CORPORATE REPORTING PROFESSIONAL 1 EXAMINATION - APRIL 2014

Transcription

1 CORPORATE REPORTING PROFESSIONAL 1 EXAMINATION - APRIL 2014 NOTES: You are required to answer Questions 1, 2 and 3. You are also required to answer either Question 4 or 5. (If you provide answers to both Questions 4 and 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first answer to hand for Question 4 or 5 will be marked.) Provided are pro-forma: Statements of Profit or Loss and Other Comprehensive Income By Expense, Statements of Profit or Loss and Other Comprehensive Income By Function, and Statements of Financial Position. TIME ALLOWED: 3.5 hours, plus 10 minutes to read the paper. INSTRUCTIONS: During the reading time you may write notes on the examination paper, but you may not commence writing in your answer book. Please read each Question carefully. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded to pay particular attention to your communication skills, and care must be taken regarding the format and literacy of your solutions. The marking system will take into account the content of your answers and the extent to which answers are supported with relevant legislation, case law or examples, where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question attempted. The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.

2 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND CORPORATE REPORTING PROFESSIONAL 1 EXAMINATION APRIL 2014 Time allowed 3.5 hours, plus 10 minutes to read the paper. You are required to answer Questions 1, 2 and 3. You are also required to answer either Question 4 or 5. (If you provide answers to both Questions 4 and 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first answer to hand for Question 4 or 5 will be marked.) You are required to answer Questions 1, 2 and Bagehot plc (Bagehot) is a public limited company based in Ireland. It has shareholdings in two other companies, Nero plc (Nero) and Kartone plc (Kartone). Statements of financial position are shown below for all three companies as at 31 March Statements of Financial Position as at 31 March 2014 Bagehot plc Nero plc Kartone plc million million million Non-current assets: Property, plant & equipment Investments Current assets: Inventories Trade receivables Cash & bank Total assets Equity: Equity share capital of 0.50 each Share premium Retained earnings: Balance 1 April Year to 31 March Current liabilities: Trade payables Bank overdraft Dividends proposed Total equity & liabilities The following additional information is to be taken into account in so far as it is relevant: (i) (ii) Bagehot bought 30 million ordinary shares in Kartone on 1 April 2013, paying an amount of 40 million cash for these shares. This investment has been correctly recorded at cost in the books of Bagehot, included under the heading Investments. Bagehot bought a 90% holding in the ordinary shares of Nero on 1 July The consideration consisted of an immediate cash payment of 50 million together with an issue of equity shares at the rate of one share in Bagehot for every six shares acquired in Nero. The fair value of Bagehot s equity shares at 1 July 2013 was 5.20 each. The cash consideration has been correctly recorded in the books of Bagehot, but the equity issued by Bagehot has not been recorded at all. The remaining investments consist of investments carried at fair value through profit or loss, and are correctly carried at fair value. Page 1

3 (iii) (iv) (v) The share capital and share premium of Nero and Kartone have not changed since their respective dates of acquisition. Retained earnings for each year should be assumed to accrue evenly over that year. The group accounting policy is to value any Non-Controlling Interests (NCI) at fair value at the date of acquisition, and goodwill should be calculated accordingly. Fair value of NCI should be measured using the share prices of the respective companies. The share price of Nero was 2.10 on 1 July The share price of Kartone was 1.50 on 1 April On the acquisition dates, the fair values of the assets of Nero and Kartone were equivalent to their book values with one exception. The buildings of Kartone were worth 10 million in excess of their book value on the date Bagehot acquired its holding. These buildings had an estimated remaining economic life of 25 years from the acquisition date. (vi) During the financial year ended 31 March 2014 Nero had purchased goods from Bagehot amounting to 7.5 million. The purchase price included a mark-up of 50% on cost. 30% of these goods remained in the stock of Nero at the reporting date. (vii) (viii) (ix) (x) Recorded in the books of Bagehot was an intra-group trade receivable of 2 million owed by Nero at year-end. However the books of Nero showed a balance of 1.3 million owed to Bagehot. Cash in transit at the reporting date was the reason for this difference. Bagehot has not accounted for any dividend receivable from its group companies. Both Bagehot and Kartone have proposed dividends as shown in current liabilities. Kartone s proposed dividend relates entirely to the postacquisition period. No other dividends were paid or proposed in the year. Goodwill was reviewed for impairment at the reporting date, and a 20% impairment loss was considered necessary to the goodwill of both Nero and Kartone. All workings may be rounded to the nearest 0.1m. REQUIREMENT: Prepare the consolidated statement of financial position for the Bagehot group as at 31 March 2014 in accordance with International Financial Reporting Standards. (23 marks) Format and Presentation (1 mark) IFRS 11 describes two types of joint arrangement and specifies the accounting requirement for each. Distinguish between a Joint Operation and a Joint Venture as described by IFRS 11 Joint Arrangements. Outline the accounting treatment applicable to each type of arrangement. (6 marks) [Total: 30 MARKS] Page 2

4 2. Drucker plc is a public listed wholesaler. Its summarised financial statements for the year ended 31 December 2013 (and 2012 comparatives) are as follows: Statements of Profit or Loss and Other Comprehensive Income for the years ended 31 December: million million Revenue Cost of sales (200) (100) Gross profit Operating costs (36) (30) Investment income - 2 Gains on revaluation of investments held at fair value through P/L (5) 10 Finance costs (5) (5) Profit (loss) before taxation Income tax expense (4) (15) Profit for the year Other comprehensive income (Amounts that will not be reclassified to profit or loss) Revaluation losses on property plant & equipment (45) - Total comprehensive income (loss) for the year (20) 62 Statements of Financial Position as at 31 December: million million Assets Non-current assets: Property, plant and equipment Investments at fair value through profit or loss Current assets Inventory Trade receivables Bank Total assets Equity and liabilities Equity: Equity shares of 1 each Revaluation reserve Retained earnings Non-current liabilities: Bank loan Current liabilities: Trade payables Bank overdraft Current tax payable Total equity and liabilities You are a newly recruited accountant working for Drucker plc. The draft financial statements for year ended 31 December 2013 have just been produced. Your managing director, Tom Kirby, has asked you to explain to him what the above financial statements mean for the company s performance for the year 2013 and its financial position at 31 December He makes you aware of the following points and opinions. Page 3

5 (i) (ii) (iii) (iv) (v) Drucker plc has traditionally been very profitable, but in recent years has been finding it difficult to keep up its sales level due to the effects of internet sales. Basically it finds more customers are buying directly online from suppliers and cutting out the middleman, which includes Drucker as a wholesaler. To counteract this, on 1 January 2013, Drucker launched a strategy of cutting its prices in the hope that this would generate additional sales volume and profits. To support the new strategy and allow faster movement of goods, a new product movement and control system was commissioned and installed on 1 January 2013 at a cost of 40 million. This is being depreciated over a 5 year useful economic life. The old system was disposed of for nil consideration on the same date, but had been carried at 15 million at the date of disposal. The loss was taken to Cost of Sales, as is depreciation. No other non-current assets were acquired or disposed of in either of the two years. Tom expresses the opinion that this strategy has not failed so far, as the total on the statement of financial position has remained the same from year to year. This proves (he claims) the company has retained its book value and therefore has not suffered any deterioration in performance from 2012 to The share price has declined from 2.80 per share on 31 December 2012 to 1.60 per share on 31 December Tom does not understand the reasons for this. Tom is aware that there are valuable tools for analysing profitability, liquidity and efficiency. However he has no knowledge of how to calculate or interpret these. REQUIREMENT: (c) Calculate at least 8 suitable ratios for each financial year in order to assist in addressing the issues raised by the managing director. (8 marks) Discuss Tom s assertion in point (iii) above that the new strategy has not failed because the company has retained its book value. (4 marks) Analyse and discuss the financial performance and position of Drucker plc as portrayed by the financial statements on Page 3 and the additional information provided. Pay particular attention to the issues raised by Tom and their impact on the performance and position of the company. (14 marks) (d) Identify the limitations of your analysis. (4 marks) [Total: 30 MARKS] Page 4

6 3. The following multiple choice question contains eight sections, each of which is followed by a choice of answers. Only one answer is correct in each case. Each question carries equal marks. REQUIREMENT: Give your answer to each section in the answer sheet provided. [Total: 20 MARKS] 1. During the year ended 31 March 2014, it was discovered that the published financial statements for year ended 31 March 2013 included 25,000 of goods in closing inventory, which had in fact been sold during March Assume this is a material amount in the context of the financial statements. In compliance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, how should this matter be dealt with during the preparation of the financial statements for year ended 31 March 2014? (c) (d) Treat the matter as a current period error, and correct in the 2014 financial statements; Treat the matter as a prior period error, and correct by adjustments to the 2013 comparatives; Treat the matter as a change of estimate, and correct in the 2014 financial statements; Recall all copies of the 2013 annual report and reissue a corrected version. 2. Kerrydam plc is a construction contractor. It implements a policy of using the value of work certified basis of measuring the degree of completion of contracts in progress. On 1 April 2013 it commenced work on a contract to build a solar farm on behalf of a client. The contract price was agreed at 36 million. By the reporting date, 31 March 2014, the following details were available: Work certified complete had a value of 12 million. Costs incurred to date were 15 million. Costs remaining to complete the job were estimated at 26 million. Under IAS 11 Construction Contracts, what figures should appear in the financial statements in respect of this contract? Revenue Profit or loss 13.2 million 5 million loss 13.2 million 3 million loss (c) 12 million 3 million loss (d) 12 million 5 million loss 3. IAS 17 Leases defines a finance lease as A lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Which of the following lease conditions would NOT support a conclusion that the substantial risks and rewards of the asset are transferred under a lease containing these conditions? (c) (d) The leased assets are highly specialised and could only be used by the lessee without major modifications; The lease term is 5 years and the asset s useful economic life is estimated to be 6 years; The present value of the minimum contractual lease payments amounts to 75% of the asset s fair value (both measured at the date of inception of the lease); Legal title to the asset may be acquired by the lessee for a nominal sum at the conclusion of the lease term. 4. Moon plc bought a new, fully fitted, office building on 1 April 2013 for 20 million. On the same date it issued a 25 million bond at an annual yield of 7.5%, primarily to pay for the new building. The building remained idle for 4 months as the directors of Moon plc decided not to move offices until the summer. On 1 August 2013 the company occupied the building, and remained in occupation for the balance of the financial year. The reporting date is 31 March Under IAS 23 Borrowing Costs, how much interest should be capitalised to the buildings account? nil 500,000 (c) 625,000 (d) 1,875,000 Page 5

7 5. Under IAS 32 Financial Instruments: Presentation, how are preference shares in issue classified in the Statement of Financial Position? (c) (d) Equity in all cases; Liabilities in all cases; Equity if redeemable or cumulative, liabilities in all other cases; Liabilities if redeemable or cumulative, equity in all other cases. 6. Which of the following is true of IAS 34 Interim Financial Reporting? (c) (d) IAS 34 requires that half-yearly reports must be published; IAS 34 requires that quarterly reports must be published; IAS 34 requires that monthly reports must be published; IAS 34 does not prescribe the production of interim reports or their frequency; it merely regulates their content if required by national governments or stock exchanges. 7. George plc received a government grant of 200,000 on 1 July 2013 to assist with the purchase of an asset on the same date. The asset had a 5-year useful economic life from that date. George plc adopts a policy of recognising government grants within deferred income until recognised in profit or loss. At the reporting date 31 March 2014 what figures should appear in the statement of financial position of George plc with respect to the grant? Current Liabilities Non-current Liabilities 200,000 Nil 40, ,000 (c) 40, ,000 (d) 10, , IFRS 10 Consolidated Financial Statements requires an entity to judge whether or not another entity is a subsidiary by assessing whether it controls the other entity. Which of the following statements is NOT consistent with the IFRS 10 definition of control? (c) (d) The investor must have exposure to variable returns from its involvement with the investee; The investor must have sufficient power over the investee to affect the returns it generates from the investee; Power exists when the investor has the ability to direct relevant activities to affect its returns; The investor must own over 50% of the voting shares. Page 6

8 Answer either Question 4 or Question 5 4. IFRS 8 Operating Segments seeks to assist the user of financial statements gain a clearer understanding of the performance of the business by requiring disaggregation of the reported financial information into segments. Gedward plc is a conglomerate whose equity shares are quoted on the Dublin stock exchange. The group manufactures, distributes and retails food products. It also operates a hotel chain for diversification of revenues. The financial controller presents the following data to you. She wishes to know if IFRS 8 applies to the entity, and if so what segments should be reported on. She informs you that the operating results of each of the divisions below are internally reported separately to the chief operating decision maker. Business Revenue (External) Revenue (Internal) Profit (loss) Assets million million million million Manufacturing ,450 Distribution Retailing Hotel chain (14) 100 REQUIREMENT: Discuss the requirements of IFRS 8 regarding: (i) The identification of reportable segments; and (ii) The information to be presented in respect of each reportable segment. (10 marks) By applying IFRS 8 to the above financial data, explain with reasons which of the above businesses of Gedward plc are reportable segments. (10 marks) OR [Total: 20 MARKS] 5. IAS 37 Provisions, Contingent Liabilities and Contingent Assets is an important standard regulating the recognition of liabilities and the use of provisions. It has been especially useful in controlling the abuse of provisions to manage reported earnings. REQUIREMENT: Define a provision and discuss in detail the three conditions that must be satisfied in order for a provision to be recognised under IAS 37. Your answer should explain how the requirements of IAS 37 are consistent with the principles contained in the conceptual framework. (10 marks) Discuss briefly how each of the following transactions and events should be recorded by Henmark plc in compliance with the requirements of IAS 37. (i) (ii) (iii) (iv) A decision was taken by the board of Henmark plc shortly before the year-end to close down a division. The costs of the closure are estimated to total 30 million. The decision was announced in principle, but detailed implementation plans have not been made yet. (2 marks) Henmark plc has traditionally repainted its premises every five years. The next painting is due in a year s time. The entity proposes to accrue as a provision the expected cost of repainting the premises.(2 marks) Henmark plc has sold 5,000 units of a product to customers during the past 12 months with a year s warranty attaching. Past experience has shown that 3% of goods sold require warranty repair at an average cost of 200 per unit. (4 marks) Henmark plc has guaranteed the debts of its associate company up to a maximum amount of 3 million. The associate is in excellent financial health and the directors are of the opinion that it is unlikely the guarantee will ever be called in. (2 marks) [Total: 20 MARKS] END OF PAPER Page 7

9 SUGGESTED SOLUTIONS THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND CORPORATE REPORTING PROFESSIONAL 1 EXAMINATION APRIL 2014 SOLUTION 1 Marking Scheme: Basic consolidation (100% Bagehot + 100% Nero + 100% Kartone) 4 Goodwill and impairment thereof (including NCI at acquisition date) 4 Recording of shares issued on acquisition of Nero 1 Fair value adjustments and post acq movements 2 Intra group sales of inventory 2 Intra group balances outstanding & cash in transit 3 Intra-group dividend 2 Reserves calculation and consolidation 3 NCI calculation at reporting date 2 Presentation 1 Subtotal 24 Key distinguishing point whether control is over individual assets or over an entity s assets collectively 2 Method of accounting for each type of arrangement brief clear description 2 Any two other relevant points * 1 mark each 2 6 [Total: 30 Marks] Page 8

10 Suggested Solution Group structure: Bagehot 90% ownership in Nero for 9 months Subsidiary Bagehot 60% ownership in Kartone for full year - Subsidiary Consolidated statement of financial position of Bagehot Group plc as at 31 March 2014 million Non current assets: Property, plant and equipment ( (W5-note v)) Goodwill (W2) ( ) 66.0 Other investments ( (W2) 40 (W2)) Current assets: Inventories ( (W5 vi) Trade receivables ( (W5-viii) 1.3 (W5-viii) 84.0 Cash & bank ( (W5-viii) Total assets Equity: Equity shares ( (W1) Share premium ( (W1) Retained earnings (W3) Non-controlling interest (W4) ( ) Current liabilities Trade payables ( (W5-viii) Bank overdraft (5) 5.0 Dividends proposed ( (W5-x) Total equity & liabilities W1 Acquisition of Nero plc and Kartone plc (equity issue not recorded yet) Nero million Kartone million Total equity capital (per SOFP) Number of shares ( 0.50 each) Percentage acquired by Parent 90% 60% Number acquired by Parent Exchange arrangement 1/6 Number of Bagehot shares issued in consideration 15 Consideration given in exchange for an interest in subsidiaries must be valued at fair value. Hence: Fair value of shares issued in consideration ( 5.20 each) 78 Nominal value to equity share capital ( 0.50 each) 7.5 Balance to share premium account 70.5 Journal to record equity issue: DR million CR million Dr Goodwill (or investments for subsequent transfer to goodwill) 78 Cr Equity share capital 7.5 Cr Share premium 70.5 Page 9

11 W2 Calculation of Goodwill Nero Kartone million million Consideration Equity shares (W1: 15 * 5.20) 78 Cash FV of NCI (100 shares * 10% * 2.10), (50 * 40% * 1.50) FV of net assets acquired Equity share capital Share premium Pre-acquisition reserves *(see note below) FVA Building (W5-note v) (93.5) 10 (43) Goodwill Impairment loss (20% - to be split pro rata between parent and NCI) (11.1) (5.4) Balance *Note: Pre-acquisition retained earnings for Kartone may be read from the SOFP as the date of acquisition corresponds to the reporting date 1 year ago. The equivalent figure for Nero needs to be calculated as this acquisition happened during the year.the balance on 1 April 2013 was 26m.The amount earned for the year ended 31 March 2014 was 10m. Of this, 2.5m is assumed to have been earned by 1 July 2013 (as earnings are assumed to accrue evenly over the year (note (iii), therefore 10 * 3/12 would be earned in the first three months). Hence the total earnings retained at 1 July 2013 was the balance at 1 April 2013 plus the amount earned in the three months to 1 July This amounts to = 28.5m. W3 Group retained earnings at 31 March 2014 Bagehot Nero Kartone m m m Balance per SOFP (total at y/e) Less balance at acquisition (310 + (90 * 6/12)) (28.5) (8) Movement on FVA (buildings) (W5-note v) (0.4) URP in inventory re intra-group sale of goods to Nero (W5-vi) (0.8) Intra group dividends proposed (W5-x) 1.2 Share of goodwill impairment (11.1 * 90% * 60%) (13.2) Adjusted reserves for consolidation Consolidate Nero (90% * 7.5) 6.8 Consolidate Kartone (60% * 3.6) 2.2 Group total W4 Non-controlling interest at 31 March 2014 Nero Kartone m m Balance at acquisition (fair value from W2) Share of post-acquisition reserves from W3 (10% * 7.5), (40% * 3.6) Share of goodwill impairment (11.1 * 10%), (5.4 * 40%) (1.1) (2.2) Total Page 10

12 W5 Adjustments Note (v) Fair value adjustments: At acquisition Movement At rep. date Buildings Kartone 10m ( 0.4m)** 9.6m **Movement = depreciation of the adjustment for 1 full year since acquisition: 10m / 25 yrs = 0.4m. This is charged to the earnings of the company holding (and therefore depreciating) the asset, Kartone. Hence: Dr PPE Dr Retained earnings Kartone Cr Goodwill DR 9.6m 0.4m CR 10.0m Note (vi) Intra-group trading of goods (Nero) Unrealised profit (URP) on goods held in closing inventory: ( 7.5m * 50/150) * 30% (sold by Bagehot therefore NCI NOT affected) 0.75m Adjustment to reduce reserves (Bagehot) and Inventory (round to nearest 0.1m as instructed): Dr Retained Earnings (Bagehot) Cr Inventory 0.8m 0.8m Note (vii) intra-group balance outstanding & cash in transit Bagehot & Nero Cash in transit is 2m - 1.2m = 0.8m.This needs to be recorded in the books of the company yet to record the transaction. Here, this is Bagehot. Dr Cash Cr Trade receivables 0.7m 0.7m Following the adjustment for cash in transit, the intra group receivables and payables now balance at 1.2m. Hence we must cancel those balances. Dr Trade payables Cr Trade receivables 1.3m 1.3m Note (viii) Dividends Kartone s proposed dividend 2m Amount payable to parent company (60%) 1.2m Adjustment to reduce liability to pay dividends (Kartone) and increase retained earnings (Bagehot). Dr Dividends proposed Cr Retained earnings (Bagehot) 1.2m 1.2m Note (ix) Goodwill impairment Amount of impairment is 20% of the calculated balance. This reduces the balance of goodwill taken to noncurrent assets. See goodwill and retained earnings workings for calculation and treatment. As the goodwill was calculated using the full fair value method, the charge is shared between the parent and NCI in their profit-sharing proportion (rounded to the nearest 0.1 million). Page 11

13 A joint arrangement is a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control. There must be a contractual agreement between the parties which gives at least two of them joint control over the enterprise. Joint control means decisions need unanimous consent. There are two types of joint arrangement. These are: Joint operation Joint Venture Joint operation Joint operations are arrangements in which each venturer has control of individual assets and liabilities of the arrangement, as determined by the substance of the contract setting up the joint operation. The operation may or may not be a separate entity. Each venturer accounts for the elements (assets, liabilities, expenses and income) under its control on an individual basis, line by line. Joint venture A Joint venture arises when two or more parties set up a separate entity to be operated under joint control. Neither venturer controls individual assets or liabilities. Rather they are jointly in control of the entire venture. There must be a separate legal entity. The entity will prepare its own separate accounts and will be dealt with in the books of each venturer using equity accounting as for associate companies. Page 12

14 SOLUTION 2 Marking Scheme: (c) (d) Ratios Calculation of 8 ratios * 1 mark each 8 Subtotal 8 Tom s Assertion Recognition that SOFP total does not equal company book value 2 Recognition that same performance should lead to growth in book value 2 Other valid points will be considered for marks Subtotal 4 Analysis 14 valid points * 1 mark each. At least 7 points must exhibit higher order thinking and analysis skills, demonstrating understanding of the ratios and information analysed. In order to get full marks, at least three exceptionally insightful points must be offered. 14 Subtotal 14 Limitations Any 4 relevant limitations * 1 mark each 4 Subtotal 4 [Total: 30 Marks] Suggested Solution Gross Margin 75/275 = 27.3% 100/200 = 50% Net Margin (PBIT / Revenue) 34/275 = 12.4% 82/200 = 41% ROCE (PBIT / D+E) 34/270 = 12.6% 82/290 = 28.3% ROE (PAT / E) 25/220 = 11.4% 62/240 = 25.8% Current Ratio 92/72 = /52 = 1.10 Acid Test 52/72 = /52 = 0.73 Inventory Days 40/200*365 = 73 19/100*365 = 69 Receivables Days 52/275*365 = 69 28/200*365 = 51 Payables Days 50/200*365 = 91 39/100*365 = 142 Operating Cycle (days) = = -22 Adjusted Ratios (excluding the effects of the loss on disposal): Gross margin (75+15)/275 = 32.8% Net Margin (34+15)/275 = 17.8% ROCE (34+15)/270 = 18.1% Inventory Days 40/(200-15)*365 = 78.9 Payables Days 50/(200-15)*365 = 98.6 Excluding the effects of the loss on disposal and the movement in fair value of investments: Net margin ( )/275 = 19.6% (82-10)/200 = 36% Tom s statement is fallacious in two key respects. The total on the SOFP reflects total assets on one side, and total liabilities plus equity on the other. This total does not give any indication of the company s performance or of its value. For example, if the company were to purchase an asset and finance it by borrowing, both totals would increase. However, no additional performance need necessarily result. A better measure of performance is the equity total. This has declined by 20 million, indicating that the book value of the business is less that previous years. Page 13

15 Secondly, Tom s assumption that equal value would imply equal performance is false. If the company had performed as well as the previous year, it would have earned total comprehensive income of 62 million. This would have added an equivalent amount to the book value of the firm. Anything less than a 62 million increase in book value represents a deterioration in performance. (c) From an analysis of the financial statements supplied and the ratios calculated above, it seems clear that the performance of Drucker plc has deteriorated form 2012 to Even allowing for the distorting effect of the loss on disposal and the negative revaluation of non-current assets does not close the gap in performance. Profitability: Headline gross margin has dropped from 50% to 27.3%, the latter figure being 32.8% when the loss on disposal is omitted. This is a clear consequence of the strategy of lowering prices, and a decline should have been expected. The key question is whether this strategy was successful. In other words was the lower margin compensated for by greater volume. Whilst we do see increased sales volume, 37.5% in fact, the overall gross profit is lower. Gross profit has declined from 100m to 75m, the latter figure being 90m if the loss on disposal were excluded from cost of sales. This is an underlying decline of 10%. This is not a disaster. It is possible that the new strategy and system took some time to gain traction in the market, and it would be very useful to see month by month figures to ascertain if there was an improvement over the year. It is also entirely possible that the result would have been much worse had the new strategy not been implemented. After all the real comparison is not with last year, but with what this year would have been had no change occurred. This is probably impossible to know. Net margins are also down substantially (from 41% to 12.4%, the latter increasing to 17.8% excluding the loss on disposal). If we further adjust these figures to exclude the gains and losses on fair value investments, the figures are 19.6% (2013) and 36% (2012). This is a smaller decline, but still significant. However, if we look at the actual PBIT figure as adjusted, it has declined by just 18m, from 72m to 54m. This is almost entirely accounted for by the decline in gross profit ( 10m) and increase in operating costs ( 6m). The increase in operating costs is not surprising considering revenue has increased by 37.5% in value terms, and much more in unit terms due to the reduction in prices. Hence we can conclude that operating cost efficiency has not materially deteriorated. Liquidity: Headline liquidity ratios are poor. The current ratio has actually improved from 1.1:1 to 1.28:1, however the levels are still very poor. The acid test ratio looks even worse, declining from 0.73:1 to 0.72:1. It seems that the company s cash position is also poor, with a positive 10m cash balance turning into a negative 20m over the year. Apart from the bank overdraft, trade payables seem to be financing much of the company s liquidity needs. However it is important to bear in mind that the company bore large one-off investments in 2013, particularly the new 40m control system. This was financed from cash flow, as neither equity nor borrowings have increased. Also, it is likely that the increase in inventory and receivables (both absorbing cash) are related to the expansion of sales levels, and may not be repeated. However, that said, it is vital that the company examines closely its future cash flow needs, and considers raising new equity or debt as protection against unexpected events. The company is dangerously exposed at present. The decline in the share price may have discouraged the company from raising equity finance, and the bank may be co-operative in extending the overdraft. It would be important to know when the bank loan is due for repayment, as the company is not in a position to repay it at present. Presumably the investments could be sold if necessary. This provides a cushion of support. Page 14

16 Efficiency: Although there have been significant increases in the figures for inventory, receivables and payables, when expressed as a percentage of revenue and cost of sales as appropriate, the increases are not that large. However, it would be expected that an increase in sales volume would result in a proportionally lower increase in working capital needs. Hence there may be some scope for tighter inventory and receivables management. Receivables days shows the greatest disimprovement, and it is important to ensure that credit quality has not declined in the drive to increase sales volume. When adjusted for the loss on disposal, cost of sales has reduces, causing an increase in the payables days and inventory days (as these are based on cost of sales). Payables are being paid down more quickly than 2012, albeit from a very high base. It is important to guard against risks of being charged higher prices if payment is slow. In the case of inventory, obsolescence may be a risk, depending on the type of product being stored. Tighter inventory management reduces this risk. Overall Comment: Recognising the fact that the industry trends are against Drucker plc, it does seem that the company is making a credible attempt to counter the challenges it faces. Looking at the underlying financial performance (stripping out the effects of the one-off disposal and fluctuation in the value of the investments), the deterioration has been remarkably small. It will take another year to confirm the success or otherwise of the plan. Meanwhile, the company should focus on increasing sales, maintaining its margins, and controlling liquidity very tightly through strong working capital management. (d) Limitations of Ratio Analysis: Accounts contain financial information only. There may be many other factors of a non-financial nature not reflected in the accounts, e.g. the quality of the workforce, the likelihood of new products being introduced, or the prospect of a competitor entering the market. The comparison of accounts may be hindered by the use of different accounting policies. Wherever possible, the analyst should adjust accounts for policy differences before calculating ratios or carrying out any other analysis. Comparisons are also hindered by significant once-off events which distort underlying trends. The effects of once-off items should be stripped out in order to make meaningful interpretations of trends. Results are aggregates in most accounts. This means trends can be masked. For example, growth in sales of 5% may be the net result of excellent growth in one product and a decline in others. The SOFP is only a snapshot of the business at a particular date. It may not be representative of the year as a whole. Different analysts may interpret things differently. Page 15

17 SOLUTION 3 Marking Scheme: Each correct mark gains 2.5 marks. No partial marks are awarded. Workings are not marked. 1 Answer IAS 8 requires that all material errors occurring in a prior period are corrected by adjusting prior year figures as soon as possible following discovery of the error. 2. Answer (d) Degree of completion under Kerrydam s policy = 12/36 Other methods are allowable under IAS 11 as a matter of policy choice by the reporting entity. Revenue reported = 12/36 * 36 (degree of completion * contract price) 12m As the contract is expected to be loss making the entire loss should be recognised immediately. Expected loss = 36m (15+26) 5m 3. Answer (c) IAS 17 suggests that a lease is considered to transfer significantly all the risks and rewards of ownership to the lessee when the present value of the minimum lease payments is approximately equal to the fair value of the asset at inception. 75% is not approximately equal. 4. Answer IAS 23 requires capitalisation of borrowing costs to cease when the asset is substantially ready for use. The fact that the entity chooses not to use the asset does not change the fact that it is ready for use. 5. Answer (d) IAS 32 requires a financial instrument be classified as a liability if there is an obligation to transfer economic benefits under its terms and conditions. A redemption clause creates a contractual obligation to repay the amount stated in the clause. Cumulative dividends likewise represent an obligation on the entity as they must be discharged before any distribution can be made to equity holders. 6. Answer (d) Answer is self-explanatory 7. Answer (c) Under IAS 20, government grants held in deferred income are amortised to profit or loss over the useful economic life of the underlying asset. Unamortised balances are held in current liabilities if they are expected to be amortised within 12 months of the reporting date, and in non-current liabilities otherwise. Here, the annual amortisation is 40,000 (200,000 / 5 years). In the year ended 31 March 2014, 9 months have passed since the asset was acquired, hence 30,000 should have been amortised during the year. This leaves a total unamortised balance of 170,000, of which 40,000 will be amortised over the following 12 months. Hence, 130,000 will remain to be amortised after 12 months. 8. Answer (d) It is not required that the shareholding be over 50%. The existence of a majority shareholding will act as evidence to support a conclusion that control exists, but is not a necessary condition for control to exist. The other three answers are consistent with IFRS 10 s definition of control. Page 16

18 SOLUTION 4 Marking Scheme: (i) Definition of segment (3 parts) 3 10% revenue rule explained 1 10% assets rule explained 1 10% profits / losses rule explained 2 Combination of segments with similar economic characteristics 1 Requirement to account for at least 75% of revenue through reported segments 1 (ii) Up to 6 pieces of information at 1 mark each 6 Subtotal (overall maximum for part ) 10 Applicability of IFRS 8 to Jedward plc 2 Conformance with qualitative criteria 3 Conformance with quantitative criteria: Revenue 3 Profit 4 Assets 2 Conclusion and judgment 1 Subtotal (overall maximum for part ) 10 [Total: 20 Marks] Suggested Solution: (i) Definition of a reportable segment IFRS 8 requires an entity to report financial and descriptive information about its reportable segments. Reportable segments are operating segments or aggregations of operating segments that meet specified qualitative and quantitative criteria. An operating segment is a component of an entity: that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), whose operating results are regularly reviewed by the entity s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. An entity shall report separately information about an operating segment that meets any one of the following quantitative thresholds: Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments. The absolute amount of its reported profit or loss is 10 per cent or more of the greater, in absolute amount, of (i) the combined reported profit of all operating segments that did not report a loss and (ii) the combined reported loss of all operating segments that reported a loss. Its assets are 10 per cent or more of the combined assets of all operating segments. Further provisions: Reporting segments may be combined if they have similar economic characteristics. At least 75% of the entity s total external revenue must be accounted for by reportable segments. Additional segments must be identified if this is not the case. Page 17

19 (ii) Information to be reported The IFRS requires an entity to report a measure of operating segment profit or loss and of segment assets. It also requires an entity to report a measure of segment liabilities and particular income and expense items if such measures are regularly provided to the chief operating decision maker. It requires reconciliations of total reportable segment revenues, total profit or loss, total assets, liabilities and other amounts disclosed for reportable segments to corresponding amounts in the entity s financial statements. General disclosures: Factors used to identify reportable segments Types of products and services from which each reportable segment derives its revenues. Reconciliations of segment totals (for revenue, profit, loss, assets, liabilities and other material amounts) to entity financial statement amounts. Restatement of prior period amounts to be comparable with current period disclosures. Specific disclosures required in respect of each reportable segment: o Revenues from external customers o Revenues from intra-group transactions o Interest revenue o Interest expense o Depreciation & amortisation o Material income and expense items Entity wide disclosures: o Information about products and services o Revenue from external customers for each product and service. o Information about geographical areas o Revenue from home country plus total revenue from foreign countries. o Non-current assets located in home country and total NCAs located overseas. o o Information about major customers If a single customer accounts for more than 10% of total revenue, disclose this, the amount of revenue so accruing, and the segment reporting this revenue. There is no requirement to disclose the identity of the customer. First of all, IFRS 8 is applicable to all entities that offer shares or bonds to the investing public. As Gedward plc has equity shares quoted on the Dublin stock exchange, IFRS 8 applies to it. Each of the four segments seems to meet the general qualitative criteria in that: They engage in business activities, Their operating results are reviewed by the chief operating decision maker, and Separate financial information is available. In terms of the quantitative criteria the segments perform as follows: Revenue (IFRS 8 requires that internal and external revenue must be combined to ascertain compliance with the 10% threshold.) Revenue Percentage million Manufacturing Distribution Retailing Hotels Total 1, Under this condition, Manufacturing and Retailing are reportable segments, their total revenue exceeding 167.5m (10% of total group revenue - internal and external. Page 18

20 Profit or Loss (IFRS 8 requires that segment profit or loss must exceed 10% of total profit of profitable segments or total loss of loss making segments, whichever total is higher.) Profit Percentage million Manufacturing Distribution Retailing Total profit of profitable segments Hotels (14) 12.7 Total loss of loss making segments (14) The relevant threshold for qualification of a reportable segment is 10% of the higher numerical total. Here this is 10% of 110m, or 11m. Under this condition, Manufacturing, Retailing and Hotels qualify as reportable segments. Assets (IFRS 8 requires that segment gross assets exceed 10% of total group gross assets. Liabilities are not relevant.) Assets Percentage million Manufacturing 1, Distribution Retailing Hotels Total 2, Under this condition, Manufacturing, Distribution and Retailing qualify as reportable segments. A segment needs to qualify under all the qualitative criteria and any one of the quantitative criteria in order to be considered a reportable segment. Hence, all four segments are considered reportable under IFRS 8. (10 marks) [Total: 20 MARKS] Page 19

21 SOLUTION 5 Definition of a Provision A provision is a liability of uncertain timing or amount. Recognition A provision should be recognised when, and only when: (c) an entity has a present obligation (legal or constructive) as a result of a past event; it is probable (ie more likely than not) that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation. Assessing whether or not there is a present obligation can be problematic. There must be an actual obligation. This means there must be no reasonable way of avoiding settlement. Just because a payment would be in the entity s interest is not by itself an obligation on the entity to make the payment. This obligation must be as a result of a past event, called an obligating event. If the obligation is dependent on a future event, it is NOT a present obligation. For a constructive obligation to qualify as a present obligation there must be a valid expectation that the entity will discharge the obligation and the entity must intend to discharge it. In rare cases it is not clear whether there is a present obligation. In these cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. An outflow of economic benefits is deemed to be probable if it is more likely than not to occur. This generally means more than 50% likely. Just because an outflow is probable does not automatically mean there is an obligation. There must be an obligating event also. The Standard notes that it is only in extremely rare cases that a reliable estimate will not be possible. If any one of the above three conditions in not met, there is a contingent liability, and disclosure of this should be made if material. Consistency with the Framework The key part of the framework relevant to provisions is the definition of a liability. This definition is as follows: A present obligation arising from past events, the settlement of which is expected to result in an outflow of resources from the entity. It can be clearly seen that the first condition laid down by IAS 37 for recognition of a provision is directly based on the framework definition of a liability.the value added by IAS 37 is a mechanism to deal with the uncertainty regarding the timing or the amount. IAS 37 also gives substantial application guidance for applying these principles to specific circumstances known to cause difficulty. The second and third conditions above are based on the recognition chapter of the framework. This explains that any element should be recognised when (1) it is probable that the economic benefit associated with it will flow to or (in this case) from the enterprise, and (2) The item has a cost or value that can be measured with reliability. IAS 37 refines the probability judgment and insists that an estimate be made even if this is not capable of verification. Adjustments to the estimate can be made in future periods if this proves necessary. The key purpose of IAS 37 is to get liabilities on the books if they are genuinely likely to result in outflows of resources, whilst preventing the recording of liabilities if they are unlikely to do so. (10 marks) Page 20

22 (i) IAS 37 requires in its application guidance that two conditions be met in order to recognise a provision for restructuring costs. These are: 1. The decision has been announced, and 2. A detailed implementation plan has been drawn up. Here, only one of these conditions has been met, therefore no provision should be recognised as there is no present obligation. A note should disclose the existence of the contingent liability with an estimated cost of 30 million. (2 marks) (ii) No present obligation exists to paint the premises, hence the accrual of a provision is not permitted by IAS 37. No contingent liability exists either, unless a commitment has been made to a supplier to carry out the work. (2 marks) (iii) There is a present obligation in this case even though there is no proof of the number of repairs required. The obligation is established by the past event of selling the products with the warranty promise attaching. The promise is the obligation. Past experience shows us that it is probable that an outflow of resources will be required to settle this obligation (as 3% of goods have been faulty in the past and there is no reason to believe this will be any different this year). We can make a reliable estimate of the cost of repair. Therefore the three conditions are met, and a provision for repair of defective goods sold and qualifying for warranty at the reporting date must be set up. The amount of the provision is based on the best available estimate at the reporting date. If this is significantly different by the date of signing off, this should be treated as an adjusting event after the reporting date under IAS 10. The amount would be 5,000 * 3% * 200 = 30,000. This should be charged to expenses and credited to current liabilities. (4 marks) (iv) There is a present obligation, as the entity has undertaken to guarantee the debts of another party. However it seems unlikely that this guarantee will be called in. Hence it is not probable at the reporting date that an outflow of resources will be required to settle the obligation. Therefore the second condition has not been met, and no provision should be recognised in the financial statements. If an outflow of resources is judged possible but not remote, disclosure of a contingent liability of 3 million should be made in the notes. (2 marks) Page 21