Management Level Paper

F2 – Financial Management
November 2014 examination
Examiner’s Answers

Note: Some of the answers that follow are fuller and more comprehensive than would be
expected from a well-prepared candidate. They have been written in this way to aid
teaching, study and revision for tutors and candidates alike.

SECTION A

Answer to Question One

Rationale

This question was intended to test two of the key areas in Syllabus Section B, being retirement
benefits and share-based payments. The retirement benefits section focuses on the accounting
rules for a defined benefit plan and includes the revised rules for accounting for past service
cost. The share-based payment part requires knowledge and practical application of IFRS 2 and
an understanding of why the requirements are necessary.

This question examined learning outcome B1(f).

Suggested Approach

Candidates should have been familiar with the format required for the answer and those who had
completed past exam questions in their studies are likely to have prepared their workings in the
format on the next page.

Turn over for answers to (a) and (b)

November 2014 1 Financial Management

(a)
Pension plan
(i) Actuarial gains and losses:

FV of plan assets PV of plan liabilities

$000 $000
Opening balance 8,200 8,500
Service cost 2,100
Interest cost (6% x opening 492 510
balances)
Benefits paid (500) (500)
Contributions 1,900
Past service cost 2,000
10,092 12,610
Actuarial gain on plan assets 108
Actuarial gain on plan liabilities 110
Closing balance 10,200 12,500

The net actuarial gain in OCI is $218,000 for the year.

(ii) Statement of financial position: $000

Present value of pension plan liabilities at 31 March 2014 12,500
Fair value of pension plan assets at 31 March 2014 (10,200)
Net pension liability 2,300

(b)
(i) Statement of profit or loss:

Eligible employees (800-50-110) = 640

Equivalent total cost = 640 employees x 1,000 options x FV$7 = $4,480,000
Allocate over 3 year vesting period, therefore $1,493,333 is the charge for the year to 31
March 2014.

(ii) Share options, such as those granted by NB, are given by an entity in return for services
provided by its employees. In effect the share options are given to the employees as a
form of bonus or reward for these services and are therefore part of the employee’s
remuneration package. The value of these options (or relevant part thereof) must then be
reflected in the staff costs included within the statement of profit or loss.

Financial Management 2 November 2014

 Answer to question two starts on the next page

November 2014 3 Financial Management

 Answer to Question Two

Rationale

This question was intended to test consolidation techniques in drafting a group statement of
profit or loss and other comprehensive income. The complex area being tested was piecemeal
acquisition with control being gained in the period, resulting in equity accounting for 9 months
and full consolidation for 3 months.

This question tested learning outcomes A1(a) and (b).

Suggested Approach

Establishing the group structure during the year would have been essential. Drafting up the pro-
forma group statement of profit or loss and other comprehensive income would have been the
next best step, inserting a line for the associate and for the group gain/loss on the de-recognition
of the associate. A key part of the answer was the calculation of the NCI allocation of profit and
TCI, and the calculation of goodwill at the date control was gained.

(a) Goodwill:

$m
Consideration transferred on 1 January 2014 320
Fair value of existing holding of 35% at date control is gained 280
Fair value of non-controlling interest at date of control 180
780
Fair value of the net assets acquired (710)
Goodwill arising on the acquisition 70

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(b)

Summarised statement of profit or loss and other comprehensive income $m

for the QA Group for the year ended 31 March 2014
All workings in $m
Profit from operations (410 + (3/12 x 200) 460
Consolidated gain on de-recognition of associate (W1) 11
Finance costs (70 + (12 x 3/12)) (73)
Share of profit of associate (144 x 9/12 x 35%) 38
Profit before tax 436
Income tax expense (100 + (3/12 x 44)) 111
Profit for the year 325
Other comprehensive income:
Items that will not be reclassified to profit or loss
Revaluation of property, net of tax (50 + (3/12 x 20)) 55
Share of associate’s OCI (20 x 9/12 x 35%) 5
Other comprehensive income for the year 60
Total comprehensive income 385

Profit for year attributable to:

Equity shareholders of the parent 316
Non-controlling interest (144 x 3/12 x 25%) 9
325
Total comprehensive income attributable to:
Equity shareholders of the parent 375
Non-controlling interest (164 x 3/12 x 25%) 10
385

Workings

1. Group profit on de-recognition of associate $m $m

All workings in $m
Fair value of existing 35% investment at date control obtained 280
Carrying value of the associate in QA’s financial statements at
date control obtained:
Cost of investment 255
Plus 35% of post-acquisition retained earnings (710-670) 14
(269)
Gain on de-recognition 11

Note: the fair value gains reported in the OCI of QA that arose on the re-measurement of its
investment in LM do not appear in the group accounts as the investment is treated as an
associate and then a subsidiary in the group accounts and not in accordance with IAS 39.

November 2014 5 Financial Management

Answer to Question Three

Rationale

This question tested the calculation of basic and diluted earnings per share. The basic EPS
question included dealing with two issues during the year, a bonus issue and an issue at full
market price. The diluted EPS required candidates to incorporate share options when
calculating diluted EPS.

This question examined learning outcome C1(a).

Suggested Approach

The question was deliberately split into (a) and (b) to help candidates focus on the fact that both
the bonus and full market price issue were to be included in the basic EPS and the diluted EPS
then adjusted for the potential ordinary shares. The formats of candidates’ workings were
expected to follow the approach shown below.

(a)

Basic eps:
Profit attributable to ordinary shareholders $7,500,000
Weighted average number of issued ordinary shares
during the year ended 31 March 2014:
In issue throughout the year 20,000,000
Bonus issue (1 for 5) 4,000,000
Full market price issue 4,000,000 x 3/12 1,000,000
Weighted average number of shares in issue 25,000,000
Basic eps 30.0 cents
Basic eps for y/e 31 March 2013 (restated) 34 cents x 20/24 28.3 cents

(b)

(i) Diluted eps:

Profit attributable to ordinary shareholders $7,500,000
Weighted average number of issued ordinary shares
during the year ended 31 March 2014 from part (a): 25,000,000
Shares held under option 2,000,000
Shares that could have been issued at average
market price (2,000,000 x $4.50/5.60) (1,607,143)
Shares effectively issued for nil consideration 392,857
Weighted average number of issued ordinary shares and potential
ordinary shares during the year ended 31 March 2014 25,392,857

Diluted eps 29.5 cents

(ii) Reporting entities must disclose the diluted eps to effectively illustrate how the eps would
change in the future if these potential ordinary shares are issued. The shares that are
added to the weighted average number of shares are those that would bring no additional
resources to the entity and in essence are therefore potential bonus shares. Shareholders
are then able to see the effect on current earnings of the potential ordinary shares that the
entity is committed to issue. The most dilutive scenario is reported.

Financial Management 6 November 2014

Answer to Question Four

Rationale

This question tested the accounting of financial instruments and foreign currency translation.
Part (a) required candidates to explain, rather than do any related calculations for, how a
convertible debt instrument would be initially recognised in the financial statements. Part (b)
asked for the initial and subsequent measurement of an available for sale investment. The
second part required candidates to analyse the features of the scenario given in order to
determine the entity’s functional currency.

This question tested learning outcome B1(d),(e) and A2(b).

Suggested Approach

Candidates should have described how the liability and equity elements were split and initially
measured. Part (b) required journal entry for both initial recording and subsequent measurement
with gains/losses being recorded in other comprehensive income in accordance with the
standard. Candidates should have used the scenario to prompt them to consider and explain the
guidance in the accounting standard to determine the functional currency and then used the
scenario to help justify their answer and make it specific to the scenario.

(a)

IAS 32 requires that the equity and liability elements within convertible instruments be initially
recognised separately. The initial carrying amount of the liability is estimated by measuring
the fair value of a similar instrument that has no conversion element. This is achieved by
calculating the present value of the future cash flows associated with the instrument assuming
that it is not converted on redemption (ie: the interest and principal repayment cash flows)
discounted at the prevailing market rate for a similar instrument without conversion rights. The
difference between this amount and the proceeds of issue (ie: the residual) is recognised as
equity.

(b)

(i) Dr Investment $3,420,000

Cr Bank $3,420,000
Being initial recording of the purchase including transaction fees

Dr Investment $180,000
Cr other reserves $180,000
Being the increase in fair value being recorded within equity/OCI

(ii) The functional currency of a foreign enterprise is the currency of the primary economic
environment in which the entity operates. The key considerations would be:

• The currency which principally influences selling prices for goods and services;
• The country that most influences the selling prices of the entity’s goods and services
through its competitive forces and regulation;
• The currency that mainly influences labour, material and other costs.

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If it is still unclear which currency should be the functional currency then consider the
currency in which funding is primarily raised and in which operating receipts are retained.
Where the subsidiary operates relatively autonomously, rather than as an extension of the
parent, this provides evidence that the functional currency of this subsidiary should be the
local currency in which it operates.

It is likely that AB would adopt the Yip as its functional currency. Its results would be
impacted by the local currency as it would be sourcing goods locally and recruiting local
workforce. In addition, it is subject to local tax regulations. AB sales are both domestic and
overseas, however it raised finance locally and has continued to operate autonomously, so
the Yip is likely to be its functional currency. AB will prepare its financial statements using the
Yip.

Financial Management 8 November 2014

 Answer to Question Five

Rationale

This question tested Section D of the syllabus, and specifically the expansion of
narrative/voluntary disclosures in respect of human capital.

This question tested learning outcome D1(d).

Suggested Approach

It was essential that candidates absorbed the small scenario provided and presented answers
that were relevant to the entity and scenario given.

(a)
The recognition of assets requires certain criteria to be met; an asset must be “a resource
controlled by an entity as a result of a past event and from which future economic benefit is
expected to flow”. This asset must then be capable of being reliably measured in order to be
recognised in the statement of financial position.

TY would expect its human resources to generate future economic benefit, however the resource
is one that TY cannot control. Staff members are free to leave at any time taking their skills and
intellectual capital with them.

There are also a number of issues concerning the measurement of a staff resource as an asset.
The cost of staff is their training costs and remuneration. It could be argued that training costs
have an on-going benefit and therefore could be capitalised. However, remuneration relates to a
service provided by the staff in that year and therefore should be taken to profit or loss as a
period cost. It is possible to value assets on a fair value basis, however, for staff this would
involve establishing future cash flows and discounting to present value. It is difficult to see how
this could be achieved on a reliable basis due to the estimation required.

Staff resource therefore fails the recognition criteria for an asset and cannot be included in the
statement of financial position.

(b)
TY depends on human resources to generate its revenue but may have a relatively low level of
capital investment. This could make its statement of financial position look under-capitalised and
it is difficult for investors to see where the value of TY lies. Common ratios targeting efficiency
and financial position, like return on capital employed and return on assets, will not provide
useful measures as the key revenue generating resources of the business are not reflected in
the financial statements of TY. The inclusion of voluntary information would ensure that
investors do not arrive at incorrect conclusions about the financial performance and position of
TY. Where investors feel they can rely to some extent on this additional information it could
encourage them to invest or stay invested.

Potential investors tend to rely on the information contained in the financial statements in order to
help them make their investment decisions. This “missing” information may make TY look a less
attractive investment to potential investors. Including information about key revenue-generating
resources may improve the market’s opinion of TY, and could lead to investment and
improvement of share price.

November 2014 9 Financial Management

The gap between market capitalisation and book value of net assets of TY could be considerable
and it is therefore important to inform the market of key personnel resources, processes or
intellectual capital. Illustrating that TY has “assets” that are not included on the SOFP may lower
the market’s perception of the riskiness of TY which could improve the entity’s P/E ratio.

Answers to Section B start on the next page

Financial Management 10 November 2014

SECTION B

Answer to Question Six

Rationale

This question examined candidates’ understanding of vertical group structures. The question
included consolidation of both a subsidiary and sub-subsidiary and so candidates could achieve
a large portion of the marks by adopting the basic procedure of consolidation of a subsidiary.
Accounting for debt instruments was also tested.

This question tested learning outcomes A1(a) and (b), B1(e).

Suggested Approach

The first step would be to establish the group structure and identify the complex issue in the
question and how this would affect the answer given that a SOFP was to be prepared. Drafting
up the pro-forma SOFP and inserting lines for goodwill and NCI would have been the next step.
Candidates would then insert the aggregated figures or cross reference to workings where
appropriate.

Consolidated statement of financial position as at 31 March 2014 for BX

Group (workings in $ millions)
ASSETS $m
Non-current assets
Property, plant and equipment (210 + 88 + 110) 408
Goodwill (W1) 28
436
Current assets (60 + 46 + 28) 134
Total assets 570

EQUITY AND LIABILITIES

Equity attributable to owners of the parent
Share capital ($1 equity shares) 200
Share premium 50
Retained earnings (W2) 89
339
Non-controlling interest (W3) 77
Total equity 416

Non-current liabilities (25 + 10 + 4 + 1 (W4) + 2 cont liab) 42

Current liabilities (60 + 34 + 18) 112
Total liabilities 154
Total equity and liabilities 570

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Workings

1. Goodwill Acquisition of Y Acquisition of

Z
$m $m
Consideration transferred for Y ($148m - $18m) 130
for Z (75% x ($76m - $6m)) 52
NCI at fair value in Y (25% x 80 million shares x 40
$2.00) 42
in Z (40% x 60 million shares x $1.75)
170 94
Net assets acquired
Share capital 80 60
Share premium 20 10
Retained earnings 45 20
Contingent liability – at acquisition (5)
140 90
Goodwill at acquisition 30 4
Impairment of 20% for goodwill on acquisition of Y (6)
Goodwill at 31 March 2014 24

Total goodwill at 31 March 2014 is $28m.

2. Retained earnings Group Y Z

$m $m $m
As per SOFP at 31 March 2014 65 60 46
Pre-acquisition reserves (45) (20)
Goodwill impairment (W1) (6)
Adjustment for movement in contingent liability on 3
acquisition of Y
Adjustment for long term bond (W4) (1)
12 26
Group share of Y (75% x $12m) 9
Group share of Z (60% x $26m) 16
Consolidated retained earnings 89

3. Non-controlling interests Acquisition of Y Acquisition of

Z
$m $m
At acquisition (as per W1) 40 42
NCI share of post-acquisition retained earnings of Y 3
(25% x $12m)
NCI share of post-acquisition retained earnings of Z 10
(40% x $26m)
Less cost of investment in Y (25% x $70m) (18)
NCI at 31 March 2014 25 52

Total NCI at 31 March 2014 is therefore $77 million.

Financial Management 12 November 2014

4. Long term bond
Opening balance Effective interest Interest paid 5.5% Closing balance
9.5%
$m $m $m $m
24.75 2.35 1.38 25.72

Adjusting both the bond and retained earnings by $1m will correct the posting of the
transaction costs and record the additional finance cost to account for the effective interest,
since interest paid has already been charged.

November 2014 13 Financial Management

 Answer to Question Seven

Rationale

This question was a standard-style analysis covering Section C of the syllabus. Candidates
were required to calculate P/E ratio for FG and then briefly comment on that and the share price.
The detailed analysis was then drawn from the calculation of 6 further ratios.

Suggested Approach

Candidates should have calculated ratios and then considered the results in conjunction with the
opening scenario.

(a) (i) Calculation of P/E ratio

2014 2013
Share price $3.94 $5.29
EPS $18,000,000/40,000,000 $23,000,000/40,000,000
45.0 cents per share 57.5 cents per share
P/E ratio 8.8 9.2

(ii)

The share price has fallen significantly following poor interim results being published and the
announcement about the dividend. Earnings per share has also fallen as a result of reduced
profit for the year. The profit has been reduced by the impairment of goodwill recorded in the
year, otherwise reported profit would have shown an increase in operating profit. The market is
clearly concerned about FG’s future since the P/E ratio has fallen from 9.2 to 8.8 which is not
surprising since those investors looking for short term returns will have been disappointed by the
announcement.

(b)

FG’s gross profit margin has fallen from 29.2% to 26.8%, which is likely to be a direct impact of
the pressure on selling prices from the new market entrant. Combining this with increased
revenue overall and the fall in inventories in the year suggests that FG has made a deliberate
move to sell inventories at a reduced price. This is a positive indicator that management has
responded quickly to market pressures and to avoid being left with obsolete inventories.

Both operating profit margin and profit for the year have reduced in the year, however FG
suffered an additional expense from the impairment of the goodwill arising on its subsidiary.
Adjusting for this allows us to assess the core operating profits of FG. Without the impairment
expense of $10 million the operating profit margin would have increased to 7.4%, indicating that
FG’s directors have controlled operating costs well in the year.

The cost control has not been reflected in the return on capital employed which has decreased
due to both decreased profits and increased capital employed from short term borrowings.
The profit margin for the year has fallen by 0.9% and has been affected in part by the increased
finance costs although the average rate of interest being charged has not increased significantly.
The fall in profit has affected the interest cover. Cover has fallen from 8.6 to 5.0, however this
would still be adequate cover should FG pursue additional finance raising.

Financial Management 14 November 2014

The year end overdraft has resulted in an increased gearing level of 33%, compared with 23.1%
the previous year. Long term funding has not increased, other than the amortisation of the
effective interest. The short-term borrowing has been required despite a significant drive to
collect receivables faster, with collection down from 63 to 55 days. The increase in short term
borrowing is likely to be the result of payables falling from 97 days to 62 days during the year,
possibly suppliers have demanded shorter payment terms as a result of uncertainty in the market
and increased competitive pressure. Inventory holding period has fallen from 65 days to 46 days
and this could be a deliberate attempt to clear older items.

There is no evidence that FG has extended its long-term capital in order to acquire further PPE
so we can only assume that cash has been used. It is not wise to invest in long-term capital
using short-term funds, however this may have been a forced reaction from the new market
entrant.

The current and quick ratios do not indicate serious liquidity issues, however the statement of
financial position shows no cash and outstanding payables that must be settled. FG must secure
longer term finance especially if it is to continue to invest in PPE and compete with the new
entrant in the market. It is also important to investors to resume dividend payouts and this would
hopefully improve the market’s perception of FG.

FG should be able to secure long-term funding as the PPE provides adequate security, with only
$65 million of existing long term borrowings at the year-end date. The management appear to
be in the main responsive and commercial, albeit made a poor decision on the investment in
PPE for cash. I think the investment should be considered further and we may be able to take
advantage of the current low share price.

November 2014 15 Financial Management

Appendix A – Ratios
Relevant ratios that could be calculated include:

All workings in $m 2014 2013

Gross profit margin 182/680 x 100 = 26.8% 187/640 x 100 = 29.2%

(GP/Revenue x 100)
Operating profit
(Profit before finance 40/680 x 100 = 5.9% 43/640 x 100 = 6.7%
costs/revenue x 100)
Profit margin 22/680 x 100 = 3.2% 26/640 x 100 = 4.1%
PFY/revenue x 100
ROCE % 40/(276+65+26) x 100 = 43/(260+60) x 100 =
Operating profit/capital employed 10.9% 13.4%
Inventories 63/498 x 365 = 46 days 81/453 x 365 = 65 days
Inventories / cost of sales x 365
Payables 84/498 x 365 = 62 days 120/453 x 365 = 97 days
Payables/cost of sales x 365
Receivables 103/680 x 365 = 55 days 110/640 x 365 = 63 days
Receivables /revenue x 365
Current ratio 166/110 = 1.5 210/120 = 1.8
Current asset/current liabilities
Quick 103/110 = 0.9 129/120 = 1.1
CA – inventories/current liabilities
Gearing (65 + 26)/276 x 100 = 33.0% 60/260 x 100 = 23.1%
Debt/Equity
Interest cover 40/8 = 5.0 times 43/5 = 8.6 times
Operating profit/finance cost
Average cost of lending 8/(65 + 26) x 100 = 8.8% 5/60 = 8.3%
Finance costs/interest bearing
borrowings

Financial Management 16 November 2014