f2 september 2012 examiner's answers

Financial Management 1 September 2012

The Examiner's Answers F2 - Financial Management

September 2012

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 test two of the key areas in Syllabus Section B, being retirement benefits and share-based payments. The share-based payment involves the calculation of a cash-settled share-based payment in year two of recognition plus requires an explanation of the measurement and recording of an equity-settled share-based payment. In part (b) the actuarial gains and losses were to be calculated and it was important that candidates demonstrated an understanding of how each element of pensions affects the assets and liabilities of the plan, in addition to the calculation of the net expense recorded in the income statement.

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 are likely to have prepared their workings in this format.

(a) (i) Share-based payment 2011 Eligible employees (500-42-75) = 383 Equivalent cost of SARs = 383 employees x 1,000 rights x FV$9 = $3,447,000 Allocate over 3 year vesting period $3,447,000/3 = $1,149,000 equivalent charge to the income statement in the first year. 2012 Eligible employees (500 -42-28-25) = 405 Equivalent cost of SARs = 405 employees x 1,000 rights x FV$11 = $4,455,000

September 2012 2 Financial Management

Cumulative amount to be recognised as a liability = $4,455,000 x 2/3 years = $2,970,000 Less amount previously recognised = $2,970,000-$1,149,000 = $1,821,000 equivalent charge for the second year. The expense will be recorded as: Dr staff costs $1,821,000 Cr liability $1,821,000 (ii) If a share-based payment was settled in equity rather than cash the implications would be: Recognition: There would be a credit to other reserves within equity in the statement of financial position, rather than a liability. However the debit would still be to staff costs. Measurement: The amount would be initially and subsequently measured using the fair value of the rights at the grant date rather than re-measured at each year end.

(b) Pension plan (i) Income statement expense $000

Service cost 500 Interest cost (8% x $2,400,000) 192 Expected return (5% x $2,200,000) Net expense in profit or loss

(110)

582

(ii) Other comprehensive income

Actuarial gain on plan assets (W1) (140) Actuarial loss on plan liabilities (W1) Net actuarial gain in OCI

58

(82)

Working 1 FV of assets PV of liabilities $000 $000 Opening balance 2,200 2,400 Service cost 500 Interest cost (8% x $2,400,000) 192 Expected return (5% x $2,200,000) 110 Contributions paid in 300 Paid to retired members (450) (450) Actuarial gain on plan assets 140 Actuarial loss on plan liabilities Closing balance

58 2,300

2,700


Question Two

Rationale

This question was intended to test the principles of consolidation. Only the workings for the cash flows for the investing and financing activities section were asked for and the marks were therefore able to be focussed on the areas that are specific to consolidated cash flows, including dividend paid to NCI, dividend from associate, acquisition of a subsidiary in the period, etc. This question examined leaning outcomes A1(a) and A2(b).

Suggested Approach

The most logical approach to preparing a cash flow statement (or parts thereof) is to annotate the statements provided in the question and the additional information, marking each with the section of the cash flow that it will affect, eg share capital and share premium will affect cash flows from financing. Candidates could have drafted the pro-forma headings and worked through the annotated question paper inserting or calculating the cash flow from each.

All workings are in $000

(i) Cash flows from investing activities $000 $000

Acquisition of property, plant and equipment (W1) (2,300) Acquisition of subsidiary, net of cash acquired (300 – 200) (100) Dividend received from associate (W2) 1,300 Cash outflow from investing activities (1,100)

(ii) Cash flows from financing activities Proceeds of share issue (W3) 5,050 Dividend paid to non-controlling interest (W4) (250) Repayment of long term borrowings (26,200 – 20,550) (5,650) Cash outflow from financing activities (850)

1. Acquisition of PPE $000 Opening net book value 22,200 On acquisition 1,200 23,400 Revaluation 1,000 Depreciation (1,200) 23,200 Additions (balancing figure) 2,300 Closing balance 25,500

2. Dividend received from associate $000 Opening balance 5,700 Share of associate’s profit 1,800 7,500 Dividend received from associate (balancing figure) (1,300) Closing balance 6,200


3. Proceeds of share issue $000 Opening balance 15,000 Issued on acquisition (1 million x $2.15) 2,150 17,150 Issue for cash (balancing figure) 5,050 Closing balance (18,000+4,200) 22,200

4. Dividend paid to non-controlling interest $000 Opening balance NCI 9,100 On acquisition (25% x net assets of $2.2m) 550 NCI share of TCI for year 350 10,000 Dividend paid to NCI (balancing figure) (250) Closing balance NCI 9,750


Question Three

Rationale This question was intended to test candidates’ ability to analyse key financial data. The key financial indicators in this case were provided and so candidates were then tested on their ability to draw conclusions about the 3 entities from the ratios given. The limitations were intended to be specific to the acquiring entity in a takeover situation rather than a recall of knowledge. The question tested learning outcome C2(a) and C2(d). Suggested Approach Candidates should have commented on each of the key indicators and draw conclusions about the type of business or environment in which each is operating and comment on the impact that A and B could have on MLR. The limitations should have been specific to the scenario, as per the requirement.

(a) Entity B has almost double the revenue of A and would result in a considerable increase in the size of the combined MLR. Entity A earns a better gross margin than B, 28% as opposed to 19%. Entity B’s gross margin would have a highly negative impact on MLR’s margin. Further investigation would help establish whether the gross margins were as a result of the two entities operating in quite different market conditions, as entity B’s strategy may be for low margin and high volume.

Both A and B have similar net profit margins, although significantly below that achieved by MLR. A combination with either entity would have a negative impact on MLR. Entity A earns only a 10% net margin from a 28% gross margin, suggesting that it is subject to significant overheads. It may be, as a smaller entity, it is not able to take advantage of economies of scale or has a high level of fixed costs. Alternatively, it could be an indicator of poor cost control by management. The net profit of A will also have been affected by the finance costs incurred. Although paying a lower rate of interest, entity A is highly geared and hence is likely to have a significant level of finance costs which will lower the net profit. The smaller differential between gross and net margins for B may well be the result of management’s efforts to keep costs under control and such efficient management strategies may be a positive sign for MLR. The differences between the gross and net margins could also be an indication that the entities are operating in countries with different tax regimes to each other and indeed to MLR.

The gearing of A will have a negative impact on the financials of MLR. Normally such high gearing would suggest the entity is high risk. However, entity A is able to borrow at much lower rates than the other entities and so this could be a deliberate strategy to take advantage of relatively cheap financing. In contrast, entity B’s low gearing could provide MLR with the opportunity to take advantage of the additional borrowing capacity of B. However, the average rate of interest of 10% may be a deterrent.

The P/E ratio is an important ratio for investors and MLR’s P/E would be adversely affected by acquisition of either entity, with entity B minimising the negative impact. Entity A’s risk profile may be affected by the level of gearing but until the markets are investigated further it is difficult to assess the relative risk of either entity.

(b) The limitations of using this form of analysis to MLR include the following:


• The entities are listed on different stock exchanges and so may prepare their financial statements using different accounting standards. This will reduce the comparability of the financial indicators.

• The ratios provided do not cover the relative efficiency of the entities and whether or not their management styles would complement MLR.

• The entities might apply different accounting policies that could impact on the ratios, eg equity could be boosted by a revaluation of non-current assets which would reduce the gearing ratio and could mask an increase in borrowings.

• Using only one year’s worth of data gives no indication of whether the entities are in a growth phase or in decline.


Question Four

Rationale This question tested the classification and measurement of a held to maturity investment and the ability of the candidates to calculate amortised cost. The second part tested the treatment of a derivative instrument where hedge accounting is adopted. The question tested learning outcomes B1(d) and B1(e). Suggested approach Candidates should have been able to identify a held to maturity investment from the information given in the question. The calculation of amortised cost should have been straightforward provided candidates realised that it was an investment and not a liability. For part (b), provided candidates understand that hedge accounting is largely about changing the rules of recognition for a derivative that is linked to another item, the first few marks should have been easy to attain.

(a) (i) The investment should be classified as held to maturity investment because EMR intends to

hold the investment until its redemption date. Initially the investment will be measured at its fair value (which in this case is its cost), plus any associated issue costs. The initial journal entry required is therefore:

DR: Investment in HTM investment $4,200,000 CR: Cash $4,200,000

(ii) Subsequent measurement

Year end 30 June

Opening balance

Effective interest 8.4%

Interest received 7% x $4m

Closing balance

$000 $000 $000 $000 2011 4,200 353 (280) 4,273 2012 4,273 359 (280) 4,352

The investment will be held at $4,352,000 in the statement of financial position at 30 June 2012.

(b) This forward contract is an example of a derivative and in accordance with IAS 39 such derivative

contracts are classified as an asset or liability held at fair value through profit and loss. This would mean that at each year end the contract would need to be re-valued to its fair value (being the difference between the derivative price and the market price of the underlying asset under the contract). Any gains or losses would usually then be recorded in profit or loss. However this contract is specifically intended to mitigate the risk of future adverse cash flows as a result of potential increases in raw material prices. This contract is therefore being used as a cash flow hedge (because it’s being used to fix the price of material to be acquired in the future on 1 August). In such circumstances IAS 39 has some special hedge accounting rules. Hedge accounting allows the gains or losses on a derivative contract being used in a cash flow hedge to be taken to reserves until the cash flow it is designed to hedge against is recognised in the financial statements. In this case, the gains or losses will be held in reserves until the year ended 30 June 2013, which is the year in which the cash flow is actually incurred, and then released to the profit or loss.


In this case, a loss on the derivative of $400,000 (100,000 x $(105-101)) will be included in reserves at 30 June 2012.


Question Five

Rationale This question tested Section D of the syllabus, and required an element of application by candidates. Human capital accounting and intellectual property are areas that candidates should 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 require them to focus on the specifics of the question. The key element being the recognition principles of IFRS. Part (b) focussed on the increasing voluntary disclosures and the benefits to investors and part (c) asked for limitations of these voluntary disclosures.

(a) Recognition The framework defines an asset as a resource controlled by an entity and from which economic benefits will flow. The amount also has to be measured with sufficient reliability to be recognised in the financial statements. The value associated with human capital cannot be controlled as employees are free to leave, taking their skills elsewhere. In addition, the amount of potential value created is uncertain. There is no way of measuring this with sufficient reliability. Therefore human capital is not recognised in the financial statements.

(b) Pressure to extend narrative reporting and advantages to investors Financial statements are by their nature backward-looking, based primarily on historical information and are therefore limited in their usefulness for decision-making by investors. In addition, this entity is service-based and as the main resource is not included on the financial statements it is difficult for users to estimate future revenue streams. This has led to general pressure by the markets and investors for entities to provide additional information to that contained in the financial statements. Investors in SR would benefit in this case from additional information on the resources available to the entity in order to generate future revenue. This information could be useful for users in estimating future profits and returns. It would also help users identify any key personnel or skills that the entity relies on and this helps users determine the risks that threaten the future income streams of SR. In addition, it would help show the hidden assets of the business without which traditional ratios like ROCE are meaningless, preventing comparison with other entities.

(c) Potential drawbacks The absence of formal guidance on the content and structure of voluntary disclosures does reduce the level of comparability between entities. 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 by only reporting the positive aspects. 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.


Question Six

Rationale This question tested consolidation. The first section tested the basics of preparing a statement of financial position for a group, including the calculation of goodwill, NCI and group retained earnings. The complex area tested in part (a) was acquiring a controlling interest in the year but the basic consolidation techniques accounted for more than 80% of the marks. Part (b) dealt specifically with an acquisition (control to control) and an adjustment to parent’s equity. 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 the SOFP and then systematically work through the headings, preparing consolidation adjustments where required. Annotating the additional information highlighting the balances that require adjustment is always a worthwhile exercise.

(a) Consolidated statement of financial position for the AB Group as at 30 June 2012: All workings in $000

AB ASSETS $000 Non-current assets Property, plant and equipment (58,000+8,500+760(W1)) 67,260 Goodwill (W2) 325 67,585 Current assets Inventories (15,500 +2,000 - 125 (W3)) 17,375 Receivables (16,500 + 4,750) 21,250 Cash and cash equivalents (3,000+ 750) 3,750 42,375 Total assets 109,960 EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) 50,000 Retained earnings (W4) 19,935 Other components of equity (W5) - 69,935 Non-controlling interest (W6) 3,025 Total equity 72,960 Non-current liabilities (9,750 + 2,000) 11,750 Current liabilities (20,250+ 5,000) 25,250 Total liabilities 37,000 Total equity and liabilities 109,960


Working 1 FV adjustments $000 $000 $000 Uplift in PPE 800 Additional dep’n (800/10 yrs x 6/12) (40) 760

Working 2 Goodwill $000 $000 Consideration transferred for the 60% 5,175 Fair value of 10% holding at 1 January 2012 1,000 Fair value of non-controlling interest 2,700 8,875 Net assets acquired: Share capital 2,500 Retained earnings (6,500 – (2,500 x 6/12)) 5,250 FV adjustment (W1) 800 (8,550) Goodwill at acquisition 325

Working 4 Retained earnings AB CD $000 $000 As at 30 June 2012 18,975 6,500 Pre-acquisition (W2) (5,250) Less unrealised profit of CD (W3) (125) FV adjustment (W1) (40) Group share 70% 760 1,085 Group profit on derecognition of AFS Investment – to deemed disposal date, 1 January 2012 (1,000 – 800)

200

Consolidated retained earnings 19,935

Working 5 Other components of equity and AFS investments $000 Cost of 60% investment (1 Jan 2012) 5,175 Cost of 10% investment (1 Feb 2009) 800 Therefore, cost of 70% investment 5,975 Compared with fair value of 70% investment (30 June 2012) 7,000 Resultant gain recognised by AB in individual accounts since 1 Feb 2009 and balance in other reserves of AB

1,025

This gain will be removed from the consolidated accounts as the group gain on derecognition of the original investment is the relevant figure for the consolidated accounts, leaving a balance of NIL in the group accounts for other reserves.

Working 6 Non-controlling interest $000 Fair value at 1 January 2012 2,700 Plus 30% adjusted post-acquisition reserves of 1,085 (W4) 325 NCI at 30 June 2012 3,025

Working 3 Unrealised profit on inventories $000 Sales from CD to AB 1,000 50% in inventories 500 Profit margin 25% 125


(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 $000 Dr Reduction in NCI at 1 July 2012 (10/30% x $3,025,000)

1,008

Dr Retained earnings 164 Cr Bank - consideration transferred 1,172 Being adjustment to parent’s equity


Question Seven

Rationale The question was a standard-style analysis question covering Section C of the syllabus. Candidates were required to calculate EPS and P/E and then select and calculate a further 6 ratios in order to analyse the financial performance and position of the entity. This question tested learning outcomes C1(a), C2(a) and C2(b). 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’ recommendations based on the information available and then highlighted the post-year end info that could be available to investors.

(a) Earnings per share 2012 2011

Profit attributable to parent $8,000,000 $14,000,000 Equity shares in issue 20,000,000 20,000,000 Eps 40 cents 70 cents P/E ratio Share price $2.50 $4.34 Eps 40 cents 70 cents P/E (share price/eps) 6.25 6.2

(b) Report to client Re TYU Gross profit margin has fallen from 35% to 32.4%, which is likely to be a direct impact of the pressure on selling prices from the new market entrant. TYU appears to have reacted well to this and has controlled expenses resulting in an increase in operating profit margin from 4.9% to 5.2%. This indicates TYU management are reasonably able to react quickly and positively to changes in economic conditions. The profit for the year has reduced but largely due to the loss making activities of the associate. The attention to cost control has resulted in ROCE increasing, despite the increase in capital employed from the revaluation of PPE. The current ratio has fallen significantly although still offers sufficient cover of liabilities, however the quick ratio shows that TYU have an immediate problem that threatens going concern. The quick ratio has fallen from 1.1 to 0.5 at the year-end. This is due to issues with all the component parts of working capital. Cash has fallen from a positive $24m to an overdraft of $47m and is dangerously close to breaching the agreed banking terms for short-term borrowings. This may have been the motivation for holding back on payments to creditors, resulting in an increase in payables days from 109 days to 156 days. This increase is unlikely to have been authorised as TYU was already being extended 3 months of credit. This is likely to put TYU in an unfavourable position with its suppliers, not a good position when the suppliers have a new entrant to switch to. Despite the cash crisis, TYU has failed to collect its debts timeously, with receivables days sliding from 61 days to 64 days. Inventories days have also increased significantly from 100 days to 167 days at the year-end. This may indicate TYU has an issue with obsolete inventory resulting from the inflow of cheaper products in the market.


Conversely, it could mean that TYU has been stocking up at the year-end for a concerted sales promotion to combat the competition. Gearing has increased during the year due to the increase in short-term borrowings, despite the fact that there has been a revaluation in the year. The change in revaluation policy may be a deliberate attempt to boost equity and make the gearing level appear more attractive, to enable TYU to raise additional long-term finance. Although this is sometimes seen as misleading, it is a commercially valid adjustment as the property is likely to act as security for any loan and having an updated valuation makes good business sense. The interest cover however has dropped from 3.8 to 1.8 and shows an increased risk. This increased risk is reflected in the average rate of borrowing which has increased from 8.9% to 13.9%. The short-term borrowings are being charged at a much higher rate and it is imperative that TYU secures longer-term finance to ease the cash flow issue, pay suppliers and hopefully lower interest payable. TYU announced a final dividend despite the cash crisis suggesting that it is under significant pressure from shareholders to provide a return. The P/E ratio has remained constant despite the reduction in earnings per share, which suggests that investors still have confidence in the management of TYU.

Conclusion Despite the current cash crisis the management team appears to have reacted positively to the market pressures, by reducing prices to be more competitive and by actively cutting costs to maintain margins. Provision of longer-term finance would enable TYU to pay suppliers and meet interest payments which must be seen as a priority. TYU remains a possible target for investment, although some additional information is required.

(c) Additional information

The post-year end situation will, to a certain extent, answer the main questions raised about cash availability. If the dividend has been paid, then this suggests that finance has in fact been raised. Corporate research will highlight if the entity’s suppliers have taken action to recover amounts due – if not, then it is likely again that finance has been raised/generated and supplier accounts settled. It must be remembered that there will be limited information in the public domain, but if TYU has survived this cash crisis then it indicates a strong management team and an investment that is worth pursuing.


Appendix A – Ratios

Relevant ratios that could be calculated include:

All workings in $m 2012 2011 Gross profit margin (GP/Revenue x 100)

220/678 x 100 = 32.4% 216/618 x 100 = 35.0%

Operating profit (Profit before associate and finance costs/revenue x 100)

35/678 x 100 = 5.2% 30/618 x 100 = 4.9%

Profit margin PFY/revenue x 100

11/678 x 100 = 1.6% 17/618 x 100 = 2.8%

ROCE % Operating profit/capital employed

35/(409+90+47-21) x 100 = 6.7%

30/(404+90 -24) x 100 = 6.4%

Inventories Inventories / cost of sales x 365

210/458 x 365 = 167 days 110/402 x 365 = 100 days

Payables Payables/cost of sales x 365

196/458 x 365 = 156 days 120/402 x 365 = 109 days

Receivables Receivables /revenue x 365

118/678 x 365 = 64 days 103/618 x 365 = 61 days

Current ratio Current asset/current liabilities

328/243 = 1.3 237/120 = 2.0

Quick CA – inventories/current liabilities

118/243 = 0.5 127/120 = 1.1

Gearing Debt/Equity

(90 + 47)/409 x 100 = 33.5% 90/404 x 100 = 22.3%

Gearing Debt/Debt + Equity

(90 + 47)/(409+90+47) x 100 = 25.1%

90/(404+90) x 100 = 18.2%

Interest cover Operating profit/finance cost

35/19 = 1.8 times 30/8 = 3.8 times

Average cost of lending Finance costs/interest bearing borrowings

19/(90 + 47) x 100 = 13.9% 8/90 = 8.9%

f2 september 2012 examiner's answers

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