ACCT2127 Accounting For Management Decisions

Question 1

(a) Let the breakeven agency monthly revenue be $ X

Monthly Variable Costs

Sales staff Commission = (55/100)*X = 0.55X

Supplies & Printing = (12/100)*X = 0.12X

Usage costs for phones & computers = (9/100)*X = 0.09X

Total variable costs = 0.55X + 0.12X + 0.09X = 0.76X

Monthly Fixed Costs

Office rent = $ 4,000

Electricity = $ 700

Multi-line telephone system = $ 600

Computer Cabling Connection = $400

Salary of office manager = $ 8,500

Office furniture depreciation = $ 500

Total fixed costs = 4000 + 700 + 600 + 400 + 8500 + 500 = $ 14,700

Break even Analysis

For break even, Revenue = Costs

Hence, X = 0.76X + 14700

Solving the above, we get X = $ 61,250

Thus, to break even the agency must generate monthly revenue of $ 61,250.

(b) Intended monthly net profit (Assumed before tax)  = $ 15,000

Profit = Revenue – Total Costs

Let the requisite monthly revenue be $ Y

15000 = Y- 0.76Y -14700

Solving the above, we get Y = $ 123,750

(c) Commission made by the real estate agent is 6% of the gross property sales

Hence, if the real estate agency has to earn $ 15,000 in pre-tax profits, then the property sales should be such that the commission revenue generated must be $ 123,750.

Let the gross property sales be $ Z

Hence, (6/100)*Z = $ 123,750

Solving the above, Z = $2,062,500

(d) The CVP analysis is based on certain assumptions which are satisfied in the given case. One of the key assumptions is that the sale price, variable cost per unit and fixed cost would remain constant. Clearly, this is true for the given business where commission is a fixed percentage of the gross property sale and all the variable costs are constant functions of the revenue of agency. Further, the revenue and cost functions are linear as is apparent from the description. Also, there is no issue of any dynamic product mix owing to which the contribution margin for the business can be assumed to remain constant (Drury, 2016).

Question 2

(a) Accounting rate of return

The tax rate has been assumed as 30%

This method involves calculating the average profit for the investment.

Project A (Investment) = $ 250,000

Project A (Average annual profit) = [175000-(250000/5)]*0.7 = $ 87,500

Project A (Accounting rate of return) = (87500/250000) = 35%

Project B (Investment) = $ 1,000,000

Project B (Average annual profit) = [300000-(1000000/5)]*0.7 = $ 70,000

Project B (Accounting rate of return) = (70,000/1000000) = 7%

Project C (Investment) = $ 500,000

Project C (Average annual profit) = [200000-(500000/5)]*0.7 = $ 70,000

Project C (Accounting rate of return) = (70000/500000) = 14%

Payback Period

Project A (Investment) = $ 250,000

Project A (Annual cash inflows) = 175000*0.7 + (250000/5)*0.3 = $137,500

Project A (Payback period) = 1+ (112500/137500) = 1.82 years

Project B (Investment) = $ 1,000,000

Project B (Annual cash inflows) = 300000*0.7 + (1000000/5)*0.3 = $270,000

Project B (Payback period) = 3+ (190000/270000) = 2.70 years

Project C (Investment) = $ 500,000

Project C (Annual cash inflows) = 200000*0.7 + (500000/5)*0.3 = $170,000

Project C (Payback period) = 2+ (160000/170000) = 2.94 years

Net Present Value

Project A (Investment) = $ 250,000

Project A (Annual cash inflows) = 175000*0.7 + (250000/5)*0.3 = $137,500

Project A (NPV) = -250000 + 137500 (0.877+ 0.769+ 0.675+ 0.592 +0.519) = $ 221,900

Project B (Investment) = $ 1,000,000

Project B (Annual cash inflows) = 300000*0.7 + (1000000/5)*0.3 = $270,000

Project B (NPV) = -1,000,000 + 270,000 (0.877+ 0.769+ 0.675+ 0.592 +0.519) = -$ 73,360

Project C (Investment) = $ 500,000

Project C (Annual cash inflows) = 200000*0.7 + (500000/5)*0.3 = $170,000

Project C (NPV) = -500000 + 170000 (0.877+ 0.769+ 0.675+ 0.592 +0.519) = $ 83,440

(b) The best investment would be project A since it has the highest ARR, lowest payback period and highest positive NPV. The next in line would be project C which has a positive NPV. This ranking is not supported by payback period and ARR since both those measures fail to take the time value of money in consideration. Project B is not feasible and hence rejected owing to the NPV being negative (Parrino and Kidwell, 2014).

(c) Besides NPV also, there are several other alternative techniques of project analysis and capital budgeting. The various advantages of NPV are indicated below (Arnold, 2015).

• It considers the time value of money into cognizance which is essentially considering the fact that money has opportunity cost. ARR, payback period fail to consider this.
• NPV considers the cash flows of the project over the complete project life unlike payback period which considers cash flows till the achieving of break even.
• Also, NPV is very useful in reliable ranking of different projects.

The various shortcomings of NPV are listed below (Petty et. al., 2015).

• NPV computation is quite sensitive to discount rate and hence it needs to be computed accurately which is not easy.
• Forecasting of the future cash flows especially over a longer period can be quite challenging and often unreliable.
• People lacking finance background find difficulty in interpreting this.

Question 3

(a) The requisite reasons are as indicated below (Bhimani et. al., 2017).

• The cost of sales as reflected in the accrual income statement is only $ 850,000. In comparison, the actual amount that has been given to suppliers during the year is 1,610,000 which is leading to operational cash flow being negative.
• In the income statement, the sales are reported as $ 1,800,000 whereas the corresponding cash receipts in cash flow statement are significantly lower at $ 1,330,000.
• In the income statement, the other expenses are $ 22,000. In sharp contrast, the corresponding payment to these other expenses during the year is $ 112,000 which is leading to cash flow from operations being negative.

(b) The performance is more accurately reflected by the income statement since it is based on accrual basis. The accrual basis considers the revenue that is earned from the business operations and also considers the various expenses incurred in this process. The actual cash flow may have a lag and the same presents a distorted picture as the effect of transactions in multiple periods is captured in the cash flow statement. Hence, accrual system based income statement is more representative of financial performance (Heisinger, 2014).

(c) Balance sheet highlights the financial position of the company and provides information about the asset and liabilities outstanding on a given date for the company. It provides information about capital structure, liquidity and solvency. The income statement is reflective of the profitability of the operations and hence indicates the profits generated by the company during the given year. The cash flow statement is prepared on cash basis and highlights the transactions in cash that take place to reflect the closing cash balance (Arnold, 2015).

Question 4

(a) Based on the given data, it is apparent that the accounts receivable days have surged during the period at a rate which is significantly higher than the industry average. This indicates difficulty on the company’s part in collection of receivables arising from credit based sales. The effect of this is witnessed on the cash cycle which becomes longer and hence leads to working capital requirement increase (Petty et. al., 2015).

With regards to inventory days, the trend is similar to that which has been witnessed for the accounts receivable days. Also, consideration needs to be given to the continuously rising closing inventory balance which is indicative of the lack of demand for the products of the company which leads to rising inventory and lower sales for the business (Parrino & Kidwell, 2014). The accounts payable days for the company are on the rise which potentially can imply lowering cash cycle and limited working capital requirements. But, in this case considering the rising accounts payable balance coupled with the decreasing cash balance, it seems likely that the company is facing a severe cash crunch and thereby delaying the payment to the suppliers (Damodaran, 2015).

On the basis of the above, it is apparent that the company currently is facing a short term liquidity crunch which is negatively impacting the company’s operations and the severity of the issue can be gauged from the fact that at FY2017 end, the cash balance for the company stood at $ 5,000 only (Arnold, 2015).

(b) The various actions that need to be urgently taken by the company to improve the situation are outlined as follows.

• There is a need to bring down the accounts receivable days. This can be enabled by extending attractive discounts to those customers who pay in cash instead of credit or make early payment. The concern of this strategy is in the form of shrinking margins but it should prove effective for resolving the liquidity crisis (Damodaran, 2015).
• There is a need to reduce the inventory turnover days.  The inventory is continuously piling owing to the company’s inability to generate sales. Lucrative discounts should be given on the inventory so that this could be converted into cash. The concern of this strategy is in the form of shrinking margins but it should prove effective for resolving the liquidity crisis (Petty et. al., 2015).
• Even though accounts payables days have increased but this increase is not because of favourable terms from suppliers but delay in payments. The company should make efforts to provide payments to as many suppliers as possible so as not to default on any payment. Further, for those suppliers for whom payment would be delayed, some financial incentive should be provided (Parrino and Kidwell, 2014).

Question 5(a)

(a) Method A = Straight line depreciation

Reasoning: Depreciation remains same in 2017 and 2018

Method B = Units of production depreciation

Reasoning: Depreciation increases in 2018 and so does the production

Method C = Declining balance depreciation

Reasoning: 2017 has the higher depreciation while the depreciation expense for 2018 is lower

(b) Method A

Method B

Method C

(c) In accordance with the matching principle, the recognition of expense and revenue must be carried out in the same period. As depreciation constitutes an expense, thus, it should be captured in accordance with the asset usage which leads to generation of revenue. Hence, based on the usage and asset type, the suitable depreciation method must be selected  (Arnold, 2015).

(d) I am in disagreement with the given statement as there can be sizable divergence between the asset carrying value and market value. The asset carrying value is dependent on depreciation driven by accounting policies and standards but the actual depreciation in value of asset could be different which leads to different market value (Emmauel and Otley, 2015).

(e) Asset carrying value (2018) = Purchase price – Accumulated depreciation = 132000 = 24000 = $ 108,000

This asset is liquidated for $ 98,000 and hence there is a loss of $ 10,000 on asset disposal.

Asset change = Increase in cash (98,000) = Decrease in non-current assets (108,000) = -$ 10,000

The liabilities would not change. Further, the loss on the sale would be reflected in the equity which would be decreased by $ 10,000 and hence lead to the accounting equation balancing.

References

Arnold, G. (2015) Corporate Financial Management. 3^rd ed. Sydney: Financial Times Management.   

Bhimani, A., Horngren, C.T., Datar, S.M. and Foster, G. (2017), Management and Cost Accounting 4^th ed. Harlow: Prentice Hall/Financial Times

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Drury, C. (2016) Cost and Management Accounting: An Introduction. 6^th ed. New York: Cengage Learning

Emmauel, R.C. and Otley, T.D. (2015) Accounting for Management Control. 8^th ed. London: Cengage Learning.

Heisinger, K.(2014) Essentials of Managerial Accounting 4^th ed. London: Cengage Learning.

Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed..  NSW: Pearson Education, French Forest Australia