Tips for written bits and pieces Level 4 Financial Performance

This comes from an article published by AAT back in 2010/11. Whilst it refers to FNPF (AQ2010) and PEV (NVQ Standards), what Cliff Floyd says stands true for FPFM today,

Finding the right words for the right numbers

Correct calculation is all well and good, but correct explanation is essential. Cliff Floyd presents some ideas on how to express Financial Performance concepts This article deals with written tasks in the Financial Performance (FNPF) unit of AAT Level 4 Diploma in Accounting. The FNPF examination consists of two sections. Section 1 contains 8 tasks covering numerical and short answer
questions and Section 2 contains two written tasks, task 1 covering standard costing and variance analysis and task 2 covering key performance indicators and what if analysis.

Many candidates struggle to provide a competent answer to these questions and this may be due to lack of preparation as well as the nature of these tasks. The key to success on these tasks is to undertake detailed preparation to develop knowledge and understanding, and detailed practice to apply the knowledge and understanding. The prepared student is able to score high marks on these tasks and clearly demonstrate that they have studied a range of practice questions.

TASK: Variance analysis

The task will be based upon a brief scenario including some standard costing variances and some basic information to aid the analysis of the variances. For example, the direct material price variance may be given as £10,000 adverse and it may be stated that a high quality material was purchased. The task may require the candidate to prepare a report covering all or some of the following:

REQUIREMENT:

An explanation of what the given variance means

ANSWER: The adverse material price variance means that the actual price paid was more than the budgeted price (alternate terms which will receive full credit could be expected price, planned price or standard price). The important point is to explain that the actual price was greater than the original plan.

REQUIREMENT:

Give one possible reason for each given variance

ANSWER: the variance may have been caused by the purchase of a higher quality material which was more expensive than the standard price. This is the obvious answer but any reasonable reason will receive full marks.

REQUIREMENT:

An explanation of any links between the variances

ANSWER: the variance may be linked to some or all of the other variances. The higher quality material may allow for a lower quantity to be used in each product and therefore create a favourable direct material usage variance, the better quality material may have also lead to a favourable labour efficiency variance because it allowed the labour to finish the product more quickly because it was
easier to work on (only one link is required).

REQUIREMENT:

State any action that could have been taken

ANSWER: The answer to this will depend on the data given and other variances for example if the other variances are favourable and the net effect of purchasing the higher quality material was for a saving on usage and labour efficiency which is greater than the adverse price variance the answer may be to take no action because the overall savings are greater.

Over the past few months many candidates have scored very highly on this task on the online examination and clearly many candidates are preparing themselves for this topic. One way to help the preparation is to work through previous PEV (Unit 8) papers which similar tasks in section 1.

TASK: Analysis of key performance indicators and what if analysis

The task will be based upon a brief scenario including some key performance indicators and extracts from the accounts. The requirements may include some or all of the following:

• An explanation of why the gross profit margins are different in each scenario by considering the key variables of sales price, volume, material, labour and overhead costs at the given variance means
• An explanation of why the gross profit is different between two scenarios
• An explanation of the net profit margin
• An explanation of the return on net assets
• A recommendation as to which option should be taken and why
• A recalculation of key indicators or profit based upon given information

A very common problem with this task is the confusion demonstrated by many students over the difference between the gross profit and the gross profit margin and how the variables affect one or other. It is common for a task to require the analysis of the gross profit margin by considering the variables that affect it. The following table will be used to illustrate common errors made by students.

In order to be successful at this task, candidates need to understand the mathematics of the gross profit and gross profit margin.

REQUIREMENT:

An explanation of why the gross profit margin is different between S1and S2 by considering the sales price and sales volume

ANSWER: The sales price is higher for scenario 1 which will improve the gross profit margin for S1. However, the sales volume is higher for S2, which will improve the gross profit margin for this scenario if there are fixed production costs because these costs will be spread over more units therefore increasing the gross profit per unit.

COMMON ERRORS: Many candidates simply say something like ‘the sales price is lower for scenario 2 but the volume is higher this gives a greater margin’. This answer does not really explain the effects.

REQUIREMENT: An explanation of why the gross profit margin is different between S1 and S2 by considering the material cost ANSWER: The material cost per unit is constant which therefore has not effect on the gross profit margin.

COMMON ERRORS: Many students are unable to correctly explain the relationship between the variable costs and demonstrate confusion between the gross profit and gross profit margin. Common statements include ‘the material costs increase with increased volume of production and therefore reduce the margin for S2’ this is obviously incorrect because the unit cost is constant and although the total material cost increases it increases in proportion to the sales revenue and therefore has no effect on the margin.

REQUIREMENT:

An explanation of why the gross profit margin is different between S1 and S2 by considering the fixed production cost 

ANSWER: The fixed production cost is constant which means that the increased volume will reduce the fixed cost per unit. A lower fixed cost per unit will increase the gross profit margin for S2.

COMMON ERRORS: A very common incorrect response is ‘the fixed costs are constant and therefore do not effect the margin’. This is clearly incorrect but is used by many candidates.

Students again are advised to work through all the past/sample papers to practice these types of tasks. 

Also, students are directed to the AAT website to review Assessment Performance Feedback Reports.

There's also some Accounting Technician articles here

Take a tablet... A spoonful of ethics help the medicine go down...

On a side note, I've been included in a pilot to use tablet computers in the classroom. To say I'm worried is an understatement but I have started to take things like Osborne Books' Professional Ethics material and adapt it for use with tablets. 

Watch this space as this particular unit needs a lot of thinking about...!

Here's a taste of things to come

My Trial Ethics material

Bad debts aren't so bad!

IRRECOVERABLE AND DOUBTFUL DEBTS

Debtors should only be included as assets in a balance sheet if they are expected to settle the amounts due from them. The prudence concept requires an organisation to recognise future losses as soon as it becomes aware of their existence. This means that as soon as an organisation is aware that a debt may not be settled, then the asset value should be reduced by an adjustment being put through the accounts.

Irrecoverable debts (Bad debts)

This is a debt that will NOT be recovered. It should be completely removed from the ledger accounts and therefore from the balance sheet.

Double entry to account for an irrecoverable debt

Dr Irrecoverable debt                    X          (Income statement)

Cr SLCA                                             X          (Statement of financial position)

Example

Doubtful debts

This is a debt about which there is some question as to whether or not the amount will be settled. We must recognise this doubt in the accounts but we should not write off the debt completely, because the cash may be received. In any event we need to keeping pressing for it to be settled. Therefore we still need to show the debt as outstanding.

Example 1

Doris has debtors at her year-end of £25,000.

There is concern about whether £5,000 of this will be settled.

Dr Allowance for doubtful debt adjustment £5,000

Cr Allowance for doubtful debt £5,000

The allowance for doubtful debts is offset against the receivables’ balance in the statement of financial position.

Statement of financial position extract

This treatment clearly shows that there is doubt as to whether the debt will be received but does not write it off and we can continue chasing it. Receivables will be reduced by the £5,000 in the statement of financial position.

Changes in allowance

As you are aware, any item that appears in the statement of financial position is carried forward into the next accounting period. This means that there may be a balance on the allowance for doubtful debts account brought forward.

It is unlikely that the allowance will stay the same from one year to the next, so you may need to change the amount carried in the statement of financial position.

The key thing to remember is that you only need to take account of either the increase or the decrease in the allowance, in the profit and loss account.

Increase

Dr Allowance for doubtful debt: adjustments               X

Cr Allowance for doubtful debts                                                  X

In each case you would only enter the increase in the allowance e.g. last year £5,000 this year £7,000 therefore only an extra £2,000 would be charged to the irrecoverable debt account.

Decrease

Dr Allowance for doubtful debts                                      X         

Cr Allowance for doubtful debt: adjustments                           X

In each case you would only enter the decrease in the allowance e.g. last year £5,000 this year £3,000 therefore only remove £2,000.

It is common for students to change the allowance by the new allowance figure instead of to the new allowance figure - don't fall into that trap!

Appreciation of Depreciation

Another area people struggle with is depreciation of non-current assets.

What is depreciation and what is it there for?

Depreciation aims to charge the cost of the fixed asset that has been consumed during the period of the profit and loss account as an expense in order to match the income that the fixed asset has earned in the period (the accruals concept).

IAS 16 (Property, Plant and Equipment) has this to say about depreciation:

“Depreciation is the measure of the cost of the economic benefits of the tangible non-current assets that have been consumed during the period. Consumption includes the wearing out, using up or other reduction in the useful economic life of a tangible non-current asset whether arising from use, effluxation of time or obsolescence through either changes in technology or demand for the goods and services produced by the asset”

What does this mean?

• Machinery and motor vehicles wear out over time and so this accounting standard takes care of this wearing out. 

• Leases on buildings are consumed with the passage of time and so their value diminishes. 

• Computer technology becomes obsolete as technology advances and so their value is reduced. 

• Freehold land, however, has infinite life and so cannot be consumed by the business although the buildings on the land may be depreciated.

Methods of Depreciation

Straight Line Depreciation

The aim of the straight line method of depreciation is to charge the same amount of depreciation on the fixed asset each year of the asset’s life.

Before we can work out the depreciation charge, we need to know two things:

• The original cost of the asset
• The estimated useful life of the asset

Example

Jo has a vehicle which cost £15,000 and has a useful life of 5 years. Calculate the annual depreciation charge using the straight line method.

Workings
Cost - residual value		£15,000 - £0
Expected useful life		5 years
Depreciation =		£3,000 per annum

This assumes that the asset has no residual value (value at the end of its useful economic life).

Here the depreciation will, eventually, bring the carrying value to zero.

If the asset does have a residual value, the calculation is slightly different.

Example:

Jo has a vehicle which cost £15,000 and has a useful life of 5 years with a residual value of £5,000. Calculate the annual depreciation charge using the straight line method.

Workings
Cost - residual value		£15,000 - £5,000
Expected useful life		5 years
Depreciation =		£2,000 per annum

Sometimes you will be given the depreciation charge as a percentage using the straight line method e.g. £15,000 –depreciated at 20% on cost.

This would be calculated thus:

Workings

(Cost - Residual value) x % = (£15,000 - £0) x 20% 

Depreciation = £3,000 per annum

Reducing/Diminishing Balance Method

The reducing/diminishing balance method has a higher charge for depreciation in the early years of the fixed asset’s life but a lower charge in later years.

In this method, the depreciation charge is a fixed percentage of the carrying value or carrying amount(the cost of the asset – depreciation to date). The determination of the percentage if a complicated calculation but you will not be required to carry this out, you will be given the percentage.

How it works

Jo has a vehicle which cost £15,000. Depreciation is charged at 30% per annum using the reducing/diminishing balance method.

Workings

Year 1

Cost x % = £15,000 x 30% = £4,500

This leaves the carrying value (net book value) at the year end as: £15,000 - £4,500 = £10,500

Year 2

Carrying value x % = £10,500 x 30% = £3,150

So the carrying value at year end is £7,350

Unlike with the straight-line method, the carrying value under reducing balance will never reach zero.

The double entry for depreciation 

Depreciation is an expense - but a non-cash expense. We do not write a cheque for depreciation (this is important if you study cash management at Level 4!)

Therefore we need to record an expense for depreciation each year.

If we look at the last example, we will see that:

Year 1

Debit Depreciation expense (charge) account £4,500

Credit Accumulated depreciation account £4,500

The Accumulated depreciation is carried forward to next year whilst the expense is transferred to the Statement of profit or loss.

The debit (expense) is recorded in the Statement of profit or loss whilst the credit serves to reduce the value of the non-current asset on the Statement of financial position. 

The t-accounts look like this:

In the statement of financial position we see the following:

In year 2 we see the following occur

Debit Depreciation expense £3,150

Credit accumulated depreciation £3,150

Again the debit is transferred at year end to the Statement of profit or loss whilst the credit builds the value of the Accumulated depreciation to further reduce the carrying value of the non-current asset.

In the statement of financial position we see the following:

 Note:

There is no one 'correct' way to depreciate assets. However, one should always aim to depreciate them according to the expected useful life so, so example, we would aim to depreciate an asset over 5 years if we expected its useful life for us to be 5 years.

It is important to remember that the accumulated depreciation is used to assess whether we have made a gain or loss on disposal (see my first blog entry). Whilst we may want to see the word profit (gain), here it tells us that our depreciation figure was too much and we were over-estimating the value of the 'using up or wearing out' of the non-current asset. Similarly, if we make a 'loss' on the disposal, we haven't depreciated enough.

Quick reference guide for debits and credits

Assets, liabilities income, expense, debit credit... so what?

Afternoon all!

During my time teaching, it never ceases to amaze me how many students fail to create a link between units. For example, the Level 2 unit PBKT and CJBS link naturally to the Level 3 units ACPR and FSTP which, in turn link through FSTM at Level 4.

Throughout these units, basic principles remain constant - an expense is an expense, an asset is an asset etc.

One of the big problems that face students is deciding what type of account and item is - is it an income, expense, liability or asset? You must take time to understand the difference between these types of account (which I will look at next time).

One of the many problems students seem to have is to understand what is going on when we debit or credit an account.

In order to try to help people, why not look at the following table where the effect of a transaction is shown as an increase é or decrease  ê in value.

The effect of a debit or credit on different account types with examples	Debit	Credit
Expense	é	ê
Telephone Rent paid Interest paid Heat & light Motor expenses Repairs Discounts allowed Carriage in/out Administration Loss on disposal Depreciation
Income	ê	é
Sales revenue Rent received Interest received Discounts received Profit on  disposal Commission received
Asset	é	ê
Non-current assets Property Plant Equipment Computers Fixtures Fittings Furniture Motor vehicles Current assets Inventory at end of year Trade receivables(debtors/SLCA) Non trade receivables (prepayments) Bank , Cash and  cash equivalents
Liability	ê	é
Current liabilities Trade payables (creditors/PLCA) Non-trade payables (accruals, VAT Liability) Bank overdraft Non-current liabilities Bank loans Director/partner loans Debentures

Note: Capital is a type of liability as it signifies how much the business owes to its owner(s).

The other problem students have is to remember where each type of account appears in the financial statements - Statement of profit or loss and Statement of financial position.

Statement of Profit or Loss (SPL)

The ‘SPL’ is used to identify how well the business has performed during the year and whether it has achieved a profit or loss. Profit/loss is the difference between Income and Expenditure and the SPL shows two elements:

·      The trading account

This shows the profit or loss generated from the day to day trading activities (i.e. the main activities of the business)

·      The profit and loss account

This shows the profit of loss after taking into account all of the other income received and expenses incurred during the reporting period.

It is important to note that in your assessment in FSTP, the two elements will be combined into the Statement of Profit or Loss.

Statement of profit or loss for the year ending …………………………………

The Trading Account

	£	£
Sales revenue		xx
Less: sales returns		(xx)
		xx
Less: cost of sales
Opening inventory	xx
Purchases	xx
Less: purchases returns	(xx)
	xx
Carriage inwards	xx
Less: closing inventory	(xx)
		(xx)
Gross profit		xx

The Profit and Loss Account

Sundry income
Discounts received		xx
Rent received		xx
		xx
Less expenses
Discounts allowed	xx
All other running expenses	xx
Depreciation charges	xx
Allowance for doubtful debts: adjustments	xx
Irrecoverable debts	xx
		(xx)
Profit for the year		xx

Note:

·         The sales returns and purchases returns are netted off against the sales and purchases respectively.

·         Discounts received have been shown as sundry (miscellaneous) income under gross profit.

·         The profit for the year is transferred to the Statement of Financial Position as an addition to capital

·         All SPL accounts are closed off at the end of the year.

TThe Statement of Financial Position (SFP)

The ‘SFP’ shows a snapshot of the business’ financial position (assets, liabilities and capital) at a specified point in time (normally the reporting period end date).

The SFP reflects the Accounting Equation:

ASSETS – LIABILITIES = CAPITAL

Statement of Financial Position as at ………………………..

	Cost	Accumulated depreciation	Carrying amount
	£	£	£
Non-current assets
Buildings	xx	(xx)	xx
Furniture & fittings	xx	(xx)	xx
Motor vehicles	xx	(xx)	xx
Computers	xx	(xx)	xx
	xx	(xx)	xx
Current assets
Inventory		xx
Receivables	xx
Less: allowance for doubtful debts	(xx)
		xx
Prepayments		xx
Bank		xx
Cash		xx
		xx
Current liabilities
Payables	xx
VAT	xx
Accruals	xx
		(xx)
Net current assets			xx
Non-current liabilities
Loans			(xx)
Net Assets			xx
Financed by
Capital			xx
Profit			xx
			xx
Less: Drawings			(xx)
			xx

x

Note:

The allowance taken off the Receivables figure is the allowance for doubtful debt.

All SFP accounts are carried forward and provide the starting point for the next accounting period.

The highlighted figures should agree (or balance) and this is from where the 'old' name for the financial statement - the balance sheet - takes its name.

Hopefully you can now see the importance of linking units together as, without this basic understanding, none of the financial statements would be possible.