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

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

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