Paper 8 – Financial Analysis

Post Exam Guide

May 2005 Exam

General Comments

This examination produced a very broad spectrum of marks. At the top end, some candidates
scored very highly indeed, producing a full complement of excellent answers. However, a
substantial minority of candidates appeared to have virtually no useable knowledge of the syllabus.

Section A produced the full range of marks from 0 to 20. However, the mark in this section
generally reflected the overall standard of the candidate as demonstrated in the rest of the paper.
Question 1.8 elicited many wordy discussions of substance over form, but far fewer journal entries.

In Section B, the appearance of a question requiring identification of the appropriate classification of

financial assets in accordance with IAS 39 Financial Instruments: Recognition and Measurement
apparently caused some consternation. The minority (small) of candidates who were well prepared
for this section of the syllabus gained very good marks on the question, with several scoring 9s and
10s. Many students chose to ignore the question, but a large number attempted answers that
variously classified the financial assets in the scenario as liabilities or equity, or tried to fit them into
a business combinations framework. Many of the answers in this category covered a great deal of
paper, but gained no marks.

Section B also contained a compulsory consolidation question involving a part disposal of an

interest in a subsidiary. On the whole this was well done, although some candidates do not know
how to deal with a disposal. The other compulsory question, on earnings per share and the price
earnings ratio was often well handled in respect of the calculation, but candidates found it more
difficult to explain the significance of the P/E in part b).

In Section C, question seven, which involved analysis and interpretation and also some knowledge
of environmental and social issues, was avoided by most candidates. Question five produced some
very sound answers (although some that were less sound), and question six, a consolidation
question for 25 marks, was answered well by the majority.

Many queries were received prior to the examination about the examinability of various standards
under the new syllabus. Guidance was provided via relevant articles in Financial Management, but
these were not sufficient, apparently, to allay all the concerns of candidates and tutors. I hope that
now, having seen an example of the paper, candidates and tutors will be reassured that my
intention is to examine strictly within the confines of the syllabus. Pre-requisite knowledge
requirements for this paper are as indicated in the Qualification Structure and Syllabus document,
that is the CIMA Certificate in Business Accounting or equivalent.

However, it should also be noted that all areas of the syllabus (excepting those that are rendered
obsolete by changes in regulation) are regarded by me as examinable.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

SECTION A – 20 MARKS
ANSWER ALL EIGHT SUB-QUESTIONS
Question One

Question 1.1

The FG group of entities comprises FG and its subsidiaries, HI and JK.

FG acquired 80% of HI’s ordinary shares on 31 December 2001, when the reserves of HI stood at
$10,000,000, and the reserves of JK stood at $7,600,000.

HI acquired 75% of JK’s ordinary shares on 31 December 2000, when the reserves of JK stood at
$7,000,000.

At 31 December 2004, HI’s reserves stood at $12,200,000, and JK’s reserves stood at $10,600,000.

There have been no other acquisitions and disposals in the group, and no impairments of goodwill or intra-
group trading adjustments have been recorded.

How much profit has been added to consolidated reserves in the FG group in respect of the investments
in HI and JK between acquisition and 31 December 2004?

A $3,560,000
B $3,920,000
C $4,010,000
D $4,460,000
(2 marks)

The answer is A

Workings

Since the group was formed on 31 December 2001, the following amounts of profit have been added to
consolidated reserves in respect of the investments in HI and JK:

$
HI: 80% x ($12⋅2m - 10m) = 1,760,000
JK: 60% x ($10⋅6m - 7⋅6m) = 1,800,000
3,560,000

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question 1.2

On 1 March 2005, PB, a listed entity, acquired 80% of 3,000,000 issued ordinary shares of SV. The
consideration for each share acquired comprised a cash payment of $1⋅20, plus two ordinary shares in
PB. The market value of a $1 ordinary share in PB on 1 March 2005 was $1⋅50, rising to $1⋅60 by the
entity’s year end on 31 March 2005. Professional fees paid to PB’s external accountants and legal
advisers in respect of the acquisition were $400,000.

What is the fair value of consideration in respect of this acquisition, for inclusion in PB’s financial
statements for the year ended 31 March 2005?

A $10,080,000
B $10,480,000
C $10,560,000
D $10,960,000
(2 marks)

The answer is B

Workings

Fair value of consideration:

$1⋅20 (cash) + (2 x $1⋅50) (shares) = $4⋅20 per share acquired

$4⋅20 x (3,000,000 x 80%) = $10,080,000 + 400,000 (fees) = $10,480,000

Question 1.3

Where the purchase price of an acquisition is less than the aggregate fair value of the net assets acquired,
which ONE of the following accounting treatments of the difference is required by IFRS 3 Business
Combinations?

A Deduction from goodwill in the consolidated balance sheet.

B Immediate recognition as a gain in the statement of changes in equity.
C Recognition in the income statement over its estimated useful life.
D Immediate recognition as a gain in the income statement.
(2 marks)

The answer is D

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question 1.4

On 1 March 2004, NS acquired 30% of the shares of TP. The investment was accounted for as an
associate in NS’s consolidated financial statements. Both NS and TP have an accounting year end of 31
October. NS has no other investments in associates.

Net profit for the year in TP’s income statement for the year ended 31 October 2004 was $230,000. It
declared and paid a dividend of $100,000 on 1 July 2004. No other dividends were paid in the year.

What amount will be shown as an inflow in respect of earnings from the associate in the consolidated cash
flow statement of NS for the year ended 31 October 2004?

A $20,000
B $26,000
C $30,000
D $46,000
(2 marks)

The answer is C

Workings

The amount that should appear in the cash flow statement is the cash inflow from the associate. This is
the dividend received by the holding company:
$100,000 x 30% = $30,000

Question 1.5

Which of the following statements, in respect of foreign currency translation, are correct according to IAS
21 The Effects of Changes in Foreign Exchange Rates?

(i) The functional currency of an entity is selected by management

(ii) The presentation currency of an entity is selected by management
(iii) The functional currency of an entity is identified by reference to circumstances of the business
(iv) The presentation currency of an entity is identified by reference to circumstances of the business

A (i) and (ii) only

B (iii) and (iv) only
C (i) and (iv) only
D (ii) and (iii) only
(2 marks)

The answer is D

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question 1.6

During the financial year ended 28 February 2005, MN issued the two financial instruments described
below. For EACH of the instruments, identify whether it should be classified as debt or equity, explaining
in not more than 40 words each the reason for your choice. In each case you should refer to the
relevant International Accounting Standard or International Financial Reporting Standard.

(i) Redeemable preferred shares with a coupon rate of 8%. The shares are redeemable on
28 February 2009 at a premium of 10%.
(2 marks)

(ii) A grant of share options to senior executives. The options may be exercised from 28 February
2008.

(2 marks)
(Total = 4 marks)

Answer

(i) DEBT. This instrument requires regular distributions to the holders and it is redeemable at a fixed
amount at a fixed future date. The relevant standard is IAS 32 Financial instruments: Disclosure
and Presentation.

(ii) EQUITY. The grant of share options should be accounted for in accordance with IFRS 2 Share
Based Payment. It should be classified as equity in the balance sheet because it is issued instead
of cash in return for services provided.

Question 1.7

The following statement contains a missing word:

“Current purchasing power accounting is based upon the concept of _____ capital maintenance.”

Which ONE of the following is the missing word?

A Real
B General
C Physical
D Cash-based
(2 marks)

The answer is A

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question 1.8

On 1 February 2004, BJ sold a freehold interest in land to a financing institution for $7⋅2 million. The
contractual terms require that BJ repurchase the freehold on 31 January 2007 for $8⋅82 million. BJ has
the option to repurchase on 31 January 2005 for $7⋅7 million, or on 31 January 2006 for $8⋅24 million.
Prior to the disposal, the land was recorded at its carrying value of $6 million in BJ’s accounting records.
The receipt of $7⋅2 million has been recorded with a corresponding credit to suspense account. No other
accounting entries have been made in respect of this transaction.

At 31 January 2005, BJ’s directors decide not to take up the option to repurchase.

Briefly explain the substance of this transaction, and prepare journal entries to record it correctly in the
accounting records of BJ for the year ended 31 January 2005.

(4 marks)

Answer

The substance of the transaction is that BJ has borrowed $7⋅2 million against the security of a piece of
freehold land. IAS 39 Financial Instruments: Recognition and Measurement requires initial recognition of
the liability, and the related interest expense should be recognised over the relevant period. In this case,
the increase each year in the repayable amount reflects an interest charge. This is accounted for in the
year ended 31 January 2005 as follows:

$000 $000
DR Suspense account 7,200
CR Non-current liabilities 7,200
DR Interest expense for year
($7⋅7 - 7⋅2m) 500
CR Non-current liabilities 500

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

SECTION B – 30 MARKS
ANSWER ALL THREE QUESTIONS

Question Two

(a) Calculate the earnings per share for CB for the year ended 31 January 2005, and its P/E ratio at
that date.
(6 marks)

(b) Discuss the significance of P/E ratios to investors and CB’s P/E ratio relative to those of its
competitor and business sector.
(4 marks)
(Total for Question Two = 10 marks)

Rationale

Requirement (a) asks candidates to calculate EPS and the P/E ratio for a financial year in which a rights
issue took place. Requirement (b) requires discussion of the significance of P/E ratios.

Suggested Approach

• Calculate theoretical ex-rights price, selecting correct share value.

• Calculate bonus fraction.
• Calculate weighted average of number of shares in issue in the year.
• Calculate EPS and then P/E ratio.
• Discuss significance of P/E ratios to investors.
• Discuss CB’s P/E ratio.

Marking Guide Marks

Calculation of theoretical ex-rights price 1

Calculation of bonus fraction 1
Calculation of weighted average shares in issue 2
Calculation of EPS and P/E 2
Discussion of significance of P/E ratios 2
Discussion of CB’s P/E ratio 2

Examiner’s Comments

Earnings per share is an important syllabus area within Section C of the syllabus, with its own chapter in
the Study System. A ten mark question was set on earnings per share in the Pilot Paper. Most
candidates were able to calculate earnings per share and the resultant P/E ratio, and there was a high
proportion of accurate answers to part (a) of the question.

However, far fewer candidates were able to explain the significance of P/E ratios to investors. It is
insufficient simply to say that the ratio expresses the relationship between price and earnings, and no
marks were awarded for such observations.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Common Errors
• Probably the most common error was wasting time in part (b) with lengthy and repetitive
explanations that the P/E ratio is price divided by earnings per share. Also, there was a minority of
candidates who were unable to make a credible attempt at the calculations in part (a).

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question Three

Prepare the summarised consolidated income statement for RW for the year ended 31 December 2004.

(Total for Question Three = 10 Marks)

Rationale

This question required candidates to apply their knowledge of the treatment of disposals in consolidated
income statements. The question focuses upon a partial disposal resulting in the retention of a subsidiary.

Suggested Approach

• Calculate goodwill on consolidation, the unimpaired goodwill relating to the disposal, and include it
in the profit/loss on disposal calculation.
• Calculate tax charge on profit on disposal and include it in income tax charge.
• Calculate share of net assets at disposal date.
• Prepare consolidated income statement using principle of aggregation and including profit on
disposal.
• Calculate minority interest and include it in the correct position in the consolidated income
statement.

Marking Guide Marks

Aspects of goodwill calculation 3

Tax charge 2
Share of net assets at disposal 2
Preparation of income statement including profit on disposal 2
Minority interest 1

Examiner’s Comments

Disposals of interests in a subsidiary forms part of syllabus topic A. A whole chapter is devoted to this
area in the Study System, in which the impact of various levels of disposal is thoroughly explored.

This question produced some very good answers. However, some candidates simply do not know how to
deal with a disposal. The level-headed amongst this group could and did pick up marks for calculations
such as goodwill and minority interest.

Common Errors
• Consolidating only a proportion of revenue and costs, and failing to realise that SX remains a
subsidiary after the disposal.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question Four

In accordance with IAS 39 Financial Instruments: Recognition and Measurement

(a) identify the appropriate classification of these three categories of financial asset and briefly explain
the reason for each classification.
(6 marks)

(b) explain how the financial assets should be measured in the financial statements of PX at 31
December 2004.
(4 marks)

(Total for Question Four = 10 marks)

Rationale

This question relates to topic area B in the syllabus, specifically the learning outcome: “Identify
circumstances in which amortised cost, fair value and hedge accounting are appropriate for financial
instruments, and explain the principles of these accounting methods”. The learning objective requires the
demonstration of comprehension of the treatment of financial instruments. Three different categories of
financial asset are briefly described in the question.

Suggested Approach

• Correct classification with reason for each financial asset.

• Fair value measurement is an option for any financial asset.
• Held-for-trading and available for sale to be measured at fair value.
• Held-to-maturity to be measured at amortised cost.

Marking Guide Marks

Correct classification with reason 6

Fair value an option for any financial asset 1
Explanation of appropriate measurement for each classification 3

Examiner’s Comments

Accounting for financial instruments constitutes an important element of topic B of the syllabus. Chapter
13 of the Study System covers the requirements of IAS 39.

As noted in the general comments, this question was very badly done, where it was attempted at all.
Many candidates wasted valuable time writing answers that were wholly incorrect. It can only be
supposed that few candidates have studied this area of the syllabus.

Common Errors
• Complete lack of knowledge.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

SECTION C – 50 MARKS
ANSWER TWO QUESTIONS OUT OF THREE

Question Five

(a) Prepare a report, addressed to the investor, analysing the performance and position of DM based on
the financial statements and supplementary information provided above. The report should also
include comparisons with the key sector ratios, and it should address the investor’s concerns about
the possible manipulation of the 2004 financial statements.
(20 Marks)
(b) Explain the limitations of the use of sector comparatives in financial analysis.
(5 Marks)
(Total for Question Five = 25 Marks)

Rationale

This question provides an income statement, summarised statement of changes in equity and a balance
sheet, all with comparatives, for a listed entity that runs a chain of supermarkets. Contextual information
is given that suggests that the financial statements may have been manipulated prior to a potential
takeover.

Suggested Approach

• Calculation of relevant accounting ratios.

• Appropriate commentary upon significant items emerging from the analysis.
• Comparisons with sector information.
• Comments on the possible manipulation of the financial statements.
• Explanation of the limitations of sector comparatives.

Marking Guide Marks

Accounting ratios 5
Analysis and interpretation 8
Sector comparisons 3
Possible manipulation of the financial statements 4
Limitations of the use of sector comparatives 5

Examiner’s Comments

Analysis and interpretation of financial statements is a key topic area in the Financial Analysis syllabus,
and questions requiring reports on analysis can be expected to recur very frequently. This question
explores some of the issues relating to the syllabus area: “The need to be aware of aggressive or unusual
accounting policies, “creative accounting”, (for example in the areas of cost capitalisation and revenue
recognition).” These issues are explored in some depth in Chapter 19 of the Study System.

The better answers to the question linked the analysis to the situation outlined in the scenario. Some
candidates calculated pages of ratios but were unable to take the step from calculation to analysis. It is
not sufficient simply to note that figures have increased or decreased. Care should be taken in analysis
and interpretation questions to calculate only those ratios that are likely to be relevant to the scenario.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Common Errors

• Many candidates confused “reassessment of useful lives” with asset revaluation. It was relatively
common to find many ratio calculations appended to a short and unsatisfactory analysis. The issue
of possible creative accounting was sometimes either denied or ignored. Many answers dismissed
the possible existence of creative accounting techniques, either within this scenario or more
generally. Answers to section b) quite often majored on problems with ratio analysis generally
rather than discussing the specific point of sector comparatives.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question Six

(a) Explain, with reasons, how the investments in BK and CL will be treated in the consolidated financial
statements of the AJ group.
(5 marks)

(b) Prepare the consolidated balance sheet for the AJ group at 31 March 2005. Full workings should be
shown.
(20 marks)
(Total for Question Six = 25 marks)

Rationale

Information is given in the question to support the conclusion that BK should be treated as a subsidiary
and CL as an associate. The consolidation therefore requires that the assets and liabilities of BK should
be aggregated with those of the parent, and that the investment in associate should be presented in
accordance with the principles of equity accounting. The question tests candidates’ ability to deal with
adjustments relating to fair value on acquisition, a provision for unrealised profit, and an impairment loss in
the value of goodwill.

Suggested Approach

• Identification and explanation of relationships within the AJ group.

• Calculation of impaired value of goodwill and inclusion in the balance sheet.
• Investment in associate.
• Provision for unrealised profit, treatment of revaluation.
• Minority interest and consolidated reserves calculation.
• Understanding of principles of consolidation.

Marking Guide Marks

Identification and explanation of group relationships 5

Goodwill in subsidiary 3
Investment in associate 3
Provision for unrealised profit and revaluation 5
Minority interest and consolidated reserves 4
Understanding of principles of consolidation 5

Examiner’s Comments

As group financial statements account for 35% of the syllabus, a 25 mark, calculation-based, question on
the topic is likely to appear quite frequently in Section C of the paper.

This relatively straightforward question required the production of a consolidated balance sheet of a
holding entity, a subsidiary and an associate. Many candidates produced very good answers, showing a
thorough grasp of consolidation techniques. Their facility in these techniques reflects well upon their
tutors. However, there is a minority of candidates who appear to have little knowledge of group
accounting. Given the syllabus weighting, their chances of success in this paper are much reduced.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Common Errors

• Failing to calculate the residue of other financial assets correctly, or to include a figure for this
element in the balance sheet.
• Including the fair value adjustment to PPE in consolidated reserves.
• Stating in part (a) an intention of applying equity accounting in respect of the associate but then
proceeding to consolidate it, with a 60% minority interest, in part (b).
• Deducting the whole of the provision for unrealised profit from consolidated reserves.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Question Seven

In your position as assistant to FW’s Chief Financial Officer produce a briefing paper that

(a) analyses and interprets the effects of making the environmental provision on FW’s key financial
ratios. You should take into account the possible effects on the public perception of FW.
(12 marks)
(b) identifies the advantages and disadvantages to FW of adopting the chief executive’s proposal to
publish an environmental and social report.
(7 marks)
(c) describes the THREE principal sustainability dimensions covered by the GRI’s framework of
performance indicators.
(6 marks)

(Total for Question Seven = 25 Marks)

Rationale

This question is set in the context of a major oil company that is obliged to recognise a significant
provision in respect of a liability for damage to the environment. Its requirements combine elements of
syllabus topic areas C and D. The first part of the question requires recalculation of certain key ratios
(supplied in the question) following the recognition of the provision, and analysis of the effects on those
ratios. The second part and third parts are drawn from syllabus topic area D, and require specific
knowledge of the contents of the GRI’s framework.

Suggested Approach

• Adjustments required as a result of the provision, and recalculation of key ratios.

• Discussion of the effects of the provision.
• Advantages and disadvantages to FW of publishing an environmental and social report.
• Description of the principal sustainability dimensions covered by the GRI framework.

Marking Guide Marks

Adjustments and recalculations 7

Discussion, including effects on public perception of the entity 5
Advantages and disadvantages to FW of publishing report 7
Identification and description of sustainability dimensions 6

Examiner’s Comments

As stated in the general comments, this question was avoided by most candidates. It was clear that some
of those who attempted it had not allowed it a full time allocation, and were attempting to obtain the
relatively easy marks (for those who know anything about the Global Reporting Initiative) available in part
(c).

Part (a) was badly done in almost all cases; few candidates attempted the ratio calculations, and any
comments, in consequence, were ill-informed and often inaccurate. There were some better attempts at
part (b); candidates who had allowed sufficient time to do the question properly gained a high proportion of
the available marks. Part (c) was either done well or very badly. A few candidates had obviously never
heard of the GRI, but attempted to answer the question anyway with some vague references to pollution
and global warming.

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Paper 8 – Financial Analysis
Post Exam Guide
May 2005 Exam

Common Errors

• Failure to attempt one or more parts of the question.

• Fabrication of the GRI’s sustainability dimensions.

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