Blog

MARCH 2020 EXAMINATIONS EXAMINATIONS FOR THE MSC IN FINANCE, MSC IN ACCOUNTING AND FINANCIAL MANAGEMENT AND MSC IN ADVANCED FINANCIAL ANALYSIS AcF603 FINANCIAL REPORTING FOR COMPLEX ENTITIES AcF642 ADVANCED FINANCIAL REPORTING AND ANALYSIS Time: 3 hours (no additional reading time) This exam is open book. Answer TWO questions, one from Section A and one from Section B. All questions carry equal marks. SECTION A A1. HighGrowth Plc. On 1 January 2017, HighGrowth Plc. granted 5,000 share options to each of its 100 top executives. Each share option allows the holder to purchase one share of HighGrowth Plc. At an exercise price of ￡4 per share. Each share of HighGrowth Plc has a nominal value of ￡2. The share options can be exercised by the executives up to 5 years after the vesting date. The share options vest in 3 years’ time provided a) the employee is in continuous employment with the company throughout the vesting period, b) Sales increase by an average of 10% per year over the vesting period and c) the share price increases by an average of 5% per year over the vesting period. On 1 January 2017, HighGrowth Plc. expects 20% of its top executives to leave the company before the end of the vesting period and using an IFRS 2 option-pricing model it estimates that the fair value of each share option at grant date is ￡5 per option. In the year ended 31 December 2017, 10 top executives left HighGrowth Plc., sales increased by 9% and the share price increased by 2%. On 31 December 2017, HighGrowth Plc. estimated that another 20 top executives will leave the company over the next 2 years; that the rate of increase in sales will be 15% per year over the next 2 years and that the rate of increase in share price will remain 2% per year over the next 2 years. The fair value of the share options at 31 December 2017 was ￡4. In the year ended 31 December 2018, 10 top executives left HighGrowth Plc., sales increased by 15% and the share price increased by 5%. On 31 December 2018, HighGrowth Plc. estimated that another 8 top executives would leave the company by the end of the vesting period; that the increase in sales for the following year would be just 2% and that the share price would increase by 6% in the following year. The fair value of the share options at 31 December 2018 was ￡2. In the year ended 31 December 2019, no top executive left the company, sales increased by 12% and share price increased by 2%. The share options did not vest because the share price condition was not met. The fair value of the share options at 31 December 2019 was ￡3. REQUIRED i) Explain why share based payments are typically used in executive remuneration contracts. (8 marks) ii) By referring to HighGrowth Plc. identify the different types of vesting conditions typically found in share based payments and explain how the type of vesting conditions affect the accounting for share based payments. (15 marks) iii) Calculate the compensation expense that HighGrowth Plc. needs to recognise in its financial statements for financial years ending 31 December 2017; 31 December 2018 and 31 December 2019 in respect of the share based payment scheme described above. Explain your workings. (15 marks) iv) Show the journal entries to be undertaken at the end of financial years ending 31 December 2017; 31 December 2018 and 31 December 2019 by HighGrowth Plc. to record the compensation expense in respect of the share based payment scheme. Explain the journal entries. (12 marks) (TOTAL 50 MARKS) A2. GoodFood Plc. You are a newly appointed Accountant for GoodFood Plc. and you have been asked to prepare a report to be submitted to the Board of Directors of the company in which you discuss the Statement of Other Comprehensive Income. In your report you are required to: a) Explain why the standard setter require the presentation of the Statement of Other Comprehensive Income in the financial statements. In your answer you are required to compare clean surplus accounting to dirty surplus accounting. (10 marks) b) Provide examples of items typically included in the Statement of Other Comprehensive Income and by referring to the persistence of these items justify why such items are included in the Statement of Other Comprehensive Income rather than the Income Statement. (20 marks) c) Explain the concept of recycling of items of Other Comprehensive Income to the Income Statement and discuss how recycling influences the usefulness of financial statements. (20 marks) (TOTAL 50 MARKS) SECTION B B1. Vetch plc Claudia Thiel is preparing for a job interview for a role within the group finance team of a large international conglomerate, Vetch plc. The group has interests in manufacturing, distribution and retail across Europe with particular expertise in products associated with infrastructure such as steel and cement. Claudia is aware that a majority of the growth has been through strategic acquisitions and suspects that knowledge of the financial reporting issues associated with group accounting will feature prominently in her interview questions. She is already friends with an employee at the company who has provided her with some publicly available financials on the group and some of its recent investments, and will use these to revise the skills she learned for her accountancy qualification. Details of the investments made by Vetch plc included the following information: On 1 January 2016 a 90% controlling stake was purchased in Mallow plc for ￡450m. The consideration comprised 1 share in Vetch plc for every 5 shares in Mallow plc. At the date of the investment the retained earnings of Mallow plc were ￡80m. On 31 August 2018 Vetch plc purchased a 50% stake in Oxlip plc for ￡200m when the retained earnings of the target company were ￡46m. The remaining 50% of the equity in Oxlip plc is owned by an American company operating in the transportation sector and an agreement has been reached with Vetch plc that all operating and financing decisions relating to Oxlip plc will require the agreement of both investors. The statements of financial position of the three companies as at 31 December 2019, their year end reporting date, are shown below and already reflect the investments by Vetch plc in Mallow plc and Oxlip plc: Vetch Mallow Oxlip ASSETS ￡m ￡m ￡m Tangible non-current assets 2,100 110 240 Intangible non-current assets – 20 – Investment – Mallow 450 – – Investment – Oxlip 200 – – Inventory 1,011 480 120 Receivables 329 70 40 Other monetary assets 250 205 176 4,340 885 576 Vetch Mallow Oxlip ￡m ￡m ￡m EQUITY AND LIABILITIES Ordinary shares (￡1 nominal) 800 50 100 Share premium 650 200 130 Other reserves 100 – – Retained profits 1,340 200 170 2,890 450 400 Non-current liabilities: Loans 1,200 280 90 Current Liabilities: Trade payables 197 120 66 Tax accrual 53 35 20 4,340 885 576 Additional information: The intangible assets in the books of Mallow Plc are patents linked to dry line cement technology. At the acquisition date the fair value of Mallow plc’s non-current property assets was identified as being ￡40m more than their book value. These assets had a 20-year remaining useful life as at 1 January 2016. The inventory of Mallow plc at 31 December 2019 includes ￡60m of steel transferred from Vetch plc at a transfer price of ￡100 per tonne. The original transfer was ￡120m but 50% had already been sold to a third-party customer by the year end. Vetch plc had purchased this steel for ￡80 per tonne in the open market. The share capital of Mallow plc and Oxlip plc have remained unchanged since the date of the investment made by Vetch plc. There have been no impairments to goodwill since the acquisition dates. The pro-rata net assets approach is adopted for the calculation of non-controlling interests (i.e. there is no grossing up for goodwill) Claudia has also located an article by a leading financier in a business magazine that is highly critical of the approach taken by Vetch plc accounts team when recording some of its investments. He believes they have overstated the Group’s key performance indicators and hence the share price has been artificially inflated. The key criticisms stated were: [1] Vetch has used equity accounting for its joint venture in Oxlip plc…surely proportional consolidation would be more appropriate [2] Equity accounting always makes a company’s gearing look better! When practising consolidated accounts in advance of her interview Claudia keeps making errors when calculating goodwill and its post-acquisition treatment. Concerned that this might prove important on the day she has emailed her sister-in-law who works as a senior audit manager with one of the ‘Big Four’ accountancy practices seeking her advice. The email is detailed below: ___________________________________________________________________________ Sue Hope all is well in the world of auditing! I want to pick your brains in advance of an interview for a new job at Vetch plc and remembered that you were always strong when it came to the calculations! I am struggling to understand the approach to goodwill and its subsequent treatment in the accounts and would really value your help. The best way for me to highlight the problems encountered is to detail two questions I have been attempting and repeatedly getting wrong. (continued overleaf) a) Sloe plc holds a 18% stake in Hellebore plc at cost of ￡200,000. On 31 January 2020, it acquires a further 62% for a cost of ￡950,000. As at 31 January 2020: Hellebore plc’s net assets had a fair value of ￡1,000,000 The fair value of the non-controlling interest was ￡225,000 The fair value of the 18% stake was ￡300,000 Calculate the goodwill arising on the stepped acquisition. Assume that it is the group policy to use the full goodwill method. b) Greenweed plc owns 75% of the voting share capital in Bennet plc, and considers the latter to be a single cash generating unit (CGU). As at 31 December 2019 this CGU has assets with the following carrying values: ￡m TOTAL goodwill 2,600 Financial assets 2,000 Other assets 5,100 9,700

i) Greenweed group uses THE FULL GOODWILL approach. ii) There are no market value-related constraints on the writing down of ‘other assets’, and the financial assets are already measured at their current market value. Assume the NPV-based ‘value in use’ of the CGU has been estimated at ￡8,000m. Calculate the amount and allocation of goodwill impairment Thanks in advance for your help. Best wishes Claudia REQUIRED a) Calculate the following figures as they would appear in the consolidated statement of financial position as at 31 December 2019: i) Goodwill (4 marks) ii) Tangible non-current assets (4 marks) iii) Inventory (3 marks) iv) Share capital (2 marks) v) Retained profits (5 marks) vi) Non-controlling interests (3 marks) (TOTAL 21 MARKS) b) Claudia has identified that the Vetch group uses the pro-rata net assets approach when calculating goodwill. Discuss how this would differ from any other allowed alternative under IFRS, and identify at least one major challenge associated with the capture of relevant information of any alternative described. (5 marks) (continued overleaf) c) Briefly respond to the two criticisms highlighted by the magazine article written by a leading financier, determining if you consider them to be valid. o Criticism 1 (3 marks) o Criticism 2 (3 marks) d) Calculate the goodwill attributable to the stepped acquisition as described in Claudia’s first question. (5 marks) e) Calculate the amount of any impairment and its allocation using the details set out in Question 2 of Claudia’s email and determine the impact on both goodwill and non-controlling interests. (6 marks) f) Subsequent to the resolution of her queries Claudia is confident about her ability to tackle difficult questions linked to the detailed calculations that underpin the preparation of consolidated financial statements. However, she is concerned that questions may also be more discursive around the principles and logic for group accounting. She decides to prepare a key features list that will summarise acquisition accounting in a maximum of four bullet points together with a brief description of the principle that commercial substance will override the strict ‘letter of the law’. What information would you expect to be included in Claudia’s notes (7 marks) (TOTAL 50 MARKS) B2. Oregon plc Oregon plc is a long-established company that specialises in the supply of tinned fruit. Its head office and manufacturing unit are in Sheffield (UK) and it has a subsidiary in California (USA), Mandarin Corp, that grows citrus fruits; notably oranges and satsumas, and also purchases and retails a range of other fruits. After some poor trading results the executive management team of Oregon plc has changed including the finance director with Karen Street being head hunted from a major competitor to take up this post. Karen is aware she needs to make an impact quickly and decides to speak with all the major stakeholders of Oregon plc including key shareholders, stock market analysts and lending institutions. It is quickly apparent that all of these parties have grown nervous about the performance of Oregon plc and in particular the lack of predictability, pointing to reported profits that often deviate significantly from forecasts released to the financial markets. Karen decides that the failure to hedge foreign currency exposures is the largest factor for the performance volatility, and asks her finance team to prepare a brief report for the Board that addresses the following questions: Q1: Is hedge accounting the same as commercial hedging Q2: Why would hedging be beneficial and are there any downsides She also wants an appendix which gives a numerical example of the approach, and has asked that it is based on a historical purchase of a new canning machine so that the actual outcome can be compared with the outcome that would have been achieved if hedge accounting had been applied. Details of the purchase were as follows: The canning machine was imported to the UK from Thailand where it was constructed and customised to the specific requirements of Oregon plc The price agreed as at 1 April 2019 was THB 40 million [TBH = Thai Baht], but settlement was made on delivery The machine was delivered three months after the contract was signed To hedge the currency exposure a three-month forward contract would have been used committing Oregon plc to purchase TBH 40 million at a contracted rate of TBH 39 to ￡1. Further details relating to the exchange rate were as follows: The challenge of foreign currency exposure is not restricted to the acquisition of capital assets, but also relates to the translation of the year-end financial statements of Mandarin Corp and the production of consolidated figures. Each year Oregon plc sends an instruction list to the finance manager of Mandarin Corp and requests information on exchange rates, transaction dates etc, but it has always proved difficult to get a prompt response. The finance manager of Mandarin Corp has a challenging task convincing his fellow directors that the information request is really necessary as they insist it is not a priority. For example on 31 March 2018 Mandarin Corp purchased a new fruit picking machine at a cost of $500,000 which was reflected in their statement of financial position at the year-end; given this recognition the company directors were irritated to receive a ‘confrontational’ email from the finance team of Oregon plc demanding further details regarding the spot exchange rate on the purchase date of the picker. The one thing that both management teams can agree on is that the useful economic life of the picker is 5 years and that there will be no salvage value. (continued overleaf) TBH to ￡1 1 April 2019 40 30 June 2019 37 Average three months ended 30 June 2019 38.5 Although the management team of Mandarin Corp are viewed as difficult, they always comply, if slowly, with the requests made by Oregon plc as the latter likes to take an active involvement in their day to day operations. However, it should be noted that all purchases made by Mandarin Corp are in US $, and they arrange all long-term funding locally without interference from the parent company. This mixture of parental involvement is something that has been mentioned to Karen Street by one of the non-executive directors, who has no detailed accounting knowledge, but had recently seen an article whilst travelling in California about differences in the approach to foreign currency translation of overseas entities dependent on the operational and financial involvement of the parent company. They have no doubt about Karen’s competence but have asked her to explain how the content of the article applies to Oregon plc with emphasis on two approaches, temporal and closing rate, that were specifically referred to in the article. Both Oregon plc and Mandarin Corp have a 31 December year end, and their summary statements of financial position for 2019 were as follows: Oregon Mandarin ￡000 $000 PPE 2,500 1,110 Investment – Mandarin 910 – Inventory 920 200 Receivables 250 320 Other monetary assets 610 550 5,190 2,180 Share capital 1,000 500 Retained profits 3,180 940 4,180 1,440 Loans 800 650 Current payables 210 90 5,190 2,180 Additional information: Oregon holds an 80% equity stake in Mandarin Corp. This was acquired on 31 March 2015 when the retained earnings of Mandarin Corp were $480,000. It is group policy to use the net assets approach for the calculation of goodwill Both Oregon plc and Mandarin Corp apply straight line depreciation to definite life tangible non-current assets with a full year being charged in the year of purchase and none in the year of disposal. With the exception of the new picker purchased in 2018 the only other non-current asset attributable to Mandarin Corp is land which has an indefinite expected life; consequently it incurred no depreciation The inventory of Mandarin Corp comprises of two elements [1] $135,000 of lemons and grapefruits purchased from a local (i.e. USA based) supplier; it holds this inventory in refrigerated storage for an average of one month between purchase and sale (continued overleaf) [2] $65,000 of oranges and satsumas; typically these fruits are held for less than one day before being sold and transported to Oregon plc to ensure optimum freshness There have been no asset impairments recorded by either company in the last five years Exchange rates: REQUIRED a) Briefly explain the difference between hedge accounting and commercial hedging. (3 marks) b) Summarise what you expect to be some of the main benefits and disadvantages of hedge accounting as detailed by the finance team in the report they prepare for the board. (6 marks) c) Calculate the impact of the purchase of the new canning machine on the reported profits with and without the existence of the forward currency contract. Additionally, briefly explain i) why the use of the forward contract has been beneficial ii) Criticisms of the exchange rate contracted [Calculations to the nearest ￡’000] (10 marks) d) In response to the concerns raised by the non-executive director describe when the temporal and closing rate approaches are used to translate the financial books of an overseas equity investment and highlight if there is any differences in their application under IFRS and US GAAP. State what approach is most likely to be used Oregon plc for the translation of Mandarin Corp. Remember Oregon plc uses IFRS in the preparation of its group financial statements (as required for EU listed groups since 2005). (9 marks) e) Calculate the amount shown in the consolidated statement of financial position of Oregon plc as at 31 December 2019 for each of the following under both the temporal and closing rate methods: 1) PPE (8 marks) 2) Inventory (8 marks) 3) Other monetary assets (6 marks) [Calculations to the nearest ￡’000] (TOTAL 50 MARKS) END OF EXAM $ to ￡1 31 March 2015 1.62 31 March 2018 1.5 30 November 2019 1.35 31 December 2019 1.3 Average for year ended 31 December 2019 1.25