The Examiner's Answers –

F2 - Financial Management
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

The consolidated income statement for the KL Group for the year ended 31 December 2010:

All workings in $000 $000

Revenue (4,000 + 1,500 - 140) 5,360
Cost of sales (2,300 + 1,000 – 140 + 14(W4)) (3,174)
Gross profit 2,186
Distribution costs (900 + 120) (1,020)
Administrative expenses (350 + 150 + 60 (W1) + 40 (W2)) (600)
Share of profit of associate (W3) 12
Profit before tax 578
Income tax expense (250 + 80) (330)
Profit for the year 248

Attributable to:
Equity holders of the parent 237
Non-controlling interest (W5) 11

Workings:

W1 Goodwill impairment $000

Consideration transferred 8,200
Non-controlling interest at fair value 2,200
Fair value of the net assets acquired (10,000)
Goodwill at acquisition 400
15% impairment in 2010 60

W2 Additional depreciation on fair value adjustment

Fair value adjustment on depreciable assets $240K
Remaining useful life of assets 6 years
Annual depreciation charged to group admin expenses $40K

W3 Share of profit of associate $000

Profit after tax of NP 120
Pro-rata from date of acquisition – 3 months 30
40% group share 12

Financial Management 1 March 2011

W4 Unrealised profit on inventories $000
Sales value of goods in inventories at year end ($140K x ½ ) 70
Unrealised profit at 20% margin 14

W5 Non-controlling interest $000

Profit for the year for LM (as reported) 150
Additional depreciation on fair value uplift (W2) (40)
Goodwill impairment (W1) (60)
Unrealised profit in inventories (W4) (14)
36
30% NCI share 11

Answer to Question Two

(a) Analysis of financial statements of service and knowledge-based industries

Entities operating in service and knowledge-based industries are often heavily reliant upon
intellectual capital for revenue generation. Intellectual capital can be defined as “knowledge
which can be used to create value” and includes human resources, intellectual assets and
intellectual property. For many entities operating in service and knowledge-based industries
the most important element of their intellectual capital will be the collective experience,
knowledge and skills of their staff.
Entities that depend on their staff and other intellectual capital to generate revenue will often
have a relatively low level of physical assets. This makes the statement of financial position
look under-capitalised and it is difficult to see where the value of the entity lies. Common
ratios targeting efficiency and financial position, like return on capital employed and return on
assets will not provide investors with useful measures as the key assets of the business are
not reflected in the financial statements.
For successful entities the gap between market capitalisation and book value of net assets
can be considerable and it is therefore important for entities to inform the market of key
personnel resource, processes or intellectual capital.
Key members of staff are likely to be the resource that helps the business generate future
revenue but without any information on the resource itself it will be difficult for potential
investors to estimate the future revenue generating ability of the business.
(b) Recognition Issues:

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.
Human resources (staff) are expected to generate future economic benefit for the entity,
however the resource is one that cannot be controlled. Staff members are free to leave at
any time taking their skills and intellectual capital with them.
Notwithstanding the issue of control, 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 the income statement 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.

March 2011 2 Financial Management

Answer to Question Three
(a) (i)

Share-based payment

2009 (300-25-40) x 1,000 x $1.22 = $286,700 over 3 years = $95,567 charge for 2009
2010 (300-25-15-20) x 1,000 x $1.22 = $292,800 x 2/3 years = $195,200
recognisable to date
Less amount recognised in 2009 $(195,200 – 95,567) = $99,633 charge for 2010

Charge for 2010 of $99,633 will be recorded as:

Dr Income statement – staff costs $99,633
Cr Other reserves (equity) $99,633

Being the charge for share-based payment for the year ended 31 December 2010

(ii)

Share-based payments that are to be settled in cash would be credited instead to

liabilities in the statement of financial position and the liability would be remeasured
using the fair value of the shares at each year-end date until the end of the vesting
period.

(b) Defined benefit pension plan

(i)

Statement of financial position $m

PV of plan liability 13.9
FV of plan assets (13.1)
0.8
Unrecognised actuarial losses (0.5)
Net pension liability 0.3

(ii) IAS 19 Employee benefits permits actuarial gains or losses to be included in

profit or loss (ie: the income statement) in a way that recognises them faster than
the corridor approach. Alternatively, an amendment to IAS 19 now allows the full
amount of the gains or losses to be included in other comprehensive income in
the year and charged to equity.

Financial Management 3 March 2011

Answer to Question Four
(a)
(i) The held to maturity investment will be initially recorded at fair value plus
transaction costs. It will be subsequently measured at each year-end at
amortised cost using the effective interest rate.

(ii) Held to maturity investment -amortised cost using effective interest rate of
7.05%.

Year Opening Effective interest Interest Closing

end balance 7.05% received balance
$ $ $ $
2010 3,200,000 225,600 (180,000) 3,245,600

Investment income - Income from HTM investment $225,600

Non-current assets - Held to maturity investment $3,245,600

(b) Held for trading investment

Initial recording:
Dr Current asset investment $300,000
Cr Bank $300,000
Being the purchase of shares

Being the purchase of the shares

Dr Income statement $12,000
Cr Bank $12,000

Being the write off of the transaction costs to the income statement as the investment is an
asset held at fair value through profit or loss

Subsequent measurement
Dr Current asset investment $40,000
Cr Income statement – gain $40,000

Being the uplift in value and the recording of the gain in the income statement

March 2011 4 Financial Management

Answer to Question Five

FGH has managed to generate significant cash from operating activities which is a positive
sign for any business wishing to be a going concern, particularly since it appears that FGH is
expanding. In addition to the inflow of cash from trading, the directors have clearly made
some good investment decisions as income of $180,000 has been included in the year and
also profit of $50,000 has been earned from the sale of some of these investments.

It does look as if FGH needs to improve working capital as receivables have increased in the
year and it looks like the entity has in turn withheld payment to payables with an increase of
$550,000. The increase in receivables may be a deliberate attempt to secure new customers
by offering them favourable credit terms but it is essential that good working capital
management is not compromised. The increase in inventories has probably arisen in order to
meet future expected demand from the expansion. It should also be noted that FGH has
acquired a subsidiary during the year, although the effect of the subsidiary on the working
capital balances will have been adjusted for in the completion of the statement of cash flows.

The expansion is shown in two areas of investment, with the acquisition of a subsidiary and in
the purchase of property, plant and equipment. The sale of property, plant and equipment for
$70,000 resulted in a loss of $45,000. It’s possible that the expansion has resulted in the
need for new equipment and hence management have taken the view to sell some of the old
equipment whilst there is still a second hand market for it. The sale of investments for
$150,000 has probably been undertaken in order to generate funds for the expansion. The
only note of caution is that these investments seem to be profitable and hence given that a
proportion has been sold during the year, future income from investments will be reduced.

It is clear from the cash flows from financing that FGH appears to have the backing of its
shareholders. A share issue has been supported and the shareholders have been rewarded
with a significant dividend in the year. . A good sign is that FGH has managed to fund the
expansion without increasing the overall gearing of the business, as equal amounts of debt
and equity have been raised as new finance. It indicates good stewardship of assets when
long term expansion is financed by long term financing. FGH appear to have used a mixture
of long term financing and retained earnings generated in the year, together with the sale of
some investments to fund the expansion. However, this is not to the detriment of
shareholders as they have still received a significant dividend during the year and it’s possible
that the new investments in a subsidiary and PPE will generate greater returns in the future
than the investments which have been sold. In times of exapnsion, however, a more modest
dividend may have negated the need for long term financing and the interest costs associated
with it.

Financial Management 5 March 2011

SECTION B

Answer to Question Six

(a) Fair value adjustments
Impact on calculation of goodwill at acquisition:
In this case the calculation of goodwill on the acquisition of BNM should be based on
the fair value of the consideration paid plus the fair value of the NCI less the fair value
of the net assets acquired. The fair value of the net assets acquired should include any
fair value adjustments required to take the book values of individual assets and
liabilities up to (or down to) their fair value.

The increase in the values of property, plant and equipment and inventories will
increase the value of net assets at acquisition, which in turn will reduce goodwill. The
intangible asset will be recognised as an asset at acquisition because it meets the
definition of an intangible asset in IAS 38. It will increase the net assets at acquisition
and hence reduce goodwill.

The contingent liability is also specifically allowed to be included within the fair value of
the net assets at acquisition. However, as a liability this will reduce the fair value of net
assets and hence increase goodwill.

Impact on consolidated financial statements for year ending 31 December 2010:

PPE:
In the consolidated statement of financial position as at 31 December 2010 the value of
PPE will be increased by $800,000 and reduced by the additional depreciation arising
for the period. The additional depreciation is calculated as the FV adjustment divided
by the estimated remaining life of the assets from the date of acquisition. This
additional depreciation will be charged to the consolidated income statement each
year.

Inventories:
As the inventories have been sold by 31 December 2010, no adjustment will be
required to the inventories balance in the statement of financial position. However, in
the consolidated income statement an additional charge should be made within cost of
sales. This will obviously also impact retained earnings for the group.

Intangible Asset:
The intangible asset will be recorded in the consolidated statement of financial position
and amortised over its life (which in this case is 20 months). The amortisation charge
will go through the consolidated income statement and impact group retained earnings.

Contingent Liability:
The contingent liability will be recorded as a current liability in the consolidated
statement of financial position. In the consolidated income statements the reduction in
the liability will in effect increase profits.

March 2011 6 Financial Management

(b) Consolidated statement of financial position as at 31 December 2010 for the ERT
Group

All workings in $000

ASSETS $000
Non-current assets
Property, plant and equipment (12,000 + 4,000 + 750(W1)) 16,750
Goodwill (W2) 208
Intangible asset (W1) 90
17,048
Current assets
Inventories (2,200 + 800 -30 (W3)) 2,970
Receivables (3,400 + 900) 4,300
Cash and cash equivalents (800 + 300) 1,100
8,370
Total assets 25,418

EQUITY AND LIABILITIES

Equity
Share capital ($1 equity shares) 10,000
Retained earnings (W4) 7,893
Total equity attributable to parent 17,893
Non-controlling interest (W5) 1,741
Total equity 19,634
Non-current liabilities
Long term borrowings 2,700
Current liabilities (2,000 + 1,000 + 84) 3,084
Total liabilities 5,784
Total equity and liabilities 25,418

Workings
1. Fair value adjustments
At acquisition Movement 31 December
date 2010
$000 $000 $000
PPE 800 (50) 750
Inventories 200 (200) -
Intangible assets 150 (60) 90
Liabilities (210) 126 (84)
940 (184) 756

2. Goodwill
$000 $000
Consideration transferred 3,800
NCI at fair value 1,600
5,400
Net assets at fair value:
Share capital 1,000
Retained earnings 3,200
Fair value adjustments 940
(5,140)
Goodwill on acquisition 260
20% impairment (52)
Goodwill at 31 December 2010 208

Financial Management 7 March 2011

 3. Unrealised profit on inventories
Sales of $300k x 20% x 50% left in inventories at y/e = $30k

4. Retained earnings
$000 $000
As per SOFP 7,500 4,000
Pre-acquisition reserves (3,200)
Adjustments arising from movement in
FV adjustments (184)
616
Group share 75% 462
Unrealised profit on inventory transfer (30)
Goodwill impairment (75% x 52)(W2) (39)
Consolidated reserves 7,893

5. Non-controlling interests
$000
NCI at acquisition (at fair value) 1,600
25% x post acquisition retained earnings $616,000 (W4) 154
Goodwill impairment (25% x 52)(W2) (13)
1,741

Answer to Question Seven

(a) To friend

Report on financial performance and position

The revenue has only marginally increased in the year by 1.6%, however, profit margins have
all increased significantly. In particular the gross profit margin has increased from 10% to
19%, which is likely to be as a result of reduced purchase prices from the new supplier
contract that was secured in the year. Whilst this is a very positive and important step for
DFG (given its low margin in the previous year) it will be important to establish whether this
reduced cost also means a reduced level of quality. If quality is being compromised then this
increase in margin maybe short-lived as customers may be driven away in the longer term.

In addition, the switch in supplier may be responsible for the lawsuit. It is a risky strategy to
pursue aggressive revenue and margin targets at the expense of supplying good quality
products. Although a contingent liability of $30 million is included in the notes, the lawyer’s
assessment is that DFG is likely to lose the court case and the payout may be more. There is
already serious pressure on the entity’s finances and the entity may not survive if the payout
is any more or if other customers decide to sue. There is a potential issue of going concern
that would need clarification before you arrive at a final decision concerning employment.

Both administration and distribution costs have increased significantly when compared to a
1.6% increase in revenue. Whilst these costs are not that large in relation to revenues, it will
be important to establish that management have good control over expenses for the long
term.

The increase in TCI is largely due to the revaluation gain reported within other comprehensive
income. The valuation was performed by an internal member of staff, which is perhaps not as
ideal as someone external, however you noted that these financial statements were finalised
and so I assume they have been audited and that the valuations are fair. One note of caution
though is why the directors have chosen this year to change the policy - could it be an attempt
to boost income and reduce gearing to make further borrowing easier, especially as the long
term borrowings will need to be repaid or re-negotiated relatively soon. However, it maybe

March 2011 8 Financial Management

shows good commercial sense to ensure that assets that are to be used as security for
finance are at the most up-to-date valuation.

The overall liquidity of DFG is on the low side at 1.3:1 and has fallen significantly from 2009.
One contributing factor to the worsening liquidity is the significant increase in inventories in
the year. This could be as a result of bad publicity about below standard goods and customer
orders being cancelled. There is then an increased risk of obsolete inventories. This is
reinforced by the inventories days which have increased from 146 days to 191 days.
Receivables days have also increased from 71 days to 104 days, and this be could be as a
result of disputed invoices. DFG may then have a problem with slow/non-payment of these
debts. Payables days have increased from 108 days to 171 days and this could be resulting
from a deliberate attempt by DFG to improve the cash flow by delaying payment or extended
credit terms given by the new supplier to attract DFG’s business.

The cash position of DFG is clearly a concern as the cash has moved from a positive balance
to an overdraft and the long term borrowings are soon to be repaid or re-negotiated. This
coupled with the poor working capital management would indicate that DFG must raise some
additional funding if it is to survive. The gearing ratio shows deterioration on the previous
year, despite an increase in equity from the revaluation. However, it is likely to be the lack of
interest cover that would put lenders off. It is unlikely that DFG could afford to pay interest on
any additional funding.

I would recommend investigating DFG in more detail before making your decision. Losing the
court case and having a large settlement to pay could result in the entity collapsing and
despite the fact that details of this are only in the notes, the seriousness of this should not be
overlooked. The entity may struggle to survive anyway as there is a lack of cash and funding
options (and it should be noted that DFG did not pay a dividend in 2010). The increases in
profitability are not enough of an indicator of a stable/growing entity – especially an entity
involved in the building trade which is known for its sensitivity to the economy around it.

(b) Limitations of ratio analysis

The financial statements provide only historic information and reflect a point in time (ie: the
year-end). However, the situation of the entity in question could have progressed significantly
by the time you are analysing the information. For example, with the contingent liability for
the court case, it could have progressed or be settled and the financial statements will not
have reflected that.

The ratio analysis conducted on DFG showed an improvement in profitability margins, in cost
of sales particularly, however it looks likely that quality has been compromised in favour of
better margins and the result of that has been the filing of a law suit against DFG. This is
something that threatens the future of the business but is not reflected in the ratios calculated.

Changes in accounting policies can impact ratio calculations. DFG has changed the
accounting policy for subsequent measurement of PPE from depreciated historic cost to
revaluated amount. The revaluation in the year then improves the gearing ratio and reduces
non-current asset turnover but is due only to a change of policy rather than changes to the
underlying environment.

Financial Management 9 March 2011

Appendix A

Relevant ratios that could be selected and calculated:

2010 2009
(Workings in $m)
Gross profit 49/252 x 100 = 19.4% 25/248 x 100 = 10.1%
GP/revenue x 100%
Operating profit (49-18-16)/252 x 100 = (25-13-11)/248 x 100 =
Profit before finance 6.0% 0.4%
costs/revenue
Net profit 7/252 x 100 = 2.8% (5)/248 x 100 = (2.0)%
PFY/revenue x 100%
Gearing (91+39)/231 x 100 = 91/184 x 100 = 49.5%
Debt/total equity 56.3%
Current ratio 178/134 = 1.3 : 1 143/66 = 2.2 : 1
Current assets/current liabilities
Quick ratio (178-106)/134 = 0.5 : 1 (143-89)/66 = 0.8 : 1
CA – inventories/current liabilities
Receivables days 72/252 x 365 days = 104 48/248 x 365 days = 71
Receivables/revenue x 365 days days days
Payables days 95/203 x 365 days = 171 66/223 x 365 days = 108
Payables/cost of sales x 365 days days days
Inventories days 106/203 x365 days =191 89/223 x 365 days =146
Inventories/cost of sales x 365 days days
days
Return on capital employed (49-18-16)/(231+91) = (25-13-11)/(184+91) =
Profit before finance costs/capital 15/322 x 100 = 4.7% 1/275 x 100 = 0.4%
employed x 100%
Non-current asset turnover 252/254 = 0.99 248/198 = 1.3
Revenue/non-current assets
Interest cover (10+12)/12 = 1.8 ((7)+8)/8 = 0.1
Profit before finance costs/finance
costs

March 2011 10 Financial Management