Ask a tutor
Other pages in this section
| Exam questions | Post exam guides | Study guides | Articles archive | Maths table | Ask a tutor |Questions and answers
We hold events twice a year which give you the opportunity to ask an experienced tutor a question.
You can use our 'ask a tutor' events to put a syllabus topic that you are having problems with to our tutors. All you need to do is log into your My CIMA account during the advertised days and submit your question using our online form. We'll get a response to you by email as soon as possible.
Details and dates of our next event will be published here and in Velocity, our student e-magazine.
Below are questions and answers relating to paper P7 Financial Accounting and Tax Principles from past events.
Question
Please explain the term ' substance over form'?
Answer
"Substance over form" refers to looking at the reality of a situation rather than only the legal position.
An example would be where a business leases an asset rather than buying it themselves, but effectively pays out the same amount of money as they would had they taken out a loan and bought it (and in most cases, does actually buy it at the end of the lease period). They are often responsible for insuring it, maintaining it, and can use it as they wish. In law, they do not own a leased asset, so in theory should not show it on their balance sheet or depreciate it, but the reality is that they will treat it as their own, the lease period will be similar to the expected useful life of the asset so no-one will want it then. Thus, they should treat it in the same way as an asset which they own outright, and set up a liability for the capital value of the lease payments.
Question
Please can you explain the basics of IAS 11 'Construction Contracts'?Answer
A construction contract often extends over several accounting periods. At the outset, a price is quoted and an estimate made of the costs, and hence the profit. One method of accounting for this is to do nothing until the contract is completed and to then take the whole selling price and all of the costs into the profit calculation for that accounting period. But this is seen as unduly harsh as the profit will have been earned over several accounting periods. It is therefore permissable to account for some of this profit as work progresses. How much profit should be accounted for can be determined by several different methods, such as by calculation the proportion of costs incurred to date compared to the total expected costs, and to use the same proportion to calculate sales revenue and profit. Another method is to obtain a valuation of the work performed to date, compared with the total expected revenue and use that proportion.
Suppose the contract price is $5m, expected costs $3m, expected profit $2m. After the end of the first year, $1m has been spent (1/3 of the total cost). You could therefore calculate 1/3 of the sales revenue and 1/3 of the profit to take into account. But an independent valuer might feel that its value at that stage is only 25% of the value of the finished contract (we call this the "value of work certified"), so it would be more prudent to only take 25% of the revenue, costs and profit to the income statement (the remainder of the costs already incurred that are NOT taken to the income statement would be carried forward to a later period). We refer to this taking of profit to the income statement as "recognising" profit.
The above is over-ridden if the outcome of the contract is not reasonably certain, for example if it is too early in the contract to be sure that it will be profitable.
However IAS11 states that if a loss is expected on the contract, then that should be "recognised" at once. If profits have already been recognised in previous periods, these must be reversed.
Care should also be taken with payments received from the customer. Once it has been decided to recognise an amount of revenue, the customer will be invoiced, so if the payments are for or towards that invoice they simply reduce the amount he owes. But if they are advance payments for work not yet certified they are liabilities for the time being.
Question
Could you explain the finance and operating lease in simple points?
Answer
An operating lease is where an organisation leases an asset over a period of time which belongs both legally and practically to the lessor (owner), for example the owner maintains the asset, depreciates it, claims tax allowances on it, insures it, and at the end of the period takes it back and possibly leases it to someone else (so the lessee only has it for a part of its useful life). Such an asset will not appear on the organisation's balance sheet (it will appear on the lessor's balance sheet). It is effectively hiring the asset, so the payments it makes will be hire charges as they would be for renting any asset on an annual basis.
A finance lease is where an organisation effectively regards and uses the asset as their own and is really just borrowing money to acquire it. Such an asset will remain with the lessee until the end of its useful life (unless sold before then), and the amount they pay (at present value) will effectively be the whole value of the asset. They will probably buy it outright from the lessor at the end of the term, for a small sum. During the period of use, they will probably maintain it, etc. therefore it should be regarded as an asset on the balance sheet and depreciated in accordance with normal policy. The lease payments will consist of two elements, a capital element (which reduces the initial loan, equal to the fair value of the asset when acquired), and an interest element which is debited to the income statement.
Use your textbook to learn the exact terminology for determining a finance lease.
Question
Why is the finance charge sometimes taken out of the operating activities and then added back later on. (that is when presenting a cashflow statement)?
Answer
The costs of financing (for example loan notes) are not part of operating profits. The idea is that operating profits should only include items common to all enterprises, and not all enterprises finance through loans. So where finance costs have been deducted in the income statement (correctly for the presentation of the income statement), these need to be added back to arrive at the profit from operating activities.
But of course, they do represent an outflow of cash, so have to be deducted somewhere in the cash flow statement, and this is normally under the heading of Financing Activities.
Question
Yield to Maturity is very popular in P7. Please can you, with an example, explain how this is calculated?
Answer
Yield to maturity is the effective yield on a redeemable security, taking into account any gain or loss due to the fact that it was purchased at a price difference from the redemption value.
For example, a bond has a coupon rate of 8%. It will repay its face value of $100 at the end of 15 years. Other similar bonds have a yield to maturity of 12%.
We can use this data to calculate a price for the bond based on the fact that during its life, we will receive interest of 8% per annum (discounted over the 15 years), and $100 in 15 years' time.
$8 x (annuity factor for t=15 and r=12) + ($100 x discount factor for 7=15 and r=12)
= ($8 x 6.811) + ($100 x 0.1827) = $72.76. Therefore if we pay this sum for the bond we will get a return equal to other similar bonds. If we pay more, we will get a smaller return, and if we pay less we will get a larger return.
Suppose we pay $78.40. First pick two assumed rates of return, let's say 10% and 14%. It does not matter what you choose, but it is wise to choose a rate slightly lower than the norm, and a rate slightly higher.
The time is still 15 years, so using the same formula as previously:
Using r=10% ($8 x 7.606) + ($100 x 0.239) = $84.75 Using r=14% ($8 x 6.142) + ($100 x 0.140) = $63.14
These are the possible returns for the two rates. The correct rate (yield) is somewhere between the two.
We use interpolation to get an approximate yield:
= 10% + (84.75 - 78.40)/(84.75 - 63.14) x 4% (the difference in the two rates) = 11.17%
Question
According to IAS 10 "Adjusting event: An event after the balance sheet date that provides further evidence of conditions that existed at the balance sheet" then reduction in value of closing stock is adjusting or non-adjusting. If adjusting how is it as no evidence existed at balance sheet date?
Answer
I appreciate your confusion. It depends on whether the stock had lost value before the balance sheet date, but the enterprise only became aware of that when they came to sell it. For example, an item might be valued at $10, and expect to be sold for $20. If it then actually sold for only $5, and it is felt that this decline already existed at the balance sheet date, then it is adjusting event. However, if the decline occurred after the balance sheet date (say new legislation introduced after the balance sheet date made it illegal to sell the item for its original purpose), that would not be an adjusting event as the condition did not exist at the balance sheet date. It is usual if an enterprise sells an item shortly after the balance sheet date for less than the value included in the accounts, and there is no other reason given for this, to assume that it had already fallen in value at the balance sheet date.
Question
Are Wealth Tax and Property Tax also part of Indirect Taxes as the study text has included these in Chapter 3 Indirect Taxes?
Answer
The distinction between Direct and Indirect taxes is not clear-cut.
Generally a direct tax is one which is levied on the person/enterprise responsible for paying it (usually as a result of their "normal" activities, e.g. trading, and it therefore takes account of the person's ability to pay - if there is a profit, then it follows that the person must have the means to pay), and an indirect tax is one levied on a person/enterprise but the "collecting" enterprise pays it (e.g. VAT, which takes no account of ability to pay).
Wealth taxes and property taxes may be direct, e.g. if an enterprise sells property a tax may be levied on the gain, but in many cases taxes such as stamp duty, excise duties etc. are not related to ability to pay.
Question
Please give an Example of Regressive Tax Structure?
Answer
Regressive tax structure is one where proportionately less tax is paid as income rises.
An example is the UK system of National Insurance paid by employees. It is levied at 11% on earnings between about £100 a week up to about £600 a week, and at 1% on earnings above £600. So, a person earning £500 would pay £400 x 11% = £44, which is 8.8% of their total earnings, while a person earning £700 would pay £500 x 11% plus £100 x 1%, a total of £56, which is only 8% of their total earnings.
Question
What is the difference between treasury shares and capital reserves?
Answer
It is quite a tricky area to understand.
Treasury shares is a special term used on the face of the balance sheet to represent shares in an enterprise which the enterprise has re-purchased from its shareholders. IAS32 covers this. It is not possible to use Retained earnings for such a transaction, so some other method is needed. There are, in fact, two allowed methods.
Example - an enterprise has one million $1 ordinary shares at the start of the year. The balance sheet shows:
Share capital $1 shares 1,000,000
Share premium 600,000
(sub-total $1,600,000)
Retained earnings 500,000
Total equity and reserves 2,100,000
It buys back 300,000 of its shares for $1.30 each (total $390,000). There are two ways of dealing with this. Both are allowable.The first is to reduce the nominal share capital by $300,000 and reduce the share premium account by $90,000.
Using that method, the balance sheet would now show:
Share capital $1 shares 700,000
Share premium 510,000
Retained earnings 500,000
Total equity and reserves 1,710,000 (gone down by $390,000 - equals drop in cash)
The second method is to leave the equity shares and share premium account at the original amounts, and create a treasury shares account for the total of $390,000, which is deducted from the equity shares/premium, as follows:
Share capital $1 shares 1,000,000
Share premium 600,000
(subtotal 1,600,000)
Treasury shares (390,000)
Retained earnings 500,000
Total equity and reserves 1,710,000
Either method is allowed, but the second is preferred, as it indicates a 'permanent capital' figure of $1,600,000 in both the original balance sheet and the new, and the treasury shares are clearly shown, so everyone knows they have been bought back.
Note that Retained earnings is not affected by either method.
Special rules exist in some circumstances, for example where an enterprise is not quoted on a recognised stock exchange. In such cases, it would be difficult for investors to sell their shares and the only method of an individual being able to do so may be if the enterprise bought them back (a 'forced' purchase). In this case, it is possible to use Retained earnings for the purchase price, reduce the nominal value of shares, and create a capital redemption reserve for the nominal value.
Using the same figures as above, the balance sheet would be as follows:
Share capital $1 shares 700,000
Share premium 600,000
Capital redemption reserve 300,000
Retained earnings 110,000
Total equity and reserves 1,710,000
Capital reserves includes the share premium account, the capital redemption reserve account, and other accounts which are non-distributable except in particular cirumstances.
Question
Should heavy advertisement expenses be deferred to the future period , how is this item treated in the financial statements and which IAS covers deferred expense treatment?
Answer
The Framework for the Preparation and Presentation of Financial Statements covers the treatment of such expenditure. Whether it can be carried forward or not depends on the reliability of future expected economic benefit from the expenditure. It is an area of much uncertainty in accounting.
I am imagining an example of an intensive advertising campaign, the results of which are likely to be long-lasting, but with disproportionately large expenditure in the current (or a previous) period.
If it is agreed that such expenditure be carried forward, to be matched with future income, it would be shown in the balance sheet under current assets (trade and other receivables which includes 'prepayments' which is effectively what your item is). If the amount is sufficiently large as to require disclosure (and it may require disclosure anyway as an accounting policy), it might warrant a separate line on the balance sheet.
Question
Please explain with illustrations the difference between financial capital maintenance and physical capital maintenance?
Answer
You don't need to have a great understanding of the difference between these two concepts.
Financial Capital Maintenance is the most commonly used - if the net assets (or capital employed) are the same at the end of a period as they were at the beginning, the financial capital has been maintained. If they are higher at the end, a profit has been made. We normally calculate profit in this way, using historical costing principles. It is possible to re-state the historical cost profit using a unit of 'constant purchasing power', which means that the figures are adjusted by some factor, such as a rate of inflation. For example, if net assets at the start of the year were $10m, and inflation has risen by 10%, we would need net assets at the end of the year to be $11m to say that financial capital has been maintained. At this level, there would be no profit.
Physical Capital Maintenance is more complex and refers to the actual operating capacity of the enterprise, and different elements of the financial statements might be affected by different factors. For example, if a stock level of $1000 last year represented 1,000 items, and stock costs have risen by 20% (which might be different to the rate of inflation), then stocks need to be $1,200 to represent 1,000 items.
Fixed assets are another consideration in maintaining physical capital - a machine bought five years ago for $10m, being depreciated over 10 years, charges profit with $1m a year, and is currently shown in the balance sheet at $5m. It might currently cost $20m for a machine with similar capacity, so perhaps the depreciation charge should be $2m a year to represent the usage based on current costs. This is known as Currrent Cost Accounting. It is a difficult concept, and you really do not need any more knowledge at this level.
The difference between the two concepts is the way in which they treat the effects of increases in the prices of assets (and liabilities - a liability due for payment in six months could be discounted to its net present value, to take account of changing price levels).
