ACCA

P2 Corporate Reporting Mock Examination Jun 2010

SECTION A

ONE compulsory question

1 Uzielli

Uzielli, a public limited company in the house-building trade, acquired the following shareholdings in Walker and Oglesby:

Date of acquisition Retained earnings Share capital Fair value of net
at acquisition acquired assets at
$m $m acquisition
$m
Walker 1 November 20X7 120 200 450
Oglesby 1 November 20X6 260 300 700 The following statements of financial position relate to Uzielli, Walker and Oglesby as at 31
October 20X8.
Uzielli Walker Oglesby
Assets $m $m $m
Non-current assets
Property, plant and equipment 310 300 400
Investment in Walker (at cost) 380
Investment in Oglesby (at cost) 550
Held to maturity financial asset 62.5
--
t?Q~:~ 300 400
Current assets
Inventories 400 150 300
Trade receivables 160 80 190
Cash and cash equivalents 140 90 110
-~.-.-
700 320 600
TOTAL ASSETS s,QQ1& 620 1,909
Equity
Share capital of $1 500 250 400
Share premium 100 50 40
Retained earnings 652.5 180 310
"._ .. -
Total equity 1,g~~:~ 480 750
Non-current liabilities 400 40 100
Current liabilities 350 100 150
Total liabilities 750 140 250
TOTAL EQUITY AND LIABILITIES ~;"2_Q~~~ 620 .1&00 The following information is relevant to the preparation of the group financial statements for the Uzielli Group:

(a) There have been no new issues of shares in the group since 1 November 20X6 and the fair value adjustments have not been included in the individual companies' financial records. The

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group policy is to value non-controlling interests at the date of acquisition at the proportionate share of the fair value of the acquiree's assets acquired and liabilities assumed.

(b) Any increase in the fair value of the Walker's and Oglesby's' net assets over their carrying values at acquisition is attributable to plant and equipment which had a remaining useful life of 6 years at 1 November 20X7

(c) On 10 September 20X8, Uzeilli sold inventories to Oglesby at an agreed price of $5 million, at a mark up of 25% on cost. Oglesby had sold half of these goods to third parties by the year end and had settled all amounts owing to Uzielli.

(d) Uzielli had purchased a debt instrument with five years remaining to maturity on 1 November 20X6. The purchase price and fair value was $60 million at the date. The instrument will be repaid on 31 October 20Y1 at an amount of $75 million. The instrument carries fixed interest of 4.7% per annum paid annually on 31 October on the principal of $75 million and has an effective interest rate of 10% per annum. In the current period the fixed interest has been received and accounted for as finance income, but no other accounting entry has been made.

(e) Uzielli recognised a trade receivable on 1 November 20X6 due from its customer Thompson at $51,542,000 payable in three annual instalments of $20,000,000 commencing 31 October 20X7 discounted at a market rate of interest adjusted to reflect the risks to Thompson of 8%. During November 20X8 (before Uzielli's financial statements were authorised for issue), Thompson entered into liquidation and the liquidator notified Uzielli the creditors would receive 80% of amounts owed on original payment dates. An appropriate market rate of interest (adjusted as above) was 9% at the year end.

(f) Walker entered into a futures contract during the year to hedge a forecast sale in the year ended 31 October 20X9. The futures contract was designated and documented as a cash flow hedge. At 31 October 20X8, had the forecast sale occurred, Walker would have suffered a loss of $1.9m and the futures contract was standing at a gain of $2m. No accounting entries have been made to record the futures contract.

(g) At 31 October, Uzielli conducted an impairment test on Walker and Oglesby, which are both cash-generating units in their own right. The recoverable amount of Walker was found to be $520 million (excluding any effect on net assets of the cash flow hedge) and there had been no impairment of Oglesby.

(h) On 31 October 20X8, Uzielli sold to some of its land (which had cost $8 million) to Hendrix Bank for $10 million, its open market value determined by an independent surveyor. The terms of the agreement were as follows:

• Uzielli has the right to develop the land at any time during the bank's ownership. For this right, Uzielli has to pay all the outgoings on the land plus an annual fee of 5% of the purchase price;

• Hendrix Bank maintains a memorandum account for the purpose of determining the price to be paid by Uzielli, should Uzielli ever re-acquire the land or any adjustments be necessary to the original purchase price. In this account will be entered the purchase price, any expenses incurred by Hendrix Bank in relation to the transaction, a sum added quarterly (or on the sale by Hendrix Bank of the land), calculated by reference to Hendrix Bank's lending rate plus 2% per annum applied to the daily balance on the account; and from the account will be deducted the annual fees paid by Uzielli to Hendrix Bank;

• Uzielli has the option to acquire the land at any time within 5 years from the date of sale; the acquisition price is to be the balance on the memorandum account at that time;

,. On the expiry of 5 years from the date of acquiring the land, Hendrix Bank will offer it for sale generally; and at any time prior to that it may with the consent of Uzielli, offer the land for sale;

• In the event of Hendrix Bank selling the land to a third party, the proceeds of the sale shall be deducted from the memorandum account and the balance shall be settled between Uzielli and Hendrix Bank in cash, as a retrospective adjustment of the price at which Hendrix Bank originally purchased the land from Uzielli.

• The finance director of Uzielli entered into this transaction to raise finance without increasing the gearing ratio of Uzielli. He has recorded the transaction as a normal disposal of property, plant and equipment.

(i) On 31 July 20X8, Uzielli sold 140 million of their 300 million shares in Oglesby for consideration of $300m. Subsequent to the disposal, Uzielli maintained significant influence over Oglesby. The fair value of the remaining shareholding at 31 July 20X8 was $340m. Oglesby's profit (and total comprehensive income) for the year ended 31 October 20X8 was $20 million and no dividends were paid or declared in the year. This disposal has not yet been accounted for.

Required:

(a) Prepare the consolidated statement of financial position of the Uzielli group as at 31 October 20X8.

Work to the nearest $0.1m

(35 marks)

(b) Discuss whether the finance director's proposed accounting treatment of the sale and the

repurchase of land (item (h) above) is correct. (7 marks)

(c) Discuss briefly the importance of ethical behaviour in the preparation of financial statements and whether the finance director's proposed accounting treatment for the sale and repurchase

of the land could constitute unethical behaviour. (8 marks)

Note: Requirement (c) includes two professional marks for the development of the discussion of the ethical responsibilities of the Uzielli group.

(Total = 50 marks)

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2 Tele2

Tele2 is a company in the telecommunications industry providing landline and mobile telephone connections and equipment and other telecommunications services such as internet access. The company is currently preparing its consolidated financial statements for the year ending 31 December 2008.

When Tele2 charge a connection fee to a customer together with the related equipment, the entire connection fee is recognised at the date of connection even if the length of the customer relationship is

expected to span a number of accounting periods. (2 marks)

The purchase of licences for operations from governments are treated as intangible assets and are capitalised at their initial cost. In cases where Tele2 is confident that the licence will be renewed (at no

additional cost) then the licence will not be amortised. (3 marks)

Tele2 has recently been suffering a shortage of cash and to help to alleviate this had sold one of their office buildings to a third party institution on 1 January 2008 and then leased it back for a period of 15 years. The sale price of the building and its fair value are $8.5 million which is the present value of the minimum lease payments. At the end of the agreement the building will be transferred back to Tele2 at nil cost. At 31 December 2007 the carrying value of the building was $7 million. The rental under the lease agreement is $0.8 million per annum payable in advance and the interest rate implicit in the lease is 5.44%. The directors of Tele2 are proposing to include the profit on disposal of $1.5 million in profit or

loss for the year and to treat the lease as an operating lease. (9 marks)

On 1 January 2008 Tele2 held a 30% holding in a communications software development company CSD, which originally cost $24 million a number of years ago. On 31 March 2008 Tele2 sold a 15% holding in CSD reducing its investment to a 15% holding meaning that Tele2 no longer exercises significant influence over CSD. Before the sale of the shares the net asset value of CSD at 31 March 2008 was $100 million, rising from $70 million on the date of the original acquisition. Tele2 received $20 million for its sale of the shares in CSD and the fair value of its remaining holding in CSD at 31 March 2008 was $17 million. At 31 December 2008 the fair value of this holding was $19 million. (7 marks)

Tele2 has a number of properties held under finance leases which are surplus to requirements. Although every effort has been made to sub-let these premises in the current economic climate it is recognised that it may not be possible to do so immediately. Therefore there will be a shortfall arising from sublease

rental income being lower than the lease costs being borne by Tele2. (2 marks)

Effective communication to the directors. Required:

Write a report to the directors of Tele2 explaining how each of these matters should be dealt with in the group financial statements for the year ending 31 December 2008.

(2 marks)

(Total: 25 marks)

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3 Financial instruments

One of the greatest challenges facing the accountancy profession today is the accounting treatment of financial instruments. Internationally, lAS 39 deals with the recognition and measurement of financial instruments, lAS 32 deals with presentation, while IFRS 7 deals with the disclosure aspects.

Revisions were made recently to lAS 32 and lAS 39 aimed at streamlining and simplifying the standards. The IASB has indicated that the revised lAS 32 and lAS 39 will remain in place as part of the 'stable platform' developed for 2005 for some time.

Draft financial statements have been prepared for JJW, a public limited company, and these show a profit before tax of $1,110,000 for the year ended 30 September 20X6, but no accounting entries have been made in respect of the financial instruments.

The following information relates to the financial instruments held by JJW during the year:

(i) $1,200,0006% 4 year bonds issued by JJW at a discount of 3',1.;% on 1 October 20X5. The internal rate of return of the debt is 7%.

(ii) 6% debentures in LKW, redeemable at par on 30 September 20X7 with interest paid annually on 30 September. JJW had paid $500,000 (the nominal value) for the debentures on 1 October 20X5. JW intends to hold these debentures until their maturity date. Market rates for similar debentures were 7% on 30 September 20X5 and throughout the year to 29 September 20X6 and 7.5% on 30 September 20X6.

On 16 October 20X6, JJW was notified that due to financial difficulties, LKW will only be able to repay $400,000 on the original maturity date. All interest will however be paid in full.

(iii) 150,000 $1 ordinary shares issued at par when JJW was set up in 20X4 and a further 50,000 $1 ordinary shares issued on 1 January 20X6 at $2.40 per share. Issue costs amounted to $2,000 in 20X4 and $1,500 in 20X6. Market value of each share was $3.00 at 30 September 20X5 and $3.50 at 30 September 20X6.

(iv) 250,000 $1 redeemable preference shares issued at par by JJW on 1 October 20X5 with a dividend rate of 7%. Market interest rates on similar shares were 7% throughout the year ended 30 September 20X6. Open market value of the shares is equal to book value.

(v) Shares held as an investment in another company BCW. The shares were bought in March 20X5 for $99,000 inclusive of transaction costs of $1 ,000. Open market value of the shares was $120,000 at 30 September 20X5. The shares were sold for $114,000 in August 20X6.

JJW's accounting policy states that fair values are determined by reference to open market values where available and where not available by discounting the relevant cash flows at a market rate of interest on similar instruments.

Required

(a) Prepare a calculation of the revised profit before tax after making the necessary adjustments in respect of the financial instruments. Include an explanation of the treatment of each of the

financial instruments. (11 marks)

(b) There has been a great deal of debate over the accounting treatment of financial instruments, particularly over the increased use of fair values. Discuss the benefits and drawbacks of using fair values to measure financial instruments and how these remeasurements are presented in

the statement of comprehensive income. (6 marks)

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(c) The directors of JJW have asked for your advice on the accounting implications of two transactions.

(i) JJW (whose currency is $) is negotiating a contract to sell components to a French purchaser, whose currency is €. The contract is denominated in €. This is the first contract that JJW has entered into with this purchaser but the terms relating to physical delivery of the components are identical to those of their normal sales.

(ii) JJW is considering leasing a property. Under the terms of the agreement the rental payments are contractually fixed for the first year but thereafter fluctuate in line with the increase or decrease in the company's share price.

Required

Explain the principles outlined in the lAS 39 Financial Instruments: Recognition and Measurement in respect of embedded derivatives and how the two transactions should be reflected in the financial statements of JJW for the year ended 30 September 20X6. (6 marks)

Appropriateness and quality of discussion. (2 marks)
Work to the nearest $'000. Ignore deferred tax. (Total = 25 marks)
Present values
Period 6% 7% 7Y:>% 8%
1 0.943 0.935 0.930 0.926
2 0.890 0.873 0.865 0.857
3 0.840 0.816 0.805 0.794
4 0.792 0.763 0.749 0.735
Present value of annuities
Period 6% 7% 7Y:>% 8%
1 0.943 0.935 0.930 0.926
2 1.833 1.808 1.796 1.783
3 2.673 2.624 2.601 2.577
4 3.465 3.387 3.349 3.312 4 Developments in reporting

In October 2005, the IASB issued a discussion paper entitled Management Commentary. Required

(a) Why is a management commentary accompanying a set of financial statements considered

necessary? (5 marks)

(b) Identify and explain the key contents of a management commentary.

(5 marks)

(c) Critically appraise the following extract from a company's management commentary section

on business performance and prospects: (7 marks)

Business performance

Sales revenues from the Group's continuing businesses rose to $59 million in 20X5, an increase of 12% in local currencies (9% in dollars); these results exclude the results of businesses which were sold in 20X4. Both of the Group's divisions, Office products and Office systems, grew significantly faster than the global market. The Office products division sales advanced 13% in local currencies (10% in dollars). In the Office systems division sales rose 8% in local currencies (6% in dollars), which posted growth significantly above the market average.

Operating profit from continuing businesses was up substantially for the year, advancing 24% in local currencies (20% in dollars) to nearly $14 million (before exceptional items). The operating profit margins in both divisions again increased sharply. In the Office products division the operating profit margin rose 1.9 percentage points to 25.7%, while the margin in the Office systems division gained 2.4 percentage points to reach 21.4%. Strong sales growth, productivity improvements and the gains realised on the disposal of non-core products and technologies as the Group continued to realign its product portfolio were major contributors to the Group's improved profitability. Together these factors more than offset increased costs for new product launches and expenditures on licensing agreements for products and technologies. Even excluding gains from the disposal of products, the operating margin improved significantly.

Thanks to the strong operating performances of the Group's continuing businesses, EBITDA from these businesses increased by 15% to $9.2 million. The EBITDA margin in the Office products division reached 32.6%, compared with 31.5% the year before, and in the Office systems division the EBITDA margin advanced 2.7 percentage points to 31.2%.

The sale of non-core areas of the Office products division resulted in an exceptional pre-tax gain totalling $4.6 million.

The Group also completed a major acquisition during the year, purchasing Tentax in the United States in early 2005 for a total consideration of $3.6 million.

Future prospects

In 20X6 the results in the Office products division will be influenced by the expiry of the US patent for a key product and by costs for product launches in key markets and significant development activities. As an overall outcome we anticipate local-currency sales growth above the world market and an operating profit margin (before exceptional items) broadly in line with that for 20X5.

In 20X6 the Office systems division expects to outgrow the world market again in terms of local-currency sales. The division also expects further progress towards its goal of an operating profit margin (before exceptional items) of around 23% in 20X7.

The United Nations Conference on Trade and Development (UNCTAD) published a review looking at practical issues relating to the implementation of IFRS, highlighting some of the benefits arising, and

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problems encountered, as the use of IFRS becomes more widespread. The report has a particular focus on issues facing developing countries.

Required

(d) Discuss the main advantages to developing countries of adopting IFRS and some of the

practical difficulties they may face. (6 marks)

Appropriateness and quality of discussion of items in (a)-(d)

(2 marks) (Total = 25 marks)