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Below are questions and answers relating to paper P8 Financial Analysis from past events.
Question
I wonder how to calculate goodwill when the simple investment in an entity has become an associate and then a subsidiary to a parent company.
Answer
This is the problem of piecemeal acquisition – eventually the parent company has a controlling interest, but this is built up over a number of transactions.
The rule in IFRS 3 is that each transaction should be treated separately by the acquirer – in other words, the comparison to calculate goodwill is done step by step.
So, once the investment is significant enough for goodwill to be necessary, calculate it in separate “chunks” for each separate investment.
Question
Can you please explain the treatment of defined benefit pension schemes in the income statement and balance sheet?
Answer
Pension schemes are covered by IAS 19, and a defined benefit scheme is one where the eventual benefits to be paid out are defined by the scheme, rather than the contributions to be made. Actuaries decide how much must be contributed in order to provide for these benefits.
To account for a defined benefit scheme, the first step is to estimate how much benefit employees have accrued in return for current period service. For example, if the scheme provides for a payment of 3% of final salary for each year of service, and the eventual final salary is estimated at $20,000, this year’s service will have earned the employee an eventual benefit of $600. This entitlement is then discounted to present value to arrive at the current year service cost, which is shown as an expense in the income statement. Bearing in mind that this happens each year, the present value of previous year’s accrued benefits will increase (as they get closer to the actual date of payment), and this will result in an interest expense in the income statement. For example, if the eventual benefit of $600 is payable in 3 years time and the discount rate is 10%, its present value will be $600 x 0.751 = $451. Next year, this benefit will only require discounting by two years, to $600 x 0.826 = $496. The difference of $45 (i.e. $451 x 10%) will be shown as an interest expense next year, along with next year’s service cost. The pension cost is finally reduced by the expected return on pension scheme assets.
The balance sheet must show the net total of the present value of pension obligations (what will have to be paid out), plus unrecognised actuarial gains less unrecognised actuarial losses (gains and losses due to actuarial assumptions and actual experience), less the fair value of scheme assets (the use to which contributions has been put).
Question
Can you please explain the treatment of intra-group transactions where parent sales to a subsidiary as well as an associate and there are both opening and closing inventories at the balance sheet date?
Answer
If inventories include items purchased from a subsidiary or parent, then they will include a profit element which is unrealised from the group perspective, and must be removed. This is effected by setting up a provision for unrealized profit, which offsets inventory in the consolidated balance sheet.
As with other provisions, and adjustment is made each year (via cost of sales) to change the provision to what is required.
For example, suppose inter-company sales are made at cost plus 25%, and inter-company items in stock are as follows:
At 1 January 2006 £1,000
At 31 December 2006 £1,200
The year end inventory includes an unrealised profit of £1,200 x 25/125 = £240. However, the opening inventory included an unrealised profit of £1,000 x 25/125 = £200, so the provision must now be INCREASED by £40 (so cost of sales is INCREASED by £40).
Suppose inventory at 31 December 2007 included inter-company items worth £800. The required provision would now be £800 x 25/125 = £160, requiring a REDUCTION of £80. Cost of sales for the year would also be REDUCED by £80.
Question
What is the difference between cashflow hedge & fairvalue hedge?
Answer
Hedging is a management technique for dealing with volatility and risk – something is chosen as a hedging instrument because changes in its value will offset those in the item being hedged.
A fair value hedge is one where the fair value of the item changes as market prices change. For example, a liability in a foreign currency – the fair value of the liability (i.e. in the domestic currency) will change between now and maturity, but there will be no related cash flows until maturity. The liability could be hedged by a forward exchange contract to buy the relevant amount at the relevant date.
A cash flow hedge is one where cash flows related to the item change as market prices change. For example, debt which is subject to a floating rate will involve cash flows which will be affected by changes in the interest rate – this debt may be hedged by using a swap to exchange it for fixed rate debt.
Question
Could you please explain discounting and PV of cash flows with an example?
Answer
Discounting is a technique for comparing cashflows which arise at different times. It recognises the time value of money, i.e. the fact that money now is worth more than money later.
Put simply, imagine that money can be invested at 10%, and that you have £1,000 now. If you invest this, in one year it will be worth £1,000 x 1.10 = £1,100. After two years, it will be worth £1,000 x 1.10 x 1.10 = £1,210.
One way of expressing this is to say that the future value in two years of £1,000 at 10% is £1,210. Another way is to say that the present value at 10% of £1,210 in two years time is £1,000. In other words, you would be indifferent between receiving £1,000 now and £1,210 in two years time.
By converting all cash flows to present value, the value of a project/asset can be seen in today’s terms, enabling more meaningful comparison.
Question
How do we adjust the cost of sales figure in the consolidated income statement when there is inter-group sales and there is unsold stock at the balance sheet date?
Answer
I think it is best to think of this adjustment in two steps.
First, the whole value of the inter company sale must be removed from both revenue AND cost of sales – this will be necessary whether there is any unsold stock at the balance sheet date or not.
Second, if there is unsold stock, the profit element included in this stock must be removed (since from the group perspective it is unrealised). This is effected by ADDING the unrealised profit to cost of sales (effectively reducing the value of closing stock)
For example, suppose goods which originally cost £3,000 were sold to another group company for £4,000, and that ¼ of these remain in stock at the year end.
STEP 1: Reduce both revenue AND cost of sales by £4,000
STEP 2: Increase cost of sales by £250 (£1,000 x ¼)
Note that if the sale was from subsidiary to parent, the minority interest would need to be reduced by the minority’s share of the unrealized profit.
Question
Can you please explain the methodical approach for the Calculation of Earnings per Share under IAS 33, to include the effect of bonus issues, rights issues and convertible stock?
Answer
The basic calculation of EPS is as follows:
Net profit attributable to ordinary shareholders
--------------------------------------------------
weighted average number of ordinary shares
The profit must be stated after everything including preference dividends, but before the deduction of ordinary dividends. The number of shares must be calculated as a weighted average if shares have been issued or repurchased during the year, using time for the weighting.
A bonus issue creates problems with consistency – the number of shares increases, but there is no injection of capital (and hence no resultant increase in profitability). In such cases, EPS is calculated as if the bonus shares had always been in issue (and the comparative is revised to reflect this).
A rights issue is more complicated – fresh capital IS raised, but the issue is usually at less than full market price. It is therefore treated as a combination of a bonus issue and an issue at market price. The bonus fraction is calculated as:
Fair value before the issue
--------------------------------------
Theoretical ex-rights price
The bonus fraction is applied to the comparative as before, as well as the current period, and a weighted average is calculated with the remainder of the issue.
For example, suppose there are 200,000 shares in issue with a market price of £2.50 per share, and a rights issue of 1 for 4 is made at £2.00. The theoretical ex-rights price is calculated as:
Original holding, 4 shares @ £2.50 10.00
New share, 1 @ £2.00 2.00
--------
Revised holding, 5 shares 12.00 / 5 = £2.40 per share
So, the bonus fraction is £2.50 / £2.40 = 1.041667
Shares including bonus element = 200,000 x 1.041667 = 208,333
In other words, the issue is treated as a bonus issue of 8,333 shares and an full issue of 41,667 shares.
Convertible debt comes into the reckoning for diluted EPS. This statistic is intended to show how EPS could change if conversion occurred. Both elements of the fraction are adjusted to show what they would be if conversion had occurred at the beginning of the period (even though actual conversion may not be possible for many years).
The number of shares must be changed according to the terms of the conversion. Additionally, the profit will increase, as conversion will remove the need for an interest payment.
Question
Please can you explain about deferred tax in brief and about the temporary difference?
Answer
Deferred tax recognizes that accounting profits will usually differ from taxable profits. Some of this may be a permanent difference – for example, in the UK any business entertaining expenses will be deducted from profit in the financial statements, but are simply not allowable as an expense for tax. Some of the difference may be temporary – for example, capital allowances may be given by the tax authorities at a different rate to that used for depreciation in the financial statements, but over the life of an asset the difference may even out.
Deferred tax recognizes that temporary differences will give rise to future tax consequences. Since they have been caused by past transactions and events, IAS 12 requires them to be recognized. Note that deferred tax does NOT affect the amounts to be paid to the tax authorities – it merely adjusts the financial statements to reflect all tax consequences (current and future) of past transactions.
Question
Please explain elimination procedure for inter group transactions for the following situations: parent selling to subsidiary, parent selling to associate subsidiary, selling to parent and associate selling to parent?
Answer
Your query concerns inter company trade within a group
If one group company sells to another, the first step is to remove the transaction completely from sales and cost of sales. Note that this happens regardless of whether the goods have been sold on, and regardless of the direction of sale.
Second, if any of the goods remain in stock, the profit on these items must be removed (debit cost of sales, credit closing stock in the balance sheet), since from the group’s perspective it is unrealized.
Finally, if an unrealized profit has been removed, the direction of sale must be checked. If from parent to subsidiary, no further action is required. If from subsidiary to parent, the minority interest must be reduced accordingly.
Question
Please explain in detail about Financial Instruments Measurement?
Answer
Financial instruments are contracts which give rise to a financial asset of one entity and a financial liability or equity instrument of another. Initial measurement of both should be at fair value, and subsequent measurement should also be at fair value, except for the following:
- Loans and receivables, held-to-maturity investments, and non-derivative financial liabilities should be measured at amortised cost using the effective interest method.
- Investments in equity instruments with no reliable fair value measurement (and derivatives indexed to such equity instruments) should be measured at cost.
- Financial assets and liabilities that are designated as a hedged item or hedging instrument are subject to measurement under the hedge accounting requirements of the IAS 39.
- Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or that are accounted for using the continuing-involvement method, are subject to particular measurement requirements.
If you’d like further information, a good source is http://www.iasplus.com/ where you will find summaries of all standards, including IAS 39.
Question
What is the exact difference between consolidation and combination, how is IAS 27 different from IFRS 3? If a business holds 51% share in another business does it come under IAS 27 or IFRS 3?
Answer
Both IAS 27 and IFRS 3 are applicable to groups of companies and consolidated accounts. IFRS 3 is primarily concerned with the identification of the acquirer in a business combination, and specifies the method which must be used to account for the combination (the acquisition method). It also defines and specifies the treatment for goodwill.
IAS 27 focuses on the principles to be applied in consolidation, and any exemptions from the requirement.
There is a degree of overlap between the standards. One way to look at them is that IFRS 3 tells you how to identify a combination, and what to do when it happens, whilst IAS 27 is more concerned with the ongoing treatment of the acquisition. The bottom line is, both must be observed.
Question
Is there any difference in calculating figures for goodwill, reserves and MI in consolidation when a parent has acquired a subsidiary first and the subsidiary has then acquired another company (in a later date which will be a sub subsidiary for the parent), as opposed to the situation for a company that has acquired a subsidiary first and we -as a parent-have acquired that company later. I am in doubt about the use of true percentage representing the parent company's share of goodwill of the sub-subsidiary.Answer
The key here is that the sub-subsidiary is consolidated only from the date of effective control. So if H acquires S on 1 January 2006 and S acquires SS on 1 June 2006, SS is included in the consolidated accounts of H from 1 June 2006. If H acquires S on 1 January 2006 and S acquires SS on 1 October 2005, SS is included in the group accounts of H from 1 January 2006. These dates also dictate the figures to be used in the goodwill calculation.
In the exam, you must make sure you get the easy marks on offer. With the above in mind, much of the consolidation is no different to that of a simple group, so I’d suggest doing the basics first and leaving the more complex figures (e.g. goodwill, consolidated reserves, minority interest) until the end.
When working out goodwill, remember that you must calculate from the ultimate holding company’s perspective. So if H owns 80% of S who owns 75% of SS, you must compare 80% of the price paid by S with 80% x 75% = 60% of the net assets of SS to work out the goodwill in SS from H’s perspective. Alternatively, calculate as normal for S and then multiply the result by 80% to get H’s share.
When calculating minority interest, remember to adjust for H’s minority interest in S’s cost of investment in SS – since this cost of investment has not been included in the consolidation, the share of net assets given to the minority must be reduced (in the above example, 20% of the original cost of SS, as paid by S, must be deducted from minority interest).
Question
Please guide me how can be able to select the most appropriate ratios in analyse and interpretation of financial statements?
Answer
In selecting appropriate ratios, be guided by the question. Look to see what the main issue is (e.g. profitability, liquidity). Remember that at this level, the comments you make are at least as important as the calculations – for each ratio you are considering, ask yourself whether you could draw any conclusions that are relevant to the specific question asked, and if not, don’t bother calculating it!
Question
The investment made in working capital is largely a function of sales and, therefore, it is useful to consider the problem in terms of a firms (cash operating) cycle. I don't quite understand the meaning of this. Could you explain it by giving a numerical example?
Answer
Working capital is the finance needed by a business to meet its day-to-day requirements, and the operating cycle is a good way to illustrate these requirements.
The operating or cash cycle represents the delay between having to pay suppliers for raw materials and receiving money from customers. The length of this cycle will vary from business to business, but could be fairly long for a manufacturing concern.
When raw materials are delivered, the first delay is that they may require manufacturing before they can be sold. So there is a delay whilst they sit in stock (as raw materials, WIP and eventually finished goods). Once sold, there may be a delay because credit terms are offered to customers (so we have to wait for debtors to pay).
These two delays may be considerable, but may be mitigated by the fact that businesses take credit from suppliers as well as offering it to customers. In summary, the operating cycle may be calculated as stock days plus debtor days less creditor days, and represents the time elapsed between paying for raw materials and receiving money from debtors.
Question
I don't quite understand the treatment for excess of sale price over fair value for leaseback in IAS 17. As it can not be recognised as profit why is it credited to income? What is the double entry for it?
Answer
IAS 17 says that if an asset is sold and leased back, and the selling price exceeds fair value, this excess should be deferred and amortised over the lease term or period of use. This recognizes that a high sales value is likely to be matched by higher lease rentals – it is almost as if the seller has obtained a loan secured on the asset, and a higher loan requires higher interest. So, rather than take the excess as an immediate profit, it is matched with the finance charges. In double entry terms, it is set up as a deferred credit in the balance sheet (like a provision), and an amount is released to the Income Statement each year – think of it as depreciation in reverse.
Question
How should proposed dividends be treated if the entity has been acquired on the last day of the reporting period? Are they due to previous owner or to the new one?
Answer
There are a number of issues here. The easiest is “who gets the money” – that is simply the holder of the share when the dividend is declared, whether they have held the share for one day, one year, or whatever.
Second, you have asked about a proposed dividend. Under IAS 10, proposed dividends declared after the balance sheet date are NOT recognized as liabilities, so the problem of how to treat them does not arise until they are paid.
Finally, what about accounting treatment? There are two possibilities – treat the dividend as realized profits in the hands of the parent (i.e. “normal” treatment for dividends received), or treat the dividend as a refund of part of the cost of investment. Accounting standards are not entirely clear on which should be chosen, but state that the cost of an investment should be reduced by dividends only if they clearly represent a recovery of part of cost.
Question
What is referred to as investment income? Why should it be eliminated when preparing the consolidated income statement? How is it to be treated? Why isn't interim dividend considered when preparing consolidated financial statements? How do we account for trade investments?
Answer
Investment income is, as the name suggests, income received as a result of holding investments. It could be interest received, but in group accounting questions, it usually comprises dividends received.
It is usually eliminated on consolidation because it cancels with (part of) the dividends payable by the subsidiary – it is an inter-company transaction. If the parent has investments other than in the subsidiary, then this other part of investment income will NOT be eliminated.
Interim dividends do not usually require any consideration on balance sheet consolidation, because they have usually been paid and accounted for correctly in both sets of books. However, in the Income Statement, cancellation is necessary as above.
If a company has trade investments as well as the investment in its subsidiary, then this will simply be shown as such on the consolidated balance sheet.
Question
How do I identify if the working capital has deteriorated from positive to negative?
Answer
Working capital is usually defined as current assets minus current liabilities - it represents the amount of short-term capital the business has available to meet its day-to-day needs. It is a figure shown in the balance sheet, often called "net current assets."
As such, positive working capital would suggest that current assets exceed current liabilities. Negative working capital would suggest that current liabilities exceed current assets.
Question
How does one know when to restate prior period's EPS figures?
Answer
The need to restate EPS for the previous year arises because it is vital to ensure comparability.
Normally, a new issue of shares is accompanied by a fresh injection of capital, and there is no need to restate the comparative.
However, in the case of a bonus issue, there is no such injection, and the comparative must be restated as if the bonus shares had always been present.
Similarly, when a rights issue occurs, it is treated as if it is a bonus issue plus an issue at full price. In this case, the comparative figure must be restated not for the whole issue, but just for that part deemed to be the bonus.
To summarise, restatement is necessary when there is a bonus or rights issue.
Question
The concept "hedging" confuses me. It talks about a hedged item and a hedging instrument?
How come hedging can reduce the risk and volatility in the management of assets and liabilities?
Answer
Hedging is indeed all about minimising risk. A common example of its use is with foreign currency investments.Suppose you own an investment in a foreign currency. You will be concerned about preserving the value of this investment, and worried that a change in exchange rates will erode the value. If the foreign currency weakens, the value to you of the investment will fall, and you will make a loss.
To guard against this loss, you might finance the investment with a loan in the same foreign currency. That way, if the exchange rate moves and the value of the investment goes down, so will the value of the liability. The loss you make on the investment will be offset (partly or wholly) by the gain you make on the loan (the investment is worth less, but you owe less too).
In this case, the investment is the hedged item and the loan is the hedging instrument.
Question
The P/E ratio is quite easy to calculate but how can I properly interpret that ratio?
What is the meaning of dividing the current market price per share by the EPS? What is the logic behind all these matters?
Answer
The price earnings ratio is sometimes referred to as "the multiple" as it shows how much investors are prepared to pay per pound/dollar/etc. of earnings. It reflects how confident investors are about the future - a high ratio shows expectation of high future earnings (think of it as if the investor is buying so many years of earnings).
P/E can also be said to indicate value for money - a high P/E would indicate that the share is relatively expensive.
However, like any ratio, P/E must be interpreted with caution. Among other problems, remember that earnings are based on accounting profit, so accounting policies will have a significant impact.
