PROFESSIONAL 2 EXAMINATION - APRIL 2007

NOTES:
Answer all questions.

ADVANCED FINANCIAL ACCOUNTING

PRO-FORMA INCOME STATEMENT BY NATURE, INCOME STATEMENT BY FUNCTION AND BALANCE SHEET ARE PROVIDED

TIME ALLOWED: INSTRUCTIONS:

3.5 hours, plus 10 minutes to read the paper.

During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.

The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ADVANCED FINANCIAL ACCOUNTING

PROFESSIONAL 2 EXAMINATION - APRIL 2007 TIME ALLOWED: 3.5 hours and 10 minutes to read the paper. Answer ALL questions.

You are the Finance Director of ELY Limited (ELY), a successful medium-sized Irish company that prepares its financial statements to the 31st December each year. ELYs balance sheet as at 31st December 2006, and its income statement for the year ended 31st December 2006, are as follows: ELY Balance Sheet as at 31st December Note ASSETS Non Current Assets Land Office equipment Intangible assets brand names Available-for-sale investments Current Assets Trade receivables Provision for bad debts Interest receivable Bank deposits (30 day) Cash at bank

2006

2005

1 2 3

5,500,000 2,100,000 400,000 150,000

5,000,000 1,800,000 440,000 130,000

4 5

280,000 (28,000) 20,000 80,000 40,000 8,542,000

250,000 (24,000) 26,000 65,000 45,000 7,732,000

EQUITY AND LIABILITIES Capital and Reserves 1 ordinary shares Land revaluation reserve Investment revaluation reserve Retained earnings Non Current Liabilities Borrowings Current Liabilities Borrowings Trade payables Taxation Interest payable

1,450,000 1,500,000 50,000 3,980,000

1,170,000 1,000,000 30,000 3,500,000

520,000

400,000

60,000 300,000 652,000 30,000 8,542,000

60,000 250,000 1,298,000 24,000 7,732,000

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ELY Income Statement for the Year Ended 31st December 2006 Revenue Cost of sales Gross profit Expenses: Salaries and wages Depreciation Bad debts Interest on borrowings Interest received on deposit accounts Profit on sale of office equipment Impairment of intangible assets brand names Profit before tax Income tax expense Profit after tax 4,800,000 (2,200,000) 2,600,000 (1,370,000) (200,000) (30,000) (80,000) 65,000 95,000 (40,000) 1,040,000 (260,000) 780,000

Additional Information 1. 2. During the year ended 31st December 2006, land was revalued upwards by 500,000. Office equipment comprises: Cost At 1st January 2006 Additions Disposals At 31st December 2006 Accumulated Depreciation At 1st January 2006 On disposal Charge for year At 31st December 2006 Net Book Value At 31st December 2006 At 31st December 2005 3. 4,600,000 800,000 (600,000) 4,800,000

2,800,000 (300,000) 200,000 2,700,000

2,100,000 1,800,000

Available-for-sale investments are valued at fair value, with increases and decreases being recognised in the investment revaluation reserve until the investments are sold. There were no new investments purchased during 2006 nor were there any disposals. The provision for bad debts comprises: 24,000 30,000 (26,000) 28,000

4.

At 1st January 2006 Charge for year Bad debts written off At 31st December 2006 5.

Thirty day bank deposits are used in the course of the daily cash management of ELY.

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6.

Under a dividend reinvestment share scheme, shareholders have the right to receive additional shares in lieu of cash dividends. Dividends paid on 1st July 2006 comprised: 20,000 280,000 300,000

Dividends paid in cash Dividends reinvested

7.

Trade payables include: 2006 20,000 2005 15,000

Amounts owing in respect of office equipment 8.

Warrants to buy 500,000 1 ordinary shares at 8 per share were issued on 1st July 2006. The warrants expire on 30th June 2010. The average market price of ELYs shares for the year ended 31st December 2006 was 10.

1.

REQUIREMENT (a) Prepare the cash flow statement in accordance with IAS 7 Cash Flow Statements for ELY for the year ended 31st December 2006 using the direct method of presenting cash flows from operating activities; and (23 Marks) Format & Presentation (b) Prepare the summary of cash flows from operating activities using the indirect method. (10 Marks) [Total: 35 Marks] (2 Marks)

2.

REQUIREMENT Prepare a statement of changes in equity for ELY for the year ended 31st December 2006 in accordance with IAS 1 Presentation of Financial Statements. (15 Marks) [Total: 15 Marks]

3.

REQUIREMENT (a) Outline the potential problems for investors of placing undue emphasis on the earnings per share figure; and (10 Marks) (b) In accordance with IAS 33 Earnings Per Share, calculate for ELY for the year ended 31st December 2006: (i) (ii) The basic earnings per share; and The fully diluted earnings per share. (5 marks) (5 marks)

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[Total: 20 Marks]

4.

The intangible assets included in ELYs balance sheet represent brand names. REQUIREMENT Discuss: (a) The accounting treatment of brands in accordance with IAS 38 Intangible Assets; and (6 Marks) (b) The potential problems associated with the recognition of brands. (9 Marks) [Total: 15 Marks]

5.

ELY has recently voluntarily adopted International Financial Reporting Standards. REQUIREMENT Prepare a report for the companys shareholders which explains: (a) The reasons for switching to international financial reporting standards; and (9 Marks)

(b) Whether it is in a countrys best interests to develop its own accounting standards. (5 Marks) Format & Presentation (1 Mark)

[Total: 15 Marks] [Total: 100 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ADVANCED FINANCIAL ACCOUNTING

PROFESSIONAL 2 EXAMINATION - APRIL 2007 Examination Paper Focus This paper is the final test of students ability to understand the theory of financial reporting and how to apply that knowledge to a number of practical accounting issues. Students have to demonstrate both a strong technical understanding of how to solve external financial reporting issues as well as displaying an ability to communicate effectively to various groups of readers who may themselves not have that technical expertise. The key objectives are to ensure that students have:
G

the ability to prepare financial statements; a detailed knowledge and the ability to implement financial reporting standards; the ability to analyse and evaluate financial statements and prepare detailed reports on these statements.

The examination approach is designed to test a students:

G

ability to apply in depth knowledge of the syllabus to practical accounting problems; understanding of the main accounting issues currently facing the professional qualified accountant in the field of financial accounting; communication skills particularly in relation to the production of both internal memoranda and external financial reports for a wide variety of user groups.

The first three questions are primarily computational. Question One requires candidates to prepare of a cash flow statement in accordance with IAS 7 Cash Flow Statements using both the direct and indirect methods. Question Two requires candidates to prepare a statement of changes in equity in accordance with IAS 1 Presentation of Financial Statements, while Question Three examines earnings per share (IAS 33 Earnings per Share). Question Four focuses on accounting for intangible assets and the potential problems associated with the recognition of brands (IAS 38 Intangible Assets). The final question examines a candidates awareness of current developments in financial reporting, requiring the preparation of a report to the companys shareholders.

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SOLUTION 1 ELY Cash Flow Statement for the Year Ended 31st December 2006 Net cash flow from operating activities Cash flows from investing activities (w7) Cash flows from financing activities (w8) Net increase in cash and cash equivalents Cash and cash equivalents at 1st January 2006 Cash and cash equivalents at 31st December 2006 310,000 (400,000) 100,000 10,000 110,000 120,000 Format & presentation 2 Marks Note: Dividends paid may be included as part of operating activities or financial activities. Interest received may be included as operating activities or investing activities. Workings: 1. Direct Method (a) Receipts from customers Sales Increase in trade receivables Bad debts written off 4,800,000 (30,000) (26,000) 4,744,000 2 Marks (b) Payments to suppliers Cost of sales Increase in trade payables (w3)

2,200,000 (45,000) (2,155,000) 2 Marks

(c) Cash paid to and on behalf of employees Salaries and wages

(1,370,000) 1 Mark

= Cash generated from operations Interest paid (w4) Interest received (w5) Income tax paid (w6)

1,219,000 (74,000) 71,000 (906,000) 310,000 3 Marks

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2. Indirect Method Profit before tax Depreciation Interest on borrowings Interest on deposit accounts Profit on sale of office equipment Impairment of brand names

1,040,000 200,000 80,000 (65,000) (95,000) 40,000 1,200,000 5 Marks (30,000) 4,000 45,000 1,219,000 3 Marks (74,000) 71,000 (906,000) 310,000 3 Marks

Increase in trade receivables Increase in bad debt provision Increase in trade payables (w3)

Interest paid (w4) Interest received (w5) Income tax paid (w6) Net cash from operating activities

3. Trade Payables Trade payables at 31st December 2006 Less office equipment payable

300,000 (20,000) 280,000 250,000 (15,000) 235,000 45,000 2 Marks

Trade payables at 1st January 2006 Less office equipment payable

Increase in trade payables

4. Interest Paid Opening balance Income statement Closing balance

24,000 80,000 (30,000) 74,000 2 Marks

5. Interest Received Opening balance Income statement Closing balance

26,000 65,000 (20,000) 71,000 2 Marks

6. Tax Opening balance Income statement Closing balance

1,298,000 260,000 (652,000) 906,000 2 Marks

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7. Cash Flows from Investing Activities (a) Purchase of office equipment Additions during year (n2) Movement in office equipment payable (n7)

800,000 (5,000) 795,000 2 Marks

(b) Proceeds from sale of office equipment NBV of disposal (n2) Profit on sale of equipment

300,000 95,000 395,000 2 Marks

Cash flows from investing activities 8. Cash flows from Financing Activities Increase in borrowings Dividends paid in cash

(400,000) 120,000 (20,000) 100,000 2 Marks [Total: 35 Marks]

SOLUTION 2 ELY Statement of Changes in Equity for the Year Ended 31st December 2006 Ordinary Land Investment share revaluation revaluation Retained capital reserve reserve earnings Balance at 1st January 2006 1,170,000 1,000,000 30,000 3,500,000

Total 5,700,000

Gain on land revaluation Gain on investments taken to equity Profit for year Total recognised income and expenditure for the year Dividends paid Share issue Balance at 31st December 2006

280,000 1,450,000

500,000 500,000 1,500,000

20,000 20,000 50,000

780,000 780,000 (20,000) (280,000) 3,980,000

500,000 20,000 780,000 1,300,00 (20,000) 6,980,000

[Total: 15 Marks]

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SOLUTION 3 (a) If undue importance is placed on the EPS figure, it is possible that this could lead to simplistic interpretations of financial performance. Consequently, accounting regulators have attempted to de-emphasise EPS, with companies being encouraged to provide additional EPS figures on a more meaningful basis. There is also a view that EPS is not an appropriate subject for a standard since it deals with financial analysis rather than financial reporting. The purpose of EPS is to allow comparability between companies. However, the earnings stated in corporate reports are not necessarily comparable with each other because of differing accounting policies and there will be different levels of earnings from non-trading transactions, which will not be representative of a company's earnings potential. Additionally, the level of taxation suffered may not be consistent between companies. Thus there may be problems if the EPS figure is used for investment purposes or as part of the Price Earnings ratio when valuing a company's shares, if the inconsistencies in corporate financial reporting are not taken into account and a wider range of information about the company is not provided. (10 Marks) (b) (i) Basic EPS PAT No. ordinary shares (w1)

780,000 1,310,000

= 0.595 (3 Marks)

(ii)

Diluted EPS PAT No. ordinary shares (w2)

780,000 1,360,000

= 0.574 (3 Marks)

W1 (1,170,000 x 6/12) + (1,450,000x 6/12) W2 Warrants were issued at a discount of 2 or 20% = 500,000 x 0.2 x 6/12

= 1,310,000

(2 Marks)

= 50,000

(2 Marks) [Total: 20 Marks]

SOLUTION 4 (a) The accounting treatment of brands in accordance with IAS 38 Intangible Assets
G

internally generated: - internally generated intangibles must meet the recognition criteria in para 57; - para 63 specifically excludes the recognition of internally generated brands. acquired brands: - recognised at cost; - if acquired as part of a business combination must meet the recognition criteria of IFRS 3, para 37 (c), namely that fair value can be measured reliably [see also paras 45-46 of IFRS 3]; - initially measured at cost = fair value; - subsequently can be measured at cost or revalued amount, but use of the latter requires the existence of an active market; - amortisation based on useful life, or non-amortisation on indefinite life. (6 Marks)

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(b)

The potential problems associated with the recognition of brands Problems relate to:
G G G

measurement of the brands; subsequent measurement of the brands; amortisation of the brands.

Consider a major brand of whiskey e.g. Chivas Regal or Johnny Walker etc. There is an argument that the brand name is worthless if separated from the company, for example, could Chivas Regal sell the brand name to another company making whiskey that tastes different from the Chivas Regal whiskey? Or is the brand an integral part of the whole company? For example, Coca-Cola, would a lemonade company buy the brand name Coca Cola or is the brand an integral part of the whole product of the company? (9 Marks) [Total: 15 Marks]

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SOLUTION 5 REPORT Format & presentation 1 Mark Date dd/mm/yy The Shareholders, As promised, I have outlined below (a) The reasons for switching to international financial reporting standards The case in favour of switching to IFRSs can be made on two bases: First, legal or stock exchange requirements to use IFRSs and second, benefits to the company from using IFRSs: Legal and stock exchange requirements: The European Union accounting regulation requires all companies domiciled in an EU member state that are listed in an EU public securities market, such as the London Stock Exchange or Euronext, to use IFRSs starting in 2006. Companies from countries outside the EU have until 2008 to switch to IFRSs. The European Commission is studying whether any foreign GAAPs should be regarded as equivalent to IFRS so non-European companies can continue to use those GAAPs. The only three under study are US GAAP, Canadian GAAP, and Japanese GAAP, not Swiss GAAP. Benefits to the company: The move to international financial reporting standards could be a significant benefit if the company is trying to attract new capital from outside investors. However, any company that goes to the public capital markets gives up its privacy. Transparency (that is, full financial disclosure) is required by national securities laws and stock exchange regulations to protect investors. The concern about too much disclosure will arise regardless of where the company lists. Furthermore, investors and financial analysts are likely to expect to see IFRS financial statements. IFRS information will bring credibility and comparability, which in turn should reduce the companys cost of capital. Even if the law does not require IFRSs, market pressure is very likely to. (9 Marks) (b) Whether it is in a countrys best interests to develop its own accounting standards Whether a country should develop its own accounting standards depends significantly on the globalisation of its economy:
G G

If its companies seek capital in capital markets outside the countrys borders, then IFRSs make sense; If the country is trying to attract foreign investors in its companies, then IFRSs make sense. IFRSs can reduce the obstacles in communicating financial information to investors in other countries. Most countries cannot expect foreign investors, lenders, and financial analysts to know the countrys GAAP; There is also the cost saving from not having its own accounting standards setting structure.

On the other hand, IFRSs may be burdensome for companies in developing economies or for small companies. IFRSs may not accommodate all national laws and tax and political structures. The IASB currently is working on developing separate standards for small and medium-sized entities. (5 Marks) [Total: 15 Marks] [Total: 100 Marks]

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