Management Level Paper F2 - Financial Management September 2014 The Examiner's Answers 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 Question One Rationale This question tested syllabus section B and included substance over form and share-based payments. Both parts of the question required application of skills. The question tested learning outcomes B1(c) and B1(f). Suggested Approach It was important that candidates used the scenario to ensure that all aspects of the transaction were addressed and then concluded on the economic substance underlying the transaction. The second part of the question is something that candidates should have been prepared for and anyone who had attempted past exam questions would have followed the approach on the next page. Financial Management 1 September 2014
(a) Inventories 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 which party to the transaction holds the principal risks and benefits associated with, in this case, an asset. Therefore in order to determine the correct accounting treatment we need to consider whether it is MW or LR which holds the significant risks and benefits of the vehicles and therefore which entity should record the vehicles held on MW s premises as inventory. In this situation the key factors are: MW is responsible for insuring the vehicles whilst on its premises. This would indicate that MW holds the risk of holding and storing the inventory. MW can return the vehicles at any time to LR without penalty. This would indicate that LR holds the risk of inventory obsolescence. The vehicles are sold at the price determined on the date of sale to 3 rd party. This would indicate that the risk of ultimate price movements (ie: with respect to the end customer) is with LR. This is a consignment inventory arrangement as the above factors show there is no clear cut answer as to who holds the significant risks and benefits. In this situation, we should consider the key risks which are likely to be the risk of obsolescence and the fact the LR is not protected from price changes up to date of sale. Given the terms of right of return, the obsolescence risk is with LR and therefore it is LR which should record the vehicles held at MW s premises at the year end as inventory. Therefore the books of MW should be amended to de-recognise the inventory and adjust cost of sales. (b) Share-based payment (i) Share options: The expense relating to the share options will be recorded as: Dr Profit or loss (staff costs) $120,533 Cr Other reserves/equity $120,533 Being the year s charge for related staff costs of options Working Recognisable to 30/6/14 (500 20 14 25) x $8 x 100 options = $352,800 Recognisable to date = $352,800 x 2/3 yrs $235,200 Recognised to 30/6/13 (500 20 50) x $8 x 100 options = $344,000 Recognised to 30/6/13 = $344,000 x 1/3 yrs Charge to income statement in year to 30/6/14 $114,667 $120,533 (ii) If cash-settled rights were granted instead of share options then they would be re-measured at their fair value at each reporting date. The credit entry would be to liabilities rather than to equity. September 2014 2 Financial Management
Please turn over for answers to question two Financial Management 3 September 2014
Question Two Rationale This question was intended to test candidates application of both full consolidation and equity accounting. The second part of the question required an understanding of establishing functional currency and required an element of knowledge and then application to the entity itself. The question tested learning outcomes A1(a) and (b) and A2(b). Suggested Approach The logical start would have been to set up the pro-forma for the income statement and then work systematically through the headings. Part (b) required an explanation of the rules of IAS 21 and then to use the scenario to apply those rules. Consolidated statement of profit or loss and other comprehensive $m income for the AB Group for the year ended 31 December 2013 All workings in $m Profit from operations (580 + 280 8 (W1)) 852 Share of profit of joint venture (50% x 90) 45 Finance costs (90 + 16) (106) Profit before tax 791 Income tax expense (160 + 64) (224) Profit for the year 567 Other comprehensive income: Items that will not be reclassified to profit or loss Revaluation of property, net of tax (120 + 40) 160 Share of joint venture s OCI (50% x 20) 10 Other comprehensive income for the year 170 Total comprehensive income 737 Profit for year attributable to: Equity shareholders of the parent 529 Non-controlling interest ((200 8 (W1)) x 20%) 38 567 Total comprehensive income attributable to: Equity shareholders of the parent 691 Non-controlling interest ((240 8 (W1)) x 20%) 46 737 Working 1 Goodwill on acquisition of GH: $m Consideration transferred 405 NCI at fair value 100 Fair value of net assets acquired (465) Goodwill on acquisition 40 20% Impairment 8 September 2014 4 Financial Management
(b) Functional currency The functional currency of the foreign entity, KM, should be the currency of the primary economic environment in which it operates. The key considerations would be: the currency which principally influences selling prices for goods and services; the country that most influences the selling prices of KM s goods and services through its competitive forces and regulation; and the currency that mainly influences labour, material and other costs. If it is still unclear which currency should be the functional currency then consider the currency in which funding is primarily raised and in which operating receipts are retained. If the subsidiary is to operate relatively autonomously, rather than as an extension of AB, then the functional currency of KM should be the local currency in which it operates. Financial Management 5 September 2014
Question Three Rationale This question required the analysis of a cash flow statement to draw conclusions about the performance and position of the entity in the year. The question tested learning outcome C2(b). Suggested Approach A good approach would be to consider the individual cash flows and then to consider them in relation to the others within the same heading and overall. Cash from operating activities LM has generated a significant amount of cash from its trading activities. This has been helped by, what would appear to be, deliberate improvements in the management of working capital. There has been a reduction in the inventories held and a reduction in receivables, both of which will have had a positive impact on cash flow. In addition, payments to creditors have been withheld as can be seen from an increase in payables. Improvements in cash management during a period of expansion are an indicator of good stewardship by the directors, although care must be taken that payables are not stretched too far as this could lead to a loss of supplier goodwill. It appears that management has made a good investment in the associate as it has brought both significant income and cash via dividend to LM. Cash from investing and financing activities LM appears to be expanding its activities with acquisitions of PPE and a subsidiary in the year resulting in a substantial outflow of cash from investing activities. We do not know whether these acquisitions occurred at the start of the year or the end of the year, but if at the end of the year then we can expect a significant increase in profitability and operating cash flow in future years. The management has adopted a wise strategy of funding this expansion through long term capital, which we can see from the financing activities - cash being raised by both a share issue and the raising of long term debt. The gearing will have been positively impacted since the proceeds from the share issue are significantly greater than the funds raised through debt. It should be noted however that more long term finance than required in the year was raised, which could indicate that LM has expansion plans in 2014. The shareholders have been rewarded for their support of the share issue with a dividend payout of over $2m. Without knowing the dividend policy of LM it is difficult to comment on whether this is an unusually high level of dividend or not. However, it is encouraging that the cash from operations covers more than double the value of the dividend, indicating that LM can support this level of dividend. Overall the cash position has significantly improved at the year end and this may be in advance of further expansion, which will improve future profitability and cash flow. September 2014 6 Financial Management
Question Four Rationale This question tested the initial recognition and subsequent measurement of a convertible instrument, requiring candidates to correctly transfer their own figure to the amortised cost calculation. The recognition and measurement of financial investment was also tested. The question tested learning outcomes B1(d) and (e). Suggested approach Candidates should have used PV calculations to determine the liability and equity elements of the instrument and prepared the journal for this accordingly. Only the liability element should have been remeasured. The recording of the investment should have been presented in J/E form (a) Convertible instrument $000 $000 (i) Dr Bank 5,000 Cr Liabilities (W1) 4,603 Cr Other reserves/equity 397 Being the recording of the convertible bonds being issued. Working 1 Liability element $000 PV of the principal (at 8% for 5 years) = ($5m x 0.681) 3,405 PV of interest of 6% on $5m for 5 years = ($5m x 0.06 x 3.993) 1,198 Total value of liability element 4,603 Total amount raised on issue Value of equity element 5,000 397 (ii) Subsequent measurement of the liability Opening balance Finance cost at 8% Interest paid 6% Closing balance $000 $000 $000 $000 4,603 (W1) 368 (300) 4,671 A liability of $4,671K will be included in the SOFP as at 30 June 2014. (b) Dr Investment $400,000 Cr Bank $400,000 Being the initial recording of the investment Dr Profit/loss agency costs $2,000 Cr Bank $2,000 Being the agency costs incurred expensed to profit Dr Profit/loss loss on investment ($400,000 - $390,000) $10,000 Cr Investment $10,000 Being the subsequent measurement of the investment at the reporting date. Financial Management 7 September 2014
Question Five Rationale This question tested the candidates knowledge of the development of the convergence project and then required the application of that knowledge in order to consider the potential benefits to both investors and reporting entities. The question tested learning outcome D1(e). Suggested Approach Part (a) should have primarily been a timeline of how the project developed and would have been knowledge-based. Part (b) should have been candidates own assessment of the potential benefits that convergence brings. (a) Convergence project The convergence project was intended to achieve alignment in the financial reporting standards that are applied globally and involves both FASB and IASB. The FASB and the IASB agreed to work towards convergence using two main strategies: To eliminate minor differences between a list of target standards. To develop new accounting standards jointly to ensure common approach and wording. New standards have been developed jointly and incorporate new agreed definitions and wording. The FASB agreed that its approach needs to switch from a rules-based system of reporting to a principles-based approach like that adopted by the IASB. This was the reason that the two bodies started jointly reviewing and revising the Framework for Preparation and Presentation of Financial Statements as the underlying basis for all future jointly developed accounting standards. An agreed framework of principles for recognition, measurement and presentation would result in transactions and balances being treated consistently and will improve comparability of the entities listed on the main stock exchanges. The progress of the convergence project achieved its initial objectives faster than expected and as a result the SEC in the US no longer requires entities to provide reconciliation from IAS to US GAAP for entities adopting IAS and listed on the US stock exchange. The review of the Conceptual Framework for Financial Reporting was paused and consideration of some of the chapters (eg recognition) will continue as an IASB-only review, while other projects are pursued jointly. (b) Advantages to investors and entities Financial statements prepared using accounting standards that follow the same principles can easily be compared. Prior to convergence, it would have been necessary to adjust certain figures in the financial statements that would have been recognised or measured on different bases. Increased comparability and transparency should result in greater liquidity in investment markets and promote cross-border investment. This is all positive for investors, as it is easier to trade investments and realise capital gains. Entities that operate globally are likely to be reviewing financial statements of suppliers, customers, investment targets, etc. There would be a time-saving benefit if all these financial statements were being prepared on a consistent basis less need to compare the accounting policies of different entities and make adjustments to be able to assess them on a consistent basis. Convergence could have a negative impact regarding the cost to entities of changing/updating their financial reporting systems as convergence is producing change at a faster pace. However, increased convergence does mean less need to adjust the financial statements of overseas investments for accounting policy differences which potentially has a cost saving. September 2014 8 Financial Management
Please turn over for answers to question six Financial Management 9 September 2014
SECTION B Question Six Rationale This question tested consolidation. The first section tested the preparation of the statement of financial position including the complex area of piecemeal acquisitions. Part (b) required an adjustment to parent s equity for the same entity. The question tested learning outcomes A1(a) and (b). Suggested Approach The most efficient method would have been to set up the pro-forma for the SOFP and then work systematically through the headings, preparing the consolidation adjustments where required. (a) Consolidated statement of financial position for the EMR Group as at 30 June 2014 All workings in $000 ASSETS $000 Non-current assets Property, plant and equipment (80,650 + 17,000 + 1,520(W1)) 99,170 Goodwill (W2) 900 100,070 Current assets Inventories (18,000 + 4,000 - PUP 200) 21,800 Receivables (30,000 + 9,500 intracompany 3,000) 36,500 Cash and cash equivalents (6,000+ 1,500 + cash in transit 2,000) 9,500 67,800 Total assets 167,870 EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) 50,000 Retained earnings (W3) 70,526 Other components of equity (W4) - 120,526 Non-controlling interest (W5) 4,144 Total equity 124,670 Non-current liabilities (10,000 + 4,000) 14,000 Current liabilities (20,200+ 10,000 intracompany 1,000) 29,200 Total liabilities 43,200 Total equity and liabilities 167,870 September 2014 10 Financial Management
Workings Working 1 FV adjustments $000 $000 $000 Uplift in PPE 1,600 Additional dep n (1,600/10 yrs x 6/12) (80) 1,520 Working 2 Goodwill $000 $000 Consideration transferred for the 60% 10,350 Fair value of 20% holding at 1 January 2014 3,950 Fair value of non-controlling interest 3,700 18,000 Net assets acquired: Share capital 5,000 Retained earnings 10,500 FV adjustment on acquisition (W1) 1,600 (17,100) Goodwill at acquisition 900 Working 3 Retained earnings EMR XY $000 $000 As at 30 June 2014 68,000 13,000 Pre-acquisition retained earnings (W2) (10,500) FV adjustment (W1) (80) Unrealised profit $(1,000 x 20%) (200) Group share 80% 1,776 2,220 Group profit on derecognition of AFS Investment to deemed disposal date, 1 January 2014 750 (3,950 3,200) Consolidated retained reserves 70,526 Working 4 Other components of equity and AFS investments $000 Cost of 60% investment (1 Jan 2014) 10,350 Cost of 20% investment (1 Feb 2010) 3,200 Therefore, cost of 80% investment 13,550 Compared with fair value of 80% investment (30 June 2014) 14,350 Resultant gain recognised by EMR in individual accounts since 1 Feb 2010 800 and balance in other reserves of EMR This gain will be removed from the consolidated accounts as the group gain on derecognition of the original investment is the relevant figure for the consolidated accounts, leaving a balance of NIL in the group accounts for other reserves. Working 5 Non-controlling interest $000 Fair value at 1 January 2014 3,700 Plus 20% adjusted post-acquisition reserves of 2,220 (W3) 444 Non-controlling interest at 30 June 2014 4,144 Financial Management 11 September 2014
(b) Additional acquisition of shares Adjustment to parent s equity $000 Consideration transferred 2,200 Reduction in NCI at 1 July 2014 (10/20% x $4,144,000) Adjustment to retained earnings - debit (2,072) 128 Recorded as: Dr NCI $2,072,000 Dr Group retained earnings $128,000 Cr Bank $2,200,000 Being the adjustment to parent s equity September 2014 12 Financial Management
Question Seven Rationale This question was the main test of financial analysis and tested candidates calculation of ratios and analysis based on a scenario. There was a focus on the investor and required consideration of whether this would be a good investment option. The question tested learning outcomes C1(a) and C2(b). Suggested Approach Calculation of the ratios would be the first step and then consideration of the ratios together with the opening scenario. It was important to remember that the analysis was being performed from the investor s perspective and so recommending how the entity could improve future performance was not relevant in this case. (a) The supermarket contract has clearly had a positive impact on revenue with an increase of more than 37% for 2013, despite only including four months of contract revenue. The revenue figure will also include any external sales from the newly acquired subsidiary, albeit for just one month. Gross profit margin has increased by 7%. This significant increase could be due to deliberate cost savings or as a result of better margins from the supermarket contract. There could be further increases following the acquisition of RT, however this acquisition took place just one month prior to the reporting date and is unlikely to have had such a significant impact. The operating profit margin has also increased by 6% and this is despite a substantial increase in administrative expenses. Given that there is likely to have been increased professional fees from both the investigation into the chemical leak and the contract negotiations with the supermarket, it is possible that these expenses will not recur and future profit may increase further. Distribution costs appear to have been better controlled in 2013 as the percentage of distribution cost to revenue has fallen from 5.2% to 4.5% and this will have contributed to an improved operating profit margin. The profit before tax margin has increased by 5.7%. It is evident that QW is not considered to be financially risky as the rate of interest being charged has remained fairly constant at approximately 7%. The acquisition of RT may not have had a significant impact on the profit in the year but within the statement of financial position all the closing balances of RT for 2013 will have been included. The impact can be seen in both the goodwill and non-controlling interest balances, which have both increased significantly as a result of the acquisition. There has been an increase in PPE of $120 million and there is a finance lease for just $50 million. Given that cash seems not to have been affected greatly and there has been a reduction in the long-term borrowings we can conclude that either RT is heavily capitalised and these assets have been consolidated, or that it was cash rich and the group has invested in PPE following the acquisition. Alternatively, it could be that some of the monies raised from the issue of new equity has been used to acquire PPE. In any event the ROCE has shown an improvement from the prior year indicating that the net assets are working efficiently in the generation of profit. On initial review, QW does not appear to have working capital issues with an increase in the current ratio from 1.4 to 1.7. However the quick ratio shows that the entity would struggle to meet its short term liabilities with a fall from 0.8 to 0.7. It perhaps is not a huge issue as QW operated in 2013 with a quick ratio of just 0.8, but the entity now also has finance lease repayments to meet. Payable and receivables days have remained constant. It is surprising that the supermarket contract has not had an impact on the receivables days, perhaps the directors managed to negotiate favourable payment terms. The main issue for QW is that inventories days have increased from 37 days to 71 days. This may have arisen from the consolidation of RT or from a deliberate increase in inventories to meet the Financial Management 13 September 2014
new contract terms. It would be beneficial to reduce the inventories held especially given that QW is operating with low liquidity. QW appears to be in a good financial state with low gearing and more than adequate interest cover. There is definitely scope for additional long-term financing and given the entity appears to be expanding it would be wise for it to explore financing options. Given the low level of gearing debt finance is likely to be readily available, especially given the increased profitability and the abundance of security available over QW s assets. There has been an issue of shares in the period presumably to principally fund the acquisition of RT. Despite the increase in the number of shares, EPS has shown a marked increase because of the improvement in profitability. Share price has also increased significantly. However, when we look at the P/E ratio we see that it has actually fallen from 12.6 to 10.9, indicating that the market would have expected an even higher share price to reflect the higher profitability. It s possible the share price as at 31 December 2013 is slightly depressed as a result of the uncertainty surrounding the contingent liability (which presumably would have been reported in the press and hence would be known to investors). The contingent liability is a concern, especially for an entity that is seen to be environmentally friendly producing recyclable products. The possibility of additional legal fees, clean-up costs and financial penalty should make securing additional finance a priority for the management. Based on the analysis above, QW appears to be a good equity investment at this time. The management appear to be competent and there is definitely scope for increased growth with the new contract and acquisition in both a subsidiary and PPE. An investor could reasonably expect increased future profitability, although more information would need to be sought regarding the contingent liability. (b) It would be essential for a potential investor to establish the dividend policy/history of QW, especially if the investor was concerned with annual returns rather than capital growth. Nine months on from the reporting date should be adequate time to assess the outcome of the investigation into the chemical leak and the corrective action that was taken by management. This information should be reasonably easy to obtain as the entity is listed and will be relatively high profile. The current position of the share price will be an indication of how the market has reacted to the results of the investigation and the action of the directors. Interim results should also be available for QW which will provide a better indication of the impact of RT and the supermarket contract on revenue and margins. This will enable potential investors to better predict the future performance of QW. September 2014 14 Financial Management
Appendix A All workings in $m 2013 2012 Gross profit margin (GP/revenue x 100) Operating profit margin Operating profit/revenue x 100 Profit before tax margin PBT/Revenue x 100 ROCE (Operating profit/capital employed x 100) Inventory days (Inventories / cost of sales x 365) Payable days (Payables/cost of sales x 365) Receivable days (Receivables /revenue x 365) Current ratio (Current asset/current liabilities) Quick (CA inventories/ CL) NCA turnover (Revenue /NCA) Gearing Debt/Equity x 100 Interest cover Profit before interest and tax/finance costs Average rate of borrowing x 100 Finance costs /debt (inc fin lease) Earnings per share Profit for the year/number of shares Price/earnings Share price/eps 170/660 x 100 = 25.8% 90/480 x 100 = 18.8% 96/660 x 100 = 14.5% 41/480 x 100 = 8.5% 90/660 x 100 = 13.6% 38/480 x 100 = 7.9% 96/574 x 100 = 16.7% 41/399 x 100 = 10.3 % 95/490 x 365 days = 71 days 40/390 x 365 days = 37 days 93/490 x 365 days = 69 days 74/ 390 x 365 days = 69 days 70/660 x 365 days = 39 days 52/480 x 365 = 40 days 172/103 = 1.7 100/74 = 1.4 77/103 = 0.7 60/74 = 0.8 660/505 = 1.3 480/373 = 1.3 84/500 x 100 = 16.8% 40/359 x 100 =11.1% 96/6 = 16.0 41/3 = 13.7 6/84 x 100 = 7.1% 3/40 x 100 = 7.5% 63/200 = 31.5 cents 23/170 = 13.5 cents $3.42/ 0.315 = 10.9 $1.70/0.135 = 12.6 Financial Management 15 September 2014