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Financial Accounting November 2010

Suggested answers and examiner’s comments Important notice When reading these answers, please note that they are not intended to be viewed as a definitive ‘model’ answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from candidates in the examination.

Section A 1. (a) The profit attributable to the ordinary shareholders of Gravesend plc, for the year to

30 September 2010, was £60 million after deducting interest on £120 million 12% non-current liabilities. The issued ordinary share capital amounts to 300 million shares of £1 each.

The holders of non-current liabilities have the right to convert their holding into

ordinary shares at any date after 1 January 2014. The terms of the conversion are 120 ordinary shares for every £100 of debenture stock.

Required Calculate the basic and fully diluted earnings per share of Gravesend plc for the year ended 30 September 2010 in accordance with the provisions of IAS 33 ‘Earnings per Share’.

(4 marks)

Suggested answer Basic EPS: (60 million ÷ 300 million) x 100 = 20p. Fully diluted EPS: Shares: 300 million + (120 million ÷ 100 x 120) = 444 million Earnings per share: 60 million + 14.4 million (£120 million x 12%) = 74.4 million ÷ 444 million = 16.8p

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Examiner’s comments Most candidates succeeded in calculating correctly the basic earnings per share. The most common errors made when calculating the fully diluted earnings per share were: (i) failure to add back to profit the interest charge on the 12% non-current liabilities; and (ii) an incorrect calculation of the number of shares received on the conversion of non-current liabilities into ordinary shares.

(b) On 11 March 2010, Portsmouth plc purchased 400 personal computers from

Computertastic Pty of Ruritania where the local currency is the Ruritanian franc (RF). The purchase price for the consignment is RF384,000 and, at 11 March 2010, the exchange rate was RF2.30 to the £1. Settlement of the liability was made in Ruritanian francs on 9 November 2010 when the spot rate was RF2.00 to £1. The exchange rate on 30 September 2010, Portsmouth plc’s accounting year end, was RF2.14 to £1.

Required Produce journal entries to record in the books of Portsmouth plc:

The initial purchase.

The profit or loss to be recognised in the accounts for the year ended 30 September 2010.

(4 marks)

Suggested answer

The purchase is recorded in the books on 11 March 2010 at the prevailing rate of exchange, i.e. £166,956.52 (RF384,000 ÷ 2.30).

Date Debit Credit

11 March 2010 Purchases £166,956.52

11 March 2010 Computertastic Pty, creditor £166,956.52

The unrealised loss at the balance sheet date is £12,482.73 (£179,439.25 [RF384,000 ÷ 2.14] - £166,956.52).

Date Debit Credit

30 September 2010 Loss on exchange £12,482.73

30 September 2010 Computertastic Pty, creditor £12,482.73

Examiner’s comments Most candidates calculated the purchase price of the computers in £s sterling on 11 March 2010. A significant minority of candidates erroneously computed the loss to be recognised in the accounts based on the exchange rate on 9 November 2010 (settlement date) rather than the exchange at the year end. Many appeared to believe there to be a profit on exchange rate variations rather than a loss. The requirement to present the transactions in the form of journal entries was not often done in answers, indicating a lack of understanding of this basic bookkeeping procedure.

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(c) The following summarised balance sheet is provided for Southampton Ltd as at 30 September 2010.

£000

Non-current assets at carrying value 2,500 Net current assets 3,500

6,000

Issued share capital (£1 ordinary shares) 1,500 Retained profit 4,500

6,000

Lowndes Ltd purchased 1,200,000 shares in Southampton Ltd on 30 September 2010 for £7,500,000. The non-current assets of Southampton Ltd possessed a fair value of £3,500,000 on 30 September 2010. There were no differences between the carrying values and fair values of Southampton Ltd’s net current assets at that date.

Required

Calculate the following balances to be reported in the consolidated balance sheet of the Lowndes Ltd group of companies as at 30 September 2010:

The goodwill arising on the acquisition of the shares in Southampton Ltd.

The non-controlling (minority) interest in the financial affairs of the Lowndes group of companies.

(4 marks)

Suggested answer

Equity at 30 September 2010: £6,000,000 + £1,000,000 (revaluation) £7,000,000

Attributable to Lowndes Ltd, £7,000,000 x 80% £5,600,000

Less: Price paid £7,500,000

Goodwill £1,900,000

Non-controlling interest, £7,000,000 x 20% £1,400,000

Examiner’s comments There were many good answers to this question, though a significant minority of candidates did not include the revaluation surplus when calculating goodwill and the minority interest in the Lowndes group of companies.

(d) Gerrard Ltd agreed to lease a non-current asset from Lampard plc on 1 January

2010. The finance lease contract provided for an initial rental payment of £10 million on 1 January 2010, and four further annual rental payments of £10 million commencing 1 January 2011. The interest rate implicit in the lease payments is 11%.

The non-current asset, which could alternatively be purchased for an immediate payment of £31,025,000, has an estimated useful life of five years and a zero residual value at that time. Gerrard Ltd prepares its accounts on the calendar year basis. Required Show the following items, relating to the leased non-current asset, as they should appear in the accounts of Gerrard Ltd prepared for the year to 31 December 2010 so as to comply with IAS 17 ‘Leases’:

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(i) Depreciation charge for 2010. (ii) Interest charge for 2010. (iii) Amount due to Lampard plc on 31 December 2010.

(4 marks)

Suggested answer

£

(i) Depreciation charge 31,025,000 ÷ 5 6,205,000

(ii) Interest charge (31,025,000 - 10,000,000) x 11% 2,312,750

(iii) Amount due to Lampard plc 31,025,000 - 10,000,000 + 2,312,750 23,337,750

Examiner’s comments This was a well answered question, indicating that candidates are becoming familiar with the procedures involved in accounting for a finance lease. Nearly all candidates computed correctly the depreciation charge. A minority of candidates did not identify the need to take account of the fair value of the non-current asset when computing the interest charge and amount due to Lampard plc.

(e) Hyton Ltd has been liquidated and the total proceeds amount to £4,100,000. The

financial obligations of the company are:

£000

Ordinary shareholders 2,500

Preference shareholders 1,000

Debenture holders (the debenture was secured on a property which was sold for £1,800,000, and that sum is part of the £4,100,000 referred to above)

2,800

Creditors, including preferential creditors of £300,000 2,300

Cost of liquidation 200

Required Show the distribution of the assets of Hyton Ltd between its various stakeholders, indicating clearly the order of priority of repayments made.

(4 marks)

Suggested answer

£000 £000

Liquidation proceeds 4,100 Debenture holders – secured element 1,800

2,300 Cost of liquidation 200

2,100 Preferential creditors 300

Unsecured creditors: 1,800 Debenture holders – unsecured element 1,000 Other creditors, 2,300 – 300 2,000 3,000

Unsecured creditors get 1,800 ÷ 3,000 = 60p in the £ Unsecured element owing to debenture holders, 1,000 x 60p 600

Other creditors, 200,000 x 60p 1,200

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Examiner’s comments Most candidates made some progress in answering this question, and there were some very good answers. Common errors were: (i) ranking preference shareholders ahead of some of the creditors; and (ii) deducting the full amount due to the debenture holders from the proceeds from liquidation.

(f) State the principal purpose of an auditors’ report, and identify the accounting

information that it covers. (4 marks)

Suggested answer The auditors’ report is addressed to the shareholders and expresses an opinion on whether the accounts show a true and fair view. Where this is not the case, the audit report is qualified. The auditors’ report covers the information contained in the four principal financial statements: the income statement; the balance sheet; the change of equity statement; and the cash flow statement. In preparing their report, the auditors are also required to consider whether the information contained in the directors’ report is consistent with the accounts and, if it is not, they are required to say so. Examiner’s comments Some very good answers were provided for this question.

(g) Explain the difference between a finance lease and an operating lease in accordance

with the relevant provisions contained in IAS 17 ‘Leases’. Why was it important to introduce this distinction?

(4 marks)

Suggested answer A finance lease is one which transfers substantially all the risks and rewards of ownership to the lessee. Although, strictly, the leased asset remains the property of the lessor, in substance the lessee is considered to have acquired the asset and to have financed the acquisition by obtaining a loan from the lessor. An operating lease is any lease which is not a finance lease and substantially exhibits the character of a rental agreement. The purpose of the distinction was to enable the introduction of a requirement for finance leases to be capitalised and reported in the balance sheet of the lessee and, in that way, counter an arrangement designed to achieve off-balance sheet financing. Examiner’s comments Most candidates demonstrated an understanding of the difference between a finance lease and an operating lease in their answers, although a few got the definitions the wrong way around. Far fewer answers explained why it proved necessary for the regulators to introduce the distinction between these two types of leases.

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(h) Explain what is meant by the term ‘obligating event’ in accordance with the provisions of IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’.

(4 marks) Suggested answer An obligating event is deemed to exist only where there is either a contractual obligation or a constructive obligation. The latter results from an entity’s actions where:

By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities.

As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

In other words, an obligating event results in an entity having no realistic alternative to settling that obligation – there is effectively a liability. If expenditure, although appearing prudent, is avoidable, it must not be provided for in the accounts, although it probably should be referred to in the narrative in order to ensure that users are properly informed of the company’s intentions. Examiner’s comments This was the least well answered part of Question 1. Most candidates simply discussed contingent assets and contingent liabilities. These are of course important aspects of IAS 37, but they are not relevant to a discussion of an obligating event.

(i) Explain how the application of current cost accounting principles affects the figures

for reported profit and shareholders’ equity during a period when replacement costs of fixed assets have increased.

(4 marks)

Suggested answer CCA capital is the operating capacity of the assets purchased with funds invested in the firm. It is these assets that generate income, so nothing must be distributed until sufficient resources have been retained in the business to enable the replacement of assets, which are sold or have been worn out. If the replacement cost of fixed assets has risen, reported profit will be reduced as the result of the necessary increase in the depreciation charge whereas shareholders’ equity will increase due to the creation of holding gains. Examiner’s comments There were quite a few good answers to this question, but not as many as expected. A common error was to conclude that, because higher charges in the income statement produce a lower profit figure, this automatically translates into a lower figure for shareholders’ equity.

(j) Identify the steps involved in computing and accounting for an impairment loss

arising in respect of a cash generating unit. (4 marks)

Suggested answer The main steps are:

(i) Identify the cash generating unit. (ii) Prepare cash flow estimates for the cash generating unit.

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(iii) Compute the value in use by applying the appropriate discount rate. (iv) Identify the net selling price. (v) Compute the recoverable amount as the higher of (iii) and (iv). (vi) Impairment = carrying value minus recoverable amount.

Allocate the impairment loss first to goodwill and then to all other assets on a pro rata basis. However, in applying this rule, the carrying value of assets should not be reduced below their recoverable amount. Examiner’s comments Candidates appeared to be either familiar with the calculation of an impairment loss and scored well, or simply attempted to guess the answer and made little progress.

Section B

2. The following information, which remained unchanged between 1 October 2008 and 30

September 2010, is provided relating to the long-term capital employed by two public companies engaged in identical business activities; Savigne plc (‘Savigne’) and Hommes plc (‘Hommes’):

Savigne Hommes

£ million £ million

Issued share capital (£1 ordinary shares) 800 500

Long-term borrowings: 8% debentures 200 500

Each company earned an operating profit before finance charges of £60 million during the twelve months to 30 September 2009, and £120 million during the twelve months to 30 September 2010. You may assume that corporation tax is charged at 30% on the operating profits of each company after finance charges have been deducted. The directors of Savigne and Hommes adopt the policy of paying out the entire after-tax profits as dividends. You may assume that interest payments and dividends are made on the last day of the accounting period to which they relate. Required

(a) Prepare summary income statements, dealing with the results of each of the two

companies’ activities during each of the accounting years to 30 September 2009 and 2010 so far as the information given above permits.

(6 marks)

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Suggested answer Income statements

Savigne Hommes

2009 2010 2009 2010 £m £m £m £m Profit before finance charges 60.0 120.0 60.0 120.0 Loan interest 16.0 16.0 40.0 40.0

Profit before tax 44.0 104.0 20.0 80.0 Taxation 13.2 31.2 6.0 24.0

Profit after tax 30.8 72.8 14.0 56.0

(b) For each company, for each year, calculate:

(i) Rate of return on long term capital employed. (ii) Rate of return (after tax) on shareholders’ equity.

Ratios should be calculated to one decimal place.

(4 marks)

Suggested answer

Savigne Hommes

Rate of returns on: 2009 2010 2009 2010

Long term capital employed 6.0% 12.0% 6.0% 12.0%

Shareholders’ equity 3.9% 9.1% 2.8% 11.2%

(c) Carry out an examination of the relative performance of Savigne and Hommes from the viewpoint of their shareholders during each of the years to 30 September 2009 and 2010, based on your calculations under 2(b), above.

(10 marks)

Suggested answer

The post-tax rate of return earned for the shareholders of Savigne is higher than that for Hommes in the year to 30 September 2009 whilst the position is reversed in the following year. The changes that have taken place in the relative performance of Savigne and Hommes over the two year period are explicable in terms of the financial effects of gearing, i.e. the relationship between securities attracting a fixed rate of interest and those that benefit from the payment of a dividend whose amount, as in this case, depends on the level of profits. Hommes is relatively ‘highly’ geared (debt = equity) which means that, when profits are low, a disproportionately large slice of the company’s earnings will be required in order to finance debt capital. In the year to 30 September 2009, the pre-tax return on long term capital is 6% but the interest rate payable on loans is 8%, and this results in an after tax return of just 2.8% for shareholders. This may be contrasted with Savigne where the claims of the debenture holders are less and so the ordinary shareholders got more, in this case 3.9%. When profits rise the position alters. Additional profits of £60 million which, after tax, increase the balance available for ordinary shareholders by £42 million represents an increase of 5.2% to shareholders of Savigne, but 8.4% to the shareholders of Hommes.

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Therefore, the return to the ordinary shareholders of Savigne increases only a little above the doubling of profits, whereas the return earned for the shareholders of Hommes increases four-fold. Examiner’s comments Answers to part (a) were generally of a good standard, as were those to part (b)(ii). The problem with answers to part (b)(i) was that candidates often based their calculations of the rate of return on long-term capital employed on profit after tax rather than profit before tax. Most candidates were able to draw attention, under part (c), to the differential returns earned by the two companies and the fact the returns altered between 2009 and 2010. However, far too few answers explored in detail the significance for rates of return on capital of differential levels of gearing (leverage) at each of the two companies.

3. The following trial balance relates to the financial affairs of Winchester plc (‘Winchester’)

as at 30 September 2010:

£000 £000

Accumulated depreciation on leasehold properties to 1 October 2009

3,240

Administration, selling and distribution expenses 10,600 Cash at bank 5,355 Cost of long term contracts to date 5,000 Cost of sales 20,250 Deferred tax account 1,420 Freehold properties 13,505 Goodwill 3,750 Inventories 10,000 Leasehold properties at cost 18,000 Long-term borrowing 8,500 Payables and accruals 7,750 Receivables and prepayments 5,575 Retained profit at 1 October 2009 10,625 Sales revenue 35,500 Share capital (ordinary shares of £0.50 each) 25,000

92,035 92,035

The following additional information is provided:

(i) The long-term borrowing was raised on 1 October 2009 and interest of 5% is paid

annually in arrears on a face value of £10,000,000, which is repayable on 30 September 2014. The effective rate of interest implicit in this arrangement is 8.84%.

(ii) The freehold properties were acquired for their investment potential on 1 April 2010.

It is the company’s policy to report investment properties at their fair value which, on 30 September 2010, was estimated to be £15,500,000.

(iii) The leasehold properties are depreciated on the straight line basis over the 50 year

period of the lease. (iv) Sales during October 2010 of inventories held on 30 September 2010 revealed that

carrying value in the above trial balance exceeded net realisable value by £465,000. (v) The following information is provided in relation to a long term contract entered into

in January 2010.

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£000

Total contract price 12,500

Value of work completed to 30 September 2010 5,750

Costs incurred to 30 September 2010 5,000

Estimated costs to completion 5,500

(vi) The taxable profit for the year to 30 September 2010 is estimated to be £3,800,000.

Reversing temporary differences amount to £400,000. The rate of corporation tax is to be taken at 30%.

(vii) It has been estimated that goodwill has suffered impairment due to changes in

government regulations relating to Winchester’s activities. It is now worth £3,526,000.

Required Prepare the income statement of Winchester in respect of the year to 30 September 2010 and balance sheet at that date, conforming as far as possible with relevant statements of standard accounting practice.

(20 marks) Notes:

All items are material.

Calculations to the nearest £000.

Ignore any taxation implications of the additional information provided under (ii), above.

Suggested answer Income Statement for year ended 30 September 2010

Workings £000 £000

Sales revenue 35,500 + 5,750 [contract] 41,250 Cost of sales 4,620 20,250 + 5,000 [contract] + 465 [post

balance sheet event] 25,715

3,230 15,535 Administration expenses etc 10,600 + 360 [depreciation] 10,960 Impairment of goodwill 3,750 - 3,526 224

Operating profit 945 4,351 Surplus on remeasurement of investment properties at fair value

15,500 - 13,505 1,995

Finance costs 8,500 x 8.84% 751

Profit before taxation 995 5,595 Taxation 3,800 x 30% = 1,140 Transfer from DTA (33) 333 400 x 30% = 120 1,020

Profit after tax 662 4,575

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Balance sheet at 30 September 2010

Non-current assets Workings £000 £000

Leasehold properties at cost 18,000 Less: Accumulated depreciation 3,240 + 360 3,600

14,400 Goodwill at impaired amount 3,526

17,926 Investment properties at open market valuation 15,500 Current Assets Inventories 10,000 - 465 9,535 Receivable on contract work in progress 5,750 Receivables and prepayments 5,575 Cash at bank 5,355

26,215

59,641

Equity and liabilities: Share capital (ordinary shares of £0.50 each) 25,000 Income statement 10,625 + 4,575 15,200

40,200

Non-current liabilities 8.84% long-term borrowing 8,500 + 751 - 500 8,751 Provision for deferred taxation 1,420 - 120 1,300

6,736 10,051

Current liabilities Payables and accruals 7,750 Corporation tax 1,140 Interest payable 500

9,390

8,662 59,641

Examiner’s comments Most candidates attempting this question achieved good marks, but relatively few achieved high marks. The main problems were:

Failure to record the effective rate of interest on long-term borrowing in the income statement or to make appropriate adjustments to the carrying value of the long-term borrowing in the balance sheet.

The omission from the income statement of the reduction in the carrying value of the inventories.

The failure to take any account of the information provided relating to the long-term contract.

Difficulties in accounting for taxation, both in relation to the current charge for the year and to the impact on the balance for deferred taxation.

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4. The following information is provided in respect of Elm Ltd:

(i) The company was incorporated on 1 October 2009 and immediately issued 75,000 shares of £1 each for cash.

(ii) On 1 October 2009, the company purchased, for cash, premises costing £50,000 and

ten mountain bikes for £2,500 each. (iii) On 1 October 2009, the company sold five mountain bikes for cash, £4,000 each. On

30 September 2010, the company sold the remaining five mountain bikes for cash, £4,000 each.

(iv) On 30 September 2010, the company paid operating expenses, in cash, amounting

to £6,000. (v) The directors plan to pay out as dividends, on 1 October 2010, the full amount of

profits reported in the income statement for the year to 30 September 2010. (vi) The replacement cost of mountain bikes on 1 October 2010 is expected to be £2,950

each.

Movements in the general price index are as follows:

1 October 2009 100

31 March 2010 110

30 September 2010 120

Required

(a) Prepare separate income statements of Elm Ltd for the year ended 30 September

2010 and balance sheets at that date on each of the following bases:

(i) Historical cost accounting (HCA). (ii) Current purchasing power (CPP) accounting.

(10 marks)

Suggested answer Income statements 2010

HCA CPP

£ £ Sales revenue 20,000 120÷100 24,000 20,000 20,000

40,000 44,000 Cost of goods sold 25,000 120÷100 30,000

Gross profit 15,000 14,000 Operating expenses 6,000 6,000

Operating profit 9,000 8,000 Loss on net monetary assets, 20,000 x 20÷100 - 4,000

Net profit 9,000 4,000

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Balance sheets 30 September 2010

HCA CPP

£ £ Premises at cost 50,000 120÷100 60,000 Cash at bank (75,000-50,000-25,000+20,000+20,000-6,000)

34,000 34,000

84,000 94,000

Share capital 75,000 120÷100 90,000 Retained profit 9,000 4,000

84,000 94,000

(b) Discuss four advantages of CPP accounting, and illustrate these advantages, where possible, by reference to the accounts you have prepared.

(10 marks)

Note: Ignore taxation and depreciation of premises. Suggested answer

CPP accounting identifies the amount that must be retained in a business if the purchasing power of the shareholders’ investment is to be maintained intact. In this case, the amount required for that purpose is £15,000 (£75,000 x 20%). If the whole of the historical cost profit of £9,000 is paid out in dividends, £5,000 is in effect a return of capital to the shareholders and the carrying value of their investment, in terms of purchasing power, declines to £85,000. CPP accounting measures whether the purchasing power of the shareholders’ capital has been maintained intact. It does this by expressing all transactions in terms of year end £s. It can thus be seen, in this case, that the real value of the shareholders’ investment has declined by £5,000. There are two elements to this loss: the reduction in gross profit resulting from the fact that the increased cost of goods sold, expressed in year end £s, is £1,000 more than the sales value computed on a similar basis; and a loss arising from holding monetary assets during the year of £4,000. The restatement of asset values in terms of a stable money value provides a more meaningful basis for comparison with other companies. Similarly, provided that previous year’s profits are restated into CPP terms, it is also possible to compare more realistically the current year’s results with past performance. CPP accounting restates all £s in terms of year end values and this avoids the mixing together of different generations of pounds that occurs under HCA. Examiner’s comments This was the least well answered question in Section B. Most candidates were of course able to prepared the historical cost accounts, though many appeared to encounter unexpected difficulty in calculating the revised figure for cash at bank. Very few candidates made much progress in preparing financial statements in accordance with current purchasing power accounting procedures. Answers to part (b) sometimes made relevant general comments concerning the advantages of CPP accounting, but few attempted to illustrate these advantages by drawing on information in the accounts they had prepared.

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5. The following information is provided relating to the financial affairs of Challonnes plc:

Income statement for the year ending 30 September 2010

£million Sales revenue 1,040 Other cost of goods sold (including depreciation) -792

Gross profit 248 Administrative expenses -96 Distribution costs -74

Operating profit 78 Interest paid -20

Profit before taxation 58 Taxation Charge for the year -22

Transfer to deferred tax account -4

-26

Profit after taxation 32

Balance Sheet at 30 September 2010 2009

£million £million Non-current assets Property, plant and equipment at cost 840 580 Less: Accumulated depreciation 206 172

634 408

Current assets Inventories 398 266 Receivables 246 158 Cash balance - 30

644 454

1,278 862

Equity and liabilities Called up share capital 200 160 Share premium account 16 14 Retained earnings 144 112

360 286

Non-current liabilities Debentures 400 400 Provision for deferred taxation 36 32

436 432

Current liabilities Trade payables 196 54 Taxation 22 24 Bank overdraft 264 66

482 144

1,278 862

The company did not sell any non-current assets during the year. Required

(a) A cash flow statement for Challonnes plc for 2010 prepared in accordance with the

requirements of IAS 7 ‘Statement of Cash Flows’. You should use the direct method to calculate cash flow from operating activities.

(12 marks)

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Suggested answer

Cash flow statement for year ended 30 September 2010 £000 £000

Cash flows from operating activities Cash receipts from customers 952 Cash paid to suppliers and employees 918

Cash generated from operations 34 Interest paid -20 Tax paid -24

Net cash generated from operating activities

-10

Cash flows from investing activities Purchase of plant 840 - 580 -260 Cash flows from financing activities Proceeds from issue of share capital 40 + 2 42

Net decrease in cash -228 Cash at beginning of period -36

Cash at end of period -264

Workings £000

Sales 1,040 Opening receivables 158 Closing receivables -246

Cash receipts from customers 952

Other costs of goods sold (including depreciation) 792 Depreciation -34 Opening inventories -266 Closing inventories +398

Purchases 890 Opening payables +54 Closing payables -196 Administrative costs 96 Distribution costs 74

Cash paid to suppliers and employees 918

(b) A discussion of the main financial developments during 2010. (8 marks) Suggested answer

Answers should have discussed the following points:

Cash generated from operations is just £34,000; most of the resources generated from trading (profit of £58,000 + depreciation of £34,000) have been absorbed by the net increase in working capital.

Cash generated from operating activities is insufficient to cover interest payments and tax which together amount to £44 million.

The company has undertaken a significant investment in non-current assets suggestive of an increase in capacity of nearly 50%.

The increase in inventories and receivables represent further evidence of a material increase in the scale of operations.

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Some of the finance for this development has been provided from long-term sources in the form of a share issue

The company has raised insufficient long-term finance to fund its development, with the result that the bank overdraft has increased by nearly seven-fold and the increase in the trade payables is disproportionate to the apparent rise in the level of activity.

The company’s financial position has suffered significant deterioration. Examiner’s comments Candidates displayed a good degree of familiarity with the general procedures involved in the preparation of the cash flow statement, although most answers displayed weaknesses when attempting to apply candidates’ knowledge to the calculation of items for inclusion in that financial statement. Many candidates used the indirect method rather than the direct method, as specified, to calculate cash flow from operating activities. Other common errors were: (i) to include the tax charge for year 2009-10 rather than tax paid during the year; and (ii) to overlook the increase in the share premium account balance when computing the proceeds from the share issue. Answers to part (b) usually contained relevant comments though many answers strayed beyond the instruction to concentrate on ‘financial developments’.

6. Drawing on the content of the International Accounting Standards Board’s ‘Framework

for the Preparation and Presentation of Financial Statements’:

(a) Identify and discuss the nature and purpose of the two ‘underlying assumptions’. (10 marks)

Suggested answer These ‘underlying assumptions’ are: (i) Accrual basis Financial statements, other than the cash flow statement, are prepared using the accrual basis of accounting. The accruals basis of accounting requires:

Expenses to be recognised in the income statement on the basis of a direct association between costs incurred and the earning of specific items of income (matching).

Revenues and expenses to be included in the income statement as they are earned and incurred rather than when they are received and paid.

Financial statements prepared on the accrual basis are powerful because they inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. (ii) Going concern concept The going concern concept assumes that the company will continue in business for the foreseeable future. The main effect of this assumption is that the liquidation value of assets and liabilities, which may be significantly different from carrying value, can be ignored because there is no intention to discontinue business activity. The only circumstances in which liquidation values are to be used are where management:

Intends to liquidate the enterprise or to cease trading.

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Has no realistic alternative but to do so.

(b) Explain fully the role of the qualitative characteristic of ‘reliability’. (10 marks)

Suggested answer For information to be useful, it must also possess the characteristic of reliability. Information in financial statements is judged to be reliable if it is free from material error and bias and can be depended upon by users to faithfully represent events and transactions. Faithful representation – There is almost always some risk that financial information does not provide a completely faithful representation of what it purports to portray. This may not be due to the fact that the information is biased, but rather to difficulties, either in identifying transactions and other events that should be measured, or with the measurement methods and presentation techniques. In certain cases, the measurement of the financial effects of an item can be so uncertain that it should not be recognised in the financial statements. If, for example, the validity of, and the amount of, a claim for damages is the subject of legal dispute, it may be inappropriate to recognise the amount in the statement of financial position. Instead, it may be appropriate to disclose the amount and the circumstances relating to the claim by way of a note to the accounts. Substance over form – If information is to represent faithfully the transactions and other events that it purports to portray, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Neutrality – This requires that published information should be neutral and free from bias. The financial statements are not neutral if, through the selection or presentation of information, they influence decisions and assessments with the aim of achieving a predetermined result or outcome. Prudence – The preparers of financial statements must deal with the uncertainty that is inevitably associated with many events and circumstances, for example, the prospects of receiving payment for doubtful receivables, the probable useful life of non-current assets and the number of claims for guarantees that can be predicted. Prudence is, therefore, designed to help ensure that that assets and revenue are not overstated and that liabilities and expenses are not understated. Completeness – To be reliable, the information in the financial statements must be complete within the bounds of what can be considered to be material in relation to the cost of producing the information. Excluding information can have the affect that the accounts are incorrect or misleading and, therefore, neither reliable nor relevant. Examiner’s comments There were some very good answers to this question. In particular, candidates scored very well in their answer to part (a). Most candidates demonstrated that they understood the nature of the qualitative characteristic of reliability, though few answers identified the five areas which require attention if published financial information is to comply fully with that concept.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.