Standard Answers (in my own words)

Social responsibility
The operation of a business often affects many stakeholders so firms should try to be sustainable when
conducting their operations. Sustainability refers to developments that meet the present need without
compromising the ability of future generations meeting their needs (Acted CB1 Core Reading 2020 chapter 15).
A company should recognise the fact that the actions they take now will have implications for the future
generations. For example, externalities such as emissions and pollution can create health hazards and increase
the risk of global warming. If the business has many factories with large production line, it could generate a
significant amount of pollution if they don’t consider their social responsibilities. However, being socially
responsible can be expensive for companies as they would incur costs to process any emissions or find
alternative/more sustainable ways to conduct operations. Social responsibility can also be considered from an
economic point of view. E.g. companies than conducts their manufacturing offshore where minimum wage
doesn’t exist. The company’s reputation might be damaged as customers may be unwilling to associate with
such company. Often companies that are socially responsible and consider economic, social and environmental
factors can attract and retain employees as well as customers. It also increases the competitiveness of the
company in the market and can have a positive impact on the company’s reputation. This can often translate
into higher share prices for companies that are socially responsible.

Preference shares
 Preference shares are sometimes accounted for as debt rather than equity
 Preference shares hold characteristics of both debt and equity.
 Preference shares pay a fixed stream of dividend similar to a fixed-interest borrowing. These fixed
payments increase the risk of ordinary shareholders in the same way as fixed payments associated with
debt as dividends on preference shares must be paid before ordinary shares. If preference dividends are
suspended, they will be carried forward to the next period so they will be paid to preference
shareholders eventually.
 In a wind up, preference shareholders are ranked before ordinary shareholders but after loan capital.
 Preference shares is less risky than ordinary shares and therefore have a lower expected return.
However, it is riskier to hold a preference share than a loan stock so the expected return on preference
shares is higher than that of loan stock/debt.
 Unlike interests on debts, the company can choose to not pay any preference dividends if the company
cannot afford to pay any. However, this means no dividends can be paid on ordinary shares as well.
Frequent suspension of preference dividends can cause reputational damages.

Budgeting Ch17
Top-down budgeting occurs when budgetary targets are being set by the senior management team and imposed
on the junior employees. When budgeting expenses relating to staff travel and accommodation, top-down
budgeting might be more suitable and effective. This is because if budgets were set bottom-up, managers would
have more incentive to set a slack budget so they can spend more when they travel and make their trip more
luxury, comfortable and enjoyable e.g. hotel suites, first class plane tickets etc. In other words, junior managers
can benefit directly from a bigger travel budget. Top-down budgets also allow the senior managers to set an
appropriate standard.

Budgeting can also be bottom-up where junior managers can set their own budgets for their team and then
integrated into an overall budget for the business. This type of budgeting method can help motivate junior
managers and employees as it makes them feel more involved in the process. Bottom-up budgeting may be
most effective when the business has many branches/teams, and the senior management team does not have a
good understanding of the granular costs involved in the operation of each branch/team.

There is also zero-based budgeting where the process begins with a blank piece of paper and all changes need to
be justified. This method can be effective when the company feels like it has a lot of excessive expenses that are
not required as beginning with a zero budget can help eliminate such expenses. However, this method is
generally very time consuming.

Cash flow Statement

The company’s cash flow statement highlights whether the business is able to generate sufficient cash from its
operations. Cash flow statements allow users to understand the cashflows generated from the company’s
operating, investing and financing activities and identify any large cash inflows and outflows. While looking at
the cash flows can provide an indication of the performance of the company, it does not offer a complete view
of the company’s activities. This is because any assets purchased on credit will not be reflected in the cash flow
statement. Similarly, any sales that have not been settled yet will not be in the cashflow statement. Cash flow
and profit are also not the same as profit can be affected by many variables such as depreciation which has
elements of subjectivity. Users are also able to see the company’s cash movement by looking at the change in
bank balance in the statement of financial position.
Accounting standards IFRS/IASB
The primary purpose of financial statements is to inform decisions. The accounting standards are set by IASB.
IASB must ensure that the standard they set addresses the needs of all key stakeholder/users of the financial
statements. As different users have different needs, IASB need to first identify the stakeholders in order to
address their interests. For example, shareholders may be more interested in the profit or loss of the company
as it will directly impact their wealth, lenders would want to see evidence that the company has sufficient assets
and cashflows to repay interests and loans.
Accounting standards are in place to ensure that all companies prepare their financial statements consistently
so they can be compared with each other and from year to year. Having consistent financial statements with
less variations can also draw more meaningful conclusions when being compared. Accounting standards also
make the financial statements more credible to readers. Accounting standards also provide a benchmark for
auditors to check the fair presentation of the financial statements. Complying to the standard also means that
companies may need to disclose more information than that required by laws.

Share price to manage directors

The share price of a quoted company can provide an indication of the market’s view of the company’s directors
and any expected future cash flows. In a way, the share price is a reflection of both the business and its
management. The fact that the share price is sensitive to the behaviours of the directors can help prevent any
reckless or irresponsible decisions from the directors. For example, a fall in the share price could be a sign that
the market is dissatisfied with the directors. As a result, the directors will change their behaviour as they will
fear that continuous fall of the share price could attract a takeover bid. This is because predators usually believe
that poor/weak share price performance is a sign of a potentially profitable business and would offer a premium
over the share price to take over the business. In addition, shares are often offered as part of the director’s
remuneration to provide incentive to act in the best interest of the company’s shareholders as they would want
to try and maximise their own wealth. This reduces the risk of any agency problems.

Agency issues
Principals (e.g. shareholders or owners) generally appoint agents (e.g. directors or management team) to act on
their behalf. Agency problems arise when the interest of the principals and agents diverge. Sometimes conflict
of interest will cause the agents to abuse their power so the principals may feel like they can no longer trust the
agents. For example, if the agents’ salary or bonuses is linked to the company’s profit, the directors may choose
to switch to a different approach for calculating depreciation in order to inflate the profit. The fear of agents
acting in such a way may give rise to agency costs which can be very expensive.

Futures
A future is a standardised, exchange tradable contract between two parties to trade a specified asset on a
specified day in the future at a specified price. There is no exchange of cash until the maturity date. As there are
2 counterparties involved, there is an underlying risk that one party may not fulfil their obligation or default.
However, futures contracts are generally traded via a third-party clearing house. To reduce the risk of
participants defaulting, the clearing house will collect margin payments. An initial margin is paid when the
contract is first truck, then additional margin payments (based on some underlying rates) are paid to the
clearing house on a daily basis to minimise the exposure to default risk. The clearing house holds a margin to
ensure that if one party default, there is sufficient amount to settle any liability. For the two parties involved,
paying a margin can tie up cash which could potentially lend to liquidity issues if they trade a large number of
futures. Also, there is no interest earned on the margin deposits.

Currency futures can be used to mitigate risk against currency movements. For example, the company may have
some trade receivables in a foreign currency and there is significant risk that the currency could move adversely
before settlement date in which case the company would receive less payment. Currency future can be used to
guarantee the future receipts.

Gearing Ratio
The company’s gearing ratio represents the relative proportion of long-term debt and equity. A high gearing
ratio means that the company has a high level of debt financing relative to equity. In theory, the optimal level of
gearing ratio is where the weighted average cost of capital is at its minimum. The company can initially reduce
its WACC by increasing debt as debt is cheaper than equity and offers some tax relief. However, if the level of
debt financing is too high, both debt and equity holders will require a higher level of return, thus increasing the
WACC. The turning point where the cost of increasing debt outweighs the savings represents the optimal level
of gearing.

The optimal gearing level for each company is different as it also depends on the line of business. It is generally
harder and more expensive for companies with few tangible assets to acquire additional debt finance. For
example, a property company that owns many real estate can afford to have a higher gearing ratio than say, a
consulting firm with few tangible assets. Also, debt will attract interests which can be a significant expense if
gearing is high. Therefore companies also need to consider the impact on its cashflows when deciding what its
optimal gearing level is. A benefit of debt is that interest payments are tax deductible. A high amount of debt
finance will also increase the volatility of returns. This usually means that a stable business with a steady stream
of income can afford to increase its borrowing whereas a business in a volatile industry should avoid having too
much debt finance as it will increase the risk of failure.

Gearing ratio in different countries Q16 April 2017

PE Ratio
A company’s PE ratio can inform its directors of the market’s perception of the company’s performance and
earnings. For example, a low PE ratio could be an indication that the market believes the company is not an
attractive investment option due to the high level of risk and/or weak potential earnings. This means that the
company’s share price is relatively low in comparison to other similar companies and that the shareholders are
willing to pay a lower multiple of the company’s EPS. This information is useful to the directors as it could
indicate that there are problems that need to be addressed. The directors may need to review the company’s
current strategies and perhaps find alternative ways to maximise profits. If performance and profits can be
improved, then the company’s share price and PE ratio will increase. A prolonged period of declining PE ratio is
unfavourable as it could indicate that the business is failing, and some drastic changes may be required.

External Audit
As the company’s directors are responsible for the preparation of financial statements, the external auditors
play a crucial role as they must express their opinion of whether the statements have been prepared in
accordance with the accounting standards and whether it gives a true and fair view. After gathering, reviewing
and analysing all relevant data and policies, the auditors will produce an audit report where it will state the
auditor’s opinion on the truth and fairness of the produced statements. If no issues are found in the audit
process, the audit report will be an unqualified opinion, meaning that shareholders can rely on the figures in the
company’s financial statements. The auditor report merely expresses the truth and fairness of the company’s
financial statements and does not comment on things like the credit worthiness of the company or if the
company is a good investment or not so it’s up to the readers on how they interpret the information.

A company’s financial statements are used by many stakeholders and needs to be credible. As the financial
statements contain information which can be used to evaluate the company’s directors, users might fear that
directors might manipulate the statements to make the company look more profitable than it actually is if the
statements are not audited by an external auditor. It is important for the financial statements of the company to
be credible in order to be reputable and trustworthy.

The main challenge for external auditors is that truth and fairness can be subjective and are hard to define. For
example, if the auditor provides an unqualified opinion on a company but later receives a complaint which
challenges the truth and fairness of the company’s statement, the auditor and its associated company could lose
credibility. Although there are accounting standards in place to govern the process, but the standards can be
vague and open to interpretation. Also, auditors need to pay extra attention to identify any creative accounting
and any abuse of subjectivity in the preparation of accounts.

Tax on gain on revaluation

As a gain on revaluation of asset represents an increase in shareholders’ wealth, it should be taxed when the
gain occurs. However, as the market value of asset can fluctuate from time to time, it may be hard to calculate
the tax liability. For example, if the market value falls in the future, then the tax paid on the revaluation gain
should be refunded to the company. If tax is calculated every time the market value changed, it would make the
process very difficult to manage. Therefore, for simplicity, gains on revaluation are not taxed.

Diluted EPS
While the based EPS only takes into account the number of shares in issue, the diluted EPS is adjusted to reflect
any potential impact of any conversion rights or options on the ordinary shares. For example, the company may
issue financial instruments that permits their holder to purchase new shares at a future date or within a
specified period. The diluted EPS assumes that all the conversion rights and/or options were exercised on the
first day of the financial period. When the basic EPS and diluted EPS have a large difference, it means the
company has a large amount of warrants or other financial instruments in issue. This information should be
disclosed to the shareholders as they would want to know how diluted their holdings can potentially become
and help them recognise the possible impact on EPS and the PE ratio. If the company has a very large number of
options and/or warrants in issue, the ordinary shareholders would not be aware of its impact until they have
been exercised IF the company does not disclose their diluted EPS. In general shareholders do not wish to see
their interests/holdings being diluted. However, the basic EPS is more relevant to shareholders in determining
the effectiveness of the directors in managing the company. The diluted EPS is simply a “worst case scenario”.

Financial statements
The purpose of financial statements is to inform decisions. However, the usefulness of the figures in the
financial statements is hindered by the fact that it is historical and out of date by the time it is published. In
other words, the information in the financial statements is mostly retrospective. Lenders and shareholders may
be more interested in the company’s future cash flows and its ability to generate profit and repay loans.

Accounting Ratios
While accounting ratios can provide some useful insight into the business, it should not be used in isolation. It is
crucial to understand the business and take into account the industry the company operates in when analysing
the ratios. The accounting ratios can vary significantly between companies in different industries. For example,
the inventory turnover period for a supermarket would be much higher than say, a car dealership. It is easy to
overlook many key information if the user focuses solely on the ratios. The ratios are based on the information
disclosed in the company’s financial statements which only represents the company at one point in time. For
example, a company may have low liquidity ratios, but past trends have shown that it has had a low but stable
ratio for many years thus the low ratio is acceptable and adequate. In addition, there is a delay in publishing
financial statements meaning by the time the annual reports are published, the information will be out of date
thus hindering the usefulness of the information. Analysing trends can also help identify how effective the
company manages its liquidity and operations. Viewing ratios at one point in time can be misleading when
analysed in isolation. Furthermore, directors can manipulate and distort the numbers in the statements by
changing the accounting policy which will also distort the ratios. Ratio analysis can be complicated and it would
be very unwise to base any decisions on a single ratio.

Liquidity Ratios
Liquidity is important as it ensures the survival of the company in the short term. Liquidity problems can cause a
company to fail due to an inability to pay debts as they fall due. It is important to maintain an adequate level of
liquidity. Having too much cash tied up can also be a problem as it means that the resources are not being used
efficiently to generate greater returns. In liquidity is already at an adequate level then there is no immediate
advantage to have more tied up in cash/working capital.

Profitability Ratios
A company’s profitability ratios are particularly useful to shareholders as it can help them see if the company is
generating sufficient returns. Shareholder’s wealth is directly related to the company’s profitability – greater
profits will increase shareholder’s wealth. When a company is consistently profitable, it reduces the chance of
running into liquidity issues as profits generally indicates that the company has the ability to generate sufficient
cash flows from its operations. A company’s annual profit figure can be found in the Statement of Profit or Loss.
There are a number of useful indicators of profitability: return on capital employed (ROCE), return on equity
(ROE), profit margin and asset utilisation ratio. ROCE is the most useful as it indicates how much profit is
generated for each dollar of capital. This also provides insight into how efficient the managers are at managing
the capital. A low ROCE may be a sign that the profit generated does not justify the amount ofcapital tied up in
the business. The other profitability measures also provide some insights into the key aspects of the company.
For example, analysing the profit margin can reveal some information about the company’s pricing strategy and
whether products are priced appropriately. Shareholders may be more interested in the company’s return on
equity (ROE) as it tells them how much profit is generated on equity.

ROCE should be reviewed annually, not monthly 215 April Q19 iii)

Determining Company Tax

The calculation should start with the accounting profit figure in the financial statements (statement of profit and
loss) then apply adjustments according to the relevant tax laws to get the taxable profit. The adjustments
include things like adding back and expenses which are not allowable for tax, deducting any other expenses that
are tax-deductable and adding back depreciation (as it is not an expense for tax purposes) and deducting any
capital allowances. After all these adjustments, we would arrive at the taxable profit. The company’s tax
expense for the year is generally a percentage of the taxable profit as set out for the tax authorities.

Non-controlling interest
When the parent company has controlling interest in a subsidiary company, it has 100% control of the
subsidiary’s assets but only owns a portion of the subsidiary’s shares. A non-controlling interest will be present if
the parent company has a partial ownership in a subsidiary company. In other words, non-controlling interest
represents the portion held by other (minority) shareholders of the subsidiary company. The non-controlling
interest will be shown in the consolidated statement of financial position to highlight the fact that the parent
does not wholly own the subsidiary company. The purpose of showing non-controlling interest is to enable the
parent company’s shareholders to recognise how much of the subsidiary company’s equity is funded by external
shareholders. This also allow the parent company’s shareholders to identify the fact that external shareholders
of the subsidiaries could potentially constrain decisions. The subsidiary’s external shareholders do not have any
rights to the parent company, but they are entitled to a share of the subsidiary’s profits.
Personal tax allowance
All individuals have a personal tax allowance which means they do not have to pay any tax if their income is
below the allowance level. The main purpose of the personal tax allowance is to create more fairness within the
tax system as people with low income cannot afford to pay the same tax rate as people on much higher
incomes. People who earn just over the tax allowance level will be required to pay tax, but at a much lower rate
than the basic level. In a progressive tax system, the tax rate an individual must pay increases with their income.
The personal tax allowance also simplifies the tax collection process as people on very low income (below the
threshold) are not required to pay any tax, therefore reducing the amount of administrative work from the tax
authority.

Swaps
A swap is a contract between two parties to exchange a series of future cash flows. Each party will generally
choose an arrangement that is beneficial for them or suit their circumstances better. For example, if a fixed
interest rate borrower expects the interest rate to fall and wishes to pay floating rate instead, then he/she can
enter into a swap with another borrower that pays floating rate but prefers a fixed rate (this borrower may have
the opposite expectation as the other borrower). Such interest rate swap effectively allows the two parties to
take over each other’s cash flows without an exchange of capital amounts. There are also currency swaps where
the parties can exchange a series of interests and capital amount in one currency for the same in another
currency. However, there are market risks as well as credit risks to swaps.
Swaps can also provide opportunities for certain individual to capitalise on any of their advantage. For example,
if a bank is able to borrow at a variable rate that is lower than most other borrowers, then the bank can enter
swap arrangements with fixed rate borrowers

Interest rate swaps

 An interest rate swap involves 2 parties where one party agrees to pay a series of fixed interests for a
fixed period of time and the other agrees to pay a series of variable interests based on the level of a
benchmark rate (often the short-term interest rate). The 2 parties can arrange a net payment from one
to the other instead of both parties paying the full interest amount.
 There is no exchange of capital amounts
 For example, if a fixed rate borrower fears interest rate might fall, he/she could enter into an interest
rate swap with a variable rate borrower who believes interest rate might increase. This means that the
fixed rate borrower is effectively paying a variable rate while the variable rate borrower pays a fixed
rate.
 There is credit risk in such arrangement as one party could default. Credit risk can be reduced by
conducting due diligence and credit checks on the counterparties.
 There is also the risk that if one party defaults, the other party will be left unprotected from the interest
rate movement which is why the swap is in place initially.
 An interest rate swap can be organised with banks. The bank who acts as an intermediary can request
deposits from both parties to mitigate credit risks.
 Holding a portfolio of fixed and variable rate loans will reduce the risk of adverse movements in interest
rates.
 Companies may have taken out aa fixed rate loan at a time where interest rate was expected to increase
but it may no longer be the case so the company want to switch to variable rate. Swaps are cheaper
than repaying the existing loan early then take out a new loan.
 Some firms like banks have a particular advantage – banks take bank deposits at variable rates so wishes
to mitigate risk by having variable rate liabilities. Therefore it may be possible to have a variable rate
loan via a swap at a more attractive rate.

How banks use interest rate swaps to manage the cost of interest Q15 Sep 2015

Dividend policy
There are a number of considerations to take into account when setting an appropriate dividend policy. In
general, the amount of dividend paid per year should be relatively consistent. This may mean that the company
might have to hold back some profits in good years to pay for dividends during bad years. There’s no point in
paying all the profits out as dividends in a good year if the company is not confident that it can maintain the
same dividend level in the future. Any reduction in dividend can cause adverse market reaction which can
negatively impact the company’s share price. Shareholders generally prefer a stable dividend as it can help them
plan their cash flows and tax liabilities. The company also need to ensure that they can afford the dividends. If
the company already has a very low level of reserves, paying a large dividend could significantly increase the risk
of bankruptcy.

Another important consideration is the tax profile of the company’s shareholders. For example, if a large
proportion of the company’s shareholders pay a lower rate on capital gains and get taxed heavily on income,
then it may be justifiable to withhold more profits and pay less dividends. On the contrary, investors who have
income below the tax-free threshold (eg pensioners) might prefer more dividend.

Dividend is also influenced by any growth or expansion plans. If the company is planning to invest in some large
projects then it should retain more profits meaning less dividends. The level of dividends paid by competitors is
another factor to consider.

Dividends vs Capital Gains

A company will generally attract shareholders with tax preferences that are consistent with the company’s
dividend policies. Dividends are considered income and are taxed using the same rate as the individual’s
marginal tax rate. Each individual has an annual personal tax allowance which means they can offset some or all
of the dividends against their allowance. Individuals on low income below the tax-free threshold may prefer
dividends over capital gains as they might not be required to pay any tax on the dividends. On the other hand,
there are individuals that prefer capital gains over dividends. In additional to the personal tax allowance,
individuals also get an annual capital gain allowance. This means capital gains up to the allowance level can be
tax free. Individuals on income above the personal tax allowance level but have not used all of their capital gain
allowance might prefer more capital gains. The tax rate on capital gains is generally lower than the tax rate on
income. Additionally, capital gain is only taxed when the gain is realised (i.e. when the asset is sold) so some
individual prefer capital gains as they can plan their tax liability in advance. For example, if a person wants to sell
an asset but he has used up all his capital gain allowances for the current year, he can wait and sell the asset
next year where some or all of the capital gains can be tax free. This means the individual can delay the payment
of tax by holding onto the asset for longer. Dividends, on the contrary does not allow much scope for tax
planning.

Limited liability partnership vs partnership

A traditional partnership comprises of two or more people and each person is called a ‘partner’. A limited
liability partnership also comprises of two or more people but they are called members. Each partner in a
partnership has unlimited liability and is jointly liable for the debts of the business. This means individuals in a
partnership can risk using all their personal assets (e.g. their car, house, savings etc.) if the firm does not have
sufficient asset to settle obligations. This makes a traditional partnership very risky. On the other hand,
members of a limited liability partnership have limited liability – each member’s liability is limited to the amount
they contributed to the business. This is the key benefit of a limited liability partnership as the individual’s
personal assets are not at risk. However, in the event of a default, it is still possible to lodge claims against each
individual members which diminishes the benefit of limited liability.
A partnership does not have its own legal identity separate to its partners, but a limited liability partnership has
its own distinct legal entity. A LLP need to be registered at Companies House. No agreement or documentation
is required for a traditional partnership, but a partnership agreement is needed for a LLP.
If a business switches from a partnership to a LLP, it could send a signal of lack of confidence. Clients may
suspect that the firm isn’t doing well and that the partners want to protect their own wealth in case of business
failure.
Share Buyback
A share buyback often sends a positive signal as it indicates that the company is doing well and has a large
surplus to distribute to shareholders. A share buyback is a good alternative to dividends. It may not be a good
idea for the company to distribute a large amount of dividends if the company is not confident that this level
can be maintained in future years. Therefore, a share repurchase can help avoid any unrealistic future dividends.
A share repurchase is essentially buying some shares back from the shareholders at a price above the current
share price. This also means that shareholders will lose some of their equity as a result. Some shareholders
prefer a share buyback over dividends, especially if they have unused capital gain tax allowances.
A drawback of a buyback is that some shareholders may get the impression that the share repurchase only
happened because the directors were not able to find more efficient use of the company’s cash reserves (e.g.
expansion, new projects etc.)

Scrip Issue Ch5

A scrip issue involves giving all existing shareholders free shares in proportion to their holdings. This process
would decrease the share price and increase the number of shares in issue so each shareholder’s total holdings
would not change. When the company considers a scrip issue, it should ensure that the fall in share price would
not drive the market price below the nominal level as this can prevent making any further issues. Whether the
share price will increase or decrease in the short-medium term following a scrip issue depends on whether the
impact on the share price from increased confidence from the market will outweigh the decrease in share price
from the issue.
A scrip issue is generally an indication of confidence as it implies that the issuing company’s share price is well
above the nominal price. Companies will make a scrip issue only if they have large reserves which is another sign
of confidence. Also, if the company maintains the same dividend per share, there is an expectation that
dividends will increase as shareholders would be entitled to more dividends with more units of shares. Following
a scrip issue, the share capital component under the equity section of the statement of financial position will
increase and retained earnings/reserves will decrease. Shareholders can also benefit from a scrip issue. As they
now have more shares at a lower price, the marketability of the shares would be better as it is now more
affordable.

Double Taxation Agreements

Some countries have a double taxation agreement with each other, so individuals do not pay tax on the same
income or profit twice. Many companies and businesses operate both locally and overseas, so they have
multiple sources of income. The double taxation agreement allows individuals and companies to offset their tax
paid overseas against their local tax liability. If the overseas tax rates are significantly higher than the domestic
tax rates, the company or individual can only offset up to the amount equal to its local tax rate. Such agreement
also provides incentives for companies to expand and trade overseas as they do not have to worry about paying
tax twice on their income.

Parent company and its subsidiaries

Whether a company is subsidiary of another company depends on if the parent company has control over the
subsidiary. The parent company doesn’t always have to hold over 50% of the sub’s shares to exercise control,
although over 50% shareholding generally means that the parent will have control. There are other ways to
exercise control like being able to appoint and remove the Sub’s board members by having majority of voting
rights.

The parent company and all its subsidiaries are presented as a single unit and as a result, a single consolidated
financial statement is published that combines all the group’s assets and liabilities. The consolidated statement
is prepared by cancelling out any investments between group members and any interrelated items to eliminate
double counting. All the items in the statements are then summed together. The entire value of the subsidiaries’
assets are reflected in the consolidated statement. A goodwill item may be present if the parent company paid
more than the book value of the subsidiary when it was acquired. If the company has any non-controlling
interests it should be reflected in the consolidated account as well.

Even though the parent company has control over its subsidiaries, it is not legally obliged to settle any debts for
the subsidiary company in the case of any financial hardship. In other words, the parent company is no more
responsible for the subsidiary’s debts than the other shareholders in the event of a default. Although it is
unlikely that the parent would allow the subsidiary to liquidate (as it would generate negative publicity and
damage its reputation), it is still a possibility. Also, letting the subsidiary fail also means the parent company
would lose its investment in the company and would lose any future potential profits from the subsidiary. In
order to reduce credit risk, lenders of the subsidiary company could request a written assurance that states that
the parent company or another company in the group will settle any obligation in the event of a default by the
subsidiary company.

Associate company (associated undertaking)

An associate company is one that is not a subsidiary company but is subject to significant influence from the
parent company. The parent company can generally obtain significant influence by holding 20% to 50% of the
associate company’s shares or voting rights. Exerting influence can include appointing directors and voting at
board meetings, it does not mean that the parent company has control over all the associate’s assets. As a
result, the consolidated financial statements will not include the full value of the associate’s assets and profits,
instead, it will only reflect the proportion that the parent company holds.

Quoted vs unquoted company (listed vs unlisted)

A quoted company must satisfy all the disclosure requirements and as a result, must provide more information
related to the business. An unquoted company on the other hand are less regulated which makes it harder for
investors to obtain full or complete information/data about the company. There is a risk that decisions might be
made on incomplete data which can have negative consequences. The key benefit of a quoted company is that
the shares are more liquid as it is traded on the stock exchange. This significantly reduces the risk of having
capital tied up in the company due to the inability to find a buyer. Investors in unquoted company may find it
difficult to negotiate a suitable price and find a buyer when he/she wants to exit, especially if the company is
small. It is also easier for a quoted company to raise capital as its shares can be easily valued and are therefore
more marketable. Due to this reason, it also makes it easier for shareholders to plan their tax liability as they can
easily value their shares. However this also means that the original owners will lose ownership of the company
and will not have any control over the future shareholders. Owners of an unquoted company has greater control
over the company. Although there are many advantages of seeking a quotation, it does not necessarily mean
that a quoted company is always less risky than an unquoted one. Companies may choose to remain unlisted for
a number of reasons – they want to maintain full control of the company, it is a family business etc.

Cost of equity of quoted vs unquoted company – 2020 Sep Q16.

EBITDA vs Profit
It can be argued that using EBITDA to make comparisons can lead to more accurate results as it a more objective
measure than profit. This is because the elements being excluded (interest, tax, depreciation and amortisation)
can be subjective. For example, the directors can abuse the subjectivity of the calculation of depreciation by
selecting a method that result in depreciation being less than what it actually is (e.g. using a longer useful life in
the calculation). If depreciation are understated, profit will be inflated which can be very misleading. By
excluding these subjective elements in the EBITDA, comparisons between years and different companies might
be more meaningful.

Market value vs. historical cost

The most obvious advantage of recording assets using their current market value is that it is more relevant than
using cost less depreciation, especially if the asset was purchased a long time ago. Using the current asset value
portrays a more realistic view of the amount of assets the company own. If the asset values have increased, it
may also help the company negotiate cheaper loans. Shareholders may also interpret an upward valuation of
the asset as a sign of good stewardship.

The main drawback of using market value instead of historical cost is that it can be more expensive and
complicated to administer. The market value for assets may not be readily available and observable and it may
be very costly to seek a valuation from a third party. Also, it can be argued that fair value is only useful if all the
items in the financial statements are recorded at their market value. Only having some recorded at market value
can be potentially misleading and confusing for users. Furthermore, market value can be volatile which makes it
even harder to observe and interpret. If an asset is revalued upwards, the gain is not realised unless the
company sells the asset. A higher asset value will also attract higher depreciation expense which will increase
cost of sales and decrease profit.

Revaluation reserve
A revaluation reserve will arise when the book value of the company’s asset increases. The revaluation reserve is
a component under the equity section in the statement of financial position. As a result of an upward valuation,
the assets will be shown at their new, higher fair values. The difference between the new asset value and the
asset’s book value is the gain on revaluation. This gain on revaluation is also shown in the statement of
comprehensive income under ‘other comprehensive income’. Revaluing assets and showing the asset values at
its current value can increase the relevance of the figures shown in the financial statements, especially if the
assets were purchased a long time ago (using cost less depreciation may no longer be relevant). However, it may
appear on the financial statements that equity has increased as a result of the revaluation, it is important to
note that the gain has not been realised as the asset has not been sold yet. The value of the asset could still fall
in the future in which case the gain on revaluation may need to be reversed. There is a degree of subjectivity in
the revaluation process as well. For example, if the company choose to revalue its property during periods
where the property market is currently very volatile, it may create a false impression of a revaluation gain (as
the value may fall the next day). A loss on revaluation is treated as an expense and is a component of cost of
sales.

Convertible loan stock

A convertible loan stock is an unsecured loan stock that can be converted into ordinary shares of the company
at a future date. Companies can use convertible loan stocks to reduce its cost of debt. Interests on a convertible
loan stock is generally lower than that of a normal unsecured loan stock as it offers the opportunity to convert
into ordinary shares which can potentially attract capital gains and/or dividends. For this very reason, a
convertible loan stock is more attractive than an ordinary loan stock. The main risk to the lenders (i.e. the holder
of a convertible loan stock) is that the favourable scenario may not eventuate in which case the lender will
choose not to convert. This also means that the conversions will only take place if the event is advantageous to
the lender. If conversion doesn’t take place, then existing shareholders and the issuing company will benefit
from the lower interest rate offered on the loan. If all convertible loan stock holders exercises their right to
convert into ordinary shares, then existing shareholders’ equity and wealth will be diluted.

Project appraisal
When conducting project appraisal, it is important to take into account both qualitative and quantitative factors.
Quantitative requirements could be a positive NPV, and a qualitative factor might be having a good strategic fit
with the company. It is not always the case where the project with the highest NPV should be accepted. For
example, a company may choose to proceed with a project that has a lower NPV than another project because it
is a better strategic fit and it’s expected to achieve synergy with existing projects.
The process should also be well documented. The document should include the objective of the project and all
details of the assumptions made (e.g. inflation, income growth) to project future cashflows and the source of
data used. The assumptions should be explicit and made in consultation with relevant experts (AA, investment
managers etc) to ensure it is reasonable and justifiable. The criteria for accepting and rejecting a project should
also be made explicit in the document. Having a detailed document provides a framework for the project
appraisal process and also helps the project team to stay on track (if there’s a specified timeline). In addition, it
can help justify any decisions made. The document can also assist with any similar future projects as the same
methodology may be adopted.

Opportunity Cost
When a company decides to proceed with a project/investment, they must give up any other alternative or
mutually exclusive projects and its benefits as capital is generally limited. The opportunity cost of a project
represents the next best opportunity forgone. It is important to consider the opportunity cost of a project as it
can help the company determine whether there are any alternative projects that can provide more benefits for
the company or is a better fit for the business. There could be several projects with a positive NPV, and some
could have higher NPVs than the one the company is considering so the opportunity to invest in the alternatives
would be lost. It is not always easy to evaluate all potential opportunities and can be costly and time consuming.
Spending too much effort seeking alternative projects can cause unnecessary delays. Also, some projects may
appear to be better but there could be risks and consequences that may be hard to identify at the evaluation
stage. It is not an easy job rank all potential projects.

Simulation
 Establish key variables e.g. interest rate, inflation rate
 Build a cash flow model based on the key variables – deterministic or stochastic
 Test the sensitivity of each variable i.e. how sensitive is cashflow to an increase in interest rate?
 Run the model many times until some trends start to develop or result start to converge
 Consider a few scenarios – best case and worst case. This may give a distribution of expected outcome
 If there is a large variance in the outcome, then it could be a sign that the project is very risky. The
results may need to analysed further in order to make a decision

Finance Lease
A finance lease is when the company leases the asset from the lessor. The lease term is generally very close to
the useful life of the asset. While the ownership of the asset remains with the lessor, the lessee will take on
most of the risks and rewards from the asset. If the lessor defaults on the lease payments then the lessor can
take possession of the asset. A finance lease can be cheaper then taking out a loan and buying the asset outright
as the company will not hold ownership of the asset in a finance lease. However, the main disadvantage of the
finance lease is that it does not provide much flexibility. For example, if the company wishes to upgrade the
asset, they would not be able to do so before the end of the lease term whereas if the company purchased the
asset outright then it can decide when to sell or replace the asset.

Creative accounting
Creative accounting can occur when the directors abuse the subjectivity of producing financial statements to
distort figures. Such behaviour can be hard to identify as it will generally look like the company did everything
right and complied with all accounting standards. For example, the directors can choose to adopt a particular
method of calculating depreciation to understate depreciation so that profit will look better than it actually is.
Another way to distort depreciation is by using an overly optimistic (but yet believable) estimate of the useful
life of the asset. This will have the same effect on profit as the amount of depreciation charged per year would
be lower.

Share price
A company’s share price is a reflection of the present value of all future cash flows and is driven by the market.
Share prices are observable and are generally objective. Any positive news like a new investment or an
expansion would likely increase the company’s share price as shareholders expects that future cash flows would
increase as a result of the change. However, sometimes the movement in share price does not correspond
perfectly with news due a number of possible reasons. For example, if the market has already anticipated the
change when they invested in the company so the share price already reflects this expectation and as a result,
the increase in share price may not be as dramatic as the company might expect. Other reasons include that the
market may not see the change as optimistic as the company thinks. Also there may be information asymmetry
where the shareholders does not have the full information of the new project and are therefore not aware of its
full potential. In general, the share price will only rise of the shareholders know and understand the whole scope
of the project and its benefits (which is rarely the case because companies are likely to withhold some details to
prevent competitors from copying the idea).

Treasury Bills
 Low risk as it is issued by the government
 Issued at a discount
 A x% T-bill means the return on the bill is x%
 No coupon payments
 Short-term often one year or less
 The longer to maturity, the higher the interest

Debenture stocks
Debenture stocks are generally secured against the company’s assets so if the company runs into financial
hardship the debenture holders can take possession of the asset and its associated incomes. Debenture stocks
are much securer than other forms of finance such as unsecured loan stocks or shares/equity. The lower risk
associated with debenture stocks also means the rate of return (i.e. the interest rate) is also lower. Depending
on whether the debenture has fixed or floating charge, the issuing company may need to seek permission from
the debenture holder before they can replace any assets. Debenture stocks’ marketability is not as good as say,
government bonds due to the lower volumes traded.

Sale and leaseback

A sale and leaseback occur when the owner of the asset sells the asset then leases it from the buyer in exchange
for a series of rent payment. In doing so, it will help the company release some cash as will receive a large
proceed from the asset sale and the rent payment will be relatively affordable. However, this also means that
the company will no longer hold ownership of the asset and will have very limited control over the future of the
asset. The company will also be unable to benefit from any capital appreciation from the asset. It may not be a
good idea to do a sale and leaseback on the company’s main and possibly only real asset. The lessor may decide
that at the end of the lease period to not renew the contract with the company which means the company will
lose access to the asset which would cause significant disruption to the business. Not having any real asset will
also limited the company’s ability to raise more funds in the future.

Beta and risks (systematic and unsystematic) – why a risky project can have a low required rate of return
A security’s beta coefficient represents the systematic risks or undiversifiable risks of that asset. Specific risks
can be diversified away so any remaining risks (i.e. systematic risks) relates to factors affecting the market as a
whole like inflation, politics, currency movements, and interest rates. Unsystematic risks are specific to the
company like geographic risks, changes in legislation for the industry the company operates in and demand for
its product. The idea of diversification is that if the investor holds a sufficiently large portfolio with a very diverse
range of companies in different industries and location, the specific risks will be cancelled out, leaving only risks
that are common to all companies.
The market does not provide additional rewards to investors holding many stocks in the same industry and
having large unsystematic risks as they can be diversified away through portfolio diversification. A security with
a beta of over 1 means that its return is more volatile than the market and a beta between 0 and 1 means that
its return is less volatile than the market. A security with a beta of 1 suggests that the asset’s return is as volatile
as the market and a beta of 0 means that its return is uncorrelated with the market. In general, a stock with high
beta is riskier but also offers greater potential for future returns while a low beta stock has less risks but also
offers lower returns. A company with low beta (close to 0) means its return is not significantly affected by the
market so it has low systematic risk. It also means that any volatility is most likely to be driven by unsystematic
factors. An asset’s beta coefficient may change over time as different assets may be more sensitive to certain
conditions than others. Any change in demand of the security may also increase or decrease the beta.

IRR
An IRR represents the rate of return that gives the project a NPV of 0. IRR is more complicated to calculate than
NPV. IRR also does not take into account the size of the project which can be misleading when using IRR to
compare projects. If there are more than one net negative cashflows during the life of the project then multiple
IRR can occur. For example, this can happen if there is a large cost at the end of the project which could make
the NPV of the cashflows negative, especially if a low discount rate is being used. If the two IRR are x% and y%
where x<y, it means that NPV is positive if the required rate of return is between x% and y%. If the project’s
hurdle rate falls between the 2 IRR, then the project can be accepted even though it means that return will be
capped at y%.

Strategic fit
Having a positive NPV means that the project is expected to increase the company’s wealth. While the NPV is
generally a good indicator of the viability of a project, it should be considered in conjunction with other factors
like strategic fit before accepting or rejecting a project. A project with a good strategic fit is important as it can
generate benefits that are not easily quantified.
Although the NPV of the project is negative, it is a good fit for the business as it creates future opportunities for
expansion and growth. It may also attract more talented employees and result in a higher staff retention rate.
The project may also create synergies with the company’s existing business and improve efficiency. Clients may
see the company is more prestigious and successful thus attracting more clients and sales. These benefits are
mostly non-monetary and might be hard to value with great certainty at the evaluation stage, so therefore it
was not included in the projection of future cashflows. These potential opportunities and benefits might be
difficult to identify at the initial evaluation stage but will be lost if the company decides to reject the project.

Factoring
Factoring can help increase the company’s cash flow by receiving some of its trade receivables in advance.
Factoring can be recourse and non-recourse. Recourse factoring occurs when the company (i.e. the supplier)
passes on their trade invoices issued to customers and receives the amount on the invoices from the factor but
the company is still responsible for chasing up any non-payment. This means any credit and default risk lies with
the company. The factor will pay the company a percentage of the amount on the invoice in advance which
would help improve the company’s cash flows. However, the factor will charge the company interest based on
the period from the payment advance date to when the customer pays the invoice. Recourse factoring is
generally more suitable for companies that make credit sales to established customers and if the total amount is
not too significant. This is because the company will still need to bear credit risk and conduct its own credit
checks on new customers. Using recourse factoring on established and trustworthy customers will reduce the
risk of non-payment.

Non-recourse factoring on the other hand occurs when the company passes on its invoices to the factor and the
factor becomes responsible for the collection of all the debts. This more expensive than recourse factoring as
the credit and default risk lies with the factor and that the factor is responsible for following up on payments.
Similar to recourse factoring, the company will receive a percentage of the invoiced amount in advance. It is
important to note that the factor may not accept invoices from customers that are considered high risks or may
charge a significant fee for the additional risks. This method is generally more suitable if the company makes
very large credit sales and need to release some cash tied up in trade receivables. Non-recourse factoring can
potentially damage relationships with customers as the factoring company generally only focuses on the
collection of payments from customers.

Corporate governance: corporate structure, key roles and responsibilities

Directors are responsible for the preparation of financial statements and the company’s administration. This
includes ensuring that the company is compliant with all relevant standards and legislations. Although they are
ultimately responsible for these tasks, they can delegate some of the work to managers if they wish.

External auditors are responsible for ensuring that the company’s financial reports are prepared in accordance
with the relevant accounting standards and commenting on the truth and fairness of the company’s financial
statements. A larger audit company may be more credible and reputable but it does not necessarily mean that
the quality of service would be better as all auditors have the same qualifications. The cost may outweigh any
benefits.

Businesses should take into account any ethical considerations in its decisions making process. However, agents
and principals might have different focus. Agents should act in line with the principal’s ethical stances. For
example, while it may be appropriate for the company to set a policy to not invest in tobacco companies, it
would not be right for managers to turn away customers that smoke.

Shareholders vs lenders
Although both shareholders and lenders wish for the company to be financially sound, they do have different
interests and focus. The shareholders will benefit from the company’s profit as their wealth is directly related to
the company’s profitability. Lenders on the other hand will not receive any benefit from profits. Having a profit
will only provide a signal to the lenders that the company should be able to meet its loan obligations. In other
words, there is no upside risks for lenders as they do not receive any additional benefits if the company
performs well. Lenders are only concerned about whether the company is able to make the agreed interest
payments and loan repayments on time. A fall in the company’s share price will not necessarily translate into a
fall in the market value of the debt instruments issued by the company. This is because the share price is a
reflection of the company’s ability to generate future profit, but the value of the loans depends on the
company’s ability to meet interest and capital obligations. In the event of liquidation, lenders are ranked before
shareholders meaning there may be nothing left for shareholders if the company has a large amount of debt.
This means increasing debt will increase the risks for shareholders. Some lenders will require the company to
have an upper limit on the amount of borrowing they can have to reduce their risk of not being about to receive
their full repayments.

Director vs shareholders (differing risk perspective)

Shareholders are more likely to accept projects that are risky but with potential to deliver high returns than
directors. This is because shareholders is able to diversify the risk from the project by holding a portfolio of
investments. Directors on the other hand are unlikely to be able to invest in a diverse range of projects (due to
limited capital and resources) so they are more risk averse when it comes to taking on new projects. Also, if a
risky project fails, the directors will be blamed for their poor decisions and could damage the company’s share
price and reputation.

Gearing ratio and its importance

The gearing ratio provides insight into the financing structure of the company – what proportion of finance is
provided by lenders and shareholders? A high gearing ratio means that the company has a large amount of
borrowing relative to equity. This information is useful for lenders as it would mean that the lender would be
competing with many other creditors in the event of failure, so it is more risky to lend to companies with a high
gearing ratio. Having a high gearing ratio can also increase the risk for the company as borrowings will attract
interests. Banks or lenders will generally impose an upper limit on the company’s gearing ratio in order to
reduce risk. If the company’s gearing ratio do rise to a level above the limit, the lender may have the right to
take possession of the asset and foreclose the loan.

Revaluation of assets
It can be argued that showing asset value at its latest market value (i.e. the revalued figure) is more relevant to
users as it is a better reflection of how much the asset is worth today than its book value. Revaluing the
company’s fixed assets regularly has some benefits including making directors more aware and accountable of
the company’s resources. This may lead to more responsible decisions as directors fear if they do not maintain
and look after the assets, the lower market value will be reflected in the financial statements. Whenever an
asset gets revalued upwards, the revaluation reserve will increase. This may lead to a more accurate return on
capital employed. If assets are only shown at book value, it could result in the return on capital employed to
look better than it actually is (as profit would be divided by a smaller amount of equity).

Importance of notes to financial statements

Financial statements often have notes attached to them to provide any additional detail and description of the
key figures shown in the statements. The main purpose of having notes is to help readers better understand the
numbers by providing additional information if the reader wants to understand a particular figure better. In
simple terms, notes are in place in case readers want to find out more about the statements. Notes can be
interpreted as supplementary information to the main accounts and can contain both qualitative and
quantitative factors of which many disclosures are required by law. By having notes to accounts, companies can
avoid having an excessive amount of information in the body of its financial statements.

Rights issue Ch5

A rights issue is when a company offers its existing shareholder the opportunity to purchase shares at a given
price (below the current market price) in proportion to their shareholdings. For example, a 1-for-5 rights issue
means for every 5 shares held, the shareholder can purchase 1 new share. Companies may make a rights issue
when they want to raise new equity capital. Rights issues are cheaper and less complicated than making an issue
to the public. Also, companies may choose to make a rights issue instead of say, taking out a loan because they
have already reached the maximum gearing required by the lender. Shareholders can benefit from a rights issue
as they can purchase new shares at a price below the current share price and may be able to benefit from
greater dividends in the future. Rights issues also prevents the dilution of equity of the company’s existing
shareholders. Shareholders who do not take up their rights can also sell the right. The market value of these nil-
paid right is the difference between the new share price and the rights issue price. The company’s share price
will be lower immediately following the rights issue. The company need to ensure that the share price won’t fall
below par value and that the total share capital in issue would not exceed the authorised level.
The amount of cash raised following a rights issue is #of new shares x offer price. Current asset will also increase
by this amount. Reserves (share premium account) will increase by the share premium (i.e. offer price – nominal
price) x #of new shares.

Integrated reporting
Integrated reporting is an alternative to traditional financial reporting. An integrated report combines both
qualitative and quantitative elements to portray a more complete view of the company’s performance and
goals. Integrated reporting will generally give readers a better understanding of the company and how it’s
managed which can help investors better understand the risks involved. An integrated report generally covers
topics such as sustainability, quality of governance, ESG, and quality of management. There’s a shift of focus to
environmental and social governance goals (ESG) in recent years. Having ESG is important as it will attract
investors with similar views or lose investors that do not agree with the company’s ethical views. Some
companies incorporate a sustainability report as an element of the integrated report to highlight the ways the
company has considered the economic, social and environmental impacts of its operations.
Causes of risks/risk analysis Ch22
There are risks involved in almost all project so having an effective risk management is very important. Risk can
be specific (diversifiable) or systematic (non-diversifiable). The first step is to identify the risks involved in the
key stages of the project. This could include discussions with key industry experts or referring to any past similar
projects. The risks involved should not outweigh the potential benefits otherwise the project won’t worthwhile.
A risk matrix can be used to aid the risk analysis. Causes of risk can be political (government and regulations,
wars terrorist attacks etc.), social (changes in workforce, health), natural (earthquakes and floods), economic
(changes in oil prices, currency, interest rates etc), financial (raising finance) and project (resignation of project
manager, unable to find supplier etc). These risks can arise at any stages in the project including design, project
approval, raising of capital, construction, operation etc.

Managing liquidity

-speed up invoicing process and reduce trade receivables turnover

-negotiate with suppliers to have a longer payment period. This will increase payables turnover period

-consider factoring if invoices are taking too long to settle.

-sell and leaseback some assets to free up some cash

-negotiate a bank overdraft