THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ADVANCED FINANCIAL ACCOUNTING

PROFESSIONAL 2 EXAMINATION - AUGUST 2005

Time allowed: 3.5 Hours and 10 minutes to read the paper. Answer ALL questions

In recent years, TARA plc (TARA) has pursued a policy of external acquisition rather than internal growth in order
to expand its business. On 1st June 2004, TARA purchased all of the ordinary share capital of SHORE Ltd.
(SHORE), acquiring the following net assets:
€ million
Property, plant and equipment 3,000
Inventory 1,400
Trade receivables 2,300
Cash at bank and in hand 50
Bank overdraft (80)
Trade payables (1,900)
Bank loans (1,200)
3,570
The consideration was satisfied by:
Shares 1,120
Cash 3,150
4,270

Since acquisition, SHORE has contributed €308 million to the group’s net operating cash flow, paid €9.8 million
in respect of investing activities and used €21 million for financing activities. The consolidated income statement
of TARA for the year ended 31st December 2004, and the balance sheet as at that date, are shown below.

TARA plc
Consolidated Income Statement for the Year Ended 31st December 2004

€ million
Revenue 2,100
Cost of sales (1,600)
Gross profit 500
Net operating expenses (250)
Operating profit 250
Interest receivable and similar income 30
Interest payable and similar charges (25)
Profit on ordinary activities before taxation 255
Tax on profit on ordinary activities (55)
Profit on ordinary activities after taxation 200
Equity minority interest (10)
Profit for financial year 190

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 TARA plc
Consolidated Balance Sheet as at 31st December 2004
Note 2004 2003
€ million € million
ASSETS
Non Current Assets
- Tangible assets 1 19,500 12,700
- Intangible assets 2 700 1,300
20,200 14,000

Current Assets
- Inventory 4,300 3,900
- Trade receivables 7,300 7,100
- Cash in hand and at bank 2,650 2,600
14,250 13,600

34,450 27,600

EQUITY AND LIABILITIES

Capital and Reserves
Called up share capital 3 4,280 4,000
Share premium account 3 3,730 2,900
7% preference shares 4 200 200
Other reserves 1,260 1,260
Retained earnings 5,100 5,050
14,570 13,410
Minority interests (equity) 530 1,840
15,100 15,250

Non Current Liabilities 5 6,700 2,950

Current Liabilities 6 12,650 9,400

34,450 27,600
Additional Information:
1. Tangible fixed assets
€ million
Cost or valuation
At 1st January 2004 15,700
Subsidiary acquired 4,500
Additions financed by finance lease 100
Additions 5,650
Disposals (600)
25,350

Accumulated depreciation
At 1st January 2004 3,000
Charge for year 1,600
Subsidiary acquired 1,500
On disposal (250)
5,850
Net book value
At 31st December 2004 19,500
At 31st December 2003 12,700
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2. Intangible fixed assets comprise:
Goodwill Patents Total
€ million € million € million
At 1st January 2004 400 900 1,300
Additions 700 - 700
Impairment / Amortisation during the year (450) (850) (1,300)
At 31st December 2004 650 50 700

Goodwill was impaired by €450 million during the year ended 31st December 2004. Patents are amortised
over the shorter of the anticipated period of profitable exploitation and the period to the expiry of the right.

3. Capital and Reserves

€1 Ordinary Share
shares premium
€ million € million
At 1st January 2004 4,000 2,900
Shares issued on acquisition 280 840
Expenses connected with share issue - (10)
At 31st December 2004 4,280 3,730

During the year ended 31st December 2004, dividends of €140 million were debited to equity.

4. 7% Preference Shares € million

At 31st December 2003 and 2004 200

The preference shares are convertible to ordinary shares in 2006 on the basis of two ordinary shares for
each preference share.

2004 2003
€ million € million
5. Non Current Liabilities
10 % loan stock (see note 7) 240 -
Bank loans 4,510 -
Finance lease obligations 1,950 2,950
6,700 2,950

6. Current Liabilities
Bank overdraft 150 -
Trade payables 5,700 3,500
Tangible asset payable 3,200 2,150
Finance lease obligations 200 280
Corporation tax 2,555 2,745
Dividends 800 700
Accruals and deferred income 45 25
12,650 9,400
All preference dividends due were paid during the year.

Accruals and deferred income comprise interest payable on:

- finance leases 15 15
- bank borrowings 30 10
45 25

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7. TARA has €240m of 10% loan stock in issue. The terms of conversion per €100 nominal value of loan stock
are as follows:

Conversion date No. of shares

30th June 2005 120
30th June 2006 110
30th June 2007 100
30th June 2008 90

8. Net operating expenses include a profit on disposal of plant and equipment of €15 million.

9. The rate of corporation tax is 30%.

QUESTION 1

REQUIREMENT

In accordance with IAS 7 Cash Flow Statements, prepare each of the following for TARA in respect of the year
ended 31st December 2004:

(a) A consolidated cash flow statement; (40 Marks)

(b) A reconciliation of operating profit to net cash flow from operating activities; (10 Marks)

(c) The disclosure which is required in accordance with IAS 7 Cash Flow Statements in respect of the
acquisition of SHORE by TARA during the year ended 31st December 2004.
10 Marks)

[Total: 60 Marks]

QUESTION 2

REQUIREMENT

Calculate the basic and diluted earnings per share for the year ended 31st December 2004 for TARA in
accordance with IAS 33 Earnings Per Share.

[Total: 12 Marks]

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QUESTION 3

Revenue recognition is a topical area of debate in the accounting profession. Difficulties may arise in determining
how much income to include in the income statement.

DERRA GmBH. (DERRA), a German company, has approached TARA to sell DERRA’s products in Ireland.
DERRA has offered the following alternatives to TARA:

(i) TARA acts as DERRA’s agent and sells the products at a fixed price calculated to yield a profit margin of
50%, receiving commission of 15% of sales; or

(ii) TARA buys the products from DERRA and sells them at a gross profit margin of 20%.

REQUIREMENT

Prepare a report for the Board of Directors of TARA that explains:

(a) The principles and difficulties with revenue recognition; and

(b) How TARA should account for each of the proposed arrangements for the sale of DERRA’s products
assuming TARA achieves total sales of €125 million per annum from DERRA’s products.

[Total: 15 Marks]

QUESTION 4

The directors of TARA are aware that all listed companies in the EU must prepare financial statements using
International Financial Reporting Standards (IFRSs) from 1st January 2005, but are unaware of the differences
between Irish/UK standards and IFRSs.

REQUIREMENT

Prepare a report for the directors of TARA outlining the main differences between Irish/UK Standards and IFRSs
and the likely impact on local companies.

[Total: 13 Marks]

Total: 100 Marks

END OF PAPER

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 TUTORIAL CONTENT

INTRODUCTION

As in previous years, the case study is designed to test a candidate’s communication skills as well as the application of
financial reporting standards. One pleasing aspect of this examination was that the vast majority of candidates
attempted all parts of the case study, suggesting that there were no timing problems.

QUESTION 1

This is a relatively straightforward, practical question, requiring candidates to prepare a consolidated cash flow
statement in accordance with IAS 7, Cash Flow Statements, together with a reconciliation of operating profit to net cash
flow from operating activities, an analysis of changes in net funds and the disclosure which is required in respect of the
acquisition of a subsidiary undertaking.

Most candidates presented the consolidated cash flow statement in a clear manner, and few had any problems
reproducing the standard headings. Furthermore, Part (b), the reconciliation of operating profit to net cash inflow from
operating activities, was reasonably well answered. With respect to the reconciliation of operating profit, while a number
of candidates incorrectly dealt with the inventory trade receivables and trade payables acquired from SHORE, a number
of candidates failed to correctly add back goodwill impairment and depreciation (figures that are given in notes 1 and 2
respectively of the question). (Under IFRS goodwill is not longer amortised but tested for impairment).

Parts (c) and (d) were by far the least well answered elements of the question. While Part (c) was generally just poorly
attempted, many candidates did not even attempt Part (d) despite it simply requiring the reproduction of the opening
paragraphs of the background information to the case study.

On a more positive note, with respect to the various workings, most candidates were able to properly calculate many of
the ‘standard’ cash flow adjustments such as: interest paid; dividends paid; tax paid; and the cash received from the
sale of non-current assets. The main problem areas were computing the cash paid to purchase tangible non-current
assets and the capital element of the finance lease payments. Although, with the exception of calculating the cash paid
to purchase tangible non-current assets, most candidates did actually cope reasonably well with the different workings,
and no one issue was consistently dealt with poorly. However, the calculation of payments to minority interests, the
treatment of the share issue expenses and the inclusion of the loans acquired from SHORE did frequently pose a
challenge for candidates. Furthermore, as mentioned above with respect to Part (b), many candidates struggled to deal
with the inventory, trade receivables and trade payables balances acquired from SHORE.

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SUGGESTED SOLUTIONS

ADVANCED FINANCIAL ACCOUNTING

PROFESSIONAL 2 EXAMINATION - AUGUST 2005

SOLUTION 1

(a)
TARA plc
Consolidated Cash Flow Statement for the Year Ended 31st December 2004

€m €m
Operating activities
Net cash flows from operating activities (See (b)) 6,275

Cash Flows from Investing Activities

Receipts from sales of tangible assets (W 8) 365
Payments to acquire tangible assets (W9) (4,600)
Purchase of subsidiary undertaking (W13) (3,180)
Net cash flows from investing activities (7,415)

Cash Flows from Financing Activities

Dividends paid to minority shareholders in subsidiary undertakings (W6) (1,320)
Capital element of finance leases (W10) (1,180)
Share issue expenses (10)
Debentures (W12) 240
Bank loans (W11) 3,310
Net cash flows from financing activities 1,040

Change in Cash and Cash Equivalents (100)

Cash and Cash Equivalents at 1st January 2004 2,600

Cash and Cash Equivalents at 31st December 2004 2,500

Interest received & share expenses 1 Mark Each
Format & presentation 6 Marks

(b) Reconciliation of operating profit to net cash inflow from operating activities
€m
Operating profit 252
Profit on disposal of plant and equipment (15)
Amortisation of patents and goodwill impairment (Note 2) 1,300
Depreciation (Note 1) 1,600
Decrease in inventory (W1) 1,000
Decrease in trade receivables (W2) 2,100
Increase in trade payables (W3) 300
Interest received (IS) 30
Interest paid (W4) (19)
Tax paid (W7) (245)
Equity dividends paid (W5) (26)
Net cash inflow from operating activities 6,275

Amortisation & depreciation 1 Marks Each

Other item 2 Marks Each
10 Marks
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c) • Where a group buys or sells a subsidiary, a note to the cash flow statement should show a summary of the
effects of acquisitions and disposals indicating how much of the consideration comprised cash;

• In the case of a subsidiary joining or leaving a group during a year, the cash flows of the subsidiary will be
included in the group cash flow statement for the same period as the group’s profit and loss account
includes the subsidiary’s results; and

• Where the sale or purchase of a subsidiary has a material effect on the amounts reported under the
standard headings in the cash flow statement, a note should be appended showing these effects as far as
practicable.

Example:
During the year ended 31st December 2004, TARA acquired a subsidiary, SHORE. The fair value of assets
acquired and liabilities assumed were as follows:

Purchase of subsidiary undertaking

Net assets acquired: €m
Property, plant and equipment 3,000
Inventory 1,400
Trade receivables 2,300
Cash at bank and in hand 50
Bank overdraft (80)
Trade payables (1,900)
Bank loans (1,200)
3,570
Goodwill 700
4,270
Satisfied by:
Shares 1,120
Cash paid 3,150
4,270

Since acquisition, the subsidiary undertaking acquired during the year, SHORE, has contributed €308
million to the group’s net operating cash flow, paid €9.8 million in respect of investing activities and utilised
€21 million for financing activities.
10 Marks

Workings:

1. Decrease in stocks €m
Balance at end of year 4,300
Inventory acquired from SHORE (1,400)
2,900
Balance at beginning of year (3,900)
Decrease in inventory (1,000)
2 Marks
2. Decrease in trade receivables €m
Balance at end of year 7,300
Receivables acquired from SHORE (2,300)
5,000
Balance at beginning of year (7,100)
Decrease in trade receivables (2,100)
2 Marks
3. Increase in trade payables €m
Balance at end of year 5,700
Payables acquired from SHORE (1,900)
3,800
Balance at beginning of year (3,500)
Increase in trade payables 300
2 Marks

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4. Interest paid €m
Balance at beginning of year 25
Income statement 25
Balance at end of year (45)
Paid during the year 5
Preference dividend 14
19
4 Marks

5. Dividends paid €m
Balance at beginning of year 700
Income statement (€140m - €14m) 126
Balance at end of year (800)
Paid during the year 26
2 Marks

6. Dividends paid to minority shareholders €m

Balance at beginning of year 1,840
Income statement 10
Balance at end of year (530)
Paid during the year 1,320
2 Marks

7. Tax paid €m
Balance at beginning of year 2,745
Income statement 55
2,800
Balance at end of year (2,555)
Paid during the year 245
2 Marks

8. Cash from sale of property, plant and equipment €m

Per income statement (Note 8) 15
NBV of assets disposed (€600m - €250m) 350
Cash received 365
2 Marks

9. Purchase of property, plant and equipment €m

Balance at end of year (NBV) 19,500
Net book value of assets acquired from SHORE (3,000)
Additions by finance lease (100)
Net book value of disposals 350
Depreciation charge 1,600
Increase in tangible asset payable (€3,200m - €2,150m) (1,050)
17,300
Balance at start of year (NBV) (12,700)
Cash paid 4,600
5 Marks

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10. Capital element of finance leases €m
Balance at beginning of year (€280m + €2,950m) 3,230
Additions 100
Balance at end of year (€200m + €1,950m) (2,150)
1,180
3 Marks

11. Bank loans €m

Balance at end of year 4,510
Acquired from SHORE (1,200)
3,310
Balance at beginning of year -
3,310
2 Marks

12. Debentures €m
Balance at the end of year 240
At beginning of year -
Cash received 240
2 Marks

13. Purchase of Subsidiary

Cash paid per question 3,150
Less cash of SHORE (50)
Add overdraft of SHORE 80
3,180
2 Marks

Total question 1: 60 marks

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 TUTORIAL COMMENT

QUESTION 2

This short question requires the calculation of the basic and diluted earnings per share for the year ended 31st
December 2004 for TARA in accordance with IAS 33 Earnings per Share. Not surprisingly, candidates made a much
better attempt at calculating the basic earnings per share figure compared with the diluted figure.

The main points arising in relation to this question were:

• Calculation of basic earnings – uncertainty by some over how to treat the preference dividend;

• Calculation of basic number of shares – failure to account for or time apportion the ‘shares issued on acquisition’;
and

• Calculation of fully diluted earnings – failure to account for the tax on the debenture interest ‘saved’ and/or failure
to recognise the preference dividend ‘saved’ in the preference share conversion.

SOLUTION 2

Basic EPS

Profit for the year is €190m including preference dividend of €14m.

Therefore profit available to equity shareholders is €176m.

Weighted average number of shares: (4,000 x 5/12) + (4,280 x 7/12) = 4,163 (rounded)

EPS: €176m = 0.0423 = 4.23p

4,163m
5 Marks

Additional Profits Additional shares Eps

€m Million
Debenture conversion
Interest
€240m @ 10%
tax at 30%
240m*10(1-0.3) 16.8

Max conversion
240m/100*120 288 .05833 antidilutive

Preference Share conversion

Preference dividend 14 400 .035

Only preference share conversion taken into account

€m Million
Basic eps 176 4,163 4.23pps
Preference shares 14 400
190 4,573 4.16pps
7 marks

Total question 2: 12 marks

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 TUTORIAL COMMENT

QUESTION 3

This again is a very practical question, requiring candidates to prepare a report for the Board of Directors of TARA
explaining: (a) the principles and difficulties with revenue recognition; and (b) how TARA should account for each of the
proposed arrangements for the sale of Derra’s products. While most candidates were able to outline the key aspects
of revenue recognition, some had difficulty applying the principles to the two scenarios. Indeed, Part (b) was frequently
not answered. However, most candidates did prepare their answers in the form of a report.

SOLUTION 3

REPORT

Date dd/mm/yy

The Directors,

Further to our recent conversation and based upon the information available, I have outlined below…

Format & presentation 1 Mark

(a) The critical event in the operating cycle of a business is the point at which most or all of the uncertainty
surrounding a transaction will be removed. This is the point at which revenue is recognised.

The points in the operating cycle are as follows:

• The placing of an order by a customer, prior to manufacture;

• The purchase of goods or raw materials;
• The production of goods;
• The obtaining of an order from a customer from goods in stock;
• Delivery of goods to a customer;
• Collection of cash;
• Provision of warranties and after sales service.

For most transactions the critical event in the operating cycle is the point at which most or all of the uncertainty
surrounding a transaction is removed. This is usually when the goods or services are delivered, and is (normally)
the point at which revenue is recognised. However, the critical event could occur at other times in the operating
cycle, depending on the circumstances. [Note: The points in the operating cycle are outlined further in Appendix
One.]

However, the growing complexity and diversity of business activity has resulted in a variety of forms of revenue-
earning transactions that were never considered when the ‘point of sale’ was established as the general rule for
revenue recognition. As we move further towards a balance sheet based fair-value approach to revenue
recognition, long established principles centred on accruals and prudence may no longer be appropriate. In
addition, with the prospect of a single statement of financial performance, there is the possibility that traditional
concepts of revenue resulting from success, or otherwise, of selling goods and services may become meshed
with newer concepts of holding gains and losses.

The objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain types of
transactions and events, namely:

• the sale of goods;

• the rendering of services;
• the use by others of organisation assets yielding interest, royalties and dividends.

Revenue is measured at the fair value of the consideration received or receivable. The consideration is usually
cash. If the inflow of cash is significantly deferred, and there is no interest or a below-market rate of interest, the
fair value of the consideration is determined by discounting expected future receipts. If dissimilar goods or
services are exchanged (as in barter transactions), revenue is the fair value of the goods or services received or,
if this is not reliably measurable, the fair value of the goods or services given up.
Revenue from the sale of goods is recognised when:

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 • significant risks and rewards of ownership are transferred to the buyer;
• the seller has no continuing managerial involvement or control over the goods;
• the amount of revenue can be measured reliably;
• it is probable that economic benefits will flow to the seller; and
• the costs of the transaction (including future costs) can be measured reliably.

Revenue from rendering services is recognised by reference to the stage of completion if the following conditions
are satisfied:
• the amount of revenue can be measured reliably;
• it is probable that economic benefits will flow to the service provider;
• the stage of completion of the transaction can be measured reliably; and
• the costs of the transaction (including future costs) can be measured reliably.

If the outcome cannot be measured reliably, revenue is recognised only to the extent of the expenses recognised
that are recoverable.

[Note: The specific requirements of IAS 18 are generally similar to those of Application Note G to FRS 5 (issued
in November 2003).]
8 Marks

(b) DERRA
The two proposals put forward by DERRA are very different.

Under scheme (a) TARA would act as DERRA’s agent. Under this arrangement TARA must only record in income
the amount of commission it is entitled to under the agreement, amounting to €18.75 m based on budgeted
figures.

Under scheme (b) TARA would buy the goods from DERRA as principal and the sales and cost of sales would
be included in TARA’s profit and loss account as normal.

€M
Sales 125
Less cost of sales (100)
Gross Profit 25

6 Marks

Total Question 3: 15 Marks

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APPENDIX ONE

Timing of Criteria Examples of

Recognition Practical Application

Placing of an order by a As there is likely to be uncertainty Long-term contracts.

customer, prior to regarding the final outcome of such
manufacture. contracts it would not be prudent to
recognise profit at this point.

During production. Revenues accrue over time, and no Accrual of interest, dividends
significant uncertainty exists as to and royalties.
measurability or collectability.

A contract of sale has been entered into Accounting for long-term con-
and future costs can be estimated with tracts using the percentage of
reasonable certainty. completion method.

At the completion of production, This is nearing the point where most of Certain precious metals and
i.e. from goods in stock. the uncertainties are resolved; however commodities.
recognition is usually delayed until
delivery. There should exist a ready
market for the commodity, together with
a determinable and stable market price.
There should be insignificant marketing
costs involved.

At the time of sale (but The goods must have already been Certain sales of goods, e.g.
before delivery). acquired or manufactured, and be bill and hold sales.
capable of immediate delivery. The
selling price should be established and
all material related expenses, including Property sales where there is
delivery, ascertained. No significant an irrevocable contract.
uncertainties remain, e.g. ultimate cash
collection or returns.

On delivery. Criteria for recognition before delivery Most sales of goods and
were not met and no significant services. Property sales where
uncertainties remain. In the vast there is doubt that he sale will
majority of cases this is the point at be completed.
which revenue is recognised.

Subsequent to delivery. Significant uncertainty regarding Sales where right of return

collectability at the time of delivery. At exist. Goods shipped
the time of sale it was not possible to subject to conditions, e.g.
value the consideration with sufficient installation, inspection or
accuracy. maintenance.

On an apportionment basis Where the revenue represents the Franchise fees. Sales of
(revenue allocation approach supply of initial and subsequent goods with after sales
goods/services. services.

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 TUTORIAL COMMENT

QUESTION 4

This question asks candidates to write a report for the directors of TARA outlining the main differences between Irish/UK
Standards and International Financial Reporting Standards (IFRSs), and the likely impact on local companies. It should
have been a very ‘obvious’ question as the move to IFRSs is a very topical issue that has received extensive coverage
in the accounting press. However, despite this, too many candidates appeared unprepared for this question and many
answers lacked structure.

Overall, too many answers were poorly structured and a number of candidates failed to address the second element of
the question, namely, the likely impact on Irish companies.

SOLUTION 4
REPORT
Date dd/mm/yy

The Directors,

Further to our recent conversation…and based upon the information available, I have outlined below…

Format & presentation 1 Mark

Points might include:

Ø International Accounting Standards (IAS) have been developed since the early 1970s by the International
Accounting Standards Committee (IASC) and the International Accounting Standards Board (IASB), while
UK/Irish Statements of Standards Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs) have
been developed by the Accounting Standards Board (ASB) and its predecessor the Accounting Standards
Committee (ASC).

Ø Two sets of standards had developed which had a considerable number of differences.

Ø Some significant differences that would arise at present are as follows:

• The profit and loss account will be replaced by an income statement, with dividends shown in a statement
of changes in equity instead of the in the profit and loss account. The Statement of Total Recognised Gains
and Losses (STRGL) will no longer be prepared.
• Proposed dividends will be longer be recognised as a liability in the balance sheet.
• Development Expenditure: under IAS 38 Intangible Assets development expenditure must be capitalised,
whereas under SSAP 13 Accounting for Research and Development capitalisation is optional
• Pensions: FRS 17 Retirement Benefits requires immediate recognition of actuarial gains and losses in the
STRGL, whereas IAS 26 Accounting and Reporting by Retirement Benefit Plans requires recognition in the
income statement. These gains and losses can be recognised immediately or deferred over the average
remaining working lives of employees. This difference in recognition and disclosure could have a major
impact on the reported profit.
• Deferred Tax: both sets of standards use a different method to determine the provision. IAS 12 Income
Taxes is based on temporary differences and FRS 19 Deferred Tax on timing differences. Different methods
mean that different amounts of deferred tax are likely to be recognised and it is probable that IAS 12 will
require a larger provision.
• Merger accounting will no longer be allowed.

Ø The modern global economy has meant that more businesses than ever operate across international borders.
This made two sets of standards increasingly difficult to operate.

Ø A process of convergence between UK/Irish standards and IAS is underway. This is a two part project:
• The ASB has undertaken responsibility for revisions to UK/Irish GAAP and seeking to any necessary
changes to company law;
• The IASB should deal with revisions to IASs / IFRSs.
Ø Most British/Irish FRSs are broadly in line with the relevant IAS. FRSs are formulated with due regard to
international developments, and the ASB supports the IASB in its aim to harmonise international financial

Page 15
 reporting. As part of this support, FRSs contain a section explaining how it relates to the equivalent IAS. In many
cases, compliance with an FRS ensures compliance with the relevant IAS.

Ø In many cases the required treatment is the same in both sets of standards but the disclosure is different.
12 Marks

Total question 4: 13 Marks

Overall Total: 100 Marks

CONCLUSION

Overall, candidates must show both a good technical knowledge and also an ability to write clearly. The marking scheme
is always positive. It is imperative that candidates practise as many past paper questions as possible, as soon as
possible and as often as possible.

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