The Examiner's Answers – F2 - Financial Management March 2011

The Examiner's Answers – F2 - Financial Management 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 The consolidated income statement for the KL Group for the year ended 31 December 2010: All workings in $000 Revenue (4,000 + 1,500 - 140) Cost of sales (2,300 + 1,000 – 140 + 14(W4)) Gross profit Distribution costs (900 + 120) Administrative expenses (350 + 150 + 60 (W1) + 40 (W2)) Share of profit of associate (W3) Profit before tax Income tax expense (250 + 80) Profit for the year Attributable to: Equity holders of the parent Non-controlling interest (W5)

$000 5,360 (3,174) 2,186 (1,020) (600) 12 578 (330) 248

237 11

Workings: W1 Goodwill impairment Consideration transferred Non-controlling interest at fair value Fair value of the net assets acquired Goodwill at acquisition 15% impairment in 2010

$000 8,200 2,200 (10,000) 400 60

W2 Additional depreciation on fair value adjustment Fair value adjustment on depreciable assets Remaining useful life of assets Annual depreciation charged to group admin expenses

$240K 6 years $40K

W3 Share of profit of associate Profit after tax of NP Pro-rata from date of acquisition – 3 months 40% group share

Financial Management

$000 120 30 12

1

March 2011

W4 Unrealised profit on inventories Sales value of goods in inventories at year end ($140K x ½ ) Unrealised profit at 20% margin

$000 70 14

W5 Non-controlling interest Profit for the year for LM (as reported) Additional depreciation on fair value uplift (W2) Goodwill impairment (W1) Unrealised profit in inventories (W4)

$000 150 (40) (60) (14) 36 11

30% NCI share

Answer to Question Two

(a)

Analysis of financial statements of service and knowledge-based industries

Entities operating in service and knowledge-based industries are often heavily reliant upon intellectual capital for revenue generation. Intellectual capital can be defined as “knowledge which can be used to create value” and includes human resources, intellectual assets and intellectual property. For many entities operating in service and knowledge-based industries the most important element of their intellectual capital will be the collective experience, knowledge and skills of their staff.

Entities that depend on their staff and other intellectual capital to generate revenue will often have a relatively low level of physical assets. This makes the statement of financial position look under-capitalised and it is difficult to see where the value of the entity lies. Common ratios targeting efficiency and financial position, like return on capital employed and return on assets will not provide investors with useful measures as the key assets of the business are not reflected in the financial statements.

For successful entities the gap between market capitalisation and book value of net assets can be considerable and it is therefore important for entities to inform the market of key personnel resource, processes or intellectual capital.

Key members of staff are likely to be the resource that helps the business generate future revenue but without any information on the resource itself it will be difficult for potential investors to estimate the future revenue generating ability of the business.

(b)

Recognition Issues:

The recognition of assets requires certain criteria to be met; an asset must be “a resource controlled by an entity as a result of a past event and from which future economic benefit is expected to flow”. This asset must then be capable of being reliably measured in order to be recognised in the statement of financial position.

Human resources (staff) are expected to generate future economic benefit for the entity, however the resource is one that cannot be controlled. Staff members are free to leave at any time taking their skills and intellectual capital with them.

Notwithstanding the issue of control, there are also a number of issues concerning the measurement of a staff resource as an asset. The cost of staff is their training costs and remuneration. It could be argued that training costs have an on-going benefit and therefore could be capitalised, however, remuneration relates to a service provided by the staff in that year and therefore should be taken to the income statement as a period cost. It is possible to value assets on a fair value basis, however, for staff this would involve establishing future cash flows and discounting to present value. It is difficult to see how this could be achieved on a reliable basis due to the estimation required.

Staff resource therefore fails the recognition criteria for an asset and cannot be included in the statement of financial position.

March 2011

2

Financial Management

Answer to Question Three

(a)

(i) Share-based payment 2009 (300-25-40) x 1,000 x $1.22 = $286,700 over 3 years = $95,567 charge for 2009 2010 (300-25-15-20) x 1,000 x $1.22 = $292,800 x 2/3 years = $195,200 recognisable to date Less amount recognised in 2009 $(195,200 – 95,567) = $99,633 charge for 2010 Charge for 2010 of $99,633 will be recorded as: Dr Income statement – staff costs Cr Other reserves (equity)

$99,633 $99,633

Being the charge for share-based payment for the year ended 31 December 2010 (ii) Share-based payments that are to be settled in cash would be credited instead to liabilities in the statement of financial position and the liability would be remeasured using the fair value of the shares at each year-end date until the end of the vesting period.

(b)

Defined benefit pension plan (i) Statement of financial position PV of plan liability FV of plan assets Unrecognised actuarial losses Net pension liability (ii)

$m 13.9 (13.1) 0.8 (0.5) 0.3

IAS 19 Employee benefits permits actuarial gains or losses to be included in profit or loss (ie: the income statement) in a way that recognises them faster than the corridor approach. Alternatively, an amendment to IAS 19 now allows the full amount of the gains or losses to be included in other comprehensive income in the year and charged to equity.

Financial Management

3

March 2011

Answer to Question Four

(a)

Year end 2010

(i)

The held to maturity investment will be initially recorded at fair value plus transaction costs. It will be subsequently measured at each year-end at amortised cost using the effective interest rate.

(ii)

Held to maturity investment -amortised cost using effective interest rate of 7.05%.

Opening balance $ 3,200,000

Effective interest 7.05% $ 225,600

Interest received $ (180,000)

Closing balance $ 3,245,600

Investment income - Income from HTM investment

$225,600

Non-current assets - Held to maturity investment

$3,245,600

(b)

Held for trading investment

Initial recording: Dr Current asset investment Cr Bank Being the purchase of shares

$300,000 $300,000

Being the purchase of the shares Dr Income statement Cr Bank

$12,000 $12,000

Being the write off of the transaction costs to the income statement as the investment is an asset held at fair value through profit or loss Subsequent measurement Dr Current asset investment Cr Income statement – gain

$40,000 $40,000

Being the uplift in value and the recording of the gain in the income statement

March 2011

4

Financial Management

Answer to Question Five FGH has managed to generate significant cash from operating activities which is a positive sign for any business wishing to be a going concern, particularly since it appears that FGH is expanding. In addition to the inflow of cash from trading, the directors have clearly made some good investment decisions as income of $180,000 has been included in the year and also profit of $50,000 has been earned from the sale of some of these investments.

It does look as if FGH needs to improve working capital as receivables have increased in the year and it looks like the entity has in turn withheld payment to payables with an increase of $550,000. The increase in receivables may be a deliberate attempt to secure new customers by offering them favourable credit terms but it is essential that good working capital management is not compromised. The increase in inventories has probably arisen in order to meet future expected demand from the expansion. It should also be noted that FGH has acquired a subsidiary during the year, although the effect of the subsidiary on the working capital balances will have been adjusted for in the completion of the statement of cash flows.

The expansion is shown in two areas of investment, with the acquisition of a subsidiary and in the purchase of property, plant and equipment. The sale of property, plant and equipment for $70,000 resulted in a loss of $45,000. It’s possible that the expansion has resulted in the need for new equipment and hence management have taken the view to sell some of the old equipment whilst there is still a second hand market for it. The sale of investments for $150,000 has probably been undertaken in order to generate funds for the expansion. The only note of caution is that these investments seem to be profitable and hence given that a proportion has been sold during the year, future income from investments will be reduced.

It is clear from the cash flows from financing that FGH appears to have the backing of its shareholders. A share issue has been supported and the shareholders have been rewarded with a significant dividend in the year. . A good sign is that FGH has managed to fund the expansion without increasing the overall gearing of the business, as equal amounts of debt and equity have been raised as new finance. It indicates good stewardship of assets when long term expansion is financed by long term financing. FGH appear to have used a mixture of long term financing and retained earnings generated in the year, together with the sale of some investments to fund the expansion. However, this is not to the detriment of shareholders as they have still received a significant dividend during the year and it’s possible that the new investments in a subsidiary and PPE will generate greater returns in the future than the investments which have been sold. In times of exapnsion, however, a more modest dividend may have negated the need for long term financing and the interest costs associated with it.

Financial Management

5

March 2011

SECTION B

Answer to Question Six

(a)

Fair value adjustments Impact on calculation of goodwill at acquisition: In this case the calculation of goodwill on the acquisition of BNM should be based on the fair value of the consideration paid plus the fair value of the NCI less the fair value of the net assets acquired. The fair value of the net assets acquired should include any fair value adjustments required to take the book values of individual assets and liabilities up to (or down to) their fair value.

The increase in the values of property, plant and equipment and inventories will increase the value of net assets at acquisition, which in turn will reduce goodwill. The intangible asset will be recognised as an asset at acquisition because it meets the definition of an intangible asset in IAS 38. It will increase the net assets at acquisition and hence reduce goodwill.

The contingent liability is also specifically allowed to be included within the fair value of the net assets at acquisition. However, as a liability this will reduce the fair value of net assets and hence increase goodwill.

Impact on consolidated financial statements for year ending 31 December 2010: PPE: In the consolidated statement of financial position as at 31 December 2010 the value of PPE will be increased by $800,000 and reduced by the additional depreciation arising for the period. The additional depreciation is calculated as the FV adjustment divided by the estimated remaining life of the assets from the date of acquisition. This additional depreciation will be charged to the consolidated income statement each year.

Inventories: As the inventories have been sold by 31 December 2010, no adjustment will be required to the inventories balance in the statement of financial position. However, in the consolidated income statement an additional charge should be made within cost of sales. This will obviously also impact retained earnings for the group.

Intangible Asset: The intangible asset will be recorded in the consolidated statement of financial position and amortised over its life (which in this case is 20 months). The amortisation charge will go through the consolidated income statement and impact group retained earnings.

Contingent Liability: The contingent liability will be recorded as a current liability in the consolidated statement of financial position. In the consolidated income statements the reduction in the liability will in effect increase profits.

March 2011

6

Financial Management

(b)

Consolidated statement of financial position as at 31 December 2010 for the ERT Group

All workings in $000 ASSETS Non-current assets Property, plant and equipment (12,000 + 4,000 + 750(W1)) Goodwill (W2) Intangible asset (W1)

$000 16,750 208 90 17,048

Current assets Inventories (2,200 + 800 -30 (W3)) Receivables (3,400 + 900) Cash and cash equivalents (800 + 300)

2,970 4,300 1,100 8,370 25,418

Total assets EQUITY AND LIABILITIES Equity Share capital ($1 equity shares) Retained earnings (W4) Total equity attributable to parent Non-controlling interest (W5) Total equity Non-current liabilities Long term borrowings Current liabilities (2,000 + 1,000 + 84) Total liabilities Total equity and liabilities

10,000 7,893 17,893 1,741 19,634 2,700 3,084 5,784 25,418

Workings 1. Fair value adjustments At acquisition date $000 PPE 800 Inventories 200 Intangible assets 150 Liabilities (210) 940

Movement $000 (50) (200) (60) 126 (184)

31 December 2010 $000 750 90 (84) 756

2. Goodwill $000 Consideration transferred NCI at fair value Net assets at fair value: Share capital Retained earnings Fair value adjustments

1,000 3,200 940 (5,140) 260 (52) 208

Goodwill on acquisition 20% impairment Goodwill at 31 December 2010

Financial Management

$000 3,800 1,600 5,400

7

March 2011

3. Unrealised profit on inventories Sales of $300k x 20% x 50% left in inventories at y/e = $30k 4. Retained earnings As per SOFP Pre-acquisition reserves Adjustments arising from movement in FV adjustments Group share 75% Unrealised profit on inventory transfer Goodwill impairment (75% x 52)(W2) Consolidated reserves

$000 7,500

$000 4,000 (3,200) (184) 616

462 (30) (39) 7,893

5. Non-controlling interests NCI at acquisition (at fair value) 25% x post acquisition retained earnings $616,000 (W4) Goodwill impairment (25% x 52)(W2)

$000 1,600 154 (13) 1,741

Answer to Question Seven

(a)

To friend

Report on financial performance and position The revenue has only marginally increased in the year by 1.6%, however, profit margins have all increased significantly. In particular the gross profit margin has increased from 10% to 19%, which is likely to be as a result of reduced purchase prices from the new supplier contract that was secured in the year. Whilst this is a very positive and important step for DFG (given its low margin in the previous year) it will be important to establish whether this reduced cost also means a reduced level of quality. If quality is being compromised then this increase in margin maybe short-lived as customers may be driven away in the longer term.

In addition, the switch in supplier may be responsible for the lawsuit. It is a risky strategy to pursue aggressive revenue and margin targets at the expense of supplying good quality products. Although a contingent liability of $30 million is included in the notes, the lawyer’s assessment is that DFG is likely to lose the court case and the payout may be more. There is already serious pressure on the entity’s finances and the entity may not survive if the payout is any more or if other customers decide to sue. There is a potential issue of going concern that would need clarification before you arrive at a final decision concerning employment.

Both administration and distribution costs have increased significantly when compared to a 1.6% increase in revenue. Whilst these costs are not that large in relation to revenues, it will be important to establish that management have good control over expenses for the long term.

The increase in TCI is largely due to the revaluation gain reported within other comprehensive income. The valuation was performed by an internal member of staff, which is perhaps not as ideal as someone external, however you noted that these financial statements were finalised and so I assume they have been audited and that the valuations are fair. One note of caution though is why the directors have chosen this year to change the policy - could it be an attempt to boost income and reduce gearing to make further borrowing easier, especially as the long term borrowings will need to be repaid or re-negotiated relatively soon. However, it maybe

March 2011

8

Financial Management

shows good commercial sense to ensure that assets that are to be used as security for finance are at the most up-to-date valuation.

The overall liquidity of DFG is on the low side at 1.3:1 and has fallen significantly from 2009.

One contributing factor to the worsening liquidity is the significant increase in inventories in the year. This could be as a result of bad publicity about below standard goods and customer orders being cancelled. There is then an increased risk of obsolete inventories. This is reinforced by the inventories days which have increased from 146 days to 191 days.

Receivables days have also increased from 71 days to 104 days, and this be could be as a result of disputed invoices. DFG may then have a problem with slow/non-payment of these debts. Payables days have increased from 108 days to 171 days and this could be resulting from a deliberate attempt by DFG to improve the cash flow by delaying payment or extended credit terms given by the new supplier to attract DFG’s business.

The cash position of DFG is clearly a concern as the cash has moved from a positive balance to an overdraft and the long term borrowings are soon to be repaid or re-negotiated. This coupled with the poor working capital management would indicate that DFG must raise some additional funding if it is to survive. The gearing ratio shows deterioration on the previous year, despite an increase in equity from the revaluation. However, it is likely to be the lack of interest cover that would put lenders off. It is unlikely that DFG could afford to pay interest on any additional funding.

I would recommend investigating DFG in more detail before making your decision. Losing the court case and having a large settlement to pay could result in the entity collapsing and despite the fact that details of this are only in the notes, the seriousness of this should not be overlooked. The entity may struggle to survive anyway as there is a lack of cash and funding options (and it should be noted that DFG did not pay a dividend in 2010). The increases in profitability are not enough of an indicator of a stable/growing entity – especially an entity involved in the building trade which is known for its sensitivity to the economy around it.

(b) Limitations of ratio analysis The financial statements provide only historic information and reflect a point in time (ie: the year-end). However, the situation of the entity in question could have progressed significantly by the time you are analysing the information. For example, with the contingent liability for the court case, it could have progressed or be settled and the financial statements will not have reflected that.

The ratio analysis conducted on DFG showed an improvement in profitability margins, in cost of sales particularly, however it looks likely that quality has been compromised in favour of better margins and the result of that has been the filing of a law suit against DFG. This is something that threatens the future of the business but is not reflected in the ratios calculated.

Changes in accounting policies can impact ratio calculations. DFG has changed the accounting policy for subsequent measurement of PPE from depreciated historic cost to revaluated amount. The revaluation in the year then improves the gearing ratio and reduces non-current asset turnover but is due only to a change of policy rather than changes to the underlying environment.

Financial Management

9

March 2011

Appendix A Relevant ratios that could be selected and calculated:

(Workings in $m) Gross profit GP/revenue x 100% Operating profit Profit before finance costs/revenue Net profit PFY/revenue x 100% Gearing Debt/total equity Current ratio Current assets/current liabilities Quick ratio CA – inventories/current liabilities Receivables days Receivables/revenue x 365 days Payables days Payables/cost of sales x 365 days Inventories days Inventories/cost of sales x 365 days Return on capital employed Profit before finance costs/capital employed x 100% Non-current asset turnover Revenue/non-current assets Interest cover Profit before finance costs/finance costs

March 2011

2010

2009

49/252 x 100 = 19.4%

25/248 x 100 = 10.1%

(49-18-16)/252 x 100 = 6.0%

(25-13-11)/248 x 100 = 0.4%

7/252 x 100 = 2.8%

(5)/248 x 100 = (2.0)%

(91+39)/231 x 100 = 56.3% 178/134 = 1.3 : 1

91/184 x 100 = 49.5%

(178-106)/134 = 0.5 : 1

(143-89)/66 = 0.8 : 1

72/252 x 365 days = 104 days 95/203 x 365 days = 171 days 106/203 x365 days =191 days

48/248 x 365 days = 71 days 66/223 x 365 days = 108 days 89/223 x 365 days =146 days

(49-18-16)/(231+91) = 15/322 x 100 = 4.7%

(25-13-11)/(184+91) = 1/275 x 100 = 0.4%

252/254 = 0.99

248/198 = 1.3

(10+12)/12 = 1.8

((7)+8)/8 = 0.1

10

143/66 = 2.2 : 1

Financial Management