acca | f7 - financial reporting solved past papers

Financial Reporting (International)

Time allowed Reading and planning: 15 minutesWriting: 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

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Fundamentals Pilot Paper – Skills module

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The Association of Chartered Certified Accountants

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ALL FIVE questions are compulsory and MUST be attempted

1 On 1 October 2005 Pumice acquired the following non-current investments: – 80% of the equity share capital of Silverton at a cost of $13.6 million – 50% of Silverton’s 10% loan notes at par – 1.6 million equity shares in Amok at a cost of $6.25 each.

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

PumiceSilvertonAmok $’000 $’000 $’000

Non-current assets Property, plant and equipment 20,000 8,500 16,500 Investments 26,000 nil 1,500 46,000 8,500 18,000 Current assets 15,000 8,000 11,000 Total assets 61,000 16,500 29,000 Equity and liabilities Equity Equity shares of $1 each 10,000 3,000 4,000 Retained earnings 37,000 8,000 20,000 47,000 11,000 24,000 Non-current liabilities 8% loan note 4,000 nil nil 10% loan note nil 2,000 nil

Current liabilities 10,000 3,500 5,000 Total equity and liabilities 61,000 16,500 29,000

The following information is relevant:

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

(ii) In the post acquisition period Pumice sold goods to Silverton at a price of $6 million. These goods had cost Pumice $4 million. Half of these goods were still in the inventory of Silverton at 31 March 2006. Silverton had a balance of $1.5 million owing to Pumice at 31 March 2006 which agreed with Pumice’s records.

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

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

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

Required:

(a) Discuss how the investments purchased by Pumice on 1 October 2005 should be treated in its consolidated financial statements. (5 marks)

(b) Prepare the consolidated balance sheet for Pumice as at 31 March 2006. (20 marks) (25 marks)



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2 The following trial balance relates to Kala, a publicly listed company, at 31 March 2006:

$’000 $’000 Land and buildings at cost (note (i)) 270,000 Plant – at cost (note (i)) 156,000 Investment properties – valuation at 1 April 2005 (note (i)) 90,000 Purchases 78,200 Operating expenses 15,500 Loan interest paid 2,000 Rental of leased plant (note (ii)) 22,000 Dividends paid 15,000 Inventory at 1 April 2005 37,800 Trade receivables 53,200 Revenue 278,400 Income from investment property 4,500 Equity shares of $1 each fully paid 150,000 Retained earnings at 1 April 2005 119,500 8% (actual and effective) loan note (note (iii)) 50,000 Accumulated depreciation at 1 April 2005 – buildings 60,000 – plant 26,000 Trade payables 33,400 Deferred tax 12,500 Bank 5,400 739,700 739,700

The following notes are relevant:

(i) The land and buildings were purchased on 1 April 1990. The cost of the land was $70 million. No land and buildings have been purchased by Kala since that date. On 1 April 2005 Kala had its land and buildings professionally valued at $80 million and $175 million respectively. The directors wish to incorporate these values into the financial statements. The estimated life of the buildings was originally 50 years and the remaining life has not changed as a result of the valuation.

Later, the valuers informed Kala that investment properties of the type Kala owned had increased in value by 7% in the year to 31 March 2006.

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

(ii) On 1 April 2005 Kala entered into a lease for an item of plant which had an estimated life of five years. The lease period is also five years with annual rentals of $22 million payable in advance from 1 April 2005. The plant is expected to have a nil residual value at the end of its life. If purchased this plant would have a cost of $92 million and be depreciated on a straight-line basis. The lessor includes a finance cost of 10% per annum when calculating annual rentals. (Note: you are not required to calculate the present value of the minimum lease payments.)

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

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

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

Required, prepare for Kala:

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

(b) A statement of changes in equity for the year ended 31 March 2006. (4 marks)

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

(25 marks)



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3 Reactive is a publicly listed company that assembles domestic electrical goods which it then sells to both wholesale and retail customers. Reactive’s management were disappointed in the company’s results for the year ended 31 March 2005. In an attempt to improve performance the following measures were taken early in the year ended 31 March 2006:– a national advertising campaign was undertaken,– rebates to all wholesale customers purchasing goods above set quantity levels were introduced,– the assembly of certain lines ceased and was replaced by bought in completed products. This allowed Reactive to

dispose of surplus plant.

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

Incomestatement $million Revenue (25% cash sales) 4,000 Cost of sales (3,450) Gross profit 550 Operating expenses (370) 180 Profit on disposal of plant (note (i)) 40 Finance charges (20) Profit before tax 200 Income tax expense (50) Profit for the period 150

Balancesheet $million $million Non-current assets Property, plant and equipment (note (i)) 550 Current assets Inventory 250 Trade receivables 360 Bank nil 610 Total assets 1,160 Equityandliabilities Equity shares of 25 cents each 100 Retained earnings 380 480 Non-current liabilities 8% loan notes 200

Current liabilities Bank overdraft 10 Trade payables 430 Current tax payable 40 480 Total equity and liabilities 1,160



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Below are ratios calculated for the year ended 31 March 2005. Return on year end capital employed (profit before interest and tax over total assets less current liabilities) 28.1% Net asset (equal to capital employed) turnover 4 times Gross profit margin 17% Net profit (before tax) margin 6.3% Current ratio 1.6:1 Closing inventory holding period 46 days Trade receivables’ collection period 45 days Trade payables’ payment period 55 days Dividend yield 3.75% Dividend cover 2 times

Notes:

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

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

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

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

Required:

(a) Calculate ratios for the year ended 31 March 2006 (showing your workings) for Reactive, equivalent to those provided above. (10 marks)

(b) Analyse the financial performance and position of Reactive for the year ended 31 March 2006 compared to the previous year. (10 marks)

(c) Explain in what ways your approach to performance appraisal would differ if you were asked to assess the performance of a not-for-profit organisation. (5 marks)

(25 marks)

4 (a) The qualitative characteristics of relevance, reliability and comparability identified in the IASB’s Framework for the preparation and presentation of financial statements (Framework) are some of the attributes that make financial information useful to the various users of financial statements.

Required:

Explain what is meant by relevance, reliability and comparability and how they make financial information useful. (9 marks)

(b) During the year ended 31 March 2006, Porto experienced the following transactions or events:

(i) entered into a finance lease to rent an asset for substantially the whole of its useful economic life.

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

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

Required:

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

(15 marks)



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5 IAS 11 Construction contracts deals with accounting requirements for construction contracts whose durations usually span at least two accounting periods.

Required:

(a) Describe the issues of revenue and profit recognition relating to construction contracts. (4 marks)

(b) Beetie is a construction company that prepares its financial statements to 31 March each year. During the year ended 31 March 2006 the company commenced two construction contracts that are expected to take more than one year to complete. The position of each contract at 31 March 2006 is as follows:

Contract 1 2 $’000 $’000 Agreed contract price 5,500 1,200 Estimated total cost of contract at commencement 4,000 900 Estimated total cost at 31 March 2006 4,000 1,250 Agreed value of work completed at 31 March 2006 3,300 840 Progress billings invoiced and received at 31 March 2006 3,000 880 Contract costs incurred to 31 March 2006 3,900 720

The agreed value of the work completed at 31 March 2006 is considered to be equal to the revenue earned in the

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

Required:

Calculate the amounts which should appear in the income statement and balance sheet of Beetie at 31 March 2006 in respect of the above contracts. (6 marks)

(10 marks)

End of Question Paper



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Answers



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Pilot Paper F7 (INT) AnswersFinancial Reporting (International)

1 (a) As the investment in shares represents 80% of Silverton’s equity, it is likely to give Pumice control of that company. Control is the ability to direct the operating and financial policies of an entity. This would make Silverton a subsidiary of Pumice and require Pumice to prepare group financial statements which would require the consolidation of the results of Silverton from the date of acquisition (1 October 2005). Consolidated financial statements are prepared on the basis that the group is a single economic entity.

The investment of 50% ($1 million) of the 10% loan note in Silverton is effectively a loan from a parent to a subsidiary. On consolidation Pumice’s asset of the loan ($1 million) is cancelled out with $1 million of Silverton’s total loan note liability of $2 million. This would leave a net liability of $1 million in the consolidated balance sheet.

The investment in Amok of 1.6 million shares represents 40% of that company’s equity shares. This is generally regarded as not being sufficient to give Pumice control of Amok, but is likely to give it significant influence over Amok’s policy decisions (eg determining the level of dividends paid by Amok). Such investments are generally classified as associates and IAS 28 Investments in associates requires the investment to be included in the consolidated financial statements using equity accounting.

(b) Consolidated balance sheet of Pumice at 31 March 2006 $’000 Non-current assets: Plant, property and equipment (w (i)) 30,300 Goodwill (4,000 (w (ii)) – 400 impairment) 3,600 Investments – associate (w (iii)) 11,400 – other ((26,000 – 13,600 – 10,000 – 1,000 intra-group loan note)) 1,400 46,700 Current assets (15,000 + 8,000 – 1,000 (w (iv)) – 1,500 current account) 20,500 Total assets 67,200

Equity and liabilities Equity attributable to equity holders of the parent Equity shares of $1 each 10,000 Reserves: Retained earnings (w (v)) 37,640 47,640 Minority interest (w (vi)) 2,560 Total equity 50,200 Non-current liabilities 8% Loan note 4,000 10% Loan note (2,000 – 1,000 intra-group) 1,000 5,000 Current liabilities (10,000 + 3,500 – 1,500 current account) 12,000 67,200 Workings in $’000 (i) Property, plant and equipment Pumice 20,000 Silverton 8,500 Fair value – land 400 – plant 1,600 2,000 Additional depreciation (see below) (200) 30,300

The fair value adjustment to plant will create additional depreciation of $400,000 per annum (1,600/4 years) and in the post acquisition period of six months this will be $200,000.

(ii) Goodwill in Silverton: Investment at cost 13,600 Less – equity shares of Silverton (3,000 x 80%) (2,400) – pre-acquisition reserves (7,000 x 80% (see below)) (5,600) – fair value adjustments (2,000 (w (i)) x 80%) (1,600) (9,600) Goodwill on consolidation 4,000



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The pre-acquisition reserves are: At 31 March 2006 8,000 Post acquisition (2,000 x 6/12) (1,000) 7,000

(iii) Carrying amount of Amok at 31 March 2006 Cost (1,600 x $6.25) 10,000 Share post acquisition profit (8,000 x 6/12 x 40%) 1,600 11,600 Impairment loss per question (200) 11,400

(iv) The unrealised profit (URP) in inventory is calculated as: Intra-group sales are $6 million of which Pumice made a profit of $2 million. Half of these are still in inventory, thus there

is an unrealised profit of $1 million.

(v) Consolidated reserves: Pumice’s reserves 37,000 Silverton’s post acquisition (((2,000 x 6/12) - 200 depreciation) x 80%) 640 Amok’s post acquisition profits (8,000 x 6/12 x 40%) 1,600 URP in inventory (see (iv)) (1,000) Impairment of goodwill – Silverton (400) – Amok (200) 37,640

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

2 (a) Kala–Incomestatement–Yearended31March2006 $’000 $’000 Revenue 278,400 Cost of sales (w (i)) (115,700) Gross profit 162,700 Operating expenses (15,500) 147,200 Investment income – property rental 4,500 – valuation gain (90,000 x 7%) 6,300 10,800 Finance costs – loan (w (ii)) (3,000) – lease (w (iii)) (7,000) (10,000) Profit before tax 148,000 Income tax expense (28,300 + (14,100 – 12,500)) (29,900) Profit for the period 118,100

(b) Kala–Statementofchangesinequity–Yearended31March2006

Equity Revaluation Retained Total shares reservr earnings $’000 $’000 $’000 $’000 At 1 April 2005 150,000 nil 119,500 269,500 Profit for period (see (a)) 118,100 118,100 Revaluation of property (w (iv)) 45,000 45,000 Equity dividends paid (15,000) (15,000) At 31 March 2006 150,000 45,000 222,600 417,600



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(c) Kala–Balancesheetasat31March2006 Non-currentassets $’000 $’000 Property, plant and equipment (w (iv)) 434,100 Investment property (90,000 + 6,300) 96,300 530,400 Current assets Inventory 43,200 Trade receivables 53,200 96,400 Total assets 626,800

Equity and liabilities Equity (see (b) above) Equity shares of $1 each 150,000

Reserves: Revaluation 45,000 Retained earnings 222,600 267,600 417,600

Non-current liabilities 8% loan note 50,000 Deferred tax 14,100 Lease obligation (w (iii)) 55,000 119,100 Current liabilities Trade payables 33,400 Accrued loan interest (w (ii)) 1,000 Bank overdraft 5,400 Lease obligation (w (iii)) – accrued interest 7,000 – capital 15,000 Current tax payable 28,300 90,100 Total equity and liabilities 626,800 Workings in brackets in $’000 (i) Cost of sales: Opening inventory 37,800 Purchases 78,200 Depreciation (w (iv)) – buildings 5,000 – plant: owned 19,500 – plant: leased 18,400 Closing inventory (43,200) 115,700

(ii) The loan has been in issue for nine months. The total finance cost for this period will be $3 million (50,000 x 8% x 9/12). Kala has paid six months interest of $2 million, thus accrued interest of $1 million should be provided for.

(iii) Finance lease: $’000 Net obligation at inception of lease (92,000 – 22,000) 70,000 Accrued interest 10% (current liability) 7,000 Total outstanding at 31 March 2006 77,000

The second payment in the year to 31 March 2007 (made on 1 April 2006) of $22 million will be $7 million for the accrued interest (at 31 March 2006) and $15 million paid of the capital outstanding. Thus the amount outstanding as an obligation over one year is $55 million (77,000 – 22,000).

(iv) Non-current assets/depreciation: Land and buildings: At the date of the revaluation the land and buildings have a carrying amount of $210 million (270,000 – 60,000). With

a valuation of $255 million this gives a revaluation surplus (to reserves) of $45 million. The accumulated depreciation of $60 million represents 15 years at $4 million per annum (200,000/50 years) and means the remaining life at the date of the revaluation is 35 years. The amount of the revalued building is $175 million, thus depreciation for the year to 31 March 2006 will be $5 million (175,000/35 years). The carrying amount of the land and buildings at 31 March 2006 is $250 million (255,000 – 5,000).

Plant: owned



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The carrying amount prior to the current year’s depreciation is $130 million (156,000 – 26,000). Depreciation at 15% on the reducing balance basis gives an annual charge of $19.5 million. This gives a carrying amount at 31 March 2006 of $110.5 million (130,000 – 19,500).

Plant: leased The fair value of the leased plant is $92 million. Depreciation on a straight-line basis over five years would give a

depreciation charge of $18.4 million and a carrying amount of $73.6 million.

Summarising the carrying amounts: Land and buildings 250,000 Plant (110,500 + 73,600) 184,100 Property, plant and equipment 434,100

3 (a) Note: figures in the calculations are in $million Return on year end capital employed 32.3 % 220/(1,160 – 480) x 100 Net asset turnover 5.9 times 4,000/680 Gross profit margin 13.8 % (550/4,000) x 100 Net profit (before tax) margin 5.0 % (200/4,000) x 100 Current ratio 1.3 :1 610:480 Closing inventory holding period 26 days 250/3,450 x 365 Trade receivables’ collection period 44 days 360/(4,000 – 1,000) x 365 Trade payables’ payment period (based on cost of sales) 45 days (430/3,450) x 365 Dividend yield 6.0% (see below) Dividend cover 1.67 times 150/90

The dividend per share is 22.5 cents (90,000/(100,000 x 4 ie 25 cents shares). This is a yield of 6.0% on a share price of $3.75.

(b) Analysis of the comparative financial performance and position of Reactive for the year ended 31 March 2006

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

of performance) has improved by 15% (32.3 -28.1)/28.1). Looking in more detail at the composition of the ROCE, the reason for the improved profitability is due to increased efficiency in the use of the company’s assets (asset turnover), increasing from 4 to 5.9 times (an improvement of 48%). The improvement in the asset turnover has been offset by lower profit margins at both the gross and net level. On the surface, this performance appears to be due both to the company’s strategy of offering rebates to wholesale customers if they achieve a set level of orders and also the beneficial impact on sales revenue of the advertising campaign. The rebate would explain the lower gross profit margin, and the cost of the advertising has reduced the net profit margin (presumably management expected an increase in sales volume as a compensating factor). The decision to buy complete products rather than assemble them in house has enabled the disposal of some plant which has reduced the asset base. Thus possible increased sales and a lower asset base are the cause of the improvement in the asset turnover which in turn, as stated above, is responsible for the improvement in the ROCE.

The effect of the disposal needs careful consideration. The profit (before tax) includes a profit of $40 million from the disposal. As this is a ‘one-off’ profit, recalculating the ROCE without its inclusion gives a figure of only 23.7% (180m/(1,160 - 480m + 80m (the 80m is the carrying amount of plant)) and the fall in the net profit percentage (before tax) would be down even more to only 4.0% (160m/4,000m). On this basis the current year performance is worse than that of the previous year and the reported figures tend to flatter the company’s underlying performance.

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

1.3 (1.5 is usually considered as a safe minimum). With the trade receivables period at virtually a constant (45/44 days), the change in liquidity appears to be due to the levels of inventory and trade payables. These give a contradictory picture. The closing inventory holding period has decreased markedly (from 46 to 26 days) indicating more efficient inventory holding. This is perhaps due to short lead times when ordering bought in products. The change in this ratio has reduced the current ratio, however the trade payables payment period has decreased from 55 to 45 days which has increased the current ratio. This may be due to different terms offered by suppliers of bought in products.

Importantly, the effect of the plant disposal has generated a cash inflow of $120 million, and without this the company’s liquidity would look far worse.

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

but as the company has maintained the same dividend (and dividend per share as there is no change in share capital) , the ‘improvement’ in the yield is due to a falling share price. Last year the share price must have been $6.00 to give a yield of 3.75% on a dividend per share of 22.5 cents. It is worth noting that maintaining the dividend at $90 million from profits of $150 million gives a cover of only 1.67 times whereas on the same dividend last year the cover was 2 times (meaning last year’s profit (after tax) was $180 million).



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

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

(c) It is generally assumed that the objective of stock market listed companies is to maximise the wealth of their shareholders. This in turn places an emphasis on profitability and other factors that influence a company’s share price. It is true that some companies have other (secondary) aims such as only engaging in ethical activities (eg not producing armaments) or have strong environmental considerations. Clearly by definition not-for-profit organisations are not motivated by the need to produce profits for shareholders, but that does not mean that they should be inefficient. Many areas of assessment of profit oriented companies are perfectly valid for not-for-profit organisations; efficient inventory holdings, tight budgetary constraints, use of key performance indicators, prevention of fraud etc.

There are a great variety of not-for-profit organisations; eg public sector health, education, policing and charities. It is difficult to be specific about how to assess the performance of a not-for-profit organisation without knowing what type of organisation it is. In general terms an assessment of performance must be made in the light of the stated objectives of the organisation. Thus for example in a public health service one could look at measures such as treatment waiting times, increasing life expectancy etc, and although such organisations don’t have a profit motive requiring efficient operation, they should nonetheless be accountable for the resources they use. Techniques such as ‘value for money’ and the three Es (economy, efficiency and effectiveness) have been developed and can help to assess the performance of such organisations.

4 (a) Relevance Information has the quality of relevance when it can influence, on a timely basis, users’ economic decisions. It helps to evaluate

past, present and future events by confirming or perhaps correcting past evaluations of economic events. There are many ways of interpreting and applying the concept of relevance, for example, only material information is considered relevant as, by definition, information is material only if its omission or misstatement could influence users. Another common debate regarding relevance is whether current value information is more relevant than that based on historical cost. An interesting emphasis placed on relevance within the Framework is that relevant information assists in the predictive ability of financial statements. That is not to say the financial statements should be predictive in the sense of forecasts, but that (past) information should be presented in a manner that assists users to assess an entity’s ability to take advantage of opportunities and react to adverse situations. A good example of this is the separate presentation of discontinued operations in the income statement. From this users will be better able to assess the parts of the entity that will produce future profits (continuing operations) and users can judge the merits of the discontinuation ie has the entity sold a profitable part of the business (which would lead users to question why), or has the entity acted to curtail the adverse affect of a loss making operation.

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

from material error (accurate) and a faithful representation of that which it purports to portray (i.e. the financial statements are a faithful representation of the entity’s underlying transactions). There can be occasions where the legal form of a transaction can be engineered to disguise the economic reality of the transaction. A cornerstone of faithful representation is that transactions must be accounted for according to their substance (i.e. commercial intent or economic reality) rather than their legal or contrived form. To be reliable, information must be neutral (free from bias). Biased information attempts to influence users (perhaps to come to a predetermined decision) by the manner in which it is presented. It is recognised that financial statements cannot be absolutely accurate due to inevitable uncertainties surrounding their preparation. A typical example would be estimating the useful economic lives of non-current assets. This is addressed by the use of prudence which is the exercise of a degree of caution in matters of uncertainty. However prudence cannot be used to deliberately understate profit or create excessive provisions (this would break the neutrality principle). Reliable information must also be complete, omitted information (that should be reported) will obviously mislead users.

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

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

(b) (i) This item involves the characteristic of reliability and specifically reporting the substance of transactions. As the lease agreement is for substantially the whole of the asset’s useful economic life, Porto will experience the same risks and rewards as if it owned the asset. Although the legal form of this transaction is a rental, its substance is the equivalent to acquiring the asset and raising a loan. Thus, in order for the financial statements to be reliable (and comparable to those where an asset is bought from the proceeds of a loan), the transaction should be shown as an asset on Porto’s balance sheet with a corresponding liability for the future lease rental payments. The income statement should be charged with depreciation on the asset and a finance charge on the ‘loan’.



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(ii) This item involves the characteristic of comparability. Changes in accounting policies should generally be avoided in order to preserve comparability. Presumably the directors have good reason to be believe the new policy presents a more reliable and relevant view. In order to minimise the adverse effect a change in accounting policy has on comparability, the financial statements (including the corresponding amounts) should be prepared on the basis that the new policy had always been in place (retrospective application). Thus the assets (retail outlets) should include the previously expensed finance costs and income statements will no longer show a finance cost (in relation to these assets whilst under construction). Any finance costs relating to periods prior to the policy change (i.e. for two or more years ago) should be adjusted for by increasing retained earnings brought forward in the statement of changes in equity.

(iii) This item involves the characteristic of relevance. This situation questions whether historical cost accounting is more relevant to users than current value information. Porto’s current method of reporting these events using purely historical cost based information (i.e. showing an operating loss, but not reporting the increases in property values) is perfectly acceptable. However, the company could choose to revalue its hotel properties (which would subject it to other requirements). This option would still report an operating loss (probably an even larger loss than under historical cost if there are increased depreciation charges on the hotels), but the increases in value would also be reported (in equity) arguably giving a more complete picture of performance.

5 (a) The correct timing of when revenue (and profit) should be recognised is an important aspect of an income statement showing

a faithful presentation. It is generally accepted that only realised profits should be included in the income statement. For most types of supply and sale of goods it is generally understood that a profit is realised when the goods have been manufactured (or obtained) by the supplier and satisfactorily delivered to the customer. The issue with construction contracts is that the process of completing the project takes a relatively long time and, in particular, will spread across at least one accounting period-end. If such contracts are treated like most sales of goods, it would mean that revenue and profit would not be recognised until the contract is completed (the “completed contracts” basis). This is often described as following the prudence concept. The problem with this approach is that it may not show a faithful presentation as all the profit on a contract is included in the period of completion, whereas in reality (a faithful representation), it is being earned, but not reported, throughout the duration of the contract. IAS 11 remedies this by recognising profit on uncompleted contracts in proportion to some measure of the percentage of completion applied to the estimated total contract profit. This is sometimes said to reflect the accruals concept, but it should only be applied where the outcome of the contract is reasonably foreseeable. In the event that a loss on a contract is foreseen, the whole of the loss must be recognised immediately, thereby ensuring the continuing application of prudence.

(b) Beetie Incomestatement Contract1Contract2 Total $’000 $’000 $’000 Revenue recognised 3,300 840 4,140 Contract expenses recognised (balancing figure contract 1) (2,400) (720) (3,120) Expected loss recognised (contract 2) (170) (170) Attributable profit/(loss) (see working) 900 (50) 850

Balancesheet Contact costs incurred 3,900 720 4,620 Recognised profit/(losses) 900 (50) 850 4,800 670 5,470 Progress billings (3,000) (880) (3,880) Amounts due from customers 1,800 1,800 Amounts due to customers (210) (210)

Workings (in $’000) Estimated total profit: Agreed contract price 5,500 1,200 Estimated contract cost (4,000) (1,250) Estimated total profit/(loss) 1,500 (50)

Percentage complete: Agreed value of work completed at 31 March 2006 3,300 Contract price 5,500 Percentage complete at 31 March 2006 (3,300/5,500 x 100) 60%

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

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



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Pilot Paper F7 (INT) Marking SchemeFinancial Reporting (International)

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

1 (a) 1 mark per relevant point 5

(b) Balance sheet: property, plant and equipment 2½ goodwill 3½ investments – associate 3 – other 1 current assets 2 equity shares 1 retained earnings 3 minority interest 1½ 8% loan notes ½ 10% loan notes 1 profit and loss account 1 20 Total for question 25

2 (a) Income statement revenue ½ cost of sales 4½ operating expenses ½ investment income 1½ finance costs 1½ taxation 1½ 10

(b) Movement in share capital and reserves brought forward figures 1 revaluation 1 profit for period 1 dividends paid 1 4

(c) Balance sheet land and buildings 2 plant and equipment 2 investment property 1 inventory and trade receivables 1 8% loan ½ deferred tax ½ lease obligation: interest and capital one year 1 capital over one year 1 trade payables and overdraft 1 accrued interest ½ income tax provision ½ 11 Total for question 25



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3 (a) one mark per ratio 10

(b) 1 mark per valid point maximum 10

(c) 1 mark per valid point maximum 5 Total for question 25

4 (a) 3 marks each for relevance, reliability and comparability 9

(b) 2 marks for each transaction ((i) to (iii)) or event 6 Total for question 15

5 (a) one mark per valid point to maximum 4

(b) revenue (½ mark for each contract) 1 profit/loss (½ mark for each contract) 1 amounts due from customers (contract 1) 2 amounts due to customers (contract 2) 2 6 Total for question 10



FinancialReporting(International Stream)

PART 2

THURSDAY 5 DECEMBER 2002

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST beanswered

Section B THREE questions ONLY to be answered

Pape

r 2.5

(IN

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Section A – This ONE question is compulsory and MUST be attempted

1 Hydrate is a public company operating in the industrial chemical sector. In order to achieve economies of scale, it hasbeen advised to enter into business combinations with compatible partner companies. As a first step in this strategyHydrate acquired all of the ordinary share capital of Sulphate by way of a share exchange on 1 April 2002. Hydrateissued five of its own shares for every four shares in Sulphate. The market value of Hydrate’s shares on 1 April 2002was $6 each. The share issue has not yet been recorded in Hydrate’s books. The summarised financial statementsof both companies for the year to 30 September 2002 are:

Income statement – year to 30 September 2002:Hydrate Sulphate$000 $000

Sales revenue 24,000 20,000Cost of sales (16,600) (11,800)

––––––– –––––––Gross profit 7,400 8,200Operating expenses (1,600) (1,000)

––––––– –––––––Operating profit 5,800 7,200 Taxation (2,000) (3,000)

––––––– ––––––– Profit after tax 3,800 4,200

––––––– –––––––

Balance Sheet – as at 30 September 2002Non-current assets $000 $000 $000 $000Property, plant and equipment 64,000 35,000Investment nil 12,800

––––––– –––––––64,000 47,800

Current AssetsInventory 22,800 23,600 Accounts receivable 16,400 24,200Bank 500 39,700 200 48,000

––––––– ––––––– ––––––– –––––––Total assets 103,700 95,800

––––––– –––––––Equity and liabilitiesOrdinary shares of $1 each 20,000 12,000Reserves:Share premium 4,000 2,400Accumulated profits 57,200 61,200 42,700 45,100

––––––– ––––––– ––––––– –––––––81,200 57,100

Non-current liabilities8% Loan note 5,000 18,000Current liabilitiesAccounts payable 15,300 17,700Taxation 2,200 17,500 3,000 20,700

––––––– ––––––– ––––––– –––––––103,700 95,800––––––– –––––––

The following information is relevant:– The fair value of Sulphate’s investment was $5 million in excess of its book value at the date of acquisition. The

fair values of Sulphate’s other net assets were equal to their book values. – Consolidated goodwill is deemed to have a five-year life, with time apportioned charges (treated as an operating

expense) in the year of acquisition.– No dividends have been paid or proposed by either company.

2



Required:

(a) (i) Prepare the consolidated income statment and balance sheet of Hydrate for the year to 30 September 2002 using the purchase method of accounting (acquisition accounting); and

(13 marks)

(ii) Prepare a consolidated income statement and the consolidated SHAREHOLDERS FUNDS section of thebalance sheet of Hydrate for the year to 30 September 2002 using the uniting of interests method ofaccounting (merger accounting). (7 marks)

(b) Describe the distinguishing feature of a uniting of interests, and discuss whether the business combinationin (a) should be accounted for as a uniting of interests. (5 marks)

(25 marks)

3 [P.T.O.



Section B – THREE questions ONLY to be attempted

2 The following figures have been extracted from the accounting records of Bloomsbury on 30 September 2002:$000 $000

Sales revenue (note (i)) 98,880Cost of sales 56,000Joint venture account (note (ii)) 1,200Operating expenses 14,000Loan interest paid 1,800Investment income 700Investment property at valuation 10,00025-year leasehold factory at cost (note (iii)) 50,00015-year leasehold factory at cost (note (iii)) 30,000Plant and equipment at cost (note (iii)) 49,800Depreciation 1 October 2001 – 25 year leasehold 10,000Depreciation 1 October 2001 – 15 year leasehold 10,000Depreciation 1 October 2001 – plant and equipment 19,800Accounts receivable (note (i)) 16,700Inventory – 30 September 2002 7,500Cash and bank 500Accounts payable 9,420Deferred tax – 1 October 2001 (note (iv)) 2,100Ordinary shares of 25 cents each 40,00010% Redeemable (in 2005 at par) preference shares of $1 each 10,00012% Loan note (issued in 2000) 30,000Accumulated profits – 1 October 2001 6,100Investment property revaluation reserve – 1 October 2001 2,000Interim dividends (note (v)) 1,500

–––––––– ––––––––239,000 239,000–––––––– ––––––––

The following notes are relevant:(i) On 1 January 2002, Bloomsbury agreed to act as a selling agent for an overseas company, Brandberg. The terms

of the agency are that Bloomsbury receives a commission of 10% on all sales made on behalf of Brandberg. Thisis achieved by Bloomsbury remitting 90% of the cash received from Brandberg’s customers one month afterBloomsbury has collected it. Bloomsbury has included in its sales revenue $7·2 million of sales on behalf ofBrandberg of which there is one month’s outstanding balances of $1·2 million included in Bloomsbury’saccounts receivable. The cash remitted to Brandberg during the year of $5·4 million (i.e. 90% of $6 million) inaccordance with the terms of the agency, has been treated as the cost of the agency sales.

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

Details of Bloomsbury’s joint venture transactions are: $000Plant and equipment at cost 1,500Share of joint venture sales revenues (50% of total sales revenues) (800)Related cost of sales excluding depreciation 400Accounts receivable 200Accounts payable (100)

––––––Net balance of joint venture account 1,200

––––––

Plant and equipment should be depreciated in accordance with the company’s policy in note (iii).

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(iii) On 1 October 2001 Bloomsbury had its two leasehold factories revalued (for the first time) by an independentsurveyor as follows:25 year leasehold $52 million15 year leasehold $18 million

Bloomsbury depreciates its leaseholds on a straight-line basis over the life of the lease.

The directors of Bloomsbury are disappointed in the value placed on the 15-year leasehold. The surveyor hassaid that the fall in its value is due mainly to its unfavourable location, but in time the surveyor expects its valueto increase. The directors are committed to incorporating the revalued amount of the 25-year leasehold into thefinancial statements, but wish to retain the historic cost basis for the 15-year leasehold. Revaluation surplusesare transferred to accumulated realised profits in line with the realisation of the related assets.

Prior to the current year, Bloomsbury had adopted a policy of carrying its investment property at fair value, withthe surplus being credited to reserves. For the current year it will be applying the fair value method of accountingfor investment properties in IAS 40 ‘Investment Property’. The value of the investment property had increased bya further $500,000 in the year to 30 September 2002.

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

(iv) A provision for income tax for the year to 30 September 2002 of $5 million is required. Temporary differences(related to the difference between the tax base of the plant and its balance sheet written down value) on 1 October 2001 were $7 million and on 30 September 2002 they had declined to $5 million. Assume a tax rateof 30%. Ignore deferred tax on the property revaluations.

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

Required:

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

– An Income Statement; (9 marks)

– A Statement of Changes in Equity; and (3 marks)

– A Balance Sheet. (13 marks)

Notes to the financial statements are not required.

(25 marks)

5 [P.T.O.



3 The principle of recording the substance or economic reality of transactions rather than their legal form lies at the heartof the Framework for Preparation and Presentation of Financial Statements’ (Framework) and several InternationalAccounting Standards. The development of this principle was partly in reaction to a minority of public interestcompanies entering into certain complex transactions. These transactions sometimes led to accusations that companydirectors were involved in ‘creative accounting’.

Required:

(a) (i) Explain, with relevant examples, what is generally meant by the term ‘creative accounting’; (5 marks)

(ii) Explain why it is important to record the substance rather than the legal form of transactions anddescribe the features that may indicate that the substance of a transaction is different from its legalform. (5 marks)

(b) (i) Atkins’s operations involve selling cars to the public through a chain of retail car showrooms. It buys mostof its new vehicles directly from the manufacturer on the following terms:

– Atkins will pay the manufacturer for the cars on the date they are sold to a customer or six months afterthey are delivered to its showrooms whichever is the sooner.

– The price paid will be 80% of the retail list price as set by the manufacturer at the date that the goodsare delivered.

– Atkins will pay the manufacturer 1·5% per month (of the cost price to Atkins) as a ‘display charge’ untilthe goods are paid for.

– Atkins may return the cars to the manufacturer any time up until the date the cars are due to be paidfor. Atkins will incur the freight cost of any such returns. Atkins has never taken advantage of this rightof return.

– The manufacturer can recall the cars or request them to be transferred to another retailer any time upuntil the time they are paid for by Atkins.

Required:

Discuss which party bears the risks and rewards in the above arrangement and come to a conclusion on howthe transactions should be treated by each party. (6 marks)

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

– Atkins can re-purchase the plots of land for the full fair value of $3·2 million (the value determined atthe date of sale) any time until 30 September 2004; and

– On 1 October 2004, Landbank has the option to require Atkins to re-purchase the properties for $3·2million. You may assume that Landbank seeks a return on its investments of 10% per annum.

Required:

Discuss the substance of the above transactions; and (3 marks)

Prepare extracts of the income statement and balance sheet (ignore cash) of Atkins for the year to 30 September 2002:

– if the plots of land are considered as sold to Landbank; and (2 marks)

– reflecting the substance of the above transactions. (4 marks)

(25 marks)

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This is a blank page.

Question 4 begins on page 8.

7 [P.T.O.



8

4 The financial statements of Nedberg for the year to 30 September 2002, together with the comparative balance sheetfor the year to 30 September 2001 are shown below:

Income Statement – year to 30 September 2002:$m $m

Sales revenue 3,820Cost of sales (note (1)) (2,620)

––––––Gross profit for period 1,200Operating expenses (note (1)) (300)

––––––900

Interest – Loan note (30)––––––

Profit before tax 870Taxation (270)

––––––Net profit for the period 600Dividends: ordinary – Interim (120)Dividends: ordinary – Final (280) (400)

––––– –––––Net profit for period 200

–––––Balance sheets as at 30 September: 2002 2001Non-current assets $m $m $m $mProperty, plant and equipment 1,890 1,830Intangible assets (note (2)) 650 300

–––––– ––––––2,540 2,130

Current assetsInventory 1,420 940Accounts receivable 990 680Cash 70 2,480 nil 1,620

–––––– –––––– –––––– ––––––Total assets 5,020 3,750

–––––– ––––––Equity and liabilitiesOrdinary Shares of $1 each 750 500ReservesShare premium 350 100Revaluation 140 nilAccumulated profits 2,010 1,700Less dividends paid and declared (400) 1,610 (300) 1,400

–––––– –––––– –––––– ––––––2,850 2,000

Non-current liabilities (note (3)) 870 540Current liabilities (note (4)) 1,300 1,210

–––––– ––––––Total equity and liabilities 5,020 3,750

–––––– ––––––



9 [P.T.O.

Notes to the financial statements:

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

(2) Intangible non-current assets:2002 2001$m $m

Deferred development expenditure 470 100Goodwill 180 200

–––– ––––650 300–––– ––––

(3) Non-current liabilities:10% loan note 300 100Government grants 260 300Deferred tax 310 140

–––– ––––870 540–––– ––––

(4) Current liabilities:Accounts payable 875 730Bank overdraft nil 115Accrued loan interest 15 5Declared dividends unpaid 280 200Taxation 130 160

––––– –––––1,300 1,210––––– –––––

The following additional information is relevant:(i) Intangible fixed assets:

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

(ii) Property, plant and equipment/revaluation reserve:– The company revalued its buildings by $200 million on 1 October 2001. The surplus was credited to a

revaluation reserve.– New plant was acquired during the year at a cost of $250 million and a government grant of $50 million

was received for this plant.– On 1 October 2001 a bonus issue of 1 new share for every 10 held was made from the revaluation reserve. – $10 million has been transferred from the revaluation reserve to realised profits as a year-end adjustment

in respect of the additional depreciation created by the revaluation.– The remaining movement on property, plant and equipment was due to the disposal of obsolete plant.

(iii) Share issues:In addition to the bonus issue referred to above Nedberg made a further issue of ordinary shares for cash.

Required:

(a) A cash flow statement for Nedberg for the year to 30 September 2002 prepared in accordance with IAS 7 ‘Cash Flow Statements’. (20 marks)

(b) Comment briefly on the financial position of Nedberg as portrayed by the information in your cash flowstatement. (5 marks)

(25 marks)



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5 You are a partner in a small audit and accounting practice. You have just completed the audit and finalised thefinancial statements of a small family owned company in discussion with its managing director Mrs Harper. After themeeting Mrs Harper has asked for your help. She has obtained the published financial statements of several quotedcompanies in which she is considering buying some shares as a personal investment. She presents you with thefollowing information:

(a) In the year to 30 September 2002, two companies, Gamma and Toga, reported identical profits before tax of$100 million. Information in the Chairmen’s reports said both companies also expected profits from their coreactivities (to be interpreted as from continuing operations) to grow by 10% in the following year. Mrs Harper hasextracted information from the income statements and made the following summary:

Gamma Toga Operating profit: $ million $ millionContinuing activities 70 90Acquisitions nil 50Discontinued activities 30 (40)

––– –––100 100––– –––

A note to the financial statements of Toga said that both the discontinuation and acquisition occurred on 1 April 2002 and were part of an overall plan to focus on its traditional core activities after incurring large losseson a new foreign venture.

Required:

(i) Briefly explain to Mrs Harper why information on discontinued operations is useful; (3 marks)

(ii) Calculate the expected operating profit for both companies for the year to 30 September 2003(assuming the Chairmen’s growth forecasts are correct):

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

– based on the information provided above. (4 marks)

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

Earnings per share:Year to 30 September 2002 2001Basic earnings per share 25 cents 20 cents

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

Balance sheet extracts: $ million $ million8% Convertible loan stock 200 200

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

Note to the financial statements:There are directors’ share options (in issue since 1999) that allow Taylor’s directors to subscribe for a total of 50 million new ordinary shares at a price of $1·50 each.

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

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



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Required:

(i) Explain why the trend of earnings per share may be different from the trend of the reported profit, andwhich is the more useful measure of performance; (3 marks)

(ii) Calculate the diluted earnings per share for Taylor based on the effect of the convertible loan stock andthe directors’ share options for the year to 30 September 2002 (ignore comparatives); and (5 marks)

(iii) Explain the relevance of the diluted earnings per share measure. (4 marks)

(c) Mrs Harper has noticed that the tax charge for a company called Stepper is $5 million on profits before tax of$35 million. This is an effective rate of tax of 14·3%. Another company Jenni has an income tax charge of $10million on profit before tax of $30 million. This is an effective rate of tax of 33·3% yet both companies state therate of income tax applicable to them is 25%. Mrs Harper has also noticed that in the cash flow statements eachcompany has paid the same amount of tax of $8 million.

Required:

Advise Mrs Harper of the possible reasons why the income tax charge in the financial statements as a percentageof the profit before tax may not be the same as the applicable income tax rate, and why the tax paid in the cashflow statement may not be the same as the tax charge in the income statement. (6 marks)

(25 marks)




Answers



15

Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) December 2002 Answers

1 (a) (i) Using the purchase (acquisition) method of accounting.Hydrate – Consolidated Income Statement – year to 30 September 2002

$000Sales revenue (24,000 + (6/12 x 20,000)) 34,000Cost of sales (16,600 + (6/12 x 11,800)) (22,500)

–––––––Gross profit 11,500Operating expenses (1,600 + (6/12 x 1,000) + 3,000 goodwill depreciation (w (ii))) (5,100)

–––––––6,400

Taxation (2,000 + (6/12 x 3,000)) (3,500)–––––––

Profit for the year 2,900–––––––

Consolidated balance sheet at 30 September 2002:Non-current assets $000 $000Property, plant and equipment (64,000 + 35,000) 99,000Investments (12,800 + 5,000 fair value adjustment) 17,800Goodwill (30,000 – 3,000 (w (ii))) 27,000

––––––––143,800

Current AssetsInventory (22,800 + 23,600) 46,400Accounts receivable (16,400 + 24,200) 40,600Bank (500 + 200) 700 87,700

––––––– –––––––Total assets 231,500

–––––––

Equity and liabilities:Ordinary shares of $1 each (20,000 + 15,000 (w (ii))) 35,000Reserves:Share premium (4,000 + 75,000 (w (ii))) 79,000Accumulated profits (w (i)) 56,300 135,300

––––––– ––––––––170,300

Non-current liabilities8% Loan notes (5,000 + 18,000) 23,000

Current liabilitiesAccounts payable (15,300 + 17,700) 33,000Taxation (2,200 + 3,000) 5,200 38,200

––––––– –––––––231,500–––––––

(ii) Using the uniting of interest (merger) method of accounting.Hydrate – Consolidated Income Statement – year to 30 September 2002Sales revenue (24,000 + 20,000) 44,000Cost of sales (16,600 + 11,800) (28,400)

–––––––Gross profit 15,600Operating expenses (1,600 + 1,000) (2,600)

–––––––13,000

Taxation (2,000 + 3,000) (5,000)–––––––

Profit for the year 8,000–––––––

Hydrate – Share capital and reserves as at 30 September 2002:$000 $000

Ordinary shares of $1 each (20,000 + 15,000 (w (ii))) 35,000Reserves:Share premium 4,000Capital reserve (reclassification of Sulphate’s share premium) 2,400Accumulated profits (w (iii))) 96,900 103,300

––––––– ––––––––138,300––––––––



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(b) The distinguishing features of a uniting of interests are:– It is not possible to identify an acquirer. Instead of a dominant party, the shareholders of the joining entities unite in a

substantially equal arrangement to share control over the combined entity.– All parties to the combination participate in the management of the combined business.– The sizes of the combining entities should be broadly similar leading to a substantially equal exchange of voting common

shares. This should ensure that no one party is in a position to dominate the combined business due to its previousrelative size.

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

The above is generally evidenced by:– The substantial majority of (if not all) of the voting shares of the combining parties are exchanged or pooled.– The fair value of one entity is not significantly different from that of the other parties.– The shareholders of each party maintain substantially the same voting rights and interests, relative to each other, in the

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

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

It is not possible to be absolutely certain from the limited information given in the question whether all of the above criteriafor a uniting of interest have been satisfied, but it does appear likely. The following observations can be made:– Although Hydrate is acting on a strategy of acquisition to achieve economies of scale, the use of the phrase ‘compatible

partner companies’ may be indicative of a uniting of interests rather than an acquisition approach.– The sizes of the companies are broadly similar (20,000 : 15,000 shares). There is no guidance in IAS 22 ‘Business

Combinations’ of how the term ‘substantially equal’ should be interpreted.– The consideration is all in the form of equity and satisfies the share exchange criterion.– The composition of the new management and whether all shares rank equally would need to be determined from the

details and terms of the combination agreement.

WorkingsAcquisition accounting:(i) Consolidated accumulated profits: $000s

Hydrate’s reserves per question 57,200Sulphate’s post acquisition reserves (6/12 x 4,200) 2,100 Goodwill amortisation (see below) (3,000)

–––––––56,300–––––––

(ii) Goodwill/Cost of control in Sulphate:Hydrate issued 5 shares for every 4 in Sulphate. Therefore Hydrate issued 15 million (12 million/4 x 5) shares at avalue of $6 each to the shareholders of Sulphate. This would be recorded in Hydrate’s books as ordinary share capitalof $15 million and share premium of $75 million.

$000s $000sInvestment at cost (15 million x $6) 90,000 Less – ordinary shares of Sulphate 12,000Less – share premium 2,400Less – pre-acquisition reserves (42,700 – 2,100 see (i)) 40,600Less – revaluation of investment 5,000 (60,000)

––––––– –––––––Goodwill on consolidation 30,000

–––––––

Amortisation of goodwill for the year to 30 September 2002 will be $30 million/5 years x 6/12 = $3 million

(iii) Uniting of interests: A feature of a uniting of interests is that most, if not all, of the subsidiary’s reserves will be included as group reserves.

For Hydrate the consolidated reserves will be: $000Hydrate’s reserves per question 57,200Sulphate’s reserve per question 42,700 Adjustment re share capital (15,000 issued – 12,000 acquired) (3,000)

–––––––Accumulated profits at 30 September 2002 96,900

–––––––



17

2 Bloomsbury Income Statement – Year to 30 September 2002$000 $000

Sales revenue (98,880 – 7,200 (w (i)) + 800 (w (ii))) 92,480Cost of sales (w (i)) (61,700)

–––––––Gross profit 30,780

Other operating income:Agency commission (w (i)) 720Investment income – surplus on investment property (iii) 500

Invement ince– other 700 1,200––––

Operating expenses (14,000)Loss on revaluation of property (w (iii)) (2,000)Loan interest (1,800 + 1,800 accrued) (3,600)Preference dividends (500 + 500 accrued (w (v))) (1,000) (20,600)

––––––– –––––––Operating profit 12,100Taxation (5,000 – 600 deferred tax (w (iv))) (4,400)

–––––––Net profit for the period 7,700

–––––––

Bloomsbury – Statement of Changes in Equity – Year to 30 September 2002Share capital Revaluation Investment Accumulated Total

reserve prop. revaln profits$000 $000 $000 $000 $000

Balance at 1 October 2001 40,000 nil 2,000 6,100 48,100Surplus on revaluation of property (w (iii)) 12,000 12,000Net profit for the period 7,700 7,700Ordinary dividends (w (v)) (5,800) (5,800)Transfer to realised profits (w (iii)) (600) (2,000) 2,600 nil

–––––– –––––– –––––– –––––– ––––––Balance at 30 September 2002 40,000 11,400 nil 10,600 62,000

–––––– –––––– –––––– –––––– ––––––

Bloomsbury – Balance Sheet as at 30 September 2002Tangible non-current assets $000 $000Property, plant and equipment (w (iii)) 90,800Investments – investment property (10,000 + 500 revaluation) 10,500

––––––––101,300

Current AssetsInventory 7,500Accounts receivable (16,700 – 1,200 + 120 (w (i)) + 200 (w (ii))) 15,820Cash 500 23,820

––––––– ––––––– Total Assets 125,120

––––––––Equity and liabilities:Ordinary shares of 25 cents each 40,000Reserves:Accumulated profits ((b) above) 10,600Revaluation reserve (12,000 – 600 (w (iii))) 11,400 22,000

––––––– –––––––62,000

Non-current liabilities (w (vii)) 41,500Current liabilitiesTrade and other payables (w (vi)) 11,820Taxation 5,000Proposed dividends (w (v)) 4,800 21,620

–––––– ––––––––Total equity and liabilities 125,120

––––––––



18

Workings (i) Cost of sales: $000 $000

Per question 56,000Brandberg adjustment – see below (5,400)Depreciation – leaseholds (w (iii)) 4,400Depreciation – plant and equipment (w (iii)) 6,300 10,700

––––––Joint venture expenses (see (ii)) 400

–––––––61,700–––––––

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

Dr CrSales revenue 7,200Cost of sales 5,400Accounts receivable 1,200Commission receivable (10% x $7·2 million) 720Due from Brandberg (Accounts receivable) 120

–––––– ––––––7,320 7,320

–––––– ––––––

(ii) The joint venture with Waterfront qualifies to be treated under IAS 31 ‘Financial Reporting of Interests in Joint Ventures’ as ajointly controlled operation. The Standard requires that each party should account for its own assets, liabilities and resultsaccording to the terms of the agreement. Thus Bloomsbury transactions with the joint venture will be treated as if they wereBloomsbury’s own transactions and included in the appropriate line items together with other similar transactions e.g. salesrevenues will include $800,000 in respect of the joint venture.

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

25-year leasehold – revaluation surplus is $12 million (52m – (50m – 10m))15-year leasehold – revaluation deficit is $2 million (18m – (30m – 10m)

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

The balance sheet values of the properties will be:

at revalued amount depreciation NBV$000 $000 $000

25-year leasehold 52,000 2,600 49,40015-year leasehold 18,000 1,800 16,200

––––––– –––––– –––––––70,000 4,400 65,600––––––– –––––– –––––––

The accumulated depreciation on the 25-year leasehold of $10,000 represents five years’ depreciation, thus after itsrevaluation it would have a remaining life of 20 years. A similar exercise with the 15-year leasehold gives a remaining life of10 years. These figures are used to calculate the depreciation charges, which are charged to cost of sales.

Investment propertyUnder IAS 40 movements in the fair value of investment properties must be taken to income. Also on the first adoption ofthe Standard any previous surplus on an investment property revaluation reserve is transferred to realised profits.

Plant and equipment:The plant used as part of the joint venture is included with other plant: $000

Plant at cost (49,800 + 1,500 joint venture) 51,300Accumulated depreciation 1 October 2001 (19,800)

–––––––Net book value before depreciation for year 31,500Depreciation for year (charged to cost of sales) (20% x 31,500) (6,300)

–––––––Net book value at 30 September 2002 25,200

–––––––



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(iv) As the temporary differences have fallen by $2 million this will cause a reversal of deferred tax of $2 million x 30% =$600,000. This will reduce the tax charge for the year and the deferred tax balance will be $2,100,000 – $600,000 =$1,500,000.

(v) The interim dividends are half of the preference dividend of $500,000 (10% x $10 million x 6/12) and the balance must bean interim ordinary dividend of $1 million. The final proposed dividend is another $500,000 preference and $4·8 millionordinary (40 million x 4 x 3 cents). Under IAS 32 ‘Financial Instruments: Disclosure and Presentation’ redeemable preferenceshares have the characteristics of debt and must be treated as such. The preference dividends will be treated as interest costsand the shares will appear under non-current liabilities, not equity.

(vi) Current liabilitiesAccounts payable per question 9,420Joint venture creditor 100Accrued loan interest 1,800Accrued preference dividend 500

–––––––11,820 –––––––

(vii) Non-current liabilities12% Loan note 30,00010% Redeemable preference shares (w (v)) 10,000Deferred tax (2,100 – 600 (w (iv))) 1,500

–––––––41,500–––––––

3 (a) (i) Creative accounting is a term in general use to describe the practice of applying inappropriate accounting policies orentering into complex or ‘special purpose’ transactions with the objective of making a company’s financial statementsappear to disclose a more favourable position, particularly in relation to the calculation of certain ‘key’ ratios, than wouldotherwise be the case. Most commentators believe creative accounting stops short of deliberate fraud, but is nonethelessundesirable as it is intended to mislead users of financial statements.

Probably the most criticised area of creative accounting relates to off balance sheet financing. This occurs where acompany has financial obligations that are not recorded on its balance sheet. There have been several examples of thisin the past:– finance leases treated as operating leases– borrowings (usually convertible loan stock) being classified as equity – secured loans being treated as ‘sales’ (sale and repurchase agreements)– the non-consolidation of ‘special purpose vehicles’ (quasi subsidiaries) that have been used to raise finance– offsetting liabilities against assets (certain types of accounts receivable factoring)

The other main area of creative accounting is that of increasing or smoothing profits. Examples of this are:– the use of inappropriate provisions (this reduces profit in good years and increases them in poor years)– not providing for liabilities, either at all or not in full, as they arise. This is often related to environmental provisions,

decommissioning costs and constructive obligations.– restructuring costs not being charged to income (often related to a newly acquired subsidiary – the costs 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. Mostof these companies do not (yet) make any profit so other performance criteria such as site ‘hits’, conversion rates(browsers turning into buyers), burn periods (the length of time cash resources are expected to last) and even salesrevenues are massaged to give a more favourable impression.

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



20

Common features which may indicate that the substance of a transaction (or series of connected transactions) is differentfrom its legal form are:– Where the ownership of an asset does not rest with the party that is expected to experience the risks and reward

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 transactionscan be a difficult and sometimes subjective procedure.

(b) (i) This is an example of consignment inventory. From Atkins’s point of view the main issue is whether or at what point intime the goods have been purchased and should therefore be recognised. As is often the case in these types ofagreement there is conflicting evidence as to which party bears the risks and rewards relating to the vehicles. Themanufacturer retains the legal right of ownership until the goods are paid for by Atkins. Consistent with this themanufacturer also has the right to have the goods returned or passed on to another supplier. The fact that Atkins maychoose to return the goods to the manufacturer is also indicative that the manufacturer is exposed to the risk ofobsolescence or falling values. These factors would seem to suggest that the vehicles have not been sold and shouldtherefore remain in the inventory of the manufacturer and not be recognised in the accounting records of Atkins.

There are, however, some contrary indications to this view. The price for the goods is fixed as of the date of transfer, notthe date that they are deemed ‘sold’. This means that Atkins is protected from any price increases by the manufacturer.The 1·5% paid to the manufacturer appears to be in substance a finance charge, despite it being described as a ‘displaycharge’. A finance charge indicates that Atkins must have a liability to the manufacturer; in effect this liability is theaccount payable in respect of the cost of the vehicles. Although Atkins has a right of return, it cannot exercise this withouta cost. There is an explicit freight cost, but this may not be the only cost. It could well be that Atkins may suffer poorfuture supplies from the manufacturer if it does return goods. The question says that Atkins has never taken advantageof this option, which would seem to suggest that it should be ignored.

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

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

Assuming the land is sold:Income statement – year to 30 September 2002 $ $Sales 2,400,000Cost of sales (3/5 x $2 million) 1,200,000

––––––––––Profit on sale of land 1,200,000

Balance sheet as at 30 September 2002Non-current assetsDevelopment land ($2 million – $1·2 million above) 800,000

Assuming the arrangement is secured loan:Income statement – year to 30 September 2002Interest on loan (240,000)(10% of in substance loan of $2·4 million)

Balance sheet as at 30 September 2002Non-current assetsDevelopment land at cost 2,000,000

Non-current liabilitiesSecured loan 2,400,000Accrued interest 240,000 (2,640,000)

–––––––––



21

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

Cash flows from operating activities $m $mNet profit before interest and tax 900Adjustments for:Amortisation – development expenditure (w (i)) 130Amortisation – goodwill (200 – 180) 20 150

–––Depreciation – property, plant and equipment 320Amortisation of government grant (w (ii)) (90)Loss on sale of plant 50Increase in inventory (1,420 – 940) (480)Increase in accounts receivable (990 – 680) (310)Increase in accounts payable (875 – 730) 145

–––– Cash generated from operations 685Interest paid (30 – (15 – 5 accrual adjustments)) (20)Income tax paid (w (iii)) (130)

–––– Net cash from operating activities 535

Cash flows from investing activitiesPurchase property, plant and equipment (w (iv)) (250)Capitalised development costs (w (i)) (500)Receipt of government grant 50Proceeds of sale of plant (w (iv)) 20Net cash from operating activities –––– (680)

Cash flows from financing activitiesIssue of ordinary shares (w (v)) 450Issue of loan notes (300 – 100) 200Dividends paid (200 final for 2001 + 120 interim for 2002) (320)

––––Net cash generated from financing activities 330

––––

Net increase in cash and cash equivalents 185Cash and cash equivalents at beginning of period (115)

––––Cash and cash equivalents at end of period 70

––––

Workings(i) Development expenditure:

Balance b/f 100Amount capitalised 500Amortisation – balancing figure (130)

––––Balance c/f 470

––––

(ii) Government grant:Balance b/f 300Cash received 50Amortisation (90)


––––

(iii) Income tax:Tax provision b/f 160Deferred tax b/f 140Charged to income statement 270Tax provision c/f (130)Deferred tax c/f (310)

––––Difference cash paid 130

––––



22

$m $m(iv) Property, plant and equipment:

Balance b/f 1,830Revaluation surplus 200Plant acquired 250Depreciation (320)Disposal at net book value – balancing figure (70)

–––––Balance c/f 1,890

–––––

Disposal of plant:Net book value from above 70Loss on sale (from question) (50)

–––Difference is sale proceeds 20

–––

(v) Share capital:Ordinary shares b/f (500)Bonus issue 1 for 10 (from revaluation reserve) (50)Ordinary shares c/f 750

––––Difference issue for cash 200Plus increase in share premium (350 – 100) 250

––––Total cash proceeds of issue of ordinary shares 450

––––

(vi) Reconciliation of reserve movementsRevaluation reserve:Balance b/f nilRevaluation of buildings 200Bonus issue (50)Transfer to realised profits (10)


––––

Accumulated profits:Balance b/f 1,400Net profit for period 600Dividends – paid (120)Dividends – declared (280) (400)

––––– Transfer from revaluation reserve 10

––––––Balance c/f 1,610

––––––

(b) The cash flows generated from operations of $685 million are relatively healthy and more than adequate to pay the interestcosts and taxation, but not as large as the equivalent profit figure. For most companies the operating cash flows tend to behigher than the profit before interest and tax due to the effects of depreciation/amortisation charges (which are not cash flows).In the case of Nedberg the depreciation/amortisation effect has been more than offset by a much higher investment in workingcapital of $645 million. Inventory has increased by over 50% and accounts receivable by 45%. This may be an indicationof expanding activity, but it could also be an indication of poor inventory management policy and poor credit control, or eventhe presence of some obsolete inventory or unprovided bad accounts receivables.

A cause of concern is the size of the dividends, at $400 million they represent 67% of the profit for the period and cash flowsfor dividends (last year’s final plus this year’s interim) are also high at $320 million. This is a very high distribution ratio, andit seems curious that the company is returning such large amounts to shareholders at the same time as they are raisingfinance. $450 million has been received from the issue of new shares and $200 million from a further issue of loan notes.

The company has invested considerably in new plant ($250 million) and even more so in development expenditure ($500million). If management has properly applied the capitalisation criteria in IAS 38 ‘Intangible Assets’, then this indicates thatthey expect good future returns from the investment in new products or processes. The net investment in non-current assetsis $680 million which closely correlates to the proceeds from financing of $650 million. In general it is acceptable to financeincreases in the capacity of non-current assets by raising additional finance, however operating cash flows should financereplacement of consumed fixed assets.



23

5 (a) (i) The requirement in IAS 35 ‘Discontinuing Operations’ to provide an analysis between continuing and discontinuingoperations is intended to improve the predictive usefulness of financial statements. In essence there can be no moreimportant information when trying to assess the future performance of a company than to know which parts of it arecontinuing their operations and those which have ceased or been sold or are about to be in the near future. Only theresults of continuing operations should be used in forecasting future results; profits or losses from discontinuingoperations will not be repeated.

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

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

Utilising the available information, a very different picture emerges:Gamma Toga$ million $ million

Forecast profit 77 209

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

Toga’s forecast is also based on its continuing activities, but it is in two parts. The ‘existing’ activities that made profitsof $90 million would be expected to produce profits of $99 million in 2003. Its newly acquired activities would beexpected to produce profits of $110 million. The latter figure is based on the $50 million profit in 2002 being for onlysix months, a full year would have presumably yielded $100 million. In 2003 this would increase by 10% to $110million.

(b) (i) The trend shown by a comparison of a company’s profits over time is rather a ‘raw’ measure of performance and canbe misleading without careful interpretation of all the events that the company has experienced. In the year to 30 September 2002, Taylor’s eps has increased by 25% (from 20 cents to 25 cents), whereas its profit has increasedby a massive 67% (from $30 to $50 million). It is not possible to determine exactly what has caused the differencebetween the percentage increase in the eps and the percentage increase in the reported profit of Taylor, but a simplerexample may illustrate a possible explanation. Assume company A acquired company B by way of a share exchange.Both companies had the same market value and the same profits. A comparison of A’s post combination profits with itspre-combination profits would be very misleading. They would have appeared to double. This is because the postcombination figures incorporate both companies’ results, whereas the pre-combination profits would be those ofcompany A alone (assuming it is not accounted for as a uniting of interest). The trend shown by the earnings per sharegoes some way to addressing such distortion. In the above the increase in post combination profit would also beaccompanied by an increase in the issued share capital (due to the share exchange) thus the reported eps of companyA would not be distorted by its acquisitive growth. It can therefore be argued that the trend of a company’s eps is a morereliable measure of its earnings performance than the trend shown by its reported profits.

(ii) Both the convertible loan stock and the directors’ share options will give rise to dilution:8% Loan stock – on conversion there will be 140 million new shares (200 million x 70/100)The interest saved, net of tax at 25%, will be $12 million ($200 million x 8% x 75%)

The directors’ share options will yield income of $75 million (50 million x $1·50). At the market price of $2·50 thiswould be sufficient to purchase 30 million shares. As the options are for 50 million shares the dilutive effect of theoptions is 20 million shares.

Diluted eps year to 30 September 2002:Earnings $62 million (basic $50 million + $12 million re loan stock)Number of shares 360 million (basic 200 million + 140 million re loan stock + 20 million re options)Diluted eps 17·2 cents

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



24

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

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



25

Part 2 Examination – Paper 2.5(INT)FInancial Reporting (International Stream) December 2002 Marking Scheme

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

1 (a) (i) Income statement: marksall line items 1 mark each 3except operating expenses 2Balance sheet:property, plant and equipment 1investments 1goodwill 3inventory and accounts receivable 1bank and loan note 1accounts payable and tax 1share capital 1share premium 1accumulated profits 1

available 16maximum 13

(ii) Income statement:all line items 1/2 mark each 2profit b/f Hydrate and Sulphate, 1 mark each 2

Equity and reserves:share premium 1share premium of Sulphate now classed as a capital reserve 1accumulated profits – Hydrate plus Sulphate 1qccumulated profits – share capital adjustment 1


(b) 1 mark for each feature together with compliance comment 5Maximum for question 25



26

marks2 (a) Income statement

sales revenue 2cost of sales 3commission 1investment income plus operating expenses 1surplus on investment property (as income) 1loan interest 1preference dividend (as an expense) 1loss on revaluation of 15 year leasehold 1taxation 1


(b) Changes in equityprofit for period 1revaluation surplus of 25 year leasehold 1dividend 1transfers to realised profits 1


(c) Balance sheet property, plant and equipment 5investment property 1inventory and cash 1accounts receivable 2trade and other payables 2income tax provision 1dividends 1deferred tax 1share capital 1revaluation reserves 1

available 16maximum 13Maximum for question 25

3 (a) (i) description of creative accounting 2examples of creative accounting 3

maximum 5

(ii) importance of substance 2features indicating a difference between substance and legal form 3

maximum 5

(b) (i) 1 mark per relevant point to a maximum 6

(ii) 1 mark per relevant point to a maximum 3and 1 mark per correct figure in the financial statements to a maximum 6

Maximum for question 25



marks4 (a) net cash flows from operating activities

1 mark per item 8except – loan interest 2except – taxation 2capital expenditure – proceeds from the sale of the plant 2capital expenditure – other items,1 mark per component 3financing – equity shares 2financing – loan note 1 equity dividends 2movement in cash and cash equivalents 1


(b) 1 mark per relevant point to a maximum 5Maximum for question 25

5 (a) (i) 1 mark per relevant point to a maximum 3

(ii) $110 for both companies if no information available 1applying the information available – $77 million for Gamma 1applying the information available – $209 million for Toga 2

maximum 4


(ii) number of shares re loan stock 1interest saved 1dilutive number of share re options 2calculation of diluted eps 1

maximum 5

(iii) 1 mark per relevant point to a maximum 4

(c) 1 mark per relevant point to a maximum 6Maximum for question 25

27




PART 2

THURSDAY 5 JUNE 2003

QUESTION PAPER





Pape

r 2.5

(IN

T)




1 In recent years Hillusion has acquired a reputation for buying modestly performing businesses and selling them at asubstantial profit within a period of two to three years of their acquisition. On 1 July 2002 Hillusion acquired 80%of the ordinary share capital of Skeptik at a cost of $10,280,000. On the same date it also acquired 50% of Skeptik’s10% loan notes at par. The summarised draft financial statements of both companies are:

Income statements: Year to 31 March 2003Hillusion Skeptik

$000 $000Sales revenue 60,000 24,000Cost of sales (42,000) (20,000)

––––––– –––––––Gross profit 18,000 4,000

Operating expenses (6,000) (200)Loan interest received (paid) 75 (200)

––––––– –––––––Operating profit 12,075 3,600Taxation (3,000) (600)

––––––– –––––––Profit after tax for the year 9,075 3,000Accumulated profit brought forward 16,525 5,400

––––––– –––––––Accumulated profit per balance sheet 25,600 8,400

––––––– –––––––

Balance Sheets: as at 31 March 2003Tangible non-current Assets 19,320 8,000Investments 11,280 nil

––––––– –––––––30,600 8,000

Current Assets 15,000 8,000––––––– –––––––

Total assets 45,600 16,000––––––– –––––––

Equity and liabilitiesOrdinary shares of $1 each 10,000 2,000Accumulated profits 25,600 8,400

––––––– –––––––35,600 10,400

Non-current liabilities10% Loan notes nil 2,000

Current liabilities 10,000 3,600––––––– –––––––

Total equity and liabilities 45,600 16,000––––––– –––––––


(i) The fair values of Skeptik’s assets were equal to their book values with the exception of its plant, which had afair value of $3·2 million in excess of its book value at the date of acquisition. The remaining life of all of Skeptik’splant at the date of its acquisition was four years and this period has not changed as a result of the acquisition.Depreciation of plant is on a straight-line basis and charged to cost of sales. Skeptik has not adjusted the valueof its plant as a result of the fair value exercise.

2



(ii) In the post acquisition period Hillusion sold goods to Skeptik at a price of $12 million. These goods had costHillusion $9 million. During the year Skeptik had sold $10 million (at cost to Skeptik) of these goods for $15 million.

(iii) Hillusion bears almost all of the administration costs incurred on behalf of the group (invoicing, credit controletc.). It does not charge Skeptik for this service as to do so would not have a material effect on the group profit.

(iv) Revenues and profits should be deemed to accrue evenly throughout the year.

(v) The current accounts of the two companies were reconciled at the year-end with Skeptik owing Hillusion$750,000.

(vi) Consolidated goodwill is to be written off as an operating expense over a three-year life. Time apportionmentshould be used in the year of acquisition.

(vii) Hillusion uses the allowed alternative treatment in IAS 22 ‘Business Combinations’ for recording (anddepreciating) the fair values of assets and liabilities in its consolidated financial statements.

Required:

(a) Prepare a consolidated income statement and balance sheet for Hillusion for the year to 31 March 2003(20 marks)

(b) Explain why it is necessary to eliminate unrealised profits when preparing group financial statements; andhow reliance on the entity financial statements of Skeptik may mislead a potential purchaser of the company.

(5 marks)

(25 marks)

Note: your answer should refer to the circumstances described in the question.

3 [P.T.O.




2 The following trial balance relates to Allgone at 31 March 2003:

$000 $000Sales revenue (note (i)) 236,200Purchases 127,850Operating expenses 12,400Loan interest paid 2,400Preference dividend 1,000Land and buildings – at valuation (note (ii)) 130,000Plant and equipment – cost 84,300Software – cost 1 April 2000 10,000Stock market investments – valuation 1 April 2002 (note (iii)) 12,000Depreciation 1 April 2002 – plant and equipment 24,300Depreciation 1 April 2002 – software 6,000Extraordinary item (note (iv)) 32,000Trade receivables 23,000Inventory – 1 April 2002 19,450Bank 350Trade payables 15,200Ordinary shares of 25c each 60,00010% Preference shares 20,00012% Loan note (issued 1 July 2002) 40,000Deferred tax 3,000Revaluation reserve (relating to land and buildings and the investments) 45,000Accumulated profits – 1 April 2002 4,350

–––––––– ––––––––454,400 454,400–––––––– ––––––––

The following notes are relevant:(i) Sales include $8 million for goods sold in March 2003 for cash to Funders, a merchant bank. The cost of these

goods was $6 million. Funders has the option to require Allgone to repurchase these goods within one month ofthe year-end at their original selling price plus a facilitating fee of $250,000.

The inventory at 31 March 2003 was counted at a cost value of $8·5 million. This includes $500,000 of slowmoving inventory that is expected to be sold for a net $300,000.

(ii) Non-current assets:On 1 April 2002 Allgone revalued its land and buildings. The details are:

cost 1 April 1997 valuation 1 April 2002$000 $000

land 20,000 25,000building 80,000 105,000

The building had an estimated life of 40 years when it was acquired and this has not changed as a result of therevaluation. Depreciation is on a straight-line basis. The surplus on the revaluation has been added to therevaluation reserve, but no other movements on the revaluation reserve have been recorded.

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

Software is depreciated by the sum of the digits method over a 5-year life.

(iii) The investment represents 7·5% of the ordinary share capital of Wondaworld. Allgone has a policy of revaluingits investments at their market price at each year-end. Changes in value are taken to the revaluation reservewhich at 1 April 2002 contained a surplus of $5 million for previous revaluations of the investments. The stockmarket price of Wondaworld’s ordinary shares was $2·50 each on 1 April 2002 and by 31 March 2003 thishad fallen to $2·25.

4



(iv) The extraordinary item is a loss incurred due to a fraud relating to the company’s investments. A senior employeeof the company, who left in January 2002, had diverted investment funds into his private bank account. Thefraud was discovered by the employee’s replacement in April 2002. It is unlikely that any of the funds will berecovered. Allgone has now implemented tighter procedures to prevent such a fraud recurring. The company hasbeen advised that this loss will not qualify for any tax relief.

(v) The directors have estimated the provision for income tax for the year to 31 March 2003 at $11·3 million. Thedeferred tax provision at 31 March 2003 is to be adjusted to reflect the tax base of the company’s net assetsbeing $16 million less than their carrying values. The rate of income tax is 30%. The movement on deferred taxshould be charged to the income statement.

(vi) The directors declared a final ordinary dividend of 3c per share on 25 March 2003.

Required:

In accordance with International Accounting Standards and International Financial Reporting Standards as far asthe information permits, prepare:

(a) the Income Statement of Allgone for the year to 31 March 2003; and (7 marks)

(b) the Statement of Changes in Equity for the year to 31 March 2003; and (5 marks)

(c) a Balance Sheet as at 31 March 2003. (13 marks)

Notes to the financial statements are not required.(25 marks)

5 [P.T.O.



3 Revenue recognition is the process by which companies decide when and how much income should be included inthe income statement. It is a topical area of great debate in the accounting profession. The IASB looks at revenuerecognition from conceptual and substance points of view. There are occasions where a more traditional approach torevenue recognition does not entirely conform to the IASB guidance; indeed neither do some International AccountingStandards.

Required:

(a) Explain the implications that the IASB’s Framework for the Preparation and Presentation of FinancialStatements (Framework) and the application of substance over form have on the recognition of income. Giveexamples of how this may conflict with traditional practice and some accounting standards. (6 marks)

(b) Derringdo sells goods supplied by Gungho. The goods are classed as A grade (perfect quality) or B grade, havingslight faults. Derringdo sells the A grade goods acting as an agent for Gungho at a fixed price calculated to yielda gross profit margin of 50%. Derringdo receives a commission of 12·5% of the sales it achieves for these goods.The arrangement for B grade goods is that they are sold by Gungho to Derringdo and Derringdo sells them at agross profit margin of 25%. The following information has been obtained from Derringdo’s financial records:

$000Inventory held on premises 1 April 2002 – A grade 2,400

– B grade 1,000Goods from Gungho year to 31 March 2003 – A grade 18,000

– B grade 8,800Inventory held on premises 31 March 2003 – A grade 2,000

– B grade 1,250

Required:

Prepare the income statement extracts for Derringdo for the year to 31 March 2003 reflecting the aboveinformation. (5 marks)

(c) Derringdo acquired an item of plant at a gross cost of $800,000 on 1 October 2002. The plant has an estimatedlife of 10 years with a residual value equal to 15% of its gross cost. Derringdo uses straight-line depreciation ona time apportioned basis. The company received a government grant of 30% of its cost price at the time of itspurchase. The terms of the grant are that if the company retains the asset for four years or more, then norepayment liability will be incurred. If the plant is sold within four years a repayment on a sliding scale would beapplicable. The repayment is 75% if sold within the first year of purchase and this amount decreases by 25%per annum. Derringdo has no intention to sell the plant within the first four years. Derringdo’s accounting policyfor capital based government grants is to treat them as deferred credits and release them to income over the lifeof the asset to which they relate.

Required:

(i) Discuss whether the company’s policy for the treatment of government grants meets the definition of aliability in the IASB’s Framework; and (3 marks)

(ii) Prepare extracts of Derringdo’s financial statements for the year to 31 March 2003 in respect of theplant and the related grant:

– applying the company’s policy;

– in compliance with the definition of a liability in the Framework. Your answer should considerwhether the sliding scale repayment should be used in determining the deferred credit for the grant.

(6 marks)

6



(d) Derringdo sells carpets from several retail outlets. In previous years the company has undertaken responsibilityfor fitting the carpets in customers’ premises. Customers pay for the carpets at the time they are ordered. Theaverage length of time from a customer ordering a carpet to its fitting is 14 days. In previous years, Derringdohad not recognised a sale in income until the carpet had been successfully fitted as the rectification costs of anyfitting error would be expensive. From 1 April 2002 Derringdo changed its method of trading by sub-contractingthe fitting to approved contractors. Under this policy the sub-contractors are paid by Derringdo and they (the sub-contractors) are liable for any errors made in the fitting. Because of this Derringdo is proposing to recognise saleswhen customers order and pay for the goods, rather than when they have been fitted. Details of the relevant salesfigures are:

$000Sales made in retail outlets for the year to 31 March 2003 23,000Sales value of carpets fitted in the 14 days to 14 April 2002 1,200Sales value of carpets fitted in the 14 days to 14 April 2003 1,600

Note: the sales value of carpets fitted in the 14 days to 14 April 2002 are not included in the annual sales figureof $23 million, but those for the 14 days to 14 April 2003 are included.

Required:

Discuss whether the above represents a change of accounting policy, and, based on your discussion,calculate the amount that you would include in sales revenue for carpets in the year to 31 March 2003.

(5 marks)

(25 marks)

7 [P.T.O.



4 Rytetrend is a retailer of electrical goods. Extracts from the company’s financial statements are set out below:

Income statement for the year ended 31 March: 2003 2002$000 $000 $000 $000

Sales revenue 31,800 23,500Cost of sales (22,500) (16,000)

––––––– –––––––Gross profit 9,300 7,500Other operating expenses (5,440) (4,600)

––––––– –––––––Operating profit 3,860 2,900Interest payable – loan notes (260) (500)Interest payable – overdraft (200) (460) nil (500)

––––– ––––––– ––––––– –––––––Profit before taxation 3,400 2,400Taxation (1,000) (800)

––––––– –––––––Profit after taxation 2,400 1,600Dividends (600) (400)

––––––– –––––––Net profit for the period 1,800 1,200Accumulated profits – brought forward 5,880 4,680

––––––– –––––––Accumulated profits – carried forward 7,680 5,880

––––––– –––––––

Balance Sheets as at 31 March 2003 2002$000 $000 $000 $000

Non-current assets (note (i)) 24,500 17,300

Current AssetsInventory 2,650 3,270Receivables 1,100 1,950Bank nil 3,750 400 5,620

––––– ––––––– ––––––– –––––––Total assets 28,250 22,920

––––––– –––––––Equity and liabilitiesOrdinary capital ($1 shares) 11,500 10,000Share premium 1,500 nilAccumulated profits 7,680 5,880

––––––– –––––––20,680 15,880

Non-current liabilities10% loan notes nil 4,0006% loan notes 2,000 nil

Current liabilitiesBank overdraft 1,050 nilTrade payables 2,850 1,980Proposed dividends (declaredbefore the year end) 450 280Taxation 720 630Warranty provision (note (ii)) 500 5,570 150 3,040

––––––– ––––––– ––––––– –––––––Total equity and liabilities 28,250 22,920

––––––– –––––––

8



Notes(i) The details of the non-current assets are:

Cost Accumulated depreciation Net book value$000 $000 $000

At 31 March 2002 27,500 10,200 17,300 At 31 March 2003 37,250 12,750 24,500

During the year there was a major refurbishment of display equipment. Old equipment that had cost $6 millionin September 1998 was replaced with new equipment at a gross cost of $8 million. The equipment manufacturerhad allowed Rytetrend a trade in allowance of $500,000 on the old display equipment. In addition to thisRytetrend used its own staff to install the new equipment. The value of staff time spent on the installation hasbeen costed at $300,000, but this has not been included in the cost of the asset. All staff costs have beenincluded in operating expenses. All display equipment held at the end of the financial year is depreciated at 20%on its cost. No equipment is more than five years old.

(ii) Operating expenses contain a charge of $580,000 for the cost of warranties on the goods sold by Rytetrend. Thecompany makes a warranty provision when it sells its products and cash payments for warranty claims arededucted from the provision as they are settled.

Required:

(a) Prepare a cash flow statement for Rytetrend for the year ended 31 March 2003. (12 marks)

(b) Write a report briefly analysing the operating performance and financial position of Rytetrend for the yearsended 31 March 2002 and 2003. (13 marks)

Your report should be supported by appropriate ratios. (25 marks)

9 [P.T.O.



5 (a) Most companies prepare their financial statements under the historical cost convention. In times of rising pricesit has been said that without modification such financial statements can be misleading.

Required:

(i) Explain the problems that can be encountered when users rely on financial statements prepared under thehistorical cost convention for their information needs. (6 marks)

Note: your answer should consider problems with the income statement and the balance sheet.

(ii) Update has been considering the effect of alternative methods of preparing their financial statements. As anexample they picked an item of plant that they acquired from Suppliers on 1 April 2000 at a cost of $250,000.The following details have been obtained:

– the company policy is to depreciate plant at 20% per annum on the reducing balance basis.– the movement in the retail price index has been:

1 April 2000 1801 April 2001 2021 April 2002 20631 March 2003 216

– Suppliers’ price catalogue at 31 March 2003 shows an item of similar plant at a cost of $320,000. Onreading the specification it appears that the new model can produce 480 units per hour whereas the modelowned by Update can only produce 420 units per hour.

Required:

Calculate for Update the depreciation charge for the plant for the year to 31 March 2003 (based on year endvalues) and its balance sheet carrying value on that date using:

– the historical cost basis;

– a current purchasing power basis; and

– a current cost basis. (6 marks)

(b) Extracts of Niagara’s consolidated income statement for the year to 31 March 2003 are:

$000Sales 36,000Cost of sales (21,000)

––––––––Gross profit 15,000Other operating expenses (6,200)

––––––––Operating profit 8,800Income from associated companies 1,500Interest payable (800)Impairment of non-current assets (4,000)

–––––––Profit before tax 5,500Taxation (2,800)

–––––––Profit after tax 2,700Minority interest (115)

–––––––Profit for financial year 2,585

–––––––

10



The impairment of non-current assets attracted tax relief of $1 million which has been included in the tax charge.

Niagara paid an interim ordinary dividend of 3c per share in June 2002 and declared a final dividend on 25 March 2003 of 6c per share.

The issued share capital of Niagara on 1 April 2002 was:

Ordinary shares of 25c each $3 million8% Preference shares $1 million

The preference shares are non-redeemable.

The company also had in issue $2 million 7% convertible loan stock dated 2005. The loan stock will beredeemed at par in 2005 or converted to ordinary shares on the basis of 40 new shares for each $100 of loanstock at the option of the stockholders. Niagara’s income tax rate is 30%.

There are also in existence directors’ share warrants (issued in 2001) which entitle the directors to receive750,000 new shares in total in 2005 at no cost to the directors.

The following share issues took place during the year to 31 March 2003:

– 1 July 2002; a rights issue of 1 new share at $1·50 for every 5 shares held. The market price ofNiagara’s shares the day before the rights was $2·40.

– 1 October 2002; an issue of $1 million 6% non-redeemable preference shares at par.

Both issues were fully subscribed.

Niagara’s basic earnings per share in the year to 31 March 2002 was correctly disclosed as 24c.

Required:

Calculate for Niagara for the year to 31 March 2003:

(i) the dividend cover and explain its significance; (3 marks)

(ii) the basic earnings per share including the comparative; (4 marks)

(iii) the fully diluted earnings per share (ignore comparative); and advise a prospective investor of thesignificance of the diluted earnings per share figure. (6 marks)

(25 marks)


11



Answers



Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) June 2003 Answers

1 (a) Hillusion Consolidated income statement for the year to 31 March 2003

$000 $000Sales revenue (60,000 + (24,000 x 9/12) – 12,000 intra-group sales) 66,000Cost of sales (w (i)) (46,100)

––––––––Gross profit 19,900Operating expenses (6,000 + (200 x 9/12) + 300 goodwill (w (ii)) (6,450)Loan interest ((200 x 9/12) – 75 intra-group)) (75) (6,525)

–––––––– ––––––––13,375

Taxation (3,000 + (600 x 9/12)) (3,450)––––––––

Profit after tax 9,925Minority interest (((3,000 x 9/12) – 600 depreciation adjustment) x 20%) (330)

––––––––Profit after tax and minority interest 9,595Accumulated profit b/f 16,525

––––––––Accumulated profit c/f 26,120

––––––––

Consolidated balance sheet at 31 March 2003Non-current assetsGoodwill (w (ii) 1,200 – 300) 900Tangible non-current Assets (19,320 + 8,000 + 3,200 – 600 depreciation adjustment (w (i))) 29,920

––––––––30,820

Current Assets (w (v)) 21,750––––––––

Total assets 52,570––––––––

Equity and liabilitiesOrdinary shares of $1 each 10,000Reserves:Accumulated profits (w (iii)) 26,120

––––––––36,120

Minority interest (w (iv)) 2,600Non-current liabilities10% Loan notes (2,000 – 1,000 intra-group) 1,000

Current liabilities (w (v)) 12,850––––––––

Total equity and liabilities 52,570––––––––

Workings in $000

(i) Cost of salesHillusion 42,000Skeptik (20,000 x 9/12) 15,000Intra-group sales (12,000)URP in inventory 500Additional depreciation 600

––––––––46,100

––––––––

The unrealised profit (URP) in inventory is calculated as:

Intra-group sales are $12 million of which Skeptik has sold on $10 million leaving $2 million (1/6) still in inventory atthe year-end. The cost of the sales made by Hillusion to Skeptik was $9 million giving Hillusion a profit of $3 million (12m – 9m). The unrealised element of this is $500,000 ($3 million x 1/6).

The fair value adjustment to the tangible non-current assets is $3·2 million. At the date of acquisition they have aremaining life of four years. Additional depreciation would be $800,000 per annum which requires apportioning by 9/12 = $600,000.

15



(ii) Goodwill/Cost of control in Skeptik:Investment at cost (11,280 – 1,000) 10,280Less – ordinary shares of Skeptik (2,000 x 80%) (1,600)

– pre-acquisition reserves (6,150 x 80% (see below)) (4,920)– fair value adjustments (3,200 x 80%) (2,560) (10,080)

–––––––– ––––––––Goodwill on consolidation 1,200

––––––––

Goodwill amortisation will be $1,200/3 x 9/12 = 300––––––––

The pre-acquisition reserves are:Brought forward 1 April 2002 5,400To date of acquisition (3,000 x 3/12) 750

––––––––6,150

––––––––

(iii) Consolidated reserves:Hillusion’s reserves 25,600Skeptik’s post acquisition (((3,000 x 9/12) – 600 depreciation adjustment (w (i))) x 80%) 1,320URP in inventory (see (i)) (500)Goodwill amortisation (w (ii) above) (300)

––––––––26,120

––––––––

(iv) Minority interestOrdinary shares of Skeptik (2,000 x 20%) 400Fair value adjustments (3,200 x 20%) 640Accumulated profits ((8,400 – 600 depreciation adjustment (w (i))) x 20%) 1,560

––––––––2,600

––––––––

(v) Current assets and liabilitiesCurrent assets:Hillusion 15,000Skeptik 8,000URP in inventory (500)Intra-group balance (750)

––––––––21,750

––––––––

Current liabilitiesHillusion 10,000Skeptik 3,600Intra-group balance (750)

––––––––12,850

––––––––

16



(b) The main reason why intra-group unrealised profits must be eliminated on consolidation is to achieve the main objective ofgroup financial statements which is to show the position of the group as if it were a single economic entity. As such, a groupcannot trade with itself, nor can it make a profit out of itself. In a similar way it cannot increase its sales or its net assets bytransferring assets and liabilities between members of the group. As a simple illustrative example, but for the requirement toeliminate intra-group profits, a group could buy an item of inventory; sell it to another member of the group (at a profit), whoin turn could sell it to another member of the group and so on. The result would be that each member of the group wouldmake a profit which would then be combined to form a large group profit. This would be ‘balanced’ by an over inflatedinventory value in the balance sheet (in practice this effect would be limited by the application of the lower of cost and netrealisable value principle of valuing inventory). Such accounting would not show a true and fair view.

The main problem with using Skeptik’s entity financial statements to assess its performance is that it is a related party of itsparent, Hillusion. Related party transactions can distort the true economic performance and financial position of a company.In this case, the related party relationship extends to complete control of Skeptik by Hillusion.

From the information in the question, it can be seen that most of Skeptik’s trading is from goods it buys from Hillusion. Salesof non-group sourced goods are only $9 million (out of $24 million). It may be that these have been transferred at afavourable price allowing Skeptik to achieve a higher level of sales and make a higher than normal profit. Ultimately thiscourse of action is no real detriment to the group as a whole as most of Skeptik’s profits (and all of them if it were 100%owned) are consolidated into the group profit. In a similar manner the fact that Hillusion does not make any charge forSkeptik’s administration costs acts to increase Skeptik’s profit. If Skeptik was to be purchased by an external party, all thesebeneficial effects would cease and Skeptik’s profit would then be much lower. It could be observed that Hillusion may be‘massaging’ Skeptik’s financial statements with a view to obtaining a favourable price on its future sale. Hillusion’s past recordof success in selling previous businesses at a considerable profit after only a short period of ownership supports this view.

2 (a) Allgone Income Statement – Year to 31 March 2003$000

Sales revenue (236,200 – 8,000 (see below)) 228,200Cost of sales (w (i)) (150,000)

–––––––––Gross profit 78,200Operating expenses (12,400)

–––––––––Profit from operations 65,800Financing cost (w (ii)) (3,850)

–––––––––Profit before tax 61,950Taxation (w (iii)) (13,100)

–––––––––Net profit from ordinary activities for the period 48,850

–––––––––

The sale of goods to Funders is an attempt to ‘window dress’ the balance sheet by improving its liquidity position. It is insubstance a (short term) loan with a finance cost of $250,000.

(b) Allgone – Statement of Changes in Equity – Year to 31 March 2003Ordinary Revaluation Accumulated TotalShares reserve profits$000 $000 $000 $000

Balance at 1 April 2002 60,000 5,000 4,350 69,350Fundamental error (see below) (32,000) (32,000)

––––––– ––––––– –––––––– ––––––––Restated balance 60,000 5,000 (27,650) 37,350Surplus on revaluation of land and buildings (w (iv)) 40,000 40,000Transfer to realised profits re building (35,000/35 years) (1,000) 1,000Deficit on value of investments (1,200) (1,200)Net profit for the period 48,850 48,850Dividends – Preference (1,000 + 1,000) (2,000) (2,000)

– Final ordinary (60,000 x 4 x 3c) (7,200) (7,200)––––––– ––––––– ––––––– ––––––––

Balance at 31 March 2003 60,000 42,800 13,000 115,800––––––– ––––––– ––––––– ––––––––

The discovery of the major fraud is not an extraordinary item. As it occurred in previous years and is so fundamental, it shouldbe treated as a prior period adjustment.

17



(c) Allgone – Balance Sheet as at 31 March 2003

Non-current assets $000 $000Software (w (iv)) 2,000Property, plant and equipment (w (iv)) 175,000Investments (12,000 – 1,200 (w (iv))) 10,800

––––––––187,800

Current AssetsInventory (w (i)) 14,300Trade receivables 23,000 37,300

––––––– ––––––––Total assets 225,100

––––––––

Total equity and liabilities:Ordinary shares of 25c each 60,00010% Preference shares $1 each 20,000

––––––––80,000

Reserves:Accumulated profits (see (b) above) 13,000Revaluation reserve (see (b) above) 42,800 55,800

––––––– ––––––––135,800

Non-current liabilities (w (v)) 44,800

Current liabilitiesTrade payables 15,200Bank overdraft 350In substance loan from Funders 8,000Accrued finance costs (1,200 + 250 (w (ii))) 1,450Taxation 11,300Proposed dividends (1,000 + 7,200) 8,200 44,500

––––––– ––––––––Total equity and liabilities 225,100

––––––––

Workings(i) Cost of sales: $000

Opening inventory 19,450Purchases 127,850Depreciation (w (iv)) – software 2,000

– building 3,000– plant 12,000

Closing inventory (8,500 – 200 + 6,000 see below) (14,300)––––––––150,000––––––––

The slow moving inventory requires a write down of $200,000 to its net realisable value of $300,000. The cost of thegoods of the sale and repurchase agreement ($6 million) should be treated as inventory.

(ii) Finance costs:Per question 2,400Accrued loan interest (see below) 1,200Accrued facilitating fee for in substance loan (treated as a finance cost) 250

––––––––3,850

––––––––

The loan has been in issue for nine months, but only six months interest has been paid. Accrued interest of $1,200,000is required.

(iii) Taxation:Provision for year 11,300Deferred tax (see below) 1,800

––––––––13,100

––––––––

The difference between the tax base of the assets and their carrying value of $16 million would require a balance sheetprovision for deferred tax of $4·8 million (at 30%). The opening provision is $3 million, thus an additional charge of$1·8 million is required.

18



(iv) Non-current assets/depreciation/revaluation:The software was purchased on 1 April 2000 with a five-year life. The depreciation for the year to 31 March 2003 willbe for the third year of its life. Using the sum of the digits method this will be 3/15 of the cost i.e. $2 million. This willgive accumulated depreciation of $8 million ($6 million b/f + $2 million).

Land and buildings Buildings Land$000 $000

Cost 1 April 1997 80,000 20,000Five years’ depreciation (80,000 x 5/40) (10,000)

––––––––Net book value prior to revaluation 70,000Valuation 1 April 2002 105,000 25,000

–––––––– –––––––Revaluation surplus 35,000 5,000

–––––––– –––––––

Depreciation year to 31 March 2003 (105,000/35 years) 3,000

Plant depreciation ((84,300 – 24,300) x 20%) 12,000

Summarising: cost/valuation accumulated depreciation Net book value$000 $000 $000

Land and building (25 + 105) 130,000 3,000 127,000Plant and equipment 84,300 36,300 48,000

–––––––– –––––––– ––––––––Property, plant and equipment 214,300 39,300 175,000

–––––––– –––––––– ––––––––

Software 10,000 8,000 2,000–––––––– –––––––– ––––––––

Revaluation reserve:Per trial balance 45,000Loss of value of investments (12,000 – (12,000 x 2·25/2·50)) (1,200)Transfer to realised profits re building (35,000/35 years) (1,000)

––––––––Balance at 31 March 2003 42,800

––––––––

(v) Non-current liabilitiesDeferred tax (3,000 + 1,800 (w (iii))) 4,80012% Loan note 40,000

––––––––44,800

––––––––

3 (a) The Framework advocates that revenue recognition issues are resolved within the definition of assets (gains) and liabilities(losses). Gains include all forms of income and revenue as well as gains on non-revenue items. Gains and losses are definedas increases or decreases in net assets other than those resulting from transactions with owners. Thus in its Framework, theIASB takes a balance sheet approach to defining revenue. In effect a recognisable increase in an asset results in a gain. Themore traditional view, which is largely the basis used in IAS 18 ‘Revenue’, is that (net) revenue recognition is part of atransactions based accruals or matching process with the balance sheet recording any residual assets or liabilities such asreceivables and payables. The issue of revenue recognition arises out of the need to report company performance for specificperiods. The Framework identifies three stages in the recognition of assets (and liabilities): initial recognition, when an itemfirst meets the definition of an asset; subsequent remeasurement, which may involve changing the value (with acorresponding effect on income) of a recognised item; and possible derecognition, where an item no longer meets thedefinition of an asset. For many simple transactions both the Framework’s approach and the traditional approach (IAS 18)will result in the same profit (net income). If an item of inventory is bought for $100 and sold for $150, net assets haveincreased by $50 and the increase would be reported as a profit. The same figure would be reported under the traditionaltransactions based reporting (sales of $150 less cost of sales of $100). However, in more complex areas the two approachescan produce different results. An example of this would be deferred income. If a company received a fee for a 12 monthtuition course in advance, IAS 18 would treat this as deferred income (on the balance sheet) and release it to income as thetuition is provided and matched with the cost of providing the tuition. Thus the profit would be spread (accrued) over theperiod of the course. If an asset/liability approach were taken, then the only liability the company would have after the receiptof the fee would be for the cost of providing the course. If only this liability is recognised in the balance sheet, the whole ofthe profit on the course would be recognised on receipt of the income. This is not a prudent approach and has led to criticismof the Framework for this very reason. Arguably the treatment of government grants under IAS 20 (as deferred income) doesnot comply with the Framework as deferred income does not meet the definition of a liability. Other standards that may be inconflict with the Framework are the use of the accretion approach in IAS 11 ‘Construction Contracts’ and a deferred tax liabilityin IAS 12 ‘Income Tax’ may not fully meet the Framework’s definition of a liability.

19



The principle of substance over form should also be applied to revenue recognition. An example of where this can impact onreporting practice is on sale and repurchase agreements. Companies sometimes ‘sell’ assets to another company with theright to buy them back on predetermined terms that will almost certainly mean that they will be repurchased in the future.In substance this type of arrangement is a secured loan and the ‘sale’ should not be treated as revenue. A less controversialarea of the application of substance in relation to revenue recognition is with agency sales. IAS 18 says, where a companysells goods acting as an agent, those sales should not be treated as sales of the agent, instead only the commission from thesales is income of the agent. Recently several Internet companies have been accused of boosting their revenue figures bytreating agency sales as their own.

(b) Sales made by Derringdo of goods from Gungho must be treated under two separate categories. Sales of the A grade goodsare made by Derringdo acting as an agent of Gungho. For these sales Derringdo must only record in income the amount ofcommission (12·5%) it is entitled to under the sales agreement. There may also be a receivable or payable for Gungho in thebalance sheet. Sales of the B grade goods are made by Derringdo acting as a principal, not an agent. Thus they will beincluded in sales with their cost included in cost of sales.

$000Sales revenue (4,600 (w (i)) + 11,400 w (ii)) 16,000Cost of sales (w (ii)) (8,550)


Workings: (all figures in $000) A grade(i) Opening inventory 2,400

Transfers/purchases 18,000–––––––20,400

Closing inventory (2,000)–––––––

Cost of sales 18,400Selling price (to give 50% gross profit) 36,800


Commission (12·5% x 36,800) 4,600

B grade(ii) Opening inventory 1,000

Transfers/purchases 8,800–––––––

9,800Closing inventory (1,250)

–––––––Cost of sales 8,550

Selling price (8,550 x 4/3 see below) 11,400–––––––

A gross profit margin of 25% is equivalent to a mark up on cost of 1/3. Thus if cost of sale is multiplied by 4/3 this willgive the relevant selling price.

(c) (i) The IASB’s Framework defines liabilities as obligations to transfer economic benefits as a result of past transactions.Such transfers of economic benefits are to third parties and normally as cash payments. Traditionally and in compliancewith IAS 20 ’Accounting for Government Grants and Disclosure of Government Assistance’, capital based governmentgrants are treated as deferred credits and spread over the life of the related assets. This is the application of the matchingconcept. A strict interpretation of the Framework would not normally allow deferred credits to be treated as liabilities asthere is usually no obligation to transfer economic benefits. In this particular example the only liability that may occurin respect of the grant would be if Derringdo were to sell the related asset within four years of its purchase. A possibleargument would be that the grant should be treated as a reducing liability (in relation to a potential repayment) over thefour-year claw back period. On closer consideration this would not be appropriate. The repayment would only occur ifthe asset were sold, thus it is potentially a contingent liability. As Derringdo has no intention to sell the asset there is noreason to believe that the repayment will occur, thus it is not a reportable contingent liability. The implication of this isthat the company’s policy for the government grant does not comply with the definition of a liability in the Framework.Applying the guidance in the Framework would require the whole of the grant to be included in income as it is ‘earned’i.e. in the year of receipt.

20



(ii) Treatment under the company’s policyIncome statement extract year to 31 March 2003 $Depreciation – plant ((800,000 – 120,000 estimated residual value)/10 years x 6/12) Dr 34,000Government grant ((800,000 x 30%)/10 years x 6/12) Cr 12,000

Balance sheet extracts as at 31 March 2003Non-current assets:Plant at cost 800,000Accumulated depreciation (34,000)

––––––––766,000––––––––

Current liabilities:Government grant (240,000/10 years) 24,000

Non-current liabilities:Government grant (240,000 – 12,000 – 24,000) 204,000

Treatment under the FrameworkIncome statement extract year to 31 March 2003Depreciation – plant ((800,000 – 120,000 estimated residual value)/10 years x 6/12) Dr 34,000Government grant (whole amount) Cr 240,000

Balance sheet extracts as at 31 March 2003Non-current assets:Plant at cost 800,000Accumulated depreciation (34,000)

––––––––766,000––––––––

(d) On first impression, it appears that the company has changed its accounting policy from recognising carpet sales at the pointof fitting to recognising them at the point when they are ordered and paid for. If this were the case then the new accountingpolicy should be applied as if it had always been in place and the income recognised in the year to 31 March 2003 wouldbe $23 million. Without the change in policy, sales would have been $22·6 million (23m + 1·2m – 1·6m). Sales made fromthe retail premises during the current year, but not yet fitted ($1·6 million) will not be recognised until the following period.A corresponding adjustment is made recognising the equivalent figure ($1·2 million) from the previous year. The differencebetween the $23 million and $22·6 million would be a prior year adjustment (less the cost of sales relating to this amount).This analysis assumes that the figures are material.

Despite first impressions, the above is not a change of accounting policy. This is because a change of accounting policy onlyoccurs where the same circumstances are treated differently. In this case there are different circumstances. Derringdo haschanged its method of trading; it is no longer responsible for any errors that may occur during the fitting of the carpets. Anaccounting policy that is applied to circumstances that differ from previous circumstances is not a change of accounting policy.Thus the amount to be recognised in income for the year to 31 March 2003 would be $24·2 million (23m + 1·2m). Whilstthis appears to boost the current year’s income it would be mitigated by the payments to the sub-contractors for the carpetfitting.

21



4 (a) Rytetrend – Cash Flow Statement for the year to 31 March 2003:

Cash flows from operating activitiesNote: figures in brackets are in $000 $000 $000Operating profit per question 3,860Capitalisation of installation costs less depreciation (300 – 60) (w (i)) 240Adjustments for:

depreciation of non-current assets (w (i)) 7,410loss on disposal of plant (w (i)) 700 8,110

––––––increase in warranty provision (500 – 150) 350decrease in inventory (3,270 – 2,650) 620decrease in receivables (1,950 – 1,100) 850increase in payables (2,850 – 1,980) 870

–––––––Cash generated from operations 14,900Interest paid (460)Income taxes paid (w (ii)) (910)

–––––––Net cash from operating activities 13,530Cash flows from investing activities (w (i)) (15,550)

–––––––(2,020)

Cash flows from financing activity:Issue of ordinary shares (1,500 + 1,500) 3,000Issue of 6% loan note 2,000Repayment of 10% loan notes (4,000)Ordinary dividends paid (280 + (600 – 450) interim) (430) 570

––––––– –––––––Net decrease in cash and cash equivalents (1,450)Cash and cash equivalents at beginning of period 400

–––––––Cash and cash equivalents at end of period (1,050)

–––––––

Workings $000(i) Non-current assets – cost

Balance b/f 27,500Disposal (6,000)Balance c/f (37,250 + 300 re installation) (37,550)

–––––––Cost of assets acquired (16,050)Trade in allowance 500

–––––––Cash flow for acquisitions (15,550)

–––––––

DepreciationBalance b/f (10,200)Disposal (6,000 x 20% x 4 years) 4,800Balance c/f (12,750 + (300 x 20%)) 12,810

–––––––Difference – charge for year 7,410

–––––––

DisposalCost 6,000Depreciation (4,800)

–––––––Net book value 1,200Trade in allowance (500)

–––––––Loss on sale 700

–––––––

(ii) Income tax paid:Provision b/f (630)Income statement tax charge (1,000)Provision c/f 720

–––––––Difference cash paid (910)

–––––––

22



(b) Report on the financial performance of Rytetrend for the year ended 31 March 2003

To:From:Date:

Operating performance

(i) revenue up $8·3 million representing an increase of 35% on 2002 figures.

(ii) costs of sales up by $6·5 million (40% increase on 2002)

Overall the increase in activity has led to an increase in gross profit of $1·8 million, however the gross profit margin has easedslightly from 31·9% in 2002 to 29·2% in 2003. Perhaps the slight reduction in margins gave a boost to sales.

(iii) operating expenses have increased by $600,000 (($5,440,000 – $240,000) – $4,600,000), an increase of 13% on2002 figures.

(iv) interest costs reduced by $40,000. It is worth noting that the composition of them has changed. It appears thatRytetrend has taken advantage of a cyclic reduction in borrowing cost and redeemed its 10% loan notes and (partly)replaced these with lower cost 6% loan notes. From the interest cost figure, this appears to have taken place half waythrough the year. Although borrowing costs on long-term finance have decreased, other factors have led to a substantialoverdraft which has led to further interest of $200,000.

(v) The accumulated effect is an increase in profit before tax of $1·24 million (up 51·7% on 2002) which is reflected byan increase in dividends of $200,000.

(vi) The company has invested heavily in acquiring new non-current assets (over $15 million – see cash flow statement).The refurbishment of the equipment may be responsible for the increase in the company’s sales and operatingperformance.

Analysis of financial position

(vii) Inventory and receivables have both decreased markedly. Inventory is now at 43 days from 75 days, this may be dueto new arrangements with suppliers or that the different range of equipment that Rytetrend now sells may offer lesschoice requiring lower inventory. Receivables are only 13 days (from 30 days). This low figure is probably a reflectionof a retailing business and the fall from the 2002 figure may mark a reduction in sales made by credit cards.

(viii) Although trade payables have increased significantly, they still represent only 46 days (based on cost of sales) which isalmost the same as in 2002.

(ix) A very worrying factor is that the company has gone from net current assets of $2,580,000 to net current liabilities of$1,820,000. This is mainly due to a combination of the above mentioned items: decreased inventory and receivablesand increased trade payables leading to a fall in cash balances of $1,450,000. That said, traditionally acceptable normsfor liquidity ratios are not really appropriate to a mainly retailing business.

(x) Long-term borrowing has fallen by $2 million; this has lowered gearing from 20% (4,000,000/19,880,000) to only9% (2,000,000/22,680,00). This is a very modest level of gearing.

The cash flow statement

This indicates very healthy cash flows generated from operations of $14,900,000, more than sufficient to pay interest costs,taxation and dividends. The main reason why the overall cash balance has fallen is that new non-current assets (costing over$15 million) have largely been financed from operating cash flows (only $1 million net of new capital has been raised). IfRytetrend continues to generate operating cash flows in the order of the current year, its liquidity will soon get back to healthylevels.

Note: The above analysis takes into account the net effect of capitalising the staff costs.

5 (a) (i) The most common problem associated with the use of historical cost financial statements is that they can be misleadingand can distort comparisons with other companies’ financial statements. The problems relate to both the incomestatement and the balance sheet. In times of rising prices historical values in the balance sheet can quickly becomeirrelevant. Where current values are significantly higher than carrying values the following problems can be identified:

(i) The value of the net assets is equal to the capital employed of an entity. Many important accounting ratios arebased on these figures e.g. the return on capital employed, asset utilisation ratios etc. The usefulness of such ratiosis limited if the net assets/capital employed are understated.

(ii) Due to the above, inter company comparison of performance can be invalidated. This point is not immediatelyobvious as many people may consider that as long as historical cost is compared with historical cost then thecomparison is being made on a consistent basis. This is not the case. Historical cost can be thought of as ‘mixed’values’ in that historical costs may represent out of date values (when particular assets were acquired many yearsago), but in other cases they may represent current values (when assets have been acquired recently). Thusequivalent assets may be shown at considerably different values.

(iii) Understatement of asset values tends to overstate gearing (another important ratio), and leads to a low asset pershare value and can make the company vulnerable to a take over.

23



(iv) Where assets, particularly land and buildings, are being used as security to raise finance, it is the current valuethat lenders are interested in, not historical values.

The problems historical costs cause in the income statement are mainly due to certain costs being understated in termsof their current cost. Most notable of these are depreciation charges being based on out of date values of their respectiveassets and the cost of sales figure may be understated as it does not include current values for bought in items ormanufactured goods. The understatement of operating costs leads to an overstatement of profit. There is a possibilitythat this may lead to higher taxation, wage demands and dividend expectation (based on overstated earnings per share).The combination of these effects is that a company may overspend or over distribute its profits and not maintain itscapital base.

The above problems affect all users not just shareholders. Managers may not be allocating scarce resources in an optimalway, lenders can be misled (as above), arguably the government is not levying taxes on a fair basis, employees may notbe aware of the wealth (or added value) that they are generating, and analysts and advisors encounter comparabilityproblems.

(ii) Non-current assets as at 31 March 2003 currenthistorical purchasing current

cost power cost$ $ $

Cost/valuation 250,000 300,000 280,000Accumulated depreciation (122,000) (146,400) (136,640)

–––––––– –––––––– ––––––––Carrying value 128,000 153,600 143,360

–––––––– –––––––– ––––––––

Income statement extract year to 31 March 2003Depreciation of plant 32,000 38,400 35,840

Workings:

Historical cost:

Depreciation at 20% on $250,000 on the reducing balance method would give depreciation of $50,000 in the year to31 March 2001; $40,000 ((250,000 – 50,000) x 20%) in the year to 31 March 2002; and $32,000 ((250,000 –50,000 – 40,000) x 20%) in the year to 31 March 2003. The accumulated depreciation at 31 March 2003 is$122,000 (50,000 + 40,000 + 32,000).

Current purchasing power:

The historical cost of the asset will be remeasured using the increase in the RPI. Thus the CPP cost will be:

$250,000 x 216/180 = $300,000

The remaining figures are calculated as per the historical cost method only using $300,000 as the cost.

Current (replacement) cost:

Although the list price of the new model is $320,000, the two are not directly comparable as the new model is moreefficient than the old. A sensible approach would be to reduce the cost of the new model in proportion to its increasedefficiency.

Equivalent cost $320,000 x 420/480 = $280,000. The remaining figures are calculated on a similar basis to thehistorical cost figures.

(b) (i) The ordinary dividends for the year to 31 March 2003 are: $Interim (12 million (3 million x $1/25c) x 3c) 360,000Final (12 million x 1·2 x 6c) 864,000

––––––––––1,224,000––––––––––

Earnings attributable to ordinary shares (see (ii)) 2,475,000Dividend cover (2,475,000/1,224,000) 2·02 times

The dividend cover is the number of times the current year’s ordinary dividends could have been paid out of the currentyear’s profit attributable to ordinary shareholders. It is an indication of the company’s dividend policy i.e. a companyhaving a dividend cover of three has paid out one third of its profit as dividends. In terms of maintainable dividends, thedividend cover is a basic measure of risk, the higher the dividend cover the less is the risk that dividends would bereduced if profits suffer a downturn. Conversely, a low dividend cover means that future dividends are more vulnerableto a deterioration in profit. A dividend cover of less than one means the company has used previous years’ retainedearnings to pay the current year’s dividend. This is not a good sign and is not sustainable in the long term.

24



(ii) All items in arriving at the profit for the financial year are included in the calculation of the earnings per share.

Earnings attributable to the ordinary shares are after the payment of preference dividends:

$8% on $1 million for full year 80,000new issue 6% on $1 million for six months 30,000

–––––––––110,000

–––––––––

Earnings attributable to ordinary shares (2,585,000 – 110,000) 2,475,000Weighted average number of shares in issue:Calculation of theoretical ex-rights price:

100 shares at $2·40 would be worth 240rights to 20 shares at $1·50 each costing 30120 shares now worth 270 This gives a theoretical ex-rights value of $2·25 per share ($270/120)

Weighted average calculation:12,000,000 x $2·4/$2·25 x 3/12 3,200,00014,400,000 (12 million x 1·2) x 9/12 10,800,000

–––––––––––Weighted average number 14,000,000

–––––––––––

Earnings per share is 17·7c ($2,475,000/14,000,000 x 100)

Restated earnings per share for the year to 31 March 2002 is 22·5c (24 x 2·25/2·40)

(iii) Fully diluted earnings per share

On conversion the loan stock would create an extra 800,000 new shares ($2 million x 40/$100)The effect on earnings would be a saving of interest of $140,000 ($2 million x 7%) before tax and $98,000 after tax(140,000 x (100% – 30%))

The directors’ warrants would create an additional 750,000 new shares without any effect on earnings.Fully diluted earnings per share is 16·5c ((2,475,000 + 98,000)/(14,000,000 + 800,000 + 750,000))

The basic earnings per share is a measure of past performance. The diluted earnings per share figure is more forwardlooking and is intended to act as a warning to existing and prospective shareholders. Although it is still based on pastperformance, it does give effect to potential ordinary shares outstanding during the period. Its disclosure is requiredwhere circumstances exist that would cause the eps to be lower if those circumstances had crystallised. It is not aprediction of the future earnings per share figures, as these will be based on the future profits and the number of sharesin issue in the future. The diluted eps is more a ‘theoretical’ value, as it is unlikely that the profit in the period when thecircumstances crystallise will be the same as the current year’s profit. The convertible loan stock in the question is agood example of diluting circumstance. On conversion the share entitlement will cause the number of shares in issuein the future to be greater than the present (assuming loan stockholders opt for conversion). There will be acompensating increase in profit as a result of the non-payment of interest but overall the expected conversion will causea dilution.

25



Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) June 2003 Marking Scheme

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

1 (a) Income statement: markssales revenue 2cost of sales 3operating expenses including goodwill 2loan interest 1tax 1minority interest 1accumulated profit b/f 1 Balance sheet:goodwill 3tangible non-current assets 2current assets 2accumulated profits 1minority interest 210% loan notes 1current liabilities 2


(b) I mark per relevant point to maximum 5Maximum for question 25

2 (a) Income statementsales revenue 1cost of sales 3operating costs 1finance costs 2taxation 2


(b) Changes in equityunrealised gains and losses 1 each 2prior year adjustment 1dividends 2

maximum 5(c) Balance sheet

software 1property, plant and equipment 3investments 1inventory 1trade receivables and payables 1in substance loan 1share capital 1revaluation reserve 2accumulated profits 1non-current liabilities 2accrued finance costs 1income tax provision 1proposed dividends 1


27



marks3 (a) one mark per valid point to max 6

(b) A grade treated as agency sales; B grade as own sales 2cost of sales for A and B grade – 1 mark each 2commission from A sales 1sales figure for B grade 1


(c) (i) deferred credits not liabilities 1consider claw back as a contingent liability 1take grant to income in year of receipt 1

maximum 3

(ii) depreciation of plant 1government grant to income, 1 mark under each treatment 2non-current asset figure 1company policy: current liabilities 1

non-current liabilities 1no liability under Framework 1


(d) discussion on change of accounting policy 2sales figure if treated as a change of policy 1prior period adjustment 1not a change of policy 1sales figure should be $24·2 million 1


4 (a) operating profit 1depreciation adjustment 1loss on sale of plant 1warranty provision 1working capital changes 2interest paid 1tax paid 1purchase of non-current assets 2share issue; issue/redemption of loan 2ordinary dividends 1decrease in cash 1


(b) relevant ratios available 5appropriate comments available 9

––14

maximum 13Maximum for question 25

28



marks5 (a) (i) one mark per valid point to maximum 6

(ii) historic cost figures 1CPP figures 2CCA figures 3

maximum 6

(b) (i) calculation of ordinary dividends 1calculation of dividend cover 1significance 2


(ii) preference dividends deduction 1ex-rights price 1weighted number of shares 1calculation of eps 1restatement of comparative 1


(iii) shares on conversion 1option shares 1effect on earnings 1calculation 1comments on significance up to 3


29




PART 2


QUESTION PAPER





Pape

r 2.5

(IN

T)




1 Highmoor, a public listed company, acquired 80% of Slowmoor’s ordinary shares on 1 October 2002. Highmoor paidan immediate $2 per share in cash and agreed to pay a further $1·20 per share if Slowmoor made a profit withintwo years of its acquisition. Highmoor has not recorded the contingent consideration.

The balance sheets of the two companies at 30 September 2003 are shown below:

Highmoor Slowmoor $ million $ million $ million $ million

Tangible non-current assets 585 172Investments (note (ii)) 225 113Software (note (iii)) nil 140

–––– ––––810 225

Current assetsInventory 185 42Accounts receivable 195 36Tax asset 1nil 80Bank 120 1,200 nil 158

––– –––––– ––– ––––Total assets 1,010 383

–––––– ––––

Equity and liabilitiesCapital and reserves:Ordinary shares of $1 each 1400 100Accumulated profits – 1 October 2002 230 150Accumulated profits – profit/loss for year 100 1330 (35) 115

–––– –––– –––– ––––730 215

Non-current liabilities12% loan note 1nil 1358% Inter company loan (note (ii)) 1nil nil 145 180

–––– ––––

Current liabilitiesAccounts payable 210 171Taxation 170 1nilOverdraft 1nil 1,280 117 188

–––– ––––– –––– ––––Total equity and liabilities 1,010 383

––––– ––––The following information is relevant:(i) At the date of acquisition the fair values of Slowmoor’s net assets were approximately equal to their book values.

(ii) Included in Highmoor’s investments is a loan of $50 million made to Slowmoor. On 28 September 2003,Slowmoor paid $9 million to Highmoor. This represented interest of $4 million for the year and the balance wasa capital repayment. Highmoor had not received nor accounted for the payment, but it had accrued for the loaninterest receivable as part of its accounts receivable figure. There are no other intra group balances.

(iii) The software was developed by Highmoor during 2002 at a total cost of $30 million. It was sold to Slowmoorfor $50 million immediately after its acquisition. The software had an estimated life of five years and is beingamortised by Slowmoor on a straight-line basis.

2



(iv) Due to the losses of Slowmoor since its acquisition, the directors of Highmoor are not confident it will return toprofitability in the short term.

(v) For the purposes of realising any negative goodwill, in its acquisition plan, Highmoor had estimated at the dateof acquisition that Slowmoor would make losses of $15 million (of which $12 million would be attributable toHighmoor) before returning to profitability. The remaining weighted average useful life at the date of acquisitionof the acquired depreciable non-monetary assets can be taken as four years (straight-line basis). The groupaccounting policy for any positive goodwill is to write it off on a straight-line basis over a period of four years.

(vi) Highmoor uses the allowed alternative treatment in IAS 22 ‘Business Combinations’ to account for the fair valueof identifiable assets and liabilities on acquisition.

Required:

(a) Prepare the consolidated balance sheet of Highmoor as at 30 September 2003, explaining your treatment ofthe contingent consideration. (20 marks)

(b) Describe the circumstances in which negative goodwill may arise. Your answer should refer to the particularissues of the above acquisition. (5 marks)

(25 marks)

3 [P.T.O.




2 The following extracted balances relate to Tourmalet at 30 September 2003:

$000 $000Ordinary shares of 20 cents each 50,000Accumulated profits at 1 October 2002 47,800Revaluation reserve at 1 October 2002 18,5006% Redeemable preference shares 2005 30,000Trade accounts payable 35,300Tax 2,100Land and buildings – at valuation (note (iii)) 150,000Plant and equipment – cost (note (v)) 98,600Investment property – valuation at 1 October 2002 (note (iv)) 10,000Depreciation 1 October 2002 – land and buildings 9,000Depreciation 1 October 2002 – plant and equipment 24,600Trade accounts receivable 31,200Inventory – 1 October 2002 26,550Bank 3,700Sales revenue (note (i)) 313,000Investment income (from properties) 1,200Purchases 158,450Distribution expenses 26,400Administration expenses 23,200Interim preference dividend 900Ordinary dividend paid 2,500

–––––––– ––––––––531,500 531,500–––––––– ––––––––

The following notes are relevant:(i) Sales revenue includes $50 million for an item of plant sold on 1 June 2003. The plant had a book value of

$40 million at the date of its sale, which was charged to cost of sales. On the same date, Tourmalet entered intoan agreement to lease back the plant for the next five years (being the estimated remaining life of the plant) at acost of $14 million per annum payable annually in arrears. An arrangement of this type is deemed to have afinancing cost of 12% per annum. No depreciation has been charged on the item of plant in the current year.

(ii) The inventory at 30 September 2003 was valued at cost of $28·5 million. This includes $4·5 million of slowmoving goods. Tourmalet is trying to sell these to another retailer but has not been successful in obtaining areasonable offer. The best price it has been offered is $2 million.

(iii) On 1 October 1999 Tourmalet had its land and buildings revalued by a firm of surveyors at $150 million, with$30 million of this attributed to the land. At that date the remaining life of the building was estimated to be 40 years. These figures were incorporated into the company’s books. There has been no significant change inproperty values since the revaluation. $500,000 of the revaluation reserve will be realised in the current year asa result of the depreciation of the buildings.

(iv) Details of the investment property are:Value – 1 October 2002 $10 millionValue – 30 September 2003 $9·8 million

The company adopts the fair value method in IAS 40 ‘Investment Property’ of valuing its investment property.

(v) Plant and equipment (other than that referred to in note (i) above) is depreciated at 20% per annum on thereducing balance basis. All depreciation is to be charged to cost of sales.

4



(vi) The above balances contain the results of Tourmalet’s car retailing operations which ceased on 31 December2002 due to mounting losses. The results of the car retailing operation, which is to be treated as a discontinuingoperation, for the year to 30 September 2003 are:

$000Sales 15,200Cost of sales 16,000Operating expenses 13,200

The operating expenses are included in administration expenses in the trial balance. Tourmalet is still payingrentals for the lease of its car showrooms. The rentals are included in operating expenses. Tourmalet is hopingto use the premises as an expansion of its administration offices. This is dependent on obtaining planningpermission from the local authority for the change of use, however this is very difficult to obtain. Failing this, thebest option would be early termination of the lease which will cost $1·5 million in penalties. This amount hasnot been provided for.

(vii) The balance on the taxation account in the trial balance is the result of the settlement of the previous year’s taxcharge. The directors have estimated the provision for income tax for the year to 30 September 2003 at $9·2 million.

Required:

(a) Comment on the substance of the sale of the plant and the directors’ treatment of it. (5 marks)

(b) Prepare the Income Statement; and (17 marks)

(c) A Statement of Changes in Equity for Tourmalet for the year to 30 September 2003 in accordance withcurrent International Accounting Standards. (3 marks)

Note: A balance sheet is NOT required. Disclosure notes are NOT required.(25 marks)

5 [P.T.O.



3 IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ was issued in 1998. The Standard sets out theprinciples of accounting for these items and clarifies when provisions should and should not be made. Prior to itsissue, the inappropriate use of provisions had been an area where companies had been accused of manipulating thefinancial statements and of creative accounting.

Required:

(a) Describe the nature of provisions and the accounting requirements for them contained in IAS 37. (6 marks)

(b) Explain why there is a need for an accounting standard in this area. Illustrate your answer with threepractical examples of how the standard addresses controversial issues. (6 marks)

(c) Bodyline sells sports goods and clothing through a chain of retail outlets. It offers customers a full refund facilityfor any goods returned within 28 days of their purchase provided they are unused and in their original packaging.In addition, all goods carry a warranty against manufacturing defects for 12 months from their date of purchase.For most goods the manufacturer underwrites this warranty such that Bodyline is credited with the cost of thegoods that are returned as faulty. Goods purchased from one manufacturer, Header, are sold to Bodyline at anegotiated discount which is designed to compensate Bodyline for manufacturing defects. No refunds are givenby Header, thus Bodyline has to bear the cost of any manufacturing faults of these goods.

Bodyline makes a uniform mark up on cost of 25% on all goods it sells, except for those supplied from Headeron which it makes a mark up on cost of 40%. Sales of goods manufactured by Header consistently account for20% of all Bodyline’s sales.

Sales in the last 28 days of the trading year to 30 September 2003 were $1,750,000. Past trends reliablyindicate that 10% of all goods are returned under the 28-day return facility. These are not faulty goods. Of these70% are later resold at the normal selling price and the remaining 30% are sold as ‘sale’ items at half the normalretail price.

In addition to the above expected returns, an estimated $160,000 (at selling price) of the goods sold during theyear will have manufacturing defects and have yet to be returned by customers. Goods returned as faulty haveno resale value.

Required:

Describe the nature of the above warranty/return facilities and calculate the provision Bodyline is required tomake at 30 September 2003:

(i) for goods subject to the 28 day returns policy; and

(ii) for goods that are likely to be faulty. (8 marks)

(d) Rockbuster has recently purchased an item of earth moving plant at a total cost of $24 million. The plant hasan estimated life of 10 years with no residual value, however its engine will need replacing after every 5,000hours of use at an estimated cost of $7·5 million. The directors of Rockbuster intend to depreciate the plant at$2·4 million ($24 million/10 years) per annum and make a provision of $1,500 ($7·5 million/5,000 hours) perhour of use for the replacement of the engine.

Required:

Explain how the plant should be treated in accordance with International Accounting Standards andcomment on the Directors’ proposed treatment. (5 marks)

(25 marks)

6



This is a blank page.Question 4 begins on page 8.

7 [P.T.O.



8

4 Comparator assembles computer equipment from bought in components and distributes them to various wholesalersand retailers. It has recently subscribed to an interfirm comparison service. Members submit accounting ratios asspecified by the operator of the service, and in return, members receive the average figures for each of the specifiedratios taken from all of the companies in the same sector that subscribe to the service. The specified ratios and theaverage figures for Comparator’s sector are shown below.

Ratios of companies reporting a full year’s results for periods ending between 1 July 2003 and 30 September 2003Return on capital employed 22·1%Net assets turnover 1·8 timesGross profit margin 30%Net profit (before tax) margin 12·5%Current ratio 1·6:1Quick ratio 0·9:1Inventory holding period 46 daysAccounts receivable collection period 45 daysAccounts payable payment period 55 daysDebt to equity 40%Dividend yield 6%Dividend cover 3 times

Comparator’s financial statements for the year to 30 September 2003 are set out below:Income statement $000

Sales revenue 2,425Cost of sales (1,870)

––––––Gross profit 555Other operating expenses (215)

–––––Operating profit 340Interest payable (34)Exceptional item (note (ii)) (120)

–––––Profit before taxation 186Income tax (90)

–––––Profit after taxation 96

–––––Extracts of changes in equity:

Accumulated profits – 1 October 2002 179Net profit for the period 96Dividends paid (interim $60,000; final $30,000) (90)

–––––Accumulated profits – 30 September 2003 185

–––––



9 [P.T.O.

Balance Sheet $000 $000Non-current assets (note (i)) 540

Current AssetsInventory 275Accounts receivable 320Bank nil 595

–––– –––––1,135–––––

Share Capital and ReservesOrdinary shares (25 cents each) 150Accumulated profits 185

–––––335

Non-current liabilities8% loan notes 300

Current liabilitiesBank overdraft 65Trade accounts payable 350Taxation 85 500

–––– –––––1,135–––––

Notes(i) The details of the non-current assets are:

Cost Accumulated depreciation Net book value$000 $000 $000

At 30 September 2003 3,600 3,060 540

(ii) The exceptional item relates to losses on the sale of a batch of computers that had become worthless due toimprovements in microchip design.

(iii) The market price of Comparator’s shares throughout the year averaged $6·00 each.

Required:

(a) Explain the problems that are inherent when ratios are used to assess a company’s financial performance.Your answer should consider any additional problems that may be encountered when using interfirmcomparison services such as that used by Comparator. (7 marks)

(b) Calculate the ratios for Comparator equivalent to those provided by the interfirm comparison service.(6 marks)

(c) Write a report analysing the financial performance of Comparator based on a comparison with the sectoraverages. (12 marks)

(25 marks)



10

5 (a) (i) IAS 12 ‘Income Tax’ was issued in 1996 and revised in 2000. It details the requirements relating to theaccounting treatment of deferred tax.

Required:

Explain why it is considered necessary to provide for deferred tax and briefly outline the principles ofaccounting for deferred tax contained in IAS 12 ‘Income Tax’. (5 marks)

(ii) Bowtock purchased an item of plant for $2,000,000 on 1 October 2000. It had an estimated life of eightyears and an estimated residual value of $400,000. The plant is depreciated on a straight-line basis. Thetax authorities do not allow depreciation as a deductible expense. Instead a tax expense of 40% of the costof this type of asset can be claimed against income tax in the year of purchase and 20% per annum (on areducing balance basis) of its tax base thereafter. The rate of income tax can be taken as 25%.

Required:

In respect of the above item of plant, calculate the deferred tax charge/credit in Bowtock’s income statementfor the year to 30 September 2003 and the deferred tax balance in the balance sheet at that date.

(6 marks)Note: work to the nearest $000.

(b) Bowtock has leased an item of plant under the following terms:Commencement of the lease was 1 January 2002Term of lease 5 years Annual payments in advance $12,000Cash price and fair value of the asset – $52,000 at 1 January 2002Implicit interest rate within the lease (as supplied by the lessor) 8% per annum (to be apportioned on a timebasis where relevant).The company’s depreciation policy for this type of plant is 20% per annum on cost (apportioned on a time basiswhere relevant).

Required:

Prepare extracts of the income statement and balance sheet for Bowtock for the year to 30 September 2003for the above lease. (5 marks)

(c) (i) Explain why events occurring after the balance sheet date may be relevant to the financial statementsof the previous period. (4 marks)

(ii) At 30 September 2003 Bowtock had included in its draft balance sheet inventory of $250,000 valued atcost. Up to 5 November 2003, Bowtock had sold $100,000 of this inventory for $150,000. On this datenew government legislation (enacted after the year end) came into force which meant that the unsoldinventory could no longer be marketed and was worthless.

Bowtock is part way through the construction of a housing development. It has prepared its financialstatements to 30 September 2003 in accordance with IAS 11 ‘Construction Contracts’ and included aproportionate amount of the total estimated profit on this contract. The same legislation referred to above (inforce from 5 November 2003) now requires modifications to the way the houses within this developmenthave to be built. The cost of these modifications will be $500,000 and will reduce the estimated total profiton the contract by that amount, although the contract is still expected to be profitable.

Required:

Assuming the amounts are material, state how the information above should be reflected in the financialstatements of Bowtock for the year ended 30 September 2003. (5 marks)

(25 marks)




Answers



13

Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) December 2003 Answers

1 (a) Consolidated Balance Sheet of Highmoor as at 30 September 2003:$ million $ million

AssetsNon-current assetsTangible (585 + 172) 757IntangibleConsolidated negative goodwill (40 – 19 (w (ii))) 1(21)Software (w (v)) 124Investments (225 – 160 shares – 50 loan (w (iv)) + 13) 128

––––1788

Current assetsInventory (85 + 42) 127Accounts receivable (95 – 4 in transit (w (iv)) + 36) 127Tax asset 180Bank (20 + 9 in transit (w (iv))) 129 363

–––– –––––Total assets 1,151

–––––Equity and liabilitiesCapital and reserves:Ordinary shares $1 each 400Accumulated profits (w (i)) 305

––––705

Non-current liabilities12% loan notes 1 35

Minority interest (w (iii)) 1 43

Current liabilitiesAccounts payable (210 + 71) 1281Overdraft 1117Taxation 1170 368

–––– –––––Total equity and liabilities 1,151

–––––Workings (Note: all figures in $ million)(i) Accumulated profits

Highmoor Slowmoor Highmoor SlowmoorUnrealised profit (w (v)) 116 B/f 330 115Minority interest (20% x 115) 123 Post acq loss 1(28)Pre-acq profit (80% x 150) 120 Realisation of negative

goodwill (w (ii)) 119Post acq loss (80% x 35) (28)Balance c/f 305

–––– –––– –––– ––––321 115 321 115–––– –––– –––– ––––

(ii) Cost of controlInvestments at cost Ordinary shares

(100 x 80% x $2) 160 (80% x 100) 180Pre acq profit (w (i)) 120

Negative goodwill 140–––– ––––200 200–––– ––––

The contingent consideration has not been included in the above calculation. IAS 22 ‘Business Combinations’ onlyrequires contingent consideration to be included in the cost of an acquisition if it is probable that the amount will bepaid and it can be measured reliably. The additional $96 million (i.e. $1·20 per share) is only payable if Slowmoormakes a profit within two years of acquisition. In the year since acquisition the company made a loss of $35 million,much higher than the $15 million in its acquisition plan, and the directors of Highmoor are now less confident of thefuture prospects of Slowmoor. This seems to indicate that it is unlikely that any further consideration will be paid andthe above treatment is justified.



14

The negative goodwill of $40 million will be realised as follows:Attributable to: Proportion realised year to 30 September 2003 amount

expected losses attributable to Highmoor 12 100% 12non-monetary assets 28 25% (four year life) 17

––– –––Total negative goodwill 40 19

––– –––

(iii) Minority interestOrdinary shares (20% x 100) 20Accumulated profits (w (i)) 23

Balance c/f 43––– –––43 43––– –––

(iv) Elimination of loan and accrued interest:The investments of Highmoor will show an unadjusted amount of $50 million as a loan to Slowmoor. The cash in transitof $9 million from Slowmoor should be applied $4 million to cancel the accrued interest receivable and the balance of$5 million to the investment (loan). When this adjustment is made the investment and the loan will cancel each otherout.

(v) The net book value of the software in Slowmoor’s books is $40 million. If the software had been depreciated on itsoriginal cost of $30 million it would have a book value of $24 million ($30 less $6 million depreciation at 20% perannum). Thus there is an unrealised profit on the transfer of the software of $16 million ($40 million – $24 million).

(b) Negative goodwill arises in bookkeeping where the consideration given for a business is less than the fair value of the netassets acquired. Intuitively it does not make sense for a vendor to sell net assets for less than they are worth. This view isreflected by the IASB as they appear rather sceptical about the existence of negative goodwill. They say where an acquisitionappears to create negative goodwill, a careful check of the value of the assets acquired and whether any liabilities have beenomitted is required.

Negative goodwill may arise for several reasons; the most obvious is that there has been a bargain purchase. This may occurthrough the vendor being in a poor financial position and needing to realise assets quickly, or it may be due to good negotiatingskills on the part of the acquirer, or the vendor may not realise how much the assets are really worth.

A more controversial occasion where negative goodwill arises is where a company, in determining the amount of considerationit is willing to pay for a business, will take into account the cost of anticipated future losses and post acquisition reorganisationexpenditure that it believes will be required. The effect of this is that it would reduce the consideration offered/paid. As thesecosts cannot generally be recognised as a liability at the date of purchase, this can lead to the consideration being lower thanthe recognisable net assets.

In relation to the acquisition of Slowmoor the following are questionable issues:– Highmoor may be trying to deliberately create losses at Slowmoor to avoid paying the further consideration. An example

of this may be the transfer price of the software. The additional consideration of $96 million, if payable, would changethe negative goodwill into positive goodwill of $56 million.

– The tax asset of Slowmoor may be questionable. Accounting standards are quite restrictive over the recognition of taxassets.



15

2 (a) The sale of the plant has been incorrectly treated on two counts. Firstly even if it were a genuine sale it should not have beenincluded in sales and cost of sales, rather it should have been treated as the disposal of a non-current asset. Only the profitor loss on the disposal would be included in the income statement (requiring separate disclosure if material). However eventhis treatment would be incorrect. As Tourmalet will continue to use the plant for the remainder of its useful life, the substanceof this transaction is a secured loan. Thus the receipt of $50 million for the ‘sale’ of the plant should be treated as a loan.The rentals, when they are eventually paid, will be applied partly as interest (at 12% per annum) and the remainder will bea capital repayment of the loan. In the income statement an accrual for loan interest of 12% per annum on $50 million forfour months ($2 million) is required.

(b) Tourmalet Income Statement – Year to 30 September 2003continuing discontinuing Totaloperations operations

$000 $000 $000Sales revenues (313,000 – 50,000 (see above)) 247,800 15,200 263,000Cost of sales (w (i)) (128,800) (16,000) (144,800)

––––––––– –––––––– –––––––––Gross profit (loss) 119,000 (800) 118,200Distribution expenses (26,400) nil (26,400)Administration expenses (w (iii)) (20,000) (4,700) (24,700)

––––––––– –––––––– –––––––––Profit (loss) on the ordinary activities before interest 72,600 (5,500) 67,100

––––––––– ––––––––Financing cost (w (iv)) (3,800)Loss on investment properties ($10 million – $9·8 million) (200)Investment income 1,200

–––––––––Profit before tax 64,300Income tax (9,200 – 2,100) (7,100)

–––––––––Profit for the period 57,200

–––––––––

Note: IAS 35 ‘Discontinuing Operations’ does not require a specific presentation of the results of a discontinued operation.The above is only one of several acceptable presentations.

(c) Tourmalet Statement of Changes in Equity – Year to 30 September 2003Accumulated Revaluation Ordinary Total

Profits reserve shares$000 $000 $000 $000

At 1 October 2002 47,800 18,500 50,000 116,300Profit for period 57,200 57,200Transfer to realised profit 500 (500)Ordinary dividends paid (2,500) (2,500)

–––––––– –––––– ––––––– ––––––––At 30 September 2003 103,000 18,000 50,000 171,000

–––––––– –––––– ––––––– ––––––––

Note: IAS 32 ‘Financial Instruments: Disclosure and Presentation’ says redeemable preference shares have the substance ofdebt and should be treated as non-current liabilities and not as equity. This also means that preference dividends are treatedas a finance cost in the income statement.

Workings(i) Cost of sales: $000

Opening inventory 26,550Purchases 158,450Transfer to plant (see (a)) (40,000)Depreciation (w (ii)) 25,800Closing inventory (28·5 million – 2·5 million see below) (26,000)

––––––––144,800––––––––

The slow moving inventory should be written down to its estimated realisable value. Despite the optimism of theDirectors, it would seem prudent to base the realisable value on the best offer so far received (i.e. $2 million).



16

(ii) Non-current asset depreciation: $000Buildings $120/40 years 3,000Plant – per trial balance ((98,600 – 24,600) x 20%) 14,800Plant – plant treated as sold (40,000/5 years) 8,000

–––––––25,800–––––––

Note: investment properties do not require depreciating under the fair value model in IAS 40. Instead they are revaluedeach year with the surplus or deficit being taken to income.

For information only:in the balance sheet cost/valuation accumulated net book

depreciation value$000 $000 $000

Land and buildings 150,000 12,000 138,000Plant – per trial balance 98,600 39,400 59,200Plant incorrectly treated as sold 40,000 8,000 32,000

––––––––229,200––––––––

(iii) It would seem prudent to accrue for the penalty on the lease as it is uncertain that the permission for a change of usewill be granted. In these circumstances, the payment of the penalty will be the lowest liability. This gives totaladministration expenses of $24,700 (23,200 + 1,500), of which $4,700 (3,200 + 1,500) is classed asdiscontinuing.

(iv) Finance costs: incomestatement

$000Accrued interest on in-substance loan (see (a)) 2,000Preference dividends (30,000 x 6%) 1,800

––––––3,800

––––––

Note this balance sheet is provided for information only. It does not form part of the answer or marking scheme.Tourmalet – Balance Sheet as at 30 September 2003

$000 $000Non-current assets (w (ii)) 229,200Investment properties 9,800

––––––––239,000

Current AssetsInventory (w (i)) 26,000Trade accounts receivable 31,200Bank 3,700 60,900

––––––– ––––––––Total assets 299,900

––––––––Equity and liabilitiesCapital and Reserves:Ordinary shares of 20c each 50,000Accumulated profits 103,000Revaluation reserve (see (c)) 18,000 121,000

–––––––– ––––––––171,000

Non-current liabilities6% Redeemable preference shares $1 each 30,000In-substance loan (see (a)) 50,000 80,000

––––––––Current liabilitiesTrade accounts payable 35,300Accrued penalty cost (w (iii)) 1,500Accrued finance costs (2,000 + 900) 2,900Taxation 9,200

––––––– 48,900––––––––

Total equity and liabilities 299,900––––––––



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3 (a) IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ only deals with those provisions that are regarded asliabilities. The term provision is also generally used to describe those amounts set aside to write down the value of assetssuch as depreciation charges and provisions for diminution in value (e.g. provision to write down the value of damaged orslow moving inventory). The definition of a provision in the Standard is quite simple; provisions are liabilities of uncertaintiming or amount. If there is reasonable certainty over these two aspects the liability is a creditor. There is clearly an overlapbetween provisions and contingencies. Because of the ‘uncertainty’ aspects of the definition, it can be argued that to someextent all provisions have an element of contingency. The IASB distinguishes between the two by stating that a contingencyis not recognised as a liability if it is either only possible and therefore yet to be confirmed as a liability, or where there is aliability but it cannot be measured with sufficient reliability. The IASB notes the latter should be rare.

The IASB intends that only those liabilities that meet the characteristics of a liability in its Framework for the Preparation andPresentation of Financial Statements should be reported in the balance sheet.

IAS 37 summarises the above by requiring provisions to satisfy all of the following three recognition criteria:– there is a present obligation (legal or constructive) as a result of a past event;– it is probable that a transfer of economic benefits will be required to settle the obligation;– the obligation can be estimated reliably.

A provision is triggered by an obligating event. This must have already occurred, future events cannot create current liabilities.The first of the criteria refers to legal or constructive obligations. A legal obligation is straightforward and uncontroversial, butconstructive obligations are a relatively new concept. These arise where a company creates an expectation that it will meetcertain obligations that it is not legally bound to meet. These may arise due to a published statement or even by a pattern ofpast practice. In reality constructive obligations are usually accepted because the alternative action is unattractive or maydamage the reputation of the company. The most commonly quoted example of such is a commitment to pay forenvironmental damage caused by the company, even where there is no legal obligation to do so.

To summarise: a company must provide for a liability where the three defining criteria of a provision are met, but converselya company cannot provide for a liability where they are not met. The latter part of the above may seem obvious, but it is anarea where there has been some past abuse of provisioning as is referred to in (b).

(b) The main need for an accounting standard in this area is to clarify and regulate when provisions should and should not bemade. Many controversial areas including the possible abuse of provisioning are based on contravening aspects of the abovedefinitions. One of the most controversial examples of provisioning is in relation to future restructuring or reorganisation costs(often as part of an acquisition). This is sometimes extended to providing for future operating losses. The attraction ofproviding for this type of expense/loss is that once the provision has been made, the future costs are then charged to theprovision such that they bypass the income statement (of the period when they occur). Such provisions can be glossed overby management as ‘exceptional items’, which analysts are expected to disregard when assessing the company’s futureprospects. If this type of provision were to be incorporated as a liability as part of a subsidiary’s net assets at the date ofacquisition, the provision itself would not be charged to the income statement. IAS 37 now prevents this practice as futurecosts and operating losses (unless they are for an onerous contract) do not constitute past events.

Another important change initiated by IAS 37 is the way in which environmental provisions must be treated. Practice in thisarea has differed considerably. Some companies did not provide for such costs and those that did often accrued for them onan annual basis. If say a company expected environmental site restoration cost of $10 million in 10 years time, it might arguethat this is not a liability until the restoration is needed or it may accrue $1 million per annum for 10 years (ignoringdiscounting). Somewhat controversially this practice is no longer possible. IAS 37 requires that if the environmental costs area liability (legal or constructive), then the whole of the costs must be provided for immediately. That has led to large liabilitiesappearing in some companies’ balance sheets.

A third example of bad practice is the use of ‘big bath’ provisions and over provisioning. In its simplest form this occurs wherea company makes a large provision, often for non-specific future expenses, or as part of an overall restructuring package. Ifthe provision is deliberately overprovided, then its later release will improve future profits. Alternatively the company couldcharge to the provision a different cost than the one it was originally created for. IAS 37 addresses this practice in two ways:by not allowing provisions to be created if they do not meet the definition of an obligation; and specifically preventing aprovision made for one expense to be used for a different expense. Under IAS 37 the original provision would have to bereversed and a new one would be created with appropriate disclosures. Whilst this treatment does not affect overall profits,it does enhance transparency.

Note: other examples would be acceptable.



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(c) Guarantees or warranties appear to have the attributes of contingent liabilities. If the goods are sold faulty or develop a faultwithin the guarantee period there will be a liability, if not there will be no liability. The IASB view this problem as two separatesituations. Where there is a single item warranty, it is considered in isolation and often leads to a discloseable contingentliability unless the chances of a claim are thought to be negligible. Where there are a number of similar items, they shouldbe considered as a whole. This may mean that whilst the chances of a claim arising on an individual item may be small,when taken as a whole, it should be possible to estimate the number of claims from past experience. Where this is the case,the estimated liability is not considered contingent and it must be provided for.

(i) Bodyline’s 28-day refund policy is a constructive obligation. The company probably has notices in its shops informingcustomers of this policy. This would create an expectation that the company will honour its policy. The liability that thiscreates is rather tricky. The company will expect to give customers refunds of $175,000 ($1,750,000 x 10%). This isnot the liability. 70% of these will be resold at the normal selling price, so the effect of the refund policy for these goodsis that the profit on their sale must be deferred. The easiest way to account for this is to make a provision for theunrealised profit. This has to be calculated for two different profit margins:Goods manufactured by Header (at a mark up of 40% on cost):

$24,500 ($175,000 x 70% x 20%) x 40/140 = $7,000Goods from other manufacturers (at a mark up of 25% on cost)

$98,000 ($175,000 x 70% x 80%) x 25/125 = $19,600

The sale of the remaining 30% at half the normal selling price will create a loss. Again this must be calculated for bothgroup of sales:

Goods manufactured by Header were originally sold for $10,500 (175,000 x 30% x 20%). These will be resold (at aloss) for half this amount i.e. $5,250. Thus a provision of $5,250 is required.

Goods manufactured by other manufacturers were originally sold for $42,000 (175,000 x 30% x 80%). These will beresold (at a loss) for half this amount i.e. $21,000. Thus a provision of $21,000 is required.

The total provision in respect of the 28 day return facility will be $52,850 (7,000 + 19,600 + 5,250 + 21,000).

(ii) Goods likely to be returned because they are faulty require a different treatment. These are effectively sales returns.Normally the manufacturer will reimburse the cost of the faulty goods. The effect of this is that Bodyline will not havemade the profit originally recorded on their sale. This applies to all goods other than those supplied by Header. Thusthese sales returns would be $128,000 (160,000 x 80%) and the credit due from the manufacturer would be$102,400 (128,000 x 100/125 removal of profit margin). The overall effect is that Bodyline would have to removeprofits of $25,600 from its financial statements.

For those goods supplied by Header, Bodyline must suffer the whole loss as this is reflected in the negotiated discount.Thus the provision required for these goods is $32,000 (160,000 x 20%), giving a total provision of $57,600 (25,600+ 32,000).

(d) The Directors’ proposed treatment is incorrect. The replacement of the engine is an example of what has been described ascyclic repairs or replacement. Whilst it may seem logical and prudent to accrue for the cost of a replacement engine as theold one is being worn out, such practice leads to double counting. Under the Directors’ proposals the cost of the engine isbeing depreciated as part of the cost of the asset, albeit over an incorrect time period. The solution to this problem lies in IAS 16 ‘Property, Plant and Equipment’. The plant constitutes a ‘complex’ asset i.e. one that may be thought of as havingseparate components within a single asset. Thus part of the plant $16·5 million (total cost of $24 million less $7·5 assumedcost of the engine) should be depreciated at $1·65 million per annum over a 10-year life and the engine should bedepreciated at $1,500 per hour of use (assuming machine hour depreciation is the most appropriate method). If a furtherprovision of $1,500 per machine hour is made, there would be a double charge against profit for the cost of the engine. IAS 37 also refers to this type of provision and says that the future replacement of the engine is not a liability. The reasoningis that the replacement could be avoided if, for example, the company chose to sell the asset before replacement was due. Ifan item does not meet the definition of a liability it cannot be provided for.



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4 (a) Ratios are used to assess the financial performance of a company by comparing the calculated figures to various othersources. This may be to previous years’ ratios of the same company, it may be to the ratios of a similar rival company, toaccepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processesare several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessmentof how well a company has performed, they merely raise the questions and direct the analyst into trying to determine whathas caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills ofthe person using them. It is also true that any assessment should also consider other information that may be availableincluding non-financial information.

More specific problem areas are:– Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their

ratios. For example return on capital employed is materially affected by revaluations of assets. Comparing this ratio fortwo companies where one has revalued its assets and the other carries them at depreciated historic cost would not bevery meaningful. Similar examples may involve depreciation methods, inventory valuation policies etc.

– Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the useof debtor factoring. If one company collects its accounts receivable in the normal way, then the calculation of theaccounts receivable collection period would be a reasonable indication of the efficiency of its credit control department.However if a company chose to factor its accounts receivable (i.e. ‘sell’ them to a finance company) then the calculationof its collection period would be meaningless. A more controversial example would be the engineering of a lease suchthat it fell to be treated as an operating lease rather than a finance lease.

– Balance sheet averages: many ratios are based on comparing income statement items with balance sheet items. Theratio of accounts receivable collection period is a good example of this. For such ratios to have meaning, there is anassumption that the year-end balance sheet figures are representative of annual norms. Seasonal trading and otherfactors may invalidate this assumption. For example the level of accounts receivable and inventory of a toy manufacturercould vary largely due to the nature of its seasonal trading.

– Inflation can distort comparisons over time.

– The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there isan obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt +equity). Also where a ratio is partly based on a profit figure, there can be differences as to what is included and what isexcluded from the profit figure. Problems of this type include the treatment of extraordinary items and finance costs.

– The use of norms can be misleading. A desirable range for the current ratio may be say between 1·5 and 2 : 1, but allbusinesses are different. This would be a very high ratio for a supermarket (with few accounts receivable), but a lowfigure for a construction company (with high levels of work in progress).

– Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combinationwith other ratios.

A more controversial aspect of ratio analysis is that management have sometimes indulged in creative accounting techniquesin order that the ratios calculated from published financial statements will show a more favourable picture than the trueunderlying position. Examples of this are sale and repurchase agreements, which manipulate liquidity figures, and off balancesheet finance which distorts return on capital employed.

Inter firm comparisons:

Of particular concern with this method of using ratios is:

– they are themselves averages and may incorporate large variations in their composition. Some inter firm comparisonagencies produce the ratios analysed into quartiles to attempt to overcome this problem.

– it may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of thespecific company. The type of products or markets may be different.

– companies of different sizes operate under different economies of scale, this may not be reflected in the industry averagefigures.

– the year end accounting dates of the companies included in the averages are not going to be all the same. This highlightsissues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this bygrouping companies with approximately similar year-ends together as in the example of this question, but this is not acomplete solution.



20

(b) Calculation of specified ratios:Comparator Sector average

Return on capital employed (186 +34 loan interest/635) 34·6% 22·1%Net assets turnover (2,425/635) 3·8 times 1·8 timesGross profit margin (555/2,425 x 100) 22·9% 30%Net profit (excluding exceptionals) margin (306/2,425 x 100) 12·6% not availableNet profit (before tax) margin (186/2,425 x 100) 7·7% 12·5%Current ratio (595/500) 1·19 : 1 1·6 : 1Quick ratio (320/500) 0·64 : 1 0·9 : 1Inventory holding period (275/1,870 x 365) 54 days 46 daysAccounts receivable collection period (320/2,425 x 365) 48 days 45 daysCreditor payment period (350/1,870 x 365) (based on cost of sales) 68 days 55 daysDebt to equity (300/335 x 100) 90% 40%Dividend yield (see below) 2·5% 6%Dividend cover (96/90) 1·07 times 3 times

The workings are in $000 (unless otherwise stated) and are for Comparator’s ratios.

The dividend yield is calculated from a dividend per share figure of 15c ($90,000/150,000 x 4) and a share price of $6·00.Thus the yield is 2·5% (15c/$6·00 x 100%).

(c) Analysis of Comparator’s financial performance compared to sector average for the year to 30 September 2003:To: From: Date:

Operating performanceThe return on capital employed of Comparator is impressive being more than 50% higher than the sector average. Thecomponents of the return on capital employed are the asset turnover and profit margins. In these areas Comparator’s assetturnover is much higher (nearly double) than the average, but the net profit margin after exceptionals is considerably belowthe sector average. However, if the exceptionals are treated as one off costs and excluded, Comparator’s margins are verysimilar to the sector average. This short analysis seems to imply that Comparator’s superior return on capital employed is dueentirely to an efficient asset turnover i.e. Comparator is making its assets work twice as efficiently as its competitors. A closerinspection of the underlying figures may explain why its asset turnover is so high. It can be seen from the note to the balancesheet that Comparator’s non-current assets appear quite old. Their net book value is only 15% of their original cost. This hasat least two implications; they will need replacing in the near future and the company is already struggling for funding; andtheir low net book value gives a high figure for asset turnover. Unless Comparator has underestimated the life of its assets inits depreciation calculations, its non-current assets will need replacing in the near future. When this occurs its asset turnoverand return on capital employed figures will be much lower. This aspect of ratio analysis often causes problems and to counterthis anomaly some companies calculate the asset turnover using the cost of non-current assets rather than their net bookvalue as this gives a more reliable trend. It is also possible that Comparator is using assets that are not on its balance sheet.It may be leasing assets that do not meet the definition of finance leases and thus the assets and corresponding obligationsare not recognised on the balance sheet.

A further issue is which of the two calculated margins should be compared to the sector average (i.e. including or excludingthe effects of the exceptionals). The gross profit margin of Comparator is much lower than the sector average. If the exceptionallosses were taken in at trading account level, which they should be as they relate to obsolete inventory, Comparator’s grossmargin would be even worse. As Comparator’s net margin is similar to the sector average, it would appear that Comparatorhas better control over its operating costs. This is especially true as the other element of the net profit calculation is financecosts and as Comparator has much higher gearing than the sector average, one would expect Comparator’s interest to behigher than the sector average.

LiquidityHere Comparator shows real cause for concern. Its current and quick ratios are much worse than the sector average, andindeed far below expected norms. Current liquidity problems appear due to high levels of accounts payable and a high bankoverdraft. The high levels of inventory contribute to the poor quick ratio and may be indicative of further obsolete inventory(the exceptional item is due to obsolete inventory). The accounts receivable collection figure is reasonable, but at 68 days,Comparator takes longer to pay its accounts payable than do its competitors. Whilst this is a source of ‘free’ finance, it candamage relations with suppliers and may lead to a curtailment of further credit.

GearingAs referred to above, gearing (as measured by debt/equity) is more than twice the level of the sector average. Whilst this maybe an uncomfortable level, it is currently beneficial for shareholders. The company is making an overall return of 34·6%, butonly paying 8% interest on its loan notes. The gearing level may become a serious issue if Comparator becomes unable tomaintain the finance costs. The company already has an overdraft and the ability to make further interest payments could bein doubt.



21

Investment ratiosDespite reasonable profitability figures, Comparator’s dividend yield is poor compared to the sector average. From the extractsof the changes in equity it can be seen that total dividends are $90,000 out of available profit for the year of only $96,000(hence the very low dividend cover). It is worthy of note that the interim dividend was $60,000 and the final dividend only$30,000. Perhaps this indicates a worsening performance during the year, as normally final dividends are higher than interimdividends. Considering these factors it is surprising the company’s share price is holding up so well.

SummaryThe company compares favourably with the sector average figures for profitability, however the company’s liquidity andgearing position is quite poor and gives cause for concern. If it is to replace its old assets in the near future, it will need toraise further finance. With already high levels of borrowing and poor dividend yields, this may be a serious problem forComparator.

Yours faithfully

5 (a) (i) An explanation of the origins of why deferred tax is provided for lies in understanding that accounting profit (as reportedin a company’s financial statements) differs from the profit figure used by the tax authorities to calculate a company’sincome tax liability for a given period. If deferred tax were ignored (flow through system), then a company’s tax chargefor a particular period may bear very little resemblance to the reported profit. For example if a company makes a largeprofit in a particular period, but, perhaps because of high levels of capital expenditure, it is entitled to claim large taxallowances for that period, this would reduce the amount of tax it had to pay. The result of this would be that thecompany reported a large profit, but very little, if any, tax charge. This situation is usually ‘reversed’ in subsequentperiods such that tax charges appear to be much higher than the reported profit would suggest that they should be.Many commentators feel that such a reporting system is misleading in that the profit after tax, which is used forcalculating the company’s earnings per share, may bear very little resemblance to the pre tax profit. This can mean thata government’s fiscal policy may distort a company’s profit trends. Providing for deferred tax goes some way towardsrelieving this anomaly, but it can never be entirely corrected due to items that may be included in the income statement,but will never be allowed for tax purposes (referred to as permanent differences in some jurisdictions). Where taxdepreciation is different from the related accounting depreciation charges this leads to the tax base of an asset beingdifferent to its carrying value on the balance sheet (these differences are called temporary differences) and a provisionfor deferred tax is made. This ‘balance sheet liability’ approach is the general principle on which IAS 12 bases thecalculation of deferred tax. The effect of this is that it usually brings the total tax charge (i.e. the provision for the currentyear’s income tax plus the deferred tax) in proportion to the profit reported to shareholders.

The main area of debate when providing for deferred tax is whether the provision meets the definition of a liability. If theprovision is likely to crystallise, then it is a liability, however if it will not crystallise in the foreseeable future, thenarguably, it is not a liability and should not be provided for. The IASB takes a prudent approach and IAS 12 does notaccept the latter argument.

(ii) IAS 12 requires deferred tax to be calculated using the ‘balance sheet liability method’. This method requires thetemporary difference to be calculated and the rate of income tax applied to this difference to give the deferred tax assetor liability. Temporary differences are the differences between the carrying amount of an asset and its tax base.

Carrying value at 30 September 2003 $000 $000Cost of plant 2,000Accumulated depreciation at 30 September 2003 (2,000 – 400)/8 years for 3 years (600)

––––––Carrying value 1,400

––––––Tax base at 30 September 2003Initial tax base (original cost) 2,000Tax depreciation

Year to 30 September 2001 (2,000 x 40%) 800Year to 30 September 2002 (1,200 x 20%) 240Year to 30 September 2003 (960 x 20%) 192 1,232

–––– ––––––Tax base 30 September 2003 768

––––––Temporary differences at 30 September 2003 (1,400 – 768) 632Deferred tax liability at 30 September 2003 (632 x 25% tax rate) 158Income statement credit – year to 30 September 2003 ((200 – 192) x 25%) 2



22

(b) $Income statement extracts year to 30 September 2003Depreciation of leased asset (w (i)) 10,400Lease interest expense (w (ii)) 2,672

Balance sheet extracts as at 30 September 2003Leased asset at cost 52,000Accumulated depreciation (7,800 + 10,400 (w (i))) 18,200

–––––––Net book value 33,800

–––––––Current liabilitiesAccrued lease interest (w (ii)) 1,872Obligations under finance leases (w (ii)) 9,504

Non-current liabilitiesObligations under finance leases (w (ii)) 21,696

Workings(i) Depreciation for the year ended 30 September 2002 would be $7,800 ($52,000 x 20% x 9/12)

Depreciation for the year ended 30 September 2003 would be $10,400 ($52,000 x 20%)

(ii) The lease obligations are calculated as follows:Cash price/fair value 52,000Rental 1 January 2002 (12,000)

––––––––40,000

Interest to 30 September 2002 (40,000 x 8% x 9/12) 2,400 Interest to 1 January 2003 (40,000 x 8% x 3/12) 800

–––––––43,200

Rental 1 January 2003 (12,000)–––––––

Capital outstanding 1 January 2003 31,200Interest to 30 September 2003 (31,200 x 8% x 9/12) 1,872Interest to 1 January 2004 (31,200 x 8% x 3/12) 624

–––––––33,696

Interest expense for the year to 30 September 2003 is $2,672 (800 + 1,872 from above), of which $1,872 is a currentliability. The total capital amount outstanding at 30 September 2003 is $31,200 (the same as at 1 January 2003 as nofurther payments have been made). This must be split between current and non-current liabilities. Next year’s payment willbe $12,000 of which $2,496 (1,872 + 624) is interest. Therefore capital repaid in the next year will be $9,504 (12,000– 2,496). This leaves capital of $21,696 (31,200 – 9,504) as a non-current liability.

(c) (i) Most events occurring after the balance sheet date should be properly reflected in the following year’s financialstatements. There are two circumstances where events occurring after the balance sheet date are relevant to the currentyear’s financial statements. The first category, known as adjusting events, provides additional evidence of conditions thatexisted at the balance sheet date. This usually means they help to determine the value of an item that may have beenuncertain at the year-end. Common examples of this are post balance sheet receipts from accounts receivable and salesof inventory. These receipts help to confirm the bad debt and inventory write down provisions.

The second category is non-adjusting events. As the name suggests these do not affect the amounts contained in thefinancial statements, but are considered of such importance that unless they are disclosed, users of financial statementswould not be properly able to assess the financial position of the company. Common examples of these would be theloss of a major asset (say due to a fire) after the balance sheet date or the sale of an investment (often a subsidiary)after the balance sheet date.



(ii) Inventory Sales of goods after the balance sheet date are normally a reflection of circumstances that existed prior to the year end.They are usually interpreted as a confirmation of the value of inventory as it existed at the year end, and are thusadjusting events. In this case the sale of the goods after the year-end confirmed that the value of the inventory wascorrectly stated as it was sold at a profit. Goods remaining unsold at the date the new legislation was enacted areworthless. Whilst this may imply that they should be written off in preparing the financial statements to 30 September2003, this is not the case. What it is important to realise is that the event that caused the inventory to become worthlessdid not exist at the year end and its consequent losses should be reflected in the following accounting period. Thus thereshould be no adjustment to the value of inventory in the draft financial statements, but given that it is material, it shouldbe disclosed as a non-adjusting event.

Construction contractOn first appearance this new legislation appears similar to the previous example, but there is a major difference. Profitson an uncompleted long term construction contract are based on assessment of the overall eventual profit that thecontract is expected to make. This new legislation will mean the overall profit is $500,000 less than originally thought.This information must be taken into account when calculating the profit at 30 September 2003. This is an adjustingevent.

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Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) December 2003 Marking Scheme


Marks1 (a) discussion of contingent consideration 2

tangible non-current assets 2negative goodwill (2 for credit to realised profit) 4software 2investments 2inventory 1/2accounts receivable 1tax asset 1/2bank balance in hand 1ordinary shares 1accumulated profits 2provision 1minority interest 2accounts payable 1/2overdraft 1/2tax liability 1


(b) 1 mark per relevant point to maximum 5Maximum for question 25

2 (a) should not be treated as sales/cost of sales 1normally only the profit in income (may require disclosure) 1the substance of the transaction is a secured loan 1plant should be left on balance sheet 1‘sale’ proceeds of $50 million shown as loan 1rentals are partly interest and partly capital repayments 1


(b) Income statementdiscontinuing operations figures 3sales 2cost of sales 5distribution expenses 1administration expenses 2finance costs (including 1 for preference dividends) 2loss on investment properties 1investment income 1taxation 2


(c) Changes in equityprofit for period 1dividends 1transfer to realised profits 1




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Marks3 (a) one mark per valid point to max 6

(b) the need for the Standard and examples to a max of 2 each 6

(c) 28 day refund policy – constructive obligation 1calculation of provision for unrealised profits where goods resold at full price 1calculation of provision for loss on goods sold at half normal price 1the product warranties are treated collectively 1warranty cost can be estimated reliably therefore a liability, not a contingency 1faulty goods other than from Header – not a loss, but 1must remove profit made on them – quantified 1return of faulty goods manufactured by Header creates a loss 1quantification of loss 1


(d) directors’ treatment is incorrect 1this is an example of a complex asset 1depreciation is $1·65m per annum plus $1,500 per machine hour 2replacement does not meet the definition of a liability 1


4 (a) up to 1 mark for each limitation maximum 7Note: a good answer must refer to inter firm comparison issues

(b) 1/2 mark for each relevant ratio maximum 6

(c) format 1discussion of: profitability 3discussion of: liquidity (and working capital ratios) 4discussion of: gearing 2discussion of: investment ratios 3discussion of: other issues 2discussion of: summary 1


5 (a) (i) one mark per valid point to maximum 5

(ii) carrying value and tax base at 30 September 2003 3caculation of deferred tax at 30 September 2003 2deferred tax credit in income statement 2


(b) depreciation of leased asset 1lease interest expense 1net book value of leased asset 1current liabilities: accrued lease interest 1current liabilities: obligations under finance leases 1non-current liabilities: obligations under finance leases 1


(c) (i) one mark per valid point to maximum 4

(ii) discussion of value of inventory up to 3discussion of effect on construction contract up to 2





PART 2


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1 (a) Hapsburg, a public listed company, acquired the following investments:

– On 1 April 2003, 24 million shares in Sundial. This was by way of an immediate share exchange of twoshares in Hapsburg for every three shares in Sundial plus a cash payment of $1 per Sundial share payableon 1 April 2006. The market price of Hapsburg’s shares on 1 April 2003 was $2 each.

– On 1 October 2003, 6 million shares in Aspen paying an immediate $2·50 in cash for each share.

Based on Hapsburg’s cost of capital (taken as 10% per annum), $1 receivable in three years’ time can be takento have a present value of $0·75.

Hapsburg has not yet recorded the acquisition of Sundial but it has recorded the investment in Aspen.

The summarised balance sheets at 31 March 2004 are:

Hapsburg Sundial AspenNon-current assets $000 $000 $000 $000 $000 $000Property, plant and equipment 41,000 34,800 37,700Investments 15,000 3,000 nil

———– ———– ———–56,000 37,800 37,700

Current AssetsInventory 9,900 4,800 7,900Trade and other receivables 13,600 8,600 14,400Cash 1,200 24,700 3,800 17,200 nil 22,300

———– ———– ———– ———– ———– ———–Total assets 80,700 55,000 60,000

———– ———– ———–

Equity and liabilitiesCapital and reservesOrdinary shares $1 each 20,000 30,000 20,000Reserves:Share premium 8,000 2,000 nilAccumulated profits 10,600 18,600 8,500 10,500 8,000 8,000

———– ———– ———– ——–– ———– ———– 38,600 40,500 28,000

Non-current liabilities10% loan note 16,000 4,200 12,000

Current liabilitiesTrade and other payables 16,500 6,900 13,600Bank overdraft nil nil 4,500Taxation 9,600 26,100 3,400 10,300 1,900 20,000

———– ———– ———– ———– ———– ———–Total equity and liabilities 80,700 55,000 60,000

———– ———– ———–

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(i) Below is a summary of the results of a fair value exercise for Sundial carried out at the date of acquisition:Asset Carrying value Fair value

at acquisition at acquisition Notes$000 $000

Plant 10,000 15,000 remaining life at acquisition four yearsInvestments 3,000 4,500 no change in value since acquisition

The book values of the net assets of Aspen at the date of acquisition were considered to be a reasonableapproximation to their fair values

(ii) The profits of Sundial and Aspen for the year to 31 March 2004, as reported in their entity financialstatements, were $4·5 million and $6 million respectively. No dividends have been paid by any of thecompanies during the year. All profits are deemed to accrue evenly throughout the year.

(iii) In January 2004 Aspen sold goods to Hapsburg at a selling price of $4 million. These goods had cost Aspen$2·4 million. Hapsburg had $2·5 million (at cost to Hapsburg) of these goods still in inventory at 31 March2004.

(iv) Goodwill is to be written off over a five-year life with a proportionate charge in the year of acquisition.

(v) All depreciation/amortisation is charged on a straight-line basis.

(vi) Hapsburg uses the Allowed Alternative Treatment in IAS 22 ‘Business Combinations’ to record the fair valueof assets and liabilities.

Required:

Prepare the Consolidated Balance Sheet of Hapsburg as at 31 March 2004. (20 marks)

(b) Some commentators have criticised the use of equity accounting on the basis that it can be used as a form of offbalance sheet financing.

Required:

Explain the reasoning behind the use of equity accounting and discuss the above comment. (5 marks)

(25 marks)

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2 Reproduced below is the draft balance sheet of Tintagel, a public listed company, as at 31 March 2004. $000 $000

Non-current assets (note (i))Freehold property 126,000Plant 110,000Investment property at 1 April 2003 (note (ii)) 15,000

————251,000

Current AssetsInventory (note (iii)) 60,400Trade receivables and prepayments 31,200Bank 13,800 105,400

———– ————Total assets 356,400

————

Equity and liabilitiesCapital and Reserves:Ordinary shares of 25c each 150,000

Reserves:Share premium 10,000Accumulated profits – 1 April 2003 52,500Accumulated profits – Year to 31 March 2004 47,500 110,000

———– ————260,000

Non-current liabilitiesDeferred tax – at 1 April 2003 (note (v)) 18,700

Current liabilitiesTrade payables (note (iii)) 47,400Provision for plant overhaul (note (iv)) 12,000Taxation 4,200

———– 63,600

Suspense account (note (vi)) 14,100————

Total equity and liabilities 356,400 ————

(i) The income statement has been charged with $3·2 million being the first of four equal annual rental paymentsfor an item of excavating plant. This first payment was made on 1 April 2003. Tintagel has been advised thatthis is a finance lease with an implicit interest rate of 10% per annum. The plant had a fair value of $11·2 millionat the inception of the lease.

None of the non-current assets have been depreciated for the current year. The freehold property should bedepreciated at 2% on its cost of $130 million, the leased plant is depreciated at 25% per annum on a straight-line basis and the non-leased plant is depreciated at 20% on the reducing balance basis.

(ii) Tintagel adopts the fair value model for its investment property. Its value at 31 March 2004 has been assessedby a qualified surveyor at $12·4 million.

(iii) During an inventory count on 31 March 2004 items that had cost $6 million were identified as being eitherdamaged or slow moving. It is estimated that they will only realise $4 million in total, on which sales commissionof 10% will be payable. An invoice for materials delivered on 12 March 2004 for $500,000 has beendiscovered. It has not been recorded in Tintagel’s bookkeeping system, although the materials were included inthe inventory count.

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(iv) Tintagel operates some heavy excavating plant which requires a major overhaul every three years. The overhaulis estimated to cost $18 million and is due to be carried out in April 2005. The provision of $12 millionrepresents two annual amounts of $6 million made in the years to 31 March 2003 and 2004.

(v) The deferred tax provision required at 31 March 2004 has been calculated at $22·5 million.

(vi) The suspense account contains the credit entry relating to the issue on 1 October 2003 of a $15 million 8%loan note. It was issued at a discount of 5% and incurred direct issue costs of $150,000. It is redeemable afterfour years at a premium of 10%. Interest is payable six months in arrears. The first payment of interest has notbeen accrued and is due on 1 April 2004. Apportionment of issue costs, discounts and premiums can be madeon a straight-line basis.

Required:

(a) Commencing with the accumulated profit figures in the above balance sheet ($52·5 million and$47·5 million), prepare a schedule of adjustments required to these figures taking into account anyadjustments required by notes (i) to (vi) above. (11 marks)

(b) Redraft the balance sheet of Tintagel as at 31 March 2004 taking into account the adjustments required innotes (i) to (vi) above. (14 marks)

(25 marks)

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3 (a) During the last decade it has not been unusual for the premium paid to acquire control of a business to be greaterthan the fair value of its tangible net assets. This increase in the relative balance sheet proportions of intangibleassets has made the accounting practices for them all the more important. During the same period manycompanies have spent a great deal of money internally developing new intangible assets such as software andbrands. IAS 38 ‘Intangible Assets’ was issued in September 1998 and prescribes the accounting treatment forintangible assets.

Required:

In accordance with IAS 38, discuss whether intangible assets should be recognised, and if so how theyshould be initially recorded and subsequently amortised in the following circumstances:

– when they are purchased separately from other assets;

– when they are obtained as part of acquiring the whole of a business; and

– when they are developed internally. (10 marks)Note: your answer should consider goodwill separately from other intangibles.

(b) Dexterity is a public listed company. It has been considering the accounting treatment of its intangible assets andhas asked for your opinion on how the matters below should be treated in its financial statements for the year to31 March 2004.

(i) On 1 October 2003 Dexterity acquired Temerity, a small company that specialises in pharmaceutical drugresearch and development. The purchase consideration was by way of a share exchange and valued at$35 million. The fair value of Temerity’s net assets was $15 million (excluding any items referred to below).Temerity owns a patent for an established successful drug that has a remaining life of 8 years. A firm ofspecialist advisors, Leadbrand, has estimated the current value of this patent to be $10 million, however thecompany is awaiting the outcome of clinical trials where the drug has been tested to treat a different illness.If the trials are successful, the value of the drug is then estimated to be $15 million. Also included in thecompany’s balance sheet is $2 million for medical research that has been conducted on behalf of a client.

(4 marks)

(ii) Dexterity has developed and patented a new drug which has been approved for clinical use. The costs ofdeveloping the drug were $12 million. Based on early assessments of its sales success, Leadbrand haveestimated its market value at $20 million. (3 marks)

(iii) Dexterity’s manufacturing facilities have recently received a favourable inspection by government medicalscientists. As a result of this the company has been granted an exclusive five-year licence to manufactureand distribute a new vaccine. Although the licence had no direct cost to Dexterity, its directors feel itsgranting is a reflection of the company’s standing and have asked Leadbrand to value the licence.Accordingly they have placed a value of $10 million on it. (3 marks)

(iv) In the current accounting period, Dexterity has spent $3 million sending its staff on specialist trainingcourses. Whilst these courses have been expensive, they have led to a marked improvement in productionquality and staff now need less supervision. This in turn has led to an increase in revenue and costreductions. The directors of Dexterity believe these benefits will continue for at least three years and wish totreat the training costs as an asset. (2 marks)

(v) In December 2003, Dexterity paid $5 million for a television advertising campaign for its products that willrun for 6 months from 1 January 2004 to 30 June 2004. The directors believe that increased sales as aresult of the publicity will continue for two years from the start of the advertisements. (3 marks)

Required:

Explain how the directors of Dexterity should treat the above items in the financial statements for the yearto 31 March 2004. (15 marks as indicated)

Note: The values given by Leadbrand can be taken as being reliable measurements. You are not required toconsider depreciation aspects.

(25 marks)

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4 The following information relates to Planter, a small private company. It consists of an opening balance sheet as at 1 April 2003 and a listing of the company’s ledger accounts at 31 March 2004 after the draft operating profit beforeinterest and taxation (of $17,900) had been calculated.

Planter – Balance sheet as at 1 April 2003$ $

Non-current assetsLand and buildings (at valuation $49,200 less accumulated depreciation of $5,000) 44,200Plant (at cost of $70,000 less accumulated depreciation of $22,500) 47,500Investments at cost 16,900

————108,600

Current AssetsInventory 57,400Trade receivables 28,600Bank 1,200 87,200

——— ————Total assets 195,800

————

Equity and liabilitiesCapital and Reserves:Ordinary shares of $1 each 25,000Reserves:Share premium 5,000Revaluation reserve 12,000Accumulated profits 70,300 87,300

———– ————112,300

Non-current liabilities8% Loan notes 43,200

Current liabilitiesTrade payables 31,400Taxation 8,900 40,300

———– ————195,800————

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Ledger account listings at 31 March 2004 Dr Cr$ $

Ordinary shares of $1 each 50,000Share premium 8,000Accumulated profits – 1 April 2003 70,300Profit before interest and tax – year to 31 March 2004 17,900Revaluation reserve 18,0008% Loan notes 39,800Trade payables 26,700Accrued loan interest 300Taxation 1,100Land and buildings at valuation 62,300Plant at cost 84,600Buildings – accumulated depreciation 31 March 2004 6,800Plant – accumulated depreciation 31 March 2004 37,600Investments at cost 8,200Trade receivables 50,400Inventory – 31 March 2004 43,300Bank 1,900Investment income 400Loan interest 1,700Ordinary dividend 26,100

———— ————277,700 277,700———— ————

Notes(i) There were no disposals of land and buildings during the year. The increase in the revaluation reserve was

entirely due to the revaluation of the company’s land.

(ii) Plant with a net book value of $12,000 (cost $23,500) was sold during the year for $7,800. The loss onsale has been included in the profit before interest and tax.

(iii) Investments with a cost of $8,700 were sold during the year for $11,000. The profit has been included inthe profit before interest and tax. There were no further purchases of investments.

(iv) On 10 October 2003 a bonus issue of 1 for 10 ordinary shares was made utilising the share premiumaccount. The remainder of the increase in ordinary shares was due to an issue for cash on 30 October 2003.

(v) The balance on the taxation account is after settlement of the provision made for the year to 31 March 2003.A provision for the current year has not yet been made.

Required:

From the above information, prepare a cash flow statement using the indirect method for Planter in accordancewith IAS 7 ‘Cash Flow Statements’ for the year to 31 March 2004. (25 marks)

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5 (a) (i) Linnet is a large public listed company involved in the construction industry. Accounting standards normallyrequire construction contracts to be accounted for using the percentage (stage) of completion basis. Howeverunder certain circumstances they should be accounted for using the completed contracts basis.

Required:

Discuss the principles that underlie each of the two methods and describe the circumstances in which theiruse is appropriate. (5 marks)

(ii) Linnet is part way through a contract to build a new football stadium at a contracted price of $300 million.Details of the progress of this contract at 1 April 2003 are shown below:

$ millionCumulative sales revenue invoiced 150Cumulative cost of sales to date 112Profit to date 38

The following information has been extracted from the accounting records at 31 March 2004:

$ millionTotal progress payment received for work certified at 29 February 2004 180Total costs incurred to date (excluding rectification costs below) 195Rectification costs 17

Linnet has received progress payments of 90% of the work certified at 29 February 2004. Linnet’s surveyorhas estimated the sales value of the further work completed during March 2004 was $20 million.

At 31 March 2004 the estimated remaining costs to complete the contract were $45 million.

The rectification costs are the costs incurred in widening access roads to the stadium. This was the resultof an error by Linnet’s architect when he made his initial drawings.

Linnet calculates the percentage of completion of its contracts as the proportion of sales value earned to datecompared to the contract price.

All estimates can be taken as being reliable.

Required:

Prepare extracts of the financial statements for Linnet for the above contract for the year to 31 March 2004.(8 marks)

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(b) (i) Large companies often conduct their operations across many different industrial and geographical areas.IAS 14 ‘Segment Reporting’ is based on the principle that, without supplementary information, the‘aggregated’ financial statements of such companies are of little use to analysts and other users of financialstatements.

Required:

Describe how the provision of segment information is intended to assist users of financial statements, andidentify the main problems of providing segment information. (6 marks)

(ii) The Bilberry group is a large public company that operates in a single geographical market. Its directors haveidentified three distinguishable business segments; food processing, paint manufacturing and retailing ofmotor vehicles. The following information is available regarding its operations for the year to 31 March2004:

– Segment sales revenue of the group (including inter-segment sales of $25 million) is $825 million madeup of $270 million from food processing; $315 million from paint manufacturing and the remainder frommotor vehicle retailing. The motor vehicle division sold cars at a gross profit of 20% to the other twodivisions.

– The segment operating profit (before interest, tax and associated company income) is $187 million(including the profit from inter-segment sales). Food processing made a profit of $70 million and paintmanufacturing made a profit of $65 million.

– The segment operating profit does not include $50 million of administration overheads which cannot beapportioned on a reasonable basis, nor $3 million interest received and $12 million finance costs.

– The group’s share of the results of its equity accounted associated company (see below) is $30 million.

– The group’s total assets are $890 million. These are attributable to $250 million to food processing;$270 million to paint manufacturing; $200 million to motor vehicle retailing and $140 million carryingvalue of the associated company investment. The associate operates entirely within the food processingsector. The remainder of the total assets are long-term investments in corporate bonds.

Note: you may assume that the assets and related depreciation charges have been adjusted for theunrealised profits in the motor vehicles.

– The group’s total liabilities are $120 million. These are attributable to $50 million to food processing;$45 million to paint manufacturing; and $25 million to motor vehicle retailing.

Required:

Prepare a segment report for Bilberry for the year ended 31 March 2004 incorporating the above informationin accordance with IAS 14. (6 marks)

(25 marks)


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Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) June 2004 Answers

1 (a) Consolidated Balance Sheet of Hapsburg as at 31 March 2004:$000 $000

Non current assetsGoodwill (16,000 – 3,200 (w (i))) 12,800Property, plant and equipment (41,000 + 34,800 + 3,750 (w (i))) 79,550Investments:

– in associate (w (iv)) 15,150– ordinary (3,000 + 1,500 (fair value increase) 4,500 19,650

——— ————112,000

Current AssetsInventory (9,900 + 4,800 – 300 (w (v))) 14,400Trade receivables (13,600 + 8,600) 22,200Cash (1,200 + 3,800) 5,000 41,600

——— ————Total assets 153,600

————

Equity and liabilitiesOrdinary share capital (20,000 + 16,000 (w (i))) 36,000Reserves:Share premium (8,000 + 16,000 (w (i))) 24,000Accumulated profits (w (ii)) 8,050 32,050

———– ———–68,050

Minority interests (w (iii)) 9,150

Non-current liabilities10% Loan note (16,000 + 4,200) 20,200Deferred consideration (18,000 + 1,800 (w (vi))) 19,800

———– 40,000

Current liabilities:Trade payables (16,500 + 6,900) 23,400Taxation (9,600 + 3,400) 13,000 36,400

———– ————Total equity and liabilities 153,600

————

Workings – Note: all working figures in $000.

The 80% (24m/30m shares) holding in Sundial is likely to give Hapsburg control and means it is a subsidiary and shouldbe consolidated. The 30% (6m/20m shares) holding in Aspen is likely to give Hapsburg influence rather than control andthus it should be equity accounted.

(i) Cost of controlInvestments at cost (see below) 50,000 Ordinary shares (30,000 × 80%) 24,000

Share premium (2,000 × 80%) 1,600Pre acq profit (w (ii)) 3,200Fair value adjustments (see below) 5,200Goodwill 16,000

———– ———–50,000 50,000———– ———–

The purchase consideration for Sundial is $50 million. This is made up of an issue of 16 million shares (24/3 × 2) at$2 each totalling $32 million and deferred consideration of $24 million ($1 per share) which should be discounted to$18 million (24 million × $0·75). The share issue should be recorded as $16 million share capital and $16 millionshare premium.

The goodwill will be depreciated over five years at $3·2 million per annum.



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Fair value adjustments:

The Allowed Alternative treatment in IAS 22 requires the full fair value adjustment to be recorded with the minority beingallocated their share.

Fair value adjustment: Total group share (80%) minority (20%)Property, plant and equipment 5,000 4,000 1,000Investments 1,500 1,200 300

——— ——— ———6,500 5,200 1,300

——— ——— ———

The fair value adjustment of $5 million to plant will be realised evenly over the next four years in the form of additionaldepreciation at $1·25 million per annum. In the year to 31 March 2004 the effect of this is $1·25 million charged toSundial’s profits (as additional depreciation); and a net of $3·75 million added to the carrying value of the plant.

Goodwill on acquisition of Aspen:

Purchase consideration (6 million × $2·50) 15,000Share capital 20,000Profits up to acquisition (8,000 – (6,000 × 6/12)) 5,000

———–Net assets at date of acquisition 25,000 × 30% (7,500)

———Difference – goodwill 7,500

———

Goodwill of $7·5 million depreciated over a five-year life would give a charge of $750,000 (i.e. six months only) for the yearto 31 March 2004.

(ii) Accumulated profitsHapsburg Sundial Hapsburg Sundial

Additional depreciation (w (i)) 1,250 Per question 10,600 8,500URP in inventory (w (v)) 300 Post acq profit 2,600Unwinding of interest (w (vi)) 1,800 Share of Aspen’s profitMinority interest ((8,500 – 1,250) × 20%) 1,450 (6,000 × 6/12 × 30%) 900Pre-acq profit ((8,500 – 4,500) × 80%) 3,200Post acq profit ((4,500 – 1,250) × 80%) 2,600

Amortisation of goodwill:Sundial (w (i)) 3,200Aspen (w (i)) 750Balance c/f 8,050

———– ——— ———– ———14,100 8,500 14,100 8,500———– ——— ———– ———

(iii) Minority interest

Ordinary shares (30,000 × 20%) 6,000Share premium (2,000 × 20%) 400Accumulated profits (w (ii)) 1,450

Balance c/f 9,150 Fair value adjustments (w (i)) 1,300——— ——— 9,150 9,150

——— ———

(iv) Investment in associate:Investment at cost 15,000Share of post acquisition profit (w (ii)) 900Less goodwill amortisation (w (i)) (750)

———–15,150———–

Alternative calculation:Share of net assets at 31 March 2004 (28,000 × 30%) 8,400Goodwill (7,500 – 750) 6,750

————15,150

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(v) Unrealised profit in inventoryAs the transaction is with an associate, only the group share of unrealised profits must be eliminated:$1·6 million × 2·5 million/4 million × 30% = $300,000

(vi) The deferred consideration of $24 million has been discounted to $18 million. The discounted amount will be‘unwound’ at 10% per annum. In the year to 31 March 2004 this will give an accrued finance cost of 10% (added tothe carrying value of the deferred consideration).

(b) In recent years many companies have increasingly conducted large parts of their business by acquiring substantial minorityinterests in other companies. There are broadly three levels of investment. Below 20% of the equity shares of an investeewould normally be classed as an ordinary investment and shown at cost (it is permissible to revalue them to market value)with only the dividends paid by the investee being included in the income of the investor. A holding of above 50% normallygives control and would create subsidiary company status and consolidation is required. Between these two, in the range ofover 20% up to 50%, the investment would normally be deemed to be an associate (note, the level of shareholding is notthe only determining criterion). The relevance of this level of shareholding is that it is presumed to give significant influenceover the operating and financial policies of the investee (but this presumption can be rebutted). If such an investment weretreated as an ordinary investment, the investing company would have the opportunity to manipulate its profit. The mostobvious example of this would be by exercising influence over the size of the dividend the associated company paid. Thiswould directly affect the reported profit of the investing company. Also, as companies tend not to distribute all of their earningsas dividends, over time the cost of the investment in the balance sheet may give very little indication of its underlying value.Equity accounting for associated companies is an attempt to remedy these problems. In the income statement any dividendsreceived from an associate are replaced by the investor’s share of the associate’s results. In the balance sheet the investmentis initially recorded at cost and subsequently increased by the investor’s share of the retained profits of the associate (anyother gains such as the revaluation of the associate’s assets would also be included in this process). This treatment meansthat the investor would show the same profit irrespective of the size of the dividend paid by the associate and the balancesheet more closely reflects the worth of the investment.

The problem of off balance sheet finance relates to the fact that it is the net assets that are shown in the investor’s balancesheet. Any share of the associate’s liabilities is effectively hidden because they have been offset against the associate’s assets.As a simple example, say a holding company owned 100% of another company that had assets of $100 million and debtof $80 million, both the assets and the debt would appear on the consolidated balance sheet. Whereas if this singleinvestment was replaced by owning 50% each of two companies that had the same balance sheets (i.e. $100 million assetsand $80 million debt), then under equity accounting only $20 million ((100 – 80) × 50% × 2) of net assets would appearon the balance sheet thus hiding the $80 million of debt. Because of this problem, it has been suggested that proportionateconsolidation is a better method of accounting for associated companies, as both assets and debts would be included in theinvestor’s balance sheet. IAS 28 ‘Accounting for Investments in Associates’ does not permit the use of proportionateconsolidation of associates, however IAS 31 ‘Financial Reporting of Interests in Joint Ventures’ sets as its benchmarkproportionate consolidation for jointly controlled entities (equity accounting is the allowed alternative).

2 (a) Tintagel: $000 $000Accumulated profits at 1 April 2003 52,500Reversal of provision plant overhaul (w (iv)) 6,000

———–58,500

Profit for the year to 31 March 2004 47,500Lease rental charge added back (w (i)) 3,200Lease interest (w (i)) (800)Depreciation (w (ii)) – building 2,600Depreciation (w (ii)) – owned plant 22,000Depreciation (w (ii)) – leased plant 2,800

———– (27,400)Loss on investment property (15,000 – 12,400) (2,600) Write down of inventory (w (iii)) (2,400)Unrecorded trade payable (500)Reversal of provision for plant overhaul (w (iv)) 6,000Increase in deferred tax (22·5 – 18·7) (3,800)Loan note interest (0·6 + 0·3 (w (v))) (900) 18,300

———– ———–Accumulated profits at 31 March 2004 76,800

———–

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(b) Tintagel – Balance sheet as at 31 March 2004:Tangible Non-current assets $000 $000Freehold property (126,000 – 2,600 (w (ii))) 123,400Plant – owned (110,000 – 22,000 (w (ii))) 88,000– leased (11,200 – 2,800 (w (ii)) 8,400Investment property 12,400

————232,200

Current AssetsInventory (60,400 – 2,400 (w (iii))) 58,000Trade receivables and prepayments 31,200Bank 13,800 103,000

———– ————Total assets 335,200

————

Equity and liabilitiesCapital and Reserves:Ordinary shares of 25c each 150,000

Reserves:Share premium 10,000Accumulated profits – 31 March 2004 (part (a)) 76,800 86,800

––––––– ————236,800

Non-current liabilitiesDeferred tax 22,500Finance lease obligations (w (i)) 5,6008% Loan note (14,100 + 300 (w (v))) 14,400

———– 42,500

Current liabilitiesTrade payables (47,400 + 500) 47,900Accrued lease finance interest (w (i)) 800Accrued loan interest (w (v)) 600Finance lease obligation (w (i)) 2,400Taxation 4,200 55,900

———– ————Total equity and liabilities 335,200

————

Workings(i) Finance lease:

The lease has been incorrectly treated as an operating lease. Treating it as a finance lease gives the following figures:$000

Cash price/recorded cost 11,200First instalment (reversed in income statement) (3,200)

———–Capital outstanding at 1 April 2003 8,000Interest at 10% p.a. to 31 March 2004 (current liability) 800

The capital outstanding of $8 million must be split between current and non-current liabilities. The second instalment payableon 1 April 2004 will contain $800,000 of interest (8,000 × 10%), therefore the capital element in this payment will be$2·4 million and this is a current liability. This leaves $5·6 million (8,000 – 2,400) as a non-current liability.

(ii) Non-current assets depreciation: $000Buildings (130 × 2%) 2,600Non-leased plant (110 × 20%) 22,000Leased plant (11,200 × 25%) 2,800

(iii) The damaged and slow moving inventory should be written down to its estimated realisable value. This is $3·6 million($4 million less sales commission at 10%). Therefore the required write down is $2·4 million ($6 million – $3·6 million).

(iv) A provision for a future major overhaul does not meet the definition of a liability in IAS 37 ‘Provisions, Contingent Liabilitiesand Contingent Assets’ and must be reversed; this will increase the current year’s profit and the previous year’s profit by$6 million each.

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(v) International accounting standards require issue costs, discounts on issue and premiums on redemptions of loan instrumentsto be included as part of the finance costs: $000 $000

Issue proceeds (15,000 × 95%) 14,250Issue costs (150)

———–Initial carrying value (as per suspense account) 14,100LessPayable on redemption (15,000 × 110%) 16,500Total interest payments (15,000 × 8% × 4 years) 4,800 (21,300)

———– ————Total finance costs (7,200)

————

The question says these may be apportioned on a straight-line basis at $1·8 million pa. The loan stock was issued on1 October 2003 therefore an interest charge of $900,000 is required for the current year. Of this $600,000 is representedby the accrual to be paid on 1 April 2004 and the remainder is also accrued, but added to the carrying value of the loanstock on the balance sheet.

3 (a) Goodwill:International Accounting Standards state that goodwill is the difference between the purchase consideration and the fair valueof the acquired business’s identifiable (separable) net assets. Identifiable assets and liabilities are those that are capable ofbeing sold or settled separately, i.e. without selling the business as a whole. Purchased goodwill should be recognised on thebalance sheet at this value and amortised over its estimated useful economic life. The useful economic life is the period oftime over which an asset is expected to be used by the enterprise. There is a rebuttable presumption that the life should notexceed 20 years. However, in the rare cases where there is persuasive evidence where it can be demonstrated that the life ismore than 20 years, then it should be amortised over the best estimate of its useful life. Where this occurs the estimatedrecoverable amount must be estimated at least annually and written down if it is impaired. IAS 38 specifically states thatinternally generated goodwill (but not necessarily other intangibles) cannot be capitalised.

Other intangibles:Where an intangible asset other than goodwill is acquired as a separate transaction, the treatment is relatively straightforward.It should be capitalised at cost and amortised over its estimated useful economic life (similar rules apply to the lives of otherintangible assets as apply to goodwill as referred to above). The fair value of the purchase consideration paid to acquire anintangible is deemed to be its cost.

Intangibles purchased as part of the acquisition of a business should be recognised separately to goodwill if they can bemeasured reliably. Reliable measurement does not have to be at market value, techniques such as valuations based onmultiples of turnover or notional royalties are acceptable. This test is not meant to be overly restrictive and is likely to be metin valuing intangibles such as brands, publishing titles, patents etc. The amount of intangibles that may be recognised isrestricted such that their recognition cannot create negative goodwill (as a balancing figure). Any intangible not capable ofreliable measurement will be subsumed within goodwill.

Recognition of internally developed intangibles is much more restrictive. IAS 38 states that internally generated brands,mastheads, publishing titles, customer lists and similar items should not be recognised as intangible assets as these itemscannot be distinguished from the cost of developing the business as a whole. The Standard does require development coststo be capitalised if they meet detailed recognition criteria.

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(b) (i) The purchase consideration of $35 million should be allocated as: $mNet tangible assets 15Work in progress 2Patent 10Goodwill 8

—–35

—–

The difficulty here is the potential value of the patent if the trials are successful. In effect this is a contingent asset andon an acquisition contingencies have to be valued at their fair value. There is insufficient information to make a judgmentof the fair value of the contingent asset and in these circumstances it would be prudent to value the patent at $10million. The additional $5 million is an example of where an intangible cannot be measured reliably and thus it shouldbe subsumed within goodwill. The other issue is that although research cannot normally be treated as an asset, in thiscase the research is being done for another company and is in fact work in progress and should be recognised as such.

(ii) This is an example of an internally developed intangible asset and although the circumstances of its valuation are similarto the patent acquired above it cannot be recognised at Leadbrand’s valuation. Internally generated intangibles can onlybe recognised if they meet the definition of development costs in IAS 38. Internally generated intangibles are permittedto be carried at a revalued amount (under the allowed alternative treatment) but only where there is an active market ofhomogeneous assets with prices that are available to the public. By their very nature drug patents are unique (even forsimilar types of drugs) therefore they cannot be part of a homogeneous population. Therefore the drug would be recordedat its development cost of $12 million.

(iii) This is an example of a ‘granted’ asset. It is neither an internally developed asset nor a purchased asset. In one senseit is recognition of the standing of the company that is part of the company’s goodwill. IAS 38’s general requirementrequires intangible assets to be initially recorded at cost and specifically mentions granted assets. IAS 38 also refers toIAS 20 ‘Accounting for Government Grants and Disclosure of Government Assistance’ in this situation. This standardsays that both the asset and the grant can be recognised at fair value initially (in this case they would be at the sameamount). If fair values are not used for the asset it should be valued at the amount of any directly attributable expenditure(in this case this is zero). It is unclear whether IAS 38’s general restrictive requirements on the revaluation of intangiblesas referred to in (a) above (i.e. the allowed alternative treatment) are intended to cover granted assets under IAS 20.

(iv) There is no doubt that a skilled workforce is of great benefit to a company. In this case there is an enhancement ofrevenues and a reduction in costs and if resources had been spent on a tangible non-current asset that resulted in similarbenefits they would be eligible for capitalisation. However the Standard specifically excludes this type of expenditurefrom being recognised as an intangible asset and it describes highly trained staff as ‘pseudo-assets’. The main reason isthe issue of control (through custody or legal rights). Part of the definition of any asset is the ability to control it. In thecase of employees (or, as in this case, training costs of employees) the company cannot claim to control them, as it isquite possible that employees may leave the company and work elsewhere.

(v) The benefits of effective advertising are often given as an example of goodwill (or an enhancement of it). If this view isaccepted then such expenditures are really internally generated goodwill which cannot be recognised. In this particularcase it would be reasonable to treat the unexpired element of the expenditure as a prepayment (in current assets) thiswould amount to 3/6 of $5 million i.e. $2·5 million. This represents the cost of the advertising that has been paid for,but not yet taken place. In the past some companies have treated anticipated continued benefits as deferred revenueexpenditure, but this is no longer permitted as it does not meet the Standard’s recognition criteria for an asset.

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21

4 Cash Flows From Operating Activities – Planter for the Year to 31 March 2004:

Reconciliation of operating profit to net cash inflow from operating activities$ $

Net profit before interest and tax (per question) 17,900Adjustments for:depreciation – buildings (w (i)) 1,800depreciation – plant (w (i)) 26,600

———– 28,400loss on sale of plant (w (i)) 4,200profit on sale of investments (11,000 – 8,700) (2,300)decrease in inventory (57,400 – 43,300) 14,100increase 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 flow from operating activities 24,400

Cash Flows from Investing ActivitiesPurchase of plant (w (i)) (38,100)Purchase of land and buildings (w (i)) (7,100)Investment income 400Sale of plant (w (i)) 7,800Sale of investments 11,000

———— (26,000)

Cash flows from financing activitiesIssue of ordinary shares (w (ii)) 28,000Redemption of 8% loan notes (3,400)Ordinary dividend paid (26,100) (1,500)

———— ———–Net decrease in cash and cash equivalents (3,100)Cash and cash equivalents at 1 April 2003 1,200

———–Cash and cash equivalents at 31 March 2004 (1,900)

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Workings(i) Non-current assets:

Land and buildingsValuation b/f 49,200Revaluation surplus (18,000 – 12,000) 6,000Acquisitions – balancing figure 7,100

———–Valuation c/f 62,300

———–

Depreciation b/f 5,000Charge for year – balancing figure 1,800

———–Depreciation c/f 6,800

———–

PlantCost b/f 70,000Disposals at cost (23,500)Acquisitions – balancing figure 38,100

———–Cost c/f 84,600

———–

Depreciation b/f 22,500Disposals (11,500)Charge for year – balancing figure 26,600

———–Depreciation c/f 37,600

———–

Disposal of plant:Net book value 12,000Proceeds from question (7,800)

———–Loss on sale 4,200

———–

(ii) Share capital and share premium:Ordinary shares b/f 25,000Bonus issue 1 for 10 (from share premium) 2,500Ordinary shares c/f (50,000)

–——— Difference issue for cash 22,500

–———

Share premium b/f 5,000Bonus 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———–

(iii) Reconciliation of revaluation reserve Balance b/f 12,000Difference revaluation of land 6,000

———–Balance c/f 18,000

———–

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5 (a) (i) Long-term construction contracts span more than one accounting year-end. This leads to the problem of determininghow the uncompleted transactions should be dealt with over the life of the contract. Normal sales are not recogniseduntil the production and sales cycle is complete. Prudence is the most obvious concept that is being applied in thesecircumstances, and this is the principle that underlies the completed contract basis. Where the outcome of a long-termcontract cannot be reasonably foreseen due to inherent uncertainty, the completed contracts basis should be applied.The effect of this is that sales revenue earned to date is matched to the cost of sales and no profit is taken.

The problem with the above is that for say a three year contract it can lead to a situation where no profits are recognised,possibly for two years, and in the year of completion the whole of the profit is recognised (assuming the contract isprofitable). This seems consistent with the principle that only realised profits should be recognised in the incomestatement. The problem is that the overriding requirement is for financial statements to show a true and fair view whichimplies that financial statements should reflect economic reality. In the above case it can be argued that the companyhas been involved in a profitable contract for a three-year period, but its financial statements over the three years showa profit in only one period. This also leads to volatility of profits which many companies feel is undesirable and notfavoured by analysts. An alternative approach is to apply the matching/accruals concept which underlies the percentageof completion method. This approach requires the percentage of completion of a contract to be assessed (there areseveral methods of doing this) and then recognising in the income statement that percentage of the total estimated profiton the contract. This method has the advantage of more stable profit recognition and can be argued shows a more trueand fair view than the completed contract method. A contrary view is that this method can be criticised as being a formof profit smoothing which, in other circumstances, is considered to be an (undesirable) example of creative accounting.Accounting standards require the use of the percentage of completion method where the outcome of the contract isreasonably foreseeable. It should also be noted that where a contract is expected to produce a loss, the whole of theloss must be recognised as soon as it is anticipated.

(ii) Linnet – income statement extract – year to 31 March 2004 (see working below):$ million

Sales revenue 70Cost of sales (64 +17) (81)

——Loss for period (11)

——

Linnet – balance sheet extracts – as at 31 March 2004Current assetsGross amounts due from customers for contract work (w (iii)) 59

Workings:cumulative 1 April 2003 cumulative 31 March 2004 amounts for year

$ million $ million $ millionSales 150 (w (i)) 220 70Cost of sales (112) (w (ii)) (176) (64)Rectification costs nil (17) (17)

––– ––– –––Profit(loss) 38 (w (ii)) 27 (11)

––– ––– –––

(i) progress payments received are $180 million. This is 90% of the work certified (at 29 February 2004), therefore thework certified at that date was $200 million. The value of the further work completed in March 2004 is given as$20 million, giving a total value of contract sales at 31 March 2004 of $220 million.

(ii) the total estimated profit (excluding rectification costs) is $60 million:$ million

contract price 300 cost to date (195)estimated cost to complete (45)

——estimated total profit 60

——

The degree of completion (by the method given in the question) is 220/300 Therefore the profit to date (before rectification costs) is $44 million ($60 million × 220/300). Rectification costs mustbe charged to the period they were incurred and not spread over the remainder of the contract life. Therefore afterrectification costs of $17 million the total reported contract profit to 31 March 2004 would be $27 million.

With contract revenue of $220 million and profit to date of $44 million, this means contract costs (excluding rectificationcosts) would be $176 million. The difference between this figure and total cost incurred of $195 million is part of the$59 million of the amount due from customers shown in the balance sheet.

(iii) The gross amounts due from customers is cost to date ($195 million + $17 million) plus cumulative profit ($27 million)less progress billings ($180 million) = $59 million.

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(b) (i) The financial statements of large diversified companies are an aggregation of all their separate activities. Their resultsare a composite of their individual segments. Each of the separate segments may have different results. The segmentsmay have wide ranges of profitability, cash flows, growth, future prospects and risks. Without information on theseseparate segments, these differences would be concealed and it would be impossible for users of financial statementsto properly assess past performance and future prospects. IAS 14 ‘Segment Reporting’ requires primary and secondaryreporting formats which are based on business and geographical segments. Providing information on sales revenues,results (profit) and net assets of each segment goes some way to resolving the difficulties outlined above.

The main problems with the provision of segmental information are:

– defining what is a reportable segment. Although accounting standards give guidance on this, ultimately it is a matterfor the directors to determine. This means that comparability between different companies can be impaired as theymay be using different interpretations of what constitute reportable segments. IAS 14 has both primary and secondaryreporting formats (by product group and geographically or vice versa). Similar companies may choose different primaryformats to each other.

– apportionment between the segments of some costs on a reasonable basis can be difficult. This could be true for manycommon costs such as central administration. The Standard says where a reasonable basis of apportionment cannotbe found they should be shown as a deduction from the aggregated profit and not apportioned. However it is possiblethat companies may use the apportionment of such costs to manipulate the relative profitabilities of their differentsegments.

– similar to the above there are some assets and liabilities that cannot be attributed to individual segments. Interestbearing assets are an example of this, as too are some forms of borrowing. Again the Standard says that such assetsand liabilities should not be allocated to segments. Related interest receivable and finance costs are also examples ofcommon items as referred to above.

(ii) Bilberry – Segment report Year to 31 March 2004

Food Paint Motors Total$ million $ million $ million $ million

RevenueExternal sales 270 315 215 800Inter-segment sales nil nil 25 25

—— —— —— ——Total revenue 270 315 240 825

—— —— —— ——

ResultsSegment profit 70 65 47 (w (i)) 182Unallocated corporate expenses (50)

——Operating profit 132Interest expense (12)Interest income 3Group share of associate 30 30

——Group profit before tax 153

——

Other informationSegment assets 250 270 200 720Investment in associate 140 140Unallocated corporate assets 30

——Consolidated total assets 890Segment liabilities (50) (45) (25) (120)

——Total net assets 770

——Working(i) The profit before tax of $187 million given in the question needs to be adjusted for $5 million profit (deducted) made

on inter-segment sales ($25 million × 20%).

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25

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1 (a) Balance sheet: Marksgoodwill (four for total figure, one for depreciation) 5land and buildings 1plant 2investment in associate 3other investments 1inventory 2trade receivables and cash 1current liabilities 110% loan notes 1deferred consideration 2minority interest 2share capital and share premium 1accumulated profits 3


(b) reasoning behind equity accounting 3discussion of off balance sheet financing 2


2 (a) accumulated profitsreversal of cyclic repair provision 2depreciation charges 3add back lease rental 1lease interest 1loan interest 1loss on investment property 1inventory write down 1unrecorded creditor 1deferred tax 1


(b) Balance sheetfreehold 1plant 2investment property 1inventory 2receivables and prepayments and bank 1trade receivables 1accrued lease interest 1accrued loan interest 1lease obligation (current liability) 1taxation 1lease obligation (non-current liability) 18% loan note 2deferred tax 1ordinary shares and share premium 1




26

Marks3 (a) discussion of goodwill 3

other intangibles – separate transactions 2other intangibles – part of an acquisition 3other intangibles – internally developed 3


(b) (i) One mark for each item in balance sheet 4

(ii) does it qualify as development expenditure 1the need for an active market 1drugs are unique, not homogeneous 1

(iii) neither an acquired asset nor internally generated 1 really recognition of goodwill 1can recognise both the asset and the grant at fair value 1or at cost – granted asset has zero cost 1

(iv) in reality a valuable asset, in accounting a pseudo-asset 1cannot control workforce 1does not meet recognition criteria 1

(v) effective advertising really part of goodwill 1cannot be recognised as a non-current asset 1prepayment of $2·5 million 1cannot spread over two years 1


4 reconciliation of operating profit to operating cash flows, one per item 8interest paid 2investment income 1taxation 2purchase of plant 2purchase of land and buildings 2sale of plant 1sale of investments 1ordinary dividend 2issue of ordinary shares 2redemption of loan notes 2decrease in cash 1

available 26Maximum for question 25

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(ii) sales revenues 3cost of sales 4gross amounts due from customers 2


(b) (i) one mark per valid point to maximum 6

(ii) total sales 1less inter-segment 1profit before tax 1common costs and net interest 1share of associate 1segment assets 1share of associate’s net assets 1unallocated assets 1segment liabilities 1





PART 2


QUESTION PAPER





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1 Holdrite purchased 75% of the issued share capital of Staybrite and 40% of the issued share capital of Allbrite on 1 April 2004.

Details of the purchase consideration given at the date of purchase are:Staybrite: a share exchange of 2 shares in Holdrite for every 3 shares in Staybrite plus an issue to the shareholders

of Staybrite 8% loan notes redeemable at par on 30 June 2006 on the basis of $100 loan note for every250 shares held in Staybrite.

Allbrite: a share exchange of 3 shares in Holdrite for every 4 shares in Allbrite plus $1 per share acquired in cash. The market price of Holdrite’s shares at 1 April 2004 was $6 per share.

The summarised income statements for the three companies for the year to 30 September 2004 are:

Holdrite Staybrite Allbrite$000 $000 $000

Revenue 75,000 40,700 31,000Cost of Sales (47,400) (19,700) (15,300)

–––––––– –––––––– ––––––––Gross Profit 27,600 21,000 15,700Operating expenses (10,480) (9,000) (9,700)

–––––––– –––––––– ––––––––Operating Profit 17,120 12,000 6,000Interest expense (170)

–––––––– –––––––– ––––––––Profit before tax 16,950 12,000 6,000Income tax expense (4,800) (3,000) (2,000)

–––––––– –––––––– ––––––––Profit for period 12,150 9,000 4,000

–––––––– –––––––– ––––––––

The following information is relevant:(i) A fair value exercise was carried out for Staybrite at the date of its acquisition with the following results:

Book Value Fair Value$000 $000

Land 20,000 23,000Plant 25,000 30,000

The fair values have not been reflected in Staybrite’s financial statements. The increase in the fair value of theplant would create additional depreciation of $500,000 in the post acquisition period in the consolidatedfinancial statements to 30 September 2004.Depreciation on plant is charged to cost of sales.

(ii) The details of each company’s share capital and reserves at 1 October 2003 are:Holdrite Staybrite Allbrite$000 $000 $000

Equity shares of $1 each 20,000 10,000 5,000Share premium 5,000 4,000 2,000Retained profits 18,000 7,500 6,000

(iii) In the post acquisition period Holdrite sold goods to Staybrite for $10 million. Holdrite made a profit of $4 millionon these sales. One-quarter of these goods were still in the inventory of Staybrite at 30 September 2004.

(iv) Impairment tests on the goodwill of Staybrite and Allbrite at 30 September 2004 resulted in the need to writedown Staybrite’s goodwill by $750,000. Allbrite’s goodwill was not impaired.

(v) Holdrite paid a dividend of $5 million on 20 September 2004.

2



Required:

(a) Calculate the goodwill arising on the purchase of the shares in both Staybrite and Allbrite at 1 April 2004.(8 marks)

(b) Prepare a consolidated income statement for the Holdrite Group for the year to 30 September 2004.(15 marks)

(c) Show the movement on the consolidated retained profits attributable to Holdrite for the year to 30 September2004. (2 marks)

(25 marks)

Note: The additional disclosures in IFRS 3 ‘Business Combinations’ relating to a newly acquired subsidary are notrequired.

3 [P.T.O.




2 The following trial balance relates to Chamberlain, a publicly listed company, at 30 September 2004:

$000 $000Ordinary share capital 200,000Retained profits at 1 October 2003 162,0006% Loan note (issued in 2002) 50,000Deferred tax (note (v)) 17,500Land and buildings at cost (land element $163 million (note (i))) 403,000Plant and equipment at cost (note (i)) 124,000Plant on lease to customer at cost (note (ii)) 56,000Accumulated depreciation 1 October 2003 – buildings 60,000Accumulated of depreciation 1 October 20 – plant and equipment 44,000Trade receivables 48,000Inventory – 1 October 2003 35,500Bank 12,500Trade payables 45,000Revenue 246,500Purchases 78,500Construction contract balance (note (iii)) 5,000Operating expenses 29,000Loan interest paid 1,500Interim dividend 8,000Rental income from plant (note (ii)) 16,000Research and development expenditure (note (iv)) 40,000

–––––––– ––––––––841,000 841,000–––––––– ––––––––


(i) The building had an estimated life of 40 years when it was acquired and is being depreciated on a straight-linebasis. Plant and equipment, other than the leased plant, is depreciated at 12·5% per annum using the reducingbalance basis. Depreciation of buildings and plant and equipment is charged to cost of sales.

(ii) On 1 October 2003 Chamberlain purchased an item of plant for $56 million which it leased to a customer onthe same date. The lease period is four years with annual rentals of $16 million in advance. The plant isexpected to have a nil residual value at the end of the four years. Chamberlain has been advised that this is afinance lease with an interest rate of 10% per annum.

(iii) The construction contract balance represents costs incurred to date of $35 million less progress billings receivedof $30 million on a two year construction contract that commenced on 1 October 2003. The total contract pricehas been agreed at $125 million and Chamberlain expects the total contract cost to be $75 million. The companypolicy is to accrue for profit on uncompleted contracts by applying the percentage of completion to the totalestimated profit. The percentage of completion is determined by the proportion of the contract costs to datecompared to the total estimated contract costs. At 30 September 2004, $5 million of the $35 million costsincurred to date related to unused inventory of materials on site.

Other inventory at 30 September 2004 amounted to $38·5 million at cost

(iv) The research and development expenditure is made up of $25 million of research, the remainder beingdevelopment expenditure. The directors are confident of the success of this project which is likely to becompleted in March 2005.

(v) The directors have estimated the provision for income tax for the year to 30 September 2004 at $22 million. Thedeferred tax provision at 30 September 2004 is to be adjusted to a credit balance of $14 million.

4



Required:

Prepare for Chamberlain:

(a) An income statement for the year to 30 September 2004; and (11 marks)

(b) A balance sheet as at 30 September 2004 in accordance with International Financial Reporting Standardsas far as the information permits. (14 marks)

Note: A Statement of Changes in Equity is NOT required.Disclosure notes are ONLY required for the leased plant in item (ii) above.

(25 marks)

3 Historically financial reporting throughout the world has differed widely. The International Accounting StandardsCommittee Foundation (IASCF) is committed to developing, in the public interest, a single set of high quality,understandable and enforceable global accounting standards that require transparent and comparable information ingeneral purpose financial statements. The various pronouncements of the IASCF are sometimes collectively referredto as International Financial Reporting Standards (IFRS) GAAP.

Required:

(a) Describe the functions of the various internal bodies of the IASCF, and how the IASCF interrelates with othernational standard setters. (10 marks)

(b) Describe the IASCF’s standard setting process including how standards are produced, enforced andoccasionally supplemented. (10 marks)

(c) Comment on whether you feel the move to date towards global accounting standards has been successful.(5 marks)

(25 marks)

5 [P.T.O.



4 Bigwood, a public company, is a high street retailer that sells clothing and food. The managing director is verydisappointed with the current year’s results. The company expanded its operations and commissioned a famousdesigner to restyle its clothing products. This has led to increased sales in both retail lines, yet overall profits are down.

Details of the financial statements for the two years to 30 September 2004 are shown below.

Income statements: year to 30 September 2004 year to 30 September 2003$000 $000 $000 $000

Revenue – clothing 16,000 15,600Sale s – food 7,000 23,000 4,000 19,600

––––––– –––––––Cost of sales – clothing 14,500 12,700Cost of sales – food 4,750 (19,250) 3,000 (15,700)

––––––– ––––––– ––––––– –––––––Gross profit 3,750 3,900Other operating expenses (2,750) (1,900)

––––––– –––––––Operating profit 1,000 2,000Interest expense (300) (80)

––––––– –––––––Profit before tax 700 1,920Income tax expense (250) (520)

––––––– –––––––Profit for period 450 1,400

––––––– –––––––

Summarised Changes in Equity: year to 30 September 2004 year to 30 September 2003$000 $000

Retained profit b/f 1,900 1,100Profit for the period 450 1,400Dividends paid (600) (600)

––––––– –––––––Retained profit c/f 1,750 1,900

––––––– –––––––

Balance sheets as at: 30 September 2004 30 September 2003$000 $000 $000 $000

Property, plant and equipment at cost 17,000 9,500Accumulated depreciation (5,000) (3,000)

––––––– –––––––12,000 6,500

Current AssetsInventory – clothing 2,700 1,360Inventory – food 200 140Trade receivables 100 50Bank nil 3,000 450 2,000

–––––– ––––––– –––––- –––––––Total assets 15,000 8,500

––––––– –––––––Equity and liabilitiesIssued ordinary capital ($1 shares) 5,000 3,000Share premium 1,000 nilRetained profits 1,750 1,900

––––––– –––––––7,750 4,900

Non-current liabilitiesLong-term loans 3,000 1,000Current liabilitiesBank overdraft 930 nilTrade payables 3,100 2,150Current tax payable 220 4,250 450 2,600

––––––– ––––––– ––––––– –––––––15,000 8,500––––––– –––––––

Note: the directors have signalled their intention to maintain annual dividends at $600,000 for the foreseeablefuture.

6



The following information is relevant:(i) The increase in property, plant and equipment was due to the acquisition of five new stores and the

refurbishment of some existing stores during the year. The carrying value of fixtures scrapped at the refurbishedstores was $1.2 million; they had originally cost $3 million. Bigwood received no scrap proceeds from thefixtures, but did incur costs of $50,000 to remove and dispose of them. The losses on the refurbishment havebeen charged to operating expenses. Depreciation is charged to cost of sales apportioned in relation to floor area(see below).

(ii) The floor sales areas (in square metres) were: 30 September 2004 30 September 2003Clothing 48,000 35,000Food 16,000 15,000

––––––– –––––––54,000 40,000––––––– –––––––

(iii) The share price of Bigwood averaged $6·00 during the year to 30 September 2003, but was only $3·00 at 30 September 2004.

(iv) The following ratios have been calculated: 2004 2003Return on capital employed 9·3% 33·9%Net assets turnover 2·1 times 3·3 timesGross profit margin– clothing 9·4% 18·6%– food 32·1% 25%Net profit (after tax) margin 2·0% 7·1%Current ratio 0·71:1 0·77:1Inventory holding period– clothing 68 days 39 days– food 15 days 17 daysAccounts payable period 59 days 50 daysGearing 28% 17%Interest cover 3·3 times 25 times

Required:

(a) Prepare, using the indirect method, a cash flow statement for Bigwood for the year to 30 September 2004(12 marks)

(b) Write a report analysing the financial performance and financial position of Bigwood for the two years ended30 September 2004. (13 marks)

Your report should utilise the above ratios and the information in your cash flow statement. It should refer tothe relative performance of the clothing and food sales and be supported by any further ratios you considerappropriate.

(25 marks)

7 [P.T.O.



8

5 (a) Derwent, a publicly listed company, made the following share capital transactions on 1 October 2003.

(i) the purchase and immediate cancellation of five million of its own ordinary shares. Derwent paid $1·75 pershare in an open market purchase. These shares had originally been issued at par.

Derwent is registered in a country that permits a company to purchase and immediately cancel its own sharecapital. In order to protect creditors the nominal value of the redeemed share capital must be replaced by anew issue of shares or by a transfer from accumulated profits to a capital reserve. Any premium paid on theredemption of shares must be charged to retained profits.

(ii) an issue of one million 5% preference shares of $1 each at par. This issue was made in order to help financethe above purchase.

Derwent’s share capital and reserves at 30 September 2003 were:$000

Ordinary shares of 25c each fully paid 25,000Retained profits 55,000

–––––––80,000–––––––

On 1 January 2004 Derwent paid an interim dividend of 3c per share and on 1 June 2004 it paid a furtherdividend of 5c per share.

Derwent’s profit after tax for the year to 30 September 2004 was $12 million.

Required:

(i) Prepare extracts from Derwent’s balance sheet for share capital and reserves at 30 September 2004; calculate the dividends paid for the year to 30 September 2004. (8 marks)

(ii) State the advantages of companies being able to purchase and then cancel their own shares.(4 marks)



9

(b) Advent is a publicly listed company.

Details of Advent’s non-current assets at 1 October 2003 were:

Land and building Plant Telecommunications Totallicense

$m $m $m $mCost/valuation 280 150 300 730Accumulated depreciation/amortisation 1(40) (105) 1(30) (175)

–––– –––– –––– ––––Net book value 240 45 270 555

–––– –––– –––– ––––

The following information is relevant:(i) The land and building were revalued on 1 October 1998 with $80 million attributable to the land and $200

million to the building. At that date the estimated remaining life of the building was 25 years. A furtherrevaluation was not needed until 1 October 2003 when the land and building were valued at $85 millionand $180 million respectively. The remaining estimated life of the building at this date was 20 years.

(ii) Plant is depreciated at 20% per annum on cost with time apportionment where appropriate. On 1 April2004 new plant costing $45 million was acquired. In addition, this plant cost $5 million to install andcommission. No plant is more than four years old.

(iii) The telecommunications license was bought from the government on 1 October 2002 and has a 10 yearlife. It is amortised on a straight line basis. In September 2004, a review of the sales of the products relatedto the license showed them to be very disappointing. As a result of this review the estimated recoverableamount of the license at 30 September 2004 was estimated at only $100 million.

There were no disposals of non-current assets during the year to 30 September 2004

Required:

(i) Prepare balance sheet extracts of Advent’s non-current assets as at 30 September 2004 (includingcomparative figures), together with any disclosures required (other than those of the accounting policies)under current International Financial Reporting Standards. (9 marks)

(ii) Explain the usefulness of the above disclosures to the users of the financial statements. (4 marks)

(25 marks)




Answers



13

Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) December 2004 Answers

1 (a) Cost of control in Staybrite:Consideration $000 $000Shares (10,000 x 75% x 2/3 x $6) 30,0008% loan notes (10,000 x 75% x $100/250) 3,000

–––––––33,000

LessEquity shares 10,000Share premium 4,000Pre acq reserves (see below) 12,000Fair value adjustment (5,000 + 3,000) 8,000

–––––––34,000 x 75% (25,500)

–––––––Goodwill 7,500

–––––––

The pre acquisition reserves are:At 1 October 2003 7,500To 1 April 2004 (9,000 x 6/12) 4,500

–––––––12,000–––––––

Goodwill on the purchase of Allbrite:Consideration Shares (5,000 x 40% x 3/4 x $6) 9,000Cash (5,000 x 40% x $1) 2,000

–––––––11,000

LessEquity shares 5,000Share premium 2,000Pre acq reserves (6,000 + (4,000 x 6/12)) 8,000

–––––––15,000 x 40% (6,000)

–––––––Goodwill 5,000

–––––––

(b) Holdrite GroupConsolidated income statement for the year ended 30 September 2004

$000 $000Revenue (75,000 + (40,700 x 6/12) – 10,000) 85,350Cost of sales (w (i)) (48,750)

––––––––Gross profit 36,600Operating expenses (w (ii)) (15,730)

––––––––Profit from operations 20,870Income from associate (w (iii)) 1,200

––––––––22,070

Interest expense (170)––––––––

Profit before tax 21,900Income tax expense – Group (4,800 + (3,000 x 6/12)) (6,300)Income tax expense – Associate (w (iii)) (400) (6,700)

–––––– ––––––––Profit for the period 15,200

––––––––Attributable to:Equity holders of the parent 14,200Minority interest (w (iv)) 1,000

––––––––15,200

––––––––



14

$000(c) Net profit for period 14,200

Dividend paid (5,000)––––––––

9,200Retained profit b/f (Holdrite only) 18,000

––––––––Retained profits c/f 27,200

––––––––Workings ($000) $000(i) Cost of sales

Holdrite 47,400Staybrite (19,700 x 6/12) 9,850Additional depreciation of plant 500Intra group purchases (10,000)Unrealised profit in inventory (4,000 x 25%) 1,000

––––––––48,750

––––––––

(ii) Operating expensesHoldrite 10,480Staybrite (9,000 x 6/12) 4,500Impairment of Staybrite’s goodwill 750

––––––––15,730

––––––––(iii) Associated company

Profit for the year (6,000 x 6/12 x 40%) 1,200Taxation (2,000 x 6/12 x 40%) 400

(iv) Minority Interest9,000 x 6/12 4,500less additional depreciation (500)

––––––––4,000

––––––––x 25% 1,000

––––––––

2 (a) Chamberlain – Income statement – Year to 30 September 2004$000

Revenue (246,500 + 50,000 (w (i))) 296,500Cost of sales (w (ii)) (146,500)

––––––––– Gross profit 150,000Operating expenses (29,000)

–––––––––Profit before interest and tax 121,000Investment income (w (iii)) 4,000Interest expense (1,500 + 1,500 accrued) (3,000)

––––––––– Profit before tax 122,000Income tax (22,000 – (17,500 – 14,000)) (18,500)


–––––––––



15

(b) Chamberlain – Balance Sheet as at 30 September 2004Non-current assets $000 $000Property, plant and equipment (w (iv)) 407,000Development costs (40,000 – 25,000) 15,000

––––––––422,000

Current assetsInventory 38,500Amounts due from construction contracts (w (i)) 25,000Trade receivables 48,000Net investment in finance lease – Note 1 (w (iii)) 40,000Accrued finance lease income (w (iii)) 4,000Bank 12,500 168,000

–––––––– ––––––––Total assets 590,000

–––––––– Equity and liabilitiesCapital and reserves:Ordinary share capital 200,000Retained profits – 1 October 2003 162,000Accumulated pr – Year to 30 September 2004 103,500Accumulated pr less dividends paid (8,000) 257,500

–––––––– ––––––––457,500

Non-current liabilities (w (v)) 64,000

Current liabilitiesTrade payables 45,000Accrued finance costs 1,500Taxation 22,000 68,500

–––––––– ––––––––Total equity and liabilities 590,000

––––––––Note 1Net investment in finance lease:Amount receivable within one year 12,000Amount receivable after more than one year 28,000

––––––––40,000

––––––––



16

Workings (all figures in $000) $000(i) Construction contract:

Contract price 125,000Estimated cost (75,000)

––––––––Estimated total profit 50,000

––––––––

Contract cost for year (35,000 – 5,000 inventory on site) 30,000Estimated cost 75,000Percentage complete (30,000/75,000) 40%

Year to 30 September 2004 Contract revenue – included in sales (125,000 x 40%) 50,000Contract 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) 55,000Less progress billings received (30,000)

––––––––25,000

––––––––

(ii) Cost of sales:Opening inventory 35,500Purchases 78,500Contract costs (w (i)) 30,000Research costs 25,000Depreciation (w (iv)) – buildings 6,000Depreciation (w (iv)) – plant 10,000Closing inventory (38,500)

––––––––146,500––––––––

(iii) Finance lease:Net investment at inception of lease 56,000First rental payment – 1 October 2003 (16,000)

––––––––Investment outstanding to 30 September 2004 40,000Accrued interest 10% (current asset) 4,000

In the year to 30 September 2005 the second rental payment of $16,000 will be received, of this $4000 is for theaccrued interest for the previous year, thus $12,000 will be a capital receipt. Therefore the analysis of the investmentoutstanding at 30 September 2004 of $40,000 is that $12,000 will be receivable within one year and $28,000 aftermore than one year.

(iv) 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 perannum.This gives accumulated depreciation at 30 September 2004 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 $80,000 (124,000 – 44,000). Depreciation at 12·5% onthe reducing balance basis gives an annual charge of $10,000. This gives a carrying value at 30 September 2004 of$70,000 (80,000 – 10,000). Therefore the carrying value of property, plant and equipment at 30 September 2004 is$407,000 (337,000 + 70,000).

(v) Non-current liabilities6% loan note 50,000Deferred tax 14,000

–––––––64,000–––––––



17

3 Note: The International Accounting Standards Board (IASB) has decided that their standards will be called International FinancialReporting Standards (IFRS), and that this term should be taken to encompass both Standards and Interpretations issued bythe IASB (IFRS and IFRIC), and the International Accounting Standards (IAS) and Standing Interpretations CommitteeInterpretations (SIC) issued by its predecessor standard setter, the IASC Board. References in this answer to IFRS should betaken to have the same meaning as that used by the IASB.

(a) In recognition of the increasing importance of international accounting standards, in 1999 the Board of the IASBrecommended and subsequently adopted a new constitution and structure. After a two year process a new supervisory body,The International Accounting Standards Committee Foundation, was incorporated in the USA in February 2001 as anindependent not-for-profit organisation. It is governed by 19 IASC Foundation Trustees who must have an understanding ofinternational issues relevant to accounting standards for use in the world’s capital markets. The main objectives of the IASCFoundation are:

to develop a single set of global accounting standards that require high quality, transparent and comparable information infinancial statements to help users in making economic decisions;

to promote the use and application of these standards; and

to bring about convergence of national accounting standards and international accounting standards

The subsidiary bodies of the IASC Foundation are the International Accounting Standards Board (IASB) (based in London UK),the Standards Advisory Council (SAC) and the International Financial Reporting Interpretations Committee (IFRIC).

The International Accounting Standards BoardThe result of a restructuring process saw the IASB assume the responsibility for setting accounting standards from itspredecessor body, the International Accounting Standards Committee. The Trustees appoint the members of all of the abovebodies. They also set the agenda of and raise finance for the IASB; however the IASB has sole responsibility for settingaccounting standards, International Financial Reporting Standards (IFRS), following rigorous and open due process.

The Standards Advisory Council provides a forum for experts from different countries and different business sectors with aninterest in international financial reporting to offer advice when drawing up new standards. Its main objectives are to giveadvice to the Trustees and IASB on agenda decisions and work priorities and on the major standard-setting projects.

The International Financial Reporting Interpretations Committee has taken over the work of the previous StandingInterpretations Committee. It is really a compliance body whose role is to provide rapid guidance on the application andinterpretation of international accounting standards where contentious or divergent interpretations of international accountingstandards have arisen. It operates an open due process in accordance with its approved procedures. Its pronouncements(interpretations – SICs and IFRICs) are important because financial statements cannot be described as complying with IFRSsunless they also comply with the interpretations.

Other BodiesThe prominence of the IASB has been enhanced even further by its relationship with the International Organisation ofSecurities Commissions (IOSCO). IOSCO is an influential organisation of the world’s security commissions (stock exchanges).In 1995 the IASC agreed to develop a core set of standards which, when endorsed by IOSCO, would be used as an acceptablebasis for cross-border listings. In May 2000 this was achieved. Thus it can be said that international accounting standardsmay be the first tentative steps towards global accounting harmonisation. As part of its harmonisation process the EuropeanUnion will require listed companies in all member states to prepare their financial statements using IFRSs by 2005.

National standard setters such as the UK’s Accounting Standards Committee and the USA’s Financial Accounting StandardsBoard have a role to play in the formulation of international accounting standards. Seven of the leading national standardsetters are members of the IASB. The IASB see this as a ‘partnership’ between IASB and these national bodies as they worktogether to achieve the convergence of accounting standards world wide. Often the IASB will ask members of nationalstandard setting bodies to work on particular projects in which those countries have greater experience or expertise. Manycountries that are committed to closer integration with IFRSs will publish domestic standards equivalent (sometimes identical)to IFRSs on a concurrent timetable.

(b) The International Accounting Standard Setting ProcessAs referred to above the IASB is ultimately responsible for setting international accounting standards. The Board (advised bythe SAC) identifies a subject and appoints an Advisory Committee to advise on the issues relevant to the given topic.Depending on the complexity and importance of the subject matter the IASB may develop and publish Discussion Documentsfor public comment. Following the receipt and review of comments the IASB then develops and publishes an Exposure Draftfor public comment. The usual comment period for both of these is ninety days. Finally, and again after a review of any furthercomments, an International Financial Reporting Standard (IFRS) is issued. The IASB also publishes a Basis for Conclusionswhich explains how it reached its conclusions and gives information to help users to apply the Standard in practice. Inaddition to the above the IASB will sometimes conduct Public Hearings where proposed standards are openly discussed andoccasionally Field Tests are conducted to ensure that proposals are practical and workable around the world.

The authority of international accounting standards is a rather difficult area. The IASB has no power to enforce internationalaccounting standards within those countries/enterprises that choose to adopt them. This means that the enforcement ofinternational accounting standards is in the hands of the regulatory systems of the individual adopting countries. There is nodoubt the regulatory systems in different parts of the world differ from each other considerably in their effectiveness. Forexample in the UK the Financial Reporting Review Panel (FRRP) is a body that investigates departures from the UK’sregulatory system (which will soon include the use of international accounting standards for listed companies). The FRRP haswide and effective powers of enforcement, but not all countries have equivalent bodies, thus it can be argued that international



18

accounting standards are not enforced in a consistent manner throughout the world. Complementary to internationalaccounting standards, there also exist international auditing standards and part of the rigour and transparency that the useof international accounting standards brings is due to the fact that those companies adopting international accountingstandards should also be audited in accordance with international auditing standards. This auditing aspect is part of IOSCO’srequirements for financial statements to be used for cross-border listing purposes.

Where it becomes apparent (often through press reports) that there is widespread inconsistency in the interpretation of aninternational accounting standard, or where it is perceived that a standard is not clear enough in a particular area, the IFRICmay act to remedy/clarify the position thus supplementing the body of international standards. However where it becomesapparent (perhaps through a modified audit report) that a company has departed from IFRSs there is little that the IASB cando directly to enforce them.

(c) The success of the processAny measure of success is really a matter of opinion. There is no doubt that the growing acceptance of IFRSs through IOSCO’sendorsement, the European Union requirement for their use by listed companies and the ever increasing number of countriesthat are either adopting international accounting standards outright or basing their domestic standards very closely on IFRSsis a measure of the success of the IASB. Equally there is widespread recognition that in recent years the quality of internationalaccounting standards has improved enormously due to the improvements project and subsequent continuing improvements.However the IASB is not without criticism. Some countries that have developed sophisticated regulatory systems feel thatIFRSs are not as rigorous as the local standards and this may give cross-border listing companies an advantage over domesticcompanies. Some requirements of international accounting standards are regarded as quite controversial, e.g. deferred tax(part of IAS 12), financial instruments and derivatives (IAS 32 and 39) and accounting for retirement benefits (IAS 26). ManyIFRSs are complex and the benefits of applying them to smaller enterprises may be outweighed by the costs. Also somesecurities exchanges that are part of IOSCO require non-domestic companies that are listing by filing financial statementsprepared under IFRSs to produce a reconciliation to local GAAP. This involves reconciling the IFRS income statement andbalance sheet assets, liabilities and equity, to what they would be if local GAAP had been used. The USA is an importantexample of this requirement. Critics argue that this requirement negates many of the benefits of being able to use a single setof financial statements to list on different security exchanges. This is because to produce reconciliation to local GAAP is almostas much work and expense as preparing financial statements in the local GAAP which was usually the previous requirement.

Despite these criticisms there is no doubt that the work of IASB has already led, and in the future will lead, to furtherimprovement in financial reporting throughout the world.

4 (a) Bigwood – Cash Flow Statement for the year to 30 September 2004:

Note: figures in brackets are in $000 $000 $000Net profit before tax 700Adjustments for:depreciation – non-current assets (w (i)) 3,800loss on disposal of fixtures (w (i)) 1,250interest expense 300 5,350

––––––– –––––––Operating profit before working capital changes 6,050increase in inventory (2,900 – 1,500) (1,400)increase in trade receivables (100 – 50) (50)increase in trade payables (3,100 – 2,150) 950

–––––––Cash generated from operations 5,550Interest paid (300)Income tax paid (w (ii)) (480)

–––––––Net cash from operating activities 4,770

Cash flow from investing activitiesPurchase of Property, plant and equipment (w (i)) (10,500)Disposal costs of fixtures (w (i)) (50) (10,550)

––––––– –––––––(5,780)

Cash flows from financing activitiesIssue of ordinary shares (2,000 + 1,000) 3,000Long term loans (3,000 – 1,000) 2,000Equity dividend paid (600) 4,400

––––––– –––––––Net decrease in cash and cash equivalents (1,380)Cash and cash equivalents at beginning of period 450

–––––––Cash and cash equivalents at end of period (930)

–––––––



19

Workings (all figures in $000)(i) Property, plant and equipment – cost

Balance b/f 9,500Disposal (3,000)Balance c/f (17,000)

–––––––Difference cash purchase (10,500)

–––––––DepreciationBalance b/f (3,000)Disposal (3,000 – 1,200) 1,800Balance c/f 5,000

–––––––Difference charge for year 3,800

–––––––DisposalCost 3,000Depreciation (1,800)

–––––––Net book value 1,200Cost of disposal 50

–––––––Total loss on disposal (1,250)

–––––––

(ii) Income tax paid:Provision b/f (450)Income statement tax charge (250)Provision c/f 220

–––––––Difference cash paid (480)

–––––––

(b) Report on the financial performance of Bigwood for the year ended 30 September 2004

To: From: Date:

Operating performance:Bigwood’s overall performance as measured by the return on capital employed has deteriorated markedly. This ratio iseffectively a composite of the company’s profit margins and its asset utilisation. The expansion represented by the acquisitionof the five new stores has considerably increased investment in net assets. The asset turnover (a measure of asset utilisation)has fallen from 3·3 times to just 2·1 times. This is a relatively large fall and is partly responsible for the deterioratingperformance. However, it should be borne in mind that it often takes some time before new investment generates the samelevel of sales as existing capacity so it may be that the situation will improve in future years.

Of more concern in the current year is the deteriorating gross profit margin of the company’s clothing sales. This has fallenfrom 18·6% to 9·4%. The effect of this is all the more marked because sales of clothing (in the current year) represents nearly70% of turnover. It should also be noted that the inventory holding period of clothing has also increased significantly from39 days in 2003 to 68 days in the current year. This may be a reflection of a company policy to increase inventory levels inorder to attract more sales, but it may also be an indication that there is some slow-moving or obsolete inventory. The clothingindustry is notoriously susceptible to fashion changes, the new designs may not have gone down well with the buying public.By contrast the profit margin on food sales has increased substantially (from 25% to 32·1%) as indeed have the salesthemselves (up 75% on last year). These improvements have helped to offset the weaker performance of clothing sales.

A more detailed analysis shown by the ratios in the appendix confirms the position. The expansion has created a 35%increase in the sales floor area, but the proportionate increase in turnover is only 17·3%. Breaking this down between thetwo sectors shows that the clothing sector is responsible for this deterioration; an increase in capacity of 37% has led to anincrease in sales of only 2·6%, whereas a more modest increase of 20% in the food floor area has led to a remarkableincrease of 75% in food sales. In the current year food retailing has generated sales of $1,167,000 per square metre,whereas clothing sales per square metre has fallen from $446,000 to $333,000. When the relative profit margins of clothingand food are considered it can be seen that food retailing has been far more profitable than clothing retailing and this gap inmargins has increased during the current year.

This deterioration in trading margins has continued through to net profit margins (falling from 7·1% to only 2·0%). It can beobserved that operating expenses have increased considerably, but this is to be expected and is probably in line with theincrease in the number of stores.



20

In summary, the increase in capacity has focused on clothing rather than food retailing. On reflection this seems misguidedas the performance of food retailing was superior to that of clothing (in 2003) and this has continued (even more so) duringthe current year.

Liquidity/solvencyThe increase in the investment in new stores and the refurbishment of existing stores has been largely financed by increasinglong term loans by $2 million and issuing $3 million of equity. The effect of this is an increase in gearing from 17% to 28%.Although the level of gearing is still modest, the interest cover has fallen from a very healthy 25 times to a worrying low 3·3times. The investment has also taken its toll on the bank balance falling from $450,000 in hand to an overdraft of $930,000.This probably explains why the company has stretched its payment of accounts payable to 59 days in 2004 from 50 daysin 2003.

The company’s current liquidity position has deteriorated slightly from 0·77 : 1 to 0·71 : 1. No quick ratios have been given,nor would they be useful. Liquidity ratios are difficult to assess for retailing companies. Most of the sales generated by suchcompanies are for cash (thus there will be few trade receivables) and normal liquidity benchmarks are not appropriate. Thecash flow statement reveals cash flows generated from operating activities of $5,550,000. This is a far more reliable indicatorof the company’s liquidity position. The $5,550,000 is more than adequate to service the tax and the dividend payments.Indeed the operating cash flows have contributed significantly to the financing of the expansion programme.

Share price and dividends:Bigwood’s share price has halved from $6·00 to $3·00 during the current year. The dilution effect of the share issue at $1·50per share (2 million shares for $3million) would account for some of this fall (to approximately $4·20), but the further fallprobably represents the market’s expectations of the company’s performance. It is worth noting that the company hasmaintained its dividends at $600,000 despite an after tax profit of only $450,000. Whilst this dividend policy cannot bemaintained indefinitely (at the current level of profits), the directors may be trying to convey to the market a feeling ofconfidence in the future profitability of the company. It may also be a reaction designed to support the share price. It shouldalso be noted that although the total dividend has been maintained, the dividend per share will have decreased due to theshare issue during the year.

SummaryThe above analysis of performance seems to give mixed messages, the company has invested heavily in new and upgradedstores, but operating performance has deteriorated and the expansion may have been mis-focused. This appears to haveaffected the share price adversely. Alternatively, it may be that the expansion will take a little time to bear fruit and thedeterioration may be a reflection of the current state of the economy. Cash generation remains sound and if this continues,the poor current liquidity position will soon be reversed.

Signed A N Other

AppendixThe following additional ratios can be calculated:

clothing food overallIncrease in sales area (13,000/35,000) 37% (1,000/5,000) 20% (14,000/40,000) 35%Increase in turnover (400/15,600) 2·6% (3,000/4,000) 75% (3,400/19,600) 17·3%

sales per sq mtr 2004 sales per sq mtr 2003$000 $000

Overall (23,000/54) 426 (19,600/40) 490Clothing (16,000/48) 333 (15,600/35) 446Food (7,000/6) 1,167 (4,000/5) 800



21

5 (a) (i) Derwent share capital and reserves at 30 September 2004:$000 $000

95 million ordinary shares of 25c each fully paid ((100 million – 5 million) x 25c) 23,750One million 5% preference shares of $1 each 1,000Capital reserve (w (ii)) 250Retained profits (w (ii)) 51,600 51,850

––––––– –––––––76,600–––––––

Dividends – year to 30 September 2004Preference dividend ($1 million x 5%) 50Ordinary dividendsJanuary 2004 ((100 million – 5 million) x 3c) 2,850June 2004 (95 million x 5c) 4,750 7,600

–––––––Workings(i) The premium on redemption is $7·5 million (5 million x (175c – 25c)) and this must be charged to accumulated

profits.

(ii) $000 $000Retained profits b/f 55,000profit after tax for the year (from question) 12,000preference dividend (from above) (50)ordinary dividends (from above) (7,600)premium on redemption (w (i)) (7,500)transfer to capital reserve (see below) (250) (3,400)

––––––– –––––––51,600–––––––

The transfer to the capital reserve is the nominal value of share capital redeemed of $1·25 million (5 million x 25c)less the proceeds of the new issue of $1 million.

(ii) Advantages of purchasing (then cancelling) own shares:– it is a method of returning excess cash/capital surpluses to shareholders (without paying dividends)– if a company believes its shares are undervalued on the stock market, it may be able to improve its share price

(and p/e ratio) by buying shares in the open market. The demand created by the purchase may cause an increasein price and, if these shares are cancelled (as they often are), this means the remaining shareholders own a greaterproportion of the company.

– private companies (whose shares have no active market) can take advantage of the company being able topurchase shares. This may be used to buy out shares held by employees (say on retirement) who have receivedthem as part of a profit sharing scheme. Companies may buy out dissenting shareholders, or buy shares from theestate of a deceased shareholder. Companies normally purchase shares in these circumstances when the othershareholders do not wish to purchase any more of the company’s shares.

(b) (i) Non-current assets 30 September 2004 30 September 2003$million $million

Property, plant and equipment (note 1) 316 285Intangible assets (note 2) 100 270

Note 1 Property, plant and equipment Land and building Plant Total$million $million $million

Cost or valuation:At 1 October 2003 280 150 430Additions 150 150Revaluation (5 – 20) 1(15) 1nil 1(15)

–––– –––– ––––At 30 September 2004 265 200 465

–––– –––– ––––Accumulated depreciation:At 1 October 2003 140 105 145Charge for year 119 135 144Revaluation 1(40) 1nil 1(40)

–––– –––– ––––At 30 September 2004 119 140 149

–––– –––– ––––Carrying value 30 September 2004 256 160 316

–––– –––– ––––



The land and buildings were revalued by an appropriately qualified valuer on an existing use basis on 1 October 2003.They are being depreciated on a straight-line basis over a 25 year life. Plant is depreciated at 20% per annum on cost.

Note 2 Intangible fixed assets:Telecommunications license Total

$million $millionCost at 1 October 2003 300 300

–––– ––––And at 30 September 2004 300 300

–––– ––––Accumulated amortisation 1 October 2003 130 130Amortisation charge for year 30 30Impairment charge for year 140 140

–––– ––––At 30 September 2004 200 200

–––– ––––Carrying value 30 September 2004 100 100

–––– ––––

After the impairment charge the license will be amortised over its remaining life of eight years on a straight-line basis.

(ii) The usefulness of the above disclosures is:– users can determine which type of non-current assets a business owns. There is a great deal of difference between

owning say land and buildings compared with intangibles. The above figures give an illustration of this; theproperty has increased in value whereas the licence has fallen dramatically. Another factor relevant to thisdistinction is that it is usually easier to raise finance using property as security, whereas it can be difficult to raisefinance on intangibles due to the volatility of their values.

– it is useful to know whether non-current assets are carried at historical cost or at revalued amount. If a companyis using historical cost, it may be that balance sheet values are seriously understated with a consequential effecton depreciation charges.

– information on accumulated depreciation gives a broad indication of the age of the relevant assets. In the case ofAdvent above, other than the plant acquired during the year, plant is almost fully depreciated. The implication ofthis, assuming the depreciation policy is appropriate, is that further acquisitions will be required in the near future.This in turn has future cash flow implications.

– it can also be noted that no disposals of plant have occurred, thus the acquisition of plant represents an increasein capacity. This may be an indication of growth.

– the disclosure of the impairment charge as part of the accumulated depreciation disclosures is self-evident. Userscan determine that the acquisition of the license appears to have been a financial disaster. Where a non-currentasset is carried at historical cost, as in this case, the impairment is included as part of the depreciation rather thanas a write down (revaluation) of the cost of the asset.

22



Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) December 2004 Marking Scheme


Marks1 (a) Goodwill of Staybrite:

value of shares exchanged 18% loan notes issued 1equity shares and share premium 1pre acquisition reserves 1fair value adjustments 1Goodwill of Allbrite:value of shares exchanged 1cash paid 1equity shares and share premium 1pre acquisition reserves 1

–––available 9

–––maximum 8

–––

(b) Income statement:revenue 2cost of sales 4operating expenses 2interest expense 1income from associate 2income tax 2minority interest 3


–––maximum 15

–––

(c) dividends 1retained profits b/f and c/f 1

–––maximum 2

–––Maximum for question 25

–––

23



Marks2 (a) Income statement

revenue 2cost of sales 6operating costs 1investment income 1interest expense 2taxation 2


–––maximum 11

–––

(b) Balance sheet development costs 1property, plant and equipment 2amounts due from construction contract customers 2inventory and accounts receivable 1investment in finance leases (one for figure 1 for disclosure note) 2accrued finance income 1bank and trade creditors 1accrued finance costs 1income tax provision 1non-current liabilities 2share capital and reserves (including 1 mark for dividend paid) 2


–––maximum 14

––– Maximum for question 25

–––

3 (a) 1 mark per relevant point to a maximum 10(b) 1 mark per relevant point to a maximum 10(c) 1 mark per relevant point to a maximum 5

––– Maximum for question 25

–––

24



Marks4 (a) net profit before tax 1

depreciation 1loss on disposal 1working capital items 3interest paid 1income tax paid 1capital expenditure 1disposal proceeds 1equity dividends 1financing – equity shares 1financing – loans 1 decrease in cash 1


–––maximum 12

–––

(b) up to 3 marks for additional ratios 31 mark per relevant point including 1 mark for format 10

–––maximum 13


–––

5 (a) (i) ordinary shares 1preference shares 1capital reserve 2retained profits 2preference dividend 1ordinary dividends 2


–––maximum 8

–––

(ii) 1 mark per relevant point to a maximum 4

(b) (i) property, plant and equipmentcost and accumulated depreciation at 1 October 2003 2additions 1revaluation 1depreciation charges 1total columns 2license stays at cost of $300 million 1charge for year 1carrying value at 30 September 2004 1disclosure note 1


–––maximum 9

–––

(ii) 1 mark per relevant point to a maximum 4 –––

Maximum for question 25–––

25




PART 2


QUESTION PAPER







Pape

r 2.5

(IN

T)





1 Highveldt, a public listed company, acquired 75% of Samson’s ordinary shares on 1 April 2004. Highveldt paid animmediate $3·50 per share in cash and agreed to pay a further amount of $108 million on 1 April 2005. Highveldt’scost of capital is 8% per annum. Highveldt has only recorded the cash consideration of $3·50 per share.

The summarised balance sheets of the two companies at 31 March 2005 are shown below:

Highveldt Samson$million $million $million $million

Tangible non-current assets (note (i)) 420 320Development costs (note (iv)) nil 40Investments (note (ii)) 300 20

–––– ––––720 380

Current assets 133 91–––– ––––

Total assets 853 471–––– ––––

Equity and liabilities:Ordinary shares of $1 each 270 80Reserves:Share premium 80 40Revaluation reserve 45 nilRetained earnings – 1 April 2004 160 134

– year to 31 March 2005 190 350 76 210–––– –––– –––– ––––

745 330 Non-current liabilities10% inter company loan (note (ii)) nil 60

Current liabilities 108 81–––– ––––

Total equity and liabilities 853 471–––– ––––


(i) Highveldt has a policy of revaluing land and buildings to fair value. At the date of acquisition Samson’s land andbuildings had a fair value $20 million higher than their book value and at 31 March 2005 this had increasedby a further $4 million (ignore any additional depreciation).

(ii) Included in Highveldt’s investments is a loan of $60 million made to Samson at the date of acquisition. Interestis payable annually in arrears. Samson paid the interest due for the year on 31 March 2005, but Highveldt didnot receive this until after the year end. Highveldt has not accounted for the accrued interest from Samson.

(iii) Samson had established a line of products under the brand name of Titanware. Acting on behalf of Highveldt, afirm of specialists, had valued the brand name at a value of $40 million with an estimated life of 10 years as at1 April 2004. The brand is not included in Samson’s balance sheet.

(iv) Samson’s development project was completed on 30 September 2004 at a cost of $50 million. $10 million ofthis had been amortised by 31 March 2005. Development costs capitalised by Samson at the date of acquisitionwere $18 million. Highveldt’s directors are of the opinion that Samson’s development costs do not meet thecriteria in IAS 38 ‘Intangible Assets’ for recognition as an asset.

(v) Samson sold goods to Highveldt during the year at a profit of $6 million, one-third of these goods were still inthe inventory of Highveldt at 31 March 2005.

(vi) An impairment test at 31 March 2005 on the consolidated goodwill concluded that it should be written down by$22 million. No other assets were impaired.

2



Required:

(a) Calculate the following figures as they would appear in the consolidated balance sheet of Highveldt at31 March 2005:(i) goodwill; (8 marks)(ii) minority interest; (4 marks)(iii) the following consolidated reserves:

share premium, revaluation reserve and retained earnings. (8 marks)Note: show your workings

(b) Explain why consolidated financial statements are useful to the users of financial statements (as opposed tojust the parent company’s separate (entity) financial statements). (5 marks)

(25 marks)

3 [P.T.O.




2 Reproduced below are the draft financial statements of Harrington, a public company, for the year to 31 March 2005:

Income statement – Year to 31 March 2005 $000Sales revenue (note (i)) 13,700Cost of sales (note (ii)) (9,200)_______Gross profit 4,500Operating expenses (2,400)Loan note interest paid (refer to balance sheet) (25)

–––––––Profit before tax 2,075Income tax expense (note (vi)) (55)

–––––––Profit for the period 2,020

–––––––Balance Sheet as at 31 March 2005

$000 $000Property, plant and equipment (note (iii)) 6,270Investments (note (iv)) 1,200

–––––––7,470

Current assetsInventory 1,750Trade receivables 2,450Bank 350 4,550

–––––– –––––––Total assets 12,020

–––––––Equity and liabilities:Ordinary shares of 25c each (note (v)) 2,000Reserves:Share premium 600Retained earnings – 1 April 2004 2,990

– Year to 31 March 2005 2,020– dividends paid (500) 4,510

–––––– –––––––7,110

Non-current liabilities10% loan note (issued 2002) 500Deferred tax (note (vi)) 280 780

––––––

Current liabilitiesTrade payables 4,130

–––––––12,020–––––––

4



The company policy for ALL depreciation is that it is charged to cost of sales and a full year’s charge is made in theyear of acquisition or completion and none in the year of disposal.

The following matters are relevant:

(i) Included in sales revenue is $300,000 being the sale proceeds of an item of plant that was sold in January2005. The plant had originally cost $900,000 and had been depreciated by $630,000 at the date of its sale.Other than recording the proceeds in sales and cash, no other accounting entries for the disposal of the planthave been made. All plant is depreciated at 25% per annum on the reducing balance basis.

(ii) On 31 December 2004 the company completed the construction of a new warehouse. The construction wasachieved using the company’s own resources as follows:

$000purchased materials 150direct labour 800supervision 65design and planning costs 20

Included in the above figures are $10,000 for materials and $25,000 for labour costs that were effectively lostdue to the foundations being too close to a neighbouring property. All the above costs are included in cost ofsales. The building was brought into immediate use on completion and has an estimated life of 20 years (straight-line depreciation).

(iii) Details of the other property, plant and equipment at 31 March 2005 are:$000 $000

Land at cost 1,000Buildings at cost 4,000Less accumulated depreciation at 31 March 2004 (800) 3,200

––––––Plant at cost 5,200Less accumulated depreciation at 31 March 2004 (3,130) 2,070

–––––– ––––––6,270

––––––

At the beginning of the current year (1 April 2004), Harrington had an open market basis valuation of itsproperties (excluding the warehouse in note (ii) above). Land was valued at $1·2 million and the property at$4·8 million. The directors wish these values to be incorporated into the financial statements. The properties hadan estimated remaining life of 20 years at the date of the valuation (straight-line depreciation is used). Harringtonmakes a transfer to realised profits in respect of the excess depreciation on revalued assets. Note: depreciation for the year to 31 March 2005 has not yet been accounted for in the draft financialstatements.

(iv) The investments are in quoted companies that are carried at their stock market values with any gains and lossesrecorded in the income statement. The value shown in the balance sheet is that at 31 March 2004 and duringthe year to 31 March 2005 the investments have risen in value by an average of 10%. Harrington has notreflected this increase in its financial statements.

(v) On 1 October 2004 there had been a fully subscribed rights issue of 1 for 4 at 60c. This has been recorded inthe above balance sheet.

(vi) Income tax on the profits for the year to 31 March 2005 is estimated at $260,000. The figure in the incomestatement is the underprovision for income tax for the year to 31 March 2004. The carrying value of Harrington’snet assets is $1·4 million more than their tax base at 31 March 2005. The income tax rate is 25%.

Required:

(a) Prepare a restated income statement for the year to 31 March 2005 reflecting the information in notes (i)to (vi) above. (9 marks)

(b) Prepare a statement of changes in equity for the year to 31 March 2005. (6 marks)

(c) Prepare a restated balance sheet at 31 March 2005 reflecting the information in notes (i) to (vi) above.(10 marks)

(25 marks)

5 [P.T.O.



3 (a) IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ was issued in June 2003. Its mainobjectives are to ensure high quality information that is transparent and comparable over all periods presentedand to provide a starting point for subsequent accounting under International Financial Reporting Standards(IFRS) within the framework of a cost benefit exercise.

Required:(i) Describe the circumstances where the presentation of an entity’s financial statements is deemed to be

the first-time adoption of IFRSs and explain the main financial reporting implementation issues to beaddressed in the transition to IFRSs. (7 marks)

(ii) Describe IFRS 1’s accounting requirements where an entity’s previous accounting policies for assets andliabilities do not comply with the recognition and measurement requirements of IFRSs. (8 marks)

(b) Transit, a publicly listed holding company, has a reporting date of 31 December each year. Its financialstatements include one year’s comparatives. Transit currently applies local GAAP accounting rules, but isintending to apply IFRSs for the first time in its financial statements (including comparatives) for the year ending31 December 2005. Its summarised consolidated balance sheet (under local GAAP) at 1 January 2004 is:

$000 $000Property, plant and equipment 1,000Goodwill 450Development costs 400

––––––1,850

Current assetsInventory 150Trade receivables 250Bank 20

––––––420

Current liabilities (320)––––––

Net current assets 100––––––1,950

Non-current liabilitiesRestructuring provision (250)Deferred tax (300) (550)

–––––– ––––––1,400

––––––Issued share capital 500Retained earnings 900

––––––1,400

––––––

6



Additional information:

(i) Transit’s depreciation policy for its property, plant and equipment has been based on tax rules set by itsgovernment. If depreciation had been based on the most appropriate method under IFRSs, the carrying value ofthe property, plant and equipment at 1 January 2004 would have been $800,000.

(ii) The development costs originate from an acquired subsidiary of Transit. They do not qualify for recognition underIFRSs. They have a tax base of nil and the deferred tax related to these costs is $100,000.

(iii) The inventory has been valued at prime cost. Under IFRSs it would include an additional $30,000 of overheads.

(iv) The restructuring provision does not qualify for recognition under IFRSs.

(v) Based on IFRSs, the deferred tax provision required at 1 January 2004, including the effects of the developmentexpenditure, is $360,000.

Required:

Prepare a summarised balance sheet for Transit at the date of transition to IFRSs (1 January 2004) applying therequirements of IFRS 1 to the above items.

Note: a reconciliation to previous GAAP is not required. (10 marks)

(25 marks)

7 [P.T.O.



8

4 (a) Casino is a publicly listed company. Details of its balance sheets as at 31 March 2005 and 2004 are shownbelow together with other relevant information:

Balance Sheet as at 31 March 2005 31 March 2004Non-current Assets (note (i)) $m $m $m $mProperty, plant and equipment 880 760Intangible assets 400 510

–––––– ––––––1,280 1,270

Current assetsInventory 350 420Trade receivables 808 372Interest receivable 5 3Short term deposits 32 120Bank 15 1,210 75 990

–––––– –––––– –––––– ––––––Total assets 2,490 2,260

–––––– ––––––Share Capital and ReservesOrdinary Shares of $1 each 300 200ReservesShare premium 60 nilRevaluation reserve 112 45Retained earnings 1,098 1,270 1,165 1,210

–––––– –––––– –––––– ––––––1,570 1,410

Non-current liabilities12% loan note nil 1508% variable rate loan note 160 nilDeferred tax 90 250 75 225

–––––– ––––––

Current liabilitiesTrade payables 530 515Bank overdraft 125 nilTaxation 15 110

670 625––––––––––––

––––––––––––

Total equity and liabilities 2,490 2,260–––––– ––––––

The following supporting information is available:

(i) Details relating to the non-current assets are:

Property, plant and equipment at:31 March 2005 31 March 2004

Carrying CarryingCost/Valuation Depreciation value Cost/Valuation Depreciation value

$m $m $m $m $m $mLand and buildings 600 12 588 500 80 420Plant 440 148 292 445 105 340

–––– ––––880 760–––– ––––

Casino revalued the carrying value of its land and buildings by an increase of $70 million on 1 April 2004. On31 March 2005 Casino transferred $3 million from the revaluation reserve to retained earnings representing therealisation of the revaluation reserve due to the depreciation of buildings.

During the year Casino acquired new plant at a cost of $60 million and sold some old plant for $15 million ata loss of $12 million.

There were no acquisitions or disposals of intangible assets.



(ii) The following extract is from the draft income statement for the year to 31 March 2005:$m $m

Operating loss (32)Interest receivable 12Finance costs (24)

––––Loss before tax (44)Income tax repayment claim 14Deferred tax charge (15) (1)

–––– ––––Loss for the period (45)

––––

The finance costs are made up of:Interest expenses (16)Penalty cost for early redemption of fixed rate loan (6)Issue costs of variable rate loan (2)

––––(24)

––––

(iii) The short term deposits meet the definition of cash equivalents.

(iv) Dividends of $25 million were paid during the year.

Required:

As far as the information permits, prepare a cash flow statement for Casino for the year to 31 March 2005in accordance with IAS 7 ‘Cash Flow Statements’. (20 marks)

(b) In recent years many analysts have commented on a growing disillusionment with the usefulness and reliabilityof the information contained in some companies’ income statements.

Required:

Discuss the extent to which a company’s cash flow statement may be more useful and reliable than itsincome statement. (5 marks)

(25 marks)

9 [P.T.O.



5 Triangle, a public listed company, is in the process of preparing its draft financial statements for the year to 31 March2005. The following matters have been brought to your attention:

(i) On 1 April 2004 the company brought into use a new processing plant that had cost $15 million to constructand had an estimated life of ten years. The plant uses hazardous chemicals which are put in containers andshipped abroad for safe disposal after processing. The chemicals have also contaminated the plant itself whichoccurred as soon as the plant was used. It is a legal requirement that the plant is decontaminated at the end ofits life. The estimated present value of this decontamination, using a discount rate of 8% per annum, is$5 million. The financial statements have been charged with $1·5 million ($15 million/10 years) for plantdepreciation and a provision of $500,000 ($5 million/10 years) has been made towards the cost of thedecontamination. (8 marks)

(ii) On 15 May 2005 the company’s auditors discovered a fraud in the material requisitions department. A seniormember of staff who took up employment with Triangle in August 2004 had been authorising payments for goodsthat had never been received. The payments were made to a fictitious company that cannot be traced. Themember of staff was immediately dismissed. Calculations show that the total amount of the fraud to the date ofits discovery was $240,000 of which $210,000 related to the year to 31 March 2005. (Assume the fraud ismaterial). (5 marks)

(iii) The company has contacted its insurers in respect of the above fraud. Triangle is insured for theft, but theinsurance company maintains that this is a commercial fraud and is not covered by the theft clause in theinsurance policy. Triangle has not yet had an opinion from its lawyers. (4 marks)

(iv) On 1 April 2004 Triangle sold maturing inventory that had a carrying value of $3 million (at cost) to Factorall, afinance house, for $5 million. Its estimated market value at this date was in excess of $5 million. The inventorywill not be ready for sale until 31 March 2008 and will remain on Triangle’s premises until this date. The salecontract includes a clause allowing Triangle to repurchase the inventory at any time up to 31 March 2008 at aprice of $5 million plus interest at 10% per annum compounded from 1 April 2004. The inventory will incurstorage costs until maturity. The cost of storage for the current year of $300,000 has been included in tradereceivables (in the name of Factorall). If Triangle chooses not to repurchase the inventory, Factorall will pay theaccumulated storage costs on 31 March 2008. The proceeds of the sale have been debited to the bank and thesale has been included in Triangle’s sales revenue. (8 marks)

Required:

Explain how the items in (i) to (iv) above should be treated in Triangle’s financial statements for the year to 31 March 2005 in accordance with current international accounting standards. Your answer should quantify theamounts where possible.

The mark allocation is shown against each of the four matters above.

(25 marks)


10



Answers



13

Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) June 2005 Answers

1 (a) (i) Goodwill calculation $m $mInvestments at cost Cash consideration (80 x 75% x $3·50) 210Deferred consideration (see below) 100

––––310

LessOrdinary shares (75% x 80) 60Share premium (75% x 40) 30Pre acq profit (see working) 87Fair value adjustments: brand (75% x 40) 30

land and buildings (75% x 20) 15 (222)–––– ––––

Goodwill on acquisition 88Impairment at 31 March 2005 (from question) (22)

––––Goodwill at 31 March 2005 66

––––

The deferred consideration of $108 million must be discounted for one year at a cost of capital of 8% to $100 million(108/1·08). The $8 million difference is the finance charge in the year to 31 March 2005 (see (iii)).

Although the internally generated brand cannot be recognised in Samson’s entity financial statements, it should berecognised in the consolidated balance sheet on the acquisition of Samson. This is because the method given in thequestion is an acceptable method of valuation and thus the brand can be ‘reliably measured’. The fair value adjustment for Samson’s land and buildings on acquisition is $20 million. The subsequent increase invalue of $4 million in the year to 31 March 2005 is treated as a revaluation. The minority interest in the fair value adjustments and revaluation is $16 million (25% of (24 + 40)) see below.

(ii) Minority interest $m $mOrdinary shares (25% x 80) 20Share premium (25% x 40) 10Retained earnings (see working) 41Fair values (see (i) above) 16

––––87

––––

(iii) Consolidated reserves:Share premium: Highveldt only 80

Revaluation reserve: (45 + (75% x 4)) 48

Retained earningsHighveldt – from question 350Post acq profit of Samson (see working) 36Interest receivable (see below) 6

––––392

Finance cost on deferred consideration (see (i) above) 8Impairment of goodwill 22 (30)

–––– ––––Retained earnings in consolidated balance sheet 362

––––

The intra group interest has not been recorded by Highveldt. To do so it would credit interest receivable (which increasesthe profit for the year) and debit cash (in transit).

Working (Note: all figures in $million)The pre and post acquisition profits of Samson are calculated as follows:

Pre Post at 31 March 2005Per question 134 76Apportionment of development costs (18) (22)URP in inventory (6/3) (2)Amortisation of brand (40/10 years) (4)

–––– ––––116 48 164–––– –––– ––––

Therefore minority interest is 25% x 164 = 41Pre acquisition earnings are 75% x 116 = 87Post acquisition earnings are 75% x 48 = 36



14

(b) The objective of consolidated financial statements is to show the financial performance and position of the group as if it wasa single economic entity. There is a view that, as the entity financial statements of the parent company contain theinvestments in subsidiaries as non-current assets, they reflect the assets of the group as a whole. The more traditional viewis that entity financial statements do not provide users with sufficient information about subsidiaries for them to make areliable assessment of the performance of the group as a whole. The following illustrates benefits of consolidated financialstatements:

– they identify the nature and classification of the subsidiary’s assets. For example, the investment in a subsidiary may bealmost entirely in intangible assets or conversely they may be substantially land and buildings. Such a distinction is ofobvious importance to users.

– the amount of the subsidiary’s debt could not be assessed from the parent’s entity financial statements. In effect thesubsidiary’s assets and liabilities are netted off when it is shown as an investment. This means group liquidity and gearingcannot be properly assessed.

– the cost of the investment does not reflect the size of a company. For example a parent company may show an investmentin a subsidiary at a cost of $10 million. This may represent the purchase of a subsidiary that has $10 million of assets andno liabilities. Alternatively this could be a subsidiary that has $100 million in assets and $90 million of liabilities. Clearlythe latter subsidiary would be a much larger company than the former.

– the cost of the investment may be a fair representation of its value at the date of purchase, but with the passage of time(assuming the subsidiary is profitable), its value will increase. This increase would not be reflected in the original cost, butit would be reflected in the consolidated net assets of the subsidiary (and the increase in group reserves).

– the cost of the investment might represent all of the ownership of the subsidiary or only just over half of it i.e. there wouldbe no indication of the minority interest.

To summarise, in the absence of a consolidated balance sheet, users would have no information on the current value of asubsidiary, its size, the composition of its net assets and how much of it was owned by the group.

2 (a) Harrington:Restated income statement – Year to 31 March 2005 $000Sales revenues (13,700 – 300 plant sale proceeds) 13,400Cost of sales (w (i)) (8,910)

–––––––Gross profit 4,490Operating expenses (2,400)Investment income (1,320 – 1,200) 120Loan interest (25 + 25) (50)

––––––Profit before tax 2,160Income tax expense (55 + 260 + (350 – 280) deferred tax) (385)

––––––Profit for the period 1,775

––––––

(b) Statement of Changes in Equity – Year to 31 March 2005Retained Revaluation Ordinary Share TotalProfits reserve shares premium$000 $000 $000 $000 $000

At 1 April 2004 2,990 nil 1,600 40 4,630Rights issue (see below) 400 560 960Profit for period (see (a)) 1,775 1,775Revaluation of property (w (ii)) 1,800 1,800Transfer to realised profit 80 (80) nilOrdinary dividends paid (500) (500)

–––––– –––––– –––––– –––––– ––––––At 31 March 2005 4,345 1,720 2,000 600 8,665

–––––– –––––– –––––– –––––– ––––––

The number of 25c ordinary shares at the year end is 8 million ($2 million x 4). This is after a rights issue of 1 for 4. Thusthe number of shares prior to the issue would be 6·4 million (8 million x 4/5) and the rights issue would have been for 1·6 million shares. The rights issue price is 60c each which would be recorded as an increase in share capital of $400,000(1·6 million x 25c) and an increase in share premium of $560,000 (1·6 million x 35c).



(c) Balance Sheet as at 31 March 2005Non-current assets $000 $000Property, plant and equipment (6,710 + 1,350 (w (ii))) 8,060Investments (1,200 x 110%) 1,320

–––––––9,380

Current assets Inventory 1,750Trade receivables 2,450 Bank 350 4,550

–––––– –––––––Total assets 13,930

–––––––

Equity and liabilities:Ordinary shares of 25c each 2,000Reserves (see (b)):Share premium 600Revaluation reserve (w (ii)) 1,720Retained earnings (from (b)) 4,345 6,665

–––––– –––––––8,665

Non-current liabilities 10% loan note (issued 2002) 500Deferred tax (1,400 x 25%) 350 850

––––––

Current liabilitiesTrade payables 4,130Accrued loan interest ((500 x 10%) – 25 paid) 25Current tax payable 260 4,415

–––––– –––––––Total equity and liabilities 13,930

–––––––

Workings (all figures in $000):(i) Cost of sales:

per question 9,200profit on sale of plant ((900 – 630) – 300) (30)depreciation – plant (w (iii)) 450

– buildings (w (ii)) 290capitalised expenses net of error (w (ii)) (1,000)

––––––8,910

––––––

(ii) Land and buildings: cost/revaluation depreciationSelf constructed (see below) 1,000 50 (20 year life)Revalued 6,000 240 (see below)

–––––– –––––7,000 290

–––––– –––––

The carrying value of the land and buildings at 31 March 2005 is $6,710,000 (7,000 – 290).Depreciation on the building element will be $240 (4,800/20 years). The revaluation of the land and buildings will create arevaluation reserve initially of $1,800 (6,000 – (1,000 + (4,000 – 800)), however a transfer of $80 (1,600/20 buildingelement of the revaluation) to realised profit is required.

Self constructed asset:purchased materials 150direct labour 800supervision 65design and planning costs 20error in construction (10 + 25) (35)

––––––1,000

––––––

Note: the cost of the error cannot be capitalised; it must therefore be written off.

15



(iii) Plant cost depreciation carrying value31 March 2004

per balance sheet 5,200 3,130disposal (900) (630)

–––––– ––––––4,300 2,500 1,800

Depreciation for the current year will be $450,000 (25% reducing balance), giving a net book value at 31 March 2005of $1,350,000.

3 (a) (i) It is important to determine which financial statements constitute the first-time adoption of International FinancialReporting Standards (IFRSs) because IFRS 1 only applies to those financial statements. It does not apply to subsequentfinancial statements that are prepared under IFRSs as these must be prepared under the whole body of IFRSs (includingIASs). A first time adopter is an entity that makes an explicit and unreserved statement that its financial statementscomply with (all) IFRSs. Compliance with some, but not all, IFRSs is insufficient as is compliance with all IFRSs withoutthe inclusion of an explicit statement of compliance.The main issues to be addressed in the transition to IFRSs are:– deciding the date of transition.– selecting accounting policies that comply with IFRSs.– preparing (but not presenting) an opening balance sheet at the date of transition to IFRSs as a basis for subsequent

accounting. The date of transition to IFRSs is the beginning of the earliest comparative period. If the company’sreporting date for its first IFRS financial statements is say 31 December 2005 and it intends to disclose one year’scomparatives, then the date of transition is 1 January 2004.

– determining estimates of values for both the opening IFRS balance sheet and all other presented comparative balancesheets; and finally

– presenting IFRS financial statements (including the required disclosures relating to the transition).Note: some credit would be given for references to practical issues such as required changes to information systems andthe recruitment of personnel with IFRS experience.

(ii) When a company adopts IFRSs for the first time it must use the IFRSs that are in force at the reporting date. TheseIFRSs should be applied throughout all of the periods presented – normally two years. This means that comparativefinancial statements must comply with the IFRSs in force at the reporting date even if they were not in issue at the dateof the comparatives (or different from those that were in issue).The general principle is that the adoption of IFRSs should be applied retrospectively i.e. as if the entity had alwaysapplied each IFRS. This is contrary to the specific transitional requirements contained in some individual IFRSs (theyoften allow prospective application). More specifically an entity must:– recognise all assets and liabilities that fall to be recognised by IFRSs (e.g. IFRSs require deferred tax to be recognised

on a ‘full’ provision basis)– not recognise assets and liabilities if IFRSs do not permit their recognition (e.g. IFRSs do not permit ‘general’ provisions

to be made and some proposed dividends are not treated as liabilities)– reclassify certain items under IFRSs (e.g. convertible debt must be split between its equity and debt components under

IFRSs, but in some jurisdictions it may have been classed entirely as debt)– apply IFRS rules to measure the value of all recognised assets and liabilities. This may mean for example using a non-

discounted value to measure an item whereas under previous GAAP it may have been discounted– give specified reconciliations for equity and reported profits between previous GAAP and IFRSs, together with details

of any recognition or reversals of impairments when implementing first time reporting.The resulting adjustments arising from the above must be recognised directly in equity at the date of transition.The Standard contains some specific exemptions and exceptions to the above in the areas of values of property, plantand equipment, employee benefits, translation differences for net investments in foreign operations and derivativeinstruments. In essence the exemptions and exceptions allow the use of alternative value measures in limitedcircumstances and where the cost or effort required in determining the value measurements under IFRSs would beexcessive.The exemptions are permitted but not required and can be applied in full or individually, whereas exceptions (toretrospective application) are mandatory.A particularly important exemption is that the IFRS rules governing business combinations are not appliedretrospectively. However any intangible that was recognised under previous GAAP that cannot be recognised under IFRSsshould be reclassified as goodwill and the entity must test for impairment of goodwill at the date of transition.

16



(b) As Transit intends first-time adoption for the year ended 31 December 2005 and to disclose one year’s comparatives, thedate of transition to IFRSs is 1 January 2004.

Transit – summarised balance sheet at 1 January 2004$000 $000

Property, plant and equipment (w (i)) 800Goodwill (450 + 300 (w (ii))) 750Development costs (w (ii)) nil

––––––1,550

Current assetsInventory (150 + 30 (w (i))) 180Receivables 250Bank 20 450

–––––– ––––––Total assets 2,000

––––––

Issued share capital 500Retained earnings (w (v)) 820

––––––1,320

Current liabilitiesTrade and other payables 320

Non-current liabilitiesRestructuring provision (w (iii)) nilDeferred tax (w (iv)) 360

––––––Total equity and liabilities 2,000

––––––

In addition the goodwill will be tested for impairment and if there is any indication of impairment to the other identifiableassets, they too must be tested for impairment.

Workings (all figures in $000)(i) Property, plant and equipment and inventory are restated to their IFRS base valuations of $800,000 and $180,000

respectively.(ii) Acquired intangible assets that do not qualify for recognition under IFRSs must be reclassified as goodwill after allowing

for the effect of deferred tax. Thus an amount of $300 (400 – 100 re deferred tax) is transferred to goodwill and $100debited to deferred tax.

(iii) The restructuring provision does not qualify for recognition under IFRSs.(iv) Summarising the effect on deferred tax:

per question 300re development costs (100)

––––200

required balance (360)––––

charge to retained earnings (160)––––

(v) Summarising the effect on retained earnings:per question 900property, plant and equipment (200)inventory 30elimination of restructuring provision 250deferred tax (160)

––––820––––

17



4 (a) Cash Flow Statement of Casino for the Year to 31 March 2005:$m $m

Cash inflows from operating activitiesOperating loss (32)Adjustments for:Depreciation – buildings (w (i)) 12

– plant (w (ii)) 81– intangibles (510 – 400) 110

Loss on disposal of plant (from question) 12––––– 215

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

–––––Cash generated from operations (168)Interest paid (16)Income tax paid (w (iii)) (81)

–––––Net cash outflow from operating activities (265)

Cash flows from investing activitiesPurchase of – land and buildings (w (i)) (110)

– plant (w (ii)) (60)Sale of plant (w (ii)) 15Interest received (12 – 5 + 3) 10 (145)

–––––

Cash flows from financing activitiesIssue of ordinary shares (100 + 60) 160Issue of 8% variable rate loan (160 – 2 issue costs) 158Repayments of 12% loan (150 + 6 penalty) (156)Dividends paid (25) 137

––––– –––––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 activitiesas appropriate.

Workings (in $ million)(i) Land and buildings

net book value b/f 420revaluation gains 70depreciation for year (12)net book value c/f (588)

––––– difference is cash purchases (110)

–––––

(ii) Plant:cost b/f 445additions from question 60balance c/f (440)

––––– difference is cost of disposal 65loss on disposal (12)proceeds (15)

–––––difference accumulated depreciation of plant disposed of 38

–––––

depreciation b/f 105less – disposal (above) (38)depreciation c/f (148)

–––––charge for year (81)

–––––

18



19

(iii) Taxation:tax provision b/f (110)deferred tax b/f (75)income statement net charge (1)tax provision c/f 15deferred tax c/f 90

–––––difference is cash paid (81)

–––––

(iv) Revaluation reserve:balance b/f 45revaluation gains 70transfer to retained earnings (3)

–––––balance c/f 112

–––––

(v) Retained earnings:balance b/f 1,165loss 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 income statement has the effect of smoothing cash flows for reportingpurposes. This practice arose because interpreting ‘raw’ cash flows can be very difficult and the accruals process has theadvantage of helping users to understand the underlying performance of a company. For example if an item of plant with anestimated life of five years is purchased for $100,000, then in the cash flow statement for the five year period there wouldbe an outflow in year 1 of the full $100,000 and no further outflows for the next four years. Contrast this with the incomestatement 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 an income statement, however it isimportant to realise that profit is affected by many subjective items. This has led to accusations of profit manipulation orcreative accounting, hence the disillusionment of the usefulness of the income statement.Another example of the difficulty in interpreting cash flows is that counterintuitively a decrease in overall cash flows is notalways a bad thing (it may represent an investment in increasing capacity which would bode well for the future), nor is anincrease in cash flows necessarily a good thing (this may be from the sale of non-current assets because of the need to raisecash 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

subjective profits).– cash flows are an easy concept for users to understand, indeed many users misinterpret income statement 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 suspicionof profit manipulation or creative accounting.



20

5 (i) Future decontamination costs must be provided for in full at the time they become unavoidable. Where they are based onfuture values, they should be discounted to their present value (as has been done in this example). Rather than beingimmediately written off to the income statement, the decontamination costs are added to the cost of the related asset andamortised over the expected life of the asset. The current treatment of these costs by Triangle is incorrect. The depreciationcharge must be based on the full cost of the plant which must include the decontamination costs. Also an imputed financecost must be applied to the provision (often referred to as unwinding). Applying this, the extracts of the financial statementsof Triangle at 31 March 2005 would be:

Non-current assets $millionPlant at cost ($15 million + $5 million) 20·0Depreciation at 10% per annum (2·0)

–––––18·0

–––––Non-current liabilitiesProvision 5·0Accrued finance costs 0·4

–––––5·4

–––––Income statementDepreciation 2·0Accrued finance costs ($5 million x 8%) 0·4

(ii) This is an example of an adjusting event after the balance sheet date. To some extent the figures in the draft financialstatements already reflect the effects of the fraud (up to the amount at the year end i.e. $210,000) in that presumably thecost of the materials paid for are included in cost of sales. However, the financial statements are incorrect in their presentation.As the fraud is considered material, $210,000 should be removed from the cost of sales and included as an income statementoperating expense (perhaps with separate disclosure). This will affect the gross profit and other ratios, though it will not affectthe net profit. The further costs beyond the year end of $30,000 should be noted as a non-adjusting event (if material in theirown right).

(iii) Triangle is of the opinion that the cost of the fraud may be covered by an insurance claim. However the insurance companyis disputing the claim. This appears to be a contingent asset. If a contingent asset is probable it should be noted in thefinancial statements. However if it is only possible, it should be ignored. As this claim is at an early stage and the companyhas not yet sought a legal opinion, it would be premature to consider the claim probable. In these circumstances thecontingent asset should be ignored and the financial statements will be unaffected.

(iv) Although this transaction has been treated as a sale, this is probably not its substance. The clause allowing Triangle torepurchase the inventory makes this a sale and repurchase agreement. Assuming Triangle acts rationally it will repurchasethe inventory if its retail value at 31 March 2008 is more than $7,320,500 ($5 million plus compound interest at 10% forfour years) plus the accumulated storage costs (as these can be recovered from Factorall in the event that the inventory is notrepurchased). There is no indication in the question as to what the inventory is likely to be worth on 31 March 2008.However it is unlikely that a finance company will really want to acquire this inventory (it is not its normal line of business)and thus it would not have entered into the contract unless it believed Triangle would repurchase the inventory. If the aboveis correct the substance of the transaction is that it is a secured loan rather than a sale. The required adjustments wouldtherefore be:– Remove $5 million from sales (debit) and treat this as a long term (4 year) loan.– Remove $3 million from cost of sales and treat this as inventory.– The receivable for the storage cost should be removed from trade receivables and added to the cost of the inventory.– Accrued interest of $500,000 ($5 million x 10%) should be charged to the income statement and added to the carrying

value of the loan.



Part 2 Examination – Paper 2.5 (INT)Financial Reporting (International Stream) June 2005 Marking Scheme


1 (a) (i) goodwill Marks– consideration given 2– share capital and premium 1– pre acq profit 2– fair value adjustments 2– goodwill impairment 1

–––maximum 8

(ii) minority interest– share capital and premium 1– retained earnings 2– fair value adjustment 1

–––maximum 4

(iii) consolidated reserves– share premium 1– revaluation reserve 2retained earnings– post acq profit 2– interest receivable 1– finance cost 1– goodwill impairment 1

–––maximum 8


2 (a) Restated income statementsales revenue 1cost of sales 5operating expenses 1investment income 1loan interest 1income tax 2


(b) statement of changes in equitybrought forward figures 1rights issue 1(restated) profit for the financial year 1surplus on land and buildings 2transfer to realised profits 1dividend paid 1


21



Marks(c) Balance sheet

land and buildings 1plant 1investments 1inventory and trade receivables 1bank and trade payables 1accrued loan interest 1current tax 110% loan note 1deferred tax 1share capital and premium 1revaluation reserve 1retained earnings 1


3 (a) (i) one mark per valid point to max 7(ii) one mark per valid point to max 8

(b) Property, plant and equipment 1development costs/goodwill 3inventory 1retained earnings 3restructuring provision eliminated 1deferred tax 2


4 (a) cash flows from operating activitiesoperating loss 1depreciation and loss on sale adjustments 4working capital items 3interest paid 1income tax 2investing activities 7financing 1 mark per item 4cash and cash equivalents b/f and c/f 1



22



23

Marks5 (i) explanation of treatment of provision 2

cost of plant at $20 million 1revised depreciation 1provision initially at $5 million 1increase by finance cost 1income statement charges 1 each 2

maximum 8

(ii) an example of an adjusting event 1no overall effect on profit, but presentation incorrect 1remove from cost of sales and show as an expense 1$30,000 is a non-adjusting event if material 1disclose as a note to the financial statements 1

maximum 5

(iii) due to the dispute this is an example of a contingent asset 1describe the treatment of contingent assets 1not probable therefore ignore, financial statements unchanged 2

maximum 4

(iv) identify it as a sale and repurchase agreement (or financing arrangement) 1substance is not likely to be a sale 1will repurchase if value is more than $7,320,500 plus storage costs 2business of Factorall is financing therefore terms likely to favour repurchase 1adjustments to – sales/loan; cost of sales/inventory; 2

– trade receivables/inventory (re storage costs); accrued finance costs/loan 2available 9maximum 8





PART 2


QUESTION PAPER







Pape

r 2.5

(IN

T)





1 Hedra, a public listed company, acquired the following investments:

(i) On 1 October 2004, 72 million shares in Salvador for an immediate cash payment of $195 million. Hedra agreedto pay further consideration on 30 September 2005 of $49 million if the post acquisition profits of Salvadorexceeded an agreed figure at that date. Hedra has not accounted for this deferred payment as it did not believeit would be payable, however Salvador’s profits have now exceeded the agreed amount (ignore discounting).Salvador also accepted a $50 million 8% loan from Hedra at the date of its acquisition.

(ii) On 1 April 2005, 40 million shares in Aragon by way of a share exchange of two shares in Hedra for eachacquired share in Aragon. The stock market value of Hedra’s shares at the date of this share exchange was$2·50. Hedra has not yet recorded the acquisition of the investment in Aragon.

The summarised balance sheets of the three companies as at 30 September 2005 are:Hedra Salvador Aragon

Non-current Assets $m $m $m $m $m $mProperty, plant and equipment 358 240 270Investments – in Salvador 245 nil nil

– other 45 nil nil–––– –––– ––––648 240 270

Current AssetsInventories 130 80 110Trade receivables 142 97 70Cash and bank nil 272 4 181 20 200

–––– –––– –––– –––– –––– ––––Total assets 920 421 470

–––– –––– ––––

Equity and liabilitiesOrdinary share capital ($1 each) 400 120 100Reserves:Share premium 40 50 nilRevaluation 15 nil nilRetained earnings 240 295 60 110 300 300

–––– –––– –––– –––– –––– ––––695 230 400

Non-current liabilities8% loan note nil 50 nilDeferred tax 45 45 nil 50 nil nil

–––– –––– ––––

Current liabilitiesTrade payables 118 141 40Bank overdraft 12 nil nilCurrent tax payable 50 180 nil 141 30 70

–––– –––– –––– –––– –––– ––––Total equity and liabilities 920 421 470

–––– –––– ––––


(a) Fair value adjustments and revaluations:

(i) Hedra’s accounting policy for land and buildings is that they should be carried at their fair values. The fairvalue of Salvador’s land at the date of acquisition was $20 million in excess of its carrying value. By 30 September 2005 this excess had increased by a further $5 million. Salvador’s buildings did not requireany fair value adjustments. The fair value of Hedra’s own land and buildings at 30 September 2005 was$12 million in excess of its carrying value in the above balance sheet.

(ii) The fair value of some of Salvador’s plant at the date of acquisition was $20 million in excess of its carryingvalue and had a remaining life of four years (straight-line depreciation is used).

2



(iii) At the date of acquisition Salvador had unrelieved tax losses of $40 million from previous years. Salvadorhad not accounted for these as a deferred tax asset as its directors did not believe the company would besufficiently profitable in the near future. However, the directors of Hedra were confident that these losseswould be utilised and accordingly they should be recognised as a deferred tax asset. By 30 September 2005the group had not yet utilised any of these losses. The income tax rate is 25%.

(b) The retained earnings of Salvador and Aragon at 1 October 2004, as reported in their separate financialstatements, were $20 million and $200 million respectively. All profits are deemed to accrue evenly throughoutthe year.

(c) An impairment test on 30 September 2005 showed that consolidated goodwill should be written down by $20 million. Hedra has applied IFRS 3 Business combinations since the acquisition of Salvador.

(d) The investment in Aragon has not suffered any impairment.

Required:

Prepare the consolidated balance sheet of Hedra as at 30 September 2005.

(25 marks)

3 [P.T.O.




2 The following trial balance relates to Petra, a public listed company, at 30 September 2005:

$’000 $’000Revenue (note (i)) 197,800Cost of sales (note (i)) 114,000Distribution costs 17,000Administration expenses 18,000Loan interest paid 1,500Ordinary shares of 25 cents each fully paid 40,000Share premium 12,000Retained earnings 1 October 2004 34,0006% Redeemable loan note (issued in 2003) 50,000Land and buildings at cost ((land element $40 million) note (ii)) 100,000Plant and equipment at cost (note (iii)) 66,000Deferred development expenditure (note (iv)) 40,000Accumulated depreciation at 1 October 2004 – buildings 16,000

– plant and equipment 26,000Accumulated amortisation of development expenditure at 1 October 2004 8,000Income tax (note (v)) 1,000Deferred tax (note (v)) 15,000Trade receivables 24,000Inventories – 30 September 2005 21,300Cash and bank 11,000Trade payables 15,000

–––––––– ––––––––413,800 413,800–––––––– ––––––––


(i) Included in revenue is $12 million for receipts that the company’s auditors have advised are commission sales.The costs of these sales, paid for by Petra, were $8 million. $3 million of the profit of $4 million was attributableto and remitted to Sharma (the auditors have advised that Sharma is the principal for these transactions). Boththe $8 million cost of sales and the $3 million paid to Sharma have been included in cost of sales.

(ii) The buildings had an estimated life of 30 years when they were acquired and are being depreciated on thestraight-line basis.

(iii) Included in the trial balance figures for plant and equipment is plant that had cost $16 million and hadaccumulated depreciation of $6 million. Following a review of the company’s operations this plant was madeavailable for sale during the year. Negotiations with a broker have concluded that a realistic selling price of thisplant will be $7·5 million and the broker will charge a commission of 8% of the selling price. The plant had notbeen sold by the year end. Plant is depreciated at 20% per annum using the reducing balance method.Depreciation of buildings and plant is charged to cost of sales.

(iv) The development expenditure relates to the capitalised cost of developing a product called the Topaz. It had anoriginal estimated life of five years. Production and sales of the Topaz started in October 2003. A review of thesales of the Topaz in late September 2005, showed them to be below forecast and an impairment test concludedthat the fair value of the development costs at 30 September 2005 was only $18 million and the expected periodof future sales (from this date) was only a further two years.

(v) The balance on the income tax account in the trial balance is the under-provision in respect of the income taxliability for the year ended 30 September 2004. The directors have estimated the provision for income tax for theyear ended 30 September 2005 to be $4 million and the required balance sheet provision for deferred tax at30 September 2005 is $17·6 million.

4



Required:

Prepare for Petra:

(a) An income statement for the year ended 30 September 2005; and (10 marks)

(b) A balance sheet as at 30 September 2005. (10 marks)

Note: A statement of changes in equity is NOT required. Disclosure notes are NOT required.

(c) The directors hold options to purchase 24 million shares for a total of $7·2 million. The options were grantedtwo years ago and have been correctly accounted for. The options do not affect your answer to (a) and (b) above.The average stock market value of Petra’s shares for the year ended 30 September 2005 can be taken as 90 cents per share.

Required:

A calculation of the basic and diluted earnings per share for the year ended 30 September 2005(comparatives are not required). (5 marks)

(25 marks)

5 [P.T.O.



3 (a) IAS 36 Impairment of assets was issued in June 1998 and subsequently amended in March 2004. Its mainobjective is to prescribe the procedures that should ensure that an entity’s assets are included in its balance sheetat no more than their recoverable amounts. Where an asset is carried at an amount in excess of its recoverableamount, it is said to be impaired and IAS 36 requires an impairment loss to be recognised.

Required:

(i) Define an impairment loss explaining the relevance of fair value less costs to sell and value in use; andstate how frequently assets should be tested for impairment; (6 marks)

Note: your answer should NOT describe the possible indicators of an impairment.

(ii) Explain how an impairment loss is accounted for after it has been calculated. (5 marks)

(b) The assistant financial controller of the Wilderness group, a public listed company, has identified the mattersbelow which she believes may indicate an impairment to one or more assets:

(i) Wilderness owns and operates an item of plant that cost $640,000 and had accumulated depreciation of$400,000 at 1 October 2004. It is being depreciated at 121/2% on cost. On 1 April 2005 (exactly half waythrough the year) the plant was damaged when a factory vehicle collided into it. Due to the unavailability ofreplacement parts, it is not possible to repair the plant, but it still operates, albeit at a reduced capacity. Alsoit is expected that as a result of the damage the remaining life of the plant from the date of the damage willbe only two years. Based on its reduced capacity, the estimated present value of the plant in use is$150,000. The plant has a current disposal value of $20,000 (which will be nil in two years’ time), butWilderness has been offered a trade-in value of $180,000 against a replacement machine which has a costof $1 million (there would be no disposal costs for the replaced plant). Wilderness is reluctant to replace theplant as it is worried about the long-term demand for the product produced by the plant. The trade-in valueis only available if the plant is replaced.

Required:

Prepare extracts from the balance sheet and income statement of Wilderness in respect of the plant forthe year ended 30 September 2005. Your answer should explain how you arrived at your figures.

(7 marks)

(ii) On 1 April 2004 Wilderness acquired 100% of the share capital of Mossel, whose only activity is theextraction and sale of spa water. Mossel had been profitable since its acquisition, but bad publicity resultingfrom several consumers becoming ill due to a contamination of the spa water supply in April 2005 has ledto unexpected losses in the last six months. The carrying amounts of Mossel’s assets at 30 September 2005are:

$’000Brand (Quencher – see below) 7,000Land containing spa 12,000Purifying and bottling plant 8,000Inventories 5,000

–––––––32,000–––––––

The source of the contamination was found and it has now ceased.

The company originally sold the bottled water under the brand name of ‘Quencher’, but because of thecontamination it has rebranded its bottled water as ‘Phoenix’. After a large advertising campaign, sales arenow starting to recover and are approaching previous levels. The value of the brand in the balance sheet isthe depreciated amount of the original brand name of ‘Quencher’.

The directors have acknowledged that $1·5 million will have to be spent in the first three months of the nextaccounting period to upgrade the purifying and bottling plant.

Inventories contain some old ‘Quencher’ bottled water at a cost of $2 million; the remaining inventories arelabelled with the new brand ‘Phoenix’. Samples of all the bottled water have been tested by the healthauthority and have been passed as fit to sell. The old bottled water will have to be relabelled at a cost of$250,000, but is then expected to be sold at the normal selling price of (normal) cost plus 50%.

6



Based on the estimated future cash flows, the directors have estimated that the value in use of Mossel at30 September 2005, calculated according to the guidance in IAS 36, is $20 million. There is no reliableestimate of the fair value less costs to sell of Mossel.

Required:

Calculate the amounts at which the assets of Mossel should appear in the consolidated balance sheetof Wilderness at 30 September 2005. Your answer should explain how you arrived at your figures.

(7 marks)

(25 marks)

7 [P.T.O.



4 The following draft financial statements relate to Tabba, a private company.

Balance sheets as at: 30 September 2005 30 September 2004$’000 $’000 $’000 $’000

Tangible non-current assets (note (ii)) 10,600 15,800Current assetsInventories 2,550 1,850Trade receivables 3,100 2,600Insurance claim (note (iii)) 1,500 1,200Cash and bank 850 8,000 nil 5,650

–––––– ––––––– –––––– –––––––Total assets 18,600 21,450

––––––– –––––––

Equity and liabilitiesShare capital ($1 each) 6,000 6,000Reserves:Revaluation (note (ii)) nil 1,600Retained earnings 2,550 2,550 850 2,450

–––––– ––––––– –––––– –––––––8,550 8,450

Non-current liabilitiesFinance lease obligations (note (ii)) 2,000 1,7006% loan notes 800 nil10% loan notes nil 4,000Deferred tax 200 500Government grants (note (ii)) 1,400 4,400 900 7,100

–––––– ––––––

Current liabilitiesBank overdraft nil 550Trade payables 4,050 2,950Government grants (note (ii)) 600 400Finance lease obligations (note (ii)) 900 800Current tax payable 100 5,650 1,200 5,900

–––––– ––––––– –––––– –––––––Total equity and liabilities 18,600 21,450

––––––– –––––––


(i) Income statement extract for the year ended 30 September 2005:$’000

Operating profit before interest and tax 270Interest expense (260)Interest receivable 40

––––Profit before tax 50Net income tax credit 50

––––Profit for the period 100

––––

Note: the interest expense includes finance lease interest.

(ii) The details of the tangible non-current assets are:Cost Accumulated depreciation Carrying value

$’000 $000 $’000At 30 September 2004 20,200 4,400 15,800At 30 September 2005 16,000 5,400 10,600

8



During the year Tabba sold its factory for its fair value $12 million and agreed to rent it back, under an operatinglease, for a period of five years at $1 million per annum. At the date of sale it had a carrying value of $7·4 millionbased on a previous revaluation of $8·6 million less depreciation of $1·2 million since the revaluation. The profiton the sale of the factory has been included in operating profit. The surplus on the revaluation reserve relatedentirely to the factory. No other disposals of non-current assets were made during the year.

Plant acquired under finance leases during the year was $1·5 million. Other purchases of plant during the yearqualified for government grants of $950,000.

Amortisation of government grants has been credited to cost of sales.

(iii) The insurance claim relates to flood damage to the company’s inventories which occurred in September 2004.The original estimate has been revised during the year after negotiations with the insurance company. The claimis expected to be settled in the near future.

Required:

(a) Prepare a cash flow statement using the indirect method for Tabba in accordance with IAS 7 Cash flowstatements for the year ended 30 September 2005. (17 marks)

(b) Using the information in the question and your cash flow statement, comment on the change in the financialposition of Tabba during the year ended 30 September 2005. (8 marks)

Note: you are not required to calculate any ratios.

(25 marks)

9 [P.T.O.



5 (a) Elite Leisure is a private limited liability company that operates a single cruise ship. The ship was acquired on 1 October 1996. Details of the cost of the ship’s components and their estimated useful lives are:

component original cost ($million) depreciation basisship’s fabric (hull, decks etc) 300 25 years straight-linecabins and entertainment area fittings 150 12 years straight-linepropulsion system 100 useful life of 40,000 hours

At 30 September 2004 no further capital expenditure had been incurred on the ship.

In the year ended 30 September 2004 the ship had experienced a high level of engine trouble which had costthe company considerable lost revenue and compensation costs. The measured expired life of the propulsionsystem at 30 September 2004 was 30,000 hours. Due to the unreliability of the engines, a decision was takenin early October 2004 to replace the whole of the propulsion system at a cost of $140 million. The expected lifeof the new propulsion system was 50,000 hours and in the year ended 30 September 2005 the ship had usedits engines for 5,000 hours.

At the same time as the propulsion system replacement, the company took the opportunity to do a limitedupgrade to the cabin and entertainment facilities at a cost of $60 million and repaint the ship’s fabric at a costof $20 million. After the upgrade of the cabin and entertainment area fittings it was estimated that their remaininglife was five years (from the date of the upgrade). For the purpose of calculating depreciation, all the work on theship can be assumed to have been completed on 1 October 2004. All residual values can be taken as nil.

Required:

Calculate the carrying amount of Elite Leisure’s cruise ship at 30 September 2005 and its relatedexpenditure in the income statement for the year ended 30 September 2005. Your answer should explainthe treatment of each item. (12 marks)

(b) Related party relationships are a common feature of commercial life. The objective of IAS 24 Related partydisclosures is to ensure that financial statements contain the necessary disclosures to make users aware of thepossibility that financial statements may have been affected by the existence of related parties.

Required:

(i) Describe the main circumstances that give rise to related parties. (4 marks)

(ii) Explain why the disclosure of related party relationships and transactions may be important.(3 marks)

(iii) Hideaway is a public listed company that owns two subsidiary company investments. It owns 100% of theequity shares of Benedict and 55% of the equity shares of Depret. During the year ended 30 September2005 Depret made several sales of goods to Benedict. These sales totalled $15 million and had cost Depret$14 million to manufacture. Depret made these sales on the instruction of the Board of Hideaway. It isknown that one of the directors of Depret, who is not a director of Hideaway, is unhappy with the parentcompany’s instruction as he believes the goods could have been sold to other companies outside the groupat the far higher price of $20 million. All directors within the group benefit from a profit sharing scheme.

Required:

Describe the financial effect that Hideaway’s instruction may have on the financial statements of thecompanies within the group and the implications this may have for other interested parties. (6 marks)

(25 marks)


10



Answers




1 Consolidated balance sheet of Hedra as at 30 September 2005:$m $m

Non-current assetsProperty, plant and equipment (358 + 240 + 12 + 20 + 5 +15 (w (iv))) 650Goodwill (100 – 20 (w (i))) 80Investment in associate (w (v)) 220Other investments 45

––––––995

Current AssetsInventories (130 + 80) 210Trade receivables (142 + 97) 239Cash and bank 4 453

–––– ––––––Total assets 1,448

––––––

Equity and liabilitiesEquity attributable to the parentOrdinary share capital (400 + 80 (w (v))) 480Reserves:Share premium (40 + 120 (w (v))) 160Revaluation (15 + 12 + (5 x 60%) (w (iv))) 30Retained earnings (w (ii)) 261 451

–––– ––––––931

Minority interest (w (iii)) 112––––––1,043

Non-current liabilitiesDeferred tax (45 – 10) 35

Current liabilitiesBank overdraft 12Trade payables (118 + 141) 259Deferred consideration (w (i)) 49Current tax payable 50 370

–––– ––––––Total equity and liabilities 1,448

––––––

Workings – Note: all working figures in $million.The investment in Salvador represents 60% (72/120) of its equity and is likely to give Hedra control thus Salvador should beconsolidated as a subsidiary. The investment in Aragon represents 40% (40/100) of its equity. Normally this would give Hedrasignificant influence and Aragon would be classed as an associate that should be equity accounted.

(i) Cost of controlInvestment at cost – immediate 195 Ordinary shares 72

– deferred 49 Share premium (50 x 60%) 30Pre acq profit (w (ii)) 12Fair value adjustments (w (iv)) 30Goodwill 100

–––– ––––244 244–––– ––––

The deferred contingent consideration has now become payable and has to be accounted for.

(ii) Retained earningsHedra Salvador Hedra Salvador

Additional depreciation (w (iv)) 5 Per balance sheet 240 60Minority interest ((60 – 5) x 40%) 22 Post acq profit 21Pre-acq profit (20 x 60%) 12 Share of Aragon’s profitPost acq profit ((55 – 20) x 60%) 21 ((300 – 200) x 6/12 x 40%) 20Impairment of goodwill 20Balance c/f 261

–––– ––– –––– –––281 60 281 60–––– ––– –––– –––

13



(iii) Minority interestOrdinary shares (120 x 40%) 48Share premium (50 x 40%) 20Retained earnings (w (ii)) 22Fair value adjustments (w (iv)) 20

Balance c/f 112 Post acq revaluation (5 x 40% (w (iv))) 2–––– ––––112 112–––– ––––

(iv) Fair value adjustments/revaluationLand and buildings 20Plant 20Deferred tax asset (40 x 25%) 10

–––50

–––Group share (60%) 30Minority share (40%) 20

The increase in the fair value of the land at the date of acquisition is accounted for as a fair value adjustment. The increaseof a further $5 million in the year ended 30 September 2005 is a revaluation increase (accounted for as 60% to the grouprevaluation reserve and 40% to minority interest).

The fair value adjustment of $20 million to plant will be realised evenly over the next four years in the form of additionaldepreciation at $5 million per annum. In the year ended 30 September 2005 the effect on the consolidated financialstatements is that $5 million will be charged to Salvador’s profit (as additional depreciation); and a net $15 million added tothe carrying value of the plant.

(v) Investment in associate:Investment at cost (100 x 40% x 2 x $2·50) 200Share of post acquisition profit (100 x 6/12 x 40%) 20

––––220––––

The purchase consideration by way of a share exchange (80 million in Hedra for 40 million in Aragon) would be recorded asan increase in share capital of $80 million ($1 nominal value) and an increase in share premium of $120 million (80 x$1·50).

2 (a) Petra – Income statement for the year ended 30 September 2005$’000

Revenue (197,800 – 12,000 (w (i))) 185,800Cost of sales (w (ii)) (128,100)

––––––––Gross profit 57,700Other income – commission received (w (i)) 1,000

––––––––58,700

Distribution costs (17,000)Administration expenses (18,000)Interest expense (1,500 + 1,500) (3,000)

––––––––Profit before tax 20,700Income tax expense (4,000 +1,000 + (17,600 – 15,000)) (7,600)

––––––––Profit for the period 13,100

––––––––

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(b) Petra – Balance sheet as at 30 September 2005

Non-current assets (w (iii)) cost acc depn carrying amount$’000 $’000 $’000

Property, plant and equipment 150,000 44,000 106,000Development costs 40,000 22,000 18,000

–––––––– ––––––– ––––––––190,000 66,000 124,000–––––––– –––––––

Current assetsInventories 21,300Trade receivables 24,000Bank 11,000Held for sale assets – plant (w (iii)) 6,900 63,200

–––––––– ––––––––Total assets 187,200

––––––––

Equity and liabilities:Ordinary shares of 25c each 40,000Reserves:Share premium 12,000Retained earnings (34,000+ 13,100) 47,100 59,100

––––––– ––––––––99,100

Non-current liabilities6% loan note 50,000Deferred tax 17,600 67,600

–––––––

Current liabilitiesTrade payables 15,000Accrued interest 1,500Current tax payable 4,000 20,500


––––––––

(c) Basic EPS:A nominal value of 25c per share would mean that the $40 million share capital represented 160 million shares. The basicEPS would thus be 8·2 cents ($13·1 million /160 million shares)

Diluted EPS:The existence of the directors’ share options requires the disclosure of a diluted EPS. The dilution effect of the options is:Proceeds from options when exercised $7·2 million. This is equivalent to buying 8 million shares at full market value (7·2 million/90c). Thus the dilutive number of shares is 16 million (24 million – 8 million).

Diluted EPS is 7·4 cents ($13·1 million /(160 + 16 million shares))

Workings (figures in brackets are $’000)(i) Agency sales:

Petra has treated the sales it made on behalf of Sharma as its own sales. The advice from the auditors is that these areagency sales. Thus $12 million should be removed from revenue and the cost of the sales of $8 million and the $3 million ‘share’ of profit to Sharma should also be removed from cost of sales. Petra should only recognise thecommission of $1 million as income. The answer has included this as other income, but it would also be acceptable toinclude the commission in revenue.

(ii) Cost of sales: $’000Cost of sales (114,000 – (8,000 – 3,000) (w (i))) 103,000Depreciation (w (iii)) – buildings 2,000

– plant 6,000Amortisation (w (iii)) – development expenditure 8,000Impairment of development expenditure (w (iii)) 6,000Impairment of plant held for sale (w (iii)) 3,100

––––––––128,100––––––––

15



(iii) Non-current assets/depreciation:The buildings will have a depreciation charge of $2 million (100,000 – 40,000)/30 years) giving accumulateddepreciation at 30 September 2005 of $18 million (16,000 + 2,000). IFRS 5 Non-current assets held for sale and discontinued operations requires plant whose carrying amount will berecovered principally through sale (rather than use) to be classified as ‘held for sale’. It must be shown separately in thebalance sheet and carried at the lower of its carrying amount (when classified as for continuing use) and its fair valueless estimated costs to sell. Assets classified as held for sale should not be depreciated. Applying this:

cost depn at 1 Oct 2004 carrying value$’000 $’000 $’000

Plant and equipment per trial balance 66,000 26,000 40,000Plant held for sale (16,000) (6,000) (10,000)

–––––––– ––––––– ––––––––Plant held for continuing use 50,000 20,000 30,000Land and buildings 100,000 16,000 84,000

–––––––– ––––––– ––––––––Property, plant and equipment 150,000 36,000 114,000

–––––––– ––––––– ––––––––

The continuing use plant will have a depreciation charge of $6 million ((50,000 – 20,000) x 20%) giving accumulateddepreciation at 30 September 2005 of $26 million. The total accumulated depreciation for property, plant andequipment at 30 September 2005 will be $44 million (18,000 + 26,000).Plant held for sale must be valued at $6·9 million (7,500 selling price less commission of 600 (7,500 x 8%)) as thisis lower than its carrying amount of $10 million. Thus an impairment charge of $3·1 million is required for the plantheld for sale.Development expenditure:This has suffered an impairment as a result of disappointing sales. The impairment loss should be calculated aftercharging amortisation of $8 million (40,000/5 years) for the current year. Thus the impairment charge will be $6 million((40,000 – 16,000) – 18,000). The carrying amount of $18 million will then be written off over the next two years.

3 (a) (i) An impairment loss arises where the carrying amount of an asset is higher than its recoverable amount. The recoverableamount of an asset is defined in IAS 36 Impairment of assets as the higher of its fair value less costs to sell and itsvalue in use (fair value less cost to sell was previously referred to as net selling price). Thus an impairment loss is simplythe difference between the carrying amount of an asset and the higher of its fair value less costs to sell and its value inuse.

Fair value:The fair value could be based on the amount of a binding sale agreement or the market price where there is an activemarket. However many (used) assets do not have active markets and in these circumstances the fair value is based ona ‘best estimate’ approach to an arm’s length transaction. It would not normally be based on the value of a forced sale.In each case the costs to sell would be the incremental costs directly attributable to the disposal of the asset.

Value in use:The value in use of an asset is the estimated future net cash flows expected to be derived from the asset discounted toa present value. The estimates should allow for variations in the amount, timing and inherent risk of the cash flows. Amajor problem with this approach in practice is that most assets do not produce independent cash flows i.e. cash flowsare usually produced in conjunction with other assets. For this reason IAS 36 introduces the concept of a cash-generating unit (CGU) which is the smallest identifiable group of assets, which may include goodwill, that generates(largely) independent cash flows.

Frequency of testing for impairment:Goodwill and any intangible asset that is deemed to have an indefinite useful life should be tested for impairment atleast annually, as too should any intangible asset that has not yet been brought into use. In addition, at each balancesheet date an entity must consider if there has been any indication that other assets may have become impaired and,if so, an impairment test should be done. If there are no indications of impairment, testing is not required.

(ii) Once an impairment loss for an individual asset has been identified and calculated it is applied to reduce the carryingamount of the asset, which will then be the base for future depreciation charges. The impairment loss should be chargedto income immediately. However, if the asset has previously been revalued upwards, the impairment loss should first becharged to the revaluation surplus. The application of impairment losses to a CGU is more complex. They should firstbe applied to eliminate any goodwill and then to the other assets on a pro rata basis to their carrying amounts. However,an entity should not reduce the carrying amount of an asset (other than goodwill) to below the higher of its fair valueless costs to sell and its value in use if these are determinable.

(b) (i) The plant had a carrying amount of $240,000 on 1 October 2004. The accident that may have caused an impairmentoccurred on 1 April 2005 and an impairment test would be done at this date. The depreciation on the plant from 1 October 2004 to 1 April 2005 would be $40,000 (640,000 x 121/2% x 6/12) giving a carrying amount of $200,000at the date of impairment. An impairment test requires the plant’s carrying amount to be compared with its recoverableamount. The recoverable amount of the plant is the higher of its value in use of $150,000 or its fair value less costs tosell. If Wilderness trades in the plant it would receive $180,000 by way of a part exchange, but this is conditional onbuying new plant which Wilderness is reluctant to do. A more realistic amount of the fair value of the plant is its current

16



disposal value of only $20,000. Thus the recoverable amount would be its value in use of $150,000 giving animpairment loss of $50,000 ($200,000 – $150,000). The remaining effect on income would be that a depreciationcharge for the last six months of the year would be required. As the damage has reduced the remaining life to only twoyears (from the date of the impairment) the remaining depreciation would be $37,500 ($150,000/ 2 years x 6/12).Thusextracts from the financial statements for the year ended 30 September 2005 would be:

Balance sheetNon-current assets $Plant (150,000 – 37,500) 112,500

Income statementPlant depreciation (40,000 + 37,500) 77,500Plant impairment loss 50,000

(ii) There are a number of issues relating to the carrying amount of the assets of Mossel that have to be considered. Itappears the value of the brand is based on the original purchase of the ‘Quencher’ brand. The company no longer usesthis brand name; it has been renamed ‘Phoenix’. Thus it would appear the purchased brand of ‘Quencher’ is nowworthless. Mossel cannot transfer the value of the old brand to the new brand, because this would be the recognitionof an internally developed intangible asset and the brand of ‘Phoenix’ does not appear to meet the recognition criteria inIAS 38. Thus prior to the allocation of the impairment loss the value of the brand should be written off as it no longerexists. The inventories are valued at cost and contain $2 million worth of old bottled water (Quencher) that can be sold,but will have to be relabelled at a cost of $250,000. However, as the expected selling price of these bottles will be $3 million ($2 million x 150%), their net realisable value is $2,750,000. Thus it is correct to carry them at cost i.e.they are not impaired. The future expenditure on the plant is a matter for the following year’s financial statements.

Applying this, the revised carrying amount of the net assets of Mossel’s cash-generating unit (CGU) would be $25 million ($32 million – $7 million re the brand). The CGU has a recoverable amount of $20 million, thus there isan impairment loss of $5 million. This would be applied first to goodwill (of which there is none) then to the remainingassets pro rata. However under IAS2 the inventories should not be reduced as their net realisable value is in excess oftheir cost. This would give revised carrying amounts at 30 September 2005 of:

$’000Brand nilLand containing spa (12,000 – (12,000/20,000 x 5,000)) 9,000Purifying and bottling plant (8,000 – (8,000/20,000 x 5,000)) 6,000Inventories 5,000

–––––––20,000–––––––

17



4 (a) Cash flow statement of Tabba for the year ended 30 September 2005:

Cash flows from operating activities $’000 $’000Profit before tax 50Adjustments for:Depreciation (w (i)) 2,200Amortisation of government grant (w (iii)) (250)Profit on sale of factory (w (i)) (4,600)Increase in insurance claim provision (1,500 – 1,200) (300)Interest receivable (40)Interest expense 260

––––––(2,680)

Working capital adjustments:Increase in inventories (2,550 – 1,850) (700)Increase in trade receivables (3,100 – 2,600) (500)Increase in trade payables (4,050 – 2,950) 1,100

––––––Cash outflow from operations (2,780)Interest paid (260)Income taxes paid (w (iv)) (1,350)

––––––Net cash outflow from operating activities (4,390)

Cash flows from investing activitiesSale of factory 12,000Purchase of non-current assets (w (i)) (2,900)Receipt of government grant (from question) 950Interest received 40

––––––Net cash from investing activities 10,090

Cash flows from financing activitiesIssue of 6% loan notes 800Redemption of 10% loan notes (4,000)Repayment of finance leases (w (ii)) (1,100)

––––––Net cash from financing activities (4,300)

–––––––

Net increase in cash and cash equivalents 1,400Cash and cash equivalents at beginning of period (550)

–––––––Cash and cash equivalents at end of period 850

–––––––

Note: interest paid may also be presented as a financing activity and interest received as an operating cash flow.

Workings ($’000)(i) Non-current assets:

Cost/valuation b/f 20,200New finance leases (from question) 1,500Disposals (8,600)Acquisitions – balancing figure 2,900

–––––––Cost/valuation c/f 16,000

–––––––

Depreciation b/f 4,400Disposal (1,200)Depreciation c/f (5,400)

–––––––Charge for year – balancing figure (2,200)

–––––––

Sale of factory:Net book value 7,400Proceeds (from question) (12,000)

–––––––Profit on sale (4,600)

–––––––

(ii) Finance lease obligationsBalance b/f – current 800

– over 1 year 1,700New leases (from question) 1,500Balance c/f – current (900)

– over 1 year (2,000)––––––

Cash repayments – balancing figure 1,100––––––

18



(iii) Government grant:Balance b/f – current 400

– over 1 year 900Grants received in year (from question) 950Balance c/f – current (600)

– over 1 year (1,400)––––––

Difference – amortisation credited to income statement 250––––––

(iv) Taxation:Current provision b/f 1,200Deferred tax b/f 500Tax credit in income statement (50)Current provision c/f (100)Deferred tax c/f (200)

––––––Tax paid – balancing figure 1,350

––––––

(v) Reconciliation of retained earnings Balance b/f 850Transfer from revaluation reserve 1,600Profit for period 100

––––––Balance c/f 2,550

––––––

(b) Consideration of the cash flow statement reveals some important information in assessing the change in the financial positionof Tabba in the year ended 30 September 2005. There is a huge net cash outflow from operating activities of $4,390,000despite Tabba reporting a modest operating profit of $270,000. More detailed analysis of this difference reveals someworrying concerns for the future. Many companies experience higher operating cash flows than the underlying operating profitmainly due to depreciation charges being added back to profits to arrive at the cash flows. This is certainly true in Tabba’scase, where operating profits have been ‘improved’ by $2·2 million during the year in terms of the underlying cash flows.However, the major reconciling difference is the profit on the sale of Tabba’s factory of $4·6 million. This amount has beencredited in the income statement and has dramatically distorted the operating profit. If the sale and lease back of the factoryhad not taken place, Tabba’s operating profits would be in a sorry state showing losses of $4·33 million (ignoring any possibletax effects). When Tabba publishes its financial statements this profit will almost certainly require separate disclosure whichshould make the effects of the transaction more transparent to the users of the financial statements. A further indication ofpoor operating profits is that they have been boosted by $300,000 due to an increase in the insurance claim provision (againthis is not a cash flow) and $250,000 amortisation of government grants.Many commentators believe that the net cash flow from operating activities is the most important figure in the cash flowstatement. This is because it is a measure of expected or maintainable future cash flows. In Tabba’s case this highlights avery important point; although Tabba has increased its cash position during the year by $1·4 million, $12 million has comefrom the sale of its factory. Clearly this is a one off transaction that cannot be repeated in future years. If the drain on theoperating cash flows continues at the current rates, the company will not survive for very long.

The tax position is worthy of comment. There is a small tax credit in the income statement, perhaps due to current year tradinglosses, whereas the cash flow statement shows that tax of $1·35 million has been paid during the year. This payment of taxis on what must have been a substantial profit for the previous year. This seems to confirm the deteriorating position of thecompany.

Another relevant point is that there has been a very small increase in working capital of $100,000. However, underlying thisis the fact that both inventories and trade receivables are showing substantial increases (despite the profit deterioration),which may indicate the presence of bad debts or obsolete inventories, and trade payables have also increased substantially(by $1·1 million) which may be a symptom of liquidity problems prior to the sale of the factory.

On the positive side there has been substantial investment in non-current assets (after allowing for the sale of the factory),but even this is partly due to leasing assets of $1·5 million (companies often lease assets when they do not have the resourcesto purchase them outright) and finance from a government grant of $950,000.

The company appears to have taken advantage of the proceeds from the sale of the factory to redeem the expensive 10% $4 million loan note (this has partly been replaced by a less expensive 6% $800,000 loan note).

In conclusion the cash flow statement reveals some interesting and worrying issues that may indicate a bleak future for Tabbaand serves as an illustration of the importance of a cash flow statement to the users of financial statements.

19



5 (a) The cruise ship is an example of what can be called a complex asset. This is a single asset that should be treated as if it wasa collection of separate assets, each of which may require a different depreciation method/life. In this case the questionidentifies three components to the cruise ship. The carrying amount of the asset at 30 September 2004 (eight years afteracquisition) would be:component cost depreciation carrying value

$m $m $mship’s fabric 300 96 (300/25 x 8) 204cabins and entertainment area fittings 150 100 (150/12 x 8) 50propulsion system 100 75 (100/40,000 x 30,000) 25

–––– –––– ––––550 271 279–––– –––– ––––

Ship’s fabricThis is the most straightforward component. It is being depreciated over a 25 year life and depreciation of $12 million(300/25 years) would be required in the year ended 30 September 2005. The repainting of the ship’s fabric does not meetthe recognition criteria of an asset and should be treated as repairs and maintenance.

Cabins and entertainment area and fittingsDuring the year these have had a limited upgrade at a cost of $60 million. This has extended the remaining useful life fromfour to five years. The costs of the upgrade meet the criteria for recognition as an asset. The original fittings have not beenreplaced thus the additional $60 million would be added to the cost of the fittings and the new carrying amount of $110 million will be depreciated over the remaining life of five years to give a charge for the year of $22 million.

Propulsion systemThis has been replaced by a new system so the carrying value of the system ($25 million) must be written off and depreciationof the new system for the year ended 30 September 2005 (based on use) would be $14 million (140 million/50,000 x5,000).

Elite Leisure – income statement extract – year ended 30 September 2005:$m

Depreciation – ship’s fabric 12– cabin and entertainment fittings 22– propulsion system 14

Disposal loss – propulsion system 25Repainting ship’s fabric 20

–––93

–––

Elite Leisure – balance sheet extract – as at 30 September 2005Non-current assetsCruise ship (see working) 406

Workings (in $ million):component cost depreciation carrying value

$m $m $mship’s fabric 300 108 (300/25 x 9) 192cabins and entertainment area fittings 210 122 (110/5 + 100) 88propulsion system 140 14 (140/50,000 x 5,000) 126

–––– –––– ––––650 244 406–––– –––– ––––

(b) (i) IAS 24 Related party disclosures says that a party is related to an entity if:– the party, directly or indirectly, controls, is controlled by or is under common control with the entity (e.g.

parent/subsidiary or subsidiaries of the same group)– one party has an interest in another entity that gives it significant influence over the entity (e.g. an associate) or

has joint control over the entity (e.g. joint venturers are related parties)In addition members of key management and close family members of related parties are also themselves related parties.

(ii) In the absence of related party disclosures, users of financial statements would assume that an entity has actedindependently and in its own best interests. Principally within this assumption is that all transactions have been enteredinto willingly and at arm’s length (i.e. on normal commercial terms at fair value). Where related party relationships andtransactions exist, this assumption may not be justified. These relationships and transactions lead to the danger thatfinancial statements may have been distorted or manipulated, both favourably and unfavourably. The most obviousexample of this type of transaction would be the sale of goods or rendering of services from one party to another on non-commercial terms (this may relate to the price charged or the credit terms given). Other examples of disclosabletransactions are agency, licensing and leasing arrangements, transfer of research and development and the provision offinance, guarantees and collateral. Collectively this would mean there is hardly an area of financial reporting that couldnot be affected by related party transactions.

It is a common misapprehension that related party transactions need only be disclosed if they are not at arm’s length.This is not the case. For example, a parent may instruct all members of its group to buy certain products or services (on

20



commercial terms) from one of its subsidiaries. In the absence of the related party relationships, these transactions maynot have occurred. If the parent were to sell the subsidiary, it would be important for the prospective buyer to be awarethat the related party transactions would probably not occur in the future. Indeed even where there are no related partytransactions, the disclosure of the related party relationship is still important as a subsidiary may obtain custom, receivefavourable credit ratings, and benefit from a superior management team simply by being a part of a well respected group.

(iii) The subsidiaries of Hideaway are related parties to each other and to Hideaway itself as they are under common control.One of the important aspects of related party relationships is that one of the parties may have its interests subordinatedi.e. it may not be able to act in its own best interest. This appears to be the case in this situation. Depret (or at leastone of its directors) believes that the price it is charging Benedict is less than it could have achieved by selling the goodsto non-connected parties. In effect these sales have not been made at an arm’s length fair value. The obvious implicationof this is that the transactions have moved profits from Depret to Benedict. If the director’s figures are accurate Depretwould have made a profit on these transactions of $6 million (20 – 14) rather than the $1 million it has actually made.The transactions will also affect reported revenue and cost of sales and working capital in the individual financialstatements of Benedict and Depret. Some might argue that as the profit remains within the group, there is no real overalleffect as, in the consolidated financial statements, intra-group transactions are eliminated. This is not entirely true. Theimplications of these related party sales are serious:– Depret has a minority interest of 45% and they have been deprived of their share of the $5 million transferred

profit. This could be construed as oppression of the minority and is probably illegal.– there is a similar effect on the profit share that the directors of Depret might be entitled to under the group profit

sharing scheme as Depret’s profits are effectively $5 million lower than they should be.– shareholders, independent analysts or even the (independent) managers of Depret would find it difficult to appraise

the true performance of Depret. The related party transaction gives the impression that Depret is under-performing.This may lead to the minority selling their shares for a low price (because of poor returns) or calls for the company’sclosure or some form of rationalisation which may not be necessary.

– the tax authorities may wish to investigate the transactions under transfer pricing rules. The profit may have beenmoved to Benedict’s financial statements to avoid paying tax in Depret’s tax jurisdiction which may have high levelsof taxation.

– in the same way as Depret’s results appear poorer due to the effect of the related party transactions, Benedict’sresults would look better. This may have been done deliberately. Hideaway may intend to dispose of Benedict inthe near future and thus its more favourable results may allow Hideaway to obtain a higher sale price for Benedict.

21



Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) December 2005 Marking Scheme


Marks1 goodwill 5

goodwill impairment 1property, plant and equipment 3investment in associate 3other investments 1inventories and trade receivables 1cash and bank 1share capital and premium 1revaluation reserve 2retained earnings 3minority interest 4deferred consideration 1deferred tax 1elimination of 8% loan note 1trade payables and tax 1overdraft 1


2 (a) income statementrevenue 1cost of sales 1 mark per each item maximum 6commission 1distribution and administration 1interest expense 1income tax 2


(b) balance sheetdevelopment costs 1property, plant and equipment (held for continuing use) 2plant held for sale (1 mark for separate presentation) 2inventories 1trade receivables and cash and bank 1ordinary shares and share premium 1retained earnings 16% loan note 1deferred tax 1trade payables 1current tax 1


(c) basic eps 2diluted eps 3


23



Marks3 (a) (i) impaired where carrying amounts higher than recoverable amounts 1

discussion of fair value 2discussion of value in use 2discussion of CGU 1goodwill/intangibles with indefinite life tested annually 1review for indicators of impairment each balance sheet date 1only test if there is an indication of impairment 1


(ii) impairment loss – individual asset:impairment loss applied to carrying value of asset 1and charged to any previous revaluation surplus then income 2CGU:Applied to goodwill 1then pro rata to other assets 1other assets not reduced below fair value/value in use 1


(b) (i) depreciation/carrying value 1 April 2004 2fair value less costs to sell is disposal value of $20,000, not trade-in value 2recoverable is therefore $150,000 1impairment loss is $50,000 1depreciation six months to 30 September 2004 1carrying value $112,500 1


(ii) old brand written off, cannot recognise new brand 2inventories correct at cost 2improvement to plant not relevant 1impairment loss is $5 million 1land reduced to $9 million 1plant reduced to $6 million 1


24



Marks4 (a) profit before tax 1/2

depreciation 1amortisation of government grant 1profit on sale of factory 1increase in insurance claim 1working capital items 1 mark each 3adjustment for interest receivable/payable 1/2interest paid 1income tax paid 2sale of factory 1purchase of non-current assets 1receipt of government grant 1interest received 1redemption of 10% loan 1issue of 6% loan 1repayment of finance lease 2cash b/f and c/f 1


(b) 1 mark per relevant point to a maximum 8Maximum for question 25

5 (a) principle that each component is treated separately 1explanation of treatment of each component 1 mark each 3charges to income statement, 1 each 5carrying value at 30 September 2005ship’s fabric 1cabins etc 2propulsion system 2



(ii) 1 mark per relevant point to a maximum 3

(iii) effect of related party transaction is to subordinate Depret’s interest 1profit of $5 million has moved from Depret to Benedict 1also effect sales/cost of sales working capital 1in consolidated financial statements most transactions eliminated 1implication for users, 1 mark per point up to 4


25




PART 2


QUESTION PAPER







Pape

r 2.5

(IN

T)





1 On 1 October 2005 Hydan, a publicly listed company, acquired a 60% controlling interest in Systan paying $9 pershare in cash. Prior to the acquisition Hydan had been experiencing difficulties with the supply of components that itused in its manufacturing process. Systan is one of Hydan’s main suppliers and the acquisition was motivated by theneed to secure supplies. In order to finance an increase in the production capacity of Systan, Hydan made a non-dated loan at the date of acquisition of $4 million to Systan that carried an actual and effective interest rate of10% per annum. The interest to 31 March 2006 on this loan has been paid by Systan and accounted for by bothcompanies. The summarised draft financial statements of the companies are:

Income statements for the year ended 31 March 2006Hydan Systan

pre-acquisition post-acquisition$’000 $’000 $’000

Revenue 98,000 24,000 35,200Cost of sales (76,000) (18,000) (31,000)

––––––– ––––––– –––––––Gross profit 22,000 6,000 4,200Operating expenses (11,800) (1,200) (8,000)Interest income 350 nil nilFinance costs (420) nil (200)

––––––– ––––––– –––––––Profit/(loss) before tax 10,130 4,800 (4,000)Income tax (expense)/relief (4,200) (1,200) 1,000

––––––– ––––––– –––––––Profit/(loss) for the period 5,930 3,600 (3,000)

––––––– ––––––– –––––––

Balance sheets as at 31 March 2006Hydan Systan$’000 $’000

Non-current assetsProperty, plant and equipment 18,400 9,500Investments (including loan to Systan) 16,000 nil

––––––– –––––––34,400 9,500

Current assets 18,000 7,200––––––– –––––––

Total assets 52,400 16,700––––––– –––––––

Equity and liabilitiesOrdinary shares of $1 each 10,000 2,000Share premium 5,000 500Retained earnings 20,000 6,300

––––––– –––––––35,000 8,800

Non-current liabilities7% Bank loan 6,000 nil10% loan from Hydan nil 4,000

Current liabilities 11,400 3,900––––––– –––––––

Total equity and liabilities 52,400 16,700––––––– –––––––


(i) At the date of acquisition, the fair values of Systan’s property, plant and equipment were $1·2 million in excessof their carrying amounts. This will have the effect of creating an additional depreciation charge (to cost of sales)of $300,000 in the consolidated financial statements for the year ended 31 March 2006. Systan has notadjusted its assets to fair value.

2



(ii) In the post acquisition period Systan’s sales to Hydan were $30 million on which Systan had made a consistentprofit of 5% of the selling price. Of these goods, $4 million (at selling price to Hydan) were still in the inventoryof Hydan at 31 March 2006. Prior to its acquisition Systan made all its sales at a uniform gross profit margin.

(iii) Included in Hydan’s current liabilities is $1 million owing to Systan. This agreed with Systan’s receivables ledgerbalance for Hydan at the year end.

(iv) An impairment review of the consolidated goodwill at 31 March 2006 revealed that its current value was 12·5%less than its carrying amount.

(v) Neither company paid a dividend in the year to 31 March 2006.

Required:

(a) Prepare the consolidated income statement for the year ended 31 March 2006 and the consolidated balancesheet at that date. (20 marks)

(b) Discuss the effect that the acquisition of Systan appears to have had on Systan’s operating performance.(5 marks)

(25 marks)

3 [P.T.O.




2 The following trial balance relates to Darius at 31 March 2006:

$’000 $’000Revenue 213,800Cost of sales 143,800Closing inventories – 31 March 2006 (note (i)) 10,500Operating expenses 22,400Rental income from investment property 1,200Finance costs (note (ii)) 5,000Land and building – at valuation (note (iii)) 63,000Plant and equipment – cost (note (iii)) 36,000Investment property – valuation 1 April 2005 (note (iii)) 16,000Accumulated depreciation 1 April 2005 – plant and equipment 16,800Joint venture (note (iv)) 8,000Trade receivables 13,500Bank 900Trade payables 11,800Ordinary shares of 25c each 20,00010% Redeemable preference shares of $1 each 10,000Deferred tax (note (v)) 5,200Revaluation reserve (note (iii)) 21,000Retained earnings – 1 April 2005 17,500

–––––––– ––––––––318,200 318,200–––––––– ––––––––


(i) An inventory count at 31 March 2006 listed goods with a cost of $10·5 million. This includes some damagedgoods that had cost $800,000. These would require remedial work costing $450,000 before they could be soldfor an estimated $950,000.

(ii) Finance costs include overdraft charges, the full year’s preference dividend and an ordinary dividend of 4c pershare that was paid in September 2005.

(iii) Non-current assets:

Land and buildingThe land and building were revalued at $15 million and $48 million respectively on 1 April 2005 creating a $21 million revaluation reserve. At this date the building had a remaining life of 15 years.

Depreciation is on a straight-line basis. Darius does not make a transfer to realised profits in respect of excessdepreciation.

PlantAll plant, including that of the joint venture (note (iv)), is depreciated at 12·5% on the reducing balance basis.

Depreciation on both the building and the plant should be charged to cost of sales.

Investment propertyOn 31 March 2006 a qualified surveyor valued the investment property at $13·5 million. Darius uses the fairvalue model in IAS 40 Investment property to value its investment property.

4



(iv) On 1 April 2005 Darius entered into a joint venture with two other entities. Each venturer contributes their ownassets and is responsible for their own expenses including depreciation on joint venture assets. Darius is entitledto 40% of the joint venture’s total revenues. The joint venture is not a separate entity.

Details of Darius’s joint venture transactions are:$’000

Plant and equipment at cost 12,000Share of joint venture revenue (40% of total sales revenue) (8,000)Related joint venture cost of sales excluding depreciation 5,000Trade receivables 1,500Trade payables (2,500)

––––––Net balance included in the above list of balances 8,000

––––––

(v) The directors have estimated the provision for income tax for the year ended 31 March 2006 at $8 million. Thedeferred tax provision at 31 March 2006 is to be adjusted (through the income statement) to reflect that the taxbase of the company’s net assets is $12 million less than their carrying amounts. The rate of income tax is 30%.

Required:

(a) Prepare the income statement for Darius for the year ended 31 March 2006. (10 marks)

(b) Prepare the statement of recognised income and expense for Darius for the year ended 31 March 2006.(2 marks)

(c) Prepare the balance sheet for Darius as at 31 March 2006. (13 marks)

Notes to the financial statements are not required.

(25 marks)

5 [P.T.O.




6



3 (a) The IASB’s Framework for the preparation and presentation of financial statements (Framework) sets out theconcepts that underlie the preparation and presentation of financial statements that external users are likely torely on when making economic decisions about an enterprise.

Required:

Explain the purpose and authoritative status of the Framework. (5 marks)

(b) Of particular importance within the Framework are the definitions and recognition criteria for assets and liabilities.

Required:

Define assets and liabilities and explain the important aspects of their definitions. Explain why thesedefinitions are of particular importance to the preparation of an entity’s balance sheet and income statement.

(8 marks)

(c) Peterlee is preparing its financial statements for the year ended 31 March 2006. The following items have beenbrought to your attention:

(i) Peterlee acquired the entire share capital of Trantor during the year. The acquisition was achieved througha share exchange. The terms of the exchange were based on the relative values of the two companiesobtained by capitalising the companies’ estimated future cash flows. When the fair value of Trantor’sidentifiable net assets was deducted from the value of the company as a whole, its goodwill was calculatedat $2·5 million. A similar exercise valued the goodwill of Peterlee at $4 million. The directors wish toincorporate both the goodwill values in the companies’ consolidated financial statements. (4 marks)

(ii) During the year Peterlee acquired an iron ore mine at a cost of $6 million. In addition, when all the ore hasbeen extracted (estimated in 10 years time) the company will face estimated costs for landscaping the areaaffected by the mining that have a present value of $2 million. These costs would still have to be incurredeven if no further ore was extracted. The directors have proposed that an accrual of $200,000 per year forthe next ten years should be made for the landscaping. (4 marks)

(iii) On 1 April 2005 Peterlee issued an 8% $5 million convertible loan at par. The loan is convertible in threeyears time to ordinary shares or redeemable at par in cash. The directors decided to issue a convertible loanbecause a non-convertible loan would have required an interest rate of 10%. The directors intend to showthe loan at $5 million under non-current liabilities. The following discount rates are available:

8% 10%Year 1 0·93 0·91Year 2 0·86 0·83Year 3 0·79 0·75 (4 marks)

Required:

Describe (and quantify where possible) how Peterlee should treat the items in (i) to (iii) in its financialstatements for the year ended 31 March 2006 commenting on the directors’ views where appropriate.

The mark allocation is shown against each of the three items above.

(25 marks)

7 [P.T.O.



4 Shown below are the summarised financial statements for Boston, a publicly listed company, for the years ended 31 March 2005 and 2006, together with some segment information analysed by class of business for the year ended31 March 2006 only:

Income statements: Total TotalCarpeting Hotels House building 31 March 2006 31 March 2005

$m $m $m $m $mRevenue 90 130 280 500 450Cost of sales (note (i)) (30) (95) (168) (293) (260)

––– ––– –––– –––– ––––Gross profit 60 35 112 207 190Operating expenses (25) (15) (32) (72) (60)

––– ––– –––– –––– ––––Segment result 35 20 80 135 130

––– ––– ––––Unallocated corporate expenses (60) (50)

–––– ––––Profit from operations 75 80Finance costs (10) (5)

–––– ––––Profit before tax 65 75Income tax expense (25) (30)

–––– ––––Profit for the period 40 45

–––– ––––

Balance sheets: Total TotalCarpeting Hotels House building 31 March 2006 31 March 2005

$m $m $m $m $mTangible non-current assets 40 140 200 380 332Current assets 40 40 75 155 130

––– –––– –––– –––– ––––Segment assets 80 180 275 535 462Unallocated bank balance 15 nil

–––– ––––Consolidated total assets 550 462

–––– ––––

Ordinary share capital 100 80Share premium 20 nilRetained earnings 232 192

–––– ––––352 272

Segment current liabilities – tax 4 9 12 25 30– other 4 51 53 108 115

Unallocated loans 65 40Unallocated bank overdraft nil 5

–––– ––––Consolidated equity and total liabilities 550 462

–––– ––––

The following notes are relevant

(i) Depreciation for the year to 31 March 2006 was $35 million. During the year a hotel with a carrying amount of$40 million was sold at a loss of $12 million. Depreciation and the loss on the sale of non-current assets arecharged to cost of sales. There were no other non-current asset disposals. As part of the company’s overallacquisition of new non-current assets, the hotel segment acquired $104 million of new hotels during the year.

(ii) The above figures are based on historical cost values. The fair values of the segment net assets are:

Carpeting Hotels House building$m $m $m

at 31 March 2005 80 150 250at 31 March 2006 97 240 265

8



(iii) The following ratios (which can be taken to be correct) have been calculated based on the overall group results:

Year ended: 31 March 2006 31 March 2005Return on capital employed 18·0% 25·6%Gross profit margin 41·4% 42·2%Operating profit margin 15% 17·8%Net assets turnover 1·2 times 1·4 timesCurrent ratio 1·3:1 0·9:1Gearing 15·6% 12·8%

(iv) The following segment ratios (which can be taken to be correct) have been calculated for the year ended 31 March 2006 only:

Carpeting Hotels House buildingSegment return on net assets 48·6% 16·7% 38·1%Segment asset turnover (times) 1·3 1·1 1·3Gross profit margin 66·7% 26·9% 40%Net profit margin 38·9% 15·4% 28·6%Current ratio (excluding bank) 5:1 0·7:1 1·2:1

Required:

(a) Prepare a cash flow statement for Boston for the year ended 31 March 2006. (10 marks)

Note: you are not required to show separate segmental cash flows or any disclosure notes.

(b) Using the ratios provided, write a report to the Board of Boston analysing the company’s financialperformance and position for the year ended 31 March 2006. (15 marks)

Your answer should make reference to your cash flow statement and the segmental information and considerthe implication of the fair value information.

(25 marks)

9 [P.T.O.



5 (a) Torrent is a large publicly listed company whose main activity involves construction contracts. Details of three ofits contracts for the year ended 31 March 2006 are:

Contract Alfa Beta CetaDate commenced 1 April 2004 1 October 2005 1 October 2005Estimated duration 3 years 18 months 2 years

$m $m $mFixed contract price 20 6 12Estimated costs at start of contract 15 7·5 (note (iii)) 10Cost to date:at 31 March 2005 5 nil nilat 31 March 2006 12·5 (note (ii)) 2 4Estimated costs at 31 March 2006 to complete 3·5 5·5 (note (iii)) 6Progress payments received at 31 March 2005

(note (i)) 5·4 nil nilProgress payments received at 31 March 2006

(note (i)) 12·6 1·8 nil

Notes

(i) The company’s normal policy for determining the percentage completion of contracts is based on the valueof work invoiced to date compared to the contract price. Progress payments received represent 90% of thework invoiced. However, no progress payments will be invoiced or received from contract Ceta until it iscompleted, so the percentage completion of this contract is to be based on the cost to date compared to theestimated total contract costs.

(ii) The cost to date of $12·5 million at 31 March 2006 for contract Alfa includes $1 million relating tounplanned rectification costs incurred during the current year (ended 31 March 2006) due to subsidenceoccurring on site.

(iii) Since negotiating the price of contract Beta, Torrent has discovered the land that it purchased for the projectis contaminated by toxic pollutants. The estimated cost at the start of the contract and the estimated coststo complete the contract include the unexpected costs of decontaminating the site before construction couldcommence.

Required:

Prepare extracts of the income statement and balance sheet for Torrent in respect of the above constructioncontracts for the year ended 31 March 2006 (12 marks)

(b) (i) The issued share capital of Savoir, a publicly listed company, at 31 March 2003 was $10 million. Its sharesare denominated at 25 cents each. Savoir’s earnings attributable to its ordinary shareholders for the yearended 31 March 2003 were also $10 million, giving an earnings per share of 25 cents.

Year ended 31 March 2004On 1 July 2003 Savoir issued eight million ordinary shares at full market value. On 1 January 2004 a bonusissue of one new ordinary share for every four ordinary shares held was made. Earnings attributable toordinary shareholders for the year ended 31 March 2004 were $13,800,000.

Year ended 31 March 2005On 1 October 2004 Savoir made a rights issue of shares of two new ordinary shares at a price of $1·00each for every five ordinary shares held. The offer was fully subscribed. The market price of Savoir’s ordinaryshares immediately prior to the offer was $2·40 each. Earnings attributable to ordinary shareholders for theyear ended 31 March 2005 were $19,500,000.

Required:

Calculate Savoir’s earnings per share for the years ended 31 March 2004 and 2005 includingcomparative figures. (9 marks)

10



(ii) On 1 April 2005 Savoir issued $20 million 8% convertible loan stock at par. The terms of conversion (on1 April 2008) are that for every $100 of loan stock, 50 ordinary shares will be issued at the option of loanstockholders. Alternatively the loan stock will be redeemed at par for cash. Also on 1 April 2005 the directorsof Savoir were awarded share options on 12 million ordinary shares exercisable from 1 April 2008 at $1·50per share. The average market value of Savoir’s ordinary shares for the year ended 31 March 2006 was$2·50 each. The income tax rate is 25%. Earnings attributable to ordinary shareholders for the year ended 31 March 2006 were $25,200,000. The share options have been correctly recorded in the incomestatement.

Required:

Calculate Savoir’s basic and diluted earnings per share for the year ended 31 March 2006 (comparativefigures are not required).

You may assume that both the convertible loan stock and the directors’ options are dilutive. (4 marks)

(25 marks)


11



Answers




1 (a) HydanConsolidated income statement year ended 31 March 2006

$’000 $’000Revenue (98,000 + 35,200 – 30,000 intra-group sales) 103,200Cost of sales (w (i)) (77,500)

––––––––Gross profit 25,700Operating expenses (11,800 + 8,000 + 375 goodwill (w (ii))) (20,175)Interest receivable (350 – 200 intra-group (4,000 x 10% x 6/12)) 150Finance costs (420)

––––––––5,255

Income tax expense (4,200 – 1,000 tax relief) (3,200)––––––––

Profit for the period 2,055––––––––

Attributable to:Equity holders of the parent 3,455Minority interest (w (iv)) (1,400)

––––––––2,055

––––––––

Consolidated balance sheet as at 31 March 2006Non-current assets:Property, plant and equipment (18,400 + 9,500 + 1,200 – 300 depreciation adjustment) 28,800Goodwill (3,000 – 375 (w (ii))) 2,625Investment (16,000 – 10,800 – 4,000 loan) 1,200

–––––––32,625

Current assets (w (v)) 24,000–––––––

Total assets 56,625–––––––

Equity attributable to holders of the parentOrdinary shares of $1 each 10,000Share premium 5,000Retained earnings (w (iii)) 17,525

–––––––32,525

Minority interest (w (iv)) 3,800–––––––

Total equity 36,325Non-current liabilities7% bank loan 6,000

Current liabilities (w (v)) 14,300–––––––

Total equity and liabilities 56,625–––––––

Workings in $’000(i) Cost of sales

Hydan 76,000Systan 31,000Intra-group sales (30,000)URP in inventories 200Additional depreciation re fair values 300

–––––––77,500–––––––

(ii) Goodwill/Cost of control in Systan:Investment at cost (2,000 x 60% x $9) 10,800Less – ordinary shares of Systan 2,000

– share premium 500– pre-acquisition reserves (6,300 + 3,000 post acq loss) 9,300– fair value adjustment 1,200

–––––––13,000 x 60% (7,800)

––––––Goodwill on consolidation 3,000

––––––

Goodwill is impaired by 12·5% of its carrying amount = 375––––––

15



(iii) Consolidated reserves:Hydan’s reserves 20,000Systan’s post acquisition losses (see below) (3,500 x 60%) (2,100)Goodwill impairment (w (ii)) (375)

–––––––17,525–––––––

The adjusted profits of Systan are:Per question 6,300Adjustments – URP in inventories (4,000 x 5%) (200)

– additional depreciation (300) (500)––––– –––––––

5,800–––––––

(iv) Minority interest in income statementSystan’s post acquisition loss after tax 3,000Adjustments from (w (iii)) 500

––––––Adjusted losses 3,500 x 40% = 1,400

Minority interest in balance sheetOrdinary shares and premium of Systan 2,500Adjusted profits (w (iii)) 5,800Fair value adjustments 1,200

––––––9,500 x 40% = 3,800

(v) Current assets and liabilitiesCurrent assets:Hydan 18,000Systan 7,200URP in inventories (200)Intra-group balance (1,000)

–––––––24,000–––––––

Current liabilities:Hydan 11,400Systan 3,900Intra-group balance (1,000)

–––––––14,300–––––––

(b) Although Systan’s revenue has increased since its acquisition by Hydan, its operating performance appears to havedeteriorated markedly. Its gross profit margin has fallen from 25% (6m/24m) in the six months prior to the acquisition to only11·9% (4·2m/35·2m) in the post-acquisition period. The decline in gross profit is worsened by a huge increase in operatingexpenses in the post-acquisition period. These have gone from $1·2 million pre-acquisition to $8 million post-acquisition.Taking into account the effects of interest and tax a $3·6 million first half profit (pre-acquisition) has turned into a $3 millionsecond half loss (post-acquisition). Whilst it is possible that some of the worsening performance may be due to marketconditions, the major cause is probably due to the effects of the acquisition. As the question states Hydan has acquired acontrolling interest in Systan and thus the two companies are related parties. Since the acquisition most of Systan’s saleshave been to Hydan. This is not surprising as Systan was acquired to secure supplies to Hydan. The terms under which thesales are made are now determined by the management of Hydan, whereas they were previously determined by themanagement of Systan. The question says sales to Hydan yield a consistent gross profit of only 5%. This is very low andmuch lower than the profit margin on sales to Hydan prior to the acquisition and also much lower than the few sales thatwere made to third parties in the post acquisition period. It may also be that Hydan has shifted the burden of some of thegroup operating expenses to Systan – this may explain the large increase in Systan’s post acquisition operating expenses. Theeffect of these (transfer pricing) actions would move profits from Systan’s books into those of Hydan. The implications of thisare quite significant. Initially there may be a tendency to think the effect is not important as on consolidation both companies’results are added together, but other parties are affected by these actions. The most obvious is the significant (40%) minorityinterest, they are effectively having some of their share of Systan’s profit and balance sheet value taken from them. It mayalso be that the management and staff of Systan may be losing out on profit related bonuses. Finally, any party using Systan’sentity financial statements, for whatever purpose, would be basing any decisions they make on potentially misleadinginformation.

16



2 (a) Darius income statement for the year ended 31 March 2006$’000 $’000

Revenue (w (i)) 221,800Cost of sales (w (i)) (156,200)

–––––––––Gross profit 65,600Operating expenses (22,400)Investment income 1,200Loss on investment property (16,000 – 13,500 w (ii)) (2,500)Financing cost (5,000 – 3,200 ordinary dividend (w (v)) (1,800)

–––––––––Profit before tax 40,100Income tax expense (w (iii)) (6,400)


–––––––––

(b) Statement of recognised income and expense for the year ended 31 March 2006Unrealised surplus on land and building 21,000Profit for the period 33,700

–––––––Total recognised income and expense for the period 54,700

–––––––

(c) Darius balance sheet as at 31 March 2006Non-current assetsProperty, plant and equipment (w (iv)) 87,100Investment property (w (ii)) 13,500

––––––––100,600

Current assetsInventories (10,500 – 300 (w (i))) 10,200Trade receivables (13,500 + 1,500 JV) 15,000 25,200

––––––– ––––––––Total assets 125,800

––––––––

Equity and liabilities:Ordinary shares of 25c each 20,000Reserves:Revaluation 21,000Retained earnings (w (v)) 48,000 69,000

––––––– ––––––––89,000

Non-current liabilitiesDeferred tax (w (iii)) 3,600Redeemable preference shares of $1 each 10,000 13,600

–––––––

Current liabilitiesTrade payables (11,800 + 2,500 JV) 14,300Bank overdraft 900Current tax payable 8,000 23,200


––––––––

Workings in $’000(i) Revenue

Per question 213,800Joint venture revenue 8,000

––––––––221,800––––––––

Cost of sales:Per question 143,800Closing inventories adjustment (see below) 300Joint venture costs 5,000Depreciation (w (iv)) – building 3,200

– plant 3,900––––––––156,200––––––––

The damaged inventories will require expenditure of $450,000 to repair them and then have an expected selling priceof $950,000. This gives a net realisable value of $500,000, as their cost was $800,000, a write down of $300,000is required.

17



(ii) The fair value model in IAS 40 Investment property requires investment properties to be included in the balance sheetat their fair value (in this case taken to be the open market value). Any surplus or deficit is recorded in income.

(iii) Taxation:Provision for year 8,000Deferred tax (see below) (1,600)

––––––6,400

––––––

Taxable temporary differences are $12 million. At a rate of 30% this would require a balance sheet provision for deferredtax of $3·6 million. The opening provision is $5·2 million, thus a credit of $1·6 million will be made in the incomestatement.

(iv) Non-current assetsLand and building

Depreciation of the building for the year ended 31 March 2006 will be (48,000/15 years) 3,200

–––––––Plant and equipmentPer trial balance 36,000Joint venture plant 12,000

–––––––48,000

Accumulated depreciation 1 April 2005 (16,800)–––––––

Carrying amount prior to charge for year 31,200Depreciation year ended 31 March 2006 at 12·5% (3,900)

–––––––Carrying amount at 31 March 2006 27,300

–––––––

Summarising: cost/valuation accumulated depreciation carrying amountLand and building 63,000 3,200 59,800Plant and equipment 48,000 20,700 27,300

–––––––– ––––––– –––––––Property, plant and equipment 111,000 23,900 87,100

–––––––– ––––––– –––––––

(v) Retained earningsBalance b/f 17,500Profit for period 33,700Ordinary dividends paid (20,000 x 4 x 4c) (3,200)

–––––––48,000–––––––

3 (a) The purpose of the Framework is to assist the various bodies and users that may be interested in the financial statements ofan entity. It is there to assist the IASB itself, other standard setters, preparers, auditors and users of financial statements andany other party interested in the work of the IASB. More specifically:

– to assist the Board in the development of new and the review of existing standards. It is also believed that the Frameworkwill assist in promoting harmonisation of the preparation of financial statements and also reduce the number ofalternative accounting treatments permitted by IFRSs

– national standard setters that have expressed a desire for local standards to be compliant with IFRS will be assisted bythe Framework

– the Framework will help preparers to apply IFRS more effectively if they understand the concepts underlying theStandards, additionally the Framework should help in dealing with new or emerging issues which are, as yet, notcovered by an IFRS

– the above is also true of the work of the auditor, in particular the Framework can assist the auditor in determiningwhether the financial statements conform to IFRS

– users should be assisted by the Framework in interpreting the performance of entities that have complied with IFRS.

It is important to realise that the Framework is not itself an accounting standard and thus cannot override a requirement of aspecific standard. Indeed, the Board recognises that there may be (rare) occasions where a particular IFRS is in conflict withthe Framework. In these cases the requirements of the standard should prevail. The Board believes that such conflicts willdiminish over time as the development of new and (revised) existing standards will be guided by the Framework and theFramework itself may be revised based on the experience of working with it.

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(b) Definitions – assets:The IASB’s Framework defines assets as ‘a resource controlled by an entity as a result of past events and from which futureeconomic benefits are expected to flow to the entity’. The first part of the definition puts the emphasis on control rather thanownership. This is done so that the balance sheet reflects the substance of transactions rather than their legal form. Thismeans that assets that are not legally owned by an entity, but over which the entity has the rights that are normally conveyedby ownership, are recognised as assets of the entity. Common examples of this would be finance leased assets and othercontractual rights such as aircraft landing rights. An important aspect of control of assets is that it allows the entity to restrictthe access of others to them. The reference to past events prevents assets that may arise in future from being recognised early.

– liabilities:The IASB’s Framework defines liabilities as ‘a present obligation of the entity arising from past events, the settlement of whichis expected to result in an outflow from the entity of resources embodying economic benefits’. Many aspects of this definitionare complementary (as a mirror image) to the definition of assets, however the IASB stresses that the essential characteristicof a liability is that the entity has a present obligation. Such obligations are usually legally enforceable (by a binding contractor by statute), but obligations also arise where there is an expectation (by a third party) of an entity assuming responsibilityfor costs where there is no legal requirement to do so. Such obligations are referred to as constructive (by IAS 37 Provisions,contingent liabilities and contingent assets). An example of this would be repairing or replacing faulty goods (beyond anywarranty period) or incurring environmental costs (e.g. landscaping the site of a previous quarry) where there is no legalobligation to do so. Where entities do incur constructive obligations it is usually to maintain the goodwill and reputation ofthe entity. One area of difficulty is where entities cannot be sure whether an obligation exists or not, it may depend upon afuture uncertain event. These are more generally known as contingent liabilities.

Importance of the definitions of assets and liabilities:The definitions of assets and liabilities are fundamental to the Framework. Apart from forming the obvious basis for thepreparation of a balance sheet, they are also the two elements of financial statements that are used to derive the equity interest(ownership) which is the residue of assets less liabilities. Assets and liabilities also have a part to play in determining whenincome (which includes gains) and expenses (which include losses) should be recognised. Income is recognised (in theincome statement) when there is an increase in future economic benefits relating to increases in assets or decreases inliabilities, provided they can be measured reliably. Expenses are the opposite of this. Changes in assets and liabilities arisingfrom contributions from, and distributions to, the owners are excluded from the definitions of income and expenses.

Currently there is a great deal of concern over ‘off balance sheet finance’. This is an aspect of what is commonly referred toas creative accounting. Many recent company failure scandals have been in part due to companies having often massiveliabilities that have not been included on the balance sheet. Robust definitions, based on substance, of assets and liabilitiesin particular should ensure that only real assets are included on the balance sheet and all liabilities are also included. Incontradiction to the above point, there have also been occasions where companies have included liabilities on their balancesheets where they do not meet the definition of liabilities in the Framework. Common examples of this are general provisionsand accounting for future costs and losses (usually as part of the acquisition of a subsidiary). Companies have used thesegeneral provisions to smooth profits i.e. creating a provision when the company has a good year (in terms of profit) andreleasing them to boost profits in a bad year. Providing for future costs and losses during an acquisition may effectively allowthem to bypass the income statement as they would become part of the goodwill figure.

(c) (i) Whilst it is acceptable to value the goodwill of $2·5 million of Trantor (the subsidiary) on the basis described in thequestion and include it in the consolidated balance sheet, the same treatment cannot be afforded to Peterlee’s owngoodwill. The calculation may indeed give a realistic value of $4 million for Peterlee’s goodwill, and there may be nodifference in nature between the goodwill of the two companies, but it must be realised that the goodwill of Peterlee isinternal goodwill and IFRSs prohibit such goodwill appearing in the financial statements. The main basis of thisconclusion is one of reliable measurement. The value of acquired (purchased) goodwill can be evidenced by the methoddescribed in the question (there are also other acceptable methods), but this method of valuation is not acceptable asa basis for recognising internal goodwill.

(ii) Accruing for future costs such as this landscaping on an annual basis may seem appropriate and was common practiceuntil recently. However, it is no longer possible to account for this type of future cost in this manner, therefore thedirectors’ suggestion is unacceptable. IAS 37 Provisions, contingent liabilities and contingent assets requires such coststo be accounted for in full as soon as they become unavoidable. The Standard says that the estimate of the future costshould be discounted to a present value (as in this example at $2 million). The accounting treatment is rathercontroversial; the cost should be included in the balance sheet as a provision (a credit entry/balance), but the debit isto the cost of the asset to give an initial carrying amount of $8 million. This has the effect of ‘grossing up’ the balancesheet by including the landscaping costs as both an asset and a liability. As the asset is depreciated on a systematicbasis ($800,000 per annum assuming straight-line depreciation), the landscaping costs are charged to the incomestatement over the life of the asset. As the discount is ‘unwound’ (and charged as a finance cost) this is added to thebalance sheet provision such that, at the date when the liability is due to be settled, the provision is equal to the amountdue (assuming estimates prove to be accurate).

(iii) The directors’ suggestion that the convertible loan should be recorded as a liability of the full $5 million is incorrect. Thereason why a similar loan without the option to convert to equity shares (such that it must be redeemed by cash only)carries a higher interest rate is because of the value of the equity option that is contained within the issue proceeds ofthe $5 million. If the company performs well over the period of the loan, the value of its equity shares should rise and

19



thus it would (probably) be beneficial for the loan note holders to opt for the equity share alternative. IAS 32 and 39dealing with financial instruments require the value of the option is to be treated as equity rather than debt. Thecalculation of value of the equity is as follows:

$’000Year 1 400 x 0·91 364Year 2 400 x 0·83 332Year 3 5,400 x 0·75 4,050

––––––Present value of the cash flows 4,746Proceeds of issue (5,000)

––––––Difference is value of equity 254

––––––

Initially the loan would be shown at $4,746,000.

The Income statement would show:$’000 $’000

Loan interest paid ($5m x 8%) 400Accrued finance costs (balance) 75 475 (i.e. $4·746m x 10%)

––––

At 31 March 2006 the loan would have a carrying amount of $4,821,000 ($4,746,000 + $75,000)

4 (a) Boston – Cash Flow Statement for the year ended 31 March 2006:

Cash flows from operating activitiesNote: figures in brackets are in $’000 $’000 $’000Profit before tax 65Adjustments for:

depreciation of non-current assets 35loss on sale of hotel 12interest expense 10

––––122

increase in current assets (155 – 130) (25)decrease in other current liabilities (115 – 108) (7)

––––Cash generated from operations 90

Interest paid (see note) (10)Income taxes paid (30)

––––Net cash flow from operating activities 50

Cash flows from investing activities: purchase of non-current assets (see below) (123)sale of non-current assets (40 – 12) 28

––––Net cash used in investing activities (95)

Cash flows from financing activitiesIssue of ordinary shares (20 + 20) 40Issue of loans (65 – 40) 25

––––Net cash from financing activities 65

–––Net increase in cash and cash equivalents 20Cash and cash equivalents at beginning of period (5)

–––Cash and cash equivalents at end of period 15

–––

Workings $’000Non-current assets – carrying amountBalance b/f 332Disposal (40)Depreciation for year (35)Balance c/f (380)

–––––Cost of assets acquired (123)

–––––

Note: interest paid may also be presented as a cash flow from financing activities.

20



(b) Report on the financial performance of Boston for the year ended 31 March 2006

To: The Board of BostonFrom: A N OtherDate:

Profitability (note figures are rounded to 1 decimal place)The most striking feature of the current year’s performance is the deterioration in the ROCE, down from 25·6% to only 18·0%.This represents an overall fall in profitability of 30% ((25·6 – 18·0)/25·6 x 100). An examination of the other ratios providedshows that this is due to a decline in both profit margins and asset utilisation. A closer look at the profit margins shows thatthe decline in gross margin is relatively small (42·2% down to 41·4%), whereas the fall in the operating profit margin is downby 2·8%, this represents a 15·7% decline in profitability (i.e. 2·8% on 17·8%). This has been caused by increases inoperating expenses of $12m and unallocated corporate expenses of $10m. These increases represent more than half of thenet profit for the period and further investigation into the cause of these increases should be made. The company is generatingonly $1·20 of sales per $1 of net balance sheet assets this year compared to a figure of $1·40 in the previous year. Thisdecline in asset utilisation represents a fall of 14·3% ((1·4 – 1.2)/1·4 x 100).

Liquidity/solvencyFrom the limited information provided a poor current ratio of 0·9:1 in 2005 has improved to 1·3:1 in the current year. Despitethe improvement, it is still below the accepted norm. At the same time gearing has increased from 12·8% to 15·6%.Information from the cash flow statement shows the company has raised $65 million in new capital ($40m in equity and$25m in loans). The disproportionate increase in the loans is the cause of the increase in gearing, however, at 15·6% thisis still not a highly geared company. The increase in finance has been used mainly to purchase new non-current assets, butit has also improved liquidity, mainly by reversing an overdraft of $5 million to a bank balance in hand of $15 million.

A common feature of new investment is that there is often a delay between making the investment and benefiting from thereturns. This may be the case with Boston, and it may be that in future years the increased investment will be rewarded withhigher returns. Another aspect of the investment that may have caused the lower return on assets is that the investment islikely to have occurred part way through the year (maybe even near the year end). This means that the income statementmay not include returns for a full year, whereas in future years it will.

Segment issuesSegment information is intended to help the users to better assess the performance of an enterprise by looking at the detailedcontribution made by the differing activities that comprise the enterprise as a whole. Referring to the segment ratios it appearsthat the carpeting segment is giving the greatest contribution to overall profitability achieving a 48·6% return on its segmentassets, whereas the equivalent return for house building is 38·1% and for hotels it is only 16·7%. The main reason for thebetter return from carpeting is due to its higher segment net profit margin of 38·9% compared to hotels at 15·4% and housebuilding at 28·6%. Carpeting’s higher segment net profit is in turn a reflection of its underlying very high gross margin(66·7%). The segment net asset turnover of the hotels (1·1 times) is also very much lower than the other two segments (1·3 times). It seems that the hotel segment is also responsible for the group’s fairly poor liquidity ratios (ignoring the bankbalances) the segment current liabilities are 50% greater than its current assets ($60m compared to $40m); the opposite ofthis would be a more acceptable current ratio.

These figures are based on historical values. Most commentators argue that the use of fair values is more consistent and thusprovides more reliable information on which to base assessments (they are less misleading than the use of historical values).If fair values are used all segments understandably show lower returns and poorer performance (as fair values are higher thanhistorical values), but the figures for the hotels are proportionately much worse, falling by a half of the historic values (as thefair values of the hotel segment are exactly double the historical values). Fair value adjusted figures may even lead one toquestion the future of the hotel activities. However, before jumping to any conclusions an important issue should beconsidered. Although the reported profit of the hotels is poor, the market values of its segment assets have increased by a net$90 million. New net investment in hotel capital expenditure is $64 million ($104m – $40m disposal); this leaves anincrease in value of $26 million. The majority of this appears to be from market value increases (this would be confirmed ifthe statement of recognised income and expense was available). Whilst this is not a realised profit, it is nevertheless asignificant and valuable gain (equivalent to 65% of the group reported net profit).

ConclusionAlthough the company’s overall performance has deteriorated in the current year, it is clear that at least some areas of thebusiness have had considerable new investment which may take some time to bear fruit. This applies to the hotel segmentin particular and may explain its poor performance, which is also partly offset by the strong increase in the market value ofits assets.

Yours A N other

Appendix Further segment ratios Carpeting Hotels House buildingReturn on net assets at fair values (35/97 x 100) 36·1% 8·3% 30·2%Asset turnover on fair values (times) (90/97) 0·9 0·5 1·1

Note: workings have been shown for the figures for the carpeting segment only, the other segments’ figures are based onequivalent calculations.

21



5 (a) Income statement for the year ended 31 March 2006

Alfa Beta Ceta Total$m $m $m $m

Revenue 8 2·0 4·8 14·8Cost of sales (7) (3·5) (4·0) (14·5)

––––– –––– –––– –––––Profit/(loss) 1 (1·5) 0·8 0·3

––––– –––– –––– –––––

Balance sheet as at 31 March 2006Gross amounts due from customers (see below) 2·4 4·8 7·2Gross amounts due to customers (see below) (1·3) (1·3)

Gross amounts from and to customers:Contract cost incurred 12·5 3·5 4·0 20·0Recognised profits less (losses) 2·5 (1·5) 0·8 1·8Provision for losses to date (1·5) (1·5)Payments received (12·6) (1·8) (nil) (14·4)

––––– –––– –––– –––––Due from customers 2·4 4·8 7·2

––––– ––––Due to customers (contract liability) (1·3) (1·3)

–––– –––––

Workings (in $m):

Alfa at 31 March 2005 at 31 March 2006 Year ended 31 March 2006Work invoiced (5·4/90%) 6·0 (12·6/90%) 14·0 8Cost of sales (balancing figure) (4·5) (11·5) (7)

–––– ––––– ––Profit (see below) 1·5 2·5 1

–––– ––––– ––Percentage complete (6/20 x 100) 30% (14/20 x 100) 70%Attributable profit ($5m x 30%) 1·5 (($5m x 70%) – $1m rectification) 2·5

Prior to the rectification costs (which must be charged to the year in which they are incurred), the estimated total profit onthe contract is $5 million ($20m – $15m).

BetaDue to the increase in the estimated cost Beta is a loss-making contract and the whole of the loss must be provided for assoon as it is can be anticipated. The loss is expected to be $1·5 million ($7·5m – $6m). The sales value of the contract at31 March 2006 is $2 million ($1·8/90%), thus the cost of sales must be recorded as $3·5 million. As costs to date are $2 million, this means a provision of $1·5 million is required.

CetaBased on the costs to date at 31 March 2006 of $4 million and the total estimated costs of $10 million, this contract is 40%complete. The estimated profit is $2 million ($12m – $10m); therefore the profit at 31 March 2006 is $0·8 million ($2m x40%). This gives an imputed sales (and receivable) value of $4·8 million.

(b) (i) Savoir – EPS year ended 31 March 2004:

The issue on 1 July 2003 at full market value needs to be weighted:

40m x 3/12 = 10mNew shares 8m

––––48m x 9/12 = 36m

––––46m––––

Without the bonus issue this would give an EPS of 30c ($13·8m/46m x 100).

The bonus issue of one for four would result in 12 million new shares giving a total number of ordinary shares of 60 million. The dilutive effect of the bonus issue would reduce the EPS to 24c (30c x 48m/60m). The comparative EPS (for 2003) would be restated at 20c (25c x 48m/60m).

22



EPS year ended 31 March 2005:

The rights issue of two for five on 1 October 2004 is half way through the year. The theoretical ex rights value can becalculated as:

Holder of 100 shares worth $2·40 = $240Subscribes for 40 shares at $1 each = $40

––– –––––Now holds 140 worth (in theory) $280 i.e. $2 each.

––– –––––

Weighting:60m x 6/12 x 2·40/2·00 = 36 million

Rights issue (2 for 5) 24m––––

New total 84m x 6/12 = 42 million––

Weighted average 78 million––

EPS is therefore 25c ($19·5m/78m x 100). The comparative (for 2004) would be restated at 20c (24c x 2·00/2·40).

(ii) The basic EPS for the year ended 31 March 2006 is 30c ($25·2m/84m x 100).

Dilution

Convertible loan stockOn conversion loan interest of $1·2 million after tax would be saved ($20 million x 8% x (100% – 25%)) and a further10 million shares would be issued ($20m/$100 x 50).

Directors’ optionsOptions for 12 million shares at $1·50 each would yield proceeds of $18 million. At the average market price of $2·50per share this would purchase 7·2 million shares ($18m/$2·50). Therefore the ‘bonus’ element of the options is 4·8 million shares (12m – 7·2m).

Using the above figures the diluted EPS for the year ended 31 March 2006 is 26·7c ($25·2m + $1·2m)/(84m + 10m+ 4·8m)).

23





Marks1 (a) Income statement:

revenue 2cost of sales 3operating expenses including 1 mark for goodwill 2interest receivable/payable 1income tax 1minority interest 2Balance sheet:goodwill 3tangible non-current assets 2investments 1current assets/current liabilities 27% bank loan 1elimination of 10% intra group loan 1minority interest 2share capital and share premium 1retained earnings 1


((bb)) 1 mark per relevant point to maximum 5Maximum for question 25

2 (a) Income statementrevenue 1cost of sales 4operating costs 1investment income 1loss on investment 1finance costs 2income tax 2


(b) Statement of recognised income and expensesurplus on land and buildings 1profit for period 1

maximum 2

(c) Balance sheet property, plant and equipment 4investment property 1inventories 1trade receivables 1share capital 1revaluation reserve 1retained earnings (1 for dividend deduction) 2overdraft 1trade payables 1current tax payable 1deferred tax 1preference shares (shown as a liability) 1



25



Marks3 (a) one mark per valid point to max 5

(b) one mark per valid point to max 8

(c) (i) acceptable method to value goodwill of subsidiary 1although no difference in nature of goodwill; 1cannot use this method to value goodwill of parent 1IFRS specifically prohibits recognition of internal goodwill 1main issue is reliable measurement 1


(ii) IAS 37 requires immediate recognition (as a provision) of such costs 1future costs discounted to present value 1added to cost of the asset (increases depreciation) 1unwinding of discount is a finance cost 1

maximum 4

(iii) directors’ suggestion is incorrect, part of proceeds is equity 1IFRS require equity component to be calculated (residual equity method) 1Debt is $4,746,000; equity is $254,000 1Income statement charge is $475,000 1Non-current liability at 31 March 2006 $4,821,000 1



4 (a) profit before tax 1depreciation 1loss on sale of hotel 1increase in current assets 1decrease in current liabilities 1interest paid 1income taxes paid 1purchase of non-current assets 1sale of non-current assets 1share issue 1issue of loan 1cash and cash equivalents b/f and c/f 1


(b) one mark per valid point to max 15Maximum for question 25

26



Marks5 (a) Income statement

revenue 4cost of sales/profit 4balance sheetgross amounts due from customers 4provision 1


(b) (i) EPS – year ended 31 March 2004 4– year ended 31 March 2004 comparative 1– year ended 31 March 2005 4– year ended 31 March 2005 comparative 1


(ii) EPS year ended 31 March 2006– basic EPS 1– dilution effect of options 1– effect of convertible loan stock 1– calculation 1


27




PART 2


QUESTION PAPER







Pape

r 2.5

(IN

T)





1 Hosterling purchased the following equity investments:

On 1 October 2005: 80% of the issued share capital of Sunlee. The acquisition was through a share exchange ofthree shares in Hosterling for every five shares in Sunlee. The market price of Hosterling’s shares at 1 October 2005was $5 per share.

On 1 July 2006: 6 million shares in Amber paying $3 per share in cash and issuing to Amber’s shareholders 6%(actual and effective rate) loan notes on the basis of $100 loan note for every 100 shares acquired.

The summarised income statements for the three companies for the year ended 30 September 2006 are:

Hosterling Sunlee Amber$’000 $’000 $’000


–––––––– –––––––– ––––––––Gross profit/(loss) 37,000 25,500 (11,000)Other income (note (i)) 400 nil nilDistribution costs (4,000) (2,000) (4,500)Administrative expenses (7,500) (7,000) (8,500)Finance costs (1,200) (900) nil

–––––––– –––––––– ––––––––Profit/(loss) before tax 24,700 15,600 (24,000)Income tax (expense)/credit (8,700) (2,600) 4,000

–––––––– –––––––– ––––––––Profit/(loss) for the period 16,000 13,000 (20,000)

–––––––– –––––––– ––––––––


(i) The other income is a dividend received from Sunlee on 31 March 2006.

(ii) The details of Sunlee’s and Amber’s share capital and reserves at 1 October 2005 were:

Sunlee Amber$’000 $’000

Equity shares of $1 each 20,000 15,000Retained earnings 18,000 35,000

(iii) A fair value exercise was carried out at the date of acquisition of Sunlee with the following results:

carrying fair value remaining life (straight line)amount$’000 $’000

Intellectual property 18,000 22,000 still in developmentLand 17,000 20,000 not applicablePlant 30,000 35,000 five years

The fair values have not been reflected in Sunlee’s financial statements.

Plant depreciation is included in cost of sales.

No fair value adjustments were required on the acquisition of Amber.

(iv) In the year ended 30 September 2006 Hosterling sold goods to Sunlee at a selling price of $18 million.Hosterling made a profit of cost plus 25% on these sales. $7·5 million (at cost to Sunlee) of these goods werestill in the inventories of Sunlee at 30 September 2006.

(v) Impairment tests for both Sunlee and Amber were conducted on 30 September 2006. They concluded that thegoodwill of Sunlee should be written down by $1·6 million and, due to its losses since acquisition, the investmentin Amber was worth $21·5 million.

(vi) All trading profits and losses are deemed to accrue evenly throughout the year.

2



Required:

(a) Calculate the goodwill arising on the acquisition of Sunlee at 1 October 2005. (5 marks)

(b) Calculate the carrying amount of the investment in Amber at 30 September 2006 under the equity methodprior to the impairment test. (4 marks)

(c) Prepare the consolidated income statement for the Hosterling Group for the year ended 30 September 2006.(16 marks)

(25 marks)

3 [P.T.O.




2 The following trial balance relates to Tadeon, a publicly listed company, at 30 September 2006:

$’000 $’000Revenue 277,800Cost of sales 118,000Operating expenses 40,000Loan interest paid (note (i)) 1,000Rental of vehicles (note (ii)) 6,200Investment income 2,00025 year leasehold property at cost (note (iii)) 225,000Plant and equipment at cost 181,000Investments at amortised cost 42,000Accumulated depreciation at 1 October 2005 – leasehold property 36,000

– plant and equipment 85,000Equity shares of 20 cents each fully paid 150,000Retained earnings at 1 October 2005 18,6002% Loan note (note (i)) 50,000Deferred tax balance 1 October 2005 (note (iv)) 12,000Trade receivables 53,500Inventories at 30 September 2006 33,300Bank 1,900Trade payables 18,700Suspense account (note (v)) 48,000

–––––––– ––––––––700,000 700,000–––––––– ––––––––


(i) The loan note was issued on 1 October 2005. It is redeemable on 30 September 2010 at a large premium (inorder to compensate for the low nominal interest rate). The finance department has calculated that the effectiveinterest rate on the loan is 5·5% per annum.

(ii) The rental of the vehicles relates to two separate contracts. These have been scrutinised by the financedepartment and they have come to the conclusion that $5 million of the rentals relate to a finance lease. Thefinance lease was entered into on 1 October 2005 (the date the $5 million was paid) for a four year period. Thevehicles had a fair value of $20 million (straight-line depreciation should be used) at 1 October 2005 and thelease agreement requires three further annual payments of $6 million each on the anniversary of the lease. Theinterest rate implicit in the lease is to be taken as 10% per annum. (Note: you are not required to calculate thepresent value of the minimum lease payments.) The other contract is an operating lease and should be chargedto operating expenses.

Other plant and equipment is depreciated at 121/2% per annum on the reducing balance basis.

All depreciation of property, plant and equipment is charged to cost of sales.

(iii) On 30 September 2006 the leasehold property was revalued to $200 million. The directors wish to incorporatethis valuation into the financial statements.

(iv) The directors have estimated the provision for income tax for the year ended 30 September 2006 at $38 million.At 30 September 2006 there were $74 million of taxable temporary differences, of which $20 million related tothe revaluation of the leasehold property (see (iii) above). The income tax rate is 20%.

(v) The suspense account balance can be reconciled from the following transactions:

The payment of a dividend in October 2005. This was calculated to give a 5% yield on the company’s shareprice of 80 cents as at 30 September 2005.

The net receipt in March 2006 of a fully subscribed rights issue of one new share for every three held at a priceof 32 cents each. The expenses of the share issue were $2 million and should be charged to share premium.

Note: the cash entries for these transactions have been correctly accounted for.

4



Required:

Prepare for Tadeon:

(a) An income statement for the year ended 30 September 2006; and (8 marks)


Note: A statement of changes in equity is not required. Disclosure notes are not required.

(25 marks)

5 [P.T.O.



3 (a) Recording the substance of transactions, rather than their legal form, is an important principle in financialaccounting. Abuse of this principle can lead to profit manipulation, non-recognition of assets and substantial debtnot being recorded on the balance sheet.

Required:

Describe how the use of off balance sheet financing can mislead users of financial statements.

Note: your answer should refer to specific user groups and include examples where recording the legal formof transactions may mislead them. (9 marks)

(b) Angelino has entered into the following transactions during the year ended 30 September 2006:

(i) In September 2006 Angelino sold (factored) some of its trade receivables to Omar, a finance house. Onselected account balances Omar paid Angelino 80% of their book value. The agreement was that Omarwould administer the collection of the receivables and remit a residual amount to Angelino depending uponhow quickly individual customers paid. Any balance uncollected by Omar after six months will be refundedto Omar by Angelino. (5 marks)

(ii) On 1 October 2005 Angelino owned a freehold building that had a carrying amount of $7·5 million and hadan estimated remaining life of 20 years. On this date it sold the building to Finaid for a price of $12 millionand entered into an agreement with Finaid to rent back the building for an annual rental of $1·3 million fora period of five years. The auditors of Angelino have commented that in their opinion the building had amarket value of only $10 million at the date of its sale and to rent an equivalent building under similar termsto the agreement between Angelino and Finaid would only cost $800,000 per annum. Assume any financecosts are 10% per annum. (6 marks)

(iii) Angelino is a motor car dealer selling vehicles to the public. Most of its new vehicles are supplied onconsignment by two manufacturers, Monza and Capri, who trade on different terms.

Monza supplies cars on terms that allow Angelino to display the vehicles for a period of three months fromthe date of delivery or when Angelino sells the cars on to a retail customer if this is less than three months.Within this period Angelino can return the cars to Monza or can be asked by Monza to transfer the cars toanother dealership (both at no cost to Angelino). Angelino pays the manufacturer’s list price at the end ofthe three month period (or at the date of sale if sooner). In recent years Angelino has returned several carsto Monza that were not selling very well and has also been required to transfer cars to other dealerships atMonza’s request.

Capri’s terms of supply are that Angelino pays 10% of the manufacturer’s price at the date of delivery and1% of the outstanding balance per month as a display charge. After six months (or sooner if Angelinochooses), Angelino must pay the balance of the purchase price or return the cars to Capri. If the cars arereturned to the manufacturer, Angelino has to pay for the transportation costs and forfeits the 10% deposit.Because of this Angelino has only returned vehicles to Capri once in the last three years. (5 marks)

Required:

Describe how the above transactions and events should be treated in the financial statements ofAngelino for the year ended 30 September 2006. Your answer should explain, where relevant, thedifference between the legal form of the transactions and their substance.

Note: The mark allocation is shown against each of the three transactions above.

(25 marks)

6




7 [P.T.O.



4 Minster is a publicly listed company. Details of its financial statements for the year ended 30 September 2006,together with a comparative balance sheet, are:

Balance Sheet at 30 September 2006 30 September 2005$000 $000 $000 $000

Non-current assets (note (i))Property, plant and equipment 1,280 940Software 135 nilInvestments at fair value through profit and loss 150 125

–––––– ––––––1,565 1,065

Current assetsInventories 480 510Trade receivables 270 380Amounts due from construction contracts 80 55Bank nil 830 35 980

–––– –––––– –––– ––––––Total assets 2,395 2,045

–––––– ––––––Equity and liabilitiesEquity shares of 25 cents each 500 300ReservesShare premium (note (ii)) 150 85Revaluation reserve 60 25Retained earnings 950 1,160 965 1,075

–––– –––––– –––– ––––––1,660 1,375

Non-current liabilities9% loan note 120 nilEnvironmental provision 162 nilDeferred tax 18 300 25 25

–––– ––––Current liabilitiesTrade payables 350 555Bank overdraft 25 40Current tax payable 60 435 50 645

–––– –––––– –––– ––––––Total equity and liabilities 2,395 2,045

–––––– ––––––

Income statement for the year ended 30 September 2006Revenue 1,397Cost of sales (1,110)

––––––Gross profit 287Operating expenses (125)

––––––162

Finance costs (note (i)) (40)Investment income and gain on investments 20

––––––Profit before tax 142Income tax expense (57)

––––––Profit for the year 85

––––––


(i) Included in property, plant and equipment is a coal mine and related plant that Minster purchased on 1 October2005. Legislation requires that in ten years’ time (the estimated life of the mine) Minster will have to landscapethe area affected by the mining. The future cost of this has been estimated and discounted at a rate of 8% to a

8



present value of $150,000. This cost has been included in the carrying amount of the mine and, together withthe unwinding of the discount, has also been treated as a provision. The unwinding of the discount is includedwithin finance costs in the income statement.

Other land was revalued (upward) by $35,000 during the year.

Depreciation of property, plant and equipment for the year was $255,000.

There were no disposals of property, plant and equipment during the year.

The software was purchased on 1 April 2006 for $180,000.

The market value of the investments had increased during the year by $15,000. There have been no sales ofthese investments during the year.

(ii) On 1 April 2006 there was a bonus (scrip) issue of equity shares of one for every four held utilising the sharepremium reserve. A further cash share issue was made on 1 June 2006. No shares were redeemed during theyear.

(iii) A dividend of 5 cents per share was paid on 1 July 2006.

Required:

(a) Prepare a cash flow statement for Minster for the year to 30 September 2006 in accordance with IAS 7 Cashflow statements. (15 marks)

(b) Comment on the financial performance and position of Minster as revealed by the above financial statementsand your cash flow statement. (10 marks)

(25 marks)

9 [P.T.O.



10

5 (a) (i) State the definition of both non-current assets held for sale and discontinued operations and explain theusefulness of information for discontinued operations. (4 marks)

Partway is in the process of preparing its financial statements for the year ended 31 October 2006. Thecompany’s main activity is in the travel industry mainly selling package holidays (flights and accommodation) tothe general public through the Internet and retail travel agencies. During the current year the number of holidayssold by travel agencies declined dramatically and the directors decided at a board meeting on 15 October 2006to cease marketing holidays through its chain of travel agents and sell off the related high-street premises.Immediately after the meeting the travel agencies’ staff and suppliers were notified of the situation and anannouncement was made in the press. The directors wish to show the travel agencies’ results as a discontinuedoperation in the financial statements to 31 October 2006. Due to the declining business of the travel agents, on1 August 2006 (three months before the year end) Partway expanded its Internet operations to offer car hirefacilities to purchasers of its Internet holidays.

The following are Partway’s summarised income statement results – years ended:

31 October 2006 31 October 2005Internet travel agencies car hire total total$’000 $’000 $’000 $’000 $’000

Revenue 23,000 14,000 2,000 39,000 40,000Cost of sales (18,000) (16,500) (1,500) (36,000) (32,000)

–––––––– ––––––– ––––––– –––––––– ––––––––Gross profit/(loss) 5,000 (2,500) 500 3,000 8,000Operating expenses (1,000) (1,500) (100) (2,600) (2,000)

–––––––– ––––––– ––––––– –––––––– ––––––––Profit/(loss) before tax 4,000 (4,000) 400 400 6,000

–––––––– ––––––– ––––––– –––––––– ––––––––

The results for the travel agencies for the year ended 31 October 2005 were: revenue $18 million, cost of sales $15 million and operating expenses of $1·5 million.

Required:

(ii) Discuss whether the directors’ wish to show the travel agencies’ results as a discontinued operation isjustifiable. (4 marks)

(iii) Assuming the closure of the travel agencies is a discontinued operation, prepare the (summarised)income statement of Partway for the year ended 31 October 2006 together with its comparatives.

Note: Partway discloses the analysis of its discontinued operations on the face of its income statement.(6 marks)

(b) (i) Describe the circumstances in which an entity may change its accounting policies and how a changeshould be applied. (5 marks)

The terms under which Partway sells its holidays are that a 10% deposit is required on booking and the balanceof the holiday must be paid six weeks before the travel date. In previous years Partway has recognised revenue(and profit) from the sale of its holidays at the date the holiday is actually taken. From the beginning of November2005, Partway has made it a condition of booking that all customers must have holiday cancellation insuranceand as a result it is unlikely that the outstanding balance of any holidays will be unpaid due to cancellation. Inpreparing its financial statements to 31 October 2006, the directors are proposing to change to recognisingrevenue (and related estimated costs) at the date when a booking is made. The directors also feel that this changewill help to negate the adverse effect of comparison with last year’s results (year ended 31 October 2005) whichwere better than the current year’s.

Required:

(ii) Comment on whether Partway’s proposal to change the timing of its recognition of its revenue isacceptable and whether this would be a change of accounting policy. (6 marks)

(25 marks)




Answers




1 (a) Cost of control in Sunlee:Consideration $’000 $’000Shares (20,000 x 80% x 3/5 x $5) 48,000LessEquity shares 20,000Pre acq reserves 18,000Fair value adjustments (4,000 + 3,000 + 5,000) 12,000

–––––––50,000 x 80% (40,000)

–––––––Goodwill 8,000

–––––––

(b) Carrying amount of Amber 30 September 2006 (prior to impairment loss):At cost $’000Cash (6,000 x $3) 18,0006% loan notes (6,000 x $100/100) 6,000

–––––––24,000

LessPost acquisition losses (20,000 x 40% x 3/12) (2,000)

–––––––22,000–––––––

(c) Hosterling GroupConsolidated income statement for the year ended 30 September 2006

$’000Revenue (105,000 + 62,000 – 18,000 intra group) 149,000Cost of sales (see working) (89,000)

––––––––Gross profit 60,000Distribution costs (4,000 + 2,000) (6,000)Administrative expenses (7,500 + 7,000) (14,500)Finance costs (1,200 + 900) (2,100)Impairment losses:

Goodwill (1,600)Investment in associate (22,000 – 21,500) (500)

Share of loss from associate (20,000 x 40% x 3/12) (2,000)––––––––

Profit before tax 33,300Income tax expense (8,700 + 2,600) (11,300)


––––––––

Attributable to:Equity holders of the parent 19,600Minority Interest ((13,000 – 1,000 depreciation adjustment) x 20%) 2,400

––––––––22,000

––––––––

Note: the dividend from Sunlee is eliminated on consolidation.

Working $’000Cost of salesHosterling 68,000Sunlee 36,500Intra group purchases (18,000)Additional depreciation of plant (5,000/5 years) 1,000Unrealised profit in inventories (7,500 x 25%/125%) 1,500

––––––––89,000

––––––––

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2 (a) Tadeon – Income statement – Year to 30 September 2006$’000 $’000

Revenue 277,800Cost of sales (w (i)) (144,000)

–––––––––Gross profit 133,800Operating expenses (40,000 + 1,200 (w (ii))) (41,200)Investment income 2,000Finance costs – finance lease (w (ii)) (1,500)

– loan (w (iii)) (2,750) (4,250)––––––– –––––––––

Profit before tax 90,350Income tax expense (w (iv)) (36,800)


–––––––––

(b) Tadeon – Balance Sheet as at 30 September 2006

Non-current assets $’000 $’000Property, plant and equipment (w (v)) 299,000Investments at amortised cost 42,000

–––––––––341,000

Current assetsInventories 33,300Trade receivables 53,500 86,800

––––––– –––––––––Total assets 427,800

–––––––––

Equity and liabilitiesCapital and reserves:Equity shares of 20 cents each fully paid (w (vi)) 200,000ReservesShare premium (w (vi)) 28,000Revaluation reserve (w (v)) 16,000Retained earnings (w (vii)) 42,150 86,150

––––––– –––––––––286,150

Non-current liabilities2% Loan note (w (iii)) 51,750Deferred tax (w (iv)) 14,800Finance lease obligation (w (ii)) 10,500 77,050

–––––––

Current liabilitiesTrade payables 18,700Accrued lease finance costs (w (ii)) 1,500Finance lease obligation (w (ii)) 4,500Bank overdraft 1,900Income 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: $’000Per trial balance 118,000Depreciation (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 isidentified as finance lease rentals. The operating rentals have been included in operating expenses.

Finance lease $’000Fair value of vehicles 20,000First rental payment – 1 October 2005 (5,000)

–––––––Capital outstanding to 30 September 2006 15,000Accrued interest 10% (current liability) 1,500

–––––––Total outstanding 30 September 2006 16,500

–––––––

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In the year to 30 September 2007 (i.e. on 1 October 2006) the second rental payment of $6 million will be made, ofthis $1·5 million is for the accrued interest for the previous year, thus $4·5 million will be a capital repayment. Theremaining $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%, amortisation of the large premium on redemption, gives aneffective interest rate of 5·5% (from question). This means the finance charge to the income statement will be a total of$2·75 million (50,000 x 5·5%). As the actual interest paid is $1 million an accrual of $1·75 million is required. Thisamount is added to the carrying amount of the loan in the balance sheet.

(iv) Income tax and deferred taxThe income statement charge is made up as follows: $'000Current year’s provision 38,000Deferred tax (see below) (1,200)

–––––––36,800–––––––

There are $74 million of taxable temporary differences at 30 September 2006. With an income tax rate of 20%, thiswould require a deferred tax liability of $14·8 million (74,000 x 20%). $4 million ($20m x 20%) is transferred todeferred tax in respect of the revaluation of the leasehold property (and debited to the revaluation reserve), thus the effectof deferred tax on the income statement is a credit of $1·2 million (14,800 – 4,000 – 12,000 b/f).

(v) Non-current assets/depreciation:Non-leased plantThis has a carrying amount of $96 million (181,000 – 85,000) prior to depreciation of $12 million at 121/2% reducingbalance to give a carrying amount of $84 million at 30 September 2006.

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 2006 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 revaluationon 30 September 2006 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 betransferred to a revaluation reserve. The question says the revaluation gives rise to $20 million of the deductibletemporary differences, at a tax rate of 20%, this would give a credit to deferred tax of $4 million which is debited to therevaluation 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 200,000Non-leased plant 181,000 97,000 84,000Leased vehicles 20,000 5,000 15,000

–––––––– –––––––– ––––––––401,000 102,000 299,000–––––––– –––––––– ––––––––

(vi) Suspense accountThe called up share capital of $150 million in the trial balance represents 750 million shares (150m/0·2) which havea market value at 1 October 2005 of $600 million (750m x 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 issueof 250 million (150m/0·2 x 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 x 20 cents) to equity sharecapital 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 suspenseaccount balance of $48 million.

(vii) Retained earnings $,000At 1 October 2005 18,600Year to 30 September 2006 53,550less dividends paid (w (vi)) (30,000)

–––––––42,150–––––––

3 (a) Most forms of off balance sheet financing have the effect of what is, in substance, debt finance either not appearing on thebalance sheet at all or being netted off against related assets such that it is not classified as debt. Common examples wouldbe structuring a lease such that it fell to be treated as an operating lease when it has the characteristics of a finance lease,complex financial instruments classified as equity when they may have, at least in part, the substance of debt and ‘controlled’entities having large borrowings (used to benefit the group as a whole), that are not consolidated because the financialstructure avoids the entities meeting the definition of a subsidiary.

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The main problem of off balance sheet finance is that it results in financial statements that do not faithfully represent thetransactions and events that have taken place. Faithful representation is an important qualitative characteristic of usefulinformation (as described in the Framework for the preparation and presentation of financial statements). Financialstatements that do not faithfully represent that which they purport to lack reliability. A lack of reliability may mean that anydecisions made on the basis of the information contained in financial statements are likely to be incorrect or, at best, sub-optimal.

The level of debt on a balance sheet is a direct contributor to the calculation of an entity’s balance sheet gearing, which isconsidered as one of the most important financial ratios. It should be understood that, to a point, the use of debt financingis perfectly acceptable. Where balance sheet gearing is considered low, borrowing is relatively inexpensive, often tax efficientand can lead to higher returns to shareholders. However, when the level of borrowings becomes high, it increases risk inmany ways. Off balance sheet financing may lead to a breach of loan covenants (a serious situation) if such debt were to berecognised on the balance sheet in accordance with its substance.

High gearing is a particular issue to equity investors. Equity (ordinary shares) is sometimes described as residual returncapital. This description identifies the dangers (to equity holders) when an entity has high gearing. The dividend that theequity shareholders might expect is often based on the level of reported profits. The finance cost of debt acts as a reductionof the profits available for dividends. As the level of debt increases, higher interest rates are also usually payable to reflect theadditional risk borne by the lender, thus the higher the debt the greater the finance charges and the lower the profit. Manyoff balance sheet finance schemes also disguise or hide the true finance cost which makes it difficult for equity investors toassess the amount of profits that will be needed to finance the debt and consequently how much profit will be available toequity investors. Furthermore, if the market believes or suspects an entity is involved in ‘creative accounting’ (and off balancesheet finance is a common example of this) it may adversely affect the entity’s share price.

An entity’s level of gearing will also influence any decision to provide further debt finance (loans) to the entity. Lenders willconsider the nature and value of the assets that an entity owns which may be provided as security for the borrowings. Thepresence of existing debt will generally increase the risk of default of interest and capital repayments (on further borrowings)and existing lenders may have a prior charge on assets available as security. In simple terms if an entity has high borrowings,additional borrowing is more risky and consequently more expensive. A prospective lender to an entity that already has highborrowings, but which do not appear on the balance sheet is likely to make the wrong decision. If the correct level ofborrowings were apparent, either the lender would not make the loan at all (too high a lending risk) or, if it did make the loan,it would be on substantially different terms (e.g. charge a higher interest rate) so as to reflect the real risk of the loan.

Some forms of off balance sheet financing may specifically mislead suppliers that offer credit. It is a natural precaution thata prospective supplier will consider the balance sheet strength and liquidity ratios of the prospective customer. The existenceof consignment inventories may be particularly relevant to trade suppliers. Sometimes consignment inventories and theirrelated current liabilities are not recorded on the balance sheet as the wording of the purchase agreement may be such thatthe legal ownership of the goods remains with the supplier until specified events occur (often the onward sale of the goods).This means that other suppliers cannot accurately assess an entity’s true level of trade payables and consequently the averagepayment period to suppliers, both of which are important determinants in deciding whether to grant credit.

(b) (i) Debt factoring is a common method of entities releasing the liquidity of their trade receivables. The accounting issue thatneeds to be decided is whether the trade receivables have been sold, or whether the income from the finance house fortheir ‘sale’ should be treated as a short term loan. The main substance issue with this type of transaction is to identifywhich party bears the risks (i.e. of slow and non-payment by the customer) relating to the asset. If the risk lies with thefinance house (Omar), the trade receivables should be removed from the balance sheet (derecognised in accordancewith IAS 39). In this case it is clear that Angelino still bears the risk relating to slow and non-payment. The residualpayment by Omar depends on how quickly the receivables are collected; the longer it takes, the less the residualpayment (this imputes a finance cost). Any balance uncollected by Omar after six months will be refunded by Angelinowhich reflects the non-payment risk.

Thus the correct accounting treatment for this transaction is that the cash received from Omar (80% of the selectedreceivables) should be treated as a current liability (a short term loan) and the difference between the gross tradereceivables and the amount ultimately received from Omar (plus any amounts directly from the credit customersthemselves) should be charged to the income statement. The classification of the charge is likely to be a mixture ofadministrative expenses (for Omar collecting receivables), finance expenses (reflecting the time taken to collect thereceivables) and the impairment of trade receivables (bad debts).

(ii) This is an example of a sale and leaseback of a property. Such transactions are part of normal commercial activity, oftenbeing used as a way to improve cash flow and liquidity. However, if an asset is sold at an amount that is different to itsfair value there is likely to be an underlying reason for this. In this case it appears (based on the opinion of the auditor)that Finaid has paid Angelino $2 million more than the building is worth. No (unconnected) company would do thisknowingly without there being some form of ‘compensating’ transaction. This sale is ‘linked’ to the five year rentalagreement. The question indicates the rent too is not at a fair value, being $500,000 per annum ($1,300,000 –$800,000) above what a commercial rent for a similar building would be.

It now becomes clear that the excess purchase consideration of $2 million is an ‘in substance’ loan (rather than salesproceeds – the legal form) which is being repaid through the excess ($500,000 per annum) of the rentals. Althoughthis is a sale and leaseback transaction, as the building is freehold and has an estimated remaining life (20 years) thatis much longer than the five year leaseback period, the lease is not a finance lease and the building should be treatedas sold and thus derecognised.

16



The correct treatment for this item is that the sale of the building should be recorded at its fair value of $10 million, thusthe profit on disposal would be $2·5 million ($10 million – $7·5 million). The ‘excess’ of $2 million ($12 million – $10 million) should be treated as a loan (non-current liability). The rental payment of $1·3 million should be split intothree elements; $800,000 building rental cost, $200,000 finance cost (10% of $2 million) and the remaining$300,000 is a capital repayment of the loan.

(iii) The treatment of consignment inventory depends on the substance of the arrangements between the manufacturer andthe dealer (Angelino). The main issue is to determine if and at what point in time the cars are ’sold’. The substance isdetermined by analysing which parties bear the risks (e.g. slow moving/obsolete inventories, finance costs) and receivethe benefits (e.g. use of inventories, potential for higher sales, protection from price increases) associated with thetransaction.

Supplies from MonzaAngelino has, and has actually exercised, the right to return the cars without penalty (or been required by Monza totransfer them to another dealer), which would indicate that it has not ‘bought’ the cars. There are no finance costsincurred by Angelino, however Angelino would suffer from any price increases that occurred during the three monthholding/display period. These factors seem to indicate that the substance of this arrangement is the same as its legalform i.e. Monza should include the cars in its balance sheet as inventory and therefore Angelino will not record apurchase transaction until it becomes obliged to pay for the cars (three months after delivery or until sold to customersif sooner).

Supplies from CapriAlthough this arrangement seems similar to the above, there are several important differences. Angelino is bearing thefinance costs of 1% per month (calling it a display charge is a distraction). The option to return the cars should beignored because it is not likely to be exercised due to commercial penalties (payment of transport costs and loss ofdeposit). Finally the purchase price is fixed at the date of delivery rather than at the end of six months. These factorsstrongly indicate that Angelino bears the risks and rewards associated with ownership and should recognise theinventory and the associated liability in its financial statements at the date of delivery.

17



4 (a) Cash Flow Statement of Minster for the Year ended 30 September 2006:

Cash flows from operating activities $000 $000Profit before tax 142Adjustments for:Depreciation of property, plant and equipment 255Amortisation of software (180 – 135) 45 300

––––Investment income (20)Finance costs 40

––––462

Working capital adjustmentsDecrease in trade receivables (380 – 270) 110Increase in amounts due from construction contracts (80 – 55) (25)Decrease in inventories (510 – 480) 30Decrease in trade payables (555 – 350) (205) (90)

–––– ––––Cash generated from operations 372Interest paid (40 – 12 re unwinding of environmental provision) (28)Income taxes paid (w (ii)) (54)

––––Net cash from operating activities 290

Cash flows from investing activitiesPurchase of – property, plant and equipment (w (i)) (410)

– software (180)– investments (150 – (15 + 125)) (10)

Investment income received (20 – 15 gain on investments) 5––––

Net cash used in investing activities (595)

Cash flows from financing activitiesProceeds from issue of equity shares (w (iii)) 265Proceeds from issue of 9% loan note 120Dividends paid (500 x 4 x 5 cents) (100)

––––Net cash from financing activities 285

––––Net decrease in cash and cash equivalents (20)Cash and cash equivalents at beginning of period (40 – 35) (5)

––––Cash and cash equivalents at end of period (25)

––––

Note: interest paid may be presented under financing activities and dividends paid may be presented under operatingactivities.

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

carrying amount b/f 940non-cash environmental provision 150revaluation 35depreciation for period (255)carrying amount c/f (1,280)

––––––difference is cash acquisitions (410)

––––––

(ii) Taxation:tax provision b/f (50)deferred tax b/f (25)income statement charge (57)tax provision c/f 60deferred tax c/f 18

––––difference is cash paid (54)

––––

(iii) Equity sharesbalance b/f (300)bonus issue (1 for 4) (75)balance c/f 500

–––––difference is cash issue 125

–––––

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Share premiumbalance b/f (85)bonus issue (1 for 4) 75balance c/f 150

–––––difference is cash issue 140

–––––

Therefore the total proceeds of cash issue of shares are $265,000 (125 + 140).

(b) Report on the financial position of Minster for the year ended 30 September 2006

To: From: Date:

Minster shows healthy operating cash inflows of $372,000 (prior to finance costs and taxation). This is considered by manycommentators as a very important figure as it is often used as the basis for estimating the company’s future maintainablecash flows. Subject to (inevitable) annual expected variations and allowing for any changes in the company’s structure thisfigure is more likely to be repeated in the future than most other figures in the cash flow statements which are often ‘one-off’cash flows such as raising loans or purchasing non-current assets. The operating cash inflow compares well with theunderlying profit before tax $142,000. This is mainly due to depreciation charges of $300,000 being added back to the profitas they are a non-cash expense. The cash inflow generated from operations of $372,000 together with the reduction in networking capital of $90,000 is more than sufficient to cover the company’s taxation payments of $54,000, interest paymentsof $28,000 and the dividend of $100,000 and leaves an amount to contribute to the funding of the increase in non-currentassets. It is important that these short term costs are funded from operating cash flows; it would be of serious concern if, forexample, interest or income tax payments were having to be funded by loan capital or the sale of non-current assets.

There are a number of points of concern. The dividend of $100,000 gives a dividend cover of less than one (85/100 = 0·85)which means the company has distributed previous year’s profits. This is not a tenable situation in the long-term. The sizeof the dividend has also contributed to the lower cash balances (see below). There is less investment in both inventory levelsand trade receivables. This may be the result of more efficient inventory control and better collection of receivables, but it mayalso indicate that trading volumes may be falling. Also of note is a large reduction in trade payable balances of $205,000.This too may be indicative of lower trading (i.e. less inventory purchased on credit) or pressure from suppliers to pay earlier.Without more detailed information it is difficult to come to a conclusion in this matter.

Investing activities:The cash flow statement shows considerable investment in non-current assets, in particular $410,000 in property, plant andequipment. These acquisitions represent an increase of 44% of the carrying amount of the property, plant and equipment asat the beginning of the year. As there are no disposals, the increase in investment must represent an increase in capacityrather than the replacement of old assets. Assuming that this investment has been made wisely, this should bode well for thefuture (most analysts would prefer to see increased investment rather than contraction in operating assets). An unusual featureof the required treatment of environmental provisions is that the investment in non-current assets as portrayed by the cashflow statement appears less than if balance sheet figures are used. The balance sheet at 30 September 2006 includes$150,000 of non-current assets (the discounted cost of the environmental provision), which does not appear in the cash flowfigures as it is not a cash ‘cost’. A further consequence is that the ‘unwinding’ of the discounting of the provision causes afinancing expense in the income statement which is not matched in the cash flow statement as the unwinding is not a cashflow. Many commentators have criticised the required treatment of environmental provisions because they cause financingexpenses which are not (immediate) cash costs and no ‘loans’ have been taken out. Viewed in this light, it may be that theinformation in the cash flow statement is more useful than that in the income statement and balance sheet.

Financing activities:The increase in investing activities (before investment income) of $600,000 has been largely funded by an issue of sharesat $265,000 and raising a 9% $120,000 loan note. This indicates that the company’s shareholders appear reasonablypleased with the company's past performance (or they would not be very willing to purchase further shares). The interest rateof the loan at 9% seems quite high, and virtually equal to the company’s overall return on capital employed of 9·1%(162/(1,660 + 120)). Provided current profit levels are maintained, it should not reduce overall returns to shareholders.

Cash position:The overall effect of the year’s cash flows has worsened the company’s cash position by an increased net cash liability of$20,000. Although the company’s short term borrowings have reduced by $15,000, the cash at bank of $35,000 at thebeginning of the year has now gone. In comparison to the cash generation ability of the company and considering its largeinvestment in non-current assets, this $20,000 is a relatively small amount and should be relieved by operating cash inflowsin the near future.

19



SummaryThe above analysis shows that Minster has invested substantially in new non-current assets suggesting expansion. To financethis, the company appears to have no difficulty in attracting further long-term funding. At the same time there are indicationsof reduced inventories, trade receivables and payables which may suggest the opposite i.e. contraction. It may be that thenew investment is a change in the nature of the company’s activities (e.g. mining) which has different working capitalcharacteristics. The company has good operating cash flow generation and the slight deterioration in short term net cashbalance should only be temporary.

Yours …………………..

5 (a) (i) IFRS 5 Non-current assets held for sale and discontinued operations defines non-current assets held for sale as thoseassets (or a group of assets) whose carrying amounts will be recovered principally through a sale transaction rather thanthrough continuing use. A discontinued operation is a component of an entity that has either been disposed of, or isclassified 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 such, or (iii) is a subsidiary acquired exclusively for sale.

IFRS 5 says that a ‘component of an entity’ must have operations and cash flows that can be clearly distinguished fromthe rest of the entity and will in all probability have been a cash-generating unit (or group of such units) whilst held foruse. This definition also means that a discontinued operation will also fall to be treated as a ‘disposal group’ as definedin IFRS 5. A disposal group is a group of assets (possibly with associated liabilities) that it is intended will be disposedof in a single transaction by sale or otherwise (closure or abandonment). Assets held for disposal (but not those beingabandoned) must be presented separately (at the lower of cost or fair value less costs to sell) from other assets andincluded as current assets (rather than as non-current assets) and any associated liabilities must be separately presentedunder liabilities. The results of a discontinued operation should be disclosed separately as a single figure (as a minimum)on the face of the income statement with more detailed figures disclosed either also on the face of the income statementor in the notes.

The intention of this requirement is to improve the usefulness of the financial statements by improving the predictivevalue of the (historical) income statement. Clearly the results from discontinued operations should have little impact onfuture operating results. Thus users can focus on the continuing activities in any assessment of future income and profit.

(ii) The timing of the board meeting and consequent actions and notifications is within the accounting period ended 31 October 2006. The notification of staff, suppliers and the press seems to indicate that the sale will be highly probableand the directors are committed to a plan to sell the assets and are actively locating a buyer. From the financial andother information given in the question it appears that the travel agencies’ operations and cash flows can be clearlydistinguished from its other operations. The assets of the travel agencies appear to meet the definition of non-currentassets held for sale; however the main difficulty is whether their sale and closure also represent a discontinued operation.The main issue is with the wording of ‘a separate major line of business’ in part (i) of the above definition of adiscontinued operation. The company is still operating in the holiday business, but only through Internet selling. Theselling of holidays through the Internet compared with through high-street travel agencies requires very different assets,staff knowledge and training and has a different cost structure. It could therefore be argued that although the companyis still selling holidays the travel agencies do represent a separate line of business. If this is the case, it seems theannounced closure of the travel agencies appears to meet the definition of a discontinued operation.

20



(iii) Partway income statement year ended:31 October 2006 31 October 2005

$’000 $’000Continuing operationsRevenue 25,000 22,000Cost of sales (19,500) (17,000)

–––––––– ––––––––Gross profit 5,500 5,000Operating expenses (1,100) (500)

–––––––– ––––––––Profit/(loss) from continuing operations 4,400 4,500Discontinued operationsProfit/(loss) from discontinued operations (4,000) 1,500

–––––––– ––––––––Profit for the period 400 6,000

–––––––– ––––––––Analysis of discontinued operationsRevenue 14,000 18,000Cost of sales (16,500) (15,000)

–––––––– ––––––––Gross profit/(loss) (2,500) 3,000Operating expenses (1,500) (1,500)

–––––––– ––––––––Profit/(loss) from discontinued operations (4,000) 1,500

–––––––– ––––––––

Note: other presentations may be acceptable.

(b) (i) Comparability is one of the four principal qualitative characteristics of useful financial information. It is a vital attributewhen assessing the performance of an entity over time (trend analysis) and to some extent with other similar entities.For information to be comparable it should be based on the consistent treatment of transactions and events. In effect achange in an accounting policy breaks the principle of consistency and should generally be avoided. That said there arecircumstances where it becomes necessary to change an accounting policy. These are mainly where it is required by anew or revised accounting standard, interpretation or applicable legislation or where the change would result in financialstatements giving a more reliable and relevant representation of the entity’s transactions and events.

It is important to note that the application of a different accounting policy to transactions or events that are substantiallydifferent to existing transactions or events or to transactions or events that an entity had not previously experienced doesNOT represent a change in an accounting policy. It is also necessary to distinguish between a change in an accountingpolicy and a change in an estimation technique.

In an attempt to limit the problem of reduced comparability caused by a change in an accounting policy, the generalprinciple is that the financial statements should be prepared as if the new accounting policy had always been in place.This is known as retrospective application. The main effect of this is that comparative financial statements should berestated by applying the new policy to them and adjusting the opening balance of each component of equity affected inthe earliest prior period presented. IAS 8 Accounting policies, changes in accounting estimates and errors says that achange in accounting policy required by a specific Standard or Interpretation should be dealt with under the transitionalprovisions (if any) of that Standard or Interpretation (normally these apply the general rule of retrospective application).There are some limited exemptions (mainly on the grounds of impracticality) to the general principle of retrospectiveapplication in IAS 8.

(ii) This issue is one of the timing of when revenue should be recognised in the income statement. This can be a complexissue which involves identifying the transfer of significant risks, reliable measurement, the probability of receivingeconomic benefits, relevant accounting standards and legislation and generally accepted practice. Applying the generalguidance in IAS 18 Revenue, the previous policy, applied before cancellation insurance was made a condition ofbooking, seemed appropriate. At the time the holiday is taken it can no longer be cancelled, all monies would have beenreceived and the flights and accommodation have been provided. There may be some compensation costs involved ifthere are problems with the holiday, but this is akin to product warranties on normal sales of goods which may beimmaterial or provided for based on previous experience of such costs. The appendix to IAS 18 specifically refers topayments in advance of the ‘delivery’ of goods and says that revenue should be recognised when the goods are delivered.Interpreting this for Partway’s transaction would seem to confirm the appropriateness of its previous policy.

The directors of Partway wish to change the timing of recognition of sales because of the change in circumstancesrelating to the compulsory cancellation insurance. The directors are apparently arguing that the new ‘transactions andevents’ are substantially different to previous transactions therefore the old policy should not apply. Even if this doesjustify revising the timing of the recognition of revenue, it is not a change of accounting policy because of the reasonsoutlined in (i) above.

An issue to consider is whether compulsory cancellation insurance represents a substantial change to the risks thatPartway experiences. An analysis of past experience of losses caused by uninsured cancellations may help to assessthis, but even if the past losses were material (and in future they won’t be), it is unlikely that this would override thegeneral guidance in the appendix to IAS 18 relating to payments made in advance of delivery. It seems the mainmotivation for the proposed change is to improve the profit for the year ended 31 October 2006 so that it comparesmore favourably with that of the previous period.

21



To summarise, it is unlikely that the imposition of compulsory cancellation insurance justifies recognising sales at thedate of booking when a deposit is received, and, even if it did, it would not be a change in accounting policy. This meansthat comparatives would not be restated (which is something that would actually suit the suspected objectives of thedirectors).

22



Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) December 2006 Marking Scheme


Marks1 (a) Goodwill of Sunlee:

consideration 1equity shares 1pre acquisition reserves 1fair value adjustments 2

maximum 5

(b) Carrying amount and impairment of Amber:cash paid 16% loan note 1post acquisition loss 2

maximum 4

(c) Income statement:revenue 2cost of sales 4distribution costs and administrative expenses 1finance costs 1impairment of goodwill 1impairment of associate 1share of associate’s loss 2income tax 1minority interests 2eliminate dividend from Sunlee 1


2 (a) Income statementrevenue 1cost of sales 2operating expenses 1investment income 1finance costs 2income tax expense 3


(b) Balance sheet property, plant and equipment 3investment 1inventory and trade receivables 1share capital and premium 3revaluation reserve 2retained earnings (including 1 mark for the dividend) 2loan note 2deferred tax 1lease obligation (1 for current, 1 for long-term) 2trade payables and overdraft 1accrued lease finance costs 1income tax payable 1


23



Marks3 (a) 1 mark per relevant point to a maximum 9


(ii) sale price not at fair value raises substance issues 1leaseback is not a finance lease 1treat building as sold (derecognise) at a profit of $2·5 million 1rental treated as: $800,000 rental cost 1

$200,000 finance cost 1$300,000 loan repayment 1

maximum 6

(iii) general discussion of risks and rewards re consignment goods 2Issues and accounting treatment relating to supplies from Monza 2Issues and accounting treatment relating to supplies from Capri 2


4 (a) cash flow from operating activityprofit before tax adjusted for investment income and finance cost 1depreciation/amortisation 2working capital items 2finance costs 2income taxes paid 2investing activities (including 1 for investment income) 4financing – issue of ordinary shares 1

– issue of 9% loan 1dividend paid 1cash and cash equivalents b/f and c/f 1


(b) 1 mark per relevant point 10Maximum for question 25

5 (a) (i) definitions 2usefulness of information 2

maximum 4

(ii) discussion of whether a discontinued operation 3conclusion 1

maximum 4

(iii) figures for revenue from continuing operations (2005 and 2006) 1figures for revenue from discontinued operations (2005 and 2006) 1figures for cost of sales from continuing operations (2005 and 2006) 1figures for cost of sales from discontinued operations (2005 and 2006) 1figures for profit from continuing operations (2005 and 2006) 1figures for profit from discontinued operations (2005 and 2006) 1

maximum 6

(b) (i) 1 mark per relevant point maximum 5

(ii) 1 mark per relevant point maximum 6Maximum for question 25

24




PART 2


QUESTION PAPER







Pape

r 2.5

(IN

T)





1 Parentis, a public listed company, acquired 600 million equity shares in Offspring on 1 April 2006. The purchaseconsideration was made up of:

a share exchange of one share in Parentis for two shares in Offspringthe issue of $100 10% loan note for every 500 shares acquired; anda deferred cash payment of 11 cents per share acquired payable on 1 April 2007.

Parentis has only recorded the issue of the loan notes. The value of each Parentis share at the date of acquisition was75 cents and Parentis has a cost of capital of 10% per annum.

The balance sheets of the two companies at 31 March 2007 are shown below:

Parentis Offspring$ million $ million $ million $ million

AssetsProperty, plant and equipment (note (i)) 640 340Investments 120 nilIntellectual property (note (ii)) nil 30

–––– ––––760 370

Current assetsInventory (note (iii)) 76 22Trade receivables (note (iii)) 84 44Bank nil 160 4 70

–––– –––– –––– ––––Total assets 920 440

–––– ––––Equity and liabilitiesEquity shares of 25 cents each 300 200Retained earnings – 1 April 2006 210 120

– year ended 31 March 2007 90 300 20 140–––– –––– –––– ––––

600 340Non-current liabilities10% loan notes 120 20

Current liabilitiesTrade payables (note (iii)) 130 57Current tax payable 45 23Overdraft 25 200 nil 80

–––– –––– –––– ––––Total equity and liabilities 920 440

–––– ––––


(i) At the date of acquisition the fair values of Offspring’s net assets were approximately equal to their carryingamounts with the exception of its properties. These properties had a fair value of $40 million in excess of theircarrying amounts which would create additional depreciation of $2 million in the post acquisition period to 31 March 2007. The fair values have not been reflected in Offspring’s balance sheet.

(ii) The intellectual property is a system of encryption designed for internet use. Offspring has been advised thatgovernment legislation (passed since acquisition) has now made this type of encryption illegal. Offspring willreceive $10 million in compensation from the government.

(iii) Offspring sold Parentis goods for $15 million in the post acquisition period. $5 million of these goods are includedin the inventory of Parentis at 31 March 2007. The profit made by Offspring on these sales was $6 million.Offspring’s trade payable account (in the records of Parentis) of $7 million does not agree with Parentis’s tradereceivable account (in the records of Offspring) due to cash in transit of $4 million paid by Parentis.

(iv) Due to the impact of the above legislation, Parentis has concluded that the consolidated goodwill has beenimpaired by $27 million.

2



Required:

Prepare the consolidated balance sheet of Parentis as at 31 March 2007.

(25 marks)

3 [P.T.O.




2 The summarised draft financial statements of Wellmay are shown below.

Income statement year ended 31 March 2007:$’000

Revenue (note (i)) 4,200Cost of sales (note (ii)) (2,700)

––––––Gross profit 1,500Operating expenses (470)Investment property rental income 20Finance costs (55)

––––––Profit before tax 995Income tax (360)

––––––Profit for the period 635

––––––

Balance sheet as at 31 March 2007:$’000 $’000

AssetsNon-current assetsProperty, plant and equipment (note (iii)) 4,200Investment property (note (iii)) 400

––––––4,600

Current assets 1,400––––––

Total assets 6,000––––––

Equity and liabilitiesEquityEquity shares of 50 cents each (note (vii)) 1,200Reserves:Revaluation reserve 350Retained earnings (note (iv)) 2,850 3,200

–––––– –––––––4,400

Non-current liabilities8% Convertible loan note (2010) (note (v)) 600Deferred tax (note (vi)) 180 780

––––––Current liabilities 820

––––––Total equity and liabilities 6,000

––––––

The following information is relevant to the draft financial statements:

(i) Revenue includes $500,000 for the sale on 1 April 2006 of maturing goods to Westwood. The goods had a costof $200,000 at the date of sale. Wellmay can repurchase the goods on 31 March 2008 for $605,000 (basedon achieving a lender’s return of 10% per annum) at which time the goods are estimated to have a value of$750,000.

(ii) Past experience shows that in the post balance sheet period the company often receives unrecorded invoices formaterials relating to the previous year. As a result of this an accrued charge of $75,000 for contingent costs hasbeen included in cost of sales and as a current liability.

4



(iii) Non-current assets:Wellmay owns two properties. One is a factory (with office accommodation) used by Wellmay as a productionfacility and the other is an investment property that is leased to a third party under an operating lease. Wellmayrevalues all its properties to current value at the end of each year and uses the fair value model in IAS 40Investment property. Relevant details of the fair values of the properties are:

Factory Investment property$’000 $’000

Valuation 31 March 2006 1,200 400Valuation 31 March 2007 1,350 375

The valuations at 31 March 2007 have not yet been incorporated into the financial statements. Factorydepreciation for the year ended 31 March 2007 of $40,000 was charged to cost of sales. As the factory includessome office accommodation, 20% of this depreciation should have been charged to operating expenses.

(iv) The balance of retained earnings is made up of:$’000

balance b/f 1 April 2006 2,615profit for the period 635dividends paid during year ended 31 March 2007 (400)

––––––2,850––––––

(v) 8% Convertible loan note (2010)On 1 April 2006 an 8% convertible loan note with a nominal value of $600,000 was issued at par. It isredeemable on 31 March 2010 at par or it may be converted into equity shares of Wellmay on the basis of 100new shares for each $200 of loan note. An equivalent loan note without the conversion option would have carriedan interest rate of 10%. Interest of $48,000 has been paid on the loan and charged as a finance cost.

The present value of $1 receivable at the end of each year, based on discount rates of 8% and 10% are:

8% 10%End of year 1 0·93 0·91

2 0·86 0·833 0·79 0·754 0·73 0·68

(vi) The carrying amounts of Wellmay’s net assets at 31 March 2007 are $600,000 higher than their tax base. Therate of taxation is 35%. The income tax charge of $360,000 does not include the adjustment required to thedeferred tax provision which should be charged in full to the income statement.

(vii) Bonus/scrip issue:On 15 March 2007, Wellmay made a bonus issue from retained earnings of one share for every four held. Theissue has not been recorded in the draft financial statements.

Required:

Redraft the financial statements of Wellmay, including a statement of changes in equity, for the year ended 31 March 2007 reflecting the adjustments required by notes (i) to (vii) above.

Note: Calculations should be made to the nearest $’000.

(25 marks)

5 [P.T.O.



3 (a) A trainee accountant has been assisting in the preparation of the financial statements of Toogood for the yearended 31 March 2007. He has observed that the corresponding figures (i.e. for the year ended 31 March 2006)in the financial statements for the year ended 31 March 2007 do not agree in several instances with theequivalent figures that were published in the company’s financial statements for year ended 31 March 2006. Inparticular:

consolidated goodwill (gross figure before impairment) appears to have been recalculated,several other non-current assets have been revised,the brought forward retained earnings have been restated and;several income statement line items are also different.

The trainee accountant has also noted that even when the revised earnings figure for the year ended 31 March2006 is divided by the weighted average number of shares in issue during that year, it still does not agree withthe comparative earnings per share figure (i.e. for the year ended 31 March 2006) reported in the financialstatements for the year ended 31 March 2007.

Required:

Explain three circumstances where accounting standards require previously reported financial statementfigures to be amended when they are reproduced as corresponding amounts.

Note: It may help to consider, among other things, the items mentioned by the trainee accountant.(12 marks)

(b) The trainee accountant has been reading some literature written by a qualified surveyor on the values of leaseholdproperty located in the area where Toogood owns leasehold property. The main thrust is that historically, annualincreases in property prices more than compensate for the fall in the carrying amount caused by annualamortisation until a leasehold property has less than 10 years of remaining life. Therefore the trainee accountantsuggests that the company should adopt a policy of carrying its leasehold properties at cost until their remaininglives are 10 years and then amortising them on a straight-line basis over 10 years. This would improve thecompany’s reported profit and cash flows as well as showing a faithful representation of the value of the leaseholdproperties.

Required:

Comment on the validity and acceptability of the trainee accountant’s suggestion. (7 marks)

(c) The trainee accountant notes that Toogood acquired the Trilogy group during the year ended 31 March 2007. The Trilogy group consists of Trilogy itself and two wholly owned subsidiaries. Toogood has onlyconsolidated Trilogy and one subsidiary with the other subsidiary being shown as a current asset. The traineeaccountant wonders if this is because the non-consolidated subsidiary is making losses.

Required:

Explain why the two subsidiaries may require the different treatments that Toogood has applied. (6 marks)

(25 marks)

6




7 [P.T.O.



4 Greenwood is a public listed company. During the year ended 31 March 2007 the directors decided to ceaseoperations of one of its activities and put the assets of the operation up for sale (the discontinued activity has noassociated liabilities). The directors have been advised that the cessation qualifies as a discontinued operation andhas been accounted for accordingly.

Extracts from Greenwood’s financial statements are set out below.

Note: the income statement figures down to the profit for the period from continuing operations are those of thecontinuing operations only.

Income statements for the year ended 31 March: 2007 2006$’000 $’000

Revenue 27,500 21,200Cost of sales (19,500) (15,000)

–––––––– ––––––––Gross profit 8,000 6,200Operating expenses (2,900) (2,450)

–––––––– ––––––––5,100 3,750

Finance costs (600) (250)–––––––– ––––––––

Profit before taxation 4,500 3,500Income tax expense (1,000) (800)

–––––––– ––––––––Profit for the period from continuing operations 3,500 2,700Profit/(Loss) from discontinued operations (1,500) 320

–––––––– ––––––––Profit for the period 2,000 3,020

–––––––– ––––––––

Analysis of discontinued operations:Revenue 7,500 9,000Cost of sales (8,500) (8,000)

–––––––– ––––––––Gross profit/(loss) (1,000) 1,000Operating expenses (400) (550)

–––––––– ––––––––Profit/(loss) before tax (1,400) 450Tax (expense)/relief 300 (130)

–––––––– ––––––––(1,100) 320

Loss on measurement to fair value of disposal group (500) –Tax relief on disposal group 100 –

–––––––– ––––––––Profit/(Loss) from discontinued operations (1,500) 320

–––––––– ––––––––

8



Balance Sheets as at 31 March 2007 2006$’000 $’000 $’000 $’000

Non-current assets 17,500 17,600

Current assetsInventory 1,500 1,350Trade receivables 2,000 2,300Bank nil 50Assets held for sale (at fair value) 6,000 9,500 nil 3,700

–––––– ––––––– –––––– –––––––Total assets 27,000 21,300

––––––– –––––––Equity and liabilitiesEquity shares of $1 each 10,000 10,000Retained earnings 4,500 2,500

––––––– –––––––14,500 12,500

Non-current liabilities5% loan notes 8,000 5,000

Current liabilitiesBank overdraft 1,150 nilTrade payables 2,400 2,800Current tax payable 950 4,500 1,000 3,800

–––––– ––––––– –––––– –––––––Total equity and liabilities 27,000 21,300

––––––– –––––––

Note: the carrying amount of the assets of the discontinued operation at 31 March 2006 was $6·3 million.

Required:

Analyse the financial performance and position of Greenwood for the two years ended 31 March 2007.

Note: Your analysis should be supported by appropriate ratios (up to 10 marks available) and refer to the effectsof the discontinued operation.

(25 marks)

9 [P.T.O.



5 (a) The following is an extract of Errsea’s balances of property, plant and equipment and related government grantsat 1 April 2006.

accumulated carryingcost depreciation amount

$’000 $’000 $’000Property, plant and equipment 240 180 60

Non-current liabilitiesGovernment grants 30

Current liabilitiesGovernment grants 10

Details including purchases and disposals of plant and related government grants during the year are:

(i) Included in the above figures is an item of plant that was disposed of on 1 April 2006 for $12,000 whichhad cost $90,000 on 1 April 2003. The plant was being depreciated on a straight-line basis over four yearsassuming a residual value of $10,000. A government grant was received on its purchase and was beingrecognised in the income statement in equal amounts over four years. In accordance with the terms of thegrant, Errsea repaid $3,000 of the grant on the disposal of the related plant.

(ii) An item of plant was acquired on 1 July 2006 with the following costs:

$Base cost 192,000Modifications specified by Errsea 12,000Transport and installation 6,000

The plant qualified for a government grant of 25% of the base cost of the plant, but it had not been receivedby 31 March 2007. The plant is to be depreciated on a straight-line basis over three years with a nilestimated residual value.

(iii) All other plant is depreciated by 15% per annum on cost

(iv) $11,000 of the $30,000 non-current liability for government grants at 1 April 2006 should be reclassifiedas a current liability as at 31 March 2007.

(v) Depreciation is calculated on a time apportioned basis.

Required:

Prepare extracts of Errsea’s income statement and balance sheet in respect of the property, plant andequipment and government grants for the year ended 31 March 2007.

Note: Disclosure notes are not required.(10 marks)

(b) In the post balance sheet period, prior to authorising for issue the financial statements of Tentacle for the yearended 31 March 2007, the following material information has arisen.

(i) The notification of the bankruptcy of a customer. The balance of the trade receivable due from the customerat 31 March 2007 was $23,000 and at the date of the notification it was $25,000. No payment is expectedfrom the bankruptcy proceedings. (3 marks)

(ii) Sales of some items of product W32 were made at a price of $5·40 each in April and May 2007. Salesstaff receive a commission of 15% of the sales price on this product. At 31 March 2007 Tentacle had12,000 units of product W32 in inventory included at cost of $6 each. (4 marks)

(iii) Tentacle is being sued by an employee who lost a limb in an accident while at work on 15 March 2007.The company is contesting the claim as the employee was not following the safety procedures that he hadbeen instructed to use. Accordingly the financial statements include a note of a contingent liability of$500,000 for personal injury damages. In a recently decided case where a similar injury was sustained, asettlement figure of $750,000 was awarded by the court. Although the injury was similar, the circumstancesof the accident in the decided case are different from those of Tentacle’s case. (4 marks)

10



(iv) Tentacle is involved in the construction of a residential apartment building. It is being accounted for usingthe percentage of completion basis in IAS 11 Construction contracts. The recognised profit at 31 March2007 was $1·2 million based on costs to date of $3 million as a percentage of the total estimated costs of$6 million. Early in May 2007 Tentacle was informed that due to very recent industry shortages, buildingmaterials will cost $1·5 million more than the estimate of total cost used in the calculation of the percentageof completion. Tentacle cannot pass on any additional costs to the customer. (4 marks)

Required:

State and quantify how items (i) to (iv) above should be treated when finalising the financial statements ofTentacle for the year ended 31 March 2007.

Note: The mark allocation is shown against each of the four items above.(25 marks)


11



Answers




1 Consolidated Balance Sheet of Parentis as at 31 March 2007:$ million $ million

AssetsNon-current assetsProperty, plant and equipment (640 + 340 + 40 – 2) 1,018IntangibleConsolidated goodwill (135 (w (i)) – 27 impairment) 108

––––––1,126

Current assetsInventory (76 + 22 – 2 URP) 96Trade receivables (84 + 44 – 11 intra-group) 117Receivable re intellectual property 10Bank 4 227

–––– ––––––Total assets 1,353

––––––Equity and liabilitiesEquity attributable to equity holders of the parentEquity shares 25c each (w (i)) 375Reserves:Share Premium (w (i)) 150Retained earnings (w (ii)) 264 414

–––– ––––––789

Minority interest (w (iii)) 89––––––

Total equity 878

Non-current liabilities10% loan notes (120 + 20) 140

Current liabilitiesTrade payables (130 + 57 – 7 intra-group) 180Cash consideration due 1 April 2007 (60 + 6 interest) 66Overdraft (25 – 4 CIT) 21Taxation (45 + 23) 68 335

–––– ––––––Total equity and liabilities 1,353

––––––

Workings (Note: all figures in $ million)

(i) Goodwill:The acquisition of 600 million shares represents 75% of Offspring’s 800 million shares ($200m/25c). The share exchangeof 300 million (i.e. 1 for 2) at $0·75 each will result in an increase in equity share capital of $75 million (the nominal value)and create a share premium balance of $150 million (i.e. $0·50 premium on 300 million shares).

Consideration:Equity shares (600/2 x $0·75) 22510% loan notes (see below) 120Cash (600 x $0·11/1·1 i.e. discounted at 10%) 60

––––405

Acquired:Equity shares (600m x 25c) 150Pre acquisition retained earnings (120 x 75%) 90Fair value adjustment to properties (40 x 75%) 30 (270)

–––– ––––Goodwill 135

––––

The issue of the 10% loan notes is calculated as 600 million/500 x $100 = $120 million.

15



(ii) Retained earnings:Parentis 300Interest on deferred consideration (60 x 10%) (6)Goodwill impairment (from question) (27)Offspring 140URP in inventory (see below) (2)Additional depreciation (from question) (2)Write down intellectual property (30 – 10) (20)Pre acquisition (120)

––––(4) x 75% (3)

––––264––––

The unrealised profit in inventory (URP) is $5m/$15m of the profit of $6 million made by Offspring.

(iii) Minority interestOffspring net assets at 31 March 2007 340Fair value adjustment 40URP in inventory (2)Additional depreciation (2)Write down intellectual property (30 – 10) (20)

––––356 x 25% 89–––– –––

2 Wellmay Income Statement year ended 31 March 2007:$’000 $’000

Revenue (4,200 – 500 (w (i))) 3,700Cost of sales (w (ii)) (2,417)

––––––Gross profit 1,283Operating expenses (470 + 8 depreciation) (478)Investment property – rental income 20

– fair value loss (400 – 375) (25) (5)––––Finance costs (w (iii)) (113)

––––––Profit before tax 687Income tax (360 + 30 (w (v))) (390)

––––––Profit for the period 297

––––––

Statement of changes in equity – year ended 31 March 2007Equity shares Equity Revaluation Retained Total

option reserve earnings$’000 $’000 $’000 $’000 $’000

Balances at 1 April 2006 1,200 350 2,615 4,165Equity conversion option (w (iv)) 40 40Bonus issue (1 for 4) 300 (300)Revaluation of factory (w (vi)) 190 190Profit for the period 297 297Dividends (400) (400)

–––––– –––– ––––– –––––– ––––––Balances at 31 March 2007 1,500 40 540 2,212 4,292

–––––– –––– ––––– –––––– ––––––

16



Balance sheet as at 31 March 2007:$’000 $’000

Non-current assetsProperty, plant and equipment (w (vi)) 4,390Investment property (w (vi)) 375

––––––4,765

Current assets (1,400 + 200 inventory (w (i))) 1,600––––––

Total assets 6,365––––––

Equity and liabilities (see statement of changes in equity above)Equity shares of 50 cents each 1,500Equity option (w (iv)) 40

––––––1,540

Reserves:Revaluation reserve 540Retained earnings 2,212 2,752

–––––– ––––––4,292

Non-current liabilitiesDeferred tax (w (v)) 2108% Convertible loan note ((560 + 8) (w (iv))) 568 778

––––––

Current liabilities (820 – 75 (w (ii))) 745Loan from Westwood (500 + 50 accrued interest (w (i))) 550 1,295

–––––– ––––––Total equity and liabilities 6,365

––––––

Workings (note: all figures in $’000)

(i) The ‘sale’ to Westwood is, in substance, a secured loan. The repurchase price is the cost of sale plus compound interest at10% for two years. The correct accounting treatment is to reverse the sale with the goods going back into inventory and the‘proceeds’ treated as a loan with accrued interest of 10% ($50,000) for the current year.

(ii) Cost of sales:From draft financial statements 2,700Sale of goods added back to inventory (see above) (200)Reversal of contingency provision (see below) (75)Depreciation transferred to operating costs (40 x 20%) (8)

––––––2,417

––––––

General or non-specific provisions do not meet the definition of a liability in IAS 37 Provisions, contingent liabilities andcontingent assets and must therefore be reversed.

(iii) Finance costs:From draft financial statements 55Additional accrued interest on convertible loan (w (iv)) 8Finance cost on in-substance loan (500 x 10%) 50

––––113––––

(iv) Convertible Loan:This is a compound financial instrument that contains an element of debt and an element of equity (the option to convert).IAS 32 Financial instruments: disclosure and presentation requires that the substance of such instruments should be appliedto the reporting of them. The value of the debt element is calculated by discounting the future cash flows (at 10%). Theresidue of the issue proceeds is recorded as the value of the equity option:

Cash flows factor at 10% present value $’000year 1 interest 48 0·91 43·6year 2 interest 48 0·83 39·8year 3 interest 48 0·75 36·0year 4 interest, redemption premium and capital 648 0·68 440·6

––––––total value of debt component 560·0proceeds of the issue 600·0

––––––equity component (residual amount) 40·0

––––––

For the year ended 31 March 2007, the interest cost for the convertible loan in the income statement should be increasedfrom $48,000 to $56,000 (10% x 560) by accruing $8,000, which should be added to the carrying value of the debt.

17



(v) Taxation:The required deferred tax balance is $210,000 (600 x 35%), the current balance is $180,000, and thus a further transferof $30,000 (via the income statement) is required.

(vi) Properties:The fair value model in IAS 40 Investment property requires the loss of $25,000 on the fair value of investment propertiesto be reported in the income statement. This differs from revaluations of other properties. IAS 16 Property, plant andequipment requires surpluses and deficits to be recorded as movements in equity (a revaluation reserve). After depreciationof $40,000 for the year ended 31 March 2007, the factory (used by Wellmay) would have a carrying amount of $1,160,000(1,200 – 40). The valuation of $1,350,000 at 31 March 2007 would give a further revaluation surplus of $190,000(1,350 – 1,160) and a carrying amount of property, plant and equipment of $4,390,000 (4,200 + 190) at that date.

3 (a) As a general principle the reported financial statements for (in this case) the year ended 31 March 2006 should become(without amendment) the corresponding amounts in the financial statements ended 31 March 2007. However, there are anumber of circumstances where this general principle is modified:

(i) As part of a business combination it is necessary to determine the goodwill as the residual amount in the process ofallocating the consideration paid to the identifiable assets, liabilities and contingent liabilities acquired. IFRS 3 Businesscombinations requires the allocation process to be completed within a period of 12 months from the date of acquisition.Within this allowed period it is likely that the parent company will have to produce annual financial statements. Thus itmay be necessary to determine (some) fair values on a provisional basis. The consequences are that in the followingaccounting period the provisional values may need to be restated. IFRS 3 requires the confirmed values to be recognisedas from the date of acquisition. This would mean restating the goodwill and any asset or liability whose provisionalestimate has been revised in the corresponding amounts of the financial statements following the year of acquisition.This would mean that the corresponding figures presented would not agree with the original presentation of thosefinancial statements. Depreciation charges (and possible impairments of goodwill) may also need revision. It is importantto note that any adjustment to provisional values must reflect conditions that existed at the date of acquisition. Fair valuechanges as a result of subsequent events are not part of this process.

(ii) Another situation where corresponding amounts are restated is for the correction of errors (discovered subsequent topublication of the financial statements). The error may be one of recognition, measurement or presentation. Such errorsmust be either material or immaterial and deliberate (i.e. done intentionally to improve the appearance of the financialstatements). The revision of an accounting estimate is not a prior period error. IAS 8 Accounting policies, changes inaccounting estimates and errors requires prior period errors to be accounted for retrospectively. This is achieved byrestating any affected comparative amounts for the prior periods presented or by restating opening balances of assets,liabilities and equity if the error occurred before the earliest prior period presented.

(iii) Comparability is an important characteristic of financial statements. If a company changes an accounting policy this islikely to impair comparability because the current year’s financial statements (applying a new accounting policy) willhave been prepared on a different basis to the corresponding amounts (using the previous policy). In order to minimisethe effect of this IAS 8 requires changes in accounting policy to be applied retrospectively. This means that the financialstatements presented (including corresponding amounts) should be presented as if the new accounting policy hadalways been in place. This will mean that the corresponding financial statements will be different to when they wereoriginally published.

(iv) All of the above examples can lead to a revision of the profit shown in the corresponding financial statements. This inturn would cause the corresponding eps figure to be revised. The example in the question says that even allowing forthe revised profit, the eps does not compute correctly. The probable reason for this is there has been a bonus issue ofshares (or an issue of shares containing a bonus element) in the current year (i.e. ended 31 March 2007 in Toogood’scase). In order to preserve comparability of the trend shown by the eps figures, any previously reported eps presentedmust be adjusted for the dilutive effect of any bonus issues. Thus in Toogood’s case the corresponding eps will havebeen recalculated based on the revised earnings and then adjusted for the effects of the bonus issue made in the yearto 31 March 2007.

Note: only three examples were required and other examples may be acceptable.

(b) The trainee accountant is getting confused with valuation and the purpose of amortisation/depreciation. What the surveyorsays in relation to the value of leasehold properties may be correct, but it does not remove the need to amortise propertieswith a life of more than 10 years. The purpose of amortisation (and depreciation) is to spread the cost of non-current assetsover the period they give benefits. It is in essence a cost allocation process in compliance with the accruals/matchingprinciple; depreciation is not a valuation model. Thus the suggestion by the trainee is unacceptable; each accounting periodmust bear a charge for amortisation of the leaseholds reflecting the proportion (measured in time) of the lease that hasexpired.

If it is considered important that the balance sheet reflects the current value of leaseholds, then under IAS 16 Property, plantand equipment, Toogood may revalue its leasehold property (the gain going to equity) to fair (market) value. This course ofaction would still require amortisation to be charged, but it would now be on the revalued amounts. Ironically this would leadto higher charges for amortisation and thus reduce profit. The trainee accountant’s comment that non-amortisation of theleasehold would improve cash flows is misguided; decreasing (or increasing) amortisation has no effect on cash flows.

18



(c) IAS 27 Consolidated and separate financial statements normally requires that when a parent acquires control of an entity,the entity must be consolidated from the date of acquisition/control. This is the treatment applied to Trilogy and one subsidiary.An acquired subsidiary cannot be excluded from consolidation simply because it is making losses. In this case it seems likelythat Toogood intends to sell the non-consolidated subsidiary (perhaps because it is making losses). This means that Toogood’scontrol of the subsidiary will be temporary. In these circumstances IAS 27 used to allow an exemption from consolidation(such that they were treated as available for sale investments under IAS 39 Financial instruments: recognition andmeasurement) and it seems that Toogood has applied this exemption. However IFRS 5 Non-current assets held for sale anddiscontinued operations has removed this exemption from IAS 27. IFRS 5 requires that a subsidiary acquired with a view tosale is classified as a disposal group (of assets and liabilities). The effect of the new treatment is not very different from thatrequired by IAS 27. The assets of the subsidiary should be shown as held for sale within current assets and the liabilities ofthe subsidiary should be shown as held for sale within current liabilities (under IAS 27 they appeared net). The other notabledifference is that under IFRS 5 the non-current assets of a disposal group are not depreciated, instead the subsidiary’s assetsshould be measured at the lower of cost and fair value less cost to sell.

4 Note IFRS 5 uses the term discontinued operation. The answer below also uses this term, but it should be realised that the assetsof the discontinued operation are classed as held for sale and not yet sold. In some literature this may be described as adiscontinuing operation.

Profitability/utilisation of assetsAn important feature of the company’s performance in the year to 31 March 2007 is to evaluate the effect of the discontinuedoperation. When using an entity’s recent results as a basis for assessing how the entity may perform in the future, emphasis shouldbe placed on the results from continuing operations as it is these that will form the basis of future results. For this reason most ofthe ratios calculated in the appendix are based on the results from continuing operations and ratio calculations involving netassets/capital employed generally exclude the value of the assets held for sale.

On this basis, it can be seen that the overall efficiency of Greenwood (measured by its ROCE) has declined considerably from33·5% to 29·7% (a fall of 11·3%). The fall in the asset turnover (from 1·89 to 1·67 times) appears to be mostly responsible forthe overall decline in efficiency. In effect the company’s assets are generating less sales per $ invested in them. The othercontributing factors to overall profitability are the company’s profit margins. Greenwood has achieved an impressive increase inheadline sales revenues of nearly 30% (6·3m on 21·2m) whilst being able to maintain its gross profit margin at around 29% (nosignificant change from 2006). This has led to a substantial increase in gross profit, but this has been eroded by an increase inoperating expenses. As a percentage of sales, operating expenses were 10·5% in 2007 compared to 11·6% in 2006 (they appearto be more of a variable than a fixed cost). This has led to a modest improvement in the profit before interest and tax margin whichhas partially offset the deteriorating asset utilisation.

The decision to sell the activities which are classified as a discontinued operation is likely to improve the overall profitability of thecompany. In the year ended 31 March 2006 the discontinued operation made a modest pre tax profit of $450,000 (this wouldrepresent a return of around 7% on the activity’s assets of $6·3 million).This poor return acted to reduce the company’s overallprofitability (the continuing operations yielded a return of 33·5%). The performance of the discontinued operation continued todeteriorate in the year ended 31 March 2007 making a pre tax operating loss of $1·4 million which creates a negative return onthe relevant assets. Despite incurring losses on the measurement to fair value of the discontinued operation’s assets, it seems thedecision will benefit the company in the future as the discontinued operation showed no sign of recovery.

Liquidity and solvencySuperficially the current ratio of 2·11 in 2007 seems reasonable, but the improvement from the alarming current ratio in 2006 of0·97 is more illusory than real. The ratio in the year ended 31 March 2007 has been distorted (improved) by the inclusion ofassets of the discontinued operation under the heading of ‘held for sale’. These have been included at fair value less cost to sell(being lower than their cost – a requirement of IFRS 5). Thus the carrying amount should be a realistic expectation of the net saleproceeds, but it is not clear whether the sale will be cash (they may be exchanged for shares or other assets) or how Greenwoodintends to use the disposal proceeds. What can be deduced is that without the assets held for sale being classified as current, thecompany’s liquidity ratio would be much worse than at present (at below 1 for both years). Against an expected norm of 1, quickratios (acid test) calculated on the normal basis of excluding inventory (and in this case the assets held for sale) show an alarmingposition; a poor figure of 0·62 in 2006 has further deteriorated in 2007 to 0·44. Without the proceeds from the sale of thediscontinued operation (assuming they will be for cash) it is difficult to see how Greenwood would pay its creditors (and taxliability), given a year end overdraft of $1,150,000.

Further analysis of the current ratios shows some interesting changes during the year. Despite its large overdraft Greenwoodappears to be settling its trade payables quicker than in 2006. At 68 days in 2006 this was rather a long time and the reductionin credit period may be at the insistence of suppliers – not a good sign. Perhaps to relieve liquidity pressure, the company appearsto be pushing its customers to settle early. It may be that this has been achieved by the offer of early settlement discounts, if sothe cost of this would have impacted on profit. Despite holding a higher amount of inventory at 31 March 2007 (than in 2006),the company has increased its inventory turnover; given that margins have been held, this reflects an improved performance.

GearingThe additional borrowing of $3 million in loan notes (perhaps due to liquidity pressure) has resulted in an increase in gearing from28·6% to 35·6% and a consequent increase in finance costs. Despite the increase in finance costs the borrowing is acting in theshareholders’ favour as the overall return on capital employed (at 29·7%) is well in excess of the 5% interest cost.

19



SummaryOverall the company’s performance has deteriorated in the year ended 31 March 2007. Management’s action in respect of thediscontinued operation is a welcome measure to try to halt the decline, but more needs to be done. The company’s liquidityposition is giving cause for serious concern and without the prospect of realising $6 million from the assets held for sale it wouldbe difficult to envisage any easing of the company’s liquidity pressures.

AppendixROCE: continuing operations 2007 2006(4,500 + 400)/(14,500 + 8,000 – 6,000) 29·7% (3,500 + 250)/(12,500 + 5,000 – 6,300) 33·5%

The return has been taken as the profit before interest (on loan notes only) and tax from continuing operations. The capitalemployed is the normal equity plus loan capital (as at the year end), but less the value of the assets held for sale. This is becausethe assets held for sale have not contributed to the return from continuing operations.

Gross profit percentage (8,000/27,500) 29·1% (6,200/21,200) 29·2%Operating expense percentage of sales revenue(2,900/27,500) 10·5% (2,450/21,200) 11·6%Profit before interest and tax margin (5,100/27,500) 18·5% (3,750/21,200) 17·7%Asset turnover (27,500/16,500) 1·67 (21,200/11,200) 1·89Current ratio (9,500:4,500) 2·11 (3,700:3,800) 0·97Current ratio (excluding held for sale) (3,500:4,500) 0·77 not applicableQuick ratio (excluding held for sale) (2,000:4,500) 0·44 (2,350:3,800) 0·62Inventory (closing) turnover (19,500/1,500) 13·0 (15,000/1,350) 11·1Receivables (in days) (2,000/27,500) x 365 26·5 (2,300/21,200) x 365 39·6Payables/cost of sales (in days) (2,400/19,500) x 365 44·9 (2,800/15,000) x 365 68·1Gearing (8,000/8,000 + 14,500) 35·6% (5,000/5,000 + 12,500) 28·6%

5 (a) Errsea – income statement extracts year ended 31 March 2007

$Loss on disposal of plant – see note below ((90,000 – 60,000) – 12,000) 18,000Depreciation for year (wkg (i)) 75,000Government grants (a credit item) – see note below and (wkg (iv)) (19,000)

Note: the repayment of government grant of $3,000 may instead have been included as an increase of the loss on disposalof the plant.

Errsea – balance sheet extracts as at 31 March 2007

accumulated carryingcost depreciation amount$ $ $

Property, plant and equipment (wkg (v)) 360,000 195,000 165,000–––––––– –––––––– ––––––––

Non-current liabilitiesGovernment grants (wkg (iv)) 39,000

Current liabilitiesGovernment grants (wkg (iv)) 27,000

Workings

(i) Depreciation for year ended 31 March 2007 $On acquired plant (wkg (ii)) 52,500Other plant (wkg (iii)) 22,500

–––––––75,000–––––––

(ii) The cost of the acquired plant is recorded at $210,000 being its base cost plus the costs of modification and transportand installation. Annual depreciation over three years will be $70,000. Time apportioned for year ended 31 March2007 by 9/12 = $52,500.

(iii) The other remaining plant is depreciated at 15% on cost $(b/f 240,000 – 90,000 (disposed of) x 15%) 22,500

(iv) Government grantsTransferred to income for the year ended 31 March 2007: $From current liability in 2006 (10,000 – 3,000 (repaid)) 7,000From acquired plant (see below): 12,000

–––––––19,000–––––––

20



Non-current liability $b/f 30,000transferred to current (11,000)on acquired plant (see below) 20,000

–––––––39,000–––––––

Grant on acquired plant is 25% of base cost only = $48,000This will be treated as:To income in year ended 31 March 2007 (48,000/3 x 9/12) 12,000Classified as current liability (48,000/3) 16,000Classified as a non-current liability (balance) 20,000

–––––––48,000–––––––

Note: government grants are accounted for from the date they are receivable (i.e. when the qualifying conditions for thegrant have been met).

Current liabilityTransferred from non-current (per question) 11,000On acquired plant (see above) 16,000

–––––––27,000–––––––

(v) accumulated carryingcost depreciation amount$ $ $

Property, plant and equipmentBalances b/f 240,000 180,000 60,000Disposal (90,000 ) (60,000 ) (30,000 )Addition (w (ii)) 210,000 52,500 157,500Other plant depreciation for year (wkg (iii)) 22,500 (22,500)

–––––––– –––––––– ––––––––Balances at 31 March 2007 360,000 195,000 165,000

–––––––– –––––––– ––––––––

(b) (i) This is an example of an adjusting event within IAS 10 Events after the balance sheet date. This means that animpairment of trade receivables of $23,000 must be recognised (and charged to income). The increase in the receivableafter the year end should be written off in the following year’s financial statements.

(ii) Sales of the year-end inventory in the following accounting period may provide evidence that the inventory’s netrealisable value has fallen below its cost. This appears to be the case for product W32 and is another example of anadjusting event. With a selling price of $5·40 and after paying a 15% commission, the net realisable value of W32 is$4·59 each. Assuming that the fall in selling price is not due to circumstances that occurred after the year end and thatthe selling price is typical of what the remainder of the product will sell for, inventory should be written down (via acharge to the income statement) by $16,920 ((6·00 – 4·59) x 12,000 units).

(iii) Tentacle has correctly treated the outstanding litigation as a contingent liability. The settlement of a court case after thebalance sheet date may confirm (or otherwise) the existence of an obligation at the year end and would be an exampleof an adjusting event. This would then require that either the disclosure note of the contingency is removed or theobligation should be provided for dependent on the outcome of the litigation. However, this is not quite the case inTentacle’s example. The circumstances of the claim against Tentacle are different from those of the recently settled case.So this settlement does not appear to have any effect on the likelihood of Tentacle losing the case. What it does(potentially) affect is the estimated amount of the liability. IAS 10 refers to this situation as an updating disclosure. Theonly required change to the financial statements would be to update the disclosure note on the contingent liability toreflect that the potential liability has increased from $500,000 to $750,000.

(iv) Normally the effect of price increases of materials after the balance sheet date would be a matter for the following year’sfinancial statements as such increases do not affect the costs as they existed at the balance sheet date (i.e. they wouldnot be an adjusting event). However, Tentacle’s method of recognising profit (using a cost basis to determine thepercentage of completion) requires an estimate (at 31 March 2007) of the future costs of the contract. This estimatedirectly determines the amount of profit recognised at 31 March 2007. Therefore the information indicating that the totalestimated costs of the contract have increased should be taken as providing additional evidence of conditions that existedat the year end. Thus this is an adjusting event which requires the recognised profit to be recalculated. The originalestimate of the recognised profit at 31 March 2007 of $1·2 million would be half of the estimated total profit of $2·4 million (percentage of completion is 50% i.e. $3 million/$6 million). The increase in the costs of $1·5 millionmeans the revised estimated total profit is only $900,000 (2·4m – 1·5m). The revised total costs are $7·5 million (6m + 1·5m). Thus the recognised profit on the contract should be recalculated as $360,000 (900,000 x 3m/7·5m)with appropriate amendments to the income statement and balance sheet figures.

21





Marks1 non-current assets 2

goodwill (1 for impairment) 7inventory 1trade receivables 1receivable re intellectual property 1bank 1/2equity shares 1share premium 1retained earnings 4minority interest 310% loan notes 1trade payables 1deferred consideration 1overdraft 1tax liability 1/2


2 Income statementrevenue 1cost of sales 3operating expenses 1rental income 1loss on investment property (in income statement) 1finance costs 3income tax 2

Changes in equitybalances b/f 1equity option 1bonus issue 1revaluation 1profit for period 1dividends 1

Balance sheetproperty, plant and equipment 2investment property 1current assets (re inventory) 1deferred tax 18% loan note 2loan from Westwood 2current liabilities 1


3 (a) up to 4 marks for each example maximum 12

(b) 1 mark per point to a maximum 7

(c) 1 mark per point to a maximum 6Maximum for question 25

23



Marks4 up to 10 marks for relevant ratios 10

up to 5 marks for effect of discontinued operation 5up to 1 mark per relevant interpretive comment 10


5 (a) loss on disposal 1depreciation for year 2government grant to income ($19,000) 2property, plant and equipment 3current liability 2non-current liability 2


(b) (i) adjusting event 1impairment of $23,000 2

maximum 3

(ii) adjusting event 1NRV is $4·59 1impairment loss $16,920 2

maximum 4

(iii) settlement of court case normally adjusting event 1this case does not alter nature of contingency 2example of updating disclosure 1revise amount of contingency disclosure to $750,000 1


(iv) after date increase not normally adjusting event 1as future costs are part of profit calculation this is adjusting event 1calculation of new estimate of total profit ($900,000) 1recalculation of profit for year ($360,000) 2


24



Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours



During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.


Pape

r F7

(IN

T)

Financial Reporting(International)

Tuesday 11 December 2007





1 On 1 October 2006 Plateau acquired the following non-current investments:

– 3 million equity shares in Savannah by an exchange of one share in Plateau for every two shares in Savannahplus $1 per acquired Savannah share in cash. The market price of each Plateau share at the date of acquisitionwas $6.

– 30% of the equity shares of Axle at a cost of $7·50 per share in cash.

Only the cash consideration of the above investments has been recorded by Plateau.

The summarised draft balance sheets of the three companies at 30 September 2007 are:

Plateau Savannah Axle$’000 $’000 $’000

AssetsNon-current assetsProperty, plant and equipment 18,400 10,400 18,000Investments in Savannah and Axle 12,000 nil nilAvailable-for-sale investments 6,500 nil nil

––––––– ––––––– –––––––36,900 10,400 18,000

Current assetsInventory 6,900 6,200 3,600Trade receivables 3,200 1,500 2,400

––––––– ––––––– –––––––Total assets 47,000 18,100 24,000

––––––– ––––––– –––––––

Equity and liabilitiesEquity shares of $1 each 10,000 4,000 4,000Retained earnings – at 30 September 2006 16,000 6,500 11,000

– for year ended 30 September 2007 8,000 2,400 5,000––––––– ––––––– –––––––34,000 12,900 20,000

Non-current liabilities7% Loan notes 5,000 1,000 1,000

Current liabilities 8,000 4,200 3,000––––––– ––––––– –––––––

Total equity and liabilities 47,000 18,100 24,000––––––– ––––––– –––––––


(i) At the date of acquisition the fair values of Savannah’s assets were equal to their carrying amounts with theexception of Savannah’s land which had a fair value of $500,000 below its carrying amount; it was written downby this amount shortly after acquisition and has not changed in value since then.

(ii) On 1 October 2006, Plateau sold an item of plant to Savannah at its agreed fair value of $2·5 million. Its carryingamount prior to the sale was $2 million. The estimated remaining life of the plant at the date of sale was fiveyears (straight-line depreciation).

(iii) During the year ended 30 September 2007 Savannah sold goods to Plateau for $2·7 million. Savannah hadmarked up these goods by 50% on cost. Plateau had a third of the goods still in its inventory at 30 September2007. There were no intra-group payables/receivables at 30 September 2007.

(iv) Impairment tests on 30 September 2007 concluded that the value of the investment in Axle was not impaired,but consolidated goodwill was impaired by $900,000.

(v) The available-for-sale investments are included in Plateau’s balance sheet (above) at their fair value on 1 October2006, but they have a fair value of $9 million at 30 September 2007

(vi) No dividends were paid during the year by any of the companies.

2



Required:

(a) Prepare the consolidated balance sheet for Plateau as at 30 September 2007. (20 marks)

(b) A financial assistant has observed that the fair value exercise means that a subsidiary’s net assets are includedat acquisition at their fair (current) values in the consolidated balance sheet. The assistant believes that it isinconsistent to aggregate the subsidiary’s net assets with those of the parent because most of the parent’s assetsare carried at historical cost.

Required:

Comment on the assistant’s observation and explain why the net assets of acquired subsidiaries areconsolidated at acquisition at their fair values. (5 marks)

(25 marks)

3 [P.T.O.



2 The following trial balance relates to Llama, a listed company, at 30 September 2007:

$’000 $’000Land and buildings – at valuation 1 October 2006 (note (i)) 130,000Plant – at cost (note (i)) 128,000Accumulated depreciation of plant at 1 October 2006 32,000Investments – at fair value through profit and loss (note (i)) 26,500Investment income 2,200Cost of sales (note (i)) 89,200Distribution costs 11,000Administrative expenses 12,500Loan interest paid 800Inventory at 30 September 2007 37,900Income tax (note (ii)) 400Trade receivables 35,100Revenue 180,400Equity shares of 50 cents each fully paid 60,000Retained earnings at 1 October 2006 25,5002% loan note 2009 (note (iii)) 80,000Trade payables 34,700Revaluation reserve (arising from land and buildings) 14,000Deferred tax 11,200Suspense account (note (iv)) 24,000Bank 6,600

–––––––– ––––––––471,000 471,000–––––––– ––––––––


(i) Llama has a policy of revaluing its land and buildings at each year end. The valuation in the trial balance includesa land element of $30 million. The estimated remaining life of the buildings at that date (1 October 2006) was20 years. On 30 September 2007, a professional valuer valued the buildings at $92 million with no change inthe value of the land. Depreciation of buildings is charged 60% to cost of sales and 20% each to distributioncosts and administrative expenses.

During the year Llama manufactured an item of plant that it is using as part of its own operating capacity. Thedetails of its cost, which is included in cost of sales in the trial balance, are:

$’000Materials cost 6,000Direct labour cost 4,000Machine time cost 8,000Directly attributable overheads 6,000

The manufacture of the plant was completed on 31 March 2007 and the plant was brought into immediate use,but its cost has not yet been capitalised.

All plant is depreciated at 121/2% per annum (time apportioned where relevant) using the reducing balancemethod and charged to cost of sales. No non-current assets were sold during the year.

The fair value of the investments held at fair value through profit and loss at 30 September 2007 was $27·1 million.

(ii) The balance of income tax in the trial balance represents the under/over provision of the previous year’s estimate.The estimated income tax liability for the year ended 30 September 2007 is $18·7 million. At 30 September2007 there were $40 million of taxable temporary differences. The income tax rate is 25%. Note: you mayassume that the movement in deferred tax should be taken to the income statement.

(iii) The 2% loan note was issued on 1 April 2007 under terms that provide for a large premium on redemption in2009. The finance department has calculated that the effect of this is that the loan note has an effective interestrate of 6% per annum.

4



(iv) The suspense account contains the corresponding credit entry for the proceeds of a rights issue of shares madeon 1 July 2007. The terms of the issue were one share for every four held at 80 cents per share. Llama’s shareprice immediately before the issue was $1. The issue was fully subscribed.

Required:

Prepare for Llama:

(a) An income statement for the year ended 30 September 2007. (9 marks)


(c) A calculation of the earnings per share for the year ended 30 September 2007. (3 marks)

Note: a statement of changes in equity is not required.

(25 marks)

5 [P.T.O.



3 Shown below are the recently issued (summarised) financial statements of Harbin, a listed company, for the yearended 30 September 2007, together with comparatives for 2006 and extracts from the Chief Executive’s report thataccompanied their issue.

Income statement 2007 2006$’000 $’000


–––––––– ––––––––Gross profit 50,000 30,000Operating expenses (26,000) (22,000)Finance costs (8,000) (nil)

–––––––– ––––––––Profit before tax 16,000 8,000Income tax expense (at 25%) (4,000) (2,000)

–––––––– ––––––––Profit for the period 12,000 6,000

–––––––– ––––––––

Balance sheetNon-current assetsProperty, plant and equipment 210,000 90,000Goodwill 10,000 nil

–––––––– ––––––––220,000 90,000–––––––– ––––––––

Current assetsInventory 25,000 15,000Trade receivables 13,000 8,000Bank nil 14,000

–––––––– ––––––––38,000 37,000

–––––––– ––––––––Total assets 258,000 127,000

–––––––– ––––––––

Equity and liabilitiesEquity shares of $1 each 100,000 100,000Retained earnings 14,000 12,000

–––––––– ––––––––114,000 112,000–––––––– ––––––––

Non-current liabilities8% loan notes 100,000 nil

–––––––– ––––––––Current liabilitiesBank overdraft 17,000 nilTrade payables 23,000 13,000Current tax payable 4,000 2,000

–––––––– ––––––––44,000 15,000

–––––––– ––––––––Total equity and liabilities 258,000 127,000

–––––––– ––––––––

Extracts from the Chief Executive’s report:

‘Highlights of Harbin’s performance for the year ended 30 September 2007:

an increase in sales revenue of 39%gross profit margin up from 16·7% to 20%a doubling of the profit for the period.

In response to the improved position the Board paid a dividend of 10 cents per share in September 2007 an increaseof 25% on the previous year.’

6



You have also been provided with the following further information.

On 1 October 2006 Harbin purchased the whole of the net assets of Fatima (previously a privately owned entity) for$100 million. The contribution of the purchase to Harbin’s results for the year ended 30 September 2007 was:

$’000Revenue 70,000Cost of sales (40,000)

–––––––Gross profit 30,000Operating expenses (8,000)

–––––––Profit before tax 22,000

–––––––

There were no disposals of non-current assets during the year.

The following ratios have been calculated for Harbin for the year ended 30 September 2006:

Return on year-end capital employed 7·1%(profit before interest and tax over total assets less current liabilities)Net asset (equal to capital employed) turnover 1·6Net profit (before tax) margin 4·4%Current ratio 2·5Closing inventory holding period (in days) 37Trade receivables’ collection period (in days) 16Trade payables’ payment period (based on cost of sales) (in days) 32Gearing (debt over debt plus equity) nil

Required:

(a) Calculate ratios for Harbin for the year ended 30 September 2007 equivalent to those calculated for the yearended 30 September 2006 (showing your workings). (8 marks)

(b) Assess the financial performance and position of Harbin for the year ended 30 September 2007 comparedto the previous year. Your answer should refer to the information in the Chief Executive’s report and theimpact of the purchase of the net assets of Fatima. (17 marks)

(25 marks)

7 [P.T.O.



4 (a) An important requirement of the IASB’s Framework for the Preparation and Presentation of Financial Statements(Framework) is that in order to be reliable, an entity’s financial statements should represent faithfully thetransactions and events that it has undertaken.

Required:

Explain what is meant by faithful representation and how it enhances reliability. (5 marks)

(b) On 1 April 2007, Fino increased the operating capacity of its plant. Due to a lack of liquid funds it was unableto buy the required plant which had a cost of $350,000. On the recommendation of the finance director, Finoentered into an agreement to lease the plant from the manufacturer. The lease required four annual payments inadvance of $100,000 each commencing on 1 April 2007. The plant would have a useful life of four years andwould be scrapped at the end of this period. The finance director, believing the lease to be an operating lease,commented that the agreement would improve the company’s return on capital employed (compared to outrightpurchase of the plant).

Required:

(i) Discuss the validity of the finance director’s comment and describe how IAS 17 Leases ensures thatleases such as the above are faithfully represented in an entity’s financial statements. (4 marks)

(ii) Prepare extracts of Fino’s income statement and balance sheet for the year ended 30 September 2007in respect of the rental agreement assuming:

(1) It is an operating lease (2 marks)

(2) It is a finance lease (use an implicit interest rate of 10% per annum). (4 marks)

(15 marks)

8



5 Product development costs are a material cost for many companies. They are either written off as an expense orcapitalised as an asset.

Required:

(a) Discuss the conceptual issues involved and the definition of an asset that may be applied in determiningwhether development expenditure should be treated as an expense or an asset. (4 marks)

(b) Emerald has had a policy of writing off development expenditure to the income statement as it was incurred. Inpreparing its financial statements for the year ended 30 September 2007 it has become aware that, under IFRSrules, qualifying development expenditure should be treated as an intangible asset. Below is the qualifyingdevelopment expenditure for Emerald:

$’000Year ended 30 September 2004 300Year ended 30 September 2005 240Year ended 30 September 2006 800Year ended 30 September 2007 400

All capitalised development expenditure is deemed to have a four year life. Assume amortisation commences atthe beginning of the accounting period following capitalisation. Emerald had no development expenditure beforethat for the year ended 30 September 2004.

Required:

Treating the above as the correction of an error in applying an accounting policy, calculate the amounts whichshould appear in the income statement and balance sheet (including comparative figures), and statement ofchanges in equity of Emerald in respect of the development expenditure for the year ended 30 September2007.

Note: ignore taxation.(6 marks)

(10 marks)


9



Answers



Fundamentals Level – Skills Module, F7 (INT)Financial Reporting (International) December 2007 Answers

1 (a) Consolidated balance sheet of Plateau as at 30 September 2007$’000 $’000

AssetsNon-current assets:Property, plant and equipment (18,400 + 10,400 – 400 (w (i))) 28,400Goodwill (w (ii)) 3,600Investments – associate (w (iii)) 10,500

– other available for sale 9,000–––––––51,500

Current assetsInventory (6,900 + 6,200 – 300 URP (w (iv))) 12,800Trade receivables (3,200 + 1,500) 4,700 17,500

––––––– –––––––Total assets 69,000

–––––––

Equity and liabilitiesEquity shares of $1 each (w (v)) 11,500Reserves:Share premium (w (v)) 7,500Retained earnings (w (vi)) 28,650 36,150

––––––– –––––––47,650

Minority interest (w (vii)) 3,150–––––––

Total equity 50,800Non-current liabilities7% Loan notes (5,000 + 1,000) 6,000

Current liabilities (8,000 + 4,200) 12,200–––––––


Workings (figures in brackets are in $’000)(i) Property, plant and equipment

The transfer of the plant creates an initial unrealised profit (URP) of $500,000. This is reduced by $100,000 for eachyear (straight-line depreciation over five years) of depreciation in the post-acquisition period. Thus at 30 September2007 the net unrealised profit is $400,000. This should be eliminated from Plateau’s retained profits and from thecarrying amount of the plant. The fall in the fair value of the land has already been taken into account in Savannah’sbalance sheet.

(ii) Goodwill in Savannah:Investment at cost: $’000 $’000Shares issued (3,000/2 x $6) 9,000Cash (3,000 x $1) 3,000

–––––––12,000

Less – equity shares of Savannah (3,000)– pre-acquisition reserves (6,000 x 75% (see below)) (4,500) (7,500)

––––––– –––––––Goodwill on consolidation 4,500

–––––––

Goodwill is impaired by $900,000 thus has a carrying amount at 30 September 2007 of $3·6 million.

Savannah’s pre-acquisition reserves of $6·5 million require an adjustment for a write down of $500,000 in respect ofthe fair value of its land being below its carrying amount. Thus the adjusted pre-acquisition reserves of Savannah are$6 million. A consequent effect is that the post-acquisition reserves which are reported as $2·4 million in Savannah’sbalance sheet will become $2·9 million. This is because the fall in the value of the land has effectively been treated bySavannah as a post-acquisition loss.

(iii) Carrying amount of Axle at 30 September 2007 $’000Cost (4,000 x 30% x $7·50) 9,000Share post-acquisition profit (5,000 x 30%) 1,500

–––––––10,500–––––––

(iv) The unrealised profit (URP) in inventory is calculated as:Intra-group sales are $2·7 million on which Savannah made a profit of $900,000 (2,700 x 50/150). One third of theseare still in the inventory of Plateau, thus there is an unrealised profit of $300,000.

13



(v) The 1·5 million shares issued by Plateau in the share exchange at a value of $6 each would be recorded as $1 pershare as capital and $5 per share as share premium giving an increase in share capital of $1·5 million and a sharepremium of $7·5 million.

(vi) Consolidated retained earnings: $’000Plateau’s retained earnings 24,000Savannah’s post-acquisition ((2,900 – 300 URP) x 75%) 1,950Axle’s post-acquisition profits (5,000 x 30%) 1,500URP in plant (see (i)) (400)Gain on available-for-sale investment (9,000 – 6,500) see below 2,500Impairment of goodwill (900)

–––––––28,650–––––––

The gain on available-for-sale investments must be recognised directly in equity.

(vii) Minority interestAdjusted equity at 30 September 2007: (12,900 – 300 URP) = 12,600 x 25% 3,150

–––––

(b) IFRS 3 Business Combinations requires the purchase consideration for an acquired entity to be allocated to the fair value ofthe assets, liabilities and contingent liabilities acquired (henceforth referred to as net assets and ignoring contingent liabilities)with any residue being allocated to goodwill. This also means that those net assets will be recorded at fair value in theconsolidated balance sheet. This is entirely consistent with the way other net assets are recorded when first transacted (i.e.the initial cost of an asset is normally its fair value). The purpose of this process is that it ensures that individual assets andliabilities are correctly classified (and valued) in the consolidated balance sheet. Whilst this may sound obvious, consider whatwould happen if say a property had a carrying amount of $5 million, but a fair value of $7 million at the date it was acquired.If the carrying amount rather than the fair value was used in the consolidation it would mean that tangible assets (property,plant and equipment) would be understated by $2 million and intangible assets (goodwill) would be overstated by the sameamount (note: in the consolidated balance sheet of Plateau the opposite effect would occur as the fair value of Savannah’sland is below its carrying amount at the date of acquisition). There could also be a ‘knock on’ effect with incorrect depreciationcharges in the years following an acquisition and incorrect calculation of any goodwill impairment. Thus the use of carryingamounts rather than fair values would not give a ‘faithful representation’ as required by the Framework.

The assistant’s comment regarding the inconsistency of value models in the consolidated balance sheet is a fair point, but itis really a deficiency of the historical cost concept rather than a flawed consolidation technique. Indeed the fair values of thesubsidiary’s net assets are the historical costs to the parent. To overcome much of the inconsistency, there would be nothingto prevent the parent company from applying the revaluation model to its property, plant and equipment.

2 (a) Llama – Income statement – Year ended 30 September 2007$’000 $’000

Revenue 180,400Cost of sales (w (i)) (81,700)

––––––––Gross profit 98,700Distribution costs (11,000 + 1,000 depreciation) (12,000)Administrative expenses (12,500 + 1,000 depreciation) (13,500) (25,500)

––––––––

Investment income 2,200Gain on fair value of investments (27,100 – 26,500) 600 2,800

––––––––Finance costs (w (ii)) (2,400)

––––––––Profit before tax 73,600Income tax expense (18,700 – 400 – (11,200 – 10,000) deferred tax) (17,100)


––––––––

14



(b) Llama – Balance sheet as at 30 September 2007$’000 $’000

AssetsNon-current assets Property, plant and equipment (w (iv)) 228,500Investments at fair value through profit and loss 27,100

––––––––255,600

Current assetsInventory 37,900Trade receivables 35,100 73,000

–––––––– ––––––––Total assets 328,600

––––––––Equity and liabilities EquityEquity shares of 50 cents each ((60,000 + 15,000) w (iii)) 75,000

Share premium (w (iii)) 9,000Revaluation reserve (14,000 – 3,000 (w (iv))) 11,000Retained earnings (56,500 + 25,500) 82,000 102,000

–––––––– ––––––––177,000

Non-current liabilities2% loan note (80,000 + 1,600 (w (ii))) 81,600Deferred tax (40,000 x 25%) 10,000 91,600

––––––––Current liabilitiesTrade payables 34,700Bank overdraft 6,600Current tax payable 18,700 60,000

–––––––– ––––––––Total equity and liabilities 328,600

––––––––

Workings (monetary figures in brackets are in $’000)(i) Cost of sales: $’000

Per question 89,200Plant capitalised (w (iv)) (24,000)Depreciation (w (iv)) – buildings 3,000

– plant 13,500–––––––81,700–––––––

(ii) The loan has been in issue for six months. The total finance charge should be based on the effective interest rate of 6%.This gives a charge of $2·4 million (80,000 x 6% x 6/12). As the actual interest paid is $800,000 an accrual (addedto the carrying amount of the loan) of $1·6 million is required.

(iii) The rights issue was 30 million shares (60 million/50 cents is 120 million shares at 1 for 4) at a price of 80 cents thiswould increase share capital by $15 million (30 million x 50 cents) and share premium by $9 million (30 million x 30 cents).

(iv) Non-current assets/depreciation:Land and buildings:On 1 October 2006 the value of the buildings was $100 million (130,000 – 30,000 land). The remaining life at thisdate was 20 years, thus the annual depreciation charge will be $5 million (3,000 to cost of sales and 1,000 each todistribution and administration). Prior to the revaluation at 30 September 2007 the carrying amount of the building was$95 million (100,000 – 5,000). With a revalued amount of $92 million, this gives a revaluation deficit of $3 millionwhich should be debited to the revaluation reserve. The carrying amount of land and buildings at 30 September 2007will be $122 million (92,000 buildings + 30,000 land (unchanged)).

PlantThe existing plant will be depreciated by $12 million ((128,000 – 32,000) x 121/2%) and have a carrying amount of$84 million at 30 September 2007.

The plant manufactured for internal use should be capitalised at $24 million (6,000 + 4,000 + 8,000 + 6,000). Depreciation on this will be $1·5 million (24,000 x 121/2% x 6/12). This will give a carrying amount of $22·5 millionat 30 September 2007. Thus total depreciation for plant is $13·5 million with a carrying amount of $106·5 million(84,000 + 22,500)

Summarising the carrying amounts: $’000Land and buildings 122,000Plant 106,500

––––––––Property, plant and equipment 228,500

––––––––

15



(c) Earnings per share (eps) for the year ended 30 September 2007

Theoretical ex rights value $Holding (say) 100 at $1 100Issue (1 for 4) 25 at 80 cents 20

–––– ––––New holding 125 ex rights price is 96 cents 120

–––– ––––

Weighted average number of shares120,000,000 x 9/12 x 100/96 93,750,000150,000,000 (120 x 5/4) x 3/12 37,500,000

––––––––––––131,250,000––––––––––––

Earnings per share ($56,500,000/131,250,000) 43 cents

3 (a) Note: figures in the calculations of the ratios are in $million2007 workings 2006 2007 re Fatima (b)

Return on year end capital employed 11·2 % 24/(114 + 100) x 100 7·1% 18·9%Net asset turnover 1·2 times 250/214 1·6 0·6Gross profit margin (given in question) 20% 16·7% 42·9%Net profit (before tax) margin 6·4% 16/250 4·4% 31·4%Current ratio 0·9:1 38/44 2·5Closing inventory holding period 46 days 25/200 x 365 37Trade receivables’ collection period 19 days 13/250 x 365 16Trade payables’ payment period 42 days 23/200 x 365 32Gearing 46·7% 100/214 x 100 nil

The gross profit margins and relevant ratios for 2006 are given in the question, and some additional ratios for Fatima areincluded above to enable a clearer analysis in answering part (b) (references to Fatima should be taken to mean Fatima’s netassets).

(b) Analysis of the comparative financial performance and position of Harbin for the year ended 30 September 2007. Note:references to 2007 and 2006 should be taken as the years ended 30 September 2007 and 2006.

IntroductionThe figures relating to the comparative performance of Harbin ‘highlighted’ in the Chief Executive’s report may be factuallycorrect, but they take a rather biased and one dimensional view. They focus entirely on the performance as reflected in theincome statement without reference to other measures of performance (notably the ROCE); nor is there any reference to thepurchase of Fatima at the beginning of the year which has had a favourable effect on profit for 2007. Due to this purchase,it is not consistent to compare Harbin’s income statement results in 2007 directly with those of 2006 because it does notmatch like with like. Immediately before the $100 million purchase of Fatima, the carrying amount of the net assets of Harbinwas $112 million. Thus the investment represented an increase of nearly 90% of Harbin’s existing capital employed. Thefollowing analysis of performance will consider the position as shown in the reported financial statements (based on the ratiosrequired by part (a) of the question) and then go on to consider the impact the purchase has had on this analysis.

ProfitabilityThe ROCE is often considered to be the primary measure of operating performance, because it relates the profit made by anentity (return) to the capital (or net assets) invested in generating those profits. On this basis the ROCE in 2007 of 11·2%represents a 58% improvement (i.e. 4·1% on 7·1%) on the ROCE of 7·1% in 2006. Given there were no disposals of non-current assets, the ROCE on Fatima’s net assets is 18·9% (22m/100m + 16·5m). Note: the net assets of Fatima at theyear end would have increased by profit after tax of $16·5 million (i.e. 22m x 75% (at a tax rate of 25%)). Put another way,without the contribution of $22 million to profit before tax, Harbin’s ‘underlying’ profit would have been a loss of $6 millionwhich would give a negative ROCE. The principal reasons for the beneficial impact of Fatima’s purchase is that its profitmargins at 42·9% gross and 31·4% net (before tax) are far superior to the profit margins of the combined business at 20%and 6·4% respectively. It should be observed that the other contributing factor to the ROCE is the net asset turnover and inthis respect Fatima’s is actually inferior at 0·6 times (70m/116·5m) to that of the combined business of 1·2 times.

It could be argued that the finance costs should be allocated against Fatima’s results as the proceeds of the loan note appearto be the funding for the purchase of Fatima. Even if this is accepted, Fatima’s results still far exceed those of the existingbusiness.

Thus the Chief Executive’s report, already criticised for focussing on the income statement alone, is still highly misleading.Without the purchase of Fatima, underlying sales revenue would be flat at $180 million and the gross margin would be downto 11·1% (20m/180m) from 16·7% resulting in a loss before tax of $6 million. This sales performance is particularly poorgiven it is likely that there must have been an increase in spending on property plant and equipment beyond that related tothe purchase of Fatima’s net assets as the increase in property, plant and equipment is $120 million (after depreciation).

16



LiquidityThe company’s liquidity position as measured by the current ratio has deteriorated dramatically during the period. A relativelyhealthy 2·5:1 is now only 0·9:1 which is rather less than what one would expect from the quick ratio (which excludesinventory) and is a matter of serious concern. A consideration of the component elements of the current ratio suggests thatincreases in the inventory holding period and trade payables payment period have largely offset each other. There is a smallincrease in the collection period for trade receivables (up from 16 days to 19 days) which would actually improve the currentratio. This ratio appears unrealistically low, it is very difficult to collect credit sales so quickly and may be indicative of factoringsome of the receivables, or a proportion of the sales being cash sales. Factoring is sometimes seen as a consequence ofdeclining liquidity, although if this assumption is correct it does also appear to have been present in the previous year. Thechanges in the above three ratios do not explain the dramatic deterioration in the current ratio, the real culprit is the cashposition, Harbin has gone from having a bank balance of $14 million in 2006 to showing short-term bank borrowings of $17 million in 2007.

A cash flow statement would give a better appreciation of the movement in the bank/short term borrowing position.

It is not possible to assess, in isolation, the impact of the purchase of Fatima on the liquidity of the company.

DividendsA dividend of 10 cents per share in 2007 amounts to $10 million (100m x 10 cents), thus the dividend in 2006 would havebeen $8 million (the dividend in 2007 is 25% up on 2006). It may be that the increase in the reported profits led the Boardto pay a 25% increased dividend, but the dividend cover is only 1·2 times (12m/10m) in 2007 which is very low. In 2006the cover was only 0·75 times (6m/8m) meaning previous years’ reserves were used to facilitate the dividend. The lowretained earnings indicate that Harbin has historically paid a high proportion of its profits as dividends, however in times ofdeclining liquidity, it is difficult to justify such high dividends.

GearingThe company has gone from a position of nil gearing (i.e. no long-term borrowings) in 2006 to a relatively high gearing of46·7% in 2007. This has been caused by the issue of the $100 million 8% loan note which would appear to be the sourceof the funding for the $100 million purchase of Fatima’s net assets. At the time the loan note was issued, Harbin’s ROCEwas 7·1%, slightly less than the finance cost of the loan note. In 2007 the ROCE has increased to 11·2%, thus the mannerof the funding has had a beneficial effect on the returns to the equity holders of Harbin. However, it should be noted that highgearing does not come without risk; any future downturn in the results of Harbin would expose the equity holders to muchlower proportionate returns and continued poor liquidity may mean payment of the loan interest could present a problem.Harbin’s gearing and liquidity position would have looked far better had some of the acquisition been funded by an issue ofequity shares.

ConclusionThere is no doubt that the purchase of Fatima has been a great success and appears to have been a wise move on the partof the management of Harbin. However, it has disguised a serious deterioration of the underlying performance and positionof Harbin’s existing activities which the Chief Executive’s report may be trying to hide. It may be that the acquisition was partof an overall plan to diversify out of what has become existing loss making activities. If such a transition can continue, thenthe worrying aspects of poor liquidity and high gearing may be overcome.

4 (a) Faithful representationThe Framework states that in order to be useful, information must be reliable and the two main components of reliability arefreedom from material error and faithful representation. The Framework describes faithful representation as where the financialstatements (or other information) have the characteristic that they faithfully represent the transactions and other events thathave occurred. Thus a balance sheet should faithfully represent transactions that result in assets, liabilities and equity of anentity. Some would refer to this as showing a true and fair view. An essential element of faithful representation is theapplication of the concept of substance over form. There are many examples where recording the legal form of a transactiondoes not convey its real substance or commercial reality. For example an entity may sell some inventory to a finance houseand later buy it back at a price based on the original selling price plus a finance cost. Such a transaction is really a securedloan attracting interest costs. To portray it as a sale and subsequent repurchase of inventory would not be a faithfulrepresentation of the transaction. The ‘sale’ would probably create a ‘profit’, there would be no finance cost in the incomestatement and the balance sheet would not show the asset of inventory or the liability to the finance house – all of whichwould not be representative of the economic reality. A further example is that an entity may issue loan notes that are(optionally) convertible to equity. In the past, sometimes management has argued that as they expect the loan note holdersto take the equity option, the loan notes should be treated as equity (which of course would flatter the entity’s gearing). Insome cases transactions similar to the above, particularly off balance sheet finance schemes, have been deliberately enteredinto to manipulate the balance sheet and income statement (so called creative accounting). Ratios such as return on capitalemployed (ROCE), asset turnover, interest cover and gearing are often used to assess the performance of an entity. If theseratios were calculated from financial statements that have been manipulated, they would be distorted (usually favourably)from the underlying substance. Clearly users cannot rely on such financial statements or any ratios calculated from them.

(b) (i) The finance director’s comment that the ROCE would improve, based on the agreement being classified as an operatinglease is correct (but see below). Over the life of the lease the reported profit is not affected by the lease being designatedas an operating or finance lease, but the balance sheet is. This is because the depreciation and finance costs chargedon a finance lease would equal (over the full life of the lease) what would be charged as lease rentals if it were classed

17



as an operating lease instead. However, classed as an operating lease, there would not be a leased asset or leaseobligation recorded in the balance sheet; whereas there would be if it were a finance lease or an outright purchase. Thuscapital employed under an operating lease would be lower leading to a higher (more favourable) ROCE. IAS 17 Leasesdefines a finance lease as one which transfers to the lessee substantially all the risks and rewards incidental to ownership(an application of the principle of substance over form). In this case, as the asset will be used by Fino for four years (itsentire useful life) and then be scrapped, it is almost certain to require classification as a finance lease. Thus the financedirector’s comments are unlikely to be valid.

Fino(ii) (1) Operating lease $

Income statement – cost of sales (machine rental) (100,000 x 6/12) 50,000

Balance sheetCurrent assetsPrepayment (100,000 x 6/12) 50,000

(2) Finance leaseIncome statement – cost of sales (depreciation) (350,000/4 x 6/12) 43,750Income statement – finance costs (see working) 12,500

Balance sheetNon-current assetsLeased plant at cost 350,000Depreciation (from above) (43,750)

––––––––306,250––––––––

Non-current liabilitiesLease obligation (250,000 – 75,000) 175,000

Current liabilitiesAccrued interest (see working) 12,500Lease obligation (100,000 – 25,000 see below) 75,000

––––––––87,500

Working:Cost 350,000Deposit (100,000)

––––––––250,000

Interest to 30 September 2007 (6 months at 10%) 12,500––––––––

Total obligation at 30 September 2007 262,500––––––––

The payment of $100,000 on 1 April 2008 will contain $25,000 of interest ($250,000 x 10%) and a capitalrepayment of $75,000.

5 (a) The Framework defines an asset as a resource controlled by an entity as a result of past transactions or events from whichfuture economic benefits (normally net cash inflows) are expected to flow to the entity. However assets can only be recognised(on the balance sheet) when those expected benefits are probable and can be measured reliably. The Framework recognisesthat there is a close relationship between incurring expenditure and generating assets, but they do not necessarily coincide.Development expenditure, perhaps more than any other form of expenditure, is a classic example of the relationship betweenexpenditure and creating an asset. Clearly entities commit to expenditure on both research and development in the hope thatit will lead to a profitable product, process or service, but at the time that the expenditure is being incurred, entities cannotbe certain (or it may not even be probable) that the project will be successful. Relating this to accounting concepts wouldmean that if there is doubt that a project will be successful the application of prudence would dictate that the expenditure ischarged (expensed) to the income statement. At the stage where management becomes confident that the project will besuccessful, it meets the definition of an asset and the accruals/matching concept would mean that it should be capitalised(treated as an asset) and amortised over the period of the expected benefits. Accounting Standards (IAS 38 Intangible Assets)interpret this as writing off all research expenditure and only capitalising development costs from the point in time where theymeet strict conditions which effectively mean the expenditure meets the definition of an asset.

(b) 30 September 2007 30 September 2006Emerald Income statement: $’000 $’000Amortisation of development expenditure 335 (w (ii)) 135 (w (i))

Balance sheetDevelopment expenditure 1,195 (w (iv)) 1,130 (w (iii))

Statement of changes in equityPrior period adjustment (credit required to restate retained earnings at 1 October 2005)(cumulative carrying amount at 2005 of 300 + 165) 465

18



Workings (All figures in $’000. Note: references to 2004, 2005 etc should be taken as for the year ended 30 September2004 and 2005 etc.)

Year 2004 2005 2006 cumulative 2006 2007 cumulative 2007Expenditure 300 240 800 1,340 400 1,740

–––– –––– –––– –––––– –––– ––––––Amortisation (25%) nil (75) (75) (150) (75) (225)

nil nil (60) (60) (60) (120)nil nil nil nil (200) (200)

–––– –––– –––– –––––– –––– ––––––Total amortisation nil (75) (w (i)) (135) (210) (w (ii)) (335) (545)

–––– –––– –––– –––––– –––– ––––––Carrying amount 300 165 665 (w (iii)) 1,130 65 (w (iv)) 1,195

–––– –––– –––– –––––– –––– ––––––

19



Fundamentals Level – Skills Module, F7 (INT)Financial Reporting (International) December 2007 Marking Scheme


Marks1 (a) Balance sheet:

property, plant and equipment 2goodwill 4investments – associate 2

– other 1current assets 2equity shares 1share premium 1retained earnings 4minority interest 17% loan notes 1current liabilities 1

20

(b) 1 mark per relevant point 5Total for question 25

2 (a) Income statementrevenue 1/2cost of sales 31/2distribution costs and administrative expenses 1investment income and gain on investment 11/2finance costs 1tax 11/2

9

(b) Balance sheet property, plant and equipment 3investments 1current assets 1equity shares 1share premium 1revaluation reserve 1retained earnings 12% loan notes 11/2deferred tax 1trade payables and overdraft 1income tax provision 1/2

13

(c) Earnings per sharecalculation of theoretical ex rights value 1weighted average number of shares 1earnings and calculation of eps 1

3Total for question 25

3 (a) one mark per required ratio 8

(b) for consideration of Chief Executive’s report 3impact of purchase 6remaining issues 1 mark per valid point 8


21



Marks4 (a) one mark per valid point to maximum 5

(b) (i) one mark per valid point to maximum 4

(ii) (1) operating lease – income statement charge 1(1) operating lease – prepayment 1–––

2

(2) finance lease – income statement: depreciation and finance costs 1(2) finance lease – balance sheet: non-current asset 1(2) finance lease – balance sheet: non-current liabilities 1(2) finance lease – balance sheet: current liabilities interest and capital 1–––


5 (a) one mark per valid point to maximum 4

(b) income statement amortisation 11/2cost in balance sheets 1accumulated amortisation 11/2prior year adjustment in changes in equity 2


22









Pape

r F7

(IN

T)


Tuesday 10 June 2008





1 On 1 August 2007 Patronic purchased 18 million of a total of 24 million equity shares in Sardonic. The acquisitionwas through a share exchange of two shares in Patronic for every three shares in Sardonic. Both companies haveshares with a par value of $1 each. The market price of Patronic’s shares at 1 August 2007 was $5·75 per share.Patronic will also pay in cash on 31 July 2009 (two years after acquisition) $2·42 per acquired share of Sardonic.Patronic’s cost of capital is 10% per annum. The reserves of Sardonic on 1 April 2007 were $69 million.

Patronic has held an investment of 30% of the equity shares in Acerbic for many years.

The summarised income statements for the three companies for the year ended 31 March 2008 are:

Patronic Sardonic Acerbic$’000 $’000 $’000


–––––––– ––––––– –––––––Gross profit 56,000 27,000 20,000Distribution costs (7,400) (3,000) (3,500)Administrative expenses (12,500) (6,000) (6,500)Finance costs (note (ii)) (2,000) (900) nil

–––––––– ––––––– –––––––Profit before tax 34,100 17,100 10,000Income tax expense (10,400) (3,600) (4,000)

–––––––– ––––––– –––––––Profit for the period 23,700 13,500 6,000

–––––––– ––––––– –––––––


(i) The fair values of the net assets of Sardonic at the date of acquisition were equal to their carrying amounts withthe exception of property and plant. Property and plant had fair values of $4·1 million and $2·4 millionrespectively in excess of their carrying amounts. The increase in the fair value of the property would createadditional depreciation of $200,000 in the consolidated financial statements in the post acquisition period to 31 March 2008 and the plant had a remaining life of four years (straight-line depreciation) at the date ofacquisition of Sardonic. All depreciation is treated as part of cost of sales.

The fair values have not been reflected in Sardonic’s financial statements.

No fair value adjustments were required on the acquisition of Acerbic.

(ii) The finance costs of Patronic do not include the finance cost on the deferred consideration.

(iii) Prior to its acquisition, Sardonic had been a good customer of Patronic. In the year to 31 March 2008, Patronicsold goods at a selling price of $1·25 million per month to Sardonic both before and after its acquisition. Patronicmade a profit of 20% on the cost of these sales. At 31 March 2008 Sardonic still held inventory of $3 million(at cost to Sardonic) of goods purchased in the post acquisition period from Patronic.

(iv) An impairment test on the goodwill of Sardonic conducted on 31 March 2008 concluded that it should be writtendown by $2 million. The value of the investment in Acerbic was not impaired.

(v) All items in the above income statements are deemed to accrue evenly over the year.

(vi) Ignore deferred tax.

2



Required:

(a) Calculate the goodwill arising on the acquisition of Sardonic at 1 August 2007. (6 marks)

(b) Prepare the consolidated income statement for the Patronic Group for the year ended 31 March 2008.

Note: assume that the investment in Acerbic has been accounted for using the equity method since itsacquisition. (15 marks)

(c) At 31 March 2008 the other equity shares (70%) in Acerbic were owned by many separate investors. Shortlyafter this date Spekulate (a company unrelated to Patronic) accumulated a 60% interest in Acerbic by buyingshares from the other shareholders. In May 2008 a meeting of the board of directors of Acerbic was held at whichPatronic lost its seat on Acerbic’s board.

Required:

Explain, with reasons, the accounting treatment Patronic should adopt for its investment in Acerbic when itprepares its financial statements for the year ending 31 March 2009. (4 marks)

(25 marks)

3 [P.T.O.



2 Below is the summarised draft statement of financial position of Dexon, a publicly listed company, as at 31 March2008.

$’000 $’000 $’000AssetsNon-current assetsProperty at valuation (land $20,000; buildings $165,000 (note (ii)) 185,000Plant (note (ii)) 180,500Investments at fair value through profit and loss at 1 April 2007 (note (iii)) 12,500

––––––––378,000

Current assetsInventory 84,000Trade receivables (note (iv)) 52,200Bank 3,800 140,000

–––––––– ––––––––Total assets 518,000

––––––––

Equity and liabilitiesEquityOrdinary shares of $1 each 250,000Share premium 40,000Revaluation reserve 18,000 Retained earnings – at 1 April 2007 12,300

– for the year ended 31 March 2008 96,700 109,000 167,000––––––– –––––––– ––––––––

417,000Non-current liabilitiesDeferred tax – at 1 April 2007 (note (v)) 19,200Current liabilities 81,800

––––––––Total equity and liabilities 518,000

––––––––


(i) Dexon’s income statement includes $8 million of revenue for credit sales made on a ‘sale or return’ basis. At 31 March 2008, customers who had not paid for the goods, had the right to return $2·6 million of them. Dexonapplied a mark up on cost of 30% on all these sales. In the past, Dexon’s customers have sometimes returnedgoods under this type of agreement.

(ii) The non-current assets have not been depreciated for the year ended 31 March 2008.

Dexon has a policy of revaluing its land and buildings at the end of each accounting year. The values in the abovestatement of financial position are as at 1 April 2007 when the buildings had a remaining life of fifteen years. Aqualified surveyor has valued the land and buildings at 31 March 2008 at $180 million.

Plant is depreciated at 20% on the reducing balance basis.

(iii) The investments at fair value through profit and loss are held in a fund whose value changes directly in proportionto a specified market index. At 1 April 2007 the relevant index was 1,200 and at 31 March 2008 it was 1,296.

(iv) In late March 2008 the directors of Dexon discovered a material fraud perpetrated by the company’s creditcontroller that had been continuing for some time. Investigations revealed that a total of $4 million of the tradereceivables as shown in the statement of financial position at 31 March 2008 had in fact been paid and themoney had been stolen by the credit controller. An analysis revealed that $1·5 million had been stolen in theyear to 31 March 2007 with the rest being stolen in the current year. Dexon is not insured for this loss and itcannot be recovered from the credit controller, nor is it deductible for tax purposes.

(v) During the year the company’s taxable temporary differences increased by $10 million of which $6 millionrelated to the revaluation of the property. The deferred tax relating to the remainder of the increase in thetemporary differences should be taken to the income statement. The applicable income tax rate is 20%.

4



(vi) The above figures do not include the estimated provision for income tax on the profit for the year ended 31 March2008. After allowing for any adjustments required in items (i) to (iv), the directors have estimated the provisionat $11·4 million (this is in addition to the deferred tax effects of item (v)).

(vii) On 1 September 2007 there was a fully subscribed rights issue of one new share for every four held at a priceof $1·20 each. The proceeds of the issue have been received and the issue of the shares has been correctlyaccounted for in the above statement of financial position.

(viii) In May 2007 a dividend of 4 cents per share was paid. In November 2007 (after the rights issue in item (vii)above) a further dividend of 3 cents per share was paid. Both dividends have been correctly accounted for in theabove statement of financial position.

Required:

Taking into account any adjustments required by items (i) to (viii) above

(a) Prepare a statement showing the recalculation of Dexon’s profit for the year ended 31 March 2008.(8 marks)

(b) Prepare the statement of changes in equity of Dexon for the year ended 31 March 2008. (8 marks)

(c) Redraft the statement of financial position of Dexon as at 31 March 2008. (9 marks)

Note: notes to the financial statements are NOT required.

(25 marks)

5 [P.T.O.



3 Pinto is a publicly listed company. The following financial statements of Pinto are available:

Statement of comprehensive income for the year ended 31 March 2008 $’000Revenue 5,740Cost of sales (4,840)

––––––Gross profit 900Income from and gains on investment property 60Distribution costs (120)Administrative expenses (note (ii)) (350)Finance costs (50)

––––––Profit before tax 440Income tax expense (160)

––––––Profit for the year 280

––––––Other comprehensive incomeGains on property revaluation 100

––––––Total comprehensive income 380

––––––

Statements of financial position as at 31 March 2008 31 March 2007$’000 $’000 $’000 $’000

AssetsNon-current assets (note (i))Property, plant and equipment 2,880 1,860Investment property 420 400

–––––– ––––––3,300 2,260

Current assetsInventory 1,210 810Trade receivables 480 540Income tax asset nil 50Bank 10 1,700 nil 1,400

––––– –––––– –––––– ––––––Total assets 5,000 3,660

–––––– ––––––

Equity and liabilitiesEquity shares of 20 cents each (note (iii)) 1,000 600Share premium 600 nilRevaluation reserve 150 50Retained earnings 1,440 2,190 1,310 1,360

––––– –––––– –––––– ––––––3,190 1,960

Non-current liabilities6% loan notes (note (ii)) nil 400Deferred tax 50 50 30 430

––––– ––––––Current liabilitiesTrade payables 1,410 1,050Bank overdraft nil 120Warranty provision (note (iv)) 200 100Current tax payable 150 1,760 nil 1,270

––––– –––––– –––––– ––––––Total equity and liabilities 5,000 3,660

–––––– ––––––

6




(i) An item of plant with a carrying amount of $240,000 was sold at a loss of $90,000 during the year. Depreciationof $280,000 was charged (to cost of sales) for property, plant and equipment in the year ended 31 March 2008.

Pinto uses the fair value model in IAS 40 Investment Property. There were no purchases or sales of investmentproperty during the year.

(ii) The 6% loan notes were redeemed early incurring a penalty payment of $20,000 which has been charged asan administrative expense in the income statement.

(iii) There was an issue of shares for cash on 1 October 2007. There were no bonus issues of shares during the year.

(iv) Pinto gives a 12 month warranty on some of the products it sells. The amounts shown in current liabilities aswarranty provision are an accurate assessment, based on past experience, of the amount of claims likely to bemade in respect of warranties outstanding at each year end. Warranty costs are included in cost of sales.

(v) A dividend of 3 cents per share was paid on 1 January 2008.

Required:

(a) Prepare a statement of cash flows for Pinto for the year to 31 March 2008 in accordance with IAS 7Statement of cash flows. (15 marks)

(b) Comment on the cash flow management of Pinto as revealed by the statement of cash flows and theinformation provided by the above financial statements.

Note: ratio analysis is not required, and will not be awarded any marks. (10 marks)

(25 marks)

7 [P.T.O.



4 (a) The IASB’s Framework for the Preparation and Presentation of Financial Statements requires financialstatements to be prepared on the basis that they comply with certain accounting concepts, underlyingassumptions and (qualitative) characteristics. Five of these are:

Matching/accruals Substance over formPrudence ComparabilityMateriality

Required:

Briefly explain the meaning of each of the above concepts/assumptions. (5 marks)

(b) For most entities, applying the appropriate concepts/assumptions in accounting for inventories is an importantelement in preparing their financial statements.

Required:

Illustrate with examples how each of the concepts/assumptions in (a) may be applied to accounting forinventory. (10 marks)

(15 marks)

5 Pingway issued a $10 million 3% convertible loan note at par on 1 April 2007 with interest payable annually inarrears. Three years later, on 31 March 2010, the loan note is convertible into equity shares on the basis of $100 ofloan note for 25 equity shares or it may be redeemed at par in cash at the option of the loan note holder. One of thecompany’s financial assistants observed that the use of a convertible loan note was preferable to a non-convertibleloan note as the latter would have required an interest rate of 8% in order to make it attractive to investors. Theassistant has also commented that the use of a convertible loan note will improve the profit as a result of lower interestcosts and, as it is likely that the loan note holders will choose the equity option, the loan note can be classified asequity which will improve the company’s high gearing position.

The present value of $1 receivable at the end of the year, based on discount rates of 3% and 8% can be taken as:

3% 8%$ $

End of year 1 0·97 0·932 0·94 0·863 0·92 0·79

Required:

Comment on the financial assistant’s observations and show how the convertible loan note should be accountedfor in Pingway’s income statement for the year ended 31 March 2008 and statement of financial position as atthat date.

(10 marks)


8



Answers



Fundamentals Level – Skills Module, Paper F7 (INT)Financial Reporting (International) June 2008 Answers

1 (a) Cost of control in Sardonic: $’000 $’000Consideration Shares (18,000 x 2/3 x $5·75) 69,000Deferred payment (18,000 x 2·42/1·21 (see below)) 36,000

––––––––105,000

LessEquity shares 24,000Pre-acquisition reserves:At 1 April 2007 69,000To date of acquisition (13,500 x 4/12) 4,500Fair value adjustments (4,100 + 2,400) 6,500

––––––––104,000 x 75% (78,000)

––––––––Goodwill 27,000

––––––––

$1 compounded for two years at 10% would be worth $1·21. The acquisition of 18 million out of a total of 24 million equity shares is a 75% interest.

(b) Patronic Group

Consolidated income statement for the year ended 31 March 2008 $’000Revenue (150,000 + (78,000 x 8/12) – (1,250 x 8 months intra group)) 192,000Cost of sales (w (i)) (119,100)

–––––––––Gross profit 72,900Distribution costs (7,400 + (3,000 x 8/12)) (9,400)Administrative expenses (12,500 + (6,000 x 8/12)) (16,500)Finance costs (w (ii)) (5,000)Impairment of goodwill (2,000)Share of profit from associate (6,000 x 30%) 1,800

–––––––––Profit before tax 41,800Income tax expense (10,400 + (3,600 x 8/12)) (12,800)

–––––––––Profit for the year 29,000

–––––––––Attributable to:Equity holders of the parent 26,900Minority interest (w (iii)) 2,100

–––––––––29,000

–––––––––

(c) An associate is defined by IAS 28 Investments in Associates as an investment over which an investor has significantinfluence. There are several indicators of significant influence, but the most important are usually considered to be a holdingof 20% or more of the voting shares and board representation. Therefore it was reasonable to assume that the investment inAcerbic (at 31 March 2008) represented an associate and was correctly accounted for under the equity accounting method.

The current position (from May 2008) is that although Patronic still owns 30% of Acerbic’s shares, Acerbic has become asubsidiary of Spekulate as it has acquired 60% of Acerbic’s shares. Acerbic is now under the control of Spekulate (part ofthe definition of being a subsidiary), therefore it is difficult to see how Patronic can now exert significant influence overAcerbic. The fact that Patronic has lost its seat on Acerbic’s board seems to reinforce this point. In these circumstances theinvestment in Acerbic falls to be treated under IAS 39 Financial Instruments: Recognition and Measurement. It will cease tobe equity accounted from the date of loss of significant influence. Its carrying amount at that date will be its initial recognitionvalue under IAS 39 and thereafter it will be carried at fair value.

Workings(i) Cost of sales $’000 $’000

Patronic 94,000Sardonic (51,000 x 8/12) 34,000Intra group purchases (1,250 x 8 months) (10,000)Additional depreciation: plant (2,400/ 4 years x 8/12) 400

property (per question) 200 600––––

Unrealised profit in inventories (3,000 x 20/120) 500––––––––119,100––––––––

Note: for both sales revenues and cost of sales, only the post acquisition intra group trading should be eliminated.

11



(ii) Finance costs $’000Patronic per question 2,000Unwinding interest – deferred consideration (36,000 x 10% x 8/12) 2,400Sardonic (900 x 8/12) 600

––––––5,000

––––––

(iii) Minority interestSardonic’s post acquisition profit (13,500 x 8/12) 9,000Less post acquisition additional depreciation (w (i)) (600)

––––––8,400x 25% = 2,100

2 (a) $’000 $’000Retained profit for period per question 96,700Dividends paid (w (i)) 15,500

––––––––Draft profit for year ended 31 March 2008 112,200Discovery of fraud (w (ii)) (2,500)Goods on sale or return (w (iii)) (600)Depreciation (w (iv)) – buildings (165,000/15 years) 11,000

– plant (180,500 x 20%) 36,100 (47,100)––––––––

Increase in investments ((12,500 x 1,296/1,200) – 12,500) 1,000 Provision for income tax (11,400)Increase in deferred tax (w (v)) (800)

––––––––Recalculated profit for year ended 31 March 2008 50,800

––––––––

(b) Dexon – Statement of Changes in Equity – Year ended 31 March 2008

Ordinary Share Revaluation Retained Totalshares premium reserve earnings$’000 $’000 $’000 $’000 $’000

At 1 April 2007 200,000 30,000 18,000 12,300 260,300Prior period adjustment (w (ii)) (1,500) (1,500)

––––––––Restated earnings at 1 April 2007 10,800Rights issue (see below) 50,000 10,000 60,000Total comprehensive income (from (a) and (w (iv)) 4,800 50,800 55,600Dividends paid (w (i)) (15,500) (15,500)

–––––––– ––––––– ––––––– –––––––– ––––––––At 31 March 2008 250,000 40,000 22,800 46,100 358,900

–––––––– ––––––– ––––––– –––––––– ––––––––

Rights issue: 250 million shares in issue after a rights issue of one for four would mean that 50 million shares were issued(250,000 x 1/5). As the issue price was $1·20, this would create $50 million of share capital and $10 million of sharepremium.

12



(c) Dexon – Statement of financial position as at 31 March 2008:

Non-current assets $’000 $’000Property (w (iv)) 180,000Plant (180,500 – 36,100 depreciation see (a)) 144,400Investments at fair value through profit and loss (12,500 + 1,000 see (a)) 13,500

––––––––337,900

Current assetsInventory (84,000 + 2,000 (w (iii))) 86,000Trade receivables (52,200 – 4,000 – 2,600 (w (ii) and (iii))) 45,600Bank 3,800 135,400

––––––– ––––––––Total assets 473,300

––––––––

Equity and liabilitiesEquity (from (b))Ordinary shares of $1 each 250,000Share premium 40,000Revaluation reserve 22,800Retained earnings 46,100 108,900

––––––– ––––––––358,900

Non-current liabilitiesDeferred tax (19,200 + 2,000 (w (v))) 21,200Current liabilities (81,800 + 11,400 income tax) 93,200

––––––––Total equity and liabilities 473,300

––––––––

Workings (figures in brackets in $’000)

(i) Dividends paidThe dividend in May 2007 would be $8 million (200 million shares at 4 cents) and in November 2007 would be $7·5 million (250 million shares x 3 cents). Total dividends would therefore have been $15·5 million.

(ii) The discovery of the fraud means that $4 million should be written off trade receivables. $1·5 million debited to retainedearnings as a prior period adjustment (in the statement of changes in equity) and $2·5 written off in the incomestatement for the year ended 31 March 2008.

(iii) Goods on sale or returnThe sales over which customers still have the right of return should not be included in Dexon’s recognised revenue. Thereversing effect is to reduce the relevant trade receivables by $2·6 million, increase inventory by $2 million (the cost ofthe goods (2,600 x 100/130)) and reduce the profit for the year by $600,000.

(iv) Property The carrying amount of the property (after the year’s depreciation) is $174 million (185,000 – 11,000). A valuation of$180 million would create a revaluation surplus of $6 million of which $1·2 million (6,000 x 20%) would betransferred to deferred tax.

(v) Deferred taxAn increase in the taxable temporary differences of $10 million would create a transfer (credit) to deferred tax of $2 million (10,000 x 20%). Of this $1·2 million relates to the revaluation of the property and is debited to therevaluation reserve. The balance, $800,000, is charged to the income statement.

13



3 (a) Statement of cash flows of Pinto for the Year to 31 March 2008:

Cash flows from operating activities $’000 $’000Profit before tax 440Adjustments for:Depreciation of property, plant and equipment 280Loss on sale of property, plant and equipment 90 370

––––––Increase in warranty provision (200 – 100) 100Investment income (60)Finance costs 50Redemption penalty costs included in administrative expenses 20

–––––––920

Working capital adjustmentsIncrease in inventories (1,210 – 810) (400)Decrease in trade receivables (540 – 480) 60Increase in trade payables (1,410 – 1,050) 360 20

–––––– –––––––Cash generated from operations 940Finance costs paid (50)Income tax refund (w (ii)) 60

–––––––Net cash from operating activities 950Cash flows from investing activitiesPurchase of property, plant and equipment (w (i)) (1,440)Sale of property, plant and equipment (240 – 90) 150Investment income received (60 – 20 gain on investment property) 40

––––––Net cash used in investing activities (1,250)Cash flows from financing activitiesProceeds from issue of equity shares (400 + 600) 1,000Redemption of loan notes (400 plus 20 penalty) (420)Dividends paid (1,000 x 5 x 3 cents) (150)

––––––Net cash from financing activities 430

–––––––Net increase in cash and cash equivalents 130Cash and cash equivalents at beginning of period (120)

–––––––Cash and cash equivalents at end of period 10

–––––––

Note: investment income received and dividends paid may alternatively be shown in operating activities.

Workings (in $’000)

(i) Property, plant and equipment:carrying amount b/f 1,860revaluation 100depreciation for period (280)disposal (240)carrying amount c/f (2,880)

–––––––difference is cash acquisitions (1,440)

–––––––

(ii) Income tax:tax asset b/f 50deferred tax b/f (30)income statement charge (160)tax provision c/f 150deferred tax c/f 50

––––difference is cash received 60

––––

(b) Comments on the cash management of Pinto

Operating cash flows:Pinto’s operating cash inflows at $940,000 (prior to investment income, finance costs and taxation) are considerably higherthan the equivalent profit before investment income, finance costs and tax of $430,000. This shows a satisfactory cashgenerating ability and is more than sufficient to cover finance costs, taxation (see later) and dividends. The major reasons forthe cash flows being higher than the operating profit are due to the (non-cash) increases in the depreciation and warrantyprovisions. Working capital changes are relatively neutral; a large increase in inventory appears to be being financed by asubstantial increase in trade payables and a modest reduction in trade receivables. The reduction in trade receivables is

14



perhaps surprising as other indicators point to an increase in operating capacity which has not been matched with an increasein trade receivables. This could be indicative of good control over the cash management of the trade receivables (or adisappointing sales performance).

An unusual feature of the cash flow is that Pinto has received a tax refund of $60,000 during the current year. This wouldindicate that in the previous year Pinto was making losses (hence obtaining tax relief). Whilst the current year’s profitperformance is an obvious improvement, it should be noted that next year’s cash flows are likely to suffer a tax payment(estimated at $150,000 in current liabilities at 31 March 2008) as a consequence. In any forward planning, Pinto shouldbe aware that the tax reversal position will create an estimated total incremental outflow of $210,000 in the next period.

Investing activities:There has been a dramatic investment/increase in property, plant and equipment. The carrying value at 31 March 2008 issubstantially higher than a year earlier (admittedly $100,000 is due to revaluation rather than a purchase). It is difficult tobe sure whether this represents an increase in operating capacity or is the replacement of the plant disposed of. (The voluntarydisclosure encouraged by IAS 7 Statement of cash flows would help to assess this issue more accurately). However, judgingby the level of the increase and the (apparent) overall improvement in profit position, it seems likely that there has been asuccessful increase in capacity. It is not unusual for there to be a time lag before increased investment reaches its fullbeneficial effect and in this context it could be speculated that the investment occurred early in the accounting year (becauseits effect is already making an impact) and that future periods may show even greater improvements.

The investment property is showing a good return which is composed of rental income (presumably) of $40,000 and avaluation gain of $20,000.

Financing activities:It would appear that Pinto’s financial structure has changed during the year. Debt of $400,000 has been redeemed (for$420,000) and there has been a share issue raising $1 million. The company is now nil geared compared to modest gearingat the end of the previous year. The share issue has covered the cost of redemption and contributed to the investment inproperty, plant and equipment. The remainder of the finance for the property, plant and equipment has come from the veryhealthy operating cash flows. If ROCE is higher than the finance cost of the loan note at 6% (nominal) it may call into questionthe wisdom of the early redemption especially given the penalty cost (which has been classified within financing activities)of the redemption.

Cash position:The overall effect of the year’s cash flows is that they have improved the company’s cash position dramatically. A sizeableoverdraft of $120,000, which may have been a consequence of the (likely) losses in the previous year, has been reversed toa modest bank balance of $10,000 even after the payment of a $150,000 dividend.

SummaryThe above analysis indicates that Pinto has invested substantially in renewing and/or increasing its property, plant andequipment. This has been financed largely by operating cash flows, and appears to have brought a dramatic turnaround inthe company’s fortunes. All the indications are that the future financial position and performance will continue to improve.

4 (a) The accruals basis requires transactions (or events) to be recognised when they occur (rather than on a cash flow basis).Revenue is recognised when it is earned (rather than when it is received) and expenses are recognised when they are incurred(i.e. when the entity has received the benefit from them), rather than when they are paid.

Recording the substance of transactions (and other events) requires them to be treated in accordance with economic realityor their commercial intent rather than in accordance with the way they may be legally constructed. This is an importantelement of faithful representation.

Prudence is used where there are elements of uncertainty surrounding transactions or events. Prudence requires the exerciseof a degree of caution when making judgements or estimates under conditions of uncertainty. Thus when estimating theexpected life of a newly acquired asset, if we have past experience of the use of similar assets and they had had lives of (say)between five and eight years, it would be prudent to use an estimated life of five years for the new asset.

Comparability is fundamental to assessing the performance of an entity by using its financial statements. Assessing theperformance of an entity over time (trend analysis) requires that the financial statements used have been prepared on acomparable (consistent) basis. Generally this can be interpreted as using consistent accounting policies (unless a change isrequired to show a fairer presentation). A similar principle is relevant to comparing one entity with another; however it is moredifficult to achieve consistent accounting policies across entities.

Information is material if its omission or misstatement could influence (economic) decisions of users based on the reportedfinancial statements. Clearly an important aspect of materiality is the (monetary) size of a transaction, but in addition thenature of the item can also determine that it is material. For example the monetary results of a new activity may be small,but reporting them could be material to any assessment of what it may achieve in the future. Materiality is considered to bea threshold quality, meaning that information should only be reported if it is considered material. Too much detailed (andimplicitly immaterial) reporting of (small) items may confuse or distract users.

15



(b) Accounting for inventory, by adjusting purchases for opening and closing inventories is a classic example of the applicationof the accruals principle whereby revenues earned are matched with costs incurred. Closing inventory is by definition anexample of goods that have been purchased, but not yet consumed. In other words the entity has not yet had the ‘benefit’(i.e. the sales revenue they will generate) from the closing inventory; therefore the cost of the closing inventory should not becharged to the current year’s income statement.

Consignment inventory is where goods are supplied (usually by a manufacturer) to a retailer under terms which mean thelegal title to the goods remains with the supplier until a specified event (say payment in three months time). Once the goodshave been transferred to the retailer, normally the risks and rewards relating to those goods then lie with the retailer. Wherethis is the case then (in substance) the consignment inventory meets the definition of an asset and the goods should appearas such (inventory) on the retailer’s statement of financial position (along with the associated liability to pay for them) ratherthan on the statement of financial position of the manufacturer.

At the year end, the value of an entity’s closing inventory is, by its nature, uncertain. In the next accounting period it may besold at a profit or a loss. Accounting standards require inventory to be valued at the lower of cost and net realisable value.This is the application of prudence. If the inventory is expected to sell at a profit, the profit is deferred (by valuing inventoryat cost) until it is actually sold. However, if the goods are expected to sell for a (net) loss, then that loss must be recognisedimmediately by valuing the inventory at its net realisable value.

There are many acceptable ways of valuing inventory (e.g. average cost or FIFO). In order to meet the requirement ofcomparability, an entity should decide on the most appropriate valuation method for its inventory and then be consistent inthe use of that method. Any change in the method of valuing (or accounting for) inventory would break the principle ofcomparability.

For most businesses inventories are a material item. An error (omission or misstatement) in the value or treatment of inventoryhas the potential to affect decisions users may make in relation to financial statements. Therefore (correctly) accounting forinventory is a material event. Conversely there are occasions where on the grounds of immateriality certain ‘inventories’ arenot (strictly) accounted for correctly. For example, at the year end a company may have an unused supply of stationery.Technically this is inventory, but in most cases companies would charge this ‘inventory’ of stationery to the income statementof the year in which it was purchased rather than show it as an asset.

Note: other suitable examples would be acceptable.

5 Accounting correctly for the convertible loan note in accordance with IAS 32 Financial Instruments: Presentation and IAS 39Financial Instruments: Recognition and Measurement would mean that virtually all the financial assistant’s observations areincorrect. The convertible loan note is a compound financial instrument containing a (largely) debt component and an equitycomponent – the value of the option to receive equity shares. These components must be calculated using the residual equitymethod and appropriately classified (as debt and equity) on the statement of financial position. As some of the proceeds of theinstrument will be equity, the gearing will not be quite as high as if a non-convertible loan was issued, but gearing will be increased.However, if the loan note is converted to equity in March 2010, gearing will be reduced. The interest rate that would be applicableto a non-convertible loan (8%) is representative of the true finance cost and should be applied to the carrying amount of the debtto calculate the finance cost to be charged to the income statement thus giving a much higher charge than the assistant believes.

Accounting treatment: financial statements year ended 31 March 2008

Income statement:Finance costs (see working) $693,920

Statement of financial position:Non-current liabilities3% convertible loan note (8,674 + 393·92) $9,067,920

EquityOption to convert $1,326,000

Working (figures in brackets in $’000)cash flows factor at 8% present value $’000

year 1 interest 300 0·93 279year 2 interest 300 0·86 258year 3 interest and capital 10,300 0·79 8,137

–––––––total value of debt component 8,674proceeds of the issue 10,000

–––––––equity component (residual amount) 1,326

–––––––

The interest cost in the income statement should be $693,920 (8,674 x 8%), requiring an accrual of $393,920 (693·92 – 300i.e. 10,000 x 3%). This accrual should be added to the carrying value of the debt.

16



Fundamentals Level – Skills Module, Paper F7 (INT)Financial Reporting (International) June 2008 Marking Scheme


Marks1 (a) Goodwill of Sardonic:

consideration 2net assets acquired calculated as:equity shares 1pre acquisition reserves 2fair value adjustments 1

6

(b) Income statement:revenue 2cost of sales 5distribution costs and administrative expenses 1finance costs 2impairment of goodwill 1share of associate’s profit 1income tax 1minority interest 2

15

(c) 1 mark per relevant point to 4Total for question 25

2 (a) Adjustments:add back dividends 1balance of fraud loss 1goods on sale or return 1depreciation charges 2investment gain 1taxation provision 1deferred tax 1

8

(b) Statement of changes in equitybalances b/f 1restated earnings b/f 1rights issue 2total comprehensive income 3dividends paid 1

8

(c) Statement of financial positionproperty 1plant 1investment 1inventory 1trade receivables 2equity from (b) 1deferred tax 1current liabilities 1


17



Marks3 (a) operating activities

profit before tax 1/2depreciation/loss on sale 1warranty adjustment 1/2adjustments for investment income/finance costs 1/2adjustment for redemption penalty 1working capital items 11/2finance costs 1income tax received 2investing activities (including 1 for investment income) 3financing activitiesissue of equity shares 1redemption of 6% loan note 1dividend paid 1cash and cash equivalents b/f and c/f 1

15

(b) 1 mark per relevant point 10Total for question 25

4 (a) explanations 1 mark each 5

(b) examples 2 marks each 10Total for question 15

5 1 mark per valid comment up to 4use of 8% 1initial carrying amount of debt and equity 2finance cost 2carrying amount of debt at 31 March 2008 1

Total for question 10

18









Pape

r F7

(IN

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Tuesday 9 December 2008





1 On 1 April 2008, Pedantic acquired 60% of the equity share capital of Sophistic in a share exchange of two sharesin Pedantic for three shares in Sophistic. The issue of shares has not yet been recorded by Pedantic. At the date ofacquisition shares in Pedantic had a market value of $6 each. Below are the summarised draft financial statementsof both companies.

Income statements for the year ended 30 September 2008Pedantic Sophistic$’000 $’000


–––––––– ––––––––Gross profit 22,000 10,000Distribution costs (2,000) (2,000)Administrative expenses (6,000) (3,200)Finance costs (300) (400)

–––––––– ––––––––Profit before tax 13,700 4,400Income tax expense (4,700) (1,400)

–––––––– ––––––––Profit for the year 9,000 3,000

–––––––– ––––––––

Statements of financial position as at 30 September 2008AssetsNon-current assetsProperty, plant and equipment 40,600 12,600

Current assets 16,000 6,600–––––––– ––––––––

Total assets 56,600 19,200–––––––– ––––––––

Equity and liabilitiesEquity shares of $1 each 10,000 4,000Retained earnings 35,400 6,500

–––––––– ––––––––45,400 10,500

Non-current liabilities10% loan notes 3,000 4,000

Current liabilities 8,200 4,700–––––––– ––––––––

Total equity and liabilities 56,600 19,200–––––––– ––––––––


(i) At the date of acquisition, the fair values of Sophistic’s assets were equal to their carrying amounts with theexception of an item of plant, which had a fair value of $2 million in excess of its carrying amount. It had aremaining life of five years at that date [straight-line depreciation is used]. Sophistic has not adjusted the carryingamount of its plant as a result of the fair value exercise.

(ii) Sales from Sophistic to Pedantic in the post acquisition period were $8 million. Sophistic made a mark up oncost of 40% on these sales. Pedantic had sold $5·2 million (at cost to Pedantic) of these goods by 30 September2008.

(iii) Other than where indicated, income statement items are deemed to accrue evenly on a time basis.

(iv) Sophistic’s trade receivables at 30 September 2008 include $600,000 due from Pedantic which did not agreewith Pedantic’s corresponding trade payable. This was due to cash in transit of $200,000 from Pedantic toSophistic. Both companies have positive bank balances.

(v) Pedantic has a policy of accounting for any non-controlling interest at fair value. For this purpose the fair valueof the goodwill attributable to the non-controlling interest in Sophistic is $1·5 million. Consolidated goodwill wasnot impaired at 30 September 2008.

2



Required:

(a) Prepare the consolidated income statement for Pedantic for the year ended 30 September 2008. (9 marks)

(b) Prepare the consolidated statement of financial position for Pedantic as at 30 September 2008. (16 marks)

Note: a statement of changes in equity is not required.

(25 marks)

3 [P.T.O.



2 The following trial balance relates to Candel at 30 September 2008:

$’000 $’000Leasehold property – at valuation 1 October 2007 (note (i)) 50,000Plant and equipment – at cost (note (i)) 76,600Plant and equipment – accumulated depreciation at 1 October 2007 24,600Capitalised development expenditure – at 1 October 2007 (note (ii)) 20,000Development expenditure – accumulated amortisation at 1 October 2007 6,000Closing inventory at 30 September 2008 20,000Trade receivables 43,100Bank 1,300Trade payables and provisions (note (iii)) 23,800Revenue (note (i)) 300,000Cost of sales 204,000Distribution costs 14,500Administrative expenses (note (iii)) 22,200Preference dividend paid 800Interest on bank borrowings 200Equity dividend paid 6,000Research and development costs (note (ii)) 8,600Equity shares of 25 cents each 50,0008% redeemable preference shares of $1 each (note (iv)) 20,000Retained earnings at 1 October 2007 24,500Deferred tax (note (v)) 5,800Leasehold property revaluation reserve 10,000

–––––––– ––––––––466,000 466,000–––––––– ––––––––


(i) Non-current assets – tangible:The leasehold property had a remaining life of 20 years at 1 October 2007. The company’s policy is to revalueits property at each year end and at 30 September 2008 it was valued at $43 million. Ignore deferred tax onthe revaluation.

On 1 October 2007 an item of plant was disposed of for $2·5 million cash. The proceeds have been treated assales revenue by Candel. The plant is still included in the above trial balance figures at its cost of $8 million andaccumulated depreciation of $4 million (to the date of disposal).

All plant is depreciated at 20% per annum using the reducing balance method.

Depreciation and amortisation of all non-current assets is charged to cost of sales.

(ii) Non-current assets – intangible:In addition to the capitalised development expenditure (of $20 million), further research and development costswere incurred on a new project which commenced on 1 October 2007. The research stage of the new projectlasted until 31 December 2007 and incurred $1·4 million of costs. From that date the project incurreddevelopment costs of $800,000 per month. On 1 April 2008 the directors became confident that the projectwould be successful and yield a profit well in excess of its costs. The project is still in development at 30 September 2008.

Capitalised development expenditure is amortised at 20% per annum using the straight-line method. Allexpensed research and development is charged to cost of sales.

(iii) Candel is being sued by a customer for $2 million for breach of contract over a cancelled order. Candel hasobtained legal opinion that there is a 20% chance that Candel will lose the case. Accordingly Candel has provided$400,000 ($2 million x 20%) included in administrative expenses in respect of the claim. The unrecoverablelegal costs of defending the action are estimated at $100,000. These have not been provided for as the legalaction will not go to court until next year.

4



(iv) The preference shares were issued on 1 April 2008 at par. They are redeemable at a large premium which givesthem an effective finance cost of 12% per annum.

(v) The directors have estimated the provision for income tax for the year ended 30 September 2008 at $11·4 million. The required deferred tax provision at 30 September 2008 is $6 million.

Required:

(a) Prepare the statement of comprehensive income for the year ended 30 September 2008. (12 marks)

(b) Prepare the statement of changes in equity for the year ended 30 September 2008. (3 marks)

(c) Prepare the statement of financial position as at 30 September 2008. (10 marks)

Note: notes to the financial statements are not required.

(25 marks)

5 [P.T.O.



3 Victular is a public company that would like to acquire (100% of) a suitable private company. It has obtained thefollowing draft financial statements for two companies, Grappa and Merlot. They operate in the same industry andtheir managements have indicated that they would be receptive to a takeover.

Income statements for the year ended 30 September 2008Grappa Merlot

$’000 $’000 $’000 $’000Revenue 12,000 20,500Cost of sales (10,500) (18,000)

–––––––– ––––––––Gross profit 1,500 2,500Operating expenses (240) (500)Finance costs – loan (210) (300)

– overdraft nil (10)– lease nil (290)

–––––––– ––––––––Profit before tax 1,050 1,400Income tax expense (150) (400)

–––––––– ––––––––Profit for the year 900 1,000

–––––––– ––––––––Note: dividends paid during the year 250 700

–––––––– ––––––––

Statements of financial position as at 30 September 2008AssetsNon-current assetsFreehold factory (note (i)) 4,400 nilOwned plant (note (ii)) 5,000 2,200Leased plant (note (ii)) nil 5,300

–––––––– ––––––––9,400 7,500

Current assetsInventory 2,000 3,600Trade receivables 2,400 3,700Bank 600 5,000 nil 7,300

–––––––– –––––––– –––––––– ––––––––Total assets 14,400 14,800

–––––––– ––––––––

Equity and liabilitiesEquity shares of $1 each 2,000 2,000Property revaluation reserve 900 nilRetained earnings 2,600 3,500 800 800

–––––––– –––––––– –––––––– ––––––––5,500 2,800

Non-current liabilitiesFinance lease obligations (note (iii)) nil 3,2007% loan notes 3,000 nil10% loan notes nil 3,000Deferred tax 600 100Government grants 1,200 4,800 nil 6,300

–––––––– ––––––––

Current liabilitiesBank overdraft nil 1,200Trade payables 3,100 3,800Government grants 400 nilFinance lease obligations (note (iii)) nil 500Taxation 600 4,100 200 5,700

–––––––– –––––––– –––––––– ––––––––Total equity and liabilities 14,400 14,800

–––––––– ––––––––

6



Notes(i) Both companies operate from similar premises.

(ii) Additional details of the two companies’ plant are:Grappa Merlot$’000 $’000

Owned plant – cost 8,000 10,000Leased plant – original fair value nil 7,500

There were no disposals of plant during the year by either company.

(iii) The interest rate implicit within Merlot’s finance leases is 7·5% per annum. For the purpose of calculating ROCEand gearing, all finance lease obligations are treated as long-term interest bearing borrowings.

(iv) The following ratios have been calculated for Grappa and can be taken to be correct:

Return on year end capital employed (ROCE) 14·8%(capital employed taken as shareholders’ funds plus long-term interest bearing borrowings – see note (iii) above)Pre-tax return on equity (ROE) 19·1%Net asset (total assets less current liabilities) turnover 1·2 timesGross profit margin 12·5%Operating profit margin 10·5%Current ratio 1·2:1Closing inventory holding period 70 daysTrade receivables’ collection period 73 daysTrade payables’ payment period (using cost of sales) 108 daysGearing (see note (iii) above) 35·3%Interest cover 6 timesDividend cover 3·6 times

Required:

(a) Calculate for Merlot the ratios equivalent to all those given for Grappa above. (8 marks)

(b) Assess the relative performance and financial position of Grappa and Merlot for the year ended 30 September2008 to inform the directors of Victular in their acquisition decision. (12 marks)

(c) Explain the limitations of ratio analysis and any further information that may be useful to the directors ofVictular when making an acquisition decision. (5 marks)

(25 marks)

7 [P.T.O.



4 (a) The definition of a liability forms an important element of the International Accounting Standards Board’sFramework for the Preparation and Presentation of Financial Statements which, in turn, forms the basis for IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Required:

Define a liability and describe the circumstances under which provisions should be recognised. Give twoexamples of how the definition of liabilities enhances the reliability of financial statements. (5 marks)

(b) On 1 October 2007, Promoil acquired a newly constructed oil platform at a cost of $30 million together with theright to extract oil from an offshore oilfield under a government licence. The terms of the licence are that Promoilwill have to remove the platform (which will then have no value) and restore the sea bed to an environmentallysatisfactory condition in 10 years’ time when the oil reserves have been exhausted. The estimated cost of thison 30 September 2017 will be $15 million. The present value of $1 receivable in 10 years at the appropriatediscount rate for Promoil of 8% is $0·46.

Required:

(i) Explain and quantify how the oil platform should be treated in the financial statements of Promoil forthe year ended 30 September 2008; (7 marks)

(ii) Describe how your answer to (b)(i) would change if the government licence did not require anenvironmental clean up. (3 marks)

(15 marks)

5 On 1 October 2005 Dearing acquired a machine under the following terms:

Hours $Manufacturer’s base price 1,050,000Trade discount (applying to base price only) 20%Early settlement discount taken (on the payable amount of the base cost only) 5%Freight charges 30,000Electrical installation cost 28,000Staff training in use of machine 40,000Pre-production testing 22,000Purchase of a three-year maintenance contract 60,000Estimated residual value 20,000Estimated life in machine hours 6,000Hours used – year ended 30 September 2006 1,200

– year ended 30 September 2007 1,800– year ended 30 September 2008 (see below) 850

On 1 October 2007 Dearing decided to upgrade the machine by adding new components at a cost of $200,000.This upgrade led to a reduction in the production time per unit of the goods being manufactured using the machine.The upgrade also increased the estimated remaining life of the machine at 1 October 2007 to 4,500 machine hoursand its estimated residual value was revised to $40,000.

Required:

Prepare extracts from the income statement and statement of financial position for the above machine for eachof the three years to 30 September 2008.

(10 marks)


8



Answers



Fundamentals Level – Skills Module, Paper F7 (INT)Financial Reporting (International) December 2008 Answers

1 (a) Pedantic Consolidated income statement for the year ended 30 September 2008

$’000Revenue (85,000 + (42,000 x 6/12) – 8,000 intra-group sales) 98,000Cost of sales (w (i)) (72,000)

–––––––Gross profit 26,000Distribution costs (2,000 + (2,000 x 6/12)) (3,000)Administrative expenses (6,000 + (3,200 x 6/12)) (7,600)Finance costs (300 + (400 x 6/12)) (500)

–––––––Profit before tax 14,900Income tax expense (4,700 + (1,400 x 6/12)) (5,400)

–––––––Profit for the year 9,500

–––––––

Attributable to:Equity holders of the parent 9,300Non-controlling interest (((3,000 x 6/12) – (800 URP + 200 depreciation)) x 40%) 200

–––––––9,500

–––––––

(b) Consolidated statement of financial position as at 30 September 2008

AssetsNon-current assetsProperty, plant and equipment (40,600 + 12,600 + 2,000 – 200 depreciation adjustment (w (i))) 55,000Goodwill (w (ii)) 4,500

–––––––59,500

Current assets (w (iii)) 21,400–––––––

Total assets 80,900–––––––

Equity and liabilitiesEquity attributable to owners of the parentEquity shares of $1 each ((10, 000 + 1,600) w (ii)) 11,600Share premium (w (ii)) 8,000Retained earnings (w (iv)) 35,700

–––––––55,300

Non-controlling interest (w (v)) 6,100–––––––

Total equity 61,400Non-current liabilities10% loan notes (4,000 + 3,000) 7,000

Current liabilities (8,200 + 4,700 – 400 intra-group balance) 12,500–––––––


Workings (figures in brackets in $’000)(i) Cost of sales $’000

Pedantic 63,000Sophistic (32,000 x 6/12) 16,000Intra-group sales (8,000)URP in inventory 800Additional depreciation (2,000/5 years x 6/12) 200

–––––––72,000–––––––

The unrealised profit (URP) in inventory is calculated as ($8 million – $5·2 million) x 40/140 = $800,000.

11



(ii) Goodwill in SophisticInvestment at cost $’000 $’000Shares (4,000 x 60% x 2/3 x $6) 9,600Less – Equity shares of Sophistic (4,000 x 60%) (2,400)

– pre-acquisition reserves (5,000 x 60% see below) (3,000)– fair value adjustment (2,000 x 60%) (1,200) (6,600)

–––––– ––––––Parent’s goodwill 3,000Non-controlling interest’s goodwill (per question) 1,500

––––––Total goodwill 4,500

––––––

The pre-acquisition reserves are:At 30 September 2008 6,500Earned in the post acquisition period (3,000 x 6/12) (1,500)

––––––5,000

––––––

Alternative calculation for goodwill in SophisticInvestment at cost (as above) 9,600Fair value of non-controlling interest (see below) 5,900

–––––––Cost of the controlling interest 15,500Less fair value of net assets at acquisition (4,000 + 5,000 + 2,000) (11,000)

–––––––Total goodwill 4,500

–––––––

Fair value of non-controlling interest (at acquisition)Share of fair value of net assets (11,000 x 40%) 4,400Attributable goodwill per question 1,500

––––––5,900

––––––

The 1·6 million shares (4,000 x 60% x 2/3) issued by Pedantic would be recorded as share capital of $1·6 million andshare premium of $8 million (1,600 x $5).

(iii) Current assets $’000 $’000Pedantic 16,000Sophistic 6,600URP in inventory (800)Cash in transit 200Intra-group balance (600)

–––––––21,400–––––––

(iv) Retained earningsPedantic per statement of financial position 35,400Sophistic’s post acquisition profit (((3,000 x 6/12) – (800 URP + 200 depreciation)) x 60%) 300

–––––––35,700–––––––

(v) Non-controlling interest (in statement of financial position)Net assets per statement of financial position 10,500URP in inventory (800)Net fair value adjustment (2,000 – 200) 1,800

–––––––11,500 x 40% = 4,600–––––––

Share of goodwill (per question) 1,500––––––6,100

––––––

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2 (a) Candel – Statement of comprehensive income for the year ended 30 September 2008

$’000Revenue (300,000 – 2,500) 297,500Cost of sales (w (i)) (225,400)

–––––––––Gross profit 72,100Distribution costs (14,500)Administrative expenses (22,200 – 400 + 100 see note below) (21,900)Finance costs (200 + 1,200 (w (ii))) (1,400)

–––––––––Profit before tax 34,300(Income tax expense (11,400 + (6,000 – 5,800 deferred tax)) (11,600)

–––––––––Profit for the year 22,700

Other comprehensive incomeLoss on leasehold property revaluation (w (iii)) (4,500)

–––––––––

Total comprehensive income for the year 18,200–––––––––

Note: as it is considered that the outcome of the legal action against Candel is unlikely to succeed (only a 20% chance) it isinappropriate to provide for any damages. The potential damages are an example of a contingent liability which should bedisclosed (at $2 million) as a note to the financial statements. The unrecoverable legal costs are a liability (the start of thelegal action is a past event) and should be provided for in full.

(b) Candel – Statement of changes in equity for the year ended 30 September 2008

Equity Revaluation Retained Totalshares reserve earnings equity$’000 $’000 $’000 $’000

Balances at 1 October 2007 50,000 10,000 24,500 84,500Dividend (6,000) (6,000)Comprehensive income (4,500) 22,700 18,200

––––––– –––––– ––––––– –––––––Balances at 30 September 2008 50,000 5,500 41,200 96,700

––––––– –––––– ––––––– –––––––

(c) Candel – Statement of financial position as at 30 September 2008

Assets $’000 $’000Non-current assets (w (iii))Property, plant and equipment (43,000 + 38,400) 81,400Development costs 14,800

––––––––96,200

Current assetsInventory 20,000Trade receivables 43,100 63,100

––––––– ––––––––Total assets 159,300

––––––––

Equity and liabilities:Equity (from (b))Equity shares of 25 cents each 50,000Revaluation reserve 5,500Retained earnings 41,200 46,700

––––––– ––––––––96,700

Non-current liabilitiesDeferred tax 6,0008% redeemable preference shares (20,000 + 400 (w (ii))) 20,400 26,400

–––––––

Current liabilitiesTrade payables (23,800 – 400 + 100 – re legal action) 23,500Bank overdraft 1,300Current tax payable 11,400 36,200


––––––––

13



Workings (figures in brackets in $’000)(i) Cost of sales: $’000

Per trial balance 204,000Depreciation (w (iii)) – leasehold property 2,500

– plant and equipment 9,600Loss on disposal of plant (4,000 – 2,500) 1,500Amortisation of development costs (w (iii)) 4,000Research and development expensed (1,400 + 2,400 (w (iii))) 3,800

––––––––225,400––––––––

(ii) The finance cost of $1·2 million for the preference shares is based on the effective rate of 12% applied to $20 millionissue proceeds of the shares for the six months they have been in issue (20m x 12% x 6/12). The dividend paid of$800,000 is based on the nominal rate of 8%. The additional $400,000 (accrual) is added to the carrying amount ofthe preference shares in the statement of financial position. As these shares are redeemable they are treated as debt andtheir dividend is treated as a finance cost.

(iii) Non-current assets:Leasehold propertyValuation at 1 October 2007 50,000Depreciation for year (20 year life) (2,500)

––––––––Carrying amount at date of revaluation 47,500Valuation at 30 September 2008 (43,000)

––––––––Revaluation deficit 4,500

––––––––

$’000Plant and equipment per trial balance (76,600 – 24,600) 52,000Disposal (8,000 – 4,000) (4,000)

––––––––48,000

Depreciation for year (20%) (9,600)––––––––

Carrying amount at 30 September 2008 38,400––––––––

Capitalised/deferred development costsCarrying amount at 1 October 2007 (20,000 – 6,000) 14,000Amortised for year (20,000 x 20%) (4,000)Capitalised during year (800 x 6 months) 4,800

––––––––Carrying amount at 30 September 2008 14,800

––––––––

Note: development costs can only be treated as an asset from the point where they meet the recognition criteria in IAS 38 Intangible assets. Thus development costs from 1 April to 30 September 2008 of $4·8 million (800 x 6 months)can be capitalised. These will not be amortised as the project is still in development. The research costs of $1·4 millionplus three months’ development costs of $2·4 million (800 x 3 months) (i.e. those incurred before 1 April 2008) aretreated as an expense.

3 (a) Equivalent ratios from the financial statements of Merlot (workings in $’000)

Return on year end capital employed (ROCE) 20·9% (1,400 + 590)/(2,800 + 3,200 + 500 + 3,000) x 100Pre tax return on equity (ROE) 50% 1,400/2,800 x 100Net asset turnover 2·3 times 20,500/(14,800 – 5,700)Gross profit margin 12·2% 2,500/20,500 x 100Operating profit margin 9·8% 2,000/20,500 x 100Current ratio 1·3:1 7,300/5,700Closing inventory holding period 73 days 3,600/18,000 x 365Trade receivables’ collection period 66 days 3,700/20,500 x 365Trade payables’ payment period 77 days 3,800/18,000 x 365Gearing 71% (3,200 + 500 + 3,000)/9,500 x 100Interest cover 3·3 times 2,000/600Dividend cover 1·4 times 1,000/700

As per the question, Merlot’s obligations under finance leases (3,200 + 500) have been treated as debt when calculatingthe ROCE and gearing ratios.

14



(b) Assessment of the relative performance and financial position of Grappa and Merlot for the year ended 30 September2008

IntroductionThis report is based on the draft financial statements supplied and the ratios shown in (a) above. Although covering manyaspects of performance and financial position, the report has been approached from the point of view of a prospectiveacquisition of the entire equity of one of the two companies.

ProfitabilityThe ROCE of 20·9% of Merlot is far superior to the 14·8% return achieved by Grappa. ROCE is traditionally seen as ameasure of management’s overall efficiency in the use of the finance/assets at its disposal. More detailed analysis reveals thatMerlot’s superior performance is due to its efficiency in the use of its net assets; it achieved a net asset turnover of 2·3 timescompared to only 1·2 times for Grappa. Put another way, Merlot makes sales of $2·30 per $1 invested in net assets comparedto sales of only $1·20 per $1 invested for Grappa. The other element contributing to the ROCE is profit margins. In this areaMerlot’s overall performance is slightly inferior to that of Grappa, gross profit margins are almost identical, but Grappa’soperating profit margin is 10·5% compared to Merlot’s 9·8%. In this situation, where one company’s ROCE is superior toanother’s it is useful to look behind the figures and consider possible reasons for the superiority other than the obvious oneof greater efficiency on Merlot’s part.

A major component of the ROCE is normally the carrying amount of the non-current assets. Consideration of these in thiscase reveals some interesting issues. Merlot does not own its premises whereas Grappa does. Such a situation would notnecessarily give a ROCE advantage to either company as the increase in capital employed of a company owning its factorywould be compensated by a higher return due to not having a rental expense (and vice versa). If Merlot’s rental cost, as apercentage of the value of the related factory, was less than its overall ROCE, then it would be contributing to its higher ROCE.There is insufficient information to determine this. Another relevant point may be that Merlot’s owned plant is nearing the endof its useful life (carrying amount is only 22% of its cost) and the company seems to be replacing owned plant with leasedplant. Again this does not necessarily give Merlot an advantage, but the finance cost of the leased assets at only 7·5% ismuch lower than the overall ROCE (of either company) and therefore this does help to improve Merlot’s ROCE. The otherimportant issue within the composition of the ROCE is the valuation basis of the companies’ non-current assets. From thequestion, it appears that Grappa’s factory is at current value (there is a property revaluation reserve) and note (ii) of thequestion indicates the use of historical cost for plant. The use of current value for the factory (as opposed to historical cost)will be adversely impacting on Grappa’s ROCE. Merlot does not suffer this deterioration as it does not own its factory.

The ROCE measures the overall efficiency of management; however, as Victular is considering buying the equity of one of thetwo companies, it would be useful to consider the return on equity (ROE) – as this is what Victular is buying. The ratioscalculated are based on pre-tax profits; this takes into account finance costs, but does not cause taxation issues to distort thecomparison. Clearly Merlot’s ROE at 50% is far superior to Grappa’s 19·1%. Again the issue of the revaluation of Grappa’sfactory is making this ratio appear comparatively worse (than it would be if there had not been a revaluation). In thesecircumstances it would be more meaningful if the ROE was calculated based on the asking price of each company (whichhas not been disclosed) as this would effectively be the carrying amount of the relevant equity for Victular.

GearingFrom the gearing ratio it can be seen that 71% of Merlot’s assets are financed by borrowings (39% is attributable to Merlot’spolicy of leasing its plant). This is very high in absolute terms and double Grappa’s level of gearing. The effect of gearingmeans that all of the profit after finance costs is attributable to the equity even though (in Merlot’s case) the equity representsonly 29% of the financing of the net assets. Whilst this may seem advantageous to the equity shareholders of Merlot, it doesnot come without risk. The interest cover of Merlot is only 3·3 times whereas that of Grappa is 6 times. Merlot’s low interestcover is a direct consequence of its high gearing and it makes profits vulnerable to relatively small changes in operatingactivity. For example, small reductions in sales, profit margins or small increases in operating expenses could result in lossesand mean that interest charges would not be covered.

Another observation is that Grappa has been able to take advantage of the receipt of government grants; Merlot has not. Thismay be due to Grappa purchasing its plant (which may then be eligible for grants) whereas Merlot leases its plant. It may bethat the lessor has received any grants available on the purchase of the plant and passed some of this benefit on to Merlotvia lower lease finance costs (at 7·5% per annum, this is considerably lower than Merlot has to pay on its 10% loan notes).

LiquidityBoth companies have relatively low liquid ratios of 1·2 and 1·3 for Grappa and Merlot respectively, although at least Grappahas $600,000 in the bank whereas Merlot has a $1·2 million overdraft. In this respect Merlot’s policy of high dividendpayouts (leading to a low dividend cover and low retained earnings) is very questionable. Looking in more depth, bothcompanies have similar inventory days; Merlot collects its receivables one week earlier than Grappa (perhaps its credit controlprocedures are more active due to its large overdraft), and of notable difference is that Grappa receives (or takes) a lot longercredit period from its suppliers (108 days compared to 77 days). This may be a reflection of Grappa being able to negotiatebetter credit terms because it has a higher credit rating.

SummaryAlthough both companies may operate in a similar industry and have similar profits after tax, they would represent verydifferent purchases. Merlot’s sales revenues are over 70% more than those of Grappa, it is financed by high levels of debt, itrents rather than owns property and it chooses to lease rather than buy its replacement plant. Also its remaining owned plantis nearing the end of its life. Its replacement will either require a cash injection if it is to be purchased (Merlot’s overdraft of

15



$1·2 million already requires serious attention) or create even higher levels of gearing if it continues its policy of leasing. Inshort although Merlot’s overall return seems more attractive than that of Grappa, it would represent a much more riskyinvestment. Ultimately the investment decision may be determined by Victular’s attitude to risk, possible synergies with itsexisting business activities, and not least, by the asking price for each investment (which has not been disclosed to us).

(c) The generally recognised potential problems of using ratios for comparison purposes are:

– inconsistent definitions of ratios– financial statements may have been deliberately manipulated (creative accounting)– different companies may adopt different accounting policies (e.g. use of historical costs compared to current values)– different managerial policies (e.g. different companies offer customers different payment terms)– statement of financial position figures may not be representative of average values throughout the year (this can be

caused by seasonal trading or a large acquisition of non-current assets near the year end)– the impact of price changes over time/distortion caused by inflation

When deciding whether to purchase a company, Victular should consider the following additional useful information:

– in this case the analysis has been made on the draft financial statements; these may be unreliable or change when beingfinalised. Audited financial statements would add credibility and reliance to the analysis (assuming they receive anunmodified Auditors’ Report).

– forward looking information such as profit and financial position forecasts, capital expenditure and cash budgets and thelevel of orders on the books.

– the current (fair) values of assets being acquired.– the level of risk within a business. Highly profitable companies may also be highly risky, whereas a less profitable

company may have more stable ‘quality’ earnings– not least would be the expected price to acquire a company. It may be that a poorer performing business may be a more

attractive purchase because it is relatively cheaper and may offer more opportunity for improving efficiencies and profitgrowth.

4 (a) A liability is a present obligation of an entity arising from past events, the settlement of which is expected to result in anoutflow of economic benefits (normally cash). Provisions are defined as liabilities of uncertain timing or amount, i.e. they arenormally estimates. In essence provisions should be recognised if they meet the definition of a liability. Equally they shouldnot be recognised if they do not meet the definition. A statement of financial position would not give a ‘fair representation’ ifit did not include all of an entity’s liabilities (or if it did include, as liabilities, items that were not liabilities). These definitionsbenefit the reliability of financial statements by preventing profits from being ‘smoothed’ by making a provision to reduce profitin years when they are high and releasing those provisions to increase profit in years when they are low. It also means thatthe statement of financial position cannot avoid the immediate recognition of long-term liabilities (such as environmentalprovisions) on the basis that those liabilities have not matured.

(b) (i) Future costs associated with the acquisition/construction and use of non-current assets, such as the environmental costsin this case, should be treated as a liability as soon as they become unavoidable. For Promoil this would be at the sametime as the platform is acquired and brought into use. The provision is for the present value of the expected costs andthis same amount is treated as part of the cost of the asset. The provision is ‘unwound’ by charging a finance cost tothe income statement each year and increasing the provision by the finance cost. Annual depreciation of the asseteffectively allocates the (discounted) environmental costs over the life of the asset.

Income statement for the year ended 30 September 2008 $’000Depreciation (see below) 3,690Finance costs ($6·9 million x 8%) 552

Statement of financial position as at 30 September 2008Non-current assetsCost ($30 million + $6·9 million ($15 million x 0·46)) 36,900Depreciation (over 10 years) (3,690)

–––––––33,210–––––––

Non-current liabilitiesEnvironmental provision ($6·9 million x 1·08) 7,452

(ii) If there was no legal requirement to incur the environmental costs, then Promoil should not provide for them as they donot meet the definition of a liability. Thus the oil platform would be recorded at $30 million with $3 million depreciationand there would be no finance costs.

However, if Promoil has a published policy that it will voluntarily incur environmental clean up costs of this type (or ifthis may be implied by its past practice), then this would be evidence of a ‘constructive’ obligation under IAS 37 andthe required treatment of the costs would be the same as in part (i) above.

16



5 Year ended/as at: 30 September 2006 30 September 2007 30 September 2008Income statement $ $ $Depreciation (see workings) 180,000 270,000 119,000Maintenance (60,000/3 years) 20,000 20,000 20,000Discount received (840,000 x 5%) (42,000)Staff training 40,000

–––––––– –––––––– ––––––––198,000 290,000 139,000–––––––– –––––––– ––––––––

Statement of financial position (see below)Property, plant and equipmentCost 920,000 920,000 670,000Accumulated depreciation (180,000) (450,000) (119,000)

–––––––– –––––––– ––––––––Carrying amount 740,000 470,000 551,000

–––––––– –––––––– ––––––––

Workings $Manufacturer’s base price 1,050,000Less trade discount (20%) (210,000)

––––––––––Base cost 840,000Freight charges 30,000Electrical installation cost 28,000Pre-production testing 22,000

––––––––––Initial capitalised cost 920,000

––––––––––

The depreciable amount is $900,000 (920,000 – 20,000 residual value) and, based on an estimated machine life of 6,000hours, this gives depreciation of $150 per machine hour. Therefore depreciation for the year ended 30 September 2006 is$180,000 ($150 x 1,200 hours) and for the year ended 30 September 2007 is $270,000 ($150 x 1,800 hours).

Note: early settlement discount, staff training in use of machine and maintenance are all revenue items and cannot be part ofcapitalised costs.

Carrying amount at 1 October 2007 470,000Subsequent expenditure 200,000

––––––––Revised ‘cost’ 670,000

––––––––

The revised depreciable amount is $630,000 (670,000 – 40,000 residual value) and with a revised remaining life of 4,500hours, this gives a depreciation charge of $140 per machine hour. Therefore depreciation for the year ended 30 September 2008 is $119,000 ($140 x 850 hours).

17



Fundamentals Level – Skills Module, Paper F7 (INT)Financial Reporting (International) December 2008 Marking Scheme


Marks1 (a) Income statement:

revenue 11/2cost of sales 3distribution costs 1/2administrative expenses 1finance costs 1/2income tax 1/2non-controlling interest 2

9

(b) Statement of financial position:property, plant and equipment 2goodwill 5current assets 11/2equity shares 1share premium 1retained earnings 2non-controlling interest 210% loan notes 1/2current liabilities 1


2 (a) Statement of comprehensive income:revenue 1cost of sales 5distribution costs 1/2administrative expenses 11/2finance costs 11/2income tax 11/2other comprehensive income 1

12

(b) Statement of changes in equity:brought forward figures 1dividends 1comprehensive income 1

3

(c) Statement of financial position:property, plant and equipment 2deferred development costs 2inventory 1/2trade receivables 1/2deferred tax 1preference shares 1trade payables 11/2overdraft 1/2current tax payable 1


19



Marks3 (a) Merlot’s ratios 8

(b) 1 mark per valid comment up to 12

(c) 1 mark per relevant point 5Total for question 25

4 (a) 1 mark per relevant point 5

(b) (i) explanation of treatment 2depreciation 1finance cost 1non-current asset 2provision 1

7

(ii) figures for asset and depreciation if not a constructive obligation 1what may cause a constructive obligation 1subsequent treatment if it is a constructive obligation 1


5 initial capitalised cost 2upgrade improves efficiency and life (therefore capitalise) 1revised carrying amount at 1 October 2007 1annual depreciation (1 mark each year) 3maintenance costs charged at $20,000 each year 1discount received (in income statement) 1staff training (not capitalised and charged to income) 1

Total for question 10

20

