INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
26 April 2012 (am)

Subject CT2 Finance and Financial Reporting Core Technical

Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE 1. Enter all the candidate and examination details as requested on the front of your answer booklet. You must not start writing your answers in the booklet until instructed to do so by the supervisor. Mark allocations are shown in brackets. Attempt all 20 questions. From question 11 onwards begin your answer to each question on a separate sheet. Candidates should show calculations where this is appropriate.

2.

3. 4.

5.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper.
In addition to this paper you should have available the 2002 edition of the Formulae and Tables and your own electronic calculator from the approved list.

CT2 A2012

Institute and Faculty of Actuaries

For questions 110 indicate in your answer book which one of the answers A, B, C or D is correct.

Why should an eligible bill of exchange be regarded as a very secure investment? A B C D The issuer is eligible to issue secure bills of exchange. The holder of the bill is eligible to claim repayment in full at any time. The bill has been guaranteed by a bank. The bill has been drafted by an eligible intermediary. [2]

What aspect of a limited liability partnership (LLP) is limited? A B The liability of individual members is limited to 100,000. The liability of individual members is limited to their agreed share of the partnerships liabilities. No member can suffer loss due to the acts or omissions of another member. The LLPs creditors cannot normally seek payment from the members themselves. [2]

C D

A quoted company made a substantial rights issue. A shareholder who had a substantial shareholding did not wish to take up the right to buy shares and forgot to sell those rights. Which of the following best describes the effects of this forgetful shareholders actions? A The forgetful shareholder was worse off because of the rights issue and the other shareholders were unaffected. The forgetful shareholder was worse off because of the rights issue and the other shareholders were better off. The forgetful shareholder was unaffected by the rights issue and the other shareholders were better off. The forgetful shareholder was unaffected by the rights issue and the other shareholders were worse off. [2]

CT2 A20122

Which of the following best supports the assertion that the payment of a dividend signals confidence on the part of the directors? A B C D The dividend is paid out of past profits that have actually been earned. The directors are keen to receive dividends from their own shareholdings. The directors have to find the cash with which to pay the dividend. The shareholders will react badly to the non-payment of a dividend. [2]

The net present value criterion is generally claimed to provide the most consistent and relevant basis for the selection of investment projects. Which of the following situations creates the greatest threat to the validity of evaluating projects using net present value in practice? A B C D Net present value ignores risk. Shareholders may disagree with the results of a net present value calculation. The calculation of net present value can lead to two solutions. Managers may wish to undertake the project for selfish reasons and could manipulate the analysis. [2]

A companys external auditor included an emphasis of matter in the audit report. Which of the following statements best describes the meaning of an emphasis of matter? A The auditor wishes to draw attention to an important matter that has been disclosed in the notes to the financial statements. The auditor wishes to draw attention to the limitations of the work undertaken during the audit. The audit report is being qualified. The auditor disagrees with the information in the financial statements. [2]

C D

CT2 A20123

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Which of the following is most likely to arise as a consequence of the money measurement concept? A B C D Assets will be recorded at cost. Some valuable assets will be excluded from the financial statements altogether. Expenses will be accrued regardless of when the associated payment is made. Assets will not be written down to their break-up values. [2]

Which of the following statements relating to current assets is correct? A B C Current assets will be realised within one year. Current assets have short expected useful lives. Current assets comprise cash and items that will be converted into cash in the normal course of business. Current assets always comprise inventories, receivables, bank and cash. [2]

Which of the following best explains why investment analysts often calculate Earnings before Interest, Taxation, Depreciation and Amortisation (EBITDA)? A B C D EBITDA is less prone to fluctuations and volatility than net profit. Depreciation and amortisation are not real costs to the business. Investment analysts are only interested in performance before tax. EBITDA is regarded as less prone to manipulation than net profit. [2]

CT2 A20124

10

Net asset value per share is calculated by subtracting intangible assets from ordinary shareholders equity and dividing the remainder by the number of shares in issue. Which of the following best explains the relevance of net asset value per share? A In the event that the entity is wound up the chances are that its intangible assets will not have any market value, but the shareholders will be certain to receive the value of the remaining net assets after disposal. In the event that the entity is wound up the net asset value per share is likely to represent the best possible outcome that the shareholders can expect. The shareholders should monitor the net asset value per share and should insist that the entity be wound up in the event that net asset value per share exceeds the market value of the companys shares. Net asset value per share is likely to correspond to the value that an unquoted companys shares would have on the open market. [2]

11

Explain why, from a tax perspective, many individual shareholders prefer to earn a return from an increase in the share price rather than payment of a dividend. [5]

12

Martha is seeking funding for a company that she wishes to establish. Her plans involve too much risk for a conventional bank loan but a venture capital company has offered to invest in convertible loan stock. Discuss the disadvantages to Martha of funding her company by issuing convertible loan stock to a third party. [5]

13 14

Outline the uses to which currency futures can be put.

[5]

Four engineers have established a company to manufacture a new product that they have patented. Each of the directors owns 25% of the companys equity. They have employed a qualified accountant to manage the companys record-keeping and to engage with potential lenders on the companys behalf. Describe the respective legal responsibilities of both the companys directors and its accountant in relation to record-keeping and lenders. [5]

15

Explain how a lessee can take on the risks and rewards of ownership of an asset, even though the leased asset remains the property of the lessor. [5]

CT2 A20125

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16

Explain how there could be a conflict between the interests of directors and shareholders over the raising of additional finance, where the directors would prefer the company to issue equity and the shareholders would prefer the company to borrow. [5]

17

Explain why accounting information that is relevant may not be reliable and why accounting information that is reliable may not be relevant. [5]

18

Discuss the usefulness and limitations of a companys annual report to the companys lenders. [5]

CT2 A20126

19

Barton manufactures animal feed using machinery that is both very simple and very robust. The company has operated independently since it was founded. Bartons primary product cannot be manufactured using modern technology and Barton faces very little competition within its market niche. The product is popular with horseracing stables and other horse owners who wish to promote the health and stamina of their animals. Bartons owner is planning to retire and has offered to sell the company to Nufeed, an animal feed business that manufactures animal feed using heavily industrialised processes. Nufeed is interested in acquiring Barton because it will complement its existing product range and will demonstrate Nufeeds commitment to manufacturing traditional products using traditional methods. Bartons owner proposes that the companys selling price should be set by multiplying the most recent profit figure by a multiple that has yet to be agreed. Nufeeds chief financial officer is reviewing Bartons financial statements in order to establish whether that is a realistic suggestion. Bartons property, plant and equipment figures are as follows: Plant and equipment 000 250 9 259

Property 000 Cost As at 31 March 2011 Additions As at 31 March 2012 Aggregate depreciation As at 31 March 2011 Charge for year As at 31 March 2012 Net book value As at 31 March 2012 As at 31 March 2011 800 50 850

Total 000 1,050 59 1,109

272 16 288

170 10 180

442 26 468

562 528

79 80

641 608

All of Bartons property, plant and equipment is shown at cost less depreciation. Property is depreciated at a rate of 2% of cost every year and plant and equipment at a rate of 4% of cost. Property comprises a large factory building located in the countryside, close to several large farms that provide the companys raw materials. Plant and equipment comprises heavy milling and mixing equipment that was built to Bartons specifications when the company was established. The equipment is maintained to a very high standard by Bartons head of production, who has worked for the company for almost 20 years.

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Nufeed commissioned a report on the plant and equipment. The report stated that it would cost at least 1.2 million to replace the production machinery. With the correct maintenance, this type of equipment can have a very long useful life, but very few engineers have the skills to repair ongoing wear and tear. In the absence of such a skilled maintenance team, the bearings would wear out after approximately ten years, resulting in the scrapping of the equipment. The equipment has almost no resale value because it is too large and heavy to be dismantled and removed. Nufeeds chief financial officer has asked Bartons owner to restate the depreciation charge to deal with the effects of inflation. Bartons owner has refused on the basis that it could be argued that depreciation ought to be zero because the plant and equipment has no market value. Furthermore, he has not asked Nufeed to pay anything for Bartons good name and loyal customer base because neither of those assets is recognised in the companys statement of financial position (balance sheet). (i) Explain why it appears that Bartons depreciation charge may have been understated.

[5]

(ii)

Calculate an alternative more relevant depreciation charge for Bartons plant and equipment that would better reflect the use of these resources. [3] Explain the logic underlying your depreciation calculation. [3]

(iii) (iv)

Outline the logic behind Bartons owners claim that the depreciation charge should be zero. [3] Discuss the validity of the claim made by Bartons owner that he has not charged Nufeed anything for the companys reputation and customer base. [6] [Total 20]

(v)

CT2 A20128

20

Manor is a quoted property company that specialises in the development and resale of commercial office buildings. The company frequently invests in large projects that run for between three and five years, with that being the typical timescale from the acquisition of a new property to its resale after redevelopment. Manor evaluates potential investments using the net present value (NPV) criterion. The NPVs of all proposals are calculated using a discount rate of 8% p.a. The criterion has been in place for at least the past ten years. The finance director is unhappy that the companys principal investment criterion has been in place for so long that none of the present senior executives were in post when it was introduced. As a result, nobody knows the reasons for its selection. That has become an issue in recent years because the property market has been depressed and most of the investment opportunities have offered a negative NPV when discounted at 8% p.a. The shareholders are beginning to become anxious that the company is not putting its assets to good use because the proceeds of selling developed properties are being banked instead of being reinvested in fresh projects. The chief executive has asked the finance director to consider the following possibilities: Calculate the NPV using a discount rate of 5% p.a., at least until the property market improves and creates the possibility of higher returns. Continue to discount investment opportunities at 8% p.a., but take a more optimistic view of future cash flows from projects under consideration. Most projects have a range of possible outcomes and many become desirable when evaluated using the best possible outcome for costs and revenues rather than the most likely. Discuss the validity of Manors policy of using an 8% p.a. discount rate when calculating the NPV of investment opportunities. [8] Discuss the logic behind reducing the discount rate for evaluating projects to 5% p.a. until the property market improves. Your discussion should cover both the validity of the proposed reduction in the discount rate and the likely impact on Manors share price. [8] Discuss the validity of evaluating projects using the best possible forecast outcomes instead of the most likely. [4] [Total 20]

(i)

(ii)

(iii)

END OF PAPER

CT2 A20129

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2012 examinations

Subject CT2 Finance and Financial Reporting Core Technical

Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and who are using past papers as a revision aid, and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. Although Examiners have access to the Core Reading, which is designed to interpret the syllabus, the Examiners are not required to examine the content of Core Reading. Notwithstanding that, the questions set, and the following comments, will generally be based on Core Reading. For numerical questions the Examiners preferred approach to the solution is reproduced in this report. Other valid approaches are always given appropriate credit; where there is a commonly used alternative approach, this is also noted in the report. For essay-style questions, and particularly the open-ended questions in the later subjects, this report contains all the points for which the Examiners awarded marks. This is much more than a model solution it would be impossible to write down all the points in the report in the time allowed for the question. T J Birse Chairman of the Board of Examiners July 2012

Institute and Faculty of Actuaries

Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

General comments on Subject CT2 This paper examines basic finance including raising funds by a variety of methods, taxation, net present value and project appraisal and other topics, it has both calculations and essay type questions on these topics. The paper also examines financial reporting including preparation of the main financial statements and interpretation of financial statements it also considers the basis of the preparation of statements and the information needs of a variety of end users of financial statements. Different numerical answers may be obtained to those shown in these solutions depending on whether figures obtained from tables or from calculators are used in the calculations but candidates are not penalised for this. However, candidates may be penalised where excessive rounding has been used or where insufficient working is shown. Comments on the April 2012 paper Although, the general performance was slightly poorer than in September 2012, wellprepared candidates scored well across the whole paper. As in previous diets, overseas candidates did not perform quite so well as UK candidates. The comments that follow the questions concentrate on areas where candidates could have improved their performance. Candidates approaching the subject for the first time are advised to concentrate their revision in these areas. The main questions that caused candidates difficulty were Q19 and 20.

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

1 2 3 4 5 6 7 8 9 10

C D B C D A B C D B

The MCQs were done well.

11

Most individual shareholders pay income tax at their highest marginal rate when they receive any dividend income. They have very little opportunity to manage that liability and so tax will almost certainly become payable whenever a dividend is received. If the company retains earnings then, in theory, the share price will rise. Shareholders are not taxed on that gain unless they realise it by selling their shares. That gives the shareholders an opportunity to plan their pattern of taxable gains in any given year because they can time the realisation by delaying the sale of their shares if they so wish. In addition, individual shareholders receive an annual allowance that can reduce the amount paid on gains beneath the allowance to zero. Furthermore, the tax rate on capital gains is generally lower than that which would be suffered on income.

This question was done well by candidates with most having good knowledge of the tax system.

12

The advantages to the lender generally cause equivalent disadvantages to the borrower. Martha will have to find the cash to pay interest on the bonds during the debt phase of the instrument. While that interest may be payable at a lower rate than would be paid on an outright loan, it is still a commitment that the new business will have to make. In the event that Marthas business succeeds, the chances are that the bondholder will convert the bond to shares. That will dilute her equity and will reduce her return from having taken the initiative to start this business and work to make it a success. Thus, the bond will impose all of the downside risks associate with borrowing when the business is at its most vulnerable and will reduce the upside risks associated with any success that the business enjoys.

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

This question was not done well by candidates In general points written down were too few and at too high a level.

13

Currency futures can be used to manage risk exposures. The most logical use for a future would be to manage downside risk on a future receipt or payment of foreign currency. For example, if a company had made a sale to a foreign customer and had been forced to invoice in the customers currency there could be a risk that the rates will move adversely during the period before settlement. A currency future could be entered into so that the sum due is sold for delivery at a future date, thereby guaranteeing the companys future receipt. The only significant cost would be the interest foregone on the margin deposit that would have to be made. Futures can also be used to create a substantial exposure for speculative purposes. An investor who predicted a significant shift in a particular currency that appears to have been mispriced could enter into a futures contract in order to obtain a more significant position than could be possible using cash reserves to buy and hold the currency itself.

This question was done badly my many candidates. Many answers were extremely brief and had very little detail. Candidates had very little knowledge of this area. Many knew what futures were, but did not know much more and were unsure what they were for.

14

The directors are ultimately responsible for the companys administration and any relationships that it develops with third parties. They cannot make somebody else responsible for those matters even if their expertise in engineering means that they are not particularly well equipped in business or financial management. They can, of course, delegate the actual work of maintaining books or talking to banks to a financial manager if they so wish. The companys accountant will be required to fulfil the duties that are spelled out in the contract of employment. Those duties may have to be discharged in accordance with standards imposed by the accountants professional body. The directors will bear the ultimate legal responsibility for ensuring that the company is compliant with all relevant legislation, but the directors will be entitled to expect that the work will be completed to a very high standard of quality.

This question was answered reasonably well.

15

The lessee may sign a lease that grants the right to use the asset for a specified period that amounts to virtually the whole of the assets anticipated useful life. Provided the lessee makes the agreed lease payments the lessor will have little or no rights over the asset. Thus, the lessee can make full use of the asset for most or all of its useful life and thereby enjoys the full rewards of ownership. Such lease arrangements are unlikely to be cancellable because the lessor will normally acquire the asset to meet the lessees specifications. The lease payments will

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

continue even if the asset becomes obsolete or redundant because the lessees needs change. The lessee will almost certainly have to agree to accept responsibility for any loss or damage to the asset while it is in the lessees custody. Thus, the lessee will effectively have to pay for the cost of the asset plus interest (via the lease payments) and suffer all the risks of ownership in the process. This question was answered well by most candidates.

16

The shareholders prefer the entity to borrow, within reason, because debt is cheaper than equity. The shareholders enjoy the benefit of the wealth created from the lenders investment and they also enjoy the benefits of the tax shield on borrowing. The risks associated with borrowing are borne directly by the company and so the shareholders will not have to risk their personal assets in the event that the company fails. The directors are more directly exposed to the risks of gearing. If the company fails because it cannot meet its loan commitments then the directors will face the loss of their jobs. If they issue further shares then the shareholders will be unlikely to ever have an incentive to put the company into receivership because they will lose everything that they have invested.

This question was answered very well by most candidates.

17

Relevant information is generally future-oriented. Users find information relevant if it informs decisions that have to be made and that will typically involve a comparison of the outcomes the different decisions will have. For example, the decision as to whether an asset should be retained or sold requires an understanding of the future cash flows that it will generate and also of the amount that it will realise on the open market. Information is reliable if it can be checked easily and measured against an objective benchmark. Generally, reliable information is historical and may not necessarily have much predictive value. For example, the historical cost of an asset is a very reliable measure because it can be verified against its associated invoice.

This question was done reasonably well the part on reliable information was poorer than the section on relevant information.

18

The financial statements are prepared by the directors and audited with a view to informing the shareholders. The figures in the financial statements may be designed to report past profitability, whereas the lenders would prefer a conservative evaluation of the present position to inform decisions about collectability. The information in the financial statements is largely historical, whereas lenders are primarily interested in future cash flows to ensure that they are capable of servicing a loan commitment. The statement of financial position will list the companys debts and the assets that are available to settle them and so that gives an insight into security, but the asset values

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

are not necessarily guaranteed in the event of a failure and associated disposal under conditions of duress. There is also a problem in that the annual report is not sufficiently frequent for the lender to monitor the security of an advance. This question was not done very well by candidates. The answers were usually too short and general. Many candidates only wrote two sentences. This was not enough to pass the question, as the allocation of marks available indicates.

19

(i)

Depreciation is effectively the recognition of the fact that an entity consumes resources in the form of property, plant and equipment when manufacturing goods. Bartons depreciation charge is based on a percentage of the historical cost of the assets being used. Bartons assets are very old and so those historical costs have become virtually meaningless. The resulting depreciation figure is perfectly consistent with accounting regulations, but it is not necessarily representative of the costs being incurred when reporting to decision makers. Any comparable business would have to report a much higher depreciation charge because it could not acquire assets for the same price as Barton. The property is stated at historical cost and therefore the depreciation charge is likely to be lower than if it was charged on current values.

This question was done very poorly with a surprising number of candidates having little idea what depreciation is. (ii) Notional cost of assets = 1.2m Notional useful life = 10 years Charge = 1.2m/10 = 120,000 per annum

This question was straightforward but was generally not answered correctly. (iii) This charge is calculated on the basis that the replacement cost of the assets is more relevant than their historical cost. The resulting depreciation recognises the economic cost of the wear and tear. The useful life is based on the argument that ten years is realistic when the company does not employ a craftsman such as Bartons head of production. Even if Barton has such an employee in post, there is no guarantee of retaining that person indefinitely and so the artificially long lives of the assets will be curtailed. This question was also not done well. Candidates had difficulty with the idea that having a craftsman as head of production could affect the useful life.

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

(iv)

The negotiation of the selling price of a business is complicated by the fact that accounting regulations do not necessarily lend themselves to every situation. Bartons machinery has been fully depreciated on a historical cost valuation and the fair value of the assets is normally determined by looking at their market valuation, which is also zero. Thus, Bartons owner can claim that depreciation on production machinery is zero and such a claim is consistent with accounting regulations. If the owner insists on making the best possible use of this loophole then profit may be overstated and that could be used as an argument to inflate the selling price for the business.

This question was answered incorrectly by many candidates who felt that the market value was relevant to the depreciation calculation. (v) The proposal involves basing the selling price on a multiple of profit. That automatically incorporates the effects of the factors that the owner has mentioned. The companys good name and customer base will have contributed to past profits and so they are included in the valuation of the company as a going concern. The fact that they are not being priced separately does not mean that they are being excluded altogether. It could be argued that the good name will become less valuable if Barton is taken over and becomes associated with a large and modern company. Part of the reason for companys success in this niche is the fact that it is a small company manufacturing in a traditional way. This part of the question was poorly answered with some candidates just missing it out.

20

(i)

This criterion takes some account of the time value of money. It also requires all investments to achieve positive NPV using a discount rate that has, presumably, been arrived at through trial and error or on some other basis. Perhaps the standard discount rate of 8% p.a. will not reflect the risks of any particular project, but the alternative would be to invest significant time and effort in determining a more realistic target for each investment and there is no guarantee that the resulting figures will be any more suitable. All investment decisions require subjective decisions about the risks and returns. The fact that Manor is investing in property means that it is fairly unlikely that it will be faced with a massive risk of loss on a project, even if it is necessary to hold an investment until a market blip sorts itself out. Also, the fact that the projects have a typical life of three to five years means that using a different discount rate would have very little impact on the overall net present value. More stringent criteria would be justified in the case of a different industry with longer project lives, but the impact in this case would not be material.

This part was not done very well by candidates. They generally did not mention the scenario set out in the question at all but just discussed NPV in general terms.

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

(ii)

There is no justification for reducing the discount rate just to make more projects appear to be profitable. It would make just as much sense to abandon project appraisal altogether and simply accept all projects on some random basis. If the market is declining then that might suggest that it is riskier and a higher discount rate than 8% p.a. should be used. If the shareholders discover that the company is seeking only a modest return on its investments then the share price will decline. Logically, the shareholders will evaluate projects using their own evaluation of risk and return and the share price will decline if the company accepts projects that have a negative NPV when evaluated in the shareholders terms. Clearly, the shareholders will not necessarily be aware of investments unless the directors inform them. Even if the fact that an investment is being made is disclosed, the directors will not publish their forecasts on NPV calculations. If the directors do make a series of poor investments because of this strategy then the shareholders will only become aware of that when the results of those investments start to appear in the published accounts. It may take at least two or three years before a series of weak returns starts to impact on reported ROCE.

This part was done badly by almost all candidates. Candidates did not mention shareholders and did not discuss the discount rates in any detail. Where candidates discussed this in part (i) credit was given. (iii) The most obvious risk is that any evaluation based on best possible is unlikely to achieve the anticipated results and is likely to be a disappointment. The shareholders will almost certainly wish the directors to evaluate any projects on the basis of the outcomes that are likely to be achieved and they may regard the use of will lead to the acceptance of best possible as a dishonest attempt to justify unsuitable investments. It could be worth considering the best possible outcome as one aspect of decision-making. Risky projects often have an upside potential as well as a downside and so the possibility that an upside may be enjoyed is worth considering as one factor in choosing between competing projects. This part of the question was done better than parts (i) and (ii).

END OF EXAMINERS REPORT

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