Professional Documents
Culture Documents
FINANCIAL ACCOUNTING
MAN2907L
MAIN PAPER MAY 2010
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Section B
Question One
The investment in Touch represents 80% (400,000/500,000) of its equity and is likely to give Sense
control thus Touch should be consolidated as a subsidiary. The investment in Sight represents
25% (200,000/800,000) of its equity and is normally treated as an associate that should be equity
accounted.
(a)
i) Goodwill:
000
Cost of the controlling interest in Touch
600
Equity shares
Pre-acquisition profit
Tangible assets fair value adjustments
80
Fair value of net assets at acquisition
80% thereof
Goodwill
Cost of the associate interest in Sight 300
Net assets at acquisition (800+92) x 25% 223
Goodwill
250
380
(710)
568
32
77
109
000
1,610
12
10)
1,788
235
(15)
220
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186
560
196
391
1,455
109
235
195
1,994
1,147
3,141
600
1,788
2,388
186
2,574
000
270
297
567
3,141
(80% marks)
(b)
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reflected in the consolidated net assets of the subsidiary (and the increase in group
reserves).
The cost of the investment might represent all of the ownership of the subsidiary or only
just over half of it, i.e. there would be no indication of the minority interest.
To summarise, in the absence of a consolidated balance sheet, users would have no
information on the current value of a subsidiary, its size, the composition of its net assets
and how much of it was owned by the group.
(20% marks)
(Total 100% marks)
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Question Two
(a)
(b)
Brief Report
To:
From: Student
Date April 2010
Subject: Financial Appraisal of Kingdom Using Accounting Ratios
Introduction
The purpose of this report is to analyse the financial performance of Kingdom over the last
three years using accounting ratios.
Return on capital employed
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The return on capital employed has declined over the last three years from 16.2% to 13.9%
and is now well below the industry average (16.2%). This should be a cause for concern to
the board of directors because if investors can obtain a higher return elsewhere then they
may withdraw their investment.
Alternatively they may seek to change the management board. It would be helpful to have
more information on the market in which Kingdom operates, e.g. is the market growing or
declining, are there many buyers and sellers or just a few.
Gross profit percentage
The gross profit percentage has risen over the period from 30.4% to 37.5%. Clearly the
company has either increased the selling price of its goods, e.g. perhaps it is able to sell at
a premium because of perceptions regarding the quality of the goods sold or reduced the
cost of its supplies. Possibly changing suppliers or obtaining greater discounts as sales
volume has increased.
It would be useful to know what the company is selling and the volume of sales analysed by
product and year.
Operating profit percentage
The operating profit percentage has declined over the period from 19.3% to 15.6% and is
significantly below the industry average of 17.3%, and seems to be the main contributor to
the weakening of the ROCE. This is worrying considering the increase in the gross profit
percentage over the same period. The decline in the operating profit percentage suggests
that the selling & admin. overhead costs may not be tightly controlled within the company.
More detailed information on expenditure during the period would be helpful in identifying
the reasons for the decline in profitability.
Quick (or acid test) ratio
The quick ratio has also declined significantly during the period from 1.5 to 0.67 suggesting
the company may be experiencing liquidity problems. This view is also supported when the
ratio is compared to the industry average which is over double that of Kingdom. The level
of inventory may be a concern as it is tying up cash. More information on the type of
inventory and the level of inventory turnover (currently 90 / 200 x 365 = 165 days) would be
useful.
discourage potential investors from investing in the company and may not be sufficient to
keep existing shareholders.
Conclusion
Although the company has managed to increase its gross profit over the period, this has
not resulted in a similar increase in net profit. In summary the ratios indicate poor internal
control of costs and poor management of working capital. The return on capital employed
and the EPS ratios are unlikely to be sufficiently attractive to potential investors or to
existing shareholders.
(40% marks)
(c)
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Question Three
(a)
(b) The main need for an accounting standard in this area is to clarify and regulate when
provisions should and should not be made. Many controversial areas including the possible
abuse of provisioning are based on contravening aspects of the above definitions.
i) Future restructuring or reorganisation costs
This is sometimes extended to providing for future operating losses. The attraction of
providing for this type of expense/loss is that once the provision has been made, the future
costs are then charged to the provision such that they bypass the statement of
comprehensive income (of the period when they occur). Such provisions can be glossed
over by management as exceptional items, which analysts are expected to disregard when
assessing the companys future prospects. If this type of provision were to be incorporated
as a liability as part of a subsidiarys net assets at the date of acquisition, the provision itself
would not be charged to the statement of comprehensive income. IAS 37 now prevents
this practice as future costs and operating losses (unless they are for an onerous contract)
do not constitute past events.
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According to IAS 37, a present obligation (legal or constructive) must be arisen as a result
of a past event (the obligating event). As the 10% discount promise hinges only on a future
second purchase event, a provision for the discount should not be recognised for the year
ended 30 June 2009. The management, however, may consider whether it should be
disclosed as a contingent liability according to the possibility of happening.
The amount recognised as a provision should be the best estimate of the expenditure
required to settle the present obligation at 30 June 2009, that is, the amount that the
manufacturer would rationally pay to settle the obligation at that date or to transfer it to the
insurance company. This means provisions for large populations of the warranties are
measured at a probability weighted expected value. In reaching its best estimate, the
manufacturer should take into account the risks and uncertainties that surround the
underlying events.
Expected cash outflows should be discounted to their present values, where the effect of
the time value of money is material using a risk adjusted rate (5% in this situation). As the
expenditure required settling the second year of the extended warranty provision is
expected to be reimbursed by the insurance company, the reimbursement should be
recognised as a separate asset when, and only when, it is virtually certain that
reimbursement will be received if the manufacturer settles the obligation. The amount
recognised should not exceed the amount of the provision. In measuring a provision future
events should be considered. The provision for the warranty claim will be determined by
using the expected value method.
Year 1 warranty
70% x Nil
20% x 40,000 x 80
10% x 40,000 x 250
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Expected value
000
Discounted
expected value
(5%)
000
0
640
1,000
1,640
1,562
0
728
975
1,703
1,545
The past event which causes the obligation is the initial sale of the product with the
warranty given at that time. It would be appropriate for the manufacturer to make a
provision for the Year 1 warranty of 1,640,000 and Year 2 warranty of 1,703,000, which
represents the best estimate of the obligation. Only if the insurance company has validated
the counter claim will the manufacturer be able to recognise the asset and income.
Recovery has to be virtually certain. If it is virtually certain, then the manufacturer may be
able to recognise the asset. Generally contingent assets are never recognised, but
disclosed where an inflow of economic benefits is probable.
The company could discount the provision if it was considered that the time value of money
was material. The majority of provisions will reverse in the short term (within two years)
and, therefore, the effects of discounting are likely to be immaterial.
In this case, using the risk adjusted rate (IAS 37), the provision would be reduced to
1,562,000 in Year 1 and 1,545,000 in Year 2. The manufacturer will have to determine
whether this is material.
(40% marks)
(Total 100% marks)
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Question Four
(a)
An intangible asset arising from development (or from the development phase of an
internal project) shall be recognised if, and only if, an entity can demonstrate all of the
following:
The technical feasibility of completing the intangible asset so that it will be available for
use or sale.
Its intention to complete the intangible asset and use or sell it.
Its ability to use or sell the intangible asset.
Its ability to measure reliably the expenditure attributable to the intangible asset during
its development.
How the intangible asset will generate probable future economic benefits. Among other
things, the entity can demonstrate the existence of a market for the output of the
intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset.
The availability of adequate technical, financial and other reTouchces to complete the
development and to use or sell the intangible asset.
Benchmark could demonstrate to achieve, at most, the first four criteria. It seems doubtful
whether Benchmark could finance the development project with millions of pounds for its
completion if experiencing a liquidity problem. Further, in view of the modest profit condition
and volatile market condition, the development project might not be able to generate
ultimate economic benefits to Benchmark.
As the recognition of development cost as an intangible asset needs to fulfill all the criteria,
Benchmark should expense the 500,000 development cost immediately in the year.
(20% marks)
(b)
IAS 2 states:
Inventory should be valued at the lower of cost and net realisable value.
Cost = all expenditure (in normal course of business) to bring inventory to its present
location and condition.
NRV = expected selling price less any costs to bring inventory to sale.
This treatment is to ensure that profit is not anticipated and any loss is recognised at the
earliest point based on the accounting principle of prudence. This approach also meets
requirements of the matching concept by matching cost (and therefore profit) with revenue
earned on the sale. It is important because reported profit is directly affected by inventory
value. If inventory is overvalued by 1, profit is overstated by 1.
Long term contracts, governed by IAS 11 Construction Contracts, are not valued on the
same way because it would result in reporting profit on contracts completed, rather than on
work carried out in period. This is contrary to rule of matching or accruals. Financial
statements will not show a fair presentation, with much profit in some years and little, if any,
in others, although sustainable economic activity has taken place.
(20% marks)
(c)
Contract WIP
Contract value basic
4,000,000
Costs
to date
to complete
Thus
Expected profit
4,000,000
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2,032,000
983,000
3,015,000
985,000
2,032,000
variations to date
298,000
2,330,000
1,959,750
370,250
(30% marks)
(d)
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Question Five
(a)
000
3,770
380
200
(270)
470
(50)
4,500
(350)
290
70
4,510
270
(370)
(920)
3,490
(2,020)
320
(1,700)
400
550
(1,180)
(230)
1,560
(470)
1,090
Note: IAS 7 allows interest paid and dividend paid to be an operating cash flow or a
financing cash flow. Interest received can be an operating cash flow or an investing cash
flow either treatment by students is acceptable
Workings:
W1: Additions of property, plant and equipment:
000
Opening net book value (2,040 - 860)
Disposals (450 - 180)
Depreciation
Additions (balancing figure)
Closing net book value (3,610 - 1,060)
1,180
(270)
(380)
2,020
2,550
860
380
(180)
1,060
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1,380
90
1,470
3,120
(1,180)
3,410
(60% weighting)
(b)
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