Financial Reporting and Governance July 2014 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 examination session was 74%. The percentage of distinction and merit candidates increased, indicating an overall increase in the standard of candidates for this session. There was a significant improvement in the standard of answers presented, with only a small number of candidates omitting questions, or providing answers that were difficult to follow, or did not meet the question requirement.
Section A Answer all parts of Question 1. Select only one of the options A, B, C or D for each part. 1 (i) According to FRS 18, financial statements must be prepared on an accruals basis. However,
which section of the financial statements should not use the accruals basis?
A Income statement.
B Statement of financial position.
C Cash flow statement. D Non-current assets disclosure note.
(ii) On the statement of financial position, the share premium account represents the:
A Called up amount of shares issued, less the paid up value of those shares. B Issue price of shares, less the nominal value of those shares. C Nominal value of shares issued, less the called up value of those shared. D Authorised value of shares, less the issued value of shares.
(iii) Which of the following is not a permitted method to communicate the formation of a company
with Companies House? A Electronic filing service. B Web incorporation service. C Paper filing.
D Telephone filing. (iv) In the USA, what is the main purpose of the legislation referred to as the ‘Dodd-Frank Act’?
A To reform the regulatory framework and protect consumer interests. B To establish the Public Company Accounting Oversight Board.
C To extend the powers of the Securities Exchange Commission. D To set professional and legal requirements regarding the appointment of Financial
(v) According to IAS 39, what must a company do in respect of its financial assets at the end of
each accounting period?
A Revalue all assets to market value. B Recognise gains on individual assets but not revalue assets for any losses made. C Perform an impairment review. D Disclose the market values but leave the accounts values unchanged.
(vi) Pontupine Ltd has sales of £451,074 and cost of sales of £367,209. Distribution and
administration costs for the same are £57,584. What is the gross profit percentage of Pontupine?
A 5.8% B 18.6% C 81.4% D 87.2%
(vii) Banks have to comply with registration conditions applicable in an offshore centre before
being allowed to operate. Failure to comply with a registration condition is likely to result in what action from the regulator?
A A fine not exceeding £50,000. B Enforcement notice to comply with the condition within 7 days. C Increased regulatory supervision when the bank starts to operate. D Immediate withdrawal of licence and restriction on re-applying for a licence within 2
years. (viii) The main focus of the Walker Review, published in 2009, was:
A Effectiveness of internal controls in trading companies. B Transparency of published accounts regarding disclosure of director remuneration. C Reviewing the entire corporate governance code in the UK. D Corporate governance of UK banks and making recommendations for improvement.
(ix) A bank agrees to rent out one floor of its building to a firm of architects. The annual rent is
£9,000 payable in advance. During 2013, the rent was due on 1 July, received on 1 August and the bank’s year-end is 30 September. How much rental income will be recognised in the bank’s income statement to 30 September 2013?
A £1,500 B £2,250 C £6,750 D £9,000
(x) Many central banks play the part of ‘market lender of last resort’. What does ‘market lender of last resort’ mean?
A The central bank will lend to the government when other banks won’t. B The central bank requires other banks to lend money to the central bank to limit the
supply of money. C The central bank will intervene in interbank lending when other banks are reluctant to
lend to each other. D The central bank will guarantee the deposits of individual lenders with other banks.
(Total: 10 marks)
(i) C Cash flow statement. Examiner’s explanation: This is the specific exemption from FRS 18.
(ii) B Issue price of shares, less the nominal value of those shares. Examiner’s explanation: The share premium account shows the excess of consideration received for shares
over the nominal value of those shares. (iii) D Telephone filing.
All other methods are specifically allowed in the Companies Act. (iv) A To reform the regulatory framework and protect consumer interests.
The main purpose of the Act is as described in the above answer, following various global financial crises in the 2000’s.
Examples of trust capital include and assets originally vested into the trust such as:
Shares in companies.
There were many good answers to this question. In some answers, examples of capital and income were not given, or there was no comment on the need to distinguish between capital and income in a trust.
4 Explain the term ‘dividend cover’ and the effect a low dividend cover may have on a company. (4 marks)
Suggested answer Dividend cover is the number of times a dividend can be paid out of the profits of a company. The calculation is profits divided by the amount of dividend. Alternatively, the earnings per share figure can be divided by the dividend per share to obtain the same result. Dividend cover is important for shareholders as they want to receive regular and stable dividend payments. A dividend cover of say less than 2 may indicate that dividend payments are under threat due to declining profits.
Examiner’s comments The majority of candidates explained dividend cover correctly and problems concerning low cover. However, some answers provided various other (incorrect) methods of calculating this ratio, the most common mistake being to divide dividend by profits rather than the other way around for the correct calculation. A small number of answers also used cash to calculate dividend cover which is also incorrect.
5 The concept of tax jurisdiction is important in order to determine where individuals and companies
pay tax. Briefly explain how tax authorities determine which jurisdiction a company pays tax in, and how this is determined for an individual.
(4 marks) Suggested answer The main issue with individual and company taxation is to ensure that tax is not paid twice on the same income in two jurisdictions. For individuals, the tax authorities will normally look at the concepts of residence and domicile to determine liability to taxation. Basically, where an individual spends significant time within one jurisdiction they become liable to tax there. Double-taxation agreements ensure income is only taxed once. For companies, the tax authorities look for where the management and control of the company is. The jurisdiction where management and control are effectively determine liability to taxation. The latter however may be difficult to prove and companies continue to attempt to show their income is based in the lowest taxation jurisdiction to avoid taxation payments.
A small number of answers did not indicate knowledge of this topic.
6 In relation to FRS 18 ‘Accounting Policies’, define an ‘accounting policy’ and an ‘estimation
technique’ and explain two situations where an estimation technique will be used. (4 marks)
Suggested answer According to FRS 18, accounting policies are “those principles, bases, conventions, rules and practices applied by an entity that specify how the effects of transactions and other events are to be reflected in its financial statements through recognising, selecting and presenting assets, liabilities, gains and losses etc. An estimation technique is a method used by an entity to implement an accounting policy. Estimation techniques may be used in the following situations:
Measurement of the disposal value of an asset.
The method of applying depreciation to non-current assets (e.g. 40% reducing balance) rather than the need apply depreciation (the accounting policy).
Determining the amount of obsolete inventory rather than the need to ensure inventory is valued at the lower of cost and net realisable value (which is the accounting policy).
This question was generally poorly answered. Very few candidates could explain an accounting estimate in terms of implementing an accounting policy and most answers were limited to providing one example (normally depreciation) although the requirement of the question was for two examples.
7 Explain four roles of an audit committee, as set out in the Smith Report. (4 marks)
Suggested answer Any four of the following:
To ensure that the company’s financial statements present a true and fair view of the state of affairs and performance of the company for the reporting period.
To monitor the company’s financial control and risk management systems where alternative arrangements are not in place (that is a risk-management committee).
To make recommendations to the board in respect of the appointment of the internal auditor and to review the effectiveness of the internal audit function.
To make recommendations to the board in respect of the appointment of the external auditor and ensure that recommendations not taken up by the board are explained to the shareholders.
To regularly review the external auditor’s terms of appointment ensuring that the auditor is independent, objective and effective.
To set and monitor a policy on the provision of non-audit services ensuring these do not conflict with external auditor independence.
To report on its activities in the annual report.
The chairman of the audit committee should attend the AGM and be available to answer questions.
This question was generally answered well.
8 According to IAS 1 ‘Presentation of Financial Statements’, a company must present a complete set
of financial statements on at least an annual basis. List four components of financial statements according to IAS 1.
(4 marks) Suggested answer Any four of the following:
Statement of financial position / balance sheet as at the reporting date.
Statement of comprehensive income / profit and loss account for the period or an income statement plus a statement showing other comprehensive income.
Statement of changes in equity for the reporting period.
Statement of cash flows.
Notes (comprising a summary of significant accounting policies and other explanatory notes). Examiner’s comments
A very straight-forward question with many candidates obtaining full marks. Some answers also listed requirements from the Companies Acts or governance requirements such as reports of audit committees which did not attract any marks.
9 Explain securitisation (in relation to assets) and why linked presentation may apply to these assets.
(4 marks) Suggested answer Securitisation is a method of raising finance by creating and issuing asset-backed securities such as mortgage bonds. The income generated by the asset (for example, the mortgage payments) acts as security. The assets are normally pooled according to the risk associated with default, and then sold to investors in affordable packages. Regarding the accounting treatment, linked presentation may apply. Linked presentation is allowed under FRS5 which means that the finance amount of the securitisation transaction is deducted from the gross amount of the asset it finances. The items are linked, and the net amount of the asset is shown on the statement of financial position.
Examiner’s comments Many candidates were unable to explain the term securitisation, and only a few were aware of the accounting provisions of FRS5.
10 In terms of cash flow statements, explain the term ‘operating activities’ and provide six examples of
those activities that are normally found on a cash flow statement. (4 marks) Suggested answer Operating activities are those activities which generate revenue for a company. In other words, they relate to the manufacturing of products or the provision of services. Examples of operating activities include:
Net profit for the year.
Net gain on financial assets at fair value through profit of loss.
Increase / decrease in receivables.
Increase / decrease in inventories.
Increase / decrease in payables.
Depreciation of tangibles.
Amortisation of investments.
Increase / decrease in taxation provision. Examiner’s comments
Most candidates could define “operating activities”. However, the accuracy of the example of operating activities varied considerably. Some answers tended to provide a list of every single item that can be found in a cash flow statement, with only few candidates actually focusing on operating activities only.
11 Set out the provisions and penalties of section 802 of the Sarbanes Oxley Act.
(4 marks) Suggested answer This section of the Act applies to officers knowingly altering, destroying, concealing or falsifying documents with the intent to obstruct or impede an investigation. The main penalties are fines and/or up to 20 years’ imprisonment. The section also applies to auditors who have to retain working papers for a period of five years from the end of the fiscal period to which the audit relates. The penalty for “knowingly and wilfully” violating the rules is a fine and/or imprisonment for up to 10 years.
Examiner’s comments This question was poorly answered by many candidates. Only a small number of candidates recognised that section 802 relates to document amendment and retention and even fewer knew the penalties facing directors and auditors. Most answers provided a general list of the provisions of the different sections of the Sarbanes Oxley Act.
(b) Payables days This is a measure of how quickly a company pays its payables. Higher days indicate that the company is taking more time to pay payables. Very high days (over, say, 90 days) indicate that a company may be in financial difficulties and cannot pay its payables. It can be argued that high ratios are unethical, especially where a company does have the cash to pay its payables; for example, supermarkets which have low receivables balances but still take excessive time to pay their payables. In Kerpig, payables days have fallen from 68 to 60 indicating that the company is paying its payables more quickly this year than last. 60 is still quite a high payables days figure, meaning that payments frequency must still be monitored to ensure that Kerpig’s payables continue to provide the goods Kerpig requires; that is, Kerpig is not denied goods due to late payment. Receivables days This is a measure of how quickly a company receives cash from its receivables. Higher days indicate that the company is taking longer to obtain payment from receivables. Very high days (say, over 60 days) indicates that the company’s credit control is not collecting debts quickly enough, and there is an increased risk of some of those debts remaining unpaid or becoming unpayable (bad debts). In Kerpig, this ratio has fallen from 25 to 19 days indicating that the company is very successful in collecting its debts. No further action is needed at present; in fact, Kerpig could try and increase its sales by offering enhanced credit terms. Inventory days This is a measure of how many days of inventory are available to a company. Higher results indicate that the company has relatively high levels of inventory compared to sales, whereas low results indicate relatively little inventory is held. Whether the ratio is good or bad depends on many factors such as the type of industry and the company policy on holding inventory. For example, a company building houses will have a very high inventory days figure (houses taking a long time to build) compared to say a milk-processing company where inventory (the milk) is held for a matter of days at most.
In Kerpig, the ratio is almost unchanged moving from 35 to 33 days. This indicates that Kerpig continues to maintain good control over inventory, limiting the risk of obsolete inventory and the cost of writing this off. Gearing ratio This is a measure of the solvency of a company. The ratio is a measure of long-term debt to shareholders funds. There are many different ways of calculating gearing; one of main methods is debt divided by equity. Ratios over 1 indicate a higher debt level than equity with higher results indicating higher risk to the company. In Kerpig, the gearing ratio has changed from 0.91 to 1.05. This indicates that Kerpig now has more long-term debt than equity, meaning that the company may find it more difficult to borrow additional funds due to the risk involved to the lender. Interest cover This is a measure of a company’s ability to pay interest from its earnings. The ratio is calculated by taking the profit before interest and tax figure, and dividing this by the interest paid. A ratio of 2, for example, indicates that a company can pay its interest charge twice from its earnings. Figures of below 1 are concerning as the company cannot pay interest from earnings. In Kerpig, the interest cover has changed from 2.62 to 1.18. While there is a fall in cover and the interest has increased reflected increased borrowing, Kerpig Ltd is still able to pay interest charged comfortably. However, falls in profit or increases in interest rate may adversely affect the company in the longer term. (c) Comment on changes from 2012 to 2013 A highly-geared company may be considered more risky than a low-geared company because it will have relatively higher interest payments. This results in various risk as outlined below. The company will be exposed to increases in interest rates increasing the amount of interest to be paid, placing further pressure on the gearing ratio. Increases in interest payments will also mean that fewer funds will be available to provide a return to shareholders, either in dividend payments or simply increase in shareholders’ funds within the company. Interest payments have to be made contractually; there is therefore a risk for the highly-geared company to be placed into administration by the debt-holder if the interest payments are not made. High gearing ratios may also mean a company has difficulty in finding new finance from loan providers given that there will be concern that the company cannot pay the interest charges (or capital repayments) as they fall due. Both ratios as based on cost of sales, and payables are by and large the amounts due for inventory purchased, and the ratios will normally move roughly in line with each other.
In this situation, both ratios have fallen, as expected. The fall in payables days in more than inventory days, possibly because the company wants to show its payables that it can afford to pay them! Payables days of 68 is quite high, so some fall places less pressure on payables not to provide the inventory needed. The small fall in inventory days indicates either a deliberate decision not to hold as much inventory or possibly the use of more efficient machinery, the increase in non-current assets confirming this.
In part (a), most candidates were able to calculate the required ratios correctly. Overall, this part produced some very high marks. In part (b), the interpretation of the ratios was on the whole less clear. Most candidates could state that the ratios had changed but could not give any reasons for this. Stating reasons and actions such as good credit control causing the fall in receivables days, or the possibility that discounts are offered for quick payment, would have increased the number of marks attained by many candidates. In part (c), a small number of candidates made comments about the overall situation of the company, and obtained reasonable marks. However, most answers tended to repeat points from part (b), and so were limited in the marks that could be obtained.
13 You work in the company secretarial department of Kerplet, a firm of business advisors in an
offshore jurisdiction. The main activities of Kerplet include offering investment advice to individuals from other jurisdictions, as well as managing and investing various funds in tax-efficient vehicles within your country.
You are currently assisting the office manager with development of the company, which includes attempting to expand Kerplet’s client base. This week, the office manager is on vacation and you have been asked to answer basic queries from potential clients. The following letter has just been received from a potential client.
1701 Station Road Arbour
Anyshire The Office Manager Kerplet 111 High Street Lotown The Island
8 July 2014
Dear Sir or Madam I recently received a brochure from your company explaining that you can offer investment advice. I currently have a portfolio of around £4,500,000 which I am considering investing “offshore”. I understand there are various types of investment entity or vehicle that could be used to invest this money, while providing some protection in case of a failure of that investment entity/vehicle. Can you kindly advise me on the different types of investment entity/vehicle that are available to me, including a brief explanation of that particular entity/vehicle and the advantages and disadvantages of investing in it. I look forward to hearing from you.
Required Write a letter responding to the request from Mr Badall.
1701 Station Road Arbour Anyshire 15th July 2014 Dear Mr Badall Thank you for your letter dated 8th of this month. As requested, I summarise below the different types of investment entity/vehicle you can use in an offshore location including the advantages and disadvantages of each. Limited Company These are entities that have their own legal personality. The shareholders own the company although directors manage the company. Although shareholders and directors can be the same individuals, the roles are often split; the directors use their expertise to run the company whereas shareholders simply take returns from the company in terms of dividends or capital growth of the company itself. Most offshore jurisdictions offer their own type of limited company (most of which being similar to the UK limited company), and so this could be used as an investment vehicle. Advantages A limited company provides protection for the shareholder in case of failure (only the initial investment of share capital will be lost), and can be run by directors in an offshore location. Funds can also be retained in the company until required. Disadvantages However, service providers in an offshore location will need to carry out due diligence on the shareholders (which is not normally a problem but needs to be stated as a requirement now). Furthermore, there are various legal issues to comply with, such as publishing financial statements which limits the transparency available with this entity.
Cell companies A cell company is a private or public company which is able to segregate its assets and liabilities between different cells. Each cell is then used to carry out a separate and independent business. In your situation, individual cells could be established for different investing operations such as shares and cash investments. Advantages The main benefit of a cell company is that each individual cell cannot be sued for the debts of other cells. As you are looking for investment opportunities rather than trading, there will be few debts, and so this benefit is limited. This protection is also called ring-fencing.
Disadvantages Potentially the main problem with setting up a series of cell companies is the additional administrative complexity compared to having just one company to operate. Cells may therefore not be appropriate for you. Foundations A foundation is an entity that is similar to a company in that it can own assets and contract in its own name. They are established by a one-off donation from the “founder”, and then the foundation is run in accordance with the wishes of that person. Many foundations are setup for charitable purposes, but they could be used as an investment vehicle. Advantages They do provide some taxation protection (for example, in inheritance planning) as well as some element of confidentiality for the founder. This may be beneficial to you depending on your life stage and need for confidentiality. More detailed advice will be needed if you wish to go down this route. Disadvantages There are restrictions on commercial activities which may not benefit you with regards to the need to invest. Trusts A trust is a legal arrangement whereby one or more persons, known as the trustees, are entrusted with the legal ownership of assets of another party, known as the settlor. The trustees hold those assets (which can include investments and cash) for the benefit of one or more beneficiaries. Trusts are often used in estate planning where significant sums of money are held on trust until beneficiaries reach a certain age or meet other conditions of the trust. The trustees hold the funds, and make investment decisions on behalf of the settlor. Advantages The trust can be managed by experienced trustees who will hopefully ensure that any initial capital amounts accumulate income as quickly and effectively as possible.
Disadvantages The settlor loses title to the assets, and the trust has no limited liability. In theory (and often in practice), poor investment decisions by the trustees will never be recouped by the settlor. However, given the specialist advice available to run this trust, this may be your best option. Please contact me again if we can assist you with your investment requirements or need additional information on the entities explained above. Yours sincerely A Singh Acting Office Manager
This question produced some good and detailed answers, with candidates explaining correctly many different types of entities and vehicles that can be used to aid investment. The overall standard was therefore a clear pass.
However, some candidates provided excessive detail on listed companies which were much less relevant for an individual wanting to make offshore investments.
14 The LRG Company (‘LRG’) provides trust and investment services in an offshore location. LRG employs 35 investment advisors providing investment services to over 2,500 clients. While management accounts are prepared on a monthly basis, LRG’s main financial statements are prepared annually on an accruals basis to 31 December. During the preparation of the annual accounts, the following matters were identified by LRG’s part-qualified accountant. No action has yet been taken on these matters.
Event 1 As at 31 December, the fees due from one client, Mr Smith, totalled £4,076. However, Smith was declared bankrupt on 2 February and so it is unlikely that he will be able to pay his fees. Smith withdrew all his investments from LRG in January and so LRG cannot recover the amount due from these. Event 2 Due to a sudden decrease in the need for investment advice in 2014, the directors of LRG decided to make five consultants redundant at the beginning of February. Each consultant will receive a redundancy package of £35,000, and they were asked to leave LRG as soon as the redundancies were announced. They are now on ‘gardening leave’, working out their notice period with LRG.
Event 3 During the external audit of LRG’s books and records to 31 December 2013, the external auditors discovered a weakness in the control systems in LRG. One accounts clerk was able to initiate transfers between the investments held by LRG’s client accounts for values below £250 without authorisation. The clerk had made weekly transfers to his own bank account during the whole of 2013 for amounts ranging between £100 and £235. The fraud was not identified within LRG due to the relatively small amounts involved and the lack of reconciliation between the client accounts and bank balances. The clerk has now been dismissed. As a result of this fraud, assets in LRG’s client accounts are overstated by £9,750.
Required (a) According to IAS 10, define:
(i) Events after the reporting period. (ii) Adjusting events. (iii) Non-adjusting events.
(b) Explain whether Events 1, 2 and 3, above, are adjusting or non-adjusting events in accordance with IAS 10.
(c) Explain any actions that the directors of LRG can take to try and minimise the chance of an
incident such as Event 3 occurring in the future. (7 marks)
(5 marks) (Total: 25 marks) Suggested answer (a) (i) Events after the reporting period
According to IAS 10, events after the reporting period, these are events, both favourable and unfavourable, that occur between the date of the statement of financial position and the date when the financial statements are authorised for issue.
(ii) Adjusting events
Adjusting events provide evidence on conditions that existed at the date of the statement of financial position which are adjusting events after the reporting period.
(iii) Non-adjusting events
Non-adjusting events are indicative of conditions that arose after the date of the statement of financial position which are non-adjusting events after the reporting period.
The amount of £4,076 was included in receivables at the end of the year. The bankruptcy of AS after the end of the year provides evidence that these amounts are not receivable. This is therefore an adjusting event according to IAS 10 and the balance due from AS must be written down to £0. This means that receivables will be credited with £4,076 and the income statement debited with the same amount. The effect of this adjustment will be to decrease the profit of LRG by this amount for the year.
It appears that the downturn in the need for investment advice was sudden, and so was not foreseen at the end of the financial year. In this case, the redundancies do not affect the conditions existing at the end of the year and are therefore a non-adjusting event according to IAS 10. Disclosure of the redundancy amount may be required to ensure that the members understand the position of LRG, but no adjustment is needed to the payroll expense.
As well as being a serious weakness in internal control, this event shows that assets in the client accounts were over-stated by £9,750 at the year-end. This is an adjusting event according to IAS10 given that the over-valuation affects those year-end assets. They must be written down by £9,750.
The directors must also consider whether provision is required for any dismissal costs of the clerk, and possible legal costs if the clerk challenges the dismissal. No doubt the directors will attempt to recover the money from the clerk, but it is very uncertain whether this will be possible; therefore the company will need to provide for the loss now.
Actions to take to minimise the likelihood of events recurring. Employ a qualified accountant LRG currently employs a part-qualified accountant. Although a qualified accountant may not necessarily be able to produce the financial statements to a higher standard, they will have more experience of establishing and maintaining control systems, and so may be able to stop situations such as the fraud occurring. Appoint an internal auditor An internal auditor would be an employee of LRG. His or her role would be to provide an independent confirmation that LRG’s internal control systems and risk-management systems are working effectively. Again, this may not actually stop fraud and errors occurring, but would provide some deterrent where employees know that their work will be checked. Establish an audit committee One of the roles of an audit committee is to monitor a company’s financial control and risk- management systems. In this sense they are a deterrent to employees breaking those systems (as with the internal auditor), but they may also be able to provide external advice on weaknesses in those systems and how to reduce them. The situation of a clerk being able to make unauthorised transfers is an example of this. Improve control systems The fraud carried out by the clerk was only possible in part due to lack of reconciliations between the bank accounts and the assets apparently held by LRG. Ensuring that these two items are reconciled on a regular basis will help identify this type of fraud in the future.
Examiner’s comments In part (a), the overall definition answers were of a high standard. However, a small number of candidates linked events after the reporting period to the going-concern situation of the company; implying that only events affecting the going concern were the subject of IAS10, which is not correct.
In part (b), the three events were generally categorised correctly as either adjusting or non-adjusting. There was some confusion in some answers regarding the status of Events 1 and 2 in particular, with answers tending to be weaker in explaining why the events were adjusting or not. Very few candidates mentioned the financial impact of the events of the previous year’s financial statements where adjustment was necessary. In part (c), many good answers were given in response to minimising the likelihood of adverse events such as fraud occurring with credit being given for commercial and realistic points.
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.