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Return on Equity

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Return on Equity

Each of the questions 1 through 5 considers the effects of a particular accounting policy on a company. For each policy, two alternatives are presented: case A and case B. In each part, you are asked to identify the effect of the chosen accounting policy on specified financial statement items at the end of the accounting period. Each question (1 through 5) should be considered independently of the other parts.

Explanations for your answers are required.

  1. The company pays its employees monthly.

Case A: The company pays salaries for each month on the first day of the following month.
Case B: The company pays salaries for each month on the last day of that month. In both cases, assume the accounting period is one month.

1.1. Which case will result in a higher cash balance on the balance sheet?

  1. a) Case A
  2. b) Case B
  3. c) Cash will be the same for both A and B
  4. d) Cannot tell from the information given

1.2 Which case will result in higher expenses?

  1. a) Case A
  2. b) Case B
  3. c) Expenses will be the same for both A and B
  4. d) Cannot tell from the information given

1.3 Which case will result in higher accounts payable?

  1. a) Case A
  2. b) Case B
  3. c) Accounts payable will be the same for both A and B
  4. d) Cannot tell from the information given
  1. The company sells products on credit.

Case A: The company makes no provision for bad debt when it sells its products.
Case B: The company makes a provision for bad debt equal to 1% of its sales.

Assume the accounting period is one month, and no write-offs of Accounts Receivable are made during this month.

2.1. Which case will result in higher net profit?

  1. a) Case A
  2. b) Case B
  3. c) Profit will be the same for both A and B
  4. d) Cannot tell from the information given

2.2. Which case will result in higher assets?

  1. a) Case A
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given

2.3. Which case will result in a higher current ratio?

  1. a) Case A
  2. b) Case B
  3. c) Current ratio will be the same for both A and B
  4. d) Cannot tell from the information given
  1. The company uses a molding machine in its production process. The machine was purchased on the first day of the accounting period, which in this case is one year.

Case A: The company depreciates the machine over 10 years, with no salvage/residual value.
Case B: The company depreciates the machine over 6 years, with a salvage value of 30% of cost.

3.1 Which case will result in higher depreciation expense?

  1. a) Case A
  2. b) Case B
  3. c) Depreciation expense will be the same for both A and B
  4. d) Cannot tell from the information given

3.2 Which case will result in higher assets?

  1. a) Case A
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given
  1. The company leases warehouse facilities for its business.

Case A: The company classifies the lease as an operating lease.
Case B: The company classifies the lease as a capital lease.

Assume that the lease terms are the same in both cases, and the accounting period is one year.

4.1 Which case will result in higher assets?

  1. a) Case A
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given

4.2 Which case will result in higher liabilities?

  1. a) Case A
  2. b) Case B
  3. c) Liabilities will be the same for both A and B
  4. d) Cannot tell from the information given

4.3 Which case will result in higher cash flow?

  1. a) Case A
  2. b) Case B
  3. c) Cash flow will be the same for both A and B
  4. d) Cannot tell from the information given
  1. The company’s current liabilities are 20% of its assets.

Case A: The company’s long term capital (remaining 80% of assets) is entirely made up of equity. Case B: The company’s long term capital (remaining 80% of assets) is split evenly between equity, and long term debt carrying an interest rate of 2% annually. The debt has been outstanding the entire year, and the company’s interest rate coverage ratio is 5.

For this question, ignore taxes (assume the tax rate is 0), and assume assets and equity at the beginning of the year were equal to assets and equity at the end of the year. The accounting period is one year.

5.1 Which case will result in a higher return on assets?

  1. a) Case A
  2. b) Case B
  3. c) Return on assets will be the same for both A and B
  4. d) Cannot tell from the information given

5.2 Which case will result in a higher return on equity?

  1. a) Case A
  2. b) Case B
  3. c) Return on equity will be the same for both A and B
  4. d) Cannot tell from the information given
  1. Following are inventory records for a clock shop (a merchandiser). All clocks sold by the store are identical and of a high quality. Each clock purchased from the supplier is assigned a unique identification number, and this identification number is linked with the clock’s cost in the store’s inventory tracking system. The shop uses an accounting period of one month.
1st May Beginning inventory is 20 clocks, which cost £480 each.
7th May Sold 10 clocks for a price of £700 each.
16th May Purchased 25 clocks for inventory at a cost of £420 each.
22nd May Sold 30 clocks for a price of £720 each.

Solution

  1. The company pays its employees monthly.

Case A: The company pays salaries for each month on the first day of the following month.
Case B: The company pays salaries for each month on the last day of that month.

In both cases, assume the accounting period is one month.

1.1. Which case will result in a higher cash balance on the balance sheet?

  1. a) Case A
  2. b) Case B
  3. c) Cash will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: In Case B there is only cash outflow accounted for the month making cash balance negative while in Case A there is no cashoutflow, as salaries will be paid on the first day of the following month hence cash balance will be higher in Case A

1.2 Which case will result in higher expenses?

  1. a) Case A
  2. b) Case B
  3. c) Expenses will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Assuming companies books are following accrual accounting, Salary Expenses are booked on the same month and hence Expenses will be the same for both A and B

1.3 Which case will result in higher accounts payable?

  1. a) Case A
  2. b) Case B
  3. c) Accounts payable will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: In Case A as salary account needs to be paid on first day of following month liability is created under the name of accounts payable, hence Case A will have higher account payable

  1. The company sells products on credit.

Case A: The company makes no provision for bad debt when it sells its products.
Case B: The company makes a provision for bad debt equal to 1% of its sales.

Assume the accounting period is one month, and no write-offs of Accounts Receivable are made during this month.

2.1. Which case will result in higher net profit?

  1. a) Case A
  2. b) Case B
  3. c) Profit will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Net profit = gross profit – expenses (includes tax, interest, overhead charges etc.)

In income statement Bad debt provision is reported as Bad Debt Expense, hence in Case B expenses become higher leading to decrease in net profits therefore Case A has higher net profit due to absence of provision for Bad Debt

2.2. Which case will result in higher assets?

  1. a) Case A
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: The Company is following the policy of creating provision on the basis of sales hence there will be no change debtors(assets). This provision comes under liability. Hence assets remain same for both cases

2.3. Which case will result in a higher current ratio?

  1. a) Case A
  2. b) Case B
  3. c) Current ratio will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. Current ratio is a comparison of current assets to current liabilities, calculated by dividing your current assets by your current liabilities. Assuming other current assets and liabilities remain the same in both the cases Current liability increases in case B as the provision for Bad debt comes under liability as it is on the basis of sale

  1. The company uses a molding machine in its production process. The machine was purchased on the first day of the accounting period, which in this case is one year.

Case A: The company depreciates the machine over 10 years, with no salvage/residual value.
Case B: The company depreciates the machine over 6 years, with a salvage value of 30% of cost.

3.1 Which case will result in higher depreciation expense?

  1. a) CaseA
  2. b) Case B
  3. c) Depreciation expense will be the same for both A and B
  4. d) Cannot tell from the information given

Answer:

Depreciation expense = ( Machine cost – salvage value)/life time

Machine cost = X

Case A :Depreciation expense at the end of one year =X/10 = 0.1X
Case B :Depreciation expense at the end of one year = (X – 0.3X)/6 = 0.12X

Hence Case B will result in higher depreciation expense

3.2 Which case will result in higher assets?

  1. a) CaseA
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Year-end Asset Value = Year beginning Asset Value – Depreciation

Case A: Year-end Asset Value = X – 0.1X = 0.9X
Case B: Year-end Asset Value = X – 0.12X = 0.88X

Hence Case A will result in higher assets

  1. The company leases warehouse facilities for its business.

Case A: The Company classifies the lease as an operating lease.
Case B: The Company classifies the lease as a capital lease.

Assume that the lease terms are the same in both cases, and the accounting period is one year.

4.1 Which case will result in higher assets?

  1. a) CaseA
  2. b) Case B
  3. c) Assets will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Assuming Company is taking warehouse on lease, Case A the operational lease has following effects on balance sheet:

  • Balance sheet – No assets or liabilities are recorded.

Case B, if company classifies the lease as a capital lease it will have following effects on balance sheet:

  • Balance sheet – At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.

Hence Case B will result in higher assets

4.2 Which case will result in higher liabilities?

  1. a) CaseA
  2. b) Case B
  3. c) Liabilities will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Assuming Company is taking warehouse on lease,

Case A the operational lease has following effects on balance sheet:

  • Balance sheet – No assets or liabilities are recorded.

Case B, if company classifies the lease as a capital lease it will have following effects on balance sheet:

  • Balance sheet – At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.

Hence Case B will result in higher assets

4.3 Which case will result in higher cash flow?

  1. a) CaseA
  2. b) Case B
  3. c) Cash flow will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: Cash flow statements remain unaffected by the choice of classifying leases as operating or capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease obligation. The principal repayment on the lease obligation payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO by the amount included in CFF and understate CFF.

  1. The company’s current liabilities are 20% of its assets.

Case A: The Company’s long term capital (remaining 80% of assets) is entirely made up of equity.
Case B: The Company’s long term capital (remaining 80% of assets) is split evenly between equity, and long term debt carrying an interest rate of 2% annually. The debt has been outstanding the entire year, and the company’s interest rate coverage ratio is 5.

For this question, ignore taxes (assume the tax rate is 0), and assume assets and equity at the beginning of the year were equal to assets and equity at the end of the year. The accounting period is one year.

5.1 Which case will result in a higher return on assets?

  1. a) CaseA
  2. b) Case B
  3. c) Return on assets will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: return on assets = netprofit/total assets

Also, netprofit = gross profit -interest – tax

As in both the cases total assets remain the same, Case A company do not have any taxes and Interest to be paid whereas in Case B company has interest on debt that needs to be paid hence net profit will be lower in this case subsequently return on assets will be lower in case B

5.2 Which case will result in a higher return on equity?

  1. a) CaseA
  2. b) Case B
  3. c) Return on equity will be the same for both A and B
  4. d) Cannot tell from the information given

Answer: return on equity = netprofit/total equity

Assuming total assets = X

CaseA: Equity = 0.8X ; Debt = 0 ; Interest on debt = 0
CaseB: Equity = 0.4X ; Debt = 0.4X ; Interest on debt = 0.08X

Hence in Case B, though Net profit will be lower by difference of 0.08X but total equity will take a bigger dip by 0.4X hence the ratio of return on equity for B will be higher

6. Following are inventory records for a clock shop (a merchandiser). All clocks sold by the store are identical and of a high quality. Each clock purchased from the supplier is assigned a unique identification number, and this identification number is linked with the clock’s cost in the store’s inventory tracking system. The shop uses an accounting period of one month.

6.1 First, assume that the shop uses the specific identification cost flow assumption. Demonstrate how the store’s management could maximize its gross profit for the month by specifically selecting which clocks to sell on the 7th and 22nd of May.

Answer- 7th May: Has only inventory of 20 clocks, which cost £480 each hence will sell 10 clocks for a price of £700 each

22nd May: For maximizing profit clocks with lower price i.e 25 clocks with cost of £420 each should be sold first and than 5 clocks of cost £480 each should be sold

6.2 Now, instead assume that the shop uses the First In, First Out (FIFO) cost flow assumption. Calculate cost of goods sold and gross profit for the month under FIFO.

Answer- First In, First Out (FIFO) cost flow assumption

Cost of goods sold = 10*480 + 10*480 + 20*420 = 18000

Gross Profit = 700*10 + 720*30 – 18000 = 10600

6.3 Finally, assume instead that the shop uses the average cost method assumption. Calculate cost of goods sold and gross profit for the month under this method.

Answer- Assuming perpetual system for average cost method assumption,

Cost of goods sold = Cost of goods sold = 10*480 + 30*437.14 = 17914.3

Gross Profit = 700*10 + 720*30 – 17914.3 = 10685.71

6.4 Which method do you think the shop should use, and why?

Answer Out of these two perpetual average costing system should be used as it reports the cost of goods sold lesser showing higher profits on books

7.1 What kind of company do you think this is – a merchandiser, manufacturer or service company? Why?

Answer- Looking and analyzing the financial statements of the company I think it is a service company because looking at the inventories which are very small and negative can never be of merchandiser who always have a large percentage of inventories and neither of manufacturer which has fixed set of inventory in each production cycle. Also Property, Plant and Equipment might create confusion but in this case it surely represents thee fixed assets like land or building or offices of service Provider Company.

7.2 Where is this company likely to be in its life cycle – start-up, growth stage, mature, or declining? Explain your answer.

Answer- Looking at the decreasing Share Capital which indicated that company is paying the investors to buy back the equity hence retained earnings are increasing, Net Cash flow from Financing Activities has also increased tremendously from -0.1 to -6.3 . Cost of good as a percentage of sales are decreasing while gross profit is increasing hence company should be in its growth stage

7.3 Evaluate the company’s profitability, liquidity and solvency, using figures from the financial statements to support your answer.

Profitability, liquidity and solvency

Solvency: Debt to equity = Total Liabilities / Total equity =31.1/68.9

Debt to Asset = Total liability / Total interest = 31.1/100

Debt to capital = Debt / Debt + Equity = 31.1/(31.1+68.9)

Interest Coverage = EBIT/Interest = No interest expense

Profitability

Grossprofit margins = Gross Income/ Net Revenue = 46.8/100

Operating Income margins = Operating Income/ Net Revenue = 10.1/100

Netprofit margins = Net Income/ Net Revenue = 8.3/100

Return on investment = Net Income/Total Assets = 8.3/100

Return on investment = Net Income/Total Equity = 8.3/68.9

Liquidity

Current Ratio = Current Assets/ Current liabilities = 61.1/ 29.3

Woking Capital = Current Assets – Current Liabilities = 61.1-29.3

Quick Return ratio = (24.2+36)/29.3

Cash Reserve = 24.2/29.3

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