Income statement and balance sheet, Exercises of Business Economics

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Fundamentals Level – Skills Module, Paper F7 (HKG) Financial Reporting (Hong Kong) June 2010 Answers

1 (a) Consolidated statement of financial position of Picant as at 31 March 2010

$’000 $’ Assets Non-current assets: Property, plant and equipment (37,500 + 24,500 + 2,000 – 100) 63, Goodwill (16,000 – 3,800 (w (i))) 12, Investment in associate (w (ii)) 13, –––––––– 89, Current assets Inventory (10,000 + 9,000 + 1,800 GIT – 600 URP (w (iii))) 20, Trade receivables (6,500 + 1,500 – 3,400 intra-group (w (iii))) 4,600 24, ––––––– –––––––– Total assets 114, –––––––– Equity and liabilities Equity attributable to owners of the parent Equity shares of $1 each 25, Share premium 19, Retained earnings (w (iv)) 27,500 47, ––––––– –––––––– 72, Non-controlling interest (w (v)) 8, –––––––– Total equity 80, Non-current liabilities 7% loan notes (14,500 + 2,000) 16, Current liabilities Contingent consideration 2, Other current liabilities (8,300 + 7,500 – 1,600 intra-group (w (iii))) 14,200 16, ––––––– –––––––– Total equity and liabilities 114, –––––––– Workings (fi gures in brackets are in $’000) (i) Goodwill in Sander $’000 $’ Controlling interest Share exchange (8,000 x 75% x 3/2 x $3·20) 28, Contingent consideration 4, Non-controlling interest (8,000 x 25% x $4·50) 9, ––––––– 42, Equity shares 8, Pre-acquisition reserves: At 1 April 2009 16, Fair value adjustments – factory 2,

• software (see below) (500) (26,000) ––––––– ––––––– Goodwill arising on acquisition 16, ––––––– Goodwill is impaired by $3·8 million and therefore has a carrying amount at 31 March 2010 of $12·2 million. The goodwill impairment is charged against Sander’s retained earnings (see working (iv)), thus ensuring it is allocated between the controlling and non-controlling interests in proportion to their share ownership in Sander. The effect of the software having no recoverable amount is that its write-off in the post-acquisition period should be treated as a fair value adjustment at the date of acquisition for consolidation purposes. The consequent effect is that this will increase the post-acquisition profi t for consolidation purposes by $500,000. (ii) Carrying amount of Adler at 31 March 2010 $’ Cash consideration (5,000 x 40% x $4) 8, 7% loan notes (5,000 x 40% x $100/50) 4, Share of post-acquisition profi ts (6,000 x 6/12 x 40%) 1, ––––––– 13, –––––––

(b) Dune – Statement of financial position as at 31 March 2010

$’000 $’ Assets Non-current assets Property, plant and equipment (w (vi)) 46, Investments at fair value through profi t or loss 28, –––––––– 74, Current assets Inventory 48, Construction contract – amounts due from customer (w (ii)) 13, Trade receivables (40,700 – 8,000 (w (i))) 32,700 94, ––––––– Non-current assets held for sale (w (iii)) 33, –––––––– Total assets 202, –––––––– Equity and liabilities Equity Equity shares of $1 each 60, Retained earnings (38,400 + 19,950 – 10,000 dividend paid) 48, –––––––– 108, Non-current liabilities Deferred tax (w (v)) 4, 5% loan notes (2012) (w (iv)) 20,450 24, ––––––– Current liabilities Trade payables 52, Bank overdraft 4, Accrued loan note interest (w (iv)) 500 Current tax payable 12,000 69, ––––––– –––––––– Total equity and liabilities 202, –––––––– Workings (fi gures in brackets in $’000) (i) This appears to be a ‘cut off’ error in that Dune has invoiced goods that are still in inventory. The required adjustment is to remove the sale of $8 million (6,000 x 100/75) from revenue and trade receivables. No adjustment is required to cost of sales or closing inventory. (ii) Construction contract: $’000 $’ Agreed selling price 40, Costs to date 8, Costs to complete 15, Plant (12,000 – 3,000) 9,000 (32,000) ––––––– –––––––– Total estimated profi t 8, –––––––– Amounts for inclusion in the income statement for the year ended 31 March 2010 Revenue (40,000 x 30%) 12, Cost of sales (balance) (9,600) –––––––– Gross profi t (8,000 x 30%) 2, –––––––– Amounts for inclusion in the statement of fi nancial position as at 31 March 2010 Cost to date – materials, labour and other direct costs 8, Plant depreciation ((12,000 – 3,000) x 6/18) 3, –––––––– 11, Profi t to date 2, –––––––– 13, Payments received (nil) –––––––– Amounts due from customer 13, ––––––––

(iii) Cost of sales $’ Per question 294, Construction contract (w (ii)) 9, Depreciation of leasehold property (see below) 1, Impairment of leasehold property (see below) 4, Depreciation of plant and equipment ((67,500 – 23,500) x 15%) 6, –––––––– 315, –––––––– The leasehold property must be classed as a non-current asset held for sale from 1 October 2009 at its fair value less costs to sell. It must be depreciated for six months up to this date (after which depreciation ceases). This is calculated at $1·5 million (45,000/15 years x 6/12). Its carrying amount at 1 October 2009 is therefore $37·5 million (45,000 – (6,000 + 1,500)). Its fair value less cost to sell at this date is $33·5 million ((40,000 x 85%) – 500). It is therefore impaired by $4 million (37,500 – 33,500). (iv) The fi nance cost of the loan note, at the effective rate of 10% applied to the carrying amount of the loan note of $19·5 million is, $1·95 million (the issue costs must be deducted from the proceeds of the loan note; they are not an administrative expense). The interest actually paid is $500,000 (20,000 x 5% x 6/12); however, a further $500, needs to be accrued as a current liability (as it will be paid soon). The difference between the total fi nance cost of $1·95 million and the $1 million interest payable is added to the carrying amount of the loan note to give $20·45 million (19,500 + 950) for inclusion as a non-current liability in the statement of fi nancial position. (v) Deferred tax Provision required at 31 March 2010 (14,000 x 30%) 4, Provision at 1 April 2009 (6,000) ––––––– Credit (reduction in provision) to income statement 1, ––––––– (vi) Property, plant and equipment Property, plant and equipment (67,500 – 23,500 – 6,600) 37, Construction plant (12,000 – 3,000) 9, ––––––– 46, –––––––

3 (a) (i) Deltoid – Statement of cash flows for the year ended 31 March 2010:

(Note: fi gures in brackets are in $’000) $’000 $’ Cash fl ows from operating activities: Loss before tax (1,800) Adjustments for: depreciation of non-current assets 3, loss on sale of leasehold property (8,800 – 200 – 8,500) 100 interest expense 1, increase in inventory (12,500 – 4,600) (7,900) increase in trade receivables (4,500 – 2,000) (2,500) increase in trade payables (4,700 – 4,200) 500 –––––– Cash defi cit from operations (6,900) Interest paid (1,000) Income tax paid (w (i)) (1,900) –––––– Net cash defi cit from operating activities (9,800) Cash fl ows from investing activities: Disposal of leasehold property 8, Cash fl ows from fi nancing activities: Shares issued (10,000 – 8,000 – 800 bonus issue) 1, Payment of fi nance lease obligations (w (ii)) (2,100) Equity dividends paid (w (iii)) (700) –––––– Net cash from fi nancing activities (1,600) –––––– Net decrease in cash and cash equivalents (2,900) Cash and cash equivalents at beginning of period 1, –––––– Cash and cash equivalents at end of period (1,400) ––––––

to (the forecast) interest payments. The higher this ratio the less risk of interest default. The calculations would be made for all four years to ascertain any trends that may indicate a deterioration or improvement in these ratios. As with other profi t-oriented entities the nature and trend of the income should be investigated: for example, are the club’s sources of income increasing or decreasing, does the reported income contain ‘one-off’ donations (which may not be recurring) etc? Also matters such as the market value of, and existing prior charges against, any assets intended to be used as security for the loan would be relevant to the lender’s decision-making process. It may also be possible that the sports club’s governing body (perhaps the trustees) may be willing to give a personal guarantee for the loan.

4 (a) For fi nancial statements to be of value to their users they must possess certain characteristics; reliability is one such important characteristic. In order for fi nancial statements to be reliable, they must faithfully represent an entity’s underlying transactions and other events. For fi nancial statements to achieve faithful representation, transactions must be accounted for and presented in accordance with their substance and economic reality where this differs from their legal form. For example, if an entity ‘sold’ an asset to a third party, but continued to enjoy the future benefi ts embodied in that asset, then this transaction would not be represented faithfully by recording it as a sale (in all probability this would be a fi nancing transaction). The features that may indicate that the substance of a transaction is different from its legal form are:

• where the control of an asset differs from the ownership of the asset
• where assets are ‘sold’ at prices that are greater or less than their fair values
• the use of options as part of an agreement
• where there are a series of ‘linked’ transactions. It should be noted that none of the above necessarily mean there is a difference between substance and legal form.

(b) Extracts from the income statements (i) reflecting the legal form: Year ended: 31 March 2010 31 March 2011 31 March 2012 Total $’000 $’000 $’000 $’ Revenue 6,000 nil 10,000 16, Cost of sales (5,000) nil (7,986) (12,986) –––––– ––– ––––––– ––––––– Gross profi t 1,000 nil 2,014 3, Finance costs nil nil nil nil –––––– ––– ––––––– ––––––– Net profi t 1,000 nil 2,014 3, –––––– ––– ––––––– ––––––– (ii) refl ecting the substance: Year ended: 31 March 2010 31 March 2011 31 March 2012 Total $’000 $’000 $’000 $’ Revenue nil nil 10,000 10, Cost of sales (nil) nil (5,000) (5,000) ––––– ––––– ––––––– ––––––– Gross profi t nil nil 5,000 5, Finance costs (600) (660) (726) (1,986) ––––– ––––– ––––––– ––––––– Net profi t (600) (660) 4,274 3, ––––– ––––– ––––––– –––––––

(c) It can be seen from the above that the two treatments have no effect on the total net profi t reported in the income statements, however, the profi t is reported in different periods and the classifi cation of costs is different. In effect the legal form creates some element of profi t smoothing and completely hides the fi nancing cost. Although not shown, the effect on the statements of fi nancial position is that recording the legal form of the transaction does not show the inventory, nor does it show the in-substance loan. Thus recording the legal form would be an example of off balance sheet (statement of fi nancial position) fi nancing. The effect on an assessment of Wardle using ratio analysis may be that recording the legal form rather than the substance of the transaction would be that interest cover and inventory turnover would be higher and gearing lower. All of which may be considered as reporting a more favourable performance.

5 (a) Where borrowing costs are directly incurred on a ‘qualifying asset’, they must be capitalised as part of the cost of that asset. A qualifying asset may be a tangible or an intangible asset that takes a substantial period of time to get ready for its intended use or eventual sale. Property construction would be a typical example, but it can also be applied to intangible assets during their development period. Borrowing costs include interest based on its effective rate (which incorporates the amortisation of discounts, premiums and certain expenses) on overdrafts, loans and (some) other fi nancial instruments and fi nance charges on fi nance leased assets. They may be based on specifi cally borrowed funds or on the weighted average cost of a pool of funds. Any income earned from the temporary investment of specifi cally borrowed funds would normally be deducted from the amount to be capitalised. Capitalisation should commence when expenditure is being incurred on the asset, which is not necessarily from the date funds are borrowed. Capitalisation should cease when the asset is ready for its intended use, even though the funds may still

be incurring borrowing costs. Also capitalisation should be suspended if there is a suspension of active development of the asset. Any borrowing costs that are not eligible for capitalisation must be expensed. Borrowing costs cannot be capitalised for assets measured at fair value.

(b) The fi nance cost of the loan must be calculated using the effective rate of 7·5%, so the total fi nance cost for the year ended 31 March 2010 is $750,000 ($10 million x 7·5%). As the loan relates to a qualifying asset, the fi nance cost (or part of it in this case) can be capitalised under HKAS 23. The Standard says that capitalisation commences from when expenditure is being incurred (1 May 2009) and must cease when the asset is ready for its intended use (28 February 2010); in this case a 10-month period. However, interest cannot be capitalised during a period where development activity is suspended; in this case the two months of July and August 2009. Thus only eight months of the year’s finance cost can be capitalised = $500,000 ($750,000 x 8/12). The remaining four-months finance costs of $250,000 must be expensed. HKAS 23 also says that interest earned from the temporary investment of specific loans should be deducted from the amount of finance costs that can be capitalised. However, in this case, the interest was earned during a period in which the finance costs were NOT being capitalised, thus the interest received of $40,000 would be credited to the income statement and not to the capitalised finance costs. In summary: $ Income statement for the year ended 31 March 2010: Finance cost (debit) (250,000) Investment income (credit) 40, Statement of financial position as at 31 March 2010: Property, plant and equipment (fi nance cost element only) 500,

• property, plant and equipment 1 (a) Statement of financial position:
• goodwill
• investment in associate 1 1 /
• inventory 11 /
• receivables
• equity shares 1 /
• share premium 1 /
• retained earnings 41 /
• non-controlling interest
• 7% loan notes 1 /
• contingent consideration
• other current liabilities
• (b) 1 mark per relevant point - Total for question
  • revenue 2 1 / 2 (a) Income statement
  • cost of sales 41 /
  • distribution costs 1 /
  • administrative expenses
  • investment income 1 /
  • gain on investments 1 /
  • fi nance costs 11 /
  • income tax expense
  • property, plant and equipment 11 / (b) Statement of financial position
  • investments 1 /
  • inventory 1 /
  • construction contract
  • trade receivables
  • non-current asset held for sale
  • equity shares 1 /
  • retained earnings (1 for dividend)
  • deferred tax
  • 5% loan note
  • trade payables 1 /
  • accrued loan note interest 1 /
  • bank overdraft 1 /
  • current tax payable 1 /
    • Total for question
• 3 (a) (i) loss before tax 1 / Marks - depreciation - loss on sale of leasehold - interest expense adjustment (added back) 1 / - working capital items 11 / - interest paid (outfl ow) 1 / - income tax paid 11 / - sale proceeds of leasehold - share issue - repayment of lease obligations 11 / - equity dividends paid - cash b/f 1 / - cash c/f 1 / - (ii) 1 mark per valid point
  • (b) 1 mark per valid point - Total for question
• 4 (a) 1 mark per valid point
  • (b) (i) and (ii) – 1 mark per reported profi t fi gure
  • (c) 1 mark per valid point - Total for question
• 5 (a) 1 mark per valid point
  • (b) use of effective rate of 7·5%
    • capitalise for eight months
    • charge to income statement
    • interest received to income statement - Total for question