P8 PEG May 09 - Ready to be uploaded. PAPER 8 FINANCIAL ANALYSIS Examiner s general comments

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1 PAPER 8 FINANCIAL ANALYSIS Examiner s general comments The marking team was unanimous in its view that the quality of the analysis answers in this diet showed continuing improvement on previous diets. There were fewer incomplete scripts and there was little evidence of candidates being time pressured. As a result candidates were able to display knowledge and encouragingly, practical skills, in the core areas tested in this paper and therefore many of those passing were achieving good marks across a range of technical subjects rather than a reliance on one area to achieve a pass. Many more candidates were achieving more than 60% and a higher number achieving more than 80%. There were fewer borderline candidates and the gap between those who were prepared and those not was considerable. There was an improvement generally in how workings and calculations were displayed and referenced which was encouraging. Once again, overseas candidates were relying on the numerical questions to get them through and as a significant part of the syllabus requires analysis and interpretation, the pass rate was again below that of UK candidates.. Section A Section A contained a mixture of numerical and narrative questions, MCQ and short questions. The MCQ questions were well answered. The first question required a calculation of minority interest for a vertical group, which most candidates answered incorrectly. The narrative questions on human asset accounting and historical cost accounting were answered very well. The calculation of the goodwill in the foreign subsidiary was well attempted although a surprising number of candidates managed to multiply rather than divide the value of goodwill. It was again disappointing how few candidates could calculate basic earnings per share. Most correctly dealt with the dilution but few could time weight the shares in the current year to calculate the basic eps. Section B Candidates can see that Section B of the syllabus carries a 20% weighting. The section includes financial instruments, substance over form, pensions and problems with profit measurement and asset valuations. In order to adequately test the syllabus, it is likely that at least two or more of these areas will be covered in any exam. Technical areas like financial instruments and substance over form have a huge impact on financial reporting and yet we are continually surprised with how unprepared candidates are for Syllabus Section B subject matter. Section B of the exam contained a 10 mark question on pensions which was dreadfully answered. It appeared that candidates had rote learned certain aspects of pension calculation particularly the calculation of the actuarial gain/loss in the period and the amount to be recognized using the corridor approach. It was clearly evident that most did not know what to do with these calculations. There was no appreciation of what makes up the income statement expense or the balance sheet net asset/liability. Some candidates chose to waste their precious time by rewriting the details in the question in one long list! Those candidates that could prepare a two-sided journal entry that balanced were few and far between. Section B contained a 10-mark question on substance over form, looking at equity and liabilities and sale and repurchase. Many candidates made a good attempt at discussing the issue of substance in respect of the sale and repurchase but could not prepare the correcting entry this should have been the easy part as it was reversing a sale of a non-current asset an alarming number of candidates seemed determined to correct revenue for the cost of the asset. The identification of the financial liability proved to be a problem for most, with many concluding that it was a hybrid instrument. The remaining question was a 10-mark question involving a part disposal and preparation of a consolidated income statement. The disposal was generally well handled although some got The Chartered Institute of Management Accountants Page 1

2 confused between the calculation of the gain in the group accounts and individual accounts. The preparation of the income statement was less well done, with many not time apportioning the results of the subsidiary and inserting the gain on disposal and share of profit in associate in the wrong place in the income statement. Section C Question 5 was relatively well answered. Most candidates managed to calculate relevant ratios although a disappointing number failed to calculate ROCE and interest cover correctly. The quality of the analysis had improved from previous exams and many candidates were able to identify the main issue of working capital and cash crisis. Candidates were able to draw conclusions from the results of the ratios, however few seemed willing to have the courage of their convictions often sitting on the fence when it came to the recommendations. Candidates scoring well will have displayed an understanding of how important timescale was in this question the borrowing covenants had been breached and suppliers had not been paid the timescale required was immediate if the entity was to be saved. Overseas candidates were particularly poor in this area. Many calculated the ratios correctly and then made almost no attempt to analyse the results, often just having an introductory paragraph and a closing statement of no consequence. Financial analysis carries a 35% weighting in this paper and candidates cannot expect to pass with no real attempt at analysis. The overseas candidates poor knowledge of how to deal with pensions compounded the problem of being vastly under prepared. The consolidation question was not as well answered as in previous diets the complexity of the piecemeal acquisition on the calculations of goodwill, retained earnings and minority interests left many candidates illustrating that they could not apply their knowledge in a sensible and consistent manner something that is required to pass a test of practical skills. The final question was answered by so few candidates that it was difficult to observe a pattern. Those that attempted it did in fact answer it very well. The accounting adjustments proved no problem whatsoever and many were able to display an excellent knowledge of the progress on convergence. Examination technique Candidates are urged to show clear workings, including the figures used in ratios calculations. Please also read the exam instructions clearly on the front cover of the exam paper - each question should be started on a new page with the exception of Q1, which does not require a new page for each sub-question. Overseas candidates are asked to take note of the syllabus, 35% on analysis and 10% on developments in external reporting they appear to be relying on the numerical questions to pass but there will rarely be a paper that has more than 50% marks for calculation. The testing of higher skills requires that discussion and evaluation are core elements in any paper and so all candidates should prepare themselves accordingly. The Chartered Institute of Management Accountants Page 2

3 SECTION A 20 MARKS Question 1.1 H acquired 70% of the ordinary share capital of M in 2002 for $4 2 million and 30% of the ordinary share capital of N in 2006 for $1 6 million. M acquired 80% of the ordinary share capital of P in 2005 for $2 0 million. None of the entities in the group have any other investments. The net assets of the entities as at 31 December 2008 are as follows: H M N P $16 7 million $9 6 million $6 8 million $4 6 million Calculate the minority interest to be incorporated in the consolidated balance sheet of the H Group as at 31 December (2 marks) Solution MI % Net assets MI share of NA Group share of M is 70% - net assets of M less 30% $(9 6m - $2 28m cost of investment in P 2m) Group share of P is 70% x 80% = 56% 44% $4 6m $2 024m Total MI in group accounts $4 304m N is an associate and therefore is not included in the MI calculation. Question 1.2 AB had 10 million $0 50 ordinary shares in issue at 1 January On 1 August 2008 AB issued 2 million $0 50 ordinary shares at a premium of $0 30. Throughout the year AB had in issue $2 million 7% convertible bonds redeemable in The terms of the instrument allow the bondholders to convert every $100 of bonds held to 50 ordinary shares of $0 50. AB s profit available to ordinary shareholders was $3 million for the year ended 31 December AB pays tax at 30%. Calculate the basic and diluted earnings per share for AB for the year ended 31 December (4 marks) The Chartered Institute of Management Accountants Page 3

4 Solution Earnings $3,000,000 Weighted average number of shares: 10,000,000 x 7/12 12,000,000 x 5/12 5,833,333 5,000,000 10,833,333 Basic earnings per share $3,000,000/10,833, cents Earnings $3,000,000 Post tax saving of interest 70% x (7% x $2,000,000) $98,000 $3,098,000 Weighted average number of shares: 10,833,333 Shares to be issued on conversion (2,000,000/100 x 50) 1,000,000 11,833,333 Diluted earnings per share $3,098,000/11,833, cents Question 1.3 Social and environmental accounting is adopted by many corporate organisations, albeit on a voluntary basis. Identify TWO reasons why the voluntary nature of these disclosures might affect the usefulness of what is reported. (2 marks) Solution Lack of reliability in the absence of formal guidance, entities can choose the information to report. This could result in biased information. Lack of comparability it will be difficult for users to compare reports of different entities as no standard format of reporting is required. Question 1.4 BX owns 25% of the share capital of CY, an entity set up under a contractual arrangement as a joint venture between BX and three other venturers. During the year to 31 January 2009, CY sold goods to BX with a sales value of $100,000. Half of these goods remained in BX s inventories at the year end. CY makes 25% gross margin on all sales. The reduction in inventories in BX required to eliminate the unrealised profit is A $3,125 B $6,250 C $12,500 D $25,000 (2 marks) The Chartered Institute of Management Accountants Page 4

5 Solution Unrealised profit on sale from CY $ Sales value 100,000 Half left in inventories 50,000 Profit element 25% margin 12,500 Group share of unrealised profit 25% 3,125 Therefore the answer is A Question 1.5 Z, an entity based in the USA, presents its financial statements in US dollars. On 1 January 2008, Z purchased 80% of the ordinary share capital of B. B s functional currency is the Euro ( ) and the 80% investment cost 20 million. The fair value of the net assets of B at the date of acquisition was 19 million. The directors of Z estimate that the goodwill arising on acquisition has suffered 20% impairment in the year and this should be reflected in the consolidated financial statements. Z has no other investments. The relevant exchange rates are as follows: 1 January 2008 $1 : December 2008 $1 : 0 74 Average for 2008 $1 : 0 68 Calculate the value of goodwill that will appear on the consolidated balance sheet of Z as at 31 December (3 marks) Solution Cost of investment 20,000 Net assets acquired 19,000 80% acquired 15,200 Goodwill arising on acquisition 4,800 Impairment 20% (960) Closing goodwill on 31 December ,840 $000 Translated at closing rate 0 74 Euro to $1 5,189 The Chartered Institute of Management Accountants Page 5

6 Question 1.6 PN owns 40% of JK and accounts for its investment using equity accounting. The value of the investment in associate, as reported in PN s group balance sheet as at 31 January 2009 is $668,000 ($578, ) and the consolidated income statement includes $180,000 in respect of the share of associate s profit. What figure will appear in the consolidated cash flow statement for the year to 31 January 2009 in respect of the associate, assuming no other transactions took place between the two entities in the period? A inflow of $36,000 B inflow of $72,000 C inflow of $90,000 D inflow of $180,000 (2 marks) Solution Cash flow from associate $ Value of investment ,000 Plus share of profit of associate 180, ,000 Dividend received (balancing figure) 90,000 Value of investment ,000 Dividend received is an inflow of $90,000. Therefore the answer is C Question 1.7 Briefly explain why, in times of rising prices, historical cost accounting could fail to achieve relevance and comparability. (2 marks) Solution In times of rising prices the results reported in the income statement could match revenues at current prices with cost of sales at prices from an earlier date, which are understated and the values recorded for assets in the balance sheet may no longer be relevant as they will not be reflecting current asset values. Comparisons over time will be affected by the rising prices as the unit prices used to determine revenues and costs will not be consistent from one period to the next. The Chartered Institute of Management Accountants Page 6

7 Question 1.8 A common criticism of financial statements is that they fail to incorporate what is commonly a major asset of the business human capital. Explain the recognition criteria for assets in accordance with IFRS and give TWO reasons why human capital does not meet the criteria. (3 marks) Solution The IFRS criteria for recognising an asset on the balance sheet is that the resource is controlled by the entity and economic benefit will flow to the entity and that it can be reliably measured. The arguments against recognising human capital as an asset on the balance sheet include: No control over staff they can leave at any time; Cannot reliably measure the value of staff only the cost, being wages paid; No guarantee that the staff will generate future economic benefit. The Chartered Institute of Management Accountants Page 7

8 SECTION B 30 MARKS ANSWER ALL THREE QUESTIONS Question 2 Required: Prepare the consolidated income statement in accordance with IAS 1 Presentation of Financial Statements for the SGB group for the year ended 31 December (Total for Question Two = 10 marks) Rationale The candidates are required to account for a partial disposal of an investment and prepare the consolidated income statement. Partial disposals have been tested before, however this time the follow through is to the consolidated income statement and not the balance sheet. The disposal results in the investment moving from a subsidiary to an associated company part of the way through the year and so the question tests candidates application of both full consolidation and equity accounting. IAS 1 format is required primarily to test candidates on the position of the gain and the share of associate s profit and the split of MI and profit attributable to shareholders of the parent. Suggested Approach The candidates approach should draft the pro-forma income statement and then insert the figures systematically as they complete the relevant workings. The income statement should follow IAS 1 format. Marking Guide Marks Calculation of gain on disposal to be incorporated in the consolidated income statement 5 Preparation of the consolidated income statement 5 Total 10 Examiner s Comments Many candidates answered this well with some gaining full marks. Most candidates displayed a basic understanding of how the gain/loss should be calculated but often got mixed up with the workings. Common errors included calculating the gain in the individual accounts and then deducting the unimpaired goodwill, calculating the tax on gain based on the consolidated profit, and failing to calculate the net assets at the date of disposal. It was surprising to note that many candidates were unsure of where to put both the gain on disposal and the share of associate s profit with the gain being included in revenue and the share of the associate appearing before operating expenses. Question practice is something that should focus the candidate s mind on where items are included in the financial statements. The Chartered Institute of Management Accountants Page 8

9 Question 3 Required: (a) (b) Explain how the sale of property transaction should be treated in accordance with IFRS. Prepare any correcting journal entries that are required to be made to the financial statements for the year to 31 January 2009 in respect of this sale of property transaction. (6 marks) Explain how the share issue should have been classified in accordance with IAS 32 Financial instruments: presentation, and prepare any correcting journal entries that are required to be made to the financial statements for the year to 31 January 2009 in respect of this share issue transaction. (4 marks) (Total for Question Three = 10 marks) Rationale Candidates were required to illustrate their knowledge of substance over form in 2 areas sale and repurchase and IAS 32 classification of non-equity shares. The testing in this area has to date primarily been narrative in nature and candidates have performed reasonably well. This question will give them the opportunity to explain the appropriate treatment; however they are then required to apply their technical knowledge of this key area identifying the incorrect treatment that has been processed in producing correcting entries. Suggested Approach Candidates should explain, with reference to the accounting standards and principle of substance over form, why the transactions have been treated inappropriately and how the transactions should be treated. The journal entries should then follow what they have described in the answer. Marks are awarded here for the correcting entries. Marking Guide Marks Sale and repurchase 6 Cumulative preference shares 4 10 Examiner s comments Well prepared candidates did exceptionally well in the question and were able to articulate the inappropriate accounting treatment, justify their conclusion by referencing the accounting guidance and recommending the correct treatment. Few were able to prepare the correcting entries, and it was most disappointing to see that many candidates at this stage of their professional learning still could not prepare a journal entry that balanced or that had more than one side! Common errors were mistaking the sale and repurchase for a lease and many candidates commented that the preference shares had already been correctly treated as equity. Candidates should take note that I do not set trick questions the question asked for correcting entries and was for 4 marks saying that it is fine the way it is, is an unrealistic answer. The Chartered Institute of Management Accountants Page 9

10 Question 4 Required: (a) (b) Calculate the expense, in respect of the pension scheme, that FDE will include in its income statement for the year ended 31 March (3 marks) Calculate the net pension asset or liability that will appear in the balance sheet of FDE as at 31 March (5 marks) (c) IAS 19 currently permits alternative treatments for actuarial gains or losses. Briefly explain the impact of adopting ONE of these alternative treatments on the financial statements of FDE. (2 marks) (Total for Question Four = 10 marks) Rationale Pensions was an area that previously appeared in section B and candidates performed reasonably well. However, when tested in section A recently candidates appeared very confused by how the balance sheet asset/liability was arrived at. The question was intended to combine a test of the corridor approach, which the candidates should be well versed on, with the workings to arrive at the balance sheet figure. It tested candidates understanding of how the pension scheme affects the financial statements as a whole. Suggested Approach Candidates should have started with the layout for charge to income statement and balance sheet and complete the workings systematically to enable insertion of the relevant figures. Marking Guide Marks Income statement expense in respect of pension plan 3 Calculation of the net pension liability 5 Alternative treatment 2 Maximum marks awarded 10 Examiner s Comments Most candidates seemed surprisingly unprepared for this and this was clearly evident from their workings. Most understood the process for calculating the actuarial gain/loss in the year but then did not know what to do with it in respect of the financial statements. This rote learning approach to an exam paper which is set at a level that tests application and skills was very alarming. Most common mistakes included calculating the corridor based on closing values of assets and liabilities, including almost everything in the question in a long list and netting them off to arrive at an income statement charge, and showing the net actuarial gain or loss for the year as the net pension asset/liability. The Chartered Institute of Management Accountants Page 10

11 SECTION C 50 MARKS ANSWER TWO QUESTIONS FROM THIS SECTION Question 5 Required: (a) Calculate the ratios required as part of the review of covenants and any other ratios that are relevant to assess the financial performance and position of ELB. (8 marks) (b) Prepare a report that explains the financial performance and position of ELB for presentation to the Board of Directors, including reference to the banking covenants. (12 marks) (c) Identify, and briefly describe, any other points that should be added to the meeting agenda for the Board of Directors to discuss in respect of the future financing of ELB. (5 marks) ) (Total 25 marks) Rationale The question gave 4 key ratios to be calculated. Candidates were then asked to identify other relevant ratios that would enable them to comment on profitability and financial position (note there were 8 marks in total for the ratios it was safe to assume that at least another 4 relevant ratios were required). The additional ratios selected should have been geared to profitability and efficiency ratios as the key ratios specified in the question helped in assessment of financial position. Part (c) required candidates to think about how the info in the balance sheet would affect the future prospects of the business, primarily management of WC and longer term funding solutions. Suggested Approach Candidates should have ensured that the key ratios were calculated and selected (at least another 4) additional ratios. Their commentary should have taken cognisance of the fact that the report was intended for internal use. Comparing the ratios to the targets was an essential part of the answer and candidates should have shown a sense of urgency about actions that were essential to keep the lender on side. Candidates should have highlighted points in part (c) that were specific to this scenario debentures, sale of investments instead of making general points about how to turnaround the funding issue remembering that these were points for the agenda for a board meeting. An appreciation of the timescales and what can be achieved short term was important. Marking Guide Marks Ratios 8 Analysis of financial performance 6 Analysis of financial position (including efficiency and working capital) 6 Additional agenda points 5 Total available 25 The Chartered Institute of Management Accountants Page 11

12 Examiner s comments The quality of the financial analysis answers has improved significantly over the last few diets and thankfully this continued in this exam. Many good answers pointed out the lack of cash and urgency required as the covenants had been breached. There was good analysis of working capital and profitability and it was most encouraging to see that candidates, in the main, were mindful of the fact that the report was for internal use. Many candidates correctly suggested that realisation of the investments would be a good way to release cash and pointed out that relationships with suppliers could be compromised. A sense of urgency and an appreciation of the timescales involved were rewarded. Common mistakes included incorrect calculation of interest cover and return on capital employed, wrongly concluding that gearing had not reached the target set by the bank, instead of realising that the bank had set a maximum ceiling, suggesting that working capital was fine but that they should extend suppliers further as a good source of finance and yet again the most concerning mistake was suggesting that retained earnings should be utilised as an immediate source of finance. The Chartered Institute of Management Accountants Page 12

13 Question 6 Required: (a) Explain how each of the three investments held by AC should be accounted for in the consolidated financial statements. (5 marks) (b) Prepare the consolidated balance sheet of the AC group as at 31 December (20 marks) (Total for Question Six = 25 marks) Rationale This question was designed to test both full consolidation and equity accounting. The balance sheet was reasonably short, however the acquisition of a further stake in the subsidiary provided an additional hurdle for the calculation of goodwill and consolidated retained earnings. The investment in associate was a bit more complex as there were internal transactions and a revaluation in the year. The impairment was required for the associate s goodwill to ensure that the candidates understood that goodwill is adjusted through the value of the investment and that goodwill arising on the acquisition of an associate does not appear separately on the balance sheet. Suggested Approach To discuss investments based on control and significant influence and IAS 39. To set up a pro-forma balance sheet, annotate the question paper to get familiar with what adjustments need to be made and work systematically through the headings of the balance sheet, preparing the consolidation workings in turn. Marking Guide Marks Part (a) explanation of accounting treatment of investments 5 Preparation of balance sheet 7 Preparation of accounting adjustments, including goodwill, associate and minority interest 13 Total 25 Examiner s Comments This question was a classic example of where rote learning put candidates at risk as many were unable to apply their consolidation techniques to a more complex scenario. Many are still wasting time preparing net asset tables and tree diagrams which are often not used in their final answer. Most candidates appreciated their need to calculate the remaining investment and encouragingly most then included the remaining investment at fair value. As is often the case, they did not think about the full effect of this on the balance sheet the $300K uplift often not being recorded in reserves. It is alarming that many candidates still do not know how to equity account for an associate, many not taking the group s share and again not calculating the investment in associate under IAS 28 rules. The biggest challenge in this question was the calculation of goodwill on the piecemeal acquisition and although many at least recognised the need for two calculations, few got it correct. It was encouraging to see that the calculation of retained earnings had improved but very disappointing to see that most candidates did not understand that minority interest should be based on the percentage held at the balance sheet date, with many attempting some sort of time apportionment. The Chartered Institute of Management Accountants Page 13

14 Question 7 Required: (a) (i) (ii) Explain how the convertible bonds are accounted for under IAS 32 Financial Instruments: Presentation. Prepare a revised balance sheet for TRP, taking account of all the necessary adjustments required to comply with the requirements of IFRS. (9 marks) (b) (c) Recalculate the ratios and provide a brief analysis on how suitable TRP is as an acquisition target for NGO. (Do NOT calculate diluted earnings per share.) (9 marks) The Finance Director had commented on the convergence project and the progress that had been made. Explain the process that is being adopted to pursue convergence and identify THREE examples of where progress has been achieved. (7 marks) (Total for Question Seven = 25 marks) Rationale The question tested the candidates ability to process accounting adjustments, including applying the treatment for convertible instruments under IAS 32, and discussing how these adjustments impacted the ratios identified. The other adjustments are given and do not require a knowledge of US v IFRS (tested in part (c), those candidates who read the question carefully should have understood this. Part (b) required them to recalculate ratios based on their reworked figures and comment and conclude on whether the entity made a suitable acquisition target. Part (c) then tested their understanding of the current developments on the convergence project previously tested in section B but instead integrated into a scenario based question. Suggested Approach It was important that students adopt a logical approach and apply their understanding of accounting adjustments ensuring that they adjusted for both sides only then would the reworking of the ratios make any sense. Part (c) could have been answered independently and candidates may have chosen to answer this first. Marking Guide Marks Accounting adjustments 6 Convertible instrument calculation 3 Recalculation of ratios 2 Report on revised position 7 Convergence 7 25 Examiner s comments Very few candidates chose to attempt this question, which was surprising as it was relatively straight forward and many candidates would have been prepared for the convergence part of the question. Those who did select it did well and scored highly. The knowledge of convergence was thorough and it was encouraging to see that many included the most up to date position. The Chartered Institute of Management Accountants Page 14