The Examiner's Answers F2 - Financial Management 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 Accounting entries Accounting entries for year ended 31 December 2011: Share options Dr Staff costs (income statement) (W1) $178,200 Cr Equity $178,200 Share appreciation rights Dr Staff costs (income statement) (W2) $649,500 Cr Liabilities (non-current) $649,500 Working 1 1,000 options x (400-15-22-36) employees x FV$2.20 x 2/4 years = $359,700 Less recognised in 2010: 1,000 options x (400-15-55) employees x FV$2.20 x 1/4 years = Charge for 2011 $181,500 $178,200 Working 2 500 SARs x (400-15-22-36) employees x FV$14 x 2/4 years = $1,144,500 Less recognised in 2010: 500 SARs x (400-15-55) employees x FV$12 x 1/4 years = Charge for 2011 $495,000 $649,500 In accordance with IFRS 2, the share options and the share appreciation rights are recognised as an expense in the income statement as they are awarded in return for employee service. The treatment of each, however is different in the statement of financial position. The share appreciation rights will result in a future outflow of cash and therefore represent an obligation and are presented as a liability. The liability should reflect the most reliable measurement at each balance sheet date and so the total amount payable that is estimated at each year-end date is estimated using the updated fair values. Financial Management 1 March 2012
The options represent an equity-settled share-based payment and do not meet the definition of obligation, and so instead the entry is to equity. The equity element is measured initially and subsequently at the fair value at the grant date. Answer to Question Two Translation gain or loss for the year ended 31 December 2011 (Workings in Crowns 000) A$000 Closing net assets at the closing rate (opening NA 15,800 + PFY 450) = 16,250/1.52 10,691 Less PFY at average rate (450/1.58) (285) Less opening NA at opening rate (15,800/1.61) (9,814) Translation gain on net assets of subsidiary Plus gain on translation of goodwill (W1) Translation gains for the year ended 31 December 2011 592 54 646 Consolidated statement of comprehensive income The consolidated statement of comprehensive income for the HM Group for the year ended 31 December 2011 is shown below: HM Group A$000 Revenue (5,200 + (4,500/1.58)) 8,048 Cost of sales (3,200 + (3,000/1.58)) (5,099) Gross profit 2,949 Distribution costs (800 + (420/1.58)) (1,066) Administrative expenses (450 + (450/1.58) + 213 (W1)) (948) Other income 80 Profit before tax 1,015 Income tax expense (250 + (180/1.58)) (364) Profit for the year 651 Other comprehensive income Exchange gains on translating foreign operations (part ) 646 Total comprehensive income 1,297 Profit for the year attributable to: Owners of the parent (651-14) 637 Non-controlling interests (W2) 14 651 Total comprehensive income attributable to: Owners of the parent (1,297-143) 1,154 Non-controlling interests (W2) 143 1,297 Workings 1. Impairment of goodwill Crowns 000 A$000 Consideration paid (A$8,686 x 1.61) 13,984 NCI at FV 3,496 Net assets acquired (15,800) Goodwill on acquisition 1,680 @1.61 1,043 Impairment 20% (336) @1.58 (213) Gain on translation of goodwill (bal fig) Goodwill at 31 December 2011 830 54 1,344 @1.52 884 March 2012 2 Financial Management
2. Non-controlling interests PFY TCI Profit of sub for year Crowns 450,000 Translated at average rate 1.58 A$000 A$000 285 20% NCI share 57 57 Less 20% share of impairment of goodwill (43) NCI share of PFY 14 Plus 20% gains on translation of sub (part ) 20% x 646 (since NCI at FV) NCI share of TCI Answer to Question Three (43) 14 129 143 Benefits to investors The GRI is a recognised framework and where entities have adopted its guidelines it will provide investors with greater confidence that they are receiving relevant and useful information. Comparability and transparency improves where accepted guidelines exist as many entities are then following a similar approach to disclosures. Consistent compliance with the GRI guidelines will give investors confidence that they are receiving complete information rather than just the positive aspects designed to improve reputation. Goals, targets and benchmarks being included will provide a performance measurement which will help investors decide whether they are happy to invest going forward. GRI sustainability guidelines The economic aspects are likely to contain information about how the entity impacts on the economic conditions of its shareholders and on the economic systems of both the area in which it operates and globally. An entity may also include its policies regarding local and global economies and disclose targets and its strategy for meeting those economic targets and its performance to date. The environmental aspect of sustainability provides information about how an entity impacts on the environment. Disclosures are likely to include managements policies on waste, emissions and pollution. Targets on wastage and pollution, etc are likely to be set and strategies for achieving these and performance to date could also be included. The social aspect of sustainability relates to the impact the entity has on the social systems in which it operates. The GRI focuses on performance in the areas of human rights, labour practices, including employer/employee relations, occupational health and safety and equal opportunity. Financial Management 3 March 2012
Answer to Question Four BN issue of convertible bonds: 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 liability that has no equity 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 (ie: the residual) is recognised as equity. The bonds are initially recognised as: $000 $000 Dr Bank (proceeds of issue) 6,000 Cr Liability (W1) 5,609 Cr Equity (W2) 391 Working 1 Liability element $000 PV of the principal (at 9% after 4 years) = ($6m x 0.708) 4,248 PV of interest of 7% on $6m for 4 years = ($6m x 0.07 x 3.24) Total value of liability element 1,361 5,609 Working 2 Equity element $000 Total proceeds raised on issue 6,000 Total value of liability element Value attributable to equity (5,609) 391 (i) In accordance with IAS 39, the liability element will be subsequently measured at amortised cost using the effective interest rate (which in this case is the interest rate used to discount the principal to PV, ie 9%). The equity element is not subsequently re-measured. The interest of $420,000 (7% x $6m) has already been paid and recorded. The additional finance cost is recorded as: $000 $000 Dr Finance costs (W1) 85 Cr Liability element of bonds 85 (ii) Extracts from statement of financial position $000 Equity and Liabilities Equity - Other component of equity 391 Liabilities (W1) 5,694 Working 1 Opening balance $000 Finance cost at 9% Interest paid 7% $000 $000 5,609 505 (420) 5,694 Closing balance $000 Tutorial note: The total finance cost for the year ended 31 December 2011 is $505K, however the interest paid of $420K has already been recorded so only the difference of $85K is recognised. March 2012 4 Financial Management
Answer to Question Five Benefits of operating segment information to investors Investors are normally looking for information that can help them estimate the future performance of an entity, in order to decide whether to make an investment, stay invested or to dispose of an investment. While the financial statements give the performance of the entity as a whole, the operating segment disclosures provide information on the performance and resources of the parts of the business that the management consider to be separately identifiable. Investors can then see the parts of the business that are expanding or declining, those with high or low margins and the resources that each is using to generate those returns. Entities are growing in complexity and often operate across many business sectors, eg wholesale, retail, financial services. The risks associated with these sectors will be different and so to accurately assess the future risks facing an entity, users will need more than the combined figures in the financial statements. Entities may also operate in different geographical areas and be subject to different economic environments and again different risks. Operating segment disclosures provide information about where resources are based and from where revenues are generated. IFRS 8 intends that the information provided in the operating segment disclosures reflects the information that the chief operating decision maker uses to make decisions about the business and so investors could be getting an inside view of the entity. Limitations of using operating segment information Under IFRS 8, the entity s managers determine the reportable segments that exist in the entity. This is based on how the segments are viewed internally. Segments may be selected differently by each entity which reduces the comparability of segmental disclosures across entities. Also, not all of the financial information can easily be allocated to segments eg head office expenses and finance costs. This again makes it difficult for users to get a complete picture of the performance of segments and reduces comparability as allocation of costs and revenues may differ between entities. (c) IFRS 8 and costs of preparing information IFRS 8 requires that operating segment disclosures be based on the information that the entity produces for internal purposes in order to make decisions on how resources will be allocated, which areas to expand etc. If the information is already being internally produced it should not therefore cost much to comply with the IFRS 8 disclosures. The guidance provided by the standards is that operating segment disclosures should reflect the information that would typically be reviewed by the chief operating decision-maker in the organisation. Financial Management 5 March 2012
Answer to Question Six The change in group structure represents a disposal where group control is retained. Initially UV is an 80% subsidiary, but with the disposal of 20,000 out of the 200,000 shares owned, UV becomes a 72% subsidiary. As a result of staying a subsidiary there is no change to group goodwill and UV remains fully consolidated in both the statement of comprehensive income and the statement of financial position. Since control is retained, no gain or loss is calculated on the disposal, instead it is accounted for as a transaction between owners of the business. NCI is increased from 20% to 28% and the difference between the increased NCI at the date of disposal and the proceeds received is shown as an adjustment to equity in group retained earnings. Consolidated statement of financial position of the ST Group as at 31 December 2011 (Workings shown in $000 s) ASSETS $000 Non-current assets Property, plant and equipment (2,760 + 1,000 +(240 88(W2))) 3,912 Goodwill (W1) 336 4,248 Current assets Inventories (550 + 200 10 (W5)) 740 Receivables (850 +225) 1,075 Cash and cash equivalents (200 + 75) 275 2,090 Total assets 6,338 EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) 2,500 Retained earnings (W6) 2,020 4,520 Non-controlling interest (28% x (250 + 1,000 + (240-88))) 393 Total equity 4,913 Non-current liabilities Long term borrowings 675 Current liabilities (500 + 250) Total liabilities Total equity and liabilities 750 1,425 6,338 W1 Unimpaired goodwill $000 $000 Consideration transferred 1,100 Non-controlling interests (20% x net assets $850k) 170 1,270 Fair value of net assets acquired: Share capital 250 Retained earnings 360 Fair value uplift 240 (850) Goodwill on acquisition of UV 20% impairment Goodwill as at 31 December 2011 420 (84) 336 March 2012 6 Financial Management
Working 2 Fair Values $000 FV uplift on 1 May 2008 240 Additional Depreciation: Total number of months to be depreciated (12x 10) 120 Number of months to 1 October 2011 41 Therefore depreciation to 1 October 2011 (41/120 x $240K) 82 Number of months to 31 December 2011 44 (44/120 x $240K) 88 Working 3 NA of UV at date of disposal $000 Share capital 250 Retained earnings ($1,000K ($220K x 3/12)) 945 Fair value ($240K - $82K (W2)) 158 1353 Working 4 Adjustment to parents equity $000 Proceeds 115 Increase to NCI 8% x NA at date of disposal (8% x $1,353K (W3)) Credit to group equity (108) 7 Working 5 Adjustment for unrealised profit $000 Amount remaining in inventory 50% x $80K 40 25% profit margin 10 Working 6 Retained earnings $000 ST s retained earnings 1,785 80% share to date of disposal 80% x ($945K (W3) $360K $82K(W2)) 402 72 % share of profits for last 3 months 72% x (($220k x 3/12) - ($88k - $82K (W2))) 35 Adjustment to parent s equity (W4) 7 Correction of the posting of proceeds of share disposal (115) Impairment of goodwill (84) Unrealised profit on inventory transfer (W5) (10) 2,020 Tutorial note: The gain on the increased fair value of the available for sale investment (IAS 39) would not be recognised in the consolidated accounts, only in the individual accounts of ST. Financial Management 7 March 2012
Answer to Question Seven Report to client re SDF Revenues have grown by a considerable 43% on the previous year, due mainly to the increasing sales from existing customers and the new contract secured at the start of the financial year. SDF has also had a significant increase in the profit margins in the year. Gross profit has increased from 32% to 40% in 2011, showing that the prices within the new contract were well negotiated by the management of SDF and that there are clearly economies of scale from increasing production. Expenses have been well controlled although there has been an increase in administration expenses perhaps relating to the negotiating and managing of the new contract. ROCE has seen a significant increase from 26% to 52%. SDF appears, at the moment to be able to generate significant returns with existing equity, although as is noted later, SDF must match long term investment with long-term finance options. This return is unlikely to continue at this level as SDF requires cash. Receivables have remained at a satisfactory level at 40 days. This reflects well on management, who must have negotiated with the new customer for quick payment. SDF, however is facing a cash crisis and there is no evidence that the management has secured any short or long term funding. This would be a priority. The cash has dropped from $60 million to $3 million in the year and now payables have been stretched from 76 days to 88 days. It is vital that suppliers are kept on board if SDF is to continue to service the existing contracts. SDF has invested in PPE in the year, although the increase is marginal relative to the increase in revenue. This is borne out by the non-current asset turnover ratio which has increased from 1.3 to 1.7, showing that the non-current assets held within the business have generated greater revenues this year. This may reinforce the point above about the gross margin improvement being as a result of greater economies of scale from production. It s possible the production machinery has not been working at anything like full capacity which has allowed the increase in revenue for relatively little investment. SDF has also invested in an associate in the year and this together with the relatively small investment in PPE must have been paid out of cash reserves as capital and long-term liabilities show no change. SDF should aim to fund long-term investment through long-term resources. SDF should also consider the return on investments since the return on the associate is well below the ROCE earned by the entity in the period. Inventories days have increased from 46 days to 79 days, which maybe necessary to meet the contract terms of the new customer, however this is using up valuable cash resources. The cash crisis is highlighted by the liquidity ratios. Although the current ratio has fallen it is 1.7, which would normally not be cause for concern. However the quick ratio has fallen from 1.6 to 0.8 in the year, indicating a cash crisis facing SDF, which management must address immediately. It is possible that SDF had the opportunity to bid for the new contract and took it before considering the expanding working capital requirement, but this must now be addressed. Management have clearly made good decisions regarding sales, profits and investments, given that the investment in associate has earned $7 million in the 7 months since acquisition, however an expansion should not be funded by short-term working capital. In addition, it was very short-sighted to pay such a substantial dividend when the entity is short of cash. As a potential investor the earnings per share and P/E ratio are of significant relevance, in addition to the dividend policy of the entity. Earnings per share has increased from 31 cents per share to 59 cents per share and the market would appear to be confident about the entity s future as the share price has increased from $2.80 to $4.90 in the year. However, when considering share price it is March 2012 8 Financial Management
important to consider the P/E ratio which has actually fallen slightly from 9 to 8.3. This indicates that despite the high growth in earnings the market is not viewing the future prospects of SDF as favourably as last year this may be the result of specific concerns about SDF or the result of a general downturn in the market. It would be useful to be able to compare the P/E ratios of similar entities and the most recent share price as the market would at this time have reacted to any interim results by the year end date. The management must secure funding with immediate effect, even if this is short-term with a view to issuing shares in the future as the entity is likely to have the backing of its shareholders. SDF should not find it difficult to raise external funds as there is no existing debt and there is more than sufficient interest cover based on current profitability. In addition, the PPE could provide adequate security for a loan. In terms of future cash flow, SDF is likely to have increased contributions to make as a result of the pension liability at 31 October 2011 and if the contingent liability results in SDF being found negligent then cash will be needed to settle the liability. This highlights the need for finance to be put in place with immediate effect. Overall, there are many positives shown by an analysis of the financial statements of SDF at this time. The need for longer term funding is obviously a key priority for SDF, however the capacity to raise such finance would not appear to be an issue. Therefore at this time I believe SDF to be a good investment. Additional information The contingent liability relates to a chemical leak and an investor would want to ensure that the entity had a good record in respect of environmental policies and strategies for minimising harmful effects on the environment. Given the new contract is with a high-profile entity, the investor would want to ensure that this incident did not adversely affect SDF s professional reputation as this may have a detrimental effect on future revenues and profits. The handling of the incident is possibly more important than whether or not SDF was negligent. The investor will be looking for signs that SDF is a good citizen and has taken responsibility for clear up if required, which can be established from looking at the press and the internet. Financial Management 9 March 2012
Appendix A Ratios Relevant ratios that could be calculated include: All workings in $m 2011 2010 Gross profit margin (GP/revenue x 100) Operating profit margin (Profit before associate and investment income/revenue x 100) Profit 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/current liabilities) NCA turnover (Revenue /NCA) Total asset turnover (Revenue / total assets) Earnings per share Profit for the year/number of shares Price/earnings Share price/eps 268/663 x 100 = 40% 148/463 x 100 = 32% 213/663 x 100 = 32% 111/463 x 100 = 24% 221/663 x 100 = 33% 117/463 x 100 = 25% 213/(465-56) x 100 = 52% 111/423 x 100 = 26% 86/395 x 365 = 79 days 40/315 x 365 = 46 days 95/395 x 365 = 88 days 66/315 x 365 = 76 days 72/663 x 365 = 40 days 48/463 x 365 = 38 days 161/95 = 1.7 148/66 = 2.2 (161-86)/95 = 0.8 (148-40)/66 = 1.6 663/381 = 1.7 463/346 = 1.3 663/(598-56) = 1.2 463/494 = 0.9 176/300 = $0.59 93/300 = $0.31 4.90/0.59 = 8.3 2.80/0.31 = 9.0 March 2012 10 Financial Management