Management Level Paper F2 - Financial Management

Management Level Paper

F2 - Financial Management September 2013

The Examiner's Answers 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 Question One Rationale This question was intended to test two of the key areas in Syllabus Section B, being retirement benefits and share-based payments. Candidates were asked how a defined benefit plan would be reflected in the statement of financial position and also how past service costs are accounted for under the revised provisions of IAS 19. The share-based payment involved a calculation of a cash-settled share-based payment in year two of recognition and required an explanation of the principles of recognition of IFRS 2. This question examined learning outcome B1(f).

Suggested Approach Candidates should have been familiar with the format of the answer provided and those who have completed past paper questions are likely to have prepared their workings in this format.

Financial Management

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September 2013

(a) (i) Share appreciation rights: The expense relating to the SARs will be recorded in 2012 as: Dr Profit or loss (staff costs) $198,800 Cr Liability $198,800 Being the year’s charge for related staff costs of SARs Working Recognisable to 31/12/12 (500 – 20 – 15 – 18) x $11 x 100 rights = $491,700 Recognisable to date = $491,700 x 2/3 yrs Recognised to 31/12/11 (500 – 20 – 50) x $9 x 100 = $387,000 Recognised to 31/12/11 = $387,000 x 1/3 yrs Charge to income statement in year to 31/12/12

$327,800

$129,000 $198,800

(ii) If share options were granted instead of SARs then this would be an equity settled share based payment rather than cash settled. As a result the options would be measured at their fair value at the grant date and would not be updated for any changes in fair value. Also, the credit entry would be to equity/other reserves rather than a liability.

(b) (i)

MLR should reflect a net pension liability of $3 million in its statement of financial position. Although MLR will not make any payments directly to retired members, the entity does have an obligation to ensure that its plan holds sufficient plan assets to cover the expected liabilities and so MLR must show its net position with the plan at the year-end date.

(ii) The improvements to the pension plan represent past service costs and IAS 19 requires them to be recognised immediately as an expense in profit or loss.

September 2013

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Please turn over for answers to question two


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September 2013

Question Two Rationale This question was intended to test consolidation techniques in drafting a group income statement. Candidates were tested on their ability to correctly classify the investment during the period – since it was preparation of income statement. The complex area being tested was piecemeal acquisition with control being gained in the period. This question tested learning outcomes A1(a) and (b).

Suggested Approach Establishing the group structure during the year would have been essential. Drafting up the pro-forma group income statement would have been the next best step, inserting a line for the associate and for the group gain/loss on the disposal of the associate. A key part of the answer was the calculation of the NCI allocation of profit and TCI.

Consolidated statement of profit or loss and other comprehensive income for the ZX Group for the year ended 31 December 2012 All workings in $m Profit from operations (290 + (3/12 x 140) Consolidated gain on de-recognition of associate (W1) Share of profit of associate (100 x 9/12 x 40%) Finance costs (45 + (8 x 3/12)) Profit before tax Income tax expense (80 + (3/12 x 32)) Profit for the year Other comprehensive income: Items that will not be reclassified to profit or loss Revaluation of property, net of tax (60 + 3/12 x 20)) Share of associate’s OCI (20 x 9/12 x 40%) Other comprehensive income for the year Total comprehensive income Profit for year attributable to: Equity shareholders of the parent Non-controlling interest (100 x 3/12 x 30%) Total comprehensive income attributable to: Equity shareholders of the parent Non-controlling interest (120 x 3/12 x 30%)

September 2013

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$m

325 40 30 (47) 348 (88) 260

65 6 71 331

252 8 260 322 9 331


Workings 1. Group profit on de-recognition of associate All workings in $m Fair value of existing 40% investment at date control obtained Carrying value of the associate in ZX’s financial statements at date control obtained: Cost of investment Plus 40% of post-acquisition retained earnings (800 - 600)

$m

$m 390

270 80 (350) 40

Gain on de-recognition

Note: the fair value gains reported in the OCI of ZX that arose on the remeasurement of its investment in NM do not appear in the group accounts as the investment is held there as an associate and then a subsidiary and not in accordance with IAS 39.


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September 2013

Question Three Rationale This question examined operating segments which is a key element of Section C of the syllabus. Part (a) was intended to be knowledge –based and then (b) and (c) required thought and application, looking at benefits and limitations. This question tested learning outcome C2(c).

Suggested Approach Part (a) required a brief overview of the principle of IFRS 8 in respect of utilising the information that is generated internally. It was important that in parts (b) and (c), candidates considered the scenario that JK was in and kept the answers specific to the entity.

(a) IFRS 8 and costs of preparing information IFRS 8 requires that operating segment disclosures be based on the information that the entity already produces for internal purposes in order to make decisions on how resources will be allocated, which areas to expand etc. If the information is already being internally produced by JK it should not involve significant costs to comply with the IFRS 8 disclosures. The guidance provided by the standard is that operating segment disclosures should reflect the information that would typically be reviewed by the chief operating decision-maker in the organisation.

(b) Benefits of operating segment information to investors Investors are normally looking for information that can help them estimate the future performance of an entity, in order to decide whether to make an investment, stay invested or to dispose of an investment. While the financial statements of JK will provide information on the performance of the entity as a whole, the business operates in both retail and wholesale. The risks associated with these sectors will be different and so to accurately assess the future risks facing an entity, users will need more than the combined figures in the financial statements. In addition JK operates in different countries and again the risks associated with each geographical area may differ. The operating segment disclosures on the performance and resources of the parts of the business that the management consider to be separately identifiable will then provide the investors with an insight into the risks and potential returns of each element of the business that is reported. Investors can use the segment information to identify the areas of the business that are expanding or declining, those with high or low margins and the resources that each is using to generate those returns. IFRS 8 intends that the information provided in the operating segment disclosures should reflect the information that the chief operating decision maker uses to make decisions about the business and so investors could be getting an inside view of the entity.

(c) Limitations of using operating segment information Under IFRS 8, the management of JK would determine the reportable segments that exist in the entity. This is based on how the segments are viewed internally. Segments may be selected differently by each entity which reduces the comparability of segmental disclosures across entities. Also, not all of the financial information can easily be allocated to segments – eg head office expenses and finance costs. This again makes it difficult for users to get a complete picture of the performance of segments and reduces comparability as allocation of costs and revenues may differ between entities.

September 2013

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Question Four Rationale This question examined two elements of financial instruments, a long term investment and a liability, which are both central to the preparation of financial statements. This question examined learning outcomes B1(d) and (e).

Suggested approach Candidates who had worked through previous exam papers would appreciate exactly how to set this out. The explanation had to provide a brief description of the classifications discussed in the accounting standards and then the journal entries should have included the treatment of the transaction costs.

(a) (i)

This instrument should be classified as a liability despite shares being issued. The redeemable nature of the shares means that there will be an outflow of economic resources at the redemption date and therefore the instrument meets the definition of a liability. There is no indication that the dividend is cumulative so no conclusion can be drawn regarding this, however there is no need since the redeemable nature of the instrument is sufficient to justify it being recognised as a liability. The initial recording of the shares will be: Dr Bank $4,800,000 Cr Liabilities (net proceeds) $4,800,000 Being the issue of non-equity shares net of transactions costs

(ii)

The instrument should be classified as a liability and therefore any return payable, in this case the 6% preference dividend, should be included in finance costs and deducted in arriving at profit for the year.

(b) (i)

This investment should be classified as a held to maturity asset as the instrument has a fixed term, cash flows are also fixed and MAT intends to hold the instrument until its maturity. The asset will be initially recorded at its fair value including any transaction costs.

(ii)

The investment will subsequently be re-measured at amortised cost using the effective interest rate and at 31 December 2012 will have a value of $2,136,000.

Workings in $000 Opening carrying value Effective interest (2,100 x 8.4%) Less interest received (7% x 2,000) Carrying value at 31 December 2012


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$000 2,100 176 (140) 2,136

September 2013

Question Five Rationale This question tested Section D of the syllabus, the expansion of narrative/voluntary disclosures. This question tested learning outcome D1(c).

Suggested Approach It was essential that candidates absorbed the small scenario provided and presented answers that were relevant to the entity and scenario given.

(a)

SR is likely to have been subject to negative publicity following the environmental damage and subsequent penalty. This is also likely to have had an adverse affect on SR’s share price. It is therefore important that the directors highlight the remedial action that was taken and the priority given to the improvement in the entity’s policies in an attempt to recover from any adverse market reaction. Voluntary disclosures would enable SR to report on the appointment of the consultant and would provide a platform for highlighting the environmental targets that the entity has set. The information would not be found anywhere else in the financial statements but it lets the investors, in particular, know that the directors have taken steps to protect future profitability from fines and losses from potential clean-ups. SR reporting on targets for reduced emissions and the fact that the first year target has been achieved is likely to have a positive impact on investors and other stakeholders. It is now acknowledged that there is value in being a good corporate citizen as it is seen to indicate that the entity is sustainable and one that is likely to avoid penalties in the future. This will help to attract investors that have these concerns and to ensure that the share price of SR improves.

(b)

The investors in SR will be particularly interested in the environmental policies of SR as the entity has been exposed to losses from this in the past. The investors will want to see that SR is adhering to environmental restrictions of other countries to ensure future profitability is not threatened by financial penalties for non-compliance. They are likely to want details of the environmental targets that have been set and the strategy in place to achieve these, together with the estimated costs. SR operates in many countries and so its investors will want to see that the entity has a stated policy relating to social responsibility. Following the negative publicity on the environmental damage, investors will want to see that SR is actively trying to improve its public perception by becoming a good corporate citizen. Given that SR is a multinational entity, investors will also be interested in information on how the entity interacts with the local communities and is adhering to local human resource requirements and laws.

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SECTION B Question Six Rationale This question examined candidates’ understanding of vertical group structures. The question included consolidation of both a subsidiary and sub-subsidiary and so candidates could achieve large a portion of the marks by adopting the basic procedure of consolidation of a subsidiary. This question tested learning outcomes A1(a) and (b).

Suggested Approach The first step would be to establish the group structure and identify the complex issue in the question and how this would affect the answer given that a SOFP was to be prepared. Drafting up the pro-forma SOFP and inserting lines for goodwill and NCI would have been the next step. Candidates would then insert the aggregated figures or cross reference to workings where appropriate.

(a) (i)

The investments that AZ and B hold in B and C respectively have been classified as available for sale as there is no indication that they have been classified as held for trading at initial recognition nor is there any indication that they are being held purely for short term gain. The investments will be subsequently measured at fair value and any gains or losses arsing will be recorded in other reserves.

(ii)

The consolidated financial statements of AZ will include the fully consolidated figures for both B and C on the basis that AZ controls both entities. Control is the power over an investee and the ability to exercise that power to affect the returns from the investment. AZ therefore controls B and therefore consequently controls C (through its control of B). They are therefore included as subsidiaries in the group financial statements of AZ. On consolidation the subsidiaries are aggregated on a line by line basis and the investments shown in the parent’s accounts are eliminated. The consolidated financial statements will show the assets and liabilities controlled by AZ (SOFP) and the returns generated as a result of that control (SOCI). The non-controlling interest in the SOFP will reflect the net assets owned by third parties and the SOCI will reflect the returns in the year attributable to the non-controlling interest. Any excess of the investment over the fair value of the net assets acquired is recognised as goodwill within consolidated noncurrent assets of the group.


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September 2013

(b) Consolidated statement of financial position as at 31 December 2012 for AZ Group (workings in $ millions) ASSETS Non-current assets Property, plant and equipment (70 + 44 + 55) Goodwill (W1)

$m 169 13 182 67 249

Current assets (29 + 24 + 14) Total assets EQUITY AND LIABILITIES Equity attributable to owners of the parent Share capital ($1.00 equity shares) Share premium Retained earnings (W2) Non-controlling interest (W3) Total equity

50 20 72 142 37 179

Non-current liabilities (15 + 8 + 2) Current liabilities (20 + 16 + 9) Total liabilities Total equity and liabilities

25 45 70 249

Workings 1. Goodwill Consideration transferred for B ($68m - $3m) for C (80% x ($38m - $2m)) NCI at fair value in B (20% x 40 million shares x $2.25) in C (40% x 30 million shares x $1.60)

Acquisition of B $m 65

Acquisition of C $m 29

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Net assets acquired Share capital Share premium Retained earnings Goodwill at acquisition Impairment of 20% for goodwill on acquisition of B Goodwill at 31 December 2012

83

19 48

40 10 23 73 10 (2) 8

30 5 8 43 5 5

Total goodwill at 31 December 2012 is therefore $13 million. 2. Retained earnings

Group $m 59

As per SOFP at 31 December 2012 Pre-acquisition reserves Goodwill impairment (W1) Group share of B (80% x $5m) Group share of C (60% x $15m) Consolidated retained earnings September 2013

B $m 30 (23) (2) 5

C $m 23 (8) 15

4 9 72 10


3. Non-controlling interests At acquisition (as per W1) NCI share of post-acquisition retained earnings of B (20% x $5m) NCI share of post-acquisition retained earnings of C (40% x $15m) Less cost of investment in B (20% x $36m) NCI at 31 December 2012

Acquisition of B $m 18

Acquisition of C $m 19

1 6 (7) 12

25

Total NCI at 31 December 2012 is therefore $37 million.


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September 2013

Question Seven Rationale This question formed the main test of financial analysis and tested candidates’ calculation of ratios and analysis of the information the ratios provided. This question tested learning outcomes C1(a) and C2(b).

Suggested Approach Calculation of the ratios and then re-reading the opening scenario would have been the natural first steps, ensuring that the ratios selected were relevant for this question and covered both financial performance and position.

(a)

Report on KL – review of financial performance and position

Revenue has increased by 13% since 2011. This is a significant increase in one period and if this is mainly due to the expansion in Asia then KL could expect increased revenue in 2013 as only 2 months of Asia trading is included in the 2012 figures. KL has also increased the gross profit margin in the period by 4.7 percentage points, which is again a significant amount and could be due to increased selling prices due to the development of the brand, or cost savings from economies of scale. Another positive sign is that the management of KL’s expenses has been controlled allowing the majority of the increased gross margin to flow through to the operating profit and profit for the year. The distribution costs have increased since 2011 from 9.1% to 11.9% of revenue and are likely due to the expansion into the Asian markets. However, administrative expenses appear to be controlled more efficiently in 2012 at 4.4% of revenue as opposed to 6.0%, with a decrease in the absolute level of expense incurred. All of this indicating that KL appears to be managing its costs well. The liquidity of KL has improved in the year and we can see evidence that working capital was an issue with a quick ratio of only 1.0 in 2011. The quick ratio is now 1.4 and the current ratio has increased from 2.8 to 4.3 and with cash in the bank, KL has clearly prioritised the management of working capital. The balances within working capital are, however very high with inventory days being 320 days and receivables days of 105 days. It is more likely that KL requires high levels of inventories in order to have the full product range across all the main department stores, rather than inventories being slow moving with a risk of obsolescence. Receivables days have decreased from 127 to 105 days, perhaps as a result of better terms being agreed with the new customers in Asia. Payables have decreased significantly from 2011. KL may have negotiated for lower prices with quicker payment terms which have contributed to the increase in gross profit margin. Efficiency ratios are not particularly relevant in the case of KL, as there are very few tangible assets in the business. Instead, KL has invested in the development of the brand, however this is not shown on the statement of financial position as it is internally generated. KL has significant shareholder funds and the only external financier is Mr B, as holder of the convertible instrument. This suggests that any future profits will either be invested in the business or distributed to shareholders from 2013 as there will be no finance costs to pay. It is unlikely that dividends have been paid as the retained earnings were a debit balance in 2011 and the business was initially loss making. In addition, the founder and main shareholder was clearly investing in the entity’s expansion rather than looking for annual returns and so any dividend calculation is inappropriate for this entity. One last point is that should the bond be converted to equity then clearly there will be significant scope for KL to borrow in the future as it will have no debt. This means that there are likely to be significant funds available in the debt markets to fund any further expansion into other markets or even into direct retail selling, which could have a dramatic effect on future earnings. September 2013

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(b) Additional risk factors to be considered by Mr B There are clearly two key individuals who are central to the success of KL, being the founder Miss K and her actress friend who is the face of the advertising campaign and central to the brand. It is not clear how these two are tied to the future of the business and their value is not reflected in the financial statements. Therefore, Mr B is taking a risk by investing in equity before clarifying that both of these key individuals will continue their involvement with the business. The expansion into another market usually increases the risk of the business as the returns can be affected by economic conditions (eg exchange rates), which are not within the control of management. An expansion into a new market also may require an understanding of the different cultures and the likely financial impact on the entity. It would be wise to ensure that the entity has someone with the appropriate skills and knowledge of this new market in order that future profitability is not adversely affected. There is also a risk that new customers are not reliable payers and this could put additional pressure on working capital. There is no track record of dividends being paid or that a dividend policy even exists in KL, and for a potential equity investor it is vital that they are able to see what the capital and/or revenue returns are likely to be in order to make an investment decision.


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September 2013

Appendix A

All workings in $000 Gross profit margin (GP/Revenue x 100) Operating profit (Profit before finance costs/revenue x 100) Distribution cost as % of revenue (DC/revenue x 100) Admin expenses as % of revenue (AE/revenue x 100) Profit margin PFY/revenue x 100 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

September 2013

2012

2011

800/2,600 x 100 = 30.8%

600/2,300 x 100 = 26.1%

376/2,600 x 100 = 14.5%

253/2,300 x 100 = 11.0%

310/2,600 x 100 = 11.9%

210/2,300 x 100 = 9.1%

114/2,600 x 100 = 4.4%

137/2,300 x 100 = 6.0%

250/2,600 x 100 = 9.6%

165/2,300 x 100 = 7.2%

1,580/1,800 x 365 = 320 days

1,556/1,700 x 365 = 334 days

550/1,800 x 365 = 112 days

850/1,700 x 365 = 183 days

750/2,600 x 365 = 105 days

800/2,300 x 365 = 127 days

2,375/550 = 4.3

2,416/850 = 2.8

795/550= 1.4

860/850 = 1.0

360/1550 x 100 = 23.2%

336/1,300 x 100 = 25.8%

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Management Level Paper F2 - Financial Management

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