ACCOUNTANCY A LEVEL(FORM SIX) NOTES – WEAKNESS OF ESTIMATION METHOD

Weakness of Estimation Method

1. The stock estimation technique assumes that the gross profit margin remains stable during the period of estimation.
2. It also assumes that the closing stock will be representative of all items available for sale.
3. If these assumptions are not true, misleading values will be produced.
4. These techniques must take into account the realities encountered to yield an acceptable approximation.

On 1^st April 2012, stock at cost was 30,000/=.

Purchases were 15,000/=.

Sales were 10,000/=.

The normal rate of gross profit on cost price is 25%; however, allowances of 2,000/= have been made to customers.

Calculate:

• Closing stock estimate as at 30^th April 2012.

Exercise 2

Due to administrative reasons, W. Mahwa, the wholesaler, had to take his stock on 28^th December 2004, on which date it was valued at cost at 73,260/=. The following transactions took place in the next 3 days:

1. Sales book 3,400/=
2. Cash sales 1,940/=
3. Purchases book total 2,310/=
4. Returns inward book 220/=
5. Returns outward book 170/=
6. Carriage inward 425/=

A detailed examination of the books also revealed the following information:

1. Sales book includes one invoice for 280/= against which goods were delivered on 2^nd January 2005.
2. Cash sales include sales of an item that had a cost value of 42/= but was sold for 36/= as it was damaged in store.
3. All purchases made had been duly received from the supplier.
4. A customer returned books invoiced at 80/= on 29^th December 2004 but was issued with a credit note on 3^rd January 2005.
5. Carriage inward was paid in respect of goods bought in December 2004.
6. Stock with a cost value of 295/= had stayed in store for too long and is estimated to have a realizable value of only 178/=.
7. Goods costing 126/= were returned to a supplier on 30^th December 2004 but the credit note was received four days later.
8. No records have been made of drawings in the form of goods by the owner of this business, W. Mahwa, amounting to 203/=.
9. The usual gross profit margin is 33% on cost.

Calculate the cost or net realizable value, whichever is lower, of the stock as at 31^st December 2004.

Insurance Claim

Illustration 1

J.A has insured stock for 10,000/=. On 31^st March 2008, when the total cost value of stock in his store was 12,000/=, his store caught fire. The value of stock salvaged from fire was 3,000/=. Calculate the amount he can claim from the insurance company.

Notes

If stock is not fully insured, that is, if the value of stock in store is more than the sum insured, the insurance company pays the following portion of the value of stock destroyed by fire:

Insurance claim = 10,000 × 9,000 / 12,000

Insurance claim = 7,500/=

• Owner J.A of the go-down should claim 7,500/= from his insurance company.

Illustration 2

Stock on 31^st March 2005 (last year end) was 6,200/=.

Debtors on 31^st March 2005 were 4,600/=.

Creditors on 31^st March 2005 were 5,400/=.

Receipts from debtors (1^st April to 5^th May) were 5,700/=.

Discount allowed to debtors was 100/=.

Discount received from creditors was 180/=.

Payment to creditors was 5,120/=.

Stock donated to charity (cost value) was 340/=.

Stock salvaged from fire was 600/=.

Gross profit margin is 25% on cost.

Calculate:

1. The cost value of stock in store on 5^th May 2005 considering that on that day debtors amounted to 6,500/= and creditors to 4,900/=.
2. The amount to be claimed from the insurance company.

Solution

Exercise 2

Stock as at 28^th December 2004

Workings

• Note (i)

Sort out all items concerning sales:

Cash sales: 1,940/=

Credit sales: 3,400/=

Total sales: 5,340/=

Less: goods not delivered: 280/=

Net sales: 5,060/=

Less: damaged value: 36/=

Net sales after damage: 5,024/=

5,024 × 75% = 3,768/=

Add: cost before damage: 42/=

Cost of Goods Sold (COGS): 3,810/=

• Note (ii)

Stock with a cost value = 295/=

Less: Realizable value = (178/=)

Loss in value of stock = 117/=

Estimation of Stock

Royalty

Concept of Royalty

Minimum rate and short workings.

Accounting entries in the books of lessor/landlord.

Accounting entries in the books of lessee/tenant.

Royalty is the remuneration payable to a person in respect of the use of an asset, calculated with reference to the quantity produced or sold as a result of the use of such asset.

Royalty is a periodic payment to the owner of an asset for the use of his ownership rights; that is, royalty is compensation made to the owner of an asset in exchange for the right to use that asset.

Royalty may arise in respect of the following:

• Extraction of minerals or materials from the ground.
• Publishing of books with the permission of the author.
• Use of artistic works like movies, etc.

Any lump sum amount paid for the use of any asset is never called royalty because it is a capital payment.

Terms Used in This Topic:

i) Lessor / Landlord: The owner of the asset. The person to whom the right to use the land is granted is called tenant or lessee.

ii) Short workings: The difference between royalty and minimum rent, or the excess of minimum rent over royalty.

iii) Minimum rent / dead rent / rock rent / flat rent: The guaranteed amount that the landlord or the owner of the copyright is to receive.

iv) Recoupment of short workings: According to the short workings clause or contract, the tenant is empowered to recover the amount paid in excess of actual royalty out of the excess royalty over minimum rent (surplus). Until the stage of recovery is reached, the tenant can accumulate the short workings, and once the stage of surplus is reached, recover the excess of minimum rent, and after full recovery, pay the actual royalty. Usually, in contracts where there is provision for minimum rent, there is also a provision for recoupment of short workings. Generally, recoupment is the right of getting back from the landlord excess payment made by the tenant in earlier years. The right to recoup short workings may be either fixed or floating.

In case of a fixed right of recoupment of short workings, the right is available only for a fixed period of time.

If the tenant is not in a position to recoup the short workings during this period, the balance amount will be a loss to him, which will be written off from the profit and loss (P&L) account.

Illustration 1

A limited company leases a mine at a royalty of 20/= per tonne of coal raised, with a dead rent of 400,000/= per annum and further to recoup short workings during the first five years of the lease. Output during the first five years is as follows:

Required:

Show journal entries and ledger accounts in the books of lessor and lessee.

Royalty Table

The following accounts are made:

A) When there is no provision for dividend or minimum rent:

i) Royalty based on actual production:

DR: Royalty payable a/c

CR: Landlord’s a/c

ii) Cash paid to the landlord:

DR: Landlord a/c

CR: Cash a/c

B) When there is provision for minimum rent:

i) Royalty based on production:

DR: Royalty payable a/c

CR: Landlord a/c

ii) Short workings to be recovered in future:

DR: Short workings a/c

CR: Landlord a/c

iii) Cash paid to landlord:

DR: Landlord a/c

CR: Cash a/c

iv) Short working unrecovered (if any):

DR: Profit & Loss a/c (Bad debts)

CR: Short workings a/c

C) When royalty exceeds minimum rent:

i) Royalty based on actual production:

DR: Royalty payable a/c

CR: Landlord a/c

ii) Short working recouped, if any:

DR: Landlord a/c

CR: Short working a/c

iii) Cash paid to landlord:

DR: Landlord a/c

CR: Cash a/c

Note: Cash paid to landlord must not be less than minimum rent.

iv) Short workings irrecoverable:

DR: Profit & Loss a/c

CR: Short working a/c

Workings:

DR Royalty Payable Account CR

DR A. Ltd’s Account CR

DR Landlord Account CR

DR Tenant Account (S.G Coy Ltd) CR

DR Royalty Suspense Account CR

Illustration III

Mr. R Company leased a royalty from Mr. A of 1 E per tonne with a minimum rent of 30,000 E.P.A each year. Excess of dead rent over royalty is recoverable out of the royalties of the next five (5) years. In the event of strike and the minimum rent not being reached, the lease provided that the actual royalty for the year should be paid. The results of workings were as follows:

Sub-Lease

• The lease agreement sometimes gives the right to the lessee to subcontract the right for the use of the asset; this is known as “Sub-lease”.
• The person who is subcontracted is known as sub-lessee or sub-tenant.
• The accounting treatment for the sub-lease and the lease and the lessee is similar to that of the landlord and sub-lessee.
• In the case of sub-lease, the lessee takes the legal stand of the landlord to the sub-lessee.
• It must be noted that there is no agreement between the original landlord and the sub-lessee as per the original agreement terms. But what eventually is paid to the original landlord is calculated based on the total output of both lessee and sub-lessee.
• The lessee is paid based on the output produced or manufactured by the sub-tenant.
• In most cases, the lessee charges a higher price to the sub-lessee than he is charged by the original landlord. Profit from such price differences is transferred to the P&L account.

Accounting Treatments:

i) Royalty payable (own + sub-lessee):

DR: Royalty payable a/c

CR: Landlord’s a/c

ii) Royalty receivable a/c (Based on sub-tenant production):

DR: Sub-tenant a/c

CR: Royalty receivable a/c

iii) Short working recoverable in future by sub-lessee:

DR: Sub-tenants

CR: Short workings

iv) Royalty payable by tenants on sub-tenants production:

DR: Royalty receivable a/c

CR: Royalty payable a/c

v) Profit on sub-lease:

DR: Royalty receivable a/c

CR: P&L a/c

Illustration

Doti Limited acquired rights from Note Ltd to manufacture and sell a certain brand of perfume on the following terms:

1. Royalty shall be paid on the number of bottles manufactured at 20/= per bottle/unit.
2. The minimum royalty in any one year shall be 500,000/=.
3. Short working will be recouped within the first two years of short workings.
4. The agreement becomes effective on 1^st July 2000.
5. All settlements were made on 31^st December each year.

On 1^st January 2000, Doti Limited granted rights to Mwingine Ltd to manufacture and sell the same perfumes on the following terms:

1. Royalty shall be paid on the number of bottles manufactured at 30/= per bottle/unit.
2. The minimum royalty in any one year shall be 200,000/=.
3. Short working recouped only in the year following the year of short workings.

The following information is provided:

Required:

Show ledger accounts in the books of Doti Ltd.

Royalty Table (i) Original Lease

Royalty Table (ii)

Profit on sub-lease:

Royalty payable – 20/=

Royalty receivable – 30/=

Difference – 10/=

2001: 6,000 × 10 = 60,000/=

2002: 7,000 × 10 = 70,000/=

2003: 11,000 × 10 = 110,000/=

2004: 5,000 × 10 = 50,000/=