Question 1
a) Useful information is not always economically beneficial information for the company. There may be different situations when importance of economic considerations outweigh that of usefulness and a company would prefer to manipulate numbers in a way that distort realistic picture in order to provide benefits. Depending on the current objectives of a firm, there might different approaches towards similar accounting issues. If a company wants to boost confidence of investors, it would aim to increase earnings per share and may underreport certain costs, such as amortisation and depreciation; if a company needs to show positive cash flow, it may purposely delay particular transactions not to have them in the reporting period. On the other hand, during the good times, companies can artificially decrease profit, as it is the main base for taxation by “inventing” additional costs. All of these activities pursue economic benefits distorting the picture and making reports less useful.
b) Worksheet
Question 3
(See scan attached)
a) FIFO, or first-in, first-out technique implies that for each sale the oldest inventories are recorded, which not necessarily means that exactly the same physical items have been actually used for production of goods. The opposite to FIFO is LIFO (last-in, first-out), when the newest inventories are recorded for sales, while Weighted Average method is in between – is uses average cost of inventories as cost for each sale. The difference between the techniques is only palpable when the prices for inventories are not constant during the period – in the given case FIFO method gave lower cost of goods (and, correspondingly, higher value of ending inventory) than Weighted Average method, as the costs of inventory were constantly growing (LIFO would have given even higher cost), however, the difference was not huge (around 2%), because changes in purchasing costs of inventory over time were not dramatic.
b) The method used matters significantly during the time of inflation (the higher inflation is, the more important the choice of the technique is). With differences between the methods being technical, not actual, the firms tend to prefer the technique that maximizes cost of sales reducing profit and amount of taxes due, though the motivation might different – public companies often need to inflate their profit to boost investors’ confidence. Easy to see that FIFO method minimizes reported cost of sales for the company, LIFO maximizes it and Weighted Average method provides the result in between the former two ones.
Question 5:
a) (See scan for calculations)
i) To hire a new salesperson with $35,000 per year salary and to maintain current profit, the company needs to increase its sales by $35,000, or by 14%, selling additional 7,000 units (if the price stay fixed).
(Please note that if “sale revenue” refers to price in this case, it should go up 14% to 5,7$/per unit)
ii) The next two tables present the components of income statement before and after the new production system introduced.
b) With variable cost of producing the car pats in house at $101 per unit, the company might earn $1,715,000 in additional profit by internalizing the production of them, so it seems more than reasonable at the first glance. However, fully ignoring fixed overhead costs is legitimate only if the opportunity cost is accounted for, and the company must evaluate the possibility of producing windscreens at full capacity before making the decision.
Question 4: (See scanned paper)
Activity-based costing is a more sophisticated and precise method, which consists in proportional distribution of overhead costs with regards to every particular activity, as compares to direct labour hours, where labour hours are the only thing that matters, while their allocation to particular activities and productivity of every hour is irrelevant. However, with overhead cost constituting small fraction of unit cost (less than 7%), one may argue that Direct Labour Hours methods gives good enough approximation not to engage in more subtle calculations.
