Financial Reporting

(International Stream)
PART 2 THURSDAY 7 DECEMBER 2006

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A This ONE question is compulsory and MUST be answered THREE questions ONLY to be answered

Section B

Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall

The Association of Chartered Certified Accountants

Paper 2.5(INT)

Section A This ONE question is compulsory and MUST be attempted 1 Hosterling purchased the following equity investments: On 1 October 2005: 80% of the issued share capital of Sunlee. The acquisition was through a share exchange of three shares in Hosterling for every five shares in Sunlee. The market price of Hosterlings shares at 1 October 2005 was $5 per share. On 1 July 2006: 6 million shares in Amber paying $3 per share in cash and issuing to Ambers shareholders 6% (actual and effective rate) loan notes on the basis of $100 loan note for every 100 shares acquired. The summarised income statements for the three companies for the year ended 30 September 2006 are: Hosterling $000 105,000 (68,000) 37,000 400 (4,000) (7,500) (1,200) 24,700 (8,700) 16,000 Sunlee $000 62,000 (36,500) 25,500 nil (2,000) (7,000) (900) 15,600 (2,600) 13,000 Amber $000 50,000 (61,000) (11,000) nil (4,500) (8,500) nil (24,000) 4,000 (20,000)

Revenue Cost of sales Gross profit/(loss) Other income (note (i)) Distribution costs Administrative expenses Finance costs Profit/(loss) before tax Income tax (expense)/credit Profit/(loss) for the period The following information is relevant: (i)

The other income is a dividend received from Sunlee on 31 March 2006.

(ii) The details of Sunlees and Ambers share capital and reserves at 1 October 2005 were: Sunlee $000 20,000 18,000 Amber $000 15,000 35,000

Equity shares of $1 each Retained earnings

(iii) A fair value exercise was carried out at the date of acquisition of Sunlee with the following results: carrying amount $000 18,000 17,000 30,000 fair value $000 22,000 20,000 35,000 remaining life (straight line)

Intellectual property Land Plant

still in development not applicable five years

The fair values have not been reflected in Sunlees financial statements. Plant depreciation is included in cost of sales. No fair value adjustments were required on the acquisition of Amber. (iv) In the year ended 30 September 2006 Hosterling sold goods to Sunlee at a selling price of $18 million. Hosterling made a profit of cost plus 25% on these sales. $75 million (at cost to Sunlee) of these goods were still in the inventories of Sunlee at 30 September 2006. (v) Impairment tests for both Sunlee and Amber were conducted on 30 September 2006. They concluded that the goodwill of Sunlee should be written down by $16 million and, due to its losses since acquisition, the investment in Amber was worth $215 million. (vi) All trading profits and losses are deemed to accrue evenly throughout the year.

Required: (a) Calculate the goodwill arising on the acquisition of Sunlee at 1 October 2005. (5 marks)

(b) Calculate the carrying amount of the investment in Amber at 30 September 2006 under the equity method prior to the impairment test. (4 marks) (c) Prepare the consolidated income statement for the Hosterling Group for the year ended 30 September 2006. (16 marks) (25 marks)

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Section B THREE questions ONLY to be attempted 2 The following trial balance relates to Tadeon, a publicly listed company, at 30 September 2006: $000 Revenue Cost of sales Operating expenses Loan interest paid (note (i)) Rental of vehicles (note (ii)) Investment income 25 year leasehold property at cost (note (iii)) Plant and equipment at cost Investments at amortised cost Accumulated depreciation at 1 October 2005 leasehold property plant and equipment Equity shares of 20 cents each fully paid Retained earnings at 1 October 2005 2% Loan note (note (i)) Deferred tax balance 1 October 2005 (note (iv)) Trade receivables Inventories at 30 September 2006 Bank Trade payables Suspense account (note (v)) 118,000 40,000 1,000 6,200 2,000 225,000 181,000 42,000 36,000 85,000 150,000 18,600 50,000 12,000 53,500 33,300 1,900 18,700 48,000 700,000 $000 277,800

700,000

The following notes are relevant: (i) The loan note was issued on 1 October 2005. It is redeemable on 30 September 2010 at a large premium (in order to compensate for the low nominal interest rate). The finance department has calculated that the effective interest rate on the loan is 55% per annum.

(ii) The rental of the vehicles relates to two separate contracts. These have been scrutinised by the finance department and they have come to the conclusion that $5 million of the rentals relate to a finance lease. The finance lease was entered into on 1 October 2005 (the date the $5 million was paid) for a four year period. The vehicles had a fair value of $20 million (straight-line depreciation should be used) at 1 October 2005 and the lease agreement requires three further annual payments of $6 million each on the anniversary of the lease. The interest rate implicit in the lease is to be taken as 10% per annum. (Note: you are not required to calculate the present value of the minimum lease payments.) The other contract is an operating lease and should be charged to operating expenses. Other plant and equipment is depreciated at 121/2% per annum on the reducing balance basis. All depreciation of property, plant and equipment is charged to cost of sales. (iii) On 30 September 2006 the leasehold property was revalued to $200 million. The directors wish to incorporate this valuation into the financial statements. (iv) The directors have estimated the provision for income tax for the year ended 30 September 2006 at $38 million. At 30 September 2006 there were $74 million of taxable temporary differences, of which $20 million related to the revaluation of the leasehold property (see (iii) above). The income tax rate is 20%. (v) The suspense account balance can be reconciled from the following transactions: The payment of a dividend in October 2005. This was calculated to give a 5% yield on the companys share price of 80 cents as at 30 September 2005. The net receipt in March 2006 of a fully subscribed rights issue of one new share for every three held at a price of 32 cents each. The expenses of the share issue were $2 million and should be charged to share premium. Note: the cash entries for these transactions have been correctly accounted for. 4

Required: Prepare for Tadeon: (a) An income statement for the year ended 30 September 2006; and (b) A balance sheet as at 30 September 2006. Note: A statement of changes in equity is not required. Disclosure notes are not required. (25 marks) (8 marks) (17 marks)

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(a) Recording the substance of transactions, rather than their legal form, is an important principle in financial accounting. Abuse of this principle can lead to profit manipulation, non-recognition of assets and substantial debt not being recorded on the balance sheet. Required: Describe how the use of off balance sheet financing can mislead users of financial statements. Note: your answer should refer to specific user groups and include examples where recording the legal form of transactions may mislead them. (9 marks) (b) Angelino has entered into the following transactions during the year ended 30 September 2006: (i) In September 2006 Angelino sold (factored) some of its trade receivables to Omar, a finance house. On selected account balances Omar paid Angelino 80% of their book value. The agreement was that Omar would administer the collection of the receivables and remit a residual amount to Angelino depending upon how quickly individual customers paid. Any balance uncollected by Omar after six months will be refunded to Omar by Angelino. (5 marks)

(ii) On 1 October 2005 Angelino owned a freehold building that had a carrying amount of $75 million and had an estimated remaining life of 20 years. On this date it sold the building to Finaid for a price of $12 million and entered into an agreement with Finaid to rent back the building for an annual rental of $13 million for a period of five years. The auditors of Angelino have commented that in their opinion the building had a market value of only $10 million at the date of its sale and to rent an equivalent building under similar terms to the agreement between Angelino and Finaid would only cost $800,000 per annum. Assume any finance costs are 10% per annum. (6 marks) (iii) Angelino is a motor car dealer selling vehicles to the public. Most of its new vehicles are supplied on consignment by two manufacturers, Monza and Capri, who trade on different terms. Monza supplies cars on terms that allow Angelino to display the vehicles for a period of three months from the date of delivery or when Angelino sells the cars on to a retail customer if this is less than three months. Within this period Angelino can return the cars to Monza or can be asked by Monza to transfer the cars to another dealership (both at no cost to Angelino). Angelino pays the manufacturers list price at the end of the three month period (or at the date of sale if sooner). In recent years Angelino has returned several cars to Monza that were not selling very well and has also been required to transfer cars to other dealerships at Monzas request. Capris terms of supply are that Angelino pays 10% of the manufacturers price at the date of delivery and 1% of the outstanding balance per month as a display charge. After six months (or sooner if Angelino chooses), Angelino must pay the balance of the purchase price or return the cars to Capri. If the cars are returned to the manufacturer, Angelino has to pay for the transportation costs and forfeits the 10% deposit. Because of this Angelino has only returned vehicles to Capri once in the last three years. (5 marks) Required: Describe how the above transactions and events should be treated in the financial statements of Angelino for the year ended 30 September 2006. Your answer should explain, where relevant, the difference between the legal form of the transactions and their substance. Note: The mark allocation is shown against each of the three transactions above. (25 marks)

This is a blank page. Question 4 begins on page 8.

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Minster is a publicly listed company. Details of its financial statements for the year ended 30 September 2006, together with a comparative balance sheet, are: Balance Sheet at Non-current assets (note (i)) Property, plant and equipment Software Investments at fair value through profit and loss Current assets Inventories Trade receivables Amounts due from construction contracts Bank Total assets Equity and liabilities Equity shares of 25 cents each Reserves Share premium (note (ii)) Revaluation reserve Retained earnings Non-current liabilities 9% loan note Environmental provision Deferred tax Current liabilities Trade payables Bank overdraft Current tax payable Total equity and liabilities Income statement for the year ended 30 September 2006 Revenue Cost of sales Gross profit Operating expenses Finance costs (note (i)) Investment income and gain on investments Profit before tax Income tax expense Profit for the year The following supporting information is available: (i) Included in property, plant and equipment is a coal mine and related plant that Minster purchased on 1 October 2005. Legislation requires that in ten years time (the estimated life of the mine) Minster will have to landscape the area affected by the mining. The future cost of this has been estimated and discounted at a rate of 8% to a 30 September 2006 $000 $000 1,280 135 150 1,565 480 270 80 nil 510 380 55 35 30 September 2005 $000 $000 940 nil 125 1,065

830 2,395 500

980 2,045 300

150 60 950

1,160 1,660

85 25 965

1,075 1,375

120 162 18 350 25 60

300

nil nil 25 555 40 50

25

435 2,395

645 2,045 1,397 (1,110) 287 (125) 162 (40) 20 142 (57) 85

present value of $150,000. This cost has been included in the carrying amount of the mine and, together with the unwinding of the discount, has also been treated as a provision. The unwinding of the discount is included within finance costs in the income statement. Other land was revalued (upward) by $35,000 during the year. Depreciation of property, plant and equipment for the year was $255,000. There were no disposals of property, plant and equipment during the year. The software was purchased on 1 April 2006 for $180,000. The market value of the investments had increased during the year by $15,000. There have been no sales of these investments during the year. (ii) On 1 April 2006 there was a bonus (scrip) issue of equity shares of one for every four held utilising the share premium reserve. A further cash share issue was made on 1 June 2006. No shares were redeemed during the year. (iii) A dividend of 5 cents per share was paid on 1 July 2006. Required: (a) Prepare a cash flow statement for Minster for the year to 30 September 2006 in accordance with IAS 7 Cash flow statements. (15 marks) (b) Comment on the financial performance and position of Minster as revealed by the above financial statements and your cash flow statement. (10 marks) (25 marks)

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(a) (i)

State the definition of both non-current assets held for sale and discontinued operations and explain the usefulness of information for discontinued operations. (4 marks)

Partway is in the process of preparing its financial statements for the year ended 31 October 2006. The companys main activity is in the travel industry mainly selling package holidays (flights and accommodation) to the general public through the Internet and retail travel agencies. During the current year the number of holidays sold by travel agencies declined dramatically and the directors decided at a board meeting on 15 October 2006 to cease marketing holidays through its chain of travel agents and sell off the related high-street premises. Immediately after the meeting the travel agencies staff and suppliers were notified of the situation and an announcement was made in the press. The directors wish to show the travel agencies results as a discontinued operation in the financial statements to 31 October 2006. Due to the declining business of the travel agents, on 1 August 2006 (three months before the year end) Partway expanded its Internet operations to offer car hire facilities to purchasers of its Internet holidays. The following are Partways summarised income statement results years ended: 31 October 2006 Internet travel agencies car hire $000 $000 $000 23,000 14,000 2,000 (18,000) (16,500) (1,500) 5,000 (2,500) 500 (1,000) (1,500) (100) 4,000 (4,000) 400 31 October 2005 total total $000 $000 39,000 40,000 (36,000) (32,000) 3,000 8,000 (2,600) (2,000) 400 6,000

Revenue Cost of sales Gross profit/(loss) Operating expenses Profit/(loss) before tax

The results for the travel agencies for the year ended 31 October 2005 were: revenue $18 million, cost of sales $15 million and operating expenses of $15 million. Required: (ii) Discuss whether the directors wish to show the travel agencies results as a discontinued operation is justifiable. (4 marks) (iii) Assuming the closure of the travel agencies is a discontinued operation, prepare the (summarised) income statement of Partway for the year ended 31 October 2006 together with its comparatives. Note: Partway discloses the analysis of its discontinued operations on the face of its income statement. (6 marks) (b) (i) Describe the circumstances in which an entity may change its accounting policies and how a change should be applied. (5 marks)

The terms under which Partway sells its holidays are that a 10% deposit is required on booking and the balance of the holiday must be paid six weeks before the travel date. In previous years Partway has recognised revenue (and profit) from the sale of its holidays at the date the holiday is actually taken. From the beginning of November 2005, Partway has made it a condition of booking that all customers must have holiday cancellation insurance and as a result it is unlikely that the outstanding balance of any holidays will be unpaid due to cancellation. In preparing its financial statements to 31 October 2006, the directors are proposing to change to recognising revenue (and related estimated costs) at the date when a booking is made. The directors also feel that this change will help to negate the adverse effect of comparison with last years results (year ended 31 October 2005) which were better than the current years. Required: (ii) Comment on whether Partways proposal to change the timing of its recognition of its revenue is acceptable and whether this would be a change of accounting policy. (6 marks) (25 marks) End of Question Paper 10