ACCA

Paper P2 (International) Corporate Reporting

Tuition Mock Examination December 2011 Question Paper
Section A Question 1 is compulsory and MUST be attempted. Section B You must attempt two out of three questions (answer 2 questions from questions 2, 3, and 4) Time Allowed 15 minutes 3 hours Reading and planning Writing

 The Accountancy College Ltd, October 2011 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, recording or otherwise, without the prior written permission of The Accountancy College Ltd.

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SECTION A
There is one compulsory question. Question 1 must be answered in full.

Question 1 Purposeful
At the year start, Purposeful purchased 15% of the equity of Sedentary. The investment was classified as one in which the gains should be reported through the profit or loss. The cost of the investment was $190,000. Exactly half way through the year, Purposeful acquired another 60% of the share capital of Sedentary and 30% of the share capital of Available. Purposeful acquired 60% of Sedentary by way of share for share exchange. Purposeful issued five of its own shares for two Sedentary shares. The market value of Purposeful shares was $30 on that day. The share issue has not yet been recorded. The fair value of the previously owned 15% equity had risen to $900,000 at the point that control was attained. Available shares were acquired for $800,000 cash consideration. It is the groups policy to value the non-controlling interest at fair value, which at acquisition was measured at $1,800,000. The summarised draft financial statements are as follows: Income Statement or Profit and loss account for the year ended 31 October (including a movement on reserves) Purposeful $000 Revenue Cost of sales Gross profit Operating expenses Operating profit Interest Dividends received from Sedentary Profit before tax Tax Profit after tax Dividends paid Profit retained Retained earnings brought forward Retained earnings carried forward 24,000 (18,000) _____ 6,000 (3,100) _____ 2,900 (700) 32 _____ 2,232 (732) _____ 1,500 (500) _____ 1,000 19,180 _____ 20,180 _____ Sedentary $000 6,600 (2,800) _____ 3,800 (2,900) _____ 900 (300) ___ 600 (200) ___ 400 (40) ___ 360 3,440 ___ 3,800 ___ Available $000 1,820 (1,400) ___ 420 (220) ___ 200 (70) ___ 130 (30) ___ 100 (0) ___ 100 400 ___ 500 ___

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Statement of financial position as at 31 October (equity presentation) Purposeful $000 $000 Non current assets Land & building 13,000 Plant & machinery 15,000 Investment in Available 800 Investment in 15% Sedentary 190 Investment in other shares 390 ______ 29,380 Current assets Inventory Receivables Bank 1,400 1,900 700 _____ 4,000 _____ Current Liabilities Trade Corporation tax 1,600 1,700 _____ 3,300 _____ 700 Non Current Liabilities Loan (4,900) ______ 25,180 ______ Share capital ($1 nominal each) Share premium Retained earnings 4,000 1,000 20,180 ______ 25,180 ______ 1,200 1,050 390 ___ 2,640 ___ 1,140 100 ___ 1,240 ___ 1,400 (4,500) _____ 4,200 _____ 100 300 3,800 _____ 4,200 _____ Sedentary $000 $000 4,000 2,800 Available $000 $000 800 700

500 _____ 7,300 70 170 40 ___ 280 ___ 60 30 __ 90 __

50 _____ 1,550

190 (1,040) _____ 700 _____ 160 40 500 ___ 700 ___

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The following information is relevant: (1) At acquisition the fair value of all Availables assets were reasonably represented by the book value. The same was true of Sedentary with the exception of some land and plant. These had fair values of $900,000 and $1,000,000 above book values. The plant had a remaining life of five years. Depreciation is charged to cost of sales. In the post acquisition period Sedentary sold goods to Purposeful at $240,000. Transfer transactions were calculated to give a margin of 20% (mark up of 25%). Sedentary held one sixth of these goods in inventory at the year end. Goodwill related to the Available acquisition was subject to a brief impairment review at the year end and this was sufficient to confirm that there was no impairment. However, a similar review of the goodwill related to Sedentary revealed that there may be an impairment. So a more detailed review was conducted which revealed a value in use of $7,000,000 and a net realisable value of $6,560,000. Goodwill impairment is separately discloseable on the face of the income statement. The current account between Purposeful and Sedentary did not agree due to cash in transit from subsidiary to parent of $7,000. Purposeful recorded a receivable of $25,000 at the year end. Dividends were paid in the last month before the year end. At the year start, four Purposeful directors were each given 200,000 options each. These were valued at $4 each at the year start and $7 each at the year end. The options vest after five years from the year start, provided that the directors remain with the group. It is expected that one director will leave and the others will remain. Purposeful purchased investment property land in a foreign country for 20 million Grotniks(G) at the year start. The same property was valued at 11million Grotniks(G) at the year end. The foreign exchange rate has moved from 20G:$1 to 44G:$1 from the year start to the year end. The cost of the investment has been translated into $ and included in land and buildings at that cost within the statement of financial position.

(2)

(3)

(4)

(5)

(6)

Required (a) Income statement (Profit or loss report) and statement of financial position (balance sheet) for the group for the year ended 31 October. The statement of financial position should be presented using the usual assets and liabilities presentation rather than the equity presentation used in the question above. (Answer should be presented to nearest $1,000.) (35 marks)

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The presentation of the position statement utilised above in the draft financial statements is frequently referred to as the equity presentation. The International Accounting Standards Board (IASB) has proposed its adoption in preference to the usual assets and liabilities presentation used presently. Required (b) Discuss why the equity presentation is preferred by the IASB and how the process of development operates. (8 marks)

The board has a mix of executive and non-executive directors. One of the nonexecutive directors has calculated two ratios and both cause her concern. The two ratios are income statement interest to position statement loan and income statement tax to position statement tax. Required (c) Calculate these two ratios for both parent and subsidiary (not group nor associate) and comment on why the ratios might be of concern. (7 marks) (Total 50 marks)

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SECTION B
There are three questions of which you must answer two.

Question 2 Fudge
Fudge is a medium industrial group that is listed on a major world stock exchange. It has finally succeeded in acquiring a controlling interest in its principle supplier, Sugar. This acquisition is seen by the board as a great achievement, as in the past, concerns over supply have frustrated the board and worried the shareholders. You are advising the Chief Finance Officer (CFO) regarding the issues raised by the acquisition. She has various concerns, much of which relates to the financial reporting of the acquisition and the conceptual reasons underlying the financial reporting. The acquisition of Sugar was achieved in stages. Sugar is a traditional raw materials supplier and had until recently been under family ownership and control. Fudge has for a number of years been in negotiations with the family to purchase shares, but only for the first time last year was Fudge offered shares in Sugar. Fudge purchased 25% (25,000 shares) at the end of last year for $2million and obtained a seat on the main board of five directors. The fair value of the identifiable net assets of Sugar at that time was $4million. Last week Fudge acquired a further 35% (35,000 shares) for $3.5 million and obtained control. The fair value of the identifiable net assets of Sugar at this second point of purchase was $5million. The fair value of the previous ownership of 25% was measured at $2.25million and the fair value of the non-controlling interest was measured at $3.2million. These latter two fair values have been measured using appropriate models. It is approaching the year end and the CFO wants to understand how the above purchase will be reported, both in the financial statements and elsewhere. She understands that there are new rules regulating group accounting and that these have been motivated partly by the need for global accounting convergence. She is particularly keen to understand the underlying principles behind the accounting and also the application of fair value to the process of measuring goodwill. However, she is also concerned that the acquisition, which is a major strategic success might not be communicated to shareholders appropriately because of an over focus on the accounting. Negotiations with Sugar shareholders continue and Fudge hopes to purchase a further 10% (10,000 shares) early next year. It is expected that the consideration will be $1million and that the identifiable net assets of Sugar will be $6 million at this anticipated third point of purchase. The CFO would like to understand how this third purchase will be reported, should it go ahead. Goodwill remains unimpaired throughout.

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Required Write a report to the CFO that addresses the following requirements: (a) (b) (c) Calculate the goodwill attributable to Sugar at the current year end. Explain the conceptual basis for the calculation of goodwill. (13 marks) Explain how the important strategic reasons for the acquisition could be communicated to the Fudge shareholders. (5 marks) Calculate the transfer in equity and the reduction to equity that is attributable to the parent shareholders that would result from the third purchase, assuming it occurs as predicted. Explain the conceptual basis for this transfer. (7 marks) (Total 25 marks)

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Question 3 Low Paints

On 1 November, the current year start, the chief executive of Low Paints, Mr Low, retired from the company. The ordinary share capital of $1 at the time of his retirement was $6 million. Mr Low owned fifty-two per cent of the ordinary shares of Low Paints at that time and the remainder was owned by employees. As an incentive to the new management, Mr Low agreed to a new executive compensation plan which commenced after his retirement. The plan provides cash bonuses to the board of directors when the companys earnings per share exceeds the normal earnings per share which has been agreed at $0.50 per share. The cash bonuses are calculated as being twenty per cent of the profit generated in excess of that required to give an earnings per share figure of $0.50. The new board of directors has reported that the compensation to be paid is $360,000 based on earnings per share of $0.80 for the year ended 31 October. However, Mr Low is surprised at the size of the compensation as other companies in the same industry were either breaking even or making losses in the period. He was anticipating that no bonus would be paid for the year as he felt that the company would not be able to earn the equivalent of the normal earnings per share figure of $0.50. Mr Low, who had taken no active part in management decisions, decided to take advantage of his role as non-executive director and demanded an explanation of how the earnings per share figure of $0.80 had been calculated. His investigations revealed the following information: (i) The company received a grant from the government of $5 million towards the cost of purchasing a non-current asset of $15 million. The grant had been credited to the income statement in total and the non-current asset had been recognised at $15 million in the balance sheet and depreciated at a rate of 10% per annum on the straight line basis. The directors explained that current thinking by the International Accounting Standards Board was that the accounting standard on government grants was conceptually wrong because it misstates the assets and liabilities of the company and hence they were following the approach which has been advocated in a recent magazine article. Shortly after Mr Low had retired from the company, Low Paints made an initial public offering of its shares. The sponsor of the issue charged a fee of $300,000. The fee on 1 January was paid by issuing one hundred thousand $1 shares at a market value of $120,000 and by cash of $180,000. The directors had charged the cash paid as an expense in the income statement. Further they had credited the value of the shares issued to the sponsor in the income statement as they felt that the shares were issued for no consideration and that, therefore, they should offset the cash paid by the company. The public offering was made on 1 January during the current year and involved vesting four million ordinary (exclusive of the sponsors shares) shares of $1 at a market price of $1.20. Mr Low and other current shareholders decided to sell three million of their shares as part of the offer leaving one million new shares to be issued.

(ii)

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(iii)

The directors sold on 1 November at the current year start a property under a twenty year lease to a company, Highball, which the bank had set up to act as a vehicle for investments and special projects. The consideration for the lease is $4.5 million. Low Paints has signed an unconditional agreement to repurchase the lease of the property after four years for a fixed amount of $5.5 million. The property has been taken off the balance sheet and the profit on the transaction, which has been included in the income statement, is $500,000. The profit has been calculated by comparing the carrying value of the property with the consideration received. Depreciation on the property would normally be charged at 10% per annum on the carrying value of the asset. Low Paints had made a gain of $200,000 on an investment property. The gain has been recorded straight to equity. The gain was based on a valuation using the existing use basis. The surveyor used this basis and market value in his report. The market value was $100,000 more.

(iv)

The directors had calculated earnings per share for the year ended 31 October as follows: Net profit Ordinary shares of $1 Earnings per share $4.8 million 6,000,000 $0.80

Mr Low was concerned over the way that earnings per share had been calculated by the directors and also he felt that some of the above accounting practices were at best unethical and at worst fraudulent. He, therefore, had asked your technical and ethical advice on the practices of the directors. Required Advise Mr Low as to whether earnings per share has been accurately calculated by the directors showing a revised calculation of earnings per share. Discuss whether the directors may have acted in an unethical manner in each case (i) to (iv) above. Note: each paragraph (i) to (iv) above has equal mark allocation. (Total 25 marks)

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Question 4 Commentators
Some commentators question the relevance of financial reporting. They argue that the market has such widespread access to information that financial reporting is no longer relevant. Other commentators argue that the classic traditional ratios like gearing and return on capital employed are irrelevant. These other commentators state that market analysts use quite different tools for measuring company value and therefore the traditional ratios are outdated. Still other commentators take a different angle to the above. They argue that on the contrary many market players remain obsessed by financial reporting but fail to really analyse the financial statements they are paid to analyse. These commentators argue that market players often ignore the detail and simply hone in on the earnings. These commentators often criticise those market players for wilfully ignoring the information laid out in modern financial statements. This general disillusionment can be demotivating for the International Accounting Standards Board (IASB) who invest their time in improving International Financial Reporting Standards (IFRS). One of the improvements that has been most successful but at the same time most controversial has been the move away from Historical Cost Accounting (HCA) towards Fair Value Accounting (FVA). Required (a) Discuss whether financial statements are ignored by financial markets and whether the importance of financial reporting has been eroded over recent years. (7 marks) Discuss the importance of simple financial statement ratio analysis and the development of newer analytical tools used by analysts. (4 marks) Explain why an over focus on earnings is problematical. Discuss the improvements in IFRS recently and under development. (8 marks) Explain the principals underlying historical cost accounting (HCA) and fair value accounting (FVA). Discuss whether increasing FVA reduces HCA and why analysts might prefer FVA. (6 marks) (Total 25 marks)

(b)

(c) (d)

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