elliottv10

Instructor’s Manual Financial Accounting & Reporting Tenth edition Barry Elliott and Jamie Elliott For further instructor material please visit:

www.pearsoned.co.uk/elliott ISBN 0 273 70365 X

 Pearson Education Limited 2006

Lecturers adopting the main text are permitted to download the manual as required.

1 © Pearson Education Limited 2006

Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 2006 ©Pearson Education 2006 The rights of Barry Elliott and Jamie Elliott to be identified as authors of this Work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN: 0 273 70365 X All rights reserved. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, 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, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP.


Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual

Contents Chapter 1

4

Chapter 2

13

Chapter 3

25

Chapter 4

38

Chapter 5

58

Chapter 6

64

Chapter 7

67

Chapter 8

73

Chapter 9

89

Chapter 10

109

Chapter 11

114

Chapter 12

130

Chapter 13

136

Chapter 14

143

Chapter 15

149

Chapter 16

153

Chapter 17

162

Chapter 18

172

Chapter 19

181

Chapter 20

189

Chapter 21

196

Chapter 22

211

Chapter 23

215

Chapter 24

233

Chapter 25

242

Chapter 26

253

Chapter 27

265

Chapter 28

275

Chapter 29

301

Chapter 30

318

Chapter 31

320

Chapter 32

329



CHAPTER 1

Chapter 1: Question 1 – Jane Parker (i)

Cash budget (£000) Jan

Initial capital

Feb

Mar

150.00

Customers Total receipts

Apr

May

June

82.50

Total 232.50

.

.

.

.

60.00

75.00

135.00

150.00

.

.

82.50

60.00

75.00

367.50

Machinery

30.00

30.00

Motor vehicles

24.00

24.00

Premises

75.00

75.00

Drawings

1.20

Suppliers Rates

1.20

1.20

1.20

1.20

1.20

7.20

30.00

48.00

60.00

60.00

60.00

258.00

1.20

Wages

2.25

1.20

2.25

2.25

2.25

2.25

2.25

13.50

0.75

0.75

0.75

0.75

0.75

3.75

.

.

.

.

.

2.10

2.10

132.45

35.40

52.20

64.20

64.20

66.30

414.75

17.55

(35.40)

(52.20)

18.30

(4.20)

8.70

Balance b/f

–

17.55

(17.85)

(70.05)

(51.75)

(55.95)

Balance c/f

17.55

(17.85)

(70.05)

(51.75)

(55.95)

(47.25)

General expenses Insurance Total payments Net cash flow

(ii)

(47.25)

Cash flow summary statement (£000) Realised operating cash flows for the period ended 30 June 20X1

Receipts from customers

135.00

Payments to: Suppliers

258.00

Rates

1.20

Wages

13.50

General expenses

3.75

Insurance

2.10 278.55 (143.55)



For information only Statement of financial position as at 30 June 20X1 £000 Capital – introduced

232.50

– withdrawn Net operating cash flows

(7.20) :Realised :Unrealised

(143.55) (7.80) 73.95

Premises (NRV)

75.00

Vehicles (NRV)

19.20

Machinery (NRV)

27.00

Net cash balance

(47.25) 73.95

(iii)

Further information re Jane Parker (a) Nature of business linked to Parker’s business background, technical ability, special skills, know how, existing/terminated business involvement, contacts, associates, related parties. (b) Type of business unit to be used and rationale for its selection. (c) Sources of long and short-term capital. (d) Products’ life cycle, cash flow projections over product life cycle. (e) Initial investment in fixed assets and their terminal value at the end of the life cycle. (f) Parker’s attitude to risk and how this affects the choice of discount rate and payback period.



Chapter 1: Question 2 – Mr Norman (a)

Purchases budget (£000) Jan

Feb

Mar

Apr

May

June

15.00

20.00

35.00

40.00

40.00

45.00

Gross profit

3.00

4.00

7.00

8.00

8.00

9.00

Purchases

12.00

16.00

28.00

32.00

32.00

36.00

12.00

16.00

28.00

32.00

32.00

Sales

Payments

Notes: •

This is a start-up situation.

•

Purchases = projected sales less a gross margin on sales at 20%.

•

Goods are bought in month of sale; assume stocks remain constant.

(b)

Cash flow statement (£000) Jan

Initial capital

7.50

Credit Sales

Rent and rates

Mar

Apr

May

June

50.00

Cash Sales

Premises

Feb

50.00 10.00

17.50

20.00

20.00

22.50

97.50

-

7.50

10.00

17.50

20.00

20.00

75.00

57.50

17.50

27.50

37.50

40.00

42.50

222.50

80.00 2.20

Suppliers Commission

80.00 2.20

2.20

2.20

2.20

2.20

13.20

12.00

16.00

28.00

32.00

32.00

120.00

0.30

0.40

0.70

0.80

0.80

3.00

0.60

0.60

0.60

0.60

0.60

3.60

Wages

0.60

Insurance

3.50

-

-

-

-

-

86.30

15.10

19.20

31.50

35.60

35.60

(28.80)

2.40

8.30

6.00

4.40

6.90

(28.80)

(26.40)

(18.10)

(12.10)

(7.70)

(26.40)

(18.10)

(12.10)

(7.70)

(0.80)

Net cash flow Balance b/f Balance c/f

Total

(28.80)


3.50 223.30

(0.80)


(c)

Statements of operating cash flows and financial position Realised operating cash flows for the period ended 30 June 20X8 £000

Receipts from customers

172.50

Payments to: Suppliers

120.00

Rates

13.20

Wages

3.60

Commission

3.00

Insurance

3.50 143.30 29.20

Notes: •

The cash flow statement with summary attached is effectively a six-month cash budget showing the cash received, cash paid each month and the resulting month-end balances.

•

It is necessary to separate sales and purchase transactions into cash and on credit and to identify clearly the month of receipt and payment.

•

Commission is paid in the month after the sale is made, and all other cash flows are clearly indicated and allocated to specific months.

•

Note that the format of the cash flow statement brings out key figures – for management decision and control, e.g. •

Month-end balances – assists in the control of liquidity

•

cash deficiencies – identifies how much must be financed

•

early warning – allows management to approach appropriate sources

•

cash surpluses – identifies amounts to be invested on best terms. Statement of financial position as at 30 June 20X8 £000

Capital – introduction Net operating cash flows

50.00 :Realised :Unrealised

29.20 (4.00) 75.20

Premises (NRV)

76.00

Net cash balance

(0.80) 75.20



Notes: •

This statement shows net assets of £75,200 •

make up: premises £76,000 less the negative cash balance £800.

•

The negative cash balance indicates need for overdraft arrangements.

•

The statement is based on cash flow concept •

it ignores accrual-based figures (£36,900 less £25,250)

•

accruals are not regarded as real assets and liabilities

•

critics of the cash flow concept would maintain that its utility has therefore been seriously diminished.

(d) •

Letter to bank requesting an overdraft facility should include The maximum overdraft facility of £28,800 •

required at the end of January

•

will be eliminated by July

•

Overdraft will fall progressively as per the cash budget.

•

It might be practical to request a limit of £30,000

•

•

for the full six-month period

•

reducing to £15,000 thereafter to allow for contingencies. The facility only to be called on as required.

Refer to the Cash Budget to support the request •

confirm that it is based on the most likely scenario

•

agree a repayment schedule.

•

Specify that collateral security is available in form of premises if it should be required.

•

If not an existing customer •

give outline details of business background

•

explain future plans.



Chapter 1: Question 3 – Fred and Sally (i) (a) Decision to close in winter April Opening balance Sales (Wk1)

May

June

July

Aug

Sept

Oct

Nov

Dec

Jan

Feb

£

£

£

£

£

£

33,660

34,660

35,660

36,660

33,660

34,660

35,660

36,660

£

£

£

£

£

£

100

12,100

29,860

35,120

40,380

45,640

14,000

19,760

19,760

19,760

19,760

19,760

10,000

10,000

10,000

10,000

10,000 10,000

59,620

64,880

70,140

75,400

66,660 55,160

Boards (custom-built) 14,100

31,860

50,900 45,160

March

5,760

Salary in Lanzarote: Fred and Sally: income

500

500

500

500

500

500

Staff: income

500

500

500

500

500

500

34,660

35,660

36,660

37,660

Purchases

16,000

16,000

16,000

16,000

16,000

16,000

6,500

6,500

6,500

6,500

6,500

6,500

Materials for boards (custom-built)(Wk2) Wages

1,000

1,000

1,000

1,000

1,000

1,000

Rent

500

500

500

500

500

500

Misc. costs

500

500

500

500

500

500

12,100

29,860

35,120

40,380

45,640

50,900

45,160 33,660

£ Wk1 (£120,000/6)

= –

20,000

Wk 2 Under this alternative

6,000 (paid by credit card)

Materials

14,000 (cash received in month) +

£500

Sails (not Dryline)

5,760 (last month’s credit card sales less 4%) 19,760 9 © Pearson Education Limited 2006

Per board 150

650 × 10 = £6,500

Total


(i) (b) Decision to remain open in winter and keep Dryline agency

Opening balance Sales

April

May

June

£

£

£

July £

Aug

Sept

£

£

100 11,5839,41017,237 24,064

30,891

37,718

14,000 19,76019,76019,760 19,760

5,760

5,760

576 Boards

1,000

Oct

Nov

Dec

Jan

Feb

£

£

£

£

£

38,761

37,994

37,227

1,976

1,976

1,976

1976

1,000

1,000

1,000

42,504

41,737

40,970

40,203

32,295 40,528

10,000

£

5,760 1,400

1,000

March

10,000

10,000

10,000

10,000 10,000

1,000

Purchases (Wk3/4)

15,676 32,343

40,170

46,997

53,824

60,651

54,878 44,271

1,493 14,933

14,933

14,933

14,933

14,933

14,933

1,493

1,493

1,493

1,493

1,493

Boards

600

6,000

6,000

6,000

6,000

6,000

6,000

600

600

600

600

600

Wages

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

Rent

500

500

500

500

500

500

500

500

500

500

500

500

Misc costs

500

500

500

500

500

500

150

150

150

150

150

150

11,583

9,410

17,237

24,064

30,891

37,718

32,295 40,528

38,761

37,994

37,227

36,460

Closing balance Wk 3

Non Dryline

Dryline

Wk4 20,000 ×

2,000 ×

60%

60%

12,000 ×

1,200 ×

80%

80%

9,600 + 8,000 × 2/3

960 + 800 × 2/3

5,333

533

14,933

1,493 10 © Pearson Education Limited 2006


Notes supporting (i) (a) Assuming closure during the winter months means that: •

there are no sales from October to March

•

salaries of £1,000 per month are received from October to March

•

a start-up situation arises each April with consequential effect on cash from sales of both custom-built and non-custom-built boards.

Cash from sales is calculated as follows: Non-custom-built (i) 70% received immediately (ii) 30% via credit card finance less 4% (£6,000 – 240)

= =

14,000 5,760 19,760

However, only £14,000 is received in first month and £5,760 in October. Custom-built Received per month – two months in arrears

=

£10,000

Cash payments are calculated as follows: Non-custom-built 80% of the sales value is paid two months after purchase Custom-built Materials cost £650 each; total £6,500 per month; paid 2 months after purchase Other fixed costs Wages, rent, miscellaneous costs at uniform monthly rate of £2,000 for 6 months Projected cash balances show an upward trend to September and then they fall away. Notes supporting (i) (b) Cash receipts are calculated as follows: Non-custom-built Receipts are in two cycles: April to September and October to March. April cash received is £14,576 made up of 70% of £20,000 being the April sales plus 96% of March’s credit card sales (i.e. 96% of £600). From May to September (inclusive) cash receipts will be the same as calculated on the closure assumption i.e. £19,760 per month. October receipts are £7,160 i.e. £5,760 from September plus £1,400 from October sales with £1,976 again for five subsequent months. Custom-built Cash receipts from June to November will be £10,000 per month as under the closure assumption.



In the winter months there will be a further £6,000 except that customers took an unexplained average of three months in winter, receipts are nil in December. Cash payments are calculated as follows: Non-custom-built From May to October purchases are £14,933 and 10% of this for the remaining six months Custom-built As for closure assumption Other fixed costs Wages, rent, miscellaneous costs at uniform monthly rate of £2,000 for 6 months

(ii)

Additional information required in order to advise

At first glance closing in the winter generates more cash but: 1. What about loss of future earnings from Dryline? 2. Is there any potential damage to customer goodwill? 3. Will this allow competition to creep into market? Notes relating to part (a): •

This is a start-up situation.

•

Purchases = projected sales less a gross margin on sales at 20%.

•

Goods are bought in month of sale; assume stocks remain constant.

We need to know more about the business e.g: •

•

Objectives •

What are Fred/Sally’s objectives?

•

Is it a short-term pleasant lifestyle with high income, or long-term market maximisation?

Demand •

state of market

•

whether demand for Dryline sails is expanding or contracting

•

possibility of other agencies

•

possibility of opening in other areas

•

possibility of increasing winter sales

•

higher profile for custom-made boards e.g. outline in Lanzarote

•

whether or not the custom-made boards are independent of the rest of the business i.e. a different market.



CHAPTER 2

Chapter 2: Question 1 – Jane Parker (a)

Cash budget (€000) Jan

Initial capital

Feb

Mar

Apr

May

150.00

Customers Total receipts

150.00

June

Total

75.00

225.00

60.00

75.00

75.00

210.00

60.00

75.00

150.00

435.00

Machinery

30.00

30.00

Motor vehicles

24.00

24.00

Premises

75.00

75.00

Drawings

1.50

Suppliers

1.50

1.50

1.50

1.50

1.50

9.00

30.00

48.00

60.00

60.00

60.00

258.00

2.25

2.25

2.25

2.25

2.25

13.50

0.75

0.75

0.75

0.75

0.75

3.75

26.40

26.40 439.65

Rates Wages

2.25

General expenses Insurance

Net cash flow Balance b/f

132.75

34.50

52.50

64.50

64.50

90.90

17.25

(34.50)

(52.50)

(4.50)

10.50

59.10

17.25

(17.25)

(69.75)

(74.25)

(63.75)

(17.25)

(69.75)

(74.25)

(63.75)

(4.65)

–

Balance c/f

17.25

(4.65)

All balances are overdrawn except for January 20X1

o/d

Feb

Mar

Apr

May

June

17.25

69.75

74.25

63.75

4.65

Note: No entries will be made for the 20X0/X1 local taxes that are paid in Feb 20X2 – this situation arose because Jane Parker had assumed that the business would only pay the taxes from the start of the tax year e.g. 1.4.20X1. However, there will be an entry in the profit and loss and balance sheet.



(b) Jane Parker – profit and loss account for six months ended 30.6.20X1 €000 Sales

€000

[60.00 + (5 × 75.00)]

435.00

Purchases

378.00

Closing inventory

(30.00)

Cost of sales

348.00

Gross profit

87.00

Wages

13.50

General expenses

4.50

Local taxes [1.1.X1 – 30.6.X1]

4.00

Insurance

13.20

Depreciation – Vehicles

2.40

– Machinery

1.50

39.10

Net profit

47.90

Budgeted balance sheet as at 30 June 20X1 Capital

225.00

Net profit

47.90

Less: Drawings

(9.00) 263.90

Non-current assets Premises Vehicles Less: Depreciation Machinery Less: Depreciation

75.00 24.00 2.40

21.60

30.00 28.50

1.50

Current assets Inventory trade receivables [3 × 75.00] Insurance

30.00 225.00 13.20

268.20



Current liabilities Trade payables

120.00

Local taxes [1.1.X1 – 30.6.X1]

4.00

Bank overdraft

4.65

General expenses

0.75

(129.40)

Net current assets

138.80 263.90

(c) Possible action to deal with exceeding agreed overdraft limit •

Approach bank to re-negotiate the overdraft or arrange a loan facility for an agreed term.

•

The amount and period that additional facilities are required depends on preparing a projected cash flow statement for a longer period taking into account future plans e.g. owner’s drawings requirement, any additional capital expenditure.

•

In particular, consider alternatives such as: –

leasing vehicles and/or machinery

–

mortgaging the property

–

getting debts in quicker

–

introducing more capital

–

obtaining or providing loan capital.



Chapter 2: Question 2 – Mr Norman (a)

Purchases budget ($000)

Sales units

Jan

Feb

Mar

Apr

May

Jun

1.65

2.20

3.85

4.40

4.40

4.95

0.55

0.96

1.10

1.10

1.24

– Closing inventory + Closing inventory

0.55

0.96

1.10

1.10

1.24

1.38

Purchases units

2.20

2.61

3.99

4.40

4.54

5.09

Purchases

Sales

$000

$000

Jan

(2,200 × 40)

88.00

82.50

(1,650 × 50)

Feb

(2,610 × 40)

104.40

110.00

(2,200 × 50)

Mar

(3,990 × 40)

159.60

192.50

(3,850 × 50)

Apr

(4,400 × 40)

176.00

220.00

(4,400 × 50)

May

(4,540 × 40)

181.60

220.00

(4,400 × 50)

Jun

(5,090 × 40)

203.60

247.50

(4,950 × 50)

913.20

1,072.50

(b)

Cash flow forecast (£000) Jan

Initial capital

150.00

Cash Sales

41.25

Credit sales 191.25 Premises

Insurance Total payments

Apr

May

June

150.00 55.00

96.25

110.00

110.00

123.75

536.25

41.25

55.00

96.25

110.00

110.00

412.50

96.25

151.25

206.25

220.00

233.75

1098.75 80.00

2.20

3.85

4.40

4.40

16.50

88.00

104.40

159.60

176.00

181.60

709.60

8.00

8.00

8.00

8.00

8.00

8.00

48.00

17.00

17.00

17.00

17.00

17.00

17.00

102.00

0.35

0.35

105.35

114.65

131.60

188.45

205.40

211.00

85.90

(18.40)

19.65

17.80

14.60

22.75

Balance b/f

–

85.90

67.50

87.15

104.95

119.55

Balance c/f

85.90

67.50

87.15

104.95

119.55

142.30

Net cash flow

Total

1.65

Suppliers Wages

Mar

80.00

Commission Administration

Feb


956.45


(c)

Budgeted profit and loss account for six months ended 30 June 20X8 $000

$000

Sales

1072.50

Purchases

913.20

Closing inventory [1,380 units × £40]

(55.20)

Cost of sales

858.00

Gross profit

214.50

Wages

102.00

Administration

48.00

Commission [2% of 1072.50]

21.45

Insurance

0.18

Amortisation of lease

8.00 179.63

Net profit

34.87

Budgeted balance sheet as at 30 June 20X8 $000 Capital

$000 150.00

Net profit

34.87 184.87

Non-current assets Leasehold premises

80.00

Less amortisation

(8.00) 72.00

Current assets Inventory

55.20

Trade receivables

123.75

Prepayments – insurance Cash

.17 142.30 321.42

Current liabilities Trade payables Commission

203.60 4.95 208.55

Net current assets

112.87 184.87



(d)

Investment of surplus funds

•

Acid test ratio At the end of the first six months’ trading Norman’s balance sheet shows that the acid test ratio is 1.28:1 (266.22/208.55) – this is higher than the basic 1:1 ratio but it should be compared with that of similar businesses in the same industry to establish a norm. It would appear however that the business has surplus funds to invest.

•

Amount to invest A projected cash flow statement is required taking into account future plans re owner’s drawing requirements, future capital commitments and working capital criteria e.g. debtor collection and creditor payment terms.

•

Period to invest The projected cash flow will give an indication of the period of the investment e.g. it could range from overnight on the money market to term investments.

The important aspect is that the owner should be aware of the projected cash flows so that return on surplus funds can be maximised.



Chapter 2: Question 3 – The Piano Warehouse Company Limited (a) Conventional profit calculation (i)

(ii)

4 sold £

2 part made

£

Sales

(iii) 2 repaired/sold

£

£

8,000

3,000

Materials

2,000

900

1,800

Labour

2,800

800

400

800

100

5,600

1,800

2,200

–

1,800

–

Overheads Cost of production Less: inventory

£

Cost of sales

5,600

2,200

Profit

2,400

800

Comments on profit calculation: (i) (ii)

4 pianos sold: profit is simply sales less cost. 2 partly completed pianos: •

No profit has been recognised

•

Delay recognition until sale to comply with matching concept

•

Work-in-progress carried forward. Ō Match with revenue when sales take place

(iii)

Ō presumably in the following year. Rebuilt pianos: profit has been taken in full •

Assumes no default on hire purchase payments.

•

An alternative procedure that could be considered would be to Ō provide for unrealised profit on instalments outstanding Ō create a provision of £533 [2/3 of £800] Ō this reduces profit from £800 to £267 [1/3 of £800].

(b)

It has been assumed that •

the work-in-progress is held at cost; and

•

no profit has been recognised.

•

The payment in advance of £900 will be shown as a creditor in the balance sheet.



Given the facts that •

there is an assured market for work-in-progress; and

•

the pianos are 50% complete

a case could be made out for attributing a % of the total profit of £900 (£4,500 – £ 3,600 estimated cost to produce). Except in the simplest cases, the matching process can be highly subjective. The conventional approach is to recognise revenue •

at the point of sale or, alternatively

•

on completion of production or receipt of payment.

The core determinant is the identification of the completion of the earnings cycle as signalled by a critical event e.g. production, delivery, receipt of payment. Applying these alternatives to The Piano Warehouse Company and assuming the critical event is: (i) On sale/delivery Recognise profit from the sale of 4 pianos (ii) During production Recognise profit from the 50% complete pianos (iii) On receipt of payment Restrict the profit from the 2 rebuilt pianos to the proportion of cash received. A more detailed consideration in IAS 18 relating to the sale of goods suggests the critical event for revenue recognition hinges on 2 conditions:

(c)

(d)

•

There has been a transfer to the buyer of the significant risks and rewards of ownership, and

•

no significant uncertainty exists concerning the sale price, costs, likelihood of rejection and return.

The significant cost conventions are: •

Accruals for recognising profit

•

Matching for associating costs incurred and to be incurred in arriving at a profit figure

•

Prudence in attributing/not attributing profit on work-in-progress.

The profit for the year could be increased by the recognition of a proportion of the profit on the two pianos in the course of production with an estimate of the amount earned to date. The maximum figure would normally be £450 [50% of the estimated total profit] but this would be dependent upon being reasonably certain that the future costs will not exceed the estimate. Conversely, it could be argued that the £800 profit on the rebuilt pianos should be reduced to £267.



Chapter 2: Question 4 – FRRP and Wiggins Group FRRP membership The Chairman of the Panel is Richard Sykes QC and the Deputy Chairman Matthew Patient CBE. There are currently 15 other Panel members drawn from a broad spectrum of commerce and the professions. Individual cases are normally dealt with by specially constituted groups of 5 or more members.

FRRP remit The remit of the Financial Reporting Review Panel is to examine the annual accounts of public and large private companies to see whether they comply with the requirements of the Companies Act 1985. Within this framework a main focus is material departures from accounting standards where such a departure results in the accounts in question not giving a true and fair view as required by the Act.

Action if accounts are defective Where a company’s accounts are defective the Panel will, wherever possible, endeavour to secure their revision by voluntary means, but if this approach fails it is empowered to make an application to the court under section 245B of the Companies Act 1985 for an order compelling their revision. To date no court applications have been made, though in some instances the necessary steps have been at an advanced stage.

FRRP is reactive not proactive The Panel does not itself monitor or actively initiate scrutinies of company accounts for possible defects, but acts on matters drawn to its attention, either directly or indirectly. The Panel’s responsibilities do not extend to the directors’ report, summary financial statements or interim statements.

Wiggins: Revenue recognition Company policy It is the company’s accounting policy to recognise revenue in respect of commercial property sales on exchange of contract. In the 1999 accounts however, two sales had been recognised on the basis of non-binding heads of agreement and a third in respect of a contract dated after the end of the 1999 accounting period. In the 2000 accounts, the directors accepted that these treatments were not appropriate and adjusted the 1999 comparatives by the £21.5m turnover incorrectly recognised.



FRRP questions raised re contracts In those accounts, the directors did not address other concerns previously expressed by the Panel in connection with these contracts. One of the contracts was conditional upon the company obtaining planning permission on terms satisfactory to the purchaser without which he had certain rights not to proceed. A second contract had the appearance of a financing transaction rather than an outright sale which, under FRS 5, should not be recognised until the risks and rewards of ownership pass at a future date. In the particular circumstances, the Panel was of the view that neither contract could be recognised in the 2000 accounts. The directors have now accepted the Panel’s view and, in the revised accounts, have adjusted for these and other sales in earlier years, applying the same principles. Revenue recognition

Company policy in 1999 accounts The 1999 accounts contained an accounting policy for turnover in the following terms: ‘Commercial property sales are recognised at the date of exchange of contract, providing the Group is reasonably assured of the receipt of the sale proceeds.’

FRRP accepted policy in itself was not objectionable The Panel accepted that this wording was similar to that used by many other companies and was not on the face of it objectionable. In reviewing the company’s 1999 accounts the Panel noted that the turnover and profits recognised under this policy were not reflected in similar inflows of cash; indeed, operating cash flow was negative and the amount receivable within debtors of £46m represented more than the previous two years’ turnover of £44m. As a result, the Panel enquired into the detailed application of the policy.

FRRP enquired into detailed application of the policy where contracts not exchanged This enquiry established that revenue in respect of the sale of Manston Park and the Northern Grass area of Manston Airport had been recognised at 31 March 1999 on the strength of nonbinding Heads of Agreement which were not turned into contracts until 29 July 1999. The enquiry also established that the sale contract for Fairfield had not been signed until 1 April 1999. In the Panel’s view the manner in which these transactions had been accounted for was not in accordance with the stated accounting policy and was unacceptable. The Panel also expressed its concern that the chairman’s statement for 1999 compounded the error in the accounts by stating that during the year the most important achievements were the exchange of contracts with MEPC for the sale and development of Manston Park and London Manston Airport when the contract with MEPC for Manston had, in fact, not been exchanged during that year.



Company response The company accepted that the 1999 accounts were in error in respect of these transactions and decided to recognise turnover on exchange of contracts in accordance with its stated accounting policy which it did in the 2000 accounts by amending the 1999 comparatives.

FRRP enquired into detailed application of the policy where contracts were exchanged However, the Panel had also questioned whether it would be correct to recognise revenue in respect of two of these transactions even after the contracts had been exchanged in the following year. The contract for the sale of Fairfield, concluded on 1 April 1999, was conditional upon the company’s subsequent fulfilment of a material condition: namely, that planning permission had been obtained on terms satisfactory to the purchaser and without which the purchaser had certain rights not to proceed. Furthermore, the contract for the sale of the Northern Grass area of Manston appeared to have the characteristics of a financing deal rather than an outright sale and, under FRS 5, should not be recognised until the risks and rewards of ownership pass at a future date. The company’s decision to recognise turnover and profit in respect of the conditional Fairfield contract and the Northern Grass transaction in its 2000 accounts was made without discussion with the Panel and in spite of the Panel’s reservations. The directors justified their recognition of revenue from the sale of Fairfield on the basis that they believed the planning permission was ‘virtually certain’ to be obtained in due course. The Panel noted that the company had first recognised revenue in respect of Fairfield in its 1997 and 1998 accounts and had had to reverse those amounts in its original 1999 accounts when the contracts had lapsed. The contracts signed on 1 April 1999 replaced these original contracts. On the principle of reflecting sales of property that are subject to planning permission, the Panel had two main concerns, which are interrelated. The first is that, if the company has still to perform a significant amount of work in order to satisfy the condition, it has not yet completed the earning process sufficiently to entitle it to recognise the revenue at the balance sheet date. The second is that the outcome of a conditional contract is necessarily uncertain, and unless that uncertainty has been reduced to an acceptable level by the time that the accounts have been finalised, in general, the prudent course would be not to recognise the conditional contract until the condition is satisfied. The Panel accepts that there may be specific instances where it might be appropriate to recognise a sale even though it remains conditional; for example, where all the work required to satisfy the conditions has been performed and the relevant costs have been incurred before the year-end and the relevant conditions satisfied before the accounts are issued, it may be reasonable to recognise the sale. Those basic steps had not been effected in the case of Fairfield before the 2000 accounts were issued. The company has now accepted the Panel view. The amount of turnover recognised in the 2000 accounts in error and now to be corrected amounts to £37m.

Revisions required to the accounts – turnover restated As indicated in its interim statement, the company has also acknowledged that applying these principles, £2.34m turnover included in the 1996 accounts and subsequently reversed in 1997



and 1998 should not have been recognised in the 1996 accounts. The accounts for 1996 to 1998 are being revised to correct these entries. A similar adjustment is being made by the company to its 1995 accounts.

Revisions required to the accounts – compliance with FRS 5 As to the sale of Northern Grass the Panel considered that the substance of the transaction reflected a development being financed by the purchaser with the company paying an interest cost on monies received from the purchaser and retaining certain risks and rewards for the time being. Accordingly, in compliance with FRS 5, the transaction should have been treated as a financing arrangement until the interest payments ceased, either on completion of the development or on 30 January 2002, whichever is the earlier. The company has now accepted the Panel view. The amount of turnover recognised in the 2000 accounts in error and now to be corrected amounts to £5m. Debtors The Companies Act 1985 requires the amounts of debtors that are receivable after more than one year to be separately disclosed. In the 1999 accounts £10m of the anticipated proceeds from the sale of Manston Park was wrongly included in debtors due within 12 months. The company agreed to correct this error in the 2000 accounts but in the event recognition of the sale was reversed in its entirety.



CHAPTER 3

Chapter 3: Question 1 – Jim Bowater (a)

Refer to Question 2 (a) below for description of underlying theory

(b)

Jim Bowater ideal economic income model:

Investment of £36,000, cost of capital 20% (i) Jim’s economic income (£) for each of the three years is: 31 Dec 20X5 6,828 31 Dec 20X6 6,695 31 Dec 20X7 6,833 (ii) Jim’s economic capital will be preserved at the 1 January 20X5 level of £34,144 provided: •

he reinvests excess actual income of £672 on 31 December 20X5 and £34,107 at 31 December 20X7, generating a return of 20%

•

an excess of actual income of £695 at 31 December 20X6 created, in effect, a cumulative injection of capital of (672 – 695) £23

•

to maintain his income of 20% p.a. will necessitate an investment of £34,167 from the proceeds of the proposed sale.

Workings (A) Ideal economic income (i.e. conditions of certainty) Period

C

Kt

Kt–1

Ye

C – Ye

20X5 t0 – t1

7,500

33,472 (b)

34,144 (a)

6,828

672

20X6 t1 – t2

6,000

34,167 (c)

33,472 (b)

6,695

(695)

20X7 t2 – t3

41,000

34,167 (c)

6,833

34,167

20,356

34,144

54,500 (a) t0 – t1

7,500 + 1.2

(b) t1 – t2

6,000 1.2

6,000 + 1.2

(c) t2 – t3

+

2

41,000

=

34,144

=

33,472

41,000 =

34,167

3

1.2

41,000 2

1.2

1.2



(B) Reinvestment under certainty to maintain 20% p.a. income Economic income from: original investment t0 – t1

6,828

t1 – t2

6,695 (20% 672)

t2 – t3

6,833 (20% 23)

reinvestment total –

economic income 6,828

133 (approx.)

6,828

(5) (approx.)

6,828



Chapter 3: Question 2 – Hicks’s Concept of Income; Spock (a)

Hick’s economic model of income and capital

Hicks’s economic model of income and capital is based on his concept of ‘welloffness’. •

Welloffness is: the maximum income enjoyed by the individual without depleting that individual’s capital stock.

•

It is based on the precept of consumption which embraces the opportunity for consumption as well as actual consumption.

•

As an extension of Fisher’s original model: it takes savings into account.

It is an ex ante model in that it usually measures expected income in advance of the time period concerned. •

Measurement of capital is necessitated in order to compute income.

•

Income is the difference between opening and closing valuations of capital stock.

•

The capital stock is computed by utilising the concept of present values.

•

This concept adopts the idea of compound interest in order to compensate for the time element between cash flows.

Limitations In the field of accountancy there are serious practical limitations in measuring the accountant’s version of income and capital e.g. •

Subjectivity: the present value factor, often referred to as the discount cash flow element, is subjective.

•

It requires the use of an interest rate and, as such, depending upon personal inclinations, it can utilise opportunity cost of capital, or the return on existing capital employed within a business entity, or contemporary short-term interest rates such as that charged on bank overdrafts, or the average rate pertaining in the current economic climate, or a speculative rate as assessed on the basis of perceived risk involved.

•

Unrealised and realised flows: the model uses a mix of unrealised and realised cash flows. As a measure it is thus not of practical value in determining taxation liability and dividend policy.

•

Financial strategy: attainment of flows as per a financial strategy is an integral part of the calculations. Targets are rarely achieved with precision. Variations from target destroy the model’s accuracy. Predictions are invariably unachievable with absolute accuracy.

•

Windfalls: windfall flows cannot be foreseen and consequently cannot be incorporated within the model.

•

Balance sheet values: balance sheet valuations of net assets or capital employed concern aggregations of individually valued assets and itemised liabilities. It is not easy to apply the concept of present values across a range of individual assets and liabilities for balance sheet discount purposes.



(b)

Calculate Spock’s ideal economic income using Hicks’s theorem Economic capital value of the business at KO

Year

Cash Flow

DCF Factor 1/(1+r)

PV

n

£

£

K1

400

0.909

364

K2

500

0.826

413

K3

600

0.751

451

400

0.751

300

1,900

1,528

Economic value at X0 i.e. the beginning of the year is £1,528 [Note: initial capital was £1,000 therefore subjective goodwill is £528]

Economic capital value of the business at K1 Year

Cash Flow

DCF Factor 1/(1+r)

PV

n

£

£

K1

400

1.000

400

K2

500

0.909

455

K3

600

0.826

496

400

0.826

330

1,900

1,681

Economic value at K1

= £1,681. So Y for Y1 = £1,681 – £1,528 = £153

Rate of income return

= £153 / £1,528 = 10%


Cash Flow

DCF Factor 1/(1+r)

PV

n

£

£

K1

400

1.100

440

K2

500

1.100

500

K3

600

0.909

546

400

0.909

363

1,900

1,849

Economic value at K2 = £1,849. So Y for Y2

= £1,849 – £1,681 = £168

Rate of income return = £168/£1,681 = 10%




Cash Flow

DCF Factor 1/(1+r)

PV

n

£

£

K1

400

1.121

484

K2

500

1.100

550

K3

600

1.000

600

400

1.000

400 2,034

1,900 Economic value at K3 = £2,034. So Y for Y3

= £2,034 – £1,849 = £185

Rate of income return = £185/£1,849 = 10% Note rate of income return is a constant 10%.



Chapter 3: Question 3 – Jason (a) (i) Accounting income for Jason (using historical cost concept and applying conventional accounting by compiling an Income Statement account). Income statement for the year ended 31 December,20X1 £

£

Opening inventory

10,000

Sales less purchases

36,200

Gross profit c/d

41,700

Closing inventory

15,500

51,700 Depreciation

51,700

5,000

Net profit

Gross profit b/d

41,700

36,700 41,700

41,700

(Note: The Sales less purchases figure of £36,200 is derived from the debtors/creditors account below.)

So accounting profit = £36,700 (assumes traditional concept of going concern). Workings are shown below in T account form Cash Book 1 Jan 20X1 Balance

135,000

1.1.20X1

Purchase of business Legal costs

40,000

31 Dec 20X1

Drawings

25,000

Balance

15,000

40,000 1 Jan 20X2 Bal b/d

5,000 135,000

135,000 20X1 Debtors/creditors

130,000

40,000

15,000

Purchase of business 1 Jan 20X1 Cash

130,000

1 Jan 20X1

Premises Stock

______

100,000 10,000

Debtors

4,000

Goodwill

16,000 130,000

130,000

Shop premises 1.1.20X1

Purchase of business

100,000

31 Dec 20X1


Balance

105,000


Cash Legal costs capitalised

5,000 105,000

105,000

Depreciation 31 Dec 20X1

Balance c/d

5,000

31 Dec 20X1

P&L a/c

5,000

5,000 5,000

1 Jan 20X2

Balance b/d

5,000

Inventory 1 Jan 20X1

Purchase of business

10,000

31 Dec 20X1

P&L a/c

15,500

1 Jan 20X1

Purchase of

31 Dec 20X1

P&L a/c

10,000

Goodwill business

16,000

Capital 31Dec 20X1

Drawings Balance c/d

25,000 146,700

1 Jan 20X1

Cash

31 Dec 20X1 P&L a/c

171,700

135,000 36,700 171,700

1 Jan 20 × 2

Balance b/d

146,700

Trade receivables/trade payables account [prepared in order to derive net sales less purchases] 1 Jan 20X1

Purchase of

31 Dec 20X1

Cash balance

31 Dec 20X1

Receivables c/d

40,000

business: receivables 20X1 Sales –

purchases

= balancing figure 31Dec 20X1

4,000

Payables c/d

36,200 5,000

45,200

45,200 1 Jan 20X2

Receivables b/d

5,200

5,200

1 Jan 20 × 2

Payables b/d

5,000

Drawings 31 Dec 20X1 Cash

25,000

31 Dec 20X1


Capital a/c

25,000


Balance sheets (NA0)

(NA1)

At 1 Jan 20X1 Premises

At 31 Dec 20X1

100,000

100,000

5,000

5,000

105,000

105,000

Add capitalisation of legal costs Less depreciation

5,000 105,000

100,000

Goodwill

16,000

16,000

Inventory

10,000

15,500

4,000

5,200

Trade receivables Cash

40,000

Less drawings

25,000

Trade payables

(5,000) 135,000

So profit

15,000 146,700

= NA1 – NA0 + Drawings = 146,700 – 135,000 + 25,000 = £36,700 as confirmed by the profit and loss account above.

Comparing the opening and closing balance sheets and allowing for drawings will enable profit to be derived but it is usual for accounting profit to be shown via a profit and loss account. •

It has been assumed that the traditional historical cost concept applies.

•

It was intended that the legal costs be capitalised giving a fair value at 1 January 20X1 of £105,000

•

(ii)

•

Thus depreciation is £5,000 (£105,000 – £100,000)

•

Alternatively the £5,000 could have been treated as an expensed cost (i.e. written off in the profit and loss account)

•

The net profit would remain as £36,700, the depreciation having been replaced by the legal costs.

It was assumed that opening balance sheet values represent fair values (i.e. cost) of the individual assets concerned.

Realisable income Y0-1

= Net RV1 – Net RVo + drawings = £136,200 – £135,000 + £25,000 = £26,200



Workings: Net realisable values At 1 Jan 20X1

At 31 Dec 20X1

Premises

85,000

105,000

Goodwill

16,000

16,000

Inventory

20,000

10,000

5,200

4,000

Trade receivables Cash

40,000

Less drawings

25,000

15,000

Trade payables

(5,000)

Net realisable values

136,200

135,000

Assumptions: (a) The realisable values are not based on an enforced sale. (b) Goodwill would possess a realisable value equivalent to its original cost in an enforced sale. (c) The entity is capable of being sold as a business entity in order to realise goodwill. Note: Some commentators might dispute the validity of goodwill because the concept of realisable income contravenes the going concern concept. In this situation the realisable income would be £10,200.

(iii)

Economic income ex ante Ye

= C1 + (K1t – Kt – 1) = 25,000 + (142,361 – 139,467) = £27,894 income for 20X1

Assumptions: (a) The difference of £4,467 between the actual cost of opening capital of £135,000 and its present value of £139,467 is to be treated as subjective goodwill. (b) The anticipated drawings represent expected cash flows. (c) The discount factor does not vary over the timespan. (d) The cash flows predicted will materialise. (e) Only the original capital of a present value of £139,467 needs to be maintained. (f) All the price levels are constant.



Workings: = capital at 1 January 20X1 ex ante

Kt – 1

K1t

=

CF ——– (1+r)n

=

£139,467

=

25,000 —–—– (1.2)

25,000 —–—– (1.2)2

+

25,000 + 150,000 ––––––––––––––– (1.2)3

+

= capital at 31 December 20X1 ex ante =

CF 25,000 ——– = —–—– (1.2) (1+r)n

=

+

25,000 + 150,000 —–—–––––––––– (1.2)2

£142,361

An extension of the tabulated workings might be helpful: Year

C

1

1 t

K

Kt –1

Ye

Y0–Y1 X1

25,000

142,361

139,467

27,894

Y1–Y2 X2

35,000

175,000

175,000

35,000

Y2–Y3 X3

210,000

175,000

270,000

W

(1)

(2,894)

67,639

(32,639)

35,000

35,000

175,000

97,894

130,533

139,467

(2)

(iv)

(2) 175,000 175,000 175,000

35,000 ––––– + (1.2)

1

C – (Ye+W)

27,894 32,639

Workings: Y1–Y2 20X2 Y2–Y3 20X3

Ye+W

(1) (2)

35,000 + 175,000 ––––––––––––––– = £175,000 (1.2)2

35,000 + 175,000 –––––––––––––––– = £175,000 (1.2)

Economic income ex post

Ye = C + (Kn – Kn – 1) = 35,000 + (175,000 – 175,000) = £35,000



Assumptions: (a) The difference of £40,000 between the actual cost of opening capital of £135,000 and its present value of £175,000 is to be treated as subjective goodwill. (b) The discount factor is not subject to change. (c) Price levels are constant. (d) Cash flows for years following 20X1 will be as predicted. (e) All flows occur at the year-end. Workings: W1 =

CF –––– = (1+r)n =

35,000 –––––– + (1.2)

35,000 –––––– + (1.2)2

35,000 + 175,000 –––––––––––––– (1.2)3

£175,000

CF W2 = ––––– (1+r)n =

35,000 35,000 + 175,000 ––––– + –––––––––––––– (1.2) (1.2)2

= £175,000

A tabular extension of the workings might be helpful: Year

C

1

Kn

Kn – 1

Ye

W Ye+W

Y0–Y1

35,000 175,000 W2 175,000 W1 35,000

35,000

Y1–Y2

35,000 175,000 W3 175,000

35,000

35,000

Y2–Y3

35,000

35,000

35,000

--

175,000

175,000

______

280,000

W3 =

35,000 + 175,000 –––––––––––––– 1.2

1

C – (Ye+W)

105,000

_____

______

= £175,000

(b)

Evaluation of the income figures

(i)

Accounting income (£36,700)

As an indicator of performance •

Based on actual transactions in this respect it is objective. •

However, it also utilises subjective data (e.g. depreciation) which incorporates an element of estimation into the results for the year.



•

If such subjective data are substantial as a proportion of total costs, then the resultant profit or loss would be of reduced reliability.

•

Being based on historical cost it can be misleading as an indicator of real profit in times of changing price levels.

•

It ignores unrealised capital gains/losses in pursuit of the going concern concept.

•

•

It could be said therefore that on the one hand the figure is incorrect; but

•

on the other it is realistic because there is no intention to realise the net assets.

The balance sheet is not a valuation statement. Consequently, profit expressed as a return on capital employed may be incorrect as an indicator of performance.

As an aid in decision making •

•

It is historic and history may not be a guide to the future. •

Circumstances of trade, costs and setting prices may be subject to factors not encountered by the results to date.

•

However, historical trends over years may be of considerable assistance.

It does not enable precise comparisons to be made with the return yield of other businesses as historical costs can mean differing values across trade and industry as inflation develops. •

(ii)

In general, accounting income has a considerable degree of authenticity because •

of its objective nature

•

it is traditional and it is understood

•

it can be of assistance as an indicator of performance and as an aid in decision making if it is used as a base figure capable of amendment in the light of: •

subjective content

•

a changing price economy and anticipated future commercial trends regarding costs and sales.

Realisable income (£26,200)

As an indicator of performance •

It avoids the subjective assessment of depreciation and in this sense its measured income can be said to be realistic, but it embraces unrealised capital gains and losses which can be said to be irrelevant when the intention to sell does not exist.

•

If the going concern concept is paramount then as an indicator realisable-value-based profit is unrealistic.

•

Realisable values are subjective.

As an aid to decision making •

It can be said to equate asset values with opportunity cost which is relevant when considering the going concern versus the cash realisation potential of disposal.



(iii)

Economic income ex ante (£27,894)

As indicator of performance •

Very subjective figure in terms of future cash flows in respect of amount, timing and discount factor. These effects can make it impractical to implement as a system.

•

However, it can accommodate inflation by taking account of changing price levels when forecasting the future cash flows

•

As an indicator it is predictive and thus windfall gains can occur in this system when anticipated cash flows are changed by new circumstances.

•

It is a guide to prudent conduct as it represents maximum consumption for a defined period without eroding capital.


By attempting to value a business at different time points it takes account of a strict capital maintenance concept via a time value of money •

thus the possibility of profit distributions being excessive and consequently eroding the capital is restricted

•

this is not so with historical cost.

•

The adoption of a discounting factor enables cash flows to be adjusted to take account of risk.

•

Whilst these two qualities are perhaps too subjective in terms of valuing the entire business entity they can be of considerable assistance when considering investment in the individual asset where choice amongst alternatives or the option of buying or renting exists.

(iv)

Economic income ex post (£35,000)

As indicator of performance •

•

Accuracy is dependent upon the validity of the forecasting cash flows as with the ex ante system. •

However, unlike that model adjustments can be made to past as well as future capital values.

•

Thus as an indicator of performance it has the potential to better the ex ante concept.

By adjusting past as well as future cash flows due to windfall elements it tends to have characteristics akin to traditional accounting. The figure of £35,000 is close to the traditional accounting figure of £36,200.


Expectations can change over time thereby affecting income and capital calculations.

•

Windfall gains and losses can influence the calculations and thus inhibit confidence in the reliability of the measure. Will the profit be £35,000 next year?

•

However absolute accuracy is not pretended by the model; as with the ex ante measure its intention is to give guidance only.



CHAPTER 4

Chapter 4: Question 1 – Shower Ltd 20X3 HC

CPP/PLA £

Sales Inventory

£

(iv)

(i)

(8,000 units)

20,000

(4,000 units)

Purchase (6,000 units) C Inventory (2,000 units)

RC £P

CoCoA

£P

£

(ii) 240/120

40,000

4,000

240/100

9,600

HC × 150/100

6,000

9,000

240/120 18,000

HC × 150/150

9,000

13,000

27600

3,000

10,000

240/120

£

(iii)

(iv)

20,000

20,000

12,000

10,000

8,000

10,000

15,000

6,000 21,600

10,000

£

HC × 150/150

3,000

18,400

Sundry expenses

5,000

240/120

10,000

HC × 150/150

5,000

5,000

Depn £6,000/5

1,200

240/100

2,880

HC × 200/100

2,400

0,000

600

5,000

3,800

5,520 Monetary gains

Realised holding

Price variation

gains

adjustments

Loan

FA

FA

(8,000 × 240) – 8,000

2,400–1,200

(100)

11,200

Inventory 12,000–10,000


1,200

6,000–2,000 (4,000) Inventory

2,000

3,000–5,100 2,100


Monetary Losses

Unrealised holding

Capital Maintenance

Gains (6,000 × 240) – 6,000 (120)

FA (6,000)

9,600–4,800

4,800

2,000 × 240

Inventory 5,100–3,000 PLA Net Income

10,720


100 2,100 10,700

–2,000

(2,800) 300


Balance sheets as at 31 December 20X3 HC Share capital

2,000

× 240/100

Retained earnings

3,800

PLA

CPP/PLA

RCA

CoCoA

4,800

2,000

2,000

10,720

600

300

Realised holding

3,200

Unrealised holding

6,900 Capital maintenance reserve 2,000 × 240

2,800

100 –2,000 Loan

8,000

8,000

8,000

8,000

£13,800

£23,520

£20,700

£13,100

Non-current asset

6,000

Depn

1,200

240/100 14,400 2,880

200/100

12,000

11,520

200/100

2,400

6,000

255/150

4,800

240/100

Inventory

3,000

240/120

Cash

6,000

6,000

6,000

6,000

£13,800

£23,520

£20,700

£13,100


9,600

NRV

2,000

5,100

NRV

5,100


Chapter 4: Question 2 – Toy plc (a) 1. Cost of sales adjustment •

This is the amount by which the historic cost of goods sold and charged in the historical cost income statement falls short of the replacement cost of those goods as at the date of sale.

•

The CCA model requires all costs, assets, revenues and liabilities to be reported at their current entry value.

•

The COSA is therefore an additional charge to the income statement account intended to bring the historical cost of sales to their replacement cost equivalent.

•

The COSA is regarded as a realised holding gain in the sense that it is a gain relating to realised assets (i.e. sold inventory) and one made during the asset holding period.

2. Additional depreciation •

Is an amount charged to the income statement to make charge for year equate to that related to the replacement cost.

3. MWCA •

This is the gain or loss from holding monetary working capital.

•

If prices are rising MWCA will be a gain if net monetary liabilities are held and a charge if net monetary assets are held.

4. Gearing adjustment •

Is an amount that is based on the proportion of the above charges that accrues to ordinary shareholders because there are lenders who bear a proportion of the charges.

5. Accumulated current cost depreciation •

This is to provide sufficient retention of funds to allow for the replacement of the fixed asset.

6. Current cost reserve •

This is a revaluation reserve where all holding gains (realised as well as unrealised) are credited in order to avoid the distribution of such gains and therefore reserve enough funds to replace assets at their current replacement costs as they are consumed.



•

The composition of the CCA reserve account is likely to include realised items as follows: •

debits: backlog depreciation gearing adjustment

•

credits: COSA monetary working capital adjustment.

and the following unrealised items: •

closing inventory revaluation increase

•

non-current asset revaluation increase.

(b) It quantifies cost of sales and depreciation after allowing for changing price levels so that the trading results are free of inflationary elements and provide a clearer picture of management performance. •

Resources are maintained by eliminating the risk of disturbing profits out of real capital.

•

Time series and inter firm comparisons are more indicative of management performance.



Chapter 4: Question 3 – Parkway plc (a)

Monetary working capital

Making and stating assumptions: •

COSA provides for the maintenance of inventory levels in times of inflation.

•

There is a view that MWC is also an integral part of daily operating activities and should be treated similarly via a provision out of revenue, from any detrimental impact caused by rising price levels.

•

However, a consensus does not exist.

•

•

in that some commentators maintain that MWC is not a part of the operating capital and so should be ignored when considering the operating capital maintenance concept,

•

apparently in the belief that investment in such items as debtors is not an essential ingredient of day-to-day operations.

Even where critics accept MWC is a part of operating activities, varying views exist as to which assets and liabilities should be included in the MWC calculation. Conflicting views are: •

MWC should embrace monetary assets only; or

•

all monetary assets less all monetary liabilities should be taken into account; or

•

only short-term monetary liabilities should be accepted into the calculation; that longterm monetary liabilities should be part of the gearing adjustment; or

•

even short-term monetary liabilities should be ignored; or

•

only monetary assets and liabilities that have been generated by operating activities should be involved and thus these should be segregated from other monetary assets and monetary liabilities.

Usual inclusions: •

In spite of ongoing contentious debate, there is general acceptance to include the following items as part of MWC: •

trade receivables, including prepayments, trade bills receivable and VAT recoverable on trade purchases

•

trade payables, including accruals, trade bills payable and VAT payable on turnover; and

•

any stock not subject to COSA.

Usual exclusions: •

receivables and trade payables arising from fixed assets sold, bought or under construction or those arising out of any other non-trading activities;

•

any cash or bank balances; and



•

certain investments such as long-term and short-term investments. The former will be treated as fixed assets and the latter as cash and bank balances.

Some critics formulate a case for including all or a portion of liquid resources as part of MWC: •

If cash is essential to support day-to-day ordinary operations (e.g. a retail supermarket), then such cash is part of the MWC.

•

Similarly if part of a bank balance or overdraft is subject to temporary but material changes as a reaction to fluctuations in levels of stock, trade debtors, trade purchases or sales then it should be treated as MWC.

•

Any surplus will become part of the gearing adjustment.

Taking account of the above scenarios the following MWCA calculation involves the assumptions stated below and corresponding reasons for making them i.e. that: •

MWC is part of day-to-day ordinary operating activities.

•

‘Trade receivables’ are substantial •

at £60,000 this is almost 50% of the capital invested in fixed assets (£126,000)

•

they amount to 63% of inventories (after eliminating an average profit content in debtors of 16% of sales i.e. £118,000/738,000 × 100 based on the year-end debtors figure of £60,000 i.e. 84% of £60,000/£80,000 × 100) = 63%.

•

If COSA is considered necessary in respect of inventories of £80,000 then so too is MWC in respect of trade receivables, inclusive of profit, of £60,000.

•

Total inventories of £80,000 are all subject to COSA.

•

Trade payables, being also substantial at £90,000, are deemed essential to the entity’s daily operating activities. Trade payables amount to an average 37 days’ credit i.e. [((£80,000 + 70,000)/2) / £738,000] × 365 during 20X8.

•

Short-term investments are not essential to MWC, i.e. they do not constitute a provision of finance for, say, imminent investment in trade receivables as part of a marketing strategy to stimulate sales by increasing terms of credit to customers.

•

Cash and bank balances, and any part thereof, are essential to day-to-day ordinary activities.

•

The rate of credit given and taken remains unchanged over the period.

•

Inventories have been charged out on the basis of FIFO and the inventory price level index is appropriate to the MWCA.

•

Inventory movements have been evenly spread throughout the year.

Calculation of MWCA Trade receivables Trade payables

30.6.20X8

1.X.20X7

60,000

40,000

(90,000)

(60,000)

(30,000)

(20,000)


Change

(10,000)


Adjustment to average price levels: 30,000 × 160

–

20,000 × 160

180 = 26,667

140 –

22,857 = Volume change

Reduction in MWC

(b)

(3,810) 6,190

Critical evaluation of the influence of MWCA

•

The concept of a MWCA acknowledges the existence of the interaction of physical assets and monetary assets by allowing for the protection of MWC against erosion by inflation in the same way that COSA protects capital in stocks consumed.

•

The provision for additional MWC supplements the provision for extra depreciation and COSA in maintaining the capital substance of the entity.

•

The calculation is not over-prudent as it takes cognisance of the protection granted by credit suppliers in their indirect funding of credit customers.

•

The inclusion of monetary assets and trade payables within the inflation protection framework reduces the risk of an excess dividend being paid. This could threaten the going concern by overlooking the impact of inflation on the monetary working funds.

•

The concept recognises the lag between realising a sale and realising the resultant cash.

•

Changes in credit periods between that granted to trade receivables and that given by suppliers can be affected by inflation in that impact may otherwise remain hidden if the MWCA were not applied.

•

However, a point of criticism is that if trade creditors become unstable in terms of credit given and credit received, the MWCA calculation increases in complexity and may not be so readily understood by the users of the accounts.

•

A further criticism lies in the determination of any cash floats and bank balance movements deemed to be part of MWC by some business entities. These may be very subjective and, consequently, inaccurate or prone to abuse by the compilers.



Chapter 4: Question 4 – Raiders plc (a)

All in £000s

(i)

Cost of goods sold

Note: Closing inventory purchased on average on 31 December. Average index is index at 30.9.X4 i.e. 150 Alternatively calculate the average of indices at 1.4.X4 and 31.3.X5 (138 + 162 ) ( 2 )

= 150 HC ×

Revaluation

= Current

ratio Inventory 1.4.X4 Purchases

cost

9,600

150/133

10,827

39,200

150/150

39,200

48,800

(ii)

Inventory 31.3.X5

11,300

COGS

37,500

150/156

10,865 39,162

Inventory figure in balance sheet Balance sheet value

(iii)

50,027

11,300

162/156

11,735

Equipment depreciation charge HC ×

Revaluation ratio

= Current cost 1.4.X4

31.3.X5

Purchased 1.4.X2 16,000

180/145

19,862

1.4.X3 20,000

180/162

22,222

1.4.X4 21,600

180/180

21,600 63,684 × 200/180

CC depreciation =15% × [63,684 + 70,760] [

2

=

]

Alternatively calculate as: 15% × £70,760

= 10,614


10,083

70,760


(iv)

Balance sheet value of equipment Purchase date

Current cost × 200 @ 1.4.X4

Gross CC

180

Accumulated depreciation

1.4.X2

19,862

22,069

(45%)

9,931

1.4.X3

22,222

24,691

(30%)

7,407

1.4.X4

21,600

24,000

(15%)

3,600

70,760

20,938

Net balance sheet value = 70,760 – 20,938 = £49,822

(b)

Evaluation of incremental informational content Discuss users and their decisions and how current cost number should improve predictions and control. Should also refer to recent empirical evidence and may discuss ongoing controversy within (and outside) ASB.

(c)

Consider power of providers; cost; economic companies, etc.



Chapter 4: Question 5 – Smith plc (i) CPP requires the restatement of the income statement and balance sheet in terms of purchasing power of money at the end of the accounting period in units of CPP. It is rather like translating the historic figures into another currency. •

CPP accounts are derived from the historic accounts by applying the general price index, and are issued as supplementary statements aimed at the shareholders. The intention is to ensure that shareholders’ capital is maintained in terms of general purchasing power and distributions would be restrained during a period of general inflation.

•

CPP accounts are objective/factual because they are •

based on HC figures updated to year end values;

•

as such can be audited.

They show gains and losses on monetary items not incorporated into basic CCA model.

(ii)

(a) Restate the income statement in £CPP CPP income statement for the year ended 31.12.20X8 HC£000

Sales

2,000

Index

CPP£000

236/228

2,070

Cost of sales Inventory Purchases

320

236/216

350

1,680

236/228

1,739

2,000 Closing inventory

280

Gross profit Depreciation Admin. expenses Net profit

2,089 236/232

(285)

1,720

1,804

280

266

20

236/120

39

100

236/228

104

120

143

160

123



(b)

Restate the closing balance sheet in £CPP Balance sheet as at 31.12.20X8 HC£000

Index

CPP£000

Non-current assets Land and buildings

1,180

236/120

2,321

Inventory

280

236/232

284

Trade receivables

160

160

Cash/bank

120

120

560

564

(140)

(140)

420

424

Net total assets

1,600

2,745

Equity

1,600

2,745

Net current assets

Less Trade payables

(c)

Restate the opening balance sheet in £CPP (as at 31.12.20X8 rate) Balance sheet as at 31.12.20X7 HC£000

Index

CPP£000

Non-current assets Land and buildings (net)

1,200

236/120

2,360

320

236/216

350

Trade receivables

80

236/220

86

Cash/bank

40

236/220

43

Net current assets Inventory

440 Less Trade payables

(200)

479 236/220

(215)

240

264

Net total assets

1,440

2,624

Equity (balancing figure)

1,440

2,624

(d)

Calculation of monetary loss as at 31/12/20X8 Equity [balance] at 31.12.20X7 in CPP£000

2,624

Equity [balance] at 31.12.20X8 in CPP£000

2,745

Increase

121

Profit per income statement in CPP£000

123

Monetary loss

2 49 © Pearson Education Limited 2006


(e)

Reconciliation of monetary loss as at 31.12.20X8 HC£000

Index

CPP£000

Net monetary liabilities at 31.12.20X7

(80)

236/220

(86)

Increase

220

236/228

228

Net monetary assets at 31.12.20X8

140

Monetary loss [140 – 142]

142

2

Net monetary liabilities are made up as follows: 31.12.20X7

31.12.20X8

£000

£000

Trade receivables

80

160

Bank

40

120

(200)

(140)

(80)

140

Trade payables



Chapter 4: Question 6 – Aspirations Ltd Income statement for year ended 31 December 20X1, prepared on RCA basis Sales

868,425

Purchases

520,125

Less: Inventory at 31.12.X1

24,250 495,875

Add: Cost of sales adjustment

(W1)

7,717

Adjusted cost of sales

503,592

Adjusted gross profit

364,833

Expenses

95,750

Depreciation

(W2)

33,000 128,750

Operating gain

236,083

Balance sheet as at 31st December 20X1 – RCA Basis Non-current assets Freehold property

(W3)

975,000

Depreciation

(W3)

9,750 965,250

Office equipment Depreciation

465,000 23,250 441,750

Current assets Inventories at replacement cost Trade receivables Cash

24,250 253,500 1,090,300 1,368,050

Less: Current Liabilities Payable within 1 year Net current assets

116,250 1,251,800

Less: Non-current liabilities Payable after 1 year

500,00 751,800 2,158,800



Issued share capital 1,500,000 ordinary shares at £1 each Holding gains

1,500,000 (W4)

422,717

Retained earnings

236,083 2,158,800

Workings for RCA Model W1 Cost of sales adjustment (COSA) HCA Initial stock 1.1.X1 Purchases

Indexed

RCA

Difference

34,375

×

130/115

38,859

4,484

485,750

×

130/ 130

485,750

–

524,609

4,484

21,017

3,233

503,592

7,717

520,125 Closing inventory 31.12.X1

24,250

×

130/ 150

495,875

The calculation has utilised the device of averaging. The user of an average index assumes that inventory was consumed on average at a price applying midway through the financial period. The increase in the cost of sales due to upward-moving price levels is £7,717. Purchases have been acquired evenly throughout the year, apart from the initial inventory, therefore the historical cost also represents average current cost and thus will not require any amendment. The advantages of averaging are those of speed and convenience. W2 Depreciation Depreciation is being based on the year-end replacement cost. HCA

Indexed

Depn Property Equipment

RCA Depn

6,500

× 127/110

7,505

18,750

× 145/125

21,750

25,250

29,255

As far as the balance sheet is concerned, however, the cumulative depreciation for one year based on year-end values would still have to be £33,000. The difference of £3,745 (£33,000– 29,255) would constitute backlog depreciation for the current year. This is an important aspect of the calculation if average price level movements are used to determine depreciation. At first sight many students find the concept of backlog depreciation for the current year as distinct from previous years more difficult to understand.



W3 Revaluation of non-monetary items at balance sheet date HCA

Indexed

RCA

Difference

Freehold property

650,000

×

165/110

975,000

325,000

Office equipment

375,000

×

155/125

465,000

90,000

1,440,000

415,000

1,025,000 Inventory

×

24,250

145/145

24,250

The index of 145/145 used to convert the inventory to RCA is not strictly correct. Inventories of £24,250 were part of purchases for the year and as such were not bought on the last day of the year. However we have assumed that the inventory was bought in the closing days of the year and is tending towards the specific price level measured at 145. If the inventory had been bought much earlier and the amount was material then it would be necessary to ascertain the index at the date of purchase. W4 Holding gains: £ On stocks consumed (W1)

7,717

On stocks carried at the year-end

nil

On fixed assets (W3)

415,000 422,717

Income statement for year ended 31.12 20X1, GPP basis £ Sales Initial inventory

(W6)

43,287

Purchases

(W6)

532,758

Less: Inventory 31 December

(W6)

(24,250)

Cost of sales

(W5)

£ 952,466

(W6)

551,795

GPP gross

400,671

Expenses

(W7)

105,016

Depreciation

(W8)

31,796 136,812

GPP net profit before loss on monetary items Less: Loss on monetary items

263,859 (W10)

GPP net profit after loss on monetary items


142,003 121,856


Balance sheet as at 31st December 20X1, GPP Basis Non-current assets:

Cost

Depn

Freehold property

(W9)

818,518

8,185

810,333

Office equipment

(W9)

472,222

23,611

448,611

1,290,740

31,796

1,258,944

Current assets: Inventories at GPP valuation (W6)

24,250

Trade receivables

253,500

Cash

1,090,300 1,368,050

Less: Current Liabilities Payable within 1 year

116,250

Net current assets

1,251,800

Less: Non-current liablities Payable after 1 year

500,000 751,800 2,010,744

Issued share capital 1,500,000 ordinary shares fully paid

1,888,888

Retained earnings

121,856 2,010,744

Workings (W): General or current purchasing power model With the GPP model historic pounds must be converted into general purchasing power pounds as at the end of the financial year. Where sales are generated and costs incurred evenly throughout the year, we may convert the historic pounds by using an average general price index. However, where substantial outlays of cash are involved on a particular day, as in the case of fixed assets and initial acquisition of inventories it will be more precise to utilise the index applying at that date, if available. HCA W5 Sales

868,425

×

Adjustment

GPP/CPP

170

952,466

155 W6 Initial inventory acquired

34,375

×

170

43,287

135 Purchases

485,750

×

170

532,758

155 520,125 54 © Pearson Education Limited 2006

576,045


Closing inventory

(24,250)

× 170 170 = no change (24,250)

Cost of sales

551,795

495,875

Inventory assumed acquired on or close to December 31 W7 Expenses

95,750

×

105,016

170 155

W8 Depreciation

25,250

×

170

31,796

135 W9 Fixed assets HCA

HCA

cost

Depn

£

£

NBV

Index

£

CPP

CPP

cost

Depn

CPP£

CPP£

CPP£

Freehold

650,000

6,500

643,500

× 170/135

818,518

8,185

810,333

Equipment

375,000

18,750

356,250

× 170/135

472,222

23,611

448,611

1,025,000

25,250

999,750

1,290,740

31,796

1,258,944

W10 Gain or loss on monetary items £ Change in trade receivables during year:

253,500

Change in cash occurring during year: In hand at 31 December 20X1

1,090,300

Received 1 January 20X1

1,500,000

Less payments – non-current assets

(1,025,000)

– inventory

(34,375)

In hand at 1 January 20X1

440,625

Change (increase) during year

649,675

Change in payables occurring during year Trade payables (increase)

(116,250)

Other payables – Loans (increase)

(500,000) (616,250)

Change in monetary assets occurring during year


286,925


So: Loss on holding net monetary assets during

CPP:

year’s inflation 286,925 × (170 – 155)/155

27,767

Add loss on holding cash during the year i.e. balance at 1 January was held for full year and excluded from the above calculation: 440,625 × (170 – 135)/135

114,236 142,003

Income statement for year ended 31.12.20X1 – NRV basis £ Sales

868,425

Purchases

520,125

Less: Inventory at 31.12.X1

24,250

Cost of sales

495,875

Gross profit

372,550

Expenses

95,750

Depreciation

(W11)

35,000 130,750

Operating gain

241,800

Holding gain

(W12)

18,188 259,988

Balance sheet as at 31 December 20X1 – NRV basis £

£

Non-current assets Freehold property

(W11)

640,000

Equipment

(W11)

350,000

(W12)

42,438

Current assets Inventories at NRV Trade receivables Cash

253,500 1,090,300 1,386,238

Less: Current Liabilities Payable within 1 year

116,250

Net current assets

1,269,988



Less: Non-current liabilities Payable after 1 year

500,000 769,988 1,759,988

Issued share capital 1,500,000 ordinary shares at £1 each

1,500,000

Retained earnings

259,988 1,759,988

W11 Reduction in value of non-current assets at 31 December 20X1 Freehold

Equipment

Total

£

£

£

HCA

650,000

375,000

1,025,000

Less: NRV at 31.12.X1

640,000

350,000

990,000

10,000

25,000

35,000

The reduction in value is treated as depreciation W12 Holding gain in inventory at 31 December 20X1 NRV = cost + profit content of 75% £24,250 + 75% of £24,250

42,438

Less: Cost

24,250 18,188



CHAPTER 5

Chapter 5: Question 1 – Membership of FRC, ASB and FRRP FRC members The membership of the Council is designed to include wide and balanced representation at the most senior levels of preparers, auditors and users of accounts and others interested in them. The members are:

Chairman Sir Bryan Nicholson

Sir Bryan has been Chairman of the Financial Reporting Council since 2001; Pro-Chancellor and Chair of the Council, Open University since 1996; Chairman of Education Development International plc since 2004 and non-executive director of Equitas Holdings Ltd since 1996. Born in 1932, Sir Bryan joined Unilever as a management trainee following National Service as a Second Lieutenant in the Royal Army Service Corps (RASC) and graduated with Second Class Honours from Oriel College, Oxford, where he read Politics, Philosophy and Economics (PPE). Having progressed within sales and marketing management at Unilever he moved first to the Jeyes Group as Sales Manager and then to the Remington division of Sperry Rand in 1964 as Sales Director. In 1966 he became General Manager in Australia and returned to Europe in 1969 as Managing Director for the UK and France. He joined Rank Xerox in 1972 as Director, Operations, Rank Xerox (UK) Limited becoming Chairman in 1979. He also supervised the European Subsidiaries of Rank Xerox. In 1984 the Government invited him to become Chairman of the Manpower Services Commission (MSC) and he was knighted in 1987 for his work at the MSC. In October 1987 he became Chairman and Chief Executive of the Post Office for five years until the end of December 1992. He was Chairman of BUPA from 1992 to 2001, Chairman of Varity (Europe) Limited from 1992 to 1996 and Chairman of The Cookson Group Plc from 1998 to 2003. Sir Bryan was also Chairman of the Council for National Academic Awards (CNAA) from 1988 to 1991 and of the National Council for Vocational Qualifications (NCVQ) from 1990 until 1993. He was Chancellor of Sheffield Hallam University from 1992 to 2001. Sir Bryan was President of the Confederation of British Industry (CBI) from 1994 to 1996. He was a member of the National Economic Development Council (NEDC) from 1985 to 1992. He is a past President of the Oriel



Society and in 1989 was elected an Honorary Fellow of Oriel in recognition of his services to the College.

Deputy Chair Barbara Thomas

Barbara Thomas received her BA from the University of Pennsylvania. She then went on to NYU Law School where she received a JD degree with honors. Thereafter she practised corporate and securities law in New York, becoming a partner of Kaye, Scholer, Fierman, Hays & Handler in 1978. In 1980 she was appointed youngest ever Commissioner of US Securities and Exchange Commission and an informal spokesman for its accounting division. In 1983 she moved to Hong Kong as the first woman main board director of a London merchant bank, Samuel Montagu & Co. Ltd. In 1993 she came to the UK as an executive director of News International plc. She subsequently led a buy-in of Scotia Haven Food Group and then of Whitworths Food Group. Currently she is Chairman of Private Equity Investor plc and Deputy Chairman of Friends Provident plc, as well as a nonexecutive director of Capital Radio plc and Quintain Estates and Development plc, among others. She is also a Trustee of the Royal Academy of Arts and of The Wallace Collection, and a member of the Governing Body of the School of Oriental and African Studies. In addition, she is Chairman of the Professional Standards Advisory Board of the Institute of Directors.

Directors Sir John Egan

President of the CBI

David Illingworth

Chairman of the Consultative Committee of Accountancy Bodies and President of the Institute of Chartered Accountants in England and Wales

Vacancy

Investor Community Representative

Members (ex-officio) Sir John Bourn KCB

Chairman, Professional Oversight Board for Accountancy

Richard Fleck

Chairman, Auditing Practices Board

Mike Fogden

Chairman, Accountancy Investigation and Discipline Board

Mary Keegan

Chairman, Accounting Standards Board

Bill Knight

Chairman, Financial Reporting Review Panel



Members Charles Allen-Jones

Formerly Senior Partner, Linklaters & Alliance

Mike Barnes

Head of Technical Development, Audit Commission

Scott Bell CBE

Formerly Group Managing Director, The Standard Life Assurance Company

Sir Victor Blank

Chairman, GUS plc and Chairman of Trinity Mirror plc

Sir John Bond

Group Chairman, HSBC Holdings plc

Martin Broughton

Chairman, British American Tobacco plc

Sir David Clementi

Chairman, Prudential plc

Don Cruickshank

Formerly Chairman of the London Stock Exchange

Michael Foot CBE

Managing Director, Deposit Takers & Markets Directorate, Financial Services Authority

Stephen Haddrill

Director General, Fair Markets Group (Government nominee)

Sir Derek Higgs

Senior Adviser in the UK, UBS Warburg

Douglas Kerr

Group Finance Director, CPL Industries Ltd

Rory Murphy

Joint General Secretary, UNIFI

Paul Myners CBE

Chairman, Guardian Media Group plc

Richard Pearson

Senior Partner, PKF

Colin Perry

Chairman, LTE Scientific Ltd

Ian Plaistowe

Formerly Chairman, Auditing Practices Board

Sir Nigel Rudd

Chairman, Boots Group plc and Pilkington plc

Vincent Sheridan

Chief Executive, VHI Healthcare

Sir Robert Smith

Chairman, The Weir Group plc

Rosemary Thorne

Group Finance Director, Bradford & Bingley plc

Graham Ward

Senior Partner, Global Energy and Utilities, PricewaterhouseCoopers

Observers Sir John Bourn KCB

Comptroller & Auditor General, National Audit Office

Peter Brierley

Head of Domestic Finance Division, Bank of England (Bank of England nominee)

Sir Andrew Likierman

Managing Director, Financial Management, Reporting and Audit, HM Treasury, and Head of the Government Accountancy Service

Secretary Ann Wilks CBE 60 © Pearson Education Limited 2006


ASB members Membership of the ASB is limited to a maximum of ten, of whom two (the chairman and the technical director) are full-time members and the remainder are part-time members. Appointments to the ASB are made by an Appointments Committee which comprises the FRC chairman and deputy chairman together with three members of council.

Chairman Mary Keegan

On 1 January 2001 Mary Keegan, then head of the Global Corporate Reporting Group of PricewaterhouseCoopers (PwC), succeeded Sir David Tweedie as full-time Chairman of the ASB. She joined Price Waterhouse (now PwC) in 1974, becoming, in 1985, the first woman admitted to partnership as an auditor in the UK firm. In 1991 she took charge of PW’s UK technical function and in 1993 joined the group running the firm’s European audit practice. She formalised the firm’s support for the International Accounting Standards Committee (IASC). She served on the UITF 1993–99 and was a founder-member of IASC’s Standing Interpretations Committee. She served on the Technical Committee of the Hundred Group of Finance Directors 1996–2000. From 1990 she actively contributed to the work of the ICAEW, including membership of its Council. From 1997 to 2000 she represented the UK accountancy bodies on the Council of the Fédération des Experts Comptables Européens (FEE) and was a vice president of FEE.

Technical Director Andrew Lennard

Members Michael Ashley

Partner, KPMG

Douglas Flint

Group Finance Director, HSBC Holdings plc

Huw Jones

Director of Corporate Finance, M&G Investment Management Limited

Roger Marshall

Partner, PricewaterhouseCoopers

Isobel Sharp

Partner, Deloitte & Touche

John Smith

Director of Finance, Property & Business Affairs, British Broadcasting Corporation

Jonathan Symonds

Chief Financial Officer, AstraZeneca plc



Observers Allan Cook CBE

Member of the European Financial Reporting Advisory Group’s Technical Expert Group

Bernadette Kelly

Director, Company Law and Investigations, Department of Trade and Industry

Sir Andrew Likierman

Managing Director, Financial Management, Reporting and Audit, HM Treasury, and Head of the Government Accountancy Service

Professor Geoffrey

Liaison member of the International Accounting

Whittington CBE

Standards Board

Secretary Charles Bridge

FRRP members Chairman Bill Knight

Bill Knight is a solicitor and a former Chairman of the Law Society’s Company Law Committee. He was senior partner at Simmons & Simmons until 2001. He is currently Deputy Chairman of Council at Lloyd's of London and Chairman of the Enforcement Committee of the General Insurance Standards Council.

Deputy Chairman Ian Brindle

Ian Brindle BA Econ FCA retired from PricewaterhouseCoopers on 30 June 2001 having been appointed the Senior Partner of Price Waterhouse in 1991, and the Chairman of PricewaterhouseCoopers on the merger in 1998. Before joining the Accounting Standards Board in 1993 he served as a founder member of the Board's Urgent Issues Task Force. He was previously a member of the Auditing Practices Committee, becoming its Chairman in 1990. He was a member of the Council of the Institute of Chartered Accountants in England and Wales from 1994 to 1998.

Members Rupert Beaumont

Formerly Partner, Slaughter and May

Sir John Bourn KCB

Comptroller & Auditor General, National Audit Office

Stephen Box

Formerly Finance Director, The National Grid Group plc 62 © Pearson Education Limited 2006


Michael Brindle QC

Barrister

Richard Delbridge

Formerly Group Chief Financial Officer, NatWest Group

Martin Eadon

Partner, Deloitte

John Grieves

Formerly Senior Partner, Freshfields

Gordon Hamilton

Partner, Deloitte

Andrew Higginson

Finance Director, Tesco plc

Robert Hildyard QC

Barrister

Nigel Macdonald

Formerly Partner, Ernst & Young

David Mallett

Formerly Group Head of Finance, Standard Chartered Bank

Ron Paterson

Formerly Partner, Ernst & Young

Andrew Popham

Partner, PricewaterhouseCoopers

George Rose

Finance Director, BAE Systems plc

Rosemary Thome

Group Finance Director Bradford & Bingley plc

Tony Wedgwood

Formerly Partner, KPMG

Secretary Ann Wilks CBE

Director, Panel Operations Carol Page



CHAPTER 6

Chapter 6: Question 1 – Financial Statements from Different Countries Most companies will begin their accounting policies note with an explanation of the general accounting convention (e.g. US GAAP or IASs). The first point that should be considered is whether the overall convention is what might be expected given the origin and/or listing of the company. Secondly, although the companies are based in different countries, they may be using the same overall accounting convention. Students might comment that this is helpful as it allows greater comparability. The next stage of the analysis should involve a comparison of the accounting policies for dealing with specific accounting items. Things to look out for might include: •

Level of detail – does one country give more than the other? Is this related to the level of regulation or is it down to the individual company?

•

Which items are treated in the same way?

•

Which items are treated differently?

•

What is the effect of the differences?

•

Is there a common thread in the differences? For example, might one set of regulations seem to be protecting a particular user group (e.g. creditors) or might there be some other underlying assumption (e.g. earnings should not be volatile)?

Chapter 6: Question 2 – Web Exercise using EDGAR The approach to this question should probably be similar to that for Question 1. However, this question allows students to measure the relative importance of the differences in policies. Students will identify the main areas of difference from the numerical reconciliations, but will need to refer to the narrative disclosures to understand the reasons. This exercise would work well with groups, asking different members of the group to look at particular countries. Tutors may wish to steer students towards particular countries to allow representation of different parts of the world. It is worth remembering that disclosures that satisfy the SEC’s requirements need not necessarily be easy for an outsider to follow. If students are studying the book in the order it is presented, then care should be taken that they do not get bogged down with the detail of different methods of accounting at this stage – they will have an opportunity to address this later.



Chapter 6: Question 3 – Taxation and Financial Reporting The chapter refers to the relationship between tax and financial reporting fairly briefly. A full answer to this question would probably require some further reading. Suggestions might include: Haller, A. (1992) ‘The relationship of financial and tax accounting in Germany: a major reason for accounting disharmony in Europe’, International Journal of Accounting, Vol. 27, pp. 310–23. Hoogendoorn, M.N. (1996) ‘Accounting and taxation in Europe – a comparative overview’, European Accounting Review, Vol. 5 (Supplement), pp. 783–94. Lamb, M., Nobes, C.W. and Roberts, A.D. (1998) ‘International variations in the connections between tax and financial reporting’, Accounting and Business Research, Vol. 28 (3), pp. 173–89. Nobes, C.W. (2003) A Conceptual Framework for the Taxable Income of Businesses and How to Apply It under IFRS, Certified Accountants Educational Trust (this can be downloaded from the ACCA website: www.accaglobal.com). Aisbitt, S. (2002) ‘Tax and accounting rules: some recent developments’, European Business Review, Vol. 14 (2), pp. 92–7. The question hinges on whether the tax and commercial accounts are (or will be) based on the same figures (congruence). Some advantages and disadvantages of congruence are set out below. Congruence between tax and commercial accounts Interest group

Advantages

Disadvantages

(a) Preparers

Only one set of information

Tax

required

drive commercial decisions

Clear relationship between

Accounts do not necessarily

figures in accounts and tax

reflect economic reality –

charge – no need for de-

they are prepared so as to

ferred tax

minimise tax liabilities

Clear information that has

May become involved in ac-

been fully audited

counting issues rather than

(b) Users

(c) Tax authorities

considerations

might

concentrating on macroeconomic policy issues

If there is (or will be) a high degree of congruence, then tax authorities need to know the extent to which income under IASs will differ from income under current regulations in order to estimate their expected share of that income. Further action may be required (e.g. in terms of grants or changes in tax rates) to achieve policy objectives. In the UK, the Inland Revenue is aiming for transition to IASs to be ‘tax neutral’.



In the longer term international bodies (e.g. the EU) may impose the tax base, e.g. consolidated IAS financial statements. However, the financial reporting lobby (e.g. Nobes, 2003) would oppose that on the basis that 'tax pollution' of financial statements is undesirable due to the differing needs of the user groups (tax authorities versus investors).



CHAPTER 7

Chapter 7: Question 1 – MCRV Ltd (a)

Operations Statement for year ended 31.12.20X8 £

Turnover

£ 200

Opening stock at market price

50

Purchases at cost

80 130

Closing stock at market price

66

Charge for goods sold

64

Contribution

136

Salaries

30

Interest paid

9 39

Wealth created by operations

(b)

97

Statement of changes in wealth £

Increase in wealth due to operations

97

Increase in value of fixed assets

40

Decrease in value of long-term loans

20

Realisable increase in net assets

157

Changes in wealth: •

The net assets have increased from 195 to 352.

•

Fixed asset values reviewed at net realisable value £270 overall at the end of the year.

•

Long-term loan value reviewed at net realisable value £70 at the end of the year due to rise in yields on long-dated stocks.

•

Movements are set out in W1 (cash flow) and W2 (worksheet).

(c) The value of long-term loans is affected by changes in the prevailing interest rates. In the example the yields have increased. If they had decreased, the value of the loans would have been increased.



W1: Cash flow statement

£

Cash held at start of year

10

Cash flow from operations

*66

Long-term loan finance raised

30 106

Fixed assets acquired

30

Cash held at end of year

76

* MCRV does not prescribe the amount of detail which might be shown here. The conclusions of the feasibility study were that it would be appropriate to report inflows and outflows in the level of detail shown in the following cash book summary.

Notes on transactions during year £

Cash book:

£

Cash received during year –

credit customers

190

–

long-term loans

30 220

Cash paid during year –

credit suppliers

85

–

fixed assets

30

–

salaries

30

–

loan interest

9 154

Net increase in cash included in cash flow statement

66 £

Journal:

£

DR Debtors

200

CR Sales

200

DR Stock

80

CR Creditors

80

Credit purchases for year DR Cost of goods sold

70

CR Stock

70

Goods issued for sales DR Stock

6

CR Cost of goods sold

6

Uplift in closing stock value from cost to net realisable value



W2: Worksheet for information Assets

and

liabilities

at

Cash

Journal

Changes in

transactions

Operations

wealth

Fixed assets

Cr

Stock Debtors

50 30

Cash

10

at

end of year Dr

Cr

Dr

Cr

220

Inc

Dec

Dr

Cr

190 154

86 200

Dr

Cr

270

40

30

200

and

liabilities

start of year Dr

Assets

66 40

70

76 85 30

80

35

Creditors

30 Long-term loan

60

Net assets

195

70

20

352

157 200

200

Sales Cost of sales

70

64

6

30 30

Salaries 9

Interest paid

9 Operations 97

97 290

290

374

374

356

356

157

157

200

200

(d) The ratio will differ to the extent that NRV differs from historical costs.


452

452


Chapter 7: Question 2 – Conceptual Framework (a) Statements of Principles or Financial Reporting which set out the concepts that underlie the preparation and presentation of financial statements for external users have been widely developed. Their primary purpose is to provide a coherent frame of reference for standard setters to use in the development and review of accounting standards. In particular the framework provides a basis for choosing between alternative accounting treatments. (b) In practice the conceptual framework has provided standard setters with a framework for developing standards rather than providing a frame of reference for practitioners in resolving questions in the absence of a specific promulgated standard. Auditors are under pressure to accept practices which are commercially convenient to the client in the absence of a standard, e.g. selecting favourable revenue recognition criteria, adopting merger accounting where possible, massaging income in times of recession.



Chapter 7: Question 3 – Fairness (a) There is an overriding requirement that financial statements should give a true and fair view of the financial position, performance and financial adaptability of an enterprise. In the UK, the ASB considers it to be a dynamic concept whose content will evolve in response to matters such as advances in accounting and changes in business practice. The Board considers that the evolution of the interpretation of the concept will be influenced over time by the accounting standards and other statements that the Board issues. It is an important concept in the UK because it allows companies to override statutory requirements. In such a case the company is required to include a note to the accounts giving particulars of any such departure, the reasons for it and its effect. The use of the override has been considered at various times by the Financial Reporting Review Panel, e.g. •

FRRP Press Notice 42 – Sutton Harbour The Financial Reporting Review Panel considered the 1995 accounts of Sutton Harbour Holdings plc. The Panel accepted the directors’ justification for their departure from the provisions of Statement of Standard Accounting Practice (SSAP) 4 in the particular circumstances of the company.

•

AIM Group The Financial Reporting Review Panel considered the Report and Accounts of AIM Group plc for the year ended 30 April 1998 and discussed them with the company’s directors. The primary matter at issue was the departure from compliance with Financial Reporting Standard (FRS) 7 Fair Values in Acquisition Accounting and the use of the true and fair override following the company’s acquisition of certain of the assets and business of Hunting plc.

(b) This raises the question of the feasibility of general purpose accounts to satisfy the information needs of non-equity shareholders. Discussion should embrace the interests of each of the user groups and consider the effectiveness of current measurement systems (HC/CPP/RCA/NRVA) and disclosure requirements e.g. socio-economic information, three bottom lines, environmental reporting.



Chapter 7: Question 4 – Control of Standard Setting There is no unique answer to this question – it may be approached in a number of ways, e.g. PRO arguments Technical requirements. These are now so complex as transactions have become more complex, e.g. financial instruments, that accountancy international professional firms are the only professional group with competence in many of the areas that will require standards in the future. Globalisation. National standard setters do not have the breadth that exists within the international firms. Accountability requirements. Standards will be set that are feasible based on current expertise and costs. Liability. Given that the main liability lies with the professional firms it is important that they are actively involved in formulation of standards. CON arguments Enforcement. The major requirement is for effective enforcement of existing standards which can only be achieved by making the international firms accountable. Lack of independence. The firms are too closely allied with the client and are therefore inclined to accept measurement and disclosure practices which do not comply with existing international standards. Investor confidence. This depends on transparency – the existence of standards; their effective enforcement and adequate monitoring of audit performance. In practice, this requires the active participation of all parties: the companies preparing accounts, the accounting standard setters, the profession and user groups.



CHAPTER 8

Chapter 8: Question 1 – Old NV (a)

Income Statement (internal) for the year ended 31 December 20X1 (€000)

Sales

12,050

Less: returns

350

Inventory at 1.1. 20X1

825

Purchases

11,700

6,263

Carriage on purchases

13

Less: returns

(313)

5,963 6,788

Inventory at 31.12.20X1

1,125 5,663

Depreciation of plant

313

5,976 5,724

Gross Profit Administration: Wages

738

Administration expenses [286–12]

274

Directors’ remuneration

375

Selling: Salesmen’s salaries

800

Distribution: Distribution expenses

290

Depreciation of vehicles

187

Carriage

125

Financial: Goodwill impairment

177

Audit fee

38

Debenture interest

25

Rent receivable

(100)

2,929 2,795

Tax

562

Profit for year

2,233



(b)

Income statement for publication Income Statement of Old NV for the year ended 31 December 20X1 €000

Sales

€000 11,700

Cost of sales

5,976

Gross profit

5,724

Distribution costs W1

1,402

Administrative expenses W2

1,602

Other operating income

(100) 2,904

Trading profit

2,820

Interest payable

25

Profit on ordinary activities before tax

2,795

Income tax

562

Profit on ordinary activities after tax

2,233

W1 Salesmen’s salaries

800

Distribution expenses

290

Depreciation of vehicles

187

Carriage

125

1,402

W2 Wages

738

Administrative expenses

274


375

Goodwill impairment

177

Audit fee

38

There will be a disclosure note as follows: Profit on ordinary activities after tax is after charging Goodwill impairment Audit fee

177 38

Depreciation

500


375


1,602


Balance Sheet of Old NV as at 31 December 20X1 €000

€000

Non-current assets Intangible assets [1062 – 177] Property, plant and equipment

885 Note 1

1,074

Current assets Inventories

1,125

Receivables

3,875

Cash at bank and in hand

1,750

Prepayments

12 6,762

Current liabilities Payables

738

Provision for income tax

562

Accrued charges

63

Dividends proposed

362 1,725

Net current assets

5,037

Total assets less current liabilities

6,996

Non-current liabilities Debentures

250 6,746

Capital and reserves Ordinary shares of €1 each

3,125

Preference shares of €1 each

625

Share premium

250

Retained earnings

Note 2

2,746 6,746



Disclosure notes to show make-up of balance sheet items Note 1:

Property, plant and equipment


Motor Plant

vehicles

Total

€000

€000

€000

1,200

1,125

2,325

1,562

1,125

2,687

At 1.1.20X1

738

375

1,113

Charge for year

313

187

500

1,051

562

1,613

At 31.12.20X1

511

563

1,074

At 31.12.20X0

824

750

1,574

Cost At 1.1.20X1 Additions

362

Disposals At 31.12.20X1 Accumulated depreciation

At 31.12.20X1 Net book value

€000

Working: Accrued expenses Audit fee

38

Debenture interest

25

Note 2:

Movements on reserves €000

Retained earnings at 1.1.20X1

875

Amount transferred from income statement Dividends proposed

2,233 (362)

Balance at 31.12.20X1

2,746



Chapter 8: Question 2 – HK Ltd (a)

Income Statement for year ended 30 June 20X1 $000

Turnover

$000 381,600

Cost of sales Per trial balance

318,979

+ Hire 2,400 + depreciation 799 – Insurance 150 + inventory loss 250

3,299

Gross profit

322,278 59,322

Administration expenses Per trial balance 9,000 + Directors 562 + Bad Debt 157 + Auditor remuneration 112

9,831

Distribution costs

35,100

44,931 14,391

Profit on disposal of fixed assets

536

Profit before tax and interest

14,927

Interest payable [454 + 151 tax on interest]

605 14,322

Other operating income

17

Profit before tax

14,339

Income tax at 35%

4,887

Tax on profit on disposal

461

Profit for the year

5,348 8,991

Note: Depreciation consists of Buildings 94 + Plant 619 + Fixtures 86

Balance sheet as at 30 June 20X1

(b)

Intangible non-current assets

Goodwill

480

Tangible non-currrent assets Freehold land Freehold buildings Aggregate depreciation

2,880 4,680 648

Plant and machinery

3,096

Aggregate depreciation

1,857

Fixtures and fittings

864

Aggregate depreciation

259

Current assets


4,032 1,239 605


Inventory [11,794 – 500 obsolescence]

11,294

Receivables [7,263 + 250 inventory sale + 150 insurance]

7,663

Bank

11,561 30,518


2,591

Dividends

486

Tax [4,887 + 461]

5,348 8,425

Net current assets

22,093 31,329

Non-current liabilities 9% loan

7,200 24,129

Deferred Income – Government grant (see Note)

68 24,061

Capital Ordinary shares 50c each

3,600

9% preference shares of $1 each

5,400

Reserve for increased cost of plant

310

Retained earnings [6,364 + 780 Revaluation now realised – 310 transfer to Increased Cost of Replacement Reserve + 8,991 profit for the year – 1,074 dividends]

14,751 24,061

Note: The grant could be deducted from the cost of the plant under IAS 20.

(c)

The usefulness of the non-current asset schedule

(1) The column headings allow the user to see the type of non-current assets owned by the business. This can give helpful initial indications, for example: Realisability – intangible assets might be more difficult to sell than property. Appreciation – land is more likely to appreciate than office equipment. Depreciation – licences are subject to amortisation and possible fall in value due to competion Security – land and buildings are more likely to be accepted as security for loans and overdrafts than intangible assets.



(2) The carrying values may be at cost or revaluation. If at cost it may be that the balance sheet gives too low an indication of current market values – this is often an important consideration if existing shareholders are assessing a takeover offer. (3) The accumulated depreciation figure when related to the cost gives an indication of the age of the assets and possible need for capital outlays to replace with cash flow implications. (4) Disposals may be an indication that there is replacement occurring which could indicate growth or maintenance of existing capacity. If no replacement then consider implications for future capacity or other reason e.g. change of direction, disposal of non profit making parts of the business.



Chapter 8: Question 3 – Basalt plc (a)

Income statement for the year ended 31.12.20X0 (£000)

Turnover (962 – 27 returns)

935

Cost of sales

Note 1

Gross profit

460 475

Distribution costs

Note 2

218


Note 3

118 139

Other operating income (i.e. rent receivable)

7


146

Tax on profit of ordinary activities

58

Profit on ordinary activities after tax

88

Retained profits brought forward

55 143

Proposed ordinary dividend

75

Retained profits carried forward

68 £000

Note 1: Opening inventory

66

Purchases

500

Carriage inwards

9

Returns out

(25)

Closing inventory

(90) 460

Note 2: Warehouse wages

101

Salesmen’s salaries

64


6

Hire of vehicles

19

Depreciation

28 [7/11 of 20% of £220,000] 218

Note 3: Admin. wages

60

Admin. expenses

10


30

Auditors’ remuneration

2

Depreciation (4/11)

16 118



Balance Sheet as at 31 December 20X0 (£000) Non-current assets Tangible assets [cost 220 – Dep’n b/f 49 – Dep’n for year 44]

127


90

Trade receivables

326

Cash at bank

62 478

Liabilities Amounts falling due within 1 year: Trade payables

66

Other payables [Audit 2 + Corporation tax 58 + Dividends 75]

135 201

Net current assets

277


404

Capital and reserves Called-up share capital

300

Share premium a/c

20

General reserve

16

Retained earnings

68 404

(b) (i) Directors’ report must deal with certain matters by law, e.g. •

Proposed dividends

•

Likely future developments in the company’s business

•

Principal activities of the company

•

Political and charitable contributions

•

Must be consistent with other statements – reviewed by auditors

(ii) Chairman’s report •

May be highly personalised review of the business, its developments and the environment in which it operates

•

Not subject to audit

(iii) Auditors’ report expresses an opinion as to whether the financial statements give a ‘true and fair view’.



Chapter 8: Question 4 – Raffles Ltd (a)

Income Statement for the year ended 31 December 20X6 $

Revenue

1,628,000

Cost of sales [W1]

1,098,400

Gross profit

529,600

Administration expenses [W2]

(71,050)


(32,800)

Operating profit

[2]

425,750

Income from fixed asset investments

[5]

6,000

Interest payable and similar charges

[6]

[18,000 Deb + 3000]

(21,000)

Exceptional costs

[7]

(150,000)

Profit before tax on ordinary activities Tax on ordinary activities

260,750 [8]

115,750

Profit after tax on ordinary activities

145,000

W1: Cost of sales $ Per question

1,100,000

Less: Realisable on obsolescent inventory

(5,600)

Add: depreciation

14,000

Less: capital item incorrectly posted

(10,000) 1,098,400

W2: Administration expenses Per question

206,300

Less: restructuring expense

(150,000)

Less: provision written back

(1,500)

Audit: fee

7,000

Goodwill impairment

2,500

Depreciation

6,750 71,050



Balance sheet as at 31 December 20X6 Non-current assets Intangible

[1]

40,000


[2]

341,250

Investments

[3]

130,000 511,250

Current assets Inventory [156,360 + Inventory obsolescence realisable 5,600]

161,950

Receivables [179,830 + 1500 Provision written back]

181,330 343,280

Current liabilities

[4]

(210,530)

Net current assets

132,750


644,000

Non-current liabilities

[5]

(180,000) 464,000

Share capital

250,000

Revaluation reserve

25,000

Retained earnings [b/f 98,000 + 91,000]

189,000 464,000

(b)

Notes to the income statement

1

Accounting policies General Depreciation Exceptional items

2

Operating profit is stated after charging audit fee 7,000

3

Staff costs Purchasing Distribution Administration

6 3 1 10

4

Directors’ emoluments Chairman nil Highest paid director £19,800 Other directors earn salaries in the range of £15,000 – £20,000

5

Income from non-current asset investments


45,000 22,500 7,500 75,000

£ 6,000


6

Interest payable and similar charges Bank interest Debenture interest paid and payable

7

Exceptional costs Restructuring Less: Tax relief

8

9

£ 3,000 18,000 21,000 150,000 (45,000) 105,000

Taxation on ordinary activities Tax on profits [165,000 – 45,000 from Note 7] Overprovision

120,000 (4,250) 115,750

Dividends Interim at 3.6p Proposed at 7.2p

£ 18,000 36,000 54,000

Notes to balance sheet Non-current assets 1

Intangible assets – Goodwill Cost at 1 January 20X6

50,000

Impairment

2

At 1 January 20X6

7,500

Charge for year included in Administration expenses

2,500

At 31 December 20X6

10,000

Net book value at 31 December 20X6

40,000

Net book value at 1 January 20X6

42,500

Property, plant and equipment Land/

Plant/

blgs

machinery

Fixtures

Total

78,000

323,000

Cost At 1.1.20X6

225,000

Additions

20,000 90,000

Disposals Revaluation At 31.12.20X6

90,000 (24,000)

25,000 250,000

(24,000) 25,000

110,000


54,000

414,000


Depreciation At 1.1.20X6

9,000

16,000

37,500

62,500

Charge

3,000

11,000

6,750

20,750

(10,500)

(10,500)

Disposals At 31.12.20X6

3

12,000

27,000

33,750

72,750

NBV 31.12.20X6

238,000

83,000

20,250

341,250

NBV 1.1. 20X6

220,000

4,000

40,500

260,500

Investments Listed on recognised stock exchange

£130,000

Notes relating to Liabilities, Post balance sheet events and Capital 4

Current liabilities Bank overdraft

12,700

Trade payables

32,830

Taxation

120,000

Dividends

36,000

Accrual – interest

9,000 210,530

5

Non-current liabilities 10% Debentures redeemable 2003

£180,000

(i)

Provisions for liabilities – Lawsuit details.

(ii)

Post balance sheet events – Details re investment in Diat P’or.

(iii)

Share capital Details of authorized capital Reserves

Revaluation

Income statement

At 1.1.20X6 Movement during year

–

98,000

25,000

145,000

Less dividends (Note 9)

(54,000)

At 31.12.20X6

189,000



Comments Provision •

is an amount retained from profit

•

provides for a loss or liability likely to be incurred but amount is uncertain

•

is shown in balance sheet after creditors or deducted from assets e.g. bad debt provision

Reserve •

is a realised or unrealised gain which has not either legally or at the company’s discretion been distributed as dividends, i.e.

•

is retained in the business, e.g. retained profits, share premium, revaluation reserve

•

is shown in the balance sheet after share capital

Liability •

is an obligation in the future requiring the transfer of assets, e.g. cash payment or provision of services to other entities

•

entails a probable future sacrifice

•

may also include the amount owed to the owners of the business

•

is reported under current or long-term liabilities

Contingent liability •

is a condition that exists at the balance sheet date where the outcome will be determined by a future uncertain event appears as a note to the balance sheet



Chapter 8: Question 5 – Phoenix plc (a)

Income Statement for year ended 30 June 20X7 £000

Revenue

6,465

Cost of sales [4,165 +280 dep]

(4,445)

Gross profit

2,020

Distribution cost

(669)

Administration expense [1,126 + 31 dep + 415]

(1,572)

Operating loss

(221)

Exceptional item: Gain on disposal of associate

75

Dividend received

80

Loss before taxation

(66)

Taxation

(96)

Loss after taxation

(b)

(162)



4,159

Investment

365


1,468

Trade receivables

947

Cash at bank

175

Current liabilities

(868)

Net current assets

1,722 6,246

Share capital and reserves Share capital

4,500

Share premium

500

Revaluation reserve

1,170

Retained earnings

76 6,246



(c)

Statement of Movement of Property, plant and equipment

Balance b/f Disposal

L&B

P&M

F&F

Total

2,400

1,800

620

4,820

(150)

Revaluation reserve

(150) 160

Balance c/f

2,250

160

1,960

620

4,830

540

360

900

Accumulated depreciation Balance b/f Revaluation reserve

(540)

(540)

P&L charge

280

31

311

Balance c/f

280

391

671

1,680

22

4,159

WDV at 30.6.20X7

2,250

Current assets Trade receivables

947

Creditors Trade payables

566

Taxation

122

Dividend proposed

180 868

Balances in revaluation reserve and retained earnings are made up as follows: Revaluation reserve

Retained earnings

Balance b/f

600

Plant and machinery revaluation

700

Transfer on disposal

(30)

30

(100)

100

Transfer – additional depreciation

488

Loss for year

(162)

Dividends

(380)

Balance c/f

(d)

1,170

Statement of Recognised Gains and Losses

Loss after taxation

(162)

Revaluation gain

700

Total recognised gain

538


76


CHAPTER 9

Chapter 9: Question 1 – Springtime Ltd (a)

Income Statement for the year ended 31 March 20X4 Continuing operations

Discontinued operations

Total

Turnover

30,000

5,000

35,000

Cost of sales

19,000

4,000

23,000

Gross profit

11,000

1,000

12,000

Distribution costs

(3,065)

(425)

(3,490)

Administrative costs

(1,225)

(15)

(1,240)

6,710

560

7,270

Closure costs

(350)

Operating profit

6,710

210

Income from fixed asset investment

(350) 6,920 1,200 8,120

Taxation [3200 – 200 + 150]

3,150

Profit for the year

4,970

Note: Tax: Income Tax 3,200 – Overprovision 200 + Transfer to deferred tax account 150

Workings Continuing

Discontinued

Total

Distribution costs Delivery costs

900

Dep’n – vans

40

40

Dep’n – stores equip.

50

50

1,000

1,000

700

700

Storeroom costs Delivery staff Directors Storeroom staff

300

1,200

75

25

100

300

100

400

3,065

425

3,490



Admin. costs Audit

30

30

Depreciation – cars

10

10

Office expenses

800

800

Directors

300

300

Office staff

85

15

100

1,225

15

1,240

Note: as allowed under IFRS 5, disclosures are given on the face of the income statement

(b) IFRS 5 has required companies to disclose in detail activities that are discontinued. This disclosure is both numerical and narrative and provides a full explanation of the activities to be discontinued, when the discontinuance should occur and the financial effect of the discontinuance. This information is useful to users in enabling them to interpret the future performance of the enterprise and assessing the performance of management over the period. When considering the future performance of an enterprise only the continuing operations should be considered as it is only these that will continue into future periods. The management performance can be assessed to some extent by having knowledge of discontinuing activities because the users will be able to judge whether the management decision to discontinue is a good one. Users can also get benefits from the disclosure in understanding the future strategic direction of the business. By discontinuing activities the management may be refocusing the business towards more core areas and this would be seen through the disclosures.

(c) Reasons why accounting policy notes are important to users. •

The underlying reason for a change might be more important than the change itself, e.g. Ō a reduction in the life over which assets are depreciated could indicate a threat from technological changes within the sector; or Ō a structural change, e.g. repositioning in the market.

•

Inter-company comparison requires ideally that two companies should have similar accounting policies, or that their accounting policies should be amended to make them uniform, e.g. restating all non-current assets at current replacement costs.

•

This is important when comparing ROCE, and a policy note about the use of modified historical accounts, together with reconciliations to historical cost profit required by some national standards (eg FRS 3 in the UK) might improve the interpretation of differences.



Chapter 9: Question 2 – Olive A/S (a)

Income Statement for year ended 30 September 20X4

Revenue

3,460

Cost of sales

W1

Gross profit

(1,557.1) 1,902.9

Distribution cost

W2

(362)

Administration expenses

W3

(917.9)

Operating profit

623

Exceptional items: Gain – disposal of fixed assets

6

Dividend received

45

Interest and similar charges

(30) 644

Taxation (Sch 1)

(197)

Profit for the year

(b)

447

Balance Sheet as at 30 September 20X4

Non-current assets Intangible assets

425

Tangible assets (Sch 2)

1,480

Investments

248

Current assets Inventory [364 + 40]

404

Receivables (Sch 3)

599

Cash and bank

38

Current liabilities (Sch 4)

(636)

Net current assets

405 2,558

Non-current liabilities 12% debentures

500

Net capital employed

2,058

Share capital: ordinary shares of £1 each Share premium account

600 30

Retained earnings (Sch 5)

1,055

Revaluation reserve

373 2,058



Schedule 1: Taxation charge Income tax

185

Underprovision 20X3 (140 – 128)

12 197

Schedule 2: Statement of Movement of Non-current Assets Land and Buildings

Plant and Machinery

Fixtures Prepayand fittings ments

Balance b/f

600

520

80

–

1,200

Revaluation

300

–

–

–

300

Acquisitions

–

320

40

60

420

Disposal

–

(240)

–

–

(240)

Balance c/f

900

600

120

60

Balance b/f

80

160

26

–

266

Revaluation

(80)

–

–

–

(80)

Income charge

15

54

11

–

80

Disposal

–

(66)

–

–

(66)

Balance c/f

15

148

37

–

200

WDV 30.9.X4

885

452

83

60

WDV 30.9.X3

520

360

54

–

Total

1,680

1,480 934

Schedule 3: Receivables Trade receivables

584

Prepaid rent

15 599

Schedule4: Current liabilities Trade payables

296

Debenture interest (3 months)

15

20X3 Income tax

140

20X4 Income tax

185 636



Schedule 5: Statement of Movement of Reserves Share premium A/c Balance b/f

Revaluation reserve

Income statement

150

–

661

(120)

–

–

Profit for the year

–

–

447

Dividend paid

–

–

(60)

Revaluation gain

–

380

–

Transfer – extra depreciation

–

Balance c/f

30

Formation expenses w/off

(7) 373

7 1,055

Notes 1

Expenses charged in the year includes the following: Depreciation written off Directors’ emoluments Directors’ pension Audit fees and expenses

€80,000 €180,000 €18,000

€198,000 €65,000

2

Company employs 646 persons, of whom 428 work at the factory and the rest at the head office.

3

Land and Buildings were revalued during the year by Messrs XYZ, Chartered Valuers, at open market value on existing use basis and the surplus recorded in a Revaluation Reserve.

4

Administration expenses includes an exceptional item of €60,000 being the underprovision for a claim that arose in a previous year.

Workings W1 Cost of Sales Inventory on 1.10.20X3

211

Purchases

925

Carriage inwards

162

Depreciation – Building

9

Depreciation – Machinery [18 + 28 + 8] Salaries

[55% of 820]

54 451

Pension cost [10% of 451]

45.1

Heat and light [80% of 80]

64

Inventory 30.9.20X4

(364) 1557.1



W2 Distribution cost Advertising

112

Sales commission

92

Bad debts

158 362

W3 Administration expenses Depreciation – Buildings

6

Depreciation – Fixtures and equipment [8 + 3]

11

Underprovision for litigation

60

Salaries

369

Directors’ emoluments

180

549

Pension costs [10% of 549]

54.9

Heat and Light

16

Audit fees and expenses

65

Stationery

28

Other administrative expenses

128 917.9



Chapter 9: Question 3 – Cryptic plc (a) •

Company is wise to depreciate buildings because IAS 16 requires the depreciation of all assets with finite life.

•

This can be treated as a change in accounting policy; however, the guidance is not clear. If it is a change of policy, the material amount of backlog depreciation up to 30.6.X3 should be treated as a prior period adjustment, and explained in a note to published accounts.

(b) •

The company is not merely permitted, it is encouraged to undertake a periodical review of its estimate of UEL of fixed assets. Ō Necessary for avoiding situation where assets already fully written off continue in use and assist in earning income.

•

The change in the estimate of UEL is not a change in accounting policy and hence the impact of the change would not qualify to be treated as prior period adjustment.

•

The written-down value of the machinery on 30.6.20X4 of £288,000 should be written off Ō over the remainder of its revised UEL (of two years) Ō on the same policy (straight-line method). Ō the current year’s charge will be £144,000 and this will be included in the figure of Cost of Sale.

•

(c)

Since the current year’s charge of £144,000 exceeds the normal charge of £48,000 by a substantial amount, the difference may be reported in a note to accounts as an exceptional item.

Statement of Movement of Property, Plant and Equipment Land and buildings

Plant and

Furniture,

machinery

tools etc.

Total

£000

£000

£000

£000

Balance b/f

600

480

380

1,460

Acquisitions

150

–

–

150

–

–

(80)

(80)

750

480

300

Disposals Balance c/f


1,530


Acc. depreciation Balance b/f – Prior period adj

192

95

287

64

–

–

64

9

144

18

171

(9)

Income statement charge Disposal

–

–

Balance c/f

73

336

104

513

WDV on 30.6.20X4

677

144

196

1,017

WDV on 30.6.20X3

600

288

285

1,173

(d)

(9)

Income Statement for the year ended 30 June 20X5 £000

Revenue

£000 2,285.0

Cost of sales (Note 1)

(1,466.2)

Gross profit

818.8

Distribution cost (Note 1)

( 60.6)

Administration expenses (Note 1)

(281.2)

Operating Profit:

477.0

Dividend income

24.0

Finance cost

(24.0)

Unusual items: Results of discontinued operations

(192)

Fundamental reorganisation

(145)

Disposal of fixed assets

(7)

(344.0) 133.0

Taxation (Note 2)

(33.0)

Profit for the year

100.0

Balance Sheet as at 30 June 20X5 Non-current assets Property, plant and equipment (Ans c) Non-current asset investments

1,017 240



Current assets Inventory (Sch 3)

590

Receivables

475

Cash and bank balance

29

Current liabilities (Note 3)

(497)

597 1,854

Non-current liabilities Deferred tax (Note 2)

(174)

Preference shares @ £1 each

(200) 1,480

Share capital Ordinary shares @ 50p each

1,000

Share premium account

150

Retained earnings

330 1,480

Workings Cost of sales

Distribution

Administration

Inventory Raw materials Work-in-progress Finished goods Purchases

112 76 264 1,200

Depreciation Machinery Buildings

144 3.6

0.9

Furniture Salaries Rent Electricity

18.0 288

18

54

72

18

30

3.6

Advertising Factory power

4.5

7.2

25.2

65 48

Stationery

12

Other administration expenses [468–310]

158

Audit fee

18

Inventory Raw materials Work-in-progress

(172) (54)



Finished Goods

(364) 1,621.2

Less: discontinued operations

109.1

319.7

(155.0)

(48.5)

(38.5)

1466.2

60.6

281.2

Notes (1)

Discontinued operations

The results of discontinued operations are made up from: ‘000 Revenue

215

Cost of sales

(155)


(48.5)


(38.5)

Costs of cancelling contracts

(165) (192)

(2)

Taxation

Income tax

65,000

Overprovision for 20X4 taxation

(21,000)

Deferred tax

(11,000) 33,000

Deferred tax Balance b/f

185,000

Taxation for the year

(11,000) 174,000

(3)

Current liabilities

Audit fee

18

Sales tax [(2,875 × 15/115) – (1,380 × 15 /115) – 165]

30

Trade payables

360

Tax Dividend

65 (charged as interest)

24 557



Items to be disclosed

Expenses charged in the year Expenses charged in the year includes the following: Depreciation

£171,000

Auditor’s remuneration

£18,000

Unusual item: Depreciation charged on machinery includes an exceptional item of £96,000 arising from the revision of estimated useful life of machinery. Prior period adjustment The company has decided to depreciate buildings. The effect of this change in policy of £64,000 has been charged against Retained Earnings b/f.



Chapter 9: Question 4 – Reporting Financial Performance (a)

Statement of Changes in Equity

The Statement of Changes in Equity is of benefit to both investors and lenders to a company in a number of ways. The statement highlights the way that shareholders’ funds have changed over a period, and also the gains and losses recognised in the financial statements in the period that have not been charged or credited to the income statement. Investors will use the information in the statement to understand how the financial position of the company has changed. This will help the investors to understand whether the performance of the company has been good or poor. Investors will also see gains and losses that are not recognised in the income statement. For example the company could have been holding property that is increasing in value in the period, and this will be seen in the statement if the company has revalued in the period. Lenders will use the information in the statement to help assess the financial position of the company with a view to lending to it. The recognition of revaluation gains in the statement will help a lender to decide whether a company has a sufficient asset base to give security to loans. It can be argued that all the information that is in the Statement of Changes in Equity is already available in other disclosures in the financial statements. The statement, however, more clearly presents the information and therefore it is of benefit to users. Segmental disclosures Segmental disclosures provide information about the performance and position of an enterprise by reference to its business activities and geographical locations. The disclosures are quite extensive for primary segments and less extensive for secondary segments. The primary segmentation can either be by business activities or geographical location; it is the one that has the biggest impact on business risk. Investors want to make decisions on whether to buy, sell or hold shares in a company. Investors will need to understand how risky the investment is therefore as the return required will vary depending on the level of risk. Risk can either be financial risk or business risk, and segmental disclosures give information about the business risk that a company faces. If a company operates in a number of different business lines, for example, it will be exposed to less business risk than an enterprise that operates in only one. Investors can also use segmental disclosures to help to assess the quality of management. The investors will be able to see the performance of management in all of the entity’s trading activities and therefore they will be able to see if the performance is poor in any area. Lenders will use the information in a similar way but to make decisions on whether to lend to the enterprise. The level of business risk to a lender may have an influence on the rate of interest that is set by the lender and the other terms of the loan.



Discontinued activities IFRS 5 requires companies to present information about their continuing and discontinued activities separately. This information will often be presented on the face of the income statement although disclosure in the notes is acceptable. Users (investors, lenders and other users) like to see information about discontinued activities so that they can try to assess the future performance of the enterprise. When assessing the future performance of an enterprise the discontinuing activities should be ignored as these are not present in the future. If, for example, it can be seen that the discontinuing activities are the poorly performing activities of an enterprise, the enterprise might be a good investment even though overall its performance is not very good. Also the separate information about discontinued activities will help assess the performance of management. Users will be able to assess if the management is discontinuing unprofitable or profitable business activities. This will help the users decide whether the company is a good or poor investment decision. Disclosed information about future discontinuances that the company intends to undertake will also be useful to users in assessing the longer-term future potential. Companies must disclose information about discontinued activities as soon as the operations are classified as held for sale, and this could be before the actual discontinuance occurs.

(b) Bedok Ltd 20X9 financial statements Note to the accounts On 1 June 20X9 the board of directors announced a plan to dispose of the clothing manufacturing segment as this segment is not in line with the core activities of the company. The company is actively seeking a buyer and hopes to have completed the sale by the end of 20Y0. At 31 December 20X9 the carrying amount of the clothing segment assets was £20 million and the liabilities were £4 million. The clothing division had revenue of £65 million, incurred expenses of £50 million, had an operating profit of £14 million and a tax charge of £5 million on the profits for the year ended 31 December 20X9. A provision of £1 million has been made in respect of redundancy costs expected when the division is sold.



20Y0 financial statements Income statement for 20Y0 Discontinued

activities

20Y0

20X9

£000

£000

Turnover

40,000

65,000

Expenses

(32,000)

(50,000)

Redundancy costs

(1,000)

Provision for redundancy costs

1,000

(1,000)

Operating profit

8,000

14,000

Profit on disposal of division

2,000

Taxation

(3,000)

(5,000)

Please note that 20X9 has been restated to present the results as discontinuing activities.

Note to the accounts On 10 May 20Y0 the board signed an agreement to sell the clothing division for £20 million. This plan had been announced on 1 June 20X9. The company decided to dispose of the division because its activities were inconsistent with the core activities of Bedok Ltd. Bedok Ltd recognised a provision of £1 million in 20X9 for the costs of redundancy of employees, and this provision was released in 20Y0. Actual redundancy costs of £1 million were paid. The process of selling the company was completed on 1 July 20Y0 and the assets of the division at this date were £23 million and liabilities were £5 million. A pre-tax profit of £2 million was made on the disposal.



Chapter 9: Question 5 – Parnell Ltd (a)

Accounting treatment of items 1–5

Item 1 is an exceptional unusual item •

General rule is to include under format heading to which it relates Ō In this case distribution costs Ō No adjustment necessary to the income statement but disclose bad debt by way of note.

Item 2, profit/loss on the sale or termination of an operation should be •

Shown separately on face of the income statement after operating profit and before interest

•

Analysed under appropriate heading as continuing or discontinued.

Item 3 enables distinction to be made between continued and discontinued operations •

Improves the comparability of current year with previous and next year.

Item 4 would normally be considered a change of accounting policy and requires •

A depreciation charge of £6m for 2003 and

•

A prior year adjustment of £12m in respect of 2001/2002 to be charged against retained profits brought forward.

Item 5 is an exceptional unusual item which should be charged •

As an administrative expense in respect of continuing operations

•

No adjustment is required to the income statement but the restructuring costs must be disclosed by way of note.

(b)

Redraft of the income statement for 2003 Continuing

Discontinued

Total

£m

£m

£m

Sales

463

100

563

Cost of sales

280

30

310

183

70

253

Distribution costs

45

Administration expense (W1)

94

00

94

Operating profit

44

70

114

10

10

80

124

Profit on disposal of asset

45


44

Taxation

45

Retained profit

79 103 © Pearson Education Limited 2006


Reserves Retained earnings £m At beginning of year

101

Prior year adjustment

(12) 89

Transfer from income statement At year-end

79 168

W1 78 per question + 10 being profit on sale of distribution division to be separately disclosed + 6 depreciation on offices.



Chapter 9: Question 6 – Related Party Scenarios (a) IAS 24 para. 9 states that a related party is a party that can exercise significant influence over another party. Significant influence would normally be assumed if a party owns at least 20% of voting rights. Arthur is therefore presumed to be a related party. However, Arthur would not appear to be able to influence the financial and operating policies because of the disagreement. Further enquiry would be required to establish that this has actually been the effect of the disagreement. (b) Brenda appears to fall within the definition of key management personnel. Brenda is therefore presumed to be a related party. Supporting evidence: Key management is defined as a person in a senior position having authority or responsibility for directing or controlling the major activities and resources of the reporting entity. Brenda’s ability to take 30% of the turnover with her would be prima facie evidence of such authority. (c) Donald and Emma through their relationship with Carrie would be related parties of Z Ltd. Both would be presumed to be related parties to Z Ltd. However, Donald is an employee and there would be no requirement to disclose emoluments. Supporting evidence: Emma is not an employee and amounts paid to Emma by Z Ltd would be disclosed. The disclosure required by para.17 of IAS 24 includes: (i) description of relationship (ii) description of the transaction (iii) the amounts involved (iv) any additional information required to understand the transaction (v) amounts due at balance sheet date. (d) This requires consideration of the difference between common control and common influence.



•

Control brings with it the ability to cause the controlled party to subordinate its separate interests, whereas

•

the outcome of the exercise of influence is less certain.

Paragraph 11(a) of IAS 24 states that two entities are not related simply because they have a director in common. Further enquiry is required to consider whether one or both transacting parties, subject to control and influence from the same source or common influence, have subordinated their own separate interests in entering into that transaction.



Chapter 9: Question 7 – Maxpool plc Sale of factory outlet: •

As Bay plc is an investor owning more than 20% of Ching Ltd it is a related party of Ching Ltd.

•

Details of the transaction will have to be included in both sets of financial statements for the financial year ending 31 December 20X0.

•

Disclosure is required of any elements of the transactions necessary for an understanding of the financial statements. Ō In this case it means that, as the factory site was sold to a major investor, the financial statements should note that the price was determined by an independent surveyor.

What is position re Maxpool? •

Although both Maxpool plc and Bay plc have an investment in Ching Ltd this does not by itself make these companies related parties. There would appear to be no related party relationship between them and therefore there will be no disclosure in Maxpool plc’s financial statements.

•

If Maxpool and Bay fall within IAS 24 para. 9(a) and there is control or influence over Maxpool Group plc they could be related parties. Ō Evidence of influence would, for example, be presumed if Maxpool plc persuaded Bay to sell the factory at below market value.

What is effect of changes in shareholdings in 20X1? •

Maxpool plc is a related party of Ching Ltd.

•

Maxpool plc is presumed to be a related party of Bay plc as Maxpool plc has a holding of more than 20% as per IAS 24 para. 9(b).

•

Bay plc is not necessarily a related party of Ching Ltd because there is no presumption that 10% of shareholders have the requisite level of influence. Ō although Maxpool plc controls Ching and has influence over Bay plc, the relationship between Bay and Ching would not automatically justify their being treated as related parties of each other. Ō However, one would have to check whether one party has subordinated its interests to the other.

How is the sale of vehicles treated? •

As regards the disclosure of the purchase of the vehicles by Bay plc, as it appears that Bay and Ching are not related parties there is no disclosure required in the financial statements of either company.

•

Although Bay plc is not a related party of Ching Ltd it is an associate of Maxpool plc and therefore a related party of Maxpool plc. 107 © Pearson Education Limited 2006


Ō Maxpool plc will have to disclose details of the transaction between a group member and Bay plc in the group financial statements.



CHAPTER 10

Chapter 10: Question 1 – Distribution Rules (a) A distribution is every description of distribution of a company’s assets to its members whether in cash or otherwise with the exception of: •

an issue of bonus shares

•

redemption of a company’s own shares out of capital

•

a reduction in share capital by reducing the outstanding liability on unpaid shares or by paying off paid-up share capital.

•

a distribution of assets to shareholders on winding up.

(b) The rules for distribution are made to ensure that losses are properly made good before any dividends are paid ensuring that the capital of the company is not eroded. Before 1980, case law had not made this position clear, thus statute was enacted to clarify the position.

(c)

Profits available for distribution are: •

accumulated realised profits less accumulated realised losses in so far as they have not already been distributed or capitalised

•

capital and revenue profits are taken together provided they are realised

•

unrealised profits are not available for distribution.

The additional rule for a public limited company is that the accumulated realised and unrealised profits must exceed the unrealised and realised losses of a company before a distribution can be made. Net unrealised profits are not distributable.

(d) Other constraint on the company’s ability to distribute may be liquidity i.e. availability of cash to pay a dividend.



(e)

(i) A and B as private companies A

B

£000

£000

90

–

5

10

–

15

loss

–

(13)

Distributable profits for a private limited company

95

12

A

B

£000

£000

Profit and loss account is the only distribution profit (i)

Add back depreciation charged on revalued amount allowed by companies specifically for distribution

(ii)

Add adjustment to take account of gain now realised on sale of property

(iii)

Take off contingent loss as it is probable. Should be accrued for and hence in accordance with general accounting principles be treated as a realised

(ii) A and B as public companies

The fixed asset investment is an unrealised loss take into account but offset against unrealised profits

(10)

(10)

40

35

95

12

revaluation reserve therefore no adjustment to distributable profits



Chapter 10: Question 2 – V.R. Confident Ltd (a) In a private company: accumulated realised profits less accumulated realised losses by the balance sheet date. For a public company: as above but net unrealised losses also need to be deducted.

(b)

Maximum distributable profits £000 Profit after tax – as per accounts

£000 314.0

Less: (c) Stock

90.0

(e) Bad debts

60.0 150.0

Tax saving at 33%

49.5

(100.5) 213.5

Add:

(b) Depreciation

60.0

(a) Asset revaluation reserve

90.0 363.5

Less: Profit and loss a/c brought forward

(288.0) 75.5

Add:

General reserve

160.0

Maximum available for distribution

235.5

Less: Preference share dividend

18.0

Maximum distribution for ordinary shareholders

217.5

Assumptions: •

Research and development – unrealised

•

Profit and loss a/c brought forward – all realised

•

General reserve – all realised

No difference here if the company was a public company as no accumulated net unrealised losses.



Chapter 10: Question 3 – Alpha, Beta and Gamma (a)(i) Private companies For a private company the maximum distribution that can be made is

(ii)

•

accumulated realised profits of the company (to the extent that they have not previously been distributed or capitalised) less

•

its accumulated realised losses (to the extent that they have not been written off in a reduction or reorganisation of capital).

•

Such profits and losses may be revenue or capital in origin.

Public companies For a public company the same rules apply subject to the additional restriction that •

IF accumulated unrealised losses exceed accumulated unrealised profits

•

THEN the net unrealised loss must be deducted from the amount otherwise available for distribution.

Again profits and losses may be revenue or capital in origin.

(b)(i) Alpha plc Maximum amount available for distribution at 31 March 20X7: Realised capital profit

1,600

Realised revenue profit brought forward

800

Realised revenue profit for year

400 2,800

Depreciation relating to revaluation surplus treated

(ii)

as realised (2,200/50)

44

Maximum distribution

2,844

Beta plc Maximum amount available for distribution at 31 March 20X7: Realised revenue profit brought forward Realised revenue loss for year

1,000 (400) 600

Net unrealised capital loss (revaluation deficit) Maximum distribution

(400) 200



(iii)

Gamma Ltd Maximum amount available for distribution at 31 March 20X7: Realised revenue loss brought forward Realised revenue profit for loss

(3,200) 400 (2,800)

No distribution possible – accumulated realised losses exceed accumulated realised profits.



CHAPTER 11

Chapter 11: Question 1 – Distribution – identifying unrealised and realised profits (a) (i) Share premium is the amount by which the value at which a company issues its shares exceeds their nominal value.

(ii) Section 130(1) of the Companies Act 1985 requires that ‘where a company issues shares at a value that exceeds their nominal value a sum equal to the difference between the issue value and the nominal value must be transferred to a share premium account’. Three circumstances in which this is necessary are as follows: 1. Where the company issues its shares for a cash consideration and the total amount it expects to receive in cash exceeds the par value stated on the share certificate. 2. Where shares were forfeited and re-issued thereafter, and the total consideration received on both transactions exceeded the nominal value. 3. Where the company issues shares for a consideration other than cash (e.g. in relation to an acquisition of business or merger) and the fair value of the shares issued exceeds their fair value.

(iii) Company law seeks to protect any balance in the share premium account from abuse, because: •

it is part of the capital paid up by shareholders and

•

it forms the creditors’ buffer that, according to company law, ought to be protected, in the interest of those whose interests are at peril on account of the privilege of limited liability.

Company law seeks to protect the balance in share premium from abuse by specifically stating the purpose for which alone such a balance may be applied as follows: •

pay up fully paid bonus shares

•

write off preliminary expenses

•

write off any expenses of any issue of shares or debentures

•

write off commission paid or discount allowed on any issue of shares or debentures

•

provide for any premium payable on redemption of debentures and provide for any premium payable on redemption of its own shares under the circumstances specified in answer to question (b)(i) below.



(b) (i) Depreciation Depreciation on a fixed asset is a realised expense BUT where the fixed asset has been revalued the depreciation on the revalued portion may be treated as a realised profit which is available for distribution.

(ii)

Development Development expenditure capitalised in the balance sheet and subsequently charged to the profit and loss account is a realised loss •

in the year the expense appears in the profit and loss account

•

NOT when the cost is incurred.

(iii)

Associates The share of profits from an associated company to an investing company which is not included in consolidated financial statements is not considered to be realised profits; only the dividends received are considered realised.

(iv) Profit on disposal The profit on disposal of a fixed asset which has been revalued will be the difference between the proceeds and the valuation of the asset. •

However, the excess of the valuation over net book value will not have been treated as realised profit in the year of valuation and so in the year of disposal the whole of the profit (proceeds less net book value) will be treated as realised.

(v)

Provisions

•

The fact that the provision appears in the balance sheet, and not as a note to the balance sheet concerning a contingent liability, clearly indicates that the directors expect to pay damages.

•

This decision is probably based on legal advice and, in accordance with SSAP 2 Disclosure of Accounting Policies, has been provided for in the accounts.

•

In these circumstances this would be regarded as a realised loss.

(vi)

Revaluation surplus

•

Any surplus arising from a revaluation of an asset would be regarded as unrealised.

•

It would only be realised when the asset was sold. This is in accordance with SSAP 2 prudence concept.

(vii) A provision for bad debts A provision would be realised since it is generally accepted accounting practice to make such provisions in accordance with the prudence concept in SSAP 2.



Chapter 11: Question 2 – Smith Family Ltd To: From: Date: Subject:

Directors of Smith Family Ltd The Auditor August 20X7 Report on the Proposed Buyback of Ordinary £1 shares held by Mr Otto Smith Senior

1. Introduction 1.1 Otto Smith Senior wishes to retire from the business and dispose of his holding of 200,000 ordinary £1 shares. These have been valued by independent valuers at £300,000 and the price is not disputed. 1.2 The purpose of this report is to explain: •

whether the company may make the purchase

•

the procedure which must be followed

•

the rules relating to private companies in respect of the purchase of shares from capital.

1.3 The report will also include illustrative figures and journal entries for the two financing options (internal resources and a combination of internal resources and a new share issue) and will explain the changes to the balance sheet. (a) 2. Power to purchase own shares •

The Companies Act 1985 permits the purchase whether or not the shares were issued as redeemable.

•

Power to purchase must also be permitted by Smith Family Ltd’s Articles of Association.

(b) 3. Procedure to be followed • • •

Off market purchase will, therefore, require specific contract approval by special resolution in general meeting. Shares bought in from Otto Senior must be cancelled immediately and not reissued. Permanent capital (share capital and undistributable reserves, e.g. share premium) generally required to be preserved by Companies Act 1985. •

•

A transfer must normally be made from distributable profits to undistributable reserves (capital redemption reserve) equivalent to the difference between the proceeds of the new issue (if any) and the nominal value of the shares bought back.

The premium on redemption (£100,000 in respect of Otto Senior’s shares) must normally be met from distributable reserves (profit and loss) •

although some limited relief may apply if the buyback is partly or wholly financed by a new share issue and Otto Senior’s shares were originally issued at a premium, as indeed they were.

(c) 4. Redemption from capital – private companies •

Smith Family Ltd, as a private company, may be allowed to reduce its permanent capital (share capital and undistributable reserves) where undistributable reserves are insufficient to finance the buyback. The amount of permissible reduction is found by the formula:



Redemption cost less sum of the distributable reserves and the proceeds of any new issue. This is called the permissible capital payment (PCP). •

Purchase must be permitted by the company and a special resolution is needed.

•

Statutory declaration of solvency is required by directors that, immediately after the buyback and within 1 year of the buyback, the company will be able to pay its debts. The directors may become personally liable for the debts.

•

Report from company auditors must be attached to the declaration stating their agreement.

•

Dissenting shareholders who did not vote can apply to the courts to have the purchase from capital set aside.

(d)

Option 1: Purchase from internal resources Balance sheet after buyback:

Before

After

£000

Net assets

£000

400

Cash

100 (400 – 300)

850

Other sundry assets

850

1,250

950 Financed by:

1,000 100 – 150

Ordinary £1 shares

800 (1,000 – 200)

Share premium

100

Capital redemption reserve

50 (200 NV–150 PCP)

Profit and loss

– 950

1,250 Workings:

Redemption cost

300,000

Less: Distributable reserves

(150,000)

Permissible capital payment (PCP)

150,000

Transfer to capital redemption reserve (CRR) Nominal value of shares redeemed

200,000

Less: PCP

(150,000)

Transfer to CRR

50,000 Dr

Journal entries: Ordinary £1 shares

Cr

200,000

Purchase of ordinary £1 shares

200,000

Write out of shares to be bought back



Profit and loss account

100,000


100,000

Premium payable on buyback Purchase of ordinary £1 shares

300,000

Cash account (or bank)

300,000

Payment to buy back shares Profit and loss account

50,000


50,000

Transfer from distributable to undistributable reserves in accordance with the requirements of the Companies Act 1985. (Nominal value of shares redeemed 200 less permissible capital payment 150.)

Explanation: •

Distributable reserves (£100,000) are lower than the redemption costs (£300,000), therefore, as a private company, Smith Family Ltd will be permitted to reduce its permanent capital.

•

Permissible capital payment (the amount of permitted reduction) is the redemption cost (£300,000) less the distributable reserves (£150,000), that is £150,000 and the permanent capital after the buyback has fallen by this amount from £1,100,000 to £950,000.

•

The capital redemption reserve is created because the nominal value of the shares redeemed (£200,000) that is, the amount by which the permanent capital of the company would fall after the buyback, is higher than the permissible capital repayment of £150,000.

•

Cash falls by £300,000, the cost of redemption.

•

The profit and loss balance (distributable reserves) is wiped out by the premium due on redemption and the statutory transfer to capital redemption reserve.

•

Ordinary shares fall to 800,000 after the buyback.



Option 2: Partly from internal resources and partly by a new issue of ordinary £l share Balance sheet after buyback: Before £000

After Net assets

£000

400

Cash

200 (400 – 300 + 100)

850

Other sundry assets

850 1,050

1,250 Financed by: 1,000 100 – 150

Ordinary £1 shares

850 (1,000 – 200 + 50)

Share premium

110 (100 + 50 – 40)


50

Profit and loss

40 (150P – 60 (Prem) – 50 CRR) 1,050

1,250 Workings:

PCP

£000

Redemption cost

£000 300

Less: Distributable reserves

150

Proceeds of new issue PCP

100

PCP

(250) 50

Transfer to capital redemption reserve: Nominal value of shares redeemed

200

Less: PCP

50

Proceeds of new issue (to ordinary shares and share premium)

100

Transfer to capital redemption reserve

(150) 50

Premium on redemption: treatment Redemption costs partly financed by new issue and Otto Smith Senior’s shares originally issued at a premium: Premium on issue 200,000 @ 20p

40,000

Premium on buyback (300 – 200)

100,000

Proceeds of new issue

100,000

Balance on share premium after new issue (100 + 50)

150,000

∴ Write £40,000 of premium due on buyback off against share premium and write balance of £60,000 off against profit and losses.



Journal entries: Dr Ordinary £1 shares

Cr

200,000


200,000

Write out of shares to be bought back Profit and loss account

60,000

Share premium

40,000


100,000

Premium payable on buyback Purchase of ordinary £1 shares

300,000

Cash account (or bank)

300,000

Payment to buy back shares The following two entries may be combined: Cash account

100,000

Application and allotment account

100,000

Proceeds of new issue Application and allotment account

100,000

Ordinary £1 shares

50,000

Share premium

50,000

Allotment at a premium of £1 Profit and loss account

50,000


50,000

Statutory transfer from profit and loss to capital redemption reserve: nominal value of shares bought back (£200,000) exceeds the combined total of the permissible capital payment (£50,000) and the proceeds of the new issue (£100,000). Explanation: •

Distributable reserves and proceeds of new issue are lower than the redemption costs therefore, as a private company, Smith Family Ltd will be permitted to reduce its permanent capital on the buyback.

•

Permissible capital payment is £50,000 and the permanent capital would have fallen by this amount except that part of the premium due on buyback may be financed through share premium, and therefore permanent capital has fallen by £90,000, the combined effect of the PCP (£50,000) and the write-off against share premium (£40,000).



•

Capital redemption reserve is created because the nominal value of the shares redeemed (£200,000) exceeds the combined sum of the PCP (£50,000) and the proceeds of the new issue (£100,000).

•

Cash falls by £200,000, the net difference between the redemption cost and the proceeds of the new issue.

•

Share premium account shows a net increase of £10,000, being the difference between the premium on the new issue of £50,000 and the permitted amount of £40,000 of the premium due on the buyback which has been charged against the share premium.

•

Profit and loss falls to £40,000, after charging £60,000 premium due on the buyback and transferring £50,000 to capital redemption reserve.

•

Ordinary shares fall to £850,000, showing the net effect of the buyback (£200,000) and the new issue (£50,000).

Conclusions and recommendations Option 2, partly financed by new share issue, is the more favourable because: •

Company is still left with distributable reserves (£40,000 – profit and loss).

•

Share premium, which is a restricted reserve in terms of utilisation, may be used to absorb some of the cost (£40,000) of the premium due on the buyback.



Chapter 11: Question 3 – Telin plc (i) 1/10

Cash and bank Balance

5,450,000

4/10

Debentures

2,340,000

12/10

Ord. shares

6,000,000

31/10

Share premium

600,000

P&L a/c

275,000

28/10

31/10

Redemption of preference shares

8,480,000

Balance c/d

6,185,000 14,665,000

14,665,000 1/11

Balance b/d

6,185,000 10% debentures 4/10

31/10

Balance c/d

Bank Deb. discount

2,400,000 1/11

Balance b/d

2,340,000 60,000 2,400,000

Discount on debentures 4/10

Debentures

60,000

6/10

Share premium

60,000

Share premium 6/10

Deb. discount

29/10

Premium on

31/10

60,000

1/10

Balance

redemption

160,000

12/10

Cash

Balance c/d

4,380,000 4,600,000

4,000,000 600,000 4,600,000

1/11

Balance b/d

4,380,000

1/10

Balance

4,600,000

31/10

Cash (profit)

Profit and loss 6/10

Research exp.

29/10

Dividends on pref. shares

29/10

31/10

80,000

275,000

Premium on redemption

29/10

1,400,000

240,000


1,400,000

Balance c/d

1,755,000 4,875,000


4,875,000


Product development costs 1/10

Balance

1,400,000

6/10

P&L a/c

1,400,000

Ordinary share capital

31/10

Balance c/f

1/10

Balance

12/10

Bank

30/10

(Bonus issue) CRR

12,000,000 6,000,000 900,000 18,900,000

18,900,000 1/11

Balance c/d

18,900,000

12% preference share capital 29/10

Redemption of shares

8,000,000

1/10

Balance

8,000,000

Redemption of preference shares 29/10

Cash

8,480,000

29/10

Pref. shares Premium on red. P&L a/c

8,480,000

8,000,000 400,000 80,000 8,480,000

Premium on redemption 29/10

Redemption a/c

400,000

29/10

Share premium

160,000

P&L a/c

240,000

Capital redemption reserve 30/10 31/10


29/10

bonus issue

900,000

Balance c/d

500,000

P&L a/c

1,400,000

1,400,000 1/11

(ii)

1,400,000

Bal. b/d

500,000

Balance sheet as at 31 October 20X5


18,900,000


Sundry assets

32,170,000

Cash at bank

6,185,000

500,000

Share premium

4,380,000

Retained profits

1,755,000



10% debentures Creditors

2,400,000 10,420,000 38,355,000

38,355,000

Note: Advantageous course of action for shareholders is not to reduce distributable profits unless there is no other course of action. Therefore, whenever legally possible, reduction has been made from share premium account. Bonus issue was made from capital redemption reserve, as this is restricted to bonus issues only whereas share premium can be used for some other purposes also.

(iii)

Under the Companies Act 1981:

(a) Premium on redemption of shares can be written off against share premium – maximum allowed being premium received on the issue of shares, which are now being redeemed i.e. 2% of £8,000,000 = £160,000 to share premium. Balance must be written off against profits. (b) Transfer to capital redemption reserve is the amount by which the aggregate receipts from specific new issue exceeds the nominal value of shares redeemed. Nominal value of shares redeemed Less: total receipts from new issue To capital redemption reserve (from distributable profits)

8,000,000 6,600,000 1,400,000



Chapter 11: Question 4 – Alpha Ltd (a)

Capital reduction and reorganisation account £000

£000

7¾% notes

50

Ordinary shares

75

Ordinary shares – reissue

15

Ordinary shares

15

Profit and loss account

177

Preference shares

250

Shares in sub.

55

Freehold property

14

Plant

57

___

354

354

(b)

Balance sheet as on 1 July 20X8 £000

£000

Fixed assets Tangible assets Freehold property

55

Plant

22 77

Investment Shares in subsidiary company

45

Loans

40

85 162


132

Trade receivables

106

Bank

107 345

Payables: Amounts falling due within one year Trade payables

282

Net current assets

63 225

Payables: Amounts falling due after one year 7¾% notes

200

Total assets less liabilities

25


25



Ordinary share capital £000

£000

Capital reduction

75

Balance b/f

75

Capital reduction

15

Bank

25

Balance c/f

25

Reissue

15

115

115 Balance

25

Bank OSC 7¾% notes

25 150

Balance b/f

58

Shares in sub.

10

Balance c/f 175 Balance b/f

107 175

107 7¾% notes

Balance c/f

200

Bank Capital reduction

200

150 50 200

Balance b/f


200


Chapter 11: Question 5 – Doxin plc This question is essentially concerned with the issue and redemption of shares by a plc where there is a trading loss impacting on the cash liquidity position. Part (a) requires students to illustrate the effect on key balance sheet components. Part (b) requires a discussion and evaluation of the effects of applying the Companies Act 1985 capital maintenance rules in circumstances where shares are redeemed partly out of distributable profits. Opening

(i)

(iia)

(iib)

(iii)

(iv)

(v) Closing BS

£000 £000 £000 Ord. shares

800

Pref. shares

300

£000

£000

200

£000

£000

5

£000 1,005

(300)

-

Capital red. Reserve

80

Share premium Reserves

20

80

(15)

200

(5) (80)

(500)

(380) 705

Creditors

400

400

Debentures

400

400

1,700 Bank

200

Other assets

1,505 220

(315)

360

(500)

1,500

(35) 1,500

40

Debenture discount

40

1,700

1,505

(i) (a) Premium on redemption •

out of profits or

•

lowest of: •

premium received on issue of shares to be redeemed (£75,000)

•

balance of share premium account including premium on new issue (£20,000)

•

total proceeds of the new issue (£220,000).

(ii) (b) Capital redemption reserve: •

excess of nominal value of shares redeemed over (£300,000 – 220,000 = 80,000)


total receipt from new issue


Comments on Doxin plc (a) (i) The issue of 200,000 ordinary shares at a premium of 10p each increases the share capital, the share premium and cash balance; note that the issue must be made within specified time limits if it is to be effective in applying the capital maintenance rules which require a transfer to capital redemption reserve. (ii) On redemption of the preference shares it is necessary to calculate the extent to which the premium on redemption can be charged to the share premium account, and the transfer, if any, to the capital redemption reserve from distributable profits – in this case from the general reserve £200,000. The full premium on redemption can be charged to the share premium account which was brought into existence by the replacement issue. The limitation imposed by % premium originally received on the shares does not apply. The preference shares (300,000) disappear from the balance sheets and the share premium account becomes £5,000 with the bank balance reduced by £315,000. The transfer from general reserve to CRR is always in excess of nominal value redeemed over the proceeds of other issue (made specifically for redemption). (iii) The issue of 7% debentures £400,000 valued at 90 results in a long-term liability of £400,000 and a net increase in the bank balance of £360,000 with discount on debentures £40,000. The Companies Act 1985 is silent on treatment of this item apart from the option to write it off against the share premium account. Write-off over the life of the debenture might be the appropriate treatment. (iv) The use of the share premium balance £5,000 to cover a bonus issue of ordinary shares is reflected by a transfer to the ordinary share capital account as permitted by the Companies Act 1985. (v) The trade loss £500,000 incurred in the year is recorded as impacting on the bank balance where it creates an overdraft of £35,000. (b)

The interest of creditors is protected by the creation of the CRR £80,000 which is nondistributable and can only be used to issue bonus shares.

However, because of the use of SPA to cover premium on redemption £15,000 the original capital of £1,100,000 is only maintained up to £1,085,000 capital meaning issued share capital plus undistributable reserves. The effect of this loophole in capital maintenance regulation could be remedied by an additional transfer from distributable profit to CRR – in this case of £15,000.



Chapter 11: Question 6 (a)

The advantages of purchasing and cancelling own shares are:

It is a method of returning surplus cash that a company is unable to invest profitably within the company It is a method of overcoming a problem as when shares are acquired from a dissenting shareholder so as to remove the nuisance value. It is a method of providing cash as a help to a shareholder in liquidating their shareholding as where shares have been issued to employees as part of a profit sharing scheme and the employee wishes to convert to cash or they are acquired from the estate of a deceased shareholder It is a possible method of improving the share price if the directors consider the current share price are undervalued – on cancellation each remaining share has a greater interest in the net assets. It is taken as a means of increasing the earnings per share.

(b)

The advantages of purchasing and holding shares in treasury

It provides a company with greater flexibility in managing its share capital It allows a company to optimise its gearing by buy back rather than by increasing or decreasing its debt It reduces the cost of raising new capital if the shares are reissued later through a Broker rather than through a more expensive placing or rights issue. It can stimulate an inactive market particularly if existing shareholders have been finding it difficult to sell their shares It can lead to an increase in the earnings per share Treasury shares can be used to satisfy the exercise of employee share options and may be acquired at the date the option is granted and held in treasury.



CHAPTER 12

Chapter 12: Question 1 – Post Balance Sheet Events (a) IAS 10 requires that financial statements should be prepared on the basis of conditions existing at the balance sheet date, and therefore lays down the following treatment for events after the balance sheet date. A material event after the balance sheet date requires changes in the amounts to be included in financial statements where: •

it is an adjusting event (i.e. an event which provides additional evidence of condition existing at the balance sheet date); or

•

it indicates that application of the going concern concept to the whole or a material part of the company is not appropriate. A material event after the balance sheet date should be disclosed where:

•

it is a non-adjusting event Ō i.e. an event which concerns conditions which did not exist at the balance sheet date Ō of such materiality that its non-disclosure would affect the ability of the users of financial statements to reach a proper understanding of the financial position; or

•

it is the reversal or maturity after the year end Ō of a transaction entered into before the year end Ō the substance of which was primarily to alter the appearance of the company’s balance sheet.

The purpose of the recommended treatment is: •

To ensure that the financial statements show the true position as it existed at the year end.

•

All information available to management at the date that the financial statements are finalised should be taken into account.

•

To the extent that such information relates to the financial year dealt with in the financial statements, they should be adjusted.

•

To the extent that material matters relate to the subsequent period the user should be informed by way of note so that they are not misled as to the current position of the company. However, Ō If events subsequent to the year end indicate a need to consider whether the enterprise (or a material part of it) is a going concern they are to be treated as adjusting events Ō because the use of the going concern basis implies a belief that the company will continue in business for the foreseeable future.



(b) (i) •

This fraud is an adjusting event, because it has been discovered that the financial statements will not be correct unless they are adjusted for it.

•

The £8,000 should therefore be written off in the profit and loss account so that a true and fair view is shown.

(ii) •

As the agreement to purchase this business relates to the period after the year end it is a nonadjusting event. Ō Knowledge of it in no way affects the position of the company at 31 December 20X6. Ō Therefore it should be disclosed by way of note.

(iii) •

The rights issue relates entirely to the period after the year end, therefore it is a nonadjusting event.

•

It would be wrong to adjust the company’s share capital and cash at 31 December 20X6 because of a subsequent share issue.

•

This should be disclosed by way of note.

(iv) •

This is an adjusting event because it provides evidence of conditions existing at the balance sheet date.

•

The potential loss of £9,000 should be written off in the income statement and deducted from debtors in the balance sheet.



Chapter 12: Question 2 – SEAS Ltd (i) The closure of the Garratt factory is a discontinuance of a business segment, as it was clearly a material and separately identifiable component of the company’s business operations. Under IFRS 5, disclose under discontinuing heading. (ii) The fraud is an adjusting event under IAS 10, and, as it has been discovered, the financial statements will not show a true and fair view unless they are adjusted for it. The $30,000 should therefore be written off in the income statement. (iii) This is an exceptional item, because it is material but arises from the ordinary activities of the business. It should be charged in arriving at the profit on ordinary activities, and should be disclosed separately. (iv) The agreement to purchase this business relates to the period after the year end and is therefore a non-adjusting event under IAS 10, as knowledge of it does not affect the company’s position at 31 March 20X8. However, disclose the information by way of note. (v) This is also an exceptional item and should be treated as in (iii) above. It is not a prior year adjustment because it arises from a change in trading conditions and not from a change in accounting policy or a fundamental error. (vi) Under IAS 10 this is an adjusting event as it provides evidence of conditions existing at the balance sheet date. The potential loss of £30,000 should be written off in the income statement and deducted from the debtors in the balance sheet. (vii)The rights issue relates entirely to the period after the year end, therefore it is a nonadjusting event under IAS 10. This should be disclosed by way of note.



Chapter 12: Question 3 – World Wide Nuclear Fuels (a)

Explanation

(i)

Need for guidance

Difficulties included: •

Definition – the IASB define provisions as a ‘liability of uncertain timing or amount’.

•

Treatment of future operating losses – considered these should be accounted for in the future.

•

Provisions differ from liabilities in that provisions are often subject to disclosure requirements whereas other creditors are not e.g. statutory requirement to disclose – may however be insufficient detail.

•

Adequate level of disclosure of movements is important as these do not go through Income Statement once provision is established.

•

Unacceptable practice of big bath provisioning used to absorb expenses incurred in later years.

•

Management has been able to control the recognition and timing of movements so that user does not have a clear picture of current year’s performance – smoothing profits.

•

There has been inconsistency between the accounting for provisions between different companies.

(ii)

Recognition

IAS 37 applies Framework approach – provisions are an element of the liabilities and not a separate element of the financial statements. Provisions should therefore be recognised only when: (i) an enterprise has a present legal or constructive obligation and benefits as a result of past events (ii) it is probably that an outflow of resources embodying economic benefits will be required to settle the obligation (iii) a reasonable estimate of the amount required to settle the obligation can be made. IAS 37 takes a balance sheet perspective by concentrating on liability recognition rather than the recognition of an expense. Criteria include: •

An obligation exists when the entity has no realistic alternative to making a transfer of economic benefits – may be legally enforceable or constructive.

•

Only recognised if existing at balance sheet date.

•

Must have arisen from past events.

•

Must exist independently from the company’s future actions.



•

If avoidable by future actions then no provision is recognised.

•

No provision should be recognised for future operating losses.

•

A constructive obligation for restructuring only exists when the recognition criteria laid out in IAS 37 are satisfied.

•

If an enterprise has a contract which is onerous, the present obligation should be recognised and measured as a provision.

(b)

Transactions

Although IAS 37 states that no provision should be made for future operation losses, this does not apply if there is an onerous contract. This contract appears to be onerous and so the provision of $135m should remain in the financial statements. With regard to the provisions for environmental liabilities, the question is whether this is a constructive obligation. There is no current obligation but it could be argued that there is a ‘constructive obligation’ to provide for the remedial work because the conduct of the company has created a valid expectation that the company will clean up the environment. We say ‘could be argued’ because there is no clear answer and it may well be determined by the subjective assessment of the directors and auditors as to whether there is a ‘constructive obligation’. The example 2B in IAS 37 would support making a provision.



Chapter 12: Question 4 The proposal to include the £62.5m and £40m in sales and cost of sales is incorrect. If it were a genuine disposal it should have been treated as the disposal of a non-current asset with the profit included in the income statement, separately disclosed if material. The substance of this transaction is, however, a secured loan in that the company is going to have the continued use of the equipment for the whole of its economic life. There should be a charge of 10% in the Income Statement for the three months from 1 October 20x5. In the balance sheet the asset will continue to be shown as a non-current asset and a year’s depreciation charged. There will also be a liability for the amount of the loan less any capital repayment that has been made.



CHAPTER 13

Chapter 13: Question 1 – DDB AG Issue of deep discount bond Charges to income statement and carrying value in BS shown in tabular form (i)

(ii)

Cash Carrying value At

(iii)

Finance charge

flows

to IS

in BS

£000

£000

£000

1 Apr

1

(2,500–125–100)

(2,275)

–2,275.000

At 31 Mar

1

(10% of 2,500)

(2,250

(12.5% × 2,275)

284.375

–2,309.375

At 31 Mar

2

(10% of 2,500)

(2,250

(12.5% × 2,309.375)

288.671

–2,348.046

At 31 Mar

3

(10% of 2,500)

(2,250

(12.5% × 2,348.046)

293.506

–2,391.552

At 31 Mar

4

(10% of 2,500)

(2,250

(12.5% × 2,391.552)

298.944

–2,440.496

At 31 Mar

5

(2,500 +10% of 2500)

(2,750

(12.5% × 2,440.496)

305.062

Adj.* Net cash flow

–

4.442

1,475

1,475.000

*Adjustment necessitated by rounding of implicit rate to 12.5%

Workings Implicit rate has been determined by interpolation via formula t=n

Σ

=

t=1

At (1+r)t

The initial cost of 2,275,000 is deducted to arrive at the net present value. Using 13% t=n

Σ

=

t=1

250 + 1.131 1.132

250 + 1.133

250 + 1.134

250 + 1.135

2,750

–

2,275,000

= 221,239 + 195,787 + 173,263 + 153,330 + 1,492,590 – 2,275,000 = –38,791 then using 12% t=n

Σ

=

223,214 + 199,298 + 177,945 + 158,880 + 1,560,424 – 2,275,000 = 44,761



t=1 Implicit rate = 12% +

44,761 (44,761 + 38,791)

[(

= 12.5%

) ] × 1%

= 12.536 say



Chapter 13: Question 2 – RPS plc Redemption of preference shares The treatment of the finance cost of preference shares follows the pattern of loan debt. IAS 32 requires that redeemable preference shares are presented and treated as debt instruments because they are in substance debt. Calculation of finance costs and outstanding principal sum

Balance

(i)

(ii)

Cash

Finance

flows

charge

£000 At

1 Oct

1 (100 – 50)

(iii)

£000

£000

–

950

(950)

At 30 Sept

1 (Div 5% 1,000)

50

(6.2% × 950)

58.9

958.9

At 30 Sept

2 (Div 5% 1,000)

50

(6.2% × 958.9)

59.5

968.4

At 30 Sept

3 (Div 5% 1,000)

50

(6.2% × 968.4)

60.0

978.4

At 30 Sept

4 (Div 5% 1,000)

50

(6.2% × 978.4)

60.7

989.1

At 30 Sept

5 (1000+div of 5% 1,000) 1050

(6.2% × 989.1)

61.3

Adj.*

(0.4)

Net cash flow

300

300.00

*Adjustment caused by rounding in determining implicit rate of 6.2%, namely

t=n

Σ

At (1+r)t

=

t=1

–1 = 0

For interest, using 6% t=n

Σ

=

t=1

50 + 50 + 50 1.061 1.062 1.063

=

47.2 +

44.5

=

50 + 50 + 1.071 1.072

+ 50 + 1050 1.064 1.065

+ 41.98 +

– 950

39.60 + 784.6 – 950 = 7.88

then 7% = t=n

Σ

t=1 =

46.7

+ 43.7 +

(

50 + 1.073

50 + 1050 – 950 1.074 1.075

40.8 + 38.1

+ 748.6 – 950 = 32.1

)



Interpolation gives rate of 6% + 39.98

7.88

× 1%

= 6.2%

Treatment of total finance costs through the life-span of the capital instrument IAS 32 stipulates that the finance costs of redeemable preference shares are to be shown in the income statement but separately after interest. Income Statement for year ended 30 September (extracts) Years 1

2

3

£000

£000

4

£000

5

£000

£000

Interest Finance cost on redeemable

preference shares

58.9

59.5

60.0

60.7

60.9

The balance sheet extracts reveal the impact of the IAS regarding liabilities as follows: Balance Sheet as at 30 September (extracts) Years 1 £000

2 £000

3 £000

4 £000

5 £000

Long-term liabilities: Redeemable preference shares

958.9

968.4

978.4


989.1

–


Chapter 13: Question 3 – Little Raven (a)

The considerations involved in deciding how to account for the issue:

•

the issue is made at a substantial discount

•

the coupon rate is significantly below market rates

•

adopting substance over form, the discount is effectively rolled-up interest and should be accounted for over the period of the borrowing

•

the balance sheet should report the obligation to redeem at par and the income statement should report the true cost of the borrowing. If the borrowing was accumulated for:

(i) As per the question: DR Cash

4,000 4,000

CR Debt and each year,

DR Income statement

300

CR Cash

300

neither the obligation to repay nor the true cost of the borrowing would be fairly reported. (ii) Taking advantage of the legal point (available in some countries) that permits discount on issue to be debited to share premium account, the debt could be reported as follows: DR Cash

4,000

DR Share premium a/c

1,000

CR Debt and, each year

DR Income statement

5,000 300

CR Cash

300

in which case the amount of debt would be fairly reported but not the true cost of the debt. (iii) Alternatively, DR Cash

4,000

DR Unamortised discount

1,000

CR Debt And, each year, DR Income statement

5,000 300

CR Cash DR Income statement

300 X

CR Unamortised discount

with amortisation of discount on an appropriate basis over period of debenture.



At each year-end the debt would be reported as £5,000 less unamortised discount. Such accounting achieves the objective of reporting the actual amount repayable and the true cost of the debt but is not the approach adopted by IAS 32. (iv) Under IAS 32 the approach would be: •

on issue date DR Cash

X

CR Debt

X

with the net proceeds of issue.

•

determine finance costs as total amounts repayable (interest plus redemption) less net proceeds of issue

•

allocate finance costs to each period at a constant rate on the carrying amount of the debt by DR Income statement

X

CR Debt

X

DR Debt

X

CR Cash

X

with amounts paid in each period

(b)

Carrying

Finance

Period

amount at

cost

y/e

beginning

(11.476%)

Carrying Payments

amount at end

£000

£000

£000

£000

30.9.X2

4,000

459

(300)

4,159

30.9.X3

4,159

477

(300)

4,336

30.9.X4

4,336

498

(300)

4,534

30.9.X5

4,534

520

(300)

4,754

30.9.X6

4,754

546

(300 + 5,000)

–

2,500 (300 x 5 = 1,500 + 5,000 = 6,500 – 4,000 = 2,500)

Revised income statements for the year ended 30 September 20X5

20X4 (restated)

Turnover

6,700

6,300

Cost of sales

(3,025)

(2,900)

Gross profit

3,675

3,400

Overheads Interest payable

– debenture

(600)

(550)

(520)

(498)

(75)

(50)

– other



Profit for the financial year

2,480

2,302

Retained profit brought forward, as previously stated 4,300

1,800

Prior year’s adjustment

(336)

[159 + 177] [159 + 177 + 208]

(544)

Retained profit brought forward restated

3,756

1,464

Retained profit, carried forward

6,236

3,766



CHAPTER 14

Chapter 14: Question 1 – Kathryn (a)

The original IAS 19 approach to defined benefit pension schemes needed to be reviewed for a number of reasons as follows:

Misleading balance sheet The original approach to the valuation of the asset or liability for pensions in the balance sheet was potentially misleading to users of the accounts, and did not follow the statement of principles. The income statement charge was ‘smoothed’ out across all the years of service of the employees. The concept that was being followed in doing this was the accruals concept. Problems for presentation rose when surplus or deficits arose on the pension scheme. For example suppose a company had: Normal contributions Surplus Average remaining working life of staff

£5m per annum £10m 5 years

The actuary recommended a two-year contribution holiday. The annual income statement account charge would be £3m (the surplus of £10m has been spread over the remaining working lives of 5 years), but in the balance sheet after one year would be a liability of £3m. This liability would grow to £6m in the second year, and would only return to nil by the end of year 5. This balance sheet liability could be understood by users of the financial statements to mean that the company owed the pension fund money. In fact if anything the company had overpaid into the pension scheme. This approach to pension accounting does not meet the Framework Document in two ways. Firstly the framework prioritises the balance sheet over the income statement whereas the original IAS 19 made the income statement the key statement; and secondly the balance sheet asset or liability does not meet the definition of the item. In the above example for instance the liability that is created is not an obligation to transfer economic benefits as a result of past transactions or events. Internationally inconsistent The original version of IAS 19 was out of line with the approaches in US GAAP. The revised version of the standard is nearer to the requirements to US GAAP as it follows similar valuation principles for assets and obligations, although variations still exist in recognition of gains and losses. Valuation of pension fund assets and liabilities The original IAS 19 did not use valuation principles for assets and liabilities that were internationally consistent or the most realistic methods available. Assets were valued at actuarial



value as opposed to a market value and liabilities of the pension fund were discounted at the expected rate of return on assets, not a realistic discount rate for liabilities. The amended standard has addressed this by requiring pension scheme assets to be measured at market values and liabilities to be valued using the ‘projected unit credit method’ discounted at an appropriate corporate bond rate.

(b)

Income statement Operating cost £000 Pension cost – current service cost (W2)

£000 (600)

Financing cost Expected return on assets (W1) Interest cost (W2)

1,155 (1,020)

Net return

135

[Under IAS 19 it is not necessary to include the income statement income or expense as operating and finance costs, it would all be acceptable under operating costs, however this split is appropriate given the nature of the income and expense items.] Balance sheet Pension liability Present value of obligations Market value of assets

(10,900) 10,700 (200)

Statement of movement in equity Actuarial gain on the obligations (W2) Actuarial loss of the assets (W1) Loss in equity

120 (855) (735)

WORKINGS W1

Assets of the pension fund Market value of assets as at 1 May 2000 Expected return on assets – 11% Contributions Benefits paid Actuarial gains (losses) – bal. fig. Market value of assets as at 30 April 2001


£000 10,500 1,155 700 (800) (855) 10,700


W2

Obligations of the pension fund Present value of the obligations as at 1 May 2000 Interest cost – 10% Current service cost Benefits paid Actuarial (gains) losses – bal. fig.

Present value of obligations as at 30 April 2001


10,200 1,020 600 (800) (120) 10,900


Chapter 14: Question 2 – Donna In 2004 the IASB amended IAS 19 Employee Benefits and introduced an extra treatment for actuarial gains and losses. Under the previous version of the standard actuarial gains and losses had to be recognised in the income statement, but only if they exceeded the greater of 10% of the present value of the obligations or 10% of the assets. In December 2004 an amendment to the standard was issued however that gave an extra treatment. If a company chooses immediate recognition of all gains and losses they can recognise the gains and losses outside the income statement, which would mean in equity. The impact of these approaches is shown below:

Workings Change in the obligation 2002

2003

2004

Present value of obligation, 1 January Interest cost Current service cost Benefits paid

3,500 210 150 (140)

3,600 180 160 (150)

3,500 140 170 (130)

Actuarial (gain)/loss on obligation (balancing figure)

(120)

(290)

(480)

Present value of obligation, 31 December

3,600

3,500

3,200

Fair value of plan assets, 1 January Expected return on plan assets Contributions Benefits paid

3,200 320 120 (140)

3,400 306 120 (150)

3,600 288 130 (130)

Actuarial gain/(loss) on plan assets (balancing figure)

(100)

(76)

(288)

Fair value of plan assets, 31 December

3,400

3,600

3,600

Change in the assets

10% corridor The limits of the ‘10% corridor’ need to be calculated in order to establish whether actuarial gains or losses exceed the corridor limit and therefore need recognising in the income statement. Actuarial gains and losses are recognised in the income statement if they exceed the 10% corridor, and they are recognised by being amortised over the remaining service lives of employees.



The limits of the 10% corridor are set (at 1 January each year) at the greater of: (a) 10% of the present value of the obligation before deducting plan assets; and (b) 10% of the fair value of plan assets. 2002

2003

2004

320

340

350

(1 January)

–

20

234

Actuarial gain (loss) recognised over 10 years

–

–

–

Cumulative unrecognised gains (losses)

–

20

234

120

290

480

(100)

(76)

(288)

20

234

426

–

–

–

20

234

426

Limit of ‘10% corridor’ (at 1 January) Actuarial gains and losses unrecognised

(1 January) Gains (losses) on the obligation Gains (losses) on the assets Cumulative gains (losses) before amortisation Amortisation in the period Cumulative unrecognised gains (losses) (31 December)

There would be some recognition of actuarial gains in 2005 as the unrecognised gains and losses in 2004 exceed the 10% corridor as measured at 31 December 2004. Accounts presentation The final step is to work out the balance sheet and income statement position for the company. Income statement 2002

2003

2004

Current service cost

150

160

170

Interest cost

210

180

140

(320)

(306)

(288)

40

34

22

Expected return on plan assets Income statement charge



Balance sheet Present value of obligation, 31 December Fair value of assets, 31 December Unrecognised actuarial gains (losses) Liability in balance sheet

3,600

3,500

3,200

(3,400)

(3,600)

(3,600)

20

234

426

220

134

26

Equity recognition approach The working will still remain the same, but the recognition of actuarial gains and losses changes. Income statement 2002

2003

2004

Current service cost

150

160

170

Interest cost

210

180

140

(320)

(306)

(288)

40

34

22

3,600

3,500

3,200

(3,400)

(3,600)

(3,600)

200

(100)

(400)

20

234

426

Expected return on plan assets

Income statement charge

Balance sheet Present value of obligation, 31 December Fair value of assets, 31 December Liability (Assets) in balance sheet

Statement of movement in equity Actuarial gains recognised in the period



CHAPTER 15

Chapter 15: Question 1 – Notes to Assist in Answering The Government deliberately sets up special provisions to reduce taxes in order to encourage certain conduct. Examples might be allowance for payments in to pension funds or for capital investment. The running of a company’s affairs to take maximum benefit of items such as these is tax planning. When a company alters its behaviour solely for tax purposes, with no commercial reason, with the intention of saving tax by using the tax system in a way not intended by Parliament, this is called tax avoidance. Tax evasion is when a company illegally hides income from the tax authorities. Tax planning is to be encouraged, and it is for an accountant to point out the opportunities to use it. Tax evasion is illegal, and an accountant is under an obligation to prevent it happening. Tax avoidance is legal; an accountant is under an obligation to ensure that steps are not taken which are illegal and that details are reported accurately to the authorities. In all dealings relating to the tax authorities, an accountant must act honestly and do nothing that might mislead the authorities, but he must do all that he can to assist his employer within these criteria.




Accounts (Depreciation)

Tax (capital allowances)

Difference (timing)

31/3/20X2 Cost Depn/allce

25,000.00 2,812.50

25,000.00 4,687.50

1,875.00

31/3/20X3 Depn/allce

22,187.50 3,750.00

20,312.50 5,078.13

1,875.00 1,328.13

18,437.50

15,234.38

3,203.13

3,750.00

3,808.59

58.59

14,687.50 3,750.00 10,937.50 3,750.00

11,425.78 2,856.45 8,569.34 2,142.33

3,261.72 (893.55) 2,368.16 (1,607.67)

7,187.50

6,427.00

760.50

31/3/20X4 Depn/allce 31/3/20X5 Depn/allce 31/3/20X6 Depn/allce

Tax Calculated By Deferral Method

31/3/20X2

1,875.00

Deferred tax charge in year 20% 375.00

Deferred tax provision 375.00 Balance at 31/3/20X2

31/3/20X3

1,328.13

30%

398.44

773.44

Balance at 31/3/20X3

31/3/20X4

58.59

20%

11.72

785.16


31/3/20X5

(893.55)

19%

(169.77)

615.38


31/3/20X6

(1,607.67)

19%

(302.57)

310.12


Tax Calculated By Liability Method Difference As at (timing) Tax rate

As at 31/3/X2 20%

31/3/X2

1,875.00

31/3/X3

As at 31/3/X3 30%

As at 31/3/X4 20%

As at 31/3/X5 19%

As at 31/3/X6 19%

3203.13

31/3/X4

3261.72

31/3/X5

2368.16

31/3/X6

760.50 ---------

--------

---------

--------

----------

375.00

960.94

652.34

449.95

144.69

(b) Under the liability method the focus is on the balance sheet (the objective being to compute the deferred tax liabilities), whereas the deferral method places the focus on the Profit and Loss Account (the objective being to show the annual effect that has arisen in the year of account).



Chapter 15: Question 3 – Notes to Assist in Answering The law has been amended to allow the Inland Revenue to accept accounts drawn up in accordance with IFRS, so that two different standards will be acceptable for some years. Therefore the legislation will have to provide for different treatment of specific items under UK GAAP and IFRS. The Finance Act 2004 included legislation which ensured that companies that adopted IFRS to draw up their accounts would receive broadly equivalent tax treatment to companies that continue to use UK GAAP. The clear intention of these provisions is to defer the major tax effects of most transitional adjustments until the tax impact becomes clearer. It remains to be seen whether the taxation effects of any significant changes in profit resulting from the change from UK GAAP to IFRS will be deferred until UK GAAP becomes truly aligned with IFRS. The move towards IFRS is leading to a detailed study of accounting theory and principles, so that the accounting treatment may eventually become the benchmark standard for taxation purposes, although this will take several years to reach fruition (if it proves to be attainable).



Chapter 15: Question 4 – Notes to Assist in Answering For Discounting: •

Most transactions take place at fair value.

•

Rational buyers and sellers will ensure that this fair value reflects the time value of money and the risk associated with the future expected cash flows, which means that market prices generally will reflect such factors.

•

To be consistent, these factors need also to be reflected in the other measures that can be used to determine the carrying amount of assets (in other words, value in use and net realisable value) and the carrying amount of any liabilities measured by reference to expected future cash flows.

•

It follows that, when basing carrying amounts on future cash flows, those cash flows will need to be discounted.

Against Discounting: •

The reliable determination of deferred tax assets and liabilities on a discounted basis requires detailed scheduling of the timing of the reversal of each temporary difference. In many cases such scheduling is impracticable or highly complex.

•

Therefore, it is inappropriate to require discounting of deferred tax assets and liabilities.

•

To permit, but not to require, discounting would result in deferred tax assets and liabilities which would not be comparable between enterprises.

•

Discounting would result in deferred tax assets and liabilities which would not be comparable between enterprises unless there was a set methodology using standard prescribed discount rates.

•

In some cases where capital expenditure is uneven, an unexpected effect of discounting could be to turn an eventual liability into an initial asset.

•

Discounting is not generally used in financial accounting, so its use for deferred taxation would be an exception to general accounting principles.



CHAPTER 16

Chapter 16: Question 1 – Universal Entrepreneurs plc (a) The principles outlined in IAS 16 are that: •

A non-current asset is assessed at the year end to ensure that it has not been impaired.

•

Fair charge is made to the income statement each year for the benefit of accruing to that accounting period for use of the asset concerned.

•

In no way does the IAS address the notion of showing on the balance sheet under the heading of ‘Non-current assets’ either the value of the assets to the enterprise or the value at which they might be sold.

•

It was this factor that caused property investment companies to feel that they were disadvantaged by the requirements of IAS 16 to depreciate buildings when these formed the major proportion of their asset structure. Ō They argued strongly that the assets were not USED in the business but were held, like any other investment, for their income-producing value and potential capital growth. Ō As a result of these representations the IASC developed IAS 40.

(b)

(i) (ii) (iii) (iv) (v)

Depreciate on the basis of the rate of extraction of growth over the 10 year period in reviewing annually. The cost of the building (£4,000,000) should be depreciated over its useful life. It is not an investment property and the period of the lease granted is irrelevant. 20% per annum straight-line. Depreciate on the basis of actual flying hours. Treat as an investment property, revaluing annually but providing depreciation as it is a base of less than 20 years.

(c) • The revalued amount of the buildings should be depreciated over the remainder of their useful lives, taking account of the amounts of depreciation already provided. • Unless the value of the land is being consumed in some way (e.g. by mining) this should not be depreciated over the remaining period of the bases, again having account of the amounts of amortisation already provided. • When the valuer is instructed in respect of the freehold properties it must be made clear that interests of land need to be distinguished from those in the buildings thereon.



Chapter 16: Question 2 – Mercury (a)

Identifying the method

The method of depreciation is the diminishing balance method. The following calculations show that the rate applied at 20%. 20X6 charge 20X7 charge Cumulative provision

(b)

= 20% of £80,000 = 20% of £64,000

= = =

16,000 12,800 28,800

How the accumulated depreciation in line (B) was calculated

B/d from (a) above: 20X6 20X7 20X8

20% of £80,000 20% of £64,000

= =

Balance b/f st Less: 1 disposal 20X6:£15,000 x 20% = 20X7: £12,000 x 20% =

16,000 12,800 £28,800

£3,000 £2,400

(£5,400)

£6,000 £4,800

(£10,800)

nd

Less: 2 disposal 20X6: £30,000 x 20% = 20X7: £24,000 x 20% =

20% of (£80,000 – £45,000 disposed of) – £12,600 for accumulated depreciation 20% of £50,000 replacement for 2nd disposal = Depreciation on other asset Total given in question

(c)

(16,200) 12,600 4,480 10,000 1,000 28,080

How the figures for 20X9 are calculated

20X9 Property, plant and equipment

Cost Depreciation to date Charge for 20X9

Acquired 20X6

Acquired 20X7

£ 35,000 17,080 17,920 3,584 14,336

£ 50,000 10,000 40,000 8,000 32,000


Acquired 20X8 (balancing figure) £ 5,000 1,000 4,000 800 3,200

Total 20X9 £ 90,000 28,080 61,920 12,384 49,536


(d)

Calculation of profit/(loss) on disposal

Plant disposal I £ 15,000 (5,400) (8,000) 1,600

Cost Less: Depreciation Cash Loss

Plant disposal II Cost Less: Depreciation Cash Profit

30,000 (10,800) (21,000) 1,800



Chapter 16: Question 3 – Amy (a) The figures should be the total cost of making the non-current asset usable, excluding all costs of actually using it. Therefore, 11,000 + 100 + 200 + 400 = £11,700 The additional component is cost of machine as it enhances the revenue-earning capacity of the asset. The replacement parts are cost of using machine – hence the difference in treatment between the two. Maintenance is obviously a cost of usage. (b) Depreciation spreads the cost (or value) of an item over its useful life, in appropriate proportion to the benefit (usefulness). It is necessary in accordance with the matching convention – allocating expense against corresponding benefit, as part of the profit calculation. (c) The straight-line method charges a constant percentage of the cost (or value) each year. The diminishing balance method charges a constant percentage of the net book value (cost less accumulated depreciation brought forward). Thus the straight-line method has a constant charge but the diminishing balance method has a charge reducing each year of the asset life. The two methods therefore make different assumptions about the usefulness, the trend or pattern of benefit, of the fixed asset concerned. (d) Objectivity implies lack of bias. It removes the need for, and the possibility of, subjectivity, of personal opinion. For an accounting figure to be objective, it must be expected that all accountants would arrive at the same figure. Clearly the figure stated on an invoice has a high degree of objectivity. However, the calculation of depreciation is based on estimates of future life and future usefulness and is therefore highly subjective. (e) This practice can claim the advantage of greater prudence, as the expense is always the higher of the two possibilities. However, it seems to lack consistency. Perhaps more importantly, it obviously fails to attempt to follow the matching convention. It makes no attempt to make the trend of expenses consistent with the trend of benefit or usefulness. If the profit figure, or profit trend, is regarded as important, then it seems an unsatisfactory practice.



Chapter 16: Question 4 – Small Machine Parts Ltd (a) Opening balance Interest at 15% Depreciation

Year 1 £ 20,000.00 3,000.00 23,000.00 5,914.43 17,085.57

Year 2 £ 17,085.57 2,562.84 19,648.41 5,914.43 13,733.98

Year 3 £ 13,733.98 2,060.10 15,794.08 5,914.43 9,879.65

Year 4 £ 9,879.65 1,481.95 11,361.60 5,914.43 5,447.17

Year 5 £ 5,447.17 817.08 6,264.25 5,914.43 349.82

The income from secondary assets is calculated at 15% of the depreciation charge less the notional interest.

Depreciation Interest 15%

Year 1 £ 5,914.43 3,000.00 2,914.43 437.16

Year 2 £ 5,914.43 2,562.84 3,351.59 502.74 437.16

Year 3 £ 5,914.43 2,060.10 3,854.33 578.15 437.16 502.74

Year 4 £ 5,914.43 1,481.95 4,432.48 664.87 437.16 502.74 578.15

Year 5 £ 5,914.43 817.08 5,097.35 764.60 437.16 502.74 578.14 664.87 2,182.92

437.16

939.90

1,518.05

Year 1 £ 25,000.00 5,914.43 19,085.57

Year 2 £ 25,000.00 5,914.43 19,085.57

Year 3 £ 25,000.00 5,914.43 19,085.57

Year 4 Year 5 £ £ 25,000.00 25,000.00 5,914.43 5,914.43 19,085.57 19,085.57

19,085.57 3,000.00 22,085.57

437.16 19,522.73 2,562.84 22,085.57

939.90 20,025.47 2,060.10 22,085.57

1,518.05 2,182.92 20,603.62 21,268.49 1,481.85 817.08 22,085.57 22,085.57

Income statement entries Cash flow

Operating CF Depreciation Operating profit Income from secondary assets Interest Net profit

(b) The annuity method is recommended because it attempts to show the effect of the loss of interest suffered as a result of investing the funds in non-current assets within the organisation. It does this by charging notional interest in addition to the depreciation charge with a reduction for the estimated secondary income on the difference between the depreciation charge and the notional interest. The method suggested of charging the annual average cost is frequently met in practice but is less accurate in that it fails to take account of the opportunity cost of the interest foregone.



Chapter 16: Question 5 – Calculation of Depreciation (a) Year 1 Straight-line (SF800,000 – SF104,000)/4

= SF174,000

Reducing balance 40% of SF696,000

= SF278,400

(b) Comment to include: •

Directors responsible under IAS 16 for selecting an appropriate method.

•

Little guidance given as to how to exercise the choice but the following matters may be relevant: Ō risk of technological change Ō incidence of repairs Ō extent to which the asset characteristics favour a particular method, e.g. a lease would be amortised evenly over its life.



Chapter 16: Question 6 – AB (a) IAS 36 (i) Indicators (assuming significant in all cases) •

Market value lower than book value

•

Lower expected cash flows affecting the value in use

•

Rates of return have increased adversely affecting the recoverable amount

•

Adverse change in the environment e.g. technological, economic or legal or in physical state of asset e.g. obsolescence or damage

•

Adverse change in the use to which asset is put e.g. reorganisation programme

•

Evidence that the economic performance of the asset will be worse than expected

•

The asset has suffered considerable physical change, or obsolescence or physical damage

• Cost of construction over-run making asset less profitable (ii) Recognition and measurement IAS 36 Impairment of Assets says that if indicated under the above, then undertake a review to establish the extent of any impairment. Criteria in HCA model •

An asset should not be valued at an amount greater than its cost or recoverable amount

•

The recoverable amount being the higher of net selling price and value in use (net present value of future cash flows).

Criteria in Revaluation model •

Compare the carrying value of the asset with its net selling price or value in use. •

If the net selling price OR value in use exceeds the carrying value, no write-down is necessary

•

If the recoverable amount is lower than the carrying value, the asset is impaired and the carrying amount of the asset should be reduced to its recoverable amount.

Recognition •

Any recognition is an impairment loss to be recognised as an expense immediately in the income statement.

What if it is not possible to estimate the recoverable value of an individual asset? This can occur if the asset does not generate independent cash flows and in such a case, the recoverable amount of the asset’s cash generating unit should be calculated together with value in use on the same basis.



An impairment loss is only recognised where its recoverable amount is less than the carrying amounts of the items in that unit. Allocation of impaired amount where the HCA model is being followed Any specific impairment of assets should be dealt with initially then allocate first to goodwill, then to intangible assets which have no active market, then to assets whose Net Selling Price is less than their carrying value and finally to other assets on a pro rata basis. Allocation of impaired amount where the Replacement model is being followed An impairment loss relating to a revalued asset is treated as a revaluation decrease and therefore charged to revaluation account. Where the impairment loss is greater than the carrying amount of the asset, a liability should only be recognised where it is required by other International Standards. After recognition of an impairment loss, the depreciation charge should be adjusted to allocate the revised carrying amount (less residual value) systematically over its remaining life. An enterprise should review the balance sheet to assess whether a recognised impairment loss still exists or has decreased. Any reversal of an impairment loss should be recognised in the income statement. (b) AB (i) Impairment of machinery Indicators are the inventory losses and the taxi business problems. Procedure: Compare the carrying value ($290,000) with its recoverable amount which has to be calculated. The calculation is to determine the higher of an asset’s net selling price ($120,000) and its value in use. The value in use is $100,000 discounted at 10% for three years, i.e. $248,600 approx. Thus the recoverable amount would be deemed to be $248,600. AB would therefore write down the asset from $290,000 (carrying value) to $248,600 (its value in use) and recognise the loss of $41,400 in the income statement. (ii) Impairment of the car taxi business treated as a CGI Impairment losses should be recognised if the recoverable amount of the cash generating unit is less than the carrying value of the items of that unit. At 1 February 20X1 1.1.X1 Goodwill Intangible assets Vehicles Sundry net assets

$000 40 30 120 40 230

Impairment loss $000 (15) (30) (45)

1.2.X1 $000 25 30 90 40 185

An impairment loss of $30,000 is recognised first for the specific asset (i.e. the stolen vehicles) and the balance ($15,000) is attributed to goodwill.



Goodwill Intangible assets Vehicles Sundry net assets

1.2.X1 $000 25 30 90 40 185

At 1 March 20X1 Impairment $000 (25) (5) (30)

1.3.X1 $000 25 90 40 155

Note the tricky point – that is that the net selling price of the sundry net assets has not fallen. It is therefore not permissible to reduce the sundry net assets.



CHAPTER 17

Chapter 17: Question 1 – Grabbit plc (a) PV of future lease payments = £350,000 (cost of asset) The interest rate to apply to the six payments of £92,500 to equate to a PV of £350,000 is 15%. This is calculated as follows: 80,435 + 69,943 + 60,820 + 52,887 + 45,989 + 39,990 = 350,064 Balance sheet Assets

£

Cost of leased asset

350,000

Depreciation for year

43,750 306,250

Liabilities PV of future lease payments 80,435 + 69,943 + 60,820 + 52,887 + 45,989 = 310,074, say

310,000

Income statement Interest on leasing obligation (£350,000 × 15%)

52,500

Depreciation on leased asset

43,750

Liability at year end

96,250

(NB

350,000 52,500

Cost Interest

402,500 (92,500)

Payment

310,000

Bal. c/f)

(b) The obligations under a long-term lease are in substance no different from those under a loan but prior to the introduction of the leasing standard they did not appear on the balance sheet. This made the balance sheet unreliable as one could not be confident that there were not undisclosed liabilities such as leases. Further, where a business had essentially the control of an asset for a substantial period of time they had most if not all of the benefits and risks associated with ownership. It was considered a deficiency that these asset rights were not reflected in the balance sheets, even if they were different in nature to outright ownership. Therefore the leasing standard attempted to capture the assets and liabilities which occurred when longer-term ownership like contracts were entered into.



(c) The advantage would be that the obligation would no longer involve the lessee in a longterm commitment although they would probably have long-term access. This would take the relationship out of the financial lease category and put it in as an operating lease. As a consequence, under existing standards it would not have to be capitalised but rather would be disclosed under operating leases. The ratios would be better but only if influential investors did not adjust their figures for the long-term obligations that would probably arise.



Chapter 17: Question 2 (a) •

The ‘title’ to the goods acquired on a hire purchase agreement or lease finance remains legally vested in the lessor.

•

Yet in commercial substance, at the point of getting custody of the asset the lessee acquires substantially all the risks and rewards of owning the asset.

•

Hence accountants have preferred to overlook the legal form and focus more on the commercial substance. For example, they have accounted for assets acquired on HP terms or on finance lease terms as if the title passes to the lessee at the date of transfer of the custody of the asset.

•

IAS 17, while endorsing the accounting practice, changes the conceptual basis for this accounting practice. It emphasises that what the lessor capitalises, at the point of acquiring custody of the leased assets, is not the asset itself (which admittedly he does not own yet), but his own right to use that asset.

The amount at which he capitalises this right is the present value of the minimum lease payments he commits himself to.

(b)

In accordance with IAS 17:

•

A finance lease is a lease that transfers to the lessee substantially all the risks and rewards of owning an asset.

•

All other leases are operating leases.

•

The Standard sets out a presumption that a lease transfers substantially all the risks and rewards of ownership to the lessee IF ‘at the inception of a lease the risks and rewards of ownership are transferred to the lessee’ and if ‘at the inception of a lease the present value of the minimum lease payments, including any initial payment, amounts substantially to all of the fair value of the leased asset’.

Other criteria such as transference of legal title and the right to use the asset for all its life are also considered.

(c)

(1) Smarty plc Machine acquired under a finance lease

1.8.X7

Obligation

15,000

Provision for depreciation on machine 31.3.X8

Depreciation

2,000

31.3.X9

Depreciation

3,000

31.3.X0

Depreciation

3,000

31.3.X1

Depreciation

3,000



Finance charges account 31.3.X8 Obligation under fin. lease

31.3.X8

Income statement

1,200

31.3.X9

Income statement

1,229

31.3.Y0

Income statement

543

31.3.Y1

Income statement

28

1,200

31.3.X9 Obligation under fin. lease

1,229

31.3.Y0 Obligation under fin. lease

543

31.3.Y1 Obligation under fin. lease

28 Obligation under finance lease on machinery account

Cash

4,000

1.8.X7

Machinery a/c

31.3.X8 Balance c/d

12,200

31.3.X8

Finance charges a/c

16,200 6,000

1.4.X8

Balance b/d

31.3.X9 Balance c/d

7,429

31.3.X9

Finance charges a/c

Cash

6,000

1.4.X9

Balance b/d

31.3.Y0 Balance c/d

1,972

31.3.Y0

Finance charges a/c

1.4.Y1

Balance b/d

31.3.Y1

Finance charges a/c

2,000

7,429 543 1,972 28 2,000

Income statement entries for y/e 31 March 20X8 extracts: £ Finance charge

1,200

Depreciation

2,000

£

Balance sheet as at 31 March 20X8 extracts: Non-current asset

15,000

Depreciation

(2,000)

Liability

1,229

7,972

7,972

(2)

12,200 13,429

13,429

2,000

1,200 16,200

Cash

Cash

15,000

13,000

12,200



Chapter 17: Question 3 – The Mission Company Ltd (a)

Income statement 20X6

20X7

£

£

Item Y

20,000

20,000

Item Z

30,000

30,000

As an operating lease each annual payment is simply rent.

(b) £

Workings (Item Y) Total lease price: 10 × £20,000

=

200,000

Purchase price

=

160,000

Finance charge

=

40,000

Period of lease: 10 years Sum of the digits = 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55 Therefore

Charge to 20X6 = 4/55 × £40,000 Charge to 20X7 = 3/55 × £40,000 Finance charge to income statement 20X6

Item Y

20X7

£

£

2,909

2,182

Working (Item Z) Total lease price: 10 × £30,000

=

Purchase price =

£300,000 £234,000 £ 66,000

Sum of the digits = 55 Therefore

Charge to 20X6 = 6/55 × £66,000 Charge to 20X7 = 5/55 × £66,000 Finance charge to income statement

Item Z

20X6

20X7

£

£

7,200


6,000


Depreciation charge to income statement 20X6

20X7

Item Y

16,000

16,000

Item Z

19,500

19,500

(c)

Balance sheet 20X7 Non-current assets

Cost

Accumulated Dep’n NBV

£

£

£

Item Y

160,000

128,000

32,000

Item Z

234,000

117,000

117,000

Current liabilities £

[20,000 −

Item Y

2 × 40,000] 55

Item Z

18,545 25,200

Non-current liabilities £ Item Y

19,273

Item Z

82,800

Note: Minimum lease commitments at 31 December 20X7 in relation to finance leases were: Item Y

Item Z

£

£

20X8

20,000

30,000

20X9

20,000

30,000

20Y0

30,000

20Y1

30,000 40,000

120,000

2,182

12,000

37,818

108,000

Interest

C/forward

£

£

£

20,000

7,273

147,273

Less: Finance charge allocated to future periods Workings: to liabilities Item Y Year

B/forward

Cost

£

£

20X0

160,000

Repayment

20X1

147,273

20,000

6,545

133,818

20X2

133,818

20,000

5,818

119,636

20X3

119,636

20,000

5,091

104,727



20X4

104,727

20,000

4,364

89,091

20X5

89,091

20,000

3,636

72,727

20X6

72,727

20,000

2,909

55,636

20X7

55,636

20,000

2,182

37,818

20X8

37,818

20,000

1,455

19,273

20X9

19,273

20,000

727

-

£40,000 Therefore current liability non-current liability

= 20,000 – 1,455 = £18,545 = 37,818 – 18,545 = £19,273 Item Z

Year

B/forward

20X2

Cost

Repayment

Interest

C/forward

234,000

30,000

12,000

216,000

20X3

216,000

30,000

10,800

196,800

20X4

196,800

30,000

9,600

176,400

20X5

176,400

30,000

8,400

154,800

20X6

154,800

30,000

7,200

132,000

20X7

132,000

30,000

6,000

108,000

20X8

108,000

30,000

4,800

82,800

20X9

82,800

30,000

3,600

56,400

20Y0

56,400

30,000

2,400

28,800

20Y1

28,800

30,000

1,200

–

£66,000 Therefore

current liability

= 30,000 –

4,800 = £25,200

non-current liability

= 108,000 – 25,200 = £82,800



Chapter 17: Question 4 – X Ltd (a) Workings to provide figures for income statement and balance sheet entries Period

Liability

Rental

Liability

Finance

Liability

at start

payment

during

charge

of period

period

1.1.X4

100,000

12,000

88,000

3,831

91,831

1.7.X4

91,831

12,000

79,831

3,475

83,306

1.1.X5

83,306

12,000

71,306

3,104

74,410

1.7.X5

74,410

12,000

62,410

2,717

65,127

1.1.X6

65,127

12,000

53,127

2,313

55,440

1.7.X6

55,440

12,000

43,440

1,891

45,331

1.1.X7

45,331

12,000

33,331

1,451

34,782

1.7.X7

34,782

12,000

22,782

992

23,774

1.1.X8

23,774

12,000

11,774

513

12,287

1.7.X8

12,287

12,000

287

12

299

at end

(4.3535%) of period

120,000 Depreciation is over useful economic life, using the historical cost of the leased asset 100,000 = £12,500 per year 8 Income statement Finance

Depreciation

Total

Charge 20X4

7,306

12,500

19,806

20X5

5,821

12,500

18,321

20X6

4,204

12,500

16,704

2,443

12,500

14,943

20X7

(3,831 + 3,475)

(1,451 + 992)

The balance sheet is as follows: Assets 20X4

20X5

20X6

20X7

100,000

100,000

100,000

100,000

12,500

25,000

32,500

50,000

87,500

75,000

62,500

50,000

Equipment under finance lease Depreciation



Liabilities Within 2–5 years Within 1 year

65,127

45,331

23,774

299

*18,179

19,796

21,557

23,475

83,306

65,127

45,331

23,774

* The £18,179 = £24,000 – interest (£3,104 + £2,717)



Chapter 17: Question 5 – Bridge Finance plc Workings for the lease receivable account $ 1 Jan × 5

Cost

37,200

Direct expense 31 Dec × 5

708

Balance

37,908

10% interest

3,791

Cash

–10,000

1 Jan × 6

Balance

31,699

31 Dec × 6

Interest

3,170

Cash

–10,000

1 Jan × 7

Balance

24,869

31 Dec × 7

Interest

2,487

Cash

–10,000

Balance

17,356

As this is a finance lease the accounts in the lessor’s books would be; Income Statement Interest revenue

$2,487

Balance sheet Asset Lease receivable

$17,356

Current

8,265

Non-current

9,091

This can be reconciled as follows: Gross cashflows receivable

$20,000

Less interest

2,644

Net amount

17,356



CHAPTER 18

Chapter 18: Question 1 – Environmental Engineering plc (i)

Referring to IAS 38 criteria in (ii) below, only (c) might qualify for deferral as development expenditure. (a) is applied research. (b) is development cost (£1.2m) that has not yet been incorporated into a specific, separate viable project. However, the line between categories is often indistinct in practice, e.g. between development and production costs.

Looked at in general, all three relate to a specific project to which it appears expenditure can be separately allocated. However, the outcome is not reasonably certain as to either technical feasibility or commercial viability. We have no idea or projections of sales volume or price/revenue in total and whether it will exceed costs. It is assumed that a plc would have the necessary resources to complete the project but there is no evidence of this. Item (c) would not stand out from (a) and (b) and it is recommended that all be written off as expenses. It could be capitalised later when evidence is produced as to criteria for proceeds.

(ii)

IAS 38 criteria (para. 45): (a) Technical feasibility (b) Intention to complete and use or sell (c) Ability to use or sell (d) Asset will generate possible future income – demonstrate existence (e) of a market, availability of technical, financial and other resources to complete the development or to use or sell.

(iii) •

Amortisation should begin with the commencement of production.

•

Any write-off should be over the period the product is expected to be sold. Ō This implies that the amortisation costs can be included in stocks being produced for sale. •

Deferred development expenditure should be reviewed at the end of each accounting period and, Ō to the extent that it is not considered recoverable, it should be written off.



Chapter 18: Question 2 – Italin NV IAS 38: Pure and applied research, always written off in period incurred; development expenditure may be carried forward in certain circumstances. Income Statement for the year ended 30 September (extract) 20X1

20X2

20X3

20X4

20X5

20X6

20X7

–

50

50

50

50

50

50

300

300

300

300

300

300

300

Research expenditure 200 Development cost Depreciation

Balance Sheet as at 30 September (extract)

Intangible fixed assets Tangible fixed assets

20X1

20X2

20X3

20X4

20X5

20X6

20X7

300

250

200

150

100

50

–

2,200 1,900

1,600

1,300

1,000

700

–

Projects must be reviewed each year. Treatment of fixed assets used in R&D as for any assets.

Disclosure •

Accounting policy

•

Consistency and application of IAS 38 Ō amounts written off in the period Ō pure and applied research is written off Ō development expenditure is capitalised and written off over six years

•

Movement on development costs capitalised

•

Fixed assets used are depreciated in the normal way over their useful life of 7 years.



Chapter 18: Question 3 – Oxlag plc (i) Research and Development Costs Account £000 Capital costs b/f at

£000 Capitalised costs c/f

start of year (project C)

200

Project C

500

Costs incurred in year: Project A

25

Project C

265

Project D

78

Costs written off to Profit & loss account: Project A

35

Project D

98

133

Depreciation: Laboratory: Project C

20

Equipment: Project A

10

Project C

15

Project D

20 633

Capitalised costs b/f Project C

633

500

(consists of 200 b/f + 265 costs incurred + 20 laboratory depreciation and 15 equipment depreciation) Fixed Assets: Specialized Laboratory Account

£000 Cost b/f at start of year

500

£000 Depreciation b/f at start of year

Depreciation c/f at end of year

45

Depreciation charge for year20 Cost c/f at end of year

545 Cost b/f at start of year

500

25 500 545

Depreciation b/f at start of year


45


Fixed Assets: Specialized Equipment Cost £000 Cost b/f at start of year:

£000 Depreciation b/f at start of year

Project C

75

Project C

15

Project D

50

Project D

10

Additions:

Depreciation provided in year:

Project A

50

Project A

10

Project D

50

Project C

15

Project D

20

Depreciation c/f at end of year

70

Cost c/f at end of year

295

295 Cost b/f at start of year

225

225

Depreciation b/f at start of year

70

Market Research Costs Account £000 Costs b/f at start of year

250

Costs in year

£000 Costs c/f at end of year

325

75 325

Costs b/f at start of year

325

325

Assumption is that this is a contract that will continue in future years.

(ii)

Amount to be charged as research costs charged in the income statement for the year ended 31 January 20X2 Fees Per T a/c

Project A: Project D:

Costs

25

Dep’n

10

Costs

78

Dep’n

20

Fees 35 98 133

(iii)

Basis of amortisation:

•

Any reasonably systematic basis of amortisation per IAS 38.

•

Amount spent and written off reconciled with opening and closing balances in the balance sheets.

•

Most likely basis here will be expected sales of the new drug with amortisation being calculated as the proportion of total sales sold during each year.



Disclosure •

Accounting policy stating basis of capitalisation and basis of write-off

(iv)

Balance sheet amounts

Fixed assets

£000

Intangible assets: Deferred development expenditure (recovery assured by projected future sales)

500

Tangible assets: Land and buildings: Specialised laboratory

455

Plant and machinery: Specialised laboratory equipment

155

Current assets Inventories: Long-term work-in-progress

(v)

325

Disclosures about new improved drug sales

Identify as non-adjusting post balance sheet event which requires disclosure if material in accordance with IAS 10, having arisen between the end of year 31.1.20X2 and the date of signing the accounts on 14.7.20X2. This does appear to nbe material, therefore the accounts will need to disclose: •

date of new drug going on sale

•

success of new drug •

expectation that the sales of the new drug will significantly increase following year’s profits.



Chapter 18: Question 4 – Goodwill and Intangible Assets (a) IFRS 3 defines goodwill as ‘any excess of the cost of the acquisition over the acquirer’s interest in the fair value of the identifiable assets, liabilities and contingent liabilities acquired at the date of the exchange transaction’ (i.e. the date the assets were acquired). The cost of the acquisition is the cash or cash equivalent paid or the fair value, at the date of exchange, of the other purchase consideration given in exchange for control over the net assets of the other enterprise plus any costs directly attributable to the acquisition. Fair value is defined as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction. The fair value of the assets or liabilities at the date of purchase can include a provision for reorganisation costs, provided a plan has been developed within three months of the date of acquisition. The costs included in the provision can only include costs relating to the acquired business for employee redundancy, closing facilities, eliminating product lines and terminating onerous contracts. (b) IFRS 3 requires an impairment test to be carried out. Unless goodwill is impaired continue to carry at cost. (a) Total net assets per balance sheet 58,234 (i) No adjustment as no readily ascertainable market and no information to verify directors’ estimate (but see (vi) below) (ii) Valuation

23,000

Other tangible fixed assets

18,000

Total fair value

41,000

Value in balance sheet

38,300

Revaluation

2,700

(iii) Inventories at net realisable value

20,000

(less than replacement cost) 21,600 Loss

(1,600)

(iv) Bank loan 3

Loan at 31.5.09: 12,100×1.1

16,105

Discounted to 31.5.06 at 7%

13,146

Value in balance sheet

12,100

Increase in liability (v) No adjustment required (as the reorganisation was decided before acquisition and future losses cannot be


(1,046)


included in the provision) (vi) Impairment of brand names Fair value of Yukon at acquisition

(6,020) 52,268

Goodwill: Cost of acquisition 2.5 × 2.25 × 10,000 × 80%

45,000

Fair value of net assets acquired 80% × 52,268

41,814

Goodwill

3,186

Valuation of goodwill

1,000

Impairment

2,186



Chapter 18: Question 5 – The Brands Debate Many of the arguments for including brands in the balance sheet are given in Section 18.12 of Chapter 18. Including brands in the balance sheet increases shareholders’ funds and thus reduces gearing. A reduction in gearing reduces investors’ and banks’ perception of the risk of the company and it is likely to increase the company’s ability to borrow funds. Also, including brands in the balance sheet shows investors and management the value of the company’s brands, thus providing more information to those users of accounts and enabling them to make more rational decisions. A brand which has been purchased by a company can be included in the balance sheet. Under IAS 38 Intangible Assets, the brand is included at cost and amortised over its useful life. The ‘allowed alternative treatment’ enables the brand to be revalued and reductions in the brand’s valuation below its original cost are charged to the income statement. IAS 38 says that internally generated goodwill should not be recognised as an asset (para. 36). However, the cost of developing a brand could be taken as development expenditure and this cost subsequently capitalised in the balance sheet and amortised in the income statement. So, it is possible to capitalise internally generated brands. However, the cost of developing a successful brand is likely to be considerably less than its market value (if the brand was purchased, it would be shown in the balance sheet at its market value). So, the treatment of purchased and internally generated brands is different, and in most situations internally generated brands will not be included in the balance sheet (whereas purchased brands would be included). It would be possible to include an internally generated brand in the balance sheet at its current market value, provided it was initially included as development expenditure and the ‘allowed alternative treatment’ (of IAS 38) of including the brand at its fair value was included for the balance sheet valuation. However, IAS 38 does require the fair value to be determined by reference to an active market. On the subject of separability of brands, when a business is acquired, it is likely to be difficult to distinguish between brands and other goodwill. The total amount of goodwill, being the difference between the purchase consideration and the fair value of assets acquired, can be determined. However, dividing this total goodwill between brands and other goodwill will be difficult and is likely to be subjective. Also, in acquiring a company, a number of brand names may be acquired, and it is likely to be very difficult (and subjective) to say how much each of the brands is worth. On purchased vs home-grown brands, the different accounting treatment has been discussed above. In most situations, purchased brands will be included as an asset in the balance sheet, whereas home-grown brands will not. As both purchased and home-grown brands have value, this different accounting treatment is not consistent. However, this different accounting treatment arises because accountants are prepared to include an item in assets when its purchase price is known (as with purchased brands) but are reluctant to include it as an asset when it has been internally generated (and its market value is not certain). For investors, ideally they would like the value of both purchased and home-grown brands to be included in the balance sheet, but this creates the risk that directors may artificially inflate the value of home-grown brands and thus mislead investors.



As with land and buildings, some companies argue that brands have an infinite life. Current expenditure on advertising and marketing the product (e.g. a Mars Bar) maintain the value of the brand, so no amortisation of the brand’s value is justified. IAS 38 says that intangible assets should be amortised over their life, which should not normally exceed 20 years. One can see that some brands have a life of significantly less than 20 years. For instance, a 1 GHz microprocessor has a life of, at most, only a few years as it is superseded by faster processors. Although the brand of ‘Intel’ may have a relatively long life, the company must continue to develop its products (i.e. make the microprocessors faster) in order to keep its brand alive. However, other brands, like the Mars Bar, have a life of significantly more than 20 years – the Mars Bar existed more than 60 years ago. For most brand names, a life of 20 years is a realistic maximum (many brands have a life of less than 20 years), but some brands may have a significantly longer life. However, although a brand may have had a life of more than 20 years, there is no certainty that it will continue to exist for another 20 years. Many computer companies which were successful 20 years ago no longer exist (e.g. Commodore, Sinclair). How many of today’s well-known brands will no longer exist in 10 or 20 years’ time? All buildings eventually fall down or are demolished, and all brands will eventually die. So, we would argue that the cost of brands should be amortised in the income statement. It is wrong not to amortise the cost of brands, as eventually they will be worthless. There is a further argument that even if the brand continues to be reported in the balance sheet at the existing value, the reality is that expenditure has been currently incurred which effectively replaces the original brand value. This means that there has been a substitution of a new brand for the old rather than a maintenance of the old brand.



CHAPTER 19

Chapter 19: Question 1 – Sunhats Ltd 1. The principle usually followed is to include in the stock valuation only those expenses which relate to the bringing of the product to its present condition and location. In practice, this often entails: •

including factory (or production) expenses

•

excluding selling, finance and administration expenses.

2. Sunhats Ltd factory expenses to be included in inventory valuation: Wages of storemen and foremen Salary of production manager Rent and rates, repairs and depreciation; proportion relating to factory and stores would be included e.g. electric power. 3. Expenses to be excluded from inventory valuation: •

Salaries of sales manager and salespeople, advertising and carriage outwards. These expenses are excluded as they relate to selling and distributing the goods, not to the production of them.

•

Bad debts and bank interest*: these finance charges are excluded as they relate to the business as a whole and not merely to production.

•

Salaries of personnel officer*, buyer*, accountant* and company secretary*, and directors’ fees*: these administration expenses are excluded, as they similarly relate to the business as a whole.

•

Development expenditure: this is excluded as it is clearly not relevant to the cost of existing stock.

*The items marked with an asterisk are marginal. It can be argued that part of these expenses relate to production and should therefore be regarded as factory overheads. 4. It is important to ensure that the overhead expenses included in the inventory valuation are: •

appropriate in the circumstances of the business, and

•

included on a consistent basis from year to year.



Chapter 19: Question 2 – Inventory Valuation Methods (i)

Receipts

Issues

Balance

Date Quantity

Rate

£

Quantity

Rate

£

Quantity

Rate

£

FIFO 1/7

100

10

1,000

10/7 12/7

80 100

9.8

10

800

980

14/7

20 80

10 9.8

200

100

10

1,000

20

10

200

100

9.8

980

20

9.8

196

784

15/7

50

9.6

480

50

9.6

480

20/7

100

9.4

940

100

9.4

940

80

9.4

752

30/7

20

9.8

196

50

9.6

480

20

9.4

188

Cost of goods sold

2,648

LIFO 1/7

100

10

1,000

10/7 12/7

80 100

9.8

10

800

980

14/7

100

10

1,000

20

10

200

100 100

9.8

980

20

9.8 10

980 200

15/7

50

9.6

480

50

9.8

480

20/7

100

9.4

940

100

9.4

940

30/7

90

9.4

Cost of goods sold

846

20

10

200

50

9.6

480

10

9.4

94

2,626

Weighted average 1/7

100

10

1,000

10/7 12/7

80 100

9.8

10

800

980

14/7

100

9.83 983

100

10

1,000

20

10

200

100

9.8

980

120

9.83

20

9.83

196.7

1,180

15/7

50

9.6

480

50

9.6

480

20/7

100

9.4

940

100

9.4

940

170

9.5

1,615

80

9.5

760

30/7

90

9.5

Cost of goods sold

855 2,638



(ii)

Advantages and disadvantages

FIFO •

The movement of some stock follows this pattern in reality e.g. perishables.

•

However, the charge to cost of sales will still represent out-of-date prices.

•

This means that a distribution policy based on profits calculated using this method will reduce the operating capital base.

•

The balance sheet value will value stock at approaching current values.

LIFO •

The movement of stock does not follow this pattern and detailed records will be required to track costs.

•

The charge to cost of sales will represent prices prevalent at date of sale.

•

This means that a distribution policy based on profits calculated using this method will tend to maintain the operating capital base.

•

However, the balance sheet value will value stock at out-of-date values.

Average cost •

This is a common compromise between the two methods.

•

The advantage is that the average represents a compromise between the FIFO and LIFO methods.

•

However, there is a disadvantage in that the average cost has to be recalculated after each purchase.

(iii)

Effect of a physical shortage of inventory

FIFO Closing inventory 75 @ 9.4

705

Cost of sales increased by 5 @ 9.4

47

LIFO Closing inventory 15 @ 10.0

150

50 @ 9.6

480

10 @ 9.4

9.4 724



Cost of sales increased by 5 @ 10

50

Weighted average Closing inventory 75 @ 9.5

712.5

Cost of sales increased by 5 @ 9.5

47.5



Chapter 19: Question 3 – Alpha Ltd Principles The basis on which the stocks are valued in this solution is the one which is most commonly used by companies, i.e. the lower of cost and net realisable value. The term ‘cost’ includes those overheads which have been incurred in bringing the stocks to their existing condition, namely manufacturing overheads. Selling and distribution expenses have been excluded from cost as it is assumed that these are not incurred until the units are sold. Valuation details

Raw materials: 100 tons × cost £140 per ton = £14,000 The net realisable value is assumed to be greater than this amount as the finished units (which incorporate the steel) sell at a profit, as follows £ Selling price

500

Less: Selling and distribution expenses

60

Net realisable value

440

Manufacturing costs (see workings below)

350

Profit per unit

90

The current replacement price has not been taken, as it is not within the basis of valuation stated above. However, as the replacement price has fallen this is a suitable time to consider whether the client should be advised to amend the basis of stock valuation to ‘the lower of cost, replacement price and net realisable value’, which is more conservative. On this basis the stock would be valued at £130 per ton. Finished units: 100 × cost £350 = £35,000 The cost comprises: Per unit £ Materials

50

Labour

150

Manufacturing overheads – 100% of labour

150 £350

Net realisable value is greater than the cost: Selling price

500

Less: Selling and distribution expenses Net realisable value

60 £440



Damaged, finished units: 10 × £240 = £2,400 These units have been valued at cost less the amount of the loss that will be incurred when the units have been rectified, as follows: Per unit

Valuation

£

£

Cost of finished units

350

350

Cost to rectify

200

Total cost

550

Less: Net realisable value

440

Loss

£110

Amount per unit included in the balance sheet

110 £240

Semi-finished units: 40 × cost £250 = £10,000 The cost comprises: Per unit £ Materials

50

Labour

100

Manufacturing overheads – 100% of labour

100

Total cost per unit so far

£250

An estimate should be made of the cost required to finish the work. If the total estimated cost exceeds the net realisable value, then the excess must be provided for by deducting it from the £250 cost; this is similar in principle to the treatment of the damaged units. For example: Per unit £ Total cost per unit so far (as above)

250

Estimated costs to complete

220

Estimated total costs to completion

470

Less: Net realisable value

440

Estimated loss on completion

30

Valuation: Total cost per unit so far

250

Less: Estimated loss on completion

30 220



Chapter 19: Question 4 – Beta Ltd 1. As the raw materials will realise more than cost, they have obviously been valued at the standard cost, namely £30,000. 2. A review of the price variance account shows that, in total, the actual cost of materials has consistently been well above the standard costs. 3. Consequently, the £30,000 standard cost of raw materials in stock is significantly below the actual cost; and, unless the stock figure is adjusted to the actual cost, this year’s profit will be understated. (Moreover, the understatement of stocks this year will result in next year’s profits being artificially inflated.) 4. Therefore, the figure to be included in the balance sheet should not be the standard cost but a figure which is reasonably close to actual cost. This could be done in one of the following ways: (a) Value each item at the actual cost paid for it, by referring to the purchase invoices concerned. However, this may be too laborious, in which case method (b) or (c) should be considered. (b) If the company has revised the standard costs for use in the following year, then it may be suitable to use these revised costs for valuing the stocks in the balance sheet. (Presumably the revised standards are based on the cost applicable around the year-end.) (c) If methods (a) and (b) are impracticable, a rough and ready method may be used, as follows: £ Balance on raw materials control account

30,000

This is equal to the goods purchased in October, November and December, when the price variances totalled

2,700

Value of raw materials at year-end

32,700

Care is needed in using this method, as the price variances may have arisen over a narrow range of materials, in which case the calculations of the adjustment needed should embrace only those materials. Conclusion Standard costs are used mainly as a tool of management control; their use in the valuation of stocks for accounts purposes is merely identical. Standard costs should not be used for stock valuation unless they are reasonably close to actual costs.



Chapter 19: Question 5 – Bottom Bottom income statement using FIFO inventory valuation $000 Revenue

75,000

Cost of sales

(37,600)

Gross profit

37,400

Other operating expenses

(9,000)

Profit from operations

28,400

Investment income Finance cost

(4,000)

Profit before tax

24,400

Income tax expense

(7,000)

Net profit for the period

17,400

The change from LIFO to FIFO would be a change of accounting policy. Under IAS 8 (revised) the effects of such a change should be applied retrospectively and comparative figures restated, with the opening balance of retained profits adjusted. Working – cost of sales $000 As originally stated

38,000

Increase to opening Inventory

00,500

Increase to closing Inventory As restated

(900) 37,600



CHAPTER 20

Chapter 20: Question 1 – MACTAR (£m)

M1

M6

M62

Costs to date

2.1

0.3

2.3

Future costs

0.3

1.1

0.8

2.4

1.4

3.1

Contract sum

3.0

2.0

2.75*

Expected profit/(loss)

0.6

0.6

(0.35)

* assumes a 10% increase in contract price is allowed and negotiated. Recognised profit Value of work certified

1.8

0.1

1.3

% of work certified to total

60%

5%

47%

Note 1

Note 2

So Recognised profit

0.36

Note 1 Contract M6 is probably at too early a stage of completion to recognise any profit. Note 2 The anticipated loss on contract M62 must be recognised in full on the grounds of prudence. £m

M1

M6

M62

Recorded as revenue

1.8

0.1

1.3

C of S balance

1.44

0.1

1.65

Profit

0.36

nil

(0.35)

2.3

Balance sheet work-in-progress Costs to date

2.1

0.3

Plus recognised profits

0.36

–

Less: recognised losses Less: progress billings Closing balance

(0.35) (1.75)

(0.1)

(1.0)

0.71

0.2

0.95

1.75

0.1

1.0

(1.5)

nil

(0.75)

0.25

0.1

0.25

Receivables Progress billings Less: Payment received Closing balance



Thus the overall profit on these three contracts is £0.01m (£10,000) for the year. This is of course a prudent view as one of the projects (M6) has only just started, one project is set for a cost over-run (M62) and one contract is very nearly complete (M1).



Chapter 20: Question 2 – Lytax Ltd Contract No. Contract price Costs incurred to date

1

2

3

4

5

£000

£000

£000

£000

£000

1,100

950

1,400

1,300

1,200

664

535

810

640

1,070

106

75

680

800

165

30

10

45

20

5

800

620

1,535

1,460

1,240

300

330

Estimated further cost to complete Estimated cost of postcompletion work Estimated profit/(loss) On contracts

(135)

(160)

(40)

(135)

(160)

(40)

Recognised profit/(loss) 580/800 × 300

218

470/620 × 330

250

Notes 1 2

Recognised profit on the profitable contracts is taken as the proportion that costs taken to revenue bear to total anticipated costs. Other sensible proportions would be acceptable. Losses on unprofitable contracts are recognised in full.

The balance sheet work-in-progress balance will show: 1

2

3

4

5

£000

£000

£000

£000

£000

Costs incurred to date

664

535

810

640

1,070

Recognised profits less

218

250

(135)

(160)

(40)

(615)

(680)

(615)

(385)

(722)

Awaited

(60)

(40)

(25)

(200)

(34)

Retained

(75)

(80)

(60)

(65)

(84)

Closing balance

132

(15)

(25)

(170)

190

foreseeable losses Progress billings: Received

The positive balances on contracts 1 and 5, totalling £322,000, will be presented as an asset. The negative balances on contracts 2, 3 and 4, totalling £210,000, will be presented as a liability. The difference between total progress billings and total receipts will be shown as a receivable.



Chapter 20: Question 3 – Beavers Ltd (a)

Contract Account £

Wages

91,000

Materials

36,000

Other costs

18,000

£

HO costs (see Note)

6,000

Progress billings 150,000

Plant (12/15 × £8,000)

6,400

Materials c/f

Recognised profit

40,500

WIP c/f

197,900

3,000 44,900 197,900

Note It is assumed that the Head Office costs are associated with the provision of contract-related services that cannot be directly allocated to a specific contract. In these circumstances IAS 11 allows their inclusion in ‘contract costs’. Any apportionment of general Head Office costs would not be permitted under IAS 11.

(b)

Balance sheet extract as at 30 June 20X7

Current assets Inventory – materials

3,000

Long-term contract balance

(c)

44,900

Calculation of profit

Contract price

240,000

Costs to date [157,400 – 3,000 material on site]

154,400

Estimated further costs to complete [10,000 + 12,000 + 8,000 + 1,600 plant]

31,600 186,000

Estimated profit

54,000

Recognised profit (say) £180,000/240,000 × 54,000 = £40,500 Amount recoverable on long-term contract (180,000 – 150,000) £30,000



Chapter 20: Question 4 – Newbild SA (a)

Contract Account €

€

Materials – Stores

13,407

Progress billing

Materials – Site

73,078

(see Note)

Wages

39,894

Site expenses

4,815

Administration

3,742

Plant – Depreciation

5,160

Subtotal

140,096

Recognised profit

Materials Bal c/f WIP Bal c/f

134,800

5,467 22,928

23,099 163,195

163,195

Note The progress billing is the amount received from the customer grossed up by the 15% retention. Calculation of profit Contract price

780,000

Costs to date [140,096 – 5,467]

134,629

Estimated further costs to complete

490,000

Guarantee work [2.5% of 780,000]

19,500 644,129

Estimated profit

135,871

Recognised profit The work certified as complete has a value of €134,800 ($114,580/0.85). Therefore the contract is around 17% complete (€134,800/$780,000 is 17.28%). Therefore recognised profit could be 17% × €135,871 = €23,099.

(b)

Income statement

Revenue

134,800

Cost of sales

111,701

Profit

23,099

Balance sheet extract Current assets Inventory – materials

5,467

Long-term contract balance

22,928

Receivables – amount recoverable on long-term contract

20,220



Chapter 20: Question 5 – Good Progress SpA Note that the contract is 25% complete at the end of 20X0 and 40% complete by the end of 20X1. Therefore 15% of the contract was completed in 20X1. Income statement entries:

Revenue

20X1

20X0

€

€

150,000

250,000

112,500

187,500

37,500

62,500

Cost of goods sold Profit [15%/25%] Balance sheet entries Current assets

20X1

20X0

€

€

Long-term contracts balance [117,000 – 112,500]

4,500

[265,000 – 262,500]


2,500


Chapter 20: Question 6 Solution (a) Water Away The following extract from the Balfour Beatty 2003 Annual Report deals with such a situation: Revenue on Aberdeen Environmental Services Limited (AES) is related to the volume and quality of the wastewater processed by the plant. AES therefore takes demand risk and has a fixed asset, which is depreciated over the life of the concession. The revenue is recognised as turnover as it is earned.

Solution (b) Learn A head The following extract from the Balfour Beatty 2003 Annual Report deals with such a similar situation: Hospitals and Schools Balfour Beatty's hospitals and schools concessions receive income based on the availability of the asset, rather than their actual usage. The costs of constructing the asset are therefore accounted for as amounts recoverable on contracts during the course of construction and reclassified to contract debtors when construction is complete. The contract debtor gives rise to an interest income calculation based on an appropriate rate of return for the asset concerned. The income is split into two elements: that relating to the contract debtor, and that relating to the provision of other services such as cleaning and catering. The element of revenue relating to the contract debtor is split between principal repayments, reducing the amount owed to the concession, and interest income, which is credited to the profit and loss account as it is earned. The revenue relating to services is recognised as turnover as it is earned, reflecting the continuing provision of services to the concession.



CHAPTER 21

Chapter 21: Question 1 – Parent Ltd (a)

Parent Ltd balance sheet as at 1 January 20X1 Ordinary Shares of 1 each

40,500

Retained earnings

4,500 45,000

Investment in Daughter Ltd

10,800

Cash[20,000 – 10,800]

9,200

Other net assets

25,000 45,000

Note: The investment is shown as its fair value of 10,800 and the cash has been reduced by consideration. Consolidated balance sheet as at January 20X1 Parent

Daughter

Add

Eliminate

CBS

(Dr)/Cr Ordinary shares Retained earnings

40,500

9,000

49,500

(9,000)

40,500

4,500

1,800

6,300

(1,800)

4,500

55,800

10,800

55,800

45,000

Investment in Daughter Cash Other net assets

10,800

10,800

10,800

9,200

2,000

11,200

11,200

25,000

8,800

33,800

33,800

55,800

10,800

55,800

Q

45.000

Note: Because the cash paid exactly equalled the value of the net assets acquired, there was no difference on consolidation i.e. no positive or negative goodwill.

(b)

Parent Ltd balance sheet as at 1 January 20X7

Ordinary Shares of 1 each (40,500+(10,800/2)

45,900

Share premium

5,400

Retained earnings

4,500 55,800




10,800

Cash

20,000

Other net assets

25,000 55,800

Note: The investment is shown as its fair value of 10,800 and the shares are issued at their fair value of 5,400 par value and 5,400 premium. Consolidated balance sheet as at January 20X7 Parent

Daughter

Add

Eliminate

CBS

(Dr)/Cr Ordinary shares

45,900

9,000

54,900

Share premium

5,400

5,400

Retained earnings

4,500

1,800

6,300

55,800

10,800

66,600

(9,000)

40,500 5,400

(1,800)

4,500 55,800

Investment in Daughter

10,800

10,800

10,800

Cash

20,000

20,000

Other net assets

25,000

10,800

35,800

___

35,800

55,800

10,800

66,800

Q

45.000

20,000

Note: Because the value of the shares issued exactly equalled the value of the net assets acquired, there was no difference on consolidation i.e. no positive or negative goodwill.




Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of 1 each

40,500

Retained earnings

4,500 45,000

Investment in Daughter Ltd Cash

16,200

[20,000 – 16,200]

3,800

Other net assets

25,000 45,000


Daughter

Add

Eliminate

CBS


40,500

9,000

49,500

(9,000)

40,500

4,500

1,800

6,300

(1,800)

4,500

55,800

10,800

55,800

45,000

Investment in Daughter Cash Other net assets

16,200

16,200

10,800

5,400

3,800

2,000

5,800

5,800

25,000

8,800

33,800

___

33,800

55,800

10,800

55,800

Q

45.000

Note: Because the cash paid exceeded the value of the net assets acquired, there was a difference on consolidation of 5,400 which appears in the consolidated balance sheet as an asset goodwill – this will be reviewed for possible impairment.

(b)

Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of 1 each (40,500+(16,200/3)

45,900

Share premium

10,800

Retained earnings

4,500 61,200


16,200

Cash

20,000

Other net assets

25,000 61,200



Note: The investment is shown as its fair value of 16,200 and the shares are issued at their fair value of 5,400 par value and 10,800 premium. Consolidated balance sheet as at January 20X7 Parent Ordinary shares

45,900

Share premium

10,800

Retained earnings

Daughter 9,000

Add 54,900

Eliminate

CBS

(Dr)/Cr (9,000)

45,900

10,800

4,500

1,800

6,300

61,200

10,800

72,000

10,800 (1,800)

4,500 61,200


16,200

16,200

Cash

20,000

20,000

Other net assets

25,000

10,800

35,800

___

35,800

55,800

10,800

72,000

Q

61,200

10,800

5,400 20,000

Note: Because the value of the shares issued exceeded the value of the net assets acquired, there was a difference on consolidation.




Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of £ 1 each

40,500

Retained earnings

4,500 45,000


16,200

Cash [20,000 – 16,200]

3,800

Other net assets

25,000 45,000


Daughter

Add

Eliminate

CBS


40,500

9,000

49,500

(9,000)

40,500

4,500

1,800

6,300

(1,800)

4,500

55,800

10,800

55,800

Retained earnings

45,000


16,200

16,200

Revaluation increase Cash Other net assets

10,800 (1,200)

4,200

3,800

2,000

5,800

5,800

25,000

8,800

33,800

1,200

35,000

55,000

10,800

55,800

Q

45.000

Note: 1. The net assets in the CBS will be increased by 1,200. 2. The fair value of the shares issued (16,200) exceeded the fair value of the net assets acquired (12,000). This difference on consolidation will be reported as goodwill and reviewed for impairment.

(b)

Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of 1 each (40,500+(16.200/3)

45,900

Share premium

10,800

Retained earnings

4,500 61,200



16,200


Cash

20,000

Other net assets

25,000 61,200

Note: The investment is shown as its fair value of 16,200 and the shares are issued at their fair value of 5,400 par value and 10,800 premium. Consolidated balance sheet as at January 20X7 Parent

Daughter

Add

Eliminate

CBS


45,900

Share premium

10,800

Retained earnings

Daughter

9,000

54,900

(9,000)

10,800

4,500

1,800

6,300

61,200

10,800

72,000

Investment in 16,200

16,200

Revaluation increase

45,900 10,800

(1,800)

4,500 61,200

10,800 (1,200)

20,000

4,200

Cash

20,000

20,000

Other net assets

25,000

10,800

35,800

1,200

37,000

55,800

10,800

72,000

Q

61,200

Note: 1. The net assets in the CBS will be increased by 1,200. 2. The fair value of the shares issued (16,200) exceeded the fair value of the net assets acquired (12,000). This difference on consolidation will be reported as goodwill and reviewed for impairment.



Chapter 21: Question 4 – Parent Ltd Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of £ 1 each

40,500

Retained earnings

4,500 45,000

Investment in Daughter Ltd Cash

6,000

[20,000 – 6,000]

14,000

Other net assets

25,000 45,000


Daughter

Add

Eliminate

CBS



40,500

9,000

49,500

(9,000)

40,500

4,500

1,800

6,300

(1,800)

4,500

55,800

10,800

55,800

6,000

6,000

45,000 10,800

(4,800)

Cash

14,000

2,000

16,000

16,000

Other net assets

25,000

8,800

33,800

___

33,800

55,800

10,800

55,800

Q

45.000

Note: Because the cash paid was less than the value of the net assets acquired, there was a credit difference on consolidation i.e. negative goodwill which will be credited to the retained earnings.



Chapter 21: Question 5 – Parent Ltd Parent Ltd balance sheet as at 1 January 20X7 Ordinary Shares of £ 1 each

40,500

Retained earnings

4,500 45,000


9,000

Cash [20,000 – 9,000]

11,000

Other net assets

25,000 45,000


Daughter

Add

Eliminate

CBS


40,500

9,000

49,500

(6,750) a (2,250) b

Retained earnings

4,500

1,800

6,300

(1,350) a (450) b

Minority interest

40,500 4,500

2,250 b 450 b 45,000

10,800

55,800

2,700 47,700


9,000

9,000

6,750 a 1,350 a

900

Cash

11,000

2,000

13,000

13,000

Other net assets

25,000

8,800

33,800

___

33,800

45,000

10,800

55,800

Q

47,700

Note: Because the cash paid was more than the value of the net assets acquired, there was a debit difference on consolidation of 900. (a) represents the elimination of the shares and reserves of the company acquired against the investment in the company acquired. (b) Represents the transfer to the minority shareholders their 25% interest in the net assets of 10,8700 in Daughter Ltd.





Property

43,400

Plant and equipment

12,320


51,324

Trade receivables

22,829

Cash

63,500 137,713


63,700

Income tax

6,440 70,140

Net current assets

67,573 123.293

Share capital

56,000

Retained earnings

67,293 123.293

Reserves at date of acquisition Investment

151,200

Less shares

50,400

Goodwill

100,800 85,680

Reserves

15.120

Step 1: Calculate the % ownership Proposed dividend in CBS

11,760

Proposed dividend in Parent

11,200

Minority dividend Dividend receivable by Parent

560

10%

5,040

90%

Step 2: Calculate the retained earnings balance Consolidated balance

79,884

Less Parent

35,280 44,604



Add Profit on stock (4,200 – 3,360)

840 45,444

Add Minority interest (10% of 50,493 or 1/9 of 45,444))

5,049

Add Pre-acquisition Parent (90% o £16,800)

15,120

Minority (10% of 16,800) Subsidiary retained earnings

1,680 67,293

Step 3: Reconcile the minority interest Shares

5,600

Retained earnings post-acquisition

5,049

Retained earnings pre-acquisition

1,680 12,329

Worksheet Non-current assets Group

Parent

Subsidiary

Adjustment

Property

127,400

84,000

43,400

43,400

Plant

62,720

50,400

12,320

12,320

Inventory

121,604

71,120

50,484

840

51,324

Receivables

70,429

51,800

18,629

4,200

22,829

Cash

24,360

24,360

39,200

63,560

4,200

63,700

Current assets


140,420

80,920

59,500

Income tax

27,160

20,720

6,440


6,440


Chapter 21: Question 7 – Rouge plc Rouge plc Balance Sheet as at 1 January 20X0 ASSETS

£ Million Non-current assets

Property, plant and equipment [100 + 60] Goodwill [132 – 100]

160 32

Current assets [80 + 70]

150 342

Common £10 shares

200

Retained earnings

52

Share capital and reserves

252

Current liabilities

90 342



Chapter 21: Question 8 – Ham plc (a) Ham plc Balance sheet as at January 20X0 ASSETS

£000

Non-current assets Property, plant and equipment [250 + 100]

350

Goodwill [90 – 110]

(20)


170 500

Common £5 shares

200

Retained earnings

160


360

Current liabilities

140 500

(b)

See discussion in chapter.

Following recent changes in the treatment of goodwill, negative goodwill will be taken to income statement immediately.



Chapter 21: Question 9 – Berlin plc Berlin plc Balance sheet as at 1 January 20X0 (a)

(b)

Cash acquisition

Share exchange

£000

£000


250

250

Investment in Hanover

100

100

50

150

400

500

200

250

Additional paid-in capital

–

50

Retained earnings

80

80


280

380

Current liabilities

120

120

400

500

ASSETS Non-current assets

Current assets

Common £5 shares



Chapter 21: Question 10 – Bleu plc Bleu plc Balance sheet as at January 20X0 ASSETS

£ Million

Non-current assets Property, plant and equipment [150 + 120] Goodwill [210 – (80% × 180) ]

270 66


213 549

Common £10 shares

300

Retained earnings

78


378

Minority interest [20% × 180]

36

Current liabilities [90 + 45]

135 549



Chapter 21: Question 11 – Base plc Base plc Balance sheet as at January 20X0 ASSETS

£000

Non-current assets Property, plant and equipment [250 + 120] Goodwill [90 – (60% × 110) + (40% × 20)]

370 12


170

Total assets

552

Common £5 shares

200

Retained earnings

160


360

Minority interest [(40% × 110) + (40% × 20)]

52


140

Total equity and liabilities

552



CHAPTER 22

Chapter 22: Question 1 – Sweden Sweden Balance Sheet as at 31 December 20X1 ASSETS

Krm

Non-current assets Property, plant and equipment Goodwill

[264 + 120] [200 – (110 + 10 + 70) – 2]

384 8


300

Total assets

692

Common Kr10 shares

400

Revaluation reserve

20

Retained earnings [104 +10 – 2]

112


532


160


692



Chapter 22: Question 2 – Summer plc Summer plc Balance Sheet as at 31 December 20X1 ASSETS

£000

Non-current assets Property, plant and equipment [200 + 200]

400

Goodwill [141 – 60% (20 + 35 + 160) – 1]

11


240 651

Common £5 shares

175


25

Retained earnings [161 + 60% (40 – 35) – 1]

163


363

Minority interest [40% × 220]

88


200 651



Chapter 22: Question 3 – Gold plc Gold plc Balance Sheet as at 31 December 20X1 ASSETS

£

Non-current assets Fixed assets, including land [82,300 + 108,550 + 3,000] Goodwill

193,850

(Note 1)

1,240

Inventories [23,200 +10,000 – 300]

32,900

Other current assets [5,000 + 7,500]

12,500

Current assets

Total assets

240,490

Common £10 shares

55,000

Preferred shares

10,000


5,000

Retained earnings [(75,000 + 75% (21,200 – 16,000)) – 300 – 310)]

78,290

Share capital and reserves Minority interest

148,290

(Note 2)

26,950

Non-current liabilities [12,500 +14,000]

26,500

Current liabilities Bond interest payable [625 + 700] Other current liabilities [18,550 + 18,875]

1,325 37,425

38,750 240,490

Note 1:

Goodwill £

Investment in Silver Acquired

£ 46,000

75% × 24,000

18,000

30% × 20,000

6,000

20% × 17,500

3,500 27,500

75% × 3,600

2,700

75% × 3,000

2,250

75% × 16,000

12,000

Goodwill

44,450 1,550



Impairment @ 20% Goodwill at 31.12.20×1 Note 2:

= £310 = £1,550 – 310 = £1,240

Minority interest £ 25% × 24,000

6,000

70% × 20,000

14,000

25% × 3,600

900

25% × 3,000

750

25% × 21,200

5,300 26,950



CHAPTER 23

Chapter 23: Question 1 – Bill plc Bill SA Consolidated Income Statement for the year ended 31 December 20X1

£ Sales [300,000 + 180,000 – 12,000]

468,000

Cost of sales [90,000 + 90,000 – 12,000 + 2,000]

170,000

Gross profit

298,000

Expenses [88,623 + 60,000]

148,623

Impairment of goodwill

3,000

Profit before taxation

146,377

Taxation [21,006 + 9,000]

30,006

Profit after taxation

116,371

Minority interest [(20% (21,000 – 4,500)) + (90% x 4,500)] Profit attributable to the group

7,350 109,021

Dividend paid

60,000

Retained profit for the year

49,021

Retained profit brought forward [104,004 + 80% (81,000 – 45,000)] Retained profit carried forward


132,804 181,825


Chapter 23: Question 2 – Morn Ltd Morn Ltd Consolidated Income Statement for the year ended 31 December 20X1 Gross profit [360,000 + 180,000)]

£ 540,000

Expenses [120,000 + 110,000]

230,000


310,000

Taxation [69,000 + 18,000]

87,000

Profit after taxation

223,000

Minority interest [10% × 52,000]

5,200

Profit after taxation belonging to the group

217,800

Dividends paid

120,000


97,800



Chapter 23: Question 3 – River plc River A/S Consolidated Income Statement for the year ended 31 December 20X1 Sales [100,000 + [(9/12 × 60,000)]

£ 145,000

Cost of sales [30,000 +[(9/12 × 30,000])

52,500

Gross profit

92,500

Expenses [20,541 + (9/12 × 15,000)]

31,791

Interest payable on 5% bonds [9/12 × (5,000 – 500)]

3,375

Impairment of goodwill

4,000


53,334

Taxation [7,002 + (9/12 × 3,000)] Profit after taxation

9,252 44,082

Minority Interest [10% × 7,000 × 9/12]

525

Profit after taxation belonging to the group

43,557

Dividends paid

20,000 23,557

Profit and loss account balance brought forward from previous years 34,668 58,225



Chapter 23: Question 4 – Mars plc Balance Sheet as at 31 December 20X2

Assets £

£

Non-current assets [330,000 + 157,500]

487,500

Goodwill

37,100

Current assets Inventories [(225,000 + 67,500) – 3,000]

289,500

Trade receivables [180,000 + 90,000]

270,000

Bank [36,000 + 18,000]

54,000

Total assets

613,500 1,138,100

Equity and liabilities Capital and reserves Issued capital

196,000

General reserve [245,000 + 10,800]

255,800

Retained earnings [222,000 + 44,000]

266,000 717,800

Minority interest

51,300

Current liabilities Trade payables [283,500 + 40,500] Taxation [31,500 + 13,500]

324,000 45,000 369,000 1,138,100

W1: Cancel inter-company balances

•

Current accounts of £22,500

•

Dividends receivable in Mars of £9,000 cancels with £9,000 of the dividends payable in Jupiter, leaving £2,250 payable to the minority interest. Consolidated Income Statement for the year ending 31 December 20X2

£ Sales [1,440,000 + 270,000 – 18,000]

1,692,000

Cost of sales [1,045,000 + 135,000 – 18,000 + 3,000]

1,165,000

Gross profit

527,000

Expenses [123,500 + 90,000]

213,500

Profit before tax

313,500

Taxation [31,500 + 13,500]

45,000



Profit after tax

268,500


6,300 262,200

Dividend paid

180,000

Retained profit

82,200

Accumulated profit brought forward [(156,000 + 80% (114,750 – 80,000))

183,800 266,000

W2:

Goodwill £

Investment in Jupiter

£ 187,500

£1 Ordinary shares [80% × 90,000]

72,000

Accumulated profits [80% × 80,000]

64,000

General Reserve [80% × 18,000]

14,400 150,400

Goodwill W3:

37,100

Unrealised profit on inter-company sales

50/150 × 18,000 = 6,000. Only half the stock is unsold at the year end so 6,000/2 is the provision required against the closing stock figure. W4:

The income statement of Jupiter £

Balance at 31/12/20X2 as per the balance sheet

£ 135,000

Pre-acquisition profit held by Mars

64,000


27,000

91,000 44,000

W5:

The income statement of Mars

£ Balance at 31/12/20X2 as per the balance sheet Less: Provision for unrealised profit

225,000 3,000 222,000



W6:

The minority interest £

20% × 90,000 Shares

18,000

20% × 31,500 General reserve

6,300

20% × 135,000

27,000 51,300

W7:

Jupiter general reserve £

Balance at 31/12/20X2 as per balance sheet

31,500

Less: Mars share of pre-acquisition 80% × 18,000 = Minority interest 20% × 31,500

(14,400) (6,300) 10,800



Chapter 23: Question 5 – Red Ltd Consolidated Balance Sheet as at 31 December X2 Assets

$

$

Non-current assets Tangible [120,000 + 70,000]

190,000

Intangible – Goodwill (W1)

51,500

Current assets Inventories [100,000 + 30,000 – 1,500] (W2)

128,500

Trade receivables [80,000 + 40,000]

120,000

Bank [16,000 + 8,000]

24,000

272,500 514,000

Total assets Equity and liabilities Capital and reserves Issued capital

176,000

General reserve [20,000 + (75% × (14,000 – 8,000))]

24,500

Retained earnings [(100,000 + (75% × (60,000 – 30,000) – 1,500))]

121,375 321,875

Minority interest

25% × (114,000 – 1,500)

28,125

Current liabilities Creditors [125,996 + 18,000]

143,996

Taxation [14,004 + 6,000]

20,004

164,000 514,000

Income Statement for the year ending 31 December X2

£ Sales

[200,000 + 120,000 –12,000]

308,000

Cost of sales [60,000 + 60,000 –12,000 + 1,500

109,500

Gross profit

198,500

Expenses [59,082 + 40,000]

(99,082)

Profit before tax

99,418

Taxation [14,004 + 6,000]

20,004

Profit after tax

79,414

Minority interest [25% × (14,000 – 1,500]

3,125 76,289

Dividend paid

40,000



Retained profit

36,289

Accumulated profit brought forward (W3)

85,086 121,375

W1:

Goodwill $

Investment in Pink

110,000

$1 Common shares [75% × 40,000]

30,000

Accumulated profits [75% × 30,000]

22,500

General Reserve [75% × 8,000]

6,000 58,500

Goodwill

W2:

51,500

Unrealised profit on inter-company sales

Mark-up = 9,000 × 1/3 = $3,000 Only half the stock is unsold at the year end so $3,000/2 is the provision required against the closing stock figure = $1,500 W3:

Red

69,336

Pink [75% × (51,000 – 30,000)]

15,750 85,086



Chapter 23: Question 6 – Try plc Try

Hard

CPL

£000

£000

£000

Profit before tax

80

56

Tax

42

28.60

70.60

38

27.40

65.40

6.85

6.85

38

20.55

58.55

Dividends

20

.

20.00

Carried forward

18

20.55

38.55

Minority interest [25%]

136.00



Chapter 23: Question 7 – Mother plc (a) Consolidated income statement for the year ended 31 December 20x6 Mother

Daughter

CPL

000

000

000

Profit before tax

300

100

400

Less Intra-company dividend

(20)

Income tax

(20)

(120)

(30)

(150)

160

70

230

20

(20)

180

50

230

Transfer to general reserve

(30)

(20)

(50)

Dividends

(50)

Retained

100

30

130

50

10

60

150

40

190

Mother

Daughter

CBS

000

000

000

Non-current assets

300

150

450

Investment in Daughter plc

200

Net current assets

280

110

390

780

260

840

Share capital

500

200

500

General reserve

130

20

150

Retained earnings

150

40

190

780

260

840

Profit after tax Intra-group dividend

Balance b/f at 1.1.20x6

(50)

Consolidated balance sheet as at 31 December 20x6



(b)

The consolidated balance sheet:

•

The parent company has 100% control of the subsidiary.

•

The subsidiary was acquired at the date of incorporation when the net assets were equal to share capital with both stated at £200,000, there was therefore no goodwill.

•

The CBS is formed by the aggregation of the assets and the reserves. Only the share capital of the parent company is included.

The consolidated income statement: •

Items are aggregated except for dividend.

•

Intra-group dividends are cancelled.

•

Only the dividend of the parent company is shown.

•

Reserves are aggregated because they are post-acquisition



Chapter 23: Question 8 – Mother plc (a)

Consolidated income statement for the year ended 31 December 20x6 Mother

Daughter

CPL

000

000

000

Profit before tax

300

100

400

Less Intra-company dividend

(16)

Income tax

(16)

(120)

(30)

(150)

164

70

234

20% of 70 (14)

(14)

164

56

220

16

(16)

180

50

220

Transfer to general reserve

(30)

80% of 20 (16)

(46)

Dividends

(50)

Retained

100

Profit after tax Less minority interest Intra-group dividend

Balance b/f at 1.1.20x6

50 150

(50) 24

124

8

58

80% of 40 32

182

80% of 10

Consolidated balance sheet as at 31 December 20x6

Non-current assets

Mother

Daughter

CBS

000

000

000

300

150

450

Goodwill (200,000-160,000)

40

Investment in Daughter plc

200

Net current assets

280

110

390

780

260

880

Share capital

500

200

500

General reserve

130

20

146

Retained earnings

150

40

182

Minority interest 20% of 260,000

52 780

260


880


(b) • •

The consolidated balance sheet: The parent company holds 80% of the shares There is a 20% minority interest •

In CPL it is 20% of post tax profit

•

In the CBS it is 20% of the closing net assets of 260,000

•

The intragroup dividend is 80% of the Daughter plc dividend i.e. 80% of 20,000

•

The retained earnings is then 80% of the closing balance i.e. 80% of 40,000.

•

Goodwill has arisen because Mother paid more than the fair value of the net assets i.e. 200,000 for net assets of 160,000.

•

The CBS is formed by the aggregation of the assets and the reserves. Only the share capital of the parent company is included.

The consolidated income statement:

•

Items are aggregated except for dividend.

•

Intra-group dividends are cancelled.

•

Only the dividend of the parent company is shown.

•

Reserves are aggregated because they are post-acquisition




Consolidated income statement for the year ended 31 December 20X6 Mother

Daughter

CPL

000

000

000

Retained

150

30

130

Balance b/f at 1.1.20X6

50

5

55

35

185

150

(Note 1)

Consolidated balance sheet as at 31 December 20X6 000 Non-current assets

450

Net current assets

390 840

Share capital

500

Negative goodwill [Cost £200,000 - net assets £220,000]

20

General reserve

135

Retained earnings

185

(Note 2) [only includes post-acquisition]

840

(b) Note 1. The group share of Daughter's retained profit is 100% of the post-acquisition profits i.e. 100% of 40,000 – 5,000 that existed at 1.1.20X2. Note 2. The price paid is less than the fair value of the net assets. This can be attributed either to a bargain purchase perhaps because the vendor needs to achieve a quick sale or to expectation of future losses whereby the purchase price has been reduced to take account of future costs, such as reorganisation costs, or losses that do not represent identifiable liabilities at the balance sheet date.




Consolidated income statement for the year ended 31 December 20X6 Mother

Retained Bal b/f at 1.1.20X6

Daughter

CPL

£000

£000

£000

100

24

124

4

54

28

178

50 150

[80% × 5] (Note 1)

Note 1. The group share of Daughter's retained profit is 80% of the post-acquisition profits i.e. 80% of 40,000 – 5,000 that existed at 1.1.20X2. Consolidated balance sheet as at 31 December 20X6 000 Goodwill [200,000 – 80% of 220,000]

24

Non-current assets

450

Net current assets

390 864

Share capital

500

General reserve [130,000 + 80% of 5,000]

134

Income statement

178

Minority interest [20% of 260,000]

52 864

(b) In this case a minority interest is recorded representing the minority's 20% interest in the net assets at the balance sheet date which are under the control of the majority shareholder.



Chapter 23: Question 11 – Tailor Ltd Plant

[207,900–184,900]

Depreciation [44,000–32,000]

23,000 12,000

Inventory [70,000 – 63,000 + 300 unrealised profit]

7,300

Receivables

2,000

[25,000–23,000]

11,000

9,300 20,300

Less: Payables

[58,000 – 56,000]

2,000

Overdraft

[6,000–0]

6,000

8,000 12.300

Capital

7,000

Reserves

5,300 12,300

Reconcile the reserves: (1)

Cost of control Cash for investment - per balance sheet

9,100

Capital reserve - per Note 2 in question

800

Less:

9,900

Shares

(6,300)

Reserves as the difference

3.600

Reserves of 3,600 is a 90% interest (i.e. 6300/7000 × 100) Therefore 100% interest was 4,000 (2)

Calculate distributable profits Minority interest per consolidated balance sheet Less Shares

1,200 (700)

Post-dividend reserve

500

Dividend (1/9 of 900 in parent balance sheet)

100

Pre dividend reserve

600

Less Pre-acquisition (1/9 of 3,600 from Working 1 above)

(400) 200

10% is £200, therefore 100% is £2,000



(3)

Calculate the reserve of subsidiary Profits were from (2) above

2,000

Add profit on stock (inter-group)

300 2,300

(4)

Less dividend

(1,000)

Retained

1,300

Balance b/f

4,000

Balance c/f

5.300

Treatment of reserves on consolidation Balance

5,300

Less: Inventory adjustment

300

Minority interest

500

Pre-acquisition

3,600

Post-acquisition

900 5.300



Chapter 23: Question 12 – H and S Ltd (a)

% of S Ltd owned by H Ltd Derived from the minority interest figures Income statement 170/680 × 100 Balance sheet 555/2,220 × 100

=

75%

= =

25% 25%

(b)

Inter-company sales = 500 The amount eliminated in the Income Statement Parent 4,000 + subsidiary 2,200 - group 5,700

(c)

Inventory unrealised profit = 45 Parent 410 + subsidiary 420 - group 785

(d)

Inter-company receivables and payables offset/eliminated Receivables: Parent 535 + subsidiary 220 - group 595 = 160 Payables: Parent (300) + subsidiary (260) - group 355 = 225

(e)

S Ltd – retained earnings on acquisition = 960 Comprising: Cost Less Share capital Goodwill Reserves attributable to 75% Total reserves 720/75 × 100


1,700 570 410

980 720 960


CHAPTER 24

Chapter 24: Question 1 – Swish (a)

Income Statement for the year ended 31 December 20X3 £

Sales

[300,000 + 160,000 – 16,000]

Cost of Sales

444,000

[90,000 + 80,000 – 16,000 + 3,200]

157,200 286,800

Expenses

[95,000 + 50,000]

145,000

Group profit before taxation

141,800

Share of Associated Company profits [25% × 30,000]

7,500

Profit before taxation Taxation

149,300

–

Group [30,000 + 7,000]

–

Associate [25% × 8,000]

37,000 2,000

39,000 110,300

Minority Interest (10% × 23,000)

2,300 108,000

Dividends paid

40,000


68,000

Retained earnings brought forward [94,000 + ( 90% × 47,000) + (25% × 6,000)]

137,800 205,800

(b)

Consolidated Balance Sheet as at 31 December 20X3 Cost

Non-current assets

Dep’n £

Net £

Intangible: Goodwill in subsidiary Tangible

[120,000 + 110,000]

Investment in Associate

£ 17,600

500,000

270,000

[18,000 + 28,000]

230,000 46,000 293,600

Current Assets Inventories

[120,000 + (60,000 – 3,200)]

Trade receivables

[130,000 + 70,000]


176,800 200,000


Current account – Handle (Note 1) Bank

3,000

[24,000 + 7,000]

31,000 410,800


[132,000 + 25,000]

157,000

Taxation payable

37,000 194,000

216,800 510,400

Financed by £1 Common shares

250,000

General reserve [30,000 + 3,600 + (25% × 4,000] (Note 2)

34,600

Retained earnings [150,000 – 3,200 + 54,000 + (25% × 20,000) (Note 2)

205,800 490,400

Minority interest

20,000 510,400

Notes 1. The inter-company current account balance with the associated company has not been cancelled because the associated company is not a member of the group. 2. The group’s share of the retained earnings and general reserve is calculated on the postacquisition accumulated profits and general reserve of Handle, i.e. General reserve per Handle balance sheet is

12,000

Pre-acquisition (see question)

8,000

Post-acquisition

4,000

Retained earnings per Handle balance sheet

50,000


30,000

Post-acquisition

20,000

3. Goodwill in Broom Cost of investment

140,000

Less 90% of share capital

60,000

General reserve

16,000

Retained earnings

60,000 136,000

90% Goodwill

122,400 17,600



4. Unrealised profit in Inventory Swish sold Broom

16,000

Remaining unsold at year end

12,800

Profit element 25%

3,200



Chapter 24: Question 2 – Stop Group (a)

Consolidated income statement for year to 31 December 20X1 £

Sales

375,000

Cost of sales

125,000 250,000

Expenses

149,750 100,250

Share of profits of Associate

[43,750 × 30% × 0.75]

9,844 110,094

Taxation – Group – Associate

25,000 [11,250 × 30% × 0.75]

2,531 27,531 82,563

Dividends paid

50,000


32,563

Balance brought forward

112,500 145,063

(b)

Consolidated Balance Sheet at 31 December 20X1 £

Fixed assets at cost

375,000

Depreciation

125,000 250,000

Goodwill Investment in Start Ltd

7,000 [204,375 × 30%]

61,313


160,000

Trade receivables

165,000

Current a/c Start Ltd

15,000

Bank

12,500 352,500




187,500

Taxation

25,000 212,500 140,000 458,313

Financed by Ordinary shares of £1 General reserves

281,000

[31,500 + (2,500 × 30%)]

32,250

Retained earnings

145,063 458,313

Working 1 Investment in Start [63,250 – 750] (see Note)

62,500

Shares acquired

18,750

Retained earnings [102,500 × 30%]

30,750

General reserve [20,000 × 30%]

6,000 55,500

Goodwill

7,000

Note: The £750 which has correctly been credited to Stop’s investment in Start represents the share of the dividend receivable out of the profits of Start before it became an associate i.e. £10,000 × 30% × 3/12 = 750. This amount is not a profit made by the group and must not therefore be in the group profit and loss. In effect this adjustment restores the net assets purchased on acquisition to their full amount.



Chapter 24: Question 3 – Ant Co (a)

Consolidated Income Statement for the year ended 31 December 20X9 $

Sales

[225,000 + 120,000 – 12,000]

Cost of sales

333,000

[67,500 + 60,000

– 12,000 + 2,700]

118,200 214,800

Expenses

[70,500 + 37,500]

108,000

Group profit before taxation

106,800

Share of Associated Company profits [25% × 22,500]

5,625


112,425

Taxation – Group [22,500 + 5,250]

27,750

– Associate [25% × 6,000]

1,500

29,250 83,175

Minority interest

[20% × 17,250]

3,450 79,725

Dividends paid

30,000


49,725

Retained earnings brought forward [70,500 + (80% × 35,250*) + (25% × 4,500*)

99,825 149,550

* Post-acquisition profits brought forward

(b)

Consolidated Balance Sheet as at 31 December 20X9 Cost $

Dep’n $

Net $

Non-current assets Intangible: Goodwill in subsidiary Tangible: [90,000 + 82,500] Investment in Associate

8,400 375,000

202,500

[21,000 + 13,500]

172,500 34,500 215,400


[105,000 + 45,000 – 2,700]


147,300


Trade receivables

[98,250 + 52,500]

150,750

Current account – Nit (Note 1)

2,250

Bank [17,750 + 5,250]

22,500 322,800


[99,000 + 18,750]

Taxation payable

117,750 27,750 145,500

177,300 392,700

Financed by $1 common shares

187,500

General reserve [22,500 + 2,400 + (25% × 3,000)] (Note 2)

25,650

Retained earnings

149,550 362,700

Minority interest (20% × 150,000)

30,000 392,700

Notes 1. The inter-company current account balance with the Associated company has not been cancelled because the Associated company is not a member of the group. 2. The group’s share of the Associated retained earnings and General Reserve is calculated on the post-acquisition retained earnings and General reserve of Nit, i.e. General reserve per Nit balance sheet is

9,000


6,000

Post-acquisition

3,000

Retained earnings per Nit balance sheet

37,500


22,500

Post-acquisition

15,000



Chapter 24: Question 4 – Twist plc (a)

Consolidated Income Statement for year to 31 December 20X3 £

Sales

450,000

Cost of sales

150,000 300,000

Expenses

171,000 129,000


[74,000 × 30% × 0.25]

5,550 134,550

Taxation – Group – Associate

30,000 [14,000 × 30% × 0.25]

1,050 31,050 103,500

Minority interest

10,000

Attributable to the shareholders of the parent

93,500

Dividends paid

60,000 33,500

Retained earnings brought forward

136,000 169,500

(b)

Consolidated Balance Sheet at 31 December 20X3 £


450,000

Depreciation

150,000 300,000

Investment in Turn [(244,000 × 30%) + 3,300] (W1)

76,500


180,000

Trade receivables

207,000

Current a/c Turn

18,000

Bank

18,000 423,000




225,000

Taxation

30,000 255,000 168,000 544,500

Financed by Common shares of £1 each

200,000

General reserve

37,000

Retained earnings [168,000 + (20,000 × 25% × 30%)]

169,500 406,500

Minority interest

138,000 544,500

Working 1 Investment in Turn

75,000

Shares acquired

21,000

Retained earnings [137,000 × 30%]

41,100

General reserve [32,000 × 30%]

9,600 71,700 3,300

Goodwill



CHAPTER 25

Chapter 25: Question 1 – Fry Ltd The profit or loss on foreign exchange in these cases will be as follows:

Name of account:

Foreign currency at exchange rate on

Texas Inc Alamos Inc Chicago Inc Creditor

American

Dollar

bank

bank account

Payable

Receivable

Loan creditor

$40,000

$60,000

$100,000

$90,000

$90,000

2.60

2.60

2.40

2.40

2.40

£15,385

£23,077

£41,667

£37,500

£37,500

$40,000

$30,000

$80,000

2.40

2.40

2.30

£16,667

£12,500

£34,783

$30,000

$20,000

$90,000

$90,000

2.10

2.10

2.10

2.10

000 000

£14,286

£9,524

£42,847

£42,857

(£1,282)

£3,709

(£2,640)

(£5,357)

£5,357

date of initial transaction

Foreign currency at exchange rate on date of settlement Foreign currency at exchange rate on date of balance sheet Profit/(loss) on foreign exchange



Chapter 25: Question 2 – Walpole Ltd (a)

Translate the financial statements of Paris SA into sterling

Income statement Paris SA

Exchange rate

€000 Sales

200,000

Purchases

(90,000)

Other expenses

(7,000)

Interest

(3,000)

Taxation

(15,000)

Translated

£000

85,000

3.0

28,333

Note 1

Opening inventories

(22,000)

2.5

(8,800)

Note 2

Closing inventories

12,000

4.5

2,667

Depreciation

(30,000)

3.5

(8,571)

Note 3

Dividend paid

(10,000)

5.0

(2,000)

Note 4

Net profit carried forward

35,000

11,629

Notes 1

Sales, purchases and expenses have been translated at an average which is an approximation of the rate when they were originally recorded. This requirement of the IAS has been rather more loosely interpreted in the case of interest and taxation, which have been translated at the rates or approximate rates when they originally accrued. Under the wording of the IAS it might be more strictly correct if the taxation and interest were translated at the date they were first recorded in the books.

2

Translated at the actual date of acquiring the inventories.

3

The rate is that applicable to the date of revaluation rather than that at the date of acquiring the fixed assets.

4

The closing rate has been taken as the actual rate in this case.

Balance sheet Non-current assets

150,000

3.5

42,857

Note 3

Inventories

12,000

4.5

2,667

Note 5

Receivables

40,000

5.0

8,000

Note 6

Cash

11,000

5.0

2,200

Current assets




(18,000)

5.0

(3,600)

Walpole Ltd

(12,000)

5.0

(2,400)

Taxation

(15,000)

5.0

(3,000)

Non-current assets – bonds

(10,000)

5.0

(2,000)

Total assets less liabilities

158,000

44,724

Equity Share capital

60,000

2.0

30,000

Note 7


20,000

2.0

10,000

Note 8

30,229

Note 9

70,229

Note 10

3,428

Note 11

Accumulated Profit [66,000 – 35,000]

31,000

Balancing figure

111,000 Revaluation reserve

12,000

Profit for the year

35,000

3.5 see above

Loss on exchange Total equity

158,000

11,629

Note 12

(40,562)

Note 13

44,724

Notes 5

As inventories are non-monetary assets they are translated at actual.

6

The receivables and all the following assets in the balance sheet are monetary items and therefore retranslated at the closing rate.

7

Share capital issued should be translated at the date of acquiring the subsidiary or at the date of issue if later. At this stage of the process we are attempting to find the figure of profit or loss on exchange differences up to the beginning of the current year so that we can isolate the profit or loss on exchange in the current year. One way to do this is to split the share capital and reserves into the amount arising this year and the balance at the end of the previous year. In this question the balance at the end of the previous year can be calculated as €111,000 (see Note 10). The rest (profit for the year 35,000 and revaluation reserve 12,000) arose in the present year. If we can then translate the 111,000 into pounds sterling at the end of the previous year, we can eventually find this year’s profit or loss on exchange. In practice we could obtain the sterling equivalent of the €111,000 from the workings for the previous year’s consolidated accounts.

8

The additional paid-in capital (share premium) is translated at the same rate as the shares to which it relates.

9

The accumulated profit at the end of the previous year can be taken as the balancing figure after translating the €111,000. The accumulated profit will have been translated at many different rates over the years. In practice the translated figure would be available from the previous years’ consolidated accounts.

10 The 111,000 represents a mixture of monetary and non-monetary assets. The amount can be translated by applying the exchange rates used in the balance sheet in the previous year. This is calculated as follows:



Non-current assets

150,000

Depreciation

30,000 180,000

Revaluation

(12,000)

Opening inventory

168,000

2.0

84,000

22,000

2.5

8,800

190,000

92,800

Balance = Monetary Liabilities at 31/12/20X1

(79,000)

Net assets at 31/12/20X1

3.5

(22,571)

111,000

70,229

11 The revaluation reserve is translated at the rate when the revaluation took place in the current year. 12 The income statement was translated to give the profit figure in sterling. 13 The loss on exchange differences is the balancing figure but can be found directly, as shown below. Calculating the exchange difference for the year (i) The monetary net liabilities at the beginning of the year of €79,000 (see Note 10 above) have been retranslated into sterling at 31 December 20X2 and a gain of £6,771 has been made since translation at the end of the previous year. £ Opening net monetary liabilities: €79,000 @ opening rate

3.5 =

22,571

Opening net monetary liabilities: €79,000 @ closing rate

5.0 =

15,800

Gain

6,771

(ii) Any profit made during the year initially goes into monetary net assets. The translation of these at the year-end rate will give a profit in this case of the difference between the actual or average rate (as an approximation of the actual rate) used for translating the income statement items and the year-end rate used for translating monetary items in the balance sheet. £ Translated – at average rate – at closing rate Loss

85,000 @ 3.0 = 28,333 85,000 @ 5.0 = 17,000 11,333

(iii) The fixed assets were acquired when the rate of exchange was 2 euros to the £ and this was the rate applied to them at 31 December 20X1. On 1 January 20X2 the fixed assets were revalued when the rate was 3.5 euros to the £ and this was therefore the rate applied to these fixed assets at 31 December 20X2. This produced a loss of £36,000 being (£168,000/2.0) – (£168,000/3.5). Total loss on changing exchange rates (11,333 + 36,000 – 6,771) = £(40,562)



(b)

Prepare consolidated accounts – Walpole

Balance Sheet as at 31 December 20X2 ASSETS

£000

Non-current assets Goodwill (W1)

550

Other [94,950 + 42,857]

137,807 138,357

Current assets (W2) Inventories [60,000 + 2,667]

62,667

Receivables [59,600 + 8,000]

67,600

Bank [11,000 + 2,200]

13,200 143,467

Total assets

281,824

Equity and liabilities Common share capital

80,000


6,000

Revaluation reserve [10,000 + 3,085] (W3)

13,085

Retained earnings [67,000 – 3,334] (W4)

63,666 162,751

Minority interest (W5)

4,473

Non-current liabilities (W2) Bonds [40,000 + 2,000]

42,000

Current liabilities Payables [45,000 + 3,600]

48,600

Taxation [21,000 + 3,000]

24,000 114,600


281,824

W1: Goodwill

£000

Investment in Paris Common share in Paris [90% × 30,000] Retained earnings [90% × 5,000*] Additional paid-in capital [90% × 10,000*]

£000 41,050

27,000 4,500 9,000 40,500 550

Goodwill

* Pre-acquisition retained earnings translated at the exchange rate on the day of acquisition (£1 = €2)



W2: Cancel inter-company balances Current accounts of 2,400 W3: Paris SA revaluation reserve £000 Balance at 31/12/20X2 as per balance sheet

3,428

Minority interest 10% × 3,428

343

Consolidated balance sheet

3,085

W4: Retained earnings of Paris £000 Balance at 31/12/20X2 as per the balance sheet [11,629 + 30,229 – 40,562 loss on exchange] Pre-acquisition profit

1,296 4,500


130

4,630 (3,334)

W5: The minority interest £000 Common shares [10% × 30,000]

3,000

Retained earnings [10% × 1,296]

130

Additional paid-in capital [10% × (9,800 +10,000)] Revaluation reserve [10% × 3,429]

1,000 343 4,473

The consolidated income statement for the year ended 31/12/20X2 includes the subsidiary figures using the exchange rates as shown in the question. £ Sales [317,200 + (200,000/3)]

383,867

Cost of sales [170,000 + (8,800 + 90,000/3 – 2,667)]

(206,133)

Gross profit

177,734

Depreciation [30,000 + 8,571]

(38,571)

Expenses [15,000 + 7,000/3]

(17,334)

Loss on foreign exchange

(40,562)

Interest [6,000 + 3000/3]

(7,000)

Profit before tax

74,267

Taxation [21,000 + 15,000/3]

26,000

Profit after tax

48,267

Minority interest [10% × (11,629 + Div 2,000 – 40,562)] Net profit for the year

2,693 50,960



Dividend paid

(20,000)

Retained profit

30,960

Retained earnings brought forward (W6)

32,706 63,666

Group statement of changes in equity for the year ended 31/12/20X2 This statement will appear as follows: £ Retained earnings brought forward (W6)

32,706

Net profit for the year

50,960

Dividend paid

(20,000)

Accumulated profit carried forward

63,666

W6: Group retained earnings brought forward at 1/1/20X2 £ Walpole [67,000 – this year 57,000] Paris [90% × (30,229 – Pre-acquisition 5,000 (W1))]

10,000 (22,706) 32,706



Chapter 25: Question 3 – Paris SA Walpole Question 3

(a)

Income statement Paris SA

Exchange rate

Translated

35,000

See sol to Qn 2

11,629

158,000

5.0

31,600

Share capital

60,000

2.0

30,000

Additional paid in capital

20,000

2.0

10,000

31,000

Balancing figure

(8,286)

111,000

3.5

31,714

Revaluation reserve

12,000

3.5

3,428

Profit for the year

35,000

See above

11,629

As in solution 2 Balance sheet Net assets

Retained earnings (66,000– 35,000)

Loss on exchange

(15,171) 31,600

158,000

Total equity

Proof of the loss on translation £ (i)

Opening net assets €111,000

@ opening rate 3.5

=

31,714

Closing net assets €111,000

@ closing rate 5.0

=

22,200 Loss

(ii)

Income statement €85,000

@ average rate 3.0

=

28,333

@ closing rate 5.0

=

17,000 Loss

(iii)

Opening inventories €22,000

Closing inventories €12,000

(11,333)

@

2.5

=

8,800

@

5.0

=

4,400 Profit

(iv)

(9,514)

4,400

@

4.5

=

2,667

@

5.0

=

2,400 Loss


(267)


(v)

Depreciation

€30,000

@

3.5

=

8,571

@

5.0

=

6,000 Profit

(vi)

Revaluation Reserve €12,000

@

3.5

=

3,428

@

5.0

=

2,400 Loss

Total loss [ (9,514) + (11,333) +(267) + (1,028) – 2,571 – 4,400] = Add loss on retranslation of goodwill

2,571

550 (@2) – 220 (@5)

(1,028) (15,171)

=

(330)

(b) Prepare consolidated accounts – Walpole Balance sheet as at 31 December 20x2 Non-current assets

£

Goodwill

(W1)

£ 220

Other (94,950 + 150,000/5)

124,950 125,170

Current assets

(W2)

Inventories (60,000 + 12,000/5)

62,400

Receivables (59,600 + 8,000)

67,600

Bank

13,200

(11,000 + 2,200)

143,200 Total assets

268,370

Equity and liabilities Common share capital

80,000

Additional paid in capital

6,000

Revaluation reserve (10,000 + 3,085) (W3)

13,085

Retained earnings

51,525

(67,000 – 15,475) (W4)

150,610 Minority interest

(W5)

Non-current liabilities

(W2)

Bonds (40,000+2,000)

3,160

42,000

Current liabilities Payables (45,000 + 3,600)

48,600

Taxation (21,000 + 3,000)

24,000 114,600


268,370



W1 Goodwill £ Investment in Paris

41,050

Common shares in Paris (90% of 30,000)

27,000

Retained earnings (90% of 5,000)

4,500

Additional paid in capital (90% of 10,000*

9,000

Goodwill

•

£

40,500 550

Pre-acquisition retained earnings translated at the exchange rate on the day of acquisition (£1 = €2) Restated at the rate on 31/12/20X2 as goodwill is treated as the asset of the subsidiary. Restated at 5.0 = £330.

W2 Cancel inter-company balances Current accounts of 2,400 W3 Paris SA revaluation reserve £000 Balance at 31.12.20x2 per balance sheet

3,428

Minority interest 10% of 3,428

343

Consolidated balance sheet

3,085

W4 Retained earnings of Paris £000

£000

Balance at 31.12.20x2 per the balance sheet (11,629 – 8,286 – 15,171)

(11,828)

Pre-acquisition profit

4,500

Minority interest 10% of (11,829)

(1,183)

(3317) (15,145)

Loss on restatement of goodwill

(330) (15,475)

W5 The minority interest £000 Common shares (10% of 30,000) Retained earnings (W4)

3,000 (1,183)

Additional paid in capital (10% of 10,000) Revaluation reserve (10% of 3,428)

1,000 343 3,160

The consolidated income statement for the year ended 31.12.20x2 includes the subsidiary figures using the exchange rates as shown in the question



£

£

(317,200 + (200,000/3)

383,867

[170,000 + (8,800 + 0,000/3 – 2,667)]

(206,133)

Sales Cost of sales Gross profit

177,734

Depreciation Expenses Interest

(30,000 + 8,571)

(38,571)

(15,000 + 7,000/3)

(17,333)

(6,000 + 3,000/3)

(7,000)

Profit before tax

114,830

Taxation

(21,000 + 15,000/3)

Profit after tax

26,000 88,830

Minority interest

[10% of (11,629 + Div 2,000)]


(1,363) 87,467

Dividend paid

(20,000)

Retained profit

67,467

Group statement of changes in equity for the year ended 31.12.20x2 £ Retained earnings brought forward (W6)

(1,957)


87,467

Dividend paid

(20,000) 65,510

Loss on translation (90% of 15,171)

(13,655)

Loss on restatement of goodwill

(330)

Retained earnings carried forward

51,525

W6 Group retained earnings brought forward at 1.1.20x2

Walpole Paris

£

£

(67,000 – this year 57,000)

10,000

[90% of ( (8,286) – pre-acquisition 5,000 (W1)]

(11,957) (1,957)

Note that in this example the loss on translation has been taken to retained earnings. In practice such gains or losses might be taken to a separate foreign currency reserve.



CHAPTER 26

Chapter 26: Question 1 – Alpha plc (i) Step 1 Theoretical ex-rights calculation The shareholders get an element of bonus at the same time as the company receives additional capital. The bonus element may be quantified by the calculation of a theoretical ex-rights price, which is compared with the last market price prior to the issue; the difference is a bonus. The theoretical ex-rights price is calculated as follows: £ 4 shares at fair value of £1 each prior to rights issue

=

4.00

1 share at discounted rights issue price of 80p each

=

0.80

∴5 shares at fair value after issue (i.e. ex-rights)

=

4.80

The theoretical ex-rights price is £4.80/5shares

=

0.96

The bonus element is fair value £1 less 96p

=

0.04

Step 2 The time-weighted average number of shares is calculated for the current year No. of shares Shares to date of rights issue Shares × Increase by bonus fraction

× Time adjustment

2,000,000

×

9/12

=

1,500,000

×

9/12

=

62,500

×

3/12

=

625,000

Bonus :

((2,000,000 × 100/96) – 2,000,000)

Shares from date of issue 2,500,000 × Weighted average number of shares

2,187,500

Step 3 Calculate BEPS for current year BEPS for 20X1 is then calculated as £5,000,000/2,187,500 shares =


£2.29


(ii) Step 4 Adjusting the previous year’s BEPS for the bonus element of a rights issue This bonus element will affect the comparison with the previous year’s BEPS which will need to be reduced to ensure comparability. The approach is to reduce the prior year by multiplying it by: Theoretical ex-rights fair value per share Fair value per share immediately before the exercise of rights

=

£0.96 £1.00

Assuming that the earnings for 20X0 and 20X1 were £4.5m and £5m respectively, the 20X0 BEPS figures will be reported as follows: As reported in the 20X0 accounts £4.5m/2m As restated in the 20X1 accounts (£4.5m/2m) × (0.96/1.00)

= =

£2.25 £2.16

The same effect is achieved by increasing the number of shares in the denominator by 100/96 for 20X0: Earnings/(Number of shares × Bonus fraction ) £4,500,000 / (2,000,000 × (100/96) = £2.16



Chapter 26: Question 2 – Beta Ltd Beta Ltd weighted average number of shares Time

Bonus

Bonus element

apportion

adjustment

in rights issue

1 January – 31 March 1,000,000

×

3/12

×

3/2

×

7/6

=

437,500

×

1/12

×

3/2

×

7/6

=

218,750

×

4/12

×

×

7/6

=

875,000

2/12

×

×

7/6

=

631,944

2/12

×

=

722,222

1 April – 30 April 1,500,000 1 May – 31 August 2,250,000

1 September – 31 October 3,250,000

×

1 November – 31 December 4,333,333

×

Weighted average number of shares

Note: bonus element in rights issue calculated as follows: 3 shares at $5.60

=

16.80

1 share at $2.40

=

2.40

Fair value of 4 shares

19.20

Theoretical ex-rights price

$4.80

Fair value

$5.60

Bonus factor = 5.6/4.8 = 7/6


2,885,416


Chapter 26: Question 3 – Nottingham Industries plc (a)

EPS complying with IAS 33 definition of earnings:

Earnings for EPS calculation is ‘profit of the period after tax, minority interests and extraordinary items and after preference dividends’. Basic EPS calculation:

£000

Equity earnings: Profit after tax and extraordinary items

580

Preference dividend [10% of £1,000,000]

(100) 480

Weighted average number of ordinary shares (25p) Actual no. 1.4.X5 in issue 1.7.X5 bonus issue

16,000,000

Bonus

Weighted

time

factor

average

3/12

6/5

4,800,000

3,200,000 19,200,000

1.10.X5 Purchase 31.3.X6 in issue

Weight

3/12

4,800,000

6/12

9,350,000

(500,000) 18,700,000

18,950,000 Basic EPS for 20X6

£480,000/18,950,000

Comparative for 20X5

(b)

= £0.022 × 5/6

=

£0.0253

=

£0.0183

Diluted EPS calculation

Equity earnings: £000 As for Basic EPS

480

The computation of Basic and Diluted EPS is as follows: Per share Net profit for 20X6

Earnings

Shares

£480,000

Weighted average shares during 20X6 Basic EPS (£480,000/18,950,000)

18,950,000 £0.02533

Number of shares under option

200,000

Number that would have been issued At fair value (200,000 × £1.00)/ £1.10 Diluted EPS

(181,818) £0.0253


£480,000

18,968,182


(c)

Usefulness of EPS figures

It is helpful to users to have a standardised EPS figure. This is provided by applying the IIMR calculation as follows. IIMR headline EPS Headline earnings per share are based upon the headline earnings figure stated in accordance with the Institute of Investment Management and Research Statement of Practice No. 1 The Definition of Headline Earnings and accordingly exclude profit on sale of the major operation. £000 Equity earnings: Profit after tax and extraordinary items

580

Exclude capital items such as profit on sale of a major operation: £120,000 less tax £38,000 IIMR Headline EPS

(82) 498

Less: preference dividend

(100) 398

Even when standardised the ASB considers that there is too much emphasis on a single profit figure and encourages users to refer to the information set as a whole when appraising performance and predicting future earnings. Nevertheless, the EPS figure has remained an important figure in the eyes of many investors and analysts.



Chapter 26: Question 4 – Simrin plc (a)

Calculation of Basic EPS

As per IAS 33: EPS = =

Profit after tax, Minority interest, Preference dividends and extraordinary items Number of ordinary shares £79,000 – £9,000 100,000

Basic Earnings per Share = 70p per share

(b)

Calculation of the Diluted EPS £ Subscription monies received

= £1.28 × 50,000 =

64,000

Notional number at fair value: £64,000/£1.1 (fair value of a share)

=

58,182

Notional number at no value

=

5,818 64,000

Profit after tax and preference dividend MI & extraordinary items

70,000

Number of shares: At 1 January 20X0

100,000

From warrants at no value Total number of shares

5,818 105,818

Diluted EPS = £70,000/105,818 = 66.15p per share

(c) • •

(i) Need to disclose DEPS Company able to finance projects using convertible securities which carried fixed interest rate and also future benefits causing dilution of shares in the future on conversion. Trend revealed by diluted EPS is more meaningful to shareholders as it enables them to identify the final effect on company’s EPS by using convertible debt.



(ii) Relevance to shareholders •

Relevance is questionable.

•

It shows dilution of future earnings per share and it is reasonable that existing shareholders should be given a warning of the potential dilution.

(d) •

Reliance on EPS as single most important indicator of financial performance There is no one correct answer for this, but discussion of the Institute of Investment Management and Research headline figure is required.



Chapter 26: Question 5 – Gamma Ltd There are two steps in arriving at the Diluted EPS, namely: Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares Step 2 Determine the potential ordinary shares to include in the Diluted Earnings per Share

(a)

Convertible preference shares receive a dividend of £2.50

Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares Increase in earnings

Increase in number Earnings per of ordinary shares

incremental share

Convertible preference shares Increase in net profit 50,000 shares × £2.50

125,000

Incremental shares 50,000/1

50,000

2.50

125,000

0.12

10% Convertible bond Increase in net profit £250,000 × 0.10 × (1 – 0.4)

15,000

Incremental shares 250,000/1000 × 500

Step 2 Determine the potential ordinary shares to include in the computation of diluted earnings per share Net profit attributable to continuing operations As reported 10% Convertible loan Convertible preference shares

Ordinary shares

5,000,000

1,000,000

15,000

125,000

5,015,000

1,125,000

125,000

50,000

5,140,000

1,175,000


Per share 5.00 4.46 dilutive 4.37 dilutive


(b)

Convertible preference shares receive a dividend of £6 per share.

Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares Earnings per Increase in

Increase in number

incremental

earnings

of ordinary shares

share

50,000

6.00

125,000

0.12

Convertible preference shares Increase in net profit 50,000 shares × £6.00

300,000

Incremental shares 50,000/1 10% Convertible bond Increase in net profit £250,000 × 0.10 × (1 – 0.4)

15,000

Incremental shares 250,000/1000 × 500

Step 2 Determine the potential ordinary shares to include in the computation of diluted earnings per share Net profit attributable to continuing operations As reported 10% convertible loan Convertible preference shares

Ordinary

Per share

shares

5,000,000

1,000,000

15,000

125,000

5,015,000

1,125,000

300,000

50,000

5,315,000

1,175,000

5.00 4.46 dilutive 4.52 anti-dilutive

•

Since the Diluted EPS is increased when taking the convertible preference shares into account (from 4.46p to 4.52p) , the convertible preference shares are anti-dilutive and are ignored in the calculation of Diluted EPS.

•

The lowest figure is selected and the Diluted EPS will, therefore, be disclosed as 4.46p.



Chapter 26: Question 6 – Delta NV (a)

Calculate theoretical ex-rights value of a share

Market value of a share prior to rights issue was €1.10. 4 shares at €1.10 per share 1 share at 60p 5 shares Theoretical ex-rights value

= = = =

(b)

Bonus issue factor

(c)

BEPS 20X8 440,000/(4,000,000 × 11/10)

4.40 .60 5.00 1.00

=110/100

= €0.10

previously calculated as: 440,000/4,000,000

(d)

= €0.11

BEPS 20X9

Uplift shares prior to issue by 110/100 4,000,000 × (110/100) × 6/12 months

=

2,200,000

Weight shares after issue: 5,000,000 × 6/12 months Total shares for BEPS calculation

= =

2,500,000 4,700,000

BEPS = €500,000/4,700,000

=

€0.106



Chapter 26: Question 7 – X Ltd (a) Ordinary shares Net profit after tax

Profit

EPS

Effect

18,160

Less preference dividend

(160) 40,000

18,000

45p

40,400

18,000

44.6p

dilutive

3,200

160

43,600

18,160

41.7p

dilutive

Options (W1)

400

Convertible preference shares Convertible loan stock Interest [6% × £20m ×s 0 .67]

804

Discount

200

Shares converted [(20m/200) × 23]

2,300 45,900

• •

_____ 19,164

41.8p

anti-dilutive

Since the loan stock is anti-dilutive it is ignored in the calculation of Diluted Earnings per Share Diluted EPS will be reported as 41.7p.

W1 Fair value of one ordinary share

£1.50

Number of options

2,000,000

Exercise price

£1.20

Proceeds from exercise of options Number of shares assumed to be issued at fair value

£2,400,000 1,600,000

Number of shares issued for no consideration (2m – 1.6m) = 400,000

(b) •

An option is treated as if – there was an issue of shares for full market value/fair value; and – an issue for no consideration (a bonus issue). – The bonus element is treated as being the dilutive effect.

•

IAS 33 is saying that by issuing options to directors/employees the company is making a bonus issue of shares plus a full issue of shares, the latter being assumed not to have a dilutive effect.



•

Only potential ordinary shares that would dilute EPS should be taken into account and any anti-dilutive potential ordinary shares will be ignored.

•

This procedure essentially means that certain categories of potential

•

ordinary shares will not be used in the calculation.

•

Thus the calculation will be based on the concept of prudence rather than on the substance of what is realistically going to occur. All items of income or expense that would cease on conversion are to be added back.

•

Prudent disclosure.

As regards the ranking of potential ordinary shares from most to least dilutive and the subsequent calculations, an alternative solution would be to disclose both the fully diluted EPS and the maximum dilution of EPS. This would essentially mean that the more realistic calculation and the prudent calculation of IAS 33 would be disclosed.



CHAPTER 27

Chapter 27: Question 1 – Example Ltd £000

£000

Cash flows from operating activities Net profit before tax

500

Adjustments for: Depreciation

102

Profit on sale of plant

(13)

Interest expense

20

Operating profit before working capital changes

609

Increase in trade and other receivables

(260)

Increase in inventories

(400)

Decrease in trade payables

(40)

Cash generated from operations

(91)

Interest paid

(20)

Income taxes paid

(220)

Net cash used in operating activities

(331)

Cash flows from investing activities Purchase of property, plant and equipment

(560)

Proceeds from sale of equipment

241

Payment to acquire government securities

(20)

Net cash used in investing activities

(339)

Cash flows from financing activities Proceeds from issuance of share capital

300

Redemption of debentures

(50)

Dividends paid

(120)

Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of the period


130 (540) 72 (468)


Chapter 27: Question 2 – Martel plc (a)

£000

£000

Cash flows from operating activities Net profit before tax

427

Adjustments for: Depreciation

292

Profit on sale of plant

(8)

Interest expense

52


763

Increase in trade and other receivables

(132)

Increase in inventories

(174)

Increase in trade payables

46


503

Interest paid

(52)

Taxes paid

(79)

Net cash used in operating activities

372

Cash flows from investing activities Purchase of property, plant and equipment

(714)

Proceeds from sale of equipment

20

Purchase of government securities

(40)


(734)

Cash flows from financing activities Proceeds from issuance of share capital

150

Proceeds from 9% debenture issue

82

Dividends paid

(76)

Net cash from financing activities

156

Net increase in cash and cash equivalents

(206)

Cash and cash equivalents at the beginning of the period

22

Cash and cash equivalents at the end of the period

(184)

Note 1: Cash and cash equivalents 20X1 Bank

20X0

–

22

Overdraft

(184)

–

Cash and cash equivalents

(184)

22



(b) Martel plc has invested heavily in fixed assets during the year and although it has raised additional capital it has had to rely on a bank overdraft. The acid test ratio is lower in the current year (304 : 642). However, we do not have information on the projected cash flows that supported the capital investment decisions – this is where narrative information within the annual report could be helpful in identifying the company’s strategic planning for future years, e.g. new markets, new products, greater productive efficiency.



Chapter 27: Question 3 – Flow Ltd Cash flow Statement for the year ended 31 December 20x6 for Flow Ltd Net cash inflow from operating activities

191,025

Cash flows from investing activities Payment to acquire non-current assets

(265,500)

[1,983,750 + 25,500–1,743,750] Receipts from sale of non–current assets

6,225

Net cash paid on investing activities

(259,275)

Cash flows from financing activities Issue of common shares

180,000

Dividends paid (could be shown as operating cash flow)

(45,000)

Net cash inflow from financing activities

135,000

Net increase in cash and cash equivalents [75,000–8,250]

66,750

Net cash inflow from operating activities: Profit (176,625 –(387,000–300,000–45,000))

134,625

Non cash items Depreciation

[619,125–551,250 +(25,500–9,375)]

Loss on disposal [9,375–6,225]

84,000 3,150

Changes in working capital Decrease in inventory

15,750

Increase in trade receivables

(22,500)

Decrease in trade payables

(24,000)

Net cash inflow from operating activities

191,025



Chapter 27: Question 4 – Blue Ting plc (a)

Cash Flow Statement for the year ended 31 May 20X5 £m

£m

Cash flows from operating activities Profit before tax

96

Adjustments for: Depreciation expense Amortisation of development expenditure

37 1

Interest income

(3)

Interest expense

7

Loss (gain) on disposal of property, plant and equipment Operating profit (loss) before working capital changes Increase in accounts receivable

(2) 136 (20)

Decrease in inventories

15

Increase in payables

89

Cash generated from (used in) operations Interest paid

220 (4)

Interest income

3

Interest element in finance lease rental payment

(3)

Tax paid [10 + 22 – 16]

(16)

Dividends paid [12 + 8]

(20)

Net cash from operating activities

180

Cash flows from investing activities: Proceeds from disposal of property, plant and equipment Purchase of property, plant and equipment

21 (104)


(83)

Cash flows from financing activities: Proceeds from issuing shares

14

Share issue costs

(1)

Purchase of own shares Capital repayments under finance leases

(12) (7)

Net cash used in financing activities

(6)

Net increase (decrease) in cash and cash equivalents

91

Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

3 94

(Note: Dividends paid have been treated in their optional position in operating activities and the cash and liquid resources have been assumed to be cash and cash equivalents.) 269 © Pearson Education Limited 2006


(b)

Published forecast cash disadvantages to users

flow

information:

advantages

and

Advantages •

Provides the benefit of: Ō management’s knowledge of future cash flow Ō their views as to future cash flows Ō committing management to future planning Ō committing to considering going concern issues.

•

Reduces the benefits of insider dealing as information would be in the public domain.

•

Makes it more possible to evaluate managerial performance

•

Aids investors and creditors to assess the ability of the company to meet its obligations in the future.

Disadvantages •

They are uncertain.

•

They are subjective as based on the opinions of management.

•

They can be manipulated by management although a poor history of accuracy will become apparent over time.



Chapter 27: Question 5 – Carver plc Cash Flow from Operations for the year ended 30 September 20X4 £000

£000

Profit before tax 1,985 Adjustments for: Depreciation

W1

Investment income

325 (155)

Interest payable

150

Share of profit of associate

(495)

Profit on sale of machinery

(100)


1,710

Increase in inventory

W2

(943)

Increase in trade receivables

W3

(547)

Increase in trade payables

W4

152


372

Interest paid

(100)

Taxes paid

W5

(250)

Net cash from operating activities

22

Cash from investing activities Purchase of machinery

W6

Sale of machinery

(1,085) 500

Purchase of subsidiary

W7

98

Dividends received from associate

W8

250

Dividends received from fixed asset investments

155

Cash used in investing activities

(82)

Cash flow from financing Proceeds from the issue of share capital

W9

Issue of loan stock

W10

920

Capital payments under finance leases

W11

(270)

Dividends paid to group shareholders Dividends paid to minority interests


2,453

(300) W12

(48)


Cash flow from financing

2,755

Increase in cash and cash equivalents

2,695

Cash and cash equivalents brought forward

1,820

Cash and cash equivalents carried forward

4,515

Workings W1: Depreciation charge Buildings

125

Machinery Closing aggregate amount

1,200

Less: Opening aggregate amount(1,100) 100 Add: depreciation on disposal

100

200 325

W2: Inventory Closing balance

1,975

Less: Opening balance

1,000

Arising on acquisition

32

(1,032) 943

W3: Trade receivables Closing balance

1,850


1,275


28

(1,303) 547

W4: Trade payables Closing balance

500


280


68

(348) 152

W5: Tax Opening balances Income tax

217

Deferred tax

13

Transfer from profit and loss account Closing balances


495


Income tax

(462)

Deferred tax

(30) 233

Acquisition tax

17 250

W6: Investment in machinery Cost at 30.9.20X4

3,000

Less: Cost at 1.10.20X3

(1,400) 1,600

Add: Disposal

500 2,100

Less: Arising from acquisition

(165)

Leased

(850)

Cash outflow

1,085

W7: Cash Cash acquired from acquisition

112

Less: Cash consideration

(14)

Cash inflow

98

W8: Dividends received from associate Opening balance Add: Share of profit Less: Tax

1,000 495 (145)

350 1,350

Closing balance

(1,100)

Cash inflow

250

W9: Shares Closing balances Shares

3,940

Premium

2,883 6,823

Less: Opening balances Shares

(2,000)

Premium

(2,095)



Non-cash consideration Shares

(220)

Premium

(55)

Cash inflow

2,453

W10: Loans Closing balance

1,460


(500) 960

Less: Increase finance cost

(40)

Cash inflow

920

W11: Lease – capital payments Opening balances [200 + 170]

370

Add: new lease commitment

850 1,220

Less: Closing balances [240 + 710] Cash outflow

(950) 270

W12: Minority interests Opening balance

–

Add: Profit for year

100

Arising from acquisition

63 163

Closing balance

(115)

Cash inflow

48



CHAPTER 28

Chapter 28: Question 1 – Saddam Ltd (a) Profitability – ROCE •

Camel Ltd is the most profitable of the three companies.

•

An inspection of the secondary ratios shows that this is due to efficient utilisation of assets since its net profit ratio is well below that of the other two companies.

•

Examination of gross profit percentages confirms the observation that Camel Ltd seems a high volume, low margin business compared with the others.

Liquidity •

Ali Ltd has a current ratio which is out of line with the other two, being very much higher suggesting surplus investment in working capital.

•

The acid test ratio reinforces this view and also indicates that Baba Ltd appears to have a liquidity problem with current liabilities considerably greater than cash and debtors (despite having the greatest number of weeks’ debtors outstanding of the three companies).

•

Baba Ltd also has considerably more weeks of stock outstanding than the other two companies which may be linked with the high level of creditors.

•

Ali Ltd also has stock levels well in excess of Camel Ltd explaining in part at least the high current ratio.

Dividends Camel Ltd is paying a higher proportion of profits out in dividends, which may have the effect of raising shareholder loyalty and the bid price. Conclusion •

Baba Ltd appears to have considerable liquidity problems arising out of excess investment in stock.

•

Camel Ltd is a lean enterprise able to survive on a lower gross profit margin due to superior asset utilisation. Why is the gross profit margin low?

Before a final decision is made the absolute figures in the financial statements should be studied and questions raised such as: •

Are the activities of the firms really the same?

•

What are the relative turnovers?

•

What is the growth over a period of years?

•

What are the trends of all the ratios?

•

How old are the assets?

•

Are asset ages distorting ROCE comparisons between the companies? 275 © Pearson Education Limited 2006


Also need to assess managerial skills, product potential etc. which are not shown in the financial statements.

(b) Why balance sheet is unlikely to show the true market value of the business The accounting policy in the UK is to state fixed assets at cost less depreciation or at historical cost modified by revaluation of all or selected classes of fixed assets. The true market value of a listed company is available from the market capitalisation figure based on current share prices. The true market value of an unquoted company is not readily available and would require the future cash flows to be evaluated.



Chapter 28: Question 2 – Esrever Ltd Forecast profit and loss account for year ended 30 June 20X1 £ Turnover

[87,007 × 100/32]

Opening stock

£ (S3)

271,897

22,040

Purchases

(S5) 194,205 216,245

Closing stock

[184,890 × 61.9/365]

(S5)

31,355

Cost of sales

[271,897 × 68%]

(S4)

184,890

Gross profit

[20,290 × 100/23.32]

(S2)

87,007

Depreciation –

buildings

[132,000 × 2%]

(S6)

2,640

–

fixtures etc.

[96,750 × 20%]

(S6)

19,350

[50,000 × 12%]

(S7)

6,000

(S8)

33,655

Loan interest

Credit expenses (balancing figure)

61,645 Profit before tax

25,362

Corporation tax

[20,290 × 20/80]

Profit after tax

[181,808 × 11.16%]

Dividends

[200,000 × 2.5p]

(S9)

5,072 (S1)

20,290

(S10)

5,000

Profit retained

(S11)

15,290

Profit retained b/f

(S12)

66,518

Retained profit c/f

(S13)

81,808

Forecast balance sheet as at 30 June 20X1 £

£

Fixed assets (NBV) Land and buildings

[132,000 – 2,640]

129,360

Fixtures, fittings

[96,750 – 19,350]

77,400 (S14) 206,760

Current assets Stock

(S15) 31,355

Debtors [(271,897 × 42.6/365) × 1.15]

(S16) 36,494 67,849



Creditors: amounts falling due in less than one year Bank overdraft (a balance figure based on note 2)

(S20)

9,756

Creditors [(194,205 + 33,655) × (29.7/365) × 115%]

(S17) 21,321

Other creditors [5,072 tax + 5,000 dividends + 1,652 VAT]

(S18, S19)

11,724 42,801

Net current assets

25,048

Total assets less current liabilities (per Note 3)

231,808

Creditors: amounts falling due in more than one year 12% loan

(S23)

50,000 181,808

Ordinary shares

(S21)

100,000

Profit and loss account (balancing figure)

(S22)

81,808 181,808

VAT:

Output tax Input tax

[271,897 × 15%]

40,785

[(194,205 + 33,655) × 15%]

34,179

Net amount for year

6,606

6,606 × 0.25

1,652

Approach to Esrever profit and loss account (S1) (S2) (S3) (S4) (S5)

Start with post-tax profit i.e. 11.16% of (231,808 – 50,000) per notes 3 & 4 = £20,290 From post-tax profit 20,290 derive gross profit as 100/23.32 × 20,292 based on Note 4 = £87,007 Next, derive turnover as 100/32 × 87,007 based on Note 6. Cost of goods sold = 68% of turnover. Therefore turnover = 100/32 × gross profit = £271,897 From sales and gross profit derive cost of goods sold as 271,897 – 87,007 = £184,890 You can now find components of cost of sales (£184,890) as: £ (a) Opening stock 22,040 (given in question) (b) Purchases 194,205 (balance figure) 216,245 (c) Closing stock (31,355) (61.9 × 184,890) 365 Total costs of goods sold 184,890 Note: Start with closing stock 61.9 days based on Note 7; all other figures are derived and the opening stock is given as £22,040.



(S6)

Depreciation:

2% × 132,000 for buildings = £2,640 20% × 96,750 for fixtures etc. = £19,350 based on Note 1 and opening asset given (S7) Loan interest is 12% of 50,000 = 6,000 (S8) Expenses – this is a balancing figure as we already have all the other figures in the profit and loss account = 33,655 (S9) Taxation charge is 20/80 × 20,290 based on Note 5 = 5,072 (S10) Dividend – see Note 9 (200,000 × 2.5p) = 5,000 (S11) Retained profit = 15,290 (S12) Retained profit b/forward is a balancing figure = 66,518 (S13) Retained profit c/down (see S22 below) = 81,808 Approach to Esrever balance sheet Projected balance sheet as at 30/6/20X1 is built up as follows: (S14) Fixed assets are derived from the opening figure less depreciation (S15) Stock has already been computed at (S16) Debtors, based on Note 10, assuming 42.6 days’ credit, are 42.6/365 × 271,897 = 31,734 × 1.15 to cover VAT (S17) Creditors, assuming credit of 29.7 days, are 29.7/365 × 227,860 × 1.15 (S18) Other creditors (dividends 5,000 + tax 5,072) (S19) VAT 15% net of sales – purchases and expenses is 15% (271,897 – 194,205 – 33,655) x 0.25 (S20) Overdraft is balancing figure based on Note 2 Current liabilities Total assets less current liabilities per Note 3 (S21) Share capital given in question (S22) Retained profit (balancing figure) (S23) 12% loan

= =

206,760 31,355

=

36,494

= =

(21,321) (10,072)

=

(1,652) (11,724) (9,756) 42,801 231,808 100,000 81,808 50,000 231,808

=

Note: Retained profit is the balancing figure to make up £231,808. The bank overdraft of £9,756 is the overall balance sheet balancing figure.



Chapter 28: Question 3 – Amalgamated Engineering plc (a) Cash flow statement for year ended 31 December 20X6 £000

£000

Net cash inflow from operating activities

495

Returns on investing and servicing of finance Interest paid

195

Net cash outflow

195 300

Taxation Tax paid

375 (75)

Capital expenditure Payment to acquire plant

(450)

Receipt from sale of investments

300 (150)

Equity dividends paid

(225)

Net cash outflow before financing

(450)

Financing

-

Increase in overdraft

(450)

Reconciliation of operating profit to net cash inflow from operating activities Operating profit

795

Depreciation

300

Increase in stocks

(375)

Increase in debtors

(300)

Increase in creditors

75 495

(b)

20X5

20X6

Current assets – inventory

1,125

1,125

Current liabilities

1,125

1,575

Liquid ratio

=

1


=

0.71


Interest cover Profit before interest Interest charge

885

795

135

195

= 6.56 times

= 4.08 times

Return on average shareholders’ funds Profit after tax

…….375

Av. shareholders funds (Could revalue property)

(4,575 + 4,425) / 2

…………..300 (4,650 + 4,575) / 2

= 8.3%

= 6.5%

Long-term loans

1,500

1,500

Shareholders’ funds

4,575

4,650

= 32.8%

= 32.3%

1,500

1,500

Gearing ratio

or Long-term loans Long-term loans and shareholders’

(1,500 + 4,575)

(1,500 + 4,650)

= 24.7%

= 24.4%

Cost of sales

4,410

4,680

Inventory

1,125

1,500

= 3.92 times

= 3.12 times

funds

Stock turnover ratio

(c)

Main points in report should cover the following. Most important points are with an asterisk.

Profitability *(1)

Given unchanged sales volume (NB cannot tell from historical cost accounts without date on specific price movements), price rises have been below the level of general inflation (4.8%). Is this deliberate policy or just poor management? If deliberate appears not to have improved sales.

(2) Cost of materials and labour also increased below level of inflation (5% and 5.6% respectively). More efficient use? (3) Overheads increased 10% – in line with inflation (both production and administrative) – led to falling margins (gross and net). (Further information by product might help see if one particular area is a problem – or if it is right across the board.) (4) Increased interest has caused profit before tax to fall 20% although interest cover still looks OK. (NB Is this relevant? Interest is paid from cash.)



*(5)

Trends are worrying – falling margins and rising interest seem to indicate problems soon. How long can firm continue to hold the dividend? (Need more years’ data – longterm picture. Is this a recent trend or not?)

Solvency/liquidity (6) Working capital rising – trade receivables and inventories are up a lot. *(7)

Reflected in worsening liquid ratio – quite a large fall. (Again, need more years’ data. What is norm?)

*(8)

Inventory turnover is getting worse – 3.85 months’ inventory on hand (20X5 3.06). Need more information here – slow-moving inventory? Or is it just poor management of working capital?

*(9)

Trade receivables’ turnover ratio has got worse (20X5 7.64; 20X6 5.87). In their state they need to be collecting more quickly. Is there one or a few debts causing this, or is it general sloppiness?

(10)

Flow of funds – company is investing in new equipment so is presumably not contracting operations. Need information as to use equipment is being put to, and future capital expenditure plans. *Purchases of assets (+ payment of tax + dividend) have been partly paid for by selling off short-term investments. This is a one-off – bad sign. Could use previous 5 years’ funds flow statements – trends quite important.

*(11) The increased overdraft is financing the increased stocks and debtors. (12) Gearing ratio is OK – but the problem is one of liquidity at the moment. Could argue the overdraft appears to be a permanent feature of this firm. The gearing ratio looks worse if the overdraft is included (+ an overdraft of 1,500,000 makes it look even more unhealthy). (Gearing ratios calculated using book values may not be too useful – could recalculate using market values of debt and equity, where quoted.) General points *(13) Why does firm want to increase the overdraft? Seems to be to finance working capital. Could be risk for the bank if the firm’s profitability is in a long-term decline (Does not mean don’t lend – could charge more interest.) *(14) Or could secure the overdraft – market value of the land and buildings is well in excess of the debentures. *(15) How will firm pay off the overdraft? Need to ask for cash forecasts for next few years (firm should have – if not, poor management). (NB Historical cost accounts generally of little help with respect to forward-looking data.) (16) More data on management. Old, young? Likely to let firm stagnate? Also need to see strategic plans – in what direction is firm going? Do they know?



(d) Response to director (i) Debt Service Coverage Ratio •

This ratio requires the figures for interest, tax, depreciation and amortisation charge to calculate EBITDA.

•

The ratio gives the bank an indication of the company’s ability to meet its capital debt repayments as well as annual interest payments from its cash flow from operations.

(ii) Cash flow from operations to current liabilities •

This ratio requires the cash flow from operations figure in the cash flow statement.

•

The ratio gives additional information to the current and acid test ratios which are static in the sense that both the numerators and denominators are based on year-end figures which are capable of manipulation or management e.g. running down stocks or exceptional cash receipts at the year-end.

(iii)

Cash recovery ratio

•

This ratio requires the figures for cash flow from operations and proceeds of sale of fixed assets from the cash flow statement.

•

The ratio gives an indication of the payback time i.e. how quickly the company will recoup its investment in fixed assets from its cash flow. The manager would naturally regard a shorter period as less risky.



Chapter 28: Question 4 – Sally Gorden (a) EPS

Ruby

Earnings: Profit

Sapphire

£280,000

Pref. div.

(90,000) 190,000

Number of shares: 1.7.X3 – 30.9.X3: 1,500,000 × 3/12

=

375,000

1.10.X3 – 31.6.X4: 2,000,000 × 9/12

=

1,500,000 1,875,000

£190,000 / 1,875,000 × 100 =

10.13p

£240,000 / 3,000,000 × 100 =

8p

(b) Price/earnings ratio 475/10.13 = 480/8

47 times 60 times

(c) PE ratio of Sapphire plc is almost twice that of Ruby plc. •

This would reveal that there is much higher demand for shares in Sapphire.

•

This in turn indicates greater confidence the investing public has in that company.

•

This confidence may be based on •

the type of industry

•

growth potential, growth rate

•

track record of past performance

•

diversity of its products

•

quality of management

•

customer attachment and so on.

(d) Other matters that should be considered (i) What Sapphire’s EPS would have been if there had been no bonus issue: 240,000/2,000,000 × 100 Sapphire appears better than Ruby


12p


(ii) Return on capital employed (ROCE) PBIT/capital employed × 100 588,000 / 2,710,000 × 100 = 445,000 / 2,450,000 × 100 =

21.7% 18.2%

(iii) Return on equity capital (ROEC) PBT less pref. Div./equity cap + reserves 354,000/1,310,000 × 100 = 385,000/1,950,000 × 100 = • Ruby provides a better return on equity • but its EPS is not quite so favourable • it is more geared, and • had borrowed at a significantly higher cost than Sapphire.

27% 19.7%

(iv) Gearing ratio Prior charge capital/total CE × 100 1,400,000/2,710,000 × 100 = 500,000/2,450,000 × 100 = •

51.66% 20.4%

Though both companies are geared, Ruby is highly geared. This means that any fall in profit will affect equity shares more than in proportion.

(e) Advantages of gearing •

Equity shareholders benefit if the return on investment exceeds the cost of borrowing.

•

There is no dilution of the existing shareholders’ interest if funds are raised by borrowing rather than by an issue to new shareholders.

•

Loan interest is allowable for tax relief.

•

Lenders normally obtain some form of security in the form of either a charge on assets or prior rights on liquidation. This means that their risk is lower and therefore their required rate of interest is lower.

Disadvantages of gearing •

Impact on company’s funding if loan covenants are breached e.g. may be required to renegotiate the loan at a higher rate of interest or even by issuing additional ordinary shares to the lenders in recognition of their increased risk.

•

Impact on company’s funding if equity shareholders perceive that there is a greater risk to equity funds if there is high gearing and as a result require a higher return on their investment.

•

Adverse impact on amount available for distribution to shareholders if profits fall.



Chapter 28: Question 5 – Segmental Reporting (i) The case for segmental reporting – two arguments for •

It will reveal in more detail how well management has performed.

•

Management will not be able to hide its failures behinds its successes.

•

Both will be disclosed and shareholders will be better able to judge the performance of directors.

•

In addition, disclosure of segment results may encourage management to exercise greater care when making investment decisions and be more positive in correcting any mistakes.

•

The first argument is, then, that segmental reporting will result in improved managerial performance.

•

The data provided by segmental reporting will be more useful for the investors.

•

This is because many financial statement users have said that consolidated financial information, while important, would be more useful if supplemented with disaggregated information to assist them in assessing those uncertainties that surround the timing and amount of expected cash flows.

•

This would allow them, therefore, to assess the risks related to a personal investment in or a loan to an enterprise that may well operate in different industries or in different areas of work.

•

The results of a diversified enterprise are composed of the results of its parts and the financial users consequently regard financial information on a segmental basis as also important.

(ii) The case against segmental reporting •

The case against segmental reporting arises from a consideration of cost and reliability.

•

An important consideration in assessing the desirability of disclosing segmental data is a comparison of the benefits arising from and the costs incurred by any such disclosure.

•

If the benefits exceed the costs, then the disclosure is desirable.

•

This comparison is difficult to make in practice because the benefits are enjoyed by the users while the costs are incurred by the statement providers.

•

It is not surprising that users express a need for segmental data because it costs them nothing.

•

Equally, it is not surprising that the statement providers do not want to incur the costs of disclosing segmental data because

•

•

they are unlikely to receive any benefits and,

•

even worse, they run the risk of their managerial deficiencies being revealed.

The costs that may be incurred by the statement providers include •

the costs of collecting and processing the information,

•

the costs of audit,



•

the costs of disseminating it to those who must receive it and

•

the costs of disclosure in the form of a loss of competitive advantage vis-à-vis trade competitors or trade unions with a consequent effect on wage demands.

•

It follows that a comparison of the private costs incurred by the providers and the private benefits enjoyed by the users is likely to be inconclusive.

•

A more fruitful, but again difficult, approach would be to compare the social costs with the social benefits. The social costs would be the resources consumed in the gathering, processing and publication of the segmental data. The social benefits would be the improved allocation and more efficient use of resources.

•

The second major objection to the provision of segmental data is their reliability.

•

It is argued that segmental data are not sufficiently reliable to justify disclosure. If this is true the unreliable data may be just as misleading as no segmental data at all.

•

The unreliability is due to the fact that there is the necessity to make arbitrary allocations of both costs and revenues amongst the various segments of the business.

•

The degree of arbitrariness will depend upon the nature and size of the reporting segments and the amount of detail disclosed for each segment. There are other specific objections to the disclosure of segmental data that may be made. These include: Investors invest in a company and not its individual segments. Whilst this is correct it cannot be denied that data about the operations of individual segments may permit investors to make better informed decisions about investments. The data are difficult to interpret and may confuse readers or be misunderstood with inappropriate inferences being drawn. It is usually assumed, however, that the statement users are technically competent and able to understand accounting data. Segmental data cannot be prepared with sufficient reliability and it is beyond the scope of external financial reporting to provide such analytical or interpretive data. It is true then that there are reliability problems with producers of segmental data, but whether those problems are sufficient to warrant non-disclosure of the data is a matter of judgement. It is sometimes maintained that the disclosure of segmental data constitutes analysis and interpretation and is, therefore, beyond the scope of financial reporting. However, this is a matter of opinion. Whilst analysis and interpretation do usually involve the study or reordering of existing published data, segmental reporting provides additional data not otherwise available. It is difficult to argue, therefore, that the provision of segmental data constitutes analysis and interpretation. There may be a negative impact on corporate innovation and experimentation. If mistakes are disclosed, management may be inclined to minimise risk to avoid mistakes, and innovation may suffer. This argument is difficult to assess. In the long run, of course, a lack of innovation will lead to poor performance and dissatisfaction with management. It seems likely that investors will be sufficiently sophisticated to realise that continued success requires innovation, which means that some risks must be taken. The costs of providing segmental information are too high. 287 © Pearson Education Limited 2006


The objection relates primarily to a fear that disclosure of segmental data may weaken the firm’s competitive position. This objection has been fairly widely researched and the general conclusion seems to be that researchers found that companies rarely ‘if ever, encounter(ed) any real loss of competitive advantage as a result of segment reporting’.



(b)

Chapter 28: Question 6 – Filios Products plc

(a)

Refer to Chapter 28: Question 5.

(b)

Segmental statement (£m)

Classes of business

Beer & pub

Hotel

Other drinks

business

& leisure

Total operations

Turnover Turnover

508

152

368

1,028

85

45

18

148

Profit Segment profit (W1) Common costs

15

Operating profit

133

Interest

14

Published net profit

119

Net assets Segment net assets (W2)

1,127

391

403

Unallocated assets (W2)

1,921 82

Published net assets

1,839

Workings W1 Sales

508

152

368

Cost of sales

316

81

287

Administration

43

14

18

Distribution costs

64

12

25

423

107

350

85*

45

18

Fixed assets book value

890

332

364

Stocks and debtors

230

84

67

73

15

28

12

303

99

95

12

66

40

56

31

237

59

39

(19)

Segment profit W2 Net assets

Bank Less Current liabilities Net current assets


77


10% Debentures

(140)

Net assets

1,127*

391

403

(82)

* Excluding interest and interest bearing loans as appropriate

(c) Analysis calculations Accounting ratios:

Operating divisions Beer &

Hotel

Pub

business

%

%

Operating profit %

16.7

29.6

Asset turnover

45.1

38.9

7.5

11.5

Return on assets

Competitors Other % 4.9 91 4.5

Dean

Clarke

%

%

13.3

40.0

46.0

50.0

6.2

20.0

(i) Possible comments: •

The best performing segment, based on the primary accounting ratio, the return on assets, is the hotel division.

•

The superior performance of the hotel division is attributable to the fact that it is able to generate higher operating margins than either of the other segments, and this outweighs the fact that it has the lowest asset turnover.

•

It would appear that Filios’ beer and pub division pursues a policy of higher selling prices and margins while also endeavouring to maintain asset turnover.

•

It would appear that the hotel business division is performing poorly both in terms of cost control and use of assets, and each of these areas requires detailed investigation.

•

The third division – other drinks and leisure – is making a contribution to profit of £18m but performance is mediocre by all measures, including a return on net assets of just 4.5%.

(ii) •

In order to interpret effectively the performance of the company, the results achieved by each division need to be compared with its direct competitor.

•

The beer and pub division achieved a return on assets higher than that of its competitor, Dean. The beer and pub division has achieved a far higher profit margin that has more than compensated for the marginally inferior asset turnover.

•

Filios’ hotel business division performs poorly compared with its competitor, producing a return on assets of not much more than half of that achieved by Clarke. The division’s profit margin and rate of asset turnover are both lower than those of its competitor.



•

The performance of each of the two divisions for which competitor information is available is not encouraging. The position is even worse when it is recognised that there are unallocated common costs of £15m and interest of £14 million. All the indications are that Filios is not being managed in the most effective manner.

•

The rate of return on assets earned by Filios Products as a whole (6.5%) is marginally better than that achieved by its competitor Dean, but far below that of Clarke.



Chapter 28: Question 7 – Chaldon District Council Report To From Date Subject

1

Client Services Committee Accountant Roofing Contract: Financial Appraisal of Tenderers

Introduction

1.1 Four tenderers, including CDS, have been short-listed for appraisal. The tenders have been submitted by: Tender A B C D

Name Nutfield & Sons Chaldon Direct Services (CDS) Tandridge Tilers Limited Redhill Roofing Contractors plc

Objective – to determine to whom the roofing contract should be awarded. Basis of appraisal Tenderers will be appraised on financial and qualitative grounds. Accounting ratios will be employed to assess profitability, solvency (long and short term), speed of cash collection and payment. Details are provided in Appendix A. Reference to limitations of approach: •

analysis is indicative only, not definitive

•

analysis is based on historical information

•

need for several years’ figures in order to consider trends.

2

Interpretation of ratios

2.1 Profitability Despite having the lowest profit margin, A’s ROCE is the highest at 77% due to its very high asset turnover of 13 times per annum. This is probably a reflection of the nature of the business – a small family concern; this probably also accounts for the firm’s relatively low stockholding. The asset turnover of the other two companies is similar, and C’s higher ROCE is due to its higher margins. D’s stock turnover is considerably higher than its competitors’ which could be a cause for concern. 2.2 Long-term security A has no long-term debt and, therefore, does not bear any interest charges. The other two companies are highly geared with C’s long-term debt being equivalent to its equity finance which is a cause for concern.



2.3 Short-term security D has the best current ratio, although the quick ratio of the three businesses is similar, C having the lowest. Interest cover is only relevant for C & D and does not appear problematic in either given current profit levels. 2.4 Cash flow ratios A takes longer to settle its creditors and collect from its debtors than the other two companies whose ratios are similar.

3 Other factors 3.1 An analysis of the make-up of the tenders is as follows Labour

Materials

Overheads

%

%

%

A

59

35

6

B

63

25

12

C

75

20

5

D

57

34

9

The variation between the components of the various tenders does not provide for any meaningful comparison, although CDS (B) does have the highest proportion of its bid for overheads and profit. Nutfield and Sons (A) have been employed by the Council for small contracts which they have performed satisfactorily. However, this contract is substantially larger than others they have won and, given a workforce of only six, they may not be able to fulfil a contract of this scale. CDS (B) is obviously well known to the authority and its management have striven to improve its financial position recently in order to achieve a satisfactory rate of return this year. Tandridge Tilers Limited (C) have not performed satisfactorily on other contracts that they have carried out for the Council. Redhill Roofing Contractors plc have not been employed by this authority and the standard of their work is not known.

4

Conclusions

Although the financial standing of Nutfield and Sons (A) does not give cause for concern, and although it has submitted the lowest tender bid, there are doubts as to whether it is capable of carrying out a contract of this scale. Include a comparison of uses in private and public sector. Main points should include:



Private sector •

Weaknesses of historical cost (HC) accounts in times of high inflation; undervaluing assets; overstating profits; not providing for maintenance of capital.

•

Can give a better indication of actual profits earned, separates holding gains from earned profits.

•

Can give better indication of value of individual assets to the business.

•

Based on concept of providing useful information for users of accounts. Not accepted in public sector; accountants not able to agree on bases and methods of adjustments required, or capital maintenance to use.

Public Sector Need to show effective use of public assets. Real-terms measure seen as more appropriate: •

Many public sector organisations have very long lived assets, HC is particularly misleading as result.

•

Financial objectives of many public sector bodies are stated in real terms and test discount rates used to evaluate capital projects based on real rates of inflation.

HC is objective and services stewardship function. HC can provide information to enable users of accounts to make their own adjustments, comparisons etc., but fuller disclosure of information would be required. There is a wide range of external information available to users of private sector company accounts. This is not the case with many public sector bodies. CCA-adjusted figures argued to be more useful bases of assessing performance. Does this imply the government views performance evaluation as more important for public sector bodies than investors do for private companies? CDS (B) submitted the second lowest tender. There is no reason to suspect that it will not be able to deliver the contract to the appropriate standard. The longer-term financial security (gearing) of Tandridge Tilers Limited (C), the second highest tenderer, and the quality of its work give major causes for concern. The highest bid was submitted by Redhill Roofing Contractors plc and, although its financial standing does not cause concern, its quality is unknown.



5

Recommendation

5.1 It is recommended that the contract be awarded to CDS. Appendix A: Accounting ratios Profitability A

B

C

77.1

21.2

16.5

6.0

19.5

17.3

Asset turnover (times p.a.)(AT)

12.8

1.1

1.0

Stock turnover (days) (ST)

17

Return on capital employed (%) (ROCE) Profit margin (%)(PM)

46

94

50.0

37.0

4.0

5.6

Long-term solvency Gearing (%)

0.0

Short-term solvency Interest cover (times)

n/a

Current ratio

0.9:1

1.3:1

1.9:1

Quick ratio

0.7:1

0.6:1

0.7:1

Cash flow ratios Creditors’ settlement period (days)

59

37

40

Debtors’ settlement period (days)

41

27

29

Notes ROCE PM AT ST Gearing

= = = = =

Interest cover Current ratio Quick ratio Creditors’ settlement period Debtors’ settlement period

= = = = =

(Operating profit/net assets) × 100 (Operating profit/sales) × 100 (Sales/net assets) (Stock and WIP × 365)/direct costs (Non-equity finance/equity finance and non-equity finance) × 100 Net profit before tax and interest/interest payable Current assets: current liabilities (Current assets – stock and WIP): current liabilities (Creditors × 365)/operating costs (Debtors × 365/sales) A

C

D

£000

£000

£000

612

1,741

3,080

37

339

534

Current liabilities)

48

1,600

3,241

Non-equity finance

–

800

1,200

Turnover Operating profit Net assets (total assets less



Equity and non-equity finance

48

1,600

3,241

Interest payable

–

85

96

410

1,191

1,735

Stock and WIP

27

149

449

Operating costs

575

1,402

2,546

Current assets

96

290

690

104

232

356

Current assets excl. stock

69

141

241

Creditors

93

141

280

Debtors

69

131

241

Direct costs

Current liabilities



Chapter 28: Question 8 – Chelsea plc (a) Profitability: ROCE •

Wimbledon outperformed: the industry by 8% and Kensington by 6%.

Profit margins: •

•

Wimbledon follows a high volume/low profit pricing policy •

Low profit evidenced by extremely low profit margin.

•

High volume evidenced by the asset turnover figures of 12 and 4 for fixed assets and total assets.

Kensington and the industry, in contrast, have achieved 2.3 and 1.5; and 5.1 and 2.5 respectively. Kensington perhaps moving up market with lower volume/ higher margin.

Cost control: •

Wimbledon’s 7% (12 – 5) shows lower overhead costs as a percentage of sales compared with Kensington and industry averages of 14% and 13%.

Liquidity: •

Wimbledon has a lower debtor collection period and stockholding period – suggests better working capital management than in Kensington.

•

Kensington’s acid test ratio of 0.5 appears low compared with 0.9 in Wimbledon and the industry average of 1.3. This appears dangerously low when taking into account the long debtor collection period.

Overall, Wimbledon appears the better investment: •

making better use of assets

•

better cost control

•

well managed working capital

•

potential for borrowing to gear up

•

return on equity is healthy.

(b)

Matters to be investigated before a final decision can be made:

•

Check if activities of companies are actually similar.

•

Obtain the absolute figures (£) for turnover, profits, assets etc.

•

Determine unexpired economic lives of fixed assets in each company.

•

Check quality of management and confirm whether likely to remain.

•

Confirm management’s strategy – increased markets or diversification.

•

Obtain details of date of redemption of debt.




North is achieving a higher profit margin than South or East, with East achieving the lowest margin at 3%. North

South

East

(i) Profit/Sales × 100

5%

4%

3%

(ii) Asset turnover

5 times

3 times

4 times

ROCE (i) × (ii)

25%

12%

12%

Whilst North has the highest profit to sales, the effect of the differences in the rate of asset turnover on the comparative performance of South and East means that their ROCE is the same at 12%. The ROCE indicates that North is performing better than South and East which have the same return of 12%. However, there are different levels of gearing as shown by the financial multiplier and when this is taken into account the position is as follows: North

South

East

(i) Profit/Sales × 100

5%

4%

3%

(ii) Asset turnover

5 times

3 times

4 times

ROCE (i) × (ii)

25%

12%

12%

Financial leverage

2

4

5

ROE

50%

48%

60%

For a lender North has the lowest gearing and less risk (assuming that there are no other contra-indications such a s solvency or liquidity problems), for a minority investor East shows the highest ROE. However, as a measure of management performance, although East has the highest ROE it is underperforming at an operational level. If it were to achieve North’s performance (perhaps under new management) then its ROE would increase to 175% (5% margin × 5 times asset turnover × 5 times financial multiplier).

(b)

Decision usefulness of consolidated accounts

Pros: •

Consolidated accounts give an overview of the group’s results and financial position.

•

Shareholders in parent company can see how their funds have been invested:



•

•

How much of the net assets belongs to the minority shareholders.

•

The amount of profit attributable to their shareholding.

•

The amount of profit expressed as EPS with implication for share price movements.

Impossible for a shareholder in parent of a complex group to obtain such information without group accounts which are prepared: •

using uniform accounting policies across all group companies

•

eliminating inter-group transactions.

Cons: •

Group accounts might combine very disparate companies with different levels of profitability, liquidity and risk profiles.

•

Detailed information on an individual company may be disguised e.g. excessive gearing.

•

Some group companies may be making losses – this will only become apparent if the parent decides to sell the loss-making subsidiary and it is reported under discontinued operations.

•

Also not possible to identify any extremely profitable subsidiary although this might become apparent from the segmental report.

•

The volume of intra-group trading and intra-group indebtedness by each company will not be apparent.

•

Where there is a minority interest, unrealised profit on intra-group sales will be eliminated 100% although it could be considered that the proportion relating to the minority interest has been realised.



Chapter 28: Question 10 PROFILE

31/07/2004

31/07/2003

31/07/2002

31/07/2001

12 months

12 months

12 months

12 months

787,126

730,913

601,295

483,968

46,316

56,139

53,568

44,317

677,710

680,989

660,447

575,223

288,954

318,628

310,133

273,839

Profit Margin (%)

5.88

7.68

8.91

9.16

Return on Share-

16.03

17.62

17.27

16.18

6.83

8.24

8.11

7.70

0.22

0.24

0.24

0.29

143.19

121.51

120.96

110.06

Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) Shareholders Funds

holders Funds (%) Return on Capital Employed (%) Liquidity Ratio Gearing Ratio (%)



CHAPTER 29

Chapter 29: Question 1 – Wandafood Products plc •

Profit to sales was low in 20×7.

•

Decline in return on assets in 20×7.

•

Consider the profit to turnover and asset turnover movements.

•

Interest and dividend cover is falling from 20×6.

•

Further decline could create problems.

•

There is an upward move in the level of borrowings.

•

Debt to equity as indicated by the relationship between the net borrowings and the sum of net borrowings and shareholders’ funds is 1:10 in 20×6 and 1:2.5 in 20×9 indicating increased borrowing.

•

Liquidity as indicated by the trend in the liquid and current ratios is levelling out.

Asset ratios •

Sales to working capital ratio shows a steadily increasing trend. May indicate more efficient use of working capital.

•

Assets per share are increasing indicating that the company is ploughing back profits.



Chapter 29: Question 2 – Bouncy plc (a) Ratios for a potential shareholder 20×6 (i) Return on equity

Profit after tax and Preference dividends /Ordinary share capital +

20×5

1,300/6,700

900/5,650

= 19.4%

= 15.9%

Reserves (ii) Earnings per

Profit after tax and Preference divi-

1,300/6000

900/6,000

share

dends/No.of Ordinary shares

= 21.67p

= 15p

(iii) Dividend cover

Equity profits/Proposed dividend

1,300/250

900/250

= 5.2 times

= 3.6 times

1,500/8,200

1,500/7,150

= 18.3%

= 21.0%

(iv) Gearing

Debt capital/Debt + Equity

(b) Solvency ratios for a potential lender (i) Debt equity

Debt:Equity

1,500:6,700 = 1:4.5

1,500:5,650 = 1:3.8

(ii) Solvency

Current assets:Current liabilities

3,810:1,960 = 1.9:1

3,610:2,060 = 1.8:1

(iii) Interest cover

Profit before interest:Interest

2,200/170 = 13 times

1,570/150 = 10 times

(iv) Liquidity

Current assets – Stock:Current li- 1,710:1,960 abilities = 0.87:1

1,540:2,060 = 0.75:1

(c) Comments from potential shareholder’s viewpoint The return on equity has improved by approximately 25%. The dividend is well covered and has improved in 20×6 from 3.6 in 20×5 to 5.2 in current year. The EPS figure is in line with the return on equity and is acceptable. The gearing is low at 18.3% so that the business enjoys lower earnings risk. Comments from viewpoint of lender The current ratio at 1.9 and acid test ratio at 0.87 are both improving and interest is well covered at 13 times. Gearing is low and coupled with the improving return on equity and sound interest cover means that the company is able to increase its long-term borrowing. The increase in the share price over the last three years is understandable given the picture presented by the ratios.



(d) Advising on scheme to choose It is interesting to assess the schemes from their impact on earnings per share and return on equity. Assuming a rights issue £000

£000

Profit before interest and tax

2200

Interest expense currently

(170)

Less: Debenture interest (10% of £1.5m)

150

Bank charge interest

(20) 2180

Taxation

(730)

Loss of interest allowance 40% of 150,000

(60) (790)

Revised profit after tax

1390

Earnings per share: Shares in issue £3,000,000/£0.5 =

6,000,000

New shares £6,000,000/£1.5

4,000,000

=

10,000,000 EPS = £1,390,000/10,000,000

= 13.9p

Return on Equity = 1,390/(6,700+6,000) × 100

= 11%

13% Debentures £000 Profit before interest and tax

£000 2,200

Interest expense (6,000 × 13%)

(780) 1,420

Taxation

730

Less tax savings on loan interest (780 – 170) × 40%

(244) 486

Revised profit

934

EPS = 934/6,000 = 15.6p Return on Equity = (934/6,700) × 100 = 14% The decision based on EPS and return on equity supports the loan funding scheme. Other factors to be taken into account: Consider the increase in gearing from 18.3% to 47.2% (6,000/12,700) 303 © Pearson Education Limited 2006


Chapter 29: Question 3 – Liz Collier (a) Option 1

Year 1

Year 2

£

£

[21,000 × 140/100]

29,400

29,400

Less interest at 10% per annum

1,000

1,000

28,400

28,400

Profit

Comments: (i) The loan of £10,000 is paid out of incremental cash flow generated by profit in 14.5 months. (ii) It is likely that some benefit will continue after the end of year 2 and marginally improve her lifestyle. (iii) It is assumed that the 40% increase is a reasonable and feasible forecast. Option 2 Partnership profit

Year 1

Year 2

£

£

39,600

39,600

[profit is £33,000 × 120/100] Less cost of amalgamation

(6,870)

Less salaries Liz – 2% of £126,000

(2,520)

(2,520)

Joan – 2% of £72,000

(1,440)

(1,440)

28,770

35,640

Liz 3/5

(17,262)

(21,384)

Joan 2/5

(11,508)

(14,256)

2,520

2,520

17,262

21,384

19,782

23,904

Profit share:

Comment: (i)

Liz will receive Salary Profit share

Liz is worse off in year 1 by £1,218 [21,000 – 19,782] and better off by £2,904 in year 2. Her share of the initial investment is £4,122 i.e. 3/5 of £6,870. This investment will be repaid in 2.5 years and the benefit will accrue in perpetuity. From year 2 onwards it generates a ROCE of 70% i.e. £2,904/£4,122. It seems a good proposal assuming the figures are reliable and that the partners are able to work in harmony. There is potential for expansion with synergy effect.



Joan will derive a benefit in year 1 and a higher return in subsequent years i.e. £3,696/£2,748 × 100 = 134% in year 2. This might indicate that the profit-sharing ratio is unfair to Liz and should be reviewed if this option is selected. Option 3

Year 1

Year 2

Profit [£21,000 × 8/10]

16,800

16,800

Franchise profit

15,000

17,250

Less interest @ 10% per annum

(8,000)

(8,000)

Total profit

23,800

26,050

Comments: (i) Incremental profit compared with present position is:

£2,800

£5,050

(ii) Franchise projected profit: Year 3: £19,838;

Year 4: £22,813;

Year 5: £22,813

It will take 6 to 7 years to repay £80,000 from incremental cash flows. After year 8 it could be a very profitable proposition. (b) Option 1 gives a 40% increase over two years. It is unlikely that this increase can be maintained in year 3 and subsequent years without additional expense on advertising etc. The initial outlay is moderate and is repaid quickly from additional cash flow. Liz will maintain her independence and improve somewhat her standard of living/lifestyle. Option 2 shows a reduction in profit in year 1 compared with the present and a £2,900 increase thereafter in year 2 and subsequently. The initial outlay is moderate and there may be longerterm prospects without additional expense after year 3. There is however a loss of independence as a partner. There may be hidden costs not provided for and high opportunity costs. Option 3 requires substantial investment of £80,000 which may be repaid until about year 7 out of incremental cash flows. (c) Reservations Option 1 •

The ability to increase turnover by 40% and the maintenance of the level of sales after year 2.

Option 2 •

The ability to work amicably with Joan in the partnership.

•

Risk of poor decisions by the other partner which then bind the firm.

•

Possibility of administration costs not included in the estimates given.

•

Basis of profit-sharing ratio seems to be biased in favour of Joan.



Option 3 •

Need to reduce existing sales.

•

Involvement with franchise constitutes a refocusing of the business with attendant risks.

•

Reliability of the estimates particularly after the first 2 years.



Chapter 29: Question 4 – Chekani plc (a) Principles of share valuation: •

No one method of valuing shares.

•

Accounting values only a guide as to starting point and/or maximum value for negotiating between parties.

•

Share value is the amount that the buyer is willing to pay and the vendor willing to accept.

Methods or bases of valuation: •

Dividend yield basis.

•

Price/earnings ratio.

•

Net asset value based on a going concern or break-up value.

•

Valuation of an unlisted company of this type needs to take account of the difficulty associated with selling the shares and the increased risk of the investment, by adjusting quoted company yields or PE ratio.

•

Minority holdings usually valued on dividend yield basis, which is not appropriate for majority holdings of this type.

•

Majority holdings valued on PE basis, using adjusted quoted company PEs; the net asset value, as a going concern, gives a minimum valuation.

(b) Alternative valuations (see appendix for calculations) Dividend yield basis. For calculations, see appendix. Discussion of investor’s required rate of return, quoted company yields and possible uplift % for an unlisted company. Appendix shows £1.28 (with 30% adjustment for unquoted status). Method not appropriate here. Net asset basis For calculations, see appendix. Discussion of treatment of: •

contingent liability

•

purchased goodwill unamortised

•

book value v current market value of assets

•

relating goodwill and current market values.



Preference shares •

These could be deducted at their nominal value as the liability due to outside interests.

•

Alternatively, the better student could argue that the approach to be adopted should be to value the company as a whole, e.g. Gross asset value, the amount Chekani would pay for the whole enterprise, including the preference shares, and then to deduct the value of the preference shares, i.e. total value less the amount that will not be acquired.

Debentures •

Either the premium is an extra cost to Chekani and is ignored in the valuation,

•

or it is included on the basis that it is part of the value of the company’s net assets.

Earnings basis Calculations per appendix •

Comment on use of P/E ratios for quoted companies and discount rate applied.

•

Treatment of exceptional item, maintainable earnings.

(c) Appropriate strategy •

Normally do not sell below net asset value, based on revalued amounts. This is the highest price here, £3.02, and may not be acceptable to the purchaser due to factors such as: •

falling profits over last three years, return on investment may be more important than asset value

•

value includes estimate of current values which may not be realisable

•

future prospects and forecasts are not given and cannot be taken into account, but they could provide evidence to support a higher (upturn in prospects expected) or lower (no improvement or downturn forecast) price.

•

The final price is likely to be between the two net asset basis prices, the revalued asset basis figure £3.02 and the value based on net assets per balance sheet, £2.175.

•

Opening bid should be around the higher figure, say £3.00, leaving room to negotiate downwards, possibly with a view to agreeing a final price around £2.60.

Appendix Dividend yield Net dividend on ordinary shares

£3m

Dividend per share £3 million/40 million

7.5 pence

Investors’ required rate of return, based on average gross yield of the two quoted companies given, (4.9 + 4.1)/2 = 4.5% 308 © Pearson Education Limited 2006


Value per share: No allowance for different risk (£1 × 7.5/4.5) = £1.67 per share Adjusted yields, allowing for increased risk of unquoted share, using 30% (Note: other adjustment % are permissible), (4.5% × 1.3) = 5.85%, so £1 × 7.5/5.85 = £1.28 per share. Asset valuation basis Assets at balance sheet values

Assets revalued/ goodwill written off etc.

Goodwill

15,000

0

Property

30,000

56,250

Plant

60,000

60,000

Investments

15,000

22,500

Net current assets

12,000

12,000

Contingent liabilities

(3,000)

(3,000)

10% Debentures

(30,000)

(33,000)

Preference shares

(12,000)

(10,800)

87,000

103,950

Value per share

87,000/40,000 = £2.175 103,950/40,000 = £2.60

Other variations could be: Goodwill not written off

103,950 + 15,000 = 118,950 118,950/40,000 = £2.97

Debentures and preference shares

103,950 + 1,800 = 105,750

at nominal value

105,750/40,000 = £2.64

Goodwill not written off and

103,950 + 15,000 + 1,800 = 120,750

debenture/preference at nominal

120,750/40,000 = £3.02

value (maximum valuation of assets)



Valuation on an earnings basis Capitalised using PE ratio of similar listed companies: Average of 11.3 and 8.2 = 9.75

Discount at 30% = 6.825

Earnings: Profit before interest and tax

21,000

Interest

(3,000) 18,000

Tax

5,550 12,450

Preference dividends

840 11,610

EPS = 11,610/40,000 = 29.025 pence per share 29.025 × 9.75/100 = £2.83 Discounted 29.025 × 6.825/100 = £1.98



Chapter 29: Question 5 – Johnson Products Ltd (a) (i) Sale of shares to Sonar Products Ltd The 75% holding constitutes a controlling interest and can be valued on an earnings basis to indicate the amount that the buyer could offer and reasonably assume would be acceptable to the seller. A valuation on an earnings basis gives a value of approximately £300,000 or 37p per share. The value is computed using the following formula: Value = Earnings/% earnings yield required For this part of the question we need to estimate the amount of the earnings that are to be capitalised and the percentage earnings yield required from the information given in the question. The earnings could be based on the final year figure or perhaps a weighted average. For the purpose of illustration the weighted average is being used in this solution, calculated as follows: Earnings

Weight

Product

£

£

79,400 (27,600) 56,500

1

56,500

88,300

2

176,600

97,200

3

291,600

6

524,700

Average earnings = £524,700/6 = £87,450

Note that in part (c) of the question there is a further discussion required of the principal matters that need to be taken into account when assessing future maintainable earnings. The percentage earnings yield required is based on the information provided in the question about the three other companies: Gross dividend

Retention

% yield

Earnings

%

% yield

Eastron

15

25

20

Westron

10.5

16

12.5

Northron

13.4

20

16.75

The average percentage earnings yield = (20 + 12.5 + 16.75)/3 = 16.4%.

Based on the estimated average earnings which are regarded as maintainable and the estimated percentage earnings yield required, the valuation of the 75% shareholding is as follows:



= £87,450 × 100/16.4 =

Value of company Value of 75%

£533,232

= £533,232 × 75/100 =

£399,924

Less say 25% for lack of marketability

£99,981 £299,943

This value is an estimate of the amount that would be acceptable to R. Johnson.

(ii) Sale of shares to the staff • • •

The possible sale to the staff would result in a widely held share capital with no single person holding in excess of 4% of the share capital. Consequently it is felt that the shares should be valued on a dividend basis using the formula that the value of a share would be the dividend divided by the percentage dividend yield required less 25% for lack of marketability. The dividend is assumed to be 5p per share and the percentage dividend yield required is estimated at 12.97 being the average of the yields for the three comparator companies. The value of a share = 5/12.97 × 100 = Less 25%

38.55p 9.64

Value per share

28.91

Value of 810,000 shares

£234,171.00

(iii) Sale to Divest plc The realisable value of the business is: Land

480,000

Premises

630,000

Equipment

150,000

Stock

98,000

Debtors

168,000

Cash

70,000

Creditors

(335,000)

Non-current creditors

(158,000)

Realisable value

1,103,000

Less 16.7% (based on the need to obtain 20% return)

183,833

Value of business

919,167

Value of 75%

689,375

The three values are therefore: (i)

Sale to Sonar Products Ltd

£299,943

(ii)

Sale to minority interests

£234,171

(iii)

Sale to Divest plc

£689,375



(b)

Maximum that would be offered by Sonar Products Ltd on basis of information provided in the question

The valuation would be calculated on a return on capital basis to indicate the maximum amount the buyer would be prepared to offer. The maximum that Sonar Products would be prepared to pay may be estimated by reference to the rate of return that they presently achieve. Given that they currently achieve a rate of return on capital employed of 12.5% the amount they would regard as maximum is £524,700 calculated as follows: Average

Capitalised at

earnings

% return on

% Holding

Maximum value

capital £87,450

(c)

×

(100/12.5) ×

(75/100)

=

£524,700

Principal matters to take into account when estimating future maintainable earnings

There are a number of matters that could be mentioned and in this answer a selection of relevant matters is given. There are others that could be put forward as satisfactory replies to this question.

(i)

Past performance

•

Past performance, i.e. past earnings, is the main indicator of future potential.

•

One cannot merely carry out an extrapolation of the past three to five years

•

But it is an indication of how well the company has operated in the past in comparison with other companies within the same industry.

•

This means that one would need to obtain information about the earnings of the three comparator companies over say the past three to five years and assess how well Johnson Products Ltd has fared in comparison with these.

•

One could pay attention to the compound annual growth rates in sales and operating profits and profits for the year, and look at the implication of financial and operating gearing.

(ii)

Forecast for the industry

•

It is important to form a view on the possible growth or decline within the industry sector in the future.

•

Although the past earnings are the base from which accountants start, they also needs to have regard to the expected movements within the industry in the future.

•

We are attempting to estimate future maintainable earnings and clearly the rate of growth in the industry is important.



(iii)

Changes in the activities undertaken

•

The activities that generated the past earnings will be known.

•

It is important to identify the extent to which these will be varied.

•

There are various indicators that will be apparent from an examination of the accounts themselves, such as •

research and development expenditure

•

new fixed assets

•

capital investment contracts outstanding at the balance sheet date, and even

•

surplus funds that are not currently invested within the business because they indicate the capacity to move into new activities or to expand the level of existing operations.

(iv) •

Rationalisation

Consideration needs to be given to the likelihood of the acquirer selling off parts of the acquired company in order •

to improve performance or

•

to release cash for the payment of interest or for other purposes.

(v)

Management and staff

•

These are an important component for success in any business.

•

It is possible to gain an impression from the accounts and filed documents of average wage levels and the stability of the board.

•

However, to obtain more detailed information, it would be necessary to have the cooperation of the company because one would be seeking more detailed information on

(vi) •

•

service contracts

•

performance-related pay

•

the rate of labour turnover.

•

It is clearly more fruitful if it is possible to obtain the co-operation of management to obtain these data.

Accounting policies

If it is assumed that the new owners will be able to control the accounting policies then clearly it is of interest to identify how the past policies will be varied. For example, there are the areas such as depreciation and long-term contracts where the company might follow a more or less conservative accounting policy.



(vii)

nterim accounts

•

If it is possible to obtain access then the interim accounts, management accounts, budgets and forecasts will give an indication of the company’s strategy and its success over the immediate past few months.

•

This could give a more current feel for the company’s progress.

(viii) Ratio analysis of balance sheet •

The matters referred to in paras (ii)–(vii) are specifically towards the future.

•

Whilst the emphasis is on the future we also need to refer to the last balance sheet to pick up items such as •

high gearing,

•

poor liquidity

•

references to post balance sheet events, or

•

contingent liabilities that might impact on the future prospects of the company.

•

In conclusion therefore the question is looking for a recognition that the valuer needs to be forward looking, identifying as clearly as possible the future maintainable earnings.



Chapter 29: Question 6 – Business Risk Management (a)

Identification and prioritisation of risks

All types of risk are relevant to an existing or potential shareholder including both downside risks (possible losses) and volatility risks (possible gains or losses). Shareholders are not protected if they only receive details of downside risks and sell their shares inappropriately. Developments to date have been aimed at addressing a particular problem e.g. SSAP 25 Segmental Reporting. This has meant that companies have had prescriptive requirements which might not have reflected the actual risks which are relevant to their company. Risk that may be relevant include: •

product or service failure

•

new regulations

•

product development with heavy R&D costs before cash flows in.

Internal risks include: •

process risks e.g. arising from employees such as risk of losing key staff, suppliers and manufacturing process whereby products are not delivered on time or to correct specification.

•

financial risks e.g. price, liquidity and credit risks.

External risks include: •

social, political and economic forces, e.g. risk of new employee protection regulations

•

financial risks, e.g. exchange rate movements.

Risk prioritisation The normal materiality criterion applies and attention should be drawn to risks in accordance with their significance.

(b)

Managing risk

There are different views on the nature of the disclosure. One view is that it is sufficient to confirm that the company has complied with the Combined Code. There is also the view that there should be detailed disclosure of particular steps taken e.g. insurance, hedging, outsourcing.

(c)

Measuring risk

There is a wide range of measures that could be applied to measuring risk and it is important not to concentrate only on deterministic data e.g. potential losses on exchange, but also to consider how to report on strategic risks.



Accounting measures already exist internally, e.g. reporting provisions and contingencies and producing ratios such as gearing and liquidity, trend analysis and benchmarking. Accounting measures also exist externally, e.g. bond rating by credit agencies, benchmarking. Non-accounting measures are also important, e.g. price competitiveness, delivery times, level of warranty claims.



CHAPTER 30

Chapter 30: Question 1 The IFRS Taxonomy has the element Inventories identified as bearing the name of Inventories, being of the type monetaryItemType and that it is expected to have a debit balance

As the explanations in this text do not go in detail as to the different structures of all the files used in XBRL, it is not expected that students would be able to reproduce this type of coding. Students may have visited the example at http://www.xbrl.org/Example1/ and come up with the following: 100000

Although this is an example of XBRL works, the coding really is from an Instance Document and not from the underlying schemas etc. If the students followed the naming conventions used (see http://xbrl.org.au/training/ XBRLNamingConventions.pdf) then it is probably more likely that students come up with: CurrentAssets Inventory Or: CurrentAssets CashAndCashEquivalents Inventory

The placement of Inventory depends thus on the standard’s position as to Inventory belonging to the class of Cash and Cash Equivalents or to Other Current Assets. Agricultural assets may well be split between Current and Non Current (Timber Trees or plantations) Another good overview example of the application of the IFRS can be found at http://xbrl.iasb.org/int/fr/ifrs/gp/2005-01-15/Samples.htm



Chapter 30: Question 2 List the steps in the approval process for a taxonomy to be considered to have ‘final’ status. (Hint: look at www.xbrl.org ) Students would have looked at http://www.xbrl.org/FormingAJurisdiction/ and perused the zip file and found that there are 2 different classifications for Jurisdictions as listed in the table below: Established Jurisdiction

A non-profit organisation, involved in business reporting, that collects dues from ten or more members and pays dues to XBRL International.

Provisional Jurisdiction

A non-profit organisation involved in business reporting that has a group of individuals (often called a working party) creating an XBRL Taxonomy or other XBRL work products, and that pays dues to XBRL International.

Jurisdictions are normally established within a country where a particular accounting standard is applicable. Should a country adapt the IFRS then, technically, it may not need to form a jurisdiction. Should there be a need to adapt (XBRL refers to this as ‘extend’) then there will be a need if the country needs to use XBRL.



CHAPTER 31

Chapter 31: Question 1 – BC (a)

Provision at 31.12.×0 = no. of shares × option price × probability of achieving the option × 1/3 = 1,000,000 × 0.05 × 0.6 × 1/3 = 10,000 Provision at 31.12.×1 = no. of shares × option price × probability of achieving the option × 2/3 = 1,000,000 × 0.10 × 0.7 × 2/3 = 46,667 Provision at 31.12.×2 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.15 × 0.85 = 127,500 Provision at 31.12.×3 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.30 × 1.0 = 300,000 Final cost at 30.6.×4 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.35 × 1.0 = 350,000

Year ended

Provision

P&L a/c charge

31 Dec 20×0

10,000

10,000

31 Dec 20×1

46,667

36,667

31 Dec 20×2

127,500

80,833

31 Dec 20×3

300,000

172,500

31 Dec 20×4

50,000

Total charge

350,000

There will be no provision in the financial statements for the year ended 31 December 20×4, as the option will have been awarded to the director. The total cost of the option at 30 June 20×4 will be charged as directors’ remuneration and credited to the share premium account.



(b) The total cost of the share option using the different methods will be: Method

Total cost

IAS 37

£350,000

US FAS123 & IFRS 2

£30,000

UK recommendation

£300,000

(c) (i) The IAS 37 method gives a cost for the option which is consistent with the International Accounting Standard and the IASC’s Framework for the Preparation and Presentation of Financial statements. Taking the value of the option and the probability of the option being granted tends to give an uneven charge for the option, with a higher charge in later years. This example tends to exaggerate this uneven charge, but the charge will tend to be higher in later years because the probability of the option being granted is higher near the end of the option entitlement period (and less in earlier years). Also, there is an element of discounting in determining the option price, so the option price will be lower in earlier years than later ones. In addition, the option price will be lower in earlier years as it is less certain that the share price will be above the option price in earlier years than later ones. (ii) In this example, FAS 123/IFRS 2 gives a charge to the profit and loss account of only 8.6% of the cost of the IAS 37 method (and only 10% of the UK recommendation). This charge occurs in the year ended 31 December 20×0, and there is no subsequent charge in the profit and loss account. (iii) The UK recommendation gives a charge of 86% of the IAS 37 method, which is a more realistic figure than using the second method. However, the charge only occurs at 31 December 20×3, which is 3 years after the option was granted to the director. It would seem more appropriate if the charge was made during the period the director earned the entitlement to the share option.



Chapter 31: Question 2 – Rolls Royce (a) The composition of the Remuneration Committee is appropriate as it comprises entirely non-executive directors. It is good that they meet regularly and receive appropriate professional advice. However, the statement that they ‘meet regularly’ is vague and could be more specific, stating the number of meetings held in the year ended 31 December 1999. There appears to be a slight conflict in that the Chairman and Chief Executive attend the meetings. They are virtually members of the Remuneration Committee. However, the Remuneration Committee need relevant information on the performance of the executive directors, and one good way of obtaining this is from the Chairman and Chief Executive. Also, the Chairman and Chief Executive may have relevant information on comparable salaries for directors in other similar companies. However, there may be problems with the Chairman and Chief Executive attending the meeting, as the Remuneration Committee may want to discuss information provided by the Chairman and Chief Executive but with both the Chairman and Chief Executive being absent from the meeting. For instance, it would not be possible for the non-executive directors to discuss the point ‘do we believe what the Chairman and Chief Executive are saying’ when those people are present at the meeting. Thus, the non-executive directors should have the opportunity to discuss matters alone. The note to the financial statements suggests that either the Chairman or Chief Executive would be present at the meeting. The likely close relationship between the Chairman and Chief Executive could result in the Chairman disclosing to the Chief Executive confidential matters relating discussions by the Remuneration Committee on the Chief Executive’s performance and remuneration. One would be more confident about the independence of the Remuneration Committee if the financial statements disclosed that the non-executive directors of the Remuneration Committee have the right to discuss matters without the Chairman and Chief Executive being present. (b) Like Diageo plc, the statement about ‘Base Salary’ is qualitative rather than quantitative. It appears that the ‘median-level base salary’ would be given even if the performance of the directors is poor. Also, mention of ‘performance-related schemes’ does not seem relevant and appropriate in a section discussing ‘Base Salary’. As explained in the main body of the Chapter, it is difficult to determine the effectiveness of directors’ performance. The financial performance of a company may be poor because the directors’ performance is poor, or the performance may be poor because of a recession in the market for the company’s products. Also, directors may work very hard when the company is performing poorly to overcome the problems it is experiencing. Directors should be paid on how hard and effectively they work, and financial performance may be a poor measure of their performance. (c) This paragraph explains that the annual performance award scheme gives a performance award of up to 60% of basic salary. It talks about a ‘reducing scale of maximum percentages for senior employees’ - are these non-directors or do they include directors? It is unclear about whether the performance award is graduated, so that the achievement of the full performance requirement obtains 60% of salary, with reducing figures for lower achievement of the performance. Also, at what point is no performance award made?



On the award itself, it says that a third of the award is paid in Rolls-Royce shares. How and when is the charge for these shares made in the financial statements? It would appear that the charge should be made when the shares are purchased. However, the charge could be avoided at that stage by including the shares at cost in the balance sheet. If a third of the award is made in shares, then two-thirds must be made in ‘cash’. When is the charge for the cash part of the award made? This charge is probably when the payment is made, whereas it would be better to make the charge during the period when the director works to achieve the performance target. The final statement in this paragraph says the performance award ‘provides a culture of share ownership amongst the Group’s senior management’. From the company’s financial statements, it is very difficult to see whether this is happening. The directors held more (or the same number of) shares at 31 December 1999 than they did a year earlier, but there was no information on the number of shares issued to directors in that period. (d) Once again, the directors can obtain an award of 60% of salary under the LTIP. This seems like ‘double counting’ as they can also obtain 60% of their salary from the annual performance award scheme (APAS). This gives a total possible bonus of 120% of the base salary. The wording of the paragraph is very similar to that for the APAS, so the comments are similar. There is maximum award of 60% of salary, but is this proportionally reduced when the full target is not met? There is some explanation of how the award is calculated, and no award is made if the company’s performance is below average (i.e. 10th out of 19 or below). The timing of the charge for the LTIP to the profit and loss account is uncertain, in a similar way to the APAS. It is probable that the cost is charged when the shares are purchased, but the cash portion is only charged when the payment is made to the director, rather than during the period when the director is working to achieve the target. The last paragraph is clear in explaining that no award was made in the year ended 31 December 1999, and none was realised (i.e. paid). (e) The ‘Combined Code’ recommends that rolling contracts should be no more than a year, whereas the company is providing a rolling contract of two years to most of its executive directors. The ‘rolling contract’ means that if a director is dismissed, he/she is paid one (or two) years’ salary on termination. One would have to look at the financial statements of other companies to see if they are using a one-year rolling contract for directors, or a longer period. It appears that most companies now comply with the one-year term of the ‘Combined Code’, so Rolls-Royce’s terms are generous to its directors. On new directors who are initially given a two-year rolling contract, there is no explanation of the ‘initial period’ after which the contract is reduced to one year. (f) The first paragraph under ‘Compensation and mitigation’ seems reasonable, as it appears to prevent incompetent directors from receiving a large termination payment. Also, if a director was close to the retirement age it would be unreasonable to give the director a termination payment which extends beyond the retirement age. For example, if the director was exactly 64 and the retirement age was 65, then the termination payment should be limited to 1 year, so it only covers the period until he is 65. So, the first paragraph seems reasonable.



The second paragraph gives an example of the application of the first paragraph. The compensation paid to the director seems generous and there are many unanswered questions. Although the individual was a director until the company’s year end of 31 December 1999, he is not included in the list of directors and their biographies. So, there is no disclosure of the age of the director at 31 December 1999 and his position in the company. One would have to look at the previous year’s financial statements for this information, and, like many other shareholders, I have thrown away the 1998 financial statements! Thus, the financial statements should give biographical details of all directors who served the company during the year. There is a need for such a requirement under the Companies Acts or Stock Exchange codes. The other unanswered question is ‘why did the director retire early?’ The Chairman’s statement only thanks the retiring director for his services, and the only other information on this payment is given in this question. How long had the director served the company and in what positions? In practice, it is unlikely that companies will disclose reasons why directors leave the company or retire early. Sometimes, they express appreciation for the director’s contribution to the company. However, there may have been heated disagreements between the directors with the losing directors leaving the company. These ‘losing directors’ may be given a generous termination payment on the understanding they will ‘keep quiet’ about the dispute. There is likely to be little or no mention of these problems in the company’s financial statements. Also, full disclosure of the problems by the company is likely to lead to expensive legal action by the ‘losing directors’ against the company. It is probably much better to obtain information about the director’s resignation from the financial press than from the company’s annual financial statements. From the figures given in the question, it is apparent that the retiring director has been given two years’ basic salary in compensation payment. This is very generous. Also, there is almost no disclosure of information about the director in the financial statements, so it is impossible to determine whether there should be any reduction in the termination payment, using the rules in the first paragraph of the statement. It appears that many UK companies are very generous in their termination payments to directors. Very few UK employees who are not directors are given two years’ termination payment when they retire early. Some directors can earn large sums from termination payments. For instance, a director working for company A may obtain a job at company B in six months’ time. Then, he makes a nuisance of himself at company A which results in him being dismissed from company A with a generous compensation payment. He then moves on to company B, obtains a job at company C, makes a nuisance of himself at company B and is dismissed and so on!



Chapter 31: Question 3 – Risk-Averse Auditors Explanations of why auditors perform more work than is necessary include: (d) being sued involves a lot of scarce senior management time (e) it is very worrying to be sued, so auditors would want to keep the number of claims to a minimum (f) being sued damages the reputation of the audit firm, which is likely to reduce the number of new audits acquired and losing some existing audits (g) if the auditor is found to be negligent, he/she will have to pay out damages. Most of this would be covered by Professional Indemnity Insurance (PII insurance). If there are many claims, the PII insurance company is likely to increase the insurance premiums



Chapter 31: Question 4 – Audit Firms and Consultancy (a) An audit firm can provide significant help to the audit client through consultancy work. The audit firm will know the audit client from the audit, so this will reduce the learning time when carrying out consultancy work, thus reducing its cost. Also, audit firms have knowledge in specialised areas, which would benefit the audit client. Audit firms have been developing financial and related business services as part of their consultancy business, so there are many areas where the audit firm can help the audit client. The audit firms have specialised skills in information and computer systems, and E-commerce and Internet applications. Also, audit firms have always had specialists who deal with company and personal taxation, and accountants’ skills in this area are probably better than those of any other business. So, it can be seen that auditors can provide high quality services to audit clients, often at a lower cost than could be provided by other consultants. (b) The provision of consultancy services creates independence problems for the audit firm: (i) The auditor may be reporting on his/her own work, such as when reporting on financial statements prepared by the auditor, or accounting systems which have been recommended by the audit firm. If the auditor both prepares and audits the financial statements, the quality of the audit will be less than if these two functions were undertaken by different people. This is because one is poor at checking the accuracy of one’s own work. An independent person is much better at detecting errors in another person’s work. Also, if the auditor finds errors in work carried out by the firm, he/she will be reluctant to highlight these errors, as they could be a sign to the audit client of the low quality of the audit firm’s work. So, the audit firm may give an unqualified audit report when the audit report should have been qualified (modified) because of material errors in the financial statements. (ii) the second problem is that with the higher fee from the combined audit and consultancy work, the auditor will be reluctant to qualify the audit report, as this could result in a loss of both the statutory audit and the consultancy work. The profitability of the nonaudit work for the FTSE 100 listed companies is six times the profits from audit work. (iii) The ethical rules of most of the accounting bodies, the IFAC and the US SEC say the auditor should avoid making management decisions when performing consultancy work. However, there are problems in defining the situations when the auditor would be making management decisions, and it is difficult for third parties and regulators to detect whether audit firms are carrying out management decisions for the client company. The easiest solution to this problem is to prohibit auditors from carrying out consultancy work for audit clients. (c) Audit firms want to continue to perform consultancy work because of the high profits from this work. If an audit firm has acquired a new audit, it is both a regular annual income stream from the audit, and, being auditor, the firm has a greater chance of being selected for consultancy work than competitor consultants. This is because the audit firm’s consultants will be able to avoid some of the learning costs and the audit client will know the audit firm (and probably have a good relationship with the audit firm) so they will feel more confident in awarding the consultancy work to the audit firm than to a consultant who they have no experience of.



Chapter 31: Question 5 – Auditor Accountability (a) Where the auditor reports to shareholders, the work the auditor carries out is determined by the information required by the shareholders. In a statutory audit (i.e. one governed by the country’s legislation) the work the auditor needs to carry out is determined by the information the country’s law requires the auditor to report on. In addition, it is common for the statutes to give the auditor the right of access to the company’s accounting records and to obtain explanations from the company’s staff, including the directors. In this situation, it is the shareholders or the country’s statutes which determine the work the auditor is required to carry out. In this situation, the directors cannot limit the work the auditor is required to carry out. This is quite different from situation (b). (b) Where the auditor is providing consultancy services for the client company, the directors specify the work the audit firm is required to carry out. Thus, the audit firm’s responsibility is to the directors of the company. For consultancy work, the directors can prevent the audit firm from looking at parts of the company’s business. This limitation of the auditor’s work is not allowed for the statutory audit. So, for consultancy work, the auditor’s work is controlled by the directors. For the audit, the auditor’s work is determined by statute (or the shareholders) and it cannot be limited by the directors. If the directors tried to limit the auditor’s work in carrying out an audit, the auditor would probably give a qualified (modified) report on the financial statements, stating the way the directors have restricted the auditor’s work and its possible effects on the financial statements.



Chapter 31: Question 6 – Auditors as Shareholders There is a concern that auditors should be impartial and also be seen to be impartial in carrying out their duties as auditors. This means that they should have no personal pressure to influence the reported income of the business. Whilst it is of course possible for an independent auditor to ignore the personal implication of the shareholding and to act professionally and objectively, the public might well take a critical view. Consequently the professional bodies prohibit an auditor from holding shares in a client company.



CHAPTER 32

Chapter 32: Question 1 – Plus Factors Group plc (a)

Value added statement for year ended 30 September 20X9 20X9 £000

20X8 %

£000

Turnover

8,613.6

7,560.1

Bought-in materials and services

4,815.4

4,096.4

Value added by group

3,798.2

3,463.7


%

10.9

-

10.7

-

3,809.1

100.0

3,474.4

100.0

2,193.5

57.6

2,153.6

62.0

To providers of capital

735.7

19.3

566.5

16.3

To government

464.7

12.2

527.9

15.2

For asset maintenance and expansion

415.2

10.9

226.4

6.5

3,809.1

100.0

3,474.4

100.0

Applied the following ways: To employees

(b) 20X9

20X8

£

£

Sales per employee

43,974

37,612

Value added per employee

20,379

17,232

Average remuneration per employee

11,201

10,714

(c)

Problems arise because there is no standard defining the terms e.g. turnover gross or net of VAT, treatment of minority interests, should VAT appear in the government section?



Working 20X9 20X8 £000

£000

Sales including VAT

9,905.6

8,694.1

VAT at 15%

1,292.0

1,134.0

8,613.6

7,560.1

Creditors at end of year

1,244.2

1,109.1

Add: Payments in year

3,622.9

2,971.4

4,867.1

4,080.5

Less: Creditors at start of year

1,109.1

987.2

Materials purchased in year

3,758.0

3,093.3

Add opening stock

804.1

689.7

Less closing stock

(837.8)

(804.1)

Turnover

Bought-in materials and services Cost of materials

Add: Bought-in services Auditors’ remuneration

12.2

11.9

Hire charges

66.5

367.3

1,012.4

738.3

4,815.4

4,096.4

Other overheads Employees

£

£

Benefits

109.9

68.4

Pensions

319.8

222.2

1,763.8

1,863.0

2,193.5

2,153.6

Salaries and wages Providers of capital Debenture interest

[11% of £600,000]

Debenture interest

[11% of £550,000]

Discount on debentures

66.0 60.5 4.0

Dividends Preference

[7% of £200,000]

Preference

[7% of £500,000]

Ordinary

[8m at 4.28p]

Ordinary

[10m at 4.69p]

Minority interest


14.0 35.0 342.4 469.0 167.2

144.1

735.7

566.5


Maintenance and expansion of assets Profit before tax

1,437.4

1,156.4

464.7

527.9

Minority interest

167.2

144.1

Dividends

504.0

356.4

Retained profits

301.5

128.0

Depreciation

113.7

98.4

415.2

226.4

Less: Taxation



Chapter 32: Question 2 – David Mark (a)

Your proposal to close the branch is ill advised. Apart from the social implications of closure referred to below, the loss accruing to your organisation based on 20X4 figures would be approximately £2,800 made up as follows: £

Contributions/gross profit lost

£ 95,700

Expenses/costs save: Salaries and wages (all)

78,540

Rates (all)

2,865

Advertising (specified)

1,320

Delivery van expenses (all)

5,280

General expenses assuming all relate to branch

1,188

Telephone (specified)

1,056

Wrapping materials

2,640

Loss if closed

(b)

92,889 2,811

Increased turnover if Peter’s suggestion is followed

To cover £125,500 expenses (including presumably the extra staff required) will need additional gross profit of (125,500 – 111,237) £14,263 thus requiring £ Sales (14,263 × 4) of

57,052

But current expenses of £111,237 are not covered by currently generated gross profit because a loss of £15,537 occurs. If this is to be absorbed then additional turnover is necessary (15,537 × 4) Total additional turnover

62,148 119,200

This assumes that the branch will be expected to absorb existing fixed charges i.e. salary of D. Mark £10,560, advertising £1,320 and telephone of (1,584 – 1,056) £528 and, if demanded, the delivery charge attributable to Arton of £5,280. [Total costs estimated of £125,500 have presumably allowed for additional wages and the van charge; or additional wages, having deducted the van charge. One way or the other the wages figure will have compensated for the van be it a plus or minus. If van is included then wage figure will be incorrectly budgeted in the data of the question, because it should have been excluded.]



Extra part-time workers necessary per formula =

119,200

= 4

30,000

If figures are to be based on costs specific to the branch of £92,889 then the additional turnover will still be £119,200 because Peter’s expenses of £125,500 remain unadjustable for fixed expenses, be they included or excluded, in this solution. i.e. (125,500 – 92,889) × 4 =

130,444

But the 92,889 already includes a contribution of 2,811 via sales (×4) of

11,244

So extra turnover is:

119,200

Or required turnover of 25% gross profit content to generate absorption of Peter’s estimated costs of £125,500 = × 4

= £502,000

Current level per accounts

= £382,800

Additional turnover

= £119,200

(c)

Comments on social implications of closure

1. Loss of a local shopping amenity in village. 2. Inconvenience to local residents travelling to nearest supermarket. 3. Loss of employment for 8 people and loss of the benefit of their disposable income if they are local residents. 4. Impact on family life with parents having to work. Comments on social implications of Peter’s recommendation. This would avoid the problems referred to above.



Chapter 32: Question 3 – Hythe plc (a)

Value added statement – year ended 31 December 20X6 20X6 £000

Turnover Bought-in materials and services

(W1)

Value added

20X5 %

£000

%

5,124

4,604

3,275

2,770

___

1,834

100

1,849

100

Applied in the following way: To pay employees Wages and salaries

(W2)

810

43.8

796

43.4

To pay providers of capital Interest on loans Preference shareholders’ dividend Equity shareholders’ dividend

168

9.1

151

8.2

24

1.3

24

1.3

288

15.6

256

14.0

480

431

To pay government Corporation tax

402

21.7

393

21.4

To provide for maintenance and expansion of assets Depreciation Retained profits

155

8.4

144

7.9

2

0.1

70

3.8 214

157 £1,849 Value added per employee Sales per employee Average earnings per employee

100.0

£1,834

46,225

43,667

128,100

109,619

20,250

18,952


100.0


20X620X5 Workings

£000

£000

2,934

2,482

290

242

Hire of plant and machinery

41

38

Auditors’ remuneration

10

8

3,275

2,770

Wages

607

598

Salaries

203

198

810

796

(1) Bought-in materials and services Materials consumed Fuel consumed

(2) Wages and salaries

(b) A value added statement is a measure of the wealth created by a business. It is the amount of value added by manufacturing, distribution and other businesses to the cost of raw materials, products and services purchased. It shows the total wealth created and how it was distributed, taking into account the amounts retained and reinvested in the group for the replacement of assets and development of operations. Financial statements have been regarded as primarily intended for equity investors whose interest has been focused on profitability, capacity to adapt and solvency. The value added statement has perhaps been seen as of more interest to staff who have had little recognition by standard setters. Even in 2004 when there is a growing interest in social, environmental and ethical issues there is no financial reporting standard relating to human asset accounting in the balance sheet or value added statements. There is a further argument that the data already appears within the existing primary reporting statements and that there is consequently little point in producing yet another statement.



Chapter 32: Question 4 – Gettry Doffit 1 Quantities of chemicals received by the company for disposal on site represent a liability for costs of disposal at the year-end. The work would be undertaken by Gettry Doffit plc on a contractual basis and, clearly, income from contracts (short-term as defined in the original SSAP 9) should not be credited to profit and loss account until the work has been completed i.e. on the completion of the contract. Therefore, it would appear that such quantities should be carried in the balance sheet as a liability at the higher of: (i) invoice cost to the customer or (ii) estimated cost of disposal. Applying these principles to (A) axylotl peroxide and (B) pterodactyl chlorate: Re (A) This contract will give rise to certain revenue of £87,179 i.e. 170 million won @ 1,950 to the £. This is because the invoice value in won has been ‘sold forward’ at the stated rate of the forward contract. It is therefore appropriate, and permissible per SSAP 20, to use the forward rate as the transaction value in the books at all dates, and given such treatment, no exchange differences will arise. There should be a debtor and creditor for this amount in the balance sheet i.e. the debtor for the certain amount receivable should not be dealt with as income until the contract is completed. Any profit arising would be dealt with in the year to 31 March 20X6. Dr Debtors

£87,179

Cr Creditors – accruals and deferred income

£87,179

It is possible that the company could choose as a matter of accounting policy to use rates on the date of the transaction and then retranslate on settlement/balance sheet date giving rise to exchange differences. The alternative numbers arising are dealt with below. The costs incurred up to the year-end will be dealt with as follows Dr Creditors

£60,000

Cr Bank

£60,000

The creditor balance would be debited with the estimated further costs to completion of £15,000 in 20X5/X6 leaving the company with profit of £12,179 in 20X5/X6. Also in 20X5/X6 – 1.5.X5 – the company would receive 170 million won and realise, per the terms of the forward contract, £87,179, thus eliminating the debtor. Had actual rates been used: Dr Debtors 170 million won @ 1,900 =

£89,473

Cr Creditors

£89,473

The balance on creditors in 20X5/X6 will then be a profit of £14,473. However, the debtor would have to be retranslated at the 20X5 year-end – 170 million won @ 2,000 to the £ = £85,000 giving rise to a loss in that year of £4,473. On settlement the debtor will realise £87,179 giving rise to a gain of £2,179.



In total, £14,473 plus £2,179 less £4,473 = £12,179 (as when the forward rate was used to start with) would be credited to profit and loss account, though in this case partly in 20X4/X5 and partly in 20X5/X6. Re (B) As this is disposed of per the terms of this contract, neither a debtor nor a liability arises. The point where revenue should be recognised is the date of processing, and it is clear per the terms of the contract that no loss can arise. The costs of the break-down should therefore be carried forward as work-in-progress, perhaps reduced for the worth of the by-products. 2 The won forward contract has been exhaustively dealt with above. As the contract to buy dollars is to be used to finance trade purchases overseas, the transaction poses no problems provided the dollars will be used to purchase stocks whose realisable amount is greater than (70,000 @ 1.60) = £43,750. Indeed, it would make sense not to reflect such a contract in the accounts, it being more appropriate to disclose the detail under commitments. There are, however, other pertinent points to be made. If the dollars are not to be applied towards a trade purchase, the company would have surplus dollars which may only be converted back to sterling at a loss. Such a loss should be recognised in accordance with the prudence concept, although there may be mitigating factors such as an alternative use for dollars. 3 Given the raising of the irrevocable letter of credit, all that the Nigerian supplier has to do is to ship the goods specified in the letter, present the bill of lading as proof of shipment, and await payment. Thus, the company must pay for goods supplied in accordance with the contract terms, and cannot cancel. Therefore, a liability of (130 – 90)/130 × £65,000 = £20,000 should be recognised immediately, unless a variation can be negotiated with the supplier or an alternative use found for the chemical. 4 The spillage is a post balance sheet event. No liability should be recognised in the accounts unless the going concern concept is threatened. However, the potential liability is so material as to require disclosure under SSAP 17. •

In a normal joint venture the companies trade as partners, with joint and several liability.

•

The precise apportionment of the liability may require a contribution from Dumpet Andrunn plc.

•

If they cannot pay, it is likely that Gettry Doffit plc will have to.

•

The likelihood of a liability crystallising, the likely amount, and any recovery from Dumpet Andrunn plc, must be assessed, and full details given in the notes to the accounts and referred to in the directors’ report. •

As it is likely that the company will resist the claim, the maximum payable should probably be disclosed as a contingent liability.

•

The possibility of an insurance recovery should also be examined.


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