B301 Company Accounting
Suggested solution to Specimen Examination (October 2001)
Section A -- Both questions are compulsory
Question 1 (20 marks)
(a)
Under a financial concept of capital, capital is the net assets of the enterprise. Under a physical concept of capital, capital is regarded as the productive capacity of the enterprise, for example, units of output. The capital can be measured in financial and physical terms.
Under the financial concept of capital maintenance, capital can be measured in nominal money (that is the basis currently being used by the enterprises) or constant purchasing power. Profit represents the increase in capital over the period, expressing either in terms of nominal money or constant purchasing power. In the latter case, profit represents the increase in physical productive capacity over the period.
Under the physical concept of capital maintenance, capital is measured by physical productive capacity. The capital is maintained (in terms of the physical productive capacity) if the productive capacity at the end of the period can produce a constant supply of goods and services as that at the beginning of the period. Suppose a company started a business with 100 units of goods at the beginning of the year, any additional units of stock over 100 at the end of the period can be regarded as profit. Profit is the amount in excess of that required to maintain the operating capacity (i.e. 100 units of stock) of the enterprise as at the beginning of the period.
(b)
Different measurement bases (historical cost, general purchasing power, current cost) and concepts of capital maintenance (financial capital maintenance, physical capital maintenance) can be adopted for determining the amount of profit and accounting model to be used in the preparation of the financial statements. Accounting models are derived from combining different measurement bases (historical cost or value to the business), unit of measurement (nominal dollar or constant dollar), and capital maintenance concepts (FCMC or OCMC).
Historical cost in nominal dollar and financial capital maintenance concept are currently being adopted for the determination of profit and in the preparation of financial statements.
The historical cost is the most objective amount for recording in the accounting books as no estimation or judgement is involved.
(c)
However, historical cost accounting method (HCA) is usually criticized for not reflecting realistic profit and financial position of the company. Firstly, the use of historical cost of fixed assets would not reflect their real value and thus value of assets in balance sheet might be understated. Less depreciation would be charged to income statement and thus profit would be overstated. Consequently, dividend might be over-distributed to shareholders.
Secondly, HCA cannot provide useful information for decision-making since the assets and liabilities in the financial statements are not in current value.
Thirdly, HCA fails to provide information about the ability of the company to continue to operate at the same level as preceding years. Historical cost of assets does not present a current measure of resources employed.
Question 2 (30 marks)
(a)
The income statement can be prepared according to the classification of expenses either by function or by nature. If the classification of expenses is by function, the expenses are divided into cost of sales, distribution costs and administrative expenses. On the other hand, the expenses may be classified by their nature and divided into change in inventories, goods purchased, staff costs, depreciation and other operating expenses. No matter which method is adopted, profit derived is the same.
(b)
(1) It is a non-adjusting post balance sheet event and disclosure of such event in the notes is required.
(2) It is a prior period adjustment (i.e. correction of fundamental error) and its journal entries are:
Dr. Previous years’retained earnings 800,000
Cr. Investment 800,000
(3) Journal entries for revaluation of land and buildings are:
Dr. Accumulated depreciation 10m
Cr. Land and buildings 10m
Dr. Land and buildings 5m
Cr. Revaluation reserve 5m
(4) Proposed dividends of $400,000 would not be shown as liabilities in balance sheet. It would be included as a component of shareholders’ fund.
(5) There is an obligating event or constructive obligation to pay redundancy payment in next year. A provision for redundancy payment is to be provided in the year 2001. The training cost is not an obligating event and thus no provision for it is required in the year 2001.
Dr. Profit and loss 560,000
Cr. Provision for redundancy payment 560,000
(c)
Income statement for the year ended 31 December 2001
$000
Turnover 21,000
Cost of sales 9,050
Gross profit 11,950
Distribution costs 2,600
Administrative expenses * 4,360
4,990
Finance charge 180
Profit before tax 4,810
Tax 860
Net profit for the year 3,950
=====
Dividend -- Interim 200
- Final
400
600
===
* (3,800 + 560)
(d)
For the sake of clarity, income statement and balance sheet present summary financial information only. The explanatory notes for the basis of preparation of financial statements and the breakdown of certain items in these statements are included in ‘notes to the financial Statements’. The notes provide additional information for those interested users to assess the company’s performance and financial position. The notes generally include the following items of information:
a) measurement bases and specific accounting policies selected;
b) changes in equity; and
c) other disclosures (e.g. nature of operations, name of ultimate holding company, etc.).
Section B -- Answer
TWO questions in this section.
Question 3
(a)
As a small investor, Peter will concern more with the earnings of his shares and dividends to be distributed to him. The aggregate profit or earning figure cannot serve that purpose. For example, the company may double its profit but the number of shares may be trebled. As a result, the small investors are worse off because they share lesser earnings.
“Earnings per share” (EPS) is an useful ratio to highlight the performance of the company in terms of the earnings for each share. It also forms the basis for the “price earnings ratio” (i.e. market price per share/earnings per share or simply P/E) which help investors and shareholders judge how much a company’s share is worth.
(b)
Sometimes, the increase in the number of equity shares in future may be expected for a number of circumstances. Such increase in the number of equity shares (i.e. potential ordinary shares) may lead to a decrease in future EPS as the number of equity shares is the denominator of the formula for determining EPS. Investors and creditors concern the decrease in the future earnings in terms of each equity share (i.e. dilution of earnings per share). Therefore, HKSSAP 5 prescribes the disclosure of diluted earnings per share on the face of income statement. The reason for this disclosure requirement is to inform the users of financial information of the possibility that the company’s earnings per share may be reduced in future.
(c)
2001
$000
Earnings (71,000 - 1,000) 70,000
No. of shares
40,000 + 4,000 44,000
Basic EPS $1.59
Restated comparative EPS ($1.5 x 1/1.10) $1.36
(d)
Incremental Incremental Incremental
No. of shares earnings EPS
Share options
No. of shares issued 2,000,000
No. of shares to be
issued at fair value 1,250,000 750,000 0 Nil
10% Convertible
debentures 1,200,000 840,000 $0.7
(1,000,000 x 84%)
Share options has nil incremental EPS, so the sequence of determining diluted EPS is share options and then 10% convertible debentures.
Earnings No.
of shares EPS
$000 000
As reported 70,000 44,000 $1.59
Share options -- 750
70,000 44,750 1.56 Dilutive
Convertible debentures 840 1,200
70,840 45,950 1.54 Dilutive
The diluted EPS is $1.54.
(e)
The earnings per share of the company is increased by 17% as compared with last year (i.e. $1.59 vs. $1.36). The diluted earnings per share is $1.54 and that does not dilute the basic EPS much. However, dividend yield (i.e. [$1.59 x l0%]/$8) is around 2%. In view of low return and high risk of share price fluctuation, Sunshine is not an attractive investment.
Question 4 (25 marks)
(a)
Share premium refers to the amount of issue price in excess of nominal value of shares. It is one of statutory reserves and can only be used for specific purposes, such as bonus issue, setoff against premium on redemption of shares and issuing expenses. Profit and loss refers to the retained earnings not yet distributed to shareholders. It is a non-statutory reserve and is kept for general purpose. The amount can be distributed to shareholders by means of dividends or used in any other ways, such as bonus issue.
(b)
(i) Issue of ordinary shares
Dr. Bank 120,000
Cr. Application of ordinary shares 120,000
(Application money received)
Dr. Application of ordinary shares 20,000
Cr. Bank 20,000
(Refund of application money)
Dr. Application of ordinary shares 100,000
Cr. Ordinary shares 80,000
Cr. Allotment of ordinary shares 20,000
Dr. Bank (400,000 x 1.3 -20,000) 500,000
Cr. Allotment of ordinary shares 500,000
(Allotment money received)
Dr. Allotment of ordinary shares 520,000
Cr. Ordinary shares (400,000 x 0.3) 120,000
Cr. Share premium (400,000 x 1) 400,000
Dr. First and final call (400,000 x 0.5) 200,000
Cr. Ordinary shares 200,000
Dr. Bank (390,000 x 0.5) 195,000
Dr. Call in arrears 5,000
Cr. First and final call 200,000
(Call money received)
Dr. Investment in own shares 5,000
Cr. Call in arrears 5,000
Dr. Bank (10,000 x 0.5) 5,000
Cr. Investment in own shares 5,000
(ii) Redemption of preference shares
$ $
Dr. Preference shares 1,000,000
Dr. Share premium 300,000
Dr. Profit and loss account 200,000
Cr. Bank 1,500,000
(Redemption of preference shares)
Dr. Profit and loss account 200,000
Cr. Capital redemption reserve * 200,000
*
Nominal value of preference shares redeemed 1,000,000
Gross proceeds of ordinary shares issued 800,000
Amount transferred to capital redemption reserve 200,000
(c)
Extract of shareholders’ fund in the balance sheet immediately after the issue of ordinary shares and redemption of preference shares:
Ordinary shares 3,400,000
Capital redemption reserve 200,000
Share premium 400,000
Profit and loss account 800,000
4,800,000
Question 5 (25 marks)
(a)
Deferred tax is the provision of tax attributable to the difference between accounting and taxable profits caused by timing differences. In other words, provision for the tax not paid in one period but that would be paid in another period (i.e. timing differences) is required. The tax liabilities not paid in this year are generally to be paid in later years and thus the deferred tax is warranted to be provided according to accrual or matching concept of accounting. It may not be much difference with the accounting treatment of accrued electricity expenses. “Profit after tax” is an important performance indicator and that is used for computing earnings per share (EPS) and other accounting analysis. Therefore, failure to provide for deferred tax may distort the reported earnings per share and P/E ratio, dividends may be over distributed to shareholders consequently.
(b)
Deferred tax for year 2001
Year Timing difference/(Reversing) Cumulative total
$000 $000
2002 250 250
2003 (500) (250)
2004 600 350
2005 (1,600) (1,250)
Total timing differences up to year 2001 = $2,500,000 and the timing differences expected to be reversed in next few years are $1,250,000.
$000
Closing balance (1,250 x 20%) 250
Opening balance (bid from Yr. 2000) 220
Deferred tax charged to profit and loss 30
Full potential deferred tax (2,500 x 20%) 500
Deferred tax not provided (500-250) 250
250
Deferred tax for year 2002
Year Timing difference/(Reversing) Cumulative total
$000 $000
2003 (500) (500)
2004 600 100
2005 (1,600) (1,500)
Total timing differences up to year 2002 = $2,500,000 + 250,000 = $2,750,000 and the timing differences expected to be reversed in the next few years are $1,500,000.
$000
Closing balance (1.500 x 20%) 300
Opening balance (bid from Yr. 2001) 250
Deferred tax charged to profit and loss 50
Full potential deferred tax (2,750 x 20%) 550
Deferred tax not provided (550 - 300) 250
Deferred tax for year 2003
Year Timing difference/(Reversing) Cumulative total
$000 $000
2004 600 600
2005 (1,600) (1,000)
Total timing differences up to year 2003 = $2,750,000 9-500,000 = $2,250,000 and the timing differences expected to be reversed in next few years are $1,000,000.
$000
Closing balance (1,000 x 30%) = 300
Opening balance (b/d from Yr. 2002) 300
Deferred tax charged to profit and loss 0
Full potential deferred tax (2,250 x 30%) 675
Deferred tax not Provided (675 - 300) 375
Deferred tax for year 2004
Year Timing difference/(Reversing) Cumulative total
$000 $000
2005 (1,600) (1,600)
Total timing differences up to year 2004 = $2,250,000 + 600,000 = $2,850,000 and the timing differences expected to be reversed in next year are $1,600,000.
$000
Closing balance (1,600 x 35%) 560
Opening balance (b/d from Yr. 2003) 300
Deferred tax charged to profit and loss 260
Full potential deferred tax (2,850 x 35%) 997.5
Deferred tax not provided (997.5 - 560) 437.5
(d)
Extract of balance sheets as at 31
December
2001 2002 2003 2004
$000 $000 $000 $000
Non-current liabilities
Provision for deferred tax 250 300 300 560
Notes to the accounts
Full potential deferred tax 500 550 675 997.5
Deferred tax not provided 250 250 375 437.5
***End of suggested solution***