The foregoing discussion reveals that many items on the asset side are susceptible to multiple valuation:
1 Fixed assets can be depreciated at many rates and by many methods.
2 Inventories can be valued by many methods and may include varying proportions of factory overheads.
3 Debtors may be reduced by whatever amount management considers to be prudent for a provision against bad debts.
Other items on the balance sheet are absolutely fixed and unalterable: cash, creditors, long-term loans and so on. How is it then that the balance sheet always balances, given this array of possible valuations?
The secret lies in understanding the role of the profit and loss account and how it relates to the balance sheet.
Consider the situation of a management facing the decision to switch their inventory valuation from LIFO to FIFO; the economic environment is inflationary and unit prices of the inventory items are rising. If management made the switch, the balance sheet valuation for inventory would rise, reflecting the most recent, and highest, unit prices trapped in inventory at the end of the accounting period.
But the knock-on effects of such a switch are clear too:
• a relatively high closing inventory valuation (in the balance sheet); leads to
• a relatively low charge for cost of goods sold (in the profit and loss account);
which leads to
• a relatively high reported profit (in the profit and loss account); which leads to
• a relatively high ‘profit retained’ figure in the balance sheet.
Example
The figures of the illustration in Module 2 are given below.
Altogether 1200 units were purchased in a period of rising raw material prices at two-monthly intervals as follows:
February 200 units @ £1.00 each £200
April 200 units @ £1.50 each 300
June 200 units @ £2.00 each 400
August 200 units @ £2.50 each 500
October 200 units @ £3.00 each 600
December 200 units @ £3.50 each 700
1 200 units £2 700
The opening inventory of 100 units was valued at £1 per unit. Therefore the total costs to be allocated amount to £2800.
Assume the alternative facing management is to value inventory on either a LIFO or a FIFO basis. The total costs to allocate are £2800. The profit and loss account would appear as follows:
Under LIFO Under FIFO
Sales:
1000 units @ say £4.00 £4 000 £4 000
Opening stock £ 100 £ 100
Purchases:
1200 units @ varying prices 2 700 2 700
£2 800 £2 800
Less: Closing stock 300 units 350 1 000
Cost of goods sold 2 450 1 800
Gross profit £1 550 £2 200
Valuation of closing stock LIFO FIFO
300 units 100 units @ £1.50 = £150 100 units @ £3.00 = £300 200 units @ £1.00 = £200 200 units @ £3.50 = £700
£350 £1 000
Assuming no tax or distribution to shareholders:
Balance sheet under LIFO
Owner’s equity increased by £1550 Inventory valuation £350
Balance sheet under FIFO
Owner’s equity increased by £2200 Inventory valuation £1000 (an increase over LIFO of £650) (an increase over LIFO of £650) It can be seen that the profit and loss account acts as a kind of trampoline into which are dropped changes in asset valuation and out of which will bounce a matching impact on profits. The balance sheet will always balance because of this role played by the profit and loss account.
3.8 Summary
The balance sheet is often described as a snapshot of a company’s resources on a given date. Imagine the view from a helicopter sent up to take an aerial photograph of a company. Plant and equipment, land and buildings, piles of inventory (raw materials, work-in-progress and finished goods) would be picked out by the camera, maybe even the cash drawers stuffed with money! In other words, the assets would be fairly clearly visible and the reader would have to imagine how these assets have been funded (unless the camera spotted a queue of bankers and creditors at the factory gates shouting for their money).
The profit and loss, by contrast, could be regarded as a video of the company’s activities during the year. A video is a moving picture, not a static snapshot, and would reflect the constantly fluid operations of accomplishment and effort, the purchasing, manufacturing and selling activities which reflect the company’s raison d’ˆetre.
Balance sheets contain assets measured by reference to historic cost. Historic costs are a favourite among accountants and auditors because they can be easily verified and not influenced by too much subjective assessment. But does it really matter what a company paid for an asset years ago? Wouldn’t it be better to attempt to reflect the value to the company of the asset today? This would involve either assessing how much the company would receive if the asset were sold today, or future income streams which the asset will generate discounted back to today. These are complex matters, so complex, in fact, that members of the accounting profession cannot agree among themselves which method is superior or how to go about the valuation profession.
Readers of this text should be aware that the relevance of historic cost is under constant review but until the accounting profession can agree on what is to replace it, they should master the techniques, and understand the philosophy, of historic cost accounting.
Review Questions
3.1 The following items appear in balance sheets.
(i) Cash, as current assets.
(ii) Inventories, as fixed assets.
(iii) Plant, as current assets.
(iv) Creditors, as current liabilities.
Which of the following is correct?
(a) (i) and (ii) only.
(b) (i) and (iv) only.
(c) (i), (ii) and (iii) only.
(d) (i), (ii) and (iv) only.
3.2 Companies acquire fixed assets for a variety of reasons, including:
(i) to act as a hedge against inflation;
(ii) to resell at a profit in the future;
(iii) to avoid cash surpluses;
(iv) to use in the course of the business.
Which of the following correctly reflects their primary reason(s)?
(a) (i) only.
(b) (i) and (ii) only.
(c) (iii) and (iv) only.
(d) (iv) only.
3.3 To accountants, capitalising expenditure and writing off expenditure have iden-tical impacts on the profit and loss account. True or false?
The following information applies to Questions 3.4–3.6.
A major electronics company has acquired a greenfield site to build a new factory.
The land cost £1.5 million and there were professional fees of £100 000. The site requires remedial work costing £500 000 on old mineshafts before any building can commence. The company plans a massive advertising drive to promote the factory and to recruit skilled personnel. An initial package of £400 000 has been agreed with their advertising agents for this purpose.
3.4 How much of this expenditure will be written off in the profit and loss account?
(a) £100 000.
(b) £400 000.
(c) £500 000.
(d) £900 000.
3.5 What is the cost of the land in the company’s balance sheet?
(a) £1.5 million.
(b) £1.6 million.
(c) £2.0 million.
(d) £2.1 million.
3.6 If, after a two-year property boom, the land was revalued at £2.9 million, how much might then be transferred to a revaluation reserve?
(a) £0.8 million.
(b) £0.9 million.
(c) £1.3 million.
(d) £1.4 million.
3.7 There are several benefits for companies in choosing to lease fixed assets, rather than purchase them outright, including:
(i) beneficial cash flow impact of smaller payments;
(ii) overstatement of profits;
(iii) improved operational efficiency of assets;
(iv) replacement of assets without generating gains or losses.
Which of the following is correct?
(a) (i) and (ii) only.
(b) (i) and (iv) only.
(c) (ii) and (iii) only.
(d) (ii) and (iv) only.
3.8 The accounting profession has developed guidelines to deal with leased assets.
In which of the following contractual agreements do these guidelines apply?
(a) Contract hire, for a vehicle.
(b) Rental, for a van.
(c) Finance lease, for a photocopier.
(d) Short-term hire, for a compressor.
3.9 The exclusion of leased assets from a balance sheet has the effect of:
(a) overstating both assets and liabilities;
(b) understating assets, but overstating liabilities;
(c) understating both assets and liabilities;
(d) overstating assets, understating liabilities.
3.10 Which of the following is NOT a current asset?
(a) Cash.
(b) Inventories.
(c) Vehicles.
(d) Debtors.
The following information applies to Questions 3.11–3.14.
Thames Limited has listed the following amounts in its balance sheet:
Cash £10 000 Debtors £55 000
Buildings £75 000 Plant £30 000
Creditors £25 000 Inventories £60 000
Taxes payable
£15 000 Dividends
payable
£20 000
3.11 What is the amount of total current assets?
(a) £125 000.
(b) £150 000.
(c) £180 000.
(d) £255 000.
3.12 What is the amount of total fixed assets?
(a) £75 000.
(b) £105 000.
(c) £130 000.
(d) £190 000.
3.13 What is the amount of total current liabilities?
(a) £35 000.
(b) £40 000.
(c) £50 000.
(d) £60 000.
3.14 What is the amount of net current assets?
(a) £40 000.
(b) £45 000.
(c) £65 000.
(d) £95 000.
The following information applies to Questions 3.15–3.17.
Humber Limited has extracted the following information for its financial year-ends 20x0–20x2:
Debtors Specific bad
debts written off
20x0 £150 000 Nil
20x1 £180 000 £3 500
20x2 £210 000 £5 700
Its policy towards bad debts is to make a general provision of 4 per cent of debtors.
Specific bad debts have already been written off during each year.
3.15 What is the amount of the provision for bad debts at the end of 20x1?
(a) £7 200.
(b) £10 700.
(c) £13 200.
(d) £16 799.
3.16 What is the amount charged for bad debts in the profit and loss account in 20x2?
(a) £5700.
(b) £6900.
(c) £7200.
(d) £8400.
3.17 What is the amount of debtors less provision for bad debts at the end of 20x2?
(a) £192 400.
(b) £194 400.
(c) £195 900.
(d) £201 600.
The following information applies to Questions 3.18–3.19.
Gleneagles Golf Club Limited has a financial year which runs to 31 March each year.
The annual subscription has been fixed at £500 for the years to 31 March 20x0, 20x1 and 20x2. At 31 March 20x0, ten members had paid their annual subscriptions in advance. At 31 March 20x1, all 400 members were fully paid up, but 20 had paid their subscriptions in advance for the year to 31 March 20x2.
3.18 What is the subscription revenue for the year to 31 March 20x1?
(a) £195 000.
(b) £200 000.
(c) £205 000.
(d) £210 000.
3.19 What is the amount of deferred revenue at 31 March 20x1?
(a) £Nil.
(b) £5 000.
(c) £10 000.
(d) £15 000.
The following information applies to Questions 3.20–3.21.
The following balances have been extracted from the accounting records of Mersey Limited at 31 January 20x0.
Creditors £20 000 Prepayments £2 000
Taxes payable
£10 000 Accruals £4 500
Loan stock £40 000 Bank overdraft £8 500
Debtors £45 000 Leasing creditor £9 000
Additional information is available:
1 The leasing creditor comprises a further three years of lease payments of £3000 per annum.
2 The loan stock is repayable in four equal annual instalments, the first of which is due on 31 January 20x1.
3.20 What is the amount of total current liabilities at 31 January 20x0?
(a) £43 000.
(b) £46 000.
(c) £52 000.
(d) £56 000.
3.21 What is the amount of total long-term liabilities at 31 January 20x0?
(a) £36 000.
(b) £39 000.
(c) £46 000.
(d) £49 000.
3.22 In preparing year-end financial statements, which of the following is the correct treatment for deferred revenue?
(a) As a current asset in the balance sheet.
(b) As a current liability in the balance sheet.
(c) As a long-term liability in the balance sheet.
(d) As an expense in the profit and loss account.
3.23 In more profitable years, ordinary shareholders can expect a higher return on their investment than lenders of long-term loans. True or false?
3.24 Which of the following costs will normally be excluded from the valuation of inventories?
(a) Direct materials.
(b) Variable manufacturing overhead.
(c) Selling and distribution overhead.
(d) Fixed manufacturing overhead.
The following information applies to Questions 3.25–3.26.
Solway Limited has the following three-year record of profits before interest:
Year £
1 55 000
2 36 000
3 48 000
Assume that owner’s equity is fixed at £100 000 for each of the three years. The company has been offered long-term loan stock at 10 per cent per annum.
3.25 In Year 2, how much long-term loan stock would result in a return on owner’s equity of 25 per cent?
(a) £110 000.
(b) £230 000.
(c) £300 000.
(d) £350 000.
3.26 In Year 3, how much long-term loan stock would result in a gearing ratio of 37.5 per cent?
(a) £37 500.
(b) £60 000.
(c) £137 500.
(d) £160 000.