MARKING SCHEME

FINANCIAL ACCOUNTING
MAN2907L
MAIN PAPER August 2013

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FINANCIAL ACCOUNTING

MULTIPLE CHOICE QUESTION ANSWER SHEET

STUDENT REGISTRATION NO. .

PLEASE PLACE A CROSS AGAINST THE LETTER CORRESPONDING TO YOUR
ANSWER FOR EACH QUESTION ONE ANSWER ONLY FOR EACH QUESTION
THIS ANSWER SHEET MUST BE ATTACHED TO AND RETURNED WITH THE
QUESTION PAPER
EACH QUESTION CARRIES TWO MARKS: THERE IS NO NEGATIVE MARKING

Question

(A)

(B)

(C)

4
5

*
*

9
10

*
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11

12

13

14
15

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Section B
ANSWER TO SEEN CASE QUESTION:
a i)Goodwill:
000
Cost of the controlling interest in MTech
1,440
Equity shares
Pre-acquisition profit
Tangible assets fair value adjustments
Fair value of net assets at acquisition
80% thereof
(1,363.2)
Goodwill
76.8

600
912
192
(1,704)

(5 marks)
a ii) Investment in NW-Com (an associate)
000
Cost of investment in NW-Com
Share of post-acquisition retained earnings in NW-Com
(336 220.8)*25%

720
28.8
748.8
(2 marks)

a iii) Consolidated retained earnings:

000
e-Coms retained earnings
3,864
MTechs post-acquisition profits ((1476 - 912 -36) x 80% see below)
NW-Coms post-acquisition profits [(336 220.8) x 25%]
28.8
URP in Inventories (120 x 25/125)
(24)

422.4

4,291.2
MTechs retained earnings:
Post-acquisition (1476 - 912)
Additional depreciation
(36)
Adjusted post-acquisition profits

564
528
(5 marks)

a iv) Non-controlling interest

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000
MTech adjusted net assets (2,076+192-36) x 20%
446.4
(3 marks)
(Allow rounding errors)
(b)

The uses of consolidated statements

The objective of consolidated financial statements is to show the financial
performance and position of the group as if it was a single economic entity. For
example, in the consolidation of the e-Com Group plc, all assets and liabilities are
added together, as if the group were a single entity (so, for example, trade
receivables of 288 and 192 are added together, subtracting any outstanding intragroup balances). The single entity concept also means that any intra-group
transactions and balances need to be eliminated, as otherwise items would be
double counted in the context of the group as a single entity. For example,
(1) because e-Com sold goods for 120,000 to MTech Ltd with a 25% mark-up rate
on cost and the goods are still in MTech Ltds inventory (i.e. not yet sold outside
the group), the related profit has not yet been realised and needs to be
subtracted from the group retained earnings as well as the inventory amount as if
the group were a single entity. Otherwise, the inventory and group retained profit
will both be overstated.
(2) e-Coms trade receivable of 9,600 owed by its subsidiary MTech Ltd needs to be
eliminated; the trade payables of 7,200 in MTech Ltd owed to e-Com needs to
be eliminated; and the 2,400 of cash in transit needs to be included under cash.
There is a view that, as the entity financial statements of the parent company contain
the investments in subsidiaries as non-current assets, they reflect the assets of the
group as a whole (i.e. the substance of the group arrangement). The more
traditional view is that entity financial statements do not provide users with sufficient
information about subsidiaries for them to make a reliable assessment of the
performance of the group as a whole. The underlying principle is the distinction
between control and ownership. Control is reflected by including all of the
subsidiarys assets, liabilities, income and expenses in the consolidated financial
statements, even where the parent does not own 100% of that subsidiary (e.g. for eCom, 100% of MTech Ltds inventories are added in even though, in effect, e-Com
only owns 80% of those inventories). Ownership is then reflected by showing that
part of the subsidiarys net assets and results included in the consolidation, which is
not owned by the parent, as a non-controlling interest. e-Coms consolidated
statement of financial position shows a non-controlling interest of 446,400,
representing that part of MTech Ltd not owned by e-Com. Where an investor (e-Com)
does not have control but does have significant influence over an investee (NW-Com
Ltd), line-by-line consolidation is not appropriate, because e-Com cannot control NWCom Ltds assets and liabilities. But because e-Comh has this influence, it should be
accountable for the total investment in NW-Com Ltd, i.e. cost plus share of postacquisition retained earnings.
The following illustrates benefits of consolidated financial statements:

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 They identify the nature and classification of the subsidiarys assets. For
example, the investment in a subsidiary may be almost entirely in intangible
assets or conversely they may be substantially land and buildings (for example,
in the case of MTech Ltd, the company is heavily tangible non-current assets
focused). Such a distinction is of obvious importance to users.
The amount of the subsidiarys debt could not be assessed from the parents
entity financial statements. In effect the subsidiarys assets and liabilities are
netted off when it is shown as an investment (e.g. MTech Ltd has non-current
liabilities of 288,000 and current liabilities of 168,000). This means group
liquidity and gearing cannot be properly assessed.
The cost of the investment does not reflect the size of a company. For example a
parent company may show an investment in a subsidiary at a cost of 10 million.
This may represent the purchase of a subsidiary that has 10 million of assets
and no liabilities. Alternatively this could be a subsidiary that has 100 million in
assets and 90 million of liabilities. Clearly the latter subsidiary would be a much
larger company than the former.
The cost of the investment may be a fair representation of its value at the date of
purchase, but with the passage of time (assuming the subsidiary is profitable), its
value will increase. This increase would not be reflected in the original cost, but it
would be reflected in the consolidated net assets of the subsidiary (and the
increase in group reserves) (e.g. MTech Ltds additional fair value of 192,000 in
PPE, and e-Coms share in MTech Ltds post-acquisition retained earnings of
422,400 after the deduction of 36,000 additional depreciation).
The cost of the investment might represent all of the ownership of the subsidiary
or only just over half of it, i.e. there would be no indication of the non-controlling
interest (as discussed above).
To summarise, in the absence of a consolidated statement of financial position, users
would have no information on the current value of a subsidiary, its size, the
composition of its net assets and how much of it was owned by the group.
(15 marks)
(Marks awarded for relevant discussions)
(Total 30 marks)

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Section C
Question 1
(a) Although contract costs originally estimated at 8 million are now estimated at 9 million
(6,000 + 3,000), the contract is still estimated to generate a profit of 1.5 million (10,500 9,000). Contract revenue and expenses should be recognised by the stage of completion
method.
(i) Using the contract costs method, the contract is 2/3 (6,000 as a proportion of 9,000)
complete, in excess of the 40% cut-off point. So 2/3 of contract revenue and contract
profit should be recognised in profit or loss, so 7 million (2/3 x 10,500) and 1 million
(2/3 x 1,500) respectively.
In the statement of financial position, gross amounts due from customers should be
presented as contract costs incurred plus recognised profits less invoices raised to
customers (see below for calculations). Trade receivables should include 0.75 million
(6,500 invoiced less 5,750 payments received).
(ii) Using the certified sales value method, the contract is 70% (7,350 as a proportion of
10,500) complete, in excess of the 40% cut-off point. So contract revenue of 7.35
million should be recognised in the income statement, together with cost of sales of 6
million (the costs incurred). A profit of 1.35million should be recognised.
In the statement of financial position, gross amounts due from customers should be
presented in the same way as for the contract costs method (see below for calculations)
and trade receivables should include the same 0.75 million.
Income statement

Revenue
Cost of sales
Profit

Contract costs
000
7,000
(6,000)
1,000

Work certified
000
7,350
(6,000)
1,350

Statement of financial position

Gross amount due from customers

Costs incurred
Recognised profits
Progress billings
Trade receivables

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Contract costs
000

Work certified
000

6,000
1,000
7,000
(6,500)
500
750

6,000
1,350
7,350
(6,500)
850
750

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An alternative presentation of profit and cost of sales under the work certified basis would be
to calculate cost of sales as a proportion of total expected costs, rather than actual costs
incurred to date:
Work certified
000
Income statement
Revenue
7,350
Cost of sales (9m x 0.7)
(6,300)
Profit
1,050
Statement of financial position
Gross amount due from customers
Costs incurred
Recognised profits
Progress billing

6,000
1,050
7,050
(6,500)
550
(25 marks)

(b) The contract costs method assumes that the same profit margin is earned on all parts of a
construction contract. The certified sales method can, and in this instance does, take account
of the margin on certain parts of a contract being higher than on others, perhaps because the
customer places a higher value on those parts.
But over the life of the contract, the profit is the same under both methods; it is just its
allocation to the reporting periods in which work is done which is different.
(5 marks)
(c) The current approach in IAS 11 and IAS 18 is to use a perception of completion method
where revenue and profit are recognised according to an estimate of the stage of completion
of the asset or service. This allowed costs, revenues and profits to be recognised gradually
during the construction period. This approach is preferred than the completed contract
method as it better allows the matching of revenue and expense in the period of the
economic benefit generated. Other benefit could include that it helps to eliminate confusing
timing differences from tax to financial statements. Also, under the method, losses can be
recognised on contracts before the job is complete. However, the method does require
reliable estimates of the degree of completion and anticipated costs to complete the project.
The passing of control as major thresholds are met approach proposed in the IASB
exposure draft suggests that revenue is recognised at the point the performance obligation to
the customer is performed by transferring the good or service to the customer. The transfer of
good or service to the customer occurs when the customer has taken control of the good or
service.
This proposed change of approach has caused uncertainty around when revenue should be
recognised on a construction contract. To determine when revenue should be recognised the
point at which control of the asset passes to the customer needs to be decided. The
exposure draft indicates that the customer obtains control of good service when they have
the ability to direct the use of, and receive the benefit from, the good or service. To be able to
direct the use of the asset the customer should have present access to the future economic
benefits, which could be from use of the asset, the ability to sell the asset, pledge the asset
or exchange the asset, for example. For a construction contract there is a risk that the
contractor only transfers the asset to the customer on completion of the contract, effectively
meaning that revenue and profit can only be recognised on completion. The IASB was keen
to highlight that this was not the intention of the exposure draft and in many cases in
construction contracts control of the asset can pass in stages before full completion.

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However, it is not certain that the revenue and profits will be recognised at the points they are
under IAS 11. There is provision in the exposure draft for assets to transfer continuously over
the period of the contract, in which case some sort of continuous revenue recognition
approach would be needed based for example on outputs, inputs, or the passage of time.
Overall, we are still to see whether the IASB will introduce an accounting standard with the
requirements of the exposure draft. However, it is likely that some changes in accounting for
revenue will be necessary in the future. What impact it will have on the accounting for
construction contracts is also, as yet, uncertain.
(10 marks)

(Total 40 marks)

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Question 2
(a) Statement of cash flows for the year ended 31 December 2012
Claud plc
Statement of cash flows for the year ended 31 December 2012
000
Cash flow from operating activities
Operating profit
6,300
Depreciation
1,770
Loss on sale of tangible non-current assets
270
Increase in inventories
(60)
Increase in receivables
(270)
Increase in payables
180
Cash generated from operations
8,190
Interest paid
(420)
Dividends paid (4,020+7,350-1,0290)
(1,080)
Tax paid (1,860+1,290-1,530)
(1,620)
Net cash flow from operating activities
Cash flow from investing activities
Payments to acquire tangible non-current assets
Receipts from sales of tangible NCA (Working)
Net cash outflow from investing activities
Cash flow from financing activities
Issues of share capital (360 + 36 340 - 24)
Long term loans repaid (500 200)
Net cash from financing activities
Decrease in cash and cash equivalents
Cash and cash equivalents at 1 January 2011
Cash and cash equivalents at 31 December 2011

Mark
000
0.5
1.0
1.0
1.0
1.5
1.5
1.5

5,070

1.0
1.5
1.5
0.5

(1,170)

0.5
1.0
5.0
0.5

(1,350)
180

480
(4,500)
(4,020)
(120)
840
720
(120)

0.5
2.0
1.0
0.5
0.5
0.5
0.5

Working : non-current asset disposals

As at 1 Jan 2011
Purchases

As at 31 Dec 2011
Depreciation on disposals
NBV of disposal (810 - 360)
Net loss reported
Proceeds of disposals

000
23,400
1,350
24,750

Cost
Mark
0.5
0.5

000 Mark
23,940
0.5
810
0.5
24,750

As at 31 Dec 2011
Disposals (balance)

Accumulated Depreciation
000
Mark
4,770
0.5
As at 1 Jan 2011
360
0.5
Depreciation for year
5,130
450
0.5
(270)
0.5
180

000 Mark
3,360
0.5
1,770
0.5
5,130

(Total 25 marks)

(b) Relevance of statement of cash flows

i)

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Given that the objective in most management decisions is to generate cash

rather than profit, a statement of cash flows is of more use to both managers
and shareholders. As many users of financial statements may find the accruals
concept difficult to understand, the focus on cash provides information which is
easier to understand.

It is also more difficult to mask the effects of transactions through creative

accounting. Different accounting policies will have less impact on the results
reported by a cash flow. This means that using cash to compare performance
between firms is made easier. Financial statements are intended to provide
information on financial performance, financial position, generation of cash and
financial adaptability. Clearly a statement of cash flows contributes to this
objective with regard to generation of cash.
(5 marks)

ii) Creditors
For creditors and lenders, the ability of the firm to meet its obligations will be
more important than profitability. Reporting cash movements is more objective
than reporting income and expenses, as is done in the statement of
comprehensive income, and assets and liabilities, as is done in the statement
of financial position. This means that the information provided in a statement of
cash flows may be regarded as more reliable than the information in the
statement of comprehensive income or statement of financial position.
(5 marks)
iii) Managers
Statement of cash flows provides important information to users of financial
statements. Perhaps the most important aspect is that by reporting on how
cash is generated and used, the statement provides information on the
resource which is essential for business survival cash. The fact that a firm
generates a profit does not mean that it will generate cash. This is because
cash will be used to pay tax, dividends and loans.
(5 marks)
(Subtotal 15 marks)

(Total 40 marks)

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Question 3
(a)
(i)

Definition the IASB define provisions as a liability of uncertain timing or

amount.

Treatment of future operating losses it is considered that these should be

accounted for in the future.

Provisions differ from liabilities in that provisions are often subject to disclosure
requirements, whereas other creditors are not; e.g. statutory requirement to
disclose may, however, be insufficient detail.

Adequate level of disclosure of movements is important as these do not go

through income statement once provision is established.

Unacceptable practice of big bath provisioning used to absorb expenses incurred

in later years.

Management has been able to control the recognition and timing of movements
so that the user does not have a clear picture of the current years performance
smoothing profits.

There has been inconsistency between accounting for provisions between different
companies.
(15 marks)
Marks awarded for relevant discussions

(ii)

Nature of provisions and its accounting requirements

IAS 37 Provisions, Contingent Liabilities and Contingent Assets only deals with those
provisions that are regarded as liabilities. The term provision is also generally used to
describe those amounts set aside to write down the value of assets such as
depreciation charges and provisions for diminution in value (e.g. provision to write down
the value of damaged or slow moving inventory). The definition of a provision in the
standard is quite simple; provisions are liabilities of uncertain timing or amount. If there
is reasonable certainty over these two aspects the liability is a creditor. There is clearly
an overlap between provisions and contingencies. Because of the uncertainty aspects
of the definition, it can be argued that to some extent all provisions have an element of
contingency. The IASB distinguishes between the two by stating that a contingency is
not recognised as a liability if it is either only possible and therefore yet to be confirmed
as a liability, or where there is a liability but it cannot be measured with sufficient
reliability. The IASB notes the latter should be rare.
The IASB intends that only those liabilities that meet the characteristics of a liability in its
Framework for the Preparation and Presentation of Financial Statements should be
reported in the statement of financial position.
IAS 37 summarises the above by requiring provisions to satisfy all of the following three
recognition criteria:
There is a present obligation (legal or constructive) as a result of a past event;
It is probable that a transfer of economic benefits will be required to settle the
obligation;
The obligation can be estimated reliably.

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A provision is triggered by an obligating event. This must have already occurred; future
events cannot create current liabilities.
The first of the criteria refers to legal or constructive obligations. A legal obligation is
straightforward and uncontroversial, but constructive obligations are a relatively new
concept. These arise where a company creates an expectation that it will meet certain
obligations that it is not legally bound to meet. These may arise due to a published
statement or even by a pattern of past practice. In reality constructive obligations are
usually accepted because the alternative action is unattractive or may damage the
reputation of the company.
To summarise: a company must provide for a liability where the three defining criteria of
a provision are met, but conversely a company cannot provide for a liability where they
are not met.
(15 marks)
(iii)Although IAS 37 states that no provision should be made for future operation loss, this
does not apply if there is an onerous contract (an onerous contract is one where the
costs of completing the contract exceed the revenues and where compensation is
payable if the contract is not completed). This contract appears to be onerous and so
the provision of 265 million should remain in the financial statements.
With regard to the provisions for environmental liabilities, the question is whether this is
a constructive obligation. There is no current obligation but it could be argued that there
is a constructive obligation to provide for the remedial work because the conduct of the
company has created a valid expectation that the company will clean up the
environment.
We say could be argued because there is no clear answer and it may well be
determined by the subjective assessment of the directors and auditors as to whether
there is a constructive obligation. An example (2B) provided in IAS 27 acts as a guide
for a similar situation which would support making a provision.
(10 marks)
(Total 40 marks)

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