Question

Simple Advice to a Chief Executive

This activity requires you to advise a business’s Chief Executive on how to maximise the profit figure reported in the business’s financial statements. The purpose is to illustrate how the generally accepted accounting conventions and principles, employed in preparing financial statements, impact on profit measurement.

Food services business

Peter Smith is the owner and Chief Executive of a business that provides food services. He believes that the business has considerable growth potential but needs to raise additional funds to finance the additional assets that will be required. Peter wants to present the year’s performance in as favourable a light as possible; his rough estimate is that sales revenue will be about £1,500,000 and net profit before tax about £200,000.

He has identified a number of imminent transactions and is considering possibly delaying them until after the financial year end – depending on the impact that each transaction will have on this year’s profit and loss account. He is uncertain about this, as he is not familiar with the various accounting principles and conventions that are employed in determining profit. He is aware, however, that delaying some transactions could have operational consequences for the business.

The transactions being considered by Peter are as follows.

• Spend £50,000 on advertising, which Peter estimates will increase sales by 20% in the next financial year (although he is not certain of the relationship between advertising and sales).
• Take out goods worth £5,000 for his own use.
• Sell goods for £50,000 on credit (at a 30% gross profit margin) if the customer is granted an extra month’s credit period in which to pay. (This means that the cash will certainly not be received until after the current financial year end.) Without the additional credit period, the customer would not be prepared to purchase the goods before Peter’s year end.
• Replace a motor van which is used for delivering goods to customers’ premises but is in a poor state of repair. This would cost £30,000 for a vehicle with an estimated useful life of 6 years and zero scrap value at the end of that period.
• Purchase plastic containers and paper napkins for food jobs at much lower prices than normal, if purchased immediately for cash, due to abnormal but temporary market conditions. Total outlay involved would be £25,000. It is certain, however, that these stocks will not be used before the end of the current financial year.

Task

Advise Peter what to do, giving reasons for your recommendations. Use the Table to record your output. In making your recommendations, you should:

• explain the impact of each transaction on the current year’s profit and loss account
• the particular accounting principle or concept this impact reflects
• any likely operational consequences of delaying the transactions until after the year end.

Think carefully about the meaning of each of the conventions or principles in terms of the cost or revenue figures to be included in the financial statements. Then consider each transaction in turn.

Note for guidance: Although there are many accounting conventions and principles, the transactions in this activity will only be affected by one or more of: accruals/matching, revenue recognition, prudence, entity concepts.

TABLE Report: Advice on maximising reported profit figure

Problem identification
Analysis (investigation)
Conclusion to the analysis (results of the investigation)
The solution, listed as a set of SMART recommendations
Strengths and weaknesses of the recommendations
The implications of the solution, if implemented

Answer 1

Problem identification	Peter smith wants to raise additional funds because He believes that the business has considerable growth potential therefore he wants to present the year’s performance in as favourable a light as possible; his rough estimate is that sales revenue will be about £1,500,000 and net profit before tax about £200,000. The problem here is to present good profit in order to raise funds.
Analysis (investigation)	Peter wants to spend 50,000 on advertisement that will increase sales by 20%. Take out goods worth £5,000 for his own use. Sell goods for £50,000 on credit (at a 30% gross profit margin) if the customer is granted an extra month’s credit period in which to pay. Replace a motor van which is used for delivering goods to customers’ premises but is in a poor state of repair. This would cost £30,000 for a vehicle with an estimated useful life of 6 years and zero scrap value at the end of that period. Purchase plastic containers and paper napkins for food jobs at much lower prices than normal, if purchased immediately for cash, due to abnormal but temporary market conditions. Total outlay involved would be £25,000. It is certain, however, that these stocks will not be used before the end of the current financial year.
Conclusion to the analysis (results of the investigation)	If Peter spends on advertisement his sales will also get increased by 20% which will increase his profit but also advertisement expense will decrease his profit. Most probably the effect of advertisement will be seen slowly at not suddenly with might reduce current year profit. If he withdraws goods for his personal use it will reduce his profits as his stock gets reduces by 5000 without adding anything to revenue Purchasing of new vehicle will increase the depreciation expense which will reduce the profit. Purchasing too much stock at the same time will effect the profit figure as the profit will get reduced.
The solution, listed as a set of SMART recommendations	It is not beneficial to spend on advertisement in current year as it will reduce profit. Most probably the effect will be seen slowly and not suddenly. If he wants to show good profit he do not have to withdraw the goods for his personal use. He can purchase the new vehicle if necessary as it will effect the profit with just marginal amount of depreciation of 5000 and not by the whole cost of vehicle i.e 30000. He do not have to purchase too much stock as it will not get sold before the year end and this will reduce the profit by amount of stock purchase of 25000.
Strengths and weaknesses of the recommendations	Strengths Current year profit will get increased. Weakness May effect the profit in long run. Eg:Stock which I recommended he do not have to purchase right now at lower cost ,the same stock he have to purchase in future at hogh price which will effect the financial position of business.
The implications of the solution, if implemented	If the above mentioned solution is implemented he can increase the profit by around 80,000 which I think helps in maintaining the desired profit before tax of £200,000.