BA3: Preparing financial statements

Answer: D. The £24,000 covers 1 October to 30 September. By the year end of 31 December, only 3 months (October to December) have been used, an expense of £24,000 × 3/12 = £6,000. The remaining 9 months (January to September) are prepaid: £24,000 × 9/12 = £18,000. The £6,000 figure is the rent expense for the period, not the prepayment. The prepayment is the amount paid in advance that relates to the next financial year. £2,000 is one month's rent, not the nine months paid in advance.

Answer: A. Writing off an irrecoverable debt removes the asset and recognises an expense: debit irrecoverable debts expense (increasing expenses) and credit receivables (removing the amount owed). Reversing the entry would wrongly reinstate the asset, and a cash entry would imply the customer had paid, which is not the case for a write-off. The debt is removed because it is no longer expected to be recovered.

Answer: B. IAS 2 requires inventory to be measured at the lower of cost and net realisable value, applying prudence so that inventory is never carried above the amount expected to be recovered from selling it. Valuing at selling price would anticipate profit before it is earned, and taking the higher of the two figures would overstate the asset. Net realisable value is the estimated selling price less the costs to complete and sell the goods.

Answer: C. Under FIFO (first in, first out), the earliest purchases are treated as sold first. The 120 units sold comprise all 100 of the £5 units and 20 of the £6 units, leaving 80 units from the second batch at £6 = £480 as closing inventory. The £440 figure is the AVCO valuation. FIFO leaves the most recent (and here higher) costs in closing inventory, because the older costs are charged to cost of sales first. £400 values the 80 remaining units at the earlier £5 cost, which is what LIFO would leave.

Answer: D. Under AVCO, a weighted average cost is calculated: total cost (100 × £5 + 100 × £6 = £1,100) ÷ total units (200) = £5.50 per unit. Closing inventory of 80 units × £5.50 = £440. The £480 figure is the FIFO valuation, which uses the later price for the units remaining. AVCO smooths out price changes by averaging the cost of all units available for sale. £400 values the 80 remaining units at the earlier £5 cost.

Answer: A. Cost of sales = opening inventory + purchases − closing inventory = £10,000 + £60,000 − £15,000 = £55,000. Gross profit = sales − cost of sales = £100,000 − £55,000 = £45,000. The £55,000 figure is the cost of sales itself, not the gross profit. Closing inventory is deducted because those goods have not yet been sold, so their cost is carried forward to the next period rather than charged against this period's sales. £35,000 reverses the inventory adjustment (cost of sales £60,000 − £10,000 + £15,000 = £65,000), and £40,000 ignores both inventory figures (£100,000 − £60,000).

Answer: B. Under IAS 7, buying or selling non-current assets is classified under investing activities, which covers cash flows relating to the acquisition and disposal of long-term assets and investments. Operating activities cover the main revenue-generating trading cash flows, and financing activities cover changes in equity and borrowings. Capital expenditure on a non-current asset is a classic investing cash outflow.

Answer: D. Under the accruals concept, the expense is the amount relating to the period, whether or not it has been paid: £900 paid + £300 owing (accrued) = £1,200. The £300 accrual is also shown as a current liability in the statement of financial position. The £900 figure is only the amount paid, ignoring the accrual. Expenses are matched to the period they relate to, not to when cash is paid. £600 deducts the accrual instead of adding it.

Answer: A. The allowance = receivables × allowance percentage = £50,000 × 4% = £2,000. This allowance is set against receivables in the statement of financial position, reducing them to the amount expected to be recovered (£48,000), and the charge appears as an expense. The £48,000 figure is the net receivables after the allowance, not the allowance itself. The allowance reflects prudence over amounts that may not be collected. £500 and £200 apply the wrong percentage (1% and 0.4%) instead of 4%.

Answer: B. Only the increase in the allowance is charged as an expense: £2,000 − £1,500 = £500. The opening allowance of £1,500 was already charged in a previous period, so charging the full £2,000 would double-count it. The £3,500 figure adds the two balances. If the required allowance had fallen, the reduction would instead be credited (a reduction in the expense).

Answer: C. Under LIFO, the most recent purchases are treated as sold first. The 120 units sold comprise all 100 of the £6 units and 20 of the £5 units, leaving 80 units from the first batch at £5 = £400 as closing inventory. The £480 figure is the FIFO valuation and £440 the AVCO valuation. LIFO leaves the oldest (here lower) costs in closing inventory, because the most recent costs are charged to cost of sales first.

Answer: D. Prime cost is the total of all direct manufacturing costs: direct materials £20,000 + direct labour £15,000 + direct expenses £2,000 = £37,000. The £35,000 figure omits the direct expenses. Adding factory overheads to prime cost would give the total production cost, a later figure in the manufacturing account. Prime cost captures only the directly attributable costs of production before indirect overheads. £22,000 omits the direct labour, and £50,000 does not follow from the direct costs given.

Answer: A. Net profit = gross profit − operating expenses = £45,000 − £20,000 = £25,000. Gross profit is sales less cost of sales; net profit then deducts the other operating expenses such as administration and distribution costs. The £65,000 figure adds the expenses instead of subtracting them. Net profit is the overall measure of trading performance after all operating costs.

Answer: B. Trade receivables are a current asset because they are expected to be converted into cash within the normal operating cycle (usually within twelve months). Land and buildings are non-current assets, a ten-year bank loan is a non-current liability, and share capital is equity. Current assets are short-term resources such as inventory, receivables and cash, distinguished from the long-term assets and the sources of finance.

Answer: C. A mark-up of 25% on cost is added to the cost of sales: sales = £40,000 × 1.25 = £50,000 (the £10,000 mark-up plus the £40,000 cost). Mark-up is based on cost, unlike margin, which is based on selling price. The £32,000 figure would deduct rather than add. Incomplete-records questions often rely on a known mark-up or margin to derive a missing sales or cost figure.

Answer: A. Income earned but not yet received is accrued income (also called accrued revenue), recognised as a current asset because the entity is owed the amount. Deferred income is the opposite — cash received in advance of earning it, shown as a liability. A prepayment is an expense paid in advance, and an accrual is an unpaid expense. The accruals concept requires earned income to be recognised when earned, not when received.

Answer: B. Under IAS 2, inventory is valued at the lower of cost (£5,000) and net realisable value (£4,200), so it is carried at £4,200. The £800 difference is written down as an expense, reflecting prudence. The £5,000 cost would overstate the asset above its recoverable amount, and £9,200 adds the two figures. Inventory is never carried above the amount expected to be recovered from selling it.

Answer: C. Total production cost = prime cost + factory overheads = £37,000 + £13,000 = £50,000. Prime cost covers the direct costs, and adding the indirect factory overheads gives the full cost of production (before any adjustment for work-in-progress). The £37,000 and £13,000 figures are the two components themselves. The manufacturing account builds from prime cost to production cost in this way. £63,000 adds the overheads twice.

Answer: D. Depreciation is an expense in the statement of profit or loss, spreading the cost of using a non-current asset over its useful life. Drawings are a reduction of the owner's capital, not an expense; the purchase of a non-current asset is capital expenditure shown in the statement of financial position; and a dividend is a distribution of profit, not an expense. Only depreciation among these reduces reported profit as an operating cost.

Answer: A. A bank loan repayable in five years is a non-current liability, because it is not due for settlement within twelve months. Trade payables, a bank overdraft and accrued expenses are all current liabilities, expected to be settled within the normal operating cycle or twelve months. The distinction between current and non-current liabilities is based on when the obligation falls due for payment.

Answer: B. Depreciation is a non-cash expense that reduced profit but involved no outflow of cash, so under the indirect method it is added back to profit to move toward the cash figure. A cash sale already affects cash through working-capital changes, a dividend received is an actual cash flow classified separately, and a loan repayment is a financing cash flow. Non-cash items such as depreciation are the classic add-backs in the indirect method.

Answer: C. A margin of 30% is based on selling price, so gross profit = £80,000 × 30% = £24,000 and cost of sales = sales − gross profit = £80,000 − £24,000 = £56,000. The £24,000 figure is the gross profit, not the cost of sales. Margin is calculated on sales, unlike mark-up, which is calculated on cost — a distinction that is essential in incomplete-records questions. £104,000 adds 30% to sales, which confuses margin with mark-up and moves in the wrong direction.

Answer: D. Rent received in advance is deferred income (income received but not yet earned), shown as a current liability because the business owes the tenant the use of the property in the future. It is not recognised as revenue yet, under the accruals concept, because it has not been earned. Accrued income and prepayments are different items relating to amounts earned-but-unreceived and expenses-paid-in-advance respectively.

Answer: A. As the debt was already written off, the receivable no longer exists, so the recovery is recorded as income: debit cash and credit irrecoverable debts recovered (or credit the irrecoverable debts expense account). Crediting receivables would be wrong because there is no longer a receivable to reduce. The unexpected recovery effectively reverses part of the earlier expense, improving profit in the period of recovery.

Answer: B. Under FIFO, the oldest units are sold first. The 120 units sold comprise the 50 opening units at £4 (£200) and 70 of the new units at £5 (£350), giving a cost of sales of £200 + £350 = £550. £480 values all 120 units at the opening £4 cost, and £600 values them all at the later £5 price. FIFO charges the earliest costs to cost of sales, leaving the most recent costs in closing inventory.

Answer: C. Cost of goods manufactured = total production cost + opening work in progress − closing work in progress = £50,000 + £3,000 − £5,000 = £48,000. The increase in work in progress means some production cost relates to goods not yet completed, so it is carried forward rather than transferred. The £52,000 figure reverses the work-in-progress adjustment. Only completed production is transferred to the trading account. £58,000 adds both the opening and the closing work in progress.

Answer: D. Retained earnings carried forward = opening retained earnings + profit for the year − dividends = £40,000 + £15,000 − £5,000 = £50,000. Profit increases retained earnings, while dividends are a distribution that reduces them. The £60,000 figure adds the dividends instead of subtracting. Retained earnings are the accumulated profits kept in the business rather than distributed to shareholders. £55,000 ignores the dividends, and £35,000 ignores the profit for the year.

Answer: A. Dividends paid are a distribution to owners and so appear in the statement of changes in equity, which reconciles opening and closing equity through profit, dividends, share issues and other movements. Depreciation, cost of sales and carriage inwards are all items in the statement of profit or loss, affecting profit rather than appearing directly in the equity reconciliation. The statement of changes in equity reports movements in owners' funds.

Answer: B. Cost of sales = opening inventory + purchases − closing inventory, so purchases = cost of sales − opening inventory + closing inventory = £60,000 − £8,000 + £10,000 = £62,000. Because closing inventory is higher than opening, more was bought than was sold, so purchases exceed cost of sales. The £58,000 figure reverses the inventory adjustment. Rearranging the cost-of-sales formula is a common incomplete-records technique. £78,000 adds both inventory figures to cost of sales.

Answer: C. An increase in inventory means cash has been used to buy stock that has not yet been sold, so it is deducted from profit when arriving at cash generated from operations. A decrease in inventory would be added back. Inventory movements are working-capital adjustments within operating activities, not financing items, and they cannot be ignored. The indirect method adjusts profit for non-cash items and working-capital changes to reach the cash figure.

Answer: A. The expense = opening prepayment + cash paid − closing prepayment = £300 + £2,400 − £400 = £2,300. The opening prepayment relates to this year's cover (so it is added), while the closing prepayment relates to next year (so it is deducted). The £2,400 figure is simply the cash paid, ignoring the prepayment adjustments. Matching the expense to the period requires adjusting cash paid for amounts paid in advance at each end. £2,500 reverses both prepayment adjustments, and £3,100 adds both.

Answer: B. The general allowance applies to the receivables after removing the specifically doubtful debt: 5% × (£40,000 − £2,000) = 5% × £38,000 = £1,900. Total allowance = specific £2,000 + general £1,900 = £3,900. The £4,000 figure applies 5% to the full £40,000 and adds it incorrectly, or otherwise misallocates. The specific debt is allowed for in full and excluded before the general percentage is applied.

Answer: C. The weighted average cost = total cost ÷ total units = (100 × £4 + 300 × £5) ÷ 400 = (£400 + £1,500) ÷ 400 = £1,900 ÷ 400 = £4.75 per unit. The £4.50 figure is the simple average of £4 and £5, which ignores that there are three times as many units at £5. AVCO weights the cost by the quantity at each price, so the average is closer to the more numerous £5 units.

Answer: D. Gross profit = revenue × gross profit margin = £150,000 × 40% = £60,000. Because margin is expressed as a percentage of revenue, the gross profit is found directly by applying the percentage to sales. The £90,000 figure is the cost of sales (the remaining 60% of revenue). Margin is based on selling price, unlike mark-up, which is based on cost — a key distinction in profit calculations. £40,000 reads the 40% margin as an amount, and £375,000 divides revenue by 0.40 instead of multiplying.

Answer: A. A loan repayable in 18 months is a non-current liability, because settlement is due more than twelve months after the reporting date. A liability is current only if due within twelve months. The loan is an obligation, not an asset, and it is debt rather than equity. Where part of a long-term loan falls due within twelve months, that portion is reclassified as a current liability.

Answer: B. Using the change in net assets: profit = closing net assets − opening net assets + drawings − capital introduced = £80,000 − £60,000 + £15,000 − £0 = £35,000. Drawings are added back because they reduced net assets but were not a business expense. The £20,000 figure is just the change in net assets, ignoring drawings. This net-assets approach derives profit when detailed records are unavailable. £5,000 deducts the drawings instead of adding them back, and £25,000 does not follow from the figures.

Answer: C. A decrease in receivables means more cash was collected from customers than the revenue recognised, so it is added to profit when calculating cash generated from operations. An increase in receivables would instead be deducted. Receivables movements are working-capital adjustments within operating activities, not investing items, and they affect the cash figure. The indirect method converts profit to cash by adjusting for such working-capital changes.

Answer: D. Dividends paid are commonly classified under financing activities, because they are a return to the providers of equity finance. IAS 7 does permit classification under operating activities as an alternative, but financing is the usual treatment for a distribution to owners. Dividends paid are a genuine cash outflow, not excluded from the statement, and they relate to financing rather than the day-to-day operations or investment in assets.

Answer: B. A prepayment removes from the current period an expense that relates to the next period. If it is not accounted for, the full amount paid is left as an expense, so expenses are overstated and profit is understated. Recognising the prepayment would reduce the expense and increase profit, and also create a current asset. The accruals concept requires only the expense relating to the period to be charged.

Answer: C. Closing inventory is deducted in arriving at cost of sales, so overstating it makes cost of sales too low and gross profit too high — profit is overstated. The error also overstates the current asset in the statement of financial position. Because closing inventory becomes next year's opening inventory, the error reverses in the following period, but the current year's profit is overstated.

Answer: D. Cost of sales = cost of goods manufactured + opening finished goods − closing finished goods = £48,000 + £6,000 − £4,000 = £50,000. Because finished goods inventory fell, more was sold than was manufactured, so cost of sales exceeds the cost of goods manufactured. The £46,000 figure reverses the inventory adjustment. This links the manufacturing account to the trading account through the finished goods inventory movement. £58,000 adds both the opening and the closing finished goods.

Answer: A. Operating profit = gross profit − distribution costs − administrative expenses = £80,000 − £15,000 − £25,000 = £40,000. Operating profit is the profit from trading before finance costs and tax. The £55,000 and £65,000 figures deduct only one of the two expense categories. Operating profit is a key subtotal in the statement of profit or loss, showing performance from the core operations. £120,000 adds the expenses instead of deducting them.

Answer: B. Total equity = share capital + share premium + retained earnings = £100,000 + £20,000 + £55,000 = £175,000. Equity comprises the amounts contributed by shareholders (share capital and premium) plus the profits retained in the business. The £155,000 and £120,000 figures omit one of the components. Total equity represents the owners' interest in the net assets of the company. £75,000 omits the share capital.

Answer: C. Cash takings = cash banked + cash expenses paid + closing cash − opening cash = £20,000 + £3,000 + £700 − £500 = £23,200. The takings must cover everything paid out of cash plus the increase in the cash held. The £22,800 figure reverses the cash-in-hand movement. Reconstructing a cash account like this is a standard way to find missing sales figures in incomplete-records questions. £23,000 ignores the change in cash in hand, and £20,200 omits the expenses paid in cash.

Answer: D. Cash raised from issuing shares is a financing activity, because it relates to obtaining funds from the providers of equity finance. Operating activities cover trading cash flows, and investing activities cover the purchase and sale of long-term assets. A share issue is a genuine cash inflow, not excluded from the statement. Financing activities report changes in the size and composition of the entity's equity and borrowings.