Esc-Clermont Sup de Co

Programme Mastère

Course : Introduction to Accounting and Finance

Teacher : André Cabannes

 

Please write your name in this box :

 

 

 

 

Final exam

Novembre, 2006

 

With corrections

 

 

1,5  hour, 12 questions, each worth the same number of points. Write your answers on this document in the blank space below each question.

 

 

Question 1 : A computer shop F sells a computer, for 2000 euros on credit, to a cloth shop G. What are the two entries in the accounting system of F ?

 

Credit Sales 2000

 

Debit Clients 2000

 

 

 

What are the two entries in the accounting system of G ?

 

Debit Computer equipment 2000

 

Credit Suppliers 2000

 

 

 

Question 2 : This computer had been bought by F, a few days before, for 1200 euros on credit. What were the two entries in F accounting system at that time ? (Two possible answers, depending whether F has a real time stock management or not.)

 

 

Answer 1 : If we follow the traditional accounting method (with a Purchases account and a computation of COGS at the end of the accounting period) :

 

Debit Purchases 1200

 

Credit Suppliers 1200

 

 

Answer 2 :  If the firm F has a real time stock monitoring system :

 

Debit Stocks 1200

 

Credit Suppliers 1200

 

 

 

 

Question 3 : Explain what are the “Revenue accounts” and what are the “Capital accounts” in the list of all the accounts of a firm.

 

Among the accounts recording value entering the firm, there is a fundamental dichotomy between two types of accounts.

  • Some value is already consumed or will be quickly consumed: these are called "revenue accounts". And the Sales account is included in the Revenue accounts.
  • Some value stays in the firm for a long time, several accounting periods, or forever: these accounts are called "capital accounts" (don't mix this up with the "Capital account", recording initial money put in by the owners).

 

The Revenue accounts are those making up the Income statement : the idea is to start from the Sales and subtract all the consumptions “matching” these sales. The result is the Net profit or loss of the period.

 

The firm may carry out many other transactions than revenue expenditures during the same period (purchase of land, investment into some overseas holdings, long term borrowing of money, payment of suppliers, receipt of payment from some debtors, etc.), these transactions do not concern the Income Statement. They do not involve revenue accounts. They only involve capital accounts.

 

The Capital accounts are all the accounts that are not Revenue accounts. And the P&L goes into the Capital accounts.

 

Revenue accounts are set anew (new balance equal to zero) at the beginning of each accounting period, whereas capital accounts carry a balance from one year to the next, and start the new accounting period with the ending balance of the preceding period.

 

 

 

 

Question 4 : Here is the journal of the first eight transactions of a new firm E :

  1. Initial founding capital 100 000 euros paid in cash
  2. Purchase of goods for 30 000 euros from Cathy, on credit
  3. Sale of two third of our stock for cash, for 40 000 euros
  4. Pay Cathy with cash
  5. Acquisition of equipment (paid cash) 60 000 euros
  6. Sale of the remainder of our stock for 25 000 euros to Mark, and we grant him a credit.
  7. Purchase of goods for 20 000 euros (paid cash)
  8. Payment of salary (cash) 10 000 euros

 

 

Open all the necessary accounts, and post all the transactions. (Next page is blank to give your room.)

 

 

 

(all figures in thousands of euros)

 

Transaction 1 : Initial founding capital 100 000 euros paid in cash

 

 

 

 

 

 

Transaction 2 : Purchase of goods for 30 000 euros from Cathy, on credit

 

 

(We also make a note that our stock is now : 30.)

 

 

 

 

Transaction 3 : Sale of two third of our stock for cash, for 40 000 euros

 

 

(We also make a not that our stock is now : 10. This note is equivalent to a “real time stock monitoring system”.)

 

 

 

Transaction 4 : Pay Cathy with cash

 

 

 

 

Transaction 5 : Acquisition of equipment (paid cash) 60 000 euros

 

 

 

 

Transaction 6 :   Sale of the remainder of our stock for 25 000 euros to Mark,

and we grant him a credit.

 

 

(Now our stock of goods for sale is temporarily empty. We have to replete it before we can make a further sale.)

 

 

 

Transaction 7 : Purchase of goods for 20 000 euros (paid cash)

 

 

(Now our stock of goods for sale is : 20.)

 

 

 

Transaction 8 : Payment of salary (cash) 10 000 euros

 

 

 

 

 

 

Question 5 : Establish the preliminary Trial balance.

 

 

It is the list of all the account balances :

 

 

 

 

 

Question 6 : Make an inventory, and make the corresponding adjustment to the TB.

 

 

We kept track “in real time” of what was our stock. So we know that the ending stock, right now, is 20.

 

 

We can prepare an “adjusted” trial balance :

 

 

 

 

 

Question 7 : (We assume no other adjustments than the stocks.) Prepare the Income statement (from transaction 1 to transaction 8 included).

 

The Income statement is constructed with the Revenue accounts of the adjusted trial balance. Here are these accounts (in green) :

 

 

And here is the Income statement (a different presentation of the green accounts shown above, leading to a calculation of the Profit or Loss) :

 

 

 

 

 

And the Balance sheet (after transaction 8).

 

 

The balance sheet is nothing more than a different presentation of all the account balances remaining in the adjusted trial balance, once we have replaced all the revenue accounts by just one account : the P&L (added to the possible past retained earnings ; here there are none because it’s the first accounting period).

 

 

 

 

 

Question 8 : Explain what is meant by “the time value of money”. (Try and be detailed, with an example for instance.)

 

In finance, as opposed to accounting, we take into account when a sum of money arrives into the firm or leaves the firm.

 

Viewed from an initial date t0 (usually today), for any sum of money, or any value, we shall record its “face value” and its date. And we shall also try to evaluate the risk (or probability) that it is still worth its face value when the time arrives to its date.

 

For instance, a piece of paper promising a payment of $100 in one year by John, and signed by John, has a face value of $100. But this face value refers to a value in one year. When the time comes, John may default, and then the value of the piece of paper is zero.

 

This piece of paper has a value today. It is called its present value.

 

This present value depends upon the risk represented by John. But at any rate it is less than $100.

 

To compute its value today, we must know what is the yearly interest paid by “risk-free” securities. If it is 5%, then the value today of John’s promise is, at the most,

 

$100 /  (1 + 5%) ≈ $95

 

 

 

 

Question 9 : We can buy today, in the stock market, a stock S for the price 50 euros. (Assume S pays no dividend – like Microsoft from 1986 until 2003.) From an examination of the past prices of S, we know that next year, S will have a value X, which is – viewed from today – a random variable.

 

X will take a value in the following set : {40€, 45€, 50€, 55€, 60€, 65€, 70€} (all in euros)

The corresponding probabilities are {5%, 10%, 20%, 30%, 20%, 10%, 5%}

 

What is the expected value of S in one year ?

 

Apply the formula taught in class (the weighted average of the possible outcomes, weighted with their respective probabilities) : we get 55€.

 

We may also just note that the “distribution of probabilities” is symmetrical around 55, therefore it is the mean.

 

 

 

What is the expected profitability of our purchase of S ?

 

10%

 

 

 

 

 

 

Question 10 : What are the variance and the standard deviation of the future value of S ? (Remember : Variance of X = Expected value of the square deviation around its mean.)

 

Var X = 52,5 (the unit is square euros)

 

Standard deviation = 7,25 €

 

 

 

 

 

Question 11 : What is the risk of S ? (Use the definition given in class for the risk of a security.)

 

It is the standard deviation of the profitability of S. Calculations yield : 14,49%

 

 

 

 

 

Question 12 : Explain what are securities with no risk.

 

Securities promising a payment in the future, and we can be sure of this payment.

 

In practice, it is only the short term Government bonds of prosperous countries.

 

(Why short term ? Ans. Are you sure today’s US government bonds, or today’s French government bonds will be worth much in 30 years ?)

 

 

 

What is their usefulness (for the buyer, and for the seller) ?

 

For the buyer of the bonds, it is a way to have one’s money work (produce interest, instead of staying idle) with no risk.

 

For the seller, it is a way to raise money to finance various things – hopefully investments, rather than revenue expenditures. But the French state, for the past 25 years, has been financing a part of its revenue expenditures with debt. This is severe mismanagement from the part of the French government (ref. Rapport de la Commission Pébereau, Robert Laffont, 2006). And it will cause much trouble in the future. It’s likely to be solved either by european-wide inflation, or by a default from the French state. The rating agencies are following closely the quality of French paper, and have begun to mention the possibility of downgrading it in the near future.

 

When a friend of yours borrows money – say, from you – and keeps borrowing money, at some point you say “stop”. When do you say “stop” ? And what will happen to the debt due to its creditors (that is, you) ? If someone asks you for money, do you want to know what he or she will do with it ? Most people don’t ask because they don’t understand money very well, and anyway it is the State, so it must be reliable. Unfortunately the chaps who have been in charge of managing France for the past few years have no understanding of money, don’t care about it, and pay their private expenses with cash obtained from selling their political influence.

 

Defaulting by “trustable” entities is a common situation in History. A well known example is “Russian bonds”, but there are many more, beginning, in modern history, with Philip II in the late XVIth century when Holland wanted to become free. All French and German savers were gypped after WWI. It is one of the causes of WWII (aside from Clemenceau’s incapacity to understand what George and Keynes were telling him). German middle class, in 1933, voted for Hitler, just like now 17% of French people vote for Le Pen.

 

The most likely, concerning French public debt, is that, in 5 or 10 years, the French population will be told that “a problem arose with our debt. We will pay what we owe foreign creditors, but French creditors won’t be paid”. This will give rise to much traffic to have one’s debt classified as foreign.

 

Actually, the teacher thinks that the problem of the debt will be solved by the appearance of new money. We will witness more and more transactions (books, discs, clothes, then furniture, refrigerators, cars, etc.) carried out in new moneys. At first it will be considered anecdotical (like a Brazilian top model who does not want to be paid in dollars), but it will be more and more frequent. These transactions will escape the fiscal nets of the State. And little by little (over the course of 20 years) the economy will get rid of the ludicrous debt, and currency it is expressed in, left by the French governments over the past 30 years. But these views are non standard as of 2007.

 

 

 

What are, in mid-November 2006, the profitabilities of risk free securities in the US and in the Euro zone.

 

US : approximately 5,5%

 

Euro zone : approximately 3,5%

 

(We use the term “approximately” because in this simple presentation, we mix up r0 with the prime rate, the one year rate, and the various other short term rates.)