Financial Reporting - Professional Stage September 2012

MARK PLAN AND EXAMINERS COMMENTARY

The marking plan set out below was that used to mark this question. Markers were encouraged to use discretion
and to award partial marks where a point was either not explained fully or made by implication. More marks
were available than could be awarded for each requirement. This allowed credit to be given for a variety of valid
points which were made by candidates.

Question 1
Total Marks: 21
General comments: A financial statement analysis question. The candidate was asked to prepare initial
analysis (from the point of view of an institutional investor) of a group providing pet supplies and pet services
direct to the public. The income statement and statement of financial position were provided. The business
invested heavily in plant and equipment following the expansion of dog grooming services in-store, funded by
debt. Its number of outlets had increased. In the previous year it obtained the UK rights to sell the most
popular US high-end dog food; however a recent court case in the US had a bad effect on the brand, and the
right was impaired during the current year. In an effort to diversify, it acquired 100% interest in a company
specialising in dog boarding services during the year (goodwill included).
10 September 2012
Report to: Manager of Investment company
From: Chartered Accountant
Analysis of PetNation Group plc
Additional Relevant Ratios:
These could include (but are not limited to):
Gross margin
2
Revenue per m of floor space
Revenue per employee
Operating costs % (excluding non-recurring items)
Operating margin % (excluding non-recurring items)
Turnover per employee
Training costs per employee
Operating Profit per employee
Operating Profit per employee (excluding non-recurring items )
Return on capital employed (ROCE)
Return on capital employed (ROCE) (excluding non-recurring items)
Return on Shareholders Funds (ROSF)
Interest cover (times)
Gearing (Net Debt / equity)
Current Ratio
Quick ratio
Inventory turnover
Inventory Days
Trade payables payment period (days)
Earnings per share (pence)
Dividend yield
P\E ratio (times)
Dividend cover (times)

2012
50.9%
1,610
103,260
38.2%
12.6%
103,259
575.18
6,327
13,038
21.9%
45.0%
7.6%
2.5
4.4%
1.4
0.92
8.38
43.6
65.0
21.4
14.3%
10.8
0.65

2011
51.1%
1,911
118,025
35.4%
15.7%
118,025
782.27
18,514
18,514
81.8%
81.8%
49.0%
12.1
n/a
1.1
0.41
7.80
46.8
32.8
285.8
53.8%
1.1
1.71

Introduction
As a small investor in the PetNation group, we need to review all areas of the business: profitability, liquidity,
efficiency and any investor ratios that can be calculated from the information given. PetNation has faced a
year of capital expansion, opening a further 37 new superstores (16.6% increase), as well as expanding
operations within the stores and investing in training facilities. The group has also acquired a subsidiary

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Financial Reporting - Professional Stage September 2012

operating in a new area, dog boarding.
PetNations gearing level has worsened following the requirements for funding non-current asset investment;
and these may well rise in the forthcoming year given the intention to invest in the new subsidiary. Concerns
over a provision relating to legal claims on a product that the group has the sole rights to sell (and impairment
of inventories) require addressing.
Performance
Revenue and Gross Profit
Revenue has increased by 4% in the year. When compared with an increase in available sales floor space of
23%, and given the number of new stores opened, the increase in revenue could be regarded as
disappointing. However, the store openings may have arisen near the end of the financial year, which may
mean that the revenue from the new stores will be recognised in full next year.
Nevertheless, if the directors are suggesting that owners are increasing their spend on premium pet foods, it
would be interesting to compare the revenue growth with PetNations direct competitors and the industry. The
directors have commented on an improved sales mix, from which one would expect to see improved margins.
In fact, the gross profit margin in 2012 has fallen to 50.9% from 51.1% in 2011. It is difficult to tell whether the
fall is because of a change in prices or costs, as information is limited. However, the OFR highlights that there
has been an expansion in direct sourcing (mainly from China); the transport and foreign exchange costs
associated with this may have had a detrimental effect.
Another concern for shareholders is that although the product may be cheaper, the quality may be lower.
Presumably quality product is vital as the group specialises in premium foods.
The company is also facing legal claims over one of their key products (Pooch Cuisine - see later), and
sales of this product may have had a detrimental effect on the revenue figure, although the effect may be
limited, given the write-off occurred a month before the end of the year. However, the sales mix and the gross
margin may have been affected, if sales dropped significantly, given the products positioning at the high-end
of the range of products sold.
Information on staff numbers allows a measure of revenue per employee, to review the efficiency of the staff
in generating revenue. There was a 12% fall in sales per employee in 2012 compared with 2011, which
perhaps ties in with lower training costs. However as the 37 new stores may not have been open the full year,
likewise with staff numbers, it is not clear if these staff numbers are an average or year-end figure. Ideally the
staff numbers should be an average, weighted for months of employment. The same logic may explain the
2
apparent decline in revenue per m sales floor space, which has also dropped from 1,911 to 1,610: this
may be distorted unless the floor space is weighted to account for availability in the year.

Operating Profit
The operating margin has dropped dramatically to 6.1% (2011: 15.7%). However three significant exceptional
items arose in the year all relating to the legal claims over the Pooch Cuisine product. It is unclear whether
further adjustments may be required, but these costs are distorting operating profit in 2012 compared to 2011.
Taking operating profit before exceptional costs may allow a more meaningful comparison with 2011 (in which
no such costs exist), so that we can compare the underlying performance of normal trading. After adding
back exceptional items, operating margin for 2011 is still only 12.6%, some 3% below 2011. Likewise, the
operating costs % has risen in 2012.
There is very limited information as to where the extra expense arose; one area that the directors commented
upon - staff training - has in fact fallen in the year (which may have an impact on revenue given the
importance the business appears to place on customer satisfaction). However, it is possible that this fall is the
result of the opening of two new training academies; PetNation may be shifting its focus to cheaper in-house
training rather than costlier outsourcing.
A full analysis of operating expenses is required to provide a better explanation of the increase in costs,
although one expense that can be expected to increase is depreciation (given the large investment in PPE in
the year), the impact of new depreciation will depend on when the assets were ready for use.
Finance costs
In 2012 there has been a significant increase in interest-bearing debt, which has risen from 10.5m to
44.5m. The interest charge has risen from 4.7m to 9.2m; this is not consistent with the change in debt
levels, suggesting that perhaps additional debt was raised closer to the end of the financial year. This may be
a concern for the future: if debt levels are maintained (or even rise, given the directors aims of investing in

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Financial Reporting - Professional Stage September 2012

the new subsidiary), a full years charge of interest could have a detrimental impact on the results of 2013.
That said, profit is lower in 2012 as a result of the exceptional costs. Interest cover has declined from 12.1
times to 2.5 times, which is a worrying drop for lenders, potential lenders and, of course, the shareholders
(see later). Future lenders will see this drop as additional risk and increase their interest rates accordingly;
and if additional debt is being sought, then prospective lenders will need to consider the extent to which
assets are still available as security.
Tax
The effective tax rate in 2012 of 44% is not consistent with 2011s 34% and may be worth investigating in the
full notes to the financial statements
ROCE and ROSF
Return on Capital Employed has dropped from 70.6% to 15.9%. If exceptional costs are excluded, the drop is
still severe: to 32.7%. The return in the year may be less than normally expected, given the hefty increase in
PPE, mainly from new store openings: it is unclear as to when these stores were opened. If opened close to
the end of the year, their impact on earnings will not be seen until next year, although the funds relating to
their investment are included in the ROCE ratio.
The Return on Shareholders Funds (ROSF) has fared even worse: dropping from 49% to 7.6%. This has
worsened as a result of the increased costs, leaving profit attributable to the shareholders of only 7.7m
(2011: 34.3m). As previously mentioned, the unexpected increase in effective tax rate has also impacted on
the profit attributable to shareholders.

Financial Position
Long-term
PetNation has expanded significantly in 2012. It has invested heavily in Property, Plant and Equipment (the
carrying amount of which has risen by 40.5m). This significant increase is explained by the 37 new
superstores, 2 new training centres, 35 new grooming centres and the acquisition of a new subsidiary. The
subsidiary will also be consolidated into the financial statements in 2012, further explaining the increase in
PPE (and other components), but also explaining the increase in intangible assets (goodwill on acquisition).
Intangibles have increased overall to 17.2m (2011: 8.0), and the impairment of 11.1m suggests a net
increase of 20.3m which is presumably the goodwill on acquisition. This is a significant amount: more
information is needed to ascertain if the increase is wholly goodwill on acquisition, or if other intangibles were
acquired in the year.
Debt and Equity appear to have been equally utilised to fund the acquisitions: new shares raised some 35m
(including a premium, suggesting a full market issue as opposed to rights) and debt rose by 34m between
2011 and 2012. However, gearing (based on net debt) has increased to 4.4%. The poor return to the
shareholders in the year, after dividends, resulted in a negative movement in retained earnings. The
proportionate rise in debt to equity will be of concern to any potential lenders and the shareholders (see
section on investors perspective). This is particularly relevant given the directors comments of expansion of
the new dog boarding operation which may require additional funds.
Short-term
Short term liquidity has improved in 2012, probably the result of PetNations increase in funds (debt and
equity) leaving a balance of 40m cash at the year end; however it should be noted that trade payables are
much higher in 2012 too, some of the cash held will probably be used to pay this off. Cash may also be earmarked for the investments in the new dog boarding operations that are mentioned in the OFR; but the
provision for legal claims may also require a cash payment to settle these claims in the near future. The quick
ratio is less than 1 in both years: inventory levels are high as is expected in a retail organisation. Retailers
tend to have few receivables (as in this case) and utilise cash from sales quickly, but finance their inventories
from trade payables. A low quick ratio is therefore not normally a concern.
Inventory turnover/inventory days are relatively constant and of no real concern at first glance, although there
has been a significant impairment in the Pooch Cuisine line of 7.1m, which may be distorting the ratios.
That said, inventory levels would be expected to be higher given the increase in shops in the year.
Trade payable days have risen significantly from 33 to 65 days. The OFR includes information on enhanced
terms with suppliers, however whether this extends to a doubling of the payment days is questionable. This
delay in payment could be putting a strain on relations, and may lead, for example, to withdrawal of supplies
pending payment. However whether this happens depends on the relative dependency and overall power that

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Financial Reporting - Professional Stage September 2012

PetNation has over its suppliers.
Receivable days are insignificant in a cash sales-based retail organisation.
Overall, the short-term cash cycle has improved in 2012 as a result of the doubling of trade payable days.
Assuming that this was the result of the enhanced terms, with no pending repercussions or immediate
requests for settlement, this explains the improved cash from operations/profit from operations of 4.1 times
compared to 1.3 times in 2011. Cashflow has benefited from increasing trade payables by 17.1m from 2011
to 2012.

Investors Perspective
The shareholders may be concerned with the results for 2012. Operating profit is much lower, partly due to
the exceptional items (mentioned in more detail below). Increased gearing and a subsequent higher interest
expense has eaten into this profit. If the debt increase was not for the full year, then higher interest charges
may mean less profit is available to shareholders in future.
There has also been a decline in dividend payment (about 12m in 2012 compared to 20m in 2011).
Dividend cover has fallen from to 0.7 (2011: 1.7), so that dividends have been paid from retained earnings in
2012, which is not sustainable.
The dividend yield has also fallen significantly, although comparison between years is complicated by the
significant share issue in the year. Investors may be encouraged by the increase in the price/earnings ratio,
which may suggest that the market views the drop in earnings this year as a one-off.
Exceptional Items
Shareholders will be very concerned with the press report comments, and the 24.5m exceptional expenses
that were incurred in the year. PetNation has impaired an intangible, the UK rights to sell the most popular
American high-end dog food, following mass litigation from US dog owners. The impairment is presumably
because PetNation has doubt over the products future sales in the UK. The fact that PetNation has also
made a provision for legal claims is equally worrying: more information is needed (from the notes to the
financial statements) to explain this provision. The impact this may have on sales of other products in the
future is questionable, but the newspaper report is suggesting that PetNations reputation may be tarnished.
The share price has fallen to 2.30 on 30 June 2012 from a price of 3.10 a year earlier, so the market
appears to be less confident.

Matters requiring further investigation

In addition to the several points raised above, this report is based upon very limited information and
clearly a full set of financial statements should be reviewed, including the statement of cash flows, and full
notes to the financial statements. The supporting notes should explain the increase in intangible assets
(despite significant write down of the rights), and the impact on the consolidated financial statements of
the newly acquired subsidiary which may be affecting comparability with 2011.

Of particular interest would be the auditors report, which should be reviewed for any issues over going
concern following the exceptional items and press reports.

Interim financial statements and press releases for the period from 30 June 2012 to date, to review the
situation regarding the Pooch Cuisine impairments and legal claim provisions, and impact on sales post
year-end. There may be the need for additional impairment if the rights were not fully impaired on 30
June 2012

Conclusion
The PetNation Group has had a disappointing year in terms of profit, mainly the result of a product failure
near the end of the year resulting in write downs of inventory, impairment of the rights to sell the product, and
provisions for legal claims. This should be a major concern to the shareholders, who are already seeing a
decline in their attributable earnings, as finance charges have risen alongside the gearing level.

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Financial Reporting - Professional Stage September 2012

The majority of scripts included 5 correctly calculated ratios and gained the presentation mark for report
format. In most cases the ratios were selected with some thought to the questions references (financial
performance, liquidity and financial position) and this helped structure their answers. However, a significant
minority of candidates failed to apply the net debt figure correctly when calculating the gearing and ROCE
ratios, and the interpretation of turnover ratios continues to cause difficulties. A number of candidates focused
too much on working capital (trade receivables is of little concern to a cash-based retail organisation). Only a
minority of candidates clearly addressed their answers from an investor perspective, and very few
appreciated the limitations such a perspective posed in relation to the additional information they might expect
to call upon. Many candidates prepared a list of matters for further investigation which tended to be too
general, and often not information that would be available. Similar to the exam in June, many candidates
tended to repeat the information given to them in the scenario, giving standard textbook reasons for
movements in ratios/figures, even in some cases where these were clearly not relevant.
The stronger candidate identified the fact that the new stores may not have been in operation for the whole
year, thus distorting NCA turnover. Some identified the impact of the acquisition on intangibles, and most
identified the large cash balance being held for either future acquisitions and/or settlement of the provision.
Better answers focussed on the investor perspective, including comments on the lower dividend yield, the
drop in share price, the fall in interest cover, and the impact of share issue in the year. However, very few
calculated the P/E ratio which could have been seen to suggest a positive reaction by the market to the
expansion.
Total possible marks
Maximum full marks

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45
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Financial Reporting - Professional Stage September 2012

Question 2
Total Marks: 38
General comments: The scenario was based on an Adventure Holidays specialist. The company was
redeveloping a coastal resort left in disrepair, with some government support. Limited extracts on the draft
financial statements were provided (to allow reworking of the ratios). The issues to be resolved [requirement
(a)] were: a mid-year subsidiary acquisition (goodwill calculation involving deferred consideration, FV
adjustment, and summarised consolidation), the capitalisation of borrowing costs regarding the coastal
redevelopment, the treatment of a capital grant (incorrectly shown as income) and the sale and operating
leaseback of the head office (below FV but with future lease payments below market levels). Requirement (b)
asked for the impact of subsequent adjustments on gearing and ROSF. Part (c) questioned the ethical issues
of financial interests (and suggested safeguards).
(a)
1. Brightdays: Acquisition of Subsidiary
Calculation of Goodwill
Control is the key to whether Brightdays is a subsidiary. Advent acquires control on 1 October 2011, and so
this is when consolidation is required, and goodwill ascertained. Consideration may not necessarily pass to
the acquirees shareholders at the date of acquisition as is the case here. Deferred consideration should be
measured at its fair value at the acquisition date. The fair value depends on the form of the deferred
consideration.

If the deferred consideration is in the form of cash: recognise a liability at the present value of the amount
payable.
If the deferred consideration is in the form of equity shares: the fair value should be measured at the
acquisition date, and the deferred amount recognised as part of equity, under a separate heading (eg:
shares to be issued). The market value of the shares at the acquisition date is regarded as representing
the present value of the future benefits arising from those shares. No subsequent adjustment is therefore
made for any change in fair value to the date of issue.

Advent should therefore recognise a liability for the deferred consideration in cash, being the present value of
the 3.7m future payment, discounted at 6%, 3.7m / 1.06 = 3,490,566
and recognise an increase in equity of 1.84m (800,000 x 2.30), being the present value of the shares to be
issued in a years time.
Goodwill is therefore calculated by adding the cash and deferred consideration to the non-controlling
interests share of net assets, and deducting the fair value of net assets from this.
Goodwill Calculation at Acquisition 1st October 2011
Cash
Deferred Cash
Deferred shares
NCI (20% of Net assets, 6.6m)
Net assets (and at FV)
Goodwill:

520,000
3,490,566
1,840,000
5,850,566
1,320,000
(6,600,000)
570,566

Tutorial note
Correcting journal entries
Dr
Dr
Cr
Cr
Cr
Cr

Goodwill
Net Assets (consolidated at acquisition)
NCI
Equity ("shares to be issued")
Liability (deferred consideration)
AFS Investment

570,566
6,600,000

7,170,566

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1,320,000
1,840,000
3,490,566
520,000
7,170,566

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Financial Reporting - Professional Stage September 2012

Deferred consideration balance at 30 June 2012

The deferred consideration should be increased each year by the unwinding of the discount at 6%. In the
case of Advent, the acquisition took place 9 months before the year-end, so a finance cost of 157,075 (9/12
x 6% x 3,490,566) is recognised in profit or loss, and the deferred consideration liability increased by the
same amount.
Tutorial note
Correcting journal entries
Dr Finance Cost (profit or loss) [9/12 x 6% x 3,490,566]
Cr Liability (deferred consideration)

157,075

157,075

Consolidation of Brightdays into Advents consolidated Statement of Financial Position

Brightdays was acquired mid-year, meaning that the company will be generating 9 months of post-acquisition
profit. Extracts are provided that show the net assets of Brightdays have increased by 600,000 (7.2m
6.6m). Brightdays has therefore generated post-acquisition profits of 600,000, which is attributable to
Advent and NCI in the proportions 80:20.
Tutorial note
Correcting journal entries
Dr Net assets (increase post-acquisition)
Cr NCI share of post-acquisition profit (20%)
Cr Group Reserves

600,000

120,000
480,000

2. Brightdays: Capitalised Borrowing costs

Under IAS 23, certain borrowing costs form part of the cost of a qualifying asset. A qualifying asset is an
asset that takes a substantial period of time to get ready for its intended use or sale. This includes property,
plant and equipment provided it is not ready for use. The development of the coastal resort is therefore a
qualifying asset, as it was in disrepair and not in use.
Borrowing costs are defined as interest and other costs that an entity incurs in connection with the borrowing
of funds. Only borrowing costs that are directly attributable to the acquisition, construction or production of the
qualifying asset can be capitalised which are those borrowing costs that would have been avoided if the
expenditure on the qualifying asset had not been made. If the construction is financed out of the general
borrowing of the entity, then:

The borrowing costs that should be capitalised is calculated by reference to the weighted average cost of
the borrowings
The weighted average calculation excludes borrowings to finance a specific purpose or building.

In the case of Brightdays, there are two loans, neither are for a specific purpose, and so the weighted
average cost of the loans can be used to determine the borrowing cost rate for capitalisation purposes.
The correct calculation of the weighted average borrowing rate is therefore:
[(1.8m x 5%) + (1.2m x 8.5%)] / 3m = 6.4%
Capitalisation of borrowing costs should commence when the entity meets all three of the following
conditions:
1. It incurs expenditures for the asset (1 January 2012)
2. It incurs borrowing costs (already being incurred)
3. It undertakes activities that are necessary to prepare the asset for its intended use or sale. Such activities
include obtaining planning permission. (1 November 2011)
Brightdays incurred expenditure on 1 January, which is the date at which capitalisation is permitted (being the
latest date of the three conditions, and hence when all conditions are met). So the period for capitalisation is
six months (1 January to 30 June 2012) rather than nine months
The correct amount to be capitalised is therefore: 800,000 x 6.4% x 6/12 = 25,600, and an adjustment to
correct finance costs capitalised in error is needed of 25,400 (51,000 25,600). As this is a correction in the
financial statements of Brightdays, the Advent group will need to apportion this between the group (80%) and
NCI (20%), so that group profit will fall by 20,320 (25,400 x 80%) and NCI by 5,080 (25,400 x 20%).

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Financial Reporting - Professional Stage September 2012

Tutorial note
Correcting journal entries
(In the financial statements of Brightdays):
Dr
Finance costs (profit or loss)
Cr
Non-Current Assets (51,000 25,600)
(In the Consolidated Statement of Financial Position of Advent):
Dr
Profit or Loss
Dr
Non-controlling interest
Cr
Non-Current Assets

25,400

25,400

20,320
5,080

25,400

3. Advent: Government Grant

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires government
grants to be accounted for under the income approach. The grant should be recognised in profit or loss over
the periods in which the entity recognises as expenses the costs which the grants are intended to
compensate. It is against the accrual principle to recognised grants in profit or loss on a cash receipts basis
(which is the method Advent is currently using).
Government grants provided to assist in the acquisition of an asset should be presented in the statement of
financial position either:
1.

2.

By setting up the grant as deferred income in the statement of financial position, and recognising it in
profit or loss on a systematic basis over the useful life of the asset, normally corresponding to the method
of depreciation of the asset.
By deducting the grant in arriving at the carrying amount of the asset (ie: netting off), thereby reducing the
depreciation charge. This method will make the entity less comparable with a similar entity without
government assistance.

For Advent, therefore, the two methods will result in the following presentation in the statement of financial
position and income statement:
Statement of Financial Position
Asset (400,000 200,000)
less depn ((400 / 200) / 4yrs x 9/12)

Method 1:

400,000
(75,000)
325,000

Deferred income

162,500

Income Statement
Charge: Depreciation
Credit: Deferred income

(75,000)
37,500

Method 2:

200,000
(37,500)
162,500
-

(37,500)

The net effect on income and net assets will be the same under either method: grant income is matched with
the use of the asset. The grant recognised in the year is 37,500 (200,000 / 4 years x 9/12). There is no
impact on NCI as the grant is accounted for in Advents financial statements.
Tutorial note
Correcting journal entries
Dr
Cr

Profit or loss
Non-Current Assets

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162,500

162,500

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Financial Reporting - Professional Stage September 2012

4. Advent: Sale and Operating Leaseback
The substance of the transaction arising from the sale and immediately leaseback on a short 2-year term of
Advents Head Office, is that a sale has taken place. The risks and rewards of ownership are not substantially
reacquired when the leaseback is an operating lease, and have passed to the lessor. Therefore a genuine
profit or loss should be recognised. Advent has shown the transaction correctly as a disposal.
However the amount to be recognised as a gain on disposal will depend upon the terms of the agreement. If
the sale price is at fair value, then the profit or loss is recognised immediately, as proceeds (fair value) less
the carrying amount. If the sale price is higher than fair value (as is the case here), then the excess over fair
value should be deferred and amortised over the period for which the asset is expected to be used. The
reasoning behind this is that as the lessor has agreed to pay above fair value at acquisition, the rentals
payable by Advent will be at higher than normal market levels to compensate.
Proceeds
Less: Fair Value
Gain on Disposal to defer and recognise over lease period

1,500,000
1,300,000
200,000

The gain of 200,000 should be deferred and recognised over the 2-year lease period. This means that 3 of
the 24 months worth of the deferred income will be recognised to profit or loss by the year-end.

Deferred income
200,000
Recognised by end of 30 June 2012: 200,000 x 3/24 =
(25,000)
Deferred income at year-end:
175,000
The remaining gain (represented by the difference between fair value and carrying amount) can be
recognised immediately. This amount is 100,000 (1.3m less 1.2m).
This means that Advent has overstated its profit on the disposal by 175,000, which should be shown as
deferred income at the year-end.
Tutorial note
Correcting journal entries
7
Dr Profit on Disposal
Cr Deferred income (SOFP)
Cr Deferred income (to profit or loss in year)

200,000

175,000
25,000

The majority of candidates achieved good marks across all four issues in requirement (a), with the majority of
lost marks arising from the failure to support the figures calculated with appropriate explanations, or to follow
through fully in relation to all the points covered. The need to adjust certain of the figures to a part year basis
also created problems. In short, the first part of the requirement was to explain the treatment; but many
candidates went straight to the calculations.
Points in relation to the individual issues are:

Consolidation of new subsidiary: candidates often launched straight into the calculation of the
consideration and goodwill, without clearly identifying the incorrect nature of the FDs proposed treatment.
Only a minority of candidates made reference to the treatment of the post acquisition profits.
Capitalised borrowing costs: except for the omission of the split of the finance cost adjustment between
the group and the NCI, this issue was the most comprehensively dealt with of the four. However, some
candidates failed to list the three requirements for commencement of capitalisation.
Government grant: although virtually all candidates identified the two treatments available, many failed to
provide a full set of calculations for both alternatives. In quite a few cases the calculations would be
based on incorrect periods.
Sale and operating lease back: This issue presented the most difficulty. Although the question didnt
specify the assets useful economic life, credit was given for comments on the leases short term. Most
candidates correctly identified this as an operating lease. However some candidates failed to distinguish
which of the two elements of profit should be deferred or treated the whole of the profit as deferred.

Total possible marks

Maximum full marks

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Financial Reporting - Professional Stage September 2012

(b)
Revised Figures for Advent Group plc 30 June 2012:
Profit to
Equity
Ord S/Hs (excl. NCI)

PER QUESTION:
2,100,000
6,800,000
1 Consolidation of NCI
1 Consolidation of Debt
1 Shares to be issued
1,840,000
1 Deferred income unwinding
(157,075)
(157,075)
1 Post-acq profit (to Advent / NCI)
480,000
480,000
2 Capitalisation of borrowing costs
(20,320)
(20,320)
3 Grant
(162,500)
(162,500)
4 Sale and Operating Leaseback
(175,000)
(175,000)
2,065,105
8,605,105

NCI

1,320,000

3,000,000

120,000
(5,080)

1,434,920

Gearing
Revised Figures:

5.7m / (8.61+1.43)m =

56.8%

Debt

2,700,000

5,700,000
ROSF

2.07m / 8.61m =

24.0%

(nb: gearing uses Equity including NCI)

A significant minority failed to attempt this part or having done so, to fully complete it. The revised figures
calculations was less well done than in previous sittings, perhaps because of the added complication of the
NCI element and hardly any candidates calculated the two revised ratios on the correct basis: most failed to
include the NCI in the equity element of gearing.
Total marks available
Maximum marks

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(c)
Both gearing and ROSF have worsened considerably following the adjustments to the draft financial
statements. Higher gearing usually indicates increased risk to the shareholders; if profits fall, debts will need
to be financed, leaving smaller profits available to shareholders. The return on shareholders funds (ROSF) is
the return on the funds provided by the parent companys shareholders (excluding NCI). A fall in ROSF
(mainly due to the inclusion of deferred share exchange on acquisition of Brightdays) will not be regarded
favourably; Advents share of the post-acquisition profit in Brightdays is not sufficient to warrant the deferred
issue of shares.
As are a chartered accountant, I am expected to demonstrate the highest standards of professional conduct.
The ICAEWs Code of conduct, a principles-based code, outlines my responsibilities to identify threats to
compliance with the fundamental principles (including integrity, objectivity and professional competence),
evaluate their significance and implement safeguards to reduce or eliminate them.

I should act with integrity: I should not be associated with any reports containing false or misleading
information.
I should not allow bias, conflict of interest or undue influence of others to override my professional
judgements
I should maintain professional knowledge via continuing professional development

As I am working under a probationary period, a self-interest threat may exist: I have personal concern over
employment security. David Chin, the Finance Director has the ultimate decision on whether the company will
recruit me permanently, and could be seen to exert influence and pressure - particularly given his intentions
to maintain certain ratios in the financial statements.
Such a position could also be regarded as an intimidation threat: David may be deterring me from adjusting
the draft financial statements and acting objectively. David has a dominant position which may influence the
decision making process.
Initially my concerns would be regarding the true and fair representation of the financial statements. I should
start by discussing the proposed amendments with David, and refer him to the applicable accounting
standards. It may be that David is lacking the relevant professional knowledge (as a chartered accountant he
should be maintaining professional knowledge and competence and act diligently in accordance with relevant
standards). If he has made genuine errors, then I should refer him to relevant continuing professional
development courses.
However, if he refuses to amend the financial statements, then I should document all discussions, and may
need to seek advice on how to proceed: for example, find out if the company has any internal policies for
referring the matter. A discussion with David about the consequences of the misstatements may resolve the
issue. For example, I can explain how the auditors will identify the misstatements and insist on their correction
for a true and fair view. The company may have implemented safeguards to counter such threats, such as a
system of corporate oversight. Although unlikely given its size, that there may be an audit committee or other
independent party to which I could ultimately raise any concerns.
A refusal by David to amend the financial statements would be serious, in that it suggests that David is
attempting to understate the effects in the financial statements: he is not acting ethically. It would be
advisable to seek professional advice from the ICAEW or legal advisers, if the matter cannot be resolved
internally.

In general candidates displayed sufficient knowledge of the ethical issues involved, although despite the
statement in the requirement, there was often little or no attempt to address the effect of the changes to the
two ratios as a result of the revised figures. Some candidates made assumptions about David being
influenced by a bonus, which is not in the question.
Candidates continue to prepare very standard answers to the ethics questions and seem to pay little regard to
the number of marks available. Seven marks were available for this issue to recognise that time should be
spent on the ratios discussion as well; however this seemed to pass most candidates by.
Total marks available
Maximum marks

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Question 3
Total Marks: 23
General comments: This was an open-ended, unstructured, scenario question (medium sized company).
Topics questioned were: the accounting treatment of a portfolio of investments (AFS, FVTPL and HTM) with
examples of impairment and tainting (HTM to AFS), revenue recognition (deferred consideration and 0%
finance), and choice of treatment of a new jointly controlled entity (proportionate or equity method). Part (b)
questions how a medium-sized company may benefit from adopting the IFRS for SMEs, and whether the
company would be eligible to adopt it
(a)
Portfolio of Investments
Bonds in Lostat
Dinsdale has elected to treat this investment as Held to Maturity (under IAS 39), so should have a positive
intention and ability to hold this investment to maturity. This should be reassessed at the end of each
reporting date.
In the following year, the investment was disposed of for 51,800. As a result, a profit on disposal of 3,404
(51,800 - 48,396) is recognised in profit or loss.
However the decision to sell will have repercussions. The HTM category cannot be used if an entity has sold
(or reclassified) HTM investments in the current or the two preceding financial reporting periods. This
tainting rule does not however apply if the sale is of insignificant amount and from a non-recurring isolated
incident beyond the entitys control that the entity could not have reasonably anticipated. In this case, the sale
is regarded as significant to Dinsdale, and as a result, the company is now unable to adopt the HTM category
for the next two years.
Ordinary shares in Copperas plc
As these are not held for trading, they will be categorised as Available for Sale and measured at fair value at
the end of each reporting period. Any gain or loss arising from a change in fair value will be recognised in
other comprehensive income, and held in equity in a separate reserve, commonly known as the available-forsale (AFS) reserve.
The shares would initially be recognised at their cost of 55,000. At 30 June 2011 they will be re-measured to
fair value of 52,000 (5.20 x 10,000). The decrease in fair value of 3,000 is recognised in other
comprehensive income and AFS reserve. There is no evidence of impairment at this time (a decline in value
below cost is not evidence on its own of impairment - unless there is a prolonged decline).
By the end of the next year, Copperas has announced a profits warning: its severe financial difficulties is
evidence that the investment is impaired. The investment will be shown at fair value of 26,000 (2.60 x
10,000), and a total of 29,000 recognised as a loss in profit or loss. This amount includes the difference
from previous carrying amount (52,000 26,000), as well as the 3,000 previously recognised in other
comprehensive income and held in equity, which should now be reclassified to profit or loss.
Sale on 0% finance
The sale takes place on 1 January 2012, when the product is delivered. The payment of the 5,000 deposit is
in the same reporting period, so there is no impact on the financial statements, but it should technically be
recorded as deferred income until Dinsdale has performed its part of the agreement by delivering the goods.
By 1 January, therefore, Dinsdale has received a total of 20,000, although this forms only part of the true
revenue. The customer is to pay the balance of 80,000 in 4 years time. This represents an extended period
of credit, and so the revenue receivable has two separate elements:

The fair value of the goods on the date of sale (ie: the cash price)
Financing income

In order to separate the two elements, the future receipt of 80,000 must be discounted to present value at a
suitable interest rate (4.5% in this case) which represents the prevailing rate for lending to the customer, or
the rate which discounts the receivable back to the current selling price.
By discounting the receivable, therefore, the finance element is recognised over the period the finance is
being provided.

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4

The present value of the receivable on the date of sale (1 January 2012) is: 67,085 [80,000 x 1/(1.045) ],
and so the revenue recognised on 1 January is a total of 87,085 (20,000 + 67,085).
Finance income on the receivable of 67,085 is then recognised over the next four years, and the receivable
is unwound. By the end of the current year, on 30 June 2012, the receivable should be increased by six
months worth of interest at 4.5%, bringing it to 68,594. Finance income of 1,509 will be recognised in the
year.

Receivable at 1 January 2012

67,085
6/12 x 4.5% x 67,085
1,509
Receivable at 30 June 2012
68,594
Jointly controlled entity
A jointly controlled entity (JCE) is a joint venture arrangement where a separate legal entity is set up, with the
ownership of that entity being share by the venturers. In this case Arald Ltd is a separate company, which will
maintain its own accounting records, own its own assets, incur its own liabilities and earn its own income.
IAS 31 requires each venturer in a JCE to recognise in its consolidated financial statements its share of the
entity by either:

Proportionate consolidation, or
The equity method of accounting.

Whilst allowing the latter, IAS 31 states that proportionate consolidation better reflects the substance of and
economic reality of the venturers interest: the control of its share of economic benefits. Regardless of which
method is adopted, the share of Aralds profits will be the same. The JCE was created in the year; however
there is no complication of pre- and post-acquisition profits, and no goodwill.
As Dinsdales preferred accounting policy is proportionate consolidation this policy should be used.
Proportionate consolidation involves replacing the original investment of 40,000 with a combination of
Dinsdales 50% share of each of the assets, liabilities, income and expenses of Arald, by either:

Showing separately: splitting each line of the financial statements between Dinsdale and the 50%
share of Aralds (showing two figures for each line, coming to the total figure shown in the line-by-line
method)
Line-by-line (adding the 50% share of Aralds figures to Dinsdales, i.e. showing a single figure for
each line) or

Proportionate consolidation is preferred because it reflects the existence of joint control: only the 50%
(Dinsdales share) of the assets, liabilities, income and expenses of Arald are included. It also provides more
detail than the equity method.
Working 1
Draft Summary Consolidated Statement of Financial Position:
Dinsdale Group

Non-current assets (242 - 40 + (87 x 50%))

Current Assets (67 + (27 x 50%)
Current Liabilities (46 + (22 x 50%))
Equity [263 + (50% x (92-80)]

Proportionate
consol
'000
245.5
80.5
(57.0)
269.0

Rae plc: convertible debentures

Despite Dinsdales positive intention to hold to maturity, this investment is not permitted to be categorised
as Held to Maturity, following the tainting of the bonds in Lostat. As the debentures are quoted, the only
available category is Available for Sale (AFS). The investment is therefore amortised using the effective
interest rate, and then measured at fair value at each reporting date:

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Cost
Effective interest (14,700 x 5.3% x 6/12)
Less: receipt in period (none received)
Carrying amount
Transfer to AFS reserve and OCI
Fair value on 30 June 2012

14,700
390
15,090
360
15,450

Budbel Ltd: Ordinary Shares

As the investment is speculative and held for trading, it should be categorised as Fair Value through profit
or loss. The asset is measured at fair value (9,440) at the year end and the gain of 480 (9,440 8,960)
recognised in profit or loss.

The majority of candidates scored well in this part, although with the exception of the Budbel shares,
performance across the various issues was variable and some candidates displayed a degree of confusion as
to the treatment of the different classes of financial asset.
Comments in relation to the individual issues are:
Lostat bonds: many candidates spent unnecessary time and effort re-calculating the carrying amount of
the investment despite being given the correct figure in the question. Almost all candidates identified the
impact of tainting on the HTM category, however very few candidates commented on the possibility of no
tainting where the change in use is insignificant and isolated.
Copperas shares: Candidates correctly classified this as AFS. Whilst the issue of impairment was
identified in most cases, only a minority of candidates identified the need to reclassify the 2011 AFS
reserve loss to profit or loss as a result of the subsequent impairment.
Sale on 0% finance: several candidates discounted the whole of the consideration or discounted
particular elements of the consideration for incorrect periods of time.
Jointly controlled entity: the proportionate consolidation method was generally well done although a
number of candidates made no reference to the alternative choice of the equity method.
Convertible debentures: the most common error was to ignore the tainting effect of the Lostat bond sale
and thus deal with this investment as HTM.
Total possible marks
Maximum full marks

30
20

(b)
IASB and small and medium sized entities
IFRS are generally accepted to be most suitable for large, multinational organisations operating in capital
markets. However, the IASB estimates that small and medium sized entities (SMEs) comprise 95% of all
companies; and has recognised the need for rigorous and common accounting standards for the smaller and
medium-sized businesses. The IASB issued the International Financial Reporting Standard for Small and
Medium-sized Entitles (IFRS for SMEs) in 2009.
The IFRS for SMEs is completely separate from all other IFRSs (the full IFRS). It is structured by topic,
drawing from the full IFRS but amended to be most suitable for the SME.
Each topic contains simplified recognition and measurement rules. For example, development expenditure is
recognised as an expense, as an SME is unlikely to assess commercial viability on an ongoing basis.
The standard also omits certain full IFRS rules in situations deemed unlikely to be encountered by SMEs.
The IASB believes that IFRS for SMEs will
Provide better comparability for users of financial statements.
Increase overall confidence in the financial statements of an SME.
Reduce the significant costs of maintaining standards on a national basis.
Provide a platform for growing businesses preparing to enter public capital markets where the full
IFRS is required.

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Who can adopt it?

Local jurisdictions decide on which entities should be allowed or required to adopt IFRS for SMEs (eg: most
likely it will be the EU in the case of the UK). The IFRS for SMEs gives guidance, however, by defining SMEs
as entities which:

Do not have public accountability

Publish general purpose financial statements for external users.

An entity has public accountability if it:

Has filed, or is filing, its financial statements with a securities commission or other regulatory authority for
the purpose of issuing any class of financial instruments in a public market, or
Holds assets in a fiduciary capacity for a broad group of outsiders (eg: a bank, insurance company,
securities broker, pension fund or investment banking entity).

This part was not attempted by some candidates, or in many cases the answer was minimal thereby affecting
the average mark. However a few provided a good answer which highlighted the importance of a lack of
public accountability.
Total possible marks
Maximum full marks

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Question 4
Total marks for this question: 18
General comments: This was a consequential unstructured scenario question focusing in part (a) on: the
methods by which a company can account for its investment properties (a new activity of the company),
including alternative treatments (cost or FV), with one property being disposed of via a finance lease. Part
(b) asked for the identification of areas in which UK GAAP differs from IFRS, with explanation of the
differences.
(a)
Investment Property is property (land, building or both) held to earn rentals or for capital appreciation (or both),
rather than for use in the business or sale in the ordinary course of the business. Once recognised as
investment properties, there is a choice of treatment under IAS 40: the IAS 16 cost model, or the fair value
model. The first consideration is whether the properties meet the definition of an investment property.
Measurement of Investment Property A
Initial Measurement
Property A was originally held as inventory (held for resale in the normal course of business); however on 1
July 2011 it was decided to hold it to generate future rental income, and so should be transferred to investment
properties in accordance with IAS 40. Where investment properties are measured at fair value, the property
should be re-valued at the date of change of use and any difference recognised immediately in profit or loss.
Subsequent Measurement
This is an operating lease; however as the lessee is holding the asset for own use rather than as an investment
property, Walsden has a choice of treatment in respect of Property A under IAS 40.
At cost:
Using the cost model, this investment property is accounted for in accordance with IAS 16:

Initial carrying amount (1 July 2011)

Depreciation: Straight-line (260 / 20 years)
Impairment (247,000 - 242,000)
Carrying amount at 30 June 2012

Property A

260,000
(13,000)
247,000
(5,000)
242,000

In the case of Property A, the fair value of 240,000 at the year-end is an indication that an impairment test is
required. An impairment occurs when an assets carrying amount exceeds its recoverable amount (being the
higher of its fair value less costs to sell and its value in use). Value in use is calculated by discounting the
future cash flows expected to be derived from the asset to their present value. Walsden has calculated this to
be 242,000. An impairment is therefore required of 5,000.
Under the cost model, therefore, the income statement will show a depreciation charge of 13,000, and an
impairment of 5,000 relating to Property A.
At Fair Value:
If the fair value model is adopted, then investment properties should be measured at fair value at the end of
each accounting period, with changes in fair value recognised in profit or loss. No depreciation is recognised.
As stated above, using the fair value model requires a change in the carrying amount of Property A to fair value
at the date of transfer to investment properties from inventory.

Carrying amount (30 June 2011)

Transfer to profit
Carrying amount (1 July 2011)
Change in fair value (to profit or loss)
Carrying amount (fair value) at 30 June 2012

Property A

260,000
5,000
265,000
(25,000)
240,000

The adoption of the cost or the fair value model does not constitute a change in accounting policy: Walsden is
accounting for investment property for the first time, so this is a new policy.
Rental income

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Property A generates rental income of 30,000 with no issues of deferred income.
Property B: Finance Lease (building) and Operating Lease (Land)
Property B has been leased out. The lease term extends over the useful life of the building, so the buildings
element within the lease should be classified as a finance lease. In substance, Walsden is a lessor who has
transferred the risks and rewards of ownership of the building to the lessee, so the building should be
derecognised. The useful life of the land, however, is indefinite: so this element should be classified as an
operating lease.
The two elements (Land and Buildings) should be measured by reference to the fair value of the leasehold
interests:
Fair Value of Land
Fair Value of Building
Total Fair value:

68,000
612,000
680,000

10%
90%
100%

The operating lease of the land will generate rental income of 4,800 pa (10% of the annual 48,000 receipt).
There is no deferred income as the rental payment covers the financial year in full. This amount should be
recognised as rental income.
The finance lease is recognised as a receivable: a financial asset from which finance income is earned over the
lease term. This asset is valued at the lower of the 612,000 fair value and the 585,000 (90% x 650,000)
present value of the lease payments. As the building is derecognised, a profit on disposal of 5,000 is
recognised in income, being the difference between the present value of the lease payments (585,000) and
the carrying amount of the building (580,000).
The rental in advance relating to this receivable is 43,200 (90% x 48,000); which is deducted from the asset,
leaving a receivable of 541,800 upon which finance income of 32,508 (541,800 x 6%) will be recognised for
the year. The financial asset stands at 574,308 at 30 June 2012:
Finance
Opening
Lease
income
Closing
Working: Lease receivable
Balance
receipt
Balance
(6%)
Balance

Year ended 30th June 2012

585,000
(43,200) 541,800
32,508 574,308
Income Statement
Operating Lease rental income
Finance Income
Profit on Disposal of Building (585,000 - 580,000)
Statement of Financial Position
Land
Financial Asset (Lease receivable)

4,800
32,508
5,000
50,000
574,308

Property A:
Few candidates provided logically developed answers to this question, often confusing the treatment
under the alternative cost and fair value methods or ignoring the impact of the differing types of lease.
Property A was an operating lease, and identified as such in almost all cases, as was the fact that the
property could have been treated under cost or FV. However many candidates revalued the asset to FV
upon identification as an investment property which is incorrect in the case of treating at cost. A
significant number also failed to deal appropriately with the impairment issue, either applying the value in
use to the FV method rather than cost, or in some cases claiming the value in use information irrelevant.
However, many answers were so confusing and muddled it was difficult to see whether candidates
understood any of the differences between cost and FV and hence lost marks as a result.
Property B:
Although most candidates identified the building as a finance lease, a minority failed to identify the need to
deal separately with the land and building elements or having done so, to then actually calculate the
figures on a split basis.
Total marks available
Maximum marks

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(b)
The accounting treatment of investment property differs under IFRS and UK GAAP as follows:
IFRS 40 allows a choice of accounting treatment, whereas the UK equivalent standard does not permit a
choice. In the UK all investment property must be remeasured at every year end. Remeasurement in the UK is
at open market value, not fair value.
Gains: IAS 40 requires that gains or losses are recognised in profit or loss. Under UK GAAP, gains or losses
are recognised in the statement of total recognised gains and losses, which means that gains and losses are
offset in a pool. The balance of gains and losses is usually presented as the investment property revaluation
surplus, separately from any revaluation surplus relating to other non-current assets.
Under SSAP 21 the lease of land and buildings is considered as one lease, rather than separately assessing
the elements. The lease of land and buildings under SSAP 21 is normally treated as an operating lease,
although where the present value of the minimum lease payments amounts to substantially all (normally 90%
or more) of the fair value of the leased asset, there is a rebuttable presumption that the lease is a finance
lease. As the present value of the minimum lease payments amounted to 650,000 in the case of Property B,
this exceeds 90% of the fair value (90% x (68,000 + 612,000) = 612,000). The whole of property B would be
accounted for as a finance lease.

Most candidates explained the differences adequately, although in some cases candidates would mention
only the treatment under UK GAAP rather than meeting the requirement of explaining the differences
between UK GAAP and IFRS.
Total marks available
Maximum marks

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