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MARKING SCHEME

FINANCIAL ACCOUNTING
MAN2907L
MAIN PAPER MAY 2010

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DO NOT INCLUDE IN ANY EXAMINATION SCRIPT!!


***
Section A

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Section B
Question One
The investment in Touch represents 80% (400,000/500,000) of its equity and is likely to give Sense
control thus Touch should be consolidated as a subsidiary. The investment in Sight represents
25% (200,000/800,000) of its equity and is normally treated as an associate that should be equity
accounted.
(a)

i) Goodwill:
000
Cost of the controlling interest in Touch
600
Equity shares
Pre-acquisition profit
Tangible assets fair value adjustments
80
Fair value of net assets at acquisition
80% thereof
Goodwill
Cost of the associate interest in Sight 300
Net assets at acquisition (800+92) x 25% 223
Goodwill

250
380
(710)
568
32
77
109

ii) Investment in Sight


000
235

25% of present net assets of Sight - 940 x 25%


iii) Consolidated retained earnings:

000
1,610

Senses retained earnings


Touchs post-acquisition profits (220 x 80% see below) 176
Sweets post-acquisition profits (140-92 x 25%)
URP in Inventories (50 x 25/125)

12
10)
1,788

Touchs retained earnings:


Post-acquisition (615 - 380)
Additional depreciation
Adjusted post-acquisition profits

235
(15)
220

iv) Minority interest


000
Touch adjusted net assets (865+80-15) x 20%

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186

Consolidated balance sheet of Sense as at 31 December 2009:


000
Non-current assets
Tangible (870 + 520 + 80 - 15)
Goodwill (Working i)
Investments
Investment in associate (Working ii)
Available-for-sale investments
Current assets
Inventory (350 + 220 - 10 URP (Working iii)
Trade receivables (120 + 80 - 4)
Cash (210 + 180 + 1)
Total assets

560
196
391

Equity and liabilities


Equity attributable to the parent
Equity shares
Retained earnings (Working iii)

1,455
109
235
195
1,994

1,147
3,141

600
1,788
2,388
186
2,574

Minority interest (Working iv)


Total equity
Non-current liabilities (150 + 120)
Current liabilities (230 + 70 - 3)
Total equity and liabilities

000

270
297

567
3,141
(80% marks)

(b)

The uses of consolidated statements


The objective of consolidated financial statements is to show the financial performance and
position of the group as if it was a single economic entity. There is a view that, as the entity
financial statements of the parent company contain the investments in subsidiaries as noncurrent assets, they reflect the assets of the group as a whole. The more traditional view is
that entity financial statements do not provide users with sufficient information about
subsidiaries for them to make a reliable assessment of the performance of the group as a
whole. The following illustrates benefits of consolidated financial statements:
They identify the nature and classification of the subsidiarys assets. For example, the
investment in a subsidiary may be almost entirely in intangible assets or conversely
they may be substantially land and buildings. Such a distinction is of obvious
importance to users.
The amount of the subsidiarys debt could not be assessed from the parents entity
financial statements. In effect the subsidiarys assets and liabilities are netted off when
it is shown as an investment. This means group liquidity and gearing cannot be
properly assessed.
The cost of the investment does not reflect the size of a company. For example a
parent company may show an investment in a subsidiary at a cost of 10 million. This
may represent the purchase of a subsidiary that has 10 million of assets and no
liabilities. Alternatively this could be a subsidiary that has 100 million in assets and
90 million of liabilities. Clearly the latter subsidiary would be a much larger company
than the former.
The cost of the investment may be a fair representation of its value at the date of
purchase, but with the passage of time (assuming the subsidiary is profitable), its value
will increase. This increase would not be reflected in the original cost, but it would be

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reflected in the consolidated net assets of the subsidiary (and the increase in group
reserves).
The cost of the investment might represent all of the ownership of the subsidiary or only
just over half of it, i.e. there would be no indication of the minority interest.
To summarise, in the absence of a consolidated balance sheet, users would have no
information on the current value of a subsidiary, its size, the composition of its net assets
and how much of it was owned by the group.
(20% marks)
(Total 100% marks)

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Question Two
(a)

Return on capital employed


PBIT / Capital employed x 100%
50 / 360 x 100% = 13.9%
Gross profit percentage
Gross profit / Revenue x 100%
120 / 320 x 100% = 37.5%
Operating profit percentage
PBIT / Revenue x 100%
50 / 320 x 100% = 15.6%
Quick/Acid test ratio
(Current assets - inventory) / Current liabilities
(150 - 90) / 90 = 067 times
Debtors collection period
Trade debtors / Revenue x 365
50 / 320 x 365 = 57 days
Earnings per share
Profits on ordinary activities after tax / No. of ordinary shares in issue
20 / 100 = 20p per share
(20% marks)

(b)

Brief Report
To:
From: Student
Date April 2010
Subject: Financial Appraisal of Kingdom Using Accounting Ratios
Introduction
The purpose of this report is to analyse the financial performance of Kingdom over the last
three years using accounting ratios.
Return on capital employed

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The return on capital employed has declined over the last three years from 16.2% to 13.9%
and is now well below the industry average (16.2%). This should be a cause for concern to
the board of directors because if investors can obtain a higher return elsewhere then they
may withdraw their investment.
Alternatively they may seek to change the management board. It would be helpful to have
more information on the market in which Kingdom operates, e.g. is the market growing or
declining, are there many buyers and sellers or just a few.
Gross profit percentage
The gross profit percentage has risen over the period from 30.4% to 37.5%. Clearly the
company has either increased the selling price of its goods, e.g. perhaps it is able to sell at
a premium because of perceptions regarding the quality of the goods sold or reduced the
cost of its supplies. Possibly changing suppliers or obtaining greater discounts as sales
volume has increased.
It would be useful to know what the company is selling and the volume of sales analysed by
product and year.
Operating profit percentage
The operating profit percentage has declined over the period from 19.3% to 15.6% and is
significantly below the industry average of 17.3%, and seems to be the main contributor to
the weakening of the ROCE. This is worrying considering the increase in the gross profit
percentage over the same period. The decline in the operating profit percentage suggests
that the selling & admin. overhead costs may not be tightly controlled within the company.
More detailed information on expenditure during the period would be helpful in identifying
the reasons for the decline in profitability.
Quick (or acid test) ratio
The quick ratio has also declined significantly during the period from 1.5 to 0.67 suggesting
the company may be experiencing liquidity problems. This view is also supported when the
ratio is compared to the industry average which is over double that of Kingdom. The level
of inventory may be a concern as it is tying up cash. More information on the type of
inventory and the level of inventory turnover (currently 90 / 200 x 365 = 165 days) would be
useful.

Debtors collection period


The time taken to collect debts has increased over the period from 32 days to 57 days.
This seems very high when compared to the industry average debt collection period of just
35 days. The ratio suggests that there is little control over debt collection.
In addition, the lengthening of the collection period means it is more likely that some debts
will not be paid by customers.
The poor control over debt collection will be a factor contributing to the adverse liquidity
situation of the company.
Earnings per share
The earnings per share deteriorated over the period from 36p per share to 20p per share.
This level of EPS is also significantly below the industry average and it is likely to
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discourage potential investors from investing in the company and may not be sufficient to
keep existing shareholders.
Conclusion
Although the company has managed to increase its gross profit over the period, this has
not resulted in a similar increase in net profit. In summary the ratios indicate poor internal
control of costs and poor management of working capital. The return on capital employed
and the EPS ratios are unlikely to be sufficiently attractive to potential investors or to
existing shareholders.
(40% marks)
(c)

Related party disclosures


In the absence of related party disclosures, the financial analyst would assume that
Kingdom has acted independently and in its own best interests. Principally within this
assumption is that all transactions have been entered into willingly and at arms length (i.e.
on normal commercial terms at fair value). Where related party relationships and
transactions exist, this assumption may not be justified. These relationships and
transactions lead to the danger that financial statements may have been distorted or
manipulated, both favourably and unfavourably. The most obvious example of this type of
transaction would be the sale of goods or rendering of services from one party to another
on noncommercial terms (this may relate to the price charged or the credit terms given).
Other examples of disclosable transactions are agency, licensing and leasing
arrangements, transfer of research and development and the provision of finance,
guarantees and collateral. Collectively this would mean there is hardly an area of financial
reporting that could not be affected by related party transactions.
It is a common misapprehension that related party transactions need only be disclosed if
they are not at arms length. This is not the case. For example, Kingdom may instruct all
members of its group to buy certain products or services (on commercial terms) from one of
its subsidiaries. In the absence of the related party relationships, these transactions may
not have occurred. If the parent were to sell the subsidiary, it would be important for the
prospective buyer to be aware that the related party transactions would probably not occur
in the future. Indeed even where there is no related party transaction, the disclosure of the
related party relationship is still important as Kingdom may obtain custom, receive
favourable credit ratings, and benefit from a superior management team simply by being a
part of a well respected group.
(40% marks)
(Total 100% marks)

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Question Three
(a)

Nature of provisions and its accounting requirements


IAS 37 Provisions, Contingent Liabilities and Contingent Assets only deals with those
provisions that are regarded as liabilities. The term provision is also generally used to
describe those amounts set aside to write down the value of assets such as depreciation
charges and provisions for diminution in value (e.g. provision to write down the value of
damaged or slow moving inventory). The definition of a provision in the standard is quite
simple; provisions are liabilities of uncertain timing or amount. If there is reasonable
certainty over these two aspects the liability is a creditor. There is clearly an overlap
between provisions and contingencies. Because of the uncertainty aspects of the
definition, it can be argued that to some extent all provisions have an element of
contingency. The IASB distinguishes between the two by stating that a contingency is not
recognised as a liability if it is either only possible and therefore yet to be confirmed as a
liability, or where there is a liability but it cannot be measured with sufficient reliability. The
IASB notes the latter should be rare.
The IASB intends that only those liabilities that meet the characteristics of a liability in its
Framework for the Preparation and Presentation of Financial Statements should be
reported in the balance sheet.
IAS 37 summarises the above by requiring provisions to satisfy all of the following three
recognition criteria:
There is a present obligation (legal or constructive) as a result of a past event;
It is probable that a transfer of economic benefits will be required to settle the
obligation;
The obligation can be estimated reliably.
A provision is triggered by an obligating event. This must have already occurred; future
events cannot create current liabilities.
The first of the criteria refers to legal or constructive obligations. A legal obligation is
straightforward and uncontroversial, but constructive obligations are a relatively new
concept. These arise where a company creates an expectation that it will meet certain
obligations that it is not legally bound to meet. These may arise due to a published
statement or even by a pattern of past practice. In reality constructive obligations are
usually accepted because the alternative action is unattractive or may damage the
reputation of the company.
To summarise: a company must provide for a liability where the three defining criteria of a
provision are met, but conversely a company cannot provide for a liability where they are
not met.
(30% marks)

(b) The main need for an accounting standard in this area is to clarify and regulate when
provisions should and should not be made. Many controversial areas including the possible
abuse of provisioning are based on contravening aspects of the above definitions.
i) Future restructuring or reorganisation costs
This is sometimes extended to providing for future operating losses. The attraction of
providing for this type of expense/loss is that once the provision has been made, the future
costs are then charged to the provision such that they bypass the statement of
comprehensive income (of the period when they occur). Such provisions can be glossed
over by management as exceptional items, which analysts are expected to disregard when
assessing the companys future prospects. If this type of provision were to be incorporated
as a liability as part of a subsidiarys net assets at the date of acquisition, the provision itself
would not be charged to the statement of comprehensive income. IAS 37 now prevents
this practice as future costs and operating losses (unless they are for an onerous contract)
do not constitute past events.
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ii) Environmental provisions


Practice in this area has differed considerably. Some companies did not provide for such
costs and those that did often accrued for them on an annual basis. If say a company
expected environmental site restoration cost of 10 million in 10 years time, it might argue
that this is not a liability until the restoration is needed or it may accrue 1 million per
annum for 10 years (ignoring discounting). Somewhat controversially this practice is no
longer possible.
IAS 37 requires that if the environmental costs are a liability (legal or constructive), then the
whole of the costs must be provided for immediately. That has led to large liabilities
appearing in some companies balance sheets.
iii) Big bath provisions
In its simplest form this occurs where a company makes a large provision, often for nonspecific future expenses, or as part of an overall restructuring package. If the provision is
deliberately overprovided, then its later release will improve future profits. Alternatively the
company could charge to the provision a different cost than the one it was originally created
for.
IAS 37 addresses this practice in two ways: by not allowing provisions to be created if they
do not meet the definition of an obligation; and specifically preventing a provision made for
one expense to be used for a different expense. Under IAS 37 the original provision would
have to be reversed and a new one would be created with appropriate disclosures. Whilst
this treatment does not affect overall profits, it does enhance transparency.
(30% marks)
(c)

According to IAS 37, a present obligation (legal or constructive) must be arisen as a result
of a past event (the obligating event). As the 10% discount promise hinges only on a future
second purchase event, a provision for the discount should not be recognised for the year
ended 30 June 2009. The management, however, may consider whether it should be
disclosed as a contingent liability according to the possibility of happening.
The amount recognised as a provision should be the best estimate of the expenditure
required to settle the present obligation at 30 June 2009, that is, the amount that the
manufacturer would rationally pay to settle the obligation at that date or to transfer it to the
insurance company. This means provisions for large populations of the warranties are
measured at a probability weighted expected value. In reaching its best estimate, the
manufacturer should take into account the risks and uncertainties that surround the
underlying events.
Expected cash outflows should be discounted to their present values, where the effect of
the time value of money is material using a risk adjusted rate (5% in this situation). As the
expenditure required settling the second year of the extended warranty provision is
expected to be reimbursed by the insurance company, the reimbursement should be
recognised as a separate asset when, and only when, it is virtually certain that
reimbursement will be received if the manufacturer settles the obligation. The amount
recognised should not exceed the amount of the provision. In measuring a provision future
events should be considered. The provision for the warranty claim will be determined by
using the expected value method.

Year 1 warranty
70% x Nil
20% x 40,000 x 80
10% x 40,000 x 250

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Expected value
000

Discounted
expected value
(5%)
000

0
640
1,000
1,640

1,562

Year 2 extended warranty


50% x Nil
35% x 26,000 x 80
15% x 26,000 x 250

0
728
975
1,703

1,545

The past event which causes the obligation is the initial sale of the product with the
warranty given at that time. It would be appropriate for the manufacturer to make a
provision for the Year 1 warranty of 1,640,000 and Year 2 warranty of 1,703,000, which
represents the best estimate of the obligation. Only if the insurance company has validated
the counter claim will the manufacturer be able to recognise the asset and income.
Recovery has to be virtually certain. If it is virtually certain, then the manufacturer may be
able to recognise the asset. Generally contingent assets are never recognised, but
disclosed where an inflow of economic benefits is probable.
The company could discount the provision if it was considered that the time value of money
was material. The majority of provisions will reverse in the short term (within two years)
and, therefore, the effects of discounting are likely to be immaterial.
In this case, using the risk adjusted rate (IAS 37), the provision would be reduced to
1,562,000 in Year 1 and 1,545,000 in Year 2. The manufacturer will have to determine
whether this is material.
(40% marks)
(Total 100% marks)

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Question Four
(a)

An intangible asset arising from development (or from the development phase of an
internal project) shall be recognised if, and only if, an entity can demonstrate all of the
following:
The technical feasibility of completing the intangible asset so that it will be available for
use or sale.
Its intention to complete the intangible asset and use or sell it.
Its ability to use or sell the intangible asset.
Its ability to measure reliably the expenditure attributable to the intangible asset during
its development.
How the intangible asset will generate probable future economic benefits. Among other
things, the entity can demonstrate the existence of a market for the output of the
intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset.
The availability of adequate technical, financial and other reTouchces to complete the
development and to use or sell the intangible asset.
Benchmark could demonstrate to achieve, at most, the first four criteria. It seems doubtful
whether Benchmark could finance the development project with millions of pounds for its
completion if experiencing a liquidity problem. Further, in view of the modest profit condition
and volatile market condition, the development project might not be able to generate
ultimate economic benefits to Benchmark.
As the recognition of development cost as an intangible asset needs to fulfill all the criteria,
Benchmark should expense the 500,000 development cost immediately in the year.
(20% marks)

(b)

IAS 2 states:
Inventory should be valued at the lower of cost and net realisable value.
Cost = all expenditure (in normal course of business) to bring inventory to its present
location and condition.
NRV = expected selling price less any costs to bring inventory to sale.
This treatment is to ensure that profit is not anticipated and any loss is recognised at the
earliest point based on the accounting principle of prudence. This approach also meets
requirements of the matching concept by matching cost (and therefore profit) with revenue
earned on the sale. It is important because reported profit is directly affected by inventory
value. If inventory is overvalued by 1, profit is overstated by 1.
Long term contracts, governed by IAS 11 Construction Contracts, are not valued on the
same way because it would result in reporting profit on contracts completed, rather than on
work carried out in period. This is contrary to rule of matching or accruals. Financial
statements will not show a fair presentation, with much profit in some years and little, if any,
in others, although sustainable economic activity has taken place.
(20% marks)

(c)

Contract WIP
Contract value basic

4,000,000

Costs

to date
to complete

Thus

Expected profit

4,000,000

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2,032,000
983,000
3,015,000
985,000

On the basis of work certified, contract is 65% complete


Thus, profit to date is 985,000 x 65%
=
640,250
Thus
Turnover to I/S
2,600,000
Cost of sales (balancing figure) 1,959,750
Costs to date: basic

2,032,000
variations to date

Less cost of sales


Contract WIP inventory

298,000
2,330,000
1,959,750
370,250
(30% marks)

(d)

The effect of applying the provisions of IAS 11 will be:


Reported profit will increase by 640,250
Inventory will be reduced by the amount recognised in cost of sales (1,959,750)
Debtors or cash will increase by the amount recognised in turnover (2,600,000)
Thus current assets, working capital and capital employed will increase by the
amount now recognised in profit 640,250 (2,600,000 - 1,959,750)
As a result of these changes, the following comments can be made regarding assessment
of profitability and liquidity:
Profitability
Reported profit will improve by 640,250 in the current year as this amount is being
recognised earlier than was previously reported
The Net Profit/Sales ratio (net profit margin) will almost certainly improve as the
increase in profit is almost 25% of the increase in turnover (as the company has
been reporting modest profits, it is highly unlikely that the draft accounts show a
better net profit margin)
Return on capital employed is more difficult to assess without access to the figures
reported in the accounts, but it would be expected that as both profit and net assets
will have increased by the attributable profit of 640,250, the overall effect is
positive
Liquidity
As working capital has increased by 640,250, it follows that the current ratio will
have improved as inventory has been reduced and the inventory turnover period will
be improved. As debtors have probably increased, the debtors turnover period will
have deteriorated. As the increase in debtors or cash is greater than the decrease
in inventory, the quick assets ratio will have improved.
From the above it can be seen that applying the correct treatment under IAS 11
indicates that the short term objectives of the investors are being met.
(30% marks)
(Total 100% marks)

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Question Five
(a)

Statement of cash flows for the year ended 31 October 2009


000
Cash flows from operating activities
Net profit before tax
Adjustments for:
Depreciation
Impairment on long-term investment
Interest received
Interest expenses (200 + 270)
Gains on plant disposal
Operating profit before working capital changes
Increase in inventory (2,100 - 1,750)
Decrease in receivables ((1,800 + 90) - 1,600)
Increase in trade payables (1,250 - 1,180)
Cash generated from operations
Interest received
Interest paid (150 + 470 - 250)
Tax paid (1,050 + 650 - 780)
Net cash from operating activities
Cash flows from investing activities
Purchase of PP&E (W1)
Proceeds from sale of plant (450 - 180(W2) + 50)
Net cash used in investing activities
Cash flows from financing activities
Proceeds from issue of shares (1,750 - 1,350)
New long term borrowing (2,100 - 1,550)
Dividends paid (W3)
Net cash used in financing activities
Net increase in cash and cash equivalents
Bank overdraft at the beginning of period
Cash and cash equivalents at end of period

000
3,770
380
200
(270)
470
(50)
4,500
(350)
290
70
4,510
270
(370)
(920)
3,490
(2,020)
320
(1,700)
400
550
(1,180)
(230)
1,560
(470)
1,090

Note: IAS 7 allows interest paid and dividend paid to be an operating cash flow or a
financing cash flow. Interest received can be an operating cash flow or an investing cash
flow either treatment by students is acceptable
Workings:
W1: Additions of property, plant and equipment:
000
Opening net book value (2,040 - 860)
Disposals (450 - 180)
Depreciation
Additions (balancing figure)
Closing net book value (3,610 - 1,060)

1,180
(270)
(380)
2,020
2,550

W2: Accumulated depreciation of the disposed plant:


000
Opening accumulated depreciation
Depreciation for the year
Acc. depreciation of the plant (balancing figure)
Closing accumulated depreciation

860
380
(180)
1,060

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W3: Dividends declared and paid:


000
Opening retained earnings
Prior year adjustment
Restated balance
Profit for the year
Dividends (balancing figure)
Closing retained earnings

1,380
90
1,470
3,120
(1,180)
3,410
(60% weighting)

(b)

Relevance of statement of cash flows


Statement of cash flows provides important information to users of financial statements.
Perhaps the most important aspect is that by reporting on how cash is generated and used,
the statement provides information on the resource which is essential for business survival
cash. The fact that a firm generates a profit does not mean that it will generate cash.
This is because cash will be used to pay tax, dividends and loans.
For some users, particularly creditors and lenders, the ability of the firm to meet its
obligations will be more important than profitability. Reporting cash movements is more
objective than reporting income and expenses, as is done in the statement of
comprehensive income, and assets and liabilities, as is done in the balance sheet. This
means that the information provided in a statement of cash flows may be regarded as more
reliable than the information in the statement of comprehensive income or balance sheet.
Given that the objective in most management decisions is to generate cash rather than
profit, a statement of cash flows is of more use to both managers and shareholders. As
many users of financial statements may find the accruals concept difficult to understand,
the focus on cash provides information which is easier to understand.
It is also more difficult to mask the effects of transactions through creative accounting.
Different accounting policies will have less impact on the results reported by a cash flow.
This means that using cash to compare performance between firms is made easier.
Financial statements are intended to provide information on financial performance, financial
position, generation of cash and financial adaptability. Clearly a statement of cash flows
contributes to this objective with regard to generation of cash.
(40% marks)
(Total 100% marks)

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