The Examiner's Answers F1 - Financial Operations 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 1.1 C 1.2 D 1.3 B 1.4 A 1.5 A 1.6 B 1.7 D 1.8 Total payments = 24x6 = 144 F V 106 Finance cost 38 6+5+4+3+2+1 = 21 Year 1 = 6/21x38 = 10.9 Year 2 = 5/21x38 = 9.0 Year 1 106 10.9 (24) 92.9 Year 2 92.9 9.0 (24) 77.9 Answer therefore B Financial Operations 1
1.9 C 1.10 $000 $000 Balance 1/1/09 Current tax 106 Deferred tax 27 133 Statement of 122 comprehensive income 255 Balance 31/12/09 Current tax 119 Deferred tax 38 157 98 Answer therefore A 2 Financial Operations
SECTION B Answer to Question Two (a) Tax evasion is the illegal manipulation of the tax system to avoid paying taxes. Tax evasion is the intentional disregard of the legislation in order to escape paying taxes; it can include falsifying tax returns and claiming fictitious expenses. Gee is illegally evading tax by failing to declare his full income. Tax avoidance is tax planning to the extent that the affairs of the entity are legally arranged in such a way as to minimise the tax liability. Although tax avoidance is strictly legal and within the letter of the law, it is often contrary to the spirit of the law. Many tax avoidance schemes exploit loopholes in the legislation, which the tax authorities try to close as soon as the loophole has been identified. Cee has taken advice and arranged her investments to avoid paying tax on the income from government securities. This approach is within the letter and spirit of the law. (b) A unit tax is a specific tax that is based on the weight or size of the tax base, for example, in the scenario the tax of $1 per bottle of wine is a unit tax, it can also be referred to as an excise duty. An ad valorem tax is based on the value of the tax base, these taxes are usually expressed as a percentage of the tax base, for example, a 15 per cent value added tax (VAT) is calculated as 15 per cent of the selling price before VAT. W sells wine at an average of $8.05 per bottle including VAT, this is a selling price of $7 per bottle plus 15% VAT. Tax payable by W: Excluding VAT VAT Total $000 $000 $000 Sales 70.0 10.5 80.5 Expenses 30.0 4.5 34.5 Excise duty 10.0 0 10.0 40.0 4.5 44.5 Profit 30.0 6.0 36.0 Excise duty payable $10,000 VAT Payable $6,000 Total indirect tax $16,000 Financial Operations 3
(c) Jurisdiction means that the tax authority must have the legal power to assess and collect taxes from an entity. For an entity to be subject to tax in a country, it must first be proved to be within that country's legal power to apply its tax rules to the entity. The competent jurisdiction is therefore the country whose tax laws apply to the entity. The OECD Model Tax Convention specifies the method used to determine residence of an entity. In the scenario H carries out business and management meet regularly in Country X, according to the model tax convention this makes H resident in Country X for tax purposes. On the same basis S is resident in Country Y. A withholding tax is a tax deducted from a payment at source before it is made to the recipient abroad. S has to deduct tax at 10% from any dividends paid to H. If the two countries concerned have a double tax agreement based on the OECD Model tax convention tax credit method the withholding tax will be allowed to be credited against tax due in its home country. In the scenario given, H will be able to claim a tax credit of $20,000 against tax due in Country X. (d) (i) The objective of an external audit is to enable auditors to express an opinion as to whether the financial statements of an entity give a true and fair view of the affairs of the entity at the period end and of its profit or loss for the period then ended and have been properly prepared in accordance with the relevant legislation and applicable accounting standards. (ii) The $1 million is 25% of profits and is therefore a material amount. This is a material disagreement and so the auditor must qualify the audit report (issue a modified report) in respect of the overstatement of stock. The disagreement is material, but not fundamental and so the adverse opinion is not required. The auditor would state that the accounts gave a true and fair view except for the overstatement of closing inventory and profits by $1 million. 4 Financial Operations
(e) Total Contract Profitability To 31/3/09 To 31/3/10 Contract price 63 63 Total cost 54 64 Profit/(Ioss) 9 (1) Cumulative Year to Year to Year to To 31/3/10 31/3/09 31/3/10 31/3/11 Cumulative less yr to 31/3/09 Revenue 47 22 25 16 Cost incurred 44 18 26 20 3 4 (1) (4) Provision for future loss 0 (4) 4 Profit/loss recognised 4 (5) 0 Note: As CC recognised a profit of $4 million in year to 31/3/09 the year to 31/3/10 will have to reverse this profit and add a further loss of $1 million, making a charge of $5 million loss for the year. $m Contract costs incurred to date 44 Recognised loss (cumulative) (1) 43 Less progress billings 37 Amount due from customer 6 Comprising: Unbilled contract revenue 10 Expected loss recognised (4) 6 Statement of Comprehensive Income for year ended 31 March 2010 (extract) $m Contract revenue 25 Cost of sales (26 + 4) Loss 30 Loss (5) Statement of Financial Position as at 31 March 2010 (extract) $m Current Asset Amounts due from customer 6 Financial Operations 5
(f) Briefing note IFRS 5 Non-current assets held for sale and discontinued operations specifies that discontinued operations can be separated from continuing operations and shown separately in the Statement of Comprehensive Income. To be recognised as discontinued the activity must be discontinued in the year or be classified as held for sale. To be classified as held for sale it has to be available for immediate sale and it should be actively marketed and have a programme to locate a buyer. At 31 March 2010 AD is still in negotiations and has not agreed a closure date. The factory has not been closed and cannot be classified as discontinued in the year. It is not available for immediate sale and there is no programme to locate a buyer, so it cannot be classified as held for sale. The shoe factory must be included in the results for continuing operations for the year ended 31 March 2010. CIMA's Code of Ethics for Professional Accountants sets out 5 fundamental principles that a professional accountant is required to comply with. Not following the requirements of IFRS 5 Non-current assets held for sale and discontinued operations and excluding the results of the shoe factory from the financial statements for the year ended 31 March 2010 would potentially breach three of these: Objectivity - not allowing bias, conflict of interest or the influence of other people to override professional judgement. Professional behaviour - requires an accountant to comply with relevant laws and regulations and should avoid any action that discredits the profession. Integrity - A professional accountant should be straightforward and honest in all professional and business relationships 6 Financial Operations
SECTION C Answer to Question Three EZ Statement of Comprehensive Income for the year ended 31 March 2010 $000 $000 Revenue 720 Cost of sales (467) Gross Profit 253 Loss on revaluation of land (15) Administrative expenses (211) Distribution costs (93) (304) Loss from operations (66) Finance cost (10) Loss before tax (76) Income tax expense (8) Loss for the period (84) Other Comprehensive Income Loss on revaluation of land (10) (94) EZ Statement of changes in equity for the year ended 31 March 2010 Equity Share Revaluation Retained Total shares premium Reserve Earnings $000 $000 $000 $000 $000 Balance at 1 April 400 200 10 181 791 2009 New share issue 200 100 300 Statement of Comprehensive Income (10) (84) (94) Dividend paid (92) (92) Balance at 31 March 2010 600 300 0 5 905 Financial Operations 7
EZ Statement of Financial Position at 31 March 2010 $000 $000 Non-current assets Land W7 675 Property, plant and equipment W6 285 960 Current assets Inventory 112 Trade receivables 150 Cash and cash equivalents 22 284 Total assets 1,244 Equity and liabilities Equity Equity share capital 600 Share premium 300 Retained earnings 5 Total equity 905 Non-current liabilities Long term borrowings 250 Deferred tax W4 20 Total non-current liabilities 270 Current liabilities Trade payables 32 Accrued lease payment W8 9 Tax payable W3 18 Accrued interest W5 10 Total current liabilities 69 Total equity and liabilities 1,244 Workings (All figures in $000) (W1) Cost of sales Administration Distribution Trial 418 86 69 balance Loss on 5 disposal of PPE Bad debt 125 Lease 24 Depreciation 44.. Total 467 211 93 (W2) Loss on disposal of PPE Cost less depreciation 7 Cash received 2 Loss on disposal 5 8 Financial Operations
(W3) Income tax expense Year 18 Deferred tax reduction (10) 8 (W4) Deferred Tax Balance 1 April 2009 30 Reduction (10) Balance 31 March 2010 20 (W5) Finance cost Interest on long term borrowings (250 x 4%) = 10 (W6) PPE Cost Depreciation NBV Balance per trial balance 480 144 Less disposal (37) (30) Depreciation charge for year 44 443 158 285 (W7) Land Per trial balance 700 Fair value 675 Loss 25 Write-off revaluation reserve 10 Income statement 15 25 (W8) Operating Lease 30 month lease with 6 months rent free = 24 months at 2.5 = 60 60/30 = 2 per month 12 months at 2 = 24 Income statement Paid 6 months at 2.5 = 15 Accrued lease payment SoFP = 9 Answer to Question Four (a) $000 AX profit for the year before tax 264 Add back: Depreciation 31 entertaining expenses 4 299 Less tax depreciation allowances (49) Taxable profit 250 Tax at 25% 62.5 Round to 63 Increase in temporary difference in year (49-31) = 18 Deferred tax = 18 x 25% = 4.5 round to 5 Increase provision for deferred tax by 5 Financial Operations 9
(b) Group holdings: AX in AS 100% Treat as wholly owned subsidiary AX in AA 120,000/550,000 = 22% Treat as an associate (i) Fair value of net assets of AS at acquisition $000 Equity Shares 600 Retained earnings (72) Fair value adjustment 75 603 (ij) Goodwill - AS $000 Cost 740 Fair value of net assets acquired (100%) 603 Goodwill 137 (iii) Investment in associate - AA $000 Cost 145 Add group share of post acquisition profits (100-49) = 51 x 22% = 11 Investment at 31 March 2010 156 (iv) Intra-group trading Mark up on cost 25% = 25/125 or 20% margin on selling price. Selling price $25,000; unrealised profit = $25,000 x 20% = $5,000 Dr. Cr. $000 $000 Consolidated cost of sales 5 Consolidated current assets - inventory 5 Consolidated revenue 55 Consolidated cost of sales 55 (v) Consolidated Retained Earnings $000 $000 Balance AX Per draft accounts 518 Less current tax (63) Less deferred tax increase (5) 450 AS - group share of post acquisition profits (15+72) = 87 Associate - AA, group share of post acquisition profits (iii) 11 Cancel unrealised profit in inventory (iv) (5) 543 10 Financial Operations
AX Group Consolidated Statement of Comprehensive Income for the year ended 31 March 2010 $000 Revenue (820 + 285-55) 1,050 Cost of sales (406 + 119-55 + 5) 475 575 Administrative expenses (84 + 36) (120) Distribution costs (48 + 22) (70) 385 Income from associate 11 396 Finance cost (18 + 5) (23) 373 Taxation (63 + 16 + 5) (84) Profit for the year 289 Financial Operations 11
AX Group - Consolidated Statement of Financial Position as at 31 March 2010 Non-Current Assets Property, plant and equipment $000 $000 (1,120 + 700 + 75) 1,895 Goodwill (ii) 137 Investment in associate (iii) 156 Current Assets Inventory (205 + 30-5) 230 Trade receivables (350+46) 396 2,188 Cash and cash equivalents 30 656 2,844 Equity and Liabilities Ordinary Shares 1,500 Retained Earnings (v) 543 Non-current liabilities Borrowings (360 + 80) 440 2,043 Deferred tax (120 + 16 + 5) 141 581 Current Liabilities Trade payables (92 + 29) 121 Bank overdraft 20 Current tax (63 + 16) 79 220 2,844 12 Financial Operations