Management Level Paper F2 Financial Management November 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 of the key areas in Syllabus Section B, being retirement benefits and share-based payments. The retirement benefits section focuses on the accounting rules for a defined benefit plan and includes the revised rules for accounting for past service cost. The share-based payment part requires knowledge and practical application of IFRS 2 and an understanding of why the requirements are necessary. This question examined learning outcome B1(f). Suggested Approach Candidates should have been familiar with the format required for the answer and those who had completed past exam questions in their studies are likely to have prepared their workings in the format on the next page. Turn over for answers to (a) and (b) November 2014 1 Financial Management
(a) (i) Pension plan Actuarial gains and losses: FV of plan assets PV of plan liabilities $000 $000 Opening balance 8,200 8,500 Service cost 2,100 Interest cost (6% x opening 492 510 balances) Benefits paid (500) (500) Contributions 1,900 Past service cost 2,000 10,092 12,610 Actuarial gain on plan assets 108 Actuarial gain on plan liabilities 110 Closing balance 10,200 12,500 The net actuarial gain in OCI is $218,000 for the year. (b) (ii) Statement of financial position: $000 Present value of pension plan liabilities at 31 March 2014 12,500 Fair value of pension plan assets at 31 March 2014 (10,200) Net pension liability 2,300 (i) Statement of profit or loss: Eligible employees (800-50-110) = 640 Equivalent total cost = 640 employees x 1,000 options x FV$7 = $4,480,000 Allocate over 3 year vesting period, therefore $1,493,333 is the charge for the year to 31 March 2014. (ii) Share options, such as those granted by NB, are given by an entity in return for services provided by its employees. In effect the share options are given to the employees as a form of bonus or reward for these services and are therefore part of the employee s remuneration package. The value of these options (or relevant part thereof) must then be reflected in the staff costs included within the statement of profit or loss. Financial Management 2 November 2014
Answer to question two starts on the next page November 2014 3 Financial Management
Answer to Question Two Rationale This question was intended to test consolidation techniques in drafting a group statement of profit or loss and other comprehensive income. The complex area being tested was piecemeal acquisition with control being gained in the period, resulting in equity accounting for 9 months and full consolidation for 3 months. This question tested learning outcomes A1(a) and (b). Suggested Approach Establishing the group structure during the year would have been essential. Drafting up the proforma group statement of profit or loss and other comprehensive income would have been the next best step, inserting a line for the associate and for the group gain/loss on the de-recognition of the associate. A key part of the answer was the calculation of the NCI allocation of profit and TCI, and the calculation of goodwill at the date control was gained. (a) Goodwill: $m Consideration transferred on 1 January 2014 320 Fair value of existing holding of 35% at date control is gained 280 Fair value of non-controlling interest at date of control 180 780 Fair value of the net assets acquired (710) Goodwill arising on the acquisition 70 Financial Management 4 November 2014
(b) Summarised statement of profit or loss and other comprehensive income $m for the QA Group for the year ended 31 March 2014 All workings in $m Profit from operations (410 + (3/12 x 200) 460 Consolidated gain on de-recognition of associate (W1) 11 Finance costs (70 + (12 x 3/12)) (73) Share of profit of associate (144 x 9/12 x 35%) 38 Profit before tax 436 Income tax expense (100 + (3/12 x 44)) 111 Profit for the year 325 Other comprehensive income: Items that will not be reclassified to profit or loss Revaluation of property, net of tax (50 + (3/12 x 20)) 55 Share of associate s OCI (20 x 9/12 x 35%) 5 Other comprehensive income for the year 60 Total comprehensive income 385 Profit for year attributable to: Equity shareholders of the parent 316 Non-controlling interest (144 x 3/12 x 25%) 9 325 Total comprehensive income attributable to: Equity shareholders of the parent 375 Non-controlling interest (164 x 3/12 x 25%) 10 385 Workings 1. Group profit on de-recognition of associate $m $m All workings in $m Fair value of existing 35% investment at date control obtained 280 Carrying value of the associate in QA s financial statements at date control obtained: Cost of investment Plus 35% of post-acquisition retained earnings (710-670) (269) Gain on de-recognition 11 Note: the fair value gains reported in the OCI of QA that arose on the re-measurement of its investment in LM do not appear in the group accounts as the investment is treated as an associate and then a subsidiary in the group accounts and not in accordance with IAS 39. 255 14 November 2014 5 Financial Management
Answer to Question Three Rationale This question tested the calculation of basic and diluted earnings per share. The basic EPS question included dealing with two issues during the year, a bonus issue and an issue at full market price. The diluted EPS required candidates to incorporate share options when calculating diluted EPS. This question examined learning outcome C1(a). Suggested Approach The question was deliberately split into (a) and (b) to help candidates focus on the fact that both the bonus and full market price issue were to be included in the basic EPS and the diluted EPS then adjusted for the potential ordinary shares. The formats of candidates workings were expected to follow the approach shown below. (a) Basic eps: Profit attributable to ordinary shareholders $7,500,000 Weighted average number of issued ordinary shares during the year ended 31 March 2014: In issue throughout the year 20,000,000 Bonus issue (1 for 5) 4,000,000 Full market price issue 4,000,000 x 3/12 1,000,000 Weighted average number of shares in issue 25,000,000 Basic eps 30.0 cents Basic eps for y/e 31 March 2013 (restated) 34 cents x 20/24 28.3 cents (b) (i) Diluted eps: Profit attributable to ordinary shareholders $7,500,000 Weighted average number of issued ordinary shares during the year ended 31 March 2014 from part (a): 25,000,000 Shares held under option 2,000,000 Shares that could have been issued at average market price (2,000,000 x $4.50/5.60) (1,607,143) Shares effectively issued for nil consideration 392,857 Weighted average number of issued ordinary shares and potential ordinary shares during the year ended 31 March 2014 25,392,857 Diluted eps 29.5 cents (ii) Reporting entities must disclose the diluted eps to effectively illustrate how the eps would change in the future if these potential ordinary shares are issued. The shares that are added to the weighted average number of shares are those that would bring no additional resources to the entity and in essence are therefore potential bonus shares. Shareholders are then able to see the effect on current earnings of the potential ordinary shares that the entity is committed to issue. The most dilutive scenario is reported. Financial Management 6 November 2014
Answer to Question Four Rationale This question tested the accounting of financial instruments and foreign currency translation. Part (a) required candidates to explain, rather than do any related calculations for, how a convertible debt instrument would be initially recognised in the financial statements. Part (b) asked for the initial and subsequent measurement of an available for sale investment. The second part required candidates to analyse the features of the scenario given in order to determine the entity s functional currency. This question tested learning outcome B1(d),(e) and A2(b). Suggested Approach Candidates should have described how the liability and equity elements were split and initially measured. Part (b) required journal entry for both initial recording and subsequent measurement with gains/losses being recorded in other comprehensive income in accordance with the standard. Candidates should have used the scenario to prompt them to consider and explain the guidance in the accounting standard to determine the functional currency and then used the scenario to help justify their answer and make it specific to the scenario. (a) IAS 32 requires that the equity and liability elements within convertible instruments be initially recognised separately. The initial carrying amount of the liability is estimated by measuring the fair value of a similar instrument that has no conversion element. This is achieved by calculating the present value of the future cash flows associated with the instrument assuming that it is not converted on redemption (ie: the interest and principal repayment cash flows) discounted at the prevailing market rate for a similar instrument without conversion rights. The difference between this amount and the proceeds of issue (ie: the residual) is recognised as equity. (b) (i) Dr Investment $3,420,000 Cr Bank $3,420,000 Being initial recording of the purchase including transaction fees Dr Investment $180,000 Cr other reserves $180,000 Being the increase in fair value being recorded within equity/oci (ii) The functional currency of a foreign enterprise is the currency of the primary economic environment in which the entity 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 the entity s goods and services through its competitive forces and regulation; The currency that mainly influences labour, material and other costs. November 2014 7 Financial Management
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. Where the subsidiary operates relatively autonomously, rather than as an extension of the parent, this provides evidence that the functional currency of this subsidiary should be the local currency in which it operates. It is likely that AB would adopt the Yip as its functional currency. Its results would be impacted by the local currency as it would be sourcing goods locally and recruiting local workforce. In addition, it is subject to local tax regulations. AB sales are both domestic and overseas, however it raised finance locally and has continued to operate autonomously, so the Yip is likely to be its functional currency. AB will prepare its financial statements using the Yip. Financial Management 8 November 2014
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. (a) 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. TY would expect its human resources to generate future economic benefit, however the resource is one that TY cannot control. 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 profit or loss 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. (b) TY depends on human resources to generate its revenue but may have a relatively low level of capital investment. This could make its statement of financial position look under-capitalised and it is difficult for investors to see where the value of TY lies. Common ratios targeting efficiency and financial position, like return on capital employed and return on assets, will not provide useful measures as the key revenue generating resources of the business are not reflected in the financial statements of TY. The inclusion of voluntary information would ensure that investors do not arrive at incorrect conclusions about the financial performance and position of TY. Where investors feel they can rely to some extent on this additional information it could encourage them to invest or stay invested. Potential investors tend to rely on the information contained in the financial statements in order to help them make their investment decisions. This missing information may make TY look a less attractive investment to potential investors. Including information about key revenue-generating resources may improve the market s opinion of TY, and could lead to investment and improvement of share price. November 2014 9 Financial Management
The gap between market capitalisation and book value of net assets of TY could be considerable and it is therefore important to inform the market of key personnel resources, processes or intellectual capital. Illustrating that TY has assets that are not included on the SOFP may lower the market s perception of the riskiness of TY which could improve the entity s P/E ratio. Answers to Section B start on the next page Financial Management 10 November 2014
SECTION B Answer to Question Six Rationale This question examined candidates understanding of vertical group structures. The question included consolidation of both a subsidiary and sub-subsidiary and so candidates could achieve a large portion of the marks by adopting the basic procedure of consolidation of a subsidiary. Accounting for debt instruments was also tested. This question tested learning outcomes A1(a) and (b), B1(e). 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 SOFP and inserting lines for goodwill and NCI would have been the next step. Candidates would then insert the aggregated figures or cross reference to workings where appropriate. Consolidated statement of financial position as at 31 March 2014 for BX Group (workings in $ millions) ASSETS $m Non-current assets Property, plant and equipment (210 + 88 + 110) 408 Goodwill (W1) 28 436 Current assets (60 + 46 + 28) 134 Total assets 570 EQUITY AND LIABILITIES Equity attributable to owners of the parent Share capital ($1 equity shares) 200 Share premium 50 Retained earnings (W2) 89 339 Non-controlling interest (W3) 77 Total equity 416 Non-current liabilities (25 + 10 + 4 + 1 (W4) + 2 cont liab) 42 Current liabilities (60 + 34 + 18) 112 Total liabilities 154 Total equity and liabilities 570 November 2014 11 Financial Management
Workings 1. Goodwill Acquisition of Y Acquisition of Z $m $m Consideration transferred for Y ($148m - $18m) 130 for Z (75% x ($76m - $6m)) 52 NCI at fair value in Y (25% x 80 million shares x 40 $2.00) 42 in Z (40% x 60 million shares x $1.75) 170 94 Net assets acquired Share capital 80 60 Share premium 20 10 Retained earnings 45 20 Contingent liability at acquisition (5) 140 90 Goodwill at acquisition 30 4 Impairment of 20% for goodwill on acquisition of Y (6) Goodwill at 31 March 2014 24 Total goodwill at 31 March 2014 is $28m. 2. Retained earnings Group Y Z $m $m $m As per SOFP at 31 March 2014 65 60 46 Pre-acquisition reserves (45) (20) Goodwill impairment (W1) (6) Adjustment for movement in contingent liability on 3 acquisition of Y Adjustment for long term bond (W4) (1) Group share of Y (75% x $12m) 9 Group share of Z (60% x $26m) 16 Consolidated retained earnings 89 12 26 3. Non-controlling interests Acquisition of Y Acquisition of Z $m $m At acquisition (as per W1) 40 42 NCI share of post-acquisition retained earnings of Y 3 (25% x $12m) NCI share of post-acquisition retained earnings of Z 10 (40% x $26m) Less cost of investment in Y (25% x $70m) (18) NCI at 31 March 2014 25 52 Total NCI at 31 March 2014 is therefore $77 million. Financial Management 12 November 2014
4. Long term bond Opening balance Effective interest Interest paid 5.5% Closing balance 9.5% $m $m $m $m 24.75 2.35 1.38 25.72 Adjusting both the bond and retained earnings by $1m will correct the posting of the transaction costs and record the additional finance cost to account for the effective interest, since interest paid has already been charged. November 2014 13 Financial Management
Answer to Question Seven Rationale This question was a standard-style analysis covering Section C of the syllabus. Candidates were required to calculate P/E ratio for FG and then briefly comment on that and the share price. The detailed analysis was then drawn from the calculation of 6 further ratios. Suggested Approach Candidates should have calculated ratios and then considered the results in conjunction with the opening scenario. (a) (i) Calculation of P/E ratio 2014 2013 Share price $3.94 $5.29 EPS $18,000,000/40,000,000 45.0 cents per share $23,000,000/40,000,000 57.5 cents per share P/E ratio 8.8 9.2 (ii) The share price has fallen significantly following poor interim results being published and the announcement about the dividend. Earnings per share has also fallen as a result of reduced profit for the year. The profit has been reduced by the impairment of goodwill recorded in the year, otherwise reported profit would have shown an increase in operating profit. The market is clearly concerned about FG s future since the P/E ratio has fallen from 9.2 to 8.8 which is not surprising since those investors looking for short term returns will have been disappointed by the announcement. (b) FG s gross profit margin has fallen from 29.2% to 26.8%, which is likely to be a direct impact of the pressure on selling prices from the new market entrant. Combining this with increased revenue overall and the fall in inventories in the year suggests that FG has made a deliberate move to sell inventories at a reduced price. This is a positive indicator that management has responded quickly to market pressures and to avoid being left with obsolete inventories. Both operating profit margin and profit for the year have reduced in the year, however FG suffered an additional expense from the impairment of the goodwill arising on its subsidiary. Adjusting for this allows us to assess the core operating profits of FG. Without the impairment expense of $10 million the operating profit margin would have increased to 7.4%, indicating that FG s directors have controlled operating costs well in the year. The cost control has not been reflected in the return on capital employed which has decreased due to both decreased profits and increased capital employed from short term borrowings. The profit margin for the year has fallen by 0.9% and has been affected in part by the increased finance costs although the average rate of interest being charged has not increased significantly. The fall in profit has affected the interest cover. Cover has fallen from 8.6 to 5.0, however this would still be adequate cover should FG pursue additional finance raising. Financial Management 14 November 2014
The year end overdraft has resulted in an increased gearing level of 33%, compared with 23.1% the previous year. Long term funding has not increased, other than the amortisation of the effective interest. The short-term borrowing has been required despite a significant drive to collect receivables faster, with collection down from 63 to 55 days. The increase in short term borrowing is likely to be the result of payables falling from 97 days to 62 days during the year, possibly suppliers have demanded shorter payment terms as a result of uncertainty in the market and increased competitive pressure. Inventory holding period has fallen from 65 days to 46 days and this could be a deliberate attempt to clear older items. There is no evidence that FG has extended its long-term capital in order to acquire further PPE so we can only assume that cash has been used. It is not wise to invest in long-term capital using short-term funds, however this may have been a forced reaction from the new market entrant. The current and quick ratios do not indicate serious liquidity issues, however the statement of financial position shows no cash and outstanding payables that must be settled. FG must secure longer term finance especially if it is to continue to invest in PPE and compete with the new entrant in the market. It is also important to investors to resume dividend payouts and this would hopefully improve the market s perception of FG. FG should be able to secure long-term funding as the PPE provides adequate security, with only $65 million of existing long term borrowings at the year-end date. The management appear to be in the main responsive and commercial, albeit made a poor decision on the investment in PPE for cash. I think the investment should be considered further and we may be able to take advantage of the current low share price. November 2014 15 Financial Management
Appendix A Ratios Relevant ratios that could be calculated include: All workings in $m 2014 2013 Gross profit margin (GP/Revenue x 100) Operating profit (Profit before finance costs/revenue x 100) Profit margin PFY/revenue x 100 ROCE % Operating profit/capital employed Inventories Inventories / cost of sales x 365 Payables Payables/cost of sales x 365 Receivables Receivables /revenue x 365 Current ratio Current asset/current liabilities Quick CA inventories/current liabilities Gearing Debt/Equity Interest cover Operating profit/finance cost Average cost of lending Finance costs/interest bearing borrowings 182/680 x 100 = 26.8% 187/640 x 100 = 29.2% 40/680 x 100 = 5.9% 43/640 x 100 = 6.7% 22/680 x 100 = 3.2% 26/640 x 100 = 4.1% 40/(276+65+26) x 100 = 43/(260+60) x 100 = 10.9% 13.4% 63/498 x 365 = 46 days 81/453 x 365 = 65 days 84/498 x 365 = 62 days 120/453 x 365 = 97 days 103/680 x 365 = 55 days 110/640 x 365 = 63 days 166/110 = 1.5 210/120 = 1.8 103/110 = 0.9 129/120 = 1.1 (65 + 26)/276 x 100 = 33.0% 60/260 x 100 = 23.1% 40/8 = 5.0 times 43/5 = 8.6 times 8/(65 + 26) x 100 = 8.8% 5/60 = 8.3% Financial Management 16 November 2014