The Examiner's Answers F1 - Financial Operations

Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike.

SECTION A
Answer to Question One
1.1 C

1.2

1.3

1.4

1.5

1.6

1.7

1.8 Total payments = 24x6 = FV Finance cost 6+5+4+3+2+1 = 21 Year 1 = 6/21x38 = 10.9 Year 2 = 5/21x38 = 9.0 Year 1 Year 2 Answer therefore B 106 92.9 144 106 38

10.9 9.0

(24) (24)

92.9 77.9

Financial Operations

May 2010

1.9

1.10 $000 Balance 1/1/09 Current tax Deferred tax Statement of comprehensive income Balance 31/12/09 Current tax Deferred tax 106 27 $000

133 122

255

119 38

157 98 A

Answer therefore

May 2010

Financial Operations

SECTION B

Answer to Question Two (a)

Tax evasion is the illegal manipulation of the tax system to avoid paying taxes. Tax evasion is the intentional disregard of the legislation in order to escape paying taxes; it can include falsifying tax returns and claiming fictitious expenses. Gee is illegally evading tax by failing to declare his full income. Tax avoidance is tax planning to the extent that the affairs of the entity are legally arranged in such a way as to minimise the tax liability. Although tax avoidance is strictly legal and within the letter of the law, it is often contrary to the spirit of the law. Many tax avoidance schemes exploit loopholes in the legislation, which the tax authorities try to close as soon as the loophole has been identified. Cee has taken advice and arranged her investments to avoid paying tax on the income from government securities. This approach is within the letter and spirit of the law.

(b)
A unit tax is a specific tax that is based on the weight or size of the tax base, for example, in the scenario the tax of $1 per bottle of wine is a unit tax, it can also be referred to as an excise duty. An ad valorem tax is based on the value of the tax base, these taxes are usually expressed as a percentage of the tax base, for example, a 15 per cent value added tax (VAT) is calculated as 15 per cent of the selling price before VAT. W sells wine at an average of $8.05 per bottle including VAT, this is a selling price of $7 per bottle plus 15% VAT. Tax payable by W: Excluding VAT $000 70.0 30.0 10.0 40.0 30.0 VAT $000 10.5 4.5 0 4.5 6.0 Total $000 80.5 34.5 10.0 44.5 36.0

Sales Expenses Excise duty Profit

Excise duty payable VAT Payable Total indirect tax

$10,000 $6,000 $16,000

Financial Operations

May 2010

(c)
Jurisdiction means that the tax authority must have the legal power to assess and collect taxes from an entity. For an entity to be subject to tax in a country, it must first be proved to be within that country's legal power to apply its tax rules to the entity. The competent jurisdiction is therefore the country whose tax laws apply to the entity. The OECD Model Tax Convention specifies the method used to determine residence of an entity. In the scenario H carries out business and management meet regularly in Country X, according to the model tax convention this makes H resident in Country X for tax purposes. On the same basis S is resident in Country Y. A withholding tax is a tax deducted from a payment at source before it is made to the recipient abroad. S has to deduct tax at 10% from any dividends paid to H. If the two countries concerned have a double tax agreement based on the OECD Model tax convention tax credit method the withholding tax will be allowed to be credited against tax due in its home country. In the scenario given, H will be able to claim a tax credit of $20,000 against tax due in Country X.

(d)
(i) The objective of an external audit is to enable auditors to express an opinion as to whether the financial statements of an entity give a true and fair view of the affairs of the entity at the period end and of its profit or loss for the period then ended and have been properly prepared in accordance with the relevant legislation and applicable accounting standards. (ii) The $1 million is 25% of profits and is therefore a material amount. This is a material disagreement and so the auditor must qualify the audit report (issue a modified report) in respect of the overstatement of stock. The disagreement is material, but not fundamental and so the adverse opinion is not required. The auditor would state that the accounts gave a true and fair view except for the overstatement of closing inventory and profits by $1 million.

May 2010

Financial Operations

(e)
Total Contract Profitability Contract price Total cost Profit/(Ioss) To 31/3/09 63 54 9 To 31/3/10 63 64 (1)

Cumulative To 31/3/10

Year to 31/3/09

Revenue Cost incurred Provision for future loss Profit/loss recognised

47 44 3

22 18 4 0 4

Year to 31/3/10 Cumulative less yr to 31/3/09 25 26 (1) (4) (5)

Year to 31/3/11

16 20 (4) 4 0

Note: As CC recognised a profit of $4 million in year to 31/3/09 the year to 31/3/10 will have to reverse this profit and add a further loss of $1 million, making a charge of $5 million loss for the year. $m Contract costs incurred to date 44 (1) Recognised loss (cumulative) 43 37 Less progress billings Amount due from customer 6

Comprising: Unbilled contract revenue Expected loss recognised

10 (4) 6

Statement of Comprehensive Income for year ended 31 March 2010 (extract) $m Contract revenue 25 30 Cost of sales (26 + 4) Loss Loss (5)

Statement of Financial Position as at 31 March 2010 (extract) $m Current Asset Amounts due from customer 6

Financial Operations

May 2010

(f)
Briefing note IFRS 5 Non-current assets held for sale and discontinued operations specifies that discontinued operations can be separated from continuing operations and shown separately in the Statement of Comprehensive Income. To be recognised as discontinued the activity must be discontinued in the year or be classified as held for sale. To be classified as held for sale it has to be available for immediate sale and it should be actively marketed and have a programme to locate a buyer. At 31 March 2010 AD is still in negotiations and has not agreed a closure date. The factory has not been closed and cannot be classified as discontinued in the year. It is not available for immediate sale and there is no programme to locate a buyer, so it cannot be classified as held for sale. The shoe factory must be included in the results for continuing operations for the year ended 31 March 2010. CIMA's Code of Ethics for Professional Accountants sets out 5 fundamental principles that a professional accountant is required to comply with. Not following the requirements of IFRS 5 Non-current assets held for sale and discontinued operations and excluding the results of the shoe factory from the financial statements for the year ended 31 March 2010 would potentially breach three of these: Objectivity - not allowing bias, conflict of interest or the influence of other people to override professional judgement. Professional behaviour - requires an accountant to comply with relevant laws and regulations and should avoid any action that discredits the profession. Integrity - A professional accountant should be straightforward and honest in all professional and business relationships

May 2010

Financial Operations

SECTION C
Answer to Question Three

EZ Statement of Comprehensive Income for the year ended 31 March 2010

$000 Revenue Cost of sales Gross Profit Loss on revaluation of land Administrative expenses Distribution costs Loss from operations Finance cost Loss before tax Income tax expense Loss for the period Other Comprehensive Income Loss on revaluation of land $000 720 (467) 253 (15) (304) (66) (10) (76) (8) (84) (10) (94)

(211) (93)

EZ Statement of changes in equity for the year ended 31 March 2010

Equity shares $000 400 200 Share premium $000 200 100 (10) 600 300 0 (84) (92) 5 Revaluation Reserve $000 10 Retained Earnings $000 181 Total $000 791 300 (94) (92) 905

Balance at 1 April 2009 New share issue Statement of Comprehensive Income Dividend paid Balance at 31 March 2010

Financial Operations

May 2010

EZ Statement of Financial Position at 31 March 2010

$000 Non-current assets Land Property, plant and equipment Current assets Inventory Trade receivables Cash and cash equivalents Total assets Equity and liabilities Equity Equity share capital Share premium Retained earnings Total equity Non-current liabilities Long term borrowings Deferred tax Total non-current liabilities Current liabilities Trade payables Accrued lease payment Tax payable Accrued interest Total current liabilities Total equity and liabilities $000

W7 W6

675 285 960 112 150 22

284 1,244

600 300 5 905

W4

250 20 270

W8 W3 W5

32 9 18 10 69 1,244

Workings (All figures in $000) (W1) Cost of sales Trial balance Loss on disposal of PPE Bad debt Lease Depreciation Total (W2) 418 5 Administration Distribution

86

69

125 44 467 . 211 24 . 93

Loss on disposal of PPE Cost less depreciation Cash received Loss on disposal

7 2 5

May 2010

Financial Operations

(W3)

Income tax expense Year 18 Deferred tax reduction (10) 8

(W4)

Deferred Tax Balance 1 April 2009 Reduction Balance 31 March 2010 30 (10) 20

(W5) Finance cost Interest on long term borrowings (250 x 4%) = 10 (W6) PPE Balance per trial balance Less disposal Depreciation charge for year Cost 480 (37) 443 (W7) Land Per trial balance Fair value Loss Write-off revaluation reserve Income statement (W8) Operating Lease 30 month lease with 6 months rent free = 24 months at 2.5 = 60 60/30 = 2 per month 12 months at 2 = 24 Income statement Paid 6 months at 2.5 = 15 Accrued lease payment SoFP = 9 700 675 25 10 15 25 Depreciation 144 (30) 44 158 NBV

285

Answer to Question Four (a)

AX profit for the year before tax Add back: Depreciation entertaining expenses Less tax depreciation allowances Taxable profit Tax at 25% Round to Increase in temporary difference in year (49 - 31) = 18 Deferred tax = 18 x 25% = 4.5 round to 5 Increase provision for deferred tax by 5 $000 264 31 4 299 (49) 250 62.5 63

Financial Operations

May 2010

(b)
Group holdings: AX in AS 100% Treat as wholly owned subsidiary AX in AA 120,000/550,000 = 22% Treat as an associate (i) Fair value of net assets of AS at acquisition Equity Shares Retained earnings Fair value adjustment $000 600 (72) 75 603

(ij) Goodwill - AS Cost Fair value of net assets acquired (100%) Goodwill (iii) Investment in associate - AA Cost Add group share of post acquisition profits (100-49) = 51 x 22% = Investment at 31 March 2010 (iv) Intra-group trading Mark up on cost 25% = 25/125 or 20% margin on selling price. Selling price $25,000; unrealised profit = $25,000 x 20% = $5,000 Dr. $000 5 55 55 Cr. $000 5 $000 145 11 156 $000 740 603 137

Consolidated cost of sales Consolidated current assets - inventory Consolidated revenue Consolidated cost of sales (v) Consolidated Retained Earnings

$000 Balance AX Per draft accounts 518 Less current tax (63) (5) Less deferred tax increase AS - group share of post acquisition profits (15+72) = Associate - AA, group share of post acquisition profits (iii) Cancel unrealised profit in inventory (iv)

$000

450 87 11 (5) 543

May 2010

10

Financial Operations

AX Group Consolidated Statement of Comprehensive Income for the year ended 31 March 2010
Revenue (820 + 285 - 55) Cost of sales (406 + 119 - 55 + 5) Administrative expenses (84 + 36) Distribution costs (48 + 22) Income from associate Finance cost (18 + 5) Taxation (63 + 16 + 5) Profit for the year $000 1,050 475 575 (120) (70) 385 11 396 (23) 373 (84) 289

Financial Operations

11

May 2010

AX Group - Consolidated Statement of Financial Position as at 31 March 2010

$000 Non-Current Assets Property, plant and equipment (1,120 + 700 + 75) Goodwill (ii) Investment in associate (iii) 1,895 137 156 2,188 Current Assets Inventory (205 + 30 -5) Trade receivables (350+46) Cash and cash equivalents 230 396 30 656 2,844 $000

Equity and Liabilities Ordinary Shares Retained Earnings (v) 1,500 543 2,043 Non-current liabilities Borrowings (360 + 80) Deferred tax (120 + 16 + 5) Current Liabilities Trade payables (92 + 29) Bank overdraft Current tax (63 + 16) 121 20 79 220 2,844 440 141 581

May 2010

12

Financial Operations