F2 Financial Management May 2014 examination. Examiner s Answers

Transcription

1 Management Level Paper F2 Financial Management May 2014 examination Examiner s Answers Note: Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike. SECTION A Answer to Question One Rationale This question was intended to test two key areas in syllabus section B, being retirement benefits and substance over form. The retirement benefit question involved calculation of the net interest expense and the actuarial gain/loss ensuring that candidates appreciate how defined benefit plans are reflected in the statement of comprehensive income. Substance over form was tested in a scenario where land was sold with a repurchase option. This examined candidates ability to assess the commercial substance of sale v financing arrangement. This question examined learning outcomes B1(f) and (c). Suggested Approach Candidates should have been familiar with the format of the answer for retirement benefits provided and those who had attempted past exam questions are likely to have prepared their answers in line with this. The best approach with part (b) was to use the scenario and benchmark these details against their conclusions of the underlying substance of the transaction. May Financial Management

2 (a) Pension plan (i) Profit or loss expense $000 Service cost 1,100 Net interest expense 5%($3,900, $3,700,000) Total expense 1,110 (ii) Actuarial gains and losses $000 $000 FV of plan assets at 1 Jan ,700 PV of plan liabilities at 1 Jan ,900 Service cost 1,100 Contributions paid in year 760 Benefits paid in year (340) (340) Expected return on plan assets (5% x 185 $3,700,000) Interest cost of plan liabilities (5% x 195 $3,900,000) Actuarial gain on plan assets 95 Actuarial gain on plan liabilities (155) FV of plan assets at 31 Dec ,400 PV of plan liabilities at 31 Dec ,700 There will be a net actuarial gain of $250,000 within the other comprehensive income of MR. (b) Asset sale: IAS 1 (Revised) Presentation of Financial Statements requires that financial statements must reflect the economic substance of transactions and not merely their legal form, where economic substance is determined by considering who holds the principal risks and benefits associated with in this case an asset. Despite the sale of the land, MR must buy the land back within 2 years at a higher price than it sold it for. In addition the value that the land has been sold for at $6,000,000 is lower than its market value on the sale date. These two factors together with the fact that the purchaser, CW, is unable to use the land without explicit approval from MR, means that in substance MR still holds the principal risks and benefits of the land (being exposure to changes in the market value of the land and control over how the land is used). In essence this is a financing arrangement where $6,000,000 has been raised using the land as security. The accounting entry given in the question should be reversed (ie: the asset should not be de-recognised, no gain or loss should be recorded) and a liability of $6,000,000 recorded in the financial statements for the year to 31 December Financial Management 2 May 2014

3 Answer to Question Two Rationale This question tested consolidation. There was no requirement to prepare the statement of financial position but the key group workings for the SOFP were required. Fair value adjustments and impairment were also tested. The question tested learning outcomes A1(a) and (b). Suggested Approach The most time-efficient method would have been to set up a pro-forma for relevant sections of the SOFP and then systematically work through the 3 headings, ensuring the impact of the FV adjustments were accounted for in all 3 workings. (a) Good will Consideration transferred: Cash Shares (500,000 x $4) $000 $ ,000 2,400 Non-controlling interest at fair value 560 Net assets at date of acquisition: Carrying value $(1,000, ,050,000) 2,050 FV increase on PPE $(1,320, ,200,000) Contingent liability (180) (1,990) Goodwill on acquisition 970 Impairment of 10% at 31 December 2012 (97) 873 Impairment of 20% at 31 December 2013 (175) Goodwill as at 31 December (b) Consolidated retained earnings ER MW $000 $000 As reported in SOFP 7,900 1,400 Less pre-acquisition retained earnings (1,050) Accumulated depreciation on PPE FV (48) adjustment ($120,000 x 2/5 years) Movement on contingent liability 120 Impairment of goodwill $(97, ,000) (272) 150 Group share of MW ($150,000 x 80%) 120 Consolidated retained earnings as at 31 December ,020 May Financial Management

4 (c) Non-controlling interest $000 Non-controlling interest at fair value at acquisition 560 Plus NCI share of adjusted post acquisition retained earnings 30 (as in (b) above) (20% x $150,000) Non-controlling interest at 31 December Financial Management 4 May 2014

5 Answer to Question Three Rationale This question tested candidates understanding of investor ratios and what could impact them and cause them to move in certain ways. The question also tested limitations of using ratios for comparison of overseas entities. The question tested learning outcomes C1(a), C2 (b) and C2(d). Suggested Approach The recommended approach was to first calculate the ratios and then consider the direction in which they have moved and suggest possible and valid reasons for why the movement has occurred. The limitations of ratio analysis is largely knowledge based and good answers would have relied on technical knowledge. (a) (i) Calculation of ratios P/E ratio = share price/eps $9.05/$0.65 = $5.12/$0.38 =13.5 Dividend yield = dividend per share/share price x 100 $0.17/$9.05 x 100 = 1.9% $0.30/$5.12 x 100 = 5.9% (ii) The EPS has increased from $0.38 to $0.65 suggesting that the entity has had a good performance in the year. The dividend per share has reduced however, so the entity must be retaining profit, perhaps for expansion. This together with the increase in share price has resulted in the dividend yield falling from 5.9% to 1.9% from last year. The increase in both share price and P/E ratio would suggest however, that shareholders are not unhappy with this strategy and perhaps see the profit retention resulting in increased returns in the future. The increased P/E ratio is an indicator that the market is confident in the entity s ability to provide future returns, although this could have been a result of general movement in the market. (b) Limitations of overseas comparison Share prices are not likely to be comparable if the entity is listed on an exchange in a foreign country. The liquidity of the markets could be different and the responsiveness of the market to information could be different and this in turn will limit the usefulness of comparing in particular the P/E ratios. The financial statements of the entities could be prepared using different accounting standards, resulting in incomparable profit measures, and in this case specifically EPS. In addition, if the two entities are located in different geographical markets then they will be subject to different economic pressures and economic variables such as interest rates and tax rates. Again this will distort the comparison of earnings and earnings related measures. May Financial Management

6 Answer to Question Four Rationale Part (a) of this question tested the initial recognition and subsequent measurement of 2 financial assets. Part (b) required candidates to consider the impact of IFRS 13 on fair value assessment and use the investments in part (a) to explain the provisions of the standard. The question tested learning outcomes B1(d), (e) and (a). Suggested Approach The question required journal entries as evidence that candidates knew how to record the financial instruments and treat the issue costs. The recording of the gain/loss on subsequent measurement should also have been presented in J/E form. (a) Financial investments Investment in XY Dr Investment (1m x $1.85 x 1.01%) $1,868,500 Cr Bank $1,868,500 Being the initial recording of the investment in XY including the capitalisation of the transaction costs. Dr Investment ((1m x $1.98) - $1,868,500)) $111,500 Cr Other comprehensive income $111,500 Being the subsequent measurement of the investment in XY, with subsequent gain being recorded in OCI. Investment in LM Dr Investment (200,000 x $0.70) $140,000 Dr P/L expense (0.5% x $140,000) $700 Cr Bank $140,700 Being the initial recording of the investment in LM and the write off of the transaction costs. Dr Investment (200,000 x ($1.15 $0.70)) $90,000 Cr P/L gain $90,000 Being the subsequent measurement of the investment in LM, with subsequent gain being recorded in P/L. (b) Fair value measurement techniques The valuation technique used to re-measure the investment in XY is a level 1 input as the share price used is an accessible, reliable and verifiable measure. By definition level 1 inputs are quoted prices in active markets for identical assets, which clearly applies when an entity s shares are quoted on a stock market. In the case of an investment in an unlisted entity, ABC could use: a level 2 input such as the share price of a similar entity that was listed; or a level 3 input such as the present value of the entity s future cash flows using DCF valuation techniques. Financial Management 6 May 2014

7 Answer to Question Five Rationale This question tested voluntary disclosures requiring candidates to discuss both the benefits and limitations of voluntary disclosure. The question tested learning outcome D1(a). Suggested Approach The key to answering part (a) well was to stay specific to the requirements discussing the benefits to VB. Part (b) was more knowledge-based but additional credit would have been attainable for using the scenario to keep it specific to VB. (a) Benefits to VB Information about the sustainability project will not be easily found anywhere else in the annual report. The narrative report will provide VB with an opportunity to highlight this innovative move and to detail the potential benefits that VB anticipates. VB will be able to explain the future costs involved and mitigate the possible negative impact of future costs reducing profitability and subsequently the share price. VB will be able to promote the fact that it is a sector leader, being the first to pursue a major sustainability project and take advantage of the government assistance. Reporting on this project and illustrating that the entity is actively trying to reduce its carbon footprint may also help VB to attract new customers for whom good environmental practices are important and influence their purchasing decisions. VB may also attract new investors who have a preference for being associated with environmentally friendly entities. In addition, investors may anticipate VB making cost savings in the future as a result of this project. This could then lead to improvement in returns and increases in share price. The predictive nature of this information again would be otherwise absent in the financial statements. The narrative information could also help inform existing investors that VB is aiming to secure government assistance for the funding of this project and that the project will not necessarily put undue financial pressure on the entity s resources in the short term. (b) Limitations of relying on VB s voluntary disclosures The absence of formal guidance on the content of VB s narrative disclosures will result in a lack of comparability between entities, although in this case this might perhaps be limited in the first year as VB appears to be the only entity currently pursuing this type of project. The nature of voluntary disclosures means that VB is free to choose the content and may focus on only the positive aspects and fail to report any potential obstacles or related risks eg targets that have to be met to retain any government assistance finance that may be awarded. In addition these voluntary disclosures may not be audited and are therefore less reliable than the information provided elsewhere in the financial statements, although VB s investors could reasonably expect that the information provided is at least consistent with the audited financial statements. The drafting of any additional disclosures will incur management time and therefore cost and any additional expense reduces the future returns available to VB s shareholders. May Financial Management

8 SECTION B Answer to Question Six Rationale This question tested consolidated cash flow. The testing of cash flow included elements of complex groups, including dividend received from an associate, acquisition of subsidiary in the year and dividends paid to NCI. The question tested learning outcomes A1(a) and (b). Suggested Approach The most time-efficient method would have been to set up the pro-forma CFS and systematically work through the headings using the missing figure approach to determine cash flow in the year. Consolidated statement of cash flows for the FB Group for the year ended 31 December 2013 Cash flows from operating activities (workings in 000 s) $000 $000 Profit before tax 9,200 Adjust for non-operating and non-cash items: Depreciation 4,000 Goodwill impairment (W1) 400 Share of profit of associate (2,900) Finance costs 1,900 Changes in working capital: Decrease in inventories (W2) 1,600 Decrease in receivables (W2) 5,000 Increase in payables(w2) 2,200 Cash inflow from operating activities 21,400 Less interest paid (1,200) Less tax paid (W3) (1,700) Net cash inflow from operating activities 18,500 Cash flows from investing activities Acquisition of property, plant and equipment (W4) (7,600) Acquisition of subsidiary, net of cash acquired of $(350 (150) 200) Dividend received from associate (W5) 900 Cash outflow from investing activities (6,850) Cash flows from financing activities Proceeds of share issue (W6) 9,000 Dividend paid to shareholders of parent (W7) (2,150) Dividend paid to non-controlling interest (W8) (300) Repayment of long term borrowings (W9) (6,700) Cash inflow from financing activities (150) Net inflow of cash and cash equivalents 11,500 Cash and cash equivalents at 1 January ,500 Cash and cash equivalents at 31 December ,000 Financial Management 8 May 2014

9 Workings 1. Goodwill $000 Consideration transferred (4,000,000 x $1.50)+ $350,000 6,350 NCI at fair value 450 Fair value of net assets acquired (4,400) Opening balance 2,400 Impairment (balancing figure) (400) Closing balance 2, Changes in WC Inventories Receivables Payables $000 $000 $000 Opening balance 26,000 25,000 14,000 On acquisition 3,600 2,000 3,800 29,600 27,000 17,800 Movement (bal figure) (1,600) (5,000) 2,200 Closing balance 28,000 22,000 20, Tax paid $000 Opening balance 3,200 Tax on profit 2,500 5,700 Movement (balancing figure) (1,700) Closing balance 4, Acquisition of PPE $000 Opening net book value 32,000 On acquisition 2,400 34,400 Depreciation (4,000) 30,400 Additions (balancing figure) 7,600 Closing balance 38, Dividend received from associate $000 Opening balance 9,000 Share of profit of associate 2,900 11,900 Dividend received from associate (balancing figure) (900) Closing balance 11, Proceeds of share issue $000 Opening balance 20,000 Value of shares transferred on acquisition (4,000,000 x $1.50) 6,000 26,000 Issue for cash (balancing figure) 9,000 Closing balance (share capital $30m + share premium $5m) 35,000 May Financial Management

10 7. Dividends paid to shareholders of parent $000 Opening balance on retained earnings 14,300 Profit for year attributable to equity holders 6,200 20,500 Dividend paid (balancing figure) (2,150) Closing balance 18, Dividend paid to non-controlling interest $000 Opening balance NCI Nil NCI recognised on acquisition 450 NCI share of profit for year Dividend paid to NCI (balancing figure) (300) Closing balance NCI Repayment of long term borrowing $000 Opening balance 42,000 Effective interest charged to p/l ($42,000,000 x 4.524%) 1,900 Interest paid in the year (1,200) 42,700 Capital repaid (balancing figure) (6,700) Closing balance 36,000 Financial Management 10 May 2014

11 Answers to Section B continue on the next page May Financial Management

12 Answer to Question Seven Rationale This question formed the main test of financial analysis and tested candidates calculation of ratios and analysis of the information in the scenario and that could be gained from the ratios. There was a deliberate focus on considering the answer from the investor s perspective so recommendations on how to improve working capital, etc would not have been relevant. The question tested learning outcomes C1(a) and C2(b) and (d). Suggested Approach Calculation of the ratios and then reading the opening scenario several times would have been the suggested approach. It would have been important to ensure that the ratios selected provided coverage of both performance and financial position to allow the report to address analysis of both. (a) to client: Financial performance and position of VEG Performance VEG has managed to achieve a gross profit margin of 35% and the directors are anticipating an increase in the gross profit margin to 39.2%. This could be due to better margins having been negotiated in the contract with the supermarket for the own-brand products, meaning that the production of own-brand smoothies should be pursued with other supermarkets as this is clearly a lucrative deal. Alternatively the improved gross margin could be the result of greater economies of scale in purchasing or indeed greater efficiency in the production process now that the staff are fully trained and presumably working at full efficiency. The operating profit margin was 8.8% in 2013, however this was after charging professional fees and training costs, which would not be expected to recur in such significant amounts. It is likely that further marketing may be undertaken (finance permitting), however the directors are still anticipating that the operating profit margin will increase to 20.6% in The average interest rate for 2013 was 5.1% based upon the overdraft at the year end and is forecast to rise to 6.4% based on utilising the same level of overdraft. It is possible that during 2013 the overdraft was not used until the end of the year meaning that the interest charge was relatively small, whilst in 2014 the directors are anticipating that the overdraft will be used to its full capacity for the year. This could indicate that the directors are anticipating poor cash flow. In addition it s possible that the bank has increased the interest rate charged on the overdraft as a result of its own assessment of increased risk. Position The key issues with respect to the financial position of VEG are its lack of cash, high level of gearing and its working capital position. Of particular interest to you is the impact that these issues might have on further expansion plans. At the end of 2013 VEG has an overdraft of $40,000, although a facility of $75,000. Given the fact that VEG is still in its start-up phase this level of overdraft should perhaps be expected. A detailed cash forecast would be required if the directors decide to pursue expansion as it is likely that the working capital requirement would increase, certainly in the short term. The overdraft facility is to be reviewed by the bank in April 2014 and there is always the possibility that they recall the debt, which would leave VEG in a very precarious position. As at 31 December 2013 the gearing level for VEG is 73.9% but, on the assumption that the overdraft stays the same and no dividend is paid, is forecast to fall to 57.1% at the end of This is still a high level of gearing, which coupled with the lack of track record and the Financial Management 12 May 2014

13 fact that VEG is a new entity would mean that it would be unlikely that VEG could raise more debt finance to fund expansion plans even using new property, plant and equipment as security. In the unlikely event that debt finance was available it would be likely to carry a very high interest rate to reflect the risk associated with the already high level of gearing and the fact that it s a new business. This would clearly have a detrimental effect on the future profitability of the business. It is likely therefore that the only option available to the directors of VEG to expand the business at the current time would be to raise more equity finance and therefore as already indicated they might be prepared to negotiate favourable investment terms with you. The forecast inventories levels are not expected to increase despite more than 25% expected growth in revenue. This is probably due to the nature of the items as VEG are likely to hold mainly work-in-progress and low levels of finished goods as these have a limited shelf life. In fact, the inventories days are forecast to reduce from 28 days to just 18 days and could be the result of the investment in training making the production process more efficient. Receivables are forecast to almost double what they are at the end of 2013, with receivables days increasing from 64 to 104 days. This, despite only a 25% increase in revenue. This could be due to the new contracts with supermarkets that may be able to demand extended credit terms from VEG. This is definitely a concern for a relatively new entity, especially one which will be purchasing fresh goods on a regular basis and which will be under pressure to pay suppliers promptly to avoid having purchase orders delayed or stopped. However, it is possible that if required VEG could consider factoring its receivables which would alleviate some of this pressure, although at a cost. (b) Further information The directors are likely to be relatively open to discussion given that they are open to offering shares in return for a capital injection. I would be seeking clarification on how VEG has protected the intellectual property surrounding the technology, especially since this appears to be affording VEG a competitive advantage at present. Detailed information on the supermarket contracts would also be invaluable in assessing how realistic the forecasts are for the coming year, and whether it is a model that could be extended to other supermarkets to increase market share. Given there is no plan for further capital investment it would be important to confirm what capacity exists for further expansion on the current capital base, as future expansion would require additional finance. It would also be essential that we discuss with the directors of VEG the level of finance being sought and the shareholding they would be looking to offer in return, to allow the negotiations to commence. (c) Limitations of ratio analysis in this scenario Please be advised that there are limitations on the conclusions that can be drawn from the ratio analysis performed on the financial information of VEG. The entity is new and therefore limited information is available in order to establish any trends. Using forecast figures has less reliability as the information is based on the assumptions of the directors, and we are unaware of what these assumptions are and so our conclusions are limited. The success of the business in the future could be dependent on how long VEG can utilise the technology exclusively, however information on its protection is not found in the financial information. May Financial Management

14 Appendix A Ratios All workings in $000 Forecast 2014 Actual 2013 Gross profit margin (GP/Revenue x 100) Operating profit margin (Profit before finance costs /Revenue x 100) Profit margin PBT/Revenue x 100 Interest cover PBIT/Finance costs Inventory days Inventories / Cost of sales x 365 Receivable days Receivables /Revenue x 365 Average cost of borrowing Finance costs/interest bearing borrowings Gearing Debt / Debt + Equity x 100% 400/1,020 x100 = 39.2% 280/800 x 100 = 35% 210/1,020 x 100 = 20.6% 70/800 x 100 = 8.8% 185/1,020 x 100 = 18.1% 50/800 x 100 = 6.3% 210/25 = 8.4 times 70/20 = 3.5 times 30/620 x 365 = 18 days 40/520 x 365 = 28 days 290/1,020 x 365 = 104 days 140/800 x 365 = 64 days 25/( ) x 100 = 6.4% (on the assumption that the overdraft remains at the 2013 level) 390 / ( ) x 100 = 57.8% (on the assumption that the overdraft remains the same and no dividend is paid) 20/( ) x 100 = 5.1% ( ) / ( ) x 100 = 75.0% Financial Management 14 May 2014