ACCT5001 S1 2010

Self-Study Solutions

Week 11

ACCT5001 S1 2010

Self-Study Solutions

Week 11

Ch.10: Q1, Q4, Q5, Q7, Q10, E10.9, PSA10.9, PSA10.10, PSB10.9, BBS10.5 1. (a) Separate legal existence. A company is separate and distinct from its owners and it acts in its own name rather than in the name if its shareholders. In contrast to a partnership, the acts of the owners (shareholders) do not bind the company unless the owners are duly appointed agents of the company. (b) Limited liability of shareholders. Because of its separate legal existence, creditors of a company ordinarily have recourse only to corporate assets to satisfy their claims. Thus, the liability of shareholders is normally limited to their investment in the corporation. (c) Transferable ownership rights. Ownership of a company is represented in transferable units called shares. Shareholders may dispose of part or all of their interest by simply selling their shares. The transfer of ownership to another party is entirely at the discretion of the shareholder unless the need for further authorisation is specified in the companys constitution.

of changes in equity must show, for each equity account, a reconciliation between the opening and closing balances, separately disclosing each change.

EXERCISE 10.9 Trackwork Trains Ltd (a) Plan One Issue Shares (b) Plan Two Issue Debentures

Profit before interest and taxes Interest ($2,400,000 X 13%) Profit before taxes Income tax expense (30%)

$800,000 0000,000 800,000 240,000 $560,000 $3,400,000 16%

$800,000 312,000 488,000 146,400 $341,600 $1 000,000 34%

4.

For a cash dividend to be paid, a corporation must have adequate cash such that payment of the dividend would not render the company insolvent and (Australia only) distributable profit, in the form of retained earnings or current year profits.

Profit Equity Return on equity

5.

A cash dividend decreases assets, retained earnings and total equity. A share dividend decreases retained earnings, increases paid-in capital, and has no effect on total assets and total equity.

(b) Factors would include: Ability to generate cash to meet the interest payments (Plan Two) or possible dividend payments (Plan One) in the future. Tax deductibility of Interest. The stability of interests rates in the future and their effect on the early retirement of the debt. The increase in financial risk from issuing more debt compared with the increased ROE from increased leverage.

7.

The adjustment required is to decrease assets and decrease retained earnings in the current period. In presenting financial statements for 2009, the comparative figures for 2008 should be adjusted by decreasing assets and increasing expenses with resulting decreases in profit and closing retained earnings for 2008.

10.

The Statement of comprehensive income shows the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners. The income statement forms part of the statement of comprehensive income and shows the income and expenses for the period resulting in the profit or loss which is then transferred to retained earnings. As the name suggests, the statement of changes in equity reflects the net changes in the equity accounts for the period. It shows the total comprehensive income for the period; the effects of any retrospective adjustments for accounting errors, changes in accounting policies and reclassification of amounts, as outlined in the previous section in this chapter; and the results of transactions with owners/shareholders in their capacity as owners, that is, contributions and distributions. Lastly, the statement

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010

Self-Study Solutions

Week 11

ACCT5001 S1 2010

Self-Study Solutions

Week 11

PROBLEM SET A 10.9

(c) Change in equity during the year Africa Ltd $ Share Capital ($400 000+40 000) Reserves ($50 000 +$15 000) 440 000 65 000 159 000 664 000 550 000 $114 000

Journal entries for YEJ 2011

(a) $ 15 Aug 10 Dividend Declared/Retained Earnings Dividend Payable Being declaration of final dividend for YEJ2010 (200 000 x $0.18) 01 Oct 10 Dividend Payable Cash at Bank Being payment of final dividend 06 Jan 11 Dividend Declared/Retained Earnings Share Dividend Payable Being declaration of interim share dividend (200 000 x 10% x$2) 15 Mar 11 Share Dividend Payable Share Capital Being payment of interim share dividend 30 Jun 11 Retained Earnings General Reserve Being transfer to general reserve 15,000 15,000 40 000 40 000 40 000 40 000 (d) 36 000 36 000 36 000 36 000 $

Retained earnings Equity 30 June 2011 Less: Opening Equity ($400 000+ $50 000 +$100,000) Increase in equity

Or simply equity increased by $150 000 profit less cash dividend $36,000 = $114 000

Dividends to be paid out of YEJ2011 profits are the interim share dividend of $40,000 plus the final cash dividend for FY2011 of $39,600 (220,000 x $0.18)

Dividend payout = $79,600/$150,000 = 53.1%

Return on shareholders equity = $150,000/[($664,000 + $550,000)/2] = 24.7%

(b)

Africa Ltd Statement of Changes in Retained Earnings For the Year ending 30 June 2011 Retained earnings 1 July 2010 Profit Less final 2010 dividend Less interim share dividend Transfer to general reserve Retained earnings 30 June 2011 $100,000 150,000 (36,000) (40,000) (15,000) $159,000

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010

Self-Study Solutions

Week 11

ACCT5001 S1 2010 PROBLEM SET B 10.9

Self-Study Solutions

Week 11

PROBLEM SET A 10.10 Investor Ltd (a)

Aura Ltd
$ Borrow at 8% Issue More Shares 15 Aug 10 Dividend Declared/Retained Earnings Dividend Payable 12 000 12 000 $

Profit before interest and tax Interest expense 8% x $2,500,000 Tax expense 30% profit before tax Profit Shareholders equity Return on shareholders equity

$1,200,000 (200,000) (300,000) 700,000 5,000,000 14%

$1,200,000 01 Oct 10 (360,000) 840,000 7,500,000 11.2% 06 Jan 11

Being declaration of final dividend (100 000 x $0.12) Dividend Payable Cash at Bank Being payment of final dividend Dividend Declared/Retained Earnings Share Dividend Payable 15 000 15 000 12 000 12 000

Being declaration of interim share dividend (100 000 x 10% x $1.50) Borrowing yields the greater return for Investor Ltds shareholders given the current interest rate. Other factors that should be considered include the liquidity and solvency risk associated with future interest and principal payments and potential changes in interest rates. Also to be considered is the change in ownership structure under the share issue alternative. 15 Mar 11 Share Dividend Payable Share Capital Being payment of interim share dividend 30 Jun 11 Retained Earnings General Reserve Being transfer to general reserve 10,000 10,000 15 000 15 000

(b) Aura Ltd Statement of Changes in Retained earnings

Retained earnings 1 July 2010 Profit Less final 2010 dividend Less share dividend Transfer to general reserve Retained earnings 30 June 2011

$50 000 50 000 (12 000) (15 000) (10 000) $63 000

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010

Self-Study Solutions

Week 11

ACCT5001 S1 2010

Self-Study Solutions

Week 11

BUILDING BUSINESS SKILLS 10.5 GROUP DECISION CASE

Quickdraw Ltd (c) Aura Ltd Change in equity during the year $ Share Capital ($200 000+15 000) Reserves ($50 000 +$10 000) Retained earnings Equity 30 June 2011 Less: Opening Equity ($200 000+ $50 000 +$50,000) Increase in equity 215 000 60 000 63 000 338 000 300 000 $ 38 000 (a) The directors should rank the options by comparing return on shareholders equity. However this should not be the only consideration. The issue of additional shares may affect the control of the company by existing shareholders. On the other hand, there are risks associated with taking on additional debt, such as rising interest rates (unless the interest is fixed). Another concern is the effect on liquidity and solvency of the need to make periodic interest payments and to subsequently repay the principal. This is of particular concern in the case of Quickdraw because of the high operational risk of its operation. Using debt finance would combine financial risk with the existing high operating risk. This may, in turn, have a negative impact on shareholders if their company has too much risk. This may reduce the value of the companys shares to its shareholders.

Or simply equity increased by$50 000 profit less cash dividend $12,000 = $38 000

(b)

(d)

Dividends to be paid out of YEJ2011 profits are the interim share dividend of $15,000 plus the FY2011 final cash dividend of $11,000 (110,000 x $0.10)

The advantage of the third option is that it reduces the risk to the company of being unable to repay the debt. If the subsidiary is unable to repay the debt the company as a shareholder is only liable for any unpaid capital. The disadvantage of this would be a loss of reputation. Another consideration is that structuring in a manner so as to avoid risk, while taking the benefits of any profits generated by the activity is not being a good corporate citizen.

Dividend payout = $26,000/$50,000 = 52%

Return on shareholders equity = $50,000/[($338,000 + $300,000)/2] = 15.7%

Assuming borrowing was going to be in the interest of shareholders, arguments could be raised for or against the third option. Some students may argue that structuring the operations in a way that effectively transfers risk to the creditors is acting in the best interests of the shareholders, as is the duty of directors. Others may consider such a structure to be poor business ethics as it is taking advantage of the subsidiary structure and limited liability to enable the company and its shareholders to receive the potential benefits if it succeeds while leaving the creditor to bear the loss if it fails.

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010

ACCT5001 S1 2010 Week 11 Self-Study Solutions.doc 17/05/2010