Management Level Paper
F2 – Financial Management May 2012 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 actuarial gains and losses were to be calculated and it was important that candidates displayed an understanding of how each element of pensions affects the assets and liabilities of the plan. The share-based payment involved a calculation of an equity-settled share-based payment in year two of recognition plus required an explanation of the principles of recognition of IFRS 2. This question examined learning outcome B1(f).
Suggested Approach Candidates should have been familiar with the format of the answer provided and those who have completed past paper questions were likely to set their workings out in this format.
Turn over for answers to (a) and (b)
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(a)
Calculation of the actuarial gains/losses in the year to 31 December 2011 FV of plan assets $000 1,400
Opening balance Service cost Interest cost (7% x $1,700,000) Expected return (4% x $1,400,000) Benefits paid Contributions
56 (170) 580 1,866 234
Actuarial gain on plan assets Actuarial loss on plan liabilities Closing balance
(b)
2,100
PV of plan liabilities $000 1,700 320 119 (170) 1,969 431 2,400
Share-based payment
(i) Income statement charge 2010 expense: Eligible employees (300-20-65) = 215 Equivalent cost = 215 employees x 1,000 options x FV$5 = $1,075,000 Allocate over 4 year vesting period $1,075,000/4 = $268,750 charge for the year. 2011 expense: Eligible employees (300-20-23-44) = 213 Equivalent cost = 213 employees x 1,000 options x FV$5 = $1,065,000 Cumulative amount to be recognised to date = $1,065,000 x 2/4 years = $532,500 Less amount previously recognised = $532,500 – $268,750 = $263,750 charge for the year. The 2011 expense will be recorded as: Dr staff costs $263,750 Cr equity (other reserves)
$263,750
(ii) Share options, such as those granted by DF, 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 income statement.
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Answer to Question Two
Rationale This question was intended to test the principles of consolidation. Only the key workings for the statement of financial position were asked. Fair value, unrealised profit on trading and impairment of goodwill were also tested in this question. This question examined learning outcomes A1(a) and A2(b).
Suggested Approach This question tested the basics of consolidation and candidates should have been capable of scoring full marks. Setting up the formatted workings was the most logical starting point to avoid duplication of workings (eg for post-acquisition earnings in RE and NCI, and for FV of NCI in goodwill and NCI).
(a)
Goodwill $ Consideration transferred Non-controlling interest at fair value Net assets at date of acquisition: Carrying value $(1,000,000 + 885,000) Fair value increase $(1,100,000 – 945,000)
$ 1,850,000 570,000
1,885,000 155,000 (2,040,000) 380,000 (76,000) 304,000
Goodwill on acquisition Impairment 20% in 2011 Goodwill as at 31 December 2011
(b)
Consolidated retained earnings
As reported in SOFP Less pre-acquisition retained earnings Accumulated depreciation on PPE FV adjustment ($155,000 x 2/5 years) Impairment of goodwill (as in (a) above) Unrealised profit ($400,000 x 20%) Group share of AB ($197,000 x 75%) Consolidated retained earnings
(c)
BN $ 4,200,000
AB $ 1,300,000 (885,000) (62,000) (76,000) (80,000) 197,000
147,750 4,347,750
Non-controlling interest
Non-controlling interest at fair value at acquisition Plus NCI share of adjusted post acquisition retained earnings (as in (b) above) (25% x $197,000)
$ 570,000 49,250 619,250
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Answer to Question Three
Rationale This question was intended to test candidates’ ability to analyse key financial data. The scenario at the start gave them a steer that the entity was refocusing activities, hence the additional investment in PPE and sale of a (non-core) subsidiary. This question achieved coverage of a key learning outcome in Section C of the syllabus. The question tested learning outcome C2(a).
Suggested Approach Candidates should have worked through the individual elements of the statement within each heading, highlighting key aspects of each and concluding on the links between them. It was important to keep points relevant to the scenario provided in the question.
Report to: Investor Re: QW - Cash Flow Statement Date: XX
From: XX
Overall, QW has seen a considerable increase of $530 million in its cash balance during the year. There has been a cash inflow from operations of $700 million, an inflow from investing activities of $150 million and an outflow from financing activities of $320 million. Each of these will be considered in turn. Cash inflow from operating activities: QW has generated a significant amount of cash from operating activities, a positive indicator of an entity committed to being a going concern. Indeed QW has generated a profit before taxation of $950 million which would appear to indicate a good performance in the year, although without comparative information it is difficult to be definitive if only considering profit. Investment income and gains from the sales of investments are important elements contributing to the cash inflow from operations and indicate that directors have made some good investment decisions with both investment income and gains from the sale of some of the investments. The sale of investments may have been part of the overall strategy with the cash inflow from the sale helping to fund the acquisition of PPE. A loss was made on the sale of PPE, although the amounts for the proceeds and ultimate loss were not significant. Finance costs for the year were $320 million but only $140 million has been paid in the year. This may mean that an amount for interest would have been payable immediately after the year end which will have the effect of reducing the cash balance. Alternatively, it could mean that QW has some bonds or debentures which carry a low coupon rate of interest but which will be redeemable at a premium in the future. If this is the case then interest payments will be low now but in the future QW will need to find a significant sum of money to redeem the debt. This would obviously be a drain on cash resources in the future. QW appears to have prioritised working capital management during the implementation of the new strategy. There has been a significant decrease in trade receivables whilst payables have increased. This has had a positive effect on cash flow at the year end. However, to counter-act this, inventory levels have increased indicating a possible stocking up in advance of a major sales drive (which could also be a factor as to why payables have increased).
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One last point to note regarding cash flows from operations is that the tax paid figure seems very high in relation to the profit generated during the year. However, tax is usually paid a year in arrears and therefore the tax payment made in this year will relate to the profits earned in the previous year. If this is the case then it would appear that profits have declined this year compared to last year – which could be a reason why QW has implemented a new strategy. Cash inflow from investing activities: The investing activities section is where we see the main components of the new strategy, with the sale of a subsidiary and a significant purchase of property, plant and equipment. We know that QW has refocused on core areas of the business and has helped fund this investment by the sale of a non-core subsidiary and investments. It must be noted that the sale of these profitable investments will result in associated income being reduced in future periods. Cash outflow from financing activities: It is evident from the financing section of the statement that QW has the backing of its shareholders. A share issue has been supported and the shareholders have been rewarded with a generous dividend payout. Long-term borrowings have also been raised but since this is just a fraction of that raised through the share issue the gearing of QW will have improved. One important point to make about the dividend is that the dividend paid of $1,200 million is significantly in excess of the profits earned in the year (which would be $950 million less taxation). This means that QW has paid part of the dividend out of previously retained distributable reserves. In addition, given that the net cash inflow in the year from operations and investing is $850 million, it means that QW has had to use long term finance to fund the $1,200 million dividend payment.
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Answer to Question Four
Rationale This question tested the classification of an equity and a liability instrument. The second part tested the initial and subsequent measurement of a short-term investment, classified as held for trading. The question tested learning outcomes B1(d) and B1(e).
Suggested Approach Candidates should have stated clearly the features of each instrument that determine whether it is equity or liability. The classification then determines how the associated finance costs are then presented. Candidates should by now be familiar with the requirement asking for journal entries that record the initial and subsequent measurement of an investment.
(a)
The preference shares will be classified as a liability despite being called “shares�. IAS 32 requires us to consider the substance of the instrument in order to determine whether it should be classified as debt or equity. In this case the 5% dividend payable on the shares is cumulative which will eventually result in an outflow of economic benefit for JH and hence represents an obligation. It therefore meets the definition of a liability. Once the principal amount is classed as a liability, it follows then that any payment associated with this instrument (in this case the 5% dividend) will be presented as a finance cost and be charged in arriving at profit for the year. The ordinary shares have no inherent obligation as they will not be repaid, nor do they provide any fixed return to the shareholder. Indeed ordinary shares contain only a residual interest in the profits of the entity (ie: after all obligations have been settled) and hence will be classified as equity. The associated dividend, when paid, will be presented in the statement of changes in equity as a reduction in retained earnings.
(b) (i) Initial recognition of the HFT investment is at cost and transaction costs are charged to the income statement: Dr
HFT Investment $1,400,000 Cr Bank $1,400,000 Being recognition of investment (where $1,400,000 = $2.80 x 500,000 shares) Dr
Income statement $7,000 Cr Bank $7,000 Being write off of transaction costs (where $7,000 = $1,400,000 x 0.5%), with the costs taken to profit or loss rather than included as part of the initial investment (because of being classified as HFT). (ii) Subsequent measurement is at fair value with the gain or loss taken to profit or loss: Dr
HFT Investment $310,000 Cr Income statement $310,000 Being the gain on HFT investment (where $310,000 = $(3.42 – 2.80) x 500,000 shares), with the gain being recognised in profit for the year.
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Answer to Question Five
Rationale This question tested Section D of the syllabus and required an element of application by candidates (part b). Human capital accounting and intellectual property are areas that candidates must be aware of as there has been much debate in recent years about the reasons for and against their recognition. This question tested learning outcome D1 (a) and (d).
Suggested Approach Candidates will have seen questions testing this area in previous diets, however it was intended to have them focus on the specifics of the question. The key element being the distinction between the costs that are expensed and those that are not recognised at all– and referring specifically to the recognition principles of IFRS. Part (b) extends the question into the gap that exists when human capital is not included in the financial statements.
(a)
Under the Framework 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 in an entity’s human resource: 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. In terms of the costs incurred in training employees there is an argument that such costs 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. Intellectual capital: 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. As noted above, to be recognised in the financial statements, the framework, however defines an asset as a resource controlled by an entity, from which economic benefits will flow and which can be measured with sufficient 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.
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(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.
Answers to Section B start on the next page
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SECTION B Answer to Question Six
Rationale This question tested consolidation. The first section tested the basics of preparing an income statement and statement of changes in equity for a group. The complex areas tested by this question were then separated out in additional requirements, in an attempt to help candidates keep their focus. The complex areas included an acquisition (control to control) and a second acquisition (significant influence to control). This question tested learning outcomes A1(a) and (b).
Suggested Approach The most time-efficient method would have been to set up the pro-formas for both statements and then systematically work through the headings, preparing consolidation adjustments where required. Annotating the additional information highlighting the balances that required adjustment would have been a worthwhile exercise. It was important that candidates appreciated that both (b) and (c) could be answered independently from the detailed workings of part (a).
(a) (i) Consolidated statement of comprehensive income for the year ended 31 December 2011 All workings in $000 Revenue (1,200 + 290) Cost of sales (810 + 110 + 4 (W1)) Gross profit Operating expenses (100 + 40 + 9 (W2)) Investment income (50 – intra group dividend 40 (80% x 50)) Finance costs (45 + 10) Share of associate’s profit (40% x 30) Profit before tax Income tax expense (80 + 30) Profit for the year Other comprehensive income Revaluation of property, net of tax (60 + 20) Share of associate’s OCI (40% x 10) Other comprehensive income for the year, net of tax Total comprehensive income Profit for the year attributable to: Owners of the parent (274 – 17 (W3)) Non-controlling interest
$000 1,490 (924) 566 (149) 417 10 (55) 12 384 (110) 274 80 4 84 358
257 17 274
Total comprehensive income attributable to: Owners of the parent (358 – 21 (W3)) Non-controlling interest
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AB group
337 21 358
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(a) (ii) Consolidated statement of changes in equity for the year ended 31 December 2011 All workings in $000 Equity at 1 January 2011 (W4)/(W5) Total comprehensive income for the year Dividends Dividend paid to NCI (20% x 50) Equity at 31 December 2011
AB group
NCI
Total
$000 1,868 337 (100)
$000 216 21
$000 2,084 358 (100) (10) 2,332
(10) 227
2,105
Workings Working 1 Net assets of subsidiary at
Acquisition 1 Jan 2008 $000 200 420 620 60
All workings in $000 Share capital Retained reserves Fair value adjustment Accumulated additional depreciation on FV adjustment (60/15 yrs = 4 per yr) Accumulated impairment of goodwill (W2)
31 Dec 2011 $000 200 710 910 60 (16)
$000 200 640 (bal) 840 60 (12) (30)
Adjusted net assets Post-acquisition retained reserves to 1 Jan/31 Dec
Working 2 Goodwill Consideration transferred NCI at fair value
680
858
200 420 60
Impairment 2010 (25%) Impairment 2011 (10% of carrying value)
Working 3 Non-controlling interest Profit for year/TCI of CD Less impairment of goodwill in the year (W2) Less depreciation on FV adjustment for the year (W1) 20% NCI share
10
(39) 915
178
$000
Net assets acquired: Share capital Retained earnings Fair value adjustment
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1 Jan 2011
235
$000 620 180 800
(680) 120 (30) 90 (9)
PFY $000 100 (9) (4)
TCI $000 120 (9) (4)
87 17
107 21
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Working 4 Group equity attributable to parent at 1 January 2011 Parent’s equity at 1 January 2011 as per SOCIE Plus share of post-acquisition retained reserves of CD to 1 January 2011 (80% x 178 (W1)) Plus share of post acquisition retained reserves of EF to 1 January 2011 (40% x(500-435))
$000 1,700 142
Equity attributable to parent at 1 January 2011
1,868
Working 5 Group equity attributable to NCI at 1 January 2011 At acquisition Plus share of post-acquisition retained reserves to 1 January 2011 (20% x 178 (W1)) Equity attributable to NCI at 1 January 2011
$000 180 36
26
216
(b) (i) Additional acquisition of shares The purchase of the additional 10% of CD’s share capital is treated as a transaction between owners of the entity, as NCI reduces and parent’s share increases. No additional goodwill is calculated as AB already controls CD and goodwill is only calculated when control is attained. Any difference between the consideration paid by AB and the reduction in the NCI is adjusted through group retained earnings.
(ii) Adjustment to parent’s equity Consideration transferred Reduction in NCI at 1 January 2012 (50% x $227,000) Adjustment to retained earnings – debit
(c)
$000 120 (114) 6
Additional investment in EF
The additional 20% investment will give AB the majority holding of EF’s ordinary shares. This gives the presumption of control, unless there is evidence to the contrary and once control is attained EF will be treated as a subsidiary and fully consolidated. Goodwill on acquisition is calculated at 1 January 2012 and the existing investment will be restated to FV at the date of acquisition
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Answer to Question Seven
Rationale The question was a standard-style analysis question covering Section C of the syllabus. Candidates were required to calculate 5 specific ratios (given in the question scenario) and then select another 3, which they believed to be relevant to the business problem. The second part of the question required an explanation of the limitations in comparing two such entities. This question tested learning outcomes C1(a), C2(a), C2(b) and C2(d).
Suggested Approach Candidates should have calculated ratios and then considered the results in conjunction with the opening scenario. The analysis should have included the candidates’ conclusions on why these entities may have different results.
(a) Report to the Board of XZ RE: Potential acquisition targets A and B From: xx Date: xx Terms of Reference: The purpose of this report is to compare and contrast the financial performance and financial position of potential acquisition targets A and B. The appendix to the report contains the calculation of the five key ratios identified by the chairman together with other relevant calculations. The report concludes with a brief discussion of other information that we should seek prior to concluding on the most suitable target for acquisition. Financial Performance: Both entities have similar revenues but entity A is earning a gross profit margin of 36% in contrast to entity B’s 31%. Given that we know that both entities operate in the same business then we might expect consistency. However, it is possible that A and B operate at different ends of the market and therefore have different gross margin expectations. Alternatively, it could be that the two entities classify costs differently between costs of sales and operating expenses – therefore it is important to consider profit margins lower down the income statement. When we consider the profit before tax margins we can see a significant difference in the performance of the two entities. The profit before tax figures as reported in the income statement show entity A with a 19.5% profit before tax margin compared to 14% for entity B. However, entity A’s margin includes a significant profit contribution from its associate investment. Removing this reduces A’s profit before tax margin to 11%, which is significantly below B’s. This then draws our attention to the overheads as A is making more gross profit but less net profit than B. Administrative expenses seem to be a significant cost to A, with it accounting for 9.3% of revenue as opposed to just 4.8% in B. Entity A may have large fixed overhead or be paying higher remuneration. There has been a revaluation during the year but normally any additional depreciation would be allocated across the expense types – not just to administration, so this is unlikely to be affecting administrative expenses to any degree. A’s distribution costs are considerably higher as a percentage of revenue compared to B. It may be that A is extending its target market at a significant additional cost in order to expand market share.
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Entity A appears to be more efficient in the use of its capital, earning a return on capital employed of 26.2% as opposed to that of B of 22.2%. Entity A’s percentage has been affected by the revaluation occurring in the year. Removing the effects of this increases the ROCE of A to 27.4%, which is significantly better than entity B. It may be that entity B has a newer asset base which reduces the ROCE, but will bring future returns. If this is the case it would explain the high gearing if the acquisitions were financed by debt. Financial Position: The biggest differences between the two entities occur in the financial structures. Entity B is heavily reliant on debt finance and has gearing of 55.2% as opposed to entity A with low gearing of 34.3%, albeit that A’s gearing is helped by a revaluation in the year. However, this level of gearing is slightly at odds with the finance costs shown in the income statements of the two entities. The average rate of debt finance (assuming no further short term debt) is only 8.6% for entity B but is 10% for entity A. Unless A and B are based in different geographical markets (which doesn’t seem likely), then it would appear that either A is considered more risky than B, that entity B has taken out a significant amount of new debt during the year or that entity A has repaid a significant amount of debt during the year. The first of these possibilities seems unlikely given that A and B operate in the same line of business, therefore it would appear that the gearing position has recently changed for one of the entities during the year. However, in either case, when considering B as a takeover target, the future financial commitments to service the debt must be considered. In contrast, with gearing of only 34%, entity A has additional capacity for external borrowing. In addition, the interest cover for both A and B is reasonable. One last point to note about gearing is that the different levels could be the result of the dividend policy of the entities. It is possible that B pays a significant portion of its retained earnings as dividends to the shareholders which reduces the equity balance and necessitates the need for higher debt finance to fund investment in the business. Ultimately, the dividend policy will not matter, as on acquisition we will change it to suit our purposes, however it needs to be considered in the context of why B’s gearing is so high. Liquidity appears to be well managed in both entities. It would be important to identify the elements of working capital to ensure entity B has sufficient cash resources to ensure going concern and meet finance costs as its liquidity is 1.3 as opposed to A’s 2.1. The approximate rate of tax that A and B are subject to is 23%. As expected, the rate is the same since they operate in the same country. A’s figure, however has to be adjusted for the associate, as A’s share of the associate is included net of tax.
(b) Further information required: In order to make an initial recommendation it would be important to consider: Finance structure –whether it is a deliberate strategy of B to finance by debt because of lower interest rates or a sign of financial difficultly. Liquidity – identify the component parts of liquidity to ensure B has sufficient cash resource. Also if the working capital fits a strategy that XZ is pursuing, eg high levels of cash available for use by the group, or borrowing capacity in times of expansion. Profitability – the detail of A’s administrative overhead as high expenses are causing a significant fall from GP to PBT%, ensuring these are not fixed, or evidence of high directors’ remuneration. Also details of the associate, especially since A’s profit is highly dependent on the share of income from associate. Asset base –the age of operating assets in case one of the entities requires significant investment. Trends – financial statements from previous periods would be helpful to identify trends and a full set of financial statements for this period would help to identify details of working capital and any contingent liabilities. Information about the market/competitors would also help to identify the position in the market and potential opportunities. May 2012
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Appendix A (Workings in $000) Gross profit GP/revenue x 100% Profit before tax PBT/revenue x 100% PBT without associate Return on capital employed Profit before finance costs/capital employed x 100% ROCE without revaluation Gearing Debt/equity Liquidity Current assets/current liabilities Interest cover Profit before finance costs/finance costs Average rate of borrowing Finance costs/borrowings x 100% Approx rate of tax Tax/PBT (adjusted for associate) x 100%
A
B
2,052/5,700 x 100 = 36.0%
1,643/5,300 x 100 = 31.0%
1,113/5,700 x 100 = 19.5%
742/5,300 x 100 = 14.0%
(1,113 – 456)/5,700 x 100 = 11.5% (1,113 + 120)/(3,500+1,200) x 100 = 26.2% (1,113 + 120)/(3,500200+1,200) x 100 = 27.4% 1,200/3,500 x 100 = 34.3%
(742 + 119)/(2,500+1,380) x 100 = 22.2%
1,380/2,500 x 100 = 55.2%
1,300/620 = 2.1 : 1
1,100/840 = 1.3 : 1
(1,113+120)/120 = 10.3 times
(742+119)/119 = 7.2 times
120/1,200 x 100 = 10%
119/1,380 x 100 = 8.6%
150/(1,113-456) x 100 = 22.8%
170/742 x 100 = 22.9%
( other ratios that were given credit,as part of the additional ratios that could be calculated, included profit for the year/revenue, operating profit margin, return on equity, asset turnover, distribution costs/revenue and admin costs/revenue.)
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