Accounting Theory and Practice

Revision Pack

Q1. Discuss the main differences between the Normative (prescriptive)

and Positive (Predictive) theory traditions

Q2: Effects of accounting transactions on financial statements/ratios

It is now 15 December, two weeks before the fiscal year end of Grey
Plc. If the company has no other transactions until 31 December 2018,
its yeare nd financial statements will look as follows (assume that the
company reports using IFRS):
Grey Plc, Statement of financial position at 31 December 2018
Assets Liabilities and Equity
Plant, Property Equipment (PPE) £240,000 Trade payables £30,000
Accumulated Depreciation (60,000) Wages payable £10,000
Non-Current Asset £180,000 Short term liabillity £40,000

Long term debt £160,000

Inventory £100,000
Trace receivables £40,000 Common stock £100,000
Cash £20,000 Retained earnings 1/1/18 £20,000
Current Asset £160,000 Profit for the year £20,000
Equity £140,000

Total Asset £340,000 Total liability +Equity £340,000

Required:

The firm is considering taking the following actions between today and 31
December 2018. For each of these possible actions, what would be the
adjusted ratio/figure specified in the questions below (each action should
be considered independently of all other possible actions). Ignore tax
effects

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1. Increase the managers’ bonus by £2,200. 50% of the bonus is to be paid
in cash by year end. Calculate the adjusted Current Ratio (Current ratio =
Current Assets / Current Liabilities)

2. Purchase inventory worth £7,250. Selling half of this inventory in 21

December 2018, the company will generate additional sales of 4,900, of
which 50% is expected to be on one month credit. The supplier of this
purchase demands 40% down payment and extends 2 months credit for
the remaining amount. Calculate the adjusted Current Ratio (Current
ratio = Current Assets / Current Liabilities)

3. Invest £17,000 in short-term corporate bonds which will accrue £1,200

in interest by the end of the year. The purchase is paid as cash.
Calculate the adjusted Quick Ratio
[Quick Ratio = (Cash & Cash equivalents + Receivables) / Current
Liabilities]

4. Encourage customers to place £15,000 of new orders (to be delivered in

8th January 2019) and to make an advance payment of £3,000. The
company recognises revenues at the time of delivery: Calculate the
adjusted Quick Ratio [Quick Ratio = (Cash & Cash equivalents +
Receivables) / Current Liabilities]

5. Assume that cash flow from operations will be £21,000 unless any further
action is taken. Change the estimate of useful life of a fixed asset from five
to seven years. This will change the annual depreciation expense by
£1,500. What will be the adjusted (i) cash flow from operations, (ii) profit
for the year, and (iii) total assets?

6. Assume that cash flow from operations will be £21,000 unless any further
action is taken. Speed up payment of an outstanding balance of £13,400
trade payables. In doing so, the company will benefit from a cash
discount of £250. The discount will reduce cost of sales. What will be the

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adjusted (i) cash flow from operations, (ii) Equity, and (iii) total assets?

7. Assume that the beginning balance of total assets were £288,000 and
no dividends were paid during 2018. Buy fixed asset for £33,000 on 3
year loan. Consequently, depreciation expense will increase by £3,300.
Calculate the adjusted Return on Assets (ROA) (ROA = Net Income /
Average Total Asset)

8. Assume that the beginning balance of total assets were £288,000 and
no dividends were paid during the year. Issue 12,000 new shares in the
firm for £4 each and use 75% of the proceeds to repay a portion of the
long-term loan. This will save the company £400 in interest expense.
The annual interest on this loan is paid on 31/12/2018. Calculate the
adjusted Return on Assets (ROA) (ROA = Net Income / Last two years’
Average Total Asset),

9. Assume that the beginning balance of equity was £90,000 and no

dividends were paid during the year. Issue 10,000 new shares in the firm
for £3 each and use half the proceeds to repay a portion of the long-term
loan. This will save the company £200 in interest expense. The annual
interest on this loan is paid on 31/12/2018. Calculate the adjusted Return
on Equity (ROE) (Net Income / Last two years’ Average Equity)

10. Assume that the beginning balance of trade receivables was £32,000,
and total sales for year 2018 are £182,000. You have made an additional
sale of £22,000, 75% of which is on 2-month credit. Calculate the adjusted
Trade Receivables Day (Trade Receivables Day = 365 x (Average Trade
Receivables / Sales)

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Q3. Expensing versus capitalising expenditures

Assume two identical start up companies, Hull ltd. and York ltd., start up
with £5,000 cash and £5,000 common stock. Each year the firms
receive total £4,250 cash revenues and pay £1,150 cash expenses.
At the beginning of operations, each firm spends £2,400 to purchase
equipment. Hull ltd estimates the equipment to have a useful life of 3
years and £0 salvage value at the end of 3 years, whilst York ltd
estimates a shorter useful life and expenses £2,400 immediately. The
firms have no other assets and make no other asset purchases
during the three-year period. Assume the companies pay no
dividends, earn zero interest on cash balances, have a tax rate of 20% and
use the same accounting method for financial and tax purposes

Required:
a) Prepare income statements and cash flows for three years and three-
year totals for two firms (ignore the effect of initial £5,000 paid capital on
cash flows; as we focus on operational results in the following years)

b) Which company reports (i) higher net income (ii) total cash (change in
cash), (iii) Cash from operations over the three years? Comment also on
your findings

c) Based on Return on Equity, ROE (Net Income / Average Equity) and Net Profit
Margin, NPM (Net Income / Revenues), how do the two companies’
profitability compare? Comment on your findings.

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Q4. Research and development (R&D); Expense or capitalise?

Below, is an extract from the financial statements of Kiran Plc;

Income Statement (£m) 2017 2018 2019 2020
Revenues
270,000 282,000 296,400 303,600
Costs of Sales
(189,000) (197,400) (207,480) (212,520)
R&D expenditure (*) (21,600) (22,560) (23,712) (24,288)
Selling, Gen. and Admin costs (27,000) (28,200) (29,640) (30,360)
Earnings before tax 32,400 33,840 35,568 36,432
Taxation, 20% (6,480) (6,768) (7,114) (7,286)
Profit for the year 25,920 27,072 28,454 29,146
(*) R&D expenditure in 2016 is 20,088

Statement of financial position (£m) 2017 2018 2019 2020

Selected items
Net Property plant & equipment 175,500 183,300 192,660 197,340

Deferred tax liability 19,306 20,164 21,193 21,708

Net Assets (or Equity) 157,950 164,970 173,394 177,606

R&D expenditures are evenly distributed throughout the year

Required:

Reverse back the R&D expenditures from the income statement and capitalise them
in statement of financial position as non-current assets assuming 4-year economic
life with zero residual value, and

a) Calculate cumulative R&D asset for 2019 and 2020, and amortisation
expense for 2020.
b) How would the 2020 income statement, and both 2019 and 2020 statement of
financial position be affected? (The corporate income tax rate is 20%)
c) How would the 2020 Return on Equity (ROE) [Profit for the Year / Average
Equity] be affected? Briefly comment on your finding

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Q5.

a) What is the perception of ‘economic reality’ in positive accounting

theory, and what is the implication for accounting standard setting
or regulation?
b) Discuss the ‘fundamental’ qualitative characteristics of financial information
in accordance with IFRS conceptual framework.
c) Discuss the ‘enhancing’ qualitative characteristics of financial information in
accordance with IFRS conceptual framework.

Q6. Share buyback and affecting earnings per share (EPS)

In 2008, Next Plc spent £512.8 million to buyback 26.057 million shares
from the market. The buyback is funded by bank loans with applicable
annual interest charge of 5%. Next Plc’s Reported earnings per share
(EPS) for 2008 is after the buyback is £1.687 (p.4, I/S Note 8) based on
200.90 million ordinary shares, and its net profit is £354.1 million.

Required:

a) Calculate the EPS had there not been any share buyback (assume 30%
tax)

b)

i. Comment on the effect of the operation on the company’s EPS

ii. Discuss some of the reasons for share buybacks
iii. Discuss some negative effects of this operation
iv. Discuss this operation under the relevant accounting theory
(theories) and give a brief advice to users of accounting information

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Q7. Measure earnings quality through balance sheet based accruals ratio

Below, you are given selected financial statement data of two firms (GE
and Siemens) with different currencies and different fiscal year ends.

Siemens’ selected financial statement items for the years ended 30

September 2006, 2005 and 2004 (in € millions)

GE’s selected financial statement items for the years

ended 31 December 2006, 2005 and 2004 (in $ millions)

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Required

a) Calculate Net Operating Asset (NOA) for both firms for 2006, 2005 and
2004
b) Calculate ‘balance sheet based’ Total Accruals’ for both firms for 2006 and
2005
c) Calculate ‘Accruals Ratio’ for both firms for 2006 and 2005
d) Discuss your findings and what would the accrual ratios you calculated imply
about the earnings quality of two firms?

Q8 Consolidated Statement of Financial Position

The statement of financial position for Tight and its subsidiary Loose, as at 31
December 2022 is stated below:

Tight Loose
£,000 £,000
Assets
Non-current Assets:
Property plant and
Equipment 20,000 6,000
Investment in Loose 6,800 -
26,800 6,000
Current Assets:
Inventory 18,000 4,000
Receivables 22,000 5,000
Bank 2,000 1,000
42,000 10,000
Total Assets 68,800 16,000
Equity and Liabilities
Equity:
Share capital 2,000 600
Share premium 1,000 400
Retained earnings 31,800 6,200
34,800 7,200
Non-current Liabilities 24,000 5,600
Current Liabilities 10,000 3,200
Total Equity and
Liabilities 68,800 16,000

i. On 1 January 2021 Tight acquired 90% of the ordinary share capital of Loose

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 for £6,800,000, when the retained earnings of Loose stood at £1,000,000.
ii. Loose sold goods to Tight at a transfer price of £3,600,000 at a mark-up of
50%. Two-third of these goods remained in inventory at the year end.
iii. Goodwill has suffered an impairment of £2,000,000. Tight uses the fair value
method to value non-controlling interest and the non-controlling interest at
acquisition was £800,000.
Required
Prepare a consolidated statement of financial position as at 31 December 2022.

Q9 Consolidation P&L

Zee acquired 60% holding in Bee three years ago. Both businesses have been very
successful since the acquisition and their respective statements of profit or loss for
the year ended 31 December 2020 are:-
Zee Bee
£ £

Revenue 403,400 193,000

Costs of Sales (201,400) (92,600)

Gross Profit 202,000 100,400

Distribution costs (16,000) (14,600)
Administrative expenses (24,250) (17,800)

Dividends from Bee 15,000 -

Profit before tax 176,750 68,000

Income tax expense (61,750) (22,000)

Profit for the year 115,000 46,000

Additional information
During the year Bee sold some goods to Zee for £40,000, including 25% mark-up. Half
of these items were still in inventories at the year end.
Required:
Produce a consolidated statement of profit or loss of Zee and its subsidiary for
the year ended 31 December 2020

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Q10 consolidation P& L

On the 1 January 2019 Amazon acquired 200,000 of Star Distribution's total share
capital of 250,000 £1 ordinary shares. The statement of profit or loss of Amazon and
its subsidiary is provided below:

Statements of profit or loss for the year ended 31 December 2020

Amazon Star Distribution
£000 £000

Revenue 900,000 450,000

Cost of sales 540,000 210,000

Gross profit 360,000 240,000

Operating expenses 139,500 67,500

Profit from operations 220,500 172,500

Finance costs 7,500 4,500

Profit before tax 213,000 168,000

Tax 75,000 48,000

Profit for the year 138,000 120,000

Additional information:
(i) Amazon values the non-controlling interests using the fair value method.
(ii) During the year Star Distribution sold goods to Amazon for £30,000,000 making a
mark-up of 40%. As at 31 December 2020 30% of these goods had been sold to
customers with the rest remaining in inventory.
(iii) Goodwill impairment review reveals an impairment of £7,500,000 for the current
year. This amount is to be recognised as an operating cost.
(iv) At the date of acquisition, a fair value adjustment was made, and this resulted in
an additional depreciation charge for the current year of £22,500,000. It is group
policy that all depreciation is charged to cost of sales.
Required:
Prepare the consolidated statement of profit or loss for the year ended 31
December 2020

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Q11 Consolidation with Associate
Sun Plc acquired 75% of the equity share capital of Moon Ltd several years ago,
paying £7,000,000 in cash. At this time, the balance on Moon's retained
earnings was £4,200,000.

On 1 October 2020, Sun Plc acquired 30% of the equity share capital of Venus ltd, at
a cost of 1,050,000 in cash. At 1 October 2020 the balance on Venus’ retained
earnings was £2,100,000. The statements of financial position of three entities as at
30 September 2022 are as follows:

Sun Plc Moon Ltd Venus Ltd

£'000 £'000 £'000
Non-current assets
Property 15,750 7,000 2,800
Plant and equipment 9,800 3,500 1,400
Investments 8,050
33,600 10,500 4,200
Current assets

Inventory 4,200 2,100 840

Trade receivables 2,800 1,400 700

Cash 1,400 700 560

8,400 4,200 2,100
Total assets 42,000 14,700 6,300
Equity

Share Capital (£1) 11,200 1,120 560

Share premium 2,800 280 140

Retained earnings 10,500 7,700 3,500
24,500 9,100 4,200

Non-current liabilities 11,200 1,750 700

Current liabilities:
Trade payables 4,200 2,450 1,120

Tax payable 2,100 1,400 280

Total equity and liabilities 42,000 14,700 6,300

The following information is also available:

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 i. During the year, Sun plc sold goods to Venus ltd for £1,400,000 at a mark-up
of 25%. At the year end, Venus ltd still held one quarter of these goods in
inventory.
ii. As a result of this trading, Sun plc was owed £350,000 by Venus ltd at the
reporting date. This agrees with the amount included in Venus' trade
payables.
iii. At 30 September 2022, it was determined that the investment in the associate
(Venus) was impaired by £49,000.
iv. Non-controlling interests are valued using the fair value method. The fair
value of the non-controlling interest at the date of acquisition was £2,240,000.
Required:
Prepare the consolidated statement of financial position of the Sun plc group as at
30 September 2022.

Q12 Consolidation with Associate

Below are the statements of profit or loss of the Rock group and its associated
companies, as at 31 December 2022. You are also given the following information:

Rock Stone Hardy

£'000 £'000 £'000

Revenue 77,000 20,000 12,000

Cost of sale 37,000 12,000 4,000

Gross profit 40,000 8,000 8,000

Distribution cost 6,000 2,000 1,400

Administrative expenses 4,000 1,000 600

Profit before tax 30,000 5,000 6,000

Tax 10,000 2,400 2,000

Profit for the year 20,000 2,600 4,000

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The following information is also relevant:

i. Rock acquired 900,000 of the £1 ordinary shares in Stone five years ago
when the total number of ordinary shares in Stone was 1,000,000.
ii. Rock acquired 120,000 of £1 ordinary shares in Hardy five years ago when
the total number of ordinary shares in Hardy was 400,000.
iii. During the year Hardy sold goods to Rock for £5,600,000. Rock still holds
some of these goods in inventory at the year end. The profit element included
in these remaining goods is £400,000.
iv. Non­controlling interests are valued using the fair value method.
v. Goodwill and the investment in the associate were impaired for the first time
during the year as follows:
Stone £600,000
Hardy £400,000
vi. It is group policy that impairment of subsidiary’s goodwill is charged to
administration expenses.

Required
Prepare the consolidated statement of profit or loss for Rock including the results of
its associated company for the year ended 31 December 2022

Q13

a) What is meant by the concept of market efficiency? Briefly explain the main
forms of market efficiency.

b) Discuss why the market efficiency assumption is important for capital markets?
(Suggested word count: 275, This should be an essay type answer; You
need to develop a discussion around the central question addressing the pros
and cons and the relevant theory)

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