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Suggested answers and examiner’s comments

Financial Reporting and Governance November 2015 Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive “right” answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Examiner’s general comments The pass rate for this session was 73%. As for previous sessions, most scripts were well presented. However, some scripts were difficult to read, especially where answers were presented as long paragraphs rather than breaking up the paragraphs into individual points. There was also an increase in very brief scripts in this cohort.

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Section A Answer all parts of Question 1. Select only one of the options A, B, C or D for each part. 1 (i) For an entity to comply with FRS 18, it should adopt appropriate accounting policies:

A For its particular circumstances which will give a true and fair view.

B For its particular circumstances which will give a materially correct view of its position at the entity’s year end.

C As determined by the financial reporting regime that the entity is part of, ensuring there

are no off balance sheet assets or liabilities. D Which it chooses from the financial reporting regime that the entity is part of.

(ii) With regard to the Sarbanes Oxley Act in the USA, which of the following statements is correct?

A The audit firm can only provide audit services for a client company, not other services. B Certification of financial statements which do not comply with the Act can result in fines

and imprisonment. C All board members must attest to the accuracy of the financial statements. D Auditors are appointed by the directors following the recommendation of the audit

committee. (iii) In terms of good corporate governance, who should be the chairperson of the audit

committee? A The Chairman of the board of directors. B The Senior Independent Director. C The Finance Director.

D The audit partner of the company’s auditors. (iv) Which of the following statements is true regarding futures contracts?

A The contract is only valid where the strike price is favourable to the holder. B The contract holder is not obliged to honour the contract at termination and may void

the contract prior to termination.

C They are exchange traded contracts. D The contract allows two parties to exchange different cash flows or interest rates for a

specific period of time.

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(v) A company has issued 4,000,000 shares with a nominal value of 50p each. The directors

have decided to make a rights issue of 1 new share for each 8 shares held. The offer price is £2 per share. Assuming all of the shares are sold, what will be the value of the share premium?

A £250,000 B £750,000 C £1,000,000 D £2,000,000

(vi) Which of the following events, all of which occur after the end of the reporting period, is

classified as an adjusting event according to IAS10 ‘Events after the reporting period’?

A There is the emergence of persuasive evidence that the entity can no longer continue as a going concern.

B There is flood damage to material assets. C There is an announcement that part of the business is no longer viable and will cease

to operate. D There is a fall in the market value of investments between the statement of financial

position date and the date when the financial statements are approved for issue. (vii) A company’s receivables balance at the end of the year is £340,000. The gross profit for the

year is £3,600,000 with a gross profit percentage of 60%. What are the receivables days (to the nearest whole number)?

A 3 B 21 C 34 D 52

(viii) In the UK, which companies must have a company secretary?

A All companies incorporated under the Companies Act. B All companies limited by guarantee. C Only private companies. D Only public companies.

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(ix) What is a cell company?

A A company incorporated in an offshore jurisdiction primarily to limit payment of taxation in another jurisdiction.

B A holding company with a number of subsidiaries in offshore locations. C A company limited by guarantee for the purpose of holding assets in trust. D A private or public company which is able to segregate its assets into several distinct

entities. (x) The operating profit for a company for the year ended 30 June 2015 is £1,500,000. During

the year, there has been an increase in receivables of £235,000, an increase in payables of £75,000 and a decrease in inventories of £45,000. What is the net cash inflow from operating activities in the company’s cash flow statement for the year to 30 June 2015?

A £1,145,000 B £1,235,000 C £1,385,000 D £1,855,000

(Total: 10 marks)

Suggested answers (i) A For its particular circumstances which will give a true and fair view.

Examiner’s explanation This is the requirement of FRS 18.

(ii) B Certification of financial statements which do not comply with the Act can result in fines and imprisonment. Examiner’s explanation Other audit services are allowed, although they must be authorised first (normally by the audit committee), the CEO and CFO must attest the financial statements and auditors are appointed by the audit committee.

(iii) B The Senior Independent Director. Examiner’s explanation The Senior Independent Director has recent and relevant financial experience which is necessary for this role.

(iv) C They are exchange traded contracts. Examiner’s explanation The others all relate to options, not contracts (A and B), or swaps (D).

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(v) B £750,000

Examiner’s explanation 4,000,000 / 8 = 500,000 shares issued Premium is £2.00 – 50p = £1.50 per share Premium is therefore £1.50 * 500,000 = £750,000

(vi) A There is the emergence of persuasive evidence that the entity can no longer continue as a going concern. Examiner’s explanation All the other events are non-adjusting, according to IAS 10.

(vii) B 21 Examiner’s explanation Gross profit of £3,600,000 and a profit margin of 60% gives turnover = 3,600,000 * 100 / 60 = £6,000,000 Receivables days are 340,000 / 6,000,000 * 365 = 21

(viii) D Only public companies Examiner’s explanation Since the implementation of the Companies Act 2006 only public companies are required to have a company secretary.

(ix) D A private or public company which is able to segregate its assets into several distinct entities. Examiner’s explanation This is the correct definition.

(x) C £1,385,000 Examiner’s explanation £1,385,000 (£1,500,000 - £235,000 + £75,000 + £45,000)

Examiner’s comments Almost all candidates answered this section well, showing a good overall knowledge of the syllabus. A small number of answers obtained lower marks, with this result normally coupled with not achieving a pass level for the examination overall, indicating an overall lack of knowledge.

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Section B Answer all ten questions. 2 Define ‘provision’ in terms of IAS 37 ‘Provisions, contingent liabilities and contingent assets’ and

state clearly the situations under which a provision cannot be made. (4 marks)

Suggested answer A provision is defined as a liability of uncertain timing or amount. A provision may only be made in the accounts where there is a legal or constructive obligation. If there is merely intent and not an obligation then a provision may not be recognised under IAS 37. If:

no present obligation (legal or construed) exists;

the outflow of resources to settle the obligation is improbable; and

a reliable estimate cannot be made of the amount of the obligation; then no provision may be made in a company’s financial statements under IAS 37. Examiner’s comments Most candidates provided a concise definition of a provision. However, very few answers then explained the situations when provisions cannot be made, as stated in IAS 37. Many answers tended to provide lengthy explanations of situations when provisions are made, rather than focusing on this second requirement of the question.

3 In terms of trust law, define ‘a trust’ and explain the role of the three parties normally involved in a trust.

(4 marks) Suggested answer A trust is a legal arrangement whereby one or more persons, known as the trustee(s), are entrusted with the legal ownership of the assets of another party, the settlor, and to hold those assets (which might include property, investments and cash) ‘on trust’ for the benefit of one or more beneficiaries. The parties normally involved in a trust are:

The settlor: this is the person or persons who establish a trust by placing monies into trust, establishing a trust deed to explain how the monies are to be managed and who the monies in the trust will be paid out to.

The trustee: this is the person who manages the trust in the interests of the settlor, ensuring trust funds are invested wisely and paid out to the correct people.

The beneficiaries: these are the people who receive income and/or capital from the trust in accordance with the trust deed.

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Examiner’s comments There was a good set of answers to this question, with the vast majority of answers obtaining high marks and showing a very good knowledge of trusts.

4 Explain four differences between public and private limited companies in the UK. (4 marks)

Suggested answer

The certificate of incorporation, issued by Companies House, states that the company is a public company.

Public companies must have at least £50,000 capital (nominal value of shares in issue); there is no lower limit for a private company.

A public company needs at least two directors, while a private company only needs one.

A public company needs a company secretary, while a private company does not. Examiner’s comments Most candidates clearly explained four differences between public and private limited companies as required by the question, showing good knowledge of this area.

5 Explain the ratio ‘return on assets’ and explain why banks like to use this ratio in analysing their

clients’ accounts. (4 marks)

Suggested answer Return on assets measures how a company’s assets are being used to generate profit. The ratio is calculated by dividing net profit after tax by total assets. Banks often find this ratio a useful measure of return because, unlike the return on equity ratio, it takes account of debt funding, with a high ratio indicating a well-run business. Conversely, a low ratio indicates that a company is producing limited return on assets which may indicate a fundamental weakness in terms of profitability increasing the bank’s lending risk. Examiner’s comments Many answers did not clearly explain the ratio, with a significant number using sales divided by assets as the explanation of the calculation. Comments concerning use of the ratio by banks tended to be brief with only a small number of candidates mentioning investment risk on the part of the bank, or the significance of high and low return on assets ratios.

6 Explain four uses of a cash flow statement.

(4 marks) Suggested answer It is important for a business to have short term funds available to ensure it remains solvent; the cash flow statement indicates the level of a company’s liquidity.

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The cash flow statement helps a business understand the effect of short-term and long-term borrowings on its cash flow items by separating out the financing activities and showing the movements for the financial period. The statement also provides users of accounts with a snapshot of the opening and closing balances of cash and cash equivalents and therefore helps a business identify if it has surplus cash which could be invested elsewhere to maximise shareholder wealth or which could be used to pay off capital on the interest bearing loans. Excess cash could also send a message to investors that the company is in a healthy position to invest in growth of the business and pay dividends. Examiner’s comments Most answers tended to explain the different sections of a cash flow statement, which did not address the question requirement to explain the uses of the statement. However, some answers did explain uses in terms of assessing liquidity or identifying excess cash in a company and therefore obtained a good pass standard for this question.

7 Explain the concept of ‘sale and leaseback’ and set out the different accounting treatments that

can apply to the selling company’s statement of financial position. (4 marks) Suggested answer Companies sometimes enter into sale and leaseback arrangements, whereby the company sells assets to raise short-term finance and rents them back. The leaseback terms often provide for the seller to repurchase the assets after a period of time. If the commercial substance of the transaction is (i) a genuine arm’s length sale; and (ii) the leaseback results in an operating lease, then the transaction is treated as a sale. If the substance of the transaction is effectively a secured loan resulting in a finance lease then it should be accounted for as a secured loan because the risks and rewards of ownership remain with the seller. The latter means that the financial statements will continue to show the asset in the selling entity’s statement of financial position along with a corresponding liability representing the future lease payments. In this situation, the sale is effectively a finance lease arrangement confirming that the asset continues to be shown on the statement of financial position. Examiner’s comments Most answers correctly explained the concept of sale and leaseback. However, the accounting treatments were not explained well, with only a small number of answers correctly showing the difference between operating and finance leases. Some revision on basic accounting concepts is required.

8 Explain the terms ‘limited partnership’ and ‘limited liability partnership’ and the role of a general partner in a limited partnership.

(4 marks) Suggested answer A limited partnership (LP) comprises limited partners, who invest in the partnership, and one or more general partners (GPs), who manage the partnership. Generally speaking, LPs do not have

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their own separate legal personality and each partner is jointly and severally liable for losses and debts incurred by the LP to the extent of the amount of capital committed less the amount already contributed.

General partners also have unlimited liability for the debts of the partnership and, therefore, tend to be formed as limited liability companies in order to limit their liability.

Limited liability partnerships (LLPs) are a type of limited partnership which offers its partners limited liability. These vehicles are often used by accountancy and law firms and other employee owned businesses where it is not always appropriate or desired to separate ownership and management. In some jurisdictions, such as the UK, LLPs are required to file accounts, whereas limited partnerships may keep their financial statements private.

Examiner’s comments

This question was answered very well by almost all candidates, showing a good knowledge of one of the basic legal entities used in offshore locations.

9 In terms of IAS18 ‘Revenue’, explain how revenue is generally measured and how it is measured

for the provision of a service. (4 marks)

Suggested answer General revenue recognition Under IAS 18, revenue is measured at fair value of the consideration received or receivable. IAS defines fair value as “the amount for which an asset could be exchanged or a liability settled, between a buyer and a seller interested and informed, in a free transaction”. Revenue recognition for services Provided each and every one of the following criteria are met, revenue should be recognised considering the degree of completion of the transaction for provision of services as at the statement of financial position date:

the amount of revenue can be reliably measured;

the degree of completion of the transaction can be reliably measured at the date of the statement of financial position;

the costs associated with the transaction can be reliably measured; and

it is probable that the service provider will receive the economic benefits of the transaction.

Examiner’s comments Surprisingly, no answer mentioned the basic revenue recognition criteria from IAS 18. Generally, the question was not fully answered, with only a few answers mentioning specific points regarding service revenue recognition.

10 Give four examples of the recommendations made in the Cadbury report about how boards should

be managed. (4 marks) Suggested answer Any four of the following.

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The board should meet on a regular basis, monitoring the performance of the executive management.

The roles and responsibilities of the Chief Executive Officer (CEO) and Chairman should be clearly separated to avoid domination by any one individual. If the same person occupies the position of CEO and Chairman then there should be a Senior Independent Director on the board.

There should be a sufficient number of appropriately qualified non-executive directors.

There should be a formal schedule of matters exclusively reserved for the board’s decision so as to ensure control of the company remains a matter for the board.

There should be an agreed procedure for directors to seek professional advice should they need to and this should be at the company’s expense.

All members of the board should have access to the services of the company secretary and the company secretary should not be removed without collective consent.

Examiner’s comments There were some very comprehensive answers here. The only minor point being that answers generally needed to focus on the work of the main board and not sub-committees like remuneration.

11 State the principal objectives of the Basel II framework.

(4 marks) Suggested answer Minimum capital requirements Basel II introduces enhanced regulatory capital requirements that capture risks more fully and cater for the varying complexity of international banks. The minimum regulatory capital requirements for banks are set out in Pillar 1 and are based on the following three types of risk:

credit risk;

market risk; and

operational risk.

Supervisory review process Under the Pillar 2 conceptual framework, a bank must have an internal capital assessment process. The supervisory authority should review it to determine if the self-assessed capital level is sufficient to ensure that capital is maintained above this minimum level. Market discipline Pillar 3 only applies to the top consolidated level of a banking group that reports under Basel II. It aims to enhance market discipline through the use of information disclosures in order to enable market participants to judge capital adequacy. By improving market discipline, Pillar 3 should be a valuable complement of the other two pillars.

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Examiner’s comments Candidates’ answers either provided comprehensive information about Basel II or made very general comments about the need for controls. Answers in the latter category showed a clear lack of knowledge of the Basel requirements.

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Section C Answer two questions only.

12 The Income Statement and the Statement of Financial Position for Collings plc (‘Collings’) are

shown below. Collings is a service company providing investment advice to individuals in the UK who have returned home, having worked for a number of years (normally more than five years) abroad.

Income Statement Collings plc Period ended 30 June 2015

2015 2014

£'000 £'000

Turnover 32,126 27,517

Cost of sales – salaries (14,442) (12,279)

Depreciation (647) (742)

Gross profit 17,037 14,496

Vehicle costs (2,639) (2,153) Selling expenses Revaluation surplus

(13,270)

50

(11,185)

Operating profit 1,178 1,158

Net finance (17) (39)

Profit for the year 1,161 1,119

Taxation (290) (302)

Profit after tax 871 817

Statement of Financial Position Collings plc Period ended 30 June 2015

2015 2014

£'000 £'000

Non-current assets Tangible assets – land and

buildings 6,991 5,241

Current assets Intangible assets – trade mark 90 90

Inventories 2,039 1,813

Accounts receivable 1,092 1,015

Cash 12 (89)

3,233 2,829

Total assets 10,224 8,070

Shareholders’ equity Ordinary share capital 150 100

Retained earnings 4,550 3,679

Total shareholders’ equity 4,700 3,779

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Current liabilities Trade payables 5,484 4,291

Total current liabilities 5,484 4,276

Total equity and liabilities 10,224 8,070

Required (a) As far as the information provided above allows, identify and explain any changes that

should be made to Collings’ financial statements which are required to comply with standard accounting practice (that is, IASs and Companies Act requirements). Changes must be relevant to Collings’ financial statements as disclosed above.

(15 marks)

(b) (i) Explain the benefits of using commonly agreed financial reporting standards. (4 marks)

(ii) Explain the two fundamental concepts in FRS18 ‘Accounting Policies’ that must be

followed in the preparation of financial statements. (6 marks)

(Total: 25 marks)

Suggested answer (a) Changes to be made to the financial statements with the reason for the change

Change Reason

The title ‘turnover’ should be ‘revenue’. This is the correct term for the company’s major income streams, in line with the International Accounting Standards (IASs).

Cost of sales relates totally to salaries. It is not clear whether this is the salaries of all staff due to the lack of any administration expenses. A transfer of expense below gross profit may be needed.

Expenses prior to gross profit must directly relate to the provision of goods/services for sale and so will be shown below the gross profit figure.

Depreciation expense is included before gross profit. The depreciation costs appear to relate to land and buildings owned by Collings (from the statement of financial position). These must be disclosed below gross profit.

As noted above, expenses prior to gross profit must directly relate to the provision of goods/services for sale and so will be shown below the gross profit figure.

The revaluation surplus is shown as part of trading profit. This must be disclosed separately as a movement on reserves.

A revaluation surplus is not ‘earned’ income and so cannot be shown as part of the trading profit for the year. Separate disclosure of this amount is still required but clearly shown as a non-trading amount.

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There is no revaluation surplus on the statement of financial position. This is incorrect as there was a revaluation during the year. A separate revaluation reserve is required to record this amount.

The correct accounting entry is to debit non-current assets and credit the revaluation reserve which shows clearly that the reserve is not earned income.

The ‘intangible assets – trade mark’ line item is not normally included in current assets and should be moved to non-current assets.

Useless the brands are being held for sale then they are being used to generate revenue for the company over a number of years. This means they are non-current assets rather than current assets.

The trade mark does not appear to be being amortised but is held at the same cost from year to year. The trade mark must be decreased in value by amortisation for the year.

Amortisation is required to show the consumption or fall in value over time of the intangible asset.

The negative cash figure of £89 in 2011 should be moved to current liabilities.

The negative cash figure is not an asset but rather a liability. It is therefore incorrect to show this in current assets.

The ordinary share capital figure has increased by £50k. It is not clear whether the sale of shares during the year was made at par or at a premium. If the latter then a share premium account must be created and the excess consideration over nominal value credited to this account.

The ordinary share capital figure on the statement of financial position shows the nominal value of shares issued only. The share premium account shows excess consideration.

(b) (i) Benefits of using accounting standards There is reduced disparity and variations in accounting treatment from one reporting entity to another, and from one reporting period to another, enabling greater comparability. There will be a standardised approach in producing financial statements, making it more cost-effective to produce financial statements as well as making it easier to compare financial statements between entities. There is less scope for interpretations and subjectivity on the part of individuals and entities producing financial statements. This means that the financial statements will be based on commonly agreed principles, eliminating any bias from the individual producing those statements. There is less scope for disguising liabilities and holding them off the statement of financial position, making the financial statements show a more favourable view of a company than is actually the case.

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(ii) Fundamental concepts of FRS 18 Going concern Going concern means that an entity has the ability to continue to operate for the foreseeable future. The length of the ‘foreseeable future’ varies but is normally considered to be 12 months from the date of the statement of financial position, but occasionally relates to being 12 months from the date the financial statements are authorised by the directors. If the entity is no longer trading or has no choice but to cease trading then the going concern concept no longer applies and the financial statements should be produced on a break-up basis. FRS 18 also requires that directors make an assessment of whether the entity can continue as a going concern when they produce the financial statements. Any material uncertainties must be disclosed in the financial statements to make the users of the financial statements aware of the company’s situation. Accruals FRS 18 states that an entity should prepare its financial statements, except for cash flow information, on the accruals basis of accounting. This means that transactions should be accounted for in the financial statements in the reporting period to which they relate, rather than the period when payment is made. The accruals basis should reflect only those items that meet the definition of an asset or liability. So assets and liabilities will normally be accrued for when there is sufficient information to do this. However, where there is material uncertainty about whether the economic benefit will arise from an asset or whether a liability will have to be paid, then the accruals concept is not followed.

Examiner’s comments This was the least popular of the Section C questions. (a) Most candidates accurately identified the errors in the financial statements. Credit was given for the points in the suggested answer as well as other errors, such as addition errors (these were deliberate) and suggestions to improve various headings to conform with IAS requirements. The main weakness with all answers was the lack of explanation of why figures needed changing. For example, many answers noted that depreciation was stated above gross profit and that it should be below gross profit. However, the reason for this (in that depreciation normally relates to buildings and depreciation was therefore not part of expenditure relating to the provision of goods and services), was not mentioned. (b) (i) Many good answers were provided for this part, especially where answers focused on international aspects of common reporting standards, as these enabled candidates to clearly state benefits. Other points, such as less training for accounting staff, were also credited. (ii) Most answers correctly stated and explained accruals and going concern, with clear definitions and explanations provided.

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13 BCA is a large international bank with branches in over 70 countries worldwide. The directors of BCA have decided that it needs to increase the number of countries it operates in to provide a better service for its international clients. Specifically, the bank needs to open branches in a number of offshore banking locations.

The directors of BCA are aware that the procedures for establishing and running a branch in some offshore locations may be more onerous than for other jurisdictions.

(a) Identify and explain the typical requirements that a potential bank must meet before a

banking licence will be granted in an offshore jurisdiction. (10 marks)

(b) Explain how banks are typically regulated and supervised in an offshore jurisdiction after a

licence has been obtained. (15 marks)

(Total: 25 marks)

Suggested answer (a) Obtaining a licence Banks are required to apply for a banking licence before undertaking regulated activities in offshore financial centres. The requirements differ from jurisdiction to jurisdiction and will depend on the specific licensing policy of the offshore regulator. Before issuing a license, the relevant supervisory authority will consider various features of the bank, which will include:

Ownership and control. Reputable offshore international finance centres will wish to identify the significant ultimate owners and controllers and ensure they are fit and proper. Publicly quoted banks are generally preferred to the small private banks as it is unusual for publicly quoted ‘top 500’ banks to have dominant controller shareholders.

Real presence of the bank in the jurisdiction where the licence is being applied for. This is to help prevent ‘shell banks’ being established (that is, banks which have no management and control in the offshore jurisdiction). Shell banks can be inherently risky and not desirable by regulators in some jurisdictions.

Integrity, competence, knowledge and experience of the principal persons. This is to ensure that these people do actually know how to run a bank.

Track record, including an audit history and stable management team, which will mean looking at the CVs of the key management team members as well as the financial statements of banks where they have/are currently working. Again, this is to clarify appropriate experience in running banks and to confirm that those banks did obtain ‘clean’ audit reports.

Stature of the applicant including its financial strength, risk profile, capital resources and liquidity levels. This requirement may be difficult to determine for a completely new bank. However, an established bank from another jurisdiction opening a new branch will be able to provide these details.

Internal controls and risk management systems to ensure they are taking adequate account of the nature and scope of the activities undertaken which may be by statements from the officials confirming understanding of the jurisdiction requirements or reference to existing systems in an existing bank.

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Systemic importance of the bank’s home jurisdiction such that the home jurisdiction is capable of providing support if required. This is in the case of a branch being established, that the main bank will support its branch.

(b) Supervision after obtaining a licence Supervision of banks falls into two key areas: offsite and onsite supervision. The regulatory authority will use both of the supervisory processes.

Offsite supervision This describes the desk-based supervisory activities undertaken by the regulator at its own offices. It includes the following activities:

Review of financial statements published by the bank, not only for compliance with reporting standards as appropriate but also to assess factors such as going concern and maintenance of capital ratios.

Review of reports, declarations and other documentation received, again to confirm compliance with banking regulations.

Monitoring capital levels and ensuring requirements are maintained, mainly by monitoring returns provided by the bank.

Processing of data and systems changes to reflect changes in connection with a regulated activity or the notification of significant events.

Assessing the ‘fit and proper’ status of firms and individuals, for example, directors, controlling shareholders, compliance officers, money laundering reporting officers and money laundering compliance officers. This will have been carried out when the bank was first established, but as new officers are appointed then review of these new officers will also be required.

Onsite supervision This is the term given to examinations undertaken by the regulator at the licensee’s place of business and this might be at one or more of its offices. The examination programmes are designed to enable the regulator to determine whether the bank has the necessary processes, procedures, systems and controls in place to mitigate risks within the bank and to enable it to comply with relevant legislation and regulations such as regulatory guidelines and codes of best practice. Onsite supervision will normally commence with a meeting of the bank’s management board (on an annual basis) to discuss the overall strategy and controls within the bank (a top-down approach). More detailed examinations will then follow, falling into three categories.

Themed examination This is an examination on a specific theme, for example, wire transfers, corporate governance, anti-money laundering/countering of financing of terrorism. A number of regulated entities will be subject to the same themed examination to enable the supervisory body to analyse trends and draw comparisons between regulated entities. Focused examination This is targeted at specific matters related to the regulated entity. For example, the regulator may investigate risk management at the bank, the staff structure and responsibilities and the internal systems and controls operating with the business, with specific emphasis on handling of client

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monies. Further investigations may also include reviewing the conduct of business at the bank, business continuity planning, financial standing or corporate governance. At the end of the investigation, the regulator will issue a report to the bank and ask for compliance with the report within a given time period. Compliance will be monitored in a subsequent visit. Discovery examination This is similar to a focused examination in that specific areas of the bank will be reviewed such as the bank’s risk management systems and internal controls, policies and procedures, processes, conduct of business, financial standing and corporate governance. However, the aim of the review is to discover material weaknesses, if any, within those systems at the bank. The extent of the examination will include reviewing files, minute books, breach logs, complaints files and other relevant documentation. The regulator will also conduct interviews with bank executives and staff involved with the day to day running of the banking operations. As with a focused examination, a report will be issues post-view and compliance with recommendations is required by the bank.

Examiner’s comments

This was a popular question in Section C. The generally high scoring answers indicated good knowledge in this area. The main area of weakness was the lack of detail of some forms of regulation. (a) Most answers provided a comprehensive list of requirements that a potential bank must satisfy, including a few jurisdiction specific comments (particularly from Jersey) to enhance the answer. Some answers provided very brief lists in bullet point format, which severely limited the marks obtained due to a lack of explanation. (b) Most of the key points mentioned in the suggested answer were covered by candidates, with high marks being obtained. Answers not achieving a pass level tended to simply identify the types of regulation without giving full explanation of the purpose of the regulation. For example, a themed examination based on one area (wire transfers being the most popular comment) with the reason for this being industry comparison, not being mentioned.

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14 Tess plc (‘Tess’) is a wholesaler of books, CDs, game consoles and related software. The company purchases these items from manufacturers and then sells them onto retailers. As such, Tess has no plant and machinery; its non-current assets relate entirely to warehouses for the storage of inventory. The summary statement of financial position for Tess to 30 June 2015 and 2014 are shown below. Tess had no tax liability in 2014 due to previous tax losses offsetting tax on profits for that year.

Statement of financial position

2015 £’000

2014 £’000

Non-current assets – tangible assets 472 235 Current assets Inventory 149 135 Receivables 297 275 Cash and cash equivalents 415 350

Total assets 1,333 995

Liabilities Current liabilities Payables 435 389 Taxation 116 - Equity Share capital 75 75 Retained earnings 507 481 Loan 200 50

Total equity and liabilities 1,333 995

Profit on ordinary activities (before taxation) was £142,000 in 2015 and £119,000 in 2014. Required: (a) (i) Calculate the current ratio and quick ratio for the two years 2015 and 2014.

(4 marks)

(ii) Explain the significance of the terms ‘current ratio’ and ‘quick ratio’ and suggest two possible reasons for the change in current ratio only.

(4 marks)

(b) (i) Calculate the gearing ratio for the two years 2015 and 2014. (2 marks)

(ii) Explain the significance of the term ‘gearing ratio’, suggest why the gearing ratio may

have changed and explain the impact of this on the company. (5 marks)

(c) (i) Calculate the return on capital employed for the two years 2015 and 2014 (using non-current assets as the basis for assets).

(2 marks)

(ii) Explain the significance of the term ‘return on capital employed’, suggest why the return on capital employed may have changed and explain the impact of this on the company.

(4 marks)

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(d) Explain and justify two other indicators which could be used to explain the performance of Tess.

(4 marks)

(Total: 25 marks)

Suggested answer (a) (i) Calculation of current ratio

2015 2014

Current assets Inventory, receivables + cash

£861,000

£760,000

Current liabilities Payables + taxation

£551,000 £389,000

Current ratio (Current assets/current liabilities)

1.56

1.95

Calculation of quick ratio

2015 2014

Current assets Receivables + cash

£712,000

£625,000

Current liabilities Payables + taxation

£551,000 £389,000

Current ratio (Current assets - inventory/current liabilities)

1.29

1.61

(ii)

Significance of current and quick ratios:

Current ratio: The current ratio is a measure of a company’s ability to repay liabilities due within one year out of current assets. It is calculated by taking the current assets of a company and dividing them by the current liabilities. A ratio of 1 or greater means the company has full cover. Quick ratio: The quick ratio measures a company’s ability to meet liabilities due within one year out of the assets that are the most liquid and, therefore, the most quick and easy to realise (that is, convert into cash). Inventory is not always considered to be quick and easy to realise and therefore is deducted from the current assets figure in calculating the quick ratio. The quick ratio is, therefore, a more conservative ratio than the current ratio. A ratio of 1 or greater means the company has full cover.

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Changes in the current ratio only:

The company has increased its investment in payables (increasing by 12% from 2014 to 2015). This has the effect of decreasing the current ratio where assets remain the same. This is also a new liability of the taxation expense. Again, this will decrease the current ratio as there are more liabilities in 2015 than 2014.

However, while the company has also increased all of the assets contained in the ratio this is less than the increase in liabilities, again indicating a fall in the current ratio.

(b) (i) Calculation of gearing ratio

2015 2014

Total debt Loans

£200,000

£50,000

Total equity Share capital + retained profits

£582,000

£556,000

Gearing ratio (Debt / equity)

.34

.09

(Note: alternative calculations of the ratio were accepted)

(ii)

Significance of the gearing ratio: This ratio measures debt to equity by taking the total debt figure from the statement of financial position and dividing it by the total equity. When comparing companies of similar nature and in the same industry, a low debt to equity ratio indicates less risk than a high debt to equity ratio. Reasons for increase in the gearing ratio The company has taken on more loans in the last year (£50,000 to £200,000). This increase is relatively more than the increase in retained profits meaning that the gearing ratio has increased. The impact on the company is likely to be negligible. While the ratio has increased almost 4 times in the year, it is still well below 1, the point at which debt and equity are the same. As the company continues to make profits, shareholders are unlikely to be concerned by this change; dividends will still be paid. Furthermore, it appears that the loan has been used to finance non-current assets. These have increased by £240k with the loan of £150k. Raising loan finance to pay for longer term assets is acceptable; if the loan had been used to repay current liabilities (in effect to fund working capital in the company) then there would be concern that the company is not paying its debts as they fall due, increasing shareholder concern.

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(c) (i) Calculation of return on capital employed (ROCE)

2015 2014

Profit before taxation

£142,000 £119,000

Non-current assets

£472,000 £235,000

ROCE (Earnings / NCA) * 100

30%

51%

(ii) ROCE is a measure of a company’s success at achieving a return on capital invested. It reflects the profit as a percentage of the amount of capital employed. A higher ROCE generally indicates that more profit is being produced for each £ of non-current asset. However, factors such as the type of company and whether non-current assets have been recently replaced can distort the figure significantly. In this example, the ROCE has fallen from 51% to 30%. Both figures are very high indicating that the company does not rely too much on non-current assets; in fact, Tess, as a non-manufacturing company, will only need non-current assets in terms of buildings not machinery, making the ROCE calculation of limited value. The main reason for the fall in ROCE is the purchase in the year of additional non-current assets. This means that a similar profit amount is being compared to more non-current assets, hence the fall in the ratio. However, this is not necessarily a poor indicator of performance as presumably Tess needed an additional warehouse to fund company expansion. ROCE may improve again in the future as Tess’s profits increase with the use of the second warehouse. (d) Other indicators that Tess could use to explain its performance include:

Net profit percentage before tax

The net profit percentage compares net profit to the sales being achieved in the company. The pre-tax figure shows effectively controllable profit within the company. Ongoing net profit will indicate that Tess is (or is not) profitable given different activity levels (such as the increase in non-current assets).

Gross profit percentage

This shows the profit made after deduction of cost of sales. In Tess, this will simply be the cost of books, CDs, and so on, sold, rather than any manufacturing expense. The ability of Tess to make a gross profit shows, literally, that goods are being sold for more than Tess paid for them. A negative profit figure would be very concerning as it shows a

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company is unable to add value to its purchases, let alone pay for other expenses such as administration and distribution.

(Note: Any other relevant indicator and explanation were awarded marks.) Examiner’s comments This was the most popular of the Section C questions. However, there were surprisingly low marks generally attained, which resulted from some incorrect calculations and lack of following examination instructions, as noted below. (a) Calculations of the current and quick ratios were normally accurate and clear explanations of the ratios were given. (b) There was significant confusion about the calculation of the gearing ratio, with very few candidates providing an accurate calculation. The most common errors were to use current liabilities as an indication of the debt of the company and share capital only for equity (rather than adding reserves). Most explanations concerning the changes to gearing were also inaccurate, with changes in current assets and liabilities being frequently mentioned as causing changes to gearing. (c) As with part (b), only a small number of candidates provided an accurate calculation. The question requirement specifically stated that non-current assets were to be used as the basis for assets. However, nearly all candidates used either total assets or total assets less liabilities in their answers. The point here is simply to read the question carefully. In part (c) (ii), the explanations were also unclear, with many answers again suggesting changes in current assets/liabilities and even sales as causing changes to the ratio. (d) Part (d) was attempted by relatively few candidates and was not well answered by those who did. Only a small number of answers actually mentioned two other indicators that could be used and even fewer actually applied these to the company in the scenario.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.