May 2009 Examinations Managerial Level

P8 – Financial Analysis

Question Paper 2 Examiner’s Brief Guide to the Paper 25 Examiner’s Answers 26 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com/students) from mid-September is a Post Examination Guide for the paper which provides much valuable and complementary material including indicative mark information. © The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher.

Financial Management Pillar

Managerial Level Paper

P8 – Financial Analysis 19 May 2009 – Tuesday Afternoon Session

Instructions to candidates

You are allowed three hours to answer this question paper.

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or sub-questions). The question requirements for questions in Sections B and C are highlighted in a dotted box.

ALL answers must be written in the answer book. Answers written on the question paper will not be submitted for marking.

Answer the ONE compulsory question in Section A. This has eight sub-questions on pages 2 to 4.

Answer ALL THREE questions in Section B on pages 5 to 7.

Answer TWO of the three questions in Section C on pages 8 to 13.

Maths Tables are provided on pages 15 to 17. These are detachable for ease of reference.

The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper.

Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.

Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

P8 –

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SECTION A – 20 MARKS [indicative time for answering this Section is 36 minutes] ANSWER ALL EIGHT SUB-QUESTIONS

Instructions for answering Section A:

The answers to the eight sub-questions in Section A should ALL be written in your answer book. Your answers should be clearly numbered with the sub-question number and then ruled off, so that the markers know which sub-question you are answering. For multiple choice questions, you need only write the sub-question number and the letter of the answer option you have chosen. You do not need to start a new page for each sub-question. For sub-questions 1.2 and 1.5, you should show your workings as marks are available for method for these sub-questions.

Question One 1.1 H acquired 70% of the ordinary share capital of M in 2002 for $4·2 million and 30% of

the ordinary share capital of N in 2006 for $1·6 million. M acquired 80% of the ordinary share capital of P in 2005 for $2·0 million. None of the entities in the group have any other investments.

The net assets of the entities as at 31 December 2008 are as follows:

H $16·7 million

M $9·6 million

N $6·8 million

P $4·6 million Calculate the minority interest to be incorporated in the consolidated balance sheet of the H Group as at 31 December 2008.

(2 marks) 1.2 AB had 10 million $0·50 ordinary shares in issue at 1 January 2008. On 1 August 2008

AB issued 2 million $0·50 ordinary shares at a premium of $0·30. Throughout the year AB had in issue $2 million 7% convertible bonds redeemable in 2010. The terms of the instrument allow the bondholders to convert every $100 of bonds held to 50 ordinary shares of $0·50. AB’s profit available to ordinary shareholders was $3 million for the year ended 31 December 2008. AB pays tax at 30%.

Calculate the basic and diluted earnings per share for AB for the year ended 31 December 2008.

(4 marks)

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1.3 Social and environmental accounting is adopted by many corporate organisations, albeit on a voluntary basis.

Identify TWO reasons why the voluntary nature of these disclosures might affect the usefulness of what is reported.

(2 marks) 1.4 BX owns 25% of the share capital of CY, an entity set up under a contractual

arrangement as a joint venture between BX and three other venturers. During the year to 31 January 2009, CY sold goods to BX with a sales value of $100,000. Half of these goods remained in BX’s inventories at the year end. CY makes 25% gross margin on all sales.

The reduction in inventories in BX required to eliminate the unrealised profit is A $3,125

B $6,250

C $12,500

D $25,000 (2 marks)

1.5 Z, an entity based in the USA, presents its financial statements in US dollars. On

1 January 2008, Z purchased 80% of the ordinary share capital of B. B’s functional currency is the Euro (€) and the 80% investment cost €20 million. The fair value of the net assets of B at the date of acquisition was €19 million. The directors of Z estimate that the goodwill arising on acquisition has suffered 20% impairment in the year and this should be reflected in the consolidated financial statements. Z has no other investments.

The relevant exchange rates are as follows:

1 January 2008 $1 : €0·64 31 December 2008 $1 : €0·74 Average for 2008 $1 : €0·68 Calculate the value of goodwill that will appear on the consolidated balance sheet of Z as at 31 December 2008.

(3 marks)

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1.6 PN owns 40% of JK and accounts for its investment using equity accounting. The value of the investment in associate, as reported in PN’s group balance sheet as at

31 January 2009 is $668,000 ($578,000 - 2008) and the consolidated income statement includes $180,000 in respect of the share of associate’s profit.

What figure will appear in the consolidated cash flow statement for the year to 31 January 2009 in respect of the associate, assuming no other transactions took place between the two entities in the period? A inflow of $36,000

B inflow of $72,000

C inflow of $90,000

D inflow of $180,000 (2 marks)

1.7 Briefly explain why, in times of rising prices, historical cost accounting could fail to

achieve relevance and comparability. (2 marks)

1.8 A common criticism of financial statements is that they fail to incorporate what is

commonly a major asset of the business – human capital. Explain the recognition criteria for assets in accordance with IFRS and give TWO reasons why human capital does not meet the criteria.

(3 marks)

(Total for Question One = 20 marks)

Reminder

All answers to Section A must be written in your answer book.

Answers to Section A written on the question paper will not be

submitted for marking.

End of Section A

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SECTION B – 30 MARKS [indicative time for answering this Section is 54 minutes] ANSWER ALL THREE QUESTIONS. YOU SHOULD SHOW YOUR WORKINGS AS MARKS ARE AVAILABLE FOR THE METHOD YOU USE. Question Two SGB prepares its accounts to 31 December. The entity acquired 1,600,000 of the 2,000,000 $1 ordinary shares of FMA in 2006 for $2,800,000. The retained earnings at the date of acquisition were $1,000,000. The goodwill arising on acquisition suffered impairment in 2007 and was written down by 20%. SGB sold 1,000,000 of the shares in FMA for $2,200,000 on 1 October 2008. The profits of both entities accrue evenly throughout the year. The retained earnings of FMA at 31 December 2007 were $1,150,000. SGB is charged tax at 30% on profits earned in the period. The income statements for both entities for the year ended 31 December 2008 are presented below: SGB FMA $000 $000 Revenue 8,200 3,600 Cost of sales (4,300) (1,900)Gross profit 3,900 1,700 Distribution costs (1,200) (800)Administrative expenses (800) (600)Profit before tax 1,900 300 Income tax expense (600) (100)Profit for the period 1,300 200

Required:

Prepare the consolidated income statement in accordance with IAS 1 Presentation of Financial Statements for the SGB group for the year ended 31 December 2008.

(Total for Question Two = 10 marks)

Section B continues on the next page

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Question Three GHK is preparing its financial statements to 31 January 2009 in accordance with International Financial Reporting Standards (IFRS). The financial director is querying the treatment of two transactions that occurred during the year. Property sale On 1 February 2008, GHK sold a property to a financial institution for $65 million. The property had originally been purchased in August 1998 for $60 million and was depreciated at 2% per annum straight line, with a full year’s depreciation charge being recorded in the year of purchase and none in the year of sale. The financial accountant has derecognised the property and recorded the subsequent gain on disposal in the income statement for the year ended 31 January 2009. Under the terms of the sale agreement GHK has a call option to repurchase the property at any time in the next five years. The repurchase price of $65 million set at the start of the agreement will increase by $2·5 million after the first year and $3 million in the following year. The financial institution can require GHK to repurchase the property on 1 February 2011 for $74 million, if GHK fails to exercise the option before that date. Share issue GHK issued 10 million $1 cumulative non-redeemable 6% preference shares during the year. The proceeds of the issue were debited to cash and credited to equity. Issue costs paid of $50,000 were debited to share premium and the dividend paid shortly before the year end was debited to retained earnings.

Required:

(a) Explain how the sale of property transaction should be treated in accordance with IFRS. Prepare any correcting journal entries that are required to be made to the financial statements for the year to 31 January 2009 in respect of this sale of property transaction.

(6 marks)

(b) Explain how the share issue should have been classified in accordance with IAS 32 Financial instruments: presentation, and prepare any correcting journal entries that are required to be made to the financial statements for the year to 31 January 2009 in respect of this share issue transaction.

(4 marks)

(Total for Question Three = 10 marks)

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Question Four FDE is finalising its accounts for the year ended 31 March 2009. FDE operates a defined benefit pension scheme for all its eligible employees. The current service cost of operating the scheme was $7·8 million for the year ended 31 March 2009. At 31 March 2008, the fair value of the pension scheme assets was $73 million and the present value of the pension scheme liabilities was $80 million. $8·8 million of unrecognised actuarial losses were brought forward at 1 April 2008. FDE made contributions to the scheme in the year of $8·8 million. The expected return on the pension scheme assets is 8·219% and the interest cost for the year is $10·2 million. The pension scheme paid out $4 million in benefits in the year to 31 March 2009. FDE adopts IAS 19 Employee Benefits and follows the corridor approach in recognising actuarial gains and losses. As at 31 March 2009, the fair value of pension scheme assets was $84 million and the present value of pension scheme liabilities was $95 million. The average remaining service lives of employees who participate in the scheme is 10 years.

Required: (a) Calculate the expense, in respect of the pension scheme, that FDE will include in

its income statement for the year ended 31 March 2009. (3 marks)

(b) Calculate the net pension asset or liability that will appear in the balance sheet of FDE as at 31 March 2009.

(5 marks)

(c) IAS 19 currently permits alternative treatments for actuarial gains or losses. Briefly explain the impact of adopting ONE of these alternative treatments on the financial statements of FDE.

(2 marks)

(Total for Question Four = 10 marks)

End of Section B

Section C starts on the next page

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SECTION C – 50 MARKS [indicative time for answering this Section is 90 minutes] ANSWER TWO QUESTIONS OUT OF THREE. YOU SHOULD SHOW YOUR WORKINGS AS MARKS ARE AVAILABLE FOR THE METHOD YOU USE. Question Five ELB is an entity that manufactures and sells paper and packaging. For the last two years, the directors have pursued an aggressive policy of expansion. They have developed several new products and market share has increased. ELB is finalising its financial statements for the year ended 31 December 2008. These will be presented to the Board of Directors at its next meeting, where the results for the year will be reviewed. The balance sheet at the year end and its comparative for last year are presented below: Balance sheet 2008 2007 $000 $000 $000 $000 Assets Non-current assets Property, plant and equipment 25,930 17,880 Investments – available for sale 6,200 5,400 32,130 23,280Current assets Inventories 4,500 3,600 Trade receivables 4,300 5,200 Cash and cash equivalents - 120 8,800 8,920Total assets 40,930 32,200Equity and liabilities Equity Share capital ($1 ordinary shares) 10,000 10,000 Revaluation reserve (Note 1) 4,200 1,100 Other reserves (Note 2) 1,800 1,000 Retained earnings 7,460 4,200 23,460 16,300Non-current liabilities Term loan 6,000 6,000 6% bonds 2010 (Note 3) 5,400 5,200 11,400 11,200Current liabilities Trade and other payables 5,800 4,700 Short term borrowings 270 - 6,070 4,700Total equity and liabilities 40,930 32,200

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Income statement for the year ended 31 December 2008 2007 $000 $000 Revenue 34,200 28,900 Cost of sales (24,000) (20,250) Gross profit 10,200 8,650 Distribution costs and administrative expenses (5,120) (3,300) Finance costs (520) (450) Profit before tax 4,560 4,900 Income tax expense (1,300) (1,400) Profit for the year 3,260 3,500 Note 1 The movement on the revaluation reserve relates to property, plant and equipment that was revalued in the year. Note 2 The movement on other reserves relates to the gains made on the available for sale investments. Note 3 The bonds are repayable on 1 July 2010. As part of their review, the directors will discuss certain key ratios that form part of the banking covenants in respect of the borrowing facilities as well as reviewing the performance in the year. The key ratios for the covenants include: • Gearing (debt/equity) target is 50% • Interest cover target is 9·5 times • Current ratio target is 1·5 : 1 • Quick ratio target is 1·1 : 1 You are the assistant to the Chief Financial Officer of ELB and you have been asked to perform a preliminary review of, and prepare a commentary on, the year end figures. These comments will form part of the financial presentation to the board.

Required:

(a) Calculate the ratios required as part of the review of covenants and any other ratios that are relevant to assess the financial performance and position of ELB.

(8 marks)

(b) Prepare a report that explains the financial performance and position of ELB for presentation to the Board of Directors, including reference to the banking covenants.

(12 marks)

(c) Identify, and briefly describe, any other points that should be added to the meeting agenda for the Board of Directors to discuss in respect of the future financing of ELB.

(5 marks)

(Total for Question Five = 25 marks)

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Question Six AC is a listed entity that has made several investments in recent years, including investments in BD and CF. The financial assistant of AC has prepared the accounts of AC for the year ended 31 December 2008. The financial assistant is unsure of how the investments should be accounted for and is not sufficiently experienced to prepare the consolidated financial statements for the AC group. The summarised balance sheets of AC, BD and CF are given below. Summarised balance sheets AC BD CF Assets $000 $000 $000Non-current assets Property, plant and equipment 25,700 28,000 15,000Investments 34,300 - - Current assets 17,000 14,000 6,000 77,000 42,000 21,000Equity and liabilities Equity Share capital ($1 ordinary shares) 30,000 20,000 8,000Revaluation reserve 3,000 1,000 1,000Other reserves 1,000 - - Retained earnings 22,000 9,000 9,000 56,000 30,000 18,000Non-current liabilities 6,000 4,000 - Current liabilities 15,000 8,000 3,000 77,000 42,000 21,000 Additional information: 1. Investments

AC acquired 14 million $1 ordinary shares in BD on 1 March 2003 for $18 million. At the date of acquisition BD had retained earnings of $3 million and a balance of $1 million on revaluation reserve. On 1 July 2008, AC acquired a further 20% stake in BD for $7 million. BD made profit of $1·6 million in the year to 31 December 2008 and profits are assumed to accrue evenly throughout the year. AC acquired 40% of the $1 ordinary share capital of CF on 1 February 2005 at a cost of $7 million. The retained earnings of CF at the date of acquisition totalled $6 million. The remaining investment relates to an available for sale investment. The investment has a market value of $2·6 million at 31 December 2008. The financial assistant was unsure of how this investment should be treated, so the investment is included at its original cost.

2. CF revalued a property during the year resulting in a revaluation gain of $1 million.

There were no other revaluations of property, plant and equipment in the year for the other entities in the group. All revaluations to date relate to land, which is not depreciated in accordance with group policy.

3. During the period, AC sold goods to CF with a sales value of $800,000. Half of the

goods remain in inventories at the year end. AC made 25% profit margin on all sales to CF.

4. An impairment review was performed in the period and it was estimated that the

goodwill arising on the acquisition of CF was impaired by 30%.

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Required: (a) Explain how each of the three investments held by AC should be accounted for

in the consolidated financial statements. (5 marks)

(b) Prepare the consolidated balance sheet of the AC group as at 31 December

2008. (20 marks)

(Total for Question Six = 25 marks)

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Question Seven NGO has retailing and warehousing operations in several countries and prepares its consolidated financial statements in accordance with IFRS. The directors’ expansion strategy over the last few years has been highly successful and has included both organic growth and growth through acquisition. The directors have four key financial ratios that they believe their acquisition targets must meet or exceed, if their strategy is to stay on course. The current acquisition target is TRP, an entity which operates in Highpark, a fictitious country. The country has a buoyant market and NGO is keen to exploit the opportunities that TRP has available to it. The country does not have its own accounting standard setter and TRP has been preparing its financial statements in accordance with US GAAP. The financial controller of NGO has prepared a preliminary report on TRP, including the calculation of the four key ratios used in the selection process. The ratios presented below are for TRP based on its published financial statements for the year ended 31 December 2008. They are shown alongside those calculated for NGO. The directors wish to pursue entities that will not significantly affect the key ratios of NGO in an adverse way. The ratios show that two of the four will have an adverse effect, and on that basis the financial controller made a recommendation that the interest in TRP should not be taken further. Key ratios: TRP NGOGearing (debt/equity) 54·5% 52·6%Return on assets (operating profit/total assets) 9·1% 7·9%Basic earnings per share 20·6p 102·6pCurrent ratio 2·2 : 1 1·2 : 1 The Financial Director has since pointed out that the financial statements are prepared under different accounting rules and they should be compared as if both had adopted IFRS. He added that, although the convergence project had been successful in reducing the significant differences between IFRS and US GAAP, there were three relevant areas where the policies continued to differ and where there may be a significant effect on the financial statements of TRP: 1. NGO has a policy of revaluing property, plant and equipment in the financial statements

to reflect current market values. Included within property, plant and equipment of TRP is land held at cost of $4 million. This land had an estimated market value of $5·4 million as at 31 December 2008.

2. NGO accounts for all inventories using FIFO in accordance with IAS 2 Inventories. TRP’s inventories have been valued using LIFO. The value of these inventories, had FIFO been adopted, is $3·6 million.

3. TRP issued $6 million 4% convertible bonds in December 2008 and in accordance with US GAAP it is classified as a non-current liability. Under IFRS, the instrument would be classified in accordance with IAS 32 Financial instruments: presentation. The bonds have a seven-year term and were issued at par. At the time the bonds were issued, the prevailing market interest rate for similar debt without conversion rights was 6%. As the issue was made close to the year end, no interest is to be accrued in respect of these bonds.

The Financial Director has asked that the financial statements of TRP be brought into line with the policies adopted by NGO and the ratios subsequently recalculated.

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The balance sheet of TRP as at 31 December 2008 is as follows: Balance sheet $000 $000 Assets Non-current assets Property, plant and equipment 8,600 Investment in associate 4,200 12,800 Current assets Inventories 3,300 Trade receivables 3,100 Cash and cash equivalents 1,200 7,600Total assets 20,400Equity and liabilities Equity Share capital ($1 ordinary shares) 8,000 Other reserves 500 Retained earnings 2,500 11,000 Non-current liabilities 4% Convertible bonds 2015 6,000 Current liabilities Trade and other payables 3,400Total equity and liabilities 20,400 Extracts from the income statement of TRP for the year ended 31 December 2008: $000 Operating profit 1,848 Share of profit of associate 402 Finance income 60Profit before tax 2,310 Taxation charge (660) Profit for the year 1,650

Required:

(a) (i) Explain how the convertible bonds are accounted for under IAS 32 Financial

Instruments: Presentation.

(ii) Prepare a revised balance sheet for TRP, taking account of all the necessary adjustments required to comply with the requirements of IFRS.

(9 marks)

(b) Recalculate the ratios and provide a brief analysis on how suitable TRP is as an acquisition target for NGO. (Do NOT calculate diluted earnings per share.)

(9 marks)

(c) The Finance Director had commented on the convergence project and the progress that had been made. Explain the process that is being adopted to pursue convergence and identify THREE examples of where progress has been achieved.

(7 marks)

(Total for Question Seven = 25 marks)

End of Section C. End of Question Paper.

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MATHS TABLES AND FORMULAE Present value table Present value of $1, that is (1 + r)P-n where r = interest rate; n = number of periods until payment or receipt.

Interest rates (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Interest rates (r) Periods

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

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Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years r

r n−+− )(11

Interest rates (r) Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Interest rates (r) Periods

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

May 2009 P8

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FORMULAE Annuity Present value of an annuity of $1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV = ⎥⎥⎦

⎤

⎢⎢⎣

⎡

+− nrr ][1

111

Perpetuity Present value of $1 per annum receivable or payable in perpetuity, commencing in one year, discounted at r% per annum:

PV = r1

Growing Perpetuity Present value of $1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum:

PV = gr −

1

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May 2009 P8

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LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE VERBS USED DEFINITION

1 KNOWLEDGE

What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of

2 COMPREHENSION What you are expected to understand. Describe Communicate the key features Distinguish Highlight the differences between Explain Make clear or intelligible/State the meaning of Identify Recognise, establish or select after

consideration Illustrate Use an example to describe or explain

something

3 APPLICATION How you are expected to apply your knowledge. Apply

Calculate/compute To put to practical use To ascertain or reckon mathematically

Demonstrate To prove with certainty or to exhibit by practical means

Prepare To make or get ready for use Reconcile To make or prove consistent/compatible Solve Find an answer to Tabulate Arrange in a table

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise

Examine in detail the structure of Place into a defined class or division

Compare and contrast Show the similarities and/or differences between

Construct To build up or compile Discuss To examine in detail by argument Interpret To translate into intelligible or familiar terms Produce To create or bring into existence

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

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Financial Management Pillar

Managerial Level

P8 – Financial Analysis

May 2009

Tuesday Afternoon Session

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The Examiner for Financial Analysis offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the

questions included in this examination paper.

Section A – Question One – Compulsory

1.1 Short question that required calculation of the minority interest for a group. This tested learning outcome A (iii) 1.2 Short question that required calculation of the basic and diluted EPS for an entity. This tested learning outcomes C (i). 1.3 Short question that tested knowledge of the voluntary nature of the disclosure of social and environmental accounting and the potential effects on reporting them. This tested learning outcome C (i). 1.4 OTQ that required calculation of the reduction in inventories required to eliminate the unrealised profit of an entity. This tested learning outcome D (ii). 1.5 Short question that required calculation of the value of goodwill of an entity. This tested learning outcome A (vi). 1.6 OTQ that required calculation of the figure in respect of an associate that would appear in the financial statements of the entity concerned. This tested learning outcome A (x). 1.7 Short question that tested knowledge of historical cost accounting’s potential problems to achieve relevance and comparability in times of rising prices. This tested learning outcome A (vi). 1.8 Short question that tested knowledge of the recognition criteria for assets in accordance with IFRS with specific reference to human capital. This tested learning outcome D (iv).

Section B – Compulsory

Question Two required preparation of a summarised consolidated income statement for the entity concerned. This tested learning outcomes A (v) & (vi).

Question Three part (a) required explanation of the treatment of the sale of property transaction in accordance with IFRS. Part (b) required explanation of the classification of the share issue in accordance with IFRS. In both parts, candidates were required to prepare the applicable correcting journal entries in the financial statements of the entity concerned. This tested learning outcomes B (iii) & (iv).

Question Four part (a) required calculation of the pension scheme expense in the income statement of the entity concerned. Part (b) required calculation of the net pension asset/liability that would appear in the balance sheet of the entity concerned. Part (c) required explanation of the impact of adopting an alternative treatment for actuarial gains/losses on the financial statements of the entity concerned. This tested learning outcome B (vi).

Section C – Answer two from three questions

Question Five part (a) required calculation of ratios as part of a review of covenants and of other ratios relevant to assess the financial performance and position of the entity concerned. Part (b) required preparation of a report explaining the financial performance and position of the entity concerned to its Board, with particular reference to banking covenants. Part (c) required identification, and brief description, of other Board agenda points for future consideration with respect to the financing of the entity concerned. This tested learning outcomes C (i), (ii) & (iv).

Question Six part (a) required an explanation of the treatment of the three investments in the financial statements of the entity concerned. Part (b) required preparation of the consolidated balance sheet for the entity concerned. This tested learning outcomes A (i), (iii), (v), (vi) & B (v).

Question Seven part (a) (i) required an explanation of the treatment of convertible bonds in accordance with IAS, while part (ii) required preparation of a revised balance sheet for the entity concerned in accordance with IFRS. Part (b) required recalculation of the ratios and analysis of the suitability of an entity for acquisition by the entity concerned. Part (c) required an explanation of the progress of the Convergence Project and to cite examples of progress achieved to date. This tested learning outcomes C (i), (ii), (v) & D (vi).

22

Managerial Level Paper

P8 – Financial Analysis Examiner’s Answers

SECTION A Answer to Question One 1.1

MI %

Net assets

MI share of NA

Group share of M is 70% - net assets of M less cost of investment in P

30% $(9·6m - 2m)

$2·28m

Group share of P is 70% x 80% = 56% 44% $4·6m $2·024m

Total MI in group accounts $4·304m

N is an associate and therefore is not included in the MI calculation. 1.2 Earnings $3,000,000 Weighted average number of shares:

10,000,000 x 7/12 12,000,000 x 5/12

5,833,333 5,000,000

10,833,333 Basic earnings per share

$3,000,000/10,833,333

27·7 cents Earnings $3,000,000 Post tax saving of interest

70% x (7% x $2,000,000)

$98,000 $3,098,000 Weighted average number of shares: 10,833,333 Shares to be issued on conversion

(2,000,000/100 x 50)

1,000,000 11,833,333 Diluted earnings per share

$3,098,000/11,833,333

26·2 cents

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1.3 Lack of reliability – in the absence of formal guidance, entities can choose the information to report. This could result in biased information.

Lack of comparability – it will be difficult for users to compare reports of different entities as no standard format of reporting is required.

1.4 Unrealised profit on sale from CY $ Sales value 100,000 Half left in inventories 50,000 Profit element 25% margin 12,500 Group share of unrealised profit 25% 3,125

Therefore the answer is A 1.5 €000 €000 Cost of investment 20,000 Net assets acquired 19,000 80% acquired 15,200 Goodwill arising on acquisition 4,800 Impairment 20% (960) Closing goodwill on 31 December 2008 3,840 $000 Translated at closing rate 0·74 Euro to $1 5,189 1.6 Cash flow from associate $ Value of investment - 2008 578,000 Plus share of profit of associate 180,000 758,000 Dividend received (balancing figure) 90,000 Value of investment - 2009 668,000

Dividend received is an inflow of $90,000. Therefore the answer is C

1.7 In times of rising prices the results reported in the income statement could match

revenues at current prices with cost of sales at prices from an earlier date, which are understated and the values recorded for assets in the balance sheet may no longer be relevant as they will not be reflecting current asset values.

Comparisons over time will be affected by the rising prices as the unit prices used to determine revenues and costs will not be consistent from one period to the next.

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1.8 The IFRS criteria for recognising an asset on the balance sheet is that the resource is controlled by the entity and economic benefit will flow to the entity and that it can be reliably measured. The arguments against recognising human capital as an asset on the balance sheet include:

• No control over staff – they can leave at any time; • Cannot reliably measure the “value” of staff – only the cost, being wages paid; • No guarantee that the staff will generate future economic benefit.

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SECTION B Answer to Question Two Consolidated income statement for the SGB group for year ended 31 December 2008 $000 Revenue (8,200,000 + 9/12 x 3,600,000) 10,900 Cost of sales (4,300,000 + 9/12 x 1,900,000) (5,725)Gross profit 5,175 Distribution costs (1,200,000 + 9/12 x 800,000) (1,800)Administrative expenses (800,000 + 9/12 x 600,000) (1,250)Profit generated from operations 2,125 Gain on disposal (W1) 350 2,475 Share of profit of associate (W6) 15Profit before tax 2,490 Income tax expense (W3) (810)Profit for the period 1,680 Attributable to: Equity shareholders of the parent 1,650 Minority interest (W7) 30 Workings W1.Group gain on disposal of shares $000 Proceeds 2,200 Less net assets disposed of: 1m/2m x NA (2,000,000 + 1,300,000 (W5))

(1,650)

Less unimpaired goodwill disposed of: 50/80 x $320,000 (W4)

(200)

Gain (for consolidated income statement) 350 W2. Gain on disposal of shares in SBG’s individual financial statements $000 Proceeds 2,200 Less cost of shares disposed of: 50/80 x $2,800,000 (1,750)Gain 450Tax charge on gain at 30% 135 W3. Income tax expense $000SBG tax charge $(600,000 + tax on gain 135,000 (W2)) 735FMA’s tax charge ($100,000 x 9/12) 75Total tax charge 810 W4. Goodwill $000 Cost of investment 2,800 Less net assets acquired: 80% of share capital of $2,000,000 1,600 80% of retained earnings of $1,000,000 800 (2,400)Goodwill on acquisition 400 20% impairment in 2007 (80)Unimpaired goodwill 320

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W5. Retained earnings of FMA at 1 October 2008 $000Retained earnings at 31 December 2007 1,150Plus profit for 2008 of $200,000 x 9/12 150Total as at 1 October 2008 1,300 W6. Share of profit of associate $000FMA’s PAT from 1/10/08 to 31/12/08 $(200,000 x 3/12) 50SGB’s share 30% 15 W7. Minority interest $000PAT of subsidiary $200,000 x 9/12 150MI share 20% 30 Answer to Question Three (a) The asset should not be derecognised as there are conditions attached to the sale agreement which will result in GHK repurchasing the property at some later date and not necessarily at a price that reflects market conditions at that time. IAS 18 requires that the significant risks and rewards of the asset be transferred in order that a sale be recognised. GHK remains open to the main risk and potential reward associated with property, the downward or upward movement in its market value, and therefore no sale can be recognised. The substance of the transaction is that GHK has borrowed $65 million using the property as security. The sale and subsequent gain must be reversed and the proceeds of the transaction shown as a financial liability. The increase of $2·5m in the repurchase price in the year represents the finance cost charged by the financial institution and should be recorded in the income statement. The property will be reinstated and depreciation charge for the year will be incorporated. The correcting entries are: $m $m Dr Gain on sale (W1) 17 Dr Property, plant and equipment 48 Cr Loan liability 65 The loan received and correcting entries for the sale Dr Finance cost 2·5 Cr Loan liability 2·5 The finance cost for the year ended 31 January 2009 Dr Depreciation charge (2% x $60m) 1·2 Cr PPE – accum. depreciation 1·2 The depreciation charge for the year ended 31 January 2009 Workings W1. Gain on sale calculation $m $mCost of asset 60 Accumulated depreciation (2% x 10 years) (12) Net book value 48Proceeds 65Gain on sale recorded 17

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(b) In accordance with IAS 32 the preference shares should be classified as non-equity shares and included in debt as the terms of the instrument contain an obligation to transfer economic benefit, by way of a dividend. The issue costs should be deducted from the proceeds received on issue and the dividend should be treated as a finance cost in the year and debited to the income statement. The correcting entries are: $m $m Dr Equity – share capital 10

Cr Share premium 0·05 Cr Non-current liability 9·95 The correcting entry for recording the issue and issue costs Dr Finance costs (income statement) 0·6 Cr Retained earnings 0·6 The correct recording of the non-equity dividend paid Answer to Question Four (a) Charge to income statement $mService cost 7·8 Interest cost 10·2 Expected return (8.219% x $73m) (6·0)Actuarial loss (W1) 0·08Income statement charge 12·08 Workings W1 Actuarial loss to be recognised

FDE adopts the corridor approach to recognition of actuarial gains/losses. The corridor is 10% of the higher of opening plan assets/liabilities:

10% of $80m = 8m.

Unrecognised actuarial losses brought forward totalled $8·8m, which is above the corridor so FDE will be recognising part of the loss.

The amount recognised in the income statement = $(8·8m – 8·0m)/10 years = 0·08 (b) Balance sheet $m PV of defined benefit plan liabilities 95·0 Less FV of defined benefit plan assets (84·0) 11·0 Unrecognised actuarial losses (W2) (9·52)Net pensions liability 1·48 W2. Unrecognised actuarial losses 31/3/09 $m Unrecognised actuarial losses 31/3/08 (8·8)Actuarial loss on plan liabilities (W3) (1·0)Actuarial gain on plan assets (W3) 0·2 Recognised in the period (corridor approach) (W1) 0·08Unrecognised actuarial losses 31/3/09 (9·52)

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W3. Actuarial gains/losses in period $m $m Assets LiabilitiesPV of plan liabilities at 31/3/08 (80)FV of plan assets 31/3/08 73 Current service cost (7·8)Interest cost (unwinding of discount) (10·2)Expected return on plan assets (8·219% x $73m) 6·0 Contributions 8·8 Benefits paid (4·0) 4·0 Actuarial gain on plan assets (balance) 0·2Actuarial loss on plan liabilities (balance) (1·0)Value of assets/liabilities at 31/3/09 84·0 (95·0) (c) IAS 19 currently permits faster recognition of the actuarial gains and losses through the income statement on a systematic basis. The full amounts of the actuarial gains/losses on both the pension scheme assets and obligations can be recognised in the period, but through equity. Recognition through retained earnings would minimise the effect on profit for the year and would be reported in the Statement of Recognised Income and Expense. Answer to Question Five (a) See Appendix (b) Report on ELB The following report is based on the financial statements of ELB and refers to ratios that are calculated in Appendix A of this report. Financial performance Revenue has increased by 18% since 2007 due to the aggressive expansion policy pursued in the last two years. It is encouraging that we have maintained the gross profit margin, which shows good control over cost of sales. Profit before tax, however has dropped significantly from 17% to 13·3%. This is due to a 55% increase in distribution costs and administrative expenses in the year and increased finance costs. It is likely that the expansion policy has included marketing and that new distribution channels have been introduced to service the increased market share. The interest cover has dropped from 11·9 to 9·8 and although this is still above the target of 9·5, the bank will be concerned about the falling margins and the effect this is having on the interest cover. Action should be taken to control administration and distribution costs in the coming period. Return on capital employed has fallen from 19·5% to 14·6% due to decreased profit and increased capital employed. The ratio will have been affected by the revaluation of non-current assets in the year, which accounts for a significant part of the increased capital.

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Financial position Gearing has decreased significantly from 68·7% to 48·6% in the year and has achieved the threshold set by the bank. The long term debt has not however decreased in the year, instead this fall is due to increasing equity, resulting from the revaluation in the year, profit earned in the year and the gain recognised on available for sale investments. The gearing ratio, without the revaluation would be 56%. The current ratio has dropped below the target level from 1·9 to 1·45 and the quick ratio has also dropped well below the target of 1·1 to 0·71. Cash held has decreased from a positive balance of $120,000 to an overdraft position of $270,000. In addition, trade payables at the year end have increased and receivables days have fallen from 66 days to 46 days. Customers are being pressed for payment while it looks likely that the settlement of payables is being delayed. These issues indicate problems with working capital and are signs that the ELB are overtrading. It is important that we illustrate to the bank that we have a strategy in place for easing the pressure on working capital and are not expanding too quickly. It does appear that the bank has supported us to date as we did breach the covenants at last year’s reporting date and it has still offered us the finance. (c) I have noted below some additional points that may be considered for inclusion in the agenda: • Identify sources of working capital – it is vital that we can illustrate to the bank that we

are urgently seeking to improve working capital to support the expansion strategy.

• Bonds repayable – the bonds are due to be repaid in July 2010, which is likely to be 12-18 months from now, and not only do we need the cash to repay them, we also need to secure some longer term funding if we are to continue to trade and expand. The cost of that funding will have an impact on the interest cover, which is already close to the acceptable threshold set by the bank. The bonds currently pay 6% and funding with a significantly higher associated cost is likely to decrease the interest cover further.

• Working capital control - the current approach to managing working capital indicates that ELB is chasing for payment and delaying creditor payments and this cannot be sustained in the longer term as it is likely to damage relationships with customers and suppliers.

• Sell investments – the available for sale investments performed well in the year and selling these investments could provide a good source of funding and would provide an immediate injection to working capital.

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(a) Appendix A 2008 2007 Ratios $000 $000 Gearing (debt/equity) 11,400/23,460 48.6% 11,200/16,300 68.7% Gearing without revaluation 11,400/(23,460

-3,100) 56%

Or: Gearing incl. overdraft 11,670/23,460 49.7% Interest cover (profit before interest/interest)

(4,560 + 520)/520

9.8

(4,900 + 450)/450

11.9

ROCE (profit before interest/equity + long term debt)

(4,560 + 520)/(23,460 + 11,400)

14.6%

(4,900 + 450)/(16,300 + 11,200)

19.5%

GP % (GP/turnover) 10,200/34,200 29.8% 8,650/28,900 29.9% Profitability (profit for yr/turnover)

3,260/34,200 9.5% 3,500/28,900 12.1%

Current ratio (CA/CL) 8,800/6,070 1.45 8,920/4,700 1.9 Quick ratio (CA – inventories/CL)

(8,800 – 4,500)/6,070

0.71 (8,920 – 3,600)/4,700

1.13

Receivables days (receivables x 365/turnover)

(4,300 x 365)/34,200

46 days (5,200 x 365)/28,900

66 days

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Answer to Question Six (a) The investment made by AC in BD should be accounted for as a subsidiary as the 70% initial stake allows AC to exercise control over the financial and operating policies of BD. The further 20% stake acquired is a further investment in a subsidiary. The subsidiary should be accounted for using full consolidation in the group accounts. The 40% investment in CF gives AC significant influence over the operating and financial policies of CF, making it an associate. CF will be included in the group accounts using equity accounting. The remaining investment is an available for sale investment, as per IAS 39, which will be held at fair value at the balance sheet date with any gains or losses on valuation being taken to reserves. (b) Consolidated balance sheet - The AC group at 31 December 2008 $000 $000 Non-current assets Property, plant and equipment (25,700+28,000) 53,700 Goodwill on acquisition (W1) 2,360 Investment in associate (W7) 8,140 Available for sale investments (W3) 2,600 66,800 Current assets (17,000+14,000) 31,000 97,800Equity and liabilities Equity Share capital 30,000 Revaluation reserve (W9) 3,400 Other reserves (W10) 1,300 Retained earnings (W4) 27,100 61,800Minority interest (W5) 3,000 Non-current liabilities (6,000 + 4,000) 10,000 Current liabilities (15,000 + 8,000) 23,000 97,800 Workings: W1. Goodwill 70% stake 20% stake $000 $000 $000 $000 Cost of investment 18,000 7,000 Net assets at date of acquisition Issued capital 20,000 20,000 Revaluation reserve 1,000 1,000 Retained earnings at 1 March 2003 3,000 Retained earnings at 1 July 2008 (W2) 8,200 24,000 29,200 Group share (70%/20%) 16,800 5,840 Goodwill 1,200 1,160 Total goodwill = $1,200,000 + $1,160,000 = $2,360,000 W2. Retained earnings at 1 July 2008 $000 Retained earnings at 31 December 2008 9,000 Less profit earned 1 July to 31 Dec 2008 (50% x $1.6m) (800) 8,200

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W3. Investments held by AC $000 Investment in BD at cost (18m + 7m) 25,000Investment in CF at cost 7,000 32,000Total investments as per B/S 34,300Available for sale investment 2,300 The available for sale investment should be held in the balance sheet at fair value of $2·6m and the gain of $300,000 should be credited to reserves (in this case to “other reserves”) – see W10. W4. Consolidated retained earnings $000 Retained earnings of AC 22,000Post acquisition retained earnings of BD: (70% x $(9m - 3m) (20% x $800)

4,200 160

Group share of post acquisition profits of CF (W7) 1,200Adjustment for internal transfer of goods (W8) (40)Impairment of goodwill on CF (W6) (420) 27,100 W5. Minority interest (10%) $000 Net assets of BD at 31 December 2008 Share capital 20,000 Revaluation reserve 1,000 Retained earnings 9,000 30,000Minority interest 10% share 3,000 W6. Goodwill - CF $000 $000 Cost of investment 7,000Net assets at date of acquisition Issued capital 8,000 Retained earnings at acquisition date 6,000 14,000 Group share 40% 5,600Goodwill 1,400 Impairment in the period to 31 December 2008 is 30% Impairment charge in period (the I/S charge reflected in retained earnings) 30% x $1·4m = $420,000 W7. Investment in associate $000 Cost of investment 7,000Group share of post-acquisition profits 40% x (9m - 6m)

1,200

Less unrealised profit on inventories (W8) (40)Less impairment of goodwill (W6) (420)Group share of revaluation gains (40% x $1m) 400 8,140 W8. Internal transfer of goods from AC to CF $000Profit on goods transferred (800,000 x 25%) 200,000Element of profit unrealised – 50% 100,000Group share 40% 40,000

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Both consolidated retained earnings (W4) and investment in associate (W7) will be reduced by $40,000. W9. Revaluation reserve $000 Revaluation reserve of AC 3,000Plus group share of revaluation gain of CF (40% x $1m) 400 3,400 The group is entitled to its share of the realised and unrealised gains of the associate and so the group revaluation reserve and the investment in associate (W7) are both increased by the group share of the gain in the year. W10. Other reserves $000 Other reserves of AC 1,000Gain on AFS investment (W3) 300 1,300 Answer to Question Seven (a) (i) IAS 32 requires that the liability and equity elements are shown separately on the

balance sheet. The present value of the debt element is calculated with reference to the prevailing market rate for similar debt with no conversion rights. The difference between the PV of the debt and the nominal value on issue is the amount to be recorded in equity.

(ii) Revised balance sheet incorporating the IFRS revisions Balance sheet $000 $000 $000 Assets Adjust Non-current assets Property, plant and equipment (W2) 8,600 + 1,400 10,000Investment in associate 4,200 4,200 12,800 14,200Current assets Inventories (W3) 3,300 + 300 3,600Trade receivables 3,100 3,100Cash at bank 1,200 1,200 7,600 7,900Total assets 20,400 22,100Equity and liabilities Equity Share capital ($1 ordinary shares) 8,000 8,000Other reserves (W1) 500 + 670 1,170Retained earnings (W3) 2,500 + 300 2,800Revaluation reserve (W2) + 1,400 1,400 11,000 13,370Non-current liabilities 4% Convertible bonds 2015 (W1) 6,000 - 670 5,330 Current liabilities Trade and other payables 3,400 3,400Total equity and liabilities 20,400 22,100

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Adjustments to bring into line with IFRS Workings W1 The principal amount is discounted to PV using the simple PV table (6% for Year 7 =

0·665) and the PV of the interest payable for the next seven years is calculated from the Cumulative present value table for an annuity (6% for year 7 = 5·582)

$000 PV of the principal amount of the bonds – $6,000,000 x 0·665 3,990 PV of the interest – 4% x $6m = $240,000 x 5·582 1,340Total allocated value for liability element of bonds 5,330 Total allocated to equity (balancing figure) 670Total value of the bonds 6000

Dr Debt $670,000 Cr Other reserves $670,000 The reallocation of equity element of convertible bonds

W2 Under IAS 16, the property would be held at valuation in line with the group policy.

This would increase NCA and create a revaluation reserve for the revalued amount ($10m – NBV $8·6m), recorded as:

Dr Non-current assets $1,400,000 Cr Revaluation reserve $1,400,000 Restatement of NCA held at valuation

W3 Under IAS 2, the inventories would be valued using FIFO and the value incorporated

would be $3·6m. The adjustment of $300,000 ($3·6m less amount in B/S $3·3m) will increase inventories and since closing inventories reduces cost of sales, the profit for the year (and therefore, retained earnings) would increase by this amount also, recorded as:

Dr Inventories $300,000 Cr Retained earnings $300,000 (through adjustment to cost of sales) The restatement of inventories using FIFO

Extracts from the income statement of TRP for the year ended 31 December 2008:

$000 adjust $000 Operating profit 1,848 + 300 2,148 Share of profit of associate 402 402 Finance income 60 60Profit before taxation 2,310 2,610 Taxation charge (660) (660)Profit for the year 1,650 1,950

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(b) Key ratios recalculated for TRP $000 Gearing 5,330/13,370 39·9%

Return on assets 2,148/22,100 9·7%

Earnings per share 1,950/8,000 24·4p

Current ratio 7,900/3,400 2·3 The recalculations of the ratios for TRP show that the figures achieved by TRP are better than those of NGO in three of the four areas, the exception being EPS. The convertible debt being reclassified as part equity, together with the increase in equity from the property and inventories revaluations, results in the gearing ratio reducing from 54·5% to 39·9%, which is well below the gearing ratio of NGO. The return on assets achieved by TRP was originally 9·1% which was higher than NGO. The recalculation of inventories based on FIFO results in the profit increasing and the return on assets rising to 9·7% despite the revaluation of non-current assets and increased value of inventories. The earnings per share for TRP is well below that of NGO, however it does increase from 20·6p to 24·4p when we recalculate profit for the adjustment to closing inventories. The comparison of these two figures is somewhat limited as we do not have enough information to assess the relative sizes of the entities and the number of shares each has in issue. The current ratio achieved by TRP is considerably higher than NGO’s ratio of 1·2. TRP’s ratio increases from 2·2 to 2·3 as a result of the recalculation of inventories. TRP is cash rich and the current ratio of 2·3 illustrates that the management has good control of working capital. This additional working capital facility may be attractive to NGO if the plan for expansion is to continue. The recommendation, based on this initial review, is that the acquisition of TRP be progressed and considered further by the board. (c) Convergence The IASB and FASB signed the Norwalk agreement in 2002 and set out a Roadmap of Convergence aimed at reducing the differences between IAS and US GAAP. A set of core standards were identified and the two bodies have been working together to reduce differences in the accounting policies. The two bodies are also working on joint projects to develop standards together to ensure that no further significant differences occur. The Roadmap set out short- term and long-term objectives and identified the areas that could be addressed quickly. Progress has been achieved in the following areas: • Operating segments – IFRS 8 issued following joint project; • Asset disposals and discontinued operations – IFRS 5 issued following joint project; • Borrowing costs – IAS 23 amended to bring into line with US GAAP; • Business combinations – joint project on purchase method resulted in IASs 27, 28 and

31 following completion of phase II of the review of business combinations. • The reconciliation from IAS to US Gaap is no longer required for those companies

using IAS and listing on the US stock exchange.

P8 May 2009

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