Financial Statements advice on extended writing tasks

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Financial Statements advice on extended writing tasks Andrew Coulson, the Chief Examiner, offers guidance on the approach students should take when attempting the written tasks in the Financial

1 Financial Statements advice on extended writing tasks Andrew Coulson, the Chief Examiner, offers guidance on the approach students should take when attempting the written tasks in the Financial Statements assessment. Format of the assessment The Financial Statements assessment consists of two sections. Section 1 is concerned with the drafting of financial statements of limited companies. Section 2 is concerned with the analysis and interpretation of financial statements of limited companies using ratio analysis. The legal, regulatory and conceptual frameworks are also assessed in Section 2. There are five tasks in total in Section 1. One is a written task, and you can learn more about this under Task 1.3 further down the page. For tasks 1.1, 1.2 and 1.5, you ll need to draft singular and consolidated financial statements of limited companies. Task 1.4 comprises multiple choice and true/false questions on a range of International Financial Reporting Standards (IFRSs). Section 2, meanwhile, is made up of three tasks. Task 2.1 requires you to identify ratio formulas and calculate ratios in respect of limited company financial statements. Tasks 2.2 and 2.3 are both written questions, and you can learn more about these further down the page. Advice Let s look at what students should and shouldn t do to achieve competency in the three written tasks in the Financial Statements paper. We ll draw on previous years assessments and the specimen paper, citing examples of good and bad practice. Task 1.3 This written task assesses knowledge and understanding of IFRSs. Example (taken from the June 2008 assessment) Prepare brief notes for the directors to answer the following questions: (a) What is meant by an intangible asset according to IAS 38? (b) What would [the directors] have to demonstrate about development costs before these costs can be recognised as an intangible asset in the financial statements according to IAS 38? Suggested answer The model answer to the task is: (a) an intangible asset is an identifiable, non-monetary asset, without physical substance. (b) The directors would have to demonstrate: the technical feasibility of completing the intangible asset so that it will be available for use or sale its intention to complete the intangible asset and use or sell it how the intangible asset will generate future economic benefits the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset its ability to measure reliably the expenditure attributable to the intangible asset during its development.

2 The following are extracts from two scripts for this task. They re typical of the response given to this type of question by weaker students. Take a moment to read these two examples carefully, and think about how they could be improved. Script 1 (a) Intangible assets are those assets which you cannot touch them like goodwill. (b) [If the directors] can demonstrate investment, share premium, share capital, revaluation and profit on acquisition. Script 2 (a) An intangible asset according to IAS 38 are the assets which cannot be see or touched but they are believed to have value. (b) [The directors] would have to calculate his goodwill account so as to account for the intangible assets in the financial statements. What was good about these answers, and what was weak? Feedback from the Chief Examiner - click to display/hide feedback. Although both students were awarded partial marks in (a) for stating that tangible assets cannot be touched or seen, they clearly have little knowledge and understanding of this particular IFRS. A thorough grounding in the key principles of IFRSs is essential for you to achieve competency in the FNST assessment. 21 IFRSs are potentially assessable in all, and a list of these, together with the assessable elements within them, can be found in the unit guidance notes on AAT s website. You must be able to define key terms and definitions, and be able to explain and apply the stipulated accounting treatments. Definitions, however, do not have to be cited word for word; but you must be able to demonstrate that you understand the key concepts and are able to communicate the meaning of the standards. Spelling and grammatical errors will not be penalised, as it s the quality of the content of the answer that is assessed.

3 Task 2.2 You ll typically be presented with three to five ratios in respect of a company for a particular year, and the same ratios calculated for a previous year (or those of a competitor or an industry average). Sometimes additional information may also be provided to help your analysis, such as an extract taken from the financial statements. You ll then need to analyse and interpret the ratios for the purposes of making a recommendation to an interested party. Example (a slightly revised version of Task 2.2 from the specimen paper) Nancy Charlton is considering buying shares in Limden Ltd and has asked you to assist her in determining the level of profitability and risk of the company. You have computed the following ratios in respect of Limden Ltd s financial statements for the last two years to assist you in your analysis. 20X1 20X0 Gross profit percentage 46.0% 42.0% Operating profit percentage 6.5% 8.0% Gearing 35.2% 22.4% Interest cover 2.9 times 7.5 times Prepare a report to Nancy that includes: (a) (b) a comment on the relative performance of the company for the two years based on the ratios calculated and what this tells you about the company advice, with reasons based on the ratios, on whether or not Nancy should invest. Using the gross profit percentage ratio as an example, the following are examples of typical incorrect responses to this type of question. Sample answers The gross profit percentage is a measure of profitability. It is calculated by dividing gross profit by revenue. As compared to last year: the gross profit rose from 42.0% to 46.0% the gross profit grew from 42.0% to 46.0% the gross profit rose by 4% the gross profit increased by 4% gross profit was worse than last year. Feedback from the Chief Examiner None of these answers would merit any marks. The task does not ask for the purpose of the ratio or its formula, and so this information is not relevant. Furthermore, none of the answers give any indication as to whether a higher ratio is a good thing or a bad thing. To achieve a good score for this task, you must first of all evaluate the ratios; in other words, identify if they are better or worse, and whether they ve improved or deteriorated. Next, you should explain why they are judged to be better or worse, and finally give possible reasons as to why they could be better or worse. In other words: what could be causing the ratios to be different? On this basis, it s the last answer that is probably the closest to achieving any merit as it does at least attempt to evaluate, albeit incorrectly. With this feedback in mind, think how you would approach part (a). When you re ready, compare your answer with the suggested answer which you can find below.

4 Suggested answer click to display/hide the answer. The gross profit has improved (this is the evaluation); more gross profit is being generated by sales (this is why the ratio is judged to be better); the improvement could be due to the company increasing its selling price and/or achieving a reduction in the cost price of its purchases and/or it may have changed its product mix (these are three possible explanations for the change in the ratio between the two years). The model answer in respect of the gearing ratio is: The gearing ratio has deteriorated (evaluation); the company is more risky and as a consequence it may be harder to obtain more loans in the future (both of these comments are reasons why this year s ratio is worse); the company may have taken out more loans during the year (this is a possible reason for why the ratio is different). You must also ensure that you address the requirements of the conclusion, which is part (b) in this question. Before starting to write the conclusion, it s good practice to look again at the opening data and to categorise the ratios into the areas to which they relate. So, for example, the gross profit percentage and operating profit percentage relate to profitability, and the gearing ratio and interest cover ratio relate to risk. As the introduction to this question states that Nancy is primarily interested in profitability and risk, the conclusion should address these two areas by evaluating what s happened to the ratios that are relevant to each. You must also give unequivocal decision advice. In other words, you ll be expected to say either yes, invest, or no, don t invest. You ll lose marks if you try and evade answering the question, or attempt to hedge your bets. So avoid writing, for example, more information is required, or that you should wait until next year s results before making a decision. You must also ensure that you answer the question in the format required. If you re asked to provide a report, the header should include who it s to/from and include the subject. A letter should begin with Dear Sir/Madam, and finish with Yours faithfully/sincerely as appropriate. An should begin with some indication of an address. For example, to JoeBloggs@xyz.co.uk from aatstudent@aat.org.uk. Remember to include the subject of the . Task 2.3 This task is a written question in relation to the IASB s Conceptual Framework for Financial Reporting (or the IASB s Framework for the Preparation and Presentation of Financial Statements, for assessments to be taken prior to September 2011), and/or the legal and regulatory frameworks as detailed in section of the unit guide. Many students fail to show the level of knowledge and understanding required to achieve competency in this task, even though the core content of the subject matter is far less wide ranging than it is for the IFRSs assessed in Section 1. Example (taken from the December 2009 assessment) (a) (b) List the elements that appear in financial statements according to the Framework for the Preparation and Presentation of Financial Statements. Define the elements that appear in the statement of financial position of a company in accordance with the definitions in the Framework for the Preparation and Presentation of Financial Statements. Many students gave the first answer correctly as: income expenses assets liabilities equity.

5 However, they then left it at that, or gave patchy subsequent explanations of the elements. Such answers would attract only a small proportion of the marks for this type of task. A number of students explained assets as something we own and liabilities as something we owe. While some credit would be given for this, it would still leave you well short of the published model answer. Excerpt from model answer An asset is 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. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in the outflow from the entity of resources embodying economic benefits. Equity is the residual interest in the assets of the entity after deducting all its liabilities. However, it's not necessary to use the exact language of the Framework. An example of an explanation of equity that would achieve some of the available credit is: Equity is what is left over when the assets of a business have the liabilities deducted. Equity is made up of share capital, share premiums and bank loans, less dividends that may need to be paid to shareholders. Summary Now, let s confirm and summarise what you need to do to achieve competency for the written elements of the paper. You must be able to demonstrate that: you have the necessary level of knowledge and understanding of the assessable IFRSs you can analyse and interpret calculated ratios for the purposes of advising an interested party you re able to demonstrate your knowledge and understanding of the IASB s Conceptual Framework for Financial Reporting (the IASB s Framework for the Preparation and Presentation of Financial Statements for assessments to be taken prior to September 2011), and the legal and regulatory frameworks. There may be no short cut to revising the relevant IFRSs and frameworks, but you won t be expected to repeat their exact wording in the assessment. It s much more important that you show that you understand the concepts, so your own words are perfectly acceptable provided they convey the meaning of the standards or the Framework. Don t worry about spelling and grammar and, if in doubt, keep it short, clear and always focused on the requirements of the task.

Osborne Books Tutor Zone. Financial statements. Practice assessment 2

Osborne Books Tutor Zone. Financial statements. Practice assessment 2 Osborne Books Tutor Zone Financial statements Practice assessment 2 Osborne Books Limited, 2013 2 f i n a n c i a l s t a t e m e n t s t u t o r z o n e Task 1 You have been asked to help prepare the