Financial Statements Analysis: Profit and Equity Adjustments, Study notes of Finance

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(ii) Finance costs $’ Patronic per question 2, Unwinding interest – deferred consideration (36,000 x 10% x 8/12) 2, Sardonic (900 x 8/12) 600 –––––– 5, –––––– (iii) Minority interest Sardonic’s post acquisition profit (13,500 x 8/12) 9, Less post acquisition additional depreciation (w (i)) (600) –––––– 8, x 25% = 2,

2 (a) $’000 $’ Retained profit for period per question 96, Dividends paid (w (i)) 15, –––––––– Draft profit for year ended 31 March 2008 112, Discovery of fraud (w (ii)) (2,500) Goods on sale or return (w (iii)) (600) Depreciation (w (iv)) – buildings (165,000/15 years) 11,

• plant (180,500 x 20%) 36,100 (47,100) –––––––– Increase in investments ((12,500 x 1,296/1,200) – 12,500) 1, Provision for income tax (11,400) Increase in deferred tax (w (v)) (800) –––––––– Recalculated profit for year ended 31 March 2008 50, ––––––––

(b) Dexon – Statement of Changes in Equity – Year ended 31 March 2008 Ordinary Revaluation Retained Total shares reserve earnings $’000 $’000 $’000 $’ At 1 April 2007 230,000 18,000 12,300 260, Prior period adjustment (w (ii)) (1,500) (1,500) –––––––– Restated earnings at 1 April 2007 10, Revaluation of property (w (iv)) 4,800 4, Profit for period (from (a)) 50,800 50, ––––––– –––––––– Total recognised income and expense for the period 4,800 50,800 55, Rights issue (see below) 60,000 60, Dividends paid (w (i)) (15,500) (15,500) –––––––– ––––––– –––––––– –––––––– At 31 March 2008 290,000 22,800 46,100 358, –––––––– ––––––– –––––––– –––––––– Rights issue: 250 million shares in issue after a rights issue of one for four would mean that 50 million shares were issued (250,000 x 1/5). As the issue price was $1·20, this would create $60 million of share capital.

(c) Dexon – Balance sheet as at 31 March 2008:

Non-current assets $’000 $’ Property (w (iv)) 180, Plant (180,500 – 36,100 depreciation see (a)) 144, Investments at fair value through profit and loss (12,500 + 1,000 see (a)) 13, –––––––– 337, Current assets Inventory (84,000 + 2,000 (w (iii))) 86, Trade receivables (52,200 – 4,000 – 2,600 (w (ii) and (iii))) 45, Bank 3,800 135, ––––––– –––––––– Total assets 473, –––––––– Equity and liabilities Equity (from (b)) Ordinary shares 290, Revaluation reserve 22, Retained earnings 46,100 68, ––––––– –––––––– 358, Non-current liabilities Deferred tax (19,200 + 2,000 (w (v))) 21, Current liabilities (81,800 + 11,400 income tax) 93, –––––––– Total equity and liabilities 473, –––––––– Workings (figures in brackets in $’000) (i) Dividends paid The dividend in May 2007 would be $8 million (200 million shares at 4 cents) and in November 2007 would be $7·5 million (250 million shares x 3 cents). Total dividends would therefore have been $15·5 million. (ii) The discovery of the fraud means that $4 million should be written off trade receivables. $1·5 million debited to retained earnings as a prior period adjustment (in the statement of changes in equity) and $2·5 written off in the income statement for the year ended 31 March 2008. (iii) Goods on sale or return The sales over which customers still have the right of return should not be included in Dexon’s recognised revenue. The reversing effect is to reduce the relevant trade receivables by $2·6 million, increase inventory by $2 million (the cost of the goods (2,600 x 100/130)) and reduce the profit for the year by $600,000. (iv) Property The carrying amount of the property (after the year’s depreciation) is $174 million (185,000 – 11,000). A valuation of $180 million would create a revaluation surplus of $6 million of which $1·2 million (6,000 x 20%) would be transferred to deferred tax. (v) Deferred tax An increase in the taxable temporary differences of $10 million would create a transfer (credit) to deferred tax of $2 million (10,000 x 20%). Of this $1·2 million relates to the revaluation of the property and is debited to the revaluation reserve. The balance, $800,000, is charged to the income statement.

perhaps surprising as other indicators point to an increase in operating capacity which has not been matched with an increase in trade receivables. This could be indicative of good control over the cash management of the trade receivables (or a disappointing sales performance). An unusual feature of the cash flow is that Pinto has received a tax refund of $60,000 during the current year. This would indicate that in the previous year Pinto was making losses (hence obtaining tax relief). Whilst the current year’s profit performance is an obvious improvement, it should be noted that next year’s cash flows are likely to suffer a tax payment (estimated at $150,000 in the balance sheet at 31 March 2008) as a consequence. In any forward planning, Pinto should be aware that the tax reversal position will create an estimated total incremental outflow of $210,000 in the next period. Investing activities: There has been a dramatic investment/increase in property, plant and equipment. The carrying value at 31 March 2008 is substantially higher than a year earlier (admittedly $100,000 is due to revaluation rather than a purchase). It is difficult to be sure whether this represents an increase in operating capacity or is the replacement of the plant disposed of. (The voluntary disclosure encouraged by FRS 7 Cash Flow Statements would help to assess this issue more accurately). However, judging by the level of the increase and the (apparent) overall improvement in profit position, it seems likely that there has been a successful increase in capacity. It is not unusual for there to be a time lag before increased investment reaches its full beneficial effect and in this context it could be speculated that the investment occurred early in the accounting year (because its effect is already making an impact) and that future periods may show even greater improvements. The investment property is showing a good return at 15% which is composed of rental income (presumably) of $40,000 and a valuation gain of $20,000. Financing activities: It would appear that Pinto’s financial structure has changed during the year. Debt of $400,000 has been redeemed (for $420,000) and there has been a share issue raising $1 million. The company is now nil geared compared to modest gearing at the end of the previous year. The share issue has covered the cost of redemption and contributed to the investment in property, plant and equipment. The remainder of the finance for the property, plant and equipment has come from the very healthy operating cash flows. If ROCE is higher than the finance cost of the loan note at 6% (nominal) it may call into question the wisdom of the early redemption especially given the penalty cost (which has been classified within financing activities) of the redemption. Cash position: The overall effect of the year’s cash flows is that they have improved the company’s cash position dramatically. A sizeable overdraft of $120,000, which may have been a consequence of the (likely) losses in the previous year, has been reversed to a modest bank balance of $10,000 even after the payment of a $150,000 dividend. Summary The above analysis indicates that Pinto has invested substantially in renewing and/or increasing its property, plant and equipment. This has been financed largely by operating cash flows, and appears to have brought a dramatic turnaround in the company’s fortunes. All the indications are that the future financial position and performance will continue to improve.

4 (a) The accruals basis requires transactions (or events) to be recognised when they occur (rather than on a cash flow basis). Revenue is recognised when it is earned (rather than when it is received) and expenses are recognised when they are incurred (i.e. when the entity has received the benefit from them), rather than when they are paid. Recording the substance of transactions (and other events) requires them to be treated in accordance with economic reality or their commercial intent rather than in accordance with the way they may be legally constructed. This is an important element of faithful representation. Prudence is used where there are elements of uncertainty surrounding transactions or events. Prudence requires the exercise of a degree of caution when making judgements or estimates under conditions of uncertainty. Thus when estimating the expected life of a newly acquired asset, if we have past experience of the use of similar assets and they had had lives of (say) between five and eight years, it would be prudent to use an estimated life of five years for the new asset. Comparability is fundamental to assessing the performance of an entity by using its financial statements. Assessing the performance of an entity over time (trend analysis) requires that the financial statements used have been prepared on a comparable (consistent) basis. Generally this can be interpreted as using consistent accounting policies (unless a change is required to show a fairer presentation). A similar principle is relevant to comparing one entity with another; however it is more difficult to achieve consistent accounting policies across entities. Information is material if its omission or misstatement could influence (economic) decisions of users based on the reported financial statements. Clearly an important aspect of materiality is the (monetary) size of a transaction, but in addition the nature of the item can also determine that it is material. For example the monetary results of a new activity may be small, but reporting them could be material to any assessment of what it may achieve in the future. Materiality is considered to be a threshold quality, meaning that information should only be reported if it is considered material. Too much detailed (and implicitly immaterial) reporting of (small) items may confuse or distract users.

(b) Accounting for inventory, by adjusting purchases for opening and closing inventories is a classic example of the application of the accruals principle whereby revenues earned are matched with costs incurred. Closing inventory is by definition an example of goods that have been purchased, but not yet consumed. In other words the entity has not yet had the ‘benefit’ (i.e. the sales revenue they will generate) from the closing inventory; therefore the cost of the closing inventory should not be charged to the current year’s income statement. Consignment inventory is where goods are supplied (usually by a manufacturer) to a retailer under terms which mean the legal title to the goods remains with the supplier until a specified event (say payment in three months time). Once the goods have been transferred to the retailer, normally the risks and rewards relating to those goods then lie with the retailer. Where this is the case then (in substance) the consignment inventory meets the definition of an asset and the goods should appear as such (inventory) on the retailer’s balance sheet (along with the associated liability to pay for them) rather than on the balance sheet of the manufacturer. At the year end, the value of an entity’s closing inventory is, by its nature, uncertain. In the next accounting period it may be sold at a profit or a loss. Accounting standards require inventory to be valued at the lower of cost and net realisable value. This is the application of prudence. If the inventory is expected to sell at a profit, the profit is deferred (by valuing inventory at cost) until it is actually sold. However, if the goods are expected to sell for a (net) loss, then that loss must be recognised immediately by valuing the inventory at its net realisable value. There are many acceptable ways of valuing inventory (e.g. average cost or FIFO). In order to meet the requirement of comparability, an entity should decide on the most appropriate valuation method for its inventory and then be consistent in the use of that method. Any change in the method of valuing (or accounting for) inventory would break the principle of comparability. For most businesses inventories are a material item. An error (omission or misstatement) in the value or treatment of inventory has the potential to affect decisions users may make in relation to financial statements. Therefore (correctly) accounting for inventory is a material event. Conversely there are occasions where on the grounds of immateriality certain ‘inventories’ are not (strictly) accounted for correctly. For example, at the year end a company may have an unused supply of stationery. Technically this is inventory, but in most cases companies would charge this ‘inventory’ of stationery to the income statement of the year in which it was purchased rather than show it as an asset. Note: other suitable examples would be acceptable.

5 Accounting correctly for the convertible loan note in accordance with FRS 32 Financial Instruments: Presentation and FRS 39 Financial Instruments: Recognition and Measurement would mean that virtually all the financial assistant’s observations are incorrect. The convertible loan note is a compound financial instrument containing a (largely) debt component and an equity component – the value of the option to receive equity shares. These components must be calculated using the residual equity method and appropriately classified (as debt and equity) on the balance sheet. As some of the proceeds of the instrument will be equity, the gearing will not be quite as high as if a non-convertible loan was issued, but gearing will be increased. However, if the loan note is converted to equity in March 2010, gearing will be reduced. The interest rate that would be applicable to a non-convertible loan (8%) is representative of the true finance cost and should be applied to the carrying amount of the debt to calculate the finance cost to be charged to the income statement thus giving a much higher charge than the assistant believes. Accounting treatment: financial statements year ended 31 March 2008 Income statement: Finance costs (see working) $693, Balance sheet: Non-current liabilities 3% convertible loan note (8,674 + 393·92) $9,067, Equity Option to convert $1,326, Working (figures in brackets in $’000) cash flows factor at 8% present value $’ year 1 interest 300 0·93 279 year 2 interest 300 0·86 258 year 3 interest and capital 10,300 0·79 8, ––––––– total value of debt component 8, proceeds of the issue 10, ––––––– equity component (residual amount) 1, ––––––– The interest cost in the income statement should be $693,920 (8,674 x 8%), requiring an accrual of $393,920 (693·92 – 300 i.e. 10,000 x 3%). This accrual should be added to the carrying value of the debt.

Marks

 - profit before tax 1 / 3 (a) operating activities - depreciation/loss on sale - warranty adjustment 1 / - adjustments for investment income/finance costs 1 / - adjustment for redemption penalty - working capital items 11 / - finance costs - income tax received - investing activities (including 1 for investment income) - issue of equity shares financing activities - redemption of 6% loan note - dividend paid - cash and cash equivalents b/f and c/f 

• (b) 1 mark per relevant point - Total for question
• 4 (a) explanations 1 mark each
  • (b) examples 2 marks each - Total for question
• 5 1 mark per valid comment up to
  • use of 8%
  • initial carrying amount of debt and equity
  • finance cost
  • carrying amount of debt at 31 March - Total for question