The Examiner's Answers

F2 - Financial Management
March 2013
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

Question One

Rationale

This question was intended to examine two areas of syllabus section B; retirement benefits and
share-based payments.

This question tested learning outcome B1(f).

Suggested Approach

Candidates should have been well versed in the calculation of actuarial gains and losses on
pensions. It would have been important to ensure each item affecting assets and liabilities of the
plan were entered into the correct column. The second part of part (a) required the calculation of
the net pension asset or liability. This tested candidates’ understanding of how the pension plan is
reflected in the company’s statement of financial position and it was important that candidates
stated whether the net position was asset or liability.

Part (b) tested share-based payment. On this occasion it was equity-settled and although
candidates would have been able to calculate the correct expense, they were also required to
appreciate the impact on the SOFP and record the journal entry with the credit going to
equity/other reserves.

Financial Management 1 March 2013

(a) Pension plan
(i) Actuarial gains and losses
FV of plan assets PV of plan liabilities
$000 $000
Opening balance 5,700 5,500
Service cost 1,020
Interest cost (6% x $5,500,000) 330
Expected return (3% x $5,700,000) 171
Benefits paid (280) (280)
Contributions 820
6,411 6,570
Actuarial loss on plan assets (111)
Actuarial gain on plan liabilities (70)
Closing balance 6,300 6,500

(ii) Statement of financial position $000

Present value of pension plan liabilities at 31/12/12 6,500
Fair value of pension plan assets at 31/12/12 (6,300)
Net pension liability 200

(b) Share-based payments

(i) Charge for the year

Year ended 31 December 2011

Eligible employees (400-35-80) = 285
Equivalent cost of options = 285 employees x 1,000 rights x FV$8 = $2,280,000
Allocate over 3 year vesting period $2,280,000/3 = $760,000 equivalent charge to the income
statement in 2011.

Year ended 31 December 2012

Eligible employees (400-35-28-34) = 303
Equivalent cost of options = 303 employees x 1,000 rights x FV$8 = $2,424,000
Cumulative amount to be recognised within equity = $2,424,000 x 2/3 years = $1,616,000
Less amount previously recognised = $1,616,000 – $760,000 = $856,000

(ii) Journal

Journal entry required:

DR: Staff costs $856,000
CR: Equity (other reserves) $856,000

March 2013 2 Financial Management

 Please turn over for answer to question two

Financial Management 3 March 2013

Question Two

Rationale

This question tested the core area of consolidation and specifically piecemeal acquisitions (control to
control). The principle of calculation of goodwill at the date where control is gained was a key aspect
of this question, in addition to the adjustment to parent’s equity as the acquisition of the additional 20%
was a transaction between owners.

This question tested learning outcome A1(b).

Suggested Approach

The most logical way to approach a statement of financial position question of this sort was to
aggregate the balances on the face of the statement and then process any adjustments in the
brackets. Time should have been dedicated to considering the dates of control and the group
structure before and after the 20% additional purchase.

Statement of financial position for the ZX Group as at 31 December 2012

ASSETS (all workings in $000) $000

Non-current assets
Property, plant and equipment (20,250 + 11,000) 31,250
Goodwill (W1) 2,324
33,574
Current assets (16,000 + 5,000) 21,000
Total assets 54,574

EQUITY AND LIABILITIES

Equity attributable to owners of the parent
Share capital ($1.00 shares) 5,000
Retained earnings (W2) 27,734
32,734
Non-controlling interest (W3) 2,240
Total equity 34,974
Total liabilities (14,800 + 4,800) 19,600
Total equity and liabilities 54,574

W1 Goodwill $000 $000

Consideration transferred 8,750
Non-controlling interest (40% x $10,280,000) 4,112
12,862
Net assets at date of acquisition:
Share capital 1,000
Retained earnings at acquisition date 9,280 (10,280)
Goodwill at acquisition 2,582
Impairment 10% in 2011 (258)
Goodwill at 31 December 2012 2,324

March 2013 4 Financial Management

 W2 Consolidated retained earnings ZX Group CV
$000 $000
As reported in SOFP 28,200 10,200
Less pre-acquisition retained earnings (9,280)
920

Group share of CV ($920,000 x 60%) 552

Impairment of goodwill (as in W1 above) (258)
Adjustment to parent’s equity (W4) (760)
Consolidated retained earnings 27,734

W3 Non-controlling interest $000

Non-controlling interest at acquisition (W1) 4,112
Plus NCI share of post acquisition retained earnings (as in W2 above) 368
(40% x $920,000)
NCI at date of transfer of additional 20% to ZX 4,480
50% transferred on 31 December 2012 (2,240)
NCI at 31 December 2012 2,240

W4 Adjustment to parent’s equity $000

Consideration transferred 3,000
Net assets transferred (W3) (2,240)
Debit to group retained earnings 760

Financial Management 5 March 2013

Question Three

Rationale

This question tested earnings per share and P/E ratio. The majority of the marks were for
calculations and a key test was the distinction between what transactions affect basic eps and what
affect diluted eps – something that candidates have struggled with in previous diets.

This question tested learning outcome C1(a).

Suggested Approach

Candidates should have known how to perform these calculations and follow the standard layouts
provided in the study materials. Identifying the correct profit figure was key and then time should
have been taken to consider which of the transactions/instruments would affect each of the
calculations. The calculation of the P/E ratio should have been straightforward as the relevant
information was separated out in the question and marks were awarded based on candidates own
figures from part (a).

(a) (i) Basic earnings per share for the year ended 30 September 2012

Profit after tax ($10,582,000 - $435,000) $10,147,000

Weighted average number of shares:
At 1 October 2011 8,000,000
Bonus issue 1 for 4 2,000,000
Full market price issue (1,500,000 x 3/12) 375,000
10,375,000
97.8 cents per
Basic eps for 2012 $10,147,000/10,375,000
share
Basic eps for 2011 restated 108.2 cents x bonus 86.6 cents per
fraction of 4/5 share

(ii) Fully diluted earnings per share for the year ended 30 September 2012

Reported profit after tax (as in part (a)) $10,147,000

Plus post-tax saving of finance costs (70% x 6% x
$210,000
$5,000,000)
$10,357,000
Weighted average number of shares:
As reported in part (a) 10,375,000
Dilution from potential share issue 1,000,000
11,375,000

91.1 cents per

Fully diluted eps $10,357,000/11,375,000
share

March 2013 6 Financial Management

(b) (i) Calculation of P/E ratio of VB = Share price / eps = 958 cents/97.8cents = P/E of 9.8.

(ii) The P/E ratio of VB at 9.8 is below that of its competitor at 12.2. The P/E ratio is seen as an
indication of the confidence of the market in an entity in terms of its future growth and profitability
prospects. Therefore it would appear that the market has greater confidence in the growth
prospects of the competitor compared to VB. This confidence could exist because perhaps the
competitor has been established for longer, with a more proven track record for growth.

An alternative way to look at the P/E ratio is to consider the risk of each investment. Typically,
the lower the P/E ratio, the higher the perceived risk for the investor. This would indicate that VB
is considered by the market as a riskier investment than the competitor, hence why there is
greater confidence in the competitor.

However, there are other reasons why the P/E ratios are different. For example, it’s possible that
the share price for VB has been temporarily depressed, maybe as the result of a profits warning
or the loss of a major contract at the year end. Conversely, the competitor’s share price might be
inflated in anticipation of a takeover.

Financial Management 7 March 2013

 Question Four

Rationale

This question tested the accounting of financial instruments, specifically an asset held at fair value
through profit or loss. The preparation of the journal for initial and subsequent measurement tested
three key areas – treatment of transaction costs, the subsequent measurement at fair value and
the recording of the gain/loss through profit or loss in the period.

The second part of the question tested the classification and initial recording of a convertible
instrument and then subsequent measurement of the liability element. This tested the candidates
understanding of the substance of instruments and then the detailed working of amortised cost
which is a key calculation for investments and liabilities at F2.

This question tested learning outcomes B1 (d) and (e).

Suggested approach

Candidates should have prepared at least two journal entries – one on initial recording of the
investment with transaction costs being written off to p/l and the second showing the amount of
uplift in value with the gain recorded in profit for the period.

The second part of the question required some narrative demonstrating that candidates knew why
the recording of the instrument would be split – liability and equity.

Although no initial journal entry was required, candidates had to calculate the opening value of the
liability to enable them to subsequently measure the liability using amortised cost.

Candidates should have relied on their understanding of PV calculations to ascertain the PV of the
principal amount of the liability and the PV of the interest annuity. The residual balance should
then have been clearly labelled to equity – candidates could have prepared a journal entry to
illustrate their answer, although it was not specifically required.

(a) (i) Initial recording

Dr investment – HFT asset $600,000
Dr finance costs in profit or loss $30,000
Cr bank $630,000
Being the recording of 100,000 shares purchased at $6 per share and writing off the related
transaction costs of $30,000 to profit or loss, as the investment is held for trading.

Subsequent measurement
Dr investment – HFT asset $40,000
Cr profit or loss – gain $40,000

Being the uplift in value in the HFT asset at 31 December 2012 ($640,000 - $600,000)

March 2013 8 Financial Management

(b) (i) IAS 32 requires that the equity and liability elements within convertible instruments be initially
recognised separately. The initial carrying amount of the liability is estimated by measuring the fair
value of a similar instrument that has no conversion element. This is achieved by calculating the
present value of the future cash flows associated with the instrument assuming that it is not
converted on redemption (ie: the interest and principal repayment cash flows) discounted at the
prevailing market rate for a similar instrument without conversion rights. The difference between this
amount and the proceeds of issue (ie: the residual) is recognised as equity.

(ii) Value of liability as at 31 December 2013

Opening balance Finance cost at 8% Interest paid 6% Closing balance

$000 $000 $000 $000
9,206 (W1) 737 (600) 9,343

Working 1

Liability element $000

PV of the principal (at 8% for 5 years) = ($10m x 0.681) 6,810
PV of interest of 6% on $10m for 5 years = ($10m x 0.06 x 2,396
3.993)
Total value of liability element 9,206

Financial Management 9 March 2013

Question Five

Rationale

Section D of the syllabus has limited content, but candidates are expected to be aware of
developments in voluntary reporting. This question tested their knowledge of voluntary reporting
but more importantly required them to apply their knowledge and consider the impact from the
investors’ perspective.

This question tested learning outcome D1(c).

Suggested Approach

The only approach necessary was to ensure that all comments were made to specifically answer
the question – the focus of the question parts were in bold to assist candidates.

(a) Social aspects

WRT operates in many different communities and so investors will be keen to know how the entity
interacts with all the various communities. It will be important for the entity to have clearly stated
policies relating to social responsibility and processes in place to ensure that all the divisions are
adhering to entity guidelines and complying with employment laws, which could be different
across the divisions if they are located in different countries. Failure to comply with local laws
could lead to penalties and damage to the entity’s reputation.

Investors will be concerned about the health and safety measures adopted by the entity, showing
a commitment to good social responsibility and once again adhering to local laws and avoiding
penalties.

Investors will also want information on fair pay and a clear indication that the entity is not
exploiting staff or communities as a whole with any of its activities. Investors are likely to be
particularly concerned about operations in countries that are not known for having rigorous
employment laws or effective monitoring procedures. It will be important that WRT makes it clear
that it is committed to a policy of fair pay and that its’ monitoring of foreign operations ensures this
is adhered to

Environmental issues

WRT’s investors will be interested in the level of emissions created by the manufacturing plants to
ensure that they are within legal limits as any breach could result in future losses.

They will also be keen to see that the entity’s policies are intended to minimise the environmental
damage to the local communities in which it operates. This should ensure that the reputation of
WRT remains high.

(b) Limitations

The absence of formal guidance on the content and structure of voluntary disclosures does
reduce the level of comparability between entities, because different definitions and measurement
bases will be used. In addition, reporting entities are free to choose the information they wish to
report which often results in the voluntary disclosures being more of a PR exercise whereby
entities only report the positive aspects.

March 2013 10 Financial Management

 Voluntary information is not likely to be audited and therefore may not be reliable. This reduces
the usefulness of the information.

The inclusion of voluntary disclosures will incur additional costs of preparation and therefore
reduces the future returns available to shareholders.

Financial Management 11 March 2013

SECTION B

Question Six

Rationale

The question was the main consolidation question and required the preparation of the statement
of cash flows for a group. The question included a disposal of a subsidiary in the period, which
was the main complexity from the group perspective but also had adjustments for PPE, share
capital and an associate.

This question tested learning outcomes A1 (a) and (b).

Suggested Approach

Candidates should have followed a logical approach to preparing the CFS. Annotating the
question to familiarise yourself with the question and the cash/non-cash adjustments can be time-
saving in the longer term. Ensuring they dealt with both the direct impact of the disposal – the
gain and the cash raised (less the cash lost); and the indirect impact – removing the subsidiary
from the opening SOFP balances was a key part of the question.

March 2013 12 Financial Management

 Consolidated statement of cash flows for the DF Group as at 31 December 2012:

All workings in $000

Cash flows from operating activities (workings in 000’s) $000 $000

Profit before tax 6,570
Add back non-operating and non-cash items:
Depreciation 3,100
Gain on sale of subsidiary $(8,140 - 4,400) (3,740)
Goodwill impairment (W1) 200
Share of profit of associate (2,100)
Finance costs 1,350
Changes in working capital:
Increase in inventories (W2) (2,400)
Increase in receivables (W2) (3,800)
Increase in payables(W2) 6,300
Cash inflow from operating activities 5,480
Less interest paid (1,350)
Less tax paid (W3) (2,700)
Net cash inflow from operating activities 1,430

Cash flows from investing activities

Acquisition of property, plant and equipment (W4) (7,810)
Disposal of subsidiary, net of cash disposed of $(8,140 – 200) 7,940
Dividend received from associate (W5) 1,100
Cash inflow from investing activities 1,230

Cash flows from financing activities

Proceeds of share issue (W6) 4,400
Dividend paid to shareholders of parent (W7) (2,000)
Dividend paid to non-controlling interest (W8) (2,410)
Repayment of long term borrowings $(48,000 – 42,000) (6,000)
Cash outflow from financing activities (6,010)

Net outflow of cash and cash equivalents (3,350)

Cash and cash equivalents at 1 January 2012 12,300
Cash and cash equivalents at 31 December 2012 8,950

Workings

1. Goodwill $000
Opening balance 7,200
Impairment (balancing figure) (200)
Closing balance 7,000

2. Changes in WC Inventories Receivables Payables

$000 $000 $000
Opening balance 36,000 26,400 30,600
On disposal (3,600) (2,000) (3,800)
32,400 24,400 26,800
Movement (bal figure) 2,400 3,800 6,300
Closing balance 34,800 28,200 33,100

Financial Management 13 March 2013

 3. Tax paid $000
Opening balance 2,700
Tax on profit 3,800
6,500
Movement (balancing figure) 2,700
Closing balance 3,800

4. Acquisition of PPE $000

Opening net book value 44,400
On disposal (2,400)
42,000
Depreciation (3,100)
38,900
Additions (balancing figure) 7,810
Closing balance 46,710

5. Dividend received from associate $000

Opening balance 23,400
Share of profit of associate 2,100
25,500
Dividend received from associate (balancing figure) (1,100)
Closing balance 24,400

6. Proceeds of share issue $000

Opening balance 30,000
Bonus issue 10,000
40,000
Issue for cash (balancing figure) 4,400
Closing balance (42,000+2,400) 44,400

7. Dividends paid to shareholders of parent $000

Opening balance 20,100
Bonus issue (10,000)
Profit for year attributable to equity holders 2,160
12,260
Dividend paid (balancing figure) (2,000)
Closing balance 10,260

8. Dividend paid to non-controlling interest $000

Opening balance NCI 18,300
NCI share of profit for year 610
18,910
Dividend paid to NCI (balancing figure) (2,410)
Closing balance NCI 16,500

March 2013 14 Financial Management

 Please turn over for answers to question seven

Financial Management 15 March 2013

Question Seven

Rationale

Question 7 tested financial analysis, as would have been expected. The question required
consideration of both the financial performance and the financial position, from the perspective of a
potential lender. As with previous questions, candidates were required to identify ratios that would
be relevant to the scenario, correctly calculate them and then form an opinion of the entity’s
position from a specific perspective.

The second part required a brief explanation of limitations of ratio analysis.

This question tested learning outcomes C1(a), C2(b) and C2(d).

Suggested Approach

The question was typical of what candidates have seen in previous diets – reviewing financial
performance and position but within the bounds of a specific scenario – in this case a lending
application. The candidates should have considered which ratios would have been of interest to a
potential lender and focussed on them – ensuring they had sufficient coverage for financial
performance and position. Staying focussed on the scenario was essential – no requirement for
further information, or recommendation of improvements.

(a) Report to lending department

Re QW – application for $50 million
Review of financial performance and position of QW
Date – 1 March 2013

The annual report highlights a 44% increase in revenue as a result of the entity’s expansion, which is
indeed the case; however this has been achieved at the expense of profitability. The gross margin
has fallen from 29.8% to 27.6%, a drop in the margin of 2.2% in the year, suggesting lower selling
prices have been used to attract new customers.

At first glance it appears that overall profitability has recovered slightly from the drop in the gross
margin, as the profit for the year margin has fallen from 7.5% to 5.9% (a drop in margin of 1.6%).
However much of the profit for the year is attributable to the share of profits from the associate.
Excluding the associate’s return results in the profit for the year margin falling to 4.1%, an overall drop
of 5.4% in the margin, which is worrying. This significant fall in profit is due mainly to an increase in
distribution costs, which have increased 77% in the period. It looks like the expansion has been
geographical with either goods been shipped further or new distribution centres being set up.
Inventories at the year-end have increased significantly, suggesting it is more likely to be the latter.
The additional finance costs have also contributed to lower profit, with interest on both new long-term
borrowings and the introduction of an overdraft in the period.

The return on capital employed (excluding the associate) has also fallen, although this could be partly
affected by the revaluation in the year. There is no doubt, however that the comments from the CEO
are overly positive, as the expansion has had a negative impact on the financial performance of the
operating business of QW. In addition, receivables have increased, likely to be the extension of credit
offered to attract new custom. This is appropriate when an entity has the working capital to allow it,
but this is not the case for QW.

March 2013 16 Financial Management

The gearing has increased significantly from 41.7% to 68.0% resulting from the increased loans and
short-term borrowings. This is in spite of a revaluation in the year and gains recorded through
reserves which has boosted equity in the period. QW has used up its cash resource and moved to
overdraft which is common during periods of expansion, however to invest $22 million ( $27 million -
$5 million of profit during the year) in another entity during this period appears to be rather a naive
move by the management, as it is clear the cash is needed for an increasing working capital
requirement. A closer relationship with AB may secure distribution channels or more competitive
material costs, which could improve future profitability, although there is no evidence of this so far.

The interest cover would be a concern if the loan was granted, as the majority of the cover is
generated by the associate, an entity for which we have no financial details. This creates an
additional risk. It is surprising that the entity has not taken the opportunity to generate cash by selling
its investments, which are clearly performing well and would therefore be sold relatively easily.

The CEO also commented on future profitability being generated by the investment in non-current
assets that occurred in the year. However the PPE balance has not increased significantly and much
of the movement could be due to the revaluation in the year. The other investments, the associate
and AFS investment, could generate gains but not revenue and activity. The comments by the CEO
are not necessarily a balanced view of the performance and position in the year and therefore a level
of professional scepticism is required. The results of this analysis questions whether QW is under
competent and careful stewardship and as a result the recommendation would be not to proceed with
the application.

(b) (i) QW has changed its accounting policy in the year in respect of PPE. The move to revaluation
impacts on both financial position (in terms of gearing) and financial performance (in terms of
ROCE, depreciation and profitability). This results in the two years of financial information not
being directly comparable. In addition, the entity has changed its structure with the introduction
of an associate. This affects the comparison of the profitability ratios and asset turnover ratios –
as this is a non-current asset that does not generate revenue.

(ii) The narrative elements are not specifically audited although they should be consistent with
what is reported in the financial statements. The problem is the focus of the comments – QW
revenue is up 44% - what is unsaid, is that performance and profitability have been adversely
affected. The statements can be factually correct but not necessarily balanced which is naturally
designed to draw the readers’ attention away from negative features and therefore cannot
necessarily be relied upon.

Financial Management 17 March 2013

Appendix

2012 2011
(Workings in $000)
Gross profit 80/290 x 100 = 27.6% 60/201 x 100 = 29.8%
GP/revenue x 100%
Operating profit 32 (ie: 80-16-32)/290 x 100 = 28 (ie: 60-14-18)/201 x 100 =
Operating profit/revenue x 100% 11.0% 13.9%
Profit for year 17/290 x 100 = 5.9% 15/201 x 100 = 7.5%
PFY/revenue x 100%
PFY without associate (17 – 5)/290 x 100 = 4.1%

Return on capital employed (32/ (122 +70 + 13 -27) x 100 28/(96 + 40) x 100 = 20.6%
Profit before finance costs/capital = 18.0%
employed x 100% (all exc assoc)
Gearing 70+13/122 x 100 = 68.0% 40/96 x 100 = 41.7%
Debt/equity
Gearing 83/(83 + 122) x 100 = 40.5% 40/(40 + 96) x 100 = 29.4%
Debt/debt + equity
Interest cover (24 + 13 -5)/13 = 2.5 times (21 + 7)/7 = 4.0 times
Profit before finance costs and
associate/finance costs
Receivables days 49/290 x 365 days = 27/201 x 365 days =
Receivables/revenue x 365 days 62 days 49 days
Inventories days 29/210 x 365 days= 13/141 x 365 days =
Inventories/cost of sales x 365 50 days 34 days
Payables days 20/210 x 365 days= 15/141 x 365 days=
Payables/cost of sales x 365 35 days 39 days
Quick ratio 78 – 29/33 = 1.5 45 – 13/15 = 2.1

March 2013 18 Financial Management