CIMA-F2-Financial-Management1

Analysis and interpretation of financial accounts

Determining the weighted average capital, therefore, involves two steps as
follows:

(1) adjust for the bonus element in the rights issue, by multiplying capital in
issue before the rights issue by the following fraction:
Actual cum rights price
––––––––––––––––––––
Theoretical ex rights price

(2) calculate the weighted average capital in the issue as above.

– The cum rights price is usually provided to you in the exam
question. It is the share price on the last trading day before the
rights issue i.e. the price of a share 'including' the rights.

– The theoretical ex-rights price is the theoretical share price after the
rights issue has occured. This must be calculated.

Illustration 4 - Theoretical ex rights price

C is making a 1 for 4 rights issue at $1.90 per share.

The cum rights price of C's shares is $2.00.
Required:

Calculate the theoretical ex rights price.
Solution

Before rights Number of shares x Price = Value
Rights issue 4 x 2.00 = 8.00
1 x 1.90 = 1.90
After rights
––– –––
x?

We are looking for the theoretical ex rights price (TERP) i.e. the price of
a share after the rights issue, denoted by a question mark above.

38 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Simply calculate the total value after the issue and divide it by the total
number of shares after the issue.

Number of shares x Price = Value
4
Before rights 1 x 2.00 = 8.00
Rights issue
––– x 1.90 = 1.90
After rights 5
–––

x? 9.90

TERP = 9.90/ 5 = 1.98

Example 3 - Rights issue

Example 3 answer

Test your understanding 8

On 31 December 20X1, the issued share capital consisted of 4,000,000
ordinary shares of 25c each. On 1 July 20X2 the company made a rights
issue in the proportion of 1 for 4 at 50c per share when the shares were
quoted at $1. Its trading results for the last two years were as follows:

Year ended 31 December
Profit after tax
20X1 20X2

$$

320,000 425,000

Required:

Show the calculation of basic EPS to be presented in the financial
statements for the year ended 31 December 20X2 (including the
comparative figure).

KAPLAN PUBLISHING 39

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding 9 - Rose

Extracts from Rose's financial statements for the year ended 30 April
20X4 and comparatives are shown below:

Income statement

Profit before tax Year ending Year ending
Income tax expense 30.4.X4 30.4.X3
$m $m
Profit after tax 800 650
(350) (290)
–––– ––––
450 360
–––– ––––

At 1 May 20X3 Rose has 900 million $1 ordinary shares in issue. There
had been no share issues during the year ended 30 April 20X3.

Required:

Calculate the basic EPS, with comparatives, in each of the following
situations:

(a) No changes in shares in the year ended 30 April 20X4.

(b) An issue of 50 million shares at full market price took place on 1
December 20X3.

(c) A bonus issue of 1 share for every 9 held was made on 1
September 20X3.

(d) On 1 July 20X3, a rights issue took place of 1 share for every 4 held
at $2. The market value of each share immediately before the rights
issue was $2.50.

10 Diluted earnings per share (DEPS)
Introduction

Equity share capital may change in the future owing to circumstances which
exist now. The provision of a diluted EPS figure attempts to alert
shareholders to the potential impact of these changes on the EPS figure.

40 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Examples of dilutive factors are:

• the conversion terms for convertible bonds
• the conversion terms for convertible preference shares
• the exercise price for options and the subscription price for warrants.

When the potential ordinary shares are issued the total number of shares in
issue will increase and this can have a dilutive effect on EPS i.e. it may fall. It
will fall where the increase in shares outweighs any increase in profits e.g.
due to interest payments falling.

Basic principles of calculation

To deal with potential ordinary shares, adjust basic earnings and number of
shares assuming convertibles, options, etc. had converted to equity shares
on the first day of the accounting period, or on the date of issue, if later.

DEPS is calculated as follows:

Earnings + notional extra earnings
–––––––––––––––––––––––––––––––
Number of shares + notional extra shares

Importance of DEPS

Convertibles

The principles of convertible bonds and convertible preference shares are
similar and will be dealt with together.

If the convertible bonds/preference shares had been converted:

• the interest/dividend would be saved therefore earnings would be

higher

• the number of shares would increase.

Note: there will be an interest saving on bonds but not on preference
dividends as they are not tax deductible.

Example 4 - Convertibles

Example 4 answer

KAPLAN PUBLISHING 41

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding 10

A company had 8.28 million shares in issue at the start of the year and
made no new issue of shares during the year ended 31 December
20X4, but on that date it had in issue $2,300,000 10% convertible loan
stock 20X6-20X9. Assume a tax rate of 30%.The earnings for the year
were $2,208,000.

This loan stock will be convertible into ordinary $1 shares as follows.

20X6 90 $1 shares for $100 nominal value loan stock

20X7 85 $1 shares for $100 nominal value loan stock

20X8 80 $1 shares for $100 nominal value loan stock

20X9 75 $1 shares for $100 nominal value loan stock

Required:

Calculate the fully diluted EPS for the year ended 31 December 20X4.

Options and warrants to subscribe for shares

An option or warrant gives the holder the right to buy shares at some time in
the future at a predetermined price.

The cash received by the entity when the option is exercised is less than the
market price of the shares. An option will only be exercised if the option or
exercise price is lower than the market price. The increase in resources
does not therefore match the increase in resources if the issue of shares
were at market value. The option will consequently have a dilutive effect of
EPS.

The total number of shares issued on the exercise of the option or warrant
is split into two:

• the number of shares that would have been issued if the cash received

had been used to buy shares at fair value (using the average price of
the shares during the period)

• the remainder, which are treated like a bonus issue (i.e. as having

been issued for no consideration).

The number of shares issued for no consideration is added to the number of
shares when calculating the DEPS.

42 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

The extra number of shares is equal to:

Number of options FV – OP
x –––––

FV

FV = fair value of the share price

OP = Option/ exercise price of the shares

Example 5 - Options

Example 5 answer

Test your understanding 11

A company had 8.28 million shares in issue at the start of the year and
made no issue of shares during the year ended 31 December 20X4, but
on that date there were outstanding options to purchase 920,000
ordinary $1 shares at $1.70 per share. The average fair value of ordinary
shares was $1.80. Earnings for the year ended 31 December 20X4
were $2,208,000.

Required:

Calculate the fully DEPS for the year ended 31 December 20X4.

Test your understanding 12

On 1 January the issued share capital of Pillbox was 12 million
preference shares of $1 each and 10 million ordinary shares of $1 each.
Assume where appropriate that the income tax rate is 30%. The
earnings for the year ended 31 December were $5,950,000.

You are given the following circumstances (a)–(f):

(a) there was no change in the issued share capital of the company
during the year ended 31 December

(b) the company made a bonus issue on 1 October of one ordinary
share for every four shares in issue at 30 September

(c) the company issued 1 share for every 10 on 1 August at full market
value of $4

KAPLAN PUBLISHING 43

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

(d) the company made a rights issue of $1 ordinary shares on 1
October in the proportion of 1 of every 3 shares held, at a price of
$3. The middle market price for the shares on the last day of
quotation cum rights was $4 per share

(e) the company made no new issue of shares during the year ended
31 December, but on that date it had in issue $2,600,000 10%
convertible bonds. These bonds will be convertible into ordinary $1
shares as follows:

20X6 90 $1 shares for $100 nominal value bonds
20X7 85 $1 shares for $100 nominal value bonds
20X8 80 $1 shares for $100 nominal value bonds
20X9 75 $1 shares for $100 nominal value bonds

(f) the company made no issue of shares during the year ended 31
December, but on that date there were outstanding options to
purchase 74,000 ordinary $1 shares at $2.50 per share. Share
price during the year was $4.

Required:

Calculate the EPS separately in respect of the year ended 31
December for each of the circumstances (a)-(f).

44 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

11 Chapter summary

KAPLAN PUBLISHING 45

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding answers

Test your understanding 1 - T
Profitability

20X5 20X6

Gross profit Gross profit 90/150 = 60% 115/180 = 63.9%
margin ––––––––

Revenue

Operating profit

Operating profit ––––––––––– 61.5/150 = 41% 75.1/180 = 41.7%

margin Revenue

Net profit Net profit 37.9/150 = 45.8/180 = 25.4%
margin –––––––– 25.3%
Revenue

Return on Operating profit 61.5/(92.9+125) 75.1/(146.7+150)
capital ––––––––––– = 28.2% = 25.3%
employed
Capital
Employed

Asset utilisation Revenue 150/(92.9+125) 180/(146.7+150)
–––––––––––
= 0.69 times = 0.61 times
Capital
Employed

Possible reasons why T's ratios have changed:

Gross profit margin increased:

• increase in sales due to increasing volume sold and so economies

of scale result in lower costs per unit sold

• increase in sales price per unit

• changes in product mix.

46 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Operating profit margin unchanged:

• increase in expenses such as advertising to boost revenue
• increased depreciation charges following acquisitions of non-

current assets

• poor control of costs since revenue increased by 20% but operating

expenses increased by 40%.

Net profit margin unchanged:

• Increase in finance costs in line with increase in revenue. Increased

borrowing to fund expansion has resulted in increased finance
costs.

Return on capital employed and asset utilisation fallen:

• no change in operating profit margin and so fall is due to fall in asset

utilisation

• revaluation of non-current assets will reduce asset utilisation (and

ROCE) but not a "real" deterioration in efficiency

• significant increase in non-current assets during year. If acquired

near year-end, will not have generated returns as yet.

Liquidity

20X5 20X6

Current ratio Current assets 50,000/22,100 = 64,300/33,800 =
––––––––––––
Current liabilities 2.3:1 1.9:1

Quick ratio (Current assets – Inventory) 38,000/22,100 = 49,300/33,800 =
–––––––––––––––––––
Current liabilities 1.7:1 1.5:1

Inventory Inventory 12,000/60,000 × 15,000/65,000 ×
holding period ––––––––– × 365 days 365 = 73 days 365 = 84 days
Cost of sales

Receivables Receivables 37,500/150,000 × 49,300/180,000 ×
collection ––––––––– × 365 days 365 =91 days 365 = 100 days
period Revenue

KAPLAN PUBLISHING 47

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Payables Trade payables 10,600/60,000 × 11,700/65,000 ×
payment ––––––––––– × 365 days 365 = 65 days 365 = 66 days
period Cost of Sales

Possible reasons why T's ratios have changed:
Inventory holding period increased:

• build up of inventory levels as a result of increased capacity

following expansion of non-current assets

• increasing inventory levels in response to increased demand for

product.

Receivables collection period increased:

• deliberate policy to attract customers
• poor credit control procedures.

Payables payment period largely unchanged.

Overall liquidity situation deteriorated:

• Current and quick ratios have both fallen but not yet at levels that

give cause for concern. However, T is showing signs of liquidity
issues with significant overdraft at year end. This is partially due to
increasing inventory holding and receivables collection periods but
suppliers being paid as quickly as last year. It appears that the
increase in non-current assets has also been partially funded via the
overdraft.

Capital structure

Gearing Debt 20X5 20X6
–––––––––––
Debt + Equity * 125/(125+92.9) = 150/(150+146.7)
57.4% =50.5%

Gearing Debt 125/92.9 = 134.6% 150/146.7 = 102.2%
(alternative) –––––
Equity

Interest cover Profit before 61.5/10 = 6.15 times 75.1/12 = 6.26 times
interest

–––––––––––––
Finance costs

48 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Dividend cover Net profit 37.9/25 = 1.5 times 45.8/25 = 1.8 times
–––––––
Dividends

Gearing fallen:

• primarily due to revaluation of non-current assets. Without

revaluation, gearing in line with previous year

• increase in loan, but also an increase in equity financing

• additional finance been used to increase non-current assets and on

other measures to expand company e.g. increased advertising
expenditure

• gearing ratio appears quite high, but interest cover also high and so

not an immediate cause for concern.

Dividend cover is adequate.

Test your understanding 2 - DM

(a) REPORT

To: A private shareholder
From: Management accountant
Date: XX/XX/20XX
Subject: Performance and position of DM

As requested, I have analysed the performance and position of DM. My
analysis is based on extracts from the financial statements for the year
ended 31 December 20X4 with comparative figures for the year ended
31 December 20X3. A number of key measures have been calculated
and these are set out in the attached Appendix.

Sales

The company has opened six new stores during the year. However,
sales have only increased very slightly in 20X4 and annual sales per
store have fallen. This may be because the new stores have only
opened part way through the year and have therefore not contributed a
full year’s revenue. Alternatively, there may have been an increase in the
level of sales tax.

KAPLAN PUBLISHING 49

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Annual sales per store are still above the industry average. On the face
of it, this is a good sign. However, it is possible that DM has large
stores relative to the rest of the sector.

Profitability

Gross profit margin has increased very slightly during the year and this is
a little above the industry average. However, although net profit margin
has increased significantly during the year, this is still below the industry
average. The increase in net profit margin has occurred because
operating expenses have fallen by over a quarter in 20X4. The
operating profit margin has risen from 3.8% in 20X3 to 4.5% in 20X4.

Given the information available, the most likely cause of this fall is the
increase in asset lives and the resulting reduction in the depreciation
expense. As might be expected, the company has a considerable
investment in property, plant and equipment and depreciation would
normally be a significant expense. An increase in asset lives is relatively
unusual and it is possible that the directors have used this method to
deliberately improve the operating and the net profit margins. (They may
have been particularly concerned that the net profit margin has obviously
been well below the industry average.) On the other hand, the directors
may have carried out their review of asset lives in good faith or there
could be another legitimate reason why operating expenses have fallen.
For example, the 20X3 figure may have been inflated by a significant
‘one off’ expense.

It is impossible to prove that the profit figure has been manipulated on
the basis of the very limited information available. Information about the
reasons for the fall in operating expenses and the review of asset lives
and about the property, plant and equipment held by the company would
be extremely useful.

Other matters

Non-current asset turnover has improved slightly, but is still below the
industry average. This suggests that the company uses its assets less
efficiently than others in the same sector. However, increasing the asset
lives will have reduced the ratio for 20X4; it is possible that the
company’s asset turnover would have approached the sector average
had the review not been carried out. Given that six new stores have
opened in 20X4, it is surprising that property, plant and equipment has
only increased by $5 million in the year. It is possible that most of the
investment in new property was made during 20X3.

The current ratio for both years is extremely low. Supermarkets often do
have relatively low current and quick ratios, but no average figure for the
industry is available, so it is difficult to tell whether this is normal for the
type of operation. Short-term liquidity appears not to be a problem

50 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

because the company has a positive cash balance which has increased
in the year. However, the appearance of the statement of financial
position suggests that this has been achieved by delaying payment to
suppliers. Trade and other payables have increased by nearly 9%, while
revenue and cost of sales have only increased by approximately 3%.

The debt/equity ratio has fallen in the year and gearing does not appear
to be a problem.

Conclusion

DM’s profit margins appear to be reasonable for a company in its
industry sector. Although its net profit margin is below the industry
average, this is improving. There are no apparent short-term liquidity
problems.

It is possible that at least some of this improvement has been achieved
by deliberately reducing the operating expenses for the year. If, as
seems likely, the directors wish to sell their interests in the company in
the near future, improved results will help to secure a better price.
However, it is impossible to be certain that this has happened without
much more detailed information about the reason for the fall in operating
expenses. There may be a legitimate explanation for the improvement
in the company’s profit margins.

Appendix

20X4 20X3 Key sector
ratio

Annual sales per 1,255/ 42 = 1,220/ 36 = $27.6m
store $29.9m $33.9m

Gross profit 78/ 1,255 x 75/ 1,220 x 5.9%
margin 100% = 6.2% 100% = 6.1%

Operating profit 57/ 1,255 x 46/ 1,220 x –
margin 100% = 4.5% 100% = 3.8%

Net profit margin 33/ 1,255 x 23/ 1,220 x 3.9%
100% = 2.6% 100% = 1.9%

Non-current asset 1,255/ 680 = 1,220/ 675 = 1.93 times
turnover 1.85 times 1.81 times

Current ratio 105/ 317 = 71/ 309 = 0.23:1 –
0.33:1

Debt/ equity 142/ 301 x 100% 140/ 276 x 100% –

= 47.2% = 50.7%

KAPLAN PUBLISHING 51

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts
(b) Limitations of the use of sector comparatives
It can often be useful to compare ratios for an individual company with
averages for the sector. However, this type of analysis has a number of
limitations:

• Some accounting ratios can be calculated in different ways.

Therefore a sector average may be based on ratios that have not
been calculated consistently.

• The figures in the financial statements are affected by the

accounting policies adopted and by accounting estimates.
Accounting estimates (such as the useful lives of assets) require
judgement. Some international accounting standards still allow a
choice of accounting policies.

• Entities in the same sector may operate under different business

environments. For example, DM operates in one of six provinces.
Conditions may be very different in the other five; so DM’s financial
performance and position may not be strictly comparable with
companies operating in other provinces.

• Sector comparatives are normally based on an average of several

entities. The average can be distorted by one entity that is
significantly out of line with the others. Also, the smaller the number
of entities, the less reliable the average figure will be. For example,
12 entities is quite a small number.

• Published sector averages may exclude some important ratios. For

example, it would be useful to know the average current ratio and
debt/equity ratio for DM’s industry sector.

52 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Test your understanding 3 - Expand

(a)
REPORT

To: The directors of Expand
From: The Management Accountant
Date: XX-XX-XX
Subject: Profitability of Hone and Over

This report assesses the relative profitability of Hone and Over,
based on each company’s most recent published financial
statements translated, where necessary, into dollars. Detailed
calculations of accounting ratios are shown in the appendix to this
report.

Based on the financial information provided, it appears that Over is
the more profitable company, since it has a higher return on capital
employed. However it should be noted that the profitability of both
companies has fallen somewhat over the last year.

Return on capital employed can be broken down into its component
parts of operating profit percentage and asset turnover. Since the
asset turnover for both companies has been fairly steady, the
decline in profitability can be traced to a fall in operating profit
percentage for both companies.

A key difference between the two companies is the higher operating
expenses reported by Hone. This may be partly explained by Hone’s
higher depreciation charge paid on its greater amount of non-
current assets held.

Over appears to pay a lower interest rate on its borrowings than
Hone, which may explain why Over carries a higher level of
borrowings in its statement of financial position than Hone. Since
borrowings represent a cheap source of finance, this fact has
contributed to Over’s better relative profitability. However the tax
rate paid by Over appears to be greater than the rate paid by Hone.

In conclusion the information provided shows that Over generates a
greater return of profits from the capital employed in its business, so
Over is relatively more profitable than Hone. However, before any
decision is taken to invest in either of these companies, more
investigations should be carried out, particularly in respect of any
forecast future earnings and information concerning the future
prospects of the companies. Historical information alone is
insufficient to decide on a possible investment in a company now.

KAPLAN PUBLISHING 53

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Appendix – Key accounting ratios assessing profitability

(b) There are serious limitations in using the financial information
provided as a basis to compare the profitability of the two
companies. First, we must consider the translation of the Over
results. This has been done using a single exchange rate that is in
force at 31 December 20X2. It would have been better to translate
the 31 December 20X1 balance sheet using the exchange rate at
that date, and to have used average exchange rates for 20X1 and
20X2 to translate the income statements respectively for 20X1 and
20X2.
A further problem arises in that the two companies have different
year-end dates. If both companies earn their profits evenly over
each year, then this will not be a problem. However it is more likely
that there will be seasonal variations in the financial performance of
each company, in which case the balance sheets comparisons in
particular will not be comparing like with like.
A further problem arises in that each company has drawn up their
financial statements in accordance with the domestic accounting
standards of the country in which they operate. No information is
given of how similar the GAAP in Dollarland is to the GAAP in
Francland. Different accounting practices could have a major effect
on the reported profitability of the companies, such that a direct
comparison is not valid.
Finally we have no information on whether the two companies
operate in a similar business sector. If they operate in different
sectors (e.g. house building and publishing), then one would expect

54 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

the financial statements to present a different pattern of operations.
A direct comparison would only be valid if the two sets of statements
were prepared in the same currency, for the same accounting
periods, in accordance with the same accounting practices, and for
companies in the same business sector in the same country. The
analysis in part (a) is a long way short of this ideal.

Signed: The Management Accountant

Test your understanding 4 - Price

12 October 20X1

Dear Mr A,

Re: Price

Thank you for your letter of 10 October 20X1 in which you have raised a
number of questions as a result of your perusal of the financial
statements of the above company as at 31 July 20X1.

I have replied to your questions below in the same order as raised by
yourself.

Point 1

The company has indeed earned much the same net profit this year as
last year, so might be expected to have at least the same cash balance
as last year.

However, it is a misconception that profits mean the same thing as cash
flows. The published accounts will also contain a statement of cash flows
prepared in accordance with IAS 7, the relevant International Accounting
Standard, as follows:

KAPLAN PUBLISHING 55

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Statement of cash flows for year ended 31 July 20X1

$000 $000

Cash flows from operating activities 4,100
Profit before tax 1,600
Finance cost 4,000
Depreciation
Movements in working capital: (1,200) 7,700
(1,000)
Increase in inventories (ties up cash) (4,000)
Increase in receivables (ties up cash) 200 –––––
Increase in trade payables ––––– 3,700

Cash generated from operations (1,200)
Interest paid in cash (1,200)
Tax paid (1,600)
Dividend paid –––––

Cash flows from investing activities (11,200)
Payments to acquire PPE
[(44,200 – 32,000) + 4,000 – 5,000]

Cash flows from financing activities 5,000
Proceeds of zero-rate bond issue –––––
(2,500)
Movement in cash and cash equivalents 1,500
Cash and cash equivalents b/f –––––
(1,000)
Cash and cash equivalents c/f (200 – 1,200) –––––

You can see above from the statement that the cash generated from the
company's operations together with the proceeds of the zero-rate bond
issue is not sufficient to finance the capital expenditure during the year.
This deficit was funded by utilising a bank overdraft facility.

Point 2

The accountants will be aware of the correct accounting treatment. This
is clearly laid down in IAS 16, the International Accounting Standard on
non-current assets. IAS 16 requires that all gains on revaluation should
be taken directly to equity (unless they represent reversals of revaluation
losses on the same asset). This recognises that the gain has not actually
been realised but is more of a value change which should be reported in

56 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

the statement of comprehensive income as "other comprehensive
income". This statement shows all the changes in net assets over the
year, not just those reported in the income statement.

Point 3

This is not an error. The investors forgo interest on their bonds but
receive a much larger repayment than their original investment. IAS 39,
the International Accounting Standard on financial instruments, requires
the excess of the ultimate repayment value over the issue price – in this
case $1,802,450 – to be treated as a finance cost by the company and
spread appropriately over the term of the bond. This is called measuring
the bond at amortised cost. It specifically requires the finance cost to be
charged through the income statement. As the finance cost is not
actually paid over until the end of the term it is effectively rolled up so that
the statement of financial position shows the original investment plus an
increasing amount of rolled-up finance cost. This is the quasi interest
inherent in the bond – in this case effectively 8% annual interest. The
bond is not shown at fair value in the statement of financial position
because it is held until maturity i.e. measured at amortised cost.

I hope this answers all your questions. Please do not hesitate to contact
me if you need any further information.

Signed:
Working

Issue price of bonds = $5m

Repayment price of bonds = $6,802,450

ѕ Annual interest rate is given by a discount factor of 5
–––––– = 0.735 after four years.
6.80245

From tables, the relevant interest rate is 8%.
Tutorial note

Refer to chapter 13 for further detail of financial instruments.

KAPLAN PUBLISHING 57

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding 5 - Boston

Report on the financial performance of Boston for the year ended
31 March 20X9

To: The Board of Boston

From: A N Other

Date: XX/XX/XX

Profitability (note figures are rounded to 1 decimal place)

The most striking feature of the current year’s performance is the
deterioration in the ROCE, down from 25.6% to only 18.0%. This
represents an overall fall in profitability of 30% ((25.6 – 18.0)/25.6 x
100). An examination of the other ratios provided shows that this is due
to a decline in both profit margins and asset utilisation.

A closer look at the profit margins shows that the decline in gross margin
is relatively small (42.2% down to 41.4%), whereas the fall in the
operating profit margin is down by 2.8 percentage points, representing a
15.7% decline in profitability (i.e. 2.8% on 17.8%). This has been
caused by increases in operating expenses of $12m and unallocated
corporate expenses of $10m. These increases represent more than half
of the net profit for the period and further investigation into the cause of
these increases should be made.

The company is generating only $1.20 of sales per $1 of net balance
sheet assets this year compared to a figure of $1.40 in the previous
year. This decline in asset utilisation represents a fall of 14.3% ((1.4 –
1.2)/1.4 x 100).

Liquidity/solvency

From the limited information provided, a poor current ratio of 0.9:1 in
20X8 has improved to 1.3:1 in the current year. Despite the
improvement, it is still below the accepted norm. At the same time
gearing has increased from 12.8% to 15.6%.

The statement of financial position shows the company has raised $65
million in new capital. This was in the form of $40m in equity (total
increase in share capital and share premium) and $25m in loans. The
disproportionate increase in the loans is the cause of the increase in
gearing; however, at 15.6% this is still not a highly geared company.

The increase in finance has been used mainly to purchase new non-
current assets, but it has also improved liquidity, mainly by reversing an
overdraft of $5 million to a bank balance in hand of $15 million.

58 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

A common feature of new investment is that there is often a delay
between making the investment and benefiting from the returns. This
may be the case with Boston, and it may be that in future years the
increased investment will be rewarded with higher returns. Another
aspect of the investment that may have caused the lower return on
assets is that the investment is likely to have occurred part way through
the year (maybe even near the year end). This means that the income
statement may not include returns for a full year, whereas in future years
it will.

Segment issues

Segment information is intended to help the users to better assess the
performance of an enterprise by looking at the detailed contribution
made by the differing activities that comprise the enterprise as a whole.

Referring to the segment ratios it appears that the carpeting segment is
giving the greatest contribution to overall profitability, achieving a 48.6%
return on its segment assets, whereas the equivalent return for house
building is 38.1% and for hotels it is only 16.7%.

The main reason for the better return from carpeting is due to its higher
segment net profit margin of 38.9% compared to hotels at 15.4% and
house building at 28.6%. Carpeting’s higher segment net profit is in turn
a reflection of its underlying very high gross margin (66.7%). The
segment net asset turnover of the hotels (1.1 times) is also very much
lower than the other two segments (1.3 times).

It should be noted that hotel profits have been reduced due to the loss of
$12 million on the sale of a hotel. This should potentially be treated as an
exceptional item and excluded from the analysis for comparability
purposes.

It seems that the hotel segment is also responsible for the group’s fairly
poor liquidity ratios. Ignoring the bank balances, the segment current
liabilities are 50% greater than its current assets ($60m compared to
$40m); the opposite of this would be a more acceptable current ratio.

These figures are based on historical values. Most commentators argue
that the use of fair values is more consistent and thus provides more
reliable information on which to base assessments (they are less
misleading than the use of historical values). If fair values are used, all
segments understandably show lower returns and poorer performance
(as fair values are higher than historical values), but the figures for the
hotels are proportionately much worse, falling by a half of the historic
values (as the fair values of the hotel segment are exactly double the
historical values).

KAPLAN PUBLISHING 59

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Fair value adjusted figures may even lead one to question the future of
the hotel activities. However, before jumping to any conclusions an
important issue should be considered. Although the reported profit of the
hotels is poor, the market values of its segment assets have increased
by a net $90 million. New net investment in hotel capital expenditure is
$64 million ($104m – $40m disposal); this leaves an increase in value of
$26 million. The majority of this appears to be from market value
increases (this would be confirmed if the statement of recognised
income and expense was available). Whilst this is not a realised profit, it
is nevertheless a significant and valuable gain (equivalent to 65% of the
group reported net profit).

Conclusion

Although the company’s overall performance has deteriorated in the
current year, it is clear that at least some areas of the business have had
considerable new investment which may take some time to bear fruit.
This applies to the hotel segment in particular and may explain its poor
performance, which is also partly offset by the strong increase in the
market value of its assets.

Appendix

Further segment ratios:

Carpeting Hotels House building

Return on net assets at fair value 36.1%
35/97 x 100% 8.3%
20/240 x 100%
80/265 x 100% 30.2%

Asset turnover on fair values (times) 0.9
90/97 0.5
130/240
280/265 1.1

60 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Test your understanding 6

Issue at full market price

Date Actual number of Fraction of Total
shares year
6/12 4,140,000
1 January 20X4 8,280,000 6/12 5,796,000
–––––––
30 June 20X4 11,592,000 (W1) 9,936,000

Number of shares in EPS –––––––
calculation

(W1) New number of shares 8,280,000
Original number 3,312,000
New issue –––––––––
11,592,000
New number

The earnings per share for 20X4 would now be calculated as:

$2,208,000 = 22.2c
––––––––––

9,936,000

Test your understanding 7
The number of shares to be used in the EPS calculation for both years is
7,000,000 + 1,000,000 = 8,000,000.

The EPS for 20X2 is 750,000 / 8,000,000 × 100 c = 9.4c
The EPS for 20X3 is 1,150,000 / 8,000,000 × 100 c = 14.4c
Alternatively adjust last year’s EPS:
20X2 EPS = 750,000 / 7,000,000 = 10.7c
20X2 adjusted comparative = 10.7 × 7/8 = 9.4c.

KAPLAN PUBLISHING 61

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding 8
20X2 EPS

EPS = $425,000 = 9.0c per share
––––––––
4,722,222 (W1)

20X1 EPS

Applying correction factor to calculate adjusted comparative figure of
EPS:

Theoretical ex rights price 90c (W2)

8c (W3) × –––––––––––––––––––– = 8c × –––– = 7.2c per share

Actual cum rights price 100c

(W1) Current year weighted average number of shares

Number of shares 1 July 20X1 to 31 December 20X1 (as adjusted):

4,000,000 × Actual cum rights price 6 months
–––––––––––––––––––– × ––––––
Theoretical cum rights price
12 months

4,000,000 × 100 6
––– × –– = 2,222,222 shares
90 (W2)
12

Number of shares 1 January 20X2 to 30 June 20X2 (actual):

6 5,000,000 = 2,500,000 shares
––– ×
12

Total adjusted shares for year 4,722,222
(W2) Theoretical ex rights price

Because the rights issue contains a bonus element, the comparative
EPS figures should be adjusted by the factor:

Theoretical ex rights price
––––––––––––––––––––

Actual cum rights price

$

62 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Prior to rights issue 4 shares worth 4 × $1 = 4.00
Taking up rights 1 share cost 50c = 0.50
–– ––––
5 4.50
–– ––––

i.e. theoretical ex rights price of each share is $4.50 ÷ 5 = 90c
(W3) Prior year EPS

Last year, reported EPS were $320,000 ÷ 4,000,000 = 8c

Test your understanding 9 - Rose

KAPLAN PUBLISHING 63

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

(a) No changes: If there are no changes during the year EPS is simply
equal to earnings divided by the number of shares.

(b) Share issued at full market price: Calculate the weighted average
number of shares based on when the new shares were issued. No
adjustment is necessary to the comparative because the new
shares generate additional resources which should bring additional
profits.

(c) Bonus issue: Calculate EPS as though the bonus shares had
always been in issue by multiplying the number of shares before the
issue by the bonus fraction. The comparative is multiplied by the
inverse of the bonus fraction to adjust it for comparison between the
years.

(d) Rights issue: Adjust for the rights issue bonus fraction (cum rights
price / TERP). The TERP is calculated below. The number of shares
are then time weighted. The comparative is multiplied by the inverse
of the rights issue bonus fraction.

(W1) Theoretical ex rights price

Because the rights issue contains a bonus element, the past EPS
figures should be adjusted by the factor:

Actual cum rights price
––––––––––––––––––––
Theoretical ex rights price

Prior to rights issue 4 shares worth 4 × $2.50 = $
Taking up rights 1 share cost $2.00 = 10.00
––
5 2.00
–– ––––
12.00
––––

i.e. theoretical ex rights price of each share is $12 ÷ 5 = $2.40

The fraction is:

2.50
––––––––––––––––––––

2.40

64 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

Test your understanding 10

If this loan stock was converted to shares the impact on earnings would
be as follows.

Basic earnings $$
Add notional interest saved 2,208,000
($2,300,000 × 10%)
Less tax relief $230,000 × 30% 230,000
(69,000)
Revised earnings ––––––

Number of shares if loan 161,000
converted –––––––––
Basic number of shares
Notional extra shares under the most 2,369,000
dilution possible –––––––––

8,280,000

2,300,000 × 90 2,070,000
––– –––––––––
100

Revised number of shares 10,350,000
DEPS = –––––––––
$2,369,000
––––––––– = 22.9c
10,350,000

KAPLAN PUBLISHING 65

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

Test your understanding 11 $
2,208,000
Earnings –––––––––

Number of shares 8,280,000
Basic 51,111
Options (W1)
–––––––––
8,331,111

–––––––––

The DEPS is therefore $2,208,000 = 26.5c
–––––––––––

8,331,111

(W1) Number of free shares issued

FV – OP
No. of free shares = No. of options x –––––

FV
1.80 – 1.70
No. of free shares = 920,000 x ––––– = 51,111

1.80

Test your understanding 12 000
$5,950
(a) EPS (basic) = 59.5c 10,000
Earnings ––––––
Shares
59.5c
EPS ––––––

(b) EPS (basic) = 47.6c 000
Earnings $5,950
Shares (10m × 5/4) 12,500
––––––
EPS
47.6c
––––––

66 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 2

(c) EPS (basic) = 57.1c 000
Earnings $5,950
Shares 10,416
––––––
EPS
57.1c
Pre (7/12 ×10m) ––––––
Post (5/12 ×10m ×11/10) $5,833
$4,583
(d) EPS (basic) = 52.5c
Earnings 000
Shares $5,950
11,333
EPS ––––––

Pre (9/12 × 10m × 4.00/3.75) 52.5c
Post (3/12 × 10m × 4/3) ––––––
Actual cum rights price $8,000
TERP (1@300 +3@400)/4 $3,333

(e) EPS (basic) = 59.5c $400
EPS (fully diluted) = 49.7c $375
Earnings (5.95m + (10% × 2.6m × 70%))
Shares (10m + (90/100 × 2.6m)) 000

EPS $6,132
12,340
(f) EPS (basic) = 59.5c ––––––
EPS (fully diluted) = 59.3c
Earnings 49.7c
Shares (10m + (74 x (4 - 2.50)/ 4)) ––––––

EPS 000

$5,950
10,028
––––––

59.3c
––––––

KAPLAN PUBLISHING 67

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Analysis and interpretation of financial accounts

68 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter

3

Consolidated statement of
financial position

Chapter learning objectives

On completion of their studies students should be able to:

• Explain the relationships between investors and investees and

the meaning of control;

• Identify the circumstances in which a subsidiary is excluded from

consolidation;

• Prepare consolidated financial statements for a group of

companies;

• Explain the treatment in consolidated financial statements of pre

and post-acquisition reserves, goodwill (including its
impairment), fair value adjustments, intra-group transactions and
dividends.

69

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position
1 Session content

2 What is a group?
IAS 27 Consolidated and separate financial statements

A group will exist where one company controls another company.
Control is the power to govern the financial and operating policies so as to
obtain benefits from its activities.
Control is normally achieved by the parent company owning 51% or more of
the voting rights of the subsidiary.
Legally, the parent and subsidiary are separate entities and separate
financial statements must be prepared.
In substance, the parent and subsidiary can be viewed as a single entity,
known as the group.
Group financial statements are prepared to reflect the substance of the
situation. They are referred to as consolidated accounts and are prepared in
addition to single entity financial statements.
The boundary of a group is defined by control.

70 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

There are situations in which a parent may not own the majority of the voting
rights, but control still exists:

• Power over the majority of the voting rights by virtue of an agreement

with other investors;

• Power to govern the financial and operating policies by statute or

agreement;

• Power to appoint/remove the majority of the board of directors;
• Power to cast the majority of votes at meetings of the board of

directors.

Expandable Text

Exclusions of subsidiaries

There are two situations in which a subsidiary may be excluded from the
group accounts:

• Lack of effective control

The parent is not able to govern the financial and operating policies e.g.
an entity is subject to the control of a government, court or administrator.

• Held for resale

The investment in the subsidiary meets the criteria of IFRS 5: Non-
current Assets Held for Sale and Discontinued Operations and has
been acquired and held exclusively with a view to resale within 12
months.

If however, the subsidiary has previously been consolidated but is now held
for sale, you should continue to consolidate until it is actually disposed of.

3 Acquisition accounting

IAS 27 requires acquisition accounting (the purchase method) to be used to
prepare consolidated financial statements.

This requires the following rules to be followed:

• Add the parent and subsidiary's assets, liabilities, income and

expenses;

KAPLAN PUBLISHING 71

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

• The cost of the investment in the parents' books is eliminated against

the share of subsidiary's net assets at acquisition, with any resulting
goodwill being treated in accordance with IFRS 3 (revised) Business
Combinations;

• The share capital of the group is always only the share capital of the

parent;

• Adjustments are made to record the subsidiary's net assets at fair

value;

• Uniform accounting policies must be used;
• Intra-group balances and transactions must be eliminated in full;
• Profits/losses on intra-group transactions that are recognised in assets

should be eliminated in full (the PUP adjustment).
Standard consolidated statement of financial position (CSFP)
workings

(W1) Group structure

(W2) Net assets of subsidiary Acquisition Reporting
Date Date
Share capital X X
Retained earnings X X
Other reserves X X

––––– –––––

X X

––––– –––––

(W3) Goodwill X
(X)
Cost of investment ––––
Fair value of net assets (NAs) acquired X
(X)
Goodwill at acquisition ––––
Impairment X
––––
Goodwill at reporting date

72 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

(W4) Non-controlling interests
Covered in chapter 6

(W5) Group reserves

Retained earnings Other reserves

Parent XX
Sub (% × post-acq reserves)
Impairment XX

(X) –

–––– ––––

XX

–––– ––––

4 Goodwill

As mentioned in the previous section, goodwill is treated in accordance with
IFRS 3 (revised) Business Combinations. In this chapter the assumption is
that the parent purchases 100% of the shares of another entity. Alternative
scenarios will be dealt with in later chapters.

The parent may pay more than the value of the entity's net assets because
of:

• the entity's positive reputation;
• a loyal customer base; or
• staff expertise etc.

This excess is called goodwill and is capitalised on the consolidated
statement of financial position (CSFP). It is subject to an annual impairment
review to ensure its value has not fallen below the carrying value.

Occasionally the parent company may pay less than the value of the
subsidiary's net assets. This may occur because a quick purchase is
necessary. In this rare situation the "negative goodwill" or discount on
acquisition is credited to group retained earnings (to increase group
profits).

Goodwill is calculated as:

Cost of investment X
Less: fair value of net assets acquired (X)
––––
Goodwill at acquisition X
––––

The following sections explain how to calculate the cost of investment and
fair value of the net assets of the subsidiary.

KAPLAN PUBLISHING 73

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

5 Cost of investment

The cost of the investment must equal the fair value at the acquisition date of
the consideration given by the parent. This can be made up as follows:

Cost of investment

Cash X
Shares issued by parent company (market value) X
Deferred consideration (present value of future cash flows) X
Contingent consideration (at fair value) X
–
X
–

Deferred consideration

This is consideration, normally cash, that will be paid in the future.

It is measured at its present value at acquisition for the purposes of W3 i.e.
the future cash flow is discounted.

It is recorded as part of the investment in P's statement of financial position
and also as a liability.

Every year after acquisition the liability in the consolidated statement of
financial position (CSFP) will need to be increased to reflect that the
payment is one year closer and so the present value has increased. This is
the unwinding of the discount, which is recorded as an interest cost.

If the reporting date is a year or more after acquisition:

Dr Finance cost (CIS) (and therefore W5 parent's retained earnings
in CSFP)

Cr Deferred consideration liability (CSFP)

Contingent consideration

Contingent consideration is consideration that will be transferred by the
parent to the former owners of the subsidiary if future events occur or
conditions are met. For example if profit growth targets are met, further cash
will be paid in the future.

IFRS 3 (2008) requires the recognition of this contingent consideration at
fair value on acquisition.

In exam questions it is likely that the fair value will be given or you will be told
how to calculate it.

74 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Consideration that has not been recorded

In exam questions, it is common that all or some of the consideration has not
been recorded by the parent. This means that the parent has not:

Dr Investment
Cr Bank/ Share capital + share premium/ Liabilities

On consolidation is is therefore necessary to make an adjustment by:

• Calculating the value of the consideration as part of the cost of

investment in (W3) and

• Recording the appropriate credit entry on the face of the CSFP.

Directly attributable costs

Professional, legal fees or other incremental costs directly related to the
acquisition of the subsidiary must be expensed to the income statement.

These costs are not included as part of the cost of investment.

Provisions for future losses or expenses

IFRS 3 does not permit these to be included as part of the cost of the
investment.

(The parent may still recognise them if the criteria of IAS 37: Provisions are
met, but they should be charged to profits rather than being included as part
of the cost of the investment.)

Example 1

Example 1 answer

6 Fair value of net assets of subsidiary

At acquisition, the parent recognises in the group accounts the identifiable
assets acquired and liabilities assumed of the subsidiary. They are to be
measured at their fair value as at the date of acquisition.

• An asset or liability may only be recognised if it meets the definition of

an asset or liability as at the acquisition date.
For example, costs relating to restructuring the subsidiary that are
expected to be incurred after the acquisition do not meet the definition
of a liability as at acquisition.

KAPLAN PUBLISHING 75

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

• An asset is identifiable if it either:

– Is capable of being separated (regardless of whether the
subsidiary intends to sell it)

– Arises from contractual or other legal rights

Consequently, certain intangible assets such as brand names, patents,
customer relationships that are not recognised in the subsidiary’s
individual financial statement may be recognised on consolidation if
they are identifiable.

• Contingent liabilities are not recognised in the subsidiary’s individual

financial statements. (In accordance with IAS 37, they are simply
disclosed by note). On consolidation however, they will be recognised
as a liability if there is a present obligation arising from past events and
its fair value can be measured reliably i.e. it is recognised even if it is
not probable.

The following guidance may be used for establishing fair values:
The following guidelines may be used for establishing fair values.

Item Valuation

Property, plant and Market value. If there is no evidence of market value,

equipment depreciated replacement cost should be used

Intangible assets Market value. If none exists, an amount at fair value
that reflects what the acquirer would have paid
otherwise.

Inventories (i) Finished goods should be valued at selling prices
less the sum of disposal costs and a reasonable
profit allowance.

(ii) Work in progress should be valued at ultimate
selling prices less the sum of completion costs,
disposal costs and a reasonable profit allowance.

(iii) Raw materials should be valued at current
replacement costs.

Receivables, Present value of amounts expected to be received or
payables and paid. Discounting is unlikely to be necessary for short-
loans term receivables or payables.

Depreciated replacement cost

Example 2

76 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Example 2 answer

Test your understanding 1 - Portsmouth and Southampton

Portsmouth has acquired 100% of the shares of Southampton. The
statements of financial position of both companies immediately after the
acquisition are as follows:

Portsmouth Southampton
$000 $000 $000 $000

Non-current assets 10,000 4,000
Intangible 31,000 15,000
Tangible ––––––
Investment in Southampton 41,000 ––––––
19,000
Current assets
Inventory 10,000 4,000
Receivables
Cash 2,000 4,000

1,000 4,000

–––––– 13,000 –––––– 12,000

–––––– ––––––

54,000 31,000

–––––– ––––––

Share capital $1 10,000 10,000
Retained earnings 40,000 11,000
–––––– ––––––
Loans 50,000 21,000
Current liabilities
1,000 8,000
3,000 2,000
–––––– ––––––
54,000 31,000
–––––– ––––––

(1) Portsmouth has recorded the cost of the investment in Southampton
at only the cash consideration initially paid. Under the terms of the
take-over a further $6 million must be paid in two years' time.
Portsmouth also issued two shares for every five it acquired in
Southampton. The market value of Portsmouth's shares at the date
of acquisition was $1.40. Neither the share issue nor the deferred
consideration has yet been recorded by Portsmouth.

(2) Southampton's intangible non-current asset is not capable of
reliable external measurement.

KAPLAN PUBLISHING 77

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

(3) The long-term loan in Southampton's statement of financial position
is repayable in three years' time and bears an annual interest rate of
only 5% which is paid at the end of each year.

(4) The value of Southampton's inventory which consists of finished
goods is:

At cost $4m
NRV $8m
Profit allowance $3m

(5) Southampton’s tangible non-current assets include an item whose
market value is $3m with carrying value being $2m. There is another
item included whose carrying value is $4m but no reliable market
value exists for this item. A new asset would cost $20m and be
expected to last for four years. The asset held in Southampton’s
books is three years old.

(6) Portsmouth intends to reorganise Southampton and estimates that
the cost of this will be $2 million. Southampton already has a
provision for reorganisation as it planned to restructure the company
anyway, regardless of the merger with Portsmouth. This provision is
for $500,000 and is included in Southampton’s payables balance.

(7) A court case is underway and Southampton is being sued by an ex-
employee for damages. This matter has been treated as a
contingent liability in the financial statements of Southampton. The
legal advisors of Southampton anticipate a liability of $1m arising if
Southampton lose the case.

(8) Current interest rates are 7%.

Required:

Compute the value of purchased goodwill for inclusion in the Portsmouth
Group accounts.

Example 3
Example 3 answer

78 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Test your understanding 2
Statements of financial position at 31 March 20X2

Non-current assets P S
Investment in S $000 $000
Current assets 1,650
1,100 750
−
250
––––– 650
3,000 ––––
––––– 1,400
––––

Share capital 1,500 500
Retained earnings 900 400
Current liabilities 600 500
––––
––––– 1,400
3,000 ––––
–––––

P acquires 100% of S on 31 March 20X2.
Required:

Prepare a consolidated statement of financial position (CSFP) at 31
March 20X2.

7 Pre and post acquisition

In TYU 1 the parent acquired its shares in the subsidiary on the reporting
date. In the case where the parent made the purchase some months or
years prior to the reporting date, the subsidiary's reserves must be split out
into pre and post acquisition.

The parent has influenced any change in reserves since the acquisition date
only.

Example 4

Example 4 answer

KAPLAN PUBLISHING 79

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

Test your understanding 3
Statements of financial position at 31 May 20X3

Non-current assets P S
Investment in S $000 $000
Current assets 2,300
1,000 400

900 500
––––– ––––
4,200
––––– 900
––––

Ordinary share capital 1,000 475
Retained earnings 2,750 275
Current liabilities 150
450 ––––
––––– 900
4,200 ––––
–––––

P acquired 100% of S two years ago on 1 June 20X1 when the balance
on the reserves of S stood at $125,000. Goodwill should be written down
to 75% of its original value to allow for impairment.

Required:

Prepare the consolidated statement of financial position (CSFP) at 31
May 20X3.

8 Fair value adjustment

The group accounts must include the subsidiary's net assets at their fair
value at the date of acquisition.

This reflects the "cost" to the group at acquisition and ensures an accurate
measurement of goodwill.

Therefore an adjustment is required if the subsidiary's book values are not
equal to their fair values.

Adjust:

• W2 Both columns (unless the asset is sold by the reporting date)
• Face of CSFP

80 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Example 5

Example 5 answer

Test your understanding 4 - Kemp and Solent

The following summarised statements of financial position are provided
for Kemp and Solent as at 31 December 20X7.

Non-current assets at book value Kemp Solent
Investment in Solent $000 $000
Current assets 2,000 500
1,900
200 800
––––
––––– 1,300
4,100 ––––
–––––

Share capital ($1 ordinary) 3,000 300
Retained earnings 1,000 900
Current liabilities 100
100 ––––
––––– 1,300
4,100 ––––
–––––

Kemp purchased 300,000 shares in Solent on 31 December 20X7 for
$1.9m. It is estimated that the non-current assets of Solent possessed a
fair value of $700,000 on the 31 December 20X7 but that there was no
difference between the book values and fair values of the company's net
current assets at that date.

Required:

The consolidated statement of financial position (CSFP) at 31
December 20X7.

9 Depreciation adjustment

Fair value adjustments may involve adjusting non-current asset values which
will consequently involve an adjustment to the depreciation figure.
Depreciation must be based upon the carrying value of the non-current
assets concerned so if non-current asset values are revalued at acquisition,
then so must depreciation values be changed in the post-acquisition period.

KAPLAN PUBLISHING 81

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position
Adjust:

• W2 Net assets at reporting date column
• Face of CSFP.

Example 6

Example 6 answer

10 Intra-group balances
Intra-group balances must be eliminated in full, since the group as a single
entity cannot owe balances to/from itself.
Intra-group balances may arise in the following situations:

• P and S trading with each other, resulting in current account balances

i.e. receivables and payables

• Intra-group loans, resulting in an investment and loan balance

Adjust

• Face of CSFP

Current account balances may disagree. This is most likely to be due to
cash in transit or goods in transit.
Cash in transit
Cash has been sent by one group company, but has not been received and
so is not recorded in the books of the other group company. The following
adjustment will be required:

Cr Receivables
Dr Bank
Dr Payables

82 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Goods in transit

Goods have been sent by one company, but have not been received and so
are not recorded in the books of the other group company. The following
adjustment will be required:

Cr Receivables
Dr Inventory
Dr Payables

Example 7

Example 7 answer

Test your understanding 5

The following statements of financial position exist at the 31 December
20X8.

Non-current assets P S
Investment in S $000 $000
Current assets 5,400 2,000
3,700
Inventory 140
Receivables 750 95
Cash 650 85
400
–––– ––––
10,900 2,320
–––– ––––

Ordinary share capital 7,000 1,400
Share premium 1,950 280
Retained earnings 1,050 440
Current liabilities 200
900
–––– ––––
10,900 2,320
–––– ––––

P acquired 100% of S five years ago when the balance on the retained
earnings of S was $300,000. Any goodwill arising is now thought to be
worth 2/3 of its original value. The share premium in S arose on the
issue of their ordinary shares many years ago.

KAPLAN PUBLISHING 83

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position

Some of the non-current assets of S had a fair value of $1.2m at the date
of acquisition by P. Their book value recorded at this time was $1m.
These non-current assets will be depreciated on a straight line basis
over 20 years from the date of acquisition.

P and S traded with each other and at the reporting date P owed S an
amount of $25,000. On 30 December 20X8 P sent a cheque for $5,000
to S which S had not received by year end.

Required:

A consolidated statement of financial position (CSFP) at 31 December
20X8.

11 Provisions for unrealised profits (PUPs)

P and S may sell goods to each other, resulting in a profit being recorded in
the selling company's financial statements. If these goods are still held by
the purchasing company at the year-end, the goods have not been sold
outside of the group. The profit is therefore unrealised from the group's
perspective and should be removed.

The adjustment is also required to ensure that inventory is stated at the cost
to the group.

Adjust

• W2 Net assets at reporting date column if S sells the goods or W5 if P

sells the goods

• Inventory on the face of the CSFP

Illustration 1

Parent sells to subsidiary

P sells goods to S for $400 at cost plus 25%. All goods remain in the
inventory of S at the end of the year.

25
Profit made on the sale ––– × 400 = 80.

125

Individual financial statements

P records profit 80
S records inventory 400

84 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Group financial statements should show:

Profit 0
Inventory 320

PUP adjustment

Dr Group profit reserves (W5) ↓ 80
Cr Group inventory (CSFP) ↓ 80

The group profit figure for the parent will be reduced as it is the parent
that recorded the profit in this case.

It is important to note that the adjustment takes place in the group
accounts only. The individual accounts are correct as they stand and will
not be adjusted as a result.

Subsidiary sells to parent

Individual financial statements

S records profit 80
P records inventory 400

PUP adjustment

Dr Net assets at reporting date (W2) ↓ 80
Cr Group inventory (CSFP) ↓ 80

The subsidiary's profit will be reduced as it is the subsidiary that
recorded the profit in this case. It is important that the adjustment is
made in W2 as the amended figures then flow through to the remaining
standard workings.

The distinction between making the adjustment in W2 or W5 is important
for when the parent does not own 100% of the subsidiary and non-
controlling interests are introduced in later chapters.

KAPLAN PUBLISHING 85

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

Consolidated statement of financial position
Cost structures
Test your understanding 6
P sells goods to S for $522 at a mark-up of 20%. 40% of these goods
were sold on by S to external parties by the year end.
Required:
What is the PUP adjustment in the group accounts?
Test your understanding 7
S sells goods to P at a mark-up of 33 1\3%. The selling price is $360. All
goods remained unsold at the year end.
Required:
What is the PUP adjustment in this case?
Example 8
Example 8 answer

86 KAPLAN PUBLISHING

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com

chapter 3

Test your understanding 8
The following statements of financial position exist at 30 June 20X6:

Non-current assets P S
Investment in S $000 $000
Inventory 4,000 2,000
Other current assets 3,400
100
500 300
100 –––––
––––– 2,400
8,000 –––––
–––––

Ordinary share capital 6,000 1,500
Retained earnings 1,600 700
Current liabilities 200
400
––––– –––––
8,000 2,400
––––– –––––

P acquired 100% of S when the balance on S's reserves stood at
$250,000.

During the year, S sold goods to P for $120,000 at a mark-up of 20%.
Half of these goods remain in inventory at the year end.

Required:

Prepare the consolidated statement of financial position (CSFP) of the
P group.

Note: This TYU uses the same figures as example 6 in expandable text
above but in example 6 P sells the goods to S.

12 Non-current assets PUPs

P and S may sell non-current assets to each other, resulting in a profit being
recorded in the selling company's financial statements. If these non-current
assets are still held by the purchasing company at the year-end, the profit is
unrealised from the group's perspective and should be removed.

The profit on disposal should be removed from the seller's books.

KAPLAN PUBLISHING 87

ebooks2000.blogspot.com || freeaccalectures.blogspot.com || sevno.blogspot.com || downea.blogspot.com