May 2009 Examinations Managerial Level P7 – Financial Accounting and Tax Principles Question Paper 2 Examiner’s Brief Guide to the Paper 25 Examiner’s Answers 26 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com/students) from mid-September is a Post Examination Guide for the paper which provides much valuable and complementary material including indicative mark information. © The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher.

Financial Management Pillar Managerial Level Paper

P7 – Financial Accounting and Tax Principles 21 May 2009 – Thursday Afternoon Session

Instructions to candidates

You are allowed three hours to answer this question paper.

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or sub-questions). The requirements for the questions in Sections B and C are highlighted in a dotted box.

ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking.

Answer the ONE compulsory question in Section A. This has 16 sub-questions on pages 2 to 7.

Answer the SIX compulsory sub-questions in Section B on pages 8 to 11.

Answer the ONE compulsory question in Section C on pages 12 to 15. Page 15 is detachable for ease of reference.

Maths Tables and Formulae are provided on pages 17 to 19. These pages are detachable for ease of reference.

The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper.

Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.

Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

P7 –

Fin

anci

al A

ccou

ntin

g an

d Ta

x Pr

inci

ples

TURN OVER

May 2009 P7

2

SECTION A – 40 MARKS

[the indicative time for answering this Section is 72 minutes]

ANSWER ALL SIXTEEN SUB-QUESTIONS

Instructions for answering Section A:

The answers to the sixteen sub-questions in Section A must ALL be written in your answer book. Your answers should be clearly numbered with the sub-question number and then ruled off, so that the markers know which sub-question you are answering. For multiple choice questions, you need only write the sub-question number and the letter of the answer option you have chosen. You do not need to start a new page for each sub-question. For sub-questions 1.11, 1.13, 1.14, 1.15 and 1.16 you should show your workings as marks are available for the method you use to answer these sub-questions.

Question One 1.1 State the TWO underlying assumptions outlined in the International Accounting Standard

Board’s (IASB) Framework for the Preparation and Presentation of Financial Statements.

(2 marks) 1.2 Which ONE of the following gives the true meaning of “treasury shares”? A Shares owned by a country’s Treasury

B An entity’s own shares purchased by the entity and still held at the period end

C An entity’s own shares purchased by the entity and resold before the period end at a gain

D An entity’s own shares purchased by the entity and cancelled (2 marks)

P7 May 2009

3

1.3 The following details are relevant:

• HC carries out its main business activities in Country A;

• HC is incorporated in Country B;

• HC’s senior management exercise control from Country C, but there are no sales or purchases made in Country C;

• HC raises its finance and is quoted on the stock exchange in Country D.

Assume Countries A, B, C and D have all signed double taxation treaties with each other, based on the OECD model tax convention.

Which country will HC be deemed to be resident in for tax purposes? A Country A

B Country B

C Country C

D Country D (2 marks)

1.4 Which ONE of the following would be regarded as a change of accounting estimate

according to IAS 8 Accounting policies, changes in accounting estimates and errors? A An entity started capitalising borrowing costs for assets as required by IAS 23 Borrowing

costs. Borrowing costs had previously been charged to the income statement.

B An entity started revaluing its properties, as allowed by IAS 16 Property, plant and equipment. Previously all property, plant and equipment had been carried at cost less accumulated depreciation.

C A material error in the inventory valuation methods caused the closing inventory at 31 March 2008 to be overstated by $900,000.

D An entity created a provision for claims under its warranty of products sold during the year. 5% of sales revenue had previously been set as the required provision amount. After an analysis of three years sales and warranty claims the calculation of the provision amount has been changed to a more realistic 2% of sales.

(2 marks)

Section A continues on the next page

TURN OVER

May 2009 P7

4

1.5 Which ONE of the following material items would be classified as a non-adjusting event in HL’s financial statements for the year ended 31 December 2008 according to IAS 10 Events after the reporting period?

HL’s financial statements were approved for publication on 8 April 2009.

A On 1 March 2009, HL’s auditors discovered that, due to an error during the count, the

closing inventory had been undervalued by $250,000.

B Lightning struck one of HL’s production facilities on 31 January 2009 and caused a serious fire. The fire destroyed half of the factory and its machinery. Output was severely reduced for six months.

C One of HL’s customers commenced court action against HL on 1 December 2008. At 31 December 2008, HL did not know whether the case would go against it or not. On 1 March 2009, the court found against HL and awarded damages of $150,000 to the customer.

D On 15 March 2009, HL was advised by the liquidator of one of its customers that it was very unlikely to receive any payments for the balance of $300,000 that was outstanding at 31 December 2008.

(2 marks) 1.6 Which ONE of the following is NOT an advantage for the tax authority of deduction of tax

at source? A The total amount of tax due for the period is easier to calculate

B Tax is collected earlier

C Administration costs are borne by the entity deducting tax

D Tax is deducted before income is paid to the taxpayer (2 marks)

1.7 HN purchases products from a foreign country. The products cost $14 each and are

subject to excise duty of $3 per item and VAT at 15%. If HN imports 1,000 items, how much does it pay to the tax authorities for this transaction? A $2,100

B $5,100

C $5,550

D $19,550 (2 marks)

P7 May 2009

5

1.8 Which ONE of the following would NOT normally be treated as a related party of HJ in accordance with IAS 24 Related party disclosures?

A XX, HJ’s largest customer, accounts for 75% of HJ’s turnover

B HJ2, a subsidiary of HJ, that does not trade with HJ

C HJA, an associate of HJ

D A shareholder of HJ, holding 25% of HJ’s equity shares (2 marks)

1.9 Which of the following are required by IFRS 8 Operating segments to be disclosed in an

entity’s financial statements, if they are included in the measure of segment profit or loss to be reported to the chief operating decision maker?

(i) Revenues from transactions with other operating segments within the entity

(ii) Cost of sales

(iii) Amortisation

(iv) Income tax expense

(v) Administrative expenses and distribution costs A (i), (ii) and (v) B (ii), (iii) and (iv) C (ii), (iii) and (v) D (i), (iii) and (iv)

(2 marks) 1.10 In no more than 25 words, state the objective of an external audit.

(2 marks) 1.11 HP entered into an operating lease for a machine on 1 May 2007 with the following terms:

• five years non-cancellable lease;

• 12 months rent free period from commencement;

• rent of $12,000 per annum payable at $1,000 a month from month 13 onwards;

• machine useful life 15 years. Calculate the amount that should be charged to HP’s income statement in respect of the lease, for each of the years ended 30 April 2008 and 30 April 2009.

(3 marks)

Section A continues on the next page TURN OVER

May 2009 P7

6

1.12 HD sells office stationery and adds a sales tax to the selling price of all products sold. A customer purchasing goods from HD has to pay the cost of the goods plus the sales tax. HD pays the sales tax collected to the tax authorities.

From the perspective of HD the sales tax would be said to have A formal incidence.

B effective incidence.

C informal incidence.

D ineffective incidence. (2 marks)

1.13 A trainee management accountant is preparing HY’s cash budget for the next financial

period. She has obtained the following information: Balances Actual 30 April 2009 Forecast 31 October 2009 $000 $000 Trade receivables 75 80 Trade payables 47 40 Closing inventory 29 31

Production budget has included $331,000 for cost of raw materials to be used during the six month period to 31 October 2009.

Calculate the forecast cash required to pay suppliers for the six month period ending 31 October 2009.

(4 marks) 1.14 HW puts $50,000 into a bank deposit account on 31 October 2006. The account pays

interest every six months, at a rate of 2% for every six month period.

Assume that HW reinvests all interest. Calculate how much HW will have in its bank deposit account at 30 April 2009 (to nearest $) (ignore tax).

(3 marks) 1.15 HF purchased an asset on 1 April 2007 for $220,000. HF claimed a first year tax

allowance of 30% and then an annual 20% writing down allowance, using the reducing balance method.

HF depreciates the asset over eight years using straight line depreciation, assuming no residual value.

On 1 April 2008, HF revalued the asset and increased the net book value by $50,000. The asset’s useful life was not affected.

Assume there are no other temporary differences in the period and a tax rate of 25% per annum.

Calculate the amount of deferred tax movement in the year ended 31 March 2009 and the deferred tax balance at 31 March 2009, in accordance with IAS 12 Income taxes.

(4 marks)

P7 May 2009

7

1.16 HA, a retailing entity, has annual sales of $48 million. HA earns a constant margin of 25% on sales. All sales and purchases are on credit and are evenly distributed throughout the year.

The following values are kept at a constant level throughout the year:

• Trade receivables $12 million • Trade payables $8 million

If HA’s working capital cycle is 57 days, what is its inventory turnover, to the nearest number of days?

(4 marks)

Total for Question One = 40 marks

Reminder

All answers to Section A must be written in your answer book.

Answers to Section A written on the question paper will not be submitted for marking.

End of Section A

TURN OVER

May 2009 P7

8

SECTION B – 30 MARKS [indicative time for answering this Section is 54 minutes] ANSWER ALL QUESTIONS Question Two (a) Governments use a range of specific excise duties as well as general sales taxes on

goods.

Required:

(i) Explain the reasons why a government might apply a specific excise duty to a category of goods.

(3 marks)

(ii) Explain the difference between a single stage and a multi-stage sales tax.

(2 marks)

(Total for Question Two (a) = 5 marks) (b) Selected balances in HF’s financial records at 30 April 2009 were as follows: $000 Revenue 15,000 Profit 1,500 Property, plant and equipment – net book value 23,000 Inventory 1,500 After completing the required audit work the external auditors of HF had the following observations: (1) Inventory with a book value of $500 is obsolete and should be written off. (2) Development expenditure net book value of $600,000, relating to the development of a

new product line, has been capitalised and amortised in previous years but the project has now been abandoned.

(3) Decommissioning costs relating to HF’s production facilities, estimated to be $5,000,000 in 17 years time is being provided for, over 20 years, at $250,000 a year.

Assume there are no other material matters outstanding. As external auditor you have just completed a meeting with HF management. At the meeting HF management decided the following: • Item (1) is not material, so it is not necessary to write off the obsolete inventory.

• Item (2) the development expenditure should be written off against current year profits.

• Item (3) the decommissioning cost will continue to be provided for over 20 years.

The requirements for Question Two (b) are on the opposite page

P7 May 2009

9

Required:

(i) Explain whether or not the management’s decisions taken in the meeting are correct for items (1) and (2).

(2 marks)

(ii) Explain whether you agree with the management’s treatment of the decommissioning costs in item (3) and explain the type of audit report that should be issued, giving your reasons.

(3 marks)

(Total for Question Two (b) = 5 marks) (c) HX is suffering from a constantly increasing level of outstanding balances on trade

receivables. The outstanding balance has doubled in 12 months. HX’s customers all pay by cheque. HX is considering offering a discount to its customers in an effort to improve cash flow and reduce the trade receivables outstanding balance. HX normally offers 30 day payment terms, but its customers take an average of 60 days to pay. To improve its cash flow HX is considering offering a 2·5% discount for payment within 14 days.

Required:

(i) Calculate the effective interest rate of the 2·5% discount offered to its customers by HX for early payment. Assume a 365 day year.

(3 marks)

(ii) Identify other methods that HX could use to reduce its level of outstanding trade receivables.

(2 marks)

(Total for Question Two (c) = 5 marks)

Section B continues on the next page

TURN OVER

May 2009 P7

10

(d) HS, a contractor, signed a two year fixed price contract on 31 March 2008 for $300,000 to build a bridge. Total costs were originally estimated at $240,000.

At 31 March 2009, HS extracted the following figures from its financial records:

$000 Contract value 300 Costs incurred to date 170 Estimated costs to complete 100 Progress payments received 130 Value of work completed 165

HS calculates the stage of completion of contracts using the value of work completed as a proportion of total contract value.

Required:

Calculate the following amounts for the contract that should be shown in HS’s financial statements: • Income statement:

o Revenue recognised for the year ended 31 March 2009;

o Profit recognised for the year ended 31 March 2009. • Balance sheet:

o Gross amount due to/from the customer at 31 March 2009, stating whether it is an asset or liability.

(Total for Question Two (d) = 5 marks)

(e) HL has been trading profitably, but has recently been accused of overtrading.

Required:

(i) Define the meaning of “overtrading”, and explain what is likely to happen if HL is overtrading.

(3 marks)

(ii) Identify actions that HL could take to correct the problems of overtrading.

(2 marks)

(Total for Question Two (e) = 5 marks)

P7 May 2009

11

(f) Bills of exchange are sometimes used for export transactions.

A bill of exchange with a face value of $1,000 has 91 days to maturity. The discount yield required by an investor, HG, is 7%. Assume a 365 day year.

Required: (i) Identify THREE ways in which an accepted bill of exchange can be used by the

holder. (3 marks)

(ii) Calculate the maximum price HG should be willing to pay for the bill.

(2 marks)

(Total for Question Two (f) = 5 marks)

(Total for Section B = 30 marks)

End of Section B

TURN OVER

May 2009 P7

12

SECTION C – 30 MARKS [indicative time for answering this Section is 54 minutes] ANSWER THIS QUESTION. YOU SHOULD SHOW YOUR WORKINGS AS MARKS ARE AVAILABLE FOR THE METHOD YOU USE Question Three The accountant of HZ started preparing the financial statements for the year ended 31 March 2009, but was suddenly taken ill. The draft financial statements for HZ for the year ended 31 March 2009 are given below: HZ Balance Sheets at 31 March 2009 (draft) 31 March 2008 (final) $000 $000 $000 $000 Assets Non-current assets

Property, plant and equipment 5,854 6,250 Goodwill 217 350 Other intangible assets 198 6,269 170 6,770

Current assets

Inventories 890 750 Trade receivables 924 545 Cash and cash equivalents 717 300 2,531 1,595

Total assets 8,800 8,365 Equity and liabilities

Equity share capital 2,873 2,470 Share premium account 732 530 Revaluation reserve 562 400 Retained earnings 1,623 1,840

Total equity 5,790 5,240 Non-current liabilities

10% loan notes - 1,250 5% loan notes 700 700 Deferred tax 312 250

Total non-current liabilities 1,012 2,200 Current liabilities

Trade payables 744 565 Income tax 117 247 Suspense account 1,000 - Provision 120 - Accrued interest 17 113

Total current liabilities 1,998 925Total equity and liabilities 8,800 8,365

P7 May 2009

13

Income Statement for the year ended 31 March 2009 (draft) $000 Revenue 9,750 Cost of sales (5,200)Gross profit 4,550 Distribution costs (1,195)Administrative expenses (2,990)Profit from operations 365 Finance costs (60)Profit before tax 305 Income tax expense (182)Profit for the period 123

Additional information:

i. Non-current tangible assets include properties which were revalued upwards during the year.

ii. Non-current tangible assets disposed of in the year had a net book value of $98,000; cash received on their disposal was $128,000. Any gain or loss on disposal has been included under cost of sales.

iii. During the year goodwill became impaired. The impairment was charged to cost of sales.

iv. Depreciation charged for the year was $940,000, included in cost of sales.

v. On 1 April 2008, HZ issued 806,000 $0⋅50 equity shares at a premium of 50%.

vi. On 1 April 2008, HZ issued 1,000,000 5% cumulative $1 preferred shares at par, redeemable at 10% premium on 1 April 2018. Issue costs of $70,000 have been paid and included in administrative expenses. The constant annual rate of interest is 6·72%. The cash received for the issue of the preferred shares has been debited to cash and credited to suspense.

vii. The other intangible assets relate to research and development expenditure. Development expenditure of $170,000 was incurred and paid in the year ended 31 March 2007; the remaining expenditure was incurred in the year ended 31 March 2009. At 31 March 2008, the expenditure met the IAS 38 criteria for deferral. When development expenditure was assessed at 31 March 2009, it was clear that the expenditure incurred in 2006/07 no longer met the IAS 38 criteria, but the expenditure incurred in 2008/09 did still meet the requirements. No action has yet been taken to write off any development expenditure.

viii. On 1 May 2008, HZ purchased and cancelled all its 10% loan notes at par plus accrued interest (included in finance costs).

ix. Ordinary dividends paid during the year were $290,000 and preferred share dividends paid were $50,000.

x. HZ has been advised that it is probably going to lose a court case and has provided $120,000 for the estimated cost of this case. This is included in administrative expenses.

The requirement for Question Three is on page 15, which is detachable for ease of reference

May 2009 P7

14

This page is blank

P7 May 2009

15

Required:

(a) Explain the accounting adjustments required by HZ to clear the balance on the suspense account at 31 March 2009 and calculate a revised profit before tax for the year ended 31 March 2009. (Note a detailed income statement is NOT required)

(5 marks)

(b) Prepare a cash flow statement, using the indirect method, for HZ for the year ended 31 March 2009, in accordance with IAS 7 – Cash Flow Statements.

(20 marks)

(c) Prepare HZ’s statement of changes in equity for the year to 31 March 2009, in a form suitable for presentation to the shareholders and in accordance with the requirements of International Accounting Standards.

(5 marks)

Notes to the financial statements are not required, but all workings must be clearly shown. Do NOT prepare a statement of accounting policies.

(Total for Question Three = 30 marks)

(Total for Section C = 30 marks)

End of Question Paper

Maths Tables and Formulae are on pages 17-19

TURN OVER

May 2009 P7

16

[this page is blank]

P7 May 2009

17

MATHS TABLES AND FORMULAE Present value table

Present value of $1, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt.

Interest rates (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

May 2009 P7

18

Interest rates (r) Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Cumulative present value of $1 per annum

Receivable or Payable at the end of each year for n years rr n−+− )(11

Interest rates (r) Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Interest rates (r) Periods

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

P7 May 2009

19

FORMULAE

Valuation models (i) Future value of S, of a sum X, invested for n periods, compounded at r% interest: S = X[1 + r]n

(ii) Present value of $1 payable or receivable in n years, discounted at r% per annum:

PV = nr ][1

1

+

(iii) Present value of an annuity of $1 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV = ⎥⎦

⎤⎢⎣

⎡+

− nrr ][1

11

1

(iv) Present value of $1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:

PV = r

1

(v) Present value of $1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum:

PV = gr −

1

Inventory management (i) Economic Order Quantity

EOQ = h

o

C

D2C

where: Co = cost of placing an order Ch = cost of holding one unit in Inventory for one year D = annual demand

Cash management (i) Optimal sale of securities, Baumol model:

Optimal sale = rateinterest

securitiesofsaleperCostxntsdisbursemecashAnnualx2

(ii) Spread between upper and lower cash balance limits, Miller-Orr model:

Spread = 3

31

⎥⎥⎥

⎦

⎤

⎢⎢⎢

⎣

⎡

rateinterest

flowscashofvariancexcostntransactiox4

3

May 2009 P7

20

[this page is blank]

P7 May 2009

21

[this page is blank]

May 2009 P7

22

[this page is blank]

P7 May 2009

23

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE VERBS USED DEFINITION

1 KNOWLEDGE

What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of

2 COMPREHENSION What you are expected to understand. Describe Communicate the key features

Distinguish Highlight the differences between Explain Make clear or intelligible/State the meaning of Identify Recognise, establish or select after

consideration Illustrate Use an example to describe or explain

something

3 APPLICATION How you are expected to apply your knowledge. Apply

Calculate/compute To put to practical use To ascertain or reckon mathematically

Demonstrate To prove with certainty or to exhibit by practical means

Prepare To make or get ready for use Reconcile To make or prove consistent/compatible Solve Find an answer to Tabulate Arrange in a table

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise

Examine in detail the structure of Place into a defined class or division

Compare and contrast Show the similarities and/or differences between

Construct To build up or compile Discuss To examine in detail by argument Interpret To translate into intelligible or familiar terms Produce To create or bring into existence

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

May 2009 P7

24

Financial Management Pillar

Managerial Level

P7 – Financial Accounting and Tax Principles

May 2009

Thursday Afternoon Session

P7 May 2009

25

The Examiner for Financial Accounting and Tax Principles offers to future candidates and to tutors using this booklet for study purposes, the following

background and guidance on the questions included in this examination paper.

Important Note: This paper is an all-compulsory paper, with Section A for 40 marks, Section B for 30 marks and Section C for 30 marks, which will contain one question covering at least two of four key financial reporting statements.

Section A – Question One – Compulsory Question One consists of 16 sub-questions, designed to cover a variety of syllabus topics not covered elsewhere in the paper and addressing a selection of learning outcomes in all four sections of the syllabus.

Section B – Question Two – Compulsory (a) Tests candidates’ ability to explain the reasons why a government might apply a specific

excise duty to a category of goods and to explain the difference between a single stage and a multi-stage sales tax. Tests learning outcome A (i).

(b) Tests candidates’ ability to explain in the role of external auditor whether or not three

decisions made by the management of the entity concerned were correct and appropriate. Tests learning outcome B (vii).

(c) Tests candidates’ ability to calculate the effective rate of interest of a customer discount to

encourage early payment and to identify other methods the entity concerned could use to reduce its outstanding trade receivables. Tests learning outcome D (iii).

(d) Tests candidates’ ability to calculate three amounts, in regard to a contract, to be shown

in the financial statements of the entity concerned. Tests learning outcome C (v). (e) Tests candidates’ ability to define “overtrading” and to explain both the problems and

corrective actions to the entity concerned. Tests learning outcome D (i). (f) Tests candidates’ ability to identify three uses of a bill of exchange and to calculate the

maximum price of such a bill that the investor concerned should pay. Tests learning outcome D (x).

Section C – Question Three – Compulsory Question Three tests candidates’ ability to prepare (from information provided in the question scenario) a cash flow statement (indirect method) and a statement of changes in equity for the entity concerned, together with some specific accounting adjustments. The financial statements should be in a form suitable for publication and in accordance with applicable International Financial Reporting Standards in their 2008 form and content. Tests learning outcomes A (viii), C (i) and C (ii).

May 2009 P7

25

P7 – Financial Accounting and Tax Principles

Examiner’s Answers

SECTION A Answers to Question One 1.1 Going concern and accruals based accounting 1.2 B 1.3 C 1.4 D 1.5 B 1.6 A 1.7 C Cost $14,000 Excise duty $3,000 $17,000 VAT @ 15% $2,550 $19,550 Taxes paid $3,000 + $2,550 = $5,550 = C 1.8 A 1.9 D 1.10 To enable the auditor to express an opinion as to whether the financial statements give a

true and fair presentation of the entity’s affairs.

May 2009 P7

26

P7 May 2009

27

1.11 Total payments 4 x $12,000 = $48,000 over 5 years = $48,000/5 = $9,600 per annum $9,600 charge to profit in each of the two years 1.12 A 1.13 $000 Inventory used in production 331 Adjustment for increase in inventory 2 333 Add reduction in trade payables 7 Forecast cash required 340 1.14 Invested for 2·5 years, interest payable half yearly = 5 periods ((1 + 0·02)5 – 1) x 100 = 10·408% Balance in account, including original deposit $50,000 x 1·1041 = $55,204 1.15 Tax WDV NBV Cost 220·0 220·0 First year to 31/3/08 66·0 27·5 154·0 192·5 1/4/08 revaluation - 50·0 154·0 242·5 To 31/3/09 30·8 34·6 * 123·2 207·9 * 242·5/7 = 34·6

Deferred tax balance carried forward is difference between net book value and tax written down value at the year end.

207·9 - 123·2 = 84·7 @ 25% = 21·175 Movement calculated as difference between opening and closing balance: Opening balance 66·0 - 27·5 = 38·5 at 25% = 9·625 Closing balance = 21·175 Movement = 9·625 - 21·175 = 11·55 1.16 Trade receivable turnover 12/48 x 365 = 91·25 days Trade payable turnover (8/(48 x 0·75)) x 365 = 81·11 days Inventory turnover 91·25 + Inventory Turnover - 81·11 = 57 10·14 + Inventory Turnover = 57 Inventory Turnover = 46·86 ≈ 47 days

SECTION B Answers to Question Two (a) (i) Governments apply specific excise duties:

• to discourage over-consumption of products which may harm the consumer or others, for example, duty on tobacco and alcohol;

• to alter the distribution of income by taxing “luxuries”, for example, airline tickets;

• to seek to allow for externalities, so that the social and environmental cost of consuming the product is paid for by the consumer, for example, excise duty on tobacco to help pay for the increased cost of healthcare of smokers;

• to place the burden of paying the tax on the consumer of the product/service, for example, excise duty on petrol and diesel is used by some governments to build and maintain roads, bridges and mass transit systems.

(ii) A single stage sales tax charges tax at a single rate on all sales at one level of the

production/sales cycle. The most common is at the point of sale to a customer. A single stage sales tax does not normally allow credit for taxes paid on transfers between entities.

A multi-stage sales tax charges tax on all transfers between entities. This could include a manufacturer selling goods to a wholesaler, a wholesaler selling goods to a retailer or a retailer selling goods to a customer.

A cumulative or cascade tax does not allow refunds and tax paid at each level is included in expenses. VAT is an example of a multi-stage sales tax that allows for tax paid on purchases to be reimbursed, traders recovering all of the tax that they have paid. In these systems, the entire tax burden is usually passed on to the consumer.

(b) (i) Agree that item 1 is not material, $500 is less than 0·01% of revenue and is 0·3% of profit.

The adjustment can be made in the current year. Item 2 development expenditure is covered by IAS 38 Intangible assets, the deferred development expenditure must be charged to profit or loss as soon as the expenditure ceases to meet the IAS 38 criteria for deferral. Therefore agree that the $600,000 should be charged to profit or loss in the year ended 30 April 2009.

(ii) IAS 37 Provision, contingent liabilities and contingent assets requires decommissioning costs to be recognised immediately the liability arises, which is usually immediately the facility starts to operate. HF should create a provision for the total $5,000,000 decommissioning costs, discounted to present value, and add it to the cost of the asset. This will increase depreciation charged to profit or loss and will be a material increase in the net asset value.

If the directors do not agree to change the treatment of the decommissioning costs an “except for” qualified audit report will need to be issued. All matters are correct except for the treatment of the decommissioning costs.

May 2009 P7

28

P7 May 2009

29

(c) Effective interest rate on discount is: (i) 60 – 14 = 46

365/46 = 7·935 1 + r = (1000/975)7·935

1 + r = 1·222 r = 22·2%

(ii) Other methods that HX could use to reduce the level of trade receivables include: • Offer alternative, faster methods of payment, such as direct transfer;

• Immediately implement strict adherence to credit period for new customers, while reviewing its debt collection policy for current customers. Check that the policy is being implemented, for example find out why the credit given is 30 days and the time taken to pay is 60 days. Is this bad management of the debt collection department?

• Consider factoring receivables.

• Charge interest on overdue balances. (d) HS Construction contract $000 Total revenue 300 Total costs (170 + 100) 270 Total profit 30 Stage of completion: 165/300 = 55% Contract 55% complete therefore recognise in income statement: Revenue 165·0 Profit 30 x 55% = 16·5 Contract costs that relate to future activity: Cost incurred to date 170·0 Less cost recognised 270 x 55% = 148·5 21·5 Unbilled contract revenue: Revenue recognised 165 Less progress payments received 130 35·0 Gross amount due from customer 56·5 Recognise in balance sheet under current assets: Gross amount due from customer 56·5 Alternative workings for amount due from customer: Cost 170·0 Profit 16·5 186·5 Less receipts 130·0 56·5

(e) (i) Overtrading usually means rapid expansion of the business that is supported by short-

term funding. If HL is overtrading, you would expect the following to occur: • rapid increase in revenue;

• increasing inventory and receivables and payables leading to an increase in current and non-current assets;

• increase in assets (current and non-current) funded by short-term credit;

• current liabilities exceed current assets and there is a decrease in both current and quick ratios.

(ii) Possible solutions include: • issuing more equity shares; • raising more long-term loan funds; • reducing inventory by improving inventory management; • reducing outstanding payables by factoring receivable balances or speeding up collecting

of outstanding balances; • using cash raised to reduce payables. (f) (i) A bill of exchange can be used as follows:

• to obtain cash, by holding the bill until the due date and collecting the money;

• arrange to transfer the benefit of the bill to the bank in exchange for immediate cash. The bank will make a charge for what is effectively a loan, so the amount received by the supplier will be less than the face value of the bill. This is called “discounting” the bill of exchange with the bank;

• transfer the bill to his/her own supplier in settlement of the debt. That supplier may in turn pass the bill to one of his/her own suppliers, discount it or hold it to maturity.

When the due date of the bill arrives, the person holding it at that time presents it to the original acceptor for payment.

(ii) Price is face value discounted to present value

Discount is 91/365 x 7% = 0·01745 Price is calculated using 1 – 0·01745 = 0·98255

Price = $1,000 x 0·98255 = $982·55

May 2009 P7

30

P7 May 2009

31

SECTION C Answer to Question Three (a) The accounting adjustments required by HZ to clear the suspense account are that the preferred shares will be classified as non-current liabilities according to IAS 32. The value of the preferred shares will be credited to non-current liabilities – preferred shares $1,000,000 and debited to suspense. Adjusted profit before tax $000 Per draft income statement 305 Less write off of development expenditure (170) Add back preferred share issue costs 70 Less preferred share finance cost (930 x 6·72%) (62) Profit before tax 143 HZ – Cash Flow Statement for the year ended 31 March 2009 $000 $000Cash flows from operating activities Profit before tax 143 Adjustments for: Depreciation 940 Development expenditure 170 Impairment of goodwill (W1) 133 Provision for legal claim 120 Finance cost (W2) 122 Gain on disposal of non-current tangible asset (W3) (30)Operating profit before working capital changes 1,598 Increase in inventory (140)Increase in trade receivables (379)Increase in trade payables 179 (340)Cash generated from operations 1,258 Interest paid (W4) (206)Income taxes paid (W6) (250) (456) Net cash from operating activities 802 Cash flows from investing activities Purchase of property, plant and equipment (W7) (480)Development expenditure (W8) (28)Proceeds from sale of equipment 128 Net cash used in investing activities (380) Cash flows from financing activities Proceeds from issue of share capital (W9) 605 Proceeds from issue of preferred shares (W10) 930 Repayment of loans (1,250)Equity dividends paid * (290) Net cash used in financing activities (5)

Net increase in cash and cash equivalents 417 Cash and cash equivalents at 1 April 2008 300Cash and cash equivalents at 31 March 2009 717

* this could also be shown as an operating cash flow (c)

HZ Statement of changes in equity for the year ended 31 March 2009

Equity Shares

Share Premium

Revaluation Reserve

Retained Earnings

Total

$000 $000 $000 $000 $000 Balance at 1 April 2008 2,470 530 400 1,840 5,240 New share issue 403 202 605 Loss for period (see Note 1) (39) (39) Gain on revaluation 162 162 Dividend paid (290) (290) Balance at 31 March 2009 2,873 732 562 1,511 5,678 Note 1 Revised profit before tax (own figure) 143 Tax (182) Loss for period (39) Workings, all figures in $000 W1 – Goodwill Balance b/fwd 350Impaired in year (balance) 133Balance c/fwd 217 W2 – Finance cost Balance per Income Statement 60Preferred shares finance charge 62Balance c/fwd 122 W3 – Gain on disposal of property plant and equipmentNet book value of assets sold 98Cash received 128Gain 30 W4 – Interest paid Balance b/fwd 113Income statement 60 173Balance c/fwd 17Interest paid 156Preferred shares dividends paid (classified as interest per IAS 32) 50 206

May 2009 P7

32

P7 May 2009

33

W5 – Deferred Tax Balance b/fwd 250Income Statement (to balance) 62Balance c/fwd 312 W6 – Income Taxes paid Balance b/fwd 247 Income Statement – total 182 Less deferred tax (W5) 62 120 367 Tax paid (balance) (250)Balance c/fwd 117 W7 – Purchase of property, plant and equipment Balance b/fwd 6,250 Disposals (NBV) (98) 6,152 Revaluation (562 - 400) 162 6,314 Depreciation for year (940) 5,374 Balance c/fwd 5,854Total PPE purchased in year 480 W8 – Development expenditure paid in year Balance b/fwd 170 Balance c/fwd 198Paid in year 28 W9 – Proceeds from issue of equity share capital Shares 806 x 0·5 = 403 Share premium 806 x 0·5 x 0·5 = 202Received 605 W10 – Proceeds from issue of preferred share capital Issue of preferred shares 1,000 Less issue costs 70Received 930