F7 Acca Past Exams Papers_ Financial Reporting.pdf

Reactive’s Reactive’s summarised summarised financial financial statements statements for for the the year year ended ended 31 31 March March 2006 2006 are are set set out out below: bel

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Financial Reporting (International)

Time allowedReading Reading and and planning: planning: 15 15 minutes minutes Writing: 3 3 hours hours ALL FIVE questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor

During reading and planning time only the During reading and planning time only the question paper mayquestion paper may

be annotated You must NOT write in your answer booklet untilinstructed by the supervisor

This question paper must not be removed from the examination hallThis question paper must not be removed from the examination hall

p e r F 7

( I N T

The Association of Chartered Certified Accountants

FOR FREE FOR FREE ACCA RESOURCES VISIT: ACCA RESOURCES VISIT: http://kaka-pahttp://kaka-pakistani.blogspkistani.blogspot.comot.com

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ALL FIVE questions are compulsory and MUST be

ALL FIVE questions are compulsory and MUST be attemptedattempted

1 On 1 October 2005 Pumice acquired the following non-current investments:

– 80% 80% of of the the equity equity share share capital capital of of Silverton Silverton at at a a cost cost of of $13.6 $13.6 million million

– 50% 50% of of Silverton’s Silverton’s 10% 10% loan loan notes notes at at par par

– 1.6 1.6 million million equity equity shares shares in in Amok Amok at at a a cost cost of of $6.25 $6.25 each each.

The summarised draft balance sheets of the three companies at 31 March 2006 are:

Non-current Non-current assets assets

Property Property, , plant plant and and equipment equipment 20,000 8,500 16,500

Equity Equity shares shares of of $1 $1 each each 10,000 3,000 4,000

Non-current Non-current liabilities liabilities

T Total otal equity equity and and liabilities liabilities 61,000 16,500 29,000

The following information is relevant:

(i) (i) The fair values The fair values of Silverton’s assets of Silverton’s assets were equal to were equal to their carrying amounts with the their carrying amounts with the exception of land exception of land and plant and plant Silverton’s land had a fair value of $400,000 in excess of its carrying amount and plant had a fair value of $1.6 million in excess of its carrying amount The plant had a remaining life of four years (straight-line depreciation) at the date of acquisition.

(ii) (ii) In the post In the post acquisition period Pumice acquisition period Pumice sold goods to sold goods to Silverton at a price of $6 Silverton at a price of $6 million These goods million These goods had cost P had cost Pumice umice

$4 million Half of these goods were still in the inventory of Silverton at 31 March 2006 Silverton had a balance

of $1.5 million owing to Pumice at 31 March 2006 which agreed with Pumice’s records.

(iii) (iii) The net profit after tax for the year ended 31 March 2006 The net profit after tax for the year ended 31 March 2006 was $2 million for Silverton and $8 million for Amok was $2 million for Silverton and $8 million for Amok Assume profits accrued e

Assume profits accrued evenly throughout the year venly throughout the year.

(iv) (iv) An impairment test at 31 An impairment test at 31 March 2006 concluded that March 2006 concluded that consolidated goodwill was consolidated goodwill was impaired by $400,000 and the impaired by $400,000 and the investment in Amok was impaired by $200,000.

(v) (v) No dividends No dividends were paid were paid during the during the year by a year by any of ny of the companies the companies.

Required:

(a) (a) Discuss how the invDiscuss how the investments purchasestments purchased by Pumice oed by Pumice on 1 October 2005 should be treated in itn 1 October 2005 should be treated in its consolidateds consolidated

(b) (b) Prepare the coPrepare the consolidated bnsolidated balance sheet for Palance sheet for Pumice as at 31 Mumice as at 31 March 2006.arch 2006. (20 (20 marks) marks)

(25 marks)

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Plant Plant – – at at cost cost (note (note (i)) (i)) 156,000

Investment Investment properties properties – – valuation valuation at at 1 1 April April 2005 2005 (note (note (i)) (i)) 90,000

Rental Rental of of leased leased plant plant (note (note (ii)) (ii)) 22,000

Inventory Inventory at at 1 1 April April 2005 2005 37,800

Income Income from from investment investment property property 4,500

Equity Equity shares shares of of $1 $1 each each fully fully paid paid 150,000

Retained Retained earnings earnings at at 1 1 April April 2005 2005 119,500

8% 8% (actual (actual and and effective) effective) loan loan note note (note (note (iii)) (iii)) 50,000

Accumulated Accumulated depreciation depreciation at at 1 1 April April 2005 2005 – – buildings buildings 60,000

739,700 739,700 739,700 739,700

The following notes are relevant:

(i) (i) The land and The land and buildings were purchased buildings were purchased on 1 April on 1 April 1990 The cos 1990 The cost of th t of the land was e land was $70 million No $70 million No land and land and buildings have been purchased by Kala since that date On 1 April 2005 Kala had its land and buildings professionally valued at $80 million

professionally valued at $80 million and $175 million respectively The directors wish to incorporate these values and $175 million respectively The directors wish to incorporate these values into the financial statements The estimated life of the buildings was originally 50 years and the remaining life has not changed as a result of the valuation.

Later, the valuers informed Kala that investment properties of the type Kala owned had increased in value by 7%

in the year to 31 March 2006.

Plant, Plant, other other than than leased leased plant plant (see (see below), below), is is depreciated depreciated at at 15% 15% per per annum annum using using the the reducing ba reducing balance lance method method Depreciation of buildings and plant is charged to cost of sales.

(ii) (ii) On 1 April 2005 Kala entered into On 1 April 2005 Kala entered into a lease for an item a lease for an item of plant which had of plant which had an estimated life of five years The an estimated life of five years The lease lease period is also five years with annual rentals of $22 million payable in advance from 1 April 2005 The plant is expected to have a nil residual v

expected to have a nil residual value at the end of its life If pur alue at the end of its life If purchased this plant would have a cost of $92 million chased this plant would have a cost of $92 million and be depreciated on a straight-line basis The lessor includes a finance cost of 10% per annum when calculating annual rentals (Note: you are not required to calculate the present value of the minimum lease payments.) (iii)

(iii) The loan note was The loan note was issued on 1 July 2005 issued on 1 July 2005 with interest payable six with interest payable six monthly in arrears monthly in arrears.

(iv) (iv) The provision for income tax for the year to The provision for income tax for the year to 31 March 2006 has been est 31 March 2006 has been estimated at $28.3 million The deferred imated at $28.3 million The deferred tax provision at 31 March 2006 is to be adjusted to a credit balance of $14.1 million.

(v) (v) The inventory at The inventory at 31 March 31 March 2006 was 2006 was valued at valued at $43.2 million $43.2 million.

Required, prepare for Kala:

(a) (a) An income An income statement statement for the for the year endeyear ended 31 Md 31 March 2006.arch 2006. (10 (10 marks) marks)(b)

(b) A statement A statement of changes iof changes in equity fon equity for the year r the year ended 31 Marcended 31 March 2006.h 2006. (4 (4 marks) marks)(c)

(c) A balance A balance sheet as sheet as at 31 at 31 March 2006.March 2006. (11 (11 marks) marks)

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Reactive’s Reactive’s summarised summarised financial financial statements statements for for the the year year ended ended 31 31 March March 2006 2006 are are set set out out below: below:

180 Profit Profit on on disposal disposal of of plant plant (note (note (i)) (i)) 40

Profit

Non-current Non-current assets Property Property, , plant plant and assets and equipment equipment (note (note (i)) (i)) 550

Current Current assets assets

Current Current liabilities liabilities

Bank

T Total otal equity equity and and liabilities liabilities 1,160

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Closing Closing inventory inventory holding holding period period 46 46 days days

T Trade rade receivables’ receivables’ collection collection period period 45 45 days days

T Trade rade payables’ payables’ payment payment period period 55 55 days days

Notes:

(i) (i) Reactive received $120 million Reactive received $120 million from the sale from the sale of plant th of plant that had a at had a carrying amount of $80 million at carrying amount of $80 million at the date of the date of its its sale.

(ii) (ii) the market price the market price of Reactive’s of Reactive’s shares throughout shares throughout the year averaged the year averaged $3.75 each $3.75 each.

(iii) (iii) there were no issues or there were no issues or redemption of shares or redemption of shares or loans during the year loans during the year

(iv) (iv) dividends paid during the year ended 31 dividends paid during the year ended 31 March 2006 amounted to March 2006 amounted to $90 million, maintaining the same $90 million, maintaining the same dividend dividend paid in the year ended 31 March 2005.

Required:

(a) (a) Calculate ratios Calculate ratios for the year ended for the year ended 31 March 2006 (showing 31 March 2006 (showing your workings) foyour workings) for Reactive, er Reactive, equivalent to tquivalent to thosehose

(b) (b) Analyse the financial peAnalyse the financial performance and position of Rearformance and position of Reactive for the year ended 31 March 2006 comparective for the year ended 31 March 2006 compared tod to

(c) (c) Explain in what ways yExplain in what ways your approach to performance appraiour approach to performance appraisal would differ if yosal would differ if you were asked to assess theu were asked to assess theperformance of

performance of a not-for-profit organisation.a not-for-profit organisation. (5 (5 marks) marks)

4 (a)

4 (a) The qualitative The qualitative characteristics of characteristics of relevance, reliability and relevance, reliability and comparability identified comparability identified in the in the IASB’s IASB’s Framework for the Framework for the

preparation and presentation of financial state preparation and presentation of financial statements ments (Framework) are some of the attributes that make financial (Framework) are some of the attributes that make financial information useful to the various users of financial statements.

(ii) (ii) a decision was made by a decision was made by the Board to change the Board to change the company’s accounting policy from one of the company’s accounting policy from one of expensing the expensing the finance costs on building new retail outlets to one of capitalising such costs.

(iii) (iii) the company’s income statement prepared using h the company’s income statement prepared using historical costs showed istorical costs showed a loss from operating its a loss from operating its hotels, but hotels, but the company is aware that the increase in the value of its properties during the period far outweighed the operating loss.

Required:

Explain Explain how of the of the FramewFramework’s qualitative characteristics your treatment is based.how you you would ork’s qualitative characteristics your treatment is based.would treat treat the the items items in in (i) (i) to to (iii) (iii) above above in in Porto’s Porto’s financial financial statements statements and and indicate indicate on (6 (6 marks)on whichmarks)which

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Estimated total total cost cost at at 31 31 March March 2006 2006 4,000 1,250 Agreed

Agreed value value of of work work completed completed at at 31 31 March March 2006 2006 3,300 840 Progress

Progress billings billings invoiced invoiced and and received received at at 31 31 March March 2006 2006 3,000 880 Contract

Contract costs costs incurred incurred to to 31 31 March March 2006 2006 3,900 720 The agreed value of the work completed at 31 March 2006 is considered to be equal to the revenue The agreed value of the work completed at 31 March 2006 is considered to be equal to the revenue earned in the earned in the year ended 31 March 2006 The percentage of completion is calculated as the agreed

year ended 31 March 2006 The percentage of completion is calculated as the agreed value of work completed to value of work completed to the agreed contract price.

Required:

Calculate Calculate the the amounts amounts which which should should appear appear in tin the inhe income come statement statement and band balance alance sheet sheet of Bof Beetie eetie at at 31 March31 March

2006 in respect of the above contracts. (6 (6 marks) marks)

(10 marks)

End of Question Paper

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Answers

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Pilot

Financial Reporting (International)

1 (a)

1 (a) As the investment in shares represents 80% of Silverton’s equity, it is likely to give Pumice control of that company Control

is the ability to direct the operating and financial policies of an entity This would make Silverton a subsidiary of Pumice andrequire Pumice to prepare group financial statements whic

require Pumice to prepare group financial statements which would require the consolidation of the results of Silverh would require the consolidation of the results of Silverton from theton from thedate of acquisition (1 October 2005) Consolidated financial statements are prepared on the basis that the group is a singleeconomic entity

The investment of 50% ($1 million) of the 10% loan note in Silverton is effectively a loan from a parent to a subsidiary Onconsolidation Pumice’s asset of the loan ($1 million) is cancelled out with $1 million of Silverton’s total loan note liability of

$2 million This would leave a net liability of $1 million in the consolidated balance sheet

The The investment investment in in Amok Amok of of 1.6 1.6 million million shares shares represents represents 40% 40% of of that that company’s company’s equity equity shares shares This This is is generally generally regarded regarded asas

not being sufficient to give Pumice control of Amok, but is likely to give it significant influence over Amok’s policy decisions(eg determining the level of dividends paid by Amok) Such investments are generally classified as associates and IAS 28Investments in associates

Investments in associates requires the investment to be included in the consolidated financial statements using equity requires the investment to be included in the consolidated financial statements using equityaccounting

(b) Consolidated Consolidated balance shebalance sheet of et of Pumice Pumice at 31 at 31 March 2March 2006006

Non-current Non-current assets:assets:

Plant, Plant, property property and and equipment equipment (w (w (i)) (i)) 30,300 Goodwill Goodwill (4,000 (4,000 (w (w (ii)) (ii)) – – 400 400 impairment) impairment) 3,600 Investments Investments – – associate associate (w (w (iii)) (iii)) 11,400 – – other other ((26,000 ((26,000 – – 13,600 13,600 – – 10,000 10,000 – – 1,000 1,000 intra-group intra-group loan loan note)) note)) 1,400

46,700Current

Current assets assets (15,000 (15,000 + + 8,000 8,000 – – 1,000 1,000 (w (w (iv)) (iv)) – – 1,500 1,500 current current account) account) 20,500

Non-current Non-current liabilitiesliabilities

10% 10% Loan Loan note note (2,000 (2,000 – – 1,000 1,000 intra-group) intra-group) 1,000 5,000

Current Current liabilities liabilities (10,000 (10,000 + + 3,500 3,500 – – 1,500 1,500 current current account) account) 12,000

67,200

Workings in $’000 (i) Property(i) Property, , plant plant and and equipmentequipment

The fair value adjustment to The fair value adjustment to plant will create additional depreciation of $400,000 per annum plant will create additional depreciation of $400,000 per annum (1,600/4 years) and in the post(1,600/4 years) and in the postacquisition period of six months this will

acquisition period of six months this will be $200,000.be $200,000

(ii) (ii) Goodwill Goodwill in in Silverton:Silverton:

Less Less – – equity equity shares shares of of Silverton Silverton (3,000 (3,000 x x 80%) 80%) (2,400) – – pre-acquisition pre-acquisition reserves reserves (7,000 (7,000 x x 80% 80% (see (see below)) below)) (5,600)

– – fair fair value value adjustments adjustments (2,000 (2,000 (w (w (i)) (i)) x x 80%) 80%) (1,600) (9,600)

Goodwill

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(iii) (iii) Carrying amount Carrying amount of Amok of Amok at 31 at 31 March 20March 200606

(iv) (iv) The unrealiseThe unrealised profit d profit (URP) in (URP) in inventory is calcinventory is calculated as:ulated as:

Intra-group Intra-group sales sales are are $6 $6 million million of of which which Pumice Pumice made made a a profit profit of of $2 $2 million million Half Half of of these these are are still still in in inventory, inventory, thus thus therethere

is an unrealised profit of

is an unrealised profit of $1 million.$1 million

(v) (v) Consolidated Consolidated reserves:reserves:

Silverton’s Silverton’s post post acquisition acquisition (((2,000 (((2,000 x x 6/12) 6/12) - - 200 200 depreciation) depreciation) x x 80%) 80%) 640 Amok’s Amok’s post post acquisition acquisition profits profits (8,000 (8,000 x x 6/12 6/12 x x 40%) 40%) 1,600

Impairment Impairment of of goodwill goodwill – – Silverton Silverton (400)

37,640

(vi) (vi) Minority Minority interestinterestEquity

Equity shares shares of of Silverton Silverton (3,000 (3,000 x x 20%) 20%) 600 Retained Retained earnings earnings ((8,000 ((8,000 – – 200 200 depreciation) depreciation) x x 20%) 20%) 1,560 Fair Fair value value adjustments adjustments (2,000 (2,000 x x 20%) 20%) 400

2,560

147,200 Investment Investment income income – – property property rental rental 4,500

– – valuation valuation gain gain (90,000 (90,000 x x 7%) 7%) 6,300 10,800

Finance

Profit

Income Income tax tax expense expense (28,300 (28,300 + + (14,100 (14,100 – – 12,500)) 12,500)) (29,900)

Profit

(b) Kala – Statement of changes in equity – Year ended 31 March 2006Kala – Statement of changes in equity – Year ended 31 March 2006

Profit Profit for for period period (see (see (a)) (a)) 118,100 118,100

Revaluation

Revaluation of of property property (w (w (iv)) (iv)) 45,000 45,000

At

At 31 31 March March 2006 2006 150,000 45,000 222,600 417,600

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(c) Kala – Balance sheet as at 31 March 2006

Non-current

PropertyProperty, , plant plant and and equipment equipment (w (w (iv)) (iv)) 434,100 Investment Investment property property (90,000 (90,000 + + 6,300) 6,300) 96,300

530,400 Current Current assetsassets

Current liabilities

Accrued Accrued loan loan interest interest (w (w (ii)) (ii)) 1,000

Lease Lease obligation obligation (w (w (iii)) (iii)) – – accrued accrued interest interest 7,000

Depreciation Depreciation (w (w (iv)) (iv)) – – buildings buildings 5,000

115,700

(ii) (ii) The loan has beeThe loan has been in issue for nine mn in issue for nine months The total fionths The total finance cost for this nance cost for this period will be $period will be $3 million (50,000 3 million (50,000 x 8% x 9/12).x 8% x 9/12).Kala has paid six months interest of

Kala has paid six months interest of $2 million, thus accrued interest of $1 $2 million, thus accrued interest of $1 million should be provided for.million should be provided for

Net Net obligation obligation at at inception inception of of lease lease (92,000 (92,000 – – 22,000) 22,000) 70,000 Accrued Accrued interest interest 10% 10% (current (current liability) liability) 7,000

TTotal otal outstanding outstanding at at 31 31 March March 2006 2006 77,000

The The second psecond payment iayment in the n the year to year to 31 Marc31 March 200h 2007 (m7 (made on ade on 1 April 1 April 2006) 2006) of $22 of $22 million wmillion will be ill be $7 m$7 million for illion for thetheaccrued interest (at 31 March 2006) and $15 million paid of the capital outstanding Thus the amount outstanding as

an obligation over one year is $55 million (77,000 – 22,000)

(iv) (iv) Non-current Non-current assets/depreciassets/depreciation:ation:

Land Land and and buildings:buildings:

At the date of the revaluation the land and buildings have a carrying

At the date of the revaluation the land and buildings have a carrying amount of $210 million (270,000 – 60,000) Withamount of $210 million (270,000 – 60,000) With

a valuation of $255 million this gives a revaluation surplus (to

a valuation of $255 million this gives a revaluation surplus (to reserves) of $45 million The accumulated depreciation ofreserves) of $45 million The accumulated depreciation of

$60 million represents 15 years at $4 million per annum (200,000/50 years) and means the remaining life at the date

of the revaluation is 35 years The amount of

of the revaluation is 35 years The amount of the revalued building is $175 million, thus depreciation for the year to 31the revalued building is $175 million, thus depreciation for the year to 31March 2006 will be $5 million (175,000/35 years) The carry

March 2006 will be $5 million (175,000/35 years) The carrying amount of the land ing amount of the land and buildings at 31 March and buildings at 31 March 20062006

is $250 million (255,000 – 5,000)

Plant: Plant: ownedowned

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The The fair value fair value of the of the leased leased plant is plant is $92 m$92 million illion Depreciation Depreciation on a on a straight-line straight-line basis ovebasis over five r five years wyears would give ould give aadepreciation charge of $18.4 million and a carrying amount of $73.6 million

Summarising Summarising the the carrying carrying amounts:amounts:

Land Land and and buildings buildings 250,000 Plant Plant (110,500 (110,500 + + 73,600) 73,600) 184,100

PropertyProperty, , plant plant and and equipment equipment 434,100

3 (a)

3 (a) Note: figures in the calculations are in $million

Return Return on on year year end end capital capital employed employed 32.3 32.3 % % 220/(1,160 220/(1,160 – – 480) 480) x x 100100

Net Net asset asset turnover turnover 5.9 5.9 times times 4,000/680 Gross Gross profit profit margin margin 13.8 13.8 % % (550/4,000) (550/4,000) x x 100100

Net Net profit profit (before (before tax) tax) margin margin 5.0 5.0 % % (200/4,000) (200/4,000) x x 100100

Closing Closing inventory inventory holding holding period period 26 26 days days 250/3,450 250/3,450 x x 365365

TTrade rade receivables’ receivables’ collection collection period period 44 44 days days 360/(4,000 360/(4,000 – – 1,000) 1,000) x x 365365

TTrade rade payables’ payables’ payment payment period period (based (based on on cost cost of of sales) sales) 45 45 days days (430/3,450) (430/3,450) x x 365365

Dividend Dividend yield yield 6.0% (see (see below)below)

Dividend Dividend cover cover 1.67 1.67 times times 150/90

The The dividend dividend per per share share is is 22.5 22.5 cents cents (90,000/(100,00(90,000/(100,000 0 x x 4 4 ie ie 25 25 cents cents shares) shares) This This is is a a yield yield of of 6.0% 6.0% on on a a share share price price ofof

The The measures measures taken taken by by management management appear appear to to have have been been successful successful as as the the overall overall ROCE ROCE (considered (considered as as a a primary primary measuremeasure

of performance) has improved by

of performance) has improved by 15% (32.3 -28.1)/28.1) Looking in more detail at the composition of 15% (32.3 -28.1)/28.1) Looking in more detail at the composition of the ROCE, the reasonthe ROCE, the reasonfor the improved profitability is due

for the improved profitability is due to increased efficiency in the use of to increased efficiency in the use of the company’s assets (asset turnover), increasing fromthe company’s assets (asset turnover), increasing from

4 to 5.9 times (an improvement of 48%) The improvement in the asset turnover has been offset by lower profit margins atboth the gross and net level On the surface, this performance appears to be due both to the company’s strategy of offeringrebates to wholesale customers if they achieve a set level of orders and also the beneficial impact on sales revenue of theadvertising campaign The rebate would explain the lower

advertising campaign The rebate would explain the lower gross profit margin, and the cost of gross profit margin, and the cost of the advertising has reduced thethe advertising has reduced thenet profit margin (presumably management expected an increase in sales volume as a compensating factor) The decision tobuy complete products rather than assemble them in house has enabled the disposal of some plant which has reduced theasset base Thus possible increased sales and a lower asset base are the cause of

asset base Thus possible increased sales and a lower asset base are the cause of the improvement in the asset turnover whichthe improvement in the asset turnover which

in turn, as stated above, is responsible for the improvement in the ROCE

The The effect effect of of the the disposal disposal needs needs careful careful consideration consideration The The profit profit (before (before tax) tax) includes includes a a profit profit of of $40 $40 million million from from the the disposal.disposal

As this is a ‘one-off’ profit, recalculating the ROCE without its inclusion gives a figure of only 23.7% (180m/(1,160 - 480m+ 80m (the 80m is the carrying amount of plant)) and the fall in the net profit percentage (before tax) would be down evenmore to only 4.0% (160m/

more to only 4.0% (160m/4,000m) 4,000m) On this basis the current yeOn this basis the current year performance is worse than that of the par performance is worse than that of the previous year andrevious year andthe reported figures tend to flatter the company’s underlying performance

The The company’s company’s liquidity liquidity position position has has deteriorated deteriorated during during the the period period An An acceptable acceptable current current ratio ratio of of 1.6 1.6 has has fallen fallen to to a a worryingworrying

1.3 (1.5 is usually considered as a safe minimum) With the trade receivables period at virtually a 1.3 (1.5 is usually considered as a safe minimum) With the trade receivables period at virtually a constant (45/44 days), theconstant (45/44 days), thechange in liquidity appears to be due to the levels of inventory and trade payables These give a contradictory picture Theclosing inventory holding period has decreased markedly (from 46

closing inventory holding period has decreased markedly (from 46 to 26 days) indicating more efficient inventory holding Thisto 26 days) indicating more efficient inventory holding This

is perhaps due to short lead times when ordering bought in products The change in this ratio has reduced the current ratio,however the trade payables payment period

however the trade payables payment period has decreased from 55 to has decreased from 55 to 45 days which has increased the current 45 days which has increased the current ratio This mayratio This may

be due to different terms offered by suppliers of bought in products

Importantly, Importantly, the the effect effect of of the the plant plant disposal disposal has has generated generated a a cash cash inflow inflow of of $120 $120 million, million, and and without without this this the the company’scompany’s

liquidity would look far worse

Investment Investment ratiosratios

The The current current year’s year’s dividend dividend yield yield of of 6.0% 6.0% looks looks impressive impressive when when compared compared with with that that of of the the previous previous year’s year’s yield yield of of 3.75%,3.75%,

but as the company has maintained the same dividend (and dividend per share as there is no change in share capital) , the

‘improvement’ in the yield is due to a falling share price Last year the share price must have been $6.00 to give a yield of3.75% on a dividend per share of 22.5 cents It is worth noting that maintaining the dividend at $90 million from profits of

$150 million gives a cover of only 1.67 times whereas on the same dividend last year the cover was 2 times (meaning lastyear’s profit (af

year’s profit (after tax) was $180 million).ter tax) was $180 million)

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Although Although superficially superficially the the company’s company’s profitability profitability seems seems to to have have improved improved as as a a result result of of the the directors’ directors’ actions actions at at the the start start of of thethe

current year, much, if not all, of current year, much, if not all, of the apparent improvement is due to the change in the apparent improvement is due to the change in supply policy and the consequent beneficialsupply policy and the consequent beneficialeffects of the disposal of plant The company’s liquidity is now below acceptable levels and would have been even worse hadthe disposal not occurred It appears that investors have understood the underlying deterioration in performance as there hasbeen a marked fall in the company’s share price

(c) It is generally assumed thIt is generally assumed that the objective of sat the objective of stock market listed comtock market listed companies is to maxipanies is to maximise the wealth mise the wealth of their shareholders.of their shareholders

This in turn places an emphasis on profitability and other factors that influence a company’s share price It is true that somecompanies have other (secondary) aims such as only engaging in ethical activities (eg not producing armaments) or havestrong environmental considerations

strong environmental considerations Clearly by definition not-for-profit organisatioClearly by definition not-for-profit organisations are not motivated by the need to producens are not motivated by the need to produceprofits for shareholders, but that does not mean that they should be inefficient Many areas of assessment of profit orientedcompanies are perfectly valid for

companies are perfectly valid for not-for-profit organisations; efficient inventory holdings, tight budgetary constraints, use of not-for-profit organisations; efficient inventory holdings, tight budgetary constraints, use of keykeyperformance indicators, prevention of fraud etc

There There are are a a great great variety variety of of not-for-profit not-for-profit organisations; organisations; eg eg public public sector sector health, health, education, education, policing policing and and charities charities It It is is difficultdifficult

to be specific about how to

to be specific about how to assess the performance of a assess the performance of a not-for-profit organisation without knowing what type of organisation itnot-for-profit organisation without knowing what type of organisation it

is In general terms

is In general terms an assessment of performance must be an assessment of performance must be made in the light of made in the light of the stated objectives of the organisation Thusthe stated objectives of the organisation Thusfor example in a public health service one could

for example in a public health service one could look at measures such as treatment waiting times, increasing life expectancylook at measures such as treatment waiting times, increasing life expectancyetc, and although such organisations don’t have a profit motive requiring efficient operation, they should nonetheless beaccountable for the resources they use Techniques such as ‘value for money’ and the three Es (economy, efficiency andeffectiveness) have been developed and can help

effectiveness) have been developed and can help to assess the performance of to assess the performance of such organisations.such organisations

4 (a)

4 (a) RelevanceRelevance

Information Information has has the the quality quality of of relevance relevance when when it it can can influence, influence, on on a a timely timely basis, basis, users’ users’ economic economic decisions decisions It It helps helps to to evaluateevaluate

past, present and future events by past, present and future events by confirming or perhaps correcting past evaluations of economic events There are many waysconfirming or perhaps correcting past evaluations of economic events There are many ways

of interpreting and applying the concept of relevance, for example, only material information is considered relevant as, bydefinition, information is material only if its omission or

definition, information is material only if its omission or misstatement could influence users Another common debate regardingmisstatement could influence users Another common debate regardingrelevance is whether current value information is more relevant than that based on historical cost An interesting emphasisplaced on relevance within

placed on relevance within the Framework is that relevant information assists in the Framework is that relevant information assists in the predictive ability of financial the predictive ability of financial statements.statements.That is not to say

That is not to say the financial statements should be predictive in the sense of forecasts, but the financial statements should be predictive in the sense of forecasts, but that (past) information should bethat (past) information should bepresented in a manner that assists users to assess an entity’s ability to take advantage of opportunities and react to adversesituations A good example of

situations A good example of this is the separate presentation of discontinued operations in this is the separate presentation of discontinued operations in the income statement From thisthe income statement From thisusers will be better able to assess the parts of the entity that will produce future profits (continuing operations) and userscan judge the merits of the discontinuation ie has the entity sold a profitable part of the business (which would lead users toquestion why), or has the entity acted to curtail the adverse affect of a

question why), or has the entity acted to curtail the adverse affect of a loss making operation.loss making operation

Reliability

The The Framework Framework states states that that for for information information to to be be useful useful it it must must be be reliable reliable The The quality quality of of reliability reliability is is described described as as being being freefree

from material error (accurate) and a faithful representation of that which it purports to porfrom material error (accurate) and a faithful representation of that which it purports to portray (i.e the financial statements are atray (i.e the financial statements are afaithful representation of the entity’s underlying transactions) There can be occasions where the legal form of a transaction can

be engineered to disguise the economic reality of the transaction A cornerstone of faithful representation is that transactionsmust be accounted for according to

must be accounted for according to their substance (i.e commercial intent or economic reality) rather than their legal or their substance (i.e commercial intent or economic reality) rather than their legal or contrivedcontrivedform To be reliable, information must be neutral (free from bias) Biased information attempts to influence users (perhaps tocome to a predetermined decision) by the manner in which it is presented It is recognised that financial statements cannot

be absolutely accurate due to inevitable uncertainties surrounding their preparation A typical example would be estimatingthe useful economic lives of non-current assets This is addressed by the use of prudence which is the exercise of a degree

of caution in matters of uncertainty However prudence cannot be used to deliberately understate profit or create excessiveprovisions (this would break the neutrality principle) Reliable information must also be complete, omitted information (thatshould be reported) will obviously mislead users

Comparability

Comparability Comparability is is fundamental fundamental to to assessing assessing an an entity’s entity’s performance performance Users Users will will compare compare an an entity’s entity’s results results over over time time and and alsoalso

with other similar entities This is the principal reason why financial statements contain corresponding amounts for previousperiod(s) Comparability is enhanced by the use (and disclosure) of consistent accounting policies such that users can confirmthat comparative information (for calculating trends) is comparable and the disclosure of accounting policies at least informsusers if different entities use different policies That said, comparability should not stand in the way of improved accountingpractices (usually through new Standards); it is recognised that there are occasions where it is necessary to adopt newaccounting policies if they would enhance relevance

accounting policies if they would enhance relevance and reliabilityand reliability

(b) (i) (i) This This item item involves involves the the characteristic characteristic of of reliability reliability and sand specifically pecifically reporting the reporting the substance substance of of transactions transactions As As the the leaselease

agreement is for substantially the whole of the asset’s useful economic life, Porto will experience the same risks andrewards as if it owned the asset Although

rewards as if it owned the asset Although the legal form of this transaction is a the legal form of this transaction is a rental, its substance is the equivalent torental, its substance is the equivalent toacquiring the asset and raising a loan Thus, in order

acquiring the asset and raising a loan Thus, in order for the financial statements to be reliable (and comparable to thosefor the financial statements to be reliable (and comparable to thosewhere an asset is bought from the proceeds of a loan), the transaction should be shown as an asset on Porto’s balancesheet with a corresponding liability for the future lease rental payments The income statement should be charged withdepreciation on the asset and a finance charge on the ‘loan’

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and income statements will no longer show a finance cost (in relation to these assets whilst under construction) Anyfinance costs relating to periods prior to the policy change (i.e for two or more years ago) should be adjusted for byincreasing retained earnings brought forward

increasing retained earnings brought forward in the statement of changes in in the statement of changes in equityequity

(iii) (iii) This This item item involves involves the the characteristic characteristic of of relevance relevance This This situation situation questions questions whether whether historical historical cost cost accounting accounting is is more more relevantrelevant

to users than current value

to users than current value information Porto’s current method of reporting these events using purely information Porto’s current method of reporting these events using purely historical cost basedhistorical cost basedinformation (i.e showing an operating loss, but not reporting the increases in property values) is perfectly acceptable.However, the company could choose to revalue its hotel properties (which would subject it to other requirements) Thisoption would still report an operating loss (probably an even larger loss than under historical cost if there are increaseddepreciation charges on the hotels), but the increases in value would also be reported (in equity) arguably giving a morecomplete picture of performance

5 (a)

5 (a) The correct tiThe correct timing of when ming of when revenue (and profit) revenue (and profit) should be recognisshould be recognised is an imed is an important aspect of an incportant aspect of an income statement ome statement showingshowing

a faithful presentation It is generally

a faithful presentation It is generally accepted that only realised profits should be accepted that only realised profits should be included in the income statement For mostincluded in the income statement For mosttypes of supply and sale of goods it

types of supply and sale of goods it is generally understood that a profit is realised when the goods have been manufactured (oris generally understood that a profit is realised when the goods have been manufactured (orobtained) by the

obtained) by the supplier and satisfactorily delivered to supplier and satisfactorily delivered to the customerthe customer The issue The issue with construction contracts is that the with construction contracts is that the processprocess

of completing the project takes a relatively long time and,

of completing the project takes a relatively long time and, in particular, will spread across at least one accounting period-end.in particular, will spread across at least one accounting period-end

If such contracts are treated like most sales of goods, it would mean that revenue and profit would not be recognised untilthe contract is completed (the “completed contracts” basis) This is often described as following the prudence concept Theproblem with this approach is that it may not show a faithful presentation as all the profit on a contract is included in the period

of completion, whereas in reality (a faithful representation), it is being earned, but not reported, throughout the duration of thecontract IAS 11 remedies this by

contract IAS 11 remedies this by recognising profit on uncompleted contracts in proporrecognising profit on uncompleted contracts in proportion to some measure of tion to some measure of the percentagethe percentage

of completion applied to the estimated total contract profit This is sometimes said to reflect the accruals concept, but it shouldonly be applied where the outcome of the contract is reasonably foreseeable In the event that a loss on

only be applied where the outcome of the contract is reasonably foreseeable In the event that a loss on a contract is foreseen,a contract is foreseen,the whole of the loss

the whole of the loss must be recognised immediatelymust be recognised immediately, thereby ensuring the continuing , thereby ensuring the continuing application of prudence.application of prudence

(b) BeetieBeetie

Income Income statement statement Contract Contract 1 1 Contract Contract 2 2 TTotalotal

Contract Contract expenses expenses recognised recognised (balancing (balancing figure figure contract contract 1) 1) (2,400) (720) (3,120)

Expected Expected loss loss recognised recognised (contract (contract 2) 2) (170) (170)

Attributable Attributable profit/(loss) profit/(loss) (see (see working) working) 900 (50) 850

Balance sheet Contact Contact costs costs incurred incurred 3,900 720 4,620

Recognised Recognised profit/(losses) profit/(losses) 900 (50) 850

Workings (in $’000)

Estimated Estimated total total profit:profit:

Agreed Agreed contract contract price price 5,500 1,200

Estimated Estimated contract contract cost cost (4,000) (1,250)

Estimated Estimated total total profit/(loss) profit/(loss) 1,500 (50)

PercePercentage ntage complete:complete:

Agreed Agreed value value of of work work completed completed at at 31 31 March March 2006 2006 3,300

PercePercentage ntage complete complete at at 31 31 March March 2006 2006 (3,300/5,500 (3,300/5,500 x x 100) 100) 60%

Profit Profit to to 31 31 March March 2006 2006 (60% (60% x x 1,500) 1,500) 900

At 31 March 2006 the increase in the expected total costs of contract 2 mean that a loss of $50,000 is expected onthis contract In these circumstances, regardless of the percentage completed, the whole of this loss should be recognisedimmediately

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for written answers where there may be more than one acceptable solution.more than one acceptable solution.

1 (a)

(b) Balance Balance sheet:sheet:

TTotal otal for for question question 25

2 (a)

2 (a) Income statement

cost

investment

(b) Movement Movement in in share share capital capital and and reservesreserves

(c) Balance Balance sheetsheet

land

deferred

lease lease obligation: obligation: interest interest and and capital capital one one year year 1

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5 (a) one one mark mark per per valid valid point point toto maximum maximum 44

(b) revenue revenue (½ (½ mark mark for for each each contract) contract) 1 profit/loss profit/loss (½ (½ mark mark for for each each contract) contract) 1 amounts amounts due due from from customers customers (contract (contract 1) 1) 2 amounts amounts due due to to customers customers (contract (contract 2) 2) 2

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Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST be

answered

p e r

5

(

I N

T )

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been advised to enter into business combinations with compatible partner companies As a first step in this strategy Hydrate acquired all of the ordinary share capital of Sulphate by way of a share exchange on 1 April 2002 Hydrate issued five of its own shares for every four shares in Sulphate The market value of Hydrate’s shares on 1 April 2002 was $6 each The share issue has not yet been recorded in Hydrate’s books The summarised financial statements

of both companies for the year to 30 September 2002 are:

Income statement – year to 30 September 2002:

Equity and liabilities

The following information is relevant:

– The fair valu e of Sulphate ’s investment was $ 5 million in excess of its boo k value at the date of acquisition The fair values of Sulphate’s other net assets were equal to their book values.

– Consolidated goodwill is deemed to have a five-year life, wi th time apportio ned charge s (treated as an opera ting expense) in the year of acquisition.

– No dividends have been paid or prop osed by e ither company

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p p

Required:

(a) (i) Prepare the consolidated income statment and balance sheet of Hydrate for the year to

30 September 2002 using the purchase method of accounting (acquisition accounting); and

(13 marks)(ii) Prepare a consolidated income statement and the consolidated SHAREHOLDERS FUNDS section of thebalance sheet of Hydrate for the year to 30 September 2002 using the uniting of interests method of

(b) Describe the distinguishing feature of a uniting of interests, and discuss whether the business combination

in (a) should be accounted for as a uniting of interests (5 marks)

(25 marks)

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2 The following figures have been extracted from the accounting records of Bloomsbury on 30 September 2002 :

25-y ar leasehold factory at cost (note (i ) 50,000 15-y ar leasehold factory at cost (note (i ) 30,000 Plant a d equipment at cost (note (i i) 49,800 Depre iat on 1 Octo er 2001 – 25 y ar leasehold 10,000

10% Rede mable (in 2005 at par) preference shares of $1 each 10,000

Inv stment pro erty re aluat on reserve – 1 Octo er 2001 2,000

The following notes are relevant:

(i) On 1 January 2002, Bloomsbury agreed to act as a selling agent for an overseas company, Brandberg The terms

of the agency are that Bloomsbury receives a commission of 10% on all sales made on behalf of Brandbe rg This

is achieved by Bloomsbury remitting 90% of the cash received from Brandberg’s customers one month after Bloomsbury has collected it Bloomsbury has included in its sales revenue $7·2 million of sales on behalf of Brandberg of which there is one month’s outstanding balances of $1·2 million included in Bloomsbury’s accounts receivable The cash remitted to Brandberg during the year of $5·4 million (i.e 90% of $6 million) in accordance with the terms of the agency, has been treated as the cost of the agency sales.

(ii) The joint venture account represents the net balance of Bloomsbury’s transactions in a joint venture with Waterfront which commenced on 1 October 2001 Each venturer contributes their own assets and pays their own expenses The revenues for the venture are shared equally The joint venture is not a separate entity.

Share of joint v nture sales re enues (50% of total sales re enues) (800)

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(iii) On 1 October 2001 Bloomsbury had its two leasehold factories revalued (for the first time) by an independent surveyor as follows:

25 y ar leasehold $52 mil ion

15 y ar leasehold $18 mil ion Bloomsbury depreciates its leaseholds on a straight-line basis over the life of the lease.

The directors of Bloomsbury are disappointed in the value placed on the 15-year leasehold The surveyor has said that the fall in its value is due mainly to its unfavourable location, but in time the surveyor expects its value

to increase The directors are committed to incorporating the revalued amount of the 25-year leasehold into the financial statements, but wish to retain the historic cost basis for the 15-year leasehold Revaluation surpluses are transferred to accumulated realised profits in line with the realisation of the related assets.

Prior to the current year , Bloomsbury had adopted a policy of carrying its investment property at fair value, with the surplus being credited to reserves For the current year it will be applying the fair value method of accounting for investment properties in IAS 40 ‘Investment Property’ The value of the investment property had increased by

a further $500,000 in the year to 30 September 2002.

Plant and equipment is depreciated at 20% per annum on the reducing balance basis.

(iv) A provision for income tax for the year to 30 September 2002 of $5 million is required Temporary differences (related to the difference between the tax base of the plant and its balance sheet written down value) on

1 October 2001 were $7 million and on 30 September 2002 they had declined to $5 million Assume a tax rate

of 30% Ignore deferred tax on the property revaluations.

(v) The interim dividends paid include half of the full year’s preference dividend On 25 September 2002 the directors declared a final ordinary dividend of 3 cents per share.

Required:

Prepare the financial statements for the year to 30 September 2002 for Bloomsbury in accordance withInternational Accounting Standards as far as the information permits They should include:

Notes to the financial statements are not required

(25 marks)

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of the Framework for Preparation and Presentation of Financial Statements’ (Framework) and several International Accounting Standards The development of this principle was partly in reaction to a minority of public interest companies entering into certain complex transactions These transactions sometimes led to accusations that company directors were involved in ‘creative accounting’.

Required:

(a) (i) Explain, with relevant examples, what is generally meant by the term ‘creative accounting’; (5 marks)(ii) Explain why it is important to record the substance rather than the legal form of transactions anddescribe the features that may indicate that the substance of a transaction is different from its legal

(b) (i) Atkins’s operations involve selling cars to the public through a chain of retail car showrooms It buys most

of its new vehicles directly from the manufacturer on the following terms:

– Atkins will pay the man ufacturer for the cars on the date they are so ld to a c ustomer or six mon ths afte r they are delivered to its showrooms whichever is the sooner.

– The price pai d will be 80 % of the reta il list price a s set b y the manufactur er at the date that th e goods are delivered.

– Atkins will pay the m anufacturer 1·5% pe r month (of the cost price to Atkins ) as a ‘display charge ’ until the goods are paid for.

– Atkins may r etur n the cars to the man ufact urer any ti me up u ntil the date the cars are due to be paid for Atkins will incur the freight cost of any such returns Atkins has never taken advantage of this right

of return.

– The manufacture r can recall the cars or reque st them t o be transfer red to anothe r retailer any time up until the time they are paid for by Atkins.

Required:

Discuss which party bears the risks and rewards in the above arrangement and come to a conclusion on how

(ii) Atkins bought five identical plots of development land for $2 million in 1999 On 1 October 2001 Atkins sold three of the plots of land to an investment company, Landbank, for a total of $2·4 million This price was based on 75% of the fair market value of $3·2 million as determined by an independent surveyor at the date of sale The terms of the sale contained two clauses:

– Atkins can re-pur chase the pl ots of land for the full fair value o f $3·2 million (the value det ermin ed at the date of sale) any time until 30 September 2004; and

– On 1 October 2004, Landb ank has the option to requ ire Atkins to re-purcha se the properties f or $3·2 million You may assume that Landbank seeks a return on its investments of 10% per annum.

Required:

Prepare extracts of the income statement and balance sheet (ignore cash) of Atkins for the year to

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This is a blank page

Question 4 begins on page 8

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for the year to 30 September 2001 are shown below:

Income Statement – year to 30 September 2002:

––––––

Dividends: ordinary – Interim (120)

Equity and liabilities

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Notes to the financial statements:

(1) Cost of sales include s depreciation of property , plant and equipment of $320 million and a loss on the sale of plant of $50 million It also includes a credit for the amortisation of government grants Operating expenses include a charge of $20 million for the amortisation of goodwill.

(2) Intan gible non-current assets:

The following additional information is relevant:

(i) Intangible fixed a ssets:

The company successfully completed the development of a new product during the current year, capitalising a further $500 million before amortisation charges for the period.

(ii) Pro perty , plant and equipment /revaluation reserve:

– The compan y revalued its bui ldings by $200 million on 1 October 200 1 The surp lus was cred ited t o a revaluation reserve.

– New plant was acquired d uring the year at a cost of $250 milli on and a governmen t gran t of $50 million was received for this plant.

– On 1 October 2001 a bonus issue of 1 new share for eve ry 10 held was made fro m the revalua tion reserve – $10 million has been tra nsferred f rom the revaluation res erve to re alised profits as a year-e nd adj ustment

in respect of the additional depreciation created by the revaluation.

– The remaining moveme nt on property , plant and equipment was due to the dispos al of obsolete plant (iii) Share issues:

In addition to the bonus issue referred to above Nedberg made a further issue of ordinary shares for cash.Required:

(a) A cash flow statement for Nedberg for the year to 30 September 2002 prepared in accordance with

(b) Comment briefly on the financial position of Nedberg as portrayed by the information in your cash flow

(25 marks)

O CCCC SOSO C SC S SS //

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financial statements of a small family owned company in discussion with its managing director Mrs Harper After the meeting Mrs Harper has asked for your help She has obtained the published financial statements of several quoted companies in which she is considering buying some shares as a personal investment She presents you with the following information:

(a) In the year to 30 September 2002, two companies, Gamma and Toga, reported identical profits before tax of

$100 million Information in the Chairmen’s reports said both companies also expected profits from their core activities (to be interpreted as from continuing operations) to grow by 10% in the following year Mrs Harper has extracted information from the income statements and made the following summary:

A note to the financial statements of Toga said that both the discontinuation and acquisition occurred on

1 April 2002 and were part of an overall plan to focus on its traditional core activities after incurring large losses

on a new foreign venture.

Required:

(i) Briefly explain to Mrs Harper why information on discontinued operations is useful; (3 marks)(ii) Calculate the expected operating profit for both companies for the year to 30 September 2003(assuming the Chairmen’s growth forecasts are correct):

– in the absence of information of the discontinued operations; and

(b) Taylor is another company about which Mrs Harper has obtained the following information from its published financial statements:

Earnings per share:

The earnings per share is based on attributable earnings of $50 million ($30 million in 2001) and 200 million ordinary shares in issue throughout the year (150 million weighted average number of ordinary shares in 2001).

The loan stock is convertible to ordinary shares in 2004 on the basis of 70 new shares for each $100 of loan stock.

Note to the financial statements:

There are directors’ share options (in issue since 1999) that allow Taylor’s directors to subscribe for a total of

50 million new ordinary shares at a price of $1·50 each.

(Assume the current rate of income tax for Tay lor is 25% and the market price of its ordinary shares throughout the year has been $2·50)

Mrs Harper has read that the trend of the earnings per share is a reliable measure of a company’s profit trend She cannot understand why the increase in profits is 67% ($30 million to $50 million), but the increase in the earnings per share is only 25% (20 cents to 25 cents) She is also confused by the company also quoting a diluted earnings per share figure, which is lower than the basic earnings per share.

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11

Required:

(i) Explain why the trend of earnings per share may be different from the trend of the reported profit, and

(ii) Calculate the diluted earnings per share for Taylor based on the effect of the convertible loan stock andthe directors’ share options for the year to 30 September 2002 (ignore comparatives); and (5 marks)(iii) Explain the relevance of the diluted earnings per share measure (4 marks)(c) Mrs Harper has noticed that the tax charge for a company called Stepper is $5 million on profits before tax of

$35 million This is an effective rate of tax of 14·3% Another company Jenni has an income tax charge of $10 million on profit before tax of $30 million This is an effective rate of tax of 33·3% yet both companies state the rate of income tax applicable to them is 25% Mrs Harper has also noticed that in the cash flow statements each company has paid the same amount of tax of $8 million.

Required:

Advise Mrs Harper of the possible reasons why the income tax charge in the financial statements as a percentage

of the profit before tax may not be the same as the applicable income tax rate, and why the tax paid in the cashflow statement may not be the same as the tax charge in the income statement (6 marks)

(25 marks)

End of Question Paper

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Answers

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Fina cial Re oring (ntern tio al Ste m) December 2002 Answers

1 (a) (i) Using the purchase (acquisition) method of accounting

Hydrate – Consolidated Income Statement – year to 30 September 2002

Equity and liabilities:

Ordin ry shares of $1 each (20,000 + 15,000 (w (i)) 35,000Reserves:

Sh re premium (4,000 + 75,000 (w (i)) 79,000

170,300Non-current liabilities

(ii) Using the uniting of interest (merger) method of accounting.Hydrate – Consolidated Income Statement – year to 30 September 2002

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16

(b) The distinguishing features of a uniting of interests are:

– It is not possible to identify an acquirer Instead of a dominant party, the shareholders of the joining entities unite in asubstantially equal arrangement to share control over the combined entity

– All parties to the combination participate in the management of the combined business

– The sizes of the combining entities should be broadly similar leading to a substantially equal exchange of voting commonshares This should ensure that no one party is in a position to dominate the combined business due to its previousrelative size

– There must not be a significant reduction in the rights attaching to the shares of one of the combining parties, as thiswould weaken the position of that party

The above is generally evidenced by:

– The substantial majority of (if not all) of the voting shares of the combining parties are exchanged or pooled

– The fair value of one entity is not significantly different from that of the other parties

– The shareholders of each party maintain substantially the same voting rights and interests, relative to each other, in thecombined entity

– No party’s share of the equity of the combining entities should depend on the performance of their previous business

In effect, all parties must share fairly (i.e in proportion to their previous holdings) in the future prosperity (or otherwise)

of the whole of the combined business

It is not possible to be absolutely certain from the limited information given in the question whether all of the above criteriafor a uniting of interest have been satisfied, but it does appear likely The following observations can be made:

– Although Hydrate is acting on a strategy of acquisition to achieve economies of scale, the use of the phrase ‘compatiblepartner companies’ may be indicative of a uniting of interests rather than an acquisition approach

– The sizes of the companies are broadly similar (20,000 : 15,000 shares) There is no guidance in IAS 22 ‘BusinessCombinations’ of how the term ‘substantially equal’ should be interpreted

– The consideration is all in the form of equity and satisfies the share exchange criterion

– The composition of the new management and whether all shares rank equally would need to be determined from thedetails and terms of the combination agreement

WorkingsAcquisition accounting:

Sulphate’s post acquisition reserves (6 / 12xx 4,200) 2,100

–––––––

56,300–––––––

(ii) Goodwill/Cost of control in Sulphate:

Hydrate issued 5 shares for every 4 in Sulphate Therefore Hydrate issued 15 million (12 million/4 x 5) shares at avalue of $6 each to the shareholders of Sulphate This would be recorded in Hydrate’s books as ordinary share capital

of $15 million and share premium of $75 million

Less – pre-acq isition reserv s (42,700 – 2,100 see (i) 40,600

A feature of a uniting of interests is that most, if not all, of the subsidiary’s reserves will be included as group reserves

Adjustment re sh re ca ital (15,000 is ued – 12,000 acq ired) (3,000)

–––––––

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Sales re enue (98,880 – 7,200 (w (i)) + 800 (w (i)) 92,480

–––––––

Other operating income:

Inv stment income – surplus on inv stment pro er y (i ) 500

Bloomsbury – Statement of Changes in Equity – Year to 30 September 2002

Share ca ital Re alu tio Inv stment Ac umulated T tal

reserv pro re aln profits

Bloomsbury – Balance Sheet as at 30 September 2002

Inv stments – inv stment pro er y (10,000 + 500 re alu tio ) 10,500

––––––––

101,300Current Assets

Equity and liabilities:

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18

Workings

––––––

–––––––

61,700–––––––

The company’s treatment of the transactions in relation to the agreement with Brandberg is incorrect Bloomsbury has treatedthe sales and expenses as if they were its own sales rather than acting as an agent and receiving commission The entriesrequired to correct the error are:

(iii) Tangible non-current assets – leaseholdsWhere a company chooses to revalue a non-current asset, it must revalue all the assets of the same class Thus, in this case,Bloomsbury must recognise the fall in the value of the 15-year leasehold factory

25-year leasehold – revaluation surplus is $12 million (52m – (50m – 10m))15-year leasehold – revaluation deficit is $2 million (18m – (30m – 10m)The revaluation loss must be charged to income; it cannot be offset against the surplus on the 25-year leasehold A transferfrom the revaluation reserve to retained profits must be made This will represent the partial realisation of the surplus on the25-year leasehold It is realised at $600,000 per annum ($12 million/20 years) in line with the remaining life of theleasehold

The balance sheet values of the properties will be:

Plant and equipment:

The plant used as part of the joint venture is included with other plant: $000Pla t at cost (49,800 + 1,500 joint v nture) 51,300

–––––––

Depre iation for y ar (ch rg d to cost of sales) (20% x 31,500) (6,300)

–––––––

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(iv) As the temporary differences have fallen by $2 million this will cause a reversal of deferred tax of $2 million x 30% =

$600,000 This will reduce the tax charge for the year and the deferred tax balance will be $2,100,000 – $600,000 =

$1,500,000

(v) The interim dividends are half of the preference dividend of $500,000 (10% x $10 million x6 / 12) and the balance must be

an interim ordinary dividend of $1 million The final proposed dividend is another $500,000 preference and $4·8 millionordinary (40 million x 4 x 3 cents) Under IAS 32 ‘Financial Instruments: Disclosure and Presentation’ redeemable preferenceshares have the characteristics of debt and must be treated as such The preference dividends will be treated as interest costsand the shares will appear under non-current liabilities, not equity

(vi) Current liabilities

(vii) Non-current liabilities

10% Rede ma le preference shares (w (v) 10,000

–––––––

41,500–––––––

3 (a) (i) Creative accounting is a term in general use to describe the practice of applying inappropriate accounting policies or

entering into complex or ‘special purpose’ transactions with the objective of making a company’s financial statementsappear to disclose a more favourable position, particularly in relation to the calculation of certain ‘key’ ratios, than wouldotherwise be the case Most commentators believe creative accounting stops short of deliberate fraud, but is nonethelessundesirable as it is intended to mislead users of financial statements

Probably the most criticised area of creative accounting relates to off balance sheet financing This occurs where acompany has financial obligations that are not recorded on its balance sheet There have been several examples of this

in the past:

– finance leases treated as operating leases– borrowings (usually convertible loan stock) being classified as equity– secured loans being treated as ‘sales’ (sale and repurchase agreements)– the non-consolidation of ‘special purpose vehicles’ (quasi subsidiaries) that have been used to raise finance– offsetting liabilities against assets (certain types of accounts receivable factoring)

The other main area of creative accounting is that of increasing or smoothing profits Examples of this are:

– the use of inappropriate provisions (this reduces profit in good years and increases them in poor years)– not providing for liabilities, either at all or not in full, as they arise This is often related to environmental provisions,decommissioning costs and constructive obligations

– restructuring costs not being charged to income (often related to a newly acquired subsidiary – the costs areeffectively added to goodwill)

It should be noted that recent International Accounting Standards have now prevented many of the above past abuses,however more recent examples of creative accounting are in use by some of the new Internet/Dot.com companies Most

of these companies do not (yet) make any profit so other performance criteria such as site ‘hits’, conversion rates(browsers turning into buyers), burn periods (the length of time cash resources are expected to last) and even salesrevenues are massaged to give a more favourable impression

(ii) One of the primary characteristics of financial statements is reliability i.e they must faithfully represent the transactionsand other events that have occurred It can be possible for the economic substance of a transaction (effectively itscommercial intention) to be different from its strict legal position or ‘form’ Thus financial statements can only give afaithful representation of a company’s performance if the substance of its transactions is reported It is worth stressingthat there will be very few transactions where their substance is different from their legal form, but for those where it is,they are usually very important This is because they are material in terms of their size or incidence, or because theymay be intended to mislead

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– Where a transaction is linked with other related transactions It is necessary to assess the substance of the series

of connected transactions as a whole

– The use of options within contracts It may be that options are either almost certain to be (or not to be) exercised

In such cases these are not really options at all and should be ignored in determining commercial substance.– Where assets are sold at values that differ from their fair values (either above or below fair values)

Many complex transactions often contain several of the above features Determining the true substance of transactionscan be a difficult and sometimes subjective procedure

(b) (i) This is an example of consignment inventory From Atkins’s point of view the main issue is whether or at what point in

time the goods have been purchased and should therefore be recognised As is often the case in these types of agreement there is conflicting evidence as to which party bears the risks and rewards relating to the vehicles Themanufacturer retains the legal right of ownership until the goods are paid for by Atkins Consistent with this themanufacturer also has the right to have the goods returned or passed on to another supplier The fact that Atkins maychoose to return the goods to the manufacturer is also indicative that the manufacturer is exposed to the risk of obsolescence or falling values These factors would seem to suggest that the vehicles have not been sold and shouldtherefore remain in the inventory of the manufacturer and not be recognised in the accounting records of Atkins

There are, however, some contrary indications to this view The price for the goods is fixed as of the date of transfer, notthe date that they are deemed ‘sold’ This means that Atkins is protected from any price increases by the manufacturer.The 1·5% paid to the manufacturer appears to be in substance a finance charge, despite it being described as a ‘displaycharge’ A finance charge indicates that Atkins must have a liability to the manufacturer; in effect this liability is theaccount payable in respect of the cost of the vehicles Although Atkins has a right of return, it cannot exercise this without

a cost There is an explicit freight cost, but this may not be the only cost It could well be that Atkins may suffer poorfuture supplies from the manufacturer if it does return goods The question says that Atkins has never taken advantage

of this option, which would seem to suggest that it should be ignored

Conclusion:

The substance of this transaction appears to suggest that the goods have been purchased by Atkins and the company

is paying a finance cost Therefore the vehicles should be recognised on Atkins’s balance sheet, together with therespective liability It would seem logical that if Atkins considers the goods as purchased, then the manufacturer shouldconsider them as sold The problem is that prudence may prevent the manufacturer from recognising the profit on thesale, as the period for the right to return the goods has not expired Therefore, either the sales are not recognised by themanufacturer (the goods would remain in its inventory), or if they are, a provision should be made in respect of theunrealised profits This could lead to the unusual situation that the goods may appear on both companies’ balancesheets

(ii) Although the question says that Atkins has sold the land to Landbank and even though there will be a legal transfer of the land, the substance of this transaction is that of a secured loan The two clauses in combination mean that inpractice Atkins will repurchase the land on or before 1 October 2004 This is because if its value is above $3·2 millionAtkins will exercise its option to purchase, conversely if the value is below $3·2 million Landbank plc will exercise itsoption to require a repurchase Either way Atkins will repurchase the land When this is understood it becomes clearthat the difference between the ‘sale’ price of $2·4 million and the repurchase price of $3·2 million represents a financecharge on a secured loan

Assuming the land is sold:

Assuming the arrangement is secured loan:

Income statement – year to 30 September 2002

(10% of in substance loan of $2·4 million)Balance sheet as at 30 September 2002Non-current assets

Non-current liabilities

–––––––––

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4 Cash Flow Statement of Nedberg for the Year to 30 September 2002:

Adjustments for:

–––

––––

Cash flows from investing activitiesPurchase pro er y, pla t a d eq ipment (w (iv) (250)

Cash flows from financing activities

––––

––––Workings

(i) Development expenditure:

––––

––––(ii) Government grant:

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In the case of Nedberg the depreciation/amortisation effect has been more than offset by a much higher investment in workingcapital of $645 million Inventory has increased by over 50% and accounts receivable by 45% This may be an indication

of expanding activity, but it could also be an indication of poor inventory management policy and poor credit control, or eventhe presence of some obsolete inventory or unprovided bad accounts receivables

A cause of concern is the size of the dividends, at $400 million they represent 67% of the profit for the period and cash flowsfor dividends (last year’s final plus this year’s interim) are also high at $320 million This is a very high distribution ratio, and

it seems curious that the company is returning such large amounts to shareholders at the same time as they are raisingfinance $450 million has been received from the issue of new shares and $200 million from a further issue of loan notes.The company has invested considerably in new plant ($250 million) and even more so in development expenditure ($500million) If management has properly applied the capitalisation criteria in IAS 38 ‘Intangible Assets’, then this indicates thatthey expect good future returns from the investment in new products or processes The net investment in non-current assets

is $680 million which closely correlates to the proceeds from financing of $650 million In general it is acceptable to financeincreases in the capacity of non-current assets by raising additional finance, however operating cash flows should financereplacement of consumed fixed assets

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5 (a) (i) The requirement in IAS 35 ‘Discontinuing Operations’ to provide an analysis between continuing and discontinuing

operations is intended to improve the predictive usefulness of financial statements In essence there can be no moreimportant information when trying to assess the future performance of a company than to know which parts of it arecontinuing their operations and those which have ceased or been sold or are about to be in the near future Only theresults of continuing operations should be used in forecasting future results; profits or losses from discontinuingoperations will not be repeated

Information on discontinued operations can also help to assess management’s strategy One would expect loss-makingactivities to be sold or closed down, but selling a profitable activity may indicate that a company has liquidity or debtproblems

(ii) If no information on continuing and discontinuing activities were available then the best estimate of the future profit of both companies would be $110 million (i.e $100 million x 110%)

Utilising the available information, a very different picture emerges:

$ mi io $ mi io

Gamma’s forecast is based on profit from continuing activities of $70 million increasing by 10% to $77 million

Toga’s forecast is also based on its continuing activities, but it is in two parts The ‘existing’ activities that made profits

of $90 million would be expected to produce profits of $99 million in 2003 Its newly acquired activities would beexpected to produce profits of $110 million The latter figure is based on the $50 million profit in 2002 being for onlysix months, a full year would have presumably yielded $100 million In 2003 this would increase by 10% to $110million

(b) (i) The trend shown by a comparison of a company’s profits over time is rather a ‘raw’ measure of performance and can

be misleading without careful interpretation of all the events that the company has experienced In the year to

30 September 2002, Taylor’s eps has increased by 25% (from 20 cents to 25 cents), whereas its profit has increased

by a massive 67% (from $30 to $50 million) It is not possible to determine exactly what has caused the differencebetween the percentage increase in the eps and the percentage increase in the reported profit of Taylor, but a simplerexample may illustrate a possible explanation Assume company A acquired company B by way of a share exchange.Both companies had the same market value and the same profits A comparison of A’s post combination profits with itspre-combination profits would be very misleading They would have appeared to double This is because the postcombination figures incorporate both companies’ results, whereas the pre-combination profits would be those of company A alone (assuming it is not accounted for as a uniting of interest) The trend shown by the earnings per sharegoes some way to addressing such distortion In the above the increase in post combination profit would also beaccompanied by an increase in the issued share capital (due to the share exchange) thus the reported eps of company

A would not be distorted by its acquisitive growth It can therefore be argued that the trend of a company’s eps is a morereliable measure of its earnings performance than the trend shown by its reported profits

(ii) Both the convertible loan stock and the directors’ share options will give rise to dilution:

8% Loan stock – on conversion there will be 140 million new shares (200 million x 70/100)The interest saved, net of tax at 25%, will be $12 million ($200 million x 8% x 75%)The directors’ share options will yield income of $75 million (50 million x $1·50) At the market price of $2·50 thiswould be sufficient to purchase 30 million shares As the options are for 50 million shares the dilutive effect of theoptions is 20 million shares

Diluted eps year to 30 September 2002:

Earnings $62 mi io (b sic $50 mi ion + $12 mi ion re lo n stoc )Number of shares 360 million (basic 200 million + 140 million re loan stock + 20 million re options)

Diuted eps 17·2 c nts

(iii) The relevance of the diluted earnings per share measure is that it highlights the problem of relying too heavily on acompany’s basic eps when trying to predict future performance There can exist certain circumstances which may causefuture eps to be lower than current levels irrespective of future profit performance These are said to cause a dilution of the eps Common examples of diluting circumstances are the existence of convertible loan stock or share options thatmay cause an increase in the future number of shares without being accompanied by a proportionate increase inearnings It is important to realise that a diluted eps figure is not a prediction of what the future eps will be, but it is a

‘warning’ to shareholders that, based on the current level of earnings, the basic reported eps would be lower if thediluting circumstances had crystallised Clearly future eps will be based on future profits and the number of shares inissue

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(c) There are two main reasons why the income tax charge in the financial statements is not at the same rate as the statedpercentage The first reason is that tax is payable on the taxable profits of a company, which may differ considerably from theaccounting profit Such differences may be because some items of income or expenditure included in the financial statementsmay be disallowable for tax purposes (or allowed in a different accounting period) and some taxation allowances (e.g taxdepreciation allowances) are not included in the accounting profit These differences may be mitigated by deferred tax ontemporary differences The second reason for differences is that the income tax charge does not usually consist solely of thecharge on the current year’s profit Commonly the tax charge also includes an element of deferred tax (this may be a debit orcredit) and possibly an adjustment to the previous year’s tax provision (due to it being settled at an amount different to theprovision) Other more complex items such as withholding taxes on income and double (dual) taxation relief may also beincluded in the tax charge

The main reason why the income tax charge in the income statement differs to that in the cash flow statement is that the taxcharge in the financial statements is a provision for tax that is normally settled in the following period This means that thecash flow figure for tax actually paid is the amount needed to settle the previous year’s tax liability Other differences may bedue to items referred to above such as deferred tax movements that are not cash flows

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Part 2 Examination – Paper 2.5(INT)

FIn ncial Re or ing (ntern tio al Ste m) Decemb r 2002 Marking Scheme

This marking scheme is given as a guide in the context of the suggested answers Scope is given to markers to award marks foralternative approaches to a question, including relevant comment, and where well-reasoned conclusions are provided This isparticularly the case for written answers where there may be more than one definitive solution

(ii) Income statement:

Equity and reserves:

sh re premium of Sulp ate n w clas ed as a ca ital reserv 1

Maximum for q estio 25

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(b) Changes in equity

Maximum for qu stio 25

features indicating a diference betwe n su sta ce a d le al form 3

and 1 mark per correct figure in the financial statements to a maximum 6

Maximum for qu stio 25

Tiêu đề	Financial reporting
Chuyên ngành	Accounting and finance
Thể loại	Đề thi thử
Năm xuất bản	2006

Định dạng
Số trang	240
Dung lượng	3,73 MB