PROFESSIONAL 1 EXAMINATION - APRIL 2007

Answer Questions 1 to 3 and Question 4 or 5.

FINANCIAL ACCOUNTING

NOTES

PRO-FORMA INCOME STATEMENT BY NATURE, INCOME STATEMENT BY FUNCTION AND BALANCE SHEET ARE PROVIDED

TIME ALLOWED: INSTRUCTIONS:

3.5 hours, plus 10 minutes to read the paper.

During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.

The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

FINANCIAL ACCOUNTING
PROFESSIONAL 1 EXAMINATION APRIL 2007 Time allowed 3.5 hours, plus 10 minutes to read the paper. Answer Questions 1 to 3 and Question 4 or 5.

Balance Sheets as at 31 December 2006 Stan PLC m Assets Non-current assets Property, plant and equipment 2,460 Investment in Laurel Ltd. 1,320 Investment in Keane Ltd. 520 4,300 Current assets Inventories Trade and other receivables Cash and cash equivalents Total Assets Equity and Liabilities Equity Ordinary share capital 1 Share premium Revaluation reserve Retained earnings

1.

Laurel Ltd. m

Keane Ltd. m

1,280 1,280

646 646

900 520 200 1,620 5,920

280 220 120 620 1,900

140 104 170 414 1,060

3,250 860 1,290 5,400

1,000 220 140 320 1,680

500 100 160 130 890

Non-current liabilities Loans Current liabilities Total liabilities Total Equity and Liabilities

280 240 520 5,920

60 160 220 1,900

60 110 170 1,060

Page 1

The following information is relevant to the preparation of group financial statements: (i) Stan Plc acquired 80% of the ordinary shares of Laurel Ltd. on 1 January 2003 when the Balance Sheet of Laurel Ltd. showed the following balances: m Share premium account 220 Revaluation reserve 100 Retained earnings 100 At 1 January 2003 the fair values of the property, plant and equipment and the inventories of Laurel Ltd. exceeded the book values by 50 million and 10 million respectively. The surplus on the property, plant and equipment has not been reflected in the financial statements of Laurel Ltd. but the inventories were sold during the year ending 31 December 2003. At the date of acquisition the average remaining useful life of the property, plant and equipment was 10 years. Stan Plc acquired 40% of the ordinary shares of Keane Ltd. on 1 July 2006 when the Balance Sheet of Keane Ltd. showed the following balances: m Share premium account 100 Revaluation reserve 80 Retained earnings 100 During 2006, Laurel Ltd. sold goods to Stan Plc at invoice value of 10 million on which Laurel Ltd. made a mark up of 25%. One half of these goods remained in the inventory of Stan Plc at 31 December 2006. Included in current liabilities of Stan Plc at year end is the amount due to Laurel Ltd. in respect of the goods that remained in inventories. Included in the Current Liabilities of Stan Plc, Laurel Ltd. and Keane Ltd. are dividends of 20 million, 10 million, and 15 million respectively which were approved by their respective shareholders before the year end. Stan Plc has included its share of any dividends receivable in its income statement and balance sheet receivables accounts. On 1 January 2005 Laurel Ltd. sold a piece of machinery with a net book value of 200 million to Stan Plc for 230 million. The machinery originally cost Laurel Ltd. 250 million and was being depreciated at 20% per annum. At the date of transfer its remaining useful life was increased to five years. During December 2006 Stan Plc loaned 10 million to Keane Ltd. which is due to be repaid in June 2007. This amount is included in the current assets and current liabilities of the respective companies.

(ii)

(iii)

(iv)

(v)

(vi)

(vii)

REQUIREMENT: (a) Prepare the Consolidated Balance Sheet of the Stan Group Plc for the year ended 31 December 2006 in a format suitable for publication under International Financial Reporting Standards. (18 Marks) Show the journal entries on consolidation required to deal with issues (v) and (vi) above. (4 Marks) (c) IAS 27 Consolidated and Separate Financial Statements states that a parent company should consolidate all subsidiaries, both foreign and domestic, other than a number of exclusions. (i) Describe in detail what is meant by the term subsidiary in IAS 27; (5 Marks) (ii) Briefly outline THREE circumstances when a subsidiary may be excluded from consolidation. (3 Marks) [TOTAL: 30 Marks]

(b)

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2.

You are a Senior Lending Manager in Casabank plc, one of Irelands largest commercial banks. Your main role is assessing loan applications, above a certain threshold amount, and you also engage in wealth management advice to a small number of clients of the bank. You have received a request from one of the banks corporate customers, Sandel Ltd. (Sandel) for an extension to its overdraft facilities from 160,000 to 400,000 and for a ten year term loan of 2.0m You have carried out a review of information on file for Sandel, consulted colleagues who service the customer, and you have ascertained the following:
G

Sandel has been a customer of the bank since it commenced trading approximately twelve years ago and it has had an excellent relationship with the bank. All previous borrowings have been discharged without any difficulties. Sandel is engaged in the manufacture of high quality light fittings for the household consumer market. Its sales are split between the home (60%) and European markets (40%). It has experienced a steady upward trend in business since it commenced trading, and has enjoyed a particularly successful last three to four years arising from a buoyant economy and increased disposable incomes in the domestic market. Sandel currently employs approximately 125 people in its production and selling operations which is up by ten on the 2005 number. Sandel operates from one manufacturing unit and it has two sales offices, one in Dublin and one in Paris. In addition to the above, the companys financial accountant has provided a summarised income statement and balance sheet for the year ended 31 August 2006, together with comparatives (set out below). By way of comment the Financial Accountant has stated that the fall in profits during the year ended 31 August 2006 was due primarily to increased competition. In addition, profit has been impacted by a once off write down for obsolete stock of 350,000 and legal fees of 95,000 relating to a claim of patent infringement (this matter was fully resolved by the balance sheet date). The Financial Accountant is confident that Sandels circumstances will improve because of its superior products and strong marketing team. The increased overdraft facility will help to provide competitive credit terms for customers and the term loan will facilitate the replacement of some old equipment with new state of the art robotic equipment. Summarised financial information, which has been received from the financial accountant of Sandel Ltd. for the years ended 31 August 2005 and 2006, is shown below.

SUMMARISED INCOME STATEMENTS FOR THE YEARS ENDED 31 AUGUST 2006 2005 000 000 Revenue 22,250 20,500 Gross profit 3,783 4,100 Profit before taxation 779 1,333

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SUMMARISED BALANCE SHEETS AS AT 31 AUGUST 2006 000 Freehold property at cost Plant at cost Plant accumulated depreciation 1,750 4,500 (1,500) 3,000 1,400 (400) 1,000 2,600 1,200 50 (1,400) (150) (325) (375) (820) 6,530 1,000 5,530 6,530

2005 000 1,400 4,100 (1,300) 2,800 1,200 (300) 900 2,200 900 95 (995) (90) (325) (420) 6,465 1,000 5,465 6,465

Equipment at cost Equipment accumulated depreciation

Inventory Trade receivables Cash and cash equivalents Trade payables Sundry payables Declared dividend Income tax 6% Debenture stock (repayable 2011) Net assets Share capital ( 1 ordinary shares) Retained earnings REQUIREMENTS: (a)

Prepare a report for the Head of Lending at Casabank plc (in your role as Senior Lending Manager) on the financial position of Sandel Ltd. as at 31 August 2006, and (24 marks)

(b)

In the report, set out clearly and concisely those matters on which further information should be sought by the bank before a final decision can be made in respect of the requested borrowing facilities. (6 marks) NOTE: There are three (3) marks allocated to the presentation and structure of the above report.

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3.

[Total: 30 marks] The following multiple choice question contains eight sections, each of which is followed by a choice of answers. Only one of each set of answers is strictly correct.

REQUIREMENT Give your answer to each section in the answer sheet provided. [Total: 20 marks] 1. A retailer purchased white goods from a supplier in the UK for 8,000 on 1 January 2007. At that date the exchange rate was 1 = 0.64. Half the goods were sold before the year end for 10,500 cash. At the year end, 31 March 2007, the supplier balance of 8,000 was still due. The exchange rate at 31 March 2007 was 1 = 0.80. What was the total operating profit/loss on this transaction to be reported for the year ended 31 March 2007? (a) (b) (c) (d) 4,250 6,750 6,660 4,250 profit profit profit loss

2.

Shergar Ltd., a construction company commenced a building contract, Contract Beta, on 31 July 2006 which was due to be completed on 1 August 2007. Details of the contract at the year end date of 31 March 2007 are as follows: Contract Beta 000 Cost of work performed to date Cost of work certified by architect Progress payments invoiced Progress payments received Estimate of total costs to completion Final agreed contract price 200 180 160 150 120 400

How much profit should be included in the income statement of Shergar Ltd. for the year ended 31 March 2007 in relation to Contract Beta (a) (b) (c) (d) 133,333 53,333 50,000 60,000

3. In consolidated financial statements which of the following should be excluded from consolidated revenue? (i) (ii) (iii) revenue from intra-group transactions revenue earned by group companies from sale of goods to associate companies associate company revenue (a) (b) (c) (d) (i) only (i) & (ii) only (i), & (iii) only (i), (ii) & (iii)

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4.

A declaration and payment of a dividend prior to the year end on redeemable preference share capital will appear where in a companys financial statements? (a) (b) (c) (d) Income statement and balance sheet. Balance sheet and statement of changes in equity. Statement of changes in equity only. Income statement only.

5.

Which of the following must be disclosed on the face of the income statement (classification by function format)? i. ii. iii. iv. (a) (b) (c) (d) Dividends Tax expense Depreciation Extraordinary items (ii) and (iv) only (i), (ii) and (iii) only All of the above (ii) only.

6.

During the last financial year, the Research and Development Department of Radco Ltd. spent a cash total of 750,000. Of that amount, 250,000 was spent on high-tech equipment which was used in new research costing an additional 200,000. The remainder was spent developing a product that was launched during the year. If Radco Ltd. depreciates its plant & equipment over 5 years and amortizes intangible assets over a 10 year useful life, what is the income statement charge in relation to the 750,000 spend? Non-current assets attract a full years depreciation/amortisation in the period of acquisition. (a) (b) (c) (d) 280,000 580,000 450,000 200,000

7.

Which of the following conditions would result in Tin Ltd. (Tin) not being classified as the parent undertaking of Zinc Ltd. (Zinc)? (a) (b) (c) (d) Tin holds 60% of the voting rights in Zinc and 40% of the equity in Zinc. Tin holds 40% of the voting rights in Zinc and 60% of the equity in Zinc. Tin holds no equity in Zinc but has the right to exercise dominant influence over Zinc by virtue of a provision in the Articles of Association of Zinc. Tin holds 80% of the equity in Lead Ltd. which in turn holds 65% of the equity in Zinc.

8.

On 1 January 2006 Dog Ltd. (Dog) acquired 560,000 of the 800,000 1 ordinary shares in Cat Ltd. (Cat) for 600,000. At that date the retained profits of Cat amounted to 250,000 and Cat also retained profits of 100,000 during the year ended 31 December 2006. The value attributable to minority interests in the consolidated balance sheet of Dog for the year ended 31 December 2006 is (a) (b) (c) (d) 315,000 345,000 637,000 805,000

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4.

(a)

Understanding the recognition rules is key to implementing IAS 37 Provisions, Contingent Liabilities and Contingent Assets, which sets out the accounting and disclosure requirements for all provisions, contingent liabilities and contingent assets within its scope.

Outline the requirements of IAS 37 regarding the decision of when a provision should be recognised and when the disclosure of a contingent liability is required. (8 Marks) (b) The Financial Controller of Ronaldo Enterprises Plc (Ronaldo) was aware of a number of accounting issues during the preparation of the financial statements for the year ended 31 December 2006. The draft Income Statement showed a revenue amount of 4.5 million and a profit before taxation of 750,000. The accounts are due to be signed by the Directors on 30 March 2007. He has asked you to provide advice on the following: i. Included in the Current Liabilities in the balance sheet is a provision of 50,000 in respect of replacement computers required due to a fire in the main office building in Dublin on 31 January 2007. All staff computers were, due to an oversight, not covered by the main company insurance policy. (2 Marks) Ronaldo acquired a company, Squid Ltd., during the year. Squid Ltd. has a number of products that are expected to incur trading losses during the next financial year. Ronaldo has decided to provide 300,000 during each of the next two years so as to prudently cover these anticipated losses. Restructuring plans are at present being formulated and the Finance Director expects that these will cost 500,000 in the following year. He has included these costs in the calculation of the acquired goodwill in Squid Ltd. (4 Marks) On 1 December 2006 the Directors of Ronaldo proposed a dividend of 10c per share on the 15 million ordinary shares of the company, which has been accrued for in the draft group financial statements. The company also paid a cash dividend during the year of 300,000. (2 Marks) During the year there was a large diesel spill in the yard of one of the companys factories in Peru, which leaked into the gardens of some local small farmers. There is no current anti-pollution legislation enacted in that area of Peru. Each year Ronaldo publishes in its financial statements a comprehensive environmental policy, which outlines the companys dedication to a clean and healthy environment. The companys lawyers have advised that there is no legal liability for the clean up which would cost an estimated 450,000. (4 Marks)

ii.

iii.

iv.

REQUIREMENT: Write a short report to the Financial Controller of Ronaldo Enterprises Plc regarding each of the issues outlined above, providing (i) a brief explanation of the treatment in accordance with International Financial Reporting Standards; and any journal adjustments required. [Total: 20 marks]

(ii)

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5. (a)

A significant risk to accurate and reliable financial reporting arises with regard to revenue recognition in the income statements of enterprises. IAS 18 Revenue addresses revenue recognition principles, in general, and it prescribes the accounting treatment and disclosure requirements.

REQUIREMENTS: Outline the revenue recognition criteria in respect of: (i) (ii) (iii) Sale of goods Rendering of services Interest, Royalties and Dividends (5 marks) (5 marks) (3 marks)

(b)

Varig plc is principally engaged in the provision of domestic and international passenger and cargo and mail airline services. Flights operate primarily from Sao Paulo which is both the main hub of the groups route network and the location of its corporate headquarters.

REQUIREMENT: Draft a suitable Revenue Recognition accounting policy note for inclusion in the financial statements of Varig plc. (7 marks) [Total: 20 Marks]

END OF PAPER

Page 8

SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

FINANCIAL ACCOUNTING
PROFESSIONAL 1 EXAMINATION APRIL 2007 Examiners note re solutions: The solutions presented here are intended to be comprehensive and act as a learning aid for candidates. The examiner would not anticipate that an exam candidate would have sufficient time to complete answers at the level of detail given in these solutions. Also, these narrative answers are intended to cover a range of answers and hence candidates would not generally be expected to list all the points given. Solution 1 (a) Stan Group PLC Consolidated Balance Sheet as at 31 December 2006

Stan m Assets Non-current assets Property, plant and equipment Intangible Assets - Goodwill Investment in Associates

W8 W2 W7

3,752.0 136.0 564.0 4,452.0

Current assets Inventories Trade and other receivables Cash and cash equivalents [200+120] Total Assets Equity and Liabilities Equity Ordinary share capital 1 Share premium Revaluation reserve Retained earnings Minority Interest

W9 W10

1,179.0 727.0 320.0 2,226.0 6,678.0

W5 W6 W3 W4

3,250.0 860.0 64.0 1,439.2 5,613.2 337.8 5,951.0

Non-current liabilities Loans [280+60] Current liabilities Total liabilities Total Equity and Liabilities

340.0 387.0 727.0 6,678.0

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Workings 1. Group structure Group share 80% 40% Minority Interest 20% -

Laurel - subsidiary Keane - associate 2. Goodwill Cost of investment

Cost of Control Account - Laurel 1,320.0 Share capital - 80% Share premium - 80% Revaluation reserve - 80% Retained earnings - 80% Fair value adjs (ii) (W12) Goodwill 1,320.0

800.0 176.0 80.0 80.0 48.0 136.0 1,320.0

3. Consolidated Retained Earnings Cost of control - pre-acquisition Fair value adjustment (ii) (W12) Depreciation on FV adj (ii) (W12) Unrealised Inventory profit (iv) - 80% Profit on disposal (vi) (W13) Minority interest - 20% x 320m Balance Sheet Consolidated Retained Earnings 80.0 Stan 10.0 Laurel 16.0 Interest in associate 0.8 [40% x (130 - 100)] 24.0 Deprec. - disp. profit (vi) (W13) 64.0 1,439.2 1,634.0 1,290.0 320.0 12.0 12.0

1,634.0

4. Minority Interest Depreciation on FV adj (ii) (W12) Unrealised Inventory profit (iv) - 20% Profit on disposal (vi) (W13) Minority Interest 4.0 Share capital - 20% 0.2 Share premium - 20% 6.0 Revaluation reserve Retained earnings Fair value adjs (ii) (W12) 337.8 348.0 200.0 44.0 28.0 64.0 12.0 348.0

Balance Sheet

5. Share Premium Cost of control Minority Interest 20% Balance Sheet Share Premium 176.0 Stan 44.0 Laurel 860.0 Interest in associate [40% x (100 - 100)] 1,080.0 860.0 220.0 0.0 1,080.0

6. Revaluation Reserve Cost of control Minority Interest - 20% Balance Sheet Revaluation Reserve 80.0 Stan 28.0 Laurel Interest in associate 64.0 [40% x (160 - 80)] 172.0 0.0 140.0 32.0 172.0

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7. Investment In Associate Investment in Associate 520.0 12.0 32.0 Balance Sheet 564.0

Cost of investment Retained Earnings Revaluation

564.0 564.0

Alternative approach Group share of net assets at 31 December 2006 (40% x Goodwill on acquisition of associate (see below)

890 m)

m 356.0 208.0 564.0 520.0 (312.0) 208.0

Goodwill on acquisition of associate Cost Less group share of net assets at 1 July 2006 [40% x (500+100+80+100)]

8. Property Plant and Equipment Balance per BS Stan Balance per BS Laurel Fair value adjustment (ii) (W12) Depreciation on FV adj (ii) (W12) Profit on disposal (vi) (W13) Deprec. on profit element (vi) (W13) m 2,460.0 1,280.0 50.0 (20.0) (30.0) 12.0 3,752.0

9. Inventories Balance per BS - Stan Balance per BS - Laurel Unrealised Inventory profit (iv) [ m 900.0 280.0 (1.0) 1,179.0

10m x 1/2 x 25/125]

10. Trade and other receivables Balance per BS - Stan Balance per BS - Laurel Inter-company trading balance (iv) [ 10m x 1/2] Intra-group dividends (v) [ 10m x 80%] m 520.0 220.0 (5.0) (8.0) 727.0

11. Current Liabilities Balance per BS - Stan Balance per BS - Laurel Inter-company trading balance (iv) [ 10m x 1/2] Intra-group dividends (v) [ 10m x 80%] m 240.0 160.0 (5.0) (8.0) 387.0

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12. Fair Value adjustment (ii) Tutorial note: The PPE fair value adjustment should be reflected in the value of Laurel Ltd PPE and therefore the Consolidated PPE. m 50 m 40 10

Dr Property Plant and Equipment Cr Cost of control - 80% Cr Minority interest - 20% Depreciation must be charged on the additional value. Dr Retained Earnings - 80% Dr Minority Interest - 20% Cr Property Plant and Equipment [ 50m/10 x 4years]

16 4 20

The fair value adjustment on inventory is charged against consolidated retained earnings as the goods are no longer held in inventories. Dr Retained Earnings Cr Cost of control - 80% Cr Minority interest - 20% 13. Disposal of Machinery Elimination of profit Dr Retained Earnings - 80% Dr Minority Interest - 20% Cr Property Plant and Equipment [ 230m Elimination of additional depreciation At date of transfer 'Group' depreciation New depreciation post transfer Additional depreciation charged 10 8 2

24 6 200m] 30

= = =

40m per annum [ 200m (NBV)/5 years ] - IAS 8 revision of estimate 46m per annum [ 230m/5 years] 12m [ 46m - 40m x 2 years] 12 12

Dr Property Plant and Equipment - Stan plc Cr Retained Earnings - Stan Plc 14. Associate balances

Loan or trading balances between associate and group are not required to be eliminated under IAS 28. Therefore there is no adjustment for the loan (viii) or the dividends (vi).

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(b)

Journal Entries Issue (v) Only the dividends receivable from Laurel Ltd (the subsidiary) are deemed an intra-group balance to be eliminated. Therefore the double entry required in the consolidated balance sheet workings is: Dr Current Liabilities Cr Trade and other receivables Being group share (80% x Issue (vi) m Elimination of profit Dr Retained Earnings - 80% Dr Minority Interest - 20% Cr Property Plant and Equipment [ 230m Elimination of additional depreciation At date of transfer 'Group' depreciation New depreciation post transfer Additional depreciation charged 24 6 200m] 30 m 10m) of Laurel Ltd dividend. 8m 8m

= = =

40m per annum [ 200m (NBV)/5 years ] - IAS 8 revision of estimate 46m per annum [ 230m/5 years] 12m [ 46m - 40m x 2 years]

Dr Property Plant and Equipment - Stan plc Cr Retained Earnings - Stan Plc See also working 13 above

12 12

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(c) (i)

Subsidiary Describe in detail what is meant by the term subsidiary in IAS 27; Definitions (IAS 27 para. 4) A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent). Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Para 13: Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is: 2
G G G

power over more than half of the voting rights by virtue of an agreement with other investors; power to govern the financial and operating policies of the entity under a statute or an agreement; power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

Para 15: In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of management and the financial ability to exercise or convert.

(ii)

Briefly outline THREE circumstances when a subsidiary may be excluded from consolidation.

Consolidated financial statements shall include all subsidiaries of the parent. (IAS 27, para 12) However, circumstances where non-consolidation of subsidiary companies is permitted:
(a) (b) (c) where there is a demonstrable loss of control over subsidiary operations where there is evidence of temporary control, see IN7 of IAS 27 where the inclusion of the subsidiary would be immaterial to the overall group, see paragraph 29 and 30 of the Framework for the Preparation and Presention of Financial Statements."

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SOLUTION 2 REPORT To: From: Re: 1. Head of Lending Senior Lending Manager Financial position of Sandel Ltd. as at 31 August 2006 Introduction We have received a request from Sandel Ltd. for an additional overdraft facility of 240,000 to bring the total facility up to 400,000. In addition a term loan of 2.0m repayable over ten years is being sought. Sandel Ltd. has experienced a number of problems during 2006 and while the company believes its difficulties have been overcome, additional information is necessary to determine if this is in fact the case.

2.

Profitability Revenue increased by 8.5% year on year but the gross profit margin declined from 20% to 17%. This reversal in trend is unfavourable but it is explained by the financial accountant as being due to increased competition. In addition there was a once off charge in respect of stock obsolescence of 350,000 which accounts for 1.5% in the decline in gross profit margin. We need to check the once off nature of the stock obsolescence charge. We should also look at similar gross profit margins being achieved by the competitors of Sandel Ltd. to ensure the companys margin is consistent with the industry average. The net profit percentage of 3.5% is low and gives cause for concern and again we should compare this with the industry average. The prior years margin was 6.5% which may be more normal. By adjusting the profit before tax for the two exceptional charges (obsolescence 350,000 and the legal fees of 95,000) the net profit margin would have been 5.5%, only 1% down on 2005.

3.

Activity / Utilisation of assets The sharp decline in return on capital employed from 20.62% to 11.27% is due principally to the exceptional write offs in 2006 . The return on capital employed would have been 17.32% otherwise. There may be inefficiencies in the use of the companys resources. The indicator would be more meaningful if we used the market value of the companys assets. The ratio of revenue to net assets (2006:3.4, 2005:3.17) shows a slight improvement. The funds raised from the issue of debentures during the year would seem to be having a positive impact. The inventory turnover ratio shows a small decline. benchmark against. The industry average would be very useful to

4.

Liquidity The current and liquid ratios have only marginally changed. We must consider however the reasons for the sharp increase in trade receivables and inventory from the prior year. Receivables days have dis-improved by four days (to 20 days), and although this is short of the length of time it takes to pay creditors, the risk of bad debts increases as the receivables days lengthen. An aged receivables listing will help clarify the cause of deterioration. The extension of days taken to pay suppliers by six days indicates the companys cash difficulties and could affect the goodwill of its suppliers.

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5.

Solvency / gearing
The company is not excessively in debt with a gearing ratio of 11.2% (or debt equity ratio of 12.6%) and with a new loan of 2. 0m this would rise to an acceptable 30%. Interest cover (excluding overdraft interest) is currently at almost 17 times which is very healthy. Assuming 6% interest on the proposed term loan and the same level of profits this would fall to 4.9* times, which is still quite acceptable. * (779 + (6% x 820=49)) / (49+120 (6% x 2,000))

6. Additional information required:

G

G G G G

Is the companys trade seasonal? At year end it is in a credit position. However it is seeking an extension to its overdraft facility.. If we ignore trade receivables and payables, the company requires 700, 000 to pay its corporation tax bill and dividends. How are these to be financed? We need to discuss the companys dividend policy given its cash position What security is available against the increased facility? Is the freehold property already in use as security? We require detailed audited accounts for the last two years to provide further analysis. We require a copy of the companys strategic plan, financial projections for the next three years including cash projections. Industry averages would be very useful to gauge its performance with its competitors

Appendix 1 1 Ratios Gross margin (Gross profit/ revenue) 2006: 3,783 / 22,250 2005: 4,100 / 20,500 2006
17.0% 20.0%

2005

Net margin (Profit before tax/ revenue) 2006: 779 / 22,250 2005: 1,333 / 20,500

3.5% 6.5%

Return on capital employed (Profit before interest and tax / Equity + Debenture loans) 2006: (779 + (6% x 820 =49))/ 7,350 11.27% 2005: 1,333 / 6,465 Current ratio (Current Assets: Current Liabilities) 2006: 3,850 / 2,250 2005: 3,195 / 1,830

20.62%

1.71 1.75

Liquidity ratio (Current Assets excl. Inventory: Current Liabilities) 2006: 1,250 / 2,250 0.56 2005: 995 / 1,830 Inventory turn (Inventory/Cost of goods sold) 2006: 2,600 / 18,467 x 365 2005: 2,200 / 16,400 x 365 Receivables days (Trade Receivables/Revenue) 2006: 1,200 / 22,250 x 365 2005: 900 / 20,500 x 365 Payables days (Trade Payables/Purchases) 2006: 1,400 / 18,467 x 365 2005: 995 / 16,400 x 365 Interest cover (Profit before interest and tax/ Interest) 2006: (779 + (6% x 820 =49)) / 49 2005: N/A

0.54

51 days 49 days

20 days 16 days

28 days 22 days

16.9 times N/A

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10

Gearing ratio (Debt/ (Total Capital = Equity capital + Reserves + Debt )) 2006: 820 / (1000 + 5,530 + 820) 11.2 % 2005: N/A Debt: Equity ratio (Debt/ (Equity capital + reserves)) 2006: 820 / 6,530 2005: N/A

N/A

11

12.6 %

SOLUTION 3 1 2 (b) (c) Profit on sale of goods 4,250. Gain on exchange 2,500.

Cost to date /Estimate of final cost x profit estimate = [ 200,000/ ( 200,000 + 120,000)] x [ 400,000 ( 200,000 + (i), & (iii) only

120,000)] =

50,000

3 4 5

(c) (d) (d)

Only the Tax Expense of the above items is required by IAS 1 para 81 on the face of the income statement. 200,000 (research) + 280,000. 250,000/ 5 years (PPE) + 300,000 x 10% (development) =

(a)

7 8

(b) (b) ( 100,000 + 250,000) x 30% + 800,000 x 30% = 345,000.

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SOLUTION 4 a) A provision is a liability of uncertain timing or amount. A liability is a present obligation of an enterprise arising from a past event, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. IAS 37 requires that for a provision to be recognised there must be: - a present obligation, either constructive or legal - based on a past event - with a reliable estimate of the amount If the obligation is probable the reliable estimate should be provided in the accounts. If the obligation is just possible, or a reliable estimate cannot be established, then a Contingent Liability should be disclosed in the notes to the financial statements. b) (i) IAS 10 defines events after the balance sheet as either adjusting or non-adjusting. Given that the fire took place after the balance sheet date this is a non-adjusting event as does not relate to conditions that existed at the balance sheet date. The provision for the replacement computers should be removed from the 2006 accounts, notwithstanding the fact that the insurance company will not cover the replacement cost. It is unlikely that this issue will lead to a going concern issue for the company. The existing provision is to be reversed DR CR (ii) BS Provisions IS Charge for replacement computers 50,000 50,000

A provision is a liability of uncertain timing or amount. A liability is a present obligation of an enterprise arising from a past event, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. IAS37 deals with recognition and measurement of provisions. IFRS 3 deals with the recognition of assets and liabilities in a business combination. Both standards specifically prohibit provision for future trading losses, as they do not meet the definition of a liability (IAS 37, paras 63 64 and IFRS 3, para 41(b)). The restructuring costs would be allowed if there was a present obligation to pay them, either constructive or legal (IFRS 3, para 41(a)). In this case there has been no announcement of the restructuring plans and therefore there is no obligation to pay the costs. In this case no provision is allowed so the amount of 500,000 must be deducted from the goodwill calculated. Journal required to reverse the provisions in the consolidated financial statements: Dr Cr BS Provisions Cost of control account / Goodwill 800,000 800,000

Being reversal of fair value adjustments of net assets on acquisition of Squid Ltd. provision for losses 300,000 and restructuring provision 500,000. (iii) IAS 10 requires that a dividend be paid or declared (i.e. approved by shareholders at general meeting) before it can be recognised in the financial statements. An accrual can only be allowed if it meets the IAS 37 definition of a liability i.e. there is an obligation to pay. In this case the directors have only proposed the dividend and presumably shareholders at a general meeting havent yet approved it. If this is so the dividend does not appear as a current liability in the balance sheet nor in the statement of changes in equity / note of movement in reserves. Dr Cr (iv) Dividend accrual Retained Earnings 1,500,000 1,500,000

In this case the obligating event is the contamination of the land which will give rise to a constructive obligation as the company has made known its comprehensive environmental policy which outlines the companys dedication to a clean and healthy environment. Therefore a provision should be made for the 450,000 in the financial statements of Ronaldo in accordance with IAS 37. Dr Cr IS exceptional cost BS Provisions 450,000 450,000
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SOLUTION 5 (a) (i) are Revenue from the sale of goods should be recognised if all of the five conditions mentioned below met.
G

G G

The enterprise has transferred significant risks and rewards of ownership of the goods to the buyer; The enterprise does not retain either continuing managerial involvement (akin to that usually associated with ownership) or effective control over the goods sold; The quantum of revenue to be recognized can be measured reliably; The probability that economic benefits related to the transaction will flow to the enterprise exists; and The costs incurred or to be incurred in respect of the transaction can be measured reliably.

The determination of the point in time when an enterprise is considered to have transferred the significant risks and rewards of ownership in goods to the buyer is critical to the recognition of revenue from the sale of goods. If upon examination of the circumstances of the transfer of risks and rewards of ownership by the enterprise it is determined that the enterprise could still be considered as having retained significant risks and rewards of ownership, the transaction could not be regarded as a sale. (a) (ii) When the outcome of the transaction involving the rendering of services can be estimated reliably, revenue relating to that transaction should be recognized. The recognition of revenue should be with reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when each of the four conditions set out below are met.
G G

The amount of revenue can be measured reliably; The probability that the economic benefits related to this transaction will flow to the enterprise exists; The stage of completion of the transaction at the balance sheet date can be measured reliably; and The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

This manner of recognition of revenue, based on the stage of completion, is often referred to as the percentage-of-completion method. IAS 11 also mandates recognition of revenue on this basis. Revenue is recognised only when it is probable that the economic benefits related to the transaction will flow to the enterprise. However, if there is uncertainty with regard to the collectability of an amount already included in revenue, the uncollectable amount should be recognized as an expense instead of adjusting it against the amount of revenue originally recognised. (a) (iii) Revenue arising from the use by others of the enterprises assets yielding interest, royalties and dividends should be recognized when both of the following two conditions are met: 1) 2) It is probable that the economic benefits relating to the transaction will flow to the enterprise; and The amount of the revenue can be measured reliably.

The bases prescribed for the recognition of the revenue are the following: a) b) c) (b) In the case of interest the time proportion basis that takes into account the effective yield on the assets; In the case of royalties the accrual basis in accordance with the substance of the relevant agreement; and In the case of dividends when the shareholders right to receive payment is established.

Revenue recognition Passenger, cargo, and mail revenues are recognized when the transportation is provided. Ticket sales for transportation not yet provided are included in the current liabilities of the consolidated balance sheet as sales in advance of carriage. Revenue from airline-related business is recognized when services are rendered. Revenue is stated net of sales tax.

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FINANCIAL ACCOUNTING PROFESSIONAL 1 EXAMINATION APRIL 2007 SUGGESTED MARKING SCHEME QUESTION 1 (a) Stan Group PLC Consolidated Balance Sheet Marks Assets Non-current assets Property, plant and equipment Intangible Assets - Goodwill Investment in Associates Current assets Inventories Trade and other receivables Cash and cash equivalents Equity and Liabilities Equity Ordinary share capital 1 Share premium Revaluation reserve Retained earnings Minority Interest Non-current liabilities Loans Current liabilities Total Available (b) Journal entries Issue (v) Issue (vi) Elimination of intra-group profit Elimination of additional depreciation Total Available 1.0

1.5 2.5 1.25

0.75 1.0 0.25

0.75 0.75 1.25 4.0 3.0

0.25 0.75 18.0

1.5 1.5 4.0

(c) (i) Subsidiary Clear definition of subsidiary Definition of control Presumption of control Other indicators of control Other comments / discretionary Total Available (ii) Circumstances for excluding subsidiary 1 mark for each appropriate item x 3 Total available for question
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1.5 1.0 1.0 1.0 0.5 5.0

3.0 30.0

QUESTION 2 (a) Presentation and structure of report (including introduction and conclusion) Comments on: Profitability Activity / utilisation of assets Liquidity Solvency and gearing Note: The split of marks available is indicative only with flexibility for additional valid points. Total Available

Marks

3.0

6.0 6.0 6.0 3.0

24.0

(b) 1 mark for each appropriate item x 6 Total available for question

6.0 30.0

QUESTION 3 All correct answers carry 2.5 marks Any other answer carries a nil mark Total available for question 8 x 2.5 20.0

20.0

QUESTION 4 (a) Definition and criteria for recognition of provision Further explanation / example Definition and explanation of circumstances of disclosure of contingent liability Total Available 4.0 1.0 3.0 8.0

(b) (i)

Explanation Journal Total Available Explanation 2 issues x 1.5 marks Journal Total Available Explanation Journal Total Available Explanation Journal Total Available Total available for question

1.0 1.0 2.0 3.0 1.0 4.0 1.0 1.0 2.0 3.0 1.0 4.0 20.0

(ii)

(iii)

(iv)

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QUESTION 5 (a) (i)

Revenue from sale of goods Conditions for recognition Further explanation Total Available Revenue from rendering of services Conditions for recognition Further explanation Total Available

3.0 2.0 5.0

(ii)

3.0 2.0 5.0

(iii)

Interest, Royalties and Dividends Basis for recognition of each 3 x 1 mark

3.0

(b)

Accounting policy note 1.5 marks for appropriate issues x 4 Discretionary Total Available Total available for question 6.0 1.0 7.0 20.0

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