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
(a)
Calculation of the actuarial gain/losses in year to 31 December 2010 FV of plan assets $000 2,600
Opening balance Service cost Interest cost (8% x $2,900,000) Expected return (5% x $2,600,000) Past service cost Benefits paid Contributions
130 (240) 730 3,220 180
Actuarial gain on assets Actuarial loss on liabilities Closing balance
(b)
PV of plan liabilities $000 2,900 450 232
3,400
90 (240) 3,432 68 3,500
SARs are an example of a cash-settled share-based transaction and, in accordance with IFRS 2 Share-based payments, are initially measured at fair value at the grant date and subsequently remeasured to fair value at each year-end. The liability is remeasured and any difference is charged to the income statement as an expense. (This explanation is not a required part of the answer but is included to aid understanding.) 2009 Eligible employees (300-32-35) = 233 Equivalent cost of SARs = 233 employees x 1,000 rights x FV$8 = $1,864,000 Allocate over 3 year vesting period $1,864,000/3 = $621,333 equivalent charge to the income statement in the first year. 2010 Eligible employees (300-32-28-10) = 230 Equivalent cost of SARs = 230 employees x 1,000 rights x FV$12 = $2,760,000 Cumulative amount to be recognised as a liability = $2,760,000 x 2/3 years = $1,840,000 Less amount previously recognised = $1,840,000-621,333 = $1,218,667 The expense will be recorded as: Dr staff costs $1,218,667 Cr liability
Financial Management
$1,218,667
1
May 2011
Answer to Question Two
(a) The additional 20% purchase by RBE results in an increase in the controlling interest held in the subsidiary, DCA. No further goodwill is calculated on the additional purchase as goodwill is only calculated at the date control was gained in accordance with IFRS 3. However, at the date of the additional purchase (1 October 2010) the value of NCI needs to be established. The proportion “sold” will be transferred from NCI to parent’s equity within the SOCIE. The difference between that value and the consideration transferred is included in parent’s equity as an “adjustment to parent equity” on acquisition.
(b) Statement of changes in equity for the year ended 31 December 2010
Balance at the start of the year TCI for the year (W1) Share issue (2m x $1.30) Dividends Adjustment to equity (on additional purchase of 20% of DCA shares) (W3) Balance at the end of the year
Attributable to equity holders of the parent $000 3,350 1,350 2,600 (200)
Non-controlling interest
Total Equity
$000 650 150
$000 4,000 1,500 2,600 (230)
(37)
(503)
(540)
7,063
267
7,833
Working 1 NCI share of total comprehensive income of DCA $600,000: NCI at 30% x $600,000 x 9/12 months NCI at 10% x $600,000 x 3/12 months NCI share of TCI
(30)
(W2)
$000 135 15 150
Therefore parent share of TCI of DCA is $600,000 - $150,000 = $450,000. Total TCI attributable to equity holders of parent is $900,000 +$450,000 = $1,350,000. Working 2 NCI share of dividend paid April 2010 by DCA = 30% x $100,000 = $30,000. Working 3 Value of NCI at 1 October 2010 is $650,000+$135,000(W1)-$30,000(W2) = $755,000 Therefore the value transferred is $755,000 x 2/3 = $503,333 Adjustment to parent’s equity Consideration transferred Value of non-controlling interest transferred Adjustment to parent equity
$000 540 (503) 37
Answer to Question Three
May 2011
2
Financial Management
(a)
IFRS 8 Operating segments requires that segmental information be provided by listed entities. Clearly FGH is looking to list and hence IFRS 8 will be applicable. The disclosures required are indeed extensive and should the information need to be compiled from scratch then this is likely to be time-consuming and costly. However, the essence of IFRS 8 is that the entity should utilise information prepared for internal decision making. Therefore, in accordance with IFRS 8, it is the directors who decide which components of the business are reportable segments and these segments should be the individual parts of the business that the chief operating decision maker reviews in order to make financial and economic decisions. The entity will therefore already have prepared the financial information for these parts of the business for internal management purposes and so the costs of compliance should be minimal.
(b)
(i) Relevance to investors (advantages) In accordance with IFRS 8, the operating segment analysis will reflect the information used by the chief operating decision maker of the entity to make economic decisions about the business. Therefore, investors get to view what the decision makers within the entity think is important and also get an idea of how good/bad their decision making is. This will help investors to make investment decisions which are based upon their assessment of and confidence in the management team. Many listed entities engage in varied activities and operating segment analysis could help explain the breakdown of the business activities and the principal risks affecting performance. This again will help investors to make decisions. IFRS 8 also requires that entities provide information on major customers and a geographical split of results and resources. Again this information is likely to be relevant to investors as it provides detail which is not evident in the main financial statements. Since 75% of total reported revenue must be covered by operating segment analysis, the information provided is likely to be highly relevant as it covers the majority of the business.
(ii) Limitations Since it is management that decides on which segments are reported, no two entities will necessarily use the same criteria. Therefore there is a lack of comparability between entities. There is also a risk that entities will conceal information by the way they define the reportable segments.
Financial Management
3
May 2011
Answer to Question Four
(a)
Convertible instrument A convertible instrument is considered part liability and part equity. IAS 32 requires that each part is measured separately on initial recognition. The liability element is measured by estimating the present value of the future cash flows from the instrument (interest and potential redemption) using a discount rate equivalent to the market rate of interest for a similar instrument with no conversion terms. The equity element is then the balance, calculated as follows:
PV of the principal amount $10m at 7% redeemable in 5 yrs $10m x 0.713 PV of the interest annuity at 7% for 5 yrs (5% x $10m) x 4.100 Total value of liability element Equity element (balancing figure) Total proceeds raised
$ 7,130,000 2,050,000 9,180,000 820,000 10,000,000
The equity will not be remeasured, however the liability element will be subsequently remeasured at amortised cost using the effective interest rate of 7%. The total finance cost for the year ended 31 December 2010 is $642,600 (7% x 9,180,000). The coupon rate of interest of 5% has already been charged to profit or loss in the year so a further $142,600 should be recorded: Dr Finance costs $142,600 Cr Non-current liability $142,600
(b)
Preference shares The substance of the instrument is a debt instrument. IAS 32 requires that any instrument that contains an obligation to transfer economic benefit be classified as a liability. The cumulative nature of the returns on the preference shares means that the outflow of benefit is inevitable. The preference shares would then be classified as debt and would in fact increase the gearing of the entity.
May 2011
4
Financial Management
Answer to Question Five
(a)
Potential advantages to BNM
Narrative reporting will enable BNM to provide information about social, economic and environmental policies. Many users are influenced by an entity’s policies regarding, for example, fair trade and equal opportunities and the inclusion of a narrative report on BNM progress in these areas could have a positive influence on current and potential investors. Narrative reporting could help BNM highlight to investors the entity’s reliance on the knowledge and skill of its staff. The IFRSs prohibit the recognition of human capital – but this is BNM’s main revenue generating resource. Traditional analysis (ratios) of performance and efficiency are not relevant and users will need to rely on other information – information that BNM could provide in narrative reports. Similarly the specific processes, the key customer relationships and order books are likely to influence the users’ assessment of future performance and BNM has the ability to share this information with investors in a narrative report which would otherwise be absent from the financial statements because these “assets” fail the recognition criteria. The UK’s operating and financial review is a recommended addition to the financial statements and the IASB is currently developing its “Management Commentary” which is likely to help formalise the recommended content and structure of narrative reports included in financial statements.
(b)
Drawbacks of voluntary disclosures
The absence of formal guidance on the content and structure of voluntary disclosures results in a lack of comparability between entities. The nature of voluntary disclosures means that entities are free to choose which policies and practices to disclose and this may result in entities using the disclosures as a PR opportunity by reporting on only the positive aspects. Voluntary information may not be audited and therefore may not be reliable. This may reduce the usefulness of the information to users. Additional disclosures will incur time and therefore cost and any additional expense reduces the future returns available to shareholders.
Financial Management
5
May 2011
SECTION B
Answer to Question Six Summarised consolidated statement of comprehensive income for the A group for the year ended 30 September 2010 All workings in A$000 Revenue (4,600 +3,385(W1)) Costs and expenses (3,700+2,462(W1)) Share of associate’s profit (W3) Profit before tax Income tax expense (200+231(W1)) Profit for the year Other comprehensive income Revaluation gains net of tax (200+185(W1)) Share of associate’s OCI (W3) FOREX gain in year (W4) Total OCI Total comprehensive income PFY attributable to: Equity holders of the parent Non-controlling interest (W5)
Total A$000 7,985 (6,162) 160 1,983 (431) 1,552 385 28 803 1,216 2,768
1,414 138 1,552
TCI attributable to: Equity holders of the parent Non-controlling interest (W5)
2,432 336 2,768
Consolidated statement of financial position for the A group as at 30 September 2010 (all workings in A$000) Assets Non-current assets Property, plant and equipment (7,000 + 6,349 (W1)) Goodwill (W2) Investment in associate (W6) Current assets (3,000 + 3,175 (W1)) Total assets Equity and liabilities Equity attributable to the parent Share capital Retained reserves (W8) Non-controlling interest (W7) Total equity Current liabilities (2,000 + 2,381(W1)) Total equity and liabilities
A$000
13,349 635 1,220 15,204 6,175 21,379
2,000 13,522 15,522 1,476 16,998 4,381 21,379
Workings
May 2011
6
Financial Management
W1 Translation of B Statement of comprehensive income Revenue Cost of sales and expenses Profit before tax Income tax Profit for year Other comprehensive income: Revaluation gains on PPE Total OCI Total comprehensive income Statement of financial position Non-current assets Property, plant and equipment Current assets Equity and liabilities Share capital Pre-acquisition reserves Post-acquisition reserves Total equity Current liabilities
W2 Goodwill Consideration transferred NCI @ FV NA acquired: Share capital Retained earnings Goodwill at 1 October 2007 FOREX loss (balancing figure) Goodwill at 30 September 2009 FOREX gain (balancing figure) Goodwill at 30 September 2010
B$000
Rate @ avge rate
A$000
2,200 (1,600) 600 (150) 450
A$/B$0.65 A$/B$0.65
3,385 (2,462) 923 (231) 692
120 120 570
A$/B$0.65
185 185 877
4,000 2,000 6,000
@CR B$0.63 @CR B$0.63
6,349 3,175 9,524
1,000 1,800 1,700 4,500 1,500 6,000
@HR B$0.50 @HR B$0.50 Bal fig
2,000 3,600 1,543 7,143 2,381 9,524
B$000 2,600 600
Rate A$/B$0.50 A$/B$0.50
A$000 5,200 1,200
(1,000) (1,800) 400
A$/B$0.50 A$/B$0.50
400
A$/B$0.71
400
A$/B$0.63
(2,000) (3,600) 800 (237) 563 72 635
A$/B$0.65
@CR B$0.63
W3 Share of associate’s profit/OCI Share of associate’s PFY (40% x A$400,000) Share of associate’s other comprehensive income (40% x A$70,000)
A$000 160 28
W4 FOREX gains/losses in the year Closing net assets @ CR (B$4,500,000/0.63) or from W1 Less opening net assets @ OR ((B$4,500,000 less TCI B$570,000)/0.71) Less TCI for year @ average rate (B$570,000/0.65) FOREX gain on translation of subsidiary’s net assets Plus FOREX gain on translation of goodwill Total FOREX gains on translation of subsidiary
A$000 7,143 (5,535)
W5 NCI share of PFY/TCI in year Subsidiary’s PFY/TCI (W1) 20% share FOREX gain on translation of subsidiary (20% x A$803,000)
Financial Management
7
(877) 731 72 803 PFY A$000 692 138 ___
TCI A$000 877 175 161
138
336
May 2011
W6 Investment in associate Investment at cost Plus share of post-acquisition reserves 40% x (A$1,500,000 A$700,000)
A$000 900 320 1,220
W7 Non-controlling interest NCI on acquisition (W2) NCI share of post-acquisition reserves of subsidiary (20%xA$1,543,000(W1)) NCI share of net FOREX losses on translation of goodwill (20% x A$(237,000-72,000)) NCI at 30 September 2010
A$000 1,200 309
W8 Reserves
B A$000 5,143 (3,600) 1,543
A A$000 12,100
As per SOFP Less pre-acquisition reserves (W1) Group share 80% x A$1,543,000 Group share of associate’s post-acquisition reserves (W6) Group share of net FOREX losses on translation of goodwill (80% x A$(237,000-72,000)) Group reserves
May 2011
8
(33) 1,476
1,234 320
(132) 13,522
Financial Management
Answer to Question Seven Report to Friend Analysis of financial statements of CVB
(a)
Financial performance
Turnover has increased 10% since 2009 although this is at the expense of a drop in the gross margin earned which has fallen from 35.0% to 32.7% which has resulted in only a marginal increase in the absolute value of gross profit. The decline in gross margin could be due to a changing sales mix or to a higher cost of sales for fair-trade clothing. In addition the cost of clothing is largely dependent upon cotton prices which have been increasing rapidly in recent times. CVB has managed to control administrative expenses which have actually fallen. Sales and marketing costs have increased by 10%, which is in line with revenue. The profit for the year margin has dropped from 3.2% to 1.8%. This is mainly as a result of the decrease in the gross margin but is also affected by the increase in finance costs and the losses generated by the associate. CVB has taken on short term borrowings and this has increased finance costs. The average rate of lending has also increased from 8.6% to 11.0%. This could be the result of the short term borrowings being more costly than the term loan or it could be that the short term borrowings were significantly higher during the year – which is potentially more concerning. Either way, the entity has low gearing and should look to secure more long term funding rather than relying on a short term facility. The return on capital employed has fallen from 6.7% to 6.0% due to falling returns and the revaluation and investment in PPE. The increase in PPE may not yet have generated returns, however the revaluation has improved total comprehensive income which otherwise would have been significantly lower than 2009. I don’t think we should rule out this being a deliberate attempt to boost the TCI as on the face of it the business seems to be hitting a downturn. Financial position The main issue for CVB is management of working capital. Inventories days have increased from 118 to 168 days. Given that CVB operates in the retail sector, having inventories in stock for another 50 days is likely to be problematic and lead to obsolescence of out of trend items. If this movement was in isolation it could indicate that CVB were stock piling the new fair-trade items to meet expected future demand, however given that there are other signs of overtrading this is more likely to be an unfavourable movement. The increase in payables indicates that CVB are using trade payables as a means of funding working capital. It is collecting receivable amounts at the same rate, which is what would be expected for an entity in the retail sector, but payables are being settled 43 days later than in 2009. This policy will not be well received by the market especially now that CVB is being supplied by fair-trade operators. The current ratio, although reduced from 2009 is at 1.3, however the removal of the inventories highlights the cash crisis that CVB is facing. The quick ratio has fallen to 0.5 and CVB must seek additional funding immediately. The gearing of CVB indicates a relatively low risk entity with gearing of 26.7%, however the fall in the interest cover from 4.0 to 2.5 would be a concern for any lender. CVB is potentially paying more for the short-term borrowings and there is the added risk that these amounts are likely to be repayable on demand. It would be essential for the entity to secure long-term finance to ensure it can trade for the foreseeable future. If higher returns were expected from trading activities this would help the interest cover. In addition, possibly selling the associate investment could generate some cash, although this may not be lucrative given it is currently loss-making.
Financial Management
9
May 2011
Position in the market Based on the latest share price, the P/E ratio of CVB is 5.4, a slight reduction from the P/E of twelve months ago which was 5.7. The share price has fallen by 40% over the same period which indicates that the stock market has reacted to the decline in profitability, resulting in overall stability in the P/E. Recommendation Based on the financial information presented I would recommend not investing until further investigation is conducted. The business has a cash and working capital crisis which the directors must commit to resolving immediately to ensure the business can continue as a going concern.
(b)
Further financial information that may be useful
The financial statements used in the analysis are already out of date as the year end was 9 months ago. Therefore it will be important to obtain and consider any information that CVB has published since then, such as quarterly reviews, half year accounts, profit warnings etc. Details of the held for sale assets and details of the items being sold to determine if this is the result of a change in trading focus or an attempt to raise cash. The details of the long-term financing and the state of relationships with current lenders may help assess the likelihood of securing additional funding in a short timescale. Details of the dividend policy and history of dividend payout to assess future expected returns. Details of the associate company to establish if the associate has had a one-off expense creating a loss or is in a downturn and likely to continue loss-making. The forecasts for future trading would help assess the directors’ expectations for the forthcoming period and for the fair-trade business.
May 2011
10
Financial Management
Appendix – Ratio Calculations All workings in $m Gross profit margin (GP/Revenue x 100) Operating profit (Profit before associate and finance costs/revenue x 100) Profit margin PFY/revenue x 100 Interest cover Operating profit/finance cost ROCE % Operating profit/capital employed Inventories Inventories / cost of sales x 365 Payables Payables/cost of sales x 365 Receivables Receivables /revenue x 365 Current ratio Current asset/current liabilities Quick CA – inventories/current liabilities Gearing Debt/Equity Average cost of borrowing Finance costs/interest bearing borrowings P/E ratio Price/EPS
Financial Management
2010
2009
148/453 x 100 = 32.7% 20/453 x 100 = 4.4%
144/412 x 100 = 35.0% 20/412 x 100 = 4.9%
8/453 x 100 = 1.8%
13/412 = 3.2%
20/8 = 2.5 times
20/5 = 4 times
20/(273+55+18-14) x 100 = 6.0%
20/(256+58-16) x 100 = 6.7%
140/305 x 365 = 168 days
87/268 x 365 = 118 days
144/305 x 365 = 172 days
95/268 x 365 = 129 days
75/453 x 365 = 60 days
63/412 x 365 = 56 days
215/162 = 1.3
159/95 = 1.7
75/162 = 0.5
72/95 = 0.8
55 + 18/273 = 26.7%
58/256 = 22.7%
8/(55+18) x 100 = 11.0%
5/58 = 8.6%
1.25/(7/30) = 5.4
2.08/(11/30) = 5.7
11
May 2011