MARKING SCHEME

FINANCIAL ACCOUNTING
MAN2907L
MAIN PAPER MAY 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

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Question 1
(i) The milk quota is traded in an active market and it would therefore be included in the
consolidated balance sheet at its fair value of 600,000.
(ii) The licence was acquired without any fee being required and it therefore had a nil cost to
Countrywide. However, in the consolidation, it is necessary to consider whether there is a fair
value that can be attached to it. In the circumstances given that is difficult.
This is because there is no active market in that this is the first licence to have been granted
and the estimated cash flows may not be sufficiently reliable to establish an amount as the
licence has only recently been granted and there is no experience to support the estimates. In
the circumstances, no value could be attached to the licence in the consolidated balance
sheet. This is despite it being the primary reason for the acquisition.
(iii) In considering the Naughty but Nice yoghurt trade, there is the advantage that there has
been a sale of a similar trade name that indicates the existence of a reliable value. This is
similar to the trading of brands between FCMG businesses which control large portfolios of
brands e.g. Unilever, Proctor & Gamble, United Brands etc. If this sale is accepted as
evidence, then it might be that the trade name could be reported in the consolidated balance
sheet at 2 million. However, justification would be required to support the increase above the
current sale price comparator of 1.5m. Subsequent regular review would be needed to look
out for impairment.
(100% marks)

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Question 2
a) For a group to exist there must be at least two companies who have the relationship of
holding company and subsidiary company. This situation exists when one company
controls the activities and resources of the other. This control does not necessarily require
ownership of a majority of the equity capital; nor does such ownership of a majority
necessarily confer control. These non-majority situations or vice versa are the exception
rather than the rule; however, it is the CONTROL as well as PARTICIPATING ownership
that results in the holding/subsidiary relationship and creates a group of companies.
Influence from ownership that falls short of control may often result in the status of
associate undertaking.
The group, although referred to in law and in authoritative accounting standards is not a
legal entity but an economic one representing all the activities and assets under the
control of one body of shareholders. The legal entities are the underlying component
companies all of whom have individual reporting responsibilities under the law. A number
of accounting effects arise from the creation of a group, which only emerge in the group
accounts (see c) below)
(20% marks)
b) On the assumption that control is exercised through ownership of the required majority of
shares, the A Group will comprise the following companies:
A, which is the holding company at the head of the group
C & B as a result of the direct holding by A of a majority 80% and 60% respectively
D as a result of the 100% controlling interest held by C, the intermediate holding
company.
F. The direct and indirect beneficial holding of A is only 40% plus 60% of 15% - totalling
49% and therefore not a controlling stake. However the control over B, via the 60%
holding, confers control over the underlying assets of B, including the entire 15% holding
in F. This results in A being able to vote 55% of the shares in F a majority resulting in
control and therefore subsidiary status for F.
E, with only a 25% holding by A is NOT a subsidiary of A and therefore is not a component
of the A group. It may however, depending on the level of influence exercisable by A, be
regarded as an associated undertaking of the A group.
(40% marks)
c) The statements of A, B, C, D and F should be aggregated into a consolidated balance
sheet and income statement, thus reporting the resources and activities operating under
the umbrella of common control. This consolidation is of 100% of the assets, liabilities
and profits of the holding company and its subsidiaries even where the ownership is not
a full 100%, since the control extends to 100% of the net assets and activities. The
various minority interests in the relevant subsidiaries and sub-subsidiaries will require to
be calculated and specifically disclosed in the balance sheet and income statement.
Additionally calculations will be required to establish the goodwill paid for when any
subsidiaries became part of the group through acquisition
Intra-group transactions and balances would require to be eliminated from the group
consolidated figures as would any profits made by one group member from another and
which remain unrealised at the accounting period end.
Only the holding companys share capital is dealt with tin the group accounts and group
reserves will only include the groups share of subsidiary company reserves arising after
the date of acquisition.
Finally, the investment in E will be dealt with in the group accounts on the equity basis,
overwriting the cost of the investment with the groups share of the underlying net assets
of the associated undertaking.
(40% marks)
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Question 3
a) Cash is such a vital feature of business life and so essential for business survival and
success, that it is as important to understand how a company has generated and spent cash
in any reporting period as to learn how it has generated profits (if, indeed, it has!). The two
issues cash and profit are not identical in any given time window as a result of the differing
methods of calculating profit and cash flow. Basically, 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.
This divergence requires the two statements to be provided, measuring respectively, net
income and net cash flow.
The key headings under which the cash flows will be analysed and displayed are:
Cash flow generated/absorbed by operations discloses the cash relating to the
companys trading activity. Sooner or later this will have to positive (possibly strongly so) if
the business is to survive and succeed.
Cash flow from investing activities discloses cash spent on non-current assets
essential for maintenance of the firms infrastructure and underpinning its ability to
generate future earnings/cash
Cash flow from financing activities discloses cash raised/repaid in respect of external
sources initially needed to get things started, and maybe when re-investment is required
in refreshing the infrastructure.
Cash flow from management of liquid resources.
Impact on balances of cash and cash equivalent.
(50% marks)
b) Depreciation is added back to profit in getting to a figure for operational cash flow 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.
Interest charged is added back because the figure charged in the income statement may
include opening and closing accrued amounts and therefore not equate to the cash
actually paid which will be reported elsewhere in the statement.
The three items relating to the working capital heading of trade receivables and payables
and inventories recognise that while sales and expenses may have been recorded in the
income statement they may remain uncollected or unpaid in terms of cash received or
paid as at the accounting date. Similarly cash may have been expended on inventory but
while it remains unused or unsold it is not recognised as a cost in measuring profit. Any
increase in the level of inventory or receivables over the level at the last balance sheet
date represents a reduction in cash flow compared to recorded profit more money is tied
up in inventory or remains in customers pockets thus adversely affecting cash-flow. The
reverse is the case with trade payables. Should the levels reduce (or in the case of
payables increase) this will have a correspondingly beneficial effect on the cash flow. This
effect needs to be recognised when deriving operational cash flow from the figure of
operating profit using the indirect method of calculating operational cash flow.
(50% marks)

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Question 4
a) Contract Account
Wages
Materials
Less: still in hand on site
Other costs
HO costs (see note below)
Plant depreciation (12/15 16,000)
Total costs to date (see below)
Recognised profit (see below)
Less: Progress billings
Work-in-progress c/f

182,000
72,000
(6,000) Take to balance sheet under current assets
36,000
12,000
12,800
308,800
(W-i-p at cost)
81,000
Transfer benefit to income statement
389,800
(360,000)
29,800
Take to balance sheet under current assets

Note
It is assumed that the head office costs are associated with the provision of contract-related
services that cannot be directly allocated to a specific contract. In these circumstances, IAS 11
allows their inclusion in contract costs. Any apportionment of general head office costs would
not be permitted under IAS 11.
(40% marks)
b) Balance sheet items as at 31st March, 20X9
Current assets:
Inventory materials on site
long-term contract balance
Trade receivables
Calculation of profit
Total contract price
Costs to date (314,800 6,000 material on site)
Estimated further costs to complete
(20,000 + 24,000 + 16,000 + 3,200 plant)
Estimated total costs to complete
Estimated total profit

6,000 (above)
29,800 (above)
60,000 (below)

480,000
308,800 (above)
63,200
372,000
108,000

Recognised profit to 30 June, 20X7 based on certified value of work to date 360,000
(say)
360,000/480,000 108,000 = 81,000 (credit to income statement; add to contract asset
account)
Amount receivable from Dam Ltd on long-term contract (360,000 300,000) = 60,000 (billed to
date less received)
(30% marks)
c) The principal objective of the treatment(s) required by IAS 11 is to ensure proper matching of
income and expenditure and hence the measurement of profit/loss and performance on a
contract by contract basis over the length of the contract period. Not to take profit in this way
is deemed to introduce an unacceptably high level of volatility in the results of companies
whose business cycle does not conveniently coincide with the usual accounting year
regularity of financial reporting. This moves away from the more prudent approach of
recognizing profits only when the contract is satisfactorily completed and invoiced. Prudence
is preserved in the requirement to have adequate certification of the stage of work completed
and only to take profits when the outcome of the contract can be reasonably established.
Moreover the full quantum of losses should be accounted for as soon as these become
apparent, without subsequent smoothing of these results.
(30% 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
(100% marks)

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