Start your answer to each question on a new page. ... You are the newly
appointed Financial Accountant of INCARA plc (INCARA), a successful Irish
company ...
ADVANCED FINANCIAL ACCOUNTING
PROFESSIONAL 2 EXAMINATION - AUGUST 2007 NOTES:
Answer All Questions.
Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.
PRO-FORMA INCOME STATEMENT BY NATURE, INCOME STATEMENT BY FUNCTION AND BALANCE SHEET ARE PROVIDED
TIME ALLOWED:
3.5 hours, plus 10 minutes to read the paper.
INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.
The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
ADVANCED FINANCIAL ACCOUNTING PROFESSIONAL 2 EXAMINATION - AUGUST 2007
TIME ALLOWED: 3.5 hours and 10 minutes to read the paper.
Answer All Questions.
Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.
You are the newly appointed Financial Accountant of INCARA plc (INCARA), a successful Irish company that prepares its financial statements to the 31st December each year. INCARA, whose core business is the installation of in-car entertainment systems and related products, commenced trading approximately seven years ago and has experienced rapid growth during the last two years. INCARAʼs trial balance is shown below. INCARA Trial Balance
As at 31st December 2005 DR / (CR) €ʼ000 15,480
520 200 (10) (220) (7,635) (1,000) (1,500) (1,250) (600) (3,905) (80)
Property, equipment and motor vehicles – net book value at 31st December 2005
Inventory at 31st December 2005 Trade receivables Provision for bad debts as at 31st December 2005 Trade payables Bank 10% debentures €1 preference shares 50 cent ordinary shares Share premium account Revaluation reserve Retained earnings as at 31st December 2005 Provision for staff training Revenue Purchases Operating expenses Debenture interest Other finance costs
Note
1 2 3
7
Property, equipment and motor vehicles shown in the trial balance comprises:
Valuation / Cost Accumulated depreciation at 31st December 2005 Net book value
Freehold property €ʼ000 15,000 (1,000) 14,000
Page 1
CR €ʼ000
15,480 520 360
10 1,050 70 600 1,000 2,250 5,000 600 3,905 80 6,850
4 5 6
Additional Information:
1.
DR €ʼ000
As at 31st December 2006
Equipment €ʼ000 1,800 (800) 1,000
3,750 1,250 45 10 21,415
21,415
Motor vehicles €ʼ000 600
(120) 480
Total €ʼ000 17,400
(1,920) 15,480
(note 1 continued)
Included within freehold property at 31st December 2005 is a property which was disposed of during the year ended 31st December 2006 for €650,000. Apart from debiting the bank with the proceeds, which were received in June 2006, and crediting trade payables, no other entries have been recorded in respect of this transaction. The property had originally cost €400,000 and had been revalued upwards by €200,000 in 2003. The total depreciation included within accumulated depreciation at 31st December 2005 relating to this property is €120,000, of which €24,000 relates to the excess charge over historic cost.
On 30th June 2006, INCARA purchased a property on a 25 year lease at a cost of €2,500,000 cash for both its rental income and investment potential. The property was used for the companyʼs own administration purposes until 31st December 2006, and was then leased for 12 years to a third party tenant on 1st January 2007 at an open market rent. The building was valued at €3,000,000 on 31st December 2006 by Floyd & Co., Chartered Surveyors, on an existing use basis. None of the entries with respect to the purchase of this property have been recorded in INCARAʼs books and records.
During the year ended 31st December 2006, INCARA disposed of an item of equipment for €50,000 cash that had originally cost €300,000. Its net book value at 31st December 2005 was €75,000. None of the entries with respect to the disposal of this equipment have been recorded in INCARAʼs books and records.
INCARA has historically depreciated its motor vehicles over five years. During 2006 the directors concluded that, due to increased annual mileage, the motor vehicles should be depreciated over three years. It is company policy to provide a full yearʼs depreciation in the year of purchase and none the year of disposal. All depreciation is charged to operating expenses and is calculated as follows:
2.
3.
4. 5.
6.
7. 8.
Leasehold property Freehold property Equipment Motor vehicles
-
on a straight line basis over the period of the lease; on a straight line basis over 25 years on valuation; 25% per annum on cost; and on a straight line basis over estimated useful economic life.
Inventory at 31st December 2006 was valued at €600,000. This includes satellite navigation systems at their original cost of €100,000. The replacement cost of these systems was €60,000, and their market value, based upon sales in January and February 2007, was €95,000 before non-recoverable fitting and installation costs of €10,000. It is company policy to maintain a provision for bad debts equal to 5% of gross trade receivables.
The l0% debentures, which are stated at their fair value, were issued on 1st January 2006 and are redeemable on 1st January 2011. Interest is paid quarterly in arrears and the first payment was due on 1st April 2006.
The €1 preference shares, which are stated at their fair value, were issued in 2001. Each preference shareholder is entitled to a cumulative dividend of 10% annually. The preference shareholders rank ahead of ordinary shareholders on the winding up of the company. The preference shares are redeemable for cash at the option of the holder.
On 1st January 2006, INCARA had 3,000,000 ordinary equity shares of €0.50 each in issue. INCARA operates an ordinary equity share option scheme, and under the terms of the scheme the holders of ordinary equity share options are able to purchase one ordinary equity share for every option held at a price of €3 per share. At 1st January 2006, 3,000,000 ordinary equity share options were in issue. On 30th June 2006, the holders of 1,500,000 ordinary equity share options decided to exercise their option to purchase. On 1st July 2006, 2,000,000 new options were issued on the same terms as the existing options. During the year ended 31st December 2006, the average market price of one ordinary equity share in INCARA was €4.
Due to the rapid technological change in the industry, INCARA creates a provision for staff training each year. The provision of €80,000 shown in the trial balance has been built up during 2004 and 2005. The directors of INCARA wish to provide an additional €40,000 for 2006.
During the year ended 31st December 2006, a claim was made against INCARA by a customer alleging poor workmanship, irreparable damage to their vehicle and substantial inconvenience. INCARAʼs legal advisors have indicated that the company will most likely have to pay damages of €50,000 but that it may be possible to counterclaim against the manufacturer of the equipment for €10,000. Page 2
9. 10.
A preference dividend of €100,000 is due in respect of 2006, and the directors proposed a first and final ordinary dividend of €225,000 in December 2006. All ordinary shares in issue at 31st December 2006 rank in full for dividends. A tax charge of €150,000 for the year ended 31st December 2006, which takes into account all relevant items and adjustments, should be provided for.
1.
REQUIREMENT:
2.
REQUIREMENT:
3.
4.
5.
Note: Questions 1 – 5 will be marked independently of each other.
Prepare an income statement for the year ended 31st December 2006, and a balance sheet as at that date, for INCARA in a form suitable for publication. (46 Marks) (Presentation Marks: 4 Marks) [Total: 50 Marks] Notes to the income statement and balance sheet are NOT required.
Prepare a cash flow statement for INCARA in accordance with IAS 7 Cash Flow Statements for the year ended 31st December 2006. (13 Marks) (Presentation Marks: 2 Marks) [Total: 15 Marks] Notes to the cash flow statement are NOT required. REQUIREMENT:
Prepare a statement of changes in equity for INCARA for the year ended 31st December 2006 in accordance with IAS 1 Presentation of Financial Statements. (8 Marks) (Presentation Marks: 2 Marks) [Total: 10 Marks]
REQUIREMENT:
Calculate the basic and diluted earnings per share figures for INCARA for the year ended 31st December 2006 in accordance with IAS 33 Earnings per Share. [Total: 10 Marks]
With respect to Question 4, candidates will be marked based upon their approach and NOT upon using the correct earnings figure (as derived from Question 1) in their calculations. REQUIREMENT:
Prepare a memorandum addressed to the Board of Directors of INCARA which explains:
(a)
(b)
How the leasehold property, debentures and preference shares were accounted for and disclosed in the 2006 financial statements of INCARA; and (9 Marks) The usefulness of the basic and diluted earnings per share figures calculated in Question 4.
(4 Marks) (Presentation Marks: 2 Marks) [Total: 15 Marks]
END OF PAPER Page 3
[Total: 100 Marks]
SUGGESTED SOLUTIONS
ADVANCED FINANCIAL ACCOUNTING PROFESSIONAL 2 EXAMINATION - AUGUST 2007
Examination Paper Focus
This paper is the final test of studentsʼ ability to understand the theory of financial reporting and how to apply that knowledge to a number of practical accounting issues. Students have to demonstrate both a strong technical understanding of how to solve external financial reporting issues as well as displaying an ability to communicate effectively to various groups of readers who may themselves not have that technical expertise. The key objectives are to ensure that students have:
●
●
●
the ability to prepare financial statements;
a detailed knowledge and the ability to implement financial reporting standards;
the ability to analyse and evaluate financial statements and prepare detailed reports on these statements.
The examination approach is designed to test a studentʼs: ●
●
●
ability to apply in depth knowledge of the syllabus to practical accounting problems;
understanding of the main accounting issues currently facing the professional qualified accountant in the field of financial accounting; communication skills particularly in relation to the production of both internal memoranda and external financial reports for a wide variety of user groups.
The first four questions are primarily computational. Question One requires candidates to prepare of an income statement and balance sheet, subject to a number of adjustments. The following accounting standards are addressed in this question: IAS 1 Presentation of Financial Statements; IAS 2 Inventories; IAS 16 Property, Plant and Equipment; IAS 32 Financial Instruments: Disclosure and Presentation (Superseded by IFRS 7, effective 2007); IAS 37 Provisions, Contingent Liabilities and Contingent Assets; IAS 39 Financial Instruments: Recognition and Measurement; and IAS 40 Investment Property. Question Two requires candidates to prepare a cash flow statement in accordance with IAS 7 Cash Flow Statements, while Question Three requires the preparation of a statement of changes in equity in accordance with IAS 1 Presentation of Financial Statements. Question Four examines earnings per share (IAS 33 Earning per Share).
The final question requires candidates to prepare a memorandum to the directors explaining how certain issues have been accounted for and disclosed in the companyʼs 2006 financial statements.
Page 5
SOLUTION 1
INCARA Income Statement for the Year Ended 31st December 2006
Revenue Cost of Sales: Opening inventory Purchases Closing inventory Gross profit Operating expenses Operating profit Finance costs Profit before tax Income tax Profit after tax
€ʼ000 520 3,750 (585)
(w6)
(w14)
(€45,000 (TB) + €10,000 (TB) + €15,000 (w8))
INCARA Balance Sheet as at 31st December 2006 ASSETS Non Current Liabilities Property, equipment and motor vehicles
Current Liabilities Inventory Trade receivables
EQUITY AND LIABILITIES Capital and Reserves 50 cent ordinary shares Share premium Revaluation reserve Retained earnings
Non Current Liabilities 10% debentures Current Liabilities
Bank Trade payables Income tax Debenture interest Customer claim Preference shares Preference dividend
€ʼ000 6,850 (3,685) 3,165 (2,474) 691 (70) 621 (150) 471
(Format & presentation 2 Marks)
€ʼ000
(w5)
16,614
(w6) (€360,000 (TB) - €18,000 (w7))
585 342 17,541
(€600,000 (TB) - €200,000 (w1) + €500,000 (w2b)) (w15)
2,250 5,000
900 4,556 600
(€700,000 (TB) + €2,500,000 (w2a) - €50,000 (w3)) (€1,050,000 (TB) - €650,000 (w1)) (w13) (w8) (w11) (w9) (w9)
2,520 400 150 15 50 1,000 100 17,541
(Format & presentation 2 Marks)
Page 6
1.
Workings:
Disposal of freehold property
€ʼ000 600 (120) 480 650 170
Revalued amount Accumulated depreciation Carrying value Proceeds Profit on disposal
The profit on disposal could be considered ʻexceptionalʼ and separately disclosed with ʻoperating expensesʼ. DR DR
2.
Revaluation reserve Trade payables Freehold property Operating expenses Retained earnings
CR €ʼ000 480 170 200
(4 Marks)
Purchase of leasehold property In 2006, as the property was used by INCARA, it cannot be treated as an investment property in accordance with IAS 40 Investment Property. Therefore, it should be accounted for in accordance with IAS 16 Property, Plant and Equipment. As freehold properties are recorded at their revalued amount (not fair value as would be the case for investment properties), it is reasonable to assume that the company would adopt a similar policy for leasehold properties. (Although as arguably a ʻdifferent class of assetʼ, it would be acceptable to record it at cost.) DR
Then: DR
3.
CR CR CR
DR €ʼ000 200 650
CR CR
DR €ʼ000 2,500
Leasehold properties Bank
Leasehold properties Revaluation reserve
500
CR €ʼ000 2,500 500
(4 Marks)
Disposal of equipment Proceeds Net book value Loss on disposal
€ʼ000 50,000 (75,000) (25,000)
The loss on disposal could be considered ʻexceptionalʼ and separately disclosed with ʻoperating expensesʼ. DR DR DR
4.
CR
Bank Equipment – accumulated depreciation Operating expenses Equipment - cost
DR €ʼ000 50 225 25
CR €ʼ000 300
(4 Marks)
Depreciation of motor vehicles Company policy is still to depreciate motor vehicles over their estimated useful economic life, therefore the change does not represent a change in accounting policy. (1 Mark) Page 7
5.
Property, equipment and motor vehicles Leasehold property €ʼ000
Freehold property €ʼ000
Equipment €ʼ000
Motor vehicles €ʼ000
Accumulated Depreciation At 1st January 2006 On disposals Charge for year 120 At 31st December 2006 120
600 600
17,400 2,500 500 (900) 19,500
1,000 (120) 576 1,456
800 (225) 375 950
120 240 360
1,920 (345) 1,311 2,886
12,944 14,000
550 1,000
240 480
16,614 15,480
Valuation / Cost At 1st January 2006 Additions Revaluation Disposals At 31st December 2006
Net book value At 31st December 2006 At 31st December 2005 Depreciation: Leasehold property Freehold property Equipment
Motor vehicles
2,500 500 3,000
2,880 -
15,000 (600) 14,400
€3,000,000 25 €14,400 25
1,800 (300) 1,500
€ʼ000 = 120
Total
€ʼ000
=576
€1,500,000
@ 25% = 375
€480,000 2
= 240
(Motor vehicles are now being depreciated over 3 years with 1 year already having been charged; therefore 2 years remaining.) DR
6.
CR CR CR CR
DR €ʼ000 1,311
Operating expenses Leasehold property Freehold property Equipment Motor vehicles
CR €ʼ000 120 576 375 240
(6 Marks)
Note: As leasehold and freehold property are recorded at valuation, INCARA has the option of transferring an amount from the revaluation reserve to offset the additional depreciation. This has not been done in this case.
Inventory at 31st December 2006 As per IAS 2 Inventories, inventory should be sated at the lower of cost and NRV. €ʼ000 Satellite navigation systems - cost 100 - NRV (€95,000 - €10,000) (85) - write down 15 i.e. additional evidence in 2007 of conditions existing at the balance sheet date and therefore represents an adjusting event
Therefore inventory at 31st December 2006 should be stated at €585,000 (€600,000 - €15,000). Page 8
(2 Marks)
7.
Provision for bad debts Trade receivables at 31st December 2006
€ʼ000 360
DR
DR €ʼ000 8
@ 5% Provision per TB Increase in provision required
8.
CR
18 (10) 8
Operating expenses Provision for bad debts
8
(2 Marks)
Debentures These should be disclosed as debt under ʻnon current liabilitiesʼ in the balance sheet at 31st December 2006. €ʼ000 60 45 15
The annual interest charge is €600,000 x 10% Per TB Accrual required DR
9.
CR €ʼ000
CR
IS – finance costs Current Liabilities – finance cost accrual
DR €ʼ000 15
(1 Mark)
CR €ʼ000
15
(2 Marks)
Preference shares
INCARA has a contractual obligation to preference shareholders, in respect of both dividends and to return the cash at the option of the preference shareholder. Therefore the preference dividend should be accrued as there is legal entitlement to the dividend and the preference shares should be disclosed under current liabilities.
DR
10.
CR
Retained earnings (€1,000,000 x 10%) Current liabilities – preference dividend
DR €ʼ000 100
(1 Mark)
CR €ʼ000 100
(2 Marks)
Provision for staff training There is no legal (or constructive) obligation until the training is carried out. Therefore provision should be reversed. €ʼ000 €ʼ000 DR Provisions 80 CR Retained earnings – prior year adjustment 80
(2 Marks)
Page 9
11.
Customer claim Amount payable is probable, therefore provide. DR Operating expenses CR Current liabilities – provision for claim
€ʼ000 50
€ʼ000
50
(2 Marks)
The counter claim/contingent gain should be shown in the notes only. It should not be offset as legal opinion does not suggest that the two outcomes are connected and / or that it is likely to succeed. 12.
Proposed dividends (a) Accrue preference dividend (see w9). (b)
13.
14.
15.
(1 Mark)
Ordinary dividend – as no legal obligation / entitlement until approved by the shareholders at the AGM, therefore no accrual required. (2 Marks)
Taxation DR
CR
€ʼ000 150
IS – income tax B/S – Current liabilities
€ʼ000
150
(2 Marks)
Operating expenses
€ʼ000 (1,250) (8) 170 (25) (1,311) (50) (2,474)
Per TB Bad debt provision (w7) Profit on disposal (w1) Loss on disposal (w3) Depreciation (w5) Customer claim (w11)
(3 Marks)
Retained earnings
€ʼ000 3,905 80 3,985 (100) 200 471 4,556
Per TB Provision for staff training (w10)
Preference dividend (w9) Transfer from revaluation reserve (w1) Profit after tax (IS)
(5 Marks)
[Total : 50 Marks]
Page 10
SOLUTION 2
INCARA Cash Flow Statement for the Year Ended 31st December 2006
Net cash flow from operating activities (w1) Cash flows from investing activities (w2)
(1,800)
Cash flows from financing activities (w3)
5,100
Net increase in cash and cash equivalents
5,115
Cash and cash equivalents at 1st January 2006
Cash and cash equivalents at 31st December 2006
1.
2.
3.
€ʼ000 1,815
Workings:
Net cash flow from operating activities (indirect method) Profit before tax (Q1) Depreciation (Q1, w5) Profit on disposal (Q1, w1) Loss on disposal (Q1, w3) Increase in trade receivables (€342,000 - €190,000) Increase in trade payables (€400,000 - €220,000) Interest paid (IS €70,000 - €15,000 (w8)) Income tax paid Increase in inventory (€585,000 - €520,000) Customer claim
(7,635) (2,520)
(Format & presentation 2 Marks)
€ʼ000 691 1,311 (170) 25 (152) 180 (55) (65) 50 1,815
(8 Marks)
Cash flows from investing activities Purchase of leasehold equipment Disposal of freehold property Disposal of equipment
€ʼ000 (2,500) 650 50 (1,800)
(3 Marks)
Cash flows from financing activities Proceeds from share options (€1,500,000 x €3) Proceeds from debenture issue
€ʼ000 4,500 600 5,100
(2 Marks)
[Total : 15 Marks]
Page 11
SOLUTION 3
INCARA Statement of Changes in Equity for the Year Ended 31st December 2006
Balance at 1st January 2006 – as previously stated Prior year adjustment Balance at 1st January 2006 – as restated Gain on revaluation of leasehold property Transfer on disposal of freehold property Net income recognised directly in equity
Profit for year Total recognised income and expenditure for the year Preference dividends Issue of ordinary shares Balance at 31st December 2006
Share capital €ʼ000 1,500 1,500 1,500
1,500 750 2,250
Share Revaluation premium reserve €ʼ000 €ʼ000 1,250 600 1,250 600 500 (200) 1,250 900 1,250 3,750 5,000
900 900
Retained earnings €ʼ000 3,905 80 3,985 200 4,185
Total €ʼ000 7,255 80 7,335 500 7,835
471 4,656 (100) 4,556
471 8,306 (100) 4,500 12,706
(Format & presentation 2 Marks) (Other entries 8 Marks)
[Total : 10 Marks]
SOLUTION 4
Basic EPS:
PAT – preference dividends Weighted average number of ordinary shares in issue
€471,000 – 100,000 (3,000,000) + (1,500,000 x 6/12) €371,000 3,750,000
Diluted EPS:
= 9.89 cents
PAT – preference dividends Shares in issue + Weighted average number of ordinary shares that could be issued on conversion if issued for no consideration issue
€371,000 = €0.143 4,562,500 (w1)
w1 Weighted average number of ordinary shares in issue (as per basic EPS) Total number of shares that could be issued: 3,000,000 x 6/12 3,500,000 x 6/12
Shares that could be issued under option scheme at full market price: 3,250,000 x (3/4) Shares that could be issued under option scheme for no consideration
(4 Marks)
(2 Marks)
1,500,000 1,750,000 3,250,000
(2,437,500)
3,750,000
812,500 4,562,500
(4 Marks)
Page 12
[Total : 10 Marks]
SOLUTION 5
DATE: TO: FROM:
MEMORANDUM
dd/mm/yy Board of Directors Financial Accountant
(Format & presentation 2 Marks)
SUBJECT: INCARA – 2006 Financial Statements As requested, please find… (a)
How the leasehold property, debentures and preferences shares were accounted for and disclosed in the 2006 financial statements of INCARA.
Leasehold Property Year ended 31st December 2006: IAS 40 Investment Property states that an investment property is an interest in land/buildings in which: construction is complete; and is held for its investment potential, any rental negotiated at arms length. Exceptions include properties owned and occupied by the company for their own purposes.
In 2006, as the property was used by INCARA, it cannot be treated as an investment property in accordance with IAS 40 Investment Property. Therefore, it should be accounted for in accordance with IAS 16 Property, Plant and Equipment. Consequently, the property could be treated as a depreciable asset and stated at cost less depreciation on a straight-line basis over the remaining useful period of the lease. However, as freehold properties are recorded at their revalued amount, it is reasonable to assume that the company will adopt a similar policy for leasehold properties. (Although, as leasehold property is arguably a ʻdifferent class of assetʼ, it would be acceptable to record this class of property at cost.) (2 Marks) Year ended 31st December 2007: The property can now be classed as an investment property, and should not be subject to charges for depreciation. The investment property should be included in the balance sheet at fair value. Debentures A financial liability is any liability that is a contractual obligation to: (a) (b)
(1 Mark)
deliver cash or another financial asset to another entity; or exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
Examples of financial liabilities are overdrafts, trade payables, bonds and debentures. Consequently, the debentures should be disclosed as debt under ʻnon current liabilitiesʼ in the balance sheet at 31st December 2006 in accordance with IFRS 7 Financial Instruments: Disclosures (previously IAS 32 Financial Instruments: Presentation and Disclosure). (3 Marks) Preference Shares Similarly, as INCARA has a contractual obligation to preference shareholders, in respect of both dividends and to return the cash at the option of the preference shareholder, the preference dividend should be accrued as there is legal entitlement to the dividend and the preference shares should be disclosed under current liabilities. (3 Marks)
Page 13
(b) ●
●
●
The usefulness of the basic and diluted earnings per share figures.
Over time the basic EPS provides a useful yardstick or measure of performance for equity shareholders of the profits underlying the equity share;
EPS is calculated in a standard manner in accordance with IAS 33 Earnings per Share and may therefore be used to compare performance of different companies. However the information is based upon historic information and may therefore have little bearing on future performance; The diluted EPS indicates whether at some time in the future the earnings of equity shareholders might become diluted as a result of options being exercised. It therefore can act as a measure of risk associated with holding the equity shares. (4 Marks)
[Total : 15 Marks] [Total: 100 Marks]
Page 14
