Examiner's Answers F2 - Financial Management March 2014 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 was intended to test two of the key areas in Syllabus Section B, being share-based payments and retirement benefits. The share-based part requires knowledge and practical application of IFRS 2 and an understanding of why the requirements are necessary. The pension section focuses on the accounting rules for a defined benefit plan and includes the revised rules for accounting for past service costs. 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 shown in this answer. Financial Management 1 March 2014
(a) (i) Statement of profit or loss charge: 2013 expense: Eligible employees (800-20-55) = 725 Equivalent cost = 725 employees x 500 options x FV$6 = $2,175,000 Allocate over 4 year vesting period $2,175,000/4 = $543,750 charge for the year. The 2013 expense will be recorded as: Dr staff costs $543,750 Cr equity (other reserves) $543,750 (ii) Share options, such as those granted by MR, 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. (b) (i) The amounts to be recorded in MR s profit or loss for the year in respect of the defined benefit pension plan will be the current service cost, the interest cost on the unwinding of the plan liabilities and the expected return on the plan assets. These amounts will be provided by an actuary. Actuarial gains and losses arising in the period would be presented in other comprehensive income. The statement of financial position will show the year-end position that MR has with the pension plan, either a net pension asset or liability. This will be calculated as the difference between the fair value of the pension plan assets and present value of the pension plan liabilities at the year-end date. (ii) The revised IAS 19 requires the past service costs to be recognised immediately in full. The costs will be included in the charge in arriving at profit for the year and will also be included in pension plan liabilities from the date the improvements to the plan were announced. March 2014 2 Financial Management
Question Two Rationale This question tested consolidation and required candidates to calculate and draft sections of the statement of cash flows. The question examined learning outcome A1(a) and (b). Suggested Approach The most time-efficient process would have been to annotate the question paper with the headings for the cash flows and then set up the pro-formas for the sections of the cash flow. Using the missing figure approach to calculate the cash flows would have been the most logical approach. Consolidated statement of cash flows for the ER group for the year ended 31 December 2013: All workings are in $000 (i) Cash flows from investing activities $000 $000 Acquisition of property, plant and equipment (W1) (2,300) Acquisition of subsidiary, net of cash acquired (400 150 ) (250) Dividends received from associates (W2) 400 Cash outflow from investing activities (2,150) (ii) Cash flows from financing activities Proceeds of share issue (W3) 2,500 Dividend paid to equity holders of ER (1,000) Dividends paid to non-controlling interests (W4) (400) Repayment of long term borrowings (18,000-16,000) (2,000) Cash outflow from financing activities (900) W1 Acquisition of PPE $000 Opening balance 20,200 On acquisition 1,000 21,200 Revaluation 2,000 Depreciation (1,500) 21,700 Additions (balancing figure) 2,300 Closing balance 24,000 W2 Dividends received from associates $000 Opening balance 4,700 Share of associates total comprehensive income 900 5,600 Dividends received from associates (balancing figure) 400 Closing balance 5,200 W3 Proceeds of share issue $000 Opening balance 15,000 Issued on acquisition (1 million x $1.50) 1,500 16,500 Issue for cash (balancing figure) 2,500 Closing balance (18,000+1,000) 19,000 Financial Management 3 March 2014
W4 Dividends paid to non-controlling interests $000 Opening balance 8,800 On acquisition (30% x net assets of $2m) 600 NCI share of TCI for year 200 9,600 Dividends paid to NCIs (balancing figure) 400 Closing balance 9,200 March 2014 4 Financial Management
Question Three Rationale This question tested the calculation of basic and diluted earnings per share. The 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 a convertible instrument when calculating diluted EPS. This question examined learning outcome C1(a). Suggested Approach The question was deliberately spilt 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) (i) Basic earnings per share for the year ended 31 December 2013 Profit attributable to ordinary shareholders $8,200,000 Weighted average number of issued ordinary shares during the year ended 31 December 2013: (10,000,000 x 9/12) + (12,000,000 x 3/12) + 5,000,000 (bonus) 15,500,000 Basic eps 52.9 cents Basic eps for y/e 31 Dec 2012 (restated) 62.3 cents x 2/3 41.5 cents (ii) (b) A bonus issue does not raise any new finance and therefore the profit for the year will have been generated with the same level of resources throughout the year. As the issue results in no additional resources it is treated as if it had always been in existence. Comparative figures also need to be restated as if the bonus issue was made at the earliest reported period. The issue at full market price brings additional resources, which will impact on profits from the date of issue. Therefore a weighted average number of shares is used to calculate basic eps. Diluted earnings per share Profit attributable to ordinary shareholders $8,200,000 Post-tax saving on interest expense (70% x (5% x $6,000,000)) $210,000 $8,410,000 Weighted average number of issued ordinary shares during the year ended 31 Dec 2013 from part (a): 15,500,000 Potential ordinary shares 1,500,000 Weighted average number of issued ordinary shares and potential ordinary shares during the year ended 31 December 2013 17,000,000 Diluted eps 49.5 cents Financial Management 5 March 2014
Question Four Rationale This question tested two areas. The first was a discussion of functional currency and the translation of a monetary balance in accordance with IAS 21. The second was the initial and subsequent measurement of a financial instrument. This question examined learning outcomes A2(b) and B1(e). Suggested approach In part (a) candidates should have referred to the rules for establishing functional currency as outlined in IAS 21. The second element of the foreign currency question was about restating the monetary item at the year end. Candidates should have been entirely prepared for answering part (b) of this question and for setting their answers out in journal entry format as this question is consistent with how this has been tested in past exams. (a) (i) The functional currency of an entity is the currency of the primary economic environment in which that entity operates. In arriving at the conclusion that the A$ was its functional currency RD would have considered a number of factors. 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. Other factors to consider would be: The currency in which funding is generated. The currency in which operating receipts are retained. (ii) Initial recognition of the PPE is at cost at the rate ruling at the date of transaction, A$2,500,000 (B$5,000,000/2.00). This remains at historical rate and is not retranslated. Monetary items are retranslated at the year-end rate. The payable will be measured at A$2,325,581 (B$5,000,000/2.15). The translation of the monetary item results in an exchange gain at the year-end of A$174,419, which is included in profit for the year. March 2014 6 Financial Management
(b) (i) Initial recognition of the HFT investment is at cost and transaction costs are charged to the income statement: Dr HFT Investment $810,000 Cr Bank $810,000 Being recognition of investment (where $810,000 = $4.05 x 200,000 shares) Dr Profit or loss $4,860 Cr Bank $4,860 Being write off of transaction costs (where $4,860 = $810,000 x 0.6%), with the costs taken to profit or loss rather than included as part of the initial investment (being classified as HFT). (ii) Subsequent measurement is at fair value with the gain or loss taken to profit or loss. Dr HFT Investment $36,000 Cr Profit or loss $36,000 Being the gain on HFT investment (where $36,000 = $(4.23 4.05) x 200,000 shares), with the gain being recognised in profit for the year. Financial Management 7 March 2014
Question Five Rationale This question was intended to test candidates understanding of human asset accounting and the issues around its reporting. This question examined learning outcome D1(d). Suggested Approach Part (a) should have been relatively easy to answer as candidates would have seen the discussion about non-recognition of human assets numerous times in previous diets. Part (b) marks could only be earned by specifically discussing the issues from the investor s viewpoint. (a) An asset is defined as a resource which is controlled by an entity and from which economic benefit will flow to the entity in the future. In order to be recognised this asset must be capable of reliable measurement. The investment made by an entity in its human resource will be based on the costs incurred to train and remunerate employees. Given the historical and cash-based nature of these costs, this investment can therefore be reliably measured, however typically such costs are expensed in the period rather than capitalised. This is because, certainly in the case of remuneration, these costs are paid to secure the service of employees for a particular period and should therefore be treated as period costs. There is an argument that costs incurred in training and developing employees could be capitalised given that the training will give rise to future economic benefit flowing to the entity. However, the fact the employees cannot be controlled by an entity (ie: they are free to leave employment at any time and hence take their training with them) means that capitalisation of training costs does not meet the definition of an asset in accordance with the framework. The intellectual capital gained by an entity from its human resource (ie: skills, knowledge and experience) will form an important part of its overall value. If an entity were to be sold then part of the acquisition proceeds would be for this human resource value. Therefore this value could be thought of as an intangible asset of an entity because the resource is likely to help an entity earn future revenues. To be recognised in the financial statements the item must meet the definition of an asset (noted above) and be able to be measured with reliability. There are two issues in respect of recognising the human resource asset arising from this definition. Firstly, the value created cannot be controlled as employees are free to leave, taking their skills elsewhere. Secondly, the amount of value created is uncertain. There is no way of measuring this with sufficient reliability, unless sold to a third party. Therefore the value created cannot be recognised as an asset in the financial statements. March 2014 8 Financial Management
(b) Human resource is often the main asset of service-based entities and for the reasons noted above, cannot be reflected in the financial statements. Potential investors tend to rely on the information contained in the financial statements in order to help them make their investment decisions. To this end, the financial statements of service-based entities are essentially incomplete since the main revenue-generating asset is not included. This will make the assessment of potential future revenues more difficult. Traditional efficiency ratios that investors may calculate, eg return on capital employed, will be misleading as again the assets of the entity will be undervalued. This is why investors in service-based entities are likely to be looking beyond the financial statements at additional narrative disclosures. Financial Management 9 March 2014
SECTION B Question Six Rationale This question tested consolidation. The first section tested candidates ability to prepare a group statement of financial position, including a partly-owned subsidiary and a joint venture. Impairment and the accounting for long-term borrowing were also tested. Part (b) then tested the more complex issue of a further acquisition of shares in an entity already controlled. This question examined learning outcomes A1(a) and A1(b). Suggested Approach The most time-efficient approach would have been to draft the pro-forma for the statement of financial position and then work systematically through the headings adjusting them appropriately for consolidation. (a) Consolidated statement of financial position as at 31 December 2013 for MAT Group (workings in $ millions) ASSETS $m Non-current assets Property, plant and equipment (80 + 70) 150 Goodwill (W1) 12 Investment in joint venture (W2) 42 204 Current assets (30+ 40) 70 Total assets 274 EQUITY AND LIABILITIES Equity attributable to owners of the parent Share capital ($1.00 equity shares) 60 Share premium 20 Retained earnings (W3) 79 159 Non-controlling interest (W4) 23 Total equity 182 Non-current liabilities (W5) 52 Current liabilities (18 + 22) 40 Total liabilities 92 Total equity and liabilities 274 March 2014 10 Financial Management
Workings (in $ millions unless otherwise stated) 1. Goodwill $m Consideration transferred for X (70-5) 65 NCI at fair value in X 20 85 Net assets acquired Share capital 40 Share premium 5 Retained earnings 25 70 Goodwill at acquisition 15 Impairment of 20% for goodwill on acquisition of X (3) Goodwill at 31 December 2013 12 2. Investment in joint venture (equity accounted in $m accordance with IAS 28 Associates and JV) Cost of investment in joint venture (40 2) 38 Share of post acquisition reserves (50% x (25-11)) 7 Share of PUP adj ($20m x 75% x 40% x 50%) (3) Investment in JV at 31 December 2013 42 3. Retained earnings Group X Y $m $m $m As per SOFP at 31 December 2013 65 43 25 Pre-acquisition reserves (25) (11) Goodwill impairment (W1) (3) 15 14 Group share of X (80% x $15m) 12 Group share of Y (50% x $14m) 7 Group share of unrealised profit on inventory (3) Additional interest charge on LT borrowings (2) (W5) Consolidated retained earnings 79 4. Non-controlling interests $m At acquisition 20 NCI share of post-acquisition RE of X 20% x 15 (W3) 3 NCI at 31 December 2013 23 5. Long term borrowings $m Opening balance on debt 50 8% effective interest 4 Less 4% coupon rate (2) Long term borrowings as at 31 December 2013 52 Adjustment needed to finance costs is $2 million (4-2). Financial Management 11 March 2014
(b) Additional acquisition of shares $m Consideration transferred for 10% acquisition 14 Decrease in non-controlling interest (4m/8m x $23m (W4)) (11.5) Net debit to retained earnings of MAT group 2.5 MAT already holds a controlling interest in X and so no goodwill calculation is required as a result of this additional acquisition. It is treated as a transaction between the equity owners of X (MAT and the NCI in X) and any surplus or deficit resulting from the acquisition is adjusted through the group retained earnings. This transfer results in the NCI share of assets of X reducing by half. In this case MAT has paid more than the share of the fair value of the net assets and therefore must debit the group retained earnings with the difference of $2.5m. March 2014 12 Financial Management
Please turn over for answers to question seven Financial Management 13 March 2014
Question Seven Rationale The question formed the main test of financial analysis and required candidates to calculate relevant ratios and analyse the information. There was a deliberate focus on the investor s needs when commenting on the analysis. The question examined learning outcomes C1(a), C 2(b) and C2(c). 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 and in particular the investor ratios. (a) Analysis of financial performance and position of LW Revenue has increased by almost 15% from 2012 to $470 million in this year. The increase in revenue together with an increase in gross margin from 36.6% to 39.4% indicates that the sales of the new mobile phone technology have had a positive impact on the performance of LW. The change in sales mix may have contributed to the increase in the gross margin. Given that LW manufactures in Asia and South America it is also possible that the gross margin has been benefited by favourable exchange rates and/or economic conditions in these regions. Unfortunately LW has not managed to maintain these margins to operating profit. The operating profit has fallen in the year from 13.4% to 12.6%. This may be due to the labour dispute that occurred in the year and the related legal fees that were incurred and also to the $8 million charge for the potential lawsuit. The distribution costs appear to be consistently high as a result of the manufacturing and sales channels being a significant distance apart. Without the staff dispute and lawsuit, we would expect this ratio to improve in the next financial period. The profit margin for the year has dropped from 10.0% to 8.3%. This is mainly as a result of the increase in operating expenses but is also affected by the increase in finance costs. LW has taken on short term borrowings and this has increased finance costs. The average rate of lending has also increased from 5% to 12.8%. This is likely to be the result of short term borrowings being more costly than the convertible debt or it could be that the short term borrowings were significantly higher during the year, which is potentially more concerning. Either way, the entity has low gearing and should look to secure more long term funding rather than relying on a short term facility. The return on capital employed has fallen from 16.2% to 15.1% due to falling returns and the revaluation and investment in PPE. The investment in PPE may not yet have generated returns, however the revaluation has improved total comprehensive income which otherwise would have been significantly lower than 2012. It may be that the policy of revaluation has been adopted to ensure PPE can offer the maximum available security for long term finance sought. It is unlikely to be a deliberate attempt to manipulate the figures as the gearing and interest cover are likely to be more than satisfactory for any lender. Financial position The main issue for LW is the immediate management of working capital. Inventories days have increased from 112 to 141 days. It may be that with the new technology introduced during the year, the entity has been left with unsold items and may require to sell-off or write-off out-of date inventories. It could be with increasing sales volume the year end inventories have been deliberately increased to meet expected future demand, although given that the new product launch was in April this cannot be the whole reason. An alternative explanation could be that inventory management at the two factories has declined. Given the labour dispute in South America there is a risk that local March 2014 14 Financial Management
management are not completely in control of operations leading to an increase in inventory levels. Clearly this is of concern. LW is clearly using trade payables as a means of funding working capital and this situation is not sustainable. Payables days have increased from 98 days to 154 days. Funding should be secured and payables settled to avoid any legal action from suppliers. It maybe, however that a purchase of inventories occurred immediately prior to the year end and the related invoices have not yet been settled. This together with the shortage of cash and existence of short term borrowings does indicate that this is more likely to be an issue with working capital management. The current ratio, although reduced from 2012 is at 1.4, however the removal of the inventories highlights the cash crisis that LW is facing. The quick ratio has fallen to 0.5 and LW must seek additional funding immediately. The gearing of LW indicates a relatively low risk entity with gearing of just 11%, and there is more than adequate interest cover with very low finance costs. LW is potentially paying more for the shortterm borrowings with the average lending having increased from 5% to 12.8% and there is the added risk that these amounts are likely to be repayable on demand. It would be essential for the entity to secure long-term finance to ensure it can trade for the foreseeable future. In addition to the working capital issues, the lawsuit when concluded looks likely that it will result in a cash outflow and LW will require additional cash resources to settle this. It may then subsequently need additional resource to negotiate a licence deal to ensure the entity can continue to use the related technology. One last comment is that LW appears to have paid a dividend of $67 million to its shareholders in the year. Depending on the timing of this payment this could have resulted in the short term borrowings at the year-end (although the increase in finance costs suggests that this is not likely to be the case). In any event, the level of dividend might be a factor in your investment decision, although it should be borne in mind that the dividend could decline in the future if there is increasing pressure on liquidity or if LW s management decides to invest in further technology. (b) Segmental information LW operates over a number of different geographical areas and will be subject therefore to different risks and economic influences. It would be useful to have segmental information for LW to fully appreciate the inherent risks within the business that may affect revenues and costs in the future. The manufacturing resources are operating in Asia and South America and yet the majority of the sales revenues are generated in North America and Europe. The economic factors of these areas may be significantly different and therefore appreciating the different dynamics may be important for users who are attempting to predict the future profitability of LW. In addition, having operations in different locations in the world can mean that the entity must consider adherence to local labour laws, local safety and environmental guidelines and again this changes the dynamics of the different segments of the business. In addition to the geographical split, it is likely that the segmental information will give a clearer indication of the segments that are expanding and those that are in decline, especially since LW is operating in the technology sector. The segmental information is prepared by the management based on the information that is presented to them as a basis for decision making and so provides an insight into the information that the entity is utilising internally. Financial Management 15 March 2014
Appendix Ratio calculations 2013 2012 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 NCA turnover Revenue /PPE Gearing Debt/Equity Average cost of borrowing Finance costs/interest bearing borrowings 185/470 x 100 = 39.4% 150/410 x 100 = 36.6% 59/470 x 100 = 12.6% 55/410 x 100 = 13.4% 39/470 x 100 = 8.3% 41/410 x 100 = 10.0% 59/(352 + 22 + 17) x 100 = 55/(320 + 20) x 100 = 16.2% 15.1% 110/285 x 365 = 141 days 80/260 x 365 = 112 days 120/285 x 365 = 154 days 70/260 x 365 = 98 days 75/470 x 365 = 58 days 60/410 x 365 = 53 days 185/137 = 1.4 150/70 = 2.1 75/137 = 0.5 70/70 = 1.0 470/290 = 1.6 410/235 = 1.7 (22 + 17)/352 x 100 = 11.1% 20/320 x 100 = 6.3% 5/(17 + 22) x 100 = 12.8% 1/20 x 100 = 5% March 2014 16 Financial Management