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ACCA Applied Skills · Financial Reporting · Limitations of interpretation techniques

Birch Co has opening equity of $500,000 funded entirely by non-monetary assets carried at historical cost. Profit for the year is $75,000 and general inflation is 8%. Ignoring other effects, what is Birch's profit as a percentage of opening equity in real terms, to one decimal place, after maintaining the purchasing power of opening equity?

The real return is 7.0%. Nominal profit of $75,000 is 15% of opening equity of $500,000, but 8% inflation means $40,000 must be retained to preserve purchasing power. Real profit is therefore $35,000, which is 7.0% of opening equity.

  1. A7.0%Correct
  2. B15.0%
  3. C8.0%
  4. D-7.0%

Explanation

Nominal return is 75,000/500,000 = 15%. To maintain purchasing power of opening equity, 8% x 500,000 = $40,000 must be retained, leaving real profit of $35,000. 35,000/500,000 = 7.0%. The 15% option ignores inflation; -7% subtracts in the wrong direction.

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