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f7sgp 2007 Dec A
f7sgp 2007 Dec A
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(v) The 15 million shares issued by Plateau in the share exchange at a value of $6 each would be recorded as an increase
in share capital of $9 million.
(vi) Consolidated retained earnings: $000
Plateaus retained earnings 24,000
Savannahs post-acquisition ((2,900 300 URP) x 75%) 1,950
Axles post-acquisition profits (5,000 x 30%) 1,500
URP in plant (see (i)) (400)
Gain on available-for-sale investment (9,000 6,500) see below 2,500
Impairment of goodwill (900)
28,650
The gain on available-for-sale investments must be recognised directly in equity.
(vii) Minority interest
Adjusted equity at 30 September 2007: (12,900 300 URP) = 12,600 x 25% 3,150
(b) FRS 103 Business Combinations requires the purchase consideration for an acquired entity to be allocated to the fair value
of the assets, liabilities and contingent liabilities acquired (henceforth referred to as net assets and ignoring contingent
liabilities) with any residue being allocated to goodwill. This also means that those net assets will be recorded at fair value in
the consolidated balance sheet. This is entirely consistent with the way other net assets are recorded when first transacted
(i.e. the initial cost of an asset is normally its fair value). The purpose of this process is that it ensures that individual assets
and liabilities are correctly classified (and valued) in the consolidated balance sheet. Whilst this may sound obvious, consider
what would happen if say a property had a carrying amount of $5 million, but a fair value of $7 million at the date it was
acquired. If the carrying amount rather than the fair value was used in the consolidation it would mean that tangible assets
(property, plant and equipment) would be understated by $2 million and intangible assets (goodwill) would be overstated by
the same amount (note: in the consolidated balance sheet of Plateau the opposite effect would occur as the fair value of
Savannahs land is below its carrying amount at the date of acquisition). There could also be a knock on effect with incorrect
depreciation charges in the years following an acquisition and incorrect calculation of any goodwill impairment. Thus the use
of carrying amounts rather than fair values would not give a faithful representation as required by the Framework.
The assistants comment regarding the inconsistency of value models in the consolidated balance sheet is a fair point, but it
is really a deficiency of the historical cost concept rather than a flawed consolidation technique. Indeed the fair values of the
subsidiarys net assets are the historical costs to the parent. To overcome much of the inconsistency, there would be nothing
to prevent the parent company from applying the revaluation model to its property, plant and equipment.
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(b) Llama Balance sheet as at 30 September 2007
$000 $000
Assets
Non-current assets
Property, plant and equipment (w (iv)) 228,500
Current assets
Inventory 37,900
Trade receivables 35,100
Investments at fair value through profit and loss 27,100 100,100
Total assets 328,600
Equity and liabilities
Equity
Equity shares 84,000
Revaluation reserve (14,000 3,000 (w (iv))) 11,000
Retained earnings (56,500 + 25,500) 82,000 93,000
177,000
Non-current liabilities
2% loan note (80,000 + 1,600 (w (ii))) 81,600
Deferred tax (40,000 x 25%) 10,000 91,600
Current liabilities
Trade payables 34,700
Bank overdraft 6,600
Current tax payable 18,700 60,000
Total equity and liabilities 328,600
Workings (monetary figures in brackets are in $000)
(i) Cost of sales: $000
Per question 89,200
Plant capitalised (w (iv)) (24,000)
Depreciation (w (iv)) buildings 3,000
plant 13,500
81,700
(ii) The loan has been in issue for six months. The total finance charge should be based on the effective interest rate of 6%.
This gives a charge of $24 million (80,000 x 6% x 6/12). As the actual interest paid is $800,000 an accrual (added
to the carrying amount of the loan) of $16 million is required.
(iii) The rights issue was 30 million shares (120 million shares at 1 for 4) at a price of 80 cents. This would increase share
capital by $24 million (30 million x 80 cents).
(iv) Non-current assets/depreciation:
Land and buildings:
On 1 October 2006 the value of the buildings was $100 million (130,000 30,000 land). The remaining life at this
date was 20 years, thus the annual depreciation charge will be $5 million (3,000 to cost of sales and 1,000 each to
distribution and administration). Prior to the revaluation at 30 September 2007 the carrying amount of the building was
$95 million (100,000 5,000). With a revalued amount of $92 million, this gives a revaluation deficit of $3 million
which should be debited to the revaluation reserve. The carrying amount of land and buildings at 30 September 2007
will be $122 million (92,000 buildings + 30,000 land (unchanged)).
Plant
The existing plant will be depreciated by $12 million ((128,000 32,000) x 121/2%) and have a carrying amount of
$84 million at 30 September 2007.
The plant manufactured for internal use should be capitalised at $24 million (6,000 + 4,000 + 8,000 + 6,000).
Depreciation on this will be $15 million (24,000 x 121/2% x 6/12). This will give a carrying amount of $225 million
at 30 September 2007. Thus total depreciation for plant is $135 million with a carrying amount of $1065 million
(84,000 + 22,500)
Summarising the carrying amounts: $000
Land and buildings 122,000
Plant 106,500
Property, plant and equipment 228,500
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(c) Earnings per share (eps) for the year ended 30 September 2007
Theoretical ex rights value $
Holding (say) 100 at $1 100
Issue (1 for 4) 25 at 80 cents 20
New holding 125 ex rights price is 96 cents 120
Weighted average number of shares
120,000,000 x 9/12 x 100/96 93,750,000
150,000,000 (120 x 5/4) x 3/12 37,500,000
131,250,000
Earnings per share ($56,500,000/131,250,000) 43 cents
(b) Analysis of the comparative financial performance and position of Harbin for the year ended 30 September 2007. Note:
references to 2007 and 2006 should be taken as the years ended 30 September 2007 and 2006.
Introduction
The figures relating to the comparative performance of Harbin highlighted in the Chief Executives report may be factually
correct, but they take a rather biased and one dimensional view. They focus entirely on the performance as reflected in the
income statement without reference to other measures of performance (notably the ROCE); nor is there any reference to the
purchase of Fatima at the beginning of the year which has had a favourable effect on profit for 2007. Due to this purchase,
it is not consistent to compare Harbins income statement results in 2007 directly with those of 2006 because it does not
match like with like. Immediately before the $100 million purchase of Fatima, the carrying amount of the net assets of Harbin
was $112 million. Thus the investment represented an increase of nearly 90% of Harbins existing capital employed. The
following analysis of performance will consider the position as shown in the reported financial statements (based on the ratios
required by part (a) of the question) and then go on to consider the impact the purchase has had on this analysis.
Profitability
The ROCE is often considered to be the primary measure of operating performance, because it relates the profit made by an
entity (return) to the capital (or net assets) invested in generating those profits. On this basis the ROCE in 2007 of 112%
represents a 58% improvement (i.e. 41% on 71%) on the ROCE of 71% in 2006. Given there were no disposals of
non-current assets, the ROCE on Fatimas net assets is 189% (22m/100m + 165m). Note: the net assets of Fatima at the
year end would have increased by profit after tax of $165 million (i.e. 22m x 75% (at a tax rate of 25%)). Put another way,
without the contribution of $22 million to profit before tax, Harbins underlying profit would have been a loss of $6 million
which would give a negative ROCE. The principal reasons for the beneficial impact of Fatimas purchase is that its profit
margins at 429% gross and 314% net (before tax) are far superior to the profit margins of the combined business at 20%
and 64% respectively. It should be observed that the other contributing factor to the ROCE is the net asset turnover and in
this respect Fatimas is actually inferior at 06 times (70m/1165m) to that of the combined business of 12 times.
It could be argued that the finance costs should be allocated against Fatimas results as the proceeds of the loan note appear
to be the funding for the purchase of Fatima. Even if this is accepted, Fatimas results still far exceed those of the existing
business.
Thus the Chief Executives report, already criticised for focussing on the income statement alone, is still highly misleading.
Without the purchase of Fatima, underlying sales revenue would be flat at $180 million and the gross margin would be down
to 111% (20m/180m) from 167% resulting in a loss before tax of $6 million. This sales performance is particularly poor
given it is likely that there must have been an increase in spending on property plant and equipment beyond that related to
the purchase of Fatimas net assets as the increase in property, plant and equipment is $120 million (after depreciation).
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Liquidity
The companys liquidity position as measured by the current ratio has deteriorated dramatically during the period. A relatively
healthy 25:1 is now only 09:1 which is rather less than what one would expect from the quick ratio (which excludes
inventory) and is a matter of serious concern. A consideration of the component elements of the current ratio suggests that
increases in the inventory holding period and trade payables payment period have largely offset each other. There is a small
increase in the collection period for trade receivables (up from 16 days to 19 days) which would actually improve the current
ratio. This ratio appears unrealistically low, it is very difficult to collect credit sales so quickly and may be indicative of factoring
some of the receivables, or a proportion of the sales are cash sales. Factoring is sometimes seen as a consequence of declining
liquidity, although if this assumption is correct it does also appear to have been present in the previous year. The changes in
the above three ratios do not explain the dramatic deterioration in the current ratio, the real culprit is the cash position, Harbin
has gone from having a bank balance of $14 million in 2006 to showing short-term bank borrowings of $17 million in 2007.
A cash flow statement would give a better appreciation of the movement in the bank/short term borrowing position.
It is not possible to assess, in isolation, the impact of the purchase of Fatima on the liquidity of the company.
Dividends
A dividend of 10 cents per share in 2007 amounts to $10 million (100m x 10 cents), thus the dividend in 2006 would have
been $8 million (the dividend in 2007 is 25% up on 2006). It may be that the increase in the reported profits led the Board
to pay a 25% increased dividend, but the dividend cover is only 12 times (12m/10m) in 2007 which is very low. In 2006
the cover was only 075 times (6m/8m) meaning previous years reserves were used to facilitate the dividend. The low
retained earnings indicate that Harbin has historically paid a high proportion of its profits as dividends, however in times of
declining liquidity, it is difficult to justify such high dividends.
Gearing
The company has gone from a position of nil gearing (i.e. no long-term borrowings) in 2006 to a relatively high gearing of
467% in 2007. This has been caused by the issue of the $100 million 8% loan note which would appear to be the source
of the funding for the $100 million purchase of Fatimas net assets. At the time the loan note was issued, Harbins ROCE
was 71%, slightly less than the finance cost of the loan note. In 2007 the ROCE has increased to 112%, thus the manner
of the funding has had a beneficial effect on the returns to the equity holders of Harbin. However, it should be noted that high
gearing does not come without risk; any future downturn in the results of Harbin would expose the equity holders to much
lower proportionate returns and continued poor liquidity may mean payment of the loan interest could present a problem.
Harbins gearing and liquidity position would have looked far better had some of the acquisition been funded by an issue of
equity shares.
Conclusion
There is no doubt that the purchase of Fatima has been a great success and appears to have been a wise move on the part
of the management of Harbin. However, it has disguised a serious deterioration of the underlying performance and position
of Harbins existing activities which the Chief Executives report may be trying to hide. It may be that the acquisition was part
of an overall plan to diversify out of what has become existing loss making activities. If such a transition can continue, then
the worrying aspects of poor liquidity and high gearing may be overcome.
(b) (i) The finance directors comment that the ROCE will improve, based on the agreement being classified as an operating
lease is correct (but see below). Over the life of the lease the reported profit is not affected by the lease being designated
as an operating or finance lease, but the balance sheet is. This is because the depreciation and finance costs charged
on a finance lease would equal (over the full life of the lease) what would be charged as lease rentals if it were classed
as an operating lease instead. However, classed as an operating lease, there would not be a leased asset or lease
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obligation recorded in the balance sheet; whereas there would be if it were a finance lease. Thus capital employed under
an operating lease would be lower leading to a higher (more favourable) ROCE. FRS 17 Leases defines a finance lease
as one which transfers to the lessee substantially all the risks and rewards incidental to ownership (an application of the
principle of substance over form). In this case, as the asset will be used by Fino for four years (its entire useful life) and
then be scrapped, it is almost certain to require classification as a finance lease. Thus the finance directors comments
are unlikely to be valid.
Fino
(ii) Operating lease $
Income statement cost of sales (machine rental) (100,000 x 6/12) 50,000
Balance sheet
Current assets
Prepayment (100,000 x 6/12) 50,000
(iii) Finance lease
Income statement cost of sales (depreciation) (350,000/4 x 6/12) 43,750
finance costs (see working) 12,500
Balance sheet
Non-current assets
Leased plant at cost 350,000
Depreciation (from above) (43,750)
306,250
Non-current liabilities
Lease obligation (250,000 75,000) 175,000
Current liabilities
Accrued interest (see working) 12,500
Lease obligation (100,000 25,000 see below) 75,000
87,500
Working:
Cost 350,000
Deposit (100,000)
250,000
Interest to 30 September 2007 (6 months at 10%) 12,500
Total obligation at 30 September 2007 262,500
The payment of $100,000 on 1 April 2008 will contain $25,000 of interest ($250,000 x 10%) and a capital
repayment of $75,000.
5 (a) The Framework defines an asset as a resource controlled by an entity as a result of past transactions or events from which
future economic benefits (normally net cash inflows) are expected to flow to the entity. However assets can only be recognised
(on the balance sheet) when those expected benefits are probable and can be measured reliably. The Framework recognises
that there is a close relationship between incurring expenditure and generating assets, but they do not necessarily coincide.
Development expenditure, perhaps more than any other form of expenditure, is a classic example of the relationship between
expenditure and creating an asset. Clearly entities commit to expenditure on both research and development in the hope that
it will lead to a profitable product, process or service, but at the time that the expenditure is being incurred, entities cannot
be certain (or it may not even be probable) that the project will be successful. Relating this to accounting concepts would
mean that if there is doubt that a project will be successful the application of prudence would dictate that the expenditure is
charged (expensed) to the income statement. At the stage where management becomes confident that the project will be
successful, it meets the definition of an asset and the accruals/matching concept would mean that it should be capitalised
(treated as an asset) and amortised over the period of the expected benefits. Accounting Standards (FRS 38 Intangible Assets)
interpret this as writing off all research expenditure and only capitalising development costs from the point in time where they
meet strict conditions which effectively mean the expenditure meets the definition of an asset.
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Workings (All figures in $000. Note: references to 2004, 2005 etc should be taken as for the year ended 30 September
2004 and 2005 etc.)
Year 2004 2005 2006 cumulative 2006 2007 cumulative 2007
Expenditure 300 240 800 1,340 400 1,740
Amortisation (25%) nil (75) (75) (150) (75) (225)
nil nil (60) (60) (60) (120)
nil nil nil nil (200) (200)
Total amortisation nil (75) (w (i)) (135) (210) (w (ii)) (335) (545)
Carrying amount 300 165 665 (w (iii)) 1,130 65 (w (iv)) 1,195
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Fundamentals Level Skills Module, F7 (SGP)
Financial Reporting (Singapore) December 2007 Marking Scheme
This marking scheme is given as a guide in the context of the suggested answers. Scope is given to markers to award marks for
alternative approaches to a question, including relevant comment, and where well-reasoned conclusions are provided. This is
particularly the case for written answers where there may be more than one acceptable solution.
Marks
1 (a) Balance sheet:
property, plant and equipment 2
goodwill 4
investments associate 2
other 1
current assets 2
equity shares 2
retained earnings 4
minority interest 1
7% loan notes 1
current liabilities 1
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Marks
4 (a) one mark per valid point to maximum 5
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