22107 Accounting for Business Decisions A Final

Exam Solutions Guide (Autumn 2011)

NOTE: PLEASE CHECK ALL SOLUTIONS FOR CORRECTNESS AND
INFORM ME IF THERE ARE ERRORS.

Question 2 - Marked out of 21

There are 3 marks available for each ratio. One mark should be awarded for each of the
following facts:
Correct ratio calculated (no half marks)
What the ratio measures or means (students should not discuss the financial
position or performance of the business based on ratio calculated)
One limitation of the ratio
Examples of possible answers students could provide are provided below in italics. Please
note there are other valid points student could discuss.
1. Current Ratio
Your Answer (rounded to 2 decimal places):

____ 2.5 ______________

Your Working (not marked)

250/100

Comment on the use of the current ratio:

The current ratio measure a businesss liquidity. The higher the
number, all else equal the easier the business will be able to
repay its debts in the short term. Too high a number may
indicate the business is not managing its working capital (it
has too many resources tied up in current assets that are not
earning revenue). It is only one measure of the ability of to
repay debts because it uses current assets and liabilities at a
single point of time when most of the assets to repay debts and
most of the debts that will need to be repaid will arise during
the next period.
2. Price / Earnings Ratio
1

Your Answer (rounded to 2 decimal places):

____ 16.25 (times) ___________

Your Working (not marked) - first calculate earnings per share

$160,000 / 100,000 = $1.60/share
$26.00 / $1.60 =
Comment on the use of the price earnings ratio:
The P/E ratio is a market test ratio. It is the link between the
accounting numbers and the share market price. The higher the
number the better the shareholders expect the future to be
compared to the present (willing to pay more for $1 of current
earnings,). Growth companies have high P/E ratios. The only
limitation is that associated with the earnings management
or the quality of earnings. Shareholders may believe current
earnings have been managed down leading to higher P/E or
earnings have low quality leading to lower P/Es.
3. Gross Profit Margin Ratio
Your Answer (rounded to 2 decimal places): _______ 57% or 0.57 _____________
Your Working (not marked)
570,000 / 1,000,000

Comment on the use of the gross profit margin ratio:

Gross profit margin is a profitability measure. The margin
depends on the type of business. Some businesses like
supermarkets and service stations rely on high volume and low
gross profits margins to generate enough to pay all their other
expenses like wages, rent, advertising etc. Others have high gross
profit margins and lower turnover. A business would always
prefer a higher gross profit margin, but combining both high
turnover and high gross profits attracts competition. The g.p.m.
is often industry specific and you cannot compare the profit
margin of jeweller and a green grocer. Service businesses do not
have g.p.m.
4. Receivables Turnover
2

Your Answer (rounded to 2 decimal places):

________ 15.50 (times)______

Your Working (not marked)

1,000,000 / [(79,000 + 50,000)/2] = 15.5

Comment on the use of the receivables turnover ratio:

Receivables turnover is a test of liquidity. In general the higher
the number the more efficient a business is in collecting their
debts. Depending on whom your credit customers are will often
depend on how quickly you collect your receivables. A slowing
down in receivable collections may indicate an easing of credit
terms (or a breakdown of credit procedures) or inefficiency in a
basis management function of debt collection.
5. Inventory Turnover Ratio
Your Answer (rounded to 2 decimal places): ________ 3.44 (times)________
Your Working (not marked)
430,000 / [(110,000 + 140,000) / 2] = 3.44

Comment on the use of the inventory turnover ratio:

Inventory turnover measures liquidity. It indicates on average
how long it takes to sell inventory. It is often thought that the
higher the turnover the better, but high turnover could indicate
stock outs and unsatisfied customer demand. Inventory
turnovers are very industry specific, with newspapers turning
over every day and specialist machine or car parts may turnover
once every few years. A slowdown in inventory turnover may
indicate inventory obsolesce and inattention to changing
customer tastes.
6. Quality of Income:
3

Your Answer (rounded to 2 decimal places):

_________ 1.21 ___________

Your Working (not marked) - use both the Income and Cash Flow Statements
$193,000 / $160,000 = 1.20625

Comment on the use of the quality of income:

Quality of Income is a profitability measure. The higher the
number, the higher the quality. Cash flows from operations are
thought to remove the subject measures in income of accrual
(including depreciation). It is interesting to note it is still
profits that are the single most popular measure of firm
performance not cash flows from operations! Cash flows from
operations are seen by some as the real measure of a business
unadjusted by accounting manipulations.
7. Financial Leverage Percentage
Your Answer (rounded to 2 decimal places): ________ 58.57%* ___
* Be generous for when marking this question. Provided a student has demonstrated an
understanding of financial leveraged, illustrated in their working, give them a mark.
Your Working (not marked) - need to calculate two returns.
ROE = 160 + 120 + 20 = 106.19%
(215 + 350)/2

ROE ROA = 58.57%

ROA = 160 + 120 + 20 = 47.62%

(550+710)/2

Comment on the use of the financial leverage percentage:

Financial leverage percentage is a profitability measure. It
shows the advantage or penalty of borrowing. A negative ratio
shows they have returned less on assets than they paid for debt.
Positive financial leverage ratios show the benefit to the owners
from borrowing. High ratios indicate high risk (and the fact
that the firm has achieved a higher return on assets than it
paid (interest rate) for the money borrowed) and a low ratios
often show risk adverse.

Question 3 to be marked out of 25

Part A Cash Budget
Opening Balance
Plus Inflows;
Cash Sales
Credit Sales
Bill Receivable
Total Inflows
Less Outflows
Inventory
Operating Expenses
Total Outflows

5 marks (one for each *)

100*
65
42
76
183 *
(200)
(99)
(299) *

Total Cash Available

(16)

Plus Borrowings

70 *

Closing Balance

54 *

Part B CVP
(i)

10 marks
2 marks

Contribution Margin method

Contribution Margin per box = $9.60 5.76 = $ 3.84 per box (1 mark)
Sales in boxes at breakeven = $ 1,056,000 / $3.84 = 275,000 boxes. (1mark)
Or Equation Method
At breakeven, Selling Price (Q) = Fixed Cost + Unit Variable Cost (Q)
$9.60 Q = 1,056,000 + 5.76 Q (1 marks)
Q = 275,000 boxes. (1 mark)
Sales in boxes at breakeven = 275,000 boxes.
(ii)

3 marks

Contribution Margin Ratio = $ 3.84 / $9.60 = 0.4

New Variable Production Cost = $4.80 * 1.15 = $5.52
Therefore, New Variable Cost = $5.52 + 0.96 = $6.48 (1 mark)
New Selling Price (P)
If the same Contribution Margin Ratio is to be maintained, then,
P - $6.48 / P = 0.4
Therefore P = 6.72/0.6
= $10.80

(iii)

(1 mark)

New Selling Price =$10.80 (1 mark)

3 marks

NEW Contribution Margin = $9.60 6.48 = $3.12

(1 mark)

Sales in Dollars = (1,056,000 + 441,600) / 3.12 (1 mark)

= 480000 units
(1 mark)
Please mark the theory parts in this question at your discretion. Please write comments
for answers to indicate to students where they have made mistakes and how they can
provide a better answer. Please be aware of answers that are right but may have been
expressed poorly.

(iv)

2 marks
It draws focus on fixed cost which is the challenge for businesses to
cover.
Businesses need an increased level of activity to cover fixed costs. The
contribution margin allows the accountant to directly compare the
portion of the sales revenue that goes towards covering Fixed Costs.

Part C Overheads and Flexible Budgets

10 marks

(i)

5 marks
We apply overhead because it is difficult to capture the actual overhead
costs incurred during the period. There is too much variability.
Therefore, in the interest of consistency, the budgeted overhead rate is
applied to actual production. This amount is adjusted at the end of the
period.
On top of this, students who provide the example of one advantage and
a disadvantage should be given a mark each.

(ii)

5 marks
It allows businesses to prepare for various levels of activity.
Static budgets are prepared only for one level of activity
Calculation of variances will be clearer as it is not confounded by
differences in activity levels.
On top of this, students who provide the example of one advantage and
a disadvantage should be given a mark each.

Question 4 to be marked out of 16 Marks

PART A
Explain the concept of earnings management.

(4 marks)

PART B
(8 marks)
Provide two examples of how management can manage earnings (2
marks). In each case, explain how managers further their self-interest.
For example, using a certain accounting method may result in higher
asset numbers this year; why would this be in managements interest? (6
marks).
Make different estimates e.g. estimating bad debts or residual values
Use different methods e.g. FIFO, Weighted Average or straight-line vs accelerated
Expenditure capitalise or recognise expense
PART C
Given the incentives managers have to manipulate numbers, what
prevents managers from just reporting any numbers they like?

(4 marks)

SACs
GAAP
Accounting Standards
Trying to make statements useful relevant, reliable, understandable etc.
Auditors