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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.
Management Level Paper
F2 – Financial Management
May 2012 examination
Answer to Question One
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).
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)
Financial Management 2 May 2012
(a) Calculation of the actuarial gains/losses in the year to 31 December 2011
FV of plan assets PV of pl an liabil ities
Opening balance 1,400 1,700
Service cost 320
Interest cost (7% x $1,700,000) 119
Expected return (4% x $1,400,000) 56
Benefits paid (170) (170)
Actuarial gain on pl an assets 234
Actuarial loss on plan li abilities 431
Closing balance 2,100 2,400
(b) Share-based payment
(i) Income statement charge
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.
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 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.
May 2012 3 Financial Management
Answer to Question Two
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).
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).
Consideration transferred 1,850,000
Non-controlling interest at fair value 570,000
Net assets at date of acquisition:
Carrying value $(1,000,000 +885,000) 1,885,000
Fair value increase $(1,100,000 – 945,000) 155,000
Goodwill on acquisition 380,000
Impairment 20% in 2011 (76,000)
Goodwill as at 31 December 2011 304,000
(b) Consolidated retained earnings
As reported in SOFP 4,200,000 1,300,000
Less pre-acquisition retained earnings (885,000)
Accumulated depreciation on PPE FV
adjustment ($155,000 x 2/5 years)
Impairment of goodwill (as in (a) above) (76,000)
Unrealised profit ($400,000 x 20%) (80,000)
Group share of AB ($197,000 x 75%) 147,750
Consolidated retained earnings 4,347,750
(c) Non-controlling interest
Non-controlling interest at fair value at acquisition 570,000
Plus NCI share of adjusted post acquisition retained earnings
(as in (b) above) (25% x $197,000)
Financial Management 4 May 2012
Answer to Question Three
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).
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).
May 2012 5 Financial Management
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
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
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.
Financial Management 6 May 2012
Answer to Question Four
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
The question tested learning outcomes B1(d) and B1(e).
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 J H 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.
May 2012 7 Financial Management
Answer to Question Five
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).
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 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.
Financial Management 8 May 2012
(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
May 2012 9 Financial Management
Answer to Question Six
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).
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
Consolidated statement of comprehensive income for the year
ended 31 December 2011
Al l workings in $000 $000
Revenue (1,200 +290) 1,490
Cost of sales (810 +110 +4 (W1)) (924)
Gross profit 566
Operating expenses (100 +40 +9 (W2)) (149)
Investment income (50 – intra group dividend 40 (80% x 50)) 10
Finance costs (45 +10) (55)
Share of associate’s profit (40% x 30) 12
Profit before tax 384
Income tax expense (80 +30) (110)
Profit for the year 274
Other comprehensive income
Revaluation of property, net of tax (60 +20) 80
Share of associate’s OCI (40% x 10) 4
Other comprehensive income for the year, net of tax 84
Total comprehensive income 358
Profit for the year attributable to:
Owners of the parent (274 – 17 (W3)) 257
Non-controlling interest 17
Total comprehensive income attributable to:
Owners of the parent (358 – 21 (W3)) 337
Non-controlling interest 21
Financial Management 10 May 2012
Consolidated statement of changes in equity
for the year ended 31 December 2011
AB group NCI Total
Al l workings in $000 $000 $000 $000
Equity at 1 J anuary 2011 (W4)/(W5) 1,868 216 2,084
Total comprehensive income for the year 337 21 358
Dividends (100) (100)
Dividend paid to NCI (20% x 50) (10) (10)
Equity at 31 December 2011 2,105 227 2,332
Working 1 Net assets of subsidiary at Acquisition
1 Jan 2008
1 Jan 2011 31 Dec
Al l workings in $000 $000 $000 $000
Share capital 200 200 200
Retained reserves 420 640 (bal) 710
620 840 910
Fair value adjustment 60 60 60
Accumulated additional depreciation on FV
adjustment (60/15 yrs =4 per yr)
Accumulated impairment of goodwill (W2) (30) (39)
Adjusted net assets 680 858 915
Post-acquisition retained reserves to 1 J an/31
Working 2 Goodwill $000 $000
Consideration transferred 620
NCI at fair value 180
Net assets acquired:
Share capital 200
Retained earnings 420
Fair value adjustment 60 (680)
Impairment 2010 (25%) (30)
Impairment 2011 (10% of carrying value) (9)
Working 3 Non-controlling interest PFY TCI
Profit for year/TCI of CD 100 120
Less impairment of goodwill in the year (W2) (9) (9)
Less depreciation on FV adjustment for the year
20% NCI share 17 21
May 2012 11 Financial Management
Working 4 Group equity attributable to parent at 1 January 2011 $000
Parent’s equity at 1 J anuary 2011 as per SOCIE 1,700
Plus share of post-acquisition retained reserves of CD to 1 J anuary
2011 (80% x 178 (W1))
Plus share of post acquisition retained reserves of EF to 1 J anuary
2011 (40% x(500-435))
Equity attributable to parent at 1 J anuary 2011 1,868
Working 5 Group equity attributable to NCI at 1 January 2011 $000
At acquisition 180
Plus share of post-acquisition retained reserves to 1 J anuary 2011
(20% x 178 (W1))
Equity attributable to NCI at 1 J anuary 2011 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 $000
Consideration transferred 120
Reduction in NCI at 1 J anuary 2012 (50% x $227,000) (114)
Adjustment to retained earnings – debit 6
(c) 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 J anuary 2012 and the existing investment will be restated to FV at the date of
Financial Management 12 May 2012
Answer to Question Seven
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).
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
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.
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
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
May 2012 13 Financial Management
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.
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
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.
Financial Management 14 May 2012
(Workings in $000)
GP/revenue x 100%
2,052/5,700 x 100 =36.0% 1,643/5,300 x 100 =31.0%
Profit before tax
PBT/revenue x 100%
1,113/5,700 x 100 =19.5% 742/5,300 x 100 =14.0%
PBT without associate
(1,113 – 456)/5,700 x 100 =
Return on capital employed
Profit before finance
costs/capital employed x 100%
120)/(3,500+1,200) x 100 =
x 100 =22.2%
ROCE without revaluation (1,113 +120)/(3,500-
200+1,200) x 100 =27.4%
1,200/3,500 x 100 =34.3% 1,380/2,500 x 100 =55.2%
Current assets/current liabilities
1,300/620 =2.1 : 1 1,100/840 =1.3 : 1
Profit before finance
(742+119)/119 =7.2 times
Average rate of borrowing
Finance costs/borrowings x
120/1,200 x 100 =10% 119/1,380 x 100 =8.6%
Approx rate of tax
Tax/PBT (adjusted for associate)
150/(1,113-456) x 100 =
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.)