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FINANCIAL ACCOUNTING NOVEMBER 2008

SUGGESTED ANSWERS AND EXAMINER’S COMMENTS

IMPORTANT NOTICE When reading these answers, please note that they are not intended to be viewed as a definitive “model” answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from candidates in the examination. EXAMINER’S GENERAL COMMENTS

The level of performance on this occasion showed a significant improvement compared with the June 2008 examination, with a good number of candidates achieving very high marks. The best-answered Questions were 1, 2 and 5. Nevertheless, there was evidence on the part of some candidates of a failure to read the requirements with sufficient care. For example, in answer to Question 3(d), candidates often simply described the difference between an operating and a finance lease instead of responding to the requirement to explain how the lease should be accounted for in order to comply with standard accounting practice.

SECTION A (Compulsory – answer all parts of this question)

1. (a) A company has an obsolete machine which a South American company

is willing to buy at a scrap value of £5,000. It will cost the company £6,000 to transport the machine to South America.

Is the machine an asset as defined by international accounting standards? Explain your conclusion. (4 marks)

SUGGESTED ANSWER The machine fails to meet the definition of an asset as it is not expected to generate future economic benefits for the enterprise based on the information provided. The machine‟s net realisable value is a negative figure of £1,000. Indeed, if the company decides to pursue the course described, it should recognise a liability of £1,000 in the accounts.

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EXAMINER’S COMMENTS Most candidates were familiar with the definition of an asset, but far fewer were able to follow through the logic of the definition and recognise the fact that the arrangement, if proceeded with, would give rise to a liability.

(b) An analyst is comparing the non-current asset turnover ratios of two

listed organisations engaged in similar activities. The non-current asset turnover ratio of one entity is almost 50% higher than that of the other.

REQUIRED Identify, and briefly discuss, two possible reasons for the difference. (4 marks)

SUGGESTED ANSWER Two possible reasons are: The entity with the lower asset turnover may have a policy of revaluing its non-current assets. Where revalued amounts are higher than carrying value, the non-current asset turnover ratio is, relatively, lower. The non-current assets of the entity with the higher non-current asset turnover ratio may be, on average, older than those of the other entity. This would result in lower carrying values, and therefore the ratio would be higher.

EXAMINER’S COMMENTS This question was, in the main, answered quite well.

(c) What are the implications of a decision to revalue freehold properties

upwards on the financial information reported in both the current accounting period, and future accounting periods. (4 marks)

SUGGESTED ANSWER The upward revaluation of freehold properties increases reported assets and shareholders‟ equity through the inclusion of a revaluation reserve. The result is a stronger balance sheet and a lower gearing ratio. The resultant higher carrying value for freehold properties will produce higher depreciation charges and lower reported profits in future years. As a consequence of this, companies that revalue fixed assets will report lower profits than those companies which do not revalue.

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EXAMINER’S COMMENTS Again, candidates demonstrated familiarity with the issues involved, in particular the effect of revaluation on the depreciation charge and reported profit in future accounting periods.

(d) During the year to 31 December 2008 Brodick plc entered into the

following two transactions:

(i) Having surplus cash available, Brodick made an investment in the securities of a listed entity in November 2008. The directors intend to realise the investment in February 2009 in order to fund the planned expansion of Brodick’s business.

(ii) Brodick lent one of its customers, Corrie Ltd, £3,000,000 at a

variable interest rate pegged to average bank lending rates. The loan is scheduled for repayment in 2012, and Brodick has promised Corrie that it will not assign the loan to a third party.

REQUIRED Identify the appropriate classification of the two categories of financial asset detailed above. State how each financial asset should be valued in the financial statements of Brodick plc at 31 December 2008. (4 marks)

SUGGESTED ANSWER In accordance with the provisions of IAS 39, entitled Financial Instruments: Recognition and Measurement: Item (i): Is an asset „held-for-trading‟, and should be measured at fair value. Item (ii) Is an asset „held-to-maturity‟, and should be measured at amortised cost.

EXAMINER’S COMMENTS Some very good answers were produced, but most candidates were unfamiliar with the relevant provisions of IAS 39 and, without success, attempted to guess what a correct answer should contain.

(e) Explain what you understand by the term ‘creative accounting’. (4 marks)

SUGGESTED ANSWER Creative accounting may be defined as:

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The process of structuring a transaction in such a way that, if reported in accordance with its legal form, the apparent position differs from the underlying economic reality.

The process of manipulating accounting figures so as to exploit the choices available, within the existing accounting regulations and generally accepted accounting procedures, in relation to measurement and disclosure practices. For example, the choices available concerning depreciation methods and techniques of inventories valuation.

In each case, the aim is to transform the financial statements from what they should contain into what suppliers of such information would prefer to see reported.

EXAMINER’S COMMENTS Most candidates were familiar with the nature of creative accounting and produced interesting and relevant answers although, sometimes, constructed in quite different ways.

(f) The following information is provided for a single piece of freehold

land belonging to Whitchurch plc that has been the subject of revaluation in the past.

£ million

Carrying amount at 30 September 2008 400

A further revaluation exercise carried out by professional valuers on 30 September 2008 shows the land to now be worth £500 million. You discover that, at the time of the earlier revaluation, the land had been written down by £40 million. REQUIRED Demonstrate how the recent revaluation would be reflected in the balance sheet and income statement of Whitchurch for the year to 30 September 2008. (4 marks)

SUGGESTED ANSWER Reported as follows in the Balance Sheet:

£m.

Carrying amount at 30 September 2008

400

Revalued amount (new carrying amount) 500 Upward revaluation to revaluation reserve 100

Reported as follows in Income Statement:

Credited to income statement (to reverse earlier downward revaluation) 40 Credited to revaluation reserve 60

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EXAMINER’S COMMENTS Most candidates realised that the revaluation would increase the carrying value of the freehold land and give rise to a revaluation surplus of £100 million. However, far fewer understood the need to distinguish between the amounts to be credited back to the income statement and credited to the revaluation surplus in the balance sheet.

(g) You are the Company Secretary of Tudhoe plc, a multi-national

company which makes up its accounts on the calendar year basis. On 1 January 2008, Tudhoe plc issued non-equity shares for £200 million, which are redeemable for the same amount at the end of six years. Dividends are payable of: £10 million per annum for the first two years, £19 million for the next two years, and £27 million and £26 million respectively in the remaining two years. The costs associated with the issue amounted to £2 million. The actuarial rate of return over the issue period is 9%.

REQUIRED Provide a table to show the relevant entries, in respect of the above arrangement, in the income statement and balance sheet for each of the years 2008-2013. (4 marks)

SUGGESTED ANSWER

Year Interest paid Interest charge in the income

statement, 9%

Adjustment to carrying value

Carrying value in the balance sheet

£m £m £m £m 198.0 2008 10.0 17.8 7.8 205.8 2009 10.0 18.5 8.5 214.3 2010 19.0 19.3 0.3 214.6 2011 19.0 19.3 0.3 215.0 2012 27.0 19.3 -7.7 207.3 2013 26.0 18.7 -7.3 200.0

EXAMINER’S COMMENTS Some very good answers were provided to this question, but many candidates were totally unfamiliar with the issues involved when a capital instrument of this character is issued by a company.

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(h) The following information is provided for Ewhurst plc in respect of the year to 30 September 2008.

£million Revenue 800 Total operating expenses 720

Operating profit 80

Average gross assets 600

REQUIRED Calculate the following ratios for Ewhurst plc, and demonstrate the numerical relationship between them:

(i) Rate of return on gross assets. (ii) Net profit percentage. (iii) Total (gross) asset turnover. (4 marks)

SUGGESTED ANSWER

(i) Rate of return on gross assets 80/600 x100 = 13.3%

(ii) Net profit percentage 80/800 x 100 = 10% (iii) Total asset turnover 800/600 = 1.33

Rate of return on gross assets (ii) x (iii) = (i) 10% x 1.33 = 13.3%

EXAMINER’S COMMENTS In the main, this was a well answered question. The most common errors were to invert the rate of return on gross assets calculation, and/or display a lack of familiarity with the „Du Pont formula‟.

(i) Gelligear Ltd was incorporated on 1 January 2007, with an issued

share capital of £10,000. The £10,000 was immediately invested in 20 grommets, each costing £500 each. The 20 grommets were sold on 31 December 2007 for £12,000 in cash, and were replaced at a cost of £11,200. The retail price index moved from 100 to 105 during 2007. All other costs and taxation are to be ignored.

REQUIRED Using the relevant information provided above, prepare the income statement and balance sheet of Gelligear Ltd for 2007 in accordance with the rules for current purchasing power (CPP) accounting. (4 marks)

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SUGGESTED ANSWER

Income statement for 2007

£

Revenue 12,000 Cost of sales £10,000 x 1.05 10,500

Profit 1,500

Balance sheet at 31 December 2007

Inventories 11,200 Cash 800

12,000

Share capital £10,000 x 1.05 10,500 Profit 1,500

12,000

EXAMINER’S COMMENTS Answers to this question were of a disappointing quality. Most candidates realised that inventories should be reported in the balance sheet at £11,200, but many applied aspects of the rules relating to current cost accounting rather than current purchasing power accounting.

(j) The following information is provided relating to the operation of the

bar at the Stretford Squash Club during 2007: £ Receipts from bar sales 201,300 Payments for bar supplies 106,300 Balances at 1 January 31 December £ £ Owed by bar customers 2,300 3,100 Owed for bar supplies 18,700 25,300 Bar stock 9,700 8,500

REQUIRED Prepare the bar trading account of the Stretford Squash Club for 2007. (4 marks)

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SUGGESTED ANSWER £ £ Sales 201,300+3,100-2,300 202,100 Purchases 106,300+25,300-18,700 112,900 Opening stock 9,700 Closing stock -8,500

Cost of goods sold 114,100

Bar profit 88,000

EXAMINER’S COMMENTS Most students correctly made the adjustments relating to the opening and closing bar stock. However, fewer applied the accruals concept correctly to receipts and payments, and the information was often presented in the bar trading account in a haphazard manner.

SECTION B

(Answer THREE questions from this section) 2. Fugill plc was incorporated on 1 October 2007, and issued 10,000,000 shares

with a nominal value of £1 each, for £1.40 each. Fugill made the following cash investments at the same date:

Company Number of voting equity

shares acquired Price paid

£000 £000 Gadsby Ltd 180 5,000 Harsant Ltd 1,800 4,200 Ibeson Ltd 1,200 3,800

The fair values of the assets and liabilities of Gadsby, Harsant and Ibeson were the same as their carrying values on 1 October 2007.

Fugill incurred administration expenses of £200,000 during the year to 30 September 2008, but had no further cash flows.

The following are the summarised balance sheets of Gadsby Ltd, Harsant Ltd and Ibeson Ltd at 30 September 2008:

Gadsby Ltd Harsant Ltd Ibeson Ltd £000 £000 £000 Non-current assets 3,000 7,400 2,600 Net current assets 1,970 3,700 1,400

4,970 11,100 4,000

Ordinary shares (£1 each) 2,250 6,000 1,500 Retained profit at 1 October 2007 1,220 4,000 1,200 Profit for 2007/8 1,500 1,100 1,300

4,970 11,100 4,000

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Fugill plc, under a contractual arrangement, has the power to appoint

two directors to the board of Harsant Ltd to sit alongside three other directors.

Gadsby Ltd paid an interim dividend of 40 pence per share during July 2008.

None of the companies issued or redeemed any shares during the year to 30 September 2008.

REQUIRED

(a) Outline the relationship between Fugill plc and each of the three companies, Gadsby Ltd, Harsant Ltd and Ibeson Ltd, based on the information provided. (6 marks)

SUGGESTED ANSWER

Gadsby should be accounted for as an investment as the percentage of shares acquired is 8%, with at least 20% normally being the required threshold for treatment as an associated company. In addition, there is evidence that Fugill exerts significant influence over the affairs of Gadsby. Harsant should be treated as an associated company because Fugill is in possession of more than 20% of the voting power (30%), and appears able to exercise a significant influence over Harsant‟s financial and operating policies through representation on the board of directors. Ibeson should be treated as a subsidiary in view of the fact that Fugill has acquired more than 50% of the equity voting share capital, i.e. 80% in this case, and is therefore in a position to exert a dominant influence.

(b) Prepare the legal entity-based balance sheet of Fugill plc at 30

September 2008. (4 marks) SUGGESTED ANSWER

Balance sheet of Fugill plc at 30 September 2008

Workings - £000 £000 Investments 5,000 + 4,200 + 3,800 13,000 Cash 14,000 [share issue] - 13,000

[investments] - 200 [admin. expenses] + 72 [dividend received])

872

13,872

Equity: Share capital 10,000 Share premium account 4,000 Profit and loss account 72 [dividends received] – 200 (admin.

exps) -128

13,872

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(c) Prepare the consolidated balance sheet of Fugill plc at 30 September

2008. (10 marks) Note: Assume no impairment of any goodwill arising on consolidation.

SUGGESTED ANSWER

Consolidated Balance Sheet at 30 September 2008 £m £m Assets:

Non-current assets 2,600 Goodwill 1,640 Investment in associated company - cost 4,200 - profit share - 1,100 x 30% 330 4,530

Investment 5,000 Net current assets Fugill 872 Ibeson 1,400 2,272

Total assets 16,042

Equity and liabilities:

Parent company shareholders‟ equity Share capital 10,000 Share premium account 4,000 Retained earnings Fugill -128 Harsant 330 Ibeson 1,040 1,242

15,242 Minority interest 800

Total equity 16,042

Ibeson – Subsidiary Company (80%)

Total equity

At acquisition

Since acquisition

Minority interest

£000 £000 £000 £000 Share capital 1,500 1,200 300 Retained profits: at acquisition 1,200 960 240 since acquisition 1,300 1,040 260

4,000 2,160 800

Price paid 3,800

Goodwill 1,640

EXAMINER’S COMMENTS There were many good answers to this question, with students coping particularly well with the instruction to outline, based on the information provided, the relationship between Fugill plc and each of the three companies, Gadsby Ltd, Harsant Ltd and Ibeson Ltd. Part (b) provided the weakest answers, with many students showing a lack of understanding of how the legal-entity based balance sheet of Fugill should be constructed.

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3. Arklow Ltd trades in a range of products on a cash basis, and its forecast balance sheet at 31 December 2008 is expected to contain the following information:

Balance Sheet as at 31 December 2008 Assets:

£000

Fixed assets 1,400 Inventories 420 Cash 175

1,995

Financed by: Share capital 1,000 Retained profit 995

1,995

To put into effect plans for expansion, Arklow Ltd requires a number of new lorries which will cost £499,300 in total. Each lorry is expected to have a useful life of five years. The lorries are to be written off on the straight-line basis assuming a total residual value of £99,300. Arklow has entered into an arrangement with a London City-based financial institution to lease the lorries, with the lease contract providing for an initial payment of £100,000 on 1 January 2009, and five further annual payments of the same amount commencing 31 December 2009. The interest rate implicit in the lease arrangement is 8% per annum. The management of Arklow has never previously entered into a lease as the means of securing the use of non-current assets, and is unsure how to account for the transaction. Arklow’s accountant believes that the arrangement is subject to the provisions contained in IAS17 ‘Leases’, and also understands that this standard distinguishes between operating and finance leases which must be accounted for in different ways. She has no knowledge of the details of these rules. The forecast operating profit of Arklow for 2009, before lease rental charges (if any) and the depreciation of non-current assets currently owned amounting to £200,000, is £297,000. The level of inventories is expected to remain unchanged during 2009.

REQUIRED

(a) Prepare the forecast balance sheets of Arklow Ltd at 1 January 2009,

on the assumption that the financial arrangement entered into to obtain the new lorries is to be accounted for as:

(i) An operating lease. (ii) A finance lease.

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You may assume that no other transactions are entered into on 1 January 2009. (5 marks)

SUGGESTED ANSWER

Balance Sheets at 1 January 2009 Operating Finance £000 £000 Non-current assets 1,400 1,400 Leased asset 499 Inventories 420 420 Prepaid lease rental 100 Cash [175 - 100] 75 75 Due to financial institution -399

1,995 1,995

Financed by: Share capital 1,000 1,000 Retained profit 995 995

1,995 1,995

(b) Prepare the forecast balance sheets of Arklow Ltd at 31 December

2009, on the assumption that the financial arrangement entered into to obtain the new lorries is to be accounted for as:

(i) An operating lease. (ii) A finance lease.

The forecast balance sheets should show the adjustments to cash and retained profit as the result of transactions undertaken during the year. (9 marks)

SUGGESTED ANSWER

Forecast balance Sheets at 31 December 2009

Operating Finance £000 £000 Non-current assets [1,400 – 200] 1,200 1,200 Leased asset [499 – 80] 419 Inventories 420 420 Prepaid lease rental 100 Cash 75 75 Profit before rental charges and dep. 297 297 Rental -100 272 -100 272

Due to financial inst. [399 + 32 – 100] -331

Total assets less current liabilities 1,992 1,980

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Financed by: Share capital 1,000 1,000 Retained profit 995 995 Profit before rental charges and dep. 297 297 Rental -100 Depreciation -200 -280 Interest 992 -32 980

1,992 1,980

(c) Explain how the lease should be accounted for in order to comply with

standard accounting practice. Your explanation should include a discussion of each approach in the context of the concept of substance over form, and the different effects on the gearing of the two companies at 1 January 2009. (6 marks) Note: All calculations to the nearest £1,000.

SUGGESTED ANSWER

Discussion should cover the following points:

The legal form of the transaction is a lease agreement and, if accounted for in accordance with the contractual arrangement, the transaction would be reported as an operating lease. The financing arrangement therefore remains off-balance sheet.

It was in order to counter the growing use of this technique that IAS 17 drew a distinction between an operating lease and a finance lease. The latter case requires the asset and related financial obligation to be reported in the balance sheet of the lessee.

The effect of different treatments on the balance sheet is material. Treated as an operating lease, the balance sheet at 1 January 2009 shows a zero level of gearing. However, in compliance with the requirements of IAS 17, when the arrangement is accounted for as a finance lease, the ratio of loan to equity finance becomes 0.2:1 (W1).

The treatment of the arrangement as a finance lease reflects the economic reality of the arrangements made, and demonstrates the fact that Arklow has become more highly geared than was previously the case.

W1 The gearing of the company may be computed by expressing loan finance as a

ratio of equity finance. Operating Finance £000 £000

Loan finance 0 399 Equity finance 1,995 1,995 Gearing ratio (debt:equity) zero 0.2:1

EXAMINER’S COMMENTS Of the questions in Section B, this one and Question 6 caused the most difficulty. Candidates were surprisingly weak at making the fairly basic accounting adjustments to the cash balance and the balance of retained profit, particularly at the end of the year.

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Most candidates understood the difference between an operating lease and a finance lease, but they had greater difficulty applying the differential rules to the facts provided.

4. The following information is provided in respect of Jamieson plc, a small

public company.

Income statement for the year ended 30 September 2008 2007 £000 £000 Revenue 12,412 11,242 Changes in inventories of finished goods and work in progress

340 70

12,752 11,312

Raw materials and consumables used 6,204 5,564 Employee benefits expense 1,218 1,232 Depreciation 304 70 Other expenses including impairment of goodwill 2,300 2,184

10,026 9,050

Operating profit 2,726 2,262 Finance charges 360 334

Profit before tax 2,366 1,928 Taxation 570 510

Profit for the period 1,796 1,418

Balance sheet at 30 September 2008 2007 Assets £000 £000 Non-current assets Land and buildings at valuation (2007 at cost) 5,000 3,530 Other property, plant and equipment at book value 4,320 2,200 Goodwill 432 500 Acquired brands at cost 5,600 5,000

15,352 11,230

Current assets Inventories 5,666 4,522 Trade receivables 3,380 2,696 Cash and cash equivalents 900 612

9,946 7,830

Total assets 25,298 19,060

Equity and liabilities Share capital 14,800 13,000 Share premium account 1,002 - Retained earnings 4,684 1,418

20,486 14,418

Non-current liabilities Long-term borrowings 3,000 3,204

Current liabilities Trade and other payables 1,242 928

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Taxation 570 510

Total current liabilities 1,812 1,438

Total equity and liabilities 25,298 19,060

During the financial year 2007-2008, Jamieson plc purchased new plant at a cost of £2,628,000, and sold items with a book value of £204,000 for £262,000. REQUIRED

(a) Prepare a cash flow statement for the year to 30 September 2008, so

far as the information permits. (14 marks)

SUGGESTED ANSWER

Cash Flow Statement of Jamieson plc for 2007/8 Cash flows from operating activities

£000 £000

Operating profit 2,726 Depreciation charge 304 Amortisation of goodwill 68 Profit on sale of plant -58 Increase in inventories -1,144 Increase in accounts receivable -684 Increase in accounts payable 314

Cash generated from operations 1,526 Interest paid -360 Taxation -510

Net cash generated from operating activities 656 Cash flows from financing activities Issue of shares 2,802 Redemption of long-term borrowing -204 2,598

Cash flows from investing activities Purchase of fixed assets -2,628 Purchase of brands -600 Sale of plant 262 -2,966

Increase in cash 288 Cash at beginning of period 612

Cash at end of period 900

(b) Briefly discuss Jamieson plc’s performance based on an analysis of the

information contained in the cash flow statement. (6 marks)

SUGGESTED ANSWER

Discussion and analysis should cover: The cash flow statement shows that only a little more than half of the operating profit has in fact been converted into cash during the year. Most of the balance has been used to finance an increased investment in inventories and receivables.

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A further £870,000, or 57% of cash generated from operations, has been absorbed in paying interest and taxation. Jamieson has made a substantial share issue during the year, about 10% of which has been absorbed in repaying long-term borrowing. The company has made a major investment in new fixed assets and in the acquisition of brands. This has been financed by the share issue and cash generated from operations. After all outflow, there has been a net inflow of cash of £288,000 which has increased the cash balance to £900,000.

EXAMINER’S COMMENTS In answering this question, most candidates revealed that they had a good understanding of the way in which a cash flow statement should be constructed. Answers to requirement (b) were less impressive with, again, an important weakness being the failure to answer the question asked. Whereas candidates were instructed to base their analysis of the company‟s performance on the cash flow statement, many instead focused on the income statement and balance sheet, often using irrelevant traditional accounting ratios as the basis for their assessment. At the other extreme, a few candidates improved upon the analysis contained in the above model answer by impressively informing their appraisal through the use of relevant cash flow-based accounting ratios.

5. Anglesia Ltd has been suffering from severe cash flow problems for

approximately one year. The following draft balance sheet has been prepared for consideration by the board of directors:

Balance Sheet of Anglesia Ltd as at 31 October 2008 £million £million Non-current assets Investment property at cost 60.0 Land and buildings at written down value 14.0 Plant and equipment at written down value 31.0

105.0 Current assets Inventories 22.5 Receivables 15.0

37.5

Current liabilities Payables 18.0 Bank overdraft 12.0

30.0

Net current assets 7.5

112.5 Debenture secured on investment property 45.0

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67.5

Financed by Ordinary shares of £1 each 15.0 Retained profit 52.5

67.5

Anglesia Ltd decided to diversify its operations a few years ago through the acquisition of the ‘Investment property’, shown in the above balance sheet, to be held for its investment potential. The market for property in the area has since collapsed and, in the light of its adverse cash flow, Anglesia is considering a possible sale.

The debenture is due for repayment in November 2009. The directors have approached the bank and requested an increase in

the overdraft facility. The bank has advised them to consider other options.

The two alternative courses of action under consideration by the directors are as follows: Scheme A Anglesia Ltd could sell the investment property on the open market for £15 million, and the company could then be liquidated. It is estimated that on liquidation the land and buildings, other than the investment property, would realise £22 million, and the plant and equipment £8 million. The other assets of Anglesia Ltd would realise their book values. £3 million of the payables are preferential, and the costs of liquidation would amount to £1.5 million. Scheme B The investment property is located on a site that Clifton plc wishes to develop, and it has offered Anglesia Ltd £75 million for its purchase. Anglesia would use the proceeds to repay the outstanding debenture, and redeem six million of its own shares at a price of £2.40 each. Any remaining cash would be used to repay the overdraft. In these circumstances, Anglesia would continue as a going concern with the value in use of its tangible assets, other than plant and equipment, in excess of carrying value. The plant and equipment has a recoverable amount of £25 million. REQUIRED

(a) Assuming Scheme A is put into operation, calculate the amount

received by each stakeholder in Anglesia Ltd. Indicate clearly the order in which each stakeholder would be repaid. (6 marks)

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SUGGESTED ANSWER Scheme A Calculation of the amount received by each party to the liquidation

£million £million Order of repayment Secured debenture Property 15.0 1 Debenture 45.0

Deficit 30.0

Assets realised Land and buildings 22.0 Plant and equipment 8.0 Other assets 37.5

67.5 2 Less: Liquidation costs 1.5

66.0 3 Preferential creditors 3.0

63.0 Unsecured creditors Overdraft 12.0 Payables 15.0 Deficit on debenture 30.0

5 57.0

6 Shareholders 6.0

(b) Briefly outline the rights of all the parties involved in the liquidation of

Anglesia Ltd under Scheme A. (6 marks) SUGGESTED ANSWER Claimant Rights Debenture holders: Secured up to the value of the asset. Any residual deficit ranks as

an ordinary creditor. Liquidator: The work would not be undertaken without some security for

payment. Preferential creditors: By statute these rank after costs, but before ordinary creditors. Other payables: No special rights. Overdraft: This has no special priority unless specific security is taken. Shareholders: They are the final risk takers, and rank last.

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(c) Explain to the shareholders why they would suffer a high proportion of the forecast loss on liquidation. (2 marks)

SUGGESTED ANSWER The shareholders enjoy an equity interest in the business. They therefore benefit from all residual surpluses but, equally, bear all residual losses. As a result, their shares, nominally worth £1 each are in fact shown to be worth only 40p each on liquidation. However, their liability is limited to the amount invested in the company. (d) Assuming Scheme B is put into operation, prepare the reconstructed

balance sheet of Anglesia Ltd. (6 marks) Note: Assume all transactions take place on 31 October 2008.

SUGGESTED ANSWER

Scheme B

Reconstructed Balance Sheet of Anglesia Ltd as at 31 October 2008 £million £million Fixed Assets Land and buildings at written down value 14.0 Plant and equipment at written down value 25.0

39.0 Current Assets Inventories 22.5 Receivables 15.0 Cash (W1) 3.6

41.1

Current Liabilities Payables 18.0

Net Current Assets 23.1

62.1

Financed by Ordinary shares of £1 each 9.0 Retained profit (W2) 53.1

62.1

W1 -12.0+75.0 (sale of investment property) - 45.0 (repayment

of debentures) -14.4 [6.0 x £2.4] (redemption of shares) 3.6

W2 52.5 + 15.0 (profit on sale of property) - 8.4 (premium on redemption) – 6.0 (write-down of plant and equipment)

53.1

EXAMINER’S COMMENTS The overall standard of answers to this question was good. A common error, in part (a), was the failure to allocate the proceeds from the sale of the investment property to the debenture holders who were entitled to claim it as specific security for their advance. In

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part (d), many candidates correctly computed the cash balance, but few made the appropriate adjustments to the balance of retained profit.

6. The following issues have arisen in relation to the accounts of Dundee plc for

the year ending 31 December 2008.

(i) Dundee expects to receive from a customer, during December 2008, an advance payment of £3,000,000 for the supply of services over the next three years. The directors plan to include this amount as sales revenue for 2008.

(ii) An action has been brought against Dundee for negligence during 2008. Dundee’s lawyers have been instructed to vigorously defend the action, but tell the directors that they should expect to lose £1,500,000. A court decision is not expected for at least a year.

(iii) Dundee’s Chief Accountant believes that the company should always take the most prudent approach when valuing assets for inclusion in the accounts.

(iv) A property was purchased at the beginning of 2008 for £10,000,000. On 31 December 2008 the property is expected to be worth £16,000,000, and the finance director of Dundee is not sure which figure should be used when preparing the accounts.

REQUIRED Advise the directors of Dundee plc how to deal with the above four issues in the accounts for the year ended 31 December 2008. You should base your advice on the underlying assumptions and qualitative characteristics contained in the IASB’s ‘Framework for the preparation and presentation of financial statements’. (20 marks)

SUGGESTED ANSWER (i) The underlying assumption, „accruals‟, requires revenues and expenses to be

included in the income statement as earned and incurred rather than when received and paid. The assumption also points to the need to match revenue with related costs. The cash has been received in 2008, but the revenue is earned in 2009-11. The £3m should be treated as revenue received in advance (a prepayment / liability) in 2008, and should be released to the income statement over the next three years.

(ii) The underlying assumption, „accruals‟, requires expenses to be recognised in the income statement on the basis of direct association between costs incurred and the earning of specific items of income (matching).

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The qualitative characteristic „prudence‟ does not permit the deliberate overstatement of liabilities or expenses. Therefore, prudence does not automatically justify a provision being made. Consideration needs to be given to whether a liability exists in accordance with the provisions of standard accounting practice. Given the lawyers‟ expectation that Dundee will lose, it would seem that a provision of £1.5m. is required.

(iii) Prudence is the relevant qualitative characteristic. Uncertainty requires prudent

measurement. However, the characteristic of prudence does not permit the deliberate

understatement of assets or revenue, or deliberate overstatements of liabilities or expenses. The chief accountant‟s bias should be resisted when preparing the accounts of Dundee.

(iv) The going concern concept allows the liquidation value of assets and liabilities to

be ignored unless the enterprise intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so.

However, companies may restate assets at fair value if this produces financial reports which are more relevant. Relevance depends on whether an item‟s disclosure could influence the economic decisions of users A problem with revaluation is the need not to contravene the qualitative characteristic of neutrality. This requires that published information should be neutral and free from bias. The company should choose the valuation best equipped to help the accounts reveal a true and fair view.

EXAMINER’S COMMENTS There were some very good explanations of the appropriate treatment of item (i), but candidates struggled to provide persuasive explanations for the other cases. A particular weakness was the failure of candidates to underpin their advice with appropriate discussion of the underlying assumptions and qualitative characteristics contained in the IASB‟s „Framework for the preparation and presentation of financial statements‟.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.

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