Governance and Reporting July 2011

Transcription

1 Governance and Reporting July 2011 s and examiner s comments Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive right answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Examiner s general comments The overall performance for this paper was encouraging with an improved pass rate. It was pleasing to note that almost half of the number students performed very well. Candidates performed reasonably well in Section A. The least popular question within this section was question (vi) which related to limited partnerships. In Section B, the least popular questions were question 6 (offshore banking licences), question 7 (offshore structures), and question 11 (profit margins and asset turnover). In Section C, the most popular question was question 13 (gearing, EPS, and fixed-interest cover), and the least popular question was question 14 (offshore centres). Advice for future candidates: Read the instructions of each question carefully and answer the question asked. Attempt the required number of questions (otherwise you are restricting your chances of success). Use the examiner s comments and suggested answers as key parts of the examination preparation process. Do not neglect key areas of the syllabus and avoid over reliance on question spotting. ICSA, 2011 Page 1 of 20

2 Section A Answer all parts of Question 1. Select only one of the options A, B, C or D for each part. 1. (i) Which of the following correctly describes purchased goodwill? A. It represents the difference between the total purchase price of a business and the total value of its separable net assets. B. It is an example of unascertainable internally-generated goodwill. C. It can only be positive, not negative. D. It represents the difference between the total purchase price of a business and the total value of its separable net tangible assets. (ii) All public limited companies ( plc ): A. Are much larger in number than private companies. B. Are quoted on a stock exchange. C. Can invite members of the public to invest in their equity. D. Are government-owned companies. (iii) A company has: 000 Called-up share capital 500,000 50p ordinary shares 250 Share premium account 200 The company pays a dividend of 5%. What is the cost of the dividend? A. 10,000 B. 12,500 C. 22,500 D. 25,000 (iv) A company s fully paid share capital is 2,000,000, comprising 2,000,000 ordinary shares of 1 each. It decides to make a 3-for-2 bonus issue and, immediately afterwards, a rights issue of 1-for-5 at a price of Ignoring costs and fees, how much money could the company potentially raise from the rights issue? A. 1,500,000 B. 4,500,000 C. 7,500,000 D. 9,000,000 ICSA, 2011 Page 2 of 20

3 (v) The role of the external auditor of a plc: A. Guarantees that no fraud has taken place. B. Favours equity shareholders at the expense of providers of debt finance. C. Can be undertaken by suitably qualified employees of the company. D. Plays a crucial role in good corporate governance. (vi) Limited partnerships: A. Are often described as corporate vehicles. B. Can be described as unincorporated entities. C. Will have limited and general partners, all with unlimited liability. D. Can be described as corporate vehicles in which the limited partners enjoy limited liability. (vii) FRS 18 Accounting Policies states that the appropriateness of accounting policies is to be judged against: A. Completeness, relevance, reliability and comparability. B. Measurability, relevance, reliability and understandability. C. Timeliness, relevance, reliability and understandability. D. Relevance, reliability, comparability and understandability. (viii) The accruals principle in accounting means that the income and expenditure of a company over a specified period: A. Should be recorded consistently year on year to aid comparison. B. Should be recorded on a going concern basis. C. Should be recorded in the accounts regardless of whether the income has been received or the expenses paid. D. Should be recorded in a prudent and reliable manner. (ix) FRS 5, Reporting the Substance of Transactions, is concerned with ensuring that when preparing accounts: A. Precedence is given to the underlying commercial nature rather than the legal form of a business arrangement. B. Intangible assets are recorded in the most creative manner. C. Legal title takes precedence over economic rights and control. D. Balance sheets are prepared in the most creative manner. ICSA, 2011 Page 3 of 20

4 (x) Extracts from the Profit and Loss Account for Z plc for the year ended 31 March 2011 are as follows: m Profit before taxation 5.0 Taxation (1.5) Profit after taxation 3.5 Dividend paid (2.0) Retained profit 1.5 Z plc has had 4,000,000 1 ordinary shares in issue all year and the current share price on the London Stock Exchange is 500p. What is the price / earnings ratio for Z plc? A. 4.0 B. 5.7 C D (Total: 10 marks) s (i) A. It represents the difference between the total purchase price of a business and the total value of its separable net assets. (ii) C. Can invite members of the public to invest in their equity. (iii) B. 12,500 (iv) A. 1,500,000 Examiner s explanation: Called-up share capital, 250,000 x 5% = 12,500 Examiner s explanation: Ordinary Shares in issue 2,000,000 Bonus issue, 3 for 2 3,000,000 5,000,000 Rights issue 1 for 5 1,000, = 1,500,000 (v) D. Plays a crucial role in good corporate governance. (vi) B. Can be described as unincorporated entities. (vii) D. (viii) C. Relevance, reliability, comparability and understandability. Should be recorded in the accounts regardless of whether the income has been received or the expenses paid. ICSA, 2011 Page 4 of 20

5 (ix) A. Precedence is given to the underlying commercial nature rather than the legal form of a business arrangement. (x) B. 5.7 Examiner s explanation: EPS = Profit after tax no of shares in issue = 3.5m 4.0m = 87.5p P/e ratio = market price of share EPS = 500.0p 87.5p = 5.7 Overall, Section A was well answered. Question (v) was answered correctly by most candidates. However, question (vi) was the least well answered question in this section. ICSA, 2011 Page 5 of 20

6 Section B Answer all ten questions. 2. Explain, giving examples, the difference between trust income and trust capital. Income: Income is money spent maintaining the future earning potential of an asset and the money that an asset earns from being used. Money coming in as income from assets may include dividends from investments held, rent from property, and interest from a bank deposit account. Money paid out as a running expense could include rent, rates, light and heat. Capital: Capital is money spent enhancing the future earning potential of an asset. Capital may also be seen as the money initially put into the trust whether in the form of cash or non-cash assets. This question was generally well answered. 3. Identify and explain four significant differences between ordinary shares and preference shares. Ordinary shareholders are the owners of the company and normally hold voting rights. Ordinary shares have no fixed dividend but are entitled to profits after preference share dividends (if any). Preference shareholders have priority over ordinary shareholders for dividend distributions. Preference shareholders only have class voting rights. Preference shareholders may have priority for return of capital over ordinary shareholders in the event of liquidation of the company. Both ordinary and preference shareholders are members of a company. This question was generally well answered. Some candidates appeared to have assumed that preference shareholders always take preference over ordinary shareholders in return of capital on liquidation. This will normally vary from company to company depending on the rights associated with each instrument when issued. ICSA, 2011 Page 6 of 20

7 4. Identify two examples of external stakeholders. For each of the external stakeholders you have suggested, give two types of control that each can exercise in terms of the corporate governance of a limited company. External stakeholders might include governments, stock exchanges, professional bodies, lenders and the wider public. External stakeholders such as lenders may require debt covenants. Company act regulations may require external audit. Governments generally will prescribe various laws and regulations. Professional bodies will be responsible for prescribing accounting and other regulation. This question was generally well answered. Some candidates considered existing shareholders to be external stakeholders, whereas this would apply to potential investors. 5. An international financial centre can become a safe haven (or financial haven) which is an attractive base for criminal activity such as money-laundering. Outline four of the major characteristics of such a base referred to as an ideal financial haven by the United Nations Office on Drugs and Crime (UNODC). Any four of the following major characteristics: No deals for sharing tax information with other countries. Availability of instant corporations. Corporate secrecy laws. Excellent electronic communications. Tight bank secrecy laws. A large tourist trade which can help explain major inflows of cash. Use of a major world currency, such as the US dollar, as the local currency. A government which is relatively invulnerable to external pressure. A high degree of economic dependence on the financial services sector. A geographic location that facilitates business travel to and from rich neighbours. This question was generally well answered. ICSA, 2011 Page 7 of 20

8 6. Ignoring managed banks, explain two significant levels of banking licensing applicable within many offshore jurisdictions. The two significant levels of banking licensing can be described as follows: Full banking licences ( A licences) issued to locally-owned banks, locally-controlled banks and some international banking subsidiaries. These banks will offer a wide range of services to local and international customers and will be fully-staffed operations; Restricted banking licences ( B licences) where services are restricted to those provided for non-resident customers. This question was generally well answered. 7. Identify and explain the key contexts in which the term offshore structure is used. The term offshore structure is generally the name used loosely to mean either a single-tier structure involving the use of a single vehicle such as an offshore company or an offshore trust. More strictly, the name is used to mean a structure involving more than one tier, with a trust owning the shares in one or more underlying companies. This question was generally well answered. 8. Explain three reasons why offshore companies may be perceived to be vehicles for potential illicit business practices. The following reasons are often given as to why offshore companies may be used to support illicit business practices: Strict banking and corporate secrecy laws (preventing the disclosure of information). Minimal corporate regulations, including no register of directors (or no public access to such a register) or no annual financial reporting. Opportunity to hide beneficial ownership and control by the use of bearer shares, nominee or corporate directors and re-domiciliation clauses (whereby companies formed under a particular jurisdiction may opt to operate in a different jurisdiction without losing continuity). This question was generally well answered. ICSA, 2011 Page 8 of 20

9 9. Identify four advantages of International Accounting Standards ( IASs ) and International Financial Reporting Standards ( IFRSs ). Key advantages include the following: Avoidance of inconsistencies of accounting treatment generally. Enhancement of the harmonisation of worldwide accounting regulations. As an aid to compare financial statements produced in different countries. For purposes of assisting cross-border capital raising and the international trading of financial instrument. This question was generally well answered. 10. Explain what is meant, within accounting, by the term asset, identifying two types of fixed asset and two examples of a current asset. An asset is a probable future economic benefit, obtained or controlled by a particular entity as a result of past transactions or events. A fixed asset can be tangible (e.g. land, equipment etc) or intangible (e.g. goodwill, patents or trademarks). A current asset can include items such as stock (inventory) debtors (receivables) or cash. This question was generally well answered. 11. In accounting there is often a trade-off between profit margin and asset turnover (volume). Explain why. A high profit margin means a high profit for each 1 of sales. Depending on the type of business, if the selling price is too high, then volumes of business may be restricted (e.g. asset turnover would be low). A high asset turnover means that the business has generated high volumes of sales, but, again depending on the type of business, the selling price may have to be low for this to happen (in which case profit margin would be low). It is important to remember that whatever strategy is used, sufficient gross profit must be earned to cover the organisation s operating costs so that a positive operating profit can be earned. ICSA, 2011 Page 9 of 20

10 In financial ratio analysis, the relationship between these styles and overall profitability can be reconciled as follows: ROCE = Operating profit margin x net asset turnover. This question was generally poorly answered. Many candidates failed to discuss net asset turnover and its important relationship with operating profit margin and ROCE. ICSA, 2011 Page 10 of 20

11 Section C Answer two questions only. 12. The balance sheets of OPQ Ltd as at 31 March are as follows: Fixed assets: '000 '000 '000 '000 Plant and machinery at cost 25,646 14,000 Accumulated depreciation (1,669) (1,009) 23,977 12,991 Current assets: Stock in trade Trade debtors Cash and bank ,534 Creditors payable within a year: 2,518 Trade creditors (157) (356) Taxation (776) (800) Bank overdraft (10) (235) (943) (1,391) 24,568 14,118 Capital and reserves: '000 '000 '000 '000 Ordinary shares 4,500 3,500 Share premium account 1,228 1,028 Retained profit 18,140 8,890 23,868 13,418 Long term liability: Debentures (6%) ,568 14,118 ICSA, 2011 Page 11 of 20

12 The profit and loss account of OPQ Ltd for the year ended 31 March is as follows: Sales Cost of sales Gross profit Expenses excluding depreciation Depreciation Operating profit Interest paid Profit before taxation Taxation Profit after taxation Dividend paid Retained profit for year Retained profit brought forward Retained profit carried forward '000 40,000 (25,470) 14,530 1, (1,674) 12,856 (56) 12,800 (2,300) 10,500 (1,250) 9,250 8,890 18,140 OPQ Ltd did not dispose of or revalue any fixed assets during the year to 31 March Required (a) Prepare a cash flow statement for OPQ Ltd for the year ended 31 March 2011 in accordance with the requirements of Financial Reporting Standard 1 Cash flow statements, including the note reconciling the operating profit to the net cash inflow from operating activities and the analysis of changes in net debt. (20 marks) (b) Explain the main purpose and function of the cash flow statement. (5 marks) (Total: 25 marks) ICSA, 2011 Page 12 of 20

13 (a) OPQ Ltd Cash Flow Statement for the year ended 31 March 2011 '000 Operating profit 12,856 Depreciation charges 660 Decrease in stocks 250 Increase in debtors (109) Decrease in creditors (199) Net cash inflow from operating activities 13,458 Net cash inflow from operating activities 13,458 Returns on investment and servicing of finance (56) Taxation (WN 1) (2,324) Capital expenditure (WN 2) (11,646) (568) Equity dividend paid (1,250) (1,818) Management of liquid resources 0 Financing (WN 3) 1,200 Decrease in Cash (618) Analysis of changes in net debt As at Cash As at 1 April Flows 31 March '000 '000 '000 Cash in hand and at bank 910 (843) 67 Bank Overdrafts (235) 225 (10) Debt due after 1 year (700) 0 (700) (25) (618) (643) ICSA, 2011 Page 13 of 20

14 Working Notes '000 1 Taxation Balance at start of year 800 Due in year 2,300 3,100 Balance at end of year (776) Taxation paid in year 2,324 2 Capital Expenditure Balance at end of year 25,646 Balance at start of year (14,000) Acquired in year 11,646 3 Share Capital and premium Balances at end of year 5,728 Balances at start of year (4,528) Raised in year 1,200 (b) The main purpose and functions of the cash flow statement are as follows: To provide important cash flow information which is not, in itself, available from the profit and loss account (income statement) or balance sheet (position statement); To provide information which helps to assess liquidity, solvency and financial adaptability; To highlight the significant components of cash generation; To identify key areas of cash outlay; and To facilitate comparisons with cash flows of other similar enterprises. This question was generally well answered. ICSA, 2011 Page 14 of 20

15 13. The capital and reserves of two companies, A Ltd and B Ltd, as at 31 March 2011 are as follows: Capital and reserves: A Ltd B Ltd '000 '000 '000 '000 Ordinary shares of Share premium account Retained profit Long term liability: Debentures (10%) ,000 1,000 The profit and loss accounts of A Ltd and B Ltd for the year ended 31 March 2011 are as follows: A Ltd B Ltd 000 '000 Operating profit before interest and taxation Debenture interest paid Profit before taxation Taxation at 20% Profit available for ordinary shareholders 100 (10) 90 (18) (50) 50 (10) 40 Required (a) For each of the companies, calculate: (i) (ii) (iii) The gearing ratio or the debt/equity ratio. The earnings per share. The fixed interest times covered. (6 marks) (b) For each of the companies, assuming that profit before interest and tax had been 80,000 (instead of 100,000) and that the taxation rate had remained at 20%, recalculate: (i) (ii) (iii) (iv) The profit available for ordinary shareholders. The earnings per share. The change in earnings per share. The fixed interest times covered. (12 marks) Note: You must show your calculations for (a) and (b) above. ICSA, 2011 Page 15 of 20

16 (c) (d) Explain the importance of a company s long term capital structure in terms of understanding its financial stability. Explain, using your calculations to (a) and (b) above, the impact of the financial gearing of company A Ltd and B Ltd on profit available for ordinary shareholders. (3 marks) (Total: 25 marks) (a) Gearing ratio WN % 50.0% Debt/equity ratio WN % 100.0% Earnings per share (p) WN Fixed interest times covered WN Working Notes: A Ltd B Ltd 1. Debt/TCE x 100 = 2. Debt/Equity x 100 = 100 / 1,000 x 100 = 10% 100 / 900 x 100 = 11.1% 500 / 1,000 x 100 = 50% 500 / 500 x 100 = 100% 3. PAT/Shares in issue = 72,000 / 600,000 x 100 = 12p 40,000 / 300,000 x 100 = 13.3p 4. PBIT/Fixed interest = 100,000 / 10,000 = 10 times 100,000 / 50,000 = 2 times (b) Scenario 2 A B '000 '000 Profit before interest and tax Debt interest (10.0) (50.0) Profit before tax Tax at 20% (14.0) (6.0) Profit available for ordinary shareholders Earnings per share (p) WN Change in eps (p) (2.7) (5.3) Change in eps % WN 6 (22.2) (40.0) Fixed interest times covered WN ICSA, 2011 Page 16 of 20

17 Working Notes: A Ltd B Ltd 1. PAT/Shares in issue = 56,000 / 600,000 x 100 = 9.3p 24,000 / 300,000 x 100 = 8.0p 2. (2.7)/ 12.0 x 100 = 22.2% (5.3)/ 13.3 x 100 = 40.0% 3. PBIT/Fixed interest = 80,000 / 10,000 = 8 times 80,000 / 50,000 = 1.6 times (c) The net assets of a company must be financed and the long-term capital structure of the business is instrumental in this respect. This financing will generally be by means of ordinary shares and reserves, preference shares, long term debt (or a combination of these). Ordinary share finance will always be present. The relationship between these sources of finance is important in respect of the differing rewards and obligations of each source. A company with large proportions of debt may experience difficulties in servicing the finance cost when profits are low and may find it difficult to raise further finance. In severe circumstances, the ability to remain in business may be at risk. Benefits of such borrowing include the availability of tax relief for the finance costs in some jurisdictions. (d) A 20% reduction in profit for both companies has resulted in a disproportionate reduction in earnings per share for the higher geared company as compared to the lower geared company. Had there been a 20% increase in profit, then there would have been a disproportionate increase in earnings for the lower geared company as compared to the higher-geared company. This is as a result of the fixed nature of the finance charge and the resulting effect on earnings available for equity. This question was answered by the least number of students but was the best answered of the Section C questions. However, the potential impact of the financial gearing on returns for equity shareholders was not clearly explained. ICSA, 2011 Page 17 of 20

18 14. In relation to offshore finance, explain eight legitimate ways in which a multinational corporation may use an offshore subsidiary and identify seven potential disadvantages of using offshore centres. (25 marks) Eight key legitimate ways for a multinational corporation to use an offshore subsidiary are as follows: Repository Conduit Know-how licensor Re-invoicing vehicle Intermediate holding company Offshore subsidiary as RHO Bond issuance vehicle Other special uses To earn strong marks, the above points needed to be expanded and explained. As a repository An offshore subsidiary can put money (its own money, or that of other parts of the multinational group to which it belongs) to work at interest by placing deposits in, say, the eurocurrency market. As a conduit Where group funds are to be lent to a subsidiary (in, say, jurisdiction X), the MNC could route them through an offshore subsidiary (in, say, jurisdiction Y) at a margin favourable to the offshore subsidiary. The offshore subsidiary can then accumulate profit, which it may be able to put to work tax-free. As a know-how licensor or sub-licensor A MNC can build up income in an offshore subsidiary by allowing the offshore subsidiary to buy (or license) the rights to know-how (also known as intellectual property rights [IPRs]). The offshore subsidiary in turn licenses or sub-licenses (at a higher figure) the rights to various fellow subsidiaries (in selected countries, or possibly worldwide). As a re-invoicing vehicle If components that are manufactured by one subsidiary (A) are to be purchased by another subsidiary (B), they can (instead of being sold directly to the other subsidiary B) be sold initially to the offshore subsidiary, which then sells them on to B at a margin of profit to the offshore subsidiary. The effect of benefiting an offshore part of the multinational group can be intensified if: B is made to lead (that is to say, pay in advance) to the offshore subsidiary, and/or the offshore subsidiary lags (that is to say, delays payment) to A. ICSA, 2011 Page 18 of 20

19 As an intermediate holding company (an IHC) (also known as an international holding company). There could be up to three potential strategies: As an IHC if the parent-company country does not concede pioneer relief. Several host countries offer tax holidays to encourage new investment from overseas. If, however, any profit from such a subsidiary is remitted direct to the parent company, the advantage of such tax concessions is lost if the parent-company country does not concede pioneer relief. As an IHC acting as a single-asset property company (a SAPCo). A single-asset property company (a SAPCo) can be used when a MNC hopes to make a large capital gain that it would like to keep (for a time) untaxed outside the parent-company country. As an IHC to act as a dividend trap An offshore subsidiary can be used as a so-called dividend trap (or dividend mixer company). That is to say, it can be used to avoid the wastage of overspill. In other words, the offshore subsidiary owns subsidiaries in several countries with some such countries with tax rates below the parent-company country rate of, say, 30%, and some other such countries with rates above 30%. The offshore subsidiary is thus an IHC acting as a dividend trap. That is to say, it pools income from these various sub-subsidiaries before onward remittance to the ultimate parent company. An offshore subsidiary as a regional head office (an RHO) It can be beneficial for a parent company to own (most) of its subsidiaries direct, but use an offshore subsidiary to act as a regional head office (an RHO). The RHO should sign management-services agreements (also known as advisory-services agreements) with (i) subsidiaries in the RHO's circuit, and (ii) the parent company. The RHO would charge for services (for example, training; marketing advice; credit advice; and internal auditing). The relevant tax authorities normally deem such payments acceptable, if they are arm'slength prices, i.e. market prices. As such, they would provide a way of making remittances (from high-tax jurisdictions, to the offshore centre) which are often allowable for profit-tax purposes and exempt from withholding tax. As a bond-issuance vehicle Offshore subsidiaries have been used as convenient vehicles for eurobond issues, because many international investors want freedom from withholding taxes, and exchange controls. Thus, a large MNC might incorporate an offshore subsidiary specifically for the purpose of raising money by way of bond issues. The offshore subsidiary is the issuer of the bond, but the bond might bear the guarantee of the parent company or some other financially-strong group member. ICSA, 2011 Page 19 of 20

20 The offshore subsidiary on-lends the proceeds of the bond flotation to the parent company or to other group member(s). Therefore, there needs to be a tax treaty between the offshore centre and the jurisdiction to which the funds are on-lent; or no withholding tax on interest payments. Other special uses Offshore companies can also be used for other special uses such as captive insurance and ship ownership and management. Potential disadvantages: An offshore subsidiary involves legal fees, registration duties and, potentially work permit costs. Onshore governments may tax offshore income even if it is not remitted to the parent. Shareholders will require dividends which means that parent companies will need much of the offshore profit to be remitted shortly after profits are earned. This will have taxation implications. Relief on tax paid overseas may not be available to a group if dividends from a subsubsidiary to its intermediary holding company are held offshore. Education and welfare facilities may have to be funded by companies in offshore centres where, as a result of low levels of taxation levied, such amenities are not readily available. Inward investors may not benefit from grants from the governments of some offshore jurisdictions where resources are in short supply. Potential political, socio-economical or environmental turmoil. This question was generally poorly answered, although some candidates were able to explain and expand on the key points. The scenarios included here, except where expressly identified, are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. ICSA, 2011 Page 20 of 20