F2 Financial Management May 2013 examination. Examiner s Answers

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1 Management Level Paper F2 Financial Management May 2013 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 a core element of Section B of the syllabus, which is accounting for pensions. Candidates were required to apply the revised standard and record the actuarial differences within OCI. This question tested learning outcome B1(f). Suggested Approach It would be helpful to set up the workings for income statement and actuarial differences at the same time as a number of the elements affect both calculations. (a) Income statement expense in respect of the pension plan for the year ended 31 March 2013 All workings in $000 $000 Service cost 650 Past service costs 200 Net interest cost (5% x (3, )) (5% x 2,700) = Net expense 875 May Financial Management

2 (b) Amounts to be included in OCI of GH for pension plan for the year ended 31 March 2013 All workings in $000 FV of assets PV of obligation $000 $000 Opening balances 2,700 3,000 Past service cost 200 Service costs 650 Interest cost (5% x (3, )) 160 Expected return (5% x 2,700) 135 Contributions 950 Benefits paid (320) (320) 3,465 3,690 Re-measurement component gain / loss Closing balances 3,600 3,800 Therefore the amount included in OCI will be a re-measurement component gain of $25,000 ($135,000 - $110,000). (c) Net pension asset / obligation for the statement of financial position of GH as at 31 March 2013 $000 Present value of pension plan obligation 3,800 Fair value of pension plan assets 3,600 Net pension obligation 200 Financial Management 2 May 2013

3 This page is blank Turn over for Answers to question 2 May Financial Management

4 Answer to Question Two Rationale This question was intended to test consolidation techniques in drafting a group statement of financial position. Candidates were tested on their ability to perform the main consolidation adjustments goodwill, group reserves and NCI - including FV adjustments and intra-group transfer of goods. This question tested learning outcomes A1(a) and (b). Suggested Approach Drafting up the pro-forma group statement of financial position would have been the best first step, inserting lines for goodwill and NCI. Working through the headings and preparing the associated workings would have been the most logical approach. Consolidated statement of financial position of the ER Group as at 31 December 2012 All workings in $000 ASSETS $000 Non-current assets Property, plant and equipment (5, ,000 + FV adj 280 (W1)) 8,180 Goodwill (W2) 350 8,530 Current assets (3, ,000 PUP 10 (W3)) 4,190 Total assets 12,720 EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) 5,000 Retained earnings (W4) 4,336 Equity attributable to equity holders of the parent 9,336 Non-controlling interest (W5) 584 Total equity 9,920 Non-current liabilities Long term borrowings (1, ) 1,300 Current liabilities (1, ) 1,500 Total liabilities 2,800 Total equity and liabilities 12,720 Workings 1. Fair value adjustment $000 $000 $000 Acquisition Movement Year end Uplift in PPE on acquisition Depreciation over 10 years x 3 years since - (120) (120) acq n 400 (120) 280 Financial Management 4 May 2013

5 2. Goodwill on acquisition $000 $000 Consideration transferred 2,000 Non-controlling interest at fair value on 450 acquisition Net assets acquired: Share capital 500 Retained earnings at acquisition 1,200 Fair value uplift on PPE 400 (2,100) Goodwill arising on acquisition of MR Unrealised profit on inventory sale $200,000 x 25% x 20% = $10, Consolidated retained earnings ER Group MR $000 $000 Retained earnings as per SOFP 3,800 2,000 Less pre-acquisition retained earnings (1,200) Adjustment for unrealised profit on sales (W3) (10) Additional depreciation on FV uplift (W1) (120) 670 Group share (80%) of adjusted RE of 536 subsidiary Consolidated retained earnings 4, Non-controlling interest $000 At acquisition 450 NCI share of adjusted post-acq n RE of MR (W4) (20% x $670,000) May Financial Management

6 Answer to Question Three Rationale This question tested Section C of the syllabus and included the calculation of working capital ratios that candidates would have seen many times in Question 7. The report was then intended to focus specifically on the results of the ratios, as no detailed background scenario was provided. This question tested learning outcomes C1(a) and C1(b). Suggested Approach Candidates should have been totally prepared to answer this question as working capital is an area that has appeared in numerous past paper questions. Candidates should have calculated the ratios and then considered the results as a whole, commenting on how the key working capital ratios impact on each other and the likely causes of the results. The expansion of operations has resulted in more than a 50% increase in revenue, however this has been at the expense of gross profit margin which has reduced from 27.5% to 21.9%. This is a significant decrease in the period, however it is likely that this is as a result of a strategic decision to sell a lower margin product as costs would not be expected to increase that dramatically in a 6 month period. Alternatively, it could be the result of a strategic decision to sell the new product at a discount in order to boost the volume of sales. There has been a significant increase in inventories held, increasing from 58 days to 92 days. This is not surprising in a period of expansion and it is most likely needed in order to meet the increased demand. More concerning is the position on receivables and payables, as it appears that SAF is overtrading with an increase in receivable days from 72 to 101 days in the last six months. It could be as a result of more favourable credit terms being offered to new customers, however since receivables days have increased beyond payable days the result will be increased pressure on the entity s liquidity. It could be the case that the credit control department has struggled to cope with the increased level of activity and could be addressed simply by dedicating additional resources to credit control. The current ratio has fallen. However the quick ratio is more of a concern as it has decreased from 1.6 to 1.2 and this together with the entity having moved from a positive cash position to having short term borrowings, makes it clear that the expansion has caused problems with the management of working capital. The entity should ensure that an overdraft facility is in place until procedures can be imposed to improve the management of working capital. Financial Management 6 May 2013

7 Appendix All workings in $000 s 6 months to 31 December months to 30 June 2012 Inventories 1,220/2,420 x = 92 days 460/1,450 x = 58 days Inventories / cost of sales x days Payables 1,190/2,420 x = 90 days 580/1,450 x = 73 days Payables/ cost of sales x days Receivables 1,715/3,100 x = 101 days 790/2,000 x = 72 days Receivables / revenue x days Current ratio 2,935/1,440 = 2.0 1,400/580 = 2.4 Current asset/current liabilities Quick 1,715/1,440 = /580 = 1.6 CA inventories/current liabilities Gross Profit margin Gross profit/revenue x /3,100 x 100 = 21.9% 550/2,000 x 100 = 27.5% NB: There are days in six months. An alternative approach to the calculations would be to gross up the revenue and cost of sales figures to annual amounts (by multiplying each by 2) and then multiplying by 365 days. May Financial Management

8 Answer to Question Four Rationale This question examined two elements of financial instruments, the initial classification and recording of a convertible instrument and then the subsequent measurement of a financial liability. This question examined learning outcomes B1(d) and (e). Suggested Approach Candidates who had worked through previous exam papers would appreciate exactly how to set this out. The instrument would be initially split between debt and equity and the PV calculations were required to calculate this. Candidates should have then used their own figures for (a) to remeasure the liability at amortised cost. (a) Initial recording of the convertible debt instrument: Dr Bank $4,000,000 Cr Liability $3,689,200 (W1) Cr Equity $310,800 (W1) Being the issue of convertible debt on 1 January 2012 Working 1 $ PV of the principal amount ($4,000,000 x 0.650) 2,600,000 PV of interest annuity ($4,000,000 x 7%) x ,089,200 3,689,200 Balancing figure represents the equity element 310,800 Total raised from issue 4,000,000 (b) Carrying value of the liability at 31 December 2012: $ Opening balance of liability (W1) 3,689,200 Effective interest (9% x $3,689,200) 332,028 Less interest paid (7% x $4,000,000) (280,000) Balance on liability as at 31 December ,741,228 The equity element recognised on the issue of the bonds is not subsequently re-measured and remains at $310,800. Financial Management 8 May 2013

9 Answer to Question Five Rationale This question tested Section D of the syllabus, and specifically the expansion of narrative/voluntary disclosures in respect of human capital. This question tested learning outcome D1(d). Suggested Approach It was essential that candidates absorbed the small scenario provided and presented answers that were relevant to the entity and scenario given. Entities that depend on human resources to generate revenue often will have a relatively low level of capital investment. This often makes the statement of financial position look under capitalised and it is difficult for the investor to see where the value of the entity lies. Common ratios targeting efficiency and financial position, like return on capital employed and return on assets, will not provide us with useful measures as the key revenue generating resources of the business are not reflected in the financial statements. For successful companies the gap between market capitalisation and book value of net assets can be considerable and it is therefore important for entities to inform the market of key personnel resources, processes or intellectual capital. This is often therefore highlighted in chairman s statements or director s reports within the financial statements themselves. The recognition of assets requires certain criteria to be met; an asset must be a resource controlled by an entity as a result of a past event and from which future economic benefit is expected to flow. This asset must then be capable of being reliably measured in order to be recognised in the statement of financial position. Human resources are expected to generate future economic benefit for the entity, however the resource is one that cannot be controlled. Staff members are free to leave at any time taking their skills and intellectual capital with them. There are also a number of issues concerning the measurement of a staff resource as an asset. The cost of staff is their training costs and remuneration. It could be argued that training costs have an on-going benefit and therefore could be capitalised. However, remuneration relates to a service provided by the staff in that year and therefore should be taken to the income statement as a period cost. It is possible to value assets on a fair value basis, however, for staff this would involve establishing future cash flows and discounting to present value. It is difficult to see how this could be achieved on a reliable basis due to the estimation required. Staff resource therefore fails the recognition criteria for an asset and cannot be included in the statement of financial position. There has been a marked increase in the volume of narrative reporting as entities look to find a suitable manner in which to inform investors about internally generated intangibles such as trained staff, processes and key customers. These are not recognised in the financial statements but are essential to the future success of the entity and are likely to generate future revenue. This information is therefore needed to help users make informed investment decisions. May Financial Management

10 Answers to Section B start on the next page Financial Management 10 May 2013

11 SECTION B Answer to Question Six Rationale This question examined candidates understanding of consolidation of a foreign subsidiary. Candidates were able to achieve a large portion of the marks by adopting the basic procedure of consolidation of a subsidiary, and the complex area tested was the additional calculations required for the translation. This question tested learning outcomes A1(a), (b) and A2(b). Suggested Approach The first step would be to establish the group structure and identify the complex issue in the question and how this would affect the answer, given that a SOFP was to be prepared. Drafting up the pro-forma statements and inserting lines for goodwill, NCI, etc would have been the next step. Translating the accounts of the foreign sub would then be required prior to any consolidation workings being completed. Candidates would then insert the aggregated figures or cross reference to workings where appropriate. (i) Consolidated statement of profit or loss (all workings in $000) A$000 Revenue (8, ,364 (W1)) 9,364 Cost of sales and operating expenses (4, (W1)) (5,318) Profit before tax 4,046 Income tax (1, (W1)) (1,182) Profit for the year 2,864 Profit for the year attributable to: Equity holders of the parent 2,791 Non-controlling interest (W4) 73 2,864 (ii) Consolidated statement of comprehensive income (all workings in $000) Profit for the year 2,864 Other comprehensive income Items that will not be reclassified to profit or loss Revaluation gains on property (net of tax) ( (W1)) 536 Items that may subsequently be reclassified to profit or loss Exchange differences on translating foreign operations (W2) (212) Total other comprehensive income 324 Total comprehensive income 3,188 Total comprehensive income for the year attributable to: Equity holders of the parent 3,130 Non-controlling interest (W4) 58 3,188 May Financial Management

12 (iii) Consolidated Statement of financial position (all workings in $000) ASSETS A$000 Non-current assets Property, plant and equipment (6, ,522 (W1)) 8,222 Goodwill (W3) 529 8,751 Current assets (4, ,304 (W1)) 5,304 Total assets 14,055 EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) 2,000 Retained reserves (W5) 8,720 10,720 Non-controlling interest (W6) 465 Total equity 11,185 Current liabilities (2, (W1)) 2,870 Total equity and liabilities 14,055 Workings 1. Translate statement of comprehensive income of B at B average rate of 2.20 A$000 Revenue 1,364 Cost of sales and operating expenses (818) Profit before tax 546 Income tax (182) Profit for the year 364 Other comprehensive income Items that will not be reclassified to profit or loss Revaluation gains on property (net of tax) 136 Total other comprehensive income 136 Total comprehensive income 500 Statement of financial position of B translated at closing rate B of 2.30 with net assets acquired translated at historical rate of ASSETS A$000 Non-current assets Property, plant and equipment 1,522 Current assets 1,304 Total assets 2.30) 2,826 EQUITY AND LIABILITIES Equity Share capital ($1 equity Retained reserves Retained reserves post acquisition (balance) 506 Total equity 1,956 Current liabilities 2.30) 870 Total equity and liabilities 2,826 Financial Management 12 May 2013

13 2. Exchange differences arising in the year on translation of A$000 foreign operation (all workings in B$000) Closing net assets of B at closing rate (4,500/2.30) 1,957 Less opening net assets at opening rate ((4,500 1,100)/2.10) (1,619) Less profit for the year at the average rate (1,100/2.20) (500) Exchange loss on translation of B in year to 31 December 2012 (162) Exchange loss on the translation of goodwill in the year (W3) (50) Total exchange loss for the year (212) 3. Goodwill on acq n of B B$000 Rate A$000 Consideration transferred 3, ,800 Non-controlling interest ,420 2,210 Net assets acquired: Share capital (1,000) 2.00 (500) Pre-acquisition retained reserves (1,900) 2.00 (950) Goodwill at 1 January , Impairment at 31 Dec 2011 (20%) (304) 2.10 (145) Translation loss on goodwill (bal) (36) Goodwill at 31 Dec , Translation loss on goodwill (bal) (50) Goodwill at 31 Dec , Non-controlling interest for the year PFY TCI (workings in A$000) A$000 A$000 Translated amounts for B (W1) NCI share of 20% NCI share of exchange losses on translation of B (20% x 212 (W2)) (42) Consolidated retained reserves A Group B (workings in A$000) A$000 A$000 Retained reserves of A at 31 December ,500 Post acquisition retained reserves of B (W1) 506 Less impairment of goodwill (W3) (145) Less exchange losses on translation of goodwill ( )(W3) (86) 275 Group share of adjusted retained reserves (80% 220 x 275) Consolidated retained reserves 8, Non-controlling interest (all workings in A$000) A$000 On acquisition (as per Question) % adjusted post-acquisition retained reserves (20% x 275 (W5)) 55 Non-controlling interest at 31 December May Financial Management

14 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 the ratios provided. This question tested learning outcomes C1(a) and C2(b). Suggested Approach Calculation of the ratios and then re-reading the opening scenario would have been the natural first steps, ensuring that the ratios selected were relevant for this question and covered both financial performance and position. (a) Investor ratios (workings in millions) Earnings per share Profit for the year/ number of equity shares 72/300 = $0.24 per share 76/300 = $0.25 per share P/E ratio Share price/eps $2.50/$0.24 = 10.4 $2.90/$0.25 = 11.6 Dividend yield Dividend per share /share price x 100 (40/300)/2.50 = 0.05 ie 5% (30/300)/2.90 = 0.03 ie3% (b) Review of financial performance The accident in July 2012 has clearly affected revenue, having decreased by almost 17% to $1,074 million. The gross profit margin, however, has increased from 13.2% to 14.9% in the year. This could be due to moving security services in-house through the acquisition of A and the fact that POP is now streamlining the associated costs. This is a significant improvement in gross margin, especially with a reduction in revenue as many of the costs of operating events (stage set and performer costs) will be fixed. The operating profit has increased considerably from 8.8% to 12.8%. This is likely due to a combination of reduced repairs expenses from the recent investment in new equipment coupled with the improvement in gross margin. POP may also be benefiting from streamlining administrative operations for the three entities and maybe economies of scale with larger scale operations. It is likely that POP will incur legal costs from the lawsuit and this will result in higher administrative costs. The directors should ensure the depreciation policy selected for the new equipment is realistic and not producing an artificially low charge. The profit for the year has increased but not by as much as the other two ratios as a result of increased finance costs. The average rate of interest that POP was paying in 2012 was just 4.3% but this has increased to 11.6% in The long term borrowings will be held at amortised cost and it appears that no further long term borrowings have been taken, so therefore the increase in the finance cost will mostly be due to increased use of short term borrowings. The average rate of 11.6% seems excessive, even with the inclusion of an overdraft and therefore potentially indicates that the level of short term borrowings has been Financial Management 14 May 2013

15 significantly higher than the year-end balance throughout the rest of the year. The interest cover has reduced from 7.5 to 3.0 which is a significant fall and this is despite an increase in profitability. Interest is still covered by profits but at such a high interest rate, this is unlikely to be sustainable in the future. The P/E ratio has reduced by 10% at the year end to The earnings per share has fallen slightly, as a result of marginally reduced profit for the year. It is likely therefore, that the market has reacted negatively to the accident and the subsequent lawsuit being raised against the entity. This perhaps brings into question the directors decision not to impair the value of its subsidiary. In addition, the acquisition of two new entities, one being overseas, could have resulted in a level of uncertainty among investors, especially since POP has started to suffer exchange losses as a result of exchange rates moving in an adverse way. Financial position The main issue for POP is the lack of liquid funds. There is no inventory held so current assets are represented by trade receivables and cash. The receivables will be amounts due from the ticket agent for tickets sold and not surprisingly the receivables days are relatively low, although there has been an increase from 36 days to 48 days since last year. This could be as a result of an event near to the year-end date, but POP should be prioritising debt collection when the entity is so short of funds. The payables days have remained unchanged and it is unlikely that POP could delay payment as it needs events to continue to be held and delaying payments could put that in jeopardy. Gearing has increased slightly from 36.1% to 38.7% due to the amortisation of the long term borrowings and the existence of short term borrowings at 31 March There does not appear to have been any additional long term liabilities in the year. POP is relying on shortterm borrowings and is potentially in trouble when considering a dividend is due to be paid of $40 million and that the long term borrowings might need to be redeemed within the next two years. Therefore, POP would benefit from additional investment, not only to cover short term working capital but also for the longer term. The stability of and growth in the share price is going to be one of the key concerns of management, especially given the convertible bond that is due to be either redeemed or converted in two years time. Given the current lack of liquidity and downturn in profitability, it could be difficult for POP to raise sufficient funds for the bond to be repaid at par and therefore equity conversion might well be preferred by POP. Hence a strong share price is needed in order for conversion to be attractive. However, if the bond is converted it should be noted that there will be a significant number of new shares which will dilute future earnings and dividend per share statistics. POP announced an increase of 33% in the level of total dividend when it is clearly short of liquid funds. This has resulted in a significant increase in the dividend yield far in excess of the increase expected from a fall in share price. The dividend policy could therefore be the result of a deliberate attempt by the directors to boost the share price by giving a positive message to the market about the state of the entity following the accident and subsequent lawsuit. The management appear to have good control over costs and efficiencies as the ROCE has improved as a result of increased operating profit and the fact that they addressed the health and safety issues immediately shows good business sense. However, the only doubts about the management s decision making are the proposal of a dividend in a year where there is a lack of cash and a pending lawsuit and the decision not to impair the goodwill of POP s investment of B. May Financial Management

16 (c) Additional information Reviewing any movements on share price would be a good indication of how well the market is reacting to the results of POP. Press information about dividends being paid would reassure a potential investor that funds have been raised. Details about the restrictions on the short term borrowings would be available from the detailed financial statements and would indicate how under pressure POP is from the lack of funds that is evident from the statement of financial position. Any press coverage that explains the current state of the lawsuit would be helpful as the outcome could affect the future of POP as a going concern. Financial Management 16 May 2013

17 Appendix A Ratios (workings in $ millions) Gross profit GP/revenue x 100% Operating profit Profit before finance costs/revenue Net profit before tax PBT/revenue x 100% Gearing Debt/total equity Quick ratio CA inventories/current liabilities Receivables days Receivables/revenue x 365 days Payables days Payables/cost of sales x 365 days Return on capital employed Profit before finance costs/capital employed x 100% Interest cover Profit before finance costs/finance costs Average rate of interest Finance costs/short and long term borrowings /1,074 x100 = 14.9% 170/1,290 x 100 = 13.2% 137/1,074 x 100= 12.8% 113/1,290 x 100 = 8.8% 92/1,074 x 100 = 8.6% 98/1,290 x 100 = 7.6% (367+20)/999 x 100 = 38.4% 350/969 x 100 = 36.1% 140/180 = /175 = /1,074 x 365days = 48 days 128/1,290 x 365 days = 36 days 120/914 x 365days = 48 days 145/1,120 x 365days = 47 days 137/ ( ) x 100= 9.9% 137/45 = /15 = /( ) x 100 = 8.6% 45/( ) x 100 = 11.6% 15/350 x 100 = 4.3% May Financial Management