Financial
Reporting
(International Stream)
PART 2
THURSDAY 5 DECEMBER 2002
QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A
This ONE question is compulsory and MUST be
answered
Section B
THREE questions ONLY to be answered
P
Section A – This ONE question is compulsory and MUST be attempted
1
Hydrate is a public company operating in the industrial chemical sector. In order to achieve economies of scale, it has
been advised to enter into business combinations with compatible partner companies. As a first step in this strategy
Hydrate acquired all of the ordinary share capital of Sulphate by way of a share exchange on 1 April 2002. Hydrate
issued five of its own shares for every four shares in Sulphate. The market value of Hydrate’s shares on 1 April 2002
was $6 each. The share issue has not yet been recorded in Hydrate’s books. The summarised financial statements
of both companies for the year to 30 September 2002 are:
Income statement – year to 30 September 2002:
Hydrate
Sulphate
$000
$000
Sales revenue
24,000
20,000
Cost of sales
(16,600)
(11,800)
–––––––
–––––––
Gross profit
7,400
8,200
Operating expenses
(1,600)
(1,000)
–––––––
–––––––
Operating profit
5,800
7,200
Taxation
(2,000)
(3,000)
–––––––
–––––––
Profit after tax
3,800
4,200
–––––––
–––––––
Balance Sheet – as at 30 September 2002
Non-current assets
$000
$000
$000
$000
Property, plant and equipment
64,000
35,000
Investment
nil
12,800
–––––––
–––––––
64,000
47,800
Current Assets
Inventory
22,800
23,600
Accounts receivable
16,400
24,200
Bank
500
39,700
200
48,000
–––––––
–––––––
–––––––
–––––––
Total assets
103,700
95,800
–––––––
–––––––
Equity and liabilities
Ordinary shares of $1 each
20,000
12,000
Reserves:
Share premium
4,000
2,400
Accumulated profits
57,200
61,200
42,700
45,100
–––––––
–––––––
–––––––
–––––––
81,200
57,100
Non-current liabilities
8% Loan note
5,000
18,000
Current liabilities
Accounts payable
15,300
17,700
Taxation
2,200
17,500
3,000
20,700
–––––––
–––––––
–––––––
–––––––
103,700
95,800
–––––––
–––––––
The following information is relevant:
–
The fair value of Sulphate’s investment was $5 million in excess of its book value at the date of acquisition. The
fair values of Sulphate’s other net assets were equal to their book values.
–
Consolidated goodwill is deemed to have a five-year life, with time apportioned charges (treated as an operating
expense) in the year of acquisition.
–
No dividends have been paid or proposed by either company.
Required:
(a) (i)
Prepare the consolidated income statment and balance sheet of Hydrate for the year to
30 September 2002 using the purchase method of accounting (acquisition accounting); and
(13 marks)
(ii) Prepare a consolidated income statement and the consolidated SHAREHOLDERS FUNDS section of the
balance sheet of Hydrate for the year to 30 September 2002 using the uniting of interests method of
accounting (merger accounting).
(7 marks)
(b) Describe the distinguishing feature of a uniting of interests, and discuss whether the business combination
in (a) should be accounted for as a uniting of interests.
(5 marks)
(25 marks)
Section B – THREE questions ONLY to be attempted
2
The following figures have been extracted from the accounting records of Bloomsbury on 30 September 2002:
$000
$000
Sales revenue (note (i))
98,880
Cost of sales
56,000
Joint venture account (note (ii))
1,200
Operating expenses
14,000
Loan interest paid
1,800
Investment income
700
Investment property at valuation
10,000
25-year leasehold factory at cost (note (iii))
50,000
15-year leasehold factory at cost (note (iii))
30,000
Plant and equipment at cost (note (iii))
49,800
Depreciation 1 October 2001 – 25 year leasehold
10,000
Depreciation 1 October 2001
– 15 year leasehold
10,000
Depreciation 1 October 2001
– plant and equipment
19,800
Accounts receivable (note (i))
16,700
Inventory – 30 September 2002
7,500
Cash and bank
500
Accounts payable
9,420
Deferred tax – 1 October 2001 (note (iv))
2,100
Ordinary shares of 25 cents each
40,000
10% Redeemable (in 2005 at par) preference shares of $1 each
10,000
12% Loan note (issued in 2000)
30,000
Accumulated profits – 1 October 2001
6,100
Investment property revaluation reserve – 1 October 2001
2,000
Interim dividends (note (v))
1,500
––––––––
––––––––
239,000
239,000
––––––––
––––––––
The following notes are relevant:
(i)
On 1 January 2002, Bloomsbury agreed to act as a selling agent for an overseas company, Brandberg. The terms
of the agency are that Bloomsbury receives a commission of 10% on all sales made on behalf of Brandberg. This
is achieved by Bloomsbury remitting 90% of the cash received from Brandberg’s customers one month after
Bloomsbury has collected it. Bloomsbury has included in its sales revenue $7·2 million of sales on behalf of
Brandberg of which there is one month’s outstanding balances of $1·2 million included in Bloomsbury’s
accounts receivable. The cash remitted to Brandberg during the year of $5·4 million (i.e. 90% of $6 million) in
accordance with the terms of the agency, has been treated as the cost of the agency sales.
(ii) The joint venture account represents the net balance of Bloomsbury’s transactions in a joint venture with
Waterfront which commenced on 1 October 2001. Each venturer contributes their own assets and pays their
own expenses. The revenues for the venture are shared equally. The joint venture is not a separate entity.
Details of Bloomsbury’s joint venture transactions are:
$000
Plant and equipment at cost
1,500
Share of joint venture sales revenues (50% of total sales revenues)
(800)
Related cost of sales excluding depreciation
400
Accounts receivable
200
Accounts payable
(100)
––––––
Net balance of joint venture account
1,200
––––––
Plant and equipment should be depreciated in accordance with the company’s policy in note (iii).
(iii) On 1 October 2001 Bloomsbury had its two leasehold factories revalued (for the first time) by an independent
surveyor as follows:
25 year leasehold
$52 million
15 year leasehold
$18 million
Bloomsbury depreciates its leaseholds on a straight-line basis over the life of the lease.
The directors of Bloomsbury are disappointed in the value placed on the 15-year leasehold. The surveyor has
said that the fall in its value is due mainly to its unfavourable location, but in time the surveyor expects its value
to increase. The directors are committed to incorporating the revalued amount of the 25-year leasehold into the
financial statements, but wish to retain the historic cost basis for the 15-year leasehold. Revaluation surpluses
are transferred to accumulated realised profits in line with the realisation of the related assets.
Prior to the current year, Bloomsbury had adopted a policy of carrying its investment property at fair value, with
the surplus being credited to reserves. For the current year it will be applying the fair value method of accounting
for investment properties in IAS 40 ‘Investment Property’. The value of the investment property had increased by
a further $500,000 in the year to 30 September 2002.
Plant and equipment is depreciated at 20% per annum on the reducing balance basis.
(iv) A provision for income tax for the year to 30 September 2002 of $5 million is required. Temporary differences
(related to the difference between the tax base of the plant and its balance sheet written down value) on
1 October 2001 were $7 million and on 30 September 2002 they had declined to $5 million. Assume a tax rate
of 30%. Ignore deferred tax on the property revaluations.
(v) The interim dividends paid include half of the full year’s preference dividend. On 25 September 2002 the
directors declared a final ordinary dividend of 3 cents per share.
Required:
Prepare the financial statements for the year to 30 September 2002 for Bloomsbury in accordance with
International Accounting Standards as far as the information permits. They should include:
–
An Income Statement;
(9 marks)
–
A Statement of Changes in Equity; and
(3 marks)
–
A Balance Sheet.
(13 marks)
Notes to the financial statements are not required.
(25 marks)
3
The principle of recording the substance or economic reality of transactions rather than their legal form lies at the heart
of the Framework for Preparation and Presentation of Financial Statements’ (Framework) and several International
Accounting Standards. The development of this principle was partly in reaction to a minority of public interest
companies entering into certain complex transactions. These transactions sometimes led to accusations that company
directors were involved in ‘creative accounting’.
Required:
(a) (i)
Explain, with relevant examples, what is generally meant by the term ‘creative accounting’; (5 marks)
(ii) Explain why it is important to record the substance rather than the legal form of transactions and
describe the features that may indicate that the substance of a transaction is different from its legal
form.
(5 marks)
(b) (i)
Atkins’s operations involve selling cars to the public through a chain of retail car showrooms. It buys most
of its new vehicles directly from the manufacturer on the following terms:
–
Atkins will pay the manufacturer for the cars on the date they are sold to a customer or six months after
they are delivered to its showrooms whichever is the sooner.
–
The price paid will be 80% of the retail list price as set by the manufacturer at the date that the goods
are delivered.
–
Atkins will pay the manufacturer 1·5% per month (of the cost price to Atkins) as a ‘display charge’ until
the goods are paid for.
–
Atkins may return the cars to the manufacturer any time up until the date the cars are due to be paid
for. Atkins will incur the freight cost of any such returns. Atkins has never taken advantage of this right
of return.
–
The manufacturer can recall the cars or request them to be transferred to another retailer any time up
until the time they are paid for by Atkins.
Required:
Discuss which party bears the risks and rewards in the above arrangement and come to a conclusion on how
the transactions should be treated by each party.
(6 marks)
(ii) Atkins bought five identical plots of development land for $2 million in 1999. On 1 October 2001 Atkins
sold three of the plots of land to an investment company, Landbank, for a total of $2·4 million. This price
was based on 75% of the fair market value of $3·2 million as determined by an independent surveyor at
the date of sale. The terms of the sale contained two clauses:
–
Atkins can re-purchase the plots of land for the full fair value of $3·2 million (the value determined at
the date of sale) any time until 30 September 2004; and
–
On 1 October 2004, Landbank has the option to require Atkins to re-purchase the properties for $3·2
million. You may assume that Landbank seeks a return on its investments of 10% per annum.
Required:
Discuss the substance of the above transactions; and
(3 marks)
Prepare extracts of the income statement and balance sheet (ignore cash) of Atkins for the year to
30 September 2002:
–
if the plots of land are considered as sold to Landbank; and
(2 marks)
–
reflecting the substance of the above transactions.
(4 marks)
(25 marks)
This is a blank page.
Question 4 begins on page 8.
8
4
The financial statements of Nedberg for the year to 30 September 2002, together with the comparative balance sheet
for the year to 30 September 2001 are shown below:
Income Statement – year to 30 September 2002:
$m
$m
Sales revenue
3,820
Cost of sales (note (1))
(2,620)
––––––
Gross profit for period
1,200
Operating expenses (note (1))
(300)
––––––
900
Interest – Loan note
(30)
––––––
Profit before tax
870
Taxation
(270)
––––––
Net profit for the period
600
Dividends: ordinary – Interim
(120)
Dividends: ordinary
– Final
(280)
(400)
–––––
–––––
Net profit for period
200
–––––
Balance sheets as at 30 September:
2002
2001
Non-current assets
$m
$m
$m
$m
Property, plant and equipment
1,890
1,830
Intangible assets (note (2))
650
300
––––––
––––––
2,540
2,130
Current assets
Inventory
1,420
940
Accounts receivable
990
680
Cash
70
2,480
nil
1,620
––––––
––––––
––––––
––––––
Total assets
5,020
3,750
––––––
––––––
Equity and liabilities
Ordinary Shares of $1 each
750
500
Reserves
Share premium
350
100
Revaluation
140
nil
Accumulated profits
2,010
1,700
Less dividends paid and declared
(400)
1,610
(300)
1,400
––––––
––––––
––––––
––––––
2,850
2,000
Non-current liabilities (note (3))
870
540
Current liabilities (note (4))
1,300
1,210
––––––
––––––
Total equity and liabilities
5,020
3,750
9
[P.T.O.
Notes to the financial statements:
(1) Cost of sales includes depreciation of property, plant and equipment of $320 million and a loss on the sale of
plant of $50 million. It also includes a credit for the amortisation of government grants. Operating expenses
include a charge of $20 million for the amortisation of goodwill.
(2) Intangible non-current assets:
2002
2001
$m
$m
Deferred development expenditure
470
100
Goodwill
180
200
––––
––––
650
300
––––
––––
(3) Non-current liabilities:
10% loan note
300
100
Government grants
260
300
Deferred tax
310
140
––––
––––
870
540
––––
––––
(4) Current liabilities:
Accounts payable
875
730
Bank overdraft
nil
115
Accrued loan interest
15
5
Declared dividends unpaid
280
200
Taxation
130
160
–––––
–––––
1,300
1,210
–––––
–––––
The following additional information is relevant:
(i)
Intangible fixed assets:
The company successfully completed the development of a new product during the current year, capitalising a
further $500 million before amortisation charges for the period.
(ii) Property, plant and equipment/revaluation reserve:
–
The company revalued its buildings by $200 million on 1 October 2001. The surplus was credited to a
revaluation reserve.
–
New plant was acquired during the year at a cost of $250 million and a government grant of $50 million
was received for this plant.
–
On 1 October 2001 a bonus issue of 1 new share for every 10 held was made from the revaluation reserve.
–
$10 million has been transferred from the revaluation reserve to realised profits as a year-end adjustment
in respect of the additional depreciation created by the revaluation.
–
The remaining movement on property, plant and equipment was due to the disposal of obsolete plant.
(iii) Share issues:
In addition to the bonus issue referred to above Nedberg made a further issue of ordinary shares for cash.
Required:
(a) A cash flow statement for Nedberg for the year to 30 September 2002 prepared in accordance with
IAS 7 ‘Cash Flow Statements’.
(20 marks)
(b) Comment briefly on the financial position of Nedberg as portrayed by the information in your cash flow
statement.
(5 marks)
10
5
You are a partner in a small audit and accounting practice. You have just completed the audit and finalised the
financial statements of a small family owned company in discussion with its managing director Mrs Harper. After the
meeting Mrs Harper has asked for your help. She has obtained the published financial statements of several quoted
companies in which she is considering buying some shares as a personal investment. She presents you with the
following information:
(a) In the year to 30 September 2002, two companies, Gamma and Toga, reported identical profits before tax of
$100 million. Information in the Chairmen’s reports said both companies also expected profits from their core
activities (to be interpreted as from continuing operations) to grow by 10% in the following year. Mrs Harper has
extracted information from the income statements and made the following summary:
Gamma
Toga
Operating profit:
$ million
$ million
Continuing activities
70
90
Acquisitions
nil
50
Discontinued activities
30
(40)
–––
–––
100
100
–––
–––
A note to the financial statements of Toga said that both the discontinuation and acquisition occurred on
1 April 2002 and were part of an overall plan to focus on its traditional core activities after incurring large losses
on a new foreign venture.
Required:
(i)
Briefly explain to Mrs Harper why information on discontinued operations is useful;
(3 marks)
(ii) Calculate the expected operating profit for both companies for the year to 30 September 2003
(assuming the Chairmen’s growth forecasts are correct):
–
in the absence of information of the discontinued operations; and
–
based on the information provided above.
(4 marks)
(b) Taylor is another company about which Mrs Harper has obtained the following information from its published
financial statements:
Earnings per share:
Year to 30 September
2002
2001
Basic earnings per share
25 cents
20 cents
The earnings per share is based on attributable earnings of $50 million ($30 million in 2001) and 200 million
ordinary shares in issue throughout the year (150 million weighted average number of ordinary shares in 2001).
Balance sheet extracts:
$ million
$ million
8% Convertible loan stock
200
200
The loan stock is convertible to ordinary shares in 2004 on the basis of 70 new shares for each $100 of loan
stock.
Note to the financial statements:
There are directors’ share options (in issue since 1999) that allow Taylor’s directors to subscribe for a total of
50 million new ordinary shares at a price of $1·50 each.
(Assume the current rate of income tax for Taylor is 25% and the market price of its ordinary shares throughout
the year has been $2·50)
Mrs Harper has read that the trend of the earnings per share is a reliable measure of a company’s profit trend.
She cannot understand why the increase in profits is 67% ($30 million to $50 million), but the increase in the
earnings per share is only 25% (20 cents to 25 cents). She is also confused by the company also quoting a
diluted earnings per share figure, which is lower than the basic earnings per share.
11
Required:
(i)
Explain why the trend of earnings per share may be different from the trend of the reported profit, and
which is the more useful measure of performance;
(3 marks)
(ii) Calculate the diluted earnings per share for Taylor based on the effect of the convertible loan stock and
the directors’ share options for the year to 30 September 2002 (ignore comparatives); and
(5 marks)
(iii) Explain the relevance of the diluted earnings per share measure.
(4 marks)
(c) Mrs Harper has noticed that the tax charge for a company called Stepper is $5 million on profits before tax of
$35 million. This is an effective rate of tax of 14·3%. Another company Jenni has an income tax charge of $10
million on profit before tax of $30 million. This is an effective rate of tax of 33·3% yet both companies state the
rate of income tax applicable to them is 25%. Mrs Harper has also noticed that in the cash flow statements each
company has paid the same amount of tax of $8 million.
Required:
Advise Mrs Harper of the possible reasons why the income tax charge in the financial statements as a percentage
of the profit before tax may not be the same as the applicable income tax rate, and why the tax paid in the cash
flow statement may not be the same as the tax charge in the income statement.
(6 marks)
(25 marks)
15
Part 2 Examination – Paper 2.5(INT)Financial Reporting (International Stream) December 2002 Answers
1 (a) (i) Using the purchase (acquisition) method of accounting.
Hydrate – Consolidated Income Statement – year to 30 September 2002
$000 Sales revenue (24,000 + (6/ 12x 20,000)) 34,000 Cost of sales (16,600 + (6/ 12x 11,800)) (22,500) ––––––– Gross profit 11,500 Operating expenses (1,600 + (6/
12x 1,000) + 3,000 goodwill depreciation (w (ii))) (5,100)
––––––– 6,400
Taxation (2,000 + (6/
12x 3,000)) (3,500)
–––––––
Profit for the year 2,900
––––––– Consolidated balance sheet at 30 September 2002:
Non-current assets $000 $000
Property, plant and equipment (64,000 + 35,000) 99,000
Investments (12,800 + 5,000 fair value adjustment) 17,800
Goodwill (30,000 – 3,000 (w (ii))) 27,000 –––––––– 143,800 Current Assets Inventory (22,800 + 23,600) 46,400 Accounts receivable (16,400 + 24,200) 40,600 Bank (500 + 200) 700 87,700 ––––––– ––––––– Total assets 231,500 ––––––– Equity and liabilities:
Ordinary shares of $1 each (20,000 + 15,000 (w (ii))) 35,000
Reserves:
Share premium (4,000 + 75,000 (w (ii))) 79,000
Accumulated profits (w (i)) 56,300 135,300
––––––– –––––––– 170,300 Non-current liabilities 8% Loan notes (5,000 + 18,000) 23,000 Current liabilities Accounts payable (15,300 + 17,700) 33,000 Taxation (2,200 + 3,000) 5,200 38,200 ––––––– ––––––– 231,500 –––––––
(ii) Using the uniting of interest (merger) method of accounting.
Hydrate – Consolidated Income Statement – year to 30 September 2002
Sales revenue (24,000 + 20,000) 44,000 Cost of sales (16,600 + 11,800) (28,400) ––––––– Gross profit 15,600 Operating expenses (1,600 + 1,000) (2,600) ––––––– 13,000 Taxation (2,000 + 3,000) (5,000) –––––––
Profit for the year 8,000
––––––– Hydrate – Share capital and reserves as at 30 September 2002:
$000 $000
Ordinary shares of $1 each (20,000 + 15,000 (w (ii))) 35,000
Reserves:
Share premium 4,000
Capital reserve (reclassification of Sulphate’s share premium) 2,400
Accumulated profits (w (iii))) 96,900 103,300
––––––– ––––––––
138,300 ––––––––
16
(b) The distinguishing features of a uniting of interests are:
– It is not possible to identify an acquirer. Instead of a dominant party, the shareholders of the joining entities unite in a
substantially equal arrangement to share control over the combined entity.
– All parties to the combination participate in the management of the combined business.
– The sizes of the combining entities should be broadly similar leading to a substantially equal exchange of voting common
shares. This should ensure that no one party is in a position to dominate the combined business due to its previous relative size.
– There must not be a significant reduction in the rights attaching to the shares of one of the combining parties, as this
would weaken the position of that party. The above is generally evidenced by:
– The substantial majority of (if not all) of the voting shares of the combining parties are exchanged or pooled.
– The fair value of one entity is not significantly different from that of the other parties.
– The shareholders of each party maintain substantially the same voting rights and interests, relative to each other, in the
combined entity.
– No party’s share of the equity of the combining entities should depend on the performance of their previous business.
In effect, all parties must share fairly (i.e. in proportion to their previous holdings) in the future prosperity (or otherwise) of the whole of the combined business.
It is not possible to be absolutely certain from the limited information given in the question whether all of the above criteria for a uniting of interest have been satisfied, but it does appear likely. The following observations can be made:
– Although Hydrate is acting on a strategy of acquisition to achieve economies of scale, the use of the phrase ‘compatible
partner companies’ may be indicative of a uniting of interests rather than an acquisition approach.
– The sizes of the companies are broadly similar (20,000 : 15,000 shares). There is no guidance in IAS 22 ‘Business
Combinations’ of how the term ‘substantially equal’ should be interpreted.
– The consideration is all in the form of equity and satisfies the share exchange criterion.
– The composition of the new management and whether all shares rank equally would need to be determined from the
details and terms of the combination agreement. Workings
Acquisition accounting:
(i) Consolidated accumulated profits: $000s
Hydrate’s reserves per question 57,200
Sulphate’s post acquisition reserves (6/
12x 4,200) 2,100
Goodwill amortisation (see below) (3,000)
––––––– 56,300 –––––––
(ii) Goodwill/Cost of control in Sulphate:
Hydrate issued 5 shares for every 4 in Sulphate. Therefore Hydrate issued 15 million (12 million/4 x 5) shares at a value of $6 each to the shareholders of Sulphate. This would be recorded in Hydrate’s books as ordinary share capital of $15 million and share premium of $75 million.
$000s $000s
Investment at cost (15 million x $6) 90,000
Less – ordinary shares of Sulphate 12,000
Less – share premium 2,400
Less – pre-acquisition reserves (42,700 – 2,100 see (i)) 40,600
Less– revaluation of investment 5,000 (60,000)
––––––– –––––––
Goodwill on consolidation 30,000
–––––––
Amortisation of goodwill for the year to 30 September 2002 will be $30 million/5 years x 6/
12= $3 million
(iii) Uniting of interests:
A feature of a uniting of interests is that most, if not all, of the subsidiary’s reserves will be included as group reserves.
For Hydrate the consolidated reserves will be: $000
Hydrate’s reserves per question 57,200
Sulphate’s reserve per question 42,700
Adjustment re share capital (15,000 issued – 12,000 acquired) (3,000)
–––––––
Accumulated profits at 30 September 2002 96,900
17
2 Bloomsbury Income Statement – Year to 30 September 2002
$000 $000
Sales revenue (98,880 – 7,200 (w (i)) + 800 (w (ii))) 92,480
Cost of sales (w (i)) (61,700)
–––––––
Gross profit 30,780
Other operating income:
Agency commission (w (i)) 720
Investment income – surplus on investment property (iii) 500
Invement ince– other 700 1,200
––––
Operating expenses (14,000)
Loss on revaluation of property (w (iii)) (2,000)
Loan interest (1,800 + 1,800 accrued) (3,600)
Preference dividends (500 + 500 accrued (w (v))) (1,000) (20,600)
––––––– –––––––
Operating profit 12,100
Taxation (5,000 – 600 deferred tax (w (iv))) (4,400)
–––––––
Net profit for the period 7,700
––––––– Bloomsbury – Statement of Changes in Equity – Year to 30 September 2002
Share capital Revaluation Investment Accumulated Total
reserve prop. revaln profits
$000 $000 $000 $000 $000
Balance at 1 October 2001 40,000 nil 2,000 6,100 48,100
Surplus on revaluation of property (w (iii)) 12,000 12,000
Net profit for the period 7,700 7,700
Ordinary dividends (w (v)) (5,800) (5,800)
Transfer to realised profits (w (iii)) (600) (2,000) 2,600 nil
–––––– –––––– –––––– –––––– ––––––
Balance at 30 September 2002 40,000 11,400 nil 10,600 62,000
–––––– –––––– –––––– –––––– ––––––
Bloomsbury – Balance Sheet as at 30 September 2002
Tangible non-current assets $000 $000
Property, plant and equipment (w (iii)) 90,800
Investments – investment property (10,000 + 500 revaluation) 10,500
–––––––– 101,300 Current Assets
Inventory 7,500
Accounts receivable (16,700 – 1,200 + 120 (w (i)) + 200 (w (ii))) 15,820
Cash 500 23,820
––––––– –––––––
Total Assets 125,120
–––––––– Equity and liabilities:
Ordinary shares of 25 cents each 40,000
Reserves:
Accumulated profits ((b) above) 10,600
Revaluation reserve (12,000 – 600 (w (iii))) 11,400 22,000
––––––– –––––––
62,000
Non-current liabilities (w (vii)) 41,500
Current liabilities
Trade and other payables (w (vi)) 11,820
Taxation 5,000
Proposed dividends (w (v)) 4,800 21,620
–––––– ––––––––
Total equity and liabilities 125,120
18
Workings
(i) Cost of sales: $000 $000
Per question 56,000
Brandberg adjustment – see below (5,400)
Depreciation – leaseholds (w (iii)) 4,400
Depreciation – plant and equipment (w (iii)) 6,300 10,700
––––––
Joint venture expenses (see (ii)) 400
––––––– 61,700 –––––––
The company’s treatment of the transactions in relation to the agreement with Brandberg is incorrect. Bloomsbury has treated the sales and expenses as if they were its own sales rather than acting as an agent and receiving commission. The entries required to correct the error are:
Dr Cr
Sales revenue 7,200
Cost of sales 5,400
Accounts receivable 1,200
Commission receivable (10% x $7·2 million) 720
Due from Brandberg (Accounts receivable) 120
–––––– ––––––
7,320 7,320
–––––– ––––––
(ii) The joint venture with Waterfront qualifies to be treated under IAS 31 ‘Financial Reporting of Interests in Joint Ventures’ as a
jointly controlled operation. The Standard requires that each party should account for its own assets, liabilities and results according to the terms of the agreement. Thus Bloomsbury transactions with the joint venture will be treated as if they were Bloomsbury’s own transactions and included in the appropriate line items together with other similar transactions e.g. sales revenues will include $800,000 in respect of the joint venture.
(iii) Tangible non-current assets – leaseholds
Where a company chooses to revalue a non-current asset, it must revalue all the assets of the same class. Thus, in this case, Bloomsbury must recognise the fall in the value of the 15-year leasehold factory.
25-year leasehold – revaluation surplus is $12 million (52m – (50m – 10m)) 15-year leasehold – revaluation deficit is $2 million (18m – (30m – 10m)
The revaluation loss must be charged to income; it cannot be offset against the surplus on the 25-year leasehold. A transfer from the revaluation reserve to retained profits must be made. This will represent the partial realisation of the surplus on the 25-year leasehold. It is realised at $600,000 per annum ($12 million/20 years) in line with the remaining life of the leasehold.
The balance sheet values of the properties will be:
at revalued amount depreciation NBV
$000 $000 $000 25-year leasehold 52,000 2,600 49,400 15-year leasehold 18,000 1,800 16,200 ––––––– –––––– ––––––– 70,000 4,400 65,600 ––––––– –––––– –––––––
The accumulated depreciation on the 25-year leasehold of $10,000 represents five years’ depreciation, thus after its revaluation it would have a remaining life of 20 years. A similar exercise with the 15-year leasehold gives a remaining life of 10 years. These figures are used to calculate the depreciation charges, which are charged to cost of sales.
Investment property
Under IAS 40 movements in the fair value of investment properties must be taken to income. Also on the first adoption of the Standard any previous surplus on an investment property revaluation reserve is transferred to realised profits.
Plant and equipment:
The plant used as part of the joint venture is included with other plant: $000
Plant at cost (49,800 + 1,500 joint venture) 51,300
Accumulated depreciation 1 October 2001 (19,800)
–––––––
Net book value before depreciation for year 31,500
Depreciation for year (charged to cost of sales) (20% x 31,500) (6,300)
–––––––
Net book value at 30 September 2002 25,200
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(iv) As the temporary differences have fallen by $2 million this will cause a reversal of deferred tax of $2 million x 30% = $600,000. This will reduce the tax charge for the year and the deferred tax balance will be $2,100,000 – $600,000 = $1,500,000.
(v) The interim dividends are half of the preference dividend of $500,000 (10% x $10 million x 6/
12) and the balance must be
an interim ordinary dividend of $1 million. The final proposed dividend is another $500,000 preference and $4·8 million ordinary (40 million x 4 x 3 cents). Under IAS 32 ‘Financial Instruments: Disclosure and Presentation’ redeemable preference shares have the characteristics of debt and must be treated as such. The preference dividends will be treated as interest costs and the shares will appear under non-current liabilities, not equity.
(vi) Current liabilities
Accounts payable per question 9,420
Joint venture creditor 100
Accrued loan interest 1,800
Accrued preference dividend 500
––––––– 11,820 ––––––– (vii) Non-current liabilities
12% Loan note 30,000
10% Redeemable preference shares (w (v)) 10,000
Deferred tax (2,100 – 600 (w (iv))) 1,500
––––––– 41,500 –––––––
3 (a) (i) Creative accounting is a term in general use to describe the practice of applying inappropriate accounting policies or
entering into complex or ‘special purpose’ transactions with the objective of making a company’s financial statements appear to disclose a more favourable position, particularly in relation to the calculation of certain ‘key’ ratios, than would otherwise be the case. Most commentators believe creative accounting stops short of deliberate fraud, but is nonetheless undesirable as it is intended to mislead users of financial statements.
Probably the most criticised area of creative accounting relates to off balance sheet financing. This occurs where a company has financial obligations that are not recorded on its balance sheet. There have been several examples of this in the past:
– finance leases treated as operating leases
– borrowings (usually convertible loan stock) being classified as equity
– secured loans being treated as ‘sales’ (sale and repurchase agreements)
– the non-consolidation of ‘special purpose vehicles’ (quasi subsidiaries) that have been used to raise finance
– offsetting liabilities against assets (certain types of accounts receivable factoring)
The other main area of creative accounting is that of increasing or smoothing profits. Examples of this are:
– the use of inappropriate provisions (this reduces profit in good years and increases them in poor years)
– not providing for liabilities, either at all or not in full, as they arise. This is often related to environmental provisions,
decommissioning costs and constructive obligations.
– restructuring costs not being charged to income (often related to a newly acquired subsidiary – the costs are
effectively added to goodwill)
It should be noted that recent International Accounting Standards have now prevented many of the above past abuses, however more recent examples of creative accounting are in use by some of the new Internet/Dot.com companies. Most of these companies do not (yet) make any profit so other performance criteria such as site ‘hits’, conversion rates (browsers turning into buyers), burn periods (the length of time cash resources are expected to last) and even sales revenues are massaged to give a more favourable impression.
(ii) One of the primary characteristics of financial statements is reliability i.e. they must faithfully represent the transactions
and other events that have occurred. It can be possible for the economic substance of a transaction (effectively its commercial intention) to be different from its strict legal position or ‘form’. Thus financial statements can only give a faithful representation of a company’s performance if the substance of its transactions is reported. It is worth stressing that there will be very few transactions where their substance is different from their legal form, but for those where it is, they are usually very important. This is because they are material in terms of their size or incidence, or because they may be intended to mislead.
20
Common features which may indicate that the substance of a transaction (or series of connected transactions) is different from its legal form are:
– Where the ownership of an asset does not rest with the party that is expected to experience the risks and reward
relating to it (i.e. equivalent to control of the asset).
– Where a transaction is linked with other related transactions. It is necessary to assess the substance of the series
of connected transactions as a whole.
– The use of options within contracts. It may be that options are either almost certain to be (or not to be) exercised.
In such cases these are not really options at all and should be ignored in determining commercial substance.
– Where assets are sold at values that differ from their fair values (either above or below fair values).
Many complex transactions often contain several of the above features. Determining the true substance of transactions can be a difficult and sometimes subjective procedure.
(b) (i) This is an example of consignment inventory. From Atkins’s point of view the main issue is whether or at what point in
time the goods have been purchased and should therefore be recognised. As is often the case in these types of agreement there is conflicting evidence as to which party bears the risks and rewards relating to the vehicles. The manufacturer retains the legal right of ownership until the goods are paid for by Atkins. Consistent with this the manufacturer also has the right to have the goods returned or passed on to another supplier. The fact that Atkins may choose to return the goods to the manufacturer is also indicative that the manufacturer is exposed to the risk of obsolescence or falling values. These factors would seem to suggest that the vehicles have not been sold and should therefore remain in the inventory of the manufacturer and not be recognised in the accounting records of Atkins. There are, however, some contrary indications to this view. The price for the goods is fixed as of the date of transfer, not the date that they are deemed ‘sold’. This means that Atkins is protected from any price increases by the manufacturer. The 1·5% paid to the manufacturer appears to be in substance a finance charge, despite it being described as a ‘display charge’. A finance charge indicates that Atkins must have a liability to the manufacturer; in effect this liability is the account payable in respect of the cost of the vehicles. Although Atkins has a right of return, it cannot exercise this without a cost. There is an explicit freight cost, but this may not be the only cost. It could well be that Atkins may suffer poor future supplies from the manufacturer if it does return goods. The question says that Atkins has never taken advantage of this option, which would seem to suggest that it should be ignored.
Conclusion:
The substance of this transaction appears to suggest that the goods have been purchased by Atkins and the company is paying a finance cost. Therefore the vehicles should be recognised on Atkins’s balance sheet, together with the respective liability. It would seem logical that if Atkins considers the goods as purchased, then the manufacturer should consider them as sold. The problem is that prudence may prevent the manufacturer from recognising the profit on the sale, as the period for the right to return the goods has not expired. Therefore, either the sales are not recognised by the manufacturer (the goods would remain in its inventory), or if they are, a provision should be made in respect of the unrealised profits. This could lead to the unusual situation that the goods may appear on both companies’ balance sheets.
(ii) Although the question says that Atkins has sold the land to Landbank and even though there will be a legal transfer of
the land, the substance of this transaction is that of a secured loan. The two clauses in combination mean that in practice Atkins will repurchase the land on or before 1 October 2004. This is because if its value is above $3·2 million Atkins will exercise its option to purchase, conversely if the value is below $3·2 million Landbank plc will exercise its option to require a repurchase. Either way Atkins will repurchase the land. When this is understood it becomes clear that the difference between the ‘sale’ price of $2·4 million and the repurchase price of $3·2 million represents a finance charge on a secured loan.
Assuming the land is sold:
Income statement – year to 30 September 2002 $ $
Sales 2,400,000
Cost of sales (3/
5x $2 million) 1,200,000
––––––––––
Profit on sale of land 1,200,000
Balance sheet as at 30 September 2002 Non-current assets
Development land ($2 million – $1·2 million above) 800,000
Assuming the arrangement is secured loan: Income statement – year to 30 September 2002
Interest on loan (240,000)
(10% of in substance loan of $2·4 million) Balance sheet as at 30 September 2002 Non-current assets
Development land at cost 2,000,000
Non-current liabilities
Secured loan 2,400,000
Accrued interest 240,000 (2,640,000)
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4 Cash Flow Statement of Nedberg for the Year to 30 September 2002:
Cash flows from operating activities $m $m
Net profit before interest and tax 900
Adjustments for:
Amortisation – development expenditure (w (i)) 130
Amortisation– goodwill (200 – 180) 20 150
–––
Depreciation – property, plant and equipment 320
Amortisation of government grant (w (ii)) (90)
Loss on sale of plant 50
Increase in inventory (1,420 – 940) (480)
Increase in accounts receivable (990 – 680) (310)
Increase in accounts payable (875 – 730) 145
––––
Cash generated from operations 685
Interest paid (30 – (15 – 5 accrual adjustments)) (20)
Income tax paid (w (iii)) (130)
––––
Net cash from operating activities 535
Cash flows from investing activities
Purchase property, plant and equipment (w (iv)) (250)
Capitalised development costs (w (i)) (500)
Receipt of government grant 50
Proceeds of sale of plant (w (iv)) 20
Net cash from operating activities –––– (680)
Cash flows from financing activities
Issue of ordinary shares (w (v)) 450
Issue of loan notes (300 – 100) 200
Dividends paid (200 final for 2001 + 120 interim for 2002) (320)
––––
Net cash generated from financing activities 330
––––
Net increase in cash and cash equivalents 185
Cash and cash equivalents at beginning of period (115)
––––
Cash and cash equivalents at end of period 70
–––– Workings
(i) Development expenditure:
Balance b/f 100
Amount capitalised 500
Amortisation – balancing figure (130)
––––
Balance c/f 470
––––
(ii) Government grant:
Balance b/f 300 Cash received 50 Amortisation (90) –––– Balance c/f 260 –––– (iii) Income tax:
Tax provision b/f 160
Deferred tax b/f 140
Charged to income statement 270
Tax provision c/f (130)
Deferred tax c/f (310)
––––
Difference cash paid 130
22
$m $m
(iv) Property, plant and equipment:
Balance b/f 1,830
Revaluation surplus 200
Plant acquired 250
Depreciation (320)
Disposal at net book value – balancing figure (70)
–––––
Balance c/f 1,890
––––– Disposal of plant:
Net book value from above 70
Loss on sale (from question) (50)
–––
Difference is sale proceeds 20
–––
(v) Share capital:
Ordinary shares b/f (500)
Bonus issue 1 for 10 (from revaluation reserve) (50)
Ordinary shares c/f 750
––––
Difference issue for cash 200
Plus increase in share premium (350 – 100) 250
––––
Total cash proceeds of issue of ordinary shares 450
–––– (vi) Reconciliation of reserve movements
Revaluation reserve:
Balance b/f nil
Revaluation of buildings 200
Bonus issue (50)
Transfer to realised profits (10)
––––
Balance c/f 140
–––– Accumulated profits:
Balance b/f 1,400
Net profit for period 600
Dividends – paid (120)
Dividends – declared (280) (400)
–––––
Transfer from revaluation reserve 10
––––––
Balance c/f 1,610
––––––
(b) The cash flows generated from operations of $685 million are relatively healthy and more than adequate to pay the interest
costs and taxation, but not as large as the equivalent profit figure. For most companies the operating cash flows tend to be higher than the profit before interest and tax due to the effects of depreciation/amortisation charges (which are not cash flows). In the case of Nedberg the depreciation/amortisation effect has been more than offset by a much higher investment in working capital of $645 million. Inventory has increased by over 50% and accounts receivable by 45%. This may be an indication of expanding activity, but it could also be an indication of poor inventory management policy and poor credit control, or even the presence of some obsolete inventory or unprovided bad accounts receivables.
A cause of concern is the size of the dividends, at $400 million they represent 67% of the profit for the period and cash flows for dividends (last year’s final plus this year’s interim) are also high at $320 million. This is a very high distribution ratio, and it seems curious that the company is returning such large amounts to shareholders at the same time as they are raising finance. $450 million has been received from the issue of new shares and $200 million from a further issue of loan notes. The company has invested considerably in new plant ($250 million) and even more so in development expenditure ($500 million). If management has properly applied the capitalisation criteria in IAS 38 ‘Intangible Assets’, then this indicates that they expect good future returns from the investment in new products or processes. The net investment in non-current assets is $680 million which closely correlates to the proceeds from financing of $650 million. In general it is acceptable to finance increases in the capacity of non-current assets by raising additional finance, however operating cash flows should finance replacement of consumed fixed assets.
23
5 (a) (i) The requirement in IAS 35 ‘Discontinuing Operations’ to provide an analysis between continuing and discontinuing
operations is intended to improve the predictive usefulness of financial statements. In essence there can be no more important information when trying to assess the future performance of a company than to know which parts of it are continuing their operations and those which have ceased or been sold or are about to be in the near future. Only the results of continuing operations should be used in forecasting future results; profits or losses from discontinuing operations will not be repeated.
Information on discontinued operations can also help to assess management’s strategy. One would expect loss-making activities to be sold or closed down, but selling a profitable activity may indicate that a company has liquidity or debt problems.
(ii) If no information on continuing and discontinuing activities were available then the best estimate of the future profit of
both companies would be $110 million (i.e. $100 million x 110%) Utilising the available information, a very different picture emerges:
Gamma Toga
$ million $ million
Forecast profit 77 209
Gamma’s forecast is based on profit from continuing activities of $70 million increasing by 10% to $77 million. Toga’s forecast is also based on its continuing activities, but it is in two parts. The ‘existing’ activities that made profits of $90 million would be expected to produce profits of $99 million in 2003. Its newly acquired activities would be expected to produce profits of $110 million. The latter figure is based on the $50 million profit in 2002 being for only six months, a full year would have presumably yielded $100 million. In 2003 this would increase by 10% to $110 million.
(b) (i) The trend shown by a comparison of a company’s profits over time is rather a ‘raw’ measure of performance and can
be misleading without careful interpretation of all the events that the company has experienced. In the year to 30 September 2002, Taylor’s eps has increased by 25% (from 20 cents to 25 cents), whereas its profit has increased by a massive 67% (from $30 to $50 million). It is not possible to determine exactly what has caused the difference between the percentage increase in the eps and the percentage increase in the reported profit of Taylor, but a simpler example may illustrate a possible explanation. Assume company A acquired company B by way of a share exchange. Both companies had the same market value and the same profits. A comparison of A’s post combination profits with its pre-combination profits would be very misleading. They would have appeared to double. This is because the post combination figures incorporate both companies’ results, whereas the pre-combination profits would be those of company A alone (assuming it is not accounted for as a uniting of interest). The trend shown by the earnings per share goes some way to addressing such distortion. In the above the increase in post combination profit would also be accompanied by an increase in the issued share capital (due to the share exchange) thus the reported eps of company A would not be distorted by its acquisitive growth. It can therefore be argued that the trend of a company’s eps is a more reliable measure of its earnings performance than the trend shown by its reported profits.
(ii) Both the convertible loan stock and the directors’ share options will give rise to dilution:
8% Loan stock – on conversion there will be 140 million new shares (200 million x 70/100) The interest saved, net of tax at 25%, will be $12 million ($200 million x 8% x 75%)
The directors’ share options will yield income of $75 million (50 million x $1·50). At the market price of $2·50 this would be sufficient to purchase 30 million shares. As the options are for 50 million shares the dilutive effect of the options is 20 million shares.
Diluted eps year to 30 September 2002:
Earnings $62 million (basic $50 million + $12 million re loan stock)
Number of shares 360 million (basic 200 million + 140 million re loan stock + 20 million re options)
Diluted eps 17·2 cents
(iii) The relevance of the diluted earnings per share measure is that it highlights the problem of relying too heavily on a
company’s basic eps when trying to predict future performance. There can exist certain circumstances which may cause future eps to be lower than current levels irrespective of future profit performance. These are said to cause a dilution of the eps. Common examples of diluting circumstances are the existence of convertible loan stock or share options that may cause an increase in the future number of shares without being accompanied by a proportionate increase in earnings. It is important to realise that a diluted eps figure is not a prediction of what the future eps will be, but it is a ‘warning’ to shareholders that, based on the current level of earnings, the basic reported eps would be lower if the diluting circumstances had crystallised. Clearly future eps will be based on future profits and the number of shares in issue.
24
(c) There are two main reasons why the income tax charge in the financial statements is not at the same rate as the stated
percentage. The first reason is that tax is payable on the taxable profits of a company, which may differ considerably from the accounting profit. Such differences may be because some items of income or expenditure included in the financial statements may be disallowable for tax purposes (or allowed in a different accounting period) and some taxation allowances (e.g. tax depreciation allowances) are not included in the accounting profit. These differences may be mitigated by deferred tax on temporary differences. The second reason for differences is that the income tax charge does not usually consist solely of the charge on the current year’s profit. Commonly the tax charge also includes an element of deferred tax (this may be a debit or credit) and possibly an adjustment to the previous year’s tax provision (due to it being settled at an amount different to the provision). Other more complex items such as withholding taxes on income and double (dual) taxation relief may also be included in the tax charge.
The main reason why the income tax charge in the income statement differs to that in the cash flow statement is that the tax charge in the financial statements is a provision for tax that is normally settled in the following period. This means that the cash flow figure for tax actually paid is the amount needed to settle the previous year’s tax liability. Other differences may be due to items referred to above such as deferred tax movements that are not cash flows.
25
Part 2 Examination – Paper 2.5(INT)FInancial Reporting (International Stream) December 2002 Marking Scheme
This marking scheme is given as a guide in the context of the suggested answers. Scope is given to markers to award marks for alternative approaches to a question, including relevant comment, and where well-reasoned conclusions are provided. This is particularly the case for written answers where there may be more than one definitive solution.
1 (a) (i) Income statement: marks
all line items 1 mark each 3
except operating expenses 2
Balance sheet:
property, plant and equipment 1
investments 1
goodwill 3
inventory and accounts receivable 1
bank and loan note 1
accounts payable and tax 1
share capital 1
share premium 1
accumulated profits 1
available 16
maximum 13
(ii) Income statement:
all line items 1/
2mark each 2
profit b/f Hydrate and Sulphate, 1 mark each 2
Equity and reserves:
share premium 1
share premium of Sulphate now classed as a capital reserve 1
accumulated profits – Hydrate plus Sulphate 1
qccumulated profits– share capital adjustment 1
available 8
maximum 7
(b) 1 mark for each feature together with compliance comment 5
26
marks
2 (a) Income statement
sales revenue 2
cost of sales 3
commission 1
investment income plus operating expenses 1
surplus on investment property (as income) 1
loan interest 1
preference dividend (as an expense) 1
loss on revaluation of 15 year leasehold 1
taxation 1
available 12
maximum 9
(b) Changes in equity
profit for period 1
revaluation surplus of 25 year leasehold 1
dividend 1
transfers to realised profits 1
available 4
maximum 3
(c) Balance sheet
property, plant and equipment 5
investment property 1
inventory and cash 1
accounts receivable 2
trade and other payables 2
income tax provision 1
dividends 1 deferred tax 1 share capital 1 revaluation reserves 1 available 16 maximum 13
Maximum for question 25
3 (a) (i) description of creative accounting 2
examples of creative accounting 3
maximum 5
(ii) importance of substance 2
features indicating a difference between substance and legal form 3
maximum 5
(b) (i) 1 mark per relevant point to a maximum 6
(ii) 1 mark per relevant point to a maximum 3
and 1 mark per correct figure in the financial statements to a maximum 6
marks
4 (a) net cash flows from operating activities
1 mark per item 8
except – loan interest 2
except– taxation 2
capital expenditure – proceeds from the sale of the plant 2
capital expenditure– other items,1 mark per component 3
financing – equity shares 2
financing– loan note 1
equity dividends 2
movement in cash and cash equivalents 1
available 23
maximum 20
(b) 1 mark per relevant point to a maximum 5
Maximum for question 25
5 (a) (i) 1 mark per relevant point to a maximum 3
(ii) $110 for both companies if no information available 1
applying the information available – $77 million for Gamma 1
applying the information available– $209 million for Toga 2
maximum 4
(b) (i) 1 mark per relevant point to a maximum 3
(ii) number of shares re loan stock 1
interest saved 1
dilutive number of share re options 2
calculation of diluted eps 1
maximum 5
(iii) 1 mark per relevant point to a maximum 4
(c) 1 mark per relevant point to a maximum 6
Maximum for question 25