Financial Reporting

(International Stream)
PART 2 THURSDAY 5 DECEMBER 2002

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A This ONE question is compulsory and MUST be answered THREE questions ONLY to be answered

Section B

Paper 2.5(INT)

Section A This ONE question is compulsory and MUST be attempted 1 Hydrate is a public company operating in the industrial chemical sector. In order to achieve economies of scale, it has been advised to enter into business combinations with compatible partner companies. As a first step in this strategy Hydrate acquired all of the ordinary share capital of Sulphate by way of a share exchange on 1 April 2002. Hydrate issued five of its own shares for every four shares in Sulphate. The market value of Hydrates shares on 1 April 2002 was $6 each. The share issue has not yet been recorded in Hydrates books. The summarised financial statements of both companies for the year to 30 September 2002 are: Income statement year to 30 September 2002: Hydrate $000 24,000 (16,600) 7,400 (1,600) 5,800 (2,000) 3,800 $000 64,000 nil 64,000 $000 Sulphate $000 20,000 (11,800) 8,200 (1,000) 7,200 (3,000) 4,200 $000 35,000 12,800 47,800

Sales revenue Cost of sales Gross profit Operating expenses Operating profit Taxation Profit after tax Balance Sheet as at 30 September 2002 Non-current assets $000 Property, plant and equipment Investment Current Assets Inventory Accounts receivable Bank Total assets Equity and liabilities Ordinary shares of $1 each Reserves: Share premium Accumulated profits Non-current liabilities 8% Loan note Current liabilities Accounts payable Taxation

22,800 16,400 500

39,700 103,700 20,000

23,600 24,200 200

48,000 95,800 12,000

4,000 57,200

61,200 81,200 5,000

2,400 42,700

45,100 57,100 18,000

15,300 2,200

17,500 103,700

17,700 3,000

20,700 95,800

The following information is relevant: The fair value of Sulphates investment was $5 million in excess of its book value at the date of acquisition. The fair values of Sulphates other net assets were equal to their book values. Consolidated goodwill is deemed to have a five-year life, with time apportioned charges (treated as an operating expense) in the year of acquisition. No dividends have been paid or proposed by either company.

Required: (a) (i) Prepare the consolidated income statment and balance sheet of Hydrate for the year to 30 September 2002 using the purchase method of accounting (acquisition accounting); and (13 marks)

(ii) Prepare a consolidated income statement and the consolidated SHAREHOLDERS FUNDS section of the balance sheet of Hydrate for the year to 30 September 2002 using the uniting of interests method of accounting (merger accounting). (7 marks) (b) Describe the distinguishing feature of a uniting of interests, and discuss whether the business combination in (a) should be accounted for as a uniting of interests. (5 marks) (25 marks)

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Section B THREE questions ONLY to be attempted 2 The following figures have been extracted from the accounting records of Bloomsbury on 30 September 2002: $000 $000 Sales revenue (note (i)) 98,880 Cost of sales 56,000 Joint venture account (note (ii)) 1,200 Operating expenses 14,000 Loan interest paid 1,800 Investment income 700 Investment property at valuation 10,000 25-year leasehold factory at cost (note (iii)) 50,000 15-year leasehold factory at cost (note (iii)) 30,000 Plant and equipment at cost (note (iii)) 49,800 Depreciation 1 October 2001 25 year leasehold 10,000 Depreciation 1 October 2001 15 year leasehold 10,000 Depreciation 1 October 2001 plant and equipment 19,800 Accounts receivable (note (i)) 16,700 Inventory 30 September 2002 7,500 Cash and bank 500 Accounts payable 9,420 Deferred tax 1 October 2001 (note (iv)) 2,100 Ordinary shares of 25 cents each 40,000 10% Redeemable (in 2005 at par) preference shares of $1 each 10,000 12% Loan note (issued in 2000) 30,000 Accumulated profits 1 October 2001 6,100 Investment property revaluation reserve 1 October 2001 2,000 Interim dividends (note (v)) 1,500 239,000 239,000 The following notes are relevant: (i) On 1 January 2002, Bloomsbury agreed to act as a selling agent for an overseas company, Brandberg. The terms of the agency are that Bloomsbury receives a commission of 10% on all sales made on behalf of Brandberg. This is achieved by Bloomsbury remitting 90% of the cash received from Brandbergs customers one month after Bloomsbury has collected it. Bloomsbury has included in its sales revenue $72 million of sales on behalf of Brandberg of which there is one months outstanding balances of $12 million included in Bloomsburys accounts receivable. The cash remitted to Brandberg during the year of $54 million (i.e. 90% of $6 million) in accordance with the terms of the agency, has been treated as the cost of the agency sales. (ii) The joint venture account represents the net balance of Bloomsburys transactions in a joint venture with Waterfront which commenced on 1 October 2001. Each venturer contributes their own assets and pays their own expenses. The revenues for the venture are shared equally. The joint venture is not a separate entity. Details of Bloomsburys joint venture transactions are: Plant and equipment at cost Share of joint venture sales revenues (50% of total sales revenues) Related cost of sales excluding depreciation Accounts receivable Accounts payable Net balance of joint venture account $000 1,500 (800) 400 200 (100) 1,200

Plant and equipment should be depreciated in accordance with the companys policy in note (iii).

(iii) On 1 October 2001 Bloomsbury had its two leasehold factories revalued (for the first time) by an independent surveyor as follows: 25 year leasehold $52 million 15 year leasehold $18 million Bloomsbury depreciates its leaseholds on a straight-line basis over the life of the lease. The directors of Bloomsbury are disappointed in the value placed on the 15-year leasehold. The surveyor has said that the fall in its value is due mainly to its unfavourable location, but in time the surveyor expects its value to increase. The directors are committed to incorporating the revalued amount of the 25-year leasehold into the financial statements, but wish to retain the historic cost basis for the 15-year leasehold. Revaluation surpluses are transferred to accumulated realised profits in line with the realisation of the related assets. Prior to the current year, Bloomsbury had adopted a policy of carrying its investment property at fair value, with the surplus being credited to reserves. For the current year it will be applying the fair value method of accounting for investment properties in IAS 40 Investment Property. The value of the investment property had increased by a further $500,000 in the year to 30 September 2002. Plant and equipment is depreciated at 20% per annum on the reducing balance basis. (iv) A provision for income tax for the year to 30 September 2002 of $5 million is required. Temporary differences (related to the difference between the tax base of the plant and its balance sheet written down value) on 1 October 2001 were $7 million and on 30 September 2002 they had declined to $5 million. Assume a tax rate of 30%. Ignore deferred tax on the property revaluations. (v) The interim dividends paid include half of the full years preference dividend. On 25 September 2002 the directors declared a final ordinary dividend of 3 cents per share. Required: Prepare the financial statements for the year to 30 September 2002 for Bloomsbury in accordance with International Accounting Standards as far as the information permits. They should include: An Income Statement; A Statement of Changes in Equity; and A Balance Sheet. (9 marks) (3 marks) (13 marks)

Notes to the financial statements are not required. (25 marks)

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The principle of recording the substance or economic reality of transactions rather than their legal form lies at the heart of the Framework for Preparation and Presentation of Financial Statements (Framework) and several International Accounting Standards. The development of this principle was partly in reaction to a minority of public interest companies entering into certain complex transactions. These transactions sometimes led to accusations that company directors were involved in creative accounting. Required: (a) (i) Explain, with relevant examples, what is generally meant by the term creative accounting; (5 marks)

(ii) Explain why it is important to record the substance rather than the legal form of transactions and describe the features that may indicate that the substance of a transaction is different from its legal form. (5 marks) (b) (i) Atkinss operations involve selling cars to the public through a chain of retail car showrooms. It buys most of its new vehicles directly from the manufacturer on the following terms: Atkins will pay the manufacturer for the cars on the date they are sold to a customer or six months after they are delivered to its showrooms whichever is the sooner. The price paid will be 80% of the retail list price as set by the manufacturer at the date that the goods are delivered. Atkins will pay the manufacturer 15% per month (of the cost price to Atkins) as a display charge until the goods are paid for. Atkins may return the cars to the manufacturer any time up until the date the cars are due to be paid for. Atkins will incur the freight cost of any such returns. Atkins has never taken advantage of this right of return. The manufacturer can recall the cars or request them to be transferred to another retailer any time up until the time they are paid for by Atkins.

Required: Discuss which party bears the risks and rewards in the above arrangement and come to a conclusion on how the transactions should be treated by each party. (6 marks) (ii) Atkins bought five identical plots of development land for $2 million in 1999. On 1 October 2001 Atkins sold three of the plots of land to an investment company, Landbank, for a total of $24 million. This price was based on 75% of the fair market value of $32 million as determined by an independent surveyor at the date of sale. The terms of the sale contained two clauses: Atkins can re-purchase the plots of land for the full fair value of $32 million (the value determined at the date of sale) any time until 30 September 2004; and On 1 October 2004, Landbank has the option to require Atkins to re-purchase the properties for $32 million. You may assume that Landbank seeks a return on its investments of 10% per annum.

Required: Discuss the substance of the above transactions; and (3 marks)

Prepare extracts of the income statement and balance sheet (ignore cash) of Atkins for the year to 30 September 2002: if the plots of land are considered as sold to Landbank; and reflecting the substance of the above transactions. (2 marks) (4 marks) (25 marks)

This is a blank page. Question 4 begins on page 8.

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The financial statements of Nedberg for the year to 30 September 2002, together with the comparative balance sheet for the year to 30 September 2001 are shown below: Income Statement year to 30 September 2002: $m Sales revenue Cost of sales (note (1)) Gross profit for period Operating expenses (note (1)) Interest Loan note Profit before tax Taxation Net profit for the period Dividends: ordinary Interim Dividends: ordinary Final Net profit for period Balance sheets as at 30 September: Non-current assets Property, plant and equipment Intangible assets (note (2)) Current assets Inventory Accounts receivable Cash Total assets Equity and liabilities Ordinary Shares of $1 each Reserves Share premium Revaluation Accumulated profits Less dividends paid and declared Non-current liabilities (note (3)) Current liabilities (note (4)) Total equity and liabilities $m (120) (280) $m 3,820 (2,620) 1,200 (300) 900 (30) 870 (270) 600 (400) 200 2002 $m 1,890 650 2,540

$m

2001 $m 1,830 300 2,130

1,420 990 70

2,480 5,020 750 350 140

940 680 nil

1,620 3,750 500 100 nil

2,010 (400)

1,610 2,850 870 1,300 5,020

1,700 (300)

1,400 2,000 540 1,210 3,750

Notes to the financial statements: (1) Cost of sales includes depreciation of property, plant and equipment of $320 million and a loss on the sale of plant of $50 million. It also includes a credit for the amortisation of government grants. Operating expenses include a charge of $20 million for the amortisation of goodwill. (2) Intangible non-current assets: 2002 $m 470 180 650 300 260 310 870 875 nil 15 280 130 1,300 2001 $m 100 200 300 100 300 140 540 730 115 5 200 160 1,210

Deferred development expenditure Goodwill

(3) Non-current liabilities: 10% loan note Government grants Deferred tax

(4) Current liabilities: Accounts payable Bank overdraft Accrued loan interest Declared dividends unpaid Taxation

The following additional information is relevant: (i) Intangible fixed assets: The company successfully completed the development of a new product during the current year, capitalising a further $500 million before amortisation charges for the period. (ii) Property, plant and equipment/revaluation reserve: The company revalued its buildings by $200 million on 1 October 2001. The surplus was credited to a revaluation reserve. New plant was acquired during the year at a cost of $250 million and a government grant of $50 million was received for this plant. On 1 October 2001 a bonus issue of 1 new share for every 10 held was made from the revaluation reserve. $10 million has been transferred from the revaluation reserve to realised profits as a year-end adjustment in respect of the additional depreciation created by the revaluation. The remaining movement on property, plant and equipment was due to the disposal of obsolete plant. (iii) Share issues: In addition to the bonus issue referred to above Nedberg made a further issue of ordinary shares for cash. Required: (a) A cash flow statement for Nedberg for the year to 30 September 2002 prepared in accordance with IAS 7 Cash Flow Statements. (20 marks) (b) Comment briefly on the financial position of Nedberg as portrayed by the information in your cash flow statement. (5 marks) (25 marks)

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You are a partner in a small audit and accounting practice. You have just completed the audit and finalised the financial statements of a small family owned company in discussion with its managing director Mrs Harper. After the meeting Mrs Harper has asked for your help. She has obtained the published financial statements of several quoted companies in which she is considering buying some shares as a personal investment. She presents you with the following information: (a) In the year to 30 September 2002, two companies, Gamma and Toga, reported identical profits before tax of $100 million. Information in the Chairmens reports said both companies also expected profits from their core activities (to be interpreted as from continuing operations) to grow by 10% in the following year. Mrs Harper has extracted information from the income statements and made the following summary: Operating profit: Continuing activities Acquisitions Discontinued activities Gamma $ million 70 nil 30 100 Toga $ million 90 50 (40) 100

A note to the financial statements of Toga said that both the discontinuation and acquisition occurred on 1 April 2002 and were part of an overall plan to focus on its traditional core activities after incurring large losses on a new foreign venture. Required: (i) Briefly explain to Mrs Harper why information on discontinued operations is useful; (3 marks)

(ii) Calculate the expected operating profit for both companies for the year to 30 September 2003 (assuming the Chairmens growth forecasts are correct): in the absence of information of the discontinued operations; and based on the information provided above. (4 marks)

(b) Taylor is another company about which Mrs Harper has obtained the following information from its published financial statements: Earnings per share: Year to 30 September Basic earnings per share 2002 25 cents 2001 20 cents

The earnings per share is based on attributable earnings of $50 million ($30 million in 2001) and 200 million ordinary shares in issue throughout the year (150 million weighted average number of ordinary shares in 2001). Balance sheet extracts: 8% Convertible loan stock $ million 200 $ million 200

The loan stock is convertible to ordinary shares in 2004 on the basis of 70 new shares for each $100 of loan stock. Note to the financial statements: There are directors share options (in issue since 1999) that allow Taylors directors to subscribe for a total of 50 million new ordinary shares at a price of $150 each. (Assume the current rate of income tax for Taylor is 25% and the market price of its ordinary shares throughout the year has been $250) Mrs Harper has read that the trend of the earnings per share is a reliable measure of a companys profit trend. She cannot understand why the increase in profits is 67% ($30 million to $50 million), but the increase in the earnings per share is only 25% (20 cents to 25 cents). She is also confused by the company also quoting a diluted earnings per share figure, which is lower than the basic earnings per share.

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Required: (i) Explain why the trend of earnings per share may be different from the trend of the reported profit, and which is the more useful measure of performance; (3 marks)

(ii) Calculate the diluted earnings per share for Taylor based on the effect of the convertible loan stock and the directors share options for the year to 30 September 2002 (ignore comparatives); and (5 marks) (iii) Explain the relevance of the diluted earnings per share measure. (4 marks)

(c) Mrs Harper has noticed that the tax charge for a company called Stepper is $5 million on profits before tax of $35 million. This is an effective rate of tax of 143%. Another company Jenni has an income tax charge of $10 million on profit before tax of $30 million. This is an effective rate of tax of 333% yet both companies state the rate of income tax applicable to them is 25%. Mrs Harper has also noticed that in the cash flow statements each company has paid the same amount of tax of $8 million. Required: Advise Mrs Harper of the possible reasons why the income tax charge in the financial statements as a percentage of the profit before tax may not be the same as the applicable income tax rate, and why the tax paid in the cash flow statement may not be the same as the tax charge in the income statement. (6 marks) (25 marks)

End of Question Paper

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