Advanced Corporate Reporting

(International Stream)
PART 3 TUESDAY 10 DECEMBER 2002

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A This ONE question is compulsory and MUST be answered THREE questions ONLY to be answered

Section B

Paper 3.6(INT)

Section A This ONE question is compulsory and MUST be attempted 1 The following draft balance sheets relate to Rod, a public limited company, Reel, a public limited company, and Line, a public limited company, as at 30 November 2002: Rod $m Non-current Assets Tangible non-current assets cost/valuation Investment in Reel Investment in Line 1,230 640 160 _____ 2,030 _____ Current Assets Inventory Trade receivables Cash at bank and in hand 300 240 90 _____ 630 _____ 2,660 _____ 1,500 300 625 _____ 2,425 135 100 _____ 2,660 _____ Reel $m 505 100 ____ 605 ____ 135 105 50 ____ 290 ____ 895 ____ 500 100 200 ____ 800 25 70 ____ 895 ____ Line $m 256 ____ 256 ____ 65 49 80 ____ 194 ____ 450 ____ 200 50 70 60 ____ 380 20 50 ____ 450 ____

Total assets Capital and reserves Called up share capital Share premium account Revaluation Reserve Accumulated Reserves Non-current liabilities Current liabilities Total equity and liabilities

The following information is relevant to the preparation of the group financial statements: (i) Rod had acquired eighty per cent of the ordinary share capital of Reel on 1 December 1999 when the accumulated reserves were $100 million. The fair value of the net assets of Reel was $710 million at 1 December 1999. Any fair value adjustment related to net current assets and these net current assets had been realised by 30 November 2002. There had been no new issues of shares in the group since the current group structure was created.

(ii) Rod and Reel had acquired their holdings in Line on the same date as part of an attempt to mask the true ownership of Line. Rod acquired forty per cent and Reel acquired twenty-five per cent of the ordinary share capital of Line on 1 December 2000. The accumulated reserves of Line on that date were $50 million and those of Reel were $150 million. There was no revaluation reserve in the books of Line on 1 December 2000. The fair values of the net assets of Line at 1 December 2000 were not materially different from their carrying values. (iii) The group operates in the pharmaceutical industry and incurs a significant amount of expenditure on the development of products. These costs were formerly written off to the income statement as incurred but then reinstated when the related products were brought into commercial use. The reinstated costs are shown as Development Inventory. The costs do not meet the criteria in IAS38 Intangible Assets for classification as intangibles and it is unlikely that the net cash inflows from these products will be in excess of the development costs. In the current year, Reel has included $20 million of these costs in inventory. Of these costs $5 million relates to expenditure on a product written off in periods prior to 1 December 1999. Commercial sales of this product had commenced during the current period. The accountant now wishes to ensure that the financial statements comply strictly with IAS/IFRS as regards this matter. (iv) Reel had purchased a significant amount of new production equipment during the year. The cost before trade discount of this equipment was $50 million. The trade discount of $6 million was taken to the income statement. Depreciation is charged on the straight line basis over a six year period.

(v) The policy of the group is now to state tangible non-current assets at depreciated historical cost. The group changed from the allowed alternative treatment to the benchmark treatment under IAS16 Property, Plant and Equipment in the year ended 30 November 2002 and restated all of its tangible non-current assets to historical cost in that year except for the tangible non-current assets of Line which had been revalued by the directors of Line on 1 December 2001. The values were incorporated in the financial records creating a revaluation reserve of $70 million. The tangible non-current assets of Line were originally purchased on 1 December 2000 at a cost of $300 million. The assets are depreciated over six years on the straight line basis. The group does not make an annual transfer from revaluation reserves to the accumulated reserve in respect of the excess depreciation charged on revalued tangible non-current assets. There were no additions or disposals of the tangible non-current assets of Line for the two years ended 30 November 2002. (vi) During the year the directors of Rod decided to form a defined benefit pension scheme for the employees of the holding company and contributed cash to it of $100 million. The following details relate to the scheme at 30 November 2002: Present value of obligation Fair value of plan assets Current service cost Interest cost scheme liabilities Expected return on pension scheme assets $m 130 125 110 20 10

The only entry in the financial statements made to date is in respect of the cash contribution which has been included in Rods trade receivables. The directors have been uncertain as how to deal with the above pension scheme in the consolidated financial statements because of the significance of the potential increase in the charge to the income statement relating to the pension scheme. They wish to immediately recognise any actuarial gain. (vii) Goodwill is written off over four years on the straight line basis. (viii) The group uses the allowed alternative treatment in IAS22 Business Combinations to allocate the cost of acquisition. Required: (a) Show how the defined benefit pension scheme should be dealt with in the consolidated financial statements. (4 marks) (b) Prepare a consolidated balance sheet of the Rod Group for the year ended 30 November 2002 in accordance with the standards of the International Accounting Standards Board. (21 marks) (25 marks)

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This is a blank page. Question 2 begins on page 5.

Section B THREE questions ONLY to be attempted 2 Autol, a public limited company, currently prepares its financial statements under local GAAP (Generally Accepted Accounting Practice). The company currently operates in the telecommunications industry and has numerous national and international subsidiaries. It is also quoted on the local stock exchange. The company invests heavily in research and development which it writes off immediately, and uses the pooling of interests method for accounting for its subsidiaries wherever possible. The local rules in this area are not prescriptive. The company does not currently provide for deferred taxation or recognise actuarial gains and losses arising on defined benefit plans for employees. It wishes to expand its business activities and raise capital on international stock exchanges. The directors are somewhat confused over the financial reporting requirements of multi-national companies as they see a variety of local GAAPs and reporting practices being used by these companies including the preparation of reconciliations to alternative local GAAPs such as that of the United States of America, and the use of the accounting standards of the International Accounting Standards Board (IASB). The directors have considered the use of US GAAP in the financial statements but are unaware of the potential problems that might occur as a result of this move. Further the directors are considering currently the use of the accounting standards of the IASB in the preparation of the consolidated financial statements and require advice as to the potential impact on reported profit of a move from local GAAP to these accounting standards given their current accounting practice in the areas of deferred tax, research and development expenditure, employee benefits and the uniting of interests. Required: Write a report suitable for presentation to the directors of Autol that sets out the following information: (a) the variety of local GAAPs and reporting practices currently being used by multi-national companies setting out brief possible reasons why such companies might prepare financial statements utilising a particular set of generally accepted accounting practices. (6 marks) (b) advice as to whether Autol should prepare a single set of consolidated financial statements that comply only with US GAAP . (3 marks) (c) the problems relating to the current use of GAAP reconciliations by companies and whether the use of such reconciliations is likely to continue into the future. (5 marks) (d) the potential impact on the reported profit of Autol if it prepared its consolidated financial statements in accordance with the accounting standards of the IASB in relation to its current accounting practices for deferred tax, research and development expenditure, employee benefits and uniting of interests. (11 marks) (25 marks)

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TAS, a public limited company, owns 100 per cent of the ordinary share capital of X and Y, who themselves are public limited companies. The group operates in the aircraft manufacturing industry which is currently a depressed market. It is accepted by the group that there is over capacity in the sector with several companies struggling to remain solvent. The trade payables of the company Y amount to $30 million and are exerting pressure on the group. The directors are afraid that the trade payables may attempt to prove that company Y is insolvent. Company Y has made small losses for the last two years and its liquidity is poor. The majority of its net current assets is in the form of work-inprogress which is unlikely to be sold and which needs some cash investment to complete. The directors have decided to put forward two different restructuring plans as at 30 November 2002. Plan 1 X is to purchase the whole of TAS investment in Y. The purchase consideration was to be $100 million payable in cash to TAS. This amount will then be loaned on a long-term unsecured basis to Y by TAS. Plan 2 The net assets and trade of Y are to be transferred to X. Y would become a non-trading company. For the purpose of plan 2 only, the purchase consideration was to be $71 million which represents the groups view of the value of the trade and net assets of Y. This amount will be left outstanding on the inter company account between X and Y. The net assets and trade are to be transferred at book value after any necessary adjustments required by the information below. The balance sheets of TAS and its subsidiaries at 30 November 2002 produced in summary form are as follows: TAS $m Tangible non-current assets at depreciated cost/valuation Cost of investment in X Cost of investment in Y Net current assets Long-term loan 800 150 95 155 _____ 1,200 _____ 150 1,050 _____ 1,200 _____ X $m 270 Y $m 60

130 ____ 400 ____ 80 320 ____ 400 ____

25 (10) ___ 75 ___ 70 5 ___ 75 ___

Share Capital ordinary shares of $1 Accumulated reserves

TAS acquired the investment in X on 1 December 1998. The fair value of the net assets of X at that date was $134 million. Y was purchased on 1 December 2000. The fair value of the net assets at that date was $87 million. At the dates of acquisition there was no material difference between the book values and fair values of the net assets of X and Y. The following information should be taken into account in the restructuring of the group: (a) The value of the assets of Y at 30 November 2002 is currently being discussed by the directors. The tangible non-current assets of Y comprise entirely of a manufacturing unit which is currently operating at 3035% of capacity due to the depressed market and over capacity in the sector. The unit was completed on 1 June 2001 at a total cost of DM135 million which was converted into dollars at an exchange rate of $1 = DM135. The original manufacturing unit, which was in existence at the time of TAS acquisition of Y, was sold for its carrying value on 1 June 2001 to a third party. (b) The manufacturing unit of Y was constructed with the aid of a foreign currency debt of DM13 million, which remains in the balance sheet at 30 November 2002 at its original translated amount as at 1 December 2000. Exchange rates over the last three years are: 30 November/1 December 2000 2001 2002 DM to $ 13 14 16

The trade payables of the company are arguing that because of the current strength of the dollar against the DM, the value of the manufacturing unit should be adjusted downwards to reflect current exchange rates. 6

(c) The directors have produced information about the cash flows expected to be generated by the manufacturing unit of Y which has resulted in an expected value in use of $34 million as at 30 November 2002. The net selling price of the manufacturing unit is difficult to estimate but is approximately $8 million. (d) The group writes off goodwill over four years and depreciates its non-current assets at 20% per annum straight line with a full years charge in the year of recognition for both items. Further the directors wish to make a restructuring provision of $5 million. Required: (a) Prepare the individual balance sheets of TAS, X, and Y, and the group balance sheet in accordance with Restructuring Plan 1 as at 30 November 2002. (10 marks) (b) Prepare the individual balance sheets of TAS, X and Y in accordance with Restructuring Plan 2 as at 30 November 2002. (7 marks) (c) Discuss the key considerations and implications of the proposed plans for the restructuring of the group including their effect upon the position of the trade payables. (8 marks) (25 marks)

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Transystems, a public limited company, designs websites and writes bespoke software. The company has a history of conflict with the auditors regarding its creative use of accounting standards. The following accounting practices are proposed by the directors: (a) The company acquired the whole of the share capital of Zest Software, a public limited company on 28 February 2002 and merged Zest Software with its existing business. The directors feel that the goodwill ($10 million) arising on the purchase has an indefinite economic life and, therefore, no amortisation has been provided as the goodwill is an inseparable part of the value of the business acquired. Additionally, Transystems has a 50% interest in a joint venture which gives rise to a net liability of $3 million. The reason for this liability is the fact that the negative goodwill ($6 million) arising on the acquisition of the interest in the joint venture has been deducted from the interest in the net assets ($3 million). Transystems is proposing to net the liability of $3 million against a loan made to the joint venture by Transystems of $5 million, and show the resultant balance in tangible non-current assets. The equity method of accounting has been used to account for the interest in the joint venture. It is proposed to treat negative goodwill in the same manner as the goodwill on the purchase of Zest Software and leave it in the balance sheet indefinitely. (9 marks) (b) Transystems had itself disclosed in its financial statements $15 million of music and screen production rights which it had acquired via the purchase of another subsidiary. The group policy is to classify this intangible as current assets under inventory. Further, during the current financial period, the group has capitalised its domain names acquisition costs of $1 million within tangible non-current assets, and revalued the asset to $3 million. (4 marks) (c) The turnover of the group results mainly from the sale of software under licences which provide customers with the right to use these products. Transystems has stated that it follows emerging best practice in terms of its revenue recognition policy which it regards as US GAAP. It has stated that the International Accounting Standards Board has been slow in revising its current standards and the company has therefore adopted the US standard SAB101 Revenue Recognition in Financial Statements. The group policy is as follows: (i) if services are essential to the functioning of the software (for example setting up the software) and the payment terms are linked, the revenue for both software and services is recognised on acceptance of the contract;

(ii) fees from the development of customised software, where service support is incidental to its functioning, are recognised at the completion of the contract. (5 marks) (d) The groups tangible non-current assets are split into long leasehold properties (over 50 years) and short leasehold property. The groups accounting policy as regards long leasehold properties is not to depreciate them on the grounds that their residual value is very high and the market value of the property is in excess of the carrying amount. Short leasehold properties are only depreciated over the final ten years of the lease. The company renegotiates its short leaseholds immediately before the final ten years of the lease and thus no depreciation is required up to this point. (4 marks) (e) Transystems uses a multi column format in order to present its Income Statement. It wishes to use a boxed presentation (see below) to highlight its exceptional items. Transystems Extract from Consolidated Income Statement Before Exceptional Exceptional Items Items $m $m Operating Profit Disposal of non-current assets Interest payable Profit on ordinary activities before taxation 500 (210) _____ 290 _____ (50) ____ (50) ____ Total

$m 500 (50) (210) _____ 240 _____

The group accountant has asked for your advice as to the acceptability of the above accounting practices under International Accounting Standards/International Financial Reporting Standards as he does not wish to suffer a qualification of the audit report or have any special comment in that report. (3 marks) Required: Write a report to the group accountant advising him as to the acceptability of the above accounting practices utilised by Transystems plc. Note to candidates Candidates do not need any knowledge of US Standard SAB101 Revenue Recognition in Financial Statements in order to answer this question. (25 marks)

The value relevance of published financial statements is increasingly being put into question. Financial statements have been said to no longer have the same relevance to investors as they had in the past. Investment analysts are developing their own global investment performance standards which increasingly do not use historical cost as a basis for evaluating a company. The traditional accounting ratio analysis is outdated with a new range of performance measures now being used by analysts. Companies themselves are under pressure to report information which is more transparent and which includes many non-financial disclosures. At the same time the move towards global accounting standards has become more important to companies wishing to raise capital in foreign markets. Corporate reporting is changing in order to meet the investors needs. However, earnings are still the critical number in both the company and the analysts eyes. In order to meet the increasing information needs of investors, standard setters are requiring the use of prospective information and current values more and more with the traditional historical cost accounts and related ratios seemingly becoming less and less important. Required: (a) Discuss the importance of published financial statements as a source of information for the investor, giving examples of the changing nature of the performance measures being utilised by investors. (11 marks) (b) Discuss how financial reporting is changing to meet the information requirements of investors and why the emphasis on the earnings figure is potentially problematical. (8 marks) (c) Discuss whether the intended use of fair values will reduce the importance of historical cost information. (6 marks) (25 marks)

End of Question Paper