ACCA paper f 7 financial reporting F7FR RQB as d08

REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Answer IASCF (a) Functions of bodies within IASCF In recognition of the increasing importance of international accounting standards, in 1999 the Board of the IASB recommended and subsequently adopted a new constitution and structure After a two year process a new supervisory body, The International Accounting Standards Committee Foundation, was incorporated in the USA in February 2001 as an independent not-for-profit organisation It is governed by 22 IASC Foundation Trustees who must have an understanding of international issues relevant to accounting standards for use in the world’s capital markets The main objectives of the IASC Foundation are: to develop a single set of global accounting standards that require high quality, transparent and comparable information in financial statements to help users in making economic decisions; to promote the use and application of these standards; in fulfilling the above two objectives, to take account of the special needs of small and medium sized entities and emerging economies; and to bring about convergence of national accounting standards and international accounting standards The subsidiary bodies of the IASC Foundation are the International Accounting Standards Board (IASB) (based in London UK), the Standards Advisory Council (SAC) and the International Financial Reporting Interpretations Committee (IFRIC) The International Accounting Standards Board The result of a restructuring process saw the IASB assume the responsibility for setting accounting standards from its predecessor body, the International Accounting Standards Committee The Trustees appoint the members of all of the above bodies They also set the agenda of and raise finance for the IASB; however the IASB has sole responsibility for setting accounting standards, International Financial Reporting Standards (IFRS), following rigorous and open due process The Standards Advisory Council provides a forum for experts from different countries and different business sectors with an interest in international financial reporting to offer advice when drawing up new standards Its main objectives are to give advice to the Trustees and IASB on agenda decisions and work priorities and on the major standard-setting projects The International Financial Reporting Interpretations Committee has taken over the work of the previous Standing Interpretations Committee It is really a compliance body whose role is to provide rapid guidance on the application and interpretation of international accounting standards where contentious or divergent interpretations of international accounting standards have arisen It operates an open due process in accordance with its approved procedures Its pronouncements (interpretations – SICs and IFRICs) are important because financial statements cannot be described as complying with IFRSs unless they also comply with the interpretations 1001 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Other Bodies The prominence of the IASB has been enhanced even further by its relationship with the International Organisation of Securities Commissions (IOSCO) IOSCO is an influential organisation of the world’s security commissions (stock exchanges) In 1995 the IASC agreed to develop a core set of standards which, when endorsed by IOSCO, would be used as an acceptable basis for cross-border listings In May 2000 this was achieved Thus it can be said that international accounting standards may be the first tentative steps towards global accounting harmonisation As part of its harmonisation process the European Union requires that all listed companies in all member states prepare their financial statements using IFRSs National standard setters such as the UK’s Accounting Standards Board and the USA’s Financial Accounting Standards Board have a role to play in the formulation of international accounting standards Seven of the leading national standard setters are members of the IASB The IASB see this as a “partnership” between IASB and these national bodies as they work together to achieve the convergence of accounting standards world wide Often the IASB will ask members of national standard setting bodies to work on particular projects in which those countries have greater experience or expertise Many countries that are committed to closer integration with IFRSs will publish domestic standards equivalent (sometimes identical) to IFRSs on a concurrent timetable (b) The International Accounting Standard Setting Process As referred to above the IASB is ultimately responsible for setting international accounting standards The Board (advised by the SAC) identifies a subject and appoints an Advisory Committee to advise on the issues relevant to the given topic Depending on the complexity and importance of the subject matter the IASB may develop and publish Discussion Documents for public comment Following the receipt and review of comments the IASB then develops and publishes an Exposure Draft for public comment The usual comment period for both of these is ninety days Finally, and again after a review of any further comments, an International Financial Reporting Standard (IFRS) is issued The IASB also publishes a Basis for Conclusions which explains how it reached its conclusions and gives information to help users to apply the Standard in practice In addition to the above the IASB will sometimes conduct Public Hearings where proposed standards are openly discussed and occasionally Field Tests are conducted to ensure that proposals are practical and workable around the world The authority of international accounting standards is a rather difficult area The IASB has no power to enforce international accounting standards within those countries/entities that choose to adopt them This means that the enforcement of international accounting standards is in the hands of the regulatory systems of the individual adopting countries There is no doubt the regulatory systems in different parts of the world differ from each other considerably in their effectiveness For example in the UK the Financial Reporting Review Panel (FRRP) is a body that investigates departures from the UK’s regulatory system (which will soon include the use of international accounting standards for listed companies) The FRRP has wide and effective powers of enforcement, but not all countries have equivalent bodies, thus it can be argued that international accounting standards are not enforced in a consistent manner throughout the world Complementary to international accounting standards, there also exist international auditing standards and part of the rigour and transparency that the use of international accounting standards brings is due to the fact that those companies adopting international accounting standards should also be audited in accordance with international auditing standards This auditing aspect is part of IOSCO’s requirements for financial statements to be used for cross-border listing purposes 1002 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Where it becomes apparent (often through press reports) that there is widespread inconsistency in the interpretation of an international accounting standard, or where it is perceived that a standard is not clear enough in a particular area, the IFRIC may act to remedy/clarify the position thus supplementing the body of international standards However where it becomes apparent (perhaps through a modified audit report) that a company has departed from IFRSs there is little that the IASB can directly to enforce them In 2007 the IASB has stated that all new standards will be reviewed after a two year period, to ensure that the standard is fulfilling its stated objective and that there are no undue concerns in the application of the standard (c) The success of the process Any measure of success is really a matter of opinion There is no doubt that the growing acceptance of IFRSs through IOSCO’s endorsement, the European Union requirement for their use by listed companies and the ever increasing number of countries that are either adopting international accounting standards outright or basing their domestic standards very closely on IFRSs is a measure of the success of the IASB Equally there is widespread recognition that in recent years the quality of international accounting standards has improved enormously due to the improvements project and subsequent continuing improvements However the IASB is not without criticism Some countries that have developed sophisticated regulatory systems feel that IFRSs are not as rigorous as the local standards and this may give cross-border listing companies an advantage over domestic companies Some requirements of international accounting standards are regarded as quite controversial, e.g deferred tax (part of IAS 12), financial instruments and derivatives (IAS 32 and 39) and accounting for retirement benefits (IAS 19) Many IFRSs are complex and the benefits of applying them to smaller entities may be outweighed by the costs, the IASB has issued an exposure draft aimed at small and medium sized companies Also some securities exchanges that are part of IOSCO require non-domestic companies that are listing by filing financial statements prepared under IFRSs to produce a reconciliation to local GAAP This involves reconciling the IFRS statement of comprehensive income and statement of financial position, to what they would be if local GAAP had been used The USA is an important example of this requirement, although it has been announced that the requirement to reconcile to US GAAP will no longer be required for those companies complying with IFRS Critics argue that this requirement negates many of the benefits of being able to use a single set of financial statements to list on different security exchanges This is because to produce reconciliation to local GAAP is almost as much work and expense as preparing financial statements in the local GAAP which was usually the previous requirement Despite these criticisms there is no doubt that the work of IASB has already led, and in the future will lead, to further improvement in financial reporting throughout the world 1003 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Answer SUBSTANCE OVER FORM (a) Importance In order to be useful information contained in financial statements must be relevant and reliable This can only be achieved if the substance of transactions is recorded If this did not happen the financial statements would not represent faithfully the transactions and other events that had occurred Although there are many instances where there are genuine commercial reasons for contracts and transactions adopting the legal form that they (eg, to create a secure legal title to assets), equally the legal form is often used to achieve less desirable purposes In general these amount to manipulating the financial statements to create a favourable impression The typical outcomes of such manipulation are: – – – the omission of assets, and particularly liabilities, from statement of financial position; improvements to profits and profit smoothing; improvement of other performance measures such as earnings per share, liquidity ratios, profitability ratios and gearing Clearly such effects are not helpful to users of financial statements and thus it is important that the substance of a transaction should be recorded in order to avoid the above distortions (b) Transactions The following important features are often found in transactions or arrangements where the substance may be different to the legal form These features need to be fully understood and investigated in order to determine the substance of a transaction: (i) Separation of ownership and beneficial use The separation of legal title from the benefits and risks related to an asset has been used to avoid assets, and often their related financing, from being recognised in the statement of financial position Where an asset is “sold” but the selling company still substantially enjoys the risks and rewards of ownership, then it should remain an asset of the company This is the principle used in IAS 17 “Leases” to record finance leases Often when the substance of an agreement is applied to transactions it will have a very different effect on the statement of financial position than if the legal form is recorded For example an asset that is “sold” and leased back for the remainder of its useful life is in substance a financing arrangement and not a “sale” at all The asset should remain on the statement of financial position and the proceeds should be treated as a loan (ii) Linking of transactions A common arrangement is to link a series of transactions It is not always obvious when transactions are linked, but it would be difficult to appreciate the commercial effect without considering such transactions as a “whole” Inventories may be “sold” to a third party A condition of the sale is that there is an option giving the selling company the right to buy back the inventory at a future date This is often at a predetermined value which is designed to give the purchasing company what is in substance a lenders return When all of the “linked” transactions are considered together it becomes apparent that this is again a financing arrangement and should be recorded as such This type of transaction is commonly referred to as a “sale and repurchase”, with each party to the transaction having either an option to repurchase or resell The contract would be worded in such a way that one of the parties would invoke their option and the goods would legally return to the original seller 1004 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) The “seller” would not recognise a sale from the transaction nor would they derecognise the asset but would be required to recognise a liability to the other party, emphasising that in substance this is a financing transaction (iii) Sale price at other than fair value Where assets are sold at prices below or above their fair values there is likely to be related (or linked) transactions that will explain the reason for it A selling price above fair value is almost certain to be a form of loan which will be linked to future transactions that will effect its repayment A selling price below fair value is likely to be a way of deferring the profit on sale This may be effected by reducing a future item of expense For example a company could “sell” some plant to a third party below its fair value The “sale” is linked to an agreement to lease the plant back in future years at a rental below commercial rates In effect the profit forgone on the sale is being used to reduce future rental payments, thus the profit on the sale is being spread over several accounting periods rather than being reported in the year of sale (a form of profit smoothing) (c) Sale of timber (i) Legal form Note: all figures in $000s Forest – Statement of comprehensive income year to 31 March: Revenues Cost of sales 2008 15,000 (12,000) 2009 nil nil 2010 25,000 (19,965) Total 40,000 (31,965) Gross profit 3,000 nil 5,035 8,035 The cost of sales in the year 2009 is the original selling price of $15 million plus compound interest at 10% for the previous three years (see below) Forest – Statement of financial position as at 31 March: Inventory Loan (ii) 2008 nil nil 2009 nil nil 2010 nil nil Substance Forest – Statement of comprehensive income year to 31 March: Revenues Cost of sales 2008 nil nil Gross profit nil Interest (accrued at 10%) (1,500) Net profit (loss) (1,500) 2009 nil nil 2010 25,000 (12,000) Total 25,000 (12,000) nil (1,650) 13,000 (1,815) 13,000 (4,965) (1,650) 11,185 8,035 1005 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Forest – Statement of financial position as at 31 March: 2008 Inventory 12,000 Loan 15,000 plus accrued interest 1,500 2009 12,000 15,000 3,150 Repaid 31 March 2010 2010 nil 15,000 4,965 19,965 (19,965) nil As can be seen from the figures in (i) if the legal form of the transaction is applied it results in a spreading of the profit, some in the year to 31 March 2008 the rest in 2010 The arrangement could have been made such that some of the “sale” to the bank was made in 2008 thus reporting a profit in all three years Also no inventory or loans appear on the statement of financial position; this improves many ratios, particularly gearing In contrast (ii) applies the substance of the transaction and (ignoring Forest’s other transactions) this results in “losses” in 2008 and 2009 and a large profit in 2010; there is no profit “smoothing” It also shows an interest charge, which in (i) is “lost” in the cost of sales figure In addition both the inventory and the loan (including accrued interest) appear on the statement of financial position Note both methods eventually report the same profit Answer ATKINS (a) (i) Creative accounting 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 statement of financial position 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) 1006 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) 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 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) Recording the substance 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 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 1007 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK (b) (i) Selling cars 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 in Atkins’s statement of financial position, 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’ statements of financial position (ii) Sale of land 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 October 2008 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 1008 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Assuming the land is sold: Statement of comprehensive income – year to 30 September 2008 $ Sales Cost of sales (3/5 × $2 million) Profit on sale of land Statement of financial position as at 30 September 2008 Non-current assets Development land ($2 million – $1·2 million above) 800,000 Assuming the arrangement is secured loan: Statement of comprehensive income – year to 30 September 2008 Interest on loan (10% of in substance loan of $2·4 million) Statement of financial position as at 30 September 2008 Non-current assets Development land at cost Non-current liabilities Secured loan Accrued interest Answer PETERLEE $ 2,400,000 1,200,000 ––––––––– 1,200,000 (240,000) 2,000,000 2,400,000 240,000 ––––––––– (2,640,000) (a) The purpose of the Framework is to assist the various bodies and users that may be interested in the financial statements of an entity It is there to assist the IASB itself, other standard setters, preparers, auditors and users of financial statements and any other party interested in the work of the IASB More specifically: to assist the Board in the development of new and the review of existing standards It is also believed that the Framework will assist in promoting harmonisation of the preparation of financial statements and also reduce the number of alternative accounting treatments permitted by IFRSs national standard setters that have expressed a desire for local standards to be compliant with IFRS will be assisted by the Framework the Framework will help preparers to apply IFRS more effectively if they understand the concepts underlying the Standards, additionally the Framework should help in dealing with new or emerging issues which are, as yet, not covered by an IFRS the above is also true of the work of the auditor, in particular the Framework can assist the auditor in determining whether the financial statements conform to IFRS users should be assisted by the Framework in interpreting the performance of entities that have complied with IFRS 1009 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK It is important to realise that the Framework is not itself an accounting standard and thus cannot override a requirement of a specific standard Indeed, the Board recognises that there may be (rare) occasions where a particular IFRS is in conflict with the Framework In these cases the requirements of the standard should prevail The Board believes that such conflicts will diminish over time as the development of new and (revised) existing standards will be guided by the Framework and the Framework itself may be revised based on the experience of working with it (b) Definitions – assets: The IASB’s Framework defines assets as “a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity” The first part of the definition puts the emphasis on control rather than ownership This is done so that the statement of financial position reflects the substance of transactions rather than their legal form This means that assets that are not legally owned by an entity, but over which the entity has the rights that are normally conveyed by ownership, are recognised as assets of the entity Common examples of this would be finance leased assets and other contractual rights such as aircraft landing rights An important aspect of control of assets is that it allows the entity to restrict the access of others to them The reference to past events prevents assets that may arise in future from being recognised early – liabilities: The IASB’s Framework defines liabilities as “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” Many aspects of this definition are complementary (as a mirror image) to the definition of assets, however the IASB stresses that the essential characteristic of a liability is that the entity has a present obligation Such obligations are usually legally enforceable (by a binding contract or by statute), but obligations also arise where there is an expectation (by a third party) of an entity assuming responsibility for costs where there is no legal requirement to so Such obligations are referred to as constructive (by IAS 37 Provisions, contingent liabilities and contingent assets) An example of this would be repairing or replacing faulty goods (beyond any warranty period) or incurring environmental costs (e.g landscaping the site of a previous quarry) where there is no legal obligation to so Where entities incur constructive obligations it is usually to maintain the goodwill and reputation of the entity One area of difficulty is where entities cannot be sure whether an obligation exists or not, it may depend upon a future uncertain event These are more generally known as contingent liabilities Importance of the definitions of assets and liabilities: The definitions of assets and liabilities are fundamental to the Framework Apart from forming the obvious basis for the preparation of the statement of financial position, they are also the two elements of financial statements that are used to derive the equity interest (ownership) which is the residue of assets less liabilities Assets and liabilities also have a part to play in determining when income (which includes gains) and expenses (which include losses) should be recognised Income is recognised (in the statement of comprehensive income) when there is an increase in future economic benefits relating to increases in assets or decreases in liabilities, provided they can be measured reliably Expenses are the opposite of this Changes in assets and liabilities arising from contributions from, and distributions to, the owners are excluded from the definitions of income and expenses 1010 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Answer 48 CASINO (a) Statement of Cash Flows Casino for the Year to 31 March 2008: Cash inflows from operating activities Operating loss Adjustments for: Depreciation – buildings (W1) – plant (W2) – intangibles (510 – 400) Loss on disposal of plant (from question) $m (32) 12 81 110 12 –––– Operating profit before working capital changes Decrease in inventory (420 – 350) Increase in trade receivables (808 – 372) Increase in trade payables (530 – 515) Cash generated from operations Interest paid Income tax paid (W3) Net cash outflow from operating activities Cash flows from investing activities Purchase of – land and buildings (W1) – plant (W2) Sale of plant (W2) Interest received (12 – + 3) Cash flows from financing activities Issue of ordinary shares (100 + 60) Issue of 8% variable rate loan (160 – issue costs) Repayments of 12% loan (150 + penalty) Dividends paid Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of period (120 + 75) Cash and cash equivalents at end of period (125 – (32 +15)) $m (110) (60) 15 10 160 158 (156) (25) –––– 215 –––– 183 70 (436) 15 –––– (168) (16) (81) –––– (265) (145) –––– 137 –––– (273) 195 –––– (78) –––– Interest and dividends received and paid may be shown as operating cash flows or as investing or financing activities as appropriate WORKINGS (in $ million) (1) Land and buildings net book value b/f revaluation gains depreciation for year net book value c/f difference is cash purchases 1124 420 70 (12) (588) –––– (110) –––– REVISION QUESTION BANK – FINANCIAL REPORTING (F7) (2) Plant: cost b/f additions from question balance c/f difference is cost of disposal loss on disposal proceeds difference accumulated depreciation of plant disposed of depreciation b/f less – disposal (above) depreciation c/f charge for year (3) Taxation: tax provision b/f deferred tax b/f P&L net charge tax provision c/f deferred tax c/f difference is cash paid (4) Revaluation surplus: balance b/f revaluation gains transfer to retained earnings balance c/f (5) Retained earnings: balance b/f loss for period dividends paid transfer from revaluation surplus balance c/f 445 60 (440) –––– 65 (12) (15) –––– 38 –––– 105 (38) (148) –––– (81) –––– (110) (75) (1) 15 90 –––– (81) –––– 45 70 (3) –––– 112 –––– 1,165 (45) (25) –––– 1,098 –––– 1125 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK (b) Cash flow vs statement of comprehensive income The accruals/matching concept applied in preparing a statement of comprehensive income has the effect of smoothing cash flows for reporting purposes This practice arose because interpreting “raw” cash flows can be very difficult and the accruals process has the advantage of helping users to understand the underlying performance of a company For example if an item of plant with an estimated life of five years is purchased for $100,000, then in the cash flow statement for the five year period there would be an outflow in year of the full $100,000 and no further outflows for the next four years Contrast this with the statement of comprehensive income where by applying the accruals principle, depreciation of the plant would give a charge of $20,000 per annum (assuming straight-line depreciation) Many would see this example as an advantage of a statement of comprehensive income, however it is important to realise that profit is affected by many subjective items This has led to accusations of profit manipulation or creative accounting, hence the disillusionment of the usefulness of the statement of comprehensive income Another example of the difficulty in interpreting cash flows is that a decrease in overall cash flows is not always a bad thing (it may represent an investment in increasing capacity which would bode well for the future), nor is an increase in cash flows necessarily a good thing (this may be from the sale of non-current assets because of the need to raise cash urgently) The advantages of cash flows are: it is difficult to manipulate cash flows, they are real and possess the qualitative characteristic of objectivity (as opposed to subjective profits) cash flows are an easy concept for users to understand, indeed many users misinterpret statement of comprehensive income items as being cash flows cash flows help to assess a company’s liquidity, solvency and financial adaptability Healthy liquidity is vital to a company’s going concern many business investment decisions and company valuations are based on projected cash flows the “quality” of a company’s operating profit is said to be confirmed by closely correlated cash flows Some analysts take the view that if a company shows a healthy operating profit, but has low or negative operating cash flows, there is a suspicion of profit manipulation or creative accounting 1126 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Answer 49 TABBA (a) Statement of cash flows of Tabba for the year ended 30 September 2008: Cash flows from operating activities Profit before tax Adjustments for: Depreciation (W1) Amortisation of government grant (W3) Profit on sale of factory (W1) Increase in insurance claim provision (1,500 – 1,200) Interest receivable Interest expense Working capital adjustments: Increase in inventories (2,550 – 1,850) Increase in trade receivables (3,100 – 2,600) Increase in trade payables (4,050 – 2,950) Cash outflow from operations Interest paid Income taxes paid (W4) Net cash outflow from operating activities Cash flows from investing activities Sale of factory Purchase of non-current assets (W1) Receipt of government grant (from question) Interest received Net cash from investing activities Cash flows from financing activities Issue of 6% loan notes Redemption of 10% loan notes Repayment of finance leases (W2) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period $000 50 $000 2,200 (250) (4,600) (300) (40) 260 –––––– (2,680) (700) (500) 1,100 –––––– (2,780) (260) (1,350) –––––– 12,000 (2,900) 950 40 –––––– 800 (4,000) (1,100) –––––– (4,390) 10,090 (4,300) –––––– 1,400 (550) –––––– 850 –––––– Note: interest paid may also be presented as a financing activity and interest received as an operating cash flow 1127 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK WORKINGS ($000) (1) Non-current assets: Cost/valuation b/f New finance leases (from question) Disposals Acquisitions – balancing figure Cost/valuation c/f Depreciation b/f Disposal Depreciation c/f Charge for year – balancing figure Sale of factory: Net book value Proceeds (from question) Profit on sale (2) Finance lease obligations Balance b/f – current – over year New leases (from question) Balance c/f – current – over year Cash repayments – balancing figure (3) Government grant: Balance b/f – current – over year Grants received in year (from question) Balance c/f – current – over year Difference – amortisation credited to profit or loss (4) Taxation: Current provision b/f Deferred tax b/f Tax credit in statement of comprehensive income Current provision c/f Deferred tax c/f Tax paid – balancing figure 1128 20,200 1,500 (8,600) 2,900 –––––– 16,000 –––––– 4,400 (1,200) (5,400) –––––– (2,200) –––––– 7,400 (12,000) –––––– (4,600) –––––– 800 1,700 1,500 (900) (2,000) –––––– 1,100 –––––– 400 900 950 (600) (1,400) –––––– 250 –––––– 1,200 500 (50) (100) (200) –––––– 1,350 –––––– REVISION QUESTION BANK – FINANCIAL REPORTING (F7) (5) Reconciliation of retained earnings Balance b/f Transfer from revaluation surplus Profit for period Balance c/f (b) 850 1,600 100 –––––– 2,550 –––––– Consideration of the statement of cash flows reveals some important information in assessing the change in the financial position of Tabba in the year ended 30 September 2008 There is a huge net cash outflow from operating activities of $4,390,000 despite Tabba reporting a modest operating profit of $270,000 More detailed analysis of this difference reveals some worrying concerns for the future Many companies experience higher operating cash flows than the underlying operating profit mainly due to depreciation charges being added back to profits to arrive at the cash flows This is certainly true in Tabba’s case, where operating profits have been “improved” by $2·2 million during the year in terms of the underlying cash flows However, the major reconciling difference is the profit on the sale of Tabba’s factory of $4·6 million This amount has been credited in the statement of comprehensive income and has dramatically distorted the operating profit If the sale and lease back of the factory had not taken place, Tabba’s operating profits would be in a sorry state showing losses of $4·33 million (ignoring any possible tax effects) When Tabba publishes its financial statements this profit will almost certainly require separate disclosure which should make the effects of the transaction more transparent to the users of the financial statements A further indication of poor operating profits is that they have been boosted by $300,000 due to an increase in the insurance claim provision (again this is not a cash flow) and $250,000 amortisation of government grants Many commentators believe that the net cash flow from operating activities is the most important figure in the statement of cash flows This is because it is a measure of expected or maintainable future cash flows In Tabba’s case this highlights a very important point; although Tabba has increased its cash position during the year by $1·4 million, $12 million has come from the sale of its factory Clearly this is a one off transaction that cannot be repeated in future years If the drain on the operating cash flows continues at the current rates, the company will not survive for very long The tax position is worthy of comment There is a small tax credit in the statement of comprehensive income, perhaps due to current year trading losses, whereas the cash flow statement shows that tax of $1·35 million has been paid during the year This payment of tax is on what must have been a substantial profit for the previous year This seems to confirm the deteriorating position of the company Another relevant point is that there has been a very small increase in working capital of $100,000 However, underlying this is the fact that both inventories and trade receivables are showing substantial increases (despite the profit deterioration), which may indicate the presence of bad debts or obsolete inventories, and trade payables have also increased substantially (by $1·1 million) which may be a symptom of liquidity problems prior to the sale of the factory On the positive side there has been substantial investment in non-current assets (after allowing for the sale of the factory), but even this is partly due to leasing assets of $1·5 million (companies often lease assets when they not have the resources to purchase them outright) and finance from a government grant of $950,000 1129 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK The company appears to have taken advantage of the proceeds from the sale of the factory to redeem the expensive 10% $4 million loan note (this has partly been replaced by a less expensive 6% $800,000 loan note) In conclusion the statement of cash flows reveals some interesting and worrying issues that may indicate a bleak future for Tabba and serves as an illustration of the importance of a statement of cash flows to the users of financial statements Answer 50 BOSTON (a) Boston – Statement of cash flows for the year ended 31 March 2008: Cash flows from operating activities Note: figures in brackets are in $000 Profit before tax Adjustments for: depreciation of non-current assets loss on sale of hotel interest expense increase in current assets (155 – 130) decrease in other current liabilities (115 – 108) Cash generated from operations Interest paid (see note) Income taxes paid Net cash flow from operating activities Cash flows from investing activities: purchase of non-current assets (see below) sale of non-current assets (40 – 12) Net cash used in investing activities Cash flows from financing activities Issue of ordinary shares (20 + 20) Issue of loans (65 – 40) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period 1130 $000 65 35 12 10 –––– 122 (25) (7) –––– 90 (10) (30) –––– (123) 28 –––– 40 25 –––– $000 50 (95) 65 –––– 20 (5) –––– 15 –––– REVISION QUESTION BANK – FINANCIAL REPORTING (F7) WORKINGS Non-current assets – carrying amount Balance b/f Disposal Depreciation for year Balance c/f Cost of assets acquired $000 332 (40) (35) (380) ––––– (123) ––––– Note: interest paid may also be presented as a cash flow from financing activities (b) Report on the financial performance of Boston for the year ended 31 March 2008 To: From: Date: The Board of Boston A N Other Profitability (note figures are rounded to decimal place) The most striking feature of the current year’s performance is the deterioration in the ROCE, down from 25·6% to only 18·0% This represents an overall fall in profitability of 30% ((25·6 – 18·0)/25·6 × 100) An examination of the other ratios provided shows that this is due to a decline in both profit margins and asset utilisation A closer look at the profit margins shows that the decline in gross margin is relatively small (42·2% down to 41·4%), whereas the fall in the operating profit margin is down by 2·8%, this represents a 15·7% decline in profitability (i.e 2·8% on 17·8%) This has been caused by increases in operating expenses of $12m and unallocated corporate expenses of $10m These increases represent more than half of the net profit for the period and further investigation into the cause of these increases should be made The company is generating only $1·20 of sales per $1 of net assets this year compared to a figure of $1·40 in the previous year This decline in asset utilisation represents a fall of 14·3% ((1·4 – 1.2)/1·4 × 100) Liquidity/solvency From the limited information provided a poor current ratio of 0·9:1 in 2007 has improved to 1·3:1 in the current year Despite the improvement, it is still below the accepted norm At the same time gearing has increased from 12·8% to 15·6% Information from the statement of cash flows shows the company has raised $65 million in new capital ($40m in equity and $25m in loans) The disproportionate increase in the loans is the cause of the increase in gearing, however, at 15·6% this is still not a highly geared company The increase in finance has been used mainly to purchase new non-current assets, but it has also improved liquidity, mainly by reversing an overdraft of $5 million to a bank balance in hand of $15 million A common feature of new investment is that there is often a delay between making the investment and benefiting from the returns This may be the case with Boston, and it may be that in future years the increased investment will be rewarded with higher returns Another aspect of the investment that may have caused the lower return on assets is that the investment is likely to have occurred part way through the year (maybe even near the year end) This means that the statement of comprehensive income may not include returns for a full year, whereas in future years it will 1131 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Segment issues Segment information is intended to help the users to better assess the performance of an entity by looking at the detailed contribution made by the differing activities that comprise the entity as a whole Referring to the segment ratios it appears that the carpeting segment is giving the greatest contribution to overall profitability achieving a 48·6% return on its segment assets, whereas the equivalent return for house building is 38·1% and for hotels it is only 16·7% The main reason for the better return from carpeting is due to its higher segment net profit margin of 38·9% compared to hotels at 15·4% and house building at 28·6% Carpeting’s higher segment net profit is in turn a reflection of its underlying very high gross margin (66·7%) The segment net asset turnover of the hotels (1·1 times) is also very much lower than the other two segments (1·3 times) It seems that the hotel segment is also responsible for the group’s fairly poor liquidity ratios (ignoring the bank balances) the segment current liabilities are 50% greater than its current assets ($60m compared to $40m); the opposite of this would be a more acceptable current ratio These figures are based on historical values Most commentators argue that the use of fair values is more consistent and thus provides more reliable information on which to base assessments (they are less misleading than the use of historical values) If fair values are used all segments understandably show lower returns and poorer performance (as fair values are higher than historical values), but the figures for the hotels are proportionately much worse, falling by a half of the historic values (as the fair values of the hotel segment are exactly double the historical values) Fair value adjusted figures may even lead one to question the future of the hotel activities However, before jumping to any conclusions an important issue should be considered Although the reported profit of the hotels is poor, the market values of its segment assets have increased by a net $90 million New net investment in hotel capital expenditure is $64 million ($104m – $40m disposal); this leaves an increase in value of $26 million Whilst this is not a realised profit, it is nevertheless a significant and valuable gain (equivalent to 65% of the group reported net profit) Conclusion Although the company’s overall performance has deteriorated in the current year, it is clear that at least some areas of the business have had considerable new investment which may take some time to bear fruit This applies to the hotel segment in particular and may explain its poor performance, which is also partly offset by the strong increase in the market value of its assets Yours A N other Appendix Further segment ratios Carpeting Return on net assets at fair values (35/97 × 100) 36·1% Asset turnover on fair values (times) (90/97) 0·9 Hotels House building 8·3% 30·2% 0·5 1·1 Note: workings have been shown for the figures for the carpeting segment only, the other segments’ figures are based on equivalent calculations 1132 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Answer 51 NIAGARA (i) The ordinary dividends for the year to 31 March 2008 are: Interim (12 million (3 million × $1/25c) × 3c) Final (12 million × 1·2 × 6c) Earnings attributable to ordinary shares (see (ii)) Dividend cover (2,475,000/1,224,000) $ 360,000 864,000 –––––––––– 1,224,000 –––––––––– 2,475,000 2·02 times The dividend cover is the number of times the current year’s ordinary dividends could have been paid out of the current year’s profit attributable to ordinary shareholders It is an indication of the company’s dividend policy i.e a company having a dividend cover of three has paid out one third of its profit as dividends In terms of maintainable dividends, the dividend cover is a basic measure of risk, the higher the dividend cover the less is the risk that dividends would be reduced if profits suffer a downturn Conversely, a low dividend cover means that future dividends are more vulnerable to a deterioration in profit A dividend cover of less than one means the company has used previous years’ retained earnings to pay the current year’s dividend This is not a good sign and is not sustainable in the long term (ii) All items in arriving at the profit for the financial year are included in the calculation of the earnings per share Earnings attributable to the ordinary shares are after the payment of preference dividends: 8% on $1 million for full year new issue 6% on $1 million for six months $ 80,000 30,000 ––––––––– 110,000 ––––––––– 2,475,000 Earnings attributable to ordinary shares (2,585,000 – 110,000) Weighted average number of shares in issue: Calculation of theoretical ex-rights price: 100 shares at $2·40 would be worth 240 rights to 20 shares at $1·50 each costing 30 120 shares now worth 270 This gives a theoretical ex-rights value of $2·25 per share ($270/120) Weighted average calculation: 12,000,000 × $2·4/$2·25 × 3/12 3,200,000 14,400,000 (12 million × 1·2) × 9/12 10,800,000 ––––––––––– Weighted average number 14,000,000 ––––––––––– Earnings per share is 17·7c ($2,475,000/14,000,000 × 100) Restated earnings per share for the year to 31 March 2007 is 22·5c (24 × 2·25/2·40) 1133 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK (iii) Fully diluted earnings per share On conversion the loan stock would create an extra 800,000 new shares ($2 million × 40/$100) The effect on earnings would be a saving of interest of $140,000 ($2 million × 7%) before tax and $98,000 after tax (140,000 × (100% – 30%)) The directors’ warrants would create an additional 750,000 new shares without any effect on earnings Fully diluted earnings per share is 16·5c ((2,475,000 + 98,000)/(14,000,000 + 800,000 + 750,000)) The basic earnings per share is a measure of past performance The diluted earnings per share figure is more forward looking and is intended to act as a warning to existing and prospective shareholders Although it is still based on past performance, it does give effect to potential ordinary shares outstanding during the period Its disclosure is required where circumstances exist that would cause the eps to be lower if those circumstances had crystallised It is not a prediction of the future earnings per share figures, as these will be based on the future profits and the number of shares in issue in the future The diluted eps is more a “theoretical” value, as it is unlikely that the profit in the period when the circumstances crystallise will be the same as the current year’s profit The convertible loan stock in the question is a good example of diluting circumstance On conversion the share entitlement will cause the number of shares in issue in the future to be greater than the present (assuming loan stockholders opt for conversion) There will be a compensating increase in profit as a result of the non-payment of interest but overall the expected conversion will cause a dilution Answer 52 SAVOIR (a) Savoir – EPS year ended 31 March 2006: The issue on July 2005 at full market value needs to be weighted: New shares 40m × 3/12 = 8m –––– 48m × 9/12 = 10m 36m –––– 46m –––– Without the bonus issue this would give an EPS of 30c ($13·8m/46m × 100) The bonus issue of one for four would result in 12 million new shares giving a total number of ordinary shares of 60 million The dilutive effect of the bonus issue would reduce the EPS to 24c (30c × 48m/60m) The comparative EPS (for 2005) would be restated at 20c (25c × 48m/60m) EPS year ended 31 March 2007: The rights issue of two for five on October 2006 is half way through the year The theoretical ex rights value can be calculated as: Holder of Subscribes for Now holds 1134 100 shares worth $2·40 = 40 shares at $1 each = ––– 140 worth (in theory) ––– $240 $40 ––––– $280 i.e $2 each ––––– REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Weighting: 60m × 6/12 × 2·40/2·00 = Rights issue (2 for 5) 24m –––– New total 84m × 6/12 = Weighted average EPS is therefore 25c ($19·5m/78m × 100) 36 million 42 million –––– 78 million –––– The comparative (for 2006) would be restated at 20c (24c × 2·00/2·40) (b) The basic EPS for the year ended 31 March 2008 is 30c ($25·2m/84m × 100) Dilution Convertible loan stock On conversion loan interest of $1·2 million after tax would be saved ($20 million × 8% × (100% – 25%)) and a further 10 million shares would be issued ($20m/$100 × 50) Directors’ options Options for 12 million shares at $1·50 each would yield proceeds of $18 million At the average market price of $2·50 per share this would purchase 7·2 million shares ($18m/$2·50) Therefore the “bonus” element of the options is 4·8 million shares (12m – 7·2m) Using the above figures the diluted EPS for the year ended 31 March 2008 is 26·7c ($25·2m + $1·2m)/(84m + 10m + 4·8m)) Answer 53 UPDATE (i) The most common problem associated with the use of historical cost financial statements is that they can be misleading and can distort comparisons with other companies’ financial statements The problems relate to both the statement of comprehensive income and the statement of financial position In times of rising prices historical values in the statement of financial position can quickly become irrelevant Where current values are significantly higher than carrying values the following problems can be identified: The value of the net assets is equal to the capital employed of an entity Many important accounting ratios are based on these figures e.g the return on capital employed, asset utilisation ratios etc The usefulness of such ratios is limited if the net assets/capital employed are understated Due to the above, inter company comparison of performance can be invalidated This point is not immediately obvious as many people may consider that as long as historical cost is compared with historical cost then the comparison is being made on a consistent basis This is not the case Historical cost can be thought of as “mixed” values’ in that historical costs may represent out of date values (when particular assets were acquired many years ago), but in other cases they may represent current values (when assets have been acquired recently) Thus equivalent assets may be shown at considerably different values 1135 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK Understatement of asset values tends to overstate gearing (another important ratio), and leads to a low asset per share value and can make the company vulnerable to a take over Where assets, particularly land and buildings, are being used as security to raise finance, it is the current value that lenders are interested in, not historical values The problems historical costs cause in the statement of comprehensive income are mainly due to certain costs being understated in terms of their current cost Most notable of these are depreciation charges being based on out of date values of their respective assets and the cost of sales figure may be understated as it does not include current values for bought in items or manufactured goods The understatement of operating costs leads to an overstatement of profit There is a possibility that this may lead to higher taxation, wage demands and dividend expectation (based on overstated earnings per share) The combination of these effects is that a company may overspend or over distribute its profits and not maintain its capital base The above problems affect all users not just shareholders Managers may not be allocating scarce resources in an optimal way, lenders can be misled (as above), arguably the government is not levying taxes on a fair basis, employees may not be aware of the wealth (or added value) that they are generating, and analysts and advisors encounter comparability problems (ii) Non-current assets as at 31 March 2008 Current Historical purchasing Current cost power cost $ $ $ Cost/valuation 250,000 300,000 280,000 Accumulated depreciation (122,000) (146,400) (136,640) –––––––– –––––––– –––––––– Carrying value 128,000 153,600 143,360 –––––––– –––––––– –––––––– Statement of comprehensive income extract year to 31 March 2008 Depreciation of plant 32,000 38,400 35,840 WORKINGS Historical cost: Depreciation at 20% on $250,000 on the reducing balance method would give depreciation of $50,000 in the year to 31 March 2006; $40,000 ((250,000 – 50,000) × 20%) in the year to 31 March 2007; and $32,000 ((250,000 – 50,000 – 40,000) × 20%) in the year to 31 March 2008 The accumulated depreciation at 31 March 2008 is $122,000 (50,000 + 40,000 + 32,000) Current purchasing power: The historical cost of the asset will be remeasured using the increase in the RPI Thus the CPP cost will be: $250,000 × 216/180 = $300,000 The remaining figures are calculated as per the historical cost method only using $300,000 as the cost 1136 REVISION QUESTION BANK – FINANCIAL REPORTING (F7) Current (replacement) cost: Although the list price of the new model is $320,000, the two are not directly comparable as the new model is more efficient than the old A sensible approach would be to reduce the cost of the new model in proportion to its increased efficiency Equivalent cost $320,000 × 420/480 = $280,000 The remaining figures are calculated on a similar basis to the historical cost figures Answer 54 DERWENT I (i) Derwent share capital and reserves at 30 September 2008: 95 million ordinary shares of 25c each fully paid ((100 million – million) × 25c) Capital reserve (W2) Retained earnings (W2) Dividends – year to 30 September 2008 Ordinary dividends January 2008 ((100 million – million) × 3c) June 2008 (95 million × 5c) $000 1,250 50,650 –––––– 2,850 4,750 WORKINGS $000 23,750 51,900 –––––– 75,650 –––––– 7,600 –––––– (1) The premium on redemption is $7·5 million (5 million × (175c – 25c)) and this must be charged to accumulated profits (2) Retained profits b/f profit after tax for the year (from question) ordinary dividends (from above) premium on redemption (W1) transfer to capital reserve (see below) $000 12,000 (7,600) (7,500) (1,250) –––––– $000 55,000 (4,350) –––––– 50,650 –––––– The transfer to the capital reserve is the nominal value of share capital redeemed of $1·25 million (5 million × 25c) 1137 FINANCIAL REPORTING (F7) – REVISION QUESTION BANK (ii) Advantages of purchasing (then cancelling) own shares: it is a method of returning excess cash/capital surpluses to shareholders (without paying dividends) if a company believes its shares are undervalued on the stock market, it may be able to improve its share price (and p/e ratio) by buying shares in the open market The demand created by the purchase may cause an increase in price and, if these shares are cancelled (as they often are), this means the remaining shareholders own a greater proportion of the company private companies (whose shares have no active market) can take advantage of the company being able to purchase shares This may be used to buy out shares held by employees (say on retirement) who have received them as part of a profit sharing scheme Companies may buy out dissenting shareholders, or buy shares from the estate of a deceased shareholder Companies normally purchase shares in these circumstances when the other shareholders not wish to purchase any more of the company’s shares 1138 ... $105,000 ($ 476 ,000 – $ 371 ,000) for the capital element of the finance lease non-current liabilities $ 371 ,000 for the capital element of the finance lease 1015 FINANCIAL REPORTING (F7 ) – REVISION QUESTION... Importance of the definitions of assets and liabilities: The definitions of assets and liabilities are fundamental to the Framework Apart from forming the obvious basis for the preparation of the statement... effect of this is an increase in the depreciation charge of $20,000 for the current year only 1014 REVISION QUESTION BANK – FINANCIAL REPORTING (F7 ) (3) Leased plant – this has been treated as