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Markham Ales Solutions

Question 1

Figure 2 shows that as at 31.12.21 the total assets of Markham were £11,947k and the total equity plus liabilities were exactly the same. Clearly this is not a co-incidence. Explain why this is so.

(4 marks)

Q1. This phenomenon is often described as ‘the accounting equation’.

Specifically: assets = liabilities plus equity (or variations thereof)

The left-hand side denotes all resources under control of the entity. Every £1 worth of these resources have been supplied by someone; either the owners (equity) or third parties such as banks and suppliers (liabilities).

Question 2

a) Calculate the following ratios for both 2019 and 2021:

Gross Profit Margin for owned and non–owned sales (separately)

Net Profit Margin (operating profit margin) for owned and non–owned sales (separately)

(4 marks)

b) Briefly comment on your results obtained in answer to question 1 (4 mark

Q2 a:

		2019	2021
GPM	Owned	(1107 / 2163) x 100 = 51.2%	( 787 / 1533) x 100 = 51.3%
	Non Owned	(1911 / 3555) x 100 = 53.8%	( 1101 / 2311) x 100 = 47.6%
NPM	Owned	( 301 / 2163) x 100 = 13.9%	( 192 / 1533) x 100 = 12.5%
	Non Owned	( 639 / 3555) x 100 = 18.0%	( 237 / 2311) x 100 = 10.2%

Q2 b: Comments:

Despite the coronavirus / Covid 19, Gross profit margins have been maintained. This is understandable as we would expect a slump in trade to affect volume rather than trading margins achieved.

The situation regarding Net profit margin is less clear; that for owned pubs has changed little (perhaps they were able to lay off casual / part time bar staff and waitresses whilst others were furloughed), whereas that for non-owned pubs has deteriorated noticeably. This needs investigating.

Question 3

a) Calculate, for both 2019 and 2021:

• Current ratio

• Debt collection period (assume all sales are on credit)

• Creditor payment period

• Capital gearing

• Interest cover (10 marks)                                    

	2019	2021
Current ratio	1339 : 148 = 9:05:1	1717 : 1206 = 1.42:1
Debt collection	(1277 x 365) / 5718 = 82 days	(1665 x 365) / 3844 = 158 days
Creditor payment	(68 x 365) / 556 = 45 days	(516 x 365) / 451 = 417 days
Capital Gearing	(1000 / 10031) x 100 = 10.0%	(1000 / 10741) x 100 = 9.3%
Interest Cover	940 / 130 = 7.2 times	429 / 130 = 3.3 times

b) Comment on your results obtained in answer to Question 2a.

(8 marks)                                     

All the results are consistent with the worsening economic situation owing to the pandemic, and its effect on the hospitality industry. In a recession, payment periods lengthen, in this case, dramatically so, especially in the case of trade payables. Are the suppliers of raw materials such as hops, yeast etc prepared to tolerate having to wait over a year for payment or will they refuse to supply further? The company appears to be maintaining a cash balance of around 50k and might consider using at least some of this to appease their suppliers. The current ratio has reduced dramatically but it could be said to be too high in 2019. Whist the gearing remains constant (and low, which is a good thing in times of recession) the interest cover has dropped by over half. This is to be expected because the closure of pubs means a reduction in volume of sales, whilst the same £1m of debt still needs to be serviced.

The best answers will refer to the steps being taken by the Board (The Board taking a 20% pay reduction, No ordinary dividend payments throughout the year, etc.) are evidence that Management clearly understand the need to ameliorate the effects of the Pandemic upon cash flow.

Question 4

In figure two, the value of the Brewkat brand appears as an intangible non-current asset, yet despite having three well established real ales, the Markham brand itself does not appear. Explain why this might be so. (4 marks) 

 Q4

Brewkat is an ‘acquired’ brand therefore there is an objective valuation, that being the price paid of £50k. The Markham brand is internally generated and is not permitted (under current accounting standards) to be recognised because there is no accurate measurement basis for the cost of developing the brand since 1927.

Question 5

The Managing Director frequently refers to the two Master Brewers as ‘our greatest asset’ owing to their specialist knowledge, the various awards won, and their length of service with the company. Comment on this quotation from a financial accounting viewpoint. (4 marks)

Employees do not meet the accounting definition of ‘assets’ because part of that definition is that the resource is controlled. Generally speaking, businesses are not considered to control their employees because they could hand in their resignation tomorrow. An exception is football players who sign contracts to play for a club for a number of years; in which case the player registration becomes an intangible asset.

Question 6

a) With regard to the “tunnel pasteuriser” mentioned in the notes to Figure 2, calculate the depreciation charge that will have been expensed to each of the Income Statements for 2019, 2020 and 2021 using:

i) The straight-line method

ii) The reducing balance method at a rate of 25% (calculate to the nearest £0.1k)

 Markham’s policy is to charge for a whole year of depreciation in the year of purchase.

(6 marks)

b) International Accounting Standard number 16 (‘IAS16’) states that an item of Property, Plant and Equipment “should be depreciated……over its useful life”. Explain two overall benefits of Accounting Standards such as IAS 16. (4 marks)   and depreciated so that its depreciable amount is allocated on a systematic basis over its useful life.

Q6a

All figures in £k	Straight Line	Reducing Balance
Cost in 2019	200	200
Depn charge for 2019	(40)	(50)
Nbv 31.12.2019	160	150
Depn charge for 2020	(40)	(37.5)
Nbv 31.12.2020	120	112.5
Dep’n charge for 2021	(40)	(28.1)

Q6b

Comparability – the ‘level playing field’ argument – can more easily compare accounts of different companies, or the same company over time

Credibility – confidence in the profession; legitimacy in public light by being seen as ‘a profession’

Confidence – in the reliability of accounts as a basis for valuation / investment (people will invest if they have faith in the accounting process)

Mechanism of compulsion – helps to identify and punish obscure and quasi-fraudulent reporting practices

Question 7

Discuss and decide whether or not Markham should recognise a liability in its Statement of Financial Position as at 31^st December 2021, with regard to:

i) The legal fees of £10k charged by Willstones in preparing for the lawsuit

ii) The £50k compensation that may be due the customer who claims he was poisoned in the Green Dragon.

(8 marks)

Q7.

i) A liability is defined as a present obligation arising from a past event. The past event here is the hiring of Willstones. Payment is unavoidable, therefore a liability of £10k should be recognised.

ii)  IAS37 recognises that there are rare circumstances, such as law-suits, where it is not clear whether a past event is deemed to give rise to a present obligation. In such cases a past event is deemed to give rise to a present obligation if, taking account of all available evidence (including, for example, the opinion of experts) it is more likely than not that a present obligation exists at the balance sheet date. Since the probability of being found liable is only 40%, i.e. less than 50%, this liability should not be recognised.

Question 8

a) On the assumption that Markham has a cost of capital of 16%, calculate the Net Present Value (NPV) of each of the two shirt sponsorship proposals. (8 marks)

Workings to annual revenue streams:

	FGR £k	MT £k
£20 x average gate	50	84
£240k / distance (n)	16	15
Ampney Arms bonus	15	-
Totals	81	99

DCF calculations (annuity factors have been used but students may use discount factors with no penalty) * = AF, 4 years, 16%

	FGR				MT
Payment Y0	£200k	1.000	(£200,000)	£240k		1.000	(£240,000)
Revenue Y1-Y4	£81k	2.798*	£226,638	£99k		2.798*	£277,002
NPV			£26,638				£37,002

b) Calculate the forecasted accounting rate of return (on initial investment) of each shirt sponsorship deal. (2 Marks)

	FGR	MT
Average profit	81k	£99k
Initial investment	200k	240
Arr	40.5%	41.3%

OR can use: (TR – TC ) / 4 for average profit, giving 15.5 and 16.25 respectively

c) Comment on whether Markham should focus on either of the two shirt sponsorship proposals. What other information would help them make a decision? (6 marks)

Based on NPV and ARR the MT proposal seems the better proposal. But given the current environment, perhaps neither proposal should be pursued. The current cash balance (31.12.2021 in figure 2) is only £42K; this is only 21% of the cash required to sponsor FGR and 17.5% of that required for the MT deal.

Given the steps taken to counter the cash flow problems created, this seems rather ambitious. Shareholders might quite reasonably point out that they are having to take a dividend holiday, yet cash is being ‘splashed’ on sponsorship!

In addition, we should factor in the risk that a new variant of Covid will emerge, causing either or both of pubs and football grounds to be closed to the public once again.

 It could only be financed by a further issue of shares or a loan. To consider this, Markham would require the internal rate of return of the project and the payback period.

   Question 9

a) Produce a revised ‘flexed’ budget for the Grey Heron, and calculate the variances. All calculations should be to the nearest £k. (6 marks)

b) Suggest possible reasons for the variances. (4 marks)

a) 

	Budget 2021	Actual 2021	Flexed 2021	Variance
No of covers	9,000	6,023	6,023
	£k	£k	£k	£k
Sales revenue	525	375	351	24 (fav)
Food costs	(175)	(129)	(117)	12 (adv)
Labour costs	(130)	(95)	(87)	8 (adv)
Rent and Rates	(30)	(30)	(30)	Nil
Energy Costs	(40)	(26)	(27)	1 (fav)
Managers Salary	(50)	(36)	(50)	14 (fav)

b) Sales revenue – possibly people spending more per visit because their visits are less frequent?

Food costs – many media reports of imported food price rises post-Brexit.

Labour costs – several explanations, possible labour shortage

Energy costs - negligible difference really

Managers Salary – case mentions that use was made of the furlough scheme

Question 10

The case mentions that the Board considered closure and disposal of one (or even more) pubs.

Write advisory notes for the Board, indicating:

i) What is ‘break-even’ and why does it matter?

ii) Under what circumstances should a pub be closed and disposed of?

(4 marks each = 8 marks)

Q10.

i) Break even – the concept that a unit (pub) must achieve a certain activity (sales) level in order to cover its fixed costs.

Based on the formula: B/E output = total fixed costs / contribution per unit

Contribution per unit = selling price less variable cost

So a meal sold for £14 may cost £5 to prepare, allowing £9 to be contributed towards paying for the fixed costs.

It matters to a business because any business needs to realise that a certain minimum level of activity is needed to cover the fixed costs.

ii) A pub should be disposed of if it seems set to return a negative contribution for the foreseeable future.

In other words if the marginal cost of operating the pub exceeds the marginal revenue from doing so, it ceases to become viable.

Marginal costs include fixed costs but only those that arise from the pub being operative (for example rates payable for that particular pub).

In other words, Head office costs allocated to units (pubs) should not be considered for the purpose of this decision.

Question 11

Figure 2 shows that Markham has managed to maintain a cash balance of £42k despite all the problems created by the Pandemic during 2021.

a) Explain the difference between the ‘Baumol’ and the ‘Miller and Orr’ approaches to cash management (4 marks)

b) Discuss whether Markham should adopt the ‘Baumol’ model or the ‘Miller and Orr’ model in its approach to cash management:

i) In normal (i.e. non-pandemic) times (3 marks)

ii) In times when business is affected by a Pandemic  (3 marks)

a) The Baumol model assumes that demand for cash is constant and predictable, and that debtors pay up in a predictable manner. therefore if an EOQ (economic order quantity) is pre-calculated, the same amount of cash can be ‘re-ordered’ (from other cash equivalents) in order to produce a saw-tooth effect (when presented on a graph.

The Miller and Orr model is designed to cope with unpredictability by setting upper and lower limits which, when reached should trigger the investment or de-investment of cash.  

b) i) In non-pandemic times, trade in the brewing and hospitality industries tend to follows predictable patterns (for example if you want to predict the takings for any given week of the year, simply look at what happened in the same week last year as a start point).  This scenario would lend itself to the Baumol model.

iii) Everything changes in a pandemic. All things previously known now become unknown. When will the next lockdown occur? How long will it last? Therefore considerable unpredictability enters the scenario, which suggests that the Miller and Orr model would be more appropriate.