F1 May 2012 answers

Operational Level Paper

F1 – Financial Operations May 2012 examination

Examiner’s Answers Note: Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike.

SECTION A Answer to Question One

Rationale Question One consists of 10 objective test sub-questions. These are drawn from all sections of the syllabus. They are designed to examine breadth across the syllabus and thus cover many learning outcomes.

1.1 Under the OECD model tax convention an entity will generally have residence for tax purposes in the country of its effective management.

1.2

$

Input tax 32,333 x 15% = Output tax 63,250 x 15/115 = VAT due to be paid

(4,850) 8,250 3,400

Answer $3,400

1.3

B

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1.4

Any two from: • • • • • •

Power to review and query filed returns Power to request special reports or returns Power to examine records Powers of entry and search Power to exchange information with tax authorities in other jurisdictions Power to impose penalties

1.5

D

1.6

D

1.7

C

1.8

B

1.9

A

1.10 $1,000,000 x discount rate 0.500 = $500,000 Answer C

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SECTION B Answer to Question Two

(a) Rationale To test the candidates’ understanding of the need for a statement of cash flows.

Tests learning outcome C1a.

Suggested Approach Explain the benefit, to users of the accounts, of including a statement of cash flows in published financial statements.

The benefits to users of financial statements of having a statement of cash flows included in them are: (i) (ii) (iii) (iv) (v)

(vi)

It can help users assess the liquidity and solvency of an entity. Adequate cash is required to pay debts and dividends when due, the cash flow shows the cash available.

It helps users assess financial adaptability. If an entity is able to turn inventory into cash it can reinvest in new inventory or activities.

It can help users to assess future cash flows. Current cash flows can be used to project future cash availability.

It can assist users in valuing the entity if they use the discounted cash flow model.

It provides enhanced comparability between entities as cash flows are not subjective and remain the same regardless of the accounting policies used by different entities for the same type of transactions.

It helps users identify the differences between cash flow and profit. It can help highlight where cash is being generated and where it is being spent. May help indicate problems early on.

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(b) Rationale To test the candidates’ understanding of deferred tax and provisions for income tax.

Tests learning outcome A1e.

Suggested Approach Explain how the deferred tax provision may have arisen.

Identify the most likely reason for an increase in deferred tax provision.

Explain what the over provision of $50,000 represents.

(i)

Deferred tax is the estimated future tax consequences of transactions and events that have been recognised in the financial statements of the current and previous periods.

Deferred tax arises due to the temporary differences between the accounting profit and the taxable profit. The temporary differences cause the carrying value of some items in the statement of financial position to be different from their tax base (the amount recognised for tax calculation).

(ii)

TX’s statement of comprehensive income shows an increase in deferred tax, this suggests that temporary differences increased by $800,000 in the year to 31/3/2012. The main reason was probably an increase in non-current assets causing the tax depreciation to be $800,000 more than the accounting depreciation for the year to 31/3/2012, thus causing the increase of $200,000 in deferred tax provision.

(iii) Current tax is the estimated amount of corporate income tax payable on the taxable profits of the entity for the period. The amount of current tax is accrued in the financial statements and carried forward as a current liability to the next accounting period when it will be paid. When the tax is paid there will usually be a difference between the amount paid and the amount accrued. If the amount paid is less than the amount accrued there will be an over provision of income tax. The amount over provided will be an adjustment to the income tax expense in the following period. In TX the current tax estimate for year to 31 March 2011 was $650,000, the statement of cash flows shows that $600,000 was paid in the following period leaving a balance of $50,000 over provided.

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(c) Rationale To test the candidates’ understanding of income tax calculations.

Tests learning outcome A3a.

Suggested Approach Calculate the tax due in Country X. Calculate the tax paid in Country Z. Calculate the net tax payable in Country X.

PQ Tax Calculation for year ended 31 March 2012 $000 387 (85) 100

Accounting profits before tax Less finance income after tax Add gross finance income Add back: Depreciation Amortisation

92 14 508 98 410

Less tax depreciation Taxable profits Tax at 25% Less tax suffered on foreign interest received: Gross interest 85 x 15 / 85 = Tax due

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102.5 (15) 87.5

Financial Operations

(d) Rationale To test the candidates’ understanding of indirect tax.

Tests learning outcome A1b.

Suggested Approach Explain the difference between an excise duty and a single stage sales tax.

Describe the characteristics of commodities suitable for excise duty.

(i)

Excise Duty is a selective commodity tax, levied on certain types of goods. It is a unit tax based on the weight or size of the tax base. E.g. Petroleum products, tobacco products alcoholic drinks and motor vehicles.

Single stage sales tax is a more general consumption tax. It is applied at one level of the production/distribution chain only. It can be applied to any level but when it is used in practice it is most often applied at the retail sales level. Single stage sales taxes are levied as a percentage of value, e.g retail sales value.

(ii)

From the revenue authority’s point of view, the characteristics of commodities that make them most suitable for excise duty to be applied are: • Few large producers • Inelastic demand with no close substitutes • Large sales volumes • Easy to define products covered by the duty

(e) Rationale To test candidates’ understanding of the IASB Framework.

Tests learning outcome B1d.

Suggested Approach Define income and equity in accordance with the IASB Framework.

Explain the criteria that must be met for income and equity to be recognised in an entity’s financial statements.

(i)

Income: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to combinations from equity participants; Equity: Residual interest in the assets of the entity after deducting all its liabilities.

(ii)

Income is recognised if: • It meets the definition of income in (i) above.

• The increase can be measured reliably.

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(f) Rationale To test candidates’ understanding of the need for an external audit.

Tests learning outcome B1g.

Suggested Approach Prepare a short briefing note listing the benefits of an audit.

Briefing Note To: Chief Executive The benefits of having an external audit carried out each year: •

• • •

•

The external audit should give an independent opinion on the truth and fairness of the accounts and therefore the shareholders should have comfort that there is no material error or misrepresentation of the financial position of the entity in the statements presented Whilst the auditors are conducting the audit they will consider the controls in place and may be able to give constructive advice to management Whilst the purpose of the audit is not to find fraud, the fact that an external review is taking place is likely to act as a fraud deterrent Applications to third parties for finance may be enhanced Avoids breaking the law, for some entities an audit is not an option. Local legislation relating to entities may require an annual independent audit to be carried out. Local stock exchange regulations will usually require an annual audit.

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SECTION C Answer to Question Three

Rationale To test candidates’ ability to prepare a set of financial statements for a single entity, including the application of a number of IFRS/IAS. Tests learning outcome C1a.

Suggested Approach Briefly explain how items (vi) and (vii) should be treated by DFG in its financial statements for the year ended 31 March 2012.

Prepare the non-current asset depreciation calculations.

Prepare workings for cost of sales, administration and distribution.

Prepare all other required workings.

Prepare the statement of comprehensive income.

Prepare the statement of financial position.

Prepare the statement of changes in equity.

(a) Item (vi) revenue recognition: IAS 18 specifies five conditions that must be met before revenue can be recognised. The first two conditions: • that significant risks and rewards of ownership of the goods have transferred to the buyer • the entity selling does not retain any influence or control over the goods are not satisfied by this customer order as no goods have been despatched.

DFG should not recognise any revenue in its financial statements for the year ended 31 March 2012 and should record the deposit received as a current liability.

Item (vii) impairment of intangible non-current assets: An asset should be reviewed for impairment whenever circumstances indicate that an impairment may have occurred. Due to recent economic circumstances a review has been carried out of the patent. An impairment occurs where the asset’s carrying value is more than the higher of its value in use and its fair value less cost to sell. The patent’s carrying value at 31 March 2012, $54,000 (after annual amortisation of $9,000) is more than the higher of its value in use of $50,000 and its fair value $47,000. Therefore an impairment has occurred and the patent must be written down by $4,000 to $50,000.

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(b) DFG - Statement of comprehensive income for the year ended 31 March 2012 $000 Revenue (1,200 – 15) 1,185 Cost of sales (W3) (642) Gross Profit 543 Administrative expenses (W3) (236) Distribution costs (W3) (90) (326) Profit from operations 217 Finance cost (W4) (14) Profit before tax 203 Income tax expense (W5) (77) Profit for the period 126 Statement of Changes in Equity for the year ended 31 March 2012

Balance at 1 April 2011 Profit for period Dividend paid Balance at 31 March 2012

May 2012

Equity shares

Share premium

Retained earnings

Total

$000 550

$000 110

550

110

$000 121 126 (55) 192

$000 781 126 (55) 852

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DFG Statement of Financial Position at 31 March 2012 Non-current assets Patent (W2) Property, plant and equipment Buildings (W1) Plant and equipment (W1) Current assets Inventory Trade receivables Total assets

50 906 171

186 135

1,077 1,127

321 1,448

Equity and liabilities Equity Share capital Share premium Retained earnings Total equity Non-current liabilities 5% Loan notes Deferred tax (W6) Total non-current liabilities Current liabilities Trade payables Cash and cash equivalents Tax payable Interest payable Pre-paid deposit Provisions Total current liabilities Total equity and liabilities

550 110 192 852

280 90 370

61 56 52 7 15 35 226 1,448

Workings (All figures in $000) (W1)

Depreciation Buildings Charge for year Balance b/fwd Balance c/fwd Carrying value

960 – 260 = 700 x 3% = 21 33 54 960 – 33 – 21 = 906

Plant and equipment Cost balance b/fwd Year’s depreciation Other P&E cost Depreciation already charged Carrying value at 1/4/2011 Annual depreciation (over two years) Year’s depreciation P&E Carrying value at year end

480 – 120 = 360 360 x 12.5% = 45 120 120 x 12.5% x 4 = 60 60 30 45 + 30 = 75 (480 – 234 – 45 – 30) = 171

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(W2)

Patent Balance b/fwd – cost - amortisation Annual amortisation to 31/03/12 Carrying value 31/03/12 Value in use Impairment

90 27 63 9 54 50 4

(W3) Cost of sales Trial balance: Provision Depreciation – buildings (W1) Depreciation – plant and equipment (W1) (45 + 30) Patent amortisation/impairment (W2) (9 + 4)

554

(W5) Tax Last year adjustment Current year Increase in deferred tax

Distribution Costs 90

236

90

75 13 642

(W4) Interest Paid in year Due for year (280x5%) Accrued

Administrative expenses 180 35 21

7 14 7

10 52 15 77

(W6) Deferred Tax Balance b/f 75 Current year 15 90

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Answer to Question Four

Rationale To test candidates’ ability to prepare journal entries to record a share issue.

To test candidates’ ability to prepare a set of financial statements for a group of entities Tests learning outcomes C 2 b and C 1 c and d.

Suggested Approach Prepare a journal entry to record the purchase of River in Loch’s accounting records.

Calculate goodwill arising on acquisition of River.

Calculate investment in associated entity Stream.

Prepare workings for intra-group activities.

Calculate consolidated retained earnings.

Prepare the consolidated statement of comprehensive income.

Prepare consolidated statement of financial position.

(a) Consideration for River paid in shares: Cost $950,000; share market value $2. Therefore Loch issued 475,000 shares at a premium of $475,000.

Journal

Investment in River Equity shares Share premium

Dr $000 950

Cr $000 475 475

(b) Investment of Loch in River Loch purchased all 600,000 shares in River on 1 April 2011.

100% shares purchased therefore treat River as wholly owned subsidiary of Loch from 1 April 2011.

Investment of Loch in Stream Loch purchased 156,000 of Stream’s 520,000 shares on 1 April 2011.

This gave Loch 30% of Stream’s equity.

As Loch has in excess of 20% of Stream’s equity and can exercise significant influence over all aspects of Stream’s financial and operating policies Loch will treat Stream as an associated entity from 1 April 2011.

Workings (All workings in $000) (i) Fair value of net assets of River at acquisition Equity Shares 600 Retained earnings 130 144 Fair value adjustment 874

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(ii) Goodwill - River Cost Fair value of net assets acquired: Goodwill Impairment Balance at 31 March 2012

950 874 76 20 56

(iii) Investment in associate - Stream Cost Add group share of post acquisition profits (125 - 45) = 80 x 30% = Investment at 31 March 2012

223 24 247

(iv) Intra-group trading Mark up on cost 50% = 50/150 or 33.3% margin on selling price.

Selling price 220; unrealised profit = 220 x 33.3% = 73 All goods remain in inventory, adjust inventory by 73 Dr. Consolidated cost of sales Consolidated current assets - inventory Consolidated revenue Consolidated cost of sales

Current accounts: Loch current account with River Less cheque in transit River current account with Loch

Cr.

73 73 220 220

101 26 75 75

Cancels Cancels

Dr

Cr

Loan interest: Accrue interest receivable by Loch: In books of Loch: Receivables - interest Interest receivable - SoCI Adjustments on consolidation: Receivables - interest Loan interest payable Interest payable – SoCI Interest receivable -SoCI

15 15

15 15 15 15

Consolidated interest payable = (80 + 40 - 15) = 105 Consolidated Receivables - interest (15 - 15) = 0 (v) Excess depreciation Fair value adjustment – 144 Economic life 12 years, straight line basis Excess depreciation = 144/12 = 12 (vi) Consolidated Retained Earnings Balance – Loch at 1 April 2011 (413-313) May 2012

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Financial Operations

Add consolidated profit for year Balance 31 March 2012

502 602

Alternative calculation: (vi) Consolidated Retained Earnings Balance Loch (413+15) River - group share of post acquisition profits (385-130) = Associate - Stream, group share of post acquisition profits (iii) Excess depreciation Goodwill impairment Cancel unrealised profit in inventory (iv) (vii) Consolidated Property, plant and equipment Loch River Fair value adjustment Excess depreciation

428 255 24 (12) (20) (73) 602

1,193 767 144 (12) 2,092

Loch Group – Consolidated Statement of Comprehensive Income for year ended 31 March 2012 $000 1,973 (1,038) 935 (214) 721 24 (105) 640 (138) 502

Revenue(1500+693-220) Cost of sales (865+308-220+73+12) Gross profit Expenses (124+70+20) Profit from operations Share of profit of associated entity Finance cost Profit before tax Tax (118+20) Profit for the year

Loch Group - Consolidated Statement of Financial Position as at 31 March 2012: $000 Non-Current Assets Property, plant and equipment (vii) Goodwill (ii) Investment in associate (iii)

$000

2,092 56 247 2,395

Current Assets Inventory (1107+320-73) Trade receivables (1,320 + 570) Cash and cash equivalents (62+58+26)

1,354 1,890 146 3,390 5,785

Total assets Equity and Liabilities Equity Shares (3500+475) Share premium Retained Earnings (vi)

3,975 475 602 5,052

Current Liabilities Trade payables (393+340)

Financial Operations

733 5,785

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