Institute of Chartered Accountants Ghana (ICAG) Paper 2.1 Financial Reporting

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1 Institute of Chartered Accountants Ghana (ICAG) Paper 2.1 Financial Reporting Final Mock Exam 1 Marking scheme and suggested solutions DO NOT TURN THIS PAGE UNTIL YOU HAVE COMPLETED THE MOCK EXAM

2 ii Financial Reporting The Institute of Chartered Accountants Ghana First edition 2015 ISBN All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd. Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA The Institute of Chartered Accountants Ghana 2015

3 Final Mock Exam 1: Answers 1 Question 1 L Marking scheme (a) (b) Statement of profit or loss and other comprehensive income Revenue 1 Cost of sales 2 Distribution costs and administrative expenses 1 Investment income Gain on investments in equity instruments Finance costs Income tax expense 1 Revaluation loss 1 Statement of financial position Property, plant and equipment 2 Investments in equity instruments Inventories Trade receivables Equity shares (per closing SOCIE) 1 Capital surplus (per closing SOCIE) Income surplus (per closing SOCIE) 2% loan note 2 Deferred tax Trade payables and overdraft Current tax Earnings per share Calculation of theoretical ex rights value 1 Weighted average number of shares 1 Earnings and calculation of EPS 1 Marks (a) L STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X4 Revenue (180,400 (W5) 3,900) 176,500 Cost of sales (W1) (75,700) Gross profit 100,800 Investment income 2,200 Gain on investments in equity instruments (27,100 26,500) 600 Distribution costs (W1) (11,000) Administrative expenses (W1) (17,500) Finance costs (W4) (2,400) Profit before tax 72,700 Income tax expense (W3) (17,100) PROFIT FOR THE YEAR 55,600 Other comprehensive income Revaluation loss on building (W2) (3,000) TOTAL COMPREHENSIVE INCOME FOR THE YEAR 52,600

4 2 Final Mock Exam 1: Answers L STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X4 Non-current assets Property, plant and equipment (W2) 228,500 Investment in equity instruments 27, ,600 Current assets Inventories (37,900 + (W5) 3,000) 40,900 Trade receivables (35,100 (W5) 3,900) 31,200 72,100 Total assets 327,700 Equity Equity shares (60,000 + (W6) 24,000) 84,000 Income surplus (40,500 15, ,600) 81,100 Capital surplus (14,000 (W2) 3,000) 11, ,100 Non-current liabilities 2% Loan note (W4) 81,600 Deferred tax (W3) 10,000 91,600 Current liabilities Trade payables 34,700 Current tax payable 18,700 Bank overdraft 6,600 60,000 Total equity and liabilities 327,700 Workings 1 Expenses Distribution Administrative Cost of sales costs expenses Per question 89,200 11,000 12,500 Plant capitalised (24,000) Depreciation buildings (W2) 5,000 Depreciation plant (W2) 12,000 Depreciation plant additions (W2) 1,500 'Sale or return' transaction (W5) (3,000) 75,700 11,000 17,500 2 Property, plant and equipment Land Buildings Plant Total Carrying amount at1 January 20X4 30, ,000 96, ,000 Additions* 24,000 24,000 Depreciation Buildings (100m/20 years) (5,000) (5,000) Plant b/d ((128m 32m) 12.5%) (12,000) (12,000) Plant additions (24m 12.5% 6/12) (1,500) (1,500) 30,000 95, , ,500 Revaluation loss (95m 92m) (3,000) (3,000) Carrying amount at 31 Dec 20X4 30,000 92, , ,500 * Note. All of the expenses originally charged to cost of sales in respect of the plant addition are now capitalised, giving a total amount of GHS24m.

5 Final Mock Exam 1: Answers 3 3 Taxation Current tax charge for year 18,700 Prior year overprovision (400) Movement in deferred tax (below) (1,200) Charge to profit or loss 17,100 Deferred tax liability at 1 January 20X4 11,200 Credit to profit or loss (balancing figure) (1,200) Deferred tax liability at 31 December 20X4 (40m 25%) 10,000 4 Loan note 2% loan note proceeds 80,000 Effective interest (80m 6% 6/12) 2,400 Interest paid (per trial balance) (800) Balance at 31 December 20X4 81,600 5 'Sale or return' transaction Cancel sale: DR Revenue 3,900 CR Trade receivables 3,900 Record closing inventories: DR Inventories (3, %/130%) 3,000 CR Cost of sales 3,000 6 Share issue Shares('000) Shares at 1 January 20X4 120,000 1 for 4 issue 30,000 Shares at 31 December 20X4 150,000 Receipt from rights issue (30m 80Gp) 24,000 (b) EARNINGS PER SHARE FOR THE YEAR ENDED 30 DECEMBER 20X4 Theoretical ex-rights price GHS 4 shares at GHS share at 80Gp shares 4.80 Theoretical ex-rights price is therefore GHS4.80/5 = 96Gp Weighted average number of shares Date Shares Time period Bonus fraction Weighted average '000 ' X4 120,000 9/12 100/96 93, X4 150,000 3/12 37, ,250 EPS = GHS55,600,000 / 131,250,000 = 42.4Gp

6 4 Final Mock Exam 1: Answers Question 2 S Marking scheme (i) Change in accounting policy 1 Required by IFRS or improve reliability/relevance 1 Proposed treatment may be permitted 1 If change must restate previous year's financial statements 1 Available 4 Marks Maximum 3 (ii) (iii) (iv) (v) Provisions Provision for damages at GHS4 million 2 Provision for product warranty claim at GHS3.4 million 2 Government grant Not a liability (do not use repayment schedule) 1 Credited over life of the asset at GHS800,000 per annum 1 GHS7.2m deferred income in statement of financial position 1 5% loan note Debt component 2 Equity component 1 Finance cost and carrying amount 2 Investment properties Property A depreciation 1 Capital surplus gain on reclassification 1 Revaluation gain at year end 1 Property B in S's statements 1 In the consolidated statements (i) (ii) Changing the classification of an item of expense is an example of a change in accounting policy, in accordance with IAS 8 Accounting policies, changes in accounting estimates and errors. Such a change should only be made where it is required by an IFRS or where it would lead to the information in the financial statements being more reliable and relevant. It may be that this change does represent an example of the latter, although it is arguable that amortised development costs should continue to be included in cost of sales as amortisation only occurs when the benefits from the related project(s) come on-stream. If it is accepted that this change does constitute a change of accounting policy, then the proposed treatment by the directors is acceptable; however, the comparative results for the year ended 31 December 20X3 must be restated as if the new policy had always been applied (known as retrospective application). The two provisions must be calculated on different bases because IAS 37 Provisions, contingent liabilities and contingent assets distinguishes between a single obligation (the court case) and a large population of items (the product warranty claims). For the court case the most probable single likely outcome is normally considered to be the best estimate of the liability, ie GHS4m. This is particularly the case as the possible outcomes are either side of this amount. The GHS4m will be an expense for the year ended 31 December 20X4 and recognised as a provision.

7 Final Mock Exam 1: Answers 5 (iii) (iv) The provision for the product warranty claims should be calculated on an expected value basis at GHS3.4m (((70% nil) + (20% GHS25) + (10% GHS120)) 200,000 units). This will also be an expense for the year ended 31 December 20X4 and recognised as a current liability (it is a oneyear warranty scheme) in the statement of financial position as at 31 December 20X4. Government grants related to non-current assets should, as required by IAS 20 Accounting for government grants, be credited to the statement of profit or loss over the life of the asset to which they relate, not in accordance with the schedule of any potential repayment. The directors' proposed treatment is implying that the government grant is a liability which decreases over four years. This is not correct as there would only be a liability if the directors intended to sell the related plant, which they do not. Thus in the year ended 31 December 20X4 GHS800,000 (8 million/10 years) should be credited to the statement of profit or loss and GHS7.2m should be shown as deferred income (GHS800,000 current and GHS6.4m non-current) in the statement of financial position. 5% convertible loan note Under IAS 32 Financial instruments: presentation the convertible loan note is a compound financial instrument having a debt and an equity component which must be accounted for separately. The debt value is found by discounting the expected future cash flows at 8%. The rest of the amount raised at issue is the equity value. Year ended 31 December Out flow Discount factor Present value 20X X X6 5, ,147 Debt component 4,595 Equity component (= balance) 405 Proceeds of issue 5,000 The finance cost for the year will be GHS367,600 (4,595 8%) and the carrying amount of the loan as at 31 December 20X4 will be GHS4,712,600 (4,595 + ( )). (v) Property A was property, plant and equipment whilst it was occupied by S and thus under IAS 16 Property, plant and equipment should be depreciated for the first six months of the year, with a charge to the statement of profit or loss of (2,000/20 years 6/12) GHS50,000. On 1 July when it is let it became an investment property under IAS 40 Investment property. It is no longer depreciated. It is recognised in investment properties on 1 July 20X4 at its fair value of GHS2,300,000 and a gain is recognised of (2,300 (2,000 50) GHS350,000 in the capital serplus and in other comprehensive income. At the year end it is revalued to its fair value of GHS2,340,000 and the gain of (2,340 2,300) GHS40,000 is recognised in profit or loss. Property B is occupied by another entity and so is an investment property in S's financial statements. It is revalued at the year end to GHS1,650,000 and the gain of (1,650 1,500) GHS150,000 is recognised in profit or loss. As it is occupied by a subsidiary it will be property, plant and equipment in the consolidated financial statements.

8 6 Final Mock Exam 1: Answers Question 3 LB Marking scheme (a) Finance lease Journals 2 Profit or loss Statement of financial position 1 1 Operating lease Journals 2 Profit or loss 1 Statement of financial position 1 (b) IAS 17 Substance over form 1 Asset 2 Liability 2 Importance of not netting off 1 Effect on analysis 1 (c) Branch accounting Definition 1 Advantages 2 Disadvantages 2 Marks (a) Lease 1 Journals GHS GHS On 1 January 20X4 Debit machinery 55,000 Credit finance lease liability 55,000 Debit finance lease liability 15,775 Credit cash 15,775 At the year end Debit depreciation expense (W1) 11,000 Credit accumulated depreciation 11,000 Debit finance cost (W2) 3,923 Credit finance lease liability 3,923 Lease 2 Journals On 1 January 20X4 Debit machine hire expense 12,000 Credit cash 12,000 On 31 December Debit machine hire expense 12,000 Credit cash 12,000 At the year end Debit prepayments (W3) 9,000 Credit machine hire expense 9,000

9 Final Mock Exam 1: Answers 7 In the statement of profit or loss GHS In the calculation of operating profit Depreciation expense (W1) 11,000 Machine hire expense (W3) 15,000 Finance cost (W2) 3,923 In the statement of financial position In non current assets Machinery (W1) 44,000 In current assets Prepayment (W3) 9,000 In non current liabilities Finance lease liabilities (W2) 27,373 In current liabilities Finance lease liabilities (W2) 15,775 (b) (c) Asset IAS 17 is an example of economic substance triumphing over legal form. Financial statements must reflect the effect of transactions. In legal terms, with hire purchase the leasing company is the legal owner of the asset until the final payment is made, but the lessee enjoys all the risks and rewards which ownership of the asset brings. This is the key element in the treatment in IAS 17. The lessee must recognise an asset as they maintain and run the asset through its useful life, and control the future economic benefits of the asset as a result of entering into the lease, despite not having legal ownership. Liability When an entity signs a hire purchase agreement there is an obligation to pay the instalments on the lease until it expires which must be recognised as a liability. The assets and liabilities recognised when LB signed the hire purchase agreement cannot be netted off against each other. If finance leases such as hire purchase were treated like operating leases no asset would be recognised and lease payments would be expensed through the statement of profit or loss as they were incurred. This is 'off balance sheet finance'. The company would have assets in use and liabilities to leasing companies which are not recorded in the financial statements. This would be misleading to the user of the accounts and make it appear as though the legally owned assets which were recorded were more efficient in producing returns than was actually the case. Branch accounting is an accounting system in which separate accounts are maintained in the nominal ledger for each location (or branch) of an entity. LB is likely to find branch accounting useful if it wants to calculate separate performance figures for each location, or if it wants to be aware of the value of assets and liabilities at the different locations. Separate figures allow LB to compare the costs and efficiency of the two locations at any time and that should help it to control costs, maximise revenues and promote best practice. The disadvantages of branch accounting are the time and effort that it takes to maintain separate accounts for each location, which are unnecessary for the preparation of published financial statements for the company. LB must be sure that the benefits to internal management control outweigh the extra cost before it implements a system of branch accounting. Workings 1 Depreciation 55,000/ 5 years = GHS11,000 Carrying amount = 55,000 11,000 = GHS44,000

10 8 Final Mock Exam 1: Answers 2 Finance lease liability GHS Fair value of asset 55,000 Cash 1 January 20X4 (15,775) Balance 39,225 Finance cost at 10% 3,923 Balance at year end 43,148 Cash 1 January 20X5 =current liability (15,775) Noncurrent liability 27,373 3 Operating lease GHS Cash paid in 20X4 24,000 Expense incurred in 20X4 (5 12,000)/ 4 years (15,000) Prepayment 9,000

11 Final Mock Exam 1: Answers 9 Question 4 P Marking scheme Marks (a) Statement of financial position Property, plant and equipment 1 Goodwill 1 Investment in associate 1 Current assets 1 Share capital 1 Income Surplus 3 Capital Surplus 1 Non-controlling interests 1 5% loan notes Current liabilities 1 15 (b) Statement of profit or loss and other comprehensive income Revenue 1 Share of profit of associate 1 2 (c) Treatment of joint venture 3 20 (a) P CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4 Non-current assets Property, plant and equipment (122, ,000 + (W8) 2,080) 178,080 Goodwill (W2) 8,000 Investment in associate (W3) 23, ,980 Current assets (44, ,000 (W9) 400 (W9) 1,000) 60,600 Total assets 270,580 Equity attributable to owners of the parent Share capital (15,000 + (W7) 38,400) 53,400 Income surplus (W4) 124,564 Capital surplus (W5) 13, ,164 Non-controlling interests (W6) 13, ,480 Non-current liabilities 5% loan notes 16,000 Current liabilities (36, ,100 (W9) 1,000) 50,100 Total equity and liabilities 270,580 (b) CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X2 Revenue = 180,000 + (8/12 78,000) (W9) 8,000 = GHS224million Share of profit of associate = 10,500 6/12 40% = GHS2.1million

12 10 Final Mock Exam 1: Answers (c) In the consolidated statement of financial position the joint venture will be recognised, using equity accounting, in consolidated non current assets and in consolidated reserves. Consolidated non current assets will include Investments in Joint Ventures at the cost of the shares acquired plus 60% of the post acquisition change in net assets, less any impairments. Consolidated reserves will similarly include 60% of the joint venture s post acquisition change in net assets less any impairments. Workings 1 Group structure P X X4 80% 40% S Pre-acquisition: Income surplus 32m Capital surplus surplus 5.3m 2 Goodwill Consideration transferred: Cash (10,000 80% $1.00) 8,000 Share for share exchange (W7) 38,400 46,400 Non-controlling interests (10,000 20% GHS5.80) 11,600 A Fair value of identifiable net assets at acq'n: Share capital 10,000 Income surplus (40,400 (12,600 8/12)) 32,000 Capital surplus (6,500 (1,800 8/12)) 5,300 Fair value adjustments (W8) 2,700 (50,000) Goodwill at acquisition 8,000 Impairment losses to date (0) Goodwill at year end 8,000 3 Investment in associate Cost of associate 21,600 Share of post-acq'n income surplus (W4) 2,100 Share of post-acq'n capital surplus (W5) 240 Unrealised profit (W9) (40) 23,900 4 Income surplus P S A Per question 116,600 40,400 39,000 Fair value movement (W8) (620) Unrealised profit on inventories (W9) (40) (400) Pre-acquisition (A: 39,000 (10,500 6/12)) (32,000) (33,750) 7,380 5,250 Group share of post-acquisition ret'd earnings: S (7,380 80%) 5,904 A (5,250 40%) 2,100 Group share of impairment losses to date (0) 124,564

13 Final Mock Exam 1: Answers 11 5 Capital surplus P S A Per question 12,000 6,500 3,000 Pre-acquisition (A: 3,000 (1,200 6/12)) (5,300) (2,400) 1, Group share of post-acquisition capital surplus: S (1,200 80%) 960 A (600 40%) ,200 6 Non-controlling interests (SOFP) NCI at acquisition (W2) 11,600 NCI share of post-acquisition revenue surplus (7,380 20%) 1,476 NCI share of post-acquisition capital surplus (1,200 20%) 240 NCI share of impairment losses to date (0) 13,316 7 Purchase of S (shares) DR Investments in equity instruments/goodwill 38,400 CR Share capital (10,000 80% GHS9.60) 38,400 8 Fair value adjustments At acquisition Movement At year end Plant and equipment 2,400 (320)* 2,080 Inventories 800 (800) Contingent liability (500) 500 2,700 (620) 2,080 * 2,400,000/5 years 8/12 9 Intragroup trading (1) Cancel intragroup sales/purchases (subsidiary only) DR Group revenue (1,000 8 months) 8,000 CR Group cost of sales 8,000 (2) Eliminate unrealised profit Subsidiary DR Cost of sales/income surplus (2,000 20%) 400 CR Group inventories 400 Associate DR Cost of sales (P sold)/group income surplus (1,200 20%/120% 40%) 40 CR Investment in associate (holds inventories) 40 (3) Cancel intragroup balances (subsidiary only) DR Group payables 1,000 CR Group receivables 1,000

14 12 Final Mock Exam 1: Answers Question 5 C Marking scheme (a) Components of 'Faithful representation' Explanation of faithful representation 1 1 mark for each of the three components identified and explained 3 Substance over form 1 5 (b) mark for each relevant ratio Maximum 5 Marks (c) Discussion of: Profitability 3 Liquidity (and working capital ratios) 4 Gearing and long term stability 2 Other issues 2 Summary 1 Available 12 Maximum (a) To be useful to the user of the financial statements, financial information must faithfully represent the transactions and events which have happened. In essence this means that the financial statements give an honest, true and fair account of the assets, liabilities, income and expenses of the reporting entity. The IASB Conceptual Framework for Financial Reporting states that a perfectly faithful representation would be complete, neutral and free from error. Completeness A complete depiction includes all information necessary for a user to understand the financial data being depicted. Quite simply this means that all material transactions and events that should have been accounted for have indeed been accounted for i.e. there are no omissions within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance to the user of the financial statements. Neutrality A neutral depiction is without bias in the selection and presentation of financial information. Financial statements are not neutral if the selection or presentation of information is made to achieve a predetermined result or outcome. Free from error Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. For example, a representation of an estimate of a provision can be faithful if it is clearly described as an estimate and no errors have been made in selecting and applying the process used to determine the figure. The principle of 'substance over form' is also relevant to faithful representation. It means that financial statements should report the underlying commercial reality of transactions (ie their substance) rather than the strict legal position (the form). Thus, for example, regarding the question of whether the reporting entity should recognise an asset or not, the legal ownership of the asset is irrelevant.

15 Final Mock Exam 1: Answers 13 (b) Calculations C Sector average Return on capital employed 34.6% 22.1% PBIT Debt +Equity Net asset turnover Revenue Total assets Current liabilities 2,425 1, Gross profit margin 22.9% 30% Gross profit Revenue 555 2,425 Net profit (before tax) margin 7.7% 12.5% Profit before tax Revenue 186 2,425 Current ratio 1.2 : : 1 Current assets Current liabilities Quick ratio 0.6 : : 1 Current assets Inventories Current liabilities Inventory holding period 54 days 46 days Inventories Cost of sales 1,870 Trade receivables collection period 48 days 45 days Tradereceivables Revenue 2,425 Trade payables payment period 68 days 55 days Tradepayables Cost of sales 1,870 Debt to Equity 90% 40% Interestbearingborrowings 300 Equity 335 (c) Financial performance Profitability The high return on capital employed (ROCE) of 34.6% (compared with 22.1% for all companies) shows that C's assets are being used relatively efficiently. This is despite C having a disappointing gross profit margin (22.9% compared with 30%) and net profit margin (7.7% compared with 12.5%). C has made up for this low level of profitability by having a very high level of asset utilisation, as shown by a net asset turnover ratio of 3.8 times, which is more than twice the average of 1.8 times. There are two things that complicate the analysis above: (i) The age of C's non-current assets; and (ii) The write off of inventories. These are discussed below: (i) The carrying value of C's non-current assets is only 15% of their cost, suggesting that these assets are quite old. This will have boosted the ROCE compared with a company with newer assets with a higher carrying value. However, there is not enough

16 14 Final Mock Exam 1: Answers (ii) information to investigate this further. Also, these assets will probably need replacing soon, and because C has no cash it will need to borrow more money. This will be extremely difficult (and probably expensive) as its gearing ratio is already very high (90%) compared with the sector average (40%). Cr's net profit margin is distorted by the GHS120,000 charge for writing off inventory. Without this the net profit margin would have been 12.6%, which is greater than the average of 12.5%. If this write-off really is a one-off not-to-be-repeated event then this suggests that the underlying return on capital employed is 53.5%. However, the sector averages do not include similar information on one-off costs. Long term solvency and stability As mentioned above, C's gearing ratio is already high and the need to replace old plant and equipment could push it higher. As the existing equipment cost GHS3.6m some years ago C could expect to spend at least as much again today. If all of it was borrowed, the gearing ratio would be 1,100%, which the banks would almost certainly not tolerate. The alternative would be to raise more share capital. At the current market price of GHS6 a share a further 600,000 shares would need to be issued, which would double the number of shares. This also seems an unlikely prospect. However, without new loans or share capital there can be no new equipment, and without new equipment it is unlikely that they can continue to produce furniture. Short term solvency and liquidity C's quick and current ratios are below the industry average, which suggests that there may be short term cash flow problems and poor financial management. Although the working capital cycle is relatively good (34 days compared with 36), the individual components are worse implying that there is poor inventory control, poor credit control, and a shortage of cash to pay suppliers. Poor inventory control may have caused the build-up of obsolete inventory (leading to the GHS120,000 write-off), and poor credit control can lead to an increase in bad debts. Delaying paying suppliers (who now have to wait 68 days to be paid) is a short term solution, but it can become a problem if suppliers lose patience with C and demand cash on delivery, or refuse to deliver at all. Interest cover, dividends, tax and overdraft Although the interest cover of ten looks good in terms of profits, there is no cash to pay the interest. Likewise there is GHS85,000 tax to pay. We are not told what the overdraft limit is, but it appears that C can only meet its obligations if the overdraft is increased. Summary and conclusion At first sight C's operating performance appears to be good compared with its rivals, but further analysis suggests that this might be boosted by old plant and equipment. C's financial position is worrying both in the short term and the long term, and it is difficult to see how it will be able to meet its obligations and invest in the future. Unless things improve C's going concern status must be in doubt. APPENDIX: ADDITIONAL RATIOS Comparator Sector average Net profit margin excluding write off 12.6% Not known Profitbefore tax + write off Revenue 2,425 ROCE excluding write off 53.5% 22.1% Profitbefore finance costs+ write off Assets current liabilities 635 Working capital cycle 34 days 36 days ( ) ( )