Financial Reporting and Analysis

Transcription

1 Suggested answers and examiner s comments Financial Reporting and Analysis November 2017 Important notice When reading these answers, please note that they are not intended to be viewed as a definitive model answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from candidates in the examination. Examiner s general comments As in the previous exam session, questions 1, 3 and 6 in the November 2017 paper were the most popular questions. The compulsory question on ratio analysis was very much in line with previous sessions, as was the inclusion of key topics such as group consolidation and published accounts. Inclusion of earnings per share and segmental reporting as full questions proved to be challenging for the candidates opting to answer those questions; marks were generally lower than for the other questions. The general quality of the answers for the compulsory question 1 was very good, however candidates must be mindful that question 1, although compulsory, bears no more marks than any other question and a disproportionate amount of time appears to have been spent answering question 1. This obviously leaves less time to answer the other three questions, as was reflected in all but a few scripts. A number of candidates opted to write in pencil, and this really must be discouraged. Indeed candidates need not take pencil, red or any other colour ink into the exam aside from the required blue or black. All workings are reviewed when marking a candidate s work and these must also be legible and in ink. ICSA, 2018 Page 1 of 26

2 Candidates must be encouraged in all instances to provide evidence where necessary of how they arrived at complex figures, such as in the Statement of Profit or Loss, either within the main answer itself where permissible (for example Finance Costs or Tax ) or clearly referenced to workings on a separate page if there are multiple composite calculations. Legibility of scripts in general was reasonable, although there were a number of candidates who seemed to assume more writing equated to more marks and this is clearly not the case. Candidates must pay attention to the formatting and presentation of their work, particularly written answers that require some structure and paragraphing. Indeed, candidates who demonstrated a clear format to their answers generally achieved higher marks. It is important that preparation for the exam includes developing a depth of knowledge across a range of syllabus topics and question spotting or leaving out key topics when revising is not advisable. ICSA, 2018 Page 2 of 26

3 Section A Compulsory question 1 Zenithan Industries plc ( Zenit ) is a multi-national pharmaceutical manufacturing and distribution company which has been established for many years. Its financial statements for the two years ending 30 September are shown below: Zenit Statement of Profit or Loss for years ended 30 September m m Revenue 24,708 26,547 Cost of sales (4,646) (5,842) Gross profit 20,062 20,705 Selling, general and administrative expenses (10,212) (13,002) Research and development expense (5,697) (5,579) Other income Profit from operations 4,453 2,459 Finance costs (1,075) (963) Profit before tax 3,378 1,496 Tax (209) (299) Profit for the period 3,169 1,197 Zenit Statements of Financial Position as at 30 September ASSETS m m Non-current assets Property, plant and equipment 6,413 6,010 Goodwill 11,868 11,550 Intangible assets 12,646 10,981 30,927 28,541 Current assets Inventories 2,143 1,960 Trade receivables 6,622 7,232 Cash and cash equivalents 6,240 6,360 15,005 15,552 Total assets 45,932 44,093 EQUITY AND LIABILITIES Equity Ordinary share capital ( 1 shares) 11,316 11,316 Share premium 4,304 4,304 Retained earnings 12,907 13,829 Total equity 28,527 29,449 Non-current liabilities Bank loans 12,464 8,397 ICSA, 2018 Page 3 of 26

4 Current liabilities Trade payables 3,458 3,893 Tax liabilities 1,483 2,354 4,941 6,247 Total liabilities 17,405 14,644 Total equity and liabilities 45,932 44,093 Zenit Statement of Changes in Equity (extracts) Retained earnings to 30 September m m Opening balance 13,829 16,444 Profit for the year 3,169 1,197 Dividends paid (4,091) (3,812) Closing balance 12,907 13,829 Other information from the annual review: Zenit s mix of product sales changed quite markedly in 2017 based on new market opportunities in China. Management made substantial efforts on manufacturing efficiencies and reducing core selling, general and administrative expenses. These efforts focused on targeting sales, marketing and medical cost effectiveness, improving efficiencies across support functions and IT, and optimising the global footprint. In the year to 30 September 2016, selling, general and administrative costs include a total of 313m of legal provisions relating to a number of legal proceedings in various jurisdictions in relation to several marketed products. In July 2016, the UK government issued final regulations that affected the recognition of the annual Pharmaceutical Fee imposed by health care reform legislation in As a result, entities covered by the legislation now accrue for the obligation as each sale occurs. Zenit recorded a catch-up charge of 226m in the administrative expenses in the year to 30 September 2016 to reflect this new regulation. In the year to 30 September 2017, selling, general and administrative costs included gains of 953m on the disposal of intangible assets. These disposals led to reduced revenues overall, but on products with low profit margins or related distribution difficulties. The reported tax rate of 6% for the year ended 30 September 2017 benefited from a 467m adjustment following agreement of US federal tax liabilities of prior years. Required Prepare an analysis of the performance and financial position of Zenit over the two years to 30 September Your analysis should include commentary on the additional information you would need to improve your understanding of Zenit s position and performance. (25 marks) Note: There will be a maximum of 8 marks for any pertinent accounting ratios. Ratio calculations to one decimal place. ICSA, 2018 Page 4 of 26

5 Suggested answer Ratios Profitability Return on capital Profit from operations x 100% 4,453 = 10.9% 2,459 = 6.5% employed Total equity + Bank loans 40,991 37,846 Gross profit % Gross profit x 100% 20,062 = 81.2% 20,705 = 78.0% Revenue 24,708 26,547 SG & A SG & A costs x 100% 10,212 = 41.3% 13,002 = 49.0% costs/revenue% Revenue 24,708 26,547 R&D cost / R & D costs x 100% 5,697 = 23.1% 5,579 = 21.0% revenue Revenue 24,708 26,547 Operating profit Profit from operations x 100% 4,453 = 18.0% 2,459 = 9.3% percentage Revenue 24,708 26,547 Dividend cover Profit for the year = X : 1 3,169 = 0.8:1 1,197 = 0.3:1 Dividends 4,091 3,812 Liquidity Current ratio Current assets = X : 1 15,005 = 3.0:1 15,552 = 2.5:1 Current liabilities 4,941 6,247 The acid test ratio Current assets - inventories = x:1 12,862 = 2.6:1 13,592 = 2.2:1 Current liabilities 4,941 6,247 Use of resources Inventory holding period Inventories Cost of sales x 365 days 2,143 = 168 days 4,646 1,960 = 122 days 5,842 Trade receivables collection period Trade receivables x 365 days Revenue 6,622 = 98 days 24,708 7,232 = 99 days 26,547 Trade payables Trade payables x 365 days 3,458 = 272 days 3,893 = 243 days payment period Cost of sales 4,646 5,842 Working capital cycle (days) Inventory + Receivable - Payable = - 6 days = - 22 days Asset turnover (total assets) Revenue = x : 1 Total assets 24,708 = 0.5:1 45,932 26,547 = 0.6:1 44,093 Financial position Interest cover Profit from operations 4,453 = 4.1 times 2,459= 2.5 times Finance costs 1, Borrowing cost Finance cost x 100% 1,075 = 8.6% 963 = 11.5% rate Bank loans 12,464 8,397 Gearing Bank loans x 100% 12,464 = 30.4% 8,397= 22.2% Total equity + Bank loans 40,991 37,846 ICSA, 2018 Page 5 of 26

6 Analysis Profitability There has been a marked upturn in performance across all indicators, particularly reflected in the return on capital employed which shows an increase of 68%. This is largely attributable to a change in the sales product mix arising from Zenit s targeting of the Chinese market. The revenue has declined by nearly 7% and appears to be as a result of the disposal of certain products with relatively low profit margins or related distribution difficulties. The actual figure of gross profit has only declined marginally despite the material reduction in revenues. The gross profit percentage however is at a remarkably high level, now in excess of 80% albeit a small increase on the previous year. This gives an indication of the vast profit margins available to manufacturers in the pharmaceuticals industry. Overhead control has also improved, and the selling, general and administration cost expenditure has declined markedly along with the spend as a percentage of revenue. This is partly as the result of a targeted programme of overhead control and appears to have been successful. Other factors that have exaggerated the difference between 2017 and 2016 selling, general and administrative expenses are the additional costs for ongoing legal proceedings and the newly imposed pharmaceutical fee which together have increased expenses and reduced profits by 539 million in Also the disposal of rights to products which raised 953 million has been treated as a reduction of these expenses in Expenditure on research and development has increased marginally in 2017 and now represents over 23% of Zenit s revenue. This is a major factor in the success of pharmaceutical companies and hopefully augurs well for future years. Other income is at a comparable level for the two years and is not a major factor overall in company performance. The tax bill for 2017 has also declined by 467 million due to the agreement with various tax authorities and again puts the current year in a favourable light. The dividend payment has been maintained to reward shareholders despite the relatively poor performance in 2016 which makes for a very poor dividend cover calculation. This policy will add value to the company s shares however and would make the raising of future equity far easier. Liquidity The liquidity ratios appear to be very high by modern standards and even the acid test ratio is well over the textbook benchmarks of 1:1 due to the low levels of inventory in relation to the other current assets. Indeed, it could be argued that the ratio is too good and would normally raise questions about the company s deployment of resources. However, in the case of Zenit, the company has so many strengths, that such criticism would be inappropriate. There is further evidence of Zenit s strength in terms of the substantial cash surplus at the end of both years, although this has been aided by the receipt of additional loan proceeds during the year to 30 September ICSA, 2018 Page 6 of 26

7 Use of resources The inventory holding period appears to be quite long and increasing but the products in question typically have a long shelf life. The trade receivables collection period is fairly constant and is on the high side, but is more than counterbalanced by the long payables period. The most notable feature of these ratios is the trade payables payment period which stands in excess of nine months. This is a remarkable indicator and contributes substantially to Zenit s strong liquidity position. How the company achieves such an indicator is not clear. Overall, despite the worsening of the inventory holding period, the company still maintains a negative working capital cycle which augurs well for the cash flow position of the company. Financial position The major change in this respect is the additional bank loans taken during the year. This has maintained the strong cash position at the end of the current year, but there is no indication as to how the extra finance has been spent. One possible reason for the extra finance is that the company has restructured its debt and has taken an increased amount of low cost loans. This is reflected in the lower borrowing cost rate which has declined markedly in The extra borrowing has increased the gearing ratio but this still stands at a moderate level, and future borrowings should not be a problem. Due to the increase in operating profits however, the interest cover indicator has actually improved. Overall Zenit s financial performance and position is very strong, although the performance in 2017 has been helped by some non-recurring disposal income and tax benefits. They have substantial cash reserves and strong liquidity indicators although the company still found it necessary to take on extra borrowings in the current year. Control of overheads and resources appears to be strong and indicates a management team in control of key issues impacting on the company performance. The non-recurring benefits in 2017 should see 2018 revert to a more normal performance level and it will be interesting to see if Zenit is able to maintain its generous dividend distribution policy. Additional information required Some indication on the future performance in new markets such as China, and whether sales volumes are going to recover to 2016 levels. Information from the statement of cash flows would enable understanding of the need for the additional finance in the shape of bank loans. The circumstances that enable the company to delay payments to its suppliers for a nine month period. Some background rationale to explain the length of the trade receivables collection period and the increasing inventory holding period. Segmental analysis which might shed further light on the changes in product mix, revenues and profitability. ICSA, 2018 Page 7 of 26

8 Examiner s comments The question combined a calculation of key ratios and a commentary painting a financial picture of the company performance over the two given years. Higher scoring answers calculated ratios separately following instructions provided, presented to one decimal place. The accompanying commentary picked apart these ratios with suggestions from the other information as to reasons behind incremental changes in ratios year on year. To answer this question fully, candidates had to demonstrate sound knowledge and contextualisation of the standard ratios they had calculated, highlighting the wider implications for the company. It was pleasing to see reference to benchmark against industry averages and acceptable ratio results with comments related to future impact of these ratios for Zenit. Candidates were asked to include details of further information required to improve the understanding of Zenit s performance and a large number of responses did not answer this part of the question. ICSA, 2018 Page 8 of 26

9 Section B 2 The directors of Kelner plc ( Kelner ) are in the process of preparing Kelner s financial statements for the year to 31 October The following list of account balances relates to Kelner as at the year end. Debit Credit Property 20,000 Plant and equipment at cost 184,800 Plant and equipment accumulated depreciation at 1 November ,800 Trade and other payables 36,400 Trade and other receivables 53,000 Development expenditure 32,000 Proceeds on share issue 6,000 Cash at bank 10,660 Inventories at 31 October ,240 Retained earnings at 1 November ,600 Share capital ( 1 shares) 15,000 Taxation over provision 2,200 8% bank loan repayable in ,000 Sales revenue 384,400 Cost of sales 214,000 Distribution costs 18,700 Administrative expenses 25,000 Interest paid 2,000 Dividends paid 12, , ,400 The following notes are relevant: (i) Included in sales revenue is 27 million which relates to sales made to customers under sale or return agreements. The expiry date for the return of these goods is 30 April Kelner has charged a mark-up of 20% on cost for these sales. (ii) No depreciation charge has yet been calculated for the year. On 1 November 2016, Kelner acquired a new property at a cost of 20 million. This replaced a rented property that was occupied previously. For the purpose of calculating depreciation only, the asset has been separated into the following elements. Separate asset Cost ( 000) Life Land 5,000 Freehold (no limit) Heating system 2, years Lifts 3, years Building 10, years The depreciation of the elements of the property should be calculated on the straight-line basis (assuming a zero residual value). Plant and equipment is depreciated at 20% on the reducing balance basis. All depreciation is to be charged to cost of sales. (iii) The figure for development expenditure in the list of balances represents amounts deferred in previous years in respect of the development of a new product. During the current year, the government has introduced legislation which effectively bans this type of product. As a ICSA, 2018 Page 9 of 26

10 consequence of this, the project has been abandoned. The directors are of the opinion that writing off this development expenditure represents a change of accounting policy and wish to treat it as a prior period adjustment. (iv) A provision for taxation for the year to 31 October 2017 of 15 million is required. (v) The company issued 1 million new 1 shares on 30 June 2017 at a premium of 5 per share. Required (a) Prepare Kelner s Statement of Profit or Loss and Statement of Changes in Equity for the year to 31 October In addition, calculate the figures for Trade Receivables and Inventory for inclusion in the 31 October 2017 Statement of Financial Position. (19 marks) Suggested answer Kelner - Statement of Profit or Loss for the year ended 31 October Revenue 357,400 w1 Cost of sales (254,100) w2 Gross profit 103,300 Distribution costs (18,700) Administrative expenses (25,000) Profit from operations 59,600 Finance costs (50,000 x 8%) (4,000) Profit before tax 55,600 Tax (15,000-2,200) (12,800) Profit for the period 42,800 Workings 1. Revenue 384,400 Less sale or return (27,000) 357, Trial balance 214,000 Sale or return 27,000 x 100/120 (22,500) Write off development expenditure 32,000 Depreciation Buildings 600 w3 Depreciation Plant (184,800-34,800) x 20% 30, , Heating system 2,000 / 10y 200 Lift 3,000 / 15y 200 Building 10,000 / 50y ICSA, 2018 Page 10 of 26

11 Kelner - Statement of Changes in Equity for the year ended 31 October 2017 Share capital Share premium Retained earnings Total equity Balance at 1 November ,000-71,600 86,600 Changes in equity Share issue 1,000 5,000-6,000 Profit for the year ,800 42,800 Dividends - - (12,000) (12,000) Balance at 31 October ,000 5, , ,400 Statement of Financial Position 31 October 2017 Trade receivables = 53,000-27,000 = 26,000 Inventory = 28, ,500 = 50,740 (b) In accordance with IAS 1 Presentation of Financial Statements : Explain the rules for offsetting of assets and liabilities and income and expenses. Give two examples of other comprehensive income. (6 marks) Suggested answer It is important that both assets and liabilities and income and expenses, when material, are reported separately so that users can make a proper assessment of the progress and financial position of the entity. It is for these reasons that IAS 1 states that assets, liabilities, income and expenses are not to be offset unless required or permitted by an International Financial Reporting Standard. Offsetting in either the Statement of Profit or Loss and Other Comprehensive Income or the Statement of Financial Position is required or permitted where it reflects the substance of the transaction or event. The reporting of assets net of valuation allowances for example, obsolescence allowances on inventories and doubtful debts allowance on receivables is therefore permitted. Examples of other comprehensive income include: Changes in revaluation surplus. Re-measurement gains and losses on post-employment defined benefit plans. Gains and losses on translating the financial statements of a foreign operation. Gains and losses from re-measuring available-for-sale financial assets. Effective portion of gains and losses arising in a cash flow hedge. ICSA, 2018 Page 11 of 26

12 Examiner s comments This was a popular question with candidates, drawing on knowledge and application of IAS 1. For the most part, candidates demonstrated understanding of the key elements, however, a number of answers included a Statement of Financial Position which was not required. Many candidates did not get full marks for the calculation of trade receivables and inventory that were asked for specifically. Candidates who structured their answers in line with the question, clearly showing calculations and referencing workings, gained higher marks. Where candidates provided no evidence of workings and did not give the correct final figure no further marks could be awarded. Part (b), where attempted, was not fully answered by most candidates. Many did not provide examples of other comprehensive information as required. ICSA, 2018 Page 12 of 26

13 3 Dover plc ( Dover ) acquired 80% of the issued share capital and voting rights of Herne Ltd ( Herne ), on 1 December The acquisition was by way of an immediate share exchange of three Dover shares for every five shares in Herne. The market price of Dover s shares was 4.00 on 1 December This transaction has not yet been recorded in the books of Dover. Also on 1 December 2016, Dover lent 100,000 to its newly acquired subsidiary (Herne) repayable in At the date of acquisition, Herne had issued share capital of 800,000 and retained earnings of 600,000. The Trial Balances for the two companies at 30 November 2017 are as follows: Dover ( 000) Herne ( 000) Dr (Cr) Dr (Cr) Share capital (ordinary 1 shares) (3,500) (800) Retained earnings (1,708) (520) Bank overdraft (24) (44) Long term loans (500) (100) Trade and other payables (462) (265) Property, plant and equipment carrying amount 4, Loan to Herne Current assets 1, You are provided with the following information: At acquisition, the fair value of some of Herne s assets was greater than their book value as follows: Inventories (80% sold by 30 November 2017) 100,000 Plant (five years remaining life) 200,000 During the year to 30 November 2017, Dover sold some of its inventory to Herne for 520,000 at a profit margin of 25%. Half of these goods were still in the inventory of Herne at 30 November Dover has concluded that goodwill arising on the purchase of Herne has been impaired by one half as at 30 November Dover has decided that the non-controlling interest will be valued at its proportionate share of net assets. Trade receivables of Dover include 80,000 receivable from Herne, the corresponding balance being included in trade payables of Herne. Required (a) Prepare the Consolidated Statement of Financial Position for the Dover group as at 30 November (19 marks) ICSA, 2018 Page 13 of 26

14 Suggested answer Consolidated Statement of Financial Position for Dover plc and its subsidiary undertaking as at 30 November ASSETS Non-current assets Goodwill 88 w1 Property, plant and equipment 5,867 w2 5,955 Current assets 1,991 w3 Total assets 7,946 EQUITY AND LIABILITIES Equity Share capital (3, ) 3,884 Share premium (384,000 x 3) 1,152 Retained earnings 1,395 w4 Non-controlling interest 300 w5 Total equity 6,731 Non-current liabilities Long term loans Current liabilities Trade and other payables ( ) 647 Bank overdraft Total liabilities 1,215 Total equity and liabilities 7,946 Workings 1 Goodwill 000 Consideration (800,000 x 80% x 3/5 x 4) 1,536 Share capital attributable to Dover ( 800,000 x 80%) (640) Revaluation reserve attributable Dover ( 300,000 x 80%) (240) Retained earnings attributable to Dover ( 600,000 x 80%) (480) Goodwill at date of acquisition 176 Impairment of goodwill (88) Goodwill at Consolidation 88 ICSA, 2018 Page 14 of 26

15 2 Property, plant and equipment 000 Dover 4,903 Herne 804 Fair value adjustment 200 Depreciation adjustment (200 / 5 x 1) (40) 5,867 3 Current assets 000 Dover 1,191 Herne 925 Fair value adjustment (100,000 x 20%) 20 Inter-company balance (80) Unrealised profit (520,000 x 50% x 25%) (65) 1,991 4 Retained earnings 000 Dover 1,708 Herne attributable to Dover (600, ,000) x 80% (64) Unrealised profit (520,000x 50% x 25%) (65) Impairment of goodwill (88) Fair value Inventory sold (100,000 x 80%) x 80% (64) Fair value depreciation adjustment (200,000 / 5 x 1) x 80% (32) 1,395 5 Non-controlling interest 000 Share capital ( 800,000 x 20%) 160 Revaluation reserve ( 300,000 x 20%) 60 Ret earnings ( 520,000 - (100,000 x 80%) - (200,000/5 x 1 = 40,000) x 20%) (b) Explain the requirement to adopt fair values when a parent company is consolidating a newlyacquired subsidiary. Your answer should refer to consideration given and assets and liabilities acquired. (6 marks) Suggested answer At the date of acquisition, the parent company has to restate the subsidiary company s assets and liabilities at their fair value. Fair value is the amount for which an asset can be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. ICSA, 2018 Page 15 of 26

16 Fair value is intended to reflect conditions at the time of acquisition, which refers to the time of the company takeover and not the date of the acquisition of the assets by the subsidiary. This frequently results in the individual assets and liabilities of a subsidiary being recorded at different carrying amounts in the consolidated financial statements than that at which they were recorded in the subsidiary s company financial statements. The adjustments to value need not be written into the books of the subsidiary company and used for the purpose of its legal entity-based accounts, but they must be used for consolidation purposes. The fair value of the consideration issued must also be recorded at fair value, which is particularly pertinent when the issue of shares is involved (market value must be used), or when consideration is deferred such consideration must be recorded at present value which approximates to fair value. Any contingent consideration must also be measured at fair value. The resulting computation of goodwill, in accordance with IFRS 3, defined as the excess of the price paid for the shares in the subsidiary over and above the net fair value of the identifiable assets, liabilities and contingent liabilities acquired will give rise to a true goodwill figure, because all other assets and liabilities acquired and the consideration given are measured at their fair value. Examiner s comments Well prepared candidates should have been used to this style of question. 19 marks were awarded for numerical calculations and presentation of the statements and workings, with 6 available for the written part (b). As mentioned in the general comments above, candidates must show all workings and reference these on the face of the statement, as these will be marked. Indeed candidates not attaining a pass had not shown any workings and provided incorrect figures with seemingly no basis. It is more than generally accepted practice for some simple workings to be included on the face of the answer. Workings themselves on the whole (where included) were clear and candidates appeared to follow a structured pattern. A number of candidates adopted a grid like combination of working and answer, which again is acceptable. ICSA, 2018 Page 16 of 26

17 4 Dawson plc ( Dawson ) has prepared its consolidated financial statements for the year to 30 September 2017 and extracts are shown below, along with the previous year to 30 September Profit before interest and tax 8,830 7,012 Finance cost 1, Tax charge 1,718 1,264 Ordinary dividends paid Preference dividends paid Profit attributable to non-controlling interests You have also obtained the following information in respect of the company s share capital: Ordinary shares at 1 October 2015: 3,000,000 x 50p shares. Dawson issued 500,000 ordinary shares at full market value on 1 January Dawson also made a rights issue of 2 new ordinary shares for every 10 held at 1 April The rights price was 4.25 (market value at that date was 4.80). Non-redeemable preference shares at 1 October 2016: 1,000,000 x 6% 1 shares. Required (a) Calculate the basic earnings per share of Dawson for the year to 30 September 2017 and the comparative for the year to 30 September (16 marks) Suggested answer Basic earnings Profit before interest 8,830 7,012 Less interest (1,045) (987) Less Tax charge (1,718) (1,264) Less Preference dividends paid (60) (60) Profit attributable to non-controlling interests (180) (160) 5,827 4, /16 Period Weighting Weighted average 1/10/15 1/1/16 3,000,000 x 3/12 750,000 1/1/16 30/9/16 3,500,000 x 9/12 2,625,000 Weighted average shares 3,375, /16 basic earnings per share (EPS) restated = 4,541,000 / 3,375,000 = 135p x 4.71/4.80 = 132p ICSA, 2018 Page 17 of 26

18 2016/17 Period Weighting Weighted average 1/10/16 3/3/17 3,500,000 x 6/12 1,750,000 Rights adjustment x 4.80 / ,783,439 2 for 10 rights issue 1/04/17 30/09/17 4,200,000 x 6/12 2,100,000 Rights issue =,3,500,000 x 2/10 = 700,000 Weighted Average Shares 3,883, /17 basic EPS = 5,827,000 / 3,883,439 = 150p Theoretical ex-rights price 4.80 = = / 12 = 4.71 Adjustment factor = 4.80 / 4.71 (b) Companies are required to disclose diluted earnings per share in addition to the basic measure. Explain the purpose of the diluted measure and discuss three types of dilution. (9 marks) Suggested answer Diluted EPS acts as a warning sign for investors in that it shows what the EPS could become if all potential shares were actually in issue. Presentation and disclosure of diluted EPS is required for each class of ordinary share in issue (outstanding) in total and separately in respect of continuing operations. However, potential ordinary shares are only treated as dilutive when their conversion to ordinary shares would decrease EPS from continuing operations. The purpose of presenting diluted EPS is to reflect the maximum potential dilution of current basic EPS as if the dilution took place at the later of: the beginning of the current period (for comparatives the beginning of the comparative period); and the date of issue of the potential ordinary shares (applicable only where potential ordinary shares have been issued in the current year or comparative year presented). There are effectively three types of dilution: Convertible-instruments. Options to acquire ordinary shares. Contingently issuable shares. Convertible-instruments Examples include convertible preference shares and convertible debentures. The calculation entails adjusting basic earnings and the weighted average number of shares outstanding. ICSA, 2018 Page 18 of 26

19 Earnings are adjusted positively to reflect savings in interest or dividends incurred and shares are adjusted positively to reflect additional number of shares as a result of conversion. Options to acquire ordinary shares The issue of these incentives to directors, senior staff or occasionally other parties will entail adjustments to the weighted average number of shares outstanding only. Earnings are not adjusted, shares are adjusted positively to reflect the number of shares that will be issued for no consideration as a result of being issued at below market value. Contingently issuable shares These are ordinary shares issuable for little or no consideration upon the satisfaction of certain conditions pursuant to a contingent share. The contingent event could be, for example: the maintenance of a specified level of earnings; the future market price of ordinary shares; or the opening of additional distribution outlets. Contingently issuable shares are only included in the computation of diluted EPS if the conditions are satisfied (i.e. the contingent events have occurred). Examiner s comments Answers to this question varied. Candidates answered this question reasonably well where they had knowledge of formulae. Answers not achieving a pass level did not demonstrate understanding of the topic and dilution. Part (b) was generally not answered as well as part (a). Part (b) required an explanation of the purpose of diluted EPS, with three types of dilution provided. Many candidates appeared to struggle with this written part of the question, with little discussion of the types of dilution provided. ICSA, 2018 Page 19 of 26

20 5 Parky plc ( Parky ) is a diverse company with divisions covering a range of different activities. An analysis of the division s activities is shown in the table below. Retail IT Sea Banking Other Total freight sales m m m m m m External revenue Inter-segment revenue Total revenue Reported profit Total assets 5,000 4, ,410 The directors are aware of the issue of a new accounting standard, IFRS 15 Revenue from Contracts with Customers. This important standard focuses on the 5 step model which is at the heart of the new regulation. The directors of Parky are concerned that this new standard may have an impact on their recognition of revenue. Required (a) Explain what an operating segment is and when it needs to be reported on, in accordance with IFRS 8 Operating Segments. (10 marks) Suggested answer An operating segment is defined as: a component of an entity that engages in business activities from which it may earn revenues and incur expenses (including intercompany revenues and expenses); whose operating results are reviewed regularly 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. Segment information is required to be disclosed about any operating segment that meets any of the following quantitative thresholds: (i) its revenue (both intercompany and with external customers) is 10% or more of the combined revenue (internal and external), of all operating segments; or (ii) its profit or loss is 10% or more of the greater of: the combined reported profit of all segments that did not report a loss; and the combined reported loss of all loss-making segments; or (iii) its assets are 10% or more of the combined assets of all segments. If the total external revenue reported by segments constitutes <75% of the entity s revenue, additional operating segments must be identified as reportable segments (even if they do not meet the quantitative thresholds set out above) until >75% of the entity s revenue is included in reportable segments. ICSA, 2018 Page 20 of 26

21 (b) Explain which of Parky s divisions are reportable segments under IFRS 8 Operating Segments. (5 marks) Suggested answer Given this criteria, both the retail and the IT division meet the revenue criteria (>10% of the total revenue). None of the other three divisions meet any of the three criteria. However, the retail and the IT division s external revenue combined only accounts for 74% (480/650) of the total external revenue. Therefore, we should also include segmental analysis on the shipping division (the next biggest division) to meet the 75% threshold required by IFRS 8. (c) Prepare a summary for the directors of Parky of the new accounting standard IFRS 15 Revenue from Contracts with Customers. (10 marks) Suggested answer In essence, revenue will be recognised and measured using a 5 step model: (i) Identify the contract with the customer. This contract could be for goods and services for example, a computer sale along with a one-year warranty. A contract with a customer is within the scope of IFRS 15 only when: The parties have approved the contract and are committed to carrying it out. The rights and payment terms regarding the goods and services to be transferred can be identified. The contract has commercial substance. It is probable that the entity will collect the consideration to which it will be entitled. (ii) Identify the separate performance obligations, where the performance obligation is the promise to provide goods or services to a customer. A company would account for a performance obligation separately only if the promised good or service is distinct, that is, if it could be sold separately. The performance obligations should also be separated to the extent that they are performed at different times. For example, the sale of a mobile phone with a standard two-year rental contract would comprise two performance obligations: (1) the sale of the phone; and (2) the sale of the line rental. These arrangements are known as bundle arrangements. (iii) Determine the transaction price. The transaction price is the amount of consideration to which the entity expects to be entitled. An entity should consider variable consideration (for example, discounts or price concessions), based on probabilities and weighted averages, including estimates of contingent amounts. The transaction price should also take into account the time value of money, if material (for example, where a transaction includes a significant financing component). (iv) Allocate the transaction price to the performance obligations in proportion to the stand alone selling price of the good or service. ICSA, 2018 Page 21 of 26

22 (v) Recognise revenue as each performance obligation is satisfied, that is, when the customer obtains control of the promised good or consumption of the service. Control could pass, for example, when the customer has the ability to use the asset or to obtain substantially all the remaining benefits from the asset. Performance obligations may be satisfied at a point in time, or over a period of time. Examiner s comments This question required detailed knowledge of IFRS 8 and IFRS 15 and was the least popular question. The candidates answering this question demonstrated a sufficient depth of knowledge in each topic area, using the numerical analysis to complement their written answer. Many candidates demonstrated that they were well versed in either one or the other of IFRS 8 or 15, with a small number showing knowledge of both. ICSA, 2018 Page 22 of 26

23 6 (a) The International Standards Board has issued the Conceptual Framework for Financial Reporting which, amongst other things, sets out the purpose of the conceptual framework and the fundamental and enhancing qualitative characteristics of useful information for external users. Required Explain three purposes of the Conceptual Framework for Financial Reporting and explain the two fundamental and enhancing qualitative characteristics. (16 marks) Suggested answer Purpose of Conceptual Framework for Financial Reporting Assist the International Accounting Standards Board (IASB) in the development of future International Accounting Standards and in its review of existing International Accounting Standards. Assist the IASB in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by International Accounting Standards. Assist national standard-setting bodies in developing national standards. Assist preparers of financial statements in applying International Accounting Standards and in dealing with topics that have yet to form the subject of an International Accounting Standard. Assist auditors in forming an opinion as to whether financial statements conform with International Accounting Standards. Assist users of financial statements in interpreting the information contained in financial statements prepared in conformity with International Accounting Standards. Provide those who are interested in the work of IASB with information about its approach to the formulation of International Accounting Standards. Enhancing qualitative characteristics Relevance Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions. Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. ICSA, 2018 Page 23 of 26

24 The predictive value and confirmatory value of financial information are interrelated. Information that has predictive value often also has confirmatory value. For example, revenue information for the current year, which can be used as the basis for predicting revenues in future years, can also be compared with revenue predictions for the current year that were made in past years. The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions. Faithful representation Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, original cost, adjusted cost or fair value). A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. 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. In this context, free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. (b) The ever-increasing demand for information efficiency and cost-effective information systems has led to the widespread development and use of database systems. The best known subscription databases are: Amadeus Bloomberg Datastream FAME For three of the above, explain how these subscription databases assist investors and analysts and give a summary of the information that they contain. (9 marks) ICSA, 2018 Page 24 of 26

25 Suggested answer Amadeus This contains comprehensive information on around 19 million companies across Europe. It can be used to research individual companies or search for companies with specific profiles and for analysis. It contains detailed company information for both Western and Eastern Europe, as follows: Company financials in a standard format so you can compare companies across borders. Financial strength indicators. Images of report and accounts for listed companies. Stock prices for listed companies. Detailed corporate structures. Market research. Business and company-related news. M&A deals and rumours. Directors. Original filings from a library of scanned images. Geographical distribution of companies using map analysis. Company corporate structures in tree diagrams and find all companies with the same parent. Create and analyse peer groups. Bloomberg This is an online database providing current and historical financial quotes, business newswires, descriptive information and research and statistics on over 52,000 companies worldwide. Intra-day and end-of-day market and reference data is available for all asset classes and it includes corporate actions and credit and issuer data on more than six million securities traded around the world. The world's leading investment banks, brokers, asset managers, hedge fund managers, custodians and fund administrators rely on Bloomberg data to feed their back-office applications. Datastream Comprehensive time series database: This offers access to historical financial content. It offers access up to 50 years of history, millions of global instruments and indicators and coverage for 175 countries in 60 global markets. Real-time market data: It integrates streaming real-time market data, economic news, First Call research reports and more, in a single integrated application. Charting It simplifies the graphical exploration of trends and relationships between series and enables sophisticated analysis across a broad range of financial instruments in one place. Reports: It enables the building of complex models and reports. Data and charts can be linked within Microsoft Excel, PowerPoint or Word documents to create spreadsheets, presentations and documents that can be quickly refreshed with the latest data. Automated publishing and collaboration It includes integrated publishing and collaboration tools that streamline workflow. Annotation, formatting and dynamic publishing tools increase efficiency in generating reports and help deliver insight to colleagues in real time. ICSA, 2018 Page 25 of 26

26 FAME The FAME database is widely used by professionals in all industries. It contains information on 3.1 million companies, 2.2 of which are in a detailed format in the UK and Ireland. Information on 3.7 million inactive companies. The following detailed information is contained on the top 2.2 million companies: Contact information including phone, and web addresses plus, main and other trading addresses. 29 profit and loss account and 63 balance sheet items, cash flow and ratios, credit score and rating, security and price information (listed companies only). Names of bankers, auditors and previous auditors and advisors. Details of holdings and subsidiaries (including foreign holdings and subsidiaries). Names of current and previous directors with home addresses and shareholder indicator, heads of department and shareholders. In addition to the existing ratios you can also create your own that you can display in the reports and also use in searches and analyses. A company tree diagram illustrates the structure of the group. Each company with detailed financials is part of a default peer group based on its activity codes. Integral graphs illustrate its position in this peer group. Examiner s comments Candidates were required to explain the two fundamental characteristics being relevance and faithful representation. The majority of candidates opting to answer question 6 included detailed descriptions of further enhancing characteristics (comparability, verifiability, timeliness and understandability) not strictly asked for in the question itself. Candidates were given credit for these answers. Part (b) of question 6 was reasonably well answered. However a number of candidates had clearly miss-managed their time during the exam and resorted to answering in bullet points rather than whole sentences. The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. ICSA, 2018 Page 26 of 26