53509116 acca f7 int uk practise question s answer

KAP LA N P UBL IS HI NG 62

ANSWERS

LE CTURE R RESO URCE P ACK : ANS WE RS


A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

A COMPANY

(a) Current purchasing power accounting

Current purchasing power or CPP accounting is concerned with removing the distortion caused to historical cost accounts by changes in the general purchasing power of money. It is achieved by using an index (usually a government index) to restate capital amounts, all non-monetary assets and liabilities and charges for consumption of non-monetary assets.

The advantages of CPP accounts are as follows:

(i) As results are expressed in a common currency, i.e. CPP $s, they are comparable from one period to another.

(ii) Similarly, inter-company comparisons are meaningful.

(iii) They demonstrate the effects of inflation in reducing the value of cash and the benefit of holding monetary liabilities.

(iv) The adjustments are based on a general price index which makes the calculations non-complex and reduces subjectivity.

The disadvantages can be summarised as:

(i) The use of a general price index does not recognise specific inflation effects on particular assets or industries.

(ii) The CPP profit is an unreliable measure as a basis for distributions as it is not based on fair values of assets.

(iii) Companies which are heavily geared have their profits enhanced by CPP accounting.

Current cost accounting

Current cost accounting involves the adjustment of historical cost profit by charging the current cost of assets consumed in generating profits. These adjustments are as follows:

(i) cost of sales adjustment: the excess of replacement cost of goods sold over historical cost;

(ii) depreciation adjustment: the difference between historical cost and current cost depreciation charge;

(iii) monetary working capital adjustment: takes account of the increase in the replacement cost of inventory over the credit period taken by customers. This will be offset by the credit period taken from suppliers; and

(iv) gearing adjustment: recognises the proportion of assets financed by borrowings.

In current cost accounts the statement of financial position will include assets at current cost and there is a current cost reserve in which the current cost adjustments are dealt with.

The advantages of current cost accounting are as follows:

(i) assets and liabilities are carried at a realistic value; and

(ii) current cost profit is a more realistic measure of distributable profit than historical cost profit.

PAP E R F7 ( I NT & UK ) : F INANCI AL REPO RTI NG

64 KAP LA N P UBL IS HI NG

The disadvantages of current cost accounting can be summarised as:

(i) it is complex and costly to operate;

(ii) it is subjective which reduces inter-company comparisons; and

(iii) inter-period comparisons are meaningless.

Real terms system

The real terms system of accounting involves the comparison of opening and closing shareholders' funds at current cost and providing for the decrease in purchasing power over the period which results from general inflation.

The advantages of this method of accounting are:

(i) realistic statement of financial position values; and

(ii) shows the real increase in shareholder wealth during the period.

Its disadvantages are:

(i) year on year comparisons are not particularly meaningful;

(ii) it relies on asset valuations which may be subjective; and

(iii) the real terms profit does not represent distributable profits.



LIMITATIONS OF HISTORICAL COST

Historical cost accounting (HCA) has been criticised on the following grounds.

(a) Reported results may be distorted as a result of the matching of current revenues with costs incurred at an earlier date. The full distribution of profits calculated on that basis may result in the distribution of sums needed to maintain capital. A distribution which appears well covered when measured against historical cost profit may appear much less well covered when compared with a measurement of profit that takes account of changing prices.

(b) The amounts reported in a statement of financial position in respect of assets may not be realistic, up-to-date measures of the resources employed in the business.

(c) As a result of (a) and (b), calculations to measure return on capital employed may be misleading.

(d) Because holding gains or losses attributable to price level changes are not identified, management's effectiveness in achieving operating results may be concealed.

(e) There is no recognition of the loss that arises through holding assets of fixed monetary value and the gain that arises through holding liabilities of fixed monetary value.

(f) A misleading impression of the trend of performance over time may be given because no account is taken of changes in the real value of money.

Criticism of HCA becomes most vocal in periods of high inflation, such as the late 1970s, since so many of the profits then reported are due to realised holding gains rather than true operating gains. When inflation levels are low, such as in most of the world today, there is less pressure on standard setters to recommend new accounting methods that do not suffer from the limitations of HCA noted above.

HCA has remained the principal basis for preparing accounts in most countries for many years, so it must have some advantages. Among these strengths are the following:

(a) It is more objective than adjusted-price methods. The cost of a non-monetary asset is a fact established in the past, whereas the current value of such an asset is a subjective opinion, whether the basis for the value is replacement cost, net realisable value or economic value.

(b) HCA is well established with users aware of its limitations when they make decisions from accounts drawn up under this basis. For example, quoted companies are expected to maintain a dividend cover of 2 or more; they would be criticised for over distribution were they to pay out all the historical profits that the income statement indicated they could.

(c) In times of low inflation, such as the present, HCA's problems are less serious. If one believes that inflation has been permanently squeezed out of the world economy, then there is little advantage in shifting to methods of current value accounting.



RELEVANT AND RELIABLE

In accounting some figures may be considered to be both relevant and reliable: the amount of a loan, dividends paid and the bank balance are examples of items in which the shareholders will be interested in terms of decision-making and which can be accurately determined. However, many figures in the accounts become more relevant only if a degree of reliability is sacrificed. This is because relevance usually involves the application of subjective judgements which are not wholly reliable.

The cost of a non-current asset is a reliable figure, but is not particularly relevant. Its relevance is increased by the allowance for depreciation, a calculation which involves judgements such as estimations of useful life, residual value and the most appropriate depreciation method. The relevance of the non-current asset figure may be further enhanced by performing a revaluation which relies on the judgement of a valuer.

Allowances for doubtful debts, inventory write-offs, prepayments and accruals are all accepted as necessary methods of increasing the relevance of accounts, but all involve making estimates which unavoidably leads to a decrease in reliability.

In achieving a balance between relevance and reliability, the needs of users of financial reports need to be taken into account. Different users have different information needs and what is relevant for one type of user may not be relevant for another. However, all users require reliable information, so the balance should be tipped in favour of reliability.



FOREST (a) In order to be useful, information contained in financial statements must be relevant and

reliable. This can only be achieved if the substance of transactions is recorded. If this did not happen the financial statements would not represent faithfully the transactions and other events that had occurred. Although there are many instances where there are genuine commercial reasons for contracts and transactions adopting the legal form that they do (e.g. to create a secure legal title to assets), equally the legal form is often used to achieve less desirable purposes. In general, these amount to manipulating the financial statements to create a favourable impression. The typical outcomes of such manipulation are:

the omission of assets, and particularly liabilities, from statement of financial positions

improvements to profits and profit ‘smoothing’

improvement of other performance measures such as earnings per share, liquidity ratios, profitability ratios and gearing.

Clearly such effects are not helpful to users of financial statements and thus it is important that the substance of a transaction should be recorded in order to avoid the above distortions.

(b) The following important features are often found in transactions or arrangements where the substance may be different to the legal form. These features need to be fully understood and investigated in order to determine the substance of a transaction:

(i) The separation of legal title from the benefits and risks related to an asset has been used to avoid assets, and often their related financing, from being recognised on the statement of financial position. Where an asset is ‘sold’ but the selling company still substantially enjoys the risks and rewards of ownership, then it should remain an asset of the company. This is the principle used in IAS 17 Leases to record finance leases. Often when the substance of an agreement is applied to transactions it will have a very different effect on the statement of financial position than if the legal form is recorded. For example an asset that is ‘sold’ and leased back for the remainder of its useful life is in substance a financing arrangement and not a ‘sale’ at all. The asset should remain on the statement of financial position and the proceeds should be treated as a loan.

(ii) A common arrangement is to link a series of transactions. It is not always obvious when transactions are linked, but it would be difficult to appreciate the commercial effect without considering such transactions as a ‘whole’. Inventories may be ‘sold’ to a third party. A condition of the sale is that there is an option giving the selling company the right to buy back the inventory at a future date. This is often at a predetermined value which is designed to give the purchasing company what is in substance a lenders return. When all of the ‘linked’ transactions are considered together it becomes apparent that this is again a financing arrangement and should be recorded as such. The use of options can be a problem area. Options are an important feature of modern accounting and are frequently used by companies for genuine commercial reasons, often to reduce risks. However, if, at the time an option is written, it is virtually certain that it will be exercised (due to commercial reality), then it is not in substance a real option at all. This is also the case for the reverse situation where an option will almost certainly not be exercised. Therefore such ‘options’ should be disregarded in terms of assessing commercial substance.



(iii) Where assets are sold at prices below or above their fair values there is likely to be related (or linked) transactions that will explain the reason for it. A selling price above fair value is almost certain to be a form of loan which will be linked to future transactions that will affect its repayment. A selling price below fair value is likely to be a way of deferring the profit on sale. This may be effected by reducing a future item of expense. For example a company could ‘sell’ some plant to a third party below its fair value. The ‘sale’ is linked to an agreement to lease the plant back in future years at a rental below commercial rates. In effect the profit forgone on the sale is being used to reduce future rental payments, thus the profit on the sale is being spread over several accounting periods rather than being reported in the year of sale (a form of profit smoothing).

(c) (i) Note: all figures in $000s

Forest – Income statement year to 31 March:

20X1 20X2 20X3 Total

Revenue 15,000 Nil 25,000 40,000

Cost of sales (12,000) ______

Nil ___

(19,965) ______

(31,965) ______

Gross profit 3,000 ______

Nil ___

5,035 ______

8,035 ______

The cost of sales in the year 20X3 is the original selling price of $15 million plus compound interest at 10% for the previous three years (see below).

Forest – Statement of financial position as at 31 March:

20X1 20X2 20X3

Inventory Nil Nil Nil

Loan Nil Nil Nil

(ii) Forest – Income statement year to 31 March:

20X1 20X2 20X3 Total

Revenues Nil Nil 25,000 25,000

Cost of sales Nil _____

Nil _____

(12,000) ______

(12,000) ______

Gross profit Nil Nil 13,000 13,000

Interest (accrued at 10%) (1,500) _____

(1,650) _____

(1,815) ______

(4,965) ______

Net profit (loss) (1,500) _____

(1,650) _____

11,185 ______

8,035 ______

Forest – Statement of financial position as at 31 March:

20X1 20X2 20X3

Inventory 12,000 12,000 Nil

Loan 15,000 15,000 15,000

plus accrued interest 1,500 ______

3,150 ______

4,965 ______

19,965

Repaid 31 March 20X3 (19,965) ______

Nil ______



As can be seen from the figures in (i) if the legal form of the transaction is applied it results in a spreading of the profit, some in the year to 31 March 20X1, the rest in 20X3. The arrangement could have been made such that some of the ‘sale’ to the bank was made in 20X2 thus reporting a profit in all three years. Also no inventory or loans appear on the statement of financial position; this improves many ratios, particularly gearing.

In contrast (ii) applies the substance of the transaction and (ignoring Forest’s other transactions) this results in ‘losses’ in 20X1 and 20X2 and a large profit in 20X3; there is no profit ‘smoothing’. It also shows an interest charge, which in (i) is ‘lost’ in the cost of sales figure. In addition both the inventory and the loan (including accrued interest) appear on the statement of financial position. Note both methods eventually report the same profit.



CREATIVE ACCOUNTING 1

Key answer tips

(a) Statements appear more favourable; no definition; accounting policies selected may be permitted but not appropriate; deception; inflating profit; profit smoothing; reserve accounting; IAS 11; effect on key ratios; no existing accounting standard for new/complex financial transactions; bonuses based on profits; share price; borrowing.

(b) IASB; group accounting – IAS 27, non-current assets – IAS 17; current assets – factoring, sale to finance house and repurchase of inventories.

(c) Effect of low coupon rate on earnings; loan classified as equity on statement of financial position, generous conversion terms; calculation of EPS/diluted EPS; IAS 32.

(a) Creative accounting is not a term that has a definition as such, however various commentators have described some doubtful accounting practices as ‘creative accounting’. Such practices may be used by a company’s management to make its financial statements appear favourably different from what would be commonly acceptable. It must be appreciated that the accounting policies in question are not ‘illegal’ and they may even be permitted by accounting standards. The problem lies in their inappropriate application. Creative accounting is undesirable and, at its worst, is a form of deception.

In the income statement there are generally two aspects to profit manipulation or creative accounting; that of inflating profits, and that of profit smoothing.

Inflating profit

There are several techniques of achieving this, for example management may attempt to avoid certain costs from passing through the income statement. Reserve accounting for losses is a good example of this. Another example is treating future reorganisation costs relating to an acquisition as a reduction of the acquired entity’s net assets, i.e. a liability at the date of acquisition.

Profit smoothing

The timing of revenue recognition can lead to profit smoothing. Some examples of profit smoothing are regarded as acceptable. For example recognising stage profits in relation to construction contracts (IAS 11) is common practice, whereas other methods such as ‘selling’ and later re-purchasing maturing inventories are generally considered undesirable.

In the statement of financial position creative accounting has mainly been used to improve ‘key’ reported ratios such as financial gearing and liquidity ratios.

It is important to stress that such accounting policies and practices are not illegal and must be distinguished from fraud. Deliberately overvaluing closing inventories would improve profits and liquidity but this would be fraud, not creative accounting. Although creative accounting may not be illegal, it generally prevents the financial statements of an entity from showing a ‘true and fair view’ or ‘presenting fairly the financial position’.

Creative accounting has also been used to describe less sinister practices. The modern world has many new and complex financial transactions for which existing accounting standards may not be appropriate because such transactions did not exist when the statements were produced. As a company’s management has to account for these complex transactions it has to ‘create’ an accounting policy.

There are various explanations of why management may participate in manipulating financial statements. Perhaps the most obvious is that of self-interest: management may be



remunerated (partly) in the form of a bonus based on the level of profit. Other reasons may be that creative accounting can, in the short term, increase the market price of a company’s shares, again with obvious benefits. A company with high statement of financial position gearing will find further borrowing difficult and expensive. In extreme cases high gearing may breach debt covenants. It is therefore beneficial to the company and its shareholders to reduce reported gearing in these circumstances.

(b) Accounting standards and corporate laws have to be in a written ‘form’ which describes the issues and defines accounting treatments for particular topics. In addition to their legal form they often have a spirit or ‘substance’. The International Accounting Standards Board (IASB) believes that in order for financial statements to represent faithfully that which they purport to represent, accounting transactions should be recorded by reflecting their substance or economic reality whether or not this is also the legal form of the transaction. The substance of a transaction is not always easy to determine; for guidance it is necessary to look at which parties to the transaction bear the substantial risks and rewards relating to it.

(i) Group accounting

There are several areas of current group accounting regulations that are based on the concept of substance:

Probably the most important is that the definition of a subsidiary (IAS 27) is based upon the principle of control rather than purely ownership. Where an entity is controlled by another, then the controlling entity can ensure that the benefits accrue to itself and not to other parties. Similarly, one of the circumstances where an entity which is owned must not be consolidated is where there are severe long term restrictions that prevent effective control.

(ii) Financing non-current assets

The most common example of the application of the principle of substance over form in relation to the financing of non-current assets is in the area of leasing (IAS 17 Leases). In the legal form the hirer of an asset (lessee) under a lease does not ever have legal ownership of the asset, or does not do so until an option to purchase is exercised, normally at the end of the agreement. In some countries the definition of a lease specifically prevents ownership from passing to the lessee. Regardless of the legal position, IAS 17 states that where a lease ‘transfers substantially all the risks and rewards incidental to ownership’ the asset must be included on the lessee’s statement of financial position as a finance leased asset, as too must the leasing obligation. This is despite the fact that the lessee does not currently, or may even never, legally own the asset.

Sometimes an entity may sell a non-current asset that it owns to a finance house and lease it back for use in the business. If the essence of the lease is that it is a finance lease, then the asset is effectively treated as not having been sold and the transaction is treated as a secured loan.

(iii) Measurement and disclosure of current assets

Factoring of trade receivables is an area where close attention must be paid to the substance of the arrangements. When trade receivables are ‘sold’ to a factor, often a finance house, the substance is usually determined by examining which party will bear the risk of non collection or slow collection. If the trade receivables are sold without recourse, this would mean the finance house must bear the cost of the bad debts. As such this would be a genuine sale and the trade receivables would be removed from the seller’s statement of financial position. If the receivables are sold ‘with recourse’, then the seller must bear the expense of bad debts. In this case the ‘sale’ is simply a



financing arrangement and the proceeds of the ‘sale’ should be shown as a liability. The above is a simplification of what in practice are often very complex arrangements.

Another common example in relation to current assets is the sale and repurchase of inventories. Where a company deals in maturing inventories, then, whilst they are maturing, it may sell these inventories to a finance house with an option to re-purchase them at some future date. The re-purchase price will be designed to repay the original ‘sale proceeds’ and give the finance house a return on funds lent to the seller. The inventories are not likely to leave the premises of the seller. Clearly this is a financing arrangement, not a commercial sale, and should be treated as such.

(c) (i) One could speculate that the Finance Director’s intentions are that Alpha’s earnings may be increased from the improvements to the company’s long-term asset base, although it may be that such benefits take some time to feed through to earnings. The cost of financing the asset is at a commercially unrealistic rate of 5% instead of 9%. This would improve Alpha’s earnings. In relation to the statement of financial position, the Finance Director may be intending to classify the convertible loan as equity. This may be based on the assumption that the conversion is almost certain to take place and thus ultimately the finance will be in the form of equity shares. Some companies have in the past adopted such an approach.

(ii) The regulations for the calculation of the basic earnings per share (EPS) in IAS 33 Earnings per Share do not attempt to frustrate the intentions of the Finance Director. In the absence of any other IAS, the earnings would be based on interest payments of 5% and the issuing of the loan stock would not increase the number of shares. However a further requirement of IAS 33 is the disclosure of the diluted EPS figure. This calculation is based on the assumption that conversion has taken place. The earnings would be increased by adjusting for the interest on the loan (allowing for tax effects where appropriate) and the number of shares would be increased in line with the conversion terms. The diluted EPS is likely to be lower than the basic EPS. In one sense the diluted EPS acts as a warning to shareholders of what lies in the future.

But IAS 39 Financial Instruments: Measurement has an impact on this situation. Firstly it seeks to look at the substance of the cost of the financing. In reality the 5% coupon rate is not the true cost of financing. This figure is artificially low because it is being compensated for by ‘generous’ terms of conversion into ordinary shares. As such IAS 39 states that Alpha must account for the difference between the coupon rate of interest and the true market rate. This is achieved by charging the difference to the income statement as interest costs and accruing it in the statement of financial position. By applying this requirement the earnings cannot be manipulated by the use of discounted bonds/loan stocks.

In addition IAS 32 Financial Instruments: Presentation requires financial instruments such as the one in question to be disclosed partly as equity and partly as debt on the statement of financial position until such times as the conversion occurs. This requirement means that this convertible loan cannot be ‘hidden’ in equity and will therefore cause Alpha’s gearing to increase.



CREATIVE ACCOUNTING 2

(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 statements appear to disclose a more favourable position, particularly in relation to the calculation of certain ‘key’ ratios, than would otherwise be the case. Most commentators believe creative accounting stops short of deliberate fraud, but is nonetheless undesirable as it is intended to mislead users of financial statements.

Probably the most criticized area of creative accounting relates to off balance sheet financing. This occurs where a company has financial obligations that are not recorded on its statement of financial position. 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 ‘revenue’ (sale and repurchase agreements)

– the non-consolidation of ‘special purpose vehicles’ 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 recognized in profit or loss (often related to a newly acquired subsidiary – the costs are effectively 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 revenue 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 transactions and other events that have occurred. It can be possible for the economic substance of a transaction (effectively its commercial intention) to be different from its strict legal position or ‘form’. Thus financial statements can only give a faithful representation of a company’s performance if the substance of its transactions is reported. It is worth stressing that 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 they may be intended to mislead.

Common features which may indicate that the substance of a transaction (or series of connected transactions) is different from its legal form are:



– Where the ownership of an asset does not rest with the party that is expected to experience the risks and rewards relating to it (i.e. equivalent to control of the asset).

– 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 transactions can be a difficult and sometimes subjective procedure.



REVENUE RECOGNITION

(a) Obtaining an order prior to manufacture:

This is an unlikely place for the critical event to occur. Obtaining an order for a large or long-term construction contract is often very important and gives some measure of assurance in matters such as employment security and even going concern. However, as there would be so much uncertainty with regard to the final outcome of such a contract, it would be highly imprudent to recognise any income or profit at this point.

Acquisition of goods or raw materials:

This event is a routine occurrence that could not be considered critical except in very unusual circumstances. A possible example of this is in the extraction of precious metals or gems, such as gold and diamond mining. Because gold is a valuable and readily marketable commodity the real difficulty in deriving income from it is obtaining it, thus this could become the critical event in such circumstances.

Production of goods:

Again for most industries this is routine and not critical. There are some industries where, due to a long production period, income is recognised during the production or manufacturing period. The most common example of this is the treatment of long-term construction contracts under IAS 11 Construction Contracts.

Obtaining an order for goods that are in inventory:

This is getting near to the point when most of the uncertainties in the cycle have either been resolved or are reasonably determinable. The sales/marketing department of a company would probably consider this as the critical event, but recognition is usually delayed until delivery, on the basis that the order could be cancelled.

Delivery/acceptance of the goods:

For the vast majority of businesses this is the point at which income is recognised, and it usually coincides with the transfer of the legal title to the goods. There are still some uncertainties at this point. For example, the goods may be faulty or the customer may not be able to pay for them. However past experience can be used to quantify and accrue for these possibilities with reasonable accuracy. Occasionally goods are delivered subject to a 'reservation of title' clause, which provides for recovery of the goods in the event of non-payment. But because this is an issue about payment, not about the making of the sale, it does not prevent the recognition of the revenue.

Collection of cash:

With the obvious exception of cash sales, under IAS 18 Revenue revenue recognition should only be delayed to this point if collection is perceived to be uncertain, particularly difficult or risky. Income (and profits) from high risk credit sale agreements may be one example of this, another possibility is sales made to overseas customers where the foreign government takes a long time to grant permission to remit the consideration. Particular problems may also arise when dealing with countries that have non-convertible currencies.

After sales service or warranties:

This serves as a reminder that not all the risks and associated costs are resolved when cash is received. For some products such costs can be significant (e.g. in the supply of new motor vehicles or rectification work on construction contracts), but it is normally possible to estimate



these costs and provide for them at the time of the sale. Unless the obligations go beyond normal warranty provisions, it would be unrealistic, and may cause distortions, if income was not recognised until such obligations had elapsed (IAS 18).

(b) Provided the amount can be reliably measured, income arises when economic benefits have increased as a result of increases in assets or decreases of liabilities that result in increases in equity, other than contributions from equity participants.

Provided the amount can be reliably measured, expenses arise when economic benefits have decreased as a result of decreases in assets or increases of liabilities that result in decreases in equity, other than distributions to equity participants.

With a small number of exceptions, income and expenses should be reported in the income statement.



A REGULATORY FRAMEWORK FOR FINANCIAL REPORTING

INFLUENCES

Setting an International Financial Reporting Standard

The development of International Financial Reporting Standards (IFRSs) requires several stages.

(a) The IASB sets up an Advisory Committee to advise the Board on the issues arising.

(b) The IASB may decide to publish a Discussion Document seeking public comment on the proposed course of action.

(c) Following the consideration of views received, the IASB will publish an Exposure Draft, being a draft version of the proposed standard, again seeking public comment.

(d) Following the further consideration of views received, the IASB will publish the final text of the IFRS.

The final publication of the standard requires the voting approval of at least 9 of the IASB’s 14 members.

The preparers of financial statements and other interested parties have opportunities at stages (b) and (c) above to directly communicate their views to the IASB, which could influence the eventual outcome.



FINANCIAL STATEMENTS

IAS 10, 37, 38, 40 PROBLEMS

(a) IAS 10 Events After the Reporting Date divides such events into two categories: adjusting events and non-adjusting events. Adjusting events provide additional evidence of conditions existing at the reporting date, while non-adjusting events relate to conditions that did not exist at the reporting date.

The fire broke out on 4 April, after the reporting date of 31 March, so this is a non-adjusting event. There is no evidence of a fire secretly simmering at the reporting date and exploding into life on 4 April; the evidence is that there was no fire at 31 March. So the details of the fire should be disclosed in a note to the accounts, so that readers can reach a proper understanding of the company's affairs.

The major customer went into liquidation on 27 April. However the customer owed a material balance on 31 March and it is now clear that this balance is not recoverable. The liquidation is therefore an adjusting event, and D should write off the bad debt in its financial statements prepared to 31 March 20X3.

(b) IAS 40 Investment Property states that properties which are held for their investment potential should not be depreciated. However IAS 40 defines an investment property quite precisely, and specifically excludes a property owned and occupied by a company for its own purposes.

The new office building is owned by D and occupied by the staff of the Westown factory, so it cannot be an IAS 40 investment property. The managing director's suggestion is therefore unacceptable, and the building must be depreciated according to the company's normal depreciation policy for buildings.

(c) IAS 38 Intangible Assets splits research and development expenditure into two categories: research expenditure and development expenditure. Research expenditure should be written off as incurred; development expenditure should be carried forward as an asset if all of the following can be demonstrated:

(i) the technical feasibility of the project;

(ii) the intention to complete the project and use or sell it;

(iii) the ability to use or sell the item;

(iv) how the project will generate probable future economic benefits;

(v) the availability of adequate technical, financial and other resources to complete the project;

(vi) the ability to measure the expenditure reliably.

The new pulping process does seem to satisfy the conditions listed above, so the costs to date should be carried forward in the statement of financial position as an intangible non-current asset.

The attempt to develop a new species of tree definitely fails to satisfy the conditions listed above. It is not commercially viable and may not overall recover its costs, so expenditures on the project should be written off as incurred. There is no option to defer any of the related costs to future accounting periods.



(d) IAS 37 Provisions, Contingent Liabilities and Contingent Assets defines a contingent liability as:

(i) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the enterprise; or

(ii) a present obligation that arises from past events but is not recognised because:

it is not probable that a transfer of economic benefits will be required to settle the obligation; or

the amount of the obligation cannot be measured with sufficient reliability.

Unless the possibility of any transfer in settlement is remote, an enterprise is required by IAS 37 to disclose for each class of contingent liability at the reporting date a brief description of the nature of the contingent liability and, where practicable:

(i) an estimate of its financial effect;

(ii) an indication of the uncertainties relating to the amount or timing of any outflow; and

(iii) the possibility of any reimbursement.

A present obligation to the employee arising from his injuries exists, though we are advised that it is not possible to quantify the liability. There are two possible courses of action in accounting for this item. The lawyers could be pressed to make a prudent estimate of the amount of damages, perhaps from preliminary medical reports, and this estimate should then be provided in the accounts. If the lawyers still insist that such an estimate is impossible, there is no point in guessing on a value to accrue. Instead the facts should be disclosed as a contingent liability in a note to the accounts, stating that no liability has currently been recognised since a fair estimate is impossible. However, it is important that this note is worded in such a way that no liability is admitted, for this might prejudice the company's position in subsequent legal proceedings.

The second case is clearer cut. Lawyers have advised that there was no specific agreement to supply the paper in time for the promotion, so any possible liability is remote. IAS 37 does not require the disclosure of remote contingencies; they should be completely ignored in the accounts if the possibility of an outflow of economic resources is remote.



IAS 37

Tutorial notes:

(1) Parts (a) and (b) merely require the repetition of the relevant paragraphs from IAS 37.

(2) Part (c) is not difficult. Give your reasons for the decisions you make; as long as they are reasonable, a good mark can be achieved.

(a) A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the enterprise.

A contingent liability is:

(i) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the enterprise; or

(ii) a present obligation that arises from past events but is not recognised because:

it is not probable that a transfer of economic benefits will be required to settle the obligation; or

the amount of the obligation cannot be measured with sufficient reliability.

(b) Unless the possibility of any transfer in settlement is remote, an enterprise should disclose for each class of contingent liability at the reporting date a brief description of the nature of the contingent liability and, where practicable:

(i) an estimate of its financial effect;

(ii) an indication of the uncertainties relating to the amount or timing of any outflow; and

(iii) the possibility of any reimbursement.

Where an inflow of economic benefits is probable, an enterprise should disclose a brief description of the nature of the contingent assets at the reporting date and, where practicable, an estimate of their financial effect.

(c) (i) The painting, in the opinion of the valuers, is a valuable one which should sell for $1 million; therefore it is not a 'possible asset' whose existence requires confirmation by the occurrence of an uncertain future event. As such, it falls outside the definition of a contingent asset. This asset should be recognised in the statement of financial position as a current asset (as the intention to sell within one month is indicated by the details given in the question), at its valuation. If the valuers are virtually certain that it will sell for $1 million, then this would be an appropriate value. Only if there were any doubt as to the authenticity and marketability of the painting would it be disclosed as a contingent asset rather than recognised as an asset.

(ii) As the success of the claim for damages of $200,000 is probable, it constitutes a present obligation as a result of a past event, and would therefore be accounted for as a provision. The success of the counter claim for $100,000 is also considered probable and would therefore need to be disclosed as a contingent asset (reimbursement). Only if it were considered virtually certain would the counterclaim be recognised as an asset in the statement of financial position.



(iii) Unless otherwise recommended by legal and other advisors, the likelihood of the company incurring any liability as a result of the player's claim is so remote as not even to require disclosure as a contingent liability. Litigation is only threatened and is highly unlikely to be successful.



IAS 11

CONSTRUCTION CONTRACTS (a) A construction contract is defined in IAS 11 as a contract specifically negotiated for the

construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.

(b) IAS 11 governs the treatment of construction contracts in accounts.

(i) Income statement

When the profitable outcome of a construction contract can be estimated reliably, contract revenue should be recognised according to the stage of completion of the project. The expenses of reaching that stage should also be recognised. As a result, contract profit is recognised year by year as the project progresses.

If a profitable outcome cannot be estimated reliably, revenue should be recognised only to the extent that it is probable that costs incurred will be recoverable; no profit or loss is recognised.

Any expected loss on a contract should be recognised fully and immediately.

(ii) Statement of financial position

The gross amount due from customers for construction contracts should be shown as an asset and the gross amount due to customers should be shown as a liability. There should also be disclosures of advances received, retentions and costs incurred plus recognised profits.

(c) Income statement

$000

Contract revenue (500 + 350) 850

Contract costs (450 + 400 + 60 loss) 910 ___

Loss 60 ___

Statement of financial position

$000 $000

Contract X

Costs incurred plus recognised profits (600 + (500 − 450)) 650

Less: Progress billings 525 ___

125

Contract Y

Costs incurred 400

Less: Recognised losses and progress billings ((400 − 350) + 60 + 200) 310

___

90 ___

Gross amount due 215 ___



IAS 17

USER (a) Lease agreements are either:

finance leases, where the substantially all the risks and rewards of ownership (though not necessarily the legal title) pass to the user of the asset; or

operating leases where such risks and rewards remain with the legal owner.

Where a company finances the purchase of capital assets through leasing, its financial statements should properly reflect the commercial effect of those transactions. Where the substance of those transactions is similar to the lessee purchasing the asset, the lessee's statement of financial position should show both an asset, reflecting the lessee's rights in the leased asset, and a liability, reflecting the future obligations under the lease. However, where the lease does not have the commercial effect of a financing arrangement for the acquisition of an asset (an 'operating lease'), the lessee should only account for the rental expense through its income statement.

(b) Finance leases are defined in IAS 17. The definition is complex because the dividing line between a finance lease and an operating lease needs to be clearly drawn, as the accounting treatment of each is different.

IAS 17 defines a finance lease as a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. A finance lease is therefore an arrangement that has the substance of a financing transaction for the lessee to acquire effective economic ownership of an asset. An operating lease is defined as a lease other than a finance lease.

Whether or not a lease passes substantially all the risks and rewards of ownership will be evident from the terms of the lease contract and an understanding of the commercial risks undertaken by each party. IAS 17 provides guidance in cases where there may be doubt.

In the case of User, the lease is almost certainly a finance lease. User has the use of the asset for the period in which substantially all the benefits will be derived from the asset. The equipment was purchased to User's detailed specification, and from User's choice of supplier. It is unlikely that, once the asset transfers back to the lessor, the lessor would be easily able to trade in it.

User has also agreed to bear almost all of the risks of ownership, since it is expected to be responsible for any damage to the equipment, and for any loss of use arising through breakdowns. This indicates that the leasing company is acting as a financial lender to User, rather than as a lender of one of its own assets.

(c) The IASB’s objective is to publish standards in the public interest which improve and harmonise procedures relating to the presentation of financial statements. The IASB also seeks full disclosure by companies of the commercial effect of transactions; companies must account for the substance of transactions, not merely their legal form.

The requirement introduced by IAS 17 for the recognition by a lessee of both the asset and the liability associated with a finance lease did not change what the lessee was doing; it merely revealed it to users of financial statements. If certain investors subsequently avoided companies funding a lot of their assets through finance leases, then they probably would have wished to avoid those companies prior to IAS 17's introduction but were not able to do so because they did not have access to all the information which was important to them. To that extent, such companies were misleading these investors prior to IAS 17's introduction.



The IASB should continue to develop standards which improve the quality and quantity of information available to investors and others. If new standards lead to increased valuations of some entities and reduced valuations of others, they probably merely allow correction of previous under/over-valuations.



IAS 38

CATEGORIES

(a) IAS 38 Intangible Assets defines research and development expenditure as follows:

Research: original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Development: the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production or use.

(b) Apart from the cost of non-current assets acquired or constructed in order to provide facilities for research and development activities over a number of accounting periods, IAS 38 requires development expenditure to be capitalised provided an entity can demonstrate all of the following:

(i) the technical feasibility of the project

(ii) the intention to complete the project and use or sell it

(iii) the ability to use or sell the item

(iv) how the project will generate probable future economic benefits

(v) the availability of adequate technical, financial and other resources to complete the project.

(vi) the ability to measure the expenditure reliably.

(c) The need for an accounting standard with respect to expenditure on research and development arose from a number of factors. Firstly in many instances the sums expended were of a substantial nature and their treatment in the financial statements could have a material effect on the view shown by such statements. In many instances companies with substantial research and development expenditure shown on their statement of financial position had failed to survive in order to complete the projects involved.

The second effect of capitalising research and development expenditure is to apparently 'improve' the reported profits and earnings of those companies adopting this treatment. Thirdly the disclosure of the total amount expended and/or written off in an accounting period will enable users to assess the company's investment in the future.

Fourthly, the immediate write off of expenditure on the development of commercially successful products leads to the short term understatement of both profit and assets.



IAS 32/39

TALL (a) MEMORANDUM

To: Assistant Management Accountant

From: Management Accountant

Date: xx-xx-xxxx

Subject: Presentation of financial instruments

_____________________________________________________________________

This memorandum explains the correct presentation of financial instruments in accordance with international accounting standards.

IAS 32 governs this area of accounting. The issuer of a financial instrument should classify it as a liability or as equity in accordance with the substance of the arrangement. Essentially one must look at the definitions of a financial liability and an equity instrument in IAS 32 and act accordingly.

The critical feature in identifying a financial liability is the existence of a contractual obligation on the issuer either to deliver cash or another financial asset to the holder, or to exchange instruments under conditions unfavourable to the issuer. The $1 bonds we have issued certainly qualify as a financial liability, since they are redeemable at a fixed price on a fixed date. The option to convert into equity shares is at the holders' discretion, so we have no power over this decision. There is a contractual obligation that we may have to fulfil, to pay cash in five years’ time, thus the bonds should be shown as non-current liabilities on the statement of financial position, and not as part of equity.

Since the preference shares are mandatorily redeemable at a fixed future date, they also qualify as a financial liability. They should also be shown as non-current liabilities on the statement of financial position, and not as part of equity. The fact that they are legally shares is irrelevant to their IAS 32 classification which depends on the substance of the contractual arrangement involved.

Signed: Management Accountant

(b) IAS 39 requires that a financial liability should initially be recognized at its cost ie the fair value of the consideration received for it. Subsequently, financial liabilities should be measured at amortized cost (except for liabilities held for trading, and other financial liabilities that are designated as being measured at fair value through profit or loss, which should be measured at fair value).

Capital instruments, such as bonds and redeemable preference shares, that qualify as financial liabilities like those discussed in part (a), should therefore be shown in each statement of financial position at their amortized cost. This is:

$ The amount at which initially recognized x

effective interest rate x

– repayments of interest/principal (x) ––– x



The annual movement in the carrying value of a financial liability should be reported in profit or loss as expense or income. For a bond, the expense will normally comprize two elements: the annual interest paid and the annual amortization of the premium payable on redemption. For zero interest bonds such as issued by Tall, there is no annual interest and the year’s charge to profit or loss will comprise solely the year’s amortization of the premium payable on redemption.

For zero dividend redeemable preference shares such as issued by Tall, the annual charge to profit or loss will similarly be solely the year’s amortization of the premium payable on redemption. Note that this charge is shown as a finance cost expense in the statement of comprehensive income, not as a dividend cost in the statement of changes in equity. This is true for all costs relating to preference shares that qualify as financial liabilities. Any dividends paid on such preference shares are shown effectively as an interest expense in the statement of comprehensive income, since this reflects the substance of the contractual arrangement. It is only the dividends paid on shares that qualify as equity instruments that are taken directly to equity and disclosed in the statement of changes in equity.



EARNINGS EPR SHARE – IAS 33

RADAN

Key answer tips

In part (b), for each basis, your answer should explain what it measures and then why this provides useful information.

(a) Earnings per share (EPS) for the year ended 31 March 20X7 20X6

(i) Basic basis (W1) 4.0c 6.3c (ii) Diluted basis (W2) 4.2c

Basic earnings per share must be presented for both years. Since the diluted EPS exceeds the basic EPS, the loan notes are non-dilutive and the diluted EPS should not be disclosed.

(b) The figure for the basic EPS reflects the earnings performance of the company for the year taking into account all costs and revenues that have occurred during the year. In some circumstances further figures for the EPS may be of informational value to investors and analysts.

Diluted basis

The basic EPS is based on the current year’s profit. Investors and analysts are more interested in the future performance of a company. They often use trends of past profits/EPS as a basis for assessing the future performance. There may exist circumstances whereby a company has entered into obligations that may dilute the EPS in the future. Such obligations may adversely affect existing shareholders in terms of a potential reduction in future EPS. One example of such circumstances is the convertible loan notes of Radan. Other examples are share option schemes. Where these circumstances exist, the basic EPS can be misleading. The diluted EPS is a measure of what the current year’s EPS would be if all relevant diluting circumstances had matured or were exercised. It is important however to realise that the diluted EPS is not a prediction of future EPS.

(c) Distributable profit of Radan

$000 $000

Retained earnings 1 April 20X6 750

After tax profit in draft

After tax profit in draft accounts to 31 March 20X7 910

Adjustments:

IAS 11 profit no effect Development expenditure no effect Excess depreciation (150/5) 30

___

940 _____

Distributable profit before dividends 1,690 _____

Explanations

IAS 11 requires the recognition in financial statements of stage profits when the outcome of a contract can be estimated reliably. Such profits are distributable



Development expenditure properly carried forward in accordance with IAS 38 is not a realised loss.

Any ‘excess’ depreciation is not treated as a realised loss for the purposes of determining distributable profit.

Workings

Note: All $ figures are in $000, and all numbers of shares are in thousands.

(W1) Basic earnings per share

Ordinary shares at 1 April 20X6 (4,000 4) 16,000

Bonus issue of 1 for 8 2,000 ______

18,000

Rights issue 1 for 5 3,600 ______

Ordinary shares at 31 March 20X7 21,600 ______

$

Price 5 shares at $1.40 7.00

Rights issue 1 new share at 50 cents 0.50 ______

7.50 ______

Therefore the 6 shares have a theoretical value of $7.50/6 = $1.25 each.

Weighted average number of shares

18,000 9/12 1.40/1.25 15,120

21,600 3/12 5,400 ______

20,520 ______

Earnings: $000

Profit after tax 910

Less preference dividend (80) ______

830 ______

Therefore EPS is $830/20,520 100c = 4c

Comparative figure:

Reported in 20X6, EPS 8c 8/9 (bonus) 1.25/1.40 (rights) restated as 6.3c

(W2) Diluted earnings per share

Assuming the greatest dilution, the 10% loan notes will be converted to ($2,000 120/100) 2,400 ordinary shares

The effect on earnings will be the interest saved net of tax $2,000 10% (100 − 33)% = $134

Therefore EPS is (830 + 134)/(20,520 + 2,400) 100c = 4.2c



A

Key answer tips

The calculations in this question are not particularly difficult but you have to be organized in your workings to make sure that you have presented them all for the examiner to see. Part (c) presents the opportunity to gain some easy marks so long as you make sure you remember the specific query of the investor in question.

(a) Earnings per share

20X8: 1,009.6

1,030.0 = 102c

20X7: 500

880

3.50

3.37 = 169c

Workings

Weighted average number of shares in issue:

Date No. of shares in issue Weighted average (millions) (millions)

1/10/X7 – 31/3/X8 500 6/12 3.5/3.37 259.6

1/4/X8 – 30/9/X8 1,500 6/12 750.0 __________

1,009.6 __________

Theoretical ex rights price

$

1 share @ $3.50 3.50 2 shares @ $3.30 6.60 _______

10.10 _______

Theoretical ex rights price = $10.10 3 = $3.37

Bonus fraction: price rightsex lTheoretica

price rightscum Actual =

3.37

3.50



(b) REPORT

To: Mr B

From: A Management Accountant

Subject: The change in the earnings per share of A

Date: 25 November 20X8

As requested, I have attempted to identify the key factors which may have led to the reduction in the earnings per share (EPS) of A since 30 September 20X7. My comments are based on the statements of comprehensive income and statements of financial position of A for the two years ended 30 September 20X8.

EPS is normally regarded as a key measure of a company’s profitability. However, although EPS has fallen, revenue has increased by 17.6% ((10,000 – 8,500) as % of 8,500)and net profit after tax has also increased by 17%((1,030 – 880) as % of 880). The net profit percentage has remained at 10.3% for both years.

Looking at the statement of comprehensive income in more detail, the gross profit margin has fallen slightly from 40% to 37%, but there has been a corresponding slight fall in operating expenses, from 21.2% of sales to 19% of sales.

The decrease in earnings per share has arisen, not because the company is less profitable, but because there has been a substantial issue of new shares. It appears that the company has used the extra capital to finance the acquisition of a large intangible asset and possibly also additional tangible non-current assets.

In theory, these new assets should eventually generate increased profits and cause EPS to return to a higher level. However, this is not yet happening. Return on shareholders’ equity (which measures the profit available for equity shareholders as a proportion of their investment) has fallen from 52.7% to 20.2%. As the company’s profitability has remained the same throughout the period, the company must be generating relatively less revenue from its assets than before. This is confirmed by the fact that the asset turnover ratio has fallen from 2.3 times to 1.4 times, showing that A is now only generating $1.40 of revenue for every $1 of capital employed.

Workings: Ratios

20X8 20X7

Gross profit percentage

Revenue

profit Gross

10,000

3,700 100% = 37%

8,500

3,400 100% = 40%

Net profit percentage

Revenue

after taxProfit

10,000

1,030 100% = 10.3%

8,500

880 100% = 10.3%

Operating expenses/sales

Revenue

expenses Operating

10,000

1,900 100% = 19%

8,500

1,800 100% = 21.2%



Return on shareholders’ equity

funds rs'Shareholde

after taxProfit

5,100

1,030 100% = 20.2%

1,670

880 100% = 52.7%

Asset turnover

employed Capital

Revenue

7,100

10,000 = 1.4 times

3,670

8,500 = 2.3 times

(c) The relevance of earnings per share

Earnings per share (EPS) is regarded as a key measure of a company’s performance and is also used to calculate the price earnings ratio. The price earnings ratio (P/E ratio) measures the market price of a share in relation to its EPS and is used as an indicator of market confidence in a company. Both EPS and the P/E ratio may be used to compare the performance of similar companies for the purpose of making investment decisions.

To some extent, EPS influences the market price of a share. However, it has several important limitations as a performance measure. It may be based on earnings which include large or unusual items, so that it becomes volatile, making it difficult for users of the financial statements to assess underlying trends in performance. It does not take account of inflation. Most importantly, it only measures profitability, although there are many other aspects of financial performance. For example, A has become less profitable, but also less risky as an investment, as net current liabilities (2,290 – 2,320) have become net current assets (2,900 – 2,800) and gearing has fallen from 54% to 28% (W).

In conclusion, the market price of a share is influenced by many different factors, including the strength of the company’s statement of financial position, its cash flows, its ability to compete with other businesses, and its ability to adapt to changing economic conditions.

Workings

20X8 20X7

Gearing

employed Capital

loans term-Long

7,100

2,000 100% = 28%

3,670

2,000 100% = 54%



EARNIT

Key answer tips

Make sure that you can both do the calculations and discuss their relevance for investors.

(a) Earnings per share for the year ended 31 March 20Y0

Basic: 525m

$34m = 6.48 cents

Diluted: 552.5m

$34m = 6.15 cents

Workings

(W1) Weighted average number of ordinary shares in issue

Date No. of shares in issue Weighted average (million) (million)

1 April – 30 September 500 6/12 250

1 October – 31 March (500 + 50 re

exercised options) 6/12

275

________

525 ________

(W2) Weighted average number of potential ordinary shares

Million Million

Weighted average number of ordinary shares in issue (W1) 525.0

Number of shares under option:

1 April – 30 September (100 6/12) 50.0

1 October – 31 March ((100 – 50 + 70) 6/12) 60.0 ________

110.0

Number of shares that would have been issued at fair value

(110 1.50 subscription price/2.00 average market price) (82.5) ________

27.5 ________

552.5 ________

(b) The usefulness of basic and diluted earnings per share to an equity shareholder

Basic earnings per share measures the earnings (profit) in relation to each equity share and is regarded as a key measure of performance.

IAS 33 Earnings per share sets out the method of calculation and required disclosures. Therefore shareholders can compare the return on their investment for the current period with previous periods. Shareholders can also compare the earnings underlying their investment with the earnings underlying investments in similar entities.

Earnings per share is used to calculate the price earnings ratio, which represents the market’s view of the future prospects of a share. The price earnings ratio enables shareholders to judge the cost of a share relative to the earnings that it produces.



Diluted earnings per share alerts equity shareholders to the possibility that there may be additional equity shares in future periods as the result of the exercise of existing capital instruments such as options and warrants. If this is the case, their earnings per share may be reduced. This applies to Earnit, which has issued options for shares which are likely to be exercised (because the shares can be subscribed for below the current market price). Diluted earnings per share shows the earnings per share if all the options were exercised. This is 5.1% ((6.48 – 6.15) as % of 6.48) lower than basic earnings per share and this indicates that there is a small risk associated with the shares.

The usefulness of earnings per share may be limited by the following factors:

(i) It is not necessarily a predictor of future earnings per share because it is based on historical information. It only measures past performance. This also applies to diluted earnings per share as calculated in accordance with IAS 33 and for this reason it is only of limited use as a ‘warning signal’.

(ii) The profits figure is affected by an entity’s choice of accounting policies. Therefore it may not always be appropriate to compare the earnings per share of different companies.

(iii) It does not take account of inflation. Apparent growth in profits may not be true growth.

(iv) It only measures profitability, which is only one aspect of overall performance. In the longer term, cash flow, gearing and working capital management may be equally important influences on the return on an equity investment.



NON-CURRENT ASSETS

INFORMED

Tutorial note:

A straightforward question about revaluation of non-current assets. Part (a) requires a discussion of the advantages and disadvantages. Part (b) requires simple calculations and should represent easy marks.

(a) REPORT

To: Director, Informed


Subject: Arguments for and against revaluation

Date: 20 May 20X8

The main arguments for carrying non-current assets at revalued amounts centre around the drawbacks of recording assets at their historical cost. Although historical cost accounting reflects the resources given up to acquire the assets, it has many disadvantages in a time of rising prices, the main one being that the statement of financial position fails to reflect the current value of a company’s assets. This means that shareholders are not informed of any holding gains that may have arisen, despite the fact that such increases in asset values may contribute significantly to a company’s overall performance. Users of the financial statements may not be aware of the true amount of capital employed in the organisation, and this may mean that it is vulnerable to take-over bids.

A further problem is that historical cost accounting tends to overstate profits. Profit should only be measured after sufficient resources have been set aside to maintain the capital employed in the business. Revaluation of non-current assets in periods of rising prices produces a more realistic profit figure because it results in a higher depreciation charge. Although depreciation is not primarily a means of setting aside funds to replace assets, depreciation based on current values helps to ensure that distributions to shareholders are at a level which maintains the operating capability of the business at current price levels.

Non-current assets are normally acquired at different times, so costs representing different amounts of purchasing power are added together. The real meaning of the total figure is difficult to determine.

The main disadvantage of revaluing assets is that valuation is subjective. It may also be costly. There are several possible bases for valuation. One possibility is replacement cost (sometimes called ‘entry value’), another is net realisable value (or ‘exit value’). Replacement cost is not appropriate for non-current assets that will not be replaced, and net realisable value is not appropriate when there is no intention to sell the asset. Economic value (sometimes called value in use) is another alternative, but this involves calculating the present value of future income streams arising from use of the asset – a difficult and subjective process. Many commentators favour the use of ‘fair value’, which is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.

Another practical problem is determining the frequency with which revaluation takes place. If assets are carried at a valuation, but this valuation is not kept up to date, it can be argued that the financial statements are even less meaningful than those which are based on historical cost.



At present, it is possible for entities to carry some classes of assets at a valuation, while carrying others at historical cost. This has some practical advantages, and may provide useful information to users of the financial statements, but in many cases it may simply cause confusion.

(b) (i) Income statement charges

Depreciation charge

Carrying amount

$ $

1 May 20X8 Asset purchase $40,000

Year ended 30 April:

20X9 5,000

20Y0 5,000

20Y1 5,000

20Y2 5,000

20Y3 5,000 15,000

30 April 20Y3 Revaluation to $18,000

Year ended 30 April:

20Y4 6,000

20Y5 6,000 6,000

IAS 16 Property, Plant and Equipment requires the cost of the asset (less any residual value) to be allocated to the accounting periods in which it is expected to be available for use. The useful life is set at 8 years and depreciation is charged on a straight line

basis. This gives an annual depreciation charge of $5,000 (40,000 8).

From 1 May 20Y3 onwards, the depreciation charge must be based on the revalued amount (the carrying amount) as required by IAS 16. As the remaining useful economic life of the plant is 3 years, the annual depreciation charge is $6,000 (18,000

3).

(ii) Treatment of revaluation

When the asset is revalued the revaluation surplus of $3,000 (18,000 – 15,000) is not taken to the income statement but reported as part of equity (taken to a revaluation reserve). IAS 1 Presentation of Financial Statements requires this to be presented in a statement of recognised gains and losses or a statement of changes in equity.

(iii) Gain on sale

IAS 16 requires the income statement gain or loss on the disposal of a non-current asset to be calculated as the proceeds less the carrying amount of the asset at the time of disposal, whether based on historical cost or on a valuation.

$

Sale proceeds 7,500

Less: Carrying amount at 30 April 20Y6 (6,000) _____

Profit on sale 1,500 _____

Tutorial note:

Any part of the original $3,000 revaluation surplus still carried in revaluation reserve should now be transferred to retained earnings, the transfer being presented in the statement of changes in equity.



LAND AND BUILDINGS

(a) IAS 16 requires the cost, less residual value, of property, plant and equipment (PPE) to be depreciated over its useful life. This is so even if the item is revalued. In principle land and buildings (property) are no different from plant and equipment, but:

in most cases land has an indefinite life and is therefore not depreciated;

buildings often have very long lives and thus have low depreciation rates;

certain types of buildings e.g. major institutions open to the public, are maintained by the business so that they do not 'wear out'. In such cases the buildings should still be depreciated. The only exception is if the carrying amount is less than its residual value, in which case there is nothing to depreciate;

due to their long lives it is quite common for land and buildings to be periodically revalued.

IAS 40 allows a choice of accounting treatments for investment properties:

the cost model, as set out in IAS 16; or

the fair value model, measuring the properties in the statement of financial position at fair value and recognising changes in fair value in the income statement.

(b) The key difference between properties held for their investment potential and those used within the business by their owners is the different purpose for which each type was originally acquired. IAS 40 considers that a different treatment is required for investment properties because:

the assets are not consumed in the business operations;

the disposal of the assets would not materially affect any manufacturing or trading operations;

knowledge of the fair value of the assets is of greater relevance to the user of the accounts;

disclosure of the changes in the fair value provides information about how successful management has been in achieving its objective.

(c) Accrual basis

Revaluation recognises gains or losses (arising from changes in value) in the accounting period in which they occur, not in the period in which the asset is ultimately sold for cash. This is fully compatible with the accrual basis.

Going concern

Under the going concern assumption the business will continue in operation for the foreseeable future, so assets and liabilities should be measured on the basis that there is no need to sell/settle them any sooner than normal. Fair value is the amount at which the asset could be exchanged in an arm's length transaction, which approximates to realisable value. There is therefore some conflict between periodic revaluation and going concern.

Relevant information

Revaluation provides much more relevant information than does the cost model. Even if the business will continue in operation, the fair value of land and buildings provides useful information as to the ability of a business to borrow on secured terms.



Reliable information

Revaluation to fair value is based on a hypothetical arm's length transaction, i.e. one which has not actually taken place. Two different people can justifiable come up with different amounts for fair value, because they are both making estimates. The information provided is therefore less reliable than that under the cost based approach.



HAMILTON

Key answer tips

(a) IAS 8 – consistency; changes only required by a new accounting standard or to give reliable and more relevant information to users; errors must be corrected.

(b) IAS 40 – falls charged to income; IAS 16 – cost less depreciation; IAS 8 – restate comparatives.

(a) IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires financial statements to be comparable over a period of time through the consistent application of accounting policies. However there are circumstances where the principle of consistency should be departed from:

a new accounting standard may render a previous accounting policy no longer appropriate/acceptable

if the change will result in a reliable and more relevant presentation of events and transactions.

Hamilton is proposing to change the statement of financial position classification of an asset, from an investment property (governed by IAS 40) to a normal non-investment property (governed by IAS 16). This is not as a result of a new standard coming into effect and no information is provided which would justify the conclusion that the IAS 16 approach would provide reliable and more relevant information. So the change could not be made as a change of accounting policy.

But it would seem that the office block never qualified as an investment property in the first place, since the company is occupying the top two floors for its own purposes and the remainder is available for let under short term leases. So, regardless of the expected fall in property prices, the office block should be accounted for under IAS 16.

The change in classification would be the result of the correction of an error, not a change of accounting policy. IAS 8 requires errors to be corrected as soon as they are discovered.

(b) (i) Continued classification as an investment:

The fall of $900,000 (to $2.7m) in the year to 31 March 20X8 should be recognised in the income statement as shown below:

20X8 20X7 $000 $000

Income statement:

Profit before revaluation loss (20X7 includes revaluation gain of $400)

180

300

Revaluation loss on investment (900) _____

− _____

Profit/(loss) for year (720) 300

Retained earnings b/f 410 _____

110 _____

Retained profit/(accumulated losses) c/f (310) _____

410 _____

Statement of financial position:

Investment property (3,600 − 900) 2,700 3,600

Retained earnings/(accumulated losses) (310) 410



(ii) Reclassification as property, plant and equipment:

The reclassification is required as the correction of an error and IAS 8 requires the company to restate the financial statements as soon as the error is detected. This involves restating the comparative figures, including the retained earnings brought forward at the start of 20X7.

The changes required are:

to reduce the retained earnings brought forward into 20X7 by the $200,000 ($3.2m valuation – $3.0m cost) revaluation gain arising in 20X6 and the depreciation charge of $120,000 ($3.0m/25), a total of $320,000. The $110,000 current retained earnings are adjusted to accumulated losses of $210,000

to reduce the 20X7 profit for the year by the $400,000 ($3.6m valuation – $3.2m valuation) revaluation gain arising in 20X6 and the depreciation charge of $120,000, a total of $520,000. The $300,000 current profit is adjusted to a loss of $220,000

to reduce the 20X8 draft profit (currently $180,000) by the depreciation charge of $120,000. The $180,000 current profit is adjusted to $60,000.

20X8 20X7 (restated) $000 $000

Income statement:

Profit/(loss) for year 60 (220) _____

Retained earnings b/f − 110

Prior period adjustment − (320) _____

Restated accumulated losses b/f (430) _____

(210) _____

Accumulated losses c/f (370) _____

(430) _____

Statement of financial position:

Property, plant and equipment at cost 3,000 3,000

Accumulated depreciation (360) _____

(240) _____

2,640 _____

2,760 _____

Accumulated losses (370) _____

(430) _____

The investment property presentation shows higher past profits and higher past capital employed, but a large loss in 20X8 and accumulated losses carried forward, with the carrying amount of the property sharply reduced.

The property, plant and equipment presentation shows past losses (the substantial revaluation profits recognised in 20X7 and earlier having masked trading losses) and lower past capital employed, but a small trading profit in the current year; the year end carrying amount is, by coincidence, much the same as under the investment property presentation.



IFRS 5

A

MEMORANDUM

To: Board of Directors

From: Chief Accountant

Subject: Discontinued operations and closure/restructuring programme

Date: 29 February 20X6

(a) The definitions

IFRS 5 defines a discontinued operation as a component of an entity that either has been disposed of, or is classified as held for sale, and:

(i) represents a separate major line of business or geographical area of operations;

(ii) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations; or

(iii) is a subsidiary acquired exclusively with a view to resale.

IAS 37 requires provisions for restructuring to be recognised when there is an obligation, legal or constructive, to carry through the restructuring. A constructive obligation only arises when an entity:

(i) has a detailed formal plan for the restructuring identifying the businesses concerned, the employees affected, the expenditures involved and the implementation timetable; and

(ii) raises a valid expectation in those affected that it will carry out the plan, either by commencing implementation or announcing its features to those affected.

(b) Accounting treatment of decisions taken on 30 November 20X5

(i) Closure of Spaghetti division

Prior to the end of the financial year, the closure has been fully planned and announced to the workforce affected. In the 20X5 financial statements:

the results of the Spaghetti division should be included in continuing operations. As the divisions is being closed down rather than sold, it does not meet the IFRS 5 definition of a discontinued operation until it is finally closed, i.e. on 15 March 20X6 (it will be disclosed as discontinued in the 20X6 financial statements);

the freehold factory and distribution centre were put up for sale on 15 December 20X5, on which date they meet the IFRS 5 definition of non-current asserts held for sale because they have been put on the market and the sale is expected to be competed well within 12 months from that date.

These two freehold should be measured at the lower of carrying amount and fair value less costs to sell, with any write-down being separately disclosed in the income statement. No further depreciation should be charged. In the statement of financial position they should be included as a separate line below current assets.



as the closure plan has been communicated to the affected workforce, there is a constructive obligation to close the division. Provisions should therefore be recognised under IAS 37 for all the expenditures to be incurred up to the date of closure which are directly attributable to the restructuring

because the closure will be completed before the financial statements are formally approved, the closure programme ranks as a non-adjusting event after the statement of financial position date and full disclosure should be made in the notes to the 20X5 financial statements.

(ii) Restructuring of Beans division

As this relates to A's continuing business, the costs involved will never rank for disclosure as discontinued operations.

Costs will be incurred as a result of the decision to reduce staffing levels and extensive negotiations with workers representatives regarding redundancy packages have taken place. But these negotiations do not amount to communication with the affected workforce, so no constructive obligation arises prior to 15 January 20X6. No provisions should be recognised in 20X5.

Because the restructuring will be completed before the financial statements are formally approved, it ranks as a non-adjusting event after the statement of financial position date and full disclosure should be made in the notes to the 20X5 financial statements.



CASH FLOW STATEMENTS

CASINO (a) Statement of cash flows of Casino for the Year to 31 March 20X5:

$m $m Cash flows from operating activities Operating loss (32) Adjustments for: Depreciation – buildings (W1) 12 – plant (W2) 81 – intangibles (510 – 400) 110 Loss on disposal of plant (from question) 12 215 ––––– –––––

Operating profit before working capital changes 183 Decrease in inventory (420 – 350) 70 Increase in trade receivables (808 – 372) (436) Increase in trade payables (530 – 515) 15 –––––

Cash generated from operations (168) Interest paid (18) Income tax paid (W3) (81) –––––

Net cash used in operating activities (267) Cash flows from investing activities Purchase of – land and buildings (W1) (110) – plant (W2) (60) Sale of plant (W2) 15 Interest received (12 – 5 + 3) 10 –––––

Net cash used in investing activities (145) Cash flows from financing activities Issue of ordinary shares (100 + 60) 160 Issue of 8% variable rate loan 160 Repayments of 12% loan (150 + 6 penalty) (156) Dividends paid (25) –––––

Net cash from financing activities 139 –––––

Net decrease in cash and cash equivalents (273) Cash and cash equivalents at beginning of period (120 + 75) 195 –––––

Cash and cash equivalents at end of period (125 – (32 + 15)) (78) –––––

Interest and dividends received and paid may be shown as operating cash flows or as investing or financing activities as appropriate.



Workings (in $ million)

(W1) Land and buildings

Net book value b/f 420

Revaluation gains 70

Depreciation for year (balance after revaluation) (12)

Net book value c/f (588) –––––

Difference is cash purchases (110) –––––

(W2) Plant:

Cost b/f 445 Additions from question 60 Balance c/f (440)

––––– Difference is cost of disposal 65 Loss on disposal (12) Proceeds (15)

––––– Difference accumulated depreciation of plant disposed of

38 –––––

Depreciation b/f 105 Less – disposal (above) (38) Depreciation c/f (148)

––––– Charge for year (81)

–––––

(W3) Taxation:

Tax provision b/f (110)

Deferred tax b/f (75)

Statement of comprehensive income net charge (1)

Tax provision c/f 15

Deferred tax c/f 90 –––––

Difference is cash paid (81) –––––

(W4) Revaluation reserve:

Balance b/f 45

Revaluation gains 70

Transfer to retained earnings (3) –––––

Balance c/f 112 –––––



(W5) Retained earnings:

Balance b/f 1,165

Loss for period (45)

Dividends paid (25)

Transfer from revaluation reserve 3 –––––

Balance c/f 1,098 –––––

(b) The accruals/matching concept applied in preparing an statement of comprehensive income has the effect of smoothing cash flows for reporting purposes. This practice arose because interpreting ‘raw’ cash flows can be very difficult and the accruals process has the advantage of helping users to understand the underlying performance of a company. For example if an item of plant with an estimated life of five years is purchased for $100,000, then in the statement of cash flows for the five year period there would be an outflow in year 1 of the full $100,000 and no further outflows for the next four years. Contrast this with the statement of comprehensive income where by applying the accruals principle, depreciation of the plant would give a charge of $20,000 per annum (assuming straight-line depreciation). Many would see this example as an advantage of a statement of comprehensive income, but it is important to realize that profit is affected by many items requiring judgements. This has led to accusations of profit manipulation or creative accounting, hence the disillusionment of the usefulness of the statement of comprehensive income.

Another example of the difficulty in interpreting cash flows is that counter-intuitively a decrease in overall cash flows is not always a bad thing (it may represent an investment in increasing capacity which would bode well for the future), nor is an increase in cash flows necessarily a good thing (this may be from the sale of non-current assets because of the need to raize cash urgently).

The advantages of cash flows are:

– it is difficult to manipulate cash flows, they are real and possess the qualitative characteristic of objectivity (as opposed to profits affected by judgements).

– cash flows are an easy concept for users to understand, indeed many users misinterpret statement of comprehensive income items as being cash flows.

– cash flows help to assess a company’s liquidity, solvency and financial adaptability. Healthy liquidity is vital to a company’s going concern.

– many business investment decisions and company valuations are based on projected cash flows.

– the ‘quality’ of a company’s operating profit is said to be confirmed by closely correlated cash flows. Some analysts take the view that if a company shows a healthy operating profit, but has low or negative operating cash flows, there is a suspicion of profit manipulation or creative accounting.



PLANTER

Statement of cash flows – Planter for the year to 31 March 20X4 $ $

Cash flows from operating activities

Operating profit (per question) 15,600

Adjustments for:

Depreciation – buildings (W1) 1,800

– plant (W2) 26,600

––––– 28,400

Loss on sale of plant (W1) 4,200

Decrease in inventory (57,400 – 43,300) 14,100

Increase in receivables (50,400 – 28,600) (21,800)

Decrease in payables (31,400 – 26,700) (4,700)

–––––

Cash generated from operations 35,800

Interest paid (1,700 – 300 accrued) (1,400)

Income tax paid (8,900 + 1,100) (10,000)

–––––

Net cash from operating activities 24,400

Cash flows from investing activities

Purchase of plant (W1) (38,100)

Purchase of land and buildings (W1) (7,100)

Investment income 400

Sale of plant (W1) 7,800

Sale of investments 11,000

Net cash used in investing activities ––––– (26,000)

Cash flows from financing activities

Issue of ordinary shares (W2) 28,000

Redemption of 8% loan notes (3,400)

Ordinary dividend paid (26,100)

Net cash used in financing activities ––––– (1,500)

–––––

Net decrease in cash and cash equivalents (3,100)

Cash and cash equivalents at 1 April 20X3 1,200

–––––

Cash and cash equivalents at 31 March 20X4 (1,900)

–––––



Workings

(W1) Non-current assets:

$

Land and buildings

Valuation b/f 49,200

Revaluation surplus (18,000 – 12,000) 6,000

Acquisitions – balancing figure 7,100

––––––

Valuation c/f 62,300

––––––

Depreciation b/f 5,000

Charge for year – balancing figure 1,800

––––––

Depreciation c/f 6,800

––––––

Plant

Cost b/f 70,000

Disposals at cost (23,500)

Acquisitions – balancing figure 38,100

––––––

Cost c/f 84,600

––––––

Depreciation b/f 22,500

Disposals (11,500)

Charge for year – balancing figure 26,600

––––––

Depreciation c/f 37,600

––––––

Disposal of plant:

Net book value 12,000

Proceeds from question (7,800)

––––––

Loss on sale 4,200

––––––



(W2) Share capital and share premium:

Ordinary shares b/f 25,000

Bonus issue 1 for 10 (from share premium) 2,500

Ordinary shares c/f (50,000)

––––––

Difference issue for cash 22,500

––––––

Share premium b/f 5,000

Bonus issue (2,500)

Share premium c/f (8,000)

––––––

Increase is premium on cash issue 5,500

––––––

Total proceeds of issue is (22,500 + 5,500) 28,000

––––––

(W3) Reconciliation of revaluation reserve

Balance b/f 12,000

Difference revaluation of land 6,000

––––––

Balance c/f 18,000

––––––



MNO PLC

Tutorial notes:

You will have to prepare a taxation account to calculate the tax paid figure and workings to calculate additions to property, plant and equipment. When dealing with the movement on share premium account don't forget to deal with the loss on redemption of loans.

Cash flow statement for MNO plc for the year ended 31 March 20X2

$000 $000

Cash flows from operating activities

Operating profit 1,876

Adjustment for:

Depreciation (net of profit on sale of non-current assets) 700

Loss on sale of investments (100 − 94) 6 _____

Operating profit before working capital changes 2,582

Increase in inventories (3,200 − 2,000) (1,200)

Increase in receivables (2,400 − 2,000) (400)

Increase in trade payables (1,200 − 1,000) 200 _____

Cash generated from operations 1,182

Interest paid (per IS) (320)

Tax paid (W1) (596) _____

Net cash from operating activities 266


Purchase of intangibles (per IS) (300)

Purchase of property, plant and equipment (W2) (1,600)

Proceeds of sale of property, plant and equipment 250

Purchase of non-current asset investments (400 − 200) (200)

Proceeds of sale of current asset investments 94

Interest received (per IS) 50 _____

Net cash used in investing activities (1,706)


Issue of shares (3,000 − 2,000 + 278 (W4) 1,278

Repayment of loans (400)

Equity dividends paid (400) _____

Net cash from financing activities 478 _____

Decrease in cash and cash equivalents (962)

Cash and cash equivalents at 1 April 20X1 480 _____

Cash and cash equivalents at 31 March 20X2 (514 − 32) (482) _____



Workings

(W1)

Tax

$000

Bal c/d 520

Paid (bal fig) 596 ____

1,116 ____

$000

Bal b/d 466

Income statement 650 ____

1,116 ____

(W2)

Property, plant and equipment (carrying amount)

$000

Balance b/d 1,600

Revaluation 1,000

Additions (bal fig) 1,600 ____

4,200 ____

$000

Disposal 100

Depreciation (W3) 650

Balance c/d 3,450 ____

4,200 ____

(W3) Depreciation on property, plant and equipment

$000

Depreciation charge (per IS) 700

Add: Profit on sale 150

Less: Depreciation of intangibles (400 − 200) (200) ___

Re PPE 650 ___

(W4)

Share premium

$000

Discount on loan 20

Bal c/d 858 ____

878 ____

$000

Bal b/d 600

Cash from new issue 278 ____

878 ____



LADWAY

Key answer tips

In part (b), your answer should discuss both relevance and usefulness. Notice the way in which the answer is structured in two parts.

(a) Cash flow statement of Ladway for the year to 31 March 20X8

Cash flows from operating activities $m $m

Net profit before interest and income tax 583

Adjustments for:

Depreciation of property, plant and equipment 366

Impairment of goodwill 36

Profit on disposal of plant (14 − 11) (3) ___

399

Government grants (50)

Non-cash environmental provision (67 − 15) (W1) 52 ___

984

Increase in inventories (920 – 763) (157)

Increase in trade receivables (642 – 472) (170)

Increase in trade payables (680 – 518) 162 ___

Cash generated from operations 819

Interest paid (12 – 4 accrued) (8)

Income taxes paid (W2) (164)

Dividends paid (35 + 180 + 40) (255) ___

Net cash from operating activities 392


Purchase of property, plant and equipment (W3) (723)

Receipt of government grant (W4) 110

Purchase of goodwill (450 − (410 − 36)) (76) ___

Net cash used in investing activities (689)


Proceeds from issue of share capital (W5) 120

Proceeds from long-term borrowings (W6) 80 ___

Net cash received from financing activities 200 ___

Net decrease in cash and cash equivalents (97)

Cash and cash equivalents at beginning of period 34 ___

Cash and cash equivalents at end of period (63) ___



Workings

$m

(W1) Environmental provision

Balance b/f 24

Income statement charge 67 _____

91

Balance c/f (76) _____

Cash payments during year 15 _____

(W2) Income taxes

Income tax provision b/f 185

Deferred tax b/f 30

Income statement charge 177

Income tax provision c/f (176)

Deferred tax c/f (52) _____


(W3) Property, plant and equipment

Balance b/f 1,830

Revaluation surplus 170

Trade in allowance (non-cash) 14

Plant acquired in exchange for loan note 120

Depreciation (366)

Disposal at book value (11)

Balance c/f (2,480) _____


(W4) Government grant

Balances b/f − current 40

− long-term 160

Income statement credit (50)

Balances c/f − current (50)

− long-term (210) _____

Cash receipts during year 110 _____



(W5) Share capital

Equity capital b/f 400

Bonus issue (from share premium) 40

Difference issue for cash 60 _____

Equity capital c/f 500 _____

Share premium b/f 70

Bonus issue (40) _____

30

Difference premium on issue of equity 60 _____

Share premium c/f 90 _____

Total cash proceeds of issue (60 + 60) 120 _____

(W6) Loan note

Total value issued 200

Exchanged for plant (non-cash) (120) _____

Cash receipts during year 80 _____

(b) The separate disclosure of cash flows relating to the maintenance of operating capacity is useful in enabling the user to determine whether the entity is investing adequately in the future of the entity. Without such investment, which is often capped when entities are under liquidity pressures, the entity’s future prosperity is threatened. The disclosure of cash flows representing increases in operating capacity adds to the information regarding the continued success of the entity. Prospective investors are much more likely to be attracted to entities that are expanding than those which are merely maintaining their current levels of operations. The cash flow statement also shows how these investing activities are being financed: by generating excess cash from operations, by raising loans or by issuing new equity.

The disclosure of cash flow information relating to industry and geographical segments of a entity supplements the information in other parts of the financial statements relating to segments, and in many ways has the same usefulness:

the ultimate success of the entity as a whole is a function of the success of its individual components. It is not usually possible to appreciate the financial position of a diversified business without information relating to its individual segments;

a change in the cash flows of a significant component of the business (say if it is going to be sold) may have considerable impact on the cash flows of the business as a whole. Without segmental cash flows users could not assess the impact of a (segment) disposal;

segmental cash flows provide users with information on the relative size, growth, future prospects and cash generating capacity of the different industries and geographical areas of the business.



PUBLISHED FINANCIAL STATEMENTS

TADEON

Key answer tips

Most of the work for this question is done in the statement of comprehensive income and the adjustments there lead through to the statement of financial position. So make sure that when you make an adjustment in the statement of comprehensive income that you also remember to adjust the appropriate statement of financial position figures.

(a) Tadeon – Statement of comprehensive income – Year to 30 September 20X6

$000 $000

Revenue 277,800

Cost of sales (w (i)) (144,000)

–––––––

Gross profit 133,800

Operating expenses (40,000 + 1,200 (w (ii))) (41,200)

Investment income 2,000

Finance costs – finance lease (w (ii)) (1,500)

– loan (w (iii)) (2,750) (4,250)

––––––– –––––––

Profit before tax 90,350

Income tax expense (w (iv)) (36,800)

–––––––

Profit for the period 53,550

Other comprehensive income

Gain on property revaluation (20,000 – 4,000 (w (v))) 16,000

–––––––

69,550

–––––––

(b) Tadeon – Statement of financial position as at 30 September 20X6

Non-current assets $000 $000

Property, plant and equipment (w (v)) 299,000

Investments at amortized cost 42,000

–––––––

341,000

Current assets

Inventories 33,300

Trade receivables 53,500 86,800

––––––– –––––––



Total assets 427,800

–––––––

Equity and liabilities

Capital and reserves:

Equity shares of 20 cents each fully paid (150,000 + 50,000 w (vi)) 200,000

Reserves

Share premium (w (vi)) 28,000

Revaluation reserve (w (v)) 16,000

Retained earnings (w (vii)) 42,150 86,150

––––––– –––––––

286,150

Non-current liabilities

2% Loan note (w (iii)) 51,750

Deferred tax (w (iv)) 14,800

Finance lease obligation (w (ii)) 10,500 77,050

–––––––

Current liabilities

Trade payables 18,700

Finance lease obligation (w (ii)) 6,000

Bank overdraft 1,900

Income tax payable (w (iv)) 38,000 64,600

––––––– –––––––

Total equity and liabilities 427,800

–––––––

Workings (note figures in brackets are in $000)

(i) Cost of sales: $000

Per trial balance 118,000

Depreciation (12,000 + 5,000 + 9,000 w (v)) 26,000

–––––––

144,000

–––––––

(ii) Vehicle rentals/finance lease:

The total amount of vehicle rentals is $6.2 million of which $1.2 million are operating lease rentals and $5 million is identified as finance lease rentals. The operating rentals have been included in operating expenses.

Finance lease $000

Fair value of vehicles 20,000

First rental payment – 1 October 20X5 (5,000)

––––––

Capital outstanding to 30 September 20X6 15,000

Accrued interest 10% (current liability) 1,500

––––––

Total outstanding 30 September 20X6 16,500

––––––



In the year to 30 September 20X7 (i.e. on 1 October 20X6) the second rental payment of $6 million will be made, of this $1.5 million is for the accrued interest for the previous year, thus $4.5 million will be a capital repayment. The remaining $10.5 million (16,500 – (4,500 + 1,500)) will be shown as a non-current liability.

(iii) Although the loan has a nominal (coupon) rate of only 2%, amortization of the large premium on redemption, gives an effective interest rate of 5.5% (from question). This means the finance charge to the statement of comprehensive

income will be a total of $2.75 million (50,000 5.5%). As the actual interest paid is $1 million an accrual of $1.75 million is required. This amount is added to the $50 million carrying amount of the loan in the statement of financial position to give a liability of $51.75 million.

(iv) Income tax and deferred tax

The statement of comprehensive income charge is made up as follows:

$000

Current year’s provision 38,000

Deferred tax (see below) (1,200)

––––––

36,800

––––––

There are $74 million of taxable temporary differences at 30 September 20X6. With an income tax rate of 20%, this would require a deferred tax liability of $14,8 million

(74,000 20%). $4 million ($20m 20%) is in respect of the revaluation of the leasehold property (and recognized within other comprehensive income and then debited to the revaluation reserve), thus the effect of deferred tax on profit or loss is a credit of $1.2 million (14,800 – 4,000 – 12,000 b/f).

(v) Non-current assets/depreciation:

Non-leased plant

This has a carrying amount of $96 million (181,000 – 85,000) prior to depreciation of $12 million at 12½% reducing balance to give a carrying amount of $84 million at 30 September 20X6.

The leased vehicles will be included in non-current assets at their fair value of $20 million and depreciated by $5 million (four years straight-line) for the year ended 30 September 20X6 giving a carrying amount of $15 million at that date.

The 25 year leasehold property is being depreciated at $9 million per annum (225,000/25 years). Prior to its revaluation on 30 September 20X6 there would be a further year’s depreciation charge of $9 million giving a carrying amount of $180 million (225,000 – (36,000 + 9,000)) prior to its revaluation to $200 million.Thus $20 million would be transferred to a revaluation reserve.The question says the revaluation gives rise to $20 million of the deductible temporary differences, at a tax rate of 20%, this would give a credit to deferred tax of $4 million which is recognized within other comprehensive income and then debited to the revaluation reserve to give a net balance of $16 million.



Summarising:

Cost/valuation Accumulated depreciation

Carrying amount

$000 $000 $000

25 year leasehold property 200,000 nil 200,000

Non-leased plant 181,000 97,000 84,000

Leased vehicles 20,000 5,000 15,000

––––––– ––––––– –––––––

401,000 102,000 299,000

––––––– ––––––– –––––––

(vi) Suspense account

The called up share capital of $150 million in the trial balance represents 750 million shares (150m/0.2) which have a market value at 1 October 20X5 of $600 million (750m × 80 cents). A yield of 5% on this amount would require a $30 million dividend to be paid.

A fully subscribed rights issue of one new share for every three shares held at a price of 32c each would lead to an issue of 250 million (150m/0.2 × 1/3).This would yield a gross amount of $80 million, and after issue costs of $2 million, would give a net receipt of $78 million.This should be accounted for as $50 million (250m × 20 cents) to equity share capital and the balance of $28 million to share premium.

The receipt from the share issue of $78 million less the payment of dividends of $30 million reconciles the suspense account balance of $48 million.

(vii) Retained earnings

$000

At 1 October 20X5 18,600

Year to 30 September 20X6 53,550

less dividends paid (w (vi)) (30,000)

–––––––

42,150

–––––––



CHAMBERLAIN

Key answer tips

The main complication is for the construction contract. This construction contract started at the beginning of the current year, so there are no balances b/f.

(a) Chamberlain – Statement of comprehensive income – Year to 30 September 20X4

$000

Revenue (246,500 + 50,000 (W1) 296,500

Cost of sales (W2) (151,500)

–––––––

Gross profit 145,000

Operating expenses (29,000)

–––––––

Profit before interest and tax 116,000

Interest expense (1,500 + 1,500 accrued) (3,000)

–––––––


Income tax (22,000 – (17,500 – 14,000)) (18,500)

–––––––


–––––––

(b) Chamberlain – Statement of financial position as at 30 September 20X4

Non-current assets $000 $000

Property, plant and equipment (W3) 442,000

Intangible assets (40,000 – 25,000) 15,000

–––––––

457,000

Current assets

Inventory 38,500

Amounts due from construction contracts (W1) 25,000

Trade receivables 48,000

Bank 12,500 124,000

––––––– –––––––

Total assets 581,000

–––––––




Ordinary share capital 200,000

Retained profits – 1 October 20X3 162,000

– Year to 30 September 20X4 94,500

Less dividends paid (8,000) 248,500

––––––– –––––––

448,500

Non-current liabilities (W4) 64,000

Current liabilities


Accrued finance costs 1,500

Taxation 22,000 68,500

––––––– –––––––

Total equity and liabilities 581,000

–––––––

Workings (all figures in $000)

(W1) Construction contract: $000

Contract price 125,000

Estimated cost (75,000)

––––––

Estimated total profit 50,000

––––––

Contract cost for year (35,000 – 5,000 inventory on site) 30,000

Estimated cost 75,000

Percentage complete (30,000/75,000) 40%

Year to 30 September 20X4

Contract revenue – included in sales (125,000 40%) 50,000

Contract costs – included in cost of sales (35,000 – 5,000) (30,000)

Amounts due from customers:

Cost to date plus profit taken (35,000 + 20,000) 55,000

Less progress billings received (30,000)

––––––

25,000

––––––

(W2) Cost of sales:

Opening inventory 35,500

Purchases 78,500

Contract costs (W1) 30,000

Research costs 25,000

Depreciation (W3) – buildings 6,000

D – plant 15,000

Closing inventory (38,500)

––––––

151,500



(W3) Non-current assets/depreciation:

Buildings:

A cost of $240,000 (403,000 – 163,000 for the land) over a 40 year life gives annual depreciation of $6,000 per annum.

This gives accumulated depreciation at 30 September 20X4 of $66,000 (60,000 + 6,000) and a net book value of $337,000 (403,000 – 66,000).

Plant:

The carrying value prior to the current year’s depreciation is $120,000 (180,000 – 60,000). Depreciation at 12.5% on the reducing balance basis gives an annual charge of $15,000. This gives a carrying value at 30 September 20X4 of $105,000 (120,000 – 15,000). Therefore the carrying value of property, plant and equipment at 30 September 20X4 is $442,000 (337,000 + 105,000).

(W4) Non-current liabilities

6% loan note 50,000

Deferred tax 14,000

–––––––

64,000

–––––––



J

Income statement for the year ended 30 September 20X5

$000

Revenue 9,700

Cost of sales (W1) (2,989) _____

Gross profit 6,711

Distribution costs (W2) (1,810)

Administrative expenses (W2) (1,350) _____

Profit from operations (Note 1) 3,551

Income tax expense (Note 2) (976) _____

Profit for year 2,575 _____

Statement of financial position as at 30 September 20X5

$000 $000

Non-current assets

Intangibles (Note 4) 1,440

Property, plant and equipment (Note 5) 2,950 _____

4,390

Current assets

Inventory 39

Receivables 850

Cash at bank 17 ___

906 _____

5,296 _____

Capital and reserves

Issued share capital 1,000

Retained earnings (Note 8) 2,536 _____

Equity 3,536


Deferred tax (Note 6) 390

Provision for compensation (Note 7) 200 ___

590

Current liabilities

Trade payables 230

Income tax 940 ___

1,170 _____

5,296 _____



Notes to the financial statements

1 Operating profit

Operating profit is stated after charging:

$000

Salaries (980 + 470 + 700) 2,150

Depreciation (170 + 66) 236

2 Income tax

$000

Income tax on profits for the year 940

Over provision in prior year (24)

Deferred tax (390 − 330) 60 _____

976 _____

3 Dividends

A dividend of $500,000 for 20X4 was declared and paid during the year and a dividend of $700,000 for 20X5 is proposed.

4 Intangibles

$000

Brand names:

Additions 1,600

Amortisation (160) _____

Carrying amount at 30 September 20X5 1,440 _____

5 Property, plant and equipment

Premises Plant and machinery

Total

$000 $000 $000

Cost at 1 October 20X4 and at 30 September 20X5

3,300 _____

1,200 _____

4,500 _____

Depreciation at 1 October 20X4 794 520 1,314

Charge for the year 66 _____

170 _____

236 _____

Depreciation at 30 September 20X5 860 _____

690 _____

1,550 _____

Carrying amount at 30 Sept 20X5 2,440 _____

510 _____

2,950 _____

Carrying amount at 1 October 20X5 2,506 _____

680 _____

3,186 _____

6 Deferred tax

$000

At 1 October 20X4 330

Provided during the year 60 _____

At 30 September 20X5 390 _____



7 Provision for compensation

A provision of $200,000 has been recognised during the year as a result of a customer suing for compensation for a serious injury caused by one of the company's products. The company has received legal advice that this claim is likely to succeed.

8 Retained earnings

$000

At 1 October 20X4 461

Profit for the year 2,575 _____

3,036

Less: Dividend declared (500) _____

At 30 September 20X5 2,536 _____

Workings

(W1) Cost of sales

$000

Opening inventory 32

Purchases and other manufacturing costs 1,900

Manufacturing salaries 700

Depreciation:

Premises (3,300 2%) 66

Plant and machinery (1,200 − 520) 25% 170

Less: Closing inventory (39)

Amortisation of brand (1,600/10) 160 _____

2,989 _____

(W2) Other expenses

Distribution costs

Administrative expenses

$000 $000

Administrative costs 170

Advertising costs 1,100

Distribution costs 240

Salaries − administration 980

− distribution 470

Provision for compensation _____

200 _____

1,810 _____

1,350 _____

Tutorial note:

Alternative classification of advertising costs as administrative expenses would be allowable.



T

Income statement for the year ended 31 December 20X8

$000

Revenue 10,000

Cost of sales (W) (8,540) ______

Gross profit 1,460

Distribution costs (600 + 1,000) (1,600)

Administrative expenses (800) ______

Loss on operations (Note 1) (940)

Finance costs (1,680) ______

Loss for the year (2,620) ______

Statement of financial position at 31 December 20X8

$000 $000

Non-current assets:

Intangibles (Note 2) 2,790

Property, plant and equipment (Note 3) 20,040 ______

22,830

Current assets:

Inventories (Note 4) 1,230

Receivables 2,000 ______

3,230 ______

26,060 ______

Capital and reserves:

Issued share capital 15,000

Accumulated losses (380 – 2,620) (2,240) ______

12,760


Long-term loans 12,000

Current liabilities

Trade payables 600

Bank overdraft 700 ______

1,300 ______

26,060 ______



Notes to the financial statements

1 Operating loss

$000

The operating loss for the year is stated after charging:

Depreciation (W) 1,760

Amortisation of capitalised development costs (W) 210

Staff costs (1,300 + 600) 1,900

Research expenditure written off 1,700

Exceptional item 1,000

The exceptional item consists of costs incurred in exhibiting the company's product range at a major trade fair.

2 Intangibles

$000

Development expenditure:

Cost at 1 January 20X8 2,100

Additions 900 ______

Cost at 31 December 20X8 3,000 ______

Amortisation at 1 January 20X8 –

Charge for the year (W) 210 ______

Amortisation at 31 December 20X8 210 ______

Carrying amount at 31 December 20X8 2,790 ______

Carrying amount at 1 January 20X8 2,100 ______

Development costs of $2.1m relate to products which are now in commercial production. These costs are being amortised in equal amounts over 10 years from 1 January 20X8.

The balance of the development costs are not yet being amortised as the associated products are not yet in commercial production.

3 Property, plant and equipment

Land and Plant and Total buildings machinery $000 $000 $000

Cost at 1 January 20X8 18,000 13,000 31,000

Additions – 600 600 ______ ______ ______

Cost at 31 December 20X8 18,000 13,600 31,600 ______ ______ ______

Depreciation at 1 January 20X8 1,800 8,000 9,800

Charge for the year (W) 360 1,400 1,760 ______ ______ ______

Depreciation at 31 December 20X8 2,160 9,400 11,560 ______ ______ ______

Carrying amount at 31 December 20X8 15,840 4,200 20,040 ______ ______ ______

Carrying amount at 1 January 20X8 16,200 5,000 21,200 ______ ______ ______



4 Inventories

$000

Raw materials 520

Work in progress 710 _____

1,230 _____

Workings

Cost of sales

$000 $'000

Opening inventory:

Parts and materials 400


1,300

Purchases 2,300

Factory running costs 1,200

Manufacturing wages 1,300

Research costs 1,700

Depreciation:

Factory (18,000 2%) 360

Machinery (13,600– 8,000) 25% 1,400 _____

1,760

Amortisation of development costs (2,100 10%) 210 _____

9,770

Closing inventory:

Parts and materials 520


(1,230) _____

8,540 _____



STILSON

Key answer tips

There is a lot to do for the 15 marks available. Explain in your workings the adjustments that you make to the draft figures given, so that the marker can give you credit for trying, even if you end up with the wrong numbers.

Income statement of Stilson – year to 31 March 20X1

$000 $000

Revenue (Note 1) (26,750 + 3,000 (W4)) 29,750

Cost of sales (Note 1) (W1) (19,026) ______

Gross profit 10,724

Other income (Note 2) 3,400

Operating expenses (1,340 + 1,250 property rent) (2,590)

Finance costs (200 + 200 accrued loan interest) (400) ______


Taxation (2,400) ______

Net profit for the period 8,734 ______

Stilson – Statement of changes in equity – year to 31 March 20X1

Share capital

Revaluation reserve

Retained earnings

Total

$000 $000 $000 $000

Balance at 31 March 20X0 5,000 Nil 580 5,580

Surplus on revaluation of property (W2) 5,200 5,200

Net profit for the period 8,734 8,734

Dividends (2,000 + (5m 4 15c)) (5,000) (5,000)

Transfer to realised profits (W2) _____

(280) _____

280 _____

______

Balance at 31 March 20X1 5,000 _____

4,920 _____

4,594 _____

14,514 ______

Stilson – Statement of financial position as at 31 March 20X1

$000 $000

Non-current assets


Current assets

Inventory 2,800

Amounts due from construction contracts (W4) 1,100

Trade receivables 8,620

Cash 4,180 _____

16,700 ______

Total assets 29,284 ______



$000 $000


Equity:

Equity shares of 25c each 5,000

Reserves:

Revaluation reserve (5,200 – 280 (W2)) 4,920

Retained earnings (see statement of changes in equity) 4,594 _____

9,514 ______

14,514


8% Loan Note 5,000

Provision for voucher scheme (W1) 630 _____

5,630

Current liabilities


Accrued loan interest 200

Income taxes 2,400

Dividends 3,000 _____

9,140 ______

Total equity and liabilities 29,284 ______

Notes to the financial statements:

1 Sales revenues include an amount of $3.0 million attributable to long-term construction contracts. Cost of sales includes an amount of $1.8 million attributable to long-term construction contracts.

2 Other income relates to the profit of the disposal of one of the company’s properties.

Workings

(W1) Cost of sales $000 $000

Opening inventory 1,900

Purchases 16,000

Provision for voucher scheme (see below) 630

Construction contract costs (W4) 1,800

Depreciation (W2) – buildings 600

– plant (20% 4,480) 896 _____

1,496

Closing inventory (2,800) ______

19,026 ______

The provision required for the expected liability under the voucher system is calculated as $3

million 50% (estimated redemption) 70% (eliminating the profit margin of 30% on future

sales) 0.60 (discounting to present value) = $630,000.

(W2) Depreciation: Buildings

Annual depreciation of the buildings before the revaluation would be $320,000 ($8 million/25 years). The accumulated depreciation at 31 March 20X0 of $3.2 million of the buildings represents a ten-year period. This means that the revalued amount (of the buildings only)



would be depreciated over a remaining life of 15 years. Thus the new annual depreciation would be $9 million/15 years = $600,000.

The revaluation surplus would be $5.2 million ($12 million – ($10 million – $3.2 million)). $1.0 million relates to the land and $4.2 million relates to the building. The revaluation surplus on the buildings should be released to accumulated profits as it is realised in line with the future depreciation of the buildings. The transfer for the current year would be $4.2 million/15 years = $280,000.

(W3) Property, plant and equipment

$000 $000

Land and buildings at valuation 12,000

Depreciation (W2) (600) ______

11,400

Plant: at cost 4,480

Accumulated depreciation (2,400 + 896) (3,296) ______

1,184 ______

12,584 ______

(W4) Construction contract

$000

The contract is 30% complete ($3 million/$10 million 100)

The total profit will be ($10 million $6 million) 4,000

The attributable profit based on the company policy is 30% $4 million 1,200

Contract revenue is the agreed value of work certified of 3,000

Amount charged to cost of sales would be the balancing figure:

($3 million $1.2 million) 1,800 ______

From the above, the amount due from customers is:

Contract costs to date 1,900

Plus recognised profits 1,200

Less progress billings received (2,000) ______

1,100 ______



LARCHER

Key answer tips

Begin by dealing with the revaluation and depreciation of the non-current assets. Then do the workings for the finance lease. This will enable you to draw up the income statement as far as gross profit and to start the statement of financial position by arriving at the figures for property, plant and equipment. Then apply the requirements of the IASB Framework to the factoring agreement and work out the adjustments. You should then be able to continue drawing up the income statement as far as profit before tax, remembering to accrue for the loan note interest. Finally, deal with the tax charge and the dividends.

(a) Larcher income statement for year to 30 September 20X8

$000

Sales revenue 247,450

Cost of sales (W1) (185,150) _______

Gross profit 62,300

Distribution expenses (13,400)

Administration expenses (12,300 – 500) (W3) (11,800)

Financing cost (W3) (3,600) _______


Income tax expense (W5) (9,400) _______

Profit for the period 24,100 _______

(b) Larcher – Statement of changes in equity for year to 30 September 20X8

Share Revaluation Retained Total capital reserve earnings $000 $000 $000 $000

B/f 1 October 20X7 100,000 Nil 23,440 123,440

Surplus on revaluation of properties (W6) 44,000 44,000

Transferred to retained earnings (W6) (900) 900

Net profit for the period _______

______

24,100 ______

24,100 _______

C/f 30 September 20X8 100,000 _______

43,100 ______

48,440 ______

191,540 _______



(c) Larcher statement of financial position as at 30 September 20X8

$000 $000

Assets:

Non-current assets


Current assets

Inventories 16,240

Trade receivables (W3) 35,500

Cash 7,940 ______

59,680 _______

Total assets 256,080 _______


Equity: (per part (b))

Equity shares of $1 each 100,000

Revaluation reserve – land and buildings (W6) 43,100

Retained earnings 48,440 _______

191,540

Non-current liabilities (W7) 31,950

Current liabilities

Trade and other payables (W8) 23,590

Income taxes payable (W5) 9,000 ______

32,590 _______

Total equity and liabilities 256,080 _______

Workings

(W1) Cost of sales $000

Per question 165,050

Depreciation (W2) 16,600

Contingency provision (see below) 3,500 _______

185,150 _______

The most likely (probable) outcome of the court case is damages of $3 million plus $500,000 in costs, requiring a provision of $3.5 million. In addition there would be an explanatory note that a further $3 million contingency could crystallise should Larcher be found fully responsible.



(W2) Depreciation $000

Plant (124,740 − 34,740) 15% 13,500

Buildings (see below) 2,500

Leased asset (W4) (20% 3,000) 600 _______

16,600 _______

The building depreciation is based on the revalued amount and its remaining life (120,000 − 20,000)/40 years

2,500 _______

(W3) Factored trade receivables/finance costs

Factored trade receivables:

The IASB’s Framework for the Preparation and Presentation of Financial Statements requires entities to record the substance of transactions. As Larcher still bears the risk of all bad debts, the substance of the factoring is a secured loan. The finance/administration cost of $500,000 should be charged to the period to which they relate i.e. next year not the current year. Thus the factored trade receivables of $10 million should be included on the statement of financial position at 30 September 20X8 to give $35.5 million (25.5m + 10m). This is balanced by a ‘loan’ of $9.5 million (from Merchant Financing) and a credit to administration expenses of $500,000.

Finance costs: $000

Loan note interest (1,650 + 1,650 accrued) 3,300

Interest on finance lease (W4) 300 ______

3,600 ______

(W4) Finance lease

The cash price of the leased asset of $3 million is capitalised and added to plant and equipment. As the lease has a five-year life, depreciation for the year to 30 September 20X8 will be 20% of $3 million = $600,000. It would have a net book value at 30 September 20X8 of $2.4 million. The cash price of the asset will also be the initial amount of the obligation under the lease. Interest is at 10% p.a.

The details are:

$000

Obligation 1 October 20X7 3,000

Interest at 10% pa. (charged to income) 300 ______

3,300

Deduct first rental paid 30 September 20X8 (800) ______

Total obligation at 30 September 20X8 2,500 ______

This must be split between a current liability and a non-current liability.

Next year’s rental of $800,000 will be allocated: interest of $250,000 (10% of $2.5 million), the balance of $550,000 will be a capital repayment and thus a current liability at 30 September 20X8. This leaves $1,950,000 (2.5 million − 550,000) as a non-current liability.



(W5) Taxation $000

Provision for year 9,000

Under provided last year (7,200 6,800) 400 ______

9,400 ______

(W6) Tangible non-current assets as at 30 September 20X8

Land – revalued to 20,000

Buildings – revalued at 100,000 (on 1 October 20X7) less depreciation of 2,500 97,500

Plant cost 124,740 less depreciation of 48,240 (34,740 + 13,500) 76,500

Leased asset (W4) 2,400 _______

196,400 _______

The revaluation reserve relating to the land and buildings is calculated:

$000 $000

Revalued amount 1 October 20X7 120,000

Cost (12 + 80) 92,000

Depreciation b/f (16,000) ______

Net book value at date of revaluation (76,000) _______

Initial revaluation reserve 44,000

Transfer to retained earnings (see below) (900) _______

43,100 _______

The revaluation surplus relating to the building ($44m − (£20m – £12m)) is normally released to retained earnings as it is realised in line with the future depreciation of the buildings. The transfer for the current year would be $36 million/40 years = $0.9 million.

(W7) Non-current liabilities $000

11% Loan note 30,000

Leasing obligations (W4) 1,950 _______

31,950 _______

(W8) Current liabilities $000


Contingencies (W1) 3,500

Amount due to factor (W3) 9,500

Loan note interest 1,650

Leasing obligation (W4) 550 _______

23,590 _______



DAWES

Key answer tips

(a) IAS 16 – rules for amounts included in the cost of non-current assets.

(b) IAS 23 – borrowing costs capitalised, interest on surplus funds are reduced on borrowing costs; no capitalisation when no construction taking place.

(c) IFRS 5 – disclosures on disposals/discontinued operations; division not separate legal entity – claim remains with Dawes/IAS 37 disclosure; contingent asset.

(d) Definition of depreciation; carrying value; IAS 16 and IAS 8; effect on other Dawes’s properties.

(a) Dawes

Corrected schedule of the movements on plant

Cost Depreciation $m $m

At 1 October 20X6 81.20 32.50

Addition at cost (W1) 21.50

Leased additions (W2) 16.00

Disposals (W3) (15.00) (9.00)

Depreciation charge for year (W3) _____

20.74 _____

Balance at 30 September 20X7 103.70 _____

44.24 _____

Workings $m

(W1) Additions – basic cost 20.00

– installation 1.00

– testing 0.50 _____

21.50 _____

Note: the sales tax on the plant can be reclaimed by Dawes and therefore does not form part of its cost. The company policy for government grants does not allow them to be offset against the cost of the asset. Insurance and maintenance are revenue items.

(W2) Leased additions $m

Liability b/f 21.40

Repayments (8.40)

Liability c/f (29.00) _____

Difference – new leases 16.00 _____

(W3) Disposal

The accumulated depreciation on the plant disposed of would be 20% of $15 million for three years (no charge in year of disposal) = $9 million.

The depreciation charge for the year is 20% of the corrected cost of plant at the year

end i.e. 20% $103.7 million = $20.74 million.



(b) Manufacturing plant

Where assets are financed by specific borrowings, the allowed alternative treatment in IAS 23 Borrowing Costs, requires that the specific borrowing costs related to the financing (in this case interest and amortisation of issue costs) are those that should be capitalised. Interest from the temporary investment of any surplus funds relating to the specific finance are treated as a reduction of the borrowing costs.

$

Interest on $5 million at 14% 700,000

Amortisation of issue costs using straight-line apportionment (($5 million at 2%)/4)

25,000

Less interest earned on temporary investment

Of surplus funds (72,000) _______

Amount of borrowings to be capitalised 653,000 _______

Investment property

Borrowing costs should not be capitalised during periods when no construction or development takes place. They should cease at the point in time when the asset is ready for use, notwithstanding that it may take time to market the asset, or, in this case, find a tenant. Thus during the current year the above rules exclude capitalisation of interest for the first three and the last three months of the accounting year. Where general, rather than specific, borrowings are used to finance qualifying assets then a weighted average cost of capital excluding specific borrowings should be applied to the average investment in the asset. In this case the appropriate cost of capital is 10% per annum.

$

Amount capitalised is $12 million 10% 6/12 600,000

(c) The engineering division appears to be a major and separate line of business that is clearly distinguishable from other business activities of Dawes. As such its sale requires separate disclosure, in the income statement and in the notes to the financial statements, as a discontinued operation. The following disclosures are required by IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations:

(i) A single amount on the face of the income statement comprising the total of the post-tax profit or loss of the operation and the post-tax gain or loss on the disposal of the assets constituting the discontinued operation (information not available).

(ii) An analysis of this amount into the revenue ($22 million), expenses (not available) and pre-tax profit or loss (loss $9.5 million − see below); the related income tax expense (not available); the gain or loss on disposal of the assets of the operation (loss $18 million (46-(30-2)); and the related income tax expense (not available).

(iii) The net cash flows attributable to the operating, investing and financing activities of the discontinued operation in the current year.

(iv) A description of the operation (engineering).

(v) A description of the facts and circumstances of the sale (on 20 September 20X7 to Manulite).

(vi) The industry and geographical segment in which it is reported (information not available).



Note: the operating losses are $4.5 million plus the provision for damages of $5 million (or $3 million – see below).

The directors appear to be mistaken in their views of the damages claim. If the engineering division had been a separate legal entity, say a subsidiary, then it may be that its liabilities would be sold with it. In this instance Dawes is selling some of its net assets to Manulite and the liability for the claim will remain with Dawes. Pending legal actions are examples of contingencies, however the wording of the question implies that the liability is probable, if not almost certain. In these circumstances the liability of $5 million must be accrued by Dawes in the current year’s accounts to comply with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

The contributory negligence of Holroyd relating to the failure of the sub-assembly complicates the issue. In respect of Dawes this is a contingent asset and its treatment is not necessarily a ‘mirror image’ of the liability. An assessment of the likelihood of the success of the counter-claim must be made. The most appropriate treatment in such circumstances would probably be to disclose it as a note in the financial statements giving details of the circumstances. A separate contingent asset should not be accrued unless it is virtually certain to arise.

(d) Depreciation is the process of allocating the cost (or revalued amount) less the estimated residual value of a non-current asset over the periods that are expected to benefit. It is an example of the use of the accruals and matching concept. It is not meant to be a process of valuing assets. The directors of Dawes are confusing the two issues. Even though the value of an asset may have increased, it does not mean depreciation is unnecessary. Each year a portion (1/25th) of the value of the leased property is consumed, and the depreciation charge reflects this cost. The carrying value of the leased property is a different issue. The question states that the company is based in a country where the regulatory requirements permit the directors to choose to value the property on the historic cost basis, or they can choose a ‘current value’ – in this case the current replacement cost. This situation is allowed for in IAS 16 Property, Plant and Equipment. Regardless of which valuation method is chosen, depreciation must still be charged and be based on the chosen value. Some regulatory requirements take the view that where a company can demonstrate that the life of an asset (which is of a type whose life is normally considered to be finite) can be considered to be infinite, perhaps due to exceptionally high standards of maintenance, then no depreciation may be necessary. In effect the maintenance costs become a substitute for the depreciation. Hotel properties have sometimes been treated this way. This argument would not be applicable to this leased property.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors says the initial adoption of a policy to carry property at a revalued amount is a change in accounting policy, but that it should be treated as a revaluation in accordance with IAS 16. If the directors do decide to revalue the property then all of Dawes’s properties (within the same class) must be simultaneously revalued, and these valuations must be kept up to date.



In this case the alternatives are:

Statement of financial position Historic cost Current value value (revaluation)

$000 $000

Non-current assets – property, plant and equipment

Cost 4,000 6,000

Accumulated depreciation (6 years at 4%/1 year at 5%) (960) _____

(300) _____

Carrying amount 3,040 _____

5,700 _____

$000 $000

Reserves:

Revaluation reserve (W) Nil 2,660

Income statement

Depreciation of leased property:

− 4,000 1/25 160

− 6,000 1/20 300

Working: Revaluation surplus $000

Carrying amount 1 October 20X6 ($4,000 – 5 years at 4% p.a.)

3,200

Revalued amount (6,000) _____

Revaluation surplus 1 October 20X6 2,800

Transferred to realised profits (1/20th) (140) _____

Revaluation surplus 30 September 20X7 2,660 _____



BUSINESS COMBINATIONS

HEDRA

Key answer tips

Take care with the deferred consideration and the tax losses. Not only is the deferred consideration part of the cost of Salvador but it is also a liability. The tax losses are a deferred tax asset of the group but this asset is only the tax losses at the tax rate not the full amount of tax losses. Remember also that Hedra has not yet recorded the acquisition of Aragon, therefore Hedra’s share capital and share premium must be adjusted.

Consolidated statement of financial position of Hedra as at 30 September 20X5: $m $m

Non-current assets Property, plant and equipment (358 + 240 + 12 + 25 +15 (W2)) 650 Goodwill (W3) 111 Investment in associate (W6) 220 Other investments 45 ––––– 1,026 Current assets Inventories (130 + 80) 210 Trade receivables (142 + 97) 239 Cash and bank 4 453 ––––– ––––– Total assets 1,479 ––––– Equity and liabilities Equity attributable to the parent Ordinary share capital (400 + 80 ) (W3) 480 Reserves: Share premium (40 + 120) (W3) 160

Revaluation (15 + 12 + (5 60%)) (W2) 30

Retained earnings (W5) 263 453 ––––– ––––– 933 Non-controlling interest (W4) 136 ––––– 1,069 Non-current liabilities Deferred tax (45 – 10) 35 Current liabilities Bank overdraft 12 Trade payables (118 + 141) 259 Deferred consideration (W3) 54 Current tax payable 50 375 ––––– ––––– Total equity and liabilities 1,479 –––––



Workings

(W1) Group structure

Investment in Salvador = 72m/120m = 60% – consolidate Investment held since 1 October 20X4 i.e. 1 year Investment in Aragon = 40m/100m = 40% – equity account

Investment held since 1 April 20X5 i.e. 6 mths

(W2) Net assets in Salvador

A net asset working really helps

At acquisition

At reporting period end

$m $m Share capital 120 120 Share premium 50 50 Retained earnings 20 60 Fair value adjustments: Land and buildings 20 20 Revaluation of land 5 Plant 20 20

Dep’n on plant (20 ¼) (5)

Deferred tax asset (40 25%) 10 10 ––– ––– 240 280 ––– –––

(W3) Goodwill – Salvador $m $m Cost of investment – cash 195 Cost of investment – deferred 54 –––––

249 Fair value of non-controlling interests 132 –––––

381 Net assets (240) –––––

Goodwill at acquisition 141 Impairment (30)

––– Goodwill in statement of financial position 111 –––––



Alternative presentation: $m $m Cost of investment – cash 195 Cost of investment – deferred 54 –––––

249

Net assets acquired (60% 240 (W1)) 144 –––––

Goodwill at acquisition 105 Fair value of non-controlling interest 132

Net assets (40% 240) (96) –––––

36

–––––

141 Impairment (30) –––––

Goodwill in statement of financial position 111 –––––

The shares issued in respect of acquisition of Aragon have not been recorded by Hedra.

Therefore, share capital needs increasing by 40m 2/1 $1 = $80m and share premium

needs increasing by 40m 2/1 $1.50 = $120m.

(W4) Non-controlling interest#

Fair value of non-controlling interests 132 NCI share of post-acuisition reserves

(40% (280 – 240))

16

Impairment (30 40%) (12) –––––

136 –––––

Alternative presentation Non-controlling share of net assets at reporting

period end (40% 280 (W2))

$112m

Goodwill non-controlling interest share 36

Impairment (30 40%) (12) –––––

136 –––––

(W5) Consolidated retained earnings

$m Hedra 240 Salvador – post acquisition profits (60% ((280 – 5) – 240)) 21 Aragon – post acquisition (40% (400 – 350)) 20 Impairment of goodwill (30 60%) (18) ––– 263 –––

(W6) Investment in associate

Investment in associate $m Cost 200 Group share of post acquisition profit (40% (400 – 350)) 20 ––– 220 –––



HOLDRITE, STAYBRITE AND ALLBRITE

(a) Goodwill in Staybrite – at 1 April 20X4:

Consideration $000 $000

Shares (10,000 75% 2/3 $6) 30,000

8% loan notes (10,000 75% $100/250) 3,000

––––––

33,000

Less

Equity shares 10,000

Share premium 4,000

Pre acq reserves (7,500 + (9,000 6/12)) 12,000

Fair value adjustment (3,000 + 5,000) 8,000

––––––

34,000 75% (25,500)

–––––– ––––––

Goodwill attributable to parent 7,500

Goodwill attributable to non-controlling interests 500

––––––

Full goodwill 8,000

––––––

Goodwill on the purchase of shares in Allbrite – at 1 April 20X4:

Consideration

Shares (5,000 40% 3/4 $6) 9,000

Cash (5,000 40% $1) 2,000

––––––

11,000

Less

Equity shares 5,000

Share premium 2,000

Pre acq reserves (6,000 + (4,000 6/12)) 8,000 ––––––

15,000 40% (6,000)

–––––– ––––––

Goodwill 5,000

––––––

(b) Holdrite Group Consolidated statement of comprehensive income for the year ended 30 September 20X4

$000

Revenue (75,000 + (40,700 6/12) – 10,000) 85,350

Cost of sales (W1) (48,750)

––––––

Gross profit 36,600

Operating expenses (W2) (15,980)



––––––

Profit from operations 20,620

Income from associate (4,000 6/12 40%) 800

––––––

21,420

Finance cost (170)

––––––


Income tax expense (4,800 + (3,000 6/12))

(6,300)

––––––


––––––

Attributable to:

Owners of the parent 14,200

Non-controlling interest (W3) 750

––––––

14,950

––––––

(c) Holdrite Group Movement on consolidated retained earnings attributable to Holdrite for the year ended 30 September 20X4

$000


Dividend paid (5,000)

––––––

9,200

Retained earnings b/f 18,000

––––––

Retained earnings c/f 27,200

––––––

Workings

(W1) Cost of sales

$000

Holdrite 47,400

Staybrite (19,700 6/12) 9,850

Additional depreciation of plant 500

Intra group purchases (10,000)

Unrealized profit in inventory (4,000 25%) 1,000

––––––

48,750

––––––



(W2) Operating expenses

$000

Holdrite 10,480

Staybrite (9,000 6/12) 4,500

Impairment of Staybrite’s recognized goodwill 1,000

––––––

15,980

––––––

(W3) Non-controlling Interest

$000

9,000 6/12 4,500

Less additional depreciation (500)

Less impairment (1,000)

––––––

3,000

––––––

25% 750

––––––

Tutorial note: The retained profits carried forward can be proved as:

$000

Holdrite (18,000 12,150 5,000) 25,150

Staybrite (75% 9,000 6/12 ) 3,375

Allbrite (40% 4,000 6/12 ) 800

Additional depreciation of plant (75% 500) (375)

Unrealized profit in inventory (W1) (1,000)

Impairment of goodwill (W2) (75% 1,000) (750)

––––––

27,200

––––––



ANALYSING AND INTERPRETING FINANCIAL STATEMENTS

NEEDS OF USERS OF ACCOUNTS

Seven categories of users are traditionally considered as having an interest in the financial statements of a company. The importance of the financial statements to each category will vary with the nature and size of the company and with the type of use made of the company's accounts by that category.

(a) Investors and their advisers

In a small private company the financial statements will provide shareholders with confirmation of the financial position of the company. They may provide information for other purposes, to permit, for example, valuation for transfer of shares.

In a larger public concern and in quoted companies the financial statements will provide present and potential investors with information on the financial health of the company on which to base decisions as to whether or not to invest (or continue to invest) in the company. Institutional investors such as pension funds, which often hold significant interests in public companies, wish to review the quality of the management and the company's financial statements may be the basis for their initial review of the stewardship exercised by management over the company's resources.

Analysts and advisors of third parties have a right to corporate information through the medium of those they advise who have an actual or potential interest. For larger companies such people may also take a public role in giving advice. In small companies and private concerns the amount of investment at risk in the company might be limited, so that less use may be made of such advice.

(b) Loan creditors

(i) Present

In a small company long-term loans will be from banks and individuals. In a larger company there may be loan notes in addition to bank loans.

The information requirements of the loan creditors are similar to but narrower than those of equity investors. They are interested in the past performance of the company as an indication of the security of their investment and its future income stream. This knowledge will assist decisions as to whether and when to buy or sell loan notes or whether to extend loan facilities.

(ii) Potential

Potential providers of loan capital will also be interested in financial statements as indicators of the future position of a business. They will consider its return on assets and whether this will cover interest payments, and the liquidity of the concern. They will note how profits and liquidity have varied with trading conditions: a business with volatile profits and losses does not give the solid and comfortable security provided by one with a steadily growing profit.



(c) Employees

(i) The smaller company

In a small company the trading position may be well known to employees: they will be able to see the level of sales and the associated costs. On the other hand, for a non-financially aware employee such information needs to be spelt out in formal statements.

(ii) Larger concerns

In a larger concern the position of the company will be far from readily apparent, and the only way for employees to assess the financial position of the concern will be from formal financial statements (whether from internally prepared statements or from audited external statements).

The employees need information to assess their future prospects (the stability of their jobs and future promotion) and the availability of profits to finance increased salaries and wages. Trade unions make use of financial information in collective bargaining.

(d) Customers, suppliers and other business contacts

In the case of a small company potential long-term customers may be interested in the company's financial position, because they wish to assess the company's ability to provide them with a steady supply of goods and services. Suppliers and other creditors will be concerned with the continuing ability of the business to pay. With a larger concern there is a presumption that it is a good risk but without independent information it is difficult to judge the credit-worthiness of a small company.

For a larger company illiquidity or unprofitability demonstrated by the financial statements may warn off possible creditors and customers but very often these people will be willing to trade on the basis of the name.

In both cases rivals and competitors will take an interest. In large groups the profitability of individual types of business may be hidden, reducing the usefulness of the accounts in this respect.

Another group wishing to use smaller companies' accounts will be those wishing to sue companies. They will wish to know whether there are sufficient assets to make such an action worthwhile.

(e) The Government

The Government's interest in accounts is twofold: statistical and fiscal. The statistical interest will vary according to the size of the company. The interest of the taxation authorities is in the accounts as a basis for more detailed tax computations. The use made of the accounts will be similar, therefore, for both small and large companies.

(f) The public

The public's interest in specific concerns will probably be in the larger companies: e.g., how much the highest paid director earns, what political and charitable contributions are made. In smaller companies, and to an extent with larger companies, the interest may be via statistical digests showing how profitable companies have been, what the average political contribution has been and what the average director earns.



SR

Tutorial notes:

Ensure you use a report format: addressee; author; date; subject.

Prepare appendix first: calculate ratios for profitability; short-term and long-term financing.

Split report into two sections: performance of PQ; further investigation.

Introduction to report should refer reader to appendix.

Discuss performance in terms of ratios calculated.

Describe five areas of investigation: number and explain each one.

REPORT

To: Finance Director


Date: 30 June 20XX

Subject: Performance of PQ and areas of further investigation.

This report deals with the performance of PQ over the three years from 20X1 to 20X3 and details areas where further investigation needs to be made. Calculations of supporting figures used in this report can be found in the Appendix.

(a) Performance of PQ

Profitability

PQ has seen a marked reduction in return on capital employed in 20X3; the gross profit percentage has remained almost static, with a small increase in 20X3.

The issue is that the increase in capital employed in 20X2 and 20X3 has not resulted in a corresponding increase in sales. Whilst the trading profit margin has not fallen significantly there has been an increase in interest expense arising from the increase in long-term loans.

Revenue has fallen by $68 million in 20X3 compared to 20X2 – a fall of 7%.

Working capital

The current ratio has fallen a little over the three year period whilst the quick ratio has remained almost static. But in both cases they are extremely high compared to market norms, indicating an inefficient management of working capital.

Inventory turnover has fallen and the accounts receivable collection period has increased markedly over the period, offset to some extent by the increase in the accounts payable payment period. 'Other payables' have also increased over this period. All of this is further evidence of poor working capital management.

Long-term finance

Gearing has increased significantly over the period from 5.2% in 20X1 to 15.7% in 20X2 and 16.2% in 20X3. But even at these levels gearing does not cause concern.



(b) Areas for further investigation

(i) Revenue and profits

The reason for the fall in revenue in 20X3. Was this due to a loss of market share (perhaps due to obsolescence of some product lines) or to a change in product mix?

Are the increases in selling, distribution and administration expenses due to an increase in advertising costs in an attempt to increase sales in 20X4?

(ii) Intangible assets

What do these represent? Patents for new products or deferred development expenditure?

(iii) Receivables

Have PQ given customers (or certain classes of customers) longer credit periods?

(iv) Interest

Why has interest expense increased whilst long-term loans have remained the same in 20X2 and 20X3?

(v) Other payables

What does this figure consist of? As PQ has a large cash balance, it seems unlikely that it would include bank overdrafts. The tax charge and the annual dividend have not changed, so they do not explain the increase.

Appendix

20X1 20X2 20X3 $m $m $m

Profitability ratios

ROCE %100employed Capital

interest beforeProfit

5274399

100

58138430

122

52138446

104

= 23.8% 23.9% 19.5%

Gross profit percentage

%100Revenue

profit Gross

286

840

336

981

323

913

= 34.0% 34.3% 35.4%

Net profit margin

%100Revenue

profit Trading

100

840

122

981

104

913

= 11.9% 12.4% 11.4%

Inventory turnover

Inventory

sales ofCost

237

554

303

645

294

590

= 2.3x 2.1x 2.0x



Accounts receivable collection period

days 365Revenue

sReceivable

105

840

141

981

160

913

= 46 days 52 days 64 days

Accounts payable payment period

days 365sales ofCost

payables Trade

53

554

75

645

75

590

= 35 days 42 days 46 days

Current ratio

sliabilitieCurrent

assetsCurrent

133

606

180

748

186

770

= 4.6:1 4.2:1 4.1:1

Quick ratio

sliabilitieCurrent

inventory - assetsCurrent

133

237606

180

303748

186

294770

= 2.8:1 2.5:1 2.6:1

Gearing

%100employed Capital

cash ofnet Loans,

5274399

5274

58138430

58138

52138446

52138

= 5.2% 15.7% 16.2%



REGIS

Key answer tips

As always with this type of question, it is not enough simply to calculate the ratios and to state that figures have increased or decreased. The ratios in this question show an improvement on the previous year, but this improvement is misleading. This means that your answer must look behind the figures to identify possible reasons for the changes.

(a) Superficially, it appears that the actions taken by the management of Regis during the year to 31 March 20X1 have been very effective in achieving improvements in the performance areas criticised in the previous year, when assessed using typical relevant ratios. The appendix contains the working for relevant ratios. Looking at each area in turn:

Gross profit %

A dramatic increase in this figure has been achieved. The decision to buy-in manufactured items appears to have been beneficial in that manufacturing costs have fallen considerably, but closer inspection reveals some worrying issues. The cost of sales figure includes the release of $370,000 relating to the provision for the furnace re-lining. Applying the rules in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the re-lining of the furnace is not a liability that should be recognised because it can be avoided (as turned out to be the case in this instance). The current incorrect treatment, together with (presumably) lower plant depreciation (as some plant has been sold) has given a significant boost to gross profit that may be misleading.

The over-capacity in the industry at the current time may explain why the bought-in items are cheaper (if in fact they are). This situation may not last for long. There is no indication of the length or terms of the contract signed with the external manufacturer. This may make Regis vulnerable to matters outside its control in relation to the bought-in items, e.g. delivery delays, quality control, supplier’s labour disputes etc.

Research and development

Research and development expenditure is often expressed as a percentage of sales revenue to give a basic measure of the level of its activity. Using this measure it has increased dramatically. However, on closer inspection this increase is an illusion; the opposite is in fact the case. The charge for the year ($300,000) appears to be made up of the write off of previously capitalised costs of $280,000 plus a further $20,000 expenditure incurred in the current year before the project was abandoned. The reality is that Regis is no longer engaged in any research and development activity. This may not bode well for the future.

Earnings per share

The figure has improved from 35c to 51.7c. The elements that have (partly) caused this improvement are:

the release of the furnace re-lining provision

the profit on the disposal of property

the release of the deferred tax provision (about which there is no supporting information to determine if it is justified).

These appear to have caused what is likely to be a single period improvement. Worse still is the dilution which the issue of the convertible loan note will cause in 20X5 when conversion takes place. The approximate effects of this, assuming tax at 30%, will be a diluted EPS of

33.2c [(310 + (32 10 tax))/(600 + 400)]. This should serve as a warning to shareholders.



Property, plant and equipment/revenue

The improvement in this ratio has resulted from the sale of plant referred to above and the sale of some properties. The income statement now has a charge for property rentals, which may imply that Regis undertook a sale and leaseback of the properties. If this is the case, the effect on future profits is that recurring rental charges will reduce future profitability and the profit from the sale of the properties, which offset the rental charges in the current year, will not recur in future periods. The improvement in the asset utilisation ratio is likely to be temporary. Indeed, more worryingly, revenue has actually fallen.


The previous year’s collection period of 69 days has been reduced to an almost impossible 29 days. Assuming there are no errors in the figures, this may have been caused by a decision to factor some or most of Regis’s accounts receivable. Whilst this is a perfectly normal business practice, it would make any comparison with previous years invalid and represent a one-off improvement.

Inventory turnover

The improvement here could be due to the decision to buy-in manufactured items. Regis may be in a position to hold low levels of inventory by having access to short lead times or operating a ‘just-in-time’ system with its supplier. Bought-in costs may be lower than internally manufactured costs. A less desirable possibility is that Regis has entered into a ‘sale and repurchase’ scheme. In its simplest form this would involve selling some inventory to a bank just before the year end and repurchasing it shortly afterwards. The effect of this is to ‘creatively’ reduce inventory and overdraft levels at the year end.

Accounts payable payment period

The improvement in this ratio is welcome, as excessive payment periods may jeopardise relations with suppliers. The improvement in the company’s cash inflows from sale of the property and plant, factoring/reduction of accounts receivable and raising new finance have enabled the company to eliminate the overdraft and pay accounts payable in a more acceptable period. It should be said that many of these inflows are likely to be non-recurring and this could cause problems in the future.

Liquidity ratios

The improvement in the ratios relating to inventories, receivables/payables and elimination of the bank overdraft referred to above have had the overall effect of a small improvement in the liquidity ratios as shown in the appendix. Despite this they are still poor and many of the ‘improvements’ may be temporary or illusory. It may well be that liquidity problems are being stored up for the future.

Gearing

The improvement in this ratio has come about partly by a decrease in loans, net of cash, through the 20X0 overdraft being replaced by a positive cash balance in 20X1 and the amount of the loan being less. The retained profit for the period has had the effect of increasing equity. The overall reduction in net loans is fairly modest considering the many ‘once-only’ inflows of cash referred to above. It should be noted that finance costs have been reduced partly as a result of redeeming the 12% debentures and replacing them by issuing the 8% convertible loan note. This may be due to a timely fall in interest rates or it may be that the interest on the convertibles is below market rates due to favourable conversion terms. As referred to above this may have a detrimental effect on future earnings per share.



(b) Effect on stock market

It is generally believed that the stock market is efficient enough to ‘see through’ cosmetic changes in accounting policies and will only react to real economic changes. Thus, if improvements to accounting ratios have occurred that are not due to real improvements in operating performance, then they should have no effect on the market price of a company’s shares. Devices such as factoring, sale and leaseback and sale and repurchase schemes should not impress the market, even if they lead to an improvement in certain critical ratios. This is not to say that such schemes are improper or that they do not have their merits, but that they will be assessed for what they are and they cannot hide from the market what may be fundamental weaknesses in a company’s financial position. The contrary view to this is that the market can be ‘fooled’, at least in the short term, by cosmetic, non-economic events or by creative accounting. It is probably for this reason that managers sometimes spend considerable resources undertaking such schemes. Empirical research on stock market behaviour over the years appears to have supported both positions, though in the longer term only real economic events will be reflected in the value of a company.

(c) There are many potential problems inherent in relying on ratios alone when attempting to assess corporate performance, some of which are illustrated in the answer to (a) above. Comparisons are often made from one company to another (similar) company or for the same company over a period of time (trend analysis). The following points consider both types of comparison:

Many ratios are based on averages in that they assume, sometimes falsely, that the figures in the statement of financial position are a representative average figure for that item for the whole of the year. Such assumptions are not valid where companies experience seasonal trading, have different accounting dates for year ends or have high-value changes occurring near year ends (e.g. a substantial non-current asset acquisition). Management can sometimes take advantage of this weakness and employ ‘window-dressing’ and other ‘creative accounting’ activities that distort the year end statement of financial position.

Companies and analysts may calculate ratios slightly differently. It is vital for the validity of any comparison that a ratio is precisely defined before being used by different people. This is perhaps most relevant where companies compare their ratios to similar ratios supplied through subscription to an ‘inter-firm’ comparison body.

Different accounting estimates between companies can make comparisons invalid if they are not adjusted for, although this is not as easy as may be expected. For example, if one company depreciates an item of plant over five years, whereas another company depreciates similar plant over ten years, it would seem logical to adjust for this. Such adjustment may not be valid if the first company uses the plant on a shift work system for 24 hours a day whereas the second company may only use it on a day shift for eight hours a day. Other problems in this area are that there may not be sufficiently detailed disclosures of accounting policies to permit adjustments to be made even where they would be appropriate. Also, changes in accounting policies can present similar problems when applying trend analysis.

There may be structural changes to companies from one year to the next. Examples of this may be major acquisitions/disposals of subsidiaries and capital structure changes.

The existence of related party transactions can distort results if they are conducted on non-commercial terms. These are not always disclosed.

It must be realised that ratios on their own are insufficient to assess the performance of a company. Other non-financial information may be equally or more important than ratios. Ratios are difficult to interpret; there may be several valid explanations for a change in a particular ratio, some may be indicative of a favourable event, others the reverse. A single



ratio should not be interpreted in isolation. Ratios provide only a guide; in effect, they prompt the questions rather than provide the answers.

Appendix 20X1 20X0

Gross profit percentage (960/2,400 100) 40.0% (700/2,500 100) 28.0%

R & D as % of revenue (300/2,400 100) 12.5% (80/2,500 100) 3.2%

EPS (310/600 100) 51.7c (210/600 100) 35c

Revenue to property, plant and equipment (2,400/950) 2.5 times (2,500/1,250) 2.0 times


(190/2,400 365)

29 days

(470/2,500 365)

69 days

Inventory turnover (1,440/450) 3.2 times (1,800/800) 2.3 times

Accounts payable payment period (330/1,440 365) 84 days (620/1,800 365) 126 days

Current ratio (850/630) 1.3 (1,270/1,130) 1.1

Quick ratio ((190 + 210)/630) 0.6 (470/1,130) 0.4

Gearing ((400 – 210)/(860 + 400 – 210) 100) 18.1% ((500 + 335)/(700 +

500 + 335) 100)

54.4%

Note: In the absence of a figure for purchases on credit the cost of sales figure has been used in substitute. Although this can be misleading in terms of the actual accounts payable period, it may be indicative of the trend of the payment period.



ACQUIRER AND TARGET

(a) REPORT

To: The Board of Directors of Acquirer Subject: Comparison of Target with other companies

Introduction

I have prepared a schedule of accounting ratios calculated from the latest published financial statements of Target, showing how these ratios compare with the equivalent ratios for comparable entities.

The purpose of this report is to discuss the implications of these figures, pointing out their relevance to your decision on whether to launch a takeover bid for Target.

Profitability ratios

The gross profit margin of Target is towards the top end of the range of comparable entities, while the operating profit margin is towards the bottom end. This suggests that, while Target’s operations have a good underlying profitability, there is lax control over operating expenses which have been allowed to grow to unacceptable levels. Curiously, this lack of control at present might actually be good news for us, since it suggests that we might easily be able to improve Target’s reported profits without having to radically change its operations. We would need to impose the control over expenses that is currently absent.

Return on total capital employed for Target is around the average level achieved by the comparative group of entities. Since the ROCE is calculated as the product of the operating profit margin and the asset turnover, and we have already seen that the operating profit margin is low, this suggests that the asset turnover must be higher than average. This is another encouraging statistic: as long as we can impose the controls already discussed over expenses, then the high gross profit margin and the high asset turnover should generate attractive revenues and profits.

Gearing ratios

The statement of financial position gearing ratio at 52% is towards the top end of the range of comparative entities, and seems high also in absolute terms. As would be expected, this is accompanied by a gearing ratio in statement of comprehensive income terms (the interest cover) towards the bottom end of the range. High gearing means large finance costs that are only modestly covered by available profits. The gearing ratio is not of fundamental importance to our decision as to whether to bid for Target since, whatever the capital structure, we would be responsible for financing Target after we acquired it. However, if our existing group gearing ratio is already very high, then we should hesitate before taking on additional group borrowings.

Investor ratio

Target’s dividend cover is higher even than the highest number seen in the comparative group, suggesting that very low dividends are currently being paid. Perhaps the past level of dividend payout is irrelevant to our decision to bid for the company, since we could insist on whatever dividends we wanted to be paid, if we acquire the company. However it is possible that low dividends are being paid currently due to severe liquidity problems at the company. We should research this possibility further.



Working capital ratios

The inventory turnover ratio of Target is towards the top end of the range of comparative entities, while the receivables days is towards the bottom end of the observed numbers. Both of these are indications of good control over working capital, ie low inventories being held, and low receivables at the reporting period end. These results are consistent with the high asset turnover of Target that was discussed earlier. Control over net assets appears to be sound.

Conclusion

The most important point identified above is the poor control over Target’s operating expenses that appears to be in force at the moment. If we were to buy the company, we may be able to increase profitability substantially by imposing stronger controls over these expenses.

Please contact me if I can be of any further help to you in respect of this matter.

(b) I have a number of reservations regarding the extent to which the provided ratios can contribute to an acquisition decision.

The ratios for Target have been calculated from the latest published financial statements, namely for the year ended 30 November 20X2. Are there any more recent figures available, perhaps interim figures for the first six months of the next year?

Companies may choose different accounting policies, which can affect the reported results materially. We are not told whether Target complies with IASs, or whether this is the accounting framework adopted by all the comparative enterprises, but even if all the companies concerned adopt IASs, there is still some potential for different accounting practices to be followed. For example, IAS 16 permits non-current assets to be measured either at depreciated cost or at revalued amount, a decision that can have an enormous impact on the ratios calculated. We must therefore ensure that all the companies are using the same accounting policies before we can effectively compare them.

Accounting ratios are concerned only with financial factors that are captured in a set of prepared financial statements. There are many non-financial factors that we should also consider. What is Target’s reputation in the market-place? Does it have skilled employees and managers running the company? Does it have research and development activity that is not included in the statement of financial position but may generate future profits? We must investigate all of these matters before we launch a bid. Unfortunately, the published financial statements will be of little help, though the chairman’s statement or chief executive officer’s report may give some insight into the strengths of the company that are not recognized in the statement of financial position.

Finally, accounting ratios are only concerned with the past. When we buy a company, the past is largely irrelevant and we will be buying the future earnings stream. We must be looking for any indications of future results that Target expects to report. Perhaps, again, the chairman’s statement in the annual report will indicate whether future results are expected to be higher or lower than currently achieved.

53509116 acca f7 int uk practise question s answer

Documents