (in pence per share) to be declared such that Realm plc's dividend yield would equal its market sector
Realm plc's P/E ratio
Realm plc's dividend cover.

Answer

A dividend yield of 5% of a share price of £3.00 would be achieved if total dividends for the period were 15p ((15/300) x 100 = 5%). An interim dividend of £200,000 on 5 million shares would be 4p per share. Thus the final dividend would need to be 11p per share.
Profits of £1,250,000 on 5 million shares gives an EPS of 25p (£1,250,000/5 million). The P/E ratio would be calculated as 12 (300p/25p)
Dividends of 15p per share from earnings of 25p per share would give a dividend cover of 1.67 times (25p/15p).

Ratios of companies reporting a full year's results for periods ended between 1 July 2003 and 30 September 2003

Return on capital employed	22.1%
Net assets turnover	1.8 times
Gross profit margin	30%
Net profit (before tax) margin	12.5%
Current ratio	1.6:1
Quick ratio	0.9:1
Stock holding period	46 days
Debtors' collection period	45 days
Creditors' payment period	55 days
Debt to equity	40%
Dividend yield	6%
Dividend cover	3 times

Comparator's financial statements for the year to 30 September 2003 are set out below:

Profit and loss account	£000
Turnover	2,425
Cost of sales	(1,870)
Gross profit	555
Other operating expenses	(215)
Operating profit	340
Interest payable	(34)
Exceptional item (note (ii))	(120)
Profit before taxation	186
Taxation	(90)
Profit after taxation	96
Dividends	(90)
Net profit for the period	6
Profit and loss reserve - 1 October 2002	179
Profit and loss reserve - 30 September 2003	185

Balance Sheet	£000	£000
Fixed assets (note i)		540

Current Assets
Stock	275
Debtors	320
Bank	nil
	595

Creditors: amounts falling due within one year
Bank overdraft	35
Trade creditors	350
Proposed dividends	30
Taxation	85
	(500)	95

Creditors: amounts falling due after more than one year
8% loan notes		(300)
		335

Share Capital and Reserves
Ordinary shares (25p each)		150
Profit and loss account reserve		185
		335

Notes

The details of the fixed assets are:

	Cost £000	Accumulated depreciation £000	Net book value £000
At 30 Sept 2003	3,600	3,060	540

The exceptional item relates to losses on the sale of a batch of computers that had become worthless due to improvements in microchip design.
The market price of Comparator’s shares throughout the year averaged £6.00 each.

Required:

Explain the problems that are inherent when ratios are used to assess a company's financial performance. Your answer should consider any additional problems that may be encountered when using inter-firm comparison services such as that used by Comparator (7 marks).
Calculate ratios for Comparator equivalent to those provided by the inter-firm comparison service (6 marks).
Write a report analysing the financial performance of Comparator based on a comparison with the sector averages (12 marks).
25 marks

Answer

Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years' ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are:

Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example, return on capital employed is materially affected by revaluations of fixed assets. Comparing this ratio for two companies where one has revalued its fixed assets and the other carries fixed assets at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, stock valuation policies etc.
Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debtor factoring. If one company collects its debts in the normal way, then the calculation of debtor days would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its debtors (ie 'sell' them to a finance company) then the calculation of its debtor days would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as an operating lease rather than a finance lease.
Balance sheet averages: many ratios are based on comparing profit and loss account items with balance sheet items. The above ratio of debtor's days would be a good example. For such ratios to be meaningful, it is necessary to assume that the year-end balance sheet figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example, the level of debtors and stock of a toy manufacturer could vary largely due to the nature of its seasonal trading.
Inflation can distort comparisons over time.
The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also, where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of exceptional items and finance costs.
The use of norms can be misleading. A desirable range for the current ratio may be between 1.5 and 2:1, but all businesses are different. This would be a very high ratio for a supermarket (with few debtors), but a low figure for a construction company (with high levels of work in progress).
Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

They are themselves averages and may incorporate large variations in their composition. Some inter-firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this.
It may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different.
Companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures.
The year-end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

b. Refer to Figure 1 on page 52.
c. Analysis of Comparator's financial performance compared to the sector average for the period to 30 September 2003:
To:
From: A N Allison
Date:

Figure 1: Calculation of specified ratios

	Comparator	Sector average
Return on capital employed ((186 + 34 loan interest/635)	34.6%	22.1%
Net assets turnover (2,425/635)	3.8 times	1.8 times
Gross profit margin (555/2,425 x 100)	22.9%	30%
Net profit (excluding exceptionals) margin (306/2,425 x 100)	12.6%	not available
Net profit (before tax) margin (186/2,425 x 100)	7.7%	12.5%
Current ratio (595/500)	1.19:1	1.6:1
Quick ratio (320/500)	0.64:1	0.9:1
Stock holding period (275/1,870 x 365)	54 days	46 days
Debtors' collection period (320/2,425 x 365)	48 days	45 days
Creditor payment period (350/1,870 x 365)(based on cost of sales)	68 days	55 days
Debt to equity (300/335 x 100)	90%	40%
Dividend yield (see below)	2.5%	6%
Dividend cover (96/90)	1.07 times	3 times

Cost Accounting

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Cost Accounting
Cost Accounting [ACCA]

Variances

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Variances

Variances

Bank Reconciliation

noreply@blogger.com (Unknown) — Mon, 3 May 2010 12:13:00 -0700

Bank Reconciliation

Bank Reconciliation

Limiting Factor Analysis 2

noreply@blogger.com (Unknown) — Sun, 2 May 2010 04:03:00 -0700

Limiting Factor Analysis 2

Limiting Factor Analysis 1

noreply@blogger.com (Unknown) — Sun, 2 May 2010 04:00:00 -0700

Limiting Factor Analysis 1

The Discounted Cash Flow internal rate of return

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The Discounted Cash Flow Internal Rate of Return

The Discounted Cash Flow internal rate of return

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The Discounted Cash Flow Internal Rate of Return

Overhead Absorption

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Overhead Absorption

Capital Investment Appriasal

noreply@blogger.com (Unknown) — Sun, 2 May 2010 03:42:00 -0700

Capital Investment Appraisal

Tangible Assets

noreply@blogger.com (Unknown) — Sun, 2 May 2010 03:38:00 -0700

Tangible Assets

Accounting for Partnerships

noreply@blogger.com (Unknown) — Sun, 2 May 2010 03:35:00 -0700

Accounting for Partnerships

Accounting for Non Current or Fixed Assets

noreply@blogger.com (Unknown) — Sun, 2 May 2010 03:31:00 -0700

Accounting for Fixed Assets

Suspense accounts and error correction

noreply@blogger.com (Unknown) — Mon, 15 Mar 2010 11:35:00 -0700

Suspense accounts and error correction

by Neil Stein

16 May 2007

Suspense accounts and error correction are popular topics for examiners because they test understanding of bookkeeping principles so well.

A suspense account is a temporary resting place for an entry that will end up somewhere else once its final destination is determined. There are two reasons why a suspense account could be opened:

1. a bookkeeper is unsure where to post an item and enters it to a suspense account pending instructions

2. there is a difference in a trial balance and a suspense account is opened with the amount of the difference so that the trial balance agrees (pending the discovery and correction of the errors causing the difference). This is the only time an entry is made in the records without a corresponding entry elsewhere (apart from the correction of a trial balance error - see error type 8 in Table 1).

Types of error

Before we look at the operation of suspense accounts in error correction, we need to think about types of error - not all types affect the balancing of the records and hence the suspense account. Refer to Table 1.

Table 1: Types of error

Error type Suspense account involved?

1 Omission - a transaction is not recorded at all No

2 Error of commission - an item is entered to the correct side of the wrong account (there is a debit and a credit here, so the records balance) No

3 Error of principle - an item is posted to the correct side of the wrong type of account, as when cash paid for plant repairs (expense) is debited to plant account (asset)

(errors of principle are really a special case of errors of commission, and once again there is a debit and a credit) No

4 Error of original entry - an incorrect figure is entered in the records and then posted to the correct account

Example: Cash $1,000 for plant repairs is entered as $100; plant repairs account is debited with $100 No

5 Reversal of entries - the amount is correct, the accounts used are correct, but the account that should have been debited is credited and vice versa

Example: Factory employees are used for plant maintenance:

Correct entry:

Debit: Plant maintenance

Credit: Factory wages

Easily done the wrong way round No

6 Addition errors - figures are incorrectly added in a ledger account Yes

7 Posting error

a an entry made in one record is not posted at all

b an entry in one record is incorrectly posted to another

Examples: cash $10,000 entered in the cash book for the purchase of a car is:

a not posted at all

b posted to Motor cars account as $1,000 Yes

8 Trial balance errors - a balance is omitted, or incorrectly extracted, in preparing the trial balance Yes

9 Compensating errors - two equal and opposite errors leave the trial balance balancing (this type of error is rare, and can be because a deliberate second error has been made to force the balancing of the records or to conceal a fraud) Yes, to correct each of the errors as discovered

For examination purposes we are more often concerned with the second of these - differences and error correction.

Correcting errors

Errors 1 to 5, when discovered, will be corrected by means of a journal entry between the accounts affected. Errors 6 to 9 also require journal entries to correct them, but one side of the journal entry will be to the suspense account opened for the difference in the records. Type 8, trial balance errors, are different. As the suspense account records the difference, an entry to it is needed, because the error affects the difference. However, there is no ledger entry for the other side of the correction - the trial balance is simply amended.

An illustrative question

The bookkeeping system of Turner is not computerised, and at 30 September 20X8 the bookkeeper was unable to balance the accounts. The trial balance totals were:

Debit $1,796,100

Credit $1,852,817

Nevertheless, he proceeded to prepare draft financial statements, inserting the difference as a balancing figure in the balance sheet. The draft profit and loss account showed a profit of $141,280 for the year ended 30 September 20X8.

He then opened a suspense account for the difference and began to check through the accounting records to find the difference. He found the following errors and omissions:

1. $8,980 - the total of the sales returns book for September 20X8, had been credited to the purchases returns account.

2. $49,600 paid for an item of plant purchased on 1 April 20X8 had been debited to plant repairs account. The company depreciates its plant at 20% per annum on a straight line basis, with proportional depreciation in the year of purchase.

3. The cash discount totals for the month of September 20X8 had not been posted to the general ledger accounts. The figures were:

Discount allowed $836

Discount received $919

4. $580 insurance prepaid at 30 September 20X7 had not been brought down as an opening balance

5. The balance of $38,260 on the telephone expense account had been omitted from the trial balance

6. A car held as a non-current asset had been sold during the year for $4,800. The proceeds of sale were entered in the cash book but had been credited to the sales account in the general ledger. The original cost of the car $12,000, and the accumulated depreciation to date $8,000, were included in the motor vehicles account and the accumulated depreciation account. The company depreciates motor vehicles at 25% per annum on a straight line basis with proportionate depreciation in the year of purchase but none in the year of sale.

Required:

a Open a suspense account for the difference between the trial balance totals. Prepare the journal entries necessary to correct the errors and eliminate the balance on the suspense account. Narratives are not required. (10 marks)

b Draw up a statement showing the revised profit after correcting the above errors. (6 marks)

Total (16 marks)

Discussion

The approach to the question should be:

1 Read the requirement paragraph at the end of the question.

2 Attack the question - note that narratives are not required. Begin by opening the suspense account. Which side? More debit is needed to balance the trial balance, so debit the suspense account with $56,717.

Then deal with the errors in order:

1. Sales returns should have been debited to the sales returns account and they have been credited to the purchases returns account. There are two errors here - the wrong account has been used and an entry which should have been a debit has been entered as a credit. The suspense account entry must therefore be for 2 x $8,980 or $17,960.

2. An error of principle - no suspense account entry. Depreciation must be adjusted.

3. Items have not been posted, therefore the suspense account is involved.

4. Effectively a posting error - the suspense account is again involved.

5. A trial balance error must affect the suspense account - but no ledger entry.

6. This one needs thought. Take it one sentence at a time. Is the suspense account involved? No, because we have an error of commission followed by some unrecorded transactions.

Attempt Part (a) of the question before studying the answer as detailed in Table 2. Let's now turn to Part (b). The most convenient format for the answer is two columns for - and +. Set them up and enter the adjustments appropriately. Which of the errors affect the profit? In fact they all do. Attempt Part (b) now before looking at the answer detailed in Table 3.

Table 2: Answer - Part (A)

Suspense Account

$ $

Difference 56,717 Sales returns 8,980

Discount received 919 Purchases returns 8,980

Discount allowed 836

Insurance 580

Telephone (trial balance) 38,260

57,636 57,636

Journal entries

$ $

1 Sales returns account 8,980

Suspense account 8,980

Purchases returns account 8,980

Suspense account 8,980

2 Plant account 9,600

Plant repairs account 9,600

Depreciation (income statement) 960

Plant depreciation account 960

3 Discount allowed account 836

Suspense account 836

Suspense account 919

Discount received account 919

4 Insurance account 580

Suspense account 580

5 Trial balance (no ledger entry) 38,260

Suspense account 38,260

6 Sales account 4,800

Motor vehicles disposal account 4,800

Motor vehicles disposal account 12,000

Motor vehicles asset account 12,000

Motor vehicles depreciation account 8,000

Motor vehicles disposal account 8,000

Motor vehicles disposal account 800

Income statement 800

Table 3: Answer - Part (b)

Adjustment to profit

- +

$ $

Profit as in draft income statement 141,280

1 Sales returns adjustment (2 x $8,980) 17,960

2 Plant: reduction in repairs 9,600

depreciation - 6/12 x 20% x $9,600 960

3 Discount allowed 836

Discount received 919

4 Insurance - opening balance omitted 580

5 Telephone expense omitted 38,260

6 Profit on sale of car 800

Proceeds taken out of sales 4,800

63,396 152,599

(63,396)

Revised net profit 89,203

Some hints on preparing suspense accounts

• Does a correction involve the suspense account? The type of error determines this. Practice, and study of Table 1 should ensure that you see immediately which errors affect the balancing of the records and hence the suspense account.

• Which side of the suspense account must an entry go? This is one of the most awkward problems in preparing suspense accounts. The best way of solving it is to ask yourself which side the entry needs to be on in the other account concerned. The suspense account entry is then obviously to the opposite side.

• Look out for errors with two aspects. In the illustrative question earlier, error 1 is a case in point. An entry has been made to the wrong account, but also to the wrong side of the wrong account. Both errors must be corrected. It is very easy to fall into the trap of correcting only one of the errors, especially when working quickly under examination conditions.

Neil Stein is former examiner for Paper 1.1