MARKING SCHEME

FINANCIAL ACCOUNTING
MAN2907L
SUPPLEMENTARY PAPER SEPTEMBER 2009

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FINANCIAL ACCOUNTING
MULTIPLE CHOICE QUESTION ANSWER SHEET

STUDENT REGISTRATION NO. .

PLEASE PLACE A CROSS AGAINST THE LETTER CORRESPONDING TO YOUR
ANSWER FOR EACH QUESTION ONE ANSWER ONLY FOR EACH QUESTION
THIS ANSWER SHEET MUST BE ATTACHED TO AND RETURNED WITH THE
QUESTION PAPER
EACH QUESTION CARRIES TWO MARKS: THERE IS NO NEGATIVE MARKING

Question

(a)

(b)

(c)

(d)

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Question 1
a) i) Difficulties included:

Definition the IASB define provisions as a liability of uncertain timing or amount.

Treatment of future operating losses it is considered that these should be accounted for in the
future.
Provisions differ from liabilities in that provisions are often subject to disclosure requirements,
whereas other creditors are not; e.g. statutory requirement to disclose may, however, be
insufficient detail.
Adequate level of disclosure of movements is important as these do not go through income
statement once provision is established.
Unacceptable practice of big bath provisioning used to absorb expenses incurred in later years.
Management has been able to control the recognition and timing of movements so that the
user does not have a clear picture of the current years performance smoothing profits.
There has been inconsistency between accounting for provisions between different companies.
(30% marks)

a) ii) IAS 37 applies the Framework approach provisions are an element of the liabilities and
not a separate element of the financial statements. Provisions should therefore be recognised
only when
an enterprise has a present legal or constructive obligation and benefits as a result of past
events.
it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation.
a reasonable estimate of the amount required to settle the obligation can be made.
IAS 37 takes a balance sheet perspective by concentrating on liability recognition rather than the
recognition of an expense.
Criteria include the following:
An obligation exists when the entity has no realistic alternative to making a transfer of
economic benefits may be legally enforceable or constructive.
Only recognised if existing at balance sheet date.
Must have arisen from past events.
Must exist independently from the companys future actions.
If avoidable by future actions, then no provision is recognised.
No provision should be recognised for future operating losses.
A constructive obligation for restructuring exists only when the recognition criteria laid out in
IAS 37 are satisfied.
If an enterprise has a contract which is onerous, the present obligation should be recognised
and measured as a provision.
(35% marks)
b) Although IAS 37 states that no provision should be made for future operation losses, this does
not apply if there is an onerous contract. This contract appears to be onerous and so the
provision of $135m should remain in the financial statements.
With regard to the provisions for environmental liabilities, the question is whether this is a
constructive obligation. There is no current obligation but it could be argued that there is a
constructive obligation to provide for the remedial work because the conduct of the company has
created a valid expectation that the company will clean up the environment.
We say could be argued because there is no clear answer and it may well be determined by the
subjective assessment of the directors and auditors as to whether there is a constructive
obligation. (The example 2B in IAS 37 would support making a provision.)
(35% marks)
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Question 2
(a) Referring to IAS 38 criteria in (b) below, only (iii) might qualify for deferral as development
expenditure.
(i) is applied research.
(ii) is development cost (1.2m) that has not yet been incorporated into a specific, separate
viable project. However, the line between categories is often indistinct in practice, e.g.
between development and production costs.
Looked at in general, all three relate to a specific project to which it appears expenditure can be
separately allocated. However, the outcome is not reasonably certain as to either technical
feasibility or commercial viability. We have no idea or projections of sales volume or price/revenue
in total and whether it will exceed costs. It is assumed that a plc would have the necessary
resources to complete the project but there is no evidence of this.
Item (iii) would not stand out from (i) and (ii) and it is recommended that all be written off as
expenses. It could be capitalised later when evidence is produced as to the criteria for proceeds.
(40% marks)
(b) IAS 38 criteria (para. 45):
(a)
(b)
(c)
(d)
(e)

Technical feasibility
Intention to complete and use or sell
Ability to use or sell
Asset will generate possible future income demonstrate existence of a market
Availability of technical, financial and other resources to complete the development or to
use or sell.
(30% marks)

(c)

Amortisation should begin with the commencement of production.

Any write-off should be over the period the product is expected to be sold.

This implies that the amortisation costs can be included in stocks being produced
for sale.

Decision needed as to whether period of total sales or e.g. period of premium

prices/market dominance is most appropriate as the write-off period

Should write-off be sales based or time based?

Deferred development expenditure should be reviewed at the end of each accounting period
and, to the extent that it is not considered recoverable, it should be written off.
(30% marks)

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Question 3
Swallow plc - Cash flow statement for the year ended 31st March, 20X9

(a)

Cash flows from operating activities

Profit before tax
76,800
Adjustments for:
Depreciation
16,000
Decrease in inventory
(81.6 -67.2)
14,400
Decrease in trade receivables
(48.0- 38.4)
9,600
Increase in trade payables
(52.8 48.0)
4,800
Cash generated from operations
121,600
Tax paid
(opening balance)
(27,200)
Net cash generated from operations
94,400
Cash flows from investing activities
Purchase of property
(98,560)
Purchase of plant
(see below A)
(48,000)
Net cash used in investing activities
(146,560)
Cash flows from financing activities
Issue of ordinary share capital
(168 - 120)
48,000
Equity dividends paid
(27,840)
Net cash flow generated from financing activities
20,160
Net change in cash
(32,000)
Cash at start of period
22,400
Cash at end of period - overdraft
(9,600)
A

Opening balance
Depreciation

Therefore

Closing balance
Additions

83,200
(16,000)
67,200
115,200
48,000
(50% marks)

(b)

Depreciation is added back to the profit before tax in arriving at the cash flow from
operations. This is because depreciation is a NON-CASH item of expense charged in
arriving at the net pre-tax profit, but not giving rise to any actual cash payment. The related
cash payment would have been shown, in the year of purchase, under investing activities,
for the whole amount of the asset acquired.
(25% marks)

(c)

Profits are calculated using the accruals, realisation and prudence concepts which
frequently do not involve cash flow in the years of calculation either as a result of timing
differences from credit given and taken and usage of inventory or of non-cash items such
as depreciation, amortisation and impairment. Additionally cash flow will be affected by
non-profit issues such as external financing and investment in non-current assets. It is
therefore possible for good profits to be earned while cash is slow to come in, investment
levels are high and loans have to be repaid this will result in low cash flow and strain on
liquidity.
(25% marks)

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Question 4
This question is essentially concerned with the issue and redemption of shares by a plc
where there is a trading loss impacting on the cash liquidity position.
Part (a) requires students to illustrate the effect on key balance sheet components.
Part (b) requires a discussion and evaluation of the effects of applying the Companies Act
1985 capital maintenance rules in circumstances where shares are redeemed partly out of
distributable profits.
Opening

ii(a)

ii(b)

iii

iv

000

000

000

000

000

000

000

Ord. shares

1,600

400

Pref. shares

600

10

Share premium
Reserves

160

40

160

(30)

400

(10)
(160)

(1,000)

Total equity

Bank

800

800

800

800

3,400

3,010

400

Other assets

440

(630)

720

(1,000)

3,000

Debenture disc.

(70)
3,000

80
3,400

(760)
1,410

Debentures
Creditors

000
2,010

(600)

Cap red. reserve

Closing BS

80
3,010

Issue of new shares at premium of 10p each total price 1.10 per share

ii(a) Use of proceeds (plus a bit more!) to redeem preference shares

On redemption of the preference shares, it is necessary to calculate the extent to which
the premium on redemption can be charged to the share premium account, and the
transfer, if any, to the capital redemption reserve from distributable profits in this case
from the general reserve 400,000.
The full premium on redemption can be charged to the share premium account, which
was brought into existence by the replacement issue. The limitation imposed by % of
any premium originally received on the shares does not apply.
The preference shares (600,000) disappear from the balance sheet and the share
premium account becomes 10,000 with the bank balance reduced by 630,000.
ii(b) Creation of capital redemption reserve (set up as creditor protection to maintain the
total share capital buffer):
excess of nominal value of shares redeemed over total receipts from new issue
(600,000 440,000 = 160,000).
iii

The issue of 7% debentures 800,000 at a discount of 10% (90 for every 100 face
value) results in a long-term liability of 800,000 and a net increase in the bank balance
of 720,000 with discount on debentures 80,000. The Companies Act 1985 is silent
on treatment of this item apart from the option to write it off against the share premium

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account. The discount has here been retained as an intangible asset on the balance
sheet (as is legally allowed) but more usually, it would be written off immediately
against reserves (especially share premium, if available) or maybe over the life of the
debenture.
iv

The use of the share premium balance 10,000 to cover a bonus issue of ordinary
shares to existing shareholders is reflected by a transfer to the ordinary share capital
account as permitted by the Companies Act 1985.

v Recognition of years loss of 1m all met from cash resources and thus throwing bank
into overdraft of 70,000. This would ordinarily be reclassified as a current liability
rather than a negative asset! and students may do so - but for simplicity is retained on
the same line here.
(65% marks)
(b)
The interest of creditors is substantially protected by the creation of the CRR 160,000 which
is non-distributable and can only be used to issue bonus shares.
However, because of the use of share premium account (SPA) to cover premium on
redemption, 30,000, the original capital of 2,200,000 is only maintained up to 2,170,000
capital, i.e. issued share capital plus undistributable reserves.
The effect of this loophole in capital maintenance regulation could be remedied by an
additional transfer from distributable profit to CRR in this case, 305,000.
(35% marks)

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Question 5
i) Creative accounting is usually undertaken in response to pressure on/from earnings or
borrowings or both. Typical scenarios may include.

Poor trading conditions leading to reduction in earnings

Start up situations delivering low early returns, diluting group EPS

Acquisition of "turn round" companies doing the same

Gearing levels unacceptably high

Borrowing limits being exceeded

Borrowing covenants being breached

Prospect of increasing/reducing bonuses based on earnings/share price

Prospect of losing job through poor company performance

Unrealistic market expectations

Prospective management buy-out

Regulation of utility companies

Availability of grant or other government assistance dependent on results

Resistance to predators
There are others!
ii) Areas which could be listed include:
Use/misuse of choice of accounting policies
Excessive use of judgement and exploitation of the zone of reasonableness
General window dressing and use of the once a year nature of published accounts
Use of off balance sheet techniques special purpose transactions, controlled nonsubsidiaries.
Manipulation of income recognition and allied matching processes
Use of unfair fair values in acquisition accounting.
Improper use of merger accounting for business combinations.
Unscrupulous use of valuation/revaluation of tangible and intangible assets
Undue emphasis on so-called exceptional items (formerly abuse of extraordinary items)
Lack of transparency over related party transactions
Students may also comment on the generic issue that creative accounting almost always involves
some sort of exploitation of Form over Substance, which therefore contravenes the requirement to
show a true and fair view.
iii) The creative process is often directed at "smoothing" results from one year to the next but
there is often a thin line between smoothing and distortion.
Arguments in favour of this include:

The market dislikes unpredictable variation and an orderly market is aided by "no surprises"

The true business cycle of many enterprises does not fit into the arbitrary reporting
requirement at calendar year intervals, being longer (e.g. shipbuilding) or shorter (fashion
retailing). Matching and smoothing are therefore not just legitimate but essential in periodic
measurement.

Smoothing is needed to carry out true underlying trend analysis.

Proper corporate governance should not be overly dependent on corporate financial

reporting - there are other issues at play
Arguments against include:

"rose tinted" glasses do not show a true and fair view

Users are left confused and at greater risk

The reliability and credibility of financial reporting is unacceptably compromised

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The auditing process becomes less transparent and more ambiguous when creative
accounting holds sway.
(Total 100% marks)

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