why

 a  prepaid  expense  is  treated  as  a  current  asset  on  the  balance  sheet.  
 
• Paid  by  our  business  in  advance  for  a  product  or  service  to  be  provided  to  us  in  the  
forthcoming  period  
• Benefit/value  has  not  yet  been  received/consumed  
• Will  benefit  our  business  for  one  year  or  less  –  hence  a  current  asset  
• Expenditure  not  yet  charged  in  the  income  statement  –  accruals  principle  –  therefore  carried  
forward  to  next  period  as  an  asset  
• For  example  rent  already  paid  for  January  to  March  2010  will  not  be  charged  in  the  income  
statement  for  the  year  ending  31  December  2009  but  will  be  shown  as  a  current  asset  on  the  
balance  sheet  as  at  31  December  2009  
 
In  the  space  below,  discuss  briefly  why  it  might  be  more  meaningful  to  include  the  impact  of  the  
exceptional  items  when  calculating  the  dividend  cover  for  2008  in  question  10.    
 
• Exceptional  items  are  one-­‐off  non-­‐recurring  items  that  can  distort  a  year  on  year  comparison  
but  do  they  have  an  impact  on  the  earnings  for  a  particular  year  
• If  the  exceptional  items  are  included  in  the  dividend  cover  calculation,  the  dividend  cover  is  
below  1.0  for  2008  (2957/4110  =  0.72)  
• A  dividend  cover  below  1.0  is  of  particular  significance  because  it  means  that  the  dividends  
for  the  year  exceeded  the  earnings  for  the  year  
• This  highlights  the  fact  that  the  directors  are  maintaining  the  dividend  amount  despite  a  fall  
in  earnings.  Perhaps  to  signal  confidence  to  shareholders  that  the  earnings  reduction  in  2008  
is  not  expected  to  continue  into  future  years  
 
In  the  space  below,  explain  briefly  the  similarities  and  differences  between  a  current  liability  and  a  
non-­‐current  liability.  
 
o both  are  amounts  owed  by  the  organisation  
o both  are  shown  on  the  balance  sheet  
o a  non-­‐current  liability  can  actually  be  very  similar  in  nature  to  a  current  liability,  for  example  
a  loan  that  is  due  within  thirteen  months  would  be  classified  as  non-­‐current,  even  though  it  
is  very  close  to  becoming  a  current  liability  
o a  non-­‐current  liability  is  due  after  more  than  one  year,  e.g.  five  year  bank  loan;  a  current  
liability  is  due  within  one  year,  e.g.  trade  payable  
o many  non-­‐current  liabilities  eventually  become  current  liabilities,  for  example  a  five  year  
loan  becomes  a  current  liability  in  the  fifth  year,  due  to  its  imminent  repayment  within  a  year  
 
In   the   space   below,   explain   briefly   the   difference   between   capital   expenditure   and   revenue  
(operating)  expenditure.  
 
Capital  expenditure  will  provide  benefits  to  the  business  for  more  than  one  year.  
 
It  is  not  charged  in  full  to  the  income  statement  of  the  year  that  it  is  incurred.  Instead  it  is  treated  as  a  
fixed/non-­‐current  asset  and  is  depreciated  or  amortised  through  the  income  statements  of  the  years  
that  benefit  from  the  expenditure.  At  the  end  of  each  year  the  amount  that  has  not  yet  been  charged  
to  the  income  statement  is  shown  as  a  fixed/non-­‐current  asset  on  the  balance  sheet.  
 
Example  of  capital  expenditure  =  purchase  of  office  furniture  
 
Revenue  expenditure  is  short  term  in  nature.  It  does  not  benefit  future  years  and  is  charged  to  the  
income  statement  of  the  year  in  which  it  is  incurred.  
 
Example  of  revenue  expenditure  =  electricity  expenses  
 
 
In  the  space  below,  explain  briefly  what  is  meant  by  the  term  ‘amortisation’?  
 
 
Amortisation  is  the  charge  that  is  made  to  share  out  the  cost  of  an  intangible  fixed/non-­‐current  asset  
to  the  income  statements  of  the  years  that  benefit  from  the  intangible  asset.  
 
Example  =  charging  to  successive  income  statements  the  cost  of  purchasing  a  pharmacy  licence.    
 
It  is  similar  in  nature  to  depreciation,  which  is  the  equivalent  charge  for  the  use  of  a  tangible  
fixed/non-­‐current  asset  
 
In  the  space  below,  explain  briefly  what  is  meant  by  the  term  ‘share  premium’.  
 
The  extra  amount  that  the  company  receives  for  a  share  when  it  is  first  sold,  above  the  face  or  
nominal  value  of  the  share.  
 
The  share  premium  is  a  reserve;  part  of  the  equity/shareholders’  funds  of  the  company.  
 
A  company  is  reported  to  have  a  relatively  high  gearing  ratio.  
 
In  the  space  below,  explain  briefly  what  this  means.  
 
The  company  has  a  relatively  high  proportion  of  borrowings  in  its  capital  structure,  compared  with  
equity.  
 
This  increases  the  volatility  of  earnings  and  hence  increases  the  financial  risk  to  which  shareholders  
are  exposed.    
 
Earnings  will  increase  more  rapidly  as  operating  profits  increase  but  they  will  also  reduce  more  rapidly  
as  operating  profits  decrease.    
 
 
In  the  space  below,  describe  briefly  two  actions,  which,  each  taken  in  isolation  will  increase  the  
company’s  return  on  capital  employed.  
 
 
1. Increase  the  operating  profit  by  reducing  operating  expenses,  e.g.  investigate  ways  to  reduce    
electricity  costs  
 
2. Reduce  the  capital  employed,  for  example  by  improving  credit  control  procedures  so  that  the  
amount  invested  in  debtors/receivables  reduces.  
 
Despite   a   substantial   increase   in   a   company’s   profit   for   the   latest   period,   the   cash   balance   has  
reduced.  In  the  space  below,  state  briefly  two  possible  causes  of  this  apparent  discrepancy.  
 
1. Investment  in  fixed/non-­‐current  assets.  This  reduces  cash  immediately  but  profit  is  reduced  
by  only  a  smaller  amount,  via  the  depreciation  charge.  
2. Increase  in  inventory.  Cash  is  reduced  when  the  inventory  is  paid  for  but  the  cost  of  the  
inventory  will  not  be  charged  against  profit  until  it  is  actually  sold.  
 
Events  occurring  after  the  balance  sheet  date  
 
The  financial  statements  are  significant  indicators  of  a  company’s  success  or  failure.  Therefore  it  is  
important  that  they  include  all  the  information  necessary  for  an  understanding  of  a  company’s  
position.  
 
Between  the  balance  sheet  date  and  the  date  the  financial  statements  are  authorised  (i.e.  for  issue  
outside  the  company),  events  may  occur  which  show  that  the  assets  and  liabilities  at  the  balance  
sheet  date  should  be  adjusted,  or  that  disclosure  of  such  events  should  be  given.  
 
Certain  types  of  event  require  the  assets  and  liabilities  to  be  adjusted.  These  are  called  adjusting  
events  and  they  provide  further  evidence  of  conditions  that  already  existed  at  the  balance  sheet  date.  
Examples  are:    
 
• a  customer  going  bankrupt  after  the  balance  sheet  date  
• a  property  valuation  which  provides  evidence  of  an  impairment  in  its  value  at  the  balance  
sheet  date      
• a  change  in  the  rate  of  corporate  tax,  applicable  to  the  previous  year.  
 
Other  types  of  event  are  called  non-­‐adjusting  events.  These  occur  after  the  balance  sheet  date  and  do  
not  affect  the  condition  of  assets  or  liabilities  at  the  balance  sheet  date.  However  they  are  of  such  
importance  that  non-­‐disclosure  would  affect  the  ability  of  the  users  of  the  financial  statements  to  
make  proper  evaluations  and  decisions.  Examples  are:    
 
• losses  occurring  in  a  fire  after  the  balance  sheet  date  
• where  the  value  of  an  investment  falls  between  the  balance  sheet  date  and  the  date  the  
financial  investments  are  authorised  
• the  sale  of  a  subsidiary  after  the  balance  sheet  date.  
 
Non-­‐adjusting   events   should   be   disclosed   by   way   of   a   note,   stating   the   nature   of   the   event   and   an  
estimate  of  its  financial  effect  (or  a  statement  that  such  an  estimate  cannot  be  made).  
 
Valuing  non-­‐current  assets  
 
It  is  clearly  very  difficult  to  arrive  at  reliable  valuations  of  certain  types  of  intangible  asset  such  as  
goodwill  and  brands.    They  are  not  easily  identifiable,  there  is  no  exactly  equivalent  asset  to  use  as  a  
benchmark  for  valuation  and  intangible  assets  are  often  not  separable  from  the  remainder  of  the  
business.  
 
However  the  valuation  of  tangible  assets  is  also  subjective.    
 
Certain  types  of  tangible  asset  are  more  easily  valued  than  others  but  the  valuation  of  any  asset  
depends  upon  taking  a  view  of  its  future  earning  capability.  
 
Furthermore  is  it  always  easy  to  classify  an  asset  as  tangible  or  intangible?  For  example  how  would  
you  value  a  Hilton  hotel?    
 
• Is  the  hotel  a  tangible  or  an  intangible  non-­‐current  asset?    
• Are  hotels  more  likely  to  have  their  own  separate  resale  values  than  a  brand  name?    
 
Although  classified  as  tangible  non-­‐current  assets  on  a  balance  sheet,  hotels  are  essentially  partly  
tangible  (the  actual  buildings  and  land,  etc.)  and  partly  intangible  (the  Hilton  brand).  
 
Revenue  recognition  
 
(a) Revenue  recognition  refers  to  the  point  at  which  the  value  received  or  to  be  received  from  the  
customer  for  goods  or  services  rendered  can  be  recognised  in  the  income  statement  for  the  
period.  
 
(b)  (i)  Income  statement  –  no  effect;  rooms  not  yet  occupied  so  revenue  cannot  be  recognised  
(ii)  Balance  sheet  –  cash  increase;  current  liability  (deferred  income)  increase    
(iii)  Cash  flow  statement  –  cash  flow  from  operations  increases  
Cash  flow  statements  v  income  statements    
 
Cash   flow   statements   do   help   assess   the   viability   and   financial   adaptability   of   companies.  
Furthermore  it  could  be  argued  that  cash  flows  are  more  objective  and  therefore  less  susceptible  to  
any  potential  distortions  caused  by  the  application  of  creative  accounting  techniques.  
 
However  cash  flows  are  often  very  volatile  over  time.  A  particular  year’s  cash  flows  may  relate  to  an  
event   that   occurred   a   year   before   (e.g.   collection   of   an   outstanding   debt)   or   that   will   have  
implications  for  the  future  (e.g.  capital  expenditure).  
 
Income   statements   help   deal   with   this   problem.   By   applying   the   accruals   principle   they   aim   to  
measure   the   underlying   economic   achievement   of   the   company   in   any   particular   year   and   so   provide  
a  guide  to  its  long-­‐term  cash  generating  ability.  
 
Cash  flow  statements  and  income  statements  thus  complement  each  other  and  both  are  necessary.